EXCHANGE RATE • Under a market determined exchange rate
Narrow basket of competitor currencies
• The price of a unit of foreign currency in
terms of the domestic currency
❖ Importance of Exchange Rate
1. Serve as the link between the local and
overseas market for various goods, services,
and financial assets.
2. Exchange rate movements can affect actual
inflation as well as expectations about future
price movements
✓ Changes in the exchange rate tend
to directly affect domestic prices
imported goods and services.
✓ A stronger peso lowers the peso
prices of imported goods, import
infensive services such as transport,
thereby lowering inflation
3. Exchange rate movements can affect the
country's external sector through its impact
on foreign trade.
✓ Appreciation of peso- lower the
price competitiveness of our
exports versus the product of
competitor countries whose
currencies have not changed in
value
4. Exchange rate affects the cost of servicing
(principaland interest payments] on the
country's foreign debt.
✓ Appreciation of peso reduces the
amount of pesos needed to buy
foreign exchange to pay inferest
rate and maturing obligations.
❖ Determination of Exchange Rate
• Under a free floating exchange rate system,
the value of dollar in terms of peso is being
determined by the forces of demand and
supply.
• Under a fixed exchange rate system, the par
value rate is set between the peso and dollar
by the central bank.
❖ Country's foreign exchange policy
3.
framework, the BSP does not set the foreign
exchange rate but instead allows the
❖ Trading of Foreign Exchange
• In the Phil., banks trade foreign exchange
using an electronic platform called the
Philippine Dealing and Exchange Corp.
(PDEx) through any of the following: Reuters
or Bloomberg dealing, over-the-counter or
via brokers.
✓ The PDEx captures all spot
transactions (which involve the
purchase or sale of a foreian
currency for immediate delivery,
i.e. within 1 day for US dollars and
within two days for other
convertible currencies).
✓ Banks trade for their clients, as well
as for their accounts. When they
trade for their own accounts, banks
follow the guideline of BSP.
❖ Real Effective Exchange Rate (REER)
• The weighted average of a country's
currency in relation to an index or basket of
other major currencies. The weights are
determined by comparing the relative trade
balance of a country's currency against each
country within the index.
• It takes into account not only the nominal
exchange rate movements but also the
relative inflation rates among trading and
competing countries.
• A more comprehensive measure of external
competitiveness
❖ The BSP looks at three currency baskets:
1. Major trading partners (MT's) composed of
the US dollar, Japanese Yen, Euro and UK
pound.
2. Broad basket of competitor currencies
composed of Singaporean dollar, South
Korean won, New Taiwan dollar, Malaysian
ringgit, Thai baht, Indonesian rupiah, and
Hongkong dollar.
which include the Malaysian ringgit, Thai
baht and Indonesian rupiah.
• An increase in the peso's REER index
denotes a real appreciation in external
competitiveness.
• A decrease in the peso's REER translates to a
real depreciation and corresponding gain in
external price competitiveness.
❖ Measuring the Volatility of Peso
• Coefficient of variation - the ratio of
standard deviation and the average
exchange rate of peso for a given period.
• Low coefficient of variation - indicates a
stable peso
• High coefficient of variation - reflects a
volatile peso
❖ Measures undertaken by BS to maintain
order and stability in the foreign exchange
market.
1. Participation in the foreign exchange
market.
• BSP buy and sell foreign exchange in the
FOREX market - to ensure order and temper
destabilizing swings in the exchange rate.
• If there is an artificially strong demand for
dollars - BS can sell dollars to moderate the
depreciating trend.
• If there is an artificially strong supply of
dollars - BS can soften the appreciation of
peso by buying dollars.
❖ Why did BSP adopt a floating rafe system?
• The floating exchange rate was adopted in
1970 because the government considered
the occasional, large fluctuations - typical of
the fixed exchange rate system - are more
costly, destabilizing and disruptive to the
economy.
• The floating rate system is consistent with
the country's national strategy of achieving
external competitiveness through efficiency
❖ Why not the fixed exchange rate? Or adopt
a dual or mulliple exchange rate system?
➢ Fixed exchange rate
• The CB commits to sell or buy any amount of
foreign currency demanded in excess of
what can be supplied by the market or
offered for sale in excess of what is
demanded - to keep the official exchange
rate at a certain level.
• Massive dollar inflows - CB buy the excess
dollars to keep forex at a desired level -
reserves are accumulated but pesos are
released into the system resulting to
inflationary pressures.
• Massive dollar outflows - CB sell the dollars
to accommodate excess demand - reserves
will diminish.
• Therefore, fixed exchange rate policy places
a heavy burden on monetary authorities in
terms of reserve and liquidily management.
➢ Dual or multiple exchange rate system
• Discriminatory and distorts resource
allocation
• If the government sets a high rate for
exporters and OF's, it will have to subsidize
the difference between market rates and
the fixed higherrate.
❖ Is the current exchange rate policy in line
with the inflation targeting approach to
monetary policy?
• The BSP's adherence to a free floating
exchange rate anchors its commitment to its
Constitutional mandate to maintain price
stability.
• It is consistent with the inflation targeting
framework of the country's monetary policy
to participate in foreign exchange market
only in well-defined circumstances.
❖ Why can't BS intervene more heavily during
periods of high peso volatility?
• Heavy intervention cannot be sustained for
a long period of time because it could create
problems for monetary policy.
• To sterilize intervention and mop up excess
liquidity, the CB would raise policy rates
and/or undertake open market operations.
These policy actions may not be sustainable
because they are costly to centralbank.
✓ High interest rates required to
siphon off liquidity would give
countries with fiscal difficullies and
/or weak macroeconomic
conditions.
✓ Raising interest rates will result in a
further increase in foreign capital
inflows which necessitate
sterilization resulting in vicious
cycle
❖ Advantages of Firm Peso
✓ Helps dampen inflationary pressures
✓ Translates lower debt servicing
✓ Enables the BSP to build up international
reserves; and
✓ Allows prepayment of foreign exchange
obligations
❖ Disadvantages of a Firm Peso
• Could have negative impact on certain
sectors:
✓ Export oriented companies,
domestic producers of import
substitutes, tourism sector, foreign
investors, creditors who had lent
money in foreign currency, and
overseas Filipinos and their
families.
❖ Advantages of Peso Depreciation
1. It will improve the external price
competitiveness of Phil. Products increasing
the country's foreign export earnings.
2. Peso equivalent of OFW remittances in
foreign currencies will increase.
3. Tourism and investment activities will
increase as it will be less costly and more
desirable to foreigners to travel and invest in
the Philippines.
❖ Disadvantages of Peso Depreciation.
1. Increase inflationary pressures since it would
cost more pesos to buy imported products
and raw materials such as oil.