The essence of the this-time-is-different syndrome is simple. It is rooted in the firmly held belief that financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now. We are doing things better, we are smarter, we have learned from past mistakes. The old rules of valuation no longer apply. Unfortunately, a highly leveraged economy can unwittingly be sitting with its back at the edge of a financial cliff for many years before chance and circumstance provoke a crisis of confidence that pushes it off—Carmen Reinhart and Kenneth Rogoff
In this issue:
PSEi 30’s 1Q Non-Financials Borrowing Swelled by Php 528 Billion as Earnings Fell by Php 49 Billion! BSP’s Real Estate Index Boomed as GDP Contracted in 1Q!
I. PSEi 30’s 1Q Borrowing Swells by Php 528 Billion as Net Income Decreased by Php 49 Billion!
II. Why the Massive Bailouts?
III. Rising Asset Prices from Low Rates Aren’t Signs of Stability But Disguising Risks Through Liquidity Injections
IV. Debt Crisis Represents an Outcome of the Dynamic Process of Excessive Leveraging
V. Malinvestments: Effects of Credit Easing: BSP’s Real Estate Index Boomed as the GDP Contracted!
PSEi 30’s 1Q Non-Financials Borrowing Swelled by Php 528 Billion as Earnings Fell by Php 49 Billion! BSP’s Real Estate Index Boomed as GDP Contracted in 1Q!
This outlook deals with the following:
How can there be a robust recovery when borrowings of the component members of the PSYEi 30 continue to outgrow net income?
Bailout upon bailout measures, if the economy is sound, why the need to institute a culture of bailouts?
Are surging assets signs of stability, or are they symptoms of policies designed to conceal risks?
Understanding the debt crisis cycle through its dynamic process.
Philippine property prices boomed in the 1Q as the GDP reeled, is this sustainable?
I. PSEi 30’s 1Q Borrowing Swells by Php 528 Billion as Net Income Decreased by Php 49 Billion!
In the Bangko Sentral ng Pilipinas’ latest Financial Stability Report (April 2020), one of its principal concerns has been the excess leveraging of PSE firms. (bold mine)
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.
Php 9.3 trillion of outstanding corporate debt accounts for a remarkable 40.7% of the total resources of the financial system as of the close of 2019.
In the 1Q 2020, even as revenues and net income tumbled, indebtedness of the principal equity benchmark’s 26 nonfinancial issues expanded by an incredible 12.9% or by Php 528.237 billion to Php 4.624 trillion!
Figure 1
Some statistics first.
Net income of the PSYEi 30 plummeted 27.7% to Php 127.92 billion from Php 176.88 billion a year ago or a Php 48.96 billion decrease. Excluding banks, nonfinancial firms posted a 31.42% net income plunged to Php 103.581 billion from Php 151.031 billion or down by Php 47.5 billion.
Total revenues of the index firms slipped by 5.18%, excluding bank revenues have been lower by 6%.
Since the National Government imposed the rigorous social distancing measure of the Enhanced Community Quarantine (ECQ) covering the Luzon island, which essentially shut down most of the economy starting March 17, these firms declared about two-and-a-half months of normal operations in their 1Q Financial Statements.
Even then, the damage to their bottom line has been substantial. Yet, given the likely tendency for firms to look good, the extent of published losses may not have been an accurate depiction of real conditions.
As such, plugging the actual financial deficits may have been one of the reasons for the fantastic debt surge.
Led by holding companies and the property sector, PSEi non-financial firms borrowed a staggering Php 528.24 billion even as earnings dropped by 47.5 billion. Or PSEi borrowings in 1Q accounted for an astonishing over 4x their published net income!
Please note that the low debt growth rate signifies a function of a high baseline figure.
Moreover, some of the debt acquired may have been used for either bridge financing or raising liquidity under the duration of Community Quarantine.
And with most of the economy in suspended animation in the 2Q, expect index firms to post significant losses rather than reduced income.
II. Why the Massive Bailouts?
Because the Bayanihan law shielded liability collections or sanctioned moratorium on debt repayments, aside from other regulatory easing measures implemented, expect distortions on the reporting of Financial Statements over the interim.
Furthermore, the BSP’s regulatory relief on financial institutions may also help conceal the actual conditions of banks.
The FSR enumerates the measures the BSP has undertaken in its FSR (p21-25)
Aside from the reduction of policy rates, reserve requirements, and direct support of the Bureau of Treasury through a Php 300 billion direct repo arrangement, the BSP will also be scaling down the Overnight Reverse Repurchase volume offering, it will be purchasing government securities (GS) in the secondary market, and it will be temporarily reducing the term spread on the peso rediscounting loans relative to the overnight lending rate to zero.
The BSP extended 1) operational relief measures for FX transactions, implemented regulatory relief measures for banks to encourage the supervised financial institutions to provide financial relief to their customers, clients, and employees, 2) Prudential accounting relief measures to reduce the impact of mark-to-market losses and 3) Relaxed Know Your Customer requirements for both over the counter and electronic or online transactions.
The easing up of regulations applied to the other agencies as well. 1) The PDIC announced the grant of payment relief for corporate and closed banks' clients whose payments for loans, real property purchases, and lease fall due during the community quarantine period. 2) The IC extended the coverage of insurance policies and Health Maintenance Organization agreements about to expire during the quarantine, and 3) the SEC extended the filing of annual reports and suspended the payment of cumulative penalties for covered companies.
Add this to the panoply of redistributive policies, from the Inquirer (July 4): “In its bid to make available loans to small businesses badly hit by the COVID-19 crisis, the state-run Philippine Guarantee Corp. (Philguarantee) has green-lit P37.5 billion in credit guarantees as of end-June. Philguarantee said the total credit guarantee facilities it approved during the second quarter covered 22 accredited banks serving micro, small and medium enterprise (MSME) borrowers.”
Debt repayment capacity of many PSE firms, which was already declining before the emergence of COVID-19, as the FSR pointed out, further deteriorated in the 1Q. And the amount of debt raised, Php 528.24 billion, accounts for about 95.5% of the local currency debt due this year.
And the over Php 9.3 trillion of corporate debt outstanding, which represents about 40% of the financial resources, highlights the mounting concentration risks in the financial system.
A 50% drop in EBIT earnings appears to be the maximum input the BSP used for its stress test model. What if the rate of decline in EBIT earnings will be more? What if losses occurred? How will these impact liquidity, solvency, and transactional flows in the system?
For instance, the 19.76% jump in San Miguel’s debt by Php 160.25 billion to a staggering Php 971 billion accounts for 30.34% of the overall debt increases. Yet, the firm suffered a 91.5% crash in earnings. That’s just the 1Q. How about the 2Q?
Figure 2
Interestingly, the BSP vows to unwind these emergency measures once the crisis has passed.
From the Inquirer (July 2): In a press briefing, Bangko Sentral ng Pilipinas Governor Benjamin Diokno assured his stakeholders that, once the crisis abates, the unwinding of COVID-19 relief measures will be data-driven, done gradually and prudently, and communicated correctly to all stakeholders.
When has the BSP withdrawn the emergency measures it implemented? ON RRP rates, presently at a record low, have barely returned to its base levels, after being used to support the economy from the Global Financial Crisis (GFC) almost 13-years ago!
The BSP’s debt monetization policies have barely regressed to its original levels, after being ramped up from 2007 to 2009 likewise as a shield against the GFC. Instead, it began to climb in 2015, and the rate of increases accelerated even before 2020!
If the economy, as presented by the mainstream, has been robust, why the need for such a massive 'stimulus' or policy support?
What would the financial system and the economy look like with the withdrawal of such policy steroids? Can it even withstand its absence?
And has it not been a wonder, why an economy or financial system ever so dependent on policy support, would require even greater interventions? Interventions beget interventions.
At the end of the day, BSP’s policies reinforce the ratchet effect or in Milton Friedman’s perspective, “nothing is so permanent as a temporary government program”!
As previously noted, the enactment of the controversial Anti-Terrorism bill represents part of dynamic of the ratchet effect.
The Ratchet Effect: Anti-Terrorism Bill, Bayanihan Law Extension; Reopening in Name Only: Regime Uncertainty, June 8, 2020
III. Rising Asset Prices from Low Rates Aren’t Signs of Stability But Disguising Risks Through Liquidity Injections
Resonating global developments, the massive liquidity injections by global central banks, including the BSP, have been boosting risk assets.
The domestic equity benchmark surged by a stunning 6.32% last June and an astonishing 16.66% return in the 2Q.
While most of the media tend to rationalize this optimism over either expectation of a vaccine discovery or continued publication of next year’s economic ‘recovery’, in reality, asset markets have been diverging against fundamentals. Again, massive easing measures, or liquidity injections, by the BSP have been responsible for these.
The Price Earnings Ratios (PER) published at the PSE’s website reflects on 2018 earnings per share (eps). Given that the completion of the 2019 annual performance last week, these changes have yet to be reflected.
As an aside, because the headline index comprises the holding firms and their subsidiaries, this distorts or double counts its price performance, through market cap share ranking, as well as the average eps and other fundamental data as debt.
Nonetheless, based on a 20% and 50% discount of 2018 eps, the heavily distorted equity index manifests an average PERs of 17.9 and 28.7, as of July 4, assuming the impact of the latest economic freeze on the company’s earnings. But the 27.9% plunge in 1Q net income may be a sign of things to come for the year. In short, markets have priced the index for perfection!
And given the massive disruptions in demand and supply, and the dislocations of credit flows and quality, as well as the imposition of political walls of mostly social-distancing regulations, and a possible change in consumer behavior, a recovery back to the pre-COVID, ECQ performance would likely represent wishful thinking.
Add to this the second and third-order consequences from the multitude of interventions on the marketplace.
And not just been the equity market, but the BSP's bailout of the banking system has benefited Philippine assets. The peso rallied 1.71% in the 1Q. Media admits that an avalanche of foreign borrowing has been boosting the Philippine forex reserves, thereby, the peso. Foreign borrowings have reached $7.76 billion
Yields of Philippine treasuries dropped to record lows across the curve. Again, such milepost reflects global trends, and importantly, the BSP’s policy actions of reducing its policy rates to levels unseen in history.
Figure 3
Yields of US and ASEAN 10-year bonds likewise have been drifting in historic low levels. For instance, since USTs recently plumbed to new lows, US mortgage rates have followed last week. This record-breaking streak has spilled over to the yields of corporate bond investment grades, which has been benefiting from the US Federal Reserve’s acquiring US corporate debt ETF as part of the bailout of the US financial system.
Again, such historic lows have hardly been signs of stability but about central bank interventions of disguising risks with massive infusions of liquidity.
Since all actions have consequences, the repercussions from such interventions will surface in the fullness of time.
IV. Debt Crisis Represents an Outcome of the Dynamic Process of Excessive Leveraging
Artificially low rates sow the seeds of bubble cycles.
First of all, instead of stimulus, low rates signify monetary tightening. The Interest rate fallacy as described by the Nobel Prize winner, Milton Friedman*, runs in contrast to popular wisdom.
Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.
Tightening money suggests slow growth.
Meanwhile, the risks of booming risks assets in the face of the marked deterioration of fundamentals have likewise caught the eye of the establishment institutions.
From the CNBC (June 25): The International Monetary Fund has warned that the ongoing disconnect between financial markets and the real economy could lead to a correction in asset prices.
Such IMF’s warnings represent a follow-through from their April 2020 Global Financial Stability Report: (Chapter 3)
Lower-for-longer yields may prompt institutional investors to seek riskier and more illiquid investments to earn their targeted return. This increased risk-taking may lead to a further buildup of vulnerabilities among investment funds, pension funds, and life insurers, with grim implications for financial stability. Furthermore, institutional investors’ strategies to search for yield may introduce additional risks. Low yields promote an increase in portfolio similarities among investment funds, which may amplify market sell-offs in the event of adverse shocks. The need to satisfy contingent calls arising from pension funds’ illiquid investments could constrain the traditional role they play in stabilizing markets during periods of stress. High-return guarantees and duration mismatches are driving an increase in cross-border investments by some life insurers, which could facilitate the spillover of shocks across borders. The underlying vulnerabilities could amplify shocks and should therefore be closely monitored and carefully managed.
Mismatches! Sounds familiar?
Though I am no fan of the IMF, the fact that they recognize the inherent buildup of risks underscores mounting apprehension even from the establishment.
Low rates negatively impact the banks of advanced economies, wrote the IMF. (Chapter 4)
Profitability has been a persistent challenge for banks in several advanced economies since the global financial crisis. While monetary policy accommodation has helped sustain economic growth during this period and has provided some support for bank profits, very low interest rates have compressed banks’ net interest margins (the difference between interest earned on assets and interest paid on liabilities). Looking beyond the immediate challenges faced by banks as a result of the coronavirus (COVID-19) outbreak, a persistent period of low interest rates is likely to put further pressure on bank profitability over the medium term. A simulation exercise conducted for a group of nine advanced economies indicates that a large fraction of their banking sectors, by assets, may fail to generate profits above their cost of equity in 2025. Once immediate challenges recede, banks could take steps to mitigate pressures on profits, including by increasing fee income or cutting costs, but it may be challenging to fully mitigate profitability pressures. Over the medium term, banks may seek to recoup lost profits by taking excessive risks. If so, vulnerabilities could build in the banking system, sowing the seeds of future problems.
A Working Paper for the Bank for International Settlements sees other impact of low rates on banks**.
Low interest rates tend to boost stock and bond markets (Bernanke and Kuttner (2005)). Searching for yield, banks are expected to rebalance their asset portfolio from the loan to the trading book, which should generate higher yields and fee-based income (Rajan (2005)). Likewise, at low rates, there is greater demand from retail depositors for professional portfolio management services (Albertazzi and Gambacorta (2009)). Bank managers may thus be inclined to shift their business lines towards capital market activities and raise their corresponding exposures.
Banks will also have incentives to rebalance the composition of funding. For a given risk profile, funding costs decline when interest rates are low. This includes the cost of bond issues, if term premia are compressed, and that of retail deposits. Banks may have incentives to rely more on deposits and fixed-rate long-term debt at the expense of short-term variable-rate funding.
Michael Brei, Claudio Borio and Leonardo Gambacorta Bank intermediation activity in a low interest rate environment, August 2019, BIS.org
Figure 4
Haven’t domestic banks become increasingly reliant “fixed-rate long-term debt at the expense of short-term variable-rate funding”?
That is, emerging market banks are prone to the same vulnerabilities.
Importantly, a debt crisis is a product of artificially low-interest rates.
The stages of a debt crisis according to Harvard’s Carmen Reinhart and Ken Rogoff***:
Newly developed long historical time series on public debt, along with modern data on external debts, allow a deeper analysis of the cycles underlying serial debt and banking crises. The evidence confirms a strong link between banking crises and sovereign default across the economic history of great many countries, advanced and emerging alike. The focus of the analysis is on three related hypotheses tested with both “world” aggregate levels and on an individual country basis. First, private debt surges are a recurring antecedent to banking crises; governments quite contribute to this stage of the borrowing boom. Second, banking crises (both domestic ones and those emanating from international financial centers) often precede or accompany sovereign debt crises. Indeed, we find they help predict them. Third, public borrowing accelerates markedly ahead of a sovereign debt crisis; governments often have “hidden debts” that far exceed the better documented levels of external debt. These hidden debts encompass domestic public debts (which prior to our data were largely undocumented). P.2
Consistent with Diamond and Dybvig’s (1983) famous model of banking crises, short-term debts escalate on the eve of banking crisis; the ratio of shortterm to total debt about doubles from 12 to 24 percent. A similar pattern emerges in the runup to sovereign defaults (which in this particular exercise immediately follows banking crises).
Carmen M. Reinhart Kenneth S. Rogoff, FROM FINANCIAL CRASH TO DEBT CRISIS NBER WORKING PAPER SERIES, March 2010
From M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge, and Naotaka Sugawara of the World Bank Group (Chapter 1, p 12)
The three previous waves displayed several significant similarities. They all began during prolonged periods of very low real interest rates, and were often facilitated by changes in financial markets that contributed to rapid borrowing. The three past waves all ended with widespread financial crises and coincided with global recessions (1982, 1991, and 2009) or downturns (1998, 2001). These crises were often triggered by shocks that resulted in a sharp increase in borrowing cost stemming from either an increase in investor risk aversion and risk premiums or a tightening of monetary policy in advanced economies. These crises typically featured sudden stops of capital flows. They usually led not only to economic downturns and recessions but also to reforms designed to lower external vulnerabilities and strengthen policy frameworks. In many EMDEs, inflation-targeting monetary policy frameworks and greater exchange rate flexibility were introduced, fiscal rules were adopted, and financial sector regulation and supervision were strengthened.
M. Ayhan Kose, Peter Nagle, Franziska Ohnsorge, and Naotaka Sugawara Global Waves of Debt Global Waves of Debt Causes and Consequences, December 2019
In short, a debt crisis is a product of cumulative actions, consequences, reactions and multiple feedback loops involving leveraging, therefore representing a complex and dynamic process.
Statistics, on the other hand, are data acquired from the past.
That said, the debt profile of banks and the public sector undergoes changes, especially the degree, depending on the conditions of a given time.
For instance, when the Asian crisis appeared, fiscal conditions seemed sound. From World Bank’s Global Waves of Debt (p.82)
While the fiscal positions of the Asian crisis economies were generally sound as they entered the crisis, government debt rose sharply in the ensuing deep recessions as a result of automatic stabilizers and counter-cyclical support for demand, as well as support of banks and corporates in distress. Government debt rose by more than 30 percentage points of GDP in Indonesia and Thailand during the late 1990s. While the Asian financial crisis did not lead to widespread sovereign debt crises as in LAC and SSA, several countries required official financial support during and after the crisis. IMF support included $23 billion for Indonesia, $58 billion for Korea, and $20 billion for Thailand (Fischer 1998; IMF 2000a)
Philippine public debt surged 15% year to date or by Php 1.159 trillion or by 12.2% year on year or Php 975 billion to Php 8.89 trillion last May.
Have we not been seeing similar patterns unfold?
The BSP is about to publish financial conditions of banks and its depository survey in the coming week or two.
V. Malinvestments: Effects of Credit Easing: BSP’s Real Estate Index Boomed as the GDP Contracted!
What’s wrong with this picture?
Figure 5
As the headline GDP plummeted to -.2%, the BSP’s real estate price index flew by a spectacular 12.4% in the 1Q. Booming prices of condominium (+23.6%) and duplex (+38.3%) have been responsible for most of the gains.
Have we not been told that real estate prices are supposed to manifest increases in wealth???
Banking loans to the real estate sector zoomed 22.4% in Q1 YoY along with surging property prices. And the loan figure represents the supply side of the real estate sector.
Paradoxically, the debt-fueled property mania comes in the face of soaring business closures, income cutbacks, and surging unemployment.
The real estate sector has signified the prime beneficiary from the BSP’s massive easing measure in the form of policy rate cuts and liquidity injections (aside from RRR cuts) that bolstered the growth of the industry’s loan portfolio, which subsequently diffused into prices.
According to the IMF’s Global Housing Watch, the Philippines topped the world’s housing property inflation in Q3 2019 and ranked 8th in the world in real credit growth.
With the stock market underperforming, the elites seemed to have converted property prices into a casino!
Let us see, slowing/contracting economy, booming property prices and surging loans are not signs of a colossal misdirection of resources?
As Carmen Reinhart and Kenneth Rogoff wrote in This Time is Different: Eight Centuries of Financial Folly: “What is certainly clear is that again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits.”
