OF SUBSTANCE AND SPIRIT
It was good for the Bangko Sentral ng Pilipinas to shift the release of Financial Stability Report (FSR) from annual to semestral beginning second semester of 2020. There is a dearth of reliable and timely information that the Filipino public could trust, and this report from the BSP could not have come at a better time than this.
Speaking for the Financial Stability Council, the FSR highlights the now ubiquitous problem of corporate and individual distress. The FSR documents that as of Q2 2020, “corporate results were actually diverse, ranging from lower profits to outright losses.”
Dented financials are critical in debt servicing and corporate viability. If many of our companies have bleeding bottomlines, economic recovery would remain elusive. Economic recovery could equally be slow burn.
One crucial element here is whether firms would be forced to borrow if internal funds are short. The FSR cites data on earnings before interest and taxes (EBIT). Out of 234 firms comprising the sample, the operations of 104 of them yielded losses in Q2 2020. For comparison, the FSR shows that only 85 reported losses in the quarter before. What should bother us most is that this increasing trend of corporate losses started even before the Wuhan incident. COVID-19 was the last straw that broke the corporate back.
There was no indication if these losses pushed the firms to borrow for additional buffer.
The FSR also clarifies that liquidity issue does not necessarily imply insolvency. Firms may have some temporary financial baggage, but in the long haul may actually be viable. Liquidity problems do emerge in normal operations because money logistics are not always available to cover all payables at any time. The pandemic was a wild card many firms did not expect to happen and this unforeseen event could literally upset the best financial forecasts.
Dented financials could also affect corporate viability. It is a cardinal rule for finance officers to ensure liquidity problems do not escalate into insolvency. By taking the ratio of EBIT to interest expense, the FSR computes for the interest coverage ratio (ICR). This ratio challenges a firm to maintain an ICR exceeding 1.0 to guarantee internal funds are around to service its maturing obligations including other expenses.
The FSR finds that during Q2 2020, ICR deteriorated across industries. Specifically, ICR values for the 25th percentile, median and 75th percentile of the total sample dropped relative to preceding periods. While this is something expected when firms recorded losses from operation, half of the covered sample had ICR below 1.0. The firms’ viability is questionable. This is “red flag.”
Other technical calculations support the general sense of corporate distress including the so-called debt-at-risk which climbed from 76.6 percent of corporate debt at end-March 2019 to 91.6 percent at end-June 2020.
With financial fissures starting to appear before the surge of the virus, COVID-19 further contributed to debilitating restrictions on business activities.
In fact, gross capital formation weakened significantly from 11.3 percent in 2018 to just 3.5 percent in 2019. A year earlier, the BSP raised policy rates a number of times totaling 175 basis points to deal with mainly supply shocks following surges in rice and oil prices. Lending rates recorded sharp uptrends and they could have helped weaken corporate performance early on. Even banks had to expand their capital base for regulatory compliance.
The subsequent reversal of monetary policy by 275 basis points had limited impact because demand for credit when the virus raged had dwindled, and the latest figures on outstanding loans exhibited an actual decline. Banks reacted to the pandemic in a pro-cyclical way, tightening their credit standards when corporates were desperate for some relief. If internal funds were insufficient, access to bank credit was also limited.
The FSR is correct that debt servicing has become the principal issue due to the income shock even as lending rates have started to moderate with the BSP’s accommodation. With deep recession, it would take patience before one sees some bounce back in general corporate performance.
The next key issue is economic scarring or hysteresis, in which one sees the lingering effects of both COVID-19 which remains prevalent, tarrying longer than necessary, and the direct outcome that was the deep recession of 2020 extending to Q1 2021. We see for instance, rich evidence of self-quarantine among many for fear of catching the virus and the crazy cost of health mitigation. Business would not want to start operating again due to the fear of shrunk markets.
The FSR builds the case for “slow-burn contagion.” This is one way of cross-border propagation of financial crises through bank credit. The other type is “fast and furious,” as in sudden stops when credit is sustainably tight. In July 2020, our friend Eli Remolona, produced an excellent paper also dwelling on slow-burn contagion with some quantification to support the concentration risks of certain groups of international banks relative to their loans to some ASEAN countries including the Philippines.
The lingering impact of the pandemic, the FSR contends, could be amplified because of the cross impact among the firms given their natural economic linkages. The system can be considered as “intertwined chains of related and sequenced transactions.”
We find this portion a little disappointing because the FSR immediately pivots from saying that shocks could amplify depending on how the chains are structured into simply indicating that this is the “council’s take-away from the GFC and the network analysis is applied in its surveillance of systemic risks.”
They are colorful but the FSR’s corporate supplier-buyer matrix and network visualization can claim but cannot provide evidence on the internal contagion and spillover effects.
Anyway, if indeed slow-burn contagion exists in the Philippines, its other side must be slow-burn recovery.