In the past two years, the world has been turned on its head. The Dow Jones peaked in July 2007 at 14,164—then plunged to its depth in November 2008 at around 7,500. The U.S. economy grew by a respectable 2% in 2007, but is now deep in recession.
In 2007, the advanced economies rose by 2.6 percent. In 2009, the IMF expects these economies to contract by 0.3 percent. The International Labor Organization has predicted that around 51 million will lose their jobs this year. One minute it was 85-year old Bear Stearns that collapsed, the next it was 158-year old Lehman Brothers, and then the entire global financial system needed a bail out.
Who would have thought that these two years would see once sturdy names devastated -- from Freddie Mac and Fannie Mae, to AIG, Merrill Lynch, HBOS, Wachovia, Washington Mutual and even Satyam Computer Services in India? Welcome to 2009.
As the crisis deepens and financial markets tumble, calamity jokes have sprung. Liquidity is now defined as wetting your pants after you’ve seen your investment portfolio. When you get your bank account nowadays, and it is marked ?insufficient funds,you’re not sure whether this refers, to you or to your bank. Now what is the capital of Iceland? About 3 dollars and change!
And you might be amused by the recent changes in these blue-chip corporate logos because of the crisis.
The crisis—causes and consequences
The epicenter of this crisis lay in banking systems which leveraged their balance sheets. Antecedent to this phenomenon, the exceptional high levels of liquidity, together with low interest rates, which reflected the U.S. government’s overly accommodating monetary policy after 9/11, were a toxic combination.
The creation of exotic financial instruments like credit default swaps, collaterized debt obligations and the like, contributed to this leveraged velocity. the liquidity reflected what fed chairman Ben Bernanke has called ?the global savings glut– the enormous financial surplus realized by highly successful economies like Brazil, India, China, Russia– and the oil-producing countries. Until the mid-90’s, most emerging economies ran balance of payments deficits as they imported capital to finance growth.
The Asian financial crisis of 1997 changed all that. After 1997, surpluses grew throughout Asia, in Russia, and in Brazil – which were recycled to the west in the form of portfolio investments. Facing low yields, this tsunami of liquidity naturally sought higher ones. It is axiomatic in finance that yields on loans are inversely proportional to credit quality.
Consequently, huge amounts of capital flowed into the subprime mortgage sector and towards weak credits in the U.S., Europe, and eventually to other parts of the world. And like most spikes, this one eventually reversed itself – and with a vengeance. The former dean of the Wharton School Thomas Gerrity said that the collapse reflects a “classic delusion, a madness of crowds. We’ve lived through it over and over again – and never learn.”
The implosion of the global financial system can best be described by a chart, which shows the market values of the world’s biggest financial institutions, pre- and post crisis. four of the biggest Philippine banks are included for comparison.
The Philippines—insulated from shock?
The Philippines will not escape the unpleasant effects of this crisis. Fortunately, the intrinsic structure of our economy provides us with a fair degree of protection from these external stresses. From an expenditure perspective, a large portion of our GDP –equivalent to as much as 84% -- is accounted for by domestic consumption and government expenditures. Our net exports —meaning exports minus imports — account for no more than 4% of GDP, or less than 1/20th of aggregate domestic private and government consumption.
As well, it is estimated that the decline in the net value of our exports in 2008—gross exports minus imported inputs—is only around P115 billion. In proportion to our nominal GDP of P6 trillion, this reduction accounts for a modest 2% of GDP.
The fact that exogenous elements are of moderate importance to our national income accounts, ironically highlight both a strength and a weakness—an advantage in times of crisis, but a disadvantage in times of global economic prosperity. Further, it demonstrates that our economy is not substantially integrated into the global economic mainstream.
Using Philip Medalla’s analogy: the Philippine boat never left the harbor during this crisis – as it didn’t during the Asian crisis of 1997.
Furthermore, the following features of our economy offer additional advantages: First, positive, albeit slower, growth in OFW remittances that will continue to buoy domestic consumption; second, a more diversified base of OFWs with certain parts of their employment belonging to the less vulnerable sectors; third, lower inflation reflected in reduced food and fuel prices. The fall in oil prices may balance the effects of reduced exports.
Fourth, low interest rates which offer greater monetary flexibility, and an attraction for borrowings by corporations and individuals; fifth, a healthy and liquid banking system and a corporate sector that is not, on the whole, heavily leveraged. The relatively robust condition of our banking and corporate sectors are lessons learned from the Asian crisis of 1997. Sixth, improved macro-debt dynamics such as lower government debt to GDP ratio, a decrease in total external debt to GDP, and — because of the E-vat — a slightly higher tax revenue to GDP.
If the planned economic stimulus package of P330 billion were to be implemented quickly and competently, this will help re-invigorate the economy. While it may seem that the Philippines may escape this crisis and elude recession, it cannot evade its adverse effects. A lower growth scenario in 2009 is therefore realistic.
That said, we still must ask ourselves this question: how can the strength inherent in our economy during times of global distress be translated into strength – instead of weakness -- when global prosperity returns eventually? Indeed, the question which both we in the private sector and government must strive to answer is -- how good can we make it? And not -- how bad can it get?
The government’s role
So, how have governments responded to the crisis? All of them have adopted a broadly similar menu of fiscal and financial incentives, differing only in size and detail. While this menu may seem to be an easy recipe to follow, the package hinges on three critical ingredients: the size of the package; the quality of spending; and credibility of the government and the confidence it inspires. Like a tripod, one missing leg could compromise the effectiveness of the package as a whole.
The first leg of the tripod relates to the scale of the package. Although the Bush/Obama rescue packages may together exceed a record $1.2 trillion—representing about 10% of U.S. GDP—some fear that this may not be adequate to increase output and prevent a rise in unemployment.
In the Philippines, the government proposes an "economic resiliency plan" of P330 billion-- roughly equivalent to 5 percent of GDP. Whether P 330 billion is sufficient to avert a crisis is a critical question. Some economists advocate that at a bare minimum, an additional 1.5% of GDP must be allocated for vital social spending like infrastructure and education alone. Apart from size, the quality of public spending is equally important.
We should understand that this crisis is not an unfettered license to spend. The challenge therefore must be where and how to prioritize spending. The stimulus plan may wish to focus on: 1) creating immediate short-term impact on consumer spending; 2) projects that support economic growth in the long term; and 3) programs that address poverty.
I have not tired of stressing how infrastructure investments can be a catalyst for economic growth and job creation. The maintenance and repair of existing roads and bridges for example can quickly raise consumer spending by creating employment. Investment spending has the potential to lower the cost of domestic production, providing an added incentive for foreign investors to locate domestically and promote home employment.
Government must make the pragmatic decision to concentrate its infrastructure expenditure in the country’s core-growth areas, rather than spreading it around the country. These core areas include the national capital region; the central to southern Luzon growth corridor; the metropolitan Cebu area; and the metropolitan Davao area. These areas account for a large and growing share of national output, with the national capital region and the Calabarzon area alone producing almost half— 48.4 percent—of GDP. Not only the government but also the private sector should mobilize, direct and focus their infrastructure spend in these strategic locations.
There is a range of options available for the government to help put money into consumers' pockets. Income tax cuts and reduced value added tax are alternatives. These measures, however, might be difficult in the face of weak revenue performance, exacerbated by the non-indexation of specific taxes to inflation. Moreover, measures like these hardly benefit the poor—most of whom are employed in the non-taxed sectors – and only half of their spending is covered by consumption taxes such as VAT.
The challenge, therefore, is to find the most effective way to soften the blow on the poor without heavily compromising the government's fiscal position. One program that appears to offer promise is conditional cash transfers. If correctly implemented and rightly targeted, this program can help achieve health and education outcomes that would enhance the country’s human capital stock, and improve our chances of riding the wave of recovery.
The conditional cash transfer framework has been popular in Latin America in helping poor families directly, and has the following common features: 1) direct transfer of cash to the poorest of the poor; 2) requirement for poor households to comply with certain conditions, including continued enrollment of children in schools and checkups at health centers. 3) poor households are chosen through a rigorous poverty targeting mechanism.
Of course, the simplest approach to government spending is to pay down debt, and benefit from the positive effects of a possible upgrade in creditworthiness. With the decline in debt premium, credit availability at lower cost may spur private sector investments. It must be better to spend nothing but retire public debt, than to spend something but on the wrong things.
The last leg of the tripod concerns government's capacity to execute the economic stimulus plan, and the confidence it may inspire in the process. Few details so far are known about the plan, such as which implementing agency, the areas targeted for support, and how the private sector can tap into the fund.
Governance and the crisis
This crisis reflects the greatest regulatory failure in modern history – a failure that cuts across banking supervision to securities and exchange regulation and disclosures, to credit rating oversight. The recriminations, let alone the criminal prosecutions, are just beginning.
There is unanimity that broad regulatory reforms are necessary in the U.S., and in Europe too. Apart from the external regulatory breakdown—sadly, governance in corporations had been breached. Board oversight must have been lax and deficient. More importantly, the financial incentives in place favoring the CEO and his senior managers propelled them towards unprecedented greed, excess and abuse.
The banking system was part of the problem – with leverage and exotic financial instruments, which must have befuddled both investors and regulators. These financial instruments have grown in number, variety and complexity, as to leave the regulator unprepared and ill-equipped to manage.
Imagine yourself to be a banking regulator and are presented with the Black-Scholes formula used to price a call option. Feeling a bit baffled? Can’t follow the algebra? Well, quantitative finance—or quants—developed this formula. I’m sure there are formulas for other derivatives which are more complex.
Ironically, the quants planted the seeds of their own destruction because their magic eventually made the finance business unregulateable. It can therefore be rightfully said that—those whom the gods wish to destroy, they first teach math.
Activist shareholders have proposed a range of measures to encourage chief executives to focus on the long term rather than the next quarter, to give shareholders a ?say on pay “and to make it easier for them to nominate their own candidates for board seats.”
Ultimately however, any analysis of successful companies shows there is no single governance style that guarantees success. That said, moves to make directors more responsive to shareholders – and to open board elections to challengers – could be helpful. It can also be useful to tie executive compensation with long-term results by parceling out compensation over a number of years, with provisions for withholding portions, if performance fades. At the end of the day, the best solution to governance is greater transparency.
The best solution to regulation is more courageous questioning by regulators of those they regulate. At PLDT, we recently adopted a new thrust in corporate governance called “enterprise risk management.” This approach forces us to take a sophisticated and comprehensive look at the principal risks we face – from the risks of typhoon damage or terrorist attacks, to the dangers from competition and access to funding.
Poverty and philanthrophy
When times turn rough, resources normally devoted to social work is one of the first to be axed. But the needs of the poor will still have to be addressed even in a downturn. They certainly will not disappear in this crisis. In fact, they will get worse as unemployment rises. The role of corporate philanthrophy during this time becomes even more critical than ever. This is a time for all of us to come together.
Economic progress is never a smooth one. It is a roller-coaster ride of ups and downs, lefts and rights, manias and panics, shocks and crashes, bubbles and bursts. With innovation being created so fast, accelerating changes, the mean time between crises has been telescoped. The abiding lessons of leverage – the flood of debts, asset price inflation, and the hypertrophic growth of derivatives—made us predestestined for a really big and loud bang.
In the crisis environment we now face, it is particularly critical to have business leaders who can balance the short term imperatives of the crisis, but have the courage to see opportunities beyond it. First Pacific regards 2009 as a year of two halves. In the first half, we’re seeing investment values driven by a contractionary environment, with equity and debt products undervalued but volatile. At some point in the year, these extreme valuations should provide attractive opportunities as risks growth dissipate, and deleveraging pressures ease.
It is this which drives us to encourage our companies to be affirmative in setting their goals despite the crisis; to be mindful of new investment prospects; to stay positive in outlook and spirit. PLDT is maintaining its 2008 capex level of P27 billion into 2009.
Our hospitals group has budgeted over a billion pesos in renovation and equipment capex in the next two years. Nlex will spend P2.1 billion in capex this year, ahead of the P90 million spent in 2008, and is looking at new tollways expansion. Maynilad would have spent P8 billion capex this year, compared with P6 billion last year, if tariffs had been adjusted as scheduled.
It is my hope that all of you at MAP will accept the challenge of crisis leadership, which says that it is ourselves who can best solve our problems because there is no greater empowerment than self-empowerment. Let’s listen to that ancient maxim about leadership, espoused by the philosopher Lao Tzu: “The poor leader is he who the people despise; the good leader is he who the people revere; the great leader is he who the people say, ?we did it ourselves.”
These are the author’s remarks at the 60th inaugural meeting and induction of officers of the Management Association of the Philippines (MAP) on January 30, 2009 in Makati.