Case Analysis of Thailand in May and June of 1997

The Causes

What happened in Thailand was a consequence of series of events, actions by the

Thailand Government. The process started in the 1990s when foreign investors,
particularly from the U.S started to venture into lucrative Asian Markets such as Thailand.
The local currency, Baht pegged to the US dollar was highly overvalued then. This led to
high current account deficits (CAD) as high as -7.7% of GDP in 1991(Exhibit 7). If the
currency had been allowed to float freely, the current account deficit imbalances will have
been balanced by the floating currency rates. However, this was not the case, as Bank of
Thailand (BOT) had to continually buy foreign reserves to keep the Baht pegged at a fixed
rate to the US Dollar.

The high CAD was primarily was financed with short term borrowings .The BOT gave a
free hand to financial intermediaries in Thailand to borrow foreign currency at lower rates
and lend to native customers at high rates. As the Bhat was pegged to USD, there was
not much risk. However, the foreign inflows into Thailand were primarily used in non-
productive investments such as real estate .Real estate cannot be traded and hence
would not contribute to reduce the CAD. This also led to situation where prices of assets
such as land rose largely. In order to absorb the excess amount of Baht in the market,
BOT had to buy Baht by selling their foreign reserves. The foreign exchange reserves
gradually reduced to alarming levels in 1997 to be able to fix the Baht. Moreover, by 1997,
investors started pulling out their funds out of Thailand further depleting foreign reserves.
In the end, BOT had no option but to devalue the currency.

The Solution

1. Defend it

The BOT cannot afford to hold a fixed exchange regime due to the following reasons:

Forex reserves have dwindled dangerously. Most of the available reserves

would only be sufficient to meet forward contracts.
 Holding on to a fixed regime will further allow speculative attacks on the
Baht

2. Let it float within a broader band

This seems the reasonable decision as it temporarily allows the currency to devalue
according to market forces, but prevents it from devaluing to an extent that is detrimental
to the countrys economy. The partial float will allow the Baht to reduce the disequilibrium
in CAD. At the same time, it wouldnt allow the Baht to devalue to a level that makes it
imports extremely costly.

Baht will initially depreciate due to the high CAD. A large current account deficit should
put downward pressure on Baht. If Thailand imports more than exports then this involves
selling Bahts to buy foreign currency to be able to buy the imports. A depreciating Baht
will make Thailand exports cheaper, imports more expensive and thus help to reduce
CAD and reduce the disequilibrium.

3. Devalue it at a lower pegged level

This is not a feasible solution as it enhances the chances of further speculative attacks.
Moreover, the short term borrowings of financial intermediaries will become costly and
may lead to a bank run.

4. Float it freely

This is again not a feasible solution as the short term borrowings of financial
intermediaries will become costly and may lead to a bank run.