If indeed there is going to be a huge capital flight, what should be the policy taken up by Bank of Thailand to avoid a free fall of their exchange rate and how can they achieve it? (Explain at least one instrument)
Thailand’s currency is depreciating because of the speculation caused by the current political instability in the country. The bank can increase the interest rates as a way of attracting investors. Domestic assets become attractive to investors because of the increased rates, as this means that they will get higher rates of return. The government can offer treasury bonds at impressive rates and attract foreign investment in the process. This will lead to increased capital inflows, which will in turn lead to an appreciation and strengthening of the currency. It will also ensure that domestic investors retain their investments in the country instead of looking for other markets overseas. Increasing the interest rates will lead to investors holding increased domestic assets and this will improve the balance on capital account. The increased domestic investment will heighten the demand for the country’s currency and decrease demand for foreign countries. This will in turn improve the country’s exchange rate.
The bank could also defend the currency. The bank can purchase the domestic currency in the foreign exchange market by selling its reserves. The central bank can sell the foreign reserves to prevent the currency from depreciating further. The reserves sold will depend on the difference in demand and supply. However, this will only work if the bank has sufficient reserves. It can also use foreign loans to purchase the domestic currency. These are short-term strategies. They are appropriate in this case, since the main reason why the currency is depreciating concerns speculation. Resolving the political problems in the country will improve the economic situation. Longer-term measures will include the government finding ways of increasing exports by applying supply-side policies.