Thailand's financial crisis: its causes, consequences, and implications

Journal of Economic Issues, March, 2007 by Jonathan E. Leightner

On March 3, 1997, the BOT increased reserve requirements on all financial institutions and named ten weak finance companies. Banks that hold higher reserves are viewed as stronger but adjusting to higher reserve requirements reduces the profits of banks and decreases the domestic money supply. Thus, the BOT was worried that announcing higher reserve requirements would cause a panic and snowball dumping of Thai financial institutions' stocks and bonds. Therefore, immediately prior to announcing the higher reserve requirements, the Thai government suspended (for one day) the trading of all bank and finance company stocks on the stock market. This was the first time in the 21 year history of the Thai stock market that trade was suspended. In spite of the BOT's good intentions, panic began.

These events created a run on all finance companies, especially the ones cited for being weak. The speculative bubble in the Thai property market affected finance companies much more than banks because a relatively high percentage of finance company loans were to the property market. Furthermore, the BIBF licenses held by all Thai banks made it possible for them to obtain funds (from overseas) much cheaper than Thai finance companies could, (because finance companies could only raise funds from domestic deposits). Even prior to the BIBF, the playing field between Thailand's 15 commercial banks and its 91 finance/securities companies was biased in favor of the banks. The BIBF made this bias worse and there was serious concern that all 91 of Thailand's finance and securities companies would go bankrupt (Leightner 1999; forthcoming; see also Atkinson 1999, on the menace of competition; and Elliott and Harvey 2000, on invidious distinction).

George Soros used the above events and concerns in order to lead a speculative attack on the Thai baht--the official currency of Thailand. To understand speculative currency attacks, one must understand how fixed exchange rates are maintained. If an exchange rate is fixed above equilibrium, then a surplus of the currency emerges and the government must buy up this surplus (paying for it with foreign reserves) in order to keep the exchange rate from falling. If an exchange rate is fixed below equilibrium, then a shortage of the currency emerges and the government can maintain the fixed exchange rate by printing more currency and exchanging it for additional foreign reserves.

This author does not know the actual amounts of money used in George Soros' speculative attack against the Thai baht in the spring of 1997; therefore, the numbers used in this paragraph to illustrate how a speculative attack is conducted are hypothetical. First, George Soros bought forward currency contracts on the baht in the spring of 1997. Forward currency contracts are legal agreements to exchange currency at an agreed upon rate at some date in the future. Perhaps these forward contracts gave Soros the option of selling baht at the rate of one US$ for 26 baht in January of 1998. Next Soros sells all of his baht, convinces all of his friends to sell their baht, and advertises the current problems of the Thai economy (see above) in an effort to get others to sell their baht. Soros advertised Thailand's problems because he wanted to create a panic where all foreign investors would want to sell their baht immediately for fear its value was on the verge of collapse. As everyone begins selling baht (and no one wants to buy it), the Thai government must buy up the resulting surplus in order to maintain the fixed exchange rate. Thailand spent US$6.8 billion and committed at least an additional US$23.4 billion in forward obligations in an effort to maintain the fixed exchange rate (Leightner 1999; note Thailand had US$39 billion of foreign reserves in January 1997). On July 2, 1997, the BOT gave up its fixed exchange rate and floated the baht (stopped buying and selling to keep the baht's value fixed). By January 1998, the baht had fallen to US$1 for 54 baht. In January 1998, George Soros could exchange US$1 billion for 54 billion baht on the spot market (the market using current prices). He could then use his forward contracts to exchange the 54 billion baht for more than US$2 billion--more than doubling his money. (2) Soros took advantage of Thailand's problems to make a huge personal profit and in the process Thailand was devastated.