It is a sad fact that people are reluctant to learn either from theory or from experience. Neither the disasters manifestly brought about by the deficit spending and low-interest-rate policies nor the confirmation of my theories by such eminent thinkers as Frederick van Hayek, Henry Hazlitt and the late Benjamin M. Anderson have up to now been able to put an end to the popularity of the fiat money frenzy. The monetary and credit policies of all nations are headed for a new catastrophe, probably more disastrous than any of the older slumps—Ludwig von Mises
In this issue
Kaboom! The World Bank Warns of Hidden Risks in the Philippine Financial System!
I. Kaboom! The World Bank Warns of Hidden Risks in the Philippine Financial System!
II. Risks Can Be Transferred or Concealed But Not Extinguished!
III. Statistics are Not Financial or Economic Talismans
IV. Treasury Markets Signals that the BSP is Massively Behind the Curve, Intensifying The Risk of Policy Errors!
Kaboom! The World Bank Warns of Hidden Risks in the Philippine Financial System!
I. Kaboom! The World Bank Warns of Hidden Risks in the Philippine Financial System!
I am not alone. Even the World Bank can see through the BSP’s statistical charade.
From the ABS-CBN News, February 16:
The World Bank warned that the global economic recovery may be at risk of "financial fragility," citing rise in non-transparent debt as one of the reasons.
In the newly-released World Development Report 2022, World Bank Group senior vice president and chief economist Carmen Reinhart said "there is reason to expect that many vulnerabilities remain hidden."
"It’s time to prioritize early, tailored action to support a healthy financial system that can provide the credit growth needed to fuel recovery. If we don’t, it is the most vulnerable that would be hit hardest," she said.
The Philippines was cited as an example of countries where bad debt is becoming a problem.
"In some economies, these risks are already becoming apparent. Loan defaults have been on the rise in India, Kenya, the Philippines, and a growing number of other middle-income countries. These emerging credit risks are also reflected in the worsening outlooks of the main international rating agencies for financial institutions as forbearance policies are lifted," the report read.
Remember this write up last June?
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.
See BSP’s Confession: Leverage Represents The Key Risk Today; An Analysis of the State of Financial Stability June 13, 2021
And from last week. How relief or forbearance measures sanitize bank performance:
Yet, such profit metric represents a false equivalence compared to the past, as massive distortions from relief measures have muddied bank performance in the context of statistics.
…
The relief measures designed to boost confidence through statistical magic may have led to the interim peak in NPLs in the 4Q 2021.
However, NPLs emerged from the surge of CPI of 2017-2018, which spurred rising yields. With banks weaker today than in 2018, it would be alarming if NPLs regain their momentum.
In sum, the remarkable surge of the bank profits in 2021 signifies accounting profits from the unprecedented rescue measures instituted by the BSP to sugarcoat or deodorize the balance sheet of the banking system.
See BSP Exit Measures: More About Rhetoric Than Action; Bank Profit Zooms in 2021 Even as Core Operations Suffer Deficits! February 13, 2022
This repeat quote demonstrates how authorities publicly withhold the truth about conditions of the impaired credit of the banking system.
From a speech by the BSP Chief last January* (bold mine): "And to provide relief to beleaguered borrowers, we excluded some loans from being tagged as past due or non-performing and allowed a grace period for loan settlement and restructuring of rediscounted loans."
*Benjamin E Diokno: The COVID-19 pandemic and the economy, BIS.org, January 5, 2022
Don’t count, don’t tell. Or, since banks are permitted not to report their actual state, NPLs seem to have trended lower.
In any case, here are some poignant excerpts from the World Bank Development 2022 report authored by their Chief Economist Carmen Reinhart and President David Malpass. (bold mine)
p. xiii
What we do not yet know, however, is the extent to which governments and private debtors are harboring hidden risks with the potential to stymie economic recovery. In particular, increased complexity and opacity in sovereign debt markets (as to who holds the debt and under what terms) often make it difficult to assess the full extent of risks in government balance sheets. On the private side, common elements of pandemic response programs, such as moratoria on bank loans, general forbearance policies, and a marked relaxation in financial reporting requirements, have made it difficult to determine whether debtors are facing short-term liquidity challenges or whether their incomes have been permanently affected.
p.9
If not countered by strong bank governance, robust regulatory definitions of NPLs, and careful bank supervision, hidden NPLs can create significant discrepancies between reported asset quality figures and the underlying economic realities. A lack of NPL transparency can stand in the way of a timely identification of potential banking system stress, weaken trust in the financial sector, and lead to reductions in investment and lending, which can hinder an equitable postpandemic recovery
p. 40-41
Regulatory forbearance refers to the relaxation of regulatory requirements and accounting standards in the hope that this will make it easier for lenders to issue new credit. Although some of these policies used the flexibility embedded in existing regulatory frameworks (such as the Basel III regulations), some countries relaxed prudential regulation and accounting standards beyond the emergency measures allowed by these frameworks. This may have created some respite for banks, but could create significant longer-term risks to financial stability. Regulatory forbearance policies reduce bank balance sheet transparency by enabling banks to hide the true extent of their credit risk, delay the resolution of nonperforming loans, and ultimately weaken the ability of the financial sector to provide financing to creditworthy borrowers during the recovery. Because regulatory forbearance policies can lead to the accumulation of significant hidden credit risks, they can also place further burdens on government finances should government intervention be required to support ailing financial institutions once these risks materialize
Again from this author last August 2021…
Statistics fail to distinguish conditions before the pandemic and contemporary times.
…
Under emergency measures, regulatory conditions have drastically changed such that comparative numbers of several sectors, such as banks and the financial industry, with their pasts, are meaningless.
See A Bounce is Not a Recovery: 2Q GDP 11.8% Boom: Low-Base Effect and Government Spending Boom! August 15, 2021
It is striking that the BSP’s pantomime had to be exposed by a member of the establishment of the international order.
But what stands out is that such revelation emanates from the purview of Ms. Carmen Reinhart, an expert on debt defaults and crises. Together with Kenneth Rogoff, they are the author of This Time is Different, their quotes had been cited here on several occasions.
This World Bank critique seems also a pushback against the policy excesses of the "Best Central Banker of the World."
II. Risks Can Be Transferred or Concealed But Not Extinguished!
But here is the thing.
Risks are not extinguished by statistical camouflaging. Instead, the lack of transparency magnifies it.
The World Bank enumerated some factors that drive institutional risks from such forbearance policies: The lack of transparency increases the opacity and complexity of public balance sheets. It weakens trust that may lead to diminished investments. And it may delay the resolution of non-performing loans, thereby decreasing the capacity of financial institutions to lend to creditworthy borrowers.
But the World Bank missed the more important ones: Moral hazard, dependency, and corruption. These ethical issues may metamorphose into technical issues.
The lack of transparency may induce protected parties to indulge in unnecessary risk activities that magnify vulnerabilities, thereby amplifying institutional and systemic fragilities.
For instance, to hide existing losses, the temptation to double down on either extending loans to low creditworthy borrowers or gamble on speculative market positions becomes an attractive alternative.
Such political privileges may also entrench dependency among the beneficiaries.
Industry lobbying will likely escalate. It will insist on maintaining the status quo or warn of severe repercussions to the industry and the economy should these subsidies or privileges be eliminated.
Most importantly, the arbitrary easing of regulatory standards may encourage misdemeanors in the industry.
That’s right. When the cat's away, the mice will play.
Also, the underlying conditions from such forbearance may also promote or breed corruption in some beneficiaries and regulators.
For example, since accounting chicanery will now be recognized as official, "Cooking the books" may become the next standard. Arbitrary decisions of authorities on compliance will likely be dictated by "I scratch your back, you scratch mine."
The fundamental premise is that financial institutions have become acclimatized to the incumbent regulatory climate. It is hardly a concern here that the current standards are highly flawed and distortive, which is a topic for another day.
That said, regulatory relief or forbearance, which could account for substantial changes, are likely to alter the incentives of such institutions that should magnify operational and business contortions.
At the same time, given that authorities have empowered institutions to camouflage actual risk conditions, this infers to the vast overstatement of the so-called capital structure of banks.
Forbearance policies are also subject to the law of diminishing returns. While this may temporarily provide a cosmetic fix on the credit issues, the imbalances it accrues will eventually surface.
Such policies are barely about regulatory loopholes, which capitalism, said the great Ludwig von Mises, breathes through.
And though the banking system has some semblance of competition, it seems a cartel operated and supervised by the BSP.
Wrote the great Dean of Austrian Economics, Murray N. Rothbard**,
In short, the Central Bank functions as a government cartelizing device to coordinate the banks so that they can evade the restrictions of free markets and free banking and inflate uniformly together. The banks do not chafe under central banking control; instead, they lobby for and welcome it. It is their passport to inflation and easy money
**Murray N. Rothbard, The Mystery of Banking p.134, Mises.org
Like all politics, the fixation of the BSP and central authorities are on short-term or band-aid fixes, which are dependent on hope rather than sound economics.
III. Statistics are Not Financial or Economic Talismans
Further, embellishing statistics appears to be a current thrust by the authorities.
For example, the DoF admitted to the overstatement of the financial conditions of the State-run pension funds last December 2021, which everyone seems to have ignored as if the impact is neutral.
See Stagnation is Growth! 3Q PSEi Debt Eclipsed Revenue, Net Income Bounce! DoF Admits Financial Conditions of State-Owned Pensions Overstated! December 5, 2021
For political purposes, we suspect substantial inflation of several data such as the GDP, labor, OFW remittances, the BoP, and FDIs, among others.
Authorities also tend to understate the CPI data, crime, and other politically sensitive statistics.
But this is something we have long anticipated:
5) The last option would be for the NG and BSP to manipulate markets and statistics in the hope that the markets will conform and comply with their political targets.
[See Why Interest Rates Will Rise: 1Q Fiscal Deficit Blowout Financed by BSP’s Debt Monetization (QE) and Spiking Public Debt! May 6, 2018]
Unfortunately, statistics are not economic or financial talismans.
Reality is not an option.
IV. Treasury Markets Signals that the BSP is Massively Behind the Curve, Intensifying The Risk of Policy Errors!
What is the relationship between the World Bank’s cautionary advice on the hidden risks in the financial system and the BSP’s seemingly intractable stance of maintaining the present monetary policy?
The simple answer: Despite the massive bailouts extended by the BSP, the banking system remains highly vulnerable.
From CNN, February 17 (bold mine): The Monetary Board decided to retain policy rates at an all-time low of 2% in its first meeting for 2022, announced BSP Governor Benjamin Diokno on Thursday. This is the ninth straight meeting that rates were untouched since the surprise cut in November 2020…. "We will commit to exit when we begin to actually see, based on our assessment, evidence of a sustainable recovery or end of increasing risks to inflation. The extraordinary measures can be gradually withdrawn when it appears that actual output growth is poised to already be above its potential level and inflation will rise above its target on a sustained basis," Diokno said when asked about BSP's exit plan…"The inflation projections have slightly increased from the previous monetary policy meeting, reflecting the impact of higher domestic food inflation and global oil prices. Inflation expectations have likewise risen marginally but continue to be anchored within the target band," he said during a virtual briefing. "The risks to the inflation outlook continue to lean slightly towards the upside for 2022 but remain broadly balanced for 2023," the BSP chief added.
Why the readjusted projection by the BSP for a higher CPI?
Figure 1
The Treasury markets have been pushing back vigorously against the BSP! That is why.
The spread between 10-year Treasury rates (PDS) and the BSP official rates has soared to 2018 highs! (Figure 1, upper pane)
But there is an immense difference. Unlike in 2018, where bond yields chimed with the CPI, today, the direction of the CPI and bond rates have patently diverged. (Figure 1, lower window)
It stands to reason that a lower CPI should have brought down domestic Treasury yields, similar to 2018. This scenario represents the BSP template.
But this has not been happening.
In contrast, the widening spreads illustrate that the BSP is seriously behind the curve! Or the Treasury markets have continually rebuffed the BSP policies!
The Treasury markets imply that the odds of policy errors of the BSP have only been mounting.
Figure 2
The escalating discrepancy between the Treasury markets and mainstream opinion only underscores growing friction between reality and rhetoric.
A bearish steepening slope highlights higher inflation expectations. The 10-year 2-year spread depicts such expectations (PDS). The 10-year yield has risen faster than the 2-year yield. (Figure 2, upper pane)
On the other hand, liquidity issues continue to plague the financial system as the 20-year 5-year (BVAL) spread continues to compress. (Figure 2, lower window)
A bearish flattening curve depicts a faster increase of the 5-year treasury yield vis-Ã -vis the 20-year yield, signifying increased odds of an economic contraction. Rising 5-year yields (the belly) portend hikes in the official rates of the BSP and a possible growth slowdown.
The Philippine treasury markets are harbingers of the direction of interest rates. Yet it presages a STAGFLATIONARY outcome.
The difference between the official policy rates and market yields spurs the misallocation of resources and the misdirection of credit distribution.
The BSP previously labeled this a "mismatch."
From their 1H 2018 to 2019, Financial Stability Report (p.19): If there are risk issues to raise, it will have to be the prospects of managing liquidity. Aside from simply having more loans versus deposits, using liquid assets as a source for funding more earning assets needs our attention. However, the bigger issue will be that continuing on the path of being a bank-based financial market means that the provision of credit will require taking on mismatches in tenor and in liquidity. As more credit is dispensed, such mismatches will only increase.
Figure 3
As noted elsewhere here, the CPI spurt in 2017-2018, which fueled a spike in CPI, powered bank NET NPLs higher. That was even before the pandemic. (Figure 3)
Net NPLs have recently declined primarily because of the forbearance policies granted to financial institutions like banks, as noted by the World Bank.
While it may be true that treasury yields are still significantly below the 2018 levels, system leverage (bank credit and public debt) is 54% higher at the close of 2021 compared to the end of 2017!
The greater the scale of leveraging, the lower the capacity of the financial system to absorb rate increases or financial tightening.
The banking system undergoes a real-time stress test only when financial tightening becomes apparent.
At this point, it would be on our horizon whether the vaunted toolbox of the BSP has reached its exhaustion point or if they can still "kick the proverbial can down the road."
Our bet is on the former.
On a positive note, though rising treasury yields punish bondholders (BSP, banks, and financial institutions), it is a boon to savers (saving public or the average consumers).
This relationship will become pronounced when the "real" or inflation-adjusted rates turn positive to signify the culmination of wealth transfers!
V. The Influence of Expected Changes in US Federal Reserve Policies to the Treasury Markets
Finally, others have attributed rising yields to exogenous forces like the implied hikes of the US Federal Reserves.
Figure 4
Given that the BSP's monetary policy operates around the de facto US dollar standard, expected changes in the policies of the US Fed may indeed have some influence on the domestic Treasury yields.
But it is still current domestic inflation, inflation expectations, and credit risks that determine the path of treasury yields.
Because changes in US Fed policies may influence these domestic factors, it also contributes to the dynamics of domestic Treasury yields.
The slope of domestic yield here, represented by the 10-year PDS, resonates with its counterpart, the US 10-year Treasury. But the changes in yields of the Philippine bonds have risen faster than the UST. The USD-Php continues to climb along with the price underperformance of Philippine bonds relative to the USD. (Figure 4, upmost and middle panes)
But yields of the Philippine 10-year Treasuries have risen most in the ASEAN region from December 2020, which likely translates to a deeper influence of the US Federal Reserve policies on local developments than its regional peers. (Figure 4, lowest window)
The queer thing is the establishment experts stubbornly insist on pushing the "decoupling" agenda so ardently!
The international and domestic financial markets are about to settle this debate soon.
Yours in Liberty,
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