The peso will continue to strengthen in 2008
Posted by butalidnl on 11 January 2008
Some economists are saying that they expect the US dollar would gain strength in 2008, on the logic that it has declined too much in 2007. On the face of it, it seems to make some sense. I disagree with this for two reasons.
First, the dollar decline in the last couple of years is not a normal decline caused by temporary fluctuations in international money flows. Rather, it is a result of a trend in which the dollar’s role in the world is declining. In 2000, 70% of the total international reserves kept by central banks were in dollars; while today it is about 60%. Central banks throughout the world are set to further reduce this percentage in the next couple of years. I think it would be fair to predict that this would be reduced further to 50% in the near future. So, while the dollar will remain influential, it would be less and less the currency of choice in international transactions.
Going back to the prediction of recovery – this is premised on the assumption that the dollar’s role in the world remains the same, and that a swing one way will be followed by an equal and opposite swing. But if the underlying basis for a stable dollar is itself shifting, the swing we now see is actually accompanied by the movement of the equilibrium point itself. Thus, when the dollar swings back, it will no longer go back to the original “equilibrium” point, but to one nearer its present value.
The second reason why I think the dollar will continue to deteriorate in the short term, is the a combination of the inertia of the last years’ decline, plus the recession that the US economy is entering. The potential positive effect of a cheaper currency takes up to a year (at least) to be fully reflected in terms of increased exports. At the same time, it affects import prices and volumes much faster. Since the dollar had been declining for most of 2007, it will take a whole year before increased exports would be able to counter the bad effects of imported inflation. And the coming recession will make the US economy even less able to make the necessary adjustment.
What does this mean for the Philippines? Since the dollar is set to decline, the Philippine peso is set to continue its trend of appreciating vis-a-vis the dollar in the coming year (at least). But since it has raced faster than other currencies during 2007, in 2008 it will be tempered by a tendency to fall in step with the rest of the world’s currencies. Thus, this means that the peso will only appreciate by a few percent during 2008.
Interestingly, the expectation that the dollar’s decline will continue will itself be one of the reasons spurring on its decline. Persons and companies hedging against possible loses from a falling dollar will take actions that will undermine the dollar. For example, if they dispose of their dollars as quick as possible, and exchange these for pesos or other currencies, this will help weaken the dollar. If they buy dollar put options (to insure against dollar rate drops), this will also weaken the dollar. Add to this the actions of those who want to gain from the falling dollar e.g. international investors who borrow money in dollars and invest in currencies that have both stronger currencies and higher interest rates (the so-called carry-on trades), then these will all result in a big inflow of dollars into the Philippines, and a strengthening of the peso.
The Philippine government’s plan to borrow more funds locally to finance the budget deficit in 2008 (from 68% before to up to 80% of the required funds) is supposed to help by lessening the inflows of dollars into the Philippine economy. However, a significant part of the extra government bonds would probably be bought by foreign investors wanting to gain through carry-on trading. Thus, these foreigners would first dump their dollars for pesos, and then buy the peso-denominated bonds that are going to be offered.
Thus, in 2008, the peso will continue to strengthen against the dollar, perhaps reaching an exchange rate of 38:1 by November 2008. People should just get used to the fact of the higher value of the peso, since it is here to stay for some time.
see also Peso-Dollar Rate