· ASIA' S CRASH

Thailand isn't really a small country. Has more citizens than Brit and France.
Despite rapid growth in the 1980s and 1990s, it is still a poor country; all those
people have a combined purchasing power no greater than that of the population
of Massachusetts.
1997 devaluation of Thailand's currency, the baht, triggered a financial avalanche
that buried much of Asia.
The crucial question is why that happened.

The Boom

Thailand was a latecomer to the Asian miracle.

Became a major industrial center only in the 1980s.
When the economy did take off, it did so very impressively.
Thailand began growing at 8 percent or more per year, as peasants moved from
the countryside into new urban jobs and good results experienced by the first
wave of foreign investors encouraged others to follow.
During the 1990s, however, Thailand's financial self-sufficiency began to erode.

Domestic Investment:

· - Until the early 1990s, most investments were funded by Thai savings.

· - Foreign investments built large export factories.

· - Smaller businesses and real estate developments were financed by local

businessmen and domestic bank deposits.

· - In 1991, Thailand's foreign debt was slightly less than its annual exports, a
manageable ratio compared to Latin America's debt, which averaged 2.7 times
exports.
Financial Erosion in the 1990s:

· Thailand's financial self-sufficiency began to decline.

· External factors contributed to this decline:

· The resolution of the Latin American debt crisis made investment in developing
countries more attractive.

· The fall of Communism reduced the perceived risk of investing outside the
Western world.

· Low interest rates in advanced countries in the early 1990s encouraged

investment in the Third World.

Essence of the Passage:

The author is highlighting Thailand's impressive economic transformation from an

agricultural exporter to an industrial powerhouse in the 1980s and 1990s. This
transformation was initially driven by foreign investments and later supported by
domestic savings. However, in the 1990s, Thailand's financial independence began to
erode due to external economic pressures and global financial trends. The passage
underscores the rapid economic growth and urbanization that lifted millions out of
poverty, while also pointing out the vulnerabilities that emerged as Thailand integrated
more deeply into the global economy.

Additional Context:

-Latin American Debt Crisis: This refers to the financial crisis in Latin America during the
1980s, where many countries faced massive debt burdens and economic instability. The
resolution of this crisis in the early 1990s restored investor confidence in developing
countries.

- Fall of Communism: The collapse of Communist regimes in Eastern Europe and the
Soviet Union in the late 1980s and early 1990s reduced geopolitical risks, making
investments in non-Western countries more appealing to global investors.

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The financial erosion in Thailand during the 1990s is generally seen as a negative development.
Here’s why:

Increased Vulnerability: As Thailand's financial self-sufficiency declined, the country became more
dependent on foreign capital. This increased its vulnerability to external economic shocks and fluctuations
in global financial markets.

Debt Accumulation: The influx of foreign investment led to a rise in foreign debt. While initially
manageable, this debt could become problematic if not properly managed, leading to potential financial
instability.

Economic Crisis: The financial erosion contributed to the conditions that led to the Asian Financial Crisis
of 1997. Thailand was one of the first countries to be affected, with its currency (the baht) collapsing,
leading to a severe economic downturn.

Loss of Control

In summary, while the initial influx of foreign investment helped drive economic growth, the resulting
financial erosion made Thailand more susceptible to economic crises and reduced its financial
independence, which are generally seen as negative outcomes.
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Foreign Exchange Market and Economic Impact:

- Supply and Demand: The foreign exchange market operates on the principle of
supply and demand. Increased demand for the Thai baht by finance companies would
typically raise its value.

- Central Bank Intervention: To maintain a stable exchange rate between the baht and
the U.S. dollar, Thailand's central bank increased the supply of baht by selling baht and
buying foreign currencies like the dollar or yen.

- Impact on Money Supply: This intervention led to an increase in the Bank of

Thailand's foreign exchange reserves and the Thai money supply, resulting in an
expansion of credit in the economy.

- Money Multiplier Effect: The process of lending and depositing created a money
multiplier effect, where initial loans led to further loans and credit expansion.

- Credit Expansion and Investment: The influx of foreign loans resulted in a massive
expansion of credit, fueling new investments in construction and speculative activities in
real estate and stocks.

- Speculative Boom: By early 1996, Southeast Asian economies began to resemble

Japan's bubble economy of the late 1980s due to speculative investments.
- Monetary Authorities' Response: Despite attempts by central banks to curb the
speculative boom, they were largely unsuccessful in controlling the rapid credit
expansion and speculation.

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> Role and Nature of Finance Companies:

- Not Ordinary Banks: These finance companies were not typical banks with
depositors, nor were they like Western investment banks with specialized information.

- Political Connections: Their primary advantage was political connections, often

being owned by relatives of government officials.

- Perceived Safety: Foreign banks lending to these companies believed they had extra
protection due to these connections, expecting government bailouts if investments
failed.

- Bailouts: In most cases, foreign lenders were indeed bailed out by the Thai
government during crises.

> Operations and Risks:

- Easy Borrowing: Owners of finance companies could borrow money at low rates
without much scrutiny.

- High-Risk Lending: They often lent this money at high interest rates to speculative
ventures, such as real estate developments.

- Asymmetric Risk: If investments succeeded, both the lender and borrower profited. If
they failed, the government typically intervened to save the finance company, shifting
the risk to taxpayers.

> Widespread Practice:

- Common Practice: Similar practices were prevalent in other countries facing financial
crises, indicating a systemic issue in the region.

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> Regional Financial Practices and Crisis:

- Common Practices: Similar risky financial practices were prevalent across countries
in the region, contributing to the impending crisis.

- Indonesia: Dubious transactions often involved direct loans from foreign banks to
companies controlled by the president's cronies, such as Suharto's daughter's taxi
company.

- Korea: Major borrowers were banks controlled by chaebol, large conglomerates

dominating the economy and politics.

- Implicit Guarantees: Throughout the region, implicit government guarantees

supported riskier and less promising investments, exacerbating the speculative boom.

- Crisis Development: The emergence of a crisis was expected due to these practices,
although the severity of the crisis was underestimated.

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Adverse Selection:

Explanation: When one party in a transaction has more or better information than the other, leading to an
imbalance and potentially poor decision-making.

Example: Foreign banks lending to finance companies without fully understanding the risks involved,
assuming implicit government guarantees

Asymmetric Information: refers to situations where one party in a transaction has more or better
information than the other. This imbalance can lead to adverse selection, where the party with less
information makes poor decisions.

Adverse Selection: specifically occurs when this information imbalance leads to high-risk individuals or
entities being more likely to engage in a transaction, often to the detriment of the other party.
For example, in the context of lending, banks might end up lending to riskier borrowers because they lack
complete information about the borrowers' true risk levels.

Asymmetric information often leads to adverse selection. When one party in a transaction has more or
better information than the other, it can result in the less informed party making poor decisions. This
imbalance is what drives adverse selection, where high-risk individuals or entities are more likely to
participate in the transaction, often to the detriment of the other party
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July 2, 1997
1. Reversal of Credit Boom: Thailand's economic boom, driven by easy credit and
speculative investments, began to reverse. External factors like softening export
markets and the depreciation of Japan's yen made Southeast Asian industries less
competitive.

2. Speculative Investments: Many speculative investments, financed by cheap foreign

loans, failed. This led to bankruptcies among speculators and finance companies,
causing foreign lenders to become hesitant to lend more money.

3. Self-Reinforcing Loss of Confidence: The decline in real estate and stock market
values reduced confidence, leading to fewer loans and further economic decline.

4. Central Bank Challenges: The slowdown in foreign borrowing created problems for
the Bank of Thailand. To maintain the value of the baht, the central bank had to
exchange foreign currencies for baht. However, unlike baht, which it could print, the
bank couldn't print foreign currencies, limiting its ability to support the baht.

Currency Overvaluation:
The Thai baht is overvalued, leading to economic instability.

Concept: An overvalued currency means it is stronger than market fundamentals justify,

which can harm exports and economic growth.

Interest Rate Dilemma:

To stabilize the baht, the government considers raising interest rates to attract
investment.

Concept: Higher interest rates can attract foreign capital but may discourage domestic
investment due to increased borrowing costs, creating a potential recession.

Economic Slowdown:
A decline in construction and job losses create a negative feedback loop: less income
leads to more layoffs.

Concept: This illustrates the concept of a recession, where economic activity slows,
leading to rising unemployment and reduced consumer spending.

Devaluation Risks:
Allowing the baht to devalue could damage the government’s reputation and threaten
businesses with dollar-denominated debts.

Concept: Currency devaluation makes foreign debts more expensive in local currency
terms, which can lead to business insolvency.
Government Indecision:
The Thai government hesitates between defending the baht and allowing devaluation,
opting for a waiting game.

Concept: This indecision reflects a common issue in economic crises—governments

often struggle to take decisive action, leading to worse outcomes.

Speculation and Market Behavior:

As confidence wanes, businesses begin to shift their borrowing strategies in anticipation
of a devaluation.

Concept: Speculation can create a self-fulfilling prophecy; if investors believe a currency

will devalue, their actions (like selling the currency) can lead to that outcome.

Crisis Escalation:
The shift to selling baht and acquiring dollars accelerates the depletion of foreign
reserves, reinforcing the belief in an impending devaluation.

Concept: A currency crisis often involves a run on the currency, where fear leads to
mass selling, creating downward pressure on the currency.

Final Decision to Devalue:

Ultimately, the government allows the baht to float freely, acknowledging it can no longer
maintain the currency's value.

Concept: Floating exchange rates can lead to volatility, especially when markets
perceive weaknesses in a country’s economic fundamentals.

Severe Consequences:
Contrary to initial expectations, the devaluation leads to significant economic turmoil,
challenging the belief that Thailand’s situation was different from other crises.

Concept: This illustrates that economic crises can be interconnected and that
assumptions about immunity based on past successes can be misleading.

Understanding Important Concepts:

Currency Crisis: A situation where a currency's value plummets, often due to a loss of
investor confidence, leading to economic turmoil.

Interest Rates and Investment: Higher interest rates can attract foreign investors but
may also stifle domestic economic growth, creating a delicate balance.

Speculative Attacks: Investors betting against a currency can accelerate its decline, as
their actions often lead to decreased confidence and increased selling.
Economic Feedback Loops: Economic slowdowns can create cycles of reduced
income, spending, and investment, exacerbating downturns.

Reputation and Credibility: Government actions (or inactions) during a crisis can
significantly affect market perceptions and investor behavior.

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Currency Overvaluation:
The Thai baht was overvalued, leading to economic instability and creating vulnerabilities similar to a
balance of payments issue, where the country struggled to maintain sufficient reserves.

Interest Rate Dilemma:

The government faced the challenge of raising interest rates to attract investment without pushing the
economy into a liquidity trap, where lower interest rates fail to stimulate economic activity.

Economic Slowdown:
A decline in construction and job losses created a negative feedback loop, illustrating crowding out, where
government measures to stabilize the economy could limit private sector investment.

Devaluation Risks:
Allowing the baht to devalue risked default on dollar-denominated debts, threatening the solvency of
many Thai businesses.

Government Indecision:
The government's hesitation to take decisive action reflects issues of moral hazard, as businesses might
take excessive risks, assuming government intervention would protect them.

Speculative Attacks:
As confidence in the baht weakened, speculation increased, leading to a run on the bank scenario where
investors rushed to sell baht and acquire dollars.

Crisis Escalation:
This speculative behavior drained foreign reserves rapidly, creating an environment ripe for capital flight,
where investors moved their assets out of Thailand.

Final Decision to Devalue:

Eventually, the government allowed the baht to float freely, acknowledging that maintaining the peg was
unsustainable and that they had entered a contagion phase, risking broader regional instability.

Severe Consequences:
Contrary to initial expectations, the devaluation led to significant economic turmoil, showcasing the
interconnectedness of global economies and the potential for crisis contagion.

Central Bank Interventions:

The central bank's attempts to defend the baht illustrate the complexities of monetary policy, as
interventions can sometimes exacerbate the crisis if not aligned with strong economic fundamentals.
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