Question

Explain when speculative attacks on a currency are likely to happen. List all the conditions that increase the likelihood of speculative attacks.

Answer 1

Speculative attack on a currency refers to a situation where there is sudden heavy selling of a nation’s currency by investors in the foreign exchange market. This situation usually happens when investors strongly believe that the nation’s currency is going to be depreciated or devalued. If the currency depreciates or devalued, then value of the foreign currency invested by foreign investors in the country will get reduced. So, investors will not wait for the currency to get depreciated or devalued, but will take out their money in advance.

Factors that lead to such conditions include

Central bank unable to maintain fixed exchange rate: In countries where fixed exchange rate system prevails, central banks need to hold large amount of foreign exchange as reserve to maintain that exchange rate. This they do by purchasing domestic currency and selling foreign currency to keep the exchange rate fixed. If the foreign exchange reserve of a country declines then it means that the capability of the country’s central bank to keep the exchange rate fixed is low. In such a situation if demand for foreign currency increases due to increased imports then it is very likely that the country might devalue its currency.