The BSP’s Confession to the BIS: We Have Little Knowledge About Risks! The BSP’s Harrison Plaza Blind Spot!

A high capital ratio is a direct measure of a well-funded loss-absorbing buffer. However, more bank capital could reflect more risk-taking on the asset side of the balance sheet. Indeed, we find in fact that there is no statistical evidence of a relationship between higher capital ratios and lower risk of systemic financial crisis. If anything, higher capital is associated with higher risk of financial crisis. Such a finding is consistent with a reverse causality mechanism: the more risks the banking sector takes, the more markets and regulators are going to demand banks to hold higher buffers-- Òscar Jordà, Davis Björn Moritz Schularick and Alan M. Taylor Bank Capital Redux: Solvency, Liquidity, and Crisis, Federal Reserve Bank of San Francisco

In this issue

The BSP’s Confession to the BIS: We Have Little Knowledge About Risks! The BSP’s Harrison Plaza Blind Spot!

-The Ignorance Fallacy

-The BSP’s Confession to the BIS

-The BSP’s Knowledge Dilemma Applied: The Harrison Plaza Blind Spot

-BSP Needs New Eyes: More Risks Beyond Credit

The BSP’s Confession to the BIS: We Have Little Knowledge About Risks! The BSP’s Harrison Plaza Blind Spot!

The Ignorance Fallacy

Benson: My friend, you’ve have been smoking cigarettes for about two packs a day for many years. Such smoking habit will be costly to you and your family. I, thereby, recommend that you abandon such lethal health habit. Medical findings point to the hazards of smoking, in particular, the more cigarette consumed, the greater the risk that the smoker would contract emphysema—a fatal disease.

Fast forward today…

Friend: Nice to see you, Benson. It has been three years since you’ve warned me about the perils of smoking. I recently just had my executive checkup. And I’m delighted to tell you that my doctor issued me a clean bill of health!  I feel like an adolescent! None of the risks that you have warned about has come to fruition. It never will. And I do feel real good smoking. As a matter of fact, I doubled my cigarette consumption! And this won’t hurt me a bit! May I posit that you examine your theory? Because, pardon me, but it just doesn’t work…certainly not for me. I would also guess that those studies you mentioned were fraudulent!

The absence of occurrence of risks has been associated or deduced as equivalent to the inexistence of risks.  Such sweeping dismissal of risks has been used to rationalize and, thus, justify the continuation of risky actions!

Forget cause and effect. Past performance is seen as a guarantee of future outcomes.

Interestingly, such ignorance fallacy signify a commonplace objection applicable to the current credit boom

Short term orientations and preferences has emerged to dominate public mentality and opinion. The establishment have come to believe that they have developed imagined immunity and delusional insuperability from monetary induced vices which masquerades as economic progress.

Most confuse credit growth with productivity growth while not knowing their crucial differences.

The BSP’s Confession to the BIS

Let me base the above on an official opinion.

Officials of the Bangko Sentral ng Pilipinas frequently confirms the biases of the public by saying what the public wants to hear. This is understandable. Government officials function as the ex-officio sales representative of their employers.

On the other hand, when faced with a different audience, the same institution deliberates on another set of things.

This working paper and policy panel remarks by the BSP’s assistant vice governor Johnny Noe Ravalo to his central bank audiences was a stunning revelation*.

*Johnny Noe E Ravalo Credit build-up and financial stability issues: do we know enough to calibrate appropriate intervention? Financial systems and the real economy BNM-BIS conference on “Financial systems and the real economy”, 16‒18 October 2016, Kuala Lumpur, Malaysia Monetary and Economic Department Bank for International Settlements

Let me selective quote the presentation in indent along with my comments below the paragraph. (bold mine)

The issue is that there are too many unknowns about the rise in credit. Since the specific features of the loan agreement are unknown except to the contracting parties themselves, it will not be evident to third-party analysts how corporates are using the loan proceeds by looking simply at financial statements. For example, the rise in debt and a fall in profitability may be explained by the deliberate decision to invest into long-gestating undertakings, sacrificing short-term carrying costs for an expected longer-term increase in productivity and profitability.  

This is something that I have written about elsewhere here.

The point is that reliance on aggregates alone will prove to be highly inadequate indicators of risks. The world is a highly complex environment. Each credit transaction is different from the other from multifold aspects, viz. not only are lenders and borrowers diverse, from legal and regulatory standpoint to the classification to the disbursement process or even to actual use of money are all dissimilar.

Aggregates are designed to reduce complexity. However, aggregates are bereft of the comprehensive information encapsulating the chain of risks that has evolved from credit-fueled economic expansions.

Yet the idea of a ‘one step backward two step forward’ tradeoff from the use of debt applies theoretically under free market conditions.

It would be a different scenario when the central bank subsidizes borrowers at the expense of savers through the interest rate channel. The ramification of which is to redistribute resources which favor investments towards capital-intensive projects.  Such investments would include even unprofitable projects which will get an appearance of profitability for as long as credit is loosely available.

The BSP on the Philippine corporate debt conditions (bold added)

Data compiled for the BSP Financial Stability Committee suggest that NFC leverage has increased in recent years. We also know from BIS reporting countries that cross-border debt incurred by non-bank corporates in the Philippines increased from USD 7,781 million as of end 2008 to USD 13,046 million as of March 2016.

 In the sample data we monitor, we also find that the corporations that have increased their debts have also experienced a decline in their ROE. On paper, this indicates some impairment in their capacity to pay, but more granular information tells us that the bulk of the outstanding loans will mature in three to five years. Thus, unless there are specific cross-default cross-acceleration provisions in the debt contracts, this “impairment” may not be as imminent as it may seem.

The point is that we see the debt build-up in publicly available corporate balance sheets but we do not yet fully appreciate what lies behind these figures. The financial stability concern cannot bedefined exclusively by the increase in leverage. Rather, it is the fact that the results of network analysis and contingent claims analysis tell us that debt defaults strongly link the real economy and banks.

Read the statements again.

That’s actually a stunning confession!!!

First, this signifies an amazing acknowledgment that surging credit has begun to impact corporate balance sheets!

Such is something one would hardly ever hear from media.

More importantly, the BSP shockingly admits that it actually has NO IDEA “we do not yet fully appreciate what lies behind these figures” of the risks from the swift rate of growth of corporate leveraging and its transmission channels!

Network effects and contingency claims are extensions to the linkages from leverage exposures.

So the BSP HOPES that their measures would work in times of stress. Good luck to them!

I am reminded of papers which make the case of interconnectedness risks. Mainstream experts confuse interconnection with size instead of leverage.

Trade is the essence of interconnectedness. Every transaction binds buyer and seller, borrower and lender as well as investor and investee.  Such linkages account for as interconnectedness, as well as interdependencies when transactions become regular or frequent.

A decentralized network in free markets will hardly amplify the risks from credit channels. It is when the policy-induced concentration of resources through leveraging that makes size a risk.

From the global perspective, interconnected risks stem from the politics of Systemically Important Financial “Too Big To Fail” institutions. These institutions have benefited from government policies. Via the perverse incentive of the moral hazard, these firms have amassed critical heft and size, through mergers and acquisition, mostly financed through leveraging. 

Now back to the BSP’s stance on household leveraging.

Certainly, household finance is inherently difficult to monitor. Countries such as the Philippinesdo not have direct data on household finance except for infrequent surveys that do not track the same families over time. The informal financial market is likewise an important facet in emerging market economies – as a venue for funding and in the context of financial inclusion – and this is inherently difficult to capture in quantitative studies. Furthermore, demographic data confirm that there is great variability across Philippine families, so that the very concept of a “household” is not going to be consistent across geographical locations and across socio-economic classifications.

Kudos to the BSP for the implicit cognizance that aggregates serve as false measures of economic and financial conditions!

So what are we to do with CPI, General Retail Price Index, General Wholesale Price Index and other aggregate based statistics?

Or is statistics required to make a showcase that the BSP is in control? If one doesn’t know, then there is no control. So control of what?

The closest data we have are those for consumer loans from banks. Between September 2008 and the latest figure of September 2016, consumer loans increased from PHP 400.1 billion to PHP 1,202.6 billion. The latter represents 11.6% of nominal GDP – as opposed to 5.7% in September 2008 – which appears modest when compared to often-cited Asian regional data.

Yes, the modest level of household leverage is because of the low penetration level of the population to formal credit.

It’s going to be a different story when credit will be calculated based strictly on bank enrolled population.

The key fact remains, though, that we have seen this portfolio triple in size in only eight years.Conceptually, any concern over the pace of the debt build-up can be evaluated akin to the interest coverage ratio for corporates. Thus, the household’s capacity to service its debt would have deteriorated if household saving before interest and taxes had not also tripled in eight years, which translates into an annual compounded growth of 14.75%.

Apparently, the BSP doesn’t appreciate that even among the banked population there have been very limited number of people with exposure to formal credit. Based on World Bank’s Financial Inclusion data (2014), only 31% of the population have bank accounts. Yet only 12% of the population have credit exposure to formal institutions. So while those with access to formal credit may have tripled their exposure, those banked population with no access to credit may have tripled their savings!

Currently available data, unfortunately, are not granular enough to make such a determination.Thus, at this juncture, we will continue to monitor the issue while trying to devise ways to address the material gap in data. As in the case of corporate leverage, we note that household debt (or its closest proxy indicator) shows an increase over time. Nonetheless, we do not have the full range of information needed to categorically conclude that this is a financial stability issue. Relative to our CL2 risk framework, we cannot close the issue because we do not have any basis as yet for concentration, contagion and liquidity.

Read the statement again

The above represents another striking exposé!  

Again, the BSP astonishingly recognizes that even households have been experiencing rapid balance sheet leveraging!

Once more, bear in mind that the BSP shockingly admits that it actually has NO IDEA “we do not have the full range of information needed to categorically conclude that this is a financial stability issue” of the risks from the massive growth in household leveraging and its transmission channels!

And since they have actually been clueless as to what risks are, they proceed to conclude by putting on a spin that past performance should serve as an indicator of future outcomes!

The fact that the Philippines has enjoyed 71 straight quarters of positive growth suggests expanding potential income and wealth. The increase in corporate debt may be to further augment productive capacity in the real sector while the increase in (the proxy of) household indebtedness reflects enhanced demand for real estate, credit cards, auto loans etc due to increased wealth.

Thus, unless there is better information, one cannot draw unambiguous conclusions, specifically with respect to financial stability. We should again point out that these data gaps are not trivial

As I noted above, a sweeping dismissal of risks hence justifies the continuation of risky actions!

The BSP’s Knowledge Dilemma Applied: The Harrison Plaza Blind Spot

Well let me share to what looks like augmenting productive capacity…

 

The Harrison Plaza mall used to be my favorite mall. It is a place which frequented when I had my tertiary education at a nearby university and when I was a jai-alai aficionado.

Harrison Plaza (HP), according to Wikipedia was the first shopping mall in the Philippines. Today, the mall has morphed to evince symptoms of America’s decaying suburban malls given the substantial number of vacancies. (portraits above were taken on May 4)

Apparently, SM’s Savemore and Hypermart has failed to draw in enough paying crowds to fill these vacancies

One may object that perhaps antiquatedness may have been a factor. True, but the more important forces would be prices (rental rates) and demand.

If it is true that consumer demand has been as strong as popularly assumed, then prices will consequently matter.

The mall owner and operator may pare down rental rates to accommodate new tenants. Tenants may even shoulder renovations under mutually beneficial terms to spruce up their side of the mall. Apparently, demand may have been insufficient and or that the mall owners refuse to cut down prices in the face of soaring real estate prices.

There are other options too. The mall owner may even consider totally refurbishing it before leasing it out. Or the mall owner could invite a joint venture with a prominent developer to redevelop the place.

And yet the problem of oversupply comes into the picture to most likely affect demand. It may as well, influence the owner to maintain the status quo.

Unlike the BSP’s assertion, HP is an example that economy has not been about augmenting ‘productive capacity’ but instead has been expanding unproductive and capital consuming activities.

Vacancies are signs of unproductive assets. Growing vacancies are thus signs of the deepening misallocations of resources and economic maladjustments.

Nevertheless, the continuing supply side race will spur a sustained mushrooming of vacancies. Such race will culminate with a critical mass. The dominance of losses will highlight the advent of such inflection point. And losses will prompt for the cessation of supply-side expansion. Deepening losses will then entail for a supply-side contraction.

Could this be the reason why most property stocks have been diverging from SMPH’s forced upside move?

This has hardly been anything new. The US has been leading the way.

Yet what’s striking about Harrison Plaza’s dilemma has hardly been about the vacancies alone.

Instead, what has been more astounding has been HP’s captive markets.

The main offices of the government’s key financial institutions, the Department of Finance and the Bangko Sentral ng Pilipinas are located ironically, across the mall along the Mabini Street

I say ironic because employees from these firms are patrons of the mall.

Haven’t experts from these offices noticed of the emergence of such entropic force?

Or could it have been that the lethargic developments in HP have to be junked because such micro dynamic doesn’t fit into these agencies’ macro- econometric based models?

In short, malinvestments have been staring at the very faces of these government agencies yet they can’t seem to see them!

Aren’t these awesome?

Perhaps they need a fresh idea.

At least, the BSP has confessed to their shortcomings or the knowledge problem. Although of course, such candid disclosure were made to an audience of ‘technocratic’ central bankers, spearheaded by the Bank for International Settlements.

Interestingly, mainstream experts will hardly devote enough efforts to peruse on such papers. It’s why the BSP did this on the assumption that no one reads it.

Anyway, this is a treasure trove for me!

BSP Needs New Eyes: More Risks Beyond Credit

 

The BSP’s confessions had been centered on

The swift rise in credit of the corporate and household balance sheets has signified the backbone of the BSP’s confessions

However, the BSP skipped the fact that risks have more than just been about credit.

There are ways to go around credit. For the government, the alternative to credit is the printing press.

Massive increases in spending have been the centerpiece of the present administration.

In order to shore up its macro positions, the government has previously relied in the financing of such deficits with less of debt and more of BSP’s monetization of National Government debt.

1Q 2017 fiscal deficit was at Php 83 billion. Such signified a 26% improvement from the same period last year at Php 112.5 billion (lowest window). The government financed about half of these deficits (Php 41.8 billion) via the BSP’s net claim on central government. The other half was most likely through debt.

The BSP’s monetization of government debt continues to rocket even as its foreign assets have come down to affect the agency’s balance sheet. The recourse to NG debt monetization should continue to put a strain on the peso.

And it would take more than SM’s foreign buying to tame the USD.

 

Another interesting take has been that Philippine government’s nominal revenues continue to trend lower.

While March 2017 revenues jumped 14.22% from last year, that’s mainly because March 2016’s growth rate fell -7.78% - yes, principally a base effect.

Nevertheless, nominal revenue growth rates have hardly materially improved to reverse what seems as a trend ‘inflection point’.

Meanwhile, government spending grew by 4.1% compared to 11.2% over the same period last year.

The BSP reported on bank credit and domestic liquidity conditions last week. Bank industry loans last March rocketed by 18.5% to a Dec 2014 high! Consumer loans continue to bristle with growth rates at 23.6% which was just off the November 2016 high of 24.5%.

It’s no wonder the Phisix had broken out of 7,400 early April. 18% growth rate in industry loans appears to be a key threshold for bank financed spikes in the Phisix.

The irony was that reported domestic liquidity or M3 stumbled to 11.2% the lowest rate since February 2016.Raging bank loans as domestic liquidity tapers? What’s going on?

Has such stark disparity signified a repeat of 2015? In 2015, instead of capital expansion, much of the bank credit expansion were rechanneled to pay back loans. The ramification: money supply deceleration!

Implicitly forcing credit into the public through monetary policies eventually entails balance sheet risks.

However, the experience of policy tightening in 2015 seem to have petrified the BSP for them to refuse the use of the same approach to address real time real economy price pressures

The BSP thinks that free lunches abound and thus have relied on the ignorance fallacy to justify the status quo.

The BSP seems right when they said “we do not yet fully appreciate what lies behind these figures”.

When the diminishing returns from easy money policies reach a critical mass, the BSP wouldn’t exactly know what would hit the nation.

Nobel prize winner Austrian economist Friedrich von Hayek hit the nail on the head when he wrote,

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.