Philippines: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for Philippines
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
27 Sep 2018
eISBN:
9781484378588
Language:
English
Keywords:
ISCR; CR; headline CPI inflation; Core CPI inflation; government bond bond yield; bond yield; equity price; inflation expectation; IMF staff estimate; core inflation; private sector; current account; Tax incentives
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2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Philippines

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Philippines

Context

1. The Philippines has been one of Asia’s strong performers over the past years. Sound policies and a favorable external environment have delivered robust growth, low inflation, and a strong fiscal position. Nevertheless, poverty and inequality remain high, underscoring the need for inclusive policies. The economic cabinet, which has been delegated the policymaking responsibilities, has adopted a long-term perspective on policies and reforms, which has contributed to strengthening confidence in the economy.

uA01fig01

Economic Performance During 2001–2017

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Haver Analytics; Philippines, Department of Finance: and IMF staff

2. The economy faces near-term challenges from the risk of overheating and a less benign external environment. The projected positive output gap, rising inflation and inflation expectations, high and sustained credit growth, and the planned fiscal expansion in 2018–2019 point to the risk of overheating. The rise of inflation to above the target in recent months has weakened political support for tax reform. The combination of tighter global financial conditions, higher oil prices, a widening current account deficit (CAD) and portfolio outflows, have put downward pressure on the peso.

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Selected Exchange Rates Against U.S. Dollar

(Index, January 2015=100, upward=appreciation)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Haver Analytics; and IMF staff estimates.

Recent Developments, Outlook, and Risks

3. Growth, inflation, and external account. Real GDP in 2017 grew at 6.7 percent and 6.3 percent in 2018:H1, y/y, led by strong public investment (Figure 1). Inflation rose to 5.7 percent (y/y) in July 2018, averaging 4.5 percent year to date and above the inflation target band of 2–4 percent, led by adjustments in excise taxes, the rise in global oil prices, the weaker peso, and above-trend growth. Investment-led growth and sustained supply pressures have likely raised employment and renewed wage demand pressures respectively. Following surpluses before 2016, the CAD widened to 0.8 percent of GDP in 2017, driven mainly by imports of capital goods, oil, and raw materials, reflecting strong investment growth (Figure 4).

4. Bank credit growth and stability. Bank credit continues to outpace the rate of economic growth. Banks’ high capitalization and stable nonperforming loans, and low exposure to external and FX-denominated financing provide some buffer against financial stability risks. While the pace of credit growth has slowed recently, the credit-to-GDP gap has widened, approaching early warning levels (Figure 5). Financial intermediation by the less regulated nonbank financial institutions (NBFIs) is small but has grown rapidly in recent years.

5. Outlook. Real GDP is projected to grow at 6.5 percent in 2018 and 6.7 percent in 2019, led by strong domestic demand. The government’s infrastructure push and stable FDI are expected to support investment growth. Private consumption would remain robust, underpinned by remittances and rising employment. Despite the monetary tightening since May that raised the policy rate to 4 percent, inflation is projected at above the 4 percent upper target bound in 2018 and stay in the upper half of the target band (3–4 percent) during 2019–2020. Output would stay above potential in 2018–2020, and the CAD is expected to widen to 1.5 percent of GDP in 2018 driven by a continued rise of capital goods imports, mostly financed by FDI. Over the medium term, real GDP growth would gradually rise to 6.9 percent as implementation of structural reforms promote investment and innovation.

uA01fig03

Potential GDP Growth

(In percent, adjusted for inflation)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Barro and Lee (2016) Educational Attainment Dataset; and IMF staff estimates.

6. Risks (Appendix I). On balance, risks to the growth outlook are tilted to the downside, stemming mainly from rising inflation and overheating, higher oil prices, high credit growth, intensification of global trade tension, and the impact of higher U.S. interest rates and volatile capital flows on borrowing costs over the short term. On the upside, fiscal incentive for streamlining and liberalizing foreign investment, if approved and implemented, would boost productivity over the medium term and strengthen investor confidence.

External Sector Assessment

7. External sector. In 2017, the external position was assessed to be broadly in line with fundamentals and desirable policies (Appendix II). The cyclically-adjusted current account balance was -1.0 percent of GDP, within the range of the estimated current account norm of between – 2.0 and 0.8 percent of GDP, driven by demographics and strong growth potential. The real effective exchange rate was assessed to be broadly consistent with fundamentals and desirable policy settings in 2017. Gross reserves, at US$76.7 billion as of July 2018 and equivalent to 192 percent of the IMF’s reserve adequacy metric for 2017, are ample. Compared to its regional peers, the peso depreciated significantly, by almost 6.0 percent in January–July against the U.S. dollar and about 4.5 percent in nominal effective terms.

Authorities’ Views

8. The authorities expected robust growth momentum to continue, with risks mainly originating from external sources. The projected 7–8 percent growth over the medium-term would be driven by strong private consumption, higher public spending in infrastructure and social programs, resurgence in manufacturing, and growing FDI and tourism. Based on an assessment of inflation dynamics, output, liquidity, and credit conditions, the authorities continued to see limited evidence of overheating in the economy, with the initial impact of excise tax increases on inflation stabilizing and new bank credit mostly directed to productive sectors. They expected the approval of the pending rice reform bill to replace rice import quotas with tariffs to help reduce consumer prices. The authorities agreed with the main thrust of the staff’s external sector assessment, while noting that the recent widening of the CAD has been driven by imports of capital goods, raw materials and intermediate/manufactured goods related to infrastructure investment and overall strong domestic demand. Meanwhile, they expect that while the potential direct impact of global trade tensions may not be substantial, continued trade friction could, nevertheless, affect overall investment sentiment, and increasing uncertainty on the global growth prospects could take its toll on the external sector. Nonetheless, authorities viewed that the Philippines can rely on increasing intraregional trade, strengthening domestic demand, and its robust external payments position as buffers against possible negative effects of protectionist measures.

Policy Issues

A. Adjusting the Policy Mix to a Changing Economic Environment

9. There is a need to adjust the policy mix to address rising domestic and external imbalances. The planned fiscal stimulus, combined with strong private investment and consumption growth, will feed price and current account pressures. Monetary policy should continue to be tightened to protect price stability and preserve market confidence, supported by a shift to a neutral fiscal stance centered on priority infrastructure and social spending. Exchange rate should remain flexible to play its shock absorber role against external shocks, while macroprudential measures should safeguard financial stability by keeping systemic risks in check.

Fiscal Policy—Supporting Inclusive Growth while Safeguarding Stability

10. On current policies, fiscal policy would be expansionary in 2018–2019. The authorities plan to raise the deficit from 2.2 percent of GDP in 2017 to 3 percent in 2018 and 3.2 percent in 2019, implying a fiscal impulse of 0.5 percent and 0.2 percent, respectively, led by infrastructure investment and social spending. In contrast, staff projects a lower deficit of 2.8 percent in 2018 given implementation constraints. As of June 2018, the deficit stood at 1.1 percent of projected 2018 GDP against the authorities’ target of 1.5 percent as revenue has outperformed due to an effective implementation of the Tax Reform for Acceleration and Inclusion (TRAIN), the first package of the government’s Comprehensive Tax Reform Program, while public spending remains broadly on target.

uA01fig04

Overall Fiscal Deficit

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Philippine authorities; and IMF staff proposal.

11. The Philippines has some fiscal space. Prudent fiscal management and sustained reforms helped bring the general government gross debt to 40 percent of GDP in 2017 from 52.4 percent in 2007 (Appendix III). Gross financing and long-term adjustment needs are low, although the government’s reliance on external financing poses a moderate risk.

12. Nonetheless, the current environment warrants a neutral fiscal stance to balance growth and stability objectives. A neutral stance over 2018–2019, implying a deficit of 2.4 percent in 2018 and 2.5 percent in 2019, would support pro-growth infrastructure investment without overburdening monetary policy, limit overheating risks, and help preserve buffer against unexpected adverse shocks. This could be achieved by intensifying efforts on the revenue side and containing nonpriority spending, such as new hiring of public sector employees and non-urgent capital projects. Further reduction in nonpriority spending, especially those unrelated to flagship infrastructure projects and social protection, would be warranted if tightening of global financial conditions engenders a surge in borrowing costs, while expanding social protection spending as needed.

13. The planned tax incentive reform would make the system more effective and generate economy-wide productivity gains. The current regime provides extensive tax incentives based on more than 220 laws and granted at the discretion of 14 investment promotion agencies without adequate central control, at an estimated fiscal cost of over 2 percent of GDP.Package 2 of the tax reform program focuses on streamlining tax incentives while gradually reducing the corporate income tax (CIT) rate from 30 to 25 percent. The reform would make tax incentives more effective in achieving national policy goals and improve overall productivity. Any CIT rate reduction, however, should be conditional on proportionate fiscal incentive consolidation to offset revenue losses.

14. Enhancing the VAT refund system would support the tax reforms. These require sustained efforts to improve tax authority’s administrative capacity through training and establishing dedicated staff teams. Other measures could include launching a pilot project to implement a risk-based approach for VAT refund. Such an approach could modernize and improve the entire operation of tax administration.

15. The international taxation framework could be strengthened. Outbound FDI by Philippines-based multinational corporations has risen significantly over the recent years, increasing the risk of revenue losses from base erosion and profit shifting. Addressing this risk would require increasing capacity building efforts and implementing prioritized reforms, such as limiting corporations’ interest payment deductions to a specified percentage of earnings before interest, taxes, depreciation and amortization. Strengthening transfer pricing enforcement could also address revenue losses caused by tax incentives that could allow for domestic transfer pricing.

16. There is room to gradually expand social protection. Reallocating resources from nonpriority spending, and unconditional cash transfers eventually, would allow the expansion of other programs that have been assessed to be effective in reducing poverty such as the conditional cash transfer program. Public spending on education, health, and infrastructure could also place priority on improving access to public services by low-income households (Box 1). Implementation of the approved national identification system will help improve targeting of social spending.

17. Public expenditure management should aim to maximize the return from the large infrastructure investment. Priority should be on selection and prioritization of capital projects, periodic review of ongoing programs and projects, and contingent liability management and oversight over PPP. The IMF technical assistance which conducted a Public Investment Management Assessment has helped identify specific areas of reform in public investment management and institutions.

Authorities’ Views

18. The authorities underscored the need for uninterrupted investment in infrastructure projects but were open to review the staff’s advice on the neutral fiscal stance. They saw limited scope for spending adjustment for those infrastructure projects already under construction but noted that some room exists elsewhere in case the overall spending needs to be adjusted. Regarding the tax incentive reform, the authorities’ goal is to make the system more performance- based and transparent, including by strengthening the cost-benefit analysis and delegating the central oversight role to the Department of Finance. The CIT rate cuts would supersede incentive consolidation. The authorities also agreed on the need for gradual expansion of social protection programs and further improvement of their public investment management and prospective assessment by the IMF.

Monetary and Exchange Rate Policy—Tackling Inflation, Modernizing Operations, and Maintaining a Flexible Exchange Rate

19. While temporary supply-side factors explain much of the rise in headline inflation, demand-side pressures also played a role. The price change in core services, which is less affected by those factors and hence a better indicator of domestic demand pressure, has picked up substantially since late 2017 (Box 2). The risk of unanchored inflation expectations has risen, based on survey results, and the government bond yield curve steepened, consistent with higher inflation expectations. Addressing potential second-round effects from supply pressures on broader prices and rising wage demand pressures has become a major policy issue.

Inflation Decomposition and Momentum

(In percent)

article image
Sources: Philippine Statistics Authority; and IMF staff estimates.
uA01fig05

Inflation Expectations: Up Versus Down

(Diffusion index, +0 = higher inflation expected in the current quarter)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: BangkoSentral Ng Pilipinas, and IMF staff estimates.
uA01fig06

Ten-Year Treasury Bond Yield

(In percent)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source?: Haver Analytics; and IMF staff estimates.

20. The BSP’s recent decisions to raise its policy rate were appropriate and the BSP should look to do more. Despite the monetary tightening since May that raised the policy rate by 100 bps to 4 percent this year, monetary policy remains accommodative. Staff estimates the real policy rate to be close to zero percent as of August 2018, 1–2 percentage points below the neutral real interest rate, implying the need for further tightening (Box 3). Higher rates will also mitigate inflation risks from the expected fiscal stimulus, weaker currency, and help anchor inflation expectations. The exact pace of monetary tightening should depend on evolving external and domestic conditions.

21. Exchange rate flexibility should continue to support the economy’s ability to adapt to external shocks. With official international reserves more than adequate, the authorities should continue with the policy of allowing the exchange rate to move freely in line with market forces, while limiting foreign exchange intervention to avoid disorderly market conditions.

22. The BSP has made progress in implementing its interest corridor system (IRC), and staff supports continued fine-tunings of monetary operations (Box 4). The recent advances in domestic capital market and FX liberalization reforms are also welcome and should be sustained. While the monetary effect of two bank reserve requirement cuts in 2018 (lowering the ratio to 18 from 20 percent) were largely sterilized by BSP’s term deposit auctions, the authorities’ decision to put further cuts on hold until inflation expectations are well anchored is appropriate.

Authorities’ Views

23. The BSP agreed that the higher inflation was mainly driven by supply-side factors and recent tightening of monetary policy was meant to signal the BSP’s strong commitment to ensuring macroeconomic stability, by helping anchor inflation expectations and tempering further second-round effects. At the same time, they noted the possibility of demand-side pressures that needs to be closely evaluated and monitored. The main risks to the inflation outlook would include additional upward adjustments of minimum wages, transport fares, and electricity rates. The BSP agreed that the exchange rate should remain flexible; nevertheless, sustained pressures on the peso could adversely affect inflation, requiring vigilance against the potential inflation threat from peso volatility and second-round effects. The authorities expressed strong willingness to undertake follow-through actions to help ensure inflation expectations are anchored and that the inflation target for 2019 is attained. They also plan to sustain efforts to improve the IRC and monetary operations.

B. Addressing Systemic Financial Stability Risks

24. The financial system appears sound, dominated by well-capitalized banks, but available data suggest that corporate leverage has increased. Historic low borrowing costs have fueled credit growth and asset price inflation. With increasing loans, corporate leverage for listed firms, measured by debt-to-asset ratio, has risen to 21.4 percent in 2016, surpassing the average in peer countries. Large data gaps prevent a more recent analysis and anecdotal evidence suggest that corporate FX debt has fallen. Credit growth slowed in 2018 across most sectors but is expected to accelerate as private investment gathers momentum.

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Corporate Leverage 1/

(Debt in percent of total asset, sample median)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: IMF Corporate Vulnerability Utility Database; and IMF staff estimates.1/ Based on 237 publicly traded nonfinancial firms in 2016.
uA01fig08

Nonfinancial Corporate Debt Issuance 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: IMF, Vulnerability Exercise Securities Database; and IMF staff estimates.1/ Includes syndicated loans and based on residence of issuer.

25. New initiatives have been proposed to address the slow progress in closing existing data gaps. Data gaps are particularly large for non-financial corporates (NFCs) and NBFIs outside the BSP’s regulatory perimeter. The lack of timely available data has hampered the BSP’s ability to identify and monitor emerging systemic risks outside the banking system and formulate more targeted policy measures. An Electronic Information Sharing project launched in May is intended to provide a centralized, web-based system to facilitate the sharing of reports of supervised institutions in the Philippines, which include audited financial statements of the top 1,000 corporations and related key performance indicators. Furthermore, requirements of more granular data in the reporting templates on real estate and project finance are expected to help BSP’s surveillance of vulnerabilities from related exposures and policy response to emerging credit concentration risks.

26. The approval of the proposed amendments to the BSP charter should be a priority. These will grant the BSP the authority to obtain data from any person including the NFCs for statistical and policy development purposes and for safeguarding the soundness of the banks. Other important elements of the new charter include the capitalization of the BSP, legal protection for staff, and the ability to issue BSP instruments to better control inflation.

27. The BSP has implemented macroprudential tools to pre-empt the buildup of risks to financial stability, but additional efforts are needed. The BSP has revised its guidelines on liquidity risk management, implemented targeted macroprudential policies to stem excessive credit growth in specific sectors, and approved the adoption of the Net Stable Funding Ratio to enhance banks’ ability to absorb liquidity stress. The real estate stress test (REST) limits of 25 percent write-off rates on real estate, to ensure banks have a sufficient capital buffer to withstand potential property price corrections, has been effective in moderating real estate loan growth from its previous high levels. The BSP plans to introduce the framework for implementing banks’ countercyclical capital buffer (CCyB), with the level initially set at zero. Clear communication with market participants will be important, including on the methodology and comprehensive set of indicators that will be used to calibrate the CCyB, which in staff’s assessment will need to be set above zero considering sustained rapid credit growth and credit-to-GDP gap approaching early warning levels (Figure 5). Against further concerns of credit risk, additional measures by BSP, namely the Debt-to-Earnings-of-Borrowers’ Test (DEBT), and the Borrowers Interconnectedness Index (BII) aim at assessing the debt servicing capacity of systemic borrowers under stressed market conditions, and concentration of the systemic importance of conglomerates in the banking system, respectively.

Authorities’ Views

28. The authorities view the domestic banks’ credit exposure as firmly supported by demand of a growing economy, with appropriate tools in place to safeguard financial stability. BSP’s macroprudential and strong financial surveillance policies have aimed at improving governance practices and the risk management system to support expanded lending activities. This has included adopting guidelines on Credit Risk Management Practices and on the conduct of stress testing exercises (i.e., the REST and the DEBT tests), assuming Basel III reforms which include adopting a minimum leverage ratio, enhancing the liquidity position of financial institutions, a supervisory framework for D-SIBs, and imposing the Capital Conservation Buffer as a CET1 requirement to absorb market shocks. More recently, communication issues raised by the banking industry regarding a CCyB proposal are being strengthened to secure its adoption, by stressing the CCyB buffer function in protecting the banking sector from the buildup of systemic vulnerabilities.

C. Structural Reforms to Support Inclusive Growth

29. The reform momentum should be sustained to foster inclusive growth. Despite rapid growth in recent years, poverty and inequality remain high (Figure 7), while there is room to continue to improve the business environment (Figure 8). Stringent foreign ownership restrictions and high non-tariff barriers have hampered competition and technology spillovers. Staff supports the authorities’ reform agenda to address these problems, including:

  • Replacing the rice import quota system with one based on tariffs, which would benefit consumers by reducing domestic rice prices. This action should be accompanied with policies to support the affected small farmers through training and crop substitution.

  • Shortening the foreign investment negative list (FINL), combined with effective implementation of the Ease of Doing Business Law and the Philippine Competition Act, including by streamlining government procedures and cutting the processing time for permits would support private investment.

  • Financial inclusion initiatives, including plans to create a central registry system for movable assets, which would allow easier access to credit for small- and medium-sized companies by expanding the set of eligible collateral for bank loans.

30. There is a need to modernize the labor market regulation. The authorities’ intention to eliminate the practice of repeatedly using temporary contracts (to avoid paying workers fringe benefits) is sensible. To avoid adverse effects on employment, this should be accompanied with actions that can provide more flexibility to the labor markets, such as simplifying the procedures and reducing the pecuniary costs required for laying off workers with regular status.

31. More investment in human and physical capital would be needed to leverage digital technologies. The use of mobile financial transactions is widespread in the Philippines, supported by the recent introduction of a nationwide digital identification system and retail payment systems. To reap their full benefits, however, more investment is needed in education and training and ICT infrastructure, accompanied by efforts to enhance cybersecurity. The authorities’ digital strategy is appropriately aligned with these priorities (Box 5).

uA01fig09

ICT Infrastructure 1/

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: World Bank, World Development Indicators; World Economic Forum, The Global Technology Report 2016; and IMF staff estimates.1/ Fixed broadband and mobile tell Liar subscriptions are per 100 people. Internet speed is proxied by internet bandwidth in kb/setond per user Personal computer ownership is in percent of total households. Mobile celluar tariffs are per PPP J/min.

32. Important challenges remain in the AML/CFT framework, despite recent improvements. The amended legislation covers casinos, which are now required to perform customer identification and meet record-keeping obligations, and report to the financial intelligence unit all single casino transactions above PHP5 million. Nonetheless, the AML/CFT framework could be strengthened further by amending the bank secrecy law and making tax evasion a predicate crime. The relaxation of bank secrecy law and enhanced customer due diligence measures for domestic politically exposed persons will also help improve tax compliance and anti-corruption.

Authorities’ Views

33. The authorities highlighted significant progress in promoting inclusive growth and reaffirmed their commitment to accelerate reforms. The restrictions on foreign investment have been significantly eased in recent years and the authorities plan to further shorten the FINL through executive orders and legislations. They saw a shift to a tariff-based rice import system as an important priority to promote lower domestic prices and improve access to rice by poor households. The authorities also recognized the need to protect the vulnerable farmers from increased rice imports; hence the proposed legislation also states that the proceeds from tariffs will be utilized to provide additional resources to farmers to further enhance productivity and competitiveness. They underscored the need to further develop domestic capital markets to better support the national infrastructure initiative and noted their ongoing initiatives to leverage digital technologies to promote financial inclusion and address potential disruptions to BPOs. The authorities also note the recent anti-corruption efforts, including the approval of the Ease of Doing Business Law and the creation of the Presidential Anti-Corruption Commission, and their legislative initiatives to ease bank secrecy for tax compliance verification.

Staff Appraisal

34. The economy continues to perform well but is facing new challenges. Real GDP is projected to grow strongly in 2018 and 2019, supported by domestic demand. However, short-term risks have risen, including inflation and overheating risks, and greater external uncertainty. The medium-term economic outlook remains favorable, which places the country in a good position to tackle still elevated levels of poverty and inequality.

35. To balance growth and stability objectives, the authorities should adopt a neutral fiscal stance over 2018–2019. This implies an overall deficit of 2.4 percent in 2018 and 2.5 percent of GDP in 2019 (compared to staff’s current baseline of 2.8 and 3.2 percent), which would support pro-growth infrastructure investment without overburdening monetary policy, while containing inflationary pressures. Raising tax revenues and reallocating spending from nonpriority programs can support the continued expansion of public investment and social spending.

36. Further monetary policy tightening to anchor inflation expectations is needed and its pace should be conditional on domestic and external developments. The BSP’s recent decisions to increase the policy rate three times this year were appropriate. With policy rates still well below neutral, staff welcomes the BSP’s announced readiness to take further action to safeguard price stability by controlling potential second-round effects from sustained supply pressures and rising wage inflation as well as its decision to delay the bank reserve requirement cuts until inflationary expectations are more firmly anchored.

37. Exchange rate flexibility should continue to support the economy’s ability to adapt to external shocks. Foreign exchange intervention should be limited to preventing disorderly market conditions. The external position was assessed to be broadly in line with fundamentals and desirable policies.

38. Macroprudential measures backed by sound financial surveillance should continue to safeguard financial stability against systemic risks, including those related to conglomerate structures and real estate. Implementation of the CCyB should aim at maintaining the banking sector’s appropriate flow of credit through the cycle, while there is a need to close data gaps on NBFIs and conglomerates.

39. Authorities should maintain the momentum for reforms in seeking broader economic benefits. Priorities include amendments to the BSP Charter, streamlining tax incentives, modernizing the bank secrecy legal framework, promoting competition by opening new sectors of the economy to foreign investment, and further improving the business environment, including through better infrastructure and labor regulations, and strengthened governance.

40. It is recommended that the next Article IV consultations take place on the standard 12-month cycle.

Distributional Effects of TRAIN—Scenario Analysis

Model simulation results suggest TRAIN can bring significant output gains and reduce poverty, provided its revenue is used for productive investment. But lowering inequality would require targeted pro-poor investment in physical and human capital such as the conditional cash transfer program.

TRAIN could have significant distributional impacts over the long term, depending on how its revenue is used. While essential to finance infrastructure investment without endangering long-run fiscal sustainability, the tax reform package by itself is regressive, with most of the revenue raised from consumption taxes. This aspect of the TRAIN underscores the need for designing an expenditure strategy that is both growth-enhancing and inclusive.

TRAIN’s growth and distributional effects are analyzed using a DSGE model. The theoretical framework, based on Peralta-Alva and others (2017), features three sectors—services, manufacturing, and an informal one not subject to taxation. The model is calibrated to match key characteristics of the Philippine economy, including the level and composition of tax revenue—labor, corporate income, and consumption taxes—and the overall consumption inequality (GINI index).

Two illustrative scenarios are considered to highlight the different effects of spending strategies linked to TRAIN. In the first scenario (“Infrastructure”), TRAIN revenue is invested in infrastructure projects every year and perpetually, which boosts productivity and leads to higher private investment. In the second scenario (“Unproductive Redistribution”), the revenue is redistributed equally to households as lump-sum transfers, which they can either consume or save. Under both scenarios, the annual TRAIN revenue is assumed to amount to 0.6 percent of GDP—1.5 percent gain from consumption tax increases, net of 0.8 percent of GDP revenue loss from personal income tax reduction. The steady states under the two scenarios are benchmarked against a baseline of no TRAIN.

uA01fig10

Macroeconomic Impacts

(Percentage change from “no TRAIN” levels, adjusted for inflation)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: IMF staff estimates.
uA01fig11

Distributional Impacts on Average Consumption

(Percentage change from “No TRAIN” levels, adjusted for inflation)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: IMF staff estimates.

Under the infrastructure scenario, all households would be better off, especially the poor. Infrastructure investment would increase output and reduce prices in the long run as the productive capacity expands. This strategy also lowers poverty by boosting the average real consumption of the lowest household quintile. In comparison, “unproductive redistribution” would lower investment with virtually unchanged output, engendering higher prices in the long term. Importantly, poverty reduction would be less than in the infrastructure scenario.

Regarding inequality, the results provide a mixed picture. Consumption inequality worsens in the infrastructure scenario, although marginally so, as richer households consume more than the poor. However, the opposite holds for wealth inequality: the poor households accumulate more wealth relative to their existing saving given the higher income generated by infrastructure investment. The higher saving provides a stronger buffer against large economic shocks, allowing these households to better smooth their consumption profile over time.

uA01fig12

Consumption Share of Bottom-50 and Top-10 Percent

(In percent of aggregate consumption and by consumption decile)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: IMF staff estimates.
uA01fig13

Impacts on inequality: GINI Index

(Difference from “no TRAIN” levels, 100 = perfect inequality)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: IMF staff estimates.

The analysis highlights the merit of targeted public investment in physical and human capital, which can have more direct and larger impact on poverty and inequality. These include targeted social protection program, such as the conditional cash transfer program, or basic infrastructure in rural areas, such as farm-to-market roads or water and sanitation facilities.

Inflation Momentum and Decomposition

Headline inflation rose sharply in 2018 to 5.7 percent (y/y) in July from an average of 2.9 percent (y/y) in 2017, driven primarily by goods inflation. Registering the highest reading since 2013 (2012 weights), a large part of the increase stems from higher (supply-driven) excise taxes on auto, fuel, tobacco, and sweetened beverages, higher global oil and gas prices, and challenges in managing rice inventories. Goods inflation (58 percent of the CPI basket) accelerated from 3.6 percent (y/y) in December 2017 to 7.2 percent (y/y) in July 2018. Energy and food items were the main contributors, with energy inflation rising fast following higher international oil prices since the beginning of 2015 and increased excise tax on oil imports implemented in January 2018. Non-energy goods inflation, however, was mainly driven by domestic factors as non-oil import price growth was mild. Services inflation also rose in 2018, from 1.9 percent (y/y) in Dec 2017 to 3.4 percent (y/y) in July 2018.

uA01fig14

Inflation

(In percent, y/y)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Philippine Statistics Authority; and IMF staff estimates.
uA01fig15

Inflation on Goods Items

(In percent, y/y)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Philippine Statistics Authority; and IMF staff estimates.

Core inflation has also accelerated in 2018, with core services rising more sharply than goods. Measuring the CPI change for the core consumption basket after removing selected food and energy items (largely affected by supply factors),1 core inflation rose moderately to 3.0 percent (y/y) as of July 2018. Measured on month-to-month basis (annualized), core inflation moderated somewhat in 2018:Q2 (2.4 percent) relative to Q1 (4.8 percent) before it picked up again in July (5.5 percent). Within core inflation:

  • Core goods experienced a moderate rise in price changes from 1.4 percent (y/y) in December 2017 to 1.8 percent (y/y) in July 2018.

  • Core services inflation (as a relevant indicator for domestic demand or wage pressures) has risen more sharply in 2018 (from 1.7 percent (y/y) in Dec 2017 to 3.5 percent in July 2018 (y/y), suggesting rising inflation pressures beyond supply and external factors (i.e., import prices and exchange rate fluctuations).2 The fastest rises appear to be in health services, restaurant, and housing prices.

uA01fig16

Core Inflation Rates

(In percent)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Philippines Statistics Authority; and IMF staff estimates.
uA01fig17

Core Goods and Core Services Inflation

(In percent, y/y)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: Philippine Statistics Authority; IMF staff estimates.
uA01fig18

Core Goods and Core Services Inflation

(In percent, m/m, annualized)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Sources: Philippine Statistics Authority; and IMF staff estimates.

In summary, higher core services inflation suggests inflationary pressures are partly driven by demand factors. It implies that inflationary pressures have spread from items directly affected by supply-side factors (such as rice and oil) to a broader spectrum of the economy. Although this trend abated somewhat in 2018:Q2 compared to 2018:Q1, its pickup in July requires continued monitoring.

1/ Coverage of core goods and services items defined by staff is different from the Philippines Statistics Agency (PSA). Core basket covers 80 percent of the CPI basket (2012 weight) per PSA versus 42 percent per staff. Staff excludes items whose prices are less market-based (e.g. education services) and all food and beverage items (rather than selected food and beverage items per PSA).2/ Core services are considered services items whose prices are more market-based (i.e., housing and catering services) and non-core services include items whose prices are less market-based (i.e., education services).

Estimating the Neutral Real Interest Rates

To evaluate the monetary stance in the Philippines, we estimate the neutral real interest rates (NRIRs) and compare them to actual. NRIR refers to the equilibrium interest rate where output is at its potential and inflation is stable. It is unobservable and must be estimated.

Actual real interest rates in Philippines have been on a declining path since the early 2000s. Along this path, real rates experienced bouts of temporary increases while also turning negative on occasions.1/

Structural-based estimates of the NRIRs have increased slightly in the past few years, falling within the 1–2 percent range.2/ These stable or slightly increasing NRIRs are consistent with the robust potential growth in the Philippines. Estimated neutral rates above actual rates point to a monetary stance that has been broadly loose since the global financial crisis (i.e., a period of monetary stimulus). A statistically-driven approach (Hodrick- Prescott (HP) univariate filtering) points to NRIR estimates declining steadily from 4 to 0.1 percent during 2000–2017—this method treats the trend of actual rates as proxy for neutral, ignoring the possibility that actual rates can deviate from neutral for a prolonged period time. As such, staff assesses the structural-based estimates of the NRIRs to better reflect the Philippines’ strong output and consumption growth conditions.

uA01fig19

NRIR: LW Method 1/

(In percent)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: IMF staff estimates1/ Different specifications refer to differences in the starting year of the sample and the imputed elasticities at NRIR5 with respect to trend growth rates.
uA01fig20

NRIR: HP Filter Method

(In percent)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: IMF staff estimates.
1/ The real interest rate refers to the annualized nominal policy rates minus inflation expectations. For policy rates, we use the weighted average of various BSP policy rates (RRP, TDF, ODF). For expected inflation rates, we use data from BSP Business Expectations Survey from 2013, and actual inflation rates before 2013.2/ See Laubach and Williams, LW, methodology (2003).

Progress in Modernizing the Monetary Policy Framework

In 2016, the BSP adopted an interest rate corridor (IRC) system for monetary operations. The 100-basis-point-wide IRC consists of the overnight deposit and lending rates (the floor and ceiling of the IRC) and the Reverse Repurchase Facility (RRP) rate in the middle of the IRC. The system has sought to improve monetary policy transmission by better aligning money market rates with the policy rate (RRP rate), foster money market development, and encourage banks to manage liquidity more actively. Historically, the large structural excess liquidity led to interbank interest rates falling below the RRP rate, with low market activity.

In late 2017, the BSP’s OMO started to push market rates into the upper half of the IRC (left text chart). The BSP absorbed liquidity using regular Term Deposit Facility (TDF). By late 2017, short-term market rates had drifted up within the BSP’s IRC and very few funds remained in the BSP’s overnight deposit standing facility. A reduction in structural excess liquidity reflecting a reversal of capital flows also helped push market interest rates higher. The interbank market has become more active as banks have had to more intensively manage their liquidity needs.

Attention is shifting towards fine-tuning of operations, in keeping market rates close to the policy rate. This entails, increasing the frequency of OMOs, catalyzing interbank market development through working with other agencies to develop the repo market, upgrading the settlement infrastructure used for repo transactions, developing more indicators of repo activities, and changing the way the BSP trade repos in its RRP facility. In shifting the policy rate from a fixed rate on the RRP operation to a target for market rates, the operating target can be specified as a combination of available market rates. The BSP could then offer its overnight RRP instrument via variable-rate auctions to boost price discovery in the repo market as it develops further. Last, reduce reserve requirements gradually, liquidity conditions permitting, and lengthen the reserves maintenance period (to 2–4 weeks).

uA01fig21

BSP Policy and Market Rates, 2012–2018

(In percent)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: Bangko Sentral ng Pilipinas.
uA01fig22

Interbank Call Loan Market Activity

(Average daily volume, in billions of pesos)

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Source: Bangko Central ng Pilipinas.

Digital Strategy in the Philippines

The Philippine government sees the development of its digital economy as a strategic priority. Four strategic pillars are identified to achieve the objective of transitioning to a digital economy: transparent government and efficient services delivery; internet opportunities for all people; investing in people—digital literacy for all; and ICT industry and business innovation for national development. To support these pillars, the government has also formulated a National Broadband Plan to guide the development of information infrastructure.

The National Government Portal is a key project to promote e-governance and improve government services through online platforms. The goal is to create a single online entity wherein all web-based government information is centralized, eliminating the need for maintaining multiple systems and reducing the time needed to visit government offices. The President has recently signed into law a congress-approved bill to establish a national identification system, which, once implemented, would improve service delivery through better targeting of government services. The government is also establishing an e-invoicing system to facilitate payments and tax administration.

Digitalization in the financial sector has been a major focus in improving efficiency and financial inclusion. The BSP has set an ambitious target of raising the share of electronic transactions from the present 1 percent to 20 percent by 2020. To this end, the BSP has launched two automated clearing houses under the National Retail Payments System (“PESONet” and “InstaPay”), with the latter largely aimed at SMEs and individuals to improve financial inclusion.

The government is working with the private sector to ensure its continued success in the digital age. Automation based on artificial intelligence is widely seen as a threat to low-skill, manual, and routine work, especially within the BPO industry. The government is working with the BPO industry to upgrade the skills of BPO workforces, focusing on training and retooling. This would support the industry’s efforts to move up the value chains and remain competitive. The government has also recognized the country’s weaknesses in digital infrastructure and is attempting to bring a third telecom player to break the current duopoly in the sector.

Regulatory reforms are supporting the digital economy strategy. To encourage digital innovation, the BSP has adopted a sandbox approach to regulating fintech firms. The government has also formulated a National Cybersecurity Plan and is pushing for digital literacy through training and information outreach.

Figure 1.
Figure 1.

Drivers of Growth

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 2.
Figure 2.

Inflation Dynamics

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 3.
Figure 3.

Monetary and Financial Conditions

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 4.
Figure 4.

External Sector

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 5.
Figure 5.

Macrofinancial Linkages

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 6.
Figure 6.

Fiscal Developments

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 7.
Figure 7.

Poverty and Inequality

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

Figure 8.
Figure 8.

Business Environment 1/

Citation: IMF Staff Country Reports 2018, 287; 10.5089/9781484378588.002.A001

1/ The indicators above should be taken with caution and come with the following limitations: The World Bank Doing Business indicators, from which the distance to frontier scores are derived, measure de jure business regulation facing domestic small and medium-size firms, usually using the largest city to represent the economy. The World Economic Forum Global Competitiveness Index are partly based on opinion survey of business executives. The OECD FDI restrictiveness index captures stated regulatory restrictions in national documents, and the Trade Facilitation Indicators are partly based on survey data.
Table 1.

Philippines: Selected Economic Indicators, 2013–19

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Sources: Philippine authorities; World Bank; and IMF staff estimates and projections.

Estimates exclude data of the entire Region VIII.

In National Capital Region. Latest observation as of June 2018.

Benchmark rate for the peso floating leg of a 3-month interest rate swap. Latest observation as of July 2018.

IMF definition. Excludes privatization receipts and includes deficit from restructuring of the previous Central Bank-Board of Liquidators.

Latest observation as of July 2018.

Table 2.

Philippines: National Government Cash Accounts, 2013–19

(In percent of GDP, unless otherwise indicated)

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Sources: Philippine authorities; and IMF staff projections.

Includes other percentage taxes, documentary stamp tax, and non-cash collections.

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

In percent of potential GDP. Compared to the cyclically-adjusted balance, the structural balance also controls for the effect of cyclical fluctuations

Defined as the sum of deficit, amortization of medium- and long-term debt, and the stock of outstanding short-term debt.

Includes national government debt held by the bond sinking fund and excludes contingent/guaranteed debt.

Table 3.

Philippines: General Government Operations, 2013–19 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Philippine authorities; and IMF staff projections.

Based on GFSM2001. General government includes the national government, social security institutions (SSIs), and local government units (LGUs).

National government only. The expense item related to SSIs and LGUs are not separately available and included under “Expense not elsewhere classified.”

Includes national government debt held by the bond sinking fund and excludes contingent/guaranteed debt.

Table 4.

Philippines: Depository Corporation Survey, 2013–19 1/

(End of period, in billions of pesos, unless otherwise indicated)

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Sources: IMF, International Financial Statistics, and IMF staff projections.

It includes the Bangko Sentral ng Pilipinas (BSP), the accounts of the Central Government arising from its holdings of transactions with the International Monetary Fund, and Other Depository Corporations such as universal and commercial banks, thrift banks, rural banks, non-stock savings and loan associations and non-banks with quasi-banking functions.

Table 5.

Philippines: Balance of Payments, 2013–19

(In BPM6, billions of U.S. dollars, unless otherwise indicated)

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Sources: Philippine authorities; and Fund staff projections.

An increase in either assets or liabilities is positive and a decrease is negative. Net investment is assets minus liabilities. A negative financial account balance means that the change in liabilities is greater than the change in assets.

Table 6.

Philippines: Medium-Term Outlook, 2016–23

(In percent of GDP, unless otherwise indicated)

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Sources: Philippine authorities; and IMF staff projections.

Remaining maturity basis.

Based on the depository corporations survey. In addition to universal and commercial banks, it includes thrift banks, rural banks, non-stock savings and loan associations and non-banks with quasi-banking functions.