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.