Triangle of Impossibility
   
In fact, Thailand had been pursuing a policy mix that would not be sustainable. It adopted a free flow of capital, a fixed exchange rate regime, and tried to maintain an independent monetary policy. But the three policies, generally known as the "triangle of impossibility", are mutually exclusive when they are applied simultaneously.

In spite of his stature as the country's top macro-economist, Vijit was not aware that this policy mix was not relevant to managing a more complex, internationalised and liberalised economy.
Unchecked capital inflows, encouraged by the fixed exchange regime, created an overheating in the economy. If interest rate was used as a tool to calm the inflationary pressure, it would strangle the domestic economy. In effect, the triangle of impossibility kept Thailand in a box.

Apparently, the fixed exchange rate arrangement was proving inadequate. With the fixed baht, foreign money managers found that they faced minimal exchange risks in bringing capital into Thailand to speculate on high baht interest rates.

Between 1987 and 1996 the baht fluctuated very slightly against the US dollar, moving between Bt24.92 and Bt25.74. This exchange rate movements were almost risk-free. It encouraged foreign capital inflow, which doubled the country's reserves from US$10.50 billion in 1989 to US$21.20 billion in 1992.

At the same time, the country's external debts also doubled from US$22.80 billion to US$43.60 billion in the same period. By 1996, with the country's foreign exchange reserves at US$38.7 billion, the external debts also skyrocketed to US$90.50 billion. ("The Baht Crisis," internal paper of the Banking Department, the Bank of Thailand, 1998).

To counter the inflationary pressure from the inflow of
foreign capital, Vijit resorted to tightening the monetary policy and introducing selective credit controls.

Since 1995, interest rates had been on an up trend, with the Bank of Thailand intervening fiercely in the short-term money market. In the repurchase market, bonds were issued to absorb money out of the market into the Bank of Thailand system. This trend would be dealing severe blows to the stock market, the financial system and the domestic economy.

Vijit was afraid that unpegging the baht from the US dollar would lead to an appreciation - not depreciation -- of the Thai currency, which would hurt exports. It would also complicate the management of the macroeconomy since the currency peg was the last bastion of regulatory control after a floating of the interest rates and the oil prices.

But by maintaining the currency peg, he would be losing the battle on the liquidity front. It was not yet evident to Vijit then that a more independent monetary policy and a relatively free flow of capital were far more important than keeping the value of the currency stable in a fixed exchange regime.

The currency peg system had significantly undermined the central bank's monetary control, leading to the bubble economy.

However, events in the global economy also contributed to the crisis in Thailand and Asia. In early 1998, Stanley Fischer, the International Monetary Fund's first deputy managing director, said although most of the crisis in Thailand and Asia was home-grown, it could also be attributed to the weakness of the Japanese and European economies over the past decade.

For capital was flowing out of Europe and Japan in search of the high yields elsewhere. Fischer also said the blamed the 'wide swings' of the dollar-yen rate over the past three years for the debacle in Asia. "Although the problems in these (Asian) countries were mostly home-grown, developments in the advanced economies and global financial markets contributed significantly to the buildup of the imbalances that eventually led to the crisis," Fischer said.

Stanley Fischer

"Specifically, with Japan and Europe experiencing weak growth since the beginning of the 1990s, attractive domestic investment opportunities have fallen short of available savings," he said. "Meanwhile, monetary policy has remained appropriately accommodative, and interest rates have been low...Large private capital flows to emerging markets, including the so-called carry trade, were driven, to an important degree, by these phenomena and by an imprudent search for high yields by international investors without due regard to potential risks." (Kyodo, "IMF Deputy Chief Blames Europe, Japan for Asian Crisis," January 22, 1998).

Net capital flows flooded the Thai market, reaching US$9.68 billion in 1990, US$11.29 billion in 1991, US$9.4 billion in 1992, US$10.49 billion in 1993, US$12.16 billion in 1994, about US$21.60 billion in 1995 and US$15.66 billion in the first nine months of 1996.

Foreign capital was brought into the country via the local commercial banks before it was exchanged into the Thai baht at the Bank of Thailand, which saw an increase in its foreign exchange reserves. The Bank of Thailand's purchase of the foreign currencies added more baht into the financial system, setting off sharp fluctuations in the interbank rates.

During the Mexico financial crisis in 1994-95, for instance, inter-bank rates in Thailand ranged between four to 20 per cent. Following the crisis, the interbank rate shot up to 20 per cent, although the Bank of Thailand's rule of the thumb at the time was to keep the interbank rate at 10-12 per cent.

More importantly, the foreign capital influx had posed a policy dilemma for the monetary authorities since it had increased local liquidity, driving down interest rates and exacerbating inflation and the current account deficit. With the current account deficit widening to 8.1 per cent of the gross domestic product in 1995, the authorities tried to toughen measures to restore confidence through a series of administrative measures, yet they were designed as piecemeal.

Since the fiscal policy, which should have been tightened to curb the demand pressure and the current account deficit, was in the domain of the politicians, Vijit did not have the oversight over the fiscal policy. He was only left with monetary policy left to deal with the overheating - a constraint that would prove costly indeed.
 There were reports of Ekamol Khiriwat, the deputy governor, bringing Vijit to task over his indifference to the massive inflow of foreign capital. "In one celebrated incident in 1992, Ekamol walked out of a meeting after a disagreement over whether to unpeg the baht.

Ekamol Khiriwat

“I shouted at him,” says Ekamol. “I am proud to say that. I shouted at him and I said you are ruining the economy. We mismanaged. We have had a lousy monetary policy for four years. Now we must untangle it." (Ben Davis, "The Rise and Fall of Thailand's Technocrats," Asiamoney, February 1997.)

The situation started to change since the mid-1995 when the US dollar began its up trend. Japan's reluctance to deal with its financial system and sluggish economy would be exporting its problems to Asia.

 China's emergence in the global economy also turned the tide against Thailand and Southeast Asia. In 1994, China, which was embarking on an economic liberalisation in full steam, devalued its currency by 33 to 35 per cent against the US dollar. As a result, it had sharpened its competitive edge in exports.

The Thailand would feel the full impact from the Chinese devaluation two years later, when export growth, which used to expand 15-20 per cent a year, dropped in 1996 to zero per cent.

Thailand's exports were further undermined by the weakness of the Japanese yen, although it recorded the largest trade deficits against Japan. After mid-1995 the US dollar began to appreciate significantly against the Japanese yen and other major European currencies. At that time the dollar appreciated 50 per cent against the yen. The baht, pegged to the US dollar, also appreciated 50 per cent against the yen.
Since Thailand ran the largest trade deficits against Japan, it would not be able to withstand this structural pressure. This was a structural problem beyond Thailand's control, yet the Thai authorities took very little notice of it.

Shortly after the Asian financial crisis last year, Jeff Sachs of Harvard University wrote in the Financial Times: "Investors rarely understand that the short-run currency appreciation gives an incorrect reading of future relative prices. Since the capital inflows must be repaid in the long run by increased net exports, the exchange rate is most likely to have to depreciate in real terms to service the capital inflows.

"Even though the Thai currency looked 'stable' at Bt25 per dollar until June 1997, in fact that baht appreciated from Bt0.25 per yen in January 1995 to Bt0.21 per yen in June 1997."
  Why? This could be explained by the habit of look at the baht/US dollar exchange rate. "It took 3.5 yen to buy one Thai baht in May 1995; by May 1997, one the eve of the currency crisis, it took 4.6 yen, a rise of 31 per cent. In effect, the Southeast Asian exporters were pricing themselves out of the European and Japanese markets. They were also facing off competition from China, which had devalued the yuan in January 1994. Naturally, exchange rates came under pressure."

The BIBF

Apart from its failure to stem the massive influx of foreign capital over the past three years, which led to a bubble economy, the policy designed to propel Thailand into a regional financial centre also contributed to the crisis.

As part of the Financial System Master Plan designed to turn Bangkok into the region's top financial centre, banking authorities were to hand out offshore bank licences to foreign banks, which used Bangkok as a funding centre to mobilise Eurodollars for lending in the domestic and regional markets. The enterprise was known as Bangkok International Banking Facility.

Tarrin, the finance minister, hoped the BIBF would transform Thai businesses into a sophisticated regional players through the sourcing of cheap Eurodollars to support their enterprises.

But in Thailand's banckyard was the formidable Republic of Singapore, which had already made a significant headway in becoming a truly financial centre of Southeast Asia. All the big banks were there, waiting to make their influence felt in Thailand without a physical presence.

Offshore baht trading was to take off in full stride in Singapore, equipped with a freer financial environment and more advanced telecommunications infrastructure. The foreign banks there would be more than happy to stuff dollars down Thailand's throat.

Baht trading in the island republic was 14 times larger than that in Bangkok. In 1996 daily trading of the Thai baht in Singapore reached US$14 billion, of which spot markets accounts for US$5 billion and swap markets for US$9 billion.

With this kind of financial muscle, Singapore was holding Bangkok as its hostage, dictating not only the foreign exchange market but also the money market in Thailand. The flaws in the BIBF scheme lay in the failure of the Thai authorities to also promote the development of foreign exchange market.

There were arguments that finance companies and securities companies should also be allowed to have foreign exchange licences, but the authorities viewed that it was a domain of banks. In Singapore, brokers were major players in the foreign exchange market.

The BIBF banks would complicate the problems by booking massive assets in Thailand in order to impress Thai banking authorities, who were promising them full foreign bank branch licences in return.

Starting from scratch, the BIBF banks increased their out-in exposure to the Thai market from Bt192.5 billion in 1993, to Bt452.5 billion in 1994, Bt687.5 billion in 1995 and Bt788.24 billion in the first 11 months of 1966. Through the out-in business, Thailand was importing the inflationary capital.

In three years the market share of the BIBF banks shot up from zero to 26 per cent of the total Thai banking system. Of the BIBF banks, 12 are local banks, 11 are foreign bank branches and 19 were foreign banks, seven of which already upgraded their status to foreign bank branches. In January 1997 it added another seven new foreign banks to the BIBF.

The authorities set the quantitative growth as one of the criteria for upgrading their status into full bank branches. The BIBF banks said “thank you” and earnestly converted their assets in Singapore or elsewhere into Thailand. Worse still, more than half of the loans were considered short-term, with a maturity of less than one year.

The Bank of Thailand was rectifying this mistaking by forcing the structure of the BIBF loans from short-term to longer term.

It was in September 1996 that Moody's Investors Service Inc, the US credit rating agency, downgraded Thailand's short-term debt. Moody's expressed its concern over the rapid build up of short-term capital in Thailand, which was used to finance the current account deficit. A debate ensured as to whether the BIBF loans were short-term or a disguise for foreign direct investment.

Short-term capital is defined as capital with a maturity of less than one year. The Thai authorities ordered the BIBF banks to revise their accounting methods and rebooked most of their loans as long term.

The BIBF loans became long term overnight – one year and one day!

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