Floods affect interest rates but the baht holds up for now

Floodwater may breach dykes, overwhelm homes and inconvenience millions, but financial markets must move on, particularly after a month as volatile as October.

It is still impossible to predict the ultimate extent of the floods. But one thing is certain - over the past month, estimates of the potential damage have been revised up almost continually, as almost every day another industrial estate, town or district goes under water.

This is having a big impact on interest rate expectations. At its monetary policy meeting in late August, the Bank of Thailand hiked its overnight benchmark interest rate by 0.25 per cent to 3.50 per cent, amidst inflation worries. Consensus was for the rate to rise to 4 per cent by mid-2012.

By the latest policy meeting in mid-October, the atmosphere had shifted. Worries over growth dominated the agenda, and the central bank kept its benchmark rate unchanged. 

There are also growing calls to reduce interest rates, to help support recovery.

Bond yields have been falling, and are now below the overnight rate for tenors up to 10 years. This is partly due to low bond supply, but in any case, a one-year yield at 3.30 per cent indicates that investors are pricing in future rate cuts.

So far, the floods have had less of an impact on baht exchange rates. The currency market is being driven by two global issues - Europe's debt problems and US recession risks.

Both those issues seemed to improve over the last month, boosting risk appetite. As a result, Asian currencies, including the baht, have strengthened versus the dollar.

Europe's debt crisis remains a mess, but things are a bit better than a month ago. The summit meeting in late October showed some progress on restructuring Greek debts, recapitalising banks and increasing the European rescue fund. 

Greece temporarily shocked everyone by proposing a public referendum on Europe, but then shelved the plans after a big outcry. Nevertheless, it is worrying how politics (in any one of many countries) can easily affect sentiment on European prospects.

Meanwhile, fears on whether the United States is entering a recession have abated somewhat. Key economic figures (such as change in payrolls, retail sales and manufacturing activity) have been better than expected

Recent corporate earnings reports have also been generally sound. That helped revive risk appetite. The S&P 500 stock index increased by 10.8 per cent in October, its best monthly performance since December 1991.

In any case, there are downside risks ahead for the baht. The situations in Europe and the US improved last month, but both remain fragile. It is easy to envisage bad news that could cause sentiment to shift.

Also, the floods may yet have a negative impact on the baht. The disruptions to industrial activity should cause Thai exports to fall significantly in the fourth quarter. 

Reconstruction efforts could lead to greater import requirements. Continued flooding in Bangkok might also hit tourist arrivals, just as the peak season begins in December. All these would lead to lower demand for baht in currency markets.

Parson Singha is chief markets strategist in the Global Markets Department of HSBC Thailand.