Exchange Rates Made Simple
A DISSIMILAR BUBBLE
Baht needs to be defended again if another crisis is to be avoidedStory by POST REPORTERS
Bangkok Post Article July 23, 2007
People who are not in the financial or banking sector might be confused by what is going on with the appreciating baht. About 10 years ago, the country's economy plunged into its worst-ever crisis because the baht was too weak. Now it's just the opposite. The baht is too strong, but that could cause a crisis as well. How come?
At that time, the baht was pegged against a basket of currencies, comprising the currencies of several leading economies. But the currency with the most weight in the basket was the US dollar.
The exchange rate of the baht was calculated based on the values of the currencies in the basket. However, the movement of the baht at that time was limited to a range of two satangs, up or down, a day.
As the exchange rate was almost fixed, the risk in losses from exchange rate movements was minimal. At that time, the interest rate in the local money market was high, while it was relatively low in the offshore market.
Many corporations enjoyed borrowing loans from abroad to expand their businesses, and many expanded without studying the demand and supply of their products.
In many sectors, production capacity expanded too much, resulting in supply outstripping demand by several times.
Many firms had diversified into other product lines, and the most popular then was the real estate sector, particularly condominium projects.
Demand for condominium units was artificially high because of speculation. Many so-called yuppies (young, urban professionals) made high earnings from speculation.
They would rush to every new condominium project, purchase one or two units on down-payment and then sell them within a few days at prices higher than the prices they paid by 10-20%. Then they would look for other new projects, and so on.
Such artificial demand attracted many new investors in the real estate sector. Many companies had diversified into developing condominiums. They borrowed short-term loans from abroad at low interest rates.
At the beginning, new condominium projects sold well. Almost every project sold out in a few days. And at least one or two new projects were launched each day.
Some companies also borrowed low-interest loans from abroad to deposit in local financial institutions and make gains from the interest rate difference.
However, as the economic boom was not pushed by real demand, it was like a bubble which had to burst.
Foreign hedge funds noticed the phenomenon and saw an opportunity to take advantage of Thailand. They started attacking the baht by selling baht to the Bank of Thailand and taking out the US dollar.
They spent about 25 baht buying a dollar from the central bank, betting that the central bank would eventually have to devalue the baht once it ran out of dollars in its foreign reserves.
If the baht was devalued, say to 50 baht a dollar, foreign hedge funds would have to spend only half a dollar to get their 25 baht back, making a 100% gain.
The Thai central bank tried to defend the baht by selling all the dollars it had in its foreign reserves to foreign funds.
Creditors of Thai business companies started recalling their loans from debtors, who had to pay back their loans in dollars. Thus, the dollar flowed out of the country more quickly.
Eventually, the central bank went broke and had to give up. On July 2, 1997, it unpegged the baht from the basket of currencies and allowed the baht to float. The baht value then dramatically weakened, to a position reflecting its real value. At one time, the baht was devalued to more than 50 baht a dollar.
Those who borrowed loans from abroad found that their foreign loans doubled overnight. When they borrowed $100, they exchanged it for 2,500 baht, but when they repaid, they had to spend 5,000 baht to get $100.
Worse than that, the central bank had no more dollars in hand to sell to these companies. So, it had to borrow from the International Monetary Fund.
That is what happened 10 years ago.
Now, the situation is reversed.
The central bank had kept the baht weak for a long time, enabling Thai exporters to sell their products at competitive prices. The country gained a huge sum of foreign reserves, reaching an all-time high. Again, foreign funds have seen the opportunity to make gains from the baht as they viewed that with such high foreign reserves in the Bank of Thailand's portfolio, the baht should be stronger.
So they started dumping the dollar in the Thai market in various forms, such as depositing in local banks or buying shares in the local stock market.
Assume they dumped the dollar into the Thai market when the exchange rate was 35 baht to a dollar. If, when they wanted to pull out, the baht was stronger at 33 baht a dollar, they would have to spend only 33 baht to get a dollar back, making a gain of two baht on every dollar.
Seeing the threat, the Bank of Thailand tried to defend the baht. Late last year, it implemented a regulation requiring a short-term inflow of funds to set aside 30% as reserves. This means if foreign funds bought into the Thai market at $100, they had to deposit $30 with the central bank, leaving only $70 for their investment. If they wanted to take out the fund within a year, the central bank would not return the $30 deposit to them.
The measure was aimed at preventing short-term speculative investments. However, it still failed to stabilise the baht's value, which has kept on appreciating. As the baht is now stronger, Thai exports have become relatively more expensive and less competitive.
Political uncertainty caused local investment to fall, while the Surayud administration has failed to implement any new mega-investment projects. So exports have become one of the few factors driving the country's economy.
That's why many economists express concern that if the central bank fails to implement measures to prevent the baht from rising even higher, the country's economy could be plunged into another crisis.
