A policy struggle between the Department of Finance (DOF) and the

Bangko Sentral ng Pilipinas (BSP) is threatening to break out (see
Today, 28 and 29 July 1999.) The news report state that the DOF is
under strong pressure to hike interest rates on its treasury bills. BSP
Governor Rafael Buenaventura has said that interest rate have to go up
to arrest the peso depreciation.

Buenaventura’s statement was a signal for the money market to bid up
rates on the treasury auction. Had the auction committee fully awarded the bids, the 91-day T-bill rate would have increased by 41 basis points. It is to the DOF’s credit that it so far has not succumbed to the pressure.

We have to stress that increasing interest rates at this time when the
economy remains fragile will only dampen the momentum towards full
recovery. An increase in interest rate is very untimely. Investments have yet to pick up even as inflation is declining. Similarly, an abandonment of the low interest-rate policy will cancel out the hard-earned gains resulting from the DOF drive to bring down interest rates.

Besides, the Treasury has said that its cash position at present is comfortable enough to cover the government’s programmed deficit. Simply said there is no need to borrow more and increase interest rates. This is consistent with the Treasury’s mandate to meet government’s cash obligation at the least cost.

Moreover, a sudden reversal of government policy will be unsettling to
investors. Unpredictability of policies will further dampen business’s
animal spirits.

As soon as Mr. Buenaventura assumed his post, bankers and money market
traders came knocking at his door. Buenaventura’s statement favoring an
interest rate increase all the more emboldened them to bid up interest rates. It seemed like the market was testing the waters under the new monetary board leadership. But it could very well be that the bankers were appealing to a fellow banker to promote banks’ interests. An interest rate increase will spell higher profit margins for the banks, many of which are saddled with a high proportion of non-performing loans.

Treasury bills are at a historic low, with the 91-day T-bill rate significantly declining from 19.2 percent in January 1998, to 8.38 percent as of late July 1999. The DOF and the National Treasury should be congratulated for this accomplishment.

In the past administrations, the auction committee followed the practice of awarding its offer fully except in instances of very sharp increases in interest rates. Thus, ther auction participants could second-guess the allocation and pricing of treasury issues. Under the present set-up, the National Treasury has devised ways to have greater flexibility in cash management. For example, it does a market-sensitivity analysis so that when the market points to a higher interest rate, the Treasury can look for cash sources to meet
government’s obligations. It has also introduced other instruments such
as the small investors’ program, in which small savers can avail themselves of lower-denominated treasury bills, and the longer-term treasury bonds. All this has widened the T-bill’s creditor base.

With the greater flexibility in cash management, the auction committee
has adopted the tactics of making partial awards to defend the low interest rate policy. This has made the treasury auction market fully competitive.

The banks’ margins from T-bills have thinned out in light of the low interest rates. The banks miss the days when they profited from high-yielding, default-free, and liquid T-bills during the bad times (remember the Jobo and Gabby bills).

The new BSP governor wants a policy reversal. Just one day upon assuming office, Mr. Buenaventura told the press that it is time to review the policy of low interest rates “in light of what appears to be some sentiments of the differential of peso and dollar instruments.”

The BSP has likewise stepped up its criticisms against the DOF, describing the low-interest rate strategy as a “narrow perspective.” From what the BSP governor considers a “macro” point of view, he argues that the policy of low interest rate fails to take into account the “negative” effects on the exchange rate. The BSP chief explains that interest rates are already too low, making investors shift their funds from peso to dollar assets, in turn weakening the Philippine currency.

We believe nevertheless that the DOF is on the right track even when viewed from the “macro” perspective. Regarding the exchange rate fears of the BSP, the fluctuation in the exchange rate is far from breaching worrisome levels. At this time, it is also unlikely that a speculative attack on the peso could gather force. For one thing, the foreign exchange reserves are at a comfortable level, by the governor’s own admission. For another thing, foreign portfolio investments have not yet picked up to a magnitude where a reversal caused by panic can cause a sharp depreciation. It is doubtful how far speculators can bring down the peso in the absence of a corresponding demand for foreign exchange in the real economy.

And despite the reduction of nominal interest rates, the real interest rates are significantly positive, giving investors enough incentive to hold on to peso assets. In fact, the real interest rates in the Philippines are marginally higher than Malaysia’s and Indonesia’s.

Furthermore, it is clear by now that the BSP has not fully grasped a major lesson drawn from the financial crisis: that it is not worthwhile to defend the exchange rate at the expense of sacrificing productive investments and quality growth.

The Estrada administration’s strategy of maintaining low interest rates and resisting the fetish for a strong peso signals a determination to spur an investment-led recovery that is at the same time supported by a robust trade balance. A reversal of such strategy means a return to the import- and consumption-led growth that characterized Philippine economic recoveries in the past. Such pattern has time and again proven to be unsustainable.

We hope President Estrada will uphold the strategy of low interest rates and a competitive exchange rate being engineered by his economic reformers.