The Bubble Came With Easy Money

Part of the 1997 crisis stemmed from the unforeseen danger of a build-up of short-term capital inflow. The so-called hot money flooded the financial system following a series of financial liberalisation in the early 1990s.

The baht became fully convertible through an open capital account. With the currency peg system, which tied the baht to the US dollar, easy credit grew spectacularly, setting the stage for a bubble economy.

The foreign capital swamped into the country because the currency peg ensured there were no exchange risks. The fixed exchange rate regime, formulated in 1984 after Thailand devalued the baht, was one of the cornerstones of Thailand's macroeconomic stability.

It served its function well over the following decade when the US dollar was weak against the major currencies. The baht, pegged to the dollar, also weakened against other currencies, hence propelling the Thai exports in a grandiose way.

A believer in supply-side economics, Vijit Supinit, the Bank of Thailand governor, had a strong confidence in the strength of the Thai economy. In the early 1990s, he believed that the widening current account deficit, financed by the capital inflow, would subsequently be absorbed, if not totally offset, by export earnings in the future. He did not say when, though.

Vijit Supini

Dr Olarn Chaiyapravat, the president of the Siam Commercial Bank, also predicted in 1995 that by the year 2000 Thailand would achieve a current account surplus to become a net lender status.

In the face of capital inflows, Vijit would not touch the currency peg system, believing that it was serving the confidence factor in the Thai economy. At that time, it was afraid that if the baht were to be floated, the Thai currency would appreciate - not depreciate – and hurt the Thai exports.

He would rely almost exclusively on a tightening of the monetary policy, including selective credit controls, to combat the inflationary pressure caused by the capital inflow. The tight monetary policy, which forced interest rates high, began to take its toll on the domestic economy, first hitting hard the property market.

The irony was that the money market, which was supposed to be tight to stem the inflationary pressure, was not tight at all.

High interest rates but expansionary money supply

During 1994-1996, money supply expanded by more than 20 per cent a year from 1994-1006, probably the highest rate in the world.

As a rule of thumb, money supply growth should have been limited to 11-12 per cent - or about two or three percentage points over the GDP growth rate of 8.5 per cent. The money supply growth of this scale was a recipe for the formation of a bubble economy.

Easy money opened a floodgate for inflation that would severely undermine price stability and undercut the country's competitiveness.

Bank lending also expanded massively as a result, jumping by 28.5 per cent year-on-year in 1994 and by 24.2 per cent year-on-year in 1995.

Thai commercial banks were over-leveraged themselves, as evidenced by a loan-to-deposit ratio fo 124.2 per cent in 1994, 130.5 percent in 1995 and 131.6 per cent in 1996 (Any sum above 100 percent were financed by foreign capital).

The offshore banks, under the auspieces of the Bangkok International Banking Facility (BIBF), made things worse. Scrambling to get a full branch licence, the BIBF banks booked massive offshore loans to add to the inflationary pressure and fuel the asset bubble.

In 1994 when the economy needed adjustments, as evidenced by the stock market decline, the BIBF money created another bubble on top of the wave. 
  
Thailand’s reserves ranked 11th of the world

A look at Thailand's foreign exchange reserves showed that they were expanding at a furious rate in tune with the money supply growth. Total foreign exchange reserves jumped from US$25.43 billion in 1993 to US$30.28 billion in 1994, US$36.13 billion in 1995 and almost US$37.7 billion in 1996.

Between 1994 and 1996, some Bt500 billion in high-powered money, from the sharp jump in the country's foreign exchange reserves, added to inflated the financial system. No financial system in the any country in the world could accommodate that kind of financial bubble for long. Japan went bust in 1990-91 in this similar fashion.

Thailand’s foreign exchange reserves were made of foreign borrowings by the private sector. Investors viewed that the baht had stability and the interest rate of the dollar was much lower than the baht interest rates. When the dollar was brought into the country, it was sold to the commercial banks.

In this particular case, the Bank of Thailand intervened to buy the dollar from the commercial banks to keep the baht at the fixed level. This resulted in a rapid increase in the foreign exchange reserves.
  
Vijit would frequently refer to the foreign exchange reserves as Thailand's fortress of stability. Thailand's reserves of US$37.7
billion in 1996 was ranked the 11th in the world after Japan's
US$216.6 billion, China's US$107 billion, Taiwan's US$88 billion, Germany's US$83.2 billion, Singapore's US$69.6 billion, the United States' US$64 billion, Brazil's US$60.1 billion, England's US$39.9 billion and Switzerland's US$38.4 billion.

A closer look at Thailand’s reserves found that they were formed by borrowings that exceeded the current account deficit. Unlike Singapore or Taiwan, their international reserves were formed by a surplus in the current account.

The fixed currency system encouraged the inflow of foreign money because of a seemingly absence of the exchange risks. The US dollar loans were brought into the country in a massive amount because the dollar interest rate was significantly lower than the baht interest rate.

The lenders were willing to flush their money into Thailand because of the high rates of the return. The baht interest rate had to be kept high to attract the foreign capital since Thailand was a capital-deficit country.

When the money was everywhere, easy credit went speculating for quick returns. In Thailand, the easy money went into the finance and banking sector, stocks, land and the commercial property market.

The economy began to turn sour in 1996. Exports dipped to zero growth. The Bank of Thailand introduced regulations to slow down the velocity of the money flow because the current account deficit looked unsustainable. The foreign investors began to attack the baht for fears of devaluation. Only then was it clear that things were beginning to get out of hand.

The Peg That Outlived Its Time

Under the currency peg system laid down Since 1984, the mid-rate was pegged to a basket of currencies of Thailand's major trading partners.  The Bank of Thailand did not disclose the components of its basket of currencies. But the financial markets understood that the weight for the US dollar tends to be about 80 per cent to 82 per cent; the yen, 11 percent to 13 per cent and the Deutschmark 5 per cent to 6 per cent.  (Asiamoney Currency Guide, November 1996, Page 28).

With the fixed rate, between 1987 and 1996 the baht ranged between Bt24.92 - Bt25.74 to the dollar. Between 1989 and 1992, Thailand's reserves doubled from US$10.50 billion to US$21.20 billion. The foreign debts also doubled from US$22.80 billion to US$43.60 billion.

By 1986, its foreign exchange rose to US$38.70 billion, while the foreign debts also soared to US$90.50 billion. The rapid increase in Thailand's foreign exchange reserves that shot up to US$35 billion over the past 10 years did not occur from the surplus in trade like Singapore or Taiwan. But they all derived from foreign borrowings or foreign investment, which had an outstanding of US$130 billion.

Of this amount, about US$50 billion were held by the banks and about US$38 billion by the Bank of Thailand. The balance of US$42 billion went into consumption such as Rolex watches, Mercedez cars, Motorolla handset telephones, among others.

Since foreign debts were larger than the country’s US dollar reserves, Thailand was vulnerable to a systemic risk in the event of a loss of foreign investors’ confidence and as sudden capital outflow.

Before the crisis, the baht rarely deviated from the fixed band due to the central bank's high credibility and strong intervention.  Thailand's pegged system was been an important factor in boosting its export-led economy and in securing foreign investor confidence during the past decade.

Since 1984 the baht had been pegged to a basket of currencies, with the US dollar making about 80-90 per cent of the weightings compared with 8-15 per cent for the Japanese yen and 3-8per cent for the Deutsche mark and other currencies.

Under the fixed exchange rate system, the Bank of Thailand allowed the baht to move very narrowly against the US dollar in a daily trading. If it fixed the baht at Bt25.50 to the US dollar, it would intervene, using the buffer stock or the foreign exchange reserves, to make sure that the baht would not fluctuate plus or minus two satang from the target rate, called the mid-rate.

One satang is one one-hundreds of the baht. In this particular case, the exchange rate would be kept at floor of Bt25.52 and the ceiling of Bt25.48 to the US dollar.

The baht became a favourite trading currency due to its stability, Thailand's favourable economic outlook in the past and attractive interest rate differentials against the US dollar rates.
Multinationals, who based their regional head offices in Singapore,
maintained large offshore baht positions. Thai companies also had large offshore baht positions.

As a result, there was an explosion in both spot and forward baht trading not only in Bangkok, but also in Singapore and Hong Kong.

A Bank of Thailand official quoted a private study of the Monetary Authority of Singapore as finding that baht trading amounted to around US$9-US$10 billion a day, of which US$2-US$3 billion accounted for onshore transactions and US$7-US$8 for offshore transactions.

Asiamoney estimated the daily turnover, including swaps, at more than US$2 billion a day in 1996, over three times the average daily trading amount in 1993.

Thai officials were concerned about the trading of baht offshore, but nothing was done to stop it.
   
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