CASE STUDY ON FOREIGN-EXCHANGE MARKETS: THE THAI BAHT EXPERIENCE IN 1997

A Bad Case of Bahtulism

On February 3, 1997, Goldman Sachs & Co., the large New York-based international investment banking house, announced its fears that Thailand's currency, the baht, might be devalued during the following 6 months. Goldman Sachss warnings followed on the heels of reports that Thailand's government had suffered a budget deficit and that foreign investors were withdrawing some of the short-term investments from the country in fear of a devaluation. Goldman Sachs executives were also concerned about the impact of the rising value of the U.S dollar on the international competitiveness of Thailand 's exports. The country's central bank, the Bank of Thailand, relied on a variant of fixed exchange rate systems in which the bank pegged the value of the baht to a bundle of currencies, with the U.S dollar making up about 80% of the bundle. Because of this relationship between the baht and the U.S dollar, the dollars rise in value from its nadir and summer 1995 meant that Thai exports were becoming increasingly expensive relative to goods produced in other locales.

However, the Bank of Thailand felt confident that it could maintain the bahts value in the foreign-exchange market. To counteract the short-term capital outflows, the bank raised interest rates, making Thai investments more attractive to foreign investors. If that proved inadequate, the bank pledged to spend its $38.7 billion in foreign currency reserves to support the bahts value.

Unfortunately, Goldman Sachss February warning proved accurate. Foreign currency speculators sold the r baht, believing that the Thai government would be forced to devalue the currency given the increasing uncompetitiveness of Thai exports and the long-term domestic economic damage that would be caused by high interest rates. The Bank of Thailand spent almost $10 billion of its foreign currency reserves defending the fixed value of the baht before throwing in the towel. On July 2, 1997, the bank unpegged the baht, which promptly fell 20% on the foreign-exchange market, rewarding all those speculators who believed such an action was inevitable. the devaluation baht-ered the domestic economy. Secure in the belief- false, as it turned out- that the Bank of Thailand would maintain a fixed rate to the U.S dollar, many Thai companies had borrowed dollars to fund their domestic capital needs. This had seemed to be a reasonable approach because interest rates on dollar-denominated loans secured in the international lending market while lower than the interest rates charged for locally produced baht- dominated loans. Some had even used the borrowed dollars to relend in the domestic capital market. Unfortunately, these dollar-dominated loans became much more expensive due to the devaluation- more baht would be needed to pay each dollar of interest and principal- creating cash flow problems for the borrowers and raising the likelihood that they might default on their loans and declare bankruptcy. Thai financial services firms were particularly vulnerable because many of them had funded property speculators who had trouble meeting payments as commercial real estate prices in Bangkok and other Thai cities tumbled. Even the profits of otherwise healthy companies like Siam Cement were wiped out due to the difficulty of servicing their foreign debts.

The currency crisis also hurt foreign MNCs doing business in Thailand. Goodyears subsidiary in Thailand, for example, was hit with a double whammy. First, its primary customer, the Thai new-car market, was in freefall due to the devaluation-created economic crisis. Second, its profit margins shrunk significantly, for although it sells its tires for baht, many of its cost are denominated in dollars. The company estimated that its costs increased by 20% as a result of their bahts devaluation.

Thailands problems soon spread to its neighbors. The so-called bahtulism epidemic (or Asian contagion) infected neighboring countries such as Indonesia, Malaysia, and the Philippines, all of which compete with Thailand for foreign direct investment from international businesses looking to build factories to tap the region's abundant supply of hardworking, low-cost labor. With the devaluation of the baht, Thai exports suddenly became 20% cheaper, making Indonesian, Malaysian, and Philippine exports relatively more expensive. Speculators turned their attention to these countries, believing that they too would have to devalue their currencies to remain competitive with Thailand. By early September 1997, the Indonesian rupiah had fallen in value relative to the U.S dollar by 21%, the Malaysian ringgit 14%, and the Philippine peso 13%. The epidemic then spread eastward, wracking the South Korean economy. The Korean won plummeted as bankers realized that many South Korean firms were threatened by overborrowing and devaluation-induced price-cutting by regional rivals.

The currency crisis affected more than the foreign-exchange market. Area stock markets were hit hard as well because investors feared that the burden of paying back dollar-denominated debt with the depreciated local currencies would hurt the earnings of regional corporations. By early September 1997, the average Thai stock lost 60% of its dollar value, the average Philippine stock lost 45%, the average Malaysian stock 40%, and the average Indonesian stock 30% relative to their values a year earlier. Even foreign stocks were hurt by the crisis. The prices of so-called global consumer stocks such as Coca-Cola, Gillette, and Whirlpool fell as investors realized that a slowdown in the growth of this emerging Southeast Asian markets would cost the companies sales.

As fear of a worldwide recession arose, the International Monetary Fund (IMF) and the governments of the Quad countries hurriedly assemble financial aid packages to help Thailand, Malaysia, Indonesia, the Philippines, and South Korea. More than $100 billion was pledged to restore these countries to economic health and to end the spread of the Asian contagion. The IMF's actions proved successful, and most Southeast Asian countries have been restored to economic health. Despite its success, the IMF s aid package has proven to be quite controversial, as the Point Counterpoint in Chapter 7 suggested. Critics around the world are demanding reforms in the way the IMF should address such crises in the future.

Case Questions

1. How can a central bank use its currency reserves to support the value of its country's currency in the foreign-exchange market? (2 marks)
2. Would Thailand have been better off using a flexible exchange rate system instead of the fixed system it did use? (2 marks)
3. If you had been a manager of an international business in Thailand in February 1997, what could you have done to protect your company against the possibility of a devaluation of the baht? (3 marks)
4. What impact do you think the Asian contagion had on other emerging economies, such as those in Latin America or in Eastern Europe? (3 marks)

(TOTAL 10 MARKS)