Evaluation of Policy Responses

Has Intervention Worked?

As described earlier, the BSP has engaged in both sterilized and unsterilized intervention. A simple correlation analysis indicates that intervention, as measured by the percentage of international reserves, has limited impact on the exchange rate’s level, percentage change, and volatility (Table 11 [ PDF 53.5KB | 1 page ]).¹⁰ The results indicate that intervention had a modicum of success in reducing exchange rate volatility in the Philippines between 1993 and 1996. Meanwhile, intervention prevented a rise in the exchange rate (measured in US$/peso) after the crisis, particularly during the period 2003–2007. In many instances the results are counter-intuitive, i.e. the correlation coefficient is positive, similar to the result of the impulse response function that was presented in Section III (Figure 4 [ PDF 42.8KB | 1 page ]).

The empirical results differ from those reported by the IMF (2007b) for the Philippines. However, the IMF study does find limited evidence of systematic links between sterilized intervention and exchange rates in the Philippines, Indonesia, India, Republic of Korea, and Thailand. The general result is somewhat unexpected given the low degree of substitutability of emerging market assets and the large size of interventions relative to currency market turnover in emerging markets. The IMF explains the results as follows:

“First, persistent structural factors may be driving the appreciation of the currency, obscuring any effect of intervention beyond a short period. Second, to the extent that sterilized intervention prevents the domestic interest rate from adjusting (especially downwards), it would have limited effects on capital flows driven by interest rate differentials, thereby failing to alleviate upward pressure on the currency.”

Some studies (e.g. Lamberte, 1995) support the relatively large offset coefficient of sterilized intervention in the Philippines. However, as noted earlier, the appreciation of the persistent Philippine peso should also be viewed in the general context of the weak US dollar.

On its part, the BSP argues that its intervention policy cannot be judged by the size alone. The size and nature of the shocks and the economy’s financial vulnerability should also be considered. Amid higher volatility of capital flows, BSP intervention needs to be commensurately large to maintain orderly market conditions. The Philippine foreign exchange market has expanded considerably in the past decade—by more than fivefold in terms of the daily turnover in the foreign exchange market—and the gross foreign exchange flows through the financial system have correspondingly also grown in magnitude.¹¹

Moreover, the BSP has been accumulating reserves as a form of self-insurance or precautionary reserves balance, as a first line of defense against future financial crises. This becomes more important in light of the debt burden of the Philippines which remains high relative to its comparators. Intervention should therefore be adjusted for passive intervention.¹² The BSP argues that the analysis should therefore distinguish between more permanent flows such as exports and remittances and those driven by cyclical trends (e.g., higher cross-border flows) as a result, for instance, of diversification by central banks and sovereign wealth funds (SWFs) in Asia and the Middle East, and structural portfolio adjustments in the private sector, as home bias declines worldwide. If cyclical factors are driving the trends in the inflows, intervention may be necessary to moderate the macroeconomic imbalances that could result from such large inflows.

While the Philippines’ international reserves have risen significantly in the past two years, the relative size of the stock of reserves remains considerably smaller compared to other countries in the region classified as independent floaters. This is the same observation made by Ho and McCauley (2007). The BSP cites the IMF (2007b) study which shows that for 2000–2007 the BSP’s intervention has been effective in tempering the volatility of exchange rate movements. This is precisely the principle behind the BSP’s intervention policy: reducing volatilities rather than swaying the exchange rate in one direction or changing the path of the exchange rate.

It should also be noted that money supply growth in the third quarter of 2007 fell to 12.4% without any significant rise in interest rates (Table 5 [ PDF 46KB | 1 page ]). However, intervention and the subsequent sterilization have financial costs and other central banks are facing similar circumstances. This is another reason that the BSP has built up its capital reserves. These accumulated surpluses now serve as a buffer for losses that the BSP is incurring in its stabilization efforts.

Has Inflation-Targeting been Undermined by Foreign Exchange Inflows?

In January 2002, the BSP formally shifted to an inflation targeting framework from a monetary aggregating targeting approach in formulating monetary policy. The shift in the BSP’s policy framework from a monetary aggregate targeting approach to inflation targeting was prompted by the observation that the historical relationship between inflation and money supply had weakened, thus undermining the effectiveness of the policy of targeting monetary aggregates. Innovations in financial products and financial markets, and greater financial liberalization have altered the link between money supply and inflation.

With more open capital accounts, many countries—including the Philippines—decided that a flexible exchange rate framework is better suited to cushioning domestic economic performance from external disturbances than fixed nominal exchange rates. In this context, the inflation target, rather than the fixed exchange rate, performs the role of a nominal anchor. The BSP is expected to intervene less in the foreign exchange market, allowing the exchange rate to absorb shocks induced by capital flows. The empirical results discussed indicate that the BSP may be having difficulty in implementing the inflation-targeting framework. Surges in foreign exchange inflows— both from the current and capital accounts—seem to have compelled the BSP to intervene in the exchange rate market and revert to targeting monetary aggregates. Whether this has reduced the effectiveness of inflation-targeting is an issue that has to be analyzed and discussed carefully.

A recent study by Ho and McCauley (2007) analyzes whether the policy of countering foreign exchange inflows with sterilized intervention will result in unintended adverse domestic consequences, particularly in three areas: monetary control, financial stability, and central bank profitability and balance sheet risk. In the case of monetary control, foreign reserve accumulation may lead to a “technical” sterilization problem wherein the central banks are not able to achieve their operating targets whether they be in terms of a quantity or price. Otherwise, foreign reserve accumulation may “compromise the goals” of central banks by inducing them to adopt a more accommodative monetary policy stance than that required by their inflation objective.

Ho and McCauley conclude that, with perhaps the very recent and short-lived exceptions of India and the Philippines, it is difficult to argue that Asian central banks have technical difficulties with sterilization as a result of large-scale foreign exchange purchases. Evidence from interest rate targeting central banks suggests technically effective sterilization. Meanwhile, during the period 2002–06, Asia did not provide evidence that large-scale reserve accumulation would be inflationary. The Philippines did over-shoot its inflation targets during this period but its intervention was not as heavy as the other countries. Moreover, the relatively high inflation was attributed to supply side factors.

The BSP argues that attention is given to monetary aggregates because they have important information content. Monetary and credit aggregates are some of the many variables that are examined in the conduct of monetary policy under an inflation targeting framework, which is information intensive in its consideration of the factors that should underpin policy action. There is a large, although not undisputed, body of evidence which suggests that persistently high growth of money and credit aggregates may provide useful “early warnings” of emerging financial imbalances and may serve as leading indicators of pressures on aggregate demand and on inflation expectations that matter for overall underlying price stability. The growth of monetary aggregates that are beyond the requirements of the economy will tell in the long run on the future evolution of prices.¹³

Meanwhile, an accurate representation of BSP’s treatment of the exchange rate in the IT framework is one where there is willingness to tolerate a significant degree of variability in the exchange rate and to be sufficiently disciplined to participate in the foreign exchange market only in well-defined circumstances. As noted earlier, the BSP intervenes in the market only to temper wide swings in the exchange rate that can lead to disorderly market conditions. However, it is important to underscore that in responding to capital flows, the BSP follows a package of policy measures. This policy mix includes, apart from exchange rate stability, the build-up of international reserves and the prepayment of external obligations. It was pointed out in Section V that the BSP has been encouraging the shift in the borrowing mix of the government in favor of domestic borrowing. Capital account liberalization, specifically through easing of regulations on non-trade transactions and outward capital investments, continues to be pursued, not for the sake of supporting the peso, but because of the economic gains it can bring by way of portfolio diversification and improved risk management.

Reserve Accumulation: Another Interpretation

The relatively benign effects of reserve accumulation—or central bank intervention in the foreign exchange market—have contributed to the favorable assessment of the BSP, particularly with regard to inflation-targeting. However, economic slack and consequently low domestic interest rates in Asia, including the Philippines, contributed largely to the non-manifestation of the usual effects of reserve accumulation (Ho and McCauley, 2007). In this context, Ho and McCauley suggest that reserve accumulation should not be viewed as an exogenous policy with consequences, but rather as a consequence of particular economic circumstances. In particular, the strong efforts to resist currency appreciation in Asia can be seen as a response to weak post-crisis recovery in investment (Table 12 [ PDF 53.5KB | 1 page ]).

A related view is that the accumulation of reserves is largely a consequence of the low investment rate which in turn is a direct result of the uncertainty spawned by the 1997 financial crisis. For example, Genberg et al. (2005) argue that:

“Although it may sound paradoxical, reforms that have contributed to liberalizing and opening domestic financial markets appear to have weakened investment demand throughout East Asia. Banks and other financial institutions have become much more reluctant to finance long-term and risky investment projects out of concern for the quality of their asset portfolios…Financial institutions, corporations, and governments themselves have all been preoccupied with strengthening their financial positions to insulate themselves against external financial shocks and speculative attacks.”

Asian Development Bank (2007) cites the favorable conditions for a recovery in investment in East Asia: strong profits, easy credit availability, rebound in prices of physical assets, reductions in debt, and elimination of excess capacity. The sluggish investment performance as shown in Table 12 [ PDF 53.5KB | 1 page ] is therefore rather surprising and ADB attributes this to increased uncertainty and risk. Consistent with the argument of Genberg et al., the accumulation of reserves is a response to the increase in risk and uncertainty, which ultimately has an adverse impact on fixed investment.

The sharp fall of the investment rate can partly explain the present Philippine macroeconomic situation wherein the rapid inflow of foreign exchange is accompanied by an accumulation of reserves, an appreciating currency in nominal and real terms, a current account surplus, rising money supply growth, stable interest rates and inflation, and an improving fiscal balance. The situation is markedly different from the one prior to the crisis when the inflow of foreign exchange was accompanied by less exchange market intervention, a large current account deficit, a fairly stable nominal exchange rate, relatively high inflation, interest rates and money supply growth, and a fiscal surplus. In this context, the following arguments can be made:

• The proposal of the IMF (2007a) to stem currency appreciation through fiscal restraint is not applicable to the Philippines for two reasons. First, the fiscal situation in the Philippines, while still vulnerable, has improved markedly in the past two years. And second, the recommendation of the IMF for fiscal restraint was in the context of correcting a current account deficit.
• The more relevant issue for the Philippines is stimulating private investment. This will lead to higher growth of imports and a deterioration of the current account balance which will then check the appreciation of the peso.
• The accumulation of reserves and subsequent sterilization has not undermined the policy of inflation targeting. However, as indicated earlier the rise in reserves is not necessarily an “intervention” on the part of the BSP and may not even be a result of precautionary motives on the part of economic agents. Rather, reserve accumulation is a direct result of weak investment growth, which is reflected in a current account surplus. A weak investment rate puts a cap on interest rates by lowering the demand for credit. The low interest rate cum low credit growth scenario then provides leeway for the BSP to successfully sterilize the rise in foreign exchange reserves. Nevertheless, the scenario may change dramatically once private investment recovers and central banks have to adjust their policy stance accordingly.

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