We were primarily interested in modeling the circumstances precipitating the Asian Financial Crisis in Thailand. We therefore chose as our primary reference mode the market capitalization value of the Stock Exchange of Thailand ("SET"). Market capitalization is the total value of all stock listed on the SET at the end of a given year. Our goal was to illustrate the crisis in terms of the market crash, which was affected by transparency, confidence, and changes in interest rates. The SET was therefore the best representation of the crisis for our purposes because it reflects investor confidence, and access to information, as well as changes in market conditions including interest rates. The reference mode is reproduced in Figure 1 and is shown in billions of 1997 Thai baht.

As you can see, Thailand experienced rapid growth in the early 1990s, a leveling off, and finally a crash in 1997 when stock values plummeted.

Our model consists of two main counteracting causal loops as shown in Figure 2 (attachment). The first loop illustrates the relationship between investment and liquidity. As confidence in the market’s performance increases, foreign short-term, dollar-denominated investment in notes flows into Thailand. Capital from the notes finances long-term domestic real estate loans. Money invested in long-term loans is less liquid then it was as short-term notes, which results in decreased liquidity. Decreasing actual liquidity and the effects of the exogenous influence of low transparency both cause perceived liquidity to decrease. As perceived liquidity declines so does confidence in the market, leading to a direct negative impact on the value of the Stock Exchange of Thailand (SET), expressed as total market capitalization.

The second causal loop in Figure 2 is also counteracting and pictorially explains the relationship between investment flows and vacancy rates. As confidence in the market’s performance increases, more foreign capital flows into Thailand in the form of short-term notes (in baht purchased with foreign currency), which are used to finance long-term, baht-denominated loans for office construction. As office construction increases so does office space vacancies, due to the increase in total office space independent of demand. Office space vacancies and increasing transparency cause perceived vacancies to also rise. This influences confidence as more investors see that the supply of office space is outpacing demand. Increasing perceived vacancy directly impacts confidence in the market, causing a general downturn. As confidence in the market decreases, so do capital flows into the SET, causing its value to also decline.

These two causal loops clearly illustrate the interconnectedness and interdependence of investment, perception and market performance in relation to Thailand’s economic health and stability. We chose them because they represent all essential elements of our model logic and structure.

• In the early 1990s, higher short-term interest rates in Thailand relative to the rest of the world encouraged investment from foreign investors in short-term Thai financial notes
• The influx of foreign investment into Thailand was used to finance long-term construction loans for commercial office space in Thailand
• Office space construction rapidly outpaced demand, eventually leading to high vacancy rates
• Confidence levels regarding the performance of the Thai economy were inflated by perceived levels of financial health derived from limited transparency and access to complete information
• The combination of the decreasing interest rate differential between Thailand and the rest of the world and simultaneous increased levels of transparency led investors to stop investing in short-term Thai notes, causing a liquidity crisis. At the same time, the decreased confidence also led to massive outflows of foreign capital from the SET, reinforcing the vicious cycle inherent in the boom-bust system.

Low interest rates in the U.S. and Japan and stable currencies in Southeast Asia over time led to an increase in Thai businesses borrowing in foreign currency increasing the popularity of carry trades. A carry trade is borrowing in a local currency where interest rates are lower and then re-loaning the proceeds in the local currency where interest rates are higher. In the case of Thailand, U.S. and Japanese banks, investment houses, and insurers, borrowed in dollars or yen at lower short-term interest rates, and re-loaned the proceeds in Thailand by purchasing short-term baht-denominated notes at a higher interest rate. In Thailand, the loan proceeds were then used to finance domestic long-term loans at higher-still interest rates in real estate construction and acquisition.

The system remained stable as long as relative interest rates and exchange rates remained constant. Whenever a U.S. or Japanese held note became payable, the Thai banks would float another short-term note and use the proceeds to settle the debt. This practice is known as "rolling over" the obligations. If the interest rates in the U.S. or Japan rose, the profit on the margin between interest rates would disappear and the Thai notes would be worthless.

In the same way, if the Thai baht diminished in value relative to the currency where the original loan was taken (U.S. or Japan), the loan payments would shrink in value and the "investment" would become unprofitable. A typical scenario follows: a long-term baht-denominated construction loan at 10% is granted to a Thai construction company by a Thai bank, which floated a short-term note at 8% to finance the construction loan. The note was purchased (with baht) by a U.S. bank, which borrowed dollars at 6% to finance the purchase of the Thai note. If the Thai baht decreases in value relative to the dollar, the value of the note and the interest payments (in baht) to the U.S. bank decrease in value, while the obligation of the U.S. bank (in dollars) to its lender remains constant, thereby generating a loss.

The abundance of available unregulated and unrestricted capital flowing into Thailand in the form of short-term loans primarily financed Thai bank construction loans, which comprised 25-40% of total bank loans in Thailand. Construction included "shopping malls, office buildings, condominiums, and the like." Lenders to the Thai banks did little to ascertain where the loan proceeds went and whether they financed sound projects. Paul Krugman suggests that moral hazard and perceived implicit government guarantees of the obligations conspired to drive up the asset prices financed by the debt. He argues that the proliferation of risky lending pushed up the prices of risky assets far beyond their market values. The proliferation of risky lending resulted from moral hazard as banks and investors believed a failed loan would be bailed out by the IMF or US government. In addition, Krugman contends that the rising asset prices fueled the false perception that the market was growing and strengthening and that the financial condition of intermediaries was sounder than it was.

Morris Goldstein of the International Institute for Economics adds that loan classification and provisioning practices were too lax. There was too much "connected lending," government ownership or involvement in banks, and "crony capitalism." New loans were given to troubled borrowers so they could repay old loans and lack of arm’s length independence compromised the integrity of the market.

Political stability, once thought to be essential to economic growth, has not necessarily characterized the environment in which the Thailand tiger economy once flourished. Consider the following facts regarding Thailand’s political dimension:

• Thailand has always been a monarchy.⁹
• Thailand has been controlled mainly by the military for the past 50 years.¹⁰Thailand has not necessarily accepted democratic government as evidenced in the massacre of pro-democracy demonstrators in May 1992.¹¹
• Thailand political officials have often been corrupt, bringing down the Thai government as recently as 1995.¹²
• Thailand political officials voted to amend the constitution toward more democratic inclinations as recently as 1996.¹³
• Thai political candidates are often paid large sums of money to run for a particular political party.¹⁴

Despite these conditions, there has been an overall perception, on the part of the domestic community in general and the international community in particular, of reform and movement towards democracy and political stability. This very perception led to massive inflows of investment. The perception has not been completely false though. To Thailand’s credit, the fact that the Thai government was actually overthrown by the public’s learning of corruption within the system can be interpreted as a sign of democratic reform. And as recently as March 2000, the Washington Post reported on efforts to reform the campaigning process in Thailand by mandating that candidates are not allowed to accept any money or even talk about their platform during the electoral process.¹⁵

Despite incremental steps towards democratic reform, our systems model will illustrate how a lack of fundamental democratic practices may have significantly contributed to the Thai financial crisis which touched off the massive Asian Financial Crisis. Ironically, the democratic disequilibria that contributed to the crisis may have exacerbated the situation when more democracy came into practice during the crisis as a move was made toward equilibrium. Specifically, we will analyze the following democratic principles and their relevance to the crisis noting how their absence, and then presence, contributed to destabilizing and eventual stabilizing the system:

• Transparency
• Freedom of Information
• Democratic Governance

Transparency is key to crisis prevention.¹⁶ Despite Thailand’s reputation of having one of the most robust free presses, the lack of transparency, specifically regarding financial information, was a factor in the crisis.¹⁷ Lack of transparency led foreign investors to believe that there was more economic stability in Thailand than actually existed. The paucity of transparency contributed to the perception of roaring growth and investment opportunity, resulting in an influx of short-term debt and asset bubbles. One could argue the perception of Thailand’s unyielding economic growth was the result of tight controls on financial data crucial to investors. The lack of transparency and access to fundamental financial information regarding the actual economic picture, left an unsightly and disturbing gap between reality and perception.

Information is often thought of as the "currency of democracy."¹⁸ Without the free flow of information relevant to the financial situation, economic disequilibria ensued. At the height of the crisis, information which had previously been withheld -- most notably information regarding weak international reserves -- was released, ironically exacerbating the crisis.¹⁹ Once information regarding the true financial health of the country was shared, it sent shock waves through the investment community and investors began to withdraw from Thailand.

Due to the lack of transparency, incomplete information, moral hazard, and false investor perceptions, asset prices did not reflect true value, foreign investors became overexposed on unhedged currency positions from investments in Thailand, the real estate market in Thailand became saturated, and local Thai companies overborrowed in foreign currency. The result was an unsustainable system similar to a house of cards, which came crashing down at the first sign of an unfavorable exogenous policy intervention. Immediately preceding the crisis, Japan threatened to raise interest rates. As explained above, higher interest rates would cause the short-term foreign loans to be less profitable for foreign investors. The mere threat was enough to cause some foreign banks to immediately sell their short-term notes and "unwind" their position. As they did, they sold the baht with it. More banks followed the run after recognizing they too may be overexposed. The next card to fall was the selling of investments by mutual funds and foreign investors who were invested in the Stock Exchange of Thailand ("SET"), not because the investments lost their inherent value, but because of the indirect effect of the currency devaluation. The final and heaviest card to fall was dealt by domestic corporations and businesses. Because they had borrowed billions of dollars at low rates abroad, their loan payments skyrocketed when the baht lost value. They scrambled to sell baht and buy dollars or yen to be able to make their payments. Camdessus of the IMF stated that "the most important [devastating] factor in the depreciation of exchange rates was the rush by domestic corporations to buy foreign exchange."²⁰

The central bank of Thailand drained its international reserves trying in vain to defend the baht. With more complete knowledge of the actual financial situation in Thailand, the mass exodus proceeded with such momentum, there was little anyone could do to stop it.

Overall, the lack of transparency, free flow of information and appropriate democratic policy can be noted as an absence of good governance, of political leaders unwilling (or possibly unable) to 1). create policy to forward democracy and prevent economic disequilibria and 2). promote robust debate and dialogue and encourage sustainable reform. The disconnect between the illusion of democracy witnessed by the international community and the actual fragile democratic reform process may have also created a gap that contributed to the crisis. Increased transparency and access too relevant and compete information – in short, more democracy -- may have been the key to avoiding a crisis altogether.

The crisis and subsequent economic contraction of the late 1990s forced Thailand to revisit its economic policies in an attempt to find the precarious balance between maintaining open markets while still protecting itself against severe economic jolts and disequilibria. Prime Minister Chuan Leekpai explained the specific changes and additions to Thailand’s economic policies in a talk hosted by the Council on Foreign Relations and the Asia Society in New York in March, 1998. He described how Thailand has met the IMF’s requirements to strengthen fiscal and monetary policy, reduce expenditures, raise taxes, and reform the banking sector. Prime Minister Leekpai addressed the goal of reducing the current account deficit, plans for massive privatization of state enterprises and the creation of social safety nets.

He also spoke of political reform, which arguably is tightly linked with economic policy. With the passing of a new Constitution in October 1997, Thailand has made a move toward greater public participation in public affairs, better governance, increased transparency and accountability and more equality before the law. The new Constitution introduces a number of new measures to empower civil society and safeguard individual liberties by emphasizing gender equality, environmental preservation, local resource management, community empowerment, and basic rights in health and education.

The Thai government viewed the post crisis period as an opportunity to enact real reform and address problems with infrastructure, governance, transparency, accountability, social investment, the financial sector, the banking sector, the corporate sector, and the overall economy.

The mapping level diagram shown in Figure 3 shows the interconnection between the six sectors as explained by our causal loop diagrams and reveals the "systemic" nature of the model.

These sectors are designed to reflect the effects of transparency in Thailand on perceived financial liquidity of the Thai Banks and perceived vacancy of retail office space in Thailand, and the resulting affect on investor confidence in the Thai financial markets.

The logic is that as transparency decreases, there is a greater adjustment time from perceived liquidity or vacancy to actual liquidity or vacancy and there is greater distortion between what is perceived and what is actual. The effect of the increased adjustment time and distortion due to lack of complete access to accurate information causes investors to make decisions based on perception, which may differ greatly from reality.

Figure 4 represents the affect that transparency has on perceived vacancy, which again is a function of actual vacancy, manipulated by distortion and an adjustment time, based on the level of transparency in Thailand. Perceived liquidity follows the same logic. Confidence is then expressed as a function of perceived transparency and liquidity.

Investors make the decision of whether to invest in the SET based on perception of the market manifested by their confidence in the market. Confidence therefore is directly affected by perception, which is affected by transparency. In the financial market sector, investors decide whether to invest or divest based on SET performance in the prior year and their expectations for the current and future years, represented by their confidence in the market. As you can see in Figure 3 the three sectors of perception, confidence, and the financial market are therefore inextricably linked.

The other sector affected by perception and confidence is the "Foreign Investment in ST Notes" sector. Thai banks decide whether to approve additional long term office space construction loans, based on their perceived level of office space vacancy. In addition, confidence affects foreign investor decisions of whether to invest in the short term Thai notes.

Economic factors also naturally play a role the investor’s decision to invest. The investor decision is therefore represented in the model as a function of confidence, interest rates, and exchange rates, all of which must be favorable for a foreign investor to purchase Thai notes.

Once the notes are purchased, the foreign capital enters the Thai banks and either remains a short term asset in the form of cash due to the capital withholding requirement or becomes a long term asset in the form of a domestic construction loan. Once construction loans are repaid (30 year maturity), cash once again enters the Thai banks and can be used to service short term obligations.

"ST obligations to foreigners" is simply an accounting function used in the model to calculate the actual liquidity of the Thai banks. As a new note is purchased by a foreigner and the cash enters the Thai banks, an obligation to foreigners is established, which must be repaid within a year. Liquidity therefore is represented by the ratio of ST assets to ST obligations. The liquidity crisis was the result of obligations exceeding assets, based on decisions made by both the banks and foreign investors.

As illustrated on the mapping level, capital from the short-term notes sector is used to finance long-term loans. Capital from short-term notes is used to finance long-term loans, thus increasing the total amount of new loans issued in baht by the Thai banking sector. As new loans are issued, total obligation in long-term loans also increases.

Obligations in long-term loans are eventually repaid as they mature. The number of long-term loans repaid is a function of total obligations in long-term loans divided by the maturity time of the loan (30 years). This sector illustrates how short-term capital become less liquid as it becomes invested in long-term loans that are then used to finance office construction. It also serves as a conduit for foreign capital as it moves from Thai banks to real estate construction, thereby linking the two sectors of ST investment in Thai notes and office space construction.

Figure 6 illustrates the how capital is used to finance office space construction in Thailand which eventually leads to an asset bubble. New construction is a function of new loans being issued divided by the total cost per spare meter, which converts the baht in loans to construction in square meters. New construction fuels total construction. The number of competed buildings in each current year is the result of square meters under construction divided by the total time it takes to construct a certain number of square meters in office space.

Figure 6

Construction then fuels total available space, which is also impacted by increases in occupancy levels. Changes in occupancy levels are a function of the change in the overall economic growth rate in Thailand and available space. As seen in Figure 7, as the economy grew, more space was naturally needed, and this is illustrated in the model. The vacancy rate is calculated by dividing available space by total space (sum of available space and occupied space).

Our model reproduced the reference mode showing growth in the early to mid 1990s, followed by a market crash in 1997.

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As stated in our dynamic hypothesis, as transparency increased and adverse market conditions were exposed, investors balked and the market dropped. It is interesting to note how perceived vacancy lags transparency, but does increase as transparency increases. This is a result of the distortion and adjustment time as investors gain access to and process real information.

Thailand’s steady, rapid rise to success and dramatic fall has led economists and investors to question, revise and prescribe necessary changes to Thai policy that, if only heeded earlier, could have predicted, if not prevented, the crisis and its devastating domestic impact beginning in 1997. However, to the best of our knowledge, no theorist, academician or development practitioner has laid out a systemic structural policy framework, or even a policy suggestion, that addresses the very inherent disfunctionality of Thailand’s economic and development system.

To this end, we believe that the best way for Thailand to prevent future economic shocks is to increase transparency, participation, accountability and ownership. In short, we believe that they need more democracy to govern their corporate sector. We call this system principle-based democracy, a dynamic system for a dynamic world. This principle-based system guides without prescribing so that there is room for evolution, growth and change while still maintaining the overarching objectives of the economic system.

Fundamental to policy prescriptions for Thailand’s interactions with the world economy is to find a way to better manage openness, handle economic shocks and increase economic stability. Thailand’s policy to open and integrate into the global economy did not necessarily harm its ability to grow. What was harmed was its ability to grow sustainably --whether financially, environmentally or socially – because Thailand’s economic policy framework did not yet have transparent and participatory ways of managing and regulating openness. Thailand became vulnerable to economic shocks because their system was not as participatory, transparent and accountable as it should have been at the onset. Lack of a democratic regulatory infrastructure culminated in economic crises when reports of Thailand’s economic health surfaced in the summer of 1997.

A specific look at Thailand and the Asian financial crisis reveals that the Asian economies most affected by the reversal of capital flows in the summer of 1997 were the most open but also the most lacking in a solid financial and macroeconomic framework. Policies for trade, investment and exchange were secondary.

What is needed in Thailand as demonstrated in our model is a sustained, conscious commitment to an overarching policy of principle-based democracy in recognition of the fact that globalization and the market alone do not provide guidelines for dynamic growth. Taken alone, globalization is not a policy, it is an outcome of policy. The reality is that a country cannot simply open its markets and expect that the market will regulate itself. Nor can it adopt a protectionist strategy if it is to engage in a globalized economy. What is required is a balance of openness and regulation. Principle-based democracy can provide this system. Amartya Sen, Noble Laurate in economics captures the potential of democracy transforming an economy when he says, "A country does not have to be deemed fit for democracy; rather, it has to become fit through democracy."

Could principle-based democracy have prevented the Asian crisis and facilitated more sustainable growth? We believe it could have. But ultimately, it is difficult for two American students to determine how principle-based democracy operationalized in Thailand would be made manifest. What we have suggested here is how a commitment to an overarching policy of principle-based democracy, as an economic and development framework in Thailand, could be the best systemic strategy for this country’s success in the 21^st century.

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