Thailand's currency war

The Thai finance ministry has slapped a tax on foreign bond investors in a bid to defend its currency.

Thailand is sensitive about its currency. Ever since the baht crisis matured into the Asian financial crisis in 1997, it has been paranoid about falling into the same trap, which has prompted it on several occasions to take bold action to protect its currency.

In mid-October, it did so. The finance minister, Korn Chatikavanij, made it more expensive for foreign investors to buy Thai government bonds in a vain bid to curb the baht’s relentless appreciation. Effective immediately, the withdrawal of a withholding tax exemption for foreign investors added a 15% levy on any bonds issued by the government, the Bank of Thailand and state governments.

Few expected it to achieve much, including, it seemed, both Chatikavanij and Abhisit Vejjajiva, the prime minister, who said at the time of the announcement: “Going on [global] economic trends, the baht is not expected to get any weaker in the near future.” During a trip to Washington, just days before he announced the tax hike, the finance minister also told reporters that such efforts were of limited use. “I don’t think a country like ours can forcibly change the fundamental direction of our currency,” he said.

That makes sense. After all, it is not international bond funds that are causing the baht to rise against the dollar. As with most emerging market economies today, Thailand is feeling the effects of global capital flows. In Indonesia, South Korea, Malaysia and Thailand, foreign inflows to local debt markets were up by almost 50% in August, compared to a year earlier.

With American interest rates at zero, investors have been forced on a global hunt for yield that has led many of them to Asia, causing a strong rally in most of the region’s currencies. Even China’s renminbi has risen. It might be strengthening at a slower rate, but its gradual rise adds further pressure on neighbouring currencies.

Both of these contributors are here to stay -- America will almost certainly embark on another round of quantitative easing, forcing it to keep interest rates at zero for longer, and China is committed to a gradual appreciation of the renminbi.

Frederic Neumann, HSBC’s co-head of Asian economic research, wrote recently that this flow of money to the region is relentless, though not all bad: “The set-up for Asia is sweet, but hardly sustainable. Easy money is available in the West, and everyone wants a piece of the East. The result: capital keeps pouring into the region. It’s difficult to see an end to this.”

Trying to stem this tide with a 15% withholding tax on bond investors seems futile. Indeed, even if bond investors really were driving the baht higher, the measures are still too weak to have much effect. There are two main reasons for this, according to Rahul Bajoria, an emerging markets strategist at Barclays Capital.

First, the appreciation that the tax is targeting will also make it impotent. “Bond investors will need only about 50bp to 75bp of additional annual baht appreciation in FX to compensate for losses due to withholding tax,” according to Bajoria, who forecasts the baht to rise 2.5% (or 250bp) during the next year. Second, he argued, a big part of the new money flowing into the Thai bond market comes from index-based real money managers. “Given that Thailand is a part of most of the benchmark indices, even if investors were underweight, on the margin they will need to keep buying government bonds as their AUM [assets under management] increase.”

But the problem of foreign money flooding the economy is hardly contained to the bond markets. As Bajoria points out, Thailand’s stock market had attracted $1 billion of inflows in the four weeks leading up to the decision to re-impose the withholding tax, compared to just $1.57 billion for the full year to that date.

The withholding tax measure will be ineffective, but that is not to say it will have no effect. And, in combination with other measures, the finance ministry will be hoping that it will at least win some valuable breathing room for Thai exporters.

The other measures include a $1.7 billion plan for state-owned enterprises to buy new machinery, tools and raw materials, which will likely be implemented in the fourth quarter. The central bank had already introduced measures to make it easier for Thai companies to invest and lend more overseas.

Even with all these measures, nobody expects the Thai baht to weaken against the dollar. If the government and the market both agree that the current round of baht appreciation is out of anyone’s control, why bother in the first place?

Politics is probably the best answer, as ever. Thailand’s small and medium-sized businesses have been hurt by the appreciation of the baht during the past 18 months -- back in March 2009, a dollar was worth Bt36, but today it is worth slightly less than Bt30.

The government is under pressure to act, not because it can do anything, but simply to appear to be doing something. It has few other tools at its discretion, as Neumann noted: “The main policy tool, interest rates, seems a little too blunt if growth is to be protected. Moreover, raising interest rates may only serve to attract more of the stuff that no-one really needs.”

Regulatory tightening is the only meaningful alternative, but Thailand’s finance minister knows to tread carefully here. The government learned a lesson in 2006 when it introduced tough new capital controls that led to the stock exchange’s biggest one-day loss. It is loathe to repeat that experience, but the risk remains that it could take bolder steps in the future.

Thailand and its neighbours are at the mercy of events in the US and Europe, in many ways. Capital will continue to flow into the region, which will continue to support growth and low interest rates. At some point, that must surely lead to inflation, but at HSBC, Neumann is worried that markets have discounted this too easily. “If anything, it is quite a big risk precisely because it appears to be so unanticipated by markets. A little wobble in prices, therefore, could make big waves among investors.”

Short of closing the doors, Thailand seems to have little choice but to continue encouraging capital outflows while making a song and dance about efforts to control inflows -- without spooking foreign investors so much that they all rush for the exit at the same time. The ultimate problem is one of imbalances in global capital flows, but the solution to that one is even more elusive than the answer to the shorter-term question of currency appreciation.

This article was first published in the November 2010 issue of FinanceAsia magazine.

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