The Exchange-Rate Problem

Sta. Ana coordinates Action for Economic Reforms. This article was published in the Opinion Section, Yellow Pad Column of BusinessWorld, January 22, 2007  edition, page S1/4.

Mrs. Gloria Arroyo has repeatedly said that the rapid strengthening of the peso reflects a strong economy. Whether her belief in a strong peso derives from her training in economics—she has a PhD from the University of the Philippines School of Economics—is debatable.

Economists often disagree with each other.  But on the exchange-rate issue, every economist—mainstream or unorthodox—accepts the importance of a competitive exchange rate.

Exports, most affected by a continued peso appreciation, account for more than 40 percent of the country’s economic output.  A peso appreciation makes Philippine exports more expensive.  The unabated appreciation of the peso will likely result in a shift in the preference of consumers from the country’s trading partners.  Instead of buying Philippine export goods that have become more expensive, they will opt to purchase locally made goods or the export goods of our trade competitors.  In other words, Philippine exports lose market share.

A simulation in a Philexport policy brief (unnamed author, 2006) provides some insights.  The simulation results were drawn from a 2003 Asian Development Bank (ADB) study titled “Investment Climate Survey.” The survey involved about 700 firms in four manufacturing industries, with export firms accounting for a third of the sample.

The simulation assumed that the peso appreciated by one percent vis-à-vis the US dollar.  Conceptually, the peso appreciation would reduce the cost of imports but at the same time lower the amount of sales from exports, with the assumption that the unit price and the number of units made would remain constant. The net gain or loss for a particular firm would depend on its degree of dependence on export sales and import costs.

On average, the simulation showed that all four industries—food, textiles, garments, and electronics—suffered declines in sales and gross profits, notwithstanding the reduction of their direct costs. Among the four industries, electronics, accounting for almost three-fourths of the country’s total exports, had the highest decline in gross profit (-1.17 percent for every one percent appreciation of the peso).

On the other hand, net importers in the four mentioned industries posted an increase in average gross profit, thanks to the lower direct costs arising from local currency appreciation.

But among net exporters, those in the food industry suffered the highest decline in average gross profit (-2.15 percent).  Painful stories told by food exporters are plentiful.

Producers of mangoes for exports had to absorb losses because of sudden reversals of the exchange rate.  In early 2006, they had contracts based on a price (exchange rate) of PhP53.00 to US$1.00, but then the exchange rate appreciated to PhP51.00 to US$1.00. In light of the currency movement, they pegged the price of their next contract at PhP51.00 to US$1.00.  Lo and behold, the exchange rate moved again, this time to PhP49 to US$1.00

William Tiu Lim, president of Mega Fishing Corporation, also has a woeful story to tell. Mr. Lim is not really a full-fledged exporter.  His company, the producer of Mega Sardines, mainly serves the local market.  At present, exports account for 10 percent of the company’s total production.

Being an innovator, Mr. Lim nevertheless ventured into exports. To improve the quality of his products mainly for the local market, he realized that passing the high quality standards for exports was the key.  By going into exports, his company had to meet the exacting benchmarks (passing the HACCP or Hazard Analysis and Critical Control Points) for food safety.

Unfortunately, the export side of Mr. Lim’s business is seriously threatened.  He says that he would have to absorb significant losses arising from the current exchange rate. He however cannot stop exporting despite the losses, for the name of the game is preserving his company’s market share.  The question is:  How long can he and other exporters hang on?

Although the adverse effect on exporters is commonly emphasized, it must be pointed out that domestic producers for the local market, whose inputs are mainly local, likewise suffer from a continuing peso appreciation.  A peso appreciation makes the prices of competing imports cheaper. Hence, local producers lose market share, grabbed from them by imports. A qualification though is in order:  The simulation done for Philexport, using 2002 data obtained by ADB, revealed a slight decline (-0.18 percent) in average sales of net importers.

In fine, the continued appreciation of the peso, leading to its overvaluation, is injurious to the real, productive sector of the economy, negatively affecting employment and income.

The irony, too, is that those dependent on the overseas workers’ remittances will receive less pesos for each inflow of dollar because of the continued appreciation of the peso.  A negative consequence of this is a higher inflow of dollars from relatives abroad to make up for the reduction of local currency income, leading to the further appreciation of the peso.

Indeed, without proper and timely institutional intervention, the peso will continue to appreciate, further undermining the macroeconomic fundamentals.

In fairness to the Bangko Sentral ng Pilipinas (BSP), it has intervened in the foreign exchange market to mitigate the strengthening of the peso.  For example, it has bought US dollars and has prepaid some of the country’s foreign liabilities.  It has likewise signaled to the market by way of forecast that an exchange rate of PhP52.00 to US$1.00 is feasible.

But the BSP can still be more aggressive in its intervention. The constraint is that the BSP is more concerned with taming inflation.  A peso appreciation contributes to lowering inflation, for it reduces import costs.  At the same time, a policy tool to prevent further appreciation is to expand the money supply to buy the dollars, which, however, can result in inflation. It must be said though that current inflation is already low.

The national government must likewise do its share to prevent the further appreciation of the peso.  For one thing, it should refrain from further foreign borrowing.

In economics, there will always be trade-offs.  At the present conjuncture, it is very critical that the trade-off favor arresting the movement toward overvaluing our currency.

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