Get the Basics on What Causes a Currency Crisis
Contributed by Luigi Wewege At Caye International Bank
15 June, 2020
People with offshore investments or who include currency exchange in their investment strategies are familiar with the concept of a currency crisis. Others who have not encountered this type of event in the past may wonder what it is, how it comes about, and if there's any way to determine if a crisis is about to happen.
Here are some of the basics that will help you with all of these questions as well as a few others.
What is a Currency Crisis?
The typical definition of a currency crisis is an abrupt and generally unanticipated drop in the value of a currency related to the value of one or more other currencies. The drop is not a minor amount, something that's common with Foreign Currency and Exchange (FOREX) trading on any given day. Instead, it's a significant sum that can create quite a bit of chaos among investors.
While some upward and downward movement in currency values is anticipated and actually one of the ways that people generate returns from the market, the crisis decreases the potential to gain much of anything. Until the market rights itself and can function reasonably again, the upheaval remains significant.
What Can Cause a Currency Crisis to Take Place?
The factors that can lead to a currency crisis are much like those that can trigger any type of economic upheaval. One that is often cited is the decision to focus on using fixed exchange rates in an attempt to coerce the market in a specific direction. More commonly, the use of floating exchange rates allows the market to drive itself and set the pricing. Anything that interferes with this process can temporarily undermine the market.
Other factors can set the stage for a crisis. For example, political upheaval may lead to a sharp downward loss of value for a country's currency. Until the upheaval is resolved, the crisis is likely to continue. In like manner, natural disasters that seriously harm the infrastructure of a nation could lead to a sudden drop in the currency's value relative to the value of other currencies. It's only as the infrastructure regains strength and function that the trend reverses.
Is a Currency Crisis the Same as Currency Devaluation?
While both situations do involve a loss of value, they do not refer to the same phenomenon. One key difference has to do with the rapidity and the severity of the drop in the currency's value. With a crisis, it's sudden and usually not expected. It's an event or a chain of events that take place over a short period of time that triggers the change.
By contrast, a currency devaluation is usually an event that's planned in advance and executed carefully. The goal is usually to alter the course of a country's trade balance with other nations. When successful, the currency devaluation can trigger an increase in exports and ultimately help the nation's economy. The devaluation may continue for some time before the currency incrementally begins to regain value as part of the natural flow of the marketplace.
How Long Can a Crisis Last?
There is no set time frame for correcting a currency crisis. Unlike healing a broken leg, there may not be day-to-day improvements after the currency seems to level off. The most succinct answer is that the crisis will continue for as long as the underlying causes remain in place.
With that in mind, it may be possible to move out of the crisis in a matter of days or weeks. At other times, the process could take months. For example, the election of new government officials might have a positive impact on currency value. The same could be true if a country regains levels of production that were interrupted by some type of natural disaster.
How Can I Protect Myself During a Crisis?
There are three possible courses of action that you can take during a currency crisis. It's up to you to determine which approach would be in your best interests. Consider each one in turn before settling on a response.
Hold onto the currency and see what happens. If the causes were severe but transient, riding it out could have little to no negative impact on you in the long run. With this approach, you might experience some sort-term losses.
Sell at a loss. This does have the effect of preventing more losses. If you believe the currency's value will not recover for quite some time, this may be your best bet.
Choose to exit the FOREX market for the time being. Take the money and invest it elsewhere. You can always enter the market again at a later date.
Will I Recover Once the Crisis Has Passed?
It's possible to recover your losses if you choose to remain in the market. Monitor the market movements in general and the currency in particular. As with any investments, the factors leading to the change in value could change. If that happens, what you're holding could rebound and even exceed the former value in comparison to other currencies.
There is no guarantee that you will ever recoup the losses from the crisis. For that reason, do consider how FOREX trading factors into your overall investment strategy and decide if it's worth continuing. Should you believe that it would be best to limit involvement or exit the market for a time, do so.
Are There Ways to Predict That a Crisis is Going to Happen?
Some of the events that can lead to a currency crisis occur without little to no warning. That's especially true of destruction caused by some sort of natural disaster. In those scenarios, there's not really any way to know in advance that a currency will lose value in comparison to other currencies.
When there's growing political unrest within a country, it's reasonable to expect that the currency and its value will be affected at some point. In this scenario, investors would likely begin to focus on other strategies related to currency exchange and incrementally exclude that particular currency from the investment strategy.
Is It Possible to Avoid a Currency Crisis Altogether?
There will always be factors that are beyond the ability of individuals and the market to control. That doesn't mean there's nothing that can be done to reduce the risk of a currency crisis. When and as possible, employing these strategies can prevent or at least lessen the possibility of a crisis occurring.
Using fixed exchange rates in an attempt to alter the market does mean a higher risk of experiencing a currency crisis. If this is the approach taken in hopes of achieving a certain outcome, it must be monitored with care. Fixed exchange rates don't necessarily have to result in a crisis if they are managed closely.
Emergency strategies that make it possible to recover from disasters at a faster rate are another way to minimize the impact and duration of the crisis. A sound plan that would allow a nation to restore communications, implement recovery tasks in a logical manner, and, in general, get things back to normal sooner rather than later will help keep the currency from losing a significant amount of value in a short amount of time.
Should I Not Engage in Foreign Exchange Investing and Avoid the Risk Altogether?
All investment opportunities come with some degree of risk. If you've been part of the market for some time and find that participation helps you move close to a financial goal, there's no need to stop. At best, it makes sense to make sound decisions that increase the potential of earning returns and being prepared when something out of the ordinary should take place.
Remember that other forms of investments are also affected by issues like weather damage and political unrest. Moving away from the FOREX is no guarantee that every investment you make will produce some sort of return. Depending on what's taken place, being in the market could allow you to recover a little faster or at least keep the losses to a minimum.
Educate Yourself About Currency Crises
One of your most powerful resources is understanding what can happen in different types of markets. Learn more about this type of crisis and what you can to do protect yourself.
Be prepared to make changes if the situation warrants the action. Above all, don't be intimidated because this type of trend is referred to as a crisis. Maintaining a cool head and thinking things through will go a long way toward ensuring you're fine.
The client services team at Caye International Bank can help you create a viable offshore investment portfolio. Reach out today and learn more about what we have to offer.
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