Debt Trap

Philippines is set to increase government spending on infrastructure as percentage of Gross Domestic Product (GDP) via an P8.4 trillion infrastructure spending program. Based on the data compiled by the Department of Budget and Management (DBM) from 2010 to 2016, government spending on infrastructure as percentage of GDP averaged at 2.9%. DBM stated that the infrastructure spending program will increase government spending on infrastructure as percentage of GDP from 5.3% in 2017 to 7.4% in 2022. Out of the proposed 75 infrastructure projects, the National Economic and Development Authority stated that 35 had been approved while the rest are undergoing evaluation by the concerned government agencies. In order to finance the infrastructure spending program, the Philippines will need funding from international financial institutions, multilateral development banks and traditional creditor countries. But it had chosen the road less traveled by accepting the pledge by China to fund 18 infrastructure projects worth an estimated P731.7 billion. We must be aware that Chinese loans can be generous in the short-term but can be dangerous in the long-term. Chinese loans have interest rates between 2% to 3% while Japanese loans have interest rates between 0.25% to 0.75%. Moreover, Chinese-owned companies and Chinese workers rather than Filipino-owned companies and Filipino workers will be required to work on China-funded infrastructure projects. Known as the Belt and Road Initiative (BRI), China has been funding infrastructure projects in underdeveloped countries in exchange for diplomatic relations, natural resources and regional access. Based on a study conducted by the Center for Global Development, countries participating in the BRI that will default will find themselves in a Debt Trap. The study evaluated the present and future debt levels of the 68 countries hosting China-funded infrastructure projects and found that 23 countries are at risk of default. As the BRI expands in scope so do suspicion that it is a form of economic imperialism that gives China an undue leverage over underdeveloped countries. We must be concerned that its expanded commercial presence can lead to an expanded military presence as most of these China-funded infrastructure projects can be used for commercial and military purposes. China can use its leverage over the Philippines to expand its artificial islands in the West Philippine Sea and to support its territorial interests in the South China Sea. Entering into debt bondage with China is a wrong move for the Philippines.

Rule Model

Conservatism principle requires that losses are recognized when they are quantified and that gains are recorded when they are realized. But measuring impairment on financial instruments under the old financial reporting standards is not conservative enough to ensure the reliability of the financial reporting system. Impairment on financial instruments is recognized after rather than before the default, which overstates assets and earnings and understates liabilities and expenses. How unfortunate that this liberal recognition of impairment on financial instruments has been tolerated by the accounting profession to the detriment of the users of financial statements. But the days of overstated assets and earnings and understated liabilities and expenses are gone after the Bangko Sentral ng Pilipinas (BSP) approved the guidelines on the adoption of Philippine Financial Reporting Standards (PFRS 9) – Financial Instruments for BSP-supervised Financial Institutions (BSFIs). PFRS 9 is the local adoption of the International Financial Reporting Standards (IFRS 9) – Financial Instruments, which was issued by the International Accounting Standards Board as a replacement to the International Accounting Standards (IAS 39) – Financial Instruments: Recognition and Measurement. PFRS 9 requires BSFIs to incorporate material information in measuring impairment on financial instruments under the new financial reporting standards. BSFIs are required to assess the impact of PFRS 9 on business strategies and credit risk management systems to be able to adopt policies and procedures to ensure the reliability of the financial reporting system. Based on the guidelines on the adoption of PFRS 9, the BSP will evaluate the consistency of sales activities and metrics being used in monitoring the performance of financial instruments with the business model for holding the instrument. This will align the accounting treatment with the credit risk management systems to strengthen governance over the financial reporting system. PFRS 9 requires the adoption of an Expected Credit Loss (ECL) model in recognizing impairment on financial instruments to provide accurate information to the users of financial statements under the Guidelines on Sound Credit Risk Management. Under the ECL model, an allowance for credit losses at any balance sheet date is calculated by recognizing probable defaults within the next 12 months or for the entire remaining life of the financial instrument. The estimation of ECL will be a remarkable change in the financial reporting standards. Given the importance of BSFIs in the Philippine capital market, it is important for stakeholders to develop reasonable ECL estimates to ensure the accuracy of financial statement disclosures.

Cake News

Goldilocks Bakeshop scheduled Initial Public Offering (IPO) did not push through due to the elevated political and economic risks after the unexpected outcome of the 6 May 2016 general election. This made Goldilocks Bakeshop a legitimate Merger and Acquisition (M&A) candidate due to its remarkable economic moat. From a one-store bakeshop in Makati City in 15 May 1966, Goldilocks Bakeshop became a 579-store food retailing enterprise in the Philippines with branches in Canada, Thailand, and United States. When the political and economic storm calmed down, SM Retail and Goldilocks Bakeshop started negotiating for a proposed joint venture, equity investment or cooperation agreement. SM Retail is a subsidiary of SM Investments Corporation - a public conglomerate with business interest in retail, banking, property, and equity investments. SM Retail agreed to acquire a majority stake in Goldilocks Bakeshop for an undisclosed amount and the proposed equity investment was approved by the Philippine Competition Commission (PCC) on the condition that SM Retail will be subjected to random inspections by the PCC to ensure compliance in managing potential competition issues in the transaction. SM Retail must address any competition issues and any breach of the conditions will subject it to fines and other legal remedies. Under the Philippine Competition Act (PCA), the PCC is mandated to review M&A that breach the P1 billion threshold to ensure that these transactions will not abuse the merged business position by engaging in conduct that will prevent or reduce competition. PCA defines, prohibits, and penalizes undue dominant position, anti-competitive agreements, and anti-competitive M&A. But the proposed M&A went nowhere when SM Retail announced that it had abandoned its plan to acquire a majority stake in Goldilocks Bakeshop due to changes in the general business environment. We were taken aback when the proposed M&A was canceled and what confused us was the obscure reason for the cancelation. General business environment has been stable and favorable to M&A so it is bothersome to hear a lame excuse from a renowned retail conglomerate run by postgraduate-educated management team. Perhaps the PCC imposed unreasonable conditions to ensure free market system or the due diligence revealed the business shenanigans of Goldilocks Bakeshop. We do not know the reason why the proposed M&A was canceled but what we do know is that Goldilocks Bakeshop will remain a legitimate M&A candidate due to its remarkable economic moat.

Sold Down

Philippine Stock Exchange (PSE) had been condemned by the minority shareholders when it delisted Calata Corporation (CAL) due to violations of the disclosure rules under the Securities Regulation Code (SRC). Disclosure rules stated in SRC Rule 17.1 require a public company to file a current report to make an accurate disclosure to the public of every material fact or event that occurs which is expected to influence the investors decisions in relation to those securities. In the event a news report appears in the media involving an alleged material fact or event, a current report must be made within the prescribed period in order to clarify the news report that can create public speculation if not denied or clarified by the public company. PSE alleged that CAL had committed 55 violations of the disclosure rules from 6 October 2016 to 20 June 2017. First violation of the disclosure rules carries a fine of P50,000, second violation carries a fine of P75,000, third violation carries a one month trading suspension, and fourth violation will be a ground for delisting. CAL was fined a total of P300,000 and the PSE decided to start involuntary delisting proceedings. The imposition of monetary penalties and trading suspension are without prejudice to any regulatory action that can be undertaken by the regulators in connection with the violations. Despite the absolute violation of the disclosure rules, the minority shareholders are against the decision of the PSE to delist CAL due to the absence of an exit mechanism. To appease the minority shareholders, the PSE proposed voluntary rather than involuntary delisting on the condition that a tender offer will be conducted. CAL rejected the proposed voluntary delisting as it does not have enough retained earnings to buy back outstanding shares at book value per share. Although the tender offer price must be based on a fairness opinion valuation of the business, there are no rules under the SRC that pegs the tender offer price to the book value per share. PSE had bended the disclosure rules to accommodate an exit mechanism but CAL had chosen the road most traveled to enrich themselves at the expense of the minority shareholders. When corporate governance breaks down, minority shareholders must sell and never forget. Those who break the rules are scum but those who abandon those rules are worse than scum.

Market Watch

Philippine stock market performance as measured by the Philippine Stock Exchange Index (PSEi) has been considered as one of the most turbulent among the emerging markets. The term emerging market was coined by economists at the International Finance Corporation when they were promoting the maiden mutual fund investments in developing countries. An emerging market has the features but not the standards of a developed market so it can be upgraded to a developed market or downgraded to a frontier market at the discretion of the global index providers. The year that was had shown us that buy-and-hold strategy does not work in emerging markets unless we know the balance between the desire for the lowest possible risk and the highest possible return. Low levels of risk are associated with low potential returns while high levels of risk are associated with high potential returns. But high potential losses must be reckoned because there are no guarantees. We must not measure investment returns based on passive investment strategy where an investor buys and holds stocks even with observable market threats. But we must measure investment returns based on active investment strategy where an investor buys and sells stocks anchored on favorable market sentiment. Although the MSCI Emerging Markets Index opened at 794.14 points on 31 December 2015 and closed at 862.27 points on 30 December 2016 or an investment return of +8.58%, the PSEi opened at 6952.08 points on 29 December 2015 and closed at 6840.64 points on 29 December 2016 or an investment return of -1.60%. MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) designed to measure stock market performance in emerging markets. Beyond reasonable doubt it was a bad year for passive investors but a good year for active investors. From the year low of 6084.28 points on 21 January 2016 to the year high of 8102.30 points on 21 July 2016, the PSEi made an investment return of +33.17%. But from the peak of 8102.30 points on 21 July 2016 to the trough of 6563.67 points on 23 December 2016, the PSEi made an investment return of -18.99%. PSEi had shown us that we must engage rather than evade market turbulence. But do not enter into uncharted territories unless the potential reward outweighs the potential risk. Before you jump on the bandwagon ponder that past performance does not guarantee future results.

Trade Wreck

Philippines is fortunate to have an economic growth anchored on consumption but is unfortunate to have an economic partner anchored on compulsion. Philippines and China had been ensnared in territorial dispute after China underscored the territorial claims in the West Philippine Sea that includes the shoals within the Philippines exclusive economic zone. Based on the United Nations Convention on the Law of the Sea (UNCLOS) an exclusive economic zone refers to an area within 200 nautical miles from the territorial sea of the coastal state. UNCLOS provides the regulatory framework for marine conservation, navigational rights, maritime zones and sovereignty. Due to the exhausted diplomatic channels the Philippines commenced arbitral proceedings to the Permanent Court of Arbitration but China refused to partake. As a signatory China agreed to refer the interpretation and application of the UNCLOS to the compulsory and binding dispute resolution procedure of the convention. By prohibiting reservations and adopting provisions on the basis of consensus it was the intention of the UNCLOS to eliminate the use of force in territorial dispute resolution among member states. Why did China refuse to partake? We do not know the answer but what we do know that prolonged territorial dispute could lead to adverse trade relations between Philippines and China. West Philippine Sea Coalition (WPSC) revealed that China warned the Philippines of economic consequences once it starts arbitral proceedings against them at the Permanent Court of Arbitration. WPSC was formed by the concerned citizens to protest absolute violations and pursue peaceful resolution of territorial disputes within the West Philippine Sea. Based on intelligence analysis these economic consequences could range from sanctions to sabotage. WPSC stated that parts of these economic consequences were the spontaneous import restrictions and strenuous inspection protocols imposed on Philippine banana exports to China. Based on the data compiled by Bloomberg the Philippine exports to China decreased to $19.02 billion in 2015 from $21.05 billion in 2014. Economic coincidence or economic consequence? Although the China economic growth as measured by the Gross Domestic Product (GDP) decreased to 6.8% in 2015 from 7.2% in 2014 China remains as the Philippines largest export market. Based on the data forecasted by the Development Budget Coordination Committee from 2014 to 2016 the average annual export growth is 8.0%. Perhaps the Philippines should manage export growth, expand export products and penetrate export markets before the China economic diplomacy agenda turns from bad to worst.