The Myth of Thai Growth

ONE of the hedge-fund managers, who laid siege on the Thai currency peg system, reconstructed the unfolding drama behind the collapse of the Thai baht. "We are like wolves on the ridgeline looking down on a  herd  of elk," he said (Eugene Linden, “How to Kill a Tiger,” Time Magazine, (November 3, 1997), page 24-25.
 
In that herd of elk, the hedge-fund managers and international money managers saw Thailand, a prey that perfectly fit a description in their modern economic bible, Paul Krugman's The Myth of Asia's Miracle.

Paul Krugman

Since 1994 they had been reading the Krugman manifesto on Asia with interest, hoping to find cracks in one of the weak economies (Paul Krugman, "The Myth of Asia's Miracle," Foreign Affairs, (November-December, 1984). Betting against currencies of troubled economies is their way of doing business.
 
In his controversial article, Krugman, the Massachusetts Institute of Technology economic professor, argued that Asian growth has its limit because it depends more on hard work or investment than on productivity growth.

Economic growth, in theory, can be explained by the sum of two sources of growth: increases in inputs such as growth in employment, in the education level of workers, and in the stock of physical capital (machines, buildings, roads, and so on). The other source is increases in the output per unit of input, generally known as productivity.

Krugman found similarities between growth of the Soviet economy three decades ago, which depended almost solely on the increases in inputs and very little evidence of productivity, and recent growth of the Asian economy.

"The newly industrialising countries of Asia, like the Soviet Union of the 1950s, have achieved rapid growth in large part through an astonishing mobilisation of resources. Once one accounts for the role of rapidly growing inputs in these countries' growth, one finds little left to explain," he asserted. "Asian growth, like that of the Soviet Union in its high-growth era, seems to be driven by extraordinary growth in inputs like labour and capital rather than by gains in efficiency."

Struck by this conclusion, one of the currency speculators said in the interview with Time magazine, "Well, well -- Asian growth may have a limit."

They began to focus their attention on Asia to find the cracks. Thailand looked vulnerable on the map. Thailand appeared to be carrying the Mexican disease, although its economy looked impressive on the surface. In the early 1990s Thailand earned a notable place in the International Monetary Fund's Hall of Fame as a economic role model.

This could be attributed to its adopting of a free market system, with openness to and liberalisation of trade and investment. An export-led country, Thailand enjoyed strong economic fundamentals, backed by prudent fiscal and monetary policy.

The hallmark of its macroeconomic stability was the currency peg system, which ensured exchange rate stability and price stability.

The Mexican Disease

In 1995, right after the Mexican peso crisis, John  Walker, chief economist for Credit Lyonnais Securities (Asia) Ltd, was the first to issue a warning signal over a looming Thai crisis, painting Thailand as carrying the same disease as Mexico's.

John  Walker

He voiced concern about Thailand's widening current account deficits and its heavy reliance on short-term foreign borrowings, which raised the spectre of the baht attacks.

Of course, the banking authorities were extremely upset by his remark. That was during the tenure of the powerful Vijit Supinit, who served as governor between 1990 and 1996.

At the end of 1994 Standard & Poor's, the US credit rating agency, upgraded the sovereign debts of Thailand from an A- to an A rating, reinforcing a belief that fundamentally the Thai economy was sound.

One of Credit Lyonnais Securities’ representatives was issued a stern warning over the securities firm’s damaging report on Thailand.

"Despite his normally cordial relations with the foreign business community, Vijit could also be abrasive," wrote Ben Davis in a finance journal. (Ben Davis, "The Rise and Fall of Thailand's Technocrats," Asiamoney, February 1997.)

"In one well-documented incident in mid-January 1995, he called in the representative of Credit Lyonnais Securities to explain why its senior economist had written a report claiming that Thailand was the most likely country in the region to be hit by the Mexico-style devaluation. 'It was staggering,' says one analyst. "This was the governor of the central bank.'

The scene was completely different from a decade ago. The Thai economy grew by 8-13 per cent a year between 1988 and 1995, during which the exchange rate was stable at THB25-THB26 to the US dollar. (Dr Chalongphob Susangkarn, The Crisis of The Thai Economy: The Path to Debt Repayments and Recovery, paper of Thailand Development Research Institute, 1998.)

Inflation was relatively subdued, ranging between 3-6 per cent a year. As one of the backyard of Japanese investment in Southeast Asia, Thailand was one of the main recipients of the foreign capital, which reached a net inflow by 8 per cent of the gross domestic product (GDP) in 1990 and 14 per cent in 1995.

The current account deficit, a gap between investment demand and domestic savings, hit 5-8 per cent of the GDP. The persistent shortfall in domestic savings to keep up with the investment demand indicated that Thailand was living beyond its means.
 
The foreign capital fuelled the asset bubbles and would also lead to over-investment in the heavy industries and big infrastructure projects. Even more so it created an aura of over-optimism, if not an outright self-deception that the high growth was here to stay forever.

The First Currency War

THE Bank of Thailand was no novice when it came to baht defence.

Immediately after the Mexican peso crisis, Thailand became a target of the speculative attacks. About eight hedge funds tested the strength of the baht and the mettle of the Bank of Thailand. They bet that the baht could be devalued in the same fate as the Mexican peso.

In an act of collusion, they launched a fierce three-day attack against the Thai currency, hoping to force down its value and later profit from buying it back cheaper for settlements.

On Wednesday, January 11, 1995, US institutions and hedge-fund operators dumped the baht at market prices amid hectic and heavy trading of more than US$1 billion. (Vatchara Charoonsantikul and Thanong Khanthong, "Baht falls further as rush for dollar fuels money crisis," The Nation, Friday, January 13, 1995, Page B1.)

At that time, the baht-US dollar trading normally reached US$100-US$200 million a day. Rumours were swirling in the Hong Kong dealing rooms that the baht and other Southeast Asian currencies would be devalued.

The fallout from the Mexican crisis created a ripple effect not only to foreign exchange markets but also to the regional equity markets. The foreign institutional investors, who suffered heavy losses from a 35 per cent devaluation of the peso, were heading toward the exit in a herd instinct by cutting their exposures in all the emerging markets.

The baht, which had been trading at Bt25-plus range to the US dollar, was driven down to lows of Bt26.20.

Tarrin Nimmanahaeminda, the finance minister, took control of the crisis situation, setting up a war room inside the Finance Ministry. A Harvard and Stanford graduate, Tarrin was president of Siam Commercial Bank and chairman of the Thai Bankers' Association before leaving his brilliant banking background to join the Democrat Party for a high-profile political career.

Tarrin Nimmanahaeminda

Dr Chaiyawat Wibulswasdi, the assistant governor of the Bank of Thailand, was his top lieutenant in the baht defence. Tarrin personally placed telephone calls to Chartsiri Sophonpanich, the president of Bangkok Bank, Dr Olarn Chaipravat, the president of Siam Commercial Bank, and Banthoon Lamsam, the president of the Thai Farmers Bank, asking for their cooperation. They were all his comrade in arms.

Tarrin also called the central bank of the Philippines asking it to buy up the baht at any price. The local commercial bank chieftans agreed to fully support the Thai authorities and to refrain from speculating against the baht. The hedge funds would have to be dealt with decisively and given some good lesson.

The following day on Thursday January 12, 1995 the baht opened at Bt25.10 before closing at Bt25.16 at mid-day, with intervention from the Bank of Thailand to prop up the baht.

In the afternoon, the baht further weakened to Bt25.50 under heavy selling pressure, before hitting a low of Bt26.10-Bt26.20 at around 15.00 hours. The US hedge funds spent another US$1 billion on this day alone to attack the baht.

Vijit held an emergency meeting in late afternoon for two hours with his top aides inside the Bank of Thailand's headquarters before coming out to deny the rumours over the baht devaluation. The foreign exchange market began to come back to their senses, hence seeing the baht stabilising at Bt25.50-Bt25.60.

Trying to emphasise Thailand's strong points, Vijit said: "Our economy is still basically strong. There hasn't been any change in the situation. Our GNP has grown by almost 10 per cent every year for the past 10 years. Our international reserves stand at US$30 billion, equal to seven months' worth of imports. We've had a surplus fiscal balance for eight straight years now."

It was a big opportunity for exporters, who rode on the back of the official intervention, to make quick profits by selling on-year forward contracts on US dollars at Bt26.70 to the dollar, the best rate in recent history.

Nopamat Manoleehakul, the Bank of Thailand's spokeswoman, also called the devaluation rumour as groundless and noted that the Thai currency had been moving only 2 per cent against the dollar in the last few years. The baht, pegged to the dollar, was the most stable currency in Asia, backed by the foreign exchange reserves of US$30 billion.

She tried to differentiate between Thailand and Mexico, saying that Thailand's reserves were as strong as a fortress. "So we have stronger conditions. Mexico, in contrast, has large, foreign debts and a weak trade picture," she said.

When the baht attack took place, local liquidity immediately became tight with a sudden rise of the short-term interest rates because the baht was sold out for the US dollar and was drained from the financial system. Without Bank of Thailand's intervention, the attack would have forced the value of the baht down to shock the financial markets, which were also sensitive with the upward movements of the short-term interest rates and the swap premium -- the cost of borrowing one currency against another currency.

The Bank of Thailand defended the baht by selling out the US dollar to support the value of the local currency. To help the local banks cope with the US dollar demand, the Bank of Thailand also entered into the currency swap agreements with the local banks.

In these exotic transactions, the central bank sold the US dollar for the baht to the Thai commercial banks, who then would be obliged to reverse this position by selling the US dollar and getting their baht back within seven days. The swap cost of these transactions, which reflected the interest rate differentials between the US dollar and the baht, was only two satang/US dollar.

This intervention provided the Thai commercial banks with dollar liquidity to deal with the speculators and others caught in the panic selling of the local currency.

 With heavy US dollar buying of more than US$2 billion between Wednesday January 11, 1995 and Friday January 13, the money market suddenly became tight. The inter-bank rate skyrocketed to 50 per cent on Friday before the central bank's intervention, by injecting liquidity, brought it down to 15-20 per cent.

Local and foreign banks were allowed to conduct baht swaps with the central bank to ease their liquidity. The Exchange Equalisation Fund charged them a spread of only two satang for a currency swap rate of one week. This means that the local financial institutions could swap the US dollar for baht at a mid rate of Bt25.05 before repaying it a week later at Bt25.07. The trading volume was US$500 million on Friday, compared to almost US$1 billion a day on Wednesday and Thursday.

The local treasurers estimated that foreigners could lose 10 per cent in net asset value in a hurry of their portfolios, currencies and equities. The stock market fell almost 100 points during the period.

That was really the first time that the Thai authorities went to war defending the local currency against the villains of global finance. It was held within the Bank of Thailand's circle that attacking the baht amounted to a breach Thailand's sovereignty.

A State of Denial

Thailand escaped that stormy episode, which lasted for only two days, but not until the Bank of Thailand had spent more than US$1 billion from its foreign exchange reserves of more than US$30 billion to defend the baht.

But it gave Vijit and Chaiyawat confidence that they could deal with the speculators decisively. The victory was sweet, a confirmation of the efficacy of the currency peg system.

However, the yen rise against the US dollar also put less upward pressure on the baht, which was tied to the US dollar in a basket of currencies. At that time the US dollar was relatively weak against the major currencies over an extended period after the Plaza Accord in 1985.

The baht, pegged to the US dollar, also weakened against other currencies during the same period, hence providing a platform for the Thai exports to take off in a grandiose way. Cracks in the over-leveraged Thailand were overlooked then because it was a high-growth economy. Confidence in the Thai economy remained strong.

However, there would continue to be periodic bouts against the baht in the following year when the financial markets did not witness any serious commitment of the Thai authorities to address the widening current account deficit of 8 per cent of the gross domestic product (GDP) and the rapid build-up of the short-term debts.

On July 26, 1996 there were rumours of a baht devaluation swirling around the Hong Kong and Singapore markets. "The panic carried on to Monday with continuing dollar buying against the baht on the back of the rumours of baht devaluation and the riot in Indonesia.

The baht opened at a bid/offer price of Bt25.31 to Bt25.32 in the morning before climbing to Bt25.35 and Bt25.36. Jitters in Indonesia market also dealt a blow to the baht.
 
The rupiah also weakenedsignificantly from heavy selling pressures. The rupiah closed at 2,330 against the dollar on Friday and opened at 2,350 on Monday morning and ended at 2,360, losing about one per cent of its value in a hurry.

Although the incident was far from a repeat of the Mexican financial crisis, The Thai authorities all came out to deny the devaluation rumours. Rerngchai Marakanond, who succeeded Vijit in July 1996, asserted that the banking authorities were satisfied with the present level of the exchange rate and the present exchange rate arrangements.

This implied that the monetary authorities had no policy of changing the basket of currencies, which they considered to be one of the hallmarks of Thailand's successful macroeconomic management over the past decade.

But Rerngchai did hint some time in the second half of 1996 that the central bank was constantly reviewing the mechanism by which the exchange rate policy worked in the market place so that it could achieve its exchange rate objectives in the most effective way.

Rerngchai's comment was interpreted by the financial markets as the authorities' intention to gradually moving toward embracing a more flexible exchange rate policy. This might be done by widening the band of the US dollar/baht trading.

The central bank fixed the baht on a daily basis, allow it to deviate no more than two satang either way.

Because of the relative stability of the baht, foreign money managers and speculators had poured their hot money into Thailand to enjoy the interest differentials. The capital inflow, which increased the money supply and created inflationary pressure, is posing the greatest policy challenge yet to the central bank, which had found its sovereign under the big test. (Thanong Khanthong, "Thai Economy Showing Symptoms of Mexican Disease," The Nation, September 3, 1996, Page B10.)

Then the baht was seen as undervalued - not overvalued, taking into account the growth of imports and exports. Over the previous five years, import and export growth had been expanding at the equal average of 20 per cent, which reflected the competitiveness of the baht.

The undervalued baht was another incentive for the international money managers to hold the Thai baht. Alex Erskine, regional market strategist for Citibank NA in Singapore, came over to Bangkok to present Citibank's view on the Thai currency system.

He noted about that time that since Thailand had been adopting a "gradualist policy' in its exchange rate management, he expected that it would gradually adjust the mechanism in a way that allowed the public to make the necessary adjustment.

In this way, the baht's movement within the band would be gradually widened until it achieved the final effect of flotation. By that time the Bank of Thailand would only needed to intervene in the foreign exchange market only when it was necessary, instead of being an active player as was then the case.
  
But before long the Mexican disease would return to haunt Thailand. In its August 24, 1996 issue, The Economist also identified Thailand as having more "Mexican symptoms" than any other of the fast-growing Asian economies. Before Mexico faced a financial meltdown in December 1994, its chronic diseases included a massive current account deficit, a crippling foreign debt burden and excessive monetary growth.

Thailand was also in the same boat, with symptoms of a huge current account deficit, heavy debt to gross domestic product ratio and a worrying dependence on hot money to finance its deficits. "To be fair, it has some way to go before it develops the full Mexican disease. The country has a comfortable cushion of reserves, a healthy budget surplus and its currency is under-valued," The Economist wrote.

Thai Banks Were in Shambles

In her Economics Notebook article, published in the Financial Times on October 7). Stephanie Flanders quoted a world Economic Outlook report by the International Monetary Fund, which issued a warning over the health of the Thai banking system. Although on the surface, it appeared to be robust.

Yet the Thai banking system had several characteristics similar to Mexico's system.

"Lending has growing rapidly during the past five years, despite relatively tight monetary policy, with banks earning very wide net interest spreads," wrote Flanders. "Although this has increased profits, it makes one wonder about the quality of the borrowers, especially since a rising share of this medium- and long-term lending seems to be matched by foreign currency borrowing on the banks' part."

Flanders went on to say that net foreign liabilities of the banks have been rising sharply, but asset quality - the immediate key issue of the present banking system - is not made available to the investing public because banks were not required to disclose their non-performing loans.

Due to the weakness of the Thai banking system, the IMF report concluded: "The ability of the Thai banking system to withstand a more turbulent domestic of foreign environment --including reduced access to foreign markets, a sustained increase in interest rates, and lower growth rates - cannot be taken for granted."
Hubert Neiss, the director of the IMF's Asia and Pacifid Department, summed up the problems of Thailand. "At the heart of Thailand's difficulties were a number of related problems: a rising current account deficit not sustainable over the medium term; heavy reliance on short-term foreign borrowing that increased the economy's exposure to foreign exchange risk and to a potential reversal of capital flows; a rigid link of the exchange rate of the baht to the US dollar, which had appreciated over a considerable period; and serious fragilities in the financial sector linked to excessive growth of property-based lending.

These problems, which were increasingly evident over the past year, could have been corrected at much less cost at an earlier stage. (IMF Survey, “Asian Experience Underscores Need for Swift,” Corrective Policy Action, September 17, 1997.)

The OECD report found structural weakness in Thailand and other crisis economies, including weakness in corporate governance arrangements; lack of transparency about business' financial situation and their relationship to government authorities; poor regulatory and supervisory arrangements in the financial sector and tendencies to high indebtedness and over-leveraging in business sectors and to allowing financial institutions to continue operating with high levesl of non-performing loans. (OECD Economic Outlook (June 1998), Page 9.

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