How to survive a meltdown

(Second of a series)

MANILA, Philippines – The Philippines is considered an emerging market, which is quite an irony considering that its stock exchange is actually the oldest and longest operating exchange in Southeast Asia. It has been modestly but steadily growing in the last decade, with robust domestic consumption funded by steady remittances from Filipino workers abroad.

Foreign investors poured over $3.4 billion into the capital market last year, buying up stocks, bonds and other securities. On top of that, another $2.928 billion in foreign direct investments went to companies that produced goods both for export and domestic consumption.

Combined with the steady inflow of dollars from overseas Filipinos, the influx of foreign exchange was so strong that the Philippine peso appreciated by a whopping 18 percent against the US dollar. These inflows acted as the lubricant that kept the economic machinery operating smoothly and efficiently.

When the US crisis surfaced, however, emerging markets like the Philippines were the first casualties of the resulting panic.

Preferring to put their funds in investments they considered safe, investors pulled out of emerging markets.

The latest available data from the Bangko Sentral ng Pilipinas (BSP) indicated that for the first eight months of the year, about $209.5 million worth of portfolio investments have been withdrawn from the country, a complete reversal of last year’s inflow.

Deputy central bank governor Nestor Espenilla explained that financial institutions around the world had accumulated the spoiled financial products backed by fundamentally weak mortgage loans in the US and the domino effect was cascading in full force.

Reminiscent of the 1997 crisis that started in Asia, Espenilla said the fear of loss was just as virulent and contagious. In this, another unique factor came into play and it proved to be the undoing of the entire system: investor sentiment.

Everyone had assumed that the financial system, particularly in the US and other developed markets, was mature and well developed. These mature markets had all the checks and balances so that they could anticipate and avoid a collapse of this magnitude. But the collapse of the system sent a chilling message to everybody.

If banks that big could fail, then which else is safe? The painful market realization is nothing and nobody is safe.

And with the ensuing panic, everybody seemed to rush for the exits.

Banks became too afraid to lend to one another.

Banks lend to or borrow from one another to satisfy specific financial requirements because their own funds may be locked in other investments.

This market phenomenon hardly concerns the public. But it’s a basic banking operation that keeps the system stable.

A disruption in inter-bank lending is disastrous to the whole system.

“That’s what crashed Lehman Brothers,” Espenilla said. “When institutions of that size start collapsing, it happens very fast. And when it happens to one, it starts happening everywhere.”

Perception destructive

Market confidence is a nebulous, abstract, unquantifiable concept that can make or break economies. This is why the entire world watched as US officials bickered over which step to take while financial institutions go up in flames.

“The crisis is very serious,” said Jose Isidro Camacho, former finance secretary and now the Asia-Pacific vice chairman at Credit Suisse, a financial giant based in Switzerland.

Camacho said the contagion has swiftly spread from just mortgage-backed securities to other securitized instruments, stock markets, real estate, high yield bonds and so on, in not one but all financial markets around the world.

“This has led to a confidence crisis and I am not sure anything could have prevented this given that it was substantially driven by sentiment,” Camacho said.

He explained that a credit crisis would affect the real economy because banks – hurting from the crisis – would no longer be as willing to lend as they used to be.

Even though Philippine banks are fundamentally strong, their aversion to risk-taking would force them to alter their lending behavior, taking less risks and raising credit standards that could choke borrowers.

Businesses that need to borrow would find it hard to do so. Slow credit means slow economic growth. When economic activities slow down, companies that already have bank loans would suddenly find it harder to pay back these obligations.

When businesses like these start needing refinancing, Camacho said, they would not be able to do so because banks would be too nervous to lend them more money. Credit supply could eventually dry up.

“This could lead to bankruptcy for a lot of these businesses and that would lead to unemployment,” Camacho said.

If consumers start worrying about losing their jobs in the next few months or years, they would stop spending on things they do not seriously need, like a new house or a car or even clothes.

Simple expenses like fixing the roof, replacing the washing machine or the stove may now have to wait.

Things may turn for the worse, especially for an ordinary consumer, who may now have to abandon his dream of buying a new car or a washing machine and focus instead on medical, food and tuition expenses.

When private consumption slows down, companies would cut back on production. Cutting back on production would mean downsizing the workforce, leading to more unemployment. The scenario is grim.