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Tuesday, April 2, 2013

After the upgrade, more heavy lifting

 (The Philippine Star) 
Congratulations are indeed in order for last week’s Fitch Ratings upgrade of our sovereign debt to investment grade. That certainly took a lot of work to achieve. But the work has really just started.
Fitch is just one of three ratings agencies and we have two more to convince. Then there is the matter of converting this good news in the financial sector to something that can be appreciated in the real economy. Otherwise, it will just be the elite enjoying the benefits from it.
Standard & Poor’s, one of the three ratings agencies pointed out late last year the Philippines has a problem with its low per capita income. It is even lower than Indonesia. S&P said from 1991 to 2011, Indonesia’s per capita income — estimated income of each person affected by economic growth — increased to $3,600 from $928 as against Philippines’ which rose to $2,330 from $1,014.
Our low per capita income levels remain a rating constraint, S&P said. “The wealth levels in Indonesia and the Philippines imply a low revenue base for the government to draw on, significant human and physical capital shortcomings, and hence less fiscal and political flexibility to modify policy to avoid default in the event of adverse economic developments.”
S & P said this suggested slower growth for the Philippines and we have “made little inroads in improving family planning. Its relatively high population growth rate (averaging about two percent per year), compared with 1.3 percent in Indonesia, also detracts from attaining higher per capita wealth levels.”
How will we immediately benefit from this upgrade? Being declared “investment grade” doesn’t mean we are automatically a good investment destination. It merely means we have become a good credit risk, an important factor potential investors look at.
The immediate effect is on the international borrowing costs of both the public and private sectors which will go down now that we are seen as less likely to default. Debt payments eat up the largest chunk of the annual national budget, and lower debt service costs mean savings that can be channeled to finance much needed infrastructure development, larger investment in education, health and other basic services.
An IMF working paper lists six basic variables likely to explain ratings: per capita income, GDP growth, inflation, external debt, level of economic development, and default history. The three major credit rating agencies —Moody’s Investor Services (Moody’s), Standard and Poor’s (S&P), and Fitch Ratings (Fitch) — base their assessments of government risk on these broad set of economic, social, and political factors.
The IMF working paper cited a study, Mulder and Perrelli (2001), which found that for emerging market economies the ratio of investment to GDP was the key variable explaining ratings. Another study, Mellios and Paget-Blanc (2006) found that indicators of corruption were an important determinant of ratings.
Just so we all know what goes into the ratings, here is how the IMF paper listed the relevant variables.
Macroeconomic variables:
• Per capita income in US dollars. Higher per capita income tends to suggest a larger potential tax base and a greater ability to repay debt. It also serves as a proxy for the level of economic development, which might influence default risk.
• Real GDP growth and potential GDP growth. Higher economic growth tends to decrease the relative debt burden and may help in avoiding insolvency.
• Inflation rate. A low inflation rate reveals sustainable monetary and exchange rate policies. It can also be seen as a proxy of the quality of economic management.
• Unemployment rate. A country with low unemployment tends to have more flexible labor markets making it less vulnerable to changes in the global environment. (We need a lot of work in this area).
External sector variables:
• Exports to GDP. A higher ratio suggests a greater capacity to obtain hard currency to repay foreign currency denominated debt.
• External current account to GDP. A large current account deficit suggests a high dependence on foreign capital, which can be a source of risk to macroeconomic stability.
• Private and public external debt to GDP. The higher the external indebtedness, the higher the risk of fiscal or balance of payments stress.
• Net international reserves to GDP. The higher the ratio, the more resources are available to service foreign debt. It reduces a country’s vulnerability to liquidity shocks. (Congratulations are in order for BSP’s work in this area).
Government sector variables:
• Primary balance to GDP. A low primary balance indicates that the government lacks the ability or the will to increase taxes to cover current expenses. A weak fiscal position also implies a higher likelihood that external shocks result in a default.
• Public debt to GDP. The higher the debt burden, the larger the transfer effort the government will have to make over time to service its obligations, and therefore a higher risk of default.
Financial depth:
• Broad money to GDP. Countries that have access to a deep and diversified pool of finance are in a better situation than those whose private savings are low and whose financial system is repressed. For this reason, financial depth is a useful indicator of government financial flexibility. High levels of financial intermediation, as proxied by broad money to GDP, can be associated with a greater capacity to sustain a given domestic debt burden. (We need to channel local savings beyond BSP’s SDA, devise a means to harness OFW remittances to finance developments in infrastructure and manufacturing and revisit tax rules to make the dormant Personal Equity Retirement Account or PERA law working.)
Others:
• Political risk. Rule of law and respect for property rights provide confidence that political (and civil) institutions have a strong commitment to honoring financial obligations.
• Default history. A country’s default history tends to influence its rating.
Going through that criteria is precisely why I think there are still a lot more heavy lifting to be done.
It is good to note that this administration seems determined to work on our weak areas, like revenue generation. That’s why P-Noy used his political capital to win passage of the “sin” tax law. That is also why DOF is pursuing fiscal incentives reforms. The importance of the drive to expand our tax base can be seen in recent headlines with no less than P-Noy going out to encourage better tax compliance.
 It certainly helps that the BIR chief has achieved a reputation for a tough and efficient operation while addressing the corruption factor that has reduced the agency’s credibility in the past. The BIR’s data base is being intelligently used to enable the agency to collect the most taxes at the least cost.
The factor that has impressed the ratings agencies about our country in recent years is political stability. Late last year, S&P observed that “since the inauguration of the Aquino administration in 2010, political stability and the legislative environment have improved. The president has high levels of public support and commensurate backing in the legislature.”
I am worried that gains in our political risk may be tenuous. We need to consolidate specially as the mid-term May election draws near. We also have to look beyond 2016 and potential successors to P-Noy if we want the favorable impression of our political stability to remain.
I found the Oct. 24 2012 Finance Asia interview of the associate director of sovereign ratings at Standard & Poor’s interesting.
Following a long period of rating stability, why has Standard & Poor’s upgraded the Philippines twice in a relatively short time span?
We rated the government BB+ from 1997-2002. By 2002, political risk in the Philippines had deteriorated under the administration of President Estrada, leading to a lowering of our rating on the government. The long term foreign currency rating stayed at BB- for nearly seven years until the end of 2010, after which we raised it twice to the current level of BB+.
Improvement in the Philippines political backdrop and policy setting motivated our latest actions. These improvements allowed the government to continue with fiscal consolidation process, narrow the fiscal deficits, reduce its reliance on foreign savings and rationalize the public sector.
The Arroyo administration (2001-2010) began fiscal reforms about eight or so years ago. But key components — such as expanding the revenue base, reducing tax evasion and privatizing the electricity sector — progressed slowly. This was due to a fractious political environment, in which most legislative activity was highly politicized and beset with delays.
And that folks are the continuing challenges. All these still requires a lot of heavy lifting. So, we can put down those champagne glasses for the meantime and get back to work.
Weird
The market is weird. Every time one guy sells, another one buys, and they both think they’re smart.
Boo Chanco’s e-mail address is bchanco@gmail.com. Follow him on Twitter @boochanco

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