Yearender: Monetary authorities faced difficult challenges in 2008

From the start of the year, central bank officials knew that 2008 was not going to be an easy year.

Abroad, financial markets were already reeling from the developing crisis in the US subprime market – more and more homeowners were defaulting on their mortgages and the financial derivatives that these mortgages were supporting had started to turn sour.

Moreover, oil prices were skyrocketing to record levels, cushioned only by the strength of the peso against the dollar which, in January, was trading at P40 to P41 to the greenback.

Early in the year, the inflation rate had soared to its highest level in 15 months, with the increase in the prices of basic commodities speeding up to 4.9 percent compared with 2007 price increases.

But no matter how ominous the signs were, no one expected how bad and chaotic things were about to become, with the entire global financial architecture actually shaking from its foundations.

In 2007, foreign portfolio investments surged by 35 percent, reaching $3.5 billion as investors flooded the equities market despite lingering worries over the aftermath of the crisis in the US debt market.

By January, however, inflows had weakened significantly as investors pulled their funds out of emerging markets and by June, fears had turned to panic and the Bangko Sentral ng Pilipinas (BSP) recorded a net outflow in portfolio investments of over $410 million for the first half of the year.

BSP Governor Amando M. Tetangco Jr. said the continued uptrend of oil and other commodity prices, the slowdown in economic growth and reports of mixed corporate earnings results in the first quarter, as well as the weakening of the peso fuelled negative investor sentiment during the period. 

As early as May, the BSP finally conceded its 2008 and 2009 inflation target, prompting a 25-point increase in the key policy rates of the BSP as officials projected the inflation rate to reach seven to nine percent in 2008 and four to six percent in 2009.

It was the first time the BSP admitted that inflation rate would miss both the 2008 and 2009 target set at three to five percent and 2.5 to 4.5 percent, respectively.

Missing the 2009 target indicated that the 25-point hike was not to be the last as the BSP grappled with rising commodity prices and the consequent adjustments in transport and wage rates.

June’s action raised the overnight borrowing or reverse repurchase rate to 5.25 percent and the overnight lending or repurchase rate to 7.25 percent.

Projecting more dramatic increases in the inflation rate as a result of high oil prices, the central bank surprised the market by raising its key policy rates by another 50 basis points in July after it revised its projected inflation yet again.

The Monetary Board raised its overnight borrowing rate to 5.75 percent and its overnight lending rate to 7.75 percent.

“Inflation control is the foremost priority of the BSP,” Tetangco said. “The MB noted that concurrent and interrelated shocks to the economy have contributed to elevated inflation readings.”

According to Tetangco, the BSP also noted second-round effects had set in, indicated by the rise in core inflation. “Our baseline forecasts show the risk of inflation exceeding the inflation targets for 2008 and 2009,” he added.

The BSP struggled to contain inflationary expectations with the 50-point adjustment in July, but monetary officials also came under fire for being behind the curve and failing to appreciate the shifting conditions on time.

True enough, the inflation rate continued to surge to its highest level in 17 years, reaching 12.5 percent in August because of high oil prices and the consequent adjustment in transport costs.

When the Monetary Board conducted its policy meeting in August, it decided on another 25-point hike in its key policy rates, saying that further tightening was made necessary by the persistent volatility of oil prices.

The Monetary Board raised the overnight borrowing or reverse repurchase rate to six percent while the overnight lending or repurchase rate would go up to eight percent.

“In its assessment, the Monetary Board recognized that further measured tightening of monetary policy was necessary given the latest forecasts indicating above-target inflation for both 2008 and 2009,” Tetangco said.

“Monetary policy needed to be appropriately tight to stabilize inflation to within the target range over the policy horizon and to help manage inflation expectations,” he said.

The BSP had expressed fears that the increase in oil prices would trigger a price-wage spiral where wages would have to be increased to adjust to rising costs and this, in turn would trigger another round of inflation rate hikes that would negate the impact of wage adjustments.

At about this time, however, the world was beginning to get a clearer picture of exactly how big its problem was going to be. In the US, financial giant Lehman Brothers crashed, followed by JP Morgan and Washington Mutual. US housing mortgage giants Freddie Mac and Fannie Mae followed.

The impact of the meltdown in the US financial market was expected to be muted, at least in the beginning, but still, at least six Philippine banks were immediately affected by the crash, with direct exposures of up to P17 billion.

The total exposure of banks in assets that were hit by the US crisis amounted to roughly P60 billion, but central bank authorities assured this was well within the capacity of the industry to handle.

The BSP went on “high alert”, monitoring banks on a daily basis to establish their total exposure to the on-going crisis in the US.

BSP Deputy Governor Ernesto Espenilla told reporters in September that “the exposure is actually very limited and well within the capacity of the industry,” Espenilla said. “More importantly, no single bank is heavily exposed.”

Towards the final quarter of the year, oil prices started to ease as recession started to grip developed markets where demand for oil declined dramatically.

Falling oil prices, together with the drop in food prices, triggered a corresponding drop in domestic commodity prices and the inflation rate also started coming down, falling back to single-digit levels in November – much earlier than the BSP expected.

But the BSP was then faced with another problem, anticipating tight liquidity in the market as a result of the market panic that made banks reluctant to move their funds around.

The market was expecting the BSP to start easing its policy rates but monetary officials waited until the last minute to do this, arguing that there was enough liquidity in the market. The problem, according to Tetangco, was distribution.

Instead of cutting its rates, the BSP decided to cut the reserve requirements of banks by two percentage points. Moreover, the BSP opened a dollar repurchase facility for the first time, allowing financial institutions to borrow dollars from the BSP.

But the BSP’s hand was finally forced when the US Federal Open Market Committee decided to cut its policy rates down to as low as zero. In the same week, the BSP cut its rates by 50 basis points in December.

What now?

In 2009, Tetangco said he expects inflation to continue falling, giving the MB more room for monetary flexibility. But he said banking would also be more difficult – bank lending would slow down as the Philippines feels the full impact of the global economic slowdown. This, he said, would be accompanied by a corresponding increase in bad loans.

But, according to Tetangco, the financial sector as a whole remains in a good position to weather these difficulties. Philippine banks, he said, have built up enough resilience to breeze through 2009.

The country’s balance of payments surplus is expected to fall to a mere $500 million in 2008 but Tetangco said the 2009 surplus could be better although he would not say how much better.

“We really are still churning out the numbers, we have to see where the latest data would take us before we give out projections,” he said.

But if it was any indication, the BSP’s revised 2008 forecast reflected a dramatic turnaround in market sentiments compared with the exuberance that propelled the balance of payments to a record $8.6-billion surplus in 2007.

Tetangco said his only fears were, ironically, regulatory.

The crisis in the global financial market is forcing authorities to rethink regulations but Tetangco warned against the temptation to over-regulate the financial market that he said was inherently crisis-prone.

Graded by his peers as one of the best central bankers in the world, Tetangco said it was “inevitable” for markets to go through upheavals especially following a boom cycle.

“It is tempting to simply confirm that the market landscape has been irrevocably altered by the enormity of the current difficulties,” Tetangco said. “However, it is equally important to bear in mind that it took considerable time and significant market innovation for the market as a whole to get to this point.”

Tetangco expressed fears that the current crisis would lead to over-regulation in the financial system and this, he said, was the one wrong thing that could result from the crisis.

“We cannot regulate financial crisis out of existence because the financial system is inherently crisis-prone,” Tetangco pointed out.

According to the central bank chief, it was inevitable that periods of stability would be followed by instability because the exuberance of the markets during stable periods results in risky behavior that would subsequently result in instability.

“I have said in the past, we must realize that markets and regulation can and must co-exist,” Tetangco said. “The trick is to craft regulation that would make the markets work.  This is the challenge we face as policy makers.” –Des Ferriols, Philippine Star