Special Report: The peso-dollar exchange rate (Second of three parts)

The impact of exchange rates

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For an import-dependent country like the Philippines, it is difficult to overstate the impact of currency exchange rates. There is almost no part of the economy that is not affected by them in some way, particularly because of the country’s import profile; the Philippines imports virtually all of its fuel, most of its transportation equipment, and a very large proportion of the raw materials and intermediate goods needed for manufacturing.

tableExports and OFW remittances are the two biggest sources of foreign exchange inflows to the Philippines, while imports and debt servicing are the biggest sources of outflows.

|Given that most transactions are denominated in US dollars and the amounts of money involved are enormous, even a small change in the peso-dollar exchange rate can have a significant impact on costs, and subsequently on prices.

In the first installment of this special report that appeared on Monday, we examined the factors that affect the peso-dollar exchange rate, and the various tools available to the Bangko Sentral ng Pilipinas (BSP) to moderate that rate.

In this second installment, the reasons why management of the exchange rate is a critical responsibility for the BSP—the general impact exchange rates have on the wider economy—are examined, along with ways in which companies most exposed to exchange rate fluctuations manage this particular set of financial risks on their own.


Far-reaching effects
One of the paradoxes of currency value is that a weaker currency relative to the US dollar actually may have more economic benefits than a stronger one. In general, a weaker peso supports exports by effectively making them less expensive; increased export activity should lead to expanded production and employment, and contributes directly to GDP by reducing the trade deficit or increasing its surplus, whichever the case may be.

The downside, of course, is that imports become more expensive. If export volume does not grow by enough or if some of the import consumption is not shifted to domestic consumption to compensate, then the advantage of a weaker currency can quickly disappear.

By the same token, a peso that is too strong makes exports uncompetitive. Imports become cheaper, but unless this causes an increase in consumption sufficient to compensate for a deeper trade imbalance due to decreased exports, GDP growth will suffer.

To some degree, consumption does balance a strengthening currency in the Philippines—roughly 25 percent of the country’s imports are electronic products (see graphic), and a significant portion of those are either finished goods such as cellular phones, other mobile devices, and computer components destined for the consumer market, or components for products to be assembled and sold here.

Nevertheless, there are limits; ideally, monetary authorities look for an exchange value that is neither too weak nor too strong to provide the most effective results, and trade activity supplies one method for the BSP to do that.

“One metric that we monitor as much as other parties including international financial institutions do is the real effective exchange rate, which relates the nominal exchange rate of the peso, for instance, with its key trading partners based on trade weights and deflated by inflation differentials,” explained BSP Deputy Governor Diwa Guinigundo. In other words, the value of the peso relative to other currencies is assessed according to its purchasing power rather than its actual market rate in order to give a clearer indication of its actual worth.

Beyond trade, there are other effects of currency exchange value that need to be closely monitored. A strong peso not only reduces the country’s debt burden (the government has to spend fewer pesos to pay off a given number of dollars’ worth of debt), it also attracts foreign investment, provided the peso is also relatively stable.

From a domestic perspective, however, a stronger peso has the same effect as tightening monetary policy; it helps to curb inflation, but also discourages lending because it effectively increases interest rates.

On the other hand, a weak peso, given the import reliance of the Philippines, aggravates inflation—as the currency declines, importers must raise prices to keep their margins steady. The effect is not noticeable when changes in the peso value are small, but are one of the first effects to be widely felt when there is a sustained decline.

Business strategies
To get a sense of how Philippine businesses manage potential foreign exchange risks, The Manila Times interviewed two firms whose activities are comprehensively impacted by movements in the peso-dollar exchange rate: One, a chemical firm with core businesses in food ingredients, aerosols, and specialty plastics; and the second, a small currency exchange business.

D & L Industries was originally a chemical manufacturer that has diversified its business into food ingredients—its biggest business now—aerosols, and specialty plastics. The company fits a profile typical of many Philippine manufacturers: It relies heavily on imported raw materials and components, and serves a largely domestic market, although it does have a small import market as well.

“We derive more than 80 percent of our revenues domestically and import 74 percent of our raw materials, mostly in USD,” explained Alfred Lao, D & L Industries’ chief financial officer.

For D & L, exchange-rate stability is a more important factor than its actual value. “Since we do pass on changes in our raw material costs to customers, including changes in forex, our revenues move in tandem with movements in commodity prices and forex, which are beyond our control,” Lao said.

Focusing on keeping margins steady, as a consequence, has helped the company expand its volume and profits. “We pay more attention to margins and volume growth than revenues to measure performance,” Lao said. “Even with the ups and downs in the USD-PHP exchange rate in the past four years, our margins, and in turn profits, have been stable and in recent times have been increasing.”

Beyond adjusting costs to compensate for exchange rate changes, D & L does not seem to feel additional risk reduction strategies, such as hedging, are often necessary. “We do very minimal financial hedging, though we do have hedging facilities set up with our banks.

Sometimes we do a little physical hedging but never to speculate on prices,” Lao explained.

Even so, Lao suggested that there was a great deal of room for the peso to strengthen.

“Considering how the economy has performed in recent years and the outlook going forward, the peso should be closer to the Thai baht,” he said. (The baht closed at 32.09 to $1 on Tuesday.)

An interesting contrast to D & L Industries’ low-key approach to exchange rate management is that of the currency exchange business. The general manager of a small registered foreign exchange company with six outlets in Metro Manila agreed to share some insights under conditions of anonymity.

“I’m pretty sure my competitors read your paper, too,” he said, giving a hint as to just how competitive this particular business is.

“The currency exchange business is a lot like trading forex, in that our gains are very small, and only mean something because we are moving large amounts of money,” he said.

“The BSP posts a daily reference rate for all the currencies it exchanges, so we use that as a basis, less half a percent to a percent. So for example, if the official rate is P43 to $1, we would set our rate at between P42.57 and P42.74. It depends on what other shops are doing, but more so on where we think the rate is headed in the next couple of days.”

The need to accurately forecast whether the exchange rate will narrow or widen is critical for the forex firm manager’s business because of the low margin and the fact that there is an unavoidable time lag between the setting of the rate for customers and reconverting purchased foreign currency back into pesos.

“The official rate today is actually the rate from the end of trading yesterday, so we’re already a day behind,” he explained. “By the time we exchange our receipts through the BSP, we’re two days behind. With our dollar purchases, we can hedge a little, so to speak—we have dollar deposit accounts at our banks, we can hold a little bit and hope for a better rate. But there’s a limit to that. Eventually we’re going to need that money, and if we can’t exchange it for a rate that’s better than what we gave our customers, we’re not going to make a profit, and will probably lose money. For currency other than US dollars, we have no choice, we have to exchange it right away and hope for the best, and we lose money on it quite often. Our dollar business is big enough, though, that we can usually make up for it.”

Like D & L Industries, the forex firm would like to see a stronger peso. “In reality, what we’re doing is importing dollars, so of course, the fewer pesos we have to pay for them, the better it is for us,” the manger said. “But, of course, our customers don’t see it that way, they like it when the peso ‘increases’ as they see it, when they’re getting more for every dollar.”

In the view of monetary authorities and financial analysts, a stable peso-dollar exchange rate managed in such a way as to avoid sudden changes is preferable; in the view of businesses intimately concerned with the exchange rate, a stronger peso is preferable; and for ordinary consumers, a weaker peso seems to be the preference. In the final installment of this special report on Friday, this last aspect—the effect of the exchange rate on remittance-receiving families—will be examined.

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