While I was browsing the cable over the weekend, I happen to watch Prof. Diokno being interviewed by Joey Lina over the DZMM channel. Prof. Diokno enumerated some measures to take so that the Philippines can cope up with the current global financial crisis. One of the proposal is to set the exchange rate to around Php56:US$, and keep it there. This is targeted for OFWs who will be sending remittances so that their money can buy more. While this is a noteworthy proposition, BSP has already made a position regarding fixed exchange rate on their publication, dated June 2008.
Under a system of fixed exchange rate, the central bank commits to sell or buy any amount of foreign currency demanded in excess of what can be supplied by the market or offered for sale in excess of what is demanded, to keep the official exchange rate at a certain level.
For a small open economy such as the Philippines, large capital flows can occur at any time. In times of massive dollar inflows, the monetary authorities must buy the excess dollars to keep the foreign exchange at the desired level. In so doing, reserves are accumulated but pesos are released into the system from which inflationary pressures could result. Siphoning off excess pesos for example (through the sale of government securities in the BSP’s portfolio) could entail substantial cost to the BSP in terms of the difference between the cost of borrowing to pay for the dollar purchases and the return to the BSP on the foreign exchange purchases. Apart from the fiscal costs of sterilization, the sale of government securities is likely to push up interest rates and attract additional foreign capital inflows into the economy.
On the other hand, in times of massive dollar outflows, monetary authorities must sell dollars to accommodate any excess demand. In so doing, reserves are drawn down. If the massive outflow is sustained, reserves will diminish. Before this happens, the central bank is forced to reset the official exchange rate, often opening itself to exchange losses. Thus, fixing the exchange rate places a heavy
burden on monetary authorities in terms of reserve and liquidity management.
Moreover, occasional, large fluctuations—typical of a fixed exchange rate system—are more costly, destabilizing and disruptive to the economy than the more frequent but more gradual changes that may occur in a free float system.
On the other hand, a dual or multiple exchange rate system is discriminatory and distorts resource allocation. If the government sets a high rate for exporters and OFs, it will have to subsidize the difference between market rates and the fixed higher rate. However, this is not feasible since government revenues are not yet sufficient to cover our annual budget. On the other hand, private banks will not be willing to do this as it will incur losses in the process of paying higher than prevailing market exchange rates.
My twenty five cents: BSP should intervene only to manage fluctuations but not to set the exchange rate. The poor will be jeopardized more with the resulting increase in inflation due to abnormal level of money supply. BSP’s reserves will then be depleted, and our forex obligation will be greatly affected. Remember that we are on a automatic debt servicing which means for every budget cycle we automatically pay our debt to international lenders.
We can look at other strategies, such as job creation to accomodate displaced workers abroad, increase in social spending so that people can save their money on other expenses. Fixing exchange rate for me is too dangerous to do.
So there goes my twenty five cents. What about you? What’s your twenty five cents on this issue?
