Every generation suffers its particular fantasies. So it was a century ago. Investors had grown so immune to the consequences of war that bond markets from London to Vienna didn’t flinch after the assassination that provoked World War I. Three weeks later, in the summer of 1914, the fear premium amounted to a total of one basis point. Then, in quick order, European markets ceased to function. A notable feature of this paralysis is that nothing of substance had changed – war had not been declared by any of the parties, but by now, minds were hyperventilating. Illusions today are such that financial imbalances and debt creation have grown to impossible proportion.—Frederick J Sheehan Jr.
In this issue
Bullseye! Panicked BSP Slashed Reserve Requirements in the face of Meltdown in Philippine Bonds!
-Why The Volte-Face Of The BSP? The True Reasons Behind Inflation-Targeting
-First Possible Reason: BSP’s Dread of Positive Real Rates and Monetary Tightening
-A Second Possible Reason: Shortfall in Taxes
-BSP’s Stimulus in the Face of the ROPs’ “Meltdown”
-Who Suffers from the Turmoil in the Philippine Bond Markets
-Why the Stock Market Will Be The Last To Know
Bullseye! Panicked BSP Slashed Reserve Requirements in the face of Meltdown in Philippine Bonds!
At the close of Friday’s trading sessions for stocks, bonds and the USD-PHP, the Bangko Sentral ng Pilipinas (BSP) surprisingly announced* that it cut the banking system’s reserve requirement: “The Monetary Board announced today the reduction in the reserve requirement ratio by one (1) percentage point as an operational adjustment to support the BSP’s shift toward a more market-based implementation of monetary policy as well as its broad financial market reform agenda. The reduction will apply to the reservable liabilities of all banks and non-bank financial institutions with quasi-banking functions with reserve requirement currently at twenty (20) percent”
Wow, that’s barely I week since I wrote about the BSP’s addiction to stimulus! [See As the BSP Resists From Tightening, Long-Term ROP Yields Soar! February 11, 2018]
If the Philippines have attained “sustained robust growth and macroeconomic regulatory environment” why has the BSP’s ICU or emergency policy measures remained in place? In fact, why did the BSP cut interest rates in 2016? It is not because of the “Corridor” system which it made as justification. They could have used the 2014 rates as a baseline for the new system.
Most importantly, why the need for the permanence of stimulus? Is a person considered standing normally if he/she cannot do away with crutches?
Last January 31, officials of the BSP denied that they would undertake such actions, stating that further stimulus was not required
CURRENT financial conditions are not yet ripe for planned cuts in bank reserves since the economy remains awash with cash, the central bank chief said.
Bangko Sentral ng Pilipinas (BSP) Governor Nestor A. Espenilla, Jr. said robust growth in money supply and bank lending puts off plansto trim the 20% reserve requirement ratio (RRR) which is imposed on universal and commercial banks.
“While the current manageable outlook for inflation allows scope for a reduction in RRR, domestic liquidity conditions are not unduly tight, as both M3 (domestic liquidity) and credit continue to expand at double-digit rates,” Mr. Espenilla said in an interview with GlobalSource Partners that was published on Jan. 28.
NO NEED FOR MORE STIMULUS
“Moreover, the overall pace of credit growth is also considered to be in line with the requirements of the economy, suggesting that additional stimulus to the real economy is not necessary at present.”
Why The Volte-Face Of The BSP? The True Reasons Behind Inflation-Targeting
So just what drastically changed over the span of FIFTEEN days????
Why the volte-face of the BSP? To what developments have the BSP responded to for it to abruptly embrace “additional stimulus”??? Has liquidity conditions suddenly and dramatically tightened???
And what happened to the reiterative panegyric of “robust growth and macroeconomic regulatory environment”?
Stunningly, just when about everyone had been bloviating about the supposed path towards constricting money flows, the BSP moved in theopposite direction!
International analyst William Pesek even chided the BSP chief for accommodating political exigencies which comes at the expense of the institution’s credibility
From the Nikkei Asian Review (Questions abound as Philippine central bank holds fire, February 15, 2018)
Why, then, is Philippine central bank Gov. Nestor Espenilla leaving borrowing costs unchanged?
Since the bank's no-action decision on Feb. 8, markets are abuzz with two possible explanations. The more comforting: Seven months into the job, Espenilla is taking a wait-and-see approach to the shake-up in global markets. Stirring the monetary pot now, his team may reckon, could do more harm than good. The more troubling: Politics is standing in Espenilla's way.
President Rodrigo Duterte's bloody drug war gets the headlines, but it is his assault on Philippine institutions that is chipping away at the nation's democratic bona fides. Since taking office in June 2016, Duterte has faced off against lawmakers, judges and the press. His first six months in the presidential palace saw Manila's ranking in Transparency International's corruption perceptions index fall six rungs -- to 101st from 95th in 2015.
Is the Bangko Sentral ng Pilipinas (BSP) next? So far, Duterte has avoided putting pressure directly on the nation's most respected institution. But if his antics on the campaign trail are any guide, the BSP needs to watch its back. Before he was elected, Duterte accused BSP staffers of leaking his bank records (the central bank vehemently denies it). Only the bank's inner circle knows if the BSP is pulling its monetary punches to avoid Duterte's wrath.
While the political environment will always be a component for the institution of monetary policies, the BSP’ operating framework have been glossed over: inflation-targeting.
The stated goal of “promoting price stability” through “low and stable price inflation” by raising or lowering of interest rates based on above-target or below-target inflation obscures its genuine objectives
The reality is that inflation is about financial repression, or political process of redistribution channeled through the monetary system favoring the governing political institution. Or, it is an invisible wealth transfer system of the government
To put it more precisely, as the great Ludwig von Mises explained** [bold added]
…when a government increases the quantity of paper money, the result is that the purchasing power of the monetary unit begins to drop, and so prices rise. This is called inflation…
The most important thing to remember is that inflation is not an act of God; inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy—a deliberate policy of people who resort to inflation because they consider it to be a lesser evil than unemployment. But the fact is that, in the not very long run, inflation does not cure unemployment.
**Ludwig von Mises, Fourth Lecture: Inflation. Economic Policy: Thoughts for Today and Tomorrow, Mises.org
From this perspective, inflation-targeting thereby embodies a mild or benign wealth redistribution scheme.
Furthermore, as I noted last week, the CPI is a distraction. The PSA and the BSP can produce CPI data that would conform to its desired policy which no one would know. Or, the CPI could be engineered to fit their intended policies rather than implement policies in response to the CPI.
Since neither has the private sector provided competition to countercheck the official CPI nor has the CPI been subject to audit, market prices would be the best measure to assess the efficacy of the BSP’s policies.
First Possible Reason: BSP’s Dread of Positive Real Rates and Monetary Tightening
The negative real rate regime is a channel from which the national government (NG) derives its subsidies from the BSP’s inflation-targeting policies.
First, interest liabilities of the NG are paid below free market rates.
Second, as early recipients of the newly issued money, the government bids away resources from those at the lower end of the spending chain, thus, benefiting from the resource transfer through price differentials. Cantillon Effects represents the redistributional properties from the relative price changes between the time of the creation of new money and the full adjustment to the increase in supply.
Third, the banking system, functioning as a major source of monetary inflation, likewise benefits from the Cantillon Effects. Because negative real rates serve as a subsidy to bank borrowers, at the expense of savers, bank credit expansion booms (other things being equal). The surge in bank credit provides initial stimulus to business and consumer spending, which function as implicit or indirect subsidies to taxes.
The difference between the yield of one-year ROP notes with the official CPI should serve as a worthwhile proxy of subsidies transmitted from interest rates and from the Cantillon Effects
As previously noted, the sweet spot of inflation-targeting occurred in 2012-2014. When the BSP raised policy rates in 2014 in response to spiking real economy prices, real rates turned positive. Disinflation, a slowdown in GDP and corporate earnings were its symptoms. Shopping mall vacancies emerged. The BSP panicked that prompted the use of the nuclear option: DEBT MONETIZATION. Since then, the BSP has operated in an ICU mode.
Changes in bank credit also resonated with the changes in NG’s tax revenues.
From this perspective, I offer two conjectures on the possible causes for the latest BSP’s actions.
At the end of January 2018, negative real rates as measured by the negative spread between the CPI and the 1-year yield ROP note deepened to 1.18%. And at this point, the BSP seemed satisfied. So they denied the need for a stimulus.
But the widening gap was mainly due to ramifications of TRAIN. To recall, to partly offset potential price volatility from the enactment of TRAIN, the BSP withdrew a modest amount of liquidity last December. [see Did the BSP Drain December Domestic Liquidity To Neutralize TRAIN’s Price Hikes??? February 6, 2018]
But something dramatic occurred between the end of January to mid-February.
That something was long-term ROP yields SPIKED! Or, Philippine bonds suffered a convulsion! We will talk about this later.
Even the 1-yr yield increased to 3.28% last Friday (February 16) from 3.044%.
The BSP’s apprehension most likely stems from prospects of surging yields which may lead to POSITIVE real rates.
POSITIVE real rates wouldn’t just translate to systemic tightening; it would entail the negation of implicit subsidies to the NG. And such inauspicious events emerge at the time the NG has been accelerating its infrastructure projects! Rising costs of financing could derail Public-Private Partnership financed projects. At the same time, more public borrowings would be required to finance a direct implementation of these grand projects.
A Second Possible Reason: Shortfall in Taxes
There is a second possible affiliated or related reason. Price instability caused by TRAIN combined with the withdrawal of liquidity by the BSP last December could have spurred drastic slowdown in tax collections.
Some clues:
Motor vehicle sales growth plunged to 4% in January from a stratospheric 33.4% last December.
TRAIN has amplified the volatility in motor sales activities during the last two months.
December’s stunning sales jump represented sales forwarded in response to anticipated higher prices. January’s sharp sales slowdown thereby reflected on such aberrations.
But I am impressed. Sales still posted positive growth. The offsetting effects of easy money policies have notably cushioned the decline. Nevertheless, January’s sales slack puts the downtrend (peak auto dynamics) back on track. The following months should give us a better picture of the health of the motor vehicle industry.
It needs to be recalled here that auto manufacturers have scaled down production over the past months. January production may have extended such sluggishness
Remember, transport production represents close to half of the durable investments in the PSA’s GDP! Sustained uncertainty over the transport sector will have material consequences on the statistical national accounts data.
There is more.
Has the manufacturing sector suffered another sharp slowdown? Well yes, according to Markit’s Nikkei manufacturing PMI.
From the Markit: (bold mine)
January data suggested that demand was partially hit by higher excise taxes which were effective from January 2018. Growth in new business intakes slowed to the weakest since September, prompting a marked deceleration in output growth. Production volumes increased at one of the slowest rates since the survey started in January 2016. There were signs of ongoing spare capacity in the manufacturing sector. Backlogs of work continued to fall, with the lack of capacity pressure, in turn, weighing on hiring. Jobs growth slowed to the weakest in the current four-month period of higher employment
Buying levels also rose at a slower rate in January, which led to a mild accumulation of pre-production inventories. Growth in stocks of purchases was seen at one of the lowest in the survey history. Meanwhile, increased demand for manufacturing inputs placed pressure on supply chains. Vendor performance deteriorated for a third month running at the start of the year, though the pace at which lead times lengthened slowed from December. Firms cited port congestions, poor traffic conditions and new tax laws as reasons for supply delays. Inflationary pressures built further in January, with survey data suggesting that supply-side factors remained responsible for higher prices. Input cost inflation accelerated to one of the highest rates in the survey series, with firms blaming new excise taxes as the key driver. Other reasons included a weaker exchange rate and higher world commodity prices. Rising costs led companies to raise their selling prices sharply and at the quickest rate on record.
So excise taxes, higher input prices, weak demand and logistical bottlenecks were among those mentioned as having been responsible for the manufacturing downturn. One can add the transport woes to this. That’s aside from the back shifting impact of excise taxes on targeted industries such as Coca-Cola [See HB 10963 TRAIN’s Initial Victim: Coca-Cola Will Be Laying Off Workers! The Back Shifting Effect of Excise Taxes Validated! February 8, 2018]
As a side note, I wanted to discuss the contradictory statistics of the Nikkei PMI, the PSA’s manufacturing survey and 4Q’s merchandise trade and the GDP (manufacturing, export and import), but I have run out of time. Perhaps in another time.
These numbers suggest that many parts of the economy may have been body-slammed by the excise taxes, and possibly, by the BSP’s siphoning of liquidity in December.
Yet, the lifting of the 1% reserve requirements on deposits and deposit substitutes means more money for banks to lend. Consequently, such entails to the acceleration of money supply growth, and transmitted into real economy as heightened price pressures!
The BSP has essentially been affirming my exegesis of their policies. Back in December I wrote, [See Politics Versus Markets: Aided by Fitch, The BSP Fights Off Surging ROP Bond Yields! December 17, 2017]
ROPs have been anticipating a tightening by the BSP. A better perspective would be that ROPs have virtually been pressing the BSP to raise policy rates. However, the BSP has palpably been unwaveringly resisting.
This is why I say that the BSP has been terrified by the 2015 episode for them to adamantly cling to the belief that free lunches would last forever!
These are evidence that the BSP would sacrifice the peso at the altar of the political convenience brought about by the twin bubbles: a government bubble riding on top of a credit bubble!
The BSP appears to be digging itself a bigger hole with its “ALL or NOTHING policies”. As I said last week, the BSP has very limited elbow room for conducting emergency operations. And thus, the BSP operates virtually with little margin for error.
A major policy error would crush the peso!
BSP’s Stimulus in the Face of the ROPs’ “Meltdown”
Back to the bond meltdown.
Instead of the peso, it has been the domestic bond markets that have suffered a meltdown
Let us go back basics.
As bond yields rise, bond prices fall and vice versa. Let us assume that a sovereign bond has a 10% annual coupon rate and a par value of Php 1,000. Since the bond pays 10% annually, it pays Php 100 in interest. Since its annual yield is the interest divided by its par value, Php 100 divided by Php 1,000 represents the bond's nominal yield of 10% which is the same as its coupon rate.
Let us say that the same bond was sold at Php 900. Since the new owner receives the same rate of interest of Php 100, the bond’s nominal bond yield, Php 100/Php 900 rises to 11.1%
Thus, a 10% drop in bond prices resulted in an increase of 111 basis points or 1.11% (from 10% to 11.1%) in yield.
If you revert to the first chart, you will see that yields of 10, 20 and 25-year ROPs have had a parabolic ascent.
Yields of 7, 10, 20 and 25 year ROPs have spiraled by a whopping 113 bps (1.13%), 101 bps (1.01%), 77 bps (.77%) and 105 bps (1.05%) year-to-date! (upper window)
Though most Asian sovereign bonds have begun to climb incrementally, intensifying bond volatility has been occurring only in the Philippines! (middle window)
And what had been once a convergence trade has now morphed into the divergence trade as 10 year ROPs outsprint its US Treasury counterpart! (lower window) The difference between the 10-year ROPs and USTs have been widening fast.
And the huge selloffs in Philippine bonds have now coincided with the sharp ascent in the USD peso +1.01% week on week (+4.15% year to date).
With the exception of the peso and the Chinese Yuan (-.61%), Asian currencies rallied strongly this week: Australian (+1.18%) and New Zealand (+1.8%) dollar, Japanese yen (+2.4%), South Korean won (+2.65%), Singapore dollar (+1.24%), Thai baht (+1.24%), Malaysian ringgit (+1.15%) and the Indonesian rupiah (+.76%)
Yes, the BSP has indeed been worried about something which has not been broadcasted to the public.
Oh, they won’t admit it until it becomes so obvious!
Who Suffers from the Turmoil in the Philippine Bond Markets
Long-term yields essentially comprise expectations of the path of short-term rates, the inflation, and the term premium (credit risk and supply issues).
Spiking yields suggest that the BSP’s statistical CPI numbers may have been materially understated. That's if bonds have been pricing in more of inflation expectations more than the term premium. The concentration of the selling activities at the longer end of the curve seems to validate such insight.
Rising yields will also mean higher rates for the main street.
Of course, the BSP will “do whatever it takes” to resist from tightening. However, doing so translates to continuing strains on the peso and the ROPs, which will likely force its hand one of these days. And my guess is - once forced; a disorderly adjustment process would ensue.
Will the adverse effects of higher interest rate expenses on corporations and individuals be counteracted with income growth? Or, will spiraling financing cost encumber their balance sheets?
Since the opposite side of spiraling yields is tanking bond prices, this entails LOSSES to holders of such bonds.
Who might that be?
To answer this, a detailed breakdown of the investor profile of Philippine government bonds based on the Asian Development Bank’sADBBondsOnline.org should give us clues.
The biggest holders are the banks and investment houses which held 39.7% share of total outstanding government bonds as of 3Q 2017, up from 37% 3Q 2016. Next are the Contractual Savings Institutions and Tax-Exempt Institutions (SSS, GSIS, Pagibig and life insurance companies) at 31.6% share in 3Q 2017, slightly up from 31.4% in 3Q 2016. In the third spot, the Bureau of Treasury Managed Funds which holdings had materially been down at 11.3% over the same period from 14.7% a year ago. Placed fourth are the Brokers, Custodians and Depositories which % share fell substantially to 7.2% from 9.0%. GOCCs and LGUs had .5% share in 3Q 2017 from .6% a year ago. The share of the Other account (mostly individual and private corporations) grew to 9.7% from 7.3% a year ago.
So banks, CSIs, and Others were the largest buyers of government bonds.
Considering that ROP yields were substantially higher across the curve in 3Q 2017 relative to 3Q 2016 (average increase 97 bps), potential deficits from the bond portfolio provides as an inkling as to the reason behind the spate of bank borrowing via Long Term Negotiable Notes/Certificate of Deposits last year and this year, aside from stocks rights offering of several banks this year.
Potential losses on bond holdings also provide an insight into the massive changes in the banking investment’s portfolio accentuating on Held-to-Maturity (HTM) assets.
The NG’s outstanding securities as of December 2017 tallied to Php 4.5 trillion based on Bureau of Treasury. Fixed rate T-Bonds from 2-year to 28.5-year (Php 1.921 trillion) and Retail T-bonds from 3 to 25-year bonds (Php 1.214 trillion) accounted for 70.5% of the total.
The financial industry (banks and non-banks) must be enduring substantial losses.
Why the Stock Market Will Be The Last To Know
Of course, the stock market will be the last to know.
The reason is obvious.
There has been a systematic falsification of market prices. The impairment of price discovery leads to grotesque distortions of the health conditions of the nation’s capital formation. Finally, the massive accounts of mispricing entails of a gargantuan misallocation of capital goods
The Phisix rose by 108.75 points or by 1.28% this week. The transition pumps toward the runoff period totaled 129.61 or 1.5%. Thus, the week’s ENTIRE gains emanated from price fixing!! Or, to exclude the price pumps would mean that the Phisix would close the week down!
In the broader markets, declining issues walloped advancing issues 499 to 343 for a significant margin of -156. It was a clean sweep for declining issues this holiday-truncated week.
Ever since the PSEi 30 broke out to a new record last September, market breadth has been deeply negative. Put differently, there has been little participation in the broad markets which should have confirmed the breakthrough. But this confirmation has yet to occur.
Again the reason is simple. The breakout had been pillared by pretense. These were products of unceasing manipulation of prices resonant of a Sodom and Gomorrah market.
The disfigurement of prices extrapolates to heightened fragility from the exposition of such charade. Then, all hell would break loose.
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