The depreciation of the peso and impact on the economy

By Fernando Fajardo |October 06,2016 - 08:30 PM

The peso exchange rate is determined by the supply of and demand for dollars in peso terms or the supply of and demand for pesos in dollars terms in the foreign exchange market.

The peso gets weaker if more dollars go out of the country than what go in and vice versa. This result is true in the current system of floating exchange rate where the Central Bank allows the peso to seek its own value in the market in relation to the US dollar or any currency foreign currency for that matter such as the Yen or the Euro.

Before the floating rate, there was the fixed rate system. After the last war the value of the peso was pegged at 2 pesos to a dollar. At that time the Japanese was also pegged at 360 yen to a dollar.

The scarcity of dollars forced the Central Bank to devalue the peso during the time of President Diosdado Macapagal. During the time Ferdinand Marcos came the Nixon shock with the unilateral cancellation of the direct international convertibility of the US dollar to gold in 1971. Consequently, most currencies that were pegged to the US dollar like the peso and the yen found their anchors broken. The floating rate system was born.

The US dollar is the international currency of exchange. This means that to buy from Japan, for example, we must first buy the dollars that we need to pay the Japanese exporter. When the individual value of each country’s currency is determined in relation to the dollar in the foreign exchange market, it is now possible to find the value of each currency in relation to each other. For example, if the Yen-US dollar exchange rate is 100 yens to a dollar and the peso-dollar exchange rate is 50 pesos to a dollar. The peso-yen exchange rate is one peso to 2 yens.

A weak peso means a strong dollar and this makes all our imports in dollars more expensive in peso terms. This tends to reduce imports or restrains its growth.

A weak peso, however, makes our export products cheaper to foreign buyers. This encourage them to import more from us. With declining imports and increasing exports, our net exports expands.

This contributes to higher Gross Domestic Product or GDP. This is good. Higher GDP means more income and employment for our people. The GDP is the value of our total output of goods and services in final form or the sum of the value added or contributed by all sectors to the economy. The problem arises when our exports have high import contents such as those coming from our economic zones. It means higher production cost, thus negating in part the gains of our exporters from the peso depreciation.

The depreciation of the peso also means that every dollar remitted by our OFWs could translate into more pesos received by their loved ones here. It’s the same thing with the dollar pensions received annually by foreign retirees living here, many of whom are married to the locals. For them, the depreciation of the peso is good. Dollar remittances do not add up to our GDP but it increases our Gross National Income or GNI. GNI is equal to our GDP plus our net factor income from abroad which in part includes the inward remittances from our OFWs less the outward remittances of foreign workers employed here. In all, our net factor income from abroad is positive, making our GNI larger than our GDP. Countries with negative net factor income from abroad, like Ireland, have smaller GNI than GDP. A bigger GNI means more demand. This is good.

It encourage more domestic production and push our GDP higher.

The rise in prices or inflation, especially for products with high import contents, usually comes with a falling peso. This is not good. It hurts the consumers. Among others, another consequence of the falling value of the peso is the increase in the cost of servicing our foreign debts. When our foreign debts are denominated in dollars, a weak peso means that we now have to allocate more from our budget to pay for annual interests and amortization. This is not good. Less of our budget will now be left for government programs and projects.

Finally, while the depreciation of the peso is good economically because of the GDP and GNI expansion that follows, it is not so when it creates more uncertainties to our people and investors. When the peso depreciates markedly like what just happened most recently, many will be worried as to what will happen next?

Is the trend going to continue or reverse? Faced with uncertainties, a businessman may just decide to do nothing at all and adopt a wait-and-see attitude. Otherwise, if he thinks, that the depreciation will continue and act accordingly by increasing his production for export, for example, he may lose in the end if his expectation proves wrong.

The housewife can lose too if she immediately spend the increase in pesos that she got from the higher exchange rate of the dollar in pesos that she received from her husband abroad when the peso strengthens against the dollar later on.

This goes to show that excessive movement of the exchange rate like the recent drastic fall of the peso is not necessarily good overall. The best policy is to maintain stability in the exchange rate. A stable exchange rate makes the future more predictable. More predictability of the future makes business investments decisions easier to make.

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