What to do about the appreciation of the Thai baht?
By Jon Fernquest[Introduction|Vocabulary|Article]
[Reading Questions|Answers]
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Today Dr. Chodechai Suwanaporn (director of the Financial Policy Section of the Fiscal Policy Office at the Finance Ministry) discusses international best practice in monetary policy for small open economies like Thailand.
He analyzes recent actions taken by the Bank of Thailand (BOT) to stem appreciation by the baht.
For university students, this article will help relate recent economic policy to explanations found in macroeconomics textbooks.
For further reading on this subject check out a recent BIS paper on Understanding Thai Monetary Policy and a recent paper by Dr. Chodechai on reforms to Thailand's financial system.
Currently, as a result of exchange rate controls, there is a dual exchange rate system with an official onshore (in Thailand) and unofficial offshore (outside of Thailand) exchange rates for the Thai baht.
Sontee Limtongkun recently claimed on TV (14-03-07) that profitable arbitrage opportunities exist in currency trading between offshore Singapore and Thailand. If this is the case (expert opinions of specialist economists like Dr. Chodechai being the only trustworthy guide here) how long can the differential between the onshore and offshore rates last?
Reading Questions
Here are some questions to guide your reading (See answers at end):1. What would be the best policy to reduce currency appreciation, according to the author?
What economic changes would result from this policy?
2. What two policy mistakes did the BOT make in December, according to the author?
3. Did the BOT's capital control restrictions remain fixed after they were imposed?
4. What changes in interest rates have been made recently by the BOT?
5. How did the central bank's recent monetary policy lose money?
6. What monetary policy would have likely led to a gain?
7. Does Thailand have an open or closed economy?
8. What countries have economies similar to Thailand's? How are they similar?
9. What kind of policies do these countries typically pursue when faced with strong exchange rate appreciation?
10. How did Hungary respond to speculative inflows of foreign exchange in 2003?
11. Did Hungary make a profit or a loss from their policy response?
12. How much did the BOT lose by buying foreign exchange in 2006?
13. Was the Hungarian appreciation in 2003 different from the Thai appreciation in 2006?
(Question for discussion and debate)
14. Is it difficult for speculators to beat a central bank trying to defend against currency depreciation? Why?
15. Which of the following is easier?
a. Defending against appreciation with interest rate cuts.
b. Defending against depreciation with interest rate increases.
16. Why does Thailand "have room" to make a large cut in interest rates?
17. Why was it difficult for capital to flow out of Thailand to help stem appreciation like it did in other small open economies?
Article
OPINION / THE BANK OF THAILANDThe blunder of BoT's exchange rate policy
The policy decisions of the central bank have led to a significant loss on foreign exchange transactions By DR CHODECHAI SUWANAPORNA review of international best practices show that when a central bank strives to halt the appreciation of a strong currency, the most successful approach is to cut interest rates and allow for the outflow of foreign exchange, rather than turn to capital controls as used by the Bank of Thailand. This article draws conclusions from the international experience of 11 countries, in particular the case of Hungary. These lessons learned can provide Thailand's policy-makers with options to address the rapid appreciation of the baht.
In December, the Bank of Thailand made two key policy mistakes by not cutting interest rates and not lifting the controls on capital outflows.
Instead, the central bank decided to impose capital controls, or the 30% reserve requirement on foreign exchange inflows.
Subsequently, the bank began to loosen the restrictions for capital outflows. There has also been a small cut in interest rates.
These adjustments are too little, too late.
Furthermore, the policy decisions by the central bank led to a significant loss on foreign exchange transactions, whereas a big interest rate cut would have likely led to a gain.
Most of the countries included in the study are of small and open economies similar to Thailand, including Hungary, Singapore, Malaysia, Japan, Korea, Hong Kong, Taiwan, Australia, China, Canada, and New Zealand.
Many of these economies were practising inflation-targeting policies similar to Thailand.
When faced with a strong appreciation of their domestic currency, these countries not only committed to buying foreign exchange, but also to cutting interest rates to fight off excessive capital inflows. These countries also allowed for capital outflow to prevent excessive foreign exchange accumulation.
The Singaporean central bank, the Monetary Authority of Singapore (MAS), uses interest rates to support its foreign exchange intervention.
Interest rates were thus allowed to fall to dampen the strength of its domestic currency in periods of strong capital inflows.
Another good example is Hungary which is a small, open economy that adopted an inflation targeting approach similar to Thailand.
In 2003, Hungary faced speculation that the forint (Hungary's domestic currency) was to appreciate which led to a large inflow of foreign exchange. The Hungarian central bank responded by buying 5.3 billion euros to offset a massive purchase of forint by foreign speculators.
Then in the face of heavy speculation, on Jan 15 and 16, the Hungarian Monetary Committee held an extraordinary meeting and decided to cut interest rates 100 basis points. They decided to cut interest rates, even though there was concern that a large rate cut may have led to inflation.
The result was a decrease in foreign exchange inflows, and consequently, the forint exchange rate decreased by 5%. Not only did the Hungarian central bank successfully stem the rapid appreciation of its currency, it also made a large profit on foreign exchange transactions by selling much of the euro at a profit of 43 billion forints. In turn, the speculators realised a total loss of 60 billion forints.
In contrast, recall that Thailand faced the same situation in December 2006, when there was heavy domestic currency buying.
The Bank of Thailand did not use interest rate policy as a mechanism for resolving the appreciation of the baht.
Furthermore, it lost 170 billion baht by buying foreign exchange in 2006, without the opportunity to sell at a profit since the currency has continued to strengthen.
Unlike the aftermath of the economic crisis in 1997, the Bank of Thailand was in a strong position to defend a rapid change in currency value in December 2006.
The experience of many of the countries in our study shows that it is very difficult to beat a central bank when it is defending the appreciation of a currency. This is due to a central bank's ability to intervene and cause foreign currency reserves to increase without an upper limit.
In other words, the central bank can theoretically raise an unlimited amount of domestic currency to assist in the intervention of buying foreign exchange by issuing bonds, borrowing in the repurchase market and printing currency.
Moreover, avoiding this type of currency appreciation through a reduction in interest rates, which can be a short-term measure, is much less worrisome for the financial sector than a major rise in interest rates when defending the currency against depreciation.
Due to the BoT's long-standing inflation-targeting framework, it is naturally concerned about interest rate cuts leading to inflation.
However, in the current economic situation, inflation in Thailand has been on a downward trend and is at a historically low level.
Therefore, the BoT should not be overly cautious and has room to make a large cut in interest rates.
The second mistake of the central bank was that it was too slow to allow for capital outflows. Thais were not allowed to take out capital to invest abroad until recently.
Most of the other economies in the study had liberalised their capital outflows regulations before their crisis. Since Thailand had not done so, there was no avenue for the money to flow out, causing the central bank to accumulate foreign currency reserves and become an easy target for speculation.
The Bank of Thailand has begun to liberalise the regulations, but for this crisis, it is a case of too little, too late.
Moving forward, the bank should rapidly implement further changes to allow Thais to take foreign exchange out and avoid this situation in the future.
Of course, hindsight is 20:20, so it is easy to criticise the Bank of Thailand at this time.
Subsequently, to its credit, the BoT has made some changes to the interest rate policy and capital outflow regulations. However, in comparison with the other countries in the study, the BoT adjustments are far too little to make a real difference.
Nonetheless, it is not too late for the Bank of Thailand to make a concrete decision that can provide the desired result on the exchange rate. As Hungary and other countries in the study demonstrated, the BoT should make a deep interest rate cut in a quick and decisive manner.
Dr Chodechai Suwanaporn is director of the Financial Policy Section of the Fiscal Policy Office at the Finance Ministry. He can be contacted at Chodechai
Vocabulary (in discussion above)
macroeconomics - the study of how the economies of whole countries such as Thailand, Great Britain, or Thailand work (See Wikipedia on macroeconomics)
a blunder - a mistake (made by being careless or not thinking enough before you do something)
BOT - Bank of Thailand (See Website)
best practices - a management idea which asserts that there is a most effective method or way of doing something (See Wikipedia)
central bank - (See Wikipedia on central bank)
currency appreciation - when the value of a currency increases (for example after the recent baht appreciation the baht can now buy more American goods than it did)
a strong currency - the currency is more valuable than normal (from appreciation)
foreign exchange - (See Wikipedia on foreign exchange markets)
capital controls - laws preventing investment money from coming in or going out of the country
lifting the controls - removing controls, stopping controls
x imposes y on z - x uses their authority to force z to accept y
30% reserve requirement - (See Wikipedia on Tobin Tax)
loosen the restrictions - reduce regulations
a significant loss - a large loss
inflation-targeting policies or framework - "an economic policy in which a central bank estimates and makes public a projected, or "target," inflation rate and then attempts to steer actual inflation towards the target through the use of interest rate changes and other monetary tools.(See Wikipedia on inflation targetting)
fight off - try hard to stop
Monetary Authority of Singapore (MAS) -
to dampen the strength of - to make less strong
doing x to offset y - x reduces the effect of y ()
extraordinary - special, not ordinary
100 basis points - a basis point is 1/100th of 1%, used to show the change in stocks, bonds, and other financial instruments (See Wikipedia on basis point)
stem appreciation - stop or reduce appreciation
resolving - solving a problem
the economic crisis in 1997 - (See Wikipedia on the 1997 Asian Financial Crisis)
intervene, central bank intervention in foreign currency markets -
a short-term measure - action taken to solve a problem now (but it may not solve the problem permanently, in the long-term)
has room to do x - there is enough freedom for action to do x
liberalised regulations - reduce regulations
hindsight - understanding an event after it happened
hindsight is 20:20 - it is easier to understand an event after it happens than before or while it happens
concrete - definite and specific
make a concrete decision - make a very clear decision to solve a problem
fiscal policy - (See Wikipedia on Fiscal Policy and Monetary Policy)
Answer Key:
1. What is the best policy to reduce currency appreciation, according to the author?
What economic changes would result from this policy?
Reduce interest rates.
If interest rates fall, than Thai investments are less valuable and investments outside Thailand are more valuable.
Investor demand for outside currencies like the dollar increases, so the value of dollars increase and baht decrease. This makes Thai exports cheaper, so Thai exports increase.
2. What two policy mistakes did the BOT make in December, according to the author?
a. Imposing capital controls
b. Imposing a 30% reserve requirement on foreign exchange inflows.
3. Did the BOT's capital control restrictions remain fixed after they were imposed?
No, they were loosened several times.
4. What changes in interest rates have been made recently by the BOT?
There has been a small cut in the interest rate.
5. How did the central bank's recent monetary policy lose money?
The central bank lost money on foreign exchange transactions.
6. What monetary policy would have likely led to a gain?
Cutting the interest rate by a large amount.
7. Does Thailand have an open or closed economy?
A small open economy. (See Wikipedia on Open Economy and Small open economy)
8. What countries have economies similar to Thailand's? How are they similar?
Hungary, Singapore, Malaysia, Japan, Korea, Hong Kong, Taiwan, Australia, China, Canada, and New Zealand. These economies have small open economies like Thailand's economy.
9. What kind of policies do these countries typically pursue when faced with strong exchange rate appreciation?
a. Buy foreign exchange.
b. Cut interest rates.
c. Allow capital outflow.
("When faced with a strong appreciation of their domestic currency, these countries not only committed to buying foreign exchange, but also to cutting interest rates to fight off excessive capital inflows. These countries also allowed for capital outflow to prevent excessive foreign exchange accumulation.")
10. How did Hungary respond to speculative inflows of foreign exchange in 2003?
It made large purchases of Euros to offset speculative inflows and then cut interest rates.
11. Did Hungary make a profit or a loss from their policy response?
A large profit.
12. How much did the BOT lose by buying foreign exchange in 2006?
170 billion baht.
13. Was the Hungarian appreciation in 2003 different from the Thai appreciation in 2006?
(Question for discussion and debate)
14. Is it difficult for speculators to beat a central bank trying to defend against currency depreciation? Why?
Yes, it is difficult because "the central bank can theoretically raise an unlimited amount of domestic currency to assist in the intervention of buying foreign exchange by issuing bonds, borrowing in the repurchase market and printing currency."
15. Which of the following is easier?
a. Defending against appreciation with interest rate cuts.
b. Defending against depreciation with interest rate increases.
a.
("Moreover, avoiding this type of currency appreciation through a reduction in interest rates, which can be a short-term measure, is much less worrisome for the financial sector than a major rise in interest rates when defending the currency against depreciation.")
16. Why does Thailand have "a lot of room" to make a large cut in interest rates?
"...inflation in Thailand has been on a downward trend and is at a historically low level."
17. Why was it difficult for capital to flow out of Thailand to help stem appreciation like it did in other small open economies?
There are still more regulations against investments outside of Thailand by Thais than there are in other countries.
("The second mistake of the central bank was that it was too slow to allow for capital outflows. Thais were not allowed to take out capital to invest abroad until recently.
Most of the other economies in the study had liberalised their capital outflows regulations before their crisis. Since Thailand had not done so, there was no avenue for the money to flow out, causing the central bank to accumulate foreign currency reserves and become an easy target for speculation.
The Bank of Thailand has begun to liberalise the regulations, but for this crisis, it is a case of too little, too late. ")
