Phisix: Negative Real Interest Rate and Stagflation Risks

The real interest rate is not the difference between the nominal rate and the change in the CPI; it is actually the rate of exchange between present goods and future goods. Also, there is no such thing as the real interest rate — there are a multitude of real rates, which cannot be added to a total. -Frank Shostak

In sympathy with the actions in global markets, the Phisix declined 1.82% over the week which reduced year to date gains to .44%.

Negative Real Interest Rate and BSP’s Admission of External Influences

The Philippines and most of ASEAN have so far been less politically influenced relative to other markets.

But this doesn’t make us immune.

Proof?

From Bloomberg[1],

``Bangko Sentral will review inflation forecasts for this year and 2012 at the June 16 meeting, Tetangco said. An extension of the Federal Reserve’s so-called quantitative easing, “if it happens,” will tend to boost inflows to emerging- markets, bolster liquidity and strengthen currencies, he said.”

The good governor does not directly say it; but he implicitly acknowledges that there exists a strong transmission mechanism from US Federal Reserve policies, which have substantial effects on local assets, the local economy and inflation.

Governor Amando Tetangco thinks he has all the required tools to manage this.

I quote Governor Tetangco anew from the same article,

“If you look at the May figure, inflation pressures still exist,” Tetangco told reporters in Manila today. “We will look at the options available, the instruments included in the toolkit including the policy rate, reserve requirement and macro prudential measures.”

And I have been saying that local media and the BSP have not been forthright[2] and will miscalculate on estimating inflation trends.

This has been happening.

Nevertheless, the Philippines still operates on an accommodative monetary policy.

Previously, the Philippine (CPI) inflation rate, as shown in the chart from tradingeconomics.com[3], has been slightly above interest rates which make for a negative real interest rate environment[4], where inflation is greater than interest rates. In this article, I will be wearing on the mainstream’s thinking cap on interest rates.

So accounting gains from fixed income investments on a nominal basis could likely be overestimated unless adjusted for by inflation.

The Bangko Sentral ng Pilipinas (BSP) increased its policy interest rates twice this year but so far, the level of rates are just about the level of BSP’s statistical inflation.

Yet given the public’s outcry over price hikes in energy and food, I think that the mathematical construct of the BSP’s CPI basket seems to underreport real CPI inflation.

This only means that the current operating conditions imply that negative interest rate environment could be alot greater than what can be gleaned seen using BSP computations.

The overall implication, according to Wikipedia.org[5], is that negative real interest rates leads

to commodity speculation and business cycles, as the borrower can profit from a negative real interest rate

Also, given the combination of the current level of economic growth rate, which remains far above the interest rate, coupled with the negative real interest rate outlook, suggests that the Philippines continues to operate on a loose monetary inflation stoking environment.

Easy money policies which favor debtors also mean favoring speculators. Thus, current environment remains supportive of an upbeat Phisix, despite a current slowdown elsewhere.

So both external and internal forces in fusion points towards higher inflation which will go beyond the expectations and the statistical estimates of the BSP.

The Peso yield curve seems to be indicating the same inflation outlook (chart from ADB’s Asian Bonds Online[6])

Our current yield curve (red) has further steepened from last year (yellow) implying higher future inflation.

To add, going back to the economic growth, inflation and interest rate chart, despite the slowing growth momentum (measured in quarterly changes upper window), which is signified by the red arrow, the above dynamics seems representative of symptoms known as stagflation—high inflation accompanied by high unemployment and slower economic growth[7].

So this could be a preview of what’s going to happen once inflation intensifies.

Stagflation and the EPIRA law

Aside from local and foreign monetary policies, part of the worsening of domestic inflation has recently been seeded.

The passage or the extension of the politically correct but economically unfeasible decree signified by the massive electricity subsidies based on the Electric Power Industry Reform Act [EPIRA] law[8] will be part of such force. In 2010[9], I have previously discussed on how this would contribute to today’s inflation. Apparently we see signs of price pressures[10] part of which has been due to this.

These subsidies would intensify demand for electricity consumption, where the benefits of political free lunches aimed at acquiring votes, will only be passed and added to the burdens of all productive enterprises.

The outcome will reminisce the past where increasing costs of energy will translate to higher cost of doing business, elevated risk premiums and high hurdle rates that would imply fewer investments, higher levels of unemployment, lower growth rate and importantly lower standards of living.

Moreover, this law impels for the growing risk of power supplies shortages.

Eventually socialist type of free lunches runs dry. As former UK Prime Minister Margaret Thatcher says[11], Socialism

always run out of other people's money. It's quite a characteristic of them

Proof?

Venezuelan President Hugo Chavez claims that energy is a “birthright” for Venezuelans[12]. The result has been a massive rolling blackout, a model we should look forward to especially in the face of the continued uptrend in commodity and energy prices.

In addition, like Venezuela[13], we can expect more smuggling or black market or illegal connections to take place.

Indonesia has learned from such unviable and absurd policies and has begun dismantling subsidies to all sectors.

As the Jakarta Post reports[14],

The government expects to remove the electricity subsidy completely by as early as 2014 so that it will have more funds available to fight poverty and improve healthcare directly for the poor, a minister has said..

Unfortunately we have taken the opposite route.

Yet this is an example of redistributive tax scheme, where publicly listed Meralco, a legally franchised monopoly, would serve as the conduit for such mandate. This validates only my observation about Meralco’s status as a pet company for politicians[15].

The good news is that stagflation does not automatically translate to wreckage for the stock markets. Not if we use Venezuela as a model.

Venezuela has had an amazing stock market run this year[16] despite inflation tipping towards hyperinflation earlier, along with high unemployment and a two year economic slump which she has reportedly emerged from[17].

This is not to say that stagflation is good for the stock market, instead the returns of Venezuela’s stock markets remains negative when computed for inflation.

Put differently Venezuela’s stock market could have functioned as a defensive store of value from her rapidly devaluing currency.

The other point is that Venezuela’s dynamic may or may not apply elsewhere because of every nation’s idiosyncrasy or structural uniqueness.

For most, the current state of boom bust cycles, which drives global stock markets evinces that meltdowns are a mostly result of liquidity contraction from a previous inflationary environment such as the recent cases of Bangladesh[18] and Vietnam[19] or the global 2008 crisis.

PSE: It’s a Correction Phase

Last week’s correction seem as broadmarket based.

All sectors endured losses. Even the mining sector which has sizzled for 10 consecutive weeks finally relented.

The good news is that despite the losses, market breadth hasn’t been as dire as declining issues led advancing issues moderately.

Even net foreign trade posted slightly negative.

The Peso declined along with the local benchmark market, albeit only marginally lower from php 43.205 to a US Dollar last week to php 43.28 at Friday’s close.

Market internals and the Peso’s actions have not yet been manifesting signs of sharp deterioration.

Thus, I’d read the actions in the Phisix as a consolidation phase awaiting a trigger for a next run.

One would further note that the last time the Phisix collapsed was in an environment of higher rate of inflation and higher level of interest rates than today. Of course the 2008 episode accounted for as contagion which whose origins were from external forces.

The point is I don’t see substantial signs of severe corrosion of financial and economic conditions yet.

Finally, we should expect the continuance of current global volatility until political issues abroad would get threshed out.

As for the timing of when this resolution will happen is beyond my capabilities as analyst, I can only speculate.

As Ludwig von Mises wrote[20], (bold emphasis mine)

In the real world acting man is faced with the fact that there are fellow men acting on their own behalf as he himself acts. The necessity to adjust his actions to other people's actions makes him a speculator for whom success and failure depend on his greater or lesser ability to understand the future. Every action is speculation. There is in the course of human events no stability and consequently no safety.

And since I expect the current market actions to represent more of a countercyclical reprieve than a major inflection point, then it should be considered as windows of opportunities to accumulate or for trade.

---

[1] Bloomberg.com Philippines’ Tetangco Says Inflation Pressures ‘Still Exist’ (1), June 10, 2012

[2] See The Code of Silence On Philippine Inflation, January 16, 2011

[3] Tradingeconomics.com Philippine Indicators

[4] Investorglossary.com Real Interest Rates

[5] Wikipedia.org Negative Real Interest Rates

[6] Asianbondsonline.adb.org Philippines

[7] Wikipedia.org, Stagflation

[8] Businessworldonline.com Legislators OK extension of lifeline subsidy scheme, June 7, 2011

[9] See Earth Hour In The Philippines: Rotational Brownouts! The Revenge Of Economics, April 09, 2010

[10] Philstar.com Power, fuel rates up, April 6, 2011

[11] Thatcher Margaret TV Interview for Thames TV This Week 1976 Feb 5 Th

[12] Yahoo.com Hugo Chávez challenges Venezuelan 'birthright' to cheap gas, March 4, 2011

[13] Reuters Africa, World's lowest gas prices fuel Andean smuggling, June 10, 2011

[14] Jakarta Post, Govt expects to remove electricity subsidy by 2014, March 23, 2010

[15] See Meralco’s Run Reflects On The Philippine Political Economy, July 12, 2009

[16] See Global Equity Markets: Signs of Exhaustion; What US Outperformance Means, May 17, 2011

[17] Wall Street Journal 2nd UPDATE: Venezuela 1Q GDP Up 4.5% Vs Previous Year, May 17, 2011

[18] See Bangladesh Stock Market Crash: Evidence of Inflation Driven Markets, January 11, 2011

[19] See Vietnam Stock Market Plunges on Monetary Tightening, May 24, 2011

[20] Mises, Ludwig von UNCERTAINTY: Case Probability, Chapter 6 Section 4 Human Action

The Politicking the Philippine Energy Sector

This is my reply to a foreign client on the state of the Philippine Energy (edited/revised version) and how government actions have been impacting the financial markets. I think it deserves a wider audience…

How can the Philippines attract investments when government is making the joint foreign chambers and the private sector a scapegoat for our problem? How does one attract investments when we have been threatening capitalists?

We supposedly have an Energy Policy (EPIRA) which was meant to deal with Napocor's problem by selling its assets and the liberalization of industry to attract investments.

Now intervention via "patriotism" is threatening to stall if not alter the entire process. Yet there is NO template for a viable alternative scheme! The recent proposals are nothing but patchy stop gap measures!

The administration have been passing the buck to private ownership by accusing them of overcharging the populace because of "greed"/similar to windfall profit tax on oil companies in the US.

On the first place, the "take or pay" provisions of which has been the bitter point of argument is a carryover from the Ramos Regime, where in due haste to resolve the daily 8-hour brownouts, Former President Fidel Ramos executed contracts unduly in favor of IPPs. In short, the policy mistakes of Ramos regime is the object of GMAs ire but directed to the IPPs and distribution utilities. Who signed or implemented this in the first place?

Look at the administration’s present proposals (Businessworld):

“The Finance chief said the task force had agreed to recommend:

-asking distribution utilities to absorb the value-added tax (VAT) on system losses;

-a review of the cap on systems losses to lessen the burden for consumers;

-that state-owned National Power Corp. (Napocor) offer flat rates of P4.11/kWh to Manila Electric Co. (Meralco); and

-ensuring that local government units (LGUs) allocate part of their tax share for lifeline subsidies…

- Renegotiate existing government contracts with IPPs."

It basically highlights TWO features:

one-SUBSIDIES by Napocor and LGUs and

two-asks that private companies (distribution utilities and IPPs) ABSORB Losses! Huh? Our government officials now seemingly think that the role of private institutions is similar to that of public institutions-to provide subsidies to consumers? If the private sector losses money will they be subsidized by taxpayer money??? Hellloooo???

Yet the true story is that NO MATTER what the administration does with such past contracts, it won't solve our energy predicament. It won't lower prices over the long run. Such actions WILL ONLY RESTRICT SUPPLIES! It will only create friction with the investors who will eventually refrain from investing, leading to A REPEAT of the Ramos era Brownouts and the repeat of the entire vicious cycle of supplication when we become desperate. It seems that we have not learned from our past.

Our government has failed miserably in its attempt to centrally plan the industry at a humongous cost of estimated $7.2 billion Napocor debts!

You see, the entire episode is nothing but a Public Relations stunt. And I believe the administration is aware of this and is likely to be a tactically designed political action for unstated political reasons.

In essence, the attempt to prove to the poor that the administration is "doing something", will mean RESTRICTING supply or HIGHER PRICES and or ROLLING BROWNOUTS in the future. Pretending to do something today means WORSENING OUR SITUATION TOMORROW.

Yet the administration knows that taxpayers cannot afford to shoulder any nationalization or continued subsidies of the industry because the Philippines is hobbled by debts, which ironically the industry have contributed immensely. Not to mention that this means higher taxes tomorrow in an already onerous tax regime. Besides, hostility towards foreign principals also means REDUCING ACCESS TO CAPITAL even in the international markets. So if you don’t get financing and restrict supply, what happens next? HIGHER Energy Prices or HIGHER Taxes!

So yes, the Philippines have abundant endemic non electric energy sources (think geothermal-we are second or third in the world in terms of reserves). But no, trying to win the votes or sentiment of the public by creating scapegoats and squeezing profits of energy companies will even do as more harm than good.

So investments are at risks and supply will be a future problem. Politicking which is all about the short term means more poverty and hardship for us.

The lesson here is that government intervention always distorts the distribution process of efficient resource allocation and aggravates the situation than help solves it. Even the privatization of US Senate dining services basically proves how markets function more efficiently than government actions.”

Philippine Politics: The Nationalist Hysteria Over Energy Issues

``Nine-tenths of the economic fallacies that are working such dreadful harm in the world today are the result of ignoring this lesson. Those fallacies all stem from one of two central fallacies, or both: that of looking only at the immediate consequences of an act or proposal, and that of looking at the consequences only for a particular group to the neglect of other groups.” Henry Hazlitt (1894-1993), libertarian philosopher and economist, Economics in One Lesson

Some economists propound that global demand for petroleum products will perhaps moderate enough to lower oil and petrol prices, as governments around the world work to reduce subsidies.

Subsidies mean that government absorbs the difference between the costs from market prices relative to significantly lowered prices sold to the public. If the government doesn’t have enough wherewithals to sustain the losses or subsidies then it would have to print or borrow money which eventually would rack up deficits and mean higher taxes and lower standards of living.

But, the raging acceleration of oil prices (WTIC crude benchmark skyrocketed to $139 per barrel last Friday) has been fast inflicting damage to government fiscal conditions. For instance according to the Financial Times (highlight mine),

``Government officials said Malaysia was in danger of spending M$50bn ($15bn, €10bn, £7.9bn) on fuel subsidies this year if government-set prices for petrol and diesel were not raised to reflect the surge in global crude oil prices to about $130 a barrel.

``Before today’s increase, Malaysia’s fuel subsidy ac­counted for nearly a third of total government spending and was equivalent to about 7 per cent of gross domestic product, one of the highest proportions in the world.”

So in weighing on the tradeoffs between the costs to political stability against restoring some sense of fiscal uprightness, some governments will and have opted for the latter. Indeed, Malaysia recently raised petrol prices by 40%! And this has been followed by price increases in India and Taiwan.

After all the distinction between subsidies and a pass through from market prices is all in the timeframe- subsidies are basically SHORT TERM pacification in exchange for LONGER TERM pain.

For as long as energy prices keep climbing, where governments have no revenue source to fund subsidy programs, consumers will ultimately be facing the reality of higher energy bills. In short, governments have a choice of having its consumers accept reality NOW or at a greater pain, TOMORROW.

Figure 1 Morgan Stanley: Global Oil prices as of Early 2008

For politically stable countries, the most likely path will be to lift subsidies. But this does not seem to apply to the Philippines even if petrol prices seem to be lower than the rest of the world, as shown in Figure 1 courtesy of Morgan Stanley.

While petrol prices haven’t been subsidized, which has been a plus factor for now, the trend towards subsidies or even the risks of “nationalization” appears to be gaining momentum as the incumbent government has increasingly trained its guns on the private sector.

For instance in the case of Meralco, government has used a flanking attack (this time using Energy Regulatory Commission, after the GSIS and SEC) towards squeezing the Meralco management to increase payout for a whole lot of myriad reasons (e.g. deposits). Perhaps the idea is if Meralco gets effectively hemorrhaged, stockholders will be swayed to allow government allies to assume control of the firm.

While it is true, that the Philippine government has not directed a frontal takeover of the said energy distribution monopoly by EDICT (Presidential Decree or via Franchise in Congress-yet) and has done so by corporate maneuvering, the fact that it is bleeding dry Meralco gives the public the wrong impression that the private sector has been responsible for rising electric bills! The government has even prohibited the energy (LPG) companies from making public announcements for price increases! Incredible.

At worst, the administration representatives in the Senate has even disparaged at the members of the joint foreign chambers of commerce on the latter’s appeal to reconsider changes to EPIRA.

Figure 2: IMF: Philippine Debt to Foreigners Is Half of Outstanding Liabilities

The overweening self righteous attitude of our officials assumes of the profuseness of capital in the Philippines (if we have so much capital why then are we poor?). We do not imply that they should fawn over to foreign capitalists, but rather negotiate diplomatically or cordially and not out of highhandness.

Should the Philippines undergo another financial or capital crisis; do we not supplicate on foreigners for capital as we have done in the past? The fact is Philippine foreign liabilities comprise HALF of the countries total or outstanding debt, see figure 2 from IMF, meaning much of our local spending programs in the past have been financed by foreigners. Yes, it also infers that a lot of the “corruption” by government officials has been indirectly due to foreign funding. Thus, we find intellectual dishonesty (if not a travesty) in invoking a nationalistic hysteria when dealing with energy issues.

The fact is that energy prices have been RISING around the world ENSURES of higher energy bills to Philippine consumers. Period. In addition, since we are NOT self reliant or produce enough energy to standalone- we are reportedly importing 99% of our gasoline and diesel requirements (manilastandardtoday.com)- thus are subjected to global market forces. This reality means pain at the pump and at our electric bills. No amount of political grandstanding will lower prices, even if the government or its factotums does succeed to takeover Meralco or other public utility firms -again if the aim is to subsidize, subsidies temporarily lowers bills but will be more costly to the consumers in the future. Moreover, we must be reminded that our fiscal position is still in a precarious state.

Further yet, “evil” profits which are meant to be stanched and public subsidies (the fleecing of the country’s productive sector to the unproductive) are both delusions that it is being peddled to the public as a panacea, from which the latter will want more and more of it. Anyway, the government keeps feeding on them, e.g. fertilizer (P 1,500 per farmer), energy (P 500 per family) and student loans programs. We should even doubt the efficacy of these programs if they are indeed meeting their desired targets which we suspect could end up more in the hands of the disbursers of such legal bequest, i.e. the politicos, the affiliates and their followers.

Hence, instead of a thrust towards fiscal balancing which is seen in many parts of the world, the Philippines seem on the path towards fiscal remission if not an outright regression. Yes, Philippine financial markets have borne the onus of such politicization, as seen in the state of the “depreciating” Peso, the “falling” Phisix and the “soaring” bond yields.

The next Presidential elections (if there would be any) will probably be marked by demagoguery of even more intense socialist tendencies. Don’t forget many of the world’s tyrants/despots emerged during the heydays of oil and commodity prices in the late 60s-80s. This has probably been due to the increasing clamor for social safety nets under pressures of higher cost of living and or to revenues derived from surpluses of commodity exports as a docile form of redistributive channel for more social spending programs. Today since forex surpluses have been flowing to non-democratic regimes, there has been a tendency to adopt on such paradigm e.g. Bolivia, and Venezuela.

We suspect that all these collective actions have mainly been efforts to deflect on political pressures on the administration (ZTE scandal), which has decided to turn the table against its opponents and use the present economic environment as staging point for a Public Relations (PR) Offensive.

Yes, we can also say that the administration through its subsidy programs has been attempting to buy its way to popularity or to win back favorable sentiment from the populace for allegedly “social” intents but apparently cloaked with undisclosed political reasons.

Nonetheless, the potential emerging risks arising from the actions of our public officials could also be construed as seemingly a prologue for a transitory government, from one of a political “democracy” to a prospective “statist autarky” from 2010 and beyond. I just hope the latter is just a figment of my imagination.

Post script:

A possible unintended consequence arising from the nationalistic hysteria will of course be investors withdrawing from financing of our new energy projects. This means that LIGHTS GO OUT IN THE FUTURE. (Environmentalist should love this!)

And possibly when brownouts worsen like in the Ramos Regime, we will be forced anew to embrace foreign capitalists at disadvantageous terms for us. (But advantageous for the dealmakers though! Could this be the reason behind the sudden reappearance of the virtues of patriotism?) Thus vicious cycle repeats all over again. Haven’t we learned from the past?