Currency Crisis for Beginners

(One of our objectives is to help non-specialist readers understand what they are reading in the news. Instead of appending everything onto the very long Financial Crisis for Beginners page, I’m going to start doing individual posts and linking from that page to the posts. Advanced readers can choose to skip the “beginners” posts – or they can help improve them through comments.)

In honor of Paul Krugman, recent Nobel Prize winner and “inventor” of the currency crisis, we seem to be experiencing a global currency crisis. This may prompt the question: what is a currency crisis?

Different countries (or regions, like the Eurozone) use different currencies. These currencies generally float against each other, meaning that their relative prices are set by traders on foreign exchange markets, although sometimes they are fixed (meaning just that the central bank acts on the market to keep its exchange rate where it wants it). Changes in exchange rates are normal and are driven by a number of factors, such as interest rates in different countries: a higher interest rate creates demand for a currency, and as with most things higher demand leads to a higher price (meaning that currency has greater value). More generally, a currency’s value should be related to the long-term attractiveness of the economic opportunities available in that currency.

There is no exact quantitative definition of a currency crisis, but it generally involves a sudden and rapid fall in the value of one or more currencies. It is more likely to happen in an emerging market economy that has borrowed a lot of money in foreign currency. (If I’m a big American institutional investor, I may not want to buy bonds denominated in Russian rubles, because I don’t know what the ruble will be worth in the future, but I may be willing to buy bonds denominated in dollars or euros.)

Like the varous crises of confidence we have been discussing, one nasty thing about a currrency crisis is that the fear of one can be self-fulfilling. Let’s say country A has a high level of foreign currency debt, either in its public or private sector. At some point, for some reason (recession fears, for example), the people holding that debt get worried that the country may not be able to pay off that debt. They start selling stocks and bonds in country A’s currency, the aardvark, and converting their assets back into “hard currency” (dollars, euros, yen, pounds – things that are unlikely to collapse in value). That drives down the aardvark – because more people are selling it than buying it – which makes it even harder for country A to pay off its foreign currency debts (since they just went up relative to the aardvark), which makes other investors panic and sell, and so on and so on. These dynamics can be amplified by the actions of currency speculators, who will sell a currency short if they think it is ripe for a currency crisis, and may therefore trigger the crisis (thereby making themselves a lot of money).

Currency crises can do lasting damage to countries suffering them. Loss of foreign investment hurts the real economy, often triggering a recession. Devaluation of the local currency makes imports much more expensive, reducing the standard of living. The policy measures required to boost a currency’s value – increasing interest rates (to attract investors) and reducing deficits (to restore confidence in your ability to repay your debts) – are the opposite of what you ordinarily want to do during a recession.

Currency crises can also be bad (though less so) for the countries on the other side whose currencies are appreciating. Having your currency appreciate makes it harder to export goods and services, which can dampen economic growth. More generally, having your trading partners collapse is never a good thing.

Local governments sometimes try to combat currency crises by intervening on foreign exchange markets to support the value of their currencies (by buying their own currency and selling hard currency). Countries build up foreign exchange reserves for precisely this purpose. However, this has rarely been successful, because few countries have sufficient reserves to counteract an entire world full of pessimistic investors, plus the hedge funds betting on the currency’s fall. Stabilizing currencies in the midst of crisis usually requires intervention from G7 countries with deep pocketbooks or potentially the IMF – actors with the credibility to stop a run on a currency, perhaps even without having to shell out hundreds of billions of dollars. This weekend the G7 announced that it was “concerned” about the recent appreciation of the yen, hoping that this warning shot would stop people from betting on the yen (and against a whole host of other currencies). If this fails, some of the G7 countries will probably start intervening directly to sell yen and buy euros, pounds, and other currencies that have been falling.

5 responses to “Currency Crisis for Beginners

  1. Thank you so much for doing this. It’s going to help me a lot.

  2. James, thanks for doing this. I’m now teaching Economics and your analyses have been very helpful in my own understanding. Hope you are doing well!

  3. This is a brilliantly clear piece of expository writing on a complex and difficult subject! Mr. Kwak, you have real potential to be the next Paul Krugman –that is, a man who educates many thousands of laymen in the basics of economics. (As to a Nobel, we’ll see.)

  4. Pingback: November 17, 2008 « Rising in Phoenix

  5. Excellent post, but I got a little confused at the end, why is Japan being considered “hard”er than say the EUR? Isn’t Japan still in recession? Does this have something to do with the fact that the JPY 3M-Libor has risen from about 60bps to 90bps?