Speculative attacks

A fixed exchange rate is a promise. And a promise can be tested.

A country promises its currency is always worth the same price in dollars, or in marks. To hold, its central bank keeps reserves.

If too many people sell the currency, the central bank must buy it back with its reserves. And reserves run out.

The speculator makes a simple bet. Say he borrows one hundred million in local currency, and changes it straight away into one hundred million dollars.

If the currency loses twenty per cent, he buys back his hundred million for only eighty million dollars. Twenty million of gain.

If the promise holds, he only loses the cost of borrowing. A bet where you win a lot or lose a little draws a crowd.

And the more sellers there are, the faster reserves melt. The attack ends up causing what it predicted.

The sixteenth of September nineteen ninety-two. The pound sterling is tied to the German mark, at a level seen as too high.

George Soros's fund bets about ten billion dollars against the pound. Others follow.

In the app, this chapter is animated and narrated, card by card. Start free trial.

Download on theApp Store

The Bank of England buys pounds massively, raises its rate from ten to twelve per cent, then announces fifteen. On the same day.

That evening, the United Kingdom gave up. The pound left the system and fell. Soros's fund made more than one billion dollars.

The British call that day Black Wednesday. Some say White Wednesday: freed from this straitjacket, the economy picked up.

Mexico, December nineteen ninety-four. Reserves run dry. The country devalues the peso, then lets it float.

Within months, the peso loses about half its value. The United States and the IMF put together a rescue of about fifty billion dollars.

Fear spreads across Latin America. It is called the tequila effect.

Thailand, the second of July nineteen ninety-seven. After months of defence, the central bank lets the baht go.

In six months, the baht loses more than half its value. The crisis spreads to Indonesia, South Korea, Malaysia.

Many companies had borrowed in dollars. Counted in baht, their debt more than doubled.

Russia, the seventeenth of August nineteen ninety-eight. The country devalues the rouble and stops paying part of its debt.

The rouble loses more than half its value in under a month. In September, a large American fund, LTCM, has to be rescued.

Four crises, one weakness: a fixed rate, too few reserves, and often debts in foreign currency.

Speculators do not create the crack. They find it, and bet on it before everyone else.

The lesson for you: debt in a currency other than your income's is a hidden risk. You only see it the day the rate breaks.