Phisix: A Deeper Look at the Philippine and Indonesian Stock Market Mania

A Creeping Déjà vu of the February 2013 Mania

Well, actions in the Philippine stock exchange seem like a déjà vu of the manic phase of February to early March of 2013.

We uncannily see three similar traits. One, the slope in the uptrend of the Phisix has gone parabolic or ballistic. However as discussed last week[1] the time period and intensity covering this ascent has been variable.

Second, in the trading sessions of both February 28^th of 2013 and 2014 there had been a coincidental “marking the close”[2]—where the Phisix had been substantially pushed up at the closing bell by certain parties in what seems as an attempt to accomplish some unstated goals.

Third the interim correction cycle may have begun. The beginning date of 2013’s correction: March 11^th. In 2014, this corrective phase started in March 12^th.

Creepy coincidence no?

The Phisix closed the week off 1.4%. In 2013, the depth of the correction was 6%. Since the degree of ascent has been different, I doubt if depth of the interim correction will be similar.

So far history has rhymed.

And as I have been pointing out over the past two weeks, the reason for the seeming eerie resemblance has been out of the desperate attempt by the consensus to foist a resurrection of the old bullish environment characterized by the easy money ‘tailwind’ of zero bound rates, low bond yields, suppressed inflation and a strong peso—as against today’s relatively tighter money conditions via the headwinds of a weak peso, rising price inflation and elevated bond yields. Such ‘resistance-to-change’ attitude have brought about vehement price reactions via the frenzied bidding up of asset prices rationalized from the use of selective ‘positive’ economic data to justify such actions. Such impetuousness guarantees magnified volatility.

Unlike 2013, the 2014 version of correction has been distinct in the sense of net foreign buying support as against net foreign selling last year.

Every market transaction constitutes a buyer and a seller of a particular good, service, or a financial security for an agreed price and specific volume. In the context of the Philippine Stock Exchange, there is no such thing as a “money flow” in the trading of publicly listed securities.

So what the mainstream sees as “money flows” are really changes in the composition of ownership of securities. Thus the obverse side of every foreign buying is domestic selling and vice versa. Money is simply exchanged between the buyer and the seller of securities.

And the ensuing directional changes in price levels are determined by the dominant or prevailing sentiment.

These are economic and financial truisms and not merely interpretations. They are apodictic self-evident truths (in Austrian economics terminology: synthetic a priori propositions[3]).

This becomes interpretative when we inject adjectives like “bullish” or “bearish” in the imputations of actions.

For instance, despite net foreign buying which meant foreign demand for peso assets, this week’s decline of the peso vis-à-vis the US dollar from 44.38 to 44.655 (.6%), which basically negated last week’s rally, implies that demand for US dollars must have emanated from domestic sources. In my construal of events, foreign demand for peso assets has been more than offset by local demand for US dollars for the Peso to tumble. Thus it is not farfetched to posit that since some of such ‘overt’ optimism has not extrapolated into actions, some segments of the consensus may have used “bullishness” as a decoy to conceal their actual (selling) actions. 

The Wall Street vernacular for this is “pump and dump”.

Given the current activities, where foreigners and retail accounts seem as the bullish participants based on market actions, I suspect some of local institutions as the net sellers of local stocks and have been net buyers of the US dollar.

Fugasi

The Indonesian Stock Market Bubble

In the current setting, ASEAN stock markets seem to have become a magnet for speculative foreign capital starved of yields, all justified from some mythical strength.

Based on last week’s action there has been an apparent shift in market volatility.

From June 2013 until February most of the financial tremors plagued emerging markets. This week the role switched. (I will deal with this later)

Nonetheless emerging Asia seems to be defying gravity. Anything with an ASEAN tag seemed to have been turned into gold as if touched by the magical hands of Greek mythological King Midas.

Indonesia’s equity benchmark the JCI skyrocketed last Friday by 3.23% to end the week up by an astounding 4.11%! According to news this has brought Indonesian stocks back into the “bull market”.

Why? Because a populist leader, Jakarta Governor Joko Widodo, is running for president.

Let us hear it from Bloomberg[4]:

A Widodo administration would probably boost spending on infrastructure and public welfare, CIMB Group Holdings Bhd wrote in a report last month. Indonesian shares have rallied this year as an acceleration in Southeast Asia’s largest economy, improving corporate earnings growth and the prospect of increased spending before national elections that start next month lure international investors. Foreign funds have poured $1.01 billion into the nation’s stocks so far in 2014.

Incredibly just about a few months a back, Indonesia was at a verge of a crisis.

I read one analyst effusively extolling on how Indonesia has been recovering (e.g. lower inflation, narrowing current account deficit and etc…) and of the great business environment they have been.

A half-filled glass can be seen as half-full or half-empty.

So I will simply show you what has been claimed as “recovery”.

Indonesia’s statistical inflation (top pane) has indeed slowed from a high of 8.79% to 7.75% but this still way up from 2013 lows.

Another much touted recovery has been the current account, while it is true that such deficit has been halved from the third quarter, the current levels are still above 2012.

The gains have been mentioned but not the losses.

Indonesia’s January trade balance has posted a deficit. Yet a weakening of trade balance will put pressure on the current account, which comprises of trade balance, net factor income and cash transfers.

And contributing to the weakening of Indonesia’s trade balance has been a sharp plunge in January exports that followed a December upside spike. So if the December data was an anomaly, then the January’s sharp decline could have merely neutralized such aberration. This could also mean that the halving of current account deficit in the last quarter may well be a one-off deviation caused by the December spike.

Yet outside the export spike in December, both export and import trends seem to be slowing. Such are hardly optimistic indicators of a healthy economy.

Besides even Indonesia’s statistical GDP seem as in a steady decline. From a high of the annualized growth of 6.9% in 2011, growth rate has gradually levelled off to 5.72% (4Q 2013) but slightly up 5.62% in the third quarter. This is recovery?

Indonesia’s merchandise trade, which has also been diminishing, accounts for 43.1% of her GDP as of 2012 according to World Bank.

And based on ING’s 2012 study[5], Indonesia’s top 5 export partners are (in pecking order) China, Japan, Singapore, South Korea and India. In terms of top 5 import partners, Singapore, China, South Korea, Japan and Thailand.

In short, Indonesia’s economy has been heavily leveraged to Asia which means she is highly sensitive to developments in the region.

A slowdown in China and Japan or the rest of Asia will materially affect Indonesia’s economy in terms of trading linkages. And I recently wrote about the substantial decline in exports—collapse (10%+) in Japan, China, Mexico, Russia and Brazil; sharp downdraft in South Korea; marginal declines in the Eurozone and the US—appear to be manifestations of sizeable downshift in the global economic growth[6].

Notice too that Indonesia’s slowing rate of economic growth seems synchronous with the decline in the contribution of her merchandise trade. 

And here is where it gets interesting.

Indonesia’s government budget deficit as % of GDP, which has been drifting between .5 to 1.5% from 2008 to date, have been estimated at 2.02% in 2014[7]. Notice that nominal deficit (in euro) [right window] has been cascading down but “strong” statistical economic figures offset such declines when viewed from % of GDP. This looks very much like the Philippines, but I will deal with this later.

The interesting part is exactly the paradox of what the market has been cheering at—government spending. The new government is expected to be spending a lot of money for political projects.

Currently, projected infrastructure spending for 2014 has been at $39 billion[8], so perhaps political entrepreneurs (euphemism for cronies) may be leaping for joy that the new government may divert MORE resources that will accrue to their benefit at the expense of the economy.

But aside from this, the Indonesian government has an existing major problem: SUBSIDIES.

Despite reduced upside volatility in oil prices, the 2013 depreciation of the rupiah have ballooned the cost of subsidies by more than 25% to $25 billion according to a Societe Generale study as noted by Investing.com. This will now consume about 20.9% of government revenues compared to just 14.5% in 2006. In addition, as net oil importer since 2004, oil imports will likewise swelled to a record $63.5 billion in 2018 from $40.4 billion today[9]. So oil subsidies and imports will put pressure on government budgets.

There is no free lunch. Where will the Indonesian government get financing for these?

In order to finance the welfare-infrastructure spending binge, the Indonesian government has already undertaken measures to raise a record IDR 357.96 trillion (USD $29 billion) in international and local bond markets in 2014 as I previously noted[10].

So aside from the rupiah’s depreciation in 2013, higher bond yields will translate to higher costs of servicing debt. Aside the only meaningful act undertaken by the government has been to raise official interest rates by 198 basis points in the second semester of 2014

So how will higher interest rates (or still elevated inflation rates) translate to “improving corporate earnings growth” and higher demand for the economy?

The Indonesian economy has been ramping up on her foreign dollar liabilities. While external debt has increased by 5% in 2013, CAGR from 2009 has been at 8.84%. Private sector debt has inflated by 13.81% as against 4.47% by the government. In breaking down the distribution, for 2013 overall external debt has been 47% government and 53% private sector[11].

And given the increased costs of subsidies and debt servicing of foreign claims, I think such statistics understate real credit activities.

And the stock market has celebration has barely been enthusiastically shared by the rupiah and her 10 year bond yields (in terms of degree), despite the recent rallies of the latter two.

The Pollyannaish analyst also wrote that Indonesia is a nice place to do business. Yet Indonesia has recently imposed “natural resource protectionism/nationalism” by the banning exports of ore products. The new administration is seen as maintaining a tough stance towards mineral exports[12]. Protectionism reduces economic activities. How will limiting economic activities extrapolate to economic growth?

Additionally the Indonesian government has imposed massive minimum wage increases anywhere from 10% to 222% applied distinctly for specific provinces in 2014[13]. I would estimate the median to be at 25%. I cited this last November[14]. How will forcing companies to increase business costs via minimum wages increase profits enough to attract business investments?

Moreover business groups like the European Chamber of Commerce have been appealing to the government to intensively ease of business regulations[15]. Such are symptoms of economic repression.

The Indonesian Property Bubble

Finally in 2013 I mentioned that Indonesian economy has been nurturing a bubble[16]. It appears that Indonesia’s property bubble has inflated large enough to be acknowledged by the mainstream.

Fitch ratings warned last week that Indonesia’s property bubble, which has been sizzling for the “past three years”, has been undermining bank conditions due to the proliferation of low quality special mention loans (SML). Due to deterioration of SMLs, Indonesia’s non performing loans (NPL) has reportedly been on the rise[17].

Notice that without NPLs, bubbles as expressed by rapidly surging prices financed by an explosion of credit won’t be seen by the credit rating company. You can see Indonesia’s skyrocketing residential property prices (as of March 2013) here.

The Oxford Business group likewise notes that due to increased regulations to curtail on the spiraling loan mortgages such as the “lowering of the maximum loan-to-value (LTV)” and “a new rule that prohibits banks from providing loans for unfinished residential projects”, property prices has been expected to rise by just 10% in 2014 “compared to an average of 15-17% in recent years”. Remember Indonesia’s economy has been growing by about 5-6% so property prices have been growing thrice the pace of the economy.

The group also noted that according to Bank Indonesia’s July figures, “outstanding mortgages on apartments measuring 22-70 sq metres surged 57.2% year-on-year.”[18]

Indonesia’s loans to the private sector have stunningly expanded by about triple today from 2008. Such explosion of loan growth has been transmitted through money supply growth where M2 has more than doubled over the same period. So this has been the primary cause of the surge in Indonesia’s price inflation and hardly about the earlier partial lifting of subsidies or about the Fed’s taper.

So despite the recent interest rate increases, there has been so much excess money in Indonesia looking for yields to chase at. And part of this has been the fight to reclaim yesterday’s easy money environment through the rekindling of Indonesia’s stock market bubble and the further escalation of her property bubbles.

With all the money being thrown into speculative activities, it is obvious that whatever gains achieved over the last few months have been temporary. Reasons? A surge in demand for credit will mean higher interest rates. Credit financed spending will extrapolate to relative price inflation that will mean higher bond yields and eventually higher interest rates.

And more, perhaps in sensing the narrowing spectrum of assets producing positive yields foreign money have been forcing to bid up on ASEAN assets, by conjuring myths about the sustainability of bubble economies—in apparent flagrant disregard to the various risks.

And here are more disturbing signs of the deepening mania. Prior to Friday’s bullish rampage, a report from Reuters notes that “consensus PE ratio for Indonesia is 26.3 percent above its long-term average”. Given Friday’s 3.23% surge, this would entail Indonesian PE ratios at the firmament.

Indonesian equities have also a very pricey book value, “The rally has made Indonesia one of Asia's most expensive markets, with a price to book ratio (P/B) of 3.5.” Guess who comes next? “The Philippines comes closest to that kind of valuation with a P/B ratio of 3.”[19]

In short, Indonesian equities have been trading at the fat tail end of the probability distribution curve. Yet like the Philippines, these punters see such aberrations as the new normal.

And like the Philippines, the real reason why governments promote the quasi permanent inflationary boom is to have access to money (via credit markets and taxes) to support their pet projects. And proof of this is that global debt, according to the Bank of International Settlements have ballooned to $100 trillion or a $30 trillion or a 42% increase from 2007 to 2013 due mostly to government spending[20]. Such colossal diversion of resources is why the world is now faced with a clear and present danger of a Black Swan economic and financial phenomenon.

Or perhaps as the late singer Tupac Shakur said, Reality is wrong. Dreams are for real.

Does Moody’s have a Clue?

Going back to the Philippines.

Another source of economic fiction is the claim by rating company Moody’s that the Philippines won’t be hurt by a sudden stop because “The Philippines’ household debt-to-GDP ratio is among the lowest across Asia”[21].

This is a prime example of interpreting statistics in the pretense of talking economics or economic risk analysis

First of all, the “sudden stop” has yet to occur. But Philippine markets have already responded violently with three and a half incidences of bear market strikes, the continuing slump in the peso and elevated bond yields. These are market signals that have real economic effects.

While the market turbulence hasn’t percolated significantly into the real economy (yet) it doesn’t mean that just because it hasn’t happened, it won’t happen. This signifies a cognitive fallacy called anchoring. Once the big storm truly arrives, let see how immune the Philippines will be. And it is coming.

Second, the Philippines’ household debt-to-GDP ratio is a non-sequitur. Moody’s people see ASEAN economies wearing a “one-size-fits-all” T-shirt. This isn’t economics. This is stereotyping.

Third, the Philippines have a different debt dynamic than Indonesia, Thailand or Malaysia.

In the knowledge that there are only 2 out of 10 households whom are enrolled in the formal banking system, how on earth can 20% (or less) of the overall Philippine household carry a debt load of the equivalent of Thailand and Malaysia with far larger formal sector participation? This is mistaking unique-specific dynamics or “case probability” with frequency or “class probability”[22].

Instead the Philippines debt dynamic has been weighted on its finance and non-finance sector rather than the households. The World Bank has a great chart of the difference in the debt profile of ASEAN and China. See graph here.

Officials at Moody’s seem to be looking at the wrong picture.

This also means Moody’s has seriously been underestimating risks of the Philippines.

Has Moody’s seen the debt profile of publicly listed San Miguel Corporation[23]? SMC seems embroiled deeply in both short term and long term debt. The long term debt is what the public sees.

Yet SMC rolls in and out short term debt to the tune of 200 to 250 billion pesos per quarter (and growing). And SMC appears as hardly earning enough to support the amount she owes in interest and principal. In a credit event, all liabilities (short term and long term) will surface.

Has Moody’s seen that in three quarters SMC’s short term debt rollover has accrued nearly 10% of the resources of the Philippine banking system? SMC says that these short term loans are mostly sourced from the banking system, should a SMC credit event occur will the Philippine banking system be immune?

The reason why SMC can play the musical chair game of debt in and debt out is due to zero bound rates and a strong peso. But there has been widening of cracks in the easy money scenario from which her unsustainable debt conditions depend on.

Does Moody’s have a clue?

Has Moody’s also checked with Bangko Sentral ng Pilipinas (BSP), and asked why the Philippine central bank has kept a blind eye on her self-imposed 20% loan limit to banking system’s loans to the real estate sector? The real estate loan cap as % to total loans have been breached in May of 2013, yet in November the ratio has ballooned by 10% to 22%[24]. Still no actions from the BSP, why?

To consider, the real estate industry has announced an expansion of a conservative Php 250 billion, most of these will come from loans.

Who will provide financing for these companies? They are likely to be sourced from domestic banks, shadow banks, offshore banks, domestic bond markets or foreign bond markets. If sourced through the banking system, will the real estate banking loans hit 24% of total loans in April 2014?

What are the risks of acquiring loans from the other non-domestic banking sources? How are they connected with banks? What will be the effects of the real estate spending spree on the prices, not only of properties but of goods and services of the industries supporting the property boom? How will these prices affect the balance of supply and demand of these goods and services and vice versa?

Does Moody’s have a clue?

Has Moody’s also inquired with the BSP on why the domestic money aggregates has grown by 38.6% in January despite repeated official assurances for its decline?? Does Moody’s know that 68% of M2 growth emanates from domestic claims on both the non-finance and financial segments of the private sector? What are the risks of a sustained 15 to 30+++% money supply growth to the economy and to the banking system?

Does Moody’s have a clue?

How about corporate debt? The chart above from the IMF[25] reveals that based on corporate debt-to-equity ratio, compared to ASEAN neighbors, only the Philippines in 2012 has surpassed the 1998 (Asian crisis) levels of the said ratio. 

Yet as I recently pointed out citing Deutsche Bank data, a few domestic corporations has resorted to increasing intensity of borrowing through US dollar denominated bonds in 2013[26], thus the concentration of risks.

And how about Philippine debt acquired (loans by nationality) via offshore banks and international bond markets? Based on Bank of America Merrill Lynch data as I previously noted, “While the Philippines have the least exposure in nominal US dollar based loans, at 4.34x (!) the Philippines has the 2nd biggest growth rate after Thailand.”[27]

What are the potential risks from debt acquired these channels? How are they related to the banking system and to the economy?

Does Moody’s have a clue?

The late American physicist Richard Feynman in a commencement address[28] gave a wonderful advice that should be heeded by all

The first principle is that you must not fool yourself—and you are the easiest person to fool. So you have to be very careful about that.

Phisix’s Price Earnings Bubble

And let me get back at the outrageous mispricing of Philippine stocks.

I have an update that covers the entire Phisix index 

As of Friday’s close the Phisix carries an average PE ratio of 22, based on 2013 earnings, and 25.31 based on the average 4 years. Anyway both are materially overvalued.

But it would be a mistake to treat the PSE’s PE ratio as an aggregate for the simple reason that price changes or returns for each issue have been dissimilar.

So for instance, it would signify a baseline error to suggest that based on 2013 earnings, a pullback by the Phisix to 5,557.6 from Friday’s 6,391.24 would pare the PE ratio to 15 will effectively reduce her froth. That’s because it must be understood that the overpriced PE ratio of the Phisix has been a function of the suppression of the PE ratio by the underperformance of the low PE ratios.

In the above table I show both the 5 highest and lowest pe ratios of the Phisix members based on Friday’s closing prices divided by the average eps over the past 4 years.

The 4 year compounded annualized growth rates of the above firms exhibit the variability in the performance between high pe ratio Phisix stocks and low PE ratio stocks. In other words, what has driven the Phisix to the current levels has been the dramatic overdrive of issues that led to their significantly high pe levels. This means that for the Phisix to return to any semblance of “value”, such high pe ratio stocks would need to retrench most of their frothy gains. 

As one would note while the Phisix only posted an 8.82% cagr from 2010-13, URC and ICT has generated 3.87x and 2.57x the Phisix. Yet one can’t isolate the URC and ICT because their respective returns helped produced the 8.82% annualized gains by the Phisix. Meanwhile the lowest PE has severely underperformed or even generated negative returns. Thus what seems as a suppressed PE.

What has been more interesting is the relationship between the 4-year compounded annualized returns and the 4 year compounded eps growth by the highest PE ratio companies. The return/ eps growth represents the stock market gains for every eps growth generated. In terms of URC the market has been paying Php 6.22 for every peso growth generated by the company and so forth.

The more I examine the valuation of Philippine stocks particularly of the popular issues, the more I come into the conclusion that current market has embraced delusions of grandeur.

And from the financial valuations perspective how does the PE cycle evolve?

Well according to Ed Easterling of the Crestmont Research it’s all based on inflation[29]. (bold mine)

What drives the P/E cycle? The answer is the inflation rate—the loss of purchasing power of money and capital. During periods of higher inflation, investors want a higher rate of return to compensate for inflation. To get a higher rate of return from stocks, investors pay a lower price for the future earnings (i.e. lower P/Es). Therefore, higher inflation leads to lower P/Es and declining inflation leads to higher P/Es.

The peak for P/E generally occurs at very low and stable rates of inflation. When inflation falls into deflation, earnings (the denominator for P/E) begins to decline on a reported basis (deflation is the nominal decline in prices). At that point, with future earnings expected to decline from deflation, the value of stocks declines in response to reduced future earnings—thus, P/Es also decline under deflation.

During stagflation, which has been a progressing case in the Philippines[30] and in Indonesia as shown above, such environment should theoretically lead to declining stocks from the prospects of lower PE brought about by higher inflation. But of course, the consensus whom has been inured (or may I say addicted) to central bank implied guarantees on high roller bets, have been resisting such an environment, thus continues to bid up on stocks financed by credit. The end result should be a Wile E. Coyote moment or a bubble bust or price deflation, which also means declining PE.

In the US the PE cycle has traded typically from “below 10 times earnings to levels above 20”. But during bubble periods, PE ratios “tends to peak near 25” remarked Mr. Easterling.

It seems that whether in the US or in ASEAN, we definitely see Price Earnings Bubbles.

As a side note, it is so interesting to see how Philippine authorities and media continue to be flummoxed by the high rate of joblessness and stubborn poverty levels[31]. Yet the same authorities and their experts suggest for more of the same factors causing them via “safety nets” and via proposals to close “the mismatch of skills”. 

Will the extension of schooling by the Philippine government to 13 years solve this[32]? I won’t bet on it. But there is one thing I will bet on, big league schools will be the primary beneficiaries from the mandated years of forced extended education at the expense of their pupils who should be acquiring real education via working experience than from the blackboard[33] and from pseudo school sanctioned internships. It is already sad to see that as of 2010, 2/5 of graduates have been unemployed. Yet mandated blackboard education and simulated internships will lead to more job-skill mismatches and more unemployment.

---

[1] See Phisix: The Stock Market Mania Deepens March 10, 2014

[2] See Phisix: Why Tomorrow’s Fundamentals will be Distinct from Yesterday March 3, 2014

[3] Hans Hermann Hoppe PRAXEOLOGY AND ECONOMIC SCIENCE Economic Science and the Austrian Method Mises.org

[4] Bloomberg.com Indonesia Stocks Enter Bull Market on Widodo’s Presidential Bid March 14, 2014

[5] 2012 Indonesia ING International Trade Study

[6] See EM Contagion: Based on Exports, Global Economic Growth appears to be Downshifting Fast March 12, 2014

[7] Asian News Net Indonesia's budget deficit in 2014 estimated to reach 2.02 per cent September 17, 2013

[8] Jakarta Globe Indonesia’s Infrastructure Spending Projected to Reach $39 Billion in 2014, January 10, 2014

[9] International Business Times What Indonesia's Fuel Subsidy Is Costing March 14, 2014 Investing.com

[10] see ASEAN Crisis Watch: Indonesia’s bond market selloff accelerates January 28, 2014

[11] Bank Indonesia External Debt Statistics of Indonesia February 2014

[12] Reuters.com Indonesia's next leader unlikely to ease tough mineral export rules March 11, 2014

[13] Indonesia-Investments.com 24 Indonesian Provinces Have Set New Regional Minimum Wage for 2014 November 15, 2013

[14] see Phisix: The Myth and Realities of a Yearend Rally November 6, 2013

[15] Antaranews.com Eurocham urges Indonesian govt to ease business regulations February 22, 2014

[16] see Indonesia’s Boom: Resource Based or Credit Bubble? April 11, 2013

[17] Jakarta Globe Fitch Warns of ‘Bubble-Like Symptoms’ for Indonesia March 13, 2014

[18] Oxford Business group Indonesia’s housing market likely to cool March 13, 2014

[19] Reuters.com Analysis: Indonesia's stock market set for another boost from earnings March 12, 2014

[20] Bloomberg.com Debt Exceeds $100 Trillion as Governments Binge, March 10, 2014

[21] Inquirer.net Moody’s: Sudden stop of inflows won’t hurt PH March 14, 2014

[22] Ludwig von Mises Uncertainty August 4, 2007 Mises.org

[23] See Will San Miguel’s Minsky Moment Occur in 2014? January 13, 2014

[24] See Phisix: The BSP’s Self Imposed Hobson’s Choice, March 9, 2014

[25] IMF Malaysia STAFF REPORT FOR THE 2013 ARTICLE IV CONSULTATION February 14, 2014

[26] See Phisix: Will the Global Risk OFF Environment Intensify? February 3, 2014

[27] See Emerging Market $2 trillion Carry Trade: The Pig in the Python February 24, 2014

[28] Richard Feynman Cargo Cult Science From a Caltech commencement address given in 1974

[29] Ed Easterling The P/E Report: Quarterly Review Of The Price/Earnings Ratio January 6, 2014 Crestmont Research

[30] See Phisix: Stagflation is here, Expect a Weaker Peso February 17, 2014

[31] Wall Street Journal Poverty Is Stubborn Foe in Philippines March 12, 2014

[32] MediaIndia.net Schooling Extended to 13 Years By Philippines May 17, 2013

[33] See How Bro. Armin Luisitro’s 12 Year Basic Education Cycle Will Benefit The Big League Schools, August 10, 2010

The Anatomy of Economic Fascism: Argentina Edition

Following the Repsol’s discovery of huge Shale oil and gas deposits under the "Vaca Muerta" ("Dead Cow") basin of Neuquen province, the cash strapped Kirchner regime decides to nationalize the embattled Spanish energy company.

Here is a graphic narrative of Argentina’s economic fascism from the ever eloquent Wall Street Journal columnist Mary O’Grady…

Nationalizations, particularly in the energy sector in Latin America, are nothing new. But the circumstances surrounding the Argentine grab of YPF may be. They demonstrate the special nature of kirchnerismo, an economic model that enriches friends of the government while driving the nation toward poverty.

Repsol won ownership of YPF in a 1999 privatization. It seemed like a good idea at the time. But then the 2001-2002 peso collapse hit. The economy contracted sharply and a political crisis followed. In 2003, Néstor Kirchner, husband of Cristina and a former governor of the province of Santa Cruz, was elected president—with a mere 22% plurality.

Kirchner needed to shore up support. He did so by demonizing business and promising to redistribute wealth to the have-nots, whose numbers had swelled due to the crisis. He denounced entrepreneurs, condemned profits and stirred up class warfare. To hold back inflation after the peso devaluation, he imposed price controls on food and fuel. Utilities got hit with rate freezes. But wages and taxes kept going up. Companies referred to the slow strangulation by government diktat as "asphyxia."

Repsol was trapped. The government set the price of a barrel of oil at $42 and mandated that YPF oil output could not be exported until Argentine demand was satisfied. The natural gas business was even more difficult. Repsol says that the price controls combined with subsidies drove demand through the roof, taxing the company's resources.

The relationship between the government and the Spanish company became strained. But having made a sizeable investment, Repsol did not want to exit. According to press reports supported by my own sources, the company agreed to allow Nestor Kirchner to broker a deal in 2008 to bring in an Argentine partner that he chose. That partner, the Petersen Group, was headed by banker and construction magnate Enrique Eskenazi, a long-time Kirchner ally.

According to published accounts in the Argentine press and in The Wall Street Journal, the Petersen acquisition of almost 25.5% of YPF was completed with almost no money down. Repsol agreed to finance the majority of the shares and loans from banks financed the balance. Repsol says that the Petersen Group still owes it $1.9 billion.

Repsol also agreed to increase YPF's dividend payout to 90% of earnings. Using those dividends Petersen was to pay back its loan to Repsol over time along with some $680 million in bank loans, according to Bloomberg. The company also paid one extraordinary dividend from retained earnings to help in paying down the loan.

Was this an attempt to avoid "asphyxia"? I asked Repsol why it agreed to such a deal and if it went along with the arrangement because Kirchner, who died in 2010, had been strong-arming the company. Repsol declined to comment.

Petersen's no-money-down acquisition was a sweet deal and some Argentines wonder if Kirchner set it up out of the goodness of his heart. This is a pertinent question since both Kirchner administrations have been notorious for a lack of transparency and have been plagued by corruption scandals. It is hard to answer because it is not clear who are the owners of the shares of Australian-based Petersen Energy. One Argentine source told me those shares are in bearer form, which would mean that there is no record of ownership. But when I asked Petersen if that is true and also how it financed the purchase of the YPF shares, it declined to comment. The Argentine government did not respond to requests for comment.

Read the rest here

At the end of the day, economic fascism is about cronyism and corruption through repressive laws.

The Geopolitics of Oil and Russia’s Knowledge Economy

Writes the Institutional Investor at the Minyanville

All it would take for Russian President Vladimir Putin’s regime to begin to crumble would be for the price of oil to slump to the $70-a-barrel range, former Secretary of State Condoleezza Rice told an audience last week.

Speaking at Everest Capital’s Emerging Markets Forum in Miami, Rice said that if the price of oil remains above the $100-a-barrel mark during the next few years, Putin’s Kremlin would have the means to continue paying off cronies and keeping the current regime — which she described as an “oil syndicate” — intact. With crude currently hovering around $110 a barrel, she said, there is no incentive for Russians to change the nature of their economy.

But the days of a Russia fueled exclusively by petrodollars is waning, especially if the price of crude begins to fall, she said. Ready to replace Putin’s petrostate is a knowledge-based economy crying to break free, said Rice, also a former national security adviser to President George W. Bush and an expert on the Russian political economy. “Wouldn’t it be refreshing to see that the basis of Russian power is the knowledge and creativity of its people? They could be a very big part of the 21st century,” she said.

Rice told the audience at the emerging markets summit a story about how the former president, Dimitri Medvedev, once boasted to her that Russia produced the world’s finest mathematicians. Her response: What if they were actually working in Moscow instead of in Palo Alto and Tel Aviv? She said that Medvedev acknowledged that Russia needed to provide an ecosystem in which its homegrown talent would remain at home and help the country flourish. “The arts and sciences in Russia have been legendary even in the worst of times. Can you imagine how remarkable their economy could be if their leading scientists weren’t leaving for Silicon Valley?” she said.

Besides being extraordinarily dependent on oil, Putin’s regime has done little to censor or monitor the Internet compared to, say, China, according to Rice. The former KGB agent focuses his attention on producing state television broadcasts reminiscent of the Cold War Era — an old-line communist activity that matters little to a younger generation of Russians who receive their news over the Internet, she said.

There are two things of note here:

1. The geopolitics of oil simply posits that the survival of many of the resource dependent welfare states have been moored to high oil prices. That’s because the political leadership uses revenues from resources to buy off the public’s support to maintain their privileges (usually known as the resource curse).

The same desire to use revenues to finance pet projects of politicians also serves at the main incentive for the political leadership around the world, including the Philippines, to engage in resource nationalism during commodity booms

Yet take away the lofty price oil, say by allowing free markets to work and all these autocratic regimes, such as Iran, Venezuela and etc…, collapses. So war will never be necessary for any regime changes. Just allow free markets to clear and despots and tyrants will subsequently vanish.

But the problem is that many western friendly autocratic welfare states are also dependent on elevated oil prices like the GULF states.

Also Obama’s green energy/jobs policies depends on high oil prices too.

The Investor’s Business Daily recently noted that

Energy Secretary Steven Chu admits the administration has no interest in bringing them down…At a hearing this week, Rep. Alan Nunnelee, R-Miss., specifically asked Chu if "the overall goal" of the administration is to "get our price down." Chu's answer was no.

Since this implies that deeply entrenched vested interest groups are in command of the political environment—whose survival again greatly depends on lofty oil prices—the geopolitical imperatives will focus on the manipulation of oil supply and demand, war mongering and importantly inflationist policies. In short, oil politics greatly influence, not only national welfare politics, but also foreign policies.

So while governments may pretend to express care about consumers affected by high oil prices (say by imposing subsidies, cash giving out cash transfers and etc.) and subsequently pin the blame on private companies for greed, in reality, the geopolitics of oil is about the preservation of political entitlements through redistribution of resources from consumers to the political clients (mostly oil producers and allied industries) and their political leadership patrons.

Only free markets will undo such political economic inequality.

2. Russia’s growing knowledge economy is a demonstration of how the internet has been functioning as a pivotal force in reshaping the world’s political economy.

The internet helps spur the development of commercial activities that operates in circumvention of stifling regulations that fosters more underground economy.

Chart from pyramid research

Underground or informal or shadow economies are symptoms of arbitrary and unenforceable laws, lack of property rights, byzantine red tape, high tax regimes, choking bureaucratic regulations, corruption, weak institutions and other political impediments to commerce.

The share of informal economy to Russia’s economy is one of the highest in the world. So as with the Philippines.

I recently quoted the investment guru Doug Casey which I find relevant in the discussion of informal economies,

If you're going to have a ridiculous number of impossible laws, corruption is a good thing. Increasingly, what matters is not the number or even nature of laws on the books in the place you live, but the amount of actual control the state has over private individuals. Corruption subverts idiotic laws; it's the next best thing to abolishing them.

Aside from corruption, big informal economies are to paraphrase Mr. Casey, symptomatic of the subversion of “idiotic” laws. The other way to say this is that anarchy emerges, as expressed by the existence of informal economies, out of the abject failure of the incumbent political order for these political economies.

Resource Nationalism is a Cover For Crony Capitalism: Philippine Edition

Booming commodity prices are seen as opportunities by politicians to seize more money from private sector specifically, from mining companies, via higher taxes or increased equities to finance insatiable public spending.

Resource nationalism or the "tendency of people and governments to assert control over natural resources located on their territory" (Wikipedia.org) has been an affliction common with Latin America nations. Lately politicians from Indonesia and the Philippines seem to have been contaminated by the allure of MONEY. [Indonesia reportedly wants 51% ownership of mining companies]

Writes the Inquirer.net

The government wants a bigger share, possibly as high as 50 percent, in revenues generated by mining firms operating in the country, Finance Secretary Cesar Purisima said Tuesday.

Speaking at the Philippine Economic Forum held at the Philippine International Convention Center in Pasay City, Purisima described what the government was currently getting from mining firms as “measly” and that increasing its share in mining revenues would allow the public to benefit more from the use of the country’s natural resources.

He said the government was studying revenue-sharing schemes observed by governments and mining firms in other countries to determine what can be best implemented in the Philippines. So far, the 50-50 sharing scheme is preferable, he said.

Changing the rules in the middle of the game represents signs of political immaturity. Governments like Indonesia and the Aquino administration of the Philippines cannot live by the rules they established and change them as capriciously when so deemed expedient by the political class.

So not only do they trash upon property rights of investors and the rest of citizenry (by depriving them of legal and respectable jobs and economic opportunities), they invalidate contracts by force which will turn off prospective investors. This is yet another example of arbitrary regulations.

The response has been captured by the same article.

The plan to increase taxes or to require mining firms to pay royalties has elicited complaints from some members of the mining sector. They said such a plan would be a turnoff to investors as it constituted inconsistency of policies.

The sad part is that these feel good policies will have nasty side effects.

As I previously wrote,

Resource nationalism only adds to the supply imbalances which should mean lesser supplies and subsequently further upward price pressures.

Such actions are being prompted by expectations of governments to generate more revenues with the ultimate end of having more money to spend on political projects. They are doing this in the name of nationalism.

Yet because of the higher costs of doing business or a higher hurdle rate, aside from questions of security of ownership (property rights), investors naturally would back out or become reluctant to invest. This essentially defeats government’s agenda.

In addition, the lack of investments extrapolates to the promotion of unemployment and lost opportunity to grow.

Any local investments will not be sufficient. That’s why they have not been accessed.

Besides, local investments are likely to be “politicized” which means that only the political class and their economic patrons would become the beneficiaries.

And because the resources are there, illegal extraction would occur and proliferate. Subsequently, black markets will blossom.

And illegal activities will lead to more violence, more corruption and more environmental degradation.

Yet most people don’t see that resource nationalism is a front for crony capitalism. Since economic opportunities will be politicized the beneficiaries will be the political class and their allies.

The article again captures such potentials,

On the contrary, Pangilinan expressed willingness to agree to the government’s plan.

He was quoted in an earlier Inquirer report that mining firms might give a 50-percent revenue share to the government, but that it must be based on net revenues rather than gross revenues.

First an explanation of Net revenue. According to the Economic Glossary this means,

A common term for profit, as the difference between total revenue and total cost. When used in the real world of business wheeling and dealing, this notion of net revenue general refers to accounting profit rather than economic profit. The "net" aspect of net revenue indicates that some (that something being cost) is deducted from total or "gross" revenue. Other common terms used in this same context are net income and net earnings.

I read the Inquirer excerpt covering net revenue in the following context: The company’s expenses can bloated—through ‘subsidized’ pricing to friendly suppliers of the firm, ‘consultancy’ fees for politicians and/or their appointees to the company or through many other ‘accounting means’ of skinning the proverbial cat—to a manageable amount that would be subjected to taxes.

Reducing real profits essentially would represent a transfer of resources from minority shareholders to the managers of the mining companies and to the government. Most of the cost of the new tax will indirectly be borne by the minority shareholders, like me.

In other words, woe to the minority shareholders, as the balance sheets of mining companies will also be politicized thereby depriving us of profits via dividends.

And by increasing the cost of investments in the domestic mining industry, competition will be limited, and thus would entrench the position of the incumbent leaders, that also increases their leverage to negotiate on the copious untapped mining claims and to dominate deals within the industry.

President Aquino’s resource nationalism essentially hands the silver platter to the administration’s favored investors.

I guess political developments have been turning out as I predicted.

Resource Nationalism Equals Government Greed

I keep pointing out how high energy (and commodity) prices have been partly due to the geographical access restrictions imposed by governments on investors.

This is aside from the tsunami of money being printed around the world by central banks led by the US Federal Reserve.

Likewise, the artificially low interest rates being used to promote spending that has been stoking new bubble cycles.

Yet the allure of high commodity prices has now been changing some government’s receptiveness to investors by virtue of resource nationalism

From the Wall Street Journal, (bold highlights mine)

The government-led ouster of the CEO of Brazilian mining giant Vale SA follows a string of moves by national governments to intervene in their countries' highly profitable and highly coveted natural-resources concerns.

Some of those moves have included rejections of efforts by foreign companies to gain big stakes in local mining and resource companies. Big miners who have sought global acquisitions, including BHP Billiton, Rio Tinto PLC and Xstrata PLC, had no new comment on the trend following the change at Vale, where Brazilian President Dilma Rousseff forced out CEO Roger Agnelli. The big miners said they didn't expect the Vale move to alter their investment or expansion plans, which have already factored in the rising tide of nationalism and efforts by governments to extract higher taxes.

Indeed, many miners are pulling back or reducing the target size of foreign acquisitions to avoid defensive moves by governments. In some cases, they are abandoning huge exploration projects, which are costly and may end up benefiting the local governments rather than shareholders or customers...

Commodity-rich Latin America has been a leader in extending government control over natural resources, such as oil and other raw materials, in recent years. Venezuela and Bolivia nationalized oil and gas assets, while Ecuador started taxing what it considered windfall oil profits at a 70% rate. After Brazil discovered enormous deep-water oil fields off Rio de Janeiro, the South American country rewrote the rules for rights auctions to give its state oil company, Petroleo Brasileiro SA, the lion's share of the business. In many cases the moves were a turnaround from the 1990s, when the mostly cash-strapped nations opened up their industries to foreign investment, prompting a boom in exploration.

But the protectionism extends to other countries. BHP Billiton, the world's largest miner, has already seen several of its mining projects thwarted by foreign government. Last year, Canada nixed BHP's planned $38 billion acquisition of Potash Corp., and Australia put up so many blocks between a planned joint iron-ore venture with Rio Tinto months earlier, the two miners quit that project.

Resource nationalism only adds to the supply imbalances which should mean lesser supplies and subsequently further upward price pressures.

Such actions are being prompted by expectations of governments to generate more revenues with the ultimate end of having more money to spend on political projects. They are doing this in the name of nationalism.

Yet because of the higher costs of doing business or a higher hurdle rate, aside from questions of security of ownership (property rights), investors naturally would back out or become reluctant to invest. This essentially defeats government’s agenda.

In addition, the lack of investments extrapolates to the promotion of unemployment and lost opportunity to grow.

Any local investments will not be sufficient. That’s why they have not been accessed.

Besides, local investments are likely to be “politicized” which means that only the political class and their economic patrons would become the beneficiaries.

And because the resources are there, illegal extraction would occur and proliferate. Subsequently, black markets will blossom.

And illegal activities will lead to more violence, more corruption and more environmental degradation.

All these because government wants more revenues for increased spending.

They blame capitalist for greed, what ya call this?