Currency Movement Enigma

There can be two arguments for considering high current account deficits to be dangerous in themselves. First, they are financed by large capital inflows which tend to distort resource allocation. Second, they trigger expectations about imminent currency depreciation and tend to bring on speculative attacks. While the former happened in Thailand through over-investments in real estate, the second was not believed to be likely. But when the currency crisis came, it was precipitated by the latter rather than the former.

Why were there no expectations about a speculative attack? Unlike Mexico, Thailand did not use capital inflows to finance consumption. The investment to GDP ratio shot up from 28.2 per cent in 1985 to 43.1 per cent in 1995. While this was partly financed by an increase in domestic savings, especially government savings, a good part came from foreign capital inflows. Nor was this foreign capital deployed inefficiently. Compared to Mexicos incremental capital/output ratio (ICOR) of 7, Thailand had an ICOR of 4.8. In fact, there were clear signs that foreign capital inflows were stimulating export growth and thus, no questions were asked about Thailands inability to service its external obligations. The debt service ratio, as a percentage of export earnings, declined from 31.9 per cent in 1985 to 11 per cent in 1995 and Thailand was classified as a less indebted country.

So the speculative attack was not due to any overall change in the perception of fundamentals. It was triggered by a sudden realisation that the financial sector was in bad shape and exports were temporarily down. There is more to fundamentals than just these. Once the herd instinct took over, reserves of $40 billion were not enough to sustain a speculative attack where $60 billion consisted of short-term debt. Thailands problems did not lie just with the current account deficit but the composition and destination of capital flows and vulnerability of the financial system. Globalisation makes economies increasingly vulnerable to cross-border movements of private capital, sometimes on the basis of fairly narrow considerations. Much comfort is being taken in India over its current account deficit being 1.5 per cent of GDP, when its financial system remains quite vulnerable. So further drastic financial reforms should not wait.