As the BSP Resists From Tightening, Long-Term ROP Yields Soar!

Everything is fine until inflationary pressures or something else shocks up the interest rates. And the minute they go up, it becomes obvious that government debt service has gone high enough so they will have no recourse but to have the central bank finance still more. And when that happens the writing is on the wall, the currency collapses and the inflation becomes essentially uncontrollable. This is a highly non-linear process that cannot be captured by the econometric models that are in widespread use. They are essentially linear—William R White, OECD Chairman

In this issue

As the BSP Resists From Tightening, Long-Term ROP Yields Soar!

-Monetary Policies: Limiting the Sphere of Conversation to the CPI

-The Hidden Lessons from the BSP’s Inflation Targeting

-The Peso as Exhaust Valve of Policy Errors

-ROP Yields as Indicators of Interest Rates

-BSP’s ALL or NOTHING Policies Redux

As the BSP Resists From Tightening, Long-Term ROP Yields Soar!

In line with consensus expectations, the Bangko Sentral ng Pilipinas (BSP) kept policy interest rate levels at record low for February

Monetary Policies: Limiting the Sphere of Conversation to the CPI

In predicting the BSP’s move, the focal point of the mainstream debate has always been the CPI data. For the consensus, rising CPI represents a temporal episode, thereby justifying the BSP’s stance of maintaining the current level.  On the other hand, the minority thinks that since the CPI has reached the topmost level of the policy target, the BSP should tighten to reduce risks of inflation.

The CPI is a government constructed statistic. The Philippine Statistics Authority noted that the CPI represents “a major statistical series used for economic analysis and as a monitoring indicator of government economic policy.” Being a monopoly, neither has there been competition from the private sector nor has such numbers been subjected to third-party audit to scrutinize its validity.

Needless to say, a statistic which accuracy is unclear plays a crucial role in shaping government’s economic policy. And to reinforce its importance, mainstream discussions of the prospective changes in policy have been confined to such unauthenticated spectrum

Lost in the conversation has been the necessity of the adaption of the unprecedented level of policy interest rates

In a November speech, BSP Governor Nestor A Espenilla, Jr touted*,

The Philippines is one of the world's fastest growing investment-grade economies. We registered a 6.9 percent GDP growth in the third quarter of 2017 and we have enjoyed 75 quarters of uninterrupted economic growth.  Last December, acknowledging the sustained robust growth and macroeconomic regulatory environment, Fitch upgraded the Philippines to a solid investment grade rating of BBB.

*Nestor A Espenilla, Jr: Generativity January 17, 2018 BIS.org

If the Philippines have attained “sustained robust growth and macroeconomic regulatory environment” why has the BSP’s ICU or emergency policy measures remained in place? In fact, why did the BSP cut interest rates in 2016? It is not because of the “Corridor” system which it made as justification. They could have used the 2014 rates as a baseline for the new system.

Most importantly, why the need for the permanence of stimulus? Is a person considered standing normally if he/she cannot do away with crutches?

The Hidden Lessons from the BSP’s Inflation Targeting

Will the BSP admit to the public that the National Government’s (NG) lifeblood, its revenue collection, heavily depends on the banking system’s credit growth? Will it thereby admit that raising interest rates will likely hamstring resources for public expenditures?

Will the BSP admit to the public that it is receiving interest rate subsidies through inflation targeting’s negative real rate regime? When ROPs (Republic of the Philippines treasury markets) underprice CPI, the negative spread between CPI and yields translates to an effective indirect transfer of funds to the NG. And once rates rise above CPI, not only does this signal monetary tightening but likewise translates to the end of the invisible subsidies. Will the BSP confess to this?

What are the ramifications of the sustained embrace of artificially low-interest rates?

 

Will the BSP admit to the public that by keeping interest rates below the market level, it effectively subsidizes borrowers at the expense of savers, thereby increasing systemic credit leverage?

Ever since the BSP panicked to deploy the zero bound in 2008-9 systemic credit has exploded:

Total production and consumer bank loans reached Php 6.945 trillion in 2017 which amounted to 43.95% of the Nominal GDP of Php 15.8 trillion.

Total domestic and foreign public debt tallied to Php 6.65 trillion in 2017 or 42% of the NGDP

Combined, nominal banking Loans PLUS public sector debt portfolio stood at Php 13.595 trillion which would accrue to 86.044% of the NGDP!

And that’s just part of it.

NGDP grew by 9.1% in 2017 while bank credit expanded by 18.39%. That is, for every 1% NGDP generated, 2% of bank credit growth was required.

Seen from a different lens, NGDP has become heavily dependent on bank credit growth, such that the substantial reduction in credit growth would cause NGDP (and taxes) to swoon!

And there is the asymmetric distribution of debt to consider. But we will skip this.

Needless to say, the BSP has been incorrigibly hooked or addicted to the easy money regime.

The Peso as Exhaust Valve of Policy Errors

Yet the CPI is a distraction. The PSA and the BSP can produce CPI data that would conform to its desired policy which no one would know.

Though the government may design CPI to meet its political agenda, price pressures manifest itself in many ways. These can also be seen through the financial performance of listed corporate firms or industry surveys or as political news (e.g. rising rice prices as of the moment: Inquirer.net Gov’t says rice enough but prices say otherwise February 11, 2018)

Another channel from which economics may vent a buildup of concealed imbalances is the currency markets.

Perhaps in anticipation of a possible increase in interest rates, the USD-Philippine peso fell to 51.12 a day before the BSP announcement.

But with the BSP keeping steady its policy rates, the response to the late Thursday announcement sent the USD-php surging. It tested the previous high of 51.77 in the morning. But then, a big Peso buyer/USD seller emerged during the afternoon. The entity sold the USD Php down from the 51.70s to a low of 51.43 from which it closed at 51.48, almost unchanged from last week

Sure, the BSP can intervene to prevent the USD php from rocketing, preventing a “meltdown”. But such Band-Aid treatment would have ephemeral effects that wouldn’t stop an eventual market clearing process.

Further maladjustments would be the likely outcome of bailouts. That said, market prices will again eventually adjust to reflect on the USD Php’s natural (equilibrium) levels

The USD php rose 2.73% month on month in January 2018. The BSP’s GIR for the month was down by US$ 364.3 million to US$ 81.2 billion, mainly from sales of foreign investment holdings. The BSP’s tactical support of the peso emanated from the offloading of foreign investment holdings. The increase in gold prices alleviated the GIR dilemma. The BSP also pruned their record forex asset holdings.

ROP Yields as Indicators of Interest Rates

Hidden beyond the public’s perspective have been the raging yields of Philippine (ROP) treasuries.

While the BSP has kept interest rates at present levels, ROPs have been intensely sold off which means rocketing yields.

As of Friday, both the 10- and 25-year yields spiked to 2012 levels at 6.533% and 7.016%, respectively! The 20-year yield was substantially down to 6.001% from 6.632% on Thursday. (above and bottom charts)

Although long-end yields have climbed to 2012 levels, such would account for an apples-to-oranges comparison. That’s because in 2012, yields were crumbling or bonds were bid (along with the peso and stocks). A genuine bull market would see domestic assets, specifically the peso, bonds, and stocks in a simultaneous uptrend, which is unlike today.

Present rising yields should be one for the history books. That’s because yields have risen from monumental low levels.

Moreover, a “rounded bottom” appears to be emerging from the 10-year yield trend. If validated, a secular inflection point is at hand. That is, the long-term trend of interest rates would reverse course and head upwards.

And by keeping interest rates at current levels, embedded imbalances will only mount. Thus, the BSP’s easy money regime will reinforce the formative trend dynamics.

And this process will be exacerbated by an equally significant force.

This force is no other than the political-economic transition to corporatist-state capitalism.

The umbrella of immense spending activities on socio-political programs, such as Build, Build and Build, free college, public utility and police and armed forces modernization programs, DOST’s public wifi program, enhanced conditional cash transfers, expanded bureaucracy and etc…, would compete with the private sector for scarce resources.

Such competition, known as the “crowding out” dynamic, would further inflame pressures on the ROPs and consequently interest rates

Related to the political-economic transition would be the dislocations from the structural shift in the nation’s economic profile. Aside from the BSP’s inflation tax, the main conduit for financing such lavish political spending sprees would be the expanded consumption taxes (reduced VAT exemptions and excise taxes)

The uncertainty from the displacements in the transitional economic framework should spur constraints on the liquidity environment. A good example, Coca-Cola’s response to the excise tax. [HB 10963 TRAIN’s Initial Victim: Coca-Cola Will Be Laying Off Workers! The Back Shifting Effect of Excise Taxes Validated! February 8, 2018]

The coagulation of these forces will fortify this secular trend

Pulling this all together, the end of the easy money regime has dawned.

Yes, it’s a bye bye for inflation targeting, as inflation pressures will escalate.

And it’s welcome for STAGFLATION! Stagflation is a condition of economic stagnation characterized by high inflation rates accompanied by high unemployment.

And that’s from the local dimension only.

And if the streak of rising yields around the world continues, domestic woes will be compounded. That’s because access to liquidity will become more costly even abroad!

As a matter of current events, even as yields of 10 year US Treasury notes have been surging, the ROP counterpart continues to outsprint it. (middle window)

So funds will be scarce here and abroad. And how will the record streak of deficit spending by the NG be financed?

Going back to basics, higher yields typically incorporate greater expectations of inflation pressures, a higher cumulative path of short-term rates and a term premium, viz extra yield to hold long-term bonds and credit risk premium “changes in the perceived riskiness of longer-term securities” (Ben Bernanke 2015).

As coupon rates move upwards, the influences of these forces will weigh on the BSP’s inflation targeting policies.

BSP’s ALL or NOTHING Policies Redux

And another thing.

As I have pointed earlier, the BSP’s policies signify “ALL or NOTHING” or “Winner take ALL”. In the face of a shock, it has very limited elbow room for conducting emergency operations. And thus, the BSP operates virtually with little margin for error.

Remember, the BSP has yet to normalize its emergency policies of record low-interest rates (Zero Bound Policy) and record debt monetization (Quantitative Easing/Large Scale Asset Purchases).

And as a refresher, once a slowdown in the domestic economy becomes apparent, capital flight will play a role in vacuuming up of liquidity.

And if the BSP cuts rate further and or uses its printing press to finance NG, this is when the peso MELTS DOWN! BSP on the Peso: NO “Meltdown”! BSP’s Winner Take ALL Policies Magnifies the Risks of a Peso “Meltdown”! February 4, 2018

HB 10963 TRAIN’s Initial Victim: Coca-Cola Will Be Laying Off Workers! The Back Shifting Effect of Excise Taxes Validated!

IN mid-January, I enumerated reasons why HB 10963 (Tax Reform for Acceleration and Inclusion Act) will fail. [See Four Reasons Why R.A. 10963 or the TRAIN (Tax Reform) Legislation Will Be Derailed January 15, 2018]

I wrote that since the government thinks in the context of statistics, it disregards the fundamental economic laws. I also noted since the tax reform operates on the supply side premise of having to tax consumption only, the government has scant understanding of how such policies would spawn material distortions and dislocations in the economic system

Coca-Cola’s predicament is a testament to these.

Coca-Cola Femsa Philippines Inc announced it would scale down on workers amid changes in the beverage industry and the business environment, calling it a “very difficult decision.” The decision emerged “after a careful assessment of various factors, such as operational efficiency, and the evolving regulatory environment” The estimated number of affected employees would be around 600, according to the Inquirer. [Inquirer.net Coca-Cola PH laying off workers February 6, 2018] (bold added)

The official statement was “In light of recent developments within the beverage industry and in the business landscape as a whole, the Coca-Cola System is undergoing an organizational structure assessment. This involved a comprehensive review of the roles and responsibilities within Coca-Cola FEMSA.” Furthermore, “This restructuring has been a very difficult decision. It was carried out only after an exhaustive and conscientiousassessment of the evolving regulatory environment, our operational efficiency, and consequent performance in the market.”

The Inquirer noted that the company “deferred from expounding beyond what the statement said”.

As an aside, this statement is proof of the political correctness of bubbles (credit bubble that has fostered a government bubble). To avoid from being excoriated or mob lynched or politically harassed or ostracized, evading the truth is the du jour comportment!

Back to Coca-Cola

Since the Train law imposes a P6/liter tax on beverages using caloric and noncaloric sweeteners and P12/liter on beverages using high fructose corn syrup (HFCS), industry sources previously told the Inquirer that this would hamper demand, especially since consumers would be shouldering the added cost.

The company had earlier announced of plans to invest around close to $1 billion in the country up to 2022. However, in an interview last year with Juan Lorenzo Tañada, company director for legal and corporate affairs, “a decrease in consumption rates would push the company toreevaluate its plan to have an additional investment in the country, warning that this was what any other business would do”.

To the mainstream, market prices have little relevance to the economy. That is, with the exception of real estate and the stock market. For them, tax hikes on consumption would simply be compensated by statistical GDP (whatever that means).

Coca-Cola’s dilemma validates the back-shifting effects of the excise tax. The great dean of the Austrian School of Economics, Murray N. Rothbard, I quote anew

[Murray N Rothbard, B. Partial Excise Taxes: Other Production Taxes, 4. Binary Intervention: Taxation > 3. The Incidence and Effects of Taxation Part...Power and Market: Government and the Economy Mises.org]

The general sales tax, of course, distorts market allocations insofar as government expenditures from the proceeds differ in structure from private demands in the absence of the tax. The excise tax has this effect, too, and, in addition, penalizes the particular industry taxed. The tax cannot be shifted forward, but tends to be shifted backward to the factors working in the industry. Now, however, the tax exerts pressure on nonspecific factors and entrepreneurs to leave the taxed industry and enter other, non-taxed industries. During the transition period, the tax may well be added to cost. As the price, however, cannot be directly increased, the marginal firms in this industry will be driven out of business and will seek better opportunities elsewhere. The exodus of nonspecific factors, and perhaps firms, from the taxed industry reduces the stock of the good that will be produced. This reduction in stock, or supply, will raise the market price of the good, given the consumers’ demand schedule. Thus, there is a sort of “indirect shifting” in the sense that the price of the good to consumers will ultimately increase. However, as we have stated, it is not appropriate to call this “shifting,” a term better reserved for an effortless, direct passing on of a tax in the price.

Since the consumer’s purchasing power is limited, Coca-Cola can hardly afford a price pass through. Hence, the primary effect of the excise tax is to raise the firm’s cost of production, thereby squeezing its profits.

The ramification of the excise tax on Coca-Cola is to force the streamlining of the company’s production structure, part of which is to cut down on their workforce, as well as, to “reevaluate its plan to have an additional investment”. Such measures effectively “reduce the stock of the good that will be produced”. Consequently, “the reduction in stock, or supply, will raise the market price”, “given the consumers’ demand schedule”.  That is to say, distortions from excise taxes are bound to spread.

If political circumstances compelled Coca-Cola to make a “very difficult decision”, how much more would such taxes affect the marginal firms or firms with lesser operational efficiencies in the industry? Will the marginal firms not be driven out of the business? And how will this impact the industry’s upstream and downstream supply chains? Would the natural course of action be an investment slowdown, as the Coca-Cola officialwarned, “this was what any other business would do”?

So Coca-Cola validates the back-shifting penalty theory from excise taxes.

That is not all.

Unless the laid-off workers find immediate replacements, there would be less consumption from them. Moreover, with higher prices in the economy*, the consumer’s purchasing power will diminish. So consumer will be faced with a perfect storm, lesser income**, and diminished consumption!

So the excise tax would be a double whammy: it will reduce investments and consumption.

When you tax something you get less of it.

Now some questions:

If investments and consumption decline, who will use the roads and the other forms of infrastructure that the government will build?

And with insufficient taxes, just how will these massive government expenditures (not limited to infrastructure) be funded? Will it be through debt or through inflation?

Grinding from higher prices, will there be enough spending power for consumers to satisfy the race the to-build supply of retail outlets, shopping malls, real estate projects and hotels?

Remember, the new economic paradigm: BYE BYE CONSUMERS, HELLO BIG GOVERNMENT! 

 

*The BSP reported January CPI at 4% which it attributed to the TRAIN:

Year-on-Year headline inflation increased to 4.0 percent in January from 3.3 percent in December. The higher inflation outturn was at thehigh end of the Government’s target range of 3.0 percent ± 1.0 percentage point for 2018. Likewise, core inflation—which excludes certain volatile food and energy items as a means to depict underlying price pressures—rose to 3.9 percent from 3.0 percent in the previous month. Month-on-month seasonally-adjusted headline inflation also increased to 0.7 percent in January from 0.3 percent in December.

The uptick in headline inflation for January was traced mainly to higher prices of food and non-alcoholic beverages, alcoholic beverages and tobacco items, and domestic petroleum products. Food inflation went up as most food commodities, particularly corn, meat, and milk, cheese, and eggs, posted higher prices during the month. Meanwhile, weather-related production disruptions pushed up prices of rice, fish, and vegetables in many regions. Similarly, non-alcoholic beverages and alcoholic beverages and tobacco inflation rose as a result of the implementation of the Tax Reform for Acceleration and Inclusion (TRAIN) Law. At the same time, transport inflation also increased due to adjustments in gasoline and diesel prices, largely influenced by higher international prices of crude oil and the excise tax on petroleum as prescribed by the TRAIN Law.

These numbers looked understated.

**More interesting data.

The Philippine Statistics Authority reported that “The national median monthly basic pay for 2016 was posted at P12,013, an increase of P257 (2.2%) from P11,756 in 2014”.

Since the annual CPI rates from 2014-2016 were at 4.1%, 1.4% and 1.8%, from the basic pay perspective, workers suffered NEGATIVE growth in real wages!  

Wow! If the PSA’s number is right then the race to build supply has been operating on negative wage growth! Why wouldn’t there be serious overcapacity issues?

Did the BSP Drain December Domestic Liquidity To Neutralize TRAIN’s Price Hikes???

Latest government data sheds light on the incumbent policy directions

The Bangko Sentral ng Pilipinas (BSP) withdrew Php 17.4 billion from its Net Claims from the National Government account.

Though the account remains at a record high, the rate of growth has been steeply dropping.

In 2017, the QE account grew by only Php 35.73 billion compared to 2016’s explosive Php 341.355 billion. The record budget deficit of Php 353.4 billion was financed mainly by the BSP’s stealth QE.

M3 significantly decelerated last December, posting a growth rate of only 11.95% compared to November’s 13.95% or a drop of 200 basis points.

Aside from the BSP’s reduction of NG claims, M3’s reduced rate had been a product of the dwindling speed the banking system’s consumer loan portfolio as the production loan portfolio remained the same. Consumer loans expanded by 17.17% in December compared to 20.63% in November, the slowest growth rate since May 2016. Production loans were at the same 18.50%

 

 

The awesome decline in the growth momentum of 17.52% in December compared to 26.39% in November and 32.58% in October, revealed by the banking system’s consumer loan portfolio, exhibits the eroding conditions of consumers

The contrasting pictures presented between sales and its financing accounts for the bizarre angle from the data

Or, the sharp deceleration in December auto loans came with December auto sales, which spiked 33.4%, largely in response to price increases from the new tax regime.

The gaping chasm in growth rate data either must have been filled by cash sales or that one of those numbers must have been inaccurate.

Back to consumer loans. And while credit card growth accelerated (20.37% in December, 19.83% in November), the payroll loan portfolio trend continued its southbound trek (+8.87% in December, 9.44% in November).

The quickening credit card growth has been inadequate to offset the slack in the rate of change of banking system’s auto loan portfolio.  Credit card and auto loans have an equal 42% share of the total consumer loan portfolio.

Interestingly, M1 (currency and peso demand deposits) dropped substantially (15.88%) in December (compared to November’s 17.23%).

Applied to retail finance, the M1 data suggests that cash sales have been considerably down. And only part of the slack in cash sales may have been substituted by credit card sales.

Could these be signs of consumer woes in December?

 

The National Government Debt data of the Bureau of Treasury has been the most revealing

It is unusual that the updated government debt numbers have been published ahead while the fiscal balance remains dated November.

Moreover, the publication of the fiscal balance has usually been in the third or fourth of week of every month. December’s data has been substantially delayed. The question is why???

As one would note, domestic debt soared by a whopping 12.89% in December pushing total debt growth to 9.23%. On a month-to-month basis, the NG issued an astounding Php 233 billion worth of debt, which constituted 41.5% of total debt growth in 2017 (Php 562.17 billion)!!

These numbers indicate of the likely scale of the budget deficit in 2017. Since November’s deficit was at a record Php 243.5 billion, a Php 200 billion deficit in December would tally to Php 443 billion or Php 90 billion higher than 2016’s record Php 353 billion!

Yet, exploding deficits reinforces the transition of the nation’s political-economic structure.

Here’s the rub. The reduction of BSP’s claims on NG, the slowdown consumer loans and the explosion in debt issuance by the National Government has been interlinked.

These factors had a role in the diminishing rate of change in domestic liquidity

The “crowding out” effect comes into the picture. Bank lending had been crowded out or displaced by the surge in government debt.

Consumers bore the yoke of the transition.

HB 10963 (Tax Reform for Acceleration and Inclusion) is the other key factor.

I suspect that the BSP has anticipated the price dislocations from the new tax regime.

To counteract these, it reduced its claims on NG liability and allowed the National Government to raise funding from the marketplace, knowing that these would contribute to the siphoning of liquidity from the system.

In this way, the reduced “demand” from diminished liquidity would partly neutralize price disruptions from the new tax regime

And if my suspicion is accurate, the BSP action comes at the cost of earnings of the private sector, mostly in the retail industry.

In that context, December’s fall in M3 fueled the rally of the peso.

Alternatively, I suspect that the BSP may have reactivated its QE in January to have recharged the USD-Php.

Since every action has consequences, expect the intensifying interventions in the economy to have unintended consequences.