V External Sector
Author: Mr. Charalambos Christofides
Language:
English
Keywords:
OP; Bangko Sentral ng Pilipinas; government; bank; Philippines; monetary policy; market share; balance of payments; unit price; IMF staff calculation; Exports; Imports; Global
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Abstract

Although the external sector came under heavy pressure during the Asian crisis, it proved less vulnerable than in the most heavily affected countries. The policy response to crises in the mid-1980s and early 1990s, particularly in external debt management and banking policies, helped contain the buildup of imbalances and manage the crisis as it unfolded. Nevertheless, large capital inflows in the mid-1990s nearly overwhelmed the policy framework and led to overvaluation of the peso, a growing current account deficit, and rapidly rising short-term debt. The de facto pegging of the peso to the U.S. dollar in late 1995 exacerbated the vulnerability to short-term capital flow reversals. When the tide turned in 1997, the authorities tried for a few months to defend the peso, but then adapted quickly by floating the peso, tightening financial policies, and accelerating structural reforms. These policies succeeded in stabilizing the external position without the severe disruption experienced in the other crisis countries.

Although the external sector came under heavy pressure during the Asian crisis, it proved less vulnerable than in the most heavily affected countries. The policy response to crises in the mid-1980s and early 1990s, particularly in external debt management and banking policies, helped contain the buildup of imbalances and manage the crisis as it unfolded. Nevertheless, large capital inflows in the mid-1990s nearly overwhelmed the policy framework and led to overvaluation of the peso, a growing current account deficit, and rapidly rising short-term debt. The de facto pegging of the peso to the U.S. dollar in late 1995 exacerbated the vulnerability to short-term capital flow reversals. When the tide turned in 1997, the authorities tried for a few months to defend the peso, but then adapted quickly by floating the peso, tightening financial policies, and accelerating structural reforms. These policies succeeded in stabilizing the external position without the severe disruption experienced in the other crisis countries.

Recent trade developments indicate that a favorable structural change took place in the early 1990s, with exports strongly benefiting from prior investments and regulatory changes. Philippine export market shares increased faster than three of the “Asian-5” (Indonesia, Korea, Malaysia, Philippines, and Thailand), with the exception of Korea’s. The change reflects rapidly increasing exports of electronics and electronic components. Although such growth has come partly at the expense of more traditional exports, it has shown the Philippines’ capacity to partake fully in one of the most dynamic and competitive export markets in the world.

Developments in the Balance of Payments and External Debt

Background

The Philippine economy experienced major external imbalances over the past two decades. Starting in the early 1980s, the economy slid into a full-blown balance of payments crisis, resulting in default on external debt followed by a severe recession.1 The crisis was the result of earlier policies favoring an expansion of the public sector, import substitution, and easy credit to the private sector financed through external debt. Although efforts to support exports had started as early as 1970 with the Export Incentives Act,2 effective protection remained substantial, especially in import substituting sectors. Large public and private investments initiated during this period were heavily dependent on imports and foreign financing, and eventually proved unable to generate the foreign exchange earnings to service the debt. The resulting vulnerability became unsustainable in the face of large external shocks 3 and growing political uncertainty.4

From the mid-1980s, reforms produced a gradual improvement in economic performance, but the economy remained vulnerable to a “boom-and-bust” cycle. The period 1986–89 saw a recovery of growth and investment and a return of foreign capital, supported by policy reforms, including a breakup of agricultural monopolies, import liberalization, and tighter debt management. However, import dependence remained high and domestic saving weak, and a strong recovery of growth combined with expansionary fiscal policy resulted in a return of unsustainable current account deficits (peaking at more than 6 percent of GDP in 1990). Thus, a few years of rapid growth were capped by near-exhaustion of reserves, a peso depreciation, and yet another debt rescheduling.

In the early 1990s, reforms accelerated and the economy became more resilient in the face of external shocks. Trade liberalization accelerated, with average nominal tariffs expected to fall below 10 percent by 2000 (from more than 40 percent in 1980, and 27 percent in 1990).5 In 1991, a new Foreign Investment Act was introduced, which simplified the approval process and allowed foreign ownership of up to 100 percent in many sectors. In 1992, a sweeping exchange liberalization removed current and most capital account restrictions. These reforms strengthened resource allocation in the economy, boosted exports, and were followed by full restoration of the Philippines’ access to global capital markets—setting the stage for the Philippines’ relatively robust performance during the Asian crisis (Tables 5.1-5.7).

Table 5.1.

Balance of Payments 1

(In millions of U.S. dollars)

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Sources; Philippine authorities: and IMF staff estimates represents net repurchase of Philippine-issued bonds in secondary markets abroad.

Represents net repurchase of Philippine-issued bonds in secondary markets abroad

Commercial banks’ National Food Authority will differ from the monetary survey due to differences in coverage.

Gross reserves Jess gold and securities pledged as collateral against short-term liabilities.

Broad measure of external liabilities. In addition to external debt, it includes liabilities of foreign banks operating in the Philippines to their head offices, branches, and agencies, and domestic government Securities held by nonresidents as well as some external debt not captured by regular debt statistics.

In percent of exports of goods and services.

Table 5.2.

External Indicators

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

Adjusted for gold- and security-backed borrowing.

Table 5.3.

Volume, Unit Prices, and Values of Principal Exports

(Unless otherwise indicated, volumes in thousands of metric tons; unit prices in US, dollars per ton; and values in millions of U.S. dollars)

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Source: Data provided by the Philippine, authorities.
Table 5.4.

Composition of Imports, 1993–98

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Source: Data provided by the Philippine authorities.

Imports on consignment (for export use).

Table 5.5.

Nonmerchandise Trade

(In millions of U.S. dollars)

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Source: Data provided by the Philippine authorities.
Table 5.6.

Direction of Trade

(In percent)

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Source: Data provided by the Philippine authorities.

Association of Southeast Asian Nations,

Baltics, Russia, and other countries of the former Soviet Union.

Table 5.7.

International Reserves of the Banking System

(In millions of U.S. dollars; end of period)

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Source: Data provided by the Philippine authorities.

Monetary clarms on, and liabilities to, nonresidents.

Despite severe early pressures from “contagion,” the external position has proved remarkably resilient in the face of the Asian crisis. As for other countries in the region, the crisis first manifested itself in falling equity prices and pressure on the exchange rate, with an acceleration of capital outflows, particularly in the aftermath of the Thai baht devaluation in July 1997. Contagion was evident in the lack of differentiation in the key foreign exchange bond spread indicators, which initially rose to prohibitive levels for all countries affected by the crisis, with little differentiation between borrowers.6 Compared with the most heavily affected crisis countries, however, capital outflows from the Philippines were less severe, and the hemorrhage of reserves was arrested earlier. Unlike in previous crises, external debt service was not interrupted, and the domestic banking and corporate sectors—while showing signs of stress—were able to withstand severe external shocks better than in the past.

Nevertheless, while the crisis was less severe in the Philippines than in some other countries in the region, it revealed underlying weaknesses that remain to be addressed. The trade deficit had widened to more than 10 percent of GNP by 1997, and the peso was significantly overvalued. While capital flows through the early 1990s consisted mainly of longer-term (including concessional) lending from both multilateral agencies and other bilateral sources.7 1995–96 witnessed a jump in short-term borrowing. Clearly, macroeconomic policies and prudential systems were not fully attuned to the challenges of the Philippines’ emerging integration in the globalized capital markets. Assessment of balance of payments developments was seriously hampered by statistical problems related to transactions through foreign currency deposit accounts. The remaining section explores these developments in greater detail.

Recent Developments

The Philippine current account has been marked by large cyclical swings in recent years. The current account deficit widened to more than 5 percent of GNP in 1997, followed by a surplus of 2 percent in 1998. The trade balance shifted even more sharply, from a deficit of more than 13 percent of GNP in 1997 to balance in 1998. This dramatic adjustment reflected the combined effects of weaker growth, peso depreciation, and continued expansion of the most important export market (the United States). Imports contracted sharply (by 19 percent in dollar terms) reflecting lower volumes (13 percent) as well as prices. Part of the improvement in the trade account was offset by weaker services, especially income transfers (which in the Philippines are particularly important given the large number of Philippine workers employed abroad).8

Unlike most other crisis countries, the Philippines has benefited from continued strong export growth. Exports volumes rose by 23 percent in 1997 and by 20 percent in 1998. This reflected the fact that Philippine exports go disproportionately to the United States (which continued to grow fast while Asian growth slumped), and have shown evidence of structural improvement, with strong gains in market shares arising mainly from investments in the electronic sector.9

Mirroring the current account, the capital account moved from large-scale inflows in 1995–96 to a sizable outflow in 1997. Like other Asian countries, the Philippines experienced a surge of inflows during 1993–96 (averaging about 6 percent of GNP). Net inflows fell to 1 percent in 1997 and were close to zero in 1998, the first full year following the Asian crisis. Capital inflows included foreign direct investment (which averaged about $1.2 billion during 1993–97 compared with $0.6 billion during the three preceding years), borrowing by commercial banks (with net liabilities up by almost $1 billion a year on average), and medium- and long-term loans (which rose from annual net outflows of $1.1 billion during 1990–92 to inflows of $2.3 billion during 1993–97). Trade-related capital and supplier credits stayed about the same during this period.

The growing capital inflows during 1994–96 raised concerns at the time, and policies (especially monetary and exchange rate policies) were searching for ways to contain their effects (see Section IV). The focus perhaps was too narrowly directed at limiting nominal peso appreciation and/or controlling the monetary impact of the inflows. In hindsight, a more strategic and consistent approach was warranted, especially to forestall the large rise in short-term foreign borrowing in 1995–96. By the same token, it is important to note that a significant part of the capital inflows received by the Philippines during that period were medium- to long-term investments responding to the increase in capital productivity resulting from reforms. In particular, there were large foreign investments in the fast-expanding electronics export sector (see below), which rapidly became the dominant export sector in the Philippines.

During 1997, capital withdrawals started in the equity markets, followed by turnarounds in commercial bank net foreign assets and capital flight. Trade financing and suppliers’ credits also declined, although largely in tandem with declining import volumes—there is no evidence of significant cuts in trade lines.10 Likewise, commercial banks’ large foreign currency deposit base proved stable throughout the crisis.11 There was also continued strength in medium- and long-term net inflows, and relatively strong foreign direct investment (which increased from 1997 to 1998).

Electronics Exports—Rapid Growth

Although growth of electronics exports took off only in 1994, the sector has long historic roots in the Philippines. This was evident in the continuous upgrading of the capabilities of the sector, which started in the 1970s with basic assembly and packaging of components, added assembly and testing technologies in the 1980s, and expanded to the production of complete computer peripherals, module assembly, and component manufacturing in the 1990s. Wafer fabrication and original design is considered as being within the sector’s capabilities within the next five years.

Despite the Asian crisis, 38 new electronics companies were registered during 1998 (according to Board of Investment/Philippines Economic Zone Authority data), at a total project cost of £15 billion, bringing the total number of companies to 462. Of these, 138 were Philippine (although such companies were relatively small), 133 Japanese, 46 Korean, 39 United States (accounting for about 70 percent of exports), and 20 Taiwanese.

The geographic distribution of electronics exports is well diversified, with 32 percent going to the United States, 22 percent to Europe, 15 percent to other ASEAN countries, 13 percent to Japan, 8 percent to Taiwan Province of China, and 10 percent to other destinations. In terms of employment, the sector contributes about 250,000 jobs in 1998, up from 38,000 in 1985. Employment in the semiconductor subsector has been growing more slowly than in other electronics subsectors, reflecting its relative capital intensity.

Elements contributing to the sector’s growth include:

  • A high emphasis by local producers on the quality of production, using the latest manufacturing techniques.

  • Wages are higher in the Philippines relative to China and Indonesia, but local labor is considered highly skilled, technically proficient, cost competitive, and well trained. The Philippines has significant numbers of technically trained (engineering and information technology) personnel: with a labor force of 31.2 million, of which 28.3 million are employed; the Philippines had 438,988 enrolled students in 1997–98, and graduated 74,750 students a year (in technical fields). In all, there are 1,345 colleges and universities.

  • The strategic location of the Philippines (together with human resources) is often cited as the dominant reason for foreign direct investment.

Electronics Exports

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Source: Semiconductor Industries Association.

Domestic value added in electronics exports has almost tripled since the 1980s, increasing to almost 30 percent (25 percent for computers) in 1998, from about 10 percent in the early 1990s. This finding, however, does not apply to all manufacturing processes (for example, packaging is still heavily dependent on imports, especially of wafers).

Faced with the sudden decline in net private capital inflows, the authorities increased public foreign borrowing, including from multilateral 12 and bilateral13 resources. This policy was part of a strategy to allow an orderly adjustment to the shock in private capital flows while containing the underlying vulnerabilities. The strategy to control vulnerabilities centered on a relatively tight monetary policy, a floating exchange rate (with occasional—and limited—intervention to prevent disorderly market conditions),14 measures to strengthen the banking sector, and better monitoring of short-term debt.15 The lessons learned from the earlier crises, especially the safeguards put in place to prevent renewed excessive debt accumulation, clearly contributed to the success of this strategy.

Nondeliverable Forwards; Their Use in the Philippines

A nondeliverable forward is a forward contract without an exchange of principal; instead, only the difference between the contract exchange rate and the spot rate at maturity is settled, in local currency. The nondeliverable forward typically covers the foreign exchange risk, (in case of a depreciation; the central bank makes a profit when the currency appreciates) of an underlying foreign loan, the maturity of which tends to match that of the nondeliverable forward. The contract exchange rate is usually determined by the current exchange rate adjusted for the differential between the domestic T-bill rate and the London interbank offered rate.

There is little conceptual difference between foreign exchange market intervention through nondeliverable forwards and intervention through forwards. The main exception concerns the accounting treatment of nondeliverable forwards, which makes them less transparent (as they are not reflected in reserves when they are contracted):

  • In forward (currency swap) intervention, commercial banks would make a simultaneous spot sale of dollars to the central bank and a forward purchase of dollars from the central bank. The central bank would then sell the dollars in the foreign exchange market. The net effect of these transactions on reserves would be zero (unless reserves were explicitly defined to exclude forward liabilities), but forward liabilities would go up by the full amount of the swap.

  • In intervention through nondeliverable forwards, commercial banks are encouraged to borrow abroad, selling the dollar proceeds in the foreign exchange market. In exchange, they get a nondeliverable forward from the central bank, which assures them of having enough pesos to buy the dollars they will need at the end of the contract. When the loan is unwound, the commercial banks repays the foreign dollar loan.

The Bangko Sentral ng Pilipinas has used two main types of nondeliverable forwards:

(1) Special nondeliverable forwards, contracted primarily with local branches of foreign banks. Typically, these borrow foreign exchange from their parent banks, at maturities of up to one year. The banks would sell the loan proceeds in the interbank foreign exchange market (thereby supporting the peso). The nondeliverable forward in effect covers the downside foreign exchange risk for the bank, with an upside potential for the Bangko Sentral ng Pilipinas.

(2) The currency risk protection program, applied to corporations with unhedged foreign exchange liabilities contracted prior to some cutoff date. The corporation in effect gets a foreign exchange guarantee from a local bank that “off loads” the risk through a nondeliverable forward with the Bangko Sentral ng Pilipinas.

The stock of nondeliverable forwards rose to about $1 billion in 1998 (mainly special nondeliverable forwards), following pressures in the foreign exchange market.

While the external position remained vulnerable through the summer of 1998, it has since improved. These developments were in line with global market developments, but domestic elements were also at play. In particular, while there was some market uncertainty following the May 1998 elections about the policies of the future government, confidence improved once the government had set out its policies. Since September 1998, the peso has appreciated significantly and gross usable reserves have risen to more than 120 percent of short-term debt, up from less than 80 percent in early 1998.

Following the steady decline in the debt/GNP ratio through 1996, the ratio has increased again in recent years, to 76 percent, partly influenced also by the peso depreciation. Debt-reduction operations, prudent fiscal policies, and rapid growth had reduced debt relative to GNP from 65 percent in 1990 to 47 percent in 1996. In addition, a policy of lengthening debt maturities had reduced the debt-service burden (with the debt-service ratio falling from 35 percent in 1990 to about 13 percent in 1996). Mainly because of peso depreciation, the debt-service ratio, however, has remained low at 13 percent in 1998 (Tables 5.8-5.9).

Table 5.8.

Total External Debt

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

Monitored external liabilities are defined as external debt plus liabilities o. foreign banks in the Philippines to their headquarters, branches, and agencies: some external debt not registered with the central bank; and private capital lease arrangements.

Table 5.9.

External Debt Service

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

Excluding monetary liabilities and debt conversions.

Figures for 1995–97 include some debt-equity and bond-equity conversions, as well as some prepayments.

External Competitiveness

During 1993–97, the current account deficit grew to more than 5 percent of GDP, and the peso is estimated to have become overvalued by 10–20 percent. The peso appreciated faster in real effective terms than other Asian currencies, and the current account deficit widened significantly beyond the level consistent with medium-term equilibrium even after accounting for the impact of the economic cycle

In 1998, the current account turned into a surplus, as output growth fell far below potential and the peso “overshot” to become temporarily undervalued. The exchange rate, however, has appreciated significantly since late 1998, virtually eliminating by mid-1999 all of the estimated undervaluation.

External Competitiveness Indicators

Because of recent volatility and data limitations, the usual real exchange rate indicators provide little evidence regarding the adequacy of competitiveness at a certain exchange rate. Because there are no direct measures of an “internal” real exchange rate (prices of nontradables relative to those of tradables), the proxy of nonfood prices in the consumer price index relative to the price of food was used (Figure 5.1, top panel). This measure shows sizable real appreciation during the 1990s (some 25 percent from end-1989 to end-1997; 13 percent since end-1995), but is obviously distorted by the larger volatility of food prices.16

Figure 5.1.
Figure 5.1.

Real Exchange Rate Measure 1

Sources: Philippine authorities; IMF, Information Notices System (INS); and IMF staff calculations.1 An upward movement indicates an appreciation of the peso.2 Pnt/Pt is the ratio of the price of nontradables to the price of tradables.

Other measures of competitiveness, such as the real effective exchange rate index compiled by the IMF, show a much larger appreciation prior to the crisis, followed by sizable depreciation after the float of the peso in mid-1997. Figure 5.1 (bottom panel) shows real appreciation of more than 50 percent from the trough in 1990 to mid-1997, followed by a depreciation of about 30 percent. The problem, then, is to determine an appropriate base period during which the exchange rate was judged to have been in equilibrium. While 1993 has often been cited as a year with broad equilibrium both domestically and in the external accounts, such an assessment inevitably involves a large amount of judgment.

Comparison with the “Asian-4” countries (Figure 5.2) shows that the Philippine peso has been stronger in real effective terms throughout much of the 1990s. That this relative real appreciation was not reversed during the recent crisis is significant and may indicate that fundamental structural change has been at work. A more formal assessment, based on an analysis of the medium-term underlying current account position, is given in Appendix 5.1. Figure 5.3 suggests that the current account in the Philippines responds significantly to movements in the real effective exchange rate, a finding confirmed by the econometric estimates in Appendix 5.1.

Figure 5.2.
Figure 5.2.

Asian Exchange Rates 1

Sources: IMF, Information Notices System (INS); and IMF staff calculations.1 An upward movement indicates an appreciation.
Figure 5.3.
Figure 5.3.

Current Account sand Real 1

Sources: IMF, Information Notices System (INS); WEFA; and IMF staff calculations.1 An upward movement in the exchange rate denotes depreciation.

Exports as Indicators of Competitiveness

Since the early 1990s, the Philippines appears to have experienced a favorable structural improvement in its external trade. Analysis of trade flows can provide useful insights on competitiveness. In particular, structural changes in trade flows and sustained changes in market share can be indicators of shifts in the equilibrium exchange rate. As documented in Section II, econometric analysis confirms a structural break in trade performance around the early 1990s; the ratios of export to import volumes (Figures 5.4 and 5.5) support a similar conclusion.

Figure 5.4.
Figure 5.4.

Merchandise Trade Volume

Sources: Philippine authorities; International Monetary Fund, World Economic Outlook; and IMF staff calculations.
Figure 5.5.
Figure 5.5.

Goods and Services Trade Volume

Sources: Philippine authorities; International. Monetary Fund, World Economic Outlook; and IMF staff calculations

There has been a significant gain in export market share since 1994, following a decade of relative stagnancy. Figure 5.6 shows that the growth of Philippine export market share has outpaced that of all the other Asian-5 countries, except Korea. This is indicative of a favorable structural shift, in particular since it coincided with real appreciation.

Developments in Export Components

The main driving force behind the recent favorable export performance has been the electronics sector, which has experienced rapid growth since 1994, and has become by tar the dominant export sector (Figure 5.7 and Box 5.1). To a large degree, the Philippines’ continued export-led growth is now tied to the success of electronics exports. Food exports (except coconuts) have also kept growing. Other traditional exports, especially garments, have performed less well. The worst performance has been turned in by minerals exports.

Some observers have pointed to the risks inherent in overspecialization, and have noted evidence of competitiveness problems in the comparatively weak performance of traditional exports. The local value added in electronics exports is also still relatively low (10–30 percent), as they depend considerably on imported raw and processed materials (especially wafers). The World Bank points out that this situation can only be remedied through the upgrading of local technology and growth of domestic firms that can provide a wider array of ancillary services.17 Support of small and medium-sized enterprises, including better access to finance, should also help in this context. For garments, the key was judged to be better quality of production, distribution, and marketing. Notwithstanding these caveats, it is clear that the dynamism of electronics exports could not have come at a better time for the Philippines, sustaining growth and export earnings at a time of crisis.

External Data Issues

External sector data, especially on the trade and external debt side, are generally of high quality and are available in sufficient detail and frequency, but their compilation has become increasingly difficult in recent years. In particular, increased use of foreign currency deposit units and of offshore banking units has made it difficult to correctly allocate the transactions between current/financial account categories, given banking secrecy laws. As a result, the estimates of services are affected by large uncertainties, and possibly include a sizable amount of capital account transactions.

Significant improvements have been made in recent years. In particular, the Bangko Sentral ng Pilipinas has included in external debt reports of several items previously excluded (most notably of credit lines to banks extended from headquarter banks located abroad). A simplified and more informative foreign exchange reporting form has been introduced, and the Bangko Sentral ng Pilipinas is working on a number of improvements to the reporting system on derivatives. Much of this work is in progress. It is also apparent, however, that the strict bank secrecy provisions prevent substantial progress on improving the estimates of transactions through foreign currency deposit unit accounts.

Medium-Term Outlook and Issues

Over the medium term, the current account is expected to return to a deficit that is consistent with the medium-term investment norm (2–3 percent of GDP). The speed with which the norm is reached depends on the projected paths for output and the real effective exchange rate. The extent to which exports continue to gain market share is an additional uncertainty. Given the outlook for continued foreign direct investment and rising portfolio inflows, financing the current account deficit and projected debt amortization should not pose a problem. Reserves are expected to continue to increase, to the equivalent of four months of imports by the end of the projection period (2004). Although external debt would continue to increase in absolute terms, it would decline relative to GNP (to 67 percent, from 76 percent in 1998).

In support of such a scenario, a challenging policy agenda remains:

  • Macroeconomic policies will need to combine prudent demand management with exchange rate flexibility, to preserve competitiveness and prevent the buildup of excessive leverage and debt (especially short term). Continued upgrading of prudential and supervisory standards in the banking system will also be necessary for the successful management of the “capital inflows problem.”

  • Continued trade and investment liberalization will be crucial for the Philippines to fully partake in the benefits of globalization. Average import tariffs are set to come down to 5 percent by 2004, an objective that should be maintained. In addition, protection in agriculture should be reduced to enhance productivity growth in that sector, and to permit dynamic export growth in this area of apparent comparative advantage.

  • Support for exports by building up infrastructure, enhancing access to finance for small and medium-sized enterprises, and improvements in services (including in the area of public administration) will also be necessary to sustain gains in market share.

  • Debt management should continue to be modernized, to keep pace with rapidly evolving financing techniques and, in particular, to keep on top of all forms of short-term exposures.

  • Balance of payments statistics need to improve further to prevent reliable estimates of current account developments. This should include the use of source data on transactions through foreign currency deposit unit accounts (even if provided by banks in appropriate form, to accommodate the laws on bank secrecy), or the development of reliable alternatives (survey methods).

Appendix 5.1. External Competitiveness: A Macroeconomic Balance Approach Applied to the Philippines

Analysis of external competitiveness suggests that the peso was overvalued prior to the Asian crisis, then “overshot” in the other direction, and is now close to equilibrium. Analysis based on a macroeconomic balance methodology suggests that prior to the crisis, the peso was overvalued by 10–15 percent in real effective terms,18 Following the float, the peso depreciated by more than 30 percent, resulting in undervaluation to about 10–15 percent. Since late 1998, the peso has appreciated, bringing it close to its equilibrium level.19

Figure 5.6.
Figure 5.6.

Asian Export Competitiveness

Sources: International Monetary Fund, World Economic Outlook; and IMF staff calculations.

Over the medium term, it is expected that the current account (now in surplus of 2 percent of GNP) will return to a deficit of about 2–3 percent of GNP, Such a position would be consistent with a medium-term savings-investment norm estimated using the macroeconomic balance methodology.

The Macroeconomic Balance Approach

The macroeconomic approach is adapted to the Philippines through the use of econometric techniques to provide quantitative estimates of the extent of exchange rate over/undervaluation. The starling point for the econometric investigation is a version of the equation 5.1 (given in Chapter V of Isard and Faruqee (1998), reproduced below with a few minor adaptations):20

Figure 5.7.
Figure 5.7.

Selected Export Components

Sources: Philippine authorities; WEFA, Inc.; and IMF staff calculations.
CAt=a−b(c0Rt+c1Rt−1+c2Rt−2)+mRt−mdYGAPt,

where CA denotes the current account to nominal GDP ratio, R the logarithm of the real effective exchange rate (in levels), and YGAP the domestic output gap.21 Some of the parameters given here in summary form have structural interpretations. Notable are b, which is the weighted sum of the (goods and nonfactor) import and export relative price elasticities, representing the trade volume effects of the real exchange rate and related to the Marshall-Lerner condition, and m, which is the import-output ratio—representing the value effect from full pass-through in import prices. The ci coefficients provide a lag structure with which the exchange rate influences the current account, and are assumed to sum to one (so that the full impact of the exchange rate is assumed to feed through, although the precise lag structure is likely to depend on country-specific characteristics). It is assumed (although this assumption is not qualitatively essential) that two lags (corresponding to two years, for annual data) are sufficient to allow for the exchange rate effect to pass through. Given estimates of the relevant parameters, one can then construct an estimate of the underlying current account, or the current account that would prevail at a zero output gap (a “cyclical” adjustment) and once the impact of lagged exchange rates has fully worked itself through (equivalent to past exchange rates being set equal to the current exchange rate). Written out, the equation defining the underlying current account balance is:

CAut=a−bRct+mRct,

with definitions as above, and with u denoting the underlying current account and c the current exchange rate. Once estimates of the coefficients are obtained, one can construct an estimated underlying current account balance. Statistical measures of adequacy of the estimated regression equation can also be used to partly gauge the validity of the whole procedure.

However, as it stands, the equation determining the current account is difficult to estimate directly, because of the presence of the Rt term twice together with the restriction on the lag structure coefficients. To proceed, a certain transformation is applied to the model that exploits (imposes a priori) the restriction that the lag structure coefficients (the ci sum to one, resulting in the following equation22:

CAt=a−(b−m)Rt+b[(c0−1)ΔRt+(c0+c1−1)ΔRt−1]−mdYGAPt.

The transformation results in the isolation of the level of the exchange rate (the Rt), and the introduction of terms in the current and lagged change of the exchange rate (the ΔRt which, being logarithmic changes, approximate percent changes). [Note that the Rt–2 term is embodied in the lagged change.]

With these preliminaries, a regression equation can be fitted directly to the equation immediately above. Of course, there are several issues to contend with, including the quality of the data, the fact that a regression over a given, relatively short sample (here, taken to be 1982–98) may fail to capture well the long-run tendencies, and simultaneity (the current account balance will tend to influence the output gap as well as be influenced by it). Hence, the estimates to be presented below should always be interpreted cautiously, although an attempt will be made to deal with the issue of simultaneity through the use of an instrumental variables estimation technique. A first attempt to fit the above equation results in the following (f-statistics in parentheses):

C⁢At=−1.85−0.001⁢Rt−0.15⁢Δ⁢R⁢t⁢0−0.13⁢Δ⁢Rt−1−0.55⁢Y⁢G⁢A⁢Pt,                                                    (0.05)⁢                       (0.02)⁢                 (2.02)⁢                        (2.06)⁢                                            (1.23)⁢                                           σε=2.07,D⁢.⁢W⁢.=2.05,R2−B⁢A⁢R=0.58,        

where the estimation is conducted using an instrumental variables technique, and where a constant, Rt, ΔRt, ΔRt-1, and YGAPt-1 are used as instruments (note the lagged output gap term, intended to avoid the simultaneity problem between the current account and the contemporaneous output gap term).23 Clearly, the equation generally works well, with the exception that the coefficient on the exchange rate level is extremely small and statistically insignificant (it is also surprising that the constant is insignificantly different from zero; one would expect a developing country to have a fairly robust negative average estimate for the current account balance).

Theoretically, a zero estimate for the term (b - m) most likely corresponds to a rather small export price elasticity. To demonstrate, write the structural interpretation of (b - m) in obvious notation as (M/Y)(bm-1)+(X/Y)bx—where bx, bm represent individual export and import price elasticities. For the Philippines, M/Y is slightly more than ⅓, and X/Y is about ¼. Using the estimates for developing countries quoted in Isard and Faruqee, 0.69 for imports and 0.53 for exports (smaller than for industrial countries, but still satisfying the Marshall-Lerner condition), one would expect (b - m) to equal about 0.03. For (b-m) to equal Zero. and holding the import elasticity constant, the export elasticity would have to equal about 0.4. So, the Marshall-Lerner condition is still satisfied, although just barely, but the nominal trade balance is insensitive to the exchange rate level as volume effects are broadly offset by the value effect on import prices.

Imposing the (statistically valid) restriction that (b - m) is zero, we reestimate the equation using instrumental variables (and dropping Rt from the instruments list) for the current account as follows (t- statistics in parentheses):

CAt=−2.51−0.15ΔRt−0.13Rt−1−0.56*YGAPt,                                         (4.68)      (2.76)                  (2.32)                     (1.26)σε=1.97,DW.=2.05,R2−BAR=0.62.

The equation has superior statistical properties to that earlier estimated, and is used in what follows. A chart of the actual against the (within sample) predicted current account confirms the statistical tests, as it shows that the predicted current account tracks the actual current rather well, especially during the recent sharp turnaround in the current account.

The next step in the macroeconomic balance approach is to construct an estimate for the underlying current account. Following the exposition in Isard and Faruqee, the underlying current account can be written in terms of the actual current account and the estimated terms. However, the statistically derived restriction (b - m = 0) results in a considerably simplified expression, as follows:24

CAut=CAt+b[(c0+c1−1)ΔRt−1]+mdYGAPt

The underlying current account for the Philippines is constructed using the estimated coefficients.25

A “Warranted” Current Account and the Equilibrium Exchange Rate

The next step is to construct a benchmark, or a medium-term norm, against which the underlying current account estimated above can be compared. This “warranted” current account can be constructed using the Faruqee-Debelle methodology described in Isard and Faruqee (1998) for estimating a savings-investment norm. The procedure was operationalized taking into account the influence of demographic, fiscal, and output variables for the Philippines relative to the equivalent variables in a set of industrial economies. The norm is found to fluctuate, but to be significantly less volatile than either the actual or the underlying current accounts. For 1998, for example, the norm indicates a deficit slightly above 2 percent of GDP, while the actual current account position was a surplus of 1.8 percent and the underlying current account surplus about 1 percent.

To finally draw the implications of this analysis for the exchange rate, one needs to know the long-run sensitivity of the current account to the exchange rate. Conceptually, the exchange rate is deemed overvalued (undervalued) when the underlying current account is less than (more than) the savings-investment norm. However, the above analysis has not resulted in a reliable estimate of this sensitivity. Reasonable numbers used for other crisis-affected Asian economies range from 0.25 to 0.3. Using a number in this range for the Philippines, one can estimate the degree of exchange rate adjustment that would be required to equate the underlying and warranted current accounts. Based on this analysis, the exchange rate became undervalued by 10–15 percent during 1998.26

The norm is consistent with the indications from the real effective exchange rate measures that the peso was overvalued during the period prior to the Asian crisis. The norm also indicates that the actual current account was closest to the “warranted” level in 1991, and not in 1993, as is sometimes assumed. In 1998, the current account overshot its warranted level, as it moved into sizable surplus. Corresponding to the shifts in the relationship between the cyclically adjusted and the “warranted” current accounts, the real effective exchange rate in 1998 overshot the equilibrium level, becoming undervalued (as earlier indicated) by about 10–15 percent.

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1

In 1988, debt restructuring agreements were concluded in line with a 1987 Paris Club agreement. In all, almost $13 billion of debt was restructured—about 136 percent of 1988 exports of goods and services.

2

R.A. No. 5186 offered fiscal exemptions to exporters of both goods and services to stimulate exports of nontraditional manufa