CORRECTED COPY: BAHT APPRECIATION, CAPITAL CONTROLS AND

UNCLAS SECTION 01 OF 05 BANGKOK 002392 SIPDIS SENSITIVE SIPDIS STATE FOR EAP/MLS AND EB COMMERCE FOR EAP/MAC/OKSA TREASURY FOR OASIA STATE PASS TO USTR FOR WEISEL STATE PASS TO FEDERAL RESERVE SAN FRANCISCO FOR DAN FINEMAN STATE PASS FEDERAL RESERVE NEW YORK FOR MATT HILDEBRANDT E.O. 12958: N/A TAGS: ECON PGOV PHUM PREL TH SUBJECT: CORRECTED COPY: BAHT APPRECIATION, CAPITAL CONTROLS AND EXCHANGE RATE POLICY SENSITIVE BUT UNCLASSIFIED HANDLE ACCORDINGLY REFTELS: A) BANGKOK 1399 THAILAND'S NEWLY APPOINTED MINISTER OF FINANCE B) BANGKOK 1809 BANK OF THAILAND'S LATEST EFFORT TO STOP THE BAHT C) BANGKOK 499 RECENT THAI ECONOMIC POLICY - WHY? D) BANGKOK 1702 PROSPECTS FOR THAILAND'S 2007 ECONOMIC GROWTH ¶1. (SBU) Summary: Last December, the Bank of Thailand (BOT) imposed controls on capital inflows blaming foreign speculators for appreciating the baht and reducing the competitiveness of Thai exporters. However, Thailand continues to face strong appreciation pressures on its currency but, at least since the start of the year, not due to speculative capital inflows but rather from activities related to the nation's trade account. Exporters are driving baht appreciation as imports have fallen to a level insufficient to offset exporters' demand to buy baht. The drop in imports is due to depressed domestic demand brought on primarily by ongoing political uncertainty as well as heightened regulatory risks stemming from capital controls and proposed revisions to Foreign Business Act (FBA). Thus capital controls, while stemming inflows, have had the unintended consequence of also aggravating appreciation pressures on the baht. BOT Governor Tarisa has acknowledged exporters' role in driving baht appreciation, but continues to focus public attention on speculative activity as a source of appreciation. Given this focus, the BOT is not aggressively pursuing market based solutions that would address the fundamentals of baht appreciation, although it has implemented a few incremental measures. ¶2. (SBU) Justified in the name of exporters, there is little discussion of the costs and benefits of keeping the baht depreciated. The various measures to stem appreciation - 30 percent reserve requirements on non-equity or non-hedged foreign portfolio inflows, and BOT's heavy intervention and sterilization activities in the f/x market - are not costless. The BOT is taking losses on its balance sheet, cost of funds are higher than without capital controls, and exporters are not being sent the appropriate price 
signal to improve productivity and move up the value chain as is needed to stay competitive, particularly as competition from China and Vietnam increase. Further, the benefits are not clear as only a relatively narrow group of exporters, but those in sectors with high levels of employment, appear to be the most vulnerable to baht appreciation. Also, capital controls appear to be a moral hazard as exporters hedged less foreign exchange risk immediately following capital controls. Public discussions on the baht have been distorted as they are overly-focused on the baht's 2006 nominal appreciation against the USD, despite evidence that on a real basis in the medium term the baht remains competitive and has moved in line with other regional currencies. End Summary. Exporters the Primary Driver of Baht Appreciation -------------- -------------- ¶3. (SBU) While both the current and capital account were sources of appreciation in 2006, since the start of 2007 exporters have been the main driver of baht appreciation. In January, the most recent data available for 2007, exports rose 17.8 percent y/y to $10.4 billion, but imports slowed to a 4 percent y/y growth, contributing to a widening current account surplus of $1.54 billion in January after a surplus of $1.22 billion in December and a surplus of $1.51 billion in November. Comments by BOT officials, including Governor Tarisa, and Ministry of Finance (MOF) officials, indicate that exporter's continued to be the driver of appreciation in February and March as well. Bankers have been telling us for some time that exporters were the key factor in the baht's appreciation (reftel 499). ¶4. (SBU) Without strong imports, exporters will continue to be a significant source of baht appreciation. Imports have fallen due to depressed domestic demand brought on primarily by ongoing political uncertainty as well as heightened regulatory and policy risks stemming from capital controls and proposed revisions to Foreign Business Act (FBA). Historically, exporters' foreign exchange earnings have largely been offset by imports of raw and semi-finished materials, capital goods and consumer goods. This is reflected in Thailand's relatively small average trade surplus (0.4 percent of GDP per year on average for the past 5 years). With the decline in consumer and business confidence, capital goods and consumer goods imports have been flat to down so export earnings are simply converted into baht. BANGKOK 00002392 002 OF 005 ¶5. (SBU) Exporters' need to sell foreign exchange earning will remain large, as exports equal 60-65 percent of GDP (twice the average of middle income countries) and is targeted by the government to grow 12 percent in 2007. The National Economic and Social Development Board, the Thai government's main economic statistics and forecasting body, forecasts 2007's current account surplus at $3.1 billion (1.6 percent of GDP). However, some private sector analysts have placed their forecasts higher, with Credit Suisse forecasting a 2007 current account surplus of $8.4 billion (3.5 percent of GDP). ¶6. (SBU) Further, exporter's pressure on the baht is aggravated by BOT regulations on exporters' foreign currency holdings. An exporter may freely hold up to $2 million in foreign currency. Any amount above that must be exchanged for baht within 15 days, except amounts for which the exporter presents proof that the foreign currency is to be used to satisfy a foreign currency obligation coming due within 6 months. But Governor Tarisa still Directing Public Attention on Speculators and Capital Inflows -------------- ¶7. (SBU) BOT Governor Tarisa has made remarks acknowledging that exporters are the current source of appreciation. However, with exporters the only engine of growth, and the justification for December's controversial capital controls, Governor Tarisa appears reluctant to focus public attention on this dynamic. Instead, she continues to focus on the role of speculative activities and foreign inflows as driving baht appreciation. ¶8. (SBU) Recently, as noted in Reftel 1809, Governor Tarisa called on commercial banks to stop taking foreign exchange positions that the BoT argues were putting upward pressures on the baht, noting that some had been taking larger positions than prudentially allowed (20 percent of assets) -and thus "manipulating" the currency. The BOT is now requiring that banks submit their foreign exchange books on a daily basis (prior they were submitting on a weekly or bi-weekly basis). However, closing banks' foreign exchange position has had only a minimal effect on the baht. The BOT's active foreign exchange intervention (see following section) has been the main factor in keeping the baht depreciated. ¶9. (SBU) In her most recent public speech on March 16th to the Japanese Chamber of Commerce, Governor Tarisa focused on speculation and foreign capital inflows as drivers of appreciation. She stated an "unwarranted strengthening of the currency ... prompted the introduction of the capital controls" and referred to the vulnerabilities of Thailand's economy and the risk to its economic stability from "fast-moving" international capital. She made no mention of the current account's contribution to 2006's appreciation ($3.2 billion surplus from a $7.8 billion deficit in 2005) nor the export driven appreciation of 2007. More Market-Based Solutions - Liberalization of Outflows -------------- -- ¶10. (SBU) Analysts here believe there are other actions that the BoT should be pursuing to limit further baht appreciation. First, the BOT could more aggressively pursue liberalization of capital outflows, as other countries in the region, notably Korea, have done to stem appreciation pressures on their currencies. Recently a Finance Ministry spokesperson, in calling for an increase in capital outflows, noted that not enough has been done to simplify the process for sending money abroad. ¶11. (SBU) The BOT maintains a $50 million per investment/pension fund limit on outward bound investment. Insurance companies have their own limits based on approvals from the Department of Insurance. Some analysts maintain that a bold policy move - complete removal or aggressive increase in this cap - would send a positive signal to markets that the BOT is seeking more market-based solutions and address fundamentals of baht appreciation. Removal of the cap will not have an immediate effect, as only a few large investors are constrained by this ceiling. However, greater liberalization of capital outflows could provide incentive for the private sector to more actively provide and market international funds to middle-class investors, thus propelling investor education and outflows in the medium term. Thai investments outside the BANGKOK 00002392 003 OF 005 country are small, as Thais have tended to be conservative investors, not accustomed to investing outside the country. ¶12. (SBU) However, aggressive liberalization of outflows appears to not be BOT a priority, although they have incrementally raised the cap over the past few years (prior to 2003 investment outflow was not allowed). Anecdotally, BOT officials merely cite that high-net worth Thais who wish to invest internationally already do so through work-around solutions. Funds may apply to the BOT for the cap to be raised on a case by case basis. These officials point out the $50 million cap per fund on outflows is not a hard constraint. Despite awareness of the leakages, there appears to be a strong desire at the BOT for such regulations to remain so that Thailand has a defense measure in place in case of a large disruptive capital outflow. In interviews, mid-level managers noted that if the caps were completely removed, the BOT would have no tool to deal with such an economic shock. More Currency Hedging, Less Moral Hazard -------------- ¶13. (SBU) A mid-level BOT official noted in conversation that exporters are not sufficiently knowledgeable of foreign exchange hedging products. The BOT could do more outreach to help educate exporters and to facilitate the development of foreign exchange hedging products for them. Public data is not available, but according to a presentation by a BOT researcher, exporters' hedging ratio has risen from 5 to 10 percent in 2001, to 15-20 percent in 2003, surged to 35 percent in 2004, and has since fallen to 15-25 percent in 2006 and early 2007. Recent quotes in local press by head of capital markets at Kasikorn Bank, verify exporters' recent low hedging ratio. He noted that exporters hedge fewer than 40 percent of their total transactions on average. He stated that in January, the cover ratio fell to just 20 percent to 30 percent as exporters expected the capital control to help weaken the baht. Further, importers hedging ratio have tended to be higher, suggesting exporters could hedge more. According to the BOT researcher's presentation, importer's hedging ratio has been 20 -30 percent since 2001 which increased to 30-35 percent in 2006 and early 2007. ¶14. (SBU) Hedging costs appear to be reasonable. In a recent conversation, a private sector analyst approximated - depending on transaction size - hedging costs to be less than 1 percent of hedged exposure. He also noted that his bank has seen a recent increase in exporters buying hedging products, but that many exporters do not fully hedge their foreign exchange exposure, preferring to take a position on currencies. Relax Constraints on Foreign Exchange Holding Period -------------- ¶15. (SBU) The BOT maintains regulations on individual and company holdings of foreign currency. Individual and firms (which includes exporters) are allowed to hold up to $50,000 and $2 million, respectively, in foreign currency without showing proof that a foreign currency obligation is coming due in six months. These limits have been raised incrementally, most recently in January, and may be raised again. In late March, BOT's Financial Markets and Reserve Management Senior Director said the BOT is considering allowing exporters to hold foreign exchange longer than 15 days. However, again, some observers argue that a bold policy move - rather than an incremental one - could send a strong signal to markets that the BOT is aggressively pursuing a more market based solutions, and thereby improve investor sentiment. BOT Intervention Costly - Next Stop Moral Suasion -------------- -------------- ¶16. (SBU) Throughout this period, the BOT has been actively intervening in the currency markets and sterilizing - at increasing cost to its balance sheet - to stem baht appreciation. Also, recently it returned to moral suasion, as noted in REFTEL 456, asking commercial banks to not take foreign exchange positions that were putting appreciation pressures on the baht. Moral suasion, at best, is expected by local bankers to have only a short term effect. ¶17. (SBU) Over the past year, Thailand's foreign reserves have increased rapidly compared to other countries in the region. The BANGKOK 00002392 004 OF 005 BOT has not indicated its comfort level for reserves. However, the BOT did recently note that international reserves are not high enough to establish a special investment entity similar to Singapore's GIC, thus suggesting that BOT may believe that reserves have not yet reached a critically high level. Currently Thailand's foreign reserves are approximately $68 billion dollars (30 percent of GDP) and its net forward position $9.4 billion. ¶18. (SBU) In 2006, BOT's foreign reserves, as a percentage of its overall reserves, rose at one of the fastest rates in Asia - 28.7 percent, behind India and China of 29.2 percent and 30.2 percent. As of March 23, combined reserves and net forward increased $5.4 billion since the beginning of 2007, three times the amount by which reserves and net forwards increased ($1.8 billion) in the same period last year. ¶19. (SBU) Intervention and sterilization, however, is not costless for the BOT. While the BOT enjoys a slight positive cost of carry on sterilization activities (as its return on foreign assets covers the interest cost on its sterilization),it suffered a large foreign reserve valuation loss in 2006, approximately $4.9 billion (2.4 percent of GDP). One informed analyst roughly estimated that BOT's foreign reserve composition is 60 percent USD and 20 percent each of EURO and the yen. ¶20. (SBU) Some observer's fear that losses to the central bank balance sheet could increase its susceptibility to political influence if it were to seek funding from the government for recapitalization. As noted by BOT's Deputy Governor Atchana in early March in a meeting with FinAtt and EconOff, BOT's losses have become more politically sensitive as the MOF has been leaning more heavily on the BOT to pay off Financial Institution Development Fund (FIDF) bonds. FIDF bonds (currently outstanding 232.2 billion baht) were floated in 2001 to re-capitalize banks following the Asian Financial Crises, with the agreement that the MOF would make interest payments and BOT would pay the principle. The BOT thus far has paid off only a small portion of principle, with bonds rolled over, and the MOF continuing to make interest payments. However, with the MOF looking to run a fiscal deficit for 2007 (and perhaps for a few more years thereafter),the MOF is pressuring the BOT to pay off FIDF principle so that the MOF can reduce its interest payments and free resources for other uses. Despite it All, Baht Remains Competitive -------------- ¶21. (SBU) The BOT, MOF, exporters, and local media have focused on the baht's 2006 nominal appreciation of 14 percent against the USD, greater than most other regional currencies. However, a more medium term view of the baht's nominal effective exchange rate (NEER) and real effective exchange rate (REER),shows the baht moving more in line with regional currencies. The IMF reported in its February Article IV Report on Thailand that the "medium-term appreciation of the baht is in line with other regional currencies and is not yet a major concern for competitiveness." From 2004 to 2006, the baht appreciated approximately 12 percent against the USD, third highest after the Philippines (13 percent) and Korea (28 percent). However it's NEER changed only 7 percent, more in line with other currencies (Malaysia 4 percent, Singapore 7 percent, Philippines 10 percent, Korea 26 percent). A sense of the baht's "fundamental" value is difficult to gauge. Two recent analyst reports stated opposing views on the baht: Credit Suisse noted a potential 20 percent under-valuation of the baht, Morgan Stanley a 23 percent overvaluation against the USD. Benefits of Depreciated Baht Spread Out and Not Well-targeted -------------- -- ¶22. (SBU) Not all exporters are affected by appreciation in the same way, but there is little public discussion of disaggregating exporters to identify those sectors hurt most by an appreciating baht and that would have the greatest impact on employment. According to a BOT researcher's presentation, most manufacturing firms enjoy a "natural hedge" (value of exports is relatively well balanced by value of imported content). This holds across the spectrum of firm size. In other words, export firms with a large exposure to baht appreciation are not concentrated in small-size or large-sized firms. An Executive Vice President of Kasikorn Bank (Boontuck Wungcharoen) was recently quoted in local press stating that his corporate customers in the import and export sector had not yet shown any negative effects from the stronger baht. However, he BANGKOK 00002392 005 OF 005 cautioned that impact from currency changes take about six months to show up in export/import figures. ¶23. (SBU) According to the BOT presentation, sectors with the greatest sensitivity to an appreciating baht include footwear, frozen shrimp and canned fruit and vegetables -clearly, those with the least amount of imported factors relative to overall production costs. Sectors with the highest elasticity to exchange rate changes are agriculture and labor-intensive manufacturing, at 0.36 percent and 0.23 percent respectively (as a comparison, other elasticity measures are fishery at 0.05 percent, high tech manufacturing at 0.07 percent and total exports at 0.10 percent.) These sectors also are highly sensitive for employment: agriculture employs 38 percent of the labor force; labor intensive manufacturing employs 27 percent of the total labor in manufacturing. This analysis is supported by a recent statement by Finance Minister Chalongphob who noted that multinational companies are doing well, but that labor intensive exporters are having a difficult time due to Vietnam and China catching up to all major competitors. ¶24. (SBU) However, it appears that the Federation of Thai Industries (the association representing Thailand's largest exporters) is dominating the debate, advocating for an depreciated baht in the name of all exporters. The Secretary General of FTI was quoted in the local press in March stating that the FTI supports "any" measure to keep the baht depreciated. There has been some public dissension. Recently, FTI's Deputy Secretary-General Tanit Sorat, stated that the BOT should review capital controls and revoke if inappropriate, recognizing that the capital controls, by deteriorating investor confidence, has dragged down the economy as a whole. The vice-chairman of the FTI told us that, because the association represents such a broad range of industries, arriving at a united position regarding baht appreciation has been difficult. The FTI chairman has instructed all members, if speaking for FTI, to follow the "baht should stay low" line. ¶25. (SBU) Comment: Exports, at more than 60 percent of GDP, will continue to create appreciation pressures so long as imports remain depressed. Without an increase in domestic demand and imports, the BOT will be forced to heavily intervene if it wishes to keep the baht from appreciating at market-driven rates. In the medium term, Thailand needs to shift its economy away from high export dependency, and more towards domestic consumption and investment. ¶26. (SBU) Finance Minister Chalongphob, as noted in reftel 1709, is working to increase imports to reduce appreciation pressures on the baht by pump priming the economy and restoring investor confidence. Governor Tarisa, however, appears out of touch, sticking to a line - "nab speculators" - when what is needed is a restoration of investor confidence. Bold market-based measures could send a strong signal to markets. Otherwise Thailand may be beaten out by other countries in the region that are apparently choosing more market-based solutions to address appreciation pressures on their currencies. ¶27. (SBU) Further, the benefits of a depreciated baht are not clear nor targeted. The benefits are spread to all exporters, even those that may not be overly exposed to an appreciating baht and those that have low cost options to take on foreign exchange risk through purchase of hedged products. The risk for Thailand is if the baht appreciates to a level that rice, rubber, tapioca, and cassava are no longer competitive on world markets, especially at a time when the rural sector is under some financial and political pressure from the end of Thaksin-era rural support program. Unemployment is only 1.2 percent but that is only because the agriculture sector acts as a giant sponge, soaking up workers when they have nothing else to do. ¶28. (SBU) In a meeting with FinAtt and Econoff in early March, Chalongphob noted that China's management of the Reminbi places pressures on its competitors, such as Thailand, to keep their currencies depreciated and less flexible. Given the congruence of USG and ASEAN interests regarding currency flexibility (at least regarding China),bi-lateral meetings with ASEAN member countries during the Spring IMF/World Bank meeting could provide opportunities to start discussions towards cooperative efforts. Arvizu