Speculative Assault

The following is a not-so-brief description of a very simplified speculative attack: Speculator comes to Commercial Bank #1 and borrows 5 million baht for 3 months at an annual interest rate of 60%. On the day the loan agreement is reached, the exchange rate is 5:1. When the loan comes due, Speculator will owe the bank 5 million baht for the principle, and 750,000 baht in interest (15% for 3 months x 5 million). If the exchange rate is still 5:1 when the loan comes due, this 5.75 million baht liability will equal $1,150,000. Speculator walks out of Commercial Bank #1 with 5 million baht in his pocket, and with the knowledge that in three months he owes the bank 5.75 million baht. He would not have gone to Commercial Bank #1 unless he thought that he could make more than 750,000 baht in the next three months. Speculator has a plan that he thinks will make him much more than the 750,000 baht ($150,000) he needs to pay back the loan. His plan is to pay back the 5.75 million baht when the exchange rate is 10:1. This will allow him to exchange $575,000 for 5.75 million baht to pay off the bank. If the speculator is right about this devaluation, he will make a profit of $455,000 the following way:

The same day Speculator gets his 5 million baht from Commercial Bank #1, he goes to the spot currency market (indirectly the Central Bank) and exchanges the 5 million baht for 1 million dollars (recall the exchange rate is 5:1). Later that same day, Speculator takes his 1 million dollars and goes to Commercial Bank #2. There, he purchases a 1-million-dollar, 3-month CD. Commercial Bank #2 pays 12% annual interest for a 3-month CD of this size. In three months then, Speculator will get his 1 million dollars plus $30,000 interest, or $1.03 million. 3 months have now passed. In the interim, Speculator’s bet that the exchange rate would be 10:1 turns out to be perfectly accurate. For reasons discussed elsewhere, the government of Thailand decided to free the baht from its fixed rate of 5:1, and allowed the currency markets to set the value of the currency. The currency markets set the rate at 10:1. Speculator is very happy.

First, Speculator goes to Commercial Bank #2 to get his 1.03 million dollars from the maturation of his CD. He then goes to the currency exchange table at the same bank and hands over 575,000 dollars. In return he gets 5.75 million baht (recall the exchange rate is now 10:1). Speculator then goes to Commercial Bank #1 and hands them the 5.75 million baht he owes them. Speculator has $455,000 left over as profit ($425,000 from the principle of his CD, and $30,000 in interest). And if you look back through this story, you’ll note that he did not spend a dime of his own money to make it.

The other side of this coin is that the Speculator could have been just flat wrong in making his exchange rate prediction. Assume that the exchange rate remained 5:1. Speculator would have gone to Commercial Bank #2 to pick up his 1.03 million dollars. He then would have to go to the exchange counter and hand over the whole 1.03 million for 5.15 million baht (5:1). He then would go to Commercial Bank #1 to pay off his loan. He would have only 5.15 million baht from his CD investment. He would have to come up with the extra 60 million baht ($120,000) on his own.

Now, imagine several Customers borrowing billions of baht, in anticipation that the currency will be devalued, so that they can profit the same way our fictitious customer did. The effect is that Central Bank, which takes the baht and gives the Speculators the dollars to take to Commercial Bank #2, starts to run out of dollars to give out. Its reserves of dollars rapidly dwindle, causing fear among everyone that unless the Central Bank devalues the baht, it will soon run out of dollars. This fear of devaluation causes everyone with baht to rush to exchange it at the fixed rate of 5:1, before the devaluation occurs and it takes perhaps 10 baht to buy $1. So more people are demanding dollars from the Central Bank in exchange for their baht. This causes the Central Bank’s reserves of dollars to dwindle even more. This dwindling encourages even more speculators to borrow baht, and convert it to dollars. The cycle repeats itself until the Central Bank surrenders and devalues, or floats, the currency. This is referred to as the speculators’ "self-fulfilling prophecy of devaluation." They suspect that the Central Bank’s reserve position is dangerously low, then react by betting that the peg will be abandoned, and set off a process which ultimately leads to the collapse of the peg.