Philippine Stocks and Peso Hinges On Asia’s Direction

``If demand in the US drops further, Chinese exporters will be devastated by a rapid and continuous fall in orders.”-China's commerce ministry

For us, the seeming resiliency of the Philippine equity market has been backstopped by a firming Peso and a steepened yield curve.

Since the August “credit turbulence” set in, domestic investors for the first time in the present cycle (since 2003) have lent massive support to keep index above its previous resistance level and now support at 3,400.

The Philippine Stock Exchange registered a net selling of Php 20.318 billion since the week ending August 2 or representing 75% or 15 out of 20 weeks. In short, in contrast to the past four years where foreign investors have propelled the local market, today, local investors have been weightlifting the Phisix amidst the credit crisis.

Figure 3: ADB Bond Monitor: Philippine Benchmark yields

Moreover, the yield curve of Philippine bonds has steepened as shown in Figure 3. According to the ADB’s December Bond Monitor, ``Yield curves in most economies also steepened this year, mirroring the trend in world markets. In Indonesia, Philippines, and Thailand, curves steepened as loose monetary policy pushed down yields on shorter maturities, while rising inflation pushed the yields higher on bonds with longer maturities.” (emphasis ours)

As the ADB mentioned, the steepening of our yield curve implies loose financial conditions which could have prompted for local investors to sustain the PSE at present levels, aside from the firming Peso. This comes in the face of a spurt of foreign selling following the advent of the credit crisis.

This brings us to the next level of risks…a China slowdown.

Asia’s firming currencies have been mostly symptomatic of its balance of payments or capital and/or current accounts surpluses due to the de facto “Bretton Woods 2”, or an informal “US dollar standard” arrangement where Asian currencies have been purposely kept low, as a subsidy to its producers to increase its export market share (at the expense of domestic consumption). As a corollary of trade, the surpluses of US dollars generated are either hoarded or mostly recycled into US assets e.g. treasuries, agencies, real estate or equities.

On the obverse side or viewed from the context of US or current account deficit countries, this phenomenon can contrastingly be extrapolated as a subsidy to its consumers at the expense of their domestic producers.

Where in relation to China’s currency regime as the world’s final assembly line, to quote Professor Michael Pettis, `` Rising industrial production is central to the monetary trap in which China is stuck. As production surges ahead of consumption, the trade surplus must also grow (since the excess must be exported), and as it does it forces the PBoC to expand domestic money supply in a way that then reinforces fixed asset investment and future growth in industrial production. A reduction in the rate of growth would imply a future reduction in the growth rate of the country’s trade surplus.”

In other words, should a US-Eurozone downturn meaningfully impact China’s trading activities, we could possibly see a diminishing rate of growth of its industrial production (see Figure 4), which could translate to lower trade surplus, reduced money growth or subdued rate of appreciation of the remimbi relative to the US dollar…unless increased domestic consumption fully substitutes for such weaknesses…which is quite unlikely.

Nevertheless a disorderly adjustment in China could result to the unexpected, massive outflows of speculative money which could reverse the trend of its currency’s appreciation.

Figure 4: Danske Bank: Slowing Industrial Growth

China’s Industrial production recently slowed to 17.3% (Chinaview.com), where according to Flemming J. Nielsen of Danske Bank (highlight ours), ``The most likely explanation for the recent weakness is the government’s intensified crackdown on inefficient steel producers for environmental reasons. China has recently reduced tax rebates on exports of high-energy and resource-intensive industries including steel and export of steel has plummeted by about 40% since April 2007.” Simply said, the recent slowdown can be seen in the light of domestic policies aimed at tempering industrial production growth, rather than emanating from external activities. Our fears have not yet been evident.

So if China’s currency regime as signified by its “borrowed” monetary policies from the US will be affected by the impairment in the financial flow linkages then its “expected” rate of currency appreciation could diminish or even possibly reverse. Obviously this will sap into the Philippine Peso’s recent strength, which should also risk being echoed in the activities of the Phisix.

Such is the reason why we should remain cautious until a clear trend becomes manifest.