The foreign exchange market offers to meet to exchange one currency for another, such as the exchange of the euro for the dollar
This can include banks but also companies that work with several currencies.
These currencies move from one agent to another according to their exchange rate. This exchange rate can change over time depending on many microeconomic and macroeconomic factors.
What happens when a currency loses a lot of its value?
When a currency loses value, at least 30% of the value of the dollar, it is said that the country has a currency crisis. This can happen if a country does not aspire to confidence with high inflation and especially if it has a large budget deficit
For fear of a fall in the value of the currency, the players get rid of this currency on the foreign exchange market. This event can be multiplied if speculators anticipate the loss of currency value. Thus, by selling it as long as it is still high, it is possible to make a significant profit, especially so that it can then be bought back at a lower price once it has devalued.
This is called a self-realization crisis. Indeed, by selling the currency, these speculators lower the value of the currency by increasing supply and decreasing demand.
The consequences of a currency crisis on the economy
A currency crisis has strong consequences for a country and its economy. Let’s take an example to illustrate this:
If a Swedish bank borrows $300 when one Swedish krona is equivalent to $0.12, it will have to repay 2500Kr. However, if before the repayment date, the Swedish krona loses its value (say -30%) and is only equivalent to $0.084, the Swedish bank will have to repay nearly 3571Kr for the same amount borrowed. Thus, the lower the value of a currency, the more banks indebted in foreign currencies may have repayment problems.
What to do in the face of this type of crisis?
In the face of this type of crisis, financial institutions can take action.
Central banks can increase their key rate, the rate at which they lend money to other banks, so that the latter also increase their interest rates and speculators have more difficulty borrowing and therefore buying foreign currency. This will slow supply and maintain a supply/demand balance.
Central banks also have the option of using their foreign currency reserves to rebalance supply and demand. Indeed, when central banks’ currencies are weak, they can sell their foreign currencies against their own currency in order to increase their demand and therefore their price.
However, by doing so, businesses, banks and households are all affected by this increase in the policy rate. They may not be able to borrow, repay and lend money. As a result, investments can be slowed or even stopped, growth slowed and in some cases, some banks may fail. This is called a banking crisis.
The value of a currency is an essential element for a country because it can be at the origin of different crises, including a banking crisis.
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