The Currency Crisis

A currency crisis is a situation where there is a sudden drop in a country’s currency, causing negative impacts on the economy by creating instabilities in exchange rates. Since it occurs abruptly and without warning, an effort has been made to identify the following warning signs of a currency crisis:

• Inflation tends to be notably higher in the pre-crisis period relative to a calm period.
• The ratio of exports to imports usually drops before a currency crisis.
• Foreign exchange reserves tend to decline steeply when a crisis is approaching.
• The currency rises relative to its historical mean when a crisis is approaching.
• Broad money growth and the ratio of a measure of money supply (M2) to bank reserves increase before the crisis.
• A banking crisis usually comes before or coincides with a currency crisis.
• Countries with fixed or partly fixed exchange rates are more prone to crises compared to countries that have floating exchange rates.
• Liberalized markets are more prone to currency crises since there is a free flow of capital.
• There is a massive foreign capital inflow compared to a country’s GDP, just before a crisis. The main problem arises when the short-term funding is in foreign currency.

Question

After studying the historical records of a country, an investor concludes that “despite its sound economic fundamentals, the country can still fall into currency crisis periods because of the shift in investors’ attitude towards the market due to reasons unrelated to economic issues.” The conclusion of the investor is most likely to be:

1. Incorrect because historical evidence exists of currency crisis in countries with developed economic fundamentals.
2. Correct.
3. Incorrect because there is historical evidence of cases where market shifts that are unrelated to economic issues occur.

Solution

The correct answer is B.

A currency crisis occurs without warning. So, even countries that have rigid economic fundamentals can experience a currency crisis. This, for instance, can happen when investors’ attitude towards the market shifts for non-economic reasons.

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (m) Describe warning signs of a currency crisis.