A case of rational exuberance
Exactly 21 years ago, in a speech delivered on December 5, 1996, then-US Federal Reserve Chairman Allan Greenspan used the term “irrational exuberance” to warn investors that the spectacular rally in stock prices during the period could potentially signal that global stock markets were overheating. After these words were spoken, stock markets all over the world dropped simultaneously and, yes, precipitously. Greenspan became some kind of a prophet, his speech an explicit warning about market overheating.
Nowadays, the Philippine economy has been subject to a similar concern. We are Nowadays, the Philippine economy has been subject to a similar concern. We are all aware that the Philippine economy has been growing at an incredible pace. The recently released economic data showed that the country’s GDP grew by 6.9 percent in the third quarter of 2017, bringing the economy to 18 years of consecutive and uninterrupted growth.
This growth momentum has been accompanied by a substantial rise in credit growth. As a consequence, concerns were expressed that the Philippine economy is going “too hot” and may now be displaying signs of overheating. In particular, the International Monetary Fund’s (IMF) Article IV Consultation with the Philippines flagged that the “combination of high credit growth, buoyant private investment and fiscal expansion without tax reform could lead to an overheating of the economy,” even as the country’s overall economic outlook remained favorable in the medium term.1
Is the Philippine economy getting too much of a good thing?
Unlike Greenspan’s speech, though, we argue that our economy has entered a period of “rational exuberance” rather than an irrational one. In my view, the Philippines’s growth story is that of a mature structural expansion of economic activity, profits and employment that probably has many more years to run.
1 International Monetary Fund, Staff Report for the 2017 Article IV Consultation in the Philippines, October 10 ,2017 (release date: November 6, 2017); de Vera, B. “IMF warns PH economy may overheat,” www.inquirer.net, November 8, 2017; Ocampo, J., ”IMF warns Philippine economy could overheat”, www.philstar.com, August 8, 2017; Lopez, Melissa Luz, ”IMF flags sources of domestic risk,” www.bworldonline.com, November 8, 2017.
Getting the terms right But first, how does one appreciate overheating?
Overheating occurs when an economy’s capacity to supply goods and services is not able to keep up with demand. During an economic boom, overheating materializes when there are high levels of aggregate demand (for consumption, investments, government expenditures and net exports) that exceeds what suppliers can produce on a long-term basis. To meet excess demand, producers overemploy their resources, i.e., by extending working hours or using machineries beyond their capacity. If demand is not met, prices adjust upwards in the short run until such time that supply matches demand. This will hardly become sustainable if producers’ capacity (and the economy’s capacity as a whole) to produce does not expand and results in, among others, machine breakdown or workers getting sick. This condition ultimately slows down the entire production process and may, at the same time, accelerate both inflation and inflation expectations.2 In short overheating is seen when output rises unreasonably above its potential level, followed by unanticipated acceleration in inflation due to prolonged high growth rate. The rapid rise in inflation diminishes consumers’ purchasing power. This may, subsequently and abruptly sink confidence, as both consumers and businesses realize the relative mismatch in production and demand.
This is certainly not the case for the Philippines.
Everything is relative
First, credit expansion in the country is accompanied by solid economic growth. While bank loans have been expanding at double-digit levels, the rise in lending activity has been based on solid demand for loans across key economic sectors and households. In other words, there is sustained demand for loans because the economy continues to grow.
Outstanding bank loans: Growth and trend
One does not, however, have to take loan growth numbers at face value (registered year-on-year at 21.1 percent in September 2017).3 Credit can be better assessed relative to the size of an economy (as indicated by the level of GDP),
4 resulting in a metric called credit-to-GDP ratio. This credit-to-GDP measure may be evaluated relative to its gap or difference over its long-term trend performance. This gap relative to its long-run trend performance indicates that credit expansion has been within statistically desirable limits. 5
3 This bank lending growth, in turn, leads to around 14.5-percent domestic liquidity (or M3) growth (year-on-year [YoY]) in September 2017.
4 Depending on the size of the economy, credit growth may need to be faster or slower. Small developing economies may aptly experience higher credit growth as creditors meet the requirements of faster business expansion and consumers’ or households’ greater access to financial services.
5 Based on the methodology of Drehmann, M., Borio, C., Gambacorta, L. (2010), “Countercyclical Capital Buffers: Exploring Options.” BIS Working Paper 317. Credit refers to domestic credit to the private sector. The credit gap measures (in percentage points) the deviation of the private credit-to-GDP ratio from trend. The BIS suggests a critical thresholds of 2.0 to 6.0 percent. Meanwhile, using the International Monetary Fund’s (IMF) methodology of assessing whether credit expansion exceeds the country’s average credit fluctuations also indicate that current credit growth is (1) way below the 23.5 percent threshold; and (2) well around the estimated trend of 16.9 percent (April 2004 issue of the IMF’s World Economic Outlook; see also Dell’Ariccia et al. (2012), “Policies for Macrofinancial Stability; How to Deal with Credit Booms,” IMF Staff Discussion Notes 12/06, International Monetary Fund.
Private-sector credit
IT is not surprising that domestic credit performance (whether in terms of credit or credit-to-GDP ratio) shows that, despite its already rapid expansion, credit has room to accommodate further growth. The Philippine credit-to-GDP ratio (of 63.6 percent) remains one of the lowest in the region, second only to Indonesia’s (40.6 percent). And the Philippines’s total output continues to grow and grow according to its increasing potential. More on this in the third and fourth arguments.
Numbers speak louder than words
Second, our set of monitoring tools and surveillance systems indicates that there is very little evidence of overheating.
Based on the results of the Q3 2017 Senior Loan Officers’ Survey (SLO), universal and commercial banks (UKBs) have continued to maintain their sound credit standards for corporate and consumer loans. This reflects banks’ prudent lending practices even in the face of sustained strong loan demand from enterprises and households.
Moreover, potential overheating may also be seen from the lens of the real-property sector. But the trend in this sector shows general alignment with its fundamental values. The Residential Real Estate Price Index, a measure in assessing the trends in housing prices, has been on a general decline in 2017, which reflects an easing in the buildup of price pressures in the residential property.6
Sustaining the lead with solid footing
Third, and perhaps the most important argument, the country’s macroeconomic fundamentals have remained solid and robust for the past 18 years. This growth story of 75 consecutive quarters demonstrates how income and economic growth does not have to come as magic.
6 Residential real-estate prices went down by 4.6 percent YoY in Q2 2017, a reversal from the 1.2-percent and 11.6-percent growth registered in first quarter 2017 and second quarter 2016, respectively.
There could be a clear case of overheating if such growth comes with surging price movements. But in the case of the Philippines, growth has been accompanied by a benign inflation environment. Inflation (headline, core and alternative measures) remains close to the midpoint of target range in 2017, while inflation projections show annual average inflation settling within the target range of 3.0 percent ± 1.0 percentage until 20197. It is also important to emphasize that while we see risks to inflation 8, such as the impact of the impending tax increase, both the outlook and expectations continue to be well-anchored to the inflation target over the policy horizon.9
These macroeconomic improvements have not been lost to third-party analysts, including credit-rating agencies, which have upgraded the Philippines to investment grade on account of such achievement. The government is committed to continue strengthening institutions, promoting greater transparency and enhancing competitiveness. 10
7 The year-to-date actual inflation of 3.2 percent is well within the government’s inflation target range of 3.0 percent ± 1.0 percentage point for the year.
8 While the proposed tax-reform program may exert potential transitory pressures on prices, various social safety nets and the resulting improvement in output and productivity are also expected to temper the impact on inflation over the medium term.
9 Results of the Bangko Sentral ng Pilipinas’s survey of private sector economists for October 2017 showed that mean inflation forecasts for 2017 was at 3.2 percent. Expectations for 2018 and 2019 were also seen to be slightly above the midpoint of the government’s target range of 2.0 to 4.0 percent. For the Bloomberg survey, inflation forecasts for 2017 to 2019 would continue to be within the said target.
10 Since 2010 the Philippines has received 11 credit rating upgrades, moving the long-term sovereign debt status from junk grade to investment grade.
We must also make the point that the inflation rate for the bottom 30 percent of the population has trended lower than the overall headline inflation. Poverty incidence, based on the statistics compiled by the Philippine Statistics Authority, has also illustrated that rapid economic growth has started to benefit the middle income and the poorer segments of society. Indeed, high real GDP goes beyond media, it is something that can be eaten and enjoyed; it is both enabling and empowering.
The current economic performance is, therefore, not a product of unintended drivers that bubble up growth. The country’s ability to post remarkable growth against domestic and external headwinds did not manifest overnight nor did it pop out instantly after getting exposed to some microwave excess demand.
In other words, ours is not a popcorn economy.
Sustainable growth is built on a long history of purposeful structural reforms and string of policies. In the Philippines, this is precisely the case because we have on record almost 25 years of policy and structural reforms ranging from dismantling telecom monopoly, deregulation of the power sector and the oil industry, liberalization of the banking industry and restructuring of public revenues. Its position of strength is characterized by an accelerating growth, a benign inflation environment, sound banking system, resilient external payments position, adequate buffers and responsive macroeconomic policies.
Beating the heat by expanding capacity
Fourth, in combination with the improving macroeconomic environment, the structural reforms we have pursued have, indeed, been translated into higher potential output for the economy. The country’s potential output has recently risen to 6.0 percent to 7.0 percent following: i) the recent climb in economic efficiency as indicated by the declining incremental output ratio; ii) increasing total factor productivity; and iii) favorable labor-market dynamics given the young population and improvements in the education and skill sets of those in the labor force. Moreover, with the recent policy of the government to strengthen both hard and soft infrastructures, the country’s potential output could definitely further increase.
Conclusion: When worrying is a good thing
IN view of these arguments, overheating concerns may, indeed, be misplaced. Nonetheless, these concerns are not necessarily bad. In fact, policy-makers are paid to always worry about the economy.
Sustaining the lead and beating the heat require us to remain watchful and attentive. There can be no room for complacency or benign neglect. We have a stable of analytical tools, early warning systems and stress tests that should be useful to guide us when to move the lever of monetary policy if the risks are widely spread or deploy macro-prudential measures to deal with sector-specific concerns.
It’s not bad to be exuberant but we should remain rational.
Image credits: BSP, Source: BSP and other central bank web sites