Not a storm in a Thai cup

Thailand’s December 2006 currency crisis has already been deemed a storm in a teacup. That is a mistake. It is an early warning of the dangers posed by the global imbalances. That’s not because the Thai government’s botched attempt to constrain the surge in its currency will trigger a domino reaction through South East Asia in 1997.

Far from it. History does not repeat itself exactly. A decade ago Thailand was trying to put the brakes on a massive sell-off in its currency after a boom ran out of steam. The Thais took on the speculators and lost. This time they tried to curb the rise in their currency because of the volume of foreign money flooding in to bet on the future success of a powerful emerging economy.

So far, so similar to the run-up to the 1997 crisis. The difference this time is that most of the Asian economies run a flexible exchange rate system – apart from one. The elephant in the room is China. Foreign investors pile into the liberal economies of South East Asia, knowing their rights are more likely to be protected than they are in China.

But of course the more money they pump into those economies the more those currencies will rise, in turn putting their exporters under an exchange rate pressure. The relevant exchange rate is with the dollar, the currency used by the region’s largest consumer, the United States. Rapid currency appreciation for one country simply means a loss of competitiveness in the US export market vis-à-vis China. The Americans won’t notice and the Chinese won’t care.

In other words as long Beijing holds down the yuan’s exchange rate with the dollar, then other smaller countries will be forced to accept a competitive disadvantage of try and take action to stem the rise in their currency. Given that Thailand saw its currency surge and then suddenly fall a decade ago, it is not surprising that the authorities tried to avert a repeat performance.

Many people have criticised the decision to impose a 10 per cent penalty on short-term foreign investment. It was heavy handed but what else was a small economy to do? It could have cut interest rates that would have stoked domestic inflation. They must also have decided against buying more dollars, perhaps because the current US exchange rate looks untenable.

The problem lies with the stand-off between the US and China. The US has a record trade surplus with China. Normally that would trigger a drop in the debtor’s currency to that of the creditor. But that’s not allowed to happen. The result is a surge in other Asian currencies. This unintended consequence is exactly the sort of spillover effect that the International Monetary Fund is now trying to target under its proposed new exchange rate surveillance system.

The IMF wants to refocus its surveillance operation to spot the spillover effects from one economy on to the global system rather than just worry about the domestic challenges of each of its 184 members. That is certainly the right approach to prevent the IMF making itself obsolete. But if it is find an agenda for the 21st century it needs to show it can spot the sort of tension currently playing itself out in South Asia.