BoT to ease further amid deflation risks

Keeping the baht in check could be the central bank’s biggest challenge. By Fitch Solutions

We believe the Bank of Thailand will maintain a dovish tilt over the coming quarters, as the economy struggles amid the shock from the Covid-19 pandemic and deflation risks remain elevated.

At its June 24 policy meeting, the Monetary Policy Committee (MPC) voted to unanimously keep its key policy rate on hold at 0.50%. While the MPC noted that the economy and inflation had deteriorated more than expected, it highlighted that the policy response already in place would be able to support a recovery in both to target levels.

Indeed, the central bank has cut its key policy rate by 75 basis points in the year to date, with its latest cut coming in May, and has taken other steps, including bond purchases, to bolster liquidity and loan growth.

This has come alongside a significant round of fiscal stimulus at an estimated 9% of GDP, along with macroprudential measures to ease the operating burden on banks and businesses. However, we expect that the central bank will opt to ease further before year-end in the face of baht appreciation and deflationary risks.

The central bank slashed its 2020 growth forecast to -8.1%, from -5.3%, and its inflation forecast to -1.7%, from -1.0%. However, it remains optimistic of a rebound in both growth and headline inflation in 2021, with forecasts of 5.0% and 0.9% respectively.

We at Fitch Solutions have also revised down our real GDP growth forecast to -5.4%, from -4.0%, amid a bleaker outlook for gross fixed capital formation (GFCF) due to weak foreign direct investment and an expectation for a decline in savings in 2020.

We expect the GFCF contribution to headline growth to come in at -3.1 percentage points, as spare capacity and a subdued domestic demand outlook curb investment. We are less bearish on growth in 2020 than the central bank but we expect a slower rebound in 2021, with the outlook for medium-term growth and demand-side inflationary pressures subdued.

Core inflation fell to zero in May, highlighting the threat of a deflationary spiral. The recession will leave a more indebted private sector and likely aggravate the high savings-low investment imbalance. This will result in weak demand-side pressures over the coming years, with our inflation forecast outlook revised downward.

We have lowered our 2020 headline inflation rate forecast to an average of -1.4%, from -1.1% previously, and now expect headline inflation to remain outside of the central bank’s 1-3% target range until 2023.

This will be aggravated by the appreciatory trend of the baht. Indeed, the baht reached its strongest level since the end of January on the central bank’s latest announcement. The currency remains relatively overvalued as judged by its real effective exchange rate (REER), which recovered before it dropped to its 10-year average.

Moreover, without central bank intervention, the local currency could rally further as global tourism begins to resume. But Thai policymakers will have to move cautiously if they want to weaken baht demand, or risk seeing the country on the “currency manipulator” watch list maintained by the United States.

Nevertheless, the combination of deflationary pressures and a significant fiscal shortfall will give the central bank scope to take extraordinary steps to stimulate the economy.

As such, we maintain our forecast for the key policy rate to be cut by another 25 basis points to 0.25% by the end of 2020. We also expect additional measures, such as yield curve control, in a bid to boost domestic activity and curb baht appreciation.

As it responds to the pandemic, the Bank of Thailand has shown its willingness to lower its key policy rate to all-time lows and expand its range of policy tools to include government bond purchases. Nevertheless, its real policy rate has become increasingly positive in light of the deflationary price trend, standing at 3.9% in May, making the baht relatively attractive compared to currencies of other emerging markets.

Therefore, the central bank has scope to lower its policy rate further to curb real policy rate attractiveness (although we expect it to avoid lowering rates to the zero-bound or below). In addition, yield curve control could anchor rate expectations lower for longer, aiding corporate and household refinancing, the government’s wider budget deficits and efforts to cool the baht’s appreciation.

Risks to our outlook are tilted to the upside, with the central bank potentially leaving its rate unchanged through the rest of 2020 and instead opting more unconventional measures and macroprudential reforms. This would put more onus on the government to enact supply-side reforms to stimulate the near- and long-term growth outlooks.

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The combination of deflationary pressures and a significant fiscal shortfall will give the central bank scope to take extraordinary steps to stimulate the economy.