Tale of The Tape: The Philippine Peso Versus The US Dollar

``It requires very unusual mind to make an analysis of the obvious."-Alfred North Whitehead

It has also been our exposition that the recent rally of the US dollar relative to the Philippine Peso, which has been popularly imputed to rampant “inflation”, had been based on a false premise, see Figure 2.

Figure 2: ADB Bond Monitor: Fiscal balance as % of GDP (left), Net food and petroleum exports in 2007 in $ billions (right)

In my view, the markets simply looked for an excuse (available bias) to sell down the Peso and Philippine asset classes, when it had been mostly a combination of the phenomenon of a natural countertrend cycle, the lowering of world economic growth expectations and forced liquidations from capital raising financial institutions abroad.

Although the so called food and energy driven “Inflation” (defined by mainstream as rising prices-which is not the true definition) had been somewhat a contributor, as a market driver, it signified a minor role relative to the above, but had immense political coverage or impact. Thus, in terms of easy to sell explanations for a consuming public that buys on the appeal of oversimplified information, the mainstream news accounted for what is popular backed by experts who fed on such fallacious biases (confirmation bias).

Since currency valuation comes in “pairs” or is a zero sum pricing dynamic (one advances, the other declines), the proper approach should be to cover similar variables of the nations being compared with, in assessing currency or asset pricing. You cannot deal with one factor without assessing the other because pricing comes in “pairs”.

Recently the easy and popular explanation had been- fiscal prudence relative to national balance sheets are likely to be sacrificed in order to mitigate social and political pressures arising from high food and energy costs. Thus, the fiscal costs amounts to balance sheet expansions which means rising interest rates at the expense of economic growth and the corresponding deterioration of asset valuations.

The ADB July Bond Monitor shows of the Asia’s net food and petroleum trade (right) and importantly the fiscal balance in % of GDP on the account of today’s “inflation” (see left).

The chart shows of the deterioration of fiscal balance even with the recent government actions of targeted subsidies for the Philippines as only 1% of the GDP even in the environment where the country would have to import more petroleum and food at the expense of its trade account.

But the US budget deficit projections calculated on February alone had been $410 billion for 2008 or 2.7% of GDP due to increased federal spending (yahoo).

Notwithstanding, the recent deterioration in tax revenues or collections has been putting a strain on financing the present government expenditures which has also been exacerbating the pressures of additional budget deficits especially under today’s recessionary environment. As discussed in our previous article Has The Underperformance of Philippine Markets Been Due To Policy Credibility?, the Nelson Rockefeller Institute has identified 36 states undergoing recession, which has been contributing to state budget deficits.

In addition, the present structure of US government debts have been mostly in short term instruments. Rising yields are likely to increase the costs of financing of its domestic spending requirements. Thus, the cost of financing is likewise a potential added burden for US taxpayers.

Moreover, the fiscal and monetary costs of nationalization of financial institutions, e.g. IndyMac- where the estimated costs of the Federal Deposit Insurance Corp (FDIC) takeover is $4-$8 billion (latimes) while 2 more banks were recently added to that casualty list (more of bank takeovers risks depleting the $53 billion insurance fund of the FDIC), the recent $168 billion national stimulus (with prospects of possibly more stimulus-William Gross of PIMCO is asking for $500 billion more!) and the provision of bridge financing to key financial institutions (recently including Fannie Mae and Freddie Mac) suffering from both an illiquid environment and potential insolvency.

Figure 3: Heritage Foundry: A Nation of Entitlements

It doesn’t end here. The US also bears the costs of its exploding unfunded entitlement programs which seem to likewise jeopardize the balance sheets of the Federal Government, see Figure 3.

According to the Heritage Foundry (highlight mine), ``The U.S. spends a total $1.2 trillion on the Big Three entitlement programs ($581.4 billion on Social Security, $370.8 billion on Medicare, $291.2 billion on Medicaid).”

So it isn’t as simple as inflation here should weigh on the Peso and financial assets-blah blah, because all the abovementioned costs have been a huge onus to the US economy relative to the problems in the Philippine setting.

Even in the spectrum of purchasing power, the Economist’s Big Mac Index (discussed on my recent post) shows that Asian currencies are terribly undervalued relative to the US dollar, which means that the prospects for the Peso to advance alongside its neighbors is quite compelling.

Philippine Economy: The Micro Impact of Inflation, Bullish on the Peso

``Thinking is the hardest work there is, which is probably the reason why so few engage in it."-Henry Ford

Perhaps Stephen Jen of Morgan Stanley has read our arguments and has written an article providing an academic cover for our view. He says which I quote,

``whether inflation is positive or negative for long-term economic growth depends on whether money is a substitute (a store of value) or a complement (a medium of exchange) for physical capital.

``This theoretical debate can only be settled by statistics. Here are some key statistical facts about this relationship:

``-No clear systematic relationship between inflation and long-term growth. Unlike the Phillips Curve relationship, and contrary to popular presumption, the long-term statistical relationship between inflation and growth has been rather unstable and inconsistent, over the past decades, and across countries. There were episodes of high inflation and high growth, as well as high inflation and low growth.

``-High inflation (15-30%) was often accompanied by high economic growth. When inflation rates breach 40% or so, inflation is almost always bad for growth. However, inflation of around 15% has historically not been particularly problematic for economic growth. In the 1960s, Asia and Latin America experienced high growth-high inflation phases. Per capita income growth in these countries actually accelerated when inflation rose from single-digit to double-digit levels. Further, such a state had been sustained for a long time without major disruptions. Even now, China and India’s rapid economic growth rates are accompanied by rising and high inflation, with no apparent extreme tensions in the economies.

``-Inflation reduction has output costs. Stabilisation of hyper-inflation has had no major output losses. But reducing inflation from ‘high’ to ‘moderate’ has led to costly output losses. The experience of the US under Fed Chairman Volker – with the US economy going through a recession and a period of high unemployment to bring down inflation – is particularly representative of this process.

So in effect, the impact of inflation depends on the policies of balancing the economic growth aspects relative to the risks of inflation and can be assessed only from a micro angle or from a case to case basis and not from wholesale assumptions, see figure 4.

Figure 4: ADB Change in Inflation and Output growth (in basis point)

The ADB chart exhibits the trade-offs between more inflation and less output across the region’s economies. Each country has different impacts to the problem of inflation.

Mr. Jen concludes (highlight mine), ``The role of fiat money is key in determining whether this relationship is positive or negative. For some EM economies, this relationship could be positive, justifying central banks protecting growth and allowing inflation to rise. Investors should be aware of the risk of EM central banks having a moratorium on inflation-targeting.”

As we commented last week in Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation where popular inflation indicators seem to be on the mend as declining food and oil prices across the board signifies a decline in global economic growth than from government policies, the recent substantial broad based food and energy declines abroad confirm these trends as recently posted Why Food Inflation Will Ease Over The Interim (in pictures).

Moreover, market signals combined with political pressures have been putting the lid on these pressures too. We are seeing more and more efforts from the private sector in response to market signals to increase supply as the “Adopt a Farmer” by some business and socio civic groups.

Figure 5 ADB: Updated Food and Energy Weightings in CPI basket

Remember principally it is rising food prices creating the inflation hysteria, see figure 5. The pain comes from food (46.6% of CPI) and not much from fuel (2.4%). This explains why car sales remain firm despite the rising cost of fuel contrary to popular wisdom as projected by media.

The Bangko Sentral ng Pilipinas (BSP) also holds sway on the direction of the Peso and financial markets. If the BSP manages to increase rates enough to close the real rates gap, then it is likely that the currency yield arbitrage, aside from reducing imported inflationary pressures are likely to attract foreign investors back to the market.

Relative Economic Growth, Lack of Access to Capital and Global Depression

``With greater wealth comes greater responsibility. This is inescapable. Wealth has a social function. If you own something, you must make decisions about how to use it. Consumers are always bidding for either ownership or the use of your assets. Ownership therefore has a price. If you do not respond to the offer, you are paying this price. You are paying the price in the form of forfeited opportunities. Whatever you do with the wealth, you could be doing something else with it. You cannot escape the responsibility of not doing something else with whatever you own.”-Professor Gary North, Honeymooner Politics

It can’t be an argument from the economic growth perspective too…

Figure 6: IMF: WEO Presentation: Economic growth decelerates Around the Globe

Even as global economic growth has moderated to 4 ½ in the first quarter of 2008 down from 5%, such growth clip is expected to decline further to 4.1% in 2008 and 3.9% in 2009, according to the IMF.

From the IMF’s World Economic Outlook update (emphasis mine),

``Growth for the United States in 2008 would moderate to 1.3 percent on an annual-average basis, an upward revision to reflect incoming data for the first half of the year. Nevertheless, the economy is projected to contract moderately during the second half of the year, as consumption would be dampened by rising oil and food prices and tight credit conditions, before starting to gradually recover in 2009. Growth projections for the euro area and Japan also show a slowdown in activity in the second half of 2008.

``Expansions in emerging and developing economies are also expected to lose steam. Growth in these economies is projected to ease to around 7 percent in 2008–09, from 8 percent in 2007. In China, growth is now projected to moderate from near 12 percent in 2007 to around 10 percent in 2008–09.”

In short, despite the moderating pace, the economic growth differentials are still tilted towards in favor of emerging market economies (see left pane in Figure 6).

Moreover, we can hardly buy the arguments from the deflationist proponents of a world depression or near depression see figure 7.

Figure 7: ADB: Asia’s Household Indebtedness

ADB’s data shows of the dearth of leverage or indebtedness of the household sector, which reinforces our supposition of the insufficient access to the banking system by a large segment of the Philippine economy. Similarly this represents both as a shortcoming and as an opportunity (huge growth area).

If the banking system, the main conduit for finance intermediation, has relatively low exposure, it explains why the Philippine capital market likewise lags the region or for most of the world.

It also gives credence to the outlook that a large section of the economy is levered to informal financing channels.

Basically Indonesia and the Philippines could be deemed as primeval cash based society. It also demonstrates why both countries have lagged in the aspects of developments simply because of the lack of access to capital and to paucity of sophistication to lever and recycle capital.

Figure 8: ADB: Public Sector and External Debt as % of GDP

External and Public sector Debt for most of Asia has likewise been materially improving. But the Philippines has the worst position among the peers but has likewise shown significant progress.

Of course past performance may not repeat in the future given the deteriorating conditions abroad, but given the composite framework of the Philippine economy or financials, we need to be substantially convinced of how a depression in the US will result to a depression in the Philippine economy or in Asia. We have discussed in details such linkages in ‘Is the Philippines Resilient Enough to Withstand A US Recession?’.

We also don’t share the view that advanced economies will RECOVER first given the so-called belated effects of an economic growth slowdown contagion to Asia or to emerging markets.

The reason is that the US or UK or countries presently scourged with the deleveraging process is a systemic impairment which will take a longer period for convalescence or for market clearing. Whereas Asia or emerging market’s bear market comes about from the trade and financial nexus with these economies and has not yet been a structural problem (YET).

As a reminder, from every cycle emerges a new market leader, e.g. in the US, the technology sector 1990s-2000 and financials and housing in 2003-2007 (today the energy sector appears to be at the helm) and it is likely that once a recovery phases there will likewise be a new market leader (perhaps the next bubble). And our likely candidate emanates from Asia or emerging markets.

To elaborate further, monetary inflation has been a process INTRINSIC to the fiat paper money/currency standard. Since the impact of inflation is always never equal, it gets to be absorbed in different points of the economy at different times.

For instance in 2003-2007, most of the inflationary actions by global monetary authorities got absorbed in the real estate sector backed by financial securities (structured finance, derivatives, mortgages backed securities, etc…).

Aside, the spillover from these actions led to global arbitrages which spurred a phenomenon of price values of stocks, emerging market debts and commodities.

But since the advent of the global credit crunch, much of the real estate financed securities have been deflating, thus, the inflation absorption has shifted towards hard assets. Hence, the accentuated surges in food, energy and commodity prices (which is why it gets political mileage). Now that commodity and oil prices are in a respite, our suspicion is that some asset classes are likely to takeover or benefit from these relative price adjustments or the rotating inflation.

Remember, these processes won’t come to a halt, especially under political imperatives to save the system or the poor or the society or the economy. There will always be some justifications (cloaked by technical jargons-or ‘intelligent nonsense’ as Black Swan savant Mr. Nassim Taleb would say) for such politically based actions.

Overall, if the popularly held inflation menace will be less of a threat to the global economy, aside from global markets having priced in MOST of the decline in economic growth aspects as reflected in the financial markets (markets indeed serve as great discounting mechanism) then it is likely that we should see the rotation of this inflationary assimilation into new conduits; let me guess-Asia.

Burgernomics: Where is the world’s most Expensive and Cheapest Big Mac? Peso one of the world’s cheapest.

The Economist magazine has used its premier product the Big Mac, which is served in McDonald’s 31,000 outlets in 119 countries, to gauge on a domestic currency’s purchasing power against the US dollar. These are applied to nations where McDonald's has existing branches.

So where is the cheapest and most expensive Big Mac?

Courtesy of the Economist

The most Expensive are found mainly in European countries, while the cheapest are in Asia.

According to the Economist, ``Many of the currencies in the Fed's major-currency index, including the euro, the British pound, Swiss franc and Canadian dollar, are overvalued and trading higher than last year's burger benchmark. Only the Japanese yen could be considered a snip. The dollar still buys a lot of burger in the rest of Asia too. China's currency is among the most undervalued, but a little bit less so than a year ago.”

For a little technicality on how they arrived at this comparative, we will further excerpt the Economist (highlight mine),

``The Big Mac Index is based on the theory of purchasing-power parity (PPP), which says that exchange rates should move to make the price of a basket of goods the same in each country. Our basket contains just a single item, a Big Mac hamburger, but one that is sold around the world. The exchange rate that leaves a Big Mac costing the same in dollars everywhere is our fair-value yardstick…

``PPP measures show where currencies should end up in the long run. Prices vary with local costs, such as rents and wages, which are lower in poor countries, as well as with the price of ingredients that trade across borders. For this reason, PPP is a more reliable comparison for the currencies of economies with similar levels of income…

``If that judgment is right, the squalls stirred up by the credit crises have moved at least one currency—the world’s reserve money—closer to fair value. Curiously the crunch has not shaken faith in two currencies favoured by yield-hungry investors: the Brazilian real and Turkish lira. These two stand out as emerging-market currencies that trade well above their Big Mac PPPs. Both countries have high interest rates. Turkey’s central bank recently raised its benchmark rate to 16.75%; Brazil’s pushed its key rate up to 13% on July 23rd. These rates offer juicy returns for those willing to bear the risks. Those searching for a value meal should look elsewhere.”

Courtesy of the Economist

So where does the Philippines stand?

At 44.5 per US dollar, the Philippine Peso, as measured from the Big Mac Index above, shows of a notable discount of FORTY FIVE percent against the US dollar.

The Peso is one of the cheapest after Malaysia (-52%), Hong Kong (-52%), China (-49%), Thailand (-48%), Sri Lanka (-47%) and at par with Pakistan (-45%).

This means if we take heed of the Economist advice of “PPP measures show where currencies should end up in the long run”, the Peso and most of the currencies mentioned above are likely to appreciate significantly over the longer term (all things being equal).

Another aspect worth to consider in the Economist article is that currencies of high interest rates countries such as Brazil’s Real and Turkey’s Lira appear to remain unaffected by the credit crunch.

Translation: Global liquidity appears to remain abundant enough to lure global investors towards selective high yielding "high risk" currencies.

Yes, the risk aversion has increased, but apparently the chase for yields has NOT entirely vanished.

Why Food Inflation Will Ease Over The Interim (in pictures)

Rising costs of food has recently caused a stir around the world.

According to the Economist,

``THE soaring cost of food and fuel is a concern for the governments of rich and poor countries alike. Many households in Africa and Asia shell-out more on food and fuel as a share of total spending and so are disproportionately hit by rising prices. But in some poor countries fuel subsidies help to ease the pain.”

courtesy of the Economist

The charts below, courtesy of ino.com, shows why food inflation is likely to subside over the near term…

A breakdown in Rice Prices...

Also in Wheat....

Likewise in soybeans…

And in sugar…

So while you can expect government statistics to nudge lower, politics will remain at a pitch high.

As a reminder, declining food prices reflect moderating economic activities globally and has not been prompted by policymakers.

From New Scientist: The Ten Commandments of Race and Genes

Some interesting science trivia on race and genetics. The message is that cognitive biases also apply to this field.

From New Scientist, the 10 guiding principles or the “ten commandments” for geneticists in dealing with issues of race, genetics and medicine.

1. All races are created equal

No genetic data has ever shown that one group of people is inherently superior to another. Equality is a moral value central to the idea of human rights; discrimination against any group should never be tolerated.

2. An Argentinian and an Australian are more likely to have differences in their DNA than two Argentinians

Groups of human beings have moved around throughout history. Those that share the same culture, language or location tend to have different genetic variations than other groups. This is becoming less true, though, as populations mix.

3. A person's history isn't written only in his or her genes

Everyone's genetic material carries a useful, though incomplete, map of his or her ancestors' travels. Studies looking for health disparities between individuals shouldn't rely solely on this identity. They should also consider a person's cultural background.

4: Members of the same race may have different underlying genetics

Social definitions of what it means to be "Hispanic" or "black" have changed over time. People who claim the same race may actually have very different genetic histories.

5. Both nature and nurture play important parts in our behaviors and abilities

Trying to use genetic differences between groups to show differences in intelligence, violent behaviors or the ability to throw a ball is an oversimplification of much more complicated interactions between genetics and environment.

6. Researchers should be careful about using racial groups when designing experiments

When scientists decide to divide their subjects into groups based on ethnicity, they need to be clear about why and how these divisions are made to avoid contributing to stereotypes.

7. Medicine should focus on the individual, not the race

Although some diseases are connected to genetic markers, these markers tend to be found in many different racial groups. Overemphasising genetics may promote racist views or focus attention on a group when it should be on the individual.

8. The study of genetics requires cooperation between experts in many different fields

Human disease is the product of a mishmash of factors: genetic, cultural, economic and behavioral. Interdisciplinary efforts that involve the social sciences are more likely to be successful.

9. Oversimplified science feeds popular misconceptions

Policy makers should be careful about simplifying and politicising scientific data. When presenting science to the public, the media should address the limitations of race-related research.

10. Genetics 101 should include a history of racism

Any high school or college student learning about genetics should also learn about misguided attempts in the past to use science to justify racism. New textbooks should be developed for this purpose.

The Stanford group didn't always agree when coming up with these ideas. Predictably enough, the biomedical scientists tended to think of race in neutral, clinical terms; the social scientists and scholars of the humanities argued that concepts of race cannot be washed clean of their cultural and historical legacies.

But both groups, according to the letter, recognise the power of the gene in the public imagination and the historical dangers of its misrepresentation as deterministic and immutable.

Global Markets: Oil-Inflation-Market Correlationship…Where?

``Don't try to buy at the bottom and sell at the top. It can't be done except by liars.” -- Bernard M. Baruch (1870-1965), Financer, Speculator Statesman and Presidential Adviser

And they said the Phisix’s fate belonged to oil prices.

The prevailing perspective: high oil and food prices (or consumer goods inflation) = low stocks prices. Alternatively, lower oil and food prices should translate to high stock prices. It’s as simple as that.

Well, world oil prices got whacked this week, and along with it the broader commodity sector. Instead of a shindig, the Phisix got thrashed- down by 2%. We were not alone though. Except for India and Vietnam, virtually all of the Asian markets got crushed too. So misery loves company.

It’s a mix picture elsewhere. US and Latin American stocks were in a bacchanalia while most of Europe was mixed. Middle East and African stocks were mostly lower.

Figure 1: stockcharts.com: Oil and Stocks

Figure 1 shows of how world markets reacted to falling oil prices. While major benchmarks were up (center window) along with many emerging markets (lowest pane), the broadbased weakness in Asia was pronounced (FSEAX-Fidelity Southeast Asia- pane below center window and Dow Jones Asia-pane below FSEAX).

So the single dimension “cause-and-effect” deduction does not square up with facts. What is popular doesn’t mean it is real.

Inflation: Myths And Beneficiaries

``Inflation is socially disruptive in that the management of fiat money — as all today's currencies are — causes great hardships. Unemployment is a direct consequence of the constantly recurring recessions. Persistent rising costs impoverish many as the standard of living of unfortunate groups erodes. Because the pain and suffering that comes from monetary debasement is never evenly distributed, certain segments of society can actually benefit. Ron Paul Challenge to America: A Current Assessment of Our Republic

It is commonly thought that consumer goods and services inflation is bad for EVERYONE. While inflation represents as stealth tax and is bad for the society from a generalized perspective, on a relative basis some groups benefits from inflation more than the others.

To quote Ludwig von Mises Institute President Lew Rockwell (highlight mine), ``For most people, it is seen the way primitive societies might see the onset of a disease. It is something that sweeps through to cause every kind of wreckage. The damage is obvious enough, but the source is not. Everyone blames everyone else, and no solution seems to work. But once you understand economics, you begin to see that the value of the money is more directly related to its quantity, and that only one institution possesses the power to create money out of thin air without limit: the government-connected central bank.”

So when you see people on the streets scream for price controls, in the understanding that “inflation” is caused by anything BUT the government themselves. They mistakenly believe that government can control the economic laws of demand and supply by intervening in the markets.

And you have politicians pretending to address “inflation” with even more interventionist “inflationary” actions, from Ludwig von Mises in Economic Freedom and Interventionism (emphasis mine), ``To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase. They put the responsibility for the rising cost of living on business. This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices.”

Therefore, inflation is fundamentally ALL ABOUT GOVERNMENT, whether it is caused by monetary expansion (Milton Friedman-“always and everywhere a monetary phenomenon”) or government spending (Dr. John Hussman- “government spending expansion, regardless of the form, will tend to raise the marginal utility of goods and services while lowering the marginal utility of government liabilities…but as long as a government appropriates goods and services to itself in return for pieces of paper that compete as stores of value and means of exchange in the portfolios of investors, you'll get inflation”).

Under a free market environment, marginal utility-satisfaction of consumers from consuming one or more unit of goods or services (investopedia.com)-imbalances via supply constraints or unfulfilled demands or generally “relative prices” are usually temporary and resolved by market forces, through the natural adjustments in production and consumption guided by market prices.

Thus, the prolonged nature of imbalances or the popular known “inflation” are nonetheless caused by distortions on the public’s marginal utility by government instituted policies, spending and or money expansion.

Remember, the MISMATCH OF INCENTIVES that guides government actions (preservation of political power or non-economic motives) and the general public (economics) reinforces the inflationary dynamics within a society.

A very lucid example is the biofuel subsidies in the US which have been meant to promote agri based (corn) feedstock biofuel as alternative energy source in order to reduce dependency of fossil fuel.

The subsidies had been political in nature, i.e. promoted agri industries (and its corresponding voters and political financiers) at the same time aimed to reduce the political power of unfriendly oil exporting nations by reducing revenues via lower US imports, but this came at the expense of public as an unintended outcome, i.e. through higher world food prices due to reduced acreage for food. The Guardian reports that a soon to be released study from the World Bank discloses the impact of such subsidies to as much as 75% of price hikes in food! Yeah, government knows what is best right?

Today’s monetary architecture has the de facto US dollar “paper” standard system as the ultimate source and transmitter of world inflation, especially punctuated under today’s globalized or more integrated financial landscape compounded by cumulative effects of currency pegs/US dollar links or monetary structure by many countries aside from the disparate policies (fiscal and monetary) of each nation.

While globalization has its benefits (see recent post Globalization Highlights From Past To Present), it has equally carried over some of the imperfections.

So who benefits from inflation?

Primarily the government. Political pressures from the public for government to intervene in the marketplace mean further empowerment of governments (of course the politicians and the bureaucracy).

This means more government spending or roots for added inflation in the future. Example, because of the Rice crisis, the Philippine agricultural department is asking for an additional/supplemental budget of Php 15 billion (US$337 million) allegedly “to help farmers and consumers” (inq7.net). More long term distortions in the marketplace, yet more potential loopholes for corruption for the purpose of short term mitigation.

Second, the affiliates of government or economic agents that deals directly with the government. The Banking industry, for instance, as primary agents for the fractional reserve banking system has been a recipient of “privileged deals” from the US Federal Government at the expense of US taxpayers. Think the Fed engineered JP Morgan’s takeover of Bear Stearns.

Or how about today’s Fannie Mae and Freddie Mac (F&F) episode; the recent rescue of the GSEs highlights the chain of special “political” connections by the Federal government-banking-mortgage industry.

Figure 2: US Global: World Holdings of US Long Term Agency Debt

From RGE Monitor’s Nouriel Roubini (hat tip: Craig McCarty), ``The existence of GSEs and the implicit subsidy that they provide to the housing sector and mortgage market is a major part of the overall U.S. subsidization of housing capital that will eventually lead to the bankruptcy of the U.S. economy. For the last 70 years investment in housing – the most unproductive form of accumulation of capital – has been heavily subsidized in 100 different ways in the U.S.: tax benefits, tax-deductibility of interest on mortgages, use of the FHA, massive role of Fannie and Freddie, role of the Federal Home Loan Bank system, and a host of other legislative and regulatory measures. The reality is that the U.S. has invested too much – especially in the last eight years – in building its stock of wasteful housing capital (whose effect on the productivity of labor is zero) and has not invested enough in the accumulation of productive physical capital (equipment, machinery, etc.) that leads to an increase in the productivity of labor and increases long run economic growth. This financial crisis is a crisis of accumulation of too much debt – by the household sector, the government and the country – to finance the accumulation of the most useless and unproductive form of capital, housing, that provides only housing services to consumers and has zippo effect on the productivity of labor. So enough of subsidizing the accumulation of even bigger MacMansions through the tax system and the GSEs.” (emphasis mine)

Not to mention that Freddie Mac and Fannie Mae (F&F) officials spent $170 billion during the last decade in lobbying to the US Congress to maintain such privileges. Corruption-free First World Economies? You must be joking.

The “too big to fail” rational has likewise been used as justification to shore up the ailing GSEs. This from CBS Marketwatch, ``[Treasury Secretary] Paulson said the global reach of Fannie and Freddie necessitated unprecedented action.” (highlight ours) Figure 2 from US Global funds shows of the extent of foreign ownership of Agency (F&F) Bonds.

Again this lends credence to our view that the US government’s continues to rely heavily on foreign financing and trade to buttress their economy even under today’s depressed post-bubble conditions. The problem is sustainability.

As CFA’s Brad Setser warns, ``The costs of a system that channeled huge sums of emerging market savings into the US real estate market — contributing to a bubble in US housing that is now collapsing, at a significant cost to all involved (private market players who bet that housing would only go up, the US government, and emerging market governments who bet on the dollar) and now a surge in inflation in the emerging world — are now quite apparent. It has produced a massive misallocation of resources on a global scale…And it now seems that this game will break down on the US end before it breaks on the emerging market end. The Agencies will run out of equity before central banks lose their willingness to buy Agency paper.” So will deflationary pressures in the US financial system cause a run in the US dollar?

The third beneficiary will be debtors over creditors. Creditors will be paid with depreciated currency. The public’s incentive will be to save less and consume more and consume today by borrowing more. In effect, inflation is a redistributive process of transferring real wealth from creditors to debtors. And once inflation begins to bite, people will call on government demanding compensation, aid and safety nets as we are seeing today.

Of course, the biggest beneficiary of inflation should be the biggest debtor, to quote Austrian economist Hans Senhholz in 2005, ``The biggest debtor also is the biggest inflation profiteer. With some eight trillion dollars in debt [$9,521,842,618,777.96 as of July 20, 2008 from brillig.com-mine], the Federal Government is by far the biggest winner. In fact, it gains not only from debt depreciation, which at just three percent amounts to some $240 billion every year, but also from Federal Reserve money and credit creation that enables the U.S. Treasury to suffer annual budget deficits of some $500 billion a year.”

In addition, liabilities from Medicare, Medicaid and Social Security and other welfare promises add up to $59 trillion (wikipedia.org) or $85.6 trillion (Federal Bank of Dallas President Richard Fisher).

Whereas foreign ownership of US debts have swelled over the years, this from wikipedia.org (emphasis mine), ``The US debt in the hands of foreign governments is 25% of the total, virtually double the 1988 figure of 13%. Despite the declining willingness of foreign investors to continue investing in US-dollar–denominated instruments as the US Dollar has fallen in 2007, the U.S. Treasury statistics indicate that, at the end of 2006, foreigners held 44% of federal debt held by the public. About 66% of that 44% was held by the central banks of other countries, in particular the central banks of Japan and China.”

So the likely path for the US government, as the biggest debtor, is to inflate its way out of its debts. And this we believe is functional seen via the transmission mechanism of currency pegs and US dollar links which aims to transmit stimulative policies to emerging markets see Reverse Coupling, Inflation From The Core and Current Account Deficits.

The fourth beneficiary are the industries that benefit from cross price elasticity of demand (about.com), ``the rate of response of quantity demanded of one good, due to a price change of another good. If two goods are substitutes, we should expect to see consumers purchase more of one good when the price of its substitute increases. Similarly if the two goods are complements, we should see a price rise in one good cause the demand for both goods to fall.” In short, substitution dynamics on the demand side arising from prices changes.

For instance, under high oil prices scenario, the tendency is for people to go for fuel efficient cars or bicycles or use more of public transportation as the preferred mode for transit.

This means that sales of big SUVs could be expected to decline (as it has been in the US) while smaller fuel efficient car industry sales, bicycle industry sales or public transportation revenues can be expected to rise.

But a caveat here, mainstream media suggests that the Philippines have met the threshold level of pain from energy prices enough to tilt the balance of car sales.

Look at this seemingly biased headline, “Soaring oil prices pull down June car sales”

From abs-cbnnews.com, ``Series of surges in fuel prices in the country have made their mark on automobile sales as car buyers shift from gas-guzzling and full-sized sport utility vehicles to economical and dual-purpose automobiles, the Chamber of Automotive and Manufacturers of the Philippines, Inc. and the Truck Manufacturers Association said in their joint report.

``The sales report showed that vehicle sales sustained their strength in the first-half of the year despite rising fuel prices, carrying a growth of 13.6 percent with 54,257 units sold to 61,654 units during the same period of 2007. But sales beginning in the month of June 2008 dwindled compared to the month of May, its second monthly decline for the year.

``June 2008 sales accounted to 10,772 units, 1.2 percent lower than the 10,900 sold in May. Sales, however, were still up 10.6 percent compared to the same month last year, which had 9,737 vehicles.”

Why biased? The article seems to give weight to the outcome from the reference point of month-to-month sales rather than from the year-on-year or from first half of the year sales in making such conclusions.

In other words, the article’s headline wants to reinforce the popular view that rising oil prices are having a big NEGATIVE impact on car sales, which is obviously NOT the case!

In nominal terms, June sales compared to May was 128 units lower compared to the 1,035 cars sold more relative to June of 2007. Common sense tells us that 1035 is almost 7 times greater than 128. To add, over the first semester, car sales had been up 7,397 units or an average of 10,275 units per month compared to last year’s 9,043 units per month!

So while the rate of change may be indeed by marginally decelerating, it isn’t enough to justify on the generalization that car sales were being NEGATIVELY impacted by rising oil prices!

But relative to cross price elasticity we see a confirmation of this phenomenon, `` shift from gas-guzzling and full-sized sport utility vehicles to economical and dual-purpose automobiles.”

And it goes the same way with the Philippine economy.

News accounts portray the Philippines in a helpless quagmire given the phenomenon of rising food and fuel prices. For me, such perspectives are politically designed-they are meant to either encourage government intervention or portray the incumbent as inept.

But if we examine the structural composition of the Philippine economy (as previously discussed in A Prospective Boom in Philippine Agriculture!) where agriculture accounts for about 36% of employment, 25% of exports and 16% of GDP, operating under a huge 13 million hectares (Food and Fertilizer Technology Center or agnet.org), booming agricultural prices (a.k.a. inflation) should translate to booming income for the rural farmers (ceteris paribus or all things being equal)!

Stated differently, while food prices are expected to hurt the urban poor, rural folks could be expected to benefit from rising food or agri prices.

Anyway as discussed in Politicking Weighs On Phisix, Inflation Problems Have Been Policy Induced with an accompanying chart from ADB’s Hyun H. Son, while the Poor’s expenditures for food accounts for nearly 50% of income, fuel related expenditures account for about 4% (2.5% for nonpoor), which extrapolates that food prices are having much greater impact to inflation figures more than oil prices.

As we have previously argued it is not high oil prices per se but the accelerated rate of change of oil prices that is having an impact on consumer sentiment or psychology. But overall, food is the most sensitive of all variables.

This also means that the “food inflation” menace looks likely a temporary phenomenon given the sudden shocks arising from the severe policy impelled distortions (e.g. trade prohibitions and subsidies) in the marketplace, as high “food” prices will lead to rising investment expenditures either from the government itself (e.g. nearly $1 billion in subsidies for fertilizer, rehabilitation of irrigation systems and post harvest facilities and high yielding rice varieties) or from the private sector (e.g. San Miguel-Kuok $1 billion venture) to the agricultural industry.

So from the standpoint of the incentives of political survival through government action to economic feasibility projects by the private sector all direction points towards massive investments in the agricultural industry, which should translate to higher supply in the future or lower statistical inflation data.

As aptly quoted by India’s Economic Times, ``"In virtually every country, there’s a recognition that they’ve got to increase investments in agriculture," said Robert Zeigler, director general of the Philippines-based International Rice Research Institute, which helped launch the green revolution.”

Thus while inflation is generally bad for the society because it robs the currency of its purchasing power which effectively depresses economic activities, some sectors actually benefits from the adjustments under such environment.

Hence, investing under such scenario should be selective. The notion that “inflation” is bad for all investments is a cockamamie.

Philippine Economy: World Financial Markets Allude To Diminishing Risks of Inflation

``Inflation is like sin; every government denounces it and every government practices it."- Frederick Leith-Ross, famous authority on international finance

We have been pounding on the table for the Bangko Sentral ng Pilipinas (BSP) to raise interest rates because of the external inflationary impact to the local economy (academic vernacular-cost push inflation), and true enough our BSP responded by raising 50 basis points to its policy rates to 5.75% but still way below the rate of inflation to suggest that Philippine monetary environment remains accommodative.

As we have argued in Has The Underperformance of Philippine Markets Been Due To Policy Credibility?, ``It would be a better option for the BSP to raise interest rates and reduce the negative real rates environment if they aim to defend the Peso and contain the consumer goods and services inflation pressures. But if the BSP is concerned about the impact to economic growth from higher interest rates, the market is doing it anyway for them through higher yields in domestic treasuries and from rising consumer prices. By closing the real rates gap at least they can’t be held solely responsible for “bad” policymaking.”

Domestic sovereign yields in local currency and have climbed enough to render a policy reaction or response from our BSP in spite of the IMF’s prodding. As we learned from Nassim Taleb of the Black Swan fame, policymakers are always reactive agents.

While the BSP continues to expect higher “inflation” over the rest of the year, it is likely that consumer price and goods inflation, which does NOT move in a straight line, has already peaked for this cycle.

Why?

Figure 3 stockcharts.com: Inflation Pressures Likely To Ebb

One, the decline of oil prices seems representative of a global growth slowdown as shown in Figure 3.

WTIC oil prices fell by 11% over the week below the $130 threshold crossing over the 50 day Moving Averages, which suggests that Oil is in a CORRECTIVE MODE which may last sometime.

Remember correction mode is a different animal from a Bubble bust; it is my belief that unless governments liberalize or open the oil industry by allowing increased private sector access to geological areas for exploration, or unless technology induced revolution via alternative energy that should gain the required economies of scale or unless innovative radical drilling equipments or rigs for non-conventional oil wells are introduced, oil supply will remain under pressure from declining major wells in spite of softening demand and thus put a floor on oil prices.

According to teachitworld.com ``Oil production is decreasing in 54 of the world’s top 60 oil-producing nations, including Britain (North Sea output, which peaked in 1999, has now plunged by more than half). The overall amount discovered has been falling for 40 years; easily reached oil fields are being depleted; untapped reserves are often small and hard to exploit. Many experts expect non-Opec production to peak around 2010; outside the cartel, the best hope is said to lie under the Arctic – but reserves are thought to be relatively limited, and conditions are horribly hostile.”

History has its lessons. In 2006 oil prices fell by 40% or from $80 to $50 (blue arrow) yet nearly tripled to hit $147.9 per barrel last July 11^th, from the trough of two years ago.

Two, it’s not only oil but apparently most of the commodity spectrum. The broad decline in commodity sector has likewise been reflected in the CRB index (lowest pane), while the softening of Dr. Industrial metals as shown by $GYX (pane below main window) seem indicative of slowing demand from emerging economies.

In consonance, the steep fall in WTIC Crude relative to the European benchmark Brent Crude (down only 5%) possibly signifying more economic weakness in the US. But it also suggests that Europe appears to be also losing strength.

Even the precious metal sector (above pane) has been shown in sympathy to its brethren.

Figure 4: ino.com: Softening Rice Prices

Three, with rice prices failing to breach the 50 day moving averages as shown in Figure 4, downside pressure in Rice prices means reduced “food” inflation for the Philippines or in most of the emerging world.

The infirmities in the Baltic dry Index also seems to chime in to the same tune.

Figure 5: Northern Trust: China Slows Down!

Most importantly, China’s moderating economic growth at 10.1% during the last quarter based on year to year comparison or even from first half growth of 10.4% in 2008 relative to 11.9% in 2007 (Forbes) appears to validate such thesis.

Figure 5 from Northern Trust shows of the rapidly falling rate of change in China’s real GDP aside from moderating consumer price index or “inflation”.

The declining phase in China’s economic growth suggests of a respite in resource intensive consumption, having been a major consumer of world commodities. It also suggests of a possible reprieve in rising export prices, having been the world’s second largest exporter.

It also confirms the deceleration in world trade, as one of the largest pillars of world trade and perhaps with reduced exports but with sustained outperformance of domestic demand, this should possibly translate to a slowdown in the accumulation of foreign exchange surpluses (unless speculative or hot money continues to pour in).

But if the Chinese economy decelerates further then China’s thrust to tighten might give way to policy directives towards growth (or easing bias) which may subside market expectations for the appreciation of the remimbi. This would suggest that the streak of hot money influxes could ebb.

All these adds up to a global economic slowdown which we believe has been reflected in global stock prices and should translate to lower inflation figures to the Philippine or world economy.

In the next few months, if global stock markets remain in a lackluster mode, while consumer goods “inflation” slows then the oversimplified singular causality linearly flawed inference of “high inflation equals high interest rates equals lower stock prices” will perhaps fade much like the Peso driven remittance argument of the past.

Thus the slackening the world economies are likely to magnify the downside risks of financial assets in economies that had experienced securitization backed housing boom bust cycles.

Some suggest that the next derivative pop via Credit Default Swap (CDS) would occur in Asia. We doubt this, considering the low exposure of CDS relative to US (45%) or Europe (27%) throughout the region (cumulative is 23%), with Japan accounting for about 55% of the region’s CDS, according to the Bank of International Settlements.

Although the slowing inflation backdrop will likely imply that governments, especially those exposed to the recent bust, are likely to undertake stepped up inflationary activities in the hope to “normalize” the financial system.

This in effects will breed the seeds for the next bout of inflation surges.