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CFA Level I · CFA Level I Exam · Capital Flows and the FX Market

Which of the following is most likely a characteristic of a currency crisis in an emerging market that was preceded by large capital inflows?

A sudden reversal of capital flows causing sharp currency depreciation is the most likely feature. Heavy inflows appreciate the real rate and widen the current account deficit, so when investors withdraw, the currency falls and reserves are depleted.

  1. ASudden reversal of capital flows causing sharp currency depreciation.Correct
  2. BRising foreign reserves as investors repatriate funds to the country.
  3. CReal exchange rate depreciation before the inflows reduced export competitiveness.

Explanation

Large inflows tend to appreciate the real exchange rate and widen the current account deficit. A sudden stop or reversal of flows then causes sharp depreciation and reserve losses. Reserves would fall, not rise, and the real appreciation precedes the crisis.

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