While capital inflows are generally beneficial, they are by no means cost-free. Potentially, large inflows of capital can lead to exchange rate overshooting, hurting some segments of the real sector that may have trouble adjusting. Moreover, they could seep into speculative activities and drive up asset prices. Especially vulnerable are the real estate and equity markets. As these markets heat up, more capital inflows often find their ways in, creating potential bubbles. Invariably as the bubbles burst, balance sheets of firms, individuals, banks as well as the government will be affected. The burst of these bubbles, when coupled with capital outflows, could have devastating effects. The Asian crisis over a decade ago is a good reminder for us. Currently, the Bank of Thailand has a set of tools at its disposal to help the economy deal effectively with capital inflows. These tools include (1) the flexible exchange rate and foreign exchange market intervention, (2) macro-prudential measures, and (3) capital account regulations. Together, these tools are indeed powerful, and a careful coordination is required when using them. Let me briefly elaborate on the use of each. In our framework, a flexible exchange rate is a core tool, since it can act as an automatic stabilizer towards capital inflows in general. As capital pours in, especially if driven by favorable growth potential of the economy, a flexible exchange rate can act as an automatic stabilizer that would help lessen the chance of overheating and dampen pressures on other asset prices which otherwise might turn into a bubble.
For outflow liberalization, on the one hand allowing more Thai resident outflows is beneficial as it helps lessen upward pressure on the currency as well as improve the investment profile of the Thai private sector toward a more diversified and possibly more efficient one. On the other hand, if risk assessment capacity of local investors remains low, too rapid outflow liberalization could make the country’s balance sheet more vulnerable rather than more robust. A balancing act is even more difficult when applying re-regulation on capital inflows. A measure that is too mild would lack effectiveness, while too drastic a measure would be too costly. For one thing, its distortionary effects would be large; for another, increased policy uncertainty could turn away productive investors and raise the country’s risk premium. Aware of these undesirable side effects of controls, we would limit their use to only when absolutely necessary and only on a temporary basis. On the use of interest rate policy, some may view the policy interest rate as another tool to deal with capital flows, and there have been public debates whether the recent hikes in the policy interest rate by the Bank of Thailand were consistent with our thinking on recent capital flow developments. Specifically, many have argued that the hikes would actually induce more capital inflows that add pressures on the currency. On this issue, let me say the following. Under inflation targeting, the policy interest rate is used primarily to help maintain price stability to achieve long-term balanced growth of the domestic economy.