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Currency Crisis

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Last updated date: 27th Feb 2024
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An Overview of the Currency Crisis

The decline in the value of a country's currency is referred to as a currency crisis. It negatively affects the economy of a country as it creates instability in the currency exchange rate. A currency crisis raises the probability of a banking crisis, rise in debt, less growth, and an economic crisis. A currency crisis is normally considered a part of a financial crisis. Let us read further about the currency crisis, forex crisis, forex reserve, banking crisis in India, etc.


Basket of currency which determines the exchange rate and influences currency crisis


Basket of Currency which Determines the Exchange Rate and Influences Currency Crisis


What is the Currency Crisis?

A currency crisis is a situation in which the currency unexpectedly loses its substantial value relating to other currencies in the foreign exchange market. Use of one currency crisis or money crisis is followed by a financial and a socio-political crisis.


Causes of Currency Crisis

A single reason cannot cause such a big crisis. It is also called the money crisis. There are a lot of reasons for a currency crisis.


When the value of a currency depreciates it leads to the value crisis. The features of value crisis are as follows:

  • Central bank policies that slowed down the economy.

  • Collapse in the banking structure when there is a default in debt payments and over-reliance on foreign investment and foreign debt.

  • In the case of sanctions placed by a nation.

  • Over-reliance by the country on one source of income for the economy.

  • Political disturbance, for example, the assassination of the country leader or military situations such as wars.

  • Economic situations like inflation and high fiscal deficit.


What is Forex Crisis and What are Forex Reserves?

External assets in the form of gold, foreign currency assets, special drawing rights of the IMF, and foreign direct investment accumulated by your country and controlled by the central bank. Such accumulation by the central bank of any country is called forex reserves. 


Forex reserves are held by the country for supporting and maintaining the confidence of a country’s currency in terms of monetary policy and exchange rate management. It helps to overcome any external vulnerability in the case of fluctuation in the foreign exchange market and helps to absorb any shock in times of crisis. 


To overcome the money crisis and value crisis, the central bank of a country keeps forex reserves. If there are not enough foreign exchange reserves left with a country, then it leads to a forex crisis.


What is The Financial Crisis?

A situation where the financial assets of the country lose their nominal value is known as a financial crisis. It includes stock market crashes, currency crises, banking panics, and sovereign defaults. If the financial crisis is ignored, then it can cause an economy to go towards recession or depression. During a financial crisis, businesses have trouble meeting their financial obligations and they lack sufficient cash to meet their immediate needs. In this case, the investors tend to lose their confidence in the asset value which further leads to compromises and difficulties in paying a debt.


The Banking Crisis in India

The amount of non-performing assets in the banking sector of India has been increasing in the last five years. This has been accompanied by a slowdown in investment growth. The banking sector of India has been facing many hurdles. There are many factors that have been attributed to the crisis in the banking sector, the main being the government-owned banks. 


Around 70% of the bank loans have been in the account of public sector banks and account for 90% of the total non-performing asset. This has resulted in the erosion of their capital because of the bad loans. To overcome this crisis, the government had to recapitalize the bank and form a bad bank to overcome the crisis of non-performing assets. The reason for the poor performance of the public sector bank lies in the poor governance, the influence of politicians and bureaucrats, and corruption.


The Reserve Bank of India being the sole regulator of the banking sector in India needs to have tight supervision of the public sector bank and help overcome the financial crisis that the banking sector of India is going through. A well-defined framework for resolving the situation of non-performing assets is needed.


Example of a Currency Crisis

In the 2008 global financial crisis, the world faced a major setback. Subsequently, Turkey faced the condition of a decrease in foreign investment. This led to changes in reforms by the country and making a strong banking sector by supplying the money in the market for attracting investors. Due to the heavy flow of money, the business entities borrowed a huge amount of money. Further, in 2018, the US Federal Reserve increased the interest rate which feared the borrowers as they had to repay more which resulted in the loss of faith. These conditions resulted in the devaluation of the Turkish currency and led to a currency crisis.


The features of the value crisis if ignored can cause more economic slowdown leading to recession.


Conclusion

A currency crisis is a situation when the home currency of a country starts devaluating. This crisis led to many problems such as inflation, an increase in unemployment, relying on foreign funds, and bad relations with the global world. The economic policies of the nation must be formulated in such a manner that it is in line with the world, overcome any loopholes, and focus on the economic development of the country. The financial stability of the country lies in the hands of the central bank which should frame proper monetary policy and keep a check on the financial system of the country.

FAQs on Currency Crisis

1. How to overcome the currency crisis?

The government should focus on maintaining a low inflation rate through a proper monetary policy of the central bank of the country. Investor-friendly policies must be adopted by the country to prevent the crisis. A country should maintain proper forex reserves to overcome any fluctuation in the foreign exchange market. It should also be noted that a country must maintain good trade relations with another country and try to have a stabilised currency. Also, a handful of methods like floating exchange rate, and attracting foreign investment can be adopted.

2. What is the valuation of currency?

The valuation of currency is referred to as the downward adjustment of a country’s value of money concerning foreign currency. Using a fixed exchange rate, the valuation is done as a monetary policy tool for controlling supply and demand. It may be done to increase exports, lower the trade deficit, and also to lower the cost of interest payment of the debt by the government. Sometimes the valuation can also increase in prices and also uncertainty in the market.

3. What are fixed and floating exchange rates?

A fixed exchange rate is defined as a time of exchange in which the value of the currency is fixed by the monetary authority of a country against the value of another currency, basket of currencies, or gold whereas floating exchange rate is determined according to the demand and supply in the foreign exchange market which fluctuates constantly.