How the BSP's Soft Peg will Contribute to the Weakening of the US Dollar-Philippine Peso Exchange Rate

 

Balance of payments crises are created in (soft) pegged arrangement because the monetary authority simultaneously targets both the exchange rate and interest rate and fails on both counts—Steve Hanke 

In this issue

How the BSP's Soft Peg will Contribute to the Weakening of the US Dollar-Philippine Peso Exchange Rate

I. Closing 2024: Major Interventions Boost the Philippine Peso and PSEi 30

II. A Brief History of the USDPHP's Soft Peg

III. USDPHP Peg: Tactical Policy Measures: Magnifying Systemic Risks

IV. The Cost of Cheap Dollars: Financing Challenges and Soaring External Debt

V. USDPHP Peg: The Other Consequences

How the BSP's Soft Peg will Contribute to the Weakening of the US Dollar-Philippine Peso Exchange Rate 

The Philippine peso mounted a strong rally in the last week of 2024, a hallmark of the BSP's defense of the USDPHP soft-peg regime. Why such policies would boost it past 60! 

I Closing 2024: Major Interventions Boost the Philippine Peso and PSEi 30

In the last week of December, I proposed in a tweet that the BSP and their "national team" cohorts might engage in "painting the tape" to boost Philippine asset prices during the final two trading sessions of the year.  

The BSP and their Philippine "national team" have 2 days left in 2024 to steepen Treasury markets, limit $USDPHP gains, and boost #PSEi30 returns after Friday's massive 5 minute pre-closing pump (correction: should have been Monday instead of Friday)

Figure 1 

This post turned out to be prescient. The "national team" apparently didn’t allow any major corrections on the PSEi 30 following Monday’s powerful 5-minute pump, subsequently, following it up with another two-day massive pre-closing rescue pump. (Figure 1, topmost charts)

However, the USD Philippine peso exchange rate (USDPHP) market exhibited even more prominent interventions. Despite the USD surging against 19 out of 28 pairs, based on Exante Data, the Philippine peso stood out by defying this trend, delivering the most outstanding return on December 26th. It was a mixed showing for the other ASEAN currencies. (Figure 1, middle table)

On that day too, the USDPHP traded at its lowest level from the opening and throughout the session, with depressed volatility—a clear indication of an intraday price ceiling set by the market maker, or possibly the BSP. (Figure 1, lowest graph)

By the last trading day of the year, the USDPHP weakened further, resulting in an impressive 1.64% decline over three trading sessions!

Figure 2

Notably, the Philippine peso emerged as the best-performing Asian currency during the final trading week of the year. Still, the USDPHP delivered a 4.47% return compared to the PSEi 30’s 1.22%. (Figure 2)

Figure 3

Over the past 12 years, the USDPHP has outperformed the PSEi 30 in 9 of them. Given its current momentum, this trend is likely to persist into 2025. (Figure 3, upper chart)

It is crucial to understand that such price interventions are not innocuous; they have lasting effects on the market and the broader economy.

II. A Brief History of the USDPHP's Soft Peg

The BSP employed a ‘soft peg’ or limited the rise of the USDPHP back in 2004-2005 (56.4 in 2004 and 56 in 2005).  (Figure 3, lower image)

Because of the relatively clean balance sheet following the post-Asian Crisis reforms, the BSP seemed successful—the peso rallied strongly from 2005 to 2007.

Despite the interim spike in the USDPHP during the Great Financial Crisis (GFC), it fell back to the 2007 low levels in 2013. This episode marked both the culmination of the strength of the Philippine peso and its reversal: the 12-year uptrend for the USDPHP.

Figure 4

Thanks to the expanded deployment of new tools called Other Reserve Assets (ORA), the BSP managed to generate substantial gains for the Philippine peso from 2018 to 2021. (Figure 4, upper window)

ORA includes financial derivatives (forwards, futures, swaps, and options), repos, and other short-term FX loans and assets.

However, this did not last, as the BSP launched a multi-pronged bailout of the banking system in response to the pandemic recession. The bailout comprised Php 2.3 trillion in injections (Quantitative Easing via Net claims on Central Government), aggressive RRR cuts, historic interest rate reductions, and various capital and regulatory relief measures, including subsidies. (Figure 4, lower diagram)

The USDPHP soared by about 5.4% from its 2004-2005 cap to reach the 59 level, marking the second series of its soft peg.

The USDPHP hit the 59 level four times in October 2022.

This second phase of USDPHP soft peg signified a part of the pandemic bailout measures.

Fast forward today, as the BSP maintained its implicit support via relatively elevated net claims on central government (NCoCG), the USDPHP’s 2023 countertrend rally was short-lived and rebounded through June 2024.

Promises of easy money from both the US Fed and the BSP sent a risk-on signal for global assets, including those in the Philippines sent the USDPHP tumbling to its low in September 2024.

Unfortunately, renewed signs of ‘tightening’ sent it re-testing the 59 levels three times in November-December 2024.

In short, despite recent interventions to maintain the 59 level, the numerous attempts to breach it signal the growing mismatch between the BSP’s soft peg and market forces.

III. USDPHP Peg: Tactical Policy Measures: Magnifying Systemic Risks

Yet, the BSP’s upper band limit signifies a subsidy on the USD or a price distortion that undervalues the USD while simultaneously overvaluing the peso.

This policy impacts the economy in several significant ways.

Widening Trade Deficit: First, the cap widens the trade deficit by making imports appear cheaper and exports more expensive. An artificial ceiling exacerbates imbalances stemming from the historical credit-financed savings-investment gap.

Figure 5

It is no surprise that the trade deficit hit its all-time high in the second half of 2022 as the BSP cap went into effect.

Meanwhile, in October 2024, the trade deficit reached its third highest on record, following the USDPHP run-up through June 2024 with a quasi-upper band limit of 58.8-58.9. The USDPHP hit the 59 level twice in October. (Figure 5, upper chart)

Reduced Tourism Competitiveness: Second, an artificially strong peso (due to the cap) could make the Philippines a more expensive destination for tourists. This could reduce the country’s competitiveness in the tourism sector, ultimately impacting tourism revenue negatively.

Resource Misallocation: Third, prolonged price distortions lead to resource misallocations. In the short term, an overvalued currency might fuel consumption-driven growth due to cheaper imports. However, businesses may over-import because of the cheap USD, while exporters face challenges, with some potentially shutting down, resulting in job losses.

Over time, this could lead to overinvestment in import-related and dependent sectors while underinvestment could spur declining competitiveness in exports and tourism-related industries. These represent only the first-order effects.

The intertemporal ripple effects extend through supply and demand chains, compounding the long-term economic impact.

Inflation Risks: Fourth, the policy could exacerbate domestic inflation. While one goal of the cap is to suppress rising import costs, dwindling reserves make defending the cap increasingly difficult. Once reserves are depleted, the risk of abrupt devaluation grows, potentially defeating the policy’s original purpose.

Reduced Foreign Direct Investment (FDI): Fifth, pricier peso assets and heightened inflation risks translate to higher ‘hurdle rates’ for Foreign Direct Investments (FDI). This diminishes competitiveness and results in slow or stagnant FDI inflows, hindering long-term economic growth. Since peaking in December 2021, FDI flows have been stagnating and have shown formative signs of a downtrend since falling most last September 2024. (Figure 5, lower graph)

Increased Market Volatility: Sixth, the artificial ceiling could inadvertently magnify market volatility. Although designed to maintain stability, the widening misalignment between the USDPHP and economic fundamentals may prompt speculative pressures. If markets perceive the cap as unsustainable, the result could be a destabilizing devaluation. 

Capital Flight and Financial Instability: Finally, the growing perception of an imminent, sharp devaluation might spur capital flight from prolonged price controls, increasing the risks of financial instability. 

The Long-Term Costs of Short-Term Policies: Tactical policy measures, such as an artificial cap, magnify risks over time. These stop-gap measures are not "free lunches." Instead, they increase economic inefficiencies, contribute to stagnation, and amplify systemic risks. 

IV. The Cost of Cheap Dollars: Financing Challenges and Soaring External Debt 

On top of that, there is the critical issue of financing. 

>By keeping the dollar artificially cheap, authorities ENCOURAGE USD debt accumulation. This policy may amplify medium- to long-term vulnerabilities, particularly in the face of rising global interest rates or a stronger dollar. 

>Depleting Reserves and Surging External Debt: The artificial ceiling requires substantial central bank intervention through the use of foreign reserves. However, prolonged interventions deplete these reserves and may compel the government to borrow externally to replenish them, thereby increasing public debt. 

Unsurprisingly, external debt soared in Q3 2024. 

What’s more, since the National Government’s (NG) net foreign currency deposits with the BSP include proceeds from the NG's issuance of ROP Global Bonds, external debt inflates the BSP’s Gross International Reserves (GIR).

Figure 6 

Still, the level and growth of Q3 external debt continue to outpace the GIR. (Figure 6, topmost image) 

As a side note, GIR fell by USD 2.6 billion to USD 108.5 billion last November.

>Increasing Refinancing and Liquidity Strains:

As I recently noted, 

rising external debt compounds the government’s predicament, as the lack of revenues necessitates repeated cycles of increased borrowing to fund gaps in the BSP-Banking system’s maturity transformation, creating a "synthetic US dollar short." (Prudent Investor, November 2024)

Increasing requirements for refinancing have only magnified the US dollar shortage, amplifying a race to borrow that heightens the risk of abrupt exchange rate adjustments or repayment shocks.

Additionally, banks (+34.14% YoY) and non-financial institutions (+5.5%) have also been ramping up their external debt. However, government borrowings (+18.7%) continue to outpace those of the private sector (in mil USD). (Figure 6, middle diagram) 

>Growing Short-Term Debt Concerns: Worse yet, while the BSP describes the present growth pace of external debt as "sustainable," short-term external debt has hit a record, and its share of the total has also expanded in Q3. (Figure 6, lowest window) 

The rapid rise in short-term debt is a symptom of mounting US "dollar shorts" or developing liquidity strains, which are likely to be magnified by the BSP’s caps. 

>Rising Debt Crisis Risk: Although one implicit objective of maintaining a USDPHP cap is to artificially lower the cost of debt servicing, the removal of this cap or an eventual devaluation could cause the cost of servicing foreign-denominated debt to skyrocket in local currency terms, potentially triggering a debt crisis. 

Figure 7

Eleven-month debt servicing costs have already hit a record (compared with same period and against the annual), partly due to the increasing share of foreign-denominated debt. Imagine where these costs would land if the USDPHP exchange rate breaches the 60 level!

V. USDPHP Peg: The Other Consequences

And that’s not all. 

The artificial peg may lead to additional consequences:

>Moral Hazard: Economic actors might engage in risky financial behavior, such as excessive USD borrowing, expecting government intervention to shield them from losses by perpetually maintaining a cheap dollar policy.

>Policy Tradeoffs: The BSP’s prioritization of exchange rate stability could worsen imbalances brought about by past and present monetary policy stances.

>Black Market Emergence: As USD supply becomes restricted due to prolonged interventions, a parallel or black market for the dollar may emerge.

>Social Inequality: The benefits of an artificially cheap dollar often skew toward wealthier individuals, who gain access to inexpensive foreign goods and international investment opportunities. In contrast, low-income households may face rising prices for basic goods—especially domestically produced ones—because local producers struggle with higher input costs or reduced competitiveness. 

>Economic Inequality: Moreover, such policies disproportionately favor certain groups, such as importers or holders of foreign currency-denominated assets (and related industries), and USD borrowers, at the expense of others, including exporters, local producers and savers.

>Trade Relations and Currency Manipulation Risks: A significant trade deficit driven by an undervalued dollar could strain trade relationships, potentially inviting retaliatory measures from trading partners or complicating trade negotiations. 

In extreme cases, accusations of "currency manipulation" could lead to sanctions by organizations such as the WTO. These sanctions might allow affected countries to impose tariffs on imports from the Philippines. 

All these factors point to one conclusion: the USDPHP is likely headed past 60 soon.

____

References

Prudent Investor US Dollar-Philippine Peso Retests Its All-Time High of 59, the BSP’s "Maginot Line": It’s Not About the Strong Dollar November 25, 2024

 

Supply Side Inflation? A Philippine Congressional Think Tank Warns of Runaway Inflation from Excessive Public Spending!

 

There has never occurred a hyperinflation in history which was not caused by a huge budget deficit of the state. Deficits amounting to 40 per cent or more of expenditures cannot be maintained. The examples of both Germany and Bolivia suggest that at least deficits of about 30 per cent or more of gross domestic product are not maintainable since they imply hyperinflation. In all cases of hyperinflation deficits amounting to more than 20 per cent of public expenditures are present—Peter Bernholz, Monetary Regimes and Inflation 

In this issue 

 

Supply Side Inflation? A Philippine Congressional Think Tank Warns of "Runaway Inflation" from Excessive Public Spending! 

I. Wow! Congressional Think Tank Warned of Runaway Inflation from Excessive Public Spending! 

II. How Public Spending Causes Inflation 

III. The Collateral Function of Public Debt 

IV. From Automatic Stabilizers to Fiscal Dominance  

V. Risks of Excessive Deficit Spending: Debt Crisis and Hyperinflation 

VI. Rising USD Share of Philippine Public Debt: "Rising USD Shorts" 

Supply Side Inflation? A Philippine Congressional Think Tank Warns of "Runaway Inflation" from Excessive Public Spending! 

 

A Congressional think tank has recently warned about "runaway inflation" from excessive public spending. Fiscal policy management from countercyclical to procyclical.  The rising USD "shorts." 

 

I. Wow! Congressional Think Tank Warned of "Runaway Inflation" from Excessive Public Spending!

 

Businessworld, September 28: A HOUSE of Representatives think tank has warned of runaway inflation if the government of President Ferdinand R. Marcos, Jr. fails to rein in spending. “Given the present level of inflation and the inflationary pressure accumulated in the past three years, the risks associated with maintaining a high public spending strategy are not insignificant and, perhaps more importantly, growing over time,” the Congressional Policy and Budget Research Department (CPBRD) said in a report this month. (bold added) 

 

Has the mainstream begun to admit to the inflationary repercussions of credit-financed deficit spending?   

 

Is the mainstream's narrative of supply-side "transitory" inflation falling apart? 

 

Are authorities also acknowledging the effects of diminishing returns on their fiscal tools?  Or are they running out of fiscal space? 

 

More… 

 

“The government constantly runs the risk of exacerbating inflationary pressures and, by extension, heightening the severity of economic contractions,” the CPBRD said. (bold added) 

 

Are they also admitting to the boom-bust cycles it creates? 

 

Only a few people openly acknowledge the inflationary impact of public/deficit spending, even when most economists know this.   

 

Since the mainstream embraces public/deficit spending as sacrosanct, political correctness demands conformity to this belief, hence its suppression. 

 

II. How Public Spending Causes Inflation

Figure 1 

 

Due to higher prices (from liquidity expansion), the rising trend of public revenues has mainly contributed to the present decline of the fiscal deficit (as of August). (Figure 1, topmost graph) 

 

This slowdown is about change once the economy fumbles. 

 

Even with revenues up, eight-month Treasury liquidity has been dropping.  As such, Treasury borrowings have picked up.  (Figure 1, middle chart) 

 

Deficit spending is not inflationary when funded solely by taxes.  However, since the capacity to tax is constrained, this implies innate spending limits. But that won't fit well with a populist government. 

 

Budget gaps are inflationary when funded by credit and money creation from the central bank (BSP) and the banks.   

 

Credit expansion unbacked by savings increases demand relative to supply.   

 

The long-term trend of public spending has resonated with the CPI. (Figure 1, lowest diagram) 

 

Let us use the rice industry as an example.  

 

The BSP can print money, while banks can issue credit, but both can't print rice.  Many other factors determine rice production than cheap money, such as protectionism, controlled markets, weather, productivity, farming lands, irrigation, fertilizers, returns, farmer’s income, etc. 

 

Meanwhile, increases in public spending benefit public agencies and private sector entities directly and indirectly involved with the bureaucracy and their political projects (e.g., PPPs) by expanding their demand.   

 

Or demand (for rice) from the public sector increases faster than the supply of rice.  

 

The consequential imbalances lead to tight supply and higher prices, which the government responds with price controls and even more deficit spending via subsidies.   

 

Because bailouts are integral to public spending, the recent path-dependent policy response is a byproduct or a legacy of the BSP's easy money policies.  

 

Or authorities throw money at social problems because they think financial repression (inflation tax) would accommodate it. 

 

Recently, the government has splurged on bailouts.  It has authorized billions in subsidies for farmers and sari-sari store owners affected by the rice price caps.  It also has provided grants to the transport sector affected by higher energy prices (Php 4 billion fuel subsidies).    

 

Therefore, the government's mechanical demand-based solution exacerbates supply imbalances.  

 

Besides, public spending, representing transfers, consumes people's savings.   

 

So, this vicious cycle progresses.  

 

III. The Collateral Function of Public Debt 

 

Public spending is not the only reason for the issuance of public debt.  

Figure 2 

 

Public debt has a collateral function, which banks use to obtain financing from the BSP.    

 

In essence, the BSP uses government securities (including its own BSP Securities Bill) as part of its monetary operations to provide liquidity to or withdraw liquidity from the financial system.   

 

Since its introduction, BSP Bills Payable in the BSP’s balance sheet have exploded and grabbed a substantial share of the volume of the fixed-income security markets traded at the PDS. (Figure 2) 

 

Figure 3 

 

Applied to the present, banks have recently taken over in providing liquidity to the government and financial system. 

 

The banking system's Net claims on Central Government (NCoCG) are close to their historic high even while the BSP's NCoCG has slowed (as of August). (Figure 3, topmost window) 

 

And so, while the BSP is supposedly "tightening" by raising rates, banks continue to amass public debt, providing liquidity to the government and financial system.  The chart reveals the incredible record monetization of government debt by banks. (Figure 3, middle graph) 

 

In the meantime, Treasury securities are used as collateral by banks when borrowing or obtaining finance from the BSP.  

 

Further, as the government issues even more debt, this requires more currency issuance to accommodate it.  M3 has supported public spending growth through the years. (Figure 3, lowest chart) 

 

The government benefits from "seignorage," paying bondholders with depreciated currency (Financial repression/inflation tax).  

 

Hence, because the easy money regime functions as a free lunch, government indulges in a spending orgy, which benefits banks too. 

 

IV. From Automatic Stabilizers to Fiscal Dominance  

Figure 4 

 

In the past, contemporary governments used the Keynesian framework of countercyclical policy of deficit spending as an "automatic stabilizer" tool.  Authorities embark on public works when aggregate demand slows, evidenced by high unemployment or slowing or contracting growth.   But when growth resumes and accelerates, they raise taxes to control inflation and moderate growth.   

 

But things change.   

 

In the recent past, with the idea that rising inflation is a "transitory" phenomenon, governments have become addicted to it.  Governments have leaned on pro-cyclical policies. 

 

Deficit spending became a primary policy of GDP management irrespective of conditions.    

 

This dynamic applies here too.  

 

As it is, the government previously depended on the BSP's monetary policies of low rates to provide nominal spending growth and, therefore, tax revenue growth. At the same time, the BSP uses the same money tools to manage inflation. 

 

The embedded assumption is that the economy is like a car, which can be accelerated or decelerated by its driver (the government & the BSP). 

 

This dynamic is especially relevant today as the stabilizing function of the government budget has transformed into "fiscal dominance."   The US deficit is an example. (Figure 4) 

 

The "ratchet phenomenon" syndrome has also afflicted governments. Authorities have used recent crises to justify further expansion of control and power through the fiscal channel. 

 

The popularity of the expanded powers of government has increased during the crisis.  It seems to have been supported by a psychological and ideological shift.  Increased feelings of vulnerability made people seek comfort in expanded political control. 

 

More importantly, the underlying behavioral structure could not revert to the status quo ante because the events of the crisis created new understandings of and convictions about the potentialities, workings, dangers, and desirabilities of governmental action; that is, each crisis altered the prevailing ideological climate. Though the postcrisis economy and society might, at least for a while, appear to have returned to precrisis conditions, this appearance disguised the underlying reality. In the minds and hearts of the people who had passed through the crisis and experienced the expanded governmental powers—that is, at the ultimate source of behavioral response to future exigencies—the underlying structure had indeed changed. (Robert Higgs, 1985) [bold added] 

 

Stockholm’s Syndrome?

In this context, governments increasingly have used deficit spending to centralize the economy, which means that the executive branch has taken control of policies from the central banks—as the latter has been tightening. 

 

And with the likelihood of a deepening economic downturn, which magnifies the risks of a crisis, the deficits should reaccelerate from their recent deceleration.   Deficits would soar from a revenue slump and a further spike in government spending (bailouts, fiscal transfers, "stimulus" via public works, etc.). 

 

This dynamic should apply to the Philippine political-economic setting as well.  

 

V. Risks of Excessive Deficit Spending: Debt Crisis and Hyperinflation 

 

One risk of excessive government spending is that creditors lose faith in the ability of governments to redeem their liabilities.   A "sudden stop," where creditors pull back, usually results in a debt crisis. 

 

Another risk is that when access to credit has vanished, governments increasingly depend on their central bank's printing press, leading to hyperinflation.  

 

Some governments might be crazy enough to use this to extinguish their debt. 

 

When assessing the debt burden, the rate of price inflation constitutes an important factor. Price inflation devalues outstanding debt. This happens in a creeping way when inflation rates are low and in a dramatic way when inflation rates are high. In the case of hyperinflation when ordinary goods of daily consumption fetch prices in the billions or trillions even a gargantuan public debt would evaporate. However, a deliberate fabrication of hyperinflation in order to get rid of the debt burden can hardly count as a rational strategy. Such a policy would come at the price of wreaking havoc with the economy as a whole. (Mueller, 2012) 

 

"Runaway inflation" is a path to or another word for hyperinflation. 

 

Except for the think tank above, the mainstream crowd usually ignores such risks.   

 

They have come to believe that public spending can only result in positive outcomes while the impact of debt is neutral.   

 

Again, such mindsets signify inflationary psychology borne of the programming from decades of the easy money regime.  

 

But that’s about to change too.  

 

VI. Rising USD Share of Philippine Public Debt: "Rising USD Shorts" 

Figure 5 

 

For instance, the outgrowth of foreign debt has increased its share of the total Philippine debt stock since Q1 2021 (as of August 2023).   (Figure 5, upper chart) 

 

While the frail peso may partially be responsible for its increase, a build-up of foreign-denominated debt has resulted in most increases.  Media reported that the Philippine government "secured $32.40 billion worth of loans and grants in 2022." 

 

The increase in foreign debt to fulfill near-term economic or financial requirements (say, support the peso or finance trade deficit or for BSP’s GIR management) translates to a "short USD position."   

 

"Short" implies funding mismatches. 

 

Such imbalance occurs when organic financing is inadequate to meet the maturing liabilities.   In this case, increased borrowing is used to refinance existing liabilities.  In short, shades of Ponzi finance, debt piles up on the mountain of existing debt, along with the mismatches.  

 

Once you create those “dollar” assets, you are on the hook for funding them, in “dollars”, until they are disposed of – voluntarily or not. (Jeffrey Snider, 2018) 

 

Should the peso continue to weaken, the economy would have to export more to meet its FX obligations. Otherwise, this puts further pressure on the currency—a feedback loop.  

 

This widening mismatch increases the nation's vulnerability to a currency or external debt crisis.   

 

Yet, a global USD shortage would make borrowing and refinancing costlier, exert further strains on the peso (as the BSP drains its reserves), and aggravate such risk conditions. 

 

As a side note, since 2018, "other reserve assets" (ORA) (Financial derivatives, repos, etc.) have comprised a substantial segment of the BSP's Gross International Reserve (GIR) according to the IMF's International Reserves and Foreign Currency Liquidity (IRFCL).  ORA accounted for 8.11% of the GIR as of August 2023. (Figure 5, lower window) 

 

Rising FX rates mean the costlier use of ORA to manage the GIRs, which is one possible reason its use has declined. 

 

In the end, the law of scarcity means that the Philippines is not immune to the risks emanating from excessive deficit spending.   

 

Along with the think tank's caution, with the temptation to exercise "fiscal dominance," risks should only accelerate.  

 

___ 

References 

 

Robert Higgs, Crisis, Bigger Government, and Ideological Change Independent Institute January 1, 1985 

 

Antony P. Mueller, The Economics of the Fiscal Cliff Financial Sense.com November 8, 2012 

 

Jeffrey P Snider, Some First Principles Of A ‘Dollar Short’ Alhambra Investments, April 16, 2018