The currency crises of the 1990s may have been influenced by reverse herding, the process in which money managers are less concerned about a crisis than they should be. Markets seemed complacent before these crises, even though there were reasons to believe that the next crisis might come. Reverse herding may explain this phenomenon in a principal-agent kind of story.
South Korea
The recent global financial crisis and the collapse of Lehman Brothers have had a devastating impact on the country’s financial institutions. The global credit crunch resulted in local banks having a difficult time acquiring foreign currency. This made it difficult for them to refinance loans in foreign currencies to domestic SMEs. This was particularly hard on South Korean banks with high loan-to-deposit ratios.
As a result, the Bank of Korea (BoK) stepped in to stabilize the won and alleviate funding pressures. In the process, the BOK set aside $55 billion in foreign exchange reserves and entered into swap arrangements with major trading partners.
Argentina
Argentina’s peso, the country’s currency, has suffered from a series of contagious currency crises. In 1993, economists said that pesos in Latin America were overvalued. They also suggested that the peso was overvalued because there was no constraint on monetary expansion. However, these claims proved to be wrong. The peso depreciated, and the country found itself in another currency crisis.
Argentina’s currency crisis illustrates the dangers of fixed exchange rates in a country. Eventually, such a system will lose credibility and will suffer severe disruption in its real economy. Consequently, a floating exchange rate may be a better policy in the long run.
Brazil
The series of contagious currency crises that gripped Brazil during the 1990s can be traced to several factors. First, the Brazilian economy was buffeted by a series of external shocks, including the East Asian and Russian crises. Political factors also played a role. The Brazilian government responded to the contagion effects of these shocks by raising interest rates. When the shocks were overcome, interest rates fell back. In the meantime, the Brazilian economy experienced excessively high and unstable interest rates, which led to a fluctuating growth rate.
Another factor that contributed to Brazil’s problems was the lack of a credible adjustment program. The government adopted an exchange rate-based stabilisation policy in 1994. This policy aimed at gradually reducing the inflation rate. The real was pegged to the US dollar at a ratio of 1:1. The Brazilian currency moved from a surplus of 1% of GDP in 1992 to a deficit of 4.5 percent in 1998, which caused a major drop in competitiveness and economic growth.
Spain
The Spanish peseta joined the European exchange rate mechanism in June 1989, about ten years ago. During its first 10 years, the peseta was renowned for its non-inflationary growth and rapid economic convergence. However, recent currency turbulence has led to criticism of the system, punctuated by the three devaluations of the Spanish currency since September 1992. Critics have accused the European exchange rate system of slowing growth, limiting competitiveness in several states, and anchoring the peseta to Germany. Although these criticisms may not seem as devastating today as they were at the end of the last decade, the ramifications are still a reality.
The results indicate that speculative attacks are temporally correlated and that the currency crises spread more easily to countries with similar macroeconomic conditions and close international trade links. The data, though, do not support the hypothesis that currency crises are caused by differences in the macroeconomic conditions of countries in the same region. However, this view does not imply that the spread of currency crises between countries is contagious.
Portugal
Portugal has become the second most risky country in the euro zone after Greece, with bond yields above ten percent, and its debt to GDP ratio spiking above 50 percent. This does put it in a very vulnerable position for further euro zone crisis flare-ups, since Spain is its largest export market. Portugal’s government has promised to take measures to ensure the country’s financial future.
United Kingdom
Currency crises are a global phenomenon, with different causes in each country. They’ve been caused by a variety of factors, including a political economy, economic history, and the policies of national central banks. While each crisis is different, they can have a similar impact on a country’s economy. One of the most recent examples is the recent British devaluation, which left the government in a difficult position but did little to undermine confidence in its institutions.
A currency crisis remains a speculative attack on the value of a foreign currency. It leads to sharp depreciation and forces the government to defend its currency by selling foreign exchange reserves or raising domestic interest rates. A currency crisis is considered a serious problem when its value depreciates by at least 25%, or by ten percent or more compared to its value in the previous year.