THE FINANCIAL EXECUTIVE
Business World
This article was written before the stock market's recovery on August 21, 2007. Investors, however, can expect recurring concerns about the impact of current problems in the US credit market on its economic growth and on growth in the rest of the world. Whether it was a general flight from risky assets or the unwinding of hedge funds' exposures to fund redemptions by investors alarmed by the so-called unknown unknowns, the exit of "hot money" in weeks past has pulled Philippine equity prices back to late 2006 levels.
Since the week of July 23, the composite stock price index has lost 23% while the peso has reversed course, losing nearly 4% against the dollar even as monetary authorities tempered its fall.
Local investors, who may be bracing for continued volatility as the US subprime drama plays out, have started to shift to the safety of bonds. As a result, spreads on Philippine sovereign bonds, which have been hammered by fiscal slippages reported a month ago, have narrowed in recent weeks.
Current market conditions suggest that pipeline equity initial public offerings (IPOs) are likely to be pushed out.
Nevertheless, unlike in 1997 when the financial crisis that swept across Asia quickly escalated into an economic crisis, the domestic economy this time around is in much better shape to weather the turbulence, as long as the US economy itself avoids a hard landing. Improved macroeconomic stability in recent periods, accompanied by more resilient financial institutions, has weakened the transmission channels from financial to economic crises as discussed below.
1. Re-pricing of risk and increased hurdle rates. The global flight to quality and drying up of liquidity has raised renewed concerns about government's fiscal consolidation program with fears of rising funding costs. As the narrowing of spreads in past weeks indicates, however, this risk is small as local investors, who look at government securities as safe havens, are major buyers of government bonds. At the same time, the increased depth of a still very liquid domestic market (resulting in a flatter yield curve in peso issues), coupled with the peso's recent strength, has allowed government to move away from dollar financing, borrowing in pesos to retire foreign debt.
Other factors that should provide more comfort include: (a) the decline in government's debt ratio following reduced budget deficits, healthy primary surpluses, and the economy's growth, (b) a robust dollar war chest consisting of $26 billion in gross international reserves, some $10 billion in forward dollar purchases and $18 billion in FCDU deposits, which together is enough to cover the country's $54 billion stock of foreign debt, and (c) positive current account position with no letup in remittance inflows.
2. Bank lending. The beating that bank stocks took lately may reflect investors' fears that local banks, following government's improved finances and themselves flushed with liquidity and risk appetite whetted, had invested in these securities to realize higher yields. Already, the Bangko Sentral ng Pilipinas has stated that local banks have minimal exposures (reportedly 0.2% of total assets) to collateralized debt obligations (CDOs) and that these holdings consist of higher quality tranches, not the subprimes. This is comforting news because even if the crisis spread to the higher-rated tranches (as it already has), the odds that, as a group, banks' balance sheets will be impaired will be small (especially since banks' investments in such instruments are limited by prudential rules to the size of their dollar books). Moreover, Philippine banks today are in better health, having disposed of a large part of their bad assets in recent years and mergers having led to bigger, stronger, and better capitalized banks. Bank lending has in fact started to rise in real terms - a course unlikely to be affected by any CDO holdings.
3. Corporate sector weakness. While some of the bigger firms, which had taken advantage of favorable market conditions to raise financing and have been cash-rich while waiting for investment opportunities in the domestic economy, may have parked funds in the meantime in CDOs, it is not very likely that they will be holding much of these securities, either. They would most likely have diversified their investments and even if they had initially raised financing in dollars, they would have converted to pesos by now in light of the dollar's weakness.
4. Outflow of portfolio investments. This has contributed to financial market volatility but is not likely to have any real sector impact. The peso's depreciation following its rapid appreciation in recent periods should in fact be a welcome development for monetary authorities striving to balance multiple objectives as well as for dollar earners such as exporters and overseas Filipino workers (OFW).
Be that as it may, the peso is not likely to fall back to the mid-50s level of two years ago. Unlike in 1997, the peso's strength today is fundamentally supported by surpluses in the current account, which has benefited from the regular inflow of remittances from OFWs. These remittances reached nearly $13 billion last year and grew a further 18% in 1H07. Together with the country's international reserve level, which at the end of July is equivalent to three times debts maturing in the next 12 months, these provide sufficient cushion against temporary outflows of portfolio investments.
The remaining wild card, from the domestic economy's point of view, is the risk of a hard landing in the US. While some analysts have been alerting markets to this rising risk, reading into the US Fed's liquidity infusion and 50bp discount rate cut as a shift in concern from inflation to growth, many believe that the risk is still small at the moment.
I think that the Philippine economy is resilient enough to weather a US growth slowdown. The emergence of China and increased integration of Asian economies have allowed the Philippine economy to "de-couple" to some degree from the US economy. For instance, total Philippine trade with the US has slipped from approximately 25% of overall trade in 2000 to 17% last year.
As well, the stock market's swift recovery sends a positive signal of investors' continued confidence in the economy's prospects.
Romeo L. Bernardo is president of Lazaro Bernardo Tiu and Associates (LBT), a boutique financial advisory firm based in Manila and serves as GlobalSource economist in the Philippines
