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Tuesday, March 1, 2011

On Bank of Thailand's Policy Stance in the Context of Local and Global Forces

First a brief on approaches to risk management at financial institutions and in foreign relations.

Contingent credit lines (CCLs), colloquially known as overdraft facilities are used by firms to ensure operational liquidity.  A CCL is essentially an up-and-out American barrier call option sold by an FI.  Here, the strike is the market credit spread of the client, i.e., the credit spread that the client would be charged if it were to avail a similar facility directly from the market.  And, if the client's FI-estimated default spread were to rise to hit the barrier at any time during the term of the facility then the CCL facility would be automatically cancelled [1].

FIs manage the default risk on CCLs on the basis of diversification.  Hedging is an alternative approach to managing default risk.  However that does not work for a portfolio comprising CCLs issued to SME firms in emerging markets (EMs) such as Thailand because (i) barrier options cannot be hedged when the market credit spread of the client is close to the barrier, (ii) the hedge instruments would be a portfolio of forward default swaps and there is no liquid market for forward default swap contracts written on SME firms.  So, diversification is the only practical way.

Similar approaches hold for mitigating foreign relations risk.  One of the long-term consequences of the recent events in the Middle East and North Africa (MENA) region will be a structural break in political games - they will change from (if I may exaggerate a little) one-party games to multiple-party games.  In a one-party game hedging can be practical.  Unlike in matters related to risk management at FIs, hedging turns increasingly ineffective as a tool to manage risks in foreign relations in a multi-party game, just as diversification becomes increasingly more suitable.  China’s foreign policy approach in the MENA region is predicated on the assumption that hedging would work.  This has indeed worked for China in the past.  But it will work less in the future as MENA dynamics shift to multi-party games.  China however does not appear particularly skilled at using the diversification approach to managing foreign relations risk.  Therefore the events in the MENA region do not look good when viewed from China’s perspective.

Yours, thinking about the MENA region, Analyst,


Disclaimer: The figures below are approximate.  While the general argument stands, I do not recommend using these figures for your professional work.

The US government conducted its first round of quantitative easing (QE1) in 2008 to prevent a credit crisis-induced deflation spiral in non-consumable real assets.  Despite QE1 deflation in non-consumables has continued to remain a primary concern in the US policy circles.  Consequently the US government initiated a second round of quantitative easing in 4Q2010.  The first round of quantitative easing transferred a fair bit of toxic assets to the government.  With the US government’s credit rating intact, this raised the capitalization of the US financial system from its dangerously level.  Lending to the private sector however continued to decline.  Where there was surplus capital it was recycled back into US government securities or kept aside for acquiring failing financial institutions (FIs) of which there were plenty.  The important point here is that money from QE1 did not leave the US shores.

Investment opportunities in the US have remained few.  However the risk of failure of large US-based FIs has fallen considerably since 2008.  Thus unlike during the period of QE1, reserve excess on account of QE2 flowed out of the US shores.  The EMU is expected to barely register any growth; Japan is much too dependent on international demand for growth; what China needs is not more financial capital but a rebalancing of its growth model.  The US-based FIs therefore channelized the excess due to QE2 into commodity markets [2] and countries such as Thailand [3] which have a liberal capital control framework, a robust domestic demand and, low public debt/GDP and interest payment/tax receipt ratios.

The surge in capital inflows has also found its way into the property sector which in Thailand had already started witnessing a strong upward price trend since 1H2010 due to the return of consumer confidence, economic buoyancy and the near-absence in exposure of Thai banks to toxic mortgage-backed securities or reliance on wholesale markets for funding.

Wage price inflation in Thailand is however a home-grown phenomenon - its cause is mainly structural - the chronic failure of technical education to keep pace with other factors that have made Thailand an attractive manufacturing destination.  Though in recent years attempts by political leaders to find broader acceptability has also contributed to wage inflation, particularly in low paying jobs.

While credit mispricing in the property sector and in the corporate sector is a growing concern, inflation has been the primary target of BoT’s monetary policy calibration in recent periods.  After 13 consecutive months of keeping the benchmark rate at 1.25%, BoT decoupled its interest rate policy from the West - it carried out 25 bps increases in the benchmark rate in the months of July, August and December last year and then again in Jan-2011, bringing the benchmark rate to 2.25%.

Even before Thailand began raising its benchmark rates, its currency had been appreciating.  To relieve some of the appreciation pressure in 2009 BoT began allowing Thai firms to invest directly in foreign securities.  The move however had little impact then and THB/USD strengthened 2% y/y in 2009 and 12% y/y in 2010.  Given this background the rise in Thai benchmark rates has encouraged volatile capital flows [4] which in turn have tended to boost further currency appreciation.  This could hurt non-agricultural exports in 2011 as this year the Thai economy cannot draw power from base effects and given that global recovery turned out to be much weaker in 2010 than consensus view, the expectations on recovery in 2H2011/1H2012 are more conservative. 

Liberalizing capital outflows is another tool that the Thai authorities have exercised so far.  In 2H2010 the limit on outward FDI, including on those in overseas affiliates of Thai firms, was scrapped and the limit on loans to overseas firms and on investment in offshore property were raised.

To curb THB appreciation the BoT also added calibrated capital control to their repertoire of tools.  For example, in Oct-2010, the 15% tax exemption on foreigners’ earnings from investment in Thai bonds was removed and the sale of bill of exchange [5] certificates to non-residents was banned.

Despite these measures however, short-term capital flows continued on the upward trend and with that, the THB has been appreciating against most major currencies [6].

The Thai authorities are likely to continue encouraging outward FDI and dampen foreign demand for short-term bonds and other financial assets.  Interest rates are likely to be increased further albeit at a slower rate than in 2H2010.  Major hikes are unlikely though even if they occur they are likely to occur only after the general elections that are likely to be held in 3Q2011.  Until then the government will likely continue to rely on subsidies to curb food, transportation and energy price inflation.  Hiking bank reserve ratio is unlikely to help in the case of Thailand though could be used as a signalling mechanism.  In the face of continuing uncertainty in global recovery and the looming political risk in Thailand [7], BoT is unlikely to repeat the harsh capital controls imposed during 2006-08 which triggered what turned out to be the worst peak-to-trough fall in Thailand’s stock market’s history [8].

·      Potential policy missteps with regards to capital control measures
·      Heightened awareness of political risk in the context of the on-going political instabilities in the MENA region à sharp reversal of capital flows into Thailand à a sharp fall in THB/USD à soaring inflation [9] 

[1] E. Loukoianova, S.N. Neftci, and S. Sharma, Pricing and hedging of contingent credit lines, IMF WP/06/13.
[2] Commodities serve as an inflation hedge and their prices are supported by robust consumer demand in several EM economies
[3] in SE Asia, Malaysia, Thailand and Vietnam, and to a lesser extent, Indonesia
[4] Foreigners hold 7% of Thailand’s government bonds and 37% of stock exchange assets (Dec-2010 est.).
[5] A bill of exchange offers higher interest rate than comparable deposit instrument since the former does not carry deposit insurance.
[6] except since events in the MENA region forced international investors to turn greater attention to political risk
[7] Over the past two years aversion to countries that have a debt servicing problem has been a principal factor determining global capital flows.  With the profound changes that are taking place in the MENA region, political uncertainty has come to fore in the minds of international investors.  While Thailand scores well on measures of debt serviceability, it does not on the latter.
[8] The harsh capital control measures triggered the fall but the Global Financial Crisis of 2008-09 was in large part responsible for the magnitude by which Thai stock market receded.
[9] Baring wage price inflation, other causes of inflation in Thailand will not be mitigated by capital flight.

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