The art and science of monetary policy

Posted on January 04, 2015 08:59:00 PM

BUSINESS WORLD

AMANDO M. TETANGCO took over the helm of the Bangko Sentral ng Pilipinas (BSP) in 2005 and was soon thrust into a different world that someone without his 30-year central banking experience, including during the turbulent debt crisis years in the early 1980s and the Asian financial crisis in the late 1990s, would have been ill-prepared for.

This time, he had to deal with the aftershocks of the 2007 global financial crisis where emerging markets like the Philippines were left to fend for themselves as central banks in developed economies pursued unprecedented quantitative easing, and their attempts at forward guidance produced instantaneous market reactions that rippled through financial markets everywhere.

The BSP under Governor Tetangco’s watch oversaw a long period of monetary and financial stability that made recent fiscal consolidation efforts and investment grade ratings for the sovereign credit possible. To date, the country continues to enjoy a combination of steadily higher economic growth and low inflation, high foreign exchange reserves, a well-capitalized banking system, and praises for inroads made in microfinance and financial inclusion.

Governor Tetangco is the only BSP governor to serve two terms, having been reappointed in 2011 by President Benigno Aquino for a second six-year term -- quite a feat considering how the current administration has campaigned aggressively against the previous one. The re-appointment was read by analysts and markets not only as a tribute to his personal qualities but as the coming of age of the Central Bank as a mature independent professional institution.

As the Philippines enters the 2016 presidential elections, market watchers take comfort that Governor Tetangco’s term ends in 2017. These are excerpts from an interview by Christine Tang and GlobalSource, a New York-based network of independent economic and political analysts.

Q&A: Bangko Sentral Governor Amando M. Tetangco

Markets are again bracing themselves for increased volatility. What is your baseline scenario on external economies and markets?

The global economy will continue to grow in 2015, but uncertainties remain. The US economic recovery is seen to gain traction, while the recovery in advanced economies could likely continue to be hindered by financial imbalances, and growth in some emerging market economies (EMEs) may face structural bottlenecks. We expect a continuation of divergent monetary policies between the US on one side and EU and Japan on the other; and we see global investors continuing to take their cues for capital flows from this divergence.

Are you more concerned today about Asian risks -- a Japan recession and a China slowdown -- in terms of their impact on exports than, say, six months ago?

There are certainly developments in China and Japan that bear watching. In China, growth is seen to be slowing “faster than consensus.” Some analysts describe this as a “bumpy landing.” However, the recent surprise monetary policy actions as well as market expectation of “meaningful financial sector reform” from the administration should help to rein in market confidence. These measures are expected to buoy the Chinese economy. As for Japan, its economy has entered a technical recession. And it seems like structural reforms, including new tax measures, will continue to face challenges.

Slower Asian growth could adversely affect the Philippines. However, if the US economic growth does gain traction, this could be positive for the Philippines and serve to even out the trade prospects for us.

How worried are you about contagion risk, given markets’ knee-jerk selling of anything that carries an “emerging markets” tag?

The way we see it for the Philippines, markets will eventually get their bearings back, filter out the “noise” and realize that strong domestic demand will continue to hold up.

Our policy therefore remains geared toward a careful calibration of policy interest rates, the containment of excessive volatilities in the exchange rate, selectively employing macroprudential measures when appropriate. We are also careful to communicate our policy objectives so that we eliminate (to the extent possible) market surprises, so that business planning can be more strategic and long-term.

On the domestic side, what is your baseline view and what are the major downside risks?

Our baseline view is for the economy to grow in a “within-target” inflation environment. The major risks to this view include external factors that could lead to financial market volatility that could, in turn, result in repricing risks to household and corporate debt. Other major risks are fiscal underspending, power shortage, and natural disasters.

What is your outlook on domestic economic growth, inflation and interest rates, and the exchange rate under your baseline scenario?

We see the risks to future inflation as more broadly balanced. Upside risks to inflation include pending petitions for utility rate adjustments and possible power shortage, while downside risks include slower-than-expected global economic activity. Given a manageable inflation outlook, we have room to keep rates low to support economic growth. In addition, the ample liquidity and the national government’s good cash position should keep the yield curve steady.

On the exchange rate, we don’t target a specific level, but we will maintain a presence in the market so that volatilities are kept low. We also will keep a close eye on market conduct. We are watchful of the developing “strong US dollar” scenario.

Which one poses the bigger downside risk in your 2015 outlook: fiscal underspending or disinflation?

I would say fiscal underspending rather than disinflation. I say this because confidence and aggregate demand remain buoyant to ward off disinflation. Private consumption and construction continue to contribute positively to growth.

That said, the national government has not stepped back from its target on infrastructure spending; and we do badly need infrastructure. We’re going to see spending for the improvements in relation to Asia-Pacific Economic Cooperation meetings, plus reconstruction following natural calamities, in addition to the projects that are already in the pipeline.

There is this sentiment among some analysts that monetary policy seems easy and yet inflation is held down by soft commodity prices resulting in a situation of strong growth and negative real rates. Do you agree that current policy settings are loose?

I think policy settings are currently just right. Neither too loose nor too tight. As I said, the risks to the inflation outlook are broadly balanced.

What are the factors or events in the 2015 macro horizon that will likely lead to an interest rate hike? What is your assessment of the risk of actual inflation overshooting your lower inflation target next year?

On the upside, it would be higher prices of food commodities -- due to natural calamities here and abroad, and supply chain disruptions -- that could cause inflation to overshoot the upper end. Food accounts for more than 40% of the basket. But neither this nor sustained lower international prices of oil -- which would be a very strong factor for inflation to fall below the lower end of the target next year since fuel and related items account for about 9% of the basket -- are within BSP control. Hence, we are heightening our surveillance and analytics in order for us to be able to make appropriate adjustments in a timely manner.

What is your assessment of the continuing growth in domestic credits and rising asset prices?

Our assessment remains to be that there are no general or pervasive stretched asset valuations, especially in real estate.

What are your thoughts on the view that stricter financial sector regulations may drive activities outside where excesses may build up unmonitored?

We are rather mindful of the possible perverse result whereby specific macroprudential measures and banking regulations in general encourage yield-seeking in the shadow or unregulated markets. This phenomenon has at times been referred to as the “balloon effect,” -- you squeeze one part and the other parts bulge. So far, however, the macroprudential measures we have in place have been effective in signaling policy intent, and in eliciting the anticipated market behavior.

As they say, monetary policy is an art as much as a science. It requires a healthy balance of analytics and creativity and boldness. Without getting bogged down with analysis, you craft scenarios creatively, calculate the risks of these possible actions, and make the best decision given the information you have. And equally importantly, communicate your decision well.

What is your tolerance for further peso depreciation? Would another 5% depreciation from current levels over a one-year horizon be acceptable?

Under the inflation targeting (IT) framework, there is greater tolerance for exchange rate movements. The exchange rate passthrough has gone down after the adoption of IT compared to the pre-IT period. Even so, we remain mindful of exchange rate movements because these could have balance sheet effects that can have an impact on overall inflation expectations.

We don’t target a specific level, nor do we target a full-year depreciation or appreciation rate. Given what we know of the exchange rate, that it affects different sectors differently, we essentially leave the rate level or trend to the market. What we more closely watch is the speed of the changes, within the period. In other words, volatility, especially when these threaten a potential breach of the inflation target.

Which would you say is the lesser evil for the BSP at this time: excess capital inflows or capital outflows?

At this time? The “lesser evil” would be capital inflows. I think the door for excessive inflows is narrower than it is for outflows, given the uncertainty with Fed normalization. In other words, we are more likely to see capital outflows than inflows.

The BSP is, however, geared for both scenarios. Among other instruments available in our enhanced tool kit, we have macroprudential measures in place for inflows, and we have the flexibility to maintain a strategic presence in the foreign exchange markets to address outflows.

But as we know, monetary policy cannot carry the full burden of adjustment. More fundamentally, we need to amp the absorptive capacity of the economy so that capital inflows would be “captured” and converted into permanent capital for real assets, as opposed to financial assets, that have stronger economic multiplier effects.

This involves, among others, increasing investments in infrastructure and strengthening the country’s institutions. In this way, the risk of capital outflows is minimized. The goal really is to steer inflows toward what the IMF calls “economic risk taking” rather than “financial risk taking.”

Other than the 2016 elections that can change the political/economic agenda, what structural issues would deter investment-driven growth in 2016 and beyond? How would monetary policy respond to such structural issues?

Legal, contract issues. Bidding procedures. Speed of execution. Taxation. All issues that could lead to improvements in the climate/cost of doing business in the country. On the BSP side, we will, as we always do, respond with policies that will create stability, both price and financial, so that market participants can anchor plans on these.

Going to the banking sector, could you share with us the results of your latest stress test of domestic banks? What are the macroeconomic shocks that the system is most sensitive to?

Universal and commercial banks are in a position to withstand extreme but plausible shocks in both credit and market risk. Uncertainty in the speed and extent of normalization of monetary policy in advanced economies remain the key source of risk for the banking system.

The expected rise in global interest rates, coupled with continued credit expansion to the property and consumer sector, render the banking system vulnerable to borrower default. Mindful of this, the BSP has implemented regulatory reforms to strengthen capital buffers and risk management practices.

Other risks?

Risks arising from corporate and household leverage and conglomerated lending are also closely being monitored in collaboration with counterpart regulators from a financial stability perspective.

Regarding current moves toward ASEAN financial integration, what realistically can we expect to see in the next two years?

ASEAN financial integration, particularly the entry of foreign players into our domestic market, should increase competition, help us reap the benefits of transfer of technology in terms of improvements in processes and raising human capacity, as well as broaden markets.

I foresee that there will be good synergy between the existing local banks and the new entrants. Local banks will remain dominant, especially in the growing retail banking space, while foreign banks will find their strength in providing regional and global connectivity through correspondent banking services and access to the international capital markets. Foreign banks will also be able to facilitate the banking needs of the local branches of companies from their home countries. Our local banks should use this opportunity to raise the level of their game, if they are to compete successfully with the bigger banks in the region.

Halfway through your second term, do you have other to-dos are in your worklife bucket list?

Yes, certainly. First, to deepen financial inclusion further to create a more palpable inroad into making economic growth truly inclusive and broad-based. Second, true capital market reform. Even as we speak, the capital market blueprint is being rewritten by global market reform. Third, an even stronger BSP institution.

How do you want people to remember your governorship?

When I took this job on in 2005, I said there was no need to reinvent the wheel. I was going to continue with the reform agenda of my predecessors, which after all I helped craft as an insider, and bring those to fruition.

However, the world we operate in changed dramatically in 2007. The traditional paradigms were shattered, and policy became of the “nonconventional” type. I would like to think that under my stewardship, the BSP has proven itself alert, nimble, responsive, and able to provide the stability necessary to give direction that the market needs at any time.

Part of this column was culled from a recent GlobalSource report written by Christine Tang and Romeo Bernardo. Mr. Bernardo is Philippine GlobalSource advisor and is a board director of IDEA.

romeo.lopez.bernardo@gmail.com