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.
When a country introduces a peg, the consequences do not always turn out to be positive. A country that is facing economic imbalance normally becomes the victim of high inflation and budget deficits. As a result, the affected country may use a reserve currency to peg its own legal tender. The domestic economy may get a boost out of this move, but it may soon collapse.
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.
When government creates lot of credit, which is normally the result of a peg, there tends to be an improved capital flow and a larger reserve capital. However, this lowers foreign interest loans to the domestic legal tender. As a result, borrowers and banks start taking credit in foreign currencies so as to incur lower costs. In the end, this will result into a 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.
Bubbles in the real estate sector can also cause economic instability. For a while, there is an expansion in the in the value of the domestic credit as well as equity markets. However, as the property industry stabilizes, prices begin to fall. When this happens, it results into bank runs, and banks consequently suffer from accumulated unpaid loans. High interest rates soon follow, which creates currency crisis.
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 is also a major problem in many developing economies. When government officials are overly corrupt, the country fails to secure credit through stable channels. As a result, the limited options left include volatile credits that may damage the economy.
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.
When a country introduces a peg, the consequences do not always turn out to be positive. A country that is facing economic imbalance normally becomes the victim of high inflation and budget deficits. As a result, the affected country may use a reserve currency to peg its own legal tender. The domestic economy may get a boost out of this move, but it may soon collapse.
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.
When government creates lot of credit, which is normally the result of a peg, there tends to be an improved capital flow and a larger reserve capital. However, this lowers foreign interest loans to the domestic legal tender. As a result, borrowers and banks start taking credit in foreign currencies so as to incur lower costs. In the end, this will result into a 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.
Bubbles in the real estate sector can also cause economic instability. For a while, there is an expansion in the in the value of the domestic credit as well as equity markets. However, as the property industry stabilizes, prices begin to fall. When this happens, it results into bank runs, and banks consequently suffer from accumulated unpaid loans. High interest rates soon follow, which creates currency crisis.
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 is also a major problem in many developing economies. When government officials are overly corrupt, the country fails to secure credit through stable channels. As a result, the limited options left include volatile credits that may damage the economy.
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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