Summaries of Studies on Money and Banking Sector

....

ill

i

VOLUME 1

AUGUST

1983

NO. 1

i

Editor's Note: The recent move to allow a relatively larger depreciation of the peso has sparked a lot of discussions on the state of the Philippine economy, Hence, our first issue is devoted to a discussion of research findings and recommendations on development finance, Contributions for the next issues of Development Research News are welcome, provided they are submitted typewritten and double-spaced on or before the 15th of every month, ...........

EXCHANGE RATI'5 H.EXIBILITY AND INTERVENTION POLICY IN THE PHILIPPINES, 1973-1981

Prior to 1970, under the fixed exchange rate regime, there was a great tendency to consider the exchange rate as an objective rather than as an instrument of policy in the Philippines. Maintaining the existing exchange rate was a matter of national pride and prestige, and changing the rate, or even the prospect of doing so, was considered a critical political issue. Consequently, when the country went through a period of growing external imbalances in the 1950s and 1960s, the inevitable but delayed devaluation that ensued was such that the adjustment process became very costly and painful.

more

Project No. 83-01 hy Dr. Filologo Pante Jr.,

grow and became embedded in the economic system, adjustment's would have been far less disruptive.

President, BIDS A research study on exchange rate flexibility and intervention policy in the Philippines in the post-1970 period was conducted by Dr. Filologo Pante Jr., president of the Philippine Institute for Development Studies (PIDS). The study discusses in general the implications of exchange rate flexibility in less developed countries and in particular the exchange experience of the Philippines during the period of generalized floating of major currencies from 1973 to 1981.

Since 1970, the Philippines has adopted a flexible exchange rate system. This system, however, is characterized more by a limited rather than full flexibility and the domestic currency can be more appropriately described as "crawling" rather than floating vis-a-vis the U S dollar.

This, the author says, is not unexpected in a developing country like the Philippines where certain structural characteristics preclude free floating as a feasible alternative.

(Continued next page)

Had changes in the exchange rate been undertaken promptly, before relative price distortions could

MONETARY INDICATORS 1975-1982 (In million pesos) Item I. Total domestic liquidity A. Money supply B. Savings and time deposits C. Domestic substitutes I1. Domestic credits outstanding A. By end-user i. Public sector ii. Private sector B. By institutional i. Monetary

1975

1976

1977

1978

1979

28,886 10, 315 8, 939 9,632

35,897 12,075 12,950 10,872

43,931 14,938 17,593 11,400

51,837 16,945 23,398 11,494

57,360 18,844 26,565 11,951

35,258

43,678

51,464

63,075

5,499 29,759

8,775 34,903

10,846 40,618

3,555

5,557

31,703

38,121

1_980

1981

1982

67,803 22,538 32,894 12,371

82,091 23,524 42,115 16,452

95,298 23,524 55,208 16,566

79,475

95,128

115,766

141,303

11,649 51,426

12,286 67,189

14,572 80,556

18,303 97,463

28,11.5 113,188

6,295

7,105

8,761

9;904

15,362

19,785

45,169

55,970

70,714

85,224

100,404

121,518

source

authorities

ii. Deposit monty banks

Source: Central Bank of the Philippines, The Philippine Economy, Policies and Developments 1975-1982.

PII)5 I)evelopmeni:

While

Research News

external

balance

q

I

is yet to t_e achieved,

this

Bank's reaction function

AUGUST

1983

for nominalpeso-dollarexchange

system of limited exchange rate flexibility has assisted the country in weathering the external shocks which began with the oil crisis in 1973-1974 without the exchange upheavals that are reminiscent of the 1950s and 1960s, and has probably prevented more fundamental disequilibrium from developing, making abrupt and disruptive exchange rate adjustments less of a possibility, The author also notes the monetary authorities' cornmitment to the nominal peso-dollar exchange rate. Accof ding to him, the Philippines opted to continue to be in the US dollar currency area during the period of generalized floating among major currencies because the peso has been historically tied to the US dollar and the US has remained the Philippines' principal trading partner.

The author observes that the Central Bank officially intervened in the peso-dollar exchange rate. While it is officially maintained that " all exchange transactions take place in a free market," the Central Bank exercised direct control over movements in the peso-dollar exchange rate through the purchase or sale of foreign exchange. Especially beginning in 1972, the Bank's intervention increased substantially, with the proportion of its sales and pur-

rates can be specified in terms of responses to exchanged market pressures manifested by current accouml developments in the contemporaneous as well as fairly recent periods. Because attention is focused on nominal rather than effective exchange rates, changes in the latter have not always been in the direction suggested by the needed adjustment. It would therefore be necessary to use effective exchange rate formulations in determining the extent and direction of intervention.

Finally, the author recommends an exchange policy aimed at stabilizing• a given real effective exchange rate in view of the more rapid rates of inflation in the country relative to its trading partners.

This policy will ensure that the country's international competitive position is not grossly eroded. At the minimum, the author states that the monetary authorities should be constantly vigilant of changes in real effective excharige rates.

The author further recommends the formulation and estimation of an exchange rate or balance of payments model, This would make it possible to look into the interactions among monetary, fiscal and exchange rate

chases of foreign ,exchange transactions undertaken by commercial banks accounting for about 60 percent.

The study also includes a discussion of the floating of the major currencies other than the dollar. The author points out that pegging to any one of these currencies iraplies floating vis-a-vis the currencies of other trading partnets.

He indicates the need for a measure of lhe value of the domestic currency in relation to a representative set of currencies rather than merely to that of the intervention

policies and to study the effects of ext_ernal disturbances (such as those generated by exogenous currency changes) on domestic inflation and trade flows. •

currency which is the dollar, This measure is the " effective exchange rate " or EER, which is defined as a weighted average of the exchange rates of the country's trading partners. Simply :_tated, it is the rate that reflects the peso exchange rates with all currencies, Analyzing the behavior of the monetary authorities in the foreign exchange market to explain changes in the exchange rate, the author found that authorities do not act to stabilize the "effective exchange rate."

He also found that: 1. The authorities do not follow a Purchasing-PowerParity (PPP) rule wherein exchange rate adjustments are made to compensate for inflation differentials between the domestic economy and those of major trading partners.

2. The stock of international reserves is not an important determinant of nominal exchange rate adjustments made by the authorities, 3. The Central Bank, on average, adjusts nominal exchafige rates in accordance with current account balance developments.

The rate of response has been limited, however, 4. On the whole, monetary authorities make adjustments in the intervention rate on the basis of nominal rather than effective exchange rate considerations, Thus, for the whole period 1973-1981, the Central a

_ THE INFLATIONARY EFFECTS OF LDC EXCHANGE RATE in ESSA YS IN DEVELOPMENT ECONOMICS IN HONOR OF HARR Y T. OSHIMA hv Dr. Romeo M. Bautista, UP School _f Economic.s The recent devaluation of the peso has spurred various discussions on its effects and repercussions in present Philippine economy. One significant area of discussion concerns devaluation vis-a-vis inflation or consequent changes in the domestic price indc_., Relevant 1o the area is Dr. Romeo M. Bautista's "l-he I nflationary Effect of 'LDC Exchange Ralc Changes under Generalized Currency Floating," in E.s:suvs in Developmerit Economics in Honor of Hurry 7". Oshima, published

by PIDS. The author observes that policymakcrs in less developed countries (LDCs) have been reluctant to adjust their exchange rates even if the domestic currcncy is overvalued bacause of their anxiety about induced gcneral price increases. Yet, even if there is a " pervasive belief that devaluation is inflationary, not only in the sense of a once-and-for-all price increase but also through some cost-push mechanisms (e.g., wage price spiral) which make a higher rate of inflation inevitable, " the author notes that evidence from previous cross-country studies, e.g., Cooper (1971), Connally and Taylor (1976), and Kruegcr (1978) concerning LDC experience under the Bretton ( Woods system seems to indicate that the "worst fears concerning the inflationary effect of devaluation are unfounded.

However, the devaluations examined in these studies took place under the Bretton Wood,s system of adjustable par values, involving large once-and-f0r-all -exchange rate (Continued next page)

q PIDS DevelopmentResearchNews changes. They do not include LDC experiences with small, Wadual exchange rate adjustments under generalized currenu_y floating which started in March 1973. Neither do they document experiences based on the " crawling peg " system (involving relatively large sustained currency depreciation in nominal terms) which gained importance in the post-Bretton Woods period.

Dr. Bautista's essay then presents a study of devaluation episodes in 22 developing countries during the years 1973-1979, under generalized currency floating, and " relates observed movements in the effective exchange rate (EER), measured as a trade-weighted average of the domestic currency's exchange rates with foreign currencies, to changes in the general price level. " His study presents empirical findings on the collective experience of 22 developing countries and, utilizing crosscountry data, asserts that in contrast to findings of earlier studies on price effects of devaluations in the 1950s and 1960s, price responses to exchange rate adjustments in the post-Bretton Woods period are of a very high order of practical importance to LDC policymakers, with about 80 percent of exchange rate changes estimated to have been added to the domestic price level.

Although the inflationary effect is of such magnitude, it does not however completely nullify the improvement in international competitiveness that a devaluation is supposed to give to a country's products. Yet the findings show that the ]repercussion on domestic prices brought about by the exchange rate adjustments is now so much more than it used to be.

_

AUGUST 1983

variables he looks into as they relate to domestic price changes are changes in unit labor cost and import price, the latter embodying exchange rate changes; money supply (based on the quantity theory of money); excess domestic demand; effective exchange rate; degree of openness; real GOP;and level of economic development.

As earlier mentioned, the regression results show that on the average, the general price level rises by about 80 percent of the rate of currency depreciation.

Thus, the general implication for policymakers, Bautista concludes, is that " the cost of achieving a given 'real' devaluation, in terms of higher domestic inflation rate, is now greater than what it used to be," thus "reducing the attractiveness of exchange rate adjustment as a means of improving the international competitiyeness, allocative efficiency, externai balance and real income of most developing countries."

There is therefore a need to consider other options which the author claims should be a subject for more careful study., -

STRUCTURE AND GROWTH OF THE PHILIPPINE FINANCIAL MARKET Project No. 81-06

by Dr. Edita A. Tan, UP School of Economics Ttie Philippine financiai market scenario is ably presented in a study by Dr. Edita A. Tan of the U P School of Economics.

This PIDS project, which is currently undergoing revision for publication, describes the Philippine financial system in general as consisting of a large private sec-

The author says that this patti), explained by the longer term price impact captured in his study through the use of average levels and rates of change over .a six,year period, Moreover, he claims that the exposure of the developing countries to the international economy had become stronger over the years. This is measured not simply by the weight of imports in the final expenditure basket of the " degree of openness" variable but by the "relevant group of tradables which includes close domestically produced import substitutes."

Corollary to this are the dramatic developments in the world economy in the 1970s which might have altered the economic structure underlying the price equation that prevailed under the Bretton Woods regime,

tor catering to priority activities or borrowers, a large conglomeration of commercial and financial corporations, a small segment of many rural and savings banks, and a neglected securities market.

The private commercial banks and governm_¢nt finance institutions form the two most important and influential intermediary groups in the system. Commercial banks supply mostly short-term financial instruments and credit, while government institutions like the Philippine National Bank (PNB), the Development Bank of the Philippines (DBP) and the Government Service Insurance System (GSIS) which are among the largest have contributed substantially to the growth of_the country's financial system and have provided remote areas with banking and insurance facilities.

The findings also indicate that changes in the effective exchange rate and excess domestic demand can explain to a very large extent inter-LDC differences in inflation rates for the period 1973-1979. The sensitivity of the domestic price level to exchange rate movements does not seem to differ significantly among countries adopting different methods of exchange rate adjustment, Prior to making the actual inter-country estimates,

However, financial institutions, notably large banks, are located in Metro Manila and other major cities like Cebu while the rural sector is serviced mainly by rural banks.

A special section of the study is devoted to the stock market. The portfolio theory was used to describe the behavior of this market. The model was tested using monthly data of 72 stock securities from 1976-1"979. Results of this model testing showed that the market is highly volatile and

autista describes various inflation models which have appeared in the literature and which have immediate relevance to LDCs, specifying the variables that may contribute to the explanation of observed differences in the intercountry inflation rates. He discusses some aspects of exchange rate changes which laid the ground for the subsequent estimation of their influence on the domestic price level. Among the

that there is no apparent relationship between return and risk in each year for the whole four-year period. This means that premium is not being paid for risk in any regular manner.

The yield-risk distribution of the 72 securities were examined further to devise the efficient frontier for all available assets with positive returns. The study found that the market (Continued next page) 3

PIDS Deveh_pmen!

ResearchNews portfolio was off the efficient frontier and that not all sec_ufities were included in the efficient portfolio, with only 17 securities for the l0 percent and 15 percent rate of return. It was also noted that as the rate of return increased, the portfolio became less diversified and included high-risk return securities and that there Were wide differences in the weights of the securities in the efficient portfolios, Security analysis and dissemination of vital information on the market is apparently lacking, For instance, results of this special section show that if one only knows how to choose securities correctly, he can earn fairly high rates of return at not too high a risk.

The money market constitutes still another important segment in the financial system. The main difference between the money market and the stock market is that the former caters mainly to short-term uses of funds while the latter provides long-term funds. There is, however, much overlapping between the two since both supply liquid assets to saving units, The study observes that regulations and imperfections have obstructed the interaction of the financial system into one market and prevented competitive trading of available assets and allocation of credit. Interest rates on homogenous papers, e.g., time deposits and bank bills, differed by as much as four percentage points. There was also substantial variation in money market rates. Reported money market rates could not be explained by either risk or maturity. Such behavior of the interest rate suggests a market segmentation.

Finally, the study looks into capital budgeting or finance choice of firms. Firms-could acquire financing for their capital and current expenditures from various sources like internal sources, equity, loans or bonds for capital expenditures, and current income trade credit and short-term debt instrument for current expenditures.

Sources of finance used by firms and households seem to reflect their response to the structure of cost capital.

Households including unincorporated enterprises contributed 74 percent in total saving from 1950-59 and 62 percent in the seventies while corporate saving comprised 16 percent in the seventies. Despite the increase in access to financial assets, diversification of their portfolio and the drop in the share of their own investment in physical assets, tlac proportion of household savings available for business investment remained low. Hence, one can say' that thc segmentation of the financial market has not encouraged financial investment especially by small savers whose opportunities in thc financial markct are not very attractive.

The study then examines the pattern of corporate financing of capital and other expenditures by different industrial groups. The finding is that there is a tremendous variation in the share of each source among industries.

There is as much variation in the use of alternative sources of long-term funds. Savings varied from 12 to 54 percent among industrial groups; equity, from 25 to 92 percent; loans from financial institutions from one to 46 percent and other long-term sources from 0 to 34 percent. This shows that savings was an important source of long-term funds for Philippine corporations, indicating that corporations tend to rely on internal finance and remain as family corporations.

4

_

AUGUST1983

The major policy recommendations of this study foJ reformsin the financial system are: I (1) Limit the use of rediscountingfacilities to meet targel levels of money supply.

(2) Develop the market for government securities. Small denomination bills and bonds of P200, P500 and P1,000, etc., may be floated at rates competitive with money market rates, (3) Initiate a program for developing a secondary markel for these securities. Private banks are to be encouraged tc trade in the securities and as incentive, may be allowed to use the proceeds as a source of funds.

(4) Funding for special projects should come from the proceeds of government issues which are to pay competitive rates.

(5) Foreign loans for industry should be granted at competitive rates.

(6) GSIS and other employees savings placed in governmerit agencies should earn competitive yield or at least the rate. on long-term bank deposits, thus forcing these institutions to invest the funds in profitable undertakings.

(7) A more conscious and organized dissemination of information on the availability, risk and yield of alternative assets should be set tip. Advertisement by the intermediaries of their services would be helpful. Better coordination amon8 them should be achieved to enhance competitiveness and, in thc long-run'; a healthier financial atmosphere for the country. ,--

i AN ANALYSIS OF THE BEHAVIOR OF COMMERCIAL IJrt_ject :Vo. 82-05 tJi. Dr. ,_la#-io B. Lamberte, Re.s'earch Fellow, PIDS

,,,

BANKS

Commercial banks comprise about two-thirds of the total financial resources of the country's banking system.

A study on the analysis of the behavior and growth trends of commercial banks was submitted to the Philippine Institute for Development Studies (PIDS) by Dr. Mario B. Lamberte, a research fellow of the Institute. Dr. Lamberte stated that the importance of better understanding bank behavior is seen in two aspects.

One is that banks are the most heavily regulated firms in the economy, and the effectiveness of the regulations largely depends on the behavior of commercial banks.

The other reason is that a sufficient knowledge of individual bank behavior, and how each influences the financial system, is vital in fully understanding money supply movement.

The author selects a sample of 27 domestic commercial banks, with the period 1977 to 1979 chosen as the reference period for the study.

I In studying bank behavior, the author concentrates on two peculiar characteristics of commercial banks. These • r are: 1) a bank, just like any other firm, _s a producing unit and not merely an investor; and 2) a bank is a multiproduct firm.

(Continued next page)

rIDS Development

Research News

AUGUST

Being producing units, comme/IM hanks produce several products such as loans (secured and unsecured, tthort- and long-term), investments, "and other bank ser,,ices.

And being multi-product firms, there is a need for banks to engage more in economies of scope instead of largely depending on economies of scale. This means that banks should diversify their outputs and lessen expansive activities that prove to he more expensive, •Results of this study show that a majority of the banks studied had either completely or nearly exhausted their economies of scale. Thus, the policy encouraging banks to expand further through internal capital build-up and/or merger with another bank is a less desirable policy, However, the author indicates that for some banks, there are still economies of scale to be exploited.

Nevertheless, economies of scope were found tO'he an alternative policy. Some banks were found to be already engaged in economies of scope in the production of shortand long-term loans, The study goes on to further investigate whether cost savings can be realized by producing several products together. The findings.point out that banks are likely to experience cost disadvantages if they produce all possible financial products together.

However, results indicate the desirability of producing certain subsets of financial PrOducts. In particular, cost savings would be realized if banks diversify their loan pot:tlfolio, i.e., they produce both secured and unsecured loans, and short- and long-term loans. Thus, banks still have some economies of scope to be exploited, It is cheaper Io produce both types of loans in cornm..,.,

bination rather tfilrseparately. This may serve as an argument for encouraging banks to produce both short-and long-term loans without necessarily requiring them to increase their size.

Furthermore, a need arises for banks to increase the proportion of long-term loans in relation to short-term loans. Hence, the current move of the Central. Bank to lift policies biased against long-term loans (e.g., rediscounting policies) is deemed appropriate. It could motivate banks to increase the proportion of long-term loans in their total loa'n portfolio.

The results of this s[udy can also aid in understanding the role of bank behavior and monetary policies in deter, mining the supply of money.

The study finds that the demand for borrowed funds (i.e., Central Bank and money market borrowings) and deposits is inelastic. Changing the cost of borrowed and deposit funds, i.e., changing the borrowing rates (such as rediscount rates, money market rates and deposit rates) does not affect the demand for such funds.

Hence, the Central Bank can influence the movements of money supply only through its money market operations. Its rediscounting policies are found to be powerless in influencing such movements.

In qualifying his finding, the author observes thai the inelastic demand for borrowed funds and deposits may be attributed to the setting of interest ceilings (in the case of deposits and the money market) and to the •giving of generous rediscount rates (in the case of borrowings from the Central Bank). Since regulated prices of these funds are usually lower than their free market prices, inelastic de-

i

I

I

CENTRAL

BANK

I

I

l

BANK (Universal

INSTITUTIONS

], Banks

•

[

BaJ _s

Houses

l

"--[

Stock SLAs Aside

I

INSTITUTIONS

Banks)

Building and Loan

CompaniesFinanee ]

Compa0ies

functions

Savings

of

l

.|

_

Secritles Dealers/

Mortgage

nonbank financial also undertake the thrift banks, iaslitutions

and Bank_

and thrift nonbank'

1I

Development Private

institutions.

I

Banks

'

_

---_ _

Lnr

[

Pawnshops Brokers

Managers Fund

Investors Lending

I

]

I

Private Insurance Companies

Non-banks Specialized

THE PHILIPPINE FINANCIAL Source:

Sitar,

Gerardo P,, Economics (1985)_ H| L

•

S'YS-FEM

Association

SLAs

/-rum being

commercial banks these banks can

1983

I

PIDS DevelopmentResearchNews mand

occurs. Hence,

any small change in the prices of

AUGUST1983 really,

the government

draws down its deposit

balances

these funds will hardly affect the demand, In view of this, the author recommends that rediscount rates be set at levels competitive with money market rates to make the demand for borrowed funds and demand deposits more price elastic. The author further recommends that the Central Bank's rediscounting facility be used more as an instrument for controlling movements of the money supply and less as an allocative instrument, This study also has two polic_, implications regarding the high net rate of return- to banks on investments in bonds and securities (mostly government).

One is the feasibility of developing a secondary market for government securities,

when it wishes to refrain from issuing too much debt toj finance a budget deficit.

In practice, however, the Philippine government's debt issue has usually exceeded the budget deficit, specifically 16 times in the 22-year period • under study.

During these times, the government issued more debt than the deficit required and used the excess:•funds to build up its deposits in the banking system.

The government can also issue debt of various forms to cover that part of the deficit which it does 'not finance by drawing on its cash deposits. The Philippine experience, though, shows no clear relationship between money creation and government debt issue.

The other is that the earnings realized by banks from these asscts would increase their ability to expand credit, And, since government securities can from part of total requircd reserves, the increased earnings from such assets might have reduced the effective reserve requirements ratio. The author calls this "expansionary."

In this view, the author recommends the lowering of

A framework for the analysis of the choice of the optimal mix of policy instruments is presented by maximizing the welfare of a representative household subject to financing a given budget deficit. Assuming a perfect capital market, this optimal mix consists only of money creation and public borrowing, with the mix itself depending on various cross elasticities of demand.

government securities in the to_al reserve requirements of banks than what it currently allowed. This should aid in developing the secondary market for government securities as well as enchance the effectiveness of monetary policy, Finally, there is the issue of using explicit pricing on demand deposit accounts. Explicit pricing provides cot-

The condition of a perfect capital market, however, is difficult to find in most LDCs. Hence, such framework or theory may not hold in the Philippines. There are many distortions that abound in the Philippine, capital market.

Some maybe considered minor while the others are major.

The distortions that cause a major concern are those

rect market signals to both banks and depositors. At pro. sent, banks employ an implicit pricing scheme which could give a wrong market signal, FINANCING THE BUDGET DEFICIT project No. 82-A-O2a

that arise from two particularly onerous systems of_ government interventions: the systems of financial repression, and of tariff protection. The financial repression is caused by various banking regulations, particularly usury ceilings, which have fragmented financial markets and

by Dr. Eli Remolona, UP School of Economics For the last 25 years, the government has been incurring heavy budgetary deficits. Yet, in spite of this, data on recent Philippine experience reveal that no well established guidelines on how to finance a budget deficit have been formulated, The study by Dr. Eli M. Remolona of the University of the Philippines School of Economics (UPSE) entitled "Financing the Budget Deficit" looks into the ways and means of financing a given budget deficit, considers a theOry which chooses the optimal mix of policy in-" struments that would finance the deficit, and takes the case of a less developed country like the Philippines as example, The author discusses three different methods of finan-

prevented interest rates from reflecting the real scarcity cost of capital. In terms of tariff protection, meanwhile, the tariff structure of the'country has resulted in widely varying effective rates of protection and in overinvestment in certain capital-intensive industries.

Both systems of intervention have led to the stifling of savings and the misallocation of capital. The Philippine government has respoaaded to this by embarking on a program of trade and financial liberalization. But the problem now is how to manage the transition to a liberalized economy. As long as elcments of repressive intervention remain, second-best policies or policies that do not discourage savings any further nor reinforce the patterns of investment engendered by financial repression and tariff protection are called for.

cing a budget deficit, namely: 1) the creation of base money; 2) public borrowing which can either come from domestic sources or from foreign sources; and 3) the imposition of reserve requirements on financial institutions, Determining the optimal combination of these methods is critical because they have far-reaching implications on resource allocation and the overall stability of the economy, While the author enumerates only the threc abovementioned methods as instruments to finance

The author then further evaluates the methods of financing the budget deficit in less developed countries, w'kh the Philippines as example. Each of these methods is examined from the standpoint of second-best policy in the presence of capital market distortions.

The study points out thai since financial repression isd imposed mainly through ceilings on nominal interest rates,_ base money creation (to the extent that it is inflationary) can only make matters worse. In this repressed situation, inflation is a tax not only on real money balances but also

deficits, the government can also operationally resort to drawing on its cash deposits as a temporary measure. Nor-

on savings deposits.

(Continued

6

next page)

PIDSDevelopmentResearchNews In such a situation, inflation is a p_'_icularly cruel tax.

By lowering real interest rates, it raises the subsidy on the [lready privileged class of borrowers, while making the burden on-the small savers even more oppressive, In his discussion ofpublic borrowing, meanwhile, the author distinguishes between local and foreign borrowing because of the importance to the Philippines of the balance of payments, The author points out that government debt must in one way or the other be serviced by taxes in the future.

This will be equivalent to a tax on saving. In a regime of trade and financial repression, such a tax would only aggravate the situation.

Therefore, financing the budget deficit by means of domestic borrowing should be avoided.

If domestic borrowing should be avoided, more so with foreign borrowing. Whether the government borrows locally or abroad, the debt has to be serviced by future taxes. But servicing foreign debt somehow entails taxes that are more burdensome, and hence more discouraging to savings. The study reasons out that this has to do with the perverse tendency of a repressed economy to incur current-account deficits, The author defines current-account deficit as the difference between domestic investment and domestic saving, The author further states that the more the government borrows from abroad, the greater the current-account deficit. Consequently, more painful measures will have to be instituted in the future to pay for that deficit. And, the tax burden on present savings will be greater, The author then points out that less developed countries have only one last resort to finance budget deficits: the imposition of reserve requirements on financial institutions, The reserve requirement serves as a tax on financial intermediation so long as forms of government debt used as reserve assets yield lower rates of return than the rates that prevail in the market, The study notes that when the government borrows by requiring financial institutions to hold its debt as reserves, the effect is not to tax savings but to tax loans, By raising loan rates, the rese_rve tax serves to soak up the rents accruing to the privileged borrowers who have access to cheap credit.

The author expresses concern, though, that the reserve tax be exercised with care. Furthermore, this tax should bc phased out as soon as liberalization is achieved.

At this point, money creation and public borro_ving become the preferred instruments to finance budget • deficit.o CREDIT"AI_ID PRICE POI_I_IES IN PHILIPPINE AGRICULTURE

AUGUST1983 The author traces first the growth of the country's formal agricultural credit system, then looks into the effects of government •policies on the relative prices of agricultural products and concludes with the argument that low interest rates do not alter the incentive structure facing agriculture nor resolve equity problems caused by price policies and that the availability of cheap credit has been ineffective in offsetting the various taxes imposed on agriculture.

Credit has been a major instrument used in the pursuit of agricultural development in the Philippines. As a result of the Rural Bank Law enacted in the early fifties, financial institutions catering to the rural sector have grown.

At present, there are more than a thousand rural banks operating in about 60 percent of municipalities.

They are the principal distributors of governmentsponsored supervised credit.

The study states that the government's objective of increasing the credit flow to agriculture has been hampered by low interest rate policies. Since the late sixties, official interest rates on agricultural credit have been lower than the scarcity price of loanable funds, with negative consequences on the rate of savings and investments on agriculture.

As a consequence of rapid inflation (about 20 percent during the 1970s), interest rates were negative in real terms.

This price structure rewar_led borrowers and penalized savers. It also created excess loan demand that limited the flow of loans to agriculture specially to small farmers, where the costs of transactions and risks were inherently higher.

To increase agricultural credit, the government required a certain proportion of lenders' portfolios of loans to go to credit for agriculture. In addition, a number of supervised agricultural credit programs were initiated, one of which was the Masagana 99 rice production promotion program which accounted for almost 80 percent of total loans granted by these supervised credit programs.

Over the past two decades, the increased agricultural loans came mainly from the Central Bank rediscount window rather than from additional equity capital or savings deposits.

Despite these government interventions, findings indicates that the real and relative levels of agricultural production loans granted have declined since the late 1960s.

This trend, according to the author, is not surprising since what is considered as more important determinants of relativeprofitabilityand, therefore, resource allocations are technology and relative prices across sectors and commodities, and between inputs and outputs.

It is argued that the use of credit policies, to compen-

Project No. 82-02

by Dr. Cristina C. David, Research Fellow, PIDS

sate for the effects of policies that turn terms of trade against food and agricultural exports, will have limited effects. Preferential interest rates do not affect relative pro-

A study submitted by Dr. Cristina C. David, a research fellow at the Philippine Institute for Development Studies (PIDS), examines the impact of credit policies on Philippine agricultural development and shows how credit policies relate to economic incentives in agriculture,

fitability. As the author puts it: cheap credit will not make an unprofitable activity profitable!

Hence, in the Philippines, interest rate subsidies have not significantly altered the unfavorable economic incentives in agriculture caused by government policies. The 7

study also investigates the relationshi_='of credit subsidies (through low interest rates) and the worsening of income distribution. It was found out that only a few, typically .progressive farmers benefitted from the cheap credit. This is primarily due to the fungibility of credit where addtitional liquidity supplied by credit will be allocated either to the most profitable enterprise or to consumption, whichever provides the greatest utility. Within agriculture, credit allocation is not consistent with employment and equity objectives. Low cost credit for agricultural machinery becomes biased-against the use of labor without significant impact on yield. In supervised credit programs, only farm operators are usually entitled to institutional credit despite the significant number of landless households in the rural areas.*

UPDATE

The author (xplains that when interest rates are not allowed to reflect the cost of financial intermediations,_ wealth and political power replace profitability as the basi_ for allocating credit.

The study also analyzes the effect of price intervention policies on relative prices of agricultural outputs and inputs vis-a-vis non-agriculture and the world. Findings indicate that, on the whole, these policies have had adverse effects to agriculture and have created an incentive structure that is significantly biased against agriculture.

The author reports that the choice of credit policies to compensate for the adverse effects of other policies is due to administrative ease, availability of external grants and loans, and to other short-run considerations.

This approach, however, fails to achieve either equity or efficiency

Project No. 82-A-05 An Analysis of the Institutional Framework of the Philippine Short-Term Financial Market.

Victoria S. Licuanan, Asian Institute of Management.

The study examines institutions, instruments and financial practices which make up the short-term financial markets in the Philippines today. The first stage of the pro: ject is the formulation of a model for short-term financial flows, which will subsequently be compared to western models to discover differences.

A standard monetary

objectives. Moreover, cheap credit policies due to low interest rates retard the development of viable formal financial institutions in rural areas since they do not provide incentives for mobilizing financial savings and they induce an allocation of credit that is based on size of collateral and wealth rather than productivity of credit use.

The author indicates that long-term solutions are called for to rectify these adverse effects on agriculture. This includes providing positive incentives to farmers by correcting price distortions in real and financial markets, and expanding investments in marketing infrastructure, irrigation, resea/'ch and extention. * ..............

theory of how the system operates and responds to policy stimuli will then be examined to determine its relevance , and applicability to the Philippine setting.* Project No. 83-_A-01 Development of a User's Manual for Financial Monetary Statistics.

Mitsuo Ono. Philippine Institute for Development Studies.

The project aims to come up with a User's Manual which will outline sources and methods of estimations for

Shadows Prices and Project Evaluation Lecture-Seminar A lecture-seminar on " Shadow Prices and Investment Criteria Used in Project Evaluation " was held last August 4 at the NEDA sa Pasig building.

This lecture_seminar was jointly sponsored by the Philippine Institute for Development Studies (PIDS) and the National Economic and Development Authority (NEDA).

The presentor was Dr. Erlinda Medalla, a research fellow of PIDS.

key financial statistics as Well as comments regarding their use. This will support the data requirements of studies being undertaken under the PIDS Money and Banking research and related studies on monetary and banking aolicies. 째

More details of Dr. Medalla's study on shadow prices and on investment criteria for project evaluation will be discussed in the coming issues of Development Research b/ews.*

PIDS On-Going Projects on Development Finance

DEVELOPMENT RESEARCH NEWS is a monthly publication of the PHILIPPINE INSTITUTE FOR DEVELOPMENT STUDIES (PIDS). It highlights research findings and recommendations, seminars, publications, on-going and forthcoming projects which are of interest to policymakers, planners, administrators, and researchers.

This publication is part of the Institute's program to promote the utilization of research findings and recommendations.

PIDS is a non-stock, non-profit government research institution engaged in long-term policy-oriented research.

The views and facts published here are those of the authors and do not necessarily reflect those of the Institute. Inquiries regarding any of the studies discussed in this publication may be addressed to the following: RESEARCH INFORMATION DEPARTMENT (RID) PHILIPPINE INSTITUTE FOR DEVELOPMENT STUDIES (PIDS) ROOM 515, NEDA SA MAKATI BUILDING 106 AMORSOLO STREET, LEGASPI VILLAGE, MAKATI, METRO MANILA