Sta. Ana coordinates Action for Economic Reforms.   This article was published in the Opinion Section, Yellow Pad Column of BusinessWorld, August 27, 2007 edition, page S1/4.

The Rodrik paper on the relationship of the real exchange rate and growth is a good reference point for the Philippine policy debate.  To reiterate, its main point is not only about avoiding an overvalued currency but also using an undervalued currency to stimulate and sustain growth.  In the face of institutional and market failures, undervaluation serves as an incentive for the most productive sectors, namely manufacturing and non-traditional agriculture.

It challenges the view of Philippine officialdom that favors either an appreciating peso or a market-determined exchange rate.

I recall a clarification written by Bangko Sentral ng Pilipinas (BSP) Deputy Governor Diwa Guinigundo (BusinessWorld , 7 February 2006), which was a rejoinder to my article titled Exporters’ Woes (BusinessWorld, 30 January 2006).  Although the reply was made more than a year ago, its amplification remains the BSP’s core position regarding the management of the exchange rate.

I summarize Mr. Guinigundo’s main points in his rejoinder:

  1. The BSP’s primary mandate is to keep prices stable; inflation has the greatest impact on the poor’s well being.  Hence, “the BSP should not be faulted for being ‘overly’ concerned with inflation.”  In the same vein, the BSP views monetary policy to be “best devoted to price stability.” The use of monetary policy to depreciate the peso, or for that matter to lower unemployment, “can only be done at the cost of ever-accelerating inflation.”
  2. For its inflation-targeting framework to have credibility, the BSP has to pursue a market-determined exchange rate.
  3. Structural reforms are the necessary condition for competitiveness.  Increasing productivity through structural reforms is superior to “pure price considerations” to enhance competitiveness.

The Rodrik paper actually provides an overarching answer to the above arguments.  It all begins with the government’s preferred policy framework.  If the national government subscribes to undervaluation as a policy to meet development goals, this necessarily becomes the constraint to the BSP’s actions.

The truth is, the independent BSP’s inflation targeting is constrained by the objectives set forth in the national development plan.  Starkly said, the BSP’s inflation target cannot trump the government’s development goals.

The BSP primer on inflation targeting recognizes the need to be responsive to objectives other than low inflation.  It says:  “Although the price stability objective is the BSP’s main priority, other economic goals—such as promoting financial stability and achieving broad-based, sustainable economic growth—are given consideration in policy decision-making.”

Thus, when the national government prefers a growth spurt that requires a depreciated currency, it can and should be accommodated by the BSP.  Targeting inflation or adopting a “market-determined” exchange rate strategy has to adjust and allow for undervaluation.  To quote Rodrik, “the central bank needs to signal to the public that it now cares about the real exchange rate—because the real exchange rate is important to exports, jobs, and sustainable growth. This can be done without announcing a specific target level for the exchange rate. There is a huge room to maneuver in between the extremes of targeting a specific level of the real exchange rate and disowning any interest in the real exchange rate.”

But will this sacrifice the BSP’s primary mandate to keep price stability? The BSP’s primary mandate of maintaining price stability is not disputed. After all, the strategy of undervaluation frowns upon high inflation, lest the gains from depreciation are wiped out. The question then revolves around how one defines price stability or low/moderate inflation.

A monetarist in the mode of Milton Friedman has zero tolerance for inflation.  A Keynesian has a bias for full employment, which necessitates a relaxing of the inflation target.

The tension exists between low inflation on the one hand and growth and employment on the other hand.  The role of the policymaker is to manage the tradeoff well, guided by the specific economic objectives in a given period.

Some noted economists (the Nobel laureate Joseph Stiglitz, for example) have pointed out that inflation, the low or moderate variety, does not harm output and employment.

That said, defining “low inflation” varies from country to country, taking into consideration the level of development, economic structure, history, institutions, and the like. For an advanced economy that is an inflation hawk like Germany, an inflation rate of two percent or below is the ideal standard. For developing countries, a higher but single-digit inflation rate is considered low.

In the Philippines, considering that the year-on-year inflation rate as of July 2007 is a benign 2.6 percent, the BSP has room to further relax monetary policy to address concerns regarding the appreciating peso, without violating its primary mandate.

It must likewise be stressed that inflation targeting is not an “iron-clad policy rule,” to use the term of Ben Bernanke (the current chair of the Federal Reserve System) and Frederic Mishkin.  (See their paper titled Inflation Targeting: A New Framework for Monetary Policy?, National Bureau of Economic Research Working Paper 5893, January 1997.)  The New Zealand experience, an example of the most “rule-like” inflation-targeting, shows that the Central Bank exercises the flexibility to respond to fluctuations affecting desirable objectives other than inflation like the exchange rate, employment, and output.

Peculiarly provocative—a working paper from the International Monetary Fund—is the study done by Laurence Ball and Niame Sheridan titled Does Inflation Targeting Matter? (June 2003).  The authors wanted to determine whether inflation targeting improves economic performance.  With OECD (Organisation for Economic Co-operation and Development) countries as sample, the authors found no evidence that inflation targeting made economic performance better. The authors nevertheless clarify that the results of their study are not an argument against inflation targeting.  They, for example, think that inflation targeting may have more political, rather than economic, significance.

Edmund Philips (another recipient of the Nobel Prize in economics for his work on unemployment, wages, and inflation) has an illuminating insight into inflation targeting.  He describes himself as “a little bit friendly toward inflation targeting.”  At the same time, he is “a little bit bothered by the fact that the usual formulations of inflation targeting are kind of unrealistic.”   These formulations, says Philips, “tend to assume that the policymaker knows all sort of things he couldn’t possibly know.” (From an article written by Rich Miller, Chicago Sun-Times, 10 October 2006.)

The recent upheaval arising from the US housing loan mortgage meltdown bears out the fact that central banks function not only to check inflation but also to intervene in fighting volatility and disturbances that affect the real sector.

Inflation targeting cannot be doctrinaire and allows what Bernanke and Mishkin call “constrained discretion.”

The law creating the BSP allows flexibility.  It states that the BSP’s primary objective is “to promote price stability conducive to a balanced and sustainable growth of the economy” (italics mine).

To be sure, it is not the BSP’s sole responsibility to fulfill the task of having a competitive exchange rate—nay, an undervalued currency.  This task should be the primary responsibility of the national government. The preference for undervaluation must come from the national government. The BSP can only take its cue from the national government.

Suppose that the BSP itself preferred a competitive exchange rate and thus made the appropriate intervention. This could prosper only in conjunction with complementary initiatives undertaken by the national government.

It does not make sense for the currency to depreciate when government is fiscally reckless, thus canceling out the gains from depreciation.  The government has to strive for a primary fiscal surplus, an increase in revenue effort, and a rise in domestic public and private savings.

Those opposed to BSP intervention to influence the exchange rate for competitiveness argue that it is the government’s task to put in place structural reforms to raise productivity.  But this is a huge, comprehensive task that involves a long-term process.  Amidst institutional and market imperfections, the intermediate task to advance productivity and competitiveness is to have an undervalued currency that spurs the most productive sectors.

We should not be overly critical of the BSP though.  It is the national government that defines the rules of the game.  And Mrs. Gloria Arroyo, the queen, has spoken:  She wants a strong, appreciating peso.