Repos 101: BSP’s balancing act

The Bangko Sentral ng Pilipinas (BSP) finally raised key policy interest rates last week, mainly to forestall accelerating price hikes in the coming months. The annual inflation rate has averaged 4.2 percent so far this year, the fastest since 2011. This means that for every P100 worth of goods and services we bought last year, we now have to pay P104.20. This is actually much slower than the inflation rates we saw in the past decade and most of the 1990s, when it averaged 7.8 percent. Still, recent trends have pushed the BSP to make a move, after holding steady on these interest rates for nearly two years now. Analysts and observers keenly watch these rates as they provide an important signal of government policy that could have far-reaching impacts on the performance of the economy.

What are these “key policy interest rates” I refer to? These are the rates on overnight lending under the BSP’s repurchase (repo) facility, wherein it buys from a bank government bonds—i.e., IOU notes issued by government when it borrows money. This comes with an agreement to sell those bonds back to the bank (which repurchases them, hence the name) after a pre-specified period that can be as short as one day (overnight) or up to 91 days, at the prescribed interest rate. Think of it as banks borrowing money from the BSP to fill their funding needs, using government bonds as collateral. The transaction injects money from the BSP’s vaults into the system, thus increasing money in circulation. The higher the repo interest rate, the less attractive it is for banks to borrow money from the BSP through this mechanism, and the less growth in money supply.

The transaction can also happen the other way around (a reverse repurchase or reverse repo), where the BSP sells its government bonds to a bank, with agreement to buy them back later (in this case ranging from one to 364 days) at the set interest rate. It’s as if the bank “lends” money to the BSP at an interest (the reverse repo rate), receiving government bonds from the BSP as “collateral.” Here, the bank essentially “parks” its money with the BSP, thereby reducing money in circulation, while earning a return on it. The higher the interest rate, the more attractive it is to “park” money this way. Repos and reverse repos are part of the tool kit that the BSP has at its disposal to control the supply of money circulating in the economy.

Last week, after holding the overnight repo rate at 5.5 percent and reverse repo rate at 3.5 percent since October 2012, the BSP raised them to 5.75 and 3.75 percent, respectively. The BSP called it a preemptive response to inflationary pressures and heightened inflation expectations coming from higher food prices, volatility in world oil prices, and anticipated adjustments in power rates and transport fares.

How would the repo/reverse repo rate hikes curb inflation? At the outset, banks would be less inclined to borrow money from the BSP through repos. They are also led to raise interest rates on loans to their borrowers, as the cost of obtaining the funds they lend out has also risen. Thus, credit becomes both tighter and costlier, and this dampens inflation via three channels. First, higher credit costs reduce profitability and tighter credit reduces availability of investible funds, with both effects dampening investment. Second, rising interest rates also dampen consumer spending especially on cars, appliances and other durables usually bought under credit financing schemes. Third, higher domestic interest rates attract funds from abroad to take advantage of higher yields on peso-denominated assets. This boosts the supply of foreign exchange, making it cheaper and making the peso stronger. But this dampens exports and encourages more imports, further slowing down the economy and aggregate demand. At the same time, cheaper imports would have a moderating effect on overall price increases. This effect, combined with reduced aggregate demand in the economy, dampens inflation.

The issue is that improved price stability, achieved through the above effects, could come at the expense of slower growth. After enjoying one of the fastest economic growth rates in Asia in the past year, we saw a significant slowdown from last year’s 7.2 percent full-year growth to just 5.7 percent in the first quarter. Even so, I’ve expressed confidence that the Philippine economy has achieved latent vigor, particularly manifested in the manufacturing sector’s newfound strength, further reinforced by public infrastructure investments already in the pipeline and other positive trends. Thus, notwithstanding current disturbances such as port congestion, calamity-induced setbacks and political distractions, the economy appears poised to sustain higher growth relative to its historical experience and relative to its neighbors.

In opting to raise policy interest rates now, I see the BSP demonstrating similar confidence in the economy—that its inherent growth potential is solid enough not be compromised by the BSP’s decisive move to arrest inflationary pressures.

Besides, there is nothing more immediately inclusive in its benefit than curbing inflation, as rising prices hurt all, more especially the poor among us. Making our economic growth inclusive, on the other hand, is taking time and remains a challenge yet to be overcome. The BSP, in short, is doing its balancing act well.

* * *

The Ateneo Center for Economic Research and Development’s Eagle Watch Forum on “Aquinomics: 2010-2014 and Beyond” will be held on Aug. 8, 8:30 a.m.-12 p.m. at the Ateneo Rockwell campus in Makati City. E-mail

[email protected] or call 02-426-5661 for details.