Thailand currency crisis’ central bank policy error explained to Sri Lanka
ECONOMYNEXT – Thailand’s currency crisis in 1997 was triggered by monetary policy incompatible with its exchange rate policy, a former Governor the country’s central bank, Veerathai Santiprabhob said at an economic forum in Sri Lanka.
The Bank of Thailand floated the Baht in July 1997, after running out of reserves by keeping rates down made public its International Monetary Fund program in August.
The collapse of the currency, with a domestic banking sector loaded with foreign borrowings led to sharply higher bad loans, which were already building up, triggering a banking crisis.
“And this currency crisis and banking crisis were originated firstly by policy mis-management from the central bank,” Veerathai told an economic forum organized by Colombo-based Advocata Institute in a rare admission for a central banker.
“What we call impossible trinity as anyone who studies macro-economics are fully aware, we can have a regime with free capital mobility, independent monetary policies and fixed exchange rate. Those are the impossible trinity. But we had that system.”
“The Ministry of Finance did not want to change the exchange rate regime. No politician likes to devalue.”
The Bank of Thailand was one of the best pegged central banks during the Bretton Woods era and after, where politicians had supported monetary stability and strong exchange rates, following the experience of World War II in particular.
Hard Peg
Thailand’s rulers had resisted creating a central bank in the early 1930s on the advice of British experts including James Baxter who was advising the Finance Minister.
Thailand operated a fixed exchange rate where the monetary agency under the Treasury, buying selling Baht at 10.80/11.20 against Sterling the style of a currency board.
Politicians and their advisors at the time were uncorrupted by the Harvard-Cambridge economics the destroyed developing countries after World War II.
However under pressure from Japanese during World War II, Thailand created central bank, soft-pegged to the Yen. It was forced to buy government securities and issue money against Yen which was itself inflating. Inflation rocketed and at the end of the World War II the country was without reserves.
After the war Bank of Thailand began to rebuild its reserves through a remarkable tactic of buying dollars through a surrender requirement of 40 Baht to the sterling and selling at 60 to mop up money.
It shifted the anchor to the US dollar following sterling crises, devalued with the US dollar as the Bretton Woods collapsed and later revalued to 20.
Its 20 baht to the US dollar peg had broken only twice in 1981 during the first tightening of monetary policy by US Fed Chief Volker and in 1985 during the second tightening cycle. For over 20 years Thailand had successfully kept its peg at 25.
No Deficits
Central Banks usually blame deficits, after accommodating them with printed money to keep rates down.
With a strong currency it is easy to run budget, as taxes have a high and stable real value year after year and there are no demands for subsidies since monetary stability serves as an automatic social safety net.
Since budgets are usually blamed for currency collapses, Advocata asked about the budget.
“The fiscal situation was very strong,” Veerathai said. “The fiscal deficit before the 1997 crisis was 1 to 2 percent of GDP. Our public debt was in the single digits.”
Most East Asian nations which were hit by the 1997 crisis and speculative attacks – usually through the swap market – had good budgets.
Soft-peggers generally also blame members of the public for importing goods who are usually net savers – especially in Asia where banks are risk averse – and have no ability to create currency crisis.
Liability Dollarization
In 1993 the Thailand decided to be an international financial centre mimicking Hong Kong and Singapore and set up the Bangkok International Banking Facility (BIBF).
“So the government and the central bank tried to encourage local banks to International Banking Facility, taking out regulations for what we called out-in transactions,” Veerathai said.
However unlike Singapore and Honk Kong the Bank of Thailand was not a currency board and it now had a policy rate like a floating exchange rate bank.
In a currency board, capital inflows automatically lead to spike in liquidity and an immediate fall in rates which discourage further inflows. However with a policy rate, an interest rate differential develops encouraging further inflows.
Most of the money flowed in and banks lent to domestic businesses, leading to liability dollarization.
As the central bank attempts to sterilize the liquidity stop ‘overheating’ in present day economic terminology, the interest rate differential widens further, encouraging domestic companies to borrow to get cheaper dollar loans and foreigners to lend.
“There was a big mismatch, borrowing short term and lending long term, so bank balance sheets were weak,” Veerathai said. “We also had asset price bubbles with huge inflows coming in.”
Large inflows added to the usual foreign direct investment into Thailand, widened the current account deficit sharply in the next several years.
A bank got into trouble in 1996. Several finance companies were closed. Foreign speculators who saw the widening current account deficit borrowed Baht through swaps through the offshore market and began to hit the peg.
Soros style Swaps
Bank of Thailand then made the next fatal error. It became counterparty to the swaps generating new Baht, keeping interest rates down.
Bank of Thailand lost almost all its 30 billion US dollars of reserves in 1997 and according to IMF data at the end of 1997 it had ended up with an estimated 19 billion US dollars of swaps.
To take pressure off the currency Bank of Thailand barred foreigners from borrowing domestic currency effectively closing the swap market and eventually unwound its swap stock at massive losses which were built into the IMF program.
Short term interest rates went up to 23 percent and combined with the currency collapse, bad loans topped 47 percent with firms used to low rates during the time the peg operated better.
Hong Kong, a true currency board however held, with speculators suffering large losses on their swaps as short term rates went up imposing massive costs whenever they attempted to renew a contract.
Thailand’s IMF program was based broadly on exchange rate stability but the impossible trinity was no longer in operation.
“..[I]f there is increased pressure on the exchange rate, we will raise interest rates and tighten the monetary program as necessary,” the Bank of Thailand told the IMF.
Thailand’s monetary program was also had no policy conflicts, its foreign reserve target was matched by a ceiling on net domestic assets with reserve money as an indicative target.
As bank credit collapse and investment fell and loans were repaid, the BOP turned sharply into surplus in 1998 as more loans were repaid, confidence returned, beating IMF program projections allowing rates to fall.
However the IMF no longer makes such programs.
Same impossible trinity in new bottle
At the time IMF had the benefit of Stanley Fischer, its First Managing Director who knew the difference between a clean float and a hard peg. He predicted that there will be a move to single anchor regimes.
“Hong Kong economy has successfully withstood massive external shocks, and the linked exchange rate remains strong,” Fischer said in a speech in June 1997.
“In the wake of the crisis, we are likely to see more countries adopting flexible exchange rate systems, or, if they fix, doing so in a definitive way, for example, as in Hong Kong, through a currency board,”
“Countries that adopt floating rate regimes will have to consider the basis for their monetary policy; increasingly, around the world, the benefits of an inflation targeting regime are being recognized.
“However this simple dichotomy is unlikely to be the last word, and some countries may seek intermediate regimes, for instance a broad target range for the exchange rate, around a central rate that could itself move gradually.”
Two decades later intermediate regimes have won with a violently conflicting money and exchange rate policy in the form of flexible inflation targeting which are neither clean floats nor hard pegs with in inflation targets as high as 6 percent giving enough room for policy errors.
Meanwhile real economy causes are still attributed to currency crises: trade deficits, current account deficits, factor productivity, bad governance, budget deficits, rather than discretionary or flexible central bank action. (Colombo/Oct09/2022)
