Thailand's Currency Crisis

• fixed exchange rate regime
  • Economic theory suggests that a pegged exchange rate regime can become vulnerable when cross-border capital flows are highly mobile.
  • A central bank that pegs its exchange rate to a hard currency implicitly guarantees that any investors can exchange their local currency assets for that hard currency at the prevailing exchange rate. If investors suspect that the government will not or cannot maintain the peg, they may flee the currency; this capital flight, in turn, delete hard currency reserves and force the devaluation they fear.
• Asian financial institutions had borrowed a significant amount of external liquid liabilities that were not backed by liquid assets, making them vulnerable to panics.

• Two Theories of Origins of Asian Crisis: Fundamentalist and Panic:

1. The Fundamentalist View: The fundamentalist view holds that flawed financial systems were at the root of the crisis and its spread. The seeds for the financial crisis were actually shown several years before currency pressures began. Most East-Asian countries had tied their currencies to the dollar. This tie served them well until 1995 because it promoted low inflation, supported currency stability, and boosted exports. However, the appreciation of the dollar against the yen and other major currencies since 1995 caused East Asian countries to lose their competitiveness in export markets. The crash of world trade in 1996 after two years of rapid growth also affected the Asian markets. From April 1995, the US dollar appreciated continuously and significantly. The dollar linked Asian currencies appreciated accordingly and this made their exports uncompetitive leading to large currency account deficits.
2. The Panic View. Subscribers to the panic view admit that there were vulnerabilities: increasing current account deficits, falling foreign exchange reserves, fragile financial systems, highly leveraged corporations, and overvaluation of the real exchange rate. But these vulnerabilities were not enough to explain the abruptness and depth of the crisis. They argue that economic fundamentals in Asia were essentially sound. Several factors support the premise that the crisis was panic-induced. First, there were no warning signs, such as an increase in interest rates on the region's debt or downgradings on the region's debt by debt rating agencies. Second, prior to the crisis, international banks made substantial loans to private firms and banks that did not have any sort of government guarantees or insurance. This fact contradicts the idea that moral hazard was so pervasive so that investors knowingly made bad deals, assuming that they would be bailed out. It is consistent, however, with the notion that international investors panicked in unison and withdrew money from all investments--good or bad.

• Thailand's economy surged until early 1997 partly because the Thais - specifically large corporations - found they could borrow money at low interest rates overseas, in dollars, more cheaply than they could at home, in baht.
• Thai gov't shifted controls from direct controls to more indirect market-conforming controls, such as interest rates. But it can be said that, in general, financial liberalization reduced the power of the central bank to influence monetary policy.
• Monetary policy became even more difficult with the increased liquidity on financial markets as a result of the capital inflows.
• By late 1996, foreign investors began to move their money out of Thailand because they worried about Thais' ability to repay.
  • 1990-1996: inflow was 10% of GDP
  • inflows tripled in just two years from $25.8 billion in 1994 to $83.5 billion
  • If capital inflows slow or reverse, the boom can collapse. This is precisely what happened in Thailand.
  • by 1998: outflow was 8.5% of GDP
  • foreign financing $106.6 billion in 1996 to $28.8 billion in 1997
• In February 1997, foreign investors and Thai companies rushed to convert their baht to dollars. The Thai central bank responded by buying baht with its dollar reserves and raising interest rates.
• On July 2, 1997, the central bank stopped defending the baht's fixed value against the dollar. And then the currency lost 16 percent of its value in one day.

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