Currency Crisis for Beginners

A currency crisis is a fairly technical matter and, when it happens far away from us, it is only rational to conclude that it won't have much affect on us. It seems rational to be ignorant of such things, since there are so many immediate problems that compete for our attention.

But, as we will learn, the world very interconnected. Things that happen far away can have impacts that are very important to us. We need to become much better informed about how the people of the world are linked together by things like, for example, currencies.

We are all beginners, really, in the sense that we are only beginning to realize how much we need to know about the rest of the world to make sense of what is happening in our own little piece of it. This essay is the first step towards becoming a bit better informed about the world.

The whole thing started on July 2, 1997 when Thailand's currency, the Baht, suddenly collapsed in value, an event that is called a currency crisis. This event, which was initially reported only on the back pages of the financial sections of world newspapers, started a chain-reaction of economic, political, and social effects that together are termed the Asian Crisis.

Here's what happened. The Thai government had guaranteed that the exchange rate between the Thai Baht and the U.S. dollar would be held at a rate of 25 Baht per dollar. That meant that if you had 25 Baht you could reasonably expect to exchange them for a US dollar and vice versa.

One Dollar = 25 Bhat

The Thai government did this because it wanted to encourage trade and investment between the US and Thailand for the purposes of creating income and jobs. For example, interest rates were lower in the U.S. than they were in Thailand. The government's pledge of a stable currency value encouraged Thai banks to borrow US dollars in the US, convert them to Thai Baht at the fixed exchange rate, and then lend them out, at a higher interest rate, in Thailand.

Imagine for a moment that you are a Thai banker. You borrow $1 million dollars (at, say, 10 percent interest) and convert this sum into 25 million Baht, which you expect to lend in Thailand for an interest rate of 15 percent.

With the Thai government's exchange rate promise in force, this appears to be a good deal for everyone. The US lender gets 10 percent interest. The Thai borrower gets access to funds for business investment that might not be available if you didn't borrow abroad. And you stand to gain the difference between the 15 percent interest you will collect and the 10 percent interest you owe. If everything works out as planned, you stand to collect $50,000 on this deal (5% of $1 million) from the difference in interest rates. Very nice, don't you think?

Thai banks borrowed a lot of dollars, which were lent and invested in business expansions, property purchases, and speculation on Thai stocks, among other things.

But then problems began to appear. Thai banks were found to have a lot of bad loans on their books -- loans that were unlikely to be repaid on time and perhaps could never be repaid at all. This caused international investors to become concerned about both the health of the Thai banks and the government's ability to honor their exchange rate pledge. So these investors began to pull their funds out of Thailand.

The withdrawal of foreign investment put pressure, first, on Thai banks. Anyone who has seen the movie "It's a Wonderful Life" can recall the scene where there is a "run on the bank." Since most of a bank's funds are loaned out, it can be difficult to meet the demand in the short run for cash withdrawals. The outflow of funds made weak banks weaker and put pressure on the strong ones, too.

Foreign investors who withdrew their funds wanted to convert them back into dollars, naturally. This meant that for every 25 Baht withdrawn, the Thai government had to stand ready to give one US dollar in return. As the flow of funds out of Thailand increased, the Thai government's supply of dollars was drawn down. Speculation began that the government would not be willing or able to keep its promise -- what would it do when it ran out of dollars or nearly so?

This speculation caused a panic, which is a kind of self-fulfilling prophecy. Because people worried that they Thai government could not keep its exchange rate promise, they pulled their funds out of Thailand. When everyone did this at once, it was of course impossible for the Thai government to pay everyone dollars at once.

On July 2, 1997, the situation reached a boiling point. So many Baht were leaving the country that the government was forced to abandon its pledge of a 25 Baht per dollar exchange rate. The Baht's value collapsed.

The Bhat fell from 25 Bhat per dollar to about 30 Bhat per dollar in a matter of days (as the Bhat's value falls, it takes more Bhat to buy a dollar).

The Bhat continued to fall in July and August. The crisis in Thailand caused similar currency crises in other Asian countries -- a process called "contagion." Seeing the crisis in Thailand, investors "sold Asia," pulling their funds out of other countries in the region.

The currency crises continued through the summer and into the fall.

When the dust settled, the new exchange rate was about 50 Baht per dollar. This had a variety of impacts that we can discuss here without getting too technical.

One Dollar = 50 Bhat

For Thai citizens, the most direct impact was that foreign goods were suddenly more expensive. A $10 bottle of US-made prescription drugs that used to cost 250 Baht was now priced at about 500 Baht. This was bad news both for Thai people who needed imported medicines (and other goods) and also for the US firms and workers who made these items.

US citizens were also affected by the exchange rate change. A 100 Baht sack of Thai jasmine rice, which initially cost $4.00 now had a price of just $2.00. This benefited US consumers of Thai goods, but of course put pressure on US rice farmers to match the lower Thai prices.

The currency crisis caused a major change in relative prices between the US and Thailand. Thai goods were about 50% cheaper to US buyers and US goods were 100% more expensive to Thai buyers. These changes caused many winners and losers in both countries.

However, the biggest impacts were in the financial sectors and to see this you need to think about yourself as a Thai banker again. Recall that great investment you made just a few paragraphs ago. You borrowed $1 million at 10 percent interest in the US, which you converted into 25 million Baht. You lent the Baht in Thailand at 15 percent interest. Your reward? The difference between the two interest rates, or about $50,000 per year. Not bad for a few hours' work, eh?

But this profit was based on your assumption that the government would honor its pledge to keep the exchange rate fixed at 25 Baht per dollars. Here's where you stand after the currency crisis.

You borrowed $1 million and you lent 25 million Baht. If your loan is repaid on time and with all the 15 percent interest you are due, you should get back about 28,750,000 Baht. At the post-crisis exchange rate of 50 Baht per dollar, this sum is worth only $575,000 -- much less than the $1 million you borrowed.

You are bankrupt.

You owe $1 million and you have no prospects to repay it. Although you have made good business decisions -- perhaps you have lent the money efficiently and will get repaid in full and on time (in Baht) -- you cannot possible repay your US dollar loan because to do so requires twice as much Baht as you expected.

You are bankrupt (deep in debt beyond your means to repay), but because you are a banker this problem affects many more people than you. Your depositors will become concerned about their funds and may stage a run on the bank. You will be less able to give new loans to Thai borrowers. You may have to call in existing loans, forcing current borrowers to liquidate their investments, perhaps even forcing them into bankruptcy.

This is the bottom line for the Thai currency crisis. Thai citizens who were acting rationally suddenly found themselves bankrupt -- deep in debt, the savings of a lifetime often wiped out, with few prospects for short term recovery.

Although most of the affects of the Thai crisis are felt by the Thais themselves, the world is sufficiently interlinked that some of the impacts can be felt here in the US, even by people like you. The depressed economy in Thailand, for example, could cause the Thai airlines to cancel orders for Boeing airplanes, leading to economic problems in the US and other countries.

This is how the Asian crisis began. The other sections of this web site will help you understand how the political, social, and economic events and reactions that followed affected the people of Asia and you.