Question

Why do currency crises make financial crises in emerging market economies more severe?

Answer 1

Lets try to understand this with an example.Assume an emerging country like India.There exists both importers and exporters,The currency is valued or exchanged at international rates .Lets assume there is a currency crisis with the value of Indian currency ie Rupee plunging in the international market.In such a scenario,the import will be costly.A developing country depends on foreign goods and services for its development.Weaker rupee will escalate the cost and slow down the activities.Projects get stalled,people lose jobs.Hence a financial crisis sets in.

On the other hand lets assume the currency is too undervalued,which means the exporters are all cheers but the importing country like US may impose trade restrictions to cut the outflow of dollars.hence currency valuation plays a vital role in emerging markets.

Another thing is that when a currency crises occurs due to defaultment of bonds by a central bank or government,it affects the financial credibility of the nation.Nobody will invest the nation.This will finally lead to financial crisis.

Note-ban or demonitization is another good example wherein the country suddenly feels the pain .There is no proper money flow ,which means industries dont have money to payup.There are job losses.Thus a financial crisis can happen.

Historically currency crisis has put a nation at default risk ( example European Countries like Spain,Italy) or resulted in negative ratings from global agencies leading to negative sentiment.The impact of such complications cause far more consequenced in financial crises.