Tuesday, August 14, 2007

thailand's financial market set to remain volatile on sub-prime loan woes

DARANA CHUDASRI

Local financial markets are expected to remain volatile this week as investors continue to remain nervous about developments in the US sub-prime mortgage market.

Overall exposure by Thai financial institutions to sub-prime debt is relatively small. On Friday, the Bank of Thailand said four banks had $715 million in investments in collateralised debt obligations, or just 0.1% of total assets.

Of this, sub-prime mortgage debt, which represents loans to the riskiest borrowers, accounted for only a minor portion of CDO investments.

But swings in the currency and equity markets over the past several weeks have been due not only to the sub-prime downturn, but also reflect the ''flight to quality'' by foreign investors.

The downturn in the US housing market means funds and international financial institutions that invested in CDOs and sub-prime assets may lose hundreds of millions of dollars.

Credit markets have been hit with a liquidity squeeze, worsening the potential losses for investors who hold securities that have lost a lot of their value. The losses have prompted institutional investors around the world to reassess their portfolios, including exposure to emerging markets.''From the view of foreign investors, investment in Thailand is classified as junk. With the problems in the US sub-prime market, also a type of junk investment, you're seeing investors rethink their Thai exposure as they switch to lower-risk assets,'' one banker said.

The shift in asset classes has helped push bond yields on US Treasuries downwards and helped the dollar to strengthen against emerging-market currencies such as the baht in recent days. The baht currently is quoted at 34 to the dollar, compared with 33.8 on Aug 1 and 33.2 in mid-July. In the offshore market, the baht is quoted at 31.5 to the dollar, down from 30 a month ago.

Analysts said capital outflows from the region have helped ease pressure on the Bank of Thailand to intervene in the market to stem baht appreciation.

But long-term trends remain in favour of a stronger baht, given projections for a trade and current account surplus. Capital controls under the 30% reserve rule also have limited effectiveness, particularly considering the potential arbitrage opportunities between the onshore and offshore rates.

Even with the need to set aside 30% of inflows with the central bank as a reserve, 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 then can 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.

''Basically, you can gain returns of around 8% to 9% from the baht even with the 30% control, risk-free,'' the banker said. ''Overnight borrowing rates for the baht offshore fluctuate considerably as positions unwind. We're seeing cases of 10%, 20% offered in the market.''

To eliminate the loophole, the banker said, the 30% rule should be scrapped and other intervention strategies adopted to help stem pressure on the baht.

In the bond market, analysts have seen some signs of increased foreign buying, in part because investors are selling equities in favour of lower-risk bonds.

Ariya Tiranaprakit, an executive vice-president of the Thai Bond Market Association, said the domestic market overall had not been significantly affected by the US sub-prime problems.

Liquidity in debt instruments below investment grade, such as bills of exchange or junk bonds, remains poor. Some 90% of trade is dominated by transactions in short-term treasury bills or Bank of Thailand bonds.

''Yield curves have not moved drastically. But it's a good sign that we are seeing foreign investors and non-residents turning to net buy positions for the first time this year,'' Mrs Ariya said.

In the latter half of July, non-residents were net buyers of two billion baht in debt, and net buyers of 1.5 billion in the first week of August.

Most invested in bonds with maturities over three years, offering annual yields of around 3.6% assuming full hedge coverage. Under the central bank capital controls, non-resident investments in debt instruments can be waived from the 30% reserve rule if fully hedged to maturity. Investments in the equity market are exempted from the reserve rule.

''While foreign investors accounted for just 3% of total trading volume, it's still a good sign. If non-residents significantly shift to the bond market, long-term yields could fall,'' Mrs Ariya said.

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