Currency Crisis is not a rare term in the Forex market as in the past times also this market had gone through some very tough times and faced much crisis of currency. In this article, we will discuss the main reasons behind the currency crisis and which can help a client to take an informed trading decision and avoid losses.
The first step to defeat your enemy is to recognize and understand it. To understand currency crisis it is mandatory to understand the main reason behind a currency crisis and the main reason behind it is an unstable economy of a country which results in an outflow of investment from the country and thus negatively effects the exchange rates by weakening the domestic currency. In simpler words, a currency crisis is a fast devaluation of a currency because of economic instability and a shift in demands by the investors.
Economic and political health relation to Currency Crisis:
An unstable economy or a sudden political turnaround can result in a currency crisis because in that kind of situation investors often withdraw their money from that economy because of decreased confidence in that country’s economic stability. This process of investment outflow is known as capital flight. Whenever capital flight happens the shift from domestic investments to foreign investment affects the value of the domestic currency in global markets drastically and it usually results in a heavy fall in the currency.
Central Banks defense against Currency Crisis:
Central banks play a very important role in times of a currency crisis because they have a highly effective tool which can help in times of currency crisis and that tool in monitory policy. In times of currency crisis, central banks use the Interest rates to support the domestic currency by increasing the demand for the domestic currency by increasing interest rates. To increase the Interest rates to support the currency the central banks needs to lower the money supply in the market to increase the demand for the domestic currency.
Selling the foreign reserves also plays a very important role in the support system of domestic currency because selling foreign reserves creates capital outflows and the result of the selling process is an increased domestic reserve because the payments in exchange of foreign reserve is received in the domestic currency which can be used as an asset by central bank to hold the falling currency.
How to predict a Currency Crisis:
Prediction of a currency crisis is very complex processes in which we have to take into account all the micro and macro factors which can affect a countries foreign reserve and economic health. Below we had described a few important factors which can help you to analyze and predict currency crisis before it happens.
- Heavy Foreign Debt
The most reliable indicator of a countries health is the level of foreign debt it is carrying. A country which relies on foreign funds to function properly should always be the last in the list as these are the riskiest economies and the risk of a currency crisis in that kind of economies is very high.
- Huge current account deficits
A huge current account deficit is a very serious threat to a countries economy as it creates a huge deficit in the foreign reserves which plays a very important role in the regulation of currency exchange rate management.
- Unstable political situations
An unstable political atmosphere is a clear indicator of a future crisis. In the absence of a strong political governing structure, it is nearly impossible for a country to grow.
The Bottom Line
For a Forex trader Currency crisis prediction can be the game changer. If a Forex trader pays close attention to the economic and political structure of a country and able to analyze and predict the future consequences of the current developments he can predict a currency crisis and use that heavy bearish movement to make profits out of the market by shorting the weak currency and going long on a comparatively strong currency.
A Forex trader should always keep an eye on the important economic indicators as these are the tool which can help a trader to predict the direction of the currency. Teaming up these economic report analysis and technical analysis a trader can make huge profits in Forex trading.