Will capital controls remain in the wake of last weeks liquidity crisis?
By Jon Fernquest[Reading Questions|Vocabulary]
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The controversy continues over capital controls imposed by the Bank of Thailand last Dec 18 on foreign inflows of capital.
Removing capital controls would likely improve liquidity in Thai bond markets as well as put and end to arbitrage.
Under 30% reserve required by capital controls investors can profit from arbitrage on the differential between onshore and offshore rates:
"A non-resident bringing in $100 million to invest in Thai one-year bonds can set aside 30%, or $30 million, with the central bank as a reserve...The $70 million remaining is exchanged to baht at the onshore spot rate and invested in local bonds.""The investor then can hedge currency risk by buying a one-year forward contract in the offshore market, which quotes the baht at a substantially stronger rate than in the local market. At the end of one year, the investor receives their 30% deposit from the central bank, 4-5% returns on the $70 million invested in baht bonds, and liquidity to settle the forward contract offshore."
"Basically, you can gain returns of around 8% to 9% from the baht even with the 30% control, risk-free," the banker said. "Overnight borrowing rates for the baht offshore fluctuate considerably as positions unwind. We're seeing cases of 10%, 20% offered in the market."
Whether the amount of arbitrage between the offshore and onshore rates is significant is disputed.
Capital controls have created a two tiered market for baht with separate onshore and offshore exchange rates.
The offshore now stands around 31-32 and the onshore rate at about 34 baht to the dollar.
Last week's liquidity crisis in western financial markets has reduced pressure on the baht and reduced the immediate need for controls.
Ongoing problems in the US sub-prime mortgage market reached a boiling point at the end of last week with a sudden panic that gripped credit markets.
With many portfolios facing potential losses many institutional investors have reduced their exposure to emerging markets and shifted into lower-risk assets (flight to quality).
Reading Questions
Here are some questions to guide your reading (See answers at end):1. How many baht exchange rates are there?
2. Where do these different exchange rates apply?
3. How can an arbitraguer make a profit from differences in Thai baht exchange rates?
4. What was the cause of last week's liquidity crisis in western financial markets?
5. What has the impact of last week's liquidity crisis on Thai financial markets?
Vocabulary (in discussion above)
liquidity - increase the numbers of buyers and sellers in a market and the number of transactions so that assets can be quickly converted into cash
arbitrage - buying an asset in one market and selling it in another to profit from a difference in prices
differential - a difference between two values
spot rate, spot price - pay now for delivery now
hedge - Protect against asset price fluctuations by taking on a new risk that offsets an existing one
forward contract - forwards - a contract to deliver a certain asset on a future date
settle - finish a financial transaction by exchanging cash for an asset
a financial position - overall monetary situation of an investor, assets held including cash on hand, as well as liabilities and equity at a certain time
positions unwind - selling off (liquidating) the assets that are part of a financial position
two tiered - has two levels
liquidity crisis - when there are suddenly no buyers and sellers in a market so assets cannot be bought and sold anymore, this sends the price of credit (interest rates) up and makes getting loans more difficult
sub-prime mortgages - home loans to people that are lot riskier than normal, for several different possible reasons: because the borrower's credit history is not so good, lower collateral and secutiry for the loan, higher interest rate
institutional investors - large investors
exposure - in a situation where something bad can happen (for example, he died of exposure to the weather or the riswk exposure of this portfolio is too great)
flight - run away from a problem
