A currency crisis can be broadly defined as any situation in the foreign exchange markets where a currency suddenly and/or unexpectedly loses substantial value relative to other currencies. In most cases, a currency crisis is not an isolated event and usually follows a financial or socio-political crisis.
Although modern currency crises are associated with rapid hyperinflation and sustained degradation of political and financial institutions, hyperinflation and currency crises are separate phenomena. Historical instances of currency crises include Germany after the First World War, Zimbabwe in the 2000s, Argentina in 2018, and Turkey in 2018.
Signs of a Currency Crisis
1. Increase in inflation and expected inflation
A currency crisis is almost always preceded by a period of rising inflation and inflation expectations. For example, between 2010 and the first quarter of 2018, the Turkish economy grew at a steady pace, and the country’s economy experienced a sustained period of ever-increasing inflation. In addition, during the same period, inflation expectations – i.e., what people thought Turkey’s inflation rate would be in the future – increased significantly as well.
2. Local banking crisis
A currency crisis usually starts with domestic financial institutions reneging on their debt payments. For example, after the First World War, German banks borrowed large sums of money from international lenders to help finance post-war reconstruction. Due to the 1929 Stock Market Crash and the ensuing financial crisis, the international lenders (mostly American banks) recalled their loans to German banks. However, the German financial institutions were unable to make debt payments due to the state of the domestic economy. As a result, Germany experienced severe hyperinflation and a currency crisis, which saw the government collapse.
Modern Currency Crisis – Turkey 2018
Turkey is the 17th largest economy in the world and is one of the largest emerging market economies in the world, with a population of 79.81 million. In the 2000s, the Turkish government enacted a series of political and economic reforms to attract foreign investment. After the 2008-2009 Global Financial Crisis, Turkey experienced a rapid influx of foreign capital. It was partly due to the reforms and also to the fact that most large countries lowered interest rates after the crisis to promote investment and boost aggregate demand.
In 2018, the Turkish lira (TRY) fell by almost 45% against the US dollar (USD). Between 2010 and 2018, Turkey experienced average GDP growth of around 6.5%. During the period, Turkish businesses and banks borrowed huge amounts of money from international investors. Most of the debt was dollar-denominated, which meant that Turkey was exceptionally susceptible to US monetary policy.
The crisis started when the US Federal Reserve raised interest rates in the first half of 2018. The policy change increased the total debt payments that Turkish firms and banks needed to make. In addition, global investors started losing faith in Turkish President Recep Erdogan’s government’s ability to sustain the construction boom that previously allowed Turkey to grow so quickly. All of these factors contributed to a drastic drop in the demand for the Turkish lira in foreign exchange markets.
The decline in demand increased the downward pressure faced by the lira and led to further decreases in the TRY/USD. The decreased exchange rate further raised the nominal value of USD-denominated debt owed by Turkish banks and companies. Thus, a sort of vicious circle arose, which gave rise to a currency crisis.