Exchange Rate and Currency Essay

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Exchange Rate Crisis

Exchange rate crises are quite common phenomena in the economic world. From the 1994 Mexican crisis and the 1997 Asian crisis to the 1999 Argentine crisis, currency crises have occurred with a somewhat remarkable frequency. Also, known as currency crises or balance of payments (BOP) crisis, exchange rate crises occur when a country's monetary authority (central bank) has inadequate foreign exchange reserves to sustain its set exchange rates. This is usually caused by trade shocks, persistent budget deficits, foreign interest rate shocks, political uncertainty, banking system weaknesses, and moral hazard problems. An exchange rate crisis is often symbolised by factors such as hyper-inflation, banking crisis, devaluation, and economic recession, clearly indicating the dire consequences a currency crisis can have on the economy. More importantly, an exchange rate crisis can easily spread beyond the national boundary, underscoring the need for measures to prevent the crisis. This paper discusses the ways in which a country can avoid an exchange rate crisis, as well as circumstances under which the mechanisms are likely to be effective or ineffective.

When a currency crisis occurs, a country can respond by shifting to a floating exchange rate regime, devaluing the currency, raising interest rates, borrowing internationally, bailout, and/or defaulting on debt or requesting for debt forgiveness. These measures can offer great relief in the event of an exchange rate crisis. For instance, floating the currency can result in exchange rate depreciation, improved net exports, and increased output, thereby restoring the equilibrium. Whereas these measures can successfully heal an exchange rate crisis, they are generally curative in nature. It is more desirable and effective to focus on preventing the crisis in the first place as opposed to responding when it occurs.

One way through which an exchange rate crisis can be avoided is by adopting a more sustainable exchange rate regime. A major cause of a currency crisis is a fixed exchange rate regime. Fixing exchange rates presents immense risks to an economy. This is particularly true for emerging markets, which tend to be characterised by fast capital flow as well as underdeveloped financial systems.

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In an attempt to ensure exchange rate stability, a country with fixed exchange rates often resorts to excessive borrowing, increasing exposure to exchange rate risks. With a sustainable exchange rate regime, these problems can be avoided. Nonetheless, for the underlying exchange rate regime to effectively prevent an exchange rate crisis, the prevailing monetary policy must be favourable. A sustainable exchange rate regime usually requires relinquishing the independence of monetary policy to some extent.

A country can also avoid an exchange rate crisis by strengthening capital markets. The connection between capital markets and economic development is too significant to be overlooked. Robust capital markets facilitate a smooth and efficient flow of capital, goods, and ideas between developed and developing markets. It is imperative for developing markets to ensure effective monitoring of risk and put in place measures to balance lending and borrowing. The success of the strategy requires extensive involvement of developed countries. As the international economy, will increasingly resort to developing markets for capital, it is vital for developed countries to support developing markets in strengthening their capital markets. Switzerland's Bank for International Settlements (BIS) has particularly played an instrumental role in promoting capital market efficiency. The bank has forged information sharing amongst central banks and provided guidelines for evaluating capital adequacy in banks.

Minimising vulnerability to sudden shifts in investor confidence also offers a valuable way of preventing an exchange rate crisis. When a currency crisis occurs, the confidence of investors in the affected country often shifts immediately. A country can address this vulnerability by ensuring more efficient management of its external finances, avoiding moral hazard between domestic banks and private borrowers, and maintaining the exchange rate at a sustainable level by the prevailing reserves. Vulnerability to drastic shifts in investor confidence can also be reduced by inclining towards more stable forms of foreign direct investment (FDI) as well as instituting capital controls to limit the extent to which foreign entities can pull out money from the country….....

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