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All lose in the foreign exchange debate

Thanong Khanthong traces the conflict between two camps over Thailand's foreign exchange policy.


There were two intellectual camps one led by Siam Commercial Bank president Dr Olarn Chaipravat and the other by former finance minister Dr Virabongsa Ramangkura in the debate on Thailand's foreign exchange policy right up to July 2 when the Bank of Thailand caved in to domestic pressure and floated the baht.

The central bank's decision meant the abandonment of the 13-year-old fixed exchange regime for good, amounting to a de facto devaluation of the Thai currency.

The Olarn camp was supported by the traditional banking establishment and advisers to former finance minister Dr Amnuay Viravan. The approach in assessing the Thai economic woes is financial-oriented. The key argument put forward by this camp centred on the financial crisis, which was, and still is, the root of all the economic problems.

Thailand, the Olarn camp argued, was facing a crisis of confidence at home and abroad because the government had failed to tackle the financial crisis. Capital had been draining out of the country, thus putting pressure on the baht, because foreign investors and creditors were afraid many Thai financial institutions were insolvent.

If the scope of the damages in the financial sector was not limited within a specific timeframe, it would wreak further havoc on the entire economy, inevitably draining the country's international reserves and consequently a baht devaluation. The devaluation would spell disaster for Thailand on the scale of the Mexican peso crisis.

The Olarn camp believed devaluation was not the answer to Thailand's economic ills. Eventually, somebody would have to fix the financial situation, now saddled with Bt1 trillion in non-performing loans. Of this non-performing loan amount, Bt300 billion to Bt400 billion would have to come from somewhere to be set aside as provisions and cushion the financial system from becoming insolvent.

A country cannot have a strong economy without the backup offered by a strong financial system.

Drawing a line in the sand was the other camp, represented by Dr Virabongsa Ramangkura, a former finance minister and an architect of the 1984 baht devaluation; Dr Ammar Siamwalla, a respectable economist and former head of the Thailand Development Research Institute; some members of the Chat Pattana Party; and the Thammasat University economists.

The Virabongsa camp is macroeconomic-oriented. This camp believed the Thai manufacturing sector had already been in deep trouble, losing its competitiveness to the newly emerging economies. The market share of Thai goods in the major overseas markets had been lost to Vietnam, China, Indonesia and others.

Labour costs had shot up, while Thai industries had failed to move up to more value-added production. Exports plummeted, to face negative growth last year for the first time in more than a decade. The Thai currency was thus overvalued. The only way to salvage the Thai economy, which is driven largely by the export machine, was to devalue the currency, this camp believed.

The weaker currency would give the export sector a shot in the arm. By a devaluation, half the economy would be destroyed, but the rest of the nation could be saved.

The Virabongsa camp played down the importance of the property and financial sectors, believing they were already dead in the water. There was no way to salvage them. The government should instead focus on boosting exports, which would become the key factor to lead the country onto its recovery path.

Since Thailand depends on foreign capital to finance its economic growth, it thus faces the twin problems of the current account deficit and a balance of payments crisis.

Seeing cracks in the Thai macroeconomy, foreign speculators began to attack the baht, the first time this year in February and the second time in May. The May attack forced the central bank to spend about US$12 billion from its reserves to defend the currency, according to UBS Global Research.

Fears of Thailand's economic meltdown drove capital out of the country. With its back against the wall, the Bank of Thailand had no choice but to keep interest rates high to defend the baht.

The fixed exchange regime tied the regulators' hands. They had to run down their international reserves to defend the currency. At the same time, they could not lower interest rates to give the economy some breathing space.

If the banking regulators had loosened monetary policy, they would have sent out a signal that they were not interested in defending the baht. So in effect, they were kept locked in a box.

With the financial crisis, the Thai economy has shrunk to a level where it is being supported by domestic cash. Without confidence in the finance companies, backed up by mostly substantiated rumours of their impending collapse, the public had begun to massively redeem their promissory notes (P/N).

Liquidity became tight, and short-term interest rates shot sky-high to 20 to 30 per cent. Since finance companies were offering interest returns higher than the rates at which they had lent they were digging their own graves.

Struggling to stay afloat, the finance companies, without discrimination, began to call back loans they had extended to their customers, so as to protect themselves. Good customers were turned away. The disease spread from the financial sector into the real sector, with manufacturing companies being denied the liquidity they needed to continue to operate.

Companies can manage to post losses in their financial books for years, but they cannot afford to operate without liquidity. The liquidity crisis in Thailand would spread, to bring about a collapse in the credit system.

Phatra Research Institute of Phatra Thanakit Plc, led by Viroj Nualkhair, one of the key advisers to Dr Amnuay, appears to support this line of argument. In its recent research on the Thai bubble economy, the institute clearly pointed out that fundamentally the Thai economy was sound, although it has faced years of mismanagement. What the Thai economy was facing was a financial crisis, developed by over-investment in the basic industries.

Buoyed by easy credit from abroad, Thai companies saddled themselves with foreign debts and threw the money into projects that were commercially unviable, Phatra said. Real estate was only part of the problem not the biggest problem. The basic industries from steel, telecommunications to petrochemicals soaked up most of the credit. They would eventually be unable to service repayments.

Much worse, finance companies continued throwing good money after bad in an attempt to make their books look good to investors. Almost all companies relied on debt financing, so they tried in vain to hang tough in the stock market by boosting their stocks.

Stocks were widely offered as collateral. Yet the stock market was collapsing, plunging by more than 35 per cent in 1996. It would fall below the 500 point level a meltdown of financial assets.

To avoid having to cover their melting collaterals, companies needed to support their stocks in an elusive way another classic story of throwing good money after bad.

In short, the economy fell into trouble by itself because of years of over-investment particularly since the early 1990s which was not matched by viable capital output. Most of the over-investment in the private sector was financed by foreign debt, which eventually built up to more than US$60 billion.

The picture pointed to a complete mess in Thailand's macroeconomic planning, but the banking authorities failed to grasp the fundamental problem. Instead of curbing over-investment in the basic industries, it sought to limit consumption. Credit card spending and car hire-purchase arrangements were curbed at one point. The Bank of Thailand completely missed the big picture.

''The poor corporate earnings were the cause of the problems in the Thai economy not the consequence of the economic problems," argued Phatra Thanakit.


During the months leading up to the baht float, the Olarn camp still hoped the country could avoid a damaging devaluation by tackling the financial crisis after the BOT succeeded, albeit in a very costly way, in fending off the speculators in May. If the BOT held tight with its no-devaluation policy, it would be able to muddle through.

Democrat MP Tarrin Nimmanahaeminda, an Olarn sympathiser, personally objected to a devaluation. At a Thammasat University seminar, he called for the government to reverse the reserves crisis by going out to the overseas markets to borrow and bring fresh capital into the country. Since the government enjoyed a higher credit rating, it would be in a position to issue bonds or borrow at lower costs than the corporations.

By doing so, the central bank might hope to build its reserves and buy time until the economic woes were tackled.

However the Virabongsa camp urged a quick remedy through devaluation. Virabongsa argued that devaluation would end all the uncertainty and stop reserves from being drained. The country would risk becoming another Mexico if it allowed its reserves to fall to a dangerously low level, which could not support international trade transactions.

A devaluation would give foreign investors some certainty in bringing their money back to the country, hence improving liquidity and paving the way for interest rates to come down. ''Tell me if there was any other way to save the economy," he said at one point.

The Thammasat economists also came out with a call for the central bank to tackle the economic woes by tearing down the fixed exchange regime, without taking into account the financial sector crisis.

Still, it was almost a consensus inside the Olarn and Virabongsa camp that something must be done with the foreign exchange. The question had to do with timing.

The Olarn camp said if the financial crisis was not resolved, Thailand would not have liquidity. Without liquidity, interest rates could not be brought down. Without lower interest rates, the economy could not recover.

Once the financial crisis was tackled, with some improvements in liquidity, the regulators would have a window of opportunity to unpeg the baht, the Olarn camp said. The fixed exchange regime, which should have been abandoned three to four years ago, had outlived its usefulness.

Yet at a time of crisis, the leadership was not there. With the Bank of Thailand continuing to hit the wrong targets, trust in the Thai financial system evaporated. The local rich began to shift their money out of the country. There were louder calls to devalue the baht from corporations who would benefit from a weaker currency.

Capital flight from nervous Thais caught the Olarn camp and the central bank off-guard.

The central bank, which was afraid of losing more reserves, pathetically backed away from its staunch anti-devaluation policy and caved in. Instead of a straight devaluation, though, it elected to unpeg the currency from the US dollar. It did not make much difference the baht immediately plunged by 15 per cent against the greenback on July 2.

Yet the financial crisis is lingering. The government still needs to borrow from Japan, the International Monetary Fund and other private banks to boost its reserves. Foreign capital has yet to flow in. Interest rates are being kept high to tame runaway inflation.

There are no winners or losers in this foreign exchange policy debate since all people in Thailand have now become losers. It will take years to correct the past mistakes, which, with foresight, could have been prevented. Alas, the lesson is always too expensive.



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