Thailand's financial crisis: its causes, consequences, and implications.

Author:Leightner, Jonathan E.

The Asian financial crisis began in Thailand in 1997 and then spread throughout Asia and around the world. Before the crisis passed, Thailand, South Korea, Indonesia, Brazil, and Russia accepted large loans from the International Monetary Fund (IMF). Some feared that the entire international financial system might collapse. On all corners of the globe, governments now fear facing a similar fate as evidenced by the European Union (EU) recently developing an emergency plan to deal with a possible European financial crisis. In the Financial Times article, "Ministers Plan Simulation of EU Financial Crisis" (May 16, 2005), George Parker explained, "[a]lthough there are no signs that such a problem is likely to appear in the foreseeable future, European regulators are haunted by the Asian financial crisis in 1997-98, which shook the whole region." In addition to producing systemic fear, the crisis set in motion profound shifts in Thai economic, political, and social systems.

This paper explains the causes and consequences of Thailand's financial crisis. It begins with a brief summary of the literature. Afterwards, this paper goes beyond the current literature on Thailand's crisis by extending the story to the current year and explicitly presenting some of the most important institutional consequences of the crisis.

A Brief Survey of the Literature: The Causes of the Crisis

The literature on Thailand's financial crisis includes Leighmer 1999, 2000, 2002, forthcoming; Alam and Leighmer 2001; and Leightner and Alam 2002. The story of the Thai crisis has parallels in the Japanese stories told by Ozawa (1999; 2003) and in the South Korean stories told by Zalewski (1999a; 1999b; 2002). The risks that Grabel (1999; 2000) warns of for Asia, the invidious distinction and conspicuous consumption that Elliott and Harvey (2000) warn of for Jamaica, and the problems with absentee ownership and the menace of competition that Atkinson (1999) warns of for globalization have counterparts in the Thai story. After summarizing the literature on the relationship between capital account liberalization and crises, Eichengreen (2004) argues that capital account liberalization is "unavoidable"; however, the pace of liberalization needs to be controlled and correctly sequenced to minimize the risks of future crises. Specifically, domestic financial markets need to be liberalized first and prudential supervision strengthened; foreign direct investment liberalized second; stock and bond markets third; and offshore banking last. The Thai case started with Thailand setting up an offshore banking center.

In the early 1990s, wages in Thailand increased much faster than wages increased in its neighbors--Cambodia, Laos, Malaysia, Burma (Mayamar), Vietnam, and Southern China. The Thai government was concerned that Thai manufacturers would move their production facilities to neighboring countries. In response to this concern, the Thai government decided to help those neighbors grow. The theory was that if Thailand could be the older brother (patron) that helped its younger siblings (clients), then when the siblings grew enough to threaten Thailand, they would be grateful for past help and be responsive to their older brother's needs. Therefore the Thai government established tax breaks and other incentives for Thai businesses to invest in Thailand's neighbors (Leightner 1999).

A good older brother also provides financing. Thus, Thailand decided to establish the Bangkok International Banking Facility (BIBF) which began operating in 1993. The intent of the BIBF was to attract money from the United States, Japan, and Europe to lend to Thailand's neighbors. However, the government's good intentions were subverted by business realities. (1) Since Thailand had much higher interest rates than its neighbors did, the foreign money was loaned to native Thais. Part of this foreign money fueled a speculative bubble in the Thai property market. Speculators purchased property because they expected the price of the property to rise in the near future. Their increased purchasing of the property caused the price of the property to rise, which caused even more speculative buying. When it became obvious that the current price greatly exceeded the real value of the property, speculators quickly sold, causing the price to collapse--the bubble burst (Leightner 1999).

In 1996, the Bangkok Bank of Commerce (BBC) experienced serious cash flow problems due to delinquent loans to the property sector. In an effort to solve its cash flow problems, the BBC asked politicians to whom it had made loans, to start paying on those loans for the first time. Apparently, some politicians saw BBC loans as bribes and had not intended to ever make payments on them. The Bank of Thailand (BOT), foreseeing a major political scandal, tried to cover up the BBC problems. When these problems were revealed to the public, the Bank of Thailand's reputation had been tarnished. Prior to 1996, the BOT had the reputation of being above corruption.

On March 3, 1997, the BOT increased reserve requirements on all financial institutions and named ten weak finance companies. Banks that hold higher reserves are viewed as stronger but adjusting to higher reserve requirements reduces the profits of banks and decreases the domestic money supply. Thus, the BOT was worried that announcing higher reserve requirements would cause a panic and snowball dumping of Thai financial institutions' stocks and bonds. Therefore, immediately prior to announcing the higher reserve requirements, the Thai government suspended (for one day) the trading of all bank and finance company stocks on the stock market. This was the first time in the 21 year history of the Thai stock market that trade was suspended. In spite of the BOT's good intentions, panic began.

These events created a run on all finance companies, especially the ones cited for being weak. The speculative bubble in the Thai property market affected finance companies much more than banks because a relatively high percentage of finance company loans were to the property market. Furthermore, the BIBF licenses held by all Thai banks made it possible for them to obtain funds (from overseas) much cheaper than Thai finance companies could, (because finance companies could only raise funds from domestic deposits). Even prior to the BIBF, the playing field between Thailand's 15 commercial banks and its 91 finance/securities companies was biased in favor of the banks. The BIBF made this bias worse and there was serious concern that all 91 of Thailand's finance and securities companies would go bankrupt (Leightner 1999; forthcoming; see also Atkinson 1999, on the menace of competition; and Elliott and Harvey 2000, on invidious distinction).

George Soros used the above events and concerns in order to lead a speculative attack on the Thai baht--the official currency of Thailand. To understand speculative currency attacks, one must understand how fixed exchange rates are maintained. If an exchange rate is fixed above equilibrium, then a surplus of the currency emerges and the government must buy up this surplus (paying for it with foreign reserves) in order to keep the exchange rate from falling. If an exchange rate is fixed below equilibrium, then a shortage of the currency emerges and the government can maintain the fixed exchange rate by printing more currency and exchanging it for additional foreign reserves.

This author does not know the actual amounts of money used in George Soros' speculative attack against the Thai baht in the spring of 1997; therefore, the numbers used in this paragraph to illustrate how a speculative attack is conducted are hypothetical. First, George Soros bought forward currency contracts on the baht in the spring of 1997. Forward currency contracts are legal agreements to exchange currency at an agreed upon rate at some date in the future. Perhaps these forward contracts gave Soros the option of selling baht at the rate of one US$ for 26 baht in January of 1998. Next Soros sells all of his baht, convinces all of his friends to sell their baht, and advertises the current problems of the Thai economy (see above) in an effort to get others to sell their baht. Soros advertised Thailand's problems because he wanted to create a panic where all foreign investors would want to sell their baht immediately for fear its value was on the verge of collapse. As everyone begins selling baht (and no one wants to buy it), the Thai government must buy up the resulting surplus in order to maintain the fixed exchange rate. Thailand spent US$6.8 billion and committed at least an additional US$23.4 billion in forward obligations in an effort to maintain the fixed exchange rate (Leightner 1999; note Thailand had US$39 billion of foreign reserves in January 1997). On July 2, 1997, the BOT gave up its fixed exchange rate and floated the baht (stopped buying and selling to keep the baht's value fixed). By January 1998, the baht had fallen to US$1 for 54 baht. In January 1998, George Soros could exchange US$1 billion for 54 billion baht on the spot market (the market using current prices). He could then use his forward contracts to exchange the 54 billion baht for more than US$2 billion--more than doubling his money. (2) Soros took advantage of Thailand's problems to make a huge personal profit and in the process Thailand was devastated.

Institutional Consequences of the Crisis: Credit

When the value of the baht fell from US$1 for 25 baht in June of 1997 to US$1 dollar for 54 baht in January of 1998, the dollar value of Thai exports was halved and the price Thailand had to pay for imports doubled. Thailand fell into a serious recession. On August 19, 1997, Thailand accepted a US$17.2 billion from the IMF and the World Bank. This loan came with conditions, which would cause the Thai economy to contract further, but had the implicit goal of improving foreign investor...

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