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Crushing 'thought' of devaluation


Thanong Bidaya, the new finance minister, will need a master plan to cope with the pressure for a one-time devaluation, say Vatchara Charoonsantikul and Thanong Khanthong.

Devaluation rumours reached fever pitch last Thursday following the resignation of Dr Amnuay Viravan, the finance minister. However, the financial markets calmed down significantly when they learnt that Dr Thanong Bidaya, the president of the Thai Military Bank, was to succeed Amnuay because he was likely to follow his predecessor's staunch anti-devaluation policy. Would he or would he not?

Over the weekend, Thanong side-stepped a question over the government's foreign exchange policy. ''At this point I do not want to give any opinions about the foreign exchange policy because it may create misunderstandings. I've already had an idea in my mind and have also consulted with Mom Tao (MR Chatu Mongkol Sonakul, the permanent-secretary for finance)."

On Thursday, flanked by his ''Jurassic Park" Cabinet, Gen Chavalit Yongchaiyudh, the prime minister, come out frantically to soothe nervousness in the financial markets by insisting that the government had no policy whatsoever to devalue the baht. The following day saw the onshore baht calm down to between Bt25.90 and Bt26.02 and the offshore baht to between Bt24.94 and Bt25.40, against Thursday's rates of between Bt25.85 to Bt27.02 and Bt25.10 respectively.

Thanong should have shown a hawkish stance on the foreign exchange policy by echoing the prime minister's ringing endorsement of the baht. What the banking authorities have been fighting over the past six months is defence of the baht until the country has more breathing space to rectify its macro-economic imbalances.

In an interview with Wattachak before taking over the finance portfolio, Thanong showed that he had a very good understanding of the Thai economic problems, but when it came to the question of foreign exchange policy, he did not have a ready-made answer.

''While our economy is running into problems, cutting the interest rates will further deteriorate the Thai financial cycle. With the abnormal economic conditions, speculation (in the foreign exchange market) is rampant, making it difficult to cut the rates, particularly at a time when there is a big gap between the interest rates of the commercial banks and the finance companies," he said.

Thanong threw his weight behind the central bank's stern action to defend the baht in the foreign exchange market. He noted: ''What is particularly important is that the authorities must manage the foreign exchange policy in such a fashion that it will not affect the production and distribution of goods. This is extremely difficult to do because if you tackle one point, it will have an impact on the other."

On Saturday, Thanong asserted that he'll look after capital inflows as a priority, ensure that the foreign capital is used productively instead of being channelled into bailing out the unproductive real estate sector.

While the financial markets are giving him the benefit of the doubt over his qualifications to tackle the financial and foreign exchange crises, Thanong demonstrated his humble nature by showing a willingness to learn. On Saturday he had lunch at the Siam City Hotel with Dr Suthee Singhasaneh, a former finance minister, where the guru gave him some recommendations on how to conduct and project his ministership.

Apparently, devaluation is the last thing the Bank of Thailand has in mind. As finance minister, Thanong will automatically chair the Exchange Equalisation Fund, the foreign exchange management arm of the BOT. He'll have the final say on any adjustments to the foreign exchange policy.

A study conducted by Dr Olarn Chaipravat, the president of the Siam Commercial Bank, is worth noting. It showed that there are more losses than gains in a devaluation due to the heavy dependence of the Thai industrial structure on imports for value-added re-export.

Import content accounts for about 42 per cent of total exports, while the remaining 58 per cent represents domestic value-added content, which consists of capital and labour, the study says.

In a scenario for any baht devaluation, import content will rise at the same rate as the devaluation. Capital and labour will also be affected.

On the capital side, production costs will rise after a devaluation, a rise that will be equivalent to the interest costs that will become higher. The interest costs will jump to the equivalent rate of inflation, which increases, say, at 4.5 per cent this year.

Labour will also be adversely affected by a devaluation and there would be calls for wage increases due to the increase in inflation, which is a direct consequence of the devaluation.

In a 10 per cent devaluation scenario, imports will rise by 10 per cent, pushing up the costs of the 42 per cent import content of Thailand's industrial sector by 9.89 per cent. The following is how the 9.89 per cent figure is derived:

Imports will carry a higher baht cost in proportion to the devaluation. In the case of the 42 per cent import content and a 10 per cent baht devaluation, the cost will rise by (42 per cent) X (10 per cent) = 4.2 per cent.

On the domestic value-added side, capital normally accounts for 35 per cent of total costs, compared to 65 per cent for labour. So capital costs will rise by another 4.2 per cent from a 10 per cent devaluation, on top of the interest costs they normally carry of 13 per cent (the prime rate).

Yet Thai exporters have been enjoying a subsidy from the government through the Export and Import Bank of Thailand, where they can muster a steady interest rate of 7 per cent.

Through the Exim Bank, the exporters can borrow 50 per cent cent of their total borrowing demand, so they end up paying the interest cost of (13 per cent + 7 per cent) divided by 2 = 10 per cent.

In the case of a 10 per cent devaluation, exporters' total costs will be (13 per cent + 4.2 per cent + 7 per cent) divided by 2 = 12.1 per cent. This is equivalent to an increase of (12.1 per cent - 10 per cent) divided by 10 per cent = 21 per cent.

When taking the ratio of capital and the assumption of a depreciation cost of 30 per cent, the cost increase will be equivalent to (35 per cent) X (42 per cent) X (1 - 30 per cent) X (21 per cent) = 2.98 per cent.

Labour, which makes up by about 65 per cent, will be affected by the devaluation by wage increases. Suppose that wage costs rise equivalent to the inflation rate of 4.2 per cent plus the rise in capital cost by 2.98 per cent, labour costs will increase by (65 per cent) X (58 per cent) X (7.18 per cent) = 2.71 per cent.

So when all the rising costs from the devaluation are combined, one arrives at higher over all costs for Thai exporters at (4.2 per cent + 2.98 per cent + 2.71 per cent) = 9.89 per cent.

Based on these calculations, it is clear that a 10 per cent devaluation will almost offset the rising costs of 9.89 per cent faced by Thai exporters. a devaluation in the first round will have a subsequent impact on the input of all goods manufactured afterward, with the accumulated cost rising eventually to 26.09 per cent twice as high as the devaluation, the study said.

Worse still, devaluation will affect interest and principal payments of Thai corporations, which are now saddling themselves with US$61.39 billion in external debts. A 10 per cent devaluation will cost ($61.39 billion) X (10 per cent) = $6.13 billion or Bt158.39 billion, or 3.21 per cent of Thailand's gross domestic product (GDP).

All Thai corporations which borrow either in US dollars or yen or both will face enormous losses, which will trigger bankruptcies, factory shutdowns and widespread unemployment.

To avoid a devaluation, the Olarn study suggested that the government and the private sector come up with a grand strategy to reconstruct the Thai economy.

First, the government must undertake fiscal consolidation. Both government agencies and state enterprises must cut their spending. The budget must be balanced.

Second, the baht interest rate must be cut and financial institutions must raise their credit growth to allow the economy to pick up and help the businesses to recover.

Third, all industries and companies must improve productivity and increase competitiveness so that they can compete on the global markets.

Fourth, a backforward and forward linkages strategy must be implemented to deepen the industrial structure of Thailand and increase the value-added content and substitute for raw material imports. (Reduce the import content by 42 per cent, and increase the domestic value-added component by 58 per cent).

Fifth, there should be a campaign for the private sector, businesses and the public to increase long-term savings, in order to reduce Thailand's dependence on foreign capital and narrow the investment savings gap. The current account deficit should be targeted to fall to zero per cent of the GDP within the next five years.

Sixth, gradual adjustment of the baht against the basket of currencies by widening the trading band by one to two per cent a year to attract dollars or yen into the country. This can be accomplished by international roadshows on a regular basis.

The baht interest rates must be brought down by 1 to 2 per cent in the first year of the policy implementation.

The goal is that the baht interbank rate should hover above the US dollar interbank rate by a differential of 2 per cent. Now the differential is more than 5 per cent.

If the US interbank rate or the Libor rate are up, the baht interbank rate should also rise proportionately, ideally by not more than 2 percentage points.



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