OUTSIDE THE BOX
The Bangko Sentral ng Pilipinas (BSP) raised interest rates last week by one quarter of a percent, putting the overnight lending rate to 6.50 percent from 6.25 percent. This is good news. In March rates were also raised by 0.25 percent, bringing the total interest-rate increase for the year to a half-a-percentage point.
BSP Governor Amando Tetangco Jr. said, “With these considerations, the board deemed it prudent to rein in inflation expectations further.”
That statement by Governor Tetangco is not completely true. Interest rates are traditionally raised to counter inflation if the inflation is caused by an imbalance in supply and demand. If, for example, chickens are in short supply and the price is going up, when interest rates are low, dealers will theoretically borrow money to buy more chickens to take advantage of rising prices. This borrowing, in turn, creates more of a supply/demand imbalance, causing prices to go even higher. The central bank raises interest rates to discourage buying, thereby reducing demand and this, in turn, will lower prices.
Except, current inflation has very little to do with supply/demand imbalances. The greatest part of global inflation, including in the Philippines, is “currency-induced cost-push inflation.”
Remember the good old days of 1997? When the peso/dollar exchange rate went from 26 to 36, prices went up because the cost of imported components such as milk, oil and other imported goods was more in peso terms. The “cost” of imported goods “pushed inflation” higher because the “cost” of the dollar was increasing.
Today, we have a similar situation, a much more serious situation of “currency-induced cost-push inflation.” The dollar drops 7 percent, making oil exporters increase their prices by 7 percent. But inflation is as much psychologically caused as by the actual financials. The oil exporters correctly believe the dollar is going to fall more so they raise prices faster to keep ahead of the falling dollar.
The real purpose behind the latest BSP interest-rate increase is to justify an appreciating peso, which is good. What was not said by the BSP in the original announcement came later. From the BusinessMirror: “Monetary authorities said they would rather have the exchange rate approach the consensus rate P42 per dollar and manage the external sector a tad more difficult than usual instead of having inflation average above forecast at 5.6 percent this year—which may happen if they didn’t increase policy rates.”
Let me finish the rest of that statement: “because of currency-induced cost-push inflation.”
The BSP is setting up the public and business for more peso appreciation.
Over the last six years or so, the BSP moving interest rates have not seen a good correlation with inflation rates. Granted, the BSP must walk a thin line between keeping interest rates high enough to stop inflation and low enough to keep economic activity moving.
Local banks are experiencing good times now. Nonperforming loans are at a very low level, around 3 percent of total portfolio. The average capital adequacy as of end-June 2010 remained healthy at 15.2 percent, exceeding the 10 percent level set by the BSP and the 8 percent set by the bank for International Settlements.
Bank lending grew in January 2011 at the fastest rate in almost two years since the recovery after the 2008 financial crisis hit the world. One key to that number is that production loans, used for project financing rather than just paying the ordinary bills was up over 12 percent. Consumer loans went up at a slower rate but that is not necessarily a negative. Consumers are still buying, as witnessed by the 8-percent to 10-percent increase in retail sales in the first months of 2011 and people have the cash to buy without borrowing.
Peso appreciation is an important factor for this economy as I have been saying constantly. The perception that the peso will appreciate even further over the next months has a psychology also. Dollars from both domestic and foreign sources will go to pesos believing that there will be increased trading profits from being in pesos. The fact that interest rates are up will encourage more dollars to flow into the country as deposit rates are higher at the banks than in other nations. It is a win-win situation for going into pesos.
The downside of a peso appreciation has been talked about enough. However, the positive effects of peso appreciation on the total economy will offset the negatives. If the government’s economic policymakers would ever get creative, these negatives could be mitigated, if not eliminated. While an increase in interest rates will increase the cost of government domestic borrowing, the cost of dollar borrowing and debt service will go down.
This move by the BSP is an indication to me that the BSP has taken the action that they knew was inevitable; appreciate the peso. The positive effects of more dollar inflow, a reduction in the overall cost of imported products like oil, somewhat higher profitability for the banks and reducing inflation makes this year look better for the economy.
In last week’s column about the Weiss rating of the Philippine sovereign debt, I included the wrong web site address. This is the one where you can read the country results: http://weissratings.com/news/archives/debt/110428.aspx
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Tuesday, 10 May 2011