How interest rates affect Philippine markets

The Bangko Sentral ng Pilipinas on Thursday decided to cut its key interest rate and, at the same time, scrap what it calls its “tiering scheme.” This scheme pays lower yields on large short-term deposits, and was used as a tool earlier this year to cool down the red-hot growth of money circulating in the economy.

Why should personal finance enthusiasts closely follow what the central bank does with its interest rates?

At first blush, articles on monetary policy and interest rates seem to be fit only for bankers’ ears. However, since money supply is one of the most important indicators in the Philippine economy, it has a big impact on financial markets and, eventually, on all our savings and investments.

The impact is not direct, but it is huge. Think of the economy as a big swimming pool, and the water is the amount of money moving around. I’m sure you’ll all agree that there is an ideal level of “liquidity” in the swimming pool. Very low water level is not much fun. Try sloshing around with water only up to your ankles.

Earlier this year, money supply growth reached unprecedented two-digit levels. April’s 26.6 percent money supply growth sent a collective shiver down monetary board members’ spines, I’m sure. That’s the equivalent of the water going over the sides of the pool and drenching the garden.

While Bangko Sentral Governor Amando Tetangco Jr. can hardly complain – the much needed cash was coming from foreign direct investments, foreign buying in the stock market and remittances from overseas Filipino workers – that kind of volume of “liquidity” also posed quite a challenge.

First, too much money chasing the same level of goods could cause prices to go up. This is quite a sticky point for some, but just imagine what a “normal” Filipino will do if he receives an unexpected windfall. He will go shopping, right? That’s a predictable consumer mentality all over the world and not just in the Philippines. If that sudden windfall makes everyone lust for a new refrigerator and there is only one person selling, what you’ve got is a ripe opportunity for him to raise his price. Refrigerator goes to the highest bidder, that’s the way the free market works. That’s inflationary pressure. That’s what the central bank wants to avoid.

So, what can Mr. Central Bank do? Going back to the swimming pool, he’ll go to the pumps to turn down the volume of water going into the pool. In monetary policy, that’s the equivalent of raising interest rates. When BSP raises its key rates, it makes it more attractive for banks to lend their money to the central bank and more painful to borrow money from the central bank. When that happens, the central bank effectively sucks in the liquidity in our economic swimming pool.

Keep in mind however that raising rates affects financial markets. How?

Loan markets. Banks normally respond to an increase in central banks rates by charging more from their customers who are borrowing money. We’re talking of San Miguel’s to Binalot’s loans, and of your home or car loan. Remember the 1997 financial crisis? When the central bank suddenly jacked up its rates in an effort to siphon cash that might be used to speculate on the peso, banks responded by raising their interest rates to a point where companies and individuals could no longer afford to pay their loans. We were just counting each day how many firms were going belly up. It was terrible. That’s an extreme scenario, but you get the idea.

Investments. Second, with interest rates going up, bonds and bank instruments become more attractive than stocks. People also tend to take out their investments in the foreign exchange markets, which can even be riskier than stocks. I know quite a lot of people who made a killing in 1997 by pre-terminating their time deposits so they could take advantage of the higher returns banks were willing to pay for their money.

Economic growth. End result is that consumers and corporations need to pay more to banks in terms of interest. Add to that the bills you need to pay, tuition expenses to prepare for, so you have less money to buy Jack ‘n Jill products, latte, FHM (I can’t believe how many Filipinos buy that magazine), etc. In this context, companies get hit, too. People buy less of their products.

To sum it all up, a rise in interest rates can also cause economic activity to slow down. A drop in interest rates will of course have the opposite effect, and a “neutral policy stance” will keep the status quo.

Now, do you think a slow down in the economy is anywhere near the government’s priorities this year? Nuh-uh. That’s why you’ve been seeing the central bank cooking up creative ways to hammer down money supply.

That’s where the tiering scheme and the arrangements for special deposit accounts (SDA) come in. These schemes simply allowed the central bank to siphon money supply without having to raise interest rates. Pure and simple.

oing back to Daxim Lucas’ article in Philippine Daily Inquirer I linked to above, the central bank’s twin complementary moves of cutting the overnight borrowing rate to 6.00 percent from 7.50 percent and the overnight lending rate to 8.00 percent from 9.75 percent and removal of the tiering scheme will have a zero net effect.

I love hearing from young people what they understand from business news. Here’s a reaction from Wainwright Yu, a new graduate from DLSU.

This makes equity investors (dummy transliteration: people who buy stocks) quite the merrier! When the BSP cuts its interest rates, equity begins to look much more attractive. The PHISIX hit a whole new high, at one point hitting 3,820.55 before closing at 3.786.02, following the BSP’s announcement Thursday.

Aside from that, like the good governor, other experts are saying pretty much the same thing: the effect is neutral, nada, nothing, nil. It’s a pretty quiet monetary policy day out there (economists like calling it *benign*).

Not bad..

Last word

Interest rates affect financial markets, but they are not the only reasons for these markets’ ups and downs. What I have discussed above describe broad interactions that can have many different results. By all means, pay close attention to interest rates movements with an understanding of what that will mean for your stock investments et. al. but remember that a lot of other factors also need to be considered.

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