Friday, September 09, 2005

Foreign exchange instability

From yesterday's Business World (excerpts):

Contagion from Indonesia feared; BSP cites inflation threat

SINGAPORE/MANILA -- Southeast Asian central banks are expected to raise interest rates more aggressively to pre-empt any contagion from spilling over from Indonesia and roiling their markets.

Countries such as the Philippines, Thailand and even larger economies such as India are vulnerable to speculative attacks unless they bump up rates and cut fuel subsidies, analysts yesterday said.

The comments reflect a growing uneasiness in markets that Southeast Asian central banks have been too passive in dealing with rising inflation expectations, the main spark for last week’s turmoil in Indonesia’s markets.

The Bangko Sentral ng Pilipinas (BSP), which raised rates in April for the first time in nearly two years, should raise them further to defend the peso, the Bank of Tokyo-Mitsubishi said.


After the rupiah, the Indian rupee and the peso have been Asia’s worst-performing currencies in the third quarter, reflecting market concern about the impact of soaring oil prices.

Philippine inflation has been running above the central bank’s target rate since August 2004, providing ample grounds for higher rates, Bank of Tokyo-Mitsubishi said.

"We could not help but notice the similarities between the Indonesian rupiah and the Philippine peso, such as a severely impaired fiscal balance sheet, a weak external trade position, policy inertia and modest foreign reserves," it said.

"Given the precedence set by the rupiah’s experience, we remain bearish on the outlook for the Philippine peso."

Something to watch out for: currency movements. The Indonesian rupiah has sunk to four year lows, and some analysts are warning of a contagion effect.

As usual speculative "hot money" has been blamed. However this speculative money is pouncing on real weaknesses. In the case of Indonesia, its inability to dismantle fuel price subsidies has further strained government finances. (At least we got the Oil Price Stabilization Fund albatross off our necks, years ago.)

How bad is a speculative attack on the currency? It is easy to overblow the problem. Hot money outflows imply that short-term financial investments are relatively less attractive at the same interest rate. Eventually expectations about currency movement should stabilize (and so should the currency itself). Inflationary pressures are unavoidable, but these represent one-off changes in the domestic price level in slow motion, as it were. On the other hand tightening domestic credit during an economic slowdown may not be such a good idea. A Central Bank which does a "dirty float" faces perrenial problems in balancing domestic objectives with the targeted exchange rate. Moreover if the domestic costs (of tight money) are deemed too high as to be unsustainable, the dirty float may perversely spawn speculative pressure on the currency. Finally a cheaper peso (superstitiously thought by some to be ipso facto bad for the economy) is a boost to exports. Some economists think that a cheap currency is an essential component of an export-oriented industrial policy - China's undervalued yuan is an oft-cited case. If so, speculators may be doing the Trade Secretary's job for him. And without the onus of "beggar-thy-neighbor" resentment - such as what China is getting from the US.


f said...

excellent post. central banks can really do only one thing either it chooses to stabilize the currency or manage inflation. it can't do both. if it tries to do both just ends up messing things up.

cant understand the business media's pointing out "worst-performing" currencies as if we still live in the era of mercantilism.

Econblogger said...

Thanks. I'm a bit worried about interest rates going up, simply because of a (misguided) effort to smoothen exchange rate fluctuations. Hope the BSP keeps to the straight and narrow on its announced "inflation-targeting" stance.

Anonymous said...

I've been thinking for a long time about the effects of continued depreciation. Is it good or bad?
Theoretically, this should boost exports as the peso becomes cheaper. Does anybody have any data that shows whether or not this really happens?

Econblogger said...

Check out this article:

Bahmani-Oskooee, M. and O. Kara. (2003) “Relative Responsiveness of Trade Flows to a Change
Prices and Exchange Rate,” International Review of Applied Economics 17, 293-308.

Abstract is available here.

Evidence is ambiguous. Off-the-cuff, I think we should be looking not only at exports but net factor income from abroad. I am sure depreciation and the surge in NFIA in the Philippines is related.