FRBSF Economic Letter
97-33; November 7, 1997
Lessons from Thailand
Pacific Basin Notes. This series appears on an occasional
basis. It is prepared under the auspices of the Center
for Pacific Basin Monetary and Economic Studies within the FRBSF's
Economic Research Department.
After more than a decade of maintaining the Thai baht's near-peg to
the U.S. dollar, Thai authorities abandoned the peg on July 2, 1997. By
October 24, market forces led the baht to depreciate by 60% against the
U.S. dollar. The depreciation triggered a wave of speculation against
other Southeast Asian currencies; over the same period, the Indonesian
rupiah, Malaysian ringgit, and Philippine peso depreciated by 47, 35,
and 34%, respectively. There also has been some speculation against other
East Asian currencies, but at this writing the adjustment in these currencies
has been more limited.
This Letter discusses why the peg of the Thai baht was abandoned
and what lessons we may draw from this recent episode of currency speculation.
It focuses on Thailand, which appears to have been most severely affected,
and whose experience illustrates some of the factors that may have contributed
to the spread of currency speculation to other Southeast Asian economies.
Thailand: the good years
In some ways, the attack on the Thai baht was surprising, as Thailand
has been one of Southeast Asia's outstanding performers. Thailand's growth
in the first half of the 1990s averaged over 8%, before slowing to 6.4%
in 1996. Although the inflation rate rose from 3.4% in 1993 to 5.9% in
1996, it was still moderate by the standards of emerging markets. Thailand's
domestic savings were high -- about 34% of GDP -- and the government has
run fiscal surpluses in nine of the past ten years. These indicators contrast
sharply to those of Mexico prior to the peso collapse in December 1994.
In Mexico, domestic savings were low, GDP growth was sluggish, and the
economy was still experiencing the residual effects of the triple digit
inflation of the late 1980s.
What Thailand did share with Mexico was a heavy reliance on short-term
foreign funds, attracted both by the stable baht and by Thai interest
rates that were much higher than comparable rates in the Eurodollar market
(in 1996, the spread between Thai and Eurodollar rates was around 5 percentage
points at a one-month maturity). In 1996, the net rate of foreign financing
as a percentage of GDP in Thailand (as measured by the current account
deficit) was 8%, compared to 7% in Mexico at the time of the 1994 peso
crash. In the first half of the 1990s, foreign financing supported a broad-based
economic boom that was particularly visible in the real estate market.
Slowdown and financial
pressures
The downside to Thailand's economic boom became apparent after 1995,
when economic activity slowed, led by a sharp reduction in Thai export
growth. Export growth fell in part because of a steep appreciation in
the real trade-weighted baht (against an inflation-adjusted currency basket
comprising the yen, the dollar, and the deutschemark) of 21% between April
1995 and December 1996. This appreciation reflected the close link of
the baht to a sharply appreciating U.S. dollar.
The economic slowdown was accompanied by a sharp interruption in Thailand's
real estate boom. By the end of 1996, office vacancy rates in Bangkok
exceeded 20%, and a similar glut was apparent in commercial and residential
property markets. Along with excess capacity in manufacturing and services,
weakness in the real estate market put pressure on the financial sector.
A dramatic prelude to the financial difficulties to come was the failure
of the Bangkok Bank of Commerce, which incurred over $3 billion in bad
loans and was taken over by the government in May 1996.
Resisting depreciation
After the second half of 1996, concerns about sluggish export growth
and the weak economy, accentuated by evidence of weaknesses in the financial
sector, led to sporadic pressures on the baht to depreciate. However,
the government sought to resist these depreciation pressures for several
reasons. First, the stable baht had encouraged many Thai firms to borrow
in dollars without hedging their foreign currency exposure, so a depreciation
of the baht would increase their debt burdens (by increasing the amount
of baht needed to service a given amount of U.S. dollar debt). Second,
a sharp depreciation of the baht could increase the cost of foreign borrowing
to some degree, as investors would demand to be compensated for increased
baht volatility. Finally, a weaker baht would tend to increase inflation
and reduce the purchasing power of domestic residents.
Confronted with these potential costs, the Bank of Thailand (BOT, the
Thai central bank) chose to resist depreciation pressures in a number
of ways. The central bank purchased baht with dollars in the foreign exchange
market. The BOT also raised interest rates, which increased the attractiveness
of the baht and also made it more costly for speculators to borrow baht
in order to sell it in foreign currency markets. Measures to restrict
foreigners' access to baht also were adopted after a particularly severe
episode of speculation against the baht in mid-May 1997.
In the course of using these various tools, the BOT encountered significant
constraints on its ability to resist depreciation pressures. First, paralleling
Mexico's experience in 1994, Thailand found its reserves could be depleted
very quickly if sentiment shifted against the baht. Indeed, the BOT's
foreign exchange reserves fell from $37.2 billion in December 1996 to
$30.9 billion in June 1997 (prior to the baht float). In addition, the
BOT reported in August 1997 that in the course of the year it had incurred
off-balance sheet obligations to deliver $23.4 billion dollars in the
forward market over a 12-month period, so that net reserves were actually
lower. Second, raising interest rates adversely affected an already weak
financial sector by dampening economic activity and raising the cost of
funds for existing borrowers, who might then find it difficult to service
their loans. Finally, restricting foreigners' access to baht temporarily
curbed speculation against the currency but could not prevent pressures
on the baht to depreciate from other sources. For example, if holders
of dollars were less willing to supply the amounts needed to finance Thailand's
foreign borrowing, the baht would tend to depreciate anyway.
To illustrate the implications of efforts to defend the baht, the figure shows the baht
exchange rate and the Thai one-month interbank rate since early 1996.
Starting in the summer of 1996, sporadic episodes of speculation against
the baht were resisted by intervention and occasionally by very large
increases in interest rates. After mid-May 1997, interest rates remained
several percentage points above their 1996 levels, and by the time the
peg was abandoned on July 2, interest rates had risen to over 24%. The
steep increase in interest rates imposed significant costs on the domestic
economy and the financial sector, which ultimately contributed to the
abandonment of the peg.
In order to facilitate economic recovery, Thailand has adopted an economic
stabilization program designed to repair the financial system and achieve
certain macroeconomic goals. Operations were suspended at 58 of Thailand's
91 finance companies, which had received Bt 430 billion (about $18 billion
at the exchange rate prevailing on July 1, 1997, or over 9% of 1996 GDP)
from the BOT in an effort to keep them afloat. A deposit insurance system
is being set up, and the 25% ceiling on foreign ownership of Thai financial
institutions has been raised. Thailand's stabilization plan also would
reduce the rate of foreign borrowing while maintaining an adequate supply
of foreign exchange reserves, to balance the government budget (which
went into deficit this year) and to bring greater transparency to government
finances and enhance market efficiency. This program is supported by international
assistance of close to $17 billion involving the IMF, Japan, and a number
of economies in the Western Pacific Basin. In contrast to its leading
role in mobilizing over $50 billion to support Mexico after the peso collapse,
the U.S. has played no direct role in the international assistance program
for Thailand.
Dealing with market sentiment
Ever since the Mexican peso crisis, which caught many analysts by surprise,
there has been much interest in improving the flow of information in emerging
markets. The IMF has encouraged countries to subscribe to an international
data dissemination standard that has contributed to the more timely release
of information by central banks in emerging markets. While transparency
could be further improved, it appears that the information available,
along with a better understanding of factors that may trigger speculation
against a currency, made it possible for some observers to anticipate
the potential vulnerability of the baht peg.
However, the recent episode has highlighted two difficulties in the
management of information flows that were not so apparent during the attack
on the Mexican peso. First, conventional accounting measures sometimes
provide a misleading picture of economic or financial conditions. For
example, conventional foreign exchange reserve measures do not take into
account off-balance sheet transactions, which were very large in Thailand.
(As noted earlier, BOT now has disclosed its position in forward markets.)
Accounting difficulties also cloud the assessment of weaknesses in the
financial sector, not just in Thailand, but also in other emerging markets
in the region. For example, conventional measures may understate the exposure
of the banking sector to the volatile real estate sector because they
do not reflect the extent to which lending to other sectors is backed
by collateral in the form of real property.
Second, the recent episode has illustrated the extent to which openness
has exposed Asian economies to sudden shifts in market sentiment, which
can disrupt economic activity by triggering large changes in exchange
rates and other asset prices. This experience apparently has made some
Asian policymakers very wary about how available data are interpreted
and used by financial market participants. It also has raised the stakes
in the debate on whether policymakers should respond by further increasing
transparency and giving even more leeway to market forces (the approach
adopted in more developed countries), or by curbing the activities of
market participants.
Conclusions
The recent episode of currency speculation in Thailand illustrates the
risks associated with pegging the exchange rate in small economies that
are open to capital flows and that have less developed financial sectors.
Pegging encouraged an extended period of capital inflows that supported
an economic boom and a run-up in asset prices that were not sustainable.
Years of rapid growth also disguised poor lending and investment decisions
that ultimately led to the closure of a large number of financial institutions.
Under these conditions, indicators such as rapid growth and high saving
and investment rates, or budget surpluses, provided an incomplete picture
of the ability of the economy to respond to shocks.
Policymakers had no easy choices once pressures on the exchange rate
emerged, as defending the peg or allowing the currency to depreciate both
involved significant costs. It is apparent in hindsight that this dilemma
could have been avoided by allowing the currency to appreciate during
the earlier period of capital inflows, when there was no threat of a sudden
loss in value in the currency. An appreciation of the baht would have
dampened capital inflows, thus reducing the dependence on foreign financing
and attenuating both the boom and subsequent contraction. The greater
flexibility in exchange rates also would have encouraged domestic residents
to hedge their foreign currency exposure. However, policymakers in small
open economies are often reluctant to allow the currency to appreciate
in response to capital inflows precisely because such appreciation dampens
economic growth and reduces the competitiveness of the trade sector.
Finally, this recent episode reveals that in spite of progress made
in improving information from emerging markets, conventional accounting
measures may not always provide an accurate picture. In addition, it highlights
the much greater exposure of Asian economies to shifts in market sentiment,
raising the stakes in the debate on whether transparency should be further
enhanced and financial markets further liberalized, or whether some of
the activities of market participants should be curbed.
Ramon Moreno
Senior Economist
Opinions expressed in this newsletter do not necessarily reflect
the views of the management of the Federal Reserve Bank of San Francisco,
or of the Board of Governors of the Federal Reserve System. Editorial
comments may be addressed to the editor or to the author. Mail comments
to:
Research Department
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