MAILBOX: BSP reacts to Sicat column

Dear Ms. Pamintuan:

This is in response to the article by Dr. Gerardo P. Sicat entitled “Peso exchange rate: something to correct” which appeared in the Aug. 22, 2012 issue of The Philippine STAR.

Dr. Sicat compared the nominal appreciation of five Asian countries – China, Indonesia, Philippines, South Korea, and Philippines – for the period Sept. 20, 2010-July 31, 2012. According to him, the period under study represented a phase when the world’s currencies experienced structural adjustments relative to each other. He finds that the Philippine peso has appreciated nominally the most against the US dollar compared to the currencies of Indonesia, South Korea, and Thailand. He adds that the Philippine peso tracked closely the movement of the Chinese yuan during the period in review.

In monitoring exchange rate movements, the Bangko Sentral ng Pilipinas looks at the real effective exchange rate (REER) of the peso versus a basket of currencies, which takes into account not only the nominal exchange rate movements but also the relative inflation rates among trading and competing countries. As such, the REER is a more comprehensive measure of external price competitiveness. The REER index of the peso increased by 8.2 percent from end-September 2010 to July 2012 using the basket of currencies of competitor countries in the broad series.Meanwhile, the peso appreciated by 11 percent on an inflation-adjusted basis against the basket of currencies in the narrow series.Indeed, the peso has gained strength over the years in nominal as well as in real effective terms, reflecting the country’s bright growth prospects as well as solid macroeconomic fundamentals. The weakening of the US dollar amid the fragile recovery of the US economy has also contributed to the appreciation of the peso.

Is there a fundamental reason for the peso’s appreciation in recent years? The peso appreciation has been driven – to a large extent – by structural flows. The country’s current account has continuously been in surplus since 2003, while the overall balance of payments (BOP) position has been in surplus over the past seven years now, supported by strong foreign exchange inflows from OFW remittances, business process outsourcing (BPO) revenues, and tourism receipts. Because these foreign exchange inflows are structurally-driven and are expected to be a permanent feature of the country’s external payment dynamics, some appreciation of the peso is therefore warranted.

As a matter of policy, the BSP does not target the exchange rate. While the BSP adheres to a market to temper sharp fluctuations in the exchange rate that can create large disruptions in economic activity. Without the BSP’s foreign exchange operations, it is likely that the peso would have strengthened even more. It would be instructive to know how one would engineer a peso depreciation in a period of favorable external payments position, and yet ensure external balance and internal balance in the economy.

To moderate exchange rate volatility amid the sustained and strong inflow of foreign capital to the Philippines, the BSP has employed a menu of instruments, thus allowing greater policy flexibility than would be possible if only a single instrument is used. In particular, the BSP has responded to surges in capital inflows through reserve accumulation and associated liquidity management operations to limit the increase in the money supply that could result in inflation pressures. At the same time, the BSP has pursued further liberalization of foreign exchange regulations to give corporations and individuals wider opportunities to diversify outward investments. Rising foreign exchange reserves have also provided an opportunity to prepay external obligations. Where warranted and to the extent that the inflation outlook allows, policy interest rates can be kept low, thus in the process reducing interest rate differentials, discouraging capital inflows and stemming further peso strengthening.

The National Government (NG) too has a role to play in moderating the appreciation of the peso. First, the NG will have to ensure the quick implementation of its public-private partnership program, and in the process, increase the demand for foreign exchange particularly for importation of capital goods. Furthermore, the NG could reduce its foreign-currency borrowing and shift its borrowing mix in favor of more domestic borrowing to take advantage of ample peso liquidity.

Lastly, it is instructive to note that an economy’s external competitiveness is not determined solely by the nominal rate, but also by trade policies, incentive structures, and overall macroeconomic environment which affect productivity and the cost of doing business.

                                                    (Sgd.) DIWA C. GUINIGUNDO

                                                                    Deputy Governor