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Beating on the Thai Baht Conundrums (Part 2)
By Mikka Pineda
In the previous installment of "Beating on the Thai Baht Conundrums", we explained the baht's puzzling outperformance over its regional peers despite posting the weakest GDP growth, draconian capital controls and falling interest rates: A dramatically improved trade balance and foreign portfolio equity inflows coupled with restrictions on resident portfolio outflows exerted pressure on the baht to appreciate. Political uncertainty dampened foreign direct investment as well as capital expenditures that would have demanded foreign financing. Capital controls meant to slow currency appreciation from speculative inflows did the opposite.
In this installment, we move the discussion on to another thai baht conundrum: the onshore-offshore baht divergence. The capital controls implemented by the Bank of Thailand on December 2006 and January 2007 resulted in a two-tiered currency market whereby the baht was stronger offshore than onshore. For example, the THB/USD rate offshore was nearly 4 baht stronger than onshore in early August. The spread began narrowing after capital controls were relaxed somewhat and political uncertainty dissipated towards the December 23 elections. Here, we review the evolution of Thailand's currency policy over the year then explain why exchange rates for the baht diverged between onshore and offshore markets.
Thai capital controls in review
December 19, 2006:
In an effort to stem speculative inflows causing the baht to appreciate out of line with its asian peers and Thailand's economic fundamentals, the Bank of Thailand (BoT) imposed a 30% Unremunerated Reserve Requirement (URR) on all nonresident, non-trade-related inflows greater than US$20000. 30% of these funds had to be deposited with the central bank for a year before they could be fully refunded. Only 2/3 of the reserve would be returned if withdrawal was made within the year - an effective 10% withholding tax (ANZ Investment Bank). A day later, the BoT repealed the URR on stock investments after the SET dropped 15% in reaction to the capital controls.
The baht rebounded strongly after the stock market's exemption, so the BoT supplemented the URR with a ban prohibiting Thai banks from executing offshore forward curency contracts (i.e. non-deliverable forwards, or NDFs) with foreign entities.
To boost corporate financing, the BoT further revised its capital controls by removing the URR from foreign currency loans provided that the loan is fully hedged for at least a year. By this point, however, business confidence and the related investment demand had already soured under political uncertainty.
BoT granted foreign mutual, bond and property funds a waiver from the URR as long as they were fully hedged so that they couldn't profit from baht gains. (Bloomberg)
July 16, 2007:
To curb offshore THB volatility and narrow the rate divergence between the onshore and offshore markets, the BoT allowed foreigners to borrow THB onshore for one month until August 16 to square existing (pre-Dec 19, 2006) hedged offshore positions. The move allowed nonresidents to settle or renew swap contracts locally. Borrowing had to be approved by the BoT on a case-by-case basis but was not subject to the 30% URR (IDEAglobal). During this period, the THB/USD appreciated to record highs July 23-24. The THB/USD's 19% appreciation ytd prompted the BoT to intervene.
July 24, 2007:
In response to persistent baht appreciation, BoT eased controls on residents' investment outflows. New rules permitted Thai individuals and companies to hold foreign-currency earnings offshore for 360 days, up from 120 days formerly. The rule requiring Thai residents to convert foreign currencies onshore within 15 days was abolished (MarketWatch).
Despite the BoT's efforts, the baht did not experience significant weakening until the U.S. subprime crisis blew up in August. The THB/USD reached a nadir of 33.17 on August 17. Since September, the baht recovered to pre-crisis levels, though not as strong as in July (X-rates chart). The fourth quarter has so far posted the year's (excluding July) strongest monthly average THB/USD rates.
Why Baht Rates Diverged
While the BoT's measures failed to arrest the baht's rise (in both onshore and offshore markets), they also created a gap between onshore and offshore baht rates.
The January ban on local bank NDFs with foreign entities turned off the supply of baht to the offshore market so offshore baht became harder to come by.
Nonetheless, NDFs and cross-currency swaps continued to be executed by other institutions. The offshore baht rate became more sentiment-driven than its onshore counterpart: When international investors have little access to a country’s onshore interest rate markets or deposits in local currency, the NDF prices for that currency are based primarily on the expected future level of the spot exchange rate. NDF prices for baht declined on expectations that the baht would appreciate and capital controls would be removed. (Lipscomb 2005)
A wide onshore-offshore gap increases the allure of arbitrage: THB/USD speculators would buy cheap dollars in the offshore market and sell them in the onshore market. (The Nation, January 2007). However, the gap has narrowed since the BoT temporarily permitted nonresidents to settle swap obligations locally until August 16. The US subprime crisis then bloomed that same week, prompting investors to unwind their emerging market positions. Demand for baht fell. Since then, the baht underwent a fragile recovery but the approaching Dec 23 elections cut demand for NDFs. The coming end of the military regime was associated with an eventual return to full baht convertibility. When a change in exchange rate regime is increasingly likely, there is often a greater likelihood that the validity of the 'fixing rate' for a currency as an indication of where the spot market is trading or a price where a major trade can be transacted significantly diminishes (Lipscomb 2005).
With no barrier to stock investment and low barrier to bond and other investments, offshore demand for baht can continue to be strong while onshore demand suffers from a glut of baht. (Khanthong)
With their narrow or negative interest rate differentials versus US bonds, Thai government bonds weren't particularly attractive to foreign investors. The Thai benchmark policy rate dropped 125bps below the US fed funds rate this year. Even a 75bps Fed rate cut on Dec 11, well above expectations, wouldn't turn interest rate spreads significantly in favor of Thai bonds. Furthermore, political uncertainty put infrastructure mega-projects on hold, depressing public investment. With low yields and political uncertainty, Thai bonds couldn't outshine the 30% URR on bond investments. As a result, foreign investment only accounted for up to 5% of turnover in the bond market in the first half of this year (BoT, July 2007).
Later in the year, foreign interest in bonds began to rise. 10-year bond yields rose and stabilized after BoT easing ended. The approaching return to democracy fueled hopes of a revival in mega-projects and hence government demand for financing in 2008. To attract enough foreign investors to Thai government debt, Thailand would presumably have to restore full baht convertibility (SCB, August 2007) - one reason why capital controls seemed unsustainable and offshore baht markets expected their eventual removal. The improving outlook for yields and politics put the shine back on Thai bonds. A 30% URR posed a limited barrier to foreign investment in Thai local-currency bonds and therefore offshore demand for baht (Bangkok Post):
"Investors can still profit from the wide difference in exchange rates between the two markets, one banker said. A non-resident bringing in $100 million to invest in Thai one-year bonds can set aside 30%, or $30 million, with the central bank as a reserve and still benefit, the banker added. The $70 million remaining is exchanged to baht at the onshore spot rate and invested in local bonds.The investor can then hedge currency risk by buying a one-year forward contract in the offshore market, which quotes the baht at a substantially stronger rate than in the local market. At the end of one year, the investor receives their 30% deposit from the central bank, 4-5% returns on the $70 million invested in baht bonds, and liquidity to settle the forward contract offshore"