A Comparison of the Thai (1997) and Icelandic (2008) Financial Crisis

As we have noted, one of the turning points in the perception of the fragility of Icelandic banking crisis was a short report by the research department of the Danske bank in 2006, which coined the term ‘Geyser Crisis’ for Iceland. The report looked at the financial indicators in Iceland and came to the alarming conclusion that the imbalances were even larger than those of Thailand in 1997 (and Turkey in 2001). The only indicator that was not worse in Iceland was public finances. Of course, there are significant differences between the structure of the two economies and the krona was freely floating, whereas the Thai baht was a pegged currency that closely followed the US dollar. Nevertheless, allowing for all the differences, the report comes to the conclusion that “a possible Icelandic crisis could follow much the same lines as in Thailand” (p. 7). In this section, we pursue this comparison further and look at the implications for the use of capital controls.

On the eve of the Asian Financial Crisis, Thailand was seen as one of the region’s great success stories. Growth was rapid and the country was running a budget surplus, although there was a substantial current account deficit. However, many institutional failings were hidden by this fast growth. The fundamental cause of the crisis stemmed from the substantial amount of foreign capital that poured into Thailand, partly from the carry trade and partly because Thailand was seen as an exceptional investment opportunity. A major factor was the financial liberalization that began in the 1990s. This was part of an attempt to turn Bangkok into a regional financial hub with the opening up of the capital account in 1993 and the creation of the Bangkok International Banking Facility (BIBF). Like Iceland, Thailand’s financial system was dominated by the banks.

The Asian Financial Crisis commenced with the collapse of the previously pegged Thai baht in July 1997. In the previous months, there was growing concern about the financial viability of some of Thailand’s property companies and the crisis was precipitated by the collapse of Finance One, Thailand’s largest financial institution. The financial strategy of Finance One, which was followed by many other financial institutions, was to borrow short-term US dollars by issuing Eurobonds and using the funds to lend long-term notably to Thailand’s property developers, leading to a boom in real estate finance. “Thus, greed fed speculation and then into Ponzi-type financing. Projects were launched in the expectation that they could be listed in the stock market so that the promoters could take an instant profit in the bull market. In a rising market, financial institutions agreed to provide short-term bridge loans repayable on successful listing. When the bull stopped, the projects stopped, and the banks were left with bad loans on their books” (Sheng 2009, p. 140). Moreover, as in Iceland, banks such as the Bangkok Bank of Commerce (BBC) gave huge loans, without undertaking due diligence, or insisting on collateral, to senior BBC executives and other individuals. It became clear that the Thai banking system did not have the experience to deal with this rapid explosion in financial intermediation and also did not have the capacity to effectively regulate the rapidly growing banking system.

As in Iceland, risk management in the Thai banks became weak and the financial institutions took advantage of the differential in interest rates; in this case between the USA and Thailand. However, in the case of

Thailand, the proximate cause of the crisis was the collapse of the property market and the fact that the property developers could not pay back the loans they had received from Finance One and other financial intermediaries. The causes of the Asian crisis did not fit into the traditional explanation of currency crisis. These include the attempt of governments to peg the exchange rate with only limited foreign exchange reserves. If the market believes such a defense of the exchange rate is futile then there could be a run on the currency, even leading to a self-fulfilling prophecy. But, as Krugman (1998) emphasized, this was not the case of the Asian crisis. He states that “The Asian victims did not have substantial unemployment when the crisis began. There did not, in other words, seem to be the incentive to abandon the fixed exchange rate to pursue a more expansionary monetary policy that is generally held to be the cause of the 1992 ERM crisis in Europe.” The causes bear a marked similarity to those of Iceland in spite of the vast difference in the level of economic development and the fact that Iceland had not pegged its exchange rate. Thailand, the first of the Asian countries to collapse, had liberalized in the 1990s. Foreign exchange controls had been relaxed so that it was possible to borrow from foreign markets and these borrowings could be passed on to Thai customers. The cause of the Asian Financial Crisis was the search by speculative investors for high returns in these markets. Non-bank financial intermediaries borrowed short in foreign currency (largely dollars) and lent to the speculators who invested in assets (largely real estate), causing an asset bubble. The financial intermediaries were encouraged in this by the implicit guarantees from what were seen as the close political connections with the Thai institutions, who were supplied with these funds. Hence, it was a classic case of moral hazard as these led to excessively risky investments. The rapid rise in asset and real estate prices made the financial situation of the intermediaries seem more solid than they actually were. It does not take much to cause an asset bubble to collapse. The collapse of Finance One sent a strong signal to the financial markets that the Thai government could not always be relied on to bail out failing banks. Once this became clear, and with a continuation of the fall in asset prices, there was a run on the baht by the currency traders who came to the conclusion that the rate at which the baht was pegged was unsustainable and who therefore sold the currency short. The exchange rate became unsustainable in the face of this speculative attack, because most of the Thailand’s foreign exchange reserves ($33 billion) had been tied up in forward contracts, with only $1.14 billion available. However, it is doubtful even if the remainder of the reserves had been readily available, the peg could have been saved.

The IMF was called in on 28 July 1997. Tight monetary and fiscal policies were imposed, resulting in a downturn in output of over 10 percent in 1998. In 2003, in its evaluation report, the IMF conceded that the first-phase policy recommendations had exacerbated the economic situation. Capital controls were not used.

As in the case of Iceland, it was clear that part of the problem of the Thai, and, more generally, the Asian financial crisis was that the financial intermediaries were not always able to use commercial criteria when deciding whether or not to issue a loan when dealing with politically powerful or well-connected potential borrowers. As Krugman (1998) puts it, the financial intermediaries were often owned by ‘Minister’s nephews’. A further similarity was that the rapid growth disguised the extent of the risky lending, but once doubts were raised these economies would become extremely vulnerable to a financial crisis.

What is clear in the case of both the Asian and the Icelandic financial crisis is that the primary cause was the excessive growth in foreign borrowings and lack of effective oversight by the regulatory authorities. In such circumstances, there is a case for capital controls on inflows. We have seen that the liberalization of the Thai capital account occurred too rapidly and there was not the mechanism to limit the excessive borrowing of foreign exchange by the financial intermediaries.

One of the causes of the IMF’s change in view towards capital controls is the development of theoretical models within the prevailing neoclassical paradigm, which provide a theoretical rationale for them. This has led to the so-called ‘new economics of capital controls’, of which Korinek (2011) provides a useful overview. He starts with the observation that there is a close correlation between the degree of market liberalization and financial instability. One of the reasons is the widely accepted view that rapid inflows into the emerging economies are excessive and can lead to financial instability, as evidenced by the Asian financial crisis. The question is: how to prevent this?

The case for capital controls for prudential reasons is based on the typical sequence that there is a shock to a financial variable. This leads to a fall in aggregate demand and a depreciation in the exchange rate and a collapse in asset prices. This has adverse balance sheet effects due to the declining value of collateral and net worth with the increase in the value of the foreign debt in terms of the domestic currency. With imperfect capital markets, this leads to reduced access of agents to finance and/or greater credit spreads leading to a further cut back in spending. Hence, there is an amplification effect on the initial shock and a vicious circle develops. A key assumption is that agents, when taking a decision to borrow on the foreign exchange markets, take the exchange rate and asset price, or the level of financial fragility, as given. They ignore any effect that their decision may have on increasing the fragility. But their actions have a ‘pecuniary externality’ effect when there is a borrowing constraint.

This means that the agents take on too much risk when borrowing, which leads to an excessive degree of fragility. Consequently, in this model, Pigouvian taxes on the stock of financial liabilities to reduce the overall level of risk will make all agents better off. In particular, this would reduce the amount of short-term dollar-denominated debt. Korinek (2011) illustrates this argument with a two-period representative agent model. Clearly, this presents a theoretical argument for capital controls in the case of Thailand; but in the case of Iceland it is a second best argument. This is because effective prudential banking regulation and risk assessment of loans and stress testing by the CBI should have been in place to prevent the excessive growth in loans.

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