Low Prioritization in the Banking System: The Magna Carta for MSMEs as a ‟Symbolic Law‟

 

An ever-weaker private sector, weak real wages, declining productivity growth, and the currency’s diminishing purchasing power all indicate the unsustainability of debt levels. It becomes increasingly difficult for families and small businesses to make ends meet and pay for essential goods and services, while those who already have access to debt and the public sector smile in contentment. Why? Because the accumulation of public debt is printing money artificially—Daniel Lacalle 

Nota Bene: Unless some interesting developments turn up, this blog may be the last for 2024. 

In this issue 

Low Prioritization in the Banking System: The Magna Carta for MSMEs as a ‟Symbolic Law‟

I. MSMEs: The Key to Inclusive Growth

II. The Politicization of MSME Lending

III. Bank's MSME Loans: Low Compliance Rate as a Symptom of the BSP’s Prioritization of Banking Interests

IV. Suppressed MSME Lending and Thriving Shadow Banks: It’s Not About Risk Aversion, but Politics

V. Deepening Thrust Towards Banking Monopolization: Rising Risks to Financial System Stability  

VI. How PSEi 30's Debt Dynamics Affect MSME Struggles

VII. The Impact of Bank Borrowings and Government Debt Financing on MSMEs’ Challenges 

VIII. How Trickle-Down Economics and the Crowding Out Effect Stifle MSME Growth 

IX. Conclusion: The Magna Carta for MSMEs Represents a "Symbolic Law," Possible Solutions to Promote Inclusive MSME Growth 

Low Prioritization in the Banking System: The Magna Carta for MSMEs as a ‟Symbolic Law‟ 

Despite government mandates, bank lending to MSMEs reached its third-lowest rate in Q3 2024, reflecting the priorities of both the government and the BSP. This highlights why the Magna Carta is a symbolic law.

I. MSMEs: The Key to Inclusive Growth 

Inquirer.net December 10, 2024 (bold added): Local banks ramped up their lending to micro, small and medium enterprises (MSMEs) in the third quarter, but it remained below the prescribed credit allocation for the industry deemed as the backbone of the Philippine economy. Latest data from the Bangko Sentral ng Pilipinas (BSP) showed total loans of the Philippine banking sector to MSMEs amounted to P500.81 billion in the three months through September, up by 3 percent on a quarter-on-quarter basis. But that amount of loans only accounted for 4.6 percent of the industry’s P11-trillion lending portfolio as of end-September, well below the prescribed credit quota of 10 percent for MSMEs. Under the law, banks must set aside 10 percent of their total loan book as credit that can be extended to MSMEs. Of this mandated ratio, banks must allocate 8 percent of their lending portfolio for micro and small businesses, while 2 percent must be extended to medium-sized enterprises. But many banks have not been compliant and just opted to pay the penalties instead of assuming the risks that typically come with lending to MSMEs. 

Bank lending to the MSME sector, in my view, is one of the most critical indicators of economic development. After all, as quoted by the media, it is "deemed as the backbone of the Philippine economy." 

Why is it considered the backbone?

Figure 1

According to the Department of Trade and Industry (DTI), citing data from the Philippine Statistics Authority, in 2023, there were "1,246,373 business enterprises operating in the country. Of these, 1,241,733 (99.63%) are MSMEs and 4,640 (0.37%) are large enterprises. Micro enterprises constitute 90.43% (1,127,058) of total establishments, followed by small enterprises at 8.82% (109,912) and medium enterprises at 0.38% (4,763)." (Figure 1 upper chart) 

In terms of employment, the DTI noted that "MSMEs generated a total of 6,351,466 jobs or 66.97% of the country’s total employment. Micro enterprises produced the biggest share (33.95%), closely followed by small enterprises (26.26%), while medium enterprises lagged behind at 6.77%. Meanwhile, large enterprises generated a total of 3,132,499 jobs or 33.03% of the country’s overall employment." (Figure 1, lower graph) 

Long story short, MSMEs represent the "inclusive" dimension of economic progress or the grassroots economy—accounting for 99% of the nation’s entrepreneurs, and providing the vast majority of jobs. 

The prospective flourishing of MSMEs signifies that the genuine pathway toward an "upper middle-income" status is not solely through statistical benchmarks, such as the KPI-driven categorization of Gross National Income (GNI), but through grassroots-level economic empowerment. 

Except for a few occasions where certain MSMEs are featured for their products or services, or when bureaucrats use them to build political capital to enhance the administration’s image, mainstream media provides little coverage of their importance.

Why?

Media coverage, instead, tends to focus disproportionately on the elite.

Perhaps this is due to survivorship bias, where importance is equated with scale, or mostly due to principal-agent dynamics. That is, media organizations may prioritize advancing the interests of elite firms to secure advertising revenues, and or, maintain reporting privileges granted by the government or politically connected private institutions. 

II. The Politicization of MSME Lending 

Yet, bank lending to the sector remains subject to political directives—politicized through regulation. 

Even so, banks have essentially defied a public mandate, opting to pay a paltry penalty: "The Bangko Sentral ng Pilipinas shall impose administrative sanctions and other penalties on lending institutions for non-compliance with provisions of this Act, including a fine of not less than five hundred thousand pesos (P500,000.00)." (RA 9501, 2010)

Figure 2 

With total bank lending amounting to Php 10.99 trillion (net of exclusions) at the end of Q3, the compliance rate—or the share of bank lending to MSMEs—fell to 4.557%, effectively the third lowest on record after Q1’s 4.4%. (Figure 2, upper window) 

That’s primarily due to growth differentials in pesos and percentages. For instance, in Q3, the Total Loan Portfolio (net of exclusions) expanded by 9.4% YoY, compared to the MSME loan growth of 6.5%—a deeply entrenched trend.(Figure 2, lower image) 

Interestingly, "The Magna Carta for Micro, Small and Medium Enterprises (MSMEs)" was enacted in 1991 (RA 6977), amended in 1997 (RA 8289), and again in 2008 (RA 9501). The crux is that, as the statute ages, industry compliance has diminished 

Most notably, banks operate under cartel-like conditions. They are supervised by comprehensive regulations, with the BSP influencing interest rates through various channels—including policy rates, reserve requirement ratios (RRR), open market operations, inflation targeting, discount window lending, interest rate caps, and signaling channels or forward guidance. 

In a nutshell, despite stringent regulations, the cartelized industry is able to elude the goal of promoting MSMEs. 

III. Bank's MSME Loans: Low Compliance Rate as a Symptom of the BSP’s Prioritization of Banking Interests 

Yet, the record-low compliance rate with the Magna Carta for MSMEs points to several underlying factors: 

First, banks appear to exploit regulatory technicalities or loopholes to circumvent compliance—such as opting to pay negligible penalties—which highlights potential conflicts of interest. 

Though not a fan of arbitrary regulations, such lapses arguably demonstrate the essence of regulatory capture, as defined by Investopedia.com, "process by which regulatory agencies may come to be dominated by the industries or interests they are charged with regulating" 

A compelling indication of this is the revolving-door relationship between banks and the BSP, with recent appointments of top banking executives to the BSP’s monetary board. 

Revolving door politics, according to Investopedia.com, involves the "movement of high-level employees from public-sector jobs to private-sector jobs and vice versa" 

The gist: The persistently low compliance rate suggests that the BSP has prioritized safeguarding the banking sector's interests over promoting the political-economic objectives of the Magna Carta legislation for MSMEs.

IV. Suppressed MSME Lending and Thriving Shadow Banks: It’s Not About Risk Aversion, but Politics

Two, with its reduced lending to MSMEs, banks purportedly refrain from taking risk. 

But that’s hardly the truth.

Even with little direct access to formal or bank credit, MSME’s are still borrowers, but they source it from the informal sector. 

Due to the difficulty of accessing bank loans, MSMEs in the Philippines are borrowing from informal sources such as the so-called 5-6 money lending scheme. According to an estimate, 5-6 money lending is now a Php 30 billion industry in the Philippines. These lenders charge at least 20% monthly interest rate, well above the 2.5% rate of the government’s MSME credit program. The same study by Flaminiano and Francisco (2019) showed that 47% of small and medium sized enterprises in their sample obtained loans from informal sources. 

...

An estimate by the International finance Corporation (2017) showed that MSMEs in the Philippines are facing a financing gap of USD 221.8 billion. This figure is equivalent to 76% of the country’s GDP, the largest gap among the 128 countries surveyed in the IFC report. (Nomura, 2020)

The informal lenders don’t print money, that’s the role of the banks, and the BSP.

Simply, the Nomura study didn’t say where creditors of the informal market obtained their resources: Our supposition: aside from personal savings, 5-6 operators and their ilk may be engaged in credit arbitrage or borrow (low interest) from the banking system, and lend (high interest) to the MSMEs—virtually a bank business model—except that they don’t take in deposits.

The fact that despite the intensive policy challenges, a thriving MSME translates a resilient informal credit arbitrage market—yes, these are part of the shadow banking system.

As an aside, uncollateralized 5-6 lending is indeed a very risky business: collections from borrowers through staggered payments occur daily, accompanied by high default rates, which explains the elevated interest rates.

Figure 3

That is to say, the shadow banks or black markets in credit, fill the vacuum or the humungous financing gap posed by the inadequacy of the formal financial sector. (Figure 3, upper diagram)

The financing gap may be smaller today—partly due to digitalization of transactional platforms—but it still remains significant. 

This also indicates that published leverage understates the actual leverage in both the financial system and the economy. 

Intriguingly, unlike the pre-2019 era, there has been barely any media coverage of the shadow banking system—as if it no longer exists.

As a caveat, shadow banking "involves financial activities, mainly lending, undertaken by non-banks and entities not regulated by the BSP," which implies that even formal institutions may be engaged in "unregulated activities." 

Remember when the former President expressed his desire to crack down on 5-6 lending, vowing to "kill the loan sharks," in 2019? 

If such a crackdown had succeeded, it could have collapsed the economy. So, it’s no surprise that the attempt to crush the informal economy eventually faded into oblivion. 

The fact that informal credit survived and has grown despite the unfavorable political circumstances indicates that the suppressed lending to MSMEs has barely been about the trade-off between risk and reward. 

It wasn’t risk that has stymied bank lending to MSMEs, but politics (for example, the artificial suppression of interest rates to reflect risk profiles). 

More below. 

Has the media and its experts informed you about this?

Still, this highlights the chronic distributional flaws of GDP: it doesn’t reflect the average experience but is instead skewed toward those who benefit from the skewed political policies. 

In any case, mainstream media and its experts tend to focus on benchmarks like GDP rather than reporting on the deeper structural dynamics of the economy.

V. Deepening Thrust Towards Banking Monopolization: Rising Risks to Financial System Stability

Three, if banks have lent less to MSMEs, then who constituted the core of borrowers?

Naturally, these were the firms of elites (including bank borrowings), the consumers from the "banked" middle and upper classes, and the government.

Total Financial Resources (TFR) reached an all-time high of Php 32.8 trillion as of October, accounting for about 147% and 123% of the estimated real and headline GDP for 2024, respectively. (Figure 3, lower pane)

TFR represents gross assets based on the Financial Reporting Package (FRP) of banking and non-bank financial institutions, which includes their loan portfolios.

The banking system’s share of TFR stood at 83.2% last October, marking the second-highest level, slightly below September’s record of 83.3%. Meanwhile, Universal-Commercial banks accounted for 77.8% of the banking system’s share in October, marginally down from their record 78% in September.

These figures reveal that the banking system has been outpacing the asset growth of the non-banking sector, thereby increasing its share and deepening its concentration.

Simultaneously, Universal-Commercial banks have been driving the banking system’s growing dominance in TFR. 

The significance of this lies in the current supply-side dynamic, which points towards a trajectory of virtual monopolization within the financial system. As a result, this trend also magnifies concentration risk. 

VI. How PSEi 30's Debt Dynamics Affect MSME Struggles

From the demand side, the 9-month debt of the non-financial components of the PSEi 30 reached Php 5.52 trillion, the second-highest level, trailing only the all-time high in 2022. However, its share of TFR and nominal GDP has declined from 17.7% and 30.8% in 2023 to 16.7% and 29.3% in 2024.

Figure 4

Over the past two years, the PSEi 30's share of debt relative to TFR and nominal GDP has steadily decreased. (Figure 4, upper chart) 

It is worth noting that the 9-month PSEi 30 revenues-to-nominal GDP ratio remained nearly unchanged from 2023 at 27.9%, representing the second-highest level since at least 2020. (Figure 4, lower image) 

Thus, the activities of PSEi 30 composite members alone account for a substantial share of economic and financial activity, a figure that would be further amplified by the broader universe of listed stocks on the PSE. 

Nevertheless, their declining share, alongside rising TFR, indicates an increase in credit absorption by ex-PSEi and unlisted firms. 

VII. The Impact of Bank Borrowings and Government Debt Financing on MSMEs’ Challenges

Figure 5

On the other hand, bank borrowings declined from a record high of Php 1.7 trillion (49.7% YoY) in September to Php 1.6 trillion (41.34% YoY) in October. Due to liquidity concerns, most of these borrowings have been concentrated in T-bills. (Figure 5, topmost visual) 

As it happens, Philippine lenders, as borrowers, also compete with their clients for the public’s savings. 

Meanwhile, the banking system’s net claims on the central government (NCoCG) expanded by 8.3% to Php 5.13 trillion as of October. 

The BSP defines Net Claims on Central Government as including "domestic securities issued by and loans and advances extended to the CG, net of liabilities to the CG such as deposits." 

In October, the banks' NCoCG accounted for approximately 23% of nominal GDP (NGDP), 18% of headline GDP, and 15.6% of the period’s TFR. 

Furthermore, bank consumer lending, including real estate loans, reached a record high of Php 2.92 trillion in Q3, supported by an unprecedented 22% share of the sector’s record loan portfolio, which totaled Php 13.24 trillion. (Figure 4, middle graph) 

Concomitantly, the banking system’s Held-to-Maturity (HTM) assets stood at nearly Php 3.99 trillion in October, just shy of the all-time high of Php 4.02 trillion recorded in December 2023. Notably, NCoCG accounted for 128.6% of HTM assets. HTM assets also represented 15.1% of the banking system’s total asset base of Php 26.41 trillion. (Figure 4, bottom chart) 

This means the bank’s portfolio has been brimming with loans to the government, which have been concealed through their HTM holdings.

Figure 6

Alongside non-performing loans (NPLs), these factors have contributed to the draining of the industry’s liquidity.  Despite the June 2023 RRR cuts and the 2024 easing cycle (interest rate cuts), the BSP's measures of liquidity—cash-to-deposits and liquid assets-to-deposits—remain on a downward trend. (Figure 6, upper window)

VIII. How Trickle-Down Economics and the Crowding Out Effect Stifle MSME Growth 

It is not just the banking system; the government has also been absorbing financial resources from non-banking institutions (Other Financial Corporations), which amounted to Php 2.34 trillion in Q2 (+11.1% YoY)—the second highest on record. (Figure 6, lower graph)

These figures reveal a fundamental political dimension behind the lagging bank lending performance to MSMEs: the "trickle-down" theory of economic development and the "crowding-out" syndrome affecting credit distribution. 

The banking industry not only lends heavily to the government—reducing credit availability for MSMEs—but also allocates massive amounts of financial resources to institutions closely tied to the government. 

This is evident by capital market borrowings by the banking system, as well as bank lending and capital market financing and bank borrowings by PSE firms. 

A clear example is San Miguel Corporation's staggering Q3 2024 debt of Php 1.477 trillion, where it is reasonable to assume that local banks hold a significant portion of the credit exposure. 

The repercussions, as noted, are significant: 

Its opportunity costs translate into either productive lending to the broader economy or financing competitiveness among SMEs (Prudent Investor, December 2024)

Finally, in addition to the above, MSMEs face further challenges from the "inflation tax," an increasing number of administrative regulations (such as minimum wage policies that disproportionately disadvantage MSMEs while favoring elites), and burdensome (direct) taxes.

IX. Conclusion: The Magna Carta for MSMEs Represents a "Symbolic Law," Possible Solutions to Promote Inclusive MSME Growth 

Ultimately, the ideology-driven "trickle-down" theory has underpinned the political-economic framework, where government spending, in tandem with elite interests, anchors economic development. 

Within this context, the Magna Carta for MSMEs stands as a "Symbolic Law" or "Unenforced Law"—where legislation "exists primarily for symbolic purposes, with little to no intention of actual enforcement." 

Politically, a likely short-term populist response would be to demand substantial increases in penalty rates for non-compliance (to punitive levels, perhaps tied to a fraction of total bank assets). However, this approach would likely trigger numerous unintended consequences, including heightened corruption, reduced transparency, higher lending rates, and more. 

Moreover, with the top hierarchy of the BSP populated by banking officials, this scenario is unlikely to materialize. There will be no demand for such measures because only a few are aware of the underlying issues. 

While the solution to this problem is undoubtedly complex, we suggest the following:

1 Reduce government spending: Roll back government expenditures to pre-pandemic levels and ensure minimal growth in spending.

2 Let markets set interest rates: Allow interest rates to reflect actual risks rather than artificially suppressing them.

3 Address the debt overhang through market mechanisms: Let markets resolve the current debt burden instead of propping it up with unsustainable liquidity injections and credit expansions by both the banking system and the BSP.

4 Liberalize the economy: Enable greater economic and market liberalization to reflect true economic conditions.

5 Adopt a combination of the above approaches.

The mainstream approach to resolving the current economic dilemma, however, remains rooted in a consequentialist political scheme—where "the end justifies the means."

This mindset often prioritizes benchmarks and virtue signaling in the supposed pursuit of MSME welfare. For example, the establishment of a credit risk database for MSMEs is presently touted as a solution.

While such measures may yield marginal gains, they are unlikely to address the root issues for the reasons outlined above.

_____

References 

Republic Act 5901: Guide to the Magna Carta for Micro, Small and Medium Enterprises (RA 6977, as amended by RA 8289, and further amended by RA 9501), p.17 SME Finance Forum 

Margarito Teves and Griselda Santos, MSME Financing in the Philippines: Status, Challenges and Opportunities, 2020 p.16 Nomura Foundation 

Prudent Investor, Is San Miguel’s Ever-Growing Debt the "Sword of Damocles" Hanging over the Philippine Economy and the PSE? December 02, 2024

 

 

As Housing Prices Crash at Record Speed, Chinese Government Bails Out Developer, Injects Liquidity

And the Chinese government declared that they would supposedly conduct reforms. But the reforms they have currently embarked on has been to save the status quo.

The Chinese government just rescued a major property developer.

From the New York Times:

Chinese banks have extended $16 billion in credit lines to shore up one of the country’s largest and most heavily indebted home builders, as pressure mounts on developers short of cash in a slumping property market.

The move by a group of mainly state-run banks to bolster the builder, Evergrande Real Estate Group, which is controlled by the billionaire Hui Ka Yan, is the latest sign of tumult in China’s sprawling housing sector.

Developers are rushing to secure financial support as sales volumes and housing prices plunge, weighed down by a growing overhang of unsold homes. The Kaisa Group, once a favorite of foreign investors, nearly defaulted on its offshore debt this year before being rescued by another developer.

Evergrande said on Tuesday that since February, it had secured new credit lines totaling 100 billion renminbi, or $16.2 billion. Those included a new 30 billion renminbi commitment on Monday from the Bank of China, which regards the developer as “its most important bankwide long-term partner,” Evergrande said in a news release.

The current measures has been meant as band-aid to a hemorrhage...

Analysts said the support from the banks — which also include the Agricultural Bank of China, Postal Savings Bank of China and the privately controlled China Minsheng Bank — would provide temporary relief but would fall short of addressing the company’s deeper problems.

Mounting debts and slumping sales “are fundamental challenges that can’t be resolved short term by government’s bailing them out on ‘too big to fail’ pretense,” said Junheng Li, the head of research at JL Warren Capital in New York.

“The company has been under financial distress for a long time,” she added.

Whether it is short term or not, resources redistributed to non-productive activities would worsen the current conditions going forward.

 

And this comes as the crash in Chinese home prices has even been intensifying.

From Investing.com (bold mine)

Property prices fell again in most major Chinese cities in February, amid continuing anxiety about the state of the country’s real estate sector. New house prices declined in 66 of 70 large- and medium-sized cities surveyed, according to China’s National Bureau of Statistics (NBS). Prices fell an average of 0.4 percent on the previous month, ending 5.7 percent lower than a year earlier, according to Reuters. It is the biggest year-on-year fall since the national survey began in 2011.

The only major cities that did not see a drop were the southern special economic zone of Shenzhen, where prices rose 0.2 percent, and the central industrial city of Wuhan, which saw no change. Prices for the secondary market also fell in 61 cities, though there were rises in five cities. The bureau blamed the sharp fall partly on February’s week-long Chinese New Year vacation, and predicted that prices would rebound this month. That did not stop the figures attracting widespread attention, however: one Chinese-language news website blared the headline: “Hangzhou house prices back to their level of five years ago?”

From CNBC (bold mine)

China new home prices registered their sixth straight month of annual decline in February, as tepid demand continued to weigh on sentiment despite the government's efforts to spur buying. 

New home prices fell 5.7 percent on year in February, according to Reuters calculations based on fresh data from the National Bureau of Statistics on Wednesday. The reading was worse than January's 5.1 percent decline and marks the largest drop since the current data series began in 2011.

Meanwhile, both Beijing and Shanghai clocked home price declines. In Beijing, prices fell 3.6 percent on year following a 3.2 percent drop in January, while prices in Shanghai fell 4.7 percent, following January's 4.2 percent drop.

So pressures from housing problems has filtered into the credit system, thereby manifesting strains in the repo markets.

The government’s response? Well, to inject money.

From Bloomberg: (bold mine)

China’s interest-rate swaps dropped the most in six weeks after the central bank took extra steps to boost liquidity to cushion an economy grappling with capital outflows and slowing growth.

The People’s Bank of China said it auctioned seven-day reverse-repurchase agreements at 3.65 percent, down from 3.75 percent last week. The central bank also rolled over 350 billion yuan ($73 billion) of loans it extended to banks via its medium-term lending facility in December, according to a person with knowledge of the matter, who asked not to be identified because the information hasn’t been made public. An unknown amount of lending was also added, the person said.

So reforms have actually been about the preserving the status quo.

The Chinese government reported that credit in February unexpectedly ballooned

From Bloomberg (bold mine)

Aggregate financing was 1.35 trillion yuan ($215.5 billion) in February, the People’s Bank of China said in Beijing Thursday, above economists’ median estimate of 1 trillion yuan. New yuan loans totaled 1.02 trillion yuan and M2 money supply rose 12.5 percent from a year earlier. 

With two interest-rate cuts and one reduction to the percentage of reserves banks have to set aside in the past four months, the central bank is seeking to cushion China’s slowdown. Industrial output, investment and retail sales growth missed analysts’ estimates in January and February, suggesting more stimulus is needed to boost the world’s second-largest economy.

“We see continued pretty solid core bank lending but a further slowdown in shadow banking,” said Louis Kuijs, Royal Bank of Scotland Group Plc’s chief Greater China economist in Hong Kong. “Authorities are trying to push liquidity into the system, but in terms of real economic entities, demand for credit is not very strong.”

But obviously the sponges for those credit expansion have likely been via State Owned Enterprises or politically controlled private institutions. 

As for the real economy, the disparity between credit expansion in the light of “demand for credit is not very strong”, crashing housing prices, and stagnating real economy implies that the Chinese economy has been plagued by substantial balance sheet impairments. You can lead the horse to the water but you cannot make him drink. 

However Chinese stocks continue to deviate from reality with its sustained upside move.

Of course it could most likely be that part of the credit expansion being foisted by the government to the system has been finding their way to chase yields via stocks.

So reforms has been about blowing one bubble after another. All temporary measures intended to kick the can down the road.

And naturally, because credit infused into the system will spillover to some areas of the real economy, there will be an outlet for this.  A clue to this has been that aside from retail punters, the shadow banking system have most likely been another major driver of the Chinese stock market mania.

From Reuters: (bold mine)

China's trust firms, with total assets of $2.2 trillion, are shifting more cash into frothy capital markets and over-the-counter (OTC) instruments instead of loans - blunting regulators' efforts to reduce shadow banking risk.

By redirecting money into capital markets and OTC products like asset-backed securities (ABS) and bankers' acceptances, trusts are acting less like lenders and more like hedge funds or lightly regulated mutual funds.

And the shift - a response to a clampdown last year on trust lending to risky real estate and industrial projects - means a significant chunk of shadow banking risk is migrating rather than shrinking…

Previously, people who bought into opaque wealth management products, many of which were peddled by banks but actually backed by trust assets, found themselves heavily exposed to real estate loans. Trust firms' changing asset mix means these investors may now instead find themselves exposed to high-yield corporate debt (junk bonds), volatile stock funds or risky short-term OTC debt instruments.

Oh, as for the pace at which housing prices have been crashing, they appear to be shortening the path to a Chinese recession/crisis. 

So there should be more defaults ahead.  Yet can the Chinese government fill in every defaulter's shoe? If not, market developments are likely to even deteriorate further.

As I previously noted:

Should the US housing bubble bust experience serve as a model, then a sustained housing deflation in China means that the latter's economy may fall into recession by mid 2016. 

But if the rate of the unwinding of the Chinese housing bubble accelerates, then this may shorten the time window. 

However, the Chinese government has been preemptively easing. The Chinese government has been joined by many other global central banks who appears to have also been frantically easing. 

Will such joint actions help extend or delay the process? Hmmmm.

It’s a complex world with manifold factors. But the writing is clearly on the wall.

Record stocks in the face of record imbalances at the precipice.

And once a recession/crisis has surfaced expect volatility in Chinese politics.

So what will the Chinese government do aside from reforms that has actually meant preserve the status quo?

Beat the drums of war to divert public attention from economic travails and to shore up domestic political capital, perhaps?

Will Shadow Banks Offset the Chinese Stock Market Margin Debt Crackdown?; China's GDP for 2014: 7.4%

During yesterday’s stock market meltdown, I pointed to the seeming clash of government policies between the central bank, the PBoC and the Regulatory Commission.

The Chinese central bank, the PBoC wants more credit into the system--yet  part of these funds finds its way to the stock markets--while the Regulatory Commission desires to curtail speculative credit flows into the stock markets.

So which agency will prevail, the PBoC or the Regulatory Commission?

Today’s Bloomberg report provides a clue to the possible resolution of this conundrum: Shadow banks will most likely step in or fill in the void from the formal banking. (bold mine)

China’s clampdown on margin lending by brokerages risks fueling an upswing in shadow banking as investors look for new ways to leverage their stock bets.

Wealth-management products, known as WMPs, have been used to channel 300 billion yuan ($48 billion) to 500 billion yuan into shares, Goldman Sachs Group Inc. estimated in a Jan. 19 note. Sinolink Securities Co. put the figure at 1.5 trillion yuan, up from 800 billion yuan at the end of June. Outstanding margin loans totaled a record 1.1 trillion yuan at the end of last week, China Securities Finance Corp. data show.

Chinese equities plunged the most in six years yesterday, derailing a world-beating rally, after three of the nation’s biggest brokerages were suspended from loaning money to new equity-trading clients. The amount invested in WMPs surged 24 percent in the first half of 2014 to 12.7 trillion yuan and Bank of Communications Co. said last week that the total may climb through 20 trillion yuan this year.

“The tightening of margin finance by brokerages will cause more funds to flow into stocks through banks’ WMPs,” Ma Kunpeng, a Shanghai-based analyst at Sinolink Securities, said yesterday by phone. “Money can always find its way into stocks one way or another.”

For as long as the PBoC promotes financial repression (zero bound) policies via expansionary credit into the system, yield chasing via asset speculation will be funded via different channels whether it is the formal or the informal system. There will always be novel ways to go around the curbs.

Yet here is another Bloomberg report validating my thesis that stocks and speculative assets are driven by credit and liquidity from which confidence functions as an offspring--applied to the Chinese financial markets. (bold mine)

For China’s central bank, the 36 percent stock market rally through Jan. 16 spurred in part by a surprise November interest-rate cut is the latest reminder that it’s easier to unleash money than to guide it to the right places.

Since Zhou Xiaochuan became People’s Bank of China governor in late 2002, the broad money supply base has expanded almost seven times to 122.8 trillion yuan ($20 trillion) while the economy has grown about five times. That translates to a M2/GDP ratio of about 200 percent versus about 70 percent in the U.S., according to data compiled by Bloomberg.

That liquidity springs up like a jack-in-the-box, driving property prices, then shifting to stocks, before moving on to whatever may be next. Such sprees help explain the PBOC’s reluctance to cut banks’ required reserve ratios even as the economy slows. Instead, it’s trying targeted tools to guide money to preferred areas such as farming and small business.

Nice line… “That liquidity springs up like a jack-in-the-box, driving property prices, then shifting to stocks, before moving on to whatever may be next.”

So the Chinese real economy has morphed into one gigantic speculative bubble whose economic activities have become too dependent on credit, liquidity and its offspring: confidence.

As of this writing, Chinese stocks have recovered about a quarter of yesterday’s losses.

The official figures of the Chinese economy had been released: in 2014 China’s statistical economy grew by 7.4%.

Yet here is a caustic take by the Wall Street Journal Real Times Economic Blog on the official figures: (bold mine)

Economists say it is daft to get hung up on changes of a few tenths of a percentage point in the official growth rate. The statistics bureau’s methodology is “not so scientific,” as Harry Wu, a skeptic at Hitotsubashi University in Japan, puts it. And even if statisticians at the central government level are immune to political pressure, few doubt that the local bureaus underneath them are capable of fudging the numbers to produce a more flattering picture.

Still, the general trend seems to be clear. If the government says the economy is slowing down, you can bet the slowdown is real.

Yeah, believe those government massaged statistics.

Global Shadow Banks Inflate to Over $75 Trillion in 2013 at pre-Crisis Levels!

As of 2012, I posted here  the global tally of Shadow Banks which have grown to 80% of GDP at $71 Trillion. 

At the end of 2013 global shadow banks has inflated to over $75 trillion or still about 80% of GDP to a pre-crisis high!

From the Bloomberg: (bold mine)

The shadow banking industry grew by $5 trillion to about $75 trillion worldwide last year, driven by lenders seeking to skirt regulations and investors searching for yield amid record low interest rates.

The size of the shadow banking system, which includes hedge funds, real estate investment trusts and off-balance sheet investment vehicles, is about 120 percent of global gross domestic product, or a quarter of total financial assets, according to a report published by the Financial Stability Board today.

Shadow banking “tends to take off when strict banking regulations are in place, when real interest rates and yield spreads are low and investors search for higher returns, and when there is a large institutional demand for assets,” according to the report. “The current environment in advanced economies seems conducive to further growth of shadow banking.”

Related to the the informal economy, shadow banks are essentially regulatory arbitrages where markets “skirt regulations” in order to conduct credit related activities. 

Record low interest rates only encourages the use of shadow banks when restrained in the formal banking system. As a reminder, because shadow banks are barely regulated, this implies statistical estimates may be prone to significant errors.

Here is a summary of findings from studies conducted by the  FSB’s Regional Consultative Groups (RCG), as per the Financial Stability Board (bold mine)

The main findings from the 2014 exercise are as follows:

-According to the MUNFI estimate, based on assets of Other Financial Intermediaries (OFIs), non-bank financial intermediation grew by $5 trillion in 2013 to reach $75 trillion.This provides a conservative proxy of the global shadow banking system, which can be further narrowed down.

- By absolute size, advanced economies remain the ones with the largest non-bank financial systems. Globally, MUNFI assets represent on average about 25% of total financial assets, roughly half of banking system assets, and 120% of GDP. These patterns have been relatively stable since 2008.

- Adjusted for exchange rate effects, MUNFI assets grew by +7% in 2013, driven in part by a general increase in valuation of global financial markets, while in contrast total bank assets were relatively stable. In the case of Investment Funds, adjusting for valuation effects reduced the 2013 FX-adjusted growth rate by about 10.3 percentage points (see Box 4-2). The global growth trend of MUNFI assets masks considerable differences across jurisdictions, with growth rates of OFIs ranging from -6% in Spain to +50% in Argentina.

- Emerging market jurisdictions showed the most rapid increases in OFIs. Nine emerging market jurisdictions had 2013 growth rates above 10%. However, this rapid growth is generally from a relatively small base. While the non-bank financial system may contribute to financial deepening in these jurisdictions, careful monitoring is still required to detect any increases in systemic risk factors (e.g. maturity and liquidity transformation, and leverage) that could arise from the rapid expansion of credit provided by the non-bank sector.

My comment ‘small base’ doesn’t mean less risk. Risks are not a one size fits all phenomenon. The scale of credit risk depends on the distinctive character of the political economy of every nation to intermediate credit

- Among the MUNFI sub-sectors that showed the most rapid growth in 2013 are Trust Companies and Other Investment Funds. Trust Companies experienced the fastest 2013 growth rate of 42%, which is in line with the sector’s average growth over 2007-2012. Other Investment Funds, the largest MUNFI sub-sector, recorded 18% annual growth in 2013, which represents a sharp acceleration from the average growth rate in the preceding years. It should be noted that the Hedge Funds sub-sector remains significantly underestimated in the FSB’s exercise due to the fact that offshore financial centres, where most Hedge Funds are domiciled, are currently not within the scope of the exercise. More frequent updates of the IOSCO Hedge Fund Survey and further refinement of the data presented in the survey, including the availability of time series, could provide important additions to the Global Shadow Banking Monitoring Report.

-Using more granular data reported by 23 jurisdictions, the broad MUNFI estimate of non-bank financial intermediation was narrowed down by some $27 trillion (see Section 5). The narrowing down items considered in this year’s report are comprised of assets related to self-securitisation, assets of OFIs prudentially consolidated into a banking group, and entities not directly involved in credit intermediation, including Equity Investment Funds, equity REITs, and OFIs which are part of a non-financial group and are created for the sole purpose of performing intra-group activities. This reduced total OFI assets for the 23 jurisdictions that reported granular data from $62  trillion to $35 trillion. Using the narrowed down estimate, the growth rate of shadow banking in 2013 was +2.4%, instead of +6.6% using the MUNFI. The FSB will  continue to refine the methodologies in narrowing down the estimate as well as  encourage its member jurisdictions to collect the relevant data.

-The measures of the level of interconnectedness between the banking and the non-bank financial system were improved in this year’s report by adjusting for bank’s assets and liabilities to OFIs that are prudentially consolidated into banking groups. Overall, the level of interconnectedness between the banking and the non-bank financial system declined in 2013. However, the relevance of the findings in this area is hampered by the absence of reporting of this data by a number of large jurisdictions.

As I said statistical numbers will be incomplete or inacurate, which implies these estimates may be underreporting of the real size of shadow banks.

Assets of Shadow banks are at pre-crisis high levels.

The National share of shadow banks

Sectoral composition of shadow banks

Annualized growth of shadow banks

The FSB elaborates on the potential transmission mechanism via the connection between the formal banking and shadow banks.

Systemic risks can spill over from shadow banking entities to the banking sector. This interconnectedness can take many forms, including direct and indirect linkages. For example, direct linkages are created when shadow banking entities form part of the bank credit intermediation chain, are directly owned by banks, or benefit directly from bank support, (either explicit or implicit). Funding interdependence is yet another form of direct linkage, as is the holding of each other’s assets such as debt securities. In addition, indirect linkages also exist through a market channel, as the two sectors may invest in similar assets, or be exposed to a number of common counterparties. These connections create a contagion channel through which stress in one sector can be transmitted to the other, and can be amplified back through feedback loops.

As one may realize zero bound regime has been inflating assets in both the formal and informal system. 

This implies of a great degree of fragility or a Black Swan risk.

Phisix: BSP Panics, Raises BOTH Official and SDA Rates!!!!

If you would be a real seeker after truth, it is necessary that at least once in your life you doubt, as far as possible, all things.—Rene Descartes (1596-1650) French philosopher

In this issue:

Phisix: BSP Panics, Raises BOTH Official and SDA Rates!!!!

-BSP Panics! Implements Sixth and Seventh Tightening Moves in Six Months!

-Understanding Markets via the Business Cycle

-Credit and Stock Market Cycles Converge

-The Obverse Side Of Every Mania Has Been A Crash

-Will The Firming US Dollar Index Usher In The Tetangco Moment?

-The Difference between Money Illusion and Statistical REAL GDP

-Petron Corp’s Money Illusion

Phisix: BSP Panics, Raises BOTH Official and SDA Rates!!!!

BSP Panics! Implements Sixth and Seventh Tightening Moves in Six Months!

Shocking! The BSP raised simultaneously official rates and the SDA rates last week by 25 bps apiece[1]. These marks the second rate increases for both. Incidentally, this represents the SIXTH and SEVENTH policy actions in just SIX months!!!

The BSP’s path to tightening commenced at the end of March with an increase in reserve requirements[2] as baptism. The second adjustment in reserve requirements was in May[3]. Then the BSP called for a banking stress test and upped the SDA rates in June[4]. Prior to this week’s activities, the initial official rate hike was announced at the end of July[5].

Ever wonder WHY these BSP’s drastic measures and the seeming acts of desperation??? Or why has the BSP been PANICKING???

So while domestic stock market has been in a panic buying spree[6], the BSP has been in a panic to tighten! Both of these forces are antipodal as seen from discounted cash flow analysis[7]. So who will eventually be right, the stock market bulls or the BSP?

Yet who among the mainstream domestic and international analysts covering the Philippines has seen this???

Prior to the first policy action (reserve requirement) last March, I transcribed my expectations on BSP’s possible moves[8] (bold original):

The BSP has been BOXED into a corner.

Option 1. If the BSP tightens then the whole phony credit fueled statistical economic boom collapses. So will be the destiny of free lunch for the Philippine government.

Option 2. If the BSP maintains current negative real rates or invisible subsidies via financial repression to the government through a banking financed boom, then stagflation will deepen and spur higher interest rates despite the BSP’s King Canute rhetoric.

So we are most likely to end up with Option 1 where economic reality via the markets will force the BSP to eventually tighten, or else God forbid, the Philippines suffer even a far worst fat tailed disaster: hyperinflation.

So as predicted, the BSP appears to have taken the route of Option 1, they have been “forced” to tighten—in a rather…distressed manner

And it does seem like BSP Governor Amando M Tetangco Jr. meant “real business” when he recently warned of “complacency” and on “chasing the market” as I previously noted[9] (bold original)

And if the Governor Tetangco truly means what he has warned about, or if he is true to his word, then the public should expect that this caveat will get to be transmitted into monetary policies via HIGHER policy rates. If not, then all these have merely been about political and moral posturing.

Either way, market risks have now gone mainstream!!!

So why should a supposedly “sound” boom be accompanied by symptoms of overvaluations and consumer price pressures? Why the need to tighten if the predicament has been one of supply side pressures where liberalization of imports would be the simple and commonsensical answer to address price pressures? What is the relationship of tightening (money) with supply side (real economy) constraints? What is the relationship of tightening (money) with massive asset overvaluations (financial assets)? 

Since the BSP’s message has become repeatedly been opaque, evasive, contradictory and non-transparent, I provide the answer: Credit. 

The outcome of monkeying around with interest rates has been to fuel a credit boom. Since current banking based credit expansion represents spending unbacked by savings, the deluge of new money which has entered the economic stream, as evidenced by 9 consecutive months of 30%++ money supply growth rate, has prompted for systematic price distortions that has resulted to imbalances in both the real economy and in financial assets. So we see the symptoms of excessive mispricings or financial asset overvaluations compounded by consumer price pressures.

The BSP’s panic has basically accounted for as attempts to curb and to control the unintended vices (credit based speculative orgies or the inflation Godzilla) that has been spawned and unleashed from the previous thrust to boost ‘aggregate demand’ to spike the statistical economy via the manipulation of interest rates. 

The so-called transformational boom has signified as the sweet spot from such policies. Since every policy carries with it a political dimension, the credit boom implicitly has been intended to support ambitious government spending programs as well as to generate popular approval for the populist incumbent administration.

Now that the economic backlash from unsustainable policies has surfaced, the BSP has been ‘forced’ to impose a partial reversal of such policies. Interestingly, some in the media portrays BSP’s actions as the ‘most aggressive’. They never ask, if everything has been hunky dory, then why the need for “aggressiveness”? So it’s more about desperation from a topsy-turvy condition.

Yet again since the current economic growth model has mutated to a “debt drives growth”, then what happens to G-R-O-W-T-H when the BSP succeeds at easing on credit expansion?

And since the current credit boom translates to intensive leveraging of the balance sheets of entities with access to the formal banking system and to the capital markets, the current BSP actions eventually shifts the risk equation from inflation to levered balance sheets.

Remember, only 20+ out of 100 households have bank access[10], whereas the cargo of debt have mostly been in the balance sheets of the companies owned by plutocrats or the politically connected economic elites who not only controls over 80+% of the stock market capitalization, has almost exclusive access to the bond markets—as of 1Q 2014 only 4 of the 30 largest local currency bonds[11] are from unlisted entities. Yet some of these has connections with listed firms—and most importantly whose firms constitutes about three fourths of the economy’s output[12]. In short, there is concentration of credit risk from mostly heavily levered firms.

These dynamics are ingredients to a crisis.

With their current actions, the BSP now wishes that the domestic economic and financial entities will be sturdy enough to such absorb rate increases. Yet the BSP fails to understand that her previous policies have been pivotal to the structural deformation of the nation’s economic model. Profits, earnings, income and demand have mostly become dependent on the supply side growth financed by debt. Thus, the archetype of “debt drives growth”, borrowed from policies of the US Federal Reserve, has been heavily dependent on zero bound rates. Take these foundations away will only lead to disorderly adjustments given the legacies of debt.

So hope now has become a part of BSP’s policies.

Yet even from the perspective of BSP actions alone, the chicken has come home to roost.

As one would note, things don’t just “occur” as most people think it is. Actions have consequences. Today’s events and the BSP responses have been due to previous actions.

Today’s BSP’s seemingly desperate recourse to tighten has been a scenario that I have warned about in November 2012[13]

Next year when price inflation (stagflation) becomes a real economic and market risks, will the Philippine government own up to their mess or will they simply pass the blame on the markets for these?

Oh, by the way, who in the mainstream has seen the current problems being addressed by the BSP coming?

Of course the BSP actions come way too late as the mania has taken off. Current rate increases are still benign as they remain in a negative real rate environment—consumer price inflation remains higher than the nominal official interest rates.

In Indonesia, the five rate increases totaling 175 bps in 2013 has only spurred an astonishing speculative ramp (both in stocks and in properties) financed by even more credit binge. The JKSE popped over the May 2013 highs but has fallen back. 

I expect the same reaction here.

Understanding Markets via the Business Cycle

As a money manager, it is important for me to know of the risk environment. Knowledge of the risk environment enables one to assess the risk-reward tradeoff and the probability payoff from one’s portfolio allocation.

And in the understanding that people’s actions are purposeful, where actions have been responses to incentives, the same actions underpin voluntary exchanges or the markets. Markets thus are a process of human interaction of voluntary exchanges guided by incentives.

As the great Austrian economist Ludwig von Mises once wrote[14], The market process is a daily repeated voting in which every penny gives a right to vote.

Financial markets are no different. And cycles are prominent features in the financial markets. Cycles essentially represent patterns of reactions by people to certain similar conditions.

For instance, government tampering with interest rates leads to boom bust cycles according to the Austrian Business Cycle Theory (ABCT). So if we follow the ABCT, all one needs to know is the whereabouts of the bubble cycle.

For instance in September 2010 I enumerated on why and how Philippine property markets will reach a euphoric stage[15]: (bold added)

The current “boom” phase will not be limited to the stock market but will likely spread across domestic assets.

This means that over the coming years, the domestic property sector will likewise experience euphoria.

For all of the reasons mentioned above, external and internal liquidity, policy divergences between domestic and global economies, policy traction amplified by savings, suppressed real interest rate, the dearth of systemic leverage, the unimpaired banking system and underdeveloped markets—could underpin such dynamics.

Thus the environment of low leverage and prolonged stagnation in property values is likely to get a structural facelift from policy inducements, such as suppressed interest rates which are likely to trigger an inflation fuelled boom by generating massive misdirection of resources-or malinvestments.

Of course many would argue on a myriad of tangential or superficial reasons: economic growth, rising middle class, urbanization and etc... But these would mainly signify as mainstream drivels, as media and the experts will seek to rationalize market action on anything that would seem fashionable.

Using the end of September 2010 as basis, as of Friday’s close the Phisix returned +75.65%. This has been led by holdings sector +103.17%, banking and financials +80.95% the property sector +74.33%, industrials +72.08%, mining 45.18% and services 37.03%. 

In the real sector, property euphoria has already been reached with the Philippines topping the global list of housing price gains in Q4 2013 based on IMF-Global Property Guide-OECD-Haver benchmark. The world’s hottest housing market! How can these not be euphoria??

These price gains have indeed been pillared by “a structural facelift from policy inducements” as bank credit to the property sector ballooned from 2007-2013 and outpaced other sectors. Other bubble industries such as trade, financial intermediation and construction likewise posted hefty growth in bank credit over the same period.

And indeed a “myriad of tangential or superficial reasons” have been used to justify current conditions: economic transformation, strong external position (forex reserves! forex reserves! forex reserves!), low public debt, good governance and etc…

Practically all that I have enunciated here—from market response to credit growth to media rationalization—has occurred exactly as defined.

The boom bust cycle can be analogized as the following:

Person X earns 100,000 currency units (CU) a year. Let us say Person X borrows 900,000 (CU) at zero interest rates amortized 10 years. Let us further assume that Person X will spend all the amount on consumption and leisure. At Year ZERO, Person X obtains fresh spending power from newly issued credit by a bank. Over the same period, in spending all the new money Person X will experience a consumption spending boom. As legendary investor Jim Rogers in an interview last year said, Give Me A Trillion Dollars And I'll Show You A Really Good Time!

Unfortunately after the spending boom, debt needs to be repaid. So unless Person X’s income grows, only 10,000 of annual income will be left for Person X’s personal sustenance. Thus the frontloading of debt based spending creates a temporary boom which eventually morphs into a depression.

The reason I use general currency unit is to emphasize that the law of economics are universally applicable, which means they applicable everywhere.

So even at zero bound there are limits to debt acquisition.

What if banks/ developer via in house financing offer another 100,000 currency unit loan for Person X to acquire a property at zero rates with 10 year amortization? Will Person X take it? The answer is a likely no because Person X will be left with no sustenance for survival.

In the US according to a study by the New York Federal Reserve, renters haven’t been buying homes because of too much debt, low savings/income and or deficient credit rating[16]. Has the problem been about a lack of liquidity? The answer is no, the problem has been about the renter’s balance sheet constrains.

So Person X will not have the capacity to borrow because he/she has been overleveraged.

Several lessons from here:

Today’s (short term) gains from consumption financed by debt can be tomorrow’s (long term) depression.

Having too much unproductive debt leads to LOWER growth. The Philippine economy has been heavily gorging on debt since 2009 on mostly speculative activities. This will eventually weigh on, if not collapse, real and even statistical growth.

Having high levels of unproductive debt INCREASES credit risks. The BSP’s raising of interest rates will eventually expose or bring into the spotlight unfeasible speculative or capital consuming projects made viable only BECAUSE of zero bound rates. Non Performing Loans (NPLs) which are coincident if not lagging indicators will eventually reflect on this. Philippine consumer loans on real estate and auto loans have already revealed emergent signs of rising NPLs in 1Q 2014[17].

You can lead a horse to a water fountain but you CANNOT make him drink. Once balance sheet problems have been exposed, no amount of stimulus would make balance sheet impaired entities take on credit until their respective balance sheets have been repaired.

Once credit problems surfaces in the Philippine setting, those expecting a revival from bailouts will be disappointed. The Philippines is quite sensitive to inflation pressures given that food has a significant weighting on the household budget. So government stimulus would only raise inflation risks that could lead to social instability.

Lastly, contra mainstream, things don’t happen “just because”. Rather things happen out of human responses to incentives. Former relatively clean balance sheets or as I said in 2010 “an environment of low leverage” enabled Philippines firms to wolf down on debt from zero bound rates, thus having to amplify the so-called transformational boom.

This means that the BSP’s present dramatic response may not only imply the addressing of the risks from price inflation or from asset overvaluation but from risks that system-wide private sector debt may have reached PRECARIOUS levels!

Credit and Stock Market Cycles Converge

What cyclical stage are we at from the other perspective?

First the credit cycle. The credit cycle, according to Investopedia.com, involves access to credit by borrowers. Credit cycles first go through periods in which funds are easy to borrow; these periods are characterized by lower interest rates, lowered lending requirements and an increase in the amount of available credit. These periods are followed by a contraction in the availability of funds. During the contraction period, interest rates climb and lending rules become more strict, meaning that less people can borrow. The contraction period continues until risks are reduced for the lending institutions, at which point the cycle starts again[18].

The credit boom has been accompanied by the patent lowering of lending standards. There have already been signs of financial institutions offering “no money down loans”[19]. This means the race to issue loans comes with deteriorating quality therefore increasing credit risks.

As noted last week, the domestic shadow banking industry has been bulging along with the formal banking credit growth. The shadow banking sector’s growth has mostly been through in-house financing from the property sector and also from intra-corporate loans. Part of the shadow banking activities has been in response to government regulations where shadow banks circumvent or go around them. If the formal banking system has been emitting indications of tolerating greater credit risks in order to scrimp for yields, how much more for the in-house financing of property developers in order to artificially goose up sales? So shadow banks pose as another source of loose lending practice risk.

Even the formal banking sector appears to be dabbling with financial engineering via securitization. This means domestic financial institutions may be experimenting to package into investment instruments, pools of mortgages with various risk quality aimed at the transfer of credit risk to yield starved investors. The transfer of credit risk will likely induce more hazardous risk taking by financial institutions.

Companies like SMC practice what looks like a Hyman Minsky’s Ponzi financing scheme[20] which the banking system continues to facilitate. SMC’s rolling debt in and debt out of mostly short term debt in 2013 has reached nearly 10% of the Philippine banking system’s total resources. Rising rates will magnify SMC’s debt burden and raise SMC’s portfolio’s risk with banks.

Also based on my estimates of credit to GDP from banking sector loans alone, given the accelerating rate of bank credit growth for 2014, the ratio must have surpassed by a wide margin the pre-Asian crisis levels.

The stock market valuations perspective.

As noted last week, based on Warren Buffett’s favorite metric the market cap to gdp, the ratio has already eclipsed the pre-Asian crisis levels signaling massive overvaluation. This is unsustainable for the simple reason that markets cannot continually outgrow the economy.

It’s not only market cap, price earnings and book values have already exceeded the pre-Asian crisis highs! Even the BSP’s tracking of the PSE’s PE ratio at 21.44 for July has been vastly higher than the 19 and 20 PER during 1995 and 1996

When the legendary investor the late Sir John Templeton, noted of the market cycle as “Bull-markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria”, he was referring to the dominant sentiment of the marketplace in each phase of the cycle.

For the current landscape, it has been obvious that the maturity phase of optimism has passed. The wild and frenetic churning of domestic stocks by domestic retail investors underscores euphoria, even if peso volume has been lower than that of during the 7,400 highs of May 2013.

The fear of being left out appears to govern the mindset of the current set of players whom have been incited to bouts of panic buying episodes regardless of valuations or risks. Again media’s shouting of g-r-o-w-t-h has been the conditioning signal trigger to such actions.

The “everybody is a genius” dynamic has undergirded the ONE way trade mentality. And any opposition to “stocks and economy has nowhere to go but up” religion has been treated with contempt if not with irreverence.

From the character of the dominant players, smart money dominates every stealth phase of a bubble. The entry of institutional investors reinforces the upside trend of a bubble. The next phase is the bandwagon effect from the public which turns stocks into a casino that culminates with a blow off phase. 

Yet each time the bulls are hurt by the appearance of the bears, the former fights back with ferocity as we are seeing today. 

You can see the charts of the market cycles based on sentiment and stages of the bubble here.

The Obverse Side Of Every Mania Has Been A Crash

History gives us valuable clues, especially of our mistakes or even the flaws of our ancestors.

I am not a fan of patterns, although patterns exist. To anticipate a prospective repetition of a pattern, this requires important parallels in the fundamental sphere.

At 11 years old, the current bullmarket phase in the Philippine stock exchange (2003-2014; right) is as old as its predecessor (1986-1997; left). This implies that the current bullmarket may most likely be aging.

Interestingly, today’s underlying conditions (debt, valuations) appear to be even worse than that of the pre-Asian Crisis forebears. I don’t have data to compare with in the context of sentiment.

Over the past 28 years every single chapter of manias, expressed by parabolic price movements, has been followed by crashes.

In other words, the obverse side of every mania has been a crash

The two cyclical bear markets amidst the 1986-1997 bullmarkets exhibit the phenomenon: what goes up fast, goes down fast.

The 1994 top transitioned into an incredible saga of stock market volatility which had been characterized by 3 bear market strikes until the end of 1995. The Phisix lost 33% from top to the trough of 1995 where the bulls got second wind.

The final 1996-97 manic run ended the animated bull-bear battle since 1993 with a crash. The crash preceded the Asian Crisis by about 5 months.

The 2007 top played out a little bit different.

The September-October rebound from the bear market strike of July-August, was resolved by a drip, drip, drip then a flood or a slomo downhill before a collapse.

Remember, the Philippines hardly had economic fundamental weakness except through the contagion (which was vented on asset markets and on exports). 

Yet record (forex reserves!, forex reserves!, forex reserves!) didn’t stop the stock market or the peso from cratering. 

This brings us to the 2013 mania, which if everyone recalls also suffered from a bear market strike. 

Yet the 2014 manic drama remains unresolved.

So if price patterns, fundamentals and sentiment (now even policy actions) have been converging, and if the obverse side of every mania has been a crash, then a crash cannot be discounted to happen anytime.

Because I am neither a seer nor a tarot card reader, I don’t know what will be the trigger (external or internal). I don’t know when it may happen. What I know is that history’s insights plus current events reveal that this has been the destiny, regardless of popular sentiment.

Remember confidence is fickle and can change in an instant.

Will The Firming US Dollar Index Usher In The Tetangco Moment?

As a final note on markets, the US dollar index has been firming of late. Since July 1, the US dollar index has been up by 5%!

The basket of the US dollar index consist of the euro (57.6%), the Japanese yen (13.6%), British pound (11.9%), the Canadian loonie (9.1%), the Swedish Krona (4.2%) and the Swiss franc (3.6%). 

Their individual charts reveal that the US dollar has been rising broadly and sharply against every single currency in the basket during the past 3 months.

This may have been due to a combination of myriad complex factors: ECB’s QE, expectations for the Bank of Japan to further ease, Scotland’s coming independence referendum, or expectations for the US Federal Reserve to raise rates in 1H 2015 (this has led to a sudden surge in yields of US treasuries last week), escalating Russian-US proxy war in Ukraine and now in Syria (as US Obama has authorized airstrikes against anti-Assad rebels associated with ISIS, but who knows if US will bomb both the Syrian government and the rebels?) more signs of a China slowdown and more.

Yet a rising US dollar has usually been associated with de-risking or a risk OFF environment. Last June 2013’s taper tantrum incident should serve an example.

There have been cracks in the EM space. Commodities have been guttered this week. Equities and currencies of Brazil and Turkey got slammed.

So far, the adverse impact from the rising US Dollar index on Asian-ASEAN markets has been marginal. But I wouldn’t rule out a spreading of a risk OFF environment, if the US dollar index continues to soar.

And as I have been saying here, the BSP chief has consistently been warning about the risks of market volatility from capital flight as consequence of exogenous events. Yet I have countered that foreigners are being conditioned publicly as scapegoats to what truly has been an internal imbalance problem only camouflaged by inflated statistics.

Nonetheless, will the firming US dollar index usher in the Tetangco Moment???

The Difference between Money Illusion and Statistical REAL GDP

I have been excoriated for supposedly not using “real” GDP during my discourse last week on the “money illusion”. That’s because “real” GDP, it has been held, represents the more accurate indicator of ‘g-r-o-w-t-h’.

I guess my message didn’t sink in, so let me clarify.

The intent of the money illusion treatise has been mainly to illustrate on the distortive effects of inflationism on prices and output and therefore the economy. This specifically can be seen from this excerpt (bold original) “And even if output declines, for as long as the decline will not be equal or be more than the inflation rates, the numbers will reveal “growth”. You can apply this to a firm, an industry, or a nation”. 

The mention of “a firm, an industry, or a nation” signifies of the general effects from the money illusion principle.

I applied the money illusion principle exercise to my analysis of the 2Q GDP (bold original): “All told, outside manufacturing, there has been little support to the 2Q statistical economy except through the bubble sectors, particularly trade and real estate. Thus the kernel of 2Q 2014 6.4% growth must have been through the money illusion.”[21]

Perhaps the failure to connect the dots between the money illusion and the statistical GDP has incited the reaction to readily dismiss the relationship and instead offer “real” GDP as supposedly a superior metric for economic analysis.

This represents a typical reaction from bubble worshippers where the mechanical impulse has been to resort to the citation of statistics in defense against information opposed to their beliefs.

But for me, such intuitive response represent what I call the “Talisman effect” of screaming incantations (applied here—statistics) in order to do away “evil spirits” (applied here—any contradictory information against popularly held beliefs).

Also such objection can be deemed as the attribution substitute heuristic—where such mental abbreviations represent the sidestepping of complex issues by shifting to what is seen as ‘easily calculable’, or in this case the short cut is to ‘shout’: real GDP!

But sole dependence on official statistics (whether Philippines or from multilateral institutions) extrapolates to its incontrovertibility. In other words, such assumptions are predicated on “faith” on the data provider.

But that’s where I differ. I do NOT trust or have faith on these figures!

Because of blind faith, the consensus hardly raises any questions on the methodology or the accuracy of the numbers behind official statistics or even its implications. They swallow hook line and sinker the numbers as “facts”

Let us use BSP’s current actions as example. As a matter of proportionality, official inflation figures are not only below economic growth figures but have allegedly been within the target range although at the upper limits. So logic leads us to question why should 4.9% statistical inflation rate metastasize into a nationwide based political issue? Why has CPI of 4.9% compelled the BSP to panic with 6+1 policy actions in 6 months??? Why have the BSP chief warned on “chasing the markets”??? All these seemingly desperate moves because official numbers reflects on real social conditions????

Yet the official figures are merely estimates mostly from surveys constructed by political agencies. Since people act in accordance to the individual’s underlying incentives, which applies to political agents as well, what has largely been underappreciated or has been unseen by the public is that of the incentives guiding the political institution’s calculation as previously explained at length.

As in the case of Soviet Union, present day Argentina and Venezuela, such ‘growth’ numbers neither represents reality nor substitutes for truth. In the case of USSR, even the late celebrity economist Paul Samuelson had been fooled by growth statistics as to endorse the Soviet political economic framework only to see the communist nation state disbanded 3 years after!!! What happened to ‘g-r-o-w-t-h’? Recently, due to accounting magic, Nigeria’s statistical growth DOUBLED overnight[22]! So one can have statistical ‘growth’, even while many people have been starving!

Yet more signs of massaging of statistical g-r-o-w-t-h data. In July 2013, the Chinese government admitted to selective statistical reporting or hiding of data sets at the industry level[23]. In October of the same year, since the padding of growth data has mostly been at the local level, the national government of China vowed a crackdown on ‘falsified data’[24]. In Italy, sagging economic growth has impelled the government to include the illegal drug sales, smuggling and prostitution in the gross domestic product calculation in order to buoy the statistical economy[25] in May 2014. How does one get to compute “illegal” into GDP? Beats me. The United Kingdom also followed to include the sex and drug industry[26] also in their GDP late May 2014.

As the late British economist Ronald Coase once wrote[27], “If you torture the data enough, nature will always confess”.

So to correlate “money illusion” with real GDP is either to blur/confuse or to severely miscomprehend on the issue.

Applied to the Philippines, as I recently posited, “the possible understatement of the deflator, the PCE (denominator), may have boosted “growth” story”[28]. The point is, one can easily boost GDP figures by simply underreporting estimated inflation figures or by tweaking numbers that have been based mostly on surveys.

I also previously pointed out[29] that even BSP Deputy Governor Diwa C Guinigundo in a paper to the Bank of International Settlements admitted to the limitations of domestic official statistical ‘inflation’ data (bold mine): “Excluding asset price components from headline inflation also has little effect. Currently, the CPI includes only rent and minor repairs. The rent component of the CPI is, however, not reflective of the market price because of rent control legislation. The absence of a real estate price index (REPI) reflects valuation problems, owing largely to the institutional gaps in property valuation and taxation. While the price deflator derived from the gross value added from ownership of dwellings and real estate could represent real property price, it is also subject to frequent revisions, making it difficult to forecast inflation.”

Even from the government’s lens, their own actions have functioned as an impediment to the ‘accurate’ representation of (market priced based) statistical data.

So why should I trust the government’s data when the government themselves even concede of its structural deficiencies? So why should I rely on ‘real’ GDP when inherent problems in the official ‘inflation’ data makes the price deflator ‘difficult to forecast inflation’?

Can bubble worshippers do a better job than the good BSP Deputy Governor and his team of econometricians to prove on the objective accuracy of these estimated numbers established by the government (say the PCE deflator)?

Yet my view is different from the establishment. Since there is no constancy in human action (or where the only constant is change) and where human action is subjective, accuracy of statistical economic data represents no more than a statist’s fantasy.

As the great dean of the Austrian school of economics, Murray N Rothbard wrote (bold mine)[30],

Econometrics not only attempts to ape the natural sciences by using complex heterogeneous historical facts as if they were repeatable homogeneous laboratory facts; it also squeezes the qualitative complexity of each event into a quantitative number and then compounds the fallacy by acting as if these quantitative relations remain constant in human history. In striking contrast to the physical sciences, which rest on the empirical discovery of quantitative constants, econometrics, as Mises repeatedly emphasized, has failed to discover a single constant in human history. And given the ever-changing conditions of human will, knowledge, and values and the differences among men, it is inconceivable that econometrics can ever do so.

And from this, I am on the side of the engineer of Hong Kong’s economic boom via economic freedom, the late British Finance Minister of Hong Kong, Sir John Cowperthwaite, who reportedly was averse to statistics because for him these represent tools for political interventions. 

As per the Le Quebecois Libre[31] (bold mine): Asked what is the key thing poor countries should do, Cowperthwaite once remarked: "They should abolish the Office of National Statistics." In Hong Kong, he refused to collect all but the most superficial statistics, believing that statistics were dangerous: they would led the state to to fiddle about remedying perceived ills, simultaneously hindering the ability of the market economy to work”

It’s not just statistical massaging but likewise public indoctrination of inflated statistics.

Yet here is an example of how media warps a statistical economic g-r-o-w-t-h story.

It has been reported that exports grew by 12.4% year on year in July. The time reference point of the framing matters. Month on month export growth SLOWED from June’s 21.3%. In nominal terms, Philippine exports have steadied or plateaued over the past three months from May to July 2014. The noted article has been silent on the latter two.

In short, the same number can provide different stories as seen from different angles, yet media’s presentation has been to slant information towards the popular appeal while at the same time ignoring all other dimensions. So every positive media slant from statistically inflated numbers reinforces the bias of every uncritical bubble lemming. Media says follow my lips and say G-R-O-W-T-H! Audience in a Zombie/robot like manner respond: G-R-O-W-T-H! Nice.

And this is the kind of “Talisman effect” which the consensus employs when dealing with knowledge opposite to their entrenched one way trade beliefs—they quibble from the basis of numbers that favors them (selective perception). It’s like arguing over head or tails but essentially such disagreement stems from looking at the same coin, without asking whether the coin is a counterfeit or not! Or simply said, the consensus tactic has been to debate the numbers (superficiality) rather than scrutinize over reasoning or logic behind those numbers and or the theories that has backed the origins of the statistical methodologies.

Does slavish devotion to numbers or faith based dependence on official statistics manifest an exercise of prudence or of sloppy analysis?

Petron Corp’s Money Illusion

Meanwhile, here is a real time application of the money illusion principle at the company level. Let me cite Petron Corp’s [PSE: PCOR] 1H 2014 financial standings as an example.

In a presentation from parent San Miguel to investors[32], PCOR’s net sales (total revenue less cost of sales, returns, allowances, and discounts) jumped by 18% even as volume underpinning the sales grew by only 8%. This represents a whopping 10% disparity! [To be clear, companies use current prices to calculate for financial statements hence no deflators involved] This implies that most of PCOR’s top line gains (55%) have likely been from price differentials easily attributable to the money pumped into the system from the banking system via the successive 9 months of 30% money supply growth.

Given that the bulk of Petron’s revenues come from crude, fuel and lubricants sold to distributors or resellers, the BSP’s wholesale price index over the same period appears to reflect on these dynamics. And much of those top line gains from price differentials dynamics have apparently spilled over to become ‘profits’.

In short, PCOR’s 1H 2014 financial standings exhibit how inflationism artificially boosts revenues, earnings and profits. That’s aside from the subsidies provided by zero bound interest rates that has depressed the cost of servicing existing liabilities (PCOR, like the parent, has a heavily leveraged balance sheet with 6.41 debt/Ebitda in 2014 based on 4-traders.com estimates), and from the continuing use of credit to finance operation and expansion.

Yet in order for PCOR’s financials to continue to expand at this rate, the oil firm would need the BSP to sustain her accommodative policies. But again inflationism is no free lunch, since there are wide ranging natural—social, economic and political—costs on these.

And don’t forget the BSP has launched its second official rates increase PLUS second SDA rate increase, thereby partially withdrawing subsidies to these subsidy dependent firms

Regardless of the merits of historical official data, here is the more important question: What happens, or what will statistics or financial data eventually reveal, once the effects of money illusion fade away? This applies to official statistics both nominal and real GDP, as well as to profits earned by Petron and by other levered firms and most especially the government whom has been the primary beneficiary of financial repression policies, as seen through relatively ‘low’ debt levels and from inflated taxes brought about by the subsidies from the same zero bound policies.

Does the consensus know??? To give a hint: Since inflationism has not been on their radar screens, once a reversal of this phenomenon emerges, not only will they be jolted, but they may likely experience financial angst. In short, the consensus won’t like it.

I’ll end this note with a germane quote from Samuel Langhorne Clemens popularly known by his pen name Mark Twain

It is easier to fool people than to convince them that they have been fooled.

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[1] Bangko Sentral ng Pilipinas Monetary Board Hikes Policy Rates Anew by 25 Basis Points September 11, 2014

[2] See Phisix: BSP’s Response to Peso Meltdown: Raise Banking Reserve Requirements March 31, 2014

[3] See Showbiz S&P Upgrade & BSP Actions Sends Phisix and the Peso into a Frenzied Blow off Top May 12, 2014

[4] See Phisix: BSP Under Pressure: Raises SDA Rates and Invokes Banking Stress Test June 23, 2014

[5] See Hot: BSP Raises Interest Rates! July 31, 2014

[6] See Phisix: As Risks Mounts, PANIC BUYING Grips the PSE! September 8, 2014

[7] See Phisix: 7,000 Breaks on Regional Melt-UP; The Natural Limits of Inflationism August 18, 2014

[8] See Phisix: Have You Been Aware of This Week’s Peso Meltdown? March 24, 2014

[9] See Phisix: As Mania Rages, BSP Chief Warns on “Complacency” and “Chasing the Market”!! August 24, 2014

[10] See The Flaws of BSP’s Real Estate Monitoring and Banking Stress Tests May 20 2013

[11] Asian Bonds Online ASIA BOND MONITOR June 2014

[12] See Quote of the Day: Asian Elites August 27, 2014

[13] See Philippine Economy: Lower Inflation Rates from Good Governance? November 7, 2012

[14] Ludwig von Mises IX Are the Cooperatives Democratic? 18. Observations on the Cooperative Movement Money, Method, and the Market Process Mises.org

[15] see The Upcoming Boom In The Philippine Property Sector September 10, 2010

[16] Wall Street Journal Real Times Economics Blog Why More Renters Aren’t Buying (Hint: Weak Incomes, Savings) September 8, 2014

[17] See Phisix: Stagflation Upends Boom Time Politics as BSP’s 1Q Property NPLs Surge! July 28, 2014

[18] Investopedia.com Credit Cycle

[19] See Simon Black: No Money Loans Down are signs of Philippine Bubbles May 9, 2014

[20] See Why San Miguel Corporation Looks Vulnerable September 23, 2013

[21] See Phisix: As Risks Mounts, PANIC BUYING Grips the PSE! September 6, 2014

[22] See Accounting Magic: Double Economic Growth Overnight, Nigeria Edition April 8, 2014

[23] See China’s Government Hides, Deletes and Censors Economic Data July 5, 2013

[24] See Chinese Government to Crack Down on Fake Statistical Data? October 11, 2013

[25] Bloomberg.com Cocaine Sales to Boost Italian GDP in Boon for Budget May 22, 2014

[26] Guardian.uk Drugs and prostitution to be included in UK national accounts May 29, 2014

[27] Ronald Coase "How should economists choose?" (1981) p.27 Wikiquote

[28] See Phisix: 2Q GDP Outperforms at 6.4% as Investments Plummets! September 1, 2014

[29] See Cracks in the Philippine Property Bubble? October 7, 2013

[30] Murray N Rothbard Section One Method Economic Controversies p.74-75 Mises.org

[31] Alex Singleton SIR JOHN COWPERTHWAITE, THE MAN WHO BROUGHT FREEDOM TO HONG KONG Le Quebecois Libre February 8, 2006

[32] See The Money Illusion: Petron Corp Edition September 9, 2014