BSP may tighten policy stance further

MANILA, Philippines - The Bangko Sentral ng Pilipinas (BSP) is closely monitoring the level of liquidity in the financial system after it opted to raise the reserve requirement for banks last month as market interest rates have been slow in responding to the 50 basis point rate hike imposed by the central bank last March and May.

BSP Deputy Governor Diwa Guinigundo told participants of a forum titled “Awash in Cash: Making Liquidity Work for the Economy” sponsored by the Economic Journalists Association of the Philippines (EJAP) yesterday that the Monetary Board is mindful that the strong liquidity in the financial system amid continued strong capital inflows could be blunting the impact of adjustments in the monetary policy stance on market interest rates.

“There appeared to be weak pass-through from the policy rates to market interest rates owing to the presence of ample liquidity in the system. It appears that market interest rates have been slow in responding to the previous policy rate adjustments, as the financial system remains quite liquid, and strong capital inflows have compressed yields,” Guinigundo stressed.

He pointed out that bank lending rates have increased but the pass-through is still at 46 percent.

He added that strong capital inflows could strain economy’s absorptive capacity, lead to build-up of macrofinancial risks, and pose important challenges such as managing liquidity and price pressures as well as ensuring financial stability.

Gunigundo said inflation expectations appear to be well-contained but liquidity and bank lending could continue to expand strongly.

“It is unclear under these circumstances whether further policy interest rate action alone may not be enough to temper liquidity expansion given the likelihood of stronger foreign exchange inflows due to positive market sentiment on the prospects for the Philippine economy,” Guinigundo added.

Latest data showed that domestic liquidity or M3 grew eight percent to P4.261 trillion as of end-May from P3.945 trillion in the same period last year. Liquidity growth is one of the important vehicles considered in determining the central bank’s monetary policy. At a time when the economy is booming and money supply is expanding rapidly, the central bank would normally step in to mop-up in order to ensure that inflation would not surge.

On the other hand, bank lending posted its fastest growth in 25 months after expanding 18.8 percent to P2.544 trillion as of end-May from P2.141 trillion due to the steady pace of domestic economic activity and stable financial conditions.

As a preemptive move to keep inflation expectations well anchored, the BSP raised interest rates by 25 basis points last March 24 and by another 25 basis points last May 5 due to the continued build up in inflation pressures brought about by escalating prices of oil and food in the world market. This brought the overnight borrowing rate is currently pegged at 4.50 percent while the overnight lending rate is at 6.50 percent.

Instead of raising rates last June 16, the BSP decided to raise the reserve requirement ratio for banks by 100 percentage points to 20 percent from 19 percent effective last June 24 to siphon off P38 billion from the financial system as part of efforts of the BSP’s Monetary Board to curb additional inflationary pressures arising from excess domestic liquidity.

“The Monetary Board’s decision to raise the reserve requirement is a preemptive move to counter any additional inflationary pressures from excess liquidity. An increase in the reserve requirement ratio also allows monetary tightening without encouraging short-term capital inflows,” he explained.

He argued that raising rates to counted inflation risks with the prevailing ample global liquidity could attract even more capital inflows introducing a policy dilemma for monetary authorities.

“A hike in the reserve requirement translates into a lower money multiplier as banks are required to place a larger amount of the deposits that they hold as reserves. This implies tighter credit supply which could lead to slower liquidity growth and higher market interest rates. This leads to a stronger domestic currency, which translates into lower inflation,” he said.