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.

Thanong Khanthong