History shows that it is not unusual that countries can keep borrowing even when default risk is high. A review of 89 default episodes from 1827 to 2003 shows the typical experience to be a sharp rise in borrowing, both external and domestic, in the run-up to default (Reinhart and Rogoff 2009). Ideally this time will be different, but the record is not encouraging—Jeremy Bulow, Carmen Reinhart, Kenneth Rogoff, and Christoph Trebesch
In this issue:
External Debt Growth Accelerates in Q3! Why This Uptrend Will Continue
I. Justifying Rocketing External Debt via the GDP; Debt Build-Up is a Process
II. The False Equivalence of Measuring GIR with External Debt
III. Current Public Debt Levels Surpass Asian Crisis Levels! The Shift to Activist Central Banking Promoted an Aggressive Debt Regime
IV. Quasi-USD Standard: Massive Surge of External Debt Needed to Prevent the Fall of the Peso!
V. Keeping the Peso Strong: BSP Expands FX Derivative Trades with the US Banking System; The Continuing Slack in Bank FX Deposits
VI. Deepening Dependence on External Debt: Insufficient Organic Economic Sources of FX/USD Revenues
VII. Conclusion: Mounting USD/FX Shorts Magnify the Currency Risk!
External Debt Growth Accelerates in Q3! Why This Uptrend Will Continue
I. Justifying Rocketing External Debt via the GDP; Debt Build-Up is a Process
"Move along, nothing to see here."
This trope represented the commonplace rationalization or defense by the mainstream when confronted with the data on external debt during the pre-pandemic era.
As they see it, the political economy will ably manage increases in debt levels, which they expect to rise modestly.
Well, current developments have run contrary to their expectations.
Proof?
From the Inquirer, December 13: The Philippines’ total outstanding external debt remained a prudent level as of the end of September with $105.93 billion representing 27.3 percent of the domestic economy. The Bangko Sentral ng Pilipinas (BSP) Governor Benjamin Diokno said in a statement the low ratio of total outstanding external debt to gross domestic product (GDP) means that the Philippines sustained a strong position to service foreign borrowings in the medium to long-term. “The country’s [debt to GDP] ratio remains one of the lowest as compared to other Asean member countries,” Diokno said, adding that other key external debt indicators also remained at prudent levels. Enough dollar reserves The country’s gross international reserves were pegged at $106.6 billion as of Sept. 30, representing 8.6 times cover for short-term debt. In the nine months to September, debt servicing—including principal and interest —was pegged at $7.3 billion or 2.6 percent of GDP.
Figure 1
It is incredible to see how the vulnerable public is being taken for a ride by the mirage of statistics.
Published external debt jumped USD 13.93 billion or 15.2% YoY in the 3Q to USD 105.93 billion. (Figure 1, topmost pane)
Debt flows may even be more substantial than those officially declared when we include shadow banks.
Here is the thing. The growth of external debt has been on a long-term uptrend, which slope has steepened or growth has accelerated since Q3 2018.
When interpreting statistics, it is the context that matters.
A comparison of external debt with the GDP may be misleading, not only because of the possibility of the embellishment of the statistical economy but also because the GDP may not be the appropriate measure used. This ratio assumes away the underlying conditions of the real economy (such as liquidity, fiscal deficits, et.al.) and the relevance of interest rates, among many other factors.
By the way, the Japanese Government just admitted that they have been OVERSTATING their GDP in the last eight years.
From Reuters, December 15: The Japanese government overstated construction orders data received from builders for years, Prime Minister Fumio Kishida said on Wednesday, an admission that could dent credibility of official statistics widely used by investors and economists. Prime Minister Fumio Kishida told parliament it was ‘regrettable’ that the data received from builders had been overstated, and it would not happen again While it may have a small impact on past GDP numbers, it could raise questions about the reliability of data used by economists to understand the world’s third-largest economy
See? If a highly developed economy like Japan can juggle with their economic numbers, why can’t our authorities do the same?
Because local authorities are more forthright?
Nonetheless, a charade of statistics will hardly camouflage the escalation of risks.
II. The False Equivalence of Measuring GIR with External Debt
How valid is the use of the Gross International Reserves to measure external debt serviceability?
Again, the accumulation of external debt BEGAN before the pandemic or in the 3Q 2018. The pandemic only accelerated the speed of its aggregation.
More importantly, there appears to be a synchronization of the growth of external debt and GIRs. While GIRs increased by USD 31.657 billion, external debt grew by USD 29.5 billion. This being so, external debt accounted for a whopping 93.23% of the GIR growth since 3Q 2018! (Figure 1, middle pane)
From this perspective, the growth of external debt has accounted for MOST of the increases in the GIRs since Q3 2018.
External debts are, of the essence, liabilities or US dollar shorts, and thus, are not reserves in the context of USD savings or retained earnings.
If debt comprises a significant portion, how can GIRs be used to measure it?
That being the case, it would be misleading to use GIR as an appropriate metric of debt service capability.
Moreover, external debt serviceability will not just depend on generating external revenues or cash flows (exports, tourism, debt, etc.). External monetary conditions will also play a factor. Thus, the bigger the external liability, the more sensitive the domestic economy is to the changes in the external environment.
And in this circumstance, a call on these debts will shatter the mirage of the so-called "reserves".
That said, while it is easy to infer that the recent record surge in GIRs may be attributable to external debt, there are other factors involved. (see below)
Separately, FX reserves outgrew external debt only from 2012. But current developments are pointing to a regression to the pre-2012 days. Bank conditions reflect the developing shortfall in FX liquidity.
The thing is, financial distress or a crisis does not emerge from a vacuum but rather represents an outcome of a time-consuming process. This process typically involves a sharp run-up of debt for some time before the default*. (Figure 1, lowest pane)
*Carmen M. Reinhart, Debt Challenges Ahead, Harvard University The World Bank, June 1, 2020
So unless the pace of debt accumulation (local and foreign) slows soon, it will hit a level wherein the sheer amount would place a heavy onus on the economy.
As an aside, this discussion excludes the ethical segment of public debt; in particular, the distributional effects of debt-financed public spending and debt servicing.
But the debt horse is now out of the barn door!
This week alone, the World Bank declared an approval to lend USD 600 million to the Philippines to fund reforms, and the ADB announced two tranches; USD 250 million for vaccine boosters and USD 175 million for bridges in Marikina.
Authorities also announced other loan deals this week in the name of vaccines and disaster risk management: USD 250 million from Beijing-based Asian Infrastructure Investment Bank (AIIB), USD 100 million from the Export-Import Bank of Korea-Economic Development Cooperation Fund, and 250 million euro facility from the European aid agency, Agende Française de Développement (AFD). Meanwhile, there is also a USD 500 million credit line from the World Bank, which local authorities may tap for disaster response to areas afflicted by Typhoon Odette.
All these in just one week!
So, faced with a coming deluge of USDs, the USD Php tumbled by .66% to Php 50.02 this week.
Naturally, politically motivated lenders, such as multilateral agency ADB, would like to see that they made the right choice, so they upgraded their growth projections of the Philippine economy this 2021!
But the recent experience of Argentina comes to our recall. The government of Argentina secured USD 56 billion, the largest ever loan issued by the IMF in June 2018.
Or, the IMF was too confident of the seeming makeover of the Argentine government for them to extend the record-breaking loans.
Fast forward to May 2020: the Argentine government defaulted on its loans. In August 2020, the Argentine government and the biggest creditors agreed to a restructuring.
These institutions, which took unnecessary risks with taxpayer money, were time and again proven wrong.
III. Current Public Debt Levels Surpass Asian Crisis Levels! The Shift to Activist Central Banking Promoted an Aggressive Debt Regime
Figure 2
And if the comparison of the debt-to-the-domestic GDP ratio is an inappropriate metric, then comparing with debt ratios with other economies in the region represents false equivalence (apples to oranges).
All economies are distinct. Therefore, the capacity to absorb and service debt reflects such national idiosyncrasies.
The debt-to-GDP of the ASEAN countries during the Asian Crisis demonstrated this**.
Debt to GDP ratios varied materially before and after the crisis. Because Thailand and Indonesia suffered the most, their debt-to-GDP ratio more than doubled in its aftermath. (Figure/Table 2)
**Rosario G. Manahan Analysis of the President's Budget for 2003 February 2002 Researchgate.net
It is easy to compare with the region to justify PRESENT debt conditions. But that's because most are more developed than the Philippines.
Alas, we won't likely hear or read about the following.
As of October 2021, the domestic debt-to-GDP ratio stands at 62.34% (with contingent liabilities) and 60.15% (w/o contingent liabilities), exceeding the pre-Asian Crisis levels! The NGDP here reflects the expected 7% growth rate for 2021. The deficit to GDP ratio at 6.27% has likewise topped the pre-and post-Asian crisis levels!
Unlike in the 1990s, interest rates are at a record low today. The concern here is more than debt, but malinvestments financed by debt.
Yes, it may be partially true that the modern economy is likely more productive, but debts are not free lunches.
And the contemporary economy has been established on the increasing dependence on debt.
The difference between then and today is the structural change in the character of central banks. From lender of last resort, the role of contemporary central banks has shifted to an all-encompassing activist monetary institution with the fundamental focus on liquidity provisions.
Or, the transformation of central banks accommodated this embedded reliance on debt.
IV. Quasi-USD Standard: Massive Surge of External Debt Needed to Prevent the Fall of the Peso!
Again, the popular justification for the rapid amassing of external debt is the pandemic.
But that is only partly true.
Yet, ironically, many experts are unaware that the Philippine monetary system operates on a quasi-US Dollar Standard.
Fundamentally, the foreign exchange holdings or reserves of the BSP primarily function as the anchor for its domestic or peso operations.
It is why the International Reserve assets dominate the balance sheet of the BSP. Since 2010, international reserves have drifted from a tight range of 85% to 87% of the total assets of the BSP. (Figure 2 lowest pane)
To this point, the BSP calibrates its domestic monetary operations under the FX reserve benchmark, which is also dynamically adjusted to maintain this ratio.
But the pandemic provided a politically convenient justification for the BSP's direct bailout of the banking system through asset purchases.
Since it purchased directly the securities issued by the central government and indirectly from the banking system, domestic assets zoomed at the expense of FX assets.
So the BSP made accompanying modifications, which came primarily from the FX side of its balance sheet, through public borrowings.
This historic bank rescue saw the balance sheet of the BSP soar by 58% or Php 2.929 trillion in October 2021 from December 2019! (Figure 2 middle pane)
Though the BSP’s asset growth rate has tapered, it continues to break records in peso.
Yet, with the BSP expected to keep a loose regime to accommodate the expansion of domestic money supply growth, with little support from the economy, public borrowing in foreign exchange must continue to increase rapidly to bring up its levels towards the former parameter.
Before its announcement to continue financing the debt of the National Government in 2022, the BSP increased direct QE operations by 10.3% this November. (Figure 3, topmost pane)
Interestingly, after four months of sharp increases, the currency growth issued by the BSP stalled. It grew by 9.56% in November from 9.73% a month ago.
With the domestic money supply growing faster than its FX holdings, this represents the case for a sharp depreciation of the peso.
That point made, the current flows of USD/FX from external debt help diminish pressures on the peso by kicking the proverbial can down the road.
Unfortunately, the future settlements from the massive maladjustments in FX liabilities or 'US shorts' should exacerbate the pressure on the peso.
V. Keeping the Peso Strong: BSP Expands FX Derivative Trades with the US Banking System; The Continuing Slack in Bank FX Deposits
Figure 3
With the sustained bulging FX (public and private) debt, a weak peso would likely be the Achilles heel of the financial system.
A weak peso would amplify domestic price pressures from imports. The increasing pressures on global prices may also affect domestic prices. Interest rates rise when the statistical inflation or the CPI increases.
So aside from public debt, the BSP must have expanded its toolkit to use repos and other forms of derivatives (swaps, options, et.al.) to keep the peso from falling.
Aside from the increase in external debt, the Other Reserve Assets (ORA) component also boosted the GIRs and the peso from 2018. Data from the IMF’s International Reserve and Foreign Currency Liquidity (IRFCL). (Figure 3 middle windows)
And the US banking system has functioned as the primary counterparty of the BSP operations for its short-term derivative trades. The ORA account of the BSP appears to match the US Treasury’s data on the US banking total liabilities to the Philippines. (Figure 3, lowest pane)
Figure 4
But there is more.
The paradox is that growth in FX deposits in the banking system continues to slow despite the substantial increases in public FX borrowings intended for BSP operations and financing of public spending. (Figure 4, top and middle windows)
Differently put, the continuing slack of FX liquidity hounds the banking system despite the enormous FX public borrowings and the record rise of GIRs.
So, to where have the FX liquidity flowed?
VI. Deepening Dependence on External Debt: Insufficient Organic Economic Sources of FX/USD Revenues
If we rely on the media’s narrative, we get a bizarre or twisted outlook of the financial and economic conditions.
One. The BSP, in collaboration with the National Government, through the leveraging or debt operations, could declare the swelling of remittances despite about half of OFW being displaced and repatriated in 2020. OFWs were a part of the global labor force dislocation. (Figure 4, lowest pane)
It is highly doubtful that the present conditions of the global economy have restored a significant share of this dislocated workforce for remittances to exhibit growth. The general idea from the OFW data is that ghost overseas workers took over and have become the key force in remittances. Or, debt flows may have dissimulated part of the remittances data.
Two. We remain skeptical about the vocal acclaims by authorities that they have reached their FDI targets. Even if it were true, debt has comprised most of the published FDIs. As previously discussed, such FDIs could barely be about investments. (Figure 5, top two windows)
Figure 5
Paradoxically, the PSA also reported that the nine-month approved FDI flows in 2021 dropped sharply by 49%. So, existing FDI registered firms borrowed money from their parent, and the government declared it a boom. Meanwhile, the incoming or new FDIs slowed. (Figure 5, second to the lowest pane)
Is it not a wonder why the SWS survey shows that a substantial number of the labor force (11.9 million people or 24.8%) remain unemployed in Q3?
Three. Foreign portfolio flows are volatile and sensitive to global financial developments. But foreign outflows have dominated since 2013. And foreign participation in the local financial markets has declined since 2017.
Four. Mainly closed to foreign visitors, tourism remains depressed and may barely contribute to FX revenues, perhaps until the pandemic fades.
Fifth and Last. Goods and services exports. Domestic residents and the government continue to spend or consume more than it produces. As such, trade deficits continue to balloon. (Public spending is the likely source of a critical mass of imports/deficits.) (Figure 5 lowest pane)
Perhaps, the services exports via BPOs could be the silver lining. But this will unlikely generate enough revenues to cover the BSP foreign reserve to asset deficit and other FX or USD requirements of the financial system.
The insufficient sources to generate FX revenues translates to increased reliance on external debt. And so, the accelerated borrowing spree seems likely to continue.
VII. Conclusion: Mounting USD/FX Shorts Magnify the Currency Risk!
The selective use of statistics by the establishment justifies political agenda than an expression of reality.
External debt growth, which has been on a long-term uptrend, has only accelerated. But using statistical pantomimes, the establishment assures the public, 'don't worry, be happy.'
Everyone seems to have forgotten about the run-up process of debt accumulation towards a debt crisis.
Instead of FX savings, the GIR is likely a manifestation of the massive growth of external debt, therefore, unlikely an appropriate metric for debt analysis.
The BSP must amass sufficient FX reserves to match domestic monetary operations required to maintain the de facto US currency reserve standard. Otherwise, with inadequate FX anchor, the peso must fall.
A weak peso means higher inflation and more expensive imports that affect interest rates.
A strong dollar represents a policy imperative to keep domestic and external debt from blowing up.
The BSP has used external debt and derivative trades with the US banking system to boost its GIRs and manage the exchange rates or keep the peso strong.
Surging inflows from external debt have barely helped the FX liquidity conditions of the local banking system.
FX revenues from organic economic sources are unlikely to be sufficient in restoring the FX reserve requirement of the BSP, which means the entrenchment of the escalating trend of external debt borrowing by the National Government.
Surging external debt and other reserve assets means that the economy must generate corresponding USD/FX to pay its liabilities, which signifies the USD/FX short.
Mounting USD/FX shorts amplify the currency risk.
