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Published on December 21, 2007

Yesterday Dr Olarn Chaipravat, an adviser to the Fiscal Policy Research Institute, revealed that the central bank is adopting a "managed float with a targeted foreign exchange rate" regime, and that this has been in effect since October 1 this year.

By doing this, the central bank has moved away from a free-float foreign exchange system, adopted after it floated the baht on July 2, 1997.

Strangely, it was Olarn who made it known to the public the shift in this most important macro-economic policy, at an economic seminar yesterday, although Tarisa Watanagase, the Bank of Thailand governor, should have made the announcement herself.

What is going on then? Olarn has been an architect of this crucial change in the foreign exchange policy management at the central bank. He has been complaining publicly and privately all along that the central bank has been doing a lousy job in managing the foreign exchange regime. The central bank had allowed the baht to move too freely, particularly last year, with the adverse effect of sharp currency appreciation undermined the competitiveness of Thai exports and the whole economy.

The Bank of Thailand had adopted a free-float system that harmed a small and open economy like Thailand. For example, the baht appreciated sharply by Bt2.55 to the US dollar between June and July this year alone. Small- or medium-scale manufacturers were hit hardest by the currency appreciation. If nothing was done about the currency regime, labour-intensive industries would have to close, unemployment would have risen, with the risk of labour demonstrations becoming widespread, consumption dropping and the overall economy taking a big hit.

Olarn would like the central bank to really "manage" the baht by targeting its movements in a narrow range, similar to what China and Singapore have achieved in macro-economic stability with their respective foreign exchange management.

Somehow Government House has bought Olarn's idea. Dr Virabongsa Ramangkura, another well-known economist, has gone so far as to push for the central bank to re-peg the currency. Dr Kosit Pampiemras, the deputy prime minister, was reported to have instructed the central bank to end its free-float foreign exchange system and adopt a managed float with a targeted foreign exchange regime instead.

On October 1 Tarisa and her team agreed to adopt the new system, resulting in massive and active intervention in the foreign exchange market to target the baht exchange rate. Foreign reserves have since shot up quickly.

As a result, the Thai baht, at least for the time being, has become competitive against regional currencies. There are no longer any complaints from exporters, businessmen or manufacturers.

Yet still, it appears that the top policy makers at the central bank have not yet fully embraced this new foreign exchange policy forced upon them by political pressure. At issue is the central bankers' focus on inflation targeting, which has become the anchor of macro-economic stability. This policy was laid down in 1998 by MR Chatu Mongol Sonakul, the former central bank governor.

To manage inflation, Thai central bankers rely heavily on interest rate policy to curb price pressure. By doing so, they model their macro-economic management practice on the US Federal Reserve Board. The Fed manages inflation through its monetary policy. It has the flexibility to manage money supply because the dollar is the de facto medium of global transactions. But a small and open economy like Thailand can't really manage price stability through interest rate policy alone. In fact, interest rate policy is a less effective tool in keeping price stability because Thailand heavily imports capital goods and raw materials to reprocess its exports. In the end, Thailand also imports the global inflation into its economy.

No matter how much effort the Thai central bank targets inflation by pursuing appropriate interest rate policy, it will find it can't really control prices, which are determined at the global level virtually beyond anybody's control.

So the most effective tool to manage inflation for a small and open economy like Thailand is foreign exchange policy. If the baht is priced competitively - not too strong and not too weak - it will automatically become an anchor of price stability.

It remains to be seen whether the central bank will from now on focus on price stability through effective foreign exchange management or through interest rate policy. But Tarisa, as Dr Olarn has suggested, should have come forward to announce this policy shift to the markets. This will reflect the bank's attempt to manage the foreign exchange system with transparency and on a level playing field.

Don't worry about Thailand facing the same currency crisis as in 1997 because the central bank is not going back to a fixed exchange rate regime. Under the managed float exchange rate system, the central bank still has flexibility to manage the baht's stability. This management can be fine-tuned all the time to achieve maximum competitiveness for the Thai currency.

Thanong Khanthong

The Nation