Balance of Payments

Sovereign wealth fund under consideration

That was the banner story of today’s BusinessWorld online.

Here is a direct quote from the article:

Economic managers are studying the possibility of setting up a Philippine sovereign wealth fund to maximize returns from the country’s foreign exchange holdings.
“As I understand, the national government is conducting a study on the possible operations of a sovereign wealth fund,” central bank Governor Amando M. Tetangco, Jr. said at the sidelines of yesterday’s Philippine Investment Forum.

Finance Secretary Cesar V. Purisima confirmed that the plan was being considered, although he said the review remained in the preliminary stages.

“We haven’t brought up the matter with [President Benigno S. C. Aquino III] yet. So far, it’s just look, see, study and evaluate,” Mr. Purisima said.

As readers of this space will be aware, I have been harping on this issue for over two years now. Before anyone in the upper echelons of policy making, whether fiscal or monetary, or within academia were even contemplating it, I had flagged the possibility here. The following is a compilation of the previous articles I have posted on the issue
Early this year, I developed a policy paper on this topic, which I enclose below

Fruits of Our Labour by Doy Santos

It’s good to see that after more than two years of writing and engaging with the issue, the idea is finally being seriously considered by both the Department of Finance and the Bangko Sentral as confirmed by today’s news item . Even more surprising is how prominent economists are now supporting the principle of establishing a sovereign wealth fund for the Philippines. If this should be included among the administration’s priority bills for the 16th Congress, it would be timely as the country is expected to receive investment grade status by the end of the year.

A Philippine Sovereign Wealth Fund

The Philippines is suffering from a rare form of “Dutch disease”, the negative consequences of a rapid rise in income normally associated with the export of natural reserves. In our case, the income comes from our export of labour. Overseas remittances rising every year swell our foreign currency reserves. The peso appreciates as a result. This diminishes the global competitiveness of our manufacturing sector with adverse implications for domestic employment.

Meanwhile government keeps borrowing from international markets to finance its chronic budget deficits. This contributes to the upward pressure on the domestic currency as more dollars flow in to purchase government securities. To keep its borrowing down and make credit rating agencies happy, government constrains its spending. It wants to rely on public-private partnerships (PPP) to provide infrastructure which are both time-consuming to arrange and limited in scope.

As it postpones development spending credit rating upgrades keep coming. Each time this happens, fund managers around the world increase the flow of “hot money” into the stock market, thus contributing to more upward pressure on the peso. Property developers also cash in as the value of residential and commercial assets appreciates with the rising peso, which creates even more demand for new development.

The families that receive remittances on the other hand suffer as the purchasing power of the dollar declines. And due to their dependence on these transfers, the income that families receive goes mostly to household expenditures. Very little is invested in productive activity. And when it is, the investment normally goes into retail or transport enterprises, which earn very marginal returns.

For the rest of the population, finding a job is a struggle. Life is hard as there are not enough opportunities that come by due to a dearth of fixed private capital expenditures on plant and equipment let alone research and development. Most of the inflows go to short-term investments, i.e. the stock market, or to fund property purchases, which results in very little job generation outside the construction industry which demands casual employment due to the seasonality of its activity.

This in a nutshell is the problem that confounds the Philippines.

Foreign remittances for the twelve months to January 2012 hit $20 billion according to the World Bank. Remittances for the first ten months of 2012 have already equaled that amount according to central bank figures (with the Asian Bankers Association estimating the real amount to be in the order of $27 billion). This was close to 90 per cent of the Bureau of Internal Revenue”s total tax collections for 2011, and would have been enough to finance that year’s budget deficit four times over. As of November 2012, the country’s gross international reserves (GIR) stood at $84 billion exceeding the BSP’s full year estimate of $78 billion.

This was enough to cover our imports for a full year or to settle all short-term debt obligations 12 times based on original maturity and 6.8 times based on residual maturity (that is short-term loans based on original maturity plus principal payments on medium- and long-term loans of both private and public sectors falling due in the next 12 months).

In fact back in June 2012 when the GIR stood at $76.1 billion, the country’s external debts belonging to both the public and private sectors stood at $62.5 billion. That means the BSP had enough to settle all external obligations and still have roughly $14 billion left over.

The two charts below show what has happened over the past decade. The first one shows that after a rocky first half, the country has been producing consistent balance of payments (BoP) surpluses averaging about 3.8 per cent of GDP from 2005-2011. That is the inward flow of foreign currency exceeded the outward flow by the said ratio. A quick rule of thumb is that 1 per cent of GDP is roughly $2.5 billion or Php100 billion.

So on average, the annual surplus has been about Php380 billion during the past six years. The average BoP surplus is therefore more than enough to accommodate government’s annual revenue shortfall averaging 1.11 per cent a year. The second chart shows the effect these surpluses have had on our GIR. From 2001 to 2011, it has grown on average by 16.7 per cent. Up until 2005, you can see that the line is pretty flat. Afterwards it rises steeply. This means that a tipping point in the flow of overseas remittances occurred back then which placed our BoP structurally in surplus territory from that point on.

Surpluses and deficits, in per cent of GDP

No wonder bond markets have had such confidence in the Philippines. As the saying in business goes, banks will only offer you credit when you don’t need it. The question is do we just keep accumulating these reserves knowing the problems they create for our economy? Or do we actually put the excess funds to good use by investing in the country’s development?

As the title of the piece suggests, we could set up a sovereign wealth fund (SWF) with our excess reserves. The $14 billion mentioned above, which by the end of the year will probably be $15 billion would be the seed money. That is enough to double our infrastructure spending which is currently 1.5 per cent of GDP to 3 per cent, much closer to the recommended 5 per cent, over the next four years. With that added spending, the government could easily meet its aspirational stretch target of growing the economy by 7-8 per cent a year.

Every year, depending on how well our balance of payments performs, we could just keep adding to the SWF. Assuming that the government’s new revenue measures and fiscal consolidation will mean an annual deficit of about 1 per cent of GDP and that the annual BoP surplus remains at 3 per cent of GDP, there would be enough to fund government’s deficit and set aside another 1 per cent to augment the SWF, with the remaining 1 per cent going to GIR.

But we are getting ahead of ourselves. Let us first define what is a SWF? According to the Sovereign Wealth Fund Institute, it is

a state-owned investment fund or entity that is commonly established from balance of payments surpluses, official foreign currency operations, the proceeds of privatisations, governmental transfer payments, fiscal surpluses, and/or receipts from resource exports.

The Institute cites some “interesting facts” about SWFs, namely that some of them “invest indirectly in domestic industries” and that “they tend to prefer returns over liquidity, thus they have a higher risk tolerance than traditional foreign exchange reserves. Most often SWFs receive their initial capital through “commodity exports, either taxed or owned by the government” or through “transfers of assets from official foreign exchange reserves”.

There are about US$5.1 trillion invested in SWFs globally. About three of every five dollars come from oil and gas exports, the remainder from other sources. The size of funds varies from as little as US$300 million for Indonesia to as large as US$664 billion for Norway. Of the 64 SWFs that currently exist, 39 were established since 2000.

Some have argued that the Bangko Sentral is restricted by its charter, RA 7653, the Central Bank Act, from investing in instruments other than Triple-A rated bonds of foreign governments. At the time this law was passed, the problem facing the country was chronic balance of payments deficits. More transfers out rather than in were being made.

The BSP is tasked under the law with maintaining international monetary stability in the country. Part of this according to Article II, Section 64 of the law is “to preserve the international value of the peso and to maintain its convertibility into other freely convertible currencies”.

To maintain such stability, Section 65 says that “the Bangko Sentral shall maintain international reserves adequate to meet any foreseeable net demands on the Bangko Sentral for foreign currencies”. It would have to judge for itself the adequacy of these reserves based on “prospective receipts and payments of foreign exchange by the Philippines”.

Finally, Section 66 lays out the composition of such reserves which it says “may include but shall not be limited to” gold and other assets that took the form of “documents and instruments customarily employed for the international transfer of funds; demand and time deposits in central banks, treasuries and commercial banks abroad; foreign government securities; and foreign notes and coins”.

So why did the central bank governor offer in September of 2011 to purchase Philippine treasury using its dollar reserves given that these notes are not Triple-A rated? Well, he had probably realised as I had back in November 2010 that the Bank already had an adequate supply of reserves to meet international obligations.

Given that the law says nothing about what to do if the Bank were to have more than a sufficient level of reserves we can say that the Bank is sailing in unchartered waters. If the law does not specify what it should do in such a situation, then it should be left to the discretion of its board to decide on how best to deal with it.

Currently, the return on short-term US treasury notes is between 0 and 0.25 per cent, negative in real terms, meaning that the Bank is paying the US government to borrow from its reserves. And the Fed has said that it plans to keep interest rates as low as they are for the foreseeable future until the US unemployment rate goes under 6.5 per cent (it is currently at 7.7 per cent). If the BSP lent its excess reserves to the Philippine government, it would gain a better return and preserve the value of its assets.

Now that we have cleared the financial viability and legality issues, what would be the purpose of a Philippine SWF? The nature and purpose of SWFs are varied, but in the Philippines it might be to do the following (as adapted from the SWF Institute):

  • Protect and stabilise the budget and economy from excess volatility in revenues/exports
  • Diversify our industry sector to make growth more inclusive and robust
  • Earn greater returns than on foreign exchange reserves
  • Assist monetary authorities dissipate unwanted liquidity
  • Increase savings for future generations, or
  • Fund social and economic development.

Given the need to boost productivity and improve competitiveness, addressing the infrastructure backlog would be the most obvious answer. The public-private partnership projects would be a good initial source of demand for funding as these projects are designed to earn a market rate of return for the investor. Another possibility would be for the SWF to enter into joint-ventures with mining firms for the joint-exploration and production of oil and other commodities. This would ensure that we received a larger share of the benefits from such operations.

A third possibility would be to fund innovation through government procurement, business incubators, industry clusters, and competitions aimed at the commercialisation of ideas. Government could serve as a catalyst in the germination of new activity around key areas of specialisation that the country has already exhibited proficiencies in. The expansion of our semiconductor and electronics industry into higher value adding activities could be one priority. The growth of agribusinesses into higher yield crops and again value adding processes could be another. A fourth priority could be the generation of clean technology and renewable energy.

Finally, beyond just the economic, financial, legal and commercial viability, there is the political viability of doing this. Creating a Philippine SWF would be politically astute as it would be seen as the Aquino administration’s unique contribution to the development of the country. The vice president has also expressed his support for the concept of using foreign reserves for development. This means that the measure would have the support of both leaders and their coalition partners in both houses of Congress.

Beyond that, the consensus formed by our leaders would mark the first time a remittance dependent nation’s government deliberately leveraged the income derived from its work force overseas to channel resources into highly productive activity back home. It would be a shift in the development paradigm of such countries and provide a model for them to follow. Just as conditional cash transfers were forged through a consensus among Mexico’s and Brazil’s leaders as a way to alleviate poverty, the Philippine consensus would provide a path for low income households out of poverty and into the middle class by providing jobs to people of low skills through the fruits of their countrymen’s sacrifice overseas.

If we don’t recognise the opportunity that lies before us in this regard, then when our overseas workers return home, all their hard work may come to nothing as their children will then have to go abroad because there would be no jobs left for them here. With the Aquino government’s good governance credentials, it should be able to shape the probity and prudential measures needed to ensure that the SWF is properly managed and its funds transparently and judiciously utilised for public benefit. This would prove that good governance is indeed good economics and that the righteous path can create in the Philippines opportunities not just for some but for all.

Is the Philippines a Late Bloomer?

“Whenever we find a late bloomer, we can’t but wonder how many others like him or her we have thwarted because we prematurely judged their talents. But we also have to accept that there’s nothing we can do about it. How can we ever know which of the failures will end up blooming?”
Malcolm Gladwell

In the Philippines, children trooped to school this week as yet another academic year began. It seemed like any other year, with the rising cost of private education and the shortage of classrooms and teachers plaguing the public system giving concern to parents.

There was one significant difference though: the country became one of the last in the region to adopt a K-12 (kindergarten to Year 12) structure. The additional two years to secondary education and one year of kindergarten meant that the educational system in the country has finally caught up with the rest of the world.

It is hoped that with this reform, the country would be able to lift the academic test scores of its pupils which have been lagging behind that of neighbouring states. Previously it was hypothesised, educators tried to cram in too much content within the span of ten years. It is hoped that allowing more time to learn the new national curriculum would produce better results.

But apart from giving students the tools to succeed in life, there is a number of policy areas in which the Philippines has lagged behind but could now be catching up. Reproductive health and family planning is an example of where the country has remained staunchly intransigent even when there has been a near universal consensus arrived at around the world on this issue. The long-delayed reproductive health bill that has languished in Congress for over a decade may finally pass.

In the area of peace and order and social justice, the country has one of the longest running communist insurgencies in the world. Its land reform program whose implementation has taken decades longer than expected, may finally be completed with the resolution of the Hacienda Luisita case.

After a chequered history, the revised sin tax legislation may finally pass, giving government finances a boost and allowing credit rating agencies to give a positive outlook for the country, which in turn lowers the cost of borrowing for the government. Having been a net debtor nation to the rest of the world, the nation’s ability to shore up international reserves through balance of payments surpluses now make it a net creditor.

After being the consistent laggard of Southeast Asia when it comes to attracting foreign direct investments, an investment pipeline involving infrastructure projects may soon reverse its fortunes. With growth slowing in the BRIC economies, the US and the EU, a first quarter growth of 6.4% year-on-year making the average for the past two years 5.6% make the country a stand-out along with Indonesia and Turkey (see video below for an explanation).

With employment growing and inflation easing, some are beginning to wonder if the Philippines is finally getting its act together. Two thousand and twelve could be a “breakout” year for the country.

At last, some sen$e!

Monetary officials have finally learnt how to deal with the rising peso–something I have been advocating they do since late last year.

When I flagged the problem of an appreciating peso back in November 2010 (see What Should be Done About the Rising Peso?) and suggested some ideas on how to remedy the situation (setting up a sovereign wealth fund), I was met with more than a little bit of skepticism by readers. At that time, our foreign reserves climbed to $44 billion from $33 billion a mere eighteen months earlier.

In January this year, I pointed out the strategies of similarly situated Latin American central banks and finance ministries (see What Should be Done with a $14.4 billion BoP Surplus?). My advocacy for us to turn to methods outside the traditional toolkit of monetary policy seemed far-fetched as Bangko Sentral officials then were expressing satisfaction with the effectiveness of their interventions in the currency market. Again, my ideas were met with a bit of scorn by some readers.

And then in July this year, when our gross international reserves for the first time exceeded our external debt obligations, I made the following policy pitch in Crediting the Upgrade:

To prevent the peso from rising, what the government could do is coordinate with the BSP so that it could issue treasury notes and have the BSP purchase them (much in the same way the US Federal Reserve bought US treasury securities under Bernanke). This would lower the borrowing cost of the government given the BSP’s views that the country is actually of investment grade.

The proceeds of this could either go to funding the fiscal deficit, or as we reach a balanced budget over the next two to three years be used to set up two funds. The first could be called the Philippine Enterprise Innovation Fund or PEIF. The second could be called the Regional Philippine Infrastructure Fund or RPIF.

I had honed the idea from suggesting a sovereign wealth fund that would look at investment opportunities both domestic and overseas to more inward directed investment opportunities. The channel through which the fund would be created was to be through the BSP purchasing sovereign debt issued by the National Government (in effect becoming a creditor of the government). This would reduce our need to borrow from abroad, which would lower the pressure on the peso to appreciate.

With this last pitch, I thought I had a winner, although not much in terms of reader response occurred. Also, as the storm clouds seemed to gather on the horizon, I found the BSP’s response to be similar to the government’s–a wait and see strategy, which I felt needed to be more pro-active (see Bullet-proofing the Economy and A Full-Blown Economic Storm). The government was still banking on its credit upgrade and private partnerships to save the day.

The policy space just seemed sterile with worn out mantras and textbook formulas. Then today, I gained some level of comfort in discovering that our officials might have finally “seen the light” by reading Benjamin Diokno’s column. In it, he describes the offer made by Bangko Sentral Governor Armando Tetangco to loan the government dollars and be repaid in pesos as a “Win-win Move“!

What might have tipped the conservative monetary authorities over was the Philippines attaining its full-year gross reserves target of $75 billion in the middle of the year. Diokno highlights the precariousness of maintaining current fiscal and monetary policies by saying,

(F)or every peso appreciation, BSP stands to lose P75 billion. Isn’t that awful? Hence, Mr. Tetangco is not offering the government out of the goodness of his heart; he’s doing it because it’s the prudential thing to do. It’s a win-win solution to our economic woes: it helps BSP in its war against peso appreciation and, at the same time, it helps the government pay for its foreign debt without incurring serious foreign exchange risks….

In hindsight, it was not even necessary for the Philippine government to borrow from the World Bank and the Asian Development Bank to finance its conditional cash transfer (CCT) program. Floating five-year Treasury bonds would have been a better way of financing the program.

At last, even traditional economists are beginning to realize what a golden opportunity the Philippines was sitting on! Ah, yes! There are times when it just feels good to be right. And this is definitely one of them. Let us hope our finance officials are able to learn the “policy catch-up” game just as our monetary officials have finally learned to. It’s about time they gained some sense.

Clef two-factor authentication