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Speeches

A Tale of Tail Events

Date: 11.23.2016

Place: Raffles and Fairmont Hotel Makati City

Occasion: Security Bank Economic Forum

Speaker: BSP Governor Amando M. Tetangco, Jr.


We are almost at the end of 2016 and a new year is fast approaching. As such, I thought that for my remarks this afternoon, it may be useful to look back at some highlights of 2016 and use those as points of reflection in looking at the future.

A Tale of Tail Events

In economics or statistics, there is the concept of a “tail risk”.  In technical terms, tail risk is defined as  “the risk of an asset or portfolio of assets moving more than 3 standard deviations from its current price”. In layman’s terms one can think of a tail risk as the risk of a “verrryy rare” event occurring.

It can be argued that 2016 was a year wherein a number of these tail risk events or “tail events” materialized. For instance, in June there was Brexit. Five months after, the outcome of the US elections. In both cases, mainstream media (e.g. CNN, CNBC) underestimated the underlying sentiment, which caused shockwaves across the globe.  The same was the case in the financial markets. Traders and analysts also “got these all wrong”.

Fortunately for financial markets, a turnaround from a “wrong call” can be quick.  Traders just cut their losses. They reverse their original positions. They simply put on opposite trades. And as quickly as that, their positions now reflect the current sentiment.

Unlike sentiment in the financial markets, however, the medium and long-term effects on the broader economy of “tail events” cannot be as quickly turned around. 
 
A clear lesson that we all must learn from these 2016 tail events therefore is that we should prepare for the unexpected. Now, a question you may next ask is– How?  For investors, I suggest that, for a start, you keep your eyes open and your ears to the ground. Nothing beats one’s own pencil pushing. I hope that attending fora such this can help in this regard. I suggest you demand information from your financial advisers. Then you conduct your own due diligence of the companies/projects you will invest in. Based on these, diversify your portfolios as much as your risk appetite dictates. 

From the perspective of a policy maker, like the BSP, preparing for the unexpected translates to 1) enhancing surveillance and 2) building buffers.

A Review of the Risks

Surveillance requires that we squarely identify risks. There are a number of risks from both  global and domestic sources.

Let’s begin with Brexit, one of the tail events I cited at the top of my remarks. Data suggest that its direct impact on the domestic real economy would be limited. Trade with and  FDI from the UK represent less than 1 pct of total trade and FDI, respectively. That said, it is the second round effect that we need to be concerned about. In other words, how Brexit would affect growth in the EU. In addition, there are a number of European nations holding their elections next year. We need to be watchful whether there would be others that would follow what the UK did and break away from the EU.

With regard to the forthcoming assumption to office of President-elect Trump, the second tail event I cited at the beginning, it is too early to tell how he would govern. But based on what we heard during the campaign, we need to be vigilant over possible changes in tax laws, immigration policies and financial and business regulations. Off hand, we will keep an eye on the possible impact of shifts in immigration policies on remittances as well as the prospects of sustained investments from US business process outsourcing companies.

A third risk is the on-going rebalancing of the Chinese economy. A protracted slowdown of the world’s second largest economy, as it transitions from being export-led to being services and domestic consumption-driven, could impact our external sector given the increasing bilateral relations between our two economies in recent years.

Brexit, the results of the US elections and the shift in focus of the Chinese economy.  These seem to reflect a desire within certain jurisdictions to more and more address domestic concerns with policies that are “inward-looking”.  It has been said that these events are the result of “frustration” at the failure of “openness” in both the goods and labor markets to raise economic well-being. Moreover, the continued weakness in global growth has encouraged policy makers to look to domestic aggregate demand as a key driver for economic growth.

Some have called this phenomenon a “retreat from multilateralism”. If this trend continues, we may see near-term global growth remain at low levels. Persistence of low global growth could, over time,  adversely impact our external trade and OF deployment. In turn, these may dampen remittances and relatedly, domestic consumption.

The possible negative effects of these inward-looking policies have not yet been felt in any significant measure across jurisdictions. But I believe the possible ramifications are now being recognized. At the APEC Leaders’ Meeting over the weekend in Peru,  the Leaders pledged their commitment against “all forms of  protectionism.” It remains to be seen, however,  how the written statement would translate to jobs generation and welfare improvement, and how such pronouncements would affect pent-up negative sentiment and frustration.

Turning to financial markets, analysts are putting the probability of a Fed rate hike in December (as implied by US Fed funds futures) at over 90 percent.  Together with sustained labor market improvement, the latest meeting of the Fed showed that core inflation is likewise inching up, which supports the case for a hike soon. As the Fed meeting in December nears, this probability may get even higher.

On top of all these risks from the external front, the impact of severe weather disturbances and the infrastructure gaps remain important challenges in the domestic sphere.

Building Buffers

While we try to anticipate unlikely events, this cannot be the bulk of our work. We must focus on adjusting our settings to contravene global headwinds and buoy growth. Because we cannot assign full-proof probabilities to all events, it is important that we try to scope the downside impact of these events. Then build buffers accordingly.

Building buffers means we craft policies, create the institutions, and conduct appropriate operations to ensure the economy remains resilient. Based on latest indicators, I can say, so far, we have done well.  

Q3 GDP was reported last week at 7.1 pct. This makes the Philippines the fastest-growing among major Asian emerging economies that have already released data for the quarter. We are higher than China’s 6.7 percent, Vietnam’s 6.4 percent, Indonesia’s 5.0 percent, and Malaysia’s 4.3 percent. This outturn also brings to 71 the number of consecutive quarters of positive economic growth. It is equally important to note that such strong growth performance continued under low and stable inflation.

Given that, you may ask, are we up for more surprises before the year closes? The quick answer is we are yet to see, but we can say that we are ready.

Resilience to Negative Surprises

Our growth dynamics continue to be convincing, with domestic economic activity seen to remain firm, supported by solid private household consumption and investment, buoyant business and consumer sentiment, and adequate credit and domestic liquidity. While average inflation is likely to settle slightly below the lower bound of the 2-4 percent target range in 2016, inflation is projected to rise toward the mid-point of the target range in 2017 and 2018. 

The overall balance of risks surrounding the inflation outlook is, however, tilted to the upside owing largely to the pending petitions for adjustments in electricity rates along with the proposed fiscal reform program. Nevertheless the inflation environment remains manageable. Our current monetary policy rate setting therefore continues to be appropriate.

We also note that the BSP’s monetary policy stance does not need to be in sync with the Fed should the latter decide to hike its rates in December. The policy actions of the BSP will remain data-dependent and attuned to domestic conditions and the inflation target.

Given the external headwinds, I believe our defense system is sound. I’ve been asked lately whether the recent weakness of the peso is worrisome. Our policy has always been to allow market forces to determine the exchange rate. But if we see movements that are excessive, we will not hesitate to participate in the market to keep volatility in check. Our flexible exchange rate policy provides us with a reliable tool to shield the economy from temporary gyrations, while our adequate reserves and sustained current account surplus fundamentally anchor our external position.

Our banking system also continues to be sound and effective in intermediating funds from savers to the productive sectors of the economy. We have put in place reforms to further strengthen governance and risk management in banks. Moreover, we have seen a quality improvement in our financial system. Today, long-term projects could be funded also from the bond and equity markets. 

Opportunities amidst Tail Events

Now, I must ask you, what should investors take away from here? In particular, what does the medium-term bode for the Philippine economy?

The country’s economic record continues to be  underpinned by our ability to show that our macroeconomic institutions are working. We have institutions that have well-articulated policy frameworks, emphasize anti-corruption and uphold good governance. Such institutions improve the cost of doing business, help secure confidence, and provide a dependable safeguard against negative surprises.

I believe the Philippines will continue to be an attractive destination for business and investment, given our strong potential for sustainable returns. We have policy space on the monetary side as well as on the fiscal side to address downside risks to economic growth. Moreover, the new administration’s commitment to reform the tax system should further provide room to ramp up infrastructure spending that in turn would boost productivity and further lift medium-term growth.

Conclusion

In the end, ladies and gentlemen, one of the important lessons from the tail events of 2016 is to remind us that uncertainty is always present but it is manageable. It proves once again that our long-term bias towards stability and sustainability is our most effective guidepost and tool to ride out short-term problems or shocks.

We should not be sidetracked by the unexpected, rather it should urge us to be more strategic and deliberate about our decisions.

Nassim Taleb, author of the book The Black Swan: The Impact of the Highly Improbable, admonished his readers to “Rank beliefs not by their plausibility but by the harm they cause”.  Intrinsic in such an admonition is a scoping of both the risks and options presented by the environment we operate in.

On the part of the BSP, we will continue to pursue our mandate of price and financial stability. In doing so, we will also continue to dialogue with stakeholders such as yourselves.

Thank you very much and I wish you a productive Forum!

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