Throughout the stormy events that preceded the 1997 crisis, the baht came under pressure from two battlegrounds: the spot market and the forward market.

When foreign speculators attacked the baht in the spot market by selling the local currency for US dollars, they confronted the Exchange Equalisation Fund face to face.

What they aimed to do was force a devaluation by pushing the value of the baht down immediately in the spot market and/or push up the swap premium. Either way they'd make huge profits, the thinking went, because they could repay the contracts with cheaper baht.

Another way the speculators bet against the currency was by entering into contracts with dealers who would give dollars in return for an agreement to repay a specific amount of baht some months in the future. If the baht rose in value, the seller of the contract made money; but if it fell, the buyer profited because, again, he could repay the contract with cheaper baht.

"Demand for such contracts started to drive up interest rates, and the Bank of Thailand began issuing many of these so-called forward contracts itself. This action turned out to be a fatal misstep that placed in the hands of speculators the perfect weapon with which to attack the currency. It's as though an unarmed gunslinger walked into town and the sheriff handed him a pistol," Time quoted a speculator who benefited handsomely from the baht collapse as saying.

The central bank had its own rationale for defending the baht through currency-swap contracts in the forward market. When the baht came under assault, aggravated further by capital flight, the Bank of Thailand was obliged to intervene directly in the spot market. The BOT had, after all, set the ground rules through the currency peg that the baht would deviate plus or minus two satang from the fixed exchange rate.

The Exchange Equalisation Fund, which acts as a broker or a foreign-exchange arm for the Bank of Thailand, can buy or sell US dollars without limit. But in most cases in 1997, it was obliged to sell out the US dollar to support the value of the baht at a fixed rate. By doing so, it ran down the country's foreign exchange reserves.

Without the Bank of Thailand's intervention, the baht would have weakened significantly and the short-term interest rates would have risen sky-high because the speculative attacks would have drained liquidity in the money market.

A baht attack to the tune of US$10 billion on May 14, 1997 meant that roughly Bt260 billion, based on the exchange rate of Bt25 per US dollar, would have been immediately drained from the system. This could have broken apart the payment system, since only about Bt400 billion in bank notes and coins - or the M1 money supply - was in circulation at that time.

In the absence of a well-developed bond market, financial institutions were denied a tool to adjust their liquidity in time for the currency attack. The reason was simple: the Thai government had been running budget surpluses for the past decade.

And so, during the speculative attacks, which immediately tightened the liquidity market, the Banking Department "sterilised" the contractionary effect from the dollar-buying/baht-selling attack by pumping the baht back into the system through the buy-sell swap contracts. Through this tactic (buy dollar/sell baht, with an obligation afterward to sell dollar/buy baht), the Bank of Thailand's Banking Department brought the dollar into its account and sent the baht into the system.

But some time in the future, every three months, six months or one year, the Bank of Thailand was obliged to deliver the dollar back to the contractual parties and get the baht returned. The fee for such transactions is called a swap premium, or risk premium.

The currency swap also helped stem the rise of short-term interest rates, which would certainly have hammered the fragile financial system and weak economy, and added liquidity to the system.

Thanong Khanthong