K bank multi asset strategies feb 2011

.Mean S Multi Asset Strategies
KBank Strategies
Macro / Multi Asset
USD/Asia: cyclically constructive, structurally destructive February 2011
Volume 45

As we are in the year of the Rabbit, the markets will tend to be
jumpy…with events in Tunisia and Egypt along with fear that
Kobsidthi Silpachai, CFA –Kasikornbank
Asia is behind the curve on fighting inflation is again highlighting kobsidthi.s@kasikornbank.com
USD perceived safe haven stature and risk in EM assets
Susheel Narula – KSecurities
Our main theme for USD/THB downside remains unchanged…but susheel.n@kasikornsecurities.com
our 4Q11 USD/THB target is scaled back to 29.00 from 28.00 Kavee Chukitkasem – KSecurities
kavee.c@kasikornsecurities.com
Indications from the central bank along with its perceived
preference for a less stronger baht coupled with rising KResearch
kr.bd@kasikornresearch.com
commodity prices prompts us to revise up our 4Q11 BOT repo
target to 3.25% from 2.75%
Our full-year 2011 GDP forecast remains unchanged at 4.5% YoY
Disclaimer: This report
but some components have been revised to better accommodate must be read with the
higher oil price risks Disclaimer on page 47
The divergence of economic cycles between EM and Developed that forms part of it

economies calls for a sector re-allocation towards ‘Services’ and
‘Commodities’

Strategic Thesis “KBank Multi Asset
It looks like the US dollar can do no wrong…that seems to be what the market is Strategies”
thinking for the time being. But markets have rather short memories and gives more can now be accessed on
weight to cyclical / shorter horizon factors. US data points continue to show recovery in Bloomberg: KBCM <GO>
the business sector. The labor market seems mixed but attention is being paid to the
falling unemployment rate. Structurally, the verdict might not be utterly convincing since
more people are leaving the labor force than more people getting jobs. Another
structural impediment is with the spiraling debt levels in the US federal government
which is seen to reach 140% in the not too distant future since Uncle Sam is spending
money it does not have…not to mention the 50 states. The events in Tunisia and Egypt
have turned on the risk switch of EM assets, that is political risk and inflation risks and
hence favoring the US dollar. Inflation can be thought as the depreciation rate of money
or the rate at which all people become poor. So countries that look to be “behind the
curve” will be shunned by investors. China’s move on interest rate again is an admission
that controlling money supply alone is not as effective as is hoped. Sooner or later, it will
have to look to letting the yuan flow its fundamental course , that is to strengthen. Until
then, USD/Asia will remain volatile as seen by the jump in USD/THB vols. But the
textbook response is on the wall: higher inflation, higher interest rates. Hence, we can
still see the Thai yield curve bias towards a bear flattener. On equities, the continued
rally we called last month did not happen and the market fell to 950, also below what we
predicted to be the support level at 980. The market psychology has changed and we
now no longer expect a sharp directional trade. The SET is shifting pace and will
become sideways. We recommend a sector re-allocation towards ‘Services’ and
‘Commodities’. We are Overweight on energy, agricultural, media, hotel, hospital,
commerce, contractor and industrial estate.

11

1 WWW.KASIKORNBANKGROUP.COM

Key Parameters & Forecasts at Year-end
2003 2004 2005 2006 2007 2008 2009 2010E 2011E
GDP, % YoY 7.1 6.3 4.6 5.2 4.9 2.5 -2.3 7.6 4.5
Consumption, % YoY 6.5 6.2 4.6 3.0 1.6 2.7 -1.1 4.0 3.7
Investment Spending, % YoY 12.1 13.2 10.5 3.9 1.3 1.2 -9.2 9.5 8.8
Govt Budget / GDP % -0.2 -0.2 0.3 -0.7 -1.5 -1.0 -5.6 -3.2 -3.8
Export, % YoY 18.2 21.6 15.2 17.0 17.3 15.9 -14.0 27.0 10.0
Import, % YoY 17.4 25.7 25.8 7.9 9.1 26.5 -25.2 35.0 15.0
Current Account (USD bn) 4.78 2.77 -7.6 2.3 14.1 1.6 21.9 14.2 7.5
CPI % YoY, average 1.8 2.8 4.5 4.6 2.3 5.5 -0.9 3.3 3.3
USD/THB 39.6 38.9 41.0 36.1 33.7 34.8 33.3 31.4 29.0
Fed Funds, % year-end 1.00 2.25 4.25 5.25 4.25 0.25 0.25 0.25 0.25
BOT repo, % year-end 1.25 2.00 4.00 5.00 3.25 2.75 1.25 2.00 3.25
Bond Yields
2yr, % year-end 1.73 2.78 4.94 5.02 3.91 1.98 2.17 2.35 3.75
5yr, % year-end 2.8 4.0 5.3 5.1 4.5 2.2 3.6 2.75 4.00
10yr, % year-end 4.9 4.9 5.5 5.4 4.9 2.7 4.3 3.25 4.25
USD/JPY 107.5 102.5 118.0 119.1 111.8 90.7 93.0 82.0 89.0
EUR/USD 1.26 1.36 1.18 1.32 1.46 1.40 1.43 1.40 1.30
SET Index 772.2 668.1 713.7 679.8 858.1 450.0 734.5 1040 1220

Source: Bloomberg, CEIC, KBank, KResearch, KSecurities

KBank Thai Government Bond Rich / Cheap model

30.00

20.00

10.00

0.00

-10.00

-20.00
3 mth avg
Now
-30.00
LB296A
LB113A

LB116A
LB11NA

LB123A

LB133A
LB137A

LB145B

LB14DA
LB155A

LB15DA

LB167A
LB16NA

LB175A

LB183B
LB191A

LB196A

LB198A
LB19DA

LB213A

LB24DA
LB267A

LB283A

LB396A

Source: Bloomberg, KBank

22

2

KBank THB NEER Index KBank USD/THB – FX Reserves / USD Majors model
KBank USD/THB model
Jan 1995 = 100 KBank THB Trade Weighted Index 48
110 46
44
42
100 40
+ 1 std
38
d
36
90 34
average
32
80 30
-1 std dev
28
01 02 03 04 05 06 07 08 09 10 11 12
70
00 01 02 03 04 05 06 07 08 09 10 11 actual model

Source: Bloomberg, KBank Source: Bloomberg, KBank

FX reserves – USD/THB model DXY – USD/THB model
USD/THB USD/THB since 2001
48 50
46 y = -7.6277Ln(x) + 69.875
44 2 45
42 R = 0.872
40 40
38
36 35 y = 27.699Ln(x) - 86.289
34 2
R = 0.756
32 30
30
28 25
26
70 80 90 100 110 120 130
25 50 75 100 125 150 175 200 225
DXY
FX reserves, USD bn DXY to USD/THB mapping current
FX reserves to USD/THB mapping current 2011 forecast


KBank BOT repo model SET forward dividend yield vs. 10yr bond yield
% %
5.5 9
5.0
8
4.5
4.0 7
3.5 6
3.0 5
2.5
4
2.0
1.5 3
1.0 2
0.5 1
0.0
0
01 02 03 04 05 06 07 08 09 10 11 12
00 01 02 03 04 05 06 07 08 09 10 11

actual model 10yr yields SET forward dividend yields


33

3

Thai inflation parameters Thai contribution to GDP growth
% y oy Contribution to growth
25%
15.0
20%
10.0
15%
5.0
10%
5% 0.0

0% -5.0
-5% -10.0
-10% -15.0
-15% 1Q08 2Q08 3Q08 4Q08 1Q09 2Q09 3Q09 4Q09 1Q10 2Q10 3Q10
01 02 03 04 05 06 07 08 09 10 11
Priv ate consumption Gov ernment consumption Gross fix ed capital
CPI Core CPI PPI Change in inv entories Net ex ports GDP

Source: CEIC, KBank Source: NESDB, KBank

Implied forward curve: swaps Implied forward curve: TGBs
%
Implied forward rate shifts (IRS) % Implied bond yield curve shifts
5.00 4.50
4.50
4.00 4.00
3.50
3.50
3.00
2.50 3.00
2.00
1.50 2.50
1.00
2.00
0.50
- 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
0 1 2 3 4 5 6 7 8 9 10
Feb-11 May-11 Aug-11 Jan-12 tenor (yrs) Feb-11 May-11 Aug-11 Feb-12 tenor (yrs)


US 2yr yields and implied forward US 5yr yields and implied forward

7.0 8
6.0 7
5.0 6
4.0 5
3.0 4
2.0 3
1.0 2
0.0 1
00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

2yr yields, % implied forwards 5yr yields, % implied forwards


44

4

KBank EUR/THB model KBank JPY/THB model

EUR/THB JPY/THB
43.0
56.0
54.0 41.0
52.0 39.0
50.0 37.0
48.0
46.0 35.0
44.0 33.0
42.0 31.0
40.0 29.0
38.0
36.0 27.0
34.0 25.0
01 02 03 04 05 06 07 08 09 10 11 12 01 02 03 04 05 06 07 08 09 10 11 12

actual model actual model


KBank GBP/THB model KBank CNY/THB model

GBP/THB CNY/THB
5.8
78.0
5.6
73.0
5.4
68.0 5.2
63.0 5.0
58.0 4.8
4.6
53.0
4.4
48.0 4.2
43.0 4.0
01 02 03 04 05 06 07 08 09 10 11 12 01 02 03 04 05 06 07 08 09 10 11 12



KBank THB/VND model KBank AUD/THB model
THB/VND AUD/THB
750
35.0
700
33.0
650
600 31.0
550 29.0
500 27.0
450
25.0
400
350 23.0
300 21.0
01 02 03 04 05 06 07 08 09 10 11 12 01 02 03 04 05 06 07 08 09 10 11 12



55

5

This page has been left blank intentionally

66

6

The shortest distance between two points is a straight
line

Kobsidthi Silpachai, CFA - Kasikornbank
…or so they say. Low USD liquidity is a cue for the rise in USD/THB kobsidthi.s@kasikornbank.com
volatility
Warunee Sithithaworn – Kasikornbank
As we are in the year of the Rabbit, the markets will tend to be warunee.si@kasikornbank.com
jumpy…with events in Tunisia and Egypt again highlighting USD Nalin Chutchotitham – Kasikornbank
perceived safe haven stature and risk in EM assets nalin.c@kasikornbank.com

Resumption of political activities following end of emergency
decree is giving a good excuse for foreign investors to take some
money off the table
…and reintroduces more uncertainty in the USD/THB picture
Our main theme for USD/THB downside remains unchanged…but
our 4Q11 USD/THB target is scaled back to 29.00 from 28.00
Indications from the central bank along with its perceived
preference for a less stronger baht coupled with rising commodity
prices prompts us to revise up our 4Q11 BOT repo target to 3.25%
from 2.75%
Yesterday’s darling might be today’s out of favor child
2010 was a great year for the Thai baht gaining about 11.07% against the USD. The
currency was ranked fourth after JPY, AUD and MYR. That is looking into the rear view
mirror. Looking in front passed the windshield with the year of the Rabbit in full swing, the
USD/THB has proved so far to be as jumpy as the rodent. The Thai stock market, SET,
gained about 48% in 2010 is prompting investors to take some money off the table.
Hence, looking at the following statistics, foreign investors have sold about USD 1053
mn, YTD, the most in the region after India.

Table 1. Foreign Institutional Investment in Regional Equities

Day WTD Net MTD Net YTD Net YTD Net As of
(Mil US$) (Mil US$) (Mil US$) (Mil US$) YoY%
India -117.1 -117.0 -25.8 -1,413.0 -88.6 08/02/2011
Indonesia -49.7 -34.2 -3.7 -290.9 -6.2 09/02/2011
Japan 2,418.9 2,418.9 2,418.9 10,418.7 -44.8 04/02/2011
Philippines -16.5 -15.6 -55.5 -149.2 -315.9 10/02/2011
S.Korea -451.6 -487.1 -603.9 -20.8 -108.4 09/02/2011
Taiwan -191.2 -117.7 -117.7 3,321.0 233.5 09/02/2011
Thailand -49.7 -191.4 -121.1 -1,053.8 -267.5 09/02/2011
Vietnam 2.5 5.9 5.9 64.0 13.7 09/02/2011
Pakistan 0.7 0.8 5.8 68.9 332.9 09/02/2011
Source: Bloomberg

77

7

It is not rocket science that resumption of rainbow political activities, post the end of the
emergency decree is giving a good excuse to take profits from Thailand and rotate it
elsewhere in the region. The political implosions in the likes of Tunisia and Egypt will
bring back memories of the recent past of the Bangkok events in the middle of last year
and hence, a growing distaste for Thai financial assets. The risk premium is a tad higher,
suggesting that the financial markets are expressing a sense of unease. Amidst growing
risk averse coupled with a tight USD liquidity environment, the upward move in the
USD/THB was accentuated further.

Fig 1. Thai 5yr credit default swap…a gauge of risk
Fig 2. USD/THB: 30, 60, 200 day moving averages
premium
bps over Libor Thai CDS 5Y 38
190 37
36
170 35
34
150
33
32
130
31
110 30
29
90 28
Jan-07 Jul-07 Jan-08 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11
70
Jul-09 Sep-09 Nov-09 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11 USD/THB 30 day avg 60 day avg 200 day avg

Source: Bloomberg, CEIC, KBank Source: Bloomberg, CEIC, KBank

Unfolding events prompt a rethink
There is a saying that “the shortest distance between two points is a straight line”. The
reintroduction of the Thai risk premium in light of the idiosyncratic political characteristic
complicates our call for a USD/THB target of 28.00 by 4Q11.

We have taken notice that the central bank’s stance on FX intervention as toughened
since mid November. Fig 3 shows that foreign portfolio flows have been instrumental
accentuating the moves in USD/THB. The data points include USD/THB versus the sum
of foreign flows on Thai equities and fixed income securities with the latter being larger.
Based on statistics, correlation between USD/THB and foreign investment flows up to
mid November were highly correlated up to 97%.

Fig 3. Relationship between USD/THB & foreign Fig 4. Relationship between USD/THB & foreign
portfolio flows (equity & fixed income) Jan to Nov 2010 portfolio flows (equity & fixed income) Jan 2010 to now

250 29.0 400 27
29.5 350
200 28
300 FX intervention was stepped
correlation was nearly 98% between 30.0
250 up causing a break in pattern 29
150 Jan 2010 to mid Novebmer 2010 30.5
31.0 200 30
100 150
31.5 31
50 32.0 100
50 32
32.5
0 0
33.0 33
1- 2- 3- 4- 5- 6- 7- 8- 9- 10- -50 1- 2- 3- 4- 5- 6- 7- 8- 9- 10- 11- 12- 1-
-502010 2010 2010 2010 2010 2010 2010 2010 2010 2010 33.5
2010 2010 2010 2010 2010 2010 2010 2010 2010 2010 2010 2010 2011

sum of foreign equity / fixed income flows USD/THB, right axis, inverted sum of foreign equity / fixed income flows USD/THB, right axis, inverted


88

8

The breakdown in the relation became more obvious post mid November. Table 2 shows
our estimate that in December 2010 the Bank of Thailand most likely bought an additional
USD1.9 bn in excess of the balance of payments to steer the USD/THB in a new
direction. This could be a game of “chicken”. The name might sound childish but it
actually is an important concept in economics…primarily game theory.

Table 2. Thai balance of payments, FX reserves and estimated FX intervention levels

USD mn Jan-10 Feb-10 Mar-10 Apr-10 May-10 Jun-10 Jul-10 Aug-10 Sep-10 Oct-10 Nov-10 Dec-10
Exports fob 13,610.4 14,254.7 16,083.8 13,831.7 16,434.7 17,876.5 15,475.1 16,291.6 17,954.9 17,045.5 17,584.0 17,220.0
Imports cif -13,041.9 -13,801.8 -15,082.1 -14,032.5 -14,143.7 -15,334.2 -16,266.3 -15,439.8 -14,712.2 -14,772.9 -17,093.8 -15,911.0
Trade Balance 568.5 452.9 1,001.7 -200.8 2,291.0 2,542.4 -791.3 851.7 3,242.7 2,272.7 490.2 1,310.0
Current Account
Balance 2,107.6 1,655.9 1,779.9 -299.2 1,164.0 820.9 -1,000.8 280.5 2,767.0 2,739.6 1,019.0 1,750.0
Capital and
Financial Account
Balance 2,743.4 -698.6 1,732.6 2,964.5 -2,607.8 741.2 2,979.8 3,205.9 1,125.8 2,404.6
Overall Balance
of Payments 4,965.5 119.3 3,137.3 3,749.0 -989.3 2,166.4 1,412.2 3,589.4 4,269.8 5,821.7 820.3 2,263.0

FX Reserves 142,403.5 141,797.5 144,094.1 147,588.1 143,518.6 146,759.2 151,524.7 155,186.8 163,235.3 171,061.6 167,973.9 172,128.9
Change in FX
Reserves 3,985.9 -606.0 2,296.6 3,494.0 -4,069.5 3,240.6 4,765.5 3,662.1 8,048.5 7,826.3 -3,087.7 4,155.0
Estimated
intervention -979.6 -725.3 -840.7 -254.9 -3,080.2 1,074.2 3,353.3 72.7 3,778.7 2,004.6 -3,908.0 1,892.0
Source: CEIC, BOT, KBank

The popular source of cyber knowledge, “Wikipedia” defines and discusses “chicken” as
follows:

The game of Chicken, also known as the Hawk-Dove or Snowdrift game, is an
influential model of conflict for two players in game theory. The principle of the
game is that while each player prefers not to yield to the other, the worst possible
outcome occurs when both players do not yield.

The name "Chicken" has its origins in a game in which two drivers drive towards
each other on a collision course: one must swerve, or both may die in the crash,
but if one driver swerves and the other does not, the one who swerved will be
called a "chicken," meaning a coward; this terminology is most prevalent in
political science and economics. The name "Hawk-Dove" refers to a situation in
which there is a competition for a shared resource and the contestants can
choose either conciliation or conflict; this terminology is most commonly used in
biology and evolutionary game theory. From a game-theoretic point of view,
"Chicken" and "Hawk-Dove" are identical; the different names stem from parallel
development of the basic principles in different research areas. The game has
also been used to describe the mutual assured destruction of nuclear warfare,
especially the sort of brinkmanship involved in the Cuban Missile Crisis.

The game is similar to the prisoner's dilemma game in that an "agreeable" mutual
solution is unstable since both players are individually tempted to stray from it.
However, it differs in the cost of responding to such a deviation. This means that,
even in an iterated version of the game, retaliation is ineffective, and a mixed
strategy may be more appropriate.

99

9

In 1997, the Bank of Thailand and hedge funds had locked horns in a game of “chicken”,
with the hedge funds shorting the baht while the Bank of Thailand bought baht to defend
the peg. As bystanders became more biased towards the hedge funds, the defense
crumbled since the peg was built on a house of cards with the odds stacked against the
Thai central bank such as the long list of imbalances:

persistent current account deficits,
rising financial leverage,
land / real estate speculation,
mounting short term foreign currency debt facilitated by the Bangkok
International Banking Facilities (BIBF),
Thai firms conducting interest rate arbitrage by issuing euro convertible
debentures (ECDs) encouraged by the fallacy of no FX exchange risks

For the present situation, it looks like luck has sided with the central bank as the foreign
flows are swerving into outflows. By stepping up the FX intervention, foreign investors
were discouraged from aggressively putting more money into the Thai markets since
losses on FX will reduce their returns on the financial assets i.e. local currency capital
gains and interest rate differentials.

We agree that FX intervention and sterilization should be conducted on foreign portfolio
flows since by not doing so, Thai juristic and natural persons would become
unconsciously indebted to foreign funds, since we do not have the funds’ ownership.
Conversely, the point that we have consistently stressed is that flows belonging to Thai
juristic and natural persons i.e. current account flows should not be intervened for the
following reasons:

It represents a cross subsidy between the external side and internal side of the
economy i.e. exporters gain at the expense of the general population
…correspondingly, it facilitates wealth concentration. Said another way: “Spread
the pain and concentrate the gains”
Supports moral hazard as Thai exporters would be discouraged from improving
on productivity and quality for gaining a competitive advantage and continue to
look to the Bank of Thailand to be competitive based on the price function alone.

1010

10

We are scaling back our USD/THB targets: 30.00 for 2Q11 and 29.00
for 4Q11
The new stance expressed by the Bank of Thailand on FX management reflects a more
hands on style, being more aggressive in limiting the USD/THB downside and more
lenient on the capping the USD/THB upside. This is a significant change from what we
saw for the earlier part of 2010. With consideration to these points, we are scaling back
our targets for USD/THB and revising them to:
30.00 for 2Q11
29.00 for 4Q11

Fig 5. KBank USD/THB model Fig 6. USD/THB Fibonacci levels
KBank USD/THB model
48 34
46
33
44
42 32
40 31
38
36 30
34 29
32
30 28
28 Jan-10 Mar-10 May-10 Jul-10 Sep-10 Nov-10 Jan-11
01 02 03 04 05 06 07 08 09 10 11 12
USD/THB Min Max 23.6%
actual model 38.2% 50.0% 61.8% 76.4%


We have not changed our major thesis for the USD/THB. The risk of the USD has been
temporarily dismissed from the markets for the time being. Japan’s sovereign downgrade
from AA to AA- by Standard & Poor’s is an attestation that countries can not go on
forever without fiscal discipline. Greece is a reminder and so as with the rest of the PIIGS
in the Eurozone.

The Greenback, cyclically constructive…structually destructive
The cyclical data points for the US economy seem constructive. The ISM index (the
Institute for Supply Management,
http://en.wikipedia.org/wiki/Institute_for_Supply_Management ), suggests that both the
manufacturing and services continue to expand. A print north of 50 pts indicates that the
business sectors anticipate expansions whilst a print south of 50 pts indicates
expectations of contractions. Another litmus paper indicator is shown on fig 8. This is a
calculation of the top and bottom line of companies listed on the broader S & P 500. The
chart shows that both that current revenue and net income levels are about 96% of peak
levels leading up to the financial crisis.

1111

11

Fig 7. ISM service and manufacturing Fig 8. S&P 500, revenues & net income

70.0 10,000 900
65.0
9,000 800
60.0
8,000 700
55.0
50.0 7,000 600
45.0
6,000 500
40.0
5,000 400
35.0
30.0 4,000 300
97 98 99 00 01 02 03 04 05 06 07 08 09 10 00 01 02 03 04 05 06 07 08 09 10

ISM Non-Manufacturing (service) ISM Manufacturing revenue, USD bn (mkt cap / PSR) net income, USD bn (mkt cap / PER)


The previous should provide encouragement that the “I” part of “Y” of GDP (economists
would denote Y = C + I + G +(X-M)), is looking better and better. The other and more
important facet of final demand is consumption, which no doubt is hinged on prospect of
current income, namely wages. January’s employment data points were rather
confusing…should be call it heads or tails? Heads was the lower unemployment rate
moving from 9.40% to 9.0%. Tails was the lower than expected absolute levels of job
creation, namely “non-farm payrolls”, where the shoal of economists was looking for 146k
but the reality was only 36k. The optimists blamed the lower reading on snow storms and
weather related challenges rather than on the reluctance of US companies to add human
resource costs. Fig 10 shows a worrying structural trend which is a continually declining
labor participation rate. This is the ratio between the size of the labor force (people
working and are looking for work) divided by the size of the total population. The decline
can be due to a couple of reasons we can think of:
Americans are discouraged from looking for work since it during the past two
years it has proven futile.
The demographic shifts towards an aging population as the baby boomers
(Americans born post WWII) entire retirement.

Fig 9. Number of Americans out of work, unemployment
Fig 10. US labor participation rate declines
rate
68
16000 11%
67
14000 10%
66
12000 9% 65
8% 64
10000
7% 63
8000
6% 62
6000
5% 61
4000 4% 60
2000 3% 59
0 2% 58
00 01 02 03 04 05 06 07 08 09 10 11 70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02 04 06 08 10

unemployed, k, left unemployment rate, % , right participation rate, % of total US population


Our concern here is that retirees are not active consumers which do not bode well for the
Asian export market from a structural basis. Reconsidering these facts, the US is looking
more and more like Japan. The other similarity is the “G” part of GDP. According to the
Congressional Budget Office (CBO), the US Federal (excluding state) governments will
rack up a USD 1.4 trillion budget deficit or about 9.8% of GDP. The aging population is

1212

12

definitely a factor and hence the need for healthcare reforms. But after 2011, the US
federal government is still expected to spend money it doesn’t have i.e. more fiscal
deficits which means that the mountain of debt will continue to climb… as long as Asian
central banks remain naïve to lend on the premise that such debt will not be monetized.
Sure, the US federal government will not default…when the debts become matured…
Asian central banks will trade in one piece of paper for another piece of paper. Note that
the US federal debt to GDP will exceed those severe levels during WWII.

Fig 11. US federal budget deficit to GDP Fig 12. US federal debt to GDP

4 160
2 140
0 120
-2 100
-4 80
-6 60
-8 40
-10 20
-12 0
40 44 48 52 56 60 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20
1969
1972
1975
1978
1981
1984
1987
1990
1993
1996
1999
2002
2005
2008
2011
2014
2017
2020

US budget surplus / deficit as % GDP projected US Federal Debt to GDP, % calculated, with Congressional Budget Office estimates


Beside the US Federal Government, the growing concern with the US (the United States)
is with the state and local governments’ ability to keep themselves afloat amidst mounting
debt. The following function in Bloomberg (MIFA <GO>) shows that the likes of California,
Texas, New York are experiencing ever larger deficits. This means the Fed is unlikely to
shift its ultra accommodative monetary policy anytime soon (please see the annex to the
FOMC’s recent statement). More US dollars can eventually only mean lower prices.

Table 3. The arguments for and against USD/THB directions
USD/THB positives USD/THB negatives

Resumption / escalation of political unrest, which Current account surpluses of Thailand, meaning,
prompts a more extended outflows of foreign portfolio exporters outnumber importers. This is a result of
flows out of Thailand irregularities in the Thai political and social landscape
Increasing probability that the Eurozone breaks up, which thwarts domestic demand
hence reallocation of foreign currency reserves back Expectation of further USD/CNY downside as to
to the USD supplement the fight against inflation
Service account outflows from SET dividend Continued Fed accommodative monetary policy,
repayments / Japan fiscal year closing meaning more USD, lower USD price
Increasing perceived political risk of emerging markets Better economic growth prospects in Asia relative to
as seen in Tunisia, Egypt and the spreading to other the West
parts of the Middle East and possibly Asia Political clarity on Constitutional amendments and
Concerns that Asian central banks are behind the general elections
curve in controlling inflation. Inflation is the Return of Thai portfolio flows e.g. from Korean bonds
depreciation rate of money.

Source: KBank

1313

13

Fig 13. The USA or USB, the United States of Bankruptcy

Source: Bloomberg, KBank

Federal Open Market Committee (FOMC) Statement January 26, 2011
Information received since the Federal Open Market Committee met in
December confirms that the economic recovery is continuing, though at a rate
that has been insufficient to bring about a significant improvement in labor market
conditions. Growth in household spending picked up late last year, but remains
constrained by high unemployment, modest income growth, lower housing
wealth, and tight credit. Business spending on equipment and software is rising,
while investment in nonresidential structures is still weak. Employers remain
reluctant to add to payrolls. The housing sector continues to be depressed.
Although commodity prices have risen, longer term inflation expectations have
remained stable, and measures of underlying inflation have been trending
downward. Consistent with its statutory mandate, the Committee seeks to foster
maximum employment and price stability. Currently, the unemployment rate is
elevated, and measures of underlying inflation are somewhat low, relative to
levels that the Committee judges to be consistent, over the longer run, with its
dual mandate. Although the Committee anticipates a gradual return to higher
levels of resource utilization in a context of price stability, progress toward its
objectives has been disappointingly slow. To promote a stronger pace of
economic recovery and to help ensure that inflation, over time, is at levels
consistent with its mandate, the Committee decided today to continue expanding
its holdings of securities as announced in November. In particular, the Committee
is maintaining its existing policy of reinvesting principal payments from its

1414

14

securities holdings and intends to purchase $600 billion of longer-term Treasury
securities by the end of the second quarter of 2011. The Committee will regularly
review the pace of its securities purchases and the overall size of the asset-
purchase program in light of incoming information and will adjust the program as
needed to best foster maximum employment and price stability. The Committee
will maintain the target range for the federal funds rate at 0 to 1/4 percent and
continues to anticipate that economic conditions, including low rates of resource
utilization, subdued inflation trends, and stable inflation expectations, are likely to
warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial
developments and will employ its policy tools as necessary to support the
economic recovery and to help ensure that inflation, over time, is at levels
consistent with its mandate. Voting for the FOMC monetary policy action were:
Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A.
Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I.
Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; Kevin M. Warsh; and Janet L.
Yellen.

Playing “chicken” with inflation?
Economics is the study of opportunity costs and hence any decisions taken by economic
agents will incur a trade off. The inconsistency in monetary policy of pricing baht with
respect to other currencies (FX exchange rates) and with respect to time (interest rates)
might be causing more problems than it solves. The riots in Tunisia and Egypt is said to
be partly attributable to rising inflation. In layman’s term, inflation simply means that one
is getting poorer as to oppose to gaining prosperity.

The rise of China in the global economy is proving to more like a double edge sword. On
the positive side, it is serving as a large production base as well as becoming a large
market for goods and services. On the other hand, it is clear that the planet is being
strained to supporting a population with over 1.36 billion with growing wealth of nearly
10% a year.

Coupled with more frequent supply shocks from nature i.e. floods, drought, diseases, it is
no wonder as to why the prices of commodities, whether it is metals, energy or
agriculture have consistently climb. Fig 16 shows that before the fall of Lehman Brothers,
there is a high correlation between China’s nominal GDP and the CRB (Commodity
Research Bureau) index of 19 commodities including agriculture, energy and metals.

Fig 14. China’s nominal GDP & CRB commodity index Fig 15. Not just coincidence
CRB index
100000 500
500
90000
450
80000 450
70000 400 y = 0.0044x + 121.16
400
60000 350 2
R = 0.8826
50000 350
40000 300
30000 300
250
20000 250 from Dec 99 to Jun 08
200
10000
0 150 200
99 00 01 02 03 04 05 06 07 08 09 10 150
10000 20000 30000 40000 50000 60000 70000
CH nominal GDP 4Q moving sum, CNY bn, left CRB index, right CH nominal GDP, CNY bn


1515

15

Fig 16. …neither is this: China’s nominal GDP & Thai
Fig 17. …as well as explaining a lot
CPI
TH CPI index
100000 115
115
90000
110
80000 110 y = 0.0004x + 77.118
70000 105 2
R = 0.9389
105
60000 100
50000 100
40000 95
30000 95
90
20000 90
85
10000
0 80 85
00 01 02 03 04 05 06 07 08 09 10 80
10000 20000 30000 40000 50000 60000 70000 80000 90000 100000
CH nominal GDP 4Q moving sum, CNY bn, left TH CPI index, right CH nominal GDP, CNY bn


The question is, how can an increase in Thai policy rates control Thai inflation if inflation
is more of a function of regional supply and demand rather than just Thai supply and
demand? After all, this is by design via all the Free Trade Agreements sign for regional
economic integration. Fig 17 shows that size of the Chinese economy has a large
influence on Thailand’s inflationary environment.

So, it seems that by playing “chicken” with portfolio flows, the central bank is also playing
“chicken” with inflation. By allowing the baht to weaken amidst rising commodity prices,
the transmission of imported inflation will be much more rapid.

The Bank of Thailand’s recent inflation report strongly indicates a fear of rising inflation
and that core inflation might get out of hand if interest rates remained low. The following
table is the probability distribution for core inflation going forward. With the assumption
that the repo remains at 2.25%, there is a 43% probability that core inflation will exceed
the 3% upper band in 3Q11 and a 55% probability for 4Q11.

Table 4. BOT Inflation Report, Core CPI probability distribution

Ranges: % 1Q11 2Q11 3Q11 4Q11 1Q12 2Q12 3Q12 4Q12
>3 0% 12% 43% 55% 11% 6% 3% 3%
2.5 3.0 2% 26% 31% 28% 24% 17% 11% 11%
2.0 2.5 22% 34% 19% 13% 32% 31% 25% 26%
1.5 2.0 51% 21% 6% 3% 23% 29% 32% 32%
1.0 1.5 23% 6% 1% 0% 8% 13% 21% 20%
0.5 1.0 2% 1% 0% 0% 2% 3% 7% 6%
<0.5 0% 0% 0% 0% 0% 0% 1% 1%
Source: BOT Inflation Report, Jan 2011

The major source of unease for the central bank is that economic growth has closed the
output gap. In layman’s term, fig 20 shows what an output gap is. If the actual growth is
above trend (in this figure, it is a simple best fit regression line), it suggests that the
output gap has closed, meaning that there is little slack left in the production side. This
would then indicate that the pass through of inflation (the depreciation rate of money)
would be more readily transmitted. A case in point is our current problem with palm oil. If
there is not enough slack on the supply side, there will not be enough goods to go around

1616

16

and prices have to rise anyways. Actually price ceilings might exacerbate the problem as
black markets form where the price sold is higher than the price ceiling.

Fig 18. Output gap has closed Fig 19. KBank BOT repo model
5,000,000 %
6
4,500,000
5
4,000,000 above potential growth
4
3,500,000 3
long term trend
3,000,000 2
below potential growth
2,500,000 1

2,000,000 0
93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10 11 12

Thai GDP, 1998 price, 4Q moving sum Linear (Thai GDP, 1998 price, 4Q moving sum) actual model


We have inputted the assumptions suggested by the BOT Inflation Report which we
believe that the MPC also believes in these assumptions, after all, BOT scholarships are
not cheap and easy to come by. Fig 21 shows our repo model which is a behavioral
model. Simply it gauges how the MPC responds to key economic data points (e.g. growth
and inflation) as reflected in the repo rate. With the new assumptions, we view that the
BOT is likely to take policy rates up to 3.25% by the end of the year, as opposed to our
earlier call of 2.75%. The release of the MPC minutes (the first ever) shed a lot of light of
their concerns for growing potential financial imbalances.

Minutes of the Monetary Policy Meeting of the Monetary Policy Committee
Bank of Thailand
12 January 2011
Publication date: 26 January 2011
Members Present Prasarn Trairatvorakul (Chairman and Governor), Atchana
Waiquamdee (Vice Chairman and Deputy Governor, Monetary Stability),
Suchada Kirakul (Deputy Governor, Corporate Support Services), Ampon
Kittampon, Praipol Koomsup, Siri Ganjarerndee, Krik-krai Jirapaet

Financial Markets
The Thai baht was volatile, appreciating relative to the US dollar on the back of
capital inflows while depreciating in the beginning of 2011 due to sales of equity
by foreign investors after better-than expected US economic data. Going forward,
investors are expected to give greater weight to recovery in major countries,
resulting in greater two-way movement of the baht as opposed to continued
appreciation pressure observed in the previous year. In addition, the yield curve
shifted slightly upwards following the previous MPC meeting reflecting market
pricing of an interest rate hike this meeting. The majority of market participants
surveyed expected the current MPC meeting to result in a rise in the policy rate
by 0.25 percentage points while some expected an overall rise of 0.50-1.00
percentage points in 2011.

International Economic Conditions
Risks to global economic growth have fallen. The US economic recovery
continued to strengthen. A survey of economists indicated that the majority
viewed that the US economy would grow faster than forecasted and that
employment would improve although risks from house prices remained.
Nevertheless, certain MPC members expressed concerns regarding the

1717

17

continually high rate of unemployment. The European economy stabilized
although money markets remained volatile due to concerns over sovereign debt.
However, core member countries, especially Germany, are projected to become
drivers of growth. The Japanese economy still faced deflation while the
appreciating yen may impede growth going forward. The Asian economy
continued to grow on the back of domestic demand and exports destined to both
within the region as well as new markets with high growth potential. Overall, the
region is becoming less reliant on the G3 economies. However, the risk to
inflation for the region as a whole increased significantly. The uneven growth of
advanced economies and emerging markets has led to varied monetary policy
responses. Advanced economies pursued accommodative monetary policy to
safeguard economic recovery while emerging markets tightened to maintain price
stability and are expected to accelerate the pace of interest rate normalization in
2011. As a result, challenges for Asia going forward are likely to come from
capital flow volatility and the appropriate pacing of monetary policy tightening.

Domestic Economic Conditions
Thai economic growth was projected to return to its long-term trend. The Thai
economy continued to expand in Q4 of 2010 from the previous quarter in line
with domestic and external demand. Going forward, growth will be supported by
1) private consumption expansion on the back of both agricultural and non-
agricultural income, increase in the minimum wage, low unemployment and
robust consumer confidence and 2) private investment, which despite some
slowdown after accelerating in the prior period, should expand going forward due
to favorable business confidence, high capacity utilization in many industries, and
future investment plans to meet internal and external demand for goods in
services and 3) fiscal stimulus from government income support programs for
mostly low-income earners and government investment for both large projects
and state enterprises which was expected to increase from the previous year.
Export growth in the previous year exceeded expectations and was expected to
continue its growth trend into 2011 due to Chinese and ASEAN economic
expansion as well as the rising trend in advanced orders. In addition, various
research houses projected strong export growth in 2011 supported by a rising
export prices (except for fisheries where there is low pricing power) which was
expected to partly mitigate the adverse effects of baht appreciation. Tourism
activity was solid and was expected to expand going forward.

In the monetary sector, private credit expanded well together with overall
economic growth. The expansion in commercial bank credit was primarily due to
demand from households. Corporate loans also increased and were projected to
grow continuously in 2011. Commercial banks rapidly raised both deposit and
loan rates following the policy rate hikes.

In regards to price stability, inflation pressure increased from the previous period.
Headline inflation accelerated in line with the rise in wages while core inflation
picked up due to the pass-through of production costs into goods prices,
especially prepared food and seasonings and condiments. The MPC assessed
that inflation pressure going forward has increased due to both cost-push and
demand pull factors. Cost-push factors include: 1) upward trend in oil and
commodity prices on the back of global economic expansion; 2) increased pass-
through from the Production Price Index (PPI) into Consumer Price Index (CPI)
as authorities allowed price increases in many product categories; and 3) gradual
pass-through of production costs to consumers as producers’ ability to absorb
such costs became more limited. Demand-pull factors include: 1) a diminishing

1818

18

output gap as output growth neared potential while producers have revised their
inflation expectations upwards for some time. These factors would speed up
price adjustment going forward. In addition, some MPC members expressed
concerns over the possibility that inflation may breach its target this year.

Considerations for Monetary Policy.
The MPC viewed that the risk to inflation had increased relative to the risk to
growth compared to the previous meeting.

The global economic recovery strengthened compared to the previous meeting.
The risk of a double dip recession in the US declined while Asia faced the
challenge of rising prices, particularly those of commodities. The Thai economy
continued to return to its long-term growth trend. The MPC viewed that domestic
demand would become the principal driver of growth in the coming period.

In addition, strong export performance pointed to Thailand’s economic resilience
in face of the baht appreciating in the previous period.

Inflationary pressure clearly increased due to rising oil and commodity prices, the
return of the Thai economy to its long-term growth trend and pent-up pressure
from delayed price adjustments. At the same time, increases in the minimum and
civil service wages may boost consumption expenditures more than expected
and lead to a rise in inflation expectations going forward. Some MPC members
were concerned that low real interest rates may foster financial imbalances,
depress savings and lead to asset bubbles in the future.

MPC members were unanimous in seeing the need to maintain continuity in
signaling rate normalization. Robust economic expansion together with
significantly increased inflationary pressure led to some members discussing the
possibility of a rate hike of 0.5 percentage points. Nevertheless, the majority of
MPC members viewed that policy rate adjustment should be gradual while taking
into account that the neutral rate depends on changing economic circumstances.

The MPC therefore decided unanimously (7 to 0) to raise the policy interest rate
by 0.25 percentage points per annum, from 2.00 to 2.25 per cent per annum,
effective immediately.

1919

19

Pricing in inflation risks

BoT’s message is simple – bring prices under control and correct
the level of real returns to savers
Investors had been reducing portfolio duration of portfolio during
past 3 months while the yield curve is pricing in 100bp rate hike
In Asia, monetary tightening likely to be greater in economies that
delayed rate actions – a negative for their bond markets
Local near-term inflationary threat looks benign, but Thai people’s
consumption basket shows continued increase in food prices have
greater impacts on low income and rural households
Yield curve outlook remains one of a bear-flattening
We expect consecutive policy rate hikes during the next three
meetings while Q3 may see a further 25bp increase

Local interest rates update
The Bank of Thailand (BoT) had raised its policy rate for the fourth time since July 2010
and signaled that further hikes are in the pipeline to preempt acceleration in actual price
levels and expectations. Such expressions were reiterated in its quarterly publication,
Inflation Report, released on January 24th. The BoT left forecast of core inflation rate
unchanged at 2.0 - 3.0% this year and indicated a high probability (>40%) of them
missing policy target in the third and fourth quarters. That is, given the assumption that
policy rate remained unchanged at 2.25% for the next 8 quarters. Moreover, the BoT
continued to express concerns over negative real deposit rates that could form the basis
of imbalances in the economy over the medium-run. The implication is simple - apart
from bringing prices under control, there is a need to correct the level of real
returns to savers. So far, the adjustments of fixed deposit rates and minimum lending
rates had been rapid. At least when compared to the previous policy rate up-cycle.

Fig 20. Changes in deposit rates Fig 21. Government bond yields change
% %
2.50 8.0
7.0
2.00 6.0

1.50 5.0
4.0
1.00 3.0
2.0
0.50
1.0
0.00 0.0
Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11

T-bill 3M Fixed 1Y deposit Repo Repo MLR Bond yield 5Y Corporate bond 5Y BBB


With the repeated signals from the policymaker, local markets are continually pricing in
new expectations as well. Interest rates had been on a gradual but steady up-trend

2020

20

recently, with substantial liquidity continually keeping bond yields from overshooting the
changes in the policy rate. Nevertheless, there had been a series of more aggressive
swings in bond yields and swap rates as well. This was especially so about a week prior
to the monetary policy decision day as investors adjust portfolios more actively. In
particular, investors continued to reduce their portfolio durations in expectation of further
interest rate hikes. This could be observed via the trading volume of government bonds
during the recent three months. Outright trading volume of bonds that have maturities
more than 7 years had declined by 46% from November to January while trading volume
of 1-3 year bonds increased by 44% during the same period. At the same time, bonds
with maturities 3-7 years saw a less significant change.

Table 5. Thai yield movements and curve spread
Month-end 1Y (%) Chng (bps) 2Y (%) Chng (bps) 5Y (%) Chng (bps) 10Y (%) Chng (bps) 2-5 spread 2-10 spread
Oct-10 1.98 3▼ 2.31 4▼ 2.83 27 ▲ 3.18 6▲ 52 ▲ 87 ▲
Nov-10 2.11 13 ▲ 2.38 7▲ 2.98 15 ▲ 3.59 41 ▲ 60 ▲ 121 ▲
Dec-10 2.38 27 ▲ 2.8 42 ▲ 3.26 28 ▲ 3.77 18 ▲ 46 ▼ 97 ▼
Jan-11 2.54 16 ▲ 2.96 16 ▲ 3.40 14 ▲ 3.85 8▲ 44 ▼ 89 ▼
9-Feb-11 2.60 6▲ 2.99 3▲ 3.49 9▲ 3.86 1▲ 50 ▲ 87 ▼
Source:Bloomberg and KBank

Fig 22. Outright trade volume of government and BoT
Fig 23. Government bond yields change
bonds by bond maturity
million baht bp 1 month period change in yields
160 40
T-bills Gov t and BoT Bonds 1-3Y
140 35
Gov t and BoT Bonds 3-7Y Gov t Bonds >7Y
120 30
25
100
20
80
15
60
10
40 5
20 0
0 1
6m 1 2 3 4 5 7 8 9 10 15 20
tenor (yrs)
Sep-10 Oct-10 Nov -10 Dec-10 Jan-11 Bond Change IRS Change


Inflation theme is a dominant theme in the region
Inflation risks and monetary tightening had become more prominent in Asia in recent
months. Although most economies exhibit inflation rates below 4%, the up-trend in
commodity prices, especially agricultural items, are making central banks nervous. At the
same time, high levels of liquidity in the financial markets continued to bolster asset price
increase in many of Asian economies. This suggests that central banks would have to
stay extra vigilant against economic imbalances for quite some time. The two figures
below show three things: headline inflation rates, policy rate change since central banks
started hiking in the year 2009, and market’s expectation of 1-year forward change in
short-term interest rates. We note that expectation for monetary tightening this year is
greater for the economies that were relatively slower in raising policy rate during the past
couple of years e.g. Philippines and Indonesia. This does not bode well for the bond
market in such economies. In fact, investors had started to unload some of their medium
to long-term bond holdings in the Indonesian and Filipino bond markets. Yields of 5-year
sovereign bonds saw substantial increase during the first two months of the year relative
to regional bond market.

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K bank multi asset strategies feb 2011

K bank multi asset strategies feb 2011

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