Chapter 16 Whither Thailand?
- International Monetary Fund
- Published Date:
- January 2001
Thailand is where it all began. With some luck, Thailand may be among the first to emerge from crisis. To see why, it is necessary to trace the origins and examine the dynamics of the crisis.
1. THE ONSET OF THE CRISIS
As a consequence of financial liberalisation, capital account opening, and an easing in global liquidity conditions, Thailand was the recipient of large inflows of international capital for much of the 1990s. These capital inflows fed a spurt in investment that helped to underpin strong economic growth. Booming growth was accompanied by a widening current account deficit and an appreciation of the real effective exchange rate. In the normal course of events, these imbalances would have been self-correcting. But lurking beneath the surface of Thailand were structural weaknesses that not only frustrated the normal adjustment process, but which ultimately proved the undoing of Thailand’s financial and corporate sectors.
An important reason why international capital was attracted to Thailand was that it had undertaken significant steps to liberalize its banking and non-banking financial sectors. But while market liberalization proceeded apace, measures to promote supervision, corporate governance, market discipline and financial stability had not been pursued with commensurate vigor. The upshot of this was that Thailand’s financial system did not have the capacity to channel efficiently funds (whether domestic or foreign) from savers to borrowers. Weak prudential regulation and inadequate supervision of banks let vulnerability build-up. Cracks in financial sector governance meant that regulations were often treated cavalierly, or just plain ignored. Markets were unable to discipline effectively wayward banks because reliable and timely information about their activities was often unavailable. Besides, the credit boom that financial liberalization spawned provided a smokescreen of profitability behind which accumulating vulnerabilities on balance sheets were difficult to spot.
At a macroeconomic level, apparently strong fundamentals masked a lack of policy coherence. There was too much reliance on monetary policy to attempt to “cool” domestic demand in a context where a pegged exchange rate limited the freedom of the Bank of Thailand. A comparatively tight monetary policy and pro-cyclical fiscal policy was particularly problematic in a context of expanding global liquidity. The resulting misalignment of baht and world, particularly yen, interest rates, created the opportunity for arbitrage gains on cross-currency trades. A “guarantee” of a stable nominal exchange rate encouraged domestic banks and nonbank financial institutions (NBFIs) to borrow abroad and to on-lend in domestic markets at higher interest rates. Equally, it attracted foreign capital to baht currency deposits. Attempts by the domestic monetary authorities to sterilize the monetary consequences of capital inflows served only to put further upward pressure on domestic interest rates, and invited yet further capital inflows.
The crisis in Thailand was eventually triggered by a loss of credibility of the pegged nominal exchange rate regime. To some degree, the loss of confidence was the result of adverse external events, including a cyclical downturn in world trade, and a sharp appreciation of the dollar against the yen. But, critically, growing weaknesses in the balance sheets of Thai financial institutions also served to undermine the currency peg. As local asset prices fell in response to slowing demand growth, the quality of financial institutions’ asset portfolios quickly deteriorated. In committing its support to illiquid and in some cases insolvent financial institutions, the Bank of Thailand was effectively forced to abandon the use of domestic interest rates to defend the currency peg. Higher interest rates would have served only to deepen financial distress and were incompatible with the expansion of liquidity that support for troubled institutions entailed. Attempts by the authorities to directly defend the currency peg through intervention in foreign exchange markets quickly bled reserves. Faced with the increasing likelihood of default, the Thai authorities let the Baht float on July 2, 1997, and withdrew support for distressed nonbank financial institutions.
2. THE DYNAMICS OF CRISIS
In response to Thailand’s balance of payments problems, the international financial community, led by the IMF, agreed an assistance package of $17.1 billion with the government of Thailand at the end of August 1997. The Asian Development Bank has now committed nearly $1.8 billion to this package.
The conditions that accompanied the initial IMF-led program emphasized measures to stop financial hemorrhaging, steps to strengthen fiscal balances, a new framework for monetary policy, and structural reforms to strengthen Thailand’s private sector. Essentially, these were the same measures that had worked reasonably well in stabilizing exchange rates and the balance of payments in crisis situations elsewhere, and, particularly, in Mexico only two years before. The hope was that once stabilization had been achieved, interest rates would come down, and exports would quickly lead the real economy out of recession. Alas, this was not to be. Thailand was different from Mexico, and Asia was different from Latin America.
With the benefit of hindsight, there is now little doubt that the initial macroeconomic framework and targets set under the August IMF program misread some key features of Thailand’s crisis. First, the program underestimated the depth of the structural difficulties that beset Thailand’s banking and financial system. Second, the program aimed at fiscal targets that were much too tight in a context where the economy had already suffered a massive deflationary shock. Third, the program did not anticipate the extent to which the region would become mired in financial turmoil, and the economic downdraft that this would cause. Even by late August of 1997, few foresaw the economic devastation that was about to be unleashed on the region. Despite massive hikes in real interest rates, the Thai baht continued to depreciate against the dollar and asset prices continued to spiral downwards. The Thai economy fell quickly into deep recession.
The dynamics of Thailand’s crisis quickly became destabilizing. As demand dipped, bank’s nonperforming loans mounted, and bank capital was eroded. In an attempt to shore-up their capital, distressed banks responded by curtailing their lending even to creditworthy borrowers. Some debtors, who had expected loans to be rolled over, now found that they had to liquidate assets in extremely depressed markets to meet their obligations. Others found it increasingly difficult to service their obligations in an environment where interest rates had risen sharply, and real incomes were shrinking. As banks curtailed credit, illiquid but viable businesses began to perish, and with them the jobs and incomes of workers. Exporters who had been expected to lead the recovery were starved of working and trade capital. Those who were lucky enough to retain their jobs found their real incomes being eroded through accelerating inflation.
At the root of these difficulties lay a massive coordination failure. As each bank (rationally) attempted to restore its capital adequacy, the collective actions of banks led to a credit crunch that served only to impair further the capacity of borrowers to service their obligations. The end result was that the nonperforming loans and bad debts that the banking system as a whole carried began to expand quickly, and bank balance sheets and the real economy came under even greater stress.
Caught by the severity of the economic slowdown, the failure to arrest the depreciation of the baht, a worsening regional situation, and mounting troubles in financial and corporate balance sheets, the IMF program was modified in late November 1997. Measures were announced to accelerate the needed recapitalization of banks. The ADB and the World Bank had also begun working hard to mitigate the adverse social impacts of the crisis through assistance for the social sector. However, the twin pillars of tight fiscal and monetary policy remained in place. By year’s end, real GDP had shrunk by –0.4 percent, the first decline in income for over a decade. Unemployment had risen sharply, and consumer price inflation was accelerating. The government’s budget balance, which had traditionally been in surplus, moved sharply into deficit. Asset markets were hemorrhaging. The crisis was putting Thailand’s social achievements at risk. If there was a bright spot it was that import compression had been so severe that Thailand’s balance of payments position had quickly strengthened. Thailand’s current account deficit had fallen to two percent of GDP, from nearly eight percent one year earlier, and was in surplus for the last quarter of the year.
As 1998 approached, the depreciation of the baht seemed to be relentless. In response, to the depreciating baht, monetary policy was further tightened. Interbank interest rates peaked in January and February of 1998. The baht reached also reached its nadir in February. By late February of 1998, it was clear that fiscal targets would be breached. The IMF program was then modified to permit some fiscal easing, but tight monetary policy was maintained to support the baht. In the context of a tight liquidity squeeze, selective measures were introduced to attempt to ease credit constraints for exporters. The focus on financial sector reform and restructuring continued, as did measures to buttress the social safety net. Meanwhile the situation of the banking and corporate sector continued to deteriorate as demand and incomes shrank further. Manufacturing production collapsed.
By the middle of this year, the baht had stabilized, and indeed had begun to appreciate. In response to this, monetary policy was gradually eased, and interbank interest began to fall from the peaks attained at the beginning of the year. While the authorities remained committed to supporting the baht through monetary policy, the baht has proven resilient to lower domestic interest rates. The current account has also continued to strengthen, and official foreign exchange reserves have stabilized at around $26 billion. This gives cover for a multiple of 1.5 Thailand’s short-run maturing (one year) debt. External debt may contract by around $10 billion to around $80 billion by year’s end. Other hopeful indicators are that there has been robust growth in export volumes, suggesting that trade credit difficulties may have been easing.
However, there can be little doubt that enormous difficulties remain in Thailand. GDP is expected to shrink in real terms by about seven percent this year. Gridlock in the real economy is causing severe social distress and pain. Real economic recovery has been hampered by distress elsewhere in the region, and by the more general flight from emerging markets. Despite some improvement in its financial situation, the spread on Thai debt in international markets is now around 800 basis points, up from 475 basis points at the end of 1997. Thailand’s stock market has fallen by more than half over the course of this year. The fragile nature of Thailand’s banking system still hinders the needed resumption in credit growth, and the difficulties of working-out corporate debts continues to cast a shadow over bank balance sheets.
3. STRUCTURAL REHABILITATION AND REFORMATION
Thailand has reached a critical juncture in its crisis. While much will depend on what happens in the regional and global economy, much, too, will depend on Thailand’s capacity for domestic renewal. The severity of Thailand’s difficulties, and those elsewhere in the region, are a reflection of their stock rather than flow characteristics, and of underlying structural weaknesses. It is these structural problems that now must be worked out. The Thai authorities have rightly been praised for the foresight of their macroeconomic policies, and as a result now enjoy enhanced credibility. They must now use this credibility to good effect.
The balance sheets of Thailand’s banks and corporations are seriously impaired. The overhang of debt in Thailand is a major factor blocking the economic recovery of the real sector. Since bank balance sheets are increasingly being burdened by nonperforming and bad loans, banks are reluctant to extend credit to liquidity starved businesses. Some estimates suggest that bad debt as a percentage of financial assets could be as high as thirty-five percent.
The government of Thailand has been alert to these difficulties for some time. At the outset of the crisis, the Bank of Thailand acted quickly in an attempt to restore stability to the banking system, within the broader context of the IMF-led emergency assistance program. The Bank of Thailand set capital adequacy targets. Banks that could not meet these standards were intervened (including six banks and twelve financial institutions). Loan-loss provisioning standards were gradually tightened. Regulations that restricted foreign direct investment in banks were relaxed, and markets were invited to resolve the situation of distressed banks. However, in a context of a rapidly deteriorating economy, these measures were insufficient to rehabilitate bank balance sheets. Only a small number of private banks were able to raise new capital, and most banks’ financial position continued to deteriorate along with the severe contraction in economic activity.
In response to continuing difficulties in the banking and corporate sector, a second recapitalization and restructuring plan has now been introduced. The plan has four pillars. First, the plan aims to catalyze private sector resources to facilitate bank recapitalization through offering the carrot of matching public funding support (for Tier 1 capital). Second, it seeks to extend public financial assistance to banks balance sheets (for Tier 2 capital) conditional on acceptable restructuring arrangements for the corporate debt on their balance sheets. Third, it makes provision for the establishment of private asset management corporations, to whom tax privileges would be extended. Fourth, the plan outlines a resolution strategy for banks that have been earlier intervened, and announces measures to be taken in newly intervened banks and finance companies. Mergers are to be accelerated and both private and foreign investment in the intervened banks is to be encouraged.
Thailand’s approach to restructuring and recapitalization is commendable in a number of important ways. Significant steps have been taken to mobilize private capital, bailouts have been avoided, and the risks of moral hazard largely mitigated. Taxpayer resources will only be available for recapitalization if strong conditions are met, including the dilution of the equity of existing owners or their agreement to tough debt restructuring arrangements, or both. Institutional arrangements for the implementation of the restructuring and recapitalization process are clearly assigned and credible. The government has also taken firm measures to ensure disclosure of the information that private sector investors need to make intelligent investment decisions. Prudential regulation and supervision has been strengthened and a number of important reforms that should contribute to a more efficient banking system have been undertaken. There is a clear recognition by the Thai government of the important developmental role that the banking system plays, and their support for the banking system has focused clearly on the broader significance of rectifying financial and banking sector distress.
In its recent announcement, the government of Thailand has also reaffirmed that the costs of its earlier guarantees will be fiscalized. In addition, to support the second phase of the bank-restructuring program, the government has sought authority for the issuance of $300 billion in government bonds to support Tier 1 and Tier 2 capital of banks. While these commitments have been made in a context of a comparatively low overall level of government debt to GDP, they will entail breaching IMF targets for the fiscal deficit. It is estimated that the costs of servicing new bond debt may increase the deficit to four percent in the current fiscal year. But, on the other hand, if viable banks are not nursed back to health, lending will not resume, and Thailand’s recession may deepen. The loss of fiscal revenue that this would entail would also certainly mean that deficit targets would be breached.
A particularly welcome feature of Thailand’s approach to restructuring is its intention to tackle banking and corporate difficulties within an integrated approach. The two are intertwined. In other respects, the approach taken to corporate restructuring, is market-based with the role of government being one of incentive facilitation. In this capacity, government is making important changes in the legal framework on foreclosure and bankruptcy, and on secured lending. The government is also eliminating tax disincentives that work against debt restructuring. All these measures are expected to be promulgated in October of 1998.
4. WHITHER THAILAND?
Perhaps, with some justification, it can be argued that when confronted by a financial rather than macroeconomic crisis, prolonged tight monetary policy may not have the beneficial effects that are expected. While we shall never know the counterfactual, stabilizing the baht proved to be an extremely painful experience. Maybe interest rates should have been raised much further and much sooner, to add credibility to the defense of the baht. But, maybe, hiking interest rates heightened risks, lowered expected returns, encouraged capital outflows and so pushed the baht lower. It is important that we learn the answers to these puzzles sooner rather than later, and that these answers influence the design of future policies.
But for Thailand, this debate is now somewhat academic. Its macroeconomic course was chartered along comparatively “orthodox” lines, and the balance of payments stabilization phase of its crisis seems to be drawing to an end. In going forward, it would seem Thailand is prepared to let fiscal balances take up slack demand, partly because Thailand still enjoys a low ratio of debt to GDP. The most recently agreed target for its fiscal deficit is three percent of GDP, which seems likely to be breached given the estimated fiscal costs of bank recapitalization. The monetary authorities would, however, be extremely reluctant to give up recent gains on baht without first again tightening policy.
On the structural side, the government of Thailand has shown that it is prepared to act quickly and decisively. When Thailand emerges from the crisis it will have a much more robust and efficient financial sector than it had before it began. Improved institutional capacities and governance will eventually make Thailand an even more attractive place to do business in. In the medium-term, much will depend on the resolution of Thailand’s banking and corporate sector problems.
Now that the baht has stabilized and domestic interest rates have come down, there is a glimmer of hope that growth of output may accompany the benefits of structural reforms in 1999. In recent months, there have been some signs of some stabilization in the output of Thailand’s manufacturing sector, and agricultural output should pick up with better weather conditions and favorable movements in relative prices. If Thailand begins its recovery in 1999, it will, in no small measure, be due to the clarity of vision and collective wisdom of its economic leadership.
Acknowledgment: The views expressed in this paper are those of the author, and do not necessarily represent the official view of the Asian Development Bank.