Thailand: An Imbalance of Payments

Introduction: The Thailand Financial Crisis in 1997-98

The financial crisis of the late 1990s involved many nations, public and private organizations,
and people in Southeast Asia. This economic crisis started when the Thailand government
decided to make baht, its currency a floating currency that was earlier fixed to the US
dollars. Thailand was undergoing unprecedented rapid growth and economic evolution, and
it was considered the hub of growth in the region; hence the first to go under financially.
Other east Asian countries also experienced economic shock and decline. The crisis was
entirely unexpected until the first companies and banks began to go bankrupt in Thailand.

A small open economy is susceptible to a speculative attack, and more severely, it is likely to
get hurt. Proper balances in economic components are the only way to avert such an attack.
Thailand was an open economy that was hit by speculative attacks. It had enjoyed too much
wealth earned recklessly in its good days, which led to severe imbalances on the numbers of
its economy’s components. The unjustifiably optimistic characteristic of the economy had
mainly led to the deterioration of its condition. With the weak framework, it could stand
against outside attacks from speculators. Thailand had depleted its foreign currency reserve
in attempts to fight against the speculative forces. On July 2, 1997, the country decided to
switch to a flexible exchange rate regime. The Thailand currency “baht” depreciated by
more than 50% by the end of that year leading to the first collapse of their economy.

Development of the Thai Financial Crisis

Since the early 1990s, several factors, such as the stagflation of the Japanese economy, the
recession in European countries, and the accommodating economic policies, goal, healthy-
looking conditions of Thailand, attracted massive capital volumes inflow from aboard. Strict
financial regulations had limited the credit expansion of commercial banks for a long time.
Hence, starting from the beginning of the 1990s, the Thailand government decided to
implement a policy that would deregulate the financial market and liberalize capital
account. There was a long period of nominal exchange rate stability because it was fixed to
the world's dominant currencies, especially US dollars. Baht had fluctuated very narrowly
between 24.91-25.59 baht per dollar, a stable price level of 3.3-5.9%. The high-interest rate
at around 13.25% before the crisis. The inflation rate was low, between 3.36% and 5.7%. All
these factors led to the Thailand economy seem very attractive to international speculators.
Many of these speculators channelled their capital out of Japan, which was undergoing a
lengthy period of stagflation and low-interest rate. By 1995, Thailand had a net capital
inflow of US$ 14.239 billion, doubling from its net capital inflow three years ago.

Due to this high overflow of capital, there was a rapid expansion of the domestic investment
and the banking sector. Thailand’s investment rate between 1990-96 was the first place as
compared to the other nations of Southeast Asia. Stock market prices increased by 175%
overall and by 395% in the property sector. There was an emergence of more than 50 banks
and NBFIs, which the Bank of Thailand had leniently controlled and monitored. These
financial institutions had small constraints and difficulties in borrowing quite excessively
from abroad and lending with a dear interest at home. They made a large sum of money out
of the economy. Thailand’s banks became the world’s most profitable as the banks could
charge up to 4 percentage points more interest in loans than they paid on deposits, which
led to huge discrepancies compared to the banking system of developed economies.
Thailand’s lending business constituted 58% of GDP, the highest in the East Asian group.

The unhealthy practice of lending had put a large part of the capital into non-productive
sectors like real estate. These non-productive sectors produced non-tradable goods which
were sold domestically only, resulting in a less national volume of exports. This weakened
the economy's balance of trade and the capital account. Around 10-35% of bank loans were
committed to bricks and mortar, and only a small fraction of the capital inflow could be
attributed to foreign direct investment (FDI). The proportion of FDI had decreased over time
from 33.57% in 1990 to 15.90% in 1996.
Financial institutions were lending recklessly without prudence and proper monitoring. The
financial institutions had expected a safety net provided by the Thai government or the
Bank of Thailand if customers of these banks and financial institutions withdraw their
deposits simultaneously over concerns of the bank's solvency. The foreign creditors and
depositors were also at ease with the same bailout idea, as they credited money to the
financial institutions. The lending business was significantly larger for finance and securities
companies than for banks. The private sector lending by finance and securities company was
also quite significant. Later, these finance and securities companies were severely affected
by the incident of a non-performing loan crisis. The financial institutions borrowed from
foreigners mostly in dollar denomination and needed to pay back in the foreign-nominated
currency. They re-lent that foreign-denominated currency in baht at home. This led to a
mismatch between foreign liabilities and assets, and it would become difficult to repay if
they needed those liabilities suddenly. Later, this was going to be an essential reason for the
deterioration of the nation's balance of payment.

From 1995 onwards, Thailand's economic growth slowed down due to several reasons like
the contraction in the real estate sector, China emerging as an intimidating international
trade competitor, an appreciation of the dollars post Spring 1995, and the fall of the
semiconductor demand in the world which was one of the Thai significant exports. The real
estate business owners could not pay back their debts to financial institutions when the
maturity came because the real estate business had become unprofitable. The surge in non-
performing loans marked the beginning of a banking crisis leading to deterioration of the
bank's balance sheet. The country's current account balance had a current account deficit
ranging from -5.08 to -8.10 % of GDP. The country's trade deficit balance largely contributed
to this negative sum. The import value had widely exceeded its export value. The
speculators then started selling domestic assets to claim back their foreign assets. This
resulted in bank balance sheets became increasingly deteriorated leading to the economy
facing a severe credit crunch.

Ideally, the central bank needed to forfeit its foreign reserves to counter the capital flow out
of the nation or balance of payments deficit, by inject the foreign currency into the
economy. This could satisfy the excess demand of the currency and help the economy revert
to its exchange rate equilibrium. So as the speculators had kept taking dollars out of Thai
economy, the Bank of Thailand needed to infuse dollars using its stock of foreign reserves,
into the system. However, the central bank could not do that. Considering the enormous
size of foreign liabilities, it would not have been able to supply the foreign currency to the
economy. The speculators were aware of the massive gain from the devaluation of baht,
which resulted in a first massive speculative attack on May 14-15, 1997. An exchange-rate
switching policy was soon required to prevent further depletion of foreign reserves to
defend the value of baht.

By the Spring of 1997, more than 90% of the country's foreign reserve had been utilized to
secure the baht's value. Finally, Thailand was forced to switch its exchange rate regime on
July 2, 1997. There was a devaluation of Thai baht by about 15-20 percent after the
announcement, and its value went continuously down to reach a bottom at 48.80 baht per
dollar in December of the same year ever since Thailand started keeping record in 1969. The
open economies are interrelated through capital flow and trade. The health of an economy
depended upon how well it manages itself to be in a healthy balance of capital flow and
trade. The economy becomes unstable if the balances are not obtained. But the Thai
economy did not manage its balances well. Reckless capital flow management resulted in
bank balance sheets imbalances of the financial institutions. However, an imbalance in trade
was largely caused by outside factors likely to be exogenous to the economy of Thailand,
like China emerging in international trade, dollar appreciation, and fall in demand of
semiconductor. The Thai government could have taken specific measures such as the
abandonment of an exchange rate regime and investment in research and development to
find other exports that Thailand could profitably produce and export.

Response to the Crisis

There was no farsightedness in the way the Thailand government worked, and they were
only concerned about politics. For them, the only goal was to expand the Thai economy.
However, the economy did expand but similar to another economic bubble. There was
reckless liberalization of the financial sector. GDP growth had been around 8.5% during the
early 1990s, but most of the contribution of GDP came from the production of non-tradable
goods and from capital inflow, which was speculative. The structure of the economy was not
compatible with a large amount of capital to be used in real investment. Policymaking was
politically influenced. People were shown the brighter side of the economy like the growing
of the cities and business sectors, and high GDP growth, high saving rate, government fiscal
balance surpluses, the high volume of exports, but they were not shown the high debt on
the country and reckless capital transfer and use in the economy. The government decided
not to ask IMF for a rescue package immediately after the devaluation but waited until 26
days later to eventually ask IMF for help. The delay had a serious consequence as it
exacerbated the situation of the bank run.

The loose monetary policy of the government during the period right after the first
devaluation of the baht was to promote the production and growth of the economy.
Interest rates were kept low to increase the amount of money supply to the economy,
which would promote domestic consumption and investment. This step did not work
because of the bank panic. Hence, the creditors took their money out of the system and did
not want to invest further. The continuous spiral of currency depreciation increased the real
burden of the foreign-currency liabilities. After the failure of loose monitory policy, the
government tightened the monetary policy by raising domestic interest rates with the hope
of retaining the money in the system. Unfortunately, the policy propelled a more serious
contraction of the Thai economy and credit crunch.

The Mundell-Fleming Model

According to the Mundell-Fleming model (IS-LM-BP) model, the speculation of the

devaluation of the baht would lead to decreased investment and, during a crisis, expect
consumption to decrease and government expenditure to reduce. Looking at the open
economy IS curve, Y= C(Y-T) + I(r)+ G+NX(e)

While holding NX(e) constant, a decrease in C, I(r), and G would lead to an inward shift in
the IS curve, from IS0 to IS1. There is a decreased investment and to restore confidence in
foreign investment, the government tries to keep the interest rates high. Now they are
underneath the original balance of payments and current in deficit. Hence, to increase the
interest rates and get out of deficit, the government contracts the money supply (moving to
R1 and BP1).

Interest rate rises, but the GDP decreases substantially, and foreign investors still are
cautious about investing in Thailand. The crisis further worsens, and investment
deteriorates. Consumption and government expenditure continue to decrease, and the IS
curve once again shifts inward towards IS2. The government attempts to artificially increase
the interest rates, contracting the money supply once again (moving to R2 and BP2).
Investors are still not interested in investing with even higher interest rates. GDP again falls,
and this process continues. 

Mundell Fleming's model of the impossible trinity is based on the argument that capital
controls are not workable, and if a country wants to have its own monetary policy, then
exchange rates should be floated freely.

But the Mundell Fleming model is a stylized insight relying on simplified assumptions. There
is some association between interest differentials and capital flows, but there are other
forces that motivate capital flows, and these are much more random and non-optimizing
than conceived by this model. The real world tends to be more complex and nuanced. The
changes in risk assessments, booms-and-busts, and mindless herding in the capital-
exporting countries make international capital flows volatile.

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