Tuesday, July 31, 2007

10:45 PM: I think it would be better to open a new blog on the baht crisis. The previous one is already too long. I would like, if you don't mind, to copy my latest report on Dr Olarn Chaipravat's view on the baht management. This would help us continue our long, arduous journey into the complex world of foreign exchange. (This is a slightly revised version from the printed one). 

Economist raps BOT over baht

Central bank is failing to act in halting currency rise, says Olarn

The Nation, Published on Jul 31, 2007

By Thanong Khanthong 

If the Bank of Thailand had intervened in the foreign exchange market sufficiently, it would not only have gained profits but would also have succeeded in arresting the baht's rise, said Dr Olarn Chaipravat, one of the country's top economists.

In an interview with The Nation, Olarn said: "The problem with the central bank is that it is facing foreign exchange losses not because of the intervention but because of its failure to intervene in the foreign exchange markets sufficiently."

Two weeks ago, Olarn was the first well-known economist to lash out at the central bank over its mismanagement of its foreign exchange policy. Without a specific target for the baht exchange rate, the central bank has allowed the currency to slip out of control, which has resulted in a sharp rise in its value that is hurting the overall Thai economy.

On Friday, the baht closed at 33.70 to the US dollar. Now honorary adviser to the Fiscal Policy Research Institute, Olarn calls for the central bank to keep the baht at 34 to the dollar in order to support the competitiveness of Thai exports.

He has come up with the Bt34 figure through his economic model, which compares the competitiveness of the Thai exchange rate with those of China, Vietnam and other neighbouring countries such as Ma-laysia and Singapore.

MR Pridiyathorn Devakula, the former central bank governor and finance minister, earlier called for the central bank to keep the baht at 34-35/dollar, compared with Dr Virabongsa Ramang-kura's 36/dollar.

Olarn and his research team have been closely following the capital flows and the central bank's foreign exchange operations. They have tracked the central bank's balance sheets in minute details.

To his dismay, Olarn has found that the central bank does not seem to have any foreign ex-change strategy at all to deal with the rise of the baht. Its daily foreign exchange intervention also seems to lack direction in influencing the movements of the baht to the desired levels, he said.

To illustrate his point, Olarn and his research team studied the baht situation between July 2 and July 27. The currency reached a 10-year high of 33.24 on July 16. Coincidentally, the period marked the 10th anniversary of the baht's devaluation, which triggered the full-blown financial crisis.

The baht's movements depend on supply and demand. Whenever there is more dollar supply than demand, the value of the baht will rise. When there is less dollar supply than demand, the baht's value will weaken.

Overall, capital moves into and out of the country through five channels: the current account, foreign direct investment, equity, debts and bank loans. Olarn cited the first week of July as an example. Between July 2 and July 6, Thailand posted $155 million in the current account surplus, $125 million in net foreign direct investment, $598 million in net equities, $40 million in net debt and $200 million in net loans. The total amount was around $1.11 billion.

But forward foreign exchange contracts sold by exporters and other players to help reduce the exchange risks, of US$2 billion, bringing the total dollar net inflow of US$3.118 billion in the first week of July, which exerted pressure on the baht rise.

But the central bank bought $578 million in the spot market and the forward market to stabilise the baht in the first week of July, at an average of $106 million a day, compared with $70 million a day in the last week of June.

By doing so, it issued bonds worth Bt18.03 billion ($578 million multiplied by the exchange rate of Bt34) in order to raise the baht from the financial system to purchase the dollar, in case that its intervention took place with 100 per cent in the spot market.

If its intervention was 50 per cent in the spot market and the other 50 per cent in the forward market, then it would only need to issue bonds worth about Bt9 billion because it could delay the bond issue for the forward market.

The Bt18 billion of bonds issued by the central bank that week to buy dollars came at a cost of 3.5 per cent based on its repurchase rate. It then deposited this amount at Chase Bank in New York at 5 per cent. The central bank earned around Bt700,000 a week in interest rate differential.

Without adequate foreign exchange intervention from the central bank, the burden naturally fell on the shoulders of the commercial banks, which were obliged to spend less in baht to buy dollars. With this half-hearted intervention, the central bank allowed the baht exchange rate to rise from 34.52/dollar on June 29 to 34/dollar on July 6, or an exchange rate appreciation of Bt0.52.

With the exchange rate appreciation of Bt0.52 that week, the central bank had to post book losses from its foreign reserves holdings of $83.048 billion (including forward positions) by another Bt42.911 billion when marked to market. Since it earned Bt700,000 a week from its dollar deposits in Chase New York, the central bank still ended up with a book loss of Bt42.910 billion that week.

Olarn argued that in the first week of July, if the central bank had intervened by buying up at least $2.45 billion in dollar supply both in the spot and forward markets, it would have succeeded in halting the baht's appreciation and also made profits.

The baht, he said, would have been able to stabilise exactly at 34.52 if intervention amounted to $431 million on July 2, $632 million on July 3, $556 million on July 4, $445 million on July 5 and $390 million on July 6.

In that particular case, the central bank would have issued bonds worth Bt84.65 billion to raise the baht from the financial system to buy dollars. This amount of bond issue would carry a cost of 3.50 per cent but the dollars earned would be deposited in Chase New York at 5.0 per cent.

In this instance, when marked to market, the central bank would have squared its position without any foreign exchange loss but would have gained Bt3.49 million in US dollar interest. Its foreign reserves would have increased to $84.974 billion (including the forward positions).

The central bank's book loss of Bt42.910 billion in that first week could have been prevented if it had intervened sufficiently and tactfully enough, Olarn said.

Since the beginning of this year, the central bank has posted about Bt160-Bt170 billion in book losses from its foreign exchange intervention. Without sound and target zone oriented foreign exchange operations, it will continue to pose foreign exchange losses, making it even more reluctant to intervene in the foreign exchange market.

Since the baht peaked at a 10-year record of 33.24/dollar on July 16, the central bank has increased its intervention, resulting in a downward drift of the baht to 33.70/dollar last Friday.

"Now they should target the exchange rate at Bt34 and try to work it out to that level," Olarn said.

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My Overdrive Column

Get Competitive or Be Left Behind

Union Footwear and Rangsit Footwear have become the latest victims of the strong baht and rising operating costs.

They have announced that they would be shutting down their businesses and laying off about 2,400 and 1,900 workers respectively. A month ago, Thai Silp Southeast Asia Export and Import, a textile company, also went bankrupt and laid off 5,000-6,000 workers.

Across the country, labour-intensive factories and plants are battling through hard times. What is going on with Thai industries? Is the strong baht alone responsible for these economic woes?

It is easy to blame the baht for the eroding competitiveness of Thai industries. Last year they were exporting their goods and converting the US dollar proceeds into baht, getting something like Bt36-Bt37 to the US dollar. Now with the exchange rate hovering around Bt33-Bt34, their profit margins have been badly squeezed because of the costs they incur.

The Bank of Thailand has been waging a fierce battle to curtail the baht's rise but the Thai currency has appreciated sharply along with the Philippine's peso and South Korea's won. The current account surplus and the capital inflow into the Thai stock market have largely driven up the baht's value.

Thailand had already recorded a current account surplus of US$6.2 billion (Bt209.6 billion) in the first half of this year. International money managers have also shifted their investments into Thai equities, the price/earnings ratio of which remains the cheapest in the region. The Stock Exchange of Thailand index breached 800 in early July as investors bet on the country's smooth transition to democracy and an economic recovery next year.

But the capital inflow has complicated economic conditions by pushing up the value of the bath and thus giving labour intensive industries a hard time. The future of such industries looks bleak indeed.

In fact, Thai industries have been warned all along about the need to adjust the way they do business in order to stay competitive or improve their productivity. But they are too slow to make the necessary adjustments. The appreciation of the baht is only one of many problems facing Thai industries, which are also facing rising operating costs, higher labour costs, intense competition, labour shortages and problems related to inefficient management.

You may be surprised to learn that Thailand is facing a labour deficit. We do not have enough low-wage labourers and hi-tech workers. About two to three million migrant workers from Burma represent Thailand's largest pool of cheap labour, while foreigners are dominating hi-tech industries. We do not lack labour at the middle level.

Thai industries have been complaining about the labour shortage for quite some time. Turnover is also high as workers move in and out all the time, making it difficult to provide them with proper training and improve their skills.

Most multinational exporters are doing fine because they are part of a global production network. Overall, the global economic environment has been so sound that Thai exporters continue to register double-digit growth. But labour-intensive exporters are having a difficult time keeping up.

Thailand is now arriving at a critical juncture. It needs to transform itself into a truly middle-income economy because it no longer can compete against China or Vietnam. And we are now witnessing some significant adjustments going on.

Capital flow into Thailand goes through five channels. Let's call them, in the words of Dr Ekniti Nitithanprapas of the Finance Ministry, the "Five Rivers" - Ping, Wang, Yom, Nan and Pasak. They are current account, foreign-direct investment, equity, debt, and bank loans. So far capital flow is almost a one-way street, making it difficult for banking authorities to manage baht stability.

But monetary policy is only one tool. It can't solve all the complicated problems facing the Thai economy. The Thai central bank can't cut interest rates so steeply because it would face problems with its bond issuance, which would be necessary to sterilise its foreign-exchange intervention.

Now is a good time to take advantage of the baht's rise to upgrade Thai industries through imports.

If industries start to import new equipment, they will improve their production capacities and enhance their competitiveness. Many economists say that imports should recover next year with improved domestic demand and growing confidence in the political atmosphere.

The authorities have already approved a package of foreign-exchange liberalisation measures to make it easier for Thai industries to invest abroad. Listed companies now will be allowed to take more money out of the country to do this.

Fund managers have been allowed to invest their private funds abroad to gain better yields. The Bank of Thailand may also set aside a portion of its foreign-exchange reserves to establish a sovereign wealth fund, which would invest in foreign assets.

Exporters have been permitted to hold their dollars longer, while residents of Thailand and companies have also been allowed to open foreign-currency accounts at local banks.

All of these measures are aimed at encouraging capital outflow but also at improving the management quality of Thai industrialists, money managers and investors. They are part of a medium- to long-term adjustment of the Thai economy as a whole. We have to succeed on this front otherwise we will compromise our prospects of gaining more prosperity.

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Wednesday, August 1, 2007

Half-hearted FX intervention costs dearly

2:15 PM: Why does the Bank of Thailand suffer foreign exchange losses? The losses amounted to Bt188 billion in 2006, and, according to Dr Chalongphob Susangkarn, the finance minister, about Bt170 billion between January until now.

To sum it up, the BOT has heavily suffered losses from its foreign exchange intervention because it fails to buy up enough dollar to keep the exchange rate at a certain level.

If it matches the dollar inflow with its intervention by buying up the dollar, which would help it maintain the baht stability (baht won't rise), it won't lose money from this FX operation.

If it buys the dollar too litle and retreating alternately during the intervention in the face of the dollar inflow, it will lose money because it won't be able to keep the baht from rising. When its foreign exchange reserves are marked to market, it will pose book losses, as is now the case. 

Why does the central bank keep on shooting itself at the foot? You have to find out by yourself.

Wedndesday, August 1, 2007

9:45 AM: As you can see, the BOT had been slow or clumsy to deal with the foreign exchange crisis.

It was reluctant to cut the interest rates from the outset although inflationary threats were receding. By keeping the rates high, it couraged even more capital inflow to speculate on the baht. Already, there had been huge inflow from the current account surplus and other forms of foreign investment. This led the BOT to lose even more money in its futile attempt to halt the baht rise.

However, the BOT started to cut its rate on January 17, 2007 from 5.0 per cent. After a series of cut, the BOT's policy rate now stands at 3.25 per cent.

It was not until four months after Olarn's March report that the BOT In July 2007 started to implement outward investments or embark on foreign exchange liberalisation to encourage outflow.

But it was not after Olarn came out publicly for the first time about three weeks ago to blast the BOT's failure to manage a target exchange rate policy.  

Wednesday, August 1, 2007

Capital inflow and high interest rate policy

8:30 AM: I have not finished Dr Olarn Chaipravat's critique of the Bank of Thailand yet. Let's move on to the conclusion in his March 2007 report on the BOT's policy failures.

Dr Olarn Chaipravat

How should the BOT handle its monetary policy in the face of huge capital inflow?

Capital inflow drove up the value of the baht. This led the BOT to intervene by issuing bonds in its repurchase market to borrow the baht from the financial institutions. The baht proceeds were then used to buy up the US dollar in order to keep the baht at the level the BOT would like to keep.

In 2006, the BOT issued bonds in the repurchase market totalling Bt343.51 billion. These bond issues needed prior approval from the Finance Ministry. The cost of the BOT's bonds was 5 per cent based on the 14-day repurchase rate.

By the middle of 2006, the BOT was quite at loss over the massive inflow of capital through trade and other forms of investment.

But the BOT insisted on maintaining a high interest rate policy. So there were no incentives for the state enterprises or the big companies to borrow the loans in baht term. In December 2006, in particular, the BOT ordered the commercial banks to restrict their loans to the telecom sector, forcing two telecom firms to borrow US$1 billion from abroad.

The capital inflow in that month further applied upward pressure on the baht. During this time the BOT was jumping around and blaming the foreign investors of engaging in intense baht speculation. The BOT also sent out signals to the exporters to hedge their foreign currency risks because the baht was on an up trend to Bt34-Bt35/US dollar, although the spot rate then was around Bt36-Bt37/US dollar.

This was another added pressure on the BOT to issue bonds to buy up the dollar, and in so doing creating additional demand in the purchase of the dollar to curb the baht rise.

But the point is that the real factors that drove up the value of the baht were the continuing surplus of the current account amid high export growth, and the falling oil prices in the last four months of 2006 in particular. Capital was also flowing into equity investment in the tune of US$4 billion in the first four months of the year.

The exporters and investors realised then that the capital flowing into Thailand was due to the fundamentals. If the BOT insisted on keeping its interest rate high -- while inflationary threats were receding -- it would have to shoulder more losses from its dollar foreign reserves holdings.

Market bet for rate cuts

The exporters and investors anticipated that the BOT would not be able to bear the pressure of its foreign exchange losses for long. Its cost of bond issue was at 5 per cent. They bet that eventually the BOT would have to cut its policy rate.

Based on this bet, the foreign investors further brought the dollar into the country in order to shoot two birds with one bullet.

First, they would gain from the falling interest rates in the future. This would drive up the prices of the long-term  government bonds.

Second, they would gain from the baht appreciation. Upon selling the government bond and stocks, they would use less baht to convert it back to the US dollar for profits.

The BOT ended up having to intervene even more in the foreign exchange market to curb the baht rise. But its intervention was not effective enough to keep the baht at the target rate.

Nobody knew about the target exchange rate of the BOT because it was not announced. Only the top policy makers of the BOT might have this target rate in mind.

Dr Olarn questioned the transparency and accountability in the BOT's foreign exchange management. It was not clear how the central bank was pursuing a policy to maintain baht stability or how its operations were being run in order to keep the exchange rate within the target.

When the baht continued to rise, the value of the BOT's foreign reserves dropped. When the reserves holdings were marked to market, the BOT faced huge book losses in the tune of Bt188 billion in 2006 alone.

Vicious Cycle 

One of the biggest mistakes of the BOT was to keep interest rate high while capital, either from the current account surplus or from other forms of foreign investment, was flowing into the country massively. This further encouraged even more foreign capital to speculate on the Thai baht.

As the BOT tried to slow down the pace of the baht rise, it did so half-heartedly without any effectiveness.

The high interest rate policy created a vicious cycle, leading the foreign investors and the exproters to speculate more on the baht and creating further burden on the BOT to shoulder higher losses from its intervention.

To rectify the situation, the BOT must cut its interest rate drastically to discourage capital inflow. It must also encourage more imports and outward investments in various forms serously and urgently in order to match the inflow from the current account surplus.

Olarn concluded his lengthy report by saying that the BOT must adjust its financial market oriented policy mechanism. It must have capable leadership who had a good understanding and experience in managing the foreign exchange policy like neighbours from Japan, Malaysia or Singapore.

This would help the BOT break away from the vicious cycle.

Olarn urged the BOT to cut its policy rate quickly to and improve its foreign exchange operations and policy before things got worse.

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Tuesday, July 31, 2007

BOT's Policy Failures

11:00 PM: In fact, Dr Olarn Chaipravat, the noted economist, has been quietly sending  warning signals to the finance and banking authorities over their mismanagement of the exchange rate policy.

He has been arguing that the BOT has failed to intervene in the foreign exchange market sizeable enough to slow down the pace of baht appreciation. He is not sure either whether the BOT knows what it is doing.  

On March 19, 2007 he finished his report on the baht appreciation and the policy failures of the Bank of Thailand.

Since he is one of the economic advisors of the Surayud government, he must have submitted this landmark report to the top policy-makers of Thailand.

So what happened in December 2007 that eventually led the banking authorities to introduce capital controls to curb baht speculation?

On December 18, 2006, a day when the BOT introduced capital controls, the baht strengthened to Bt35.15/US dollar. This was a far cry from Bt41.03/US dollar at the end of December 2005.

BOT Governor Tarisa Watanagase gave an interview which suggested that capital inflow at an abnormal amount in the first week of December went into Thailand to speculate on the baht assets. This had led to the sharp appreciation of the baht. It was a one-way street for the baht movements, so the authorities had no choice but to introduce the draconian measures to stabilise the baht.

But what actually happened in the month of December 2006?

Thailand's current account continued to register a surplus for five months in a row, amounting to US$1.21 billion in December 2006 alone. Of this, US$911 million accounted for the trade surplus.

This was clear that the current account surplus was one of the main reasons of the capital inflow that caused the baht appreciation.

Let's separate the event before December 18, 2006 when the capital controls were imposed, with that after December 18.

Apart from the current account surplus, foreign loans brought into the country by the state enterprises and the private companies also significantly boosted the value of the baht. The foreign loans amounted to US$1.15 billion in that month, the highest level of the year.

Conflicting policy

Dr Olarn suspected that a conflicting policy within the central bank's financial and foreign exchange management might worsen the baht crisis. The central bank's financial institution examiners had told the commercial banks to restrict their loans to the telecom sector.

Two telecom companies were hit by this regulatory supervision. So they borrowed the loans from abroad instead, amounting to a combined US$1 billion. When the US dollar loans were brought into the country and exchanged into the baht in the spot market, they exerted tremendous pressure on the baht appreciation and on the foreign exchange intervention of another unit of the central bank. 

 The central bank ended up having to shoulder a higher burden on its intervention activity to stem the baht rise.

Capital inflow through other channels -- the foreign direct investment, equity and debt market, amounted to a combined net of US$39 million. This was very small compared with the two items (current account and foreign loans) cited above.

Now you might have understood already that capital flowing into Thailand goes through five channels. Dr Ekanit Nitithanprakat of the Finance Ministry calls these five channels of capital inflow as the Five Rivers -- Ping, Wang, Yom, Nan and Pa Sak.

Foreign direct investment in December amounted to US$615 million, while investment in the debt market registered a minus US$605 million, which suggested that investors were net sellers of in the debt market amid the panic over the 30 per cent reserve requirements or capital controls.

In that month, the foreign investors were net buyers of Thai stocks. They also invested US$109 million in the Thai debts.

But the BOT said the debt market was the main channel of capital inflow that went into speculate against the baht. Olarn disputed this BOT's claim as inaccurate.

Capital inflow in the spot market in December through all the five channels amounted to US$2.488 billion, the highest level after November of that same year.

There was no pressure either on the foreign exchange forward market because the exporters and investors were not net sellers. For the whole month of December, the supply in the spot and forward markets reached a net US$2.57 billion.

Strangely enough, Olarn found out that the BOT intervened in the foreign exchange market too little at only US$1.575 billion in this month. With this half-hearted intervention, the baht strengthened Bt0.71/US dollar on average in this month. Most of the appreciation took place before December 19, reaching Bt35.15 on DEcember 18 before weakening to Bt36.05 at the last trading session of 2006.

In 2006 alone, the BOT lost Bt188 billion from its foreign exchange intervention.

Before and after December 19, 2006

Now let's analyse the baht situation before December 19 and that after December 19 when the impact of the capital controls was evident.

The main factors that led to the sharp baht appreciation in the first 18 days of December 2006 were the current account surplus and the foreign loans. Capital inflow into the spot market, where settlements take place in one day, reached US$3.26 billion.

At the same time, the commercial banks sold currency contracts in the forward market, where settlements take place some time in the future, US$3.261 billion to square their positions or to reduce their exchange risks.

Olarn argued that with the huge dollar supply in the spot and forward market, the BOT could have prevented the baht from rising too significantly by buying the dollar at the matching amount.

As it turned out, the BOT bought the dollar in the spot market for only US$245 million against the supply of US$3.463 billion in the first 18 days of December. The commercial banks were left to shoulder the burden of the remaining supply of US$3.218 billion.

The BOT also bought US$472 million in the forward market against the supply of US$3.261 billion during the same period, although this supply resulted from its intervention very lightly in the spot market. The commercial banks were also left to bear the burden of the supply of US$2.789 billion in the forward market.

Olarn said if the BOT had not pushed most of the burden to the commercial banks, the baht would not have appreciated significantly during this period. Although the baht appreciation was partly due to the capital inflow, the BOT must be fully blamed for its policy failure to intervene staunchly enough to stabilise the baht.

 A change of the tide

After December 19, the situation changed to the contrary direction of the first half of the month. Capital was flowing out of Thailand in most channels as a result of the panic over the capital controls. Only the current account and the foreign direct investment were not significantly affected from this short-term incident.

However, the financial system registered net capital outflow during this period. The commercial banks were net sellers in the spot market in order to reduce their positions taken before December 19.

The BOT became the largest buyer of US$2.926 billion in the spot market.

But in the forward market, the commercial banks were the major buyers amounting to US$3.863 billion as a consequence from their dollar sell in the spot market as mentioned earlier.

 Overall, the net supply in the spot and forward market amounted to US$878 million. The BOT stepped into the foreign exchange market to buy up the dollar heavily in the last nine trading days of the year to stem the baht rise while the exporters/importers and the investors were net sellers.

This implies that the BOT was intervening heavily in the onshore market to create more demand than supply in order to weakened the baht. As a result, at the end of the year, the baht closed at Bt36.05. 

If the baht were to close at Bt35.15 (the exchange rate of December 18, 2007), the central bank would have faced higher book losses of Bt56 billion. The central bank was trying to make its book look less ugly through the heavy intervention after the imposition of the capital controls.

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