August 11, 2007

PM backs BOT's non-targeting baht policy

10:00 PM: Prime Minister Surayud Chulanont, once again, came out to support the Bank of Thailand's foreign exchange policy. In his TV interview on Channel 11 today, he said the government would not target any baht exchange rate level.

"We can't really say that the baht won't hit Bt30/US dollar because we are not aiming for any target," he said.

"But what we can pinpoint is the currency management. Baht stability means that the exchange rate must not change abruptly and rapidly in a short period, which would impact the economy as a whole. And we can't really say what should be the level of the exchange rate because if we were to announce the target there would be people who would benefit from this. There are many capable people out there about this matter," Surayud said.

The Bank of Thailand's authorities indeed are afraid to target the baht exchange rate and make it known publicly. If they were to announce the target range, then the baht could be tested. This would put the central bank back to the similar situation in 1997 when they fixed the exchange rate and were obliged to defend it to prevent it from veering off the publicly announced rate.

Besides, if the authorities were to set the exchange rate target and then fail to defend it within the target, they would certainly feel embarassing and their credibility would be at stake.

Former finance minister Tarrin Nimmanahaeminda and Dr Ammar Siamwalla do not agree to with any attempt of the central bank to establish foreign exchange rate targeting. They both feel that the volatility of the market force will make it impossible for the authorities to defend the currency with the target range.

What Tarrin does not understand is why the Bank of Thailand was reluctant to cut interest rates from the outset. Had it slashed the rates since December, it would have been able to manage the baht appreciation more effectively in line with the market sentiment. 

August 10, 2007

Baht should be managed within framework of current account of plus and minus 2% of GDP.

9:30 PM: I met Dr Ammar Siamwalla, the noted economist, this afternoon at the Grand Hyatt Erawan Hotel. We both took part in the conference called Asian Financial Outlook: The Next 10 Years. I asked him to explain to me again what he meant by the Bank of Thailand's lack of foreign exchange policy framework, which he raised the other day at the National Legislative Assembly during a debate on the government's handling of the baht policy.

Dr. Ammar Siamwalla

Ammar's view is that the authorities should continue with their floating exchange rate regime, excuted within the target of the current account between plus and minus two per cent of the gross domestic product. This would do away with the narrow view of the baht/US dollar exchange rate on a daily basis.

Why does he use the current account as the benchmark on which to base the foreign exchange rate policy?

Well, the current account reflects the Thai economic fundamentals, Ammar said. If our current account is  zero per cent, then that means that our real sector is doing fine. "We should not take the capital account into consideration because it represents the money that flows in and out all the time," he said.

Before the crisis, Thailand ran a current account deficit of 8 per cent of the GDP. This means that we had to borrow other people's nose to breath all the time. Now Thailand is experiencing a current account surplus as our exports are doing much better than our imports. The surplus is one of the factors that has driven up the value of the baht.

Ammar said if the BOT, apart from pursuing the inflation targeting policy, establishes a policy framework of a current account plus or minus 2 per cent of the GDP in the medium term of say two to three years, then it may manage the baht exchange rate policy or allow the baht to move within this current account framework.

He is not happy that the central bank does not seem to have put in lace a foreign exchange rate framework. If it has one, it does not tell anybody. Instead, the central bank is managing the foreign exchange policy on an ad hoc basis or as a routine day to day operation.

"This is unaccountable -- I am not saying irresponsible. But if you don't have the foreign exchange policy framework, you can blame anybody or anything else for causing trouble to the baht. You yourself do not have to hold any accountability," he said.   

After the 1997 financial crisis, Ammar said he is now totally allergic to the fixed exchange rate. Well, his good friend Dr Virabongsa Ramangkura would like the central bank to refix the currency again at Bt36/US dollar. The central bank's people now also feel their hair standing if anyone mentions about fixing the baht again. They have learnt the hard lesson from the 1997 crisis.

Dr Olarn Chaipravat, another well-known economist, has a different view from Ammar's. He has insisted that the central bank establish foreign exchange policy targeting as most countries in the world have now moved toward this practice. Through economic models and a comparative study of the regional currencies, the authorities may come up with an appropriate foreign exchange rate level for Thailand to help keep the country's competitiveness.

Then the authorities may go ahead to manage its foreign exchange operations to meet this foreign exchange policy targeting.

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Dr Ammar's paper presented to the Asian Financial Outlook -- The Next 10 Years conference. 

THAILAND: TEN YEARS AFTER THE CRISIS

Ammar Siamwalla

When the Bank of Thailand floated the baht on 2^nd July 1997 – and saw its value fell by more than a half in eight months, the world naturally thought of it as primarily a currency crisis. But it is the massive failure of the financial system, the other half of the twin crises, that had a more profound impact and wrought significant institutional changes to the economic system of the country. This essay will examine the changes that occurred since 1997, and evaluate the performance of the economy that emerged, with particular emphasis on its resilience.

The story of the events that led to the denouement of 2^nd July 1997 is well enough known, so that we need merely to cover it in one short paragraph. Beginning in 1990 but accelerating in 1993, the Bank of Thailand engaged in a series of move to liberalize the capital account. The control on foreign inward movements of capital was removed, and foreign lenders were allowed to lend money to Thai financial institutions and to Thai corporations, in a regime with fixed exchange rates. Given the strength of the Thai economy prevailing in the early 1990s, these lenders found that lending to Thai banks and companies was quite profitable, and carried little risk. As the economy heated up during the bubble that preceded the collapse (from about 1993), the Bank of Thailand began to tighten up interest rates, and open up a large gap in interest rates. As could be expected, the only impact this policy had was to induce more money, mostly short-term, to flow in, with the result that Thai companies are heavily indebted in dollars. Worse, a substantial chunk of these dollar debt was intermediated by Thai banks, who borrowed short-term from foreign banks. By mid-1995 total short-term external debt from the private sector plus the annual current account deficit exceeded the foreign exchange reserves of the Bank of Thailand. After that it was a matter of time before the speculators realized that the fixed-exchange-rate regime was no longer tenable. In November 1996, the first attack on the baht began, and after three waves of attack, it was all over. The Bank of Thailand’s net foreign exchange reserves were nearly exhausted, and the baht was devalued.

Underlying all these developments, and propelling the economy towards ultimate collapse was the weakness of the keystone institution in the Thai financial system, the commercial banks and the finance companies[1], and concomitantly, the supervisory system of the central bank. Because the financial system and its supervision were the central weakness, and the focus of the post-crisis reforms – at least until the appearance on the scene of the Thaksin government, we need to dwell on the system’s pre-crisis structure before discussing the reforms that took place.

1. THE WEAKNESS OF THE PRE-CRISIS FINANCIAL SYSTEM

Before the crisis, fifteen commercial banks dominated the scene with about 100 finance companies bringing up the rear.[2] Flow-of-funds figures show them to be able to obtain about 60 per cent of household financial saving each year[3]. These household saving was essential to supplement the capital needs of the rapidly growing incorporated enterprises, because they plough back only a third of their incomes for investment. During the period 1993-1996, these enterprises obtained a majority of their outside funding through short-term and long-term bank loans. Foreign saving of loans also provided a significant direct source of funds to the firms, as well as indirectly through the banks.

TABLE 1
Source of Net Fund Flows for Incorporated Enterprises 1993-1996
(Percentages
	1993	1994	1995	1996
Liquid Financial Assets	-21.5	-7.1	-6.0	-9.2
Short term Loans and Bills	26.0	15.8	20.6	23.3
Trade Credit	-0.2	2.2	1.1	-0.9
Long term Loans	61.7	65.2	45.4	36.8
Mortgages	2.1	4.8	4.7	5.3
Debentures	4.0	9.2	4.7	0.6
Hire Purchase Debts	-13.3	-10.2	-8.5	-12.6
Foreign Debts and Claims	32.5	-13.8	20.2	38.6
Share Capital	16.1	28.8	17.9	20.7
Others	-7.2	5.1	-0.1	-2.6
Total Net Incurrence of     Liabilities	100.0	100.0	100.0	100.0
Source: NESDB, Flows of Funds Accounts, various years

Given this pattern of the flow of funds, banks are highly vulnerable for the classic reason of borrowing short and lending long. Thai banks, however, have been performing this function for decades, with relatively little mishap. In an earlier period, at the time when Thailand was primarily an agricultural exporter, banks were financing mostly short-term needs of the traders, and the problem of the maturity mismatch was not so severe. But as the country industrialized, the mismatch problem became severe, and during the bubble period, it was compounded by currency mismatch, because banks were intermediating by using dollars to finance many firms which were engaged in non-tradable activities, in particular, the property sector.[4]

The newly liberalized credit markets also compounded a chronic weakness of the Thai banking sector, which is its penchant for insider lending. Banking families had traditionally used credit from their banks to build up large business empires. To the extent that these were investments in real assets, and to the extent that the families had an interest in making productive investments, the long-term survival of this system was not threatened. The rate of bank failures was kept at about one per decade.

But, during the atmosphere of the bubble of 1993-1996, with unlimited money flowing in from overseas, a great deal of the money was diverted by bankers and borrowers to speculate in the property and stock markets. The failure of the Bangkok Bank of Commerce (BBC) in 1995 was a particularly notorious example of the sort of malpractices by the new breed of bankers.

The failure of BBC also showed the weakness of the Bank of Thailand’s supervision system. Aside from the question of the personal integrity of the personnel involved (a question that previously had never been raised as far as the central bank was concerned), there was also a structural problem with the design of the supervision system, in which forbearance was built in. The problems at BBC had been lingering for well over a decade, before it came to a head. Throughout, the central bank had not only shown extraordinary forbearance, but at various points had injected funds to shore it up, using the Financial Institutional Development Fund (FIDF) for the purpose. FIDF was managed jointly by the central bank and the Ministry of Finance, with the bank having more de facto power. Further, the fund was set up under the Bank of Thailand Act, consequently, its paper would be guaranteed by the central bank itself. Thus, it turns out that the supervisory agency, i.e. the central bank, had access to unlimited funds from the money market to rescue itself from its own folly.

One should add at this point that throughout the period until August 1997, Thailand never had a formal system of deposit guarantee. But the practice of the central bank in the past in dealing with problem banks had been to rescue them with zero impact on depositors, in many cases, with the resource for the rescue coming from FIDF.[5] 

By the first half of 1997, the weakness of the banking sector was becoming obvious. In March ten finance companies were told by the central bank to increase their capital, followed a few months later by the suspension of sixteen finance companies (including the first ten that were told to increase their capital). In August 1997, fifty-eight (out of some 91 remaining) more were suspended, and in November all but two of these were closed down altogether. A few more were closed in the following year. By the end of 1998, finance companies, whose deposits used to be as much as a third of the commercial banks’, ceased to be a significant factor in the financial system. 1998 also saw the government’s takeover of a number of smaller banks, and in the case of two of these foreign banks were allowed to acquire them, special legislation being passed in order to overcome a pre-existing ban.

The collapse of the financial system was extremely costly for the Thai treasury, totaling 1.4 trillion baht, the estimate being made as of May 2002, and including estimates of the future recovery of assets acquired by the government. This constituted about 30 per cent of the GNP of that year. Naturally, controversy surrounded the question whether the Thai government (then working under an IMF program) had taken the right course of action on the problems of the financial institutions, as well as on the method of disposal of their assets. While this question may lend itself to forensic investigations, a better question to ask is how to prevent such a collapse from happening in the first place, and if parts of the financial system had of necessity to be excised, how this could be effectively done. I shall answer this latter question at the end of this paper.

2. A RADICALLY DIFFERENT BANKING SYSTEM

Devastated by the crisis, the Thai banking system emerged from it with slightly less than half of the total deposits being in the state banks, much of it taken over during the reorganization after the crisis. The surviving private banks realized that the old business model that served it well in the pre-crisis era is no longer viable, even for the long-term.

In the short term – and it is a short term that lasted almost six years – lenders and borrowers alike were engaged in sweating out the overhang of debt accumulated during the bubble. This process took longer than was necessary. This is not surprising, given that the assets classified as non-performing touched 40 per cent. for all banks at one point.

The two governments – Democrat (1997-2001) and Thai Rak Thai (2001-2007) – had different approaches on the proper policies that the government should follow in facilitating the workout. The Democratic government relied on the reform of the bankruptcy law which was meant to speed up the workout process, which was left to the lenders and borrowers to work out for themselves. The Thai Rak Thai government decided to buy out the bad assets from the existing banks (excepting those that are already in the judicial process) and place it in the Thai Asset Management Corporation (TAMC), who would then oversee the workout, with the losses being shared between the lenders and the government. A point worth noting is that well over four-fifths of the acquired assets were from the state banks.

Of course, the non-judicial arrangement such as TAMC could easily lead to corruption. Thus far, no such charge has been made, not surprising as the procedures used have been singularly opaque, and very little information seems to have been supplied about the outcomes of its asset management.

As far as long-term strategy is concerned, private banks are now extremely wary about lending to large businesses, although they have been expanding other fee-based services to such customers, such as cash management. They have been turning to consumer banking and have expanded businesses such as credit cards and mortgages. In this they have been following the trend of banking world-wide. Households are themselves increasingly moving away from banks towards shares and mutual funds. Flow-of-fund accounts show that since 1999 they have been depositing only 20-40 per cent of their financial saving in the banks, as contrasted to over 60 per cent before the crisis, with much of the remainder going into share capital, mutual funds and government bonds, the last in years when the government made a particularly attractive flotation.

Apart from these shifts by both savers and investors, banks are now also subject to much more stringent supervision. In particular, the definition of non-performing loans has been tightened up considerably. “Evergreen” loans no longer could pass the central bank’s audit. These changes have made lending transactions to businesses considerably less attractive.

From being an essential cog in the transfer from saving to investment, the banks’ role in this intermediation has become increasingly peripheral, with the capital market taking up much of the decline. Nevertheless, it cannot be said the latter has completely taken over the role of the banks. Two observations will bear this out:

1. The investment/GDP ratio is still in the mid-20 percent range, after being consistently in the 30 plus range in the early 1990s even before the bubble.

2. Banks have been having excess liquidity since 1999, and have not been able to unload this liquidity to good borrowers.

3. THE EXPANSION OF THE CAPITAL MARKET

As banks have withdrawn from supplying capital to large firms, the latter have turned to the capital markets mostly to issue debentures and some share capital. The amounts raised by these means each year easily exceeded the increase in bank credit. For example in 2006, credits from banks increased by 426.0 billion baht, while newly issued domestic securities from private corporations was as high as 852.7 million baht.

There are two additional observations that need to be made:

1. The capital market is still the preserve of large corporations, with small firms being effectively excluded. Although it needs to be added that Thailand has an active bill-of-exchange market of an unknown size, which appears to fill the needs of at least medium-sized firms.

2. During the post-crisis period, firms have been actively using their cash-flow both to run down their debts, and to make new investments. This has been the pattern in the past at every economic downturn.

4. MONETARY AND EXCHANGE RATE POLICIES

After the violent gyrations brought on by the crisis in 1997-1998, the economy began to stabilize, albeit at a low level which persisted for a long period. With prices relatively stable despite a drastic devaluation of the baht from 26 baht to a steadier 43 baht in 2001, the Bank of Thailand felt confident enough to shift its policy regime to inflation targeting, while retaining a (mostly) flexible exchange rate regime. Having swung violently from a current account deficit of 8 percent to a surplus of 12 per cent within three months, Thailand saw continual surpluses as it worked off its debt over the next seven years, while the baht slowly appreciated, along with other Asian currencies until the last quarter of 2006.

Unfortunately, being a cleaner floater than the rest of Asia has its price. During the last quarter of 2006, as the betting in the currency markets was that the dollar will weaken, speculators found that pouring the money into the baht (as against, say, the renminbi) was quite profitable, because the baht, being more flexible, appreciated more strongly than other Asian currencies, excepting the Philippine peso and the Indonesian rupiah.

There was also the problem with the baht in that its interest rate was somewhat higher than its neighbors. But the Monetary Policy Committee held firm against lowering interest rates, because it was tethered to its inflation target. Perceiving that the rapid ascent of the baht was destabilizing the country’s trade, and reluctant to expand the remit of its inflation-targeting regime, the Bank of Thailand decided to control the inward flow of capital by using the Chilean device of requiring uncompensated reserves of 30 per cent. on most transactions including use of non-resident baht accounts to purchase stocks and other debt instruments. Coming out of the blue, this played havoc with the stock market, which saw its index declined by 15 per cent in one day. The control measure has been softened somewhat, but foreign confidence has been severely affected at least temporarily.

5. UNFINISHED BUSINESS

There have been two positive policy developments since the crisis, but one of these is as yet incomplete, and the other remain untested under trying conditions:

The incomplete policy pertains to the question of ensuring the stability of the financial institutions. Much has been achieved in improving the quality of the supervision of the central bank. Both it and the banks themselves have taken on board the idea that the central task in dealing with financial institutions is risk management. Unfortunately, while individual (private) banks have become more adept at this task, the policy framework has two very large gaps. One is the very large share of state banks in the industry. The risk posed by state banks is that despite the lessons learnt during the crisis, they still lend to politically connected individuals, as came to light in 2004 (?) in the case of Krung Thai Bank, the largest state bank. Until these banks are privatized, risks with these banks will remain. The other gap is the blanket deposit guarantee adopted during the crisis in August 1997. This needs to be reformed, and at a time when there is not much risk of a run (such as now).

The untested policy is the inflation-targeting regime which the Bank has adopted. Ever since its introduction, the stress from the demand side on inflation has been small. How the regime will last under red-hot conditions such as the one that occurred in 1993-1996 remains untested. One small problem is that the central bank is not legally independent. It is a small problem because in the past, the central bank as an institution has enjoyed the trust and support of the population to a remarkable extent. That trust and support declined sharply during the period leading up to and immediately after the crisis of 1997. However, since then the bank has recovered substantially much of its lost prestige. Nevertheless, it has to be borne in mind that even after the crisis, one of the governors was sacked. Indeed the number of governors who were sacked have become more frequent. It remains to be seen how it will fare when it became necessary “to take away the punch bowl just as the party gets going”, as an American central banker once remarked.

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The Man Who Comes from The Cold

Hubert Neiss, a former director of the IMF's Asia-Pacific Department, also took part in the Asian Financial Outlook conference. He made his trips to Thailand frequently before and after the 1997 crisis. When Thailand sought the IMF's financial rescue package, Neiss was one of the key persons who negotiated the tough conditions in the letter of intent between Thailand and the IMF.

His view then was rather hawkish, following generally the same line of the IMF. He worked through all the first three letters of intent, between August 1997 and March 1998 with Thailand before moving on to negotiated a similar financial rescue packages for Korea and Indonesia.

After retirement from the IMF, Neiss is now working as advisor on Asia for Deutsche Bank. 

In my view, governments have learned the main lessons of the painful experience 10 years ago, and another Asian crisis is, therefore, unlikely to happen. Countries are less vulnerable to a capital account crisis because they are keeping the exchange rate flexible, they have accumulated substantial foreign exchange reserves, their external position is strong, and they pursue stabilizing macroeconomic policies.

Countries are also less vulnerable to a banking crisis, because the banking system has been recapitalized and consolidated, prudential and accounting standards have been raised, and institutions are more effectively supervised.

While, in general, the lessons have been learned, I would now propose to look at some issues which specifically arose in the Thai context and which provide lessons not only for the Thai government, but also for the IMF and the larger international community. We can discuss then how well we think these lessons have been learned.

The issues concern pre-crisis developments, measures to overcome the crisis, and international financial support.

First, the events leading to the crisis. Thailand was the only country where problems could be foreseen, although not the severe crisis which actually happened. In the course of 1997, the current account deficit was widening, there were several episodes of foreign exchange market turmoil when the fixed exchange rate came under attack, forward FX obligations of the BOT were rising, and difficulties of finance companies (arising from excessive lending and speculative investment by borrowers) became increasingly obvious. But no decisive steps were taken to turn the situation around.

The lesson, and may be the most important one, from the pre-crisis experience is to take early and substantive preventive action. (I cannot help thinking that the course of history could have been different, if before mid-97 there had been a devaluation, steps to shore up ailing financial institutions, some macroeconomic tightening, and a large international rescue package.)

Second, measures taken in managing the crisis. Several of these were controversial from the beginning. In retrospect, some turned out to be right and others wrong. However, views still differ and there is no consensus on the lessons to take .

The following measures , in my view, were right: the increase in interest rates, the announcement of a “blanket guarantee” for bank deposits, and the suspension and closure of financial institutions.

The interest rate increase was necessary to stop the precipitate fall in the exchange rate, which damaged corporate balance sheets, led to a collapse of imports, and started an inflationary spiral. However, rates should probably have been reduced earlier to mitigate the recession and to assist the rehabilitation of banks. This was a difficult judgement. The “blanket guarantee” which only was accepted reluctantly by the IMF was urgently required to prevent a panic of depositors. The closure of unviable financial institutions was necessary to prevent an escalation of central bank support and to limit the cost of bank restructuring.

Now let me mention two measures which in my view were mistaken: the fiscal tightening, in particular the increase in the VAT which had an immediate effect, and the publication of BOT’s forward FX obligations at the start of the programme, as required by the IMF.

At the beginning of the crisis , there were plausible arguments for some fiscal tightening: it should make a contribution to reducing the external current account deficit, it should create some reserve for the expected high cost of bank rehabilitation, and it should help restore market confidence by demonstrating decisive government action.

It was not foreseen, however, that import and GDP growth would collapse (the first program assumed continued growth at a modest rate), and under these circumstances, the attempted fiscal tightening weakened, instead of strengthened market confidence. When the severe recession became obvious, the policy was reversed, but too late, and in any case later than the Thai government had proposed.

The publication of the forward FX obligations of the BOT, which were larger than had been widely expected, had a detrimental effect on market confidence and contributed to the impression that the program was “underfinanced” (although it was reasonable to assume that a large part of these forwards would be rolled over or not closed out). The program had thus a bad start.

Finally, a measure which was right but inadequately executed was corporate restructuring. It began too late and was drawn out too long, mainly because of the political, but also the technical difficulties involved.

Third, international financial support. Whether objectively justified or not, once markets assumed that the total financing package was inadequate, the package should have been increased substantially to restore confidence. However, this could not be done since a framework for quick action for a massive increase of support did not exist – nor does it exist today, neither on the regional nor the international level. Here is another important lesson.

Nevertheless, despite many welcome initiatives on Asian financial co-operation, a massive pooling of reserves which could be lent in an emergency, is still missing.

And despite much rhetoric in the wake of the crisis about a new “international financial architecture”, the steps actually taken – although highly desirable - are quite limited compared with the goal of making the IMF a more effective lender of last resort. (This would require a strengthened lending capacity, new mechanisms to draw in the private sector and to resolve sovereign debt, and a realistic voting distribution).