Just as Argentina concludes the restructuring of its defaulted external debt, another sovereign default looms in the Philippines. Many analysts and investors are aware that the fiscal position of the Philippines is very similar to the fiscal position of pre-default Argentina. However, the social and political similarities between the Philippines and pre-default Argentina continue to be overlooked. The risk of default in the Philippines is much higher than is generally believed.
Out With The Old, In With The New
In early March, Argentina's government is expected to announce that about 70% of the country's bondholders agreed to swap defaulted debt for new bonds, taking a capital haircut of about 75% in the process. The successful conclusion of Argentina's debt swap is being heralded as marking the end of the era of emerging market debt defaults. Investors appear to agree, as emerging market bond spreads are near historical lows.
Rather than taking Argentina's debt restructuring as a signal that emerging market credits are improving, investors should be mulling the implications of their capital loss in Argentina for other emerging market credits. Argentina's default, and those of Ecuador and Russia before it, very clearly demonstrate that the risk of default among emerging market countries is not insignificant. Current emerging market bond spreads offer no default premium.
Damn The Credit Fundamentals
The Philippines offers an excellent example of the disconnect between default risk and bond spreads. In the past year, investors and analysts have begun to understand that credit fundamentals in the Philippines are quite weak. International credit rating agencies, in their backward-looking analysis, have concurred, downgrading Philippine debt.
Evaluation of Philippine credit fundamentals, however, has been almost exclusively confined to recognition that the public sector deficit and debt stock are large. This is nothing new. The fiscal deficit, as measured by the all-inclusive public sector borrowing requirement (PSBR), has been above five percent of GDP in each of the last five years. The public sector debt stock has been above 125% of GDP over the same period.
What is apparently new is the sudden surge in public sector debt service payments. Interest and principal payments on the public sector debt stock have increased from 46% of total national government expenditure in 2002 to 68% of total national government expenditure in 2004. That debt service expenditure would leap higher was evident more than five years ago, when the public sector debt stock topped 100% of GDP.
With public sector debt service costs equivalent to almost 70% of total national government expenditure, it is painfully obvious that Philippine debt service is unsustainable. Attempts to increase fiscal revenue by raising taxes will push economic growth lower - the net effect being further reduction of tax revenue.
The Philippines is squarely in a debt trap. The Arroyo government's efforts to extricate the country from this trap are too little, far too late. Inexplicably, investors are disregarding the obvious, pushing down Philippine international bond spreads to ridiculously low levels. Perhaps the Arroyo government's promise of fiscal rectitude has consoled investors. Nonetheless, this very rectitude will prompt the country's inevitable default.
Social Revolt As The Driver Of Default
As in the Philippines, Argentina's public sector debt stock became unsustainably large long before the country's default. Again, similar to the Philippines, Argentina's attempt to tighten fiscal policy was far too late to extricate the country from its debt trap. Rather than reducing the fiscal deficit, tighter fiscal policy in Argentina reduced economic growth, making default inevitable.
One of the key reasons why economic growth slowed in Argentina was the gathering social revolt. Increasing social instability in Argentina, driven by increasing unemployment, rising taxes and non-payment of public sector wages and pensions, created political instability, the eventual collapse of the government and default. Notably, the IMF dictated to Argentina the fiscal policies that resulted in social revolt.
The same pattern is being replicated in the Philippines. The increase in public debt service costs has sharply reduced national government expenditure on social services. Social service expenditure decreased from 35% of total national government expenditure in 2000 to 23% of national government expenditure in 2004. The reduction in social expenditure has contributed to the intensification of the country's Muslim and Communist insurgencies and to growing social instability.
In addition to reduced social expenditure, the Arroyo government also seems to have adopted some of pre-default Argentina's fiscal antics. National government expenditure, in ratio to GDP, declined in 2004, most probably due to the delay of earmarked expenditure into 2005. However, President Arroyo's most socially-detrimental policy is her plan to increase fiscal revenue by raising taxes.
As fuel and utility prices escalated sharply in 2004, the Arroyo government began to implement its fiscal tightening plan in the face of mounting social instability. Legislation aimed at increasing the VAT, if implemented, will most likely touch off uncontrollable social revolt in the Philippines as fuel and utility prices are forced higher by rising international oil prices.
Gaining the support of the powerful Catholic Church, such a revolt will probably lead to the demise of the Arroyo government. Significantly, several opinion polls indicate that the majority of the Philippine electorate view the Arroyo government as illegitimate due to fraudulent elections in 2004.
As in pre-default Argentina, very weak governance in the Philippines, undermined by weak government legitimacy and low popular support for the president, will further diminish the government's tax authority. This will lead fiscal revenue lower despite the proposed tax increases.
Just like Argentina, the Philippines' eventual public sector debt default will be the result of social revolt and government collapse. Unless another large capital loss is appealing, investors should consider Argentina's default as an example of what can happen in other emerging market countries, and not as an isolated and resolved event.
Jephraim P. Gundzik is President of Condor Advisers, Inc. Condor Advisers provides emerging markets investment risk analysis to individuals and institutions globally. Condor's research foresaw Argentina's default and devaluation. Please visit www.condoradvisers.com for further information.