Chartered Financial Analyst (CFA) Practice Exam Level 2

What trend typically occurs before a currency crisis regarding foreign reserves?

1. They tend to increase rapidly

2. They remain stable

3. They decline in advance

4. They become less relevant

The correct answer is: They decline in advance

Before a currency crisis, it is common for foreign reserves to decline in advance. This decline can occur as a result of a country's attempts to stabilize its currency; authorities may sell off foreign reserves to defend the currency's value. As market participants lose confidence in the currency, they may start to convert it into foreign currencies, leading to further depletion of reserves. The decline in foreign reserves indicates that the country may be facing increasing pressure on its currency due to trade deficits, capital flight, or declining investor confidence. When a country's reserves diminish significantly, it can signal underlying economic weaknesses, making a currency crisis more likely. In contrast to this trend, a rapid increase in foreign reserves would suggest a strengthening of the currency and economic stability, while stable reserves indicate a balance that likely does not threaten the currency's value. The idea that reserves become less relevant does not hold true, as they are a critical indicator of a country’s ability to manage its currency and support international obligations.