EXCHANGE

RATE POLICY

CHAPTER 8
EXCHANGE RATE POLICY
• One way of remembering the name of a certain country is
through national currency. The money of a country is its
symbol and identity, just like its flag.
• Currencies serve not only as media of exchange but also as
units of account. That is, money is not only used as a means
of buying goods and services which are expressed in the
form of prices. Obviously, without money it is difficult to
determine the accurate value of a product.
• A Filipino can purchase goods and services with his
Philippine pesos in his own country. but if the goods and
services are to be traded in the international markets, an
international payments system is needed. such system links
together monies of various countries. this is the exchange
rate which is the price of one currency expressed in terms of
another currency.
• Exchange rate are determined by market forces of demand
and supply, unless the central bank directly interferes in
manipulating such forces.
• Example, if the Philippine demand for the us dollar is
greater than its supply of said foreign currency, then the
exchange rate increases. this means that the value of the
dollar has increased while that of the peso has decreased.
• The choice of an appropriate exchange rate policy by the
central bank depends on the economic conditions of our
country. such choice is very vital because it directly
affects our monetary stability, balance of payments
position and economic develop-change rate policy in our
country has been the product of IMF recommendations.
EXCHANGE RATES
• A foreign exchange rate is the price of a foreign money
relative to the local money. for example the price of $1 is
P25, in other words it requires 25 units of our peso to buy
1 unit of a US dollar.
• We are under the floating or flexible exchange rate
system. under this system, the price of the dollar relative
to the peso is determined by the free market forces of
demand and supply. thus exchange rate between the
dollar and the peso fluctuates, either up or down. in case
the price of the dollar increases, let us say P30, the dollar
has appreciated and the peso has depreciated.
depreciation is also known as currency devaluation.
devaluation refers to the increase of price of gold relative
for a currency.
• An exchange rate can be overvalued or undervalued.
granting that the real market value of a dollar is P25, if the
official rate of the central bank is P20, then our peso is
overvalued. in case the official exchange rate is P30, then
our peso is undervalued. Overvalued because it requires
only P20 and not P25 to buy a dollar. Undervalued
because it requires P30 and not P25 to buy a dollar.
DETERMINANTS OF EXCHANGE RATES

1. Relative in come changes – An increase in the

purchasing power of the Filipinos tends to increase
imports of US products and services. this means the
demand for the US dollar also increases. As a result, the
price of the dollar rises and the value of or peso falls.
Conversely, an increase in the purchasing power or real
income of the American people tends to increase imports
of Philippine goods and services. Such situation
increases the value of the peso against the US dollar. The
rise and fall in the exchange rates is due to the law of
supply and demand.
2. Relative price changes – In case prices of goods and
services are much higher in the Philippines than in the US,
Filipinos are inclined to buy from the US because of lower
prices. This results to greater demand for US dollars, and so
the exchange rate of the dollar increases. On the other hand,
the value of the peso falls. If it is the Philippines which has
the cheaper prices of goods and services, then there is an
increase in the demand for Philippine goods and services.
This increases the supply of dollars in the country. Thus, the
dollar falls and the peso appreciates.
3. Relative interest rates – Supposing interest rates are higher in the
Philippines than in the US. These reduce Filipino investments in the
United States while the Americans increase their investments in the
Philippines. These results to the decline in the demand for, and
increase in the supply of dollars. So the exchange rate for the dollar
falls. A reverse situation has an opposite effect on the US dollar.

4. Other factors – Without import restrictions and foreign exchange

controls, there are other factors which tend to increase our demand
for goods and services from the US and Western Europe countries
like England, France, and Germany. One factor is colonial mentality.
Another factor is the state of our economic development. We are in
the process of economic development. We are still putting up many
of our social and economic infrastructures for the foundation of our
economic growth. So we have to import these components like
machines, industrial raw materials, and technology. Such imports
require of course more dollars which means an increase in the
demand for foreighn currency. Consequently, the value of the peso
against the dollar depreciates.
EXCHANGE RATES POLICIES

• Pegged exchange rates. The price of a foreign currency, like

the US dollar is fixed by a monetary authority or central bank.
In the past we had a pegged or fixed exchange rate. The
exchange rate then was P2 to $1. Under this kind of
exchange rate policy, the Bangko Sentral is prepared to
defend the fixed price of the dollar which was P2. The
Bangko Sentral can do this by increasing the supply of
dollars to match the increase in the demand for dollars. On
the other hand, if the demnad for the USW dollar decreases,
the Bangko Sentral buys dollars to compensate for fall in
demand for dollars. In short, the Bangko Sental squates the
demnad for and supply of the US dollars in order to maintain
the equilibrium price of P2 for a dollar. This is possible if the
Bangko Sentral has sufficient US dollars in buying and
selling such foreign currency.
• Free-floating or flexible exchange rates. The price of a
foreign currency such as US dollar is determined by the
free interplay between the forces of demand and supply.
When the demand for dollars is greater than the supply of
dollars, the price of the dollar increases. If the supply of
dollars is greater than the demand for dollars, the price of
the dollar decreases. The Bangko Sentral does not
interfere in the marketr forces dealing with the demand for
and supply of dollars. Under this exchange rate policy, the
price of the dollar fluctuates upward or downward
depending on the demand for and supply of dollars.
• Managed floating exchange rates. The exchange rates are
also the result of the demand and supply forces. We have a
“clean” float and a “dirty” float. The former is one in which
the monetary authorities of a country interfere in the foreign
exchange market only for the purpose of maintaining orderly
trading conditions. In the case of the dirty float, it is one in
which the monetary authorities intervene to achieve
objectives other than the maintenance of orderly trading
conditions. A dirty float is synonymous with a managed float.
To avoid erratic or abrupt fluctuations in the exchange rates,
the central bank of a country engages in the buy and sell of
foreign currencies like the US dollars. For instance to prevent
a big fall in the price of the US dollar due to oversupply, the
central bank can buy the surplus dollars. If the value of the
dollar is extremely low, it would not be favorable to exporters
of goods and services.
FOREIGN EXCHANGE MARKETS

• The foreign exchange market is made up of the commercial

banks operating in the country. All are members of the
Bankers Association of the Philippines. In addition, foreign
exchange dealers like hotels, restaurants, tourist shops,
travel agencies, rural banks, etc. participate in the foreign
exchange market.
• The Bangko Sentral ng Pilipinas as provided for in Section 80
of the Central Bank Act, requires the banks to report the
volume and composition of their purchases and sales of gold
and foreign exchange each day and must furnish such
additional information with reference to the movements in
their accounts in foreign currencies. The Monetary Board of
the Bangko Sentral may also require other persons and
entities to report to its currently all transactions or
operations in gold, in any shape or form, and in foreign
exchange.
• Purchases and sales foreign exchange are conducted at
the Foreign Exchange Trading Center from 8:30 to 9:00 in
the morning of every banking day. All purchases and sales
of foreign exchange among member banks, whether spot
or forward are posted on a trading boards. Bids and offers
are received for posting on board are not allowed after 25th
minute of the trading session. Withdrawals of bids and
offers already posted on the board are not allowed after
25th minute. The last 5 minutes of each session are
devoted to the finalization and perfection of the bids and
offers posted on the trading board.
BLACK MARKET

• Participants in the Black market are numerous. They operate

in all parts of the country. Most of them are visible in
Avenida, Escolta and the Central Post Office. The rest are
located in every big town and city. Their purchases and sales
of US dollars do not pass through the official banking
channels. This means their foreign exchange receipts are not
reported to the Bangko Sentral.
• The supply of black market dollars is made up largely of
inward remittances of foreign exchange through the non-
banking channels and foreign exchange leakages arising
from inaccurate valuation of foreign trade transactions. The
demand for black market dollars is created mainly by
importers of goods and services in volumes and/or amounts
exceeding those allowed by the Bangko Sentral regulations
and by outgoing travellers who trace foreign exchange out of
the country in excess of the amounts allowed by
unauthorized importations of residents.
• For as long as there are foreign exchange controls, there
will always be a dollar black market. This is because the
general public such as the importers, speculators,
smugglers, or ordinary individuals who need a few more
dollars for travel purposes beyond what the Bangko
Sentral ng Pilipinas will sell them, will have to get their
dollars some place. And that inevitably is the black
market.
THE BINONDO CENTRAL BANK
• In early 1984, at the height of the speculative attitude on
the peso, the Presidential Anti-Dollar Salting Task Force
formed the Task Force Luntian, populaly known as the
“Binondo Central Bank”. In view of the political and
economic uncertainties, the black market rate at that time
reached P27 per dollar when the official rate was P14. The
Chinese syndicate had full and unhampered control of the
black market for US dollars. Such group manipulated the
exchange rate bvy as much as P1 a day. There was no
doubt that the peso headed towards downward spiral to
P30-P40 adollar. This situation would cause enormous
damage to the economy due to hyperinflation and great
sufferings to the poor masses.
• With the organization of the Task Force Luntian, the
difference between the official exchange rate and the
black market rate gradually narrowed. Despite political
and economic reverses, speculations on the rising value
of the dollar were eventually eliminated. Thus the value of
the peso has become stable. Its value have smoothly
fluctuated around P20 per dollar. The Task Force Luntian
or Binondo Central Bank has contributed $400 million to
the old Central Bank of the Philippines during its two
years existence.
ORGANIZATIONS AND OPERATIONS

1. The operation task force Luntian was organized in early 1984

by former Minister Roberto Ongpin upon instruction of the then
President Marcos.
2. Initially the biggest and best known Chinese black marketers
have been rounded up by NISA. They were told that it was the
intention of the government to organize a currency stabilization
program. The Chinese black marketers would be permitted to
continue their operations and keep their profits from their
operations provided they cooperated with the government by
buying and selling foreign exchange at government dictated
rates.
3. Originally there were 8 Chinese participants. They were
organized into a “corporation” to which they contributed a total
capital of approximately P100 million. This capital was handled
and operated by the Chinese's participants themselves and no
money was ever contributed by the government.
4. Each participant was authorized to have his own network
of buying outlets. In total there were more than 100
authorized outlets all over the country. Everyday the outlets
were advanced pesos by the corporation as capital for their
dollar buying operations.
5. The dollars were purchased by th buying outlets from the
public, tourists, families off overseas workers, and US
military personnel from Clark and Subic.
6. Security for the operations was provided by NISA, a
member of the Task Force. Former General Fabian Ver was
overall in charge of security staff, the sum of P70000 per
week to cover the expenses of NISA in providing security to
the operations of the Binondo Central Bank.
7. Under NISA security the dollars were airshipped daily to
Hong Kong throug PAL commercial flights or the Air
Mindanao lear jet. Upon arrival in Hongkong banks for
subsequent sale as TT’s (telegraphic transfers) to Philippine
Exporters and the general public who were unable to obtain
dollars through official banking channels.
8. operations were conducted in the Yuchengco Building in
Binondo. Buyers of TT’s went to purchase the dollar TT’s
which were eventually deposited to their designated dollars
accounts or paid per their instructions to the supplier of their
imports.
9. Excess dollars which were not sold to the importers and
the general public were sold to the old Central Bank through
the PASAR (Philippine Associated Smelting and Refining
Corporation).
10. The Chinese’s participants were permitted to make a
spread of 20 centavos per dollar. In two years time, they
made approximately P200 million total profits.

11. The government did not engage in actual buying and

selling operations which were undertaken entirely by the
chineses participants. The government through the Task
Force Luntian dictated the exchange rates and enforced
overall discipline in the operation.
THE CHOICE OF EXCHANGE
RATE POLICY
• The source of disturbances. In case the economic
disturbances come mainly from abroad, a flexible exchange
rate may be used to insulate the loacal economy from the
effects of such disturbances. If the economic disturbances
are internal, these can be filtered abroad better through the
fixed(pegged) exchange rate system. For example under a
flexible exchange rate policy an excess aggregate demand
creates domestic inflation. But under the fixed exchange rate
policy, some of the excess aggregate demand( (government
expenditures, household consumption and business
investments) will spread abroad through the trade sector.
• The degree of openness. An open economy is a country with
relatively large trade with other countries. It has a high
propensity to import. Countries with open economies prefer
the fixed exchange rate policy to minimize price fluctuations.
• Product diversification. A country with diversified
economy in terms of its production, exports, and imports
is likely to experience less problems in its balance of
payments, because a decrease in earnings from certain
exports may be compensated by increase earnings in
other exports.
• The relative rate of inflation. For trading countries with
similar rate of inflation, a fixed exchange rate policy is
more viable. If inflation rates are not similar, the adoption
of flexible exchange rate system is encouraged.
• The level of international reserves. A country with sufficient
international reserves has no problems in correcting its
balance of trade deficits. It can use its international reserves
to pay for the deficits. Such situation does not require
adjustment and therefore a fixed exchange rate policy is all
that is needed. On the other hand, countries with low
international reserves, and those with little access to foreign
loans, the flexible rate policy appears to be more appropriate.
• Trade elasticity's. If the price elasticity of demand for exports
and imports is low, an the price elasticity of supply of exports
is likewise low, a flexible exchange rate system is not
effective in improving the balance of payments position. The
demand for and supply of primary products of the less
developed countries are inelastic.
FEAR OF THE LCDS ABOUT
FLOATING RATES
• Business uncertainties. Due to fluctuations in exchange
rates, investors and other businessmen cannot accrately
estimate their costs of production and forecast their
profits. Any change in exchange rate means automatic
change in the prices of goods and services. Most of the
less developed countries have been experiencing balance
of payments deficits because of the vey nature of their
agricultural economy, and because of the trade
restrictions being i9mposed by the industrial countries on
the entry of products of the less developed countries in
the world markets.
• Under floating rates systems, the currencies of the less
developed countries tend to depreciate against the
currencies of the highly developed countries. This means
higher prices for goods and services for the consumers
and higher prices for goods and services for the
consumers and higher cost of production for the
producers. Such situation does not favor producers or
businessmen. Higher costs of production entails more
capital and less profits. To the consumers, higher prices
reduce their quantity demanded for goods and services.
Obviously such market situation is not conductive to
businessmen.
• Additional fluctuations in commodity prices. There is a
fear among the less developed countries that the prices of
their products are more vulnerable to external
disturbances and that they are likely to have weak control
over domestic money supply. As experienced by the poor
countries the system of floating rates have devalued their
currencies. This means higher prices.
• The unpleasant decision of de facto devaluation was
made on February 21, 1970 by the then central bank
Governor Gregorio Licaros. Such decision raised loud
howls and trong criticisms from the consumers,
manufacturers, industrialists, and other business groups.
• CB Governor Licaros had the unpleasant task of justifying
the de facto devaluation of our currency. He pictured the
dismal and serious conditions of the economy:
1. P190 foreign loans and other amounts were falling due,
2. International reserves were drained only $126 million.
3. Experts earning declined due to natural calamities and
unfavorable world prices.
4. There was a need to sustain foreign exchange needs of
vital industries.
SURRENDER TO IMF POLICY

• The CB Governor had a big problem of bridging the gap

between the lack of dollars in the face of maturing foreign
debts and the requirements of essential imports. Since the
problems could not be funded by internal sources,
monetary authorities travelled far and wide in scouting for
foreign loans. They even reached Norway to borrow $50
million. But no loans were granted to the Philippines. The
last option was to adopt floating exchange rate policy as a
condition for the release of IMF loan. The adoption of the
IMF policy resulted to the following:
 Extension of maturing foreign loans.
• Consortium of US banks granted $120 million
loans to the country.
• Japan gave the Philippines $50 million standby
credit.
IMF granted $27.5 million for our third credit
tranche.
• These were some of the serious
implications of the adoption of the
floating rate policy by the CB in
compliance with IMF condition:
1. Cost push inflation
2. Automatic increase in foreign debts
3. Decline in investments
ALTERNATIVE POLICY PROPOSALS

• There should be foreign exchange control. Dollars had to

be rationed out based on priorities.
• Imports had to be selective depending on the needs of the
economy.
• Tight credit policy should be enforced to curb inflation
• Sound fiscal policies, such as reasonable government
expenditures efficient tax administration and balanced
budget should complement the monetary policies.
• Fixed exchange rate would be more appropriate to avoid
speculations.