MGMT-6350-H01

International Business

Spring 2005

 

 

 

The Collapse of the Thai Baht in 1997

 

 

Case Discussion by Rajan Nischal

 

 

1)  Identify the main factors that led to the collapse of the Thai baht in 1997.

 

Among the several factors that led to the collapse of the Thai baht in 1997 are:

 

a.    Unsustainable current account deficits

b.   Over-dependence on short-term foreign funds

c.    Poor regulations of the Thai economy

d.   Over-inflated asset prices

e.    Macroeconomic policy, i.e. fixed exchange rates

f.     Changed sentiment amongst investors in Thailand

g.   Speculation by participants in the Thai currency markets

h.   Spillover effects in internal Thai markets

 

The real estate bubble, created by industrial expansion and an overvalued currency, could not last indefinitely. Thai domestic factors began to come into play. The country began to be marked by excess supply of real estate property, rising wages of low-skilled laborers and consequent cost increases in production of exportable goods. At the same time, Thailand’s investments in infrastructure, industrial capacity and commercial real estate were sucking in foreign goods at unprecedented rates. This eroded Thai competitiveness in labor-intensive goods vis-à-vis late-starting industrial states such as China and Vietnam. Thailand's trade deficit mounted. Also, newly rising industrial states such as China and Vietnam were attracting new and greater rates of foreign investment, diverting funds that had once been invested in Thailand for the same purposes. Thai exports, which recorded a hefty growth of 24% in 1995, flattened to an almost negligible percentage a year before the baht's collapse.

 

Throughout the early 1990s, growth in Southeast Asia attracted much foreign capital. However, by 1995 and 1996, Thailand's current account deficit had grown from 5.7% in 1993 to 8.5% in 1996. When domestic production slowed, this account imbalance represented an even greater percentage, when compared to GDP.

 

Heavy short-term borrowing that required stringent debt maintenance brought much of the instability in Thailand’s economy about. A boom in real estate and the Thai stock market attracted foreign speculation that could not be sustained in the face of investor doubts. The Thai government attempted to shore up shaky investor confidence by officially backing the financial institutions that were heavily indebted abroad. Although currency speculators are blamed for forcing devaluations the real cause lies in the elements of supply and demand. The speculators may instigate the devaluation at a particular time but they only prompt what had to occur sometime anyway. The way the speculators precipitate devaluation is to borrow the currency and sell it. The cost to the speculators is the interest charges on their borrowings. But although the sales of the currency by speculators may seem large the real movement comes when they are able to convince the general public that devaluation is inevitable and imminent. The speculators, in effect, attempt to trigger an avalanche of currency transfers by the individuals and businesses that do not want to see the value of their holdings drop virtually instantly.

 

The Thai Central Bank tried to fight this loss in confidence by increasing the domestic interest rates to discourage capital transfers, to attract new short term capital and to punish speculators by increase the cost of their borrowing. This did not help and on July 2, 1997 the Thai government bowed to the inevitable and announced it would allow the baht to float freely against the dollar. This led to the sharp decline in the baht’s value and the Thai debt bomb exploded, resulting in further decline in the baht’s value.

 

 

2)  Do you think the sudden collapse of the Thai baht can be explained by the purchasing power parity theorem?

 

The purchasing power parity (PPP) theorem states that given relatively efficient markets, i.e. markets in which few impediments to international trade exist, the price of a “basket of goods” should be roughly equivalent in each country. This can also be stated that the fiscal deficit is monetized at a constant rate of É . This is the rate of credit growth.

 

Having made the above definition, the sudden collapse of the Thai baht, as seen above, was influenced by several factors beyond the logic of the purchasing power parity theorem, among them being:

 

a.    Depletion of foreign exchange reserves by the government purchasing its own currency in an effort to prop up the exchange rate

b.   Raising of interest rates to make holding the baht more attractive

c.    A high debt-equity ratio among Thai corporations which was further aggravated with the devaluation of the baht

d.   The degree of non-performing assets with financial institutions.

 

 

3)  What role did spectators play in the fall of the Thai baht? Did they cause the fall?

 

Various spectators played varied roles in the fall of the Thai baht.

 

Despite of the looming excess in real estate an over inflated asset prices, banks were happy to lend to property companies. The Thai government’s economic policy as it pertained to investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. Thus, there was an over-dependence on short-term foreign funds where as exports were at an all time low. Thus the bank’s and government had unsustainable current account deficits. There were poor regulations of the Thai economy. The government’s macroeconomic policy, i.e. fixed exchange rates was not modest. Changed and panicking sentiment amongst investors in Thailand resulted in speculation by participants in the Thai currency markets. Although unpredicted by many accounts, a combined result of these behaviors by the spectators involved was the main cause and resulted in the fall of the Thai baht.

 

Also mentioned in the cases was the concerted attack on the Thai baht by currency traders and the short selling of the baht, which added to the increasing dilemma.

 

Thus the rapid fall in the value of the Thai baht was a financial crisis that was caused by a panic-induced illiquidity of capital markets. This stemmed from latent structural defects, induced by adverse incentives, which then encouraged excessive risk taking.

 

 

4)  What steps might the Thai government have taken to preempt the financial crisis that swept the nation in 1997?

 

To preempt the financial crisis the Thai government could have enforced sound economic policies aimed at delivering macroeconomic stability. The Thai government could have done so by making sustained rapid economic growth their principal objective. This would have been the best means of reducing poverty. Also, the Thai government should have put the right policy framework in place to ensure that rapid economic expansion can be sustained. They could have preempted the financial crisis by enforcing sound monetary and fiscal policies. Appropriate fiscal policies can make a substantial positive contribution to economic growth and poverty reduction. Sound policies can free up scarce resources, introduce appropriate liberalization and create the right incentive signals by reducing tax distortions. Sound fiscal policies should also be anti-cyclical.

 

Had the Thai government put a policy in place that exploited the opportunities provided during economic upturns to put the public finances in order, then during an economic downturn things would’ve been planned for.

 

The Thai government’s sustainability policy should have also required careful debt management policy. One that must be able to demonstrate that they can service their debts, and that these policies are designed to enable them to continue to meet their debt obligations. It is important to remember that debt can be in the form of contingent liabilities of the government when the exchange rate is, de facto, fixed. This policy should’ve been one that generally included flexible exchange rates. The benefits of short-term exchange rate stability are greatly outweighed by the risks that pegged or tightly managed exchange rate regimes bring—not least from the danger of currency mismatches in the corporate and the banking sectors.

 

Had the Thai government recognized that a strong, well-regulated financial sector was a key element in a sustainable policy framework, they could have preempted some of the financial crisis that ensued in 1997. That would have meant addressing often-difficult issues such as non-performing loans, capital adequacy, and effective supervision. Financial institutions need appropriate incentives to develop the skills required to assess and manage credit risk and returns. Effective bankruptcy laws—that strike the right balance between creditors and debtors' rights should have been put in place.

 

The case did not mention anything about bankruptcy provisions. Had the Thai government put in place an appropriate bankruptcy law, investor panicking might have been prevented. This seems to be an issue with most Asian countries.

 

 

5)  How will the collapse of the Thai baht affect businesses in Thailand, particularly that purchase inputs from abroad or export finished products?

 

As exchange rates and stock markets plunged in Thailand, foreign debt denominated in foreign currencies soared. Many domestic firms became insolvent, interest rates skyrocketed and credits dried up as panic by domestic and international investors ensued. Liberalization of capital accounts and financial systems in Thailand interacted with poor and inadequate regulatory structures. This led to rapid domestic expansion, as reflected in asset price bubbles, which in turn fuelled more borrowing. As a result, the Thai economy was held hostage to shocks like changing investor expectations. When external events pricked the bubble, the spiraling increase in asset inflation became a downward spiral of asset collapses.

 

This emphasized the role of short-term maturity debt and the term structure mismatch between assets and liabilities that made these economies extremely sensitive to investor expectations. The short-term liabilities of Thailand’s economy were very high, far exceeding its liquid reserves prior to the crisis. This made Thailand extremely vulnerable to sudden calls for repayments. Yet another scenario emphasized the policies of fixed exchange rates followed by Thailand’s government, which encouraged over borrowing and contributed to the fragility of the financial sector. When the US dollar appreciated against major industrial currencies, Thailand’s economy whose currencies were pegged to the dollar also appreciated, thus worsening their export competitiveness. Poor export performance due to lower competitiveness was compounded by weak domestic demand from Japan, and low cyclical demand for semiconductors worldwide. This, combined with the vulnerability of Thailand’s financial systems, changed its overly optimistic outlook. The stage was thus set for the currency attack and financial crisis.

 

The overall consequence was that the current account of the balance of payments shifted strongly into the red. Despite strong export growths, imports kept growing faster. Soon, the result was that Thailand was running a Current Account deficit equivalent to 8.1 percent of its GDP. When the financial crisis hit, firms and institutions with foreign debt could not service their loans and went under in a hurry.

 

 

6)  Do you notice any similarities between the collapse of the Thai baht in 1997 and the collapse of the Korean won around the same time (see the Country Focus in this chapter)? What are the similarities? Do you think these two events were related? How?

 

Although Korea and Thailand followed the classic prescription of raising their interest rate to defend their currencies, both saw continued depreciations, well in excess of what would have been predicted.

 

The key features of the crises in Korea and Thailand can be summarized as follows:

 

a.    Both currency crises were difficult to predict on the basis of standard economic indicators, such as inflation rates, monetary growth rates, or past government deficits.

b.   Neither banking crisis was difficult to anticipate, certainly not if one used publicly available information about the market value of financial firms in Korea and Thailand.

c.    When the crises came, they came with a vengeance. The Korean won and Thai baht rapidly depreciated by over 50 percent and 80 percent, respectively, vis-à-vis the dollar before partially rebounding in value. In addition to the large social costs associated with severe recessions, the crises saddled the Korean and Thai governments with very large liabilities. These arose both from their implicit guarantees and the need to restructure their respective banking systems. As we discuss below, these costs are now estimated to exceed 25 percent of Korea and Thailand’s gross domestic product (GDP).

d.   After the crises, the rates of inflation and money growth rose in both countries, though not by nearly as much as the rates of depreciation of the won and the baht. The rise in the price of tradable goods was much larger than the rise in the price of non-tradable goods.

 

 

References/Sources:

 

1)  Rajan, Ramkishen S., "(Ir)Relevance of Currency Crisis Theory to the Devaluation and Collapse of the Thai Baht" (July 2000). CIES Working Paper No. 0030. http://ssrn.com/abstract=237200

2)  Rajan, Ramkishen S. and Montreevat, Sakulrat, "Financial Crisis, Bank Restructuring and Foreign Bank Entry: An Analytic Case Study of Thailand" (June 2001). CIES Working Paper No. 131. http://ssrn.com/abstract=294579

3)  Rajan, Ramkishen S., Sen, Rahul and Siregar, Reza , "Misalignment of the Baht, Trade Imbalances and the Crisis in Thailand" (November 2000). CIES Working Paper No. 0045. http://ssrn.com/abstract=253325

4)  Karunatilleka, Eshan, “The Asian Economic Crisis” (February 1999).

5)  Craig Burnside, Martin Eichenbaum, and Sergio Rebelo, “Understanding the Korean and Thai currency crises.”