Economic Issue of the Day
Philippine Institute for Development Studies S u r i a n s a m g a Pa g -a a ral Pangkaunlaran ng Pilipinas
Vo l . V I N o . 3 ( A p r i l 2 0 0 6 )
Exchange rate
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xchange rates reflect the price of one currency in terms of another. This means that if the current rate is P52=$1, a person holding $1 can have it exchanged for P52 or equivalently, one needs P52 to buy $1.
Why is it important? Exchange rates play a crucial role in international trade because they allow one to compare the prices of goods and services in different countries. If the exchange rate stands at P52-$1, a kilo of Gouda cheese that sells $20 is approximately P1,040 in the domestic market. A change in the peso/dollar rate can alter the price of Gouda cheese assuming its dollar price remains the same. Suppose the exchange rate changes to P50-$1, then the imported cheese would now cost P1,000. Changes in exchange rates are described as depreciations or appreciations. A depreciation of the Philippine peso against the US dollar means the value of the peso fell relative to the dollar. In terms of exchange rates, this means from P52-$1 to P54-$1. An appreciation of the peso is a rise in the value relative to the dollar, i.e., from P52-$1 to P50-$1. From the example above, one can conclude that an appreciation (depreciation) of the peso makes imported products cheaper (more expensive) in the Philippines. Conversely, a depreciation favors exporters and local producers with import substitutes since they can earn extra profit without adjusting production cost.
How is the exchange rate determined? Exchange rates are determined by the demand and supply for foreign exchange from the households, firms, and financial institutions that buy and sell foreign currencies to make international payments. The market by which international currency trading takes place is called the foreign exchange market. The users of foreign currency (demand side) are weighed against the sources of dollars (supply side) and their interaction determines the rate. Some of the users are the importers and
corporations with international transactions while the sources are the exporters, foreign creditors, and the overseas contract workers. If the users of dollar outweigh the sources, this means more people are demanding dollars, thereby making it a more valuable currency over the peso. In terms of currency pricing, this will put pressure on the dollar to appreciate relative to the peso. An appreciation of the dollar is synonymous with a depreciation of the peso. When the peso is appreciating, this means there is a strong demand for peso over the dollar. The country’s balance of payments (BOP) keeps a fairly good track of the uses and sources of dollars (Table 1).
Table 1. Balance of payments (in US$ million) 2004
1. Current account Goods and services Export Import Income Receipts Payments 2. Capital and financial account Capital Receipts Payments Financial Direct investment Portfolio investment Financial derivatives Others 3. Net unclassified items 4. Overall position
2005 as of Sept.
584 (6,109) 31,281 (37,390) (184) 2,763 (2,947) (407) (13) 4 (17) (394) (39) (902) (20) 567 (353) (176)
1,205 (7,049) 32,595 (39,644) (377) 2,997 (3,374) 2,249 2 16 (14) 2,247 756 3,178 (8) (1,679) (724) 2,730
% Change
106.3 4.2 6.0
2,038.5 452.3 60.0 (396.1) 105.1 1,651.1
Source: Bangko Sentral ng Pilipinas Note: Items in italics are outflow, figures in parenthesis are negative.
Economic Issue of the Day
Exchange rate
Vo l . V I N o . 3 ( A p r i l 2 0 0 6 )
7.50 6.50 5.50 4.50 2004
2005
3.50 2.50 1.50
When does the Central Bank come in?
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(0.50)
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0.50
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While the BOP records the country’s demand and supply of dollars, regular trading is conducted in the foreign exchange market. In this market, the dollar is regarded as an asset. This means the principles governing the behavior of other asset prices like stock certificates are also applicable for exchange rates. Generally, prices of asset today are determined by what it can buy in the future; hence, expectations play a vital role in asset pricing. A person holding the dollar will either hang on to it or unload it, depending on (a) his needs for the dollar, and (b) what he expects the future price will be. Any information concerning future currency values, or news affecting people’s expectations, can cause the exchange rate to fluctuate.
Figure 1. Volatility of the peso/dollar
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Why does the rate change every day?
The Bangko Sentral ng Pilipinas, the country’s highest monetary authority, is responsible for monitoring and stabilizing peso fluctuations. Policy initiatives originate from the monetary managers in an attempt to arrest large peso fluctuations which could send detrimental signals to the investors and local consumers. Fluctuations, measured in terms of volatility, can be tamed through either interest rate changes or money supply movements. Both monetary policy tools have their strengths and weaknesses, and intended effects. A close and deep understanding of the economic forces is necessary to determine the appropriate monetary policy. Figure 1 shows that the exchange rates in 2005 were more volatile compared to the previous year. This means that the rates in 2005 were deviating more, and in large degree, from the average level. This implies an unstable peso movement which needed policy action from the monetary managers.
machineries are imported favoring a stronger peso, electronic and garment manufacturers, together with overseas contract workers, would vote for a depreciated peso. Sadly, a country cannot have two exchange rates at the same time. Market forces would eventually settle for one price. A number of Filipinos associate a stronger peso with the strength of the economy. While it is true that the peso carries the purchasing power of a consumer, it does not exactly translate to the overall performance of the Philippines. It must be kept in mind that the exchange rate is the valuation of the local currency against another currency. It is not analogous to comparing country performances. Case in point is China where the yuan is intentionally kept at a low level relative to the US dollar, yet its economy is considered to be a powerhouse. The exchange rate as well as stock prices and Treasury Bill rates are used as crude measures of performance but are highly influenced by perceptions and expectations, rather than fundamentals. ❋
Is a stronger peso good for the economy?
Reference
This is one controversial question that does not have a ready textbook answer. While important commodities like oil and heavy
Mishkin, F. 2003. Economics of money, banking and financial markets. 6th ed. Boston: Addison Wesley.
The Economic Issue of the Day is one of a series of PIDS efforts to help in enlightening the public and other interested parties on the concepts behind certain economic issues. This dissemination outlet aims to define and explain, in simple and easy-to-understand terms, basic concepts as they relate to current and everyday economics-related matters. This Issue was written by Ma. Teresa S. Dueñas-Caparas, Supervising Research Specialist at the Institute. She benefited from the comments of Dr. Erlinda M. Medalla, Senior Research Fellow. The views expressed are those of the author(s) and do not necessarily reflect those of PIDS. ❋ Philippine Institute for Development Studies NEDA sa Makati Building, 106 Amorsolo Street, Legaspi Village, Makati City z Telephone Nos: (632) 8924059 and (632) 8935705 z Fax Nos: (632) 8939589 and (632) 8161091 URL: http://www.pids.gov.ph