One of the problems with sovereign bond strategy is that it partly relies on second guessing the rating agencies. This injects a large degree of uncertainty into the process since the rating agencies are malleable to market pressure.
This was demonstrated yesterday when S&P revised its outlook on the Philippines long-term BB+ rating to negative from stable, less than two weeks after reaffirming a stable outlook! The about-face was no doubt influenced by the chronic weakness of Philippine asset markets and the peso in recent days, whereby spreads on the benchmark USD bonds have been trading wider than Argentina, implying multiple downgrades.
The formal explanation for S&P's sudden change of heart is the deterioration in the political climate. The opposition's efforts to impeach President Estrada for his alleged role in a bribery scandal are likely to drag on for months: Estrada has said he has no plans to resign, while he has a sufficient majority in Congress to ensure the impeachment does not succeed, at least until after Congressional elections next May. For their part, the opposition might extend the impeachment process and use it as part of their election campaign. S&P fears the ensuring political uncertainty will lead to administrative gridlock, as well as distracting the government from economic management.
All these are valid concerns. The risk of policy disruption is one factor behind our recent upward revision to our year-end USD/PHP forecast from 48 to 52, since we are not confident that the government will be willing to rein-in a budget deficit that may hit PHP120bn (4% of GDP) this year compared to an original IMF target of PHP62.5bn.
Moreover, the government is showing no urgency in its efforts to raise the estimated $1 billion plus in deficit financing needed by year-end, which raises the risk of a sudden need to either tap the overseas market in large size, to flood the local bond market with fresh issuance over a short period of time, and/or a large dose of formal or informal monetisation. Either way, the immediate prognosis for financial markets is bleak.
However, will weak financial markets lead to a downgrade? In a broader perspective, the Philippines still enjoys characteristics commensurate with a BB+ credit: at 35% of GDP, domestic debt is manageable, and will actually decline in 2000 as 9%-10% nominal GDP growth contrasts a 4% of GDP budget deficit; external liquidity ratios are healthy, whereby the 2000 current account surplus is forecast at 7% of GDP, the debt service ratio is a low 14.2%, while short-term foreign debt is less than 50% of FX reserves compared to 144% for Thailand and 280% for Argentina; growth prospects are reasonable sound, with real GDP growth trending around 3%-4%, low by Asian standards, but enough to diminish public indebtedness.
Contrasting this optimism of course is the view that a fiscal deficit of even 4% of GDP is alarming if it leads to a marked destabilisation of the business cycle (by raising inflation or slowing growth) which is the current fear in the Philippines. However, a suboptimal debt management policy has contributed to the government's current difficulty in raising funds which in absolute terms and relative to GDP should not impose a particularly onerous burden on the economy.
PHP120bn worth of public borrowing could be achieved without markedly destabilising the economy if it was spread over a year: a lack of domestic credit growth leaves Philippine banks with liquidity they are willing to recycle into the financial rather than the real economy; BSP has lattitude to implement fast reserve money growth due to high rates of nominal GDP growth and thus demand for money, which reduces the inflationary consequences of partial monetisation.
(Reserve money growth averaged 9.6% y/y between January-September which is broadly in line with the demand for money. Low money multipliers mean that for monetary growth to generate a marked pick-up in inflation, reserve money growth must technically be significantly in excess of nominal GDP growth.)
Instead of spreading out its borrowing, the government has left a $1 billion plus financing need loom large over the final weeks of this year. If, for instance, the Bangko Sentral ng Pilipinas monetises its remaining borrowing requirement, the sudden increase in money supply will inflate y/y reserve money growth by 20% in a short space of time. Similarly, while the bond market could have withstood increased monthly issuance throughout the year, the fear of a surge in issuance in the next 10 weeks is reducing appetite for debt, pushing up yields and forcing the authorities to reject bids at a succession of auctions.
From a ratings perspective, therefore, the current budget deficit is not an intractable problem, rather the government's funding problems represent the consequences of a poor debt management policy. The BB+ rating "should" in theory survive the review unless we see a dramatic deterioration in fiscal policy sufficient inflate the debt/GDP ratio.
However, the tendency of the rating agencies to follow the market means that a downgrade cannot be ruled out. At the present time this does not matter too much because Philippine bonds are trading at multiple downgrade levels and thus still offer medium-term value. Hence the S&P review does not alter our perception that a pronounced rally will be seen in Philippines bonds further down the line.
However, the key phrase is "further down the line". A rally first requires a credible plan of fiscal consolidation able to reduce fears of a sudden bout of monetisation/bond issuance in Q4, and into 2001 ahead of the Congressional elections.
Desmond Supple is Head of Research, Asia at Barclays Capital. Email: [email protected]