Capital Inflows Into The Philippines: 1987 to 2007

Trends and Composition

Net capital flows to the Philippines have been fairly steady from 1989–1997, except for a blip in 1996 when net capital flows jumped to $14.7 billion (Table 2 [ PDF 43.7KB | 1 page ]). FDI was a constant contributor although the level was much lower compared with neighboring countries with a similar level of development, i.e. Malaysia, Thailand and Indonesia (Table 3 [ PDF 41.1KB | 1 page ]). Portfolio investment surged in 1995 and 1996 following the global trend during this period. Meanwhile, transactions classified as “other investments” were the largest source of flows during this period, and this category largely explains the jump in capital inflows in 1996. Data indicate that this was attributable mainly to the increase in net foreign assets of commercial banks.

Between 1998 and 2007, which is the period after the East Asian financial crisis, net capital flows to the Philippines fell sharply (Table 4 [ PDF 44.6KB | 1 page ]). The only exceptions were in 1999 when there was a fairly large amount of foreign investment in debt securities, and in 2005 when there was a surge in portfolio investment. In 1999, there was an increase in borrowers availing themselves of medium and long-term loans largely in response to the adverse effects of the crisis. The category “other investments” also increased sharply in 2005 although this was followed by a turnaround in 2006.

Despite the slowdown in capital inflows after the crisis, foreign exchange inflows remained strong. This was largely due to remittances of Filipinos working abroad, which are the main component of current transfers. Net current transfers in 2006 amounted to $13.2 billion which was 11.3% of GDP (Table 4 [ PDF 44.6KB | 1 page ]). Given the dominance of current transfers, the analysis in this study should not be limited to capital flows but extended to cover inflows of foreign exchange. Historical comparison should be approached with caution, however, since adjustments to Philippine BOP data have been applied only from 1999 to the present. While capital account data are still loosely comparable, the same is not true for data on current transfers.

As a percentage of GDP, there was a jump in current transfers in 2001. This level increased steadily until 2006. This implies that while remittances are relatively high, it would be difficult to attribute the sharp rise in the peso’s value in 2006–2007 to a “surge” in remittances. This issue will be discussed in more detail in Section IV.

Capital inflows to the Philippines are largely due to “push” factors. The ebb and flow generally follow global patterns, particularly in the case of portfolio flows. If “pull” factors were dominant, FDI would have been much higher. Table 1 [ PDF 40.5KB | 1 page ] indicates a sharp rise in FDI flows to developing countries from 2004 to 2006. However, the direct investments of non-residents in the Philippines amounted to $2,086 million in 2006, which ranks only sixth among ASEAN member countries in absolute terms and eighth as a ratio GDP, and is even lower than the peak of $2,287 million in 1998 (Table 3 [ PDF 41.1KB | 1 page ] and Table 4 [ PDF 44.6KB | 1 page ]).

Meanwhile, remittances respond to both pull and push factors. Studies have shown that remittances are largely pro-cyclical and driven by investment motives (Tuaño-Amador et al., 2007). Hence, a more conducive business environment will attract more remittances. The peso appreciation could also be considered a pull factor, wherein larger dollar remittances are required to sustain a specific standard of living. On the other hand, the main push factor would be more employment opportunities and higher remuneration abroad. In this context, it should be noted that there has been an increase in demand for overseas workers particularly for nurses and caregivers.

Impact on the Macroeconomy: Econometric Results

As discussed in Section II, large inflows of capital can lead to accumulation of reserves, real appreciation of the local currency, expansion in domestic liquidity, increase in the price level, and reduction in the domestic interest rate, which, in turn, affect consumption, investment and government spending. On the other hand, some of these variables constitute the host of “pull” factors that determine capital flows—such as improved macroeconomic performance and exchange rate regime—that attract investor confidence and encourage capital inflows. Hence, the apparent endogeneity of capital inflows and other macroeconomic variables, i.e. the tendency to appear in both the left and right side of the equation, warrants the use of a non-structural multi-equation approach to analyze the impact of inflows of capital on the macroeconomy. Possible methodologies toward this end include estimation through a vector autoregression (VAR) model in case of absence of cointegration relationship among the chosen variables or a vector error correction model (VECM) in case such relationship exists among the variables.

Before proceeding with the choice of estimation methodology, the time series properties of the variables were first checked since estimations of the nonstationary series are known to be spurious. Given the expected impact of capital inflows in the economy, as discussed above, we include, apart from the measure of capital inflows—using net capital and financial account of the Balance of Payments—reserves, 91-day Treasury (T-bill) rate, real effective exchange rate (REER), M3, consumption, investment and government expenditures in the set of variables. The results of the augmented Dickey- Fuller tests (ADF) indicate that all the variables are stationary in levels except for M3 and consumption which are integrated of order two.

The nonstationarity of M3 and consumption implies that it is legitimate to search for a cointegration relationship among the variables. In performing cointegration tests using the approach of Johansen (1991), we consider the foregoing set of macroeconomic variables. Results of the Johansen cointegration tests provide evidence that a unique cointegrating vector exists among the abovementioned set of variables. The existence of cointegration relationship among the four groupings of variables warrants the use of a VECM, in lieu of an unrestricted VAR.²

The impulse response functions (IRF) derived from the various versions of the VECM could provide indications of the impact of capital flows on the macroeconomic variables included in the groupings. However, IRF results using Cholesky decomposition could be sensitive to the ordering of the variables in VECM. Since our analysis focuses on the impact of capital flows on the macroeconomy, the measure of capital flows is placed first in the ordering. The surge of capital flows could lead to accumulation of reserves so the reserves are placed second in the ordering. Meanwhile, the central bank is expected to respond to capital inflow shocks using its policy instruments such as the policy rate which could, in turn, influence market rates (Berument and Dincer, 2004). Hence, the 91- day T-bill rate enters the VECM as the third variable. Moreover, exchange rates could respond to the increase in the market rates via the interest parity condition.

In addition, exchange rates could react to capital inflows because the latter could increase reserves, as argued above, and the money supply as well. Therefore, the real exchange rate and M3 follow the 91-day T-bill rate. Meanwhile, the resulting expansion in money supply could lead to an increase in the price level, hence, the consumer price index (CPI) is placed next. Finally, other variables in the real and fiscal sectors react to changes in the market rate and the real exchange rate so that consumption, investment and government expenditures are placed at the end of the ordering. Although frowned upon by practitioners, a dummy variable was added to temper the impact of the 1997 financial crisis.

IRF results from the VECM indicate that capital inflows, in aggregate, could lead to an increase in reserves, with the impact reaching its highest magnitude in the second quarter after the capital inflow shock (Figure 3 [ PDF 48.8KB | 1 page ]). However, the impact of a positive capital flow on the 91-day T-bill rate appears insignificant. Meanwhile, capital inflows tend to lead to a real appreciation of the peso against the basket of major trading partners’ (MTP) currencies. Nevertheless, the positive impact of the capital inflow shock seems to dissipate in the second quarter after the shock so that the real exchange rate reverts to its pre-shock value in the seventh quarter but appears to appreciate again thereafter. The broadly positive results from the impulse response functions relating to M3 and CPI indicate the capital inflows could lead to an expansion in domestic liquidity and an increase in inflation. Meanwhile, the impact of capital flows on consumption, investment and government expenditure appear insignificant.

The estimated VECM was likewise utilized to generate IRFs resulting from a positive shock to reserves. An interesting result is that the reserves shock leads to a real appreciation of the peso against the basket of MTP currencies, which appears to be counterintuitive given the precautionary nature of reserves in the Philippine economy (Figure 4 [ PDF 42.8KB | 1 page ]). Reference to this result will be made in Section VI.

Different versions of the VECM were likewise estimated with the aggregate capital flows variable replaced by its direct investments and portfolio investments components and by current transfers as well. IRFs derived from a positive shock in direct and portfolio investments are either insignificant or counterintuitive.³ This is due perhaps to the volatility of direct and portfolio investments over the 1989 Q1 to 2007 Q2 sample period with coefficient of variation of 177.9 and 307.0, respectively. Meanwhile, results from the VECM using the current transfers variable, which has a coefficient of variation of 94.3, indicate that a positive shock to current transfers leads to a rise in the level of reserves, the 91-day T-bill rate, CPI and government expenditure (Figure 5 [ PDF 49.9KB | 1 page ]). Generally insignificant results were derived from IRFs relating to the real exchange rate, M3, consumption and investment.⁴ Overall, capital flows and current transfers seem to have minimal impact on the real sector. This is likely because the monetary authority may have sterilized the impact or exchange rate movements may have diluted any potential real effects.

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