Remarks of Romeo Bernardo before the FINEX Symposium,
“Weathering the Storm” October 23, 2008, Dusit Hotel, Makati
Senator Mar
Roxas, Pres. Ed Francisco, Fellow Finex Directors and Members, Mr. Kwan.
Tierra IncognitaWe are all so painfully aware of what is going and was more than fully covered by the two previous speakers, but not quite sure where we are headed and for how long.
I stumbled upon a picturesque analogy for our situation, taking off from the often repeated cliché – that the other shoe has yet to fall. But, it was observed, we are talking about Imelda’s closet.
So it is perhaps important to adopt a properly humble position. Most prognosticators need to tread carefully these days—we all have crystal balls.
Before all of these happened a couple of years ago—it was fashionable to talk about decoupling. I think what we are seeing now though is that the world is much more integrated, primarily through, finance—and also to a high degree—trade, and labor, than many were perhaps wistfully thinking. Having said that, I still come away with the conclusion that Asia will fare better than many regions—thanks to headroom for internally generated demand by China, a more robust banking sector that has been tested and rehabilitated by the Asian crisis—and that the Philippines even if not “an island of calm”, surely better placed than many, and better placed than it has ever been (just think of the 80’s debt crisis) to weather this storm.
It is widely appreciated that governments, multilateral institutions, financial players, indeed, all of us are still in the midst of a raging financial storm of unprecedented intensity and breadth
Put in simplest terms, the U.S. (and to some extent European countries) lived beyond their means for a long period of time, issuing magically prime now suddenly junk securities underwritten by highly leveraged institutions and blessed by flawed credit rating institutions while the regulators were asleep at wheel, and we are now trying to untangle the mess in a situation of global institutions exposed to these toxic assets, insufficient information on state of health of counterparties, resulting liquidity strangulation, deleveraging of investment banks and other institutions that used to provide liquidity.
This has implications and adjustments on financial markets not only in the affected countries, but due to interconnectedness of markets, even countries that have very little to do with it like ours. There are also adjustments at the country level that imply significant slow down in spending—read recession—that cannot but ripple down to others who were at the margins of this phenomenon.
Let me start by showing some slides on what it has done to various financial markets-
- PSE down deep but still above where we were during the Asian Crisis Focus on Financial Stocks
- RoP’s spreads, domestic interest rates (though the latter more driven by inflation—now no longer a concern, and reverse is true.). Risk aversion and sourcing liquidity where they can find it.
- Fx rates depreciating (tracking recently really strengthening dollar. Peso depreciated by 4 percent vs. 8 percent average depreciation for fed index of 26 currencies)
At the same time, in contrast to many banks and financial institutions, our banks have been relatively unscathed.
Why?
- Little exposure to toxic assets, no more than 2 percent of total resources
- Invested instead in Philippine government paper, in a context of an improving fiscal and external debt story.
- Asian crisis has been trigger to strengthen the banks---
- Lower NPL’s - from over 17% in 2001 to less than 5% this year
- Non-performing-assets-to-gross-assets ratio went down from over 15% in 2002 to less than 6% this year.
- Better capital adequacy ratios (now at 15% way over the 10% requirement)
At the same time, improving macro story:
- Improving fiscal accounts since 2004. Debt-to-GDP which went down to 57% from 78% in 2004 provides fiscal headroom to assist in strengthening the financial system.
- BOP, driven by OFW, BPO, etc
- Healthy reserves GIR [$36.7 billion], including FCDU’s [$26 billion]
- Professional, tried and experienced monetary and financial managers in the persons of Gov. Tetangco, Sec. Teves and their teams who have had to deal with earlier crises dating back to the debt crisis of the 80’s.
These help cushion us somewhat from some of the risks, even though our markets suffered nonetheless, perhaps it would seem to some “unjustly” but we are paying the price of having a shallow and illiquid market. Likewise, I would like to stress that stock market/financial markets are not the economy.
Looking at the economy, we still see some growth, ending the year at 4.5% and perhaps as good as 4 % next year, driven by some resilience in OFW remittances, as well as BPO, and consumer spending that may perhaps be even better this year, thanks to a more depreciated peso, that allows remittances to go a longer way, as well as sharply lower food and fuel prices.
We see both continuing, albeit slower growth in remittance, and lower oil and food imports as also cushioning the current account position and thus protecting us from what would have been in earlier times (e.g. when we were more dependent on exports) a looming pressure on balance of payments.
Resilience of OFW
OFW remittances have been growing over the years, and indeed even though some would date “US sub-prime problem” to about a year ago, still managed to run at 17% year to date.
- Graph showing how much vs. other flows, percent of GDP
Remittance year-to-date growth as of August stands at 17%
- Graph showing where from
- Growth in deployment recently (suggests some supply side response). Deployment year-to-date growth as of August stands at 26%.
Analysis by type
- U.S. around 35% of total per BSP. My guess is that less than a fifth of this are pro-cyclical to both U.S. and Philippine conditions [really in the nature of sending savings to buy homes]. This will be lost, both with the diminished wealth of Phil-Ams and with the limited upside in appreciation for Philippine real estate investments. However, for the 30% that come from current income, much will continue. Even assuming unemployment doubles from the current 6 % to 10%, (the highest level of unemployment in 75 years where data is available), and assuming Phil-Ams no differently employed than other Americans, implies a decline of 4% of 30%, i.e. 1.2% in remittance from this source.
- Other sources in the meantime should continue to grow. Countries in the Gulf, particularly heavyweight Saudi Arabia pitched their budget on $50 per barrel, and will continue their public expenditure programs, building new cities costing billions of dollars, and increased refinery capacity (which takes four years to build), many of which are already in train. There are reportedly over 4 million Filipinos just in the Middle East alone, not fully captured by POEA statistics. Indications of supply response from schools and also from construction firms that essentially become training/suppliers not just for their own but for other companies. EEI case in point with 10,000 Filipinos working globally, mostly in M.E.
- Health workers, caregivers, domestics—mostly driven by demographics—aging population, and increased labor force participation of women in richer countries. Not likely to be affected much by cyclical factors.
- We believe that these factors are enough to offset the slowdown in remittance in U.S. so that essentially we will see no contraction in OFW remittance, even if it will be in a flat to a single digit level.
At the same time, indications are that BPO earnings [estimated to be around 2.5% of GDP or approximately $3.5 billion] while slowing down initially as business activity ( including from financial institutions doing outsource work here) lets up, over time will resume long term growth as firms respond to lower profits due to slowdown by striving to bring down costs. Only scratched surface on BPO processing, supposed to be $ 450 billion in opportunities out there.
On the capital accounts side, maturing foreign currency debt of the public and private sectors for next year only at $ 6 billion, around half and half, and even with the tightness in international credit markets can be accommodated by GIR of $36.7 billion and FCDU deposits of $26.2 billion.
Lower Oil and Food Prices Bring Relief to Consumers,
With the clouds of recession in the horizon, cost of fuel is expected to stay at around $ 70, a far cry from the around $ 100 average price we paid over most of this year, which translates to about $2.5 billion in savings on an annual basis. Conversely, this will both bring savings for consumers and help us register possibly still a surplus despite assumptions on flat exports, BPO, tourism and even assuming a flat OFW remittance earnings, all told.
The lower prices of oil and food will also help keep consumption spending going, as we see a reversal in what we saw at the beginning of this year, plus a more depreciated currency than past two years, and will drive what we expect to continuing modest growth of 4%.
Prices, Interest Rates, Monetary Policy
Inflation is projected to hit an average of 9.8% and 6.5% this year and in 2009, respectively, taking into account these developments and the spent up effect of the peak in rice and oil prices.
Despite the lower inflation expected for next year due to these developments, we think there will be pressure on domestic interest rates driven by:
- Global risk re-pricing, as evidenced in higher spreads of RoPs (Show graph). Today I have just heard that this has spiked to higher than in excess of 600 bps for 5 year instruments. Also driven by rush liquidation of foreign holders who are pressed for liquidity, we saw this with high level of hot money outflows last month.
RoP’s give absolute yield higher than local rates (8.9% vs. 8.4% the other day) and coupled with no withholding tax on it, will create pressure on local rates.
Tightness in dollar liquidity and freezing/long que for bond financing may mean the government and private firms would need to rely on even more domestic borrowing than the earlier planned 75 percent of the deficit. May also mean maturing foreign currency public and private debt will be funded in domestic market putting pressure on local interest rates and the currency.
There are expectations of the BSP easing up on policy rates or reserve requirements, with the shift in balance of concerns away from inflation towards promoting growth. However, with the higher risk premium demanded by savers globally, this may simply encourage speculation against the peso. (It helps that some of the hedge fund players are no longer around.)
Fiscal Policy
We are heartened that economic managers plus one (i.e. our friend Gov. Joey Salceda) are no longer talking about a fiscal stimulus package but rather a “re-alignment” of the budget at a time when markets are nervous, spreads are rising.
I think many now recognize that growing more slowly next year to say between 3.5 to 4 percent is not the worst thing that can happen in a situation where markets are prone to irrational, sometimes, panic behavior.
We are confident that government will not throw away the gains from fiscal consolidation that has been achieved over the years, including the most helpful VAT law, and will broadly stay within its fiscal targets even if not exactly the balanced budget in 2010 earlier aimed for. There seems to be resolve, despite what may seem like “public relations” for pro-poor spending to keep to a conservative and cautious position. Clearly there will be pressure on the revenue collection side, arising from lower growth, some programmed/ legislated declines in taxes – eg. corporate income tax, exemption from income tax of minimum wage earners, underachievement of privatization revenues in an environment where market players are attaching a high premium to being liquid. But if the revenues don’t come in, I think there will be corresponding control in spending to keep it manageable, as has been done in the past. Does not promote development, but government can do worse by shooting itself in the foot.
As we move closer to 2010, or even possible earlier initiatives to mount later this year or early next year, a chacha musical show on the road, there may be relaxation in the quality of spending towards hard to audit agricultural commodities that are distributed via local governments, but I have some confidence that this will not come at the expense of macro-stability, only lower priority spending like infrastructure and maybe education and health. (This is supposed to be a joke ;^)
In this respect, we can also support Sen. Mar’s endorsement of government’s intended conditional cash transfer program, including his proposal to double it, provided it is kept away from political agenda. It would also be a good opportunity, to find the resources to support this without busting the deficit targets, to re-align spending for programs that have not proven effective, and indeed may have been source for leakages and efficiency drags on the economy, like NFA subsidies and land reform.
(Today’s papers report a proposed $2 billion fund. Some of us can only hope it goes the same way as the reported $10 billion fund.)
Government response.
There have been yesterday, which continues this morning, disturbances in emerging markets, including further widening in the ROP spreads, problems and near defaults in Pakistan, Argentina, and perhaps elsewhere that have made the concern over the health of the Philippine financial system paramount at this time.
So far, government response, especially from the BSP has been properly calibrated – by and large appreciating that over-reaction or poorly thought out responses can actually erode market confidence in a situation where confidence is at the bedrock of financial stability. This is clearly job one.
Part of the calibrated response we are seeing include:
- Easing pressures on liquidity for both peso and dollar markets, including providing special facility to liquefy ROP’s, which is over 30 percent of the banking system portfolio, and under particular stress from risk aversion;
- Potential revisions on a temporary basis of mark to market guidelines to alleviate pressure on banks’ books that drive their demand for dollars in order to fully cover dollar deposits when ROP’s are under such global stresses;
More can be done to strengthen the arsenal of our monetary and fiscal authorities to respond to global market turbulence:
- Increase the capital of the BSP to make good on what was in the BSP law passed more than a decade ago. There has been mention of tranching this on a multi-year basis in order not to create a large visible headline budget impact, and doing “securitization” financing for this. I think this is undue complication—and that a simple up front appropriation and release is the way to go. The recorded increase in the budget will be well read by keen eyed market analysts, not as expenditure – the way some of the fiscal stimulus packages we read about, whether off or on budget – but as something that strengthens the system. Besides, I gather that BSP has already earned half of that P40 billion this year and will be “dividended” up to government, i.e. offsets against this “expenditure item”.
- Similarly PDIC capitalization need to be strengthened. Can support Sen. Roxas suggestions for an increase in deposit guarantees. While some modest – and I emphasize “modest”-- upward adjustments in amount guaranteed on a time bound basis may be useful. I think we need to be careful that this does not lead to a situation where we may be rewarding banks that take imprudent risks (or worse those that may have built a business model based on exploiting moral hazard opportunities).
In this respect, it is a necessary corollary to discussion to increasing deposit guarantees that our lawmakers strengthen the supervisory powers of both the BSP and the PDIC.
In particular –
- Strengthen legal protection of bank examiners, including: revising the concept of “extra-ordinary due diligence”, unique to Philippine regulatory regime that have been used by erring owners as a sword over the heads of supervisors doing their jobs;
- Enabling power to write down value of shares of bank owners.
Other things that can be done, this time by the fiscal authorities, could be to issue more warrants (that allow conversion of dollar ROP’s in pesos) that relieve pressure on banks to unload them to meet capital requirements.
What not to do: would be to embark on interventions that are not poorly thought through, and can actually spook the markets because: a) no money, b) no execution capability, or c) no trust/credibility.
Risk Factors
A reading such as this would not be complete without an enumeration of risk factors. I will not belabor them as I consider the chances of them happening as remote and are largely manageable.
These are:
- A much deeper and longer recession globally than the base case that we used for our forecast, i.e. from October IMF, i.e. a recession and a gradual recovery towards the end of 2009.
- An event triggered widespread pressure on the financial system and against the peso driven either by a domestic event or contagion from similarly situated countries. This, against a backdrop of neighbors that have provided blanket guarantees on all bank deposits, “beggar thy neighbor” policies. (though again, highly unlikely in given health of the system and tools available to savvy authorities);
- A perfect storm – combination of stress in the economy with heightened political strife driven by very unpopular political initiatives to amend constitutional term limits. (Though I disagree with political analysts who say efforts will be pursued by the leadership by all means and at all costs.)
In sum, despite the turbulence we read every time we open our newspapers for the past months now, we are clearly better placed – thanks to fiscal consolidation, health of the banking system and healthy reserves, and financial authorities that are alert and with enough ammunition, for us all to weather the storm than perhaps at any other time in recent memory. Not an island of calm, but we will certainly stay afloat.
Thank you and good day.
