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.