Financial Liberalization and the Capital Account : Thailand, 1988-97

Thailand's economic crisis in 1997 was fundamentally one of private sector debt, rooted in private behavior that affected the magnitude and composition of investment and how it was financed. Thailand's crisis provides further evidence that financial liberalization must be carefully managed because, by increasing competition, it lowers the franchise value of existing financial institutions and creates incentives for unsound banking practices.Alba, Hernandez, and Klingebiel examine Thailand's macroeconomy and micro-economy for the period 1988-97 to assess the extent to which the country's mix of macroeconomic and financial sector policies contributed to its economic crisis in 1997.They conclude that the crisis was fundamentally one of private sector debt, rooted in private behavior that affected the magnitude and composition of investment and how it was financed.Unlike the Latin American debt crisis, the Thai crisis was not caused by excessive sovereign borrowing.Financial sector weaknesses - including inadequate regulation and supervision, implicit deposit insurance, concentrated ownership structures, and poor accounting and disclosure - combined with liberalization of the financial sector and capital accounts, increased vulnerability by creating incentives for risk-taking by financial institutions.Many macroeconomic fundamentals were strong, but the combination of tight monetary policy and an inflexible exchange rate created strong incentives for residents to expose themselves to excessive foreign exchange and liquidity risks.Weak corporate governance, including close corporate links to the banking sector, encouraged risky investments and overdiversification in the corporate sector.This paper - a joint product of the Economic Policy Division, Poverty Reduction and Economic Management Network, and the Financial Sector Strategy and Policy Department - is part of a collaborative effort with the Asian Development Bank to understand the management of private capital flows in Asia. The authors may be contacted at palba@worldbank.org, lhernand@condor.bcentral.cl, or dklingebiel@worldbank.org