Staff Views

9. Domestic demand should support growth in 2012, offsetting sluggish external demand. Growth is projected to rise from 3.7 percent in 2011 to 4.2 percent in 2012 as public and private demand strengthen, reflecting a recovery in government spending, the start of long-awaited public-private partnerships (PPPs), supportive monetary conditions, and robust remittances. With external demand still weak, net exports will continue to make a negative contribution to growth in 2012, although the drag should be smaller than in 2011 as the unwinding of inventories reduces import growth. The balance of payments is likely to remain in surplus as remittances and service exports fuel the current account, and positive growth and yield differentials versus advanced countries attract capital inflows. Inflation should move toward the mid-point of the BSP’s target range in the absence of food and fuel price shocks, as the negative output gap holds down price pressures.

10. The outlook is subject to significant downside risks that arise mainly from global spillovers. Measures to revitalize investment may increase growth relative to the staff’s forecast, but on balance the global economy represents a clear downside risk. Renewed shocks to global activity, or a prolonged period of sluggish growth, could have substantial spillovers to the domestic economy through goods and services exports, financial flows, and remittances (Box 1). At home, low lending rates may continue to fuel credit demand, and banks may face pressure to loosen lending standards as excess reserves build up and rates on alternative assets (such as Treasury bills) remain low.

11. Over the medium term, growth is projected to recover to its potential rate of around 5 percent. Although external demand may remain sluggish for some time, the impact on net exports would be mitigated by the fact that electronics (the main export) rely to a significant extent on imported inputs. Domestic demand should be supported by remittances and a continued expansion of BPO, tourism, and other sectors. The staff’s growth projection is lower than the authorities’ 7-8 percent growth target, which in the staff’s view would require additional measures to attain. Measures would be needed in particular to further strengthen the investment environment and public infrastructure, as well as job creation and productivity. The balance of payments should remain in surplus as remittances and export diversification contribute to a current account surplus of nearly 2 percent of GDP and structural drivers continue to attract capital inflows.

Authorities’ Views

12. The authorities shared the staff’s outlook and assessment of risks, although they expected growth to be somewhat higher. Agriculture, tourism, BPOs, construction, and a resumption of the Asian supply chain could contribute to a recovery in growth to 5 percent or higher in 2012 and, combined with measures to boost investment, toward the 7-8 percent target over the medium term. However, the authorities broadly shared the staff’s views on the risks to the outlook, and noted the significant impact that negative shocks from advanced economies were already having on the Philippines. The BSP was actively monitoring risks to macroeconomic stability through its early warning and financial stress exercises and found the system to be resilient to a range of potential shocks.

Box 1.

Philippines: Spillovers from the Global Economy ¹/

As a small open economy, the Philippines is influenced by global developments through both trade and financial channels. Weaker global growth causes demand for exports to decline, which in turn also affects consumption and investment. The financial system has only limited exposure to Europe and little reliance on foreign wholesale funding, but contagion could still occur through pullbacks of credit by European banks to the domestic corporate sector or a retreat by foreign investors from local equity and bond markets.

Exports, remittances, and portfolio and other capital flows are important transmission channels for external shocks. The share of goods and services exports in GDP is about 50 percent, making trade a key channel. Supply chain disruptions can have significant effects, as seen in the aftermath of the natural disasters in Japan. Philippine exports have benefited in recent years from rising demand by China, which has become an important trade partner. By the same token, a slowdown in China would affect the Philippines. The euro area has also become more important as a destination for Philippine intermediate goods exports and its share is twice as large as in ASEAN peers. More generally, the euro area and United States are key trading partners, each accounting for around 15 percent of merchandise exports, and are important destinations for Overseas Filipino Workers (OFWs). Remittances are equivalent to around 10 percent of GDP and, although they held up well during 2008-2009, a global downturn would hurt the earnings on which they are based. Non-FDI capital flows have increased in importance, driven by portfolio inflows.

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Philippines: Exports, Remittances, and Non-FDI Capital Flows

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

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The staff estimates that in a downside global scenario Philippine growth could drop by about two thirds of the decline in external growth before any fiscal and monetary response. The trade channel is more important than the financial channels. In an illustrative scenario, the output gap would turn negative, contributing to a decline in inflation, and the fiscal balance would deteriorate due to revenue automatic stabilizers. The impact on exports and fixed investment is larger than the impact on private consumption, reflecting the resilience of remittances. The current account balance falls at first as exports decline faster than imports, and then rises as weaker domestic demand leads to lower imports.

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Philippines: Deviations from Baseline in Downside Scenario ¹/

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

¹/ Assumes a -3.5 percent shock to output in the euro area and -1 percent in the United States for two years. Incorporates effects on other major economies based on the Global Integrated Monetary and Fiscal (GIMF) model.

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1/ See selected issues paper for details.

Staff Views

13. Monetary policy has responded well to changing circumstances. The start of monetary tightening in early 2011 helped to forestall inflation pressures. The pause in recent months has been justified by heightened global downside risks, low core inflation, and the relatively short lags in the Philippines between policy moves and inflation. Policy easing is, however, not needed at this time because monetary conditions are still supportive of growth. At the same time, the authorities would need to respond proactively if inflation and activity were to show signs of picking up faster than anticipated.

14. The monetary transmission mechanism is hampered by the fall in short-term Treasury and interbank rates below policy rates. ¹ In particular, moves in the policy rate might have only a limited impact on lending rates, which are influenced by interbank and Treasury rates. The BSP’s ability to mop up excess liquidity associated with large external inflows is constrained by its small remaining holdings of treasury securities for repo operations and its lack of legal authority to issue central bank securities for monetary policy operations. It is important in this context for the BSP to have the tools necessary for active liquidity management, including the ability to issue its own bills. In the interim, a close coordination of Treasury issuances and monetary policy could help strengthen the monetary mechanism.

Authorities Views

15. The authorities agreed with the staff’s characterization of monetary policy. In particular, they appreciated the staff’s view that the pause in monetary tightening was warranted. They viewed inflation pressures as moderate but felt that monetary easing was not needed at this juncture, because monetary policy was already supportive of growth and fiscal policy was expected to provide stimulus in the near term. Monetary policy could be eased if growth prospects were to deteriorate further. They agreed that it would be helpful for the BSP to be allowed to issue its own bills to enhance the effectiveness of monetary policy.

Background

16. The authorities have used a varied toolkit for managing external inflows to the Philippines in recent years. The exchange rate has appreciated in real effective terms. Meanwhile, international reserves have risen rapidly, including during the global financial crisis, and are well above standard precautionary metrics as well as the Fund’s new adequacy metric. The BSP has sterilized much of the reserve buildup in order to avoid an undue expansion in monetary aggregates, and sterilization costs have increased owing to domestic-foreign interest differentials. The authorities have liberalized controls on capital outflows, prepaid some external debt, and had in place for some years macro-prudential measures that have worked well. Effective January 2012, the BSP raised market risk weights on banks’ nondeliverable forward (NDF) positions, which were considered to be large in size and speculative in nature. The move was seen as a macro-prudential measure to forestall systemic risk to the banking system from exchange market volatility.

Philippines: Net International Reserves, End-2010

Sources: CEIC Data Company Ltd; IMF, WEO database; IMF Policy Papers, Assessing Reserve Adequacy (February 2011); and IMF staff calculations.

Philippines: Net International Reserves, End-2010

	In Months of Imports	In Percent of Short-Term Debt (STD)	In Percent of Broad Money	In Percent of STD and Foreign Currency Deposits	In Percent of New IMF Metric
Indonesia	7.5	132.6	35.0	…	150.9
Malaysia	6.8	353.4	30.3	221.8	113.8
Philippines	10.2	375.8	50.3	157.2	310.4
Thailand	10.0	307.9	44.0	282.6	308.4

Sources: CEIC Data Company Ltd; IMF, WEO database; IMF Policy Papers, Assessing Reserve Adequacy (February 2011); and IMF staff calculations.

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Philippines: Net International Reserves, End-2010

	In Months of Imports	In Percent of Short-Term Debt (STD)	In Percent of Broad Money	In Percent of STD and Foreign Currency Deposits	In Percent of New IMF Metric
Indonesia	7.5	132.6	35.0	…	150.9
Malaysia	6.8	353.4	30.3	221.8	113.8
Philippines	10.2	375.8	50.3	157.2	310.4
Thailand	10.0	307.9	44.0	282.6	308.4

Sources: CEIC Data Company Ltd; IMF, WEO database; IMF Policy Papers, Assessing Reserve Adequacy (February 2011); and IMF staff calculations.

Staff’s View

17. Reserves and exchange rate flexibility can provide a cushion against external shocks while facilitating adjustment to sustained external inflows. The real exchange rate remains broadly in line with its medium-term fundamentals based on the standard approaches as well as an alternative estimation that takes into account long-term trends in remittances and the current account that may differ from medium-term outcomes.² The staff supports the authorities’ stated policy of limiting foreign exchange market intervention to smoothing operations and allowing the exchange rate to adjust to market pressures. In this context, should volatile outflows occur, there is scope to use reserves to smooth the effects of such outflows. The regulatory move with respect to NDFs could be a useful part of the macro-prudential toolkit and help avoid disruptions to the onshore foreign exchange market. With the exchange rate not overvalued, sustained inflow pressures over the medium term, however, would need to be met by exchange rate adjustment.

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Real Exchange Rate Assessments ¹/

(Deviation from equilibrium, in percent)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

Source: IMF staff estimates.¹/ This approach derives a current account norm by smoothing remittance income to yield a constant real income stream per capita.

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Authorities’ Views

18. The authorities emphasized that their response to external inflows was based on striking a balance among a range of measures in the toolkit. Reserves were high but not, they felt, as excessive as the Fund’s adequacy metric would suggest since the insurance value was hard to measure. Reserves had provided an important buffer during the global crisis as well as the turbulence during 2011. Moreover, markets and rating agencies tended to react negatively toward emerging economies whose reserve levels fell abruptly.

Background

19. The authorities remain committed to pursuing a gradual fiscal consolidation over the medium term. The fiscal plan announced in 2010 envisaged a gradual reduction in the national government deficit from 3½ percent of GDP in 2010 to 2 percent of GDP from 2013 onwards. In 2011, the deficit has fallen significantly below the targeted 3 percent of GDP, but the authorities have retained the deficit targets for 2012 (2.6 percent of GDP) and the medium term. Under the envisaged path, fiscal consolidation over the medium term would allow for a stimulus in 2012 as expenditures pick up after their temporary drop in 2011. Over the medium term, the consolidation path would generate primary surpluses of about 1 percent of GDP and reduce the public debt to GDP ratio from 51 percent in 2011 to 44 percent by 2016.

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Public Sector Debt ¹/

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

Source: IMF, World Economic Outlook; and IMF staff estimates.^1/ The coverage of the public sector is as follows. Nonfinancial public sector for Philippines; general government for Thailand and Malaysia; central government for China and Indonesia.

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Public Sector Primary Balance ¹/

(In percent of GDP)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

Source: IMF, World Economic Outlook; and IMF staff estimates.^1/ The coverage of the public sector is as follows. Nonfinancial public sector for Philippines; general government for Thailand and Malaysia; central government for China and Indonesia.

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20. The main elements of the authorities’ fiscal strategy are stronger tax administration, a reorientation of expenditure toward social sectors and infrastructure, and a public debt management strategy that reduces exchange rate and maturity risk. Tax administration efforts are being supported by technical assistance from the U.S. Millennium Challenge Corporation compact and the Fund, and are estimated to have generated a substantial gain in revenue in 2011 (½ percent of GDP). Expenditure plans include a greater emphasis on basic education, an expansion of conditional cash transfers (CCTs) that directly benefit vulnerable people, and wider health care coverage. The PPP projects to develop infrastructure will start from 2012. The civil service wage bill, however, will continue to rise in 2012 as a result of wage adjustments under the ongoing 2009-2012 Salary Standardization exercise and will account for 40 percent of primary expenditure. The debt profile is sustainable under a range of shocks and, to reduce vulnerabilities further, the authorities have continued to issue peso-denominated global bonds and conduct debt swaps that, respectively, reduce the shares of foreign currency and short-term debt.

Staff’s Views

21. The staff supports the government’s intention to follow a revenue-based fiscal consolidation over the medium term that nonetheless allows for a supportive stance in the near term.³ Notwithstanding the rise in the deficit in 2012, the medium-term debt path would still be lower than the original plan envisaged, owing to the greater than intended debt reduction in 2011. The planned medium-term consolidation would help to expand the space for the budget to deal effectively with potential shocks including frequent natural disasters, further anchor expectations, and reduce the government’s gross financing requirement. Given the Philippines’ substantial social and infrastructure needs for building faster and more inclusive growth, it is appropriate that consolidation efforts are focusing on raising the (low) ratio of revenue to GDP while reorienting expenditure toward priority areas. Once the current round of civil service wage adjustments is completed, the civil service wage bill should be carefully managed in order to avoid crowding out other priority spending.

22. Achieving the authorities’ fiscal objectives will require a sizable tax effort. The staff supports the authorities’ initial focus on improving tax administration that should help over time to enhance revenue collection. Early actions to simplify the tax system and broaden the base should complement the planned tax administration measures, whose full benefit is hard to predict and will take time to materialize. In 2012, in order for the budgeted expenditure and deficit objectives to be achieved, an increase in revenue will be required equivalent to 1½ percent of GDP. The authorities estimate, and the staff agrees, that tax administration improvements could yield revenue increases equivalent to ½ percent of GDP. Consequently, additional tax measures are likely needed, such as measures to reform excises, rationalize fiscal incentives, and address inefficiencies in the VAT to broaden the tax base.⁴ Such measures would also make the tax system more equitable and easier to administer. In this context, the staff welcomes the authorities’ recent submission of bills to Congress to rationalize “sin taxes” and streamline tax incentives that would go some way toward raising the additional revenue needed.

23. The authorities continue to make important progress in strengthening the fiscal framework. Key recent initiatives include passage of the Government-Owned and Controlled Corporation (GOCC) reform act, and the introduction of zero-based budgeting and a fiscal risk statement.⁵ These initiatives will also complement the authorities’ efforts to limit rice and transport subsidies by GOCCs and move instead to better targeted CCTs, and efforts to monitor GOCCs’ contingent liabilities. The planned PPPs should be helpful for building infrastructure, but their fiscal risks should be monitored carefully and reflected in the fiscal accounts.⁶ The pension system for uniformed personnel is due to experience a substantial increase in benefit payments over the coming years that needs to be managed in a fiscally sustainable way.

Authorities’ Views

24. The authorities reiterated their firm commitment to medium-term fiscal consolidation. This commitment and the improvement in the public debt profile over the past year as a result of debt management operations to reduce currency and rollover risks had helped to improve the credibility of the fiscal framework and been recognized by markets and rating agencies. The authorities continued to view their fiscal plans as achieving a good balance between fiscal consolidation and an appropriate level of development spending.

25. The authorities will continue to reorient expenditure toward key priorities for inclusive growth such as social safety nets, human capital, and infrastructure. With new budget processes in place and greater transparency in public spending, the execution of public projects should be easier and less costly to implement in future, allowing budget spending to rise toward targeted levels. The PPPs that would start in 2012 would gather pace in future years. The authorities may consider introduction of a performance-based compensation system for civil servants that would enhance efficiency of the service and could help to keep in check the wage bill. The authorities were considering options to put the pension system for uniformed personnel on a sustainable footing.

26. The increase in revenue that would be required for fulfilling the 2012 deficit and expenditure objectives would be delivered by the improvements in tax administration and the sin tax and incentives measures. Other tax reforms were not planned at this time, reflecting both the authorities’ desire to first maximize the gains from improving tax administration and simplifying the tax system and the fact that the appetite for tax measures in the legislature may wane as the May 2013 mid-term elections approach. Should these revenue gains prove insufficient for meeting the fiscal objectives, the authorities would reduce nonpriority expenditure or speed up privatization to provide additional resources to support spending.⁸

Background

27. The financial sector has been resilient to the global turbulence so far. Banking sector indicators remain consistent with the 2010 Financial System Stability Assessment (FSSA) of the sector’s soundness.⁷ The BSP’s recent bank stress testing exercise suggested that the banking sector is well placed to withstand the direct effects of a range of shocks. Asset price overheating has not been a concern, with equity price earnings ratios broadly in line with historical averages and property price increases moderate. Financial markets were buffeted during the period of emerging market stress in August-September, but recovered in subsequent months.

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Selected Asia: Debt to Equity Ratio

(Market capitalization weighted average)

Citation: IMF Staff Country Reports 2012, 049; 10.5089/9781463939731.002.A001

Sources: Worldscope database; and IMF staff calculations.

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Staff’s Views

28. The staff welcomes the authorities’ careful monitoring of risks to the financial sector. Potential spillovers from global financial disruptions, real estate exposures, rapid credit growth, and concentration and interest rate risk represent some of the key vulnerabilities.⁹ The financial system has only limited exposure to Europe (1½ percent of total assets), but contagion could occur through pullbacks of credit by European banks, whose lending is equivalent to nearly 10 percent of GDP, or a retreat by foreign investors from local markets. The prominent role of conglomerates as recipients of bank credit and as owners of banks, as well as the high leverage in parts of the corporate sector, call for a close monitoring of conglomerates and of potential feedback loops among banks. Rapid credit growth may pose risks for lending standards and asset quality as the credit cycle matures. In the real estate sector, anecdotal evidence of a rise in vacancy rates and softening of rents in certain niche segments may be a sign of emerging excess supply. The real estate exposures of nonbank financial institutions, and of property developers who fall outside the regulatory purview, could be an emerging vulnerability that requires close coordination among regulators. A contingency plan may be useful for preparing how to deal with a potential tail event.

29. The authorities have continued to strengthen the supervisory and regulatory framework in recent years, and have built on the progress noted in the 2010 FSSA update. The improvements have helped the financial sector to stay resilient through the global crisis and more recent strains. An important next step for bank supervision will be prompt Congressional approval of the amendments to the New Central Banking Act (NCBA) that would enhance supervision by providing supervisors with greater legal powers and protecting them from litigation, lifting the remaining constraints of bank secrecy laws on examiners, and further strengthening the prompt corrective action and bank resolution framework, as the FSSA Update recommended. The amendments would also allow the BSP to issue its own debt securities, providing a much-needed instrument to strengthen liquidity management. With respect to the AML/CFT regime, the authorities are committed to addressing the gaps noted by the Financial Action Task Force (FATF) and are awaiting Congressional approval of bills that they have submitted with legislative amendments to adequately criminalize money laundering and terrorist financing.

Authorities’ Views

30. The authorities broadly shared the staff’s assessment of financial sector soundness and vulnerabilities. They noted, however, that European banks in the Philippines were liquid, had access to a large local deposit base, and had not displayed undue signs of stress during recent episodes of global turbulence. Trade finance and dollar funding, for example, had not been interrupted. They noted that conglomerates’ revenue was well diversified across different business lines, which mitigated concentration risk, and that supervisors continued to pay close attention to the way systemically important conglomerates interface with banks. Regulators were coordinating closely to monitor potential vulnerabilities related to real estate.

Staff’s Views

31. Further negative global shocks could have substantial spillovers to the Philippines, but there is policy space to respond across a broad front. Many of the measures that were used successfully during the 2008-2009 global crisis could be reactivated. Reserves can be used to smooth the impact, and the exchange rate can also absorb part of the shock. Monetary tightening could be recalibrated or even temporarily reversed if needed. Fiscal policy will anyway provide a stimulus to growth in 2012, and there is scope to let the automatic stabilizers operate. If necessary, expenditures could temporarily be boosted faster than currently planned subject to appropriate expenditure management safeguards and within a strategy for medium-term consolidation. The fiscal multipliers would appear to have a larger impact than easier monetary conditions at this juncture, possibly because interest rates are already relatively low and lending conditions accommodative (Box 2). Financial market liquidity could be supported by special facilities, foreign exchange swaps, and lower reserve requirements.

Authorities’ Views

32. The authorities were also of the view that policy space exists for a strong response to further shocks. They had already prepared contingency plans and agreed that the 2008-2009 toolkit remained useful. Current policy settings were seen as supportive of growth, with the monetary stance not restrictive and fiscal policy set to expand in 2012.

Box 2.

Philippines: The Effectiveness of Macroeconomic Policy Responses to Global Shocks

It is important for macroeconomic policy to stand ready to respond flexibly to changing circumstances given heightened global uncertainties. A key policy issue is the relative strengths of monetary and fiscal policy in affecting short-term output developments in the context of the flexible exchange rate regime. Headline inflation is also susceptible to volatile commodity prices. The standard policy response to commodity price shocks, particularly in advanced economies, is to accommodate the first round effects of food and energy price swings on the Consumer Price Index (CPI) but not the second round effects on other CPI components and inflation expectations.

The GDP impact of macroeconomic policies and the second-round effects of commodity prices for the Philippines are estimated by an extended Global Projection Model (GPM) using Bayesian techniques.¹/ The key results are:

• The short-term impact of a 1 percent of GDP fiscal stimulus is slightly greater than the combined impact of a 100 basis points change in the policy interest rates and lending conditions (measured as the spread between the 91-day T-bill rate and the policy rate).²/ The impact of exchange rate depreciation is relatively weak.

• Global fuel and food prices can have a significant impact on headline inflation and significant second-round effects, which suggest a need to take account of the impact of volatile commodity prices when evaluating the inflation forecast and the monetary stance.

	Fiscal Balance (In percent of GDP)	Policy Rate (In percentage points)	Lending Conditions (In percentage points)	Real Exchange Rate (In percent)
Short-term impact on output gap	0.21	0.06	0.13	0.02

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	Fiscal Balance (In percent of GDP)	Policy Rate (In percentage points)	Lending Conditions (In percentage points)	Real Exchange Rate (In percent)
Short-term impact on output gap	0.21	0.06	0.13	0.02

Fiscal policy would be more effective than monetary policy in supporting economic activity in the current juncture. In particular, a cut in policy rates would only have a modest impact of economic activity without a concomitant easing of lending conditions. With T-bill rates close to the lower bound and lending rates already at historical lows, the scope for a substantial easing of lending conditions is limited.

1/ The extended GPM model-based results in IMF Country Report No. 11/58 and the selected issues paper estimate the impact of monetary and fiscal policies as well as the role of global commodity prices and macro-financial linkages through a lending conditions variable. 2/ The estimates of the fiscal and monetary impact were also comparable to a simple recursive VAR analysis.