Vatchara Charoonsantikul and Thanong Khanthong look at how the Bank of Thailand won the initial battle of the baht but lost the war.

Under tremendous pressure to devalue the baht from almost every business and political quarter, the Bank of Thailand finally caved in.

Events leading to the managed floating of the baht showed that the central bank had lost the war from within rather than without. Speculators threw some heavy punches in mid-May which were successfully fended off by the central bank, which took the drastic step of creating separate onshore and offshore baht markets.

Although speculators were still licking their wounds, they succeeded in demoralising the Thai public. Some people frantically moved their money offshore into other currencies. Some exporters parked dollars offshore by undervaluing their invoices rather than bringing dollars into the country. Some importers overvalued their invoices so that they could take the baht out of the country for speculative gain.

There were calls from noted Thai economists for the central bank to devalue, to prevent Thailand from suffering an economic meltdown worse than Mexico's two years ago.

Not surprisingly, dirty politics played a part in the fiasco. By the time the Thai elite and politicians said let's do it, the central bank had no recourse to the pressure but to free the baht from its basket of currencies peg. It was a classic example of a self-fulfilling prophecy.

However, the BOT faced defeat with honour. Instead of swallowing its words and devaluing the baht, it elected to adopt a managed float system. Instead of fixing the baht daily within a narrow trading band, it will let market forces determine the currency's value.

If the BOT had announced a devaluation, it would have set a new benchmark for the baht. By doing so, it would have to defend the benchmark from suspicious financial markets in another endless and costly fight.

Under the managed floating system, the baht will appreciate from capital inflow and depreciate from capital outflow, and the BOT will act as lender of last resort by intervening in the foreign exchange market only when necessary.

At this point, floating the baht is tantamount to a de facto devaluation, since Thailand's macro-economic condition is deteriorating rapidly.

In the absence of an official mid-rate, Standard Chartered Bank was the first bank to test the waters by quoting the onshore baht rate at Bt28 to the dollar. Banque Indosuez followed up at Bt29.50. In the offshore market, the baht was sharply quoted down at Bt28.50, from Monday's Bt24.70, effectively converging the offshore and onshore rates.

Bangkok Bank quoted its buying rate for bank notes at Bt24.98 and the selling rate at Bt30.16.

There may be an overshooting of the baht over the next week, which might send the currency to Bt35 as the market forces will be testing the currency's new equilibrium. Chaiyawat Wibulsawasdi, the deputy central bank governor, assured that within seven days, the markets will set an equilibrium point for the baht.

Morgan Stanley Asia Ltd said: ''The new 'equilibrium' exchange value of the baht depends on where along the spectrum from first-best to worst we end up. We see the Bt32/dollar range as consistent with the need to reverse the appreciation of the real effective exchange rate that has occured since 1995 and allow for the 'crowding in' of labour and capital from the construction, property and banking and finance sectors to the manufacturing sector, which will characterise the economy's post-devaluation recovery path."

The deteriorating macro-economic situation has placed Thailand in the unfortunate circumstance of being damned if it devalued the currency and damned if it did not. It simply became a question of timing for the day of reckoning.

But it was odd for the central bankers to float the baht when they have yet to solve the financial sector crisis, restore stability to the payment system and improve liquidity. Nor do they have any medium or long-term plans to cope with the post-baht flotation. It was yet another awkward misstep.

In retrospect, if the banking authorities had done nothing to adjust foreign exchange policy, they would still have faced mounting pressure from capital outflow. Capital outflow would have placed further downward pressure on the currency, since the BOT's international reserves are all ''borrowed" reserves.

Thailand is a capital deficit country. Any foreign capital that is beyond the level of the current account deficit automatically flows into the BOT's coffers to form international reserves. Out of these borrowed reserves, the BOT defends the baht.

Defending the baht at a time of macro-economic distress amounts to self-punishment. Interest rates have to be kept high to keep capital from flowing out. High interest rates have punished the corporate sector and harmed the capital market. In effect, the central bank has no flexibility at all to manage its monetary policy.

One report estimated that between July and October some US$5 billion (Bt130 billion) in bills of exchange could have been redeemed by foreign investors, who could not mark to market their baht holdings with the two-tier currency system. Some $2 billion in negotiable certificates of deposits face redemption, not to mention another $1.5 billion in Euroconvertible bonds.

The central bank spent about $6 billion defending the baht in mid-May, but bought back $4 billion from the offshore market to rebuild its reserves to above the $30-billion mark. The official reserves figure in May was $33.3 billion.

But if $8.5 billion were to flow out by October, the central bank would be in an extremely difficult position in defending the baht except with emergency measures by the Finance Ministry or for state enterprises to go offshore to raise fresh capital to offset the outflow. There is no contingency plan whatsoever for this.

So the central bank must have thought that it was better to defend the baht in a managed float system, while it still had $30 billion in hand.

The BOT divides its international reserves into three parts. About $6 billion is for international trade transactions, covering about one and a half months of imports. Another portion is kept in short-term deposits for emergency use. The final portion goes to subscribing treasury bills of other governments, mainly US treasury bonds.

Having floated the baht and removed a crucial psychological barrier, the central bank is nervously watching to see whether it has boosted confidence, which will be tested by capital inflow.

The interbank rate shot up to less than 30 per cent, instead of the 70 to 80 per cent feared. But the stock market displayed an irrational exuberance by jumping 41.51 points to 568.79, on turnover of Bt10.42 billion.