philippines managing global integration

Report No. 17024-PH

PhilippinesManaging Global Integration(In Two Volurmes) Voliume l: Main Report

November 17, 1997

Povertv Reduction an(] Economic Managenment Sector UnitEast Asia and Pac ific Regional Office

Document of,the World Bank

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CURRENCY EQUIVALENTS(As of November 17, 1997)

Currency Unit = Peso$1.00 = 34.05 pesos

1.00 peso - $0.029

FISCAL YEAR

January 1 - December 31

WEIGHTS AND MEASURES

Metric System

Vice President Jean-Michel Severino, EAPCountry Director Vinay K. Bhargava, EACPFSector Manager (Acting) Pieter Bottelier, EASPRStaff Member Sanjay Dhar, Principal Economist, EASPR

CONTENTS

Acronyms and Abbreviations .................................................... iiiAcknowledgments ..................................................... vExecutive Summary .................................................... viiIntroduction .................................................... xv

1. ECONOMIC DEVELOPMENTS AND ISSUES: AN OVERVIEW ........................1Financial Market Instability in 1997 .................................................... 7

2. POLICY IMPLICATIONS AND PRIORITIES .................................................... 10Macroeconomic and Financial Policies .................................................... 10Structural Reform and Competitiveness .................................................... 17Issues in Manufactured Export Development .................................................... 20

3. THE ECONOMIC OUTLOOK .................................................... 26Alternative Scenarios .................................................... 27Official Development Assistance (ODA) Requirements ....................................... 27

Statistical Annex ................................................... 29

TABLES

Table 1: Selected Economic Indicators, 1992-97 ..................................................... 2

BOXES

Box 1: Lessons from the Thai Crisis ................................................... 7

FIGURES

Figure 1: Balance of Payments Trends .................................................... 4Figure 2: Financial Market Trends ..................................................... 6

Acronyms and Abbreviations iii

ACRONYMS AND ABBREVIATIONS

BAP - Bankers' Association of the PhilippinesBCDA - Bases Conversion Development AuthorityBOI - Board of InvestmentsBSP - Bangko Sentral Ng PilipinasCARP - Comprehensive Agricultural Reform ProgramCPU - Central Processing UnitCTRP - Comprehensive Tax Reform PackageDENR - Department of Environment and Natural ResourcesDOLE - Department of Labor and EmploymentDOST - Department of Science and TechnologyDRAM - Dynamic Random Access MemoryEDC - Export Development CouncilEPZA - Export Processing Zone AuthorityFCDU - Foreign Currency Deposit UnitFDI - Foreign Direct InvestmentFIAS - Foreign Investment Advisory ServiceGDP - Gross Domestic ProductGNP - Gross National ProductGOCC - Government-Owned and Controlled CorporationsGOP - Government of PhilippinesGTAP - Global Trade Analysis ProjectIC - Integrated CircuitsIDC - Industry Development CouncilIRR - Implementing Rules and RegulationsLGU - Local Government UnitMFA - Multifiber AgreementMFN - Most-Favored NationMNC - Multinational CorporationNCR - National Capital RegionNG - National GovernmentNIE - Newly Industrialized EconomyNPC - National Power CorporationNTB - Nontariff BarriersOBM - Own Brand ManufactureODA - Official Development AssistanceOEM - Original Equipment ManufacturePEDP - Philippine Export Development Plan

iv Acronyms and Abbreviations

PEZA - Philippine Economic Zone AuthorityPHILEA - Philippine Industrial Estates AssociationQR - Quantitative RestrictionRCA - Real Comparative AdvantageR&D - Research and DevelopmentRDC - Regional Development CouncilSFB - Standard Factory BuildingSITC - Standard International Trade ClassificationSME - Small and Medium EnterpriseSTAND - Science and Technology Agenda for National DevelopmentTESDA - Technical Education and Skills Development AuthorityULC - Unit Labor CostLJNCTAD - United Nations Conference on Trade and DevelopmentWTO - World Trade Organization

Acknowledgments v

ACKNOWLEDGMENTS

This report was produced by a team led by Sanjay Dhar and included FranciscoFerreira, Kumiko Imai, Fred Kilby, Sanjaya Lall (consultant), Yuzuru Ozeki, KishoreRao (consultant), T.G. Srinivasan and Vivek Suri. Hedwig Abbey and Meredith Dearbornassisted in document processing.

We gratefully acknowledge the cooperation and support of government officialsand private sector representatives for the preparation of this report.

Executive Summary vii

PHILIPPINES: MANAGING GLOBAL INTEGRATION

EXECUTIVE SUMMARY

INTRODUCTION

An integral element of the Philippines' economic turnaround in the mid-1990s hasbeen a parallel rise in trade and capital flows in proportion to the domestic economy.Faster integration into the global economy is the result of falling transport andcommunications costs worldwide, increasing diversification of investment funds, as wellas the substantial liberalization of trade and capital flows enacted by the Philippines.

More rapid integration has brought with it greater opportunities and rewardsthrough increased trade and investment, which have been instrumental in fostering greatercompetition within the domestic economy and contributing to a foreign direct investment(FDI)-led export boom within the electronics sector. At the same time, the volume andvolatility of private capital flows have increased at a much faster pace than trade. Suchflows have, hence, played an increasingly important role in real exchange ratedetermination and motivated the financial market turbulence in 1997.

The heightened rewards and risks from global integration, therefore, place a risingpremium on the quality of economic policy. In an open economy such as the Philippines,the challenge to policymakers is to incorporate realistic assessments of both opportunitiesand risks from global integration, and to align policies to take maximum advantage of theopportunities while adequately managing the risks.

FINANCIAL MARKET INSTABILITY: CAUSES AND CONSEQUENCES

Although the trigger for the shift in investor sentiment in early 1997 wasThailand's intensifying crisis, the resulting financial market turbulence should not beattributed to irrational market sentiment alone. The appreciating real exchange rate, risingtrade deficit, rapid growth of private credit facilitated in large part through intermediationin foreign currency, associated buildup in real estate prices in Metro Manila, and thelong-term consequences for the banking system of these trends were legitimate concernsprior to the exchange rate adjustment on July 11, 1997. (See, for example, World Bank1996.)

The 29 percent depreciation of the peso since July 10, the sharp increase in thelevel and volatility of interest rates, and the 40 percent decline in equity prices thus far in1997 pose potentially severe problems for corporations, particularly if the period offinancial market volatility is protracted. The risks in the current situation are aggravatedby the prospect of greater fiscal, corporate and banking stress, slower economic growth

viii Executive Summary

and higher inflation, and the adverse impact of these on investor confidence and externalcapital availability.

Conflicting policy requirements have also complicated the adjustment to the shiftin market sentiment in 1997: tight monetary policies are called for to adjust to thediminished demand for domestic assets, to limit the extent of exchange rate depreciationand increase in inflation, and to maintain the confidence of international creditors,exporters and overseas workers; yet, concerns about corporate and financial health inlight of the sharply higher interest rates witnessed are also legitimate, particularly sinceprivate investment and consumption can be expected to react adversely in the newenvironment. Fortunately, the adjustment to the new market reality has been relativelyrapid in the Philippines, and the financial policies enacted since the decision to allow amore market determined exchange rate have on balance been appropriate-even thoughthe tradeoffs involved have inevitably caused policy tensions to arise.

Notwithstanding these concerns and conflicts, in a number of aspects thePhilippines' recent performance and attributes can be differentiated from the othercountries in Southeast Asia affected by the regional currency crisis. For example:

T The period of significant foreign borrowing by the private sector and rapid creditgrowth was shorter in the Philippines relative to its neighbors. As a result, the ratio ofprivate credit/GNP is more modest, large corporations appear less leveraged, andvacancy rates for vulnerable segments of the real estate market appear lower.

* Export growth since 1995 has been the highest among market economies in theregion-and including the 23 percent growth through September 1997 ranks asamong the best export performances globally in recent years.

* Over the past decade, the Philippines has made significant progress in the areas ofstructural reform and deregulation, and has developed transparent approaches to thedesign of economic policy-progress that is increasingly valued by the investorcommunity.

* There is a recognition among policymakers that global integration is a reality that hasto be managed rather than reversed. Policy statements as well as actions since thecrisis have reflected this understanding.

POLICY IMPLICATIONS

The critical factor over the next year will be to rebuild investor confidence. Whilemore difficult in the current environment, confidence can be bolstered through theperception that macroeconomic policies will remain sound, financial institutions and theregulatory environment will continue to be strengthened, firther repercussions fromfinancial market instability will be decisively handled, structural reforms will be pursued

Executive Summary ix

in a timely manner and recent progress on improving governance will continue. Tostrengthen policy stability and predictability, developing close coordination between thekey government agencies responsible for economic policy and maintaining cooperationbetween the executive and legislative branches through the pre- and post-election periodswill both be important.

Short-Term Macroeconomic Policy

Continued vigilance over monetary and fiscal policies will clearly be vital in theshort term. To strengthen the basis for conducting monetary policy, gathering preciseinformation on the profile of foreign debt service requirements of the private sector in theshort term will be helpful to gauge pressure on the exchange rate from this source.Similarly, identifying corporations that are particularly vulnerable to high interest ratesand their primary creditors could provide the authorities with advance information ofimpending problems in the corporate and banking sectors.

Since July 11, the authorities have relied on frequent adjustments of liquidityreserve requirements to influence liquidity conditions in the market. Yet the effectivenessof monetary policy would be enhanced if greater reliance could also be placed on open-market operations. Use of the latter is, however, constrained by the ruling (effective as of1997) that banks are subject to taxation on repurchase agreements with the central bankof greater than five days' maturity; this ruling therefore needs to be reconsidered in lightof the current financial market volatility.

The prospective passage of the comprehensive tax reform bill should be beneficialto investor confidence if it is seen to significantly enhance revenue in the context ofbroadening the tax base and improving efficiency. Hence strong implementation of theprogram will be needed to attain the Administration's original revenue objectives fromthe recent legislation. On the expenditure side, if further public expenditure cuts areneeded, it would be preferable to cancel or delay projects and programs that are rankedlow in terms of economic priority, rather than administer across-the-board cuts to theentire public investment program. Poverty alleviation and social safety net programs thatare effective in attaining their objectives should be protected from cutbacks. Hence, thegovernment may wish to consider temporarily raising the share of official developmentassistance (ODA) financing of public investment, if needed to protect its high-priorityobjectives. At the same time, greater caution and selectivity is warranted in grantingfiscal incentives to promote private investment (whether through the tax system orguarantees) in view of the need to reduce the private sector-generated current accountdeficit and the risk of exacerbating overcapacity in a slowing economy.

The Supreme Court's decision on November 5, 1997 rendering the oilderegulation bill unconstitutional needs to be addressed as soon as possible (through newlegislation if necessary, as is the government's intention) to minimize damage to investor

x Executive Summary

confidence, to reestablish the deregulation objectives of increased competition andinvestment, and to protect the government's fiscal targets.

Structural Reforms

Addressing those aspects of the structural reform agenda that will place thePhilippines in a favorable position to take advantage of the post-turbulence regionalenvironment will be particularly important. To the extent that the structural reformagenda can be accelerated, this would add to investor confidence, which in turn couldhelp to ease the difficult tradeoffs the economy will have to endure in the short term.

Fiscal Policy. Lower economic growth and corporate profits and higher interestcosts are likely to pressure the fiscal accounts through 1998. Yet fiscal policy is currentlyconstrained by its relative inflexibility, forcing too high a proportion of the burden ofadjustment to be borne by cuts in maintenance and investment. If the increase over thepast three years in government personnel costs is to be reversed, streamlining publicagency roles in the context of the existing civil service reform agenda remains of highpriority. Recent progress on tax reform should be complemented with sustained attentionto strengthen tax administration, and incentives for revenue generation by localgovernments need to be strengthened. The government's intention to review the policyframework governing public enterprises is timely; in this regard, the program torestructure the National Power Corporation (NPC) and privatize its remaining generationcapacity needs to be considered with renewed vigor in view of the added pressure to itsfinancial position from exchange rate depreciation.

The Banking System. The Thai crisis indicates that strengthening the regulatoryand supervisory infrastructure for the financial system is a sound investment that cangenerate substantial payoffs in terms of forgone costs. In particular, allowing financialinstitutions that are insolvent (and likely to remain so under stable macroeconomicconditions) to continue to operate can undermine both macroeconomic stability and theincentive framework for healthy financial institutions; the cost of delaying action againstsuch institutions generally increases significantly over time. The short-term prioritytherefore is to strengthen coordination among the bank supervisory agencies to ensurethat the capacity of regulators to implement and enforce failure resolution policies isadequate and can be implemented through prompt, confidence-maintaining action torespond to sudden difficulties as they arise.

The more resilient the banking system to volatility in financial markets, the lessconstrained and more effective macroeconomic policies can be in guiding a return tostability. Hence, improving the incentive and ability of supervisors, the market andowners to monitor and support prudent banking will remain vital. Significant progress hasrecently been made in increasing capital adequacy requirements, loan loss provisions andliquidity requirements on foreign currency deposits, and further measures are envisaged

Executive Summary xi

under the General Banking Act submitted to Congress. While the pace at which furtherreform now progresses needs to be calibrated to the evolving financial market situation,the following areas are stressed:

* Strengthen the credibility of supervisors against excessive risk taking, includinginsulating supervisors from legal challenges by those who they regulate.

. Improve transparency by raising minimum disclosure standards. Strongerrepresentation of outside shareholders on bank boards-particularly those that areclosely held-would also enhance transparency.

* Incorporate a risk-weighting scheme into the definition of capital adequacy inclusiveof accounting for off-balance sheet activities.

Savings Mobilization. The recent volatility of external capital flows highlightsthe need to develop domestic capital markets in order to finance a larger proportion ofinvestment through domestic saving. In addition to increasing public saving, encouragingthe development of domestic bond markets will be important. Several factors will beneeded for this effort: establishing independent credit rating agencies (or contracting theservices of foreign agencies); creating a level playing field in terms of taxation betweendebt and equity finance; liberalizing investment constraints on the long-term investmentresources of the social security agencies; encouraging private institutions to play a greaterrole in housing finance; and developing instruments such as mortgage-backed securities,more active secondary markets and, more generally, longer-term floating rate debtinstruments to provide comfort against macroeconomic volatility.

International Competitiveness. The Philippines appears well placed to takeadvantage of integrating global markets given its high-quality English-speaking workersand its relatively deregulated economy that reflects a decade of structural reform.Competitiveness would be further enhanced if the recent real exchange rate depreciationcan be substantially sustained in a stabilized macroeconomic environment andcomplemented by efforts to increase labor productivity.

The relative stagnation of traditional industries such as garments, footwear andfood processing in recent years appears unwarranted when viewed against thePhilippines' large pool of surplus labor, rapidly growing labor force relative to majorcompetitors, and a broad base of literacy and trainability. Part of the reason may be thehigh level of minimum wages in relation to per capita income levels, exacerbated by thenearly 40 percent appreciation in the real exchange rate between 1990 and mid-1997. (Inthis regard, it is important that prospective wage adjustments do not unduly underminethe beneficial impact of the recent depreciation on competitiveness.) Part is also the shiftin sourcing patterns in its largest market, the United States, which is switching to LatinAmerican suppliers with privileged access in terms of quotas and tariffs. Upgrading of

xii Executive Summary

quality and efficiency has also been limited to the larger companies; smaller supplierswill face increasing difficulties in meeting world market standards, and may be adverselyaffected when the implicit protection given by the Multifiber Agreement comes to an endin 2004. The premature "graduation" from such industries is undesirable for enhancingcompetitiveness.

In technology-intensive industries, Philippine exports have performed very wellrecently, particularly given the slowdown of electronics exports in neighboring countries.However, these exports are highly concentrated in one product-semiconductors-and inthe lowest levels of technology with little local value added. Over the longer term, thisstructure may face an erosion of competitiveness from low-wage entrants, which alsooffer high levels of skill and a stronger local supply base.

Raising labor productivity-where growth has lagged that of neighboring marketeconomies-may be the most important element of improving competitiveness; the keypolicies in this regard relate to education, maximizing the benefits from FDI, andimproving technological support to industry, particularly small- and medium-sizeenterprises (SMEs).

In education, quality, relevance, access and completion rates need to be raised,and the length of schooling brought into line with international norms. The variation inthe quality of higher education institutions needs to be reduced, improvements in teachingstandards and equipment are needed for the high-level technical and management skillsthat competitiveness requires, and specific skills needed by traditional industries (e.g.,garments) as well as new ones (e.g., electronics) have to be better met. There needs to begreater private sector participation in the design and implementation of training programs.The enterprise sector itself, especially SMEs, has to be induced to invest more inupgrading employee skills.

The environment for FDI has considerably improved, but the benefits of FDI haveyet to reach full potential. FDI into the manufacturing sector is narrowly concentratedinto activities that generate exports at relatively low levels of local integration andtechnological complexity. Adhering to the government's program of trade liberalizationpresents the surest means of encouraging greater integration of FDI-led activity. Inaddition, the FDI promotion system needs to shift toward regional best practice, withincentives geared toward a performance-based system and away from the existing "front-loaded" system where tax holidays are provided at the beginning of the investment cycle.There is also a need to consolidate the promotion and incentive systems, by establishingclear responsibility for FDI promotion for the country as a whole, hence removingduplication and rent-seeking possibilities. (Measures to this effect are currently underconsideration.) In particular, incentives emanating from the Board of Investments and thePhilippine Economic Zone Authority need to be consolidated; the advantages of locatingwithin economic zones would nevertheless be significant, stemming from the duty-free

Executive Summary xiii

environment, streamlined procedures, and access to an integrated package ofinfrastructure and facilities.

The technology support system in the Philippines has all the necessary ingredientsin place, but needs to be better organized and made more relevant to industrial needs.There is a particular need to improve quality levels and linkages with SMEs, to upgradetheir competitiveness directly and improve their capability to act as suppliers andsubcontractors to large exporters.

The following measures are also expected to be important for enhancingcompetitiveness:

* Reversing the recent increase in agricultural protection by accelerating the schedulefor lowering agricultural tariffs to bring down import protection to at least its pre-1996 level. The motivation for this policy is twofold: to lower the prices of basic foodcommodities-which are significantly higher than in neighboring countries, and maybe an important factor in wage determination; and to enhance the competitiveness ofthe food processing industry, where current performance appears well belowpotential, in part due to higher input costs. It should be noted that reducing importprotection needs to be complemented by supporting efforts to enhance agriculturalcompetitiveness and productivity, World Bank (1997).

* One objective of a successful restructuring/privatization of NPC (discussed above)should be to provide more competitive electricity costs for industry, which have beenamong the highest in East Asia.

Responding to a Soft Landing of the Currency Crisis

The shift in investor sentiment during 1997 has meant that policy attention hashad to adjust from moderating the consequences of overexuberant markets to the oppositeconcern. It is, however, possible that the Philippines may again need to address concernsabout excessive short-term portfolio inflows and foreign borrowing in the not-too-distantfuture, particularly if regional markets were to stabilize more rapidly than anticipated.Under these circumstances, the most important policy responses would be to deepen theprogram to strengthen incentives for prudent banking, while retaining a considerabledegree of exchange rate flexibility in macroeconomic management-so that privateagents can adequately evaluate and protect against the risks associated with foreignborrowing. In addition, the experiences of other countries with influencing the nature andmaturity of capital inflows would need to be studied with respect to their applicability tothe Philippines.

Introduction xv

INTRODUCTION

This report analyzes the prospects for and consequences of continued globalintegration of the Philippine economy and examines the policy implications. Volume 1summarizes recent economic developments and the nature of the financial instabilityexperienced in 1997, and then focuses on three topics that will require ongoing policyattention in the context of continued integration: financial policies and risk management;enhancing international competitiveness; and strategic and institutional issues inmanufactured export development. Volume 1 concludes with a discussion of economicprospects and attendant requirements for official development assistance.

Volume 1 draws on three background chapters contained in Volume 2. Chapter 1of Volume 2 places the key elements of the Philippines' global integration in perspective,comparing their evolution with that of other developing and East Asian countries. It thenassesses the Philippines' competitiveness as a host for foreign direct investment (FDI),examining comparative infrastructure and labor costs across East Asia. The chapterconcludes with a more indepth labor market assessment, focusing in particular onproductivity, compensation and unit labor costs, and their impact on the competitivenessof tradable sectors.

Chapter 2 examines the underlying competitiveness of Philippine exportindustries and the sustainability of their growth. The chapter compares the characteristicsof Philippine exports with those of the more industrialized ASEAN economies, China,Korea and Taiwan (China), and describes the Philippines' competitive "positioning" inworld markets. It then deals with the position and prospects in world markets of threeproduct groups: textiles and garments, electronics, and software, and subsequentlyanalyzes the main supply-side determinants of competitiveness-inward FDI, specialeconomic zones, domestic industrial policies, skills, and technological activity andsupport. It concludes by reviewing the institutional and policy measures needed toimprove and diversify export activities.

An important aspect of Philippine export competitiveness relates to the role ofspecial economic zones (ecozones), which have expanded rapidly in recent years, andhave had a growing impact on the economy in terms of exports, investment andemployment. Chapter 3 reviews changes in the concept and development practices ofecozones and identifies international best practice. It then evaluates the performance andcompetitiveness of Philippine zones in relation to other countries, assesses areas forimprovement in the policy and institutional framework, and finally evaluates the strategicrole of ecozones over the next decade from the perspective of falling trade barriers.

xvi Introduction

Finally, using the World Bank's Global Trade Analysis Project (GTAP) modeland a set of assumptions about the world economy, two annexes in Volume 2 discuss: (a)a feasible scenario for the long-term evolution of the Philippine economy (through 2020);and (b) prospects for the Philippines' two leading exports-semiconductors andgarments.

Section 1. Economic Developments and Issues: An Overview I

PHILIPPINES: MANAGING GLOBAL INTEGRATION

VOLUME 1: THE MAIN REPORT

1. Section 1 of this volume summarizes recent economic developments and thenature of the financial instability experienced in 1997. Section 2 then focuses on threetopics that will require ongoing policy attention in the context of continued globaleconomic integration: macroeconomic and financial policies, enhancing competitivenessby pursuing further structural reform, and strategic and institutional issues inmanufactured export development. The volume concludes with a discussion of economicprospects and attendant requirements for official development assistance.

1. ECONOMIC DEVELOPMENTS AND ISSUES: ANOVERVIEW

2. Over the past four years, the Philippine economy has benefited from a decade ofstructural adjustment that has focused economic policies on trade liberalization andincreased domestic competition, privatization, and greater private management andinvestment in infrastructure. Favorable investor reaction to these changes has inducedsignificant increases in private investment and capital inflows contributing to highergrowth. In 1996 economic growth accelerated to 6.9 percent (GNP) and 5.7 percent(GDP), year-end inflation fell, investment and saving rates rose driven primarily by theprivate sector, export growth-though reduced reflecting slower external demand forelectronics exports-was the highest among market economies in East Asia. While fiscalrestraint was maintained, with the 1996 consolidated public sector account inapproximate balance, the trade deficit continued to rise to 13 percent of GNP. Privatecapital inflows rose to nearly 10 percent of GNP and worker remittances amounted toanother 12 percent of GNP in 1996, contributing to the continued strengthening of thePhilippine peso in real terms and an acceleration in credit growth. Table 1 provides asummary of the key economic parameters; further details are provided in the statisticalannex.

3. The economic turnaround of the mid-1990s has contributed to improving socialwelfare although the incidence of poverty remains a major development issue,particularly in rural areas. About 3.5 million jobs were generated during 1993-96,reducing the unemployment rate to 8.6 percent in 1996 from over 10 percent in 1991-92.Home ownership among lower-income families has sharply increased. Functional literacyhas risen to 88 percent from 75 percent in 1989. Life expectancy increased from 62.5 in1992 to 69.5 in 1997. Over the same period, the infant mortality rate declined from 53.6to 45.8 per 1,000 live births. The officially measured poverty rate declined from 40

2 Section 1. Economic Developments and Issues: An Overview

TABLE 1: SELECTED ECONOMIC INDICATORS, 1992-97

1992 1993 1994 1995 1996 1997L

(percentage change)Growth and InflationReal GNP 1.6 2.1 5.3 5.5 6.9 5.9 (Jan-Jun)Real GDP 0.3 2.1 4.4 4.8 5.7 5.3 (Jan-Jun)CPI (period average) 8.9 7.6 9.0 8.1 8.4 4.8 (Jan-Oct)CPI (end period) 8.2 8.4 7.1 10.9 5.2 5.7 (Oct)

Unemployment Rate (percent) 9.8 9.3 9.5 9.5 8.6

(in percent of GNP)Saving and InvestmentNational Saving 19.4 18.1 17.6 16.1 19.1Private 17.8 13.7 14.5 12.9 14.6Public 1.6 4.4 3.1 3.3 4.5Gross Investment 21.0 23.6 23.5 21.6 23.9Private 16.2 17.9 18.7 17.0 19.4Public 4.8 5.7 4.8 4.6 4.5

Public SectorNational GovemmentTax Revenue 15.2 15.3 15.6 15.8 16.1 16.6 (T)Investment 3.4 2.5 1.9 2.7 2.5 2.6 (T)Balance /b -1.2 -1.5 0.9 0.6 0.3 0.5 )T)Monitored Corporations Balance -0.8 -1.7 -0.5 -0.1 -0.5 -0.4 (T)Consolidated Public Sector Balance -1.9 -1.7 -0.4 -0.1 0.3 0.3 (T)

PublicDebt 118.6 127.4 109.4 110.8 95.0National Govemment Debt 71.2 84.6 70.9 66.7 58.3

(end-year percentage change)Money and CreditBroad Money 11.0 24.6 26.5 25.3 15.8 23.7 (Aug)Credit to Private Sector 24.6 38.0 27.9 43.5 51.0 32.0 (Aug)Commercial Bank Loans 24.0 32.2 25.4 35.8 51.9 39.1 (Sep)

(end-year percentage change, $ value)Balance of PaymentsMerchandise Exports 11.1 15.8 18.5 29.4 17.7 23.0 (Jan-Sep)Merchandise Imports 20.5 21.2 21.2 23.7 20.8 12.6 (Jan-Aug)

(in percent of GNP)

Trade Deficit 8.7 11.2 11.9 11.7 13.0 12.1 (Jan-Jun)Current Account Deficit 1.6 5.5 4.5 4.3 4.5 4.5 (Jan-Jun)

Intemational ReservesGross Official Reserves ($ billion) L/ 5.3 5.9 7.1 7.8 11.7 10.4 (Aug)(in months of imports) 3.3 3.1 3.1 2.6 3.1 2.6

Extemal DebtTotal ($ billion) 30.9 34.3 37.1 37.8 41.9InpercentofGNP 57.4 62.0 56.4 49.6 48.1Debt Service Ratio (percent) 17.0 17.1 17.4 15.8 12.5 11.1 (Jan-Jun)

Exchange Rate (Pesos/$; period average) 25.5 27.1 26.4 25.7 26.2 35.3 (Oct 31)Real Effective Exchange Rate (1990=100) 110.9 110.4 117.3 120.3 ' 129.8 137.7 (Jan-Jul)

La Latest period.lb Excluding central bank restructuring.L/ Including gold.ad Increase indicates appreciation.T. Official target

Source: Govemment of the Philippines, Intemational Monetary Fund, World Bank staff estimates.

Section 1. Economic Developments and Issues: An Overview 3

percent in 1991 to 36 percent in 1994; the trend of other welfare indicators since 1994suggests a further subsequent decline in poverty.'

4. The Domestic Economy. Exports and investment were the driving factorsunderlying the increasing growth rates during 1994-96. Output and export of electronicswas particularly rapid-electronics exports now account for over half of merchandiseexports, and have grown by 34 percent over the past three years. Indeed, boosted bysubstantial foreign direct investment (FDI) in industrial estates and economic zonesprimarily outside Metro Manila, the Philippines has emerged as a major center for chipassembly and testing. A further impetus for the higher growth rates witnessed through1996 has come from construction and utilities, where some 25 private power plants havecontributed to a major expansion of electricity provision. The financial services industryhas also expanded rapidly, aided by the entry of 10 new foreign banks since 1995 withreduced restrictions on their operations.

5. By contrast, expansion within the manufacturing sector as a whole has been moresubdued, with growth peaking in 1995 at 6.8 percent but slowing to 5.5 percent in 1996and to 3.9 percent in the first half of 1997. Slower manufacturing growth in 1996reflected low or negative growth among a number of traditional industries such astextiles, footwear, furniture and rubber, in which investment slowed and competitivepressures from lower wage economies appear to have increased. Finally, whileagricultural production recovered sharply in 1996 following the previous year's drought,viewed from a longer-term perspective, agricultural performance has been weak, withgrowth averaging less than 2 percent in the 1990s.

6. In the first half of 1997, real GNP growth slowed to 5.9 percent, down from 7.5percent during the same period in 1996. Real GDP growth in the first semester reached5.3 percent, with the reduced differential between GDP and GNP growth reflectingdecelerating factor income growth. Industrial production grew by 5.4 percent driven by16 percent growth within construction. The services sector and agriculture grew by 6.3and 3 percent, respectively.

7. Inflation was on a downward trend through mid-1997, averaging less than 5percent in the first half of the year, aided by lower food prices and a stable nominalexchange rate against the dollar. Even prior to the shift toward greater exchange rateflexibility on July 11, 1997, inflation was forecast to increase slightly in the second halfof the year, reflecting a projected pickup in food prices. The extent of increase in prices

Government measures of poverty use a higher income cutoff level than in many other countries. Forexample, using a standardized definition of poverty across countries-households with per capitaincomes below $1 a day in 1985 prices, at purchasing power parity (PPP) exchange rates-Ahuja et al.(1997) estimated poverty in the Philippines to have declined from 32.4 percent in 1985 to 25.5 percentin 1995.


will now also depend on the FIGURE 1: BALANCE OF PAYMENTS TRENDS

degree of exchange rate External Balancesdepreciation and the speed 13

with which domestic pricessubsequently adjust. The 6.5

government's original0~inflation targets for 1997- O

of 6.5 percent (year-average) a ,- - . Current Accountand 7.1 percent (year-end)- . -- --------------

were reinstated following -6.5~~~~~~~Trade Balance

the exchange rateadjustment, after an initial -13- I IIadjustmnt, after an initial 1990 1991 1992 1993 1994 1995 1996 1997downward revision of these QI

targets.Merchandise Trade

8. External Sector. Onthe external front, the trade 35000

deficit widened in 1996, but 30000 |

the continued buoyancy of = 25000.2 20000

remittances from overseas -workers-which grew to 10000-over $10 billion-held the 5000

current account deficit o-_ _ _ _

relatively stable at 4.5 1990 1991 1992 1993 1994 1995 1996

percent of GNP (Figure 1).2 Exports Imports - Electronics Exports

In the first half of 1997, thetrade deficit declined asexport growth rose to 22 Foreign Investment Flowspercent, more than double 8000 8000

the pace of import growth. 7000 7000

The current account deficit 5000 00c 5000 -~~~~~~~~~~~~50

in the first half of 1997 was 6 4000-4000 e 4000=hence reduced to 4.5 percent E 3000

Q" 3000 30of GNP from 6.6 percent for 2000 2000

the samne period in 1996, 1000 -- 1000notwithstanding a decelera- 0 14 o

tion in the growth of 1990 1991 1992 1993 1994 1995 1996

remittances. The overall Portfolio-in Portfolio-out - DFI-netbalance of payments

2 Difficulties in distinguishing remittances from peso conversions of foreign currency deposit units(FCDUs), and the latter from export receipts however add a measure of uncertainty to the currentaccount figures.


position through June, however, deteriorated sharply from a $2.4 billion surplus in 1996to a $209 million deficit in 1997 primarily reflecting a reversal of portfolio flows (AnnexTable 3).

9. Philippine export growth since 1995 has considerably outperformed that ofneighboring market economies (starting however from a lower base), with electronicsexports leading this expansion. Electronics exports grew by 35 percent in 1996,notwithstanding the regional slowdown within the sector. The export performance ofmanufacturing other than electronics has been less dynamic, however, with growthaveraging 11 percent during 1994-96. This factor, the relatively high import content ofelectronics exports, and the heavy demand for transport and telecommunications importshave combined to widen the trade deficit in recent years. The share of consumer goodsimports has risen in recent years but still comprised only 10 percent in 1996.Appreciation of the real effective exchange rate by about 38 percent between 1990 andmid-1997 also contributed to the widening trade deficit.

10. Foreign investment declined by about one third in 1996 as net inflows of FDI andportfolio investment both fell. While net portfolio flows turned slightly negative, bothinflows and outflows of gross portfolio flows nearly doubled to over $8 billion each. As aresult of rising portfolio flows-which have been primarily directed into and out ofequities-foreign capital accounted for at least 60 percent of the turnover in the localstock market through mid-1997 and was a major factor in the fall in equity prices in 1997.Portfolio flows turned increasingly negative in early 1997 (Annex Table 3), as investorsentiment began to shift.

11. Notwithstanding the moderation of private investment net flows, the capitalaccount surplus more than doubled to nearly $9 billion in 1996, permitting a significantaccumulation of central bank (BSP) reserves, and reflecting large increases in both short-term and long-term borrowing which continued through the first quarter of 1997. Suchborrowing appears to have been motivated by the lower cost of foreign currency loansand the expectation of a stable nominal exchange rate, and was facilitated by thePhilippines improving creditworthiness (Figure 2). The largest item of increase within thecapital account was a $4.2 billion rise in foreign borrowing and equity inflows ofcommercial banks. The foreign exchange liabilities of commercial banks have grown bysignificantly more than implied by this figure, once the increase in commercial banksliabilities from holding FCDUs are also included-as of June 1997, deposit liabilitiesfrom FCDUs amounted to $16.9 billion and FCDU loans and discounts totaled $12.2billion.

12. Credit Expansion. This growth in banks' foreign exchange liabilities fueled asignificant credit expansion that peaked in 1996: commercial bank loan growth averaged


31 percent in 1993-95 and accelerated to 52 percent in 1996,3 before declining to 34percent through July 1997. The acceleration of credit growth in 1996 occurrednotwithstanding substantial sterilization of capital inflows by the BSP. It is worth notingthat this rapid credit expansion started from a low base-even now, at 50 percent, theshare of private credit to GNP in the Philippines is significantly lower than inneighboring market economies. Nevertheless, the pace of credit expansion has raisedconcerns about the ability of banks to maintain credit quality, particularly withinsegments of the commercial and luxury real estate markets where prices rose at anunsustainable pace through 1996 but have since stagnated or declined.

FIGURE 2: FINANCIAL MARKET TRENDS

Foreign Liabilities of Commercial Banks Stock Market Index(at end of period)

25 Mar 97 30

20 283000-

240010 24 , X ~

0~~~~~~~~~~~~~~~205 -- '''''''..........22 2100 _

n - N | l l - 20 t800 I I I I I I I I I I' I -1990 1991 1992 1993 1994 1995 1995 O) OL

0 0~~~~~~~~~------ Foreign UaLilaies of CBs ind. FCDUs (left) - Exchange Rate (right) 0 u.

BSP Overnight Rate and Exchange Rate Money and Credit Growth35T -36

6 0T

25 1 ""' ' - 32 , Private Sector= 20 j_ > ; e - 40 Credit

5-'''20 '''''''' -26 e 20 X / <\015 ~~~~~~~~~~~~~~~~" 30

28 M410

0 ::IIII.III 24 10

N ; s ) o N t t 4 I : I I II I I

1990 1991 1992 1993 1994 1995 1996 1997BSP overmight rate ------ Exchange rate Q1

3 The acceleration of credit growth in 1996 also reflects the startup operations of 10 new foreign banksand the reclassification of the Philippine National Bank (PNB) as a commercial bank.


FINANCIAL MARKET INSTABILITY IN 1997

13. In early 1997, financial markets began to exhibit increased anxiety over thePhilippines' rising trade deficit, the pace of credit expansion, and the impact of a possiblecorrection in property prices on banks and real estate developers. Thailand's intensifyingeconomic and financial difficulties added to foreign investor concern toward thePhilippines and other market economies in Southeast Asia. The impact of such concernwas first felt in the stock market, which reached a record high in early February butdeclined by 40 percent (in peso terms) between January and mid-November, with bankand property stocks initially leading the decline. Since April, the flight from equitiesbegan to spill over into the foreign exchange market, and the BSP shifted from netpurchaser to net seller of foreign exchange. After accumulating substantial reserves inpast years to prevent nominal appreciation of the peso against the dollar, the BSP spentabout $2.5 billion between April and July 10 defending the peso, with the bulk of thisoccurring after Thailand's shift to a managed float exchange rate system on July 2, afterwhich the Philippine peso came under sustained pressure. The volume of turnover in boththe equities and foreign exchange markets also increased significantly in the first half of1997, with average daily turnover in the latter market exceeding $200 million andpeaking at over $1 billion after the baht float.

14. The BSP's overnight borrowing rate was increasingly used to defend thecurrency-for example on July 2, the BSP's key overnight borrowing rate (the reverserepurchase rate) was raised from 15 to 24 percent, and further to 32 percent by July 10.On July 10, faced with sustained speculative attacks and declining reserves-grossreserves had declined to $9.7 billion-the BSP announced it would allow greaterexchange rate flexibility by no longer intervening as actively in the foreign exchangemarket. The following day, the peso depreciated by 11.5 percent before trading washalted. The peso strengthened somewhat through most of July, permitting progressivereductions in the overnight interest rate, but came under renewed pressure subsequentlyand had depreciated by 29 percent between July 10 and mid-November. Increasedpressures on other currencies and stock markets in the region contributed to the generalmalaise in investor sentiment.

15. An agreement with the International Monetary Fund (IMF) was approved onJuly 18 to extend the existing Extended Financing Facility to end-1997; coupled with anaugmentation of this Arrangement, $1.05 billion was made available from the IMF, ofwhich some $700 million was subsequently disbursed. Loans from the Japan EXIM Bankand private banks were also utilized to replenish central bank reserves.

16. In the context of the IMF program, the authorities decided to retain most of theprincipal economic targets for 1997 notwithstanding the increased financial instability.Hence, real GNP growth was targeted to remain at 7 to 8 percent and inflation to average6 to 7 percent. (The growth target was subsequently adjusted to 5.5 to 6 percent). Thetarget of a small national government (NG) surplus was retained, despite weaker-than-


expected revenue performance in the first half of 1997. A series of measures to reduceboth current and capital spending have been implemented; on the revenue side, efforts toovercome delays in the tax payments system are being intensified, a number of fees andcharges are being reviewed, and access to duty free stores has been reduced. And, indeed,through September 1997 the NG surplus reached about 5 billion pesos, exceeding thegovernment's program for this period. The fiscal program for 1998, which again targets asmall public sector surplus, assuming passage of an appropriate Comprehensive TaxReform Package in 1997, or, if the revenue-enhancing features of the latter fall short,enactment of compensatory fiscal measures. Monetary policy is aimed at realizing thegovernment's inflation and reserve targets, thereby containing pressures in the foreignexchange market and implying a tight program of base money expansion.

17. In the aftermath of the exchange rate shift, pressure against the peso did notsubside, however, prompting several measures to tighten domestic liquidity, strengthenprudential requirements, and discourage further speculation: interest-bearing (liquidity)reserve requirements were raised progressively-to a high of 8 percent beforesubsequently being lowered,4 over-the-counter foreign exchange availability from bankswas reduced from $100,000 to $25,000; previous limits on banks' foreign exchangepositions were tightened as a proportion of unimpaired capital-the permissible oversoldposition was reduced from 10 percent to the smaller of 5 percent or $10 million (theoverbought position had earlier been lowered from 20 to 10 percent)-and monitoring ofbanks' forward foreign exchange positions was tightened; and access to the BSP'sovernight lending window was closed between mid-August and early October. And fortwo weeks between late July and mid-August, six major foreign banks were requested notto participate in the spot foreign exchange market, and required instead to buy foreignexchange through forward contracts of up to 90 days. The volume of trading in theofficial foreign exchange market diminished significantly following the regime shift onJuly 11, and a parallel foreign exchange market also emerged (though with only a smallpremium of 1 to 2 percent over the official rate). By September, turnover volume hadreturned to earlier levels.

18. With the peso falling to new lows in early October, BSP intervention increased,and on October 7 the Bankers' Association of the Philippines (BAP) introduced avolatility band for the peso, which consists of a series of intermediate circuit breakers andlimits overall daily volatility to 4 percent, after which trading is suspended for the day.

19. Tightened liquidity and higher short-term interest rates in response to continuedselling pressure on the peso soon spilled over into longer-term maturities, raising interest

4 Liquidity reserve requirements were raised from 2 to 3 percent on July 31; to 5 percent on August 15;and 8 percent on August 29. They were subsequently lowered in stages to 5 percent by October 15 andare scheduled to be reduced to 4 percent on November 15. In addition, the statuary (noninterest-bearing) reserve requirement of 13 percent has been maintained throughout this period.


costs on government and corporate paper as well as commercial bank lending rates.During September-October, the benchmark 91-day Treasury bill rate averaged 15 to 16percent and peaked in early October at 20 percent, compared to a low of under 10 percentin April. Prime lending rates at banks peaked at 30 to 35 percent and have averagedbetween 25 and 30 percent more recently. Interbank rates have been particularlysusceptible to credit conditions, with average rates peaking in early October at over 100percent, although for a short period and followed by swift reduction.

Box 1: LESSONS FROM THE THAI CRISIS

The unfolding Thai economic and financial crisis provides ample insight for emerging market economiesincluding the Philippines. Over the past decade, Thailand recorded among the highest economic growth,investment and saving rates in the world, maintained inflation at close to OECD levels, consistently ranfiscal surpluses prior to 1997, and witnessed a prolonged export boom prior to 1996. Large current accountdeficits in the 1990s were readily financed by bank borrowing, permitting substantial reserve accumulationthrough 1996, when gross reserves amounted to more than 6 months of imports. The practically fixedexchange rate against the dollar, coupled with higher domestic borrowing costs provided a powerfulincentive for borrowing abroad to finance domestic investment. Thailand's strong creditworthiness ratingsrendered foreign banks eager to supply such credit, although in recent years the nature of externalfinancing had begun to shift-toward short-term loans and away from FDI. The easy availability of foreigncredit fueled a credit boom, which in turn was increasingly channeled into consumption and the real estatesector, generating a boom in construction as well as property prices.

When market sentiment began to shift in 1996 and the first half of 1997, the Thai authorities initiallyresisted allowing the currency to depreciate, primarily out of concern over the impact on the financialsystem's heavy exposure to foreign exchange liabilities. Defending the exchange rate following the shift insentiment required substantial use of reserves, a prolonged period of increased interest rates, and capitalcontrols. Nevertheless, the authorities ultimately were forced to shift to a managed float exchange regimeon July 2, 1997. In the meantime, the extended period of high interest rates and slowing economic activityhad further weakened the financial system and adversely affected international creditworthiness,exacerbating the costs of the economic adjustment that followed the shift in exchange rate regime.

With the benefit of hindsight, the costs to the economy and financial system would have been lesssignificant had Thailand permitted greater flexibility in the exchange rate with less delay, once it was clearthat investor sentiment had fundamentally shifted. Another lesson from the Thai crisis is that prudent fiscalpolicy does not suffice to ensure stability; the size -of the current account deficit and the nature of itsfinancing matter, even if these are entirely driven by private agents. And indeed private agents generallyrespond to economic signals-including the perception of official policy favoring a stable exchange rate.Finally, lapses in supervision of the financial system can be extremely costly to the economy; as acorollary, efforts to upgrade the regulatory and supervisory infrastructure for the financial system can be asound investment that can generate substantial payoffs in terms of forgone costs.

10 Section 2. Policy Implications and Priorities

2. POLICY IMPLICATIONS AND PRIORITIES

20. Developments in recent years and months have illustrated well the benefits as wellas risks of rapid global integration. The Philippine export sector has boomed aided byincreased FDI, contributing to higher growth and employment, improving foreign debtservicing capacity, and upgrading the average technological content of exports. At thesame time, the increased availability of private capital contributed to a credit and propertyboom through 1996. The sudden shift in foreign investor sentiment, exacerbated by theintensifying Thai crisis, has demonstrated the risks inherent in the increased volume andvolatility of capital flows and their impact on macroeconomic variables and the bankingsystem.

21. The following sections discuss appropriate policy responses to rapid globalintegration in the areas of: (a) macroeconomic and financial policies; (b) structural reformto enhance competitiveness; and (c) strategic and institutional issues in the developmentof manufactured exports, including the evolving role of special economic zones.

MACROECONOMIC AND FINANCIAL POLICIES

22. The Philippine authorities' rapid response to shifting investor sentiment byadjusting exchange rate policy and tightening fiscal and monetary policies in the contextof an IMF program is to be welcomed. Moreover, during the year prior to the shift inexchange rate stance, a series of measures to address concerns about banks' vulnerabilityto real estate exposure, credit expansion, and foreign exchange risk were taken. A surveyof banks' exposure to real estate was commissioned in 1996 that indicated a relativelymodest exposure of 11 percent of the loan portfolio for the banking system as a whole-lower than in neighboring countries,5 notwithstanding particularly rapid expansion ofcredit within the category that includes real estate.6 Nonetheless, in April 1997, the BSPadopted two measures to tighten regulations on real estate lending by banks: it loweredthe ceiling on an individual bank's exposure to real estate from 30 to 20 percent of loanportfolio, giving banks one year to comply; and it lowered the permissible ceiling on theloan-to-value ratio for real estate lending from 70 to 60 percent of the market value of theproperty. Increases in minimum capital requirements for banks became effective as ofJanuary 1997. And in June 1997, banks were required to maintain a 30 percent foreignexchange liquidity requirement effective as of December 1997 (subsequently reduced to

5 Data as of March 1997 indicated an exposure of 11.6 percent; and 12.6 percent including banks' trustunits. These figures may be underestimated to the extent that loans to manufacturing companies forproperty-related activities are excluded.

6 Available data classify real estate exposure together with credit to financial institutions and businessservices (Annex Table 11). Commercial bank credit within this category expanded by 97 percent in1996, but slowed to 70 percent through September 1997.

Section 2. Policy Implications and Priorities 11

15 percent for an interim period) on their FCDU holdings, in order to improve thematurity profile of banks' foreign currency asset structure.

23. In light of recent market turbulence, the criteria for classifying nonperformingloans have been tightened, and a special 2 percent loan loss provision (staggered overthree years) has been applied to all banks. These measures, coupled with tighter monetarypolicy and the maintenance of a flexible exchange rate, should have a major dampeningimpact on credit growth.

Financial Market Instability: Consequences and Implications

24. In assessing the consequences of recent instability, it is useful to distinguishbetween the short and medium term. Over the medium term, there are likely to be anumber of beneficial effects. Greater exchange rate flexibility is expected to strengthenthe effectiveness of monetary policy. It should also curb the use of foreign borrowing andspeculative portfolio flows that were induced by large interest rate differentials and theimplicit assumption of a stable nominal exchange rate. Banks and corporations will alsohave greater incentive to adequately hedge their exposed foreign exchange positions ifthey continue to expect exchange rate flexibility (thereby promoting the development ofmore sophisticated hedging instruments). These factors indicate that a greater proportionof future foreign capital inflows can be expected to be driven by longer-term investmentand foreign exchange-generating objectives rather than speculative activity-thoughinitially this is expected to result in a reduced level of net capital inflow and hence theneed to reduce the current account deficit.

25. Sustaining a significant real exchange rate depreciation from recent nominalexchange rate movements-which implies the need to avoid a major wage-price spiral-would provide a boost to traditional exports, redirect investment toward tradable goods,and help to contain external deficits. Pressure on government to slow or reverse the paceof trade liberalization should also be easier to resist.

26. There will nevertheless be significant costs in the short term. As discussed inSection 3, growth in the year beginning in the third quarter of 1997 is expected to bereduced; ancd the period before which growth resumes at robust levels could beprotracted- vith regional linkages adding to the uncertainties. Public finances are likelyto be adve sely affected on balance as reduced revenue from slower growth and lowerpublic and k -ivate corporate profits and higher debt service costs can be expected todominate over increased import tariff revenue resulting from depreciation. Higher importcosts will cut profit margins and force some increase in domestic prices. The pass-through of higher overnight interest rates into longer-term rates will tend to delayinvestment plans and pressure asset prices, particularly for that portion of the real estatemarket where prices had previously been rising rapidly. Finally, corporations will beadversely affected by tighter credit conditions and will incur additional debt servicing


costs (in both foreign currency and pesos), while spreads for external borrowing can beexpected to rise.

27. These costs are exacerbated by factors that add to the risks faced in the currentenvironment and complicate the implications for policy. The risks are heightened by theheavy reliance on private capital flows (para. 2) and the scope for currency substitutionfacilitated by the FCDU system. Meanwhile, the demand for foreign currency would riseif the corporate sector expects further depreciation and hence attempts to prepay itsexternal debt servicing obligations or to more adequately hedge against its foreignliabilities. These factors indicate the need for a rapid resumption of investor confidence.

28. Yet gaining such confidence is hampered by external factors. The flow of badnews from elsewhere in the region has had a negative influence, and could continue atunpredictable intervals. And the upcoming elections in May 1998, which even undernormal circumstances would have added an element of uncertainty for investors, couldnow become a more serious cause of delay of private investment plans.

Short-Term Macroeconomic Policy

29. Short-term macroeconomic management will continue to involve difficulttradeoffs. In particular, a tight monetary stance is called for as long as demand fordomestic assets remains weak and selling pressure on the peso remains significant. Yetthe authorities cannot ignore the impact of tighter credit conditions and higher interestrates on the real economy and corporate balance sheets. Over the medium term, aninterest rate structure that causes intensifying corporate distress is not viable, particularlywhen the costs to the banking system are factored in. But at the same time, relaxing themonetary policy stance before speculative pressure on the peso has eased would not behelpful to generate confidence and would prolong the adjustment period.

30. Thus far, the authorities appear to have struck the appropriate balance in thedifficult new environment, and indeed relative to other impacted countries have copedfavorably. Nevertheless, there may be opportunities for improving policy effectiveness.For example, the frequent adjustment of liquidity reserve requirements in recent monthsas a tool for controlling liquidity, while perhaps effective in its primary objective, impactsbanks unevenly depending on their liquidity positions. Yet the alternative of greater useof BSP open market operations to influence liquidity is constrained by the recent ruling(effective from 1997) that taxes bank repurchase agreements of longer than five daysmaturity. To improve the effectiveness and reduce the cost of open market operations,taxation of repurchase agreements therefore needs to be reconsidered.

31. To strengthen the basis for conducting monetary policy, more precise informationon the profile of foreign debt service requirements of the private sector in the short termwould be helpful to gauge pressure on the exchange rate from this source. Similarly,identifying corporations that are particularly vulnerable to high interest rates and their


primary creditors could provide the authorities with advance information of impendingproblems in the corporate/banking sectors.

32. As market conditions settle, the trend of deposits and credit extended throughFCDUs-which until recently had been rising as shares of domestic intermediation-willneed to be evaluated in light of recent policy adjustments relating to liquidityrequirements and the exchange rate, and the possibility of a withholding tax on residentFCDU deposit holders as contained in the prospective tax reform bill. In conducting suchan evaluation, it should be noted that the share of FCDUs in total monetary liabilities(M4) is relatively high in the Philippines, at about 30 percent as of end-1996 with anincrease likely post-depreciation, and regulations on the use of such accounts by bothresidents and nonresidents remain relatively liberal. Particularly if FCDU intermediationis still rising in relative terms-i.e., as a proportion of M4 or total credit, additionalmeasures to level the playing field between foreign currency and peso intermediationwould need to be considered, although the current period is unlikely to be the optimaltime to introduce such measures.

33. In view of risks and regional dimensions of the financial market turbulencediscussed, monetary policy is unlikely on its own to generate a full return of investorconfidence. In particular, with the loss of exchange rate stability as a source of credibility,the perception that structural reforms continue to be pursued can be helpful to bolstercredibility. Experience during past episodes of instability indicates that countries thatresist short-term palliatives and focus on the fundamentals of sound macroeconomicpolicy and structural reform experience less output loss over the medium-term. To theextent that the structural reform agenda can be accelerated, this would add to investorconfidence and may therefore ease the difficult short-term tradeoffs that the economy willhave to endure. The following paragraphs stress measures that would be supportive to theconduct of monetary policy in the short term; the focus of the remainder of Section 2 ison the structural reform agenda, including issues in fiscal policy, banking, enhancingcompetitiveness, and strengthening the framework for manufactured export development.

34. Timely passage of the comprehensive tax reform package (CTRP) would serve toenhance confidence if it is clearly evident to be revenue-enhancing. By cbntrast, if thefinal bill that emerges indicates negative or insignificant revenue impact, investorreaction to its passage could be indifferent. In the short run, further expenditure cuts maybe required to adhere to the government's fiscal program. If further cuts in investment arerequired, projects of low economic priority should be canceled or delayed rather thanadministering across-the-board expenditure cuts. And programs that are effective forpoverty alleviation need to be protected.

35. The movement of the exchange rate has naturally generated pressures to adjustwages. Yet substantial wage adjustment at this stage would: undermine the beneficialimpact of depreciation on competitiveness-which has been adversely impacted by the


nearly 40 percent real exchange rate appreciation in the 1990s prior to July 1997;exacerbate the distress already being faced by corporations from recent movements ofinterest and exchange rates; and increase investor concerns about the likelihood ofinitiating a serious wage-price spiral with negative inflationary consequences. Theseconcerns need to be communicated during the wage bargaining process.

36. Finally, it should be noted that pressures for special treatment from the adverseimpact of exchange rate depreciation can be expected from various categories ofimporters. These pressures need to be resisted since they can adversely impact the fiscalor quasi-fiscal position, can lead to price distortions, and are inequitable-since allimporters cannot by definition be given such preferential access.

Fiscal Policy

37. Restrained fiscal policy has been one of the cornerstones of the recent economicrecovery as the consolidated public sector financial position has steadily improved since1992 and was in approximate balance in 1995-96-helping to reduce the Philippines' stillhigh public debt burden, lengthen the maturity structure of government debt, and reducepublic sector interest costs. In view of the pressures on fiscal policy arising from slowergrowth and corporate profits, the government's intention to proceed with a program tofurther strengthen public finances and raise public saving is well conceived, and theadjustment of expenditures to the lower-than-programmed revenue performance throughmid-1997 is appropriate.

38. Yet there is no room for complacency. Particularly in the coming political year, itwill be essential to demonstrate that the authorities are able to promptly calibrate fiscalpolicy adjustments to changing circumstances. But the ability to adjust fiscal expenditureremains constrained by its relative inflexibility-in 1996, over two thirds of NationalGovernment (NG) expenditures were still accounted for by personnel, interest payments,and local government unit (LGU) allotrnents-and has been hindered by the rising shareof NG personnel expenditures, which have risen by nearly 1.5 percent of GNP since1993. The latter reflects adjustments to civil service salaries that have been appliedprogressively but have not yet addressed the problem of noncompetitive salaries forsenior executives. Hence, when public expenditure needs to be adjusted, as currently, theburden of adjustment tends to fall unduly on maintenance and investment.

39. At 4.5 percent of GNP, however, public investment in 1996 had already fallen toits lowest level in the 1990s, and it is also low in comparison to neighboring countries.There are a number of mitigating factors in the Philippines, including the relatively highshare of private investment in health and education and the relatively advanced policyframework for private investment in infrastructure. But the backlog of public investmentis large within infrastructure, as is the need to strengthen the social safety net.


40. Regarding revenues, import tariffs are expected to generate declining revenue inreal terms, reflecting the tariff reduction program envisioned through 2004. This alsoimplies that the share of NG revenue allotted to LGUs-which are linked to internalrevenue-is likely to increase. Revenue from privatization peaked in 1994-95 and hasdiminished significantly since then. And the scope for raising corporate tax rates willbecome more limited, as the importance of maintaining parity with competitor countriesincreases with global integration. Finally while tax revenue has increased steadily in realterms, and at 16 percent of GNP in 1996, compared favorably with neighboring countries,public saving in the Philippines of 4.5 percent remains low relative to these samecountries.

41. Several adjustments will therefore be needed over the medium term in order tomaintain a tight fiscal stance, improve the flexibility of government expenditures, andraise public saving in a sustainable manner. On the latter, passage of the administration'soriginal proposals for tax reform represents the most appropriate vehicle for raisingrevenue without unduly raising tax rates-through broadening the tax base, ensuring thatcorporations pay a minimum level of tax, while at the same time strengthening incentivesfor investment. Parallel efforts to improve tax administration, reduce tax evasion, andstrengthen the incentives for revenue collection at the local government level will also beneeded.

42. On the expenditure side, to allow for increases in public investment whilemaintaining an appropriate fiscal stance, the recent increase in civil service personnelcosts will need to be arrested and ultimately reversed. Moreover, the evolving publicsector role from provider of services to facilitator and regulator of private activityrequires adjusting compensation at the senior and executive levels to enable selectedpublic agencies to attract and retain high-caliber staff. Hence, a complementarystreamlining of public agency roles will be needed to reverse the recent increase ingovernment personnel costs.

43. Finally, as discussed in the section on structural reform and competitivenessbelow, the urgency for restructuring and privatization of the National Power Corporation(NPC) has increased, with the fiscal costs of delaying such reform likely to grow in lightof the recent exchange rate depreciation.

Strengthening the Banking System

44. Recent developments highlight the need to ensure that the banking system canadequately cope with the increased volume and volatility of capital flows it is required tointermediate, and the resulting volatility in interest and exchange rates that this implies.The more resilient the banking system to such volatility, the less constrained and moreeffective can macroeconomic policy be in guiding a return to stability. The frequency andcost of bank solvency problems across both developing and developed countries over thepast decade makes the rationale for strengthening clear. For an open economy such as the


Philippines, the presumption has to be that regulations governing bank behavior need tobe more stringent than in OECD economies since the volume of foreign capital flows isrelatively large in relation to domestic capital markets,7 the volatility of financialvariables tends to be more substantial, and the opportunities for diversification may bemore limited.

45. The quality of bank supervision and the legal framework in the Philippinescompare favorably with many developing countries, including within the region, andcommercial bank profits have risen rapidly in recent years, including through the thirdquarter of 1997. Efforts to strengthen supervisory and regulatory skills to cope withemerging risk areas (for example, in the area of derivatives) have also intensified.

46. These efforts need to be supported and strengthened, particularly throughsupervision of commercial banks on a consolidated basis given the rapid growth in off-balance sheet activity, and increased attention to the quality of bank management and riskmanagement systems that are in place within banks. Moreover, the credibility ofsupervision will have to be reinforced by enhancing supervisors' ability to examine banksas and when needed and to take appropriate actions against excessive risk taking. Hence,the legal position of the BSP to close banks needs to be strengthened, and supervisorsneed to be insulated from legal challenges by those who they regulate. Such actionswould reduce moral hazard and generate the appropriate incentives among bank managersand owners.

47. Another priority is to improve transparency so that the market is better able todiscipline those banks taking excessive risk. Clearly this already occurs in thePhilippines, as evidenced by the sharper-than-average downturn in bank stock pricesduring 1997. Yet it is important for market participants to have access to as muchaccurate information as feasible that would allow for more discriminatory assessmentsacross banks. Minimum disclosure standards should therefore include ample informationon income, expense and loss recognition practices, asset quality, and concentration.Extending disclosure of pertinent information on brokerage firms would also enhancetransparency.

48. Coupled with efforts to strengthen supervision and market discipline, theownership structure of banks, particularly those that are closely held, could be broadenedby requiring more capital to be raised by the market. The government could also promotestronger representation of outside shareholders on bank boards, including for small andmedium-size banks.

7 Deepening the domestic capital markets is clearly an important objective. But even in the medium term,foreign capital flows are likely to comprise a large share of the total.


49. The recent increase in minimum capital adequacy requirements to 10 percent (forboth total and tier 1 capital) places the Philippines at the high end relative to other EastAsian countries (although the requirement is 12 percent in Singapore). This should nowbe complemented by reinforcing efforts to incorporate a risk-weighting scheme into thedefinition of capital adequacy, inclusive of accounting for off-balance sheet risks, ascalled for under a bill to amend the General Banking Act submitted to Congress.

50. In summary, improving the incentive and ability of supervisors, the market andowners to monitor and support prudent banking will require an ongoing investment thatshould be of high priority to the government. Similar efforts have been taken or are underway in a number of OECD and developing countries.

STRUCTURAL REFORM AND COMPETITIVENESS

51. Notwithstanding the recent regional instability, the trend of increasing FDIglobally is expected to continue in the medium term. Declining transport andcommunication costs and falling trade barriers are leading to increasing specializationand expanding trade, encouraging multinational corporations (MNCs) to organize theirproduction on a global basis through international production and subcontractingrelationships. East Asia has been at the cutting edge of this change. MNCs have investedheavily in the region, relocating component manufacturing and assembly operations totake advantage of lower labor costs, strong work ethics, and liberal trade regimes.

52. Countries that display strong macroeconomic management and stability, credibletrade and investment liberalization, high-quality infrastructure, improved governance andgreater private sector participation will stand to benefit from the globalization trend ofFDI. Structural reforms over the past decade in the Philippines have already improvedeconomic efficiency, rendering the Philippines among the more deregulated economies inthe region and making it an increasingly attractive location for FDI. Over the past year,deregulation of prices and entry into the downstream oil sector, and transfer to privatemanagement of Metro Manila's water supply system have enhanced the competitiveenvironment and prospects for investment in these two important sectors.8 Furthermore, amajor factor attracting FDI into the Philippines is the presence of a large pool of high-quality English-speaking workers-business surveys consistently rank the Philippineshigh in terms of the quality and availability of both its unskilled labor and its managersand technicians.

8 Recent Supreme Court rulings freezing oil prices for a month and then rendering the oil deregulationbill unconstitutional need to be addressed as soon as possible (as is the government's intention) tominimize damage to investor confidence, to reestablish the deregulation objectives of increasedcompetition and investment, and to protect the government's fiscal targets.


53. The Philippines has moved rapidly on tariff reforms in recent years and hasannounced its intention to move to a uniform tariff rate of 5 percent by 2004 fornonagricultural commodities.9 Further compression of the tariff structure will provideadditional impetus to improvements in economy-wide efficiency and greaterencouragement for domestic producers to move into export markets, as well as developsubcontracting arrangements with exporters who are operating on a duty-free basis in theeconomic zones. The government's trade reform goals involve deeper tariff reductionsthan required by its international commitments under WTO or APEC. This means that theultimate pace and depth of tariff reductions will reflect the resolution with which itimplements its own policy plans.

Reform Priorities

54. Against this background of encouraging progress, it is important to maintain themomentum of structural reform, to strengthen competitiveness but also to signal toinvestors that regional instability will not derail the reform process. To the extent thatplanned reforms can be accelerated, the credibility of such signaling will be enhanced.Three areas that still constrain international competitiveness and are briefly noted hererelate to agricultural trade protection, the labor market and education policy implications,and electricity prices."0

55. Agricultural Protection. Import protection provided to most agriculturalcommodities has increased since 1996-in the context of shifting from quantitativerestrictions to tariffs for agricultural commodities, protection for most affected productsincreased, with tariffs of 100 percent prevailing for many key commodities. As aconsequence, input costs for the food processing industries, which have substantialpotential for expansion in the Philippines, have risen. Relatively high food prices alsoconstrain the attainment of more competitive wages for unskilled labor referred to below.Finally, as tariff reductions for the nonagricultural sector proceed at a faster pace, relativedistortions in the tariff structure could rise in the interim.

56. Agricultural tariffs are scheduled to be reduced to the 40 to 60 percent range bythe year 2000 and to a range of 20 to 40 percent by 2004. But the targeted protection rateby 2000 still represents an increase over implicit or explicit protection provided mostcommodities prior to 1996, and the credibility associated with these reductions is lessthan for the nonagricultural sector. Accelerating the pace of tariff reduction to at leastreach pre-1996 protection levels sooner would therefore represent an important first step.

9 Official data indicate that the average nominal tariff rate (MFN) was reduced to 15.5 percent in 1996,and is expected to be reduced to 13.4 percent in 1997 and to 9 percent by 2000. Note, these figures canvary depending on the weights used.

10 Recent World Bank reports discuss these in more detail.


Subsequent tariff reductions should be complemented by the appropriate design andimplementation of transitional social assistance to poor farmers/laborers adverselyaffected by lower protection.

57. Labor Market and Education Policy. Regarding the labor market, wages andsalaries in the Philippines are high in relation to per capita income: for example,remuneration levels are close to those prevailing in Thailand, where per capita income ismore than double the level of the Philippines, and are significantly above those inIndonesia, which has a similar per capita income."' Since overall compensation in realpeso terms has been relatively stagnant in the 1990s, the nearly 40 percent real exchangerate appreciation between 1990 and mid-1997 must bear much of the responsibility forthe increased remuneration, measured in foreign currency terms. This in tum may havecontributed to the relative stagnation of traditional manufacturing industries such asgarments and footwear in recent years, a trend that appears premature when viewedagainst the Philippines' large pool of surplus labor and rapidly growing labor forcerelative to major competitors. Moreover, while unit labor costs have declined in recentyears, this is primarily the result of the declining compensation, since labor productivityhas been relatively stagnant in the 1990s, particularly in comparison with neighboringeconomies. 12

58. The recent exchange rate depreciation, if largely sustained in real terms, shouldbenefit employment generation in manufacturing industries. Yet over the longer term,enhancing labor productivity at a faster pace will remain vital. Perhaps the mostimportant policy area in this regard is to improve the quality of basic education in orderto maintain and hopefully enhance the relatively strong reputation that the Philippinesalready enjoys regarding labor quality. One priority in this area should be to lower the agefor access to public education from seven to six. This should have the effect of ratchetingup quality through the school system. If resources are constrained, shifting funds from theplethora of publicly supported nontechnical colleges across the country would represent abetter use of public funds. Some specific suggestions on skills and technologyenhancement are provided in the discussion below on manufactured export development.

59. Electricity Prices. High electricity costs in the Philippines-which have been thehighest in East Asia after Japan-reflect several factors: the relatively expensive supplyof privately generated power negotiated in the midst of the power crisis of the early1990s; the weak financial position of the National Power Corporation (NPC), whoseliabilities are large and almost entirely in foreign currency; relatively high leakageswithin the distribution system; the country's unique geography of some 7,000 islands;and geographic cross-subsidization particularly from Luzon to the more remote islands.

11 Using 1996 data on remuneration and per capita incomes.

12 The data for more recent years, however, indicate an improving productivity trend.


60. In recognition of these constraints and deficiencies, a significant adjustmentprogram to restructure NPC and privatize the bulk of its power generation capacity hasbeen initiated. But the enabling legislation for this program (the Omnibus Bill) haslanguished in Congress and needs to be enacted. The government has rightly resistedrelieving NPC of its financial burden until a major restructuring can be completed.However, in the context of implementing a satisfactory program for restructuring andprivatization that addresses existing incentive problems, the government may wish totransfer a portion of NPC's financial burden to the tax payer in the interest of enhancingcompetitiveness. Similarly, if particular geographic areas need to be subsidized for socialreasons, this too should be financed from general tax revenue rather than taxing otherelectricity users.

ISSUES IN MANUFACTURED EXPORT DEVELOPMENT

61. The Philippines' export performance has improved greatly in the 1990s. Worldmarket shares for all exports rose from 0.25 to 0.38 percent during 1990-95, and formanufactures from 0.14 to 0.39 percent. Electronics exports grew at 37 percent a yearduring 1991-96, and now account for 60 percent of manufactured exports. Machinery andtransport equipment also grew rapidly (24.5 percent), becoming the third largestmanufactured export. Garments, the largest traditional consumer export, grew at only 5.8percent, and fell in 1996; other consumer exports also rose slowly. There were thussignificant changes in the export structure: "industrial manufactures," largelynontraditional and complex items raised their share by 22 percentage points of the total.

62. A comparison of export patterns shows that the Philippines has a relativelyadvanced structure in terms of the technological complexity of its products. However, theabsolute values involved are small; its high-tech exports are around 15 percent of Koreaand Taiwan (China), 20 percent of Malaysia and 42 percent of Thailand. This reflects thelarge gap that opened up during the period of relative export stagnation; it also suggeststhat such exports may be able to grow rapidly. This is supported by the analysis of itsmarket "positioning," which shows that many manufactured exports are expanding theirworld market shares in dynamic products in world trade. The engine of its export growthare the world's leading MNCs in electronics, most of whom are planning substantialincreases in production capacity in the Philippines.

63. However, there is need for caution. Stagnation in simpler exports is undesirableand premature, since the Philippines remains a labor-surplus economy with more rapidlabor force growth than most neighbors. These exports retain considerable potential forexport growth; they are particularly important for the small and medium enterprise (SME)sector; and they offer strong externalities and "cluster" benefits. Their export slowdown,in concert with weakening growth in traditional industries at home, may indicate anundue weakening of the competitive base. The high level of product concentration on(and within) electronics is inherently risky; their export growth has been due primarily to


low-end assembly activity, which can be a secure base for long-term growth only if localvalue-added and technological levels are raised. The export-oriented sector has relativelyshallow roots in the domestic economy, and its long-term growth requires a strengtheningof these roots. This conclusion merits greater attention in view of the recent sharpslowdown of export growth in neighboring countries-in particular, Thailand andMalaysia-and the less-than-full understanding of the causes and suddenness of theseslowdowns.

64. In garments, the Philippines has done poorly for some time in relation to manyAsian exporters. The reasons do not lie only in cheaper labor elsewhere, since evencountries with higher wages have displayed faster growth. However, the Philippines'edge does not lie in cheap labor; it cannot compete with South Asia, China or Vietnam inlow-quality, standardized products. It can compete in products where skills, technology,specialization, design, marketing and flexibility are important competitive factors. Butinvestments and FDI in the industry have fallen behind those in other industries. Workerproductivity and delivery times by Philippine exporters are variable and designcapabilities are growing but remain weak. Philippine garments fetch lower unit pricesthan those of major competitors including lower-wage economies such as China, India,and Indonesia. The Philippine industry suffers from a lack of integration with theupstream local textile industry, which suffers several weaknesses and may handicapgarment competitiveness.

65. In electronics, exports are dominated by semiconductors (77 percent of the totalin 1995). The Philippines maintained high export growth in 1996, when neighboringcountries suffered large declines, because of different product compositions (CPUssuffered less than DRAM chips), the coming onstream of new facilities and the existenceof supply contracts of over one year. The main competitive edge lies in relatively low-cost, skilled and English-speaking work force, with good infrastructure for exports. Theweaknesses of the industry arise from the high concentration on semiconductors, the lowtechnological level of local manufacturing activity, and low local value added. The highlevel of concentration can be an advantage as long as semiconductors are growing indemand and new manufacturing technologies continue to be transferred, but nototherwise. The continued transfer of process technologies depends on growing localcapabilities, and progress has been slow compared to Malaysia and the newlyindustrialized economies (NIEs).

66. Much electronics activity remains at the lowest assembly and testing level; moredemanding technological functions or downstream products are not being shiftedsufficiently to the Philippines. Semiconductor technologies are subject to rapid change,and without a flexible and advanced base to cope with new products and processes,competitiveness remains uncertain: there remains the risk that new technologies will beexploited in competing locations with more advanced production, design and supplycapabilities. Low local value-added levels (20 percent in semiconductors), much below


average levels in Malaysia (45 percent) and Taiwan, China (75 percent), and itsstagnation over the past two decades, suggest that local supplier capabilities are notimproving despite growing demand from assemblers, and that specific measures arerequired to help firms, in particular SMEs, to raise their skills and technology levels.

67. The main supply-side determinants of competitiveness are FDI, domesticindustrial policies, skills, technology and the institutional framework for export strategy.The driving force behind recent export growth has been FDI. While the environment forFDI has improved greatly, the economy is still underperforming relative to its potential.Inflows into the manufacturing sector are narrowly concentrated in activities that generateexports at relatively low levels of local integration and technological complexity. TheFDI promotion system lags behind regional best practice. Incentives are not sufficientlygeared to performance; there is a proliferation of incentives and agencies offering them,leading to duplication. There is a need to rationalize and consolidate the promotion andincentive systems, establish clear responsibility for FDI promotion for the country as awhole, and remove duplication and possibilities of rent-seeking. The main promotionagency, the Board of Investments (BOI), needs to be improved: it does not devotesufficient resources to promotion, its strategy tends to be unfocused, and lacks thecapabilities needed for targeted FDI attraction.

68. The Department of Trade and Industry has recently launched several measuresaddressing these weaknesses. Their effective implementation will depend on thegovernment's ability to support promising export activities flexibly without distortingresource allocation, which in turn requires a strengthening of evaluation, monitoring andfollow-up capabilities coupled with mechanisms to ensure effective governance.

69. The industrial structure remains highly concentrated and segmented, not themost conducive for competitive new activities and enterprises. While policies are beingreformed, there still seem to be gaps in the competition regime and in its enforcement.Industry associations lag behind many regional counterparts in supporting members toenhance competitiveness. SMEs face particular hurdles in accessing finance, information,technology and skills. The SME support system is inadequate, and holds back theirgrowth as direct and indirect exporters. One reason for low local-content levels is the lowlevels of efficiency; the NIE experience suggests that strong, well-staffed and proactivegovernment and cooperative measures are needed to overcome this."3

70. In skills, literate and plentiful manpower is the Philippines' most valuableresource. However, substantial improvements are needed to the education and trainingsystem. In schooling, quality, relevance, access and completion rates need to be raised,and the length of schooling brought into line with international norms. The variation in

13 But further analysis on institutional capacity in the Philippines is needed before concluding whatlessons from NIE experience are relevant.


the quality of higher education institutions has to be reduced; a broad improvement ofteaching standards and equipment is needed for the high level technical and managementskills that competitiveness requires. The technical training system needs greater fundingand must orient its curricula to employer needs; the specific skills needed by traditionalindustries (garments) as well as new ones (electronics) have to be better met. Employeetraining by firms is undertaken mainly by large firms, but smaller firms invest little inupgrading skills of workers. There are no studies of how much training is being providedand by whom; without this, appropriate policies cannot be mounted.

71. The technology support system has the necessary elements but lacksimplementation and coherence. There is no systematic analysis of the technological needsof the country and how to achieve them. The private sector does little technologydevelopment, and there is little policy effort to stimulate technological activity inindustry. There is a need for a "technology foresight" exercise involving industry,technology institutions and academia in evaluating technological needs. The technologyinfrastructure does not provide effective support to industry. Its salary structures andmanagement are not conducive to actively seeking out and helping enterprises withtechnical problems and upgrading. There is too much attention to routine testing andlaboratory services (which could be in the private sector) and not enough on "publicgoods" like basic or (subsidized) contract research, information collection anddissemination, and extension services to SMEs. The large number of institutions need tobe rationalized, better structured and funded. A thorough analysis of the functions,structure and management of the Department of Science and Technology (DOST) seemsto be needed, with measures to link it more tightly to industry. There is a need forconsultancy and productivity-raising measures for industry, using benchmarkingtechniques and drawing upon the experience of economies like Taiwan that cater to largenumbers of export-oriented SMEs.

72. The institutional framework for export development seems well-designed, butits effectiveness needs analysis. The Export Development Council (EDC) is weak incollecting information on competitive export performance and in SWOT14 analysis ofmajor export products. There is currently little comparative assessment of the current oremerging competitiveness of Philippine exporters in technological, quality, design or costterms. The analytical framework for carrying out competitiveness studies can bestrengthened. It is not clear how effective the EDC has been in identifying and, moreimportantly, remedying constraints facing exporters, or how its sanction powers againstpoor performers are used. In theory, the private sector and various govermnentdepartments participate in its policy analysis and implementation, but their actual role andcommitment should be evaluated. The EDC could play a vital role in promotingcompetitiveness-if properly equipped with the skills, resources and authority needed to

14 Strengths, weaknesses, opportunities and threats.


develop, coordinate and implement strategies across the agencies and departmentsinvolved. Since the institution is in its formative stages, it is recommended that itsstructure and effectiveness be thoroughly evaluated and the necessary steps taken tostrengthen its capabilities.

Special Economic Zones and Export Competitiveness

73. The evidence in Volume 2, Chapter 3 suggests that special economic zones(ecozones) have been of vital and growing importance to the Philippines' recent exportsurge: by 1996, they accounted for nearly one third of merchandise exports. Theintegrated package of policies, streamlined procedures, physical infrastructure andfacilities offered by the ecozones have acted as a magnet for attracting FDI. In terms ofperformance, the Philippine ecozones also compare favorably with most other developingcountries, including within East Asia.

74. Volume 2, Chapter 3 provides an in-depth assessment of the Philippine ecozoneprogram in relation to other countries and discusses a number of specific issues andrecommendations relating to improving the competitiveness of ecozones in terms ofinstitutional and administrative arrangements, facilities and services, and the policyframework. The summary discussion here is limited to two issues: the rationale forecozones in a world of diminishing trade barriers; and an assessment of the currentincentive regime associated with ecozones.

75. Rationale. The first issue is whether ecozones should be regarded as transitionalarrangements in the face of trade policy distortions and should be phased out as tradeliberalization proceeds. While ecozones can become inadequate substitutes for (andimpediments to) full trade policy reform, the evidence in the Philippines indicates thattheir growth has coincided with progress on trade reform. Moreover, their rationaleextends beyond compensating for antiexport bias. If properly designed and efficientlymanaged, they can concentrate in one discrete area the infrastructure required for exports,the administration of tariff and other regimes, and the provision of training and varioussupport services. Thus, ecozones can not only compensate for distorted trade regimes, butalso reap economies of scale, scope and agglomeration in the production, support andadministrative activities related to exporting (as well as serving regional developmentobjectives). The prevalence of free zones in industrialized countries with open economiesalso suggests that the role of ecozones will continue to be important even with the adventof modern production concepts and approaches.

76. The dominance of the private sector in providing on-site (and increasingly off-site) infrastructure and managerial services for the more recent ecozones reduces the coststo government of their development-though it is important that social andenvironmental costs are adequately incorporated into the decision framework.


77. The development of more sophisticated ecozones, catering to specific types ofindustries and offering specialized services and facilities, is a natural outcome of thegrowth in the number of zones and increasing competition among private developmentgroups. There is little that the government needs to do to facilitate this process. On theother hand, there may be a rationale for government support for certain types of zones-such as science and technology parks, business incubators-in which case a program tofacilitate their development would have to be initiated by the Philippine Economic ZoneAuthority (PEZA).

78. Incentive Regime. The package of benefits, privileges and incentives offered bythe PEZA regime is easily among the most generous available anywhere. But there areseveral opportunities for rationalization. First, duplication of incentives among PEZA,BOI and freeport regimes offers a multitude of rent-seeking opportunities. A prioritytherefore is to eliminate the separate set of PEZA and BOI investment incentives in favorof a universal set of measures equally available to firms engaged in promoted activitieswithin and outside ecozones implemented through the tax code. This will eliminateexisting distortions which unnecessarily favor locations within ecozones over others.

79. A second priority is to shift from less effective "front-loaded" incentives such asincome tax holidays, to various "performance-based" measures available through the taxcode. Income tax holidays that are provided at the beginning of the investment cycle areless effective than performance-based measures, which reward firms that actually meetperformance targets or make qualifying expenditures. Use of these measures in the taxcode will eliminate the need for an up-front screening/evaluation process. It will alsoobviate the need for the ponderous IPP list that is used to define and restrict access to theBOI incentives. Finally, permitting duty-free imports of all project-related items goesbeyond international norms and is difficult to implement. Such privileges shouldtherefore be limited to import of production-related capital equipment, spares and inputs.

80. As described in Volume 2, Chapter 3, the competitiveness of ecozones could beimproved through addressing a number of deficiencies including: lack of clarity regardingthe ecozone concept itself, particularly as it applies to nonmanufacturing activities;unclear policies governing sales to the local market; cumbersome approval procedures fornew ecozone projects and ecozone expansions. Moreover, local purchases andsubcontracting by ecozone enterprises could be initiated through easing of regulationsgoverning subcontracting between ecozone and nonzone enterprises, and shelter planconcepts should be promoted to nonzone enterprises. The implementing rules andregulations (IRR) of the PEZA law should be streamlined. The existing IRR have manycumbersome rules and requirements that can be eliminated. An example is the time-consuming procedures required to obtain the necessary permits for a new ecozone project,and expansions of existing zones.

26 Section 3. The Economic Outlook

3. THE ECONOMIC OUTLOOK

81. Assessing the Philippines' economic prospects is complicated by the uncertainoutlook for private capital flows in the region and their repercussions for domesticfinancial markets. Several related factors will be important in determining economicprospects: the depth and duration of the current decline in net private capital inflows; thespeed with which domestic financial markets stabilize; the ability to avoid a major wage-price spiral in response to the exchange rate adjustment; and the ability to increase thedomestic saving rate in the medium term.

82. In 1996, net private capital inflows had risen to nearly 10 percent of GNP, whichis well above the level reached in past years either in the Philippines or for East Asiancountries in aggregate (Figure 1.1, Volume 2).'5 Given the extent of financial turbulencein the region during 1997, it would be prudent to provision for a substantial decline inprivate inflows at least through 1998. Although FDI inflows may be sustained at the levelof recent years, i.e., of about $1.5 billion (gross inflow), net portfolio flows are estimatedto have turned substantially negative in 1997 and may remain negative in 1998. Andforeign borrowing by commercial banks can be expected to decline sharply from its levelof over $4 billion in 1996. Even beyond 1998, it appears unlikely that private inflows inthe order of 10 percent of GNP would be sustainable.

83. The Philippines responded relatively rapidly to the shift in investor sentimentduring 1997. But an essential ingredient of that response was a tightening of monetarypolicy and an increase in interest rates, which together with a tightening of creditconditions is expected to slow economic growth in the second half of 1997. The full-yeargrowth figure for 1997 is therefore projected to slow to about 5 percent; slower growth ofnet factor income would tend to reduce the differential between GDP and GNP growthrelative to recent years. Output growth in 1998 is expected to slow further as the fullramifications of the current financial market instability are felt. The intensity of theslowdown will depend on the duration of the period during which high interest rates arerequired, the extent of distress experienced by the corporate and banking sectors as aresult, and the fiscal consequences of such distress. Disruptions caused by El Nino mayalso slow agricultural growth significantly in 1998.

84. The past four years have provided ample evidence of the Philippines' ability tocompete in international markets-for example, export growth since 1995 has been thestrongest among market economies in the region. A depreciation of the real exchange raterelative to 1996 in response to the prospect of lower capital inflows is likely, and would

15 Figure 1.1 refers to long-term private flows.

Section 3. The Economic Outlook 27

further enhance competitiveness, particularly if it occurs in the context of relatively stable(single-digit) inflation as targeted.

85. If real export growth during 1998-2000 can be maintained at close to its paceduring 1995-97 and domestic savings can continue to rise (by about 2 percentage pointsthrough 2000), a recovery of output growth to 5 to 6 percent during 1999-2000 isfeasible, notwithstanding the lower private capital inflows anticipated relative to the1994-96 period. Under this scenario, the current account deficit would average 3 percentof GNP during 1998-2000 relative to 4.3 percent during 1994-96, with private capitalinflows dropping by a similar proportion relative to 1994-96.

ALTERNATIVE SCENARIOS

86. If the current financial market instability is prolonged, there may be a need forsubstantial restructuring within the corporate and banking sectors with significant fiscalrepercussions. Under these circumstances, private capital flows may be deterred over anextended period, in which case the slower growth that is anticipated for 1998 couldbecome more extended.

87. Another factor that should be borne in mind is the almost ideal conditions thathave existed in international markets in the mid-1990s, with strong growth in tradevolumes among OECD countries and historically low interest rates particularly in Japan,the Philippines' most important source of official capital. Although major changes in theinternational environment are not anticipated through 2000 (and have not been assumedin the above scenario), the possibility of slower growth in trade and/or higher interestrates among the major OECD countries adds another element of risk to the medium-termoutlook.

88. Alternatively, the Philippines may be able to distinguish itself within the region,particularly if export growth accelerates from its recent performance, inflation falls withinits official target in 1997 and remains relatively subdued thereafter, and interest ratesreturn quickly to their preturbulence levels. Under these circumstances, the anticipatedcutback in external capital might be smaller than assumed and would permit higher thanprojected economic growth.

OFFICIAL DEVELOPMENT ASSISTANCE (ODA) REQUIREMENTS

89. Under the above base-case economic and external financing scenario, the bulk ofthe adjustment to lower private capital inflows occurs through a reduction in the currentaccount deficit (and slower reserve accumulation). The current account adjustment in turnwill likely require adjustment in both public and private spending plans; in the case of theformer, prior intentions to increase public investment-from 4.5 percent of GNP in 1996to 5.3 percent by 1998-may have to be compromised. Hence, it is assumed that publicinvestment through 1998 remains at about 4.5 percent of GNP, rising gradually thereafter.

28 Section 3. The Economic Outlook

The proportion of ODA financing of public investment can however be expected to risesomewhat from 35 percent in 1996, reflecting the overall tightening of governmentoutlays.

90. These assumptions translate into projected disbursement requirements from ODAof about $1.7 billion for 1998. Based on the projected pipeline from existingcommitments and standard assumptions relating to disbursement ratios, new ODAcommitments of some $2.5 billion, or somewhat less than in recent years, are projected tobe required.'6 A larger proportion of these funds is expected to be required to support thegovernment's initiative of increasing public investment in Mindanao.

91. The above figures do not incorporate further use of balance of payments supportfrom official sources beyond the IMF and Japan EXIM Bank resources committed in1997. The need for additional such financing, including the options of adjustment orprogram loans from multilateral institutions, would depend on the pace at which privatecapital inflows recover from their fall in 1997.

16 The lower commitment figure also reflects an assumption of real exchange rate depreciation.

Statistical Annex 29

STATISTICAL ANNEX

Table 1: National Accounts, 1987-96 (as percentage of GNP)Table 2: National Accounts, 1987-96 (growth rates)Table 3: Balance of Payments, 1992-97Table 4: Exports and Imports by Major Commodity Group, 1987-96Table 5: External Debt, 1991-97Table 6: Monetary Survey, 1992-97Table 7: Exchange Rates, Inflation and Selected Interest Rates, 1991-97Table 8: Consolidated Public Sector Financial Position, 1992-97Table 9: Outstanding Public Sector Debt, 1992-96Table 10: National Government Cash Operations, 1991-96Table 11: Loans Outstanding of Commercial Banks, 1990-97

TABLE 1: NATIONAL ACCOUNTS, 1987-96(as percentage of GNP)

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

GDPatmarketprices 101.8 100.9 101.5 100.5 99.5 98.3 98.3 97.5 97.3 96.2NetIndirectTaxes 8.9 7.2 2.3 8.2 9.1 9.7 10.0 10.4 10.6 10.0

Indirecttaxes 9.2 7.5 9.1 9.4 9.8 10.1 10.4 10.8 11.0 10.3Subsidies 0.3 0.3 6.8 1.2 0.7 0.3 0.4 0.4 0.4 0.3

GDP at factor cost 92.9 93.7 99.2 92.3 90.4 88.6 88.3 87.1 86.7 86.2Agriculture 24.4 23.2 23.0 22.0 20.9 21.5 21.2 21.4 21.0 20.6Industry 35.0 35.5 35.4 34.7 33.8 32.3 32.1 31.7 31.2 30.5

Mining and quarrying 2.1 1.9 1.7 1.6 1.4 1.2 1.1 1.0 0.9 0.8Manufacturing 25.3 25.9 25.2 25.0 25.2 23.8 23.3 22.7 22.4 21.7

Services 42.3 42.3 43.0 43.9 44.8 44.6 44.9 44.3 45.1 45.1

Imports of GNFS 26.7 27.2 30.7 33.5 32.4 33.5 39.1 39.1 43.0 49.8Exports of GNFS 27.1 28.6 28.5 27.7 29.4 28.6 30.8 33.0 35.4 40.4

Total Consumption 80.4 79.7 80.9 81.8 82.9 83.6 84.8 83.0 83.2 81.2Public 8.5 9.1 9.7 10.2 9.9 9.5 9.9 10.5 11.1 11.3Private 71.9 70.6 71.2 71.6 73.0 74.1 74.8 72.5 72.1 69.9

Statistical discrepancy 3.1 0.9 0.9 0.3 -0.6 -1.5 -1.7 -2.8 0.1 1.2

Gross domestic investment 17.8 18.8 21.9 24.3 20.1 21.0 23.6 23.5 21.6 23.3GDFI 16.8 18.0 21.1 23.2 19.9 20.6 23.4 23.0 21.6 22.3

Nonfinancial Public Sector 2.9 2.9 3.6 4.2 4.1 4.8 4.9 4.8 4.5National Government 1.9 1.9 2.3 2.7 3.0 3.4 2.5 2.4 2.6Public Enterprises 0.9 1.0 1.3 1.5 1.1 1.5 2.4 2.4 1.9

Private Sector 13.9 15.1 17.5 19.0 15.8 15.7 19.0 18.2 17.2Changes in stocks 1.0 0.9 0.8 1.0 0.2 0.4 0.2 0.4 0.0 1.0

Net factor income -1.8 -0.9 -1.5 -0.5 0.5 1.7 1.7 2.5 2.7 3.8

GNP (million pesos) 670,826 792,012 912,027 1,071,433 1,254,562 1,374,838 1,500,287 1,736,382 1,958,932 2,282,958

Source: NSCB.

TABLE 2: NATIONAL ACCOUNTS, 1987-96(Growth rates)

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

GDP at market prices 4.3 6.8 6.2 3.0 -0.6 0.3 2.1 4.4 4.8 5.7NetlndirectTaxes 25.0 -17.1 12.8 3.0 10.1 6.0 4.9 6.5 9.1GDP at factor cost 2.4 9.5 5.6 3.0 -1.6 -0.2 1.8 4.2 4.3

Agriculture 3.2 3.2 3.0 0.5 1.4 0.4 2.1 2.6 0.9 3.0Industry 4.0 8.7 7.4 2.6 -2.7 -0.5 1.6 5.8 7.0 6.3

Mining and quarrying -8.8 4.2 -2.7 -2.6 -2.9 6.7 0.7 -7.0 -0.8 -1.5Manufacturing 5.6 9.5 5.8 2.7 -0.4 -1.7 0.7 5.0 6.8 5.6

Services 5.2 7.2 7.0 4.9 0.2 1.0 2.5 4.2 5.0 6.5

ImportsofGNFS 28.6 19.6 15.2 10.0 -1.1 8.7 11.5 14.5 16.0 21.1Exports of GNFS 6.8 14.5 8.9 1.9 6.3 4.3 6.2 19.8 12.0 20.3

Total consumption 4.1 6.5 5.2 5.5 1.8 2.9 3.3 3.9 3.8 4.8Public 4.9 9.1 7.0 6.8 -2.1 -0.9 6.2 6.1 5.4 5.2Private 4.0 6.2 5.0 5.4 2.3 3.3 3.0 3.7 3.8 4.6

Gross domestic investment 19.7 14.7 20.5 15.8 -17.3 7.8 7.9 8.7 3.0 15.6GDFI 6.9 16.4 21.6 15.0 -14.2 6.4 8.7 7.5 4.7 12.0

Nonfinancial Pub. Sector 3.4 9.9 28.2 23.2 -3.1 21.5 -1.9 5.3 4.8National Government 2.5 8.7 22.9 24.4 10.1 15.4 -27.6 5.0 16.6Public Enterprises 5.3 12.3 38.7 21.1 -26.8 38.0 56.0 5.6 -7.4

Private 7.6 17.7 20.3 13.3 -16.7 2.5 16.3 4.0 6.5

Gross national product 4.6 7.7 5.6 4.0 0.5 1.6 2.1 5.3 5.0 6.9

Source: NSCB.

32 Statistical Annex

TABLE 3: BALANCE OF PAYMENTS, 1991-97 La(in $ million)

January-June1992 1993 1994 1995 1996 1996 1997

Trade balance -4,695 -6,222 -7,850 -8,944 -11,342 -6,046 -5,584(% of GNP) (8.7) (11.2) (11.9) (11.7) (13.0) (14.7) (12.1)

Exports (FOB) 9,824 11,375 13,483 17,447 20,543 9,582 11,700Imports (FOB) 14,519 17,597 21,333 26,391 31,885 15,628 17,284

Services (net) 3,020 2,507 3,964 4,765 6,839 3,012 3,199Receipts 7,443 7,497 10,550 14,374 19,006 8,221 11,100

o/w Remittances/Private transfers 3,485 3,956 5,824 8,696 10,169 5,060 6,151Payments 4,423 4,990 6,586 9,609 12,167 5,209 7,901

o/w Interest 1,703 1,513 1,579 2,179 2,167 1,055 1,261

Transfers (net) 817 699 936 882 689 326 315

Current Account Balance -858 -3,016 -2,950 -3,297 -3,814 -2,708 -2,070(% of GNP) (1.6) (5.5) (4.5) (4.3) (4.5) (6.6) (4.5)

Foreign investment (net) 737 812 1,558 1,609 1,168 1,014 -1,493Direct Investment 675 864 1,289 1,361 1,338 726 738Portfolio Investment 62 -52 269 248 -170 288 -2,231

MLT borrowing (net) 666 2,105 1,313 1,276 2,690 1,140 1,696Inflows 7,436 4,853 4,369 3,927 6,329 2,709 2,892Outflows 6,770 2,748 3,056 2,651 3,639 1,569 1,196

Short-term Capital (net) 660 -148 1,002 -56 540 214 241

Change in Commercial Banks' NFA 459 -547 465 1,309 4,211 2,949 2,800(- indicates increase)

Errors and Omissions -360 84 160 -291 -683 -198 -1,261

Others lb 188 544 254 81 -5 5 -122

Changes in net reserves L -1,492 166 -1,802 -631 -4,107 -2,416 209(- indicates increase)

La 1997 data cover the January to June periodLb Includes monetization of gold, revaluation adjustments and $469 million purchase of

collateral in 1992.k Includes net credit of IMF.

Source: BSP.

TABLE 4: EXPORTS AND IMPORTS BY MAJOR COMMODITY GROUP, 1987-96(in $ million)

1987 1988 1989 1990 1991 1992 1993 1994 1995 1996

ExportsCoconut Products 561 582 541 503 447 643 532 639 989 730SugarandProducts 71 74 113 133 136 110 129 77 74 139Fruits and Vegetables 150 306 317 326 393 371 439 429 458 486Other Agro-Based Products 585 480 454 431 503 432 476 530 575 506Forest Products 243 261 197 95 73 57 45 26 38 42Mineral Products 224 764 829 723 581 633 686 780 893 772Petroleum Products 88 162 95 155 175 150 136 132 171 273Manufactures 3,642 4,338 5,192 5,706 6,432 7,293 8,720 10,615 13,868 17,106

Elect. & Elect. Equipments 1,119 1,476 1,751 1,964 2,293 2,753 3,551 4,984 7,413 9,990Garments 1,098 1,317 1,575 1,776 1,861 2,140 2,272 2,375 2,570 2,423

Others 156 107 83 114 100 135 212 255 381 489

Total Exports 5,720 7,074 7,821 8,186 8,840 9,824 11,375 13,483 17,447 20,543

ImportsCapital Goods 1,210 1,637 2,424 3,122 2,952 4,023 5,610 6,868 8,029 10,472Raw Materials & Intermediate Goods 3,426 4,415 5,388 5,808 5,851 6,769 7,855 9,606 12,174 14,058

Unprocessed Raw Materials 303 672 807 862 841 947 961 1,278 1,562 1,720Semiprocessed Raw Materials 3,123 3,743 4,581 4,946 5,010 5,812 6,874 8,328 10,612 12,338

Manufactures 957 1,238 1,787 1,794 1,714 2,139 2,590 2,893 3,572 3,948Embroideries 334 377 437 426 514 502 468 411 472 349Materials for Elect. Equipt. 767 910 885 1,106 1,208 1,401 1,808 2,711 3,772 5,130

Mineral Fuels and Lubricants 1,249 1,096 1,397 1,842 1,784 2,050 2,016 2,040 2,461 3,008Consumer Goods 547 597 899 1,061 990 1,241 1,687 2,109 2,784 3,331

Durable 179 218 365 392 478 620 842 1,124 1,459 1,653 r4Nondurable 368 379 492 669 512 624 745 985 1,325 1,678

Others 305 414 311 373 474 436 529 710 943 1,016

Total Imports 6,737 8,159 10,419 12,206 12,051 14,519 17,697 21,333 26,391 31,885

Source: BSP.


TABLE 5: EXTERNAL DEBT, 1991-97(in $ million)

June1991 1992 1993 1994 1995 1996 1997

By Type of Debt 29,956 30,934 34,282 37,079 37,778 41,875 44,809Medium and Long-Term La 25,129 25,678 29,247 31,882 32,449 34,668 36,261Short-Term 4,827 5,256 5,035 5,197 5,279 7,207 8,548

Trade 4,589 4,937 3,495 3,401 2,674 4,096 4,513Nontrade 238 319 1,540 1,796 2,605 3,111 4,035

By Borrower 29,956 30,934 34,282 37,079 37,778 41,875 44,809Banking System LB 7,465 4,214 2,403 3,027 4,187 8,632 10,892

Central Bank 5,325 2,303 - - - - -Bangko Sentral - - 1,288 855 1,212 1,415 1,817Commercial Banks 2,140 1,911 1,115 2,172 2,975 7,217 9,075

Public and Private 22,491 26,720 31,879 34,052 33,591 33,244 33,916Public 18,453 21,745 26,583 27,193 26,340 24,132 23,060Private 4,038 4,975 5,296 6,859 7,251 9,112 10,856

By Creditor 29,956 30,934 34,282 37,079 37,778 41,875 44,809Commercial Banks 10,451 9,083 5,682 4,688 5,106 7,415 8,090Other Financial Institutions 556 324 303 841 1,239 958 1,378Suppliers' Credits 2,802 2,963 3,185 3,549 2,587 2,588 2,531Multilateral 6,499 7,168 7,949 8,216 8,028 8,634 8,304O/w IBRD 3,130 3,473 3,936 3,985 4,095 4,676 4,408

ADB 1,889 2,113 2,300 2,558 2,643 3,117 3,159IMF 1,165 1,183 1,312 1,139 814 405 278

Bilateral 9,572 11,328 13,369 15,033 14,393 13,439 13,645Export Agencies 3,659 3,351 3,997 4,487 3,939 4,677 4,520Others 5,913 7,977 9,372 10,546 10,454 8,762 9,125

Others 76 68 3,794 4,752 6,425 8,841 10,861

Memo Items:Debt service Lg 2,828 2,942 3,229 4,188 5,032 4,961 2,502Debtservice/Exports 19.6 17.0 17.1 17.4 15.8 12.5 11.1Total external debt / GNP (O/O) 65.6 57.4 62.0 56.4 49.6 48.1Total extemal debt / Exports (%) 207.1 179.2 181.7 154.3 118.7 105.9.

La Includes cumulative foreign exchange revaluation of US$-denominated multicurrency loans from theWorld Bank and Asian Development Bank of $433 and $384 million, respectively, for end-1996.

/b Effective July 3, 1993, accounts of old CB were split between Bangko Sentral ng Pilipinas and CentralBank - Board of Liquidators.

/c For 1991-94, debt service burden represents principal and interest payments after rescheduling.

Source: BSP.


TABLE 6: MONETARY SURVEY, 1992-97

August1992 1993 1994 1995 1996 1997

(in billions of pesos)

Total Liquidity 401.1 499.4 630.8 786.4 913.9 992.7Broad Money 385.4 480.3 607.6 761.4 881.4 959.9Other Liabilities 15.7 19.1 23.2 25.0 32.5 32.8

Net Foreign Assets 76.5 104.6 123.6 117.9 70.2 -11.9o/w Central Bank 45.5 56.8 91.8 118.4 232.7 202.7

Deposit Money Banks 30.9 47.9 31.8 -0.5 -162.4 -214.6

Net Domestic Assets 324.6 394.8 507.1 668.5 843.7 1,034.5Net Domestic Credit 277.1 682.1 821.5 1,084.0 1,507.8 1,712.3

Public Sector -18.6 274.1 299.8 335.3 377.2 400.5Private Sector 295.7 408.0 521.7 748.7 1,130.5 1,311.8

FCDs, residents -94.5 -136.2 -158.8 -206.7 -317.6 -366.4Other Items (net) 142.0 -151.1 -155.6 -208.8 -346.5 -311.4

(percentage change; end of period)

Broad Money 11.0 24.6 26.5 25.3 15.8 23.7Net Domestic Assets 3.0 146.2 20.4 32.0 39.1 28.1

Private Sector Credit 24.6 38.0 27.9 43.5 51.0 32.0

(in percent of GNP)

Broad Money 28.0 32.0 35.0 38.9 38.6Net Foreign Assets 5.6 7.0 7.1 6.0 3.1Net Domestic Assets 23.6 26.3 29.2 34.1 37.0

Private Sector Credit 21.5 27.2 30.0 38.2 49.5

Sources: BSP, IMF.

TABLE 7: EXCHANGE RATES, INFLATION AND SELECTED INTEREST RATES, 1991-97

1991 1992 1993 1994 1995 1996 1997Mar Jun Sep

Exchange Rates:Period Average (Pesos/$) 27.5 25.5 27.1 26.4 25.7 26.2 26.3 26.4 32.6End of Period (Pesos/$) 26.7 25.1 27.7 24.4 26.2 26.3 26.4 26.4 34.3Real Effective (1990=100) 99.8 110.9 110.4 117.3 120.3 129.8 139.6 138.6

Inflation:CPI (1990=100) 118.7 129.3 139.1 151.7 164.0 177.8 184.1 186.6 189.3Yearchange(%) 18.7 8.9 7.6 9.1 8.1 8.4 4.8 4.8 5.3

Interest Rates:(end of period)

Manila Reference Rates:MRR60 19.2 13.8 14.8 9.8 11.4 11.8 10.1 10.2 15.8MRR90 17.2 14.1 15.0 8.8 10.3 11.0 8.9 9.6 11.9MRR180 17.1 11.9 14.1 9.1 10.4 10.2 8.1 8.4 12.2All Maturities 18.7 13.7 14.7 9.6 11.1 11.6 9.9 9.9 15.5

Bank Lending Rate 23.0 18.2 16.4 13.4 14.6 14.8 13.7 13.3 18.7 p/Time Deposits:

Short-Tern(< I yr) 18.9 12.9 14.1 8.3 11.4 10.5 9.2 8.2 12.8Long-tenn(> I yr) 18.0 13.0 13.0 10.8 9.6 11.1 8.6 9.3 13.2

91-day Treasury Bill Rate 21.1 14.5 15.9 10.7 12.0 11.5 10.1 10.5 15.0ReserseRP(term)Rate 15.5 N.T. N.T. 14.0 13.4 11.1 9.9 10.3 14.7InterbankCallLoanRate 14.9 23.2 24.1 12.0 14.1 11.2 9.9 15.1 13.6

p/ Preliminary.

Source: BSP, IMF.


TABLE 8: CONSOLIDATED PUBLIC SECTOR FINANCIAL POSITION, 1992-97

Program1992 1993 1994 1995 1996 1997

(in billion pesos)

National Government -16.0 -21.9 16.3 11.1 6.3 13.0Monitored GOCCs -10.7 -25.6 -8.7 -1.3 -11.2 -9.3Central Bank Restructuring 0.0 -15.1 -24.3 -20.0 -13.8 -11.9Oil Price Stabilization Fund (OPSF) Lg 4.4 -7.9 2.6 -9.2 4.8 -0.8Adjustment to GOCCs Lb 2.5 11.9 7.6 2.8 1.5 1.4Other Adjustments L/ -0.6 2.8 0.0 0.0 0.0 0.0

Public Sector Borrowing Requirement (PSBR) -20.4 -55.8 -6.5 -16.6 -12.4 -7.7

SSS/GSIS 8.6 11.7 -12.0 0.0 8.5 5.9Bangko Sentral ng Pilipinas -21.8 -1.0 5.2 3.6 -2.3 2.1Govemment Financial Institutions 3.8 6.1 3.1 5.0 8.4 3.3Local Government Units 0.8 5.9 5.0 1.9 5.7 2.8Time Adj. of Interest Payments to BSP 3.5 7.0 -2.3 3.0 -0.7 0.0Other Adjustments -0.4 0.3 0.1 0.6 0.0 0.1

Consolidated Public Sector (CPS) -25.9 -25.8 -7.4 -2.6 7.3 6.5

(in percent of GNP)

National Government -1.2 -1.5 0.9 0.6 0.3 0.5Monitored GOCCs -0.8 -1.7 -0.5 -0.1 -0.5 -0.4Central Bank Restructuring 0.0 -1.0 -1.4 -1.0 -0.6 -0.5Oil Price Stabilization Fund (OPSF) La 0.3 -0.5 0.1 -0.5 0.2 0.0Adjustment to GOCCs Lb 0.2 0.8 0.4 0.1 0.1 0.1Other Adjustments L/ 0.0 0.2 0.0 0.0 0.0 0.0

Public Sector Borrowing Requirement (PSBR) -1.5 -3.7 -0.4 -0.8 -0.5 -0.3

SSS/GSIS 0.6 0.8 -0.7 0.0 0.4 0.2Bangko Sentral ng Pilipinas -1.6 -0.1 0.3 0.2 -0.1 0.1Government Financial Institutions 0.3 0.4 0.2 0.3 0.4 0.1Local Government Units 0.1 0.4 0.3 0.1 0.2 0.1Time Adj. of Interest Payments to BSP 0.3 0.5 -0.1 0.2 0.0 0.0Other Adjustments 0.0 0.0 0.0 0.0 0.0 0.0

Consolidated Public Sector (CPS) -1.9 -1.7 -0.4 -0.1 0.3 0.3

La Includes OPSF balance, transfers between NG and OPSF, and adjustments for PNOC share of OPSFbalance.

Lb Includes NG transfers to monitored corporations, NPC transfers to NG, NG transfers to PNOC andPNB transfers to NG.

lZ Includes adjustments for net lending for debt buyback, reconciliation of cash accounts with bank dataand other adjustments.

Sources: DOF, IMF.


TABLE 9: OUTSTANDING PUBLIC SECTOR DEBT, 1992-96(year-end, in billions of pesos)

1992 1993 1994 1995 1996

Total Public Sector Ia 1,630.0 1,910.7 1,900.5 2,170.9 2,167.8Domestic 1,082.7 1,158.6 1,170.1 1,426.8 1,467.0External 547.3 752.1 730.4 744.1 700.8

(US$ billion) 21.6 27.2 29.9 28.4 26.7Total Public Sector /b 1,062.0 1,407.2 1,347.5 1,528.4 1,504.0

Domestic 587.6 764.8 743.7 922.8 946.6External 474.4 642.4 603.8 605.6 557.4

(US$ billion) 18.7 23.2 24.7 23.1 21.2National Government Ic 979.4 1,268.8 1,232.2 1,307.1 1,331.8National Government /d 873.8 1,165.0 1,118.6 1,185.3 1,145.7

Domestic Ic 502.9 682.6 671.0 722.8 718.3External /d 476.5 586.2 561.2 584.3 583.5

(US$ billion) 18.8 21.2 23.0 22.3 22.214 Monitored GOCCs Le 188.2 242.2 228.9 343.1 358.3


(US$ billion) 3.9 5.6 6.2 5.2 5.8Central Bank/CB-BOL If 409.8 59.6 81.1 82.6 77.1


(US$ billion) 2.3 1.6 1.7 1.5 1.5Bangko Sentral /g 209.3 240.9 253.8 330.3

Domestic 173.6 183.9 185.8 262.6External 35.7 57.0 68.0 67.7

(US$ billion) 1.3 2.3 2.6 2.6Government Financial Institutions 158.2 234.6 231.1 306.1 256.4


(US$ billion) 0.6 1.1 1.2 1.1 1.4

Memo Items:Public Sector Debt Stock/GNP/a 118.6 127.4 109.4 110.8 95.0


Public Sector Debt Stock/GNP lb 77.2 93.8 77.6 78.0 65.9Domestic 42.7 51.0 42.8 47.1 41.5External 34.5 42.8 34.8 30.9 24.4

National Government Debt Stock/GNP L/ 71.2 84.6 70.9 66.7 58.3National Government Debt Stock/GNP /d 63.6 77.7 64.4 60.5 50.2

Domestic Ic 36.6 45.5 38.6 36.9 31.5External 34.7 39.1 32.3 29.8 25.6

La Includes National Government, 14 Monitored GOCCs, CB/CB-BOL/BSP and GFIs.L2 Same as La except for CB/CB-BOL/BSP and GFIs./c Includes direct, assumed and contingent liabilities.Ld Excludes direct, assumed and contingent liabilities.La Includes direct, guaranteed and assumed liabilities.Lf Includes net lending from NG, borrowings relent/guaranteed by National Government.Lg Liabilities less currency issue and intergovermment accounts.

Source: DOF.


TABLE 10: NATIONAL GOVERNMENT CASH OPERATIONS, 1991-96(in million pesos)

1991 1992 1993 1994 1995 1996

Total Revenue 220,787 242,714 260,405 336,160 361,220 410,449

Tax Revenue 182,275 208,706 230,170 271,304 310,517 367,894Bureau of Intemal Revenue 116,256 133,904 145,927 187,445 210,105 260,774Bureau of Customs 64,391 72,871 81,971 81,610 97,691 104,566Other Offices 1,628 1,931 2,272 2,249 2,721 2,554

Non-Tax Revenue 38,512 34,008 30,235 64,856 50,703 42,555

Total Expenditure 247,136 258,680 282,295 319,874 350,146 404,193

Current Expenditure 196,525 214,939 226,618 267,813 277,265 318,462Personnel Services 72,399 74,337 78,696 92,678 109,074 135,406Maintenance and Operations 36,199 33,673 34,565 46,837 46,950 48,702Subsidies 4,270 3,531 5,147 7,021 3,580 5,862Allotment to LGUs 6,708 16,114 27,773 37,753 41,394 45,275Interest Payments 74,922 79,571 76,491 79,123 72,658 76,522Tax Expenditures 1,989 7,713 3,946 4,401 3,609 6,695

Capital Expenditure and Net Lending 50,611 43,741 55,677 52,061 72,881 75,731Capital Expenditure 40,681 50,186 44,773 43,068 64,461 69,628Infrastructure and Other Capital Outlays 37,607 46,125 37,830 33,606 52,673 57,547Transfers to LGUs 3,074 4,061 6,943 9,462 11,788 12,081

Equity and Net Lending 7,667 -6,949 9,402 8,993 8,420 3,176CARP Land Acquisition and Credit 2,263 504 1,502 0 0 2,927

OPSF 10,000

Overall Surplus/Deficit -26,349 -15,966 -21,890 16,286 11,074 6,256

Financing 26,349 15,965 21,891 -16,286 -11,074 -6,256Net Domestic Financing 19,469 1,575 8,979 -4,709 2,272 -348Net Foreign Financing 6,880 14,390 12,912 -11,577 -13,346 -5,908

Memo Items: (in % GNP)

Total Revenue 17.6 17.7 17.4 19.4 18.4 18.0Tax Revenue 14.5 15.2 15.3 15.6 15.9 16.1Current Expenditure 15.7 15.6 15.1 15.4 14.2 13.9Capital Expenditure and Net Lending 4.0 3.2 3.7 3.0 3.7 3.3Overall Surplus/Deficit -2.1 -1.2 -1.5 0.9 0.6 0.3

Source: DOF.


TABLE 1 1: LOANS OUTSTANDING OF COMMERCIAL BANKS, 1990-97

Sep Ip1990 1991 1992 1993 1994 1995 1996 1997

ECONOMIC ACTIVITY

Growth rates (% on year earlier)Agriculture, fisheries, & forestry 30.6 10.1 19.1 8.1 19.6 6.4 30.9Mining and quarrying -10.5 23.2 56.9 -48.1 55.9 9.4 91.1Manufacturing -3.0 25.6 26.9 32.5 33.9 42.5 17.6Electricity, gas & water 10.6 15.4 159.5 25.7 24.7 90.6 56.8Construction 8.7 18.5 65.3 32.3 37.4 74.2 26.8Wholesale & retail trade 27.7 19.9 27.8 39.8 37.3 38.1 35.9Transportation, storage & communication 0.5 21.9 52.8 53.8 72.0 53.3 74.0Fin. inst., real estate & business services 19.2 36.1 10.1 37.4 24.8 97.2 69.7Community, Social & Personal services 3.4 25.4 92.1 -10.4 61.8 57.6 33.2

TOTAL 9.9 24.0 32.2 25.4 35.8 51.9 39.1

Share of Total Loans (%)

Agriculture, fisheries, & forestry 11.2 13.3 11.8 10.6 9.2 8.1 5.7 5.5Mining and quarrying 2.6 2.1 2.1 2.5 1.0 1.2 0.9 1.3Manufacturing 38.5 34.0 34.4 33.0 34.9 34.4 32.3 29.0Electricity, gas & water 1.3 1.3 1.2 2.4 2.4 2.2 2.8 3.1Construction 2.7 2.6 2.5 3.1 3.3 3.4 3.9 3.6Wholesale & retail trade 14.5 16.8 16.3 15.7 17.5 17.7 16.1 15.3Transportation, storage & communication 3.8 3.4 3.4 3.9 4.8 6.1 6.1 7.5Fin. inst., real estate & business services 16.9 18.3 20.1 16.7 18.3 16.8 21.8 25.2Community, Social & Personal services 8.6 8.1 8.2 11.9 8.5 10.2 10.5 9.5

TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

/p = Provisional.

Source: BSP.

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