Why a Currency Plunge Can Lead to Forex Reserves Burnout

For central banks around the globe, maintaining the stability of their nation's currency is a constant challenge. One of the key tools in this arsenal is the use of foreign exchange (FOREX) reserves. However, when a country's currency plummets, these reserves can be depleted much more quickly than anticipated. In this article, we will explore why a currency plunge can burn through Forex reserves, the mechanism behind such a plunge, and the limitations of central bank intervention.

Understanding the Mechanics of a Currency Plunge

A currency plunge occurs when there is a significant outbreak of demand for foreign currencies relative to a domestic currency. This can happen for various reasons, such as a loss of confidence in the domestic currency, economic instability, or political uncertainty. When this happens, foreign investors and traders start selling off the domestic currency in large quantities, leading to a sharp decline in its value.

Let's take the example of Bxtz (a hypothetical currency) against the USD. If the value of Bxtz starts plummeting, foreigners would be less inclined to hold Bxtz notes and instead would demand more of it in exchange for USD. To prevent this freefall, central banks step in with their abundant supply of USD.

For instance, the central bank might offer to sell 100 million Bxtz at 990 Bxtz to the USD, when the market is offering 1 USD for 1000 Bxtz. This intervention can stabilize the currency in the short term but comes with a critical caveat: the central bank's supply of USD is limited. If the central bank exhausts its reserves, the currency will again quickly decline.

Effect of Forex Reserves Exhaustion

Historical data provide clear illustrations of this phenomenon. During the 1996/1999 Asian financial crisis, the Thai Baht, denoted as BHT, serves as a prime example. The graph of the Thai Baht and Thailand's foreign exchange reserves demonstrates how a significant portion of these reserves was used to maintain the USD/THB exchange rate around 25 baht to the dollar. However, as the crisis deepened, Thailand's reserves dwindled, eventually leading to the collapse of the baht, which plummeted to nearly 60 baht to the dollar. Today, the situation has stabilized, with the price now around 30 baht to the dollar.

The lesson here is clear: central banks cannot sustain long-term interventions to stabilize a currency by depleting their reserves. Eventually, the reserves run out, and the currency is left to its own devices, leading to a significant depreciation.

Central Bank Intervention: A Double-Edged Sword

It's worth noting that central bank intervention is more effective in preventing a currency from appreciating than from depreciating. The reason for this lies in the difference in supply. Central banks can print money to prevent a currency from appreciating, as they always have an infinite supply. However, their forex reserves are limited, and depleting them can lead to a rapid decline in the value of the currency.

Therefore, central banks often face a dilemma: they can either preserve their reserves and risk a currency crash or use their reserves to stabilize the currency, risking depleting their holdings.

Conclusion

The plunge of a currency, while it presents significant challenges for central banks, also highlights the importance of maintaining robust forex reserves and long-term economic stability. The limitations of central bank intervention underscore the need for policymakers to focus on sustained economic growth, investor confidence, and macroeconomic stability to avoid the pitfalls of currency plummets and forex reserve depletion.