What Media Didn’t Tell About the Peso

``If a man tries to question the doctrines of etatism or nationalism, hardly anyone ventures to weigh his arguments. The heretic is ridiculed, called names, ignored. It has come to be regarded as insolent or outrageous to criticize the views of powerful pressure groups or political parties, or to doubt the beneficial effects of state omnipotence. Public opinion has espoused a set of dogmas which there is less and less freedom to attack. In the name of progress and freedom both progress and freedom are being outlawed.”-Garet Garrett (1878-1954), American Journalist

Meanwhile, we are pleased to say that the first segment “Gold, US Dollar and Oil: Markets Simply REFLECT On Collective Policies Imposed!” has been featured at Canadian website Safehaven.com. http://safehaven.com/article-8759.htm

Oddball comment of the week, this from Bloomberg (emphasis mine),

``Mexico's central bank Governor Guillermo Ortiz said policy makers can do little to stem rising food prices, and future interest-rate decisions will focus on stopping the spread of inflation to wages and other costs.

``Increases in the price of wheat, milk and other food items pushed Mexico's inflation rate above the bank's 2 percent to 4 percent target band in eight of the past 12 months. The five- member board led by Ortiz unexpectedly raised the benchmark interest rate on Oct. 26 to 7.5 percent from 7.25 percent, the second increase this year.

``There's little central banks around the world can do to prevent food prices from rising,'' Ortiz, 59, said in an interview in Miami today. ``But we can react to avoid second- order effects.''

Since inflation is a product of government policies, then such statement is a practical admission of arrant incompetence. What good is it for central banks to exist when they can’t control the effects of their own policies?

What Media Didn’t Tell About the Peso

In an open forum of a recently hosted “market outlook” by an international bank, the company’s treasurer was asked by a client if the it was advisable to still hold the US dollar.

To our surprise the officer says that because the Philippines have been embroiled in too much politics, particularly tainted by “corruption”, the Peso’s strength was unlikely to last. Duh! This was the same line of reasoning we were confronted with when we audaciously took on the contrarian stand to forecast the Peso to strengthen at the end of 2004, (see November 29 to December 3, 2004 The Philippine Peso’s Epiphany?).

Yet the said official admitted that contrary to their head office which saw the Peso’s rising trend to continue, the advice had been a ‘personal opinion’.

The same perspective can be gleaned from the headlines. When the Peso goes to a milestone record we read economic “experts” instinctively denounce the Peso’s rise as “baneful” to the economy given the adverse implications to the “competitiveness” of our exports and the ramifications to the OFW’s “buying power”.

Nonetheless, the common denominators attributed to the Peso’s rise are the same grounds used for such criticisms and its implied course of action; primarily remittances and trade-economic linkages.

The Endogenous View and the Framing Effect

As a contrarian analyst we try to follow the principles of French liberal economist Frédéric Bastiat’s who wrote about the Parable of the Broken Window in the 1850 essay Ce qu'on voit et ce qu'on ne voit pas (That Which Is Seen and That Which Is Unseen). The precept, of which, centers on the hidden costs of every decisions or the law of unintended consequences (usually seen through the prisms of government interventions). For example, applied to our field, while contrarians tend to serendipitously make occasional major accurate forecasts, the hidden cost or side effect of going against the crowd or of espousing a radically unpopular theme have been ostracization.

Applied to the Peso, domestic experts tell us that exchange rates are determined by demand and supply. True enough. But when we are contented to look at remittances, trade balances or foreign direct investments, we are then vetting from THE INSIDE LOOKING OUT or these variables are seen only as a FUNCTION of the Philippine Economy. That is not the complete picture.

And quite importantly, when we become totally entranced with politics to the point of logical paralysis like a deer who freezes in front of the headlights, such is called obsession or fanaticism and not analysis.

Again while exchange rates are indeed a function of demand and supply, these views purposely limits the public’s perception to the dimension of the Philippine Peso relative to the US dollar ALONE. Since currency markets reflect a ZERO sum game, where one wins at the expense of the other then it is easy to build a case against the rising Peso.

In other words, such arguments facilely plays into the variant of an economic concept known as the Dutch Disease, (wikepidia.org), ``The theory is that an increase in revenues from natural resources will deindustrialise a nation's economy by raising the exchange rate, which makes the manufacturing sector less competitive”. In our case, it is not natural resource exports yet, but of HUMAN exports.

Unfortunately this form of presentation is called the Framing Effect or (wikepidia.org) ``the packaging of an element of rhetoric in such a way as to encourage certain interpretations and to discourage others.” (highlight mine).

Objective analysis attempts to look from a balanced angle against biased analysis whose views are directed by a certain desired outcome. In the markets, losses are usually suffered by those who are consumed by their biases. It certainly seems applicable to everything we do. Since extreme biases “tunnels” our vision to the point of absolute rigidity, we become less open and flexible and squarely insist on our perceived outcomes. We simply cannot move forward if we are drowned by false expectations.

Myths versus Observable Reality

Well in contrast to such views our thoughts is that the currency markets operate from three divergent angles; namely endogenous, exogenous and market expectations (speculative capital). Hence the domestic frame we presented above could be called as endogenous or internal view.

Initially to give us a broader perspective let us examine the historical performance of Philippine Peso from two horizons, a long term 62 year time frame and a medium term 7 year period, as shown in Figure 1.

Figure 1: Philippine Peso’s Long Term or 62 year (left) and Medium Term or 7 year Historical Performance (right)

Since 1945, the Peso (left chart) has experienced about 60 years of continued depreciation relative to the US dollar with only marginal stability attained during the early 1990s or when the Philippines and the PSE’s Phisix was buoyed by a REGIONAL boom. Most of the recent decline came in the wake of the Asian Crisis.

It is important to emphasize that the Philippines has NOT moved beyond what its neighbors have been, which means luck played a substantial role when we advanced (shown below), instead of policy choices.

In short, like today, the Philippine financial markets and its economy has been captive to external forces rather than internal driven factors, subjecting us to external risks more than the internally generated one in contrast to what the others say.

Under such premise it pays to understand how the Philippines have been latched to the global economy, its shifting role relative to regional and world dynamics and the underlying drivers that could hold sway to the direction of both its financial markets and economic path.

As you can further see in the long term chart, it is only during the present period where the Philippine Peso has made a meaningful advance, particularly during the inflection point in 2005.

One should note that in 2005, the Peso attempted to advance in January but was spurned by “politics”, remember the “Hello Garci” scandal? Yet by September, the markets have simply discounted the political window and went on to adjust materially (see left chart of Figure 1). Since then, all of the significant blips of the Peso had been due to external factors. Not even the recent Glorietta blast was enough to turn the Peso around.

Before we proceed, it is an important reminder that the charts of Figure 1 or the historical trend of the Philippine Peso would serve as an ANCHOR for comparison to the subsequent charts in our discussion.

Figure 2: IMF: Remittance Flows (left), Yardeni.com: Philippine Trade Balance (right)

Mainstream media and their attendant experts always impress upon us that the strength of the Peso has been primarily due to remittances, which has now comprises about 10% of the GDP.

While we do not deny the fact that remittances has immensely added to our foreign exchange reserves and has been an important contributor to our economy, as a market observer we find the correlation or the causation of the remittance driven Peso argument as quite doubtful.

The left pane of figure 2 from the IMF (2007 country report) shows of the remittance trends of the Philippines since 1995. What can be observed are as follows:

One, remittance trends has been on a 10 year uptrend and steadily growing since and

Second, the rate of remittances has accelerated since 2002.

Now revert to figure 1 or the peso’s 7 year chart (left); notice that since 2002 the Peso continued to decline in spite of the acceleration of remittances. Again the Peso made its successful turnaround only in September of 2005 a full three years after the quickening of the upside pace. Yet, the most notable part is that in all the years prior to or before 2005, even as remittances rose, the Peso continued to fall!

So the attribution of a causality relationship with its present action or otherwise stated as the rise of the Peso as due to the gains in remittances has NOT been DIRECT. The easy way to say this is that the rise of the Peso cannot be adequately explained by the remittance trends, or simply put, PRESENT correlation does not imply causation! It is a puzzle how so called experts appears to chime in on a supposed “cause and effect” when such has not been supported by price actions.

Of course there will always be some justifications for such incongruence or a simplified explanation for such outcomes such as a “lagged effect” or the Peso could have reacted only after it reached a certain unidentified level called as the “critical mass” level which ultimately served as a tipping point.

We do not argue against these premises (here we are preempting on possible responses), but our question remains which do we follow, a 10 year or 3 year lag? Or what then has been the pivotal measure for the “critical mass” of remittances, 8-10% GDP perhaps?

Then there is the argument that the state of the Peso could also reflect our trading patterns, which appears to be even more defective. Figure 2 courtesy of Yardeni.com tell us that the Philippines have been trading on a deficit (as of August)!

Figure 3: Deutsche Bank: FDI Flows (left), IMF: Net Portfolio flows ex-US dollar assets

On the other hand, others contend that Foreign Direct Investments may have spearheaded the Peso’s rise. Figure 3 from Deutsche Bank shows that FDI compared to our neighbors have severely lagged or has not shown any vital improvements as to equally reflect on the Peso!

Next, media tells us that stock market flows have been one of its factors behind it. While this could have been true in the past, data from the Phisix should tell us of the validity of such claims.

Since the week that ended September 7, the Peso has gained by about 8% or more than half of its year to date gains of about 14%.

The reason we chose the two months of time line is to smooth out away from the talks of the latest developments in the corporate world such as San Miguel’s recent divestment of Australian Dairy National foods and Australian Premier Brewer J Boag & Son (which for us is a questionable strategy in the bottomline enhancement issue; instead the company plans to emigrate to a divergent platform of unrelated interests such as mines, energy-which deserves another article) and the privatization of PNOC-Energy Development Corp, which is said to affect further the Peso’s firming trend.

Not that we disagree with these; we do subscribe to the grounds that these “corporate events” could further support gains of the Peso. But our point is, beyond all these chatters, the fact is since September 7^th the Phisix has accrued some Php 7.0356 billion of net foreign selling in contrast to what has been reported. This foreign selling occurred in 7 out of the 10 weeks, which suggests that this has not been a one-off event. Therefore, we have not seen inflows material enough to extrapolate that the Peso rose because of stock market activities.

Of course, alternatively, we do not know if the past selling activities by foreign money actually translated into outflows since the proceeds could have been used to either acquire other Peso denominated assets or remain liquid or deposited in some banks or financial institutions.

The point of all of these is to demonstrate what is reported in media which is supported by the mainstream “experts”, has less to do with the function of the Peso’s present conditions than commonly believed. In short, the Peso as a function of the Philippine economy, the ENDOGENOUS VIEW, is only one factor but has not been accurately the ENTIRE picture.

The Exogenous Perspective

Here are some empirical based analysis alluding to the themes which supports our second thesis of what drives the Peso; the EXOGENOUS perspective.

From the prolific Stephen Jen of Morgan Stanley (highlight mine), ``Exchange rates are no longer driven by trade or concerns about trade imbalances. We don’t remember the last time someone told us that they were selling the USD because of its C/A deficit. Rather, more than ever, exchange rates are driven by cross-border flows, e.g., diversification flows by central banks in Asia and the Middle East, and structural portfolio adjustments in the private sector, as ‘home bias’ declines worldwide. These flows are very powerful, and have little to do with where USD/CNY is.”

From another article “Global Official Reserves Just Breached US$6.0 Trillion” by the same author Stephen Jen (highlight mine), ``…while the depreciation of the dollar has led to some valuation gains of EUR, GBP and other currencies, in dollar terms, most of the increases in the official reserves reflected actual interventions. Thus, the dollar has indeed weakened this year, but the size of the interventions conducted by the emerging market central banks is rather extraordinary.”

From RGE Monitor’s astute Brad Setser, ``That story – when augmented with a story about rising oil savings and the investment of the oil surplus in (offshore) dollar assets – describes the world from 2001 to 2005 rather well. The US deficit rose from $385b to $755b (an increase of $370b). That increase offset a $127b increase in developing Asia’s surplus and a $263b increase in the surplus of the oil exporters.

``But as the dollar-RMB depreciated against Europe and oil-exporters started buying more European assets, the system evolved. China started to run large bilateral surpluses with Europe. And if 1/3 of the $1.2 trillion increase in official assets is invested in Europe, Europe is now receiving a $400b capital inflow from emerging market central banks and oil funds. That inflow seems to have induced a swing in Europe’s current account balance – This swing doesn’t show up in the data for the Eurozone as clearly as it shows up in the data for the European Union as a whole. That makes sense. Eurozone banks take the inflow from Asia and the oil states and lend it to Eastern Europe. But the overall result is clear: the IMF now forecasts that the rise in the emerging world’s surplus will be offset by a rise in Europe’s deficit.”

Notice some key words: “trade/current account imbalances”, “driven by cross-border flows”, “diversification flows by central banks”, “interventions of emerging markets” and “oil savings and the investment of the oil surplus”, where none of these delve with the issues of domestic currencies relative to its respective domestic economy but rather in the context of the currency’s relationship seen in the spectrum of global trade, savings, investments and/or finance flows.

Succinctly put, the Philippine Peso can be seen as a function of the global dynamics, particularly of the present Fiat Paper money standard.

Figure 4: RB of Australia/IMF: Regional Movement

To illustrate, since we have introduced the macro perspective in currency market dynamics, the left chart in Figure 4 shows to us how ASEAN countries have performed since 1985, courtesy of Glenn Stevens Governor of the Reserve Bank of Australia in his July 18^th speech.

Since 1997, ASEAN countries have moved almost uniformly in terms of the general trend, i.e. from crash to recovery, albeit, the distinguishing factor comes with the degree of relative price actions.

In the right side of the same chart, courtesy of IMF, shows of how Asian Currencies have generally appreciated in 2006. In pecking order, the Philippines ranked fifth following Thailand, South Korea, Indonesia and Singapore.

Again our point is, evidences point toward the Philippines’ predisposition to move along with the region, concomitantly or belatedly.

Figure 5: Yardeni.com: Philippine Foreign Exchange Reserves (left), Joey Salceda/PSE Economic Stock Briefing-Feb 21, 2005 right

The right frame of Figure 5, from a PSE presentation of Presidential Chief of Staff Joey Salceda shows how the Peso severely lagged the region in early 2005, hence its present outperformance could viewed from a perspective of a “catch-up mode”.

Nonetheless, the left frame of figure 5, again from yardeni.com manifests of the explosion of Philippine forex exchange reserves at the end of 2004. This forex trend appears to show of more correlation to the Peso than that of the others, but then again such correlation seems to have incepted only in 2005.

Like us, the IMF believes that portfolio flows have been a key variable in determining the Peso’s increase here is what they wrote (emphasis ours), ``There was also a pronounced acceleration in net portfolio inflows once global risk appetite resumed in Q3 following the sell-off in May-June, with net portfolio inflows from July through November of $1.3 billion, five times the level in the same period in 2005 (Chart 8) [figure 3-ours]. Against this backdrop, the peso appreciated by 7½ percent against the U.S. dollar during 2006, even as the Bangko Sentral ng Pilipinas (BSP) continued to build reserves, while using off-balance sheet currency swaps with local banks to reduce the impact on reserve money. The authorities also used the greater availability of foreign exchange to repay external debt, and to reduce their reliance on external borrowing."

So the IMF tells us that global dynamics have had a hand in influencing portfolio inflows which has coincided with the strength of the Peso.

Hence from an exogenous point of view, one has to factor in demand and supply relative to global monetary and fiscal policies (e.g. which countries are printing more money, forex reserves allocation and trends of sovereign wealth/pension funds), global trading patterns (e.g. growing regionalization trends), macro savings and investment dynamics (e.g. oil surpluses recycled into domestic real estate investments, Japan housewives “Mrs. Watanabes” into carry trades, and demographic trends), global financing and market trends (e.g. US-Asian/Petro Economies-Vendor Financing scheme or the “Bretton Woods 2”, McKinsey’s New Power Brokers-Petro dollars, Asian dollars, Hedge funds and Private equity), evolution of the financial markets (e.g. integration and consolidation of markets, innovative securitized or structured finance products), cross border capital flows, geopolitics and economic linkages.

In our point of view, the premier variable in today’s Peso is the state of the US dollar as a consequent to these agglomerated variables. The alternative aspect is that the Philippine Peso has not been rising but rather the US dollar has fallen against almost all currencies, given the US dollar’s de facto reserve currency status in today’s Paper Money system. Given the change of perspective the issues hinged from the domestic angle changes.

Market Expectations or Speculative Capital

Non market practitioner-experts usually view issues from the perspective of theories but usually base their analysis from select or preferred statistics. Some of such analysis most frequently discounts on the dynamism of market forces, where the nomenclature is that people act or behave like automatons; easy to diagnose, responds uniformly and actions easy to forecast. This resonates very rigid thinking.

In contrast, many market practitioners clearly understand that markets reflect on the psychological output from collective investors. As such, given that people are inherently emotionally driven, markets could occasionally mirror bouts of irrationality or undergo emotional vertigos at certain points of a trend.

Since the Peso, which is traded in the currency market, is rated by investors, speculators and other market participants who are responsible for setting a price for it, based on subjective opinions then they are equally subject to such volatilities and extremities.

Hence we will borrow from George Soros’ as our third view for the currency market, called the “Speculative Capital” or in our terminology the market’s expectations.

Speculative capital essential deals with returns expectations, where as George Soros wrote in his book the Alchemy of Finance (highlight ours), ``moves in search of the highest total return. Total Return has three elements: the interest rate differentials, the exchange rate differentials, and the capital appreciation in local currency. Since the third element varies from case to case we can propose the following general rule: speculative capital is attracted by rising exchange rates and rising interest rates.”

The basic motive by any market participant is to seek the highest returns. And when a confirmatory trend is set, investors tend to pile in so as to reinforce the beliefs or convictions established by the nascent trend. Hence momentum sets in which allows for the trend to persist until a certain phase where the cycle turns or inflects.

Adds Mr. Soros (highlight ours), ``To the extent that exchange rates are dominated by speculative capital transfers, they are purely reflexive: expectations relate to expectations and the prevailing bias can validate itself almost indefinitely. The situation is highly unstable: if the opposite bias prevailed, it could validate itself. The greater the relative importance of speculation, the more the unstable the system becomes: the total rate of return can flip-flop with every changes in the prevailing bias.”

So while “fundamental factors” such as Endogenous or Exogenous facets could be utilized to establish rational based valuations for investors in the currency market, cyclical factors based on price based expectations can thus lead investors to make fundamental justifications based on prevailing price actions, instead of the other way around.

Hence, under extreme ends experts are likely to be susceptible to justify or provide simplified explanations based on present prices even if the markets have been in essence prompted by unstable speculation. A view likely to be erroneous.

This is why in contrast to the “know-them-all experts” we can say through our experience that markets can in itself become inexplicable at certain times.

So as Mr. Soros implicitly warns, one must not always trust or depend on fundamental based views when markets could actually be swayed by sheer emotions, and thus lend to boom busts cycles.

We share such view.