The hedge funds circled around the baht
 
The hedge funds started to prey on the baht in November. The attack resumed in earnest in after periodic bouts since the early 1995. It coincided with a political transition period.

Banharn Silapa-archa, the leader of the Chat Thai Party, had received a thumbs-down over his management of the economy. He lost a finance minister, Dr Surakiart Sathirathai, and a Bank of Thailand governor, Vijit Supinit, in a hurry.

The Bangkok Bank of Commerce scandal, which ended up costing some Bt120 billion in taxpayers' money bailout, undermined investors’ confidence in the supervision of the Thai financial system.

Thailand was suffering not only from the economic management credibility but also a political credibility. Banharn was seeing his premiership coming to an end and would be replaced by Chavalit Yongchaiyudh, a former general.

Two months earlier Moody's Investors Service Inc, the US credit rating agency, downgraded Thailand's short-term debts and warned about the widening current account deficit and the rapid accumulation of short-term debts.

Among the big-time currency speculators was George Soros, the man who broke the Bank of England. Soros is president of Soros Fund Management and chief investment officer of Quantum Fund NV, a US$12 billion international investment fund. In 1992 he made US$1 billion in profits from forcing the pound sterling out of the Exchange Rate Mechanism.

George Soros

It was clear to Soros and other hedge fund operators that a decade of spectacular economic growth in Thailand was coming to an end.
The hedge funds' intention was to rip apart the Thai currency peg system and profit from a forced currency devaluation. In a currency attack or speculation, the hedge funds or the money managers typically short-sell a target currency against another currency.

In this case, they would sell the baht, without necessarily holding the Thai currency in their portfolios at the time, for the US dollar. The aim was to force down the value of the baht, hoping to borrow it back cheaper for settlements and pocket the difference for the profits. In other words, they would try to establish short Thai baht positions and long US dollar positions.

The attack would take place either in the spot market, where settlements are due within two working days; or in the forward market, where settlement is due some time in the future, typically one week, one month, three months, six months or 12 months.

With the baht coming under an attack, what were the policy options of the Bank of Thailand at the time?  If it decided to defend the currency, it would be obliged to spend the US dollar from its foreign exchange reserves to prop up the baht. By doing so, it would sell the US dollar and buy the baht back into its coffers, ending up running down its foreign exchange reserves.

It could also hike the interest rates to raise the cost of the attack since the speculators would need to borrow the baht to settle their positions. If the Bank of Thailand did not intervene, the value of the baht would keep on plunging to the extent that it would be automatically forced to abandon the currency peg system.

During the attack, the money market would become tight and witness a rise in the short-term money market rates because the baht would be sucked into the Bank of Thailand's system.

Eventually, the high interest rates would have its toll on the domestic economy and confidence in the local currency would be lost. If the Bank of Thailand decided to give in and protect the foreign exchange reserves, it would have to devalue the baht or float it outright.

Throughout the stormy episode, the Bank of Thailand decided to defend the baht, going against all odds to guard the integrity of the currency peg system. It would prove to be a catastrophic mistake.

Thailand’s macroeconomic conditions were deteriorating fast. In October 1996 the balance of payments began to run into a deficit of Bt6.2 billion for the first time in living memory over concern of the export slump, accentuated by the persistently high current account deficit.

In December 1996 the balance of payments deficit hit Bt19.2 billion, sparked by a US$5 billion baht attack by the foreign speculators.
In that month alone, according to Bandid Nijathaworn, the director of the Banking Department, the BOT sold out US$4.88 billion to defend the baht, an amount large enough to drain liquidity from the system.

To alleviate the tight liquidity, the BOT sought to sterilise its dollar selling by entering into the foreign exchange swap contracts. The swap activity allowed the BOT to buy time for the new dollar would cover its dwindling reserves although it had obligation to repay dollar at a certain time in the future.

By year end the BOT's swap contracts reached US$4.75 billion and the foreign exchange reserves fell US$900 million from November to US$38.7 billion.

The baht was overvalued

Inside the Bank of Thailand, there were continuing discussions about the value of the baht and the sustainability of the fixed exchange rate system.

A report, produced by the Bank of Thailand's Economic research Department, showed that the baht began to overvalue since October 1995 when the US dollar appreciated against the Japanese yen and most European currencies. The baht, along with other emerging market currencies, which pegged to the US dollar, was also pulled along.
According to the BOT's report, using a base of 1990 = 100, the real effective exchange rate of the baht climbed to 100.08 in October 1995 compared to 99.85 in the previous month.

Since the baht devaluation and the birth of the currency peg in 1984, the baht was relatively undervalued since it was tied to a weak dollar. This in turn boosted the Thai exports and helped turn Thailand into a robust economy.

In the middle of the crisis, Chaiyawat would argue that the baht overvaluation was slight, a temporary and cyclical phenomenon, while Thailand's competitors were seeing significantly higher overvaluations of their currencies.

By October 1995, the baht began to rise against other currencies, in tempo with a stronger dollar. Then its overvaluation was 0.08 per cent. The overvaluation would continue until June 1997, the last month before the Bank of Thailand decided to float the baht.

By January 1997, the baht was overvalued by 6.45 per cent, compared to an overvaluation by 15.65 per cent for the Singapore dollar, 29.49 per cent for the Philippines, 8.32 per cent for the Malaysian ringgit, 3.90 per cent for the Indonesian rupiah.

The real effective exchange rate of the baht - or the inflation-adjusted value of the baht against the inflation-adjusted value of other currencies -- hit a peak 109.28 per cent (an overvaluation by 9.28 per cent) in March and April 1997.

The overvaluation was caused largely by the sluggishness of the Japanese economy, which led to a weak yen and exported its problem to Southeast Asia. Moreover, Thailand ran the largest trade deficit against Japan, but its currency also appreciated against the Japanese yen, which hurt Thailand's competitiveness.

Thailand's economic reform and financial liberalisation led to a spurt of foreign capital inflows, which looked after high yield returns. But the inflows in turn lead to currency appreciation, while the spending boom financed by the foreign capital also led to higher prices of non-traded goods, services and real estate.

Earlier in 1997, Rerngchai came out to calm the nervousness over the shaky Thai baht, which had been going through downward pressure. He tried to argue that the baht remained stable. Since the end of 1995, the Thai baht has weakened by 2.6 per cent against the US dollar.

Due to the basket of currencies system, the baht appreciated 15 per cent against the Japanese yen, and 11 per cent against the Deutsche mark, he said.

The governor emphasised that Thailand remained competitive against its Asean neighbours from the foreign exchange's point of view. The baht, he said, had weakened over the same period by 4.4 per cent against the Malaysian ringgit, 3 per cent against the Singapore dollar, 2.5 per cent against the Hong Kong dollar, 2.4 per cent against the Chinese yuan, and 1.2 per cent against the New Taiwan dollar.

"Imports of goods from the US may become more expensive, but Thailand's imports from japan and Germany will be cheaper," he said.
But the big question Rerngchai did not address was for how long the dollar would continue to rally against the Japanese yen. A stronger dollar would place downward pressure on the Thai baht against it, but the Thai baht would strengthen against other major currencies. The stronger baht would undermine Thailand's competitiveness.

Rerngchai talked up the baht

Movements of the US dollar did not help the baht at all. At the end of 1996, the dollar stood at Y115. It rose to 122 yen on January 30, the highest level in four years, before easing to Y120 on January 31st.

Further dollar appreciation would put more pressure on the baht and the costly baht defence. Interest rates would have to be kept high, which would depress corporate earnings. Any attempts to boost the economy through lower rates would not materialise for it would trigger capital outflow.

Rerngchai Marakanond

This was a dilemma that complicated the central bank’s management of the macroeconomy.

In January the US dollar rose about 4.5 per cent against the yen and 7 per cent against the D-mark, driven largely by stable interest rates and healthy growth in the United States, coupled with economic weakness and lower interest rates in Janapan and Germany.

But Rerngchai said a dollar correction was imminent, given the prospects of economic recovery in both Germany and Japan. He would be wrong.
However, Rerngchai and Dr Amnuay Viravan, the finance minister, would be trying to limit their comments on the Thai currency, fearing different interpretations would affect the authorities' foreign exchange policy.
Yet it was no secret that the central bank would like to adopt a more flexible baht policy to deter the unchecked capital inflow.

Due to a sharp deceleration of the Thai economy that year, Credit Lyonnais expected no change in Thailand's fixed exchange rate policy over the next 12 months. It said in its report: "While we believe the future success of Thailand was depended on achieving a more flexible policy framework by breaking the baht peg, we do not believe circumstances will allow the move to be made soon."

It added: "As long as corporate Thailand is heavily exposed to unhedged US dollar debt and corporate balance sheets are deteriorating, it will remain too risky to effect a shift in exchange rate policy."

Not since the collapse of a number of financial institutions in the late 1970s and early 1980s had the health of the Thai banking system been questioned. The Thai economy could not have come this far, to average a growth rate of at least 8 per cent a year over the past decade, without the strong banking system.

With the hard landing of the Thai economy in 1996, many had begun to ask troubling questions about how healthy the Thai banks were; or for how long the international markets would have confidence in them amid the slowing economy and a high current account deficit of 8 per cent.
Rerngchai and his team thought that they could tackle the current account deficit through tightening of the fiscal and monetary policy.

Changing the currency regime at a time when the country's debts of US$100 billion could trigger a stampede of capital flowing out of the country.

In January 1997 it would appear that capital began to flow back into the country, sending the balance of payments to record a surplus by Bt24.7 billion. However, the BOT's swap activity to rebuild its reserves accounted largely for this capital inflow.

The window of opportunity arose in the first 20 days of January 1997 when the financial market was relatively calm. However, Rerngchai decided not to take any action on the currency regime. The indecisiveness would continue well until mid June 1997 when everything was too late.

Siri repeatedly warned Rerngchai about Thailand's net foreign exchange reserves. “All you need to do is simply to plot a graph at the head of your bed to monitor the net foreign exchange reserves,” Siri told Rerngchai.   

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