[Disclaimer: I am not a trained economist and these comments, like the rest of my blog articles, are in my capacity as a private citizen. Professional advice should be sought before making any investment decisions. Caveat lector!]

Why capital inflow became a concern for Thailand

Inflows of money can be a good thing for a country and its economy. For example, foreign investment may be used to buy real estate and build factories, which in turn create jobs and produce goods which can be exported. This may be regarded as direct investment, as opposed to portfolio investment which includes stocks and bonds.

Money invested in local banks contributes to their capital supply, allowing them to provide more loans. Loans to businesses can stimulate enterprise, while personal loans can stimulate demand. (Admittedly this is a bit of a simplification -- while it is true that banks in theory could keep on lending money ad infinitum, most banks prefer to limit this. There are also many nuances to loans, as they influence the money supply and have public policy implications.)

Building a factory and exporting the goods for resale is but one way to make a profit. A foreign investor can also gain by buying and selling assets at different times. If a foreigner uses US dollars to buy a Thai asset, he can make a profit by selling the asset after the Thai baht increases in value relative to the US dollar. (Here's an abstract example to help clarify the concept: If one buys 1 packet of foreign currency at US$1, and the same unit is later worth US$2, one can make a US$1 profit by selling after the increase.)

Sometimes the market is volatile -- i.e. changes are occurring rapidly and in the short term. This has been the case of late, due to the falling US dollar. If the US dollar falls rapidly, then the above method of buying and selling assets becomes more profitable: one can buy an asset using US dollars and then resell it for more US dollars, as the US dollar weakens and the Thai baht strengthens.

Investors can also contribute to volatility. One example would be short selling, where an investor tries to profit from the decline in price of an asset (e.g. stocks, bonds or currency).

Volatility can sometimes be a problem. When the value of the Thai baht shifts upwards, it hurts Thai exports. If a local business is not lush with financial reserves, then it may not be able to weather even a temporary fall in exports, and will then have to close -- with consequent unemployment. Beyond the human cost of job losses, there are also broader economic repercussions: unemployed people do not consume as many goods, and this means fewer customers for local retail, and so on.

Also, if many foreign investors rapidly withdraw their capital (e.g. once it looks like the US dollar is no longer falling against the Thai baht), it may spark a further wave of selling of Thai assets. This, combined with other investors seeking to short sell, may cause a rapid fall in the market -- a hard landing or a market crash.

This would explain Thailand's intention of reducing the inflow of "hot money" (i.e. short-term investments).

What went wrong with Thailand's policy measures

As described by The Economist, Thailand's initial approach to the problem was as follows:

"Under the first version of the rules, anyone selling more than [US$] $20,000-worth of foreign currency, other than for the purposes of trade, would have had to deposit 30% of it with the central bank -- at zero interest -- for one year, or forfeit one-third of the deposit."

- The Economist, 19 Dec 06 [Link]

Thus for every US$1 brought in, only 70 cents would be available to the foreign investor for the originally intended purpose. If the investment was for a duration shorter than 1 year, then one third of the 30 cents deposit would be forfeit -- i.e. a 10% tax on short term investments. To put this in perspective, the Tobin Tax advocated by opponents of currency speculation would have been around 0.1% to 0.25%, much less than a 10% levy.

A comparable system existed in Chile from 1991 to 1998, called the encaje. For portfolio investment inflows, foreign investors were required to make a 30% deposit in a zero-interest account with the Chilean central bank. The Chileans also imposed a 3% penalty on early withdrawals, but this was much less than the 10% Thai requirement, and thus less likely to scare investors into leaving. [The encaje is reviewed by Neely (1999) in Review of the Federal Reserve Bank of St Louis]

Furthermore, it appears that the first version of the Thai policy did not distinguish between stock market and other investments. Thus it had a chilling effect on both.

The policy may also have approached the issue from the wrong direction. During the 1997 Asian Financial Crisis, Malaysia's capital controls prevented speculators from removing their gains until some time had passed. The strategic effect was to weight the economy in favour of long term investors (and thus long term projects such as businesses, factories and infrastructure). As a tactical decision, it prevented capital flight by imposing capital controls on short-term outflow. New "hot money" investors might have been put off, but investors already committed could not easily cut and run.

In contrast, Thailand's approach was to restrict capital inflow without any controls on outflow. While this had the same effect as the Malaysian policy in discouraging the short-term investors out to make a quick profit, it did not prevent investors from running if spooked -- and spooked they were. Thus capital inflow controls were achieved, but with the collateral damage of capital flight.

Not all of the sell-offs would have been by foreign investors: once the market dived precipitously, a wave of panic selling would have overtaken local and foreign investors alike, as they sought to cut their losses.

It seems to me that the Thai authorities did not adequately anticipate the spooked response of investors. Why else would they have proceeded as they did? Any post-mortem of the incident should explore this.

It would be an interesting study to compare investor sentiment in 1990s Chile, as compared to late 2006 Thailand. The 3% versus 10% lock-in levy is one possible reason for the different response, but other factors should also be surveyed. (I was unable to find good references about 1990s Chile online; perhaps a helpful reader could direct me to some.)

Why these events are important for Singapore

Any economic turmoil in Thailand is bound to have knock-on effects in the surrounding region, including Singapore. This phenomenon of contagion was a major problem in the 1997 Asian Financial Crisis -- hopefully it will not be as severe this time round.

Furthermore, as mentioned earlier, Singapore has investments in Thailand, including Shin Corp.

The Economist article of 19 Dec 06 notes that other worries besides currency restrictions are weighing on the minds of potential investors. Shin Corp is mentioned:

"The confusion over the currency restrictions is not the only thing to give potential investors in Thailand pause for thought. An investigation into Shin Corp, the telecoms business sold to a Singaporean government agency by the deposed prime minister, Thaksin Shinawatra, has raised doubts about the legal status of many foreign-owned firms in Thailand. Tesco, a British retailer, has been pressured to slow its Thai expansion drive, following protests by small shopkeepers. Above all, it is still unclear how stable and how market-friendly a government will emerge once elections are held, around a year from now."

- The Economist, 19 Dec 06 [Link]
(boldface highlights are my own)

Stratfor's assessment is more colloquial in language, but makes related points:

"[Following the Thai coup] while most observers -- including Washington and Wall Street -- watched with a wary eye, they withheld judgment and indulged in calming platitudes that Bangkok should soon get back to whatever Thais consider "normal." No firms were nationalized, no opposition (or former government) officials were shot, and life more or less went on."

- Stratfor - Thailand's Rash 'Lock-up' Move, 19 Dec 06 [Link]
(boldface highlights are my own)

The two issues highlighted above, among others, are of relevance to Singapore:

Foreign ownership of firms in Thailand
There is currently an ongoing Thai investigation into Shin Corp's acquisition by Temasek Holdings [Wikipedia article and Review by Yawning Bread]. One question pertains to Thai shareholders, and whether they should be defined as having nominee or agency relationships. [The existing Thai law on this is reviewed by Bennet & Savage (2006).]

The outcome may set precedents regarding the legal status of many foreign-owned firms in Thailand. According to a Bangkok Post article of 23 Aug 06 [Link], Shin Corp would not be alone in facing trouble, were Thailand's rules on corporate foreign ownership to be reinterpreted.

In the same vein, Bennet & Savage note that other prominent foreign investors such as Tesco, Holcim and Carrefour might be affected by a negative determination against Shin. The authors conclude:

"...foreign investment in Thailand, and the rule of law for which it is respected, will suffer a severe blow if the MOC [Thai Ministry of Commerce], in response to the politically motivated protests against the Shin Deal, were to change the rules, make them effective retrospectively, and issue a ruling adverse to Shin Corporation and its investors."

- Bennet & Savage (Oct 2006) Foreign Investment in Thailand: Will the Rules be Changed?
[M&A Review, AsiaLaw.com]

The prospect of nationalization
Investor concern might also ensue if private firms undergo nationalization. iTV, a broadcast company owned by Shin and now indirectly owned by Temasek, has been levelled with a fine of 90 billion baht (about Singapore $4 billion) for emphasising entertainment over news, with the fines to be paid within 45 days. [iTV fine decision will not be reversed, The Nation, 20 Dec 06]

To put this amount in perspective, in 2004 the European Union fined Microsoft an amount of US$613 million (equivalent to about 24 billion baht at the time). The iTV fine exceeds this amount.

As iTV only has about 1.2 billion baht in liquidity, its only other source of financial support will have to be Shin Corp. But could the parent company justify a 90 billion baht bailout? It is therefore more likely that iTV will declare bankruptcy and close -- or be taken over by the state in a de facto nationalization. [Setback for Temasek as Thai court fines ITV, South China Morning Post 14 Dec 06]

Conclusions
The ongoing Shin saga has implications beyond Singapore's Temasek Holdings. Decisions on Shin Corp may set precedents, which in turn can influence investor sentiment -- one key example would be the rules on foreign ownership of Thai companies.

As such, the fate of Shin Corp and its subsidaries will be closely watched by many foreign investors. An adverse decision for Shin could spook investors, especially if the outcome is seen as arbitrary.

In the current climate, it is crucial for Thailand to make decisions that preserve investor confidence. So long as this is the guiding principle for the Thai authorities in matters involving Shin Corp, then Singapore's investment in Shin may not be as precarious as some commentators have suggested.

[Many thanks to HC and BL for their input.]

**
Footnotes

[1] Some contemporaneous ChannelNewsAsia coverage can be viewed at:

19 Dec 06 - 1244hrs: [CNA] Thai stocks suspended after nosediving 10%
19 Dec 06 - 1354hrs: [CNA] Thai stocks plunge 12% after central bank moves
19 Dec 06 - 1541hrs: [CNA] Asian stocks punished as Thai govt spooks investors with capital controls
19 Dec 06 - 1928hrs: [CNA] Asian stocks slump following sharp losses in Thai shares
20 Dec 06 - 0913hrs: [CNA] Thai stocks set to recover from rout after U-turn on curbs