Minsky's Fragility Cycle Meets Wile E. Coyote: The Philippine Banking System’s Velocity Trap

 

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances—Ludwig von Mises 

In this issue

Minsky's Fragility Cycle Meets Wile E. Coyote: The Philippine Banking System’s Velocity Trap

I. Introduction: The Banking System’s Wile E. Coyote Moment

II. NPL Benchmarks Unveil Minskyan Fragility and the Wile E. Coyote Moment

III. Diminishing Returns: Policy Stimulus-Backstop Backlash

IV. Banks’ Drift Toward Consumers: Credit Cards and Salary Loans Power NPLs Higher

V. Stagflation Signals and the Death Knell of Benchmark-ism: Labor Frailty Meets Inflation’s Third Leg

VI. The Wile E. Coyote Dynamic in Bank Investments via Available For Sale (AFS) Assets

VII. AFS Surge and Recession-Grade Financial Losses

VIII. Benchmark-ism and the Illusion of Confidence

IX. Velocity or Collapse: The Wile E. Coyote Reckoning

X. BSP’s Tacit Pivot: From Sovereign Risk to Banking Backstop

XI. Conclusion: The Velocity Charade Meets Its Limits 

Minsky's Fragility Cycle Meets Wile E. Coyote: The Philippine Banking System’s Velocity Trap

The Wile E Coyote velocity game—credit expansion, AFS bets, and central bank lifelines—keeps Philippine banks afloat, but the stability it projects is an illusion

I. Introduction: The Banking System’s Wile E. Coyote Moment 

Inquirer.net, September 06, 2025: Bad debts held by the Philippine banking system rose to their highest level in eight months in July, as lenders—facing slimmer margins from declining interest rates—may have leaned more on riskier retail borrowers in search of yield. Latest data from the Bangko Sentral ng Pilipinas showed that nonperforming loans (NPL), or debts overdue by at least 90 days and at risk of default, accounted for 3.40 percent of the industry’s total loan portfolio. That marked the highest share since November 2024, when the NPL ratio stood at 3.54 percent. 

Time and again, we’ve detailed the escalating challenges facing the Philippine banking system—chief among them, its role in financing the government deficit amid elevated rates. 

This has led to record levels of held-to-maturity (HTM) securities, mounting investment losses from mark-to-market exposures, and potentially unpublished credit delinquencies buried in loan accounts. 

Together, these forces have contributed to the system’s entropic liquidity conditions: a slow, grinding erosion of institutional health masked by policy choreography. 

But recent developments take the proverbial cake. While NPLs remain elevated, their apparent ‘containment’ has served as public reassurance—an illusion of stability. 

Beneath that veneer, banks have shifted into a "velocity game" to preserve KPI optics: record-high credit expansion running in tandem with record-high NPLs. 

This statistical kabuki masks growing stress but sets the system on a path to its own Wile E. Coyote moment. 

While this sustains confidence in the short term, the moment loan growth slows, the cliff edge becomes visible—and the entire charade unravels. 

II. NPL Benchmarks Unveil Minskyan Fragility and the Wile E. Coyote Moment

Figure 1

Since the second half of 2022, Philippine banks have seen a structural uptrend in gross nonperforming loans (NPLs), with nominal levels breaching all-time highs by April 2024 and reaching a record Php 535 billion in July 2025. (Figure 1, topmost chart) 

Though the industry’s NPL ratio remains at a deceptively flat at 3.4 percent, this apparent stability is largely the effect of the ‘denominator illusion’: total loan growth (+11 percent) has been fast enough to offset the rise in bad loans.  (Figure 1, middle window) 

This accelerates procyclical risk-taking—banks extend more credit, often to riskier retail borrowers, to maintain headline ratios. 

Neo-Keynesian economist Hyman Minsky famously proposed that financial instability evolves in stages—from hedge finance to speculative finance, and finally to Ponzi finance—where borrowers can no longer generate sufficient cash flows to service debt and must rely on refinancing, rollovers, or asset sales to stay afloat (see references) 

But Minsky’s framework has a counterparty: the lender. 

In the Philippine case, banks have become enablers of this drift. To keep overleveraged firms and households solvent, they must sustain ever-faster credit expansion—rolling over weak loans, extending new ones, and deferring recognition of losses. 

This is the Minskyan drift on the supply side: not just borrower pathology, but lender complicity. 

A banking system whose apparent stability depends on pyramiding credit to increasingly marginal borrowers, refinancing delinquent accounts, and chasing yield into riskier consumer segments—exacerbating the very fragility it was meant to manage. 

The result is a velocity-dependent equilibrium—one that demands constant motion to avoid collapse. 

When the sprint falters or bad debts surge, the NPL ratio will spike—mechanically, inevitably—unveiling the proverbial skeletons long buried beneath the benchmark gloss. 

The system confronts its Wile E. Coyote moment: suspended mid-air, legs still spinning, gravity imminent. Once credit growth slows, the ground disappears—and the fragility long masked by velocity is fully revealed. 

III. Diminishing Returns: Policy Stimulus-Backstop Backlash 

This Minskyan drift is unfolding despite a full-spectrum easing cycle from the Bangko Sentral ng Pilipinas: reserve requirement cuts, interest rate reductions, the USDPHP softpeg regime, doubled deposit insurance, and lingering regulatory relief. 

Layered atop record fiscal stimulus, these measures were designed to cushion the system—but they now reveal diminishing returns. 

The irony is sharp: instead of stabilizing credit dynamics, these policies have parlayed into rising risks—encouraging yield-chasing behavior and masking stress through refinancing. 

And to maintain the illusion of stability, authorities have upped the ante on benchmark-ism—using statistical bellwethers to project ‘resilience’ while embellishing markets to fit the narrative. 

As nominal NPLs climb and consumer credit deepens, the central bank faces an unenviable dilemma: tighten policy and risk triggering defaults, or deploy unprecedented, pandemic-style liquidity injections to preserve appearances even as the system runs out of runway. At the same time, banks themselves may be compelled to conserve liquidity and pull back on credit expansion, exposing the system’s velocity game for what it is. 

Needless to say, whether in response to BSP policy or escalating balance sheet stress, banks may begin pulling back on credit—unveiling the Wile E. Coyote moment, where velocity stalls and gravity takes hold. 

IV. Banks’ Drift Toward Consumers: Credit Cards and Salary Loans Power NPLs Higher 

This fragility is no longer confined to institutional (supply side) exposures—it’s now bleeding into the household sector. 

The banking system’s transformational pivot toward consumer credit—particularly credit card loans—has deepened latent risks, building a larger stock of eventual loan portfolio losses. 

While aggregate nominal consumer loans (including real estate) hit a record high in Q2 2025, non-performing loans also sprinted higher from their December 2022 bottom. Gross consumer NPLs now sit just 4.7% below their Q2 2021 peak. (Figure 1, lowest graph) 

Though recent increases have been broad-based, the lag in consumer credit delinquencies reflects delayed stress transmission—especially in motor vehicle and real estate segments.

Figure 2

Crucially, the share of consumer loans to banks’ total loan portfolio (net of interbank) reached an all-time high of 22.34% in Q2 2025. Year-on-year growth in consumer NPLs has accelerated from single digits in 2024 to double digits in the last two quarters. (Figure 2 topmost pane)  

As noted earlier, surging NPLs have accompanied blistering growth in credit card loans—both hitting record highs in Q2. (Figure 2, middle image) 

But it’s not just credit cards: salary loan NPLs also spiked to a record, juxtaposed against all-time high disbursements. (Figure 2, lowest graph)

Figure 3

Strikingly, even as bank lending hits new highs, consumer real estate NPLs have climbed over the past two quarters. This uptick comes despite previously stable delinquency rates—a counterintuitive anomaly given the record and near-record vacancy levels observed in Q1 and Q2 2025, potentially a product of sustained refinancing. (Figure 3, topmost diagram)  

These pressures are permeating into the demand side of the economy—further evidence of a consumer squeezed by inflation, debt, and the slow erosion of repayment capacity. 

Taken together, weak household balance sheets, rising camouflaged NPLs, and a slowing economy raise systemic risks that extend well beyond macro fundamentals—threatening institutional health and reaching deep into the financial sector’s core, even as headline growth continues to mask the underlying fragility. 

V. Stagflation Signals and the Death Knell of Benchmark-ism: Labor Frailty Meets Inflation’s Third Leg 

Credit risk pressures should intensify with the July labor market data, which unexpectedly exposes the labor market’s underlying frailty. 

The unemployment rate (5.33%) and unemployed population (2.59 million) surged to pandemic-era highs (August 2022: 5.3%, 2.681 million), while the labor participation rate fell to 60.7%—slightly above July 2023’s 60.1%. (Figure 3 middle and lowest images) 

Stunningly, despite a 1.51% YoY increase in population, the non-labor force swelled to 31.45 million, the highest level since at least 2021. 

Combined, the unemployed and non-labor force accounted for a staggering 42.5% of the 15-and-above population in July 2025—a July 2023 high. 

Ironically, authorities amusingly blamed the weather. 

For banks, a looming storm is brewing: fragile household balance sheets, concealed loan delinquencies, and a deteriorating labor market set the stage for increased NPL formation in Q3 2025, with potentially systemic consequences

Figure 4

There’s more. 

Authorities also reported that despite rice price controls and the 20-peso rollout, headline CPI jumped to 1.5% in August—exposing the likely anomalous 0.9% dip in July. More concerning is the CORE CPI breakout, rising from 2.3% to 2.7%, the highest since December 2024. (Figure 4, topmost visual) 

Historically, a negative spread—where CORE CPI exceeds headline—has signaled cyclical bottoms for headline inflation. 

History rhymes. Peak CPI in October 2018 marked the launchpad for the record run in gross NPLs, which climaxed in October 2021 before slowing. (Figure 4, second to the highest image) 

Likewise, February 2023’s peak CPI became the springboard for the recent all-time highs in gross NPLs—records now eclipsed or obscured by the Wile E. Coyote velocity game. 

The pattern is clear: Each cycle shows how households use credit to bridge spending power losses during inflation surges, only to leave borrowers delinquent in its wake. 

The fatal cocktail of surging unemployment and a potential third leg of the inflation cycle—stagflation—could be the coup de grâce for NPL benchmark-ism. The illusion of resilience may not survive the next impact. 

VI. The Wile E. Coyote Dynamic in Bank Investments via Available For Sale (AFS) Assets 

There’s another aspect we’ve barely touched—yet it has become a critical factor in the banking system’s health challenges, now showing symptoms of the Wile E. Coyote dynamic: investment assets. 

First, the distribution of bank assets reveals a transformational shift—from safeguarding liquidity to an entrenched addiction to leverage. This seismic rebalancing is evident in the rising share of investments and, more recently, the rebound in loan activity, both at the expense of cash reserves. (Figure 4, second to the lowest graph) 

Since the BSP’s historic rescue during the pandemic recession, the cash share of bank assets has plunged to an all-time low of 6.93% as of July 2025. 

Second, as we’ve repeatedly noted, the pandemic-level fiscal deficit has driven the banking system’s net claim on central government (NCoCG) to a record Php 5.547 trillion (up 7.12% last July). This is mirrored in Held-to-Maturity (HTM) assets, which rose 2.15% to a record Php 4.1 trillion. Today’s deficit is not just a macro concern—it’s manifesting as a liquidity squeeze across the banking system. And that’s before accounting for the adverse effects of crowding out. (Figure 4 lowest graph) 

Third, the very investments that carried the banking system through the pandemic—buoyed by the historic BSP cash injections—have now become a source of friction. 

The need for sustained liquidity from the BSP to keep asset prices afloat has morphed into a Trojan Horse for inflation and a fuel source for increasingly speculative risk-taking engagements. 

To stave off asset deflation, the BSP must inject liquidity—primarily via bank credit expansion—yet this comes at the cost of spiking inflation risk.

Figure 5

This dynamic is most evident in Available-for-Sale (AFS) assets, which now constitute 41% of gross financial assets, fast catching up to HTMs at 52%. (Figure 5, topmost window) 

VII. AFS Surge and Recession-Grade Financial Losses 

The record build-up of AFS assets has heightened exposure to mark-to-market shocks, transmitting valuation swings directly into capital accounts and investor sentiment. 

The impact is already visible: In Q2, Philippine banks suffered an income contraction of (-) 1.96%, driven largely by a surge in losses on financial assets totaling Php 43.782 billion—the largest since December 2020, at the height of the pandemic recession. Let it be clear, these are recession-grade losses. (Figure 5, middle chart) 

With fixed income rates falling and bond prices rallying, the source of these losses becomes clear by elimination: deteriorating equity positions and bad debt. This is reinforced by the all-time high in banks’ allowance for credit losses (ACL)—a supposed buffer against rising delinquencies that signals institutional awareness of latent stress. (Figure 5, lowest diagram) 

Yet, like NPLs, these record ACLs are statistically suppressed by spitfire loan growth.

VIII. Benchmark-ism and the Illusion of Confidence

Figure 6

Nonetheless, this structural shift helps explain the growing correlation between AFS trends and the PSE Financial Index. (Figure 6, topmost window) 

In this light, banks—alongside Other Financial Corporations (OFCs)—may well represent a Philippine version of the stock market “National Team”: pursuing benchmark-ism or, perhaps, reticently tasked with pumping member-bank share prices within the Financial Index to choreograph market confidence. 

Patterns of coordinated price actions—post-lunch ‘afternoon delight’ rallies and pre-closing pumps—can often be traced back to these actors. 

Whether by design or silent coordination, the optics are unmistakable. 

IX. Velocity or Collapse: The Wile E. Coyote Reckoning 

The implication is stark: even as banks expanded their AFS portfolios —ostensibly for liquidity and yield, they deepened their exposure to volatility and credit deterioration. 

Equity-linked losses began bleeding into financial statements, and provisioning behavior revealed a system bracing for impact. 

The liquidity strain was hiding in plain sight—concealed by statistical optics and benchmark histrionics.

Compounding this is the shadow of large corporate exposures—most notably San Miguel Corporation, whose Q2 profits were largely driven by asset transfers, shielding its Minskyan Ponzi-finance model of fragility 

For instance, if banks hold AFS equity stakes or debt instruments linked to SMC, any deterioration in valuation or repayment capacity would surface as mark-to-market losses or provisioning spikes. 

Alas, like Wile E. Coyote, banks now require another velocity game—pumping financial assets higher to sustain investment optics. 

Without it, they risk compounding their liquidity dilemma into a full-blown solvency issue.

X. BSP’s Tacit Pivot: From Sovereign Risk to Banking Backstop 

The drain in the banking system’s cash reserves appears to be accelerating. 

Following June’s 11.35% jump (+Php 224.78 billion), July posted a 12.8% contraction (–Php 281.87 billion), fully offsetting gains of June, and partly last May (+Php 66.11 billion). Nonetheless, cash and due from banks at Php 1.923 trillion fell to its lowest level since at least 2014. 

And July’s slump signifies a continuum of long-term trend. However, from the slomo erosion, the depletion appears to be intensifying. 

So, despite interim growth bounce of deposits and financial assets, net (excluding equities), the cash-due banks to deposit and liquid-assets-to-deposit ratios resume their respective waterfalls.  In July, cash to deposit ratio slipped to all-time lows, while liquid assets-to-deposit fell to pre-pandemic March 2020 lows! (Figure 6, middle chart) 

Ironically, July’s massive cash drain coincided with the implementation of CMEPA. 

Importantly, banks drew a massive Php 189 billion from the central bank’s coffers as shown by the BSP’s claims on other depository corporations (ODC). (Figure 6, lowest diagram) 

This wasn’t a routine liquidity operation—it was a balance sheet pivot, redirecting support away from direct government exposure and toward the banking sector itself. The implication is clear: the system is leaning harder on central bank liquidity to offset deepening reserve depletion.

Figure 7

By shrinking its net claims on the central government (NCoCG) while expanding its claims on ODCs, the central bank has effectively told the Treasury to park its funds at BSP, while opening its own balance sheet wider to banks. This reduces BSP’s exposure to sovereign credit, but leaves banks more dependent on central bank lifelines to cover liquidity shortfalls. (Figure 7, topmost visual)  

In practice, this means banks are now forced into a double bind. On one hand, they must absorb more government securities and expand credit to keep up the optics of balance-sheet strength. 

On the other, they rely more heavily on BSP’s injections to plug holes in cash reserves. This rebalancing masks systemic strain—liquidity looks managed on paper, but the underlying dependence on continuous velocity (credit growth, AFS positioning, and central bank drawdowns) signals fragility. 

Far more crucial, what emerges is a structural shift: the BSP’s balance sheet is less about backstopping fiscal deficits and more about propping up the banking system. Yet this is not a permanent fix—if banks stumble in their velocity game or government borrowing intensifies, the pressure could quickly return in the form of crowding-out, valuation losses, and even solvency fears. In short, the pivot may buy time, but it also deepens the Wile E. Coyote dilemma: run faster, or fall.

With the BSP pivoting towards a backstop, bank borrowing growth decelerated to 8.9% YoY or fell by 14% MoM in July to Php Php 1.58 trillion—about 17% down from the record Php 1.907 trillion last March 2025. (Figure 7, middle image) 

This deceleration underscores the limits of the velocity game: even with central bank support, banks are struggling to sustain credit expansion without exposing themselves to deeper asset and funding risks. 

XI. Conclusion: The Velocity Charade Meets Its Limits 

The deepening Wile E. Coyote dynamic—where velocity props up optics of loans and investments—is unsustainable. (Figure 7, lowest cartoon) 

Surging NPLs and rising latent loan losses belie the façade of credit expansion. 

Accelerated exposure to AFS assets injects mark-to-market volatility, while HTMs tie banks to the unsparing race of public debt. 

There is no free lunch. Policy-induced fragility is no longer theoretical—it is compounding and irreducible to benchmark-ism or statistical optics. 

The illusion of managed liquidity is cracking. Each policy lifeline buys time—but only deepens the fall if velocity fails. 

Yet banks and the political economy have locked themselves in a fatal trap:

• Deposit rebuilding is punished by state policy,
• Recapitalization is constrained by fiscal exhaustion,
• Capital markets are dominated by overleveraged elites,
•  Hedge finance is crowded out by Ponzi rollovers,
• Tax and savings reform is politically dead under “free lunch” populism 

In short: a trap within an inescapable trap. 

___

References: 

Hyman P. Minsky, The Financial Instability Hypothesis, The Jerome Levy Economics Institute of Bard College, May 1992 

Prudent Investor Newsletter Substack Archives: 

-Goldilocks Meets the Three Bad Bears: BSP’s Sixth Rate Cut and the Late-Cycle Reckoning August 31, 2025 (substack) 

-Philippine Banks: June’s Financial Losses and Liquidity Strains Expose Late-Cycle Fragility August 7, 2025 (substack) 

-Liquidity Under Pressure: Philippine Banks Struggle in Q1 2025 Amid a Looming Fiscal Storm May 18, 2025 (substack) 

-BSP’s Fourth Rate Cut: Who Benefits, and at What Cost? April 13, 2025 (substack) 

CMEPA 

The CMEPA Delusion: How Fallacious Arguments Conceal the Risk of Systemic Blowback July 27, 2025 (substack)

The Seen, the Unseen, and the Taxed: CMEPA as Financial Repression by Design July 20,2025 (substack) 

  

Risks from Italy and Austria’s Elections

Today, residents of Italy and Austria will vote.

Since the Philippines is 7 hours ahead of Italy and Austria, by the time you read this, the Italian referendum and Austrian presidential election may be at its conclusion or may have already closed.

The outcome of the both will likely be crucial to the survival of the European Union, and consequently, its key monetary institution, the European Central Bank.

Austria’s presidential election represents a re-voting of the May “second runoff” election that has been annulled due to irregularities and fraud.

In May, the populist right wing anti-immigration Freedom Party (FPO) narrowly lost with 49.65 percent of the vote. And this was prior to UK’s June 2016 Brexit.

UK’s Brexit and the Trump phenomenon appears to have ushered a geopolitical movement towards the “far right” nationalism that is likely to threaten EU’s existence. 

It is widely speculated that the FPO’s victory could likely entail an exit by Austria from the EU.

Austria ranked ninth in terms of (2015) GDP in the EU.

The far bigger concern will be the Italian elections. Italy is the fourth largest EU economy.

Despite the political-institutional repercussions, today’s referendum has essentially been about a confidence vote on the incumbent Prime Minister Matteo Renzi government.

As Italian economist Alberto Mingardi described (Econolog; December 3. Bold original): “In actual fact, the constitutional reform we're going to vote on implies by no means a drastic change in our political governance. It changes the role and the composition of the Italian Senate, without sweeping it away; it re-centralizes powers from regional governments; it fine tunes the legislative process to fit the new context. It doesn't increase the powers of the prime minister, or give him the power to dissolve parliament. Mr Renzi claims the new reform will allow for faster and thus more productive law making, but it's hard to argue that Italy has a shortage of laws… This is because the referendum has by now little to do with the essence of the constitutional modifications approved by Parliament and now put to the voters: Italians will be voting for or against the Renzi government.”

And post referendum environment will be pivotal, again Mr. Mingardi: (bold mine) “What I personally find more problematic is the sort of political equilibrium that would emerge after the referendum's result. MrRenzi has approved, during his tenure, a new electoral law with a majority bonus system. However, this electoral law applies only to the House of Deputies, on the assumption that the Senate was changed by the constitutional reform into an indirectly elected organ, representing local governments. If the "no" side wins the referendum, then Italy will have two very different electoral laws, an old one for the Senate and a new one for the House. Both the chambers are supposed to give the government a confidence vote. This is why, if the no wins, there would be no immediate elections before a new electoral law, applicable to both the chambers, is enacted. If the no side wins, moreover, this will be widely considered a triumph of the populist Five Stars Movement, a heterogeneous political force that brings together an emphasis on transparency and the fight against corruption with a strong anti-business and anti-capitalism attitude.

A tenuous aftermath, again Mr. Mingardi: “Even Renzi's enemies will freak out at the perspective of the Five Stars Movement winning the next election. This is why it is very likely that the new electoral law that "establishment" parties are more likely to agree on is a pure proportional representation system.  Is that a brilliant idea? As the likelihood of any party winning a clear majority of the votes is astonishingly small, this would make Italy a country run by a permanent grand coalition between the right and the left, with the sole purpose of keeping the Five Stars at bay. In such a context, however, everybody tries to avoid the negatives for their own constituency, instead of forgoing vetoes and negotiating reforms. This would decrease and not increase the likelihood of reforms being approved, with perhaps the unintended consequence of strengthening the Five Stars Movement even further.

In short, the populist Five Stars Movement is about to gain power.

It’s not just politics.

Italy’s banking system has been experiencing tremendous difficulties. But thanks to the ECB’s QE (Large Scale Asset Purchases), such actions have delayed it from a total crisis. As proof, despite NPLs at approaching 20% of GDP, estimated at 360 billion euros ($401 billion) or bad debts equal to 12% of total loans, Italy’s 10 year sovereign yield hit a record low of 1.04% last August! That’s the kind of lunacy—utter destruction of price discovery—that has been brought upon by central bank policies. This means that Italy’s credit risk has essentially evaporated!

During the window provided by the ECB, the Renzi government has been working steadfastly for a rescue on Italy’s banks, particularly, the world’s oldest bank and Italy’s third largest, Monte dei Paschi.

Now a loss by the Renzi government would undermine such rescue effort. From Reuters (November 28): “Fears that a Renzi defeat at the referendum could sink Monte dei Paschi's recapitalization plan and have a domino effect on other lenders - including another seven already in trouble”.

So once again, the ECB reportedly will come to its rescue by buying MORE Italian bonds, should the referendum’s outcome unleash mayhem (Reuters November 29).

In short, Italy’s politics have been deeply entwined with its banking and economic rut.  And a “NO” outcome would postulate that all these years of “kick the can down the road” would meet its natural real world limits. Said differently, while central banks have successfully manipulated financial markets to shield them from their natural economic consequences during the past years, real world events have begun to neutralize such market destruction process.

Actions have consequences. Destruction of money has its consequences too.

 

Elections are about people expressing their political choice through political means. But more important is the expression of people’s actions through money. 

Italy has been experiencing a tsunami of capital flight as shown by ECB’s Target2 or the real-time gross settlement for the clearing of cross-border transfers in the Eurozone.

As Harvard economist and co-author of “This Time is Different”, Ms. Carmen Reinhart wrote in the Project Syndicate (November 23) [bold mine, see chart above]: “If interest rate hikes, depreciation or devaluation of the currency, and controls on financial outflows are not viable options, what can a country’s central bank do when faced with accelerating capital flight? If it is not part of a currency union, it can resort to market intervention to support its currency, using and losing its foreign-exchange reserves in the process. Saudi Arabia’s massive reserve losses in the wake of falling oil prices reflect this policy response. Within theeurozone, such reserve losses are automatic under Target2, the real-time gross settlement system for the euro. If a country has run out of reserves, its central bank automatically borrows to maintain the intraeuro peg. For a country experiencing capital flight (as much of the eurozone periphery has at various points since 2008), this implies a progressively more negative Target2 balance. As of September (the most recent data available), Italy’s Target2 deficit is above 20% of GDP – its worst reading to date (see figure). By some of the standard definitions, these are crisis-level reserve losses(shaded in the figure).

The Italy’s Target2 outflows in October had been much smaller at € 1.6 billion compared to € 27 billion in September. But this may be calm before the storm.

The above only goes to show that regardless of the outcome of the elections, the Italians have already been voting—and that their money votes imply of a “crisis-level reserve loss”.

The capital flight of crisis proportions may have been about the banking crisis or about the Renzi confidence referendum or most likely both. 

While a “yes” result may defer the stampede out of Italy, it will unlikely solve political, economic and financial predicaments without allowing the markets to work. Imbalances will only continue to mount.

Yet the ECB has bought the Italian government significant time for its banking system and the government to reform to no avail. That because low rates only served as a moral hazard for government to reform. Why reform if central banks can keep the status quo?

Now the proverbial chicken has come home to roost. A “NO” vote will most likely accelerate such exodus, perhaps regardless of what the ECB does.

Yet despite the ECB’s announcement to support Italian bonds, the irony has been that the ECB has been in caught in a dire fix: Asymmetric policies by global central banks and an internal predicament—the growing lack of bond market liquidity via the dissipation of available bonds by the ECB to purchase.

From the Financial Times (November 30. Bold added): The calendar is not kind to the European Central Bank. A week on Thursday, its governing council will deliberate, just days after Italy’s vote on constitutional reform, and a week before the bank’s US counterpart holds a meeting which could move the world’s bond and currency markets. Temporal pressure of another kind is also building, as the ECB buys €80bn of bonds each month in a programme that runs until March. Extending it could create a new problem, as there may not be enough German Bund’s available next year to keep the ECB’s spending on the eurozone member country’s debt in line with a carefully agreed formula.

And if I’m not mistaken, the ECB has been signaling its implicit intent to “taper” by citing (bubble) risks from its current policies.

From Reuters/Japan Times (November 30): The residential property market risks overheating in eight European Union countries, including Britain, partly from unintended effects of ultra-low interest rates, the EU’s financial risk watchdog said on Monday. The eight countries face a medium-term risk either from overvaluation or excessive household debt levels, a systemic risk to the bloc’s financial stability that requires regulatory attention, the European Systemic Risk Board said in a report. The ESRB issued warnings to Austria, Belgium, Denmark, Finland, Luxembourg, the Netherlands, Sweden and Britain. It asked local authorities to devise appropriate measures and noted the vulnerabilities of banks in an environment of persistently low interest rates. “Household indebtedness and the overvaluation of residential real estate develop over the course of years,” ESRB chair and European Central Bank head Mario Draghi said while presenting the report to an EU parliamentary committee.

Has there been an epiphany for Mr. Draghi??? Has Mr. Draghi been signaling to taper???

If he is, then just what would happen to Italy’s banking system??? What would happen to EU’s property bubbles??? And what would happen to EU’s political and financial system that had become almost entirely dependent on the ECB’s low rates????

Yet it doesn’t even require Mr. Draghi to act, because increasing imbalances are presently being ventilated via politics and through the balance sheets of the government and financial institutions…to the point that the ECB has begun admitting to this.

And consequences from these would be confined to Europe?????

The more interesting part has been for stock markets to rationalize present geopolitical developments as fodder for panic bidding.

Initial anxieties were revealed in Brexit and in the US national elections (or even the Philippines presidential elections). However, the paradox has been that conclusions to these events had been justified for a blowoff phase or a meltup.

And because of complacency developed, unfolding events in Europe appear to have been being discounted.

Sometime very soon these misperceptions will face reality.

Yes, actions have consequences. And I’m reminded by this treasure.

From John Maynard Keynes (PBS)

Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security but [also] at confidence in the equity of the existing distribution of wealth.

Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become "profiteers," who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.