Journal Issue

Philippines: Report for the June 2005 Post-Program Monitoring Discussions

International Monetary Fund
Published Date:
October 2005
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I. Introduction and Background

1. During the first year of the new administration’s term, economic reforms advanced at a significant pace. Following President Arroyo’s election victory in May 2004, important progress was made with long-awaited fiscal and structural reforms. In the power sector, average generation tariffs were raised by more than one half, substantially cutting the losses of the state-owned National Power Corporation (NPC). In the financial sector, the Special Purpose Vehicle (SPV) framework set up to facilitate the sale of nonperforming assets began to gain traction. In the fiscal area, several tax measures were taken, culminating in May 2005 with Congress passing the expanded VAT (EVAT) legislation. This bill provided for a substantial broadening of the VAT base from July, and for an increase in the VAT rate from 10 to 12 percent from next January. In conjunction with the NPC tariff increases, the EVAT set the stage for a substantial reduction in the fiscal deficit from 2006.

2. Subsequent events, however, have served to interrupt the reforms. Allegations of wrongdoing against the President and her family surfaced in June, leading to Congressional inquiries into illegal gambling and possible misconduct in the 2004 election. On July 1, in a setback for the reform program, the Supreme Court issued a temporary restraining order halting the implementation of the EVAT law in response to petitions filed by opposition politicians and certain business interests.1 On July 8, eight cabinet members, including the Finance Secretary and the Budget and Management Secretary, as well as the heads of the tax collection agencies, resigned, and called for the President to step down. At end-July, impeachment cases against the President were filed by the opposition in the House of Representatives.

3. The authorities have taken steps to calm markets. In the wake of the political turbulence, suspension of the EVAT law, and the mass resignation of Cabinet members, the stock market dropped, sovereign bond spreads rose, and the peso rapidly surrendered the gains achieved against the U.S. dollar earlier in the year. The government quickly reaffirmed its commitment to reform, and a new economic team was appointed. The team has made a case to the Supreme Court for a full implementation of the EVAT, and also proposed alternative fiscal measures that could substitute for the EVAT if it were declared unconstitutional and legislative steps to remedy this proved infeasible. The Bangko Sentral ng Pilipinas (BSP) temporarily intervened in the foreign exchange market to support the peso, and subsequently raised reserve requirements on banks to absorb liquidity. With the political scene somewhat calmer in recent weeks, the peso has stabilized, and spreads and interest rates have returned to their May levels.

4. Nonetheless, rapid resumption and deepening of reforms is key to maintaining market confidence. Although financial markets have regained some lost ground, recent events have created considerable uncertainty about the prospects for reforms. In July, the ratings agencies revised down the Philippines’ sovereign ratings outlook to reflect the heightened political uncertainty, and expressed doubts about the ability of the administration to preserve recent fiscal improvements. This concern is likely to have deepened as a result of a large tax shortfall reported for July. The Philippines will continue to remain vulnerable to shifts in market sentiment until the uncertainties about the fiscal policy direction are resolved. Reforms also need to be accelerated in other priority areas such as strengthening bank supervision and power sector privatization.

II. Recent Economic Developments

5. Growth has slowed this year. GDP grew by 4½ percent y/y in the first quarter of 2005, down from 5½ percent in the fourth quarter of 2004, reflecting the negative effects of El Niño on agriculture and a lackluster showing by manufacturing. Services growth, however, remained high, boosted by buoyancy in tourism and Business Process Outsourcing (BPO). On the demand side, exports softened, and while surging remittances continued to support incomes, higher oil prices exacted a toll on consumption. The unemployment rate, which has been on a rising trend, edged down in the first half of 2005 (on a seasonally adjusted basis), but this reflects declining participation rather than a pickup in job creation.

Contributions to GDP Growth

(In percent, y/y)

Unemployment and Underemployment Rates 1/

(In percent)

1/ Old definition. Data for 2005 1H are seasonally adjusted. Underemployment rate is defined as the number of persons working for less than 40 hours and wanting additional hours of work divided by total labor force.

6. Inflation remains high, though it has moderated slightly in recent months primarily due to base effects. Headline inflation fell to 7.1 percent in July (y/y) down from 7.6 percent in June, and 8.5 percent in each of the three previous months. With inflation running at well above the target range of 5–6 percent for 2005, the BSP raised policy rates by 25 basis points in April to avert a rise in inflation expectations. In addition, reserve requirements were lifted by 2 percentage points in July to prevent excess liquidity feeding into peso depreciation and creating inflationary pressure.

7. Foreign reserves have risen in 2005. The balance of payments recorded a surplus of $2 billion in the first half of the year; this primarily reflected a rise of more than one-fifth in overseas worker remittances (y/y), and a jump in net portfolio inflows to $1.9 billion, compared with $0.1 billion in the same period in 2004. Events since June have led to a marked slowing in portfolio inflows. Exports grew by only 3 percent through June (y/y) as a result of soft market conditions for Asian electronics, compounded by the lagged effects of relatively low investment in production capacity in recent years. Despite higher oil prices, imports remained virtually flat. Reserves (net of pledged assets) were $17.2 billion at end-July, well above the end-2004 level of $15.2 billion.

8. Fiscal performance has been broadly favorable. Aided by improved tax collections and the continued compression of capital spending, the National Government budget through June was on course to achieving the 2005 deficit target of 3½ percent of GDP (authorities’ definition, see Table 2). In conjunction with reduced losses by NPC, this would allow the nonfinancial public sector (NFPS) deficit to be reduced to 4 percent of GDP in 2005, compared to 5¼ percent of GDP in 2004. The increase in tax revenues this year has coincided with a high profile campaign to pursue tax evaders that began in April and quickly showed up in monthly collections. However, although the new finance officials have stated their commitment to continuing the fight against tax evasion, preliminary data indicates that the improvement in collections may have been interrupted in July. Nonetheless, the overall better fiscal performance in 2005, aided by strong portfolio inflows, have kept financial markets liquid; the 91-day treasury bill rate has declined by about 210 basis points in 2005 to date.

III. Outlook and Risks

9. Current uncertainties risk causing the economy to underperform. In addition to the current surge in oil prices, the primary risk to the outlook is that the prevailing state of uncertainty proves to be protracted and makes it difficult to regain the economic reform momentum enjoyed earlier this year. If reforms were to stall, staff project that investment would likely remain subdued, and GDP growth is unlikely to exceed 4¾-5 percent in 2005 and 2006 (see scenario considered in Table 5). In such a world, the exchange rate is likely to remain weak, and inflation is expected to exceed the BSP’s target range of 5–6 percent in 2005 and 4–5 percent in 2006. Meanwhile, the NFPS deficit would remain about 4 percent of GDP. With the public sector’s high level of debt (98 percent of GDP at end-2004) and large external commercial financing requirements ($3–4 billion each year), the country will remain highly vulnerable to shifts in investor sentiment as well as global interest rate developments. This year, the National Government is yet to raise $850 million out of $3.1 billion planned.

10. Such a “reforms stall” scenario has negative economic implications over the medium term as well. Growth is expected to be moderate at best, with unemployment remaining high. Debt sustainability analysis (see Annex 1) indicates that the public sector debt-to-GDP ratio will decline only very gradually under this scenario, with the projected ratio in 2010 at 88 percent. The declining trend can easily be reversed if a small (but permanent) shock hits underlying macro variables (Figure A1).

11. The outlook would be much brighter were strong reforms to resume. Implementing all the components of the EVAT package, or alternative measures with similar yield, would permit the NFPS deficit to be reduced to about 2¾ percent of GDP in 2006. This would be about half way towards the authorities’ goal of balancing the budget by 2010 (see “reforms proceed” scenario considered in Table 6). Such a significant step toward fiscal consolidation, combined with progress with reforms on other fronts, would create a climate conducive to higher investment and growth.2 This process would likely be reinforced by declining interest rates, which could potentially take significant additional pressure off the budget (Box 1). If the reform momentum continues in years ahead, the debt dynamics would be more favorable, with the public sector debt-to-GDP ratio projected to fall below 70 percent by 2010.

Box 1:The Philippines’ Risk Premium and its Budgetary Implications

The Philippines has been one of the strongest performers in the EMBI Global index this year. Philippines bonds have returned 8.2 percent in 2005 to date (compared with 5.2 percent for the overall index). This outperformance, notwithstanding the volatility of recent events, may reflect underlying optimism regarding the prospects for fiscal reform, and raises the question of how much the country might gain if reforms could be sustained, and the Philippines risk premium were permanently lowered. Some crude estimates of the implications for interest rates and the government budget are derived below. These do not address the broader impact on the economy of lower interest rates, which would also be positive.

The performance of Philippines bonds in 2005 has been quite uneven. Market reports suggest that in the first few months of the year, investors were optimistic about the passage of the EVAT legislation, and the Philippines significantly outperformed the EMBI Global index. From mid-March, however, Philippine spreads widened in line with the deterioration in external credit market conditions. In this environment, the actual passage of the EVAT law in May had little impact on spreads. More recently, a broad emerging market rally has taken hold, which the Philippines has missed out on due to the political turmoil that surfaced in June, followed by the suspension of the EVAT law in July. From end-May to date, the Philippines has therefore significantly underperformed the market.

The table below compares the performance of the Philippines relative to three benchmarks; (1) the EMBI Global index; (2) an index of equally weighted countries with BB and split BB-single B ratings, which compares countries of similar risk profiles; and (3) another index of peer countries weighted so as to roughly capture their relative liquidity and market capitalization within the EMBI Global. The last index attempts to simulate comparisons made by investors in a more realistic setting, where they choose relative value based on both fundamentals and liquidity.

Changes in spreads (bps)
PhilippinesEMBIGPeers (“Equal weight”)Peers (“Mkt weighted”)
Jan to Mid-March-50-22427
Mid-March to End-May281758
June to Date-25-100-48-44

These measures show that Philippines spreads could be 90–130 bps lower than at the beginning of the year, if the country had kept pace with the market or its peers since mid-March (the 50 bps tightening to mid-March, plus the net tightening since mid-March in the benchmark index of choice).1

The Philippines: Impact of Interest Rates on the NG Budget 1/
First year, PHLP blnFirst year, percent of GDPAfter five years, PHLP blnAfter five years, percent of GDP
New external borrowing-0.7-0.01-7.7-0.09
90-day T-bill-4.2-0.07-9.4-0.11
New bond borrowing-3.3-0.05-23.5-0.27
Source: Fund staff estimates.

These potential gains can be translated into budgetary terms. The annual gain from a 100 bps permanent reduction in average interest rates for the National Government budget would be 0.5 percent of GDP per annum over the medium term. The savings in the first year are small, but would grow over time as a result of dynamic factors, such as the gradual transmission of lower interest rates on new borrowing to average interest rates on government debt, and the reduction in required borrowing in the outer years as a result of interest savings in the earlier years

1 The spread tightening in the EMBIG since June may be overstated due to the re-weighting of Argentina, but this does not hold for the two “peer” indices, neither of which includes Argentina.

IV. Report on the Discussions

A. Fiscal Policy

12. With the EVAT law just passed, the fiscal discussions mainly covered medium-term issues, although recent events have brought the short-term policy priorities back into play.

The discussions, which were held prior to the suspension of the EVAT, focused on (i) the economic implications of the VAT reform; (ii) the medium-term fiscal strategy; (iii) the fiscal risks associated with public enterprises; and (iv) civil service and pension reforms. In the period since the mission, the new economic team has identified a list of revenue measures that could possibly substitute for the EVAT.

The Philippines: Annualized Revenue Yield from the VAT Bill 1/
MeasureYield (Billions of pesos)Yield (% of GDP, full year basis)
Widening the base30.40.5
Raising the rate from 10 to 12 percent30.00.5
Raising the CIT rate15.40.3
Reducing excises on petroleum products-13.6-0.2
Changing refund procedures15.80.3
Net impact78.01.4

13. The EVAT package has the potential to substantially reduce the fiscal deficit in 2006. Over the past few years, the fiscal deficit has been largely contained through expenditure control, and the EVAT bill, in conjunction with the NPC tariff rate hikes, represents the first significant attempt to raise public sector revenue.3 The EVAT law broadened the VAT base to include electricity, petroleum products, and selected professional services with effect from July 1, 2005, and grants the President authority to increase the rate from 10 to 12 percent after January 1, 2006. It also increases the corporate tax rate from 32 to 35 percent until 2009; introduces certain limits on investment and input VAT credits; and reduces excises on petroleum products. Even after allowing for some new spending, the EVAT package—estimated by staff to yield annual revenue of 1½ percent of GDP—should permit the NFPS deficit to be reduced to 2¾ percent of GDP in 2006. This would be close to the upfront fiscal consolidation that staff has been recommending.

14. While welcoming the VAT reform, the mission cautioned that some of the provisions might complicate tax administration and discourage investment. In particular, the staggering of the VAT investment credits over five years would likely increase the cost of capital. Furthermore, the limit on the VAT input credit risked increasing the effective taxation of businesses with a low value added margin and would lead to tax cascading. The authorities agreed with this assessment of the input cap and were considering how best to ameliorate its negative effects. In the event, limiting the VAT input credit was one of the provisions of the EVAT law that was challenged before the Supreme Court.4

15. With the EVAT law suspended, the authorities have been working on a contingency plan to replace the lost revenue. The authorities have indicated that should the Supreme Court declare aspects of the EVAT law to be unconstitutional, their first priority would be to amend the legislation to remedy the defects. Failing that, a number of alternative tax policy measures are being considered including (with the authorities’ estimated annual revenue gains in parentheses): (i) increasing import tariffs across the board by 1 percent (0.2 percent of GDP);5 (ii) rationalizing fiscal incentives (0.1 percent of GDP); and (iii) introducing Simplified Net Income Taxation (SNIT) of the self-employed (0.3 percent of GDP). However, staff consider the revenue impact of the latter two measures to be uncertain, which underscores the importance of persevering with the EVAT.

16. Even assuming that the fiscal program can be brought back on track by 2006, additional measures will be needed over the medium term. The authorities noted that the fiscal position would benefit over time from further improvements in tax compliance and expected lower interest expenditure. However, staff suggested that additional measures were also likely to be necessary, especially if the corporate income tax rate was to be reduced from 2009 (as under the EVAT law), and the share of EVAT revenue allocated to new spending was to be increased over time.6 However, the authorities responded that achieving the budget targets would take precedence over any new spending. Staff argued that there was significant additional revenue potential from the rationalization of fiscal incentives, if this applied to cooperatives. The authorities agreed, but noted that the taxation of cooperatives might be politically difficult. Other potential sources of additional revenue identified by staff included increasing alcohol, tobacco, and fuel excises and indexing them to inflation.7

17. Fiscal consolidation efforts are being extended to the public enterprises. While significant progress has been made in reducing NPC’s losses (see paragraph 20 below), an annual deficit of ½ percent of GDP has recently emerged at the National Food Authority (NFA). This is mainly due to the NFA’s provision of rice subsidies. Staff encouraged the authorities to improve targeting of this subsidy and recommended bringing the expenditure on to the budget to improve transparency and control. The authorities responded that they were closely monitoring the finances of the NFA and would limit its deficit in line with the overall fiscal targets. The authorities also noted, and staff welcomed, that they were planning to develop medium-term deficit targets for Government-Owned and Controlled Corporations (GOCCs).

18. Civil service reform has gained momentum. Implementing rules and regulations (IRRs) were issued in May and the authorities’ initial estimate is that 27,000 positions may be eliminated with total severance payments of about P 8 billion (0.15 percent of GDP), although those affected will also have the option of redeployment within the civil service. In response to earlier concerns that the severance payments were too generous, especially for civil servants close to retirement, the IRRs exclude years of service beyond age 59 from the calculation of the payments. The authorities are currently working on detailed estimates of the likely costs of civil service reform, with the help from the World Bank.

19. Pension reform is also key to strengthening the long-term fiscal position. The authorities are conducting an actuarial review of the Social Security System (SSS). The review is expected to show the continuing depletion of reserves and a need for pension benefits and contributions to be adjusted to ensure long-term solvency of the system. In the meantime, the SSS and the Government Service Insurance System (GSIS) are focusing on improving their collections and strengthening and diversifying their investment portfolios.

B. Power Sector Policy

20. The financial situation of NPC is much improved. In April 2005, the Energy Regulatory Commission (ERC) finalized approval of the P 0.98 per kWh increase in average generation tariffs that had been provisionally granted in September 2004. The ERC also allowed NPC to increase generation tariffs by another P 0.46 per kWh, primarily to recover past losses from larger-than-expected fuel and IPP power purchase costs. Taken together, these awards imply more than a 50 percent increase in NPC’s average generation tariffs, and about a 20 percent increase in retail tariffs in the Manila area. Meanwhile, NPC’s interest costs have been reduced through the government’s absorption of P 200 billion of NPC debt at the beginning of 2005. In total, these measures are expected to reduce NPC’s deficit from 1½ percent of GDP in 2004 to ½ percent of GDP in 2005 and 2006. To keep NPC losses to the new lower levels going forward, staff and the authorities agreed that generation tariffs should be adjusted in a timely manner to reflect changes in fuel and other costs.

NPC: Financial Operations

21. However, privatization has proceeded slowly. In early 2005, the bidding strategy for the concession of the transmission company (Transco) was changed again to open competitive bidding.8 Staff raised concern about whether frequent changes in the bidding strategy might discourage potential investors and damage the credibility of the privatization process. The authorities considered the latest strategy to be more transparent, although they noted that the concession bidding schedule had now been postponed until late this year. With regard to generation assets (Gencos), the authorities are likely to fall well short of their target of privatizing 70 percent of assets by end-2005; thus far, less than 15 percent has been sold. The authorities attributed the slow progress to delays in finalizing power sale contracts (Transitional Supply Contracts) between NPC and distribution utilities.

22. Other challenges lie ahead in the power sector. The ERC has approved time-of-use pricing for NPC, which once fully implemented, was expected to improve the efficiency of production. In addition, cross subsidies for residential consumers in Manila areas were scheduled to be eliminated by October 2005. The authorities also expressed their firm commitment to launching a wholesale electricity spot market in early 2006 and retail competition in mid-2006, although they recognized that a number of issues remained to be resolved to achieve the smooth introduction of a competitive market mechanism.

C. Monetary Policy

23. Inflation remains above target. Continued high inflation partly reflects additional supply shocks, including from rice prices that have been affected by El Niño and other factors. Nonetheless, staff pointed to signs, such as rising prices of clothes, rentals and services, that inflation had spread to other sectors. Indeed, excluding the effects of supply shocks on the CPI, staff judged inflation to be still considerably above target. However, in view of recent wage awards which were fairly moderate, the BSP was less convinced that inflation had become more generalized. In the BSP’s view, the increase in inflation continued to be well-explained by the first-round effects of the supply-shocks, which the inflation target should accommodate.

24. Staff expressed concern about persistent inflationary pressures, and favored an early tightening of monetary policy. Although further base effects were set to drop out in the second half of 2005, staff projected that the inflation rate would remain high because of current increases in transportation fares, as well as rising oil prices. Continued above-target inflation risked lifting long term inflation expectations. Moreover, while wage awards had not been excessive to date, rising fuel and transportation prices were likely to lead to higher wage demands in the period ahead, and all the more so if the VAT rate were to be increased. Narrowing interest rate differentials might also weaken the exchange rate and create additional inflationary pressure. The staff therefore argued that a tightening of monetary policy was appropriate, and that higher policy interest rates would help keep inflationary expectations in check.

Philippines: Headline and Underlying Inflation

(Dec. 2002 - July 2005, percent y/y)

Philippines: Percent of CPI Components with Inflation Rates Greater than Target Ceiling 1/

January 04 - July 05

1/ Data for 2004 use 1994-based CPI and target ceiling of 5 percent. Data for 2005 use 2000-based CPI and revised target ceiling of 6 percent.

25. At the time of the mission, the authorities could see no clear reason to tighten monetary policy. The BSP considered that it had been effective in communicating to the public that one-off supply shocks were the primary cause of higher inflation. This logic implied that inflation would eventually come down. The authorities also noted that aggregate demand remained weak and narrowing interest rate differentials had not led to portfolio shifts in favor of dollar assets. Nonetheless, the BSP recognized that continued high inflation might feed into an increase in inflation expectations and the rate increase in April was explicitly framed as an attempt to act on expectations. In the BSP’s view, there was no compelling evidence that the strategy had not worked and that further monetary tightening had become necessary.

26. Subsequent events led the BSP to raise reserve requirements in July. In response to the exchange rate pressures set off by the political turmoil in late June, and the potential impact on inflation, the authorities increased the regular and liquidity reserve requirements on banks from 9 to 10 percent, and from 10 to 11 percent, respectively, on July 7. The authorities view changes in reserve requirements as particularly effective in mopping up liquidity that would otherwise spill over into the foreign exchange market.

D. Financial Sector Policy

27. The staff welcomed recent developments in the banking sector. NPL ratios have declined as a result of transactions agreed under the SPV Act, and were expected to decline further in the second quarter reflecting a rush of last minute sales agreed before the expiry of the SPV framework in April. The authorities noted that sales of about P 50 billion had been completed and another P 54 billion were waiting for certificates of eligibility. Together, this would cut almost a fifth of the stock of nonperforming assets in the banking system. The staff observed, however, that banks would only be amortizing the implied losses on these transactions over time; the banks’ ability to do this without damaging their capital will depend critically on their future profits. The staff welcomed the progress made in rehabilitating intervened banks, including completion of the initial bidding for Philippine National Bank (PNB). Moreover, recent announcements of planned purchases of stakes in small banks by bigger banks will contribute to needed consolidation in the banking system.

28. The large outstanding volume of distressed assets implies a need to extend the SPV framework. Even if all the transactions in the pipeline were to materialize, about P 400 billion of nonperforming assets would remain in the banking system. To deal with the remaining stock of NPAs, the authorities were giving high priority to a draft bill that would extend the SPV framework for another two years. This bill had already been approved at the committee level in the House of Representatives. The authorities considered the prospective implementation of International Financial Reporting Standards (IFRS)—see below—in conjunction with the BSP’s decision to phase in higher risk-weighting on NPLs, to have encouraged deals under the SPV framework. They were therefore confident that recent momentum in the sale of NPA sales could be maintained should the SPV framework be extended.

29. The effective implementation of IFRS would lead to more realistic banking indicators. The authorities reaffirmed their intention to adopt IFRS and banks have up to end-December 2005 to comply with the new standards. Previous staff analysis has indicated that deficiencies in accounting and loan classification practices cause capital adequacy to be overstated in the Philippines, and particularly so for certain banks. The authorities explained that the more rigorous valuation requirements implied by IFRS rules governing loan loss reserves, deferred tax assets, and valuation of foreclosed real estate properties, would enhance transparency and promote greater discipline, consistent with the main thrust of Basle II. Nonetheless, the new standards could have a significant impact on banks’ reported earnings and capital and some institutions would need time to comply. In such instances, an understanding would need to be reached with the BSP on a recapitalization plan.

30. The proposed amendments to the BSP Charter remain fundamental to strengthening the banking system. Pressuring owners to inject fresh capital requires providing bank supervisors with adequate legal protection, and enhancing the prompt corrective action and bank resolution frameworks. In this regard, staff welcomed the priority being given to the passage of long-delayed amendments to the BSP Charter. The version of the amendments agreed in the Senate Banking Committee holds supervisors to a standard of diligence no higher than that required of all public servants, which is a significant improvement on the “extraordinary diligence” standard set under the current legislation. The amendments would also enhance the ability of the BSP to deal with problem banks by clarifying the conditions of receivership and asset disposal.9

31. The trust funds require close regulatory attention. The new BSP guidelines require that the liquid assets of the Common Trust Funds (CTFs) be transferred to newly established Unit Investment Trust Funds (UITFs) and placed in highly liquid and tradable instruments. These rules, if effectively implemented, will give rise to losses in cases where the trusts are valued at unrealistically high levels. The authorities noted that a preliminary review of some of the major players had shown that holdings in CTFs were well-provisioned. Nevertheless, the extent of provisioning for the banking sector as a whole is unclear at this point. In any case, the authorities agreed with staff that any losses should be borne by investors rather than banks where possible.

32. The pre-need industry also requires scrutiny. The pre-need industry, which is supervised by the Securities and Exchange Commission (SEC), consists of nonbank financial institutions that fund household expenditures such as education. Several pre-need companies have recently encountered financial difficulties. Although small in size, the industry is a source of risk for a number of banks that have close linkages with pre-need companies. The authorities agreed that developments in the pre-need sector should be closely monitored. In her State of the Nation Address at end-July, the President gave high priority to the passage of a Pre-need Code that would provide a specific legal framework for the industry.

E. Other Issues

33. The staff welcomed the progress achieved in AML/CFT. The Philippines was removed from the list of Non-Cooperative Countries and Territories in February 2005. The Financial Action Task Force (FATF) observes that the Philippines has since continued to implement anti-money laundering measures to remedy previously identified deficiencies.

34. Improvements have been made to the statistical data. Progress was made with consolidating the nonfinancial public sector debt data. The BSP made major revisions to BOP data in April 2005 to correct long-standing data recording deficiencies, and in line with the IMF Statistics TA mission. The revisions leave the overall BOP position essentially unchanged, but revise up measured imports to integrate an electronic system of recording and improved measurement methodology. These changes were followed by a set of broadly similar revisions to the NSO’s trade data in August, although a lack of coordination between these two sets of revisions does not permit reconciliation at this stage. The authorities have indicated that further changes to the BOP data may be forthcoming.

V. Staff Appraisal

35. President Arroyo’s election to a six-year term in May 2004 opened the way for a revival of the economy. Significant progress with much-needed economic reforms was made in the first year of the new administration. Prominent milestones achieved included the approval of power tariff hikes that will substantially stem NPC’s losses and the passage of the EVAT law. The fiscal consolidation effort was also aided by resolute control over expenditures, while a crack-down on tax evaders showed initial success in raising collections. GDP grew strongly, boosted by buoyant remittances and service sector activity, while foreign investors began to show a new-found interest in the Philippines.

36. Recent political developments, however, threaten the progress that has been made. Political uncertainties have emerged over the past few months that place the economic achievements at risk. The authorities have been quick to reassure markets about their commitment to reform, and some stability has returned to markets. However, the longer the current political issues remain unresolved, the more the markets will fear that economic reforms will be sidelined. The costs of downward revision by markets of the Philippines’ economic prospects could be substantial. Front-loaded implementation of reforms in key policy areas (fiscal, power, and banking sectors) is therefore critical.

37. The outlook is also subject to considerable uncertainties in the global economy. GDP growth of about 4¾ percent is expected in 2005-06, but soaring oil prices weigh on the outlook, particularly if they serve to soften demand for Philippine exports. Adverse developments in international capital markets are another potential risk; a correction in long-term global interest rates could have severe consequences.

38. The EVAT reform represents the best option to reduce the fiscal deficit. Some parts of the EVAT law, such as the limits on input and investment credits, may complicate tax administration and discourage investment. Nonetheless, providing the VAT rate is increased to 12 percent, the package implies a substantial and durable revenue yield, which should allow the NFPS deficit to be reduced to about 2¾ percent of GDP in 2006. This would represent front-loaded fiscal adjustment and do much to convince markets that the Philippine’s grave fiscal problems will be solved. By contrast, should EVAT implementation be further delayed, alternative revenue-raising measures would be necessary to prevent markets from reacting negatively.

39. Over the medium-term, additional measures will be needed to balance the budget. Even implementing the EVAT law as originally planned will leave the authorities short of their balanced-budget goal. Lower government borrowing will reduce interest payments over the medium term, and the yield from better tax compliance is potentially considerable, particularly if the courageous campaign launched against tax evaders earlier this year can be sustained. Nonetheless, these factors are unlikely to be sufficient to close the remaining gap. The authorities should therefore be planning measures additional to the EVAT for 2007 and beyond, such as a sweeping rationalization of tax incentives.

40. The public enterprises should be closely monitored. NPC’s losses have been substantially reduced by the recent tariff increases. To maintain this improvement going forward, NPC will need to file petitions for future tariff adjustments in a timely manner. Steps should also be taken to limit the losses that have emerged at the NFA. One priority will be to improve the targeting of the rice subsidy that the NFA provides. More generally, the authorities’ plans for developing medium-term deficit targets for GOCCs are essential to support fiscal consolidation.

41. Civil service and pension reform are critical for sustainable fiscal consolidation. The authorities are appropriately conducting an actuarial review of the SSS which is likely to show a need for parametric changes to pension benefits and contributions. Ensuring the solvency of the pension system will also be assisted by current efforts by SSS and GSIS to improve collections and strengthen their balance sheets. Civil service reform has gained momentum with the issuance of IRRs in May. The costs for the budget now look more manageable given that limits have been set on severance packages for civil servants close to retirement.

42. Challenges lie ahead in advancing power sector reform. The timetable announced for privatization has slipped. While the new open bidding strategy adopted for the Transco concession is more transparent, further delays in the bidding process risk discouraging buyers. To accelerate Gencos privatization, early finalization of Transition Supply Contracts (TSCs) between NPC and major distribution utilities is key. The TSCs should be carefully designed so as to ensure sufficient revenue predictability for potential investors. Considerable preparation needs to be made before the launch of a spot market and retail competition next year for the market-based mechanism to achieve intended efficiency gains.

43. Continued above-target inflation risks increasing inflation expectations. While base effects from last year’s supply shocks are beginning to drop out of the headline rate, inflation will remain high in the near term as a result of increases in transportation fares and the current surge in oil prices. If the VAT reform is implemented as planned, there will be an additional impact on prices of as much as 1¾ percent. Staff forecasts inflation to be 8.2 percent in 2005 and 7.5 percent in 2006, well above the inflation targets of 5–6 and 4–5 percent, respectively. As is well-recognized by the BSP, continued above-target inflation, even when caused by temporary factors, risks causing inflation expectations to be revised permanently upward.

44. Staff believe monetary policy should be tightened. Although a series of supply shocks underlie the rise in inflation, there is some evidence to suggest that price pressures have become more generalized, while increases in fuel and transportation prices may cause future wage demands to pick up. Interest rate differentials are also narrowing at a time when the Philippine political risk premium may have risen. This risks weakening the exchange rate and creating additional inflationary pressure. Staff therefore believes that the case for tightening monetary policy has gained strength, and higher policy rates are needed to forestall an increase in inflationary expectations and help preserve the credibility of the BSP’s inflation targets.

45. There have been encouraging developments in the banking sector. The planned implementation of IFRS by end-2005 and the phasing-in of higher risk weights on NPLs, appear to have encouraged banks to sell NPAs under the SPV framework. However, the resulting decline in NPA ratios exaggerates the improvement in bank balance sheets since the losses on the assets sales will be amortized over time. Other positive developments are the progress made with privatizing PNB and prospective acquisitions of banks that pave the way for necessary banking consolidation.

46. Further banking sector reform will require legislative changes. The major priority continues to be the passage of amendments to the BSP Charter necessary to strengthen legal protection for bank supervisors. Staff welcomes the proposal to hold supervisors to a standard of diligence no higher than that required of all public servants. While Congress has repeatedly blocked attempts to strengthen the BSP’s powers in the past, the amendments are a precondition for a durable strengthening of the banking system. Staff also support the bill proposing a two-year extension to the SPV framework.

47. Continued vigilance is required in other areas of the financial system. The new BSP guidelines that require trust funds to place their resources in highly liquid and tradable instruments will cause losses in cases where current assets are valued at above-market levels. The BSP rightly intends to ensure that any such losses are borne by investors rather than banks when possible. The authorities also need to address current weakness in the pre-need sector, which, although relatively small in terms of the size of balance sheets, has important inter-linkages with certain banks. Staff welcome the recent FATF judgment that the Philippines is continuing to implement anti-money laundering measures to remedy previously-identified deficiencies.

48. Improvements have been made to the statistical data. The authorities have made commendable progress in consolidating the non-financial public sector debt data. Current attempts to revise Balance of Payments data are also welcome, although there is a need to better coordinate the changes being made by different agencies.

Figure 1.Philippines: External Developments, 2001–2005

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.

1/ Adjusted for pledged assets.

2/ Includes private sector inter-company accounts, loans without BSP approval, and obligations under capital lease.

Figure 2.Philippines: Domestic Developments, 1999–2005

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.

Figure 3.Philippines: Fiscal Sector, 1997–2006

Source: Data provided by the Philippine authorities; and Fund staff estimates and projections.

1/ Fund staff definition. Excludes privatization receipts of the national government and includes operations of the Central Bank-Board of Liquidators.

Figure 4.Philippines: Banking Sector, 1998–2005

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.

1/ Nonperforming loans plus foreclosed assets over total loans plus foreclosed assets.

Table 1.Philippines: Selected Economic Indicators, 2002-06Nominal GDP (2004): P4,739 million ($84.6 billion)Population (2003, est.): 81.1millionGNP per capita (2003, est.): $1,051IMF quota: SDR 879.9 million
Staff Proj.
GDP and prices (percentage change)
Real GDP4.
CPI (2000 base; annual average)
CPI (2000 base; end year)
Investment and saving (percent of GDP)
Gross investment17.617.017.417.517.5
National saving23.318.820.119.519.4
Public finances (percent of GDP)
National government balance (authorities definition)-5.3-4.7-3.9-3.6-3.6
National government balance 1/-5.6-5.1-4.3-3.9-3.9
Nonfinancial public sector balance 2/-5.7-5.7-5.2-4.0-4.0
Revenue and grants 3/20.921.420.921.821.8
Expenditure 4/26.627.126.125.825.8
Nonfinancial public sector debt 5/93.8103.397.893.290.0
Monetary sector (percentage change, end of period)
Broad money (M3) 6/
Interest rate (91-day Treasury bill, end of period, in percent) 7/
Credit to the private sector1. 6/
External Sector
Export value (percent change)
Import value (percent change)
Current account (percent of GDP)
Capital and Financial account (US$ billions, excluding errors and omissions)1.2-2.2-2.1-1.9-1.2
Foreign direct investment (net)
Errors and omissions and trade credit (US$ billions)-4.9-0.80.4-0.2-0.2
Overall balance (US$ billions)0.7-1.70.6-0.10.6
Monitored external debt (percent of GDP) 8/77.880.872.966.763.3
Debt-service ratio (percent of exports)19.920.619.718.419.2
Reserves, adjusted (US$ billions) 9/14.314.715.215.015.6
Reserves / Short-term liabilities, adjusted 10/123.9122.9121.2109.8110.5
Exchange rate (period averages)
Pesos per U.S. dollar51.654.256.356.1 11/
Nominal effective exchange rate (Jan 2, 2003 =100)107.495.183.887.7 11/
Real effective exchange rate (Jan 2, 2003 =100)92.595.691.5
Sources: Philippine authorities; and Fund staff estimates and projections.
Table 2.Philippines: National Government Cash Accounts, 2001-06(In percent of GDP; unless otherwise noted)
Prel. EstProposed BudgetStaff Proj. 1/Staff Proj
Revenue and grants15.714.414.914.814.914.614.6
Tax revenue13.512.512.812.613.212.712.6
Bureau of Internal Revenue10.710.010.19.910.510.010.0
Bureau of Customs2.
Other offices0.
Nontax revenue2.
Of which: Central Bank-Board of Liquidators0.
Of which:Recovery of Marcos wealth0.
Expenditure and net lending20.320.
Current expenditures17.316.817.216.216.315.815.7
Personnel services6.
Maintenance and operations2.
Allotments to local government units2.
National government4.
Central Bank-Board of Liquidators0.
Capital and equity expenditure2.
Net lending 2/
On the authorities’ presentation 3/-4.0-5.3-4.7-3.9-3.6-3.6-3.6
Net external financing0.
Net domestic financing4.
Memorandum Items:
Nonfinancial public sector balance 4/-4.9-5.7-5.7-5.2-4.0-4.0
Consolidated public sector balance 4/-4.8-5.6-5.4-5.0-3.9-3.9
Primary national government balance0.9-
National government debt 5/62.866.673.271.769.368.2
(percent of NG revenues)400.6462.6490.0483.9472.9466.7
Nonfinancial public sector debt 6/87.493.8103.397.893.290.0
(percent of NFPS revenues)379.8448.1483.0469.2427.7413.4
National government gross financing requirements 7/21.423.
Of which:Domestic19.518.218.520.820.021.5
GDP (in billions of pesos)3,6313,9604,2114,7395,1225,3446,017
Sources: Philippine authorities; and Fund staff projections.
Table 3.Philippines: Balance of Payments, 2001-06(In billions of U.S. dollars)
200120022003 1/2004 1/20052006
Staff proj.
Trade Balance-0.70.4-5.5-6.4-7.2-7.9
Exports, f.o.b.31.234.435.338.740.343.9
Imports, f.o.b.
o/w: oil and related products3.
Services (net)-2.1-1.0-1.7-1.3-1.0-0.6
Receipts, of which:
Remittances of resident workers abroad 2/
Interest payments2.
Transfers (net)
Receipts, of which:
Non-resident workers remittances 2/
Capital Account0.
Financial Account1.71.2-2.3-2.1-1.9-1.2
Direct Investment1.
Portfolio Investment1.11.1-1.3-
Other Investment (excluding trade credit)-0.5-1.6-1.1-0.7-3.0-2.7
ERRORS AND OMISSIONS (incl. trade credit)-3.2-4.9-0.80.4-0.2-0.2
OVERALL BALANCE-0.20.7-1.70.6-0.10.6
OVERALL FINANCING0.2-0.71.7-0.60.1-0.6
Monetization of gold and revaluation-
Change in Net international reserves (increase =-)1.3-1.6-1.2-1.1-0.1-0.8
BSP Gross Reserves (increase =-)0.6-0.5-
Fund credit (net)0.0-0.4-0.6-0.5-0.3-0.2
Change in other BSP liabilities0.7-0.70.1-
Memorandum items:
Current account/GDP1.
Short-term debt (original maturity)
Short-term debt (residual maturity)14.013.414.113.614.715.1
Gross reserves15.616.216.916.216.016.6
Adjusted gross reserves 3/13.214.314.715.215.015.6
(in percent of st. debt by res. maturity) 4/114.3123.9122.9121.2109.8110.5
Net international reserves11.412.813.915.115.215.7
Monitored external debt (in billions) 5/58.159.762.861.664.165.3
(in percent of GDP)81.677.880.872.966.763.3
Debt service ratio 4/19.119.920.619.718.419.2
Export value (percent change)-
Import value (percent change)-
Gross external financing needs 6, 7/10.89.612.011.811.612.7
GDP (in billions)71.276.777.784.696.0103.2
Sources: Philippine authorities and Fund staff projections.
Table 4.Philippines: Monetary Survey, 2000-05
(In billions of pesos)
Net foreign assets343405551673682615693727839941
Central bank430449547637631635661690724816
Net international reserves567586693782774791801820842937
Medium and long-term foreign liabilities138136146145143156140130119121
Deposit money banks-87-4443751-203237116126
Net domestic assets1,7371,7601,7991,8011,8261,9051,8341,9851,9211,852
Net domestic credit2,0882,1062,2072,3142,3412,3822,3602,5332,4422,407
Public sector credit581645727807845874836956916855
National Government426532590620649673636764725643
Foreign exchange receivables131277777151415
Treasury IMF Accounts-41-50-50-58-58-65-65-65-65-66
Local government and others10497132184195199199191190212
Claims on CB-BOL 1/511564221100
Private sector credit1,5071,4621,4801,5071,4961,5081,5241,5771,5261,551
Other items net-351-347-407-513-515-476-526-548-520-554
Total liquidity2,0792,1652,3512,4742,5092,5212,5272,7112,7612,794
M3 (peso liquidity)1,4271,5251,6701,7251,7131,7401,7281,8841,9221,970
Foreign currency deposits, residents586586628676722707735766770759
Other liabilities66545373747464626965
(12-month percent change)
Net foreign assets4.218.336.
Net domestic assets8.
Net domestic credit8.
Public sector9.910.912.811.015.521.65.318.58.4-2.2
Idem, adjusted 2/4.410.711.59.914.119.74.917.09.6-2.4
Private sector8.1-
Idem, adjusted 2/2.4-
Memorandum items:
(In billions of pesos; unless otherwise stated)
Gross domestic credit from deposit money banks1,9992,0852,1512,3222,3862,4442,4762,5582,5442,544
Private sector1,4921,4511,4701,4981,4871,4991,5141,5661,5161,542
(12-month percent change)8.1-
Public sector5076346818248999459629921,0281,002
(In percent of total gross credit)25.430.431.635.537.738.738.838.940.439.4
(In billions of US dollars)
Net foreign assets6.97.910.211.911.910.712.112.715.316.7
Central bank8.68.710.111.311.011.111.512.113.214.5
Deposit money banks-1.7-
Foreign currency deposits residents11.711.411.812.212.812.613.013.614.013.5
Dollar-denominated credit to residents10.810.29.99.911.111.711.511.211.010.8
Public sector4.
Private sector6.
(In percent; unless otherwise stated)
Dollar denominated credit / dollar deposits92.089.484.081.086.393.088.582.578.480.0
Dollar denominated credit to public sector / dollar deposits34.138.840.353.952.456.953.849.446.345.2
Exchange rate (peso per dollar; end-period)50.051.453.155.656.456.256.356.354.855.9
Source: Philippine authorities, CEIC, and Fund staff estimates.
Table 5.Philippines: Medium-Term Outlook, 2002–10(“Reforms Stall” Scenario)
Staff Est.Staff Proj.
(Percentage change)
GDP and prices
Real GDP4.
GDP per capita (US$)9579471,0071,1181,1771,2251,2691,3121,353
CPI (2000 base; year average)
(In percent of GDP; unless otherwise indicated)
Employment (million)30.130.531.632.633.734.936.037.138.2
Employment (percentage change)
Unemployment rate (old definition, percent)11.411.411.812.
Investment and saving
Gross investment17.617.017.417.517.517.417.016.516.0
National saving23.318.820.119.519.419.419.018.217.7
Foreign saving-5.7-1.8-2.7-2.0-1.9-2.0-2.0-1.7-1.7
Public finances
Nonfinancial public sector balance 1/-5.7-5.7-5.2-4.0-4.0-4.0-4.1-4.1-4.2
Primary balance0.
Revenue and grants 2/20.921.420.921.821.821.821.721.621.5
Expenditure (primary) 3/20.820.619.419.419.519.419.419.319.3
Nonfinancial public sector gross financing27.329.528.926.427.325.927.025.626.5
Foreign currency5.
National government balance (authorities definition)-5.3-4.7-3.9-3.6-3.6-3.7-3.7-3.5-3.6
National government balance 4/-5.6-5.1-4.3-3.9-3.9-4.0-3.9-3.7-3.8
Nonfinancial public sector debt 5/93.8103.397.893.290.088.988.588.187.8
External sector
Export value (percent change)
Import value (percent change)
Trade balance0.5-7.0-7.5-7.5-7.7-7.3-7.0-6.8-6.6
Current account5.
FDI (net, US$ billions)
Reserves, adjusted (US$ billions) 6/14.314.715.215.015.615.915.915.915.9
Reserves / Short-term liabilities, adjusted 7/123.9122.9121.2109.8110.5110.7103.098.194.3
Gross external financing requirements (US$ billions) 8/9.612.011.811.612.712.913.114.315.0
Monitored external debt 9/77.880.872.966.763.361.160.159.658.9
Debt service ratio (in percent of exports of G&S)19.920.619.718.419.219.619.119.819.7
Sources: Philippine authorities; and Fund staff estimates and projections.
Table 6.Philippines: Medium-Term Outlook, 2002–10(“Reforms Proceed” Scenario)
Staff Est.Staff Proj.
(Percentage change)
GDP and prices
Real GDP4.
GDP per capita (US$)9579471,0071,1331,2501,3421,4281,5241,631
CPI (2000 base; year average)
(In percent of GDP; unless otherwise indicated)
Employment (million)30.130.531.632.633.835.036.437.839.4
Employment (percentage change)
Unemployment rate (old definition, percent)11.411.411.812.011.911.711.511.010.4
Investment and saving
Gross investment17.617.017.417.518.219.220.521.522.4
National saving23.318.820.119.520.421.222.222.823.4
Foreign saving-5.7-1.8-2.7-2.0-2.2-2.0-1.7-1.3-1.0
Public finances
Nonfinancial public sector balance 1/-5.7-5.7-5.2-4.0-2.8-1.8-1.2-0.8-0.4
Primary balance0.
Revenue and grants 2/20.921.420.921.923.323.924.324.524.5
Expenditure (primary) 3/20.820.619.419.520.
Nonfinancial public sector gross financing27.329.528.926.325.622.621.919.118.2
Foreign currency5.
National government balance (authorities definition)-5.3-4.7-3.9-3.6-2.4-1.6-1.0-0.50.0
National government balance 4/-5.6-5.1-4.3-3.9-2.7-1.9-1.2-0.7-0.2
Nonfinancial public sector debt 5/93.8103.397.891.385.080.776.872.467.7
External sector
Export value (percent change)
Import value (percent change)
Trade balance0.5-7.0-7.5-7.4-6.7-6.4-6.1-5.7-5.4
Current account5.
FDI (net, US$ billions)
Reserves, adjusted (US$ billions) 6/14.314.715.218.320.722.724.425.726.6
Reserves / Short-term liabilities, adjusted 7/123.9122.9121.2133.8146.1157.8158.4158.7157.8
Gross external financing requirements (US$ billions) 8/9.612.011.811.612.212.813.214.515.7
Monitored external debt 9/77.880.872.965.959.655.853.551.449.0
Debt service ratio (in percent of exports of G&S)19.920.619.718.518.919.318.618.818.2
Sources: Philippine authorities; and Fund staff estimates and projections.
Table 7.Philippines: Banking Sector Indicators, 1999–2005(End of year unless otherwise indicated)
Capital adequacy
Total capital accounts to total assets14.513.613.613.413.112.612.1
Net worth-to-risk assets ratio17.516.215.816.716.716.516.5
Capital adequacy ratio (solo basis)14.515.516.017.417.1
Capital adequacy ratio (consolidated basis)15.616.917.418.418.1
Asset quality
NPL ratio 1/14.616.619.016.68/16.114.413.1
NPA ratio 2/
Distressed asset ratio 3/24.427.731.731.08/30.928.627.1
NPL coverage ratio 4/45.243.745.350.28/51.558.061.6
NPA coverage ratio 5/29.828.629.630.18/30.933.234.6
Net NPL to total capital 6/28.334.537.728.98/27.421.017.3
Net NPA to total capital 7/56.369.678.973.38/72.465.459.3
Net interest income to average earning assets4.
Return on assets0.
Return on equity2.
Cost-to-income ratio 9/72.281.880.771.468.969.868.1
Liquid assets to total assets26.429.030.032.332.336.638.1
Source: Philippine authorities; and Fund staff calculations.
Table 8.Philippines: Indicators of Financial Obligations to the Fund, 2002-09
Fund repurchases and charges
In millions of U.S. dollars461.8653.0502.3347.9205.0198.235.00.0
In percent of exports of goods and services1.
In percent of total debt service due6.
In percent of quota40.553.038.625.915.
In percent of adjusted gross official reserves3.
Fund credit outstanding
In millions of U.S. dollars1686.01128.8720.6415.6223.931.40.00.0
In percent of quota140.991.655.330.916.
In percent of GNP2.
In percent of total external debt2.
Memorandum item:
US$/SDR Period average1.2951.4011.4801.5281.5301.5321.5321.532
Source: Fund staff projections.
ANNEX I: Philippines: Debt Sustainability Analysis

The sustainability of the Philippines’ public sector debt depends largely on the strength of future reforms (Table A1). Under a baseline scenario (reforms stall), nonfinancial public sector (NFPS) debt would remain high at around 88 percent of GDP in 2010. This is predicated on an assumed average real GDP growth of 4.6 percent over 2005–10 and a primary balance adjustment of about 1 percent of GDP in 2005, reflecting the recent increases in electricity rates and alcohol and tobacco excises. However, if the political situation were to deteriorate and cause reforms to be reversed, the primary balance would return to its 2004 level (reforms reverse scenario), and debt would climb (assuming that GDP growth averages 3.8 percent over 2005–10). Conversely, strong reforms (reforms proceed scenario) would put debt on a firmly downward path. This scenario assumes that a stronger primary balance adjustment of 2.4 percentage points of GDP over 2005-07 (conditioned on full implementation of the EVAT bill) would improve debt dynamics both directly and indirectly, assuming that improved confidence and higher private sector investment would raise average real GDP growth to 5.4 percent.

Future shocks could adversely affect debt dynamics. Under the baseline scenario, the Bounds Tests (Figure A1) indicate considerable sensitivity of the projected debt ratio to shocks, especially to the exchange rate and growth. In contrast, the debt dynamics would be more resilient if strong and front-loaded reforms were adopted.

Success in reducing external vulnerabilities is also likely to depend on the reform effort. Under the baseline scenario, external debt would decline gradually to about 59 percent of GDP by 2010 (Table A2), broadly consistent with what could be expected if key macroeconomic variables remained at their historical averages from 2005–10. However, gross external financing requirements would continue to increase in US$ terms or remain high relative to GDP. The external debt position would also remain highly sensitive to an exchange rate depreciation and a deterioration in the current account (Figure A2).

Table A1.Philippines: Public Sector Debt Sustainability Framework, 2000–10(Reforms Stall Scenario; in percent of GDP, unless otherwise indicated)
20002001200220032004200520062007200820092010Debt-stabilizing primary balance 10/
Baseline: Public sector debt 1/89.088.393.8103.397.893.290.088.988.588.187.81.1
o/w foreign-currency denominated43.057.561.870.064.557.652.451.350.850.148.6
Change in public sector debt4.6-
Identified debt-creating flows (4+7+12)7.0-
Primary deficit-0.7-1.3-0.1-0.8-1.5-2.4-2.3-2.4-2.3-2.3-2.2-2.3
Revenue and grants 2/
Primary (noninterest) expenditure22.321.720.820.619.419.419.519.419.419.319.3
Automatic debt dynamics 3/
Contribution from interest rate/growth differential 4/-4.0-0.6-1.50.9-4.8-4.7-4.2-1.7-0.8-0.6-0.5
Of which contribution from real interest rate0.
Of which contribution from real GDP growth-4.5-1.4-3.5-4.1-5.6-4.0-4.0-4.0-3.8-3.6-3.4
Contribution from exchange rate depreciation 5/
Other identified debt-creating flows1.2-0.6-0.10.6-
Privatization receipts (negative)-
Recognition of implicit or contingent liabilities0.
Other (specify, e.g. bank recapitalization)1.3-
Residual, including asset changes (2–3) 6/-
Public sector debt-to-revenue ratio 1/387.2383.6448.1483.0469.2427.7413.4408.6408.6407.5408.7
Gross financing need 7/28.727.227.329.528.926.427.325.927.025.626.5
in billions of U.S. dollars21.819.420.922.924.425.328.228.431.231.334.1
Scenario with key variables at their historical averages 8/93.291.890.188.386.384.1-0.9
“Reforms Proceed” Scenario91.385.080.776.872.467.7
Reform reversal96.297.598.8100.7102.8104.9
Key Macroeconomic and Fiscal Assumptions Underlying Baseline
Real GDP growth (in percent)
Average nominal interest rate on public debt (in percent) 9/
Average real interest rate (nominal rate minus change in GDP deflator, in percent)
Nominal appreciation (increase in US dollar value of local currency, in percent)-19.4-2.7-3.2-4.5-1.2
Inflation rate (GDP deflator, in percent)
Growth of real primary spending (deflated by GDP deflator, in percent)2.4-
Primary deficit-0.7-1.3-0.1-0.8-1.5-2.4-2.3-2.4-2.3-2.3-2.2

Figure A1.Philippines: Public Debt Sustainability: Bound Tests 1/

(In percent of GDP)

Source: Fund staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.

3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2006, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

Table A2.Philippines: External Debt Sustainability Framework, 2000–10(Reforms Stall Scenario; in percent of GDP, unless otherwise indicated)
20002001200220032004200520062007200820092010Debt-stabilizing non-interest
current account 6/
Baseline: External debt76.882.979.082.172.966.763.361.160.159.658.90.4
Change in external debt0.76.1-3.93.1-9.2-6.1-3.4-2.2-1.0-0.6-0.7
Identified external debt-creating flows (4+8+9)-8.51.2-14.7-3.8-11.0-5.7-5.8-5.4-5.0-4.5-4.3
Current account deficit, excluding interest payments-12.4-6.0-9.1-5.2-5.8-5.4-5.2-5.6-5.7-5.5-5.4
Deficit in balance of goods and services-
Net non-debt creating capital inflows (negative)-1.6-1.9-2.9-1.1-0.4-0.6-0.9-0.5-0.4-0.3-0.3
Automatic debt dynamics 1/5.49.2-2.62.4-
Contribution from nominal interest rate4.
Contribution from real GDP growth-3.4-1.4-3.3-2.8-5.7-3.0-3.0-2.9-2.7-2.5-2.4
Contribution from price and exchange rate changes 2/4.86.5-2.61.8-2.1
Residual, incl. change in gross foreign assets (2–3) 3/9.24.910.76.91.8-
External debt-to-exports ratio (in percent)139.1169.1159.4162.5143.9142.8132.6127.7126.2126.6127.4
Gross external financing need (in billions of US dollars) 4/5.810.89.612.011.811.612.712.913.114.315.0
in percent of GDP7.715.312.715.714.012.112.311.811.311.711.7
Scenario with key variables at their historical averages 5/66.764.061.359.457.455.1-1.8
Key Macroeconomic Assumptions Underlying Baseline
Real GDP growth (in percent)
GDP deflator in US dollars (change in percent)-5.9-7.83.3-
Nominal external interest rate (in percent)
Growth of exports (US dollar terms, in percent)5.8-
Growth of imports (US dollar terms, in percent)8.5-6.82.320.410.
Current account balance, excluding interest payments12.
Net non-debt creating capital inflows1.

Figure A2.Philippines: External Debt Sustainability: Bound Tests 1/

(In percent of GDP)

Source: Fund staff estimates.

1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.

2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.

3/ One-time real depreciation of 30 percent occurs in 2006.

ANNEX II: Philippines: Fund Relations

(As of July 31, 2005)

I. Membership Status: Joined: December 27, 1945; Article VIII

II. General Resources Account:SDR Million% Quota
Fund holdings of currency1,114.68126.68
Reserve position in Fund87.499.94
III. SDR Department:SDR Million% Allocation
Net cumulative allocation116.60100.00
IV. Outstanding Purchases and Loans:SDR Million% Quota
Stand-by arrangements292.5633.25
Extended arrangements29.703.37
V. Financial Arrangements:
ApprovalExpirationAmount ApprovedAmount Drawn
TypeDateDate(SDR Million)(SDR Million)
VI. Projected Obligations to Fund: SDR Million; based on existing use of resources and present holdings of SDRs:

VII. Exchange Arrangement:

The value of the Philippine peso is determined in the interbank foreign exchange market; the Bangko Sentral intervenes in the market in order to smooth undue short-term fluctuations in the exchange rate.

From November 1995 to June 1997 the peso was effectively fixed at around P 26.2–P 26.4 per U.S. dollar. On July 11, 1997, the peso depreciated to P 29.45 per U.S. dollar following an announcement by the central bank that the peso would be allowed to find its own level. Since then, it has gradually depreciated; during the last few months, it has fluctuated around P 55–56½ per U.S. dollar.

VIII. Article IV Consultation:

The Philippines is on the standard 12-month cycle. The 2004 Article IV Consultation was discussed by the Executive Board on March 7, 2005. At that time, Directors welcomed the efforts being made by the new administration to lay out a comprehensive package of reforms aimed at addressing the country’s long-standing problems in the fiscal, power, and banking sectors, and in reducing the high debt levels. They praised the authorities’ commitment to win the necessary political support for key reform measures, and were encouraged by a number of recent developments, including the passage of the bill raising alcohol and tobacco excises, and the provisional tariff increase awarded to NPC.

IX. FSAP and ROSC Participation:

MFD: The Philippines’ FSAP was conducted during the fourth quarter of 2001; FSAP missions visited Manila in October and November–December 2001. The final version of the report was discussed with the authorities in June 2002. The associated FSSA was discussed by the Executive Board together with the Article IV staff report in September 2002.

FAD: Discussions on fiscal transparency were held in Manila in September 2001. The ROSC report was discussed by the Executive Board in September 2002 together with the Article IV staff report, and published in October 2002. The update to the ROSC report was published in June 2004.

STA: ROSC Data Module mission was conducted in September 2003, and the report was published in August 2004.

X. Technical Assistance:

An MFD resident banking supervision advisor has been stationed in Manila since May 2003, to assist the BSP in the implementation of a new supervisory model. An MFD mission visited Manila in February 2005 to review the payment systems, central bank accounting, and government bond market development.

An STA peripatetic mission visited Manila in July-August 2003, January-February 2004, and February-March 2005 to provide technical assistance in balance of payments and international investment position statistics and in implementing the recommendations made by the ROSC Data Module mission.

An FAD mission to provide a briefing to the new tax commissioner took place in April–May 2001. An FAD mission reviewed VAT and excise administration in December 2001. An FAD staff member participated in the July 2004 PPM mission to evaluate and advise on tax measures.

A LEG legal expert visited Manila to discuss anti-money laundering initiatives in March 2002.

XI. Resident Representative:

A Resident Representative has been stationed in Manila since January 1984. Mr. Reza Baqir assumed the post of Resident Representative in July 2005.

XII. Fourth Amendment to the Articles of Agreement:

The authorities have formally communicated to the Fund their acceptance of the Fourth Amendment, which was ratified by the Upper House of Parliament (Senate) in August 2001.

The Supreme Court is expected to shortly issue a ruling on the EVAT law. A Supplement to this Staff Report explaining the implications of such a ruling for the fiscal program, as well as providing an update on other recent developments, will be issued in the week before the Board meeting.

The exchange rate and foreign reserves position would also be stronger under this scenario, although, on account of the VAT rate increase, inflation in 2006 would be slightly higher.

The other two tax bills passed by Congress have a smaller revenue impact. The increase in alcohol, cigarette and tobacco excises passed after a long delay in December 2004 is expected to yield 0.2 percent of GDP annually, and has generated little in 2005 to date due to advance stockpiling of inventories. The lateral attrition bill passed in January 2005 to incentivise revenue collectors is only likely to affect revenue gradually over time.

Other provisions of the law that came under challenge include granting the President authority to increase the VAT rate and allowing the pass through of the VAT on petroleum products and electricity to consumers.

The authorities are currently in the process of verifying that the proposed increase in import tariffs would be compatible with the Philippine commitments under the WTO and ASEAN agreements. The Philippine bound tariff average under the WTO agreement is 25.6 percent, while the actual average tariff is 7.4 percent.

At the time of the mission, the authorities were planning to use 30 percent of the revenue gain from the EVAT law in 2006 to finance priority spending, such as infrastructure investment. The share of the VAT revenue allocated to such spending would be increased gradually in subsequent years.

The revenue projections under the “reforms proceed” scenario (Table 6) assume additional revenues from such measures during 2006–2010.

The strategy had already been switched from bilateral negotiations to “limited source” competitive bidding in October 2004. The latter bidding strategy envisaged that only those investors having had bilateral negotiations with the authorities would be invited to bid.

The authorities are also working on legislation to set up a credit information system and personal equity retirement accounts, amongst other bills to strengthen the financial sector.

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