Sta. Ana coordinates Action for Economic Reforms. This piece was published in the September 20, 2010 edition of the BusinessWorld, pages S1/4 to S1/5.

Undoubtedly, the surge of the local stock market and the oversubscription of the peso-dominated bonds in the global financial markets are signs of investor bullishness toward the Philippine economy.

The Philippine Stock Exchange index has reached a record-high level of 4,000, and it is expected to breach the mark of 5,000 in 2011. The peso-denominated ten-year bond easily raised US$1.billion (or PhP44.1 billion). In fact, the peso-denominated bond were heavily oversubscribed, with demand reaching US$13.3 billion. Hence, Finance Secretary Cesar Purisima said that the bond issuance was “a landslide vote of confidence by the global financial markets” for the Philippine economy and the national leadership.

These developments will further whet the appetite of overseas investors, resulting in additional inflows of foreign exchange that will buoy up financial markets.

I am sorry for being a party pooper; I have always been skeptical of stock market bull runs and oversubscription of foreign borrowing as indicators of a healthy economy. They manifest exuberance for the short term but do not predict and in many instances threaten long-term growth.

Stock market investments are short term. Most of the stock-market transactions are not intended to create factories or increase productive capacity. The stock market’s foreign money is volatile as it can move out in an instant. Thus, it is called hot money.

Public sector foreign borrowing is unavoidable in a situation that the government suffers from a low tax effort and a huge financing gap. Be that as it may, government has to reduce reliance on foreign borrowing—even the peso-denominated one—to reduce the risk of debt and foreign exchange crises.

The peso-denominated bond for the global financial market is a novel idea, but this does not alter the fact that upon maturity, the settlement will be in US dollars. The implication here is that the price of the bond has taken into account the risk associated with a depreciation of the Philippine peso. Said another way, the investors are betting that the peso will remain stable and strong. It also means that to protect the value of the peso-denominated bond, the policy makers will lean towards a monetary and exchange-rate stance that will keep the peso strong.

But a strong peso is an overvalued currency—manifested nowadays in its quick appreciation. Analysts (Barclays, for example) predict that the peso from the current PhP44.40 per US dollar will appreciate to PhP40 per US dollar within a year.

Our rough estimate that given the sharp trend of an appreciating peso, not only attributed to hot money but also to the boost in remittances of overseas Filipino workers, the peso overvaluation can go as high as 25 percent in the short term.
This is to say that Philippine goods relative to our trading partners are priced 25 percent higher.

An overvalued currency is bad for the real sector of the Philippine economy. Those hurt by an overvalued peso are the business process outsourcing (BPO) industry—one of the few booming sectors that create quality jobs in the Philippines—and the exporters. Their competitiveness still rests to a great extent on the competitiveness of the exchange rate.

But it is a wrong perception to think that those penalized by an overvalued currency are only the export firms and BPO corporations and their workers. An overvalued peso also injures the producers for the domestic market (those producing import substitutes). The domestic producers and their workers have been complaining about the competition from cheap imports. Imported products will become cheaper with the continued appreciation of the peso.

It goes without saying that the appreciating peso will erode the purchasing power of tens of millions of families who are dependent on the remittances of overseas Filipino workers.

Some, in defense, of the peso appreciation, argue that an appreciating peso has benefits. An appreciating peso means cheaper imported inputs for production. It also reduces the foreign debt stock and foreign interest payments in peso terms.

But the benefits above are a pittance compared to the costs of overvaluation to the economy’s real sector. Said differently, the gains from a competitive (depreciating) exchange rate far outstrip the costs (mainly rising import costs).

It is consuelo de bobo for government to benefit from reduced debt payments arising from an appreciating peso. The fact is, an overvalued currency worsens the fiscal problem because direct and indirect taxes fall as the growth of the real sector slows down or declines.

The rise in the cost of imported inputs is not a serious problem, especially if the goods produced have high value added. A depreciating currency is an incentive for investments in import substitutes as well as for the production of high value-added products.

We should have learned our lesson from the Asian financial crisis in the late 1990s. We cannot afford an overvalued currency. The irrefutable fact is that a competitive exchange rate—nay, an undervalued currency—is a strong predictor of sustained high investments and growth.

The papers of the Harvard economist Dani Rodrik that convincingly show the country benefits of an undervalued currency for emerging economies are recommended reading. But we need not look afar for such insights. Our Filipino economists, epitomized by Raul Fabella, have time immemorial argued about the worthiness of undervaluation.

The appreciating peso has become a binding constraint. A new challenge for policy makers, aside from the already difficult tasks of boosting tax effort as well as ensuring predictability, coherence and transparency of rules, is preventing the exchange rate from further appreciation. These are the key ingredients at the moment to consolidate our confidence that sustained growth and investments are forthcoming.

(The volume titled Philippine Institutions: Growth and Prosperity for All, edited by Mr. Sta. Ana, has a chapter on the exchange rate as an instrument for growth and development. The book is available in popular bookstores.)