International Finance: The Bank of Thailand - Research Paper Example

?Introduction A fast appreciating Thai Baht and the ineffectiveness of capital market interventions led the Bank of Thailand (BOT) to unexpectedly announce the imposition of the Unremunerated Reserve Requirement (URR) of 30% on most types of capital flows excluding FDI and amounts not exceeding $ 20,000. The announcement came as a surprise to many investors on December 18, 2006 as the URR was to be effective from the next day (December 19, 2006). This paper aims to study the impact of URR on the Thai financial markets. Motivation behind introducing URR The key motivation of the Bank of Thailand (BOT) to introduce the URR was to control the strong inflow of short-term capital that was leading to its currency appreciation. Since early 2006, The BOT tried several policies to curb the phenomena but to no avail, and in the end, in December 2006, it introduced this policy. Below is a more detailed discussion of this. After 2004, as access to credit became easier in developed countries due to lower interest rates, investors began to look for opportunities to invest in developing countries where the interest rates were high. As a result, nearly all East Asian countries had high inflows of foreign investment, as did Thailand. While this investment can help in the development of countries, they can be equally discouraging and even disastrous if bulk of these investments are short-term and speculative in nature. The reasons for this are explained below: 1) Local currency appreciation: With more inflow of foreign investments, the local currency tends to appreciate making local exporters less competitive. 2) Large inflows: Large injections of investments in a small economy can cause distortions and even havoc if pulled out suddenly 3) “Hot money”: If the investments are pulled out suddenly, the economy can crash 4) Asset bubbles: Large investments in one sector can cause unsustainable growth on sector assets (example real estate) 5) Household credit: With inflows, households tend to borrow more leading to high household debt than they can possibly service In 2005 and 2006, Thailand saw unprecedented increase in capital inflows. This is illustrated below in table 1. However, as the FDI component (long term investments) was not in line with all the investments, it was clear that most investments are short-term in nature. Also, according to the Bank of Thailand, a large part of this money was going into currency (Thai Baht - THB) speculation which is illustrated by the continuous appreciation of THB against the US Dollar (USD) as shown in Figure 1. Table 1 Annual Flow of Foreign Investment in Thailand 2003 2004 2005 2006 Current Account 4784 2767 -7852 3240 FDI 4608 4952 7297 9563 Debt securities -827 17 487 -267 Equity securities 583 180 2158 4744 Others (Corporate & government loans + trade credit) -9293 -7232 3042 3758 Total -145 684 5132 21039 Source: FPRI Both 2005 and 2006 saw a huge increase in investments in equity securities, which is typically a short-term investment. While the FDI did register and increase, it was relatively only a small proportion of the total flow of capital. Figure 1 Exchange rate of THB against USD from mid 2005 to December 2006 As seen in figure 1, on the left, the THB was continuously appreciating against the USD from around 42 THB/USD to below 36 THB/USD. This appreciation of the THB meant that the local companies were losing competitiveness. The BOT tried several policies to prevent appreciation of THB, was unable to stem it. The key measures tried were (BOT 19-20) “Permitting a larger amount of residents’ investments abroad, as well as discouraging short-term capital inflows through raising the total permissible outstanding balance in the foreign currency deposit (FCD) accounts of corporate residents. On 4 December 2006, the Bank of Thailand implemented measures on short-term capital flows which required non-residents to hold securities for longer than 3 months and allowed domestic financial institutions to borrow baht from non-residents without underlying trades or investments in Thailand only for a maturity of longer than 6 months.” However, none of these measures could effectively slow down short-term capital inflows and were unable to reduce the pressure on the exchange rate. In the end, the BOT decided to introduce the URR. Impact of URR provision on the exchange rate of Thai Baht with other major currencies such as US$ and local currencies The URR did little to reverse the appreciation of THB against the USD as seen in Figure 2 below Figure 2 Exchange rate of THB against USD from Dec 2006 to Mar 2008 The THB went from 41.4 in December 2005 to 35.5 on 11 December 2006. While in December 2007 it was at around the 30.5 mark. The percentage appreciation in the 2005-06 period (16.6%) is the same as in 2006-07 period (16.3%). This shows that the URR was ineffective is stemming the currency appreciation against the USD. Against other local currencies also, the THB continued to appreciate as seen in Figure 3 below Figure 3 THB against other local currencies Dec 20005 to Dec 2007 Source: Bank of Thailand Impact of URR on Thai financial markets i.e. Stock Markets, Bond Markets and Money Markets Stock markets: Immediately after the announcement of the URR measure, the Thai stock market dropped by 14.48% and closed at 622.14 points of December 19. Following this, the BOT made several announcements related to softening of the measure but it wasn’t until June 2007 that the stock market reached the same level as 18th December. Figure 4 Thai Stock market index (SET) from Jan 2006 to November 2007 Source: CEIC Database Bond markets: There was a negative net buy in the bond markets and the yield fell. This is evident from figures 5 and 6 below. Figure 5 Monthly foreign net buy in bond Source: TBDC Figure 6 Yeild gap between Thai and US 2Y bond vs THB/US$ The bond yield was decreasing making the Thai bonds less attractive. Source: Reuters, TBDC Money markets: As seen from the figures 7,8 and 9 below (source: BOT), the repurchase rates, interbank rates, T-bill yield and interbank overnight lending rates registered a continuous decline after the imposition of URR. Figure 7 Repurchase Rates Nov 2006 to June 2007 Figure 8 Bangkok Interbank rates Nov 2006 to June 2007 Figure 9 T-Bills and government bond yields Nov 2006 to June 2007 Figure 10 Interbank overnight lending rates Nov 2006 to June 2007 Looking at the continuously decreasing rates and yield of T-bills, it can be inferred that the market liquidity also had been decreasing continuously. Impact of URR on neighboring financial markets such as Malaysia, Philippine, Singapore and Korea The URR affected other regional stock markets as well: in Indonesia stock markets went down by 2.85%; in Malaysia dropped by 2%; in India 2.5%; and Singapore had a drop of 2.23% (The economist). In the long-term it had little effect on the neighboring financial markets although if these markets had taken similar steps as Thailand, the effect could have been a lot worse. Conclusion Thailand’s economy is mainly export based. Since In 2005, 73.6% of its GDP came from exports (World Bank). Naturally, an ever appreciating THB in 2005 meant that the domestic exporters were getting less competitive. In this backdrop, the BOT introduced the URR to prevent speculative investment against its currency. The URR, however, was not received well by the market immediately after its announcement, as was evident from the sharp decline in the stock market the next day, and the BOT introduced amendments to the policy on the very next day. The URR did not really meet the objective of stopping the appreciation of the THB though. After two years of several amendments to the URR, in March 2008, the BOT finally removed the URR when the THB was valued at close to 31.50 to the USD. References Auster A. Robinson J. Dean K. The fallout from Thailnad’s capital controls. Economics@ANZ. Thailand update – 20 December 2006. Accessed 19 May 2011. http://www.anz.com/documents/economics/FalloutfromThailandscapitalcontrols-20Dec06.pdf BOT. Bank of Thailand. Inflation Report January 2007. P 19-20. http://www.bot.or.th/English/MonetaryPolicy/Inflation/PaperInFrame/068Reserve_Jan2007.pdf BOT historical data of financial markets. 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