Has the BSP Misread the Economy? BSP Hikes Rates by 50 Basis Points as Money Supply Growth Drops

Has the BSP Misread the Economy? BSP Hikes Rates by 50 Basis Points as Money Supply Growth Drops

There were two key events last week. The first was the disclosure of the 2Q GDP. The other was the decision of the BSP’s Monetary Board on its policy interest rates.

The BSP raised interest rates by 50 basis points last week. The BSP has increased a total of 100 basis points or 1% from May. 

To emphasize the critical pivot of the BSP’s stance, last week’s policy actions, said media, was the largest since July 2008 

Figure 1

While it may be true that the 50 bps increase signaled heightened concerns on inflation risks, the BSP merely raised policy rates to 2014 levels. [upper window chart 1]

Policy rates not only are at historic lows, it is below both statistical inflation and the GDP rate. The implication is that current rates, in spite of the recent increases, remain relatively easy. 

Nevertheless, the BSP accentuates what I have been saying here: the sunset of the era of easy money

The other thing that the BSP has signaled was that price pressures have been more than that of statistical inflation. Thus, because of the raging CPI, the BSP’s leadership wanted to be seen as “doing something”.

It is for such reason, I would guess, that aside from calling for the 50 points hike, Japanese investment house, Nomura predicts that the BSP will undertake another 100 bps hike to squelch inflation.

By virtue of manipulating Philippine treasury yields, the BSP’s QE has generated significant liquidity enough to influence CPI. (lower pane figure 1) 

So real tightening will not only entail a higher price of credit for the banking system, it requires the BSP to step back from pouring liquidity through NG debt monetization.

 

Figure 2

The BSP has been in a dire bind.

Record fiscal deficits will have to be funded.

If debt would be the main source of funding for the NG’s aggressive spending, then it would pressure rates higher even without the BSP’s actions.

Hence to elude from higher rates, in 2018, the BSP has used QE in combination with fiscal debt. 

However, the inflationary effects of the BSP’s QE have been magnified by TRAIN.

Ergo, the BSP’s interest rate response.

Yet if the BSP stays from using QE, this leaves the debt channel as the mains source. Rate hikes plus NG debt issuance would add pressure on interest rates.

If rates rise enough to reduce bank credit expansion in the system, GDP and earnings will fall. The second order effect would be to reduce tax revenues, thereby ballooning deficits. The subsequent effect would emerge as deterioration in credit quality.

Hence, a drain in liquidity translates not only to diminished subsidies to the NG through taxes, but to reduced political spending and increased economic risk.

Inflation subsidizes government through the debt channel too. 

Debt’s nominal value gets reduced with an inflated peso. As one would note in the lower chart in Figure 2, the subsidy to the NG Debts have been evident through the negative real rates or inflation rates HIGHER than and yields of 1-year Treasuries.

That the NG has become heavily dependent on BSP subsidies means that it cannot afford positive real rates. The BSP initiated the QE in 2015 to combat the positive real rates which emerged as a result of their rate 2014 interest rate hikes. Yet debt levels in 2015 were significantly less than today.

Figure 3

The most interesting part of the BSP’s recent action comes with the plunge in the growth rate of domestic liquidity last June. M3dropped sharply to 11.73% in June from a month ago at 14.3%.

This drop occurred even as bank credit (production and consumer loans) continues to expand at a rapid clip last June (+19.06%) albeit slightly down from its recent peak (+20.63%) in late 2017.

On the other hand, public sector debt has picked up speed and expanded by 9.34% in June from 7.68% a month ago.

Though one month doesn’t a trend make, the plunge in domestic liquidity could have been from the following factors: One, rising NPLs (perhaps magnified by Boracay related issues). Two, reduced BSP QE. Three, diminishing marginal returns from bank credit expansion. Four, NG’s stepped up debt borrowing. Fifth, a combo of the above.

On the other hand, the steep retrenchment in domestic liquidity occurred as CPI has rocketed to 5.7% (2012 base) last July.  If the public’s inflation expectations have become entrenched, the BSP would need to feed such expectations with money supply growth. So the recent drop would have to be offset.

Otherwise, such divergence won’t last.

Given the complexities of a highly fluid environment, that the BSP miscalculates should signify a magnified possibility.

At the end of June, public debt (domestic and external) stood at Php 7.012 trillion, while bank credit at Php 7.4 trillion. With nominal 1H GDP at Php 8.24 trillion, public debt to nominal GDP (annualized) for the period is 42.6%, while bank credit to nominal GDP (annualized) is 44.9%. Such data excludes other forms of credit.

Combined, public and bank credit debt to nominal GDP (annualized) has now reached a milestone of 87.49%!

Amplified chances of policy error and rising rates in the face of record debt stock signify a highly toxic mix for the debt-dependent economy and financial markets.