The following is from a study from UBS.
We came away from our recent visit to Manila with a strong sense that growth expectations were being adjusted downward amongst government officials, the financial sector and the private sector in general.
This said, overall perceptions were still more upbeat than our own perceptions for 2009. And it is fair to say that backward looking evidence of activity growth is still reasonable. Bank lending (net of RRPs) growth is buoyant at 22.1% yoy, USD exports were up 4% on the year in Q2 (after 5.2% in Q2), and the International Container Terminal Services Inc. reported volumes through Manila’s terminal in Q3 to be up 13% yoy (after 17.5% in Q2).
Nonetheless, we expect deteriorating financial conditions and slower overseas demand for Philippines’ exports and labor to slow the economy sharply into 2009. We look for 1.8% real GDP growth in 2009, an outcome on a par with real economic growth in 2001. We hence judge that there is some further downward adjustment of expectations for the Philippines’ private and public sector to come.
Investors should hence prepare for more bad news from the economy, but also looser fiscal and monetary policy over the next twelve months. We look for policy rate cuts of at least 50bps in 2009, with timing a function of the currency (which we expect to overshoot towards USDPHP 51). We also expect a wider fiscal deficit of at least 1.5% of GDP in 2009, 0.3ppts above the 1.2ppts now suggested by the government, and 2.3% in 2010. Excess domestic savings and a relatively low starting point for the deficit should mean successful government debt issuance is a matter of price not availability of creditors in 2009. The private sector may find life more difficult especially in terms of foreign currency borrowing, but low credit to GDP levels should mitigate the risk at the aggregate level. Finally, we highlight that politics, while not a focus now, may be a wildcard as the May 2010 election looms.
What the economy faces and why
We have long argued that the Philippines is exposed to global trade, financial market and sentiment shifts.
Historical experience suggests that, at times of global economic weakness or financial stress, Philippines real GDP growth can drop below 2.0% - we now project 1.8% real economic growth in 2009, before a recovery to 3.4% growth in 2010.
Chart 1 takes a brief look at the historical experience. The red line shows US real GDP growth, the dotted blue line world real GDP growth and the green line Philippines real GDP growth. We have labeled four distinct periods of weak growth in the Philippines. Of these the early 1990s and 2001 corresponded with a sharp slowdown in the US economy, while the late 1990s was associated with the Asian crisis. In the mid 1980s, the Philippines bucked the global economic recovery with a crisis associated with the end of the Marcos dictatorship.
Chart 2 highlights the interaction of the Philippines growth cycle with the rest of the world. Here we can see the periods of weak growth in the 1980s and 1990s were preceded by periods of current account deficits as the Philippines imported more goods and services than it exported.
The negative current account balance means that the Philippines was relying on capital inflows to finance its imports and hence domestic consumption and investment. The associated rise in net foreign liabilities was periodically halted as financing flows dried up.
In each case the halt or reversal of capital flows was preceded by, or concomitant with, signs of export weakness and hence weaker profitability and income for Philippine corporates and households - increasing the credit concerns of lenders (Chart 3). The actual trigger for reduced financing and hence the sharp drop in domestic demand and imports can also be linked to political concerns, as was the case in the 1980s; global risk aversion in the early 1990s; and regional capital flight as was the case in the late 1990s. The end result in each case was a sharp drop in imports along with real GDP growth and a rise in the current account balance.
In 2001, the effect on the current account balance was less pronounced only because exports slowed particularly sharply as the global growth slowdown was centred on the electronics sector. This said, import growth moderated just as sharply as export growth; consistent with the reduced availability of capital in a weaker global economic environment (along with political turmoil in the Philippines). As in previous cycles, real GDP growth slumped.
Which brings us to the present. The difference going into this cycle is that the Philippines has been running a current account surplus in recent years. A combination of rising remittance transfers and a declining trade deficit mean that, as the global crisis began to unfold in 2007, the Philippines has not been increasing its net foreign liabilities in recent years.
This is not the same as saying that the Philippines has experienced no inflow of capital. Or that a dramatic deterioration in global financial conditions will not impact the availability of capital in the Philippines. It is clear from the decline in the stock market, the weakness in the currency and the decline in portfolio flows that the cost of capital has gone up and the availability of capital has gone down.
What the current account surplus does mean, however, is that the pace at which capital inflows have been turned into physical investments has been moderate. This in turn reduces the risk that investments have been based on unsure assumptions or unrealistic expectations – as is common when easy money is married with an apparent track record of above normal growth. The downtrends in investment and credit to GDP shown in Charts 6 and 7 both support the idea that investment excess has not occurred in the Philippines in recent periods. Chart 8 shows this has probably been more true in the Philippines than anywhere else in the developing world.
This said, the acceleration of Philippine bank credit growth to over 20% in August is a worry since the availability of low risk investments must be deteriorating fast. Indeed, the acceleration in credit growth may be related to corporates’ desire to hold more or excess working capital for liquidity reasons. We do not expect this rate of credit growth to last because banks are most likely trying to de-risk portfolios not expand them aggressively.
Our point is that the Philippines was very late to this particular global growth party. It does not mean that the reduced availability of capital will not slow domestic growth in the Philippines. It does not mean that slower export growth will not act to reduce business sector income growth and that remittances growth will not slow sharply and potentially into negative territory. We should look for Philippines growth to slow as it has in other times there has been external economic weakness and financial stress. It is for this reason that we look for the growth outcome in 2009 to be as bad as in 2001 at 1.8%. We hence expect the following.
Export growth to fall into negative territory as global trade contracts, imports to fall both on export deterioration and lower investment (Table 1).
Investment to contract as export income and remittance income (actual and expected) reduce the willingness and ability to invest. Investment growth will also suffer from a sharply higher cost of capital and reduced availability of credit both offshore and onshore (Table 1).
Consumption growth will moderate, but not collapse, as unemployment fears rise. USDPHP strength will help keep peso remittances up, even if USD remittances slip a little. Sharply lower inflation will also support household real incomes as energy prices, along with food items like rice, fall back in price.
We expect inflation to average close to 3% in 2009, down from 9.4% in 2008 (Table 1).
In aggregate, lower commodity import prices and reduced capital and consumer goods imports should out weigh the modest decline in US dollar remittances and exports we expect. As such we look for a larger current account surplus in 2009 than in 2008 (Table 2).
The peso will remain under pressure from global risk-aversion and de-leveraging. We continue to look for an overshoot of the currency relative to expectations, before calmer capital markets and the current account surplus drive a rebound towards USDPHP 48 later in 2009 (Table 3).
All the above suggests the credit cycle should worsen, but the degree of deterioration should be milder than many of the countries on the right hand side of Chart 8.
Where does that leave us relative to market expectations? Our sense from our discussions in Manila is that growth expectations on the ground are now being quickly adjusted lower, particularly amongst the business community. Because of publication delays, this renders traditional economic consensus forecast figures
misleading. The latest government growth forecast is for 3.7%-4.7% real GDP growth in 2009. We think that most businesses are expecting something at the low end or below the government’s forecasts, but a less severe economic cycle than our own projection.
Monetary policy help is coming (but perhaps only next year)
The good news is that the door for monetary easing is opening fast. The sharp fall in commodity prices accompanying the weakness in global growth should take inflationary cost pressures out of the economy.
Recall we expect inflation close to 3% in 2009. This should ultimately open the door for policy makers to ease monetary and fiscal policy settings.
And the Bangko Sentral ng Pilipinas has already signalled a shift to a neutral stance with regards to monetary policy as commodity prices have dropped and inflation peaked. Important catalysts for more policy rate cuts will be the BSP’s and public inflation expectations for 2009 and 2010 relative to the inflation target, which will be a function of growth and the currency. We note that the 2010 inflation target is currently being debated by the government. An upwardly revised inflation target would be a catalyst for more policy rate cuts, but the implications for credibility suggest an unchanged target.
In 2006, forward inflation expectations had to fall closer to target than they are now before policy was eased (Chart 10), but growth expectations were rising, not falling, at that time (Chart 11). Meanwhile, the trade weighted peso is not excessively weak relative to the last year on average, but further near term weakness could hold up monetary easing through its implications for inflation expectations (Chart 12).
We do expect lower policy interest rates and have initially pencilled in 50bps of policy rate cuts during 2009.
If the currency depreciation from here is limited, more policy rate cuts are quite possible.
Further non-policy rate policy measures are also likely in the sense that they can guard against a tightening of monetary conditions within the banking sector. The key measures so far include:
(1) On 20 October, the BSP allowed Philippine banks to use RoP bonds to access a BSP dollar repo facility.
This complements the US dollar IOU or promissory note rediscounting facility that already existed.
(2) On 23 October the BSP allowed ‘Held For Sale’ and ‘Available For Sale’ securities (both categories subject to market to market) to be reclassified as ‘Held To Maturity’ at the price of 1 July with a deadline of 1 November. This was in line with new International Account Standards which have now been adopted by many countries in the region. ‘Held To Maturity’ securities are not subject to mark to market rules.
(3) On 6 November, reduced the regular reserve requirement on bank deposits and deposit substitutes by two percentage points effective 14 November. The BSP estimates that this is equivalent to releasing 60bn pesos into the system, or about 6% of M1 money supply.
(4) Also on 6 November, the Board agreed to increase the budget for the peso rediscounting facility from PHP20bn to 40bn to allow more banking institutions to obtain loans from the BSP against eligible promissory notes for short-term liquidity needs. The US dollar and yen exporters’ rediscounting facility budget of USD 500m was unchanged.
These and further measures should help limit risks in the banking system. However, they do not change the fact that perceived credit risks will drive credit conditions tighter both between banks and their customers and between non-bank entities in the economy, adversely impacting economic growth.
Fiscal easing on the way in 2009
Finance Secretary Gary Teves announced on 12 November that the National Government deficit would reach PHP 102bn in 2009, well above the 40bn initially pencilled into the 2009 budget. The deficit is higher than the 75bn estimated for 2008, but once intended privatisation revenues are accounted for the government will only increase its cash injection into the economy buy PHP 12bn or 0.2% of GDP1.
An important feature of the government package for 2009 is infrastructure spending. The National
Government’s infrastructure spend is budgeted to rise 25bn pesos or 0.3% of 2009 GDP in 2009. This is a positive for the economy in that it will offset some of the contraction in private sector investment and will contribute to longer term growth prospects. This is a theme we highlighted for the Philippines in Asian
Economic Perspectives – Where is ASEAN in the infrastructure cycle; Ed Teather; 25 March 2008.
Table 4: Public sector infrastructure spend
2007 2008 2009E
Total public sector 190.0 205.6 229.6
% GDP 2.8% 2.7% 2.9%
National govt. 132.4 122.2 147.5
….% GDP 2.0% 1.6% 1.9%
Source: Congressional Budget Office
A further point of note in the 2009 fiscal settings is the long planned tax cut for the corporate sector at a cost of 15-20bn pesos (0.2% of GDP) and the ongoing relief in terms of reduced taxation on low income households worth an extra 9.5bn pesos (0.1% of GDP) in 2009.
We expect the government to come up with additional stimulus measures in coming months such that the deficit to GDP ratio rises to at least 1.5%, from its current projected 1.3%. Moreover, lags in (corporate) revenue collection and the weak economic growth in 2009 should mean revenues remain weak into 2010 and the deficit to widen further to 2.3% of GDP – which will help drive the growth recovery.
Liquidity issues to be a key focus
According to our calculations in previous work, a deficit of just a little over 2.0% of GDP will still be
sustainable (in that the debt to GDP ratio falls) so long as the currency does not trend lower at 20% per annum2.
However, in 2009 we do not think long term stability of wider budget deficits will be the dominant issue.
Given the downside risks to growth, fiscal stimulus will be an important part of the policy response to the financial market crisis. Instead the pace of debt issuance and the market’s willingness to absorb it will be key.
Here it is worth noting that planned privatisation receipts may need to be replaced by borrowing because of market conditions, which matters from a market perspective, but not from the impact of the budgetary spending on the economy. Currently the government has the following asset sales lined up, with Petron to be sold in 2008 and the remainder on the block for 2009. Planned asset sales for 2008 were 30bn, of which 8bn has been achieved. Planned asset sales for 2009 are 15bn, which as we shall see is not large compared to the 131bn pesos of net borrowing the government intends to undertake in any case.
Table 5: Assets for Privatisation
Asset Reported value
Food Terminal Inc (agro industrial property) 15-20bn
PNOC-Exploration Corp. 16bn
Property in Fujimi Japan and elsewhere Na
2 Southeast Asian Focus – Philippines: Watch the peso; Ed Teather; 24 April 2008
The table below shows our estimates for the government’s planned borrowing requirements. These estimates include the latest policy guidance from Mr Teves of the 12 November. Chart 14 suggests, relative to history, the level of domestic and external net issuance is modest in peso terms.
Our expectation is that domestic issuance in 2009 will not be too much of an issue as private sector investment intentions will be down, freeing up savings to fund government expenditure. The government will no doubt find its dollar issuance programme more difficult. Although the net issuance is not large relative to history, dollar markets are difficult at present. However, we believe that the ADB and World Bank are working on making more funds available. Meanwhile the BSP’s new dollar repo facility (which accepts RoP’s) will no doubt encourage Philippine banks to take on more government dollar debt. Incoming US dollar remittance flows if increasingly saved and not spent at the margin can only help that dynamic.
Table 6: Government financing plan 2009
Absolute amount (Peso bn) Share of total financing
Gross domestic borrowing 386.5 76%
Less principle payments -290.03
Net domestic borrowing 96.47
Gross foreign borrowing 123.4 (2.6bn USD) 24%
o/w foreign debt 72 (1.5bn USD)
Less principle repayments -88.84
Net foreign borrowing 34.56
Gross domestic and foreign
Net domestic and foreign
Budget deficit 102
Budget deficit less privatisation 117
Source: UBS Estimates
More risky will be the private sector’s efforts to raise US dollars or roll over US dollar debt, especially if creditworthiness is a problem given further declines in the peso and economic weakness. The following table highlights that the BSP is in a good position to provide dollar liquidity against near term liabilities, but this will not necessarily solve the problem of peso weakness and deteriorating credit worthiness for some private sector borrowers.
In conclusion we do not expect fundamental sovereign credit problems, although sovereign credit spreads may spike higher on global risk aversion. We do acknowledge, however, that even with lower bank credit to GDP, private sector credit difficulties are quite possible.
A final wildcard: the run-up to the 2010 election.
The overwhelming consensus from our vist to Manila was that President Arroyo would run out her term in office. And while a serious bid to extend the incumbent of the Malacañang Palace’s Presidential term could be made, the focus is on the following candidates as contenders in the May 2010 presidential elections.
The election is not a focus for markets or in Manila at present; the economy is instead the dominating force.
However, periods of economic weakness often prompt loud calls for change. And if we are right about the degree of economic weakness to come globally and in the Philippines next year, economic reform may well dominate the agenda of the winning candidate. Exactly how this may play out – with populist reforms or more long term growth friendly plans remains a wildcard.
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