The foreign exchange market
Speculative attack on a currency
Voiceover: Let's revisit the scenario where everyone is trying to exit country B's currency and convert it back into country A. We saw in the last video that if, just left to its own devices, if this were to happen, if lot of Bs wanted to converted into currency A and because everyone is afraid to convert into B now because they think for whatever reason the country B is in bad shape, then you have this imbalance and if you left it to its own devices, country B's currency would become devalued. You would need more Bs to trade for an A, which is just another way to say B's value would go down, and that could be a bad thing, especially if it's a pretty steep decline. Maybe it's a country that needs to import fuel from the rest of the world. Maybe they need to import food from the rest of the world, and if their currency were to devalue dramatically, then imports could become very, very, very expensive and so people in that country might have to pay double for gas and double for basic necessities like food and whatever else. So we played out a scenario where the central bank of country B actively tries to intervene to keep this from happening, to keep the exchange rate stable, and so what they do is they could use reserves, and I'll do this in blue for country B, so they could use reserves of A that they have accumulated during better times or in previous videos, depending on how you want to view them, and they try to balance out the supply of A's with the supply of B's by selling their reserves and buying B's. So one way to think of it, they're adding supply of A's and they're also adding demand for B's. They're going to sell their reserves of A and buy their own currency. And that would work as long as they have reserves. They're going to be able to stabilize things so that this situation doesn't happen. But the problem was, and we talked about it at the end of the last video is that they can run out here. It's not like they can print another country's currency forever. They can't print it at all. They have to accumulate this. This isn't their own currency. So they have a finite amount of this. They could eventually run out. What is often the case is, currency speculators see this and they begin to smell blood. They see, okay look, people are trying to exit this currency. It would devalue if it was left to its own devices, but the central bank of country B is trying to keep it from devaluing by depleting its finite reserves of currency A. So what currency speculators will start to do is, well I can go into country B and I can borrow B's. So I could literally go to a bank in country B and borrow some of the B currency, and then I could go to the exchange markets and try to convert it into A's. Just off of looking at that superficially, what's that going to do? Well this is going to make the situation even worse for the central bank, because now you have people actively that don't even hold B's before they're going to be borrowing B's and converting them into A's. So it's going to create an even larger supply of B's and even more demand for the finite number of A's that are willing to go this way. And why is the speculator doing this? Well think about the two situations for them. Let me draw the two scenarios. Scenario one is that for whatever reason the central bank of B is able to keep the currency stabilized. So currency stays stable. And the other scenario is that the central bank runs out of reserves, and they have to essentially just let the currencies float, and B gets devalued. So central bank out of reserves, which would mean that the currencies would float and B would devalue. Well if this first scenario happens, and it's happens, and it's going to become less and less likely as more and more people pile on this strategy and more and more people try to run out of B's or try to exit B's currency. But even if this situation were to happen, the speculator says okay, the currency ended up being stable. I'll just unwind this. I'll take my A's, when I have to pay off my debt in B's, I'll take my A's, convert them into B's and pay off my debt. And so depending what the interest rates and all of that were, not a big loss or maybe even a minimal loss, and only if there's a kind of differential with interest rates or things like that, minimal to no loss. But what happens if the central bank runs out of reserves? Remember just the fact that the speculators are doing this speculative attack, they're borrowing in country B and converting to A, that's making the central bank run out of reserves even faster. It's going to deplete their reserves. Essentially when they do this, it's the central bank of country B that's going to be giving them, is going to be allowing them to convert. They don't know who they're buying these B's from with this A currency they have. So if this happens, if the central bank runs out of reserves, it floats, and then B devalues, then those currency speculators make a pretty good buck. and just to see how that could work, imagine that they borrow 100 B's, so this is what they borrow, and while the currency is being actively intervened with by the central bank, they're trying to keep it from devaluing, the exchange rate is one A for one B, so they convert on the open market, and the only reason this is able to happen at this exchange rate is because B's central bank is actively selling A's, they're able to convert to 100 A's. Now let's say that they're able to do this and the central bank runs out of A's and then a devaluation occurs. So this is happening at a conversion of one A equals one B. But let's say that these guys, they run out of reserves. The things devalue. B becomes worth a lot less, and then we go to a future state where one A is now equal to two B's. Well as soon as this happens, and remember this is this scenario right over here that we're thinking about right over here, this is what the currency speculators want to happen. If one A all of a sudden equals two B's because the central bank can't intervene any more, they are floating, B gets devalued. Then what's going to happen? These guys can take their 100 A's. Convert it back once things are floating. So now they're going to convert back into this direction. And how many B's can they convert it into? Well now they can convert it into 200 B's. They can pay off their debt because they borrowed the 100 B's, so minus 100 B's to pay debt, and then they make a pretty sizable profit. They make a profit of 100 B's. That's exactly what they're hoping for, and so you can imagine this is one of those trades that they're going to try to get more and more people to do, because the more people that jump on the band wagon and do this exact same strategy, the faster the central bank's reserves are going to deplete, and the more likely that this situation right over here plays out.