If you are trading in the currency market, you need to know why a currency becomes unstable and why it happens. A currency crisis is normally initiated by a devaluation of a country’s currency. The decline in value creates instability in the exchange of a country and has a negative effect on the economy. A simple way of looking at why crises develop is to say that it is due to an interaction between the expectations of investors and the effects of those expectations.
The Effects of Central Banks, Government Policy and Investors
If the country has a fixed exchange rate, it is possible for the central bank to start using its foreign reserves, or simply leave the rate to fluctuate. The reason for central banks tapping into its foreign reserves is to stabilise the currency rate. As soon as the market is heading towards a devaluation of the currency, the only way to stabilise it is to increase the interest rate. In order for the central bank to achieve this, it has to reduce the money supply. The reduction of the money supply will increase demand for it. The central bank will normally achieve this by selling off its foreign reserves in order to create an outflow of capital. When it sells off the reserves, the payment it receives will be in its domestic currency which it will retain as an asset and not circulate.
It is not possible for the government to prop up its exchange rate for extended periods. This will cause a reduction in foreign reserves and will affect the economic and political situation in the country. It could cause a rise in unemployment. Devaluation of a currency by an increase in the fixed rate normally results in cheaper domestic goods which normally boost the employment rate, hence there will be an increase in production. Devaluation of the currency will increase interest rates and this has to be balanced by an increased money supply and foreign reserves.
Investors are aware that this devaluation strategy may be used and often build this into their predictions. In the event that the expectation is that the central bank will devalue its currency, thereby causing an increase in exchange rate, it will not be possible to boost its foreign reserves. The central bank’s only option will be to use those reserves to decrease the money and this will increase the interest rate in the country.
The Build Up to The Forex Australia Crisis
If the confidence of investors in a country’s economy is slighted, they will try their best to get their investments out of that country. This is called ‘capital flight.’ Once they have managed to sell their domestic currency investments, they will proceed to convert their investments into a foreign currency. This causes a further slide of the exchange rate, resulting in widespread negativity towards the currency. This will make it almost impossible for the country to meet its capital spending needs.
To predict a currency crisis involves extremely complex analysis of a range of variables. Some of the common factors that have linked more recent crises include current account deficits and rapid increase of currency values. This happened during the 1994 Latin American Crisis and the Asian Crisis during 1997. It could happen in forex Australia, UK, or anywhere.
Growth rates in developing countries are normally a positive sign for forex Australia and the global economy. However, if the growth occurs too rapidly, it can cause instability with a greater risk of capital flight. Efficient central bank management will be required to curb this problem.
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