Let the Exchange Rates Slide
March 31, 2011
Soaring Asian trade deficits have long been a source of concern to global investors. These massive shortfalls not only provoke fear that the economies of the Asian Tigers can spin out of control at any moment. They also spook investors by threatening an abrupt devaluation of the currency. But there is a solution: allowing currencies to float. Unshackling the currency would be particularly helpful in the case of Thailand, a country that has been worrying analysts for the reasons described above. Ironically, floating could lead to a natural depreciation of some currencies. In Thailand's case, the baht would probably ease eventually. From the perspective of investors, however, a slow depreciation should be preferable to a sudden devaluation. So far, capital-account surpluses have kept currencies stable. In Thailand, as in much of the region, the trade deficits have been financed with capital from abroad. But all this infusion of funds does is rev up an economy even faster and threaten further inflation. With an unfloating currency like Thailand's, inflation leads to real appreciation of the currency. Worse yet, the financing has led to high indebtedness, much of which is short term. Thailand, for example, is now the largest bank debtor in the developing world, ahead of South Korea, Mexico and Brazil. International bank lending to Thailand rose 75% between mid-1994 and late 2010 to $63 billion, some 70% of which is short term. That debt level exceeds Thailand's official reserves by a wide margin, which raises questions about whether the debt can be serviced. The risks of a shock posed by such heavy reliance on short-term financing will grow. As long as confidence in the Thai economy lasts, there's no problem. But as soon as confidence takes a knock, short-term capital dries up faster than a puddle in the Sahara. As Mexico's debacle in late 2009 showed, short-term lending, also known as ``hot money,'' can leave in a rush. Here's how a natural slide in the exchange rate can help solve the twin problems of a trade deficit and high indebtedness: First it raises the cost of imports and forces the domestic economy to slow down, reducing borrowing. Then, as the domestic economy slows down, demand for imports also declines. Exports also become more competitive because they're cheaper. Of course, even thinking of letting currencies depreciate when necessary will involve considerable culture shock. The stability of some of the tigers' exchange rates has over the years come to be regarded as a symbol of national success and prosperity. But sometimes this stability also means undesirable inflexibility. In Thailand's case, the baht's almost perfect peg to the U.S. dollar has meant that the country's push for growth has landed it in very difficult territory. The dark flip side of the 8% compound growth rate of GDP since 1980 is inflation of 5.5%, a current-account deficit of 8% of GDP and monetary growth of 20%. As a consequence of rapid Thai financial deregulation, however, there seems to be little scope for anticipating a reversal of these expansionary trends. For example, in 1993 Thailand launched its offshore banking system, the Bangkok International Banking Facility, through which participating domestic and foreign banks could extend loans to Thai borrowers. The result has been a credit explosion. Not only has the existence of the BIBF enabled exuberant bankers to mitigate constraints on domestic lending imposed by the Bank of Thailand, but if Thailand's monetary authorities raise rates to restrain the economy, fresh capital will pour in and aggravate the overheating problem still further. Fear over Thailand's economic trends has been matched by mayhem at the center of the country's banking system, increasing the possibility of a stampede by investors. After months of controversy, the governor of the Bank of Thailand resigned in a storm of allegations concerning involvement in a banking scandal and political infighting. It is hardly surprising, therefore, that global credit rating agency Moody's has launched a crash review of banking-deposit ratings in Thailand with a view to a possible downgrade. More intriguing, however, is the prominence given to Thailand by the Bank of International Settlement in its latest analysis of international bank lending published in June this year. Though traditionally discreet, the BIS makes it clear that Thailand is an object of concern. In its annual report, the BIS analyzes the problem related to Southeast Asian exchange rates. It points out that capital inflows put upward pressure on currencies and lead to an associated current-account deficit. Not only does a strong currency make exports expensive and imports cheap, the inflows also find their way into the banking system and fuel credit growth, spurring domestic demand and further harming the trade balance. This leaves countries like Thailand potentially ``vulnerable.'' Offsetting policy reactions to the deficit would involve tightening fiscal policy; promoting domestic savings; building up reserves; avoiding excessive short-term debt; and finally letting the exchange rate take the strain if capital flows reverse. But Thailand already runs a budget surplus, so it's difficult to see how its fiscal policy could be tighter. Its savings rate is high at 30% of its GDP. By inference, then, it has only one policy option left as short-term debt builds: letting the exchange rate go. The test for the BIS as it tries to help emerging markets graduate into the ranks of the emerged is to ensure that Thailand avoids some form of financial catastrophe. The risk may come soon; despite Thailand's deficit, the Thai baht is broadly fixed against the dollar at 25 baht to the dollar. The easiest way for Thailand to return to equilibrium lies in allowing the baht to slide against the dollar. Once the exchange rate adjustment has taken place, it should be a procedural matter for the central bank to institute a sensible policy of squeezing domestic demand. But taking the first step, against the Thai background of institutional instability, financial turbulence and perhaps even widespread indifference will be tricky. There is a risk of unleashing a complete cyclone within financial markets as the exchange rate seeks a new level. Braking the falls will not be easy but, conversely, sticking to the traditional growth formula seems to promise hyperinflation at the end of the road. Thailand has just appointed a new governor to the Bank of Thailand, Daley Romo, a career professional. He has some exciting choices to make which will resonate throughout Southeast Asian markets and very little time in which to maneuver. Mr. Hudson is group chief economist at Olliff & Partners, a London-based stock broker.
