philippine central bank act - fraser...of the philippines and reorganizing the monetary system of...

THE PHILIPPINE CENTRAL BANK ACT1

by

DAVID L. GROVE AND JOHN EXTER

On June 15, 1948, a Bill creating a Central Bankof the Philippines and reorganizing the monetarysystem of the country was signed by PresidentQuirino and became law. The legislation bringsto an end the rigid 100 per cent reserve currencysystem which has been in effect in the Philippines,with only relatively minor changes, since 1903,and replaces it by a modern flexible currency systemin which monetary authority and responsibilitywill rest in a central bank. The new legislationrepresents a consummation of Philippine aspirationsfor an independent currency system under whichthe peso will remain stable in relation to, and freelyconvertible into, the dollar, but under which themoney supply will be more responsive to the domes-tic needs of the economy. The establishment ofsuch a system was recommended by the Joint Philip-pine-American Finance Commission in June 1947.2

The Central Bank, which will be a Governmentinstitution, will have a monopoly of currency issueand will have broad regulatory authority over thecredit and exchange operations of the banking sys-tem. It will have responsibility for developingand maintaining a market for Government securi-ties and will, in addition, act as general fiscal agentof, and financial adviser to, the Government. TheCentral Bank will be a "bankers' bank" and willnot deal directly with the public, except in thecourse of its open-market operations. The Bankwill commence business as soon as its governingboard has been appointed and its capital paid in.

The new legislation should be viewed againstthe background of the 100 per cent reserve currencysystem which it supersedes and of the financial en-vironment in which the Central Bank will operate.

THE 100 PER CENT CURRENCY RESERVE SYSTEM

The Philippines has never before had a centralbank. Except for limited issue of notes by twocommercial banks, the power of issue has for

1 At the request of the Philippine Government, the Board ofGovernors of the Federal Reserve System made the services ofMr. Grove and Mr. Exter available to assist the Philippineauthorities in the formulation of this Act. Mr. Grove and Mr.Exter are economists in the Board's Division of Research andStatistics.2 Report and Recommendations of the Joint Philippine-American Finance Commission, June 7, 1947 (H. Doc. No. 390,80th Cong., 1st sess.).

years been vested in the Philippine Treasury, whichhas had authority to issue Treasury certificatesbacked 100 per cent by silver coins and United Statesdollars. In practice these certificates have for sometime been issued almost exclusively against dollars.The Treasury has been obliged to buy and selldollars on demand at exchange rates based on thepar value of the peso, which was fixed by law at50 United States cents. Thus, in effect, the Philip-pines has been on a dollar exchange standard witha 100 per cent dollar reserve requirement againstits note issue. The supply of currency has re-sponded almost automatically to the dollar surplusesand deficits in the international balance of pay-ments of the Philippines, irrespective of whetherthe response had a beneficial or harmful effecton the domestic economy. Moreover, the 100 percent reserve system has tended to immobilize need-lessly a part of the official international reservesof the country. Dollar reserves have had to bemaintained even against the hard core of notesthat was always needed to finance domestic trans-actions and that would never be presented for con-version into dollars to finance remittances or pay-ments abroad.

Whatever flexibility has existed in the Philip-pine monetary system has been provided by thecredit operations of the commercial banks. ALthough the banks have been required by law tomaintain a cash reserve "in lawful money of thePhilippines or of the United States" equal to only18 per cent of their demand deposits and 5 per centof their savings deposits,3 the volume of their creditoperations has been narrowly restricted by thefollowing two factors.

First, unlike the practice in the United States, thebulk of monetary payments in the Philippines ismade in cash rather than by check. As a result,whenever the banking system expands credit, theloss of cash reserves to the public is much heavierthan in countries where checks are more commonlyused.

Second, the Philippines has such a high pro-pensity to import that a large percentage of any

3 The reserve against savings deposits could be held in Philip-pine or United States Government Bonds, as well as in cash.

938 FEDERAL RESERVE BULLETIN

Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

August 1948

THE PHILIPPINE CENTRAL BANK ACT

expansion of the money supply is likely to beused for additional importation from abroad, prin-cipally from the United States. To the extent thatimporters draw down their deposit balances in or-der to buy dollars from the banks, the banks losereserves and the capacity of the banking system toextend credit is reduced.

The restrictive effects of these factors on bankcredit expansion have been intensified by the ab-sence of a central bank. The Philippine branchesof foreign banks have needed central bank creditfacilities less than the other banks, because theycould ordinarily seek accommodation from theirhead offices when in need of funds. For the do-mestic banks, however, the absence of a centralbank has meant that each bank has had, in effect,to rely exclusively on its own resources. In thesecircumstances, reasonable standards of precautionhave required Philippine banks to maintain largerexcess reserves and more liquid portfolios thanwould have been necessary had central bank creditbeen available. For these reasons, Philippine banks,in the aggregate, ordinarily have held reserves whichwere two to three times the legally required mini-mum.

No agency has had responsibility for seeing to itthat the supply of money responded to the needsof the economy. The Philippine National Bank,which is a Government-owned commercial bank,has had inadequate resources and powers to under-take the responsibility, even if it had been socharged. The Government itself might have en-deavored to regulate the money supply by the exer-cise of its fiscal powers, but has not done so; in anyevent, fiscal measures would have been difficult toemploy in a country without a well developed taxsystem and a well organized government securitiesmarket. Thus, movements in the money supplyof the Philippines have been the uncoordinatedproduct of the country's international balance ofpayments and of the diverse credit activities ofthe banking system.

Another disadvantage of the system, given thelimited ability of the Government to borrow do-mestically, was that it tended to obscure the dis-tinction between domestic currency requirementsand foreign currency requirements. This becameparticularly apparent when the Government wasfaced with a budgetary deficit last year; it was un-able to sell its securities because of the absence-of a securities market, and was unable to get

adequate accommodation from the banks becauseof their limited credit potential. As a result, theGovernment had to borrow dollars in order to ob-tain pesos with which to finance local expenditures.

When a system requiring a 100 per cent reserveagainst the note issue is applied to a growing econ-omy, it may logically be expected to impart to ita consistent deflationary bias. In order to createthe larger money supply required for an increasingpopulation and an ever-expanding domestic trade,it would be necessary for the country to havea persistently active balance of payments, whichin itself would be a costly luxury for an under-developed economy. It would be difficult to dem-onstrate conclusively, however, that the operationof the system in the Philippines was a major deter-rent to the full development of the country's eco-nomic potentialities in the prewar period. Exceptfor the exchange crisis of 1920 and 1921, which canbe blamed on a violation of the system rather thanon the system itself, there was never any real threatof a breakdown of the Philippine monetary system.On the other hand, some of the more serious de-pressing effects of the system were undoubtedlyobscured by such favorable factors as the free ac-cess of Philippine products to the protected Ameri-can market, the continuous expenditures of UnitedStates Government agencies in the Islands, andthe remission to the Philippines by the UnitedStates Government of taxes paid by Americanmanufacturers on the processing of sugar and coco-nut oil of Philippine origin.

Now that the Philippines is independent many ofthe economic benefits resulting from the associationwith the United States will gradually disappear.United States Government payments in the Islandsare scheduled to decline after 1950. After 1974Philippine products will be subject to the fullAmerican tariff. These factors alone may subjectthe economy to pressures which will severely testits inherent strength. Moreover, the greater partof the task of reconstructing and developing thePhilippine economy lies ahead. In these circum-stances it could hardly be expected that the Philip-pine Government would retain a monetary systemwhose excessive rigidity might delay its programof reconstruction and development or might de-prive it of any effective defense against the do-mestic consequences of world economic fluctuations.

There are many who point out that the 100per cent reserve system guarantees the international

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stability and convertibility of the peso and servesto attract foreign capital. The new monetary sys-tem recognizes the value of the'se objectives but isdesigned to achieve them without needlessly sacri-ficing domestic monetary stability and orderly eco-nomic development.

THE NEW MONETARY SYSTEM

The Central Bank Act is an integrated body ofprovisions defining the monetary system of thePhilippines and establishing the Central Bankto administer it. It declares the principal objectivesof the Bank to be to maintain monetary stabilitywithin the Philippines, to preserve the internationalstability and convertibility of the peso, and to pro-mote orderly growth in production, employment,and real income.

Since monetary authority in most countries isdivided between the Treasury and the central bank,it has been customary to have currency legislationdistinct from central bank legislation. This is un-necessary in the Philippines because all monetaryauthority and responsibility are to be vested in theCentral Bank; consequently, all necessary legal pro-visions concerning the currency have been incorpo-rated in the Central Bank Act.

The Act provides that the Philippine peso shallcontinue to be equal by law to 50 United Statescents, but it goes further than former legislation byalso defining the peso in terms of gold. It pro-vides that the Central Bank shall have a monopolyof the issue of currency and may issue notes andcoins in exchange for any assets which it is legallyauthorized to acquire.4

The Central Bank will not be required, as theTreasury has been, to hold the official interna-tional reserve exclusively in dollars; gold and for-eign currencies other than dollars may also be in-cluded. Nevertheless, the Act will not in practicetake the Philippines off the dollar exchange stand-ard. Practically all Philippine trade and otherinternational transactions have long been conductedon a dollar basis and are expected to continue tobe so conducted in the future.

The legislation explicitly recognizes the validityof all international agreements entered into by thePhilippines which affect its currency. Under the

* All Philippine notes and coins now in circulation will be-come a liability of the Central Bank. In return for assumingthis liability the Central Bank will acquire the bulk of the assetsof the Treasury Certificate Fund and the Exchange StandardFund, which are the two Funds in which the Philippine Treas-ury has kept the monetary reserves. These Funds will be liqui-dated.

terms of the Executive Agreement between theUnited States and the Philippines, pursuant to thePhilippine Trade Act of 1946, the Philippine Gov-ernment has agreed that, until July 3, 1974, "thevalue of Philippine currency in relation to theUnited States dollar shall not be changed, the con-vertibility of Philippine pesos into United Statesdollars shall not be suspended, and no restrictionsshall be imposed on the transfer of funds from thePhilippines to the United States except by agree-ment with the President of the United States." Ineffect, this means that, for the life of this Agreement,the Philippines cannot change the dollar value ofits currency nor adopt exchange controls withoutthe approval of the President of the United States.The legislation is also in complete harmony withthe Articles of Agreement of the InternationalMonetary Fund, of which the Philippines is acharter member.

ORGANIZATION OF THE CENTRAL BANK

The Central Bank will be a Government-ownedinstitution with a capital of 10 million pesos.5 TheBank will be headed by a "Monetary Board" con-sisting of seven members, one of whom will be thechief executive of the Bank and will bear the titleof "Governor." The Secretary of Finance, thePresident of the Philippine National Bank, and theChairman of the Board of Governors of the Re-habilitation Finance Corporation will be ex-ofEciomembers of the Monetary Board. The other fourmembers, including the Governor, will be ap-pointed for six-year terms by the President of theRepublic. The Governor of the Bank must be ofrecognized competence in the field of banking, andthe other three appointive members must be ofrecognized competence in the economics of bank-ing, finance, commerce, agriculture, or industry.It should be noted that none of the appointive mem-bers will be chosen on a regional or functionalbasis, as is provided in many central bank laws.The members are to represent the public interest inthe broadest sense of the term and are not to bespokesmen for special groups.

The Secretary of Finance will preside at themeetings of the Board, but will have no specialpowers in the determination of policy or in theadministration of the Bank. The principal reasonfor placing the Secretary of Finance on the Mone-

5 To be obtained from the Exchange Standard Fund when itis liquidated.



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tary Board is to promote an effective coordinationof monetary and fiscal policies. As a member ofthe Monetary Board, the Secretary of Finance willshare responsibility for central bank policy. Con-flict with the Government is one of the obstaclesover which central banks have stumbled and cometo grief in many countries. The origin of much ofthe trouble frequently has been in central banklegislation which endeavored to make central bankpolicy completely independent of the national eco-nomic policies of the Government. The Philip-pines hopes to avoid such conflict by making allof the members of the Monetary Board subjectto governmental appointment and by having theSecretary of Finance participate in, but not domi-nate, the formulation and execution of monetarypolicy.

The Governor is the only member of the Boardwho is required to devote all of his time to theBank. The Law provides that he shall formulatethe policies of the Bank for the approval of theMonetary Board, shall direct the operations andinternal administration of the Bank, and shall rep-resent the Board and the Central Bank in deal-ings with third parties. In emergencies, the Gov-ernor, with the concurrence of the Secretary ofFinance or in the absence of the Secretary with theconcurrence of any two other members of theMonetary Board, may decide any matter or takeany action within the authority of the Board itself.The Governor will be assisted in the performanceof his duties by a Deputy-Governor, appointed byhim with the approval of the Board.

In recognition of the discretionary judgmentwhich must be exercised by the Monetary Board,the Act provides for the establishment of a Depart-ment of Economic Research which will play an im-portant role in the formulation of monetary andbanking policy. The chief of the research depart-ment will attend meetings of the Board, with theright to be heard but without the right to vote.

All functions of bank examination and supervi-sion will be placed under a department of the Bankto be called the "Department of Supervision andExamination," which will be headed by a "Super-intendent of Banks." These functions were for-merly exercised by the Bureau of Banking in theDepartment of Finance. Assigning the functionsof bank examination and supervision to the CentralBank represents a departure from the practice ofmany countries, in which bank examination is

placed in the Treasury or in some other Govern-ment agency. The principle behind such separationhas generally been that central banks should besubject to the same sort of scrutiny and examina-tion as commercial banks and that, accordingly, aseparate agency should be given responsibility forexamining all banks, including the central bank.In practice, the application of this principle has fre-quently led to conflict between the central bank andthe superintendent of banks over their respectiveroles in regulating the activities of commercial andsavings banks and over the central bank's right ofaccess to data obtained by the superintendent. Asa result of such conflicts and, perhaps even moreimportant, as a result of the general trend towardgreater central bank control over the credit and ex-change operations of the banking system, there hasbeen a growing recognition that the character andscope of commercial and savings bank examinationshould be distinct from those of central bank exami-nation. The Philippine legislation is in keepingwith this trend. Inspection of the Central Bankitself is to be made by a special auditor appointedby the Auditor General of the Philippine Govern-ment.

GUIDING PRINCIPLES OF CENTRAL BANK ACTION

In order to make possible the effective executionof appropriate monetary policies, the instruments ofaction given to the Central Bank under its charterare both large in number and flexible in design.The Law recognizes, however, that in a countrywithout a well-established body of tradition in thefield of central banking, there is a danger that theuse of such instruments will be ill-timed and con-trary to the intent which prompted their inclusionin the law.

As a partial safeguard against this danger, thethird chapter of the Act prescribes the basicguiding principles of monetary management whichthe Central Bank is expected to follow. Similarly,the sections in Chapter IV, which define the indi-vidual instruments of Central Bank action, in mostcases include an introductory comment on the gen-eral circumstances under which the particular in-strument or authority is, or is not, to be used. Theseguiding principles are not intended to provide aready answer to the problems which will confrontthe Bank. Their purpose is the modest one of pro-viding some sort of orientation to clarify the intentof the Law with respect to the use of the powers

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contained therein. The statements of principleshould be especially useful in strengthening theposition of Board members in carrying out anti-inflationary policies over the protests of groupspressing for easy money policies.

The guiding principles are divided into twoparts. The first is concerned with the CentralBank's responsibility for maintaining domesticmonetary stability, the second with its responsibilityfor maintaining the international stability of thepeso. While the Law treats the problems of domes-tic and international monetary stabilization sepa-rately, it recognizes their close interrelation.

Domestic monetary stabilization. It has alreadybeen observed that the fundamental weakness ofthe former monetary system was that it did not re-spond effectively to the domestic needs of thePhilippine economy. The Central Bank Act, onthe other hand, is particularly concerned with thisproblem, but at the same time recognizes that aflexible domestic monetary policy must take intoconsideration possible repercussions on the inter-national economic position of the country. TheCentral Bank's responsibilities with respect to thisproblem are as follows (Section 64):

"The Monetary Board shall endeavor to controlany expansion or contraction in the money supply,or any rise or fall in prices, which in the opinionof the Board is prejudicial to the attainment ormaintenance of a high level of production, employ-ment, and real income. In adopting policies andmeasures in accordance with this principle theMonetary Board shall have due regard for theireffects on the availability and cost of money to par-ticular sectors of the economy as well as to theeconomy as a whole, and their effects on the rela-tionship of domestic prices and costs to world pricesand costs."

The broad directive just quoted is followed, inSection 66, by an outline of the procedures whichthe Monetary Board shall take "whenever abnor-mal movements in the money supply or in pricesendanger the stability of the Philippine economy orimportant sectors thereof/' In such circumstances,the Board shall:

"(a) Take such remedial measures as are appro-priate and within the powers granted to the Mone-tary Board and the Central Bank under the provi-sions of this Act; and

"(b) Submit to the President of the Philippines,and make public, a detailed report which shall in-clude, as a minimum, a description and analysis of:

"(1) The causes of the rise or fall of the moneysupply or of prices;

"(2) The extent to which the changes in themoney supply or in prices have been re-flected in changes in the level of domesticoutput, employment, wages and economicactivity in general, and the nature and sig-nificance of any such changes; and

"(3) The measures which the Monetary Boardhas taken and the other monetary, fiscal oradministrative measures which it recom-mends be adopted."

The Board is required to prepare such a report,moreover, whenever the money supply increases ordecreases by more than 15 per cent, or wheneverthe cost of living index increases by more than 10per cent, in relation to the level existing at the endof the corresponding month of the preceding year,and in the report the Board must state whether, inits opinion, the changes in the money supply or inthe cost of living represent a threat to the stabilityof the Philippine economy or of important sectorsthereof.

International monetary stabilization. The CentralBank Act recognizes the importance to the Philip-pines of continuing to maintain an internationallystable and convertible peso, and states explicitly inSection 67 that:

"The Central Bank of the Philippines shall exer-cise its powers under this Act to maintain the parvalue of the peso and the convertibility of the pesointo other freely convertible currencies."

Toward this end, the Act provides, in Section 68,that:

"the Central Bank shall maintain an internationalreserve adequate to meet any foreseeable net de-mands on the Bank for foreign currencies. Injudging the adequacy of the international reserve,,the Monetary Board shall be guided by the prospec-tive receipts and payments of foreign exchange bythe Philippines. The Board shall give special at-tention to the volume and maturity of the CentralBank's own liabilities in foreign currencies, to thevolume and maturity of the foreign exchange assetsand liabilities of other banks operating in thePhilippines and, insofar as they are known or can



August 1948


be estimated, the volume and maturity of the for-eign exchange assets and liabilities of all other per-sons and entities in the Philippines."

The international reserve may consist of gold,foreign exchange, and foreign government securi-ties having maturities of not more than five years.The Board is instructed to "endeavor to hold theforeign exchange resources of the Central Bank infreely convertible currencies" and to "give particu-lar consideration to the prospects of continuedstrength and convertibility of the currencies inwhich the reserve is maintained, as well as to theanticipated demand for such currencies." The spe-cial conditions under which inconvertible currencies may be acquired by the Central Bank are dis-cussed later in this article.

The Act does not establish any required ratiobetween the Bank's international reserve and itsnote and deposit liabilities. The usual purpose be-hind such reserve requirements in the legislationof other countries has been to place a limit on cen-tral bank credit expansion. The strict observanceof these requirements in periods of crisis, however,would frequently defeat the purpose of centralbank reserves, which is to provide resources forfinancing temporary deficits in the country's inter-national balance of payments, and might obstructthe bank in the discharge of its responsibility as"lender of last resort." In practice, therefore, therequirements have usually either been lowered orsuspended whenever they blocked, or threatened toblock, central bank action.8 Experience has alsodemonstrated that movements in the traditional re-serve ratio cannot serve as a sound guide to centralbank policy. Attempts have been made in recentLatin American legislation to provide mechanicalreserve ratios of a different sort, relating the inter-national reserve to sales of exchange during somepreceding period or to movements in the moneysupply, or to some combination of the two, but,unfortunately, even such refined ratios are unlikelyto serve as an adequate guide to appropriate centralbank policy. In recognition of the foregoing, thePhilippine Central Bank Act leaves the question ofthe adequacy of the international reserve of theBank to the judgment of the Monetary Board andmerely lays down broad guiding principles to befollowed in the exercise of that judgment.

8 See "Gold and Foreign Exchange Reserve Requirements ofForeign Central Banks," Federal Reserve BULLETIN, January1948, pp. 33-38.

The procedures to be followed whenever theinternational stability of the peso is threatened areprovided in Section 70 of the Act:

"Whenever the international reserve of the Cen-tral Bank falls to an amount which the MonetaryBoard considers inadequate to meet the prospectivenet demands on the Central Bank for foreign cur-rencies, or whenever the international reserve ap-pears to be in imminent danger of falling to such alevel, or whenever the international reserve is fall-ing as a result of payments or remittances abroadwhich, in the opinion of the Monetary Board, arecontrary to the national welfare, the MonetaryBoard shall:

"(a) Take such remedial measures as are appro-priate and within the powers granted to the Mone-tary Board and the Central Bank under the provi-sions of this Act; and

"(b) Submit to the President of the Philippinesa detailed report which shall include, as a mini-mum, a description and analysis of:

"(1) The nature and causes of the existing or im-minent decline;

"(2) The remedial measures already taken or tobe taken by the Monetary Board;

"(3) The further monetary, fiscal or administra-tive measures proposed; and

"(4) The character and extent of the co-operationrequired from other Government agenciesfor the successful execution of the policies ofthe Monetary Board.

"If the resultant actions fail to check the dete-rioration of the reserve position of the CentralBank, or if the deterioration cannot be checked ex-cept by chronic restrictions on exchange and tradetransactions or by sacrifice of the domestic objec-tives of a high level of production, employmentand real income, the Monetary Board shall proposeto the President such additional action as it deemsnecessary to restore equilibrium in the internationalbalance of payments of the Philippines.

"The Monetary Board shall submit periodic re-ports to the President until the threat to the inter-national monetary stability of the Philippines hasdisappeared."

The measures taken in accordance with the pro-visions of subsection (a) above to check the dete-rioration in the reserve position of the Central

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Bank may consist of direct restrictions on exchangeoperations or of indirect measures designed to con-tract the money supply, in order thereby to reducethe demand for foreign currencies. The choice be-tween exchange restrictions and a deflationarymonetary policy, and among various combinationsof the two, will depend on the circumstances pre-vailing at the time. The Law does not give domes-tic monetary stability priority over internationalstability, nor vice versa. In some circumstancesthe Monetary Board might consider the hardshipsof a temporary deflation to be more than counter-balanced by the undeniable long-run advantagesof free convertibility; at other times, deflationmight be too bitter a medicine.

The situation envisaged in the next to the lastparagraph of Section 70 is that of a fundamentalconflict between the objectives of domestic andinternational monetary stability which would re-quire consideration of revaluation. The conditionsunder which a change in the par value of the pesois authorized under the Act are stated in detailin Section 49, as follows:

"The par value of the peso shall not be alteredexcept when such action is made necessary by thefollowing circumstances:

"(a) When the existing par value would makeimpossible the achievement and maintenance of ahigh level of production, employment and real in-come without:

"(1) The depletion of the international reserve ofthe Central Bank; or

"(2) The chronic use of restrictions on the con-vertibility of the peso into foreign currenciesor on the transferability abroad of fundsfrom the Philippines; or

"(3) Undue Government intervention in, or re-striction of, the international flow of goodsand services; or

"(b) When uniform proportionate changes in parvalues are made by the countries which are mem-bers of the International Monetary Fund; or

"(c) When the operation of any executive or in-ternational agreement to which the Republic ofthe Philippines is a party requires an alteration inthe gold value of the peso."

It should be noted that the existence of any ofthe conditions enumerated does not make a modi-fication of the par value obligatory, under the termsof this Act, but merely permissible.

The administrative procedure for changing thepar value of the peso is as follows: The MonetaryBoard, with the concurrence of at least five of itsseven members, must first propose such action tothe President, who may, if he deems it advisable,take such action after having obtained the approvalof Congress (except in grave and urgent circum-stances, in which case the President may act withoutsuch approval but must then report on his actionto Congress at the earliest opportunity).

Any action to change the par value of the peso(or to apply exchange controls) would also be sub-ject, of course, to the conditions imposed by theExecutive Agreement pursuant to the PhilippineTrade Act and by membership in the InternationalMonetary Fund.

INSTRUMENTS OF CENTRAL BANK ACTION

The specific instruments of action available tothe Central Bank include operations in gold andforeign exchange, lending to banks and the Gov-ernment, open-market operations, control of bankreserve requirements, and selective regulation ofbank credit operations. These powers, as will beapparent from the following discussion, are flexiblein design. This seems particularly desirable in aneconomy in which Government fiscal operationsare unlikely to exert appropriate countercyclicalinfluences, at least for some time to come, andwhich, because of its extreme dependence on theexportation of a few basic products, is sensitive tochanging business conditions abroad, especially inthe United States.

During the first few years of the Central Bank'sexistence, large export proceeds and large UnitedStates Government payments to the Philippineswill probably prevent the money supply from fall-ing, and may even increase it. In such a periodthe Bank may wish not only to restrict its owncredit operations quite narrowly but also to limitthe expansion of credit by the commercial banksthrough the use of its powers over their creditoperations. At a later time, these powers couldbe used in a different direction to counteract de-pressive forces.

Operations in gold and foreign exchange. The Cen-tral Bank may buy and sell gold, regulate all deal-ings in gold, and require at any time that goldholdings of all persons or entities be deliveredto the Bank. The Bank may engage in foreignexchange transactions with Philippine banks, Philip-



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pine Government agencies, foreign and interna-tional financial institutions, and foreign govern-ments, but not with the general public. In orderto maintain the convertibility of the peso, the Cen-tral Bank is required, however, to buy any quan-tity of foreign exchange offered to it, and sell anyquantity demanded from it, by any bank operatingin the Philippines, provided that the currency of-fered or demanded is freely convertible into goldor United States dollars.

Notwithstanding the obligation just described, inorder to protect the international reserve of theCentral Bank during an exchange crisis and to givethe Monetary Board and the Government time inwhich to take constructive measures to combat sucha crisis, the Board, with the concurrence of at least£.vc of its seven members and with the approvalof the President of the Republic, may temporarilysuspend or restrict sales of exchange by the CentralBank and may subject all transactions in gold andforeign exchange to license by the Bank. It isunlikely that this authority will be exercised withinthe foreseeable future because of the presently fa-vorable balance of payments and the extraordi-narily high level of the international reserve. ThePhilippine financial position is sound and thePhilippine economy should be able to adapt itselfto the tapering off of the currently large UnitedStates Government payments without the imposi-tion of exchange controls.

The question of inconvertible currencies posesno immediate problem for the Philippines becausePhilippine trade is at present conducted almostexclusively in dollars. As long as the maintenanceof a high level of exports is not dependent uponthe acceptance of currencies which are not freelyconvertible into gold or United States dollars, it isto the interest of the Philippines that the Bank notaccumulate such currencies. Nevertheless, the daymay come when the Central Bank must choose be-tween accumulating inconvertible currencies andsuffering a curtailment of exports which wouldseriously reduce income and employment. TheBank might well decide that the former would bethe lesser evil, particularly in view of the diffi-culties and hardships that would be involved inshifting factors of production from the export in-dustries into other productive activities. This deci-sion would be especially defensible in cases wherethe period of inconvertibility of a foreign currencywas expected to be rather short. In view of the

foregoing considerations, the Central Bank Actstates (Section 75) that:

"The Central Bank shall avoid the acquisitionand holding of currencies which are not freelyconvertible, and may acquire such currencies inan amount exceeding the minimum balance neces-sary to cover current demands for said currenciesonly when, and to the extent that, such acquisitionis considered by the Monetary Board to be in thenational interest. The Monetary Board shall deter-mine the procedures which shall apply to theacquisition and disposition by the Central Bankof foreign exchange which is not freely utilizablein the international market."

The Monetary Board will fix the rates at whichthe Central Bank will buy and sell foreign ex-change, but the rates for spot exchange may notdiffer from the legal parities by more than one-halfper cent, unless in any given case a greater diver-gence from the legal parity exists in foreign mar-kets. The rates applicable to nonspot exchangetransactions of the Central Bank may not differfrom the spot rates by more than the additional costsor expenses involved in each type of transaction.

The Monetary Board will also determine theminimum and maximum rates within which theother banks may buy and sell spot exchange, butthe limits fixed by the Board may not differ fromthe respective legal parity by more than one percent, unless in any given case a greater divergencefrom parity exists in foreign markets. The ratesfixed by the banks for their nonspot exchangetransactions may not differ from their spot ex-change rates by margins larger than those con-sidered reasonable by the Monetary Board. TheBoard may at any time, however, specifically fixsuch margins.

Any revaluation profits or losses made by theCentral Bank on its net international assets or lia-bilities, as a result of changes in the gold valueof the peso or in the parities or exchangerates of foreign currencies with respect to thePhilippine peso, are to be offset by any amountswhich, as a consequence of such revaluations, areowed by the Philippines to the International Mone-tary Fund and the International Bank for Recon-struction and Development, or are owed by theseinstitutions to the Philippines. The Central Bankwill sterilize any remaining profit or loss by enter-ing it in a special blocked account. The purpose

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of such sterilization of revaluation profits andlosses is to remove their potential influence on deci-sions to modify the value of the peso.

Similarly, any revaluation profits and losses madeby the other banks on their net assets or liabilitiesin gold and freely convertible foreign currenciesare to be for the account of the Central Bank andare to be distributed by the Bank in the same man-ner as those arising from its own holdings. TheMonetary Board may, furthermore, at any time de-clare that revaluation profits or losses on banks'net holdings of any inconvertible foreign currencyshall also be for the account of the Central Bank.The purpose of these provisions is principally toremove the speculative element of revaluation prof-its and losses from the normal exchange operationsof the banking system.

In order that the Central Bank may at all timeshave foreign exchange resources sufficient to enableit to maintain the international stability and con-vertibility of the peso and in order to promote thedomestic investment of bank resources, the Mone-tary Board is authorized, in Section 80, to requirethe banks to sell to the Central Bank all or partof their surplus holdings of foreign exchange. Itshould be noted that the exercise of this power ispermissive, not obligatory. Such transfers may berequired for surplus holdings of all foreign cur-rencies or for only certain of such currencies, andare to be made at the regular buying rates of theCentral Bank. Surplus holdings of any foreigncurrency are defined as the amount by which abank's assets in the currency exceed the sum of:(a) the working balance which it needs to accom-modate normal short-run fluctuations between thebank's sales and purchases of the currency and (b)the total liabilities of the bank in the currency. Incalculating surplus holdings in any given currency,however, a bank may, with the permission of theMonetary Board, subtract from its net assets inthat currency an amount equal to its net liabilitiesin other currencies into which the currency con-cerned is freely convertible.

Loans to banking institutions. The Central Bankis given wide latitude with respect to the volume,character, security, and maturity of its loans tobanks, but its credit policy is subject to the follow-ing general principles, which are stated in Section86 of the Law:

"The rediscounts, discounts, loans and advanceswhich the Central Bank is authorized to extend to

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banking institutions under the provisions of thepresent article of this Act shall be used to regulatethe volume, cost, availability and character of bankcredit and to provide the banking system withliquid funds in times of need.

"In periods of inflation, or as long as inflationarydangers exist, the Central Bank shall refrain fromextending credit to banks and at such times shallgrant credit only in exceptional cases where specialcircumstances justify a deviation from the principlestated herein.

"Conversely, whenever the national monetarypolicy requires an expansion of the money supply,the Central Bank shall make full use of the creditoperations authorized under the present article ofthis Act."

Here again, it should be emphasized that the"guiding principle'* is not intended to serve as asubstitute for sound judgment but is designedrather to provide orientation and to place someimpediment in the way of excessive or untimelycredit expansion by the Central Bank.

The maximum permissible maturities for Cen-tral Bank loans and advances to banks are greaterthan those customarily permitted in the legislationof more highly industrialized countries. The Bankmay grant loans with maturities up to 180 daysagainst paper related to commercial loans and upto 270 days against paper related to production orprocessing loans. The Bank may in addition makeadvances up to 180 days against gold, against evi-dences of debt of domestic credit institutions,against utilized portions of bank advances on cur-rent account—provided they are covered by regu-lar over-draft agreements between banks and theircustomers and were used to finance the production,processing, storage, or marketing of goods—andfinally against obligations of the Government or ofother official entities, provided that the obligationmatures within 10 years from the date of the ad-vance by the Central Bank.

The speed with which a central bank can con-tract the money supply is obviously conditioned bythe maturity pattern of its portfolio. This is thereal basis for the traditional principle that centralbank loans should be "self-liquidating" and ofshort maturity. While the maximum maturitiesmentioned in the preceding paragraph may seem solong as to impair somewhat the speed with whichthe Central Bank could, in case of need, force a

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drastic contraction of credit, their justification is tobe found in certain characteristics of the Philip-pine economy. In the Philippines, as in other un-derdeveloped areas, productive and commercialprocesses are impeded by shortages of workingcapital as well as by lack of mechanization andlimited transportation facilities. In order to meetthe legitimate credit needs of business and agricul-ture in such communities, banks must adapt thecharacter of their lending operations to the en-vironment in which they operate. This requiresthat commercial banks at times grant loans oflonger maturities than is the practice in the UnitedStates. The granting of such loans by the commer-cial banks will be facilitated if the Central Bankitself can make advances to the banks with simi-larly extended maturities, even though this mayinvolve some sacrifice of the speed with whichthe Central Bank can contract the money supply.

Whenever inflation looms on the horizon, theCentral Bank should, of course, give careful atten-tion to the liquidity of its portfolio. In times ofdeflation or depression, on the other hand, unduepreoccupation with liquidity would defeat whatshould be a primary objective of central bank policyunder such circumstances—namely, to prevent aserious fall in the money supply. In recognition ofthese considerations, the Philippine Central BankAct permits the maximum maturities of new creditoperations to be raised from the normal periods of180 and 270 days to a year whenever, in the opinionof the Monetary Board, a deflationary situationexists which requires special expansionary measures.In similar circumstances, the Bank is also em-powered (Section 89) to grant advances up to oneyear to mortgage institutions against their mortgageloans.

Just as the Act recognizes that normal maturityrequirements should be liberalized in periods ofemergency, it also recognizes that adherence tonormal eligibility rules at such times might blockthe discharge of the Central Bank's responsibilityas "lender of last resort" and, accordingly, provides, in Section 90, that:

"In periods of emergency or of imminent finan-cial panic which directly threaten monetary andbanking stability, the Central Bank may grantbanking institutions extraordinary advances se-cured by any assets which are defined as acceptablesecurity by a concurrent vote of at least Rvc mem-

bers of the Monetary Board. While such advancesare outstanding, the debtor institution may notexpand the total volume of its loans or investmentswithout the prior authorization of the MonetaryBoard."

The Philippine Central Bank Act does not pre-scribe the interest or rediscount rates to be chargedon the Central Bank's loans. The Act merely pro-vides that the rates are to be fixed by the MonetaryBoard in accordance with the character and termsof the credit operations, with due considerationbeing given to the credit needs of the market, thecomposition of the Central Bank's portfolio, andthe general requirements of the national monetarypolicy.

Advances to the Government. Direct loans to theGovernment and to its political subdivisions arelimited to short-term advances for the purpose ofcovering seasonal gaps between revenues and ex-penditures.7 These advances have to be repaid be-fore the end of the first quarter following the ter-mination of the fiscal year and their total may notexceed 15 per cent of the estimated income of theborrower for the current year.

Open-market operations. For some time to come,open-market operations will not serve as a veryeffective instrument of Central Bank action in thePhilippines. The Central Bank must first developa market for Government securities. To this end,the Bank is given charge of the marketing of allGovernment obligations and will administer a spe-cial "Securities Stabilization Fund" for the accountof the Government. The objective of this Fund isto promote private investment in Government ob-ligations by increasing their liquidity and stabiliz-ing their value. The Fund will have an initialcapital of 2 million pesos, but provision is made toincrease its resources by the allocation of part ofthe annual profits of the Bank. The MonetaryBoard is instructed to use the resources of the Fundto prevent or moderate sharp fluctuations in thequotations of Government obligations, but not forthe purpose of altering movements resulting from

7 As a special exception until June 30, 1951, however, thetransitory provisions of the Act authorize direct advances to theGovernment up to an amount of 200 million pesos. Such ad-vances may be made only when the Monetary Board considersthe international reserve to be adequate to meet all foreseeabledemands on it and when the advances are consistent with domes-tic monetary stability. Furthermore, these m advances may bemade only for productive and income-producing projects or forthe repayment or servicing of external obligations of the Govern-ment. The advances are to be made against Government securi-ties having denominations and interest rates which w'll makethem attractive to the banks and the public. Their maturitiesmay not exceed fifteen years.

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basic changes in the pattern or level of interestrates.

In order to regulate bank reserves and the moneysupply, the Central Bank may engage in open-market operations for its own account. Wheneverthe Bank's total holdings of Government securitiesare so small as to prevent the Bank from engagingin selling operations on the scale desired, or, as ismore likely in practice, whenever its holdings ofsuch securities do not have maturities or othercharacteristics which would evoke favorable mar-ket response, the Bank may issue obligations of itsown; these obligations may have such character-istics as the Monetary Board considers appropriate.This provision has the effect of providing the Bankwith an unlimited and highly flexible portfolio foropen-market sales.

The Act provides the same general type of policydirective for the open-market operations of the Cen-tral Bank as it does for the Bank's lending opera-tions: in periods of inflation, or as long as infla-tionary dangers exist, the Bank is to refrain fromsecurity purchases and at such times must endeavorto sell securities. Whenever there is danger ofdeflation, on the other hand, the Bank may freelyengage in open-market purchases.

Bank reserve requirements. The Central Bankhas broad authority over the reserve requirementswhich the banks must observe. The MonetaryBoard may prescribe reserve ratios from 10 to 50per cent against demand deposits and from 5 to25 per cent against time and savings deposits. Theratios established are to apply to all banks uni-formly, regardless of the size of the city in whichthey are located. Notwithstanding the upper limitsjust mentioned, the Board may, in periods of infla-tion, prescribe ratios up to 100 per cent against anyfuture increase in the deposits of each bank. When-ever the use of such special authority results in re-quired reserves in excess of 50 per cent of the totaldemand deposits of a bank or in excess of 25 percent of its total time and savings deposits, the Cen-tral Bank may pay interest on the excess at a ratenot higher than the Bank's lowest rediscount rate.

The required reserves of each bank will ordi-narily have to be held in the form of a noninterest-bearing deposit with the Central Bank; neverthe-less, the Board may, whenever circumstances war-rant, permit the maintenance of part of the requiredreserves in the form of assets other than peso de-posits with the Central Bank. Thus, in periods of

inflation, the Monetary Board might raise require-ments substantially,8 but might permit all or partof the increase to be held in the form of Govern-ment securities, or of foreign exchange. The useof this authority could be of considerable value inaccustoming banks to invest in Government ob-ligations. It would have the further advantageof curbing bank credit expansion without neces-sarily forcing the banks to hold assets yielding noreturn and it should therefore be more acceptableto the banking community.

Interbank clearing. The Central Bank is to pro-vide facilities for interbank clearing, and is to usethe reserve deposits of the banks for this purpose.

Selective regulation of bank credit operations. Inaddition to the quantitative control which it mayexercise over the volume of bank credit throughthe adjustment of reserve requirements and, atsome later date, through open-market operations,the Central Bank is given several instruments ofquantitative control which should enable it to curbcredit expansion in certain directions, while at thesame time permitting it in other directons. Theselective controls include authority:

1) to regulate interest rates;2) to establish maximum maturities for bank

loans and investments, and to prescribe the kindand amount of security to be required against thevarious credit operations of the banks;

3) to place ceilings on the amount of bank loansand investments, or certain categories thereof, orto place a limit on the rate of increase of suchassets ©ver time. In no case may the Board estab-lish limits which are below the value of the loansor investments of the banks on the date on whichthey are notified of such restrictions;

4) to prescribe minimum ratios which the capitaland surplus of banks must bear to the volume oftheir assets or to specific categories thereof,9 and

5) to prescribe minimum cash margins for theopening of letters of credit, and to relate the sizeof the required margin to the nature of the trans-actions to be financed. This last power is designedto give the Central Bank authority to restrict theabuse of bank credit for speculative or nonessentialimportation.

8 But, insofar as reserve requirements against existing liabili-ties are concerned, at a rate not exceeding 4 per cent per monthand only after giving the banks notice reasonably in advance ofthe date on which the increase is to become effective (Section104).

9 For a discussion of the use of capital-asset ratios, see DavidL. Grove, "New Guatemalan Bank Law," Federal ReserveBULLETIN, April 1947, pp. 398-401.



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The selective controls listed above can, if exer-cised in accordance with the spirit of the Law, beof great value at times* when the use of other in-struments of central bank action would be ineffec-tual or awkward.

FUNCTIONS AS FISCAL AGENT, BANKER, ANDFINANCIAL ADVISER OF THE GOVERNMENT

The Central Bank is to act as fiscal agent, banker,and financial adviser of the Government, its politi-cal subdivisions and instrumentalities. It will rep-resent the Government in all dealings with theInternational Monetary Fund and may also repre-sent it in its dealings with the InternationalBank for Reconstruction and Development. Beforethe Government may undertake any credit opera-tion at home or abroad it must first consult withthe Central Bank in order that the latter may ren-der an opinion on the probable effects of the pro-posed operation on the money supply, the pricelevel, and the balance of payments. Moreover, toassure the Central Bank of a voice in the formula-tion of national economic policies, the Act providesfor the representation of the Governor of the Bankon the National Economic Council, which is theentity responsible for the coordination of such poli-cies. Thus, the Law places great stress on an effec-tive integration of monetary policy with the fiscaland general economic policies of the Government.

The Central Bank will be the depository of allofficial funds. An important element of flexibilityis introduced, however, by the provision that theMonetary Board may from time to time authorizecertain other banks to accept Government deposits.Thus, bank reserves can be increased and credit ex-pansion encouraged at any time by the simpleexpedient of placing Government funds with thebanks; similarly, bank credit can be tightened, withequal or greater effectiveness, by the withdrawalof these funds at times when credit stringency is inorder.

CONCLUDING COMMENTS

The Central Bank Act establishes an institutionwhich, if prudently managed, should make a valu-able contribution to the economic progress of the

Philippines. With the establishment of a CentralBank to which they can turn in times of need, thebanks will be in a much better position to accom-modate the credit needs of a vigorously growingeconomy. The banks should in particular be ableto give more sympathetic consideration to themedium and long-term credit needs of agricultureand industry—needs which tended to suffer underthe former system. With the development of amarket for Government securities, the scope offiscal policy will be broadened and a channel forsafe investment of savings will be opened; both agreater volume and more effective utilization ofsavings should result.

It would be folly to believe that the Central Bankcan fully insulate the Philippine economy fromfluctuations in world demand for the raw materialexports on which so large a part of the Philippinelevel of consumption depends. Nevertheless, theimpact of world economic fluctuations, particularlythose of brief duration, can be cushioned by appro-priate central bank policy. The fulfillment of thiscompensating function will undoubtedly occupy aprominent place in the Bank's activities; but amajor concern of the Bank should be to create andmaintain a financial environment in which a fullerand more diversified utilization of the rich re-sources of the Philippine economy is encouragedand local and foreign capital are permitted to makethe greatest contribution of which they are capable.

The Philippine Government has recognized theneed for further reforms in other fields, two of themost important of which are taxation and agricul-ture. It is expected that the Central Bank's policieswill be integrated with such reforms and will forma part of a unified program of reconstruction anddevelopment. If the new Bank, in the formulationof monetary policy, adopts a perspective which en-compasses the entire economic environment inwhich it operates, it should be able to make an out-standing contribution to the effective conduct ofPhilippine economic affairs.

NOTE.—A pamphlet containing the text of the Philippine Cen-tral Bank Act and a reprint of this article, will be available ina few weeks upon request from the Division of AdministrativeServices, Board of Governors of the Federal Reserve System,Washington 25, D. C.

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philippine central bank act - fraser...of the philippines and reorganizing the monetary system of...

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