Foreseeing A Currency Crisis
Written by A Forex View From Afar on Thursday, October 30, 2008It was mentioned earlier that a number of currency crisis’ may emerge in the future as the world continues to head toward a recession and funding (money) becomes scarce.
Emerging economies have the most exposure to a currency crisis, because they usually have a high balance of payment deficit (with most of the debt attributed to the governments’ entities). If the country also has a pegged currency exchange, it can become a sitting duck.
The reason is that the debt must be supported by inflows of cash. If economic conditions and outlook deteriorates (as is happening these days for most of the world), inflows will slow down, and even switch to outflows. This puts double pressure on the currency, first that the government is near bankruptcy (can’t issue any more debt) and then the currency is set to depreciate due to money exiting the country.
This is where the rating agencies usually come into play, and cut the country’s debt rating. To make things worse, typically the same trade desks who issue a negative outlook for the country are the ones who initiate the currency attack, and force the country to drop the peg, or depreciate the currency at a very fast pace.
The country does not have too many options available, so it will be forced to adopt a flexible exchange rate. As the currency depreciates, the foreign debt will increase, making matters worse. These types of attacks are very well documented, such a case being the 1997 Asian Crisis and then a few years later the Argentinean crisis.
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