Question

Q6. Explain why intervention to support a currency before a financial crisis often fails, while intervention to push down a currency can be more effective.

Answer 1

Among the reasons of a likely financial crisis, two major reasons are- regular capital outflows from a country, and a significant trade deficit (where the total value of imports outweighs the total value of exports).

In such cases, it helps to devalue the currency of the country, i.e. to deliberately adjust the currency downward (by the country's government institutions) with respect to other foreign currencies. The way it becomes helpful is that after devaluations, the same amount of foreign currency buys more quantities of the country’s currency than before the devaluation. This implies that the country’s products and services are likely to be sold at lower prices in other countries' markets, making them more competitive.

Moreover, currency devaluation would also increase the cost of imports, as lesser foreign goods will be available at same price, this would decrease the demand for imported goods in the country thus boosting its domestic consumption & protecting domestic industries.

This has recently been seen when China devalued its currency in Augst 2019 for first time in a decade as a counter move to the tarriffs imposed by the US government on Chinise products.

On the other hand, intervention to support a currency before a financial crisis would have the reverse effect, i.e. its products & services would likely be sold at higher prices in foreign markets which will most likely reduce the demand for its products & services further adding to the countriy's financial woes thus leading to failure of the effor to support the currency.