Chapter 9 Outline

Closing Case The Collapse of the Thai Baht in 1997

During the 1980s and 1990s, Thailand emerged as one of Asia's most dynamic tiger economies. From 1985 to 1995, Thailand achieved an annual average economic growth rate of 8.4 percent, while keeping its annual inflation rate at only 5 percent (comparable figures for the United States over this period were 1.3 percent for economic growth and 3.2 percent for inflation). Much of Thailand's economic growth was powered by exports. Over the 1990 - 1996 period, for example, the value of exports from Thailand grew by 16 percent per year compounded. The wealth created by export-led growth fueled an investment boom in commercial and residential property, industrial assets, and infrastructure. As demand for property increased, the value of commercial and residential real estate in Bangkok soared. This fed a building boom the likes of which had never been seen in Thailand. Office and apartment buildings were going up all over the city. Heavy borrowing from banks financed much of this construction, but as long as property values continued to rise, the banks were happy to lend to property companies.

By early 1997, however, it was clear that the boom had produced excess capacity in residential and commercial property. There were an estimated 365,000 apartment units unoccupied in Bangkok in late 1996. With another 100,000 units scheduled to be completed in 1997, years of excess demand in the Thai property market had been replaced by excess supply. By one estimate, Bangkok's building boom by 1997 had produced enough excess space to meet its residential and commercial needs for at least five years.

At the same time, Thailand's investments in infrastructure, industrial capacity, and commercial real estate were sucking in foreign goods at unprecedented rates. To build infrastructure, factories, and office buildings, Thailand was purchasing capital equipment and materials from America, Europe, and Japan. As a consequence, the current account of the balance of payments shifted strongly into the red during the mid-1990s. Despite strong export growth, imports grew faster. By 1995, Thailand was running a current account deficit equivalent to 8.1 percent of its GDP.

Things started to fall apart February 5, 1997, when Somprasong Land, a Thai property developer, announced it had failed to make a scheduled $3.1 million interest payment on an $80 billion eurobond loan, effectively entering into default. Somprasong Land was the first victim of speculative overbuilding in the Bangkok property market. The Thai stock market had already declined by 45 percent since its high in early 1996, primarily on concerns that several property companies might be forced into bankruptcy. Now one had been. The stock market fell another 2.7 percent on the news, but it was only the beginning.

In the aftermath of Somprasong's default, it became clear that, along with several other property developers, many of the country's financial institutions, including Finance One, were also on the brink of default. Finance One, the country's largest financial institution, had pioneered a practice that had become widespread among Thai institutions-issuing bonds denominated in US dollars and using the proceeds to finance lending to the country's booming property developers. In theory, this practice made sense because Finance One was able to exploit the interest rate differential between dollar-denominated debt and Thai debt (i.e., Finance One borrowed in US dollars at a low interest rate and lent in Thai baht at high interest rates). The only problem with this financing strategy was that when the Thai property market began to unravel in 1996 and 1997, the property developers could no longer pay back the cash they had borrowed from Finance One. This made it difficult for Finance One to pay back its creditors. As the effects of overbuilding became evident in 1996, Finance One's nonperforming loans doubled, then doubled again in the first quarter of 1997.

In February 1997, trading in the shares of Finance One was suspended while the government tried to arrange for the troubled company to be acquired by a small Thai bank, in a deal sponsored by the Thai central bank. It didn't work, and when trading resumed in Finance One shares in May, they fell 70 percent in a single day. By this time bad loans in the Thai property market were swelling daily and had risen to over $30 billion. Finance One was bankrupt, and it was feared that others would follow.

It was at this point that currency traders began a concerted attack on the Thai currency. For the previous 13 years, the Thai baht had been pegged to the US dollar at an exchange rate of about $1=Bt25. This peg, however, had become increasingly difficult to defend. Currency traders looking at Thailand's growing current account deficit and dollar-denominated debt burden, reasoned that demand for dollars in Thailand would rise while demand for baht would fall. (Businesses and financial institutions would be exchanging baht for dollars to service their debt payments and purchase imports.) There were several attempts to force a devaluation of the baht in late 1996 and early 1997. These speculative attacks typically involved traders selling baht short to profit from a future decline in the value of the baht against the dollar. In this context, short selling involves a currency trader borrowing baht from a financial institution and immediately reselling those baht in the foreign exchange market for dollars. The theory is that if the value of the baht subsequently falls against the dollar, then when the trader has to buy the baht back to repay the financial institution, it will cost her fewer dollars than she received from the initial sale of baht. For example, a trader might borrow Bt100 from a bank for six months. The trader then exchanges the Bt100 for $4 (at an exchange rate of $1=Bt25). If the exchange rate subsequently declines to $1=Bt50 it will cost the trader only $2 to repurchase the Bt100 in six months and pay back the bank, leaving the trader with a 100 percent profit!

In May 1997, short sellers were swarming over the Thai baht. In an attempt to defend the peg, the Thai government used its foreign exchange reserves (which were denominated in US dollars) to purchase baht. It cost the Thai government $5 billion to defend the baht, which reduced its "officially reported" foreign exchange reserves to a two-year low of $33 billion. In addition, the Thai government raised key interest rates from 10 percent to 12.5 percent to make holding baht more attractive, but because this also raised corporate borrowing costs it exacerbated the debt crisis. What the world financial community did not know at this point, was that with the blessing of his superiors, a foreign exchange trader at the Thai central bank had locked up most of Thailand's foreign exchange reserves in forward contracts. The reality was that Thailand had only $1.14 billion in available foreign exchange reserves left to defend the dollar peg. Defending the peg was now impossible.

On July 2, 1997, the Thai government bowed to the inevitable and announced it would allow the baht to float freely against the dollar. The baht immediately lost 18 percent of its value and started a slide that would bring the exchange rate down to $1=Bt55 by January 1998. As the baht declined, the Thai debt bomb exploded. A 50 percent decline in the value of the baht against the dollar doubled the amount of baht required to serve the dollar-denominated debt commitments taken on by Thai financial institutions and businesses. This made more bankruptcies and further pushed down the battered Thai stock market. The Thailand Set stock market index ultimately declined from 787 in January 1997 to a low of 337 in December of that year, and this on top of a 45 percent decline in 1996!

http://www.worldwalker.com

Source: "Bitter Pill for the Thais," The Straits Times, July 5, 1997, p. 46; World Bank, 1997 World Development Report (New York: Table 2; T. Bardacke, "Somprasong Defaults on $80 Million Eurobond," Financial Times, February 6, 1997, p. 25; and T. Bardake, "The Day the Miracle Came to an End," Financial Times, January 12, 1998, pp. 6 - 7.

Case Discussion Questions

1. Identify the main factors that led to the collapse of the Thai baht in 1997?

2. Do you think the sudden collapse of the Thai baht can be explained by the purchasing power parity theorem?

3. What role did speculators play in the fall of the Thai baht? Did they cause its fall?

4. What steps might the Thai government have taken to preempt the financial crisis that swept the nation in 1997?

5. How will the collapse of the Thai baht affect businesses in Thailand, particularly those that purchase inputs from abroad or export finished products?

6. Do you notice any similarities between the collapse of the Thai baht in 1997 and the collapse of the Korean won around the same time (see the Country Focus in this chapter)? What are these similarities? Do you think these two events were related? How?