Dr. Veerathai Santiprabhob, Governor of the Bank of Thailand

Dr. Veerathai Santiprabhob, Governor of the Bank of Thailand, delivered a keynote speech at the seminar “Credit Spotlight on Thailand: The Link to Continental Southeast Asia”, organized by TRIS Rating Co., Ltd. and S&P Global Ratings.

Dr. Veerathai stated that credit rating agencies are a crucial mechanism in the financial system as they assess the quality of debt, helping to reduce information asymmetry between fundraisers and investors. This assessment impacts the cost of finance and access to funding sources for those seeking to raise capital. Moreover, it reflects the long-term sustainability of fundraisers and is linked to the overall stability of the financial system. Therefore, it is essential for credit rating agencies to evaluate risks carefully and comprehensively.

In the current environment, risk assessment has become increasingly challenging due to the VUCA world characterized by volatility, uncertainty, complexity, and ambiguity. Over the past 2-3 years, various economic phenomena have emerged that traditional economic theories struggle to explain, such as the continuous depreciation of the dollar despite multiple interest rate hikes by the U.S. Federal Reserve, or the inflation rate in the U.S. not rising as expected even with a tightening labor market.

These issues can be described as a puzzle that complicates risk assessment due to changing relationships among economic variables, which have become more complex. Many phenomena may not be sustainable and are at risk of rapid adjustments, referred to as sharp market corrections.

In such circumstances, the most dangerous factor is the complacency of market participants. Sometimes, a calm and seemingly positive market condition may be the calm before a major storm. If most market participants share a similar perspective, especially one that may not align with the fundamental economic factors, it can lead to a disconnect between market expectations and economic fundamentals.

This mismatch cannot last long, and when affected by certain factors, it may lead to rapid and severe market adjustments. The recent market correction has already been observed globally over the past month, with stock markets declining worldwide and long-term U.S. bond yields rising sharply after some economic data from the U.S. deviated from market expectations. This market correction is a positive sign that the market is beginning to adjust itself before the mismatch between market views and fundamentals becomes larger, potentially leading to more severe adjustments in the future.

Furthermore, the recent market correction serves as a reminder for all parties, including businesses, investors, and risk assessors, not to be complacent when the market appears stable or low-risk. The market correction illustrates that fundamental analysis remains crucial and must be considered in the context of rapidly changing market expectations, as both aspects influence each other.

“Today, I would like to highlight three puzzles that emerged before the market correction over the past month.”

The first puzzle is the fluctuation of oil prices in the global market. We remember that crude oil prices were above $100 per barrel for over three years from 2011 to 2014 before sharply declining to around $35 per barrel in early 2016, primarily due to the weakening global economy and the emergence of shale oil, which significantly increased global energy supply. This led many to doubt that oil prices would rise above $60 per barrel again.

However, since mid-last year, global oil prices have risen faster than many expected, reaching above $70 per barrel earlier this year before declining slightly in the past 2-3 weeks. During this rapid increase, the net long position of non-commercial oil traders, such as hedge funds and speculative investors, also reached record highs, causing oil prices to deviate further from fundamental factors at times.

The second puzzle concerns inflation rates in the U.S. and other major industrial countries, which seem not to be pressured by the improving labor market as in the past. Over the past year, the U.S. unemployment rate has continuously decreased to 4.1%, lower than the pre-global financial crisis level of 2008 and below the long-term unemployment rate estimated by the Federal Reserve at 4.6%.

Nevertheless, inflation has remained low at around 1.5% – 2.0% for the past six years, leading many to question whether the Phillips Curve theory, which explains the relationship between inflation and unemployment, still holds. These two variables should be inversely related, but since the global economic crisis, this relationship seems to have diminished or disappeared. This phenomenon is not only occurring in the U.S. but also in other industrial countries, such as Europe and Japan. This may be due to various structural factors changing, including shale oil in the U.S., the role of e-commerce, labor market structural changes, demographic shifts, and technological advancements, leading to lower production costs and higher efficiency, thus altering the relationship between labor market conditions and inflation.

However, over the past month, the Phillips Curve theory has regained attention after wages and inflation in the U.S. rose faster than the market expected in January, prompting the market to adjust its views on inflation and the trend of future interest rate hikes by the Federal Reserve, resulting in market corrections across various dimensions in the global capital and money markets.

The third puzzle is the continuous depreciation of the U.S. dollar and the yield curve of U.S. bonds not rising significantly, despite the Federal Reserve having raised interest rates four times since late 2016 from 0.5% to 1.5% currently. Looking back two years, the market largely expected that continuous interest rate hikes by the U.S. Federal Reserve would lead to a stronger U.S. dollar compared to other currencies.

However, the opposite has occurred, as the U.S. dollar has weakened against currencies in emerging markets and developed countries, including the yen, euro, and pound sterling. One key factor contributing to the dollar's depreciation is the excess liquidity in the global financial market due to the quantitative easing policies of several central banks. Even though the Federal Reserve has raised interest rates multiple times, the excess liquidity remains at very high levels.

This excess liquidity is one reason why the Fed's interest rate hikes over the past year have not effectively transmitted to the yield curve as they did in the past. Another reason may be the market's low inflation expectations, as it believes the Phillips Curve relationship has changed, as mentioned earlier. The lack of significant increases in the yield curve in line with the Fed funds rate has resulted in less upward pressure on the dollar compared to the past.

This situation is a critical issue to monitor closely, as the market correction over the past month has begun to impact the long-term yield curve of U.S. bonds more than the market anticipated. The yield on 10-year government bonds has risen to about 2.9%, the highest level in four years, which will affect borrowing costs for both the government and the private sector, especially for financially weaker private entities.

The three puzzles mentioned illustrate the hidden risks when there is a mismatch between market expectations and economic fundamentals. No one can definitively say whether the market correction that occurred over the past month will lead to larger market adjustments or when they might happen. Therefore, businesses and investors must be cautious and aware of these risks.

Additionally, it is essential to recognize that market expectations may change due to factors beyond just views on economic fundamentals, including risks arising from uncertainties in U.S. economic and trade policies, geopolitical risks in the Middle East and the Korean Peninsula, or even increasingly severe natural disasters. All these factors could create volatility in financial and capital markets, affecting commodity prices, exchange rates, long-term interest rates, and financial costs, which in turn impact debt quality and the sustainability of businesses.

“Although the global money and capital markets may face market corrections stronger than those that occurred over the past month, I believe that the Thai economy has a buffer or capacity to withstand fluctuations from the global financial market to a certain extent, as the overall Thai financial sector has several strong fundamental factors.”

Firstly, the Thai economy relies on foreign debt at a low level. Currently, the foreign debt of both the public and private sectors stands at only 36% of GDP, which is relatively low compared to international standards. The liquidity of Thailand's foreign currency remains very good, reflected by a current account surplus of 10.8% of GDP in 2017 due to strong growth in exports of goods and services.

Moreover, foreign reserves are at a high level, currently exceeding short-term foreign debt by 3.3 times and total foreign debt by 1.4 times, indicating that the Thai economy has a buffer to withstand capital flow volatility effectively.

Secondly, the financial position of Thai financial institutions remains strong, with high liquidity, enabling them to manage deteriorating asset quality. The commercial banking system has a high ratio of reserves for non-performing loans to required reserves at 171.9%, while the capital adequacy ratio is also high at 18.2%.

Additionally, the Bank of Thailand has enhanced the supervision of financial institutions in various aspects, such as aligning funding sources with usage or the Net Stable Funding Ratio, allowing commercial banks to better cope with prolonged liquidity tightness, as well as regulations governing information technology risk management and governance standards to mitigate risks arising from organizational culture.

Thirdly, the overall level of corporate debt does not pose a vulnerability to the stability of the financial system. The latest corporate debt to GDP ratio stands at 76.7%, which is not high and lower than the average of emerging market countries at 98.7%. Moreover, over three-fifths of this debt is long-term, and part of the foreign debt of businesses is held by large corporations for overseas investments, limiting exchange rate risk.

However, some business sectors still have fragile financial positions, and the debt repayment capacity of SMEs remains concerning. The profitability and interest coverage ratios of some small companies are still low. Although the non-performing loan ratio (NPL) of SMEs has begun to improve and diversify, the NPL level remains high compared to 2-3 years ago. In the future, SMEs will face challenges from technological changes that will inevitably impact their business models and competitiveness.

Furthermore, we must closely monitor the financial position of households, as many households have fragile financial conditions due to the uneven recovery of household incomes. Some household incomes have been affected by changes in labor market structures. In addition to income issues, households are also facing high levels of household debt. Although the household debt to GDP ratio has continuously decreased to 78.3%, households still need time to restructure their finances.

While the Thai economy shows a clearer and more widespread growth trend, and the financial sector has a reasonable buffer, especially in terms of foreign buffers, we must not be complacent. As mentioned earlier, we are in a VUCA era characterized by high volatility, uncertainty, complexity, and ambiguity, and the global economy is increasingly interconnected. Importantly, the excess liquidity still present in the global financial system may lead to mismatches between market expectations and economic fundamentals, which could result in severe market corrections.

These factors make risk assessment increasingly challenging. Awareness of risks and comprehensive risk management will be crucial for businesses and households to succeed and build resilience to upcoming fluctuations. It is undeniable that credit rating agencies must play a significant role in carefully and comprehensively assessing risks and must be able to connect the relationships between the financial positions of fundraisers, market expectations, economic fundamentals, factors influencing various asset prices, and the stability of the financial system and the overall economy.

Note: 1 The ratio of Thailand's foreign debt once reached 72% in 1999 (this is an estimated figure, as there was no standardized data at that time). The average foreign debt to GDP ratio for emerging market countries is around 51%.

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