Cablegate: Corrected Copy: Baht Appreciation, Capital Controls And

DE RUEHBK #2392/01 1170732
R 270732Z APR 07






E.O. 12958: N/A



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

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

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.


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