Not Every Currency Collapse Is the Market Telling the Truth

A collapsing currency is often presented as the final and most honest verdict on a country’s economic management.

Governments can manipulate statistics, postpone reforms and disguise fiscal deficits. Politicians can blame foreign investors, speculators or previous administrations. But, according to the orthodox interpretation, the exchange rate eventually reveals the truth.

There is considerable wisdom in this argument.

Currencies tend to weaken when inflation is uncontrolled, fiscal policy is unsustainable, reserves are depleted, productivity stagnates or political institutions lose credibility.

But the argument becomes dangerous when converted into an absolute principle.

Markets are powerful information systems. They are not infallible judges. Exchange rates can also be driven by leverage, global risk aversion, forced selling, thin liquidity, index rebalancing and contagion from events unrelated to the country’s fundamentals.

A new IMF Staff Discussion Note provides a useful framework for distinguishing between these two worlds.

The finding is significant: in emerging and developing economies, a substantial part of currency pressure can arise from financial shocks rather than macroeconomic fundamentals.

In those circumstances, foreign-exchange intervention may be economically defensible.

But it can also become the perfect excuse for governments determined to deny reality.

Fundamentals and financial shocks are not the same

A currency can depreciate because a country imports more than it exports, accumulates excessive debt, runs persistent fiscal deficits or allows inflation to erode purchasing power.

Such a depreciation performs an economic function. It makes imports more expensive, exports more competitive and domestic assets cheaper for foreign investors. Painful as it may be, the adjustment reflects underlying imbalances.

Intervening indefinitely against this movement usually wastes reserves and delays reform.

A different situation arises when the exchange rate moves primarily because investors demand an abnormal risk premium, market liquidity disappears or global deleveraging forces institutions to sell assets regardless of domestic conditions.

In this case, the currency can overshoot.

The depreciation then worsens the very fundamentals supposedly being measured. Companies with dollar debt face larger liabilities. Inflation rises through imported goods. Central banks increase rates. Investment declines. Banks become more cautious. Economic activity contracts.

The exchange rate does not merely communicate information about the economy. It begins to damage the economy.

What the IMF study found

The IMF study examines fifteen years of monthly data from 25 emerging and developing economies.

Its framework uses deviations from uncovered interest parity—the idea that interest-rate differences between currencies should broadly correspond to expected exchange-rate movements—to identify changes in currency risk premia and limits to arbitrage.

It combines macro-financial data, model-based restrictions and narrative evidence to distinguish shocks originating in fundamentals from those generated by financial markets.

Applications to Brazil and Chile suggest that financial shocks account for approximately one-third of fluctuations in their currency risk premia.

These episodes are also associated with significant contractions in economic activity.

That finding matters because it contradicts the simplistic belief that intervention necessarily prevents a useful adjustment. Sometimes the market movement itself becomes the shock.

Brazil and Chile are useful precisely because they are not Argentina

Brazil and Chile have comparatively developed financial markets, functioning central banks and significant experience with flexible exchange rates.

Their inclusion shows that financial distortions are not limited to economies already suffering from extreme institutional collapse.

Brazil’s real is among the most traded emerging-market currencies. That liquidity can attract international investors—but also makes the currency an instrument for expressing broader views on emerging-market risk.

During periods of global stress, investors may sell the real not because Brazil’s fundamentals suddenly changed, but because it is one of the positions they can liquidate.

Chile faces a different structure. Its currency is influenced by copper, China and global commodity expectations. A shock to international risk sentiment can move the peso beyond what immediate domestic data would justify.

In both cases, the currency can become a transmission channel for shocks originating elsewhere.

Argentina demonstrates the opposite danger

Argentina illustrates why the IMF’s more flexible approach must be applied with extreme discipline.

Successive Argentine governments have treated exchange-rate pressure as evidence of speculation while financing deficits, restricting access to foreign currency, creating multiple exchange rates and weakening confidence in the peso.

In that environment, defending the currency does not correct a temporary market failure. It often preserves a politically convenient price that is incompatible with inflation, reserves and monetary expansion.

Capital controls can reduce immediate demand for dollars, but they do not create confidence. They divide the economy between those with privileged access to the official rate and those forced into parallel markets.

The exchange rate then stops being a single price and becomes a system of political allocation.

An intervention designed to smooth volatility is fundamentally different from a government trying to legislate the value of its currency.

The first can support market functioning. The second usually suppresses information until the eventual adjustment becomes more violent.

Turkey: defending credibility after credibility has already disappeared

Turkey offers another warning.

For years, political interference weakened monetary-policy credibility while inflation accelerated. Authorities relied on reserve operations, regulations and financial engineering to support the lira.

But intervention cannot permanently substitute for a coherent policy rate.

If households and companies believe inflation will continue eroding the domestic currency, they will seek dollars, euros, gold or other stores of value. The central bank can slow that process, but it cannot eliminate the underlying incentive without restoring positive real returns and institutional credibility.

Once expectations become entrenched, stabilisation becomes far more expensive.

The relevant distinction is not between intervention and non-intervention. It is between intervention supporting credible policy and intervention replacing credible policy.

Mexico shows the value of liquidity and credibility

Mexico offers a different case.

The peso is one of the world’s most liquid emerging-market currencies. Mexico has deep connections with the United States, significant trade integration and a central bank with established credibility.

But liquidity has a paradoxical effect. It makes the peso attractive to investors, while also making it one of the first emerging-market currencies sold during global risk-off episodes.

The exchange rate can therefore move sharply even when domestic fundamentals have not changed proportionally.

For a credible central bank, intervention mechanisms can reduce disorderly conditions without establishing a rigid exchange-rate target.

This is the type of distinction policymakers must preserve: smoothing market dysfunction without promising a specific price.

How intervention can work

Foreign-exchange intervention takes several forms.

A central bank can sell reserves and purchase its own currency. It can use derivatives, swaps or forward contracts. It can provide dollar liquidity to domestic financial institutions. It can sterilise the local-currency impact by conducting offsetting monetary operations.

Each instrument addresses a different problem.

Direct reserve sales can supply foreign currency when liquidity disappears. Swaps can help banks or corporations manage temporary dollar shortages. Sterilised intervention can influence the exchange rate without changing the domestic monetary stance.

Capital controls are different. They restrict transactions rather than supply liquidity. In an emergency, temporary controls may slow destabilising flows, but they also create distortions, avoidance mechanisms and political discretion.

The more permanent they become, the more likely they are to discourage investment and produce parallel markets.

The reserve question

Intervention is only credible when reserves are sufficient.

A country with substantial reserves can discourage one-way speculation because investors know the central bank can remain active. A country with critically low reserves may invite the opposite reaction: every intervention reveals diminishing capacity and encourages markets to test the next threshold.

Headline reserve figures can also mislead.

Gross reserves may include borrowed funds, swap lines, gold, encumbered assets or deposits that are not freely available. Net liquid reserves provide a more useful measure, but even these depend on future obligations and the structure of external debt.

An intervention strategy must therefore be evaluated against short-term foreign-currency liabilities, import requirements and potential capital flight—not simply the published gross number.

Who decides whether the shock is “non-fundamental”?

This is the greatest weakness in the new framework.

A model can analyse data, risk premia and historical relationships. But governments ultimately operate in real time, under political pressure and with incomplete information.

Every government prefers to believe that its currency is undervalued because of irrational markets rather than weak policies.

A fiscal crisis can be described as speculation. Capital flight can be blamed on foreign actors. A loss of credibility can be classified as temporary volatility.

The distinction between fundamental and financial shocks is economically meaningful but politically vulnerable.

Independent central banks, transparent intervention rules and published assessments are therefore essential. Without them, a sophisticated analytical framework can become an elegant justification for exhausting reserves.

Markets can be wrong without governments being right

This is the central point.

Rejecting the belief that markets are always correct does not mean accepting that governments know the correct exchange rate.

Both can be wrong.

Markets can overshoot because of panic, leverage and liquidity. Governments can defend unsustainable prices because of elections, ideology or fear of admitting failure.

A credible policy must recognise both risks.

Intervention is most defensible when it is temporary, transparent and designed to restore market functioning. It should not protect an arbitrary exchange-rate target or postpone fiscal and monetary adjustment.

The objective is not to defeat the market. It is to prevent temporary dysfunction from becoming a macroeconomic crisis.

The currency is a price—and also a balance sheet

For advanced economies issuing debt in their own currency, exchange-rate fluctuations may be uncomfortable but manageable.

For emerging markets, depreciation can affect the entire balance sheet of the economy.

Dollar-denominated corporate debt becomes more expensive. Imported energy and food prices rise. Banks face credit losses. Governments with foreign-currency liabilities see debt ratios deteriorate. Households lose purchasing power.

This is why emerging-market central banks cannot always treat exchange rates with the indifference sometimes recommended by textbook models.

But sensitivity must not become denial.

If a depreciation reflects persistent inflation, excessive borrowing or political destruction of credibility, no level of intervention can solve the underlying problem.

Not every currency collapse is the market telling the truth.

But when governments repeatedly lie to themselves, the market eventually becomes the messenger they can no longer silence.

Sources

• IMF — Drivers of Exchange Rates in EMDEs: Implications for Foreign Exchange Intervention⁠

• IMF — Integrated Policy Framework⁠

• Bank for International Settlements — Foreign exchange markets and interventions⁠

• Central Bank of Brazil⁠

• Central Bank of Chile⁠

• Banco de México⁠

• Central Bank of the Republic of Türkiye⁠

Roberto Balbino — CEO, Fintech SCB
International Finance & Banking Executive | Independent Analyst of Finance, Economics, Geopolitics & Global Markets
www.fintechscb.com