The author is the coordinator of the research and policy advocacy group Action for Economic Reforms.
The talk of the town is the volatility of the exchange rate and the peso depreciation. Some say the problem arises chiefly from the political uncertainty attendant to the forthcoming elections. Others give greater weight to the economic fundamentals, particularly the country’s untamed budget deficit and overborrowing, the reason behind the downgrading of the country’s credit rating. Or it could be the work of manipulators and speculators.
We can gain a better understanding of the present complications by first recapitulating the factors that influence or determine the movement of the exchange rate.
At the basic level, the country’s imports and exports predict theexchange rate. A huge trade or current account deficit—that is, importpayments exceed export earnings—results in the depreciation of the peso.
One item worth mentioning is the oil bill since the country is dependent on imported crude oil.
Nevertheless, the official data on the country’s current account indicate that, with other factors constant, the exchange rate should remain stable. Latest available data show a current account surplus, albeit with a slight deficit in trade.
Incidentally, a surplus likewise marks the balance of payments. A significant inflow of foreign currency leads to an appreciation of the currency. A massive outflow of foreign currency results in devaluation.
Another basic determinant of the exchange rate is purchasing power parity (PPP)—that is, relative price levels or inflation rates. The PPP principle states that the exchange rate of the Philippine peso and the foreign currency is in equilibrium when both currencies can buy the same basket of goods and services.
To simplify, suppose that the exchange rate is PhP50 to US$1. Suppose, too, that the inflation rate in the Philippines is 10 percent and is zero for the rest of the world in a given year. Holding other factors constant, we can expect the peso to depreciate by 10 percent. The real value of a particular good has increased by 10 percent in the Philippines. If the currency remains fixed (does not depreciate)because of policy intervention, the imported good, say, a Big Mac hamburger, becomes cheaper than the local Big Mac. The rational, calculating man will exchange his PhP50 for US1 to buy the imported Big Mac sandwich, instead of purchasing the local burger that costs PhP55.
The reality though is that current inflation in the Philippines is low; hence relative prices cannot explain the recent peso depreciation.
In the past, the Philippines was forced to suddenly devalue the currency because in the first place the authorities preferred inartificially strong local currency. To shore up the peso, the monetary authorities adopted a high interest-rate policy, which was costly to growth, investments and employment. The misaligned exchange rate, in the form of a strong but overvalued peso, eventually led to the financial crisis in 1997.
But note that depreciation can be beneficial in a different context. At the very least, the nominal rate must be aligned to its real value, and this suggests letting the peso depreciate. Here, the overseas Filipino workers and their dependents are obvious gainers. Further, a depreciated currency contributes to the competitiveness of both export-oriented and import-substituting industries. Philippine exports become attractive abroad because of the cheaper foreign price. Despite this, recent export performance is disappointing, suggesting that the export sector is beset with structural problems. Import-substituting industries also benefit since the competing imports become more expensive. The depreciation likewise becomes an instrument to protect jobs in both export and import-substituting industries.
Of course, depreciation has its costs. Importers are affected. Prices of imported goods, which at any rate is consumed mainly by upper and middle classes, increase. Also, the peso equivalent to service the foreign debt increases.
Having ruled out the external balance and relative prices as the chief causes of the recent currency depreciation, we can then proceed to discuss the risk factor—both economic and political—as a crucial determinant of the exchange rate. Macroeconomic stability is undoubtedly a primary concern of investors. But investors are not fixated on short-term performance; they probe into the foreseeable future. Hence, even if most of the economic indicators look good at present—resilient growth, low inflation, healthy trade balance—investors give weight to other factors, which they perceive to have a damaging effect in the medium term. Even if the rate of return to capital in the Philippines is attractive at the moment, investors will still hesitate to bring in foreign currency, precisely because of the risk and uncertainty.
The chronic budget deficit and unsustainable government borrowing have become the Achilles heel of the economy. The news and the noise brought about by the not-too-subtle criticisms of the International Monetary Fund and the Asian Development Bank on the looming fiscal crisis, Moody’s downgrading of the country’s credit rating and Standard Chartered Bank’s dire scenario of an Argentine type of debt crisis have unnerved investors.
The political risk is likewise damaging to investors. It is vital that the electoral process be seen as fair and clean and the result credible. But recent political developments are disquieting. To name a few: the alleged tampering of archival documents to disqualify the leading presidential aspirant; the re-enactment of the 2003 budget, giving the incumbent huge discretionary funds; the covert political actions within the military; and the bribing of local officials to obtain their loyalty.
All this reinforces the view that the forthcoming elections will be costly, dirty, and antagonistic. Markets thus become edgy. It makes sense for investors and traders to anticipate the worst circumstances.