Dilemmas of Thai exchange rate and monetary policy
(30-05-07)
By Jon Fernquest[Introduction|Vocabulary|Article]
[Reading Questions|Answers]
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Despite all the concern about the vulnerability of Thai exports to baht appreciation, overall Thai exports remain healthy. (See BOT statistics page)
Despite all the worry and caution about sudden destabilising capital inflows into Thailand and the imposition of capital controls, some experts, at the IMF for instance, claim that it is actually the trade surplus that is responsible for the appreciating baht. (See recent article)
Today's article is about Thailand's exchange rate policy, the way it drives Thai monetary policy, and the future direction this policy might take. The article summarises comments by important figures in Thai banking made at a conference yesterday. The limits to current policies are discussed quite frankly. These comments have special meaning in light of a growing consensus among economists, summarised in a recent paper by economist Nouriel Roubini.
The explanation of what is happening in Asian economies runs as follows. In response to the 1997 Asian Financial Crisis ten years ago, Asian countries have adopted what has become known as the "Bretton Woods 2 regime of fixed rates in Asia." [2005 review, 2003 essay] The essential parts of this system are:
a. Asia has effectively returned to a fixed exchange rate regime.b. Asian countries are preventing exchange rate appreciation by massive foreign exchange reserve accumulation.
c. This reserve accumulation would increase the money supply and lead to inflation, but...
d. Asian central banks are "sterilising" these reserve increases. They are exchanging the new money created for bonds.
e. The money supply is still growing and that feeds inflation and asset price bubbles that may burst and destabilise Asian economies in the future.
f. Foreign exchange reserve accumulation has made Asian economies more vulnerable to the US business cycle and possible US recessions in the future.
g. Foreign exchange reserve accumulation has resulted in other problems:
1. Current account imbalances, surpluses for Asian economies and a gigantic deficit for the western countries.(Source: Nouriel Roubini's blog)2. Excessive liquidity and credit growth, bubbly asset markets, especially the Chinese stock market, and serious underpricing of risk in financial markets worldwide.
An overview published back in 2003 at San Francisco's Federal Reserve Bank provides a succinct explanation of why Asian reserve accumulation has been a reasonable strategy, the experience of the 1997 Asian Crisis being the core reason:
"Those who support holding large reserve balances argue that the cost of doing so is small compared to the economic consequences of a sharp depreciation in the value of the currency that is often associated with financial crises in emerging markets. A devaluation of the currency raises a country’s costs of paying back debt denominated in foreign currency as well as its costs of imported goods, and it also raises the spectre of inflation. With a large stockpile of foreign exchange reserves, a country’s monetary authority can buy up its currency in the foreign capital markets, which helps to uphold its value. By having its own ammunition to defend its currency in a crisis, a country with large holdings of reserves also avoids being shut out of international capital markets due to concerns that the government or the private sector will default on foreign debt payments. Therefore, these proponents argue, holding large reserve stockpiles is prudent policy for those occasions when defending the value of the currency makes sense." (Source: San Francisco Federal Reserve Bulletin, 2003)
Reserve accumulation is driven by several factors:
"Several factors may explain how much foreign exchange reserves a country wants to hold. One factor is related to the size of international financial transactions that occur there; that is, reserves holdings are likely to increase both with the size of the country’s population and with its standard of living. Another factor is related to the volatility of international receipts and payments, insofar as reserves are intended to help cushion the economy; that is, reserve holdings are likely to increase with more volatility in a country’s export receipts.A third factor is vulnerability to external shocks; reserve holdings are likely to increase with a country’s average propensity to import, which is a measure of the economy’s openness and vulnerability to external shocks. Finally, a country’s tolerance for greater exchange rate flexibility should reduce its demand for reserves, because its central bank would not need a large reserve stockpile to manage a fixed exchange rate; therefore, reserve holdings are likely to be lower the more variable the country’s exchange rate is." (Source: San Francisco Federal Reserve Bulletin, 2003)
For further reading, check out Wikipedia's list of foreign countries by foreign exchange reserves (up-to-date to within the last few months). Thailand ranks 17th in the world.
Check out Thailand's balance of payments data at the BOT and the contribution of the current account (exports - imports) as well as the capital account to the surplus. (historical data, main index to economics statistics)
Reading Questions
Here are some questions to guide your reading (See answers at end):1. Why is it not possible for countries to become wealthy with a currency that is too weak, according to the BOT official?
2. What negative scenario might result if the Thai baht appreciates too much, according to the BOT official?
3. What steps are necessary to avoid this negative scenario?
4. What costs and benefits have to be balanced in managing capital flows into Thailand?
5. Why have central banks in Asia accumulated large foreign exchange reserves?
6. What does sterilisation mean in this case? What is being sterilised?
7. Is sterilisation and massive reserve accumulation long-term sustainable? If it isn't what costs are there to this sterilisation?
8. What currency is an important large part of Thailand's foreign exchange reserves? What problem does this present?
9. How do most Asian governments favour their countries export sectors with exchange rate policy? (Explain in detail)
10. What can cause increased flows of foreign currency into a country? What positive and negative effects can stem from these inflows?
11. Do you think that the wealth transfer, that preventing baht appreciation effectively gives to the export sector, is a good or bad idea? (Express opinion)
12. What other Asian country allows it citizens to invest abroad to offset foreign capital inflows into the country? What about Thailand?
13. What is the "new paradigm" of China's financial markets that Mr. Thirachai refers to?
14. What large-scale global events are partly responsible for increased capital inflows to Thailand?
Bangkok Post Article May 30, 2007
Weak currency no help in long term
'Smooth transition' needed, says BoT WICHIT CHANTANUSORNSIRINo country in the world can attain wealth through a weak currency, according to Atchana Waiquamdee, a deputy governor of the Bank of Thailand.
"A strong currency is of benefit in the long run. If we sell things cheaply, and buy [imports] expensively, there is no way that Thailand can be wealthy through a weak currency," she said at a conference on globalisation and financial markets yesterday.
"If the currency appreciates to the point that we cannot export, the currency will adjust. But in that period, many small companies could collapse. As a result, we need a smooth transition."
The central bank shocked the financial markets in mid-December by imposing capital controls on foreign inflows and investments after the baht gained nearly 17% against the US dollar last year.
Dr Atchana said it was a considerable challenge for the central bank to limit the volatility that came with massive capital flows while also supporting development of the financial markets.
She noted that Asian central banks had accumulated foreign reserves of more than $3 trillion through efforts to "sterilise" capital flows and keep their currencies stable. Sterilisation, however, comes at a cost, as central banks are forced to issue bonds to help keep the money supply stable and avoid spurring inflation.
Holding US dollars is also a concern, given the clear trend for the greenback to weaken in the future.
Dr Atchana said that using international reserves for other purposes held its own dangers. Tapping foreign reserves to invest in domestic infrastructure, for instance, would be akin to the central bank simply printing more banknotes.
"Another key challenge is whether we are strong-hearted enough to allow the export sector to adjust on its own, or continue as other Asian central banks and intervene in the market to restrain currency appreciation," she said.
"This is an issue of public policy. But allowing the currency to weaken is similar to a wealth transfer to exporters."
Thirachai Phuvanatnaranubala, the secretary-general of the Securities and Exchange Commission, said Thailand should liberalise its regulations and allow greater flexibility for institutions and individuals to invest abroad.
"Taiwan, for instance, allows individuals to invest up to $5 million overseas," he said. In Thailand, overseas investments by individuals can only be done indirectly through foreign investment funds.
Dr Atchana said that easing capital restrictions to allow greater individual investment abroad should be done step by step over five to 10 years.
While allowing greater foreign investment by Thais would help ease appreciating pressure on the currency by facilitating capital outflows, Dr Atchana said it should be considered carefully.
"We should not think only of the immediate problems, but consider what might happen in the long term," she said.
But Mr Thirachai said Thailand needed to adjust to the "new paradigm" of the financial markets, where China benefited from low investment costs and a weak currency to dominate the world exports.
"We need to find our own opportunities to invest abroad. Building value for our industries will take time," he said.
Vichit Suraphongchai, the executive chairman of Siam Commercial Bank, said the massive capital flows that have come to Asia stemmed in part from the imbalances in the global market and the massive deficits run by the United States.
"Some investment projects don't really seem logical, such as the move in Dubai to build a new city on reclaimed land," he said.
"But investors think differently, that if they hold dollars, it is the US that benefits."
Vocabulary (in discussion above)
a weak currency - an undervalued currency, this means that the current exchange rate is less than it should be
a strong currency - an overvalued currency
a smooth transition - moving from one economic situation to another without have big problems along the way
attain - gain or achieve after a lot of effort
attain wealth - become rich after working hard to get it
Bank of Thailand - (See website and Wikipedia)
globalisation - the trend for people, firms and governments around the world to become increasingly dependent on and integrated with each other (See The Economist and Wikipedia)
capital controls -
imposing x on y - forcing y to have x
imposing capital controls on foreign inflows and investments - regulating capital inflows
volatility - changing suddenly and unexpectedly, often by large amounts, in opposite directions (See glossary)
limit the volatility - reducing the frequency and size of changes
reserves - the money that banks are required to retain rather than lend out (every increase in these reserves leads to a much larger expansion of credit and money supply (multiplier effect), domestic reserves originate from within the country's banking system, foreign reserves originate from foreign trade and investment)
foreign reserves, foreign exchange reserves -
accumulated foreign reserves -
sterilise capital flows - issuing bonds to soak up the excess liquidity (open market operations) caused by capital inflows into an economy, central bank accumulation of foreign exchange reserves increases the domestic money supply unless the central bank issues bonds, trading these bonds for the increased money that has entered the economy (See The Economist on Sterilised Intervention and Wikipedia)
spurring - causing
spurring inflation - causing inflation
the greenback - the US dollar
* trend for the greenback to weaken in the future
international reserves - foreign exchange reserves, the currencies of other countries held as reserves
tapping - using
tapping foreign reserves - using foreign exchange reserves
infrastructure - the basic services and facilities in a country such as water, electricity, transportation, and communication that make everyday life and business possible (See glossary)
intervene - become involved in a situation, you're not usually involved in (See glossary)
intervene in the market - when the government uses a policy to change the way a market operates
central bank intervention in foreign exchange markets - when the central bank of a country enters the market for the country's currency, buying or selling to effect the price of the currency (exchange rate) and the effect of foreign currency flows on the domestic money supply (sterilisation)
v transfers x from y to z - v takes x from y and gives x to z
wealth transfer - taking money (wealth) from one person and giving it to another (government policy can do this by favouring one group of people, such as exporters, over another when they make policy)
liberalise - make more free, makes rules less strict
liberalise its regulations - reduce regulations, make regulations less strict
easing capital restrictions - reducing limitations and rules on moving investment money in and out of the country
appreciating pressure on the currency - when increased demand or decreased supply of a currency pushes the value and price of the currency (exchange rate) up
facilitating - helping, making easier and more likely to succeed (See glossary)
the immediate problems - the problems that have to be solved right now, the highest priority problems that have to be solved immediately
a paradigm - a model or explanation
reclaimed land - land that was not usable, that was made usable (for example by draining a swamp, or filling a shallow water area with dirt, or by building barriers against the sea)
Answer Key:
1. Why is it not possible for countries to become wealthy with a currency that is too weak, according to the BOT official?
Because imports are too expensive. A country needs to import machines and other things that it cannot produce to develop.
2. What negative scenario might result if the Thai baht appreciates too much, according to the BOT official?
Baht appreciation may reduce exports and small export companies may go out of business before the baht weakens and once again makes exporters more competitive on international market places.
3. What steps are necessary to avoid this negative scenario?
Thailand needs a "smooth transition" to a long-term sustainable exchange rate. This is usually held to be the Purchasing Power Parity Exchange rate. (See #5 below).
But what is this exchange rate? No one knows precisely where exchange rates are heading or if the baht's appreciation is only temporary. If baht appreciation is permanent, there is little that can really be done to shelter exporters from the impact of these changes.
4. What costs and benefits have to be balanced in managing capital flows into Thailand?
Whereas capital inflows are essential in developing Thailand's financial markets, volatility in capital flows can cause an unstable and unpredictable business environment.
5. Why have central banks in Asia accumulated large foreign exchange reserves?
They are trying to stabilise their currencies (prevent appreciation in the short-run) by sterilising capital inflows.
The price of a basket of identical traded goods and services in two countries should, in theory, be the same. The exchange rate necessary to achieve this is called the Purchasing Parity Exchange Rate. The Economist's Big Mac Index is one way of measuring this exchange rate and determining if the exchange rate is currently undervalued or overvalued from what it should be in the long run.
Exchange rates often overshoot (move further than) the value they should be at given the state of the world economy.
6. What does sterilisation mean in this case? What is being sterilised?
Sterilisation means that the central bank has accumulated foreign exchange reserves and this threatens to increase the domestic money supply unless the central bank issues bonds, trading these bonds for the increased money that has entered the economy, thereby reducing the money supply. Soaking up excess liquidity with bonds like this is called "sterilisation."
The money supply change, that results from foreign reserve accumulation, is being sterilised.
[The central bank must issue bonds to: 1. soak up excess liquidity from the foreign exchange reserves they are accumulating (keep the money supply stable), and 2. avoid inflation.]
7. Is sterilisation and massive reserve accumulation long-term sustainable? If it isn't what costs are there to this sterilisation?
China has certainly tested the limits and there haven't been any negative consequences so far besides angering their trading partner the United States and having the US Congress try to pass law after law of punitive trade sanctions.
Traditional economic explanations, hold that if sterilisation is being used to maintain a balance of trade surplus as it is in Thailand, foreign exchange reserves may just accumulate to very high levels that will ultimately cause the baht's to be revalued, and profits for speculators who were bettign this would happen eventually. (See Peter E. Kennedy, Macroeconomic Essentials: Understanding Economics in the News, 2001, MIT Press)
8. What currency is an important large part of Thailand's foreign exchange reserves? What problem does this present?
Outside the United States the dollar is the most widely used reserve currency.
With ever growing huge US trade deficit with China, many people expect the Chinese Yuan to depreciate and the US dollar to appreciate. If this happens, it means that the value of the dollars that the Thai central bank holds will become less valuable and the central bank will essentially lose money on the foreign exchange reserves it is holding.
9. How do most Asian governments favour their countries export sectors with exchange rate policy? (Explain in detail)
They intervene in the foreign exchange market and buy up foreign currencies to prevent their currency from appreciating which would make their export sector less competitive on world markets.
10. What can cause increased flows of foreign currency into a country? What positive and negative effects can stem from these inflows?
Increased foreign investment (capital inflows) or a trade surplus (exporting revenue greater than import revenue) can both cause increased flows of foreign currency into an economy.
Some say that it was actually a trade surplus that was causing the baht appreciation. (See this recent Bangkok Post article)
Negative Effect: The foreigners buying Thai export goods or Thai stocks and bonds have to exchange their foreign currencies for baht. This demand for baht will increase the value of the baht and appreciate the exchange rate, making Thai exports less competitive on world markets.
Positive Effect: Investment money is available for expanding Thai business if they can put it to good use. This assumes that banks can evaluate credit risks and not just lend the money to influential people and friends. Of course, it is important that this investment money stay in Thailand for a long time, not just quickly flow in and then out, like a tsunami.
("'Another key challenge is whether we are strong-hearted enough to allow the export sector to adjust on its own, or continue as other Asian central banks and intervene in the market to restrain currency appreciation,' she said.")
11. Do you think that the wealth transfer, that preventing baht appreciation effectively gives to the export sector, is a good or bad idea? (Express opinion)
Good Idea: Export driven growth is a tried and tested method of economic development. It worked in South Korea under President Park Chung Hee and in more recent history China has gone quite far in its development with this strategy.
Bad Idea: It makes Thailand vulnerable to the influence of international markets which it cannot control and or predict the future of as was the case durign the 1997 Asian Financial Crisis. A sufficiency economy is better.
("This is an issue of public policy. But allowing the currency to weaken is similar to a wealth transfer to exporters.")
12. What other Asian country allows it citizens to invest abroad to offset foreign capital inflows into the country? What about Thailand?
Taiwan allows its citizens to individually invest up to $5 million abroad.
Thai citizens can only invest abroad through foreign investment funds.
13. What is the "new paradigm" of China's financial markets that Mr. Thirachai refers to?
a. Low investment costs.
b. A weak currency
c. Domination of foreign markets.
14. What large-scale global events are partly responsible for increased capital inflows to Thailand?
The trade deficit of the US with China which puts downward pressure on the US dollar.
("Vichit Suraphongchai, the executive chairman of Siam Commercial Bank, said the massive capital flows that have come to Asia stemmed in part from the imbalances in the global market and the massive deficits run by the United States.")
