We’ve Told You So

JUST how early did the International Monetary Fund flash warning signals to Thailand over its need to fix the foreign exchange regime in order to avoid the financial crisis? If the signals were there, couldn't they be made more openly so that the information could be equally shared? But at the same time, would the information provoke panic or a crisis in confidence?

Michel Camdessus, the managing director of the IMF, readily defended the IMF's role following criticism that he and his organisation were slow to recognise or to react on the financial and foreign exchange crises in Thailand and Asia. In short, it was the fault of Thailand, which ignored the advice or did not accept the reality that it was heading into trouble.

"We have been warning them in a low key for a long time. The first significant occasion was the executive board meeting under Article IV of Consultation with Thailand in July 1996. The board called their attention to their current-account deficit, the need to strengthen the financial sector and to take a more prudent budgetary line. Following that I have paid a visit to the Thai authorities to bring them this message. And after that it has been an endless row of visits by my deputies and other members of staff, explaining the risks and suggesting what measures should be taken," Camdessus defended his role.  (Nigel Holloway, "The Art of Control," Far Eastern Economic Review, September 15, 1997, page 64-67.)

This 15 January 1998 file photo of AFP shows then Indonesian President Suharto signing a new letter of agreement before International Monetary Fund (IMF) Director-General Michel Camdessus at Suhartos residence in Jakarta. Suharto signed the letter spelling out major reforms and austerity measures linked to a massive bailout led by the IMF.

But Camdessus could not avoid the blame over the IMF’s handling of the Asia crisis. The IMF failed to foresee the Asia crisis and moved clumsily to deal with it. The organisation was also highly unpopular, even among its major shareholders.

The US Congress was also intensifying its scrutiny over the IMF programmes, looking for excuses not to send the IMF a bill of US$18 billion it needed to strengthen its capital base and to act as a lender of last resort to countries facing balance of payments crises.

In the period up to the crisis in mid-1997, Camdesuss said he had visited Thailand four times, two in secret, trying to persuade the Thai authorities to unpeg the baht from the US dollar.

"But faced with its own political difficulties, the government had hoped for too long that a soft solution could be found with no recourse to the IMF, perhaps by being bailed out by Japan or the US," he said. (Richard Lambert, "Defending the Fund," The Financial Times, February 9, 1998, Page 13.)  

Earlier Stanley Fischer, the number two at the IMF, also assured that there had been no flaws in the IMF's early warning system against the financial crises. He said that the problem had more to do with the Thai authorities failing to heed the June 1996 warnings that its inflexible exchange-rate system was not sustainable and its large current-account deficit could cause problems.

"The early warning system worked fine," he said. "This was a case where the authorities were made aware quite early of the concerns of the Fund." (Alan Friedman, "IMF Says It Warned Thais on Baht," International Herald Tribune, September 11, 1997, Page 13.)
 
Bijan Aghevli, deputy director of the IMF's Asia Pacific Department, also defended the IMF along the similar line. "In hindsight, it would have been better if they had acted a bit earlier on our advice. We gave them a frank assessment," he said.

Aghevli said the IMF suggested that Thais reduce their current account deficit, introduce a more flexible exchange rate, raise taxes, make spending cuts and move to reform the banking system.

But the Thais always had an excuse. They told the IMF officials that they had to delay action because of "domestic constraint" This was a reference to delays in decision-making inherent in Thailand's five-party government coalition, led by the New Aspiration Party.

There had been harsh criticism against the IMF that it should have make public its early warnings on Thailand so that the market could react rationally based on the best available information demand and supply more evenly across all categories of spending.

Thailand would continue to face demand pressures and the consequent price rises in 1995, which required a tightening of the monetary conditions. By that time the BIBF or offshore banking had been around for two years, during which it further added to the bubble economy. Since Thailand had adopted a more open and deregulated financial system, it had to rely more on indirect instruments of monetary control such as bank rate and open market operations in interest-bearing securities to manage the credit growth, which was fuelling the economy.

The IMF called for Thailand to consider adopting a more flexible foreign exchange regime in order to attain an appropriate interest rate level.

"Increasing the degree of independence of Thai monetary policy would be facilitated by allowing greater flexibility in the determination of the external value of the baht. An alternative would be to rely on sterilisation, but such approach could prove costly and is unlikely to be effective in the long run," the IMF said in one of its report.
 
IMF’s directors have differnt views

The IMF's directors also expressed their contentious views on the Thai exchange rate system. In a letter dated June 29, 1995,  acting chairman Ismael cautioned Bank of Thailand governor Vijit Supinit over the Thai authorities' move to rely on credit plan to implement monetary policy.

"Credit controls could be distortive and, with increasing financial market liberalisation, become more and more difficult to apply. Directors suggested that greater reliance should be placed on market-based monetary instruments. As the effectiveness of such instruments is linked to the exchange rate system, some directors encouraged the authorities to allow greater flexibility in exchange rate policy and to allow the baht to appreciate somewhat as part of the anti-inflation strategy," the letter said. (Letter of J. E. Ismael to the Bank of Thailand governor).

Vijit Supinit

However, opinions among the IMF's directors were clearly divided at that point over exactly what to do with the Thai fixed exchange rate system. Some directors supported the anchoring role and credibility provided by the currency peg system and believed that tighter monetary policy could be implemented under the present financial conditions without having to adjust the foreign exchange rate.

But other directors called for a re-examination of the composition of the basket of currencies.

Following a review of the consultation with Thailand by the IMF's directors, J. E. Ismael, the acting chairman, despatched a message to Rerngchai, who succeeded Vijit after the Bangkok Bank of Commerce debacle. The letter, which was dated on July 22, 1996, summarised the key opinions of IMF's directors on Thailand.

It said: "Directors emphasised the need to improve the effectiveness of monetary policy and recommended the fixed exchange rate regime be replaced by a more flexible one." (Letter of the acting chairman J. E. Ismael of the IMF's directors to the Bank of Thailand governor, July 22, 1996).

The  IMF's directors also called for the Thai authorities to continue to pursue prudent macroeconomic policy in the face of economic overheating in order to contain demand pressures. They would like the Thai authorities to develop indirect monetary instruments, which would reduce the pressure of high interest rate policy and the distortion in credit planning.

At that time, Thirachai Phuvanat-naranubala, the director of the Bank of Thailand's Banking Supervision and Financial Development, was crazily churning out tighter banking regulations almost every week to curb credit growth in a desperate attempt to cool the economic overheating.

The finance companies were having a big party. Nobody dared to take away the punch bowl from the financiers. That was a sign that Thailand was losing the battle on inflation and the capital inflow.

David Robinson, another IMF man, came over to pay a visit to the Bank of Thailand in March 1997. He followed up with a recommendation on a more flexible exchange rate policy. Thailand had been fixing its exchange rate tightly to the US dollar at around Bt25/dollar. The fixed exchange rate had encouraged capital inflow, which created inflationary pressure, economic overheating and growing indebtedness.

"We continue to believe that the introduction of a more flexible exchange rate arrangement is a policy priority, both to increase monetary policy autonomy and to improve the composition of the capital account by reducing the incentives for short-term inflows,” he suggested.

“Following the opening of the BIBF, the scope for an independepent monetary policy has been eroded, while the maintenance of the peg has actively encouraged short-term capital inflows and contributed to the build-up in short-term foreign debt and financial sector fragility. In addition, the present system can hinder adjustment to external shocks; in particular, the heavy weight of the US dollar in the basket has clearly been unhelpful in present circumstances.

“During our discussions you have indicated that you intend to introduce greater exchange rate flexibility at the appropriate time; we encourage you to do so promptly, while at the same time changing the present basket to more closely reflect the pattern of Thailand's foreign trade.

“As the first step towards greater exchange rate flexibility, we would recommend widening the fluctuation margins around the central parity, which could continue to serve as the anchor for monetary policy while indirect monetary instruments are being further developed. Exchange rate movements within the fluctuation margins; combined with information on interest rates, money and credit growth, inflation, the current account deficit, and other economic and financial variables, would provide guidance on whether liquidity needed to be tightened or loosened.

“Following the introduction of a more flexible exchange rate, monetary policy would initially have to remain very firm;  however, once markets had settled and other supporting measures - including on the fiscal side - had taken hold, there would be scope to allow interest rates to decline, which would significantly benefit the corporate and banking sectors."

But the IMF’s warnings would fall on deaf ears. The Thai central bank officials felt that the IMF’s warnings were simply a mater of ongoing consultations.

Only hints, but no action
           
However, it was in mid-April 1996 that Thailand hinted for the first time about a possible change to the fixed exchange rate regime. Chaiyawat Wibulswasdi, the deputy governor of the Bank of Thailand, signalled that the central bank had been in close consultations with the IMF over the possibility of adjusting the exchange rate system in order to sustain long-term economic growth.

"The report that we are studying a more flexible baht is correct, but do not interpret that to mean we will move to alter the basket of currencies," he said. (Thanong Khanthong, "Analyst foresees more flexibility for baht exchange," The Nation, Friday, April 19, 1996, Page B14).

Chaiyawat Wibulswasdi

At the back of Chaiyawat's mind, however, any change to the currency peg was blasphemous. The system represented the cornerstone of Thailand's macroeconomic stability, and any deviation from the system would have taken Thailand to the uneventful, unpredictable course.

Along with Chavalit Thanachanan, the former governor of the Bank of Thailand, Chaiyawat had been one of the architects of the basket of currencies system. He was the one who literally put the currencies into the basket according to the weightings deemed appropriate to the Thai macroeconomic conditions.

Of course, Chaiyawat had the ears of Vijit, the central bank governor, who considered Chaiyawat his top lieutenant.

In that month the Bank of Thailand proposed to Dr Surakiart Sathirathai, the finance minister, different policy options to make the currency regime more flexible. The idea was to widen the fluctuating band of the baht - not to alter the mix of the basket of currencies.

Dr Surakiart Sathirathai

In one of the proposals, the trading band would be expanded from plus or minus two satang to seven satang and the mid-rate would not be quoted in order to create an element of surprise. This would make it more difficult or risky to speculate against the baht because the speculators would not be able to read the formula of the basket of currencies. (Thanong’s interviews with Bank of Thailand's officials.)

Another option was to widen the trading band to 15 satang. At that time the banking officials were concerned that if the currency regime was altered the baht would appreciate - not depreciate - and this would hurt the Thai exports. Moreover, a flexible currency regime, they feared, would create foreign exchange risks to Thai financial institutions or corporates at a time when the local foreign exchange market was still underdeveloped.

On April 29, 1996 while attending the Asian Development Bank in Manila, Surakiart said he was positive with the idea of expanding the fluctuating range of the baht from two satang to four satang. A lawyer by training, Surakiart was not keen in the foreign exchange policy but he was willing to go along with any recommendations from Vijit.

He indicated that the Bank of Thailand had been assigned to study the impact of this slight foreign exchange policy adjustment, which would be completed in a matter of months. This adjustment would represent a broadening of the fluctuating band by only 0.32 per cent.

Surakiart side-stepped from answering about the timing of the authorities' adopting the wider fluctuation band, which would not signal an abandonment of the currency peg system.
"We will stick to the basket. We may adjust the band a little big," Surakiart said. "Now it is too secure. We want to send a message to the speculators that there is some risk (in attacking the baht). But we won't change our basket currency system. There is no policy and no reason to do this."

Surakiart's remark signalled for the first time that a top policy-maker had suggested a more flexible adjustment to the foreign exchange rate mechanism, anchored on the basket of currencies system since 1984. The basket of currencies represented the crucial nominal anchor necessary to maintain access to low-cost foreign funding.

Other Bank of Thailand officials also came out periodically to air the views that the change to a more flexible exchange rate regime was impending.

Will you keep the baht-dollar peg?

At a Thai Bank CEO Conference held by Goldman Sachs in Bangkok on May 17, 1996, Kleo-thong Hetrakul, the research director, was asked over the baht-US dollar peg. Would it stay or would the baht be devalued?

Kleo-thong’s response was that the peg would stay, but the band would be widened to better absorb capital flows.

Around the middle of 1996, there also existed another proposal on altering the basket of currencies, which was weighted 80 per cent by the US dollars. It suggested that the US dollar weightings be gradually reduced to 75 per cent, 70 per cent, 65 per cent, 60 per cent...to better reflect the trade components of Thailand.

This would have made the baht more flexible, without having to adjust the trading band, and freed it from a hostage of the US interest-rate and business cycle.

Again, the proposal was not taken up seriously by Vijit and Chaiyawat, who were apprehensive about the loss of competitiveness of the Thai exports if the baht were to become more volatile.

It was recognised then that the fixed exchange regime would not be sustainable in the long run due to the massive inflow of foreign capital, which had constrained the domestic economic policy. Then short-term capital inflows, which rose sharply by an average of Bt60 billion a month in the first quarter of that year, became the focus of policy concern.

It not only added to the inflationary pressure but also restricted the banking authorities' ability to manage their monetary policy independently.  The inflow of foreign capital created excess demand for consumption and investment, sending the current account deficit to more than 8 per cent of the gross domestic product. A current account deficit means that Thailand was living beyond its means, with more outflow of goods and services than inflow.

The inflow of foreign capital produced a balance of payments surplus and added to the pressure for the baht to appreciate. This had forced the Bank of Thailand to intervene by buying the US dollar and selling the baht. In doing so, it massively pumped the baht into the system. For fears that the money supply growth would create inflationary pressure, it kept interest rates high. But the high interest rate would be taking its toll on the economy.

For this reason, the Bank of Thailand had witnessed substantial foreign exchange reserves growth. "Net foreign assets in the central bank's balance sheet expanded by 26.6 per cent yearly on average over the last seven years and by Bt151 billion in the first 11 months of 1995 alone," a report of UBS Global Research said. "If unsterilised, the central bank's asset growth will flow into substantial liquidity creation in the domestic financial system, with a time lag, resulting in significant inflationary pressure."

A momentum of the move to adjust the Thai currency regime took another leap following growing interest and widespread coverage of the issue in the media.  On August 5, 1996, William Murray of AP-Dow Jones, who had obtained a confidential IMF report on Thailand, flashed his story in the news wire.

He wrote about the Ismael letter, which was a summary of the IMF report on Thailand. It was a straight talk and it was prepared right before the baht came under another fresh round of attack.

It pointed out clearly that Thailand's only hope for an "enduring improvement" in its monetary controls was to adopt a more flexible foreign exchange system. The fixed exchange rate system, the report said, weakened the Thai authorities' controls over the monetary policy since Thailand's capital account was increasingly open with the financial liberalisation and had opened up a floodgate for short-term foreign capital.

This led to instability to the macroeconomic management.

Indeed, foreign capital had been flooding Thailand and the emerging markets in an unprecedented scale, raising stability concern. Economic weakness in Europe and Japan was one of the underlying reasons that drove capital to chase the high-yields elsewhere. As for Thailand, net capital inflows amounted to US$9.68 billion in 1990, US$11.29 billion in 1991, US$9.47 billion in 1992, US$10.49 billion in 1993, US$12.16 billion in 1994 and US$21.60 billion in 1995.

Total international reserves also jumped from US$25.43 billion in 1993 to about US$39 billion in 1996. The Thai financial system was swamped by foreign capital. The bubble economy was in the making.

Murray wrote further that Thailand should move ahead to restrain the tide of foreign capital by making it foreign-exchange rate system, which guaranteed exchange risks, more flexible.

Thailand had two options: either it widened the band in which the baht traded versus the US dollar or change the basket of currencies to which the baht was pegged. The IMF report noted further that the Thai authorities were actively discussing the options but did not indicate as to when they would need to make the final decisions.
 
After the IMF sent its June 1996 letter to Rerngchai with a warning over the a need to fix the foreign exchange policy, Bodi Chunnananda, the finance minister, was informed about the move. He told the central bank governor that he was ready to support any foreign exchange adjustments.

Bodi, then 61, was a budget man, not an economist. He had been preparing the budget for 20 years, serving nearly 10 years at the helm of the Budget Bureau.

In one of their meetings at the Grand Hyatt Erawan Hotel, at which Chaiyawat also attended, Bodi made it known that he was ready to support a widening of the baht/US dollar trading band. Widening the band lay within the jurisdiction of the Exchange Equalisation Fund, an independent entity from the Bank of Thailand.

Then it was proposed that the Bank of Thailand might opt to widen the trading band from plus and minus four satang to plus and minus eight satang.

But Rerngchai and Chaiyawat, who was manager of the Exchange Equalisation Fund, did not show show any enthusiastic response to Bodi's offer.

Siri Garncharoendee, the assistant governor of the Bank of Thailand, personally urged Rerngchai to take up the offer from Bodi. He argued that it was rarely would a finance minister risk initiating a move to adjust the foreign exchange system that would prove unpopular to the business sector or the political body.

The currency adjustment should normally come from the Bank of Thailand's initiative. The baht was already coming under selling pressure then.

Since 1995 the dollar had appreciated about 50 per cent against the yen. The baht, which was pegged to the US dollar, also appreciated 50 per cent against the yen. Since Thailand ran the largest trade deficits against Japan, it was pricing its products out of the international markets.

The meeting, which took place on Saturday, ended up without any decision for on that day when Banharn Silapa-arch, the prime minister, decided to dissolve Parliament. This was another significant turning point that jolted a need to fine-tune the fixed exchange rate system.

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