Mismatched Socks

Khan Academy » Finance » Macroeconomics » Math Mechanics of Thai Banking Crisis

So in 1996 the Thai baht (Thailand’s currency) was pegged to the USD by Thailand’s central bank at an exchange rate of 1 baht <=> $25. It had been like that for many years, and in 1996 interest rates in the United States were about 8% and interest rates in Thailand were about 12%. 

Thai financial institutions couldn’t help but notice the opportunity for profit.

1. Buy $1 million for 25 million baht at 8% interest (let’s imagine a 2-year loan, so you pay interest for 2 years and then pay back the principle).
2. Lend out 25 million baht at 12% interest.  That’ll earn you 3 million baht per year in interest payments, which you can convert into $120K. A $1 million loan at 8% interest has you making interest payments of $80K per year, leaving you with $40K per year profit.
3. Repeat.

Seems like free money for very little risk — but it all rests on the assumption that the exchange rate between the baht and the dollar remains pegged at 25 baht per dollar.

Then 1997 happens, and for whatever reason the baht depreciates in value. Now $1 is worth 45 baht. So you still get your 3 million baht in interest payments, but now they’re only worth $67K; and since you have to pay $80K in interest on your original $1 million loan, you’ve just lost $13K. But it gets really bad next year — in 1998 you have to pay back the principle. So even if you made some great loans and everyone paid them back, you get 25 million baht and can only convert it into $556K — and you owe $1 million!

Of course, this was a contrived example to illustrate the Thai banking crisis. In reality, financial institutions had taken out not millions, but billions in loans (so just go through the example again and add a few orders of magnitude :D).