So that we may know ..


No Free Lunch : Dealing with the rising peso
By Cielito Habito
Philippine Daily Inquirer
Posted date: January 14, 2008

A READER recently wrote: “I can’t believe that there’s nothing that can be done to stop the peso from appreciating so much. I’m sure if we were another country, like Malaysia, Japan or China, we would have found a way to stabilize it somehow, taking into account the weakened dollar, etc. that is being used as an excuse. Clearly, it’s good only for a very small sector. Surely, something can be done. Kaya lang it would mean stepping on important toes? Defying IMF-World Bank? But an appreciating peso is destabilizing.”

I am sure this is a fairly common sentiment nowadays, so I thought I’d use the next two columns to address her questions and answer them from the standpoint of economic theory and policy.

Important toes?

The “important toes” that our reader alludes to would have to come from the side of those who gain from the peso appreciation. These include consumers in general (due to cheaper imported or import-based products, which is actually the bulk of what we consume), importers, Filipinos who travel or invest abroad, and those paying for foreign loans, including the government itself. Against their interests must be weighed those of the losers, including domestic producers of tradable goods (not only exports but import-competing products as well) and the workers they employ, tourism establishments, foreign investors and the workers they may potentially employ, creditors who had lent money in a foreign currency, and OFWs and their families.

Are there small, influential segments from the first group who may be unduly influencing government policy on the exchange rate at this time? I personally don’t think so. Sure, the government itself is a huge gainer due to the large savings in foreign loan payments, estimated to be around P12 billion in 2007. But that is a gain not of specific people in government, but of taxpayers in general.

What about the IMF-World Bank? With my own knowledge of these institutions and their involvement with our economy, I see no basis for them to put any significant pressure on government exchange rate policy at this time, one way or the other.

Fixed exchange rate?

Our reader is right: There are things that we (that is, our government) can do to stop the peso from appreciating too much. At the extreme, there is always that option of fixing the exchange rate outright, which I will dwell on here. But this is a move that hardly any country would seriously consider, especially at this time when global financial markets are changing rapidly.

Why not? It may sound temptingly stabilizing to have an exchange rate fixed at a certain level and holding it there regardless of market supply and demand. But what is not obvious to most is that under current circumstances of a continuously weakening dollar, this would actually be fundamentally destabilizing and potentially disruptive of business and people’s economic activities in general. Why?

To fix the rate would mean forcing a defined price for the dollar regardless of the market equilibrium price determined by supply and demand forces. But because world market conditions have lately been characterized by weakening demand for the dollar for a host of reasons, fixing the exchange rate would lead to growing excess supplies. And unless the government can artificially increase demand or curb supply, the official rate would be openly violated in actual market transactions–i.e., a “black market” rate that would be lower than the official one. Indeed, we see this even now, a complete turnaround from the old situation we had been more familiar with, when black market rates were higher.

Defending the rate

Defending a fixed exchange rate (that is, making it stick) under current circumstances requires measures that would raise demand for or reduce supply of foreign exchange. The Bangko Sentral (BSP, the Philippine central bank) itself would inevitably have to provide most of the needed extra demand, by buying up increasingly large amounts of dollars. While this may look good because it would build up the country’s foreign reserves, it can have at least two harmful effects. One, it pours pesos into the system, thereby stimulating inflation (i.e., accelerating price increases). Wonder why inflation has ticked up lately? Well, oil prices are not the only reason, that’s for sure. Two, it would lead to large financial losses on the part of the BSP, losses that must ultimately be shouldered by someone (there’s no free lunch!).

The latter has in fact already been happening, even without fixing the exchange rate. In the course of trying to arrest a too-rapid peso appreciation, the BSP has quietly built up foreign reserves over the past year from about $23 billion in January to more than $33 billion by year’s end. This means that it has been accumulating massive amounts of an asset that is rapidly losing value, leading to losses estimated at over P40 billion so far. Remember the old Central Bank and how it ran up massive losses in the late ’80s and early ’90s from exchange rate operations (of the reverse kind)? After it was reorganized by law into the present BSP, we taxpayers ended up quietly paying for all that, in case you didn’t know.

Next week we’ll have a look at other measures we could take without fixing the exchange rate outright.

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