Philippines: Staff Report for the 2005 Article IV Consultation and Post-Program Monitoring Discussions
Author: International Monetary Fund
Publication Date:
06 Mar 2006
eISBN:
9781451831368
Language:
English
Keywords:
ISCR; CR; GDP; VAT reform package; deficit; reform; government; government balance; short-term debt; Philippine authorities; authorities definition; government rationalization program; Value-added tax; Public sector; Global; reform agenda
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The staff report for the 2005 Article IV Consultation on the Philippines highlights managing short-term vulnerabilities and higher investment and growth. Power generation tariffs have been raised to substantially cut the losses of the National Power Corporation (NPC). A risk to the near-term outlook for the Philippine economy is that political events, such as possible constitutional change, serve to sideline economic reforms. Executive Directors agreed that rebalancing the composition of public expenditure, with reduced current outlays providing space for capital and social spending, should form an integral part of the fiscal consolidation.

Abstract

The staff report for the 2005 Article IV Consultation on the Philippines highlights managing short-term vulnerabilities and higher investment and growth. Power generation tariffs have been raised to substantially cut the losses of the National Power Corporation (NPC). A risk to the near-term outlook for the Philippine economy is that political events, such as possible constitutional change, serve to sideline economic reforms. Executive Directors agreed that rebalancing the composition of public expenditure, with reduced current outlays providing space for capital and social spending, should form an integral part of the fiscal consolidation.

I. Introduction and Background

1. Since mid-2004, when the administration took office, economic reforms have moved ahead. Two reforms stand out as particularly significant. First, power generation tariffs were raised so as to substantially cut the National Power Corporation (NPC)’s losses. Second, the VAT reform law was passed, with the first phase coming into effect in November 2005. Aided by tight curbs on government spending, the nonfinancial public sector (NFPS) deficit has been reduced from 5½ percent of GDP in 2003 to an expected 3¼ percent of GDP in 2005. If the second phase of the VAT reform, an increase in the VAT rate, occurs as scheduled in February, the NFPS deficit should fall further to 2¼ percent of GDP in 2006. In other sectors, important steps have been taken to strengthen bank balance sheets, but power sector privatization has been delayed.

2. The challenge going forward will be to maintain the economic reform momentum. Economic reforms were temporarily blown off course in mid-2005 by political turbulence following allegations of wrongdoing against the President. During this period, key members of the economic team resigned and the VAT reform was suspended by the Supreme Court. The authorities quickly regrouped and succeeded in keeping fiscal consolidation on track. Impeachment charges were dismissed by Congress in September, and political uncertainties have since receded. However, political events such as possible constitutional change are likely to absorb the attention of legislators during 2006. With vulnerabilities still high and the investment climate still weak, the remaining reforms should be pursued vigorously and without delay.

II. Recent Economic Developments

3. Growth has slowed in 2005. GDP grew by 4.6 percent y/y in the first three quarters of 2005, down from 6 percent in 2004. Weak exports and a decline in investment served as a drag on activity. Private consumption has been supported by surging remittances and, to date, has shrugged off the effects of high petroleum prices. On the production side, services such as business process outsourcing (BPO), telecommunication, and tourism remain key growth drivers. Job growth was limited to 2¼ percent in 2005, insufficient to substantially reduce unemployment, which remained high at 10.3 percent in the fourth quarter.

uA01fig01

Contribution to y/y real GDP growth

(Demand side, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

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Electronics Export Growth

(Jan. 2003 - Oct. 2005, y/y, in %, underlying data in US$ bn)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Region: China, Indonesia, Korea, Malaysia, Taiwan POC, Thailand, and Singapore.

4. The balance of payments has been in surplus. Exports grew by only 2½ percent in the first 11 months of 2005 (y/y), weighed down by anemic electronics exports which are not benefiting from the regional recovery (Chart). Oil-related imports are estimated to have been $1.3 billion higher in 2005 than in 2004; however, this was offset by a decline in non-oil imports and a jump in remittances from overseas Filipino workers (OFWs). There have also been sizable equity inflows, while the government has successfully tapped sovereign bond markets, most recently with a $2.1 billion issue in early January. Foreign reserves (adjusted for pledged assets) were $18.0 billion at end-2005, $2.8 billion above the end-2004 level.

5. A sharp reduction in the fiscal deficit seems assured. The National Government budget deficit is expected to have easily achieved the 2005 target of 3.4 percent of GDP. Tax revenues through November were up 15 percent (y/y), which, if sustained, will imply an increase in the tax to GDP ratio in 2005 after seven years of decline. By contrast, expenditure, especially on the capital budget, declined in real terms. The deficit of the 14 monitored Government Owned and Controlled Corporations (GOCCs) fell sharply, led by NPC, which is estimated to have cut its losses to ½ percent of GDP in 2005, a third of the 2004 level. Meanwhile, larger surpluses are expected for the social security institutions (SSIs) reflecting lower net lending and increased contributions, including from overseas workers. Taken together, these projections would imply an NFPS deficit of 3.2 percent of GDP in 2005, compared to 5.0 percent of GDP in 2004.

uA01fig03

NG and NFPS Deficits and NG Tax Revenues

(In percent of GDP)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

1/ Staff projections under Reforms Proceed scenario (Table 5).

Breakdown of the NFPS Deficit, 2003-06

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Source: Fund staff calculations.

Staff projections under Reforms Proceed scenario (Table 5).

6. Markets have been volatile, but have reacted positively to the better fiscal news. The stock market has risen by 8 percent in peso terms, and the peso has strengthened by 4 percent against the U.S. dollar, since the November 1 implementation of the first stage of the VAT reform.

7. Inflation has risen, and monetary policy has been tightened. Due in large part to the oil price shock, inflation rose to 8.5 percent in April 2005 y/y, but with base effects coming off, declined to 6.6 percent by December. Nonetheless, inflation averaged 7.6 percent in 2005, well above the target range of 5-6 percent. Monetary aggregates have grown at annual rates of 14 percent, driven primarily by the accumulation of net foreign assets. The authorities raised policy rates in April, September, and October (25 bps each to 7.50 percent), and also increased reserve requirements in July.

III. Report on the Policy Discussions

8. Upon beginning its term in mid-2004, the administration faced critical economic problems. The unchecked fiscal deficit and build-up of external debt since the Asian Crisis had left the economy dependent on external borrowing and vulnerable to changes in market sentiment. In particular, NFPS debt stood at around 100 percent of GDP; the interest burden was 30 percent of government revenue; and the gross public sector borrowing requirement was almost 25 percent of GDP. Meanwhile, the economy had underperformed, with per capita GDP growth averaging 1 percent per annum from 19982003, and almost half the population living on less than $2 a day.1 Much of the relatively modest growth performance can be attributed to weak investment (Chart). To spur economic growth and reduce poverty, the new administration embarked on a comprehensive reform program in 2004, the Medium-Term Philippine Development Plan (MTPDP).

Review of Past Fund Surveillance

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uA01fig04

Philippines: Investment

(Gross capital formation in percent of GDP)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Source: Fund staff calculations and projections.

The mission presented an opportunity to take stock of progress made in (a) reducing short-term vulnerabilities, and (b) laying the foundations for higher investment and growth:

A. Managing Short-Term Vulnerabilities

9. Soaring oil prices presented a major challenge for the VAT reform. With the petroleum sector deregulated since 1998, the jump in oil prices immediately translated into higher domestic prices. This complicated the VAT reform, since a central component was to extend VAT to energy products. However, the authorities resisted attempts by Congress to re-exempt power and petroleum products from the VAT for fear that the whole VAT reform package would unravel. Nonetheless, to mitigate the impact on the poor, the authorities introduced measures such as a reduction in oil import duties and lower petroleum excises. The authorities regarded these measures as critical to maintaining political support for the reform. The VAT base expansion was made easier by the softening of international oil prices in November and the appreciation of the peso.

10. Staff welcomed the progress made with reducing vulnerabilities. The relatively smooth introduction of the VAT reform to date owed much to the authorities’ communication efforts to explain the mitigating measures that were being taken. The authorities’ commitment to increasing the VAT rate from February 1, 2006 was also welcome (Box 1). Markets had already responded positively, and, if the VAT reform was fully implemented and delivered the envisaged revenue, sentiment could improve further. Staff noted that the more comfortable level of reserves would allow the government to tilt its borrowing mix more toward domestic financing. The authorities agreed, noting that the BSP was already reducing its foreign borrowing, and there might be scope for the government to do likewise in 2006.

11. Higher oil prices had also posed challenges for the monetary authorities. Inflation, already above target on account of supply shocks in 2004, stayed high during 2005 as a result of the further rise in oil prices. The authorities tightened monetary policy out of concern that continued above-target inflation would increase inflation expectations at a time when liquidity was growing rapidly and interest differentials had narrowed. With regard to liquidity growth, staff questioned whether one-off factors related to regulatory changes might be overstating M3 growth in 2005. However, the authorities considered such factors to be a relatively minor explanation of high liquidity growth compared to the increase in net foreign assets.

12. Steps have been taken to reduce vulnerabilities in the financial system. Some banks in the Philippines are weak and undercapitalized, while others have been intervened and are being rehabilitated. The authorities have strengthened prudential regulations, but continue to be hamstrung by the lack of legal protection for bank supervisors. Amendments to remedy this weakness were tabled in Congress in 2004, but have yet to achieve any traction. Nonetheless, solid progress has been made under the Special Purpose Vehicle (SPV) framework, with banks selling one fifth of their stock of NPAs. Consolidation of the banking system has also moved ahead, with a number of deals recently concluded, while one large intervened bank, the Philippine National Bank (PNB), has been privatized. A new soft spot has recently emerged in the pre-need sector, with several firms experiencing financial distress (Box 2). However, with only one such firm having a direct link with a bank, the authorities did not perceive this as a systemic risk.

13. The vulnerabilities that remain weigh on the outlook. Staff expected growth to be little changed at about 5 percent in 2006. There was upside to this projection if private investment was to respond strongly to continued progress with reforms and the better macroeconomic environment. On the other hand, growth might be lower if the negative effects of the VAT reform on consumption were larger than expected and oil price effects were still to come. The heavy reliance on external commercial borrowing also put the Philippines at risk should there be a reversal of the currently benign financing environment in emerging markets, perhaps reflecting higher risk aversion or a disorderly resolution of global imbalances. Avian flu posed another risk and although there had yet to be a case in the Philippines, the authorities indicated that they had developed a contingency plan.

14. Extension of Post-Program Monitoring (PPM) was discussed against this background. The Philippines is currently expected to engage in PPM through April 30, 2006. Even though outstanding Fund credit is down to 30 percent of quota, and the fiscal position has improved, the authorities see benefits from continuing PPM for a further year through April 30, 2007.

B. Laying the Foundations for Higher Investment and Growth

15. The medium-term outlook depends on the pace of reforms. Higher economic growth will require increases in investment and productivity. Foreign direct investment, currently at very low levels, can play an important role in achieving both objectives. Staff have prepared two scenarios for the medium term that differ depending on the pace of reform. In the first scenario (Table 5), which is the staff’s recommended scenario, reforms proceed beyond the VAT reform and include tax measures additional to those the authorities are currently contemplating, as well as bold measures to improve the investment climate. In such a world, investment increases by 5½ percentage points of GDP, raising growth to 6½ percent and pushing the unemployment rate down to single digits. The authorities achieve their objective of balancing the budget over the medium term and the debt dynamics become highly favorable. On the other hand, if reforms were to stall—the VAT reform is not fully implemented and the deficit is reduced no further than the 2005 level—the outlook for investment and growth would be less rosy. Table 6 shows a scenario where growth declines, unemployment increases over time, and debt sustainability is far from assured. So as to illustrate that vulnerabilities would remain very high if reforms were to stall, the Debt Sustainability Analysis is presented for this scenario (Annex I).

16. Improving the investment climate is critical. The authorities recognized that competition from China and the region explained some of the recent weakness in export growth, particularly in the electronics sector. This situation does not seem to primarily reflect an overvalued exchange rate, as this is rarely cited as a factor impeding investment in the Philippines (Chart). Rather, in explaining the relative unattractiveness of the Philippines as an investment destination, investors tend to emphasize: (i) macro-instability and the unsustainable fiscal position; (ii) poor infrastructure and power sector problems; (iii) financial market constraints; and (iv) corruption and governance.2 The discussions covered each of these impediments to investment:

uA01fig05

Firm Perceptions Of Severe Constraints

(Percentage of firms finding a major or severe constraint)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Source: World Bank,2005.

(i) ensuring fiscal sustainability and macro stability

17. The fiscal position will be strengthened further in 2006. Provided that the VAT rate is increased as planned, the NFPS deficit is projected to fall to 2.3 percent of GDP in 2006. While applauding this adjustment, which would amount to over 3 percentage points of GDP since 2003, staff noted that the outlook was subject to several risks. First, VAT collections may be lower than expected, particularly if there is a delay in raising the rate, or there are administrative difficulties in collecting the new tax. Second, the food subsidy provided by the National Food Authority (NFA) might increase substantially if prices of imported rice continue to rise and the prices at which NFA sells imported rice to consumers are not adjusted.3 Third, the financial position of local government units (LGUs) may weaken in the run up to the 2007 local elections. In response, the authorities agreed that NFA’s finances required close scrutiny, but considered local governments to be a low fiscal risk.

18. The authorities plan to eliminate the remaining fiscal deficit over time. While welcoming the authorities’ intention to balance the budget during the term of the administration, staff cautioned that this would require additional fiscal measures. Possible options included the rationalization of tax incentives and raising and indexing excise taxes. The authorities noted that a fiscal incentive bill was already before Congress, although they recognized that this would yield limited revenue in its present form. In any case, their strategy was to first strengthen tax administration before going to Congress with requests for more tax measures.

19. The authorities’ strategy to rely primarily on tax administration to close the remaining fiscal gap highlights the pressing need to increase collection efficiency. Improving tax compliance is particularly important in the Philippines because tax policy measures have often been strongly opposed as inequitable because they imply collecting more from those who are already paying tax. It is therefore critical for the Bureau of Internal Revenue (BIR) to broaden the tax net by strengthening taxpayer registration, addressing stop filer problems, and formulating better audit strategies. The Bureau of Customs (BOC) needs to make better use of information and communication technologies to improve efficiency and reduce discretion. But going beyond these technical changes, what is needed, both for BIR and BOC, is to institute better management and incentive systems, so that tax officers will be properly motivated to pursue sustainable and equitable tax collection, instead of short-term revenue gains.4

20. The discussions covered other medium-term fiscal issues. One challenge was to ensure that the GOCCs do not undermine the fiscal consolidation effort. To this end, staff argued for the development of medium-term deficit targets for individual enterprises. The authorities’ preferred strategy was to closely monitor the most important enterprises, including NPC and NFA, and then to extend the process to all 14 GOCCs.5 With regard to the pension funds, preliminary estimates from an actuarial review show that the Social Security System (SSS) may run out of assets in 2027, which is later than previously estimated. Nevertheless, to ensure long term solvency, the contribution rate will need to be gradually increased over time. Staff welcomed SSS’s plans to strengthen its investment strategy and improve collection efficiency including by intensifying audits and reducing fraudulent claims.

21. The inflation targeting framework is key to maintaining macroeconomic stability. Staff welcomed recent policy rate increases. The absence of strong signs that inflation had become more generalized suggested that monetary policy had so far been effective in limiting the inflation caused by supply shocks to first round effects.6 Assuming that there were no further shocks, and that the recent strengthening of the exchange rate is sustained, staff expect that inflation will return to the target range in 2007 (4-5 percent). Upside risks to this forecast include second-round effects from the VAT reform, further increases in international oil prices, or a delay in reforms that serves to weaken the exchange rate. By contrast, in the event of full implementation of the VAT reform, a more pronounced rally in the peso could bring inflation back within target more quickly.

uA01fig06

Headline Inflation.

(Jan. 2003 - Dec. 2005, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

uA01fig07

Core Inflation Measures

(Jan. 2003 - Dec. 2005, m/m in percent, annualized, seasonally adjusted)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

22. The authorities indicated that monetary policy would remain vigilant. Continued rapid liquidity growth and narrow interest differentials were viewed as risks to the inflation outlook, although the authorities noted that some offset was being provided by the existing slack in the economy. Staff observed that interest differentials would be a particular concern if reforms were to stall, since in such a scenario the risk premium was likely to rise. More generally, the authorities assured staff that they stood ready to raise rates again should the inflation forecast look less favorable.

(ii) improving infrastructure and power sector reform

23. Fiscal reforms should create space within the budget for increased infrastructure spending. Pressure on the budget has led to public investment falling sharply in recent years, and the poor quality of infrastructure is cited as a deterrent by investors. Infrastructure investment is likely to have high returns, particularly in tourism, as well as in mining (where a Supreme Court ruling in early 2005 allowing foreign control of projects has opened the way for foreign investment). The authorities are appropriately allocating a portion of the proceeds from the VAT reform to boosting capital expenditure as well as social spending and the Reforms Proceed scenario considered by staff envisages public investment rising from 2.3 percent of GDP in 2003 to 3.1 percent of GDP by 2007.

24. Progress with power sector reform had been mixed. Given the importance of sustaining the turn-around in NPC’s finances, staff welcomed the proposal for a new generation rate adjustment mechanism to recover fluctuations of fuel costs in a timely way. Privatization remained key to ensuring adequate investment in the power sector and thus to avoiding future supply shortages. However, the authorities have made little headway in selling power sector assets (Box 4). The deadline for rebidding the concession for the transmission company (Transco) has been postponed to the second quarter of 2006, and the deadline for the sale of 70 percent of generation assets (Gencos) has been pushed out by six months to June 2006. The recent decline in electricity demand (in response to the hikes in tariffs) has provided the authorities with some respite since it now appears that power supply shortages will not re-emerge until the early 2010s. Nonetheless, given that power projects have long gestation periods, staff argued that privatization should remain a top priority.

uA01fig08

NPC: Financial Operations

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

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Philippines: Power Supply and Demand

(Luzon areas; In MW)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Source: Philippine authority.1/ Includes committed investment.

25. The prospects for power sector reform are uncertain. The authorities plan to introduce the wholesale electricity spot market (WESM) in early 2006, followed by open access (retail competition), although under the Electric Power Industry Reform Act (EPIRA), this is contingent on 70 percent of Gencos being privatized. The authorities explained that slow progress with Gencos privatization partly reflected difficulties in concluding power supply contracts between NPC and distributors, as well as uncertainty about the prospects for market reforms such as WESM and open access. As a measure to accelerate privatization the authorities were considering selling Gencos contingent on the implementation of open access. Staff, however, argued that a successful Transco sale might break the current deadlock.

(iii) strengthening and deepening financial markets

26. The cost and availability of financing are additional constraints on investment. The banking system has a high cost-to-income ratio and low profitability, which hampers the needed provisioning for the large holdings of NPAs and keeps spreads fairly high. The significant level of NPAs also tends to inhibit bank lending. As a result, loans have only grown in nominal terms by about 3 percent on average annually over the last five years, implying limited private sector access to bank financing. The authorities have undertaken a number of initiatives to strengthen bank balance sheets, notably by reinforcing the supervisory framework and by granting regulatory and tax advantages through the Special Purpose Vehicle (SPV) framework to banks disposing of their NPAs. To stimulate nonbank financing, the authorities have drawn up a legislative agenda to develop domestic capital markets.

27. The SPV framework has reduced NPAs, but some banks remain weak. Sales of distressed assets to SPVs have amounted to P 97 billion to date, leading to a decline in the NPA ratio from 26.2 percent in June 2004 to 20.6 percent in June 2005. The authorities regarded the expiration of the SPV framework in April 2005 as a factor behind the surge in transactions in early 2005 and noted that the prospective implementation of International Financial Reporting Standards (IFRS) had also encouraged deals. Extending the SPV framework was therefore important.7 However, discounts on NPA sales have averaged 76 percent to date, and as provided for under the SPV framework, banks can stagger loss recognition over ten years for the purpose of complying with regulatory capital requirements. Staff stressed the importance of deferred losses being shown transparently in financial statements.

28. More substantial progress in fortifying the banking system will require strengthening the powers of supervisors. Staff expressed concern about the lack of speed with which amendments to the BSP charter to strengthen legal protection for supervisors and the PCA framework were moving in Congress. The authorities acknowledged that it might still take some time for the amendments to be passed. They were therefore trying to strengthen supervisory procedures and evidence gathering to maximize the chances of winning any lawsuits that were filed against bank supervisors.

29. Effective enforcement of the IFRS provides an opportunity for bank recapitalization. With effect from the period beginning January 2005, the annual financial statements of banks are required to comply with IFRS. The authorities noted that the rules governing loan loss reserves, deferred tax assets and more rigorous valuation of foreclosed real estate properties were likely to have significant implications for certain banks. At the time of the mission, banks were carrying out simulations to assess the likely impact on reported earnings and capital. The BSP was considering whether to provide regulatory relief to any banks that need time to comply. Staff stressed that any such relief should be conditional on a clear recapitalization plan and again should be transparent to markets.

30. Steps are being taken to develop the domestic capital market. A centralized electronic marketplace for domestic fixed income securities was opened in March 2005. The authorities have given high priority to passing the Corporate Recovery Act, which aims to rationalize the rules guiding the recovery of financially distressed enterprises and allows for the appointment of a conservator. A Credit Information System Act is under discussion in Congress and would create a credit information bureau to help foster transparency in the market. A Personal Equity and Retirement Account Bill, which would promote retirement savings, is also pending before Congress. But greater efforts are needed to develop nonbank channels of financial intermediation and thereby facilitate investment.

(iv) improving governance

31. The authorities have taken a number of anti-corruption steps. Transparency International (TI) has consistently ranked the Philippines in the worst one third of countries in terms of perceived corruption. Moreover, a deterioration in tax administration is regarded by many analysts as a major cause of the decline in the tax/GDP ratio over the last seven years, and hence of the current fiscal problems. The MTPDP recognizes that the Philippines’ ability to attract investment requires building an effective government free of corruption. Indeed, a system of lifestyle checks on government officials was introduced in 2003 to reduce opportunities for misconduct by revenue collecting agencies. In addition, the Government Procurement Reform Act was passed in 2003 with the aim of promoting competitive bidding and transparency and accountability in government procurement.

32. Progress, however, is difficult to measure. There may have been some gains in reducing procurement costs over the past year, but how large is unclear. There is also some evidence suggesting that bribe taking has become less prevalent in recent years, although this is yet to be confirmed by the TI indicators of perceived corruption. With regard to tax administration, staff encouraged the authorities to recreate the atmosphere of heightened enforcement that had existed in the second quarter of 2005, but which seemed to have dissipated during the political turbulence in mid year.

33. Civil service reform has been initiated. A Government Rationalization Program was launched in 2005 to improve the efficiency and effectiveness of government. Eight government agencies and one GOCC have submitted their rationalization plans for review by the Department of Budget and Management and other relevant agencies, and two of these plans were approved in September. Separated personnel will be given an option of reassignment to other agencies or availing of separation benefits. Over the medium term, if all identified employees choose to separate from the civil service, the government expects to realize annual savings of about 0.1 percent of GDP.

34. Progress has been made with AML/CFT. The Philippines continues to be monitored by the Financial Action Task Force (FATF) as part of its standard monitoring procedure for delisted Non-Cooperative Countries or Territories (NCCTs). Staff welcomed the progress made in two areas of concern for the FATF, namely streamlining the reporting of suspicious transactions and accelerating the processing of cases.

IV. Staff Appraisal

35. Recent events have lifted sentiment. The authorities deserve credit for steadying the economic ship after the political turbulence experienced in mid-2005. With the first phase of the VAT reform now implemented, and a clear commitment made to raising the VAT rate in February 2006, the reform momentum has been regained for now.

36. But the momentum needs to be sustained in the period ahead. Progress with reforms appears to have already been priced in to some extent by markets. There might thus be a significant correction if reforms were to be interrupted again. Other near-term risks to the economy arise from possible further spikes in oil prices or an outbreak of Avian flu. In light of continued high debt levels, the Philippines is also especially vulnerable to a sudden end to the current benign external financing environment. Completing the agenda for fiscal and other structural reforms should make a material difference to the economy’s ability to absorb such shocks.

37. A significant improvement in the investment climate is essential to set the stage for higher economic growth and substantial reductions in poverty. Staff do not view the level of the exchange rate as a threat to medium-term competitiveness. Rather, what is needed to improve the investment climate is a stable macroeconomic environment, increased infrastructure investment, a strengthened financial system, and improved governance. Immediate priorities are to raise the VAT rate in February, accelerate power sector privatization, and pass legislation strengthening bank supervision.

38. Sizable fiscal consolidation is underway. Tight control was maintained over expenditure in 2005 and the tax-GDP ratio looks set to rise after many years of decline. With the financial position of NPC and the SSIs also much improved, the NFPS deficit is estimated to have declined to 3¼ percent of GDP in 2005, an adjustment of 2½ percentage of points of GDP over the past two years. After raising the VAT rate in February, the authorities need to ensure that tax administration is strong enough to collect commensurately higher VAT revenue. Providing that this happens, the NFPS deficit is set to fall further to 2¼ percent of GDP in 2006.

39. Balancing the budget over the medium-term will require additional measures. Gains from improved tax administration and interest savings are unlikely to eliminate the NFPS deficit of 2-2½ percent of GDP that will remain after the VAT reform is implemented. While strengthening tax administration remains a pressing need, additional tax policy measures will also be necessary, such as a more ambitious rationalization of tax incentives than is currently being considered.

40. Other parts of the public sector should support fiscal consolidation. The authorities are planning to closely monitor important GOCCs: priorities will be to ensure that the turn around in NPC’s finances is sustained, and that poorly targeted food subsidies do not lead to large losses at NFA. The solvency of the pension funds will be enhanced by strengthened investment strategies and improved collections of contributions.

41. Inflation risks remain. In the absence of further shocks, inflation is projected to return to target by 2007, but this outcome is far from assured. Risks to the outlook include possible second-round effects from current shocks such as the VAT reform. However, the recent rate actions by the BSP inspire confidence that rates will be raised again should the inflation forecast look less favorable. On the other hand, if sentiment continues to improve, higher capital inflows may put upward pressure on the peso and inflation could return to target more rapidly. Given the improved foreign reserve cover, the authorities can offset incipient peso strength by using dollars bought from the market to substitute for external borrowing.

42. Power sector privatization should be accelerated. Re-bidding for the Transco concession has been postponed, while far fewer Gencos have been sold by this stage than was planned. If needed investment in the power sector is to be made, the challenge is to shift sufficient power sector assets into private hands. This will require reducing the uncertainties that are deterring potential deals. Successful bidding of Transco might break this deadlock.

43. There have been positive developments in the banking system. The SPV framework has induced banks to take steps to resolve a portion of the stock of bad assets and bank consolidation is underway. However, the banking sector remains fragmented with some banks undercapitalized, and the level of NPAs continues to be high. While an extension to the SPV framework is warranted, greater pressure needs to be exerted on weak banks to raise capital and encourage mergers.

44. Passage of the amendments to the BSP Charter remains critical. The proposed amendments would strengthen the PCA framework and legal protections for bank supervisors, thus fortifying the BSP’s ability to deal with distressed banks. However, these proposals have made little progress through Congress over the last few years. Greater efforts must be made to pass these amendments so as to permit a durable strengthening of the banking system.

45. Effective implementation of IFRS should promote bank recapitalization. The BSP should clarify the conditions under which regulatory relief might be granted to banks significantly affected by the introduction of IFRS. Such relief should be granted transparently and conditional on a clear recapitalization plan. Certain banks will also be carrying large deferred losses from NPA sales under the SPV framework. IFRS will make these losses transparent to investors, which underscores the urgency of banks raising fresh capital.

46. There is a need for further financial market development. The authorities should give priority to advancing the various legislative initiatives to develop domestic capital markets. The financial difficulties being experienced by pre-need firms are probably not a systemic concern, but illustrate the need to strengthen the supervisory and regulatory framework for the industry. On AML/CFT, while noting the FATF’s continued monitoring of the Philippines, staff welcomes the progress being made with streamlining the reporting of suspicious transactions and accelerating the processing of cases.

47. Data provision for surveillance purposes is adequate overall, although staff’s analysis continues to be affected by certain deficiencies in the data. Staff welcomes the authorities’ efforts to address these shortcomings, particularly those in the balance of payments data.

48. It is recommended that the next Article IV Consultation with the Philippines be held on the standard 12-month cycle. Continuation of PPM is recommended for an additional year in light of the still vulnerable fiscal position.

The Status of Fiscal Reforms

Over the past year, the Philippine authorities have made commendable progress in advancing fiscal reforms. Since September 2004, power generation tariffs have been raised by over 50 percent. In December 2004, excises on alcohol and tobacco products were increased by 30 percent on average, while duties on imports of oil products were raised from 3 to 5 percent.1 Congress also passed the Lateral Attrition Bill intended to provide financial incentives for tax collectors to meet revenue targets. The centerpiece of the authorities’ reform agenda is the VAT reform law. Implementation of the first stage (extending the VAT base to power and petroleum products) began on November 1, 2005 a few weeks after the Supreme Court declared the law to be constitutional.

When fully implemented, the VAT reform is expected to yield 1.4 percent of GDP in revenue annually. In addition to base broadening measures, the law gives the President authority to raise the VAT rate from 10 to 12 percent in 2006; the authorities are planning to implement this increase on February 1.2 The law also increases the corporate income tax (CIT) rate from 32 to 35 percent. To protect the poor from the impact of the base broadening measures, the law eliminates excises on kerosene, and reduces excises on diesel and gasoline. In addition, the law includes a limit on input VAT credit (at 70 percent of the VAT paid on output), and a provision for staggering VAT refunds on investment over a five-year period. The last two provisions have met with resistance from segments of the business community because they increase costs of conducting business, discourage investment, and complicate tax compliance.

The Philippines: Annualized Revenue Yield and the Status of the Proposed Measures 1/

article image

Fund staff estimates.

The remaining near-term fiscal reform agenda includes the passage of three pieces of legislation. The first piece, a bill tackling the proliferation of fiscal incentives, has the highest revenue potential. However, the version before Congress has only a limited revenue impact; while the bill reduces the scope of some incentives, it also appears to extend existing incentives to cover a broader range of activities. The second bill proposes simplified (net income) taxation of the self-employed (SNITs) and contains a number of useful provisions that could simplify tax compliance and limit abuse, although they are unlikely to result in a significant revenue gain. Finally, a fiscal responsibility bill introduces measures to reduce unfunded expenditures and imposes public debt limits.

1 This measure was subsequently reversed to mitigate the impact of the VAT reform on fuel prices.2 The VAT reform law provides for a VAT rate increase from January 2006 if VAT collections as a percentage of GDP exceed 2.8 percent, or if the fiscal deficit exceeds 1.5 percent of GDP. Both conditions already look likely to have been met in 2005. However, the authorities have chosen to wait until February to raise the rate so as to minimize the chances of legal challenges that the data are too preliminary to tell whether the conditions in fact hold.

The Pre-Need Industry

The pre-need industry in the Philippines offers a popular saving instrument. The sector consists of nonbank financial institutions that cater for households who want to pre-finance future expenditure such as their children’s education. First introduced in 1966, pre-need plans have become a particularly popular savings instrument. As of end-December 2004, the sector’s assets amounted to 3.3 percent of GDP (equivalent to 4 percent of banking sector assets), with 4 million plans outstanding.

The industry is facing financial difficulties. The sector as a whole is running an actuarial deficit (estimated at 0.2 percent of GDP) and several pre-need companies have encountered difficulties meeting payment obligations. The problems apparently stem from poor investment decisions and significant increases in tuition fees following deregulation in the mid-1990s. Many companies had been selling “open-ended” education plans (the “traditional” plan), where the company promised to pay whatever the tuition is at the time of delivery. Some companies seem to have tried to cover their growing liabilities by using the proceeds from the sale of new plans to service maturing obligations. The sale of “traditional” contracts has been discontinued and some firms have been denied licenses to sell new plans, but existing obligations still need to be met.

uA01fig10

Composition of outstanding plans

(number of contracts, as of end-Dec. 2004)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

The regulatory framework and supervision have been strengthened. The Security and Exchange Commission (SEC), which is responsible for regulating the sector, has issued guidelines to improve actuarial assumptions and has imposed tighter accounting standards. Restrictions were introduced on the investments made by pre-need companies and minimum paid-up capital was increased. In addition, on-site inspections were initiated and stricter compliance with reporting requirements was sought.

Further steps, however, are necessary. According to some observers, plan holders need greater protection, and restrictions on investments should be further tightened, with connected lending forbidden. The high commissions and operational costs-up to 49 percent of a plan holder’s contribution-also need to be reviewed. A proposed Pre-Need Code is under consideration in Congress and would provide a specific legal framework for the sector, rationalizing its current regulatory environment. Furthermore, SEC’s resources and enforcement powers probably need to be strengthened.

Assessing the Monetary Policy Stance

The BSP has been less aggressive than other central banks in the region in raising policy rates. Since the start of the current tightening cycle—the Fed began its series of rate hikes in June 2004—the BSP has raised policy rates by a cumulative 0.75 percent, compared with 5.50 percent in Indonesia and 3.00 percent in Thailand (Figure 1). This might be interpreted as implying that the BSP is behind the curve in the current tightening cycle, especially given the surge in oil prices during 2005.

Figure 1.
Figure 1.

Cumulative Increase in Policy Rates

(Jun. 2004 - Jan. 2006, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

However, several considerations suggest that the BSP’s policy stance is appropriate for now. One measure of whether the policy stance is appropriate is the real interest rate, measured as the overnight borrowing rate minus core inflation. This indicator suggests that the policy stance tightened substantially in the course of 2005, due to falling core inflation and recent rate hikes (Figure 2). In addition, domestic demand in the Philippines has weakened (Figure 3), largely due to a fall in investment (excluding inventories). Going forward, weak electronics exports suggest investment may stay weak, while implementation of the VAT reform may also weaken private consumption. Demand-led inflation is thus unlikely to be a factor in the near-term.

Figure 2.
Figure 2.

Overnight Rate Minus Core Inflation

(Jan. 2004 - November 2005, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Nonetheless, the interest differential versus the U.S. has narrowed, a risk factor if the reform momentum stalls. Up until September 2004, the BSP’s overnight borrowing rate exceeded the Federal Funds rate by more than 5 percent (Figure 4). As of December 2005, this differential measured 3.25 percent. This decline may be sustainable if ongoing fiscal consolidation results in a lower risk premium for the Philippines. If reforms stall, however, the narrow interest differential could become a risk factor, if it leads to a rise in inflation expectations via anticipated weakening of the exchange rate. A further risk is the possible emergence of second-round effects from past supply shocks and the implementation of the VAT reform.

Figure 3.
Figure 3.

Domestic Demand Growth Contributions

(Q1 2001 - Q3 2005, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

(Q1 2001 - Q3 2005, in percent)
Figure 4.
Figure 4.

Policy Rates in the Philippines and the US

(Jan. 2001 - Dec. 2005, in percent)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

The Status of Power Sector Reforms

The Philippines has embarked upon comprehensive power sector reform. Given the government’s limited fiscal resources, a private-sector-led reform strategy was chosen to expand power generation and transmission capacity and avoid power shortage in the medium term. The Electricity Power Industry Reform Act (EPIRA) enacted in 2001 envisages both the privatization of power sector assets and the introduction of competitive power markets, one of the most ambitious power sector reform programs in the region.

Selected Asian Countries: Plan and Status of Power Sector Reform

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Source: Energy Information Administration, Country Analysis Brief.

Progress has been mixed. Positive developments include putting in place a new institutional framework and raising generation tariffs to close to full-cost recovery levels. Moreover, the Wholesale Electricity Spot Market (WESM) is ready for operation beginning early 2006. However, the privatization program has been delayed. Bidding for the transmission assets (Transco) concession has been continuously postponed over the last year with repeated changes made to the bidding strategy, while the delays in selling generation assets (Gencos) apparently reflect limited investor interest.

Philippines: Status of Power Sector Reform Program

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Several factors may explain the difficulty in advancing privatization. First, global investment in the power sector has remained subdued since 1997. Second, the transition of the Philippine power sector to a competitive market structure is raising concerns among investors about risks such as a possible malfunctioning of the prospective spot market. The signing of power supply contracts, which are intended to help mitigate transition risks, has been delayed, because distribution utilities are concerned about the effects of market reform on their business. Third, the investment climate in the Philippines is perceived to be relatively inhospitable. Market analysts partly attribute the limited investor interest to the heightened political noise during 2005.

Demonstration of the government’s commitment to reform might break the current deadlock. For example, successful bidding for the Transco concession might send a signal to investors about the government’s commitment to greater private sector participation in the power sector. Smooth introduction of WESM could rais investor confidence and resolve some uncertainties associated with market reform. More generally, steady progress toward the establishment of a competitive market structure—which itself requires an improvement in the regulatory environment—might be viewed by investors as a factor that strengthens the investment climate in the power sector.

uA01fig11

Private Investment in Power Sector

(In billions of 2004 U.S. dollars)

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Source: World Bank, Private Participation in Infrastructure Projects Database.
Figure 1.
Figure 1.

Philippines: External Developments, 2001–06

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.1/ Adjusted for pledged assets; staff estimates.2/ Includes private sector inter-company accounts, loans without BSP approval, and obligations under capital lease.
Figure 2.
Figure 2.

Philippines: Domestic Developments, 1999–2006

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.
Figure 3.
Figure 3.

Philippines: Fiscal Sector, 1997–2006

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

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.
Figure 4.

Philippines: Banking Sector, 1998–2005

Citation: IMF Staff Country Reports 2006, 092; 10.5089/9781451831368.002.A001

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, 2002-06

Nominal GDP (2004): P 4,826 billion ($86.1 billion)

Population (2004): 83.5 million

GDP per capita (2004): $1,031

IMF quota: SDR 879.9 million

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Sources: Philippine authorities; and Fund staff estimates and projections.

“Reforms proceed” scenario assumes VAT rate increase on February 1, 2006.

Defined as difference between gross investment and current account. There is a statistical break in national saving and balance of payments data in 2003.

Fund definition. Excludes privatization receipts of the national government, and includes net deficit from restructuring the central bank.

Includes the national government, Central Bank-Board of Liquidators, 14 monitored government-owned enterprises, social security institutions, and local governments.

The sum of all nonfinancial public sector revenue net of intra-public sector payments. It is assumed that 80 percent of Bureau of Treasury revenue represents interest and dividends from other parts of the nonfinancial public sector. Privatization receipts are excluded.

Defined as difference between nonfinancial public sector revenue and balance.

Debt is consolidated (net of intra-nonfinancial public sector holdings of debt). Data on local government debt are not available for 2001; it is assumed that these debts were the same as a share of GDP as in 2002.

As of September, 2005.

Secondary market rate.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.

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

Reserves as a percent of short-term debt (including medium- and long-term debt due in the following year). Both reserves and debt were adjusted for pledged assets.

October 2005.

Table 2.

Philippines: National Government Cash Accounts, 2001-06

(In percent of GDP; unless otherwise noted)

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Sources: Philippine authorities; and Fund staff projections.

“Reforms proceed” scenario assumes VAT rate increase on February 1, 2006.

Includes other percentage taxes and documentary stamp tax.

Excludes purchase of NPC securities and other onlending; includes capital transfers to LGUs that may be used to finance current expenditures.

Includes privatization receipts as revenue and excludes the operations of the Central Bank-Board of Liquidators (CB-BOL).

Excludes privatization receipts from revenue.

Consolidated (net of national government debt held by the sinking fund) and excludes contingent/guaranteed debt.

Nonfinancial public sector includes the national government, CB-BOL, 14 monitored government-owned enterprises, social security institutions, and local governments. Debt is consolidated (net of intra-nonfinancial public sector holdings of debt). Data on local government debt are not available for 2001; it is assumed that these debts were the same as a share of GDP as in 2002.

Defined as the deficit, plus amortization of medium- and long-term debt, plus the stock of short-term debt at the end of the last period, plus market financing on behalf of NPC.

Table 3.

Philippines: Balance of Payments, 2001–06

(In billions of U.S. dollars)

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Sources: Philippine authorities and Fund staff projections

Based on revisions to the data, made April 2005; do not include further pending data changes commenced August 2005.

“Reforms proceed” scenario assumes VAT rate increase on February 1, 2006.

The 2003-04 revisions to the data separate remittances made by Filipino residents working abroad (income), and non-resident workers’ remittances (transfers).

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

As a percent of short-term debt excluding pledged assets of the central bank.

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

In percent of goods and non-factor services.

Defined as the current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at the end of the previous period.

Table 4.

Philippines: Monetary Survey, 2000–05

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Source: Philippine authorities, CEIC, and Fund staff estimates.

The Central Bank-Board of Liquidators was established in 1993 to absorb the debts of the old central bank.

Adjusted for exchange rate valuation effects.

Table 5.

Philippines: Medium-Term Outlook, 2003-10

(Reforms proceed scenario)

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Sources: Philippine authorities; and Fund staff estimates and projections.

Defined as difference between gross investment and current account.

Nonfinancial public sector includes the national government, CB-BOL, 14 monitored government-owned enterprises, social security institutions, and local governments.

The sum of all nonfinancial public sector revenue net of intra-public sector payments. It is assumed that 80 percent of Bureau of Treasury revenue represents interest and dividends from other parts of the nonfinancial public sector. Privatization receipts are excluded.

Defined as difference between nonfinancial public sector revenue and primary balance.

Fund definition. Excludes privatization receipts of the national government, and includes net deficit from restructuring the central bank.

Debt is consolidated (net of intra-nonfinancial public sector holdings of debt). Data on local government debt are not available for 2001; it is assumed that these debts were the same as a share of GDP as in 2002.

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

Reserves as a percent of short-term debt (including medium and long-term debt due in the following year). Both reserves and debt were adjusted for gold-backed loans.

Defined as the current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at the end of the previous period.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, some external debt not registered with the central bank and private capital lease agreements.