Is Thailand becoming too hot to handle?

Strong bouts of quantitative easing in the Western world, and more recently Japan, have increased the flow of hot money to Thailand, causing the baht to rise significantly against the US dollar and other currencies. Is it a “happy problem” or is Thailand heading for yet another currency crisis?

43 (2)As 45-year-old Yingluck Shinawatra took over as Thailand’s first woman Prime Minister from her Democrat predecessor Abhisit Vejjajiva on August 5, 2011, she vowed (during her swearing-in ceremony) of national reconciliation, poverty eradication, and corporate income tax reduction. And above all, to maintain economic growth and stability. In fact, she has repeated almost exactly the same points at several occasions since she was sworn in. “But can she?” is the question that many have started asking now, not only in streets of Bangkok, Thailand’s legislative as well as financial capital, but across the globe. Reason: The ghosts of the 1997 crisis are back!

While the baht (Thailand’s national currency) has already advanced over 7% this year versus the dollar (the currency touched 28.56 baht per US dollar on April 19, the strongest level since a devaluation in July 1997 that sparked the Asian financial crisis), the most among 11 major currencies in Asia, fund managers across the globe too have been pouring money into Thai shares, driving the benchmark SET Index to a 19-year high (the SET Index has increased over 5%, more than benchmarks in Indonesia, Singapore and Malaysia). What’s more? Global fund managers bought $2.2 billion more Thai sovereign debt than they sold in the month of April, adding to net purchases of $9.8 billion in the first quarter of 2013. Thus, considering this sudden inflow of “hot money” into the land of white elephants, the question arises: Is Thailand heading for yet another currency crisis?

For the uninitiated, in 1997, Thailand devalued the baht to shore up a faltering economy, abandoning its policy of pegging the currency to the US dollar, a move that left a legacy debt of $35 billion from bailing out financial companies. International reserves fell by 31% to $27 billion in 1997 (as per Bloomberg data) and the economy became more vulnerable.

However, this time around the Thai economy appears to be in a much better shape than it was in 1997. While forex reserves have increased more than six-fold since then to $182 billion last month, Thai real GDP grew 18.9% year-on-year (yoy) in the December quarter after the third quarter’s upwardly revised 3.1% yoy. Although the fourth quarter growth was artificially boosted by the low base effects from the devastating floods in late 2011, it was still above the trend. Even on a seasonally adjusted basis, the economy expanded 3.6% quarter-on-quarter in the fourth quarter after the third quarter’s 1.5% expansion. Full-year growth for 2012 too printed at 6.4%. In short, Thai economy remains robust, fuelled by the acceleration in fixed investment (up 13.4% in Q1 2013), private consumption (up 6.4% in Q1 2013) and government spending (up 5.1% in Q1 2013).

In fact, the domestic consumption will continue to be the main driver of economic growth as minimum wages and robust labour conditions buck up household spending. The reason is simple. Shinawatra had raised the minimum wage throughout the country in January this year. Minimum wage laws (which set the minimum wage at THB300 or $10 per day) introduced across the seven most industrialised provinces in April 2012 has now been extended to the rest of the country.

44 (2)While at home the domestic economy continues to expand at a robust pace, the US sequestration and the ongoing European sovereign debt crisis, rekindled by the Cypriot banking meltdown, remain downside risks to global trade flows and by extension Thai exports. No doubt, the steady appreciation of the baht, easing inflation pressures (while the headline consumer price inflation eased to 2.69% in March following February’s 3.23% rise, core inflation is down to 1.2%, from 1.6% in February), and the ongoing sovereign debt crisis in Europe and the US all make good cases for further monetary easing. But then, Thai policymakers will not be in any rush to cut rates, as this would further stoke rampant credit growth, which could hurt financial stability and build up asset price bubbles. In fact, the Bank of Thailand has kept policy rates unchanged at 2.75% following its April meeting. The last rate cut was in October 2012, when the central bank had slashed the benchmark rate by 25 basis points.

Nevertheless, soft global commodity prices and slower growth in 2013 should help offset the impact of rising Thai wages. As a result, the underlying inflation is expected to remain within the central bank’s 0.5% to 3% target. This will allow monetary policymakers to keep rates on hold for most of 2013, with a new tightening cycle starting in late 2013, to take over price pressure from stronger exporter incomes.

However, at the same time, policymakers need to check the inflow of hot money into the country. Quantitative easing policies in the US, and more recently Japan, have increased the flow of hot money to Thailand, causing the Thai baht to rise significantly against the US dollar and other currencies. While the baht has already touched a 16-year high against the greenback, it is up 21% against the yen in the year to date. In fact, carry-trade returns have risen steadily, suggesting markets expect further baht appreciation. This is certainly a cause of concern for Thai policymakers. The reason is simple. While a rising currency will erode the competitiveness of Thai exports, hot-money inflows will create asset price bubbles, with negative consequences for the real economy.

Although Thailand reported a $500 million trade surplus in February 2013 after January’s $2.8 billion deficit, exports fell 4.6% year-on-year. On the other hand, imports were up 3.7%. All this may prompt the Bank of Thailand to reintroduce capital controls, similar to those it instituted in 2010. Agrees Fred Gibson, the Sydney based Associate Economist at Moody’s Analytics, as he tells B&E, “Increased liquidity in the global financial system is encouraging hot money flows into higher-yielding emerging market assets, potentially creating excess liquidity which could feed an asset bubble.”

Interestingly, a surge of money into Thailand in 2010 had driven the baht to its highest against the dollar since just before the Asian crisis of 1997-1998. The baht had appreciated by nearly 12% against the dollar by the second half of 2010, rattling the exporters who account for 65% of Thai GDP. And to curb inflows of “hot money” the Thai cabinet had imposed a 15% withholding tax on foreign bond holders. A similar policy needs to be adopted now if policymakers really want to nip the crisis in the bud. Further, policymakers must also pay close attention to excessive lending growth. Prior to the global financial crisis in 2008, lending increased an average of 6% per year, while nominal GDP 9%. Since 2010, however, lending growth has averaged 11% compared with 7% nominal GDP growth. Reason: When borrowed funds aren’t used for domestic investment or consumption, they tend to be invested either offshore or in domestic assets. If sustained, the latter can feed asset price bubbles. And if that happens, Thailand will not be alone to face the consequences. Hope the world hasn’t forgotten the devastating 1997 economic crisis.

42 (2)“It’s time for capital controls”

The Thai economy faces significant headwinds from the ongoing appreciation in the baht. Thailand’s solid economic outlook is spurring investor interest in the manufacturing dependent-economy, although the currency’s appreciation isn’t all fundamental. Strong bouts of quantitative easing in the Western world, and more recently Japan, have caused the baht to touch a 16-year high against the greenback. The baht is up 21% against the yen in the year to date.

The persistent appreciation in the currency will erode Thailand’s competitiveness, while also impeding import-competing industries. Increased liquidity in the global financial system is encouraging hot money flows into higher-yielding emerging market assets, potentially creating excess liquidity which could feed an asset bubble. A possible solution is to cut policy rates to lower the interest rate differential, which would put downward pressure on the currency. However, a lending surge and booming property market are constraining the central bank from pulling the trigger. Tightening rates to control the property market and lending growth are also off the table given that would place upward pressure on the currency.

The solution might be capital controls. This would allow the central bank to tighten rates later in the year to prevent the economy from overheating, while the capital controls would curb the inflow of hot money.