THB Lowered to Neutral from Overweight*

Thai baht

* = For the next 3-6 months: Leveraged funds: Short if 31.00-17 holds Real Money Funds: Marketweight vs. standard FX benchmarks Corporates: Neutral vs. forwards

Summary
Standard Chartered Bank has lowered its FX rating on the Thai baht (THB) to Neutral from Overweight. Thai growth has picked up due to higher political clarity and strong exports. However, we forecast that GDP growth will slow to 4.5% in 2008 from 4.8% as the weaker global environment will gradually hit Thai exports. Meanwhile, weak exports and booming imports due to 1) strong private and government domestic demand and 2) high costs of fuel imports will drag down the current account (C/A) surplus. We are forecasting that the full-year C/A balance/GDP will turn into a deficit in 2008 of -0.5% from a surplus of 6.5% in 2007. Downside risks to global asset markets on the back of the U.S. recession and the global credit crisis could outweigh local positives such as reduced political uncertainty and pickup in domestic demand. In sum, we expect a correction in the THB over the next 3-6 months. However, we remain bullish medium term on the THB given strong medium term growth prospects, reduced political risks. Thus, any such sustained short-term correction should be seen as a buying opportunity.

FX Economics: A Mixed Picture
Growth: Picking up – for now

The Thai economy expanded by 4.8% for full-year 2007 compared to 5.1% in 2006. However, real GDP growth picked up in Q4 to 5.70% y/y and 1.8% q/q SA from 4.80% and 1.50%. Business and consumer confidence indicators have improved since last autumn in anticipation of more political clarity and export growth has been holding up well. Going forward, Standard Chartered Bank expects growth to slow to 4.5% in 2008 from 4.8%, well below the government’s target of 6% growth. One reason why Thai exports have been holding up well compared to its regional peers is that Thailand’s exposure to electronics is less significant. (Electronics accounts for around 33% of total exports in Thailand whereas the number is 62% for Philippines, 50% for Malaysia and 40% for Singapore). However, with the U.S. economy entering into a recession this year weakness in electronics is likely to filter further down into other consumer goods which Thailand is exporting. Rice exports only accounted for around 2.3% of Thai exports in 2007 and hence higher rice prices will not be enough to slow down the USD export value of other commodities. We forecast that Thai exports will slow to 7.1% in 2008 from 18.1% in 2007. Given that exports account for 69% of GDP that will be a drag on economic growth. Expansive fiscal policy by the new government in the form of tax breaks for individuals, listed companies and SMEs and the government’s planned mega projects will provide some caution against the weaker global environment. We judge that it will add 0.5% to growth this year.

Inflation: Still Heading Higher

March headline CPI came out at 5.3% from 5.4% whereas core CPI rose slightly to 1.7% y/y from 1.5% y/y. The driving force behind higher headline CPI has been higher food prices and

transportation costs.

Current account surplus: Turning into a deficit. For full-year 2007, we estimate that Thailand recorded a C/A surplus of 6.5% up from 1.6% in 2006. The driving force was a jump in the trade surplus which rose to 4.9% of GDP in 2007 from 0.5% in 2006. Standard Chartered Bank expects that the C/A will turn into a deficit in 2008 of -0.5% of GDP. The main

Political developments: Stable for now

Political risk has clearly been reduced after the installation of the newly elected government led by the People Power Party (PPP). However, there are still a few factors that could bring political uncertainty back to the market. Potential political risk could come from 1) the electoral fraud case against Mr Tiyapairat the deputy leaders of the PPP, 2) the possible disbanding of the Chart Thai and Matchima Thipataya parties after some members were disqualified for vote buying in the general election on 23rd December 2007 and 3) the proposed amendment of the 2007 Constitution. These developments could bring political uncertainty

back in focus, and stall the progress of the recovery in domestic demand.

FX Model Valuation
As a reality check, we try to examine exchange rate valuation from the perspective of traditional FX fair value equilibrium models. On their own, they provide little short-term prescriptive power. However, they may give a clearer picture of whether or not a currency should appreciate or depreciate over the medium to long term.

REER Approach: SELL
The real effective exchange rate (REER) is a function of the price or inflation differential and the nominal effective exchange rate (NEER). The relationship between Purchasing Power Parity (PPP) and REER is a close and important one. The core idea is that if PPP is seen to hold over the long term then the REER should remain constant. That said, over the short term the REER can fluctuate significantly.

Standard Chartered Bank’s THB REER shows the THB at 111.59 as of February 2008. The THB is now well above the average since 1995 of 97.46. We have noted that since mid-05 the THB REER has caught up significantly with other AXJ currencies and it is now one of the 5 best performers since January 1996 among the 10 most traded AXJ currencies. As such, the THB looks like a sell on a REER basis given higher inflation rate than its trading partners and fast nominal appreciation of the THB since mid-05.
Monetary Approach: NEUTRAL

Linked in with PPP is the Monetary Approach to exchange rates. According to this, a change in money supply growth results in a change in price, which leads to a change in the exchange rate via PPP. Higher money supply growth would be presumed to lead to higher price growth, which should be offset by exchange rate depreciation to maintain PPP.

Thailand February M1, M2 and Monetary Base growth is at 8.42% y/y, 1.88% y/y and 7.04% y/y. By comparison, Eurozone February M3 growth is at 11.3% y/y and U.S. M3 growth is at 8% y/y. As such, this suggests a neutral signal for the THB.

Mundell Fleming Approach: NEUTRAL Thanks to the work of Robert Mundell and J. Marcus Fleming, we know that certain combinations of monetary and fiscal policy create specific exchange rate conditions. The Mundell-Fleming model illustrates how combinations of monetary and fiscal policy changes can cause temporary changes in the balance of payments relative to an equilibrium level. The exchange rate therefore becomes the transmission mechanism by which equilibrium is restored to the balance of payments

The current policy mix of Thailand is loose fiscal policy and loose monetary policy. This policy combination should lead to current account balance deterioration whereas the impact on real yields is ambiguous. The implication for the exchange rate depends on whether the C/A balance dominates the capital account. Due to the capital controls the C/A has since end-06 dominated the capital account in Thailand. We expect that the capital account will gradually become more important than the C/A on the back of the lifting of the capital controls. On balance the signal looks neutral for the THB.

Interest Rate Approach: NEUTRAL
Thanks to the seminal work of the economist Irving Fisher, we have the Interest Rate Approach to exchange rates, which focuses on interest rate and inflation differentials. Under the International Fisher Effect, the difference in interest rates should equate to the expected change in the spot exchange rate. Thus, a currency with a higher interest rate should depreciate proportionally relative to another with a lower interest rate.
The policy interest rate in Thailand is currently 3.25%. This compares with 2.25% in the U.S. and 4.00% in the Eurozone. As such, this is neutral for the THB.

Balance of Payments Approach: BUY
Under the balance of payments’ approach, changes in national income affect both the current and capital account, causing a predictable reaction in the exchange rate to restore balance of payments’ equilibrium. Under this, a change in national income results in a change in the current account balance, leading to a change in real interest rates and capital flows. As national income rises, so import demand increases causing the current account balance to deteriorate, all else being equal. On the capital account side, a rise in national income must be accompanied by a rise in real interest rates. If the current account dominates, the currency should depreciate, while if the capital account dominates the currency should appreciate.

Going forward, we expect national income to pick up in Thailand from Q3-08 onwards. This should lead to deterioration in the C/A balance, all else equal, as import demand increases. On the capital account side, an increase in national income should be accompanied by a rise in real interest rates attracting capital inflow. Since end-06 the C/A account has dominated the capital account due to the capital controls. Over the coming 3-6 months we would expect the capital account to gradually become more important than the C/A. On balance this suggests a buy signal for the THB.