Economic Crises and the Debt-Deflation Episode in Thailand

Abstract

A fixed exchange rate regime can create an illusion of a zero-exchange rate risk, while premature relaxation of capital controls can encourage overborrowing in foreign currencies. Currency and maturity mismatching of Thai commercial banks generated their overexposure to external shocks. The export shortfall in 1996 and widening current account deficit raised doubts concerning the sustainability of the baht currency peg. With the baht succumbing to speculative attacks, the Bank of Thailand decided to float it on 2 July 1997. Without a nominal anchor and given the lack of policy credibility, the value of the baht fell by 56% through to January 1998. This large currency depreciation aggravated the foreign debt burden, causing a credit crunch, high interest rates, bankruptcy, and financial disintermediation. The loss of consumer and business confidence stemming from the expected recession exacerbated the contraction in investment and consumption. Until the exchange rate rebounds to a level determined by economic fundamentals, the economy will continue this debt-deflation episode. Introduction After the baht float in July 1997 and its subsequent contagion effects, there has been a growing volume of research on the causes of the financial and currency crises in Asia. Obvious proximate causes of the crises are unproductive investment financed by short-term capital flows, overvalued exchange rates, overlending and asset price bubbles, inadequate supervision and moral hazard in the financial sector, herd behaviour, panic and self-fulfilling speculative attacks.1 In a mild cyclical downturn, caused by policy shocks, the financial system usually remains stable. However, in a deep recession financial stability is always threatened. Thailand has been struggling through the banking and currency crises, followed by a severe recession. This paper examines the causes of Thailand's economic crises and explains why Thailand has shifted dramatically from a high growth path before the economic crises to a sharp and protracted recession. Thailand's total foreign debt in July 1998 stood at US$87 billion, 68% of which was private debt. The amount of foreign debt created by the bank and financial companies totalled US$33 billion. The massive depreciation of the baht resulted in a reduction of banks and firms' net worth that led to a sharp fall in private investment. It is argued here that the baht float has aggravated the private sector's over-indebtedness that had accumulated during the booms in the early 1990s. The deflationary pressure on the Thai economy has been going on since 1995, when the contractionary monetary policy was initiated to restrain the overheated economy. Additional tight fiscal and monetary policies employed to satisfy the IMF's bailout conditionality in 1997 aggravated liquidity problems and exacerbated output contraction. Loss of confidence and growing pessimism caused by bank failures and layoffs forced households to revise downward their permanent income and cut back consumption spending. A further fall in the value of the baht triggered by regional disturbances would raise the debt burden and propagate the debt-deflation mechanism. The new flexible exchange rate regime has created foreign exchange risks and uncertainties, which Thailand had never experienced before. The need to establish exchange rate stability precludes a significant fall in the domestic interest rate and prolongs the economic recovery. The origin of the financial crisis is presented in the next section, while section 3 explains the causes of the export slowdown that triggered speculative attacks on the baht and led to the subsequent currency crisis. Section 4 investigates contractionary effects of devaluation followed by a discussion of the debt-depression episode in Thailand in Section 5. Section 6 describes further developments after the crisis and provides concluding remarks. The Root of the Thai Financial Crisis The effectiveness of monetary policy is limited under a fixed exchange rate regime, as long as capital mobility is perfect. …