Today is April Fools' day. But there is no fooling about the threat of liquidity crisis. I am sure that many readers are sceptical about the possibility of a liquidity crunch in this country. First, the government debt to GDP ratio is less than 60% which is not high by international standards. Second, Thailand now, unlike in 1997, has adopted a flexible exchange rate system which has a low risk of currency speculation. And, third, the country has international reserves equivalent to 11 months of imports of goods and services which is two times higher than IMF's suggested requirement. How could an economy this good be at risk?
The economic data of 1996 was quite spectacular as well. At that time, Thailand's external debt to GDP ratio was 63.26% which was not high by international standards. The government was running a budget surplus of 1.9% of GDP, not a deficit. Most importantly, the economy was growing at a robust rate of 5.7%. How could an economy that good be at risk?
Alas, in mid-1997, Thailand faced a worst economic crisis. The conundrum even caught the IMF and World Bank by surprise as there was no sign the economy was about to collapse.
Actually, there were plenty of signs of an economic crisis, but no one was paying attention. Except me.
I left my job as an economist at the IMF's Southeast Asia and Pacific Department in Washington DC and joined a local finance company in 1996. However, I refused to act as a chief economist at that finance company but still monitored economic data as a "hobby". My first self-assigned task was to project GDP growth for 1997. I needed the projection to plan for the next year's investment strategy as I was the head of the company's investment department.
To my surprise, I got projected growth of negative 2% for 1997. The reason was obvious. The economy did not have enough money to support positive growth and had to depend solely on foreign financing. I will give you an example. If the economy wants to grow by 5%, it will require a 5% growth in money supply to provide cash for consumption and investment. No cash, No growth. Simple as that.
The right strategy for the country (then) was to slow down economic growth and depend much less on external borrowing. By doing so, I could guarantee the crisis would never happen. But by then the government was aiming for 7% GDP growth for 1997. That, to me, would only mean one thing -- a very tight liquidity situation starting from the last quarter of 1996. Tight liquidity means a quick rise in interest rates that could result in a collapse of the stock market. And, under the worst circumstances, the Thai baht would be forced to devalue.
It was quite difficult for me to sell the idea that the economy was about to collapse, money would be hard to find, interest rates would rise above double-digit level, and, probably, the baht would depreciate. Against my analysis, the economy grew 6.4% and 7.4% in the 2nd and 3rd quarters of 1996 respectively. How could a "crisis" happen to a booming economy? If the country should need liquidity to support growth as I suggested, just borrow more from the international capital market. Some economists and bankers said that.
Fortunately, I was able to convince the finance company that I was working for to believe my economic analysis. Not because I used to be an IMF economist, but because my economic reasoning was solid. Following my advice, the company doubled the deposit base as money would be hard to find in a few months.
More importantly, when interest rates rose, we would make a handsome profit by lending through the inter-bank market. Second, we liquidated all investments in the stock market except for strategic investments. As the head of the investment department, I unloaded all stock holdings at an SET index of 1200-1400. After the crisis, the index plunged to 700. Third, we converted all short-term foreign borrowings into long term ones as I perceived a high risk of loan recalls. We did not mind paying a long-term loan premium which certain finance companies thought was a foolish move.
My analysis was right. In the 4th quarter of 1996, inter-bank interest rates soared above 10% and kept rising. The Bank of Thailand intervened in the inter-bank market briefly in November 1996 but failed as it could hold interest rates at 9% only for a week. The domestic liquidity market became very tight pushing banks and finance companies to seek more foreign loans.
Currency speculators started smelling a desperate situation in Thailand. Only a few people in Thailand knew this. Attacks on the baht occurred twice -- one in mid-February and once in mid-June of 1997. The Bank of Thailand won the first attack but lost to speculators in the second attempt. After the first attack, it was clear to me that the baht could not hold its value of 25 baht per US dollar. The baht would have to be depreciated to 30-32 baht per dollar at a minimum. In mid-March, I recommended the company to buy foreign exchange forward cover for half the company's dollar loan which was $500 million.The company agreed.
As said, signs foretelling the coming economic crisis were plenty but nobody cared to analyse them. Some economists still believed the Thai economic fundamentals remained strong and trusted the baht could hold its ground. I had the opposite point of view.
In mid-June 1997, two weeks before the changing of the exchange rate regime from a fixed system to a float system, I recommended the company buy forward cover for the remaining 250 million dollars of foreign loan. The company agreed again. The timing of my recommendations was not by luck, but based on macroeconomic and financial data of that time. To cut the story short, the finance company avoided a liquidity shortage caused by large withdrawals during the crisis and did not carry any devaluation damage. Both factors caused most finance companies to close. Later, the company was upgraded to a commercial bank.
There are two important lessons to learn from the 1997 economic crisis. First, do not only look at few economic indicators and dismiss the details behind those numbers. Be reminded that even the IMF and World Bank failed to catch numerous distress signals of the 1996 Thai economy. Second, with knowledge of the crisis, people cannot only shield themselves from the crisis but also reap the benefits as well.
Remember these two ideas -- distress signals, and shielding oneself. I will explain them further in my upcoming articles.