Ben Bernanke

Bullet-proofing the economy

Ominous clouds are hovering over the horizon, and yet the government seems unprepared.

What would happen if the US receives a credit downgrade? This scenario is appearing more likely as reported today. This same week, as Ireland joined Greece and Portugal in receiving “junk status” for its bonds, there was talk of Spain and Italy joining them. These are the so-called PIIGS economies (Portugal, Ireland, Italy, Greece and Spain) that are miring the EU and the IMF with costly bailouts.

In the US, US Fed Chair Ben Bernanke signaled that he stood ready to assist their ailing economy with a third round of stimulus via quantitative easing (translation: the central bank buying US treasury notes) but then quickly quashed speculation of it definitely happening. Meanwhile, the political leadership in Washington could still not arrive at an agreement to lift the US debt ceiling with Republican tea partyers unwilling to cut a deal with Pres Obama before the August 2 deadline.

What all this means is that global economic recovery from the financial crises of 2008 is in jeopardy. A second crisis could hit our shores soon. Some ominous signs of this are already apparent with our exports experiencing an annual decline in May. The last one was registered in October of 2009, when the first wave hit our shores.

The threats

There are two simultaneous shocks that will occur once the US credit rating is downgraded. One, the dollar will devalue, potentially leading to more portfolio investments into the country causing the peso to appreciate. This will have an adverse effect on our already dwindling exports sector. Two, the excess liquidity flowing from these funds would put upward pressure on inflation which in turn would make interest rate hikes more likely. This will impact on borrowing costs.

So in the coming months, weak demand for our products and services from advanced economies coupled with an unfavorable exchange rate will create an enormous drag on our economy. Combined with higher domestic interest rates which would dampen consumer spending and private capital expenditure, and you could end up with quite a powerful cocktail of doom and gloom.

Compounding these problems are the woes suffered by our overseas labor force in the Middle East with the policy of Saudization to impose quotas on hiring of foreign nationals as well as the overall disturbance of deployment to the region as a result of political instability, and the second half of 2011 could turn out to be pretty tough one for labor exporting countries like the Philippines.

Growth predicated on PPPs

Multilateral institutions and national economic planners have already pegged expectations for growth at 5%, but that is predicated on the government being able to wheel out its PPP projects and ramp up government spending in the second half. So far though, the roll-out has been anything but brisk, with several delays hampering the timetable. Even scheduled projects involving overseas development assistance had to be cancelled for alleged overpricing and poor technical specifications. This led Ricardo Saludo in an op-ed piece for the Manila Times to write

The government recently issued more assurances that the much-awaited partnership program guidelines are under way. But investors are getting tired of yet more pledges to roll out the program and give adequate protection to joint ventures. Until one deal actually gets done and well, PPP may only encourage the perennial wait-and-see attitude toward the Philippines.

The budget department has signaled it plans to extend social safety nets to more indigent families through the conditional cash transfers program by re-channeling unspent public works expenditures from the first half. Meanwhile, PNoy began distributing benefits relating to social reforms (land, health, and social safety nets) in an apparent move towards a permanent campaign mode.

Political circus

Congressional investigations into alleged corrupt practices involving former president Gloria Arroyo and officials of the Philippine Charity and Sweepstakes Office heat up. The pornography of corruption involving hundreds of millions of public money being siphoned off to unlawful purposes and to questionable tranfers to religious persons and their charities has once again made for captivating viewing.

As the trial of the Ampatuans over their alleged masterminding of a massacre of political rivals and their escorts in Maguindanao, a new round of poll fraud and corruption allegations involving the former first gentleman surfaced courtesy of Zaldy Ampatuan son of the accused principal conspirator, Andal, Sr as part of an offer to turn state witness. Once again, as dark economic clouds gather, the Philippines is engaged in the theatrics of political scandals, investigations and trials.

Second SONA

All eyes and ears will be turned to the president’s second State of the Nation Address to Congress on July 25 to see what set of priorities he lays down for the sophomore year of his term. Will he continue to focus on the alleged waste and corruption that took place under his predecessor? Or will he lay down a plan for bullet-proofing the economy against the increasingly menacing global environment?

In the final analysis, it will be nearly impossible to ignore the controversies involving the past administration, as it brings out the contrast between the old and the new. A year after he unveiled PPPs as his government’s centerpiece program for growth, not a single project has been awarded. Markets and observers anxiously await PNoy to pivot towards his economic blueprint for the future, before the impression that the present is just a continuation of the past settles in.

Crediting the Upgrade

The Makati Business Club which by and large supported the candidacy of PNoy paid him homage in his first year in office by crediting his administration for the numerous upgrades the country received from ratings agencies, but the underlying cause might be found elsewhere.

The MBC spoke of the way in which the administration fostered macroeconomic stability and investor confidence. Macroeconomic stability of course depends on both the national government’s fiscal policies (how it earns and spends money) and the Bangko Sentral’s monetary policies (how it regulates and intervenes in the financial system).

Although some credit is due to PNoy for the mandate he received which led to the smooth turnover of power and for not destabilizing markets or the economy, there is a more fundamental reason why rating agencies gave us an upgrade. The following chart provides a big clue as to what it was.

For the first time, the nation’s gross international reserves exceed its external debt obligations (both public and private). As of March 2011, they stood at 66 billion US dollars compared to the external obligations (both private and public) amounting to 61 billion. The reserves have been parked in fixed investments overseas, mainly US treasury notes I would imagine making the country a net lender to the rest of the world.

An examination of our balance of payments (the flow of payment in and out of the country) will tell us that the growth in our dollar reserves is due mainly to dollar remittances by overseas Filipinos and the inflow of portfolio investments into our stock market. Foreign income from our services industries contributes to it as well albeit minimally, while our export of goods continues to lag our import (see chart below).

Foreign direct investments continue to be a pittance compared to our overall economy and to our neighbors. Foreign investments are mainly being channeled into domestic firms listed in our stock market. Assuming these portfolio investments are weighted in accordance with the Philippine Stock Index (a basket of the top listed companies), these flows simply reinforce the current industry structure (not to mention the pecking order). It also runs the risk of creating a property-debt bubble in a few years.

Last year when the country posted a fourteen and a half billion dollar balance of payments surplus (a net inflow of foreign currency), I posed the question what should it do with it. The appreciation of the peso is hurting our exporters and the families of overseas Filipinos despite efforts by the BSP to stem the rise.

The other related issue has to do with where the foreign remittances are being spent: mainly on consumer goods and real property. Banks have also been benefiting from these remittances, but have not found a productive use for them. The accumulation of savings has outstripped investments as shown in the following chart making the Philippines a net saving economy rather than a net borrowing one.

This leads me to think, given that the country has extra liquidity, why has there been no effort made to channel these resources to where they are needed the most? The problem with investments in the Philippines has nothing to do with the supply side any longer (or the availability of capital), but has more to do with the demand side (or the availability and attractiveness of projects to invest in).

The Western thinking MBC might contend that the reason why investors shy away is because of the poor economic and business environment, poor governance and inadequate institutions like bad laws, regulation and red-tape. There is some truth to that. The flow of ‘hot money’ into the stock exchange however tells me that investors don’t see bad governance as a major hindrance to the growth of privately owned companies.

Causes and Effects

The other main cause for weak investment flows could be a simple lack of information about the sectors that are worth investing in. The free rider problem where everyone is waiting until somebody else proves an idea is worth pursuing and then cashing in when it becomes viable could possibly be one major factor in this.

A third possible reason for the lack of investment is simply the fact that our government does not have enough capacity to cope with its infrastructure backlog. This is primarily due to the inadequacy of the tax system to raise sufficient revenues to fund them. While private investors can fill the gap somewhat through the build, operate, transfer scheme, they cannot fill it completely as the unmet demand for schools and hospitals will attest.

There are basically three policy implications and recommendations that follow from this discussion.

  1. Improve regulatory quality, bureaucratic capacity and predictability.
  2. Improve entrepreneurial risk-taking capacity.
  3. Improve capacity for infrastructure funding.

Enough has been written with regards to the first recommendation, and the MBC is already involved in that effort. What I would like to do is focus on the last two recommendations as I have some ideas on how to pursue them.

Hurdles and Hoops

The first hurdle of course is where to source the funding. As the the preceding analysis has shown, the nation has a net stock of foreign reserves in excess of its external obligations. It has gone up by about 4 billion dollars per year on average in the last four years. This is about the size of the public sector deficit (2% of GDP).

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.

The first fund would either go towards funding Public Private Partnerships involving start-ups or be given as outright grants or concessionary loans to projects that would allow us to diversify our industry sectors or bring about the commercialization of new innovative business models.

The second would go to fund infrastructure projects in the regions where public investment is lacking. It could help bridge the education and health infrastructure gaps or to community projects or even to social and environmental projects. Priority could be given to remote places where the gaps are most severe.

Where credit is due

In crediting the upgrade to PNoy, the current problem of forced savings by the government whose surplus fetish makes it more subservient to the bond market than to the needs of the people is endorsed. It is a self-congratulatory remark to the business community as well which has failed to fund risky entrepreneurial projects that could be the source of future growth.

While the government’s good governance agenda should be continued in improving the overall environment for doing business, the capacity of the public sector in addressing ‘market failures’ and in providing much needed economic, social and environmental infrastructure must be boosted even more.