Playing Hardball

WHAT should a central bank do when its currency comes under an attack? Normally, there are three ways to respond. First, the central bank may intervene in the foreign exchange market to prop up its currency. Second, it may raise the interest rates sky-high to raise the cost of the attack. Third, it may restrict capital flows or impose capital controls.

In the previous rounds of the baht attack, the Bank of Thailand had exhausted the first two tactics in its vain efforts to restore confidence to the currency peg. The size of the speculative attack in May was so huge that the central bank lost almost all of its reserves in the fierce defence. Unperturbed, the Thai banking officials decided to play hardball to squeeze out the hedge funds and speculators once and for all.

In the morning of Thursday, May 15, 1997 Paiboon Kittisrikangwal, the chief dealer of the central bank, walked into the office of his immediate boss, Dr Bandid Nijathaworn. There he also met Prapai Suwannarat, Bandid’s deputy. He had a big idea to discuss.

Two-tier currency system

On a piece of paper, Paiboon used his pen to draw a line. He explained that the Bank of Thailand could effectively ward off the baht attack by creating a two-tier currency system.

Paiboon Kittisrikangwal

By restricting the local banks from extending baht credit to offshore banks, the hedge funds and the speculators who had shorted the baht would be denied the baht supply or would have to pay for a punitive price if they wanted to borrow the baht to unwind their positions.

Worse of all, the speculators could risk defaulting their positions if they could not get hold on the baht.

Phaiboon weighted this stragey in his mind only on the previous day. He would like to resort to this trump card to squeeze out the hedge funds and the speculators. So on that day he reduced his foreign exchange intervention activity. He engaged only US$600 million in buy-sell swaps (Memorandum No. 519/1997, the Banking Department, the Bank of Thailand, May 15, 1997).

Phaiboon would like to lure the hedge funds and the speculators into his trap.

If the plan worked out well, the Bank of Thailand would emerge with a decisive victory because the hedge funds and the speculators could have been massacred en masse if they got hurt from the two-tier currency system and defaulted on their short-baht and long-dollar positions.

Bandid immediately went along with the plan. It sounded like a perfect plan during that time of desperation.

Prapai was present during this time because she would be the key person assigned to record the minutes of the meetings. Paiboon was too busy in the dealing room to write the daily reports. By the way, Bandid would like to make sure that he would be protected by the written document in the future.

Incidentally, Dr Siri Garnjaroendee, the assistant governor of the Bank of Thailand and Bandid’s boss, walked into the room on that early Thursday morning. He was bringing along a bad news. A merger between the Thai Danu Bank and Finance One Public Company Ltd had collapsed.

Finance One was Thailand’s biggest finance company, while Thai Danu was a small bank. Failure to merge the two would send out the signal that the Thai financial system was deeply in big trouble.

Siri was worried how the central bank would handle this piece of news, which was a public relations disaster to the cause of banking reform.

Both Bandid and Phaiboon told Siri that the central bank should withhold this information until the currency battle had subsided. Afterward they informed Siri about the idea of the two-tier currency system. Resorting to a similar tactic used by Bank Negara Malaysia in 1994 to fend off the speculative attack against the ringgit, the Bank of Thailand could split the foreign exchange market into offshore and onshore.

After listening to it carefully, Siri, like Bandid, agreed to the plan. He rushed out quickly to inform Chaiyawat Wibulsawasdi, the deputy governor, and Rerngchai Marakanond, the governor, about this proposal. The speculators would be in for some real surprises.

Of course, Rerngchai and Chaiyawat, who were also at their end's wit, readily concurred with the plan. The Bank of Thailand would be putting in place the two-tier currency system in a hurry, without any formal study or without having to go through any formal procedures.

At five o'clock that morning Rerngchai went over to report to Gen Chavalit Yongchaiyudh, the prime minister, at his Pinpraphakhom residence, where he had recently moved in with his wife, Khunying Phankrua Yonchaiyudh. Incidentally, that day was the prime minister's birthday.

Later that day it was misunderstood by the local media that Rerngchai went to see the prime minister in order to pay respect and to offer him a birthday blessing. In fact, Rerngchai went to inform Chavalit about the central bank’s currency intervention. He assured the prime minister that the situation, albeit very critical, was expected to come under control.

The prime minister gave a thumb-up to Rerngchai for his handling of the foreign exchange pressure. He expressed his full support to the central bank’s defence. Upon returning to the Bank of Thailand, Rerngchai was told about the two-tier system.

It would be another hectic day for Rerngchai.

An army of the Banking Department immediately worked on the phone. Early that morning its staff called all the 29 local banks and foreign bank branches in Thailand and asked them to stop lending the baht to the offshore banks and the non-residents.

For the first time in seven years, the fully convertible baht would be restricted from flowing to the offshore markets, except for transactions with underlying trade, direct investment or equity investment. Without the baht supply, it would be technically difficult, or financially prohibitive, to short the baht. It appeared that the central bank would be heading for another difficult victory.

To be sure, some of the local treasury dealers were stunned by the order. One of them asked it would not be fair for him to go along with this order while the Krung Thai Bank, the state-controlled bank, was still making profits by buying the dollar against the baht in Singapore.

In other words, the local dealers were also having a good time making money by speculating against the baht. In any event, the Bank of Thailand’s order was a command that the banks had to obey.

Baht Interest Rates Shot Up to 1,000%

In the morning trading session before the imposition of the two-tier foreign exchange markets, the fixed exchange system continued to battle for its life. The baht was trading at Bt25.91/US dollar, staying well above the mid-rate of Bt25.81/US dollar.

At one point, the speculators hammered the baht down to Bt26.27, aiming to smash the currency peg. This prompted Paiboon and his dealers to intervene with US$1.37 billion in the spot market. The pressure on the Thai currency was slightly relieved by a more favourable exchange rate between the US dollar and the Japanese yen. The dollar weakened against the yen that morning at Y115.97-Y116.23. The Thai overnight inter-bank rate stood at 18-20 per cent a year.

But after the capital flows were restricted, the effect became spectacular: Short-term baht interest rates, due to the lack of supply, immediately soared on the offshore markets to more than 1,000 and 1,500 per cent a year. ( The Nation, May 16, 1997)

The baht quickly strengthened to Bt25.20, so did the swap premium for the T/N rate, which climbed to 200-250 satang to one US dollar. The sharp rise of the swap premium was due to the Bank of Thailand’s order to the local commercial banks not to lend out baht to the foreign banks in the foreign exchange swap market.

The hedge funds and the foreign speculators were shocked after they had learnt about the creation of the two-tier foreign exchange market and the sudden turn-about in the direction of the exchange rates and the interest rates.

They were exasperated that the Bank of Thailand was not playing by the fair game or the rules. To them, creating the two-tier system meant that the Bank of Thailand just turned the table over and threw out all the cards into their faces when it realised that it was about to lose the billion-dollar poker game.

But for the time being, the foreign speculators could do nothing else but scramble for the baht – at any costs to avoid defaults -- to cover their positions.

Since the speculators were restricted from borrowing the baht in the Bangkok market, they had to dig for the Thai currency in the offshore markets such as Singapore, Hong Kong, New York and London, where supply was limited.

Unlike the US dollar, the Deutsche mark or the Japanese yen, the baht was not comparably an international currency. With the relative small baht supply available offshore, the cost of baht borrowing exploded to more than 1,000 per cent, resulting in massive losses to the speculators, who shorted the baht on that day.

Hedge funds and speculators hurt badly

Phaiboon timed the tactical move carefully by choosing Thursday as the day to restrict the capital flows. In a currency transaction, it takes two working days to complete the settlement. Speculators, who sold the baht for the US dollar on Thursday, would be required to deliver the baht on Monday since Saturday and Sunday were a holiday.

With the interest cost skyrocketing to 1,000 per cent, that means some speculators would be paying 1,000 per cent/a year every day for borrowing the baht, totalling 3,000 per cent for the three working days.

"That hurt. Hot-money traders had to spend as much as 3 per cent a day to keep their short positions," wrote Michael R. Sesit and Laura Jereski, staff writers of The Asian Wall Street Journal. " Michael  Sesit and Laura Jereski of the Wall Street Journal. (“Baht Battle Bats Around Big Currency Speculators,” The Asian Wall Street Journal, May 23-24,
 1997, Page 1 and Page 24). “And it became expensive to get out, too, as the spread between the bid price traders were willing to pay and the offer price widened to five times its norm. Traders say those who folded included Mr Soros and Mr Robertson's Tiger fund; both declined to comment about their trade."

The fact was that Soros did not fold as yet. Although Soros also got caught in the trap of the two-tier currency system, he still had his medium positions that had not yet matured. He lost some money during this round of attack, but would make huge profits later for his Open Society orgnisation.

Callum Henderson also vividly described the blood-bath day in his book, “Asia Falling? Making Sense of the Asian Currency Crisis and Its Aftermath, Singapore: McGraw-Hill Book Co, 1998. He wrote:

"At one point that day, it actually hit 3,000 per cent before settling at around 1,500 per cent on an annualised basis. The events on Thursday May 15, 1997 are etched in the memory of may traders, salesmen and funds around the world. With suddenly no liquidity to borrow offshore and the need to instantly cover positions to avoid massive losses, many panicked. Some screamed into their phones, into the broker boxes for anyone who would lend them baht in any form, some swore and threw their chairs across the dealing room, others just looked dazed at their screens.

“The only source of spot baht borrowing to the offshore parties was the Bank of Thailand itself - at a rate of 1,400 per cent. The scramble became panic, the panic, headlong flight. Some proprietary desks were suddenly underwater by up to US$50-US$60 million each. Hedge fund losses on a market-to-market basis were estimated at up to US$450 million."

After a long day of battle, the tired Phaiboon still managed to write a brief report about his May 15 foreign exchange dealings. "Due to the pressure on dollar buying against the baht remaining strong in the morning, the Bank of Thailand needed to intervene at the spot rate of 10 satang above the mid-rate before succeeding in bringing it down by five satang," he wrote.

To achieve this very purpose, Phaiboon conveniently used up another US$1.37 billion.

There was a news report that the Bank of Japan would come to the Bank of Thailand’s rescue, which slightly improved the sentiment on the baht.  

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