Fighting Inflation

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The Bangko Sentral ng Pilipinas (BSP) has made it clear over the past week that it will do what is necessary to fight inflation and protect the nation's currency. On June 1, the BSP revealed that it had already stepped into international currency markets to protect the Peso - spending $3bn in April alone. It also hinted that a rate hike is imminent.

These measures are a response to rising inflationary concerns among policy makers and the international business community. On June 30, the BSP stated that annual inflation in June would be somewhere in the range of 10.4 to 11.2%. This represents a significant increase from April's 9.6% and far above the BSP original 2008 target of 3 to 5%.

In a statement to local media, Deputy Governor Armando Suratos said there was no single culprit behind June's increase. While rising food and energy prices have played a significant role, Suratos also cited several local factors. Among the most prominent were wage and cost-of-living allowance adjustments sanctioned by regional wage boards, the depreciation of the country's currency and the recent typhoon, which had a negative impact on local production of fruits and vegetables.

In 2007, many of these inflationary pressures were already in place. BSP policy makers were however blessed with an appreciating currency. The Peso registered a record 19% increase against the US dollar in 2007, making it Asia's best performing currency. This and other liquidity mopping strategies allowed the BSP to mitigate much of the potential damage caused by inflationary pressures.

Since the beginning of 2008 the situation has gone into reverse. The Peso has lost nearly 8.3% against the US dollar. This sets the Peso on par with the Indian rupee and close behind Asia's worst performing currency, the South Korean won, which has fallen by about 10% since the beginning of the year.

With inflationary pressures picking up steam, the change from an appreciating to deprecating currency has become increasingly important. For this reason, the BSP has become more active in protecting the nation's currency. Its two main tools in doing so are monetary interventions into currency spot markets and higher interest rates.

On June 1, the BSP revealed it had already made use of the first tool. In April, the BSP spent $3bn in an effort to ensure that the Peso did not fall below the government's target range of 42 to 45 pesos to the dollar. Policy makers believed that a breach of this target rate would have weakened confidence in the peso and lead to further deterioration.

On the same day as the BSP’s announcement, Merrill Lynch released a report arguing that the second tool, higher interest rates, would soon come into play. The report predicted that the BSP would raise interest rates by as much as 125 basis points by the end of the year. The investment bank said that it expected overnight borrowing rates, which currently stand at 5.25%, to reach 6% by the third quarter and 6.5% by the fourth quarter.

Such a move would act as a break on the country's economy. Cheap money caused by low rates have fuelled a boom in the country's banking and real estate sectors over the past several years. An end to this boom matched with lower consumption - caused by rising inflation - and a slowdown in exports and remittances - caused by the global slowdown - could create a perfect storm for the Philippine economy.

BSP can take some comfort from the fact that many of the world's economies are facing similar challenges. Inflation, currency depreciation and economic slowdowns are not a Philippine or even an Asian phenomenon. But unlike the US, the EU and other regional players, the Philippines has more room for manoeuvre.

In a recent visit to the Philippines, the IMF said it would downgrade its growth forecast for the Philippine economy from 5.8% to 5.2%, on the back of higher inflation and lagging demand. While 5.2% growth may be far below the government's initial target of 7%, it still is quite strong when compared to mature markets.

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