Tuesday, December 9, 2008

What Causes a Currency Collapse?

This year we have witnessed many currency's suddenly collapse. Iceland, Argentina, Hungary, Ukraine and others have all seen a sharp fall in the value of their currency. What causes this? and are other economies at risk?

Causes of Currency Collapse

1. Inflation.

Inflation reduces the value of money. If there is rampant inflation, then a currency will depreciate in value. For example, the hyper inflation of Zimbabwe is well documented. Inflation makes Zimbabwe currency worth less, so people will try to exchange Zimbabwe Rand for other currencies which will hold its value.
What causes inflation?
  • Printing Money. Note printing money doesn't always cause inflation. It will occur when the money supply is increased faster than the growth of real output.
  • Note: the link between printing money and causing inflation is not straightforward. The money supply doesn't just depend on the amount the government prints. The US has been increasing the monetary base substantially, but, as of yet, it hasn't led to inflation because of other factors influencing inflation.
  • Large National Debt. To finance large national debts, governments often print money and this can cause inflation. This was the case in Zimbabwe. But, national debt doesn't have to cause inflation. Japan borrowed 195% of GDP, yet have very low inflation.
2. Current Account Deficit

A current account deficit means that a country imports more goods and services than it exports. To finance this deficit, they will require a surplus on the financial / Capital account.
  • For example, at the start of this year, Iceland had a current account deficit of around 7% of GDP. They were able to finance this deficit by attracting capital flows.
  • - To give one example, their banks had high interest rates which attracted UK councils to save their money in Icelandic banks.
  • Because they were getting capital inflows from abroad, the Icelandic economy could continue to finance its current account deficit.
  • However, the problem comes when you can no longer finance this deficit - when you can no longer attract capital flows. The global credit crisis meant Icelandic banks were losing money. Therefore, people started to withdraw their savings from Iceland.
  • The capital flows were drying up, this will cause a depreciation in the exchange rate. Basically there is more money leaving Iceland coming in. This will be reflected by the fall in the exchange rate.
Another example, this year, Ukraine had a current account deficit of 6.7% of GDP, but, the IMF says next year it will be able to attract less capital flows, therefore, the maximum current account deficit it could run is 2%. Therefore, the Ukraine currency will devalue to reflect this.

3. Collapse of Confidence

If there is a collapse of confidence in an economy or financial sector, this will lead to an outflow of currency as people don't want to risk losing their currency. Therefore, this causes an outflow of capital and a depreciation in the exchange rate. Collapse in confidence can be due to political or economic factors.

4. Lower Growth and lower interest rates.

Lower rates make it less attractive to save in a country and therefore, there will be a modest depreciation. Lower rates don't usually cause a collapse in a currency, but, they will make the currency less attractive.

5. Price of Commodities

If an economy depends on exports of raw materials, a fall in the price of this raw material can cause a a fall in export revenue and a depreciation in the exchange rate. E.g. Ukraine has suffered from a fall in price of steel.


Anonymous said...

What about the collapse of Sterling Pound?

Anonymous said...

if your referring to the crash in September 92 i would call that a huge devaluation made worse by irresponsible members of our government which by the way they acted clearly lacked brain cells. i wouldn't call that a collapse. if you want to see a live collapse in motion look at the Russian ruble.if russia carries on.