INFLATION REPORT
Third Quarter 2006
Bangko Sentral ng Pilipinas
FOREWORD
he primary objective of monetary policy is to promote a low and stable rate of inflation conducive to balanced and sustainable economic growth. The adoption in January 2002 of the inflation targeting framework for monetary policy was aimed at T One of the key features of inflation targeting is greater transparency, which means greater disclosure and communication by the BSP of its policy actions and decisions. This Inflation Report is published by the BSP as part of its transparency mechanisms under inflation targeting. The objectives of this Inflation Report are: (i) to identify the risks to price stability and discuss their implications for monetary policy; and (ii) to document the rigorous economic analysis behind the conduct of monetary policy and convey to the public the overall thinking behind the BSP’s decisions on monetary policy. The broad aim is to make monetary policy easier for the public to follow and understand and enable them to better monitor the BSP’s commitment to the inflation target, thereby also helping both anchor inflation expectations and encourage informed debate on monetary policy issues.
The government’s targets for annual headline inflation under the inflation-targeting framework have been set at 4.0-5.0 percent for 2006 and 2007.
The report is published on a quarterly basis, presenting a survey of the various factors affecting inflation. These include recent price and cost developments, prospects for aggregate demand and output, monetary and financial market conditions, labor market conditions, fiscal developments, and the international environment. A section is devoted to the BSP’s view of the inflation outlook during the policy horizon. This is followed by a discussion of the implications of the assessment of inflation and economic conditions on the monetary policy settings of the BSP. This issue also features a box article on financial sector developments in the Philippines.
The Monetary Board approved this Inflation Report at its meeting on 19 October 2006.
AMANDO M. TETANGCO, JR. Governor
October 2006
THE MONETARY POLICY OF THE BANGKO SENTRAL NG PILIPINAS
The BSP Mandate
The BSP’s main responsibility is to formulate and implement policy in the areas of money, banking and credit, with the primary objective of maintaining stable prices conducive to a balanced and sustainable economic growth in the Philippines. The BSP also aims to promote and preserve monetary stability and the convertibility of the national currency.
Monetary Policy Instrument
The BSP uses the overnight repurchase (RP) rate and reverse repurchase (RRP) rate as the key policy rates to set the monetary policy stance. These two interest rates are typically adjusted in tandem by the Monetary Board.
Policy Target
The BSP uses the Consumer Price Index (CPI) or headline inflation rate (which is compiled and released to the public by the National Statistics Office (NSO)) as its target for monetary policy. The policy target is expressed in the form of a range for a given year and is set by the Development Budget Coordination Committee (DBCC) in consultation with the BSP. For 2006-2007, the government’s targets for annual headline inflation have been set at 4.0-5.0 percent.
BSP’s Exemption Clauses
These refer to the predefined set of acceptable circumstances under which an inflation-targeting central bank may fail to achieve its inflation target. These clauses recognize the fact that there are limits to the effectiveness of monetary policy and that deviations from the inflation target may sometimes occur because of factors beyond the control of the central bank. Under the inflation targeting framework of the BSP, these exemptions include price pressures arising from: (a) volatility in the prices of agricultural products; (b) natural calamities or events that affect a major part of the economy; (c) volatility in the prices of oil products; and (d) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies.
The Monetary Board
The powers and functions of the Bangko Sentral, such as the conduct of monetary policy and the supervision over the banking system, are exercised by its Monetary Board, which has seven members appointed by the President of the Philippines. Beginning in July 2006, the Monetary Board meets every six weeks to review and decide on the stance of monetary policy. Prior to July 2006, monetary policy meetings by the Monetary Board were held every four weeks.
Chairman Amando M. Tetangco, Jr.
Members Romulo L. Neri Vicente B. Valdepeñas, Jr. Raul A. Boncan Juanita D. Amatong Nelly F. Villafuerte Alfredo C. Antonio
The Advisory Committee
The Advisory Committee was established as part of the institutional setting for inflation targeting. It is tasked to deliberate, discuss and make recommendations on monetary policy to the Monetary Board. The Committee meets regularly every six weeks (beginning July 2006) but may also meet in between the regular meetings, whenever it is deemed necessary. Prior to July 2006, the Committee met every four weeks.
Chairman Amando M. Tetangco, Jr. Governor
Members Diwa C. Guinigundo Deputy Governor Monetary Stability Sector
Nestor A. Espenilla, Jr. Deputy Governor Supervision and Examination Sector
Ma. Ramona GDT Santiago Managing Director Treasury Department
Antonio B. Cintura Officer-In-Charge Department of Economic Research
CONTENTS
Overview 1
I. Inflation and Real Sector Developments 3 Prices 3 Aggregate Demand and Supply 9 Labor Market Conditions 16 II. Monetary and Financial Conditions 17 Interest Rates 17 Financial Market Conditions 19 Banking System 20 Box: Has There Been Financial Deepening in Recent 24 Years?
Exchange Rate 26 Monetary Aggregates 28 Fiscal Developments 28 III. External Developments 29 IV. Monetary Policy Developments 33 V. Inflation Outlook 35 Inflation Forecasts 35 Risks to the Inflation Outlook 37 Private Sector Economists’ Inflation Forecasts 40 VI. Implications for the Monetary Policy Stance 41 VII. Concluding Remarks 43
OVERVIEW
¾ Price pressures continued to ease in the third quarter as headline and core inflation continued to decline. Favorable agricultural production pushed down food inflation while the strengthening of the peso and easing in oil prices towards the end of the quarter helped bring down non-food inflation.
¾ Modest economic expansion continued in the second quarter of the year. Consumer spending, along with robust export growth, continued to drive aggregate demand. On the whole, improvements in demand conditions appeared to be generally uneven. Unemployment, for example, rose while capital formation remained weak. Meanwhile, on the supply side, the recovery of the agriculture sector and continued growth in services and industry sectors supported GDP growth.
¾ Market interest rates were on a generally declining path in the third quarter. Treasury bill rates eased on the back of continued strong demand for government securities amidst ample liquidity in the system. Likewise, bank lending rates were on a similar declining path during the quarter. However, on average, domestic interest rates were higher in the third quarter compared to a quarter ago.
¾ Domestic liquidity growth was slower. Domestic liquidity or M3 continued to grow as a result of strong inflows from overseas Filipino workers (OFW) remittances. However, reduced credits provided to the public sector (as a result of better fiscal performance) slowed down M3 growth.
¾ The peso continued to strengthen against the US dollar along with other Asian currencies. Positive market sentiment (owing to improvements in economic fundamentals) combined with sustained dollar inflows from remittances and investments pushed up the peso’s value against the dollar.
¾ Global economic activity remained strong in the first half. This was aided by strong consumption and a resilient services sector. However, recent developments also suggest shifts in the composition of global demand. Economic growth in the Euro area, Japan and emerging Asia continue to firm up while the United States has shown some signs of slowing down. A number of risks also remain on the global front, notably the volatility of international oil prices, disorderly unwinding of global imbalances, and the unexpected tightening of financial markets—notably those in industrial countries where housing markets are seen to be overvalued.
¾ The Monetary Board decided to keep policy settings unchanged during the quarter. Trends in current and expected inflation indicate a manageable inflation environment over the policy horizon as actual inflation continues to decelerate while forecasts are on a declining path with a likelihood of within-target inflation in 2007 in the absence of further adverse shocks.
¾ Going forward, the inflation outlook remains at risk from energy-related cost- side pressures. These pressures stem mainly from the vulnerability of international crude oil prices to supply constraints and geopolitical disruptions. Potential shifts in the public’s inflation expectations thus continue to require monitoring. The possibility of such shifts does not appear to be a pressing concern at the moment, but can become a credible risk in the future if cost pressures escalate more sharply than expected. This assessment applies equally to potential second-round pressures linked to wage- setting behavior. Developments in overall liquidity conditions also merit close monitoring in view of its potential impact on inflation.
¾ Managing the risks to inflation expectations, and from second-round effects, particularly from wage-setting, remains a key policy priority for the BSP. Policy pronouncements emphasizing the BSP’s readiness to act upon escalating risks to inflation, along with a clear depiction of the emerging outlook for inflation, can help stabilize public inflation expectations.
2
I. INFLATION AND REAL SECTOR DEVELOPMENTS
Prices
Headline inflation continues to ease in the third Price pressures continued to moderate in the third quarter. quarter, with lower headline and core inflation compared to the previous quarter. This was due to a slowdown in both food and non-food inflation. Headline Inflation Quarterly average in percent (2000=100) Apart from a brief rise in the first quarter of this 12 year, inflation has been on a declining trend since 10 the second quarter of 2005. This has been due mainly to positive supply-side developments 8 which provided a counterbalance to the impact of
6 the Reformed Value Added Tax (RVAT) Law and
volatile global energy prices on inflation. In 4 particular, favorable agricultural output has helped
2 to keep food prices stable. The peso has also continued to strengthen on surging dollar inflows
0 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 and positive market sentiment, thereby helping to keep down import prices. Moreover, the easing in international oil prices in the latter part of the quarter has led to reductions in local pump prices. At the same time, demand-induced price pressures continue to be limited given the still uneven improvements in demand conditions and continued easing in core inflation.
Headline and Core Inflation
Both food and non-food inflation post slower Average headline inflation continued to ease in price increases. the third quarter, falling to 6.1 percent from 6.9 percent in the previous quarter. The third-quarter figure was also lower than the 7.1 percent inflation in the same quarter a year ago.
Headline inflation averaged 6.8 percent for the first three quarters of the year.
3
Headline, Food and Non-food Inflation Quarterly average in percent (2000=100) Inflation for food, beverages and tobacco (FBT) 14 slowed to 5.2 percent in the third quarter from 12 5.8 percent in the previous quarter. Likewise, 10 non-food inflation was lower at 6.9 percent 8 relative to 7.9 percent in the last quarter. 6
4 Relative to their year-ago rates, FBT inflation and
2 non-food inflation were lower by 0.6 percentage
0 point and 1.4 percentage points, respectively.
-2 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 M Headline Inflation Food Inflation Non-food Inflation
Of the 6.1 percent average headline inflation rate for the third quarter, 2.4 percentage points were attributed to food alone. Fuel, light and water contributed 0.9 percentage point while services contributed 1.4 percentage points (of which 0.9 percentage point came from transportation and communication).
Likewise, core inflation continues to decelerate.
Headline and Core Inflation Quarterly average in percent (2000=100) Core inflation, an indicator of the long-term trend 12 of inflation, also continued to ease in the third
10 quarter. The official NSO core inflation was lower at 5.2 percent in the third quarter compared to 6.1 8 percent in the previous quarter. This was also 1.4 6 percentage points below the 6.6 percent core inflation in the same quarter a year ago. 4
2 The official core inflation measure averaged 5.8
0 percent in the first nine months of the year. 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Headline Inflation Core Inflation
4
Similarly, alternative measures of core inflation estimated by the BSP (such as the trimmed mean and the “net of volatile items” measures) decelerated in the second quarter. However, the weighted median core inflation measure inched up during the quarter. Nevertheless, all three measures were lower compared to their year-ago rates.
Data show fewer CPI items with above-target It would also be helpful to look at the distribution inflation rates. of price changes in the CPI basket to get an indication of whether pressures on consumer CPI Items with Inflation Above Threshold prices were becoming generalized. This could be done by determining the proportion of CPI basket 90 components (at the 4-digit level) showing inflation 80 rates above a given threshold—in this case the 70 upper end of the 4.0-5.0 target for 2006—and 60 finding out whether that proportion has been 50 increasing or declining. 40 30
20 As may be expected with lower inflation, the
10 number of items with inflation rates greater than
0 the threshold of 5.0 percent fell to 63 in the third Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 quarter from 76 in the second quarter. These 63 2004 2005 2006 Cumulative Weight (in percent) Number of Items Exceeding Threshold Inflation items accounted for 41.6 percent of the CPI basket and contributed about 4.0 percentage points to the total inflation.
Dividing the CPI basket into food and non-food components, there were 30 food items with inflation rates above threshold compared to 37 in the previous quarter. Meanwhile, 33 non-food commodities posted inflation rates higher than the upper end of the 2006 target in the third quarter compared to 39 a quarter earlier.
5
Food Prices
Good farm production supports slowdown in Food inflation continued to ease from the food inflation. previous quarter due mainly to the slowdown in price increases for all food items except corn, fish, fruits and vegetables and meat.
The easing in food inflation was due largely to robust farm production. The Bureau of Agricultural Statistics (BAS) reported a 5.1 percent growth in agricultural production in the first semester, up from 1.4 percent in the same period a year ago. Rice production, in particular, registered an 8.4 percent increase during the said period, a turnaround from the 0.1 percent decline in the previous year.1 As a result, rice inflation fell significantly to 2.0 percent from 4.4 percent in the second quarter.
By contrast, heavy rains during the quarter contributed to tighter supply and higher inflation for certain food items. The difficulty in catching fish during periods of continuous rains pushed up fish inflation. The rains also affected the deliveries to markets of fruits and vegetables leading to higher prices. Meanwhile, the increase in meat inflation could be attributed primarily to higher chicken prices.
Latest available forecasts from BAS indicate a favorable outlook for farm production, that suggest continuing stable prices. For instance, BAS expects full-year palay production to reach an all-time high level of 15.4 million metric tons, 5.7 percent higher than last year’s harvest. Likewise, BAS expects full-year corn production to be 14.4 percent higher than last year’s output level.2
1 BAS, Performance of Philippine Agriculture, January-June 2006, available online at http://www.bas.gov.ph/perfperiod.php 2 BAS, Rice and Corn Situation Outlook Volume 20, No. 3, available online at http://www.bas.gov.ph 6
Non-Food Prices
Easing energy prices contributes to lower non- Non-food inflation declined for the second food inflation. consecutive quarter. All sub-components of the non-food index registered slower inflation in the third quarter excluding clothing, which posted the same inflation rate as in the previous quarter. Services inflation fell to single-digits for the first time since the second quarter of 2004.
Oil prices continued to be the main influence on non-food inflation. Despite the observed softening, the energy-related components of the CPI basket such as fuel, light and water and transportation and communication services (which include oil, gasoline and diesel) continued to post double-digit inflation.
Energy Prices
Global oil prices soften towards the end of the International crude oil prices were on a general third quarter. easing trend during the quarter. From an average of US$69.17 per barrel in July, the spot price of Dubai crude oil declined to US$68.77 per barrel in August. It fell further in September to an average Dubai Crude Oil of US$59.82 per barrel. The downtrend was Quarterly average spot price in US dollars per barrel attributed to reports of increased US gasoline 75 inventories and easing geopolitical concerns 65 relating to Iran’s nuclear program.
55 On average, however, the price of Dubai crude oil 45 was 1.7 percent higher compared to the second 35 quarter and 19.2 percent higher than a year ago. 25
15
5 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Local oil companies reduce domestic pump In the domestic market, oil companies made a prices to reflect the moderation in world energy series of weekly reductions in petroleum prices prices. beginning 23 August 2006 in response to the softening of world crude prices. As a result, the pump prices of most petroleum products (with the exception of liquefied petroleum gas (LPG)) were generally lower at the end of the third quarter compared to a quarter earlier. In particular, the prices of premium gasoline, unleaded gasoline and kerosene were lower by P3.00, regular gasoline by P3.50 and that of diesel oil by P1.00.
7
On the other hand, LPG prices were raised seven Local Retail Prices of Selected Oil Products times during the quarter due to higher contract Price in pesos per liter prices. Relative to the end of the second quarter, 51 the price of LPG was higher by P2.22 as of 27 46 September 2006. 41 36 31 Relative to their end-December 2005 levels, the 26 prices of gasoline and diesel at the end of the 21 third quarter were higher by 9.8 percent and 13.1 16 percent, respectively. On the other hand, prices of 11 LPG have only risen by about 0.2 percent. 6 1998 1999 2000 2001 2002 2003 2004 2005 2006
Premium Gasoline Diesel Oil
Outlook for world prices remains tight. Futures prices of Dubai crude oil as estimated based on movements in Brent crude oil futures suggested possible easing in oil prices. This is
Spot and Estimated Future Prices of Dubai Crude Oil* indicated in the downward shift in futures prices Price in US dollars per barrel between end-June and end-September. However, 80 a significant decline in prices could not be as of 30-Jun-06 expected given current conditions in the global oil 70 market. In their Short-Term Energy and Winter 60 as of 29-Sep-06 Fuels Outlook, the US Energy Information as of 31-Dec-05 50 Administration (EIA) projected that, on average, 2007 oil prices will only be slightly lower than 40 average 2006 prices as surplus production 30 capacity is still limited and supply-demand 3 20 balance remain tight. In addition, prices are likely to remain vulnerable to news on geopolitical 10 2000 2001 2002 2003 2004 2005 2006 2007 2008 developments that could adversely affect oil *Futures price derived using Brent crude futures data. production.
Utility Charges
Power rates in the Meralco franchise area were The Manila Electric Co. (Meralco) reduced its reduced in August. generation charges in August by P0.79 per kwh relative to the previous month’s rate as a result of its power purchases through the electricity spot market. Meralco also attributed the reduction in rates to the higher dispatch of its independent power producers (IPPs). According to the company, generation charge fell to P4.4290 per kwh in August from P5.2177 per kwh in July.4
3 EIA, Short-term Energy and Winter Fuels Outlook, 10 October 2006, available online at http://www.eia.doe.gov/emeu/steo/pub/contents.html 4 Meralco Explains Lower Bills For Its Customers, Meralco Customer News and Updates, 17 August 2006, available online at www.meralco.com.ph 8
Power rates in the Meralco franchise area are set to decrease as soon as the Energy Regulatory Commission (ERC) issues its guidelines for Meralco’s refund scheme. In its 16 August 2006 decision, the Supreme Court (SC) ordered ERC to ensure Meralco’s compliance in refunding its customers the amount of P0.1327 per kwh representing the rate increase which took effect on June 2, 2004. It likewise suggested that Meralco deduct the amount from the consumers’ bills if the company decides against an actual refund.
Aggregate Demand and Supply
Philippine economy continued to grow during the Gross Domestic Product (GDP) rose by 5.5 second quarter of 2006. percent based on the latest available data as of the second quarter of 2006. Economic growth
was driven by resilient consumer spending and GDP and GNP Growth Rates strong exports growth, as well as the recovery in Annual Growth in Real Terms agriculture and robust expansion in 10 manufacturing. Though lower compared to the 8 previous quarter’s 5.7 percent, the GDP growth 6 rate for the second quarter of 2006 was higher 4 than the previous year’s 5.4 percent. Meanwhile, 2 Gross National Product (GNP) grew by 6.6 0 percent during the quarter, boosted by the
-2 double-digit growth in Net Factor Income from
-4 Abroad (NFIA). 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 GDP GNP
Aggregate Demand
Expenditures by major economic sectors
Consumer spending buoys growth in aggregate Consumer spending remained strong in the demand. second quarter, rising at a faster pace of 5.2 percent compared to 4.8 percent a year earlier. Higher growth rates were registered by food Domestic Demand Annual Growth in Real Terms (which contributed 3.0 percentage points to total 30 Personal Consumption Expenditure (PCE) 25 20 growth), household operations, and tobacco. 15 10 Meanwhile, expenditures on transportation and 5 0 communication slowed slightly to 13.9 percent -5 -10 from 14.2 percent in the previous year. -15 -20 -25 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Govt. Spending Private Consumption Fixed Investment
9
Prudent government spending kept its growth rate down at 0.4 percent for the second quarter. Total capital formation also weakened, as lower investments in construction and durable equipment dragged down fixed capital investments.
The national income accounts (NIA) data also showed higher growth in total imports at 4.0 percent, driven mainly by imports of goods. The top three contributors to growth in merchandise imports were electrical machinery, apparatus and appliances; textile yarns; and artificial resins and plastic materials.
Meanwhile, the latest trade data from the NSO show that growth in merchandise imports (based on FOB value in US dollars) accelerated to 16.5 percent in July from 7.7 percent in June, as all commodity groups except raw materials and intermediate goods registered higher growth rates. On a month-on-month basis, merchandise imports declined slightly by 1.5 percent following a 1.9 percent growth in June.
Other Demand Indicators
Other data continue to point to uneven trends in Various indicators continued to point to uneven domestic conditions. improvements in demand conditions. For example, survey-based production indices Average Capacity Utilization for Manufacturing showed a moderation in manufacturing activity, In percent while energy and appliance sales posted 100 declines. Consumer confidence improved in the 95 third quarter although the outlook was more 90 cautious going forward. Vehicle sales and 85 property prices increased on an annual basis, 80 while the overall business outlook remained 75 positive. 70 65 • Average capacity utilization in manufacturing 60 was unchanged at 80.2 percent in July. Close 55 to two-thirds of respondent firms reported 50 2000 2001 2002 2003 2004 2005 2006 capacity utilization rates between 70 and 89 percent, while about a third reported capacity of below 70 percent.
10
• Based on the NSO’s Monthly Integrated Growth in Volume and Value Indices of Manufacturing Production Year-on-year change in percent Survey of Selected Industries (MISSI)— which covers 509 establishments—the value of 30 production index (VAPI) rose at a slower pace 20 of 3.0 percent year-on-year in July. Meanwhile, the volume of production index 10 (VOPI) fell for the seventh consecutive month.
0 Relative to May, VAPI and VOPI posted slight decreases of 1.8 percent and 2.8 percent, -10 respectively.
-20 2000 2001 2002 2003 2004 2005 2006 Volume of Production Value of Production
• Based on data from the Chamber of Sales of Passenger Cars and Trucks and Buses Year-on-year change in percent Automotive Manufacturers of the Philippines,
Car Sales Trucks and Buses Inc. (CAMPI), growth in passenger car sales 200 140 accelerated to 15.1 percent year-on-year in
150 July. However, on a month-on-month basis, 90 100 passenger car sales registered a decline of 4.9 percent in July due to “the unavailability of 50 40 selected units, low production and weather 0 conditions.” On a seasonally-adjusted basis, -10 -50 the volume of car sales rose marginally by 0.1 percent. -100 -60 2003 2004 2005 2006 Car Sales Trucks and Buses Sales
• Sales of trucks and buses surged 56.9 percent year-on-year in July. On a month-on-month basis, growth in sales of trucks and buses decelerated slightly to 12.6 percent from 13.0 percent in June. Meanwhile, seasonally- adjusted data show a 21.7 percent growth in July, following a slight drop of 1.9 percent in the previous month.
Meralco Power Sales • Total energy sales by Meralco declined for a Year-on-year change in percent second month, falling by 2.0 percent year-on-
15 year in June. This was due to reduced energy consumption by all sectors except the 10 industrial sector. On a month-on-month basis, growth in energy sales slowed to 1.4 percent 5 in June from 4.4 percent in May. However, seasonally-adjusted energy sales showed a 0 slight increase of 1.5 percent in June following a marginal decline of 0.1 percent in the -5 previous month.
-10 2000 2001 2002 2003 2004 2005 2006
11
• Appliance sales continued to decline, with total Appliance Sales Year-on-year change in percent units sold falling by 20 percent year-on-year in
40 July. On a month-on-month basis, unit sales
30 declined, both on an unadjusted and
20 seasonally-adjusted basis.
10
0
-10
-20
-30
-40
-50
-60 2000 2001 2002 2003 2004 2005 2006
• Based on data from Colliers International Research, property values in the Makati Central Business District (CBD) and Ortigas Center were unchanged relative to the previous quarter but remained higher on a year-on-year basis. Meanwhile, the average office and residential vacancy rates in the Makati CBD continued to ease during the second quarter.
• Results of the third quarter 2006 Business Expectations Survey (BES) showed that optimists continue to outnumber pessimists as the overall diffusion index (DI) remained positive at 21.7 percent. The third quarter index, however, was lower than the previous survey’s level, reflecting in part the continued but slower expansion in business activity. Respondent firms attributed this to: (1) increases in oil prices arising from conflicts in the Middle East; (2) higher labor costs due to the implementation of wage increases; and (3) seasonal factors such as the rainy season and typhoons. Business activity is expected to be stronger in the fourth quarter, as shown by the higher DI of 40.9 percent.
12
• Results of the latest Consumer Expectations Survey (CES) showed some improvement in consumer outlook in the third quarter as the overall consumer expectation index rose by 1.5 basis points to -37.2 percent. Respondents attributed this to the following: 1) expected increase in income arising from better business conditions; 2) expectations of more family members working due to availability of more jobs; and 3) higher family savings. However, consumers also appear to be more cautious about economic and financial conditions in the fourth quarter and in the next 12 months, as indicated by the decline in the quarter-ahead and year-ahead confidence indices from the previous survey levels.
External Demand
Exports of goods and services post double-digit Real export growth, as reported in the second growth. quarter NIA data, surged to 22.3 percent from 1.6 percent in 2005. Both merchandise exports and non-factor services exports registered higher growth rates of more than 20 percent each.
The latest trade data from the NSO showed that growth in merchandise export earnings (based on FOB value in US dollars) slowed to a still-strong pace of 12.9 percent in July. This can be traced to the slowdown in manufactured exports, which comprised 85.7 percent of total. In particular, growth in electronics exports fell to 1.4 percent in July from 6.6 percent in June. On a month-on- month basis, merchandise export receipts declined by 2.3 percent from an expansion of 4.5 percent in June.
13
Aggregate Supply
Aggregate output expands on robust growth in All major production sectors contributed to the manufacturing, agriculture and services. expansion in total GDP growth. Growth in agricultural output accelerated to 6.7 percent, led Agriculture, Industry and Service Sectors Annual Growth in Real Terms by corn, palay, banana, and fishery. Favorable weather conditions and the expansion in harvest 15.0 area and yields resulting from the use of hybrid
10.0 and quality seeds boosted crop production. At the same time, banana output rose due to strong 5.0 external demand, while aquaculture continued to 0.0 boost the fishery subsector.
-5.0 Meanwhile, despite lower growth rates in most of -10.0 its subsectors, services remained the top
-15.0 contributor to overall output growth, accounting 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 for more than half of GDP growth. This was Agriculture Industry Service underpinned by the solid performance of communications, retail trade, non-bank financial services, private services, and real estate. The opening of new shopping malls contributed to the growth in retail trade and real estate, the latter shored up as well by increased income from residential projects and rental operations and strong demand for office space. The business process outsourcing (BPO) industry drove the expansion in personal and business services, which grew by 9.0 percent and 9.8 percent, respectively.
On the other hand, industry growth moderated to 4.5 percent, gaining support from manufacturing which posted its highest growth rate since the fourth quarter of 2004. Among the subsectors of manufacturing, petroleum and coal, food, basic metal, publishing and printing, and textiles posted the strongest gains.
14
GDP is likely to grow by 5.5-6.1 percent in The emerging scenario for GDP, based on latest 2006. government estimates, is a growth of 5.5-6.1 percent for 2006. On the supply side, agricultural production is likely to stabilize in the second half on prospects of normal weather conditions and sustained government interventions aimed at boosting farm productivity. Industry and services are likely to remain as the biggest contributors to economic growth. In particular, prospects for mining are bright as suggested by the double- digit expansion in durable equipment investments in the mining and construction sectors. On the demand side, the continued strong influx of OFW remittances indicates that it will remain a significant source of growth for personal consumption expenditure which has been relatively stable throughout the years. As weakness in fixed capital investments persists, PCE is seen to be the key driver of domestic demand. Meanwhile, the recent pause in US policy interest rate hikes should soften the impact of volatile oil prices and slower US GDP growth on aggregated demand.
15
Labor Market Conditions
Unemployment rate rises. Based on the latest Labor Force Survey (LFS) conducted by the NSO last July 2006, the unemployment rate settled at 8.0 percent in July 2006, higher by 0.3 percentage point compared to a year ago.5 However, this was lower than the 8.2 Unemployment Rate* percent jobless rate in April 2006. Similarly, using
15 the old definition, the unemployment rate rose to
14 11.7 percent from 10.9 percent in July 2005, but
13 was slightly lower than the 11.8 percent jobless 6 12 rate in April 2006. 11 10 Meanwhile, the total number of employed persons 9 grew by 2.3 percent, led largely by the services 8 sector, which more than made up for the jobs lost 7 in the agriculture sector. Employment in the 6 services sector rose by 5.6 percent (or 873,000 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 workers), in turn led by wholesale and retail trade * Based on the old LFS definition (333,000 workers), as well as private households with employed persons (255,000 workers). The industry sector reported a 0.2 percent (10,000 workers) increase in employment as the record 20.7 percent increase in employment in the mining and quarrying sector was partly offset by a decline in construction. On the other hand, employment in the agriculture sector declined by 1.2 percent (149,000).
Regional wage boards approve increases in All wage boards in the country’s 17 regions minimum wage. approved adjustments for minimum wage earners. The National Capital Region (NCR) wage board led by effecting increases on 11 July 2006. Other wage boards followed suit, finishing deliberations and hearings around mid-July. The recent round of wage increases approved by the Regional Tripartite Wage and Productivity Boards (RTWPBs) has been largely restrained. The P25 minimum wage increase in NCR, for example, is consistent with the BSP’s forecast assumption of an 8.0 percent increase in wages while the average nominal increase in non-agricultural wages for the various regions was 6.6 percent.
5 Starting April 2005, the new LFS questionnaire defines the unemployed to “include all persons who were 15 years old and over as of their last birthday and were reported as (1) without work; and (2) currently available for work; and (3) seeking work or not seeking work due to these reasons: a) tired/believed no work available; b) awaiting results of previous work application; c) temporary illness/disability; d) bad weather; and e) waiting for rehire/job recall”. 6 The old definition did not consider the availability criterion. 16
II. MONETARY AND FINANCIAL CONDITIONS
Interest Rates
Domestic interest rates are higher compared to a The bellwether 91-day T-bill rate averaged 5.6 quarter-ago. percent during the regular Bureau of the Treasury (BTr) auctions in the third quarter, higher than the 5.2 percent average in the previous quarter.
91-day T-bill, BSP RRP rate and KBs Lending Rate However, there has been some observed easing In percent within the third quarter. From 6.5 percent in June, 20 the 91-day T-bill rate eased to 6.1 percent in July. 18 It declined further to 5.40 percent in August 16
14 before rising to 5.44 percent in September. The
12 decline in yields within the quarter continued to be 10 driven by a strong demand for government 8 securities amidst ample liquidity in the system. 6 4 Similarly, bank lending rates averaged higher 2 2000 2001 2002 2003 2004 2005 2006 during the quarter at 8.6-10.5 percent, from an 91-day T-bill rate Overnight RRP Rate 8.3-10.0 percent average range in the previous Bank Lending Rate (Low-end) quarter.
Yield Curve
Secondary market yield curve shifts downward. The yield curve for government securities in the secondary market shifted downward in the third quarter as ample liquidity and improving fiscal Yield of Government Securities in Secondary Market performance pushed down yields in the In percent secondary markets. 13
12
11
10
9
8
Yield in percent 7
6
5 3Mo 6Mo 1Yr 2Yr 3 Yr 4Yr 5Yr 7Yr 10Yr 20Yr 25Yr Maturity Dec 2005 Jun 2006 Sep 2006 .
17
Interest Rate Differentials
Before-tax interest rate margins narrow while Compared to the end of the second quarter, after-tax spreads become more negative. before-tax differentials between local and comparable foreign interest rates narrowed while after-tax differentials became more negative at the end of the third quarter. This was attributed mainly to the sharp decline in the 91-day T-bill rate during the period.
The differential between the BSP’s policy interest BSP RRP Rate and US Fed Funds Rate rate (RRP rate) and the US federal funds target In percent rate remained at 225 basis points at the end of 16 the third quarter as both policy rates remained 14 unchanged during the quarter. 12 10 Adjusted for the risk premium (measured by the 8 differential between the 10-year ROP note and 6 the 10-year US Treasury note), the differential 4 between the BSP’s policy rate and the US federal 2 funds target rate widened to 93 basis points as of
0 end-September compared to 28 basis points at 2001 2002 2003 2004 2005 2006 end-June. BSP RRP rate US Fed funds rate
Real Lending Rate
Real lending rate inches up. The real lending rate (measured as the difference between the median bank lending rate and inflation) edged higher to 3.7 percent in September from 2.6 percent at the end of the Average Real Lending Rates: Selected Asian Countries In percent second quarter. The increase was due mainly to the declining rate of inflation. The Philippines’ real Taiwan 8.0 lending rate remained in the midrange of a India 6.4 sample of ten Asian countries. Hong Kong 5.5 Thailand 4.8 Singapore 4.6
Philippines 3.7
Malaysia 3.3
South Korea 3.2
Japan 1.6
Indonesia 1.3
0246810
18
Financial Market Conditions
Positive market sentiment and ample liquidity Ample liquidity in the domestic financial market continue to spur demand for equities and continued to fuel demand for both equities and government securities. government debt papers. A string of favorable developments in the domestic economy also boosted market sentiment.
Stock Market
Stock index rises on bullish market sentiment. Trading in the local bourse continued to ride on
upbeat market sentiment. The Philippine Stock Exchange Composite Index (PSEi) averaged 2,344.5 index points in the third quarter, up by 89 PSE Composite Index index points from the 2,255.5 average PSEi in the second quarter.7 The advances in local share 3,000 prices reflected improving market confidence as macro fundamentals strengthened. Investors 2,500 favorably viewed the significant strides in the fiscal reform agenda, continued appreciation of 2,000 the peso due to large dollar inflows, sustained
1,500 expansion of the domestic economy and the deceleration in inflation.
1,000
500 2000 2001 2002 2003 2004 2005 2006
Government Securities
Primary T-bill auctions continue to attract an Ample liquidity in the financial system continued excess of bids. to fuel banks’ demand for Treasury bills. Total excess bids or oversubscriptions at the primary T-bill auctions for the third quarter amounted to P109.5 billion, higher than the P68.3 billion Oversubscription of Primary T-bill Auction posted in the previous quarter. Average In billion pesos oversubscription for the period was P15.6 billion, 250 higher than the previous quarter’s average of P9.8 billion. The seven T-bill auctions during the 200 quarter drew a total of P151.5 billion in tenders
150 compared to a total offered amount of P42 billion.
100
50
0 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
7 The PSEi replaced PHISIX beginning 14 March 2006. 19
Banking System
The banking system remains fundamentally The Philippine banking system remained stable sound. and generally sound during the review period. Commercial banks (KBs), which account for almost 90 percent of the total assets of the banking sector, saw continued improvement in asset quality with a lower non-performing loan (NPL) ratio and a high capital adequacy ratio. Banks also remained liquid and recorded an increase in earnings despite the moderate pace of their loan operations.
Savings Mobilization
Deposit liabilities ease slightly. Deposit liabilities of the banking system declined by 1.0 percent as of end-July 2006 compared to the end-June 2006 level. However, it posted a higher growth of 8.9 percent compared to the same period last year. Demand deposit, which comprised the least share of 14.0 percent of total deposit liabilities, grew by 1.6 percent during the review period compared to the previous month. On the other hand, time and savings deposits contracted by 2.4 percent and 0.8 percent, respectively. Savings deposit continued to account for more than half of the banks’ funding base.
Lending Operations
Expansion in KB lending remains moderate. Outstanding KB loans increased by 2.5 percent year-on-year to P1.597 trillion in August 2006, a deceleration from the 4.3 percent growth posted in the previous month. On a month-on-month basis, KB loans declined by 0.9 percent compared to a 1.8 percent growth in the previous month.
20
Total Loans Outstanding of Commercial Banks The growth in KB lending was driven mainly by Year-on-year change in percent loans to the financial institutions, real estate and business services (FIREBS) sector (17.3 percent) 10 and the mining and quarrying sector (6.8 percent). 8 Other sectors which also contributed to the 6 growth in KB loans were community, social and 4 personal services sector; electricity, gas and 2 water; and agriculture. However, the increase in
0 lending to these sectors were partly offset by the
-2 declines in construction (13.8 percent); transportation, storage and communication (8.9 -4 percent); manufacturing (8.3 percent); and -6 2000 2001 2002 2003 2004 2005 2006 wholesale and retail trade (2.6 percent).
Meanwhile, the KBs’ credit card receivables (CCRs) as of end-June 2006 went up by 3.9 percent to P79.0 billion from the end-March 2006 level of P76.0 billion. The ratio of CCRs to total loan portfolio remained steady at 3.9 percent. KBs’ past due accounts stood at 19.7 percent of total CCRs, down from the 20.5 percent recorded a quarter ago.
Similarly, total auto loans were up by 4.8 percent to P60.7 billion as of end-June 2006 from the end- March 2006 level of P57.9 billion. As a ratio to total loan portfolio, auto loans stood at 3.0 percent. Only 4.4 percent of total auto loans were past due.
Institutional Developments
Resources of the banking system decline slightly The total resources of the banking system fell in July 2006. slightly by 0.9 percent from the previous month to P4.6 trillion as of July 2006. This was, however, comparatively higher by 3.3 percent from its year- ago level due mainly to the increase in banks’ deposits with the BSP (due from central bank) and cash holdings. KBs accounted for the bulk of the total resources of the banking system with an almost 90 percent share.
21
Consolidation and closure of weak banks reduce The ongoing restructuring of the banking system, number of banking institutions but the operating which involves consolidation and closure of weak network continues to expand. banks, further reduced the number of banking institutions from 872 at end-March 2006 to 871 as of end-June 2006. The total number of banking institutions comprised 41 KBs, 85 thrift banks and 745 rural banks. However, the operating network of the banking system increased to 7,693 as of end-June 2006 from 7,672 at end-March 2006 due partly to the increase in rural banks’ branches/agencies.
Banks’ NPL ratio declines slightly. The asset quality of the banking system dramatically improved to 7.8 percent as of end- July 2006 compared to 9.9 percent a year-ago. The NPL ratio during the review period was likewise lower than the previous month’s 7.9 percent. The improvement in the ratio was due mainly to the 0.6 percent rise in the total loan portfolio, and the 0.1 percent decline in the level of NPL. KBs’ NPL was likewise contained further at a single-digit level of 7.3 percent, which was likewise lower than last month’s 7.4 percent ratio.
Meanwhile, universal and commercial banks Non-Performing Loans of Commercial Banks Percentage of Total Commercial Bank Loans (U/KBs) managed to maintain the industry’s NPL ratio at a single-digit level (7.20 percent as 20 of end-August 2006) for over a year now. The 18 ratio was slightly higher than last month’s 7.17
16 percent but was significantly lower than the year-ago level of 9.40 percent. 14
12 Compared with other countries in the region, the 10 Philippines’ NPL ratio at 7.8 percent during the
8 review quarter was lower than Indonesia’s 9.3 percent and Thailand’s 8.0 percent, but higher 6 2000 2001 2002 2003 2004 2005 2006 than Malaysia’s 5.6 percent and Korea’s 1.1 percent.8 The lower NPL ratio in other Asian countries may be traced to the creation of publicly-owned asset management companies (AMC), which purchased the bulk of their NPLs.
8 ARIC Financial Indicators, ADB website. Financial system’s NPL, Thailand (May 2006); Malaysia (May 2006); Korea (KBs, December 2005); and Indonesia (February 2006). 22
The loan exposure of banks remained adequately covered as the banking system’s NPL coverage ratio remained steady at 73.4 percent as of end- July 2006, reflecting banks’ diligent compliance with the loan-loss provisioning requirements of the BSP as buffer against unexpected losses.
Capital adequacy ratio exceeds the minimum Using the new risk-based framework, the KBs levels set by the BSP and the BIS. remained adequately capitalized as of end September 2005, with the industry’s capital adequacy ratio (CAR) at 16.7 percent on a solo basis and 17.6 percent on a consolidated basis. The industry’s CAR continued to exceed the statutory level set by the BSP at 10.0 percent and the Bank for International Settlements’ (BIS) standard of 8.0 percent. This is reflective of the banking system's improved ability to cover risky assets.
The Philippines’ CAR remains comparatively higher than that of Thailand (14.3 percent), Malaysia (12.6 percent) and Korea (12.8 percent).9 Indonesia posted the highest CAR in the region at 21.2 percent as of February 2006.
Banks’ placements under the BSP’s RRP facility The total volume of banks’ placements with the increase. BSP under the RRP window amounted to P222.52 billion as of end-September 2006, higher by P51.66 billion from the end-June 2006 level. Banks’ excess funds continued to be placed with the BSP under the RRP facility as the growth in bank lending remained relatively modest and the supply of government securities limited.
9 ARIC Financial Indicators, ADB website. Commercial banks CAR: Malaysia (May 2006); Thailand (April 2006); and Korea (March 2006). 23
Box: Has There Been Financial Deepening in Recent Years?
The development of the financial system can be assessed using a broad range of indicators. Conventionally, quantity measures based on monetary and credit aggregates are used. They indicate the level of savings and credit intermediation as well as the degree of monetization in the economy. The simplest indicator is the ratio of broad money to GDP, which should rise over time if financial deepening is occurring. In addition, the level of private sector credit could provide additional insights on the financial system’s scope for credit expansion.
The Philippine’s ratio of broad money to the gross national product (GNP) averaged at about 26.3 percent in the period 1985-1992. In 1993, the M3/GNP ratio expanded to 31.8 percent and reached 42.2 percent by 1997 as structural reforms to liberalize and deregulate the country’s financial system were undertaken. These reforms enhanced market efficiency and facilitated greater integration of the local financial system with the rest of the world. The rapid increase in private sector credit in the early to mid 1990s also reflected the marked improvement in the state of the financial system. The ratio of private sector credit to GNP peaked to 57.5 percent in 1997 from just 21.0 percent in 1990.
Ratio of Broad Money and Private Sector Credit (MS Concept) to GNP M3-to-GDP Ratio of Selected Asian Countries * 1985-2005
In percent Hongkong 282.1 70 Korea 268
60 Taiwan 217.7
50 China 189.9
Malaysia 140.2 40 Singapore 125.7 30 Japan 110.2
20 Thailand 95
India 76.9 10 Indonesia 53.5 0 Philippines 37.2 6 8 0 3 5 7 9 2 4 85 87 89 92 94 96 98 01 03 05 9 9 9 99 9 9 9 9 99 0 0 0 1 198 1 198 1 1 1991 1 199 1 199 1 199 1 1 2000 2 200 2 200 2 0 50 100 150 200 250 300 M3/GNP RATIO Private sector credit/GNP ratio * Data as of end-December 2003
However, the increased financial integration also heightened the country’s vulnerability to external shocks. The 1997 Asian financial crisis weakened to some extent the country’s scope for financial intermediation as evidenced by the slight deterioration of various monetary and financial indicators. In particular, the private sector credit-to-GNP ratio dropped to 42.3 percent in 2000 and has remained modest to date while the ratio of M3 to GNP fell to 40.0 percent in the same year and declined further to 34.9 percent by 2005.
Not surprisingly, the Philippines has the one of the lowest degree of financial intermediation in the region. As of end-2003, domestic liquidity was less than half (37.2 percent) of the country’s annual nominal GDP. This is significantly lower than the M3/GDP ratio observed in neighboring countries that have pursued financial liberalization measures (i.e. removal of interest rate ceiling) around the same time that the Philippines did. This includes Malaysia (1978), Thailand (early 1980s) and Indonesia (1983).
Structural measures could also be used to examine the depth of the financial sector. Two indicators, namely, the ratio of broad money to narrow money (BM/NM) and the ratio of marketable debt and equity securities outstanding to broad money (SEC/BM), are used in this article to determine the relative importance of the financial system’s various elements/sectors as it develops overtime. Savings deposits should increase more rapidly than transaction balances as the financial system expands. A positive relationship is, thus, expected between the broad money-to-narrow money ratio and a country’s level of financial development. Similarly, the SEC/BM ratio is positively related to financial deepening as other sources of funds emerge and become increasingly important in financial intermediation. Countries with more developed financial markets, for example, have a tendency to rely more on their securities and bonds markets to finance firms’ credit needs and investment projects.
24
Structural measures also point to the limited depth of the country’s financial system. The country’s BM/NM ratio has been steady at around 3.3 since the mid-1980s. From 3.1 in 1987, the BM/NM ratio peaked to 4.1 in 1997 due mainly to the financial liberalization measures in the early 90s, and declined anew to 3.4 by end-2005. Meanwhile, from 3.7 in 1996, which reflected the booming financial sector, the SEC/BM ratio plunged to pre-financial liberalization levels of less than 2.0 in the aftermath of the Asian Financial Crisis. In 2004, the ratio had recovered to 3.6 as confidence on the soundness of the country’s financial market and economic fundamentals slowly returned.
It has also been observed that the Philippine financial system remains dominated by banks, thus, limiting the scope for financial intermediation in the country. As of July 2006, the total resources of the country’s financial system more than doubled to P5.7 trillion relative to the amount recorded in 1996. Banks account for 81.1 percent of the total assets as of that period. In fact, data shows that the banks’ share in the financial system’s total resources has been increasing steadily over the years, from 76.1 percent in 1980 to 80.5 in end 2005. This is contrary to economic theory which tells us that the relative importance of other sources of funds (i.e. non-bank financial institutions) in the financial market should increase as the financial system matures.
However, it should be noted that the Philippine financial system’s underlying fundamentals have posted steady improvements over the last fifteen years. This is due largely to reforms implemented by the Bangko Sentral ng Pilipinas (BSP) to reduce the systemic risks in the banking sector and improve overall prudential regulation. This could be seen in the growing importance of deposits as a source of funds for banking institutions. The value of total deposits, share of deposits to GNP, and total funds of the banking sector have risen steadily since the early 1980s. The banking system’s deposit liabilities expanded to P2.933 trillion as of end-December 2005, from just P1.271 trillion in 1996. This represented 49.9 percent of the country’s gross national product. Savings deposits still comprised more than half of banks’ stable funding base. Deposit mobilization activities of banks include relocation of new branches and installation of automated teller machines in new sites.
References:
Hemedes, Carmen V. and Lapid, Dennis D. A Review of Issues Concerning Reserve Requirements. Bangko Sentral Review, Volume VII – Number 2, July 2005.
Lynch, David. Measuring Financial Sector Development: A Study of Selected Asia-Pacific Countries. The Developing Economies, Volume 34-1, March 1996.
Pill, Huw and Mahmood Pradhan. Financial Liberalization in Africa and Asia. International Monetary Fund, Finance and Development, June 1997.
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Exchange Rate
The peso continues to strengthen against the US The local currency has continued to advance dollar. against the US dollar. On a quarterly basis, the peso appreciated by 1.82 percent to average P51.353/US$1 in the third quarter from 10 Daily Peso-US Dollar Rate P52.289/US$1 in the previous quarter. The peso’s appreciation was supported by positive P/US$ 60 market sentiment brought about by strong economic growth as well as the better-than- 55 expected fiscal position during the first eight months of the year. Strong regional currencies due 50 partly to market expectations that the US will pause in its tightening cycle, the government’s 45 relatively high level of dollar reserves and sustained inflows from OFW remittances, export 40 earnings and foreign portfolio and direct investments likewise contributed to the gains in the 35 11 2000 2001 2002 2003 2004 2005 2006 peso.
On a year-to-date basis, the peso appreciated by 3.67 percent against the US dollar as of 27 September 2006. Meanwhile, other regional currencies, with the exception of the New Taiwan dollar, appreciated against the US dollar on a year- to-date basis.
Volatility, as measured by the standard deviation of the daily exchange rates, averaged P0.83 in the third quarter of 2006, as in the previous quarter, following the marked appreciation of the peso which breached the P52/US$1 and P51/US$1 levels during the review period.
10 Dollar rates or reciprocal of the peso-dollar rates were used to compute for the percent changes. 11 The country’s gross international reserves (GIR) posted another all-time high record of US$21.56 billion as of end- September 2006. 26
On a real, trade weighted basis, the peso’s On a real, trade-weighted basis, the peso’s real external competitiveness weakens. effective exchange rate (REER) as of the review period appreciated against the baskets of currencies of the country’s major trading partners (MTPs) and competitor countries both in the broad and narrow series. The peso’s REER index appreciated relative to the currencies of its MTPs by 2.77 percent due to the peso’s nominal appreciation against this basket of currencies coupled with the widening of the inflation differential. Likewise, the peso’s real appreciation against the currencies of its broad and narrow competitor countries by 3.74 percent and 3.90 percent, respectively, was due to the nominal appreciation of the peso against these baskets of currencies as well as the widening of the inflation differential. The appreciation of the peso’s real effective exchange rate suggested a decline in the local currency’s competitiveness.
Sustained dollar inflows and favorable outlook In the near term, the peso is expected to stay for the domestic economy will continue to prop strong against the dollar given sustained dollar up the peso. inflows from OFW remittances, portfolio and foreign direct investments as well as export receipts. Foreign direct investments specifically in export-related industries are expected to improve markedly in 2006 due in part to renewed interests by investors in view of the country’s positive macroeconomic developments arising from improved fiscal position, strong economic growth and easing inflation. The overall positive market sentiment should also provide a boost to the local currency.
27
Monetary Aggregates
Lower credits to the public sector contribute to Demand for money slowed down in the third some easing in liquidity growth. quarter as M3 growth decelerated to 13.2 percent and 12.4 percent in July and August, respectively from 13.4 percent in June 2006.12 The slowdown in the growth of domestic liquidity may be traced in part to the decline in credits to the public sector as a result of the improved fiscal performance. In particular, net lending to the National Government in August declined by 7.8 percent from a 5.5 percent growth in June. Growth in credits to the private sector remained moderate at around 0.5 percent in July and August. Meanwhile, sustained OFW inflows allowed the BSP and the banks to build up their foreign assets and reduce their foreign liabilities.
Similarly, the year-on-year growth in reserve money (RM) decelerated to an average of 12.8 percent in the third quarter from 15.6 percent in the previous quarter.13
Fiscal Developments
Government is likely to keep deficit below target. The National Government generated a P16.2 billion fiscal deficit in September which brought down the January to September fiscal deficit to P50.4 billion, P58.1 billion or 53.5 percent lower than the deficit for the comparable period last year. The lower deficit for the period reflected the strengthening of revenue collection performance, and the restricted spending of government agencies following the non-passage of the 2006 proposed budget. The nine-month fiscal deficit is equivalent to 40.4 percent of the full-year target of P125.0 billion. This implies that the NG budget deficit is likely to fall below the target for the year.
12 M3 refers to the stock of broad money based on data on the Depository Corporations Survey (DCS). The DCS, which replaces the Monetary Survey (MS) as the basis for measuring domestic liquidity, features an expanded list of surveyed institutions that includes the BSP, commercial banks, thrift banks, rural banks, non-stock savings and loan associations and non-banks with quasi-banking functions. 13 Reserve money (RM) is a narrower definition of money supply defined as the sum of currency issue net of cash in vaults of the BTr and banks’ reserve balances with the BSP. 28
Aggregate revenue collections for the first nine months of the year reached P715.9 billion, higher by roughly 20.0 percent compared to P598.8 billion in the same period last year. Cash collections by the Bureau of Internal Revenue and the Bureau of Customs posted double-digit growth of 20.1 percent and 36.5 percent, respectively.
Meanwhile, total disbursements amounted to P766.3 billion or a modest 8.5 percent growth from the comparable disbursements in 2005.
III. External Developments
Overall global economic growth remains robust Global economic activity remained strong in the despite some slowing down in the US. first half of 2006, buoyed by robust domestic consumption and the resilience of the services sector. Sustained gains in employment along with the ongoing improvements in corporate profitability and investment also underpinned global expansion. However, recent developments appear consistent with a rebalancing in the composition of global demand. Growth in the Euro area, Japan and emerging Asia continue to firm up while the United States has shown some signs of slowing down.
Some factors continue to pose risks to the A number of risks also remain, notably the ongoing expansion. volatility in international oil prices, disorderly unwinding of global imbalances, and the unexpected tightening of financial markets— notably those in industrial countries such as the US and UK where housing markets are richly valued. At the same time, emerging market economies with weak public financial positions and weakly anchored inflation expectations are particularly vulnerable to the uncertainties facing the global financial markets. Risks to the outlook for price developments also remain on the upside. Inflationary pressures appear to have increased in countries where sustained high rates of growth have absorbed spare capacity. Against this background, the world’s major central banks have taken steps to tighten monetary conditions.
29
International Monetary Fund (IMF) estimates suggest continued robust global expansion leading to some pick-up in inflationary pressures. The baseline forecast for world output growth was revised upward to 5.1 percent in 2006 and 4.9 percent in 2007, due mainly to the stronger-than- expected economic activity in the first quarter of 2006. Meanwhile, headline inflation in advanced economies is expected to increase moderately to 2.6 percent in 2006 before decelerating to 2.3 percent in 2007. Inflation rate in emerging economies is likely to settle at 5.2 percent and 5.0 percent in 2006 and 2007, respectively.14
Economic activity slows down in the US as the Cooling housing market and lower consumer housing market cools down and consumer spending slowed the US economy significantly in spending weakens. the second quarter of 2006. Real GDP growth decelerated to 2.8 percent year-on-year from 5.6 percent in the previous quarter.15 Latest data again showed further deterioration in the housing market with the decline both in the number of new housing projects and building permits issued for privately owned housing units. Available price data, meanwhile, suggest that the country’s slower economic growth had not been enough to restrain rising prices. While the annual inflation eased slightly to 3.8 percent in August from 4.1 percent in July, core inflation increased further to 2.8 percent from 2.7 percent during the same period. Nonetheless, the US Fed maintains that inflation pressures are likely to moderate over time, reflecting contained inflation expectations as well as the cumulative effects of previous monetary policy actions and other factors restraining aggregate demand.16
14 IMF, World Economic Outlook (WEO), September 2006 15 Bureau of Economic Analysis (BEA) News release no 06-36 dated 30 August 2006 entitled “Gross Domestic Product: Second Quarter 2006 (Preliminary),” available online at http://www.bea.gov/bea/news 16 US FOMC, press release of policy rate decision, dated 20 September 2006, available on line at http://www/federalreserve.gov 30
Euro area posts solid output growth in the first Growth momentum in the euro area picked up in half of the year on the back of a rebound in the first half of the year. Euro Area real GDP construction and agriculture. growth increased to 0.9 percent, the strongest growth recorded in six years, from 0.8 percent in the preceding quarter. The said expansion was driven by the strong rebound of construction activity and agriculture. Likewise, domestic demand and inventory changes were seen to contribute positively to GDP growth.17 Corporate investment is expected to strengthen further, especially in areas where profitability has recovered and corporate restructuring is well advanced. Meanwhile, euro-zone Harmonised Index of Consumer Prices (HICP) inflation eased slightly to 2.3 percent in August from 2.4 percent in the previous month. The European Central Bank (ECB) expects inflation to remain above 2.0 percent in the months ahead, largely depending on how international oil prices evolve going forward.18
Economic expansion continues in the UK, Solid gains in consumer spending as well as the supported largely by strong private increase in government expenditure supported consumption and higher government spending. the UK’s economic growth in the second quarter. The real GDP growth was sustained at 0.7 percent. The housing market remains underpinned by sound fundamentals. However, a host of factors are expected to dampen housing demand and moderate house price inflation over the remainder of 2006, thus providing some downside risks to private consumption.19 Higher prices of recreation and culture, furniture and furnishing, and materials for maintenance and repair of dwelling pushed the August CPI inflation rate to 2.5 percent from 2.4 percent in previous month. The Bank of England’s (BOE) central projection for inflation shows a further rise above the 2.0 target rate in the near term before easing back towards the target in 2007.20
17 ECB, Monthly Bulletin, September 2006, available online at http://www.ecb.int 18 Ibid. 19 Halifax Research, Halifax House Price Index August 2006 National press release, 7 September 2006, available online at http://www.hbosplc.com/economy/NationalPressRelease.asp 20 BOE, Minutes of the 2-3 August 2006 Monetary Policy Committee Meeting, 16 August 2006, available online at http://www.bankofengland.co.uk 31
The continued recovery of the Japanese Steady recovery continued in the Japanese economy hinges on gains in consumer spending, economy. The country’s real GDP expanded by and continued growth in capital formation and 0.2 percent quarter-on-quarter in the second exports. quarter of 2006, underpinned by the sustained gains in private consumption. The growth in capital formation and exports remained robust despite some deceleration. Industrial production remained on a general uptrend in recent months, supported by ongoing improvements in business investment and corporate profitability.21 Private consumption is also increasing moderately even as consumer confidence continued to move sideways. Gradual improvements in employment conditions are expected to lend further support to the strengthening of domestic demand over the coming months. On the price front, the annual CPI inflation edged up to 0.9 percent from 0.3 percent in the previous month. The BOJ is of the view that the environment for prices is likely to increase gradually in the future as a higher level of resource utilization is observed along with expectation of higher unit labor costs.22
Growth momentum picks up in emerging Asia, Economic growth in emerging Asia accelerated in helped largely by strong exports and robust the first half of 2006 on strong exports and robust industrial production. industrial production. Renewed external demand for electronic products also stimulated growth in investment and employment in most economies. The growth of emerging Asia continued to be led by China and India. China’s real GDP growth accelerated to 11.3 percent in the second quarter from 10.3 percent in the previous quarter while, India grew by 8.9 percent in the April-June quarter given the steady expansion of industry output. Inflation rose in the region due to fuel price increases, but most central banks have succeeded in restraining core inflation with gradual increases in their respective policy rates.23 Asia’s growth prospects remain favorable, buoyed by firming domestic demand. However, persistent high oil prices, volatility in global financial conditions, the correction of the overheating Chinese economy, and more rapid than expected slowdown in the US present risks to the ongoing economic advancement in the region.
21 Japan Cabinet Office, Monthly Economic Report, July 2006, available online at http://www5.cao.go.jp/keizai3/ getsurei-e/2006jul.html 22 Bank of Japan, Outlook for Economic Activity and Prices, 1 May 2006, available online at http://www.boj.or.jp 23 IMF, Regional Economic Outlook, September 2006 32
Key central banks keep monetary policy The major central banks decided to maintain their settings unchanged in their latest policy policy rates at current levels despite indications of meetings. inflation pressures in their respective economies. The US Federal Open Market Committee (FOMC) ended its two-year campaign of raising interest rates in August as the country’s economic growth moderated from its strong pace earlier this year. The federal funds rate was kept at 5.25 percent during its 8 August and 20 September 2006 meetings. However, the FOMC noted that further policy rate increases may be needed going forward to address existing inflation risks. Similarly, the BOJ decided to maintain current policy settings as it encouraged the uncollateralized overnight call rate to remain at around 0.25 percent during its 7-8 September 2006 monetary policy meeting after raising the policy rate in July 2006.
The ECB Governing Council also decided to maintain the key interest rates during its 31 August 2006 meeting, but remained of the view that a progressive withdrawal of monetary accommodation is warranted to help ensure that medium to longer-term inflation expectations in the Euro area remain solidly anchored at levels consistent with price stability. Similarly, the BOE’s Monetary Policy Committee voted to keep the official bank rate steady at 4.75 percent during its 6-7 September policy meeting following the 25 basis point increase in its previous meeting.
IV. Monetary Policy Developments
BSP keeps a steady hand in monetary policy. During the quarter in review, the Monetary Board met twice and opted to keep monetary policy settings unchanged. The overnight RRP rate or BSP Policy Interest Rates In percent borrowing rate remained at 7.5 percent while the
18 overnight RP rate or lending rate was maintained at 9.75 percent. Policy interest rates were last 16 changed on 20 October 2005. 14
12 Overnight Repurchase (RP) Rate 10
8
6 Overnight Reverse Repurchase (RRP) Rate 4 2000 2001 2002 2003 2004 2005 2006
33
Favorable inflation developments provide During their policy meetings, the Monetary Board some scope for keeping policy rates steady. noted that a number of favorable factors support the case for keeping policy rates steady. Foremost of which, the Monetary Board’s assessment showed that evidence on current and expected inflation indicates a manageable inflation environment over the policy horizon. Actual headline inflation continued to decelerate while forecasts are on a declining path with a likelihood of within-target inflation in 2007 in the absence of further adverse shocks.
Furthermore, the sustained easing in core inflation also pointed to reduced generalized pressures on consumer prices. The Monetary Board was also of the view that favorable food prices alongside a strengthening domestic currency would continue to provide some stability to overall consumer prices.
Nevertheless, monetary authorities recognize Nevertheless, the Monetary Board has that there are risks to the inflation outlook. consistently communicated in their policy statements that there are still risks to the inflation outlook. In their assessment, the Monetary Board identified movements in oil prices as the wildcard in the prevailing macroeconomic environment due to the continued prospect of tight supply conditions and market volatility tied to geopolitical developments.
Monetary authorities also continued to pay close attention to other possible sources of inflation pressures. These included potential second- round pressures linked to wage-setting behavior and possible shifts in the public’s inflation expectations. The Monetary Board noted that, at present, inflation expectations appeared to be well-anchored. However, adverse shifts in expectations could become a potential risk in an environment of continuing supply-side risks. Lastly, liquidity conditions continued to be closely monitored in view of their potential impact on inflation.
Achievement of medium-term targets remains Going forward, the Monetary Board remains the policy priority. committed to achieving the inflation targets over the medium term and stands ready to act against the emerging risks to the outlook for inflation and to inflation expectations.
34
V. INFLATION OUTLOOK
Inflation Forecasts
Recent developments in demand and supply Limited demand-side pressures and favorable conditions suggest manageable inflation outlook, recent developments on the supply-side support going forward. the BSP’s expectation of a continued deceleration in inflation for the rest of 2006 and possible within-target inflation for 2007, barring major supply-side shocks.
Uneven improvements in demand indicators suggest limited demand-based pressures on inflation. Although national income accounts data for the second quarter indicate continued economic expansion, manufacturing activity and merchandise trade showed moderation while energy and appliance sales declined. Consumer confidence for the third quarter improved but the outlook was also more cautious going forward. In addition, the continued easing of core inflation suggests minimal demand-based inflation pressures.
On the supply side, agricultural output continued to expand as the crops subsector recovered and fishery and livestock production increased. Nonetheless, the damage caused by typhoon “Milenyo” during the close of the third quarter could pose short-term risks to agricultural production and consequently, to food prices. On the other hand, international spot and futures prices for crude oil have eased during the latter part of the third quarter on the back of increased US oil inventories and easing geopolitical tensions in the Middle East.
BSP projections show a generally declining path Extending the forecast horizon to 2008, latest for inflation. staff projections continue to show a generally declining path for inflation. Average inflation in 2006 is projected to exceed the Government- announced target of 4.0-5.0 percent while forecasts for 2007 point to a possible within-target inflation in the absence of further adverse shocks. For 2008, staff forecasts suggest a gradual decline in inflation.
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The BSP’s forecasts are based on the following assumptions:
a. Real GDP growth will average 5.5 percent in 2006; 5.7 percent in 2007; and 5.9 percent in 2008.
b. National Government deficit levels will amount to P124.9 billion in 2006 and P63.0 billion in 2007. The National Government was assumed to achieve a balanced budget in 2008.
c. The overnight RRP rate was assumed constant at 7.5 percent from October 2006 to December 2008.
d. The 91-day T- bill rates were assumed to average 5.4 percent in 2006; 6.0 percent in 2007; and 5.5 percent in 2008.24
e. International crude oil prices are consistent with the latest BSP projections (as of 13 September 2006, based on futures prices) of US$63.33 for 2006; US$67.26 for 2007; and US$67.99 for 2008. The impact on inflation of mitigating measures such as the reduction in import duty on diesel, kerosene and fuel from 5 percent to 3 percent was incorporated into the baseline forecast.
f. Baseline inflation forecasts incorporate the realized impact of the implementation of the RVAT law that repealed the VAT exemption on power, petroleum products, and other commodities beginning November 2005 and increased the VAT rate to 12 percent from 10 percent in February 2006.
g. Nominal wage rate was assumed to increase by 5 percent in June 2007; and 4 percent in 2008.
24 For the BSP’s Multi-Equation Model, the 91-day T-bill rates were determined endogenously. 36
Risks to the Inflation Outlook
Latest fan chart shows a lower inflation for the The fan chart on the next page illustrates the rest of 2006 until the first half of 2007. probability of various outcomes for inflation based on the central projection (corresponding to the baseline forecast of the BSP) and the risks surrounding the inflation outlook.
Relative to that of the previous quarter, the current fan chart depicts a slightly different path of future inflation. Firstly, the forecast horizon for the current fan chart is extended until 2008 to show the outlook for the next two years. Secondly, the current fan chart shows a lower inflation path for the rest of 2006 until the first half of 2007. This is due mainly to the lower-than - projected actual inflation outturn for the third quarter as oil and food prices eased and as the local currency gained strength during the period. Moreover, positive developments on the supply side, including improved prospects for agriculture and reduced electricity generation charges, point to easing inflation in the near term. However, increases in crude oil prices and in nominal wages that were assumed in the BSP’s forecasting models raise the central projection slightly during the second half of 2007. Thereafter, inflation is projected to decline gradually until end-2008.
As in the previous quarter, the current fan chart is skewed slightly upwards (i.e. the bands above the central projection are lower than those below it). This reflects the BSP’s assessment that the balance of risk continues to be tilted toward rising inflation.
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Inflation Profile as of Previous Quarter Latest Inflation Profile
Ye ar-o n-Ye a r I nflation Ye ar-on-Ye ar Inflation 10 10
9 9
8 8
7 7
6 6
5 5
4 4
3 3
2 2
1 1
0 0 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 Q2 Q3 Q4 2003 Q2 2004 Q1 2005Q1 2006Q1 2007Q1 2004 Q1 2004 Q1 2005 2003 Q2 2003 Q1 2006 Q1 2007 Q1 2008 The fan chart shows the probability of various outcomes for inflation over the forecast horizon. The darkest band depicts the central projection, which corresponds to the BSP’s inflation baseline forecast. It covers 25% of the probability. Each successive pair of bands is drawn to cover a further 25% of probability, until 75% of the probability distribution is covered. The bands widen (i.e. “fan out”) as the time frame is extended, indicating increasing uncertainty about outcomes.
The risks surrounding the BSP’s central projection include mainly the uncertainty in the trend of oil prices and possible shocks to agricultural output.
Uncertainty in the trend of oil prices
Despite its recent decline, crude oil prices remain the key risk in the inflation outlook.
On the whole, the global oil supply-demand balance is expected to remain relatively tight. In its September Short-Term Energy Outlook, the US EIA noted that existing and potential supply problems will continue to raise concern, particularly given limited surplus production capacity.25 Nonetheless, the stronger peso, due to the continued surge in dollar inflows, should help keep down the domestic prices of oil and other imported commodities.
25 EIA, Short-Term Energy Outlook, 12 September 2006, available online at http://www.eia.doe. gov/emeu/steo/pub/contents.html 38
Possible Shocks to Agricultural Output
Agricultural output remains vulnerable to potential weather disturbances that may affect the country. This, in turn, raises the possibility of upward pressures on food prices. As reported by the BAS, the onslaught of typhoon “Milenyo” in the NCR significantly pushed up the retail prices of selected fruits and vegetables. For the fourth quarter, the Philippine Atmospheric, Geophysical and Astronomical Services Administration (PAGASA) forecasts that four to seven tropical cyclones will enter Philippines’ area of responsibility. Furthermore, the weather bureau likewise noted that warming trends in sea surface temperatures that are indicative of a mild El Niño event will likely prevail through the end of 2006 and will continue until early 2007. However, the Government stands ready to address food supply constraints that may arise in the event of natural calamities, as done by concerned agencies on the heels of typhoon “Milenyo”. For instance, the Department of Agriculture (DA) instructed Regional Field Units (RFUs) in major vegetable-producing areas in the country (such in Baguio and Oriental Mindoro) to help facilitate the delivery of vegetables in Metro Manila to prevent shortage of vegetables in the metropolis. This will ensure that supplies of vegetables to Metro Manila will remain unhampered with minimal variation in prices. In addition, the National Economic and Development Authority (NEDA) reiterated its call for a shift of the present system of monocropping in coconut farms into diversified countryside agribusiness systems to augment the produce of coconut industry-dependent regions that were hardest hit by the typhoon.
Other risks to the inflation outlook
Other risks to the inflation outlook include the possibility of additional wage adjustments and potential liquidity expansion. The recent round of wage increases has been largely restrained and was in line with BSP’s forecast assumptions. A proposed across-the-board wage increase is currently pending in Congress. Meanwhile, the expansion in liquidity in the banking system that ensues from the continued surge in foreign exchange inflows may later on translate into increased credit demand, particularly as market interest rates remain low and overall economic activity continues to strengthen.
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Private Sector Economists’ Inflation Forecasts
Private forecasters lower their inflation Private analysts revised their inflation forecasts for 2006 and 2007. forecasts for 2006 downward as a result of declining food inflation. The mean inflation Mean Inflation Forecasts by Private Sector Economists/Analysts In percent forecast for 2006 in this quarter’s survey
7.5 declined to 6.6 percent from 6.9 percent in the previous quarter. For 2007, the mean forecast 7.0 was 5.3 percent, which is also lower than the 6.5 previous quarter’s 5.7 percent. Most analysts 6.0 cited the easing in world oil prices and the 5.5 strengthening of the peso as factors that 5.0 could help limit price pressures. The favorable
4.5 outlook for the agriculture sector is also
4.0 expected to keep down food inflation. 2004 Q3 2004 Q4 2005 Q1 2005 Q2 2005 Q3 2005 Q4 2006 Q1 2006 Q2 2006 Q3 2006 2007 However, some economists noted that concerns on political stability and the possibility of some wage adjustments are potential risks to inflation.
Probability Distribution For Analysts' Inflation Forecasts* Based on the BSP survey, analysts generally 2006 and 2007 expect 2006 inflation to fall between 6.1-7.1 80.0
66.9 percent. For 2007, expectations appear to be 70.0 more dispersed but also weighted slightly 60.0 more towards higher-than-target inflation. 50.0
40.0 31.6 30.0 Analysts also expect continued improvements
20.0 in economic activity both in 2006 and 2007.
10.0 The mean forecast for real GDP growth in
0.0 2006 rose slightly to 5.4 percent, higher than <0 1.0-2.0 2.1-3.0 3.1-4.0 4.1-5.0 5.1-6.0 6.1-7.0 7.1-8.0 8.1-9.0 9.1-10.0 >10.0 the last quarter survey of 5.3 percent. 2006 2007 However, this is still below the government’s *Probability distributions were averages of those provided by eight respondents (Source: BSP Survey) growth target of 5.5-6.1 percent. Analysts point out that progress on the country’s Probability Distribution For Analysts' GDP Forecasts* economic reforms will encourage more 2006 and 2007 infrastructure investments. The resilient services sector is also likely to push growth in 80
70 65.6 2006. They also noted that sustained OFW remittances will further spur private 60 53.1
50 consumption. For 2007, the mean GDP
40 forecast rose to 5.4 percent from the last
30 quarter’s mean forecast of 5.2 percent.
20
10 Based on the probability distribution for GDP
0 forecasts, analysts expectations for output <0 1.0-2.0 2.1-3.0 3.1-4.0 4.1-5.0 5.1-6.0 6.1-7.0 7.1-8.0 8.1-9.0 9.1-10.0 >10.0 growth appear to converge around the 5.1-6.0 2006 2007 percent range for 2006 and 2007. * Probability distributions were averages of those provided by eight respondents (Source: BSP Survey)
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Private Forecasts for Inflation and GDP Annual percent change Inflation GDP 2006 2007 2006 2007 ABN-AMRO 6.8 5.5 5.5 5.9 ATR Kim Eng Securities 6.3 4.0 5.7 6.0 Banco de Oro 6.7 7.0 5.5 5.8 Bank of America 6.6 5.3 5.4 4.9 Citigroup 6.5 4.8 5.4 5.5 Development Bank of Singapore 6.6 5.5 5.3 5.3 Economist Intelligence Unit 6.6 5.2 5.3 5.0 Equitable-PCI Bank 6.5 5.5 5.7 6.0 HSBC 7.0 5.9 5.6 4.0 ING Bank 6.5-6.7 4.7-7.8 5.5 5.5 Lehman Brothers. 6.6 6.0 5.2 6.0 Multinational Investment Bank 6.8 6.3 5.6 5.7 Nomura Securities 6.8 6.0 5.1 5.0 Philippine Equity Partner 6.4 4.3 5.4 5.1 RCBC 6.0-7.0 5.0-6.0 5.0-6.0 5.0-5.5 UBS Warburg 6.4 4.1 5.2 5.8 Wallace Business Forum 6.7 6.05.7 5.8
Median Forecast 6.6 5.5 5.5 5.5 Mean Forecast 6.6 5.3 5.4 5.4 High 7.0 7.0 5.7 6.0 Low 6.3 4.0 5.1 4.0 Number of Observations 17 17 17 17
Memo Item Government Target 4.0-5.0 4.0-5.0 5.5-6.1 5.7-6.5 Source: BSP Survey
VI. IMPLICATIONS FOR THE MONETARY POLICY STANCE
Demand- and supply-side conditions continue to The prevailing combination of favorable provide flexibility for monetary policy in the near supply-side and demand-side conditions term. continue to provide flexibility for monetary policy in the near term. Stable food prices and a strengthening currency are expected to contribute to declining inflation over the policy horizon. The continued easing of core inflation demonstrates a relative absence of demand-based inflation pressures. This is consistent with the uneven pattern of growth in aggregate demand, which has been largely driven by consumer spending.
The inflation outlook remains at risk from The inflation outlook remains at risk from energy-related cost-side pressures. energy-related cost-side pressures. These pressures stem mainly from the vulnerability of international crude oil prices to supply constraints and geopolitical disruptions. Potential shifts in the public’s inflation expectations thus continue to require monitoring. The possibility of such shifts does not appear to be a pressing concern at the moment but could become a credible risk in the future if cost pressures escalate more sharply than expected. This assessment applies equally to potential second-round pressures linked to wage-setting behavior.
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Liquidity conditions also continue to require Liquidity conditions also continue to require authorities’ attention. authorities’ attention. The continued surge in foreign exchange inflows creates a risk that the resulting expansion in liquidity in the banking system may later on translate into increased credit demand, particularly as market interest rates remain low and overall economic activity continues to strengthen.
One concern is that, based on current forecasts, the inflation path may not decelerate quickly enough to settle within the indicative target of 3-4 percent for 2008. However, discussions are ongoing at the DBCC for a possible shift to a point inflation target with a tolerance interval, as a means of increasing the flexibility of monetary policy decision-making. A shift to a point target with a tolerance interval can allow for a more gradual decline in the medium-term inflation path.
In sum, managing the risks to inflation In sum, managing the risks to inflation expectations, as well as risks from second- expectations and risks from second-round round effects particularly from wage-setting effects particularly from wage-setting remains remains a key policy priority for the BSP. a key policy priority for the BSP. Policy pronouncements emphasizing the BSP’s readiness to act upon escalating risks to inflation, along with a clear depiction of the emerging outlook for inflation, can help stabilize public inflation expectations.
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VI. CONCLUDING REMARKS
Expectations of a return to a benign path for The easing of world oil prices in recent inflation in the medium term have strengthened. months helped to reduce the cost-push risks associated with the inflation outlook, as consumers see the direct impact in the form of reductions in local pump prices. Improving agricultural output also stabilized food prices, thus helping to further bolster monetary authorities' expectations of a return to a benign path for inflation in the medium term.
However, supply-side factors remain wildcards in To be sure, these same supply-side factors the macroeconomic environment. continue to serve as wildcards in the prevailing macroeconomic environment. The possibility of a renewed oil upsurge due to supply concerns and geopolitical developments remains present given continued demand in major economies amid tight supply conditions. Other supply-side risks loom on the horizon as well, such as the possible El Niño episode.
Output growth also remains at risk, both Output growth also remains at risk. The domestically and externally. prospect of rising interest rates in advanced economies has receded somewhat in the past quarter, but robust activity in the US and steady recovery in Europe and Japan may again, at a later point, require tightening by the major central banks. Such a prospect implies a risk of a slowdown in external demand for the Philippines and other Asian economies. It could also translate into capital outflows from emerging economies, which in turn can potentially pull down equity and property prices and cause volatility in the foreign exchange market.
Domestic demand has also yet to find a solid footing, given the continued uneven pattern of growth in demand indicators. Private sector credit activity, in particular, remains relatively weak despite continued improvements in bank asset quality. Among other things, this has meant that investment spending has continued to be relatively subdued in recent quarters.
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Monetary policy needs to find the right balance The primary challenge to monetary policy, between fighting inflation and favoring growth. therefore, will be to find the right balance between addressing the risks to inflation and supporting the economy’s growth momentum. Monetary policy, going forward, will thus continue to proceed on a cautious footing; keeping a close eye on incipient inflationary pressures, at the same time ensuring that these risks do not undermine economic growth.
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Chronology of Monetary Policy Decisions
2000 of the Monetary Board under the inflation- targeting framework. 24 January 2000 14 February 2002 The Monetary Board–the policymaking body of the BSP–adopted in principle the shift to The Monetary Board opted to lower the BSP’s inflation targeting as the BSP's framework for policy rates further by 25 basis points each, conducting monetary policy. bringing the overnight RRP rate to 7.25 percent and the overnight RP rate to 9.5 percent effective 15 February 2002. 2001 The Monetary Board also approved an 26 December 2001 adjustment in tiering scheme for banks’ overnight RRP placements with the BSP as The BSP announced formally the adoption of follows: 7.25 percent for placements of up to inflation targeting as framework for monetary P5 billion, 4.25 percent for the next P5 billion policy beginning January 2002. The BSP also and 1.25 percent for placements in excess of announced the Government’s annual average P10 billion. The tiering scheme also covered inflation targets of 5.0-6.0 percent for 2002 special deposit accounts (SDAs) and would and 4.5-5.5 percent for 2003. be applied on a consolidated basis.
14 March 2002 2002 The Monetary Board decided to reduce BSP’s 17 January 2002 key policy rates by another 25 basis points. The overnight RRP rate was lowered to 7.0 The Monetary Board decided to reduce the percent while the overnight RP rate was overnight RRP and RP rates by 25 basis reduced to 9.25 percent effective 15 March points each to 7.5 percent and 9.75 percent, 2002. respectively. Correspondingly, the interest rates on Consequently, the Monetary Board also overnight RRP and SDA placements with the adopted a change in the tiering structure for BSP under the tiering scheme were adjusted banks’ overnight RRP placements with the as follows: 7.0 percent for placements of up to BSP as follows: 7.5 percent for the first P5 P5 billion, 4.0 percent for the next P5 billion billion, 4.5 percent for the next P5 billion and and 1.0 percent for placements in excess of 1.5 percent for placements in excess of P10 P10 billion. billion.
The Monetary Board also approved a two- percentage point reduction to 7.0 percent of the liquidity reserve requirements on deposits and deposit substitute liabilities, common trust funds and other trust and fiduciary liabilities of commercial banks and non-banks with quasi- 11 April, 8 May, 6 June, 4 July, 1 August, 29 banking functions. August, 26 September, 23 October, 21 November, 19 December 2002 These monetary policy measures took effect on 18 January 2003. Moreover, it could be During the monetary policy meetings held for noted that this decision marks the first action the period April-December 2002, the Monetary
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Fourth Quarter 2005
Board decided to keep the overnight RRP and 5 June 2003 RP rates steady at 7.0 percent and 9.25 percent, respectively. The Monetary Board decided to leave the overnight RRP and RP rates unchanged at 7.0 percent and 9.25 percent, respectively. 2003 The Monetary Board also decided to restore 16 January 2003 the tiering scheme on banks’ placements with the BSP under the RRP and SDA windows The Monetary Board voted to keep the BSP’s effective 5 June 2003. In particular, overnight policy rates unchanged at 7.0 percent for the RRP placements would be subject to the overnight RRP rate and 9.25 percent for the following interest rates: 7.0 percent for the first overnight RP rate. P5 billion, 4.0 percent for additional amounts in excess of P5 billion but below P10 billion 7 February 2003 and 1.0 percent for amounts in excess of P10 billion. The BSP announced the Government’s official target for the average annual inflation for 2004 2 July 2003 at 4-5 percent. The Monetary Board voted to reduce the 12 February, 13 March 2003 BSP’s key policy interest rates by 25 basis points each to 6.75 percent for the overnight The Monetary Board kept the BSP’s policy RRP rate and 9.0 percent for the overnight RP rates unchanged at 7.0 percent for the rate effective 2 July 2003. overnight RRP rate and 9.25 percent for the overnight RP rate. The interest rates on banks’ placements under the tiered system were also adjusted as 19 March 2003 follows: 6.75 percent for the first P5 billion, (Special Monetary Board Meeting) 3.75 percent for amounts in excess of P5 billion up to P10 billion and 0.75 percent in The Monetary Board decided to lift the three- excess of P10 billion. tiered scheme on banks’ placements with the BSP. Thus, overnight placements under the 31 July 2003 RRP window would be accepted at a flat rate of 7.0 percent effective 20 March 2003. The Monetary Board left the overnight RRP and RP rates unchanged at 6.75 percent and The Monetary Board also raised the liquidity 9.0 percent, respectively. reserve requirement against peso demand, savings, time deposit and deposit liabilities of universal banks and commercial banks by one-percentage point to 8.0 percent effective 21 March 2003.
10 April, 8 May 2003 28 August 2003
The Monetary Board maintained the overnight The Monetary Board opted to keep the BSP’s RRP and RP rates steady at 7.0 percent and policy rates unchanged at 6.75 percent for the 9.25 percent, respectively. overnight RRP rate and 9.0 percent for the overnight RP rate.
46
Fourth Quarter 2005
unchanged at 6.75 percent and 9.0 percent, The Monetary Board also decided to lift the respectively. tiering scheme for banks’ placements with the BSP. Thus, effective 28 August 2003, 7 April 2005 overnight RRP transactions with the BSP were accepted at a flat rate of 6.75 percent. The Monetary Board voted unanimously to raise the overnight RRP and RP rates by 25 2 October, 23 October, 20 November, 18 basis points each to 7.0 percent and 9.25 December 2003 percent, respectively.
The Monetary Board voted unanimously to 5 May, 2 June, 30 June 2005 leave the BSP’s policy rates unchanged at 6.75 percent for the overnight RRP rate and The Monetary Board decided to keep the 9.0 percent for the overnight RP rate. BSP’s policy interest rates at 7.0 percent for the overnight RRP rate and 9.25 percent for the overnight RP rate. 2004 7 July 2005 15 January 2004 (Special Monetary Board meeting)
The Monetary Board decided to keep The Monetary Board raised the regular and monetary policy settings unchanged. The liquidity reserve requirement ratios by 100 overnight RRP and RP rate were maintained basis points each to 10 percent and 11 at 6.75 percent and 9.0 percent, respectively. percent, respectively, effective 15 July 2005.
5 February 2004 28 July, 25 August 2005 (Special Monetary Board Meeting) The Monetary Board left key policy rates The Monetary Board decided to increase the unchanged at 7.0 percent and 9.25 percent for liquidity reserve requirement for universal the overnight RRP rate and overnight RP rate, banks and commercial banks by two respectively. percentage points to 10 percent effective 6 February 2004. 22 September 2005
12 February, 11 March, 15 April, 6 May, 3 The Monetary Board decided to raise the June, 1 July, 29 July, 26 August, 23 overnight RRP rate and RP rate by 25 basis September, 21 October, 18 November, 16 points to 7.25 percent and 9.5 percent, December 2004 respectively.
The Monetary Board opted to maintain the key 20 October 2005 rates steady at 6.75 percent and 9.0 percent for the overnight RRP rate and overnight RP The Monetary Board raised the key policy rate, respectively. rates by 25 basis points to 7.5 percent and 9.75 percent for the overnight RRP and RP rates, respectively.
2005 17 November, 15 December 2005
13 January, 10 February, 10 March 2005 The key policy rates were left unchanged at 7.5 percent and 9.75 percent for the overnight The Monetary Board decided to maintain the RRP and RP rates, respectively. BSP’s key overnight RRP and RP rates
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Fourth Quarter 2005
2006
12 January, 9 February, 9 March, 6 April, 4 May, 1 June, 29 June 2006, 10 August, 21 September
The Monetary Board decided to maintain the policy rates at 7.5 percent and 9.75 percent for the overnight RRP and RP rates, respectively.
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The BSP Inflation Report is published every quarter by the Bangko Sentral ng Pilipinas. The report is available as a complete document in pdf format, together with other general information about inflation targeting and the monetary policy of the BSP, on the BSP’s website:
www.bsp.gov.ph/monetary/inflation.asp
If you wish to receive an electronic copy of the latest BSP Inflation Report, please send an e-mail to [email protected].
The BSP also welcomes feedback from readers on the contents of the Inflation Report as well as suggestions on how to improve the presentation. Please send comments and suggestions to the following addresses:
By post: BSP Inflation Report c/o Department of Economic Research Bangko Sentral ng Pilipinas A. Mabini Street, Malate, Manila Philippines 1004
By e-mail: [email protected]