INFLATION TARGETING AND EXCHANGE RATE UNCERTAINTY A thesis submitted by Veronica B. Bayangos (Philippines) in fulfilment of the requirements for the degree of DOCTOR OF PHILOSOPHY IN DEVELOPMENT STUDIES Institute of Social Studies The Hague, The Netherlands November 2007 Thesis Committee Promotor: Professor Dr Rob Vos Institute of Social Studies Co-Promotor: Dr Karel Jansen Institute of Social Studies Examiners: Professor Dr H. (Hans) Visser Vrije Universiteit, Amsterdam Dr Josef T. Yap Philippine Institute for Development Studies Professor Dr Mansoob Murshed Institute of Social Studies This dissertation is part of the research programme of CERES, Research School for Re- source Studies for Development. Funded by the Netherlands Foundation for Advanced Tropical Research (WOTRO) Copyright Shaker Publishing 2007 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publishers. Printed in The Netherlands ISBN 978-90-423-0329-4 Shaker Publishing BV St. Maartenslaan BV, 6221 AX Maastricht Tel No.: 043-3500424, Fax: 043-3255090 http://www.shaker.nl 1 Acknowledgements PhD life beat me down occasionally. But I am the eternal opti- mist, glad that it took me four years to finish. The people who supported me made the time worthwhile. For one, I have the best supervision team. Professor Rob Vos and Dr Karel Jansen helped me to secure a four-year grant from WOTRO to pursue my PhD. They cannot know how happy I was when I received the news that I could finally start the research. I am extremely grateful to Rob. I have deeply appreciated his contributions to this research, even while he was in New York. All of his views, challenges, suggestions and comments helped me along the way. I am more than proud that he is my first promotor. I am equally grateful and proud to have Karel as my second promotor. I will certainly miss the way he supervised and chal- lenged the whole research. Karel has been a strict mentor to me in some respects, yet I have realized this is what I need. I trust his supervision implicitly. Sometimes, when you work with some- one you remain guarded because you are not sure about their plans. But with him, I have felt he would take me much farther than I could go on my own. Not to be missed is my field supervisor, Dr Josef Yap, who filled the technical gap and provided a practical approach to do the research. He was willing to help at any point. I would also like to mention the support given by Dr Mario Lamberte and the staff of Philippine Institute for Development Studies during my field work. iii The intellectual support beyond my supervision team was overwhelming. Dr Peter van Els and Dr Maria Demertzis from De Netherlandsche Bank and Dr Francis Dakila from Bangko Sentral ng Pilipinas helped in the initial stage of the research. They con- veyed to me the most essential requirements of inflation targeting, especially on the modelling aspects. At ISS, I am grateful for comments and help from Dr Howard Nicholas, Professor Dr Mansoob Murshed, Professor Dr Massoud Karshenas and Dr Robert Sparrow. I gained so much confidence with discussants in various con- ferences and presentations. Partly funded by the ISS, I am thankful for the support of the Dean’s Office and Academic Registrar, namely, Dr Wil Hout, Nynke Jo Smit and Lenneke Warnars. I thank Dr Ali al-Nowaihi (University of Leicester, United Kingdom), Dr Martin Sommer (International Monetary Fund, Washington DC), Dr Marco Arnone (Catholic University and CeMaFiR, Milan, Italy), Dr Valerie Mignon (Centre d’études prospectives et d’informations internationals (CEPII)), Professor Sherman Robinson, Micromacro Consultants BV headed by Marein van Schaaijk, Stephen Uy, Lesly Sendar, and Dr Jan Lemmen of the CPB Netherlands Bureau for Economic Policy Analysis. Their comments made the thesis more robust and practical. I enjoyed intellectual support as teaching and research assis- tant to Professor Marc Wuyts, Dr Max Spoor, Dr Haroon Akram Lodhi, Jan van Heemst, Dr Jos Mooij, Dr Mahmood Messkoub, Dr ThanDam Truong, Dr Anirban Dasgupta and Lorenzo Pellegrini. During the writing of the thesis, I benefited tremendously from the support of Professor Martin Doornbos, Wicky Meynen, Professor Dr Ben White, Dr Cris Kay, Dr Karin Arts, Dr Joao Guimaraes and Drs Rogier Marchand. I treasure the intellectual support and friendship of my fel- low PhDs who have since graduated - Claudius Preville, Marco Sanchez Cantillo, Le Thin Van Hue, Nicholas Aworti, Sharada iv Srinivasan, Le Thai Thuong Quan, Nguyen Van Phuc, Nicky Pouw, Mahmoud Hamid, Admasu Shiferaw and Abert Musisi. I am proud to have been in contact with my peers at the PhD programme. It was challenging for us to be in the group, and all earned my utmost respect – Georgina Gomez, Leandro Serino, Rose Namara, Roselle Leah Rivera, Manohara Khadka, Gervas Kolola, Mallika Rani Pinnawala, John Agbonifo, Jerome Abban, Akinyinka Akinyoade, Paulos Chanie, Dawood Mamoon and Sailaja Nandigama. The Student Affairs Office – Ank van de Berg, Dita Dirks, Lubna Sharwani, Maureen Koster, Martin Blok, Cynthia Recto-Carreon and Charmiane Klaring – made my life at ISS easier. Special thanks to the Finance Department – Renee de Louw, John Sinjorgo, Wim Knoester and Sylvia Cattermole. Also to OLITS – John Steenwinkel, Jeff Glasgow, Henri Robbemond, Ton Rimmelzwaan. Special thanks to Michelle Luijben for her editing. My colleagues at the Asian Development Bank headquarters in Manila have been more than supportive. Special thanks to Francis Harrigan, Kazu Sakai, Paul Turner, Sukanda Lewis, Yushu Feng, Padmini Desikachar, Ronnie Butiong, Erik Bloom, Rhodora Concepcion, Zuleikha Bisera, Marichi Manaligod, Mylene Camara-Crespo, Ma. Celina Cruz, Margarita Javier, Irene Tengco and Elizabeth Alimuring. My mentors and colleagues at the BSP in Manila, Governor Amando M. Tetangco, Jr., Deputy Governor Diwa C. Guinigundo, Deputy Governor Nesting Espenilla, Myra Pacheco Cunanan, Edith Alido, Maria Digna Paraso†, Tony Cintura, Lou Sicat, Ludy Gador, Reggie Juinio and Marah Diangson Anka. For still other reasons, I thank my friends who remain close to my heart: Claudius Preville, Roldan Cinco, Marco Sanchez Cantillo and Adelita Corcuera, Thomas and Cristy Vogel, Ro- sette Tsai, Nilda Aribon Agoo, Agnes Apostol, Linda Estrella, Gilda Fernandez, Marissa de Vera, Oliver and Joji Rey-Matias, Barry and Josel Barrientos, Joel Lasam and Evelyn Santiago. I have enjoyed rich travelling experiences and art activities in Holland and elsewhere through the International Cultural Ex- v change Group, an ex-pats group in The Hague. I thank Bo Pallavicini, Irene Shunkels, Madeleine Vrielink, J.B. Perrini, Dean Southal and Yetty Hanning for setting it up. The Roman Catho- lic Church in The Hague provided me much needed spiritual balance. My second family in The Hague, the Baxas – Ave, Boyet and Neior – provided support at some difficult stages of my PhD. There are Filipinos in the Netherlands who are equally support- ive: Norman Dytianquin, Peter and Au Payoyo, Baby Gonzales, Bessie and Wim Middendorp, Jan and Helen Hendriessen, Sifko and Malou, Ernie and Lina Pineda. My family made my life whole at every difficult stage of PhD, including when our father passed away in 2005. Thank you – Grace, Ruby Rose, Mary Joyce, Elizabeth and Roderick and their husbands, wife and partner, my nephews and my nieces and my best cousins in San Francisco – Gerry and Ellen, Rose and Ro- lando and Maria. This book is dedicated to my four greatest inspirations – Rogelio†, Vicenta†, Marciana† and my best friend Maria Digna†. Veronica Bayangos The Hague, The Netherlands September 2007 vi 1 Contents Abbreviations.............................................................................................xiii Abstract........................................................................................................xv 1 The Task Ahead: Introduction...............................................1 1.1 The context ..................................................................................................1 1.2 The need to switch monetary policy targets ..............................................2 1.3 The actual behaviour of central banks .......................................................3 1.4 Central research hypothesis and questions ................................................5 1.5 Analytical framework and methodology....................................................7 1.6 Contributions of the study .......................................................................12 1.7 Structure of the thesis ................................................................................14 2 Rebalancing Macroeconomic Imbalances in the Philippines ........17 2.1 Introduction ...............................................................................................17 2.2 Growth trends.............................................................................................18 2.2.1 The boom-bust cycle .....................................................................19 2.2.2 Unimpressive growth accounting picture ...................................21 2.2.3 Macroeconomic instability and growth........................................26 2.3 Pursuit of higher and sustainable revenue collection ............................27 2.4 How did inflation behave over these years? ............................................31