Felipe M Medalla: Opportunities and challenges - the BSP Policy Agenda in 2023

Speech by Mr Felipe M Medalla, Governor of Bangko Sentral ng Pilipinas (BSP, the central bank of the Philippines), at the 23rd Weekly Membership Meeting of the Rotary Club Manila, Manila, 11 January 2023. 

The views expressed in this speech are those of the speaker and not the view of the BIS.

Central bank speech  | 
07 February 2023
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Magandang tanghali sa inyong lahat. [Good afternoon, everyone.], and I hope it is not too late to say, "Happy new year!" Indeed, it is a privilege to be in front of you. I guess, it says something about my age that I know a lot of members of this club-at least, the older ones. In fact, I know Jimmy Laya and, even though we only met once or twice, Tito Mendoza.  

Before I begin, I would like to acknowledge two very important people who played very important roles in monetary policy. Of course, Say Tetangco, a fantastic governor who incidentally never missed [Rotary Club engagements and] always spoke to this club, right? You did not miss a single one, Say, right? In my case, my term is only one year, so I will not miss [any Rotary meeting]. And of course, my very good friend, Peter Favila. When I joined the Monetary Board, he was already there for three years. I would like to say, in my opinion, the best Secretary of the Department of Trade and Industry.  

It is an honor and privilege to speak before people who share the values that I have.  

Putting government policies under the microscope 

By the way, the [Rotary's] four-way test can also be used to evaluate government policies, although the fourth one is hard. "Is it beneficial to all concerned?" That requires a whole-of-government approach. Even [in achieving] 7.0 percent growth, somebody will get hit. That is the very nature of economic progress. When economic progress renders old activities obsolete, then it means that somebody will be hurt by progress. So, it is hard to pass the four-way test for government policies.  

But I have a suggested modification [to the fourth question in the four-way test. Revise it to:] "a change that can potentially benefit everyone." And, clearly, that requires a growing pie and a government that collects taxes so that it can help citizens because that is very hard-to collect taxes well and spend them well. Very few democracies do that very well.  

To their credit, at least, fiscal policy and monetary policy in this country, in my view, have been excellent and the best indicator of that is when I was in government with NEDA [National Economic and Development Authority]. The 10-year US [United States] government bond [in dollars] yielded 500 basis points (bps) less than the same 10-year dollar bond owed by the Philippine government. Same currency, same tenor, different interest rate. Why? Different borrower. Why? One borrower is considered inferior to the other. And, with all the reforms that happened, that spread is now 100–150 bps.  

So, there are many things that we can be very proud of in this country. In other words, if you work in government, the ability to make progress hits everyone, including those that are directly [meant to be] hit by progress. There will be better schools, better healthcare, and, of course, even [conditional cash] transfers-in the case of Pantawid Pamilyang Pilipino Program.  

So, that is how I would start. The central bank is part of a greater government.  

And, of course, we have a very well-defined mandate, which we call the three pillars. Not only that-we print money, so we do not need Congress for our budget. [Having said that], let me tell you, we print that money carefully because of our inflation target.  

Now, I will go back to some of our contributions and, later on, explain why we were able to respond to many things and create many buffers for the economy [during the pandemic].  

So, I appreciate this opportunity to share our views on the economy and our role in economic policymaking.  

Price stability in a challenging environment  

I already talked about the three pillars, [first of which is] price stability. The way it is operationalized right now is: the government sets the inflation target, which is right now 2.0 to 4.0 percent. As the process goes on, we advise [the government] that 2.0 to 4.0 percent is a good range. By the way, 1.0 percent is a bad target. For those of you who are old enough, deflation is actually more dangerous than inflation. When prices are dropping, everyone will postpone buying things, and the economy will collapse. So, we do not want to hit close to zero; 2.0 to 4.0 percent, I think, is just right.  

Now, how to do all of these things: price stability, financial stability, and an efficient-and I would say digitalized-payments and settlements system? Those are the things that we [at the central bank] have to do well.  

Now, when one looks at the [inflation] numbers, most people look at the year-on-year. [For instance, inflation for] December this year compared to December last year is a whopping 8.1 percent.  

Of course, you can exclude the extreme items. We call that core inflation and it is a bit lower at 6.9 percent. But as you can see from the chart, although core inflation is lower, its rate of acceleration or steepness is actually a bit faster.  

What most people do not see, because it is hard to discuss, because it requires the concept of removing seasonal effects, is this. For instance, even if inflation is, on average, zero, December prices will be higher than November. On the other hand, usually, February numbers will be lower than January. So, we have to account for the seasonal effects.  

What you see at the bottom of the chart is the change [in inflation] from one month to the next, after already taking out the seasonal effects. And, as short as those green bars are, they are actually quite alarming. Indeed, when you look at those charts, there were months when just one month from the next, prices have risen by 1.2 percent. If you want to shock yourself, multiply that by 12. If that trend were to continue, you would have 12 percent [annualized inflation].  

Now, if you take this chart a bit longer [back in time], you can say that this chart centers at around 0.25 to 0.35 percent, which is consistent with 3.0 percent inflation [target].  

And, when you look at the history of the central bank that [former BSP Governor] Say [Tetangco] led, the average is almost exactly that.  

Of course, there are bad months [of above-target inflation]. Worse, when you are not lucky, you will have a series of really bad months. And, boy, the last 12 to 14 months have been, as you can see, a series of bad months. We call them supply shocks-something [that] happens to supply, which, by nature, is very hard to control with monetary policy, [like] the Ukraine war, the rise in oil prices, and, for some reason, supply has been destroyed in the case of fruits and vegetables. The joke now is if you get sibuyas, you can wear it as your earrings because it has become quite expensive.  

Signs of easing inflation pressures?  

Now, our initial forecast was that month-on-month [inflation] will start to peak already in October 2022. When we changed the forecast, the peak became December 2022. The peak, in terms of month-on-month, was actually November but, in terms of year-on-year, the peak is [forecast to be] December.  

The latest reading of inflation is 8.1 percent for December, but [inflation for] December versus November is only 0.3 percent. And our model shows that unless a big shock happens, these [small month-on-month changes] will go on for the rest of the year. Of course, the momentum driven by the large inflation will not clear out in about 12 months later because of the way we compute the index. When you look at history, the longest run of inflation that is above target is 15 months because what happened was, we got [went through] four huge monthly shocks.  

The good news is the monthly shocks do not have a life of their own. Now, how can inflation have a life of its own? The moment inflation is high, people expect it [high inflation] to get repeated and repeated and repeated, which we call disanchored inflationary expectations. And the moment people do not trust their purchasing power anymore, then inflation dynamics can become a self-fulfilling prophecy. Inflation is high because we expect it to be high. What will happen? Landlords will now build in an automatic, let us say, 5.0 percent adjustment clause in their [lease] contracts. Workers, knowing that, will ask for wage raises.  

This is what we are proud of at the central bank: we make sure that supply shocks remain supply shock inflation. When the supply shocks are gone, so is the excess inflation. That is exactly our forecast. Our forecast is that the normalization in month-on-month [inflation] has started. Of course, one month of good print does not make a reality, but, when you look at our history, we have been able to do that.  

And how did we do that? We killed inflation expectations by raising interest rates.  

Pent-up demand to continue driving growth 

I have been questioned: have you not sacrificed output [by tightening policy]? The answer is, fortunately, not-because we have a period of very high demand. What happened is, because of the pandemic, a lot of things [consumption] have been postponed. I have only a sample of one. My wife [has] a lot of postponed expenditures, which she already plans to do-go to Boracay, go to Palawan, and go to restaurants. In other words, what happened is the pent-up demand arose from the postponement of goods spending. Healthy spending was postponed by two and a half years, some of that will be utang from the past, ngayon [pa lang] gagastusin. Demand that was not exercised in the past will be exercised now.  

Of course, the beautiful name for it is called revenge spending. You can see that as well in the sales of cars. Who needs a car when you cannot use it because of the lockdowns? By the way, the only thing that sold very well during the pandemic was high-quality audio-visual equipment because, at home, we did nothing but watch Netflix.  

What is happening now is that this pent-up demand is coming to the fore, and our estimate is that there is so much pent-up demand, it will still carry the economy this year.  

But what about 2024? How bad will the economy be once the pent-up demand is gone? We are saying that by that time, we have licked inflation, hopefully, and the macroeconomic and monetary policy arrangements will be much better. Although I have heard people with a very gloomy forecast for the global economy who actually see 2024 to be worse than 2023.  

Target-consistent future path 

So, I think, that is the last message [on price stability]. Our monetary policy nipped inflation in the bud and limited it to supply shocks. We prevented supply shocks from becoming permanent momentum for inflation, and we paid a relatively small price for it because the economy was quite strong anyway because of the pent-up demand.  

Hopefully, by the time we get there, which is 2024, when pent-up demand is gone, then monetary policy will be much looser than what we have now. How much looser? I do not know. It will depend on a lot of things. 

Our forecast this year is that inflation will be 4.5 percent for the simple reason I have already discussed: the momentum of inflation will have a high first half-over 4.0 percent-and the second half of the year will be below 4.0 percent. But the [lower inflation for the] second half of the year cannot offset fully the first-half [figures]. Indeed, as you can see, inflation last year was 5.8 percent, so it is going down. So, that is the main scenario forecast. The month-on-month [figures are] already normalizing. This will get detected in the year-on-year [numbers] by the third quarter of this year, and we will be back to target for the rest of the year.  

Looking to lessons from the past 

And we have a historical basis to do this. As I said, the longest streak of above-target inflation is 15 months. Now, this [current] episode of inflation is a bit more difficult, so we will say 16, 17 months.  

The longest period that we were off-target-when inflation was below [target]-I think, was in 2015–2016 [when inflation was] 0.7 percent, below 2.0 percent [target], and 1.3 percent. By the way, nobody was complaining that we were off target [at that time] for obvious reasons. A big part of it was due to global deflation.  

If you have very, very globally powerful inflation, we may have a repeat of that [period of above or beyond target inflation]. The longest was 24 months of below 2.0 percent inflation. If that gets repeated on the demand side, we now have global inflation, and, like it or not, we really are importing [inflation].  

Some might say, "I do not really see ourselves as part of the global economy." [To that, I say] "Well, you are not influenced by inflation, but, like North Korea, you [may] have no inflation, but you are poor forever." That is my problem with all my anti-globalist friends from UP [University of the Philippines]. They are so afraid of globalization. Of course, that also means they are so afraid that the government is unable to collect taxes and use the money well. No matter what we say about our system, it has its defects, but it is able to do things well.  

Why taking decisive monetary action is pro-growth 

As I said, because inflation is actually higher than the policy rate, high as the policy rate is, it is still supportive of economic growth.  

Some may argue that it is even better if we did not respond to inflation. The problem with that is if you do not respond to inflation, you have to respond to it later anyway. And, if you do that, the cost will be higher. By that time, inflationary expectations may be at risk of being disanchored.  

I always say, "We never lose output because of our first pillar." Because if we do not fight inflation, we postpone the loss in output. Because the day you fight inflation, when it is already bigger, the output loss will be bigger. So, advancing the time you fight inflation actually cuts the lost output.  

It is like any medicine: taking it late, the disease gets worse. And, instead of [having to go through] non-surgical procedures, you now need surgery, and the worst [case] is you are now in the intensive care unit because you postponed [seeking medical assistance].  

Taking a long-term view and building buffers for the future  

And we are very lucky that the Constitution actually put the independence of the central bank in our Charter. As I said, I am very lucky that my predecessors did their job very well.  

For instance, our ability to interfere in the forex (FX) market. Why? Because we have a lot of reserves. Why did we have lots of reserves? Because [former BSP Governor] Say Tetangco, when the peso was threatening to appreciate-cross 40 and become 35-he borrowed lots of pesos to buy dollars. Why borrow? If you print, it will cause inflation.  

Say, I remember, your borrowings hit ₱2.3 trillion. That took a tremendous amount of courage. You are losing money. The peso is appreciating, [yet] you are buying dollars, and you are paying interest much, much higher than what your FX reserves can earn abroad-because we are conservative on where we put our reserves. You are paying 2.0 to 3.0 percent a year in peso interest, and your dollars are earning 1.0 percent. You are accumulating [dollars]; you borrowed ₱2.3 trillion. Of course, the view is that "This too shall pass," and it did pass.  

By the way, we are lucky that we are given more powers by the government when it comes to FX reserves. Now, it is coming in very handy. While we have good FX reserves, we do not necessarily have too much. Who knows? Maybe, the next global trouble will not last one year but three years. You have enough savings if you stay in the ICU [intensive care unit] for two weeks. You do not have enough savings if you stay in the ICU for two years. And that is the value of reserves.  

Policy reforms and bright spots in the economy 

Of course, we also have to thank all the reforms that happened to the economy. For me, the most important one was rice tariffication. What happened in the past? Favoritism. 'Yung paborito ang makakakuha ng [The favored one will get the] right to import. It will actually have a very high under-the-table value.  

Indeed, imagine if we did this [tariffication] to all agricultural products. You want to protect? Impose tariffs. At least, the money will go to the government rather than the lucky guys who get the licenses. By the way, the guys who get the licenses are "friends" and can conspire to reduce supply.  

In the case of agriculture, you have phytosanitary permits because it is only correct that we do not import from countries that will bring us diseases. Unfortunately, it was used to pick favorites, to choose who can do the importing. By the way, I am citing an NBI [National Bureau of Investigation] report. Those who got the permits underutilized their permits all because of the shortage. And, because they know the shortage will come, they bought everything beforehand. 

Now, the other side of it is, of course, that we have a very, very strong labor power, which, in turn, was the basis for a very, very strong BPO [business process outsourcing]. And remittances, despite their large size, keep growing. These are the things that are going for us.  

Diminishing foreign exchange pressures 

As I already said, foreign exchange pressures have dissipated because the peak of the strength of the US dollar has gone. It was really a strong dollar more than a weak peso.  

The Philippine peso, year-to-date, has appreciated. By the way, if you are talking year-to-date last year, the worst time was [when the peso experienced] 15 percent depreciation. By the way, the Korean [central bank] Governor asked me, "What do you do when you go home?" I tell him, "Korean depreciation is more than ours." Of course, he did not find it funny.  

Depreciation pressures on the peso have somewhat diminished in recent months and, if you do believe the forecast of the Fed [US Federal Reserve] that [it will do] maybe two more 50 bps, then it is really over. No more four 75 bps-can you imagine-four 75-bps [hikes] in just four meetings.  

US dollar still king-but less of a factor in policy decisions 

Also, the concerns about the interest rate differential are not as strong as they used to be because the dollar as safe haven is now less important. It is always important, but now, it is less important.  

I do this test. Consider two instruments [with] exactly the same tenor, exactly the same borrower. The only difference is one is dollar, and the other is peso. Suppose the interest rates are the same. Who would prefer the peso? Anybody?  

[Some people raised their hands.]  

I am disappointed in you. You all have to study economics. One [the dollar] is safe haven; clearly, it has a premium because the entire international financial system is dollar-based, so much so that a poor country lends to the US, a poor country like the Philippines. Because if your country needs reliable reserves, you put it in US dollars-because no other government security has as deep and as reliable a market, liquid and predictable. [When] you read the newspapers for the price, that is, more or less, the price that you can get.  

The preference for the US dollar is still there, but there was a time when it was the main obsession, and that is why the peso sank 15 percent. But it is now down to less than 3.0 percent, so quite a bit of appreciation.  

Making full use of expanded toolkit 

Of course, I do credit what we [at the central bank] did. We acted decisively. We raised rates, and we signaled to the market that that is exactly what we are planning to do. Unfortunately, now, it is harder to tell, which is why I signal a bit less. When I do not know where to go, my wife says, "Left turn, right turn."  

At any rate, the summary is very simple-pragmatic use of our expanded toolkit:  

[We] adjust interest rates depending on inflation forecast and communicate that well. 

[We] let the peso adjust because, in one way, it was the real reason why the peso was depreciating. 

The current account deficit was initially US$5 billion per year. It became US$20 billion because of two things: higher import prices-it was two-thirds of the increase-and the other one is that we [the economy] are growing faster than our neighbors. Therefore, our imports are growing faster than our neighbors.  

And, of course, as I already said, [we make] use of FX reserves. 

And then, [we have] support from national government policies, which is to relax the import restrictions. 

Robust external inflows 

As I already said, the [country enjoys] robust inflows-we are now beginning to see the peso is actually crossing 55 [vs the dollar] temporarily, right?  

Well, of course, there will be headwinds, but the other thing that most people do not know is that foreign direct investments (FDIs) are quite healthy. Well, this is the sad thing about the Philippines. When you look only at goods and services, our receipts are half our expenditure.  

Fortunately, of course, you have remittances. FDI is about US$​7.6 billion from January to October 2022.  

Resilient banking system: a joint effort by regulators and the regulated 

Moreover, you have a banking system that is strong. I credit the strong banking system to our regulation. It is very simple. You [the bank] take on risk. We [the central bank] notice you are taking more risk than your comparable bank, we ask you to put up more capital. You do not put up the capital, you get plenty of penalties.  

This is what we see: adequate capital buffers, expanding assets, ample liquidity because we also have liquidity regulations, deposits growing rapidly, and high provisions for non-performing loans (NPL). And we are actually now seeing very healthy [loan] growth. And, since NPLs are not growing very fast, loans are outgrowing the NPLs and the NPL ratio is actually coming down.  

I also credit the bankers. Many of the current [bank] presidents were already high-ranking vice presidents when the Asian [Financial] Crisis came. So, they know the lesson: "Do not have a business model and assume that everything will be fine." They diversify. They protect and, of course, [employ] good governance.  

Third pillar-no less important 

By the way, I have to say something about payments and settlements because, of course, the key now is a cash-lite society. More and more payments are being made using your cellphone.  

Key messages 

Let me end with the following points:  

The BSP is driven by its three pillars. Growth is not part of our mandate. But if we serve our three pillars well, it will be the basis of solid long-term growth, and the BSP stands ready to do what is necessary to bring inflation back to its target-consistent path.  

Number two, the banking system is sound and stable heading into 2023, lending support to domestic prospects.  

Finally, the push for digitalization will help Filipinos navigate this post-pandemic economy.  

2023 could be uneventful or could be as challenging [as the year before], but it is important to move forward with cautious optimism as we face the challenges ahead.  

Thank you very much, and good afternoon.