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A currency crisis is a type of financial crisis, and is often associated with a real economic crisis. A currency crisis raises the probability of a banking crisis or a default crisis. During a currency crisis the value of foreign denominated debt will rise drastically relative to the declining value of the home currency. Generally doubt exists as to whether a country's central bank has sufficient foreign exchange reserves to maintain the country's fixed exchange rate, if it has any.
The crisis is often accompanied by a speculative attack in the foreign exchange market. A currency crisis results from chronic balance of payments deficits, and thus is also called a balance of payments crisis. Often such a crisis culminates in a devaluation of the currency. Financial institutions and the government will struggle to meet debt obligations and economic crisis may ensue. Causation also runs the other way. The probability of a currency crisis rises when a country is experiencing a banking or default crisis, while this probability is lower when an economy registers strong GDP growth and high levels of foreign exchange reserves. To offset the damage resulting from a banking or default crisis, a central bank will often increase Money creation, which can decrease reserves to a point where a fixed exchange rate breaks. The linkage between currency, banking, and default crises increases the chance of twin crises or even triple crises, outcomes in which the economic cost of each individual crisis is enlarged. (2025). 9781429278430, Macmillan Learning. ISBN 9781429278430
Currency crises can be especially destructive to small open economy or bigger, but not sufficiently stable ones. Governments often take on the role of fending off such attacks by satisfying the excess demand for a given currency using the country's own currency reserves or its foreign reserves (usually in the United States dollar, Euro or Pound sterling). Currency crises have large, measurable costs on an economy, but the ability to predict the timing and magnitude of crises is limited by theoretical understanding of the complex interactions between macroeconomic fundamentals, investor expectations, and government policy. Federal Reserve Bank of San Francisco, Currency Crises, September 2011 A currency crisis may also have political implications for those in power. Following a currency crisis a change in the head of government and a change in the finance minister and/or central bank governor are more likely to occur.
A currency crisis is normally considered as part of a financial crisis. Kaminsky et al. (1998), for instance, define currency crises as when a weighted average of monthly percentage depreciations in the exchange rate and monthly percentage declines in exchange reserves exceeds its mean by more than three standard deviations. Frankel and Rose (1996) define a currency crisis as a nominal depreciation of a currency of at least 25% but it is also defined at least 10% increase in the rate of depreciation. In general, a currency crisis can be defined as a situation when the participants in an exchange market come to recognize that a pegged exchange rate is about to fail, causing speculation against the peg that hastens the failure and forces a devaluation or appreciation.
Recessions attributed to currency crises include the hyperinflation in the Weimar Republic, 1994 economic crisis in Mexico, 1997 Asian financial crisis, 1998 Russian financial crisis, the 1998–2002 Argentine great depression, and the 2016 Venezuela and Turkey currency crises and their corresponding socioeconomic collapse.
Chang and Velasco (2000) argue that a currency crisis may cause a banking crisis if local banks have debts denominated in foreign currency, Burnside, Eichenbaum, and Rebelo (2001 and 2004) argue that a government guarantee of the banking system may give banks an incentive to take on foreign debt, making both the currency and the banking system vulnerable to attack.
Krugman (1999)Balance Sheets, the Transfer Problem, and Financial Crises. International Finance and Financial Crises: Essays in Honor of Robert P. Flood, Jr. Bosten: Kluwer Academic, 31-44. suggested another two factors, in an attempt to explain the 1997 Asian financial crisis: (1) firms' balance sheets affect their ability to spend, and (2) capital flows affect the real exchange rate. (He proposed his model as "yet another candidate for third generation crisis modeling" (p32)). However, the banking system plays no role in his model.
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According to some economists the Eurozone crisis was in fact a balance-of-payments crisis or at least can be thought of as at least as much as a Public finance crisis.Selected sources on viewing the Eurozone Crisis as a balance-of-payments crisis:
According to this view, a capital flow bonanza of private funds took place during the boom years preceding this crisis into countries of Southern Europe or of the periphery of the Eurozone, including Spain, Ireland and Greece; this massive flow financed huge excesses of spending over income, i.e. Economic bubble, in the private sector, the public sector, or both. The 2008 financial crisis resulted in a sudden stop to these capital inflows that in some cases even led to a total reversal, i.e. a capital flight.
Others, like some of the followers of the Modern Monetary Theory (MMT) school, have argued that a region with its own currency cannot have a balance-of-payments crisis because there exists a mechanism, the TARGET Services system, that ensures that Eurozone member countries can always fund their current account deficits. These authors do not claim that the current account imbalances in the Eurozone are irrelevant but simply that a currency union cannot have a balance of payments crisis proper. Some authors tackling the crisis from an MMT perspective have claimed that those authors who are denoting the crisis as a 'balance of payments crisis' are changing the meaning of the term.
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