127 วารสารเศรษฐศาสตรธรรมศาสตร Thammasat Economic Journal ปที่ 24 ฉบับที่ 1 มีนาคม 2549 Vol.24, No. 1, March 2006 Financial Crisis Theories Explaining the 1997 Thai Financial Crisis Il-Hyun Yoon* Abstract Two models were developed to explain financial crises; first-generation and second- generation models. First-generation models view crises as the unsustainable fiscal and monetary policies incompatible with a pegged exchange regime, or fundamental imbalances. The second- generation crisis models highlight self-fulfilling expectations and multiple equilibria. After the 1997 Asian financial crisis, alternatives to the existing models emerged. Moral hazard, financial fragility, balance sheet imbalances and contagion are captured in the so-called third-generation models. This study reviews models of financial crisis and examines the Thai financial crisis which spilled over into the rest of Asian region in 1997-1998. The Thai currency was the target for speculative attacks due to the expectation that the country’s increasing current account deficit could keep the fixed exchange rate regime no longer sustainable. [E44, F31] Keywords: contagion, financial crisis, first-generation models, self-fulfilling expectations, speculative attacks. _________________________ * I am indebted to an anonymous referee for the valuable comments and suggestions on this paper. * Research Fellow at Korea University, Department of Economics, the BK21 Research Group (Tel: 3290-2717,Email: [email protected]). This work was supported by the Brain Korea 21 Project in 2005.
Financial Crisis Theories Explaining the 1997 Thai Financial Crisis
Il-Hyun Yoon* Abstract
Two models were developed to explain financial crises; first-generation and second-generation models. First-generation models view crises as the unsustainable fiscal and monetary policies incompatible with a pegged exchange regime, or fundamental imbalances. The second-generation crisis models highlight self-fulfilling expectations and multiple equilibria. After the 1997 Asian financial crisis, alternatives to the existing models emerged. Moral hazard, financial fragility, balance sheet imbalances and contagion are captured in the so-called third-generation models. This study reviews models of financial crisis and examines the Thai financial crisis which spilled over into the rest of Asian region in 1997-1998. The Thai currency was the target for speculative attacks due to the expectation that the country’s increasing current account deficit could keep the fixed exchange rate regime no longer sustainable. [E44, F31] Keywords: contagion, financial crisis, first-generation models, self-fulfilling expectations, speculative attacks. _________________________ * I am indebted to an anonymous referee for the valuable comments and suggestions on this paper. * Research Fellow at Korea University, Department of Economics, the BK21 Research Group (Tel: 3290-2717,Email: [email protected]). This work was supported by the Brain Korea 21 Project in 2005.
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1. Introduction Until the early 1970s, under the Bretton Woods system,1 the international payments system
was shaped by Keynes’s incompatibility thesis that “flexible exchange rates and free international capital mobility are incompatible with global full employment and rapid economic growth in era of multilateral free trade” (see Davidson (2001)). The global economy experienced unparalleled growth and prosperity in a stable international monetary system under widespread capital control and financial market regulations.
In the 1970s, however, the accelerating growth of financial markets and the abandonment of the Bretton Woods system, in favour of a regime of floating exchange rates, led to increasing instability with volatile exchange rate movements and very large short-term capital flows. Especially, since 1973, when the oil price shock created huge international payments imbalances and unleashed inflationary pressures in oil-importing nations, the international financial system has grown progressively more fragile with recurrent crises in financial markets.
The 1990s witnessed several episodes of currency turmoil, most notably the EMS crisis in 1992-93, the Mexican crisis in 1994-95 and the Asian crisis in 1997-98. However, the economic effects of the Asian crisis have been especially devastating. During the first year of the crisis, the currencies of the five affected countries depreciated by 55-70 per cent (with Indonesian rupiah devalued by more than 500 per cent depreciation), dwindling substantially the wealth of the five success economies (see Table 1). The crisis was triggered by Thailand's abandonment of the peg of its currency to the US dollar on 2 July 1997.
There have been some existing models to explain the currency crisis (so-called first- and second-generation models). These models, however, are not sufficient to explain the Asian financial crisis. The Asian financial crisis brought about the advent of alternatives to the existing models.
1 It is referred to as the international monetary system that prevailed from the end of World War II until the early 1970s, based on stable and adjustable exchange rates.
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This paper reviews various financial crisis theories in the literature and investigates the Thai financial crisis which was the origin of the contagious economic turmoil in the whole Asian region.
The rest of the paper is organised as follows. Section 2 introduces financial crisis theories and section 3 investigates the Thai financial crisis while section 4 concludes.
2. Financial Crisis Theory After the collapse of the Bretton Woods system, as Tobin warned,2 there have been a string
of crises in the global financial markets. Starting with the Latin American debt-liquidity in the early 1980s, there had been many crises before the 1997 Asian crisis, including three Scandinavian countries (Norway, Sweden and Finland) in the late 1980s-early 1990s, the EMS currency crisis in 1992, and the Mexican Pesos crisis in 1994. Even after the Asian financial crisis, Russian crisis and Brazilian crisis followed in 1998 and 1999, respectively. More recent episodes of the financial crisis include the Turkish crisis of February 2001 and Argentina’s crisis of December 2001.
In order to investigate what a financial crisis is, the problem of asymmetric information, which plays an important role in financial crises, needs to be examined. Asymmetric information can be described as a situation where one side to a contract has much more exact information than the other side. The problem of asymmetric information is in turn the cause of two major concerns in the financial system: adverse selection and moral hazard. Adverse selection occurs when the potential borrowers who are the most likely to produce an adverse outcome are the ones the most likely to be selected. Exploiting the lender’s lack of information, borrowers undertaking risky activities find it convenient to hide true nature of a project.
2 Tobin warned in his ‘The New Economics One Decade Older’ (1974, Princeton) that “free international financial markets with flexible exchange rates can be extremely volatile and can be therefore have a devastating impact on specific industries and whole economies” (Davidson (2001: 14).
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Moral hazard happens in a situation where one party of a contract will do well in case of a favourable outcome, but will not suffer even though the outcome is negative. In that case the other party of the contract will bear most of the loss. Corsetti, et al. (1999b) found the existence of moral hazard when domestic financial institutions believe government will intervene to help if they are in financial trouble. The moral hazard leads to over-borrowing and over-lending.
Using the two problems arising from asymmetric information, Mishkin (2001) provided the following definition of a financial crisis:
A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities. The recurring financial crises have led to a proliferation of explanations about its origin.
Traditionally (before the 1997 Asian crisis), there had been a long-standing debate between two competing interpretations of the currency crisis: so-called “first-generation models” and “second-generation models”.3 2.1 First-generation models
In the literature on the currency crisis, one approach – often referred to as first-generation models or exogenous policy approach – views a currency crisis as the natural outcome of unsustainable policy stances incompatible with a pegged exchange regime or structural imbalances while the other approach – known as second-generation models or endogenous policy approach – regards the crisis as self-fulfilling, expectations-driven, processes, not driven by fundamental factors. First-generation crisis models, pioneered by Krugman (1979) and refined by Flood and Garber (1984), explain a crisis as the product of fiscal deficits. The government with a persistent deficit
3 A currency crisis can be defined as a speculative attack on a country’s currency that can result in a forced devaluation and possible debt default. Investors “flee a currency en masse out of fear that it might be devalued, in turn fuelling the very devaluation they anticipated”. (Krugman (2000)).
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would exhaust its limited stock reserves to defend its exchange rate and eventually abandon a fixed exchange rate. When foreign exchange reserves fall below a critical level, a speculative attack occurs because agents attempt to avoid suffering capital losses (or to achieve capital gains) in preparation of collapse of the fixed exchange rate.4
These models argue that a speculative attack on the domestic currency can result from an increasing current account deficit, which indicates an increase in the trade deficit and leads to a fiscal deficit. According to Krugman (1979), a fixed exchange rate system is the unavoidable target of a speculative attack which is a key assumption in the models. The government defends the exchange rate peg with its foreign currency reserve. As agents change their portfolios from domestic to foreign currency because of the fear due to growing fiscal deficit, the central bank must continue to exhaust its reserve to stave off speculative attack. The crisis is triggered when agents expect the government to abandon the peg. The central bank’s reserves fall to the critical level when a peg is no longer sustainable and the exchange rate regime collapses.
The first-generation models help explain some of the fundamentals that cause currency crises, but do not explain why the currency crises spread to other countries. Obstfeld (1986) diagnosed that speculative attacks appear to be self-fulfilling since they may occur “even when the level of reserves seems sufficient to handle normal balance-of-payment deficits”. There exists circumstance in which crises may indeed be purely self-fulfilling events rather than the inevitable result of unsustainable macroeconomic policies.
4 Krugman (1979: 324) stated that “a balance-of-payment problem – defined as a situation in which a country is gradually loosing reserves – becomes a balance-of-payment crisis in which speculators attack the currency”, and “balance-of-payment crises are a natural outcome of maximising behaviour by investors”.
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2.2 Second-generation models
In 1992 and 1993, the Exchange Rate Mechanism of the European Monetary System (EMS) suffered a huge speculative attack, which ended the mechanism, and led to the monetary union and its common currency (see Eichengreen (2000)). The first-generation models, in which reserve loss caused speculative attacks and devaluation, were challenged not to fit in explaining the EMS crisis that culminated in the August 1993 widening of exchange rate bands within the EMS.
The EMS crisis and the following Mexican crisis of 1994-95 led to second-generation models, developed by Obstfeld (1994) and Obstfeld (1996). According to the second-generation models, speculative attacks are triggered by just the probability, rather than existence, of inconsistencies in economic policies. In the EMS crisis that erupted in September 1992, reserve losses certainly accompanied a crisis, but they were not the factor that triggered it nor the factor that ultimately led the authorities to devalue (Obstfeld (1994)). Obstfeld (1996) noted that a “sunspot with low ex ante probability” can have devastating effects in a world of incomplete markets and cause a crisis.5 Highly indebted governments with mostly short-term or floating-rate nominal debts may suffer from a speculative attack in expectations of depreciation, as seen in the 1994-95 Mexican experience.6 A speculative attack forcing the devaluation of one country’s currency may make other counties subject to crisis, which was to become one of explanations of the origins of the 1997 Asian financial crisis.
In the second-generation models, government could fight speculation by using high interest rate and/or selling international reserves, but prefer to let the exchange rate float to avoid the real cost in terms of unemployment that could follow (Eichengreen, et al. (1996)). Faced by the speculative attacks, the government decides whether to defend a fixed (or pegged) exchange rate considering
5 For more details, see Obstfelt (1996: 1044-1045). 6 In Mexico, as a large amount of short-term foreign currency linked debt (tesobonos) was coming to maturity and foreign reserves were insufficient to service this debt, the risk of a self-fulfilling rollover crisis by investors’ panic became evident.
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trade-off between the benefits of a strong currency and the costs of higher unemployment. This endogenous policy response could trigger a crisis. The interaction between agents’ expectations and actual policy outcomes leads to self-fulfilling crises.
The second-generation models also include the existence of multiple equilibria. There is a “good” equilibrium where the markets do not attack the currency and the government’s preference is to maintain the peg, which is possible since the fundamentals allow the survival of the regime. Simultaneously, there exists a “bad” equilibrium where an attack, if it were to occur, would succeed. These multiple equilibria exist because markets act on the basis of expectations of a particular outcome. What makes a crisis occur is the belief that it can occur. Expectations that are ex ante unjustified are validated ex post by the outcome that they have provoked, which Wyplosz (1998) called “self-fulfilling”. In other words, there is more than one equilibrium that can be rationally anticipated by economic agents, and in the presence of multiple equilibria, financial and currency instability can be driven by sudden changes in agents’ coordination from one equilibrium to another, given the economic fundamentals (Corsetti (1999)).
Two traditional views of currency crises discussed above provided the two main frameworks in which to interpret cases of currency instability. The second-generation models of self-fulfilling crisis developed by Maury Obstfelt have been favoured by a number of authors after the 1997 Asian financial crisis.7
However, the two models seem to be insufficient to explain the 1997 Asian financial crisis, although they provide a partial explanation of the crisis.
7 In fact, Krugman, organiser of the first-generation crisis models of fundamentalists stories, conceded: “I was wrong; Maury Obstfelt was right” (see Krugman (1999)).
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2.3 Alternative models on the financial crisis The Asian crisis triggered by the devaluation of the Thai Baht in July 1997 inspired a new
kind of crisis model, called “third-generation crisis models”, as it did not conform to the first- and second-generation crisis models to the extent that Krugman (1999) admitted the Asian crisis aroused a “sense of humility” as well as a sense of vindication for the currency-crisis theorists. Due to the complexity and specialties of the Asian crisis,8 there has not been an identifiable consensus on the new models. Other than traditional indicators of the crises, various factors like moral hazard problem, financial fragility and balance sheet implications have become to be considered in modelling the crises.
One strand of third-generation models emphasises that the crises are driven by weaknesses in the financial sector. These include a weakly supervised and regulated financial system; moral hazard; and fixed exchange rates distorting external borrowing in the direction of short-term foreign currency debt.
Ineffective prudential regulation and supervision over the financial sector, especially in the process of capital market liberalisation, contributed to excessive borrowing from abroad and increased the risk that temporary liquidity shortages will trigger full-fledged financial crisis (IMF (1998), Pesenti and Tille (2000)).
Moral hazard as a result of implicit or explicit government guarantees encouraged over-borrowing and excessive exposure to foreign exchange by financial institutions (see McKinnon and Pill (1996) and Krugman (1998)). The essence of moral hazard is that, if things went wrong, agents “rationally expect the government to step in and modify its course of action in order to bail out troubled private firms” (Corsetti, et al. (1999a)). When visible losses led governments to withdraw
8 For example, the crisis was not jut confined to the currency markets, regional contagion was high, and problems in the crisis-hit nations were largely microeconomic problems such as maturity/currency mismatches, moral hazard, excessive leverage, etc.
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their implicit guarantees, foreign creditors suddenly withdraw their loans from even solvent borrowers and financial crisis erupt.
This financial fragility brought about self-fulfilling “international illiquidity” or a “financial panic” on the part of international lenders (see Radelet and Sachs (1998), and Chang and Velasco (1998)). Chang and Velasco (1999) attempted to build a model of financial sector illiquidity to explain recent crises as the by-product of a bank run. Bank runs are a common feature of extreme crises. During a bank run, depositors rush to withdraw their deposit due to self-fulfilling loss of confidence.
In addition, new models have stressed the role of balance sheet imbalances deriving from currency mismatches (see Krugman (1999), Cespedes, et al. (2000), Allen, et al. (2002) and Cavallo, et al. (2002)). Large currency devaluation in the presence of foreign currency liabilities (“liability dollarisation”) can increase the value of debt relative to revenues, crippling insufficiently hedged debtors and leading to business failures. The third-generation models based on balance sheet analysis were developed to understand how capital account movements lead to currency and financial crises (see Dornbusch (2001)). Balance sheet issues are fundamentally linked to mismatches. In a mismatch situation, exchange rate depreciation works in an unstable manner to increase the prospect of insolvency and hence the urgency of capital flight.
Other contributions try to model the “sudden stop” and “capital inflow reversal” phenomenon (Calvo (1998), Calvo and Reinhart (1999), Schneider and Tornell (2000) and Mendoza (2001)). Sudden stop features an abrupt stop in foreign capital inflows and/or a sharp capital outflows with a currency crisis.
A striking aspect of the crises in the 1990s was their speedy regional spread across countries. The devaluation of the Thai baht in July 1997 was followed by currency crises in Malaysia and Indonesia within a month and in Korea a few months later. This phenomenon is usually referred to as
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“contagion”.9 More precisely, Kaminsky and Reinhart (2000) defined it as “a case where knowing that there is a crisis elsewhere increases the probability of a crisis at home”. Although the transmission of shocks can not be clarified by fundamentals (Forbes and Rigobon (2000)), various explanations for the contagion across countries can be offered – common shocks, trade linkages, financial interdependence and information asymmetries.
Common shocks can affect different countries similarly, which display similar elements of domestic vulnerability. Some Asian countries shared common features such as a high reliance on foreign-denominated debt and a relatively stable exchange rate against the US dollar (Pesenti and Tille (2000)).
Contagion also spreads easily to countries which are closely tied by international trade linkages (see Eichengreen, et al. (1996)). The currency devaluation by a country reduces the price of its goods in foreign markets, leading to losing neighbouring country’s competitiveness and to deteriorating its current account deficit.
Besides, different countries are financially interdependent if they borrow form the same creditors. A currency crisis in a country reduces the ability of domestic borrowers to repay their loans to foreign lenders. Foreign banks, faced with a large portion of non-performing loans, recall their loans made to borrowers in other countries, causing credit crunch in those country.
Information asymmetries in financial markets give another explanation on the spreading of a crisis. Financial globalisation reduces incentives for gathering and processing costly country-specific information and thereby strengthens contagion (Calvo and Mendoza (2000)). Investors tend to downplay national specificities and asymmetries, and consider several countries in a region as substantially homogeneous. Under asymmetric information, as pointed out as herding behaviour by Calvo (1999), “rational but imperfectly informed” investors can be triggered by signals emitted by
9 Some crises are often called the “Tequilla effect” of 1994, the “Asian flu” of 1997, and the “Russia virus” of 1998 to stress their contagious nature.
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informed individuals. Set against the background of various explanations, next section examines the Thai crisis to investigate which financial models can be applied to explain it.
3. The Thai Financial Crisis The Thai abandonment of its currency peg in July 1997 drove the neighbouring countries into
a severe economic turmoil. Geographically, the countries hit by the crisis originating from the Thai baht devaluation are mostly located in Southeast Asia while Korea belongs to Northeast Asia.10 This section focuses on Thailand and covers the background and historical facts of the currency turbulence in the Southeast Asian region. 3.1 Background
For years before the outbreak of the Asian crisis, the success of several Asian economies created what has been called the “Asian Model” to be pursued by developing countries worldwide.
The economic success in Japan, the “four tigers” – Hong Kong, Korea, Singapore and Taiwan – were followed by the three newly industrialised countries (NICs) of Southeast Asia – Indonesia, Malaysia and Thailand.11 These eight high-performing Asian economies were the subject of the World Bank’s report ‘The East Asian Miracle: Economic Growth and Public Policy’ (see World Bank (1993)).12
These NICs constitute the Association of Southeast Asian Nations, or ASEAN, which was established on 8 August 1967 in Bangkok by the five original Member Countries, namely, Indonesia,
10 The crisis is, therefore, often called the “East Asian (financial) crisis”, as seen in “The Onset of the East Asian Financial Crisis” by Steven Radelet and Jeffrey Sachs (1998). 11 The three nations were called the “cubs of the tigers of Asia” – compared with four tigers - which had brought in the "Asian miracle" that the former had succeeded in repeating (Jomo (1997)). 12 According to the report, the 23 economies in the region grew faster than all other regions and these eight countries have grown at a rate more than twice as fast as the rest of East Asia since 1960.
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Malaysia, Philippines, Singapore, and Thailand.13 The city-state Singapore was the first ASEAN country to achieve the NICs status, while the other four member countries (hereafter referred to as ASEAN-4) suffered severely from the financial crisis and their economies have yet to recover from the shocks.
Table 2 provides the pre-crisis macroeconomic performance of the five ASEAN countries. The data suggests that these economies had for a long time enjoyed strong fundamentals, including high growth, high domestic savings, low inflation and healthy fiscal positions, while Thailand’s current account deficits were relatively high.
The sustained vigour of the economies in the 1990s raised optimism that rapid growth would continue indefinitely although the sustainability and efficiency of the growth was questioned by some scholars such as Krugman (1994) and Young (1995). Capital inflows into the region were boosted by decline in asset yields and lower interest rates and abundant liquidity in industrialised countries (see Table 3 and Table 4).
Movements in exchange rates among the major currencies have been another significant factor. Since Japan is central trading partner with ASEAN countries, any change in yen/dollar exchange rate was bound to cause their trade performance. The ASEAN-4 had special exchange rate arrangements entailing close links to the US dollar. When the US dollar continued to weaken against the yen starting from the level of 130 yen in May 1992 until reaching an all time low 79.75 yen on 19 April 1995 (see Figure 1), it increased the competitiveness of the ASEAN-4 as their currencies depreciated vis-à-vis the yen and eventually they had substantial gains in net exports and growth. However, as shown in Figure 1, when this decline in the dollar was reversed over the two years beginning in mid-1995, with the dollar recovering against the yen, the countries suffered substantial
13 Later, Brunei joined on 8 January 1984, Vietnam on 28 July 1995, Laos and Myanmar on 23 July 1997, and Cambodia on 30 April 1999.
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losses in competitiveness, with adverse effects on net exports and growth. These developments led to sharp slowdown in export revenues in these countries.
In the process of movements toward liberalisation and increasing competition without prudential regulation in place and appropriate supervision over financial institutions, the fixed exchange rate regime, along with the relatively high domestic interest rates, encouraged private financial sector in Thailand to borrow from abroad in order to exploit the interest differential.14
Looming currency turmoil in Thailand caused by a string of speculative currency attacks led to spill-over, though limited until then, into neighbouring ASEAN countries. The abandonment of Thai exchange rate peg against the dollar and the implementation of the baht to float put the other three countries under pressure to devalue and precipitated eventual huge loss in the value of their currencies. 3.2 The Thai financial crisis
The Asian crisis of July 1997 has been said to arrive with little warning. However, Thailand had shown a few warning signals ahead of full-fledged crisis.
The Thai baht had come under downward pressure in January and February 1997 due to intensified concerns regarding the sustainability of the US dollar peg due to large current account deficit, high short-term debt, the collapse of property price bubble and erosion of external competitiveness. Renewed pressures on the Thai baht in early May caused the central bank to intervene heavily in the market, introducing capital and exchange controls and higher interest rates policy. These measures failed to restore confidence in the currency.
Thai economy came to a crashing halt when increased speculative attacks on its currency forced the abandonment of the peg on 2 July 1997 after enjoying a decade of the world’s highest
14 Net government borrowing has less than half a per cent of GDP for 1990-1996 in each Southeast Asian country, except in the Philippines, where it averaged 1.3 per cent of GDP (Radelet and Sachs (1998)).
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economic growth. In fact, growth in real per capita income averaged 5 per cent each year and real Gross Domestic Product (GDP) grew at about 9 per cent a year since 1986, but slowed down in 1996 (see Table 5).
From 1960 to 1996, annual economic growth in Thailand averaged nearly 8 per cent. In the 1960s, growth was led by strong public sector investments in infrastructure and by expanding private investment in manufacturing, especially in import-substituting industries. The expansion of the industrial sector was attributed to a number of favourable factors, including abundant supplies of natural resources, labour, and economic and political stability. In addition, the government played a strong role in promoting industrialisation, influenced by Keynesianism, the dominant economic school before the 1970s.15 The Thai economy continued to expand at high rates in the seventies with rapid expansion of manufactured exports, promoted by the third NESDP (1972-1976).
In the 1980s, Thailand faced economic difficulties with GDP growth averaging 5.6 per cent from 1980 to 1985 in comparison with the average rate of nearly 8 per cent over the last decades, following the two sharp oil crises and the resulting world recession of early 1980s.16 The crisis originated in the finance companies, which were poorly supervised and had engaged in heavy speculations in shares and real estate (see Alba, et al. (1999)).
15 The Thai government’s strong influence over the economy was reflected in the establishment of government economic agencies, such as NESDB (National Economic and Social Development Board) for development strategies, MOF (Ministry of Finance) for tax policies, MOC (Ministry of Commerce) for trade policies on agricultural and industrial products. Many effective socio-economic plans formulated by these agencies included the five-year National Economic and Social Development Plan (NESDP) introduced by NESDB in 1961. At present, the ninth plan (2002-2006) is in implementation. For more information, see the website of the Royal Thai Government available at www.ThailandOutlook.com. 16 During economic recession period, 24 finance companies were closed; the current account deficit was 9 per cent of gross domestic product (GDP); foreign debt was 19.5 per cent of the total value of exports. These problems brought about the devaluation of the baht in 1984.
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Thai economy was also greatly affected by the rapid movement in some of the world major currencies. After the collapse of the Bretton Wood system, Thailand chose to continue pegging its currency with the US dollar. As the US currency appreciated against other major currencies between 1978 and 1985, Thailand lost its competitiveness. The government was forced to devalue the currency, the baht, by 1.7 per cent in April and 8.7 per cent in July 1981, and went on to abandon the single-currency fixed exchange rate to the basket system in 1984, which amounted to an effective devaluation against the US dollar by another 15 per cent (Ariff and Khalid (2000)).17 However, a dramatic turnaround emerged in the second half of the 1980s. Starting from 1986, economic growth accelerated sharply, mainly due to increasing export resulting from the weak dollar, foreign exchange income from tourism, and large inflows of foreign capital.18 The total inflow of foreign investments in the last three years of the 1980s was equivalent to the total inflow of the previous thirty years - from US$190 million in 1980 to US$ 1,105 million in 1988 (Shen (2001)). Thai capital inflows accelerated averaged a remarkably high 10.3 per cent of GDP between 1990-96, compared with 6.7 per cent in the Southeast Asian region (Radelet and Sachs (1998)).
The growth in demand for investment funds coincided with the decision of the Bank of Thailand to liberalise Thailand’s financial system. In 1990, Thailand accepted the obligations under Article VIII of the International Monetary Fund which required the lifting of all controls on all foreign exchange transactions on the current account. The opening of the capital account was also accelerated by the launching of the Bangkok International Banking Facility (BIBF) in 1993. BIBF,
17 The system of pegging the baht to the US dollar was replaced with a basket of currencies in 1984. The basket includes a heavy reliance on the US dollar, the yen, the mark, the pound sterling, the Hong Kong dollar and the Malaysian ringgit, with the US dollar having the maximum weight of 85 per cent. The weight of each currency in the basket is undisclosed and depends on the relative importance of that currency in Thai trade flows (see Ariff and Khalid (2000: 211)). 18 It included two digit growth rates of 13 per cent, 12 per cent and 11 per cent in 1988, 1989 and 1990, respectively (Data: Bank of Thailand).
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which was established to allow the free movement of financial capital in and out of country, expedited an influx of short-term loans, with a view to benefiting from the significantly high interest rate in the country in comparison with that of developed economies (see Table 4 and 5). The bulk of capital inflows came in the form of offshore borrowing by banks and private corporations, which together averaged 7.6 per cent of GDP in the 1990s (Radelet and Sachs (1998)), and the maturity structure of the debt was to a large extent on the short-term basis that had to be repaid within one year. The country’s ratios of short-term debt/total debt, and short-term debt/reserves reached 46 per cent and 107 per cent, respectively, by mid-1997 (Shen (2001)). Large capital inflows went not only into manufacturing, but also into real estate or securities which contributed to forming what was described as a “bubble economy” (see Jackson (1999) and Petprasert (2000)).19 In the meantime, the country’s current deficit increased due to the adverse balance of trade and the ballooning of its foreign debts.
Thailand was proud of its success in industrial development and export-oriented industries in which the country employed a Promotion Protection Policy (PPP) to encourage the growth of industries and the export of industrial goods. Table 6 shows the high percentage of industrial exports. However, the Thai industrial exports required the high import content due to a lack of capital goods and technology (Petprasert (2000)). Thailand had to import capital goods, raw materials, fuel, and chemical products for manufacturing production. Petprasert (2000) stated that these account for 85 per cent of the total imports. The weak structure of Thai industry led to growing trade and current account deficits. Table 7 reports growing Thai trade deficit up to the onset of the crisis.
19 From 1988 until the crisis, the price of land increased by 100 per cent to 200 per cent in a year. The stock market boom encouraged a large number of middle-class Thais to become investors; many became rich within days. This condition is termed by academics a "bubble economy", a condition in which asset prices increase rapidly because of speculation (Petprasert (2000)). However, one third of the non-performing loans that crushed the financial sector came from investments in property (Jackson (1999)).
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The rise of the baht in value due to the strong dollar in the international markets caused Thai exports to rise in price and become expensive. As Thai export products increased in price, they were no longer competitive and consumers began to look for cheaper goods. Ensuing large current account deficit led financial markets to consider its pegged exchange rate as unsustainable. However, in order to keep the Thai economy favourable for foreign investment, the government chose to maintain a pegged exchange rate regime. After a series of futile efforts to defend against speculative attacks on the baht, the peg collapsed on 2 July 1997 losing soon lost 60 per cent of its value.20
During the economic boom, vast loans to large companies were made in US dollars not in the baht, encouraged by the lower US interest rates and the baht being pegged to the dollar. Sudden fall in the value of the baht deteriorated financial status of the companies, contributing to the huge non-performing loans of the financial institutions, which owed their borrowings to foreign creditors. A reckless build-up of currency and maturity mismatches by both the financial and corporate sector made the nation vulnerable to a reversal in capital flows and devaluation in domestic currency, and culminated in the crisis.
An inflexible exchange rate encouraged financial institutions and corporations to over-borrow short-term funds from abroad without hedging, paying little attention to the risks involved. The exchange rate peg to the US dollar increased the real value of the baht as the dollar's rise against the yen started from the mid 1995 (see Figure 1), worsening a slow-down in export demand in 1995-1996, thus deepening the current account deficit over three years so that by July 1997 it had reached an unsustainable 8 per cent of GDP (data from the Bank of Thailand).
Inadequate supervision of financial institutions and weak corporate governance created incentives to invest in speculative ventures and real estate, creating the bubble economy. The financial institutions made loans secured on the assets of borrowers without analysing their
20 The baht, later, reached its lowest point of 56 to the dollar in January 1998 (12 January) before stabilising at the level of around 40 (Average rate for 1998 is 41.4).
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productivity. When the bubble burst, the borrowers were not able to repay their borrowings, leading to non-performing loan problem in the financial institutions.
In early March 1997, stock market prices in Thailand began to decline. In May the Thai baht was attacked by the currency speculators. When the government defended the fixed exchange rate by selling foreign currency, foreign currency reserves became depleted.21 On 2 July 1997, after spending billions of US dollars on the defence of the baht, the Thai Central Bank was forced to let its currency float.
On 28 July, finally, Thailand called in the IMF and received a rescue package of US$16 billion in terms that the Thai Government raise taxes, cut spending, and keep inflation below 4-5 per cent. A comprehensive restructuring of the financial sector was also to be implemented (see the Thailand Letter of Intent of the government dated 14 August 1997). Explanation of the crisis
The economic structure in Thailand leading up to the Thai currency crisis was examined. Thailand had enjoyed a long period of economic success until the outbreak of the crisis. However, the growth of industries and high portion of industrial exports also contributed to rising trade deficits due to scarce capital goods and technology. In the meantime, the country had accumulated its current account deficits which had been unnoticed by market watchers due to the optimism. Short-term capital inflows were huge, amounting to 7-10 per cent of GDP before the crisis while FDI was only 1 per cent of GDP, which were great concern compared with other nations in the Southeast Asian region.
Realising the seriousness of the widening current account deficits and spiralling short-term foreign debts, the market players began to sell the baht and buy the foreign currency in order to make
21 See the “Letter of Intent of the government of Thailand”, dated 14 August 1997. (It is also available on the IMF website at http://www.imf.org/external/np/loi/081497.htm).
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a capital gain/avoid a capital loss in rational expectation that the Thai government could not maintain the fixed exchange regime.
The first- and second-generation models of currency crisis were argued not to be sufficient to explain the Asian financial crisis. When analysing the Thai crisis alone, however, the crisis was the very example of the first-generation models, although some factors captured in the so-called third-generation models were seen. 4. Conclusions
The economic theories of the crises in the literature have been examined. First-generation models view crises as the unsustainable fiscal and monetary policies incompatible with a pegged exchange regime, or fundamental imbalances. The second-generation crisis models, motivated by the 1992 EMS crisis, highlight self-fulfilling expectations and multiple equilibria, in which market expectations directly influence policy decisions even in the absence of changes in fundamentals. The Asian crisis generated a new kind of crisis models, so-called third-generation models, in which moral hazard, financial fragility, balance sheet imbalances, contagion, etc. are captured.
The widening current account deficits and fixed exchange rate system brought speculative currency attacks on the Thai currency and the ensuing devaluation of the baht devastated the private sector, which accumulated huge foreign liabilities without hedging currency and maturity. A crisis in Thailand spread to the other countries in the region with a contagious effect.
Investigation into the Thai crisis gives a good example of the first-generation models in that a speculative attack on the baht resulted from an increasing current account deficit and the authorities exhausted the foreign reserves to defend the fixed exchange rate system and eventually had no other choice to abandon the currency peg, leading to a discrete depreciation of the currency.
In conclusion the Thai crisis was caused by poor fundamentals and was the expected outcome of unsustainable policy stances incompatible with a pegged exchange regime, which is characteristic of the first-generation models. A series of crisis in neighbouring countries after the Thai
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crisis, which has become known as ‘the 1997 Asian financial crisis’, is rather accounted for by the second-generation models or the third-generation models.
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Table 1: Impacts of the Crisis: Exchange Rates and GNP Exchange Rates to Dollars GNP in US Billion Dollars
Country 1 July 1997 1 July 1998 June 1997 July 1998
Thailand 24.8 baht 42.1 170 102
Indonesia 2,433 rupiah 14,750 205 34
Philippines 26.4 peso 41.7 75 47
Malaysia 2.52 ringgit 4.13 90 55
Korea 850 won 1,368 430 283
Source: Extracted from the data in Jackson (1999) (some data were revised)
Table 2: Key Macroeconomic Data of ASEAN Countries, 1991-96 Panel A: Per Capita Income and GDP Growth Rates
GDP Growth Rates (% per year) 1996 Per Capita Income (US$) 1991 1992 1993 1994 1995 1996
Indonesia 1,167 7.6 7.0 4.1 4.0 7.6 6.0
Malaysia 4,766 8.7 8.0 9.0 9.1 10.1 8.8
Philippines 1,184 -0.6 7.3 6.2 10.4 10.5 8.8
Singapore 25,127 7.3 6.2 10.4 10.5 8.8 7.0
Thailand 3,134 8.5 8.1 8.3 8.9 8.7 6.7
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Panel B: Gross National Savings Rates (as % of GNP)
1991 1992 1993 1994 1995 1996
Indonesia 30.4 32.3 32.8 31.9 31.4 33.7
Malaysia 29.9 34.1 35.3 35.5 36.4 38.8
Philippines 18.2 19.4 18.1 19.0 19.0 20.5
Singapore 45.8 46.5 45.9 49.2 49.9 49.7
Thailand 34.5 34.5 34.2 35.2 35.0 35.3
Panel C: Change in Consumer Prices (% per year)
1991 1992 1993 1994 1995 1996
Indonesia 9.4 7.6 9.6 8.5 9.4 7.9
Malaysia 4.4 4.7 3.6 3.7 3.4 3.5
Philippines 18.7 8.9 7.6 9.0 8.1 8.4
Singapore 3.4 2.3 2.3 3.1 1.7 1.4
Thailand 5.7 4.1 3.4 5.1 5.8 5.9
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Panel D: Current Account Balances (as % of GNP)
1991 1992 1993 1994 1995 1996
Indonesia -3.5 -2.1 -1.4 -1.6 -3.6 -4.1
Malaysia -9.2 -3.9 -4.6 -6.0 -9.0 -6.3
Philippines -2.2 -1.8 -5.5 -4.5 -3.3 -4.1
Singapore 11.1 11.1 7.3 15.9 17.6 15.3
Thailand -7.8 -5.8 -5.2 -5.8 -8.3 -8.1
Panel E: Central Government Budget Surpluses (as % of GNP)
1991 1992 1993 1994 1995 1996
Indonesia -0.7 -0.4 -0.4 0.2 -0.2 -
Malaysia -2.0 -0.8 0.2 2.3 0.9 0.6
Philippines -2.1 -1.2 -1.5 1.0 0.6 0.3
Singapore 4.7 5.4 4.6 3.4 7.4 5.4
Thailand 4.3 2.6 1.9 2.7 3.0 0.9
Source: IFS, World Economic Outlook 1997, cited by Corbette and Vines (1998), Bank of Korea.
Some items are updated from other sources.
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Table 3: GDP Growth Rates of Advanced Economies (% per year)
1991 1992 1993 1994 1995 1996
United States -0.9 2.7 2.3 3.5 2.3 3.4
Japan 3.8 1.0 0.3 0.6 1.5 3.9
United Kingdom -2.0 -0.5 2.1 4.3 2.7 2.2
Germany 5.0 2.2 -1.2 2.7 1.2 1.3
France 0.8 1.2 -1.3 2.8 2.1 1.6
Source: IMF, World Economic Outlook October 1997.
Table 4: Interest Rates of Advanced Economies
1991 1992 1993 1994 1995 1996
United States 5.4 3.4 3.1 4.4 5.7 5.1
Japan 7.0 4.1 2.7 1.9 1.0 0.3
United Kingdom 11.5 9.5 5.9 5.5 6.7 6.0
Germany 9.2 9.5 7.2 5.3 4.5 3.3
France 9.7 10.5 8.4 5.8 6.6 3.8
Note: For the US, three-month CDs in secondary markets; for Japan, three-month CDs; for the UK, Germany and France, three-month inter-bank deposits. Source: IMF, World Economic Outlook October 1997.
Note: Daily rates from 1 May 1992 to 30 June 1997 Each daily rate is the average ASK price for the day.
Source: OANDA, Inc., (available at http://www.oanda.com/)
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