A recent photo between Prime Minister Abiy Ahmed (PhD) and George Soros, the most famous hedge fund manager, kicked off a firestorm on social media. Soros, also the founder of Open Society Foundation, became famous after betting against the Bank of England in the 1990s for a gamble that made his fund a billion dollars richer. It earned Soros the nickname, “The Man Who Broke the Bank of England.”
The most famous of Soros’s speculative trades might have been the pound, but it was not the only one. What happened to Thailand, one of the fastest growing economies in Asia in the 1990s, dubbed Asian Tigers, should be a stark reminder that a developing country should not open its capital account.
In 1997, Thailand was experiencing economic problems similar to those of Ethiopia’s today. The Asian country was consuming more than it produced, paying for the difference with loans from foreign entities, had an export revenue that was declining and was subsequently running a huge trade deficit.
This arrangement left Thailand exposed. If foreign entities were tired of lending to it, the country would have to export enough to cover its import bills, repay its debt and improve its performance in the external sector, which meant that the Thai currency, the baht, would have to fall sharply.
Thailand was refusing to acknowledge reality, to abandon its link to the dollar and allow a less valued currency to restore its competitiveness. Much of the foreign lending to the country was denominated in dollars, and it was channeled into projects such as real estate that generated revenue in baht. It meant that if the dollar jumped against the baht, these debts would become impossible to service.
The similarity to the macroeconomic situation in Ethiopia today is uncanny. Ethiopia’s exports have severely underperformed, stagnating at around three billion dollars for the past eight years. The IMF has warned that policy slippage or further delays in export growth would increase debt distress.
The present value of debt to exports (PVDE) exceeds the threshold under all alternative scenarios, with the shock to exports having the largest impact. This export shock could result in breaching debt servicing as soon as the 2019/20 fiscal year.
The risk of debt distress is high due to the small export base, which Ethiopia’s government has long believed was a temporary feature. But it was not, and the problem continues to this day. Export performance in the first half of the current fiscal year shows that revenues continue to decline.
It was a Thailand under a similar circumstance that Quantum Fund, under the helm of Soros, found in the 1990s. The roots of the Thai crisis stretched to 1995 and 1996 when the central bank refused to devalue their exchange rate gradually in the face of China’s rise. The government was committed to using monetary policy short of a gradual devaluation of the currency to attract capital into the country.
The speculators began shorting the Thai baht by the billions, which is betting the currency will fall in value compared to another currency and placing a sell order on a currency pair. In this case, Quantum went long on the dollar and short on the Thai baht.
The first solution the Thai government came up with was to sell a chunk of its dwindling foreign-currency reserve and raise interest rates by three percentage points, a punishing hike for Thai banks. But since the measure came late as Quantum had taken out baht loans of six month durations and had locked in the low-interest rates that had existed before the government hiked them.
When Quantum increased its short position, the Bank of Thailand was forced to use at least six billion dollars from its reserves to maintain the Baht’s level, almost twice that of Ethiopia’s currently. Thailand’s government still refused to embrace devaluation.
The Thai authorities forbade all banks from lending baht to anyone outside the country. The clampdown on lending to foreign entities, combined with the central bank’s aggressive intervention, succeeded in reversing the baht’s fall. Thai currency gained 10pc against the dollar, and Quantum and similar hedge funds booked perhaps half a billion dollars in losses.
But the Bank of Thailand had used up 21 billion dollars worth of reserves in May alone, two-thirds of its war chest. Harassing short sellers encouraged non-nationals who had lent dollars to Thai businesses to demand repayment, and the businesses dumped baht as they scrambled to meet their obligations. This led to the Bank of Thailand running out of reserves.
After months of resistance, the baht peg snapped. Over the next three months, it fell by 32pc against the dollar, and the Soros fund gained about 750 million dollars from the devaluation.
Soros defended his action by invoking the function of the “virtuous speculator,” which was to alert governments to the need for change. This signaling could avoid hardship for ordinary people, since the more a government procrastinated on devaluation, the more brutal the eventual currency collapse would be. Thus when the crisis came, there would be nothing left to cushion the shock as capital flew out of the country.
Meanwhile, Thailand’s output collapsed by close to a fifth of its peak, destroying businesses and jobs and plunging many into poverty.
“History doesn’t repeat itself, but it often rhymes,” as Mark Twain said.
Ethiopia should take a lesson from the 1990s Asian Tigers. A developing economy should not open its capital account, because it leaves an economy with a fragile financial system vulnerable to sudden outflows. This can create a financial collapse.
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