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A new global financial architecture: a Thai perspective
/ Thanong Khanthong - [E-mail-version, electronic ed.] - [Bonn, 2000] - 30 KB, Text & Image file
. - (Studies on international financial architecture ; 2000,4 : e-mail-version)

Electronic ed.: Bonn : FES Library, 2001

© Friedrich-Ebert-Stiftung

SUMMARY

Introduction

A Mismatch

The Three Islands of Stability

Floating Exchange Rate Regime

Sound Macroeconomic Policy

Capital Controls and the Hedge Funds

Conclusion

A New Global Financial Architecture: A Thai Perspective

Thanong Khanthong

SUMMARY

Any discussion on the new international financial architecture will have to start with the mismatch between the sizes of the economies, the financial markets and the financial institutions of the more advanced countries and the developing countries. It will also have to take into account the predominant roles played by the dollar, the euro and the yen. Exchange fluctuations among these three currencies have created global financial instability. Thailand and

other emerging-market economies have been advised to adopt a floating exchange rate regime and pursue sound macroeconomics management, apart from undertaking structural reform to stay competitive. Yet it remains uncertain how the emerging market economies can cope with the forces of globalization, financial turbulence information revolution and liberalisation even though they manage to put their houses in order.

Introduction

Thailand is taking a textbook approach in strengthening its financial regime to become part of the international financial architecture, whatever it is. The economic crisis over the past three years has become a painful adjustment. It is now trying to put its house in order. The crisis has become a dear lesson. The Thai policy-makers believe that the structural reform, which is now being put in place, is expected provide a stronger regime for healthier growth and stability in the future. They also hope that it will strengthen the safeguard against a recurrence of the economic crisis.

By putting its house in order, Thailand is now working to improve governance and other internal practices. Apart from creating a more equitable social distribution and forge political development, it is trying to strengthen the competitiveness of the country as a whole. Finally, it is facing a daunting task of addressing the country’s huge public sector debt, which is now running at about 60 per cent of the gross domestic product (GDP).

Following the Asia crisis, there has been an ongoing debate over an appropriate global financial architecture, which ideally should provide a stability framework for nations to participate in global growth and prosperity. But this is not going to be the case. It remains uncertain how the new architecture will look like. There is virtually no interest on the part of the more advanced economies to change the status quo because the present system serves them well. The present international monetary system can be characterised as a mismatch between the sizes of the economies, the financial markets and the financial institutions of the more advanced countries and those of the developing countries. Also, the currencies of the emerging markets look vulnerable in the face of the floating dollar, the euro and the yen, which virtually dominate the international transactions. For the emerging-market economies, including Thailand, it is unclear how they will survive in the new global financial order, characterised by globalization, financial turbulence, information technology revolution and economic liberalisation. The best they can do is to put their house in order as a shield against the external instability.

A Mismatch

Any discussion on a new global financial architecture will inevitably have to start with a mismatch between the sizes of the financial markets of the more advanced countries and those of the developing economies. As of February 2000, the stock market capitalisation of the US amounting to a staggering US$15.48 trillion, compared to US$8.94 trillion for Europe and US$4.58 trillion for Japan. At the same time, the sizes of the emerging markets in Southeast Asia look tiny compared with the three giants, which represent the global financial centres. Malaysia’s stock market capitalisation was US$173 billion, followed by US$53 billion for Indonesia, US$51 billion for Thailand, US$37 billion for the Philippines. This mismatch in sizes is the underlying problem in the instability of the emerging markets as they open up their economies and capital markets to join the globalization bandwagon. As Stephen S Roach, the chief economist and director of global economics at Morgan Stanley Dean Witter, noted: "A 1 per cent asset allocation shift out of the United States is, in and of itself, worth US$150 billion; that would overwhelm any of the emerging equity markets – leading to the types of asset bubbles that have been all too evident in emerging markets in recent years."
[ Stephen S Roach, "Architectural Reform: Managing Financial Market Volatility in the New Millennium," paper presented to Apec Forum on Shared Prosperity and Harmony, Seoul, Korea, March 31, 2000]

A merger between Deutsche Bank and Dresdner Bank, both of Germany, would have created a banking group with a gigantic asset size of US$1.2 trillion. At the same time, a merger between Bangkok Bank and Thai Farmers Bank, Thailand’s two largest private banks, would have created a new banking entity of the size of about US$50 billion. The size of the Thai banks is equivalent to only a community or regional bank in the US with no participation in the international transactions. Moreover, Microsoft’s market capitalisation exceeds US$500 billion, compared with US$150 billion of the size of the Thai GDP as a whole. So the fundamental question is how the financial institutions or economies of the emerging markets can compete head-on against their rivals from the more advanced economies in the first place. It is like putting a flyweight boxer to face Mike Tyson in the boxing ring.

Besides, enormous capital has already been accumulated in the more advanced economies because of their development hundreds of years before. The capital from the more advanced economies has simultaneously become a blessing and a curse for the emerging-market economies. When the capital leaves the global financial centres into the emerging-market economies, it leads to economic boom and asset bubbles. When the capital is pulled back due to a reversal in sentiment, it creates financial shocks and economic dislocations.

The Thai experience is just another example of the boom-bust cycle created by capital flow. Thanks to Thailand’s financial liberalisation, foreign capital flooded the country in the tune of US$30 billion alone between 1992 and 1994. As a result, easy money drove banks into reckless lending. Companies diversified into businesses they knew very little about. All major industries poured money into expansion to create an overcapacity. The property market went out of hand. Eventually, the country ran up US$90 billion in US dollar currency debts. The financial bubbles would pop.

When sentiment changed in 1997 with the devaluation of the baht that triggered the Asia crisis, capital flew out of Thailand in droves. Between 1997 and 1998, some US$20 billion fled the country in panic, creating a currency crisis, a severe credit crunch, a banking crisis and the economic and social upheavals.

For the emerging-market economies, there appears to be no middle ground when it comes to dealing with capital flow. It is either too much money or too little money since the foreign bankers, financiers, money managers and investors largely act on a herd instinct. The dilemma for Thailand and other emerging-market economies is how they can strike a balance and cope with the volatility or financial turbulence as they open up their economies to embrace capital, technology and know-how; and how they can make the best use of globalization, where capital, which has both its beneficial and destructive elements, moves rather freely in search for the best returns.

The Three Islands of Stability

Apart from the mismatch in the size of their financial markets, the emerging-market economies are also vulnerable in the face of the foreign exchange fluctuations. Managing an appropriate foreign exchange regime has become a tough choice. For the present global financial architecture is based on a floating exchange rate regime, dominated by the dollar, the euro and the yen. They are the three islands of stability, the centres of global gravity. Over the past four to five years, the US, Europe and Japan have enjoyed internal stability through subdued inflation, which ranges at 2-3 per cent a year. Yet the dollar land, the euro land and the yen land have created financial turbulence in the rest of the world by the sharp volatility of their exchange rates. As a result, the other economies outside the three islands of instability is either inflating or deflating according to the movements of the three major exchange rates or the cycles of their economies.

Robert Mundell, the Nobel laureate in economics, views the floating exchange rate system anchored by the dollar, the euro and the yen as "an absence of monetary rule". In his speech to Apec Forum in Seoul, Korea, delivered on March 30, 2000, he made it clear that the world has to go back to the fixed exchange rate regime. "Should we have a fixed or flexible exchange rate is not an option. A fixed exchange rate is not a monetary rule – it’s the absence of monetary rule," he said. He called for a establishment of a global financial architecture based on a fixed exchange rate regime, similar to the old Bretton Wood system that the US tore apart in 1972. For the rest of the world will find it increasingly difficult to manage their own stability in the face of the exchange rate volatility triggered by the world’s three dominating currencies.

The Thai crisis can also be seen as a foreign exchange crisis emanated from the fluctuations between the dollar and the yen. In 1985, the dollar was trading at about 250 yen. But 10 years later it was at 79 yen. Between 1984 and July 1997, the baht was pegged to the dollar. The dollar weakness initially helped to boost the Thai exports. But starting in mid-1995, the dollar began to appreciate sharply against the yen, making the Thai exports less competitive and precipitating the economic crisis. There was little movements between the baht and the dollar then because it pegged to the greenback, but the baht rode on the dollar’s back to appreciate sharply against the yen to create a currency crisis.

As Mundell has suggested, it will be necessary for currencies in the emerging markets to enter a broader arrangement for create a regional fixed exchange rate mechanism – exactly the same way that Europe has done with the euro. Japan wants to play this leading role, but it is still lack the political courage to forge ahead into this direction. And there are a lot of reservations among the Asian countries, who still differ substantially on the monetary and political union.

Floating Exchange Rate Regime

At the heart of the Thai financial reform to join the global financial architecture lie the floating exchange rate system and the sound macroeconomic policy. Both the Finance Ministry and the Bank of Thailand are committed to a floating exchange rate mechanism. They believe that the value of the baht will have to be determined by the market force. Under the floating exchange rate regime, the central bank will let the baht move rather freely with the economic fundamentals of the country. It will refrain from intervening in the foreign exchange market to support the baht, except in special circumstances.

The floating exchange rate policy is in contrast with the currency peg system of the past. Between 1984 and 1997, Thailand adopted a fixed exchange rate regime. The Thai baht was then traded at 25 to 26 baht to the US dollar, compared to 37-38 baht to the US dollar presently. The currency peg acted as a nominal anchor, providing macroeconomic stability and boost confidence among the foreign investors who brought their money into the country for investment. Under this policy, the central bank, using its international reserves, would intervene in the foreign exchange market to keep the movements of the baht at a fixed rate. The fixed exchange rate policy worked well for Thailand because the baht was pegged to the US dollar, which weakened mostly against the major currencies during the period. This helped boost the Thai exports. Most of the foreign exchange rate systems in the region also pegged their currencies to the US dollar.

Overconfident with the growth prospects, Thai authorities started a series of financial liberalisations in the early 1990s, culminating in the opening up of the capital account. The policy amounted to opening up a floodgate to foreign capital, which flowed into the country en masse. As a result, foreign debt in 1996 mushroomed to more than US$90 billion, of which US$70 billion was private debt.

Cracks began to show in the Thai fixed exchange rate system in mid-1995 when the US dollar began to strengthen against the Japanese yen. Two years earlier China also devalued its currency by about 35 per cent. The Thai exports, which had been the engine of economic growth over the past decade, began to lose its competitiveness. Without strong export earnings, there was increasing concern in 1996 over how Thailand would pay off its foreign-currency debt. The crisis was looming ahead.

At the same time, the fixed exchange rate system posed a dilemma to the monetary authorities. For the fixed currencies induced foreign capital inflow, which added on domestic price pressures. This forced them to raise interest rates to bring prices under control. But wider interest rate differentials between the baht and the US dollar further encouraged foreign capital inflow. The Thai authorities were caught in a "triangle of impossibility": they could not maintain a fixed exchange rate system, allow free flow of capital and manage an independent monetary policy all at the same time.

Eventually, the monetary authorities caved in to the pressure to abandon the fixed exchange rate region by floating the baht on July 2, 1997. The crisis broke out to create a regional contagion effect. The authorities quickly introduced a series of measures to stem the tide of speculative money. In the end, the Thai authorities would be left with the task of trying to keep an independent monetary policy.

Now the floating exchange rate provides more flexibility to the monetary authorities. They don’t have to lose reserves in defending the currency. Before the fixed exchange rate automatically helped to keep prices in check. But with the floating exchange rate, the task of the monetary authorities has to shift to maintaining price stability through inflation targeting. Now inflation targeting set in the medium term will form a nominal anchor for the macroeconomic management. As discussed above, it remains doubtful that a medium-sized and open economy like Thailand can achieve stability by adopting the floating exchange rate regime due to the highly instable nature of the global financial system.

Sound Macroeconomic Policy

Thailand will be sticking to sound macroeconomic policy as another hallmark of its policy framework. Yet at this point, they have go for deficit financing for three years in a row to jump-start the ailing economy. But monetary conditions have been largely eased to accommodate the recovery. The failures of the financial system have created a huge burden on the budget, which has to fiscalise the cost of financial restructuring. The debt of the Financial Institution Development Fund, which has guaranteed the deposits of the public and senior foreign debts, have reached Bt1.3 trillion. In the medium term, the fiscal policy will have to be tightened to prevent government debt going out of control.

On the monetary front, amendment of the Bank of Thailand Act will pave the way for the Thai monetary authorities to focus their task on maintaining price stability through inflation targeting. The central bank will adopt more transparency to its operation. It will set medium term target for inflation and try to manage the monetary policy to achieve the target. It will have to report its operation to the Cabinet and to Parliament. It will also be required to publish its international reserves on a weekly basis.

Moreover, the domestic institutions are under an ongoing reform. Part of the Thai crisis can be blamed on the weak institutions that support the capitalist system. From the legal, accounting, judicial, regulatory to the financial supervisory institutions, they cannot cope with the fast change of the new business and economic environment. It was not until March last year that Thailand have put in place a bankruptcy and foreclosure framework. The bankruptcy court was created only in June that same year. Without the sophisticated institutions, economic development will eventually run into a snag.

Moreover, financial sector is going through recapitalisation and debt restructuring period. The Thai authorities are committed to liberalisation and best international practices in this sector to create more competition and efficiency.

Capital Controls and the Hedge Funds

Another important subject in the international financial architecture is how countries should cope with the flow of short-term capital and deal with the highly leveraged hedge funds. At the height of the Thai crisis, external private debt reached US$70 billion, of which US$40 billion was short-term capital. Short-term capital is defined as capital with a maturity of less than one year. The abrupt movement of the short-term capital can create instability. When Thailand faced a classic balance of payments crisis in 1997, there were fears from the foreign lenders that the country might not have enough dollar to service its foreign debt. For short-term capital of US$40 billion alone already exceeded the country’s international reserves of US$30 billion. Hence, there was a big scrambling for investors or lenders to get out of Thailand as quickly as possible.

Even a US$17.2 billion rescue fund from the IMF could not calm the panic. The outflow of short-term capital created a severe credit crunch for there was not enough dollar for the local banks or corporates could not convert their baht assets into dollar assets for repayment. Buying the dollar further put downward pressure on the baht. Besides, liquidating assets in time of the economic crisis was all the more difficult because they were no buyers or liquidity.

After the Thai crisis, there has been growing interest among emerging countries as to how they can control the flow of short-term capital. In practice, it is difficult to control short-term capital because there is always a put option if a corporate fails to meet one of the covenants in its long-term loans. Yet short-term capital or hot money will have to be dealt with for their movements affect the foreign exchange and monetary policies of a country.

Malaysia’s measures have been more direct. In September 1998, the authorities declared offshore ringgit to be inconvertible to curb speculative currency trading, thereby creating heavy losses among the hedge funds and currency speculators. In doing so, Malaysia has been able to bring stability to its ringgit, which ever since has been fixed at 3.80 to the dollar.

Hedge funds are the pirates of modern global finance. This is the unspoken view of Asian financial policy-makers. After the collapse of Long-Term Capital Management, a US hedge fund, in August 1998, there has been increasing attempt to regulate the hedge funds.

At the Seoul Apec Forum, which ended last week, the destabilising role of hedge funds was highlighted as part of an effort to create a new global financial structure. If the new financial architecture is to be fair and transparent to all participating countries, the hedge funds have to be tamed. The reason is that some of the most highly leveraged hedge funds are managed secretively. They are registered in offshore financial centres to escape the watchful eyes of the regulatory authorities.

When they take on financial markets with their sheer leverage power and intense speculative trading practices, they can create instability to the financial system. Medium-sized open economies are particularly vulnerable to hedge funds.

Members of the Association of Southeast Asian Nations have submitted a proposal to the IMF Fund on the need to improve transparency and the monitoring process of hedge funds. Yet the IMF’s response has been rather lukewarm.

Countries have different methods to cope with the hedge funds. After the baht crisis, the Thai authorities have moved to curb baht trading in the offshore markets. Local banks are restricted from supplying the baht to the hedge funds or foreign investors in the offshore market.

Hedge funds aggravated Thailand’s financial crisis when they joined in the attack on the baht in 1997. They were viewed as a necessary evil then because they imposed market discipline to the economy. With the Thai authorities refusing to face the reality of the baht, hedge funds launched a US$10 billion attack on the currency on May 14, 1997 alone. After the victory over the baht, the hedge funds went on a regional rampage, attacking national currencies and precipitating the regional crisis. The Hong Kong dollar was also come under the heavy attack, but it escaped the turmoil due to its sound fundamentals.

"If we impose more restrictions on domestic financial markets to prevent huge capital inflows, these hedge funds will move to these offshore banking units, rendering the restrictive measures ineffective," said Paul Chiu, Taiwan’s finance minister.
[ Paul C. H. Chiu, minister of finance, Chinese Taipei, "Short-term Capital Flows and the Related Financial Architecture in Emerging Market Economies," paper presented at the Apec Forum on Shared Prosperity and Harmony, March 31, 2000, Seoul, Korea]

The advanced economies are adopting measures to require the hedge funds to disclose requirements, and to require banks to enhance their risk management capabilities in order to curb excessive lending to hedge funds and other highly leveraged institutions. In this regard, hedge funds are being controlled indirectly.

The G-7 countries began to take a serious look at the destabilising effect of hedge funds only after the collapse of Long-term Capital Management. In the end the bankrupt US hedge fund had to be bailed out by other US investment banks because if it was forced to liquidate its US$1 trillion positions, it could have brought down the global financial markets. The failure of Long-Term Capital Management also pointed to poor risk management by the US and European banks, which allowed the hedge fund to leverage 20 times its capital base.

But Chiu said these disclosures or risk management measures were not enough to shield emerging market countries from the threat of the hedge funds. In Taipei, he said, foreign investors were required to register as qualified investors and to disclose pertinent information, including the names of their beneficiaries. "At the same time, Taipei has regulated hedge funds in a manner similar to regulating securities investment trust funds by prohibiting transactions supported by margin financing," he said.

Conclusion

Despite the rhetoric over the new international financial architecture, it remains uncertain how its final face will look like. But the world out there is very crude and brutal for the emerging economies. Thailand and other emerging economies are facing the dilemma of having to deal with globalization, which comes with the information technology revolution. But in globalization, there is an inherent instability of the financial markets, dominated by the dollar, the euro and the yen.

To participate in the globalization or the new architecture, Thailand will have to put its house in order and liberalise its financial system and economy. But if it fails to do so appropriately, it will risk facing another crisis.

Thanong Khanthong is Business Editor of The Nation, Bangkok, Thailand

© Friedrich Ebert Stiftung
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