Thailand's Road to Economic Crisis

By Kirida Bhaopichitr, in The Nation (Bangkok)
December 1997

In this overview of the Thai economic crisis, the writer points out that the key decision leading to the turmoil was the move to fully liberalise the country's financial system and lift capital controls. With the establishment of the Bangkok International Banking Facilities, the door was thrown open to the massive flow of foreign currencies and to the activities of financial speculators.

Thailand, a country once described by the World Bank as 'a model for economic development', is now plagued by an economic crisis characterised by massive foreign debts, unemployment, inflation and a currency that continues to depreciate.

In one decade, how did we move from double-digit growth to the situation we are in today?

In the mid-1980s, the local economy began to grow rapidly, and Thailand began the process of liberalising its financial system. Starting in 1990, as part of this process, Thailand lifted capital controls so funds could flow freely in and out of the country.

In 1993, the Bangkok International Banking Facilities (BIBF) were established. The BIBF permitted local and foreign commercial banks in Thailand to take deposits or borrowings in foreign currencies from abroad, and lend them both here and abroad. As a result, massive amounts of currency flowed into the Kingdom.

This was to a great degree caused by the interest rate spread and the fact that the baht's value was pegged at 25 to the dollar. Interest rates in Thailand were much higher than in many other countries, which caused large private firms in Thailand to begin borrowing from abroad to finance projects.

Banks and finance companies also found it advantageous to borrow funds from abroad and lend them to local borrowers. Moreover, the fixed value of the baht meant that the Bank of Thailand had essentially eliminated the exchange rate risk. Problems arose when the loans from abroad were misallocated - in other words, channelled to sectors of low productivity - and things rapidly grew worse because most of the loans were unhedged against currency fluctuations.

The steel and petrochemical industries were hit hard, but the real estate sector was devastated. The reasons were simple: Firms were borrowing funds in foreign currencies while their revenues were being generated in baht, and the funds were also being borrowed short-term to finance long-term projects. This, and the fact that most of the funds that were borrowed from abroad were unhedged, created an extremely unfavourable economic situation, a disaster waiting to happen.

Up until 1995, goods and wages in the real estate and financial sectors were highly overvalued which, in hindsight, seems to have been an economic 'bubble' waiting to burst. But this all changed in 1996, when a scandal involving the Bangkok Bank of Commerce prompted foreign money managers to begin carefully re-examining the value of the loans they had made to borrowers in Thailand.

At the same time there were signs of a weakening economy, the most alarming of which was the high percentage of current-account deficit to gross domestic product (GDP). This was primarily due to the fact that Thailand was importing much more than it was exporting. Exports became more sluggish, and the overvalued baht and increasing labour costs in the country caused Thailand to lose its competitive edge in the world market. In short, our exports had become more expensive than that of our competitors in the eyes of foreign consumers.

One of the main reasons for the baht being overvalued is that it was pegged to a 'basket of currencies', of which the US dollar made up over 80%. The baht and dollar inflation rates were roughly parallel until 1994, when the former jumped to 6% (annual rate), while the latter fell to 2%. As a result, the baht appreciated against the US dollar by roughly 4%, and this began to adversely affect our exports to the US.

As the US economy strengthened, the dollar appreciated relative to other major world currencies, including the mark, the franc, the pound and especially the yen. Being largely pegged to the dollar, the baht followed this trend, which further discouraged exports - particularly to Japan, Thailand's second largest export market.

To further aggravate the situation, important Thai exports such as textiles and canned goods were losing their share in the world market, a result of competition from countries with cheaper labour costs like China and Vietnam. And at the same time, imports of raw materials, capital goods and luxury goods did not decrease.

On top of the current account deficit, the real estate sector's bubble 'burst', resulting in a plunge in property prices and a contraction in the sector. This left many bad debts on the balance sheets of the finance companies, which had financed those loans primarily by borrowing from abroad.

When the foreign money managers realised what was going on, net capital inflows into Thailand began to run dry. Once it began to see a negative net inflow, the Thai economy slowed dramatically, which put pressure on the baht.

In late 1997, hedge fund managers and currency traders like George Soros began to make speculative attacks on the baht. They realised early on that the Thai currency was overvalued and that speculative attacks would be successful in lowering the value of the baht.

One of the ways hedge fund managers go about attacking a currency is to enter into forward contracts to sell it. In Thailand's case, fund managers would promise to sell another party a certain amount of baht for dollars at 25 to the dollar after three months, entering into these agreements in the hope that a float of the baht would lead to a more favourable return for their dollar, which is exactly what happened.

Before long, though, local investors started to realise what was happening and began selling baht for dollars in an attempt to hedge against the depreciation of the baht. Exporters with similar motives who received payments in foreign currencies found that it was in their best interest to wait a while before converting those currencies into baht.

This widespread selling only hastened the depreciation of the baht, because while there was a huge supply of baht in the money market, there was little demand for it.

In an unsuccessful attempt to defend the baht, the Bank of Thailand used the country's reserves of foreign currencies to buy up the excess supply. But in the process, foreign reserves began to dwindle, while the speculative attacks continued.

Our foreign reserves were also being used to bail out financial institutions such as the Bangkok Bank of Commerce and 16 other finance companies which had massive 'non-performing' loans - loans that they could not collect, most of which were made to the real estate sector.

By August 1997, the situation in the financial sector had become critical, and 42 more finance companies were shut down. By that time, Thailand was in serious danger of running out of reserves, and it was clear that the currency defence and the other bailout attempts had failed.

By July 1997 more than US$30 billion of foreign reserves had been used in the unsuccessful defence of the baht. On 2 July, The Bank of Thailand, unable to defend the baht any longer, announced that a 'managed float' system would be adopted to replace the 13-year-old pegged exchange rate system. This meant that the baht's value would be determined by the demand and supply of the baht in the world money market.

Since that time, the baht has fallen dramatically, reaching record lows of nearly 44 baht to the dollar in early December. This seems to contradict earlier research which had indicated that the reasonable or equilibrium value of the baht was around 32 baht to the dollar.

With the depreciated baht the private sector, particularly the banking sector, found it even more difficult to repay their foreign debts because the float had caused the debt in baht terms to rise. And because it was impossible to obtain any more foreign funds, more and more firms were forced to shut down.

With an economy left with virtually no foreign reserves and a weak private sector weighed down with foreign debts, Thailand decided to seek foreign aid to help revive its economy.

In mid-August, the International Monetary Fund (IMF) stepped in and organised a package of $17.2 billion in loans to Thailand from various Asian nations. The main condition of the bailout package was a Bt60 billion budget surplus, which meant that the government's revenues would have to exceed its expenditures by that amount.

This led to huge cuts in government expenditures, in the neighbourhood of 100 billion baht. But even with these cuts, unless the government was able to raise more revenue, it would not be able to attain a 60 billion baht surplus. Thus, the value-added tax (VAT) was increased from 7% to 10%, and other taxes on luxury items were imposed. However, even with the spending cuts and higher tax revenues, the government is still 40 billion baht short of meeting the surplus requirement.

Most analysts agree that the present economic crisis is Thailand's worst since World War II. The consequences are being felt by Thais from every economic background, but those who are feeling it most are workers in the finance and real estate sectors, as well as construction and other industries that produce goods with high import content. The skyrocketing unemployment rate in these sectors - it is estimated that about 600,000 workers have been laid off already - suggests that it will be some time before the situation improves.

Sectors that may potentially come out ahead include exporting companies that use mainly local raw materials or labour in the production process. These include industries such as rice cultivation, frozen shrimp and chicken, and rubber. Because they use raw materials, success in these industries will help boost income in the agricultural sector, which accommodates 64% of Thailand's labour force.

This is just an overview of the drastic economic changes which have affected Thailand in recent months. Where are we headed? And how should we cope with the situation? Answers to these and many other questions will hopefully be found in coming months.

- Third World Network Features

About the writer: Kirida Bhaopichitr is currently a student in the PhD Programme at Cornell University's Department of Economics.

The above appeared in December 1997 on the Web site of the Bangkok daily, The Nation, and is used here with the permission of its editors.

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