1. Thailand: Riding the Financial Crisis Roller Coaster
By: Connor Rice

2. I. Introduction
Ever since its formation in 1939, Thailand has gone through a lot of political instability.
The country was formerly called Siam, until a bloodless revolution in 1932 led to a constitutional
monarchy. The country allied with Japan during World War 2, yet switched its alliances to the
United States since their troops fought alongside America during the Korean War. In 1997,
Thailand was the cause of a major financial crisis that affected not only the economic welfare of
Thailand itself, but also the rest of Southeast Asia. During the 1990’s Thailand had been
prospering economically, which caused foreign investors to overestimate the amount of
investment they could stably put into Thailand’s economy as well as the amount of economic
stability the country had. Due to a lack of proper government practices when it came to fiscal
and monetary policy, the value of the baht ended up collapsing. The inability of politicians to
give loans to investors caused widespread bankruptcy in addition.
Thailand has dealt with a large amount of political turmoil as well in the past decade,
with the removing of Thaksin Chinnawat, the prime minister of Thailand since 2001, during a
military coup in 2006. In 2008, 2009, and 2010, there were massive protests by competing
political factions. Thaksin’s younger sister, Yinglak, gained power through winning an election
in 2011, but her power was almost overthrown due to a massive flood that hit Thailand in 2011
that almost completely inundated Bangkok. The World Bank estimated that the economic
damage caused by the flood was 1,425 billion baht. (CIA World Fact book) Throughout 2012,
the Puea Thai-led government has attempted to create government reform as well as political
reconciliation, but it faced a large amount of opposition from Thailand’s Democratic party.
Many have been killed in the violence associated with ethno-nationalist insurgency in Thailand.
The country has been speculated to potentially have another crisis, which could be caused similar

3. factors of the 1997 one. In order to stop that, Thailand needs to pay attention to a plethora of key
economic policies, since ignorance of them led to the sad story of poor policy decisions leading
to economic collapse.
II. The Buildup To Poor Decisions Due to Export-Oriented Growth And Surging FDI
As stated, one of the main drivers of this financial crisis was the sudden extreme
devaluation of Thailand’s currency, the baht. In the early 1990’s, the baht had a pegged
exchange rate against the U.S. dollar of about 25 baht per dollar. (Worldbank) However, there
was a difference in the two countries in terms of interest rates. The real interest rate in Thailand
was 9.2% in Thailand, where in the United States the real interest rate was 6.4%. (Worldbank)
Thus, many banks that were based in Thailand started borrowing from the US in terms of dollars,
converting the dollars into Baht, and then lending the baht for the higher interest rate. There is
an obvious arbitrage opportunity, as the spread among the interest rates is 2.8 percentage points.
People started noticing Thailand originally because economic performance in Thailand
was stellar from the 1980s into the early 1990s. From 1986 to 1988 real GDP growth per year
rose from 5.5 percent to 13.3 percent. (WorldBank) The main driver of such great GDP growth
was Thailand’s shift from import substitution to export oriented industrialization. Originally
Thailand and other nations in the area were called “Newly Industrialized Economies,” because
they had recently broken from military rule and were working their way to becoming developed
nations. Initially, during a period from the 1960’s to the mid 1970’s, Thailand and other
economies took a policy of import substitution, where an emphasis was put on consuming
domestic goods and services over imports to increase aggregate demand and stimulate growth of
national income. (Siriprachai 2) However, during the 1980s Thailand switched to Export oriented

4. industrialization in order to achieve more rapid economic growth. This resulted in the previously
stated GDP increase and an ensuing investment boom.
Thailand GDP Growth 1980-1990 (Source: Worldbank)
Thailand’s economy attracted a large degree of foreign direct investment at this time. The
government was loosening its policies on international trade left and right. There were decreased
tariffs, liberalized trade policies, and investment promotions. (Jiranyakul) This influx of
economic prosperity led to an increase in confidence in the investment sector, as new projects on
infrastructure increased dramatically in the 1980s until the 1990s. Thailand’s increase in
infrastructure was attributed to large foreign direct investments from foreign nations such as
Japan, the United States, the United Kingdom, and Singapore. Thailand was seen as the perfect
place to put FDI for countries with strong currencies such as Japan, where in Thailand labor was
cheap and natural resources were plentiful.

5. Exports to the three countries that were Thailand’s major trading partners (United States,
Japan, Singapore) accounted for 47.22% of exports in 1990 and 48.65% of exports in 1995
(Jiranyakul) Imports from the three partners accounted for about 49 percent of all imports in
1995. Most of the FDI was going towards non-tradable projects however, which put upward
pressures on the price level. During the late 1980’s, the percentage of Thailand’s GDP that was
exports consistently increased through the mid 1990’s. In 1983 exports made up 20% of
Thailand’s GDP, where in 1988 it made up 33% of Thailand’s GDP. (Worldbank)
Thailand also imported heavily from other countries. By 1989, Imports accounted for
35% of Thailand’s GDP. (WorldBank). These imports consisted mainly raw materials,
(including petroleum) capital goods, and chemical goods. As imports were greatly increasing
compared to exports, Thailand was becoming increasingly import dependent and was suffering
from current account deficits.
With increasing net exports, as seen by Thailand, income also increased. This increase in
demand would apply to both traded and non-traded goods and services. Tariff reductions
liberalized the importing of goods, which helped to mitigate some of the aggregate demand
increase that was attempting to push up domestic prices. If prices became to high, exports would
start to suffer, which would take a huge toll on Thailand’s export-oriented economy. This trend
continued throughout the 90’s, which caused the current account balance to decrease steadily.
The appreciation was real, as the central bank had the baht pegged to the dollar at an of
25$/Baht, but the real exchange rate ties in the price level in the country compared to price levels
of other countries, so exports would still suffer.
With the increasing price level, it was key to keep inflation down or GDP growth would
take a massive blow. The central bank, for the most part, did a fairly good job of managing

6. inflation. The inflation rate throughout 1990-1996 was consistent at about 5.1% on average.
Thailand also had an impressive savings rate situated at around 33.5% of its GDP. (Worldbank)
However, this was due to a lot of spending of foreign reserves, which came back to haunt
Thailand later on.
III. Here Comes the (Investment) BOOM
During the early 80’s the borrowing that accounted for the increase of net capital inflows
was equally distributed between the public and private sectors. (Jansen) Capital inflows for the
country also exceeded its current account, implying that Thailand was increasing its federal
reserves. A likely move, as an increase in the amount of debt incurred would require the central
bank to have backup ammunition against having to default on their debts that are owed to foreign
monies. The central bank was building up foreign reserves when times were good, because the
central bank printing money and buying foreign currency would not have terrible effects since
the economy was in an expansion. The government feared exchange rate devaluation, so while
the economy was doing well in the early 1990s, the central bank of Thailand could easily print its
own currency and sell it for currencies abroad and keep those for a later sale if people started to
think the baht was going down.
Later, in the period of 1987 to 1992, most of the borrowing was towards the non-
financial sector. Thus, most of the money went into industries that were booming at the time,
such as foreign companies that had been setup by foreign prospering nations such as Japan.
Thailand started relying heavily on cheap Japanese imports for machinery during this period.
However, during the period from 1992-1997, the focus of capital inflows was focused on
the financial sector of the economy. This change was partially due to changes in the government
policies at the time. Originally, Thailand was maintaining an interest rate ceiling at around 5%.

7. Then, once policies of the government changed, the interest rate was able to move freely and
then started to increase to around 8 or 9 percent. This attracted a new business sector of financial
institutions that started accounting for a great amount of foreign debt. Monetary policy of
Thailand also made this easy because the Bangkok international Banking facility (BIBF) was
established. The idea behind this policy was that most of the transactions would be “out-out,”
meaning countries would borrow abroad and then lend abroad. Unfortunately for Thailand, the
transactions were “out in” and as mentioned before, people were borrowing abroad and then
lending in Thailand, where interest rates were high. This meant there would be a significant
amount of risk for Thailand if interest rates abroad started to rally.
If, for instance, the interest rates in the United States start to increase, investors will see
that there is a better opportunity to earn money back in the United States than there is in
Thailand. Thus, investors will withdraw a large amount of deposits from the banks in Thailand
and start investing them in American assets or other assets abroad. The withdrawal of funds
from banks in Thailand are running out of reserves because most of their funds had been lent out,
which leads of to an inability of banks to provide liquidity. Thus, unless the central bank or some
other institution could bail out the banks, bankruptcy ensues.
Most of the major firms were highly leveraged as well, causing an even greater risk of
having large amounts of debt. The leverage ratio of Thai corporations increased from 1.6% in
1988 to 2.4% in 1996. (Worldbank) According to Karel Jensen, high amounts of leverage will
equate to large swings in exchange rates and or interest rates (Jensen 131) When Thailand policy
makers started to realize this situation, it started reverting to capital controls. There were large
attempts in 1995 to keep foreign exchange flow interaction down. The minimum amount on
foreign borrowing for the BIBF was raised to 2 million US dollars. A withholding tax was

8. introduced on interest payments on foreign loans in addition. Finally, banks and finance
companies had to make interest-free deposits at the central bank equivalent to 7 percent of short-
term non-resident deposits and of short-term foreign borrowing. (Jansen 131-132)
The Thai government did do a good job when it came to saving. Looking at the data,
fiscal spending policy was pretty stable during the early 80s up until the late 1990s. Around
1985, the government shifted to a more effective control of the budget, imposing strict
expenditure ceilings and lowering the ceiling on public sector borrowing. (Jansen 129) The
government expenditure fell from 19 percent in 1985 to 14 percent in 1989-1990. (Jansen 129)
One cause of the decrease was the massive growth in GDP that occurred, but government cuts
played a role as well. Government expenditure was stagnant from 1985 to 1999. Having a
budget surplus in the context of Thailand was beneficial because it would help keep price level
down as well as pay back loans. With the increasing domestic demand, price levels were bound
to go up, so it was good that the government didn’t worsen the price level in Thailand by
increasing the price level through spending on goods and services.
However, investment booms basically cancelled out the budget-surplus benefit, so this
was still a crucial time for the central bank of Thailand to take action. The central bank focused
on keeping the inflation rate stable, in hopes that this would balance the exchange rate
difference, which relates to purchasing power parity. Purchasing power parity suggests that one
could take any currency, trade it for another currency on the exchange rate market and then buy
the same basket of goods in the country of the foreign currency as a basket of those goods in the
original country. The inflation rate throughout 1990-1996 was consistent at about 5.1% on
average. However, the exchange rate was pegged and interest rates were high, which led to some
of the arbitrage opportunities that triggered the investment boom. At first, monetary policy was

9. mainly controlled through the direct change of money aggregates. However, there was a shift in
monetary control to interest rates once the financial sector started having a more prominent role
in Thailand’s economy, contributing to the arbitrage opportunities.
Even though a common function of Central banks is to be a lender of last resort, financial
institutions had become less and less dependent on Thailand’s central bank for credit. Central
bank credit stood at 54 percent of the monetary base and 5.1 percent of the broad monetary
aggregate at the end of 1998. (Jansen130) By 1996, these respective ratios had fallen to 20% and
1.8%. Most of the financial institutions leverage came from abroad as well. The net foreign
liabilities of commercial banks and finance companies, as a percentage of M3, increased from
less than 5 per cent in 1986–90 to 19 per cent in 1994 and 25 per cent in 1995/6. (Jansen 130).
Fiscal surplus also implied that the government was running out of bills that could be
sold. With a large current account deficit, debt was already held a fair amount by foreign
investors. To solve this problem, the central bank started printing some of its own bonds in
certain years between the late 80s and the early to mid-90’s, in attempt to reduce some of the
high liquidity that resulted from the swarm of net capital inflows. However, most of this attempt
of monetary policy contraction didn’t do much, as the central bank issued 33 million baht in
bonds, which was only a small fraction of the foreign borrowing by financial institutions. (Jansen
131)
IV. A Bad Combo Of Financial Malice and Poor Monetary Policy
Another setback that caused Thailand to exacerbate their dilemma was how poorly their
financial institutions were run. Most of the banks and financial institutions gave loans that did
not take into consideration the ability of borrowers to pay back loans, rather the criteria was
based on relationships held with the banks. A paper written by members of the Institute of

10. Economic Research at Hitotsubashi University said, “Some of the connected families are
connected to the owners of banks by marriage. For example, members of the Sophonpanich
family, which has been the largest shareholder of the largest bank in Thailand, the Bangkok
Bank, married to the Leesawattrakun and Srifuangfung families. The Lamsam family, which has
been the largest shareholder of the Thai Farmer Bank, the third largest bank as of the end of
1996, is also tied to the Wang Lee, the Yip In Tsoi, and the Chutrakul by marriage for more than
one generation.” (Chutatong Charumilind Raja Kali Yupana Wiwattanakantang 12-13) In
addition, scholars have found empirical evidence that companies with high degrees of
shareholdings are the ones who banks dealt with the most directly, “We define firms as
connected to these connected families if any of these families own at least a 10% stake in the
firms. Our results show that 22.22%, 26.30%, and 32.96% of firms in our sample are affiliated to
the top 20, 30, and 60 connected families. About 11.48% of the samples are those in which the
controlling shareholders are the major shareholders of banks and finance companies.”(13) It was
also extremely difficult for non-connected banks to get loans because they were charged interest
rates that were very high and unrealistic, “The banks stick to cartel practices, segmenting the
market between prime customers, who have to be given rates that are comparable to those on
international markets, and other customers who are charged much higher rates.” (Jansen 135)
Scholars have dubbed this practice of lending to close relatives as “cronyism” because the
process of lending is not based on merit. Often times, these bad loans had huge negative
consequences, sometimes leading the banks to foreclosure. For instance, the Bangkok bank of
commerce allegedly granted a very large amount of loans to firms that were affiliated to Rajan
Pillai, Rages Sakdina, Adnan Khashoggi and Suchat Thanchareon, who were close friends of the
bank’s president and major shareholder, Krirk-kiat Jalichandra. (Crony Lending 10)

11. The Central bank did not do a good job of preventing financial institutions from making
bad loans either. The Bank of Thailand punished neither financial institutions responsible nor
major executives for lending to risky projects that led to ill-performing loans. The BOT also
failed to recognize that problems with loans given after 1991 were serious and needed to be dealt
with urgently. (Crony Lending) To the central bank’s defense, there were plans for foreign
banks to come into Thailand in order to increase competition, but the plans were slow to
materialize and did not come in time to mitigate some of the downsides of the crony lending
done by Thai banks.
Some of the bad lending by banks and financial institutions went to assets that were
greatly overvalued as well. For instance, many loans went into backing up real estate. However,
Thailand had become less competitive in terms of exports starting around the mid 1990s.
Countries like China had increased their exports they sold which became too much competition
for Thailand to stand up against. In addition, semiconductor demand had gone down in the
world overall, which hurt Thailand because semiconductors were one of Thailand’s major
exports. Thus, around 1995, Thailand’s economic growth was becoming slow. The large amount
of buildings and residential housing that were built became less desired, so vacancy in Thailand
started increasing. Thus, many business owners were unable to pay back loans they received
from financial institutions. The dollar did not help matters either, as an increasing amount of
individuals saw the dollar as the currency to be held rather than the baht, which put even more
pressure on the central bank of Thailand to keep the baht from devaluing.
The Central Bank was trying as hard as it could to keep the exchange rate pegged. As
stated before, there was a massive building up of foreign reserves, which was held in order to
protect the baht from falling in value. It then sold these reserves in order to keep the baht stable

12. once financial liberalization kicked in. It was only a matter of time until the rest of the world
evaluated how unstable Thailand’s financial system and economic policies were. The financial
system failure would have deadly consequences as well, as financial institutions made up a
significant portion of Thailand’s stock market. If stock markets plummeted, thousands of people
would have lost the dollars they had invested, resulting in an economy-wide slump.
Thailand Total Reserves as a Percentage of Total Debt (Source: Worldbank)
V. STOP!.... Crisis Time
In late 1996, the baht finally began to come to its knees. The bad loans that were made by
Thai banks started coming to light, which caused people to believe that the banking system in
Thailand was going to fail. Because of all the uncertainty, people in Thailand started to believe

13. the baht would eventually fail. The central bank of Thailand attempted to keep the value of the
baht from decreasing by selling its foreign reserves, which would increase the supply of foreign
reserves held by the public, thus decreasing some of the need for people to trade in baht for
foreign currencies. From 1994-1996 reserves as a percentage of total foreign debt for Thailand
dropped from 46% to 34%. (Worldbank). Thus, people tried to speed up the process of baht
failure by borrowing in baht, then exchanging that for foreign currencies. Then, once the baht
lost its value, people could convert the foreign currencies they had back into baht and pay back
their loans, which have now become cheaper to pay off because of the decreasing value of the
baht. Another type of arbitrage opportunity had presented itself.
When Thai banks and financial institutions started to fail, the Thai government could not
keep its bailout promises, which many of the banks and financial institutions had been counting
on for compensation on the bad loans they made. However, because they had used so much
money to purchase foreign reserves, they could not give the banks additional funds in fear it
would trigger capital outflows. In addition, the central bank also said that it would attempt to
save “Finance One,” Thailand’s largest financial institution, by organizing a merger with another
financial institution, similar to JP Morgan purchasing Bear Stearns during the financial crisis of
2008. The central bank also failed to live up to this proposition. The bank was already
struggling defending the baht to such a great degree that when these financial institutions failed,
the central bank could do almost nothing to help them.
Finally, when practically all of its reserves had been used to defend the Baht, the central
bank switched from a fixed exchange rate to a floating exchange rate in July of 1997. As soon as
the announcement was released, the value of the baht dropped from 25 baht per dollar to 28 baht
per dollar. By December of that year, the value of the Baht had plummeted to 48 baht per dollar,

14. which means the baht became worth half of what it used to be worth. When the baht lost so
much of its value, all the people who had been borrowing in foreign currencies and lending in
baht would have a much more difficult time paying back the loans that they took out in the
foreign currencies. The arbitrage opportunities were eradicated with the baht floating and
devaluing massively. Banks that had borrowed heavily in foreign currencies now would have an
even tougher time paying back the loans they had already taken out, because now they would
have to have double the money they had before just to pay back the principals on their loans.
Some of the more connected banks were able to avoid the serious bullet of defaulting on
loans because they had an easier time getting long term loans instead of short-term ones. These
banks, instead of having to pay back principles on their loans, would only have to pay the
interest rate disadvantage. For instance, if the interest rate gap was still in effect, and a bank had
borrowed 1 million in a long term loan and then loaned it in the baht, they were making out well
at first because the interest rates in Thailand were higher than other countries. Now, with the
baht devaluing, the interest these banks would earn in Thailand would give them half the money
they were getting before, so the interest payments became a lot more expensive. The money they
needed to take out of their own pockets was feasible, however, where the short term loans had
much greater consequences because the principles of the loans were ridiculously high, which
most banks were unable to pay.
With such a great devaluation of the baht, it would mean that imports would start
becoming much more expensive. Since Thailand was already suffering from a huge current
account deficit, a devalued baht would be extremely bad news for the economy as a whole.
People’s average costs of goods would skyrocket and some people may have had trouble getting
their daily needs.

15. The uncertainty that was created throughout this failing of banks and financial institutions
and devaluing of the baht should also be mentioned. The stock market inevitably crashed thanks
to so many failing businesses. From mid 1995 to mid 1998, the stock market went from a market
value of 1400 index points to almost zero. (SET trading economics) With the stock market
crashing, businesses failing left and right and a huge devaluation kicking in, Thailand was at its
lowest low.
VI. IMF, IMF, IMF to the Rescue!
Thailand asked many institutions to aid them on their defaulted loans and lost funds due
to the financial crisis. Some declined, but Thailand ended up receiving funds from the
International Monetary Fund of 35 billion dollars for reform and adjustment to the Thai financial
system. (IMF) 85 billion dollars was also given through multilateral and bilateral resources, but
those funds were not successfully used. (IMF) The IMF also helped restructure the poor actions
taken by various firms in the financial and non-financial sectors in order to prevent ill projects
from being taken on like during the buildup to the catastrophe of 1997. All weak financial
institutions were closed in order to stop further losses, central bank supervision of financial
institutions was closed, and regulation required for financial intermediaries was tightened. (IMF)
At first, some of the policies initiated by the international monetary fund weren’t as
successful as they had hoped. First, the Thai population still questioned the effectiveness of
policy implementation due to premature rollbacks of monetary tightening and political
uncertainties. Also, information was revealed in regard to the standings of official exchange
reserves of the bank of Thailand further increased uncertainty. Thus, exchange rate
depreciations and capital outflows did not decrease as much as was hoped at first. (IMF)

16. Since the exchange rate increased to such a high extent and efforts were slow to
materialize, Thailand went into a much deeper recession than expected. During 1997 when the
crisis started, annual GDP growth decreased to -1%, and in 1998 it decreased further to -11%.
(Worldbank) Monetary policy was tight, which included the pushing up of interest rates, which
would increase the demand for the local currency. With a higher interest rate, people would
make more profit by investing in Thai baht, which would cause some capital inflow after the
massive amount of capital outflow resulting from the crisis. The crushing amount of short-term
debt had to be paid as well, which stood at about 36.5 billion US dollars and Thailand only had
2.9 billion of net official reserves (Sussangkarn).
Thailand’s situation seemed to be ameliorating to some extent once 1999 came around.
By the end of March 1999, foreign reserves had increased to about 14 billion, which is a ratio of
slightly less than .5 when compared to Thailand’s short-term debt. (Sussangkarn). The
government was hesitant to use foreign funds even though interest rates were back to pre-crisis
levels between 2000 and 2002. The global economy was also suffering from a slump during this
period, which caused Thailand’s exports to suffer and GDP to not grow as rapidly as hoped.
Bank policies were getting back on the right track, which initiated a boost in economic
growth. One bank, called Krung Thai, was government owned, which was successful in the post
crisis period because of an inundation of funding from the Thai government’s proceeds, thanks
to the IMF. Government owned asset management companies were able to eat up most of the
loans given out by commercial banks that could not be paid back, dubbed non-performing loans
(NPL’s). (FRBSF) With this boost of the company’s balance sheet, the company had an
advantage on other private owned banks and commercial banks. The government stressed banks
like Krung Thai to lend to individuals with credit problems that could not borrow from other

17. banks, which led to Krung Thai controlling 20% of Thailand’s commercial banking sector.
(FRBSF) The increasing amount of domestic credit worked successfully for the betterment of
Thailand’s business cycle, as Thai growth grew by 5.4% in 2002 and by 6.7% in 2003, and
consumption grew by 4.9% and 6.2% respectively. (FRBSF). The current account turned to a
surplus that allowed Thailand to pay off its debt to the IMF early. The Baht had slowly begun to
rise up again in the early mid 2000’s, which caused Thailand to make more off of its exports and
afford its imports. Since Thai growth was centered around domestic credit this time around,
there was no risk of the rapid depreciation of the baht through extreme amounts of net capital
outflow.
There were perceived risks that increasing credit rapidly even domestically could cause
Thailand to fall into the same set of ill circumstances that came about in 1997. Part of this was
due to the credit boom of the mid 2000’s. Policy makers and researchers feared that a high
amount of increased credit would cause a growth bubble similar to those that have occurred in
areas like real estate. The IMF had done studies showing people see the perceived growth thanks
to domestic credit expansion, but once some of the loans prove to be unsuccessful, the highly
leveraged banks that are common in emerging economies fail, causing an economy wide slump
just like the one that had previously occurred in Thailand. IMF reporting stated that private credit
booms in emerging markets are associated with a 70% probability of consumption and
investment booms, followed by banking crises with a 75% probability, and currency crises with
an 80% probability. (FSBSF) However, total growth income levels did not return to their pre-
crisis amounts until six years after the crisis. (Allen Hicken)
What was done during the crisis had a deep impact on Thailand’s political system and for
the general well-being of the Thai people. Thailand’s politics were completely revolutionized.

18. Pre-crisis, Thailand’s business elite were behind the scenes on the set of Thailand’s politics.
This played into Thailand’s connected lending problems that resulted in the plethora of NPL’s,
which led to the failure of banks and financial institutions. Thailand’s political scene also
consisted of a wide range of parties that did not have sufficient policies and were short-lived.
This brought Thai politicians to take on roles where government positions were predatory rather
than beneficial to the Thai economy. The policies of many political parties were mainly based
on gaining support for a narrow group of politicians to gain a candidate specific network of
support. Thus, most politicians did not take on policies aimed at providing public goods.
(Hicken).
VII. Conclusion
Overall, Thailand suffered from an attack from the economic triangle of fixed exchange
rates, free flowing capital, and independent monetary policy. The main lesson observed through
academics is that if a country has two of these policies instated, it is impossible to stably keep the
third. Thailand’s train of thought as to stabilizing its exchange rate was that if purchasing power
parity holds, then keeping the inflation rate low would cause the exchange rate to be relatively
stable. However, due to monopolistic tendencies of some firms, barriers to trade, and differing of
the real quality of goods across different countries all combat purchasing power parity’s validity.
In the long term it works empirically, but not in the short term, so there was no way keeping
inflation under control could maintain the fixed exchange rate. Essentially, Thailand tried to
allow free capital flows while keeping the exchange rate pegged, yet it also allowed interest rates
to become extremely high causing an inundation of foreign demand for the baht in terms of
lending. Thailand should have let the baht float early in order to balance some of the decrease in
demand for baht. This would have caused financial institutions to be able to pay their debt more

19. efficiently. Alternatively, it could have done a better job with managing interest rates. Since the
purchasing power parity doesn’t hold in the short run, the high interest rates to combat inflation
did not work; it just caused people to pursue hot money, which led to the huge increase in capital
inflows. Fearing the flows would reverse, the central bank kept their interest rates high, since
they feared investors would leave if they did not. Finally, if they really wanted to keep their
exchange rates pegged and their interest rates high, there was no way they should have allowed
that much foreign capital to come into their country because it would lead to financial crisis like
the one that occurred. Poor monetary and fiscal policy led to an obvious arbitrage gift, which
caused Thailand to be economically exploited by the whole world.

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