Philippines: Selected Issues

Abstract

Philippines: Selected Issues

Global Financial Cycles, Volatility and the Philippines1

Higher U.S. interest rates and global financial volatility could have significant macrofinancial effects on the Philippines. Staff analysis suggests that the surge in capital inflows between 2010 and mid-2013 can largely be explained by global financial factors such as global risk aversion (measured by the VIX), with exchange rate expectations and domestic fundamentals playing a secondary role. Moreover, local bond yields and retail bank rates seem to be driven by the same global factors and the U.S. term premia. Therefore, the quantitative macrofinancial impact of VIX shocks on domestic demand via capital flows and asset repricing, and of changes in the U.S. 10-year T-bond yields on bank credit and investment, are significant. The transmission of global shocks through asset repricing and a bank credit channel suggests the potential importance of balance sheet effects and financial cycles in conducting macrofinancial surveillance and policy analysis.

A. Introduction

1. Global financial cycles and volatility spillovers pose a challenge for emerging market economies (EMEs) such as the Philippines. Eichengreen and Gupta (2014) argue that a key determinant of the severity of the impact of tapering talks was the volume of prior capital inflows. Rey (2013) argues that there is a global financial cycle in capital flows, asset prices, and credit growth, and that the cycle (proxied by VIX) is mainly driven by U.S. monetary policy—affecting leverage of global banks, and cross-border capital/credit flows. Global financial market turmoil transmitted through capital flows and disruptive asset price shifts is also a particular concern at this juncture, given the asynchronous monetary policies in advanced economies (GFSR 2015, WEO 2015).

2. Capital inflows to the Philippines had increased in the wake of the global financial crisis (GFC). They surged following the Federal Reserve’s quantitative easing (QE) and ultra-low interest rate policy. What was striking about that episode is that the surge in capital inflows to the Philippines was predominantly portfolio inflows to peso-denominated securities and other inflows to the nonfinancial private sector. While that has reduced currency mismatches and dollar funding strains (see chapter 3), capital flows have become more volatile reflecting the renewed global financial turbulence following the “taper tantrum” and shifting market expectations of U.S. monetary policy normalization. Understanding the determinants of capital flows and their macrofinancial linkages is thus particularly important.

Figure 1.
Figure 1.

Net Financial Account Flow 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A001

Sources: IMF, Balance of Payments Statistics; IMF, World Economic Outlook.1/TUR, BRA, CHL, COL, MEX, PER, URY, IDN, KOR, MYS, PHL, THA, CHN, CZE, HUN, POL.

3. The risk of global financial spillovers is heightened by the current low term premia and low financial volatility as well as the asynchronous monetary policies in advanced economies. Potential surprises from U.S. interest rate normalization and spikes in global risk aversion could be accompanied with capital outflows and tightening of domestic financial conditions that would have significant macrofinancial impact on the Philippines. The quantification of the impact and the identification of the macrofinancial transmission channels are the focus of this chapter.

B. Determinants of Capital Flows to the Philippines

4. The literature on capital flows has identified “push” and “pull” factors driving cross-border movements of capital. Push factors are external conditions that influence the supply of foreign capital to EMEs. Among the major push factors analyzed in existing empirical studies are the rate of return on financial assets in advanced economies, global economic performance and uncertainty, and global liquidity (Ghosh, and others, 2012; Forbes and Warnock, 2012). On the other hand, pull factors reflect the domestic economic environment that affects the demand for foreign capital. Fiscal health, growth performance, exchange rate volatility, and rates of return on investments in the recipient country have been identified as important pull factors (Ghosh and others, 2012, and Nier and others, 2014). In addition to the traditional pull and push factors, Forbes and Warnock (2012) suggest the importance of the contagion effect in light of the increasing interconnectedness of the global economy.

5. Capital flows to the Philippines can be attributed to both push and pull factors. In order to assess the role of these factors, we estimate a quarterly time series Exponential Generalized Autoregressive Conditional Heteroskedasticity (EGARCH) model of the gross Financial Account and non-FDI inflows to the Philippines during 2000–14. The results suggest that the most important factors driving gross inflows and non-FDI inflows are:

  • The VIX, where an one percentage point rise would lower the gross Financial Account and non-FDI inflows by about one-tenth one percent of GDP;

  • A measure of the global financial cycle developed by Adler, Blanchard and de Carvalho Filho (2014) that is a consistently significant driver of gross inflows;

  • Interest rate differentials with a greater impact of domestic treasury rates than U.S. rates when included separately;

  • Domestic fundamentals such as a lower public debt-to-GDP ratio (as proxy for creditworthiness) and a higher current account balance (as proxy for currency risk) can help attract capital inflows and/or retain them in times of global financial volatility; and

  • Exchange rate expectations vis-à-vis the U.S. dollar is the most significant “pull” factor although its impact is less if the current account position is included given their close association.

6. The outlook for capital flows to the Philippines is strong given expected patterns for the main underlying factors. As the interest rate differential with the United States is expected to last somewhat longer even as the United States starts normalizing interest rates in 2015, capital inflows to the Philippines could remain strong in 2015–16. However, susceptibility to the VIX and global financial cycle also exposes the Philippines to sudden-stops in capital flows, although its strong fundamentals in terms of declining public debt and current account surplus provide a cushion. The QE policies of the ECB and BOJ could also provide a counterweight to U.S. interest rate normalization, although it is unclear whether there is a quantitatively significant impact, while exchange rate expectations against the U.S. dollar related to asynchronous monetary policies could make the Philippines susceptible to outflows as observed during the “taper tantrum.2

C. Capital Flows and Financial Cycles

7. Capital inflows present opportunities, but they can also pose stability risks. Capital inflows, if channeled effectively, represent an opportunity to address long-standing investment needs, such as in infrastructure. However, capital inflows need to be managed carefully in order to avoid macroeconomic and financial stability risks. For example, capital inflows can increase liquidity and boost domestic demand and asset prices (Gupta, Nabar, and Peiris 2010).

8. Financial cycles in the Philippines are closely related to non-FDI capital inflows. The empirical relationship between non-FDI capital inflows and domestic demand is strong (Figure 2). The main channels through which the relationship seems to work is by raising equity prices and expanding bank credit to the nonfinancial private sector. At a time of capital inflows amidst high global liquidity, the relative appeal of capital investment increases as the real cost of equity (i.e., the implied rate of return required by investors) declines, and higher equity prices makes it easier for firms to borrow from banks based on their greater net worth (the so-called “financial accelerator”). Non-FDI inflows also tend to expand bank credit to the private sector by reducing lending rates and providing wholesale funding. The impulse responses of Bayesian VARs show that non-FDI flows expands both private consumption and fixed investment, with a greater response of investment as expected. The latter also seems to be associated with higher real estate prices that probably fuel a private construction boom partly supported by lower bond yields.

Figure 2.
Figure 2.

Non-FDI Capital Flows and Domestic Demand

(Accumulated response to one Cholesky S.D. shock to non-FDI)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A001

9. Capital flows can give rise to financial stability risks through different channels, including: (i) increases in short-term wholesale funding of the banking system; (ii) increases in foreign currency funding of the financial system; (iii) contributions of capital inflows to local credit booms and asset price appreciation; and (iv) credit risks from foreign currency denominated loans. While wholesale and foreign currency funding in the Philippine banking system is limited with foreign currency lending capped by a stringent net FX exposure rule, financial cycles related to capital inflows can raise risks for asset quality and bank capital, particularly once the credit cycle matures. Asia’s past history also suggests that high liquidity growth at a time of large capital inflows increases the risk of asset price boom and bust cycles (APD REO April 2010) that could lead to potential feedback loops between the corporate/household sectors and banks. Episodes of rapid credit growth in Asia have been characterized by a higher incidence of crises relative to other EMEs (APD REO October 2011). Whether the recent wave of capital inflows and financial cycle has raised systemic risks in the Philippines is largely an empirical question and is investigated in Chapter 2.

10. Managing the impact of the global financial cycle and capital inflows is a challenge. When facing a surge in capital inflows, a country may experience asset price inflation, credit booms, overheating, and currency appreciation, and financial vulnerabilities may build up. To lean against the wind of capital inflows, policymakers have relied on macroprudential and microprudential measures, regulation/deregulation of capital flows, countercyclical fiscal policy, and foreign exchange market intervention. The effects of many of these policies—let alone their desirability—remain open to debate (Adler, Blanchard, and de Carvalho Filho 2014). Adler, Blanchard, and de Carvalho Filho (2014) show that foreign exchange intervention can be effective to “lean against the wind” of the global financial cycle in some instances, while IMF (2013, and 2014a and b) have laid out guidelines for the use of macroprudential policies and capital flow management measures.

D. Interest Rate Spillovers

11. The current global financial settings and domestic interest rate environment heighten the susceptibility to global financial volatility through interest rate spillovers. The decline in global long-term nominal interest rates reflecting primarily a decline in real interest rates, including a compression of term premiums and reductions in the expected short-term neutral rate (see the April 2015 GFSR), implies a potential risk of a sharp increase in long-term rates when rates normalize. Market expectations of the pace of U.S. interest rate increases are slower than forecast by members of the FOMC, even though the economic forecasts are broadly similar. An abrupt shift in market expectations could expose the Philippines not only to capital outflows, but also to a spike in interest rates with feedback effects on the real economy. This is particularly pronounced due to the domestic interest rate structure, in which market rates (e.g., 91-day treasury bill rates) are below the policy rate and are very sensitive to global factors.

Figure 3.
Figure 3.

Policy Rates and Three-Month T-Bill Rates

(In percent)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A001

Sources: CEIC Data Co., Ltd.; and Haver Analytics.

12. Following Peiris (2013), this chapter estimates an EGARCH (1, 1) model of sovereign bond yields in the ASEAN5 economies during 2000–14 using a comprehensive set of macrofinancial variables including global factors. The econometric analysis is based on a standard reduced-form specification for an EGARCH model with mean equation:3

IRt=α+β1πt+β2Dt1+β3EGDPt+β4CAt+β5FFRt+β6VIXt+β7USTERMt+ɛt(1)

where IR denotes nominal yields on the benchmark short-term and long-term government bonds at time t (2000:M1-2014:M6); n is the inflation rate, D is the level of gross general government debt in percent of GDP, EGDP is expected real GDP growth from consensus forecasts (to control for the country’s growth prospects), CA the current account balance as percent of GDP, FFR the U.S. Federal Funds rate, VIX the implied volatility of the U.S. S&P 500 (to control for global risk aversion), and USTERM is the U.S. term spread.

13. Global factors are key drivers of short and long term interest rates in the ASEAN5 economies, including the Philippines. The results show that a lower federal funds rate reduces short and long term government bond yields in all of the ASEAN5 economies (Tables 1 and 2). A greater U.S. term premium such as during the “taper tantrum” also results in higher long term bond yields in all ASEAN5 economies. Importantly, the results indicate that a rise in the federal funds rate and U.S. term premium could have a greater impact on Indonesia and the Philippines. Greater global risk aversion proxied by the VIX also tends to raise short-term rates but does not have as large an impact and has a mixed effect on long rates probably reflecting a flight to safety. Strong domestic fundamentals in terms of lower public debt and stronger current account balances also tend to keep bond yields down. Interestingly, better growth expectations often result in lower bond yields than vice versa suggesting that investors may see better growth prospects as a sign of improved credit fundamentals rather than just a cyclical consideration.

Table 1.

ASEAN-5: Determinants of Bond Yields

(10-year government bond)

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Table 2.

ASEAN-5: Determinants of Bond Yields

(1-year government bond)

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14. The strong influence of global factors in driving local currency government bond yields in the Philippines could have wide ranging impacts on the real economy, as government yields are benchmarks for pricing corporate bonds that have seen an issuance boom lately (see chapter 5). The strong influence of global factors on sovereign bond yields also raises the question of whether global financial conditions and risk aversion have a similar impact on domestic retail banking rates, both directly and indirectly through the monetary transmission mechanism as indicated by Ricci and Shi (2014). This is related to the observation of Rey (2013) that independent monetary policies are possible if and only if the capital account is managed, directly or indirectly, via macroprudential policies. Analyses presented in Rey (2013) suggest monetary conditions are transmitted from the U.S. to the rest of the world through gross credit flows and leverage, irrespective of the exchange rate regime. This puts the traditional “trilemma” view of the open economy into question as fluctuating exchange rates cannot insulate economies from the global financial cycle, when capital is mobile.

15. Retail bank rates and interest rate transmission through the banking system could be susceptible to global financial volatility. To investigate the spillovers of global factors to retail bank rates in the ASEAN5 countries, we follow the approach of Ricci and Shi (2014) to estimate the domestic and global determinants of both deposit and loan rates. The specification also allows for liquidity effects, rigidities, and interactions of the domestic policy rate with the Federal funds rate. The results show a high degree of sensitivity of retail bank rates to global financial factors in all countries, including the Philippines. Importantly, however, the domestic policy rate and liquidity conditions (measured by the deviation of reserve money from a Hodrik-Presscot trend) also matter, retaining a role for domestic monetary policy and liquidity management operations in influencing the financial cycle.

Table 3.

ASEAN-5: Determinants of Deposit Interest Rate

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Table 4.

ASEAN-5: Determinants of Lending Interest Rate

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E. Macrofinancial Linkages: Putting It Together

16. The sensitivity of capital flows and domestic interest rates to global factors suggests significant macrofinancial spillovers that would be important to identify and quantify. Following the approach of Miranda-Agrippino and Rey (2012), we estimate a principal component model to identify the underlying global factors that can explain the variability of a comprehensive set of domestic financial indicators.4 The principal component analysis shows that two common components explain about 65 percent of the variation of domestic financial conditions, with the first component correlated with the 10-year U.S. Treasury bond yield and the second component related to the VIX. Moreover, the first component is also more closely related to domestic bond yields, retail bank interest rates, bank credit, and corporate sector indicators, while the second component is correlated more closely with capital flows and asset prices. With the two key global macrofinancial spillover factors identified, we can estimate the transmission channels and impact.

17. Global interest rate spillovers have significant macrofinancial effects on the Philippine economy, transmitted through the banking system. Bayesian VAR estimations of the impact of U.S. long-term interest rate shocks show that higher rates tend to result in capital outflows, real depreciation, increased bank lending rates, and reduced bank credit available to the private sector, that transmits to the real economy via lower private consumption growth and lower gross fixed capital formation growth. Higher government bond yields and the moderate impact on house prices do not appear to have a large impact on investment, probably reflecting the still nascent stage of development of debt capital and mortgage markets. In addition, the transmission of global shocks to changes in lending rates and credit growth exhibit lagged but persistent impacts on the banking system. This could be related to the domestic monetary policy response as well as sticky retail bank rates and financial sector conditions. In such an environment, allowing for interest rate rigidities, credit frictions, and financial accelerator effects may be important. This may provide a rationale for the use of nonmarket monetary policy tools such as reserve requirements and macroprudential tools, in a structural setting, which is the subject of an ongoing joint research project between the BSP and Fund staff (see Anand, Delloro and Peiris, 2014).

18. Global risks aversion shocks transmitted through capital flows and asset repricing channels, amplified by “financial accelerator” effects, appears to be more dominant. The impact of VIX shocks on capital flows, equity market, and real estate prices are larger than global interest rates with a greater impact on real gross fixed capital formation probably reflecting the importance of equity finance and private construction in investment. The transmission mechanism through lower net worth of corporates and higher lending rates suggests a potential amplification of asset price shocks through “financial accelerator” effects on the real economy that would be important to take into account. Private consumption is also more susceptible to global risks aversion shocks than global interest rates as the former is a stronger driver of capital flows and wealth (related to asset repricing) in the Philippines. The association of negative global shocks with real exchange rate depreciation and lower domestic demand also highlights the potential importance of balance sheet effects (see Chapter 3).

Figure 4.
Figure 4.

Accumulated Response to One Cholesky S.D. Shock to U.S. LT Interest Rate

(Blue) and VIX (Red)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A001

References

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1

Prepared by Shanaka Jayanath Peiris (APD).

2

Measures of global liquidity and time dummies for unconventional monetary policy actions did not give significant results although a measure of the effective policy interest rate in Japan taking into account QEE held promise, albeit correlated with other global factors making interpretation difficult.

3

The inflation rate was included instead of the short-term nominal policy interest rate (to control for the effects of monetary policy on the bond yield term structure) used by Peiris (2013) as it provided a better fit in most countries and the two variables were highly correlated in this inflation-targeting period. In most countries, there was a high degree of multicollinearity between the budget balance and public debt level as expected, therefore, only the public debt level was included in the final results.

4

The domestic financial factors included about 40 variables and/or different types of capital flows that did not significantly affect the results.

Philippines: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept
  • View in gallery

    Net Financial Account Flow 1/

    (In percent of GDP)

  • View in gallery

    Non-FDI Capital Flows and Domestic Demand

    (Accumulated response to one Cholesky S.D. shock to non-FDI)

  • View in gallery

    Policy Rates and Three-Month T-Bill Rates

    (In percent)

  • View in gallery

    Accumulated Response to One Cholesky S.D. Shock to U.S. LT Interest Rate

    (Blue) and VIX (Red)