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 the
exchange rate. A huge trade or current account deficit—that is, import
payments 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 an
artificially 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
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.