It would be a serious blunder to neglect the fact that inflation also generates forces which tend toward capital consumption. One of its consequences is that it falsifies economic calculation and accounting. It produces the phenomenon of illusory or apparent profits—Ludwig von Mises, Human Action
In this issue
BSP’s Confession: Leverage Represents The Key Risk Today; An Analysis of the State of Financial Stability
I. The Banking System’s Statistical Mirage: An Apples to Orange Treatment
II. Contradictions in the BSP’s State of Financial Stability
III. Risks of Contagion and Concentration Under Control?
IV. Fiscal Policy and Monetary Policy Risks Under Control?
V. Manageable Valuations Risk?
VI. BSP’s Confession: Leverage Risk as a Clear and Present Concern
VII. Conclusion: A Holistic Approach to Risk
VIII. Post Script: The Boom from Statistical Base-Effects!
BSP’s Confession: Leverage Represents The Key Risk Today; An Analysis of the State of Financial Stability
I. The Banking System’s Statistical Mirage: An Apples to Orange Treatment
From the Businessworld (June 7): SOURED LOANS held by Philippine banks continued to rise in April, bringing the nonperforming loan (NPL) ratio to its highest in nearly 12 years as borrowers’ capacity to pay debts were affected by the reimposed restriction measures.
The BSP implemented the following rescue measures supposedly in support of the bank and financial system, the National Government, and the economy.
First, the BSP infused liquidity into the system*.
-The BSP reduced the policy rate by a cumulative 200 basis points (bps) since February 2020.
-It also reduced the reserve requirement ratios (RRR) by 200 basis points effective in April 2020.
-It extended provisional advances to the national government on a time-bound basis and within the limits prescribed by law.
-It has also been purchasing government securities in the secondary market to help shore up domestic liquidity and restore market confidence
*Benjamin E Diokno: “Philippines - traversing the path to economic recovery”, speech at the Eastern Communication E-Huddle Webinar Series "Making Remote Work and Creating Opportunities", 4 May 2021.
Second, the BSP has also relaxed prudential and regulatory standards**.
Some of the key measures.
-The credit risk weights of loans granted to MSMEs that are current in status were reduced to 50 percent. The reduced credit risk weight would be subject to review by end-December 2021.
-Loans that are guaranteed by the Philippine Guarantee Corporation, Agricultural Guarantee Fund Pool (AGFP), and the Agricultural Credit Policy Council (ACPC) were assigned zero-percent risk weight.
-New loans to MSMEs and large enterprises that were critically impacted by the pandemic were recognized as forms of alternative compliance with banks'/QBs' reserve requirements, provided these loans are not encumbered or rediscounted with the BSP.
-The Single Borrower's Limit (SBL) was temporarily raised to 30 percent from 25 percent until 31 March 2021
-The BSP Monetary Board approved the acceptance of additional eligible credit instruments and relaxed documentary requirements and availment procedures for rediscounting to the BSP until 30 April 2021, subject to further extension as may be approved by the MB.
**Benjamin E Diokno: “Impact of the pandemic and the trajectory of recovery in terms of social and economic metrics”, speech during the 39th Credit Management Association of the Philippines (CMAP) National Credit Congress & 89th Founding Anniversary, 22 April 2021, BIS.org
When have these measures been implemented outside 2020? The answer is that the combination and scale comprising this set of rescue policies have been UNPRECEDENTED.
So how can the 2020-to the present data (e.g. NPLs, capital adequacy, liquidity and profitability ratios and etc.) be a valid comparison with the historical bank statistics, say 2009 or its trend?
It is like comparing the headline equity benchmark constituting today's composite members (essentially consumer industries) with that of the 1970s (with substantial exposure to the mining industry).
Besides, why the massive rescue package?
Outside the rhetoric of “insulating the domestic economy from shocks, ensure stability and minimize scarring effects, ensure adequate liquidity flows, restore market functioning and shore up market confidence”, the current measures primarily signify the bailout of the banking and financial system, the principal financial intermediaries and financiers of the National Government and the Non-Financial corporations owned by the elites (or the plutocracy).
And to reemphasize, had the banking and financial system been as “sound”, or had banks lent “wisely”, as touted by the establishment experts, then why the historic scale of bailouts from the BSP?
Why, instead, not apply Walter Bagehot’s rule of “to avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral (good security), and at ‘high rates”?
And another important thing, why the operational, capital, and regulatory relief measures, if not to minimize statistical or accounting impairments on the books of the industry?
It stands to reason that in reflecting the likely sanitization of data, there might have been a considerable understatement of the actual conditions in the bank statistics published by the BSP.
Again, had credit losses been manageable, the banks won’t need incredible amounts of liquidity injections AND relief measures from the BSP. Yet, it did.
II. Contradictions in the BSP’s State of Financial Stability
Instead of publishing the Financial Stability Report, the BSP came with First 'State of Financial Stability' Statement. In it, they declared that they were on top of the situation. But…“Six of the eleven risk areas being monitored have been classified as under control. These are risks to monetary policy, risks to fiscal policy, contagion risk, concentration risk, liquidity risk and geo-political risk. However, servicing debts and credit-related risks are the primary concerns in the financial market today”.
The enumerated risks from the domestic financial and monetary, as so stated, are to be distinguished from each other. That is, the isolation of credit risks stands on the predicate of different causal properties in the risks of monetary policy, fiscal policy, contagion, concentration, and liquidity.
But human activities are interdependent.
Wrote the great Austrian economist Ludwig von Mises,
Economics does not allow of any breaking up into special branches. It invariably deals with the interconnectedness of all the phenomena of action. The catallactic problems cannot become visible if one deals with each branch of production separately…There is only one coherent body of economics
Ludwig von Mises, Human Action, p.870, Mises.org
Proof?
From the BSP’s 2017 FSR: “The low interest rate environment greatly encouraged the search for yield as greater risks were taken in exchange for higher returns” (p.23, bold original)
So how is it that credit risks are distinct from monetary policy, contagion, concentration, and liquidity? In 2017, the BSP acknowledged that monetary policy, which influenced liquidity, and relative excessive risk appetite conditions, functioned as the key driver of credit risks, which elements comprised of the 3Rs (repricing, refinancing, and repayment).
And isn’t it odd that the BSP is saying the same dilemma in 2017 and today, coming only under different backdrops?
And that the BSP indulges in self-contradiction shouldn't be surprising.
We shall cite a few.
III. Risks of Contagion and Concentration Under Control?
From the Statement on the State of Financial Stability (June 4) [italics mine]
Contagion and Concentration Risks
-Philippines Inc. is highly interconnected, marked by the industry leadership of identified firms.
-In normal times, the business connections between firms and across industries represent a mutually reinforcing system. However, any disturbance can also generate much larger effects.
-The Council has developed several network models to reflect the business connections between firms, across industries, and their normal activity with other jurisdictions.
-Latest data does not show any significant change in the interlinkages within the network. This indicates that the business links and/or value chains that have been formed are quite stable.
-We are currently conducting, in phases, Macroprudential Stress Tests and these network models are the defining element of these simulations.
The BSP admits to the fact that only a few companies, primarily owned by the elites, contribute significantly to the Philippine economy or the plutocratic/cartelized/trickle-down development model.
From the former BSP Chief Amando Tetangco Jr.***: “While the trickle-down approach to spread the benefits of development is good, it is not enough; we want to be more proactive.”
***Amando M Tetangco, Jr: Acting together for financial inclusion, speech at the Luzon Regional Consultation on the National Strategy for Financial Inclusion, Manila, 20 May 2015. BIS.org
Because of this top-down economic construct, the BSP believes that they can sufficiently model "the significant changes in the interlinkages within the network" that would allow them to make accurate projections of the ramifications of the downturn.
From the Businessworld (June 11): TOO-BIG-TO-FAIL banks are in a strong position despite the ongoing coronavirus pandemic, supporting the financial system’s overall stability, Bangko Sentral ng Pilipinas (BSP) Governor Benjamin E. Diokno said on Thursday. “D-SIBs (domestic systematically important banks) remain on solid footing amid the heath crisis. We see this contributing to the overall soundness of the domestic financial system and the country’s financial stability,” Mr. Diokno said at an online briefing.
A case of “Never Believe Anything Until It Is Officially Denied”?
Interestingly, the BSP prescribed significant changes in the economy in the 2H FSR: “With the disruptions in supply chains, production needs to reposition itself in the New Economy, even if a vaccine would not be available for some time. Some industries are already undergoing a noticeable shift.” P.26 (italics added)
For instance, they recommended a critical shift in the business model of the trade industry, from the brick-and-mortar to the digital or online model: “Wholesale and trade. The viability of big and bigger malls may have to be reconsidered. This is not just because of physical distancing norms, which will affect baseline assumptions about foot traffic. The bigger concern may be in the emergence of ecommerce, which has given retailers its internet-based platform to sell and market products. This provides consumers greater reach and enables households to purchase at the comfort of their homes, without being constrained with store hours or dreaded parking at the malls. With some products visible on the online market even before the pandemic, the quarantine was the trigger for the underlying, likely permanent change. Online transactions also adjust the employment frontier from the stores/retailers to the backroom services handling electronic orders. Physical stores may not be completely eliminated but a reconfiguration is likely.
The BSP appears to think that such a transformation, importantly, a policy-induced one, is seamless and cost-free.
And while they claim that ‘business connections among firms’ currently ‘does not show any significant change in the interlinkages’, their GDP data tells otherwise.
Figure 1
After reaching a high of 37.3% in the 3Q 2019, the % share of construction, trade, real estate, hotel, and food services to the real GDP plummeted to 29.1% as of 1Q 2021.
Including financials and insurance, the % share of the same group reached an all-time 46.4% in the 3Q 2019, then in the 1Q 2021, dived to 40.1%.
While all the non-financial segments contributed to the dramatic decline, the real estate and construction, the much-hyped sectors, suffered the most. And unlike the mainstream rhetoric where everything is about the pandemic, the diminishing share of real estate commenced in Q3 2015.
If this forced transformation of the trade industry towards the digital space becomes widespread, then the impact on commercial real estate will be substantial. What happens to the existing structures? Who pays for the losses, idled assets, displaced workers, consumed capital, and operational disruptions?
And yet, defying the BSP, declaring significant sums for CAPEX allotments, developers haven’t given up on the old model. Nostalgic of the pre-pandemic days, the hope for the industry's restitution is on the vaccine elixir.
Interestingly, despite the sharp decline in the GDP, the same group ex-non-financials account for the largest share of bank lending, hitting a 37.1% share in April, the fourth-highest ever.
So while the GDP share of these industries flail, bank lending to them increases, essentially, how will firms of the industry pay for such escalating financial encumbrances?
In the meantime, neither income losses nor stagnation in bank lending, its core operations appears to be any hindrance to the financial juggernaut!
Since 2005, the financial share of the GDP trended higher, accelerated in 2018, and recently turbocharged by the BSP bailout.
In the 1Q 2021, the financials grabbed an 11% share, the second-highest since 11.2% in Q2 2020. Aside from BSP's rescue measures, using its spare liquidity to move and speculate on markets appears to be the most appropriate financial model for the sector to grab the third-highest share of the GDP, after manufacturing and trade.
Aside from rescue measures to conceal impairments, banks have used the BSP's provision of spare liquidity to move the tape and speculate on markets. This model allowed the sector to grab the third-highest share of the GDP, after manufacturing and trade.
And this represents the key to 'sound' banking? Stunning.
IV. Fiscal Policy and Monetary Policy Risks Under Control?
They tell us too that risks to fiscal policy have been under control.
Risks to Fiscal Policy
-The country has taken a conservative fiscal stance in recent years and this has allowed the government to fund unscheduled expenditures to address the pressing needs arising from the COVID-19 pandemic
-However, the budget deficit has certainly increased as fiscal authorities have had to provide direct assistance to households and economic sectors. It is now estimated to top off at 9.4% of GDP for 2021, then easing to 7.7% in 2022.
-Pressure points can arise from two factors: first, funding needs may still expand as the COVID-19 pandemic continues to unravel and, second, tax revenues may be tempered as income levels take time to revert to their 2019 levels. Ongoing legislative initiatives could also affect the fiscal balance.
-A more definitive view of all of the implications on the fiscal position remains unclear and we shall update our analysis as developments unfold.
How exactly is the BSP under control of fiscal risks, when they admit to the unclear view of the implications of enlarged deficits? And more importantly, what about the risk of funding it?
Risks to Monetary Policy
-Philippine inflation currently remains elevated and above the 4% upper bound. Our current view is that this condition is transitory, with average inflation expected to fall into the band by year-end.
-With no threat of an overheating economy and the markets already liquid, the current policy rate is appropriate given the path of growth and inflation.
-Upward inflationary pressures stem from cost-driven factors that may be outside the traditional purview of monetary policy. Since November last year, world oil prices have been moving upwards with both Brent Crude and WTI prices nearing USD70 a barrel. Unsurprisingly, transport inflation has risen as a result.
Why exactly did the BSP retrench on its QE in April, if they believed that "upward inflationary pressures stem from cost-driven factors"?
Figure 2
Aside from the supply shocks, has the BSP belatedly realized that its QE contributed to the demand segment of the CPI through public spending, PPPs, and bank infusions?
Consistent with the decline in 27.14% YoY public spending, infrastructure spending grew 45% YoY in April from a low base-effect but was down 34% m-o-m, according to the Businessworld.
Now that draining commenced, as expected, yields of domestic treasuries in anticipation of the lower CPI have dropped sharply this week.
As stated last week,
So, again, why the abrupt liquidity drain? The answer, in short, is to keep interest rates down.
Stagflation Rules! BSP Pulls Back QE and Liquidity! The Peso’s Purchasing Power Declined by 22% in the last 9-Years June 6, 2021
Strikingly, the growth rate of the bank’s most liquid assets, cash and due banks, more than halved to 13.9% in April from 33.3% in March.
What would happen to the banks once liquidity thresholds revert to pre-pandemic lows?
V. Manageable Valuations Risk?
The partial exit of the BSP’s QE affected the banking system’s balance sheet.
Risk to Valuations
-Local yields are responding to the global trend. This is, however, causing trading volumes to decline, and a further decline in price discovery. The lack of actual traded prices will only fuel trading friction, which sustains the absence of “done” rates, against which both issuers and investors can make informed choices.
-A steady/strong PHP is also enticing more activity in offshore debt markets. As reported by the BIS, this is the case for NFCs and banks as well.
-If the rising trend for global secondary market rates is sustained, this will create another source of pressure on borrowers who carry debts that are subject to periodic repricing. At the current nascent stage of recovery, higher market yields pose a risk that compounds eroded incomes and impaired debt servicing capacities.
-From a market valuation standpoint, the higher yields also mean that holders of tradable securities face mark-to-market losses. Shifting tradeable assets into held-to-maturity may address valuation risks but it does come at the price of locking-in liquidity.
Sure, yield movements of US Treasuries exhibit strong correlations with local counterparts, but this serves as the most convenient excuse for shielding the impact of local policies. (figure 3 upmost left pane)
And rising yields have barely been associated with low trading volumes, as seen in the pre-2020 period. Rather, the BSP’s QE operations must have reduced the volume of securities available to the marketplace.
Political interventions, rather than pure market forces, are responsible for the derailment of price discovery. Has it not been a wonder that trading volume appears to be improving since the BSP’s partial departure from QE operations? (figure 3, upmost right window)
And notice too, they say that markets are liquid (risk to monetary policy), but carp about the low trading volume. Where has it gone then?
As for the peso exchange rate, it has been our position that Gross International Reserves (GIR) have mainly been composed of short dollar positions from derivatives and external borrowings or borrowed reserves.
From the Philstar (June 11): The Philippines’ dollar reserves slightly went down in May after the government withdrew cash from the country’s dollar stock to settle its maturing debts.
Over time, a weaker peso will be the outcome of increased USD shorts.
The strong peso expands the spectrum of mounting leverage by banks and Non-Financials from the offshore debt markets. Indeed, the strong peso has disguised the system's increased external leverage. Instead of using this opportunity to pare down debt, many have opted to expand their exposure, upsizing currency risks.
The extended exposures on speculative fixed instrument assets have prompted the banks to dread higher rates because of duration risks. Higher rates, as the BSP explained, translates to increased mark-to-market losses on such tradable securities. By shifting to held-to-maturity assets, such losses, the BSP confessed, may be veiled through accounting gymnastics. But doing so entails a cost, a drain on bank liquidity. It explains why the BSP acted to siphon liquidity to pull down CPI and interest rates.
Nevertheless, the sustained boom in Available for Sale (AFS) assets up 70.86% in April, which may include the equity positions, could have been the driving force of the current rally at the PSE. Financial assets, including the AFS, climbed 19.33% in April and have undulated effortlessly along with the PSYEi 30. (figure 3, lowest pane)
How healthy is it for banks to rely on the BSP-sponsored asset inflation?
VI. BSP’s Confession: Leverage Risk as a Clear and Present Concern
Leverage Risk
-Bank credit and GDP growth are naturally connected. As prospects for the economy improve, entrepreneurs wish to tap into business opportunities by expanding or creating new businesses through bank credit. Good economic outcomes, in turn, allow the loans to be repaid and sustained economic activity nurtures further demand for loans.
-As simple as this may sound, it reiterates the basic point that leverage should be understood in terms of what the proceeds will be used for and thus, indirectly, how the debt can be sustained. The difficulty, however, is when unexpected events occur.
-COVID-19’s direct negative effect on incomes suggests that there will be increased pressure for servicing existing debts. Borrowers who were keen on expanding (and rebalanced their balance sheet towards more leverage and less liquidity) are thus facing increased vulnerability. With an emerging New Economy that is almost certainly and fundamentally different than the pre-COVID-19 market, expectations of one’s business future also comes with notable uncertainties.
-The timing between expected revenues and when debt obligations are due is likewise critical. COVID-19 disrupted the former but contractual obligations are generally unchanged.
-Rising market yields, driven by spillovers from AEs, would also be an unfavorable complication. With incomes already impaired, raising the cost of repayment adds an unnecessary burden to debt servicing.
-For these reasons, leverage represents the key risk today. Borrowers, lenders, and financial authorities must collaborate to address an unexpected external shock that materially affects the credit standing of borrowers for reasons that are not of their doing.
Bank credit functions as the primary driver of liquidity, and consequently, the GDP or the statistical economy. That's because the banking system represents the principal financial intermediary of corporations owned by the elites, and the National Government. SMEs and the general population only have a small exposure to the formal banking system, which is the reason for the BSP program called Financial Inclusion.
In the current environment, with bank credit supposedly in deflation, authorities have assumed the role of liquidity provider through debt expansion. The paradox is that despite the supposed credit tightening, the debt stock of major listed companies continues to balloon. In this case, assuming the accuracy of bank data, outside the big-league companies, the economy may have been overwhelmed by a massive credit deflation.
Figure 4
On the surface, due to the sizzling growth of public debt (27.8% YoY), total debt soared (11.4%), even as bank lending of universal and commercial banking retrenched (-4.51%). That is to say, public debt replaced bank credit as the primary mechanism for credit expansion. And this recession is consistent with the absence of liquidity from bank credit. (Figure 4 upmost pane)
Again, the curtailment of the BSP’s liquidity measures has been designed to lower rates/yields by suppressing the CPI.
The reduction in the cash-to-deposits ratio emerged from the steep fall in bank cash reserves, as well as deposit liabilities. In contrast to the pre-pandemic days, the BSP’s liquidity support has coincided with the recent surge in the CPI. (figure 4, middle left pane)
Interestingly, the downtrend in the growth rate of bank deposit liabilities have only accelerated. Deposit liabilities grew by 6.01% in April from 7.88% a month ago. Peso deposits expanded 7.2% from 9.55%, while FX deposits shrank by a minuscule .35% from -.8% in March. (figure 4, lowest pane)
The BSP’s low rates regimes or monetary policy has stripped mined deposit liabilities. Or, the inflation tax eroded the savings of the population.
People have very short memories. The current burst in the CPI marks the third in seven years. Oddly, there has been little interest in the existence and causality of this vicious cycle to merit conversation. (figure 4, middle right window)
The CPI deflation in 2015 signified the inflection point of the Net Non-Performing Loans (NPL). In the following years, Net NPLs rose along with the CPI and accelerated upwards when the CPI fell. Declining inflation exposed many of the leveraged players even before the pandemic. The pandemic only spiked the NET NPLs despite the historic bailout measures. What would this number be without it?
The BSP’s gambit to reduce interventions, as said last week, should be a welcome development. Theoretically, this environment allows the partial healing of the economy and the rebuilding of real savings and capital. But neo-socialist policies and addiction to leverage continue to hobble the political economy.
That being the case, once prices start to fall, triggering liquidations of malinvestments funded by money supply growth, expect the BSP to turbocharge its balance sheet growth. The vicious cycle restarts…until compelled by market forces to stop.
As the late economist Herb Stein once said, “If something can’t go on forever, it will stop.”
VII. Conclusion: A Holistic Approach to Risk
At the end of the day, the BSP mentioned the various financial risks that comprise the state of financial stability, namely, leverage, valuations, macro-economy, fiscal policy, monetary policy, liquidity, contagion, and concentration are all interdependent to one another. That is to say, because of complexity and interconnectedness, to contain or control one risk is not possible without addressing the others in unison. A holistic approach is required.
Under this premise, since the BSP sees credit as a clear and present concern, then all the rest remains a pressing challenge. Add to this the global everything bubble, a global market risk, a reversal of momentum from speculative excess could likewise amplify its spillover effect here.
Though cybersecurity risk has some economic dimension, its technical qualifications dominate.
Finally, the climate change risk represents woke capitalism than a monetary or financial concern.
VIII. Post Script: The Boom from Statistical Base-Effects!
How the establishment puts a spin on statistics is just amazing.
From the Inquirer (June 11, 2021): Long-term investments that entered the Philippines from overseas rose sharply in the third month of this year due mainly to the spike in foreign loans made during the coronavirus pandemic, according to the central bank. In a statement, the Bangko Sentral ng Pilipinas (BSP) said net inflows of foreign direct investment (FDI) grew by 139.5 percent to $808 million in March 2021 from the $337 million in the same month last year.
From Philstar (June 9): Manufacturing activity recovered from a slump, posting a big hike in April as a majority of industry groups recorded gains, the Philippine Statistics Authority (PSA) said. Factory output, as measured by the Volume of Production Index (VoPI), surged 162 percent in April, coming from a 73.3 percent contraction in March and 65 percent decline in April 2020.
From Reuters (June 9): Philippine merchandise imports grew a hefty 140.9% in April from a year earlier, while exports jumped 72.1%, both rising at their fastest pace in more than a decade, government data showed on Wednesday. Imports totalled $8.45 billion, while exports reached $5.72 billion, yielding a trade deficit of $2.73 billion. This marked the tenth straight month that the gap has exceeded $2 billion, Philippine Statistics Authority data showed.
Figure 5
The boom from the base effect represents a statistical illusion. That's because the low base effects, which generated the remarkable % gains, are based on statistical anomalies. The political response to the initial outbreak of the pandemic resulted in an economic standstill, which accounted for last year's low baseline. The data essentially compares a closed economy with a partially opened one.
Nevertheless, from a nominal perspective, there barely exists a boom. Despite the low baseline of March and April, FDIs, factory output, and imports remain in their respective downtrends. On the other hand, the three-year ceiling in exports appears to hold ground despite an attempted breakthrough in March.
The factory and exports data appear to be realigning with global developments defined by transport gridlocks, material shortages, supply bottlenecks, rising prices, and surges in demand stimulated by unparalleled central bank easing, historic government transfers, and spending.
The establishment gives the public what they want to hear.
