Tuesday, 24 February 2009

Managing through challenging times

Map Insights
By Manuel V. Pangilinan
(Speech delivered by the author as guest of honor and inducting officer at the Jan. 30, 2009, MAP inaugural meeting. Mr. Pangilinan is chair of PLDT and MAP Management Man of the Year 2005 Awardee.)

Part I

It has been two years almost to the day since I was given the privilege of joining your fellowship. In those 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 US economy grew by a respectable 2% in 2007, but is now deep in recession.

In 2007, the advanced economies rose by 2.6%. In 2009, the IMF expects these economies to contract by 0.3%. 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 bailout. 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 three dollars and change!

And you might be amused by the recent changes in these blue-chip corporate logos because of 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 US 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-90s, 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 toward weak credits in the US, 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 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 highlights 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 reinvigorate 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?

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 US 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% of GDP. Whether P330 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% — of GDP. Not only the government but also the private sector should mobilize, direct, and focus their infrastructure spending 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.

(To be continued)

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