Looking at how it is that currency price movements have been such a major influence on investment positions over the last decade (as either an investment in itself, or as a driver of investment value), investors have a serious incentive to take a moment to understand what is it that drives currency price volatility in the first place.
Specifically, because of the way in which currency crises have been a key factor behind many of the great equity crashes of since the 1970s, we can look at these extreme tendencies to understand how it is that currencies as a whole adjust to market conditions. Specifically, we’re going to start by evaluating the supply of money’s relationship to its respective economy, and how it is that central banks need to manage their cash levels to create balance.
Money supply in itself cannot really act as an indicator of a currency’s ability to support an economy. In order to understand its role in supporting a currency’s value it must be taking into consideration against the actual demand for that currency in markets, as well as the ability of the central bank to support the value of that particular currency as a function of its office foreign exchange currency reserve. This is most easily visualized by imagining a small developing country with a large natural resource base.
The value of this country’s currency will mostly be supported by foreign demand for the exported natural resources that the country can offer. As larger countries import raw materials from the developing nation, they do so in the smaller country’s currency, and support the value of the local economy. From there, the smaller government will be exchanging their currency for foreign ones, and will build up an FX reserve that can be used to trade on the open markets for their own currencies in slower periods. Through the accumulation of this central FX reserve, we can see how it is that responsible government are in a position to support their currency values by buying up the outstanding amounts of their currency on the market in exchange for foreign money.
Ideally, the end result is an amount of stability, as the smaller nation will have such a small trading volume on its own currency that they will be able to make meaningful trades for or against their own value. However, as the size of the economy as a whole grows, developing countries become incrementally less able to take these sorts of steps to control their currency values.
As an economy grows, and as its currency becomes more heavily traded due to the growth, governments lose control over their ability to influence their domestic currency prices. This is because of the way in which the larger transactions in the currency markets for their domestic currency can actually exceed the value of their FX reserve accounts, to the point at which even the government does not have enough foreign reserves available to make a material impact on their currency value.
Unless the government has been able to accumulate an FX currency reserve account that grows at the same rate as the volume of transactions on that currency itself (not likely, unless the government is running an extremely aggressive tax regime) they will lose their ability to make material transactions against the currency itself. The end result is that they will only really have access to inflation as a means of making a material transaction against their currency price, while buying back the currency to support demand will be nearly impossible.
Looking at how it is that a developing country needs to maintain an FX reserve that is strong enough to support its domestic currency price against the sheer volume of foreign exchange transactions occurring with that currency in the markets, in investor can come to a conclusion about how it is that the comparative supply of money in an economy might be an indication of an impending currency crisis.
After evaluating the comparative capacity of the FX reserve, an investor can look at the growth in the inflation rate against both the growth in GDP, as well as the growth in currency exchange transactions to determine if the government is cashing in on an unsustainable currency price spike. If we see that inflation is growing at a rate that exceeds both GDP growth and currency exchange volumes, there is a strong indication that the country’s currency rate is unsustainable, and might be exposed to a currency crisis in light of an economic event that reduces demand.