The impossible trinity

MAP INSIGHTS
Business World

Over the past several months, the market has been following closely the policy pronouncements of the Bangko Sentral ng Pilipinas (BSP), in search of clues to where monetary and exchange rate policy is heading. The BSP has been forthright in expressing its concern over recent surges in capital flows that led to the strengthening of the peso (over 12% appreciation from end-May 2006 to end-May 2007) and the high growth in money supply (26% M3 growth as of April 2007).

Complicating matters, however, is that on top of inflation and the country's export competitiveness, the BSP is also worried about the continued weakness in lending activity, despite massive liquidity in the banking system.

Given multiple policy objectives, the BSP has been putting forward more and more innovative policy tools. For instance, to encourage bank lending, it introduced a tiering scheme on its policy rates in November 2006 such that higher levels of deposits with the BSP earn less interest. On the other hand, rather than removing interest rate tiering in the face of continued high growth in domestic liquidity, it opted, in early May this year, to expand its open market operations to trust entities, allowing these to deposit funds with the BSP using the same interest tiering structure. Most recently, the papers reported that it is toying with the idea of introducing a gold-backed investment instrument, using some of the foreign exchange inflows to import gold.

The BSP's policy dilemma reminds me of an article by the economist Paul Krugman that I read a long time ago. As I recall, he explained the problem using a triangle where each vertex represents policy objectives that are desirable, i.e, monetary policy independence, currency stability, and capital mobility. Each side of the triangle, corresponding to a specific policy regime, is however consistent with only two of the objectives, such that a country's economic managers would have no choice but to give up on one of the objectives.

To illustrate, the side linking policy independence and currency stability (i.e., a fixed exchange rate regime) is not consistent with capital mobility. As the 1997 Asian crisis showed, by practically fixing the exchange rate while allowing free flow of capital, the Philippines and the other crisis-hit countries became vulnerable to severe speculative attacks as soon as markets suspected that the policy regime was not sustainable without an adjustment in the exchange rate.

The side linking currency stability and capital mobility may characterize a Hong Kong-like currency board regime, or a currency union similar to that in Europe, or a return to the gold standard. Countries adopting these policy regimes do not have the flexibility to use monetary policy for stimulating or reining in growth and thus are susceptible to volatile swings in their business cycles.

Finally, the side linking policy independence and capital mobility represents a floating exchange rate regime, which is what the BSP has gradually warmed up to after the Asian crisis. As its recent actions showed, it has been using monetary policy to influence lending activity and thus economic growth. It has repeatedly shunned capital controls similar to what Malaysia did during the Asian crisis and what Thailand recently tried to do, albeit less successfully. In return, it has opted to accept the reality of a more volatile currency.

I think our financial and monetary authorities are doing a deft act of juggling, using various tools, to try to meet these three objectives (four if one factors in its own balance sheet concerns, which textbooks tell us should not be a primary consideration for a central bank) in the face of new unexpected inflows, especially "hot money." They intervene surgically to even out sharp peso appreciations, retire foreign debt with domestic debt to create demand for dollars, and ease up on outward remittance restrictions.

The good thing is that a large part of today's capital flows come from OFW remittances. Unlike hot money, these are not volatile and indeed are likely to be sustainable, considering that (a) "event risk" is minimized given the diversity in terms of type of workers and geographical distribution; (b) higher wages abroad will continue to attract Filipinos to work overseas; and (c) the aging population of industrialized countries provides the potential for a relatively younger Philippine population to fill labor gaps. Thus, we see the BSP allowing peso appreciation to reflect this reality.

The article reflects the personal opinion of the author and does not reflect the official stand of the Management Association of the Philippines. The author is director of Lazaro Bernardo Tiu & Associates and Advisor of Global Source, an international network of independent analysts (www.globalsourcepartners.com).

The impossible trinity

MAP INSIGHTS

Business World

Over the past several months, the market has been following closely the policy pronouncements of the Bangko Sentral ng Pilipinas (BSP), in search of clues to where monetary and exchange rate policy is heading. The BSP has been forthright in expressing its concern over recent surges in capital flows that led to the strengthening of the peso (over 12% appreciation from end-May 2006 to end-May 2007) and the high growth in money supply (26% M3 growth as of April 2007).

Complicating matters, however, is that on top of inflation and the country's export competitiveness, the BSP is also worried about the continued weakness in lending activity, despite massive liquidity in the banking system.

Given multiple policy objectives, the BSP has been putting forward more and more innovative policy tools. For instance, to encourage bank lending, it introduced a tiering scheme on its policy rates in November 2006 such that higher levels of deposits with the BSP earn less interest. On the other hand, rather than removing interest rate tiering in the face of continued high growth in domestic liquidity, it opted, in early May this year, to expand its open market operations to trust entities, allowing these to deposit funds with the BSP using the same interest tiering structure. Most recently, the papers reported that it is toying with the idea of introducing a gold-backed investment instrument, using some of the foreign exchange inflows to import gold.

The BSP's policy dilemma reminds me of an article by the economist Paul Krugman that I read a long time ago. As I recall, he explained the problem using a triangle where each vertex represents policy objectives that are desirable, i.e, monetary policy independence, currency stability, and capital mobility. Each side of the triangle, corresponding to a specific policy regime, is however consistent with only two of the objectives, such that a country's economic managers would have no choice but to give up on one of the objectives.

To illustrate, the side linking policy independence and currency stability (i.e., a fixed exchange rate regime) is not consistent with capital mobility. As the 1997 Asian crisis showed, by practically fixing the exchange rate while allowing free flow of capital, the Philippines and the other crisis-hit countries became vulnerable to severe speculative attacks as soon as markets suspected that the policy regime was not sustainable without an adjustment in the exchange rate.

The side linking currency stability and capital mobility may characterize a Hong Kong-like currency board regime, or a currency union similar to that in Europe, or a return to the gold standard. Countries adopting these policy regimes do not have the flexibility to use monetary policy for stimulating or reining in growth and thus are susceptible to volatile swings in their business cycles.

Finally, the side linking policy independence and capital mobility represents a floating exchange rate regime, which is what the BSP has gradually warmed up to after the Asian crisis. As its recent actions showed, it has been using monetary policy to influence lending activity and thus economic growth. It has repeatedly shunned capital controls similar to what Malaysia did during the Asian crisis and what Thailand recently tried to do, albeit less successfully. In return, it has opted to accept the reality of a more volatile currency.

I think our financial and monetary authorities are doing a deft act of juggling, using various tools, to try to meet these three objectives (four if one factors in its own balance sheet concerns, which textbooks tell us should not be a primary consideration for a central bank) in the face of new unexpected inflows, especially "hot money." They intervene surgically to even out sharp peso appreciations, retire foreign debt with domestic debt to create demand for dollars, and ease up on outward remittance restrictions.

The good thing is that a large part of today's capital flows come from OFW remittances. Unlike hot money, these are not volatile and indeed are likely to be sustainable, considering that (a) "event risk" is minimized given the diversity in terms of type of workers and geographical distribution; (b) higher wages abroad will continue to attract Filipinos to work overseas; and (c) the aging population of industrialized countries provides the potential for a relatively younger Philippine population to fill labor gaps. Thus, we see the BSP allowing peso appreciation to reflect this reality.

The article reflects the personal opinion of the author and does not reflect the official stand of the Management Association of the Philippines. The author is director of Lazaro Bernardo Tiu & Associates and Advisor of Global Source, an international network of independent analysts (www.globalsourcepartners.com).