Demystifying the forex market



    A fitting follow-through to the Manila Times’ Mid-Year Economic Review, published here in three installments two weeks ago, is a deeper look into the foreign exchange market after the peso’s surprising turn last week.

    Slipping to a three-month low against the US dollar on Friday, the Philippine currency  reflected market jitters on seeing the local economy losing steam, inflation gaining pace and political turmoil on the global scene threatening peace.

    Investors found no relief in the stock market, where trading late last week was rattled by US President Obama’s decision to permit airstrikes on Iraqi militants, while negotiations between Palestinian and Israeli peace delegations stalled and the situation in Ukraine worsened.

    Although the Philippines’ macro fundamentals remain sound, according to the country’s economic planners, and the barometers of growth continue to move within the target ranges, government projections have come under a cloud of doubt and global financial institutions have begun adjusting their own outlook on the country’s prospects.

    A local equities analyst traced Friday’s drop in the peso’s value to the latest World Bank cut in its growth forecast and an uptick in July’s inflation rate. He predicts other banks may also begin taking a second look at their forecasts for the country.

    The part about market vulnerability to such unsettling domestic and external news is easy to understand. But to the non-finance-savvy, the currency market holds a complex web of technical and human factors that determine at what point in the value range demand and supply meet.

    Today, a new three-part series begins to present analyst insights into the wheeling and dealing that goes on in the foreign exchange market, the regulations that put some limits on such transactions to protect the economy, and the impact of the movement of the exchange rate on business, consumers and the economy as a whole.

    (First of three parts)

    Shedding some light into the ‘black box’ of managing the peso’s value


    Last Thursday, trade on the Philippine Dealing & Exchange System (PDEx) took a surprising turn when the peso lost 37 centavos of dollar-relative value and closed at P44.08 to $1, marking a seven-week low.

    After having closed at P43.71 the previous day, the peso slipped amid a frenzy of activity, with nearly half a billion dollars more currency changing hands Thursday than it did on Wednesday.

    For the few days prior to Thursday, the peso had been trading firmly on a steady track, thanks largely to the announcement earlier by the Bangko Sentral ng Pilipinas (BSP) that it was raising its two benchmark interest rates by 0.25 percent each. That move by the BSP had the basic effect of helping to slow the expansion of money supply, which in turn tends to increase the relative value of the peso.

    Provided, of course, that one or more of the number of other factors which can affect the value of the peso do not have an influence, which was precisely what happened last Thursday: The US government released data indicating that the country’s economy grew by 4 percent in the second quarter, which strengthened the US dollar and made the peso less attractive to traders.

    The number of people who have a clear understanding of what all that means is relatively small, and that is the paradox of the whole concept of foreign exchange: Directly or indirectly, it affects every single person in the Philippines, and has an enormous impact on the overall economic health of the nation.

    Yet, how it does all that seems to be the proverbial “black box,” with mechanisms that are difficult to understand and even harder to predict.

    Among the various trade markets – equities, bonds, commodities, and currencies – currency trading is universally considered the most challenging and risky for investors (despite what the proliferation of online currency trading platforms in recent years would have people believe).

    Some key concepts
    Although the value of the peso is commonly expressed in US dollar-relative terms, the BSP routinely provides the exchange value in 32 different currencies, 18 of which are freely exchangeable with the peso through the BSP and 14 which are not.

    As of last week, the number of exchangeable currencies was temporarily increased by one, as the BSP opened an exchange facility for Libyan Dinars in response to the conflict in that country affecting several thousand OFWs.

    The US dollar is the world’s most widely-used index currency and comprises the vast majority of the Philippines’ foreign currency-based transactions, and so using it as a reference is largely a matter of convenience.

    The value of the peso is not, however, specifically tied to the value of the dollar. The peso is instead described by the BSP as a “free-float currency,” one in which value is determined by market supply and demand; a “fixed currency,” by contrast, is one which has a specific value in terms of an index currency or a valuable commodity such as gold.

    In actual practice, fixed currencies are not common although there are a few well-known countries, such as Saudi Arabia, the United Arab Emirates, and Denmark, who follow the practice. Likewise, true “free-float” currencies are relatively rare as well.

    By definition, a free-float currency is not subject to central bank intervention, but that is almost never the case; most central banks, including the BSP, do in fact regulate their currencies’ values to some degree in what is informally referred to as a “dirty float” system, or what central banks prefer to call a “managed float” system.

    “The law mandates the BSP to promote monetary stability and we view this in terms of both prices and the exchange rate,” explained BSP Deputy Governor Diwa Guinigundo. “As a policy, the BSP allows market-clearing determination of the exchange rate with occasional participation to prevent too much volatility.”

    Factors affecting exchange rates
    The reason the central bank has to occasionally intervene to stabilize the currency’s value is that there are a number of factors that are largely outside the BSP’s control that can affect the peso’s value.

    Differential inflation has perhaps the biggest impact. The inflation rates of two different countries are rarely the same; the difference between the two rates thus tends to have a magnifying effect on the exchange rate of their respective currencies.

    If the Philippines has a higher inflation rate than the US – as it does now, at 4.9 percent for July versus 2.1 percent for the US – that lowers the value of the peso relative to the dollar.

    Other factors that affect exchange rates include differential interest rates – higher rates tend to attract foreign currency, except in cases where inflation rates are also high, and increase the local currency’s value; current account deficits, which lower the currency’s value; public debt levels, which lower currency value as debt levels increase; terms of trade, or the ratio of import prices to export prices, which raises the currency’s value if export prices increase faster than import prices; and overall political and economic stability.

    Policy tools
    The BSP, while ostensibly adhering to a free-float regime, does have a number of policy tools at its disposal to manage the peso’s exchange value, and does employ them from time to time. Direct intervention involves tapping the country’s gross international reserves (GIR), which are ready assets controlled by the BSP that can be used to either buy or sell foreign currency, usually through the PDEx.

    It is usually difficult to determine with certainty when the BSP is using this particular policy tool. Foreign exchange traders can generally identify who traders working on behalf of the central bank are; for example, in its Market Watch note for August 7, when the peso plunged to P44.08 to $1, Unionbank made the observation that “A good volume of $1.3Bn went through [the market]today as the BSP was suspected of selling dollars to temper its surge.”

    The BSP, however, typically remains tight-lipped about its market activities, and for good reason – if traders knew for sure that the central bank was buying or selling foreign currencies, the reaction of the market would likely exaggerate whatever the BSP was trying to accomplish and defeat the purpose of the intervention.

    The BSP’s Guinigundo explained, “During times of heavy FX (foreign exchange) demand, the BSP opted to do some open mouth operation by assuring the market that liquidity shall be provided by the BSP if and when it is warranted by market events.”

    This implies that even the suggestion that the BSP might intervene in trading is sometimes enough to move the currency market, meaning that the central bank would obviously have to exercise caution in actually taking trading action.

    Besides the risk of distorting the currency market, the other major drawback to direct intervention is that it has only a shor t-term effect. In order to maintain the peso exchange rate within a target range, the BSP would have to continuously engage in foreign currency trading; this would in effect turn the peso into a fixed-rate currency, which would make inflation harder to manage. From a practical standpoint, the BSP simply does not have the financial resources to pursue that policy, either; while its GIR is considered to be at a healthy level ($81 billion as of July), it would be exhausted within a few weeks if it were applied solely to currency trading.

    Instead, the BSP relies on subtler policy tools that have an indirect, but longer-lasting effect on exchange rates. Adjusting the interest rates on overnight lending and borrowing facilities, adjusting the interest rate on special deposits accounts (SDA), and adjusting the reserve ratio for banks are all actions the BSP has taken recently, in each case, slightly raising the percentages. Those moves are intended to curb inflation by encouraging banks to lend less and keep more of their cash assets in reserve, either in their own vaults or on deposit with the BSP, all of which removes money from the financial system; this in turn reduces the supply of pesos, helping to increase the currency’s value relative to the US dollar and other currencies.

    BSP lauded by analysts
    In the view of analysts we spoke to, the BSP is following a sound policy in balancing the peso’s value against the dollar and other reference currencies. “I think that overall the BSP has done an excellent job,” said Justino Calaycay of Accord Capital Corp. “Despite the external risks, the exchange rate has been quite stable. We have not seen any untoward moves of the currency either way and investments have maintained their momentum. Except in the last two months, inflation has been reined in, and even the most recent 4.9 percent in July and 4.3 percent year-to-date figures remain within the projected band. I would not want to second-guess monetary authorities at this point as they have been able to maintain a good balance between inflation and growth. Even the inflationary pressures are not being attributed to the levels of liquidity in the financial markets, rather, most are owed to external factors.”

    Nicholas Antonio T. Mapa, Associate Economist at the Bank of the Philippine Islands, offered a similar view. “I would say that the BSP’s strategic presence in the foreign exchange market has been truly praiseworthy,”Mapa said. “There are times that the currency pair’s [peso-dollar] movement is determined by external factors, such as market panic induced by geopolitical concerns, or internal factors like credit rating upgrades which spur foreign inflow. Gi en that the USD/PHP is influenced by both sides of the market, its stability is paramount in helping provide a conducive base for economic growth. The BSP never reverses a trend, it merely smoothes out sharp fluctuations for the benefit of all market players, i.e. those who want to sell Dollar and those who want to buy them.”

    “The balancing act of not favoring a certain sector of the economy is key given that the Philippines is a small market economy that trades with the world,” Mapa explained. “The peso has generally traded ‘in the middle of the regional pack,’ ensuring our price competitiveness in terms of exports against our Asean peers. This has been through the prudent guidance of the BSP that allows market forces to flow but ensures that speculative bubbles are snuffed out immediately.”

    Given that, analysts see a continuing stable range for the peso despite occasional spikes like last week’s 37 centavo decline. “At the beginning of the year, we had pegged an exchange rate of between P43 and P45 [to $1]in our assumptions. That has not changed yet,” said Accord Capital’s Calaycay.

    On Wednesday: Part two of this special report will examine how the peso-dollar exchange rate affects the economy “in the real world” by examining its effects on businesses, particularly those in the critical import-export sector.



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