Emerging Market $2 trillion Carry Trade: The Pig in the Python

Last week, I reasoned that changes in US monetary policies and changes in the interest rate signals in the US will naturally force adjustments based on “yield spreads” which eventually will be transmitted (whether you like it or not) as emerging market monetary policies. I stated that such alterations will expose (bold original) “on the distinct vulnerabilities of these economies thereby leading to massive outflows.”[1]

I did not go further. However, one mainstream report seems to have picked up where I left off. And they came with a gala performance

As a side note, signs are that the mainstream has increasingly been recognizing that the problem of emerging markets has not been due to demons or bogeymen of current accounts, exchange rate mechanism or Non Performing loans but rather on debt, debt and debt.

The following quote is from Kermal Dervis former Minister of Economic Affairs of Turkey and Vice President of the Brookings Institution[2] (bold mine)

Unfortunately, the real vulnerability of some countries is rooted in private-sector balance sheets, with high leverage accumulating in both the household sector and among non-financial firms. Moreover, in many cases, the corporate sector, having grown accustomed to taking advantage of cheap funds from abroad to finance domestic activities, has significant foreign-currency exposure.

Where that is the case, steep currency depreciation would bring with it serious balance-sheet problems, which, if large enough, would undermine the banking sector, despite strong capital cushions. Banking-sector problems would, in turn, require state intervention, causing the public-debt burden to rise.

Mr. Dervis’ observation “taking advantage of cheap funds” and my theory “ expose on the distinct vulnerabilities that leads to massive outflows” brings into light the missing factor: the US$ 2 trillion EMERGING MARKET CARRY TRADE

In a report by Bank of America Merrill Lynch (BofAML), the troika of authors Ajay Singh Kapur, Ritesh Samadhiya,and Umesha de Silva wrote that the Fed motivated an Emerging market credit bubble and called this “the Pig in the Python”[3]. 

The QE channel worked through Emerging Markets too. By lowering the US government bond yields to a bare minimum, and zero—ish at the short end, a search for yield ensued globally. Emerging market banks and corporates have gone on an international leverage binge, yet another carry trade, the third in 20 years. The first one was driven by European banks, financing East Asian capex –that ended in 1997. The second one was global banks and equity-FDI supporting mainly capex in the BRICs. That ended in 2008. This time, it is increasingly non-equity flows: commercial banks and, more importantly, the bond market –undercounted in the BoP and external debt statistics that conventional analysis looks at.

Like me, the authors question on the accuracy of statistics where they delve deeper only to discover many unreported debt. They write of the difference between resident borrowing from a foreign bank branch in a country as loans issued by residence that is counted in the Balance of Payment (BoP) and from borrowing by the same resident in the offshore bond and inter-bank markets which they consider as loans by nationality, which appear to be unaccounted for in the BoP calculations. The difference according to them have been substantial. 

For externally-issued bonds, USD1042bn has been raised by the nationality of the EM borrower since 2009, USD724bn by residence of the borrower – a gap of USD318bn, or 44%. This undercount is USD165bn in China, USD100bn in Brazil, and USD62bn in Russia. There is evidence that this bond borrowing overseas by EM non-financial corporates is part of a carry trade, with these corporates acting like financial intermediaries. EM banks have also been busy issuing bonds overseas, a part of this carry trade. We do not have the breakdown for international bank loans by residence and nationality

Oh I noted that contra cheerleaders who think that by shouting “forex reserve!” “forex reserve!” “forex reserve!” they can drive away EM demons[4], the authors like me also note how forex reserves have been manifestations of the ‘sins’ of the credit inflation binge rather than as signs of strength.

Since 3Q2008, the US Federal Reserve QE has unleashed a massive USD2tn debt-driven carry trade into emerging markets, disproportionately increasing their forex reserves (by USD2. 7tn from end-3Q2008), their monetary bases (by USD3.2tn), their credit and monetary aggregates (M2 up by USD14.9tn), consequently boosting economic growth and asset prices (mainly property and bonds). As the Fed continues to taper its heterodox policy, we believe these large carry trades are likely to diminish, or be unwound

And here is where it gets more interesting. 

In Asia, the authors worry about the explosive external debt growth from time period of 2008 and 2013 (blue rectangles), mainly from China and Thailand in terms of bank lending and bonds. The red rectangles are the other ASEAN debt position acquired from the FED sponsored EM carry trade.

While the Philippines have the least exposure in nominal US dollar based loans, at 4.34x (!) the Philippines has the 2^nd biggest growth rate after Thailand.

This report seems consistent with the Deutsche Bank report I earlier noted which showed how the companies from the Philippines ramped up on US dollar loans in the global corporate bond markets in 2013.

And it would be natural to see a limited but concentrated bond market growth in the Philippines for one simple reason as I noted[5]

The small size of bond markets fit exactly with the low penetration level of households in the banking and financial system. This means that the dearth of savings being intermediated into investments via the banking sector or via the capital markets have hardly been signs of real growth.

Importantly, because of the small size of the corporate bond market, the top 10 share in terms of % to the total is at 90.8%. Said differently, the benefits and risks of Philippine corporate bonds have been concentrated to these top 10 issuers.

So should the BofAML’s fear of the risks from the unwinding of the massive EM carry trade materialize, it would seem unfortunate that based on the data from both Bank of America Merrill Lynch and Deutsche Bank, the Philippines or ASEAN major hardly be immune from a contagion.

Don’t forget we seem to be seeing accelerating signs of bank runs in emerging markets. Over the past one and a half weeks, Kazakhstan following the massive devaluation endured three bank runs[6], Ukraine suffered a bank run[7] and our neighbor Thailand just had a bank run on a state-owned bank[8]!

And while China hasn’t had a bank run yet, they seem to have undertaken a series of bailouts of delinquent financial institutions.

Sharp volatility in EM financial markets, stock markets fighting off bear markets, rising rates amidst spiraling debt loads, risk of unwinding of carry trades and bank runs, great moment for stocks right?

A final comment on the pig in the python EM carry trade, the above charts seem to suggest that there has been some correlation between US stocks as measured by the S&P 500 (yellow), the USDollar Yen (orange) and Emerging Markets stocks (EEM green) where all three seem to be moving in a synchronous fashion.

While correlation isn’t causation, could such synchronicity be a function of the carry trade in motion? Are performances of stocks based on ‘fundamentals’ or based on the carry trade anchored on US Federal Reserve policies?

Interesting.

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[1] See Emerging Markets: Why Adjustments For Relative Yield Spreads has been Disorderly February 17, 2014

[2] Kermal Dervis Tailspin or Turbulence? Project Syndicate February 17, 2014

[3] Ajay Singh Kapur, Ritesh Samadhiya,and Umesha de Silva Pig in the Python –the EM carry trade unwind Bank of America Merrill Lynch February 18, 2014

[4] See Emerging Market Turmoil: The Fallacy of Foreign Currency Reserves as Talisman February 3, 2014

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

[6] See Kazakhstan’s Devaluation Triggers Bank Runs February 20, 2014

[7] See Behind Ukraine’s Bank Run February 22, 2014

[8] See EM Crisis Over? Thailand Hit by a Bank Run February 19, 2014

Emerging Markets: Why Adjustments For Relative Yield Spreads has been Disorderly

Rising yields of USTs will have an impact on the policies of central banks whom has dovetailed their policies with that of the US Federal Reserve configured on zero bound rates

At the basic level, rising yields of USTs will compel for an adjustment in the respective contemporaneous ‘yield spread’ of domestic bond markets relative to the USTs that will get reflected on monetary policies.

What has made the adjustment disorderly, particularly for Emerging Markets has been the overdependence of specific economies on the zero bound regime, principally due to economic growth structured on credit expansion rather than economic reforms.

The relative yield spread adjustments has only exposed on the distinct vulnerabilities of these economies thereby leading to massive outflows.

The idea that the emerging market selloffs has passed days of turbulence neglects the importance of the fundamental relationship between respective pre-Taper/Abenomics ‘yield spreads’ of distinct EM nations with that of the USTs.

I pointed out last week how the direction of the Phisix seems to have found an anchor on the actions of USTs, where each time yields of 10 year USTs close in at 3% this seem to have spurred weakness or a spontaneous selloff in Philippine stocks.

It would seem that the same relationship holds true for ASEAN currencies. Since September 2013, where the yields of 10 year USTs (TNX, below chart) approached 3%, ASEAN currencies TWICE—particularly the USD-Philippine peso (red orange), US-Indonesian rupiah (orange), USD-Thai baht (green) and the USD-ringgit (red)—suffered convulsions from what should be normal yield spread adjustments.

Moreover, the second episode has led to greater (and not lesser) volatility where all four currencies broke beyond the September 2013 highs. So it would seem misguided to impulsively conclude that the emerging Asia’s woes have been short lived or has passed. Such assumption will have to be premised on a sustained decline of the TNX. However as pointed above, declining TNX has, of late, been accompanied by falling US stocks. And a steep drop in US stocks has likewise had a negative impact on local and regional stock market performance.

It is true that all of the region’s currencies have been rallying during the past two weeks. This has also been accompanied by buoyancy in the region’s equity markets. And again that has been largely because the TNX has dropped steeply. Nonetheless, the lull in ASEAN’s markets may be temporary as TNX has been climbing again (red ellipse). 

Notice that when the TNX peaked in September, the two month of tranquil space permitted the region’s financial markets to somewhat recover. However it is a question if the TNX has found a bottom. If it has, then it means a narrowing of the time span covering the previous peaks of September and December. This may imply that the ascent of the TNX may be accelerate or intensify. A fresh record breakout by US stocks can easily power the TNX to new highs.

Yet the current rally of domestic bonds of emerging Asia has hardly been impressive. Additionally, while regional currencies have bounced back, they are far from the lows of the post September levels. ASEAN currencies are rallying in lesser degree than during the post September lows.

The question now is if the TNX should continue to climb or spike, will the impact be devastatingly larger this time?

Presently even the mainstream has come to notice the recent bout of volatilities has exposed on the price inflation predicament of ASEAN[1]. But the emerging stagflation ogre has been seen as a supply side driven predicament rather than a credit inspired demand side imbalance. Debt exists nowhere in mainstream analysis.

Yet debt has been the anchor of any potential transmission mechanisms for a contagion

For instance, US and European banks have been found to have chased yield by having bigger exposure on EM’s the Fragile Five.

Philip Coggan of the Buttonwood Blog fame at the Economist quotes Erik Nielsen[2]

According to the BIS, US banks’ exposure to the “Fragile Five” increased by 37% to $212bn, while their exposure to the Eurozone periphery declined by 17% to $164bn. UK banks’ exposure to the Fragile Five increased by 29% to $291bn – while their exposure to the periphery declined by 30% to $277bn. German banks expanded their exposure to the Fragile Five by 34% to a relatively modest $69bn – while shrinking their exposure to the periphery by an eye-watering 50% to $354bn. French banks increased their Fragile Five exposure by a modest 15% (to $69bn) – while chopping their Eurozone peripheral exposure by 43% to $514bn. Italian banks doubled their exposure to the Fragile Five – but to a total of just $11bn, while cutting their exposure to the periphery (excluding Italy itself) by 46% to $33bn.  And Spanish banks increased their exposure to the Fragile Five by 26% to $185bn, while chopping their peripheral exposure (ex Spain) by 29% to $105bn.

So mainstream western banks flocked into the Fragile Five when the PIGS crisis surfaced.

And the powerful argument presented by Mr. Coggan has been to debunk the use of accounting identities in denying the above risk. Mr. Coggan writes, “the fragile five got that tag because they have current account deficits, but such deficits require, as an accounting identity, capital inflows. Someone had to lend these countries money so they could buy imports.”

In short behind all the smoke screens thrown by the consensus to defend the status quo via statistical figures and accounting identities, everything else will all boil down to sustainability or unsustainability of DEBT operating under the presence of the bond vigilantes.

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[1] Wall Street Journal Real Time Economics Blog, In Asia, Concerns About Inflation Re-Emerge, February 11, 2014

[2] Buttonwood, The money has to go somewhere February 10, 2014

How Rising US Treasury Yields May Impact the Phisix

Now experience is not a matter of having actually swum the Hellespont, or danced with the dervishes, or slept in a doss-house. It is a matter of sensibility and intuition, of seeing and hearing the significant things, of paying attention at the right moments, of understanding and co-ordinating. Experience is not what happens to a man; it is what a man does with what happens to him. It is a gift for dealing with the accidents of existence, not the accidents themselves. By a happy dispensation of nature, the poet generally possesses the gift of experience in conjunction with that of expression.—Aldous Huxley, Texts and Pretexts (1932), p. 5

You shall know the truth and the truth shall make you mad. ― Aldous Huxley

Last week I wrote[1]: (bold original)

Ultimately it will be the global bond markets (or an expression of future interest rates) that will determine whether this week’s bear market will morph into a full bear market cycle or will get falsified by more central bank accommodation.

US Treasury Yields Surges!

The surge of yields of US treasury will have interesting implications on global markets. 

According to the mainstream[2], Friday’s “robust” jobs data in the US supposedly would extrapolate to a so-called “tapering” or an eventual reduction of monetary policy accommodation by the US Federal Reserve. Such has been imputed as having “caused” the monumental spike US treasury yields from the 5, 10 and 30 year maturity spectrum.

But this narrative represents only half the picture.

Previously there has been a broad based boom in US financial assets (real estate, stocks and bonds). This has been changing.

Given the Fed’s accommodative policies, a financial asset boom represents symptom an inflationary boom. Such boom appears to have percolated into the real economy which has been reflected via the ongoing recovery in commercial and industrial loans which approaches the 2008 highs (upper window)[3]. Consumer credit has also zoomed beyond 2008 highs[4]. This means that the pressure for higher has been partly a product of greater demand for credit.

But treasury yields have been rising since July 2012. Treasury yields have been rising despite the monetary policies designed to suppress interest rates such as the US Federal Reserve’s unlimited QE in September 2012, Kuroda’s Abenomics in April 2013 and the ECB’s interest rate cut last May.

Rising treasury yields accelerated during the second quarter of this year, which has now been reflected on yields of major economies, not limited to G-4. And rising global yields as pointed out last week, coincides with recent convulsions in global stock and bond markets, ex-US currencies, and increasing premiums in Credit Default Swaps.

What Rising UST Yields Mean

The spike in US Treasury yields has broad based implications.

Treasury yields, particularly the 10 year note[5], functions as important benchmark which underpins the interest rates of US credit markets such as fixed mortgages and many longer term bonds.

Rising treasury yields means higher interest rates for US credit markets.

Treasury yields also serves as the fundamental financial market guidepost, via yield spreads[6], towards measuring “potential investment opportunities” such as international interest rate “carry trade” arbitrages. 

The McKinsey Global Institute estimates that the stock of global equity, bond and loan markets as of 2^nd Quarter of 2012 has been at US$225 trillion[7]

Market capitalization of global equities at $50 trillion signifies a 22% share of the total. The $100 trillion bond markets, particularly government ($47 trillion), Financial sector bonds ($42 trillion) and Corporate bonds ($11 trilllion) constitute 44%, while securitized ($13 trillion) and non-securitized loans ($ 62 trillion) account for 33% of the global capital markets.

Said differently, interest rate sensitive bond and loans markets represent 78% share of the global capital markets as of the 2^nd quarter of 2012.

And as interest rates headed for zero-bound, the global bond and loan markets grew by 5.6% CAGR since 2000, this compared with equities at 2.2% CAGR.

Higher interest rates translate to higher costs of servicing debt for interest rate sensitive global bond and loan markets. Theoretically, 1% increase in the $175 trillion bond and loan markets may mean $1.75 trillion worth of additional interest rate payments. The higher the interest rate, the bigger the debt burden.

Moreover, sharply higher UST yields will likely reconfigure ‘yield spreads’ drastically on a global scale to correspondingly reflect on the actions of the bond markets of the US and the other major developed economies.

Such adjustments may exert amplified volatilities on many global financial markets including the Philippines.

For instance, soaring US bond yields have already been exerting selling strains on the Philippine bond markets as I have been predicting[8]. 

Philippine 10 year bond yields[9] jumped 35 bps on Friday or 13 bps from a week ago.

And no matter how local officials earnestly proclaim of their intent or goal to preserve the low interest rate environment[10], a sustained rise in local bond yields will eventually compel policymakers to either fight bond vigilantes with a domestic version of bond buying program which amplifies risks of price inflation (which also implies of eventual higher interest rates), or allow policies to reflect on bond market actions.

Worst, a sustained rise in international bond yields, which reduces interest rate arbitrages or carry trades, may exacerbate foreign fund outflows. Such would prompt domestic central banks of emerging market economies, such as the Philippines, to use foreign currency reserves or Gross International Reserves (GIR) to defend their respective currencies; in the case of Philippines, the Peso.

‘Record’ surpluses may be headed for zero bound or even become a deficit depending on the speed, degree and intensity of the unfolding volatilities in the global bond markets.

Yet any delusion that the yield spreads between US and Philippine bonds should narrow towards parity, which would imply of the equivalence of creditworthiness of the largest economy of the world with that of an emerging market, will be met with harsh reality which a tight money environment will handily reveal.

The new reality from higher bond yields in developed economies are most likely to get reflected on “yield spreads” relative to emerging markets via a similar rise in yields.

Yet many banks and financial institutions around the world are proportionally vulnerable to losses based on variability of interest rate risk exposures particularly via fixed-rate lending funded that are funded by variable-rate deposits.

Importantly, the balance sheets of public and private financial institutions are highly vulnerable to heavy losses as bond yields rise.

As the Economist observed[11], (bold mine)

The immediate threat to banks is a fall in the market value of assets that banks hold. As yields of government bonds and other fixed-income securities rise, their prices fall. Because the amounts of outstanding debt are so large, the effects can be big. In its latest annual report the Bank for International Settlements, the Basel-based bank for central banks, reckons that a hypothetical three-percentage-point increase in yields across all bond maturities could result in losses to all holders of government bonds equivalent to 15-35% of GDP in countries such as France, Italy, Japan and Britain

What has been categorized as “risk free” now metastasizes into a potential epicenter of a global crisis.

It would be foolish or naïve to shrug at or dismiss the prospects of losses to the tune of 15-35% of GDP. These are not miniscule figures, and my guess is that they are likely to be conservative as these figures seem focused only on bond market losses.

While a sustained increase in the price of credit should translate to eventually lesser demand for credit, as the cost of capital rises that serves to restrict or limit marginal capital or the viability or profitability of projects, what is more worrisome is that “because the amounts of outstanding debt are so large” or where formerly unprofitable projects became seemingly feasible due high debts acquired from the collective credit easing policies by global central banks, the greater risks would be the torrent of margin calls, redemptions, liquidations, defaults, foreclosures, bankruptcies and debt deflation.

Government Debt and Derivatives as Vulnerable Spots

And such losses will apply not only to the private sector but to governments as well.

I pointed out last week of a report indicating that many central banks has been hurriedly offloading “record amount of US debt”. As of April 2013, according to US treasury data[12], total foreign official holders of US Treasury papers, led by China and Japan was $5.671 trillion.

This means that the $5.671 trillion foreign official holders (mostly central banks and sovereign funds) of USTs have already been enduring stiff losses. This is likely to encourage or prompt for more selling in order to stem the hemorrhage. I would suspect that the same forces have played a big role in this week’s UST yield surge.

Additionally, the propensity to defend domestic currencies from the re-pricing of risk assets via dramatic adjustments in yield spreads means that the gargantuan pile up of international reserves are likely to get drained for as long as the rout in the global bond markets continues.

As of April, the stock of US treasury holdings of the Philippine government (most of these are likely BSP reserves) has likewise been trending lower. That’s a month before the bloodbath. It would be interesting to see how developments abroad will impact what mainstream sees as “positive fundamentals”—or statistical data compiled based on a period of easy money.

I also previously pointed out[13] that of the $633 trillion global OTC derivatives markets as of December 2012, interest rate derivatives account for $490 trillion or 77.4%

The asymmetric risks from interest rate swap transactions as defined by Investopedia.com[14]

A plain vanilla interest-rate swap is the most basic type of interest-rate derivative. Under such an arrangement, there are two parties. Party one receives a stream of interest payments based on a floating interest rate and pays a stream of interest payments based on a fixed rate. Party two receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments. Both streams of interest payments are based on the same amount of notional principal.

Sharply volatile bond markets, in the backdrop of higher rates, increases the rate of interest payments and equally increases the risk potential of financial losses particularly on the second party who “receives a stream of fixed interest rate payments and pays a stream of floating interest rate payments”. And the corollary from the ensuing amplified losses may imply of magnified credit and counterparty risks. And we are talking of a $490 trillion market.

Yet it is not clear how much leverage has been accumulated in the US and global fixed income markets, fixed income based mutual fund markets as well as ETFs via risk exposures on Corporate bonds, Municipal bonds, Mortgage Backed Securities, Agencies, Asset Backed Securities and Collateral Debt Obligations[15], as well as, emerging market securities.

Will a sharp decline in fixed income collateral values prompt for higher requirements for collateral margins? Or will it incite a tidal wave of margin calls? How long will it last until one or more major US or global institutions “cry wolf”?

Rising interest rates in and of itself should be a good thing since this should rebalance people’s preferences towards savings and capital accumulation, the difference is that prolonged period of easy money policies has entrenched systematic misallocation of resources which has engendered highly distorted and maladjusted economies, artificially ballooned corporate profits and valuations, and has severely mispriced markets by underpricing risks.

The bottom line: If the tantrum in the bond market persists or even escalates, higher bond yields in developed economies will not only reflect on a process of potential disorderly adjustments for “yield spreads” of emerging markets such as the Philippines—under a newfangled renascent regime of the bond vigilantes—but they are likely to negatively impact the growth of the intensely leveraged, low interest rate dependent $225 trillion capital markets, as well as, the $490 trillion derivative markets.

It is imperative to see bond markets stabilize before ploughing into any type of investments.

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[1] See Phisix: Don’t Ignore the Bear Market Warnings June 30, 2013

[2] Bloomberg.com Treasury Yields Reach 2-Year High as Job Gains Boost Taper Bets July 6, 2013

[3] St. Louis Federal Reserve, Commercial and Industrial Loans at All Commercial Banks (BUSLOANS)

[4] St. Louis Federal Reserve Graph: Total Consumer Credit Owned and Securitized, Outstanding (TOTALSL)

[5] About.com 10-Year Treasury Note and Rate

[6] Investopedia.com Yield Spread

[7] McKinsey Global Institute Financial globalization: Retreat or reset? March 2013

[8] See How Volatile Bond Markets May Affect the Phisix June 3 2013

[9] Investing.com Philippines 10-Year Bond Yield

[10] Inquirer.net BSP seen to maintain easy monetary policy July 5, 2013

[11] The Economist Administer with care June 29, 2013

[12] US Department of Treasury MAJOR FOREIGN HOLDERS OF TREASURY SECURITIES

[13] See Phisix: Will Abenomics trigger a “Sell in May”? May 27, 2013

[14] Investopedia.com Interest-Rate Derivative

[15] Investopedia.com How Bond Market Pricing Works

How Volatile Bond Markets May Affect the Phisix

Many are good at solving equations but not understanding them; others are good at understanding equations but not solving them ; a few are good at both understanding and solving equations; those left over who are neither good at solving equations nor understanding them, yet insist on doing mathematics, become economists. Nassim Nicolas Taleb

Swooning over to populist politics, Philippine media immediately acclaimed that the recent statistical 7.8% economic growth for the first quarter was “stunning”[1].

Behind the “Stunning” Economic Growth has been a “Shocking” Credit Boom

Let us take the “stunning” growth narrative from the Philippine government’s National Statistical Coordination Board[2]:

The robust growth was boosted by the strong performance of Manufacturing and Construction, backed up by Financial Intermediation and Trade.

On the demand side, increased consumer and government spending shored up by increased investments in Construction and Durable Equipment contributed to the highest quarterly GDP growth since the second quarter of 2010.

The following table[3] above from the NSCB highlights the areas which supposed delivered such “stunning” growth

One would note that the growth in the household final expenditure, which represents the “demand side” (red ellipses on left table), has been significantly below the booming supply side areas particularly construction, and financial intermediation (red ellipses on right table).

Curiously and ironically, the real estate segment of the economic growth data has risen almost at par with domestic demand even as the construction sector has taken a huge leap in contributing to such statistical growth.

The table below exhibits the rate of growth of bank loans covering these sectors over the same period. 

The BSP data reveals that bank credit growth for these sectors have been even more “shocking”.

While the banking system’s general loan growth has expanded by 15% in the first quarter year-on-year or more than double the rate of demand, construction and financial intermediation has zoomed by staggering 51.2% and 31.61% correspondingly!!!

Real estate Renting and Business Services, Hotel and Restaurants and Wholesale and Retail trade has likewise been in an astounding expansion mode. During the same period banking loans on these sectors grew by 26.24%, 12.49% and 19.19% respectively!

Earlier I said “ironic” because the 1^st quarter statistical growth for the Real estate Renting and Business Services sectors grew by only 6.3% even as bank loans jumped by 26.24%. Where have borrowers from these sectors been channeling the loan proceeds?

Meanwhile the measly 5.9% credit growth in the manufacturing sector reflects on why this sector has not been a bubble.

Nonetheless the credit booming sectors now account for 53.25% of total banking loans.

Given the fantastic rate of credit growth, it would seem a puzzle why the Philippine economy grew by a miserly 7.8%.

And it is important to realize that even as domestic demand, as measured by household consumption, expanded by 5.1%, such has “partly” been backed by credit growth. I say “partly” because only a scanty number of households have access to bank credit.

Bank loans to domestic households advanced by a “modest” 11.89% during the same period. This has been supported by the expanded use of credit cards 10.62% and a rise in auto loans 13.86%.

I say “modest” because even if household loans grew by more than double the rate household consumption, compared to the scale of bank credit growth in the supply side, the demand side credit surge looks like a cinch compared to the supply side.

Banking loans for April mostly resonates on the same 1^st quarter trend but at a lesser pace of increases.

According to the latest BSP data[4], while general banking loans has moderately slowed, year-on-year credit to the construction sector remained resilient and swelled by 56.14%. The BSP’s press release again glosses over mentioning this data. 

However credit figures seem to have eased for wholesale and retail trade 10.02, financial intermediation 15.89% and real estate related loans at 22.67%.

Meanwhile loans to the hotel and restaurant sector firmed at 23.67%. And bizarrely, the “politically incorrect” mining and quarrying sector posted a surprising 67.26% spike in loan growth.

On the demand side, household loans grew at again a “moderate” rate at 11.5%. This has been backed by “modest” expansions in credit cards (9.01%) and auto loans (16.69%).

The easy money environment has also been evident in domestic money supply conditions.

Domestic liquidity (M3) increased by 13.2% on April (y-o-y) to reach Php 5.2 trillion. As the BSP notes[5],

The growth in money supply was driven largely by the sustained expansion in net domestic assets (NDA). NDA increased by 19.7 percent y-o-y in April from 25.3 percent (revised) in the previous month due largely to the continued increase in credits to the private sector of          14.3 percent, reflecting the robust lending activity of commercial banks. Similarly, claims on the public sector grew by 11.9 percent in April after rising by 15.0 percent (revised) in March, largely a result of the increase in credits to the National Government (NG).

The Philippine government has been actively tapping the credit markets for its expenditures as both revealed in the 1^st quarter and in the April 2013 data.

Yet each peso the government spends is a peso not spent by the private sector. And every additional peso the government spends means higher taxes, bigger debt and or more inflation as time goes by.

All these imply that the foundations for such “stunning” statistical growth have principally been due to ballooning credit.

And according to Investopedia.com[6] credit means borrowed money “must be paid back to the lender at some point in the future.”  In other words, such “stunning” pace of economic growth signifies a substantial frontloading of future growth to the present.

Worst, the current credit impelled growth dynamics extrapolates to a sustained massive buildup of imbalances particularly magnifying the risks of the tightly entwined or interdependent oversupply and overleverging.

Thus, take away the substance (credit), the form (statistical growth) will be exposed of its cosmetic unsustainable dynamic: Today’s manipulated boom will eventually metastasize into a bust.

Importantly behind the fanfare over such “stunning” statistical growth is the revelation of the dark side of the Philippine political economy. 

Given that the fact that the large segment of the population remains unbanked or has little or no direct access to the banking sector, (the BSP estimates that only 21.5% of households have access to banks) and where 83% of the stock market cap have been held by a few families, such credit inspired asset (property-stock market) boom which has been reflected on statistical growth, embodies of a boom vastly tilted towards political and politically connected economic financial elites.

In short, current policies represent a transfer or a subsidy to these politically privileged classes at the expense of the average Pedro or Juan.

Sad to see how the public fall prey to such disinformation, which has been disguised as economics.

Yet what people cheer for today will redound to tears in the near future.

How Media Rationalizes the Phisix Selloff

The disclosure of the “stunning” economic growth came amidst a one day heavy sell-off in the Phisix.

It was “fascinating” to see a bewildered public agonizing over how such good news could be met by a fury of sellers. Many seemed lost, as seen by comments on different social media platforms.

Beguiled by the conventional wisdom that stock market performance reflects on the real state of the economy, I said “fascinating” because the marketplace has been conditioned to see that there is no way but up, up and away for the Philippine assets.

Last week may have brought back some reality to them

The Philippine Phisix slumped by 3.81% on Thursday May 30^th partly in sympathy with Japan’s nose diving stock markets. Over the week, the Phisix lost 3.4%. Global markets have been mostly lower and such includes our ASEAN peers.

The Phisix meltdown had been rationalized by media as having been a regional phenomenon, from the prospective “tapering” of US Federal Reserve’s easing programs and from “expensive” valuations.

The above shows how current environment has turned from risk ON to risk OFF. Risk OFF extrapolates to a global, not just regional selling pressure.

And funny how the FED has repeatedly been talking about “exit” strategies from the start of the year[7], yet the supposed impact from FED communications would come only last week? Why?

In late April, chatters over “tapering” even changed to “extending bond buying”[8]. So the FED seems much in confusion as with the global markets deeply dependent on them.

The reason why tapering has been much in the news and justified as having influence to stock and bond markets have largely due to surging yields in US treasury paper claims and mortgage rates. US mortgage rates climb to the highest level in 2 years[9].

And as I have been pointing out, “after the fact” or ex post narratives as “expensive” barely explains why and how “expensive” came to be. If markets have been rational, as media and their favored analysts presume, then there would hardly be such word as “expensive” or “cheap”. There hardly will be any incidences of “parallel universes” which contrary to the consensus expectations, have been quite common features of financial markets today.

And more interestingly, reports about the contagion from Japan’s twin stock and bond markets crash had only been mentioned in passing or have been mostly muted.

The best explanation I saw as quoted by media[10] was from a multinational domestic based analyst “At the core is higher risk aversion, as evidenced by a blip in 10-year bond yields overnight”

Higher risk aversion signifies a symptom of the current or past developments. People do not just become risk averse for no reason at all or when they wake up on the wrong side of the bed.

The mainstream seems clueless on what has truly been going on.

The Mania in the Philippine Bond Markets

As I said last week[11],

Japan’s twin market crash for me serves as warning signal to the epoch of easy money.

This remains highly relevant today.

Domestic 10 year yields did spike last Thursday. Such had been the main force to the stock market selloff as I pointed out here[12]. 

But it is unclear if the surge in yields is going to be a “blip” or a temporary event.

The odds are against such a claim, why?

Rising yields have become a global phenomenon.

Since the last week of May, 10 year yields of Thailand, Malaysia and Indonesia have all been exhibiting upside actions.

And as likewise pointed out last week, yields in the US, Germany, France and the crisis stricken PIGS have been ascending.

Such dynamic has been no different to our East Asian counterparts. 10 year yields of Taiwan, South Korea, Singapore and Hong Kong have all been increasing since early May.

Does any of the above suggest that higher yields have been a “blip”? And given that global bond yields have been on an upside route, why should the Philippines defy such global trends? Because of the belief in the political “this time is different” nirvana?

Secondly, Asian currencies have been pummeled also from rising yields.

The JP Morgan Bloomberg Asia Dollar index or the ADXY is a trade weighted spot basket of 10 Asian currencies benchmarked against the US dollar[13]. The ADXY has been declining almost in correspondence with the rising yield of Asia.

Asia’s rising yields have even begun to filter into credit concerns.

As the South China Morning Post reported last week[14]:

Borrowers in Asia are seen as the least creditworthy relative to their global peers in almost a year on signs of faltering growth in China.

The Markit iTraxx Asia index of credit-default swaps traded as much as 20 basis points higher than the average of four others from around the world this month, the biggest premium since June, according to data provider CMA.

The Philippine Peso seems headed in tandem with the regional peers (Yahoo Finance). Most of the Peso’s decline has almost been in near synchronicity with the Asian currencies. The falling peso seems to have presaged the huge correction in the Phisix (stockcharts.com)

While the Peso has adjusted to reflect on global trends, the domestic bond markets apparently continues to discount or ignore international developments.

Aside from the global backdrop of rising yields, there is an even more compelling argument why low yields may not last in the Philippines.

The above charts represent the Philippine 10 year[15] and the US 10 year yield[16]. The yield spread between the domestic and the US bonds have in the norm been about 4-5 basis points. Recently such spread has abruptly collapsed over the last month. This comes as the Philippine yield hit a record low (3.04%!! in May) and as US yields has recently surged (see ellipse). Such has been much about the ballyhooed credit rating upgrades.

As of Friday trading close, the Philippines bond yield closed at 3.54% vis-à-vis the US 2.132%, the spread has narrowed substantially to 1.408 bps. 

The Philippines’ 3.54% compares with 10 year yields of our neighbors Thailand’s 3.51%, Malaysia 3.44%, and South Korea 3.1%. This makes the Philippines within their league.

Two factors shaping the collapse of the US-Philippine spread; one frenetic yield chasing dynamic, and the other, the markets see the Philippines as having established a new order.

And unless the financial markets retain such firm conviction or confidence that the Philippine credit profile has reached or attained the standings of our far richer neighbors, then the vastly narrowed Philippine-US spread may or could be an accident waiting to happen via reversion to the mean.

Yes, these are signs of an ongoing mania today in Philippine bonds.

By the way, current Philippines yield suggests that we have significantly economically and financially pulled away from Indonesia whose 10 year yield was last at 6.1% which I am highly doubtful of.

And a risk off environment could be just the apt ingredient for this.

And last week’s yield spike could be a just precursor to the coming mean reversion.

Again a sustained risk OFF environment particularly through higher yields may serve to strengthen or falsify the market’s conviction of the newfound distinction imputed on Philippine bonds—and of the entire spectrum of Philippine assets.

This will also put the recent credit rating upgrades to a crucial test.

Nonetheless a potential bedlam in the local bond markets may hardly signify a conducive environment for the stock market.

The Relationship Between Rising Yields and the Wile E Coyote Moment

The current rise in global yields may mean one of the following or a combination of the following[17]: the receding stimulative effects of easing policies, growing concerns over shortages of capital, there could be implicit concerns over rising inflation, and finally, increasing concerns over credit risks.

Given that surging yields of major economies seem to have inspired the global bond selloffs I suspect Japan’s crashing bond markets as having been the biggest influence which media consistently tries to suppress.

Rioting JGBs seem to herald the return of the bond vigilantes.

10 year bond yields of Germany (GDBR10 red orange) US (USGG10YR Green) the French (GFRN10 orange) and Japanese (GJGB10 red) appears to have significantly moved higher in conjunction since early May 2013. This was a month after the announced doubling of monetary base, and subsequently, a jump in April’s monetary base affirmed the direction of Bank of Japan’s policies[18].

Rising yield will tend to squeeze out heavily leveraged trades which mean that we should expect heavy volatilities or treacherous market ahead.

Of course some markets like the US may continue to rise even if interest rates ascend. This occurred during the mania phase of pre Lehman bankruptcy boom.

But as I previously discussed[19], rising markets on greater debt accumulation amidst higher interest rates is a recipe for the Wile E. Coyote[20] moment.

Markets can continue to run until it finally discovers that like Wile E. Coyote they have run past the cliff.

This may apply to any markets including the Philippines Phisix or ASEAN.

Finally given that the torrent of bad news which in the past provoked higher markets or “bad news is good news”, the current setting appears to have failed to incite the same expectations and results.

Such difference probably means that markets don’t see sufficient outcomes from current or prospective set of actions from policymakers.

The coming days or sessions will be very interesting.

However I expect monetary authorities to resort to even bigger actions to arrest rising yields—but the consequence may not necessarily revive the risks ON environment.

Trade with utmost caution as market risks seems very high.

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[1] Inquirer.net Economy grows a stunning 7.8% May 31, 2013

[2] NSCB.gov.ph National Accounts of the Philippines - Press Release PHILIPPINE ECONOMY POSTS 7.8 PERCENT GDP GROWTH May 30, 2013

[3] NSCB.gov.ph Key Figures PHILIPPINE ECONOMY POSTS 7.8 PERCENT GDP GROWTH May 30, 2013

[4] BSP.gov.ph Bank Lending Continues to Expand in April May 31, 2013

[5] BSP.gov.ph Domestic Liquidity Sustains Growth in April May 31, 2013

[6] Investopedia.com Credit

[7] See Poker Bluffing FOMC: Probable Stop in Bond Buying January 4, 2013

[8] Small Street Journal Fed Debate Moves From Tapering to Extending Bond Buying April 25, 2013

[9] Bloomberg.com Mortgage Rates in the U.S. Climb to Highest in a Year May 31, 2013

[10] Inquirer.net PH stocks take a big hit; peso weakens May 31, 2013

[11] See Phisix: Will Abenomics trigger a “Sell in May”? May 27 2013

[12] See JGB Watch: Nikkei Dives by 5.15%, Yields Ease, Phisix Commiserates May 30, 2012

[13] Bloomberg.com Bloomberg-JPMorgan launch first tradable Emerging Asia Currency Index October 13, 2004

[14] South China Morning Post Asian debtors' rising risk May 28, 2013

[15] Tradingeconomics.com PHILIPPINES GOVERNMENT BOND 10Y

[16] Tradingeconomics.com UNITED STATES GOVERNMENT BOND 10Y

[17] See What to Expect in 2013 January 7, 2013

[18] Japan Times Monetary base soars to highest ever: BOJ May 2, 2013

[19] see Has the Phisix has Gone Ballistic?! February 25, 2013

[20] Warner Brothers The Fiscal Cliff: America’s Wile E. Coyote Moment, The Fiscal Times October 15, 2012