October 22, 2013
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The Reasons behind an FX Trading Currency Crisis

This article looks at what an FX trading currency crisis and how central banks behave when faced with this crisis.

FX Trading Currency Crisis

In previous years there have been several cases of FX currency traders who were caught off guard when trading.  This has lead to capital flight, runs on currencies and detrimental losses on their part.  Yet, the question remains: what makes currency traders and investors behave in this manner?  How does a good trade turn into a bad trade?  This article will examine FX trading currency instability and what causes it.

What exactly is an FX trading currency crisis?

An FX trading currency crisis refers to the decline in value of a particular country’s currency.  This decrease in value will lead to instabilities in the country’s economy via changes in interest rates, employment and inflation.  The alteration in exchange rates in probably the most important to a forex trader as this means that one unit of currency can no long purchase as much of another currency that it used to.  To be effective when FX trading you must have an understanding of these effects and the implications of currency on the market.

Currency crisis and central banks

New traders must be aware that there are various players affected and involved with the emergence of a currency crisis.  When faced with the possibility of a currency crisis, the central banks of a country will attempt to maintain the present fixed exchange rate.  This is done by utilising the country’s foreign currency reserves.  In some cases the central bank may choose not to do this allowing the exchange rate to fluctuate rather than manipulate it.  Below is a more detailed explanation of these behaviours.

1. Using the foreign reserves

When the FX trading market depreciates in value, the downwards pressure placed on the currency can be lifted by an offset in an increase in the country’s interest rate.  To cause this increase, central banks must shrink their money supply by selling foreign reserves and creating a capital outflow.  When receiving the payment for foreign reserves in the form of local currency, the central bank will be able to hold it as an asset.

2. Allowing a devaluation

However, this coping mechanism is not a permanent solution as there are other social factors that cause a decline in currency value such as unemployment rates.  Devaluing the currency by increasing a fixed exchange rate will result in domestic goods being cheaper than international goods.  This not only causes job creation but also increases the level of commodity outlay.   It should be noted that devaluation does lead to a short-term rise in interest rates which must be set off by the central banks increase in foreign reserves.

The characteristics of an FX trading currency crisis

The financial market is highly unpredictable, and predicting the likelihood of a country facing a currency crisis requires thorough analysis of complex factors.  Below are some common variables that must be examined:

  • The country’s currency values.  If the values have increased there is a likelihood a crisis is to follow.
  • Is the country borrowing money from other countries?  This could lead to public debt and currency instability.
  • Political instability and government uncertainty.  This imbalance can lead to a poor economy and a lack of foreign investors.

 

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