SUSTAINING THE LEAD, BEATING THE HEAT
Deputy Governor, Bangko Sentral ng Pilipinas
ACase of Rational Exuberance. Exactly 21 years ago, in a speech delivered on December 5, 1996, then US Fed 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 all aware that the Philippine economy has been growing at an incredible pace. The recently released economic data showed that country’s gross domestic product (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. Is the Philippine economy getting too much of a good thing? Unlike Allan 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’ growth story is that of a mature structural expansion of economic activity, profits and employment that probably has many more years to run.
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.
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.
One does not, however, have to take loan growth numbers at face value (registered year-on-year at 21.1 percent in September 2017). Credit can be better assessed relative to the size of an economy (as indicated by the level of GDP), 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.
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’ 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 (RREPI), a measure in assessing the trends in housing prices, has been on a general decline in 2017, which reflects an easing in the build-up of price pressures in the residential property.
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.
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 2019. It is also important to emphasize that while we see risks to inflation 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.
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. Government is committed to continue strengthening institutions, promoting greater transparency and enhancing competitiveness.
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 macro-economic 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 6.0-7.0 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.
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, policymakers 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 macroprudential measures to deal with sector-specific concerns.
It’s not bad to be exuberant but we should remain rational.