Throughout history, sovereign debt crises have never been about mathematics alone. They have always been political crises. Governments refuse to cut spending because elections are won by promising benefits, not sacrifices. Every political party campaigns on giving voters something while sending the bill to future generations. Eventually the markets stop believing those promises can be financed. That is when governments resort to higher taxes, financial repression, capital controls, inflation, and every other desperate measure designed to preserve the system—Martin Armstrong
In this issue:
Stagflation Part 13: Record Twin Deficits Signal the Cost of Deferred Adjustment
I. Introduction: The First-Half Reckoning
II. EO 110 and the Politics of Deferred Adjustment
III. 1H 2026’s Record Fiscal Deficit and Record Public Debt Exposes the Cost of Deferred Adjustment
IV. The Adjustment Migrates to the Nation's Balance Sheet
V. Borrowed Stability: June’s BOP and GIR Improvements
VI. The BSP's Narrowing Policy Space
VII. The Politics of Deferred Adjustment: Increasing the Annual Income Tax Threshold
VIII. The Politics of Deferred Adjustment: Removing System Loss Charges from Electricity Bills
IX. Conclusion: The Record Twin Deficits and the Sovereign-Fiscal Doom Loop
Stagflation Part 13: Record Twin Deficits Signal the Cost of Deferred Adjustment
How Pandemic-Era Policies, EO 110, and Financial Interventions Transferred Inflationary Pressures Across Balance Sheets
I. Introduction: The First-Half Reckoning
The previous installments of this series argued that the Philippine government's response to the 2024 oil shock did not eliminate the inflationary adjustment. It redirected it.
This adjustment process did not begin with the oil shock. During the pandemic, emergency measures designed to stabilize demand, preserve employment, and prevent a deeper contraction were introduced as temporary countercyclical responses. Over time, however, many of these interventions became embedded features of the economic framework. EO 110 represented not a departure from that approach, but an extension of an already established pattern of using policy intervention to absorb economic pressures.
Following the pandemic-era policy expansion, policymakers continued to rely on administrative controls, fiscal support, monetary accommodation, and regulatory intervention, with EO 110 extending this approach during the oil shock.
The immediate objective was understandable: to soften the inflationary shock and sustain economic activity. Instead of allowing relative prices to coordinate the necessary adjustment, however, these measures shifted it across public and private balance sheets.
The first half of 2026 marks an important point in that process. The National Government recorded the largest January-to-June fiscal deficit on record. Outstanding public debt surpassed Php 19 trillion for the first time after posting the second-largest first-half increase on record, while the merchandise trade deficit reached a record first-half level despite June's record exports.
The Iran war's oil shock intensified these underlying dynamics within the Philippines' savings-investment gap development model. As policy increasingly relied on fiscal transfers, credit expansion, and regulatory intervention rather than market adjustment, leverage accumulated, the economy became progressively less adaptive, and policy choices became increasingly constrained.
This dynamic now extends beyond the fiscal accounts. The Bangko Sentral ng Pilipinas (BSP) faces a narrowing range of monetary options, while new proposals to reduce income taxes and electricity costs promise immediate relief by shifting additional adjustment into the future.
This installment examines how successive interventions have transformed a temporary inflationary shock into a broader stagflationary process.
II. EO 110 and the Politics of Deferred Adjustment
Every economic shock requires adjustment. The question is not whether adjustment occurs, but how.
The same principle applied during the pandemic. Emergency measures that were initially justified as temporary responses to an extraordinary shock gradually became embedded in the economic structure. What began as countercyclical intervention increasingly became a mechanism for sustaining conditions that required continued intervention.
In an unhampered market, adjustment proceeds through changes in relative prices, profits, losses, production, and consumption. Government intervention can alter that process by redistributing costs across households, firms, taxpayers, borrowers, or future budgets. It can delay or redirect adjustment. It cannot repeal scarcity.
EO 110 exemplified the continuation of this tradeoff. Like earlier pandemic-era measures, it sought to prevent an immediate economic contraction by absorbing part of the shock through government intervention. The policy reduced visible price pressures and provided temporary relief, but it also extended the process of transferring adjustment away from market signals and toward institutional balance sheets.
The remainder of this article examines how that transferred adjustment became increasingly visible during the first half of 2026.
III. 1H 2026’s Record Fiscal Deficit and Record Public Debt Exposes the Cost of Deferred Adjustment
The first-half fiscal accounts reveal the balance sheet that absorbed a significant portion of the adjustment.
The National Government recorded a Php 786.8 billion fiscal deficit during the first six months of 2026—the largest January-to-June deficit on record.
While this represented 47% of the DBCC's full-year deficit target of Php 1.659 trillion, fiscal pressures typically intensify in the second half as government spending accelerates.
Continued oil-shock subsidies and intervention programs amid strained economic conditions increase the risk of further fiscal deterioration.
The record first-half deficit was not merely a budgeting outcome. It represented the financing cost of sustaining expenditures that continued to exceed revenues.
The gap was covered through borrowing. Yet borrowing did not simply finance current expenditures.
Figure 1
First-half net public borrowing surged to Php 1.357 trillion, the second-highest level on record, narrowly below the Php 1.371 trillion recorded during the pandemic-driven stimulus driven expansion of 2021. The magnitude was consistent with the record Php 786.8 billion first-half fiscal deficit, reflecting the increasing reliance on debt financing to sustain government expenditures. (Figure 1, topmost pane)
The first semester borrowing represents 50.67% of the DBCC’s proposed Php 2.68 trillion borrowings in 2026.
Borrowings in June 2026 jumped Php 519 billion month‑on‑month, the biggest surge since March 2022 at the height of the pandemic. (Figure 1, middle graph)
The composition of borrowing also highlights growing external exposure. By June, foreign-currency denominated debt accounted for 32.67% of total debt, only slightly below April's 32.78% level—both among the highest since 2020. This occurred alongside record low peso, increasing the sensitivity of public finances to exchange-rate movements. (Figure 1, lowest image)
Borrowing therefore expanded not only the government's debt stock but also future financing obligations.
Figure 2
Total debt servicing surged 59.7% in 1H 2026, reaching the second-highest nominal level since 2024. (Figure 2 topmost window)
Interest payments alone accounted for approximately 15.2% of government spending, the highest share since 2009, while amortization soared 110% as maturing obligations were refinanced. (Figure 2, middle chart)
Government borrowing increasingly financed not only today's spending but yesterday's deficits.
Today's deficits become tomorrow's debt service obligations.
The adjustment postponed in one period reappeared in another.
This is why the deficit alone understates the fiscal challenge. The larger issue is that debt service expanding claim on future public resources continues to grow. Every peso committed to interest payments and refinancing reduces the government's capacity to respond to future shocks without additional borrowing.
The consequence extends beyond the Treasury. As financing requirements expand, fiscal policy becomes increasingly dependent on stable credit markets, abundant liquidity, and investor confidence. What began as an oil-shock response has gradually evolved into a broader financing constraint.
And government financing does not end at the public balance sheet.
It extends to the nation's balance sheet.
The alternative is to inflate debt away — whether through the inflation tax or financial repression.
That story is reflected in the country's record first semester twin deficits.
IV. The Adjustment Migrates to the Nation's Balance Sheet
Fiscal deficits tell only half the story.
The other half appears in the country's external accounts.
Government can finance expenditures through borrowing. A nation, however, cannot indefinitely sustain domestic absorption above domestic production without relying on external financing to bridge the gap.
That is exactly what the first half of 2026 reveals.
June's trade report generated optimism after merchandise exports surged 24.1 %to a record $8.8 billion, while imports increased 19.7 %to $13.07 billion, narrowing the monthly trade deficit to approximately US$4.9 billion. Q2 2026 data showed 24.95% surge in exports while imports jumped 20.44%. (Figure 2, lowest visual)
Part of this strength coincided with the ongoing global AI ‘arms race’ investment cycle, which has supported demand for semiconductor and electronics exports.
Figure 3
However, the monthly improvement did not alter the broader trend. June's trade position remained comparable to the Russian-Ukraine oil shock of 2022 levels, while the first-half trade deficit reached another record. (Figure 3)
The deterioration was reinforced by a record second quarter, with the first-half deficit exceeding even pandemic-era levels.
This outcome should not be surprising.
EO 110 softened part of the oil shock. Fiscal policy sustained domestic spending. Monetary policy, including the BSP's ‘soft peg’s regime’, and liquidity support, maintained financial conditions. These measures supported demand, but they barely created additional productive capacity.
Demand continued to expand while production struggled to keep pace. When the 2026 Iran war intensified oil-market pressures, the adjustment appeared through the import channel, similar to the 2022 oil shock following Russia's invasion of Ukraine. The difference was reflected in the size of the import bill.
This is why the fiscal deficit and trade deficit should be viewed as interdependent forces.
One reflects government spending beyond government revenues.
The other reflects national spending beyond national production.
Both describe the same adjustment process from different balance sheets, requiring funding.
A country that consistently imports more than it exports must obtain foreign exchange from somewhere else—through remittances, tourism, exports, foreign investments, or borrowing. When those sources fail to keep pace, dependence on external financing inevitably increases.
The first-half data suggest that this dependence is becoming more pronounced.
V. Borrowed Stability: June’s BOP and GIR Improvements
Figure 4
The June improvements in the Balance of Payments (BoP) and Gross International Reserves (GIR) should be viewed in the broader context of the first-half accounts. June registered a US$3.403 billion BoP surplus, while GIR edged up to US$104.74 billion. (Figure 4, upper diagram)
Although the BOP rebounded sharply over the past two months, the second-quarter merely returned to its long-term trend resistance despite the peso trading at or near record lows against the U.S. dollar. (Figure 4, lower graph)
Both indicators strengthened during June and were widely presented as evidence of improving external stability. But the improvement deserves closer examination.
A significant contributor was foreign borrowing by the National Government. In June alone, the government raised US$2.5 billion from the international capital markets and secured an additional US$1 billion through a World Bank syndicated financing package. These inflows increased foreign exchange liquidity and contributed to the rise in international reserves.
However, these external inflows also carry future obligations. Foreign borrowing strengthens the immediate external position, but it expands debt-service requirements and increases exposure to global interest-rate and exchange-rate conditions. The same borrowing that supports reserves today creates additional claims on future fiscal resources.
More importantly, external debt creates future dollar obligations. Each additional foreign liability increases the economy's effective “dollar short” position by adding claims on future foreign-exchange earnings.
That is to say, foreign exchange reaches the economy through fundamentally different channels. It can be earned through productive activity—exports, remittances, tourism, business process outsourcing (BPO), and foreign direct investment (FDI)—or obtained through external borrowing backed by future repayment.
The Balance of Payments (BoP) records both as foreign exchange inflows without distinguishing their source. International reserves likewise reflect the accumulation of these inflows regardless of whether they originate from current production or future obligations.
Financial markets, however, eventually distinguish between the quality and sustainability of those flows.
The first-half accounts suggest that organically generated dollar inflows have become less robust.
- Foreign direct investment (FDI) has fallen to its lowest level in a decade.
- At the onset of the Iran war's oil shock, several major tourism destinations—including Boracay, Baguio, Hundred Islands, and Eastern Visayas—reported a plunge in visitor traffic.
- Remittance growth has slowed to a 4-year low in May
- BPO industry has signaled weaker expansion targets.
- At the same time, the recent surge in merchandise exports has been supported by the global AI investment cycle, leaving the trade balance vulnerable should that cycle slow.
Against this backdrop, external borrowing has assumed a more prominent role in supporting the country's external accounts.
The first-half data therefore suggest that part of the apparent improvement in external stability reflects increasing reliance of foreign exchange financing rather than a broad strengthening of the economy's underlying capacity to generate dollar earnings.
Intervention may have altered the transmission of adjustment, but it did not eliminate the adjustment itself. Instead, it increasingly appeared on both the government's and the nation's balance sheets.
The apparent easing of inflation was financed through deteriorating public and external balance sheets, deferring rather than eliminating inflationary adjustment while deepening stagflationary pressures.
VI. The BSP's Narrowing Policy Space
The cumulative effects of this adjustment migration now confront the Bangko Sentral ng Pilipinas (BSP).
In theory, central banks fight inflation by tightening monetary policy. In practice, that choice becomes increasingly constrained as leverage accumulates across the economy. The first half of 2026 illustrates this dilemma.
The BSP raised policy rates only twice and has recently signaled ‘small chances’ for aggressive tightening. At the same time, it continued supporting liquidity through historic reserve requirement reductions in 2025, recent regulatory relief measures for banks, including capital relief, and peso support measures.
The policy pattern was clear: maintaining financial stability had become as important as controlling inflation.
The reason lies in the changing structure of the economy.
Higher interest rates may weigh less on households and private borrowers, but they sharply escalate government financing costs, magnify conglomerate refinancing pressures, and constrict credit conditions throughout the banking system.
As debt accumulates across public and private balance sheets, monetary tightening becomes progressively more costly.
This creates an unavoidable policy tradeoff. Measures that strengthen inflation control can increase stress across highly leveraged sectors, while measures that protect financial stability can prolong excess liquidity and delay adjustment.
Since no monetary policy action is neutral, every choice redistributes costs across different parts of the economy.
The BSP's own 2025 Financial Stability Report (FSR) highlights substantial refinancing requirements “wall of maturities” among large Philippine conglomerates over the coming years. These obligations coincide with record government borrowing and expanding sovereign financing requirements. Both depend on the same financial system. (Figure 5, topmost image)
This helps explain the increasing political priority of financial‑system stability in policy decisions. The regulatory response has provided repeated forms of support to the banking sector, most recently through various forms of regulatory relief including capital relief measures, reserve‑requirement reductions, and expanded deposit‑insurance coverage.
These actions may strengthen bank balance sheets, but they also raise questions not only about how effectively monetary accommodation is transmitted into productive economic activity but, more importantly, at what cost — and who bears them.
The credit data provide part of the answer. Despite years of liquidity support and policy accommodation, lending to micro, small, and medium enterprises (MSMEs) remains limited, accounting for less than 5% of total bank lending in Q4 2025.
As an aside, curiously, the BSP's Q1 2026 presentation subsequently reflected the same figures as the previous quarter, an apparent reporting error that complicates assessment of MSME credit conditions.
Meanwhile, banks have increasingly accumulated government securities, reinforcing the linkage between sovereign financing needs and the banking system. The share of banks' net claims on the central government (NCoCG) remained near record levels at 20.32% in June, only slightly below the previous peak of 21.06%. In nominal terms, NCoCG remained near record highs at Php 6.236 trillion in June 2026. (Figure 5, middle diagram)
Relative to money supply, NCoCG accounted for 30.84% of M3 and 31.68% of M2, reflecting a sustained upward trend since 2019. (Figure 5, lowest chart)
Government securities have therefore become an increasingly important component of bank assets and system liquidity, deepening the interdependence between sovereign financing and financial-system stability.
This creates the conditions for a sovereign-bank feedback loop: higher government financing requirements increase banks' exposure to sovereign assets, while banks' capacity and willingness to absorb government securities can reduce immediate financing pressures, potentially reinforcing continued fiscal expansion.
It also intensifies crowding-out pressures, as the government, banks, and large conglomerates increasingly compete for a limited pool of diminishing domestic savings. As public-sector financing needs expand, fewer resources remain available for smaller and more productive private-sector activities.
The result is a financial system increasingly oriented toward supporting sovereign and incumbent balance sheets rather than broad‑based private‑sector credit expansion, expanding concentration risks.
This institutional orientation also raises broader questions regarding the revolving-door political dynamic and regulatory capture.
The BSP Monetary Board are mostly members with extensive backgrounds in banking, large conglomerates, multinational corporations, and multilateral institutions. Such expertise provides valuable financial-system knowledge and institutional experience. However, close interactions and past relationships between regulators, financial institutions, and major corporate sectors can create institutional incentives that favor preserving the stability of existing financial structures — governed by public choice theory, where individual interest, rational ignorance, and rent‑seeking dynamics may shape policy decisions.
The central concern is whether policy priorities become disproportionately focused on safeguarding incumbent and national balance sheets at the expense of broader credit transmission, productive investment, and ultimately, the economy itself.
The resulting policy trade-offs will shape the economy's trajectory: whether continued intervention deepens the conditions associated with stagflation, or whether productivity gains ultimately restore greater economic flexibility and resilience.
VII. The Politics of Deferred Adjustment: Increasing the Annual Income Tax Threshold
As monetary policy becomes more constrained, political pressure naturally shifts toward fiscal and regulatory solutions.
The President's proposal in the 2026 State of the Nation Address (SONA) to raise the annual income tax exemption threshold from Php 250,000 to Php 350,000 illustrates this transition.
After several years of elevated inflation, allowing workers to retain more of their income restores part of their lost purchasing power and may strengthen incentives to work, save, and invest.
This is a welcome development, but it embodies a fiscal catch‑22 — cushioning inflation’s blow to purchasing power while eroding government revenue at a moment when fiscal space is already dangerously narrow.
Authorities estimate that the proposal would result in approximately Php 66 billion in foregone revenue. If government spending remains unchanged, the revenue reduction simply widens the financing gap.
The burden does not disappear; it shifts through other channels—higher taxation elsewhere, additional borrowing, future taxation, expenditure reductions, or inflation.
VIII. The Politics of Deferred Adjustment: Removing System Loss Charges from Electricity Bills
The same principle applies to another populist SONA proposal: removing system-loss charges from electricity bills.
Consumers understandably welcome lower electricity costs. However, electricity lost during transmission and distribution remains a real economic cost. Removing the charge from one part of the bill does not eliminate the underlying loss.
Figure/Table 6
The Philippines is not unusual in the magnitude of physical system losses, which are broadly comparable with several Southeast Asian peers. The difference lies in regulatory treatment. Rather than fully embedding these costs within network tariffs, the ERC has historically allowed a separate recoverable system-loss charge, although the allowable cap for private distribution utilities has been reduced to 5.5% since 2021.
The actual policy question, therefore, is not whether system losses exist. It is who absorbs the cost and whether the regulatory framework creates incentives to reduce those losses.
Someone ultimately pays.
Distribution utilities may absorb part of the burden, but persistent losses could eventually require government intervention, subsidies, or greater public-sector involvement. Taxpayers may bear the cost directly. Regulators may redistribute it through other tariff components.
The accounting changes.
The economics do not.
This has been the recurring theme throughout this series.
Again, government intervention can redistribute costs. It cannot abolish them.
Every intervention changes who pays, when they pay, and where the adjustment appears.
The deeper issue is the institutional structure created by years of regulatory intervention. EPIRA introduced elements of liberalization, but the electricity sector remained heavily regulated, producing a hybrid system where market mechanisms operate alongside extensive administrative control — selective monopolies.
This structure has also generated distorted incentives. Under rate-of-return regulatory frameworks, firms may have incentives to expand their regulated capital base because higher approved investments can translate into higher allowed returns. The Averch-Johnson effect illustrates how such arrangements can encourage capital expansion beyond what would occur under a fully competitive market.
In this environment, system losses can become more than an operational problem. They may also provide justification for additional capital expenditures, infrastructure programs, and regulated cost recovery. The result is that inefficiencies become embedded within the regulatory structure rather than creating sufficient incentives for cost minimization.
The push to remove system-loss charges may also become part of broader efforts to revise or even overhaul the Electric Power Industry Reform Act (EPIRA).
Populist ‘free lunch’ relief measures may boost approval ratings and improve electoral prospects—given the Philippine leadership’s recent record low popularity ratings, but scarcity ensures that there is no free lunch.
Yet, the political economy of intervention lies in the redistribution of costs: benefits are concentrated and immediately visible, while the burdens are often dispersed across taxpayers, future budgets, consumers, and future generations.
This is the dynamic the great French economist Frédéric Bastiat described in his distinction between what is seen and what is unseen. When political authority redistributes costs while concealing the economic burden from those who ultimately bear it, intervention becomes a mechanism of “legal plunder” — the use of policies to effect invisible redistribution.
The recurring pattern throughout this series is that intervention changes the location and timing of adjustment. It does not eliminate scarcity. The costs remain embedded in weaker balance sheets, distorted incentives, and reduced economic adaptability.
IX. Conclusion: The Record Twin Deficits and the Sovereign-Fiscal Doom Loop
The first half of 2026 demonstrates the consequences of deferred adjustment, now reflected in record twin deficits.
The stagflationary pressures examined throughout this series did not originate from the oil shock alone. The shock exposed the accumulated consequences of a development model constrained by a persistent savings-investment gap, where years of deepening intervention preserved demand while weakening the economy’s capacity to adjust.
The twin deficits reveal the same imbalance across different balance sheets. The fiscal deficit reflects government spending beyond available revenues. The trade deficit reflects domestic absorption exceeding productive capacity through persistent import dependence. Both imbalances require continuous financing through borrowing, foreign exchange inflows, and the recycling of existing capital flows.
At the same time, peso support through the BSP’s soft-peg framework, external financing dependence, and the refinancing requirements of large conglomerates have increased the economy’s reliance on continued liquidity and favorable credit conditions.
But the deeper consequence is the concentration of financial linkages created by a system increasingly reliant on balance-sheet expansion rather than productive adjustment.
As banks accumulate greater exposure to government securities, the risks of a sovereign-bank doom loop deepens: fiscal expansion increasingly depends on financial-system support, while financial stability becomes increasingly dependent on sovereign balance-sheet credibility. Large corporate balance sheets remain similarly connected to bank led financing conditions and continued accommodative policy support.
The result is a growing concentration of financial resources around sovereign and incumbent balance sheets. As these linkages deepen, the financial system becomes increasingly oriented toward sustaining existing obligations rather than expanding broad-based productive investment.
This is the consequence of weakening the adjustment mechanisms that normally discipline capital allocation. When price signals, losses, and capital reallocation are suppressed, malinvestments persist and accumulate until they appear as financial distress.
The policy path therefore narrows between two outcomes. Tightening risks exposing accumulated duration and leverage vulnerabilities. Continued accommodation risks extending the intervention loop and deepening the distortions behind stagflation.
The adjustment was never eliminated. It is being transferred until the system approached its limits.
The ultimate risk is that the same mechanisms used to postpone adjustment eventually become the channels through which adjustment occurs—through a broader financial and economic crisis.
___
References:
Stagflation, Part 12: The Philippines' Balance-Sheet Origins of Inflation
Stagflation Part 11: The Intervention Ecosystem Behind Moody's and Fitch's Banking Warnings
Stagflation Part 9: The Good News Mirage — Statistical Stability Amid Structural Fragility
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