46. Exchange Rate and Financial Crisis
Between the two extremes of the fixed and the floating exchange rates
are a number of intermediate regimes. One is the adjustable peg, in which
the local currency is pegged to, say, the us dollar but remains adjustable
from time to time by the central bank. The example of Thailand in 1997
shows that this regime can prove to be risky for economies with financial
weaknesses or macroeconomic imbalances.
Before the crisis, the fixed-but-adjustable peg in Thailand did give
investors and banks a false impression that exchange rate risks were more
or less eliminated. Many Thai companies and financial institutions had
confidently borrowed large amounts of foreign currency to invest in
domestic projects, mostly real estate, creating an unhealthy currency
mismatch between the foreign currency-denominated debts and the baht-
denominated earnings. At the same time, the Thai economy also suffered a
large trade deficit and did not have enough foreign exchange reserves.
These factors lead analysts to believe that it would be impossible to
maintain a fixed rate. A run on the currency started as people tried to
convert their baht holdings into US dollars. After spending most of its
foreign reserves in the market to defend the peg, the Thai central bank
finally allowed for a large depreciation of the bath in July 1997.
Since the crisis, some Asian countries have switched to more flexible
exchange rate regimes, while others continue to peg. The Thai baht, which
lost 50-60% of its value during the crisis, is now under a managed float,
whereby the baht is allowed to float within a certain range. The central
bank would intervene to defend the currency whenever the exchange rate
fluctuation were deemed to be excessive. The Malaysian ringgit, which was
also allowed to depreciate, was repegged at 25% of the pre-crisis value.
China and Hong Kong weathered the crisis and kept their pegs. The latter
will be discussed in the next article.
