Another day of reckoning for BSP

Business World, November 13, 2007

Nobel prize winner Robert Mundell will be flying into Manila this week courtesy of the Bridges Program of the International Peace Foundation to give a talk on "economic development by fitting globalization into the national development strategy." While the -topic is certainly stimulating, I would guess many will be going there, myself included, to hear what he had to say about the country's current policy dilemma, which is all about dealing with sharp peso appreciation due to exceptionally strong dollar inflows.'

If one were to think of economists whose ideas have been most relevant for emerging market economies such as the Philippines, Dr. Mundell would certainly be very high up that list.

Repeatedly, local central bankers are learning that, no matter the effort, one cannot completely defy the results of the Mundell- Fleming model (also independently studied by Marcus Fleming). The impossible trinity, an important offshoot of that analysis, states that for as long as financial capital can freely flow in and out of a country, one cannot hope to simultaneously control that country's exchange rate and money supply.

With strong inflows into the economy, particularly in the form of overseas Filipino workers' (OFWs) remittances and foreign investments, the Bangko Sentral ng Pilipinas (BSP) has been grappling with the problem of how to keep the peso from excessively strengthening.

There is understandably strong pressure to curb peso appreciation, given the impact on dollar earners such as OFWs and small- and medium-sized exporters. Even giant telecoms companies like Globe and PLDT have begun to feel the effect of a cheap dollar, noting how rapid appreciation has substantially trimmed their profits (from international operations).

Dollar-buying by the BSP to build foreign exchange reserves increases the demand for dollars in the spot market and helps to weaken the peso. However, the increase in net foreign assets leads to an increase in money supply, which is a no-no for an inflation targeter hoping to keep a lid on prices. Mopping up excess liquidity in the financial system, however, eventually requires tighter monetary policy and higher interest rates, which in turn leads to further peso appreciation, as the "impossible trinity" would dictate.

In, order to tame upside pressures on the peso, the central bank has also been using its surplus dollars to prepay foreign debt and has changed its financing mix toward domestic financing, urging the national government to do the same. While turning to the domestic market for funding means lesser inflow of dollars, it also implies competition for local funds and an increase in local borrowing rates. Again the uptick in interest rates would mean more attractive domestic assets and a possibly stronger peso

Monetary authorities have tried to bypass the policy dilemma through foreign currency swaps, wherein dollars are siphoned from the spot market and immediately swapped with pesos in order to prevent an increase in domestic liquidity.
The arrangements with counter party banks are flexible enough and can be renegotiated as needed, but still such measures have not been without cost. Recently, such transactions have turned up forex fluctuation losses (amounting to P5O billion) in the central bank's net income statements, putting the institution in the red.

Thursday will be another day of reckoning for BSP, and monetary authorities will again have to heed what Mundell said a long time ago - that is, trying to keep the value of the domestic currency stable against an anchor currency means following that foreign government's policy rates anywhere it goes.

With the Fed having cut its rates last week, the BSP wil1 have little choice but to cut its own rates during the scheduled rate-setting meeting, if it hopes to rein in further peso appreciation.

With workers' remittances remaining strong, it has been said that cutting rates may not stop dollar inflows since OFW s are largely insensitive to interest differentials (i.e., used for house hold and schooling expenses). However, for foreign investors, a higher effective return will surely make peso assets even more attractive, especially for those who were already interested in investing in the country in the first place.

Fortunately, the conditions for the BSP cutting rates are benign enough. From a strict inflation targeting perspective, current inflation, at 2.7%, remains way below the 4%-5% inflation target range (thanks largely to peso appreciation).

Domestic liquidity growth has slowed and while oil prices are rapidly rising, inflation expectations remain low, with the average forecast of private economist ranging from 2%-3% this year and 3%-4% the next.

John Maynard Keynes once said that we are, without knowing it, slaves to some dead economist. Mundell is alive and well and so are his ideas, and as we are painfully learning, neither can we escape the implications of his theories.