Impact Of Capital Inflows In The Philippines

The drawbacks of capital inflows—which can be extended to foreign exchange inflows in general—were discussed in Section II. These include (i) imbalances that threaten macroeconomic stability become likely if the absorptive capacity of the economy falls below the level of the foreign exchange inflows; (ii) a rapid appreciation of the nominal and real exchange rates if the economy has a flexible exchange regime; a substitution of domestic savings by foreign savings, which would only facilitate a consumption boom; (iii) microeconomic distortions such as asymmetric information that normally result in an inappropriate assessment of risk exposure and cause over-borrowing; and (iv) distortions from the real sector where aspects such as imperfect competition, externalities or wage rigidity, may result in inappropriate private sector adjustment such as wrong choice of technology even if the financial sector is functioning well. Meanwhile, in the event of a sudden capital outflow, these distortions would induce exchange rate overshooting, making the economic adjustment more difficult.

This section looks at the experience of the Philippines from 1987–2007 and determines whether the possible adverse outcomes of surges of foreign exchange inflows were realized. The analysis refers to the econometric results in the previous section when relevant. Basic macroeconomic indicators of the Philippines are shown in Table 5 [ PDF 46KB | 1 page ]. This investigation will help in the analysis of the impact of foreign exchange inflows on the economy and also in the evaluation of selected policy responses.

Real Sector

Knowledge of the range of impacts of current transfers and capital flows on the real sector will aid policymakers in crafting measures that will optimize their use. The results of the VAR analysis indicate that foreign exchange flows have limited impact on the real sector. The negligible impact on investment is not unexpected. The level of FDI investment in the Philippines has been historically low, reaching a maximum of 3.4% in 1998, which can even be considered an abnormal year. Moreover, the literature review pointed out that the beneficial impact of FDI is dependent on a significant improvement in the economy’s technology (Reisen, 1998) and some microeconomic studies generally suggest that FDI does not boost economic growth primarily because of the absence of evidence of positive spillovers running from foreign-owned to domestic-owned firms (Levine and Carkovic, 1999). A later study indicated that in several Southeast Asian economies including the Philippines, FDI had only direct effects while spillover effects in terms of technology transfer were minimal (Mirza and Giroud, 2004).

However, the negligible impact of current transfers on investment and consumption is not consistent with earlier studies. Using a seemingly unrelated regression technique, Lamberte (1995) finds remittances to be a significant determinant of personal consumption but not of investment. A modified form of his regressions was estimated using data from 1999–2006 (Table 6 [ PDF 46KB | 1 page ]). The results show that remittances significantly affect both investment and personal consumption, but both FDI and portfolio investment are insignificant. The reason for the difference with Lamberte’s study in terms of the impact on investment may be the size of the remittances and the behavior of households. The latter may have become sophisticated over time in managing remittances, thereby using them more productively.

A study based on the 2003 Family Income and Expenditure Survey (FIES) finds evidence that households receiving remittances tend to spend more conspicuously in terms of consumer items but also invest more on education, housing, medical care and durable goods (Tabuga, 2007). The study shows no clear relationship between remittances and tobacco and alcohol. Unfortunately, FIES data do not include capital outlays, hence the impact on investment was not considered.

Meanwhile, a study by Yang (2005) also used FIES data but focuses on the impact of exchange rate shocks on migrant income on a range of investment outcomes in Philippine households such as child schooling, child labor, and entrepreneurial activity. However, the latter does not cover capital outlays. The study finds that favorable exchange rate movements—from the perspective of the overseas worker—lead to greater child schooling, reduced child labor, and increased educational expenditure in Philippine households. Favorable exchange rate shocks also lead to differentially more hours worked in self-employment, and to differential entry into relatively capital-intensive enterprises by households receiving remittances.

The empirical results in Table 6 [ PDF 46KB | 1 page ] are consistent with the BSP study (Tuaño-Amador et al., 2007) that shows remittances to be pro-cyclical and dominated by investment motives. The analysis indicates that remittances have the potential to be a more robust source of sustainable economic growth if they are channeled to productive investments. More micro-level studies should be conducted to determine the factors that can bring this about. What would be suspect, though, is the negligible impact of remittances on consumption based on the VAR analysis. This can be considered inconclusive until such time that a consistent data series on current transfers will be extended to years prior to 1999.

What is driving the exchange rate?

The most controversial aspect of foreign exchange inflows, arguably, has been the sharp appreciation of many Asian currencies in nominal and real terms from 2004 up to the present (Table 7 [ PDF 40KB | 1 page ] and Figure 1 [ PDF 223.2KB | 3 page ]).⁵ The peso started appreciating sharply vis-à-vis the US dollar only in December 2005 and even then it was the Asian currency with the most rapid appreciation during the period 2003–07 (Table 7 [ PDF 40KB | 1 page ]). As a matter of fact, the peso had the fastest nominal appreciation in 2007. Based on the literature review and econometric evidence, the knee-jerk reaction would attribute this phenomenon to a surge in foreign exchange inflows.

Closer scrutiny of the data indicates, however, that foreign exchange inflows may have a less prominent role in the appreciation of Asian currencies than assumed. Data in Table 8 [ PDF 44.6KB | 1 page ] show the ratio of balance-of-payments components to GDP during the period 2004–06 for various Asian countries. There is no indication of a surge in current transfers among them except for the Philippines. However, Singapore and Malaysia do have substantial current account surpluses but the Singapore dollar and ringgit have significantly lower rates of appreciation.

Meanwhile, the balance in the capital and financial accounts were fairly moderate except for relatively large surpluses in the Philippines and Thailand in 2005. Moreover, as indicated in the earlier section, there has been no jump in remittances into the Philippines compared to its historical trend and even then the resulting current account surplus was much lower than that of Malaysia and Singapore. Hence, while important, it would be incorrect to cite a surge in foreign exchange inflows as the primary cause of the peso’s recent sharp appreciation.

Instead, the following factors can be considered in the context of the Philippines:

1. At the “lowest” points of the various regional currencies, the peso experienced the second largest depreciation in both nominal and real terms. Hence it is but natural to expect it to have a faster appreciation during the recovery period after the crisis. This argument, however, is tempered by the experience of Indonesia, which had the sharpest depreciation as a result of the crisis, yet experienced a net nominal depreciation of the rupiah during the period 2003–07.
2. Instead of a drawn out process, the peso’s recovery was bunched up over the period December 2005 to the present. This is largely explained by the prevailing fiscal difficulties up to that time. The Philippine government implemented stringent and decisive fiscal reforms beginning in 2005 and their success boosted investor confidence which was reflected in the peso’s strong appreciation in 2006–07.
3. Compared to other central banks in the region, the BSP did not intervene as much in terms of accumulating foreign exchange reserves. Hence it should be expected that the peso’s appreciation should be faster. This can be gleaned from Figure 2 [ PDF 49.4KB | 1 page ] which is Graph 2 of Ho and McCauley (2007). The ratio of the change in foreign exchange reserves to GDP was extended to October 2007 (Figure 2A [ PDF 71.8KB | 1 page ]) and while the Philippines moved up in rankings, the extent of intervention was still comparable to the past five years. However, this argument is also tempered by Indonesia’s experience where the degree of intervention was even lower.
4. A prevailing current account surplus since 2003 has also pushed up the peso’s value. From a current account deficit equal to 5.3% of GDP in 1998, the Philippine economy recorded a surplus of 5% of GDP in 2006 (Table 5 [ PDF 46KB | 1 page ]). This is largely due to a fall in the investment rate and reflected in a drop in the ratio of imports to GDP from 63% in 1997 to only 46% in the first three quarters of 2007 (Table 5 [ PDF 46KB | 1 page ]). The issue of the fall in the investment rate and its relation to the accumulation of reserves will be discussed in Section VI.

Rather than surges in foreign exchange inflows, the strength of Asian currencies vis-àvis the US dollar is largely attributable to the latter’s overall weakness. Data in Table 7 [ PDF 40KB | 1 page ] show that the US dollar depreciated by 38% against the euro during the period 2003–07. This is about 10 percentage points higher than the peso’s appreciation against the dollar. However, the concept of “dollar weakness” has to be translated into foreign exchange flows that affect the region’s exchange rates. One possible explanation relates to the concepts of “dollarization” and “de-dollarization.”

Dollarization and De-Dollarization

Dollar denominated assets held by residents has been increasing over time consistent with the liberalization of the economy. The relative magnitude of these assets reflects the degree of dollarization, which increased between 1990 and 2000 following the surge of foreign exchange inflows (Table 9 [ PDF 81.8KB | 1 page ]). Using the IMF standard, an economy is considered highly dollarized if the ratio of foreign currency deposits (FCDs) to money supply is greater than 30%. The data show that the Philippines was on its way to becoming a highly dollarized economy, but, after reaching 41% in 2000, the ratio fell to 29.9% in 2006 and 26.4% in October 2007.

The trend towards de-dollarization can be partly explained by the general decline in capital inflows after the crisis. However, at a certain point the fall in the FCD/M3 ratio is driven largely by the peso appreciation. In this context, making FCD/M3 an indicator of de-dollarization becomes an exercise in tautology. Data show that in 2006 and 2007 there was a jump in withdrawals in FCDs (Table 9 [ PDF 81.8KB | 1 page ]), which is a more reliable indicator of de-dollarization. The jump can be attributed to expectations of a peso appreciation which become self-fulfilling. Another indication of de-dollarization is the ratio of FCDs to foreign exchange reserves, which has fallen sharply between 2004 and 2007. The logic is that perceptions of weakness in the US dollar has prompted economic agents to withdraw from their FCDs and convert their dollar holdings to pesos in anticipation of its appreciation. This action in itself has contributed to the peso’s appreciation.

Stock Prices

Foreign portfolio investment has been the main driver of the local stock market. Hence, it is not surprising that the surge in stock prices since 2003 has been accompanied by the resurgence of non-residents’ investment in equity securities (Table 4 [ PDF 44.6KB | 1 page ] and Figure 6 [ PDF 107.8KB | 1 page ]). The results of the VECM analysis and regressions in Table 6 [ PDF 46KB | 1 page ] indicate, however, that portfolio flows have had an insignificant impact on investment and consumption.

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