Banks' free ride is over
Bank of Thailand Governor MR Pridiyathorn Devakula moved
swiftly on Friday to apply shock therapy to curb speculation in the foreign-exchange
swap market, which had caused baht volatility, triggered capital outflows
and undermined the country's foreign-exchange reserves.
He sent out a powerful psychological message by raising the 14-day interest
rate in the repurchase market, where banks borrow money by selling and
buying back securities at a determined rate, by one full percentage point
to 2.50 per cent.
In so doing, he effectively bypassed the Monetary Policy Board, lessened
the distortions in the short-term money markets and put an end to three
years of monetary easing. With the higher repurchase rate, the interbank
rate, the rate at which the banks lend short-term money to each other
without collateral, also comes under upward pressure.
The overnight interbank rate jumped from 0.50 per cent to 1.25 per cent
per cent on Thursday to 1.0 to 2.25 per cent on Friday after the announcement
of the repurchase rate hike. If the interbank rate is to rise to 2-2.50
per cent, it will make the baht more costly and reduce activity in the
foreign-exchange swap market, where foreign banks have been raising their
short-term baht and also speculating against the Thai currency.
The foreign banks can short-sell the cheap baht they get and anticipate
pocketing the profits once the Thai currency's value goes down when settlement
is due. So the immediate losers from the rate hike are the foreign bank
branches in Thailand, which have been enjoying a free ride by relying
on short-term money markets as their funding base for the baht.
As of March 2001, the 22 bank branches in Thailand maintained a combined
loan portfolio of about Bt398.07 billion, against combined deposits of
Bt193.29 billion. This implies they have been getting the balance of more
than Bt200 billion of their funding from the short-term money markets
as well as from the foreign-exchange swap market.
The foreign-exchange swap market, which always involves transactions
of two currencies in the spot market and in the forward market, has become
a vital funding source for foreign banks. They secure baht by entering
into sell/buy transactions with the local Thai banks. They do so by selling
the US dollar to the Thai banks in the spot market and get baht in return.
However, at a certain time in the future, usually one month, the foreign
banks are obliged to sell the baht back to the Thai banks in return for
the dollar. This transaction happens in the forward market. The combination
of spot and forward transactions, involving baht/dollar transactions,
completes the swap contracts. The cost of transactions is called swap
premium, which is the interest rate differential between the dollar rate
and the baht rate.
With the expected rise in the baht rates, the foreign banks will be less
tempted to enter into dollar/baht swap agreements because it will become
more costly when they need to borrow the baht to settle their forward
positions. The Thai banks, too, have been active in the swap market as
they are counter-parties to the foreign banks. Since the Thai banks are
required by central bank regulations to maintain their dollar assets at
not more than 25 per cent of their capital fund, they have to square off
their dollar positions once they have accumulated dollars in the spot
market beyond this limit. The Thai banks, after acquiring the dollar in
the spot market from the foreign banks, normally deposit the US currency
in New York or Singapore for an interest gain of 4 per cent. When the
swap cost of about 1.50 per cent is taken into account, the Thai banks
make a net gain of 2.50 per cent. If they were to keep their baht in the
interbank market, they would make only 0.75 to 1.25 per cent (last Thursday's
rate). If the interbank rate goes up to 2.50 per cent, equal to the local
banks' net gain of 2.50 per cent in the swap market, it will discourage
swap transactions, making the baht less susceptible to speculation and
discouraging the local banks from taking the money overseas.
Pridiyathorn would like the interbank rate to stay between the deposit
and lending rates. The next step that will follow is that the foreign
banks will be obliged to rely more on the interbank or repurchase markets
for their baht funding, or to treat their deposit customers more nicely.
At one point, they almost turned away their deposit customers because
they did not want to pay the high deposit rates, being able to obtain
funding cheaper from the short-term money markets. And as Pridiyathorn
plans to issues bonds periodically to absorb excess liquidity in the banking
system, it will automatically force the deposit rates to rise as banks
compete for longer-term baht funding.
Pridiyathorn is focusing more on eliminating distortions in the short-term
money market and curbing baht speculation than thinking about how the
higher rates might stall the economic recovery. To him, macroeconomic
stability is more important than economic growth at this juncture. In
contrast, MR Chatu Mongol Sonakul, Pridiyathorn's predecessor, encouraged
the Thai banks to build up their long dollar assets.
Chatu Mongol's rationale was that by shifting the money overseas, the
banks could reduce their excess liquidity and at the same time strengthen
their balance sheets with higher gains from dollar deposits. Since there
are few projects in the economy to lend to, given the capacity utilisation
of industries at 60 per cent, the banks have an excuse not to lend in
the domestic economy. But their swap transactions have led to capital
outflows. A Salomon Smith Barney report some time ago estimated that the
Thai banks had combined dollar assets of about US$20 billion (Bt900 billion)
parked in the foreign banks in the overseas markets. The banks' dollar
assets also strengthen the country's balance sheet when the external indebtedness
of the country is taken into account.
But the Thaksin government has been concerned that if the short-term
rates were kept artificially low, they would accelerate capital outflows,
affect the baht's stability and eventually undermine the foreign-exchange
reserves. With this conspicuous difference in policy views, it is no surprise
that only the removal of Chatu Mongol would make it possible to pave the
way for such a radical shift in monetary policy. Yet using this interest-rate
weapon to defend the baht implies that Pridiyathorn has his back against
the wall on day one of his office.