Thailand: Cyclical Recovery Underway

Weakest market in EM space so far

Thailand has lagged the ASEAN and emerging markets over the last three years due to political instability and the consequent impact on domestic demand. While we have seen GDP growth accelerating in almost all emerging markets in this period, Thailand’s growth has decelerated to an average of 4.8% over the last two years from an average of 6.7% in 2003-04. The stock market performance has followed a similar trend. MSCI Thailand has underperformed the MSCI EM by 33% over the last three years. Indeed, Thailand is one of the very few emerging markets that has not participated in the three common themes of increased household leverage for consumption and property investments, higher private corporate capex and government spending on infrastructure.

Apart from political problems, a relatively conservative monetary policy and the almost complete pass-through of higher international oil prices to domestic consumers (many other EMs have subsidized oil prices) have also affected domestic demand growth. Private consumption growth has indeed touched an eight-year low of 0.8%Y in 2Q07. Weak domestic demand in Thailand is also reflected in the current account surplus rising to a seven-year high of 10.0% of GDP (annualized) during the quarter ended December 2007. However, we believe that the country is now poised for a cyclical recovery. The political and economic growth outlook has improved over the last few weeks.

Domestic demand – worst is probably behind us

Weak domestic demand in the last three years has resulted in a significant improvement in Thailand’s macro balance sheet, as measured by reduced financial leverage in the system. The aggregate debt to GDP (leverage of household, corporate and government) for the country has fallen to 91.7% from the peak of 102.9% three years ago. However, domestic demand indicators have started bottoming out over the last four months. Some of the key indicators reflecting this recovery include bank credit, imports, VAT collection and retail sales growth. The four key drivers for this recovery are i) increased pent-up demand; ii) a decline in real interest rates; iii) increased government spending; and iv) improving sentiment on hopes of potential improvement in the political environment.

Uncertainty in the political environment meant a pushback in spending by the corporate sector on capex and households on consumption. However, corporate entities, households and the government are now beginning to increase their spending. Private corporate capex growth reached an eight-year low during the quarter ended March 2007. Capacity utilization in the corporate sector is already stretched at 76.9%, encouraging some spending for capex. While over the last few months the government had started to push through higher revenue expenditure, the formation of the new government should ensure some improvement in capital spending too. The recent sharp decline in real interest rates and improvement in the political outlook should provide confidence to the corporate and household sectors, supporting the recovery in domestic demand over the next few months.

Domestic demand to offset potential slowdown in exports

Despite the strong appreciation of the baht over the last two years, export growth has remained very strong. Meanwhile, on a real effective exchange rate (REER) basis, the baht has appreciated by 13.6% over three years and export growth has outperformed the region. However, a further slowdown in the US, Europe and Japan over the next few months would likely cause some slowdown in export growth. We expect the recovery in domestic demand to help to offset this, ensuring that overall GDP still accelerates to 4.8% in 2008 from 4.6% in 2007. We expect domestic demand growth to accelerate to 5.6% in 2008 from 2.1% in 2007.

Full realization of potential growth needs more stable political structure

While we expect a recovery in domestic demand in 2008 after two straight years of deceleration, we believe that a fully fledged reacceleration of GDP growth to the 6.5-7.0% achieved in 2003-04 would need a strong and stable government. Risk of military intervention is still high. So far the military has chosen to refrain from interfering actively in the formation of the new government. In our view, there is still a risk that the current six-party coalition government led by the PPP (People’s Power Party) may not survive for more than one or two years. We believe that the manner in which the PPP leadership manages some of the critical political issues over the next six months will determine how long the new government will last.

Some of the difficult issues that the PPP leaders will have to manage are as follows:

·The most important challenge is to effectively co-ordinate with the coalition partners, many of whom fought the general elections against the PPP.

·The leader of the PPP, Samak, faces legal cases. If the verdict of the court goes against him, he may have to step down from the premier position.

·The PPP will have to ensure that the conduct of the government is independent and that its decisions are not actively influenced by Thaksin.

·The PPP leaders have indicated in the past that they will seek amnesty for the 111 former executive members of the disbanded Thai Rakh Thai Party, including Thaksin, who were barred from politics for a period of five years. Currently, PPP leaders claim that they will not raise this controversial issue for the next six months. If they raise this issue, there is a risk that it will create some political tension. Similarly, if the new government decides to allow Thaksin back into Thailand, it will have to ensure a smooth entry for him.

We believe that the military coup in September 2006 has caused significant damage to the country’s political outlook. Thailand’s political structure is likely to be perceived as unstable for a long period even if the current government lasts for more than 1-2 years. Taking into account the underlying positive demographics and the strength of its corporate sector, we believe that the country’s potential growth is around 6-7%. However, realizing this growth potential is likely to be difficult until we see stabilization of its political structure.

By Chetan Ahya Singapore
Morgan Stanley
February 06, 2008