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    Southeast Asia
     Mar 30, 2006
RISKY BUSINESS
No room for Thai complacency

By Jephraim P Gundzik

(Jephraim P Gundzik is president of Condor Advisers, Inc.)

Political and social instability have risen rapidly in Thailand since the beginning of the year. Yet the stock market is up, and the baht has appreciated over the past three months. But if Thailand's political crisis deepens in the months ahead, as seems likely, it will impact already weak economic growth.

As investors begin to grasp the underlying weakness of Thailand's economic and financial fundamentals, a sharp correction in equity prices and the exchange rate is likely.

In the first three months of 2006, Thailand's benchmark SET equity index advanced by 3%, while the baht appreciated against the US dollar by almost 5%. To a certain extent, the US$1.8 billion sale of Shin Corp to Singapore's Temasek underpinned the



rise in both the stock market and exchange rate. That has contributed to a certain complacency among foreign and domestic investors about growing political and social instability and the adverse impact this will ultimately have on economic growth.

This casual attitude seems to stem from widespread perceptions that Thailand's current political crisis will soon blow over. This dovetails nicely with another widely held perception - that the underlying economic fundamentals will override political and social instability, allowing economic growth to accelerate even faster in 2006.

But Thailand's political crisis has deep roots. From the outset, Prime Minister Thaksin Shinawatra has repeatedly ruffled the political opposition as well as Thai civil society organizations with questionable ethics and heavy-handed policies aimed at shoring up his political power.

In the past several months, a growing segment of Thailand's urban-based electorate has begun to take issue with the premier's questionable policies and autocratic tendencies. This part of the electorate is made up of mostly educated and relatively wealthy Thais.

In contrast to this growing and increasingly vociferous upper and middle class opposition, Thaksin continues to enjoy strong support from his primary constituency - poor and rural Thais. This constituency, which Thaksin has in recent years courted with populist pump-priming policies, has been essential to his political fortunes over the past five years. Due to this strong rural support base, Thaksin can stake a major claim to political legitimacy, even as his political opponents are vying to bump him from power through extra-constitutional means.

Both sides in this struggle for political supremacy have deep popular support and have demonstrated their ability to marshal large-scale social action. More significantly, both sides have thrown down the gauntlet - Thaksin when he dissolved parliament and called snap elections, and the opposition when it called for a boycott of those same polls. The April 2 general election will not settle Thailand's political crisis. More likely it will drag on for months.

Parallels with Venezuela
Thus far, competing pro and anti-Thaksin demonstrations have been peaceful. This could change if Thailand's political conflict degenerates into a class conflict - pitching rural against urban dwellers. The rural poor could easily be coaxed, or paid, into fighting for the political patronage Thaksin has heaped on them. At the same time, the urban rich could be enticed to fight for the return of their democratic rights.

Venezuela offers an interesting example of how the situation could quickly degenerate into class conflict. Like Thaksin, populist promises aimed at the rural poor vaulted Venezuela's President Hugo Chavez to political power. Also similar to Thaksin, Chavez used this rural support base as a springboard for consolidating his own political power while employing autocratic policies to weaken the political opposition.

These tough tactics eventually produced a violent class conflict in Venezuela, pitting the pro-Chavez rural poor against the anti-Chavez urban rich - a damaging conflict that has only recently ebbed after raging between 2001 and 2004.

The anti-Chavez opposition in Venezuela had both political and popular constituencies, which enjoyed strong support from the country's corporate sector and media. This support emboldened the anti-Chavez opposition to mount large-scale strikes and even coup attempts. The resulting political and social instability eventually prompted Venezuela's economy to collapse. Violent class conflict is not impossible in Thailand, and Thaksin's divisive tactics increasingly seem to be pushing the country in that direction.

Economic blowback
Increasing political and social instability will eventually wreak havoc on Thailand's already slowing economic growth. According to statistics from Thailand's National Economic and Social Development Board, real GDP growth slowed to 4.5% in 2005 from over 6% in 2004. Only the very strong growth of public sector consumption and investment, which effectively helped to offset the economic impact of the December 2004 tsunami, prevented real GDP growth from slowing further in 2005.

Export growth, far and away the main engine of Thailand's economy, slowed to 15% in 2005 from 22% in 2004. Last year slowing exports combined with surging imports produced trade and current account deficits of $8.6 billion and $3.7 billion respectively. Preliminary Bank of Thailand data report a $388 million trade deficit in January this year. Rising international oil prices accounted for about 40% of total import growth and pushed up core inflation from 2.7% in 2004 to 4.5% in 2005.

Rising inflation and interest rates undermined private consumption and investment in 2005 and will continue to dampen the economy in 2006. Combined with increasing political and social instability, higher rates will push private consumption and investment even lower this year. Meanwhile, increasing instability will sap private consumption by making Thais less confident and secure about the future. Instability will have an even more dramatic negative impact on private investment, for which stability is crucial.

In addition to faltering domestic demand, weakening external demand and increasing export competition from China are likely to put a another brake on Thailand's export growth. The slowdown in export growth in 2005 was paced by weakening exports of low value-added technology goods, which advanced by only 17% after surging 27% higher in 2004. The primary factor that slowed Thailand's technology exports in 2005 was rapidly growing export competition from China.

Higher international oil prices, which could exceed $100 per barrel as North American demand peaks around July, will inevitably push US inflation and interest rates higher. This could lead to a sharp slowdown in global economic growth during the second half of the year, further undermining demand for Thai exports.

Faced with these external conditions, it will be difficult for Thai export growth to exceed 10% in 2006. With export growth continuing to slow and rising oil prices keeping import growth buoyant, a further significant deterioration in Thailand's balance of payments is probable throughout 2006.

In 2005, strong foreign investment flows provided more than adequate funds to finance the current account deficit. Net foreign direct investment reached $3.3 billion - the highest level since 2001. But alarmingly, net foreign portfolio investment soared to $4 billion and short-term external borrowing by Thailand's private sector jumped by nearly $5 billion. The last time net foreign portfolio investment and short-term external borrowing increased by such magnitudes was in 1997 - the year before capital flight induced the devaluation of the baht, provoking a crippling economic recession.

With political, social and economic fundamentals all deteriorating, strong foreign investment and short-term external credit are unlikely to be sustained in 2006. Of course, net foreign direct investment figures will be bolstered by the controversial one-off Shin Corp transaction. More broadly, however, net foreign portfolio investment could easily reverse as investor perceptions realign with Thailand's political, social and economic realities.

The recent court ruling that resulted in scrapping the planned initial public offering of the state-owned electricity generating monopoly EGAT Plc, scheduled to be Thailand's largest-ever listing, has already dampened investor perceptions about the country's economic reform trajectory. And questions are looming about the viability of Thaksin's earlier plans to spend $38 billion for new infrastructure over the next five years now that he is embroiled in political conflict. These combined factors will arguably produce a significant correction in Thai stocks later this year.

These realities will also make it difficult for Thailand's private sector to roll over its mounting short-term external liabilities, which amounted to $17 billion, or 33% of total external debt at the end of 2005. With foreign inflows increasingly scarce in 2006, Thailand will be forced to draw down its foreign exchange reserves by as much as $15 billion to finance net outflows of foreign portfolio investment and its larger current account deficit. This implies that a significant depreciation of the baht is probable in 2006.

Baht depreciation could be intensified by domestic capital flight if concerns arise about possible capital controls. In May 1997, the Bank of Thailand implemented capital controls to contain building devaluation pressure on the baht. These measures severely limited the ability of Thais to shelter assets offshore in foreign currencies.

In July 1997, the baht was devalued by 20% and by the end of that fateful year the depreciation of the baht against the US dollar exceeded 80%. As Thailand's political and social crisis deepens in the months ahead, and with it confidence in the economy, a new financial and balance of payments crisis cannot be ruled out.

Jephraim P Gundzik is president of Condor Advisers, Inc. Condor Advisers correctly forecast Thailand's exchange rate devaluation in 1997.

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