Don Nakornthab
Pailin Palitwanont
Tientip Subhanij*
May 2012
The recent dramatic increase in Thailand’s short-term external debt has caused concerns by some observers. This note provides an assessment of Thailand’s short-term external debt situation, with particular attention on the nature of these debt flows and how they are used. Our findings reveal that the recent increase in Thailand’s short-term external debt is mainly attributable to import trade credit and inter-company borrowings by foreign bank branches to provide FX swaps to domestic banks in need of USD to square off FX exposures created by increased forward selling by Thai exporters and Thai investors investing abroad. As such, their risks are limited.
Thailand’s external debt has increased significantly from 75.3 billion USD at the end of 2009 to an estimate of 118.9 billion USD at the end of March 2012, surpassing the historical peak of 112.3 billion USD recorded in June 1997. Both long-term and short-term external debt contributed to the increase, but it was the scale of the latter that have caught attention. Short-term external debt of the banking sector, in particular, more than doubled during the period (quadrupled if one goes back to the end of 2008). These developments have raised questions regarding Thailand’s external vulnerability. In this note, we show that Thailand’s short-term external debt situation remains benign, with the increase in short-term external debt to date largely explained by the country’s increasing trade and outward portfolio investment.
II. What drives the recent increase in Thailand’s short-term external debt?
Table 1 reveals that the increase in Thailand’s short-term external debt since 2010 came primarily from import trade credit and external borrowings by the banking sector.*(1) What transpired in 2010 was a revival in world trade and Thailand’s domestic economic recovery which sent both merchandise exports and imports to new record highs. Export and import trade credit rebounded accordingly. Compared to other forms of corporate sector debt, import trade credit is less worrisome because we know that it is related to genuine economic activities. In addition, a deeper look at the data reveals that a significant portion of Thailand’s import trade credit is for imports of raw materials and intermediate products for exports, thereby having some degree of natural hedge. Finally, import trade credit would generally not be extended if trading partners do not trust importers’ ability to pay. As an aside, it is worth noting that focusing on import trade credit alone overlooks the fact that export trade credit which is recorded on the asset side of Thailand’s international investment position consistently exceeds import trade credit on the liability side (Musigchai et al., 2011).
On banks’ external borrowings, three findings emerge from our study. First, the recent increase in the banking sector’s short-term external debt is mainly attributable to banks’ borrowings for foreign-currency liquidity management to accommodate an increase in FX hedging activities by Thai exporters and investors. Second, the borrowings are undertaken primarily by foreign bank branches from their parent banks and hence exhibit low roll-over risk. Third, the extent of maturity mismatch of these borrowings is less than some country with similar experience.
Figure 1 shows that from November 2010 to December 2011, the level of banks’ short-term external debt tracked closely the outstanding values of trade-related hedging (exporters’ hedges minus importers’ hedges). Most notably, they fell precipitously with the collapse of Thai exports following the Great Flood of 2011. For the first three months of this year however, banks’ short-term external debt reversed its trend, this time rising along with investment-related hedging. A closer look at the data reveals that the increase in investment-related hedging was associated with outflows of fixed-income foreign investment funds (FIFs) which generally hedge in full amount.
Mechanically, when exporters or foreign investment funds hedge foreign exchange risk by forward selling their expected USD proceeds to banks, banks will “square off” their FX exposures by selling USD spot.*(2) For the banking sector as a whole, there are two options to meet demand for spot USD: use their existing liquid foreign assets (i.e., currency and offshore deposits) or borrow. Until 2008, the first option was generally preferred. By 2009 however, the banking sector’s outstanding stock of foreign assets had declined significantly. On the other hand, the baht’s appreciation trend against the USD after the global financial crisis had led exporters to increase their hedging position, which together with the boom in exports, resulted in a dramatic increase in exporters’ hedging volume*(3), rendering the use of foreign assets alone impossible. Consequently, banks’ short-term external debt rose as the banking sector shifted to the second option for main USD source. currency deposits) against ?(banks’ net forward position) since the monthly data became available in February 2005. The latter includes also hedging for loans and other purposes as well as banks’ net forward position with the Bank of Thailand). The two series track each other closely with a correlation of 0.92.*(4)
To gain a deeper understanding of the banking sector’s short-term external debt development, one needs to look further at the institution level. The major buyers of exporters’ and foreign investment funds’ forward contracts are Thai banks. Given Thailand’s BBB/BBB+ sovereign credit ratings however, Thai banks face exorbitant short-term external borrowing cost. The onshore FX swap market therefore becomes Thai banks’ primary USD funding source.
If the story were to end here, the increase in FX hedging activities would not be accompanied by the increase in external debt, for borrowing via an FX swap contract is an off-balance sheet transaction. What happened was that the increase in hedging-induced demand for USD funding overwhelmed domestic USD supply. The resulting USD liquidity shortage in turn drove up USD funding cost in the FX swap market and certain foreign bank branches with low USD funding costs found this development to be a profit opportunity. They took advantage of the situation to provide the needed USD liquidity to Thai banks using borrowed funds from their head offices and other branches abroad. Indeed, Figure 3 illustrates that the movements in Thailand’s banking sector’s short-term external debt was due mainly to borrowings by foreign bank branches.
In a typical profit-making transaction, a foreign bank branch would supply the borrowed USD fund to the FX swap market by entering a sell-buy USD/THB swap transaction (equivalent to borrowing Thai baht with USD as collateral) and invest the baht proceeds from the first leg of the swap in the BOT-operated bilateral repurchase market. Figure 4 compares the BOT policy rate (1-day repurchase rate) and a hypothetical bank’s THB borrowing cost (computed from the implied THB interest rate in the FX swap market and the bank’s USD borrowing cost) for such transaction. From 2010 Q3 to 2011 Q3, the spread varied between 20 to 150 basis points. The collapse in exports in 2011 Q4 greatly reduced hedging demand and led to the collapse of the spread. As hedging-induced USD demand picked up in 2012 Q1, the spread widened again, luring back banks’ short-term external borrowings.*(5)
That foreign bank branches are the main short-term external debt borrowers is important because it means that these loans have low roll-over risks. In most circumstances, parent banks will likely not be willing to risk their international reputations by cutting off funding to their own branches. This stands in sharp contrast to the pre-1997 era when external lenders were third-parties. In addition, it should also be noted that in the event that these foreign banks themselves face USD liquidity crunch, the BOT can easily step in to supply the needed USD liquidity to maintain market order.
To complete the risk assessment, one needs to look also at the degree of maturity mismatch of these borrowings. Given that most banks’ short-term external borrowings were in the context of banks providing currency hedging to exporters, we look at the distribution of maturities of exporters’ forward contracts. The finding is comforting. Around 90% of Thai exporters’ forward contracts have maturities within one year, suggesting limited maturity mismatches.
Going forward, Thailand’s short-term external debt will likely increase further as imports continue to rise and the export sector recovers from the flood crisis. Rising imports is unlikely to change the overall USD shortage in the FX swap market unless they are accompanied by a significant increase in the import hedging ratio which is now less than half of the export hedging ratio or the latter experiences a substantial fall. Nevertheless, it is important to note that at its current level, Thailand’s short-term external debt represents only 18.8% and 33.5% of the country’s GDP and international reserves, respectively. As long as we can still tie increases in bank’s short-term borrowings to their underlying and the majority of them are not used to match long-dated hedging or to finance long-term loans, their risks will remain limited. Indeed, all credit rating agencies regard Thailand’s external position as the country’s strength, with Fitch (2012) being the latest to confirm that.
To sum up, the recent increase in Thailand’s short-term external debt has largely been a result of factors related to increased international trade and increased acquisition of foreign assets abroad. In addition, these external borrowings exhibit limited maturity mismatch and low roll-over risk. As such, they do not indicate vulnerability of Thailand’s external position. Nevertheless, the Bank of Thailand will continue to vigilantly monitor their developments to ensure that Thailand’s external stability remains the country’s strength.
Fitch Ratings (2012). “Fitch Affirms Thailand at 'BBB'; Outlook Stable,” Press release, May.
Musigchai, C., Pongpattananan, N. and A. Thana-anekcharoen (2011). “Thailand’s External Debt Revisited: Are We Having a D?j? Vu?,” Bank of Thailand FAQ, Issue 20, January.
- Don Nakornthab is Head of Macroeconomic and Forecasting Division, Pailin Palitwanont and Tientip Subhanij are respectively economist and Head of Balance of Payments Analysis Team at the Bank of Thailand. The authors thank Mathee Supapongse for helpful comments and Nutt Lumbikananda for his help during the early stage of the project.
*(1) 1 Of the remaining increase in short-term external debt, the most important is short-term BOT bills. This phenomenon coincides with greater demand for emerging market debt securities after the global financial crisis.
*(2) BOT regulation requires all banks operating in Thailand to maintain their net foreign exchange position within certain limits. This keeps the Thai banking system relatively free of currency mismatches. The problem in 1997 was that banks on-lent their borrowed funds to corporate clients, thereby transferring currency risk to the latter which then came back to them in the form of market risk.
*(3) During this period, importers’ hedging have been relatively stable. Rising import values were largely offset by lower import hedging ratios. Thus, it can be said that exporters’ hedging drives trade-related hedging.
*(4) The main reason that we can pinpoint the rise in banks’ short-term external debt to trade- and investment-related hedging is because the sum of other forward contracts that banks have with their clients and the BOT have been roughly stable over the past two years or so. The close relationship between the two series also suggests that the further fall in trade-related hedging in the first quarter of this year was matched by the increase in ODC foreign currency deposits, as banks used proceeds from maturing forward contract to build up their assets abroad.
*(5) It is important to note that borrowing from aboard to supply USD to the FX swap market to take advantage of interest rate differential is not riskless arbitrage, for USD-supplying banks have to take on credit risk of Thai bank counterparties. That only a handful of foreign bank branches engage in such activities reflects such risk.
Source: Bank of Thailand