Associated Press
A Chinese clerk counts U.S. dollars in exchange for the Chinese renminbi at a bank in Hefei in central China's Anhui province Sunday June 20, 2010. (AP Photo)

One lesson from the 2007 recession is that financial crises have widespread, real effects. Often, particularly in small open economies, a financial crisis is linked closely to the exchange rate. One of the major concerns with Greece and its fiscal crisis, for example, has been that it will drop out of the Euro area and devalue its currency. Similar concerns drove a crisis in Argentina in 2002 and were a major underpinning of the Asian financial crisis in 1997-98.

Foreign currency crises are almost always speculative attacks, which involve massive movements of capital in anticipation of a huge and sudden future movement in the value of a foreign currency. This always involves a currency which has been pegged — formally or informally — to the value of another currency. Under floating exchange rates, the value of a currency changes continually and movements are usually comparatively gradual. When a change in exchange rates does occur under a fixed system, it tends to be a sudden, major devaluation.

Central banks hold two major types of assets: foreign reserves and domestic assets. Foreign reserves are denominated in some “hard currency”, such as dollars, euro, yen, etc. Domestic assets are usually government bonds. Most central banks hold a much greater proportion of domestic assets than foreign reserves. If a central bank is pegging its exchange rate to the dollar, it is guaranteed to be the buyer or seller of last resort, and hence has agreed to trade domestic banknotes and reserve deposits for dollars, on demand.

The supply and demand for the currency will fluctuate from day-to-day, and if the pegged value for the exchange rate is “right,” then some days the central bank will be a net buyer of its own currency and on other days a net seller. Thus, the stock of foreign reserves it holds will also fluctuate from day-to-day. If, however, the pegged value is “wrong”, the central bank will be forced to buy continually or sell continually for an extended period. If the pegged value is too low for example, there will be an excess demand for the currency and the bank’s foreign currency reserves will rise. At the same time, the bank will be creating new money to exchange for dollars. If this continues for a long period, it will lead to inflation, but not a currency crisis. If the value of the peg is too high, however, there will be an excess supply of currency and the central bank will be the one buying the excess. This will lead to a decrease in foreign currency reserves and a drop in the money supply.

What happens if the bank continually sells off its foreign currency reserves while maintaining a pegged value? If the excess demand continues long enough, the bank will run out of foreign currency reserves. At this point, the bank will be unable to maintain the peg and the currency will “float;” that is, it will jump down to the market clearing level, resulting in a sudden and large drop in the value of the currency.

Now imagine you are a U.S. resident who owns assets denominated in the domestic currency. What do you do if you think that the central bank’s holdings of foreign currency are about to run out? Would it not be prudent to exchange these assets now for dollar denominated ones, before they suddenly drop in value when the exchange rate falls? Would you be the only one thinking this? As a result of this type of thinking, the supply of domestic currency will rise dramatically as investors rush to liquidate domestic currency assets and exchange the money from the sale for dollars. Home residents would be thinking similarly. If they can exchange their domestic currency assets for dollars, then they will make a sudden profit when the devaluation occurs.

Both these phenomena will drastically increase the supply.

Hence, there could be a sudden flood of domestic currency into the central bank and the foreign reserves will fall all the more rapidly. This sudden stampede of funds is called a speculative attack, and it can be self-fulfilling. That is, an otherwise stable currency might be forced to devalue simply because investors believe it is in danger of devaluation.

Note that expectations play a very important role in crises like these. Whenever a bank has low levels of foreign currency reserves, it will be especially vulnerable to attack. Anything that might set off a drop of reserves could ignite an attack — political unrest, bad economic news, corruption in the banking sector, or poor banking practices, attacks on other currencies, and other similar actions can lead to a speculative attack.

Comment on this story

The prudent thing for a central bank in such a situation would be to reduce its domestic money supply, making its currency more scarce and hence more valuable. However, central banks are often reluctant to do so for fear of the contractionary pressure this will put on the economy.

The lesson here is that fixing an exchange rate also requires surrendering control of one’s own money supply. Speculative attacks happen only when a central bank tries to both peg the exchange rate and conduct independent monetary policy.

Kerk Phillips is an associate professor of economics at Brigham Young University. His views do not necessarily represent those of BYU.