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Is martial law the last straw for Thai investors?

Despite months of political turmoil in Thailand, investors generally haven't wavered from the view that the business of Thailand isn't its politics, but the declaration of martial law may change their minds.

"Foreign investors may be reducing their investments in Thailand," said Mayuree Chowvikran, a strategist at Maybank-Kim Eng in Bangkok. "Some of the foreign funds have to reduce their positions in Thailand because of the limitations of their funds."

She noted that Thailand's currency reacted negatively to the news of martial law. The baht fell, with the U.S. dollar fetching as much as 32.64, compared with around 32.44 Monday, before the baht strengthened to around 32.50. Many analysts expect the central bank may intervene on the currency if its moves become too large.

Read MoreThailand's army declares martial law, says not a coup

But Mayuree doesn't expect a huge reaction from the stock market, projecting a fall of around 1 percent.

That may be because funds have already pulled their stakes from Thailand. So far this year, foreign and domestic investors in Thailand mutual fund and exchange traded funds (ETF) have pulled out around $907 million, according to data from Jefferies. Foreign investors pulled around 194 billion baht, or $6 billion, from Thai shares in 2013, reversing the inflows from the previous four years.

The stock market has generally shaken off much of the turmoil so far, with the SET index clocking an around 8.6 percent year-to-date rise. Still, Thai shares are down around 14 percent over the last 12 months and are trailing regional peers the Philippines and Indonesia, which have seen their markets tack on over 15 percent each so far in 2014.

Thai anti-government protesters face off with Airforce military
Pornchai Kittiwongsakul | AFP | Getty Images
Thai anti-government protesters face off with Airforce military

Market players are generally cautious about the military's decision early Tuesday morning, to declare martial law to restore "peace and stability," even though it's saying its actions didn't constitute a coup d'etat and the current government was functioning as normal.

Read MoreThailand's growth outlook goes under the knife

"It shows that the country has an inability to restore order," Ken Peng, an Asia strategist at Citi Private Bank, told CNBC. But he noted the reason investors have generally remained interested inthe market is companies' quality.

"The companies that are in Thailand tend to be more independently governed," he said. "Hence, the market is still attracted to it when there is a buying opportunity," Peng said, but he noted that the country's economic contraction in the first quarter is likely to deepen in the current quarter. He believes shares need to fall further before they become attractive.

Others expect the knee-jerk selloff may spur bargain hunting.

"The initial reaction will be to sell Thai-related assets, but it's difficult to gauge how much follow through selling there will be," Jonathan Cavenagh, senior foreign-exchange strategist at Westpac said in a note to clients. "Even if the bias is for equities to weaken, we could still see bargain hunters support the market," he added, citing the market's reaction after the military's coup in 2006.

Read MorePolitics won't derail Thai markets: stock exchange

"If we see the rating agencies start to talk about possible downgrades, then we could see greater capital outflow pressures," Cavenagh said.

But he noted, "In the longer term, if (martial law) brings us closer towards a political resolution, then this will be a positive development for Thailand and the baht."

Political deadlock has gripped Southeast Asia's second-largest economy after Indonesia since late last year. Earlier this month, Thailand's Constitutional Court ruled to remove Prime Minister Yingluck Shinawatra and a caretaker government has remained in power, albeit with limited authority.

Read MoreIs political violence in Thailand set to spiral?

The Election Commission has thrown cold water on hopes an election scheduled for July 20 will go ahead. The Senate is considering appointing an unelected interim government, a move likely to inflame tensions with the elected government's supporters.

Some expect the military may have declared martial law to allow the senate to install an unelected government.

"The fear they had around that was that it would inspire a backlash from the (pro-government) Red Shirts," said Amarjit Singh, a senior analyst at consultancy IHS. "By declaring martial law, it can prevent that violence from emerging."

Singh noted this month marks the four-year anniversary of the military's violent intervention in protests against the then-unelected government.

But with the military's declaration only a few hours old, "the waiting game is to see if the caretaker prime minister is allowed to carry on in office," Singh said.

—By CNBC.Com's Leslie Shaffer; Follow her on Twitter @LeslieShaffer1

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