Euphemisms, at times, go a long way in changing perceptions. What was once the Third World, gradually became a developing country, and is now an emerging market. And look how that helped in attracting money into these emerging markets.
Paul Krugman, the Nobel Prize-winning economist, in his book The Return of Depression Economics and the Crisis of 2008, writes, “Investment funds coined a new name for what had previously been called Third World or developing countries; now they were “emerging markets,” the new frontier of financial opportunity.”
And how did that help? Investors, who would have pooh-poohed investing in third world countries, came in the droves for pumping funds into emerging markets. “In 1990 private capital flows to developing countries were $42 billion…By 1997, however…the flow of private capital to developing countries had quintupled, to $256 billion,” writes Krugman.
A lot of this money went into what were seen as “apparently safer economies of southeast Asia.” Thailand was one such country, where the money came in from Europe and Japan.
And how did the game work?
Krugman explains, “A Japanese bank makes a loan to a Thai “finance company,” …The finance company now has yen, which it uses to make a loan at a higher interest rate, to a local real estate developer. But the developer wants to borrow baht, not yen, since he must buy land and pay his workers in local currency.”
The finance company lending the yen had to buy baht. “The foreign exchange market is governed by the law of supply and demand…the demand for baht by the finance company will tend to make the baht rise in value against other currencies,” writes Krugman. But the Thai central bank, the Bank of Thailand, helped keep the exchange rates stable.
“Thailand’s central bank was committed to maintaining a stable rate of exchange…To do this, it would have to offset any increase in the demand for baht, by also increasing the supply, selling baht and buying foreign currencies like the dollar or yen,” Krugman writes.
This entire process led to an increase in the foreign exchange reserves of Thailand as well as the money supply of the country. “There would also be an expansion of credit in the economy — not only the loan directly provided by the finance company but also additional credit provided by the banks in which the newly-created baht was deposited.
And since much of the money lent out would itself end up back in the banks in the form of new deposits, this would finance yet further loans,” explains the author.
As the economy was flooded with credit, new investments were made, but speculation also took off. “Some of this took the form of actual construction, mainly office and apartment buildings, but there was a lot of pure speculation too, mainly in real estate, and also in stocks,” writes Krugman.
The Bank of Thailand tried to curb the speculative boom by trying to sterilise the inflow of money. “It was obliged to sell baht in the foreign exchange market, but it would try and buy those baht back, somewhere else by selling bonds.” By doing this it was essentially borrowing back the money it had just printed to sell baht and buy foreign currencies like yen. This free flow of money drove up income levels, making exports from Thailand a tad uncompetitive.
But like all good things, this credit machine also came to an end. “Partly due to external events: markets for some of Thailand’s exports went soft, a depreciation of Japan’s yen made south-east Asian industry a little less competitive. Mostly, though, it was simply a matter of the house beating the gamblers, which in the long run it always does,” writes Krugman.
This created its own set of problems for the Thai central bank. With foreign money not coming in, the demand for the Thai baht started to fall. “With fewer yen and dollars coming in, the demand for baht on the foreign exchange market declined; meanwhile, the need to change baht into foreign currencies to pay for imports continued unabated. In order to keep the value of the baht from declining, the Bank of Thailand had to do the opposite of what it had done when the capital started coming in: it went into the market to exchange dollars and yen for baht, supporting its own currency.”
The trouble here was, when the foreign money was coming in, the Thai central bank could print all the money it required to buy the dollars and the yen coming in, to keep the value of baht stable. But now with the demand falling it had to sell dollars or yen and buy baht to support the value of baht.
Now of course, the Thai central bank couldn’t print dollars or yen. The other way of course was to simply stop buying baht and let the value of baht go for a free fall. The trouble here was that any “devaluation of currency would hurt the government’s reputation but also because many banks, finance companies, and other Thai businesses had debts in dollars. If the value of the dollar in terms of baht were to increase, many of them would find themselves insolvent.”
The central bank kept buying bahts till its foreign exchange reserves ran out. On July 2, 1997, the Thais let the baht go.
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