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. 

F&F Mix Results: Narrowing F&F Spreads But Defaults from F&F Credit Default Swaps

``In traditional finance, borrowers borrow and lenders lend. The only firms exposed to, say, home mortgages, are the banks that issue them. Thanks to derivatives, a firm with exposure can pass it off, and a firm with no exposure can assume it. Markets thus have less information about where risk lies. This results in periodic market shocks. Put differently, derivatives, which allow individual firms to manage risk, may accentuate risk for the group. Markets were stunned to discover that Long-Term Capital owned outsized portions of obscure derivatives. They dealt with that shock in typical fashion: they panicked.” - Roger Lowenstein, Long-Term Capital: It’s a Short-Term Memory

 

With the US government’s recent action to preserve the global monetary system, we find that aside from the undefined cost to taxpayers, the US treasury has now assumed the responsibility for the $5.3 trillion of mortgage securities aside from its outstanding $5.3 trillion of treasury securities as of March 2008.

 

So far, the US Treasury’s action has partially eased the yield spread of the F&F papers from its risk-free counterparts as shown in Figure 4.

Figure 4: Danske Bank: Before and After Spread of F&F vis-à-vis Fed Rate and 10 year Treasury

 

 

Even as the Federal rates had been lowered rates by 325 basis points as shown in the left panel in figure 4, the F&F rates have not equally responded. However, after the action taken by the US Treasury, the F&F rates dropped steeply as displayed in the right panel.

 

By lowering of the mortgage rates, the US government hopes to ease the burdens of homeowners smacked by a perfect storm of lack of access to credit, falling asset prices (real estate and stocks), rising unemployment, slowing economy and still high but fast declining energy/ fuel prices. 

 

And by narrowing the spreads from US treasuries, the US government hopes to provide cushion to the fast deteriorating financial and economic conditions by allowing investors access to cheap money which could feed into the mortgage market and buy F&F papers and thus restoring liquidity and confidence, aside from the credit ratings of the F&F papers.

 

But this doesn’t take away the fundamental problem of having too many houses for sale at prices buyers can’t seem to afford.

 

Moreover, the spreading of the mortgage woes to the level above the subprime market seems to be the next wave of credit concerns. The Alt-A mortgages covering about 3 million US household borrowers totaling some $1 trillion in mortgage papers with about $400 billion issued during the height of the boom in 2006 where an estimated 70% of borrowers were said to have exaggerated income (Bloomberg).

 

Aside the recent actions by the US government appear to have triggered a “credit event” in the CDS market of the F&F papers. A Credit Default Swap (CDS) is a credit derivative functioning as an insurance contract that pays if a company or “counterparty” defaults on its liabilities.

 

However unlike an insurance contract, the CDS market is many times more than size of the actual bonds referenced. The unregulated CDS market is estimated to be at around $62 trillion. The problem of which is if an outsized default occurs a contagion of non-collection from losses may lead to a systemic loss.

 

The recent “conservatorship” of F&F by the US Treasury has triggered defaults on some CDS contracts referencing to the F&F securities. The contracts affected were estimated at $250-$500 billion which should to result to some $10 to $25 billion in additional losses (Financial Times).

 

And perhaps some of these losses had been accounted for the recent volatility in the global markets.

Why Forcible “Free Texting” Will Only Lead To Increased Poverty

``Congress, devoutly promise that all their actions are based on good intentions. But it doesn't matter: bad ideas regarding the nature and role of government breed bad results and suffering occurs nevertheless. Twisted logic, Machiavellian justifications, excuse making, and short-run benefits can never justify the removal of one iota of liberty from any one person if we intend to live in a free society.” US Congressman Ron Paul, The Economics of a Free Society

People always ask why the Philippines remain “poor”? Our reply has been “because of the lack of respect of markets, the dearth of economic common sense, the dependency culture, political hubris and the incessant pandering by authorities to buy public opinion through government intervention”.

``The problem is not that supply and demand is such a complex explanation. The problem is that supply and demand is not an emotionally satisfying explanation. For that, you need melodrama, heroes and villains”, wrote Thomas Sowell. And melodrama is what has prompted for the recent “Free Text” ruction, where in essence this is all about PRICE CONTROL.

Because of the huge profits accrued, domestic telecoms companies have been portrayed by some public officials as “villains” for not providing text messaging services for free. The assumption is that telecom companies have undeservingly been making huge profits at the “expense” of consumers (the “victims”) something analogous to taxation. Thus, the soi-disant “heroes” threatens to impose redistributive “justice” by compelling these “greedy” firms to make good free text messages as part of “social” service….or else!!!

The Survivorship Bias and Earnings Cycles

English novelist George Orwell once wrote, ``Power-worship blurs political judgment because it leads, almost unavoidably, to the belief that present trends will continue. Whoever is winning at the moment will always seem to be invincible.”

Thus before passing any generalization it would be best to examine the facts behind the issues.

For starters, the telecoms industry is a capital intensive industry; it requires Billions of Pesos in capital investments for its infrastructure rollout to be able to operate.

Yet the public or our so called “heroes” DO NOT SEE or REALIZE that the huge sums of investments DO NOT automatically GUARANTEE profits. This is why it is called as RISK CAPITAL. Nobody puts at risk his or her capital without the attendant expectations of profits or return on investments (ROI). If a venture goes wrong, investors LOSE equity, on the other hand, if they are right they deservingly REAP profits. So there is ALWAYS a TRADEOFF.

In the same way, even if the domestic telecom industry have been earning today, this DOES NOT GUARANTEE that they will NOT LOSE tomorrow or sometime in the future. Risk taking endeavor is always an ONGOING DYNAMIC because the challenge is the future. Yesterday’s performance may or may not be the same for tomorrow. The past has been perfected, but the future still needs to be ascertained.

Unfortunately people and those in power simply don’t understand this. They are skewed to only see the profits and NOT the ACCOMPANYING RISKS (called survivorship bias-the fallacy of seeing winners only), hence makes a bigoted issue out of these.

It is not always cloud 9 for the industry.

Figure 1 Ed Yardeni.com: S&P Telecom P/E Ratio

As an example, figure 1 courtesy of Yardeni.com shows of the Price-Earnings Ratio of the US S&P 500 Telecommunication sector. As you can see, the PE ratio peaked in 2000 and collapsed by more than half as the dot.com bust unraveled. This shows of how investors paid exuberantly for share prices of telecom issues in 1998-2000 in the EXPECTATIONS of the continuity of astronomic earnings growth seen in the recent past (early 90s). When reality sunk in, where expectations did not match with real earnings, prices retrenched. Until now or eight years from the pinnacle, the price earnings ratio of the US telecom companies remains depressed!

So huge profits are a permanent fixture for the industry? Think again.

Remember, earnings growth in any industry undergoes cyclicality. For instance, the wireless segment of the telecom sector, the biggest earnings revenue contributor today, is likewise subject to the innovation cycle (innovation, growth, shakeout, maturity and end phase).

As the cycle segues from rapid growth (today) to the maturity phase, the explosive pace of growth will eventually slowdown to match or track the pace of the country’s economic growth or GDP. It can only manage to sustain such extraordinary levels of growth if it is able to introduce more revolutionary innovative products which consumers will patronize. But then again, that is a risk which the industry has to bear with by spending largely for its research and development.

Telecom’s Success Formula: Competition

Another, the telecom industry operates under a deregulated environment. This means that industry firms would have to STIFFLY COMPETE among each other to be able to attract enough subscribers in order to recoup on their investments and eventually earn from it.

And how do they do that? By offering BEST POSSIBLE SERVICES at the MOST AFFORDABLE PRICES.

As the “Text capital” of the world, we are said to have been privileged with the lowest “texting” rates in the region. From the Philippine Star, `` [Globe Telecom senior vice president Rodolfo Salalima] Salalima also emphasized that the Philippines has the lowest text messaging rates in the region. Because of the various promotional campaigns being offered by local telcos, particularly unlimited texting, text-messaging rates in the country have gone down to as low as 13 to 14 centavos per message.

``This rate, he stressed, is extremely low when compared to India’s 61 centavos per text message, Malaysia’s 67 centavos, Indonesian Extelcomindos’ P1.18 per message, China’s P1.55 per text, and Hong Kong CSL’s P15.91 per message.”

Meanwhile, the penetration levels for domestic mobile have reached 51% or some 46 million in early 2007(marketreserach.com), which means more than half of the population is now connected.

Yes, the success to spread connectivity in the country today is principally due to intense competition, which has immensely LOWERED prices and thus added subscriber volume or by expanding coverage.

Economics 101 tells us that if you want more of anything you simply lower the cost and if you want less of anything you increase the cost. But as a caveat this important insight from Mr. Jeff Bezo, Amazon.com’s CEO, ``Lowering prices is easy. Being able to afford to lower prices is hard", which alternately means lowering prices has its limits. You can afford to lower prices enough to keep some profits to ensure the survivability of the company.

And this has not been an isolated or a Philippine only phenomenon but a global one as shown in Figure2.

Figure 2: ITU: Global Mobile Industry has been Powered by Competition

Where monopoly once dominated the telecom industry today competition has taken over. Because of competition which brought upon affordable pricing worldwide, in 2007 mobile the penetration level have exploded to around 49% or some 3.3 billion subscribers (news.com.au).

Enormous Capital Investments Need Huge Earnings

It does not end here.

Because the industry is technology laden, this means that it would require CONTINUOUS ACCESS to risk capital in order to EXPAND CAPACITY (think nationwide coverage, reduction of dead spots, reduced time lags from message sending to receiving, international roaming et. al.), UPDATE/UPGRADE TECHONOLOGY (think Multi-media messaging, 3G) or to INNOVATE (think WIMAX, IPTV) its infrastructure or to even CUSTOMIZE PRICING (think unlimited texting or calls) for the very same purpose of attaining viability of the project by offering QUALITY and EFFICIENT SERVICES at AFFORDABLE PRICES to attract MORE subscribers and earn profits from it. As earlier mentioned it has to also spend for considerable investments on RESEARCH and DEVELOPMENT.

Not only that…billions of Pesos of existing infrastructure is similarly subject to OBSOLESCENCE RISK-where the risk to infrastructure or extant technology becomes obsolete or outmoded!

Figure 3 Ray Kurzweil: Moore’s Law

Figure 3 from futurist Ray Kurzweil shows of how technology propelled innovation have accelerated exponentially or the “S” Curve. This means that technology based companies like those in the telecoms will have to be nimble enough to adapt to the swift advances in technology or lose subscribers and money.

In short, HUGE PROFITS are thereby REQUIRED for the UPKEEP of the capital intensive system of the telecom industry to ensure its survival. Nonetheless, what needs to be further stressed is that such profits are never guaranteed and is never static since it breathes upon the patronage of fickle consumers! Consumers like voters can easily change preferences for whatever reasons.

Consumer Sovereignty and Patriotism as Refuge of Scoundrels

When consumers subscribe to a company’s service (post paid or pre paid), this is because of the perceived satisfaction or utility derived from the services offered. They are done VOLUNTARILY and NOT BY FIAT. Consumers always have the option to terminate or transfer to other firms offering similar generic services (or more) because they see it fit according to their interests. This is called consumer sovereignty. It is unlike taxation which derives revenues by FIAT or decree. By the same token it means that earning by risk taking and earning by coercion are TWO different animals.

It is obvious that the failure to understand the dynamics of the industry is by itself a manifestation of grand myopia. Thus, the projection of the “immorality” of profits is totally unwarranted, unjustified and unfair.

Yet while pretending to serve for the best interest of the populace or consumers, this propaganda or threat to intervene via price controls actually seems more of a camouflage for punishing them.

The threats to compel free text messaging signify irresponsible statements which are wantonly absurd and have far reaching dire unintended consequences. The unfortunate part of government intervention is- “they make the rules, we the nation suffer from it”.

What possibly happens when such policies gets implemented?

Since text messaging for the telecom industry today is a MAJOR profit center, it will shift to a COST CENTER or at worst transform into a SUNK COST.

Stated differently, the telecom industry’s incentives will be overhauled overnight. Companies will either (at best) marginalize on improving on the cost center subject to subsidies from HIGHER PRICES of other services (higher toll fee for wireless, landline, data and other services) or look for other sources of revenue center (maybe via a shift towards content subscription) or (at worst and most likely path) totally ABANDON the text services altogether.

In the private sector, a nonprofit cost center can only exist when it indirectly contributes to other sources of revenues. (Think GOOGLE-it provides free search engine as a come on in order to generate significant traffic volume from which attracts advertisers-the company’s main revenue source). However, if the cost to maintain the cost center exceeds the profit potential from its major sources of revenues then it bleeds the overall operation of the company which leads to imminent closure.

Plainly said, the revenues lost from text messaging will now be recovered in the form of HIGHER prices of OTHER services. If they are not able to do so, you can kiss text messaging goodbye.

Think of it, who in the right mind would spend tens of millions or billions of capital to upgrade the network if it is non-revenue generating anyway or if it does not compliment to revenue generation?

Remember, this is NOT a government bureaucracy which can afford to subsidize one sector. In the market, revenues are derived from VOLUNTARY exchanges. In government, revenues are derived from seignorage (money issuance) or taxation-which comes out of compulsion as a subject of the state. In short, taxation is predatory-people don’t have the LEGAL option to say NO to taxes, except by tax evasion or smuggling which is punishable by law.

Put differently, in the market, people have the power to say NO to poor services by voting with their money. In government, people are NOT empowered with the same privilege. Instead we will have to bear with the inadequacy of public services because it is imposed by edict.

So applied to price controls, the choice would be having jerrybuilt or substandard services (think severely delayed text messages which may take hours, days, weeks to receive-if at all) or none at all! Besides, anything free could mean an exponential rise in usage which may vastly exceed the network capacity (systems overload) of telecom firms and thus heighten risks of a network system crash!

Moreover, because of reduced earnings, companies in the embryonic stage or with razor thin margins will simply vanish due to insolvencies.

All these combined, you can be guaranteed of even more HIGHER rates for the other residual services from the remaining service providers!

As Ludwig von Mises wrote, ``If the government fixes a maximum price for certain commodities below the level which the unhampered market would have determined for them and makes it illegal to sell at the potential market price, production involves a loss for the marginal producers. Those producing with the highest costs go out of the business and employ their production facilities for the production of other commodities, not affected by price ceilings. The government's interference with the price of a commodity restricts the supply available for consumption. This outcome is contrary to the intentions which motivated the price ceiling. The government wanted to make it easier for people to obtain the article concerned. But its intervention results in shrinking of the supply produced and offered for sale.”

Because reduced supply from policy initiated incentives equals higher prices, price controls do more harm than what is intended.

At the end of the day, the road to hell is paved with noble intentions. Free text messaging equals no text messaging and or higher cost of other communication services.

On the other hand, the only more viable way to bring down prices is to liberalize the industry or open it to MORE competition as shown above.

Aside, our authorities have another option of reducing prices: REDUCE TAXES but with CORRESPONDING DEDUCTION IN SOCIAL SPENDING. Our glib talking politicians should not only vent on the industry but should look at their own bureaucracy as a source of savings. They should consider giving back to the people their wasteful and inefficacious boondoggles in the form of pork barrel!

Nationalization Next?

So once interventionism creeps in, what’s to stop the government from going further?

The next step would probably be to put a cap or ceiling on prices of the other sources of revenue sources. This should translate to humongous losses and lead to industrywide foreclosures.

In the same manner if the government compels companies to operate free text services by bleeding them dry, the industry would simply allow itself to be taken over.

Hence, government completes the transition by effectively “nationalizing” the industry.

By nationalization, government would need tons of capital from which would come from taxpayer funding. Remember, the lifeblood of this industry requires recycling of huge capital. The assumption that government can manage the monopoly profitably is wishful thinking given its horrible track record and its LACK of resources.

As a political entity, the cosmetically rehabilitated state owned company will only be an endemic source for political appointments which will be hobbled with incompetence, abuse, corruption and other forms of capital allocation inefficiencies. It will be another potential cow to milk at the expense of consumers.

If the company will offer mobile services (at subsidized rates) under subsidies from the national government, losses accumulated will be charged to the unfortunate productive taxpayers, whom will bear the brunt of higher taxes and or higher costs of living.

If they should charge for services, given the monopoly and inherent inefficiencies, whatever services will be paid for will be at VASTLY greater prices than what it is today even at the face of dysfunctional or shoddy quality of services.

Thus, your free text becomes both a DIRECT and INDIRECT tax to consumers!

In a world where technology has helped improved the lives of people by increasing communications, connectivity, interaction and business transactions and trades by lowering costs, price controls and unnecessary intrusions by government will undo these progress. We are likely to materially slowdown, if not regress.

Ultimately all these should lead to immense lost productivity, loss of competitiveness, loss of investments, capital flight, loss of jobs, higher taxes, higher cost of living, lower the standard of living, a more intensified corruption and worst of all increased poverty.

Politics Likely A Factor-“Flexing Political Muscles”

The incumbent President is an economist, so we are inclined to believe that she is very much aware of the negative repercussions from the derring-do actions of her subordinates, unless she is a closet hammer and sickle bearing ideologue (which so far enough hasn’t been the case).

That said, it is likely that the administration could be seen as “flexing its political muscle” as a demonstration of strength that it is still a power to reckon with even as her tenure approaches the twilight (or the projection that the administration is not in a lame duck state). This is especially directed to whom she perceives as her political opponents. (Yes some of the supporters of her adversaries are stalwarts from the industry).

Yet political maneuverings will do us no good by signaling to investors of the country’s vacillation to sanctify contracts and or uphold private ownership rights. Moreover, it is this kind of interventionist culture that inhibits a market economy from flourishing, aside from the perpetuation of the state of corruption.

As the illustrious economist Milton Friedman once said, ``There is no such thing as a FREE Lunch! To paraphrase, ``There is no such thing as a workable forced free texting!

As a final thought and disclaimer, my perception of the industry is one where it has been cherry picked or where the “low hanging fruits” have already been harvested. The rapid growth phase seems likely to transit into a mature phase which should grow in line with the economy over the coming years. Thus the performance of the telecom sector should reflect the growth of the Phisix than massively outperform as in the past, in my view. As a market participant who aims for “growth” and unpopular “value”, the industry has not been much of a priority, which means I DON’T OWN any telecom issues as of this writing.