Definition
A foreign exchange crisis is an economic emergency in which a country runs out of dollars or other foreign currency just when it has to repay debts borrowed abroad or pay for imports. In Korea, the term points above all to the 1997 crisis that led to the IMF bailout. No matter how much domestic money a country has, it faces a national default crisis if it has no currency that works in international trade.
Why can a country default even with plenty of its own money?
Imagine you travel abroad and walk into a restaurant. Your wallet is stuffed with Korean won, but you have not a single dollar or any local cash. No matter how much won you hold, the owner will not accept it, and you end up in a tight spot.
A national economy works the same way. At home, you can buy and sell anything with won. But when a country buys crude oil, natural gas or grain from abroad, or repays a loan from a foreign bank, the other side does not take won. It needs foreign currency that is accepted everywhere in the world, such as the dollar, the world's reserve currency.
Normally, dollars keep flowing. The country earns them by exporting, and foreigners bring more by investing at home. But once foreign investors sense trouble and start pulling their money out all at once, converting it to dollars and leaving, everything changes fast.
The dollars in the market dry up in an instant. Banks and the government's vaults run empty, and the country falls into a state of foreign currency insolvency, unable to repay its external debts.
What happens to the economy when a crisis hits?
When a foreign exchange crisis breaks out, the first thing to happen is that the exchange rate shoots up. With dollars extremely scarce in the market, the dollar's value soars. If the rate jumps from 1,000 won to 2,000 won per dollar, the won price of every imported good doubles overnight.
As oil and raw material prices surge, prices at home spiral out of control. Companies that borrowed in dollars now owe twice as much in won, and they go bankrupt one after another.
When companies collapse, the banks that lent to them fall in a chain reaction. Many workers lose their jobs, and a severe recession sets in.
In the end, to prevent a total collapse, the country asks the International Monetary Fund (IMF) for an emergency bailout loan. But this money is not free. The country has to accept painful reform conditions: steep interest rate hikes, the clearing out of failing companies, and large-scale restructuring.
To be more precise: is it just overspending?
Many people think a foreign exchange crisis happens because 'the people overspent or wasted foreign currency.' To be more precise, the core cause is said to be the problem of short-term foreign debt and maturity mismatch.
In 1997, Korean financial institutions such as merchant banks borrowed cheap short-term dollars from abroad (maturities under a year) and lent them to domestic companies for the long term (several years or more), earning a profit on the difference. Normally, when the loans came due, they simply extended (rolled over) the debt, and there was no problem.
But when financial anxiety that began in neighboring countries spread, foreign banks all refused to roll over and demanded their dollars back right away. The money Korean institutions had lent was tied up long-term, yet the debt they owed was due tomorrow, so they had no way to hold out. Heavily indebted large companies, such as Hanbo and Kia, collapsing one after another also made the crisis worse. There are several views on which of the two was the more fundamental cause.
So a foreign exchange crisis is not just about waste. It is a liquidity crisis that can hit anyone when a financial structure vulnerable to outside shocks meets a sudden outflow of capital.
Common misconceptions
A foreign exchange crisis happens because people buy too many luxury goods and travel abroad too often.
Individual spending is not the main cause. The core causes are financial institutions borrowing too much short-term foreign debt, a weak system for managing foreign exchange, and sudden capital outflows from international financial markets.
Where you meet it
In 1997 in Korea, foreign investors pulled out their short-term money all at once, Korea's foreign exchange reserves ran dry, and the country received an IMF bailout.
Mexico's 1994 peso crisis and Argentina's 2001 debt default were also foreign exchange crises, caused by a shortage of foreign currency and a surge in the exchange rate.
In one sentence
A foreign exchange crisis is a liquidity crisis in which the dollars needed for international trade and debt repayment run out and the whole national economy freezes up.