What is a Currency Crisis?

A currency crisis occurs when one county's money becomes rapidly devalued relative to the international system. The term currency crisis is used most frequently when discussing an economy from the perspective of foreign investors. The currency crisis is also sometimes called a balance-of-payment crisis, because of the way it often unfolds. Balance of payment refers to the difference between money entering and money leaving a given country. If the balance of payment becomes lopsided and the country needs to pay out more money than it is taking in, it will lose foreign investment.

The abrupt decline in the value of a currency associated with a currency crisis occurs when a government artificially ties the value of its currency to another. Typically, in order to maintain this value for its currency, it must have and occasionally use its foreign reserves — i.e., supply of foreign currency— to buy back some of its own currency. This procedure allows the government to minimize inflation domestically and maintain the same exchange rate internationally.

When investors lose confidence in currency, they will exchange it for other assets. The currency will return to the country's domestic economy, and the government will be forced to use more and more of its foreign reserves to buy its own currency and keep it out of circulation. During a currency crisis, foreign reserves are expended rapidly. When they are exhausted, an economic crisis results.

At some point in the process, a government will need to modify the exchange rate for its currency or allow its currency to "float," or trade freely. Anticipation even will amplify the ongoing economic crisis, since foreign investors will be particularly eager to sell the currency bound for devaluation. Switching to a floating exchange rate, however, may help an economy in the long run by decreasing the likelihood of another abrupt crisis.

A wisely-cited example of a currency crisis is the Mexican peso crisis of 1994. Mexico had a fixed exchange rate that attached the value of the peso to the U.S. dollar. A variety of political and economic domestic problems caused investors to sell off their pesos, overwhelming the Mexican government's ability to maintain its exchange rate using foreign reserves. The government was forced to detach the value of the peso from the dollar, causing a rapid decline in its value. The U.S. was able to soften the blow of the inflation by buying up some of the surplus pesos.