My 2 Cents:
Throwing the Baby Out With the Bath Water

          By now you must have read about the Bank of Thailand (BOT)’s controversial capital control measures that was announced on December 18th and quickly scaled back the following day after a steep 15% drop in the Stock Exchange of Thailand (SET) that rippled across much of Asia. Investors were reacting mainly to a new rule that required foreign investors to deposit 30% of the funds they bring into Thailand to buy debt instruments for less than a year. The policy was intended to give exporters a break by curbing the rapid appreciation of the Thai Baht, which has risen faster against the dollar than any other Asian currencies this year. (Please see Chart 1 below)

Chart 1

          As a result of the policy ‘flip-flop’, the BOT has severely damaged its reputation. It is not so much that investors do not like to be told what to do with their money, but that this policy was not particularly well thought out. A bit like throwing the baby out with the Bath water. On Dec. 19 the BOT went about it backward. Instead of restricting capital outflows, it restricted capital inflows. Put another way, not only did it adopt a policy designed to rein in currency speculators, it did not do it in a way that would prevent others from running. That has created a double hit to market confidence in the Thai authorities, injecting immense doubt into the belief that recently elevated technocrats such as Finance Minister and former BoT Governor MR Pridiyathorn Devakula and current BoT Governor Tarisa Watanagase have some clue as to what they were doing.

         The ill-conceived policy is a version of the so-called Tobin tax introduced in Chile in 1991. Named after Nobel prize-winning economist James Tobin, the policy was designed to tax the inflow of short-term foreign funds to limit the impact of speculative money. Unlike Chile, however, the BOT initially included foreign investments in the stock market in its new capital controls, requiring foreign investors to deposit 30% of the money they bring into the country in non-interest bearing accounts for at least a year. In effect, it was a steep tax on foreign equity investments. Sure enough, foreign investors voted with their feet by triggering a 15% dive in the SET that wiped out $ 22 billion worth of market capitalization.

          What these two policymakers do next is of critical importance. First, let’s not forget that Thailand remains dependent on foreign capital -- and the owners of that capital have a herd mentality and a mass exodus from Thailand can hardly be ruled out. In fact the number of applications for Foreign Direct Investment (FDI) has already fallen by 50% during the first ten months of 2006 (See Chart 2 below).

          Secondly, Thailand's reputation as a solid economy with questionable politics would change to a reputation of questionability on both scores. Investors did not bolt after the Sept. 19 coup because there was trust that Thai people were levelheaded enough to keep their money separate from their politics. Should the events of Dec. 19 not prove a mere hiccup, then coups will mean the same thing in Thailand that they mean everywhere else.

          What’s next? To be fair to both the BOT and the Finance Minister, it’s all too easy to criticize their policies without offering a viable alternative option. This whole mess all started with good intentions when the BOT began searching for a way to stop the rapid strengthening of the Baht, which has risen by as much as 17% against the US dollar in 2006. Foreign money was flowing into Thailand, lured by its relatively high interest rates and the prospect of further appreciation in the Baht. If the trend continued, Thai exporters would be priced out of the market, undercut by China, which does not let its currency move as freely as the Baht.

          Some economists argued that local interest rates could have been lowered but the speed of the inflows prevented the BOT from doing so, which policy makers want to do partly to boost the economy. If rates were lowered, then bond and stock prices would become more attractive and there could be more upward pressure on the Baht. In fact speculative money has been building up in local bonds and commercial debt for months in anticipation of a stronger Baht and declining interest rates. So the BOT opted to apply capital controls across the board.

          Such draconian measures were out of proportion and according to the Chilean experience, which the BOT alluded to, suggests that such measures were ineffective longer-term. Sure enough, net short-term private capital inflows fell in 1991 but the ‘net errors and omissions’ term and estimated trade mis-invoicing increased sharply. A key lesson is that the private sector will find ways to inevitably circumvent the measures.

          Personally, I would prefer direct intervention in the foreign exchange market by the BOT rather than capital control measures. Worse of all the BOT did not consult other regulators such as the Stock Exchange of Thailand (SET) nor the SEC, mainly to prevent news of it from leaking. But many market participants, particularly the stockbrokers, viewed this as arrogance by the BOT. It remains to be seen how long the BOT will retain the controls in the current format. But the curbs could hurt business confidence and foreign direct investment, which is already in the doldrums. Moreover, there is the danger that the damage on the investment climate may become more permanent. The likelihood of a private investment recovery next year now looks increasingly remote. Growth in 2007 will likely remain lackluster.

          Some options going forward for the BOT to gradually unwind the curbs include reducing penalty for early withdrawals, interest rate cuts would also reduce some of the appreciation pressures, exempting property investments from the curbs because by nature these investments are long-term in nature. However, my guts feel is that things will get worse before they get better especially in January ’07 when foreign fund managers return from their holidays. The so-called ‘January Effects’ could be particularly nasty this year when money managers finalize their asset allocation strategies for 2007 and decide whether they still want Thailand in their portfolios or not. Prolonged maintenance of these controls could permanently hurt the investment climate and seriously upset the prospects of any investment recovery.