Sunday, February 10, 2008

Is the Philippines Resilient Enough to Withstand A US Recession?

``Do what you will, this world's a fiction and is made up of contradiction.” William Blake

We recently stumbled across a Pollyannaish article whereby a domestic broker boldly declared that the Phisix as still in a bullmarket and forecasted the Philippine benchmark to reach new record levels or gain some 25% from the current levels at the end of the year (I hope they are right, but bearmarkets descends on a ladder of hope).

The article cited a string of positive “micro” developments to justify its projections which was mostly buttressed by the assumption that US-Philippine linkages have shrunk in significance to meaningfully impact the domestic economy.

While we partially sympathize with such views, we think that such sanguinity is uncalled for simply because, for us, such outlook greatly underestimates the risks involved under today’s operating environment aside from overestimating the resiliency of the Philippines.

The fact is, given today’s highly correlated financial markets as shown in Figure 1, a bullish view on the Phisix basically requires either of the two outcomes—a mild or benign US recession which recovers swiftly OR that the Philippines and to some degree other ex-US financial markets or nomenclature asset classes “decouples”.

Figure 1: Still A Bullmarket?

As you can see, global equity markets reacted in near unison (vertical blue line) last October to the recent tremors which begun last July (look at the peaks and troughs of each benchmarks).

The Phisix (center window) peaked earlier compared to the synchronous decline of the Dow Jones World Index (topmost window), emerging markets (pane below the Phisix) and Asia (ex-Japan markets). But this dynamic of tight global correlation has been evident since 2000 and has even intensified during the latest bull run, as repeatedly discussed in the past. So basically, until a “decoupling” becomes manifest, the fate of global markets is significantly dependent on the developments in the US.

Besides, on a technical standpoint, none of the above markets looks like operating under bullish conditions. In fact, with over half of global markets touching the 20% loss threshold --which is a technical definition for a bearmarket--last January 21st, this means that the Phisix and the many global markets have transitioned to an interim bearmarket as discussed in our January 21 to 25 edition [see Phisix: On A Bear Market Template, Bear Market Rules Apply].

As you readers maybe familiar with, we have been a proponent of “past performance does not guarantee future outcome”. We argued about the bullish case of “decoupling” signals in our January 21 to 25 edition [see Emerging Markets and the Philippines: The Last Shoe to Drop?] where in the past selloffs, emerging market assets were dumped across the board, but today the degree of categorical selling has diminished. In fact, there had even been signs of divergences-recent selloffs were ONLY seen in the equity markets-not the bonds or the Peso (Ok, Philippine bonds declined this week-mostly on the account of inflation concerns; emerging bonds fell too so as with the Peso).

Philippine Exports Immune From US Recession?

Figure 2: Deustche Bank: Top 5 Export partners 2004

Ok, let’s us play the devil’s advocate and assume the bearish scenario.

We read many discussions asserting the premise of Philippine economic resiliency based on the diminished linkages between the US and the Philippines, where exports to the US formerly accounted for around 35% of total exports in 1995 to 16% in 2004 see Figure 2.

On the surface, indeed our exposure to the US has significantly declined, but what is thoroughly overlooked by such analysis is that the operating dynamics of the region’s trading patterns had a significant makeover.

The recent growth of intraregion trades had been a function of “vertical integration of production chains, whose final demand”, according to ADB “is outside the region” see Figure 3.

Figure 3: ADB: Regional Supply Chain Platform

What this means is that instead of direct shipments, regional trading dynamics have morphed or shifted into an interdependent network of supply chains where intraregion exports has mainly functioned as inputs to the production processes meant for reexports to major economies or outside the region.

Today’s trading dynamics operates like a regional outsourcing. As an example we’ll take the composition of a Dell laptop as described by Gavekal Research in Our Brave New World. ``The keyboard was made in China, the PCB made in Singapore and the motherboard was made in Malaysia. The flatscreen was made in South Korea. The semis were made in Taiwan, on US-owned design patent. Some of the software were compiled in the US, some in India, some in Sweden and some in Russia. The design of the notebook itself was done in Austin, Texas. Finally the laptop assembled in China.”

As you would have probably been aware of, China has operated as the quasi-final assembly line to the regionalization of the production process. That is why we are concerned more of the evolving risks in China than the US and or how a US downturn may impact China.

However as ADB’s notes (Uncoupling Asia Myth and Realities), ``more that 70% of intra-Asian trade consists of intermediate goods used in production, and half of this intraregional trade in intermediate goods is driven by final demand outside Asia. Consequently, about 61.3% of total Asian exports (instead of 43% of total exports) are eventually consumed in the G3 countries. Within Asia, the PRC is the largest driver of regional exports, but its final demand accounted for only 6.4% of total Asian trade, which was only half of the contribution from Japan and slightly below a quarter of that from the US. The results show that the G3 countries still remain as main export destinations for final goods departing from Asian ports, when taking into account the share of intermediate goods trade that is for assembly and production within the region but that is eventually shipped out of the region.”

What this means is that Asia is still heavily reliant to the consumers of US, Europe and Japan. This is where the depression advocates emphasize- a severe drop in consumer spending in the US which may ripple to the consumers in Europe and Japan-will depress the supply chain network of the region (yes including the Philippines).

Because of the informal adoption of Bretton Woods 2, or a monetary regime of competitive managed devaluations by most Asian economies in the past, this signifies as subsidies to the production aspects of the region’s economy at the expense of the consumption side. Hence we have seen in the recent past, the soaring economic growth of emerging Asia, the migration of industries from the US to Asia, the proliferation of outsourcing, the massive accumulation of foreign currency reserves, the emergence of sovereign wealth funds and Asia’s vendor financing scheme with the west.

On the obverse side, this monetary paradigm represents subsidies to the consumers at the expense of the production side for the consumption based Western economies. Hence, the explosion of debt driven asset markets (real estate and stocks) supported by financial innovations (derivatives, structured finance, originate and distribute models) and the massive current account deficits.

Since currency adjustments are just beginning to impact Asian consumers, global depressionists say this would not be enough to stimulate Asian consumers to pick up or fill the slack from the retrenching Western consumers.

And worse, because of the huge global current account imbalances, past improvements in the current account balances of deficit countries as in the US have coincided with previous financial crisis, as global liquidity is drained or siphoned off the markets, as shown in Figure 4.

Figure 4: Black Swan Capital: Money Back to the Center?

The narrowing of US current account imbalances have in the past been associated with either US recession (1990, 2000) or a crash in the US markets (1987) as systemic deleveraging unravels. And it seems that we are feeling similar pressures today.

Money back to the center means that under a debt driven deflation scenario or contracting global liquidity, which global depression advocates predict, money dynamics will evolve from centrifugal (flowing outward from the center) to centripetal (flowing towards the center) or money will seek refuge in the US dollar, the de facto reserve currency of the world.

So by virtue of induction in the context of exports, a severe recession in the US will be transmitted throughout the world or to Asia and the Philippines. The bullish house of cards scenario based on an export-only analysis falls. Depression looms.

Will Remittances Save the Day?

Or how about remittances, many have argued that the Philippines’ resilience will be buttressed by continued flow from our “heroes” overseas workers…

Figure 5: DBS Bank: Falling overseas deployment (left pane), Falling Remittances (Peso)

Media accompanied by their coterie experts always pontificate that the Peso’s rise had been “caused” by the surging remittances. As we have pointed out in the past What Media Didn’t Tell About the Peso, and Philippine Peso And Remittances: The Unsecured Knot the correlation of the Peso and remittance growth has been more of a recent experience, in other words, causal relationship is tenuous.

Remittance growth has been exploding since 1990s yet the Peso soared only in 2005. As we have noted, analysis using remittance driven Peso dynamics suggests either a “tipping point” or “critical mass” has been reached enough to tilt the balance in favor of the peso to reverse in 2005 from its 45+ years of depreciation or there had been a tremendous “lag” time for remittances to be reflected in the Peso. For us, it is partially about remittances, and mostly about regional currency regime, the US dollar standard and regional capital flows.

Here is the comment from DBS bank on their first quarter outlook (highlight mine),

``This is the math: in the year-to-3Q07, US dollar-denominated remittances were up almost 15% compared to a year ago. In peso terms, however, this gain translated to just 4.4% YoY - only moderately faster than the 3.2% YoY pace of inflation at home. As is evident from the chart, the damage was most acute in 3Q07, when peso appreciation accelerated as remittances growth slowed. No wonder then that consumer spending, which has come to be so dependent on the income that overseas Filipinos send home, slowed noticeably in 3Q07, to 5.6% YoY from a three-year high of 6.0% in 2Q07.

``Looking ahead, consumer spending in 2008 looks set to, at best, only match the 5.7% rise we expect for this year, assuming that monetary policy will be supportive. Remittance growth is likely to slow, on a combination of a stronger peso and slower deployment of overseas workers. The government, in wanting to improve the quality of the workers it sends overseas, has been placing more stringent conditions on deployment, including the lifting of minimum wages. Foreign countries can also be partisan in their labour policies, such as the UK’s recent move to hike salaries for workers from non- European Community members.”

In the right chart of Figure 5, DBS Bank notes of how the Peso has appreciated more than the pace of growth for remittances. Here we raise some questions; why has the Peso continued to rise in the face of declining growth rate of remittances? How valid is the conventional “cause-and-effects” view of the rising Peso?

Another important variable is the question of remittance contribution to personal consumption. The highly popular explanation is that remittances have been a major contributor to personal consumption and thus has served as a major fuel for our domestic economic growth. But like the analysis above, they seem to be more of logical deduction than of analysis based on statistical estimates or figures.

In short, until we see some figures, we remain unconvinced of the so-called “multiplier effect” of remittance spending, which I believe is highly overrated (a justification used by experts to call for more Central Bank intervention). Since I wrote the National Statistical Coordination Board, to request for this info last October we have not received a reply (we wrote them again this week).

As proof again look at the analysis above, it says that because of the declining growth of remittances (using 3rd quarter stats), personal consumption should slow. Yet recent consumption data during the 4th quarter shows of a substantial rise as our domestic GDP soared to decade year highs. According to, ``consumer spending grew by 6.3 percent from 5.8 percent a year ago.” So essentially, the impact of a strengthening Peso to overall consumption (aside from the purchasing power) has been less than what is accepted wisdom.

Now, DBS suggests that the slowing overseas deployment (leftmost chart) could serve as a probable indicator or precursor to the slowing of remittance trends. Notably this comes in the light of the economic conditions PRIOR to the global credit crisis which may evolve into a meaningful global economic slowdown. This means that wildly optimistic analysis based on recent “strong” trends will get likely get slammed if declining overseas deployment trends conspires with a US recession-global economic slowdown scenario.

Conclusion: Discretion Is The Better Part of Valor

So in the context of exports and remittances, global depressionists have valid arguments which should not be discounted. But the global financial markets and the economy is not just all about exports or remittances, there are other factors at play such as government policies, technological breakthroughs, globalization (finance, trade and labor)/protectionism, geopolitics, demographic trends, monetary dynamics and others.

Let us put into the place an objective perspective, in the context of the Philippine economy, if the highly popular remittances signify 10% of GDP then there is the other unpopular 90% of which is of more significance. Using common sense, I wonder when the popular 10% has surpassed the unpopular 90% in real life importance.

Also, if exports and imports contribute 40% each to the GDP then there is the other 60% to reckon with. Unlike mainstream experts who believe that they are uniquely armed and equipped with sophisticated analysis using modern statistical data which presumably captures the entire spectrum of variable working parts of the economy….we don’t. We don’t pretend to know everything. We even don't know much of anything that's why we question. Hence, we respect randomness or the influences of unknown variables.

Bottom line: Avoid looking for reasons to rationalize one’s biases (confirmation bias). Avoid also from falling into “conflict-of-interest” traps (agency problem). In matter of portfolio risks deployment, as a saying goes, discretion is the better part of valor.


Salve said...

finally! someone who put remittances in the right context. i learned a lot from your most recent post, but got lost on "discretion is the better part of valor". can you please explain further?

benson_te said...

Hi Salve,

Thanks for your comments. Second, sorry for the vague reference on that subject. Since I am writing in the prism of an investor it means the following:

-we should not be looking for news or explanations to confirm our biases or we should be objective in evaluating the markets and not get blinded by our biases.
-we should be aware of the (conflict of interest) incentives by those making pronouncements and not easily be misguided by either extreme optimism or pessimism.
-we should not be aggressively exposed to the market under today’s heightened uncertainty. While we remain long term positive, there are substantial (mostly external) risks that may upset present momentum including a global financial and economic meltdown (my reference to global depression advocates)
-lastly, we should position according to our risk tolerance or the amount of risk we can only afford to take.

As for the Peso you may refer to my original article I wrote last November “What Media Didn’t Tell About Peso”.

Hope this clears everything.


Anonymous said...

From my point of view as an OFW, I can't stop sending back home dollar remittance. But Iam looking for options on how to reduce my income losses by converting it to other currencies aside from the dollar. Actually I want to shelve my dollar deposit this week ASAP. I heard the BSP lost a lot by trying to defend the peso last year. So if I think the peso will reach 35, how should I convert part of my income immediately ? In peso as time deposits or T Bills, in euro ? Appreciate your advice.

benson_te said...

To Whom It May Concern,

Thank you for your queries.

First of all, while I think the US dollar is in a structural long term decline (which should lead to appreciating world currencies-especially in foreign exchange rich and the creditor nations of Asia and OPEC countries), it is unclear if such newly entrenched trend will be foolproof.

What I mean is under the present scenario, where there the underlying risks is for a US recession (which could intensify) and may spillover the rest world, (some doomsday proponents are forecasting a global depression), the US dollar could rally strongly contrary to popular expectations, especially underpinned by the supposition that China gets heavily impacted. As I wrote at the start of the year, the region’s currency strength will be determined by how China’s government would allow its currency to rise under present conditions.

That is why I would recommend instead for you to diversify (keep some dollar holdings, the rest you may convert)

In addition, I read that our government has come up with programs to deal with OFW Purchasing power concerns, particularly hedging programs via insurance or forward exchange contract.

This from the Philippine Daily Inquirer…

“Under the Development Bank of the Philippines’ hedging program, a worker can avail himself of insurance that would allow him to insure one’s dollar remittance at a certain protection rate.

“The worker can later sell the dollars to the DBP at the pre-agreed protection rate.

“Apart from this unique insurance, the worker has another option to avail himself of a forward exchange contract which would allow him to sell his dollars to the DBP at a contract rate on a specified future date.

“The dollars are “locked in” at the contract rate (also forward rate) regardless of the peso depreciation or appreciation.”

Thus, I would also recommend for you to go to DBP’s website and inquire on the program details.

DBP’s website:

Lastly as you are motivated to change your dollar holdings in the face of the prospects of a furtherance of a US dollar decline, one of the impacts of a firming currency is that it would attract OFWs, migrant Pinoys or even capital from Philippine residents stashed overseas (after 40+ years of capital flight) to invest/reinvest in business, or seek alternative Peso investment channels as mutual funds or UITFs or real estate or the stockmarket.

Another advantage I seem to be gathering is that OFWs are getting to be more “financially literate”, which is a welcome news. This should pressure the government to allow market forces to fill the needs of arbitrage, hedging, rechanneling of domestic savings abroad and the development of our capital markets.

Hope this helps.

Remitter said...

Great read! It is truly important to broaden our horizons and think of the aftermaths of recession both from Philippines' point of view as well as from the Asian markets' perspective. The OFWs have already feeing the pinch and it is going to be difficult for them. The hedge funds too have not addressed the problem significantly. Many believe that the situation is similar to the economic slowdown of 1997 when Philippines recovered at a rather slow pace. I am expecting India and China to play a part in this.

Anonymous said...

From IdBagoKo, Ireland

Thank you for an excellent article on the stat of the Peso I thoroughly enjoyed reading for once what is an excellent overview of the currency's dependencies.

Of recent we have seen financial commentators extol the benefits of the OFW remittances to the Philippine economy and some of them wise enough to conclude that too high a reliance on these remittances to balance the budget is a dangerous practice lest the US economy goes into recession with the potential loss of many OFW jobs.

I am surprised that these remittances have such an influence on the value of the Peso. Either the Peso has no real indigenous economic strength backing it, or its appreciation is contrived by financial institutions hiding behind the inflow of remittances as was well illustrated by the phenomenal appreciation of the Peso at the end of 2007.

I suspect that at least to some degree this is not far from the truth, there are tell tale signs that the Peso exchange rate is not entirely based on real market values.

From Jan.2004 to Jan.2008 ** the Peso appreciated by 34% against the US Dollar on the premise the Dollar was getting weaker in the marketplace. Over the same period the Euro appreciated 33% against the US Dollar.

With the appreciation of both currencies being similar you would expect the Euro to Peso rate to be relatively flat, but that is not the case, the Peso appreciated 20% against the Euro over the same period, a miracle! no other currency achieved that. I guess the mark-up on OFW remittances from the Euro sector was not high enough and a cushion was needed in case the Dollar bubble burst; so OFWs in Europe took a hit.

What makes me laugh are statements from the Central Bank saying remittances for this year are expected to be 14% higher than last year. Do they not realize why? or do they know why, and are just keeping 'mum' about it? If I sent $1,000 to my family last year and the Peso appreciates, and I want to make sure my family gets the same Peso benefit this year, I have to send $1,140, an increase of 14%, to maintain the same benefit, you don't have to be an economist to work that out.

But all this has a dark side. If for some reason the remittances dramatically reduce, such as would happen if a recession hit the US, then the budget is in for a rough ride. The Peso would depreciate and I, like 10 Million others, would have to send less Dollars to my family for the same benefit, so remittances would be much less than expected and that would accelerate the depreciation of the Peso; unless of course the Peso rates undergo some creative massaging.

Remittances are 'Funny Money'.

** Rates Source: