Welcome to Activity 2 - here you get to test your understanding of the financial market during the Asian Financial Crisis, using the experience of Thailand as a case study!
(Note: In Activity 1, you learn about the impact of open market operation and foreign exchange intervention on the country's exchange rate. Please complete Activity 1 first before you attempt Activity 2.)
Here are some background information to the financial crisis in Thailand: In the early 1990s, interest rates in advanced economies were at exceptionally low levels; the central banks in these major economies were trying to to turn their economies out of recession:
Tasks: Assume you are the governor of the central bank. Identify the macroeconomic challenges you would face and your policy responses over the following sub-periods:
Figure 3 below shows the following periods from January 1993 to December 1999:
The chart has been marked to show 3 distinct time periods. Clicking on a time period (Each demarcated by dotted lines) will allow you to view the related content at the bottom of the page. Use these content to aid you in your decision making for each of the three periods.
You will find several graphs here (Figures 3, 4, 5, 6a, 6b), depending on the time period you select
Figure 4 on the right shows Thailand's real GDP growth(YoY) from 1990 onwards.
You have selected period 1 (January 1990 to December 1997). The economy was overheating with influx of foreign funds, and there was buying pressure for the exchange rate to appreciate.
Figure 5 has 4 quadrants
Top-Right:
shows the demand and supply of Thai Baht, against the US dollar . This is known as the foreign exchange market
Bottom-Right:
translates changes in CB intervention in forex market into Net Foreign Asset(upward sloping line, accumulating NFA). Its purpose is to link Quadrant 2 to Quadrant 4
Bottom-Left:
shows the relationship of money supply and interest rates. Lower (higher) supply of money raises (lowers) the Thai interest rates. This is known as the money market.
You may move the 'ss' lines to your desire positions and see how money supply and interest rates behave when their values change.
The Impossible Trinity posits that Central Banks can only pursue two out of the following three things:
In the 1990's, interest rates in advanced economies were at exceptionally low levels as central banks attempted to spur their economies out of recession. Global fund managers went in search of higher yields in emerging economies, such as Thailand. Foreign monies poured into Thailand and there was a massive investments and speculation activities in the asset markets (financial and property). Economy was overheating and there was strong pressure for the exchange to appreciate, and break away from the peg.
Option 1: The Thai economy was overheating, and as the central banker you could try to slow down GDP by tightening money supply (sell government bonds) to increase interest rates. However, higher rates would encourage more inflows of foreign monies in search of higher rate of return, and put further pressure on the exchange rate to appreciate. With a fixed exchange rate, you would intervene to sell Baht / buy USD and in the process accumulate NFA and increase money supply. Foreign exchange intervention negated effects of the monetary policy.
Option 2: There was pressure for the Thai Baht to appreciate, and because Thailand was on a fixed exchange rate system, as the central banker you could intervene in the foreign exchange market to sell the Baht and accumulate its official reserves, hence increasing the NFA. The accumulation translated to an increase in MS, which would mean lower interest rates and further stimulation of an economy running into full steam. (Note: as a central bank, you could sterilized your foreign exchange intervention through the sale of domestic assets, to offset an increase in base money due to the purchase of foreign assets)
Monetary policy is ineffective under fixed exchange rate regime with free capital mobility; thus option 1 is not feasible. Option 2, while it can help to resolve the Baht appreciation problem, it can worsen the economic overheating problem, if the CB did not sterilize its forex intervention. So BOT pursued option 2 and sterilized its intervention.
Outcome Decision: BOT used Option (2): The inflow of hot foreign flows caused tension in the decision that the CB needed to make: whether to slow down economic growth (by raising r) or prevent further appreciation of the Baht (by lowering r / selling Baht). In this case, the CB decided to go with option 2 (sell Baht and sterilize its foreign exchange intervention). Option 1 would not work
If as a central banker you persuaded the country to take on a flexible exchange rate system, allow for capital mobility and adopt independent monetary policy, you could increase interest rates to slow down domestic demand and, the consequent appreciation of the currency from the inflow of foreign monies would slow down exports, as well. You can pursue an independent monetary policy, if you have a flexible exchange rate system.
You have selected period 2 (January 1997 to June 1997). The economy was slowing down sharply with outflow of funds, and there was selling pressure for the exchange rate to depreciate
Figure 5 has 4 quadrants
Top-Right:
shows the demand and supply of Thai Baht, against the US dollar . This is known as the foreign exchange market
Bottom-Right:
translates changes in CB intervention in forex market into Net Foreign Asset(upward sloping line, accumulating NFA). Its purpose is to link Quadrant 2 to Quadrant 4
Bottom-Left:
shows the relationship of money supply and interest rates. Lower (higher) supply of money raises (lowers) the Thai interest rates. This is known as the money market.
You may move the 'dd' lines to your desire positions and see how money supply and interest rates behave when their values change.
In the mid-1990s current account surplus shrank as imports increased with rising spending due to consumer affluence and construction boom. As signs economic overheating emerge, investors turned cautious on the sustainability of Thai’s economy. Fund managers withdrew from Thailand and funds flowed out sharply. Economy was slowing down sharply and there was strong pressure for the exchange to depreciate, and break away from the peg.
Monetary policy is ineffective under fixed exchange rate regime with free capital mobility; thus option 1 is not feasible. Option 2, while it can help to resolve the Baht depreciation problem, it can worsen the economic recessionary problem if the CB did not sterilize its forex intervention.
As a central banker, you could attempt to raise interest rates to prevent the Baht from depreciating. But the trade-off you face was a further collapse in economic growth.
Option1, expansionary monetary policy, while it can help to resolve the economic recession problem, it worsens the Baht depreciation problem.
Option 2, while it can help to resolve the Baht depreciation problem, it worsens the economic recession problem if the CB did not sterilize its forex intervention.
Outcome Decision: See option (2): The outflow of foreign flows caused tension in the CB on whether to stimulate growth (by lowering r) or prevent further depreciation of the Baht (by raising r / buying Baht). In this case, the CB decided to buy Baht and sterilized its foreign exchange intervention.
If as a central banker you persuaded the country to take on a flexible exchange rate system, allow for capital mobility and adopt independent monetary policy, you could decrease interest rates to spur domestic demand and, the consequent depreciation of the currency from the inflow of foreign monies would boost exports, as well. You can pursue an independent monetary policy, if you have a flexible exchange rate system.
You have selected period 3 (July 1997 to January 2000). The economy recovered and the Baht was allowed to float against the dollar
Figure 5 has 4 quadrants
The CB BOT decided
In choosing between defending the pegged rate or let the economy deflate further, the BOT decided to let go of the fixed exchange rate in order to pursue loosening of its monetary policy.