Not quite capital control

Business World
Introspective

WITH quantitative easing and historically low interest rates in industrialized economies, and the euro zone still in a debt crisis, not a few have sounded warnings about the dangers of unstable capital flows especially to emerging markets. Monetary authorities in such economies, where interest and potential growth rates were higher, knew they would have to deal with the issue of exchange rate and asset volatility at some point.

But no matter how good one gets at anticipating the arrival of profit- seeking capital, how to actually cope with influx of hot money, which could lead to exchange rate pressure and asset bubbles, remains a tricky problem as ever. A well-known result in macroeconomics, after all, is that you can't have independent monetary policy (i.e. control over domestic interest rates), exchange rate stability, and be open to foreign capital all at once (the impossible trinity). Only two of these objectives, at most, could be reasonably met.
For the Philippines, the change in the international monetary environment, with global liquidity at an all-time high though subject to great uncertainty, seems to be changing the way the central bank is choosing to deal with dollar surges.

In the past, the Bangko Sentral ng Pilipinas (BSP) would address the problem of a rapidly appreciating domestic currency, which hurts exporters and Filipino families dependent on money sent home by overseas workers, through mostly uncontroversial measures.

Based on the belief that peso strength had fundamental basis because of high remittances and business process outsourcing receipts, these included steady accumulation of reserves, retirement of external debt, liberalization of the foreign exchange system, and strong encouragement given to the finance department to prepay the national government's dollar debt and alter the country's financing mix.
Lately, however, the BSP appears to be showing greater willingness to exercise control over the flow of capital into the country, particularly those deemed to be speculative in nature. Last October, it raised the market risk capital charge on banks' net open positions on NDFs (non- deliverable forwards), which are suspected to be a major vehicle used by offshore players to make one-way bets on the peso.

A couple of weeks ago, monetary authorities announced plans to prohibit non-residents from investing in SDAs (special deposit accounts), known to have relatively high yields and hence a natural target for carry traders especially factoring in currency appreciation. SDAs were introduced in 1998, put into greater use as a monetary tool in 2006, and opened to trust entities of banks in mid-2007, after which they have become the BSP's most potent liquidity-mopping instrument.

Not surprisingly, opinions have been mixed on the BSP's latest decision to rid SDAs of foreign-sourced funds. Some believe this may not be enough to quell speculative capital especially over an extended timeframe as ways to go around the rules are discovered, bringing little relief to dollar earners. Others find it a bit much, fearing harsher controls on capital in the future.

On the whole, the latest policy move seems reasonable, in our view. SDAs were explicitly designed to siphon excess domestic liquidity, and allowing these instruments to be the object of arbitrage play by foreign funds - their yields are not only higher than key foreign interest rates but also better than returns to Philippine government securities - defeats the stated purpose and needlessly raises the BSP's sterilization costs.
Closing offshore investors' access to SDAs corrects an evidently perverse scenario and need not be construed as capital control in the much- feared sense. It does not, for example, block the flow of productive capital and, by successfully preventing exchange rate volatility, can be easily justified.

The BSP as an institution, from our reading, remains averse to severe controls which by experience had been prone to abuse and extremely difficult to administer. Monetary policymakers continue to be wary of such measures believed to weaken long-term access to international capital markets and hinder the country's ability to attract foreign direct investments.

But can the new policy actually help prevent sharp peso appreciation?

In terms of size, SDAs seem to be a good choice of asset to purge of speculative money. One estimate places the amount of foreign funds in these accounts at about P200 billion, or close to $5 billion.

Under the new rules, these placements can no longer be renewed and will be terminated upon maturity (SDA tenors range from one week to a month), which should make at least a moderate impact on the exchange rate. We expect a sizable portion of the funds to exit the country in the interim as other peso assets do not seem to be quite as attractive in view of low yields of government securities and shrinking opportunities in Philippine equities, now with among the highest price-to-earnings ratios in the world.

On the risk of circumvention, we believe this to be fairly contained since it is perilous for banks to try to knowingly deceive the BSP with regard to compliance. The BSP is both the contracting party of the banks in the SDA placement transaction and their regulator. Based on the newly released memo on SDAs, key officials of banks and trust entities (their presidents and treasurers) will be asked to sign and submit a notarized Letter of Undertaking stating under oath their commitment not to invest funds that are directly or indirectly obtained from non-residents.

Of course, actual success of the policy remains to be seen and will depend on how far the BSP is willing to go to enforce it. At any rate, a strong signal has been sent that monetary authorities will not allow the domestic currency to strengthen by very much.

Until recently, currency traders had been vigorously betting on a stronger peso (e.g. a top pick of Morgan Stanley) in view of expected above-trend growth and current and financial account surpluses. The peso has correspondingly appreciated the most among Asian currencies this year, causing the real effective exchange rate to inch up especially against competing economies.

With tepid US growth and Europe still in a crisis, global liquidity seeking better returns could remain high. This means pressure on emerging market currencies to appreciate may continue.

Our guess is that monetary authorities have drawn a line in the sand for the peso-dollar rate somewhere near P41/$1, which seems to be a sensible number. Economists studying this area believe P40/$1 (and below) to be already quite harmful not only to OFW workers and exporters, but to the continued growth of the economy.

Romeo Bernardo is a board director of the Institute for Development and Econometric Analysis. This column is based on a July 24 report written by Margarita D. Gonzales for GlobalSource, a New York-based network of independent analysts.