Driver Of The Philippine Peso: Available Bias, Oil or the China’s Yuan?

``The problem is not that supply and demand is such a complex explanation. The problem is that supply and demand is not an emotionally satisfying explanation. For that, you need melodrama, heroes and villains.” - Thomas Sowell, Too "Complex"?
The Philippine Peso has lost 5.78% since it peaked at Php 40.33 (closing quote) against a US dollar in February 28^th of this year. Year to date the Peso is down 3.55%.

Falling Peso and Media’s Available Bias, What Happened To Remittances?

Yet mainstream analysis seems lost with what has been going on. We’ve heard all sorts of oversimplified explanations or narrative causations covering the rice crisis to fiscal imprudence to surging oil prices to high “inflation” to risk aversion or to political maelstrom. But these factors do not seem to add up.

Previously, the popular explanation was that the strength of the Peso has been driven primarily by remittances, with subsidiary (and belated) attributions to portfolio flows. We argued against this remittance prompted Peso-appreciation in Philippine Peso And Remittances: The Unsecured Knot and What Media Didn’t Tell About the Peso.

Nonetheless, growth from remittance inflows from OFWs continue to hit record breaking levels and remains as vigorous as ever- 16% February, 9.4% in March or 13.2% for the first quarter…yet the Peso fumbled! Overtime, false premises are eventually unmasked.

Today, high inflation or levitated oil prices appear to dominate the airspace look equally tenuous.

Way up until the end of February of 2008, oil-based on West Texas Intermediate Crude benchmark-had been drifting upwards at the $100 levels where simultaneously the Peso continued to firm. Does this imply that oil above $100 signifies as the “critical point” where the economy folds?

Such arguments have NOT been consistent with present economic data.

The country’s current account recorded a 1^st quarter surplus of $8.6 billion (manila standard) and $499 million in April (inquirer.net) despite the 106% year on year growth of crude oil imports or 960% leap of rice imports y-o-y based on February figures which led to a $379 million trade deficit (manila times).

The country’s foreign exchange reserves also reached a fresh record at $36.7 billion (inquirer.net) despite “suspicions” of the Philippine Central Bank, Bangko Sentral ng Pilipinas (BSP) intervening in the currency market (seller of US dollars) to “contain” the Peso’s depreciation.

Moreover, the nation’s economic growth should remain robust. The Agriculture sector remains buoyant higher by 4% (Reuters) while tourism growth jumped 8.5% (inquirer.net) both for the 1^st quarter.

True enough, while a global economic slowdown may have SOME impact to the Philippine economy, especially in today’s highly interconnected world (relative to the past), as we argued Is the Philippines Resilient Enough to Withstand A US Recession?, where remittances represents about 10% of GDP and foreign trade (exports and imports) accounts for about 40%, we have other highly unappreciated-underinvestment themes-that has tremendous growth potentials (which ironically constitutes as the majority of the economy) enough to offset a global slowdown such as agriculture, mining, tourism, infrastructure, business process outsourcing, real estate, finance (banking and non-banking) and other service sectors.

We presented this in many of our articles including The Philippine Mining Index Lags the World (featured at safehaven.com) in September 2003 and blog posts as A Prospective Boom in Philippine Agriculture!, Want a Stock Market tip? PGMA’s SONA was a Mouthful and Phisix: “Fear Is A Foe Of The Faddist, But The Friend Of The Fundamentalist.

Has Outcomes Started to Impact Expectations?

Our belief is that the advancing phase of the global commodity cycle compounded by a deepening process of regionalization (economic, trade and financial integration) will benefit the Philippine economy and its financial markets despite the present exogenous (global credit crisis, US recession, global economic slowdown, high “inflation”) and endogenous (political, cultural and national balance sheet or fiscal) risks.

Remember there is NO such thing as a “perfect decoupling” or a “perfect integration”. Amidst today’s globalization trends, where integration and interrelation among economies has been increasing, there will always be some idiosyncrasies within a political economy relative to the world based on culture, population (demographic) construct, intrinsic policies, willingness to open for international or global interaction, political, economic and financial market framework and others. Said differently, there is no such thing as a “one-size-fits-all” paradigm. The distinction of the impact from globalization trends depends on the degree of the country’s exposure.

Take for instance proponents of the deflationary depression scenario have been forecasting of a global recession (if not a depression) arising from the global credit crisis, as we discussed in Global Depression: A Theory Similar To A Horror Movie?, yet 10 months into the credit crisis, global economies appears to remain unexpectedly strong!

Japan’s economy stunned the consensus with a 3.3% growth on “exports on to Asia and emerging markets” (Bloomberg) equally buttressed by resilient domestic demand. It’s the same story in Europe which grew by .7% in the 1^st quarter or 2.2% from a year earlier (Bloomberg), where the Germany (the “strongest growth in 12 years”) and France surprisingly compensated for the slowdowns of some countries (e.g. Spain, and Italy) within region coming in the face of a strong “euro”, rising “inflation”, US economic slowdown and other risk variables.

Assuming a lag period for the transmission of the Credit Crisis or a US economic slowdown, this suggests that economic data should begin to reflect on such slowdown. But this has yet to surface. Of course, we don’t discount that such lag period may take longer and might eventually weigh on Japan or Europe’s economic growth.

But the all important lesson here is that forecasting based on inductions similar to Dry Bone song (toe bone is connected to the ankle bone is connected to the knee bone, etc…) overestimates what is known, and at the same time, underestimates on what is unknown. That is why projections based on the extremes are likely to be exaggerated or highly erroneous and so with the self-righteous rigid convictions which underpin such views.

The Other Side of Oil

In the interim, claims that “decoupling is a myth” based on the initial reaction of forced liquidations seem to be vacillating. Some deflation proponents have now been arguing about the dissociation of stock markets and the economy.

As you know, we have long argued that the stock market performance doesn’t always account for the activities of economies or corporate earnings simply because the stock market (or other aspects of the financial markets) can also account for the function of money as a “store of value” or the opportunity cost of holding cash. (I have to keep repeating this because many people don’t seem to get it).

As a reminder, Zimbabwe has long been in a serial recession but whose stock market has continually soared amidst declining purchasing power (hyperinflation) manifested by its currency (massive devaluation). Economic health-unemployment (80%), manufacturing capacity (5%)-and corporate earnings have not been a factor for stock market performance, but the currency’s (Zimbabwe Dollar) purchasing power has.

When people fear the value of their currency is eroding, as seen through sharply higher prices of goods and services, they tend to seek refuge in asset prices which are scarce, liquid and represents “store of value” or whose value is expected to remain against a massively devaluing currency. Yes, central banks can simply print money for myriad political purposes and accrete humongous financial claims against a dearth of hard assets.

While the others see the rise of commodity prices as a relative shift from the absorption of credit creation and intermediation to financial assets into commodities or in short- NO problem of inflation, our view is that today’s rising markets could be a symptom of a Zimbabwe like disease in the markets.

The world’s current account imbalances, whose enormous surpluses are held by non-democratic emerging markets with underdeveloped financial markets, have equally been generating massive domestic liquidity through amassing foreign currency reserves transmitted by the monetary pegs to the US dollar. In effect, US dollar policies (such as today’s negative real yields) are being diffused to emerging markets via monetary mechanism where the latter’s surpluses are recycled into democratic industrialized economies with mature financial markets which may continue to incur current account deficits.

For instance, with Oil at $126; this means intensifying wealth transfer from oil exporters to oil importers, it also means higher surpluses for oil exporting countries, aside from more money for alternative non US dollar investments via Sovereign Wealth Funds by oil exporters and other surplus generating countries and structural adjustments in the balances of the current account surplus-deficit nations based on the changing dynamics of spending, investing and trading patterns.

A very perceptive commentary from Brad Setser (highlight mine),

``It would lead to something like a $650-700 billion transfer of wealth from the oil-importing economies to the major oil-exporting economies

``Assuming that the oil exporters don’t spend and invest all that much more than they already were planning to do in 2008, the rise in the oil export revenues will translate into a comparable increase in the oil exporters' current account surplus – and a comparable rise in the oil importers deficit. Of course, there will be some adjustment in the imports of the oil-exporting economies. But spending and investment in the oil-exporting economies tends to adjust with a lag to rises in the price of oil. And both are already on a sharply upward trajectory. Governments are spending more - and the oil-exporting economies are investing more, in part real interest rates in many oil-exporting economies are incredible low. Those crazy and wildly pro-cyclical dollar pegs. If oil had stayed at its 2007 level, it is safe to assume that the oil exporters surplus – roughly $425 billion in 2007 according to the IMF – would have fallen by $100 billion, if not more.

``The Spring IMF World Economic Outlook assumed that oil would average $95 a barrel -- pushing the oil exporters current account surplus up to $620 billion. If oil says at $125 a barrel for the rest of the year and oil averages $115 a barrel for the year, the oil exporters' current account surplus could approach $900 billion range.”

So with huge surpluses from emerging market oil exporters (GCC), aside from countries with surpluses from goods and services (Japan) and countries with surpluses from capital inflows (Brazil), which maybe finding their way into global financial (possibly through equity-via the Sovereign Wealth Fund route) markets coupled with excess liquidity arising from the lack of sterilization (mopping up of excess liquidity) due to the underdeveloped financial markets could have accounted for the spillage of such liquidity excesses over to the commodity markets, could have accounted for the rising price of goods and services around the world and the appearance of recovery in the global equity markets.

The point which requires emphasis is that the spending, investing and trading patterns by these current account surplus countries are likely to determine the asset or currency values of where these spare funds will eventually be parked.

Another aspect to stress is that these surpluses amount to an ocean of money being pumped into the system, aside from the equivalent strains being produced by such surplus-deficit asymmetries.

Baltic Dry Index, Commodity Cycle and the Flawed Populism Concepts

Figure 1: Investmenttools.com: Soaring Baltic Dry Index Amidst Recovering US S&P 500

Figure 1 from Investmenttools.com shows of the near record highs of the Baltic Dry Index overlapped by the main US equity benchmark the S & P 500.

The Baltic Dry Index an index which is representative of dry bulk shipping rates covering a range of raw materials or commodities including coal, iron ore and grain indicates that there is an ongoing shortage of shipping carriers which has prompted for shipping rates to climb back to its recent record highs.

While the correlation between the S&P and Baltic Index has not been entirely strong, we do see some firming interaction since the second round implosion of the credit crisis last October. This paved way for the fall in the Baltic rates coincident to the S&P. Recently the Baltic rates appears to have led the S&P.

This posits the scenario where Baltic shipping rates could have reacted to the supposition of a marked slowdown in commodity shipments (possibly expectations of a US recession), whereas today, the Baltic Index could be sounding off a “limited impact” scenario of an economic growth slowdown relative to the commodity markets.

Further, the fresh record high of the CRB Index supports the assumption of vigorous demand for commodities. But there is also another possible factor responsible for such upsurge-supply bottlenecks brought about by high financing charges and tight lending standards-have caused cancellation of orders for additional ships.

From Bloomberg’ Todd Zeranski, ``As much as $14 billion in ship orders is threatened by cancellations and delays, equal to 94 percent of annual revenue at Hyundai Heavy Industries Co., the largest shipbuilder. Tightening credit markets mean lenders demand a bigger deposit and shorter terms for financing, said Tobias Backer, the head of shipping for the Americas at Fortis, a merchant banker.

``The loss or delay in deliveries of about 250 cargo ships, or 10 percent of orders, will tighten the supply of vessels and support rates when demand from China and India for everything from soybeans to coal has never been greater. Based on the current orders for 2,561 new cargo ships, shipping rates are expected to decline 56 percent during the next three years, futures markets show.”

So even amidst a threat of a potential slowdown in demand for commodities for whatever reasons, the restricted access to financing extrapolates to diminished output for shipping, which means supply constrains or elevated prices for commodities and the Baltic Index.

Demand is a populist Keynesian framework peddled by mainstream media, however supply is another important variable frequently ignored.

The point being, a global economic slowdown isn’t a clear cut certainty that will cause a fall commodity prices, if supply falls faster than the decrease in demand then obviously prices will continue to rise.

Currency Basics

What has this got to do with the Peso?

A lot.

First things first, when we deal with currency markets, we deal with currency pairs or currency values measured against another currency. For instance when we quote the US dollar relative to the Philippine Peso USD/Php, the US dollar serves as the base currency while the Peso is the quoted or the secondary currency.

Second currency values are fundamentally driven by fund flows (capital and trading account), expected policy actions (monetary and fiscal), prospective interest rates and or yields, economic activities, political conditions, purchasing power and others. Traders and punters likewise apply sentiment and technical measures like in the stock market.

Third, since currency values are measured against another then it is a zero sum game, when one currency rise, the other declines. Hence, valuation of currencies shouldn’t be seen from a singular perspective but from dual ends. In other words, valuation is measured by relativity.

For example when one argues that rising oil prices hurt the Peso, it misses the perspective the US is likewise an oil importer, hence oil imports are likewise potentially harmful to the US dollar, so the question should be- higher oil prices should essentially impact which currency more?

Widening Our Perspective On The Peso

Let’s us examine the Philippine Peso. As noted above the Peso continues to amass foreign exchange surpluses aside from recording current account surpluses mostly from remittances.

At the margins, the Peso’s prices have somewhat been set by foreign portfolio flows, aside from other additional minor factors as investment income or central bank forex operations. On the other hand, the US dollar is a net current account deficit currency despite its privilege as the world’s de facto currency reserve.

Figure 2: PSE: Foreign Activities: Declining Trend of Outflows?

Figure 2 exhibits the daily activities of foreign money in the Philippine Stock Exchange. It shows that foreign selling in the PSE has peaked sometime in December 2007, but seems to be gradually declining as shown by the red arrow.

By implication if the trends of foreign funds continue to improve then the Peso should strengthen. It could. But such analysis isn’t straightforward.

Figure 3: USD/Peso-Phisix relationship

Look at figure 3, the USD/Peso (black line chart), since the Peso began to appreciate in 2005 the Phisix seemed to track the USD/Peso’s performance on an inverse scale.

When the US Dollar rose, the Phisix declined, conversely when the Phisix peaked, the US dollar was in a trough (blue arrows). This relationship held until August of last year from where such correlation broke down. Bizarrely the Peso continued to appreciate even while the Phisix had been encountering a net outflow.

China’s Yuan Possible Influence On The Peso

Figure 4: Ino.com: Chinese Remimbi Resembles the Peso’s path

Figure 4 from Ino.com shows of the uncanny resemblance between the movements of the Peso and the Chinese remimbi.

Notice when the Remimbi spiked in August, the USD/Php bottomed. Over in August to September as the Remimbi weakened, the USD/PHP firmed. Next, as the remimbi soared from September until early March, so did the Peso until the last day of February.

So while correlation may not imply absolute causation, we think that the ongoing dynamics of increasing regionalization has had a hand in these. We have argued how trading structure of the region has been reconfigured into what Asian Development Bank describes as “vertical integration of production chains” or a regional outsourcing platform with China as the final assembly point.

The point is that since Asian countries have been engaged in some form of competitive devaluation or have manipulated their currencies to keep prices competitive, and since most of their exports have now shifted to within the region or to China, most of Asia’s emerging markets seem to have kept the dynamics of currency values within the parameters of Chinese remimbi as a bellwether.

And if we are correct with the analysis that the remimbi as the region’s leading benchmark, then it is likely that today’s correction will not last.

This excerpt from a speech of University of California, Berkeley’s Professor Barry Eichengreen, courtesy of RGE Global (highlight mine),

``If the U.S. is in for a long recession and serious credit problems are not over, then betting on dollar recovery would be premature. The problem is that the dollar has fallen dramatically against the euro but much less against the Asian currencies, because of the reluctance of governments and central banks there to let their currencies move against the greenback. It would be nice if those Asian governments and central banks let their currencies strengthen more against the dollar – both to make up lost ground and because Asia is the one part of the world that is growing strongly. The dollar could then recover a bit against the euro, which would take some pressure off of Europe, without appreciating on an effective basis. Indeed, if exchange rates were simply left to the markets, I would not be surprised to see the dollar fall further on an effective basis, given the weakness of the U.S. economy. That is, any recovery against the euro could be dominated by further depreciation against Asian currencies.

``But the reality is that exchange rates are not left to the markets. With inflation accelerating, Asian central banks are likely to countenance a bit more local-currency appreciation against the dollar, but only a bit. And if they limit the depreciation of the dollar against their currencies, there is not going to be much recovery of the dollar against the euro.”

So what can we learn from Prof. Eichengreen?

One growth differentials are likely to allow Asian currencies to appreciate. Two, faced with inflation pressures, given enough lever arising from strong economic growth (aside from the wide gaps of purchasing power) monetary policies will most likely adjust to present conditions. Either our BSP increase interest rates or allow for currency appreciation or a combination of both. If the BSP increases rates then yield differentials against the US dollar should widen which could attract back foreign capital.

This basically debunks arguments floated by mainstream analysts where rising oil prices or inflation is said to inhibit the Peso’s advance. This overlooks the perspective of policy maneuvers.

Next, considering that global risk taking conditions have been picking up of late, (yes we are seeing some major indices crossover the threshold away from bear markets territories) we are likely to see a reversal of portfolio outflows.

Lastly pricing in the foreign exchange markets are not entirely market-determined, hence the imbalances in the global monetary system will continue to mount.

We would further add that based on a probable shift in trade composition where eventually we should see commodity based exports (mining and agriculture) heftily contribute to our trade and current account surpluses (aside from investments and revenues from Tourism, energy and infrastructure) to compliment remittances and portfolio flows, provided the leadership maintain their fiscal discipline, the Peso’s long term path alongside its neighboring currencies is most likely to the upside! All these are also anchored on the underlying policies by the BSP (or the BSP’s tolerance for a market determined outcome).

For the meantime, while I can’t say when the USD/Php is likely to top, I would recommend using today’s rallying dollar as an opportunity for exit or to diversify.