A currency crisis is a situation in which there is serious doubt as to whether a country's central bank has enough foreign exchange reserves to maintain the country's fixed exchange rate. The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency.
A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. Currency crises can be especially destructive to small open economies or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar, Euro or Pound sterling). Currency crises have large, measurable costs on an economy, but the ability to predict the timing and magnitude of crises is limited by theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations, and government policy.
There is no widely accepted definition of a currency crisis, which is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of a currency of at least 25% but it is also defined at least 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation or appreciation, see Al-Assaf et al. (2013).
The currency crises and sovereign debt crises that have occurred with increasing frequency since the Latin American debt crisis of the 1980s have inspired a huge amount of research. There have been several 'generations' of models of currency crises.
The 'first generation' of models of currency crises began with Paul Krugman's adaptation of Stephen Salant and Dale Henderson's model of speculative attacks in the gold market. In his article, Krugman argues that a sudden speculative attack on a fixed exchange rate, even though it appears to be an irrational change in expectations, can result from rational behavior by investors. This happens if investors foresee that a government is running an excessive deficit, causing it to run short of liquid assets or "harder" foreign currency which it can sell to support its currency at the fixed rate. Investors are willing to continue holding the currency as long as they expect the exchange rate to remain fixed, but they flee the currency en masse when they anticipate that the peg is about to end.
The 'second generation' of models of currency crises starts with the paper of Obstfeld (1986). In these models, doubts about whether the government is willing to maintain its exchange rate peg lead to multiple equilibria, suggesting that self-fulfilling prophecies may be possible, in which the reason investors attack the currency is that they expect other investors to attack the currency.
'Third generation' models of currency crises have explored how problems in the banking and financial system interact with currency crises, and how crises can have real effects on the rest of the economy.
McKinnon & Pill (1996), Krugman (1998), Corsetti, Pesenti, & Roubini (1998) suggested that "over borrowing" by banks to fund moral hazard lending was a form of hidden government debts (to the extent that governments would bail out failing banks).
Radelet & Sachs (1998) suggested that self-fulfilling panics that hit the financial intermediaries, force liquidation of long run assets, which then "confirms" the panics.
Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency,
Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.
Krugman(1999) suggested another two factors, in an attempt to explain the Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, the banking system plays no role in his model. His model led to the policy prescription: impose a curfew on capital flight which was implemented by Malaysia during the Asian financial crisis.
Eurozone crisis as a balance-of-payments crisis
According to some economists the ongoing Eurozone crisis is in fact a balance-of-payments crisis or at least can be thought of as at least as much as a fiscal crisis. According to this view, a capital flow bonanza of private funds took place during the boom years preceding this crisis into countries of Southern Europe or of the periphery of the Eurozone, including Spain, Ireland and Greece; this massive flow financed huge excesses of spending over income, i.e. bubbles, in the private sector, the public sector, or both. Then following the global financial crisis of 2007–08, came a sudden stop to these capital inflows that in some cases even led to a total reversal, i.e. a capital flight.
Others, like some of the followers of the Modern Monetary Theory (MMT) school, have argued that a region with its own currency cannot have a Balance of Payments crisis because there exists a mechanism, the TARGET2 system, that ensures that Eurozone member countries can always fund their current account deficits. These authors do not claim that the current account imbalances in the Eurozone are irrelevant but simply that a currency union cannot have a balance of payments crisis proper. Some authors tackling the crisis from an MMT perspective have claimed that those authors who are denoting the crisis as a 'balance of payments crisis' are changing the meaning of the term.
- ATTAC (Association for the Taxation of Financial Transactions for the Aid of Citizens)
- Central banks - which issue currency
- Currency transaction tax
- Economic collapse
- Exorbitant privilege
- Financial market
- Financial transaction tax
- Fluctuation in exchange rates
- Foreign exchange controls
- Foreign exchange market
- Global Justice Movement
- Jubilee 2000
- Liquidity crisis
- Money market
- Paul Bernd Spahn
- Spahn tax
- Speculative attack
- Sudden stop (economics)
- Speculation in foreign exchange markets
- Tobin tax
Related economic crises
- Federal Reserve Bank of San Francisco, Currency Crises, September 2011
- Al-Assaf, G., Al-Tarawneh, A., Alawin, M., (2013), DETERMINANTS OF CURRENCY CRISIS IN JORDAN A MULTINOMIAL LOGIT MODEL, European Scientific Journal, Vol. 9. No. 34. http://eujournal.org/index.php/esj/article/view/2178
- Craig Burnside, Martin Eichenbaum, and Sergio Rebelo (2008), 'Currency crisis models', New Palgrave Dictionary of Economics, 2nd ed.
- Salant, Stephen; Henderson, Dale (1978). "Market anticipations of government policies and the price of gold". Journal of Political Economy 86: 627–48. doi:10.1086/260702.
- Krugman, Paul (1979). "'A model of balance-of-payments crises'". Journal of Money, Credit, and Banking 11: 311–25. doi:10.2307/1991793.
- Obstfeld, Maurice (1986). "'Rational and self-fulfilling balance-of-payments crises'". American Economic Review 76 (1): 72–81.
- Chang, R.; Velasco, A. (2001). "'A model of currency crises in emerging markets'". Quarterly Journal of Economics 116 (2): 489–517. doi:10.1162/00335530151144087.
- Chang, R.; Velasco, A. (2000). "'Financial fragility and the exchange rate regime'". Journal of Economic Theory 92: 1–34. doi:10.1006/jeth.1999.2621.
- Burnside, C.; Eichenbaum, M.; Rebelo, S. (2001). "'Hedging and financial fragility in fixed exchange rate regimes'". European Economic Review 45: 1151–93. doi:10.1016/s0014-2921(01)00090-3.
- Burnside, C.; Eichenbaum, M.; Rebelo, S. (2004). "'Government guarantees and self-fulfilling speculative attacks'". Journal of Economic Theory 119: 31–63. doi:10.1016/j.jet.2003.06.002.
- Balance Sheets, the Transfer Problem, and Financial Crises. International Finance and Financial Crises: Essays in Honor of Robert P. Flood, Jr. Bosten: Kluwer Academic, 31-44.
- Selected sources on viewing the Eurozone Crisis as a balance-of-payments crisis:
- Krugman, Paul (September 23, 2011). "Origins of the Euro Crisis". The New York Times.
- Krugman, Paul (November 7, 2011). "Wishful Thinking And The Road To Eurogeddon". The New York Times.
- Krugman, Paul (February 25, 2012). "European Crisis Realities". The New York Times.
- Krugman, Paul (September 14, 2013). "But Where's My Phoenix?". The New York Times.
- Krugman, Paul (August 26, 2014). "Currency Regimes, Capital Flows, and Crises". IMF Economic Review (Palgrave Macmillan) 62: 470–493. doi:10.1057/imfer.2014.9.
- Wolf, Martin (April 10, 2012). "Why the Bundesbank is wrong". Financial Times.
- Davies, Gavyn (November 6, 2011). "The eurozone decouples from the world". Financial Times.
- Verma, Sid (November 8, 2011). "The eurozone crisis as balance of payment problem". Financial Times Alphaville.
- Avent, Ryan (November 28, 2011). "Who killed the euro zone?". The Economist.
- Nixon, Simon (December 2, 2012). "Euro's Unity Continues to Defy the Bears". The Wall Street Journal.
- Sinn, Hans Werner (October 3, 2011). "How to rescue the euro: Ten commandments". Vox.
- Pisani-Ferry, Jean; Merler, Silvia (April 2, 2012). "Sudden stops in the Eurozone". Vox.
- Alessandrini, Pietro; Hallett, Andrew Hughes; Presbitero, Andrea F; Fratianni, Michele (May 16, 2012). "The Eurozone crisis: Fiscal fragility, external imbalances, or both?". Vox.
- Mansori, Kash (September 22, 2011). "What Really Caused the Eurozone Crisis? Part 1". The Street Light.
- Mansori, Kash (September 27, 2011). "What Really Caused the Eurozone Crisis? Part 2". The Street Light.
- Mayer, Thomas (October 26, 2011). Böttcher, Barbara, ed. "EU Monitor 88: Euroland's hidden balance-of-payments crisis" (PDF). Deutsche Bank Research.
- "CESifo Forum Special Issue January 2012". CESifo Group Munich. 2012.
- Pisani-Ferry, Jean; Merler, Silvia (April 2, 2012). "Sudden stops in the Eurozone". Vox. Accominotti, Olivier; Eichengreen, Barry (September 14, 2013). "The mother of all sudden stops: Capital flows and reversals in Europe, 1919-1932". Vox.
- Wray, Randall (July 16, 2012). "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 2". Economonitor.
- Pilkington, Philip (September 2, 2013). "Playing Humpty Dumpty: More on the Definition of "Balance of Payments Crisis"". Fixing the Economists.
- Wray, Randall (July 12, 2012). "MMT AND THE EURO: Are Current Account Imbalances to Blame for the Euro Disaster? Part 1". Economonitor.
- Pilkington, Philip (August 31, 2013). "Can a country without a currency have a currency crisis?". Fixing the Economists.