The Causes and Consequences of a Currency Crisis - Essay Example

 The Causes and Consequences of a Currency Crisis A currency crisis can spread like wildfire as once started, it can spread from country to country. Recession and lack of protection, which are consequences of a currency crisis, is very contagious. There are two basic views regarding currency crises as listed by Rose (1999): The first model focuses on inconsistencies between a country's external commitments, such as a fixed or pegged exchange rate, and its internal economic fundamentals. For example, a government that is running a fiscal deficit might pressure its central bank to help finance the budget by printing money. This creates inflation and a current account deficit, which may lead investors to doubt the exchange rate peg. Speculators eventually mount an attack--that is, they demand foreign reserves in exchange for the domestic currency. To defend the peg, the monetary authorities sell off foreign exchange reserves. When the reserves fall to a certain point, the government is faced with a choice: should it break its external promise (to keep the exchange rate fixed) or keep its internal political constituents happy (by not raising taxes or cutting spending)? Governments usually Last Name 2 choose internal objectives over external constraints; that is, there is a currency crisis. A model like this works well in helping to understand the breakdown of inflationary economies, like Russia in 1998. But such models don't help understand recent crises in Asia. Most Asian countries had admirable monetary and fiscal policies that were viewed as being sustainable. The second model views currency crises as shifts between different monetary policy equilibria; here speculative attacks can be self-fulfilling even against countries with sound policies. In these models, market speculators initiate attacks based on their beliefs about the willingness of policymakers to resist pressure on the exchange rate. When markets perceive that conditions, such as high unemployment or a weak banking system, compromise the central bank's willingness to defend the currency peg by raising interest rates, speculative attacks are more likely to succeed. When a country faces a currency crisis, other countries are affected mainly because of international trade. Thailand faced a financial crisis which led to Malaysia and Indonesia’s currency situation as these countries were Thailand’s main trade competitors. Hence, trade is regional so currency crises are regional. Recessions are associated with currency crises and Last Name 3 lead to a fall in imports. Trade flows are disrupted as one country’s imports fall causes another country’s exports to decrease. Once trade flows are disrupted, major issues occur as free trade is a wonderful thing. There are many models that attempt to explain the phenomenon of how a financial crisis is formed. Chang and Velasco (1998) suggest a useful model should consist of the following features, “It must not rely on government misbehavior to generate the crisis…It must be general enough to accommodate a wide variety of macroeconomic circumstances…It must be specific enough to explain why in some of these macroeconomic scenarios a crisis occurs, and in some it does not…It must account for the high observed correlation between exchange rate collapses and banking crises…It must replicate the puzzling fact that the punishment is much larger than the crime…” The transferring of information in international financial markets can cause most of the information to become trapped. Minute changes in information can cause incredible behaviour by international investors. During a currency crisis, governments tend to expropriate foreign funds in an attempt to raise funds. (Chari and Kehoe, 1997). Their model implies that only governments with weak reputations are subject to volatile capital flows. Thailand faced incredible external (foreign) debts. As its debts increased, creditors wondered if it could meet its obligations. Hence, supply of credit to Thailand was hindered. Also, increased uncertainty caused doubts in investment opportunities in Asia which may have reduced the expected return on Asian assets that lead to foreign investors’ escalation of home Last Name 4 bias by foreign investors and generated the observed collapse of foreign investment in the region. (Financial Crises in Emerging Markets, 2001.) Some economists believe that the Asian currency crisis was caused by structural weaknesses and volatile international capital markets. International trade and credit problems which caused the crisis to quickly spread and lack of banking and financial sectors increased the level of the crisis. The East Asian Financial crisis, which was the sharpest (and least expected) financial crisis since the 1982 debt crisis, affected the fasted economically-growing countries. Friedman and Schwartz (1998) report that some of the causes that lead to the crisis include “corrupt mismanaged banking systems, lack of transparency in corporate governance, the short-coming of state-managed capitalism…the crisis is a testament to the shortcomings of the international capital markets and their vulnerability to sudden reversals of market confidence. ..serious doubts about the (International Monetary Fund) IMF’s approach to manage financial disturbances originating in private financial markets…the turmoil demonstrates how policy mis-teps and hasty reactions by governments, the international community, and market participants can turn a moderate adjustment into a financial panic and a deep crisis.” Asia has been used as an example in this writing. However, many other countries have been affected. Mexico faced a currency crisis which lead to “ reserve losses, interest rate increases, and Last Name 5 weakening exchange rates suffered by countries like Argentina and Thailand in the early weeks of 1995,” as reported by Eichengreen, Rose, and Wyplosz (1997). Therefore, trade links can also be the cause of a currency crisis and not just macroeconomic policies and the country’s conditions. Eichengreen, Rose, and Wyplosz (1997) state, “Difficulties in one country pursuing a program of exchange-rate based stabilization…might lead currency traders to revise their assessment of the likelihood that other countries pursuing this macroeconomic strategy will carry it off. An attack on one country and the issuing government’s response to the pressure may provide new information relevant for expectations of how other governments will respond if placed in a similar position.” The consequences of one’s country’s currency crisis leading to other countries’ financial crisis include contagion that is transmitted via specific channels. Some believe that countries that trade disproportionately with one another are more susceptible to contagion due to the crisis-induced exchange rate. Others assume that various governments’ reaction affect the way investors react to their expectations of how government officials will respond. Other consequences include the loss of bank reserves (a bank not being able to maintain a currency peg as it does not possess enough foreign exchange reserves), the loss of credibility in the central bank, bankruptcies, recessions, a contingency policy process where one-time happenings can lead officials to substitute one policy after another, which increases the likelihood of the possibility of self-fulfilling speculative attacks. (Eichengreen, Rose, and Wyplosz, 1997). Last Name 6 Lim (2005) lists various consequences of a currency crisis in more detail: …crisis has had not only serious domestic social, political, and economic impact, it has affected intra- and extraregional international relations, as well as intellectual and policy discourse. It has precipitated a full-scale emotional debate on the fundamental values and practices of…societies as a whole, not only in the crisis-dominating realms of economics and business but also in their collateral political, social, and cultural spheres. The crisis has given rise to questions of the extent to which so-called (country’s) ways of managing economies and businesses contributed to the situation and must change as a result. This change would be, both implicitly and explicitly, toward the universalist free-market capitalism preached by Western economics textbooks and conservative ideologues. At the same time, the crisis has almost contradictorily, spawned the deepest skepticism yet among…government and business leaders…capitalist doctrine of free markets, private enterprise, international openness and political democratization as the most secure path to economic prosperity and social well-being. The Asian economies in crisis have long been considered the freest and most open of emerging economies, in some cases even in comparison with advanced industrial economies. They have been also constantly liberalizing, especially in the decade prior to the onset of crisis. Yet this relative openness and freedom did not protect them or help them recover from the Last Name 7 crisis. Indeed, many Asians and others argue that openness exacerbated these countries' vulnerability and has made their recovery more difficult. Last Name 8 References Chang, R. and Velasco, A. (1998). Financial Crises in Emerging Markets. Federal Reserve Bank of Atlanta Working Paper 98-10. June 12, 2006, . Chari. V.V. and Kehoe, P. (1997). Hot Money. International Finance and Macroeconomics. NBER Working Paper No. 6007. April 1997. June 12, 2006, < http://www.nber.org/papers/W6007.pdf >. Eichengreen, B.; Rose, A.; and Wyplosz, C. (1997). Contagious Currency Crisis. NBER Working Paper no. 5681. 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