Recognize Signs of Forex Currency Crisis
The currency crisis is a crisis that arises because of the decline in the value of the currency of a country. Negative drops of value affect the economy by creating instability in exchange rates, which means that one unit of currency is no longer able to buy as much as is used for another.
Since the early 1990s, there have been many cases of currency investors caught, which led to the flight and capital flight. What makes forex investors and international investors respond and act like this? Do they evaluate the economy, or follow their instincts?
When faced with a currency prospect, the central bank with a fixed economic exchange rate will try to maintain the current fixed exchange rate by using the country’s foreign exchange reserves, or allow the exchange rate to fluctuate freely.
Why use foreign exchange reserves is a solution? When the market expects devaluation, the pressure that occurs on the currency can only be completely offset by an increase in interest rates. To increase the exchange rate, the central bank must shrink the amount of money in circulation, which will then increase demand for the currency. The central bank can do this by selling foreign exchange reserves to generate capital outflows. When the bank sells a portion of the foreign exchange reserves, it receives its payment in the form of domestic currency, so it will hold the circulation of capital outflow as an asset.
Maintaining exchange rates can not last forever, both in terms of declining foreign exchange reserves as well as political and economic factors, such as rising unemployment. Evaluating the currency will increase the yield of a fixed exchange rate on domestic goods (domestic) to be cheaper than foreign goods (import), increase the demand for workers and also increase output. In the short term the devaluation also raises the interest rate, which must be balanced by the central bank through the increase in the money supply and the increase of foreign exchange reserves.
Maintaining exchange rates can be by taking (reducing) all the reserves of a country and devaluing the currency can add back the reserves.
If investor confidence in economic stability decreases, then they will try to run their money (capital) abroad. This is called capital flight. Once the investors sell currency denominated currency investments in the country, they will convert their investments into foreign currency. This is what causes the exchange rate to get worse, so the currency decreases, which then can make the country almost impossible to finance capital expenditure.
There are several common factors associated with the recent crisis:
- Countries have many loans
- The value of the currency is increasing rapidly
- Uncertainty over government action makes investors uneasy
Growth in developing countries is generally a positive for the global economy, but too fast growth rates can create instability, and higher opportunities for capital flight and declining domestic currency.