27 Speculative Attacks and Exchange Rate Crises
We’ve covered most of the key ideas about exchange rates so far – how they fluctuate, what drives them, and why they matter for trade, investment, and everyday life. Now, let’s take a moment to introduce some important terminology before diving into a fascinating (and sometimes dramatic) topic: speculative attacks and exchange rate crises.
The balance of payments (BoP) is a fundamental concept in understanding exchange rates and currency stability. It represents the financial transactions between a country and the rest of the world, covering trade, investment, and capital flows. The BoP is divided into two main components: the current account and the capital and financial account.
The current account includes trade in goods and services. If a country exports more than it imports, it runs a current account surplus, meaning it is earning more foreign currency than it spends. Conversely, a current account deficit means the country is spending more foreign currency than it earns, often relying on foreign borrowing or investment to cover the gap.
The capital and financial account tracks financial transactions, including foreign direct investment (FDI), portfolio investments, and changes in central bank reserves. Countries running persistent trade deficits need to attract enough foreign capital to balance their payments. If they fail to do so, their currency can come under pressure, leading to depreciation or even a crisis.
Countries with stable BoP conditions – where trade flows and capital inflows are balanced – tend to have more stable exchange rates. However, when imbalances grow too large, they create vulnerabilities that can attract speculative attacks. If investors believe a country cannot maintain its currency’s value due to a widening trade deficit or dwindling foreign reserves, they may start selling off the currency, triggering a sharp depreciation.
Speculative attacks on exchange rates occur when investors believe that a country’s currency is overvalued or that the government does not have enough reserves to defend its value. These attacks often target currencies with fixed or semi-fixed exchange rates, where speculators see an opportunity to force a devaluation and profit from it. The driving force behind these attacks is market expectations – when traders anticipate that a currency will lose value, their actions can accelerate the fall, sometimes turning it into a self-fulfilling prophecy.
A famous example is the 1992 Black Wednesday crisis in the United Kingdom. At the time, the British pound was part of the European Exchange Rate Mechanism (ERM), meaning the UK government committed to keeping the pound’s value within a set range against other European currencies. However, traders, led by billionaire investor George Soros, doubted that the UK could maintain this peg due to economic weaknesses, including high inflation and low competitiveness. Speculators began selling massive amounts of pounds, betting that the government would be forced to devalue. The UK’s central bank, the Bank of England, spent billions of dollars trying to buy back pounds and raise interest rates to attract investors. However, the pressure was too great, and the UK was ultimately forced to withdraw from the ERM, letting the pound devalue. Soros made over $1 billion from this bet, and the event remains one of the most famous speculative attacks in history.
Another striking example occurred during the Asian Financial Crisis of 1997. Thailand, Indonesia, and South Korea all had fixed exchange rates and relied heavily on foreign capital. When investors began to doubt these countries’ ability to support their currencies, speculators started selling off local currencies in exchange for US dollars. As central banks tried to defend their currencies by using foreign reserves and raising interest rates, panic spread, leading to massive capital flight. Eventually, these countries were forced to let their currencies float, causing sharp devaluations. The Thai baht, for instance, lost more than 50% of its value in a matter of months, triggering a deep economic crisis across Asia.
These examples highlight how market expectations and investor sentiment can play a decisive role in determining exchange rates. Even if a central bank has reserves to defend a currency, if the market believes the defence is unsustainable, a speculative attack can spiral out of control. This is why economic stability, strong financial institutions, and prudent policymaking are crucial in maintaining currency confidence. If investors trust that a government has the tools and willingness to back its currency, they are less likely to bet against it.
