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Math mechanics of Thai banking crisis

Going through the mechanics of how a Thai financial institution can lose their shirt when their currency devalues. Created by Sal Khan.

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Video transcript

- [Voiceover] What I want to do in this video is make a little bit of what I talked about in the last video, a little bit more concrete. So, let's say that the year is, for the sake of simplicity, let's say it's 1996 1996, and the current interest rates, and I'm just going to use round numbers here, they don't have to be exact, as long as you get the general idea. Let's say the current interest rates in the United States are 8%, 8% interest rates in the United States, and let's say that in Thailand, in Thailand, let's say, Thailand, let's say that the interest rates are 12%. So, the last video we talked about that you have this interest rate discrepancy, their exchange rate is being pegged by the Thai Central Bank, it's being managed, this could be a tempting way to make money for a Thai financial institution. So, let's say it's 1996, you're a Thai financial institution, you borrow a million dollars, so you borrow, you borrow 1 million dollars, and this is the part where we're going to make it a little bit more concrete, and in 1996 the exchange rate, let's say it's 25 Baht per dollar. So, then you convert that, you convert that into, and you're borrowing one million dollars, let's say you're borrowing it at 8%, and then you convert that to 25 million baht. So, this gets turned into 25 million 25 million baht, that you then lend at 12%, That you just then lend at 12%. Now, let's just say for the sake of simplicity, this is an interest only loan, and that the principal is due in two years. So, we're going to call this a two year loan. So, this is a two year loan. So, let's think about what happens, how you can make money as long as the currency stay stable, and how this loan will really burn you if something happens with the currency. Especially if the Baht were to devalue relative to the US Dollar. So, while the two currencies are stable, every year you're going to make 12% on the 25 million baht that you lent, and that is what? 12% of 25 million, that's going to be what? Four million a year? And I'll get the calculator out just to verify that for you. So, if I have 25 times so this gonna be in millions, so, 25 times 12%, it gets us, oh sorry, three million, I was doing my mental map incorrectly. So, that gives you three million baht a year, you're going to make in interest. So, this is going to be three million, so, you're going to get three million baht, it's going to come from whoever borrowed that money, three million baht, and then to pay the interest that you owe on that dollar loan, you can then convert that into, you're going to get 25, you're going to have 25 baht per dollar, so let's convert that into dollars, so three million baht, if you divide it by 25, is going to be, so this is in millions, so this is $120,000. So you convert this into $120,000, so it becomes $120,000, and how much interest do you have to pay? Well, you have to pay 8% on the million, which is $80,000. So, you subtract out the 80,000 in interest, minus 80k interest, and you're left with $40,000 per year. $40,000 per year profit. 40 per year, and this is just off of a million dollars, you can imagine if you did this with a billion dollars, or any amount of money, you're just getting this what seems like an almost risk free profit. The reason why I say it's almost is that this is all contingent upon this exchange rate staying stable. Now let's see how you get burned when you have this devaluation of the baht. And the first place it'll just become much harder for you to do this interest. So, now all of a sudden the currency's, the baht devalues and you go to, let's say you go to, I'll just pick an arbitrary point right over here, you get to a situation where you're at 45 baht per dollar. So, let me write this, so you have devaluation, devaluation, and now you have 45, 45 baht per US dollar. Up here it was 25 baht per US dollar. So, let's say this is happening, this is 1997 that we're talking about. Now, how'd the dynamics play out? Well, now your three million baht in interest, 'cause remember you lent this in baht, your three million baht, let me write this down, are going to be how many dollars? Let's get our calculator out, so now you're going to have three million, and you're going to have 45 baht per dollar, so divided by 45, you get this is going to be about $67,000. So, this right over here is going to be equivalent to at this new exchange rate $67,000. But your interest that you owe on the dollar loan is $80,000. $80,000 in interest, and so you actually have this $13,000 deficit that you're going to have to pay out of your pocket. So, now your little attempted arbitrage is working against you. But that's not the horrible part, you might be able to still dig up some money to pay this off. But the horrible part is what happens when you have to pay off the principal, this was a two year loan. So, in 1998 you're going to have to pay back the million dollars. Well, if everything worked out, if the exchange rate had stayed stable, the people you lent the money to would give you 25 million baht, you would be able to convert that into a million dollars and pay off the loan. But now that there's been this devaluation, in 1998, in 1998, so 1998, the people you lent the money to, assuming you lent it responsibly, and even that's in question, because the whole country was entering in something of a bubble, but you're going to get 25 million, you're going to get 25 million Thai Baht, but you're not going to be able to convert it into a million dollars anymore. We're going to have to divide this number by 45. So you divide 25, divided by 45, you're going to be able to convert it to about $556,000. So, $556,000, which is too bad because you owe a million dollars. You're going to be nearly $450,000 short, you're going to take a huge hit on this trade that you were doing just to make $40,000 here, because the baht devalued. And you can imagine, as people saw this coming, so for whatever reason people started to get afraid, they started to convert out of the baht, stop investing in Thailand as much, they started to realize that some of those investments made in those earlier years might have been going into kind of a speculative bubble. But then when this becomes apparent that there might actually be a banking crisis going on, because all of these banks were doing this, all of these actually formal banks or even informal financial institutions were doing this trade, and it could bring down the entire Thai financial system, it became even a more self-fulfilling prophesy. Because now investors were even more afraid to invest in Thailand, even more people were to pull out, and that would deplete the Thai Central Bank's reserves even more, and then on top of that, even Thai citizens would become afraid of the banking sector, they would go to their banks, they want their demand deposits back, and we all know how a fractional reserve system works, that by itself is a bank run, and so the banks wouldn't even have the reserves to pay it. So, even before the banks take the hit here, when people see it coming, it could bring down the entire system.