Coping with surges: Unlikely controls

Business World
Introspective

In the current scenario, with low forecast inflation, we are more convinced that monetary authorities will refrain from hiking policy rates until the end of the year because this could encourage further speculative flows. We believe, however, that it is highly unlikely that they will turn to capital controls despite Asian neighbors doing so except as a last resort.

There are several reasons behind the latter view. One is the BSP's consistent behavior in recent history as it allowed the exchange rate to appreciate sharply in the face of strong dollar flows. The last such episode had only been a couple of years ago when the peso was allowed to rise in value dramatically from near P50/$ in 2007 to about P40/$ by early 2008 citing a mandate to limit exchange rate volatility but not dictate trend.

Another is the belief of monetary authorities as reflected in a recently updated primer that such measures are costly to implement and likely ineffective in the long run as ways to circumvent them can be found. Past experience of the country with controls had not been pleasant (i.e., on FX, for most periods between the 1950s until 1992), as these had been difficult to administer and prone to abuse.

An aversion to capital controls remains, with the central bank fearing that re-imposition of barriers would discourage investors, weaken access to international capital markets, and hinder the ability to attract foreign investments. Not too long ago, in December 2006, fellow inflation targeter Thailand effectively taxed foreign portfolio investors by requiring unremunerated reserves, a policy move that led to a surge in stock volatility and a 15% fall in Thai equities in a single day. (N.B. This was reimposed a couple of days ago.)

Monetary policy makers typically argue that remittances and export receipts dominate foreign exchange inflows such that peso movements had fundamental basis, voiding the issue of currency overvaluation. While it is known that even fundamentally sound flows can precipitate asset booms and busts in certain sectors, they aver that peaks seen today in the local equities market hardly constitute a bubble. In the real estate sector, there is also no rapid escalation of prices so far with demand coming mostly from end-users, mainly overseas workers' families; with transactions involving contracts to sell rather than contracts of sale, meaning the property remains in the name of the seller until fully paid; and with the institutional financing setup discouraging excessive risk taking.

Other solutions to prevent the collateral impact of large capital flows are being offered by the BSP such as the use of macro-prudential regulations to prevent bubbles and administrative measures to encourage FX outflows. In addition, Mr. Guinigundo said the BSP can carefully calibrate monetary policy, balancing the need to tighten liquidity and reduce risk appetite to short an otherwise full bubble situation against the possibility of higher interest rates further attracting hot money.

To appease dollar earners who were hurting from a strong peso in 2007, steps then taken by the central bank included retiring external debt, encouraging national government to alter its financing mix or prepay debt, and liberalizing the foreign exchange system (e.g., allowing banks to take a larger overbought position) apart from some accumulation of reserves, including FX swaps. Such measures will likely be again pushed if peso strength persists.

This column was taken from the Oct. 1 report of the author and Margarita D. Gonzales. Both are advisors of GlobalSource, a New York-based network of independent analysts. Mr. Bernardo is also a board director of IDEA, the Institute for Development and Econometric Analysis.

Coping with surges

Business World
Introspective

While hot money has been flowing heavily into emerging market economies this year, it was only in the last couple of weeks that the Philippines started to feel a surge in capital. Now at the front end of the receiving line, the relatively small Philippine Stock Exchange has become the second-best performer in Asia, with the main index (the PSEi) already surpassing its peak in 2007 and, much earlier than foreseen, broken the critical 4000 mark by mid-September.

Strong demand has been fueled in large measure by foreign buying as abundant global liquidity due to quantitative easing in advanced economies naturally sought higher returns in emerging markets. The optimism has also been partly due to a surprisingly buoyant domestic economy and, to some extent, a new leadership after a period of uncertainty lowering political risk.

Apart from equities, foreign money has also flowed into government paper lured by interest differentials, where registered portfolio investment in peso securities grew by 38% in the first half to nearly $1 billion. The country's first global peso issue early in September likewise served as a magnet for funds, bringing in another $1 billion equivalent. Just a few days ago, the government swapped existing Philippine global bonds (ROPs) with securities of later maturity that were either reopened or newly minted, with the new issuances also sold for cash (about $200 million).

The result of these forces has been an even stronger peso, with the exchange rate now falling below P44/$. Unless another major downturn occurs in the world economy or the domestic fiscal situation gets out of hand, peso appreciation can be expected to continue and, in our view, drop to about P43/$ by yearend.

Assets denominated in local currency may remain attractive owing to continued strength of overseas Filipinos' remittances and a still rapidly rising export haul of BPO firms providing support to the peso. Despite a steep trajectory in stock prices, there remains room for improvement as the local bourse's price-earnings ratio still lies at the middle of the range historically and compared with other bourses in the region while forecasts of corporate profitability remain high.

To fund the national deficit, the government is expected to issue more global peso bonds which have proven to be attractive to foreign investors compared with domestic peso issuances because of ease of trading, absence of withholding taxes and offshore dollar settlement. Meanwhile, global capital moving away from advanced markets may go on combing through emerging markets for higher profit potentials.

'Complications'

As global capital has funneled into emerging markets, capital controls have suddenly become respectable, especially with the IMF lately acknowledging that such measures can be a legitimate part of the tool kit to manage capital inflows under certain circumstances. Asian economies that have experimented with controls include South Korea, which placed limits on the buildup of FX derivatives last June to reduce the risk of capital reversals, and Indonesia, which adopted measures at about the same time to discourage short-term fixed-income investment.

With risk appetites seemingly back after waning temporarily due to the euro zone sovereign debt crisis, some of the hot money flows has now also headed the way of the Philippines. After the US Fed announced last week that it was keeping the Fed's fund rate close to zero, Bangko Sentral ng Pilipinas (BSP) Governor Amando Tetangco said monetary authorities were aware that interest differentials remained in favor of emerging market economies and acknowledged that this could complicate monetary policy.

While the Philippines had already shifted to inflation targeting given the futility of trying to manage the exchange rate while simultaneously controlling domestic liquidity, difficulties remain in dealing with large capital flows, particularly given the negative impact of a strong peso on exporters and overseas workers' families. The BSP still has to walk a fine line between smoothing fluctuations in the exchange rate and keeping inflation within target.

In an e-mail exchange, Deputy Governor Diwa Guinigundo shared with us that while a sustained capital surge could lead to excessive liquidity creating inflationary pressure and asset price bubbles, the BSP was not overly concerned because the magnitude remains manageable. He believes inflows have even helped the central bank manage inflation by supporting peso appreciation, while low inflation helped partially restore competitiveness.