The Impact of Regional Financial Crises on the Forex Market

The forex market is among the most extensive and dynamic financial markets globally. It is, consequently, very sensitive to economic, political, and financial events around the globe, especially in particular regions. Evidence of this is the region-specific financial crises, such as those which happened in larger economies, that have been known to create huge volatility in the currency, thereby affecting the forex market’s trends. This article by Toofan Trading Academy looks at how regional financial crises affect the forex market and the channels through which such impacts are transmitted to the currency markets.

1. Understanding Regional Financial Crises

Regional financial crises usually occur quite suddenly in a country or group thereof and can include anything from stock market crashes, defaults by governments on their debt, high-inflammatory spikes, or sharp devaluations of local currencies. Examples include the East Asian financial crisis in 1997, the Argentine crisis in 2001, and Greece’s debt crisis over the past decade.

These crises are usually caused by one or a combination of factors that involve inappropriate fiscal policies, dependence on foreign capital, political instability, and external shocks.

2. Reaction of Forex Market to the Crisis in the Region

It is an international market where currencies are traded in various forms. The forex market shows a reaction to economic and political events across the globe, and regional financial crises, especially those affecting major economies, tend to lead instantly to sudden fluctuations of the rate of exchange, shifts in trading volumes, or even alteration of policies by central banks to contain the crisis.

Read More: Impact of Global Economic Crises on Forex Market: An Analysis

a) Devaluation of Local Currencies

The devaluation of currencies in affected countries or regions is among the first impacts that regional financial crises usually have. In crisis-like situations, investors lose confidence in the local currency and immediately shift to more stable ones such as U.S. dollars, Japanese yen, or gold. As a result, the demand for stable currencies appreciates while the value of the local currencies is severely depressed.

For example, in the East Asian financial crisis, 1997, most Asian currencies including the Thai baht and Indonesian rupiah had fallen in value as global investors pulled out of those countries in favor of safe assets.

b) Rising Demand for Safe-Haven Currencies

It is common for “safe-haven” currencies, such as the U.S. dollar, Japanese yen, and Swiss franc, to be in extremely high demand during economic crises. Investors like to move their funds toward investments that carry lower levels of risk when things start to get turbulent. Because of this, these currencies typically rise in value when regional financial crises occur.

When there was a Greek debt crisis in the 2010s, many investors fled to the euro and sought refuge in the U.S. dollar, along with other safe-haven currencies, which strengthened their values.

c) Changes in Monetary Policies

Central banks of countries or financial regions where crises are witnessed often adjust monetary policies to prevent further devaluation of the currency and to control inflation. Standard moves include hiking interest rates or controlling the currency in some ways to assume command over the crisis. The changes in monetary policy will immediately influence the forex market.

For example, the central bank of Turkey, in 2018 during the economic crisis of Turkey, sharply increased the interest rates to prevent further declines in the Turkish lira. Such a situation resulted in remarkable changes in the rates of currency exchange and seriously affected the forex market.

3. Global Markets and Forex: Spillover Effects

Beyond the local currency effects and the safe-haven currencies, regional financial crises may spill over into global markets and other currencies. In countries with robust trade interdependencies, the crisis could quickly spill over and result in widespread currency fluctuations.

a) Diminished Demand for Goods and Exports

These regional financial crises are often characterized by decreased demand for both goods and services. Those countries relying on exports might be confronted by reduced demand from crisis-affected countries, which could impair the value of the currencies in countries highly reliant on export to those areas.

For example, in the economic crisis in Greece, European countries which relied on trade with Greece saw a drop in export, weakening the euro.

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b) Systemic Risk and Chain Reactions

Sometimes, a regional financial crisis cascades into systemic and spreads to other regions and the global markets. Since a region may make up a substantial part of the world economy, its financial crisis can make other currencies fall and contribute to sharp fluctuations in the forex market.

An example of such a crisis is the financial crisis in 2008, initiated in the U.S. What initially happened in the American housing market quickly expanded to other world financial markets and significantly changed the proportions of currency exchange rates globally.

4. Conclusion

The regional financial crisis has left a mark of huge impact on the forex market. From the depreciation of local currencies and heightening demand for safe-haven currencies, monetary policy changes, to secondary effects on worldwide economies, such crises often play an important role in altering forex market trends. Traders in forex should always be observant with continuous changes in regional and global economic and political situations, shaping their strategies according to these changing positions so as to either fully exploit unexpected market fluctuations or limit probable losses to a minimum.