Maharlika's NGCP Investment: Economic Nationalism or a Bailout?

 

Don’t you need some ‘wealth’ to create a ‘wealth fund?’ Norway did it with the money it got from North Sea oil. China’s trillion-dollar wealth fund comes from its trade surpluses. Where will the US wealth come from? The government runs deficits—Bill Bonner 

In this issue 

Maharlika's NGCP Investment: Economic Nationalism or a Bailout?

I. Introduction: Maharlika's First Test: Can Conflicting Objectives Deliver Optimal Returns?

II. The Legacy of NAPOCOR: A Historical Overview and its Cautionary Lessons

III. Geopolitical Tensions Permeate the Power Sector

IV. MIC’s Investment in NGCP: A Revival of Economic Nationalism? Shades of Napocor?

A. Advance National Security by Strengthening Oversight of NGCP Management?

B. Economic Benefits: Lowering Electricity Costs by Enhancing Grid Efficiency?

V. Maharlika's NGCP Investment: A Bailout in Disguise? Potentially Inflating an SGP Stock Bubble?"

VI. Maharlika’s Risks and Potential Consequences

VII. Conclusion 

Maharlika's NGCP Investment: Economic Nationalism or a Bailout? 

Is Maharlika’s exposure to the National Grid Corp. about investments, economic nationalism, or a bailout of SGP? Or could hitting all three birds with one stone be feasible? 

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Nota Bene: This post does not constitute investment advice; rather, it explores the potential risks associated with the recent acquisition of the National Grid Corp. (NGCP) of the Philippines by the Maharlika Investment Corporation, through its controlling shareholder, Synergy Grid and Development Philippines Inc. (SGP).

I. Introduction: Maharlika's First Test: Can Conflicting Objectives Deliver Optimal Returns?

First some news quotes. (all bold mine)

Philippine News Agency, January 27, 2025: Under the deal, MIC will purchase preferred shares in SGP, granting the government a 20 percent stake in the company, which holds a significant 40.2 percent effective ownership in NGCP, the operator of the country’s power grid. Consing noted that the deal will also provide the government with board seats in both SGP and NGCP. “Once the acquisition is completed, we shall be entitled to two out of nine seats in the SGP board, after the total seats are increased from seven to nine. At NGCP, the government gains representation through two out of 15 board seats, following an increase in the total seats from 10 to 15,” he explained. The investment is seen as a crucial step for the government to regain control over the nation’s vital power infrastructure.

Inquirer.net, January 29, 2025: The country’s sovereign wealth fund is investing in the National Grid Corp. of the Philippines (NGCP) to allow the government to monitor the possible emergence of external threats, the head of Maharlika Investment Corp. (MIC) said on Tuesday. MIC president and chief executive officer Rafael Consing Jr. said they would also be interested in buying the 40-percent NGCP stake owned by a Chinese state-owned company once the opportunity arises. 

Inquirer.net, January 28, 2025: The way NGCP can contribute to lower electricity is by ensuring that that rollout indeed happens. Because once you have that transmission grid infrastructure being rolled out successfully, then you would have more power players that can in fact get onto the grid and provide supply to the grid. And, obviously, just like any commodity, as you’ve got more supply coming in, the present power will, at some point in time, come down

The Philippines' sovereign wealth fund (SWF), the Maharlika Investment Corporation (MIC), has made its first investment by acquiring a 20% stake in Synergy Grid and Development Philippines Inc. (SGP), the majority holder of the National Grid Corporation of the Philippines (NGCP), a firm listed on the Philippine Stock Exchange (PSE) 

Is this move primarily about economic interests, or does it also serve geopolitical objectives? 

Is the MIC being used to facilitate the re-nationalization of NGCP by phasing out or displacing China’s state-owned State Grid Corporation of China (SGCC), which holds a 40% stake? 

Or has this, in effect, been an implicit bailout of SGP? 

If so, how can achieving domestic and geopolitical objectives align with the goal of attaining desired financial returns?  

Or how could competing objectives be reconciled to achieve optimal returns? 

II. The Legacy of NAPOCOR: A Historical Overview and its Cautionary Lessons

To better understand the current situation, let's first examine the origins of NGCP, tracing its roots back to its predecessor, the National Power Corporation (NPC). 

The NAPOCOR (NPC), was once the behemoth of the Philippine power industry, centralizing control over both the generation and transmission of electricity. 

Established in 1936 as a non-stock, public corporation under Commonwealth Act No. 120, nationalizing the hydroelectric industry. It was later converted into a government-owned stock corporation by Republic Act 2641 in 1960. Its charter was revised under Republic Act 6395 in 1971. 

While consolidating significant influence over the Philippine electricity market, this monolithic structure came with its pitfalls. 

NAPOCOR accumulated substantial debt due to a combination of over-expansion, mismanagement, political interference, and corruption. 

The corporation's financial stability was further undermined by subsidies, price controls—both contributing to market imbalances—and costly contracts with Independent Power Producers (IPPs), which led to a cycle of financial losses. 

In response, the Electric Power Industry Reform Act (EPIRA) of 2001 was enacted, marking the beginning of the sector's restructuring through privatization. 

The Power Sector Assets and Liabilities Management Corporation (PSALM) was created to manage the sale and privatization of NPC's assets, also assuming NPC's liabilities and obligations.

Figure 1

At its peak, NAPOCOR’s debt, as reported by PSALM, had reached 1.24 trillion pesos by 2003. (Figure 1) 

The National Transmission Corporation (TRANSCO) was established to manage the transmission facilities and assets previously under NAPOCOR.

This restructuring ultimately led to the formation of the National Grid Corporation of the Philippines (NGCP) in 2009, a consortium that included local business tycoons Henry Sy Jr. and Robert Coyiuto Jr., along with China’s state-owned enterprise, the State Grid Corporation of China (SGCC). NGCP assumed operational control of the country’s power grid. 

The key takeaway from NAPOCOR’s experience is that its monopolistic structure created and fostered inefficiencies, corruption, and imbalances, which culminated in massive debt. 

Despite the privatization, NGCP remains a legal monopoly. 

Once again, NGCP operates and maintains the transmission infrastructure, such as power lines and substations, that connects power generation plants—including those owned by NAPOCOR and private generators—to distribution utilities. 

III. Geopolitical Tensions Permeate the Power Sector 

The current Philippine administration's foreign policy can be viewed through the lens of U.S. influence. 

Evidenced by hosting four additional bases for access to the U.S. military in 2023 amidst ongoing maritime disputes in the South China Sea, this stance marks a contrast with the previous Duterte administration's more China-friendly policies. 

This foreign policy shift has also been manifested in actions such as the banning of Philippine Offshore Gaming Operators (POGOs) and the legal actions against Ms. Alice Guo, a former provincial (Tarlac) mayor accused of espionage and involvement in illegal gambling. 

These tensions extend to the NGCP, where the Chinese stake has been cited by media and officials as a national security risk.  

According to a US politically influential think tank, "Fears in both Manila and Washington that Beijing could disable the grid in a time of crisis have lent urgency to efforts to reform its ownership and operational structure". (CSIS, 2024) 

Therefore, heightened scrutiny of China’ government involvement in sectors like NGCP, justified on the ‘kill switch’ or national security risk, combined with increasing military cooperation with the U.S., suggests a Philippine foreign policy trajectory heavily influenced by Washington's strategic objectives. 

IV. MIC’s Investment in NGCP: A Revival of Economic Nationalism? Shades of Napocor?

The stated objectives of MIC’s entry into NGCP through a 20% stake in SGP are twofold: 

A. Advance National Security by Strengthening Oversight of NGCP Management? 

MIC contends that this investment allows for governmental oversight of NGCP management, potentially counterbalancing foreign influence, particularly from China. They have also expressed interest in acquiring the entire SGCC’s stake. 

However, this approach risks "political interference," one of the critical factors that historically plagued the National Power Corporation's (NPC) financial stability. 

Furthermore, a move towards re-nationalization could represent a regressive step, potentially leading to deep financial losses reminiscent of NPC’s past.

B. Economic Benefits: Lowering Electricity Costs by Enhancing Grid Efficiency?

MIC has promoted the investment as a means to improve grid infrastructure, with the expectation that efficiency gains would eventually translate into lower electricity rates for consumers.

First, the latter objective appears secondary to the former. Since all government actions must be publicly justified, MIC’s interventions are presented as beneficial to the consumer.

Figure 2

The Philippines is often cited as having one of the highest electricity rates in Asia. (Figure 2, upper chart) 

However, subsidies on power firms have distorted this metric. The NPC’s subsidy program significantly contributed to its debt accumulation.

Similarly, the government’s attempt to regulate fuel prices via the Oil Price Stabilization Fund (OPSF) ended up as a net subsidy, requiring large bailouts, as noted by the International Institute for Sustainable Development (IISD, 2014). 

In short, Philippine experiences with subsidies have historically been unsuccessful. 

It is also questionable whether dependency on energy imports directly equates to high electricity prices. (Figure 2, lower image)

This simplistic logic would lead to the conclusion that nations that are most dependent on oil and energy imports would have the highest electricity rates, which is not necessarily true—because of many other factors. 

Second, MIC argues that "investing in NGCP could improve the rollout of transmission grid infrastructure, allowing more power players to supply energy to the grid."  

While this proposal is ideal in theory, its practical implementation faces significant challenges. 

One of the primary drivers behind high energy costs is the oligopolistic market structure, characterized by a concentration of power among a few large conglomerates.

Figure 3 

The most prominent players include San Miguel Corporation (PSE: SMC), Aboitiz Power Corporation (PSE: AP), First Gen Corporation (PSE: FGEN), and Manila Electric Company (PSE: MER). In Luzon, for example, seven generation companies hold an estimated 50% of the total installed capacity. (ADMU, 2022) (Figure 3) 

Despite partial deregulation, the concentration of market power among these firms potentially reduces competitive pressures and limits market alternatives, leading to price-setting behaviors that do not reflect true supply and demand dynamics. 

The Wholesale Electricity Spot Market (WESM) was introduced in 2006 to foster competition, yet allegations of anti-competitive behavior emerged soon after its inception. 

Moreover, while EPIRA led to privatization in segments of the industry, the slow pace of implementing reforms, such as open access provisions and retail competition, has maintained high electricity prices, as highlighted in a World Bank study. 

Furthermore, the incumbent regulatory framework, despite its intent to limit market power, has not fully mitigated oligopolistic tendencies, resulting in persistently high prices for consumers. Examples: Bureaucracy and red tape, cross ownership, system losses, conflicting laws, over-taxation and more. 

As a result, the oligopolistic market structure and high energy costs deter foreign direct investment (FDI), as investors seek markets with lower operational costs. 

The likely substantial influence of these oligopolists on the political sphere, which protects their interests through legal frameworks, raises the risks of collusion, cartel-like behavior, and barriers to entry, thereby constraining competition.

Therefore, while MIC’s argument for infrastructure rollout benefiting consumers through competition is necessary, it is crucially insufficient. 

Market concentration among large firms may have significant influence on regulations and their implementation, particularly in the upstream and midstream segments (generation, transmission, and distribution). 

The slow pace of reforms aimed at fostering a competitive environment has severely limited efficiency gains, and consequently, the reduction of electricity rates. 

Third, the Bangko Sentral ng Pilipinas’ (BSP) low interest rates regime has enabled these firms to accumulate substantial or large amounts of debt to finance their commercial operations, which implicitly creates obstacles for competitors unable to access cheap credit. 

Alternatively, this debt accumulation poses systemic financial and economic risks. 

In essence, despite EPIRA and its privatization efforts, monopolistic inefficiencies coupled with readily available cheap credit have effectively transferred NPC’s debt dilemma to the oligopoly. 

Lastly, decades of easy money policies from the BSP have driven a demand boom, resulting in a significant mismatch in the sector’s economic balance. This is evident in overinvestment in areas like real estate, construction, and retail, potentially diverting resources from necessary energy infrastructure and even potentially leading to overinvestment in renewable energy sources at the expense of reliable baseload power from coal, oil, natural gas, and nuclear energy. 

In sum, prioritizing the expansion of a competitive environment where the sector’s pricing reflects actual demand and supply dynamics is essential. 

Liberalization, which should lower the hurdle rate, would intrinsically encourage infrastructure investment without the need for political interventions. 

MIC’s promotion of economic gains from its interventions appears more as a "smoke and mirror" justification for politically colored actions. 

V. Maharlika's NGCP Investment: A Bailout in Disguise? Potentially Inflating an SGP Stock Bubble?" 

An even more fascinating perspective is SGP's financial health. 

Certainly, as a legal monopoly, the National Grid Corporation of the Philippines (NGCP) holds a significant economic advantage—an economic moat. 

Grosso modo, SGP, as the majority shareholder of NGCP, seemingly operates within a rent-seeking paradigm, where wealth is accumulated not through value creation but through leveraging of economic or political environments to secure favorable positions. 

OR, for monopolists, the focus shifts from open market competition, innovation, or improvement, to maintaining their monopoly status by currying favor with political stewards. Subsequently, they leverage this privilege to extract economic rents, often at the expense of consumers or other market participants. 

SGP’s financials and recent developments appear to support this narrative.

Figure 4

Revenue Stagnation: Since Q3 2022, SGP's quarterly revenue has grown by an average of 5.9% over 13 quarters through Q3 2024, with a Compound Annual Growth Rate (CAGR) of only 0.52% since Q3 2020. 

Slowing Profit Trends: During the same periods, quarterly profits expanded by 2.67%, but shrank by 2.25% based on CAGR. 

Notably, a spike in net income in Q2 2022 was attributed to "higher iMAR as approved by ERC effective January 1, 2020 and the recording of Accrued revenue for incremental iMAR 2020 for CY 2020 and 2021." 

iMAR Explanation: As per Businessworld, "iMAR stands for "Interim Maximum Annual Revenue," which refers to the maximum amount of money a power transmission company like the National Grid Corporation of the Philippines (NGCP) is allowed to earn annually from its operations, as approved by the Energy Regulatory Commission (ERC) during a specific regulatory period; essentially setting a cap on how much revenue they can collect from electricity transmission services"

Figure 5

Mounting Liquidity Issues: SGP's cash reserves have been contracting, with an average decrease of 3.9% over 13 quarters through Q3 2024 and a -6.7% CAGR since Q3 2020. 

Surging Debt Accumulation: Conversely, debt and financing charges have escalated. Debt has grown by an average of 12.1% over 13 quarters, with a 2.1% CAGR, while financing charges increased by an average of 5.7% with a 1.9% CAGR. 

SGP’s finances are not exactly healthy. 

Yet NGCP’s recent activities gives further clues. (bold mine) 

ABS-CBN, May 23, 2023: "The National Grid Corporation of the Philippines on Thursday said it was not to blame for delayed projects, and fended off criticism that it was making consumers pay even for delayed projects. The country’s power grid operator also insisted that power transmission improved since it took over operations from the government. A recent Senate hearing found that 66 projects, of which 33 were in Luzon, 19 in the Visayas, and 14 in Mindanao, remained unfinished. " 

ABS-CBN, December 23, 2024: "The Energy Regulatory Commission (ERC) has imposed a total of P15.8 million worth of fines on the National Grid Corporation of the Philippines (NGCP) over "unjustified delays" in 34 out of 37 projects. "

SGP’s tight finances, mainly evidenced by stagnant revenues, declining profits, and deteriorating liquidity, could reflect the challenges faced by NGCP. 

Further, despite the complex political nature of the operations of the grid monopoly, the ERC caps the revenue that NGCP is allowed to generate (Php 36.7 billion annually). 

This limits NGCP’s financial health, potentially leading to liquidity strains and increased borrowings by SGP to finance their projects. 

Fundamentally, his dynamic might resemble a high-stakes path towards Napocor 2.0. 

Besides, the Department of Energy (DoE) sets the plans and policies, while NGCP, as the exclusive franchise holder, is in charge of the operation, maintenance, development, and implementation of projects for the country's power transmission system. 

The ERC regulates and approves rates, monitors performance, and can impose penalties for delays or inefficiencies. 

In short, since NGCP prioritizes fulfilling the administration's political agenda, it seemingly does so with little concern for consumers—does this reflect the rent-seeking paradigm? 

This raises two crucial questions: aside from economic nationalism, could MIC’s entry into NGCP amount to an implicit BAILOUT of SGP? 

And could this package include a deal for China’s SGCC to exit? 

While we are not privy to the legal technicalities leading to MIC’s initial investment in NGCP via a 20% stake in SGP, SGP’s share prices have experienced a resurgence, or spike, since hints of MIC’s entry began to emerge late last year. 

Year-to-date (YTD) returns of SGP shares totaled 17.6% as of February 7th. 

Once again, this raises additional questions:

Figure 6

-Is a stock market bubble being inflated for SGP shares, benefiting not only corporate insiders and their networks, but also political figures and their allies behind the scenes? 

-Considering the price plunge of SGP shares from over 700 in 2017 to the present, resulting in substantial losses for its shareholders, could this potential bailout include efforts to pump up SGP shares to recoup at least a significant portion of these deficits? 

VI. Maharlika’s Risks and Potential Consequences 

The paramount concern revolves around what might happen if MIC's investment, re-nationalization, or its policy of economic nationalism regarding NGCP goes awry. 

What if NGCP replicates the pitfalls of its predecessor, the National Power Corporation (NPC)? How would the resulting losses or deficits be managed? 

Maharlika's investment capital is derived from public funds. If MIC incurs losses, would additional taxpayer money be on the line? Would there be a necessity for a bailout of MIC itself? 

How would potential deficits from MIC affect the country's fiscal health? Could this lead to higher interest rates and a weaker peso, exacerbating economic pressures? 

VII. Conclusion 

Ultimately, Maharlika's NGCP investment, executed through SGP, reflects a tension between seemingly conflicting objectives: securing national security interests and generating optimal returns. 

While proponents tout the deal as a means to lower electricity costs and improve grid efficiency, our concern—given SGP's financial weaknesses—is that MIC’s infusion could, in effect, function as a bailout. 

That is to say, the potential exposure of public funds through the SWF for political goals may conflict with, or potentially override, the Maharlika Investment Corporation’s stated goals: "to ensure economic growth by generating consistent and stable investment returns with appropriate risk limits to preserve and enhance long-term value of the fund; obtaining the best absolute return and achievable financial gains on its investments; and satisfying the requirements of liquidity, safety/security, and yield in order to ensure profitability of the GFIs’ respective funds." 

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references 

Harrison Prétat, Yasir Atalan, Gregory B. Poling, and Benjamin Jensen, Energy Security and the U.S.-Philippine Alliance, Center for Strategic and International Studies, October 21, 2024 

Maria Nimfa Mendoza Lessons Learned: Fossil Fuel Subsidies and Energy Sector Reform in the Philippines, March 2014, IISD.org p. iv 

Majah-Leah V. Ravago, The Nature and Causes of High Philippine Electricity Price and Potential Remedies, January 19, 2022 Ateneo de Manila University

Socialism via QE: Bank of Japan 'Whale' Now Owns 55% of ETFs; also Top 10 Shareholder of 90% of Nikkei Stocks!

At the end of March I wrote,

In the political spectrum, the BoJ's increasing ownership of the factors of production simply means nationalization of assets or increased embrace of or the slippery slope to socialism.

Now for the proof.

From Bloomberg: 

They may not realize it yet, but Japan Inc.’s executives are increasingly working for a shareholder unlike any other: the nation’s money-printing central bank.

While the Bank of Japan’s name is nowhere to be found in regulatory filings on major stock investors, the monetary authority’s exchange-traded fund purchases have made it a top 10 shareholder in about 90 percent of the Nikkei 225 Stock Average, according to estimates compiled by Bloomberg from public data. It’s now a major owner of more Japanese blue-chips than both BlackRock Inc., the world’s largest money manager, and Vanguard Group, which oversees more than $3 trillion.

Wow, top 10 shareholder in 90% of stocks comprising the Nikkei !

Here's more. (bold added)

Under the BOJ’s current stimulus plan, the central bank buys about 3 trillion yen ($27.2 billion) of ETFs every year. While policy makers don’t disclose how those holdings translate into stakes of individual companies, estimates can be gleaned from publicly available central bank records, regulatory filings by companies and ETF managers, and statistics from the Investment Trusts Association of Japan. The BOJ declined to comment on Bloomberg’s findings.

The estimates reveal a presence in Japan’s top firms that’s rivaled by few other big investors, often called “whales” in the industry jargon. The BOJ ranks as a top 10 holder in more than 200 of the Nikkei gauge’s 225 companies, effectively controlling about 9 percent of Fast Retailing Co., the operator of Uniqlo stores, and nearly 5 percent of soy sauce maker Kikkoman Corp. It has an estimated shareholder rank of No. 3 in both Yamaha Corp., one of the world’s largest makers of musical instruments, and Daiwa House Industry Co., Japan’s biggest homebuilder.

If the BOJ accelerates its ETF purchases this week to an annual rate of 7 trillion yen -- the pace predicted by Goldman Sachs Group Inc. -- the central bank could become the No. 1 shareholder in about 40 of the Nikkei 225’s companies by the end of 2017, according to Bloomberg calculations that assume other major stakeholders keep their positions unchanged. It could hold the top ranking in about 90 firms using HSBC Holdings Plc’s estimate of 13 trillion yen.

Astounding, 55% of ETFs now owned by BoJ!

The BoJ's QE program, which has partly been intended to bolster the stock market, implicitly means the use price controls. Such tacit price controls were originally designed to favor stock market owners through the mechanism of increased demand provided by the BoJ and reduced supply from the public in order to push equity prices higher.

Yet increases in BoJ's share ownership of a corporation means decrease in the public's share ownership.  Remember, the BoJ buys these shares from the public. Hence, intensifying implicit price controls through the deepening of BoJ's asset buying extrapolates to the path of complete nationalization of the Japan's stock market.

Furthermore, as the BoJ increases its ownership in the stock market, liquidity is reduced if the BoJ does not sell. Eventually, the greater the BoJs ownership, the lesser the trading volume/liquidity. In essence, sustained BoJ QE would mean monopolization, and thus, the end of the stock market.

Additionally, sustained QE would translate to BoJ's direct and indirect control of corporate (internal and external) activities through its increased share of ownership. 

So instead of corporations focusing to serve consumers, these corporations would have mutated to become state owned enterprises (SOE). And priorities of such SOEs would instead be directed at the attainment of political objectives of Japan's political leaders. 

Moreover, with greater government interference, employment in these firms will likely be dictated by patronage politics

All these indicate that by virtue of sustained BoJ's QE, Japan's economy would likely transform into a socialist paradise overtime!

The great Austrian economist Ludwig von Mises was prescient, there is no middle of the road policy. Price controls, in this case BoJ's monetarism, only serve as one of the main channels to achieve socialism

But when this state of all-around control of business is attained, there can no longer be any question of a market economy. No longer do the citizens by their buying and abstention from buying determine what should be produced and how. The power to decide these matters has devolved upon the government. This is no longer capitalism; it is all-around planning by the government, it is socialism.

To Nationalize or To Nationalize?

David Leonhardt of New York Times suggests of 2 kinds of government takeover of US banks:

One is premised on ideology-governments can run more institutions more "justly" or "efficiently" than private capitalists.

The second is predicated on short term expediency: government takes over (sheds shareholders, bondholders and management), repackage (segregate assets) and immediately sells back to the public.

And if the path of government action are to be based on public opinion, then the the second option appears as the proximate direction. This supposedly is the optimistic case.

But, as Ludwig von Mises once admonished, interventionism can be addictive, ``It doesn't accomplish its stated ends. Instead it distorts the market. That distortion cries out for a fix. The fix can consist in pulling back and freeing the market or taking further steps toward intervention. The State nearly always chooses the latter course, unless forced to do otherwise. The result is more distortion, leading eventually, by small steps, toward ever more nationalization and its attendant stagnation and bankruptcy."

Despite the denials of key officials, apparently the baby steps are headed towards such direction.

Inflation-Deflation Tug of War

Amidst the conservatorship of Fannie and Freddie, the rescue of Bear Stearns AIG and the bankruptcy filing of Lehman Brothers, credit markets continue to seize up on a global scale in manifestation of the rapid tightening credit conditions, aside from mounting loss recognition and forcible “deleveraging” liquidation as part of capital raising and shrinking of balance sheets by affected financial institutions which has resulted to the current downside volatility and staggering losses in global equity markets.

Courtesy of Danske Bank

A symptom of credit shortage can be found in the chart above courtesy of Danske Bank, one of the interbank rates used for stress testing (the Euribor-Overnight Indexed Swap). Importantly, the problems are obviously manifest in US Dollar denominated money markets, which of course, has been the epicenter of today’s crisis episode. Such dearth of “US dollars” available for credit have lent to the recent spike of the US dollar’s value which deflation proponents label as funneling to the “center”, aside from of course, the repatriation of US dollars to shore up foundering balance sheets of US financial institutions.

This very fitting quote from Bloomberg, ``“There’s a complete lack of faith in the markets,” said Jim O’Neill, chief economist at Goldman Sachs Group Inc. in London. “There’s a lot of cash hoarding and people losing trust in banks, so the central banks are acting to relieve that. This might not be the last time they have to act.”

Such activities characterize deflation.

So on one hand you’ve got market forces unraveling the malinvestment from the previous credit bubble, which left leaning ideologues describe as “market failure” (which has actually been more government induced-via monetary policy and special privileges; besides capitalism includes profits and losses and not only profits).

On the other hand, global governments fearing a collapse to outright deflation have worked double time to reflate the world markets.

First, by massive bailouts-despite the overextended balance sheets of the US Federal Reserve.

courtesy of the New York Times

According to the New York Times (highlight mine),

``The Fed’s balance sheet, moreover, is being stretched in ways that seemed unimaginable one year ago. As recently as last summer, the central bank’s entire vault of reserves — about $800 billion at the time — was in Treasury securities.

``By last week, the Fed’s holdings of unencumbered Treasuries had dwindled to just over $300 billion. Much of the rest of its assets were in the form of loans to banks and investment banks, which had pledged riskier securities as collateral.

``In a sign of how short the Fed’s available reserves had become, the Treasury Department sold tens of billions of dollars of special “supplementary” Treasury bills on Wednesday to provide the Fed with extra cash. The Treasury sold $40 billion of the new securities on Wednesday morning and will sell $60 billion more on Thursday. More money-raising is sure to follow.’

Harvard Professor and former IMF Chief Economist Kenneth Rogoff estimates that the US would need $1 trillion in rescue package (some say more).

And next, by the unprecedented concerted global central bank actions to provide humungous liquidity to the marketplace in order to hold down interest rates.

courtesy of the Wall Street Journal

This from the Wall Street Journal, ``The Fed boosted its currency-swap lines -- through which it gives foreign central banks access to U.S. dollars -- by $180 billion, to allow central banks to meet fierce dollar demand from commercial banks outside the U.S.

``The Fed added a record daily total of $105 billion in temporary reserves into U.S. money markets, while the European Central Bank injected an extra €25 billion ($35.88 billion) in one-day funds. The Bank of Japan injected the equivalent of $24 billion into the local yen money market, and the Bank of England offered an extra £25 billion ($45.54 billion) in short-term funds. Monetary authorities in Hong Kong, India and Australia also stepped in with cash injections.”

So global central banks are today creating a tsunami of “money from thin air” to keep afloat the global asset markets from their natural reaction to overleverage, oversupply, overspeculation and massive malinvestments.

Of course, treating insolvency with massive liquidity ain’t likely gonna solve the problem as this has not been the first time global central banks have injected liquidity ever since the credit bubble crisis surfaced last July of 2007.

And worst, it could lead to a next problem. The unintended consequences of generating the next bout of inflation.

Quoting CLSA’s Russell Napier (source fullermoney.com),

``Let's get to the bottom line. A deleveraging process is under way. It can happen against a background of bankruptcy, deflation, declining cash flows and bank bankruptcy or in a slower way against a background of inflation. Both reduce the debt burden, but one is socially jarring and led in the past to mass unemployment and arguably WWII. Democracies will choose the inflationary approach. This is not evident today, but it will be more evident soon enough as the BoJ, ECB, BoE and others realise that their current monetary policy is driving them not to slower growth and lower inflation but to deflationary calamity. Today, you can see the calamity of the deflationary disease but what will you see tomorrow, or the day after, if the monetary cure pours from the medicine jars of the global central banks? (emphasis mine)

Fannie And Freddie Bailout Designed To Save The US Dollar Standard System

``Over the past few years, the Agencies were central to the process that brought the emerging world’s savings to the US housing market. And governments were involved every step of the way. When the world’s central banks (and other big bond investors) decided that the implicit US government backing for the Agencies wasn’t enough, the US government had to make the backing explicit.”-Brad Setser, Council of Foreign Relations, So true …

 

It was a highly volatile market out there this week.

 

The initial salvo was wild cheering from global equity markets on the recent action by the US Treasury to take its Government Sponsored Enterprise (GSE)-Fannie Mae and Freddie Mac- into “convervatorship” (quasi-nationalization). However, the festiveness quickly dissipated when the realities of “a weakening global economy”, the ramifications from the credit event of the F&F takeover on the Credit Default Swap Market and concerns over the persistent deterioration of US financial conditions as manifested by the lackluster capital raising quandary by Lehman Bros, which until recently, was the 4^th largest investment bank in the US, sunk into the consciousness of global investors which resulted to a retreat from most of the earlier gains.

 

The conservatorship program includes the taking over of management control of Fannie and Freddie (F&F) by its regulator the Federal Housing Finance Agency (FHFA), where common and preferred stock would be diluted and not eliminated. The takeover now alters the corporate objective of the GSEs to “improving mortgage financing conditions” from “maximizing common shareholder returns”.

 

The program also includes capital injection into the GSEs by US Treasury and FHFA to maintain the positive net worth of these agencies in order to fulfill its financial obligations, where in exchange the US Treasury receives “senior” preferred equity shares and warrants aimed at securing solvency.

 

Aside, a new credit facility designed to secure liquidity concerns will be introduced to backstop F&F and Federal Home Loan Banks, and which is set to expire on December 2009. Lastly, a temporary program will also be put in place to acquire GSE Mortgages in order to secure market liquidity of mortgage securities also slated to expire on December of 2009.

 

For starters, Agency securities are one of the world’s most widely held securities by both private and the public sectors (Sovereign Wealth Funds and Central banks).

 

Morgan Stanley’s Stephen Jen has a great breakdown on these (highlight mine),

 

`` Total foreign holdings of long-term USD securities increased from US$7.8 trillion in 2006 to US$9.8 trillion in 2007, with US$1.3 trillion of this annual increase from increased foreign holdings of US long-term debt securities, including US Treasuries, agencies, agency ABS and corporate bonds.  Foreigners are dominant in some of these markets.  For example, some 57% of the marketable Treasury securities are held by foreign investors. 

 

``Foreign investors’ appetite for US agencies – both straight agency debt and agency-backed ABS (also called agency pass-throughs) – has risen sharply.  (Fannie Mae and Freddie Mac (F&F) are government-sponsored enterprises (GSEs) with two main activities.  First, they securitise mortgages by converting conforming mortgage loans into tradable mortgage-backed securities (MBS).  Second, they have an ‘investment portfolio’ business, whereby they issue AAA rated agency debt to finance the holding of MBS or other assets.  The latter is a ‘carry trade’, capitalising on the then-implicit government guarantee.  One key part of the policy discussion regarding F&F is whether their second activity is justified.)   Of close to US$7.5 trillion in outstanding US agency debt and agency-backed ABS, some US$1.54 trillion (according to Fed flow of funds data, June 2008) is held outside the US, with China, Japan and AXJ being the largest holders of these securities, with US$985 billion of this latter figure held by foreign central banks. (The share of total US long-term securities held by foreign investors has more than doubled since 1994 (from 7.9% of the US$16 trillion in securities back then to 18.8% of the US$49 trillion outstanding as of 2007).” 

 

We featured a chart on the composition of foreign holdings of the F&F in Inflation: Myths And Beneficiaries. Nonetheless, private ownership of Agency backed papers appears to have stagnated since 2005 while foreign public ownership has steadily increased as shown in Figure 2.

Figure 2: Northern Trust: Foreign Public-Private Exposure On F&F

 

In perspective, aside from foreign holdings GSE debt securities are likewise owned by US households and institutions or financial entities as commercial banks, savings banks, credit unions, pension funds, life insurance companies mutual funds, brokers, ABS issuers and REITs.

 

However, as % of total outstanding debt, in 2007 ownership of GSE debt in pecking order: foreigners comprise 19.92%, followed by commercial banks 13.87%, households 12.06%, mutual funds 7.67% and ABS 5.13% (Northern Trust).

 

So when US Secretary Paulson was asked of the US government’s takeover of F&F, his reply as quoted by the Washington Post,

 

``"The U.S. government had no choice," he said.

 

``Mr. Paulson, in an interview with CNBC on Monday, said foreign pressure was not the "major driver" of the takeover, but acknowledged that "there's no doubt that there's fragility in the capital markets."

 

``"These companies are so big, and they are owned by investors all around the world. You are obviously going to get concerns," Mr. Paulson said. "It was definitely concerning overseas, but there was concern in this country. I tell you, my phone is ringing the most from investors here." 

 

This means the US financial system have reached a near calamity. 

 

However many had been quick to lash at the “conservatorship” program as virtually a bailout of foreign owners of agency securities.

 

While this perception seems partly correct, I think most of these critics ignore the fact that these actions basically signify a remedial patchwork to the emerging cracks at the Fiat Paper Money “US Dollar” standard system. The massive current account imbalances a common feature in today’s world tends to amplify on the systemic flaws especially amidst today’s heightened volatility.

 

At present, countries with current account surpluses at one side of the ledger need to be offset by countries with current account deficits at the opposite side. As an example, deficits of the US have been more than sufficiently covered for by capital flows from mostly emerging markets paving way for the unorthodox pattern of “Poor countries Financing The Rich”.

 

Yes, while various politicians and experts from around the world have boisterously decried about “social inequality”, unknowing to most is that such inflationary “inequality” mechanism appears to be the imbedded on the US dollar standard platform. Think of it, while profits are privatized, losses are socialized! Wall Street’s politically connected gets rescued, while the masses pay for the mess created by the former. The failed F&F model was demonstrative of the Keynesian brand of capitalism and not of the laissez faire genre. (Please don’t associate the fiat paper money standard as epitomizing laissez faire or free markets too. Same with currency markets, interest rate markets or even oil markets! These markets are controlled heavily by governments notably on the supply side. As an aside, the “anarchy” in the Shadow Banking System wasn’t symptomatic of a free market mess, but one of going around banking regulations or taking advantage of “regulatory loopholes” in order to take on added leverage by assuming more risk to magnify returns by the establishment of off-balance sheet Structured Investment Vehicles (SIV). Going around loopholes do not signify free market paradigms).

 

Going back to the unorthodox pattern of “Poor countries Financing The Rich”, during the gold standard, current account imbalances had effectively been curtailed by the shifts in the gold reserves by nation states engaged in trade. This essentially accounted for as an automatic adjustment mechanism, which is absent today under the digitalized and unlimited printing capabilities of central banks to churn out money “from thin air”.

 

And as we noted above, current account imbalances today need to be offset. During the recent past, the nations with current account surpluses signified as subsidies to domestic export-oriented industries but came at the expense of domestic consumers, i.e. China, Asia and other emerging markets. On the other hand, current account deficit nations run subsidies on domestic consumers via expanding domestic debt (financed by current account surplus countries) at the expense of domestic production. From which the transmission mechanism had been mainly via currency pegs or dollar links.

 

The foreign buying of agency papers or US debts were meant to sustain mercantilists’ policies by frontloading currency and interest rate risks in order to keep the exchange rate undervalued and thus promote domestic export oriented industries in order to expand employment. Hence, the currency manipulation policies that led to the current account imbalances had primarily been meant as a tool to manage domestic political risks.

 

In other words, the US dollar standard system paved way for political imperatives over economic goals, see figure 3.

Figure 3: Asianbondsonline.com: China-US yield curve

 

What sense would it make for a current account surplus country as China to buy or load up on assets of a depreciating currency, thereby suffer from currency loss? What sense too for current account country as China to buy assets whose yield is less than what is offered domestically, thereby suffer from opportunity cost of low interest rate spreads (assuming holding bonds until maturity)? And this has been going on for years!

 

The same for deficit countries, domestic consumers had been financed to go into a debt driven asset buying binge which resulted to overleveraged driven massive speculation, again for political goal of sustaining finance driven economic booms, where the demand from domestic consumption boom has greased the industries of current account surplus countries as China and emerging countries.

 

The US dollar, functioning as the world’s de facto currency reserve currency, has fundamentally been used by the US government to freely load up on debt, given its special privilege to underwrite from its own currency, by selling almost unlimited financial claims to international investors to finance such speculative unsustainable booms.

 

And as the US real estate and financial boom has basically unraveled, all these seem to be in a transition.

 

Recently there had been some signs of reluctance of nations with current account surpluses to stack up into agency papers. Of course, the recent actions by the US Treasury may seem to have assuaged the concerns of repayment by buying more into US treasuries instead of agency papers.

 

So what can we see from all these?

 

One, current account surpluses nations or foreign central banks seem to have the tolerance bandwidth, given their accrued currency reserves, to suffer from the risks of currency and interest rate losses provided they get repaid for holding these securities until maturity. I guess the actions by the US treasury may have answered such “repayment” concerns.

 

Two, foreigners which have been formerly financing the US real estate securitization boom appears to be bailing out, if not help tacitly ‘nationalize’ the structurally beleaguered industries by buying into agency papers until recently.

 

It also reveals of the extent of overdependence or vulnerability of the US on relying on foreign financing. The risk seems such that if foreign central banks or state owned Sovereign Wealth Funds or affiliated institutions would deem to have accumulated more US dollar reserves than what they might think is required, and change their priorities by reducing finance exposure to the US, which can even lead to more volatility in the US. Political factors can also hold sway to the appetite of foreign financing of US deficits.

 

In addition, understanding its present predicament and limitations, the “capital short” US government seems to be working feverishly to attract or to intermediate for foreign capital participation into buying out its besieged financial institutions. Example, a syndicate led by UK’s 3^rd largest bank, Barclay’s along with a “club rescue” team of “Temasek of Singapore and China Development Bank, was reportedly have shown willingness to back a deal that would put Barclays in the top tier of financial institutions.” (timesonline.co.uk)

 

Three, it’s all about the increasing integration of geopolitics or the decreasing hegemony of the US, as seen in the “Poor financing the Rich” aside from “Autocratic and non-democratic states financing democratic countries”!

 

Some Poor but Autocratic/non democratic nations that have been a beneficiary to the ongoing wealth transfer appear to have accumulated enough political clout as to weigh on the internal political policymaking of the US. 

 

Remember this quote from Yu Yongding, a former adviser to China's central bank quoted last in our Will King Dollar Reign Amidst Global Deflation? ``If the U.S. government allows Fannie and Freddie to fail and international investors are not compensated adequately, the consequences will be catastrophic, if it is not the end of the world, it is the end of the current international financial system.” The recent political actions employed by the US government appeared to underscore such circumstances and Mr. Yu’s prayers seems to have been answered.

 

Or how about Russia’s recent military offensive against Georgia (as discussed in Toynbee’s Generational War Cycle: In Mindanao or In Georgia/South Ossetia?) which has practically left the US as a political nonparticipant to a besieged ally?

 

This only goes to show how the US looks to be losing its imperial edge over the global geopolitical economy and how the US dollar standard system appears to be in greater jeopardy.