Since the early 1990s, many investors have been caught unprepared by economic instability. This has always led to capital flight and runs on currencies from international financiers. Whether these actions are guided by gut instinct or quantifiable measures is unclear. However, such circumstances are avoidable if people can understand the cause of crisis currency. Below is a discussion of some common causes and how to avoid the situation.
The problem normally begins when a country introduces a peg. Most developing countries that suffer from financial instabilities like budget deficits and excessive inflation are the common culprits. In a response to bring the situation under control, the country may have to use a reserve currency to protect its legal tender. Although this may stabilize the domestic economy, the over-reliance on foreign exchange by investors can be disastrous.
Globalization and capital flows. The globalization of financial markets has greatly increased capital mobility. Financial deregulation, the liberalization of local markets and the elimination of capital controls, the ample creation of derivatives has intensified competition in the financial Industry and reduced transaction costs. However, these improvements pose a danger to emerging economies because they do not have well-organized banking institutions that can control the cash flow.
Excessive credit creation can also become a big problem. When there is a peg on the domestic currency, the reserve capital rises and cash flow increases into the local market. Consequently, the lower foreign interest rates will compel banks and other firms to seek credit in foreign denominations. In the long run, the country could face financial distress.
There is also the danger of moral hazard. Liquidity in the financial market causes local banks to ease their conditions for giving out loans. This is because they are protected from losses by hidden government guarantees. This way, they would result with immense profits in the event that the balance favors them, but the taxpayers will shield the burden in case of losses.
Real estate bubbles and bank runs. In most cases, the expansion of domestic credit generates a boom in the property industry and equity markets. However, the boom is soon followed by fall in prices as the market becomes saturated. This leads to an accumulation of unpaid loans. Most of the policies introduced to curb the situation normally lead to high interest rates.
Contagion of currency crises. Many other factors may contribute to a financial distress. These include pessimism from investors about the credit worthiness of a country, high volatility of short-run capital, a current recession, a new institutional framework, political unrest, and even liberalization of local markets without flanking regulative measures. All these factors are considered by investors and they may create doubt on economic potential.
Corruption and nepotism are also major problems, especially in developing countries. The country may not be able to access foreign investment alternatives that are more stable. As a result, it may be forced to seek the volatile foreign credits. This may save the situation but will take a toll on the domestic capital.
Many more factors may drive a country into crisis currency. However, this situation can be avoided by introducing financial policies that target long-term development and growth. In order to create capital outflows, a country may consider selling its foreign reserves. This would demand that payment be made in the domestic money. This would, therefore, create a locally denominated asset.
The problem normally begins when a country introduces a peg. Most developing countries that suffer from financial instabilities like budget deficits and excessive inflation are the common culprits. In a response to bring the situation under control, the country may have to use a reserve currency to protect its legal tender. Although this may stabilize the domestic economy, the over-reliance on foreign exchange by investors can be disastrous.
Globalization and capital flows. The globalization of financial markets has greatly increased capital mobility. Financial deregulation, the liberalization of local markets and the elimination of capital controls, the ample creation of derivatives has intensified competition in the financial Industry and reduced transaction costs. However, these improvements pose a danger to emerging economies because they do not have well-organized banking institutions that can control the cash flow.
Excessive credit creation can also become a big problem. When there is a peg on the domestic currency, the reserve capital rises and cash flow increases into the local market. Consequently, the lower foreign interest rates will compel banks and other firms to seek credit in foreign denominations. In the long run, the country could face financial distress.
There is also the danger of moral hazard. Liquidity in the financial market causes local banks to ease their conditions for giving out loans. This is because they are protected from losses by hidden government guarantees. This way, they would result with immense profits in the event that the balance favors them, but the taxpayers will shield the burden in case of losses.
Real estate bubbles and bank runs. In most cases, the expansion of domestic credit generates a boom in the property industry and equity markets. However, the boom is soon followed by fall in prices as the market becomes saturated. This leads to an accumulation of unpaid loans. Most of the policies introduced to curb the situation normally lead to high interest rates.
Contagion of currency crises. Many other factors may contribute to a financial distress. These include pessimism from investors about the credit worthiness of a country, high volatility of short-run capital, a current recession, a new institutional framework, political unrest, and even liberalization of local markets without flanking regulative measures. All these factors are considered by investors and they may create doubt on economic potential.
Corruption and nepotism are also major problems, especially in developing countries. The country may not be able to access foreign investment alternatives that are more stable. As a result, it may be forced to seek the volatile foreign credits. This may save the situation but will take a toll on the domestic capital.
Many more factors may drive a country into crisis currency. However, this situation can be avoided by introducing financial policies that target long-term development and growth. In order to create capital outflows, a country may consider selling its foreign reserves. This would demand that payment be made in the domestic money. This would, therefore, create a locally denominated asset.
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