D. S. Savkar and Joachim Ahrensdorf
THE PHILIPPINES gained political independence from the United States in 1946, terminating a period of control which had begun in 1898. The postwar population was about 19 million (it is now over 30 million) and there was a high degree of literacy. The Philippines had developed a close trading and political association with the United States, and U.S. aid, especially payments for damages incurred in World War II, played a vital part in enabling the Government to tackle its first major task—the reconstruction of productive facilities that had been damaged or destroyed in the hostilities.
The country chose a generally free enterprise system as the most effective framework for rapid reconstruction and development, with incentives in various forms provided for businessmen venturing into new and necessary industries, such as iron and steel products and chemicals.
The most important element in this free enterprise framework was provided, until about 1960, by the decision of the Government to maintain the prewar fixed exchange rate of P 2 per U.S. dollar. In the postwar situation P 1 would buy substantially less than 50 U.S. cents, so that this exchange rate clearly overvalued the peso. The reason was that in the course of the war domestic prices in the Philippines had more or less quadrupled, while in the United States, at that time its principal trading partner, they had only doubled. In Western Europe and Japan the rise in prices in terms of dollars (and thus of pesos) had been even less if the devaluations of 1948-49 were taken into account. Nonetheless, the Government preferred at that time to maintain the prewar exchange rate, if necessary by the imposition of import and exchange controls to restrain the demand for imports and to influence their composition. The obvious alternative was a devaluation of the peso, but this was turned down because it seemed likely to benefit mainly the highly organized export sector through windfall gains in incomes rather than the economy as a whole by stimulating production. It was widely hoped that increasing production in the Philippines would lower domestic prices while prices abroad would tend to go on rising, so that in time the overvaluation of the peso would tend to disappear.
Import and exchange controls were not immediately necessary; large U.S. disbursements in the earlier postwar years permitted sizable excesses of imports over exports. Later such U.S. payments declined, and foreign exchange reserves fell from over $670 million at the end of 1945 to about $260 million at the end of 1949. Import and exchange controls were therefore established but they did not enable a devaluation to be completely avoided. The Government introduced a partial devaluation in 1951 by imposing an exchange tax of 17 per cent on all foreign exchange sold by the Central Bank. The object was to relieve the mounting pressures on the administrative machinery by making goods more expensive to import and also to provide additional revenue for the Government. Furthermore, in 1953 the administration of import controls was assigned to the Central Bank, which had been established only in 1949, as the performance of the “Import Control Commission” was not considered satisfactory. In the absence of any devaluation of the exchange rate so far as exports were concerned, some incentives for exporters were introduced from the mid-1950’s by allowing them to “barter” part of their exports for certain types of imports which generally were highly profitable. At the beginning of 1956 the 17 per cent tax on sales of exchange was replaced by a special levy on imports with the intention that this should be gradually reduced to nil by 1966.
Broadly, this system remained in effect until mid-1959, a period during which economic developments were on the whole satisfactory. By 1950 production was restored to its prewar level. In the early 1950’s the economy grew at a rate of about 7 per cent annually and in the latter half of the decade, after the reconstruction phase had come to an end, at about 5 per cent. Domestic prices remained reasonably stable, because the expansionary effects of increased bank credit on the money supply were largely offset by a decline in foreign exchange reserves and increases in savings.
The system of controls, however, experienced a good deal of trouble. The fairly steady decline in exchange reserves, while import demand was growing and trade deficits persisting, made the administration of the controls progressively more difficult. The Central Bank became more and more exposed to criticism from vested interests, which in part had been created by the control system itself. This criticism was not so much directed against its financial policies as against the apparently arbitrary administration of these policies; since there was just not enough “cheap” foreign exchange available to accommodate all takers, allocations of exchange naturally appeared unfair to those who got less than they believed to be their share. Furthermore, there was a growing recognition that the system of controls and the overvalued exchange rate had tended to channel domestic private investment toward the production of nonessential commodities and toward mere packaging of imported materials. On the other hand, investments in basic industries, such as metal products and chemicals, had been lagging. Last, but not least, it was increasingly realized that the overvalued rate was deterring exports, which in 1957, for example, were about at the same level as in 1951. In these circumstances import controls appeared to have outlived their usefulness.
The elimination of controls was planned to take place over four years. This approach was considered as more practical and less disruptive than a devaluation accompanied by the immediate abolition of all controls. From mid-1959 a special “margin” fee of 25 per cent was collected on sales of foreign exchange for all except about 16 per cent of imports and some payments for services. In April 1960 a so-called free market was established, although in fact the Central Bank set the exchange rate. The free market rate was first set at P 3.20 = US$1 on April 25, 1960 and was later changed to P 3.00 = US$1 on September 12, 1960. Different proportions of foreign exchange transactions could be effected at the free market rate for different types of transaction and these proportions were changed from time to time. There was also a differential application of “margin” fee collections. As a result, exchanges between pesos and other currencies took place at a number of different rates. For example, on March 15, 1961, there were three different rates at which the Central Bank bought currencies from exporters (“buying rates”) and three rates at which the Central Bank sold foreign currencies to importers and others (“selling rates”).1 These were in addition to the par value rate which still applied to some types of transaction. These various exchange rates, which were set by the Central Bank, ranged in effect up to as high as P 4.00 per U.S. dollar if the “margin” fee is taken into consideration. (During most of the postwar period, incidentally, black market rates for dollars in Manila and free market quotations for pesos in Hong Kong had been nearly as high as this.) In the first phase of the program about one fourth of exchange receipts and payments were made at such depreciated exchange rates. In the third phase this proportion rose to about 75-80 per cent.
The phasing of the decontrol program in this way gave rise to growing uncertainties on the part of businessmen about the timing and degree of further depreciation of the peso. As a result, there was speculation and capital flight, e.g., by holding back export receipts. This development was aggravated by domestic inflationary pressures stemming from an expansion of bank credit by about 35 per cent in 1961. In consequence, there was a sharp deterioration in the country’s international reserves, and at the end of 1961 the Central Bank’s foreign liabilities exceeded its foreign assets.
In view of these developments, the new Administration, shortly after entering office, decided in January 1962 to adopt a free fluctuating exchange rate system and to abolish virtually all controls on import and all other payments, including capital transactions, so as to be able to determine the true exchange value of the peso, which, to the extent that it was still maintained at an artificial level, would certainly depreciate. At the same time, import duties for some 500 items were modified. Duties on items of mass consumption were lowered in order to moderate the effect that a depreciated peso would have on their prices. On the other hand, duties were raised for items which were produced domestically in sufficient quantities.
On the other side of the account were the exporters, who could expect to do very well out of a sharp depreciation (in effect a devaluation) of the peso, since the amounts of foreign currencies which they would be receiving would exchange for more pesos than before. They were, therefore, permitted to sell only 80 per cent of their receipts at the free market rate and were required to surrender to the Central Bank the remaining 20 per cent at the par value rate of P 2 = US$1. This was done because the Government took the view that to allow the export industries to enjoy the full amount of the anticipated depreciation in the form of substantially increased incomes through windfall gains would have resulted in an unfair redistribution of incomes in favor of the export sector of the economy at the expense of other sectors. It was also considered that the exchange profits accruing to the Central Bank as a result of this requirement would help to restrain monetary expansion.
Immediately after the introduction of the new system traders generally took a “wait and see” attitude. For a few weeks transactions were small, and the exchange rate fluctuated rather widely in a range between P 4.15 and P 3.48 per U.S. dollar. Subsequently these fluctuations moderated and, since May 1962, the rate has remained stable at about P 3.90 = US$1; until 1965 exporters obtained an effective rate of approximately P 3.51 (four fifths at $3.90 and one fifth at $2). As uncertainties about the exchange rate abated export receipts rose, import payments declined, and there was a reflux of private capital that had flowed out before the reform. Net international reserves improved quickly during 1962 and 1963.
Supporting the New Rate
The system of a fluctuating exchange rate was supported by financial policies designed to curb any excessive growth of domestic bank credit which under the new system could have led to a continuing further depreciation of the exchange rate. Funds that might otherwise have been used in this way were made dearer by increases in the Central Bank’s rediscount rate and scarcer by requiring banks to hold larger reserves against demand deposits, by limiting the borrowing from the Central Bank that the Government and the commercial banks might undertake, and by transfers of government deposits from commercial banks to the Central Bank.
The exchange reform was further supported by a drawing of $28.3 million from the Fund and, in April 1962, by a stand-by arrangement with the Fund for one year for the equivalent of $40.4 million. In addition, the Central Bank secured stand-by credits from the U.S. Treasury, the Federal Reserve Bank of New York, the Bank of Spain, and U.S. private commercial banks. After the stand-by arrangement with the Fund had expired in 1963, a new arrangement was concluded. Indeed, ever since, through 1966, the Republic has continued to renew its stand-by arrangements with the Fund, which, however, have never been drawn upon. Moreover, by November 1966 the drawing from the Fund made in early 1962 had been fully repaid.
In the years between 1962 and 1965 the Philippines continued to follow policies of financial restraint. Credit expansion was kept within requirements of the growth of the economy, and domestic price increases were kept within bounds. The immediate impact of the depreciation on domestic prices was much less than had initially been feared, which suggests that the market had already discounted the previous overvaluation of the peso. Imports, despite the complete removal of controls, actually declined from 1961 to 1962; only in 1963 did they rise again to about their previous level. A relatively large expansion in domestic bank credit in 1963, however, contributed to pushing them up in 1964. Exports increased in each of the three years following the introduction of the new exchange system. Their growth was most notable in 1963, when there was a rise of 30 per cent owing, in part, to favorable price developments abroad.
Manufacturing and, even more, agricultural production increased in the three years following the depreciation at a higher average rate than in the three preceding years. This development occurred in spite of adjustments in the industrial structure—sometimes painful—which arose out of the new relations of prices and costs which followed from putting an end to an unrealistic valuation of the peso. For example, enterprises producing goods with a high import content were faced with increased costs and falling sales as demand shifted from such goods to less expensive local substitutes. The Government tried to help such adjustments in various ways, e.g., by providing technical advice, special credit accommodation, and certain arrangements facilitating the repayment of foreign debts incurred prior to the exchange reform.
On November 8, 1965 the Government completed the exchange reform by establishing a unitary fixed exchange rate. It set, with the agreement of the Fund, a new par value for the Philippine peso of P 3.90 per U.S. dollar. At the same time, the Government abolished the requirement that exporters should surrender 20 per cent of the proceeds from major exports at the previous par value rate of P 2.00 = US$1.
Continuing efforts will of course be required to maintain and consolidate the progress that the Philippines have made in the fields of foreign exchange and finance. Provided appropriate development policies are implemented, this progress should help in realizing the country’s aspiration for acceleration of its economic growth. In past years such policies, for instance those directed toward investment in infrastructure and the mobilization of resources, have not always been as effective as they might have been. It is to be hoped that the Socio-Economic Development Program for fiscal years 1966/67 to 1969/70 will remove the difficulties which up to now have impeded the Philippines’ progress toward those indispensable prerequisites for attaining a high rate of economic growth.
For an explanation of this procedure, see “What Does It Really Mean?—Multiple Currency Practices,” in Finance and Development, Vol. Ill, No. 2 (June 1966), p. 113.