Political pressure on the Monetary Policy Committee (MPC) mounted as the baht shot to a 16-year high last month, inching close to 28.50 to the US dollar. Word spread that the Bank of Thailand and the Finance Ministry were ready to impose measures to curb hot money after a much-hyped meeting with the National Economic and Social Development Board last Friday.
In the end, it was all talk and no action. No measures were announced, but the market's fear of action, particularly after the next MPC meeting on May 29, has since kept the baht in check, and it is now hovering between 29.30 and 29.40, a far more reasonable level.
As a rule, a strong baht hurts Thai exporters, but the impact is not equal across all industries. A study by Bank of Thailand staff found agricultural exports are the most sensitive to exchange-rate movements. On average, their value falls by 0.36% for every percentage increase in value of the baht. Labour-intensive manufacturing trails agriculture with a 0.23% value loss.
These findings are consistent with our sectoral research. The top five losers _ sectors in which gross profit margins will likely be eaten away by baht appreciation _ are furniture and decor, rubber, processed food, automobiles, and textiles and garments. Most of these fall under the categories of agricultural and/or labour-intensive production.
It is surprising though to see automobiles on our list, as this is a technology-intensive sector and supposed to have natural hedge against unfavourable exchange movements. Export-oriented businesses that import raw materials are partially protected against a strong home currency. The reason is while their export income erodes since foreign earnings will be worth less in domestic terms, so does their cost of imports. Nevertheless, the sheer volume of Thai vehicle exports these days dictates that the automotive sector will take a hit.
How effective a natural hedge is depends on the relative values of exports and imports, also known as a natural hedge ratio, for which values can range from zero to 100%. Another recent study by the central bank reports that in the first 10 months of last year, only 2,051 or 2.19% of 93,773 international Thai traders had a substantial natural hedge (ratios above 75%); these firms account for 17.2% of Thailand's total trade volume. A stark 92.6% of businesses had very low hedge ratios below 25%, and they account for 47.8% of trade volume.
In a nutshell, Thai exporters and importers alike are at risk. No wonder the fear of baht appreciation has been a very critical political agenda item.
But exporters have been more active in hedging their risks. As of the end of 2012, the amount of dollars that exporters sold forward was about twice the amount that importers bought forward. This comes as no surprise since the baht has been following a strengthening trend against the dollar since the aftermath of the 1997 crisis.
Small and medium-sized enterprises (SMEs) will typically take a larger hit than their larger rivals. SMEs and industrial rubber producers, for example, differ mainly in size, but their products are identical and the production processes very similar.
SMEs' lack of economies of scale means they will almost certainly have higher operating costs including those for hedging risks, which result in deteriorating profit margins once exchange rates start moving against their favour. So hedging clearly benefit SMEs here.
However, the occasional outcries by exporters may reflect a deeper structural problem than the strong baht. Last year, 80% of Thailand's export receipts were in dollars. That has gradually fallen from 85% a decade ago, yet the current level remains very high, given that the US accounts for only 10% of all Thai exports. So we are talking about concentration risks here. While probably constrained by conventional business arrangements, exporters would have suffered a bit less had they been able to diversify slightly more to other currencies.
In the past 10 years, the dollar has lost well above 40% against the baht. In fact, it is the only one among the "major currencies" that has persistently shown a losing streak against Thailand's currency.
From a portfolio management perspective, this is like holding a "loser" stock, and reducing its holdings by a mere 5% will definitely be inadequate to contain losses from price falls. Our calculation shows exporters have lost 30% of their "portfolio value" by concentrating on dollars. Had they increased their share of yuan or euro transactions, they would likely take a smaller hit in currency compared with what they are facing today.
From a risk-management perspective, it makes more sense for Thai exporters to China to settle trade in yuan (or even better in baht _ if they could) than in dollars. Not only are yuan movements broadly on a par with those of the baht, but also moving away from the dollar will reduce what is known as "basis risk". This risk is associated with mismatching the denomination of a futures contract with the denomination of the underlying position. In simple terms, Sino-Thai trade is tied to product prices, material costs, quantities sellable, etc. in either baht or yuan. By introducing dollars into the transaction, the trader introduces the risk that these three currencies may not move in tandem into the equation.
If the dollar weakens against both the yuan and the baht, Thai exporters will lose, whereas Chinese importers will gain, and vice versa when the dollar strengthens. Basis risk will be lower if trade is settled in the currency pair most relevant to the position. Thai companies doing business in Asia may want to use more Asian currencies rather than dollars, as an empirical observation suggests they generally move in closer correlation and hence carry smaller basis risks.
The fear of appreciation is not new. Not this time and not for this currency. Thailand has enjoyed a long stretch of weak baht since it was floated in July 1997, touching off the Asian financial crisis, and has since built its strong economic performance based on a stellar export platform. As we will continue along a similar path in the future, it may be worthwhile to reflect on the structure of currency settlements. After all, if the dollar is not likely to rebound any time soon, then we hardly want to tag along for that ride again, do we?
TMB Analytics is the economic analysis unit of TMB Bank. Behind the Numbers is co-authored by Benjarong Suwankiri and Warapong Wongwachara. They can be reached at TMBAnalytics@tmbbank.com