If the governments devalue the currency in order to betray all creditors, you politely call this procedure 'inflation'—George Bernard Shaw
USD-Php Races to a Two-Year High! The Fragility of USD Shorts Mounts
The USD-Php pierced above the Php 52.5 resistance level to close the week at Php 52.86, a 2-year high! The 1.03% weekly climb, resulting in this breakthrough, pushed its YTD returns to 3.65%.
The Php 52.5 threshold, in my suspicion, represented the upper band limit of the dirty float currency system managed by the BSP.
This breakout will likely push the USD-Php to test the high of 54.32 attained last October 4, 2018. Once triumphant, the 2004 milestone high of 56.35 should step up to the next challenge.
Figure 1
The current moves of the USD-Php only reinforce the 52-year downtrend of the peso or the uptrend of the USD. (Figure 1)
Borrowing a Wall Street aphorism: "Don't fight the trend."
But this is more than about trend following, fundamentals anchors the weak peso.
As repeatedly pointed out here, the recent strength of the peso emanates from artificial means. It relies on leveraging or extensive exposure to "USD shorts."
Figure 2
First, BSP operations through "Other Reserve Assets" (ORA) or derivative transactions had been instrumental in fueling a rally in the peso from 4Q 2018 to 2Q 2021. Data from the IMF’s International Reserve and Foreign Currency Liquidity (IRFCL).
Also, considerable borrowings by the National Government have revved up FX inflows helping boost the Gross International Reserves (GIR) through the NET foreign assets of the BSP.
Figure 3
As of this writing, the balance sheet of the BSP remains dated at the end of 2021. Based on this, the normalization of the BSP balance sheet required the ramping up of external borrowings to offset its unprecedented emergency domestic Php 2.3 trillion liquidity operations.
The BSP previously maintained a fixed majority share of FX holdings relative to its assets, signifying a de facto USD standard. The degree of FX holdings of the BSP served as the foundation of the domestic (peso) issuance. But the recent emergency measures unmoored this relationship. (Figure 3, upper window)
Yet, the pandemic functioned as the politically convenient pretext for the massive FX borrowing. BSP’s external debt is at a record high as of Dec 2021. (Figure 3, lower window)
These inflows have led to the recent surpluses in the Balance of Payments (BOP) and gains of the GIRs.
However, since the gearing of the balance sheet incurs costs, the monetary tightening in the global sphere increases it.
In this way, the recent surge in UST yields has magnified the costs of maintaining FX leverage.
The BSP, hence, has started to prune its reliance on ORA or derivatives.
In any case, the current environment is something which we admonished.
Furthermore, to reduce credit risk through the exchange rate channel, the BSP has used derivatives and loans in shoring up its Gross International Reserves (GIR), thus helped in the powering up of the peso. Other Reserve assets continue to absorb a significant role in the BSP’s GIR.
…
Should a surge in global inflation continue, this massive USD short position can be expected to unwind dramatically.
See BSP’s Diokno: No Asset Bubbles and Excessive Credit Growth; Ex-BSP Gov. Espenilla’s Minsky Moment, and Statistical Inflation of Real Estate Prices February 22, 2021
Figure 4
As a proxy to the cost of FX leveraging, USD 10-Year Treasury swap rates soared to a 3-year watermark. (Figure 4, topmost pane)
A foreign currency swap, according to Investopedia.com, is an agreement between two foreign parties to swap interest payments on a loan made in one currency for interest payments on a loan made in another currency.
So aside from reducing ORA, the servicing costs of the surging external debt should weigh on the peso.
Once this exceeds the organic sources of FX generation (OFW remittances, services exports, tourism receipts, and FDIs) plus access to capital markets abroad (portfolio and credit flows, derivatives, Eurodollar, and more), this magnifies the risks of a sharper fall of the peso.
Further, the debt servicing costs of the external merchandise or trade deficits also function as a contributing factor. The public spending binge represents a crucial ingredient in the trade imbalance. Or the twin deficits, fiscal and trade, are entwined. (Figure 4, middle pane)
How realistic is the belief that the new administration is about to embrace austerity?
Further, the declining peso should not reflect only the political actions of the BSP but also compound price pressures in the economy, amplifying the feedback loop.
Accounts of capital exodus will likely become evident once the public realizes the increasing fragility of this façade.
We may be seeing seminal signs of this process. As pointed out in May:
Meanwhile, FX deposits are surging. It expanded 10.9% in March, its fastest rate since May 2018.
Is the public seeking a haven via a shift from the peso to FX deposits?
See Treasury or Bond Vigilantes Return with a Vengeance, Compels the BSP to Implement its First Rate Hike! May 22, 2022
For the first time since 2009, the weak peso may have incited the robust growth in FX deposits, a reflexive variance from the weak peso episode in 2013 to 2018. (Figure 4, lowest pane)
In this instance, if my hypothesis rings true, the capital flight process has just begun.
The political undertaking to prop the peso with "USD shorts" increases the risks of a massive boomerang.
Again. Don’t fight the trend.
Yours in liberty,
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