I am talking about an imaginary country which is a member of Asean. This country may or may not exist. To avoid unnecessary negative repercussions, this country shall remain nameless and be referred to as country "N" with its currency "D". This country is the star of Asean with a 5-year average GDP growth rate of 7% prior to the Covid outbreak.
Even during the outbreak, the country was able to maintain growth close to 3.0%. The World Bank projected that its 2022 GDP growth would be 7.2%, the highest among Asean countries.
Shockingly, this star country is now facing the risk of running into a crisis similar to Thailand’s Tom Yum Kung crisis in 1997.
We know three problems about this imaginary country, but we do not have clear information about the fourth problem, which naturally is the most important. The known problems are: (1) the stock market has taken a nosedive since April (2) a liquidity crunch in the third quarter, and (3) depleting foreign reserves from balance of payments deficits.
The problem that we do not know is the missing foreign exchange reserves data for July to September. The analysis is based on this information.
First problem: Evaporating investor confidence. Since April 2022, the stock index has plummeted 42.6%. This should not be happening in a country with 13.7% GDP growth in the second quarter. Under capital outflow pressure (?), the central bank raised its discount rate from 2.5% to 3.5% on Sept 22. The bank had been holding the rate constant at 2.5% since October 2020, regardless of what happened in the outside world.
Second problem: Tightening domestic liquidity. Although the central bank never admitted there has been capital outflow, the liquidity situation in the country is rather tight.
On Oct 7, many commercial banks raised their deposit rates to attract depositors. Here are the deposit rates of one major bank: 7.5% for a 6-month deposit, 7.8% for a 9-month deposit, 8% for a 12-month deposit, and 8.4% for an 18-month deposit. This is not an inflation-led interest increase as the inflation rate was only 3.94% in September.
This situation is not ordinary to me. Wouldn’t it be much cheaper for banks to pay a discount rate of 3.5% to the central bank rather than raising deposits at a cost of 7.5% and more? The situation could be similar to the first half of 1997 in Thailand. The Bank of Thailand warned financial institutions to find their own liquidity or risk a shutdown, which the Bank of Thailand actually did.
Third problem: Depleting foreign exchange reserves. The worst problem facing N, much like Sri Lanka, is inadequate foreign reserves. Foreign reserve data is only available to June.
June’s reserve data is already a point of concern. The country’s reserves are equal to 3.1 months of imports which is at the borderline of safe. According to the IMF’s recommendation, a country should have reserves to cover 3-6 months of import payments. Reserves lower than the equivalent of one month of imports means the country is in crisis. Sri Lanka began 2022 with only 1.5 months of reserves available.
Country N’s economy is a booming economy. When an economy is booming, the country will use its foreign earnings to import raw materials, stockpile products, upgrade factories, and improve infrastructure. What would one choose if one runs a smart government?
Choice A: keep lots of foreign currencies in the central bank account, which earns a 1% yield on US government bonds. Choice B: giving foreign currencies to local industries, which earn 10% profits. That is why country N’s GDP growth for 2019 was 7.2% while Thai GDP growth of that year, even with income from 40 million tourists, was 2.2%.
However, there is a line somewhere, and country N crossed that line like Thailand did in 1997.
From 1992-1996, Thailand enjoyed an average of 7.6% GDP growth. A booming economy like that was always thirsty for liquidity.
Thailand satisfied its liquidity appetite with foreign borrowing. Towards the end of 1996, the country hit its borrowing limit. It was time to make a U-turn for a soft landing. The tight liquidity situation was clear as the interbank lending rate doubled. Instead of preparing for a soft landing, the government and Bank of Thailand strived for a 7% growth for 1997.
The Bank of Thailand made an unwise move by defending its currency (and its fixed exchange rate system) by heavily intervening in the foreign exchange market. It won the currency speculation battle in March 1997 but incurred a heavy reserve loss.
To cover up the wound, the bank arranged for foreign reserves to be higher than they actually were. How this is done shall not be revealed. Let me say that this move was like handing a gun to your enemy to shoot you. What happened after is well-known.
The similarity between country N and Thailand prior to 1997 is high economic growth rates which require a constant high level of liquidity. The difference is country N adopted a flexible exchange rate regime, but Thailand in 1997 adopted a fixed exchange rate regime before the crisis.
However, the difference between the two exchange rate regimes will be none if central banks intervene in the exchange market to stabilise their currencies as if they were adopting a fixed regime. This leads to the important fourth problem.
Fourth problem: Missing third-quarter data. The central bank of N was able to report foreign trade data up to September, showing a positive trade balance of $1.14 billion. But it only reported foreign exchange reserves data up to June. This is not because of a data-gathering problem; it simply chooses not to report. This is as dubious as China currently delays the release of key economic data.
In this third quarter, the US dollar appreciated 7.7% against world major currencies. But currency D only depreciated 2.6% against the dollar.
Did the central bank of N intervene relentlessly to keep the value of its currency stable despite large capital outflows? With the fact that internal liquidity suddenly become tight and investors dumped stocks for cash, the evidence seems to point that way.
Things look worse in October. With data up to Oct 18, currency D depreciated a further 2.4%, indicating that money continues to flow out of the country. This time it is not the interest rate gap but a lack of confidence in the economy.
Another key point of concern is country N’s external debt of $130 billion, of which 26.6 billion is short-term. If short-term debt is not extended or recalled, country N’s foreign reserves could fall below two months of imports.
This is a crisis in the making, indeed. Country N must immediately restore investor confidence by ensuring enough foreign reserves to cover four months of imports, or the country could risk being like Thailand in 1997.