The anatomy of a currency crisis

A currency crisis is sometimes banal and quite predictable, yet in other instances, not so few, they can be often sudden.

Chase Bank clients in Kenya storm the Kisumu branch of the bank amidst a financial panic in the country. (Tonny Omondi/Nation Media Group)

It may be precipitated by governments, investors, central banks, or any combination of these actors. But, the result is always the same: The negative outlook causes wide-scale economic damage and a loss of capital.

So, given the situation in Egypt, and in countries facing similar challenges, let’s explore the drivers of currency crises and better understand their causes.

A currency crisis is brought on by a sharp decline in the value of a country's currency. This decline in value, in turn, negatively affects an economy by creating instabilities in exchange rates, meaning one unit of a certain currency no longer buys as much as it used to in another currency.

But a currency crisis is often the result of a challenged real economy underlying the nation's currency. In other words, a currency crisis is often the symptom and not the disease of greater economic challenge.

Investors often attempt to withdraw their money en masse if there is an overall erosion in confidence in an economy's stability. This is referred to as capital flight. Once investors sell their domestic currency-denominated investments, they convert those investments into foreign currency.

This causes the exchange rate to get even worse, resulting in a run on the currency, which can then make it nearly impossible for the country to finance its capital spending.

There are several common factors linking recent crises:

1. The countries borrowed heavily (sizable current account deficits):

2. Domestic currency values decreased rapidly; and

3. Uncertainty over a government's actions unsettled investors

What Are the Effects of a Currency Crisis?

The effects of a currency crisis include the potential for inflation, hyperinflation, stagflation, decreased real wages, increased unemployment, an increased debt burden, and lower output.

The bottom line: currency crises can come in multiple forms, but are largely formed when investor sentiment and expectations do not match the economic outlook of a country. The final effect of a currency crisis is usually a new exchange rate equilibrium when currency markets stabilize. The short term deterioration of purchasing power is the most serious consequence that will affect consumers. For producers, the most serious consequences will be dropping demand for their goods and services. Both of these consequences will challenge affected economies in the short run.

But, the lesson learned has to be that every currency crisis is the result of a challenged real economy which underpins the nation's currency. As stated, a currency crisis is often the symptom and not the disease of a greater economic challenge. Addressing these fundamental challenges is the only way forward to find economic relief, and to reclaim the loss of wealth associated to sustained devaluation which is the ultimate by-product of a currency crisis.