Gus Cosio says so

Ideas on the Philippine Stock Market

Philippine Monetary Policy

I would like to share this analysis of current monetary conditions in the Philippines.  It was written and sent to me by Dr. Victor A. Abola Ph.D. of the University of Asia & the Pacific.  It is my view that domestic interest rates wont be rising for around a year.  I think this note from my friend will bear me out.  Unfortunately, I could not upload the inflation chart.  Just try to visualize it from the numbers.


G7 central bankers, meeting at Jackson Hole late last month, rejected putting in place an “exit strategy” asked by some inflation hawks who fret about huge fiscal deficits and easy money being implemented by governments worldwide. They actually warned of too early “tightening” as the recent economic recovery remains weak and unlikely to be self-sustaining, and the threat of deflation still lurking.

Our own BSP stopped the policy rate cuts at 4% in its last meeting on August 20th, and more recently, the BSP Governor Amando Tetangco has described this policy as “appropriate”: asserting that “As the inflation outlook continues to be manageable, policy settings remain appropriate at this time.  Nevertheless, we will be watchful of local and global developments and effects that had not been earlier factored into our models and assessments.  We will then make adjustments to our policy stance as and when necessary.”

But if we look more closely at inflation and money measures, there seems to be some signs even of “tightening”.  Is a neutral stance appropriate given the “extraordinary” situation we find ourselves in, or if true, is a money tightening this early in the game the right move?

Recent Inflation Easing

Most recent headline inflation readings are showing 22-year lows, with back-to-back 0.2% and 0.1% (year-on-year) in July and August at near zero.  To be sure, despite the sharp recovery of crude oil of prices since March 2009, West Texas Intermediate (WTI) crude oil prices in August were down by 52.2% %.  And so most analysts attribute the latest plunge in inflation rates as primarily due to base effects, i.e., the base (last year) was extraordinarily high up to September 2008 due to record crude oil prices, and nearly 50% jump in rice prices.

A look into the inflation picture from another vantage point could tell us a different story. This is to analyze the inflation rates on a monthly basis, but adjusting for seasonal factors and annualizing the rate (i.e., seasonally adjusted, annualized rate, or SAAR), as is done by advanced countries, especially, the United States.  Below we show the graph of YOY and SAAR inflation rates, and we readily notice that the SAAR rates have been negative from May to July, and only a tad positive in August.  If we average the monthly inflation readings on SAAR basis, for the first eight months, it only comes to 1.9%, certainly below the lower band of BSP’s inflation target of 3% to 5%.  It must pointed also that in three of the last four months the inflation SAAR was negative.  These indicate the lack of inflationary pressures up to now.

Any Inflationary Pressures to Guard Against?

While there are no current inflationary threats, shouldn’t we be concerned that these may arise starting next year, particularly from oil prices, food prices, and overall inflation in advanced countries?  After all, they have combined easier monetary policy (near zero policy rates in U.S., Euroland, and Japan) and huge fiscal deficits to get back their economies into a self-sustaining growth mode.  We tackle the issue by looking at both the aggregate demand and supply sides of the economy.

On the demand side, the growth of RP GDP for the first half of the year was 1.0% over a year ago, way below the 5% recent trend that the Philippine has been showing in the New Millennium.   We do expect a bit of acceleration in the second semester, due to improved economic conditions abroad, especially in East Asia, and early election spending by candidates.  But even this would at best bring us to half of the growth trend on a full-year basis.

A possible source of excess demand could come from elevated money growth.  We take a quick look in the graph which shows year-on-year growth of M2 (currency in circulation plus demand deposits or M1 + savings and time deposits) and M3 (total domestic liquidity or M2+ deposit substitutes).  These two broader measures of money differ very little and so their growth rates are quite similar.  What the data and graph show is that.  Thus, while the BSP managed to boost M2 and M3 growth from October 2008 to January 2009, their growth  has been decelerating since January 2009

Supply Side Factors

On the supply side, we shall focus on forecasts of crude oil prices, rice prices, and the exchange rate pass-through (ERPT) of peso depreciation to the inflation rate.

It is undeniable that crude oil prices have more than doubled from the low of $32.40/barrel in December 2008.  However, it has remained in the $65/barrel to $73/barrel range in the past three months, which are the heavy car driving months in the U.S.  Demand has remained anemic, reflecting the expected weakness of the economic recovery in the U.S. And other advanced countries (see IMF revised forecasts in table 1)

For 2010, the momentum towards a more normal uptick after a recession is also deemed unlikely, given that the peak of the unemployment rate is still expected in the second quarter of next year.  This, and the large excess capacity of OPEC, has led the U.S. Department of Energy’s EIA to forecast an average growth in WTI crude oil prices by some 20%.  The effect of a 10% rise in international crude prices is an additional 0.5% in the inflation rate.  Thus, we may expect an incremental 1.0% in consumer prices from this source.

What about rice prices?  Is an El Nino likely?  Let us not even considering  local production which should actually be better given the increase in government spending on seed credits, irrigation, farm to market roads, and storage facilities.  We can focus on Thai rice prices in accordance with IMF forecasts.  Due to the strongly positive response of Thai, Burmese, and Cambodian farmers to the higher prices of rice, the IMF sees a further slide in these prices from 2008’s average by 26% this year and by another 9% in 2010’s.  To be sure, it more than doubled in 2008, but consumers and governments have adjusted to higher rice prices.  We can, thus, rule out any supply side pressure on inflation from this source.

Finally, we tackle the exchange rate pass through (ERPT) of a peso depreciation.  Our model sees a 4% depreciation in 2010.  What is the overall inflation impact of this?  Before anything, should note the ERPT has fallen from 30% to 35% in the pre-1993 period to o 8% to 15% in post-foreign exchange liberalization era.  On the average then, the peso depreciation in 2010 may push up the inflation rate by 0.5% , which is fairly tame.

In short, we don’t see aggregate demand getting back to its trend by 2010, and while the supply factors may contribute an added 1.5% to the inflation rate, the two together should mean only a 1.0% to 1.2% acceleration in the inflation rate in 2010. Assuming that the average inflation rate for 2009 settles at 3.0%, then for next year prices may rise by 4.2% at most.  This is in lower part of BSP’s target range of 3.5% to 5.5%.

Can the BSP Afford to Loosen Further?

Given that the inflation target is fairly easy to achieve even at the lower side, can the BSP afford to lower interest rates further in order to provide a further boost to the economy.  We first recall that these targets are compatible with the projected 1.4% and 3.0% GDP growth (mid-range) for 2009 and 2010.  Should we be content with those projections?  Are we not under extraordinary conditions so as to warrant a bit more of aggressiveness?  Actually, with slightly easier monetary policy we can achieve a 2.5% and 4% GDP expansion this year and next with minimal inflationary impact.  After all, there is a lot of excess capacity and unemployment in the economy.  Besides, as of 2006, 27 million Filipinos were below the poverty line, and an additional 2 million is likely to have been added since the Great Recession set in.  These figures are staggering and no Filipino can shrug off his shoulders and say “I can’t do anything about it.”

However, to achieve higher growth, we need to let interest rates drop below present levels and allow the peso to depreciate a little.  In our model, peso OFW remittances play an important role in nudging the economy to a faster pace, through their impact on consumption and residential property spending.  It should be noted that a peso increase in OFW remittances translates to a P2.50 rise in incomes as our input-output analysis would indicate. Thus, an additional peso depreciation from now would eventually mean an additional 0.6% rise in GDP.

If we compare domestic interest rates with the region and the U.S., we will find that our real interest rates both at the short end and the long end of the curve are higher.  There is, there no compelling reason why we shouldn’t allow local rates to fall further.

Decelerating Money Growth and Rising SDAs

A further drop in interest rates will not be possible unless the BSP tries to rev up money growth.  Unfortunately, despite the policy rate cuts over the last 18 months, the reality is that total liquidity M3 y-o-y growth has been decelerating since January 2009.  From a 16.3% rise in January, it has slowed down to 12.9% by July.  More telling is the sharper slide in lending to the private sector for the same period from 18.3% to 11.3%.  Month-on-month growth on a seasonally adjusted annualized rate (SAAR) basis would also show that for the first seven months of the year, M3 growth was averaging 10.7%. This can hardly qualify as “expansionary” or “stimulative”.

Are banks simply not lending?  Or is BSP actually tightening money creation?  If we look at the BSP’s net domestic assets (part of its Reserve Money), it shows a steady negative increase for the same period.  In January 2009, it was -P866.3B and by June -P949.2 B.  In short, BSP was taking away liquidity from the banking system during the period, as attested to also by the low 1.8% growth (y-o-y) in Reserve Money by June 2009.

This was being carried out at two fronts.  Reverse Repurchase Agreements took out liquidity by P137 B from January to June 2009.  Similar moves were being done through Special Deposit Accounts which rose by P59 B for the same period.  In terms of totals for these two liquidity-draining mechanisms, pulled out some $195 B out of the banking system for the same period covered.  Advanced figures up to August 14th would show that more money was siphoned off from the banking system since June, as the total of the two operations reached P906.3 B or another P46.5 B.

Liquidity Mopping Measures of BSP (Jan-Aug 2009)

In Billion Pesos

Tightening Tools

Jan 2009

June 2009

Mid-Aug 2009

Reverse Repos




Special Deposit Accounts








Source:  BSP

The BSP’s moves of mopping up liquidity have somehow offset its earlier “easier monetary policy” stance, and have unwittingly stunted a deeper development of capital markets.  With so much money hoarded in BSP vaults, the National Government and corporate bond issuers have had to pay higher interest rates on their debt issues.  These are needed to fund vital infrastructure and energy projects which would contribute to greater productivity for the economy.  More money for the corporate bond market would also spur a faster development of that market so as to cushion possible future upheavals. Besides, lower interest rates would depress the monthly amortization of housing loans thus, spurring much-needed for residential housing.

Finally, Dominique Strauss Kahn, Managing Director of the International Monetary Fund stresses that a “premature exit from accommodative monetary and fiscal policies is a principal concern.” He warned of a “third phase of this crisis, following on the heels of the financial and economic phases, namely, high unemployment.” (FT, Sept. 5-6, 2009, 2)

Given all these, perhaps the BSP should reconsider its present “pause policy” to allow more money and credit growth precisely at a time when a combination of monetary and fiscal policies are needed to spur the struggling economy?

September 15, 2009 - Posted by | Financial markets in Asia

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