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Financial crisis in Thailand caused by speculative attack

How a currency crisis in Thailand led to a banking crisis in the 1990s. Created by Sal Khan.

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Video transcript

What I want to do in this video is show you that some of the things that we've been talking about in the last few videos actually do happen. In particular, talk about how one of these speculative attacks on accuracy can turn into a banking crisis. So, this right over here, this is a chart from Oxford economics and it's a chart of two things of Thailand's exchange rate in short term interest rates from the early 90's until the present. And so there's a couple of interesting things that you might see over here. The first is the exchange rate. You see from the early nineties all the way to the late nineties the exchange rate was relatively fixed and, just so you understand what this chart is, this is the number of the Thai (I believe their currency is a Thai baht) relative to the US dollars. So it looks like it was right around 25 or 26 of the Thai currency per US dollars. It was pretty much pegged to it. We talked about how a central bank can peg a currency by buying and selling reserves of US dollars. But then, all of a sudden, you see right over here in 1997 there was a devaluation. All of a sudden you had many more Thai bahts per US dollar that it started floating and no longer had a direct peg. And that's because it experienced some of the dimanics that we saw in the last few videos. Now, what I want to talk about in this video is that, okay, you might think that's bad. Speculative attack on a currency, imports are going to be more expensive, it's going to raise the cost of living for people in that country... But why is it so, so bad? In this video I want to give you an example of why it can be so, so bad that a speculative attack on a currency or a massive devaluation of a currency can lead to an actual banking crisis. So let's go back to the early nineties. (So, let me write this down). And you see here that Thailand had a pretty high short term interest rate. That's this blue line right over here (let me underline). If we go to 1992 we have a short term interest rate that it looks like it's in the low teens, it's about 11, 12 % right over there. And so you can see the currency had a nice peg versus the dollar, people recognised the thailands seemed to had a pretty healthy economy and investors said "well, I can go to Thailand and get pretty high interest rates". And you could imagine a Thai bank say: "Well, look! All these people want to invest in Thailand instead of me trying to borrow money from, maybe, depositors in Thailand, why don't I borrow it from abroad and invest it in Thailand?" Let's just think about this. Think of it in terms of US investors, but it was investors from all over the world. So that's the US and this is Thailand right over here. And I have a look at the exact interest rates of the US but let's just say for the sake of arguments it was somewhat lower in the early 90's. So I'll just pick up a number. Let's just say it was 7% and in Thailand, for the sake of argument, let's say it was 11%. So you could imagine if you were an enterprising thai bank (I'll draw the bank right over here). You would say, well, why don't I go to the US, borrow dollars at 7% and then I can bring it to Thailand, I convert it to the Thai baht, I'll get 25 thai baht for every one of these dollars and then I can lend it out at 11%? So I'm pretty much going to be getting this 4% spread. And what are the risks here? What are the risks of borrowing in a foreing currency and then lending in your own? Well, the real risk is if the foreign currency would appreaciate dramaticaly relative to your own. But if you're a thai bank in the early nineties you're like "this is huge demand of other people wanting to convert their currency into the thai bank". And in order to maintain the spec the thai central bank is printing money and buying those dollars. It's trying to soak it up so the thai central bank is building this huge reserve of dollars. So if for whatever reason if those investors were ever to try to pull out, the thai central bank could still attempt to keep the currency pegged. So you tell this is a pretty stable thing and I could just make this thing. The spread is 4% spread. Easy money. But as we know it's not always that easy and risks that you're not aware of can very easily crop up and so when you go to 1997 that's exactly what happened All of a sudden, people realised that there was all this boom went on in Thailand there's all the lending going on in Thailand. but maybe that lending wasn't going on in the best possible places, and in particular it was going on in real state in the very speculative way and we all know now that real state is a good source of speculative bubbles and investors started to get scared and they started wanting to pull out. and we saw in the last videos they might naturally get scared, then you might have a speculative attack, you might have currency speculers saying "I want to start borrowing in Thailand and then I'm going to convert that to dollars and then invested in the US" hoping that this devaluation will occur and knowing that if enough people kind of jump on the bandwagon, the thai central bank would literally run out of reserves. And the reason why this is risky once they do run out of reserves what's going to happen to this person who had borrowed in dollars and then lend in Thailand? Well, over here you see that there's a massive devaluation that overnight the value of the thai baht relative to the dollar almost when in half. so all the sudden you borrowed in this currency and that currency is becoming worth twice as much as you thought it was relative to your own currency, relative to this inbound payments that you're getting right over there. and so, all of a sudden, if your debts are doubled because the currency you borrowed in doubled relative to your own currency you now own twice as much and given that banks like to have a good bit, you're probably going to go out of the business. and this was happening on a massive scale, it was happening throughout the thai financial sector the entire banking sector. And so it wasn't just a matter of imports getting expensive it was a matter of the entire financial system collapsing.