An unexpected source of foreign exchange instability

Luis F. Dumlao, Ph.D.is Associate Professor, Department of Economics, Ateneo de Manila University. The arguments presented are those of the author and not necessarily that of his institutional affiliation. This article was published in the Yellow Pad column of the BusinessWorld on August 4, 2008, pages S1/4 to S1/5.

When the foreign exchange rate changes from the current price, fundamentally speaking, there must have been a correction, from a disequilibrium rate to an equilibrium rate. As the market “corrects” and the rate reaches equilibrium, by definition the rate stays stable and relatively constant. But what if the “correction” of exchange rate to equilibrium affects an outside factor and such effect changes the equilibrium, causing a new round of “correction”? For example, suppose that foreign exchange depreciation changes the amount that overseas Filipino workers (OFWs) remit, and the change in remittance causes the foreign exchange to either appreciate or depreciate?

The outside factor is stabilizing if it causes the exchange rate to go back to the original rate of equilibrium. For example, the change of foreign exchange rate from P50/$ to P55/$ causes a change in remittance, and consequently the change of remittance causes the rate to go back from P55/$ to P50/$. On the other hand, the outside factor is destabilizing if it causes the exchange rate to go further from the original equilibrium rate. For example, the change of foreign exchange rate from P50/$ to P55/$ causes a change in remittance, and consequently the change of remittance causes the rate to go up further, say, from P55/$ to P60/$.

A paper by Dean Yang (International Migration, Remittances, and Household Investment: Evidence From Philippine Migrants’ Exchange Rate Shocks in The Economic Journal, April 2008) has a significant implication on the short-run effect of OFW (overseas Filipino worker) remittance on the stability of foreign exchange. Yang’s paper states that a depreciation of the Philippine peso with respect to the currency of the source country, like the dollar of the United States or yen of Japan, results in an increase of recipient households’ income. This is not surprising and easily comprehensible.

Take the example of the peso per United States dollar. Suppose the exchange rate is P50/$ and the income of the OFW is $100 per day. In terms of domestic currency, the income of the OFW equals P5,000 per day. Suppose there is a 10 percent depreciation, making the exchange rate P55/$.  So in domestic currency, the same $100 per day of the OFW now equals P5,500. In terms of domestic currency, income is higher. Hence, depreciation causes an increase of the recipient household’s income.

Specifically, Yang shows that a 10 percent depreciation of the peso results in an average of 6 percent increase of the recipient household’s income. For example, suppose the exchange rate is P50/$ and the average household receives an equivalent of P100 worth of remittance. Suppose that there is a 10 percent depreciation making the exchange rate P55/$. This results in a 6 percent increase of income from P100 to P106 worth of remittance.

The numbers lead to the main point of this essay. Before the depreciation at the exchange rate of P50/$, the household was receiving P100, that equaled $2. After the depreciation at the exchange rate of P55/$, the household now receives P106, that equals (P106 / P55/$) about $1.93. While income increased in terms of pesos from P100 to P106, remittance in terms of dollar actually decreased from $2 to $1.93!

What is the dynamic implication on the foreign exchange? One must first understand what happened to the supply and demand for the peso to depreciate. In the example above, the depreciation from P50/$ to P55/$ means that the dollar has become more expensive. In terms of supply and demand, a shortage of dollar supply relative to dollar demand must have prompted the price of dollar to become more expensive.

So the story goes. A shortage of dollar supply causes the peso to depreciate and “correct,” say, from P50/$ to P55/$. However, the depreciation results in a decrease of OFW remittance, say, from $2 to $1.93. The decrease of remittance causes a second round of shortage of supply. A second round of shortage of dollar supply causes the peso to depreciate and “correct” again. The story goes on.

For many, this is unexpected. The conventional wisdom is that OFW remittance has been keeping value of the peso as afloat as possible at least for the past twenty-five years. That is partially true. Without it, the country would have run into serious balance of payment deficits year after year. As a result, one might assume that remittance is keeping the peso stable. But it is one thing to talk about the remittance’s long run level-effect on the exchange rate, and another to talk about its short-run stability-effect.

This is not to say that OFW remittance caused all the depreciation of the peso that started in the first week of July 1997 to the entirety of the crisis or caused the appreciation from July 2006 to February 2008. It is only one of many factors. The global price of oil and inflation, the direction of capital flows, and speculation and sentiments are among the other factors, each factor deserving an explanation as long as this essay. Some are stabilizing while others are destabilizing. In those moments, it just so happened that the destabilizing effects outweighed the stabilizing effects. Does it mean that the recent depreciation of the peso since March 2008 will persist? No one can say with certainty, but recent history says that it will probably persist for months to come.

Is OFW remittance bad for the economy? It depends. Guns make governments powerful. But governments can use guns to abuse power and encourage chaos as much they can use guns to restore peace and order. The same goes for OFW remittance. It is money, and it is a source of power. It can destabilize the peso as much as it can be managed properly to cause stability and long-run strength of the peso. This is where right government and some active monetary policies come handy.

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