Dear Sec Gary, Dof Friends:
I hope you are keeping well despite these trying times.
The spike in RoP spreads and your most helpful briefing on BSP is doing reminded me of a piece I wrote four years ago. "Dollar RoP's: blessing or curse?" (below). I said there that the banks then were holding $ 9 billion in RoP's ( per the info we got, I think from BSP), of $ 13 billion in FCDU deposits . Gigi mentined only $ 5.5 as total bank holdings of RoP's, including trust and CLN's. (Around a fifth of FCDU deposits of over $ 25 billion, around 5 % of total bank assets.) Are these numbers also what you have? So we are actually much better placed than four years ago-- I guess the BSP's requiring full risk charge to capital for RoP's must have made banks reduce exposure in it? Or maybe the warrants you offered are netted out? ( Maybe good idea to do more?)
In that 2004 article, I was pushing for strengthening fiscal accounts (fiscal deficit then 5% of GDP vs. 1% now) , as needed to reduce risks arising from RoP concentration. Though the origins now of pressure on RoP value are wholly external, it is still helpful, I think, that government strengthens fiscal position-- so it does not add even more risks to an already nervous market. And, if needed, so that it will have the fiscal space to support the financial system. Thankfully, we are better placed now than in 2004-- but still continues to be fragile. ( Our public debt to GDP ratio down from 95% in 2004 to 66 % currently , but even at the lower level, still higher than our similarly rated peers-- even, Argentina's a year ago, though maybe not anymore..)
Some of the things that can be done to strengthen fiscal position--indexing sin taxes, rationalizing fiscal incentives, better collection of oil taxes, that will help offset reduction in collection due to slowdown, decline in corp income tax etc. -- and our leaders need to talk less about fiscal stimulus like raising tax exemptions, NFA spending and\ fertilizers- and do instead more efficient support like conditional cash transfers. We may even be able to get World Bank and ADB support for these reforms and thus help our BSP with augmentation in country's reserves at much lower cost than RoP market. ( Which should also help assuage markets, and keep us away from IMF program.)
Sharing these with you as key tested veterans of two previous financial crisis with much credibility whom political leaders in the Executive and Legislative branch-- who are often driven by reacting or talking without CSW.
Good wishes,
Romy (bernardo)
Dollar RoPs: blessing or curse?
Tuesday, October 5, 2004
BusinessWorld
By ROMEO L. BERNARDO
One aspect of government's debt problem that seems to have missed scrutiny is the large share of dollar-denominated securities issued in the international capital markets.
Popularly known as RoPs, these securities comprise 42% of government's outstanding foreign debt in 2003 compared with just 11% in 1999 (from almost nil in the early '90s). What is the significance of this?
As has often been discussed, this large exposure to the capital markets means that unlike in the past decade, government today is much more exposed to the international market's mood swings. This makes it vulnerable to "event risk," or the risk of some unexpected "news," economic or political, causing markets to close down abruptly, with government either unable to
refinance its maturing obligations or to refinance at reasonable terms.
With the country's large refinancing requirements (roughly $3 billion in 2005 for both the national government and NPC, not counting refinancing needs of private dollar bond issuers), a sudden confidence run can be costly in terms of the additional spread demanded by the market or worse, can precipitate a payments crisis.
Much less talked about is the link between fiscal solvency and financial sector solvency resulting from these RoPs. Given the attractiveness of RoPs yield-wise (estimated after tax peso return of 18% for the 10-year bond), and regulation-wise (no capital charge under currently-adopted risk-based capital standards), local banks have become major buyers of RoPs, crowding out private investments hard-pressed to compete with such superior risk-reward features. It is estimated that about US$9 billion out of US$13 billion assets of local FCDUs are invested in government's foreign currency-denominated securities. What's more, banks are not simply booking ROPs but have developed derivative instruments with ROPs as underlying assets that multiply leverage and vulnerability. These activities provide a channel through which a fiscal crisis can feed into a financial crisis.
It has been observed that a significant portion of RoPs finds its way into local hands through the banking system.
By itself, this offers some comfort as local investors can be expected to have greater appetite for its own government's risk, insulating government from any knee-jerk market reaction.
Also, under existing prudential standards where RoPs are zero risk-weighted even though they provide yields equivalent to "junk bonds", buying RoPs is a "no brainer" for banks and thus, banks and their clients constitute a captive market for these government issues, helping to bring down government's borrowing cost.
From a financial sector stability viewpoint, however, the magnitude of banks' exposure to government risk gives one pause.
On the one hand, most depositors in all likelihood do not even realize that their banks are heavily invested in RoPs, or even if they do, have limited options to move deposit accounts out of the country, especially with stringent international protocols in place pertaining to anti-money
laundering ("know your customers").
On the other hand, at the time of its debt default in 2001, Argentina's banks were similarly exposed to government risk through their holdings of government local and foreign currency bonds and loans.
Although total exposure was not extreme -- reportedly 21% of total assets in 2000, this was a source of vulnerability for the banking system, especially when confidence started to wane and depositors ran for the exit.
As analysts observed, moves in 2000 to de-link the financial system from the fiscal problem, e.g., marking government bonds to market, requiring positive weighting for government loans, came a little too late to shield the system from the fiscal blowup.
Of course, the Philippines is not in the same boat as Argentina.
Argentina's crisis was a confluence of several factors, consisting not only of weak public finances and a banking system vulnerable to government default, but perhaps most importantly, an overvalued currency due both to the appreciation of the dollar (to which the Argentine peso was pegged under a currency board arrangement) against the euro (Argentina's major trading partners) and the devaluation of Brazil's currency, which reduced
the competitiveness of Argentina's exports.
Thus, while Argentina's fiscal deficits like ours ran unabated, it also incurred deficits in its current account and experienced declines in its international reserves, at the same time that its domestic economy was contracting. Even with a large support package from the IMF in late 2000 to help restore confidence, Argentina failed to avert the crisis and in the end, had to abandon its currency peg.
In contrast, thanks to remittances from OFWs, the Philippines continues to enjoy stable, even if low-quality, GDP growth. This suggests that to some extent, government may continue to incur new debt without raising the debt ratio (assuming that the current debt ratio is optimal).
At the same time, our current account is in surplus, thus providing some assurance that dollars are available in the system even if government, for some reason, is unable to refinance its debt (at over US$3 billion, the current account surplus is just enough to meet government's refinancing requirements). The Philippines also does not have the problem of an overvalued currency masking the real magnitude of the country's debt, which should make it politically easier to pass policy reforms to correct weaknesses in the fiscal sector.
Be that as it may, there are vulnerabilities in the economy that should preclude complacency, with the fiscal problem at the top of the list. Also, it is in the nature of a highly leveraged financial system that a confidence run, triggered by one or several concurrent or sequential events (e.g., default of a large borrower, oil price shock, interest rate spike), may cause serious systemic breakdown. The fact that a crisis may be event-triggered makes it hard to predict. Is it two years as the UP economists forecasted? One year as predicted by Congressman Joey Salceda?
Or, six more years provided we can muddle through with some modicum of revenue measures, e.g., Bayanihan Fund, pseudo indexation of sin taxes, a brain-dead gross income tax, and an incredible "tax amnesty"? Who knows?
Thinking about our leveraged banking system and the vulnerabilities engendered by public debt build up, the picture in my mind is of a man standing tiptoed on one leg. I can't help but imagine how a little gust of wind or even a fly on his nose can cause him to topple over. This makes it all the more urgent for action on the fiscal front to raise market confidence, both in government and the banking system.
But there is an even more fundamental reason why urgent action needs to be taken. We may very well defuse the debt bomb by good fortune or brinkmanship. But is that all we are trying to achieve? Isn't it the role of government to create an economic and financial environment that is conducive to sustainable, higher quality growth, that encourages long-term investments and that keeps Filipinos productively employed at home? And isn't that compatible only with a robust fiscal and debt position over the long term?
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