Back to basics of growth

Diwa Guinigundo, deputy governor of Bangko Sentral ng Pilipinas, poses for a photograph following a Bloomberg Television interview on the sidelines of the 50th Asian Development Bank (ADB) Annual Meeting in Yokohama, Japan, on Friday, May 5, 2017. Guinigundo, one of the leading candidates to become the next central bank governor in the Philippines, said there is no need to adjust monetary policy as inflation is forecast to stay on target. Photographer: Kiyoshi Ota/Bloomberg via Getty Images

About a year ago, I argued that the Philippine economy has entered a period of “rational exuberance.” I used this phrase to contrast with Allan Greenspan’s famous “irrational exuberance” and thereby describe the country’s growth as being driven by mature structural expansion. This was in response to last year’s growing concern that the domestic economy was overheating.

Since then, talks of overheating have abated until recently when a number of analysts have once again suggested and perceived that the domestic economy is growing faster than what fundamentals warrant. For instance, Fitch Ratings and Deutsche Bank both expressed concerns that the domestic economy is becoming too hot and that growth rates are unsustainable. Analysts have cited high inflation and widening current account gap as evidence of overheating.

Indeed, have we fallen into a period of “irrational exuberance?”

I believe this is a good opportunity for us to go back to the basics and reiterate that the Philippine economy’s growth remains primarily driven by sound fundamentals. There are at least four reasons for this optimism.

First, inflation in 2018 was primarily driven by supply-side factors. The increase in international crude oil prices, supply bottlenecks associated with adverse weather conditions and the direct and indirect effects of the excise tax reforms pushed inflation beyond the target range in 2018.

Accordingly, demand pressures were quite limited and, therefore, price pressures have proven to be transitory. In fact, latest inflation readings have been encouraging. Headline inflation has started to decline in the last quarter of 2018. Our latest inflation forecasts stand at 3.2 percent in 2019 and 3.0 percent in 2020. This is definitely contrary to an overheating economy where inflation is expected to be more persistent at elevated levels.

Second, 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. Bank lending growth as of November 2018 has moderated. In other words, there is sustained demand for loans because the economy is expanding. Credit growth in a sense is also catching up with previous years of credit repression to sustain financial deepening.

Third, indicators show that there is limited evidence of misalignment of credit and asset prices. Our Senior Loan Officer’s Survey continues to point to banks’ prudent lending practices amid sustained strong loan demand from enterprises and households. Moreover, while the Residential Real Estate Price Index (RREPI) has increased in the third quarter of 2018 from its year-ago level, there is limited evidence that current property prices are misaligned from their fundamental values. In a period of overheating, banks tend to significantly loosen credit standards to dispose of their loanable funds, such that before long, they would be saddled with bad loans. This is not true in the Philippine banking system. Credit standards have been maintained while non-performing loans ratio remains well below 2.0 percent from a high of more than 18.0 percent in 2001.

Fourth, in addition to the improving macroeconomic environment, the structural reforms we have pursued have been translated into higher potential output for the economy. The country’s potential output has risen to 6.0 – 7.0 percent following: i) the recent climb in economic efficiency as indicated by the declining incremental capital 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. Most significantly, with the recent policy of the government to “Build, Build, Build” infrastructure in the country, the country’s potential output should accelerate the gains in productivity and multiplier effects of widening capital assets. Then, the so-called positive output gap – actual output growth exceeding potential output growth – is very, very small and would hardly qualify as a trigger to overheating.

Thus, by going back to the basics, we are provided with a clearer picture of the Philippine economy. In particular, our country’s growth story continues to be a narrative of sound macroeconomic fundamentals. I firmly believe that our exuberant growth remains rational rather than irrational.

Let me therefore allay recent market concerns on overheating by repeating a point I have argued in my article last year — It is good to be exuberant as long as we remain rational.