Amando M Tetangco, Jr: Antecedents of the global financial crisis - a
multi-factorial phenomenon
Speech by Mr Amando M Tetangco, Jr, Governor of the Central Bank of the Philippines
(Bangko Sentral ng Pilipinas), at the Sixth Sec. Alfonso Yuchengco Policy Conference,
Makati City, 2 February 2009.
* * *
Secretary Alfonso Yuchengco, distinguished guests and fellow stakeholders from the
business sector, the government and the academe, ladies and gentlemen good morning.
First, let me thank the Board of Trustees and Secretary Yuchengco for inviting me to your
sixth policy conference. It is my pleasure to be able to share with you today some thoughts
on a subject which has occupied global attention, especially since the last four months of
2008 - when marquee financial institutions in Wall Street started to crumble, and "bailout"
became a buzzword in global financial markets.
Let me put in a nutshell the Philippines' economic situation in 2008. What we had seen as an
ideal convergence of low inflation and high growth in 2007 was clearly disrupted by the highly
volatile oil and food prices, the spread of the subprime mortgage woes of the US to
international financial markets, and the recession in some key advanced economies and
economic slowdown elsewhere. Forecasts for this year and 2010 continue to be revised
downward, as more concrete data become available. A bleaker outlook is in the offing, with
the impact of the crisis trickling down to the real and external sectors, affecting trade,
investment and consumer demand.
But before we get into the details of the extent and implications of the crisis on our country's
development momentum, I suppose it is important to ask the question:
How did the current global financial crisis occur in the first place? What led to the creation of
"bubbles"?
I believe that there are two layers to the reasons for the crisis. The first layer I will refer to as
the "superstructure" or the physical - what is happening and visible to the naked eye. The
second layer is the "microstructure" or the psychology - what is underlying those that can be
seen.
Let me talk about the "superstructure" first.
The roots of the US financial crisis can be traced back to the early years of this decade when
the United States aggressively eased its monetary policy to facilitate recovery from the
dotcom bubble and the September 11 terrorist attacks.
If you will recall, the US Federal Reserve began a cycle of cuts in the Fed funds target rate
from 6.5 percent in May 2000 to as low as one percent by June 2003. On the fiscal front,
large public deficit spending beginning in 2001 was pursued to prop up the economy which
was then on the brink of recession.
The low interest rate regime fueled a boom in mortgages, including among borrowers with
doubtful credit histories or those fancifully called NINJA loans - that is, loans to No Income,
No Job or Assets loans. Thus, house prices in the US began rising in 2000, surpassing the
growth of disposable income.
The excessive lending itself would not have brought in such great financial distress because
if the borrowers turned out to be poor borrowers, then foreclosures would just have followed.
However, what made this risky behavior turn into a crisis event was the bundling of
mortgages by various financial institutions into complex securities such as collateralized debt
obligations (CDOs) which were largely unregulated.
These complex transactions were designed in search for yield and new markets. The
securitized products were sold to banks, Wall Street firms and overseas investors. The
continued appreciation of house prices ensured attractive returns for these mortgage-related
securities.
With too much liquidity in the US economy and with the price level creeping up, the US
Federal Reserve started to rein inflation in.
In June 2004, the Fed began a cycle of hikes in the Federal funds target rate, lifting the Fed
funds target rate from one percent to as high as 5.25 percent just two years later (or by June
2006).
When interest rates were raised, an asset bubble burst became imminent. The elevated
interest rates discouraged availments of mortgage loans, which led to a build up in unsold
homes. This precipitated the steep descent in house prices from their peak in 2006. As of
end-November 2008, the S&P/Case-Shiller index of 20 major metropolitan areas showed
that home prices in the US had fallen by around 25 percent below their July 2006 peak.
The immediate damage was felt in sub-prime mortgages - not only the most highly
leveraged sector in the economy but also that with the weakest capital support, least
transparency, and on which the poorest due diligence had been done. Initially, market
participants and policymakers felt the damage was an isolated case that could be "fixed".
This belief partly mirrored the (over) reliance on the most modern risk management
techniques related to derivatives and structured products. It also partly reflected inadequate
information on the extent to which sub-prime exposures had infected the balance sheets of
financial institutions.
With the glut in supply and as housing prices fell, the value of the collaterals supporting
mortgage loans eroded. Higher delinquency rates on sub-prime mortgage loans triggered a
wave of bankruptcies of sub-prime mortgage lenders. As bankruptcy filings by mortgage
lenders mounted, unnerved investors began draining liquidity from financial markets.
With banks holding on to their cash to cover losses, credit markets started to seize up. Even
creditworthy borrowers began experiencing difficulty in borrowing. Firms/ households cut
back on investment and consumption, causing a slump in economic activity, precipitating a
recessionary cycle.
Moreover, since the loans were securitized and sold to other investors as credit derivatives,
the defaults in the mortgage lending market spread to the wider credit markets, multiplied
several-fold by leverage. Eventually, losses in subprime mortgage lending and credit
derivatives would spill over to the broader financial markets and to financial institutions
elsewhere that invested in US mortgage bonds and structured products.
There were other factors that could have contributed to the credit crisis.
Mark-to-market accounting standards exacerbated selling pressures during the period of
deflating house prices as banks were forced to recognize valuation losses in their balance
sheets.
The fragmented supervision in the United States led to lack of regulation over segments of
the financial system.
Even credit rating agencies have gone under scrutiny for giving investment-grade ratings to
securitization transactions that were backed by sub-prime mortgage loans. These high credit
ratings encouraged the flow of investor funds to these securitized instruments. Critics claim
that conflicts of interest were involved, as rating agencies were paid by firms, such as
investment banks, that originated and sold the debt to investors.
However, beneath what can be seen by the naked eye is the "micro structure" or the
underpinning of the crisis.
There is a quote from Robert Shiller. He said "too little attention has been paid to the most
fundamental cause (for the housing crisis): the contagious optimism, seemingly impervious to
facts, that often takes hold when prices are rising. Bubbles are primarily social phenomena;
until we understand and address the psychology that fuels them, they're going to keep
forming".
I am a believer that all these over-structures could be explained by underlying market
psychology - Greed. Ignorance. Herd mentality. Disregard for or misuse of information.
Exuberance. Irrationality.
If we look back at the 1997 Asian financial crisis, and the other crises during the last three
decades, the pattern seems to be quite similar: crisis was preceded by rapid credit
expansion, which manifested itself in asset prices. These gains, of course, provided the
collateral to justify even more lending. The euphoria generated by such gains also seemed to
affect both the perception of risk and the appetite for risk-taking, on the side of both lenders
and borrowers. As a result, leveraging increased even as the general quality of credits
deteriorated - unfortunately, this was commonly "not perceived" at the time.
And, as we realize now, the so-called "Minsky moment" invariably comes. At a certain point,
usually when earlier expectations about profits or future income growth begin to look
unrealistic, the whole endogenous process goes into reverse. In effect, boom turns to bust,
with the stress in the financial system commonly, but not universally, aggravating the
economic damage on the downside.
Together, the superstructure and the microstructure of the crisis would explain the bubble
that just burst.
In hindsight, it is clear that global financial activities had outpaced the financial systems'
ability to manage these activities in an orderly manner. Thus, the air of uncertainty and
vulnerability as well as a general sense of eroded confidence now looms in both industrial
and emerging market economies.
One could even call this a Black Swan Event - a large-impact, hard-to-predict and rare event
beyond the realm of normal expectations.
While the epicenter of the financial turmoil is in the US, tremors have been felt worldwide.
The slowdown in growth spread to Europe, amid weak business and consumer sentiment,
terms of trade losses, and tightening credit conditions.
The impact on Asia has come through risk aversion as evidenced by: 1) the reversal of
equity capital inflows; 2) widening of sovereign credit spreads; and 3) heightened volatility in
exchange rates.
Apprehension has also risen in the Asian economies, particularly in terms of reduced
production, and weaker consumer demand.
These developments necessitated coordinated policy actions among major advanced
economies to support the global financial system on a scale not seen for decades.
Many central banks have taken strong actions to cut interest rates and expand liquidity
provision both in local and foreign currencies. Other measures taken include capital
injections into financial institutions, expansion of deposit insurance and purchase of
distressed assets.
On fiscal policy, many countries have announced and are already implementing sizeable
stimulus packages.
Evidently, there is no "one-size-fits-all" policy mix. Some countries have more fiscal and
monetary space than others.
This brings me to the next - and to most of us here - the central question - how will the
Philippine economy fare amid this highly challenging global economic turmoil?
Admittedly, we are not immune to what is happening around the world, but there are
insulations, cushions, buffers that can serve the Philippine economy in good stead in this
challenging period.
Let me provide some details on these buffers.
Output growth has continued at a respectable pace and it continues to be demand-driven.
The 4.6 percent GDP growth for 2008 was a respectable growth performance vis-à-vis those
of our Asian neighbors. It is noteworthy that the country's GDP growth for 2008 is within the
country's long-term growth trend.
Domestic demand continues to be the main driver of growth in the economy, specifically
personal consumption. Demographics - particularly in the form of the Philippines' young and
economically active population - underpins the view that consumption will continue to propel
economic growth even in these difficult times. Moreover, income levels are such that majority
of the population has a greater propensity to consume.
Weakening global demand is causing commodity prices to retreat. Reflecting the global
economic downturn, oil prices began to ease starting July 2008.
Partly because of this, headline inflation dropped sharply lower in December 2008 to 8.0
percent year-on-year. This brought the average inflation in 2008 to 9.3 percent. Lower fuel
prices and slower price increases of food and light, as well as of transportation and
communication services accounted for the retreat of inflation.
With the easing in the prices of oil and other non-oil commodities in the world market and
given moderating inflation expectations, inflation in the Philippines is expected to further
decelerate - and be within the target range - in 2009 (2.5-4.5%) and 2010 (3.5-5.5%).
This gives some flexibility to monetary policy to support growth and stabilize financial
conditions, while being highly attentive to price pressures.
Fiscal reforms, particularly the VAT reform, have strengthened the Philippines' ability to cope
with externally-induced challenges, as fiscal consolidation has improved our debt profile and
markets' view about the commitment of our authorities to difficult but much-needed fiscal
rectitude.
Recent adjustments in fiscal targets could also provide policy space to support growth. The
postponement of the balanced-budget objective due to the expected slowdown in the global
economy will provide countercyclical fiscal space for the government to boost infrastructure
spending and enhance social safety nets to support the most vulnerable segments of the
population.
The fiscal stimulus - provided that it adheres to best principles of what some would call the 4
T's (spending that is timely, targeted, transparent and temporary) or as some would say
"spending that gives the most bang for the buck" - should be supportive of durable, robust
growth.
On the external front, we have continued to build up our international reserves for
selfinsurance to reduce our vulnerabilities to the inevitable moods and swings of international
financial markets.
At year-end 2008, our reserves rose to US$37.6 billion. This suffices to cover about 6
months of imports of goods and payments of services and income, or alternatively, it could
cover our short-term external debt based on residual maturity about three times over.
We were able to do this because our external position remained in surplus in 2008,
supported by remittances of overseas Filipinos as well as higher services receipts (including
from tourism & business process outsourcing).
Meanwhile, the Philippine financial system remains stable notwithstanding the challenges
brought about by the global financial crisis.
The Asian financial crisis of 1997 had imprinted valuable lessons which provided the needed
cushion for our banking system to weather the current turmoil. For instance, we regulated the
real estate sector in relation to housing and mortgage markets; we implemented stronger
bank supervision anchored on managing risk exposures; we reduced non-performing loans
via asset vehicles; we implemented macro-prudential surveillance with due diligence in
implementing internationally accepted standards via the Basel II accord; and we participated
actively in implementing collaboration among Asian neighbors for coordinated responses and
information-sharing to mitigate contagion effects and spillovers.
Importantly too, the Philippines is relatively well-insulated from key transmission channels of
the global financial strains that are affecting other emerging market economies (EMEs). This
is so for the following reasons:
Reasons:
•
Philippine financial institutions have relatively limited exposure to structured credit
and related derivative products which were the main cause of the large losses of
crisis-affected international banks. It is helpful to point out that derivatives licenses in
the Philippines have been given out prudently.
•
Philippine banks are more domestically oriented, and rely more on traditional
banking services such as deposits than on complex products like derivatives as
sources of funds. Corporate sector bond financing is also minimal and private sector
reliance on external loans is limited.
•
Lastly, while credit growth has been steady and significant, it has not fueled
concerns of overheating or asset price booms.
What should we expect in 2009?
Even though we could lay claim to the "island of calm" status mentioned by economists in
evaluating the Philippine economic situation amidst the crisis, and even though we have
buffers that we could rely upon as we brave the current financial storm, we should not rest on
our laurels for the effects of the crisis are just beginning to show their fangs and just starting
to bite into our pockets.
The real and external sectors are yet to experience tougher challenges so let me share the
policy thrusts of the BSP this year:
Monetary policy in 2009 will continue to focus on our primary mandate of price stability. As
inflation risks moderate, the BSP will carefully consider opportunities for monetary policy
easing amidst a possible tightening in financial conditions. We will also continue to ensure
appropriate levels of market liquidity to maintain the efficient functioning of the financial
markets. Through these, we hope to provide the necessary conditions that will allow
economic growth to continue. We will at the same time endeavor to keep inflation at
manageable levels as this creates the environment for sustainable long-term growth.
The BSP's external sector policy will remain focused on ensuring our external vulnerabilities
are reduced. We expect to continue to post a surplus in our BOP, mainly due to steady OF
remittances and receipts from the BPO sector, coupled with a reduced level of imports. This
will give us the opportunity to further beef up reserves for self-insurance. We will continue to
pursue a market-determined exchange rate to allow us to maintain external competitiveness.
We will also engage in policies that would sustain a manageable external debt profile.
Banking sector policies will remain geared towards the financial system's soundness in terms
of greater risk management, stronger capital base, bolder disclosure mechanisms, and better
corporate governance standards. Since most of the experts point to the lack of regulation as
one of the root causes of the US subprime market crisis, it is therefore tempting to swing to
the other extreme of over regulation. I don't believe that we should move towards that
direction. Instead, what I believe should occur is a move towards greater accountability.
Thus, the BSP will sustain its reforms that would lead to improved disclosure practices, better
risk management and higher standards of governance in the banking system. We will
continue to pursue regulation that would make the markets work more efficiently and
advance consumer protection.
Realizing that the current crisis has taken on a global nature, we will further strengthen
engagements with our regional peers to share information, discuss emerging developments,
and pool resources, if necessary even foreign exchange reserves. It's interesting that the
current financial turmoil took on a turn for the better once the major economies began to act
in concert. Confidence had been quickly eroding until then. The coordinated and cooperative
policies that were put in place by the US and European central banks and finance ministries
beginning October last year, have helped restore some traction in the markets and
subsequently improved market confidence not only in the major economies, but also in
emerging markets.
Ladies and gentlemen, 2009 will be a critical year for our economy. But we should look at
this crisis as like the gift of fire of old. Fire is important in all facets of our lives including the
need for light, power and heat. Yet fire is not without risks to life and property. What is
important is to be able to master it and harness it to serve human needs. Thus, this crisis
should pose a challenge to us to put together and implement policies this year and beyond
that would enhance the resilience and the flexibility of our economy.
Without a doubt, this crisis shall test our resiliency and character, and it shall determine
whether our buffers would keep us afloat amidst troubled waters. The Philippines is not a
newbie in terms of facing crises, for we have hurdled quite a number of these in the past.
Each crisis we encountered was unique in its roots and causes. But we have learned from
each, every time. It's too early to make prescriptions and judgments, given that much is still
to unfold. I trust that the audience could share my vision in seeing a glass half-filled with
water as "half-full" rather than "half-empty". Let us also remain vigilant and prepared for any
circumstances that could come our way.
Let me end my remarks this morning with a quote from John D. Rockefeller. He said "These
are days when many are discouraged. In the years of my life, depressions have come and
gone. Prosperity has always returned and will again."
Thank you very much. Mabuhay ang Pilipinas!