Under control: The central bank is using monetary policy to great effect

With mounting evidence that global economic activity is tipping towards a further slowdown, the Bangko Sentral ng Pilipinas (BSP) is actively deploying monetary policy to spur domestic demand while at the same time maintaining price stability.

NEW POLICIES: Policy decisions by the central bank’s Monetary Board, which cut interest rates in two consecutive meetings during the first quarter of 2012, come against the backdrop of lower domestic economic growth that officials have attributed to the slackening economy of advanced economies as well as lower spending by the administration of President Benigno Aquino III. “The full-year GDP growth [for 2011] is lower at 3.7%, following the continued weakness in our trading partners and the slowdowns in government spending, which was in fact needed as the government put in place new governance standards in spending,” Amando Tetangco Jr, the governor of the BSP, told local reporters at a press event.

Tetangco noted that the bank will closely monitor the growth prospects of the country’s main trading partners including the US and countries in the EU, and their impact on domestic growth and inflation. During its first board meeting of 2012 on January 19 the central bank said in a statement that while the US economy had been showing signs of improvement it remained vulnerable to financial market volatility amid continued concerns about long-term fiscal sustainability. Meanwhile, it said the eurozone economy was notably weaker, with interlocking sovereign debt and banking problems weighing heavily on global sentiment.

EXTERNAL CHALLENGES: A key challenge for the BSP going forward in 2012 will be to maintain a steady exchange rate as capital inflows have heated up in light of historic low interest rates in the EU and US. Indeed, the US Federal Reserve’s decision in January to maintain short-term interest rates near zero through late 2014 caused the peso to rise against the dollar as investors developed a strong appetite for emerging market assets. A strong peso would undercut the country’s exports, notably electronics, that have been a significant driver for the country’s economy. This, in effect, highlights the so-called “trilemma” for the Philippines, meaning it cannot enjoy free capital movement, independent monetary policy and a fixed exchange rate simultaneously but must choose two out of the three. Thus the exchange rate of the Philippine peso is determined by the market. According to a report by the BSP’s deputy governor, Diwa Guinigundo, in view of the peso’s fluctuations, the BSP has initiated measures to cushion the impact of currency appreciation on exports by providing additional financing sources, and promoting the use of hedging products and through a presence in the foreign currency market.

Guinigundo went on to explain that anaemic growth in the US and other developed economies has caused an overall weakening of their currencies and generated a fresh round of loose monetary and fiscal policies. Meanwhile, the strong economic growth of emerging market economies has attracted greater foreign exchange flows, he wrote, adding that the sudden and prolonged surges in foreign exchange flows may threaten the conduct of monetary policy. “If these capital flows are not managed actively and appropriately, they can have negative repercussions, such as real exchange rate misalignments, credit and asset price booms, inflationary pressures, overheating and financial imbalances that can culminate in a full-blown financial crisis.”

However, abating inflationary pressures has given the central bank flexibility in cutting interest rates, which should not only stimulate domestic demand but keep the currency and hot money inflows at what the bank hopes will be manageable levels.

SLASHING RATES: Slower-than-expected economic annual growth, weakening external trade as well as receding inflation prompted the BSP to cut its main policy rate for the first time in two-and-a-half years in January, reducing it by 25 basis points. This brought the overnight borrowing rate to 4.25% from 4.5% and the overnight lending rate to 6.25% from 6.5%. “Inflation is not the main concern right now, but growth is," Cesar V Purisima, the country’s finance secretary, noted in a statement at the time.

As the inflation outlook remained low, the BSP further reduced the cost of money during its following Monetary Board meeting in March, when it cut an additional 25-basis points, bringing the key policy rate down all the way to a record low of just 4%.

“Steady credit growth, together with expected ample liquidity and lower market interest rates, are seen to support the domestic economy in the midst of a weaker global economic outlook,” Tetangco said in a statement. “Going forward, the BSP will continue to assess conditions in the financial system to ensure that the monetary policy stance remains appropriate to support domestic economic activity consistent with a non-inflationary path.”

At the time of research the BSP kept its inflation forecast of 3.1% for 2012 and 3.4% in 2013, and key policy rates may stay steady through the end of the year amidst a spike in oil prices and strong capital inflows, according to analysts on the ground. Indeed, a report by HSBC noted that the BSP will most likely hold rates steady at 4% for the rest of 2012.

Monetary authorities did what they could to generate more domestic spending, the report said, adding that for the remainder of 2012, inflationary concerns linked to high oil prices and abundant liquidity will restrain the BSP from further rate cuts. Indeed, according to the BSP, the growth of domestic liquidity or M3 rose to 7.2% year-on-year in January 2012 from 6.3% in December 2011 to reach P4.5trn ($102.15bn). The central bank noted the rise in liquidity came from steady foreign exchange inflows via overseas remittances and portfolio investments.

PRICES EASE: According to the latest statistics from the BSP, inflation looks to be under control. Year-on-year headline inflation – which includes food and energy prices – eased to 2.7% in February 2012 from its level of 4% in January 2012.

The year-to-date average of 3.3% fell within the government’s target range for 2012 and the BSP’s monthly forecast of 2.7-3.6%. According to the BSP, lower February 2012 inflation was due mainly to slower increases in the prices of key food items. Meanwhile, the higher inflation seen in electricity, gas and other fuels as well as higher charges for electricity rates caused a slight increase when it came to overall non-food inflation.

“Over the policy horizon, we expect inflation to be below the mid-point of our target range of 3-5%,” Tetangco said on the back of the news. “We will continue to monitor developments, particularly in the Middle East and North Africa and their impact on volatilities in international prices, to see if there is any need to adjust our policy stance.”

THE FOREIGN ELEMENT: Policy makers do indeed have reasons to closely follow events in the Middle East, especially over developments in tensions with Iran due its nuclear programme, as the Philippines imports almost all of its crude oil needs; a further rise in crude prices would cause increases in power and transport costs, undercutting local purchasing power. Coupled with subdued external demand, this will undoubtedly play a role in future monetary policy decisions going forward.

Indeed, the continued weakness in the Philippines’ exports was a key reason for the interest rate cuts in both January and March. According to the National Statistics Office, the Philippines’ exports slid by 6.9% in 2011 compared with a government estimate of 5% growth and the BSP’s forecast of a 1% decrease.

This was mostly due to slackening demand for the country’s electronics and semiconductor products. The Semiconductors and Electronics Industries in the Philippines, a trade group of foreign and local semiconductor and electronics companies, announced an over 20% decrease in the exports of electronics for 2011 due in part to a sluggish global economy.

FUTURE PROSPECTS: Monetary authorities are clearly on the side of boosting economic growth and domestic output in 2012 after the economy grew by a slower 3.7% in 2011, down from 7.6% the previous year. In its overall assessment in January 2012, the Monetary Board noted that inflation pressures were likely to remain subdued given increasingly weaker global conditions.

The US has begun to show signs of a more solid recovery. However, the euro area economy is growing notably weaker amid continued uncertainties on how the bloc’s debt crisis will be resolved. Nevertheless, upside risks to the inflation outlook remain, with the main risks associated with sustained heavy capital inflows and the consequent rapid growth in domestic liquidity. Due to potential spikes in global oil prices as a result of renewed geopolitical tensions taking place in the Middle East and North Africa, regulators are keeping a close eye on the region as well.