And it is best that the truth be fully stated and clearly recognized. He who sees the truth, let him proclaim it, without asking who is for it or who is against it. This is not radicalism in the bad sense which so many attach to the word. This is conservatism in the true sense—Henry George
In this issue:
BSP’s April 2020 FSR: PSE’s Soaring Debt-at-Risk, Bank and Financial Vulnerabilities, Risks of Re-Fitting of the Economy and More…
I. Market ‘Stability’ from BSP and Global Central Bank Injections
II. FSR Warns on Interest Rate Coverage Risks of PSE-listed Firms
III. FSR: Vulnerabilities in Banks and Elsewhere In The System
IV. The BSP’s Confession: A Knowledge Problem of a Complex and Dynamic System
V. The FSR: Radical Re-fitting of the Economy; Shopping Malls May Not Be Viable!
VI. The FSR: As Debt Soars, Taxes Will Rise; The Institutionalization of the Command and Control Economy
VII. Telltale Signs: After Deutsche, Nomura’s Exodus from the Stock Market Brokerage Business
BSP’s April 2020 FSR: PSE’s Soaring Debt-at-Risk, Bank and Financial Vulnerabilities, Risks of Re-Fitting of the Economy and More…
Last week, the Bangko Sentral ng Pilipinas led Financial Stability Coordinating Council (FSCC) released their April 2020, Financial Stability Report.
From the BSP’s press release, “The mandate of the FSCC is to make sure that the financial system is functioning properly,” FSCC Chairman Benjamin E. Diokno said. He added, however, that the Council “also understands that the ultimate goal is not just a strong financial system, but a financial system that supports a thriving economy. This is why mitigating systemic risk is all about public welfare.”
The BSP announced a shift in the schedule of the publication of the Financial Stability Report “from an annual to a semestral release reflects its commitment to being responsive to the times.” And the FSCC will likewise issue a regular publication on Macroprudential Policy Strategy Framework, referring to the intervention of authorities for managing systemic risks.
As I have been saying, the BSP communique has been directed at two audiences. (bold original)
Though the BSP releases the FSR to the public, its target audience has been the central bank member peers at the BIS, as well as, the BIS bureaucracy. In contrast, reports targeted at domestic audiences barely touches the risk agenda raised in the FSR.
Differently stated, the BSP has mostly been candid about risks in the financial system when reporting to their colleagues, but the topic about risks evaporates when it publishes the financial system conditions to its domestic audiences.
So most of the domestic media outfits megaphone the positive content of the FSR. For instance, this CNN report (June 23): Local financial markets remain resilient despite the COVID-19 pandemic, the Financial Stability Coordination Council said Tuesday, as they stressed that economic risks have risen in the face of global recession.
Interestingly, an outlier, the Philstar (June 23), took on the opposite end, “The era of cheap borrowing in previous years, which resulted in a pile of debt, is now creating financial strain in local companies. Corporates lead local borrowers that may face difficulty paying debts as cashflows stagnated when business operations halted due to the pandemic, putting into question a government strategy that heavily relies on the private sector for recovery.”
This outlook will deal with claims of a stable market and the confessions by the FSR of fragility embedded into the system.
I. Market ‘Stability’ from BSP and Global Central Bank Injections
The financial market’s stability, according to the BSP’s perspective: (p.13 to 14) [bold original, bold italics added]
There are, however, notable differences in how rebalancing has been executed in the Philippines. When compared with other Asian economies, the rebalancing in the Philippines stands out (Table 2.1). In Thailand and Indonesia, there is a shift out of every asset class, which suggests a preference for cash. Malaysia shows the shift heading towards bonds, while India curiously shows a rebalancing towards longer-term assets
The Philippines, in contrast, has shun mixed assets and shows a preference for specific asset holdings, particularly for local money market instruments. The country’s credit default swap (CDS) spreads and term premiums have also eased in the recent period. Looking at the spreads between PH and US fixed income instruments, the risk premium gap has also tapered.
With no immediate shift towards foreign currencies, the PHP has been relatively stable compared to its peers. In February, portfolio investments actually posted a net inflow after several months of outflows (BSP, 2020). Recent imports data shows a drop in YoY growth to –11.6 percent in February 2020 from 2.0 percent in February 2019 (PSA, 2020), reducing demand for the USD. Likewise, the high level of gross international reserves (GIR)19 seems to provide some assurance for the market. All these eased any downward pressure on the PHP while most EME currencies weakened sharply in the first quarter of 2020. Spot prices show a stable PHP in April 2020 amidst low trading volume since the ECQ.
Figure 1
Are money market instruments not the most liquid or cash-like assets? Faced with uncertainties, the typical magnet for people looking for safety are cash and cash-related liquid assets. And given the different architectures of the financial systems of Asia, why should flows to money market instruments be considered special? Americans have also been holding enormous amounts of cash.
Along with the BSP, haven’t risk assets around the world been significantly boosted by unprecedented injections of global central banks? Total assets of major central banks have rocketed by about USD 4 trillion to USD 24.3 trillion in May, that’s about 28% of the USD 86 trillion 2019 GDP. Meanwhile, with a tsunami of liquidity, yield chasing on the world stock markets have spiraled valuations of the MSCI index to 2002 highs! Figure 1
Yet, can stability from overriding market forces be sustained? At what costs? Are these interventions not subject to the laws of diminishing returns? Have these not spurred extreme distortions and dislocations in the financial markets that amplify the odds of more incidences of heightened volatility soon?
Aside from the BSP’s QE, wouldn’t the slew of other bailout measures momentarily calm the markets?
As to the record GIRs, from the Inquirer (June 24): The Philippines’ dollar reserves hit a historic high in May —at the peak of the COVID-19 lockdown—thanks to inflows from the government’s foreign borrowings, as well as foreign exchange earnings of the central bank.
How reliable are foreign exchange reserves constructed from financial dealings, through borrowings and derivatives than from economic transactions?
Since these borrowings require repayments, are these reserves not only artificial and temporary but represent USD shorts? That is, shorts as in “the mismatch (maturity) between short-term interbank borrowing (globally) on the liability side supporting and maintaining longer duration loan or security assets”. And as Alhambra Investment wizard Jeff Snider explains, “Once you create those “dollar” assets, you are on the hook for funding them, in “dollars”, until they are disposed of – voluntarily or not”.
The bigger their USD liabilities, the more prone the BSP is to a squeeze.
Moreover, what measures did the BSP tacitly undertake to squeeze foreign participation and foreign selling on the domestic financial markets? (see Nomura’s Exit below)
Now to the BSP’s response to risk aversion via QE injections: “To support funding markets, CBs infused liquidity while reinforcing lower-for-longer yields. As the pandemic threatened macroeconomic and financial stability, CBsre-used their monetary tools deployed during the GFC, such as the reduction of the policy rate to near — if not, at — zero and the resumption of bond-buying programs. The challenge, however, is that if the adverse effects linger further and worsen beyond GFC levels, as suggested by the IMF, financial authorities will have to consider new and additional interventions.”
So have the adverse effects worsened beyond GFC levels for the BSP to slash its overnight policy rates by 50 bps to a record low of 2.25% last week?
Or, as previously discussed*, given the fiscal deficit blowout, is the BSP deepening the use of its Financial Repression policies to reduce the cost of debt servicing, exact an inflation tax on the public through negative real rates (inflation greater than nominal rates), and ward off deflationary pressures from the recession?
*BSP’s Php 300 Billion Record QE last April Boosted Liquidity Dramatically, Raising Stagflation Risks June 22, 2020
If the financial system is sound, why resort to such a scale of bailout measures?
The historic rate cut sent Philippine yields suddenly tumbling substantially across the curve, narrowing spreads, indicating more tightening. The other week, the yield curve pointed towards a steepening. The avalanche of interventions that have mucked up the pricing system has left the financial markets dazed.
A few days does not make up a trend, though.
II. FSR Warns on Interest Rate Coverage Risks of PSE-listed Firms
Now to the risks. (p.15-16) [bold original, bold-italics mine]
A particular concern is debt-at-risk. For some time now, risk prognoses have pointed to the build-up of debt in the low-for-long era. While the level and growth of debt had been frequently cited as possible vulnerabilities, the strains imposed by the pandemic will cause debt servicing difficulties. This will primarily be driven first by reduced income due to suspended economic activity and, then second, through the interlinkage of the income fallout from one entity to another. This is the case between industries, among firms and even among household debt in the informal sector
Available data limits us only to the formal markets. Loans to residents are still dominated by corporate borrowers, accounting for approximately 60 percent of the total (Figure 2.14). For cross-border claims, the non-bank private sector represents the majority of the debt (45.1 percent of total claims), but the sharp increase in the debt of the banking industry warrants further assessment (Figure 2.15). Moreover, the outstanding corporate debt among 200 listed companies stood at PHP9.3 trillion, 28.4 percent of which is denominated in foreign currency (FCY). This year, USD3.46 billion of FCY debt will mature, while PHP553 billion in local currency is likewise due (Figure 2.16). The latter will be tested by any impairment in revenues, and thus capacity to pay, while the former will add pressure on USD liquidity, on top of income capacity.
It should be pointed out that the debt repayment capacity of some PSE-listed non-financial corporates (NFCs) was already declining before the emergence of COVID-19. The interest coverage ratio (ICR), which is a measure of the firm’s ability to service the interest obligations of their debt, has been decreasing in recent periods as interest expense has grown by an annualized rate of 20.9 percent, while earnings before interest and taxes (EBIT) has only grown by 9.0 percent over the past three years (Figure 2.17). Stress test estimates suggest that the ICR declines from 6.44 in Q4 2019 to 4.01 (at 10 percent EBIT decline) or further to 2.23 (at 50 percent EBIT drop). Although the policy rate has been reduced starting April 2019, the impact of lower rates on existing bank debts would not be felt until the repricing of those loans usually a year later.
Ever since the BSP began publishing the FSR in 2018, as a requirement to its membership at the Bank for International Settlements, it has raised the excessive valuations and the broadening mismatch between the disproportionate growth rate of debt relative to profitability plaguing the PSE.
Importantly, balance sheets of both banks and non-financials have been deteriorating even before COVID and the ECQ. As for the ICRs, San Miguel’s debt conditions look like the nation’s paradigm of a zombie-Ponzi finance scheme, as explained in early June.
Figure 2
And it is not just the National Government rushing to obtain foreign exchange financing, domestic firms are, “looking to raise a total of $2.5 billion with bonds, based on regulatory filings, according to the Bloomberg. And the reason for this? To rollover debt: “Philippine firms are set to join the global rush to borrow funds as they prepare for a massive debt bill: about $8.3 billion in corporate bonds and loans will mature in the second half of the year, before that pile climbs to a record $16.4 billion in 2021”.
How can a slowing/recessionary economy and raging debt growth be bullish for equity investors?
III. FSR: Vulnerabilities in Banks and Elsewhere In The System
On the banking and financial system. (p 16 to 17) [bold original, bold-italics mine]
The strain on the banking books will come through a further impairment in past due loans (PD). The pressure on income increases the likelihood of missed debt payments. However, even before 2020, PD were already trending upward, both in absolute amounts and as a percentage of loans (Figure 2.18)… Despite the fact that the share of the impaired accounts to total loans remain minimal, there is a need to closely monitor the PD but not yet NPLs alongside the outright NPLs, and its respective proportion to outstanding loans, to determine the eventual impact of COVID-19 on the banking books especially in the event of a more protracted contraction in economic activities
There may be vulnerabilities elsewhere in the system. For insurance companies (InsCos), massive and sudden shifts in market yields can cause a mismatch between the long-term returns promised in the policies sold to clients versus the yields realized by their investments. While actuarial estimates are still being recalibrated, there may also be a fair amount of unscheduled claims that may be redeemed by policyholders and it is not clear if liquidity is also at risk, given market conditions.
As one can see, because of the interconnectedness of the system, the BSP admits that financial strains are building up across all sectors, most notably at the heart of the system, banks, as well as other financial institutions.
For banks, liquidity problems have now morphed into credit quality issues. For the pension and insurance industry, pronounced asset-liability mismatches can become a critical source of significant financial crevices.
And though household credit may be a small segment in the BSP’s statistics, the impact of the economic freeze on the informal sector could function as another potential catalyst leading to a crisis. (p. 17)
For households, we cannot directly estimate the impact on debt servicing from the erosion of incomes. On paper, salaries and wages account for about 36 percent of GDP (based on 2018 data). This, however, includes professionals who are under contract and will be paid on a monthly basis regardless if a pandemic materializes. The most vulnerable are the workers who are part of the informal sector or whose wages depend on the occurrence of events, that is, those who are on no-work-no-pay arrangement in the “gig economy”. This aspect has not been assessed and would not benefit from the current relief program extended in the formal financial market.
If the strain on incomes and economic activity linger, systemic risks will certainly amplify…Moreover, the average induced failures are greater for simultaneous shocks to the system than the summation of the failures emanating from shocks to individual firm. This observation is critical as it highlights one of the key lessons learned in previous crises — that is, small shocks can lead to large dislocations. It is, therefore, imperative to address the brewing risks identified in this chapter before it triggers a cascading failure in the financial system.
Likewise, the BSP recognizes that it has no control over other potential triggers to a financial shock that may ripple to the system.
IV. The BSP’s Confession: A Knowledge Problem of a Complex and Dynamic System
And here’s the striking climax… [bold original, bold-italics and underline mine] (p.28)
The caveat is offered because one cannot tell yet how the public health issue will be resolved and how the corresponding stress points of eroded incomes and suspended business activities will be handled. The three cannot be dissociated, and in turn, these are symbiotic to the state of the financial market. Risk pressures will continue to build because debts will be increasingly difficult to service, banks will find it harder to source new deposits, and risk perceptions draw in further risk perceptions.
It is recommended then to address the risk premium directly. This is not to suggest that one should set aside the public health issues and its macroeconomic shocks. It is simply compartmentalizing, and part of this is an assumption of going concern. It is assumed that financial institutions remain liquid in PHP and USD terms, that depositors can routinely access automated teller machines or make electronic transactions, that clearing and settlement bottlenecks are effectively addressed, that fees for electronic payments are not a disincentive, and that the government is able to source funding for their interventions.
And the BSP’s no control over the potential trigger is a function of the knowledge problem of a complex and dynamic system. It confesses that their (Dynamic Stochastics General Equilibrium) econometric models can’t capture the interactive and interdependent feedback loops occurring spontaneously and simultaneously in the system.
The BSP then makes an important assumption of the functioning liquidity in the system, viz. allowing depositors to access both ATMs and electronic transactions and facilitating the continued clearing and settlements. But what if one of the fragile moving parts, affected by a multitude of factors, fail? Would cash run dry at the ATMs and would online accounts go offline?
And what if credit gridlocks lead to an intractable series of ‘settlement fails’ as they previously raised?
From the 2018 FSR (p.30): It also suggests why unwinding failed transactions can have broad system-level implications. Despite institutionalizing the delivery-versus payment protocol, the system remains vulnerable because a single bilateral failed trade may require a network of unwinding. Unfortunately, such data is not easily accessible and the extent to which these “settlement fails” represent a possible systemic risk—not just in size but more so in terms of interlinkages that can spillover to the rest of the economy—is not readily determinable, at least at this time. In general, payments system data remain largely untapped and not having even a cursory view of the dynamics of the payments network leaves financial authorities blind to their possible consequences. This is a major concern
That said, the establishment consensus drooling for a V-recovery has largely ignored or discounted such elevated risk profile, which even the BSP recognizes.
And yes, the belief is that “government is able to source funding for their interventions”.
But what if domestic and global funding runs out?
V. The FSR: Radical Re-fitting of the Economy; Shopping Malls May Not Be Viable!
And here is another stunning admission. (p.29)
Looking ahead, it would be a major oversight to expect that the economy could still go back to business-as-usual. COVID-19 is leaving scars that even a proven vaccine may not remove. The old economy has to “re-fit” into the new normal of social distancing. Business paradigms that relied on scale (incurring high fixed costs and catering to the retail market in mass) will have to rethink how they can operate in the post-COVID-19 world. Air transport (planes that cost from USD77 million to USD450 million depending on the model, ferrying hundreds of passengers per trip) and big shopping malls, for example, may not be as viable under reduced floor and foot traffic.
To repeat: “Big shopping malls may not be viable under reduced floor and foot traffic”. Incredible!
So what happens to the frantic race-to-build-supply? The FSR commentary virtually exposes the massive malinvestments in the economy partly due to COVID. Is the BSP aware of the costs and consequences of this radical re-fitting of this key industry into the new normal?
Does the BSP realize that shopping malls, which are part of the retail and the real estate industries, represent the biggest contributors to the GDP, bank industry borrowing, and the largest source of employment?
Retail and Real Estate sectors accounted for 24% of the 2019 GDP. The same sectors comprised 31.06% of the total bank lending portfolio at the close of 2019. More than a third of service sector employment reportedly comes from the said sectors.
Is the BSP aware that once losses become evident and escalate, the sector’s credit chain leading to the banks and bond markets will take a hit?
If the BSP FSR’s prognosis is correct, then the industry will have to face a domino of bankruptcies and liquidations, so how can a sharp GDP recovery happen next year?
VI. The FSR: As Debt Soars, Taxes Will Rise; The Institutionalization of the Command and Control Economy
Finally, the Sisyphean Task of the shoring up of the economy lies at the hands of the National Government! So said the BSP. (p.29)
The key element now is that NGs are taking on the burden for funding the needed relief program. There is no other entity in place that can absorb the ultimate risks and the corresponding financing. This will certainly mean higher debts, much less fiscal space. Intertemporally, this debt can be bridge-financed with more debt just to sustain liquidity. Ultimately though, taxes will have to adjust intergenerationally to make up for the gap. This is a policy issue that, for the moment, is pushed down the road but is unlikely to be avoided.
Translation: to maintain liquidity, public debt will skyrocket (intertemporally). But since there is no free lunch, to pay for this, taxes will have to be raised significantly over time (intergenerationally).
In contrast to the proposition of the NG to chop corporate taxes via the CREATE bill, taxes are bound to surge! The CREATE bill most likely represents a bait and switch; it would reduce corporate taxes but transfer the tax burden through significant increases in VAT, excise, and or sales taxes.
Of course, the politically convenient aim is that such tax burden should be pushed down the road, but as the FSR warned, it is unlikely to be avoided.
The current economic crisis will bring about an extraordinary legacy for our progenies, high intergenerational taxes!
Yet, to give a perspective of how this evolves, let us look at the fiscal performance for May.
Figure 3
The monthly fiscal deficit soared to Php 202.136 billion in May, the second-highest, after April’s historic Php 273.9 billion, reported the Bureau of Treasury. May’s budget gap pushed the 5-month deficit to a staggering Php 562.18 billion surpassing 2018’s Php 558.26 billion, the previous second-highest on record.
The milestone budget gap was a product of a perfect storm, the second-largest plunge in tax revenues in the face of the next highest public expenditure. BIR and BoC revenues plummeted 45.34% in May to Php 145.195 billion, a follow-up on April’s 56.74%. In the meantime, public spending surged to Php 353.63 billion in May, the second-biggest on the books, up 12.4%.
The funding of May’s deficit has yet to be disclosed by the BSP and or the Bureau of Treasury, although the jump in M3 last April demonstrates the BSP’s record injection to the financial system through QE.
The National Government projects a staggering deficit-to-GDP ratio of 8.4% or Php 1.6 trillion from 2020’s recession.
So aside from higher taxes, the institutionalization of the expanded share of public spending relative to the GDP reinforces the structural shift towards a centralized, command-and-control political economy, signifying the ratchet effect.
VII. Telltale Signs: After Deutsche, Nomura’s Exodus from the Stock Market Brokerage Business
Because of the massive interventions and manipulations, financial market prices are distorted, alright. But actual events are telltale signs.
Foreign money or investors have not only been selling the stock market, and possibly, other Philippine assets, but they have also been reducing their exposure to the real economy.
Figure 4
Through the acquisition of the PCIB Securities, BDO Unibank and Nomura Asia established a stock market brokerage firm, the BDO-Nomura Securities, in January 2016.
Last week, with the exit of Nomura, that 4-year partnership came to a close; BDO acquired the former's 49% share.
It was just last January when Deutsche Bank also exited the securities industry by selling out to its local partners.
Why Nomura’s short stint?
Here are a few guesses.
Since culminating in 2013, annual peso trading volume has been on a downward trajectory. Though the benchmark index hit a record high of 9,058.62 in January 2018, peso volume hasn't supported this. This milestone had signified a product mostly of end-session pumps on select index sensitive issues. Figure 4
Next, reduced foreign participation and outflows have been a significant factor for the decline in peso trading volume.
Or, since August 2018, the share of foreign participation relative to the total turnover has significantly been dropping.
Possibly because of the lack of volume and broad market participation, a scandal involving a 50-year old stock market broker surfaced last year, which may lead to the tightening of the regulatory environment, and raise compliance costs, squeezing profit margins.
The recent market meltdown may have compounded the lethargic broad market sentiment and volume trades.
Brokers may not be only suffering from reduced transactions but also losses on investments/speculations.
Higher taxes from current fiscal activities could also weigh on profits.
Reduced disposable income and stock market losses may limit the growth of retail participation.
Finally, a global trend of zero bound commission rates could also be a factor*.
*The PSE’s Brokerage Industry’s “Creative Destruction”: Online Platforms Take Lead as Retail Participants Chase Prices! October 20, 2019
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