Philippines
2007 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Authorities of the Executive Director for the Philippines
Author: International Monetary Fund
Publication Date:
02 Apr 2008
eISBN:
9781451831412
Language:
English
Keywords:
ISCR; CR; protection product; FX insurance; investor; rate; investor confidence; privatization receipt; current account; central bank; long-term debt; foreign currency; private sector; Public sector; Privatization; Exchange rates; Global
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Economic stability of the Philippines was discussed in this report. Private investment remained low by regional standards, but there are tentative signs of a revival. These developments and favorable global conditions led to a surge in foreign exchange inflows and the external value of the peso. Inflation remained low because of an appreciating peso and prudent monetary policy. The authorities are encouraged to strengthen the tax effort. Legislation is being considered to restore the tax base by rationalizing fiscal incentives and adjusting excise taxes.

Abstract

Economic stability of the Philippines was discussed in this report. Private investment remained low by regional standards, but there are tentative signs of a revival. These developments and favorable global conditions led to a surge in foreign exchange inflows and the external value of the peso. Inflation remained low because of an appreciating peso and prudent monetary policy. The authorities are encouraged to strengthen the tax effort. Legislation is being considered to restore the tax base by rationalizing fiscal incentives and adjusting excise taxes.

Introduction

1. Investors have responded positively to recent government economic policies. Fiscal and power sector reforms have substantially eliminated chronic public deficits, helping to cut the ratio of public debt to GDP by over one-third since 2003. Banks’ asset quality has improved and banking supervision has strengthened substantially. The reforms were well-timed and allowed the Philippines to capitalize on heightened investor interest in emerging markets. The payoff is evident: stronger external capital account, a firm peso, a buoyant equity market, tighter spreads on sovereign debt, and active foreign participation in the government’s privatization program.

uA01fig01

EMBI Global Sovereign Spreads

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: Bloomberg L.P.

2. The political situation remains stable. A December security incident, where only a small group of rebel soldiers took over a tourist hotel for a few hours calling for President Arroyo’s resignation, received little public support.

3. However, growing uncertainty over the global outlook adds urgency to strengthening reform momentum to cement recent gains. Ongoing turmoil in the financial markets portends tighter credit, and a possible global slowdown presages weaker external demand. Although the Philippines is better prepared than during previous turns of the business cycle, risks could be further reduced and growth placed more on a sustainable path. Thus, the Article IV discussions centered on further reducing vulnerabilities and providing a durable foundation for growth.

Economic Background

Background

4. Economic activity accelerated while inflation stayed low (Figure 1).

Figure 1.
Figure 1.

Domestic Developments

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.
uA01fig02

Gross Fixed Capital Formation

(in percent of GDP, s.a.)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: CEIC Data Company Ltd; and IMF staff calculations.

  • GDP rose 7¼ percent (annual average) in 2007. Private consumption firmed as remittances remained strong, part of which financed home purchases. Fiscal impetus from government spending, including on infrastructure, provided an added push to growth. Despite tentative signs of a pick up, overall investment is still very low by regional standards, contributing to a large private saving-investment surplus.

  • Services drove growth. With strengthening domestic demand, the service sector grew 8½ percent through the third quarter (y-on-y). A construction boom continued with strong demand for residential condominiums from overseas workers, as well as for commercial office space from outsourcing businesses. Forestry and mining operations expanded in response to high commodity prices and legal reforms introduced in 2004 that allowed foreigners to enter into long-term mining contracts with Philippine landowners.

uA01fig03

Contribution to GDP Growth

Production side, s.a., not annualized, q-on-q pct. change

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

  • Price pressures remained muted. Headline CPI inflation was only 2.8 percent (annual average) in 2007, aided by an appreciating peso and prudent monetary policy.

uA01fig04

Headline Inflation

Month-on-month: seasonally adjusted; annualized; Year-on-year: not seasonally adjusted

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: Philippine authorities.

  • Favorable conditions led to a surge in inflows. Although the trade deficit was large, the current account surplus was 5½ percent of GDP in the first half of 2007 (Figure 2) on high levels of transfers from overseas workers. Tighter spreads on Philippine debt lowered interest payments, and portfolio inflows turned the financial account into a small surplus. The peso appreciated 16 percent against the U.S. dollar since end-2006 (9¼ percent on a real effective basis through October). Reserves at the Bangko Sentral ng Pilipinas (BSP) reached $33¾ billion by end-December, compared with $23 billion a year earlier.

  • To date, fallout from turmoil in the global financial markets has been limited. Philippine spreads rose as much as in other emerging markets and stabilized somewhat quicker as conditions normalized, suggesting distress no longer automatically raises a red flag as in the past. Even with heightened global risk aversion since mid-2007, foreign investors have remained active, with gross portfolio flows still high.

Figure 2.
Figure 2.

External Developments

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.1/ Adjusted for pledged assets; Fund staff estimates.2/ Includes private sector inter-company accounts, loans without BSP approval, and obligations under capital lease.
uA01fig05

Foreign Portfolio Flows

Gross flows (in millions of U.S. dollars, 3-month rolling sum)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: CEIC.

  • The domestic financial system felt few reverberations. Throughout the summer, the Philippine money markets functioned with little signs of distress. At end-July, banks held around $1¾ billion (1¾ percent of asset or 15¾ percent of capital) in Credit Linked Notes (CLNs) and less than $⅕ billion in Collateralized Debt Obligations (CDOs). These, along with dollar denominated government bonds, incurred mark-to-market losses of just over $110 million when spreads rose. By end-September, however, these losses were erased as interest rates subsequently fell.

Outlook and risks

5. The economy is expected to enter 2008 with considerable momentum. Staff forecasts GDP growth of 6 percent for 2008, as fiscal impetus wanes. Net exports would contribute less to growth, reflecting a projected mark-down of global growth for the first half of the year.

6. Economic growth prospects are subject to growing downside risk with the unfolding uncertainties in the global financial market. Remittance income, particularly from workers based in non-dollar linked economies, could remain strong, and a sustained increase in investment could lift growth further. On the other hand, a sharper-than-expected global slowdown and credit crunch could undermine recent gains through a disorderly unwinding of currency flows, including possibly a sizable drop in workers remittances. Further increases in food and oil prices could weigh on consumer spending and push up inflation, and a large jump in the peso could dampen exports. However, improved fundamentals, prudent macroeconomic policies, and a strong reserve position should help the economy weather such shocks.

7. The medium-term outlook is broadly positive.

Medium-Term Outlook and Saving-Investment Balance

article image
Sources: The Philippines authorities; and Fund staff estimates and projections.

National government.

  • Baseline. Reforms to date would allow the economy to operate at a modestly higher pace of growth than in the past. With fiscal deficits under control, business sentiment would remain positive and spur private investment to expand beyond the housing rebound. The ample liquidity would provide relatively easy access to financing. Yet, without any further revenue effort, government will be unable to meet their priority targets in the medium-term expenditure framework. Thus, poor infrastructure will increasingly pose a bottleneck. On the other hand, buoyant domestic demand would lift imports, and with workers’ remittances leveling off, the saving-investment balance would normalize.

  • Reform scenario. Under the staff’s “reform scenario,” tax policies would be introduced that would strengthen the tax base, allowing higher capital and social spending. The expectation of better infrastructure in the medium term would catalyze private investment in the short run and throughout the period, leading to a rebound in domestic employment and a reduction in emigration. In addition, private capital inflows, led by foreign direct investment (FDI), would prompt a faster adjustment in the external balance toward its longer-term norm.

The authorities’ views and policy discussions

8. The authorities also forecast robust growth in the short term, and a more buoyant outlook for the medium term, corresponding to the staffs strong reform scenario. The authorities’ latest growth target for 2008 is 6.3–7.0 percent. Through 2010, the official government plan calls for a marked increase in infrastructure spending, to 4 percent of GDP. There was a shared view between the staff and the authorities that such a rebound in public investment would help drive a pickup in private activity, both in the short term and especially into the medium term. The authorities took a similar view to the staff that the fallout from the recent upheavals in the financial markets has been limited.

I. Mending Vulnerabilities and Securing a Sustainable Growth Path

9. Discussions focused on further reducing vulnerabilities and building a solid platform for growth (Box 1). The policy discussions were framed around a broad assessment of external stability, focusing especially on an assessment of the exchange rate level, balance sheet vulnerabilities, and sectoral saving-investment balances.

  • Fiscal policy: Meeting social and infrastructure needs, while balancing the budget to demonstrate fiscal prudence, would require a more sustained tax effort and a prioritization of expenditure within a medium-term framework. Shifting towards local currency debt would reduce vulnerability.

  • Monetary policy: Maintaining the current policy mix of a flexible exchange rate, sterilized intervention, lowering policy rates, and capital account liberalization appears appropriate given the strong currency inflows and benign inflation outlook.

  • Private sector development: Legislative changes are needed to lock in the benefits from the substantial improvement in banking supervision and to secure a better functioning financial system. The ongoing privatization program would further improve the fiscal position and rationalize government operations.

Vulnerability Assessment

Over the past several years, the Philippines has made substantial progress addressing long-standing fiscal, external, and financial sector vulnerabilities. Ongoing economic reforms have put debt on a steadily declining path, rendering positive debt dynamics. In the general government sector, the decline in the ratio of external debt to GDP reflects sustained fiscal consolidation and debt buybacks. In the non-bank public sector, debt prepayments of power utilities have also been significant.

The markets have responded positively to this improvement in debt fundamentals. Since 2001, Philippine EMBI spreads have fallen by around 500 basis points and moved more closely with the overall index. Lower domestic interest rates have left debt relatively insensitive to increases in interest rates.

Selected Vulnerability Indicators1

(in percent of GDP, unless otherwise indicated)

article image
Source: IMF staff estimates.

For the Philippines, data refer to the latest available information for 2007, where available. For other emerging markets, data refer to 2006 for stocks and mostly 2007 for flows. The 48 countries form a representative sample of major emerging market economies.

Short-term debt at residual maturity (maturing medium and long-term debt, domestic and external, excluding external debt to official creditors).

Current account balance plus maturing external debt.

Debt in foreign currency or linked to the exchange rate, domestic and external.

However, the currency and maturity structure of public debt remains a cause for concern. The share of public debt exposed to exchange rate risk is well above the emerging market average. A plausible 30 percent depreciation would lift ratios substantially (Appendix I). In addition, the maturity structure of public debt remains tilted toward the short end, almost three times the emerging market average. This renders the debt dynamics vulnerable to a deterioration in investor sentiment.

uA01bx01fig01

Rollover and Exchange Rate Risk, end-2006

Stock of consolidated public sector debt, in percent of GDP

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: IMF staff estimates.

Despite the impressive progress in reducing non-performing assets, banks still struggle with low profitability and high exposure to government debt. Over the past four years, the Special Purpose Vehicle law and its successor have allowed banks to sharply reduce the outstanding stock of nonperforming assets without relying on public funds. However, the share of nonperforming loans is still almost twice the emerging market average. The rate of return on assets remains low, as a large number of banks have difficulty in determining good credit risks. With large holdings of sovereign debt, banks lost just over $100 million when spreads increased sharply in end-July. While the losses were subsequently recouped, banks could suffer more significantly if spreads again widened.

A. Securing the Benefits from Fiscal Consolidation

Background

10. Despite recent gains in the fiscal position, additional tax efforts are needed.

  • There has been a remarkable turnaround in the fiscal accounts (Figure 3). Nonfinancial public sector debt is projected at about 64 percent in 2007 (from a peak of over 100 percent of GDP in 2003) because of improved performance of Government Owned or Controlled Corporations (GOCCs) and the Social Security Institutions (SSIs), lower central government deficit owing to the 2006 VAT reform, and several years of expenditure restraint. External factors also contributed, such as peso appreciation and lower interest rates. Better performance of the GOCCs reflects policy changes, most notably in the power sector, and for SSIs, higher contributions.

  • However, the momentum gained in revenue collection from the VAT reform was short lived. The government deficit widened to about 1½ percent of GDP in 2007 as expected improvements in tax administration did not materialize, while there was a welcomed pickup in public investment. While the deficit is likely to be fully financed by privatization receipts, no progress was made in further reducing the debt-to-revenue ratio, which is high relative to other countries.

  • The 2008 budget relies on expenditure-driven consolidation. New tax policy measures are minimal. The authorities again count on significant gains from stronger tax administration, which may take more time to materialize. Relative to 2007, infrastructure spending is set to fall as a share of GDP. Civil service reform is progressing, and most departments and GOCCs have submitted their rationalization proposals. Any saving is currently scheduled to be channeled to higher operating expenditures of implementing agencies.

Figure 3.
Figure 3.

Fiscal Sector

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.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.

Policy issues and staff views

11. High priority should be placed on regaining the momentum in tax collection.

uA01fig06

Contribution to tax revenue, 2005-2008

In billions of pesos

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

  • It is difficult to identify a single cause for the decline in tax receipts. Possibilities include: election-related tax evasion, discontent in the ranks of the revenue agencies, decline in compliance from repeated amnesties (which aimed to improve taxpayer registration), lifting of the VAT input cap, peso appreciation, and higher smuggling despite better screening technology at Customs.

  • Staff recommended focusing on strengthening the tax base (Box 2). Significant gains could be made through streamlining tax incentives, as proposed by the Department of Finance (DoF). Staff also argued for increasing and indexing select excises to inflation to at least partly recoup revenue lost over the past decade, amounting to 1½ percent of GDP. These tax policy measures, together with accelerated reforms at GOCCs (see below) form the basis for staff’s strong reform scenario, leading to higher public, and, over time, private investment and growth.

  • Reforming the pay-for-performance system at the revenue agencies would be effective only if coupled with deeper reforms. Higher pay should be based on a broad set of performance indicators. For pay reform to be meaningful, it will be important to first identify and address fundamental systemic weaknesses, including the lack of an effective and systemic control process of filing and payments.

12. More resources are needed to fund priority spending and maintain fiscal discipline. Staff estimates that revenue should rise by about 1½ percent of GDP, from 16¼ percent to 17¾ percent of GDP over the medium term, to meet capital spending goals of about 4½ percent of GDP while balancing the budget. These objectives are in line with the authorities’ Medium-Term Expenditure Framework (MTEF) although funding sources have yet to be identified. A dearth of public investment—roads and irrigation by the government and power and other infrastructure by GOCCs—is frequently mentioned as a barrier to FDI.

uA01fig07

Government Net Capital Stocks

In percent of GDP (Year of estimate at top of bar)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: Arestoff and Hurlin, 2006, “Estimates of Government Net Capital Stocks for 26 Developing Countries, 1970-2002,” World Bank Policy Research Working Papers 3858.

13. Staff suggested anchoring policies more firmly in a medium term fiscal framework and improving public-financial management. This could help policy makers better develop a debt management strategy. Staff welcomed the intention to set expenditure plans for Local Government Units (LGUs) in a medium-term context, which should reduce LGU concerns over cash releases and contribute to increased social spending. The authorities intend to improve budget execution and cash management, which will help better track social spending.

The authorities’ views and policy discussions

14. The authorities plan to balance the 2008 budget while at the same time beefing up priority spending.

  • The priority in 2008 is to balance the budget to cement investor confidence. To the extent that additional revenue may not be forthcoming in the short term, expenditure restraint would be inevitable. However, spending cuts would be across the board, rather than only on capital expenditure. If revenue exceeded targets or saving emerged from lower interest costs or from civil service reform, staff suggested higher public works spending, as in 2007; the authorities agreed, provided that the spending is covered by appropriations. Staff also agreed that after 2009, modest deficits could be tolerated to make room for higher social and capital spending provided tax efforts are sustained.

  • The government is targeting higher capital and social spending. The authorities agreed that privatization is only a short-term measure, and that their MTEF would require 1½ percent of GDP additional revenue efforts. In this regard, the DoF looked forward to passage of revenue-enhancing fiscal bills.

  • In meetings with legislators, staff shared results of alternative tax reform scenarios and answered questions on bills under consideration. The mission cautioned against proposals that would narrow, rather than broaden, the tax base. Key legislators and DoF officials agreed with staff that the decline in excise revenue needs to be reversed and tax incentives reformed.

Options for Establishing a Durable Tax Base

Tax collection has trended markedly lower over the last decade in the Philippines. Key reasons include: generous tax incentives, tariff reform, and a gradual erosion of excise revenue due to non-indexation. This changed in 2006, with the successful implementation of the VAT reform and tentative signs of improvements in tax administration. In 2007, however, the collection momentum slowed again at both the Bureau of Internal Revenue (BIR) and Bureau of Customs (BoC). This slowdown needs to be reversed to fund priority spending and further reduce fiscal vulnerabilities.

Options for reversing the slump in tax revenue:

Accelerating tax administration reform. There is ample scope for improvements in administration. After gains in 2006 from the VAT reform, which raised the rate to 12 percent and expanded the base, VAT productivity declined in 2007 and remains low compared to other countries (see first chart). The authorities’ reform priorities at the BIR include: taxpayer registration, arrears collection, and improving audits. At the BoC, a comprehensive reform agenda is lacking. However, based on previous FAD recommendations, priorities include: strengthening management controls and the integrity of import and export clearance system; and upgrading enforcement and intelligence functions.

uA01bx02fig01

VAT revenue productivity 1/

(as a percent of consumption)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: IMF staff.1/ Defined as VAT revenue divided by consumption and adjusted for the VAT rate. Thus, VAT productivity of unity implies (i) a uniform VAT rate; (ii) no exemptions; and (iii) no leakage.
uA01bx02fig02

Philippines: Total Excise Collection

(in percent of GDP)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: IMF staff calculations.

Raising and indexing excises. Revenue from fuel, cigarettes, and alcohol has declined by about 1½ percent of GDP since 1997, largely because most excises are not indexed to inflation (see second chart). Periodic rate increases for cigarettes and alcohol have not protected the revenue base—a task made more complicated by a four-tier rate system on tobacco. By unifying these rates, and raising and indexing excise rates, policymakers could recover revenue lost over the past decade.

uA01bx02fig03

Effective Average Tax Rate 1/

Over the eight year span of the tax holiday, in percent

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: IMF staff calculations.1/ For an equity-financed investment in plant and machinery with profitability of 20 percent.

Rationalizing tax incentives. Tax incentives substantially reduce effective tax rates on corporate income. Staff estimates (see third chart) suggest that the rationalization bill supported by the Department of Finance (DoF)—phasing out tax holidays and instead offering a reduced corporate income tax rate or a 5 percent tax on gross receipts—would broadly retain the current effective tax rates, while enabling the government to tap into tax redundancies (see Chapter 2 of the 2007 Selected Issues Papers for more details).

15. Public-private partnerships (PPPs) will continue. The cumulative value of PPP projects has grown to around 12 percent of GDP. The authorities foresaw additional PPPs as part of plans to expand capital spending. Staff cautioned against promoting PPPs purely as a means of fiscal saving and recommended installing a single unit in the DoF in charge of monitoring and approving all outstanding guarantees, a suggestion which was welcomed by the authorities.

B. Policy Response to Global Financial Pressures

Background

16. With a stable outlook for prices, the BSP has gradually eased monetary policy.

uA01fig08

Measures of Trend Inflation

Month-on-month percent changes (saar)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: Philippine authorities and IMF staff calculations.

  • Trend inflation remains low. Headline inflation reached 3.9 percent at end-2007, slightly below the BSP’s target band of 4-5 percent. Core inflation (which excludes volatile energy and food items) grew 2.6 percent (y-on-y). Measures of trend inflation, the trimmed median and weighted median, have remained below the BSP’s target in 2007, suggesting inflation expectations remain anchored. However, these measures are inching up and require close monitoring.

  • There is no clear evidence of an emerging bubble. Partly reflecting developments in Asia, asset prices have bounced back. However, property prices are still below the 1997 level. Equity market prices have risen faster with the PE ratio reaching 15½ at end-2007. Equity prices have fallen by more than 10 percent during the first three weeks of 2008, now implying a PE ratio well below the worldwide average of 21 during 2001–06.

  • Policy has turned to easing. In July, the Monetary Board removed tiering that was introduced in late 2006 to encourage credit expansion and set the reverse repurchase (RRP) policy rate at 6 percent. With inflation still low, the Monetary Board thrice reduced the RRP rate late in the year, leaving it at 5¼ percent by end-December.

uA01fig09

Asset Price Developments, 1997=100

Philippine Stock Exchange (PSE) Index; BSP’s Real Effective Exchange Rate; and CPI-deflated average home prices (size-adjusted in sq. meters)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: CEIC Data Company Ltd.

17. The authorities aided an orderly adjustment in the exchange rate.

  • The strong balance of payments reflected largely an increase in remittances and, to a lesser extent, net capital inflows. In response, the peso appreciated significantly vis-à-vis the U.S. dollar and in nominal effective terms (by 14¼ percent during 2007), notwithstanding the large buildup of gross reserves by the authorities. The authorities also intervened to smooth fluctuations of the peso along a firming trend, with no exchange rate objective. Gross reserves, inclusive of swap positions, doubled in 2007 to reach $44½ billion by year end. The authorities also prepaid external debt and relaxed limits on investment abroad in two stages.1

  • The BSP expanded its sterilization operation. In May, access to the Special Deposit Account (SDA) window was widened to more financial institutions to mop up liquidity.2 SDA deposits offered maturity-adjusted rates, just above the RRP, for up to six months. The SDA grew quickly, reaching near 9 percent of GDP, halting the growth of M3, which also allowed the easing of policy rates during 2007. The swap facility was also used more extensively to sterilize intervention.

uA01fig10

Money Stock

Broad liquidity, private sector credit, and the balance at the BSP’s deposit accounts (SDA and RRP windows), in billions of pesos

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: CEIC Data Company Ltd; and IMF staff calculations.

Policy issues and staff views

18. The current policy mix is broadly appropriate and the peso appears to be broadly in equilibrium.

  • Current monetary stance. The staff and private sector analysts forecast inflation at around 4–4½ percent in 2008 against a target of 4 percent ±1 percent, which was set in 2006. The inflation target for 2009 at 3½ percent ± 1 percent aims to continue the steady process of disinflation.

  • Current level of the exchange rate and de facto exchange rate regime. Staff estimates the underlying current account balance to be only slightly larger than the norm, suggesting the level of the current real exchange rate only slightly undervalued or close to its equilibrium level (Box 3). Staff considers that, while it is difficult in practice to differentiate between intervention and reserve buildup, and in view of the authorities’ explanations that the bulk of the intervention was for reaching their gross reserve goal at this opportune time, the de facto exchange rate regime remained independent float. The staff recommended maintaining a flexible exchange rate regime with intervention limited to smoothing erratic movements, and saw merit, in the period ahead, in preannouncing the BSP’s intended buildup of reserves as this would help the market better price the peso and underscore the authorities’ commitment to a market-determined exchange rate.

uA01fig11

Exchange Rate and Interest Rates

Appreciation of the Peso/USD exchange rate vs. Singapore and Philippine interbank offer rates

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: CEIC Data Company Ltd; and IMF staff calculations.1/ Year-over-year percent change of 3 month centered moving average.
uA01fig12

Central government foreign currency debt

In percent of total central government debt

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: Country authorities and IMF staff calculations.

  • More broadly, policy should respond flexibly if capital inflows were to strengthen significantly. With Philippine interbank rates still modestly higher than comparable rates abroad, there is some scope to further ease policy should inflows strengthen. However, rising food prices in the region and higher oil prices internationally pose upside risks to the inflation outlook and warrant caution.

Assessment of the Level of the Exchange Rate

Tentative staff estimates indicate the current level of the peso is broadly in line with fundamentals. The latest CGER estimates, after adjusting for multilateral consistency, range from an undervaluation of 13–14 percent to an overvaluation of 6 percent. While the magnitudes are somewhat different, the mission team’s estimates approximate those of the CGER (see text table). The narrowing of the undervaluation from last year appears to be due to the strengthening of the peso, which in real effective terms appreciated by 15 percent (y-o-y) through mid-2007.

uA01bx03fig01

Real Exchange Rate: ERER Estimations

(in natural logarithms)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Source: IMF staff estimates

The mission team estimated the equilibrium current account deficit at 1.4 percent of GDP under the Macroeconomic Balance (MB) approach. This is smaller than the norm of 1.9 percent deficit provided by the CGER as an adjustment of 0.5 percent of GDP was made to reflect precautionary savings from the overseas Filipino workers’ remittances originating from oil producing countries.

Equilibrium Exchange Rate Estimates

article image
Sources: CGER and mission team estimates.Note: Reference period for the CGER and the mission team’s assessments are September and November, 2007, respectively.

Ratio of current account balance to GDP.

Undervaluation="-".

Based on medium-term projections through 2012.

The underlying current account surplus is estimated to be about 0.4 percent of GDP. This is based on the assumption that the following temporary and cyclical factors have played out: (i) portfolio-type flows in tandem with the overall reflow to Asia that started in 2005-06 (about 2 percent of GDP); (ii) a slowdown in workers going abroad in response to somewhat faster domestic GDP growth (about 1 percent of GDP), and (iii) a pick up in capital goods and oil imports, in response to improved investor confidence and the expected stay of the further hike of petroleum prices in early 2008 over the medium term. Imports may have also been low in 2007 from possible under-recording due to election-related lenience this year (potentially as much as 2 percent of GDP).

Notwithstanding the relatively large margins of error surrounding such estimates, the mission’s tentative assessment is that the current level of peso is broadly in equilibrium.

19. The government could adjust its borrowing mix, with greater financing from peso-denominated bonds, to reduce exposure to exchange rate risks. The Philippines is somewhat of an outlier: foreign currency borrowings are large and, unlike in many Latin American countries, the share has not fallen in recent years. Greater issuance in pesos would reduce vulnerabilities and improve standings with ratings agencies. However, it would be prudent to maintain a modest foreign currency presence in international markets to allow the authorities to tap external funding sources if the need arose. These moves could also be part of a broader strategy to help reduce pressures on the peso.

The authorities’ views and policy discussions

20. Emergent pressures will condition whether the easing cycle continues.

  • The firm peso has helped temper the impact of higher import costs, particularly from resurgent food and oil prices. There was a shared view that wider access to the SDA had helped reduce liquidity growth. Exceptional spikes in commodity prices were being watched closely for signs of second round effects on domestic prices and for evidence that higher costs have not dislodged inflation expectations.

  • The authorities also saw risks to the global inflation outlook. Recent measures adopted by central banks to cope with seizures in the money markets have pumped a large amount of cash into the global financial system. Once conditions normalize, this liquidity could swamp markets with liquidity and add to price pressures.

21. The authorities remain committed to a flexible exchange rate system.

uA01fig13

Real Effective Exchange Rates

CPI-based, 2005=100

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: Information Notice System and IMF staff estimates.

  • BSP officials emphasized that the exchange rate is market determined. Intervention is aimed at smoothing volatility of the peso. Staff questioned to what extent the exchange rate was managed in light of the large reserve accumulation. The authorities emphasized that they took the opportunity of favorable market conditions of low inflation and stronger balance of payments position to strategically build up reserves, and thereby reduce the country’s vulnerability. Beyond that, the peso was left to the market. While other central banks accumulated reserves several years ago, the BSP has not had a similar opportunity until recently. Now, they plan to maintain a comfortable level of reserves, with memories of past financial crises still fresh, as a form of self-insurance against growing uncertainty.

  • Indeed, despite large reserves accumulation, the peso has risen at one of the fastest paces in Asia. The authorities agreed that the current level of the real effective exchange rate is broadly in line with fundamentals. However, they expressed concern about possible overvaluation in the future. The appreciating peso has adversely affected locally sourced exporters and overseas foreign workers, and both have scaled up complaints.

  • Staff supported the BSP’s exchange rate policy and decision to continue using a mix of measures to moderate the impact of capital inflows on the economy, weighing costs and benefits of each measure. The second round of foreign exchange liberalization was particularly important because it has facilitated free capital flows in an increasingly integrated market, which could also alleviate pressures on the exchange rate.

22. The authorities agreed that greater domestic borrowing would encourage local capital market development and reduce external vulnerabilities. DoF officials announced that more borrowing would be sourced locally, in pesos, with only $500 million in offshore commercial borrowing in 2008. The mission supported this shift, which would help gradually reduce exposure to currency risk—a source of vulnerability discussed in the DSA (Appendix I). At the same time, staff also suggested lengthening maturities to decrease rollover risk.

C. Financial and Structural Policies

Background

23. While challenges remain, the financial system has begun to turn the corner (Figure 4).

Figure 4.
Figure 4.

Banking Sector

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: Data provided by the Philippine authorities; CEIC; and Fund staff estimates.1/ Nonperforming loans plus ROPA (see below) over gross assets.2/ Real and other properties owned or acquired in settlement of loans and receivables, including real properties, shares of stock, and chattels formerly constituting collaterals for secured loans.3/ Return on assets for all banks is defined as net income before taxes as a share of domestic assets (assets less net claims due to headquarters’ branches or agencies.4/ Return on equity refers to the ratio of net income after taxes to average capital.

  • Banks upgraded risk management facilities ahead of the July 2007 introduction of Basel II. These included higher risk weights on non-performing assets (NPAs), new charges for operational risk, and a 100 percent weight (phased-in over three years) on Philippine foreign currency sovereign bonds.

  • The extension of the Special Purpose Vehicle Law has allowed a disposal of nearly P130 billion in distressed assets. An improving property market has also helped banks unload foreclosed properties.

  • Surveillance over banks has improved. BSP auditing functions have recently been overhauled, focusing on bank inspections, diagnostic accounting, and a clearer delineation of responsibilities within the BSP on oversight.

  • Large holdings of government debt render banks vulnerable to sharp spikes of sovereign spread risk. Lack of good lending prospects, along with high reserve and liquidity requirements and the difficulty in taking legal action against defaulters, have led banks to place around one-third of assets in government securities. However, banks’ direct holdings of structured debt instruments are around 1¾ percent of assets.

  • Critical legislation has stalled. Despite repeated attempts, Congress has not passed bills that would: improve the credit reporting system; permit a broader range of investments, including real estate investment trusts; reform insolvency rules; and amend the BSP charter that would strengthen, inter alia, legal protection to bank supervisors and inspectors, enhance data collection, and allow the BSP to issue debt.

24. Good progress has been made in power sector reforms, and efforts for rationalization of other GOCCs have begun.

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Generation Asset Privatization

(In percent of total capacity, unless otherwise indicated)

Citation: IMF Staff Country Reports 2008, 119; 10.5089/9781451831412.002.A001

Sources: CEIC Data Company Ltd; and IMF staff calculations

  • With improved investor confidence, power sector privatization made good progress in 2007. To date, over 40 percent of power generating capacity has been sold. A government owned power transmission corporation, the National Transmission Corporation (Transco), was successfully auctioned in December after repeated past failures.

  • GOCCs and SSIs had a good year in 2006 and in the first three quarters of 2007. The appreciation of the peso helped mitigate higher oil prices and reduce external debt service payments. The National Power Corporation (NPC) is expected to record a small surplus in 2007 with higher sales. SSIs benefited from a strong stock market and an increase in payroll receipts after contribution rates were increased and more overseas workers contributed to the system.

  • However, selected GOCCs are still under strain. The National Food Authority (NFA) and Light Rail Transit Authority (LRTA) have substantial, although declining, deficits stemming from cost increases and low cost recovery.

Policy issues and staff views

25. There appears to be little impact, to date, of the turbulence in global markets on the Philippine financial system. To be certain, portfolio inflows have tapered off and spreads have risen, but not disproportionately. Bank shares have been depressed, particularly for those holding large amounts of government bonds, and thus exposed to large changes in spreads. Continued vigilance is thus warranted, particularly if risk aversion builds or inflation picks up, leading to more adjustment in yields.

26. With vulnerability reduced, promoting effective financial intermediation emerges as a key challenge. Despite substantial progress in reducing NPAs, they remain large and depress bank profits. Bank lending remains low, well below funds raised in the capital market in 2007, as banks are willing to lend to only their best clients. The credit reporting system is poor, only 5½ percent of adults are currently covered, and an inefficient bankruptcy code extends recovery time to 5¾ years and reduces recovery rates to 4¼ percent. Enactment of a full legislative package would help expand access to credit for small and medium-sized enterprises, reduce external borrowing, and encourage investment.3

27. The staff welcomed efforts to further strengthen the BSP’s supervision and surveillance capacity. The staff recognized that training and reorganization of the BSP’s Supervision and Examination Sector was well underway. Reforms, including a new Prompt Corrective Action framework and close collaboration with the Philippine Deposit Insurance Corporation, have empowered auditors to track banks’ activities more closely. The mission urged BSP staff to keep monitoring developments in the property sector closely. Staff also welcomed the ongoing work within the BSP on the inaugural Financial Stability Report. The first report would be published this year, although only internally, as a dry-run.

28. The staff reviewed the GOCCs fiscal position and its durability. Staff welcomed plans to introduce performance contracts and medium-term deficit targets for GOCCs representing high fiscal risk, starting with the NFA.

The authorities’ views and policy discussions

29. BSP staff emphasized that the banking system was relatively well prepared to withstand a tightening of the global credit cycle. Internal stress tests suggested that systemically important banks could comfortably withstand further widening of sovereign spreads. Furthermore, exposure to CDOs and underlying assets of CLNs were investment grade credits. However, widening spreads have led to mark-to-market losses, which have been manageable, and a few non-systemic banks may be vulnerable if government bond yields rose sharply.

30. Further legislative changes and reform efforts are important.

  • The BSP Charter Amendment is critical. The delay in the passage of the law has required the BSP to offer indemnity insurance to its supervisory staff, reducing the fear of lawsuits, as a temporary alternative. The amendment would also allow the BSP to issue its own debt and give more power to collect data on the non-bank sector for its surveillance activities. Cooperation with the Philippine Deposit Insurance Corporation (PDIC) has enabled the BSP to take action against some banks.

  • Internal reorganization in bank supervision has made headway. The process of improving management within the BSP has been difficult. Human capital skills have been upgraded through very short-term secondment at offshore investment and commercial banks.

31. While recognizing the banking system could be more efficient, the authorities emphasized significant work has begun in this area.

  • Process of bank restructuring is ongoing. The reduction in NPAs has occurred entirely through a private-sector led framework, with no public funds used for bailouts. Moreover, banks have been consolidating. Basel II implementation, preparation for which began several years ago, has forced higher provisioning and greater attention to risk. The improved property market, however, has increased the value of the Real and Other Property Acquired, reducing the provisioning requirements. The BSP has also been active in promoting micro credit and SME lending programs.

  • Capital market development is proceeding apace. There have been welcome moves toward deepening domestic bond and equity markets. This has meant greater corporate reliance on security issuances over bank lending.

  • The BSP is not overly concerned about banks’ increased lending to the property sector. Strict exposure limits prevent real estate lending from exceeding 30 percent of loan portfolios. Related party lending is also limited to 20 percent of portfolio. Moreover, recent demand for property mainly reflects acquiring dwellings for ownership, rather than speculative investment.

32. The process of more fundamental reforms of the GOCCs is underway.

  • With ADB technical assistance, the government is currently setting up a framework of performance contracts for GOCCs, mainly for the National Development Company, the LRTA, the Philippine National Railways, and the Home Guarantee Corporation.

  • The authorities are completing the framework for streamlining the operations and strengthening the management of the NFA. However, the scope for saving may be limited since most of the NFA’s deficit is driven by factors outside its control, such as the administratively-set rice price and subsidies for school food programs.

Staff Appraisal

33. The Philippine economy is reaping the benefits of reforms, but further progress is required as uncertainties in the global outlook grow. Sustained fiscal prudence has helped to erase chronic public deficits. Bank supervision has been substantially strengthened, and the banking system’s health improved. Markets have taken note, resulting in readily available financing for the current expansion. However, attention should now turn to address infrastructure bottlenecks and social needs and to strengthen the financial sector’s ability to efficiently channel resources, including from foreign currency inflows.

34. Already, much has been done to streamline the public sector. The government’s privatization program has attracted strong investor interest. The 2006 tax reform has improved the VAT’s efficiency. These improvements, together with tight control over spending and improved performance of GOCCs, have slashed the public sector deficit and improved the Philippines’ debt dynamics further. The government’s plan to maintain a balanced budget through 2008, as a demonstration of fiscal prudence, should further cement credibility.

35. However, there is an urgent need to raise the tax effort to place priority spending on a sustainable footing. Balancing the budget and reaching targets for social and capital spending will require additional tax effort of at least 1½ percent of GDP over the medium term. While administrative reforms will help, legislation is needed to restore the tax base by rationalizing fiscal incentives and by adjusting excise taxes. Although PPPs are useful, plans to more closely monitor these projects, particularly guarantees extended to private investors, would help the government manage its exposure and further reduce fiscal risks.

36. The authorities managed the foreign exchange inflows well, while maintaining price stability. The authorities have smoothed peso fluctuations as they took a strategic opportunity to build reserves, which now appear adequate. There was a compelling case to raise the level of reserves, and staff continue to view the exchange rate as market determined. Wider access to the Special Deposit Account, together with operations through the Reverse Repurchase facility and greater use of swaps, have successfully sterilized the reserves buildup and reduced liquidity growth. Well-anchored inflation expectations and an appreciating peso have helped counter the effects of sharply higher commodity prices into 2008. If the inflation outlook remained comfortable, and capital inflows continued to put pressure on the peso, there could be scope for further easing. Nevertheless, higher regional food and oil prices warrant caution.

37. The underlying current account balance is slightly larger than the norm, suggesting the exchange rate is broadly in equilibrium. Nevertheless, groups that have been adversely affected by the peso’s strength have scaled up complaints. Continued use of a mix of measures, including a flexible exchange rate with intervention limited to smooth erratic movements and build up reserves, is appropriate. Also, the recent two-step liberalization of the financial account should help moderate net capital inflows. The government’s decision to tilt the borrowing mix more heavily toward domestic sources is encouraging; it could reduce vulnerabilities and potentially ease pressure on the peso.

38. The outlook for the financial system has improved substantially. Welcome progress has been made in disposing of non-performing assets. Following the introduction of international accounting standards and introduction of Basel II, banks have upgraded risk management facilities, raised capital, and merged. Bank monitoring has also improved, thanks to a reorganization that has created a more streamlined and effective supervision unit at the BSP. However, passage of the BSP Charter Amendment will be essential to lift the threat of legal action against supervisors, facilitate the operation of monetary policy, and improve economic surveillance of the non-bank sector.

39. Nevertheless, much work remains if the economy is to weather a serious turn of the credit cycle. The remaining stock of non-performing assets is large, depressing the return on assets—one of the lowest in the region. Banks hold a large stock of government debt that is sensitive to changes in sovereign spreads. Pending key legislation such as the Corporate Recovery Act and the Credit Information Systems Act could help improve bank profitability and lending through better pricing of loans and greater recovery rates from loans that sour.

40. Ongoing power sector privatization efforts have been successful. Sales of government assets have generated more income than expected. Greater debt prepayment and pricing reforms have allowed the NPC to improve its financial picture. The final auction of Transco, after repeated failures, is particularly welcome. These developments should help support the government’s effort to ensure that growth is not impeded by power shortages.

41. Staff recommends the next Article IV Consultation be on the standard 12-month cycle.

Table 1.

Philippines: Selected Economic Indicators, 2003–08

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

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.

Secondary market rate.

November 2007.

September 2007.

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.

Table 2.

Philippines: National Government Cash Accounts, 2003-10

(In percent of GDP; unless otherwise indicated)

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Sources: Philippine authorities; and Fund staff projections.

Includes other percentage taxes, documentary stamp tax, and noncash collections. Noncash collections are also reflected as tax expenditures under current expenditures.

Excludes purchase of NPC securities and other onlending; includes capital transfers to LGUs. May exceed public investment in years when capital transfers to LGUs exceed their reported capital spending.

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 excluding 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).

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.

For the budget, the lower bound of the range of GDP estimates.

Table 3.

Philippines: Balance of Payments, 2003–08

(In billions of U.S. dollars)

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Sources: Philippine authorities and Fund staff projections.

The 2003–04 revisions to the data separate remittances made by Filipino residents working abroad (income), and nonresident 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 nonfactor 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: Depository Corporations Survey, 2003-07

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Sources: 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.

Table 5.

Philippines: Medium-Term Outlook, 2005-13

(Baseline 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).

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.