Much ado about IRC

Ben D. Kritz

Ben D. Kritz

THE central bank tossed a bit of a surprise at financial markets this week with a cut in its key interest rates, to take effect on June 3, as an operational move toward implementing its interest rate corridor (IRC).

The IRC is fundamentally designed to make interest rate setting by the Bangko Sentral ng Pilipinas (BSP) somewhat more flexible and, theoretically at least, make the use of interest rates as monetary policy tools more efficient in responding to and encouraging changes in the macroeconomic environment. The general consensus of expert opinion so far is that the new scheme will not have much of an effect on the behavior of financial markets, but that it may have more of an impact than expected on the exchange value of the peso.

The interest rates used to create the corridor are the same ones used now, but have been repackaged. The upper boundary of the corridor is the repurchase rate, or overnight lending rate (RP), which is the rate at which the BSP lends to banks. That is being reduced from 6 percent to 3.5 percent, and is being applied to a restyled overnight lending facility (OLF) replacing the current overnight and term repurchase facility. The lower boundary of the corridor is the Special Deposit Account rate, which will now be known as the overnight deposit facility (ODF); this is the rate the BSP pays for banks’ deposits of excess cash, and it will remain unchanged for now at 2.5 percent.

In the center of the corridor is the central bank’s traditional headline policy rate, the overnight reverse repurchase rate (RRP), which is the rate at which the BSP borrows from banks. It is being reduced from its current 4 percent to 3 percent. By definition, the ‘corridor’ is the policy rate plus-or­minus 50 basis points (or 0.50 percent).

At first glance, the IRC would appear to be an unusually radical move—even though it has been planned for a long time—because a full 1­percent cut in a benchmark interest rate is a big step.

Rate cuts in an economy that is not suffering serious stagnation that requires drastic measures typically do not exceed about half a percentage point. Generally, a significant rate cut results in higher lending, because bank interest rates on loans will follow the benchmark rate lower, after some time lag.

As Singapore banking giant DBS explained earlier this week, bank rates are not directly tied to the benchmark rate, but more often follow long­term government securities yields. Those yields, however, do shift according to the benchmark rate, so even though the IRC­driven rate cut won’t result in an immediate increase in money (through bank lending) in the economy, when the impact of the cut cycles through the government securities market, lending—and hence, the money supply and inflation—should increase.

That is almost a certainty under the IRC, because the benchmark rate must always be higher than the ODF rate. That has typically been the situation up to now, but the old monetary policy model that allowed rates to be adjusted separately didn’t actually eliminate the possibility that the benchmark rate could be lower than the overnight deposit rate—which would pull money from the economy, as banks would find it more profitable to park their money in an SDA than lend it to consumers or businesses or put it into government securities.

That is where the concerns about a lower peso value come into the picture. The peso is fairly strong at the moment, despite a strong dollar; post­election optimism and the generally good picture of the economy painted by first­quarter earnings reports of listed companies have kept the local currency buoyant. An increase in money supply, however, will automatically push the exchange value lower. To add to that, the central bank’s hint that it will roll back the reserve ratio requirement (RRR) for banks at its next Monetary Board meeting on June 23—which will reduce the amount of money banks are required to hold back as a reserve, allowing them to lend more—will also push the peso value lower.

That would seem to be counterintuitive; if anything, the BSP should adjust the RRR higher to compensate for the drop in peso value caused by the new IRC rates. The BSP, however, is much less concerned about the value of the peso than it is about inflation, which has for months consistently stayed below or at the bottom end of the central bank’s target range. Up to a certain point—most believe it is about 2 percent—inflation actually encourages economic growth through wage growth and increased consumption, and that is the ‘sweet spot’ the BSP is trying to hit.

Whether it works or not will take at least a few months to discover; while the BSP’s monetary management has been very effective overall, inflation targeting is the one area it has consistently struggled to come to grips with. The IRC solution, given that it raises a couple of new risks that might move the peso value and inflation rate very quickly, may provide us with a few fireworks over the rest of this year.


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