In recent years, Venezuelan Bolivar has become a worthless piece of paper. This case, however, is not extraordinary. Currency crises occur on a regular basis.
It is worth noting, that reasons behind such situations may vary considerably. In this article, we will try to show what factors can lead to a currency crisis. Earlier, however, we will briefly describe how government and central bank can influence currency strength.
Fiscal policy and currency strength
Fiscal policy in simple words is all activities related to the management of the state budget. There are two different sides of it:
- inflows planning (determination of tax rates, debt issuance)
- expenditure planning (distribution of funds collected within the state budget).
Fiscal policy is conducted by government. In order to omit difficult theories we outline two ways in which fiscal policy can be run: recklessly or responsibly (of course it is a big simplification).
Let's start with what we call reckless policy. Two examples:
1. Distribution policy - introducing various types of benefits and subsidies for citizens, who in fact supposed to provide the ruling party a good result in the next elections. These types of activities in many cases reduce people's motivation to work efficiently (or even to take it at all). The problem is that the money given away does not come from the pockets of politicians, but from the taxpayers'.
Since fewer people work, and the need for funds to finance benefits increase, it is necessary either to increase taxes for other working people or to get in debt. Both solutions lead to currency weakening. If taxes are increased, it weakens the economy (foreign investors bypass the country as well as enterprising people leave unless they get special discounts). In turn, the second solution (borrowing) worsens financial situation of the state. Even worse if the debt is incurred in a foreign currency - then the country becomes dependent, for example, on the rating agencies. If they lower the rating, the country's currency weakens, and the country itself has to pay even more for the foreign debt repayment.
By the way, it has to be pointed out that the tax discounts are not considered as distribution policy. Allowances can be used mainly by working people, so this policy does not encourage people to be unemployed and prey on the work of others.
2. Interventionism policy - introduction of subsidies for enterprises, undertakes market intervention. The reason is the same: rulers want to win a group of voters. To this end, they intervene in those industries where many companies are threatened with bankruptcy. Using such free payments government interferes in free market processes. As a result, the economy can not get rid of unprofitable entities, which could be replaced by more effective companies. Such actions weaken economic growth, and therefore hit the currency.
Remember that if we start such a policy of "rescuing" enterprises on a large scale, then entrepreneurs would not have any incentives to rationally manage resources. This would lead to complete inefficiency of the economy. How does such economy work, where no company can fail?
Aforementioned are two clear examples of reckless fiscal policy. At this point, we could also add here a tax system that demotivates the most enterprising and creative people. Example? Keeping income tax. It works on the principle of "who works more effectively pays more money".
Unfortunately, income tax is present in most countries. In this respect, governments are pursuing an unfair, but for them cost-effective policy.
The government can also conduct a fiscal policy in a responsible manner. By this we mean:
- balancing inflows and outflows of the state budget (and ideally prohibit a budget deficit by constitution),
- minimizing all kinds of benefits or subsidies, and getting rid of social support for immigrants for at least 5 years since arriving to the country. In this way, immigrants who want to live in social life (currently popular way of life in Germany or France) are eliminated and attract only those who will drive the economy,
- maximum simplification of the tax system and complete elimination of income tax, which would lead to much faster economic development and inflow of foreign investments. As a curiosity, it should be added that about 80% of the state administration deals with income tax control, while budget revenues from this tax do not exceed 20% (in Poland). Real damage is much greater, as entrepreneurs lose a lot of time for nonsense bureaucracy.
These types of activities stabilize the situation of public finances. If the debt is low, there is no need to increase taxes. In addition, dependence on rating agencies is also relatively low, which means that the government can conduct a more independent policy.
Monetary policy and currency strength
Monetary policy conducted by the central bank is another element that strongly influences the strength of the currency. Monetary policy is primarily related to interest rates setting.
Interest rates really mean the cost of credit. They also determine the level of interest. By controlling interest rates, the central bank actually controls the economy. Lowering the interest rates can be compared to the gas pedal pressure (lower cost of credit, more loans, increase in consumption and investment, lower interest rates on deposits, less incentive to save).
In turn, increasing interest rates can be compared to pressing the brake (more expensive credit, limiting lending, less funds for consumption and investment, higher interest rates on deposits, greater propensity to save).
How does this affect the strength of the currency? Let's say that we stay in Poland and talk about the Polish zloty. If the National Bank of Poland (NBP) lowers interest rates, the currency is more easily available, and thus "less valuable". In addition, interest on deposits falls, which means that some people are looking for a place for their capital in other countries offering higher interest rates. In the end, lowering interest rates weakens the currency.
However, this is not an iron rule. Why? There may be a situation in which the NBP lowers interest rates, but other central banks do so on an even larger scale. In this situation, capital will be more eager to stick to the zloty.
The second example: we may have to deal with the migration of capital to emerging markets. In such a situation, the NBP will lower interest rates, but the enormous capital flowing to Poland will make the zloty strengthened.
Now let's look at the opposite situation and let us assume that the NBP raises interest rates. In this situation, the currency is harder to access, and it is more profitable to hold funds on deposits (they offer higher interest rates). Such a change generally attracts capital and leads to strengthening of the currency. On the other hand, like the above, it is not an iron rule.
It is worth noting here that central banks depend on the Bank for International Settlements and not on the governments of individual countries. There are few exceptions here, one of them is Iran. In any case, subjection of central banks to international institutions means that responsible government policy alone does not guarantee currency stabilisation.
Causes of currency crises
Currency crisis can be triggered by many different factors:
1. Irresponsible central bank policy - let us assume that the economic growth is accelerating, inflation is starting to rise, but the central bank does not work in advance and keeps interest rates unchanged. In this way, it allows inflation to accelerate even further. If the situation gets out of control, there may be a mass outflow from the currency. Fear intensifies if the central bank has small amounts of currency reserves (foreign currency reserves are kept in order to buy its own currency if necessary, leading to its strengthening).
2. Reckless government policy - this topic has already been discussed in the part related to fiscal policy.
3. Coordinated attack on the currency - a relatively common case in recent years. Such attacks occur most often when one of the country conducts a policy that is not following thought of the United States or financial institutions associated with the U.S.. This could be, for example, abandoning the alliance with the U.S., for closer cooperation with Russia or China. Sometimes, in turn, there is no reason and fault of a given country and it lies only in the fact that the country has large oil fields. How does exactly this coordinated attack look like? In the next part of the article we will show several scenarios.
4. Sanctions imposed by other countries - we are talking about serious sanctions that prevent a country from conducting normal trade. An example is the current situation with Iran (the United States forbade other countries to buy Iranian oil).
5. Military conflicts - war makes capital flee from a given country. Situation in Ukraine from several years ago is a good example. To stop the capital outflow, the central bank was forced to raise interest rates to 30%! For comparison, in Poland it is 1.5%, and in the euro area it is slightly below zero.
6. An unexpected change of power that brings far-reaching changes, for example governments takeover by religious fanatics.
7. Other unexpected events - e.g., natural disasters having a huge impact on the economy.
Examples of currency crises along with their causes
When describing currency crises, media most often pay attention to their effects. We hear that "shares are falling", "currency is weakening", "inflation is rising", etc. It is much harder to find out what led to the currency crisis itself.
One of the reasons for currency crises is the government disobedience of a given country. In recent years Turkey was the one which has shown such disobedience. This is the second largest army in NATO, but President Erdogan, who is ruling this country, has decided that he will conduct a multidirectional policy, doing business with both the U.S. and Russia. In this way he caused the West wrath, the effect was a coordinated attack on Turkish lira. As part of such an attack, we have seen:
- more aggressive narrative of American politicians towards Turkey, which in itself led to the withdrawal of some funds from the local market and getting rid of lira,
- sanctions threats against Turkey,
- downgrading Turkey's rating by rating agencies several times (higher the rating the better),
- media campaign against Turkish currency.
In the end, panic around the Turkish currency led to a strong rise in inflation, to which the Central Bank of Turkey responded with an interest rate increase of up to 24%. Recent data suggest that the situation is slowly coming back to normal and Turkey's inflation is falling.
By the way, this story could have ended much worse for Turkey, if not the fact that it has a very low level of debt to GDP (around 30%). In addition, only a small part of the debt is denominated in foreign currencies.
In the case of Turkey, the reason was geopolitical games. Situation is different in the case of Argentina. Currency crises occur with high frequency. However, Argentineans owe it to themselves. During the last two to three decades, the country was ruled mainly by socialists, and their policies have led to the economy collapsing several times.
In order to save state finances: savings and railway companies were nationalized or currency was simply printed. In the end, the Argentine peso was significantly weakening. By the way, it shows that we have double standards. The largest players (EU, US, Japan) can run printing, but everything is done so that it does not lead to the collapse of the currency. Euro or yen problems would have serious consequences, and the situation could get out of the bankers control. In turn, when printing is led in a developing country (e.g., Argentina), its currency quickly collapses.
Everybody must have heard about the dramatic economic collapse of Venezuela. According to the International Monetary Fund, Venezuelan economy has shrunk by 60% since 2013. Drama.
Venezuela is an interesting case because its current situation is the result of both its own mistakes (faith in a centrally planned economy) and an attack from outside. As for the first issue, we do not need to convince anyone. As for the attack from the outside, in the article "How does the United States make coups. Details of the attack on Venezuela." we described the U.S. operation "Masterstroke" which had to worsen the situation in Venezuela. Below the fragment:
- increasing the outflow of foreign currencies from Venezuela, strengthening inflationary trends,
- obstructing imports, discouraging foreign investors, so that the situation becomes unbearable for the Venezuelans themselves,
- generate greater distrust and rejection among people in power,
- ridiculing Maduro and presenting him as Cuba's puppet, eventually forcing to negotiate or leave,
- linking Venezuelan authorities with drug dealers, which would weaken their image in the world,
- establishing contact with potential allies in Venezuela in order to provoke protests, riots, acts of theft, assaults and other forms of public disorder. Causing events that will bring fatalities and then blaming the local government for death of citizens,
- leading to a situation where all sorts of specialists and professionals will run away from the country, which will further weaken Venezuela,
- supporting unstability on the border between Venezuela and Colombia.
Above mentioned actions ultimately lead to takeover of power by Juan Guaido, puppet of the United States.
We should wish Venezuelans that they would take over the power in the country themselves, instead of turning the current inept president into a person subordinated to the United States.
d) Poland 2008 and 2016
In addition to the currency crises itself, we also have short-term currency attacks. It is also worth mentioning them. Two such incidents happened in 2008 and 2016 in Poland. In 2008, there was an attack on the Polish currency, which was extremely expensive back then.
In turn, in 2016, extreme zloty depreciation was achieved. A few months earlier, Polish entrepreneurs bought a huge number of options which were to get more expensive as the euro and dollar strengthened. The problem was that after exceeding a certain level (in case of USDPLN it was 4.16) the option value dropped to zero. Properly carried out attack triggered USD and EUR to jump beyond these levels, and ultimately option holders were left with nothing.
A few years ago Trader21 wrote how the attacks themselves look like. We quote a fragment, however, indicating that the last point is used only in some cases:
1. First, US-controlled global financial institutions get short positions on the currency of the targeted country. For large investors it is a signal that something will happen. Better-informed (commercials) probably know something, and since they are usually right, it may be worth copying their movements. In this way, on the currency market, self-perpetuating pressure on a given currency is triggered.
2. Once we are prepared to make some money from the attack, the servile media starts a campaign against the economy of a given country. Considering that the six largest media companies control about 1,500 television stations, the action is not too difficult to carry out.
3. At this point a very serious outflow of capital from a given country begins. Investors sell shares lowering their prices. They get rid of bonds increasing their yields. The national currency is immediately converted into currencies recognized as safe havens (CHF, USD), thus lowering the local currency exchange rate.
4. When the situation is gaining momentum, the rating agencies are threatening of bankruptcy of the country and usually lower the rating of both the largest corporations and the country to the junk level (non-investment grade).
Currency crises resulting from inadequate government or central bank policies have been a rarity in recent times. Why? First of all, because the vast majority of central banks and governments cooperate with international financial institutions. Everything is coordinated, and the obedience of individual governments gives them the opportunity to use low credit costs. Therefore, regardless of politicians' madness, states are able to postpone the moment of serious problems arrival.
Coordinated attacks on the currency has been a much more frequent cause of currency crises in recent years. Depending on whether the reason for the attack is serious (geopolitics - Turkey, Russia, Iran) or less significant (bankers profits - Poland 2016), different tools are used. In case when it is going to trigger a currency crisis, among others, sanctions against a given country are introduced. When it comes only to an attack aimed at triggering exchange rate movements, it is carried out through a media campaign and movements of large funds.
Speaking of currencies, it's worth adding one important thing. The economic slowdown we have been writing about for several months is becoming more perceived. There is no case in this, that despite the Fed policy reverse, the dollar is getting more expensive. Capital simply flies to the currencies considered the safest. The greater foreign debt (denominated in foreign currencies) of a given country, the more dangerous situation is. Therefore, we are currently avoiding the currencies of developing countries (apart from a small exposure to the cheapest markets), and we keep cash in the dollar and Swiss franc. If the economic situation somehow suddenly does not improve, the next months can be really hard for currencies of developing countries.
Finally, word about "experts" who explain to us how important it is to weaken your own currency. It is supposed to be the key to driving the economy, because exporters can easier sell products and services. In our opinion, the currency should be properly balanced. Stability of the currency (and not its constant devaluation at all cost) means that a better environment for investment is created, and the economy attracts professionals. It was on the basis of a stable currency that Germany rebuilt its economic potential after the World War II. Do not be fooled by the pseudo-wisdoms of experts, because they are actually produced to justify high inflation. And inflation is nothing but a tax.
Independent Trader Team