Business World
Introspective
Seasoned central bankers tend to be alert to the giant sucking sound of capital inflows that make balancing the oftentimes conflicting goals of stable inflation and output growth much harder. This policy challenge stems from the impossible trinity where in a world of mobile capital, the central bank cannot expect to remain in charge of setting interest rates if it wants stable exchange rates, without imposing capital controls.
In most discussions of this policy trilemma analysts usually ignore the impact of sterilization efforts on central bank balance sheets, i.e., of having to carry low-yielding foreign exchange assets and paying high interest on local currency liabilities. This is because central banks are not supposed to worry about how their policies, aimed at keeping confidence in the domestic currency, affect their bottom lines in the short run. In practice though, the prospect of having to explain losses to a hostile congress weighs heavily on and may even skew central bankers' policy choices.
In the case of the Philippines, when the old Central Bank failed and Congress deliberated on the new monetary authority's powers, avoiding a repeat of the massive losses was of paramount concern to lawmakers. Hence, the newly set up Bangko Sentral ng Pilipinas (BSP) was barred from pursing developmental activities and constrained from financing government deficits. Regrettably, in its zeal to avoid any loss-making functions and failing to appreciate the context to which it was used, Congress also zoomed in on central bank bills. More popularly known as Jobo bills after then Central Bank governor Jose B. Fernandez, these were issued at interest rates exceeding 40% at the height of the mid-80s crisis to restore confidence as inflation spiraled (reaching 60% at one point) and the peso plunged. And so, arguing Let the Jobo bills and all these borrowings not happen again because they caused the downfall of the present Central Bank, Congress limited its use only in cases o f extraordinary movement in the price level.
Unfortunately, this legal handicap deprived the BSP of a vital tool for mopping up excess money from the system, a problem exacerbated by its limited holdings of Treasury securities that can be used for open market operations. Hence, when money started pouring in and monetary authorities found money supply growth too high for comfort, the BSP resorted to other measures including macroprudential regulation and accepting deposits not only from banks but starting mid-2007 their trust units as well. The opening up of the Special Deposit Account (SDA) to a wider investment base siphoned off hundreds of billions of pesos from the financial system (the BSP's SDA grew more than sevenfold in 2007 from approximately P50 billion at the end of 2006).
In succeeding years, as Filipino workers' earnings grew, business process outsourcing (BPO) revenues boomed and central banks in industrial countries loosened monetary conditions in response to the global financial crisis, more and more funds rushed into an economy ill-prepared to absorb them and amounts in the BSP's SDA climbed rather steeply, reaching almost P1.7 trillion by the end of 2011.
While the BSP has seemingly managed without the power to preemptively issue its own securities, its increasing reliance on SDAs, which are nontradable and fixed-term, to drain liquidity has in fact weakened the transmission of monetary policy through credit channels. This may be seen in the divergence between 90-day Treasury bill rates, to which bank lending rates are benchmarked and policy rates, with the former falling below the latter since late 2010.
Moreover, interest rates on SDAs are at a premium over comparable tradable bills indicating that these cost the BSP more to use and hurt its profit and loss account more. At the same time, by offering higher-than- market returns, SDAs also stifle capital market development as investors can opt to move as much money as they want at the set rate into these risk- free accounts.
To be sure, SDAs have one advantage over tradable securities in a highly speculative financial environment. Since they can be accessed only by banks, their trust entities and corporates they are effective in blocking certain hot money inflows and with current interest rates in the US near zero, are less vulnerable than tradable bills to the carry trade (i.e., borrowing low-interest currencies to invest in high-interest ones). Nevertheless, to the extent that a larger part of inflows into the Philippines are of the structural kind (anchored on remittances, BPO revenues and other service receipts), it makes eminent sense to amend the law and arm the BSP with the power to issue its own paper preemptively. After all, the more tools the BSP has at its disposal (even if it may never have to use some of these), the better prepared it is to manage the complexities of today's financial world and the better able it is to calibrate its interventions to achieve specific objectives.
At the end of the day, the public and its representatives in Congress should fret less about central bank short-term losses and concentrate instead on whether it is performing its basic mandate of ensuring stable prices while at the same time delivering on other growth requisites like keeping peso volatilities to a minimum, allowing continuous capital flows especially those motivated by good macro fundamentals and outlook, and retaining policy independence to help steady the economy and the financial system in the face of global shocks.
But if Congress must keep an eye on how the central bank's financial profitability affect public sector finances, it should focus instead on the BSP long-term financial sustainability, as this is what matters for central bank financial independence and to which central bankers should be held accountable. In this regard, the national government should immediately release the long-delayed P30-billion remaining capital of the BSP and not wait for the nth hour of a crisis to act, when the BSP's credibility is at stake and the amount becomes meaningless. A bolder move would require recognizing that to a degree BSP sterilization serves a political and social purpose, i.e., maintaining a competitive exchange rate, the cost of which should be borne by the national government and explicitly accounted for in its budget. This should bring monetary policy discussions properly back to the core issues of the impossible trinity.
Romeo Bernardo is a board member of The Institute for Development and Econometric Analysis and Philippine Partner of GlobalSource. He was undersecretary of Finance during the Aquino 1 and Ramos administrations.
