Policy quadrilemma

Business World
Introspective

IN A repeat move, the Monetary Board last week brought down the rate on its Special Deposit Accounts (SDA) while keeping key borrowing and lending rates steady. The latest 50bp reduction brings returns on SDAs to 2.0% which, added to the previous cut, will save the BSP over P20 billion in interest costs over a one-year period on about P1.9 trillion parked in SDAs.

While acknowledging the beneficial impact on BSP's bottom line, monetary authorities have also been quick to point out that the SDA rate cuts have not been done solely to slow the bleed in its income position. Rather, the official line is that the cuts are intended to push monies out for more productive uses and are part of plans to go into an interest rate corridor approach to conducting monetary policy.

But the large cash drain is hard to ignore. The official Web site shows that the BSP has accumulated losses reaching 1.7% of GDP in the three years to November 2012 and these have eaten into its capital which has fallen from over P200 billion in 2009 to only P58 billion as of the period. At the same time, similar to some other central banks, it is accounting for paper gains or losses by reporting these as either a net asset (e.g., if peso appreciation reduces the value of the international reserves) or a net liability (if a net gain), rather than charged directly to capital. November 2012 data show that these revaluation losses amounted to P55 billion, which if deducted from capital leaves a net worth of P3 billion. This has since been boosted by a P20-billion capital infusion by the national government towards the yearend.

Nevertheless, considering continuing quantitative easing by major central banks, analysts have started to ask whether the BSP can hold the line and if its mounting costs and expectations of negative capital would influence policy decisions. In the context of the impossible trinity (i.e., one cannot enjoy policy independence, exchange rate stability and capital mobility all at the same time), the question is which one will it have to let go?
It is easy for market players to forget that unlike commercial banks, central banks are not out to make profits albeit they are inherently profitable. As the issuer of the currency and depository of banks' reserve requirement (both these liabilities are equity-like), they fund asset purchases at virtually zero cost. Moreover in carrying out policy operations, they are in the position to borrow when interest rates are low (to mop up excess liquidity in a cash-rich situation) and lend when rates are high (to inject liquidity). Hence, the orthodox view in economics is that a central bank's financial position does not form part of the policy- making equation and that negative capital is meaningless since it can always just print money to erase the losses as long as it is willing to tolerate higher inflation.

While this may well be the textbook case, real world conditions make the central banker's task more complicated. In the recent case of the Philippines, the net losses stem from monetary authorities' efforts to achieve the twin policy goals of currency and price stability in an environment of easy money globally. With a robust current account position to start with, the large inflow of yield-seeking foreign funds and ensuing BSP action to minimize sharp peso appreciation and mop up excess liquidity have dramatically changed its balance sheet structure.

The BSP is not alone in this. One can find many examples of central banks around the world that periodically incur losses or even at some point operated with negative capital for long periods of time (e.g., Czech Republic, Chile) without raising concerns about their credibility and effectiveness to carry out policy. After all, central banks do have seigniorage revenues from currency issuances and cost-free RR deposits. In the case of the BSP, one estimate is that based on current inflation and economic growth outlook, it can fund additional, moderate increases in foreign reserves from seigniorage without prices spiking beyond its tolerance range.
And despite what looks like depleted capital on paper, the BSP in reality has a sound balance sheet that in times of stress in the external accounts when central bank strength and credibility is most needed will automatically improve with the peso's depreciation. At that point, it will also be able to sell its dollars at a profit and the decline in its reserve holdings will help reduce the negative carry. Cuts in the policy rates and signals of more cuts ahead suggest to us that indeed, its losses have entered the policy equation. But given the above, this is unlikely to have been driven by economic considerations but, due to its history, by political and reputational risks of being perceived as having weak finances.

What then moving ahead? How will the BSP resolve its policy trilemma or rather, quadrilemma?
The BSP will likely favor instruments and policies that limit its losses, including measures that reduce the running losses on its negative carry such as lowering the SDA rate which the Governor has hinted at or resorting to using the reserve requirement on bank deposits, which are non- interest bearing, to fund asset purchases (either raising the existing ratio or imposing RRs on trust products).

The risk with bringing the SDA rate even lower is the potential for asset bubbles in the already frothy stock and property markets. Considering that SDA volumes have continued to rise, it is not clear at this point if and by how much the interest rate cuts will whet investors' risk appetite especially since bond yields are already dropping in anticipation of more cuts. But a safe assumption is that a portion of any SDA withdrawals will be used to fund increased government domestic borrowings, or in the case of foreign funds that have circumvented the BSP ban, their exit will contribute to a weaker peso and thus will be good for the BSP's books. Still, if the lower rates induce banks to lend too aggressively, the BSP may then switch to raising reserve requirements apart from tightening prudential limits further.

On the other hand, if heavy capital inflows persist despite the rate cuts, BSP may tolerate a larger peso appreciation, i.e., reduce its dollar purchases from the market and its associated sterilization. Already, it has passed some of the burden of keeping the exchange rate competitive, a public policy objective, to the national government (NG) with the latter prepared to exclusively tap the local market for its (re)financing requirements this year. The NG can do more, e.g., by speeding up infrastructure investments (or approvals for private investments) which will help raise the demand for dollars or encourage the two government-run pension institutions, GSIS and SSS, to invest overseas, which is allowed under their charters. At the same time, in light of apparent closer coordination and the NG's improved fiscal position, the BSP and NG can also work out other arrangements, including seeking new legislation.

There are also talks of creating a sovereign wealth fund that will allow a portion of the BSP's international reserves to be invested in riskier assets that earn higher returns, which can help narrow if not close the negative carry. Increasing the BSP's capitalization by law is also being considered. Legislating a capital/net worth band-an automatic top-up if BSP capital falls below the lower end of band, and an automatic payout to the national government whenever it exceeds the top end - as now being discussed in our FINEX policy study group, may well be the definitive solution to this fourth corner of BSP's quadrilemma.

Part of this column came from GlobalSource Market Brief, with the same title, written by Christine Tang and the columnist. Romeo Bernardo is a board director of IDEA. He served as Undersecretary of Finance during the Aquino 1 and Ramos administrations.