Delaying gratification: Why another policy rate cut can wait

The only real mistake is one from which we learn no­thing.” –Henry Ford

In 2018, the Philippines learned some hard lessons when inflation soared to as high as 6.7 percent and breached the Bangko Sentral ng Pilipinas’ (BSP) 4-percent full year target. The country didn’t only suffer from a deluge of portfolio capital outflows, it had to delay a number of key structural reforms. Key policy initiatives had to be put on the back burner until such time that the BSP’s policy (RRP) rate was raised high enough to keep inflation within reasonable control.

One crucial reform measure that was delayed (again) when inflation soared was the planned reduction of the reserve requirement ratio (Triple-R) 2 on bank deposits to a single-digit rate. After cutting the Triple-R twice in early 2018, the BSP’s Monetary Board led by former Governor Nestor Espenilla Jr. decided to postpone Triple-R cuts until it ended its po­licy rate hikes and after inflation had fallen comfortably within its 2-4 percent target in 2019.

Therefore, learning from the 2018 inflation episode, mo­netary authorities must realize that if it wants to continue its reduction of the Triple-R this year, the po­licy rate should be kept comfortably above its estimated medium-term inflation rate forecast. Unfortunately, their hints that they will be cutting the RRP (reverse repurchase) immediately (i.e. wi­thin the first semester of 2020) from the current 3.75 percent may prevent the much needed reductions in the Triple-R in the next 12 to 18 months.

Triple cost of Triple-R

To appreciate the importance of getting the sequence of reform right, it must be established why a high Triple-R is undesirable.

First, a high Triple-R is effectively a tax on both peso depositors and Filipino-owned banks. Since Philippine banks are required to park 14 percent of all peso deposits with the BSP earning zero interest, they are­—as intermediaries­—compelled to invest or lend the funds at higher interest rates. For example, if a P1 million deposit earns 2 percent a year, a bank will only break even if this is lent out at close to 4 percent or higher considering taxes, deposit insurance and the overhead expenses alongside the effect of keeping every P140,000 of the P1 million a nonearning deposit.

Philippine banks may choose to switch from peso to foreign currency funding simply because the former is under the Triple-R rule while the latter is not.

Second, a high Triple-R also subjects Filipino borrowers to currency risks. If banks are encouraged to raise foreign currency deposits and lend them out either in pesos or dollars, the risk of currency mismatches in the balance sheets of nonfinancial Filipino corporations will persist, if not worsen. It can be recalled that this was the underlying weakness of our country during the Asian financial crisis in the 1990s where we learned that keeping the Triple-R at high levels, together with a few other factors, made us more vulnerable to capital flow reversals.

Recent evidence that total peso loans granted by Philippine commercial banks only grew by 10.9 percent year-on-year in 2019 while foreign currency loans of offshore banks to Philippine nonfinancial corporations surged by around 26 percent suggests that banks are already employing the currency switching strategy. Further delays to implementing a low, single-digit Triple-R means a heightened vulnerability to capital flow reversals. Finally, a high Triple-R also tends to favor the proliferation of offshore banking businesses over onshore.

Offshore banks can raise as much funds from abroad and lend it out to Filipino companies or individuals without the burden of Triple-R and other taxes. If the Triple-R remains high, both peso depositors (vs foreign currency depositors) and Philippine-based (vs offshore) banks will have a harder time competing with their fo­reign counterparts.

All considered, what is being recommended then is a reduction of the policy rate but not until we have delivered a long-term strategy of moving toward an environment of low, single digit RRRs. Getting the sequence mixed up can still translate to benefits, but not as much as if it is done right.

No doubt, companies and individuals that want to fund their projects with lower borrowing rates can be instantly gratified if the Bangko Sentral carries out one, two or a few more RRP cuts for the rest of 2020. However, delaying that gratification may be outweighed by benefits to the broader economy because it will allow the BSP more room to strategize its Triple-R cuts implementation not just this year but through 2023.

New, more precise tools

It is observed that at 14 percent, the Philippines’ Triple-R sticks out like a sore thumb among those of comparator countries that have reduced their Triple-R when more effective policy tools like the Basel (risk-based capital adequacy) ratios were adopted by Asean central banks. Despite the cumulative 6-percentage-point reduction for Philippine Triple-R over the last two years, regional data show that we have a long way to go to get to the low, single-digit norm: Indonesia is currently at 5.5 percent, Malaysia at 3 percent, while Thailand is at the lowest at 1 percent.

The reserve requirement tool may have been useful pre-2019 because it spared the BSP from depleting its capital in order to manage liquidity and keep inflation in check. After gaining the new charter last year, however, BSP gained the wherewi­thal to deploy more market-based tools for mopping up liquidity and like our Asean peers, can now rely less on the Triple-R to carry out monetary policy.

Lagged policy effects

There are those who claim that further reductions in the Triple-R are unnecessary by citing data on how banks allocated funds that were freed up by the Triple-R cuts 4 .

There are two arguments, however, that support the need to continue with the reductions over the next 3 years.First, just looking at changes in composition of balance sheets doesn’t provide a complete picture of whether Triple-R cuts are effective or not. What happens with the flows of onshore and offshore funds with their peso and foreign currencies instruments in between reporting periods may be indicative of how policy changes affect their behavior. The peso assets of banks at any point in time may have been funded by swaps, conversion of dollar asset to Philippine peso or borrowings from onshore and offshore banks in foreign currencies.

As already cited, the growth of the volume of lending of offshore banks to the nonfinancial and financial residents grew by 26.5 percent in 2019. Acquisition of peso assets may have also been funded through swaps or offshore bond issuances, not necessarily from the previous Triple-R cuts. Onshore banks, on the other hand, only saw total loans to local companies grow less than 11 percent even as they fund them with both onshore and offshore issuance of bonds.

Second, both historical and cross country analysis appear to suggest that the effect of Triple-R reduction comes with a lag. Operationally, this makes sense as the credit scoring and assessment processes of banks before they approve a loan requires some time. Acting out of prudence and in compliance with regulations, banks naturally have to park their funds in short-term, risk-free assets before they are lent out to credit worthy borro­wers after thorough evaluation.

The slow growth in local bank lending may also be explained by the general behavior of company CFOs of PHL based corporates, who prefer to save on funding costs. With monetary authorities signaling further cuts in their borrowing rates, CFOs may defer their actions to get a loan to the extent possible.

This “wait-and-see” behavior cannot be discounted as an explanation for the dynamic nature of decisions surrounding borrowing and lending relative to the RRP and Triple-R policy movements over the last two years.

Policy action

To conclude, the economy is likely to benefit more if policy makers do not instantly gratify the borrowing public with a lo­wer policy rate but to delay it in order to secure a greater benefit later on. By maintaining a conservative positive real yield on the RRP, our policymakers can preserve some space to finally bring Triple-R down to regional norms (i.e. low, single-digit.)

Keeping the policy rate at 3.75 percent while delivering a series of Triple-R cuts doesn’t just reduce the risk of unhedged fo­reign currency borrowing among Philippine corporates, it also will likely result in a leveling of the playing field for peso depositors and Philippine banks vis-a-vis their regional and global counterparts. Only after this goal of aligning our Triple-R with our regional peers is achieved can we recommend that the BSP follow through with a further rate cut to the RRP to 3.5 percent or even lo­wer. —CONTRIBUTED