Crisis and Recovery

As one of the most vibrant economies in the region for past several decades, Thailand has undergone continued restructuring of its economy. Starting from a resource-based agricultural economy in the 1960s, the country moved with considerable speed toward light industrialization. A policy shift to export orientation in the late 1970s brought about the fastest growing episode of the Thai economy from the mid 1980s to the mid 1990s. During this period, both exports (especially exports of manufactured products) and investment played major roles as engines of growth. A realignment of major currencies after the Plaza Accord was also regarded as a driving force behind this extraordinary growth. Unfortunately, the episode was also characterized by a bubble and massive speculation, where investments were made with little regard to sound and supportive economic fundamentals. It was only a matter of time before the whole structure would collapse, and it did in the economic crisis of 1997.

The economic crisis of 1997 not only put an end to the hyper-growth era, it has caused one of the most abrupt and profound restructurings of the Thai economy. Due to the authorities' futile attempt to defend the value of the baht, Thailand used up almost all of its foreign reserves and by mid 1997 became essentially insolvent, in the sense that its foreign reserves were insufficient to meet its foreign currency obligations. The baht was floated on 2 July 1997 and Thailand had to seek assistance from the International Monetary Fund (IMF).

The baht float resulted in a depreciation of more than 50% in the first six months. Firms that relied on foreign borrowing to finance their investments faced huge balance sheet problems and credit difficulties. Most of these firms could not service their debt which became nonperforming loans, and some corporations ceased to operate and vanished. Many of these corporations used to be among the country's leading firms that drove the economic growth. As a result, aggregate investment and private consumption fell sharply and the economy contracted by more than 10% in 1998.

Because of the large depreciation of the baht and the economic contraction, the current account turned from a precrisis deficit of about US$1 billion per month to a surplus of about US$1 billion per month toward the end of 1997. Thailand's foreign reserve position recovered fairly quickly. By the middle of 1999, the usable foreign reserves had increased to more than US$16 billion, from approximately US$2.8 billion in the middle of 1997, and Thailand did not need to draw any more from the IMF loan package.

Even though the foreign reserve position recovered fairly quickly, it took much longer for an overall economic recovery to be achieved. From Figure 1 [ PDF 34KB | 1 page ], it can be seen that the economy bottomed out around the third quarter of 1998. However, it took almost five years before output recovered to its precrisis peak. It took even longer to clean up non-performing loans in the financial system. After the crisis, the ratio of nonperforming loans in the financial system jumped to almost 50% by the end of 1998 (Figure 2 [ PDF 34KB | 1 page ]). It took about eight years after the onset of the crisis before the NPL ratio declined below 10%.

With a slow recovery in the output level, there was a lot of excess capacity in the economy and little need for new private investment. At the same time, much of the corporate sector was going through debt restructuring and did not have the financial capacity for new investment either. Thus, investment declined substantially from the precrisis level and contributed little to the postcrisis recovery. The share of investment in GDP declined by more than half from the precrisis level; from above 40% precrisis to less than 20% in 1998 (see Figure 3 [ PDF 56.4KB | 1 page ]). The ratio has remained less than 25% to the present day. While the precrisis ratio was too high, given the speculative bubble at that time, the current ratio is still much lower that what one might expect in a normal situation; for example, the average ratio from 1985-1990 was about 30%. The recovery from the crisis to a semblance of a normal economic situation took about eight years. Unfortunately, Thailand has since been hit by a period of political turmoil, and this has kept the economy from going back to anything like its normal growth path.

While domestic demand has played a relatively minor role in postcrisis growth, it has been the external sector (exports of goods and services) that has provided the growth impetus since the crisis. This is not too surprising. Thailand was an export-led economy prior to the crisis, so that with further stimulus coming from the depreciation of the baht, the export sector was able to easily respond and provided the impetus for the growth and recovery of the economy. Given that investment has not yet fully recovered, the export sector has continued to be the main engine of growth, until the recent adverse impacts of the subprime crisis.

The role played by the export sector was important in helping to cushion the impacts of the crisis on the poor. Higher domestic prices of agricultural commodities, a result of the currency depreciation, helped the rural sector to absorb some of the urban areas laid-off workers, particularly from the construction and manufacturing sectors. Other export sectors also helped in this regard. Even so, unemployment in both the rural and urban areas and poverty incidence increased in Thailand after the crisis.¹

With exports as the main growth sector, the share of export of goods and services (including tourism) to GDP rose from an average of about 38% during 1990-1996 to an average of about 65% during 1997-2006, and increase of 26.7%. This is not uncommon among countries hit by the 1997 crisis as can be seen in Table 1 [ PDF 56.4KB | 1 page ]. It must be noted, however, that Thailand's increased dependence on exports is more pronounced than most countries. For example, Korea's export share in GDP increased by 12.6 % and that of Philippines increased by 17.6% during the same period. The exception in Table 1 is Malaysia, with an increase in export share in GDP of 31.8% during the same period. It can be seen that Malaysia's economy is extremely open, with the ratio of exports to GDP greater than 100% in recent years.²

Most of the increase in merchandise exports in the postcrisis period came from the manufacturing sector (Figure 4 [ PDF 102.4KB | 1 page ]). This is not that surprising, as the structure of Thailand's exports has been increasingly shifting toward manufacturing over the past three decades, and manufactured exports now account for about 88% of total exports. However, within manufacturing, there are different types of sectors, such as food, labor intensive sectors, more technologically based sectors, as well as resource based sectors, such as chemicals and petroleum. To better illustrate how Thailand's export structure has been changing over time, Figure 5 [ PDF 102.4KB | 1 page ] classifies merchandise exports into five categories; 1) Agriculture and Food, 2) Labor intensive manufacturing, 3) High technology manufacturing, 4) Resource based exports, and 5) Other exports. First, it can be seen that Thailand's export structure has been fairly diversified in recent years. Together, the labor intensive and high technology sectors account for about 60% of total exports. The other three main categories each account for about 14% of total exports. The diversity is further emphasized once it is noted that income from tourism is also about 10% of total merchandise exports.

Since the mid-1990's, the total share of labor intensive and high technology manufactured exports has been relatively stable, at around or just above 60% of total exports. Between these two groups, however, the share of the high tech group has been increasing by about 10-15 percentage points. Actually, without the crisis, the share of the labor intensive group would have declined even more. Prior to the crisis, there was already a lot of talk about the labor intensive exporters as being “sunset” industries. The effects of fierce competition from cheaper producers, such as the People's Republic of China and Viet Nam, was already being felt prior to the crisis. In fact, intense competition was one factor that caused exports to decline by about 2% in 1996, compared with growth of more than 20% in each of the previous two years. This was one reason for the attack on the baht in early 1997, which eventually led to the crisis.

The crisis led to a substantially depreciation of the baht against the US$. While many other regional currencies also weakened, the real effective exchange rate of the bath still weakened by a significant amount for a number of years after the crisis (Figure 6 [ PDF 33.4KB | 1 page ]). Particularly important also was the fact that the People's Republic of China kept its exchange rate fixed to the US$ after the crisis. These changes in the exchange rates gave a lifeline to the labor intensive export sectors in Thailand, and they have managed to keep going over the past decade or so. In the past couple of years, however, as the baht has appreciated from current account surpluses and large capital inflows, the labor intensive sectors have found it more difficult to compete again, even ignoring the recent impacts from the subprime crisis.

Apart from the labor intensive manufactured export sectors, the share of total exports for agriculture and food exports has also been declining. This depends to some extent on commodity prices, and in the two to three years prior to the sub-prime crisis, rising commodity prices have helped to slightly increase the export share of this sector, which is now around 13.5%.³ Given that Thailand has a natural comparative advantage in agriculture, evidenced by being a top exporter of many agricultural products, such as rice, rubber, tapioca, sugar and frozen seafood, there is still room for future growth for Thai agriculture and food exports. There is a lot of potential for increasing value added from this sector, through improved quality control, value-added processing, packaging and marketing.

The largest export sector now is the high technology sector. This is in line with the need for Thailand to move up the technological ladder, as other countries with cheaper labor take over much of the labor intensive export market. Unfortunately, this is not a sector where Thailand has a natural comparative advantage. The Thai industrial corporate sector tends to be strong in areas where Thailand does have some natural comparative advantages, such as in food related sectors and in services (tourism related). For high tech products, local Thai companies do not have the technological capability to compete effectively with multinational corporations. Thailand has relied mainly on a strategy of attracting foreign direct investment (FDI) to develop various parts of the high technology sector. Thus, the high technology sector is driven mainly by foreign investment with some domestic Thai companies managing to link to the supply chain of these products. This strategy has been fairly successful in many sectors. For example, while some countries in Southeast Asia opted to go for the development of a “national car” a couple of decades ago, Thailand was very open to automotive investment from all the major companies. This has made Thailand the largest automobile producer in the region, with a particular niche in the pick-up truck segment, where Thailand is the second largest producer of pick-up trucks in the world after the US. Local companies have also been able to participate extensively in the auto parts industry and this has further increased Thailand's competitiveness in the auto industry.

Figure 7 [ PDF 31.6KB | 1 page ] shows the share of FDI in total investment. This share has increased after the 1997 crisis. This is a reflection of the decline in domestic investment from the excessive levels prior to the crisis. It is also a reflection of the continued inflow of FDI into Thailand. These are the investments that have been driving the high technology export sector as discussed above.⁴

Given that exports have been driving economic growth after the crisis and investment has been sluggish, it is not surprising that for most of the postcrisis period Thailand experienced current account surpluses. Between 1998 and 2007, the only year Thailand did not have a current account surplus was 2005, when the rapid increase in energy prices led to a deficit. This also occurred in 2008; again due to a rapid rise in oil prices in the early part of the year as well as the indirect impacts of the subprime crisis on exports in the last quarter of the year.

In the first few years after the crisis, it was crucial for Thailand to accumulate foreign reserves. This was in order to recover from the near insolvency resulting from the futile attempt to defend the baht, and also to be in a position to exit from the IMF program. Thailand managed to exit the IMF program around mid-1999, and fully repaid all the money that was borrowed from the IMF package in 2003. Since then, foreign reserves have been increasing rapidly (Figure 8 [ PDF 32.2KB | 1 page ]). This was not really a conscious decision to accumulate reserves as such, but more due to the need to prevent the exchange rate from strengthening too much in order to protect the export engine, which has basically been Thailand's only growth engine after the crisis.

The challenge for exchange rate management became particularly acute in 2006 because of large capital inflows into the country. Although the central bank has been buying foreign currencies to ease the strengthening trend of the baht, the baht strengthened from about 41 baht/US$ at the end of 2005 to about 37.6 baht/US$ at the end of the third quarter of 2006. The capital inflow became even more rapid in the last quarter of 2006. Between the beginning of October 2006 and the middle of December 2006, the central bank intervened extensively in the foreign exchange market to buy up foreign currencies that were flowing into the country. It was buying an average of about US$800 million per week for 10 consecutive weeks. Yet, the baht strengthened at the most rapid pace ever, reaching about 35.2 baht/US$ by the middle of December 2006.

Because of the baht appreciation, the authorities were under tremendous political pressures from businesses to intervene more and more. The loss of export competitiveness through currency appreciation from rapid capital inflows was seen to be unrelated to any economic fundamentals, and as exports were Thailand's main engine of growth, the loss of this engine would have wide implications for the economy as a whole. So on 18th December 2006, Thailand imposed capital controls on capital inflows by copying measures that Chile had used in the early 1990's. Inflows were subject to a 30% unremunerated reserve requirement (so only 70% of the inflows could be invested) and the capital inflow needed to be kept in the country for at least one year, otherwise there will be fine equal to 10% of the capital amount. The next day the stock market crashed by 15% and the authorities had to reverse the controls on those inflows coming to invest in the stock market.

In hindsight, it seems clear that the authorities did not really understand that a requirement to keep the capital inflow in the country for at least one year is extremely severe, because very few investors can afford to park their money in one place for that long without the flexibility to move it if needed. The inflows also created a lot of distortions and also a lot of administrative challenges for the authorities, particularly when different inflows are treated differently and there are possibilities of leakages of one type of inflow into another. One can argue that when a country has to deal with very large capital inflows (or outflows), capital control measures should not be ruled out per se, as they can provide an added valuable instrument for the authorities to manage the stability of the economy. However, it is very dangerous to simply copy measures that may have worked for some country at some point in the past. The financial system changes so rapidly and financial globalization is now much more extensive than in the early 1990's, so measures that might have worked then may be counter-productive in the present day. If capital controls are to be introduced then they must be very well designed and the authorities must be very sure of how the market will respond to them. In the Thai case, the capital controls were eventually removed in March 2008 when conditions were more favorable, as the trade balance turned into deficit following large increases in world oil prices.⁵

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