A currency crisis can be broadly defined as any situation in the foreign exchange markets where a currency suddenly and/or unexpectedly loses substantial value relative to other currencies. In most cases, a currency crisis is not an isolated event. It usually follows a financial or socio-political crisis.
Although modern currency crises are associated with rapid hyperinflation and sustained degradation of political and financial institutions, hyperinflation and currency crises are separate phenomena. Historical instances of currency crises include Germany after the First World War, Zimbabwe in the 2000s, Argentina in 2018, and Turkey in 2018.
A fall in domestic currency exchange rates occurs for several reasons, including:
• Speculative attack. The main targets are countries that adopt a fixed exchange rate and have weak economic fundamentals. Targets are usually countries with little foreign exchange reserves or running twin deficits for years. (twin deficits are when a country runs both a fiscal deficit and a current account deficit).
• Increase in inflation expectations leading to hyperinflation as explained earlier. Currency crises are typically preceded by periods of rising inflation and high inflation expectations.
• Banking crisis or default. Currency crises usually start with the failure of financial institutions to pay off their debts.
Based on an IMF working paper, several indicators are useful for providing signals and anticipating currency crisis including:
• International reserves – The credibility of the central bank’s intervention in the foreign exchange market depends on foreign reserves’ position. High foreign exchange reserves make the central bank more credible.
• Real exchange rate – Exchange rate overvaluation plays a vital role in sharp exchange rate depreciation. Overvaluation often occurs in a fixed exchange rate system, when the real exchange rate does not reflect supply and demand. That, in turn, encourages speculators to sell the domestic currency, causing acute depreciation.
• Domestic inflation – High inflation, as in hyperinflation, reduces confidence in the domestic currency. Many people switch to foreign currency and sell domestic currency. Such panic can lead to a currency crisis.
• Trade balance – Chronic trade deficits leave a country vulnerable to bouts of minor speculation on the forex market.
• Export performance – Exports are a major source of entry for foreign currencies. High exports increase the supply of foreign currency and foreign reserves. It is useful not only for covering import payments but also for intervention in the forex market.
• Money growth – Growth in the money supply, especially M2, helps predict episodes of sharp depreciation. When the money supply grows faster than real GDP growth, it creates high inflation pressure. It shows you more money chasing less stuff.
• Real GDP growth – Currency crises tend to occur when real GDP growth is low.
• Fiscal deficit – A high deficit increases government debt. To pay off debt, the government finances it through seigniorage (printing money). That will likely lead to uncontrolled inflation, increasing distrust of the domestic currency.
The possible solutions to the currency crisis include:
— Adopt a floating exchange rate.
— Raise interest rates
— Fiscal policy tightening
— Control of capital outflows
— IMF bailout funds
Malaysia only needs to raise OPR by 0.75% to 1.0% to stem the outflow and halt further depreciation of the ringgit. The other measures are not applicable at this stage as we are not in a currency crisis yet (a drastic depreciation of currency).
References:
Currency Crisis, CFI Team, Corporate Finance Institute
Currency crisis: causes, signs, impacts and possible solutions, Ahmad Nasrudin (https://penpoint.com)
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