Lessons from the 1997 Economic Crisis

There are many important lessons that can be drawn from the 1997 crisis.⁶ The most important is probably that while financial globalization can bring benefits from better access to financial resources, it can also bring about a lot of volatilities and risks, and needs extremely prudent management. Given Thailand's past development successes based on real sector globalization (through trade and FDI), the country was regarded as an example of the so-called “East Asian Economic Miracle” (World Bank 1993), and was praised internationally as being a model that other countries should emulate. Given these successes, the authorities may have become overconfident, and embarked on policies of financial liberalization in the hope of turning Bangkok into a major financial center for the region. Unfortunately, there was insufficient understanding of the implications of financial liberalization, and an incorrect policy regime was pursued and this eventually led to the crisis.

The crucial mistake of the authorities was to liberalize capital flows while sticking to a fixed exchange rate system and also trying to pursue an independent monetary policy; the classic Mundell “impossible trinity” (Mundell 1963). Thailand had successfully used a fixed exchange rate system since the end of the Second World War, and this had contributed to economic stability and growth for many decades. However, these successes were mostly achieved under an environment of modest financial capital flows. The mistake was to stick to this old paradigm in the 1990's when capital flows became very large and very volatile.

Prior to the crisis, the baht was fixed to a basket of currencies with the US dollar having by far the largest weight in the basket. This resulted in a fairly stable baht/US$ rate for many years prior to the crisis. However, Thailand also tried to pursue an independent interest rate policy. This can be seen from the gap between the Thai overnight inter-bank rate and the US overnight federal funds rate. This gap averaged about 4% between January 1989 and June 1997 (the last month before the float of the baht), and sometimes reached up to 10% (see Figure 9 [ PDF 41.5KB | 1 page ]). With liberalized capital flows, this inevitably led to a large amount of capital flows into Thailand.

Most of these capital flows came in the form of external debt, which rose rapidly from US$ 29 billion in 1990 (34% of GDP) to US$ 108.7 billion in 1996 (59% of GDP). Even more dangerous was the fact that much of this debt was short-term debt (with a maturity of less than one year).⁷ By the end of 1996, the total short-term foreign debt was about US$ 47.7 billion, which was larger than the amount of official foreign reserves at the time which was about US$ 38.7 billion. Even after taking into account the foreign assets of the banking system, the total foreign assets (official and private) were less than the amount of short-term foreign debt of the country. If these short-term foreign debt were not rolled over, there would not be enough foreign assets in the country to service these debt.

These large capital inflows fueled the economic bubble in Thailand. There was excessive investment in non-trade sectors, particularly real estate. There was also a lot of crony capitalism. Persons sitting on boards of financial institutions also sat on many boards of client companies. Banks were lending to clients without sufficient scrutiny. One bank that eventually failed, lent almost 60% of its total lending to projects initiated by relatives and friends of the owners and managers. Clearly, corporate governance as well as risk management needed to be significantly improved in order to avoid a similar crisis in the future.

The authorities were also viewing the economic situation with the wrong paradigm. As capital flows increased, the foreign reserves also increased, as the foreign borrowings were converted into local currency to invest in the country. The authorities were viewing this as a sign of strength and were looking at the adequacy of foreign reserves in terms of the number of months of imports that they covered (a current account paradigm). The fact that foreign reserves were also needed to cover foreign debt, particularly short-term debt, (a capital account paradigm) was not well-understood. This was a painful lesson from the crisis. After the crisis, the country's short-term debt has been carefully monitored to make sure that the country does not return to a situation anything like the precrisis one. The ratio of foreign reserves to external short-term debt has increased substantially, to almost five to one at the end of 2008, from less than one to one just before the crisis (see Figure 10 [ PDF 100.9KB | 1 page ]).

To avoid a similar crisis, economic management needs to be much more prudent. The authorities need to understand and look out for various risks to the economy. Major policy changes (like financial liberalization prior to the crisis) need to be carefully studied to understand the full implications and risks involved. It is also very important to carry out appropriate sequencing of policy changes.

Another important lesson is the need to improve the country's social safety nets to be able to respond appropriately to an economic crisis. After the crisis, it was very apparent that the social safety nets available at that time were very inadequate. Laid off workers had little protection, and fiscal expenditures to cushion the impacts could not be dispersed quickly enough. Borrowing from multilateral organizations, such as the World Bank and the Asian Development Bank, could not be dispersed quickly enough because of many rules and regulations on procurement and disbursement imposed by the lenders. On this issue, Thailand was very grateful that the Japanese government came forward with the so-called Miyazawa Initiative, providing financial assistance in a way that could be disbursed very quickly. Since the crisis, the system of social safety nets has been improved in many areas, most notably in the areas of universal healthcare scheme and the unemployment insurance under the Social Security System.⁸

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