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RIM January 1998, No.38

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Background and Impact of the Asian Currency Crisis

Sakura Institute of Research, Inc.
Ken Iijima

1."Lessons for Asia" from the 1994 Mexican Currency Crisis

The value of the Thai baht has gone through repeated fluctuations since last year. A warning tremor on May 14 this year presaged the start of massive selling in July. By the end of September, the baht was worth 29.1% less against the U.S. dollar than at the end of June, before the onset of the quake.

At the time of the Mexican currency crisis almost three years ago, there was concern that sparks from that fire might spread to Asian currencies. However, the situation ended without major repercussions for Asia. Today, the Thai baht has triggered a wave of depreciation that has brought down other ASEAN currencies and caused stock prices to plummet as well. As a result, the countries concerned now face a very testing time.

Shortly after the onset of the Mexican currency crisis, the Nihon Keizai Shimbun (January 21, 1995) carried an article under the headline: "New Currency Crisis and Repercussions from the Mexico Shock -Lessons for Asia." The article pointed out two aspects of the crisis. The first was excessive dependence on market funds to offset an expanding current account deficit. The second was the speed at which investors and fund operators, including American investment trusts,retreated from Latin America at the sign of Mexican currency crisis. The article also suggested that Hong Kong, which was in the midst of a real estate bubble, and which had a firm policy of linking its dollar to the Greenback, might face selling pressure on its currency. If we substitute Thailand for Mexico, and Indonesia and the Philippines for Argentina and Brazil, the situation today is extremely similar. It is fair to say that the "lessons for Asia" were not learned.

2. The Thai Economy and the Causes of the Currency Crisis

Since 1980, Thailand has actively lured Japanese companies and pursed export-led economic development. From 1987 onwards, it achieved economic growth averaging 9.5% a year and followed South Korea, Taiwan, Hong Kong and Singapore-collectively known as the "Asian NIEs"-as one of the emerging newly industrialized economies. Direct investment from Japan, which had stagnated for several years, soared to its highest level in five years and exceeded US$billion again in both 1995 and 1996.

Thailand was among the first countries to embark on an export-led industrialization strategy. In 1986, one year ahead of Singapore and Malaysia, it achieved double-digit export growth. Thailand's leadership is apparent from the fact that its annual average export growth rate (value terms, customs clearance basis) during the nine years between 1987 and 1995 was the highest among the ASEAN-4 at 23.1%, followed by 20.7% for Malaysia and 15.7% for the Philippines.

Thailand had been under strong pressure at home and abroad to apply the fruits of its economic growth since the late 1980s to such purposes as the reinforcenment of corporate fundamentals, the sophistication of its industrial structure through the improvement of technology development of supporting industries, and the creation of industrial base. Unfortunately, the administration's ability to take economic policy initiatives was weakened by the government's instability, with the result that the policies were implemented reactively. In addition inflationary pressures strengthened due to such factors as the raises in government sector wages and minimum wages agaist the backdrop of low unempolyment rate. The correction in the value of the currency was motivated by the expansion of the current account deficit, and delays in improving the financial and economic systems.

3. Exchange Rate Countermeasures by ASEAN

Governments in July-September Period

Developments in the market on May 14 appear to have provided the initial trigger for the full-scale selling of the Thai baht. On that day, selling by American institutional investors pushed the value of the Thai currency down to 26.30 bahts against the U.S. dollar. Thailand and Singapore intervened to prop up the baht, and Malaysia, Australia and Hong Kong also provided buying support. Thailand's central bank meanwhile induced a punitive rise in baht interest rates. These efforts brought the exchange rate back to 25 bahts to the dollar and temporarily stabilized the currency.

The exchange rate began to fluctuate wildly in early July. Neighboring currencies were also drawn into the upheaval, which still continues unabated.

The Thai government moved quickly in July to shift the baht to a managed floating exchange rate system and to raise the official discount rate. It also intervened actively in the foreign exchange market. In addition, Thailand asked governments and financial institutions in neighboring countries, starting with Japan, for assistance through establishing credit lines. On August 21, the International Monetary Fund (IMF) decided to provide official support.

Statistics for the ASEAN currencies show that, by the end of September, the baht had fallen by 29.1% from the end of June, the rupiah by 25.7%, the peso by 23.1%, and the ringgit by 22.1%. Furthermore, the trend had rippled outwards from Singapore to Australia. Stock prices also fell. The biggest decline, 26.8%, was registered by the Philippines, while Indonesia and Malaysia both saw their markets slump by around 24%. Interestingly, the Hong Kong dollar, which had been the subject of frequent rumors ever since the Mexican currency crisis, remained unmoved.

The affected countries implemented a variety of countermeasures while maintaining close communication with the IMF and governments that were providing support. Malaysia, Indonesia and the Philippines adopted what was in effect a de facto floating exchange rate system, while Thailand and the Philippines adjusted their reserve requirements ratios. Thailand and Malaysia also took steps to reduce their current account deficits.

4. Reasons for the Currency Crisis

(1) Basket System Centered on U.S. Dollar Creates Impression of Overvalued Baht

In 1984, Thailand switched from a fixed exchange rate system to a currency basket system. Although referred to as a "basket," it is said that mix of currencies chosen was apparently weighted as much as 85% toward the U.S. dollar.In 1984, Thailand switched from a fixed exchange rate system to a currency basket system. Although referred to as a "basket," it is said that mix of currencies chosen was apparently weighted as much as 85% toward the U.S. dollar.

Trade with the United States accounts for 14.6% of Thailand's total trade (1995, Thai central bank), while trade with Japan contributes 24.5%. Even though the majority of trade settlemets are conducted in U.S. dollars, a weighting of 85% means that the baht is in effect linked to the dollar. The baht's low against the U.S. dollar after the shift to the new system was 27.2 bahts (yearly average) in 1985. Thereafter, it remained firm at around 25 bahts, reaching a high of 24.9 bahts (yearly average) in 1995.

A comparison of movements in the currencies of Thailand and its neighbors, namely Malaysia, Indonesia and the Philippines, against the U.S. dollar and the yen over the past few years shows that they remained soft relative to the yen until 1995, reflecting the weakness of the Japanese currency. The Malaysian ringgit was extremely strong relative to the U.S. dollar The Philippines registered negative growth in 1991, and the value of the peso fell by around 13%. Since then, it has marked time. It is perceived that the baht, the ringgit and the peso are overvalued, given the fact that the Indonesian rupiah has depreciated by 4-5% annually against the U.S. dollar.

(2) Export Stagnation in 1996

Trade with the United States accounts for 14.6% of Thailand's total trade (1995, Thai central bank), while trade with Japan contributes 24.5%. Even though the majority of trade settlemets are conducted in U.S. dollars, a weighting of 85% means that the baht is in effect linked to the dollar. The baht's low against the U.S. dollar after the shift to the new system was 27.2 bahts (yearly average) in 1985. Thereafter, it remained firm at around 25 bahts, reaching a high of 24.9 bahts (yearly average) in 1995.

A comparison of movements in the currencies of Thailand and its neighbors, namely Malaysia, Indonesia and the Philippines, against the U.S. dollar and the yen over the past few years shows that they remained soft relative to the yen until 1995, reflecting the weakness of the Japanese currency. The Malaysian ringgit was extremely strong relative to the U.S. dollar The Philippines registered negative growth in 1991, and the value of the peso fell by around 13%. Since then, it has marked time. It is perceived that the baht, the ringgit and the peso are overvalued, given the fact that the Indonesian rupiah has depreciated by 4-5% annually against the U.S. dollar.

In 1995, Thailand's exports accounted for 34.5% of GDP, having grown by an annual average of 23.1% over the preceding decade. Yet in 1996, exports showed growth of -1.3% and slumped to 30.5% of GDP.

Several factors are responsible for this change. First, wages rose ahead of growth. Second, Thailand lost its price competitiveness in the areas of textiles, apparel and footwear due to market entry of products from China, which devalued the renminbi by 33.3% in January 1994 and enhanced its competitiveness, and Mexico, which was a late starter on the path to development. Both countries captured Thailand's share of the American Market, which was experiencing a downturn in consumer spending. Third, exports of semiconductors and ICs, which were driving force behind Thailand's double-degit export growth, slumped in the second half of 1996 due to a downturn in world demand and a fall in product prices resulting from excessive production capacity in Asia.

(3) Expanding Current Account Deficit Funded from Capital and Financial Balances

With the exception of 1986, Thailand's current account balance of payments has remained in deficit ever since 1960. In the 1980s, the deficits were patially offset by inflows of direct investment from Japanese businesses and other sources. By the early 1990s, however, the size of the deficits had expanded to US$7-8 billion and fair exceeded inward direct investment.

In March 1993,the government established the Bangkok International Banking Facilities (BIBF). It invited foregin banks to participate and encouraged portfolio investment and introduction of short-term funds through the BIBF. It also liberalized baht deposits by non-residents.

Inflows of foreign capital and funds were further stimulated by the wide gap between domestic and overseas interest rates, with the market interest rates of baht at least 5% higher than U.S. dollar market rates, and by a basket exchange rate system that in effect linked the baht to the dollar. Investors with dollar-based resources were able to take average of the 5% interest rate gap without serious concern about fluctuation in the future exchange rate of the baht against the dollar. Inflows of funds through the BIBF market since 1993 have exceeded Thailand's current account deficit.

Thailand's current account deficit reached $13.6 billion in 1995 and $14.7 billion in 1996. Over the past few years, the ratio of the current account deficit to GDP has been the 8% range, which is on the danger line. In 1995, Thailand's ratio stood at 8.27%, which is significantly higher than the 6.98% ratio recorded by Mexico when its currency came under attack in 1994. Market participants started to question the level of the baht exchange rate, and there were signs of moves to reexamine Thailand's economic fundamentals. In 1996, Thailand's foreign currency reserves reached $38.7 billion as a result of inflows of market funds totaling $18 billion which were needed to offset a deficit of $14.7 billion. However, external debts swelled to $79.1 billion.

In Malaysia's case, there has been a cumulative rise in current account deficit, which has risen from US$900 million in 1990 to $5.2 billion in 1996. However, this is equivalent to 5.26% of GDP. In addition, Malaysia's foreign currency reserves at the end of 1996 amounted to $27.1 billion, which is on the same level with its external debts ($28.7 billion).

(4) The Growth and Collapse of the Real Estate Bubble

Some of the money that flowed into Thailand was invested in manufacturing facilities, but most of it was channeled into real estate and stock investment. Over the years, fixed capital investment figures have grown in step with the expansion of private debt.

After the Thai stock index (SET) fell through the 1,100 level in August 1996, the government established a stock market countermeasures fund. In July 1997, it decided to implement a rescue package for the real estate industry. Moody's was meanwhile focusing on the continuing rise in short-term external debt. It sounded a warning bell by reducing the rating of Thailand's sovereign risk bonds.

During the present baht crisis, the government has directed 58 finance companies to cease trading. However, the amount of bad debts, which consist mainly of real estate loans, is reported to have reached a trillion bahts, raising concern about the impact on financial institutions and the economy as a whole.

(5) First Budget Defecit in Ten Years Predicted
The government expected the worsening economic situation to cause a decline in government revenue in FY1997. In May, it published a forecast in which it predicted the first budget deficit in ten years. This was apparently one of the triggers for the attack on the baht.

(6) Government Lacking in Stability and Political Strength

The Thai economy is confronted by a number of issues as a consequence of rapid economic growth. These include current account defecits, a shortage of technical personnel, expanding income gaps, and rising wages and the resulting decline in international competitiveness. The emergence of these problems has been accompanied by a loss of stability on the political scene. The July 1995 lower house election resulted in the replacement of the Chuan administration with a coalition of seven former opposition parties under the leadership of Mr. Banharn Silpa-archa. Measures taken to ease government spending made this regime unpopular, and it was replaced after the November 1996 lower house election by a six-party coalition led by Mr. Chavalit Yongchaiyuth. The new government announced an 18-item economic package designed to restore Thailand's economic vitality.

However, it was unable to gain the confidence of the markets. Over-confidence in the momentum of growth, government instability, and a weak political structure with limited ability to implement economic measures have led to the present situation.

5. Thailand's Comprehensive Economic Reconstruction Package

While intending to seek support from Japan and other friendly contries, the Thai government initially thought that it would be able to deal with the crisis through its own efforts. However, the situation proved to be more serious than anticipated, and the government subsequently decided to request assistance from the IMF. On August 5, it announced the following comprehensive economic reconstruction package, which encompasses conditions stipulated by the IMF during the negotiation process.

(1) Requests for International Support
  1. Thailand will seek standby credit of US$12-15 billion through the IMF to replenish its foreign currency reserves.
(2) Efforts to Reduce Budget Deficit
  1. Efforts to balance fiscal revenue and expenditure.
  2. Increase in value-added tax from 7% to 10% from October 1997 to September 1998.
  3. Increase in public utility charges (electric power, water, etc.) to reflect costs.
(3) Measures to stabilize Financial System
  1. Termination of trading by 42 finance companies.
  2. Establishment of deposit insurance system.
(4) Exchange Rate Measures
  1. Maintenance of managed floating system.
(5) Establishment of Targets for Economic Fundamentals
  1. Current account deficit: reduction to 5% of GDP in 1997 and 3% of GDP in 1998.
  2. Foreign currency reserves: maintenance at US$25 billion or higher ($38.6 billion at the end of 1996).
  3. Inflation: target of 8-9% in 1997 (5.9% in 1996).
  4. Economic growth rate: target of 3-4% in 1997 and 1998 (6.4% in 1996).
These measures are in line with the conditionality imposed by the IMF. They are indicative of Thailand's efforts to deal with some extremely difficult issues.

6. The Impact of the Currency Crisis and Reconstruction Measures on the Thai Economy

The present currency crisis and reconstruction measures are likely to bring about the following effects on the Thai economy.

(1) Short-term Effects
  1. Inflation: Upward pressure on wages will intensify due to imported inflation and increases in the value-added tax and public utility charges.
  2. Economic deceleration: Business profitability will deteriorate due to higher taxes and utility charges and other factors. This will slow economic performance.
  3. Financial instability: The impact of business by finance companies and the trillion baht (approximately US$27 billion) bad debts of financial institutions will be an excessive burden on the economy.
  4. Rising interest rates: Business profitability will be adversely affected by the continuation of high punitive interest rates.
  5. Direct investment: Direct investment will remain sluggish for the time being due to uncertainty about the outlook for the economy, the exchange rate and profitability.
(2) Medium- and Long-term Effects
  1. Support system: The situation is expected to stabilize, due to a support system led by the IMF.
  2. External debts: Thailand's external debts amount to almost US$89 billion. With the devaluation of the baht, the liability will rise to over $100 billion in real terms.
  3. Increased exports: The devaluation of the baht will enhance Thailand's export competitiveness, but the realization of this benefit through the J-curve effect will take a considerable period of time.
  4. Regional adjustments: there has been considerable development of international division of labor networks in East and Southeast Asia. Further exchange rate adjustments are likely to be implemented among the ASEAN countries in order to facilitate intra-regional trade.
The present currency crisis is not a transitional phenomenon in terms of either its extent or the size of the declines that have occurred.

(3) Impacts on ASEAN Economies

Hitherto Thailand and Malaysia have both maintained their currencies at certain levels relative to the U.S. dollar. This stance has had a number of effects. First, it has been possible to purchase parts and manufacturing facilities needed by export industries on favorable terms. Second, luxury imports and overseas travel have become more affordable to consumers, who have benefited from rising income levels. Third, with their currencies as strong as the U.S. dollar, Thailand and Malaysia have been able to invest profitably in the new markets of Indochina.

However, the values of the Malaysian and Thai currencies have fallen by 25-30% against the U.S. dollar. This will cause the situation to change in several ways. First, even if export competitiveness was still likely to benefit, industries that previously could simply rely on imported parts and capital goods will face sharply higher prices for these items. The well-balanced full-scale development of industries will become an urgent priority. Second, a more prudent approach toward consumer spending will be needed. Also, foreign direct investment is likely to stagnate temporarily due to the increased amount of foreign funds required as a result of falling currency values.

(4) The Impact on Aggressive American Investment in Asia

For the United States, which is adopting a more aggressive strategic position in Asia in both the political and economic spheres, the present situation has had extremely beneficial consequences and created a strategically favorable environment for the expansion of its overseas activitites. Benefits include the improvement of trade deficit with the region due to lower import prices, the achievement of an advantage in terms of business investment strategies in new markets, and an opportunity to flaunt the value of the U.S. dollar. That is why there are rumblings of dissatisfaction in Asia, including a rumor that the United States is punishing ASEAN for deciding, against American wishes, to admit Myanmar as its new member.

7. The Impact on Japanese Companies with Operations in Thailand

(1) Japanese Direct Investment

In early postwar years, many companies invested in Thailand to participate in such areas as import substitution industries. As a result, Thailand is the most familiar of the Southeast Asian countries to Japanese companies. According to Toyo Keizai Inc.'s Tokei Geppo (Statistics Monthly), the member of Japanese manufacturers invested in Thailand, counting just these 10% or more Japanese ownership, stood at 1,289 companies at the end of 1996, while the figures by the Ministry of Finance show that such direct investment had reached US$10 billion in value terms. Though Thailand contributes only 3.5% of Japan's trade in value terms, it relies on Japan for 17% of its exports and 29% of its imports (based on actual figures for 1996). In addition, during the late 1980s, Japanese companies built extensive networks of parts production bases in East and Southeast Asia.

Thailand became one of the hubs for the formation of international divisions of labor, and many plants were established there to produce parts or finished products.

The massive declines and a domino effect on the region's currencies that have occurred during the present currency crisis have had a huge impact on Asia's vaunted high-growth economies, especially the ASEAN countries. Japanese companies have a significant involvement in Thailand and other parts of Asia. While they will continue to built their international division of labor networks in the region, they will be forced to reassess their strategies to reflect the weakness of the Asian economies.

(2) Implications for Companies with Operations in Thailand

The currency shock will inevitably have a direct impact on Japanese companies that failed to hedge loans raised in U.S. dollars or other foreign currencies to finance the establishment or expansion of facilities. Many companies also face decrease in their sales due to the stagnation of domestic demand and cost increases. The severity of the effects varies from company to company, however, depending on differences in such factors as industry sector, business format, sources and settlement currencies for raw materials and parts, and destinations and settlement currencies for exports. The main implications for a few major industries are as follows.

1) Automobiles

Thailand imports a wide range of parts and materials from Japan, the NIEs and ASEAN. It pays for these items, which account for over 60% of its needs, in foreign currencies. Since most of its manufactured goods are sold domestically in the local currency, there will inevitably be a serious decline in profitability. Companies cannot raise their prices sufficiently to cover cost increases resulting from exchange rate fluctuations, and there are already reports that several automobile-related companies have suspended operations.

2) Electronic and Electrical Equipment

The direct impact will be limited, since over 70% of parts are imported from within the Asian region and paid for in foreign currencies, while most finished products are exported for foreign currency payments. However, there will be a significant effect, since costs will come under upward pressure from higher electric power charges, rising labor costs, and an increased value-added tax.

3) Textiles and Apparel

Raw materials are mostly procured locally and paid for in the local currency, while almost all finished products are exported to the United States and other developed countries. Thailand should therefore be able to restore its competitiveness in this area. However, while exporters hope to recoup increases in electric power charges, labor costs and other cost items through exchange gains, they are likely to face increased pressure for price reductions in their export markets.

8. The Impact on Japanese Companies and the Japanese Economy

Asia accounts for 41.0% of Japan's trade (as of FY1996). The region also attracts 24.3% of Japanese direct investment, of which one-third flows into ASEAN. The performance of Japanese companies in both the manufacturing and service sectors will clearly be affected by the depreciation of investment assets and reduced profits from local branches and subsidiaries. The financial sector will need to reevaluate Asia risk, while they will be affected depending on their foreign exchange positions and changes in the business circumstances of local borrowers.

The shift to a weak-yen trend in mid-1995 caused ASEAN currencies to appreciate sharply against the Japanese currency. This factor was partly responsible for a decline in the exports of ASEAN countries. However, the yen has firmed following the latest wave of fluctuation, and by late August, it had almost returned to its 1995 level. The situation is therefore likely to be reversed.

From the viewpoint of Japanese companies, the relative rise in the value of the yen will create a favorable environment for investment in the expansion of Asian production networks. However, the region is still emerging from a period of confusion, and investment will probably stagnate for a period. The Asian economies are expected to decelerate for the time being, and the situation will therefore cast a shadow over the Japanese economy.

9. Can the "Asian Era" Be Resurrected?

(1) A return to Growth by the End of the Century

Since the 1970s, Thailand and other Asian countries have progressed toward industrialization by aggressively introducing money and technology from the developed countries and benefiting from the resulting transfer of industries and enjoying the merits of a latecomer.

The rapid pace of development was reflected in number of negative consequences of growth, including imbalances in production factor inputs, and organizational and psychological slackeness. Yet the economies of Thailand and other ASEAN countries have grown by 7-9% over the past few years, and there has been no collapse of the industrial base. Admittedly, there are problems that will require considerable time and effort, including the disposal of the bad debts of financial institutions, and balance sheet adjustments and management strategy restructuring by individual companies. There will also be a need for restructuring to reflect higher public utility charges and wages.

Thailand and the other ASEAN countries should be able to resurrect the "Asian Era" vision as we arrive at the 21st century and once again heighten the pace of their progress toward that vision, provided that their leaders can reconsider the over-confidence in the momentum of growth and lax economic management, focus on revitalizing the venture and industries that have sustained growth in the past, and improve shortcomings in their industrial structures through fostering supporting industries, improving financial systems, and encouraging technology development.

(2) Obstacles to the Restoration of the "Asian Era" Vision Market Supremacism

Yet clearly a number of problems and issues will need to be surmounted in order to restore the "Asian era" vision. Problems include the development of export-oriented industries and dependence on the American market, the spread of excess production throughout the East Asian region, an expanding wealth gap, and an increase in over-confidence in markets with the trend toward globalization and the market principle.

The ASEAN currency crisis, which began with the Thai baht, has highlighted doubts and problems relating to the concept of globalization itself, which has been promoted by major nations on the basis of ideas put forward by neoclassical free marketeers. These ideas are being applied to an extremely wide and diverse range of markets, yet they are based on the theory of market balance, which assumes participation by uniform economic entries. Globalization of trade, investment and finance is being promoted on the grounds that freedom is the best possible path and the type of the other that the world needs, and that freedom is the key to an efficient balance and the improvement of economic well-being across wide areas.

People and goods are subject to natural limits on supply and demand, and thus under the right conditions, a balance can be achieved through market mechanisms. In the case of money (and foreign exchange and information), however, the supply side has the potential to limitlessly expand the supply beyond the scale of market due to the credit creating function.

When money sweeps over a small but open market in amounts that exceed the scale of that market, it is unlikely that balance will be achieved through the operation of the market principle. The present currency shock centering on Thailand can basically be attributed to over-confidence in the momentum of economic growth, a lack prudent and appropriate economic and financial management, and the strains imposed by a foreign exchange system based on de facto linkage to the U.S. dollar. However, the upheavals that have affected Thailand and the other ASEAN economies and the resultant long-term economic burden that will have to be borne have been greater than necessary due to the fact that huge amounts of money swept over small markets that are still at the development stage over a short period of time.

We need to review our faith in market mechanisms. We also need to create a market-freindly order to ensure that globalization does not become a tool for the establishment of economic hegemony.

The warning bells have already been sounded by Mr. Will Hutton, editor of the Observer, in an essay titled "Relaunching Western Economies" (in Foreign Affairs, November/December, 1996), by Dr. David C.Korten, and by Mr. Katsuto Uchihashi in Kisei Kanwa no Akumu (The Nightmare of Deregulation). Recently, Mr. George Soros, the international investor, remarked in an essay titled "The Threat of Capitalism" carried in the Japanese quartery magazine (Asuteion, fall 1997) that he considered the threat from the laissez-faire policies of the United Kingdom and the United States more potent today than the threat from totalitarian ideologies. This statement is all the more convincing, given that Mr. Soros is major market player.

The present currency crisis has given us much to think about.

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