currency crisis

Picture a bank where everyone trusts their deposits are safe — until a rumour spreads that the bank is shaky. Suddenly everyone rushes to pull their money out at once, and the very panic makes the bank collapse, even if it was basically sound. A currency crisis is the same dynamic played out on a whole country's money. Confidence in a currency suddenly evaporates, holders rush to sell it for safer foreign money, and the currency plunges in value, sometimes losing half its worth in days.

Crises often strike countries trying to defend a fixed or pegged exchange rate. The trigger is usually a loss of belief that the peg can hold — perhaps because the country is running big deficits, has weak reserves, or has borrowed heavily in foreign currency. Speculators, sensing the government cannot defend the rate forever, sell the currency aggressively (a 'speculative attack'). The central bank fights back by spending its foreign-exchange reserves to buy its own currency and by jacking up interest rates to make holding it attractive — but if reserves run dry, it must surrender and let the currency collapse. Cruelly, the attack can be self-fulfilling: fear of a fall causes the selling that causes the fall.

Currency crises are devastating because they rarely come alone. A collapsing currency makes imports and foreign debt explode in cost, so banks and companies that borrowed in dollars suddenly cannot repay, turning a currency crisis into a banking and economic crisis all at once — a 'twin' or 'triple' crisis. The 1997 Asian crisis, Argentina's 2001 collapse, and Mexico's 1994 'Tequila crisis' all followed this pattern, throwing millions out of work. The hard lesson is that pegs and foreign-currency borrowing offer comfort in good times but can turn a loss of confidence into a catastrophe with terrifying speed.