The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system—Ludwig von Mises
In this issue
Stagflation Ahoy! How "Limited" is the Impact of the Ukraine War on the Domestic Economy?
I. How "Limited" is the Impact of the Ukraine War on the Domestic Economy?
II. Feedback Loop 1: China’s Deteriorating Economic Conditions
III. Feedback Loop 2: Surging Fertilizers (and Commodities)
IV. Feedback Loop 3: Financial Liquidity
V. Sound Macro Foundations as a Shield to the Ukraine War? Bloomberg Study, CDS and Bond Markets Say Otherwise
Stagflation Ahoy! How "Limited" is the Impact of the Ukraine War on the Domestic Economy?
I. How "Limited" is the Impact of the Ukraine War on the Domestic Economy?
This week’s outlook, anchored on our response to the news excerpts below, represents an update on the deepening stagflationary theme we dealt with two weeks ago.
March CPI: Stagflationary Forces Enveloping the Philippine Economy One Step at a Time April 11, 2022
Here are the news quotes (all bold mine)
Manila Bulletin, April 12: The country’s inflation rate this year could move towards the 5 percent mark, but it is not likely to exceed that level, according to Bangko Sentral ng Pilipinas (BSP) official. “In (BSP’s) baseline path, the point forecast do not indicate inflation exceeding five percent (but) it could go towards five percent,” said BSP’s Zeno R. Abenoja, managing director and head of the Department of Economic Research, in an online press briefing on Tuesday, April 12.
GMA News, April 11: Russia’s invasion of Ukraine is expected to have only a “limited” impact on the Philippine economy and its banking system given its small exposure to the area both geographically and in terms of business, the central bank said Monday. In a mobile message to reporters, Bangko Sentral ng Pilipinas (BSP) Governor Benjamin Diokno downplayed the possible impact of the ongoing conflict on the Philippines. “The economic fallout from the Russia-Ukraine [conflict] on the Philippine economy is limited for three reasons: first, the country’s geographic distance from the conflict area; second, the country’s limited economic and business links with Russia and Ukraine; and third, its strong macroeconomic fundamentals,” he said.
Bloomberg/Bangkok Post, April 20: Soaring fertiliser costs have rice farmers across Asia scaling back their use, a move that threatens harvests of a staple that feeds half of humanity and could lead to a full-blown food crisis if prices are not curbed. From India to Vietnam and the Philippines, prices of crop nutrients crucial to boosting food production have doubled or tripled in the past year alone. Lower fertiliser use may mean a smaller crop. The International Rice Research Institute (IRRI) predicts that yields could drop 10% in the next season, translating to a loss of 36 million tonnes of rice, or the equivalent of feeding 500 million people. "That's a very conservative estimate," said Humnath Bhandari, a senior agricultural economist at the institute, adding that the impact could be far more severe should the war in Ukraine continue.
PSA, April 18: The total agricultural import was valued at USD 15.71 billion or a share of 13.3 percent to the country’s total imports in 2021. It increased by 24.9 percent compared with its value of USD 12.58 billion in 2020.
Authorities can facilely fabricate economic numbers hoping that the markets believe and accommodate them. Predictions of officials are thus conveniently complied with because of this.
But when street inflation goes off the rails, authorities will not limit their attempts to sanitize or embellish the estimates of actual conditions. They are also inclined to censor analysis provided by the private sector.
Surging CPI has prompted officials of Turkey to work on new legislation that threatens three years of jail time for any publication of economic numbers by the private sector if these are unapproved by its statistical agency.
Authorities believe that fear may be enough to mitigate the anguish experienced by people from a loss of purchasing power of their money.
While Turkey is not the Philippines, this account validates our premise of the elementary predisposition of governments to promote political agenda.
Because such economically sensitive numbers are neither subject to independent audits nor allowed for competition, official estimates are likely to veer away from realistic conditions.
Central bank activism, embodied by the era of easy money, has helped temper inflation, thereby accommodating the unparalleled financing of global public spending.
Unproductive private-sector debt and speculative excess in the financial markets have also signified as offspring of loose monetary policy.
Yet such epoch may have come to a close. Are authorities prepared for it? Are you?
II. Feedback Loop 1: China’s Deteriorating Economic Conditions
Authorities sell us the absurd idea that the CPI will remain tamed or fall within its target range because they are on top of the situation. They point to the "limited" DIRECT linkages of the Philippines with those nations affected by the war.
But the critical error here is to neglect the feedback loops of the chain of economic processes from the current events.
In this case: The most significant impact will emanate from feedback loops or indirect channels.
Aside from oil at $100+ per barrel, which may further reduce global goods and services output, war, sanctions, protectionism, surging costs of shipping, transportation, and logistical bottlenecks, diminished availability of cheap global finance are among the many factors that will likely impact the domestic economy.
Let us take China as an example.
Figure 1
To attain its thrust of zero-covid policy, raging COVID cases in the fully-vaxxed and boosted China have prompted authorities to impose a severe lockdown on about 40% of the economy, affecting production and employment.
Food shortages have incited massive protests in several areas.
At any rate, China’s totalitarian response to COVID should exacerbate disruptions in her domestic economy, which should have leash effects on the international division of labor, significantly affecting both demand and supply, as well as financing.
Evidence of these has started to surface.
Amplified economic frailties have substantially closed the yield differentials between Chinese Treasuries with their US counterpart. (Figure 1, upper left)
Foreign investors have reportedly been aggressively dumping China's financial assets. Aside from the above, part of the record 1Q narrowing of the yield spread may have been due to the uncertainty brought about by the Chinese government's refusal to kowtow to Western demands for her to join the bandwagon to sanction Russia. And on the domestic front, pressures emanate from the regulatory crackdown on several industries.
Plunging repo rates also possibly highlights the scramble for bank collateral amidst debt defaults, aside from PBOC liquidity injections. (Figure 1, upper right)
This week, China's currency, the offshore yuan, fell 2.3%, the most in four years. (Figure 1, lowest window)
What will be the direct and indirect effects of social, political, and economic dislocations in China to the Philippines? How about the succeeding feedback loops? Does the NEDA-BSP know?
III. Feedback Loop 2: Surging Fertilizers (and Commodities)
Local authorities think they can control street inflation from spiraling by focusing on data. That is because of their inherent inclination to fixate on regulating supply while keeping some leeway on liquidity. But "data dependency" extrapolates to looking backward than forward.
Partly due to the war, the international cost of fertilizer has been soaring.
Rising protectionism or prohibiting or limiting exports may exacerbate global supply pressures.
An example, due to looming supply shortages, Indonesia recently announced its intent to ban palm oil exports.
Reuters, April 22: Indonesia, the world's top palm oil producer, announced plans to ban exports of the most widely used vegetable oil on Friday, in a shock move that could further inflame surging global food inflation. The halting of shipments of the cooking oil and its raw material, widely used in products ranging from cakes to cosmetics, could raise costs for packaged food producers globally and force governments to choose between using vegetable oils in food or for biofuel. Indonesia counts for more than half of global palm oil supply.
Circling back to fertilizers, should surging fertilizer costs curtail the output of rice growers, this raises the risks of hunger globally.
Here, insufficient local produce requires more imports to fill the gap. But if supply is inadequate, where will authorities source their imports?
And since prices should manifest these imbalances, what will be the price levels allowable for its procurement?
Will the government subsidize the variance between the costs and its domestic selling price? What if overseas rice producers, like Indonesia's palm oil ban, cut back on exports?
As stated last week, the Philippines is partly dependent on external trade for its agricultural and other food requirements.
Figure 2
Food imports comprised about 13.9% of total merchandise imports in 2020, while agricultural imports accounted for 13.3% in 2021. The Philippine Statistics Authority noted that cereals and animal feeds accounted for the top agricultural imports. With imports up by 24.9% in 2021, the top 10 imports accounted for 86.4% of the agricultural imports. (Figure 2, middle pane)
And since bottoming in the mid-2000s, the uptrend in the share of food imports relative to the total has only accelerated. (Figure 2, topmost pane)
Along with deep-seated protectionism, the lack of investments in the agricultural industry has only increased dependency on imports.
And price pressures will unlikely stop with food.
Once again, the impact of de-globalization or the declining trend of the international division of labor, intensified by the kinetic and economic war, will most likely spread to other non-food products.
Local authorities will likely be responding to supply-side imbalances similar to the whack-a-mole game.
Simultaneously, the innate prejudice toward Keynesian demand-side management through credit expansion tilts the economy toward magnified maladjustments.
That is to say, while the BSP and the banking industry can print money, they cannot do so with rice, beef, pork, semi-conductors, and other economic goods.
In the end, there is just too much money chasing too few goods (and services)!
IV. Feedback Loop 3: Financial Liquidity
Figure 3
The spike in inflation has prompted global central banks to respond by draining liquidity from their respective system. Many have raised policy rates along with implementing a reversal of QE. (Figure 3, topmost window)
Emerging markets have experienced dramatic financial tightening from drastic measures of monetary authorities. (Figure 3, second to the highest window)
The initial effect of liquidity withdrawal has been to reduce speculative activities. Even volume in bitcoin trades has been on a marked downtrend. (Figure 3, second to the lowest pane)
With easy money on a substantial retreat, even the scale of negative-yielding bonds worldwide has collapsed. (Figure 3, lowest pane)
Here at home, it is the same story.
Figure 4
In the Philippine Stock Exchange, volume turnover has turned south even as index managers relentlessly attempt to maintain the 7,000-level. (Figure 4, topmost window)
The falling gross volume turnover resonates with the declining cash-to-deposit benchmark of the banking system. With fewer surplus cash available, this has led to a significant decrease in speculative activities. (Figure 4, second to the highest window)
Even gross volume turnover of the fixed income markets has been on a downtrend, exacerbated by the BSP’s QE. (Figure 4, second to the lowest window)
Strikingly, the BSP may have started to curb its QE. Last March, the BSP’s net claims on the central government plummeted by 49%, which put a cap on the growth of its currency issuance, which grew by 11.5% for the second straight month.
At the moment, market pressures emanate from receding liquidity. Eventually, the liquidity deficit should bring to the surface solvency issues, which likely could intensify this feedback loop.
Thus, the sustained deterioration of market liquidity magnifies the risks of downside volatilities.
So which will the BSP choose: arrest inflation and clear out malinvestments or destroy the peso?
V. Sound Macro Foundations as a Shield to the Ukraine War? Bloomberg Study, CDS and Bond Markets Say Otherwise
Figure 5
Because of the so-called sound macro-fundamentals, the BSP implies that the Philippines seem immune to the adverse economic ramifications of the Ukraine war.
"Sound macro?" But others see it differently.
Bloomberg Economics ranked the Philippines as the fourth most vulnerable in the overall exposure to the Ukraine war. It also rated the Philippines tenth in the risk of capital flight among emerging markets.
Next, if the BSP’s claim is valid, why has the BSP barely lifted the historic bailout of the banking system—the most aggressive among the emerging market central banks?
Yes, they have pruned some of the QE, but easy money policies and the numerous relief measures remain intact.
And why are investors in the credit markets pricing the Philippine debt as one of the riskiest in Asia?
On a YTD basis, the Philippines has the second-highest % increase in the ADB's Emerging Asia 5-year Senior credit default swap (CDS). On a weekly basis, the Philippines scored the second-highest bps increase in the same CDS after Malaysia.
Aside from CDS, climbing yields of the Philippine 10-year treasury signified the second fastest in Asia after Hong Kong, implying that fixed-income investors construe the BSP as most prone to "policy error."
Led by Thailand and the Philippines, yields of ASEAN treasuries have been on an uptrend since early 2020.
The broad-based increase in yields implies rising inflation for the region before the Ukraine war, which means the war only hastened the surfacing of inflationary pressures.
Yet, how will a credit-dependent economy erected from the wellspring of easy money policies survive a new era of financial tightening?
Yours in Liberty,
The Prudent Investor Newsletters
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Nota Bene: The newsletter intends to apprise readers of the market conditions based on the information available at the time of the items’ writing, whose accuracy and timeliness of the issues concerned are subject to change without prior notice. Solicitation to trade is neither intended by the contents. In the meantime, the discussion of occasional positioning on particular issues are opinions of this author.
