Philippines: Selected Issues

Abstract

Philippines: Selected Issues

Improving Public Infrastructure in the Philippines1

This chapter explores the macroeconomic effects of improving public infrastructure in the Philippines. After benchmarking the Philippines relative to its neighbors in terms of quantity and quality of public infrastructure, and public investment efficiency, it uses model simulations to assess the macroeconomic implications of raising public investment and improving public investment efficiency. The main results are as follows: (i) increasing public infrastructure investment results in sustained gains in output; (ii) the effects of improving public investment efficiency are substantial; and (iii) deficit-financed increases in public investment lead to higher borrowing costs that constrain output increases over time, underscoring the importance of revenue mobilization.

A. Introduction

1. Boosting investment is a major structural challenge in the Philippines. At 21.8 percent of GDP in 2014, the investment rate in the Philippines is well below regional peers, as reflected in its low capital stock and infrastructure quality. The main impediments to private investment are inadequate infrastructure, a weak investment climate, and restrictions on foreign direct investment. Regarding public investment, the low revenue base and fiscal consolidation have prevented sufficient resource allocation in the past, while weak implementation capacity has led to budget under-execution more recently, especially in 2013–14. Raising investment, particularly in infrastructure, would allow the country to reap the dividends of its young and growing population.

Figure 1.
Figure 1.

Investment

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A004

Source: IMF, World Economic Outlook.

2. To address this issue, the government plans to increase infrastructure spending from 3 percent of GDP in 2014 to 5 percent by 2016, while also facilitating Public Private Partnership (PPP) projects. Immediate priorities include implementation of the transport system in Manila (Manila Dream Plan approved by NEDA) and improvements in airports, road connectivity, and seaports across the country. Although there is a consensus that public infrastructure needs to be improved, the macroeconomic effects of doing so may differ depending on how this is done.

3. This chapter explores the macroeconomic implications of improving public infrastructure. First, it benchmarks the Philippines relative to its neighbors in terms of the size of public investment and capital stock; the quality of public infrastructure; and public investment efficiency. It confirms that the level of public capital and the quality of public infrastructure are low in the Philippines, and that there is room for improvement in public investment efficiency. Subsequently, the paper simulates alternative ways to enhance public infrastructure and their macroeconomic effects using the IMF’s Global Integrated Monetary and Fiscal (GIMF) model.

4. Model simulations suggest that improving public infrastructure would result in a sustained output increase. Two types of scenarios are considered: (i) a permanent increase in public investment from 3 percent to 5 percent of GDP, financed by borrowing, (ii) the same increase in public investment, financed by higher consumption taxes. Then, each scenario is divided into sub-scenarios with and without gradual improvements in public investment efficiency. All scenarios exhibit sustained gains in output because improving public infrastructure leads to permanent gains in productivity, which crowds in private investment.

5. Alternative financing scenarios affect the economy differently. The debt-financed scenario results in a substantial increase in the public debt-to-GDP ratio, increasing the borrowing cost and constraining investment. In contrast, consumption is initially subdued in the tax-financed scenario because of lower disposal income. While the output gains are initially higher in the deficit-financed scenarios, these gains are larger in the tax-financed scenarios over time, with the increase in the government’s borrowing cost in the deficit-financed scenarios playing a key role.2 Both scenarios show substantial benefits from increased public investment efficiency.

6. Public infrastructure improvement influences the external current account and inflation. It leads to a worsening current account, thereby facilitating external rebalancing. It also generates additional domestic demand initially and thus inflationary pressures. Over time, the increase in supply capacity alleviates the inflationary pressures.

7. With a low capital stock and a fast growing young population, addressing the large infrastructure gap is needed to raise potential growth and reduce poverty and external imbalances. This chapter shows that improving public infrastructure can generate sustained output growth, and improving public investment efficiency is helpful in addition to a spending increase. Given the need to ensure debt sustainability amid the large spending needs in other priority spending areas for inclusive growth, continued efforts mobilize revenue will be critical, including by enacting measures to offset any revenue eroding policy changes and preferably through a comprehensive tax reform that focuses on broadening the tax base.

B. The State of Public Infrastructure in the Philippines

Quantity and Quality of Public Infrastructure

8. Persistently low public investment has resulted in a low public capital stock relative to its neighbors. IMF (2015) measures public investment and the stock of public capital for a large sample of countries, finding that the Philippines consistently had lower public investment than other ASEAN countries in the recent past, averaging 2.5 percent of GDP in 2000–14. As a result, the public capital stock is also one of the lowest among ASEAN countries, at around 35 percent of GDP in 2013 compared to an average of 72 percent of GDP.

Figure 2.
Figure 2.

ASEAN: Public Investment and Public Capital Stock

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A004

9. Survey-based indicators also paint an unfavorable picture for the current state of public infrastructure in the Philippines. The World Economic Forum’s global competitiveness report surveys business leaders’ impressions on a wide-range of topics in the business environment on a 1-7 point scale. Regarding key infrastructure services, it places the Philippines as the second lowest among the ASEAN countries and substantially lower than the ASEAN average.

Figure 3.
Figure 3.

Overall Quality of Infrastructure

(Scale, 1-7; higher score indicates better infrastructure)

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A004

Source: IMF, World Economic Outlook.

Public Investment Efficiency

10. The Philippines has made steady progress in governance and fiscal transparency. Its relative ranking in the World Bank’s World Governance Indicators has improved every year since 2010. The improvement has been especially sharp in the control of corruption. This reflects the high priority that the current administration has given to governance reform. Regarding fiscal transparency, IMF (2015b) assessed the Philippines’ Public Financial Management (PFM) practices against the draft Fiscal Transparency Code covering the three pillars of fiscal reporting, fiscal forecasting, and fiscal analysis and management. It acknowledged the authorities’ reform efforts and reached broadly favorable conclusions. The progress in recent years has resulted in significant improvements in the investment climate, and together with increased fiscal space, translated into higher private sector confidence.

11. However, there is still much room for improvement in public investment efficiency.

  • Assessments of public investment processes identify room for improving efficiency. The Public Investment Management Index (PIMI), developed by Dabla-Norris and others (2012), evaluates the strength of public financial management institutions across four stages of public investment processes: project appraisal, selection, implementation, and evaluation, and assigns a score between 0 and 4 for 71 developing countries, including 40 low income. The Philippines’ score (1.85) is significantly lower than the best performer in the sample (South Africa, 3.53) or the best performer in ASEAN (Thailand, 2.87). Among the sub-indexes, the Philippines’ scores are relatively favorable for strategic guidance and project appraisal but relatively weak for project selection. Consistent with this, a 2014 IMF technical assistance project on the medium term budget framework reports that a medium-term planning system has been established in Philippines Development Plan (PDP) and the Public Investment Program (PIP), but the link between planning and budgeting should be strengthened. Priorities include: undertaking a critical review of the stock of development projects to eliminate duplications, unnecessary projects, and those that are no longer priorities; anchoring planning within an overall medium term resource framework and improving high level coordination; strengthening the gate-keeping role played by budget agencies to choose projects appropriately for inclusion in the budget from the long list of candidates; improving departments’ appraisal, prioritization, and selection of projects, including multiyear budget preparation at spending agencies. More generally, the new PFM bill would be helpful by institutionalizing the reform efforts and establishing and clarifying fundamental elements of PFM framework.

  • An outcome-based estimation of public investment efficiency also suggests substantial room for improvement. IMF (2015a) develops the Public Investment Efficiency indicator (PIE-X). It first estimates the relationship between the public capital stock (input) and indicators of access to, and the quality of, infrastructure assets (output) for over 100 countries. Then the frontier on potential output for a given level of inputs is estimated separately for advanced, emerging market, and low income economies, as there is a large divergence in income per capita, and the relationship between input and output is likely non-linear as income per capita increases. Finally, the efficiency score is derived for each country as a distance from the frontier. It is higher if a given level of public capital stock is associated with a higher access and quality of infrastructure assets. The estimation results show that the efficiency gap is 27 percent for EMEs on average, but substantially larger for the Philippines.

C. GIMF Simulations Model and Calibration

12. This section simulates the macroeconomic effects of public infrastructure improvement using the GIMF model. The GIMF is a multi-region general equilibrium macroeconomic model developed by the IMF’s Research Department. It has optimizing firms and households, frictions in the form of sticky prices and wages and real adjustment costs, a financial accelerator mechanism, monetary policy that follows inflation forecast targeting, and fiscal policy that ensures debt sustainability in the long run. The model includes a detailed description of fiscal policy that allows for the choice of seven different fiscal policy instruments for fiscal adjustment, encompassing both revenue and expenditure measures. Moreover, the finite lifetime of households, some of whom are liquidity constrained, generates strong macroeconomic responses to a fiscal shock. Kumhof and others (2010) and Anderson and others (2013) elaborate further on the theoretical structure and main simulation properties of the GIMF model.

13. This chapter departs from the standard calibration by assuming that not all public investment spending contributes to the formation of public capital, but is partly wasted in the form of public consumption.3 It is assumed in the baseline that 40 percent of public investment does not lead to public capital formation but is instead wasted.4 Reflecting this assumption, steady state government investment is assumed to be 2 percent of GDP although officially it has been 3.3 percent of GDP on average since 2011 at the general government level.

14. Two scenarios are considered: (i) a permanent increase in public investment from 3 percent to 5 percent of GDP, financed by borrowing; (ii) the same increase in public investment, financed by higher consumption taxes. Sub-scenarios with and without gradual improvements in public investment efficiency are considered in each scenario. In (i), an increase in the debt-to-GDP ratio is accompanied by an increase in the borrowing interest rate of 4 basis points per unit increase in the debt-to-GDP ratio.5 In (ii), consumption tax increases are chosen over labor and capital taxes in line with the Fund’s recommendations. Expenditure reallocation is not considered as a tool to finance public investment given the small size of total government expenditure in the Philippines and the existence of other spending priorities that makes it difficult to reallocate expenditure at a large scale. In the efficiency-improvement scenarios, public investment efficiency gradually improves to the level of Thailand over a period of five years.

Results

15. Both the deficit-financed and tax-financed public investment increases lead to sustained gains in real GDP. Even without an improvement in public investment efficiency, the increase in public investment results in a 5–6 percent cumulative increase in real GDP relative to the steady state after 15 years. Public investment increases have sustained output effects beyond the direct demand effect of the spending increase because of the productivity-enhancing impact of public infrastructure. As public capital is an input to the aggregate production function of the economy, the improved public infrastructure raises the overall productivity, akin to an increase in total factor productivity from the perspective of the private sector. The resulting increase in marginal productivity of capital and labor crowd in the private investment and increase demand for labor, which induce a higher consumption due to higher household income.

16. While the output gains are initially higher in the deficit-financed scenarios, these gains are larger in the tax-financed scenarios over time, with the increase in the government’s borrowing cost in the deficit-financed scenarios playing a key role.6 The tax-financed scenario results in smaller output gains in the in the short-to-medium term because the tax increase reduces consumption, partially offsetting the demand increase from higher public investment. Over time, however, the continuous increase in the debt-to-GDP ratio in the deficit-financed scenario increases domestic interest rates, with negative effects on private investment and consumption, and leading to decelerating output growth.

17. The increasing influence of the government’s borrowing cost over time can be seen by comparing the paths of long-term real interest rates, the interest rate most relevant for investment decisions of the private sector. In the GIMF model, an increase in the government’s borrowing cost due to an increase in the risk premium leads to a parallel increase in all domestic interest rates. Additionally, domestic interest rates are also affected by monetary policy. The long-term real interest rates reflect both of these factors, and increase on impact for both deficit-financed and tax-financed scenarios. However, the increase is larger for the former partly due to the stronger demand effect but also in anticipation of the future increase in the risk premium. The paths further diverge from each other over time, driven by the increasing risk premium in the deficit-financed scenario.

18. Improving public investment efficiency generates a significant additional impact. Raising public investment efficiency to the level of Thailand increases output by 5 percent after 15 years compared with the unchanged efficiency scenarios, for both tax-financed and deficit-financed scenarios. The difference in public infrastructure contribution is sizable because of the large efficiency gap. For example, given the 40 percent assumed inefficiency, the 5 percent of GDP public investment results in only about 3 percent of GDP contributing to public infrastructure without the efficiency improvement. When public investment efficiency is improved to the level of Thailand, the same 5 percent of GDP public investment results in over 4 percent of GDP contribution to public infrastructure and a cumulative increase in GDP of 9-10 percent after 15 years. This improvement in efficiency generates balanced effects, increasing consumption and investment and decreasing the debt-to-GDP ratio relative to the scenarios without improvements in public investment efficiency.

19. Additional demand from higher public infrastructure gives rise to inflationary pressures and a positive output gap, inducing an increase in the policy interest rate. Over time, the increase in supply capacity alleviates the inflationary pressures and the policy rate increase is gradually reversed.

20. The current account exhibits a sustained deterioration, mostly because of higher imports. Exports also decline initially due to the initial real appreciation associated with the policy interest rate increase. Subsequently, exports increase as investment stimulates production and the initial real appreciation is reversed in line with the reversal of initial monetary tightening, which partially offsets the reduction of the current account. The size of the current account deficit increase is roughly proportional to the output increase and reaches 0.9–1.4 percent of GDP in two years.

Figure 4.
Figure 4.

Main Simulation Results

Citation: IMF Staff Country Reports 2015, 247; 10.5089/9781513586243.002.A004

References

  • Anderson, Derek, Benjamin Hunt, Mika Kortelainen, Michael Kumhof, Douglas Laxton, Dirk Muir, Susanna Mursula, and Stephen Snudden, 2013, “Getting to Know GIMF: The Simulation Properties of the Global Integrated Monetary and Fiscal Model”, IMF Working Paper No. 13/55 (Washington: International Monetary Fund).

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  • Baldacci, Emanuele, and Manmohan S. Kumar, 2010, “Fiscal Deficits, Public Debt, and Sovereign Yields”, IMF Working Paper No. 10/184 (Washington: International Monetary Fund).

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  • Dabla-Norris, Brumby, Kyobe, Mills, and Papageorgiou (2012), “Investing in Public Investment: An Index of Public Investment Efficiency”, Journal of Economic Growth 17(3), pp 235266

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  • International Monetary Fund, 2014, World Economic Outlook, October 2014, World Economic and Financial Survey, Chapter 3 (Washington).

  • International Monetary Fund, 2015a, “Making Public Investment More Efficient,IMF Policy Paper. Available via the Internet: http://www.imf.org/external/np/pp/eng/2015/061115.pdf.

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  • International Monetary Fund, 2015b, Philippines—Fiscal Transparency Evaluation, IMF Country Report No. 15/156 (Washington).

  • Kumhof, Michael, Douglas Laxton, Dirk Muir, and Susanna Mursula, 2010, “The Global Integrated Monetary and Fiscal Model (GIMF)—Theoretical Structure,IMF Working Paper No. 10/34 (Washington: International Monetary Fund).

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1

Prepared by Takuji Komatsuzaki (FAD).

2

A potential downside to the tax-financed scenario is the increased cost of tax collection and the risk of tax evasion. We have abstracted from these in this chapter.

3

This specification follows a similar exercise in IMF (2014).

4

This is broadly in line with the Philippines’ PIE-X and PIMI scores relative to best performers.

5

Borrowing costs are affected by various factors, including both global and local ones. Chapter 1 estimates determinants of 10-year government bond yields in the Philippines while controlling for a comprehensive list of variables, and finds the marginal effect of a unit increase in the debt-to-GDP ratio to be 5-6 basis points. This chapter assumes that there have been structural changes in the Philippines’ fiscal management as reflected in credit rating upgrades in recent years, and adopted a borrowing cost response somewhat lower. If the estimate from chapter 1 was used, output from the deficit-financed scenario would be overtaken by the tax-financed scenario earlier. Regarding international evidence, Baldacci and Kumar (2010), and the review therein, estimate the response of the borrowing cost to range from 3–7 basis points per unit increase in the debt-to-GDP ratio.

6

Given the key role of the borrowing interest rates, the output effects are sensitive to assumptions on the borrowing cost increase. A higher increase would favor tax-financed scenarios more, while the opposite holds for a lower borrowing cost increase.

Philippines: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept