The baht crisis and the failure of financial services firms (FSFs) in Thailand during the second half of 1997 could be attributed to the debatable moves the Bank of Thailand (BoT) has made to control the money supply and stabilize the economy in transition from pegging to free floating exchange-rate regime amidst opportunistic speculative attacks, opaque risk-shifting behavior of FSFs, and high political uncertainties during the Chavalit administration. That the BoT maintains its independence from political intervention and integrity to execute prudent monetary policy is unquestionable. But its contingent decisions to act in time of looming crises and transitions - the depletion of foreign exchange reserves as a measure against speculative attacks and the upcoming external loan repayments - and to regulate ailing domestic FSFs to maintain intermediationary discipline remain very much in doubt.

This essay has its main purpose to evaluate the performance of the BoT in relations to the changing domestic and international economic environments. It shows some arguments that might help explain why the BoT did what it did and how it should have done otherwise. In the next two sections, I shall try to outline the impetuses that have induced the BoT's behavior against the scenario in which its moves are conditioned upon factors other than its own internal agenda. The last section shall provide some recommendation that the BoT could adopt in order to regain and strengthen its long-established credibility in both domestic market and international community.

The uneven paces between the target productivity growth in the real sector and the resultant leverage growth in the financial sector make it harder for the BoT to maintain the country's overall economic growth momentum and relatively high performance compared with other emerging economies without being subject to the pressure to deregulate the domestic financial markets. Intervention by means of monetary policy instruments and institutional regulation seems less effective, and even counter-productive, in light of international capital flows and globalized financial markets.

Three main traditional functions of generic central bank in a closed economy are: 1) to affect the money supply through the banking system; 2) to facilitate payment transfers and settle claims between banks; and 3) to regulate and monitor banks' intermediation behavior (Mishkin, 1995). When allowing the domestic economy to open for foreign trade and capital flows, the central bank has the policy option to either resort to fixed, pegging, or floating regime. The BoT has historically resorted to pegging regime, which requires it to maintain foreign exchange reserve levels against a basket of major world currencies to buffer the country's economic cycles and financial conditions. In an open economy, the central bank's effectiveness to perform the above three functions is lessened because external impetuses such as foreign exchange reserve maintenance under the pegging regime, private-sector external debt transactions, portfolio and foreign direct investments, and regulatory arbitrage in the financial services sector, have created the opposite effects that negate any attempt by the central bank to control the money supply, manage the smooth functioning of domestic payments system, and motivate the behavior of banks - domestic and international alike.

There are three general policy dilemmas that the BoT has been encountering:

1. The exchange-rate policy choices between sustaining the distorted pegging regime to smoothen the baht's convertibility which helps stabilize leverage growth and phasing into the floating regime to reflect the reality of productivity growth.
2. The financial-market policy options between regulating the FSFs' activities to prevent systemic risks that could result from the liberalization of domestic financial markets and deregulating them to promote competitiveness between domestic and foreign FSFs.
3. The financial-institution policy measures between preventing the troubled FSFs from failing in order to prevent bank and depositor runs and letting them fail while maintaining adequate liquidity level in the economy to restore public confidence in the financial services system.

Pegging for Leverage vs. Floating for Performance Back to Top

The interconnectedness between real and financial sectors is never detachable; they are truly interdependent upon each other. This has been transformed into the BoT's open-economy monetary policy to balance the pace between the two sectors. The target economic growth rates of 7-10% during the past decade had been fueled by pervasive use of financial leverage, i.e., the use of debts rather than equity capital to fund investments in real and financial assets. With the relatively low domestic savings rate and less sophisticated capital markets in the past, the country had heavily relied on foreign capitals - external debts, portfolio and direct investments - since then.

In order to smoothen the flows of foreign capital that continually strengthened the investment base of the domestic export industry, it is necessary that the baht convertibility be relatively stable vis-a-vis the basket of creditors' currencies. This pegging regime worked so well during the stage of productivity improvement and export capability enhancement that the BoT's foreign exchange reserve level had reached the record high. The tide had shifted against this pegging regime when foreign-currency-denominated public and private spendings were allocated to non-productive investments and speculations, such as in real estate projects and military purchases, without adequate internal control and regulatory supervision.

Realizing that the country's real economic performance was not as strong as it seemed during the mid-1990s and the static Mundell-Flemming model (1962) was no longer applicable, the BoT had turned to focus on defending the baht instead of trying to phase out from the pegging regime, for fear that such a move would trigger capital flight and economic downturn. The dilemma was sharply delineated with the presence of political uncertainties and government interventions in many economic and financial activities that the BoT, instead of trying to phase in the floating regime to let the market forces correct and discipline domestic spendings, had pursued its own agenda to prolong the life of the pegging regime with expectations that it could harness the short-run non-performance spending difficulties and put the real and financial sectors on their original growth track. With domestic political instability and international dynamics, the BoT is mandated to exert its independent influence over monetary and regulatory policies to intervene more rather than less to rescue the Thai economy.

Financial Liberalization vs. Institutional Regulation Back to Top

The macroeconomic policy to liberalize domestic financial markets through international banking facility (IBF) created the opportunity for foreign banks to mobilize funds without necessary and sufficient regulation and supervision. It also made domestic banks vulnerable to competitive disadvantages, which in turn induced them to pursue imprudent risk management strategies. The BoT confronted the dilemma between competitive neutrality to level the playing field between foreign and domestic FSFs in the IBF arena and systemic stability to control the effects of IBF transactions that might spill over to domestic banking transactions. As a result, it is unclear whether domestic banks whose integrated operations transcend domestic functions should be regulated. This ambivalence has created regulatory loopholes and incentives for imprudent foreign and domestic banks to shift risk and swiftly mobilize funds without being adequately monitored by the BoT, thereby destabilizing the overall banking and financial services industries.

The benefits of financial liberalization should be weighed against its costs and risks that affect the institutional safety and soundness of domestic FSFs. Those domestic FSFs facing with competitive pressure from their foreign counterparts tended to resort to high-yield, high-risk lending and investment portfolios to compensate for their disadvantageous competitive position. With the existence of IBF, many qualified FSFs took advantage of this liberalized and deregulated setting to elude regulatory constraints. With the attempt to control the segregated domestic operations of the FSFs whose international operations are not regulated, the BoT's power to control their behavior substantially diminished. In this scenario, the costs of liberalization seemed to outweigh its benefits unless there are structural changes in the financial services system.

The BoT has tried to create an environment conducive to international competition by domestic FSFs while maintaining its power over monetary policy and financial regulation. However, it has lagged to recognize the importance of developing appropriate and timely financial infrastructure - which includes: 1) the legal and accounting procedures that address the off-balance-sheet items and market value of banks' portfolios; 2) the organizations of trading and clearing facilities (i.e., market microstructure) that facilitate innovation spiral from financial intermediaries in terms of transactions cost reduction of the newly engineered and exotic derivative and contingently-claimed products and services; and 3) the dynamic regulatory structures that govern and evolve around the relations among the users of the banking and financial system (Merton, 1992) - along side with its policy to deregulate domestic financial services markets to reap the potential benefits while being immune from the dynamics and potential shocks in international financial environment.

Public Confidence vs. Market Liquidity Back to Top

Having been stuck with the widely-accepted doctrines of lender-of-last-resort and too-big-to-fail, the BoT always confronts the dilemma between maintaining sufficient liquidity level in the banking system and permitting the illiquid and insolvent banks to survive by free-riding on the Financial Institution Development Fund (FIDF) as a result of moral hazard behavior of the banks (Edwards, 1996). Its independent status from the government and the public makes its decisions opaque and unchecked against the market reality and sentiments. True, these doctrines have their defendable intrinsic value in preventing difficulties in the financial sector from spilling over to the real sector of the economy. Nonetheless, without the right publicity, timing, and follow-up monitoring, the announcement effects to subsidize the failing FSFs conveyed negative signal to and exacerbated distortion in both real and financial markets. In essence, the bail-out effort in which the funds are extracted from taxpayers has to carry with it a clear imperatives that illiquid FSFs improve their risk-capital reserve levels and that insolvent FSFs be restructured in such a way that they are able to overcome financial distress on their own or else facing closure.

To make its policy decisions and actions credible, the BoT has to resort more to the rule-based measures rather than to the discretionary ones. Any discretionary and contingent moves by the BoT, though exogenous in the short runs, will be endogenously interpreted and internalized by other market participants in the long horizons. By conditioning its actions upon explicit rules, the BoT could improve its long-term credibility. The question is whether the rules are effective and valid enough to be conditioned upon. In the open and dynamic environment to which Thailand is now exposed, it is not easy for the BoT to just follow the rules or doctrines to lend effective impacts on the economy. As external conditions change, so should the rules. But the changes in rules must be based upon the clear and logical calculus that is observable and understandable by the public. For the FSFs' bailout case, the rationale behind the rule is to make the economy stay liquid while not letting the failed FSFs free-ride on the FIDF. Supplemental plans to tackle the institutional problems have to be simultaneously promulgated to correct the institutional distortion the bailout program has created. I believe the BoT has done so in such events, but the message discerned by the markets was less than convincing and the timing to deal with and black-list each troubled FSF was too immediate after the bailout plan was launched. Thus, by phasing out the time to correct the subsequent institutional distortion, the BoT's intention to improve liquidity problem in the financial services system would be more effective and credible.

Past policy decisions and ambivalence in policy directions reduce credibility of the BoT to a large extent. However, considering the three dilemmas depicted above, the BoT should not be solely blamed without justifying its causes. I trust that the BoT is among the highly-disciplined central banks in the world; its tasks are even more difficult than the Fed or the Bundesbank to perform in light of constant domestic repercussions and international markets fluidity. One major difference between BoT and its counterparts in developed countries like the U.S. and Germany is that its policies and strategic moves, no matter how effective they are, could hardly affect the world markets, if at all. Conversely, global markets have constantly exerted exogenous pressures on the Thai economy as well as on the BoT's behavior and expectations.

The moves to float the bath freely and liberalize the financial system should remove much burden from BoT's shoulders with its credibility no longer an issue; there would be no incentive to speculate the bath movement based upon the BoT's announcements and no reason to impose any more restriction on FSFs that are geared towards internationalization. They shall instead be governed by global market forces and the protocols of international financial regimes, such as the Bank for International Settlements (BIS), the International Organization of Securities Commissions (IOSCO), and the International Swaps Dealer Association (ISDA), which are to be negotiated and adjusted on a constant basis.

What is left for the BoT to strengthen its credibility is on the issue of domestic banks and FSFs' supervision, monitoring, and enforcement. With the sheer size of the Securities Exchange of Thailand (SET) and the other rudimentary OTC and derivatives markets, financial intermediaries are still required to perform vital economic roles in 1) completing the markets by risk-bearing allocation through an arsenal of financially innovative products and services, and 2) perfecting the markets by supplying relevant price information and intelligence to their particular clientele through financial engineering activities. The BoT must exercise its utmost power to oversee these kinds of activities without hindering their innovation process and letting them jeopardizing the confidence of the public. Some regulatory reforms may seem necessary for the Thai economy to have a healthy financial services industry. Merton (1992) and Miller (1994) suggest that functional regulation be adopted in place of the current institutional regulation because financial institutions undergo more frequent changes than do their economic functions.

FSFs that are investing in sophisticated risk management techniques along with reliable risk control measures should be rewarded by the BoT in terms of their flexibility to determine their own risk-capital reserve levels. On the other hand, those FSFs that are cheating-prone and do not contribute much in the process of financial innovation while also free-riding on other FSFs' reputation and benefiting from the public misconception about their creditworthiness should be penalized or even forced to restructure or close down. The BoT, in effect, must be able to equip itself, technologically, to promote the development of efficient FSFs and measure the performance in their attempts to manage and control risks that are beneficial to the health of the overall financial services system.

My framework of analysis for the evaluation of the BoT's past performance and future credibility encompasses three issue areas namely, 1) the rough transition from pegging to floating regime which triggered domestic turmoil and region-wide contagion effects, 2) the less effective financial liberalization program without having a strong financial infrastructure to support institutional dynamics and market microstructure, and 3) the liquidity assistance and bailout plans for ailing and failing FSFs which signaled unclear messages to the markets.

The analysis focuses on the policy dilemmas facing the BoT. The BoT has to decide among the policy directions that lend the least negative impacts on the economy given the domestic political and international market environments. Somehow, the policy choices the BoT had made turned against it, especially with regard to the bailout program. Nevertheless, its behavior and past performance should be praised, with some reservations, rather than blamed myopically, compared to the similar situations in the neighboring countries.

My recommendation is that, since the financial services industry and markets structure of Thailand have recently undergone the painful transitions, the BoT has to realign its policy agenda. Instead of trying to manage the money supply in the irreversibly open-ended Thai economy directly, it should focus its efforts on developing and managing the financial infrastructure that is conducive to the stable and efficient market operations. Its credibility nexus should be founded on the basis of monitoring and enforcement of financial intermediaries' functions, which can be innovatively spiraled to financial markets. More specifically, it should initiate to coordinate the standardization of risk measurement and risk control mechanisms to be used by the FSFs. General market forces are expected to do a better job in disciplining the FSFs without too much intervention from the Bank of Thailand.

References

Flemming, J.M. (1962). Domestic Financial Policies under Fixed and Floating Exchange Rates. IMF Staff Papers, 9, 369-379.