New Dangers Lurk as the US Dollar Depreciates 111.0

Three days ago, I heard a guest at Bloomberg call out that the US has become “a source of funds for the carry trade.”

Since then, the drop in the value of the US$ and the improbable rise of the peso to PhP 47.70 to US$1 (closing today, 9/18/09) tend to support that claim.

If it persists, the drop in the US$ value (and not the Bloomberg pundit’s comment) is a deep danger signal.

Why Improbable? The peso’s rise is improbable to me as this indicates that the is Philippine economy is in better shape than the U.S. The deficit has been the key inverse determinant of the Peso:US$ rate recently, i.e. the higher the deficit the lower the peso value viz the US$.

I completed this post today, 9.19.09. And today’s issue of the Inquirer (PDI) headlines that the government had a budget deficit of PhP210 Billion for the eight months to August 2009 from a combination of low revenues and high expenses. This confirms my point above that the apparent strength of the peso comes from the weaknesses of the dollar and not from good economic administration by the Arroyo government.

By being a fund source for the carry trade, my read is that the ‘smart’ money is (a) seeing that the US$ will continue to weaken in the foreseeable future and (b) that a further change in direction will be easy to see.

Before the present crisis, in 2007, the most visible carry trade was between the Japanese Yen, as fund source, and the NZ$ for a financial play or the Australian dollar if a resource play.

The Yen was the source of choice for funds because borrowing cost in Yen was low and the economic regime of the lost decade in Japan after the asset bubble indicated that such low interest policy would stay.

On the investing side, the inflation-targeting regime of the RBNZ (See Post #35) and robust export performance indicated a stable, higher interest regime for a financial play. For Australia, the strong performance of its commodity exports prior to 2007 indicated safe bets in exporting companies like mines.

In so far as no quick change in the underlying trend is visible, this arbitrage, i.e. the carry trade, was a profitable and relatively risk-free proposition.

Before this crisis, America, was always attractive for its deeply liquid financial market and as investment area of last resort. The US Federal Reserve was seen as strong and independent (unlike the Bangko Sentral) and, thus, able to maintain a stable value of the US dollar.

Therefore, the new view that the US has become a good source of funds for the carry trade represents a sea change. Unlike the Yen, the perception of the cheapening value of the US$ comes not just from the low borrowing rate but the expected continued currency depreciation from the combined effect of low growth, low inflation from weak consumer demand, and low inflation.

At the most basic level of analysis, U.S. interest rates will only go up when the currency depreciation eventually results into rising import prices and inflation. Interestingly, this would indicate that the U.S. can become an “emerging third world country,” a phrase already used this year by some PIMCO analyst as a “new, normal” scenario.

For the Philippines, we have already seen a partial impact as the Peso has risen below the US$48 mark with today’s close. The table below presents a static financial picture of the Philippines as of yesterday:

As I discussed in Post #62, this creates political demands from exporters and OFWs to slow down the strengthening of the peso. In 2007, the Bangko Sentral (BSP) lost P102.9 billion of its capital reserves implementing a populist decision to protect a vocal few while damaging the interest of the passive majority.

Today is a good time for the BSP to be transparent to make sure there is no repeat of the debacle of 2007.

Twice in the past 100 years, our political aristocracy has robbed the country blind through the government-controlled banks.

First, in the mid-1930s when unpaid behest loans from big sugar planters required a recapitalization of the Philippine National Bank.

And second, in the mid-1980s when the old Central Bank became a bad bank holding the unpaid behest loans from cronies of the Marcos dictatorship and a new BSP capitalized to be our supposed independent Central Bank.

I suspect we just extinguished in the early 2000s, the Marcos-era bad debts held at the bad bank, CB, from dividends of the profitable operations of the present day BSP. On top of that, we managed to lose PhP107 billion and still have PhP100+ billion left over. Can you imagine how strong our country ought to be if we do not allow such shenanigans to continue under our collective noses?

Today, the BSP is in violation of R.A. 7653 which requires that the BSP release its financial statements within 90 days after the end of the period reported. The last audited financial statement was released is June 30 2008. Like Al Capone put to jail on tax evasion, can we actually put pressure on this government by filing administrative charges on the managing bureaucrats at the Monetary Board? Just wondering.

This time, after the debacle of 2007 and the failure of the government to comply with RA 7653 to fully capitalize the BSP with an additional PhP40 billion in capital, the BSP does not have the retained earnings to defend from a sharp rise of the peso.

Of course, there is the non-criminal opportunity to arbitrage on the assumption of an unabated strengthening of the peso. It is one quick way to make a quick billion before the elections of 2010.

I have been following the CB and the peso to help the innovators lock-in values and returns from a stable peso.

Instead, I see something more worrisome. If the BSP and the government do not manage the transitions and imbalances well, the country is again condemned to the usual boom-and-bust which most Filipinos do not really understand or are unempowered to do anything about.