Philippines struggles to weaken peso as capital flows increase

The country’s central bank faces a dilemma over how to stem the appreciating peso, with its latest rate cut having done little to deter capital inflows from foreign investors.

  • 07 Aug 2012
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The Bangko Sentral ng Pilipinas (BSP) is looking to halt the appreciating peso as foreign investor appetite continues to drive the Philippines peso higher against the US dollar.

The peso is the strongest performing currency in Southeast Asia year-to-date. At the time of going to press it stood at around PHP41.8 to the US dollar, up from its year to date low of PHP43.98 at the end of May.

The currency’s rise is in part due to foreign investor demand for local assets. In an attempt to forestall this and weaken the currency the central bank cut its policy interest rate by 25 basis points (bp) to 3.75% on July 26.

However, a sovereign bond auction on July 31 revealed that the cut had done little to dampen investor appetite for the local-currency debt. The 10-year bond was over three times oversubscribed, with PHP31.41 billion (US$749.7 million) worth of demand for the PHP9 billion offered. The bond’s coupon is 4.875%.

“The rate cut last week may have been aimed at reducing the interest rate premium on a possible carry trade for the peso, so in some ways they are trying to reduce the attractiveness of the currency. But on a structural level, there remains fundamental demand for the Philippine peso,” said Philip McNicholas, primary analyst for the Philippines at Fitch Ratings.

Central bank governor Amando Tetangco told local press that the BSP is evaluating additional measures to address capital inflows and halt the strengthening currency.

Market commentators suggest that he would be wise to do so, as traditional measures used to clear excess liquidity in the system are becoming saturated. These include reserve repurchase agreements, selling of government debt and the special deposit accounts (SDA), where local banks can invest their excess cash for a good yield.

The SDA constitutes 67% of total central bank deposits and according to Vaninder Singh, economist at RBS, the interest cost stands at more than PHP65 billion per year. Last month, the BSP was forced to set limits on the SDA, as it was having a negative effect on the central bank’s finances. It ruled that banks could no longer deposit funds owned by foreign clients into the deposit account, as foreign funds were using it as a stable, risk-free investment.

“These measures are starting to reach their limit. The SDA is starting to become costly, [the BSP is] having to pay a lot of interest just to keep it going, so they need to come up with new measures going forward. The idea is that when they reduce the policy rate, investors who are investing to get yield will be deterred, but I don’t think this will be hugely effective,” said a Philippine economist at a global bank.

Favourable fundamentals

The dilemma is unique, as inflows into the capital markets of other countries in the region remain choppy.

According to experts, this is due to strong macroeconomic fundamentals in the Philippines. The country’s current account surplus is underpinned by foreign worker remittances, which stand at around 9%-10% of GDP, as well as net foreign direct investment (FDI) inflows into the country that further support demand for the peso.

In addition, the Philippines does not possess strong capital controls, making it a more attractive investment opportunity for international investors than some other countries in the region.

“[The Philippines] does not have strong capital controls like India, which has made the country a very appealing destination for investors. The yield is pretty good compared to what you will get anywhere else and the country is on track towards investment grade. [Also] the currency is the strongest performer year-to-date among its Asian peers. Investors believe that this is a self fulfilling prophecy,” said the Philippine economist.

In addition, McNicholas notes that the country’s capital markets are relatively small and easily saturated by foreign investor flows.

“While the Philippines may not necessarily account for a large share of foreign investor's portfolios, there appears to be growing interest in the market for the Philippines assets, and that’s boosting the balance of payments (BoP) surplus and applying appreciation pressure on the currency,” he said.

Stabilising the peso

The BSP must step up its efforts to sterilise capital inflows or risk hurting export trade as well as encouraging the possibility of an asset market bubble, according to Vaninder Singh, economist at RBS.

“Given the emerging difficulties in sterilising flows, can the BSP abandon or reduce its efforts and allow the extra liquidity to enter the economy? Unlikely,” he said.

He argues that increased capital controls are unlikely, as the BSP appears keen to maintain the country’s status as an investment destination, but that the central bank could likely raise the reserve requirement ratio (RRR) for local banks.

“This measure is essentially a free way for the BSP to drain liquidity. Raising the reserve requirement would be especially effective as banks currently do not hold much in terms of excess reserves over what has been mandated by regulations. However, it is important to understand that changing the required reserves is like using a hammer compared to the fine chisel of the policy rate,” he said.

Because of this, he expects that the RRR requirement will be adjusted only once before the end of the year.

  • 07 Aug 2012

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