Why the Philippines is ignoring analysts' siren call (so far)

National Treasurer Rosalia V De Leon says the central bank is right to hold off raising rates as she queries why the country does not have a higher international credit rating.
Rocky ride ahead?
Rocky ride ahead?

The Bangko Sentral ng Pilipinas (BSP) has been making the right call to hold off lifting domestic interest rates, as the economy is not in danger of overheating National Treasurer Rosalia V De Leon told FinanceAsia

Economists had been expecting the central bank to raise its policy rate about two to three times in 2018 to combat rising inflation, higher US treasury yields and strong GDP growth. So far it has resisted.

"The central bank has shown they'll not be moved by market analysts calling for rates to be increased," De Leon told FinanceAsia in a wide-ranging interview examining the country’s credit metrics. "Inflation will stay in its forecast range and I do think the market will begin to digest that message."

De Leon agrees with the BSP's assessment that inflation is spiking because of short-term and transitory factors such as recent tax hikes. In March, headline inflation surged to 4.3%, up from 3.8% in February. 

As a result, inflation averaged 3.8% during the first three months of the year, right at the top of the BSP's 2% to 4% band. In a recent report, Moody’s also noted that real interest rates turned negative in January.

But De Leon says inflation will fall back into its forecast range by 2019. She also argues that one reason why domestic Treasury yields have spiked so sharply is because the domestic market has priced in three to four US interest rate hikes well ahead of time.

Over the past five months, Philippine 10-year government bond yields have witnessed the fastest and highest jump of any Asean [Association of Southeast Asian Nations] nation. Since their recent 4.6% low in early October, they have risen 240bp, breaching the 7% mark as of April 11.

By contrast, second place Indonesia saw rates climb a more modest 84bp between January and March, before they began falling back to the 6.5% level again.

This has not been good news for the Bureau of Treasury, which has enjoyed a continual reduction in funding costs over the past decade. It does not want the tide to turn just when the government is ramping up its $167 billion infrastructure programme known as Build, Build, Build (B3).

At the moment, the central bank and traders appear to be caught in a standoff, which is causing bouts of volatility and sharp swings, as market sentiment shifts one way and then another with every passing government statement.

The Treasury took advantage of one of these mood swings when it auctioned three-year bonds in March. “Rates started to settle and we received a very good bid, enabling us to make a full award in contrast to recent auctions,” De Leon said.

Golden growth

The treasurer also points to Moody’s recent report as evidence against overheating. The rating agency concluded that such risks “are not yet material,” adding that, “trends in core inflation and wage growth suggest the presence of slack in labour markets.”

The Asian Development Bank (ADB) also came up with a similar assessment in a report published this week. It says the Philippines “is going through a golden age of growth.”

It projects 6.8% GDP growth in 2018 and 6.9% in 2019 thanks to domestic demand and the government’s infrastructure programme, which is creating the country’s highest and most sustained period of economic growth for 50 years.

Financial analysts tend to concur. In a report published last month, HSBC said: “The Philippines economy appears to be humming along, which we expect to continue in the foreseeable future.”

De Leon believes the country can fund B3 and still enjoy improving credit metrics thanks to ongoing revenue-generating measures. Together they will create a virtuous circle, underpinning higher growth.

Belt and Road

One important component of that B3 funding is coming from Official Development Assistance (ODA) sources.

Back in February, one Philippine government official noted China was charging rates of 2% to 3% for its assistance compared to 0.25% to 0.75% from Japan.

De Leon refuses to be drawn beyond saying the Chinese loans carry long-term maturities and soft-financing terms, which are much more generous than anything the government could get in the commercial market.

She also says there will be no issue with the Philippines repaying the Chinese since the money is backing “very sound projects, which have been rigorously evaluated".

“These loans will allow the government to fund its infrastructure requirements without crowding out the private sector,” she commented.

Comprehensive tax reform

Revenue-generating measures are flowing from the Comprehensive Tax Reform Programme, which is already spurring increased collections. De Leon says the first few months of 2018 data are showing a very positive uptrend and believes tax revenues should increase from 14% to roughly 15% of GDP this year.

A second proposal to rationalize fiscal incentives has already been submitted to Congress and will be net neutral.

A fourth package is generating much more excitement among investors since it concerns capital market reforms that could make a big difference to the efficiency and allure of the domestic bond market.

“A reduction in the withholding tax on government securities should come by the middle of next year,” De Leon suggested.

Domestic investors are currently charged 20% withholding tax on government securities and foreign investors 30%. Market participants would like the two to be equalized and then reduced, if not scrapped altogether.

It is one of the most frequent complaints the Bureau of Treasury hears whenever it goes on international roadshows.

Lynette Ortiz, Standard Chartered’s CEO for the Philippines, also highlights other moves, which should make the market more attractive. Among these are increased frequency of issuance (from twice monthly to weekly Treasury bill and bond auctions) and improved benchmark price calculations.

“If there’s no 'done' transaction, then benchmark rates are calculated on the basis of the best bids, which creates jagged yield curves because of the sudden shifts,” she explained. “There are moves to to amend the process by selecting benchmark sized issues as the basis for benchmarks to create a smoother yield curve.”

Ortiz says that ample domestic liquidity also means there is plenty of room for domestic corporates to raise debt funding locally. But she predicts greater offshore activity about three to four years down the line when some of the bigger infrastructure projects hit their stride.

Onshore/offshore funding

De Leon also says the Republic will continue to have a 75/25 bias towards onshore funding this year. In recent years, her Treasury team has won a lot of plaudits for reducing the country’s funding costs by retiring expensive offshore debt.

It also showed itself to be ahead of the curve late last year when it issued retail Treasury bonds to lock in Ps255 billion ($490 million) of pre-funding from its planned Ps889.5 billion ($3.39 billion) 2018 total.

Some analysts argue that the Treasury appears to have fallen behind schedule so far this year, no doubt hoping that yields would settle. In March, HSBC strategist, Dayeon Hong, suggested this was creating supply pressures, which could lead to further jumps in yield.

De Leon refutes this saying the pre-funding “ gave us a strong cash buffer, which meant we could give some partial awards at some of our government bond auctions".

But there is no doubt the sovereign timed its annual benchmark dollar bond financing extremely well. It hit the market at the very beginning of January before US Treasury yields rose sharply.

So far, investors have done less well from the $2 billion 3% February 2028 transaction, which has fallen from an issue price of par to 94.58% as of Monday's close.

The Republic also issued its first Panda bond in March, raising Rmb1.46 billion ($230.8 million) from a three-year offering that was executed via Bond Connect. The deal not only marked the first sovereign issue by an Asean country, but also attracted more orders from offshore foreign investors than onshore domestic ones.

It consequently meant the government was able to shave its funding costs and price the deal cheaper than its dollar financing levels on a like-for-like basis. The Panda's 5% coupon had an indicative dollar swap equivalent rate of 2.93%, some 23bp below the then three-year dollar yield of 3.16%.

De Leon attributes the success to a number of factors not least the “meticulous preparation” the team went through including roadshows in Hong Kong and Singapore, which paved the way for the strong offshore participation through Bond Connect.

She says the sovereign will definitely return to the Panda market again and is actively looking at other “unchartered” markets, which will enable the Republic to diversify its funding sources at a time of elevated volatility in US Treasury markets.

She also flags the Philippines' rarity value as a second reason why the deal did so well. The Philippines is no longer an active offshore issuer, giving investors far less opportunity to ride the credit momentum which has propelled it ever upwards over the past decade.

Government debt to GDP stood at 42.1% at the end of 2017 and it forecasts it will drop to 36.7% by 2022. Interest payments as a percentage of GDP also hit an all-time low of 14.5% in 2017.

In addition, the sovereign’s dollar bonds have been at the top of domestic investors’ buy list over the past five years thanks to the peso’s almost continuous slide since 2013 (it has lost about 20%).

The Baa2/BBB/BBB rated credit is consequently trading at much tighter levels than higher rated sovereigns such as A3/BBB+/BBB+ rated Peru and Baa1/BBB+/BBB+ rated Thailand.

The Philippines has a stable outlook from all three agencies and has not seen any action from Moody’s or Standard & Poor’s since 2014. De Leon is not sure why given the structural improvements in the economy.

“What more needs to be done?” she asks them.

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