Philippines
2008 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Philippines
Author: International Monetary Fund
Publication Date:
20 Feb 2009
eISBN:
9781451831436
Language:
English
Keywords:
ISCR; CR; excl. privatization receipt; headline inflation; inflation outlook; economy; exchange rate; net; foreign currency; long-term debt; credit market; consumer sentiment; unquoted debt securities; Exchange rates; Global
Download PDF (708.2 KB)

The staff report for the Philippines’ 2008 Article IV Consultation is focused on economic developments and policies. A deepening of the global economic downturn presents downside risks to this outlook. Inflation is expected to reach 9½ percent in 2008 and decline to 6 percent in 2009, led by a decline in commodity prices and weaker demand. Bank surveillance has been strengthened and steps have been taken to reduce risks related to off-balance sheet activities.

Abstract

The staff report for the Philippines’ 2008 Article IV Consultation is focused on economic developments and policies. A deepening of the global economic downturn presents downside risks to this outlook. Inflation is expected to reach 9½ percent in 2008 and decline to 6 percent in 2009, led by a decline in commodity prices and weaker demand. Bank surveillance has been strengthened and steps have been taken to reduce risks related to off-balance sheet activities.

I. Introduction

1. Following solid economic performance in recent years, the economy now faces headwinds. Over the past three years (ending 2007), GDP growth averaged 5¾ percent and gross public debt declined by more than 30 percent of GDP. Progress on fiscal consolidation and financial sector reform has allowed the economy to better capitalize on the benefits from globalization. However, managing the spillovers from the global financial turmoil and economic slowdown now present challenges.

A01ufig01

Nonfinancial Public Sector Debt, 2001-09

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

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

2. Political support for reforms may wane. The government has fended off calls for a repeal of the VAT on petroleum products following the sharp rise in oil and food prices earlier in the year. However, pressure to delay tax policy reforms could grow as the 2010 Presidential elections draw nearer.

3. The 2008 Article IV consultation took place in the context of a more challenging economic and political environment. The discussions focused on policies to safeguard domestic, including financial, and external stability, especially in light of the ongoing global financial turmoil. They also focused on medium-term policies to lower vulnerability.

A01ufig02

Emerging Asia: GDP Growth

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: CEIC Data Company Ltd; and IMF staff calculations.
A01ufig03

Business and Consumer Expectations for the Next Quarter

(Diffusion Index)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

II. Recent Economic Developments

4. The impact of the global economic strains has been contained so far, but the Philippine economy is not immune.

  • GDP growth moderated to 4.6 percent in the first three quarters of 2008 from 7.2 percent in 2007. The slowdown was driven by weaker external demand and consumption as the oil and food price shock reduced real income, outweighing the positive impact from robust remittances. Later in the year, the global financial turmoil further weighed down business and consumer sentiment, indicators of which suggest the moderation will continue into next year.

  • Inflation is high, but the momentum has slowed. Headline inflation peaked in August at 12½ percent (year-on-year) led by higher food and fuel prices. However, it fell to 9.9 percent in November as annual gains in commodity prices receded. Moreover, there is currently no evidence of additional inflation pressures, including from wage adjustments.

A01ufig04

Contributions to Inflation

(Year-on-year percent change)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: Philippine Authorities; and IMF staff calculations.

  • The spillover from the global financial turmoil to domestic financial and currency markets has intensified since September. Equity prices have declined by around 45 percent in 2008, with almost half of the decline taking place since the turmoil of mid-September. The wealth effect has been limited, however, with less than 2 percent of the population invested in capital markets. Measures of credit risk have increased with (market-based) expected default frequencies of banks at elevated levels and Philippine sovereign spreads wider by 300 bps (EMBI + PHL) since end-August. Yet, spreads remain 175–200 bps lower than the EMBI+ Global average, reflecting reforms in recent years and foreign exchange reserve accumulation during good times.

A01ufig05

Equity Prices

(Index June 2007 = 100)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: Bloomberg.
A01ufig06

Spreads: Philippines CDS and EMBI Spreads

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: Bloomberg.

  • The external position has weakened and the exchange rate has depreciated. Remittances have held up well so far, increasing by 17 percent (year-on-year) through September, reflecting the geographical and professional diversification of the Philippine workers (including presence in the Middle East). Even then, the current account surplus declined during the first half of the year as external demand waned and commodity prices increased sharply. Capital inflows also weakened during the same period. Net foreign equity outflows reached US$800 million through November, of which a third took place since end-August. Against this background, the peso has depreciated by 20 percent against the U.S. dollar and the real effective exchange rate by around 6 percent in 2008.

A01ufig07

Merchandise Trade and Remittances

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: CEIC Data Company Ltd.
A01ufig08

Exchange Rates

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: Philippine Central Bank and Information Notice System.

  • During the first half of the year, corporations saw their average profits cut by a third due to waning demand. Nevertheless, strong profit growth in the past few years and some pre-financing during the capital market boom have reportedly provided a cushion to allow the large corporates to better weather the cyclical downturn in the near term. Moreover, the peso credit market, which is still liquid, could support somewhat higher domestic credit demand. However, smaller businesses, particularly in trade-oriented activities, appear to be under some stress due to slowing business and rising costs of trade credits.

III. Outlook and Risks

5. Economic activity is expected to slow over the near term.

  • Growth is projected to decelerate to 4 ½ percent and 3 ½ percent in 2008 and 2009, respectively. On the supply side, the electronics industry is most susceptible to the external slowdown with industry analysts expecting the U.S. book-to-bill ratio to decline sharply given significant oversupply. Retail trade and financial services are also expected to grow at a slower clip with consumer sentiment already at its lowest since 2005. Staff projects inflation to reach 9 ½ percent in 2008 and 6 percent in 2009 (period average). With the steep decline in global commodity prices and weakening domestic demand, inflation is projected to fall within the target range of 3½ ± 1 percent in the later part of 2009, even after taking into account the pass-through from the recent peso depreciation.

A01ufig09

Headline CPI Inflation Projection: 2008-09

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: Philippine Authorities; Haver Analytics; and IMF staff calculations.

  • Risks to the near-term outlook are tilted to the downside. Financial sector stress could intensify if the global financial turmoil worsens or is drawn out (see Section IV.A). A deepening of the global economic downturn would weaken the external position, especially if remittances contract as the recession in the United States deepens and economic activity in the Middle East slows (Box 1). Fiscal reform delays, possibly due to the upcoming elections, could further push up financing costs as investors charge a higher risk premium. On the upside, globally coordinated fiscal stimulus, if it were to take place, could mitigate the downside risk.

How Exposed is the Philippines to a U.S. Slowdown?

Philippines’ economic linkages to the United States are quite strong. Trade linkages account for about 12 percent of GDP (including trade through third countries). Moreover, financial linkages and remittances present channels for adverse balance sheet and wealth effects.

The correlation with the U.S. cycle has almost doubled since the mid-1990s. Quantitative analysis suggests that a 1 percentage point decline in U.S. growth could lower growth in the Philippines by about 0.4−0.6 percentage point (directly and through other trading partners such as China). The extent of spillovers appears to have increased over time—in part, this may be the result of the development of the electronics sector in the Philippines and also reflect the rising importance of remittances from the United States.

Impact of a 1 Percent Decline in U.S. Growth 1/

article image
Source: Asia & Pacific Regional Economic Outlook, April 2008

In percentage points.

6. The medium-term outlook depends critically on reform progress and the duration of the global economic slowdown.

  • Growth is expected to pick up only moderately over the medium term in the baseline scenario. As heightened risk aversion subsides and inflation recedes further, private investment and consumption will likely strengthen. However, absent deeper tax reforms to finance much-needed infrastructure and social spending, and measures to tackle a weak business environment, the upside is constrained.

  • A “worse” case scenario could entail a more prolonged period of strained conditions in the global financial system. The world economy would be in a deeper recession than currently envisaged in the baseline, with spreads widening substantially and domestic growth falling well below potential. Economic activity would slow markedly and remain lackluster over the next couple of years. This environment will likely impose significant stress on the domestic banking system and could result in an extended period of bank restructuring, which in turn will further subdue economic activity. The balance of payments position could weaken considerably with a sustained decline in workers remittances, and the peso would be subjected to substantial downward pressures.

7. The authorities broadly concurred with the staff’s assessment. Growth in 2009 is expected to be slightly higher than projected by staff, reaching 3.7–4.7 percent on account of stronger domestic economic fundamentals and supportive macroeconomic and financial sector policies (see Sections IV.A and IV.B). This was in part based on a more optimistic view on the resilience of workers remittances. The recent decline in oil prices was not expected to materially affect remittances from the Middle East, in part because many of the ongoing construction projects started before the spike in oil prices and were expected to be completed. Moreover, Filipino workers in the United States are increasingly employed in less cyclically sensitive professions (i.e., health care). However, the authorities shared staff’s view that the near-term economic outlook was subject to downside risks and an elevated level of uncertainty, especially as regards external demand. The authorities expect inflation to fall within the target range during the second half of 2009, in line with staff’s projections.

IV. Policy Discussions

Discussions centered primarily on (i) policies to manage the near-term risks related to spillovers from the worsening external environment and (ii) medium-term policies to reduce vulnerabilities, in particular the agenda for financial sector reform and fiscal consolidation.

A. Safeguarding Financial Stability—Tackling Global Spillovers

8. Adverse global spillovers have so far been contained, but present challenges.1

  • The exposure to failed and distressed global financial institutions is limited. As of end-September 2008, direct exposures to Lehman Brothers stood at US$350 million (3 percent of equity), but a large part has already been provisioned for. Combined exposure to Lehman Brothers and 10 other distressed major global financial institutions amounted to US$1.5 billion or 13 percent of banking system equity. However, the exposures are concentrated in a few banks.

  • Banks are exposed to market risks through their large holdings of debt securities. These account for about a quarter of total bank assets and consist primarily of Philippine government bonds, of which about half are denominated in foreign currency. Local banks are also exposed to credit linked notes (CLNs), issued by international banks and tied to foreign currency-denominated government securities. As such, changes in domestic interest rates or in sovereign spreads are leading to large mark-to-market losses.2 Exposure to other structured products are, however, limited.

  • Banks have increased their off-balance sheet activities since 2007 in the form of unit trust funds and matching pools of investors with specific projects. The size of these activities amounts to around P 1.2 trillion, or 20 percent of on-balance sheet assets.

  • Profits fell in most banks during the first three quarters of 2008. Despite increased lending, partly driven by a drying up of external funding and depressed equity markets, profits fell due to significant mark-to-market losses on fixed income instruments, lower service fees, and smaller interest margins. Moreover, a few large banks wrote down their claims on failed foreign financial institutions, particularly in the third quarter.

  • Banks are still weighed down by legacy assets. The gross nonperforming assets (NPA), including foreclosed properties, are still large relative to banking system capital, and provisioning remains low.3 Moreover, the NPA-to-equity ratio is high at around 30 percent.

9. The banking sector confronts these problems from a relatively strong position.

  • Nonperforming loans (NPL) have declined in the last few years, falling further during the first half of 2008 to 5.2 percent of total loans (excluding interbank loans) and 84 percent have been provisioned for.

  • The CAR of the banking system as a whole is high by regional standards, averaging around 15 percent by end-June 2008, although some banks are closer to the statutory limits.

A01ufig10

Nonperforming Loans to Total Loans

(In percent)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: Global Financial Stability Report.
A01ufig11

Capital Adequacy Ratios

(In percent)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: Global Financial Stability Report.

10. Moreover, risk-management practices have improved and surveillance has strengthened. In line with the regional trend, commercial and universal banks adopted Basel II in June 2007, applying the standardized approach for credit risk and either the basic indicators approach or the standardized approach for operational risk. The implementation of Basel II resulted in lower CARs for the banking system, around 300 basis points, due to capital charge for operational risk and more punitive risk weights on NPLs, Real and Other Property Acquired (ROPA), and foreign currency securities. On its part, the BSP has stepped up its risk-based supervision in recent years, enhancing the CAMELs framework for monitoring bank risks.4

Basel II Implementation Schedule for Asia

article image
Source: FitchRatings.

Policy issues and staff views

11. The banking system is exposed to domestic and external channels of risk.

  • Through the local economy: The economic slowdown will further reduce earnings and worsen asset quality as households, SMEs, and export-oriented firms find it more difficult to service their debt. In this environment, it will also be harder to dispose of the large portfolios of foreclosed properties.

  • Global spillovers: A key risk to banks stems from mark-to-market losses. For some banks, these losses have already been significant and implied problems meeting the asset cover requirement for Foreign Currency Deposit Units (FCDUs), exacerbating the downward pressure on the peso. Off-balance sheet entities, including trust accounts, could entail reputational risks and other contingency risks for banks in case of significant redemption pressures.

As a result, some of the weaker banks could be subject to heightened stress in the baseline scenario, but especially if the global economic and financial environment deteriorates further than envisaged and triggers additional spillovers.

12. In response, the BSP has introduced a number of measures to help address the fallout from the global financial crisis.

  • Surveillance and communication: The BSP has enhanced its day-to-day monitoring of the banking system and stress-testing exercises, and it has sought to assure depositors that the banking system remains sound. However, there may be scope for stepped-up surveillance, including closer monitoring and supervision of off-balance sheet activities.

  • Regulatory forbearance: Largely in accordance with the provision of the October 2008 amendments to International Accounting Standards (IAS 39), the BSP allowed banks5 a window up until November 14 to reclassify securities from mark-to-market accounts to hold-to-maturity accounts and UDSCLs (unquoted debt securities classified as loans) based on any prevailing fair value between July 1 and November 14, 2008.6 Also, the BSP exempted until March 31, 2009, unrealized mark-to-market losses from the calculation of banks’ FCDU asset cover requirement. The staff highlighted the importance of the BSP’s resolve to not let these measures impair transparency about the soundness of financial institutions. Moreover, to the extent pressures on emerging market bonds are expected to remain for a while, these measures delay rather than solve the problem.

  • Liquidity support: The BSP has appropriately introduced a number of measures to support interbank liquidity (see Section IV.B). Staff encouraged flexible application of existing liquidity facilities as needed to stem any further stress.

13. Strengthening the prompt corrective action (PCA) framework would be a good preparatory measure to adequately deal with any bank distress. The current PCA framework appears broadly adequate to deal with spillovers from the global turmoil on individual local banks. In the short run, the BSP should be given legal authority to disclose enforcement actions, while preserving the right for secrecy in situations where disclosure may aggravate panic, rather than ameliorate it. Importantly, the amendments to the BSP charter ensuring legal protection of BSP staff, a long-standing issue, should be implemented without any further delay.

14. The staff supports the authorities’ plan to raise the deposit insurance ceiling, but saw scope for a more flexible framework. The proposed doubling of deposit insurance to P 500,000 is welcome. However, to further strengthen safeguards during times of severe stress, the deposit insurance framework should provide for greater flexibility to raise the ceiling if needed.7 It will also be key to recapitalize the Philippine Deposit Insurance Corporation (PDIC) to match the higher insurance liabilities under the new limits, and change to a risk-based contribution structure to help foster financial soundness.8

15. The mission welcomes the envisaged enhancement of the banking resolution tool kit, including through the proposed introduction of a bridge-bank facility. However, a more flexible application of the purchase-and-assumption (P&A) tool,9 not contingent on the finalization of depositor payout, should also be considered. It could make takeovers more attractive and possibly lessen the need for activation of deposit insurance. To further enhance the effectiveness of the banking resolution framework, rights of existing shareholders of ailing banks should be limited; restructuring decisions should be legally irreversible; and PDIC staff should be protected against litigation.

16. Medium-term considerations include the following:

  • Shift to a more rules-based PCA framework, including by formalizing triggers at multiple stages of financial soundness tied to accelerated stringency of remedial actions. This could help fast-track action on banks experiencing distress.

  • Address large overhang of foreclosed properties, which are about 50 percent larger than the NPLs, with provisioning below 18 percent. They impair the return on capital and also leaves banks more vulnerable to property cycles. There is benefit to selling these properties with some haircut, rather than wait until property prices reach a certain threshold or establish joint ventures with developers to manage these properties. The current environment would, however, argue for a gradual sell-off.

  • Further develop capital markets to strengthen financial intermediation. Less than 250 companies are listed on the stock exchange and only a fraction of shares are traded actively. Domestic bond markets have deepened in recent years, but government securities still account for 95 percent of the market. These underdeveloped capital markets reflect high industrial concentration and large conglomerates funding their operations from retained earnings and bank borrowing. Improving the business climate should go in tandem with future developments of the capital market where a strong clearance and settlement infrastructure is a key precondition. Continued efforts to shift the public bond mix toward domestic issuance could help deepen debt markets. Moreover, transition towards funded pension schemes could help generate local portfolio investment demand.

The authorities’ views

17. The authorities agreed with the basic contours of the staff’s assessment, although they found the existing contingency framework adequate.

  • Channels of risk: They shared staff’s view on the domestic and external channels of risk. However, they noted a number of risk-mitigating circumstances: (i) despite a pickup in lending in recent years, the loan-to-deposit ratio is still low; (ii) sector loan concentration is limited and NPLs have continued to fall; (iii) bank capitalization is high and exposures to risky financial instruments are low; and (iv) corporates generally have strong balance sheets.

  • Contingency measures: The authorities agreed with the need for a proactive approach for remedial action and considered their existing PCA framework as adequate to deal with banks under stress. They pointed out that a more rules-based PCA approach would leave them with less flexibility to deal with individual bank cases, which often differ and require a more idiosyncratic response. Legal protection of supervisors and restriction of shareholder rights during bank restructuring were considered a priority. They also agreed with the need to recapitalize the PDIC and saw some merit in having flexibility to raise the deposit coverage temporarily if needed. At the same time, they did not think a more flexible application of the P&A tool would necessarily lead to more effective bank resolution, but could actually cause instability if it was perceived as a restriction on depositor rights. The authorities also pointed out that steps have been taken to reduce risks related to off-balance sheet activities, including through the introduction of enhanced client suitability requirements and disclosure/sales provisions of unit investment trust funds.

B. Monetary and Exchange Rate Policies

18. The authorities’ concerns have now shifted from inflation to global economic and financial spillovers.

  • Monetary policy was tightened midyear in response to the rapid rise in inflation, but subsequently moved to a neutral stance. The BSP raised policy rates in June, July, and August by a combined 100 bps—taking the reverse repo rate (RRP) to 6 percent. However, the BSP left rates unchanged at the October and November monetary meetings, citing an improving inflation outlook.

A01ufig12

Evolution in Consumer Price Consensus Forecast

(Year-on-year percentage change)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

A01ufig13

Output Gap 1/

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: IMF staff ectimates and projections.1/ Detrended with HP filter; lambda equal to 25 using Staff projections through 2013.

  • The central bank has taken a number of steps to support liquidity. While peso liquidity is still adequate, the reserve requirement was preemptively reduced by 2 percentage points to 19 percent, and the amount allocated for the rediscount window was doubled from P 20 billion to P 40 billion. To address some segmentation of the dollar interbank market, the BSP opened a dollar-denominated deposit window and a short-term dollar repurchase facility. Moreover, banks have entered a “gentleman’s agreement” to reduce their over-bought dollar positions by 50 percent, step up interbank dollar lending, and increase scrutiny over clients’ foreign investments.

  • The exchange rate has come under pressure from the weakening balance of payments and a shift to long dollar positions. In response, the BSP has drawn down US$9 billion of its foreign exchange swap position so far in 2008 and built up a US$1.4 billion short position of nondeliverable forwards. Gross international reserves have been kept steady at around US$36 billion (240 percent of short-term debt), partly propped up through higher external borrowing by the BSP.

A01ufig14

Foreign Exchange Volatility

(Peso-US$ 1 month option contracts)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Source: Bloomberg.
A01ufig15

Foreign Currency Reserves and Swaps

(In billions of US$)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: The Philippine Authorities and CEIC Data Company Ltd.; and IMF staff calculations.1/ Minus pledged assets.

Policy issues and staff views

19. The shift from a tightening to a neutral monetary stance was appropriate considering the rebalancing of risks. Staff shares the BSP’s assessment that inflationary pressures are beginning to recede, led by falling commodity prices and a softening demand outlook. Moreover, the downside risks to growth and the elevated level of uncertainty surrounding the near-term outlook are important considerations.

20. If downside risks materialize, the policy response would depend on the nature of the shock. In the event the economic slowdown proves protracted and inflation expectations adjust sufficiently downwards, a likely scenario, monetary policy could be eased (Box 2). In this case, the exchange rate should be allowed to fully adjust to the changing external environment, limiting interventions to smoothing erratic movements. However, in the case of a temporary financial shock arising from further global portfolio adjustment, the BSP could use a mix of interest rate hikes and limited unsterilized intervention to support the peso. In both cases, preserving the level of reserves at a sufficiently high level will help provide confidence in the peso and the resilience of the financial system.

21. The exchange rate is assessed to be broadly in line with the level implied by longer-term fundamentals. As such, it does not pose a threat to external stability. This assessment rests on a number of observations, including (i) interventions in recent years have been in both directions, intended to smooth erratic exchange rate changes; (ii) current account balances projected at a constant real effective exchange rate imply only a small improvement in the net foreign asset position over the medium term; and (iii) quantitative estimates suggest the exchange rate does not deviate significantly from its long-term equilibrium level, especially when taking remittances into account.10

Equilibrium Exchange Rate Estimates: CGER

article image
Sources: CGER and; IMF staff 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 2013.

Vulnerabilities if Downside Risks Materialize

A significant slowdown in the global economy and continued financial turmoil (international capital markets accessible but at a much higher cost and stronger capital reflows to advanced countries) could seriously disrupt the economy.

  • Financial sector: Banks will be impacted through both domestic and global channels as discussed in Section IV.A. A number of banks could buckle and the authorities would need to protect depositors and restructure weak but viable banks to contain the crisis.

  • Public finances: Revenues will fall, but the immediate impact of rising funding costs would be limited due to the high share of fixed rates. However, a significant depreciation of the exchange rate would push up the debt level. Financial sector bail outs or realization of contingent liabilities (including from government guarantees) would dent the fiscal position markedly, but not threaten sustainability (see also Appendix II).

  • External position: Sensitivity analysis shows a large effect on the external position from declines in investor confidence and remittance inflows. If FDI, portfolio flows, and rollover of private and public sector debt are cut in half (Case I), the impact is manageable. However, if in addition foreign investors liquidate half of their portfolio equity stock and one-fourth of their FDI stock (Case II), there is a more pronounced impact. Moreover, if workers remittances drop by 25 percent and total foreign currency deposits are withdrawn (Case III), a low probability scenario, reserves almost completely evaporate (see also Appendix I).

A01ufig16

Sensitivity of the Fiscal Position To Shocks in 2009

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

A01ufig17

To Shocks in 2009 Sensitivity of the Reserves to Shocks in 2009

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

The authorities’ views

22. The authorities broadly agreed with staff’s recommendations. It was too early to ease monetary policy at this stage with inflation still running high despite the recent deceleration. Moreover, the authorities were concerned that lower interest rates could add to the downward pressures on the exchange rate, which could also fuel inflation given the large share of imports in the consumption basket. However, the outlook for commodity prices and the projected economic slowdown was expected to reduce price pressures. Together with monetary easing elsewhere, this could provide them with some monetary flexibility. If downside risks to growth were to materialize and inflation expectations decline sufficiently, the authorities would stand ready to reduce policy rates. That being said, monetary policy should not carry the burden alone, but fiscal policy should also provide counter-cyclical impetus.

23. The authorities concurred with staff’s assessment of the exchange rate. They welcomed staff’s efforts to enrich the quantitative exchange rate assessment by taking into account remittances, an important determinant of the exchange rate in the Philippines. They further pointed out that the peso is market determined and interventions are limited to lessen undue volatility. This had been demonstrated clearly by the large appreciation of the peso until end-2007 and the subsequent significant depreciation. In this regard and as part of an ongoing discussion of the classification of the Philippine’s exchange rate system, the authorities reiterated their concern that the Fund’s continued focus on formal and narrow classifications of exchange rate regimes is not in sync with operational realities. Furthermore, it could detract too much attention from the underlying economic issues at hand.

C. Fiscal Policy

24. The 2008 budget will likely record a deficit of 1 ½ percent of GDP, a slight improvement over last year’s 1.7 percent of GDP. The tax effort is expected to remain broadly unchanged at around 14 percent of GDP as windfall gains from high oil prices will be broadly offset by changes to the income tax law (Box 3) and weaknesses in domestic VAT collection. On the expenditure side, higher current spending is expected to be offset by lower-than-budgeted capital expenditure, reflecting weak absorptive capacity. Nonfinancial public sector debt in percent of GDP is projected to rise modestly this year, due largely to a weaker exchange rate, reversing the recent trend.

A01ufig18

National Government Revenue

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

Sources: Data provided by Philippine authorities; and IMF staff estimates and projections.
A01ufig19

National Government Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 062; 10.5089/9781451831436.002.A001

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

25. The 2009 deficit target has been revised up and financing conditions could become more challenging in 2009. The originally envisaged 2009 budget deficit target was ½ percent of GDP, in line with plans to balance the budget in 2010. In light of the slowing economy, the proposed deficit has been revised up to 1 ½ percent of GDP to accommodate higher capital outlays and a modest increase in pro-poor spending. It now awaits Senate approval. On this basis, the public sector gross financing requirement for 2009 is estimated at 18 ½ percent of GDP, of which close to 40 percent is external. The power sector is a significant contributor to the foreign currency financing requirement, although this can partly be met from past privatization proceeds. Also, gross financing needs could increase significantly in percent of GDP if the peso were to depreciate further or contingent liabilities were to be realized, including from outstanding guarantees as well as government-linked corporations and financial institutions.

Recent Tax Policy Reforms and Options for Tax Base Broadening

Recent and planned reforms aim to stimulate investment and support household consumption, but result in a significant revenue loss—about 0.6 percent of GDP. Reforms include:

  • Personal income tax: The exemption levels for personal income taxes were raised; the optional standard deduction (OSD) was increased from 10 percent to 40 percent of gross income in lieu of listed allowable deductions; the OSD is now available to corporations (estimated loss of P 20 billion).

  • Corporate income tax: The corporate income tax rate to be reduced from 35 percent to 30 percent in early 2009 (estimated loss of P 26 billion).

  • Personal Equity and Retirement Act (PERA): Contribution is possible up to P 50,000 per year (P 100,000 for married couples) and entails a 5 percent tax credit. Withdrawals, after reaching age 55, are tax exempt (estimated loss of P 2 billion).

The authorities and staff agree that, to offset the revenue loss, tax base broadening and administration reform remain key:

  • Rationalizing tax incentives: A compromise Bill currently being discussed would phase out the income tax holiday (ITH) in six years. After it expires, companies would be subject to a lower income tax rate of 15 percent or a 5 percent tax on gross income earned.

  • Accelerating tax administration reform: Implementation of tax administration reforms agreed with the authorities in 2005 has been slow. The priorities at the Bureau of Internal Revenue include taxpayer registration, arrears collection, returns filing, and improving audits. Progress in customs administration reform has been particularly poor; priorities continue to be strengthening management controls and the integrity of the import and export clearance system and upgrading enforcement/intelligence functions.

  • Raising and indexing excises: Unifying, raising, and indexing excise rates on tobacco and alcohol products, as proposed in House Bill No. 3759 (estimated gain of P 31.8−P 33.8 billion).

Public Sector Gross External Financing Need

(In billions of U.S. dollars)

article image
Sources: BSP, DoF; and IMF staff estimates>.

26. Large deficits have emerged at the National Food Authority (NFA). The NFA buys imported and domestically produced rice and, on average, sells at a lower price to targeted poor or in remote regions where poverty is prevalent. With higher import volumes and food prices, NFA’s deficit is projected at 1 percent of GDP this year from a broadly balanced position in 2007.

27. Power sector privatization remains a priority. To date, the government has privatized around 70 percent of its generating assets (Luzon-Visayas grid), including two generation plants this year, and plans to finalize the privatization of the generating assets by 2009. FDIs will be key for the successful completion of the privatization plan and sustainable power sector development. In this regard, the slow adjustment of electricity-tariffs to global input prices (e.g., oil price) and lack of transparency in the pricing mechanism are concerns for investors.

Policy issues and staff views

28. Staff saw some scope for a measured fiscal policy easing to cushion the slowdown. The 2009 deficit target relies on an ambitious revenue target of 15.9 percent of GDP. Staff projects revenues of 14.9 percent of GDP and, thus, in the absence of additional tax efforts or some expenditure restraint, meeting the deficit target would be difficult. This could rekindle investor concerns about the authorities’ commitment to fiscal discipline, especially in light of the declining tax effort, increasing debt-to-revenue ratio, and the current challenging financing environment. Consequently, staff suggested that the deficit be capped at 2 percent of GDP, the bulk of which could be financed domestically without placing undue strain on the local market given the high level of peso liquidity in the banking system. To achieve this deficit, without unduly squeezing expenditure, it would be preferable to raise the tax effort through administrative and legislative measures, such as reforming sin taxes and streamlining fiscal incentives in line with current proposals before Congress (Box 3). Otherwise, expenditures on infrastructure, wages, and maintenance and operations will have to be kept broadly unchanged from projected 2008 levels (in percent of GDP), while protecting higher spending on well-targeted pro-poor programs.

29. Plans to streamline the operations of the NFA and other government-owned and controlled corporation (GOCCs) should move forward. Since the NFA does not target at the household level, the authorities’ goal of protecting the poor can be better realized through fundamental reform of NFA aimed at full cost recovery of operations and limiting its role to providing food security. The generated savings could in turn be used for well-targeted conditional cash transfer schemes.

30. It is important to carry through with the planned privatization of the power sector to promote more cost-efficient supply of electricity. In this regard, more transparent and market-based tariff adjustments would be desirable to attract investors’ interest. At the same time, the timing of the planned auctions should be flexible in view of the prevailing market conditions.11

31. The introduction of a more formalized medium-term fiscal framework could help better anchor fiscal policy. A good first step in this direction would be to submit the medium-term expenditure framework alongside the budget to the legislature. Consideration could also be given to adopting a Fiscal Responsibility Law, focusing on responsible and transparent budget management, including a provision requiring that new spending or tax proposals are fully financed. This could eventually be supplemented by the introduction of an explicit numerical rule to anchor fiscal policy.12

32. Public sector debt is broadly sustainable, but staff encouraged closer monitoring and management of contingent liabilities, including from outstanding government guarantees. As elaborated in Appendix I, the public debt level is sustainable but sensitive to exchange rate changes and contingent liability shocks. For example, in the event of a 10 percent of GDP increase in public debt from realization of contingent liabilities or bank recapitalization, it would take the government five years to return debt to the pre-shock level. Combined with a more formalized medium-term fiscal framework, closer monitoring of contingent liabilities could help enhance the risk management of the public sector balance sheet.

The authorities’ views

33. The authorities agreed that the near-term fiscal easing should be measured to strike the right balance between fiscal credibility and growth concerns. They considered their deficit target achievable, but acknowledged that the current uncertain economic environment presented risks to the revenue outlook. In this regard, they were hopeful that current proposed changes to sin taxes and tax incentives could be approved by the legislature. In the event they could not attain their revenue target, they would scale back expenditure and agreed that a deficit cap of around 2 percent of GDP would be appropriate.

34. The authorities reiterated their commitment to fiscal consolidation over the medium term and were receptive to the introduction of a more formalized medium-term framework. They agreed with staff that the need to enhance social and physical infrastructure called for revenue-based consolidation in line with current proposals. As staff, they saw merit in strengthening the targeting of existing cash-transfer schemes and taking steps to further build absorptive capacity to improve execution of capital spending programs. They also considered the gradual rationalization of NFA and the introduction of monitorable performance targets of other GOCCs as an integral part of the consolidation process, and were intent on finalizing the privatization of the power sector. Finally, the authorities were interested in establishing a more formalized fiscal framework to further strengthen fiscal management, but cautioned that this would require cooperation from Congress, which had not supported a previously proposed Fiscal Responsibility Law.

V. Staff Appraisal

35. The Philippines face a challenging economic environment, but starts from a position of relative strength. Growth is expected to slow to 4.4 percent in 2008 and 3½ percent in 2009, led by deceleration in external demand and private consumption as remittances level off. Inflation is projected to decline from 9 ½ percent in 2008 to 6 percent in 2009 as commodity prices recede further and demand eases. However, a prolonged global downturn present downside risk to the growth outlook.

36. Financial sector reform in recent years has strengthened bank soundness, but the sector is exposed to domestic and external sources of risk. Supervision has been strengthened in recent years through the upgrading of the BSP’s supervisory capacity, the introduction of the risk-based CAMELs approach, and the adoption of the Basel II and international accounting standards. Nevertheless, banks will not be able to escape the impact of the economic slowdown on their earnings and asset quality. Moreover, on the external side, a continuation of strained conditions in global financial markets could lead to further losses on the large security holdings. External financing conditions could be tight and off-balance sheet activities may entail reputational risks in case of severe redemption pressures.

37. To help forestall further fallout from the global financial crisis, the BSP should continue to closely monitor the banking sector and retain supervisory vigilance. Heightened surveillance should continue, including close monitoring of off-balance sheet activities. While the relaxation of mark-to-market accounting rules has provided some relief, it does not constitute a permanent solution and it is important that it is not allowed to impair transparency about financial soundness. The BSP’s proactive steps to address liquidity strains are welcome and staff encourages a flexible application of existing facilities as needed to stem further stress.

38. The PCA framework is broadly appropriate, but there is some scope for improvement. The BSP should be given legal authority to disclose enforcement actions, while preserving the right to nondisclosure if needed to avoid loss of market confidence. The introduction of a more rules-based framework and triggers tied to increasingly stringent remedial action could also be considered over the medium term. Concurrently and without any further delay, the BSP charter should be amended to strengthen legal protection of BSP staff.

39. The proposed increase in deposit coverage to P 500,000 is welcome, but further steps to strengthen the bank resolution framework are encouraged. Flexibility to increase deposit insurance coverage temporarily would be important in high stress cases. The envisaged introduction of a bridge-bank facility is welcome, but could be complemented by a more flexible application of the purchase-and-assumption tool to strengthen the resolution toolkit. Bank restructuring decisions should be irreversible and PDIC staff should be protected against litigation.

40. The current neutral monetary stance appropriately balances the risks to inflation and growth, but may have to be adjusted if downside risks materialize. The credibility of the inflation targeting framework has helped anchor inflation expectations. BSP’s commitment to the framework was underscored when they, in mid-2008, decisively hiked rates to address second-round effects from the commodity price shock. A protracted slowdown, now a likely scenario, provide scope for monetary easing if inflation expectations continue to adjust downwards. The exchange rate should in this case be allowed to adjust fully to the changing external environment, with interventions limited to smoothing erratic movements. A temporary financial shock, on the other hand, may call for a hike in interest rates and limited unsterilized intervention. Even then, preserving sufficiently high reserves will help provide confidence in the peso and the resilience of the financial system.

41. The exchange rate is assessed to be broadly in line with the level implied by longer-term fundamentals. As such, it does not pose a threat to external stability. Interventions in recent years have largely been in both directions, intended to smooth erratic exchange rate changes. Moreover, quantitative estimates suggest the exchange rate does not deviate significantly from its long-term equilibrium level.

42. Fiscal policy should help to cushion the current slowdown. Fiscal consolidation has significantly reduced the public debt-to-GDP ratio in recent years. However, the room for fiscal stimulus is limited as the debt level still remains high and the tax effort has declined, with gains from the landmark EVAT reform eroded by other tax measures. Based on this, fiscal easing should be measured to avoid compromising credibility, capping the fiscal deficit at 2 percent of GDP. To achieve this, the authorities should raise the tax effort through administrative measures and tax reform. Otherwise, expenditures will have to be contained, except for outlays on well-targeted pro-poor cash benefits.

43. Looking ahead, a formalized medium-term fiscal framework should be considered. A good first step would be to submit the medium-term expenditure framework alongside the budget to the legislature. Consideration could also be given to adopting a fiscal responsibility law, which could involve provisions requiring that new tax or expenditure measures be fully financed. It could also involve the introduction of a numerical fiscal rule to help anchor fiscal policy.

44. Operations of the NFA and other GOCCs should be streamlined further and privatization of the power sector should continue. The authorities’ goal of protecting the poor can be better realized through fundamental reform of NFA aimed at full cost recovery of operations and limiting its role to providing food security, using the savings for well-targeted conditional cash transfer schemes. A comprehensive review of the operations of other GOCCs, eventually leading to monitorable performance targets, remains a priority as well. To attract investments in power companies, a more transparent and market-based tariff adjustment mechanism would be desirable. The authorities should proceed with remaining power sector privatization, although timing of the planned auctions may need to be delayed due to the prevailing constrained market conditions.

45. Staff recommends the next Article IV consultation be on the standard 12-month cycle.

Table 1.

Philippines: Selected Economic Indicators, 2004–09

Nominal GDP (2007): P6,648 billion ($144.1 billion)

Population (2007): 88.6 million

GDP per capita (2007): $1,624

Poverty headcount ratio at $2 a day at PPP (2003): 43 percent

IMF quota: SDR 879.9 million

Main products and exports: Electronics and agricultural products

Unemployment rate (2007): 7.3 percent

article image
Sources: Philippine authorities; and IMF staff estimates and projections>.

Defined as the difference between gross investment and current account.

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).

Secondary market rate.

October 2008.

November 2008.

Defined as external debt plus liabilities of foreign banks in the Philippines to their headquarters, branches and agencies, 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 pledged assets.

Table 2.

Philippines: National Government Cash Accounts, 2005–09

(In percent of GDP; unless otherwise noted)

article image
Sources: Philippine authorities; and IMF staff projections

Staff projections based on currently-identified measures, assuming modest gains from tax incentives reform and from administrative improvements. For 200 also assumes some expenditure compression relative to the budget.

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

Excludes purchase of NPC securities and other on lending; 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, 2004–09

(In billions of U.S. dollars)

article image
Sources: Philippine authorities; and IMF staff projections

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 exports 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: Depository Survey, 2006–08

(In billions of pesos; unless otherwise noted)

article image
Sources: Philippine authorities; CEIC; and IMF staff estimates

Based on New Depository Corporation Survey.

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, 2006–13

(Currently identified measures scenario)

article image
Sources: Philippine authorities; and IMF staff estimates and projections

Defined as the 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.

Table 6.

Philippines: Banking Sector Indicators, 2003–08

(End of year; unless otherwise indicated)

article image
Sources: Philippine authorities; and IMF staff calculationsNote: ROPA = Real and Other Property Acquired. ROPA is a measure of the stock of foreclosed properties held by a bank

Nonperforming Loans (NPL) Ratio (excluding IBL).

(Nonperforming loans + ROPA) over total gross assets.

Ratio of (NPLs + Gross ROPA + current restructed loans) to (Gross total loan portfolio + Gross ROPA).

Ratio of loan loss reserves to NPLs.

Ratio of valuation reserves (for loans and ROPA) to NPAs.