Economic Mid-Year 2001

Acrimony over
new direction

Parista Yuthamanop

MONETARY POLICY

The replacementof the central bank governor in a dispute over interest-rate policy signalled an abrupt switch from keeping rates Iow as a key tool in managing the economy. As well, the baht weakened on the back of a slowdown in export performance and uncertainties over the prime minister's future and the government's economic policies

Monetary policy underwent a drastic change in June, when the Bank of Thailand reversed its two-year policy to hold interest rates low and embarked in a new direction focusing on stabilising the currency and foreign reserve levels.

M.R.Chatumongol Sonakul, appointed central bank governor under the Chuan government and widely credited with helping the institution regain market credibility, was sacked in late May after weeks of debate over interest-rate policy. M.R. Chatumongol had argued that in the absence of inflationary pressures, low interest rates were necessary to accommodate debt restructuring and economic growth, a position which had the support of many private economists as well as the International Monetary Fund.

But the government, led by Prime Minister Thaksin Shinawatra and Finance Minister Somkid Jatusripitak, had argued that a rethink of rates was necessary in light of the decline of the baht and steady capital outflows since mid-2000.

The baht was trading around 45.3 by mid-June against the US dollar, down only by 3.4 from early January. Capital outflows averaged around $780 million per month in the first quarter.

The central bank had argued that neither issue was much cause for concern, as the baht was moving in line with other regional currencies and that capital flows was primarily led by private sector repayments of foreign debt.

But the government on May 29 agreed unanimously to sack M.R. Chatumongol. Ministers stressed that the dismissal was due to lack of coordination and co-operation, not interest-rate policy.

But under the new governor, M.R. Pridiyathorn Devakula, the central bank increased its key 14-day repurchase rate by one percentage point to 2.5%, the first increase in at least 13 months.

M.R. Pridiyathorn, an experienced banker and former president of the Exim Bank, said the move was aimed at reducing market distortions and cutting the incentive for businesse to refinance their foreign debt with cheaper domestic funding.

The new governor said the priority for monetary policy would be to ensure economic stability, not accommodate growth. This was seen by many market analysts as a repudiation of the Monetary Policy Board which was established by M.R. Chatumongol to set rate policy with the goal of ensuring price stabilities and sustainable growth.

The MPB had held rates low as core inflation, excluding food and energy, was expected to remain within the 0-3.5% target to the end of 2002. But from the government's perspective, the deterioration in export performance and the narrowing trade surplus raised worries that the country's reserve position would be damaged later in the year unless action was taken.

From January to April, the country posted a trade deficit of $68 million, a sharp contrast to the $2.3 billion surplus posted the same period the year before. Exports in the first quarter fell by 2.7% in value terms year-on-year, while imports rose 9.5% for the period.

M.R. Pridiyathorn said the central bank would seek to maintain official reserves, around $32 billion as of mid-June, at around $30 billion to maintain investor confidence.

But many analysts questioned whether the government's misgivings were misplaced. Capital outflows, for instance, had helped reduce the country's foreign debt burden to $76 billion at the end of March, compared with a peak of $102 in mid-1997.

The ratio of private to public debt stood at 58:42 at the end of March, with short-term debt accounting for 19% of total foreign debt.

Low domestic interest rates and the anticipation of a weaker baht had led many companies to refinance their foreign debt with cheaper domestic funding.

By raising interbank rates to range between deposit and lending rates, the central bank expected that foreign-debt repayments would slow and the baht would gain increased stability.

Higher interest rates would also presumably help boost foreign capital inflows, while banks would come under pressure to close their spreads and rely more on deposit financing rather than borrowing in the money market.

Gross spreads stood around 5-6 percentage points by mid-year, with deposit rates of around 2-2.5% against prime lending rates of around 7-8%.

The central bank expects spreads to narrow in the second half, once 1.3 trillion baht in non-performing loans are transferred out of the banking system to the state-owned Thai Asset Management Corp.

Even so, few observers expect the central bank to push its 14-day rate any higher in the next few months, given weak domestic demand, capacity under-utilisation and low inflationary pressures.

With excess market liquidity as high as 500-600 billion baht, questions also arise about the ability of the central bank to absorb funds given its limited resources.

Open market operations would be the main tool for the central bank to raise funds. But with hundreds of billions of baht in state bond issues expected to be issued over the next year to finance spending programmes, some economists express concern about a possible crowdingout effect in the market.

Higher interest rates would also raise the government's debt service costs, as well as expenses for the Financial Institutions Development Fund.

EXCHANGE RATES

The baht has fallen gradually since the start of the year, in line with regional currencies and the yen.

The baht stood at 42.50 to the dollar in January and closed at 45.14 on June 11, with the weakest point coming at 45.80 in early April.

The currency's weaknesses was attributed to the slowdown in exports and the economy, political uncertainties over Mr Thaksin's future pending his Constitutional Court case and market confusion over economic policy changes.

The central bank had taken several initiatives to help bolster the baht indirectly, choosing to impose foreign exchange controls and tighter reporting regulations rather than outright intervention.

In January, the central bank ordered financial institutions to demand additional documentation from clients seeking transactions for foreign debt service.

Tighter reporting requirements were also announced in May, particularly. on non-resident baht accounts and transactions in currency, derivatives and other securities.

But the measures, originally set to be implemented in July, were indefinitely shelved under M.R. Pridiyathorn, although the governor has said he continues to favours close monitoring and occasional intervention to limit trading volatility.

The weak Japanese economy also contributed to the slowdown in exports.

While a gain in demand helped boost the Japanese economy in the first nine months of 2000, investment soon slowed due to a drop in domestic demand.

The yen traded at 121.47 to the dollar by mid-June, down from 114.11 earlier in the year.

In the bond market, yields for the 14-year government bond fell as low as 5.4% in February, compared with 6.6% in January.

Yields rose as high as 6.65% in June following market uncertainties over the central bank's interest-rate policies, as institutional investors dumped positions pending clarification from regulators.