Wednesday, July 30, 2008

Tough times ahead for Thailand

There is little good economic news on the horizon. Thailand's political quagmire seems intractable, opening up downside risks that are difficult to quantify.


By Supavud Saicheua,
head of research, Phatra Securities Public Co, Ltd.

There is much confusion about how things might develop in Thailand in the coming months.

At the risk of being wrong, I have identified three factors that I consider most important. These are, firstly, problems of US financial institutions which are again in the forefront. Inflation remains a worry for Asia and Thailand. Finally, the unpredictability of Thai politics has made the predictions of fortune-tellers as sought-after as the writings of political commentators.

How the US financial sector fares in the coming months will have an important bearing on the global economy. In the summer of 2007, the bursting of the US housing bubble caused financial damage to US banks because of high risk or "subprime" lending. Some thought that the damage would soon be contained, especially after various financial institutions made bold write-offs and aggressively sought new capital.

The generous participation of Sovereign Wealth Funds added to this confidence.

However, the emergency rescue of Bear Stearns in March this year made it clear that the problem has spread into various fixed income and derivative instruments.

The novel ways in which the US Federal Reserve made liquidity widely available to US financial institutions on top of the aggressive cuts in its policy rate from 5.25% to 2.0% meant that the situation was grim.

The latest financial emergency prompted the US Treasury to spearhead the rescue of Fannie Mae and Freddie Mac, two government-sponsored corporations (GSCs) that are too important to fail. The two GSCs guarantee or directly provide mortgage loans worth $5.2 trillion, nearly half the system-wide mortgages worth $12 trillion. They are highly leveraged with capital - only 1-2% of total assets. Such leverage is not a problem under normal circumstances given the perception (though not written in law) that GSCs are backed by the US government.

But with US home prices falling 15% and the prospect of more to come, the US Congress has no choice but to approve legislation that authorises the US Treasury to provide any amount of credit and equity that Fannie and Freddie may need, along with help from the Federal Reserve.

Approving a law authorising a "blank cheque" to rescue Fannie and Freddie has led to optimism that the worst may be over. Such a belief could prove premature.

Merrill Lynch now sees US GDP contracting by 2.5% in the 4Q08 and 2.3% in 1Q09. For all of 2009, Merrill Lynch sees a 0.5% contraction in US GDP, whereas others expect US GDP to expand.

The IMF's latest forecast sees the US economy growing 0.8% in 2009. The IMF considers its forecast "gloomy" because it sees global growth falling from 5.0% in 2007 to 4.1% in 2008 and weaker still to 3.9% in 2009.

Why will things not get better?

Merrill Lynch points out that US financial institutions have tightened credit significantly not just for home mortgages but for commercial mortgages, car loans, credit cards, etc.

Recently, Fannie and Freddie were the main source of additional lending for the system. The rescue of Fannie and Freddie, though dramatic, may not restore its ability to expand credit. Indeed, lending more when home prices continue to fall could prove difficult when it is clear that the bill for damages will have to be paid by US taxpayers.

Moreover, some analysts noted that the severe compression of US asset prices is likely to claim many more casualties, if past financial crises are a guide.

The Savings and Loans crisis of the late 1980s caused 1,500 US financial institutions to go under. The situation stabilised only after the establishment of the Resolution Trust Corporation to buy out and manage down bad assets.

So far, only six US financial institutions have failed, so it is feared that many more could follow suit in the coming months as the US economy heads towards recession.

Accordingly, futures markets now see inflation as less of a problem in developed economies. No US interest rate hike is expected until the yearend, while hopes of rate cuts in Europe are being revived.

The sharp fall in oil prices from $147 to $125 during the past two weeks likely reflects this increased pessimism as much as initiatives by US authorities to investigate speculation.

Meanwhile, foreign investors remain concerned about Asian inflation and the inability of our central banks to tighten monetary policy in a timely manner.

In sharp contrast to this, Asian governments and businessmen are more concerned about economic slowdown and therefore central bank tightening has been gradual and reluctantly accepted.

Asia's implicit peg to the US dollar increases the risk that Asians will find runaway inflation the unwelcome surprise for 2009.

US monetary easing risks increasing the dollar price of crude oil and other commodities, setting the global economy up for prolonged inflation, as was the case in the 1970s.

The correlation between the dollar price of crude oil and the dollar-euro exchange rate was 95% from January 2007 to July 2008. If the dollar depreciates to two US dollars to one euro, and if past correlation between oil and dollar/euro holds, the price of oil would be $219-233 per barrel.

Asia has been struggling to control inflation since 2007 and the pegging of its currencies to the US dollar increases the risk of inflation getting out of hand in 2009.

On the other hand, a US recession is necessarily deflationary. If it is severe and spreads, Asian inflation could be a minor concern in 2009.

But only one of these two scenarios is the correct one. It seems that the majority view favours the first scenario, but a slight shift is now taking place towards the second.

Further sharp reductions in oil prices could forewarn that the second scenario is becoming more likely.

Thailand's political instability means that the country's future growth is being diluted in two main ways.

First is the inability to undertake long-term economic reform and liberalisation. The Constitution Court's decision on Preah Vihear has impaired the country's ability to engage itself in the ongoing globalisation of the world economy.

In general, the government finds it difficult to push forward long-term investment projects because of general distrust and detailed oversight.

Second, any future returns expected from an investment project must be subject to a larger discount rate to reflect the increased risk that elected governments will come and go quickly in Thailand.

It is clear that the 2007 Constitution has many pitfalls and those wanting to amend it are being actively opposed.

Current political difficulties faced by this government means that its remaining lifespan could be measured in a matter of months.

The instinct that new elections may not resolve the underlying conflict is the right one.

The bottom line is that despite its lacklustre performance, the People Power party - or a reincarnation of it - may not see its seats in parliament dwindle. This is because the Democrats are likely to face difficulties in trying to win more seats in the populous North and Northeast.

Smaller parties such as Puea Pandin, Chart Thai and Matchimathipataya are at risk of being dissolved. If not, their lack of success in the last election could make it difficult for them to carry on.

But the return of PPP appears unacceptable to powerful groups in Bangkok. And the mechanics of what Thai academics call "judicial activism" and politics on the streets is likely to shorten the life of any elected government headed by populist leaders.

In conclusion, there is little good news on the horizon. Ironically, the sharper than expected slowdown in the global economy could help bring Asian inflation under control, allowing domestic expansion to offset the shortfall in global demand.

However, Thailand's political quagmire seems far more intractable, opening up downside risks for the Thai economy in a way that is difficult to quantify.

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