Report No. 18895-PH

PhilippinesThe Challenge of Economic Recovery

February 26, 1999

Povertv Recduction and Economic NManagemenit Sector UnitEast Asia ancl Pacific Regional Office

Document of the World Bank

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CURRENCY EQUIVALENTS(As of February 26, 1999)

Currency Unit = Peso$1.00 = 39.12 pesos

1.00 peso = $0.026

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS AND ACRONYMS

AMC - Asset Management CorporationBIR - Bureau of Internal RevenueBOI - Bureau of InvestmentsBOT - Build-Operate-TransferBTr - Bureau of the TreasuryBSP - Bangko Sentral Ng PilipinasCIBI - Credit Information Bureau Inc.CPSD - Consolidated Public Sector DeficitDBM - Department of Budget and ManagementDENR - Department of Environment and Natural ResourcesDOF - Department of FinanceDOTC - Department of Transport and CommunicationDPWH - Department of Public Works and HighwaysDST - Documentary Stamp TaxEDC - Export Development CouncilERB - Energy Regulatory BoardFCDU - Foreign Currency Deposit UnitFDI - Foreign Direct InvestmentGASTPE - Government Assistance to Students and Teachers in

Private EducationGOCC - Government-owned or Controlled CorporationGOP - Government of PhilippinesGRT - Gross Receipt TaxGSIS - Government Service Insurance System

Vice President Jean-Michel Severino, EAPCountry Director Vinay K. Bhargava, EACPFManager (Acting) Kyle Peters, EASPRTask Manager Sanjay Dhar, EASPR

HIGC - Home Insurance and Guaranty CorporationHUDCC - Housing and Urban Development Coordinating CouncilIASC - International Accounting Standards CommitteeICZM - Integrated Coastal Zone ManagementIRA - Internal Revenue AllotmentLGU - Local Government UnitMDF - Municipal Development FundNHMFC - National Home Mortgage Finance CorporationNEA - National Electrification AdministrationNEDA - National Economic Development AuthorityNG - National GovernnentNPC - National Power CompanyNPL - Nonperforming LoanOECF - Overseas Economic Cooperation FundOPP - Occupational Pension PlanPAYG - Pay-As-You-GoPAL - Philippine AirlinesPAS - Philippine Accounting StandardsPCFC - People's Credit and Finance CorporationPEZA - Philippine Economic Zone AuthorityPDIC - Philippines Deposit Insurance CorporationPNB - Philippine National BankPNR - Philippine National RailwaysPSE - Philippine Stock ExchangeSEC - Securities and Exchange CommissionSME - Small and Medium EnterpriseSRO - Self-Regulated OrganizationSTAND - Science and Technology Agenda for National DevelopmentSSS - Social Security SystemTSP - Total Suspended ParticlesUHLP - Unified Home Lending ProgramUSGAAP - U.S. Generally Accepted Accounting PrinciplesWTO - World Trade Organization

Table of Contents

Page No.

EXECUTIVE SUMMARY .v..........................v

INTRODUCTION ........................... xv

I. THE CHALLENGE OF ECONOMIC RECOVERY .1.

A. Recent Developments: On the Edge of the Regional Crisis .1B. Why Did the Philippines Escape the Worst of the Regional Crisis?. 8C. Policy Challenges and Opportunities .10D. Economic Prospects and Financing Requirements . 18

II. STRENGTHENING THE CORPORATE SECTOR .21

A. Introduction .21B. Structure of the Corporate Sector .. 21C. Impediments to Corporate Recovery and Growth .26D. Corporate Sector Reform Agenda. 3 1

III. FOSTERING FINANCIAL SOUNDNESS AND GROWTH. 35

A. Introduction. 35B. Implementing Reforms in the Banking System. 36C. Deepening Capital Markets .40D. Developing Long-Term Domestic Savings .42E. Reforming Housing Finance ....................... 44F. Ensuring Access to Rural, Micro and Small Enterprise Finance. 46

IV. EXPORT PERFORMANCE AND COMPETITIVENESS. 48

A. Introduction. 48B. Recent Export Performance.48C. Structural Competitiveness .52D. Implications .64

V. ECONOMIC SLOWDOWN AND THE POOR .67

A. Progress till 1997: Declining Poverty but Urban Biased .67B. The Economic Crisis: Little Impact So Far .70C. A Strategy for Social Protection .71

VI. ENVIRONMENTAL CHALLENGES AND STRATEGY ...................... 75

A. Introduction ........................................... 75B. Sources of Environmental Degradation .................................... .. 76C. Impact of the Crisis on the Environmient .................................... 80D. Challenges: Improving Governance and Coordination ..................... 80

STATISTICAL ANNEX .84

REFERIENCES.97REFERENCES .............................................................................. 9

TABLES

1.1 Selected Economic Indicators, 1993-98 ......................................... . 21.2 Sectoral Breakdown of Growth ........................................... ... 31.3 National Government Financing Requirement .................... ............... 141.4 Expenditure Shares within National Government Budget .......... ........... 151.5 External Financing Requirements and Sources, 1999-2000 ......... ......... 202.1 Corporate Sector Profitability and Level of Indebtedness in 1997 ....... ..... 234.1 Annual Growth Rates of Merchandise Exports................. 494.2 Philippines Manufactured Export Performance 1991-1998 ............... ..... 504.3 Evolution of World Manufactured Exports by Technological

Categories (1980-96) ............. 524.4 Technological Structure of Manufactured Exports, 1996 .......... ............ 534.5 Philippine Electronics Exports . ............................................... 544.6 List of Leading 50 Philippines Exporters in 1996 .............. ................ 554.7 Comparative Exports of Semiconductors ......................................... 564.8 Educational Enrollments ..................... .......................... 584.9 R&D Employment and Expenditures ............................................. 594.10 Exports as Percentage of Imports in Philippine Electronics Industry .......... 645.1 Indicators of Poverty Incidence ............................................... 675.2 Number of Poor People ................... ............................ 685.3 Poverty in East Asia, Summary Statistics: 1975-95 ............................. 685.4 Persistent Poverty in Certain Rural Regions ................................... 695.5 Indicators of Income Inequality ................................... 70

FIGURES

1.1 Domestic Demand and Domestic Credit ....................... ............ 31.2 Changes in the Unemployment Rate . ................................... 41.3 Interest Rates and Inflation ................................... 51.4 Balance of Payments ................................... 61.5 Financial Market Indicators ................................... 71.6 Regional Financial Markets ................................... 84.1 Value of major Categories of Philippines Manufactured Exports ....... ...... 514.2 Hourly Labor Costs in the Apparel Industry ........................... .......... 61

BOXES

2.1 Survey of Philippine Industry and the Asian Financial Crisis:Preliminary Results .............................................. 25

2.2 Policy Framework for Suspension of Payments ................. ................ 3 12.3 Proposals for Corporate Sector Reform . 33

ACKNOWLEDGEMENTS

This report was produced by a team led by Sanjay Dhar, and included Bernard Funckand Joven Balbosa (macroeconomy and public sector), Charles Woodruff and MaryHallward-Driemeier (corporate sector), McDonald Benjamin and Patrick Honohan(financial sector), Sanjaya Lall (consultant, export performance and competitiveness),Gurushri Swamy (poverty), Glen Morgan, Patchamuthu Illangovan and Giovanna Dore(environment). David Bisbee provided research assistance. Hedwig Abbey and GloriaElmore assisted with document processing.

The report was discussed with the Philippine authorities in February 1999. Wegratefully acknowledge the cooperation of government officials.

EXECUTIVE SUMMARY

A. IMPACT OF THE REGIONAL CRISIS

The Philippine economy has withstood the regional crisis better than most marketeconomies in East Asia as the banking and corporate sectors have resisted the type ofsystemic collapse witnessed elsewhere, export growth has remained remarkably robust,and the social repercussions of the financial crisis have perhaps been less severe to date.The more resilient response to the crisis in the Philippines reflects the shorter period ofrapid credit expansion and debt accumulation by the private sector, stronger capitalizationof major banks and lower levels of corporate leverage, greater private sector experiencewith previous crises, and a favorable macroeconomic policy response to the crisis.Moreover, following 18 months of enormous volatility, financial markets havestrengthened since September 1998 as equity prices have risen by some 85 percent fromtheir six year low in mid-September, the peso has strengthened, and real interest rateshave declined towards pre-crisis levels.

Nevertheless, the momentum of growth and optimism that had built through early1997 has been dealt a severe blow. With investor confidence shaken through much of theregion and prospects for economic recovery uncertain, the policy environment in theearly years of the new administration has undoubtedly become more challenging.

Economic activity stalled in 1998-real GDP contracted by an estimated 0.5percent, weighed down by a severe drought which reduced agricultural production bynearly 7 percent, unemployment and inflation both approached 10 percent, privateinvestment fell sharply, and banks' non-performing loans (NPLs) rose from 4 to 11percent of their loan portfolio between mid-1997 and end-1998, after reaching 12.5percent in October 1998. Reflecting higher levels of financial stress, investors remaincautious towards initiating new projects and bankers remain reluctant to extend credit tonew or small borrowers-bank credit to the private sector was flat in nominal terms in1998 (versus over 50 percent growth in 1996). While the current account shifted to asmall surplus in 1998 from a 5 percent of GNP deficit in 1997, the consolidated publicsector deficit (CPSD) is estimated to have widened to over 3 percent of GNP. And thescope for stimulating the economy through fiscal policy remains constrained by a heavypublic debt (over 90 percent of GNP in 1997), a large refinancing burden for pesodenominated debt, and an uncertain external environment for private capital-notwithstanding a successful return to the global bond market by the PhilippineGovermnent in early January 1999 after a hiatus since the Russian default.

Macroeconomic Policy Stance

The policy responses to the crisis have been basically sound, particularly whentaking into account the low level of foreign exchange reserves and the need to balance thedamaging effects of sharp depreciation and high interest rates on the banking, corporate

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and public sectors. Periodic bouts of speculative attack on the peso have been bluntedthrough a mix of short-term interest rate adjustments, tightening of liquidity, relativelymild intervention (subsequent to the initial Thai crisis), use of moral suasion with marketleaders and collaborative initiatives with the Bankers Association of the Philippines, butwithout resort to capital controls. National Government (NG) expenditures were cutsharply from initial appropriations as tax revenue fell, but once the extent of economicweakening became apparent, selective adjustments to better protect social expenditureswere enacted. In an effort to provide a modest fiscal stimulus in 1999, both current andcapital expenditures in the NG budget are targeted to rise gradually relative to 1998, andincreased reliance on external financing to finance the NG deficit is proposed in order toreduce pressure on domestic interest rates. Current projections assume that the CPSD in1999 would remain at about 3.2 percent of GNP, about the level estimated in 1998,although it is recognized that a weaker than anticipated recovery may warrant a largerpublic deficit.

The use of a larger fiscal stimulus on a sustained basis is, however, constrained bylongstanding concerns regarding fiscal sustainability and the possibility that financialdistress may yet claim more significant fiscal resources. To mitigate investor concernsarising from higher public deficits, an important immediate task is to improve taxadministration and enforcement, so that future deficit reduction can be accomplishedmore effectively as recovery takes hold, and the current reliance on higher deficits cancredibly be regarded as temporary.

Economic Outlook

Notwithstanding the milder initial impact of the crisis, the outlook for recovery isclouded by the uncertain prospects for private capital flows and high levels of corporateand banking stress, which could continue to restrain investment, credit demand and creditaccess. While the economy in 1999 may receive a boost from higher-than-trendagricultural growth from its depressed level of 1998, export growth was slowing in late1998. Declining industrial production and imports in late 1998 appear to indicate that theeconomy may not have bottomed out. Yet without an early resumption of industrialgrowth, it will be difficult to record even a modest recovery of 2 percent in 1999.

In the medium term, the pace of recovery will be heavily influenced by twofactors: the extent to which financial stress has been alleviated, thereby improving theenvironment for corporate investment and bank lending; ancd the nature of private capitalflows. In view of the uncertain outlook for private capital flows (and the undesirability ofdepending excessively upon them), it would be prudent to assume continued volatilityand a considerably smaller net inflow than witnessed during 1993-97 (when currentaccount deficits averaged nearly 5 percent of GNP). These factors point to a relativelymodest recovery in the medium term, with growth averaging about 41/2 percent during2000-03 and current account deficits remaining below 2 percent of GNP throughout thisperiod. While the rate of growth is not expected to return quickly to pre-crisis levels, thecrisis does provide an impetus to accelerate structural reforns that would improve boththe quality and sustainability of the growth that is achieved.

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B. PROTECTING THE POOR FROM GREATER HARDSHIP

Parallel to the economic turnaround through 1997, the Philippines achieved asignificant reduction in poverty incidence as the proportion of households living inpoverty fell from 40 percent in 1991 to 32 percent in 1997 according to official estimates,and other social indicators improved commensurately.' However, the reduction in ruralpoverty incidence was less significant-the number of rural poor actually increased by2.4 million between 1991 and 1997-and income inequality is estimated to haveincreased sharply during 1994-97, and rural-urban income differentials have alsowidened. Data to fully delineate the impact of the financial crisis and the drought in 1998are not yet available, although a rise in unemployment in the second half of 1998 appearsprimarily attributable to the financial crisis, as the decline in construction andmanufacturing began to reduce labor demand.

Government actions to cushion the impact of the crises have included: partiallyprotecting social expenditures in the context of a declining budgetary envelope;influencing employers and workers to promote wage restraint thereby moderatingincreases in unemployment and inflation; and using massive rice imports to stabilizedomestic prices.

Contingent measures in response to the possibility of intensifying hardshipsamong the poor and near-poor if the crisis lingers or deepens include: expansion of laborintensive employment programs which attract only the poor by setting wages below themarket rate; and protection of existing government expenditures on health and educationtargeted towards the poor. On the latter: the textbook appropriation in the 1999 budgetneeds to be increased; the school construction program restored; and decrease in coveragefor public health (malaria, shistomaisis and tuberculosis control) and immunizationprograms reversed. Financing for these programs could come from, inter alia, vetoingnew funding for state universities, freezing new hiring of school teachers untilredeployment possibilities are exhausted, and canceling the re-nationalization of twohospitals and upgrading of five others.

In addition, preventing sharp increases in food prices on items such as rice andcorn on which the poor spend higher proportions of their income remains essential. Itmay become necessary not only to import and distribute more rice than normal, but alsoto target the rice to the poor, including those who have newly become poor.Geographical targeting, income-based targeting of food coupons, as well as targeting bysubsidizing the lower qualities of rice, are all options to be considered. A well targetedfood distribution system could replace the current costly and poorly targeted system, andwould facilitate the eventual replacement of the quantitative restriction on rice with atariff.

l Governnent measures of poverty use a higher income cutoff level than in many other countries, whichmay inflate Philippine poverty estimates somewhat in international comparisons.

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Finally, since local governments are primarily responsible for administering socialsafety net programs, enhanced ability by the National Government to monitor andinfluence the effectiveness of such programs is needed on an urgent basis.

C. AN AGENDA FOR SUSTAINABLE ECONOMIC RECOVERY

The following sections outline the elements of a medium-term reform agenda.The priorities within this agenda are (i) to effectively tackle the problem of stress in thecorporate and banking sectors, without which it is difficult to envisage a robust recovery;and (ii) to improve governance within public institutions. Progress on both these fronts isneeded to strengthen investor confidence on a sustained basis, which in turn is a vitalcomponent of recovery given the Philippines' open economy and heavy reliance on tradeand capital flows.

Governance and the Reform Agenda

A common element that pervades the reform agenda is the need for a strategy onimproving governance. This report identifies several areas where improved governancein public institutions is critically needed. Examples include: even-handed implementationof tax laws; strengthening the framework for delbt resolution and governance in the publicagencies charged with this task; enhancing financial and corporate transparency throughmore rigorous enforcement of existing regulations; improving the effectiveness ofgovernment programs to protect the poor; enabling more stringent enforcement andcompliance with environmental regulations. More broadly, it is worth stressing theimportance attached by investors to items such as improved law and order, adequateinfrastructure, integrity in the process of awarding public contracts, and predictability inthe incentive regime and judicial processes. A strong and reliable legal framework forinvestment and debt resolution will be of utmost importance in the medium term.Finally, the urgency of improving public governance has increased with the onset of thecrisis, as investors and the public are likely to demand greater accountability for the useof public resources.

President Estrada's administration has recognized the importance of goodgovernance by listing as among its top priorities the goal of tackling graft and corruption.The credibility of this objective can be enhanced by taking corrective actions to addressproblems already identified, building a broader strategic agenda for strengthening publicinstitutions, and developing benchmarks for monitoring of progress. Implementingreforms to strengthen the civil service will be an. essential element of this agenda.

Reforming the Public Sector

A stronger public sector in the Philippines is needed to fulfill a number ofobjectives, including: to place public finances on a sustainable debt path withoutsacrificing essential government activities and investment; to improve regulatoryoversight and contingent liability management capacity, particularly as these involveprivate management of infrastructure; and to enhance administrative efficiency andintegrity. While the problems may be deep-rooted, the crisis should provide an impetus

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to tackle them with greater urgency. It is essential for the credibility of any fiscalstimulation that it be accompanied by measures to enable the budget to be brought backtowards balance once the need for fiscal expansion has passed.

Priorities in this respect include: (i) implementing the objectives of the"Streamlining the Bureaucracy" bill submitted to the previous Congress, which havebcgome more urgent as the personnel bill has consumed a progressively larger share ofNG expenditure; (ii) strengthening national expenditure management in the pursuit ofgreater allocative and operational efficiency, particularly through the introduction of amedium-term expenditure framework that tightens the linkage between planning,programming and budgeting; (iii) improving revenue performance by strengthening taxadministration on a sustained basis, streamlining tax incentives and privileges andreforming taxation of financial instruments; (iv) reassessing the scope of decentralizationin view of the actual performance of local governments (which requires improvedmonitoring capacity), and revising the Internal Revenue Allotment (IRA) formula whichgoverns transfers to local governments with an objective to improve its equity, incentivesfor local revenue mobilization, and fiscal sustainability; (v) enhancing transparency andaccountability at all levels of government; and (vi) institutionalizing mechanisms tomonitor the poverty impact of government programs.

The search for efficiency gains also needs to be pursued at the sectoral level.Most important from a fiscal perspective is the successful restructuring and privatizationof the National Power Corporation, whose foreign debt and contingent liabilitiesconstitute a substantial fiscal burden. But opportunities for enhancing efficiency alsoexist in the roads, rail, ports, water and food sectors where there is scope for greaterprivate participation and reforming existing public management and financingapproaches.

Corporate and Banking Reform Priorities

A strong private-led economic recovery is unlikely to occur in an environment ofhigh or rising financial stress, since firms' appetite towards new investment wouldremain diminished and banks would remain reluctant to expand lending beyond their coreclients. As a corollary, expediting the resolution of financial stress remains a prerequisitefor sustainable recovery. In the Philippine context, a fiscal stimulus may be able to limitthe severity of the current downturn, but it cannot substitute for a well-functioning bankand corporate restructuring framework that facilitates vigorous private investment-sinceinvestors recognize that a heavy public debt burden limits the scope for fiscal stimulus ona sustained basis.

Corporate Restructuring and Governance. Philippine corporations havewithstood the regional crisis better than in neighboring countries, but both the number ofdistressed corporations and the severity of stress experienced has nonetheless increasedsharply. Debt restructuring is usually enacted on an informal basis but this can fail for avariety of reasons, upon which time the distressed corporation may petition the Securitiesand Exchange Commission (SEC-which, in 1976, replaced the court system as the

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formal venue for resolving distressed corporate debt-for protection from its creditors.However, the manner in which cases are handled appears prejudicial against creditor(particularly secured creditor) interests and seldom leads to rehabilitation. Debtresolution is generally protracted, prompting both debtors and creditors to opt foralternative informal resolution mechanisms. And SEC's capacity to handle its increasingworkload has been strained by the crisis as the backlog of cases has grown.

The system for addressing corporate insolvency therefore needs a major overhaul.In the short term, given the heavy backlog of existing cases, there may be no alternativebut to augment SEC's capacity. The authorities are considering adoption of a policystatement, which would guide the creation of a new set of rules and procedures for debtresolution which, inter alia, would enhance the role of creditors. The above frameworkcould be made more credible by forming a high-level debt resolution committee (DRC)consisting of the SEC, members of the judiciary, experienced business leaders andinternational insolvency practitioners with the objective of developing a more predictableand efficient debt resolution framework, including rules on priority of claims and votingprocedures applicable to different classes of claim holders. To enforce the new system ofpriority claims, the terms of the 1976 Presidential Decree transferring corporateinsolvency jurisdiction to the SEC may need to be amended.

Whatever the mechanism for strengthening the SEC, a revamped SEC cannot beallowed to become an obstacle to the transfer of corporate insolvency jurisdiction back tothe courts. Any strengthening of the SEC should therefore be conducted in the context ofa time-bound transition to a court administered system, and will need to be buttressed byincreased focus on improving the SEC's technical capability and internal governance.

The Philippines is one of very few courntries that relies on an administrative bodyto manage insolvency cases, and recent events have indicated the practical drawbacksencountered in such a system, implying that the adoption of a modern bankruptcy law(the existing bankruptcy law dates back to 1909) and the training of judges to implementthe new law is of the utmost priority. Since building effective capacity of the courts is asubstantial task which will take time, one means of expediting the shift to a courtadministrated system would be to create a special bankruptcy court with a small numberof full-time judges.

Disclosure standards within corporations also need to be strengthened and betterenforced-as indeed proposed under the new SEC law submitted to Congress; theconcentrated ownership structure and cross-holdings between banks and corporationsmakes improved disclosure especially important. Enabling creditors to determine the truecondition of firmns through greater transparency would improve credit access in themedium term, particularly for smaller firms, and could reduce capital flow volatility.

Access to credit by small and medium enterprises (SMEs), problematic evenduring periods of strong credit growth, appears to have deteriorated during the crisis(although preliminary findings from a sample of 200 firmis in late 1998 indicates thatweakened demand for credit may have contributed more to the slowdown than tightercredit standards by banks). Improving the legal framework for secured creditors and

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rectifying current abuses of their rights in SEC administered payments suspension casesoffer an opportunity for enhancing SME credit access.

Prudential Framework for Banking. Philippine banks have weathered thecrisis better than in many neighboring countries, but the level and trend in NPLs confirmsthat the system remains under stress. The ability of the banking system to contributestrongly to the economic recovery will depend on careful attention to a strengthening ofthe prudential framework and the incentive environment.

The authorities have initiated a significant banking reform program that includes:higher minimum capital and stricter provisioning requirements; stricter disclosurerequirements; tighter restrictions on bank licensing; intensified supervision andmonitoring; explicit rules establishing a graduated response to capital shortfalls;enhanced legal authority for the central bank (BSP) to close insolvent institutions and thePhilippine Deposit Insurance Corporation (PDIC) to resolve closed banks more promptly;stronger enforcement of existing rules backed by tougher penalties for noncompliance;incentives for foreign investment in troubled banks; and measures to reduceintermediation costs and regulatory arbitrage. In addition, the Government has decided tostrengthen the Philippines National Bank (PNB)-the second largest bank in the countrywhich among the major banks has suffered disproportionately from the crisis-and sellits controlling interest to a strategic private investor, and has enlisted specialized advisorsto facilitate this process.

Recent and prospective increases in minimum capital and provisioningrequirements, coupled with rising financial stress, has prompted a number of bankmergers, and further consolidation appears likely to continue. This is desirable given thelarge number of banks in the system and the strain this poses for effective supervision.There is nonetheless no room for complacency as banking stress may not have peaked,the financial market recovery remains susceptible to external shocks, the capacity toresolve banking failures promptly is likely to be severely tested, and full implementationof the reform program will require persistence and political will. Congressional approvalof the legislative agenda proposed to facilitate banking reforms is essential for the long-term soundness of the banking system.

Strengthening the prudential and incentive framework for banking towardsinternational best practice should therefore remain among the top policy priorities in thePhilippines and will require ongoing attention. Because of its wider social implications,banking must be seen as a privilege, rather than a right. A reasoned decision by theprudential regulators to withdraw this privilege in the public interest must be adequatelyprotected by the judicial system.

Mobilizing Long-term Savings

An important dimension of the recent crisis lies in the over-reliance on foreign asopposed to domestic financing, and excessive dependence by corporations on short-termbank loans as opposed to longer-term debt and equity finance. The prospect of reduced

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access to foreign savings adds to the urgency of financing a larger proportion ofinvestment domestically. Structural reforms to support the development of capitalmarkets and promote long-tern domestic savings therefore appear warranted. Over themedium term, such reforrns would reduce pressures on the banking system, lengthen thematurity of debts, provide more equity-based financing for enterprises and reduceincentives for speculative investment in real estate.

To promote undistorted capital market development, the Government is preparingreforms to streamline taxation of securities transactions, reduce tax arbitrage loopholes,and introduce a more level playing field across instruments and institutions. Institutionalreform priorities to complement such tax policy include: increased information disclosureby issuers of debt and equity instruments; sound implementation of self-regulatedorganization (SRO) status for the Philippine Stock Exchange; increased competition inunderwriting of securities; gradual lengthening of the benchmark yield curve; andestablishing independent credit rating agencies.

Well-functioning contractual savings institutions and more efficient housingfinance can contribute importantly to capital market development, as well as fiscalsustainability and labor market flexibility. Both major public pension plans are graduallydrifting towards pay-as-you-go systems, while private occupational plans are alsocharacterized by unfunded or under-funded pension liabilities. Hence a rationalization ofpension plans, strengthening prudential regulation and supervision of contractual savingsinstitutions, and improved enforcement of existing contribution requirements is needed.Improving investment strategies within the public pension systems to assure sound, liquidinvestments that earn market rates of return can improve actuarial viability and also boostdevelopment of the domestic capital market.

The costs and contingent liabilities associated with government support for thehousing sector are significant. The Government is developing a program of reforms thataims to: provide a better framework for mortgage loan origination, underwriting,servicing, enforcement and securitization; increase transparency and efficiency inhousing subsidies; resolve non-performing assets; improve asset-liability managementand institutional strengthening; and strengthen policy formulation capacity. The ultimategoal is to achieve a higher proportion and volume of privately funded low- to middle-income housing loans, reduced delinquencies on mortgage lending, greater liquidity inhousing markets, and improved access to shelter for Filipino families.

Sustaining Export Performance and Competitiveness

In a reversal of recent economic history, Philippine export growth has outpacedthat of its neighbors since 1995; and in 1998, Philippine exports grew by 17 percent whileall its neighbors recorded negative growth. The favorable relative performance reflectsseveral factors: (i) a manufactured export structure that is heavily weighted towards hightechnology activities-84 percent of export value growth in 1991-97 came fromelectronics; (ii) the main electronic export, semiconductors, is the fastest growing productin world trade. The semiconductors made in the Philippines (microprocessors and

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custom made chips) have not suffered the recent price falls of more standardized productslike the DRAM chips made by Korea; (iii) multinationals dominate export activity, andforeign direct investment (FDI) in electronics has grown strongly, including in 1998,facilitated by the growing importance of the special economic zones (ecozones).

These trends suggest a strong base for future export growth, but there are groundsfor caution. The high dependence on one activity to drive national exports is risky,however dynamic that activity. Any slackening of FDI or a technological shift thataffects costs or productivity in the Philippines could be disastrous; the very fact that theactivity is so dynamic and globalized increases the risk, with skill and technicalrequirements changing constantly. Moreover, other Philippine exports have performedpoorly. Consumer goods exports declined between 1996 and 1998 reflecting weaknessesin most major consumer commodities-garments, footwear, toys and leather goods. Therecent performance of garment exports in non-quota markets, which face the most intensecompetition from lower-wage countries, has been particularly weak. The most importantresource-based export, processed foods, shows weak and cyclical growth performance.

It is not possible to give an unequivocal response to the question of whether theboom in semiconductor exports is temporary or sustainable. It is not obvious why therehas been a shift in multinational sourcing to the Philippines away from traditional centerslike Malaysia. If based on genuine competitive advantages like the Philippines' lessexpensive and plentiful technical labor, the shift is sustainable-provided the humancapital base upgrades in line with technological needs. If not, the sourcing simplyreflects the timing of new investments, and the boom may fade as new plants reach fullcapacity.

The rapidly changing world market implies that government policies are bestdirected towards strengthening fundamentals such as improving the quality of basiceducation and raising the school cycle towards international norms. The relevance oftraining facilities geared towards the high-tech technical and management skills neededby employers also needs upgrading. Adhering to the established path of trade reform innonagricultural goods would add to efficiencies in integrating trade, from which thePhilippines is likely to benefit. Faster reductions in agricultural protection, whichremains high, would reduce the price of basic food commodities and improve thecompetitiveness of food processing. An assessment of the major barriers to competitionand entry-both formal and informal-also appears warranted.

It is imperative for the Philippines to strengthen its competitiveness in labor-intensive export activities other than electronics. Not only is it necessary to diversify theexport base to reduce the risk inherent in high product concentration, it is inappropriatefor labor-intensive exports to lose their competitiveness. The garment industry, forexample, is falling behind relative to both higher and lower wage competitors, and needsto upgrade its product range and quality. Strategies aimed at redressing skill, technologyand marketing weaknesses in a range of manufacturing activities are warranted. Localtechnological effort is low particularly in the private sector, which will constraincompetitiveness as wages rise and more complex activities are undertaken. R&D isneeded to use new technologies effectively, to move up the value chain from assembly

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into design and manufacturing, and to promote the growth and competitiveness of localsuppliers. There are institutional weaknesses in the major support institutions andinsufficient efforts to benchmark and raise enterprise level productivity. TheGovernment is aware of these needs and deficiencies, and has mounted a comprehensiveresponse-but much of this remains to be implemented.

Safeguarding the Environment

The Philippines faces two broad categories of environmental challenges. The firstis to reduce the negative public health, ecological and aesthetic effects associated withindustrial and domestic air and water pollution. The second is to reverse the rate ofnatural resource degradation associated with unsustainable exploitation and conversion offorest land and other biologically sensitive areas for agricultural, industrial, infrastructureand settlement purposes.

While the economic crisis may temporarily ease urban pollution levels, reducedresources within firms for investment in environmental protection and compliance withexisting regulations, and reduced budgets for public agencies to develop, monitor andenforce environmental priorities represent potentially serious consequences of the crisis.A prolonged economic downturn would exacerbate degradation in the countrysidethrough increased natural resource extraction as alternative means of livelihood diminish.

The primary environmental challenge facing the nation is to translate laudablepolicy intent into tangible achievements on the ground. This will require a multi-facetedapproach involving the evolution and refinement of the legislative and regulatoryframework; use of market based mechanisms to encourage private sector investment inenvironmental protection; greater reliance on communities in the formulation andimplementation of local level environmental initiatives; and the establishment of a moreeffective system of environmental governance, compliance and enforcement. While theDepartment of Environment and Natural Resources (DENR) should continue to take thelead in framing policies and overseeing compliance, local governments need to be mademore responsible for implementation. Sectoral governnent agencies also need to becomemore accountable for environmental protection in their respective sectors. This appliesparticularly to energy and transport, while explicit programLs to address the public healthimpact of environmental degradation are also needed.

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INTRODUCTION

The objectives of this report are two-fold: to provide an assessment of theeconomic, financial and social impact of the regional crisis on the Philippines; and toassist the Government in developing a strategic agenda to promote a sustainableeconomic recovery in the medium term. The first chapter assesses the economic impactof the regional crisis, distinguishes special features in the Philippines that limited theseverity of the crisis relative to neighboring economies, discusses the policy priorities forrecovery and sustained growth, and develops a medium-term economic scenario withattendant financing requirements.

The following two chapters address reform issues within the corporate andfinancial sectors, both of which are central to the resolution of the crisis. Chapter 2provides an overview of the conditions facing the corporate sector and the nature ofadjustments in firm behavior in response to the crisis. It then assesses the framework fordebt restructuring and rehabilitation of distressed companies, outlining the priorities forimprovement. The chapter also addresses the requirements for improving corporategovernance and transparency, arguing that these would have beneficial impacts on creditaccess particularly for small and medium enterprises. The following chapter on thefinancial sector begins by reviewing the nature of stress in the banking system and thecontent of the reform program initiated. It emphasizes the importance of implementationparticularly in buttressing the prudential framework and developing a credibleenvironment for failure resolution. The remainder of Chapter 3 provides an overview ofthe inter-related issues of capital market development and reforms in the contractualsavings system and in housing finance, and concludes by assessing the issues of creditaccess for rural and micro enterprises.

Chapter 4 examines the factors underlying the Philippines' extraordinary recentexport performance and the sustainability of this performance. After examining thepositive and negative aspects of structural competitiveness, it concludes by reviewing theinstitutional and policy measures needed to improve export performance, particularlyamong labor intensive consumer goods, which have not participated in the electronicsexport boom, and indeed have weakened relative to the Philippines' major competitors.

The final two chapters address issues of social and environmental protection.Chapter 5 reviews trends in poverty and inequality prior to the crisis, assesses the impactof the crisis on the poor thus far, and outlines social protection priorities to deal with thepossibility of greater hardship to come. Chapter 6 discusses the major urban and ruralsources of environmental degradation, assesses the impact of the crisis on theenvironment, and examines implications and policy priorities in light of currentinstitutional weaknesses.

1. THE CHALLENGE OF ECONOMIC RECOVERY

A. RECENT DEVELOPMENTS: ON THE EDGE OF THE REGIONAL CRISIS

1.1 Following several years of increasing growth with GNP growth peaking in 1996at about 7 percent, the Philippine economy stagnated in 1998, inflation andunemployment rose towards double digits, private investment fell sharply, the publicsector deficit grew to over 3 percent of GNP, and the current account shifted into surplusfrom a deficit of 5 percent of GNP in 1997 reflecting both strong export growth and sharpimport contraction. Table 1.1 provides a summary of key economic indicators; detailsare provided in the Statistical Annex.

1.2 Although Philippine financial markets experienced unprecedented volatility overthe past two years, a stabilizing trend was evident since mid-September 1998 as equityprices recovered strongly from their six-year lows, the peso strengthened -and interestrates edged lower. Banking and corporate stress however continued to increase asindicated by the banking system's rising non-performing loan ratio through most of 1998.The stagnation in 1998 reflected the general malaise in the investment environmentwhich has made private investors more cautious towards committing new resources andbanks more reluctant to extend credit, particularly to new clients and small borrowers.

The Domestic Economy

1.3 Government estimates for 1998 indicate a contraction of real GDP by 0.5 percent,although real GNP growth remained marginally positive at 0.1 percent on the strength ofcontinued growth in net factor income. From the supply side (Table 1.2), agriculture andconstruction proved to be the weakest links-the former reflecting the impact of theworst drought in 30 years. Overall industrial production fell by 1.7 percent as its largestcomponent, manufacturing, also recorded a decline of about one percent. The decline inseasonally adjusted quarter-over-quarter growth rates of industrial output in the secondhalf of 1998 appears to indicate that this critical sector of the economy may not havebottomed out by end 1998. By contrast, the service sectors and utilities continued todisplay positive growth albeit slower than in 1997. Notwithstanding the sharplyweakening economy, its performance does need to be evaluated in proper regionalperspective, i.e. in the context of the much larger declines in 1998 economic activityranging from 5-7 percent in Malaysia, Thailand and Korea, and 14 percent in Indonesia.

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Table 1.1: Selected ]Economic Indicators, 1993-98

Nominal GNP (1998e) $68.2 bnPopulation (1998): 75.1 millionGNP per capita (1998e): $908

1993 1994 1995 1996 1997 1998(percentage change)

Growth and InflationReal GNP 2.1 5.3 5.5 6.9 5.3 0.1 (e)Real GDP 2.1 4.4 4.8 5.7 5.2 -0.5 (e)Inflation (CPI, period average)/a 7.6 9.0 8.1 8.4 6.0 9.7Inflation (CPI, end period) 8.4 7.1 10.9 5.2 7.3 10.4

Unemployment Rate (percent) 9.3 9.5 9.5 8.6 8.7 10.1(in percent of GNP)

Saving and InvestmentNational Saving 18.1 17.6 17.3 18.8 20.3 23.3 (e)

Private 13.7 14.5 14.2 14.9 18.3 21.9 (e)Public 4.4 3.1 3.1 3.8 2.0 1.4 (e)

Gross Investment 23.6 23.5 21.6 23.3 25.2 22.2 (e)Private 17.9 18.7 17.0 18.9 21.8 17.6 (e)Public 5.7 4.8 4.6 4.4 3.4 4.6 (e)

Public SectorNational GovernmentTotal Revenue 17.4 19.4 18.4 18.0 18.6 16.6Tax Revenue 15.3 15.6 15.8 16.1 16.1 14.9

Total Expenditure 18.8 18.4 17.9 17.7 18.6 18.4Balance/b -1.5 0.9 0.6 0.3 0.1 -1.8Consolidated Public Sector Balance -2.2 -2.3 -1.4 -0.6 -1.4 -3.2 (e)

Public Debt 127.4 109.4 109.7 96.3 91.5National Government Debt 71.6 62.3 59.4 51.1 53.4 65.0

(end-year percentage change)Money and Credit

M3 24.6 26.5 25.3 15.8 20.9 7.2 (Nov)Credit to Private Sector 37.6 28.2 43.5 51.0 28.7 0.8 (Nov)Commercial Bank Loans 32.2 25.4 35.8 51.9 26.5 -0.5 (Nov)

(end-yearpercentage change; $ value)Balance of Payments

Merchandise Exports 15.8 18.5 29.4 17.7 22.8 16.9Merchandise Imports 21.2 21.2 23.7 20.8 14.0 -18.2 (Jan-Nov)

(in percent of GNP)Trade Balance -11.2 -11.9 -11.7 -13.0 -12.9 -1.7 (Jan-Sept)Current Account Balance -5.5 -4.5 -4.3 -4.5 -5.0 +1.0 (Jan-Sept)

International ReservesGross Official Reserves 5.9 7.1 7.8 11.7 8.8 10.8

($ billion) /c(in months of imports) 3.2 3.1 2.6 3.2 2.0 2.9

External Debt /dTotal ($ billion) 35.5 38.7 39.4 41.9 45.4 46.4 (Sept)In percent of GNP 64.2 58.9 51.7 48.1 52.2 66.9 (e)Debt Service Ratio (percent) /f 23.5 20.2 15.8 12.2 11.5 11.1 (Jan-Oct)

Exchange Rate (Pesos/$; period average) 27.1 26.4 25.7 26.2 29.5 40.9Real Effective Exchange Rate 110.4 117.3 120.3 129.8 128.7 104A (Jan-Sept.)(1990=100) /ga. CPI is 1994-based for 1997-98, all other years are e. Estimate.1988-based. f After rescheduling, as a percentage of current accountb. Excluding central bank restructuring. receipts.c. Including gold. g. Period average. Increase indicates appreciationd. External debt reported by BSP.

Source: GOP; IMF, WB staff estimates

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Table 1.2 Sectoral Breakdown of Growth

(Percent Year on Year, at Constant 1985 Prices)

Annual Quarterly 19981997 1998 QJ Q2 Q3 Q4

GNP 5.3 0.1 2.0 -0.3 0.0 -1.2

GDP 5.2 -0.5 1.6 -0.8 -0.7 -1.9

Agri, Fishery, Forestry 2.9 -6.6 -3.8 -11.5 -3.1 -7.8

Industry 6.1 -1.7 1.6 -0.2 -3.4 -4.4

Manufacturing 4.2 -1.1 2.0 -0.9 -1.5 -3.4

Construction 16.2 -8.1 -5.0 -1.8 -15.6 -10.0

Utilities 4.8 4.4 7.2 6.1 3.2 1.5

Services 5.5 3.5 4.5 3.6 2.7 3.3

Transp,Stor,Telecom 8.2 6.4 8.1 6.5 5.5 5.8

Trade 3.9 2.4 4.1 2.1 1.3 2.4

Finance 13.0 4.5 6.6 5.7 3.4 2.5

Real Estate 3.8 1.6 2.3 2.1 1.3 0.8

Source: GOP; 1998 Q4 figures are estimated.

1.4 On the demand side, personal Figure 1.1 Domestic Demand and Creditconsumption expenditure rose by 3.5percent, with households tending to Growth in Domestic Demandprotect expenditure on basic (percent year on year, at constant 1985 prices)necessities while foregoing spending 20 -

on durable and luxury goods. But thiswas countered by a 17 percent fall in 0investment as corporations ran downtheir inventories and cut back on their 3 _ Lpurchase of durable equipment. The .30 Q 7 22 03 04 02 030

investment decline correlates closely 1 907 C9 nu po Go98 ver Q3 Q4* , ,,E,B, Polval eW C-nsuption _ G - -rn et C_naumpti_

to the rapid deceleration of credit -T.t.1

expansion (Figure 1.1); bank credit Growth in Domestic Demand (percentyear ongrowth to the private sector was year) and Net Domestic Creditapproximately zero in 1998, down (at constant exchange rate, percent year on year)from a peak of over 50 percent in1996. The sharp decline in investment 452 8

4T/6~ ~ ~ ~ ~~~~6and imports in late 1998 suggests 35%continued weakness in economic 304

activity in early 1999. 25h 61 2%20% Ul/O~~~~~~0

-2°h

0% 16%

Jan MEr MEry A Sep Now Jan MEhr MEY AL Sep lNbv

1997 199

-Do cem oeft ) -Dm t Ted (nt)

-4 -

1.5 As GDP decelerated, so did Figure 1.2: Changes in theemployment generation. Following a Unemployment Ratelong negative trend, farm employment (in percentfrom previousyear)

contracted abruptly at the peak of ElNifio in the second quarter of 1998, then 3

recovered quickly as the dry spell 25 l

subsided and farmers and part time farm 2

laborers returned to the fields. The l

slowdown in non-farm employment, as 0.5

with non-farm GDP, was more gradual. oDespite a surge in layoffs during the -0-5

first months of 1998-the number of 1workers affected by labor redundancies .:L5> 0 , > ., > tripled during the first quarter of 1998- 1996 1997 1998

the number of non-farm jobs actuallycontinued to grow. But as the manufacturing sector entered into recession in the secondquarter, the expansion of non-farm employment came to a stop.

1.6 The unemployment rate as of October 1998 had increased to 9.6 percent, up from7.9 percent a year ago. This rate represents a drop from the April 1998 figure of 13.2percent at the peak of El Ninlo, but a rise from its level in July (Figure 1.2). The annualround of wage adjustment implemented in February 1998 may have limited the decline inlabor absorption within industry, as real wages adjusted to the deteriorating labor marketconditions. But despite a slight increase in total employment, average unemployment in1998 still increased to 10.1 percent from 8.7 percent in 1997.

1.7 Inflation in 1998 averaged 9.7 percent notwithstanding the adverse impact ofexchange rate depreciation and climatic shocks, although by January 1999 the twelvemonth CPI had risen by 11.6 percent. Weak aggregate demand and weak worldcommodity prices particularly for petroleum products partly offset the impact of thedepreciation. Several other supply side factors contributed. First, the deregulation of thepetroleum industry enhanced competition on the domestic market. Second, the NationalFood Authority succeeded, through massive imports (1.6 million tons), in keeping thedomestic price of rice almost unchanged. Third, the National Power Company wasprevailed upon to delay the application of its automatic tariff adjustment formula untilafter elections, bringing temporary relief. In addition, Meralco (Metro Manila's powerdistributor) could not adjust its rates on the strength of a court restraining order pendingits case with the Energy Regulatory Board (ERB) with regard to the correct application ofits return-on-rate-base formula.

1.8 Short-term policy interest rates were particularly volatile in the second half of1997 (but less so since then), as the BSP sought to defend the exchange rate against boutsof speculation (Figure 1.3). Market interest rates peaked in late 1997 and early 1998 buthave declined since then: the benchmark 91-day Treasury bill rate had fallen to 12.5percent in February 1999 from a peak of nearly 20 percent in early 1998; and primelending rates have stabilized recently at 16-20 percent from a high of over 30 percent inlate 1997. The initially higher interest rate structure relative to pre-crisis levels reflectedseveral factors: an increased risk premium on the peso; increased perceptions of risk and

- 5 -

preference for liquidity among Figure 1.3: Interest Rates and Inflationbankers; and the increased cost 251 9ldayT-bills

of maintaining the deposit base A +CPl(l988based,%changeyoy)

among (mostly small) banks 20 . Aveiage Lendtng

subjected to deposit withdrawals.

1.9 Since early 1998, less ..........

intense speculative pressures, a .

reduction in financial 10- sintermediation costs throughadjustments in reserve 5

requirements, and an informalagreement coordinated by the ___Bankers' Association of the Janr Apr Jul Oct Jan Apr Jul Oct Jan Apr Jul Oct

Philippines (BAP) to limit 19% 1997 1998

lending rates have brought downreal interest rates for primeborrowers to approximately pre-crisis levels. Although this kind of collective action isnot desirable as a structural feature of the system, the agreement has limited a potentiallydamaging bidding up of deposit rates and distress borrowing.

Balance of Payments

1.10 The external sector provided some of the dynamism which the domestic marketlacked. Two factors came into play: robust export performance and favorable terms oftrade developments as commodity prices declined sharply in international markets.Reflecting these two factors, and a deepening import decline due also to weak domesticdemand and depreciation, the trade balance swung into surplus during the second half of1998-from a deficit in 1997 of 13 percent of GNP (Figure 1.4).

1.11 Export performance was truly outstanding by regional standards, making thePhilippines one of the few crisis-impacted countries to benefit from an export-ledexternal adjustment. In contrast to the rest of the region, dollar proceeds grew by 17percent in 1998, reflecting the country's favorable positioning on some of the mostdynamic segments of the world market. However, the export growth rate was slowing inlate 1998, raising questions about the sustainability of the export performance. Chapter 4provides a fuller discussion on the performance, sustainability and implications of thebooming electronics export sector as well as the more subdued record of traditionalexports.

1.12 What has sustained the double-digit exports growth so far, is electronics(particularly, semiconductors and microcircuits) and input-output peripheral units(computer related accessories and equipment). Electronics exports grew at 38 percent,coming from a peak of 50 percent growth in 1995. Within the electronics sector, thePhilippines has been able to position itself in some of the fastest growing segments of themarket by attracting firms such as Intel (which recently opened its latest Pentium IIplant), TDK (to produce magnetic heads and components), Samsung electronics (toproduce multi-layered chip capacitor), and Epson Corporation (to produce high-end

-6 -

Figure 1.4: Balance of Payments

printers). In these dynamic segments, Growth rate of Exports and Importsprices appear to have held steady, shieldingthe country from the semiconductor glut 1which hit other East Asian countries such 30

as Korea much harder. 20 - - - -- --

10 ->1.13 Other elements of the balance of 0 _

payments fared less favorably. While -0 1992 19 1994 1995 i9er 1997 \\199l

receipts from remittances held steady - ,through mid year, peso conversions of T Dforeign curren6y deposits dropped by TBralde Def($ictandSCurrent Accountnearly 50 percent ($2 billion), paralleling Ba ($US bi xrions)

the falling use of foreign currency deposit 0units (FCDUs) since mid-1997. -

1.14 Net capital inflows, having fallenfrom 9 percent of GNP in 1996 to 1 percentin 1997-triggering the crisis through 0equity outflows and curtailed bank -12

lending-are estimated to have declined 1%2 1G93 1994 IM5 IM IM7 1%Bfurther in 1998. The exception to the trendof falling inflows was foreign direct investment (FDI), which through October 1998 hadrisen relative to 1997. The periodic bouts of regional instability since mid-1997 tooktheir toll on equity markets and firms' ability to raise resources, even as bank lendingdeclined sharply. In 1997, portfolio outflows of non-residents reached $7.4 billion, morethan triple the rate in 1995. Both inflows and outflows in 1998 were howeversubstantially lower than in 1997, sharply reducing turnover in the stock market.

1.15 Commercial banks, which had raised more than $4 billion in international marketsin 1996, had reduced their net foreign liabilities through mid-1998, a trend expected tocontinue into 1999. Amid fears of further depreciation, local firms increased theirpurchases of dollars to pre-pay foreign debt service; discounts on the secondary marketvalue of corporate debt added to the incentive to pre-pay. Finally, the international bondmarket collapsed for all emerging markets after Russia's partial default in August, withspreads on Philippine paper reaching the prohibitive level of nearly 1000 basis pointsover the 10-year U.S. Treasury bond.

1.16 Since September 1998, a confluence of factors eased tensions in internationalmarkets and contributed to a revival in domestic financial markets: from a six year low inmid-September stock prices had risen by over 80 percent as of February 1999 (thoughthey were still some 40 percent below their pre-crisis peak); the peso had strengthened to38.5 to the U.S. dollar, from a low of 46 in January 1998; real interest rates had eased toapproximately pre-crisis levels; and the Philippines' spread over U.S. Treasury paper alsoeased to about 415 basis points (Figure 1.5). And in January 1999, the Philippines re-entered the global bond market for the first time since the Russian default with a $1billion issue-without bilateral or multilateral guarantees-with yields of 8.875 percentand 9.875 percent for 10 and 20 year tranches, respectively.

- 7-

Policy Responses Figure 1.5: Financial Market Indicators

PSE Composite Index1.17 The responses to the vanousepisodes of speculative pressure lencountered since mid-1997 have X

generally been well targeted. The BSPhas demonstrated a preparedness to raisei2 short-term interest rates to combat ,J speculation when it is likely to be most 1= effective, and intervention subsequent to ,.

the initial Thai crisis has been relatively Eimild. But over time, the authoritieshave become more cognizant of the Nominal and Real Effective Exchange Ratesneed to minimize the repercussions on 44 _ 0PbUSS1 ) too

the structure of longer-term commercial 41 _RWE%WM9A < rS

lending rates. Indeed, the current credit ,./

market predicament may be less one of 37

excessive real interest rates and more 3 130

that of a tightening of credit for non- 31 120

prime borrowers and the dearth of 2- _,,,,,,, / 1D

bankable projects. Looking ahead, it 27_,_,_',.,___,_,,,,,,_,,,.

would be preferable to rely more onopen market instruments rather thanreserve requirement adjustments toconfront bouts of speculation.

1.18 The public sector deficit in 1998 is estimated to have widened to over 3 percent ofGNP, which can primarily be attributed to a projected shortfall of National Government(NG) tax revenue of about 2.5 percent of GNP relative to the original budget submissionfor 1998, which in turn reflects the deterioration in corporate profits and the steep declineof dutiable imports. Higher interest payments (reflecting both domestic interest rate andexchange rate trends) and overruns of state enterprise (GOCC) budgets-accounted forby the emergency rice imports of the National Food Authority (NFA) and continuedweakness in the National Power Company's (NPC) financial condition-also contributedto the higher deficit.

1.19 In an effort to contain the prospective deficit, the authorities initially cut as muchas 25 percent of the 1998 appropriation for non-personnel expenditures of NGdepartments and 10 percent from allocations to local governments. As the economyweakened, fiscal policy was allowed to play a more supportive role, with selectiveadjustments to the drastic initial cuts in appropriations that favored social expendituresand raised their share from 38 to 43 percent of NG expenditure on an obligations basis.Nonetheless, non-interest NG expenditure is estimated to have fallen by about onepercent of GNP in 1998. In an effort to provide a modest fiscal stimulus in 1999, bothcurrent and capital expenditure in the NG budget is targeted to rise gradually relative to1998.

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B. WHY DID THE PHILIPPINES ESCAPE THE WORST OF THE REGIONAL CRISIS?

1.20 Over the past two years,Philippine financial markets have beensubjected to the same degree of volatility Equity Market Indices(as measured by movements in equity (month-end values, Index January 1997=100)prices, the exchange rate and interest 110rates) as Malaysia, Korea and Thailand 100

(Figure 1.6). (The shocks to Indonesia 80

were clearly harsher.) Although stress 7060

within the financial system has 40

consequently risen significantly, a 4030

systemic financial crisis has been avoided 20

with no need for the Governrent torecapitalize private banks or create newinstitutions to facilitate restructuring, .. Philippines *lhailand . Malaysia -. Korea

practically all major corporations remain Currency Valuescurrent on their domestic and foreign (relative to US$, Index July 1, 1997=100)debt obligations, and the economic 1l5downtum through 1998 has been mild 90

compared to the sharp output declines 80

witnessed in neighboring countries, 70

notwithstanding the worst drought in 30 60

years. 40_....._________....

-. - , 4) 0 C Ci 0 0

-*-Philippines Thailand - Malaysia _Korea

What accounts for the more limitedimpact of the crisis in the Philippines? Short-term Interest Rates

(percent)1.21 Timing of Regional Crisis in 40

Relation to the Philippines' Business 3

Cycle. The countries most impacted by 25

the regional crisis have been those where 20

extended periods of spectacular ' d5-uninterrupted growth permitted over- 5

accumulation of debt (particularly short- ° B e z i - i .Mterm external debt), deficient risk Eanalysis by creditors, and neglect of -APhilippire Overnight rate IThailandOvernightratecga- Malaysia Overnight rate + Korea Overnight ratecorporate governance and banksupervision and regulation-factors thatexacerbated the depth of the crisis. The Philippines by contrast experienced a majorbanking crisis in the 1980s and a series of economic crises in the 1980s and early 1990sand had yet to experience the sustained economic boom that neighboring countriesenjoyed. The difference in pre-crisis economic circumstance lessened the Philippines'vulnerability to the shift in investor sentiment towards the region; and both private sectorand government had developed stronger response mechanisms to deal with the crisis onceit broke.

- 9 -

1.22 Prior to the regional crisis, several of the vulnerabilities confronting neighboringeconomies-appreciating real exchange rates, rising external deficits, rapid private creditgrowth, escalating property prices-were clearly also of growing importance in thePhilippines. But these factors all prevailed for a shorter period in the Philippines,reducing the period of rapid private debt accumulation. Thus, despite the most rapidgrowth of private credit in the region during 1995-96, credit/GDP and corporate sectorleverage were comparatively modest: the debt-equity ratio for the top 5,000 corporationsin the Philippines is estimated at 1.9 as of March 1998 compared to end-1997 ratios of2.2 in Malaysia, 2.3 in Indonesia, 4.1 in Thailand and 6.4 in Korea.

1.23 Resilient Private Sector. Private banks and corporations in the Philippines werebetter equipped to handle market volatility, having been exposed to the banking andeconomic crises of the 1980s and early 1990s. The top tier private banks-whichaccount for some two thirds of banking assets-were (and remain) far better capitalizedthan their counterparts in most neighboring countries, and have therefore been able tobetter absorb increases in NPLs without the need for government assistance. Capitallevels in such banks are generally maintained at well above the 10 percent minimumcapital adequacy requirement (for Tier 1 capital), which in itself is higher than therequirement elsewhere in the region. Strategic skills among top bankers also appearstronger, perhaps having benefited from experience with earlier crises.

1.24 Both banks and non-financial firms had less short-term foreign currency debt atthe outset of the crisis (except relative to Malaysia), reducing their vulnerability to thecessation of credit lines. The reduced vulnerability in turn helped to lower concern aboutthe capacity of corporations to service debt, which helped to maintain the lines that didprevail. Corporate reliance on FCDU loans-about half of total corporate foreigncurrency debt in mid-1997 was owed to domestic banks-appears to have reducedvulnerability further since domestic banks tend to be more familiar with their corporateclients and hence more inclined to maintain credit lines to longstanding customers. Atthe same time, banks' foreign currency exposure from their dollar loans added to risks intheir portfolio, to the extent the loans were provided to unhedged borrowers.

1.25 Robust Export Performance. Philippine export growth has remainedremarkably robust through the crisis, notwithstanding declining regional demand andweakness in world semiconductor prices-factors which have combined to depressexport performance in most countries in the region. Chapter 4 investigates the factorsunderlying this performance. In addition to improving the nation's and individual firms'creditworthiness, this performance has helped to distinguish the Philippines from theplight of neighboring countries, boosting confidence. On the services side, remittancesfrom the some 5 million Filipinos that live and work abroad and support their families inthe Philippines has provided a resource inflow that has proved to be far more stable than,for example, portfolio flows or bank loans.

1.26 Favorable Policy and Institutional Environment. The private sector was notalone in learning from past crises. During the decade prior to the onset of the regionalcrisis in 1997, the Philippines had embarked upon a wide ranging set of structuralreforms that ranks high among comparable efforts in other developing countries. Withinthe financial sector, these reforms encompassed major restructuring, not only of the two

- 10-

largest development banks, but also the central bank which had become technicallyinsolvent. In 1993, the central bank was restructured and recapitalized and acquiredsubstantial independence through constitutional change. Since this major reforn, thenew BSP has been able to focus more effectively on the conduct of monetary policy andsupervision and regulation of banks. Prior to the onset of the regional crisis in 1997, theBSP had also taken a series of measures, inter alia, to tighten banks' open positions inforeign exchange, raise the liquid portion of banks' foreign currency assets, and limitbank exposures to real estate. (World Bank, 1998b)'

1.27 The institutional framework was also better developed. For example, a depositinsurance system (currently up to P100,000) provided by the Philippine DepositInsurance Corporation (PDIC) was long established, and there has been no need to offerunlimited deposit insurance during the current crisis as elsewhere in the region. ThePDIC is charged with rehabilitating or liquidating banks placed under receivership by theBSP, and liquidated an average of 15 (primarily rural) banks a year during 1995-97.

C. POLICY CHALLENGES AND OPPORTUNITIES

1.28 The short-term policy responses to the regional crisis have been well managed inthe Philippines particularly when taking account of the periodic externally-drivenpressures on the peso, the limited resources available for intervention, and the need tobalance the negative impact of depreciation on foreign currency debtors with the damagefrom higher interest rates on the corporate sector and economic activity. Confidence inthe long run should also be helped by the consistent economic policy stance maintainedacross two administrations in the midst of an exceptionally difficult period for the regionas a whole.

1.29 With respect to short-term management, debate of sensitive topics such as interestrate policy is best conducted internally-particularly during periods of tension in theregion-during which time a unified position should be presented to the public. Policyinterest rates determined by the BSP and those influenced by the DOF (at the weeklyauctions for Treasury paper) should not be viewed by the market as inconsistent.Wholesale rejection of bids at the weekly auctions should be used sparingly, since doingso on a regular basis deprives the market of a credible set of benchmarks for privatelending, and is therefore ineffective in influencing market interest rates. Moreoverdepressing rates on Treasury paper cannot be sustained without undermining monetarypolicy objectives. By the same token, allowing arrears to build on governmentobligations is also not sustainable, nor helpful to generate confidence.

1.30 As discussed in Chapter 5, the Government's initial efforts to mitigate the socialimpact of the crisis have been favorable and include: permnitting the share of socialexpenditure to rise (in the context of declining overall real expenditure); influencingemployers and workers to protect employmernt while letting real wages take the brunt ofthe adjustment; and allowing massive rice imports to limit the impact of the drought.These policies have been helpful in limiting the initial impact on unemployment andinflation of the major financial and climatic shocks faced.

Philippines: Banking System Reformn Loan, Report No. P-7235-PH, November 4, 1998.

1.31 Looking ahead, it will be important for the Government to develop a strategicagenda to promote a sustainable recovery that builds upon the Philippines' strengths andtakes credible measures to address its weaknesses. The Philippines' competitiveadvantages in the region include: a less damaged banking and corporate sector; a hithertorobust export sector; a relatively educated, English speaking labor force; and a relativelyopen and democratic society. Weaknesses include a large public debt, low domesticsavings, deficiencies in infrastructure, a larger incidence of poverty prior to the outset ofthe regional crisis that reflects the poorer record of economic growth relative to the"miracle" economies, and significant environmental problems.

1.32 The regional crisis has moreover exacerbated the vulnerabilities confronted byany small open economy subject to sudden shifts in investor sentiment. Hence thepossibility that unanticipated external shocks within or outside the region can disruptfinancial markets or further restrict capital access to emerging markets cannot bediscounted.

Investor Confidence and Governance

1.33 Given the Philippines' competitive advantages within the region, its more limitedcapacity to use fiscal policy to reactivate the economy and the firm stance of theauthorities eschewing tighter capital controls, strengthening the confidence of private andforeign investors should be a central pillar for constructing economic recovery.

1.34 Over the past decade, the transition to democratic government coupled withpolitical stability and progress on structural reforms contributed importantly to theinvestment-led economic revival witnessed prior to the regional crisis. What then are thepriorities in the new environment? Before turning to strictly economic policies, it isworth stressing the importance attached by investors to items such as improved law andorder, adequate infrastructure provided at competitive rates, integrity in the process ofawarding public contracts, predictability in the incentive regime and judicial processes.A strong and reliable legal framework for investment will be of growing importance inthe medium term.

1.35 A common element that pervades the above goals is the need for improvinggovernance and the effectiveness of public institutions. Several of the objectives coveredin this report will also depend critically on improving governance. Examples include:even-handed implementation of tax laws; strengthening the framework for debt resolutionand governance in the relevant public agencies charged with this urgent task; improvingfinancial and corporate transparency and enforcing existing regulations; raising theeffectiveness of government programs to protect the poor; enabling more stringentenforcement and compliance with environmental regulations.

1.36 President Estrada's administration has recognized the importance of goodgovernance by listing as among its top priorities the goal of tackling graft and corruptionin government. The credibility of this objective can be enhanced by taking effectivecorrective actions to address problems already identified, building a strategic agenda forimproving governance on a sustained basis, and developing benchmarks for regular

- 12

monitoring of progress. Implementing reformns to strengthen the civil service is clearly anessential element of this agenda.

Strengthening the Banking and Corporate Sectors

1.37 A strong private-led economic recovery is unlikely to occur in an environment ofhigh or rising financial stress, since banks would remain reluctant to expand lendingbeyond their core clients, and firms' appetite towards new investment would remaindiminished. As a corollary, expediting the resolution of banking and corporate stressremains a prerequisite for accelerating the onset of sustainable recovery.

1.38 The Philippines has not had to implement emergency measures or create newinstitutions to recapitalize banks or restructure the corporate sector, but this should notbecome a reason for complacency. Indeed, banks' NPLs have risen sharply from theirpre-crisis level even as financial markets have stabilized. A relapse to instability in theregion would exacerbate stress further.

1.39 A significant start has been made in the area of financial reforms; the priorities forcorporate and banking reforms are assessed in Chapters 2 and 3. The link with economicpolicy is however clear since adequate implementation of an exit policy is essential tofree up scarce capital from non-performing assets, thereby encouraging resources towardsmore productive uses. The main elements of such a policy include: adequate incentivesfor loss recognition and restructuring of non-performing assets within solvent institutions;and prompt closure and liquidation of insolvent institutions, if alternative privatesolutions are not available and when such actions do not pose systemic risks. While newinstitutions for restructuring may not be needed to implement these policies, what will beneeded is: (i) to enhance the technical capacity within existing institutions; and (ii) strongpolitical support to liquidate insolvent institutions when this constitutes the least costoption. Appropriate action in these areas will also serve as a useful tool to strengthen theincentives for prudent banking and corporate governance in the medium term.

1.40 Improving governance cannot be limited to the public sector. The aftermath ofthe regional crisis has demonstrated the importance of transparency within banks andcorporations, particularly when extensive cross-holdings between the two makeprudential regulations more difficult to enforce. Since there are no simple means forrestructuring ownership structures, exposing both banks and corporations to marketdiscipline through improving disclosure standards, and greater effort at enforcing existingregulations will be essential elements of improving corporate governance. Greatercorporate transparency can also be an important element in reducing the volatility ofcapital flows, as, by providing the market with fuller information about banks andcorporations as the basis for investment decisions, it may dampen the tendency of privateflows to swing between the extremes witnessed in recent years.

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Fiscal Policy: Managing Temporarily Larger Deficits

1.41 The appropriate fiscal stance will depend on the extent and vigor of the recoveryor lack thereof. In the context of the Government's stand-by program with the IMF, theconsolidated public sector deficit has been targeted at 3.2 percent of GNP in 1999, aboutequal to the estimated CPSD for 1998. This figure would be adjusted if the prospects forgrowth were to diverge from target.

1.42 The benefits of counter-cyclical fiscal policy are well recognized, and indeed asdiscussed in Section D, running a larger-than-projected public deficit in 1999 maybecome warranted. But there are also drawbacks to targeting larger public deficits in thePhilippine context stemming from a number of factors: the large stock of public debt andrelatively short-term maturity of domestic debt; the uncertain environment for externalfinance in the medium term; the possibility that financial restructuring could claim publicresources not yet factored into the budget; and the difficult-to-predict impact on investorand consumer confidence of higher deficits. On this latter point, it is worth noting thatwhile NG expenditure in 1998 amounted to about 18 percent of GNP, privateconsumption plus private investment together amounted to some 88 percent of GNP.Hence the expansionary impact of increased government spending (or reductions inrevenue) could easily be negated if private perceptions of a shift in fiscal policy-asreflected in private spending-are sufficiently negative. Moreover, a fiscal stimulus inthe presence of growing financial stress but with inadequate policies to address suchstress could dilute the effectiveness of the stimulus, as is evident from experienceselsewhere.

1.43 To mitigate these concerns requires credible actions by both the Government andinternational community. An important immediate task is to improve tax administrationand enforcement so that future deficit reduction-as private spending generates strongergrowth-can be accomplished effectively, and the current reliance on higher deficits cancredibly be regarded as temporary. (See subsequent section for specific proposals.)

1.44 On the expenditure side, it is important that any increase in available resourcesflow to programs that have developed a track record for effectiveness but remain under-funded. The Bank's report on social expenditure priorities (World Bank, 1998c)2provides recommendations on specific programs; Chapter 5 of this report provides anupdate. The Government in cooperation with the donor community needs to take a freshlook at existing donor-financed programs-with a view towards acceleratingimplementation of programs that remain of high priority, and restructuring or cancelingthose that do not. Where domestic resource availability is the primary constraint toimplementation, temporarily relaxing existing rules of cost sharing by donors may bewarranted.

2 Philippines: Social Expenditure Priorities, Report No. 18562-PH, November 13, 1998.

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Table 1.3 National Government Financing Requirement

(Peso Billion)

1998 1999Financing Requirement 108.8 82.3Net extemal financing 12.3 48.1Disbursements 48.3 88.7Amortization 36.0 40.6

Net Domestic Financing 96.4 34.2Source: Bureau of Treasury (Program as of February 8, 1999)

1.45 Ensuring increased external financing for the temporary larger deficits is neededto assuage private concerns about the viability of this strategy. The NationalGovernment's financing plan for 1999 envisages a marked shift towards externalfinancing; by contrast, net domestic financing is targeted to fall sharply. This shift marksa deliberate effort to minimize the impact on domestic interest rates of the higherfinancing requirement in order not to inhibit an incipient recovery. It will also limit theadditional burden of refinancing domestic bills and bonds, which average some P5-6billion on a weekly basis reflecting the still high share of short-term debt in the NG'sdomestic debt stock. The success of this strategy will be contingent on adequatefinancing from official and private sources; initial indications through early 1999 indeedsuggest an improving climate for private external financing for the PhilippineGovernment.

Public Sector Reform Agenda

1.46 Important objectives for a medium-tenn public sector reform agenda are to: placepublic finances on a sustainable debt path without sacrificing the flow of public resourcesfor essential physical or social investment that cannot be effectively implemented by theprivate sector; and improve public sector governance and the productivity of publicresource use.

1.47 Although the issues of public sector reform are deep-rooted, the crisis hasexacerbated the problems and therefore should provide aLn impetus to tackle them withgreater urgency. Despite successive tax reforms, revenue mobilization is under pressure.While internal tax revenues have grown steadily over the decade, overall revenues haveincreased more slowly, and both have declined significantly in 1998 in real terms: theestimated share of tax revenue in GNP in 1998, at 14.9 percent, negates in one year theincreases achieved since 1992. The picture is hardly more encouraging on theexpenditure side. Personnel expenditures have drifted upward for most of the decade,increasing their share in NG expenditure by 10 percentage points during 1994-98 (Table1.4), thus squeezing the share of resources available for maintenance and investment andundercutting the capacity of government to provide basic services and infrastructure,particularly to the poor. The impact of the crisis has made matters worse: interestpayments as a share of NG expenditure, after declining since 1994, increased sharply in1998.

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Table 1.4 Expenditure Shares within National Government Budget

(Shares of NG Expenditure, %)

1994 1995 1996 1997 1998

Current Expenditure 83.6 79.2 78.8 78.9 82.3Personnel Services 29.0 31.2 33.5 36.7 39.1Maintenance and 14.6 13.4 12.0 11.0 11.4OperationsSubsidies 2.2 1.0 1.4 1.3 0.9Allotment to LGUs 11.7 11.8 11.2 12.0 11.4Interest Payments 24.7 20.8 18.9 16.6 19.5Tax Expenditures 1.4 1.0 1.7 1.3 0

Capital Expenditure 13.6 18.4 18.0 20.5 17.5Equity and Net 2.8 2.4 0.8 0.6 0.2Lending

OPSF 0 0 2.5 0 0

Source: Department of Budget and Management

1.48 Under the circumstances, a sustainable expansion of anti-poverty programs andenhanced infrastructure can best be achieved through a combination of (i) efficiencygains in government programs; (ii) increased revenue efforts; and (iii) broader privatesector participation in the delivery of public infrastructures and services.

1.49 The National Govermment needs to lead these efforts, through reforms in the coremachinery:

o Administration and Civil Service. The objectives of the "Streamlining theBureaucracy" bill submitted to the last Congress remain valid. Indeed, therecent drift in personnel expenditure has made them more urgent. As thenew administration articulates its own agenda, charting a practical politicalcourse for civil service and administrative reforms should be among its topconcerns.

* Expenditure Management. There is scope for improving the efficiency ofNG expenditure. The areas under discussion include: (i) focusing budgetprogramming and approval on strategic decisions by formulating a MediumTerm Expenditure Framework (consisting of a consistent set ofmacroeconomic and revenue prospects as well as forward estimates ofexisting programs for three-years) and by rationalizing the Congressionalapproval process; (ii) increasing managerial freedom of agencies within thisagreed strategy; (iii) strengthening expenditure evaluation mechanisms, bothex ante and ex post as a quid pro quo to the increased automaticity anddevolution of resource planning and management; and (iv) reinforcinginternal management systems within agencies, and accountabilitymechanisms. The actual pace of implementation would need to take intoconsideration the readiness and technical capacity of agencies.

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1.50 The search for efficiency gains also needs to be pursued at the sectoral level. Inthe 1 990s, the Philippines embraced private sector participation and competition in manysectors (such as power, transport, telecommunications and water; food being theexception). This strategy needs to be reinvigorated. To improve cost effectiveness,efficiency and public support for this process, it is imperative that future transfers toprivate ownership and management be handled through well-defined and transparentprocesses. Developing an adequate regu]Latory framework for enhanced privateparticipation will also be essential if efficiency gains are to be sustained. Priorities in thiscontext appear as follows.

1.51 Power: Central issues in the energy sector include: (i) NPC's precariousfinances; (ii) inefficiencies in power distribution; and (iii) a low electrification ratio inrural areas (about 65 percent). To address the first issue, adequate tariff adjustments andpassage of the Omnibus Bill are on an immediate critical path. The bill allows for anenabling legal and regulatory environment to support competitive electricity markets, andrestructuring of NPC to establish separate companies for generation and transmission andchange to private ownership. A parallel redefining of the roles of the Department ofEnergy and the Energy Regulatory Board will be needed for the restructuring program tosucceed. Separately, rationalization and restructuring of the power distribution sector toimprove performance of the rural electric cooperatives is needed.

1.52 Roads: (i) depoliticizing road management, by establishing an autonomousHighway Management Authority, in charge of planning and managing theimplementation of the National Road Network and a dedicated Road Fund; (ii)facilitating private sector financing, including by acquiring rights of way for Build-Operate-Transfer projects ahead of actual needs; (iii) integrating the Department ofTransportation and Communication (DOTC) and Department of Public Works andHighways (DPWH) roles, and re-engineering road works management; (iii) upgradinglocal road; and (iv) streamlining road development within Metro Manila, particularly asregards the role of Metro Manila Development Authority.

1.53 Ports: restructuring the Philippines Port Authority (PPA), by converting majorports into autonomous authorities, and privatizing their operations wherever possible, andfocusing the remainder of PPA towards regulation (as different from operation) of privateand public ports.

1.54 Rail: (i) concessioning the Philippines National Railways (PNR), and (ii)integrating 'both physical (transfers between lines and road based modes) and policyaspects (fares, services, supply characteristics, environmental and safety) of public rail(particularly, with the LRT lines).

1.55 Water: (i) reassessing sectoral financing arrangements, particularly in the lightof the Local Water Utilities Administration's past performance, and the prospects ofprivate sector participation; and (ii) developing an effective and credible regulatoryframework for water management, distinguishing two functions of economic regulationand resource management, and assigning each of them to a separate agency.

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1.56 Food: (i) liberalizing the trade regime for food items, including by acceleratingthe reduction in tariffs on corn, sugar, livestock and livestock products, and replacingquantitative restrictions on rice with tariffs (to be subsequently reduced); and (ii)revamping the structures and operations of the National Food Authority (NFA) to attain amore cost-effective food security program.

1.57 In many cases, the success of this strategy will depend on the establishmentwithin the National Government of a stronger capacity to actively solicit private sectorparticipation (rather than sift through unsolicited proposals) and to deploy creditenhancement instruments judiciously. Clear policies (such as the pricing of guarantees)will need to be enforced in this respect, and tracking systems put in place, particularly asconcerns performance guarantees.

1.58 Efficiency gains on their own are unlikely to be enough; national governmentrevenues will also need to rise. Short of raising tax rates, this could be attained bystepping up efforts in the field of tax administration and by broadening the revenue base.Immediate priorities for reinforcing tax administration include: (i) sustained support forthe newly established Large Taxpayers Unit within the Bureau of Internal Revenues incharge of monitoring and ensuring the tax compliance of large taxpayers; (ii) ensuring thespeedy transfer of tax remittances by banks and requiring payment through selectedgovernment banks in the case of the large taxpayers; (iii) streamlining excise taxationrules and collection procedures; (iv) reviewing refund and drawback procedures for bothdomestic and international taxes, with a view to eliminate the likelihood of losses orfraud; (v) stepping up tax audit efforts, particularly for income and excise taxes; and (vi)enforcing penalties and prosecuting delinquent taxpayers and errant personnel.

1.59 Streamlining of tax privileges would further help to close loopholes. There aretwo priorities in this latter respect: (i) stopping the spread of special privileges, extendedby law, outside the framework of the Philippine Economic Zone Authority (PEZA) andBureau of Investments (BOI) and repealing them wherever possible; and (ii) shiftingaway from targeted tax incentives for investments extended under various schemes andtowards universal ones (e.g., accelerated depreciation, net operating loss carry-over,investment and reinvestment allowance, duty-free importation of capital equipment andmachinery) available through the tax code. A government working group is currentlyreviewing the means of attaining these objectives.

1.60 But the National Government cannot succeed on its own. Indeed, the LocalGovernment Code of 1991 put local governments at the forefront of the fight againstpoverty. They should be encouraged and helped to do this job more effectively.Priorities in this respect include: (i) reassessing the scope of devolved services against theactual performance of local governments; (ii) reviewing the Internal Revenue Allotment(IRA) formula with a view to improve its equity, incentives for local revenuemobilization, as well as overall fiscal sustainability; (iii) redirecting local governmentfinancing toward private sources, including by articulating a judicious policy towardssovereign and sub-sovereign guarantees, and focusing government on poorer entities andactivities with strong public goods characteristics; and (iv) improving local governmentaccountability by developing appropriate accounting and reporting standards, andenhancing the performance monitoring system by the central authorities.

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International Competitiveness

1.61 The Philippines appears well placed to take advantage of integrating globalmarkets given its high quality English speaking workers, relatively deregulated economyand highly competitive special economic zones (ecozones).3 The rapidly changing worldmarket implies that government policies are best directed towards strengtheningfundamentals such as improving the quality of basic education and the relevance oftraining facilities geared towards high-tech technical and management skills and ensuringthat cost and access to basic infrastructure can be made more competitive. With respectto the latter, the need to implement the reforms initiated in the power sector, which wouldresult in more competitive power provision and electricity ]pricing structure is a priority.

1.62 The Philippines has made significant progress on trade liberalization in the 1990sin the context of negotiations through the World Trade Organization (WTO) and ASEANFree Trade Area (AFTA). The average tariff rate was reduced from 28 percent in 1990 to11 percent in 1998, and is targeted to decline to 9 percenrt by 2000. Under the AFTAagreements, most tariffs are to be reduced to the 0-5 percent range by 2000. Adhering tothe established path of trade reform, and resisting pressures for exemptions from specificindustries, would add to efficiencies in integrating trade, from which the Philippines islikely to benefit.

1.63 As indicated in the previous section, there is significant scope for acceleratingreductions in agricultural protection, which remains very high: the maximum tariff rate of80 percent is scheduled to be reduced to 65 percent in 1999. Previous Bank reports-see,for example, World Bank (1998a) 4 -have provided detailed assessments in connectionwith parallel efforts to raise agricultural productivity and accelerate land reform. Theprimary motivation for reducing trade protection in agriculture is to reduce the price ofbasic food commodities towards international levels and enhance the competitiveness ofthe food processing industry, where current performance appears well below potential.The recent exemplary performance of electronics exports, emerging concerns and policyimplications are discussed in Chapter 4.

D. ECONOMIC PROSPECTS AND FINANCINCG REQuIREMENTS

1.64 Preliminary data through late 1998 point to few signs of imminent recovery andindeed appear to indicate the economy may not have bottomed. For example, investmentin the fourth quarter of 1998 fell by 24 percent (year-on-year), the import decline wasdeepening, export growth was slowing, credit to the private sector continued to decelerateand financial stress may not have peaked. Without faster progress on financialrestructuring, it is difficult to envisage a strong investment-led recovery in 1999. Thecombination of falling imports and the possibility of slowing growth in the U.S. andWestern Europe-which together absorb more than half of Philippine exports-also pointto slower export growth in 1999 (although exogenous developments in globalsemiconductor markets will also determine export performance). Hence, apart from

3 For a discussion of ecozones, see World Bank (1997), Philippines: Managing Global Integration,November.4 Philippines: Promoting Equitable Rural Growth, Report No. 17979.-PH, May 1998.

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agriculture, which should register a higher-than-trend growth rate assuming a morenormal climate pattern in 1999, economic activity can be expected to remain weakparticularly in the first half of 1999; and the Government's 2.6-3.1 percent target rangefor GDP growth in 1999 appears optimistic. Indeed, given the pattern of deepeningdecline in key sectors during 1998, even a growth rate of 2 percent in 1999 appearscontingent on the economy quickly bottoming out in early 1999.

1.65 In view of the downside risks to even a modest recovery in 1999-which includefurther shocks to the external environment, export slowdown, intensifying financialstress-it is possible that tax revenue does not recover as anticipated and the CPSDwidens beyond its projected level of 3.2 percent of GNP. Continued stagnation or declinemay also require greater public spending on the social safety net, widening the publicdeficit further. Hence it is incumbent upon the Government to prepare for thecontingency of weaker-than-anticipated growth in 1999, and for the donor community tostand ready for additional financing if warranted.5

1.66 Beyond 1999, the pace of recovery will be heavily influenced by two factors: theextent to which financial stress has been alleviated, thereby improving the environmentfor corporate investment and bank lending; and the nature of private capital flows. Withrespect to the latter, it would be prudent to assume continued volatility and a considerablysmaller net inflow than witnessed during 1993-97 (when current account deficitsaveraged nearly 5 percent of GNP). Hence the current account deficit through 2003 isprojected to remain below two percent of GNP; in the short run (1999-2000), a weakrecovery may in any case limit the current account to approximate balance or a smallsurplus.

1.67 The challenging reform agenda and uncertainties in the external environment pointto a relatively modest projection for recovery in the medium term, with growth averagingbelow 41/2 percent during 2000-03. The prospect of reduced availability of foreignsavings relative to the mid 1990s highlights the importance of raising domestic savings, ifinvestment rates are to recover from the estimated reduction of about 3 percent of GNPestimated in 1998 (Table 1.1). The public sector deficit, after rising above 3 percent ofGNP in 1998-99, will need to be brought back towards balance by 2003, with the speedof decline proportional to the pace of recovery, and consistent with a recovery publicrevenues to their 1997 share of GNP.

External Financing and Official Development Assistance (ODA) Requirements

1.68 In the current environment of private capital flow uncertainty, ODA flows need tobecome more flexible and to provide a greater buffer to private capital flow shocks, asindeed is envisaged-subject to the implementation of an adequate policy framework. Inaddition to the Philippines' drawing of IMF resources of approximately $700 million peryear since 1997 in the context of macroeconomic adjustment programs, the Philippineshas negotiated new balance of payments financing from the Asian Development Bank (to

5 It should be noted that the external financing needed to meet the current 1999 fiscal target has alreadybeen secured through the recent $1 billion global bond issue and commitments under Japan's MiyazawaFund.

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support reforms within the power sector and for environmental improvements), and theWorld Bank (to support banking system reforms), and expected cofinancing by Japan'sEXIM Bank and Overseas Economic Cooperation Fund (OECF). Additional financingfrom Japan's Miyazawa Fund has also been committed. Further balance of paymentsloans will need to be calibrated to the evolution of the financing situation during thecourse of 1999-2000. A feasible external financing scenario is presented below, but itshould be emphasized that under current circumstances any financing scenario willnecessarily need to be revisited on a frequent basis.

Table 1.5: External Financing Requirements and Sources, 1999-2000

(billions of U.S. dollars)

1999 2000Financing Requirements 4.4 5.5

Current Account -0.4 -0.1Amortization 3.2 3.5Increase in net reserves 1.6 2.1

Financing Sources 4.4 5.5

Private Sources (by origin) 1.6 3.1

Foreign Investment 1.5 0.8(FDI/portfolio)MLT Loans and bonds 4.0 3.3Other net private flows a -3.9 -1.0

Public Sources (by origin) 2.8 2.4BOP Finance b 1.1 0.7

Project finance c 1.7 1.7

a. Includes: short-term loans and repayments; net borrowing by commercial banks; secondary markettrading in bonds; errors and omissions.

b. Excludes IMF financing which is incorporated in net reserves.

c. Includes fimds intermediated by development banks to the private sector.

Source: GOP, IMF, WB estimates

1.69 With respect to traditional project finance, disbursement requirements from ODAare projected to average $1.7 billion during 1999-2000 (including intermediation bydevelopment banks), as public investment averages 4.5 percent of GNP, and thecontinued tight environment for release of government outlays calls for a rising share ofODA funds in investment outlays (assumed to reach 50 percent in 1999). Based onprojected disbursements from existing projects, new commitment requirements forproject finance, consistent with the above disbursement levels, are estimated at $2.4billion on an annual basis.

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2. STRENGTHENING THE CORPORATE SECTOR

A. INTRODUCTION

2.1 Philippine corporations have withstood the regional crisis relatively well. Mostlarge firms entered the crisis with manageable levels of debt and foreign currencyexposure. Robust export growth and relatively stable private consumption havemoderated the impact of the crisis on corporate balance sheets. Nevertheless there hasbeen a significant increase in the number of distressed corporations and severity ofcorporate stress, and private investment has fallen sharply. To restore investment-ledgrowth, an improved framework for debt resolution is needed, accompanied by increasedflows of working capital and credit. This will require addressing a number of constraintsand deficiencies, including:

- A legal and administrative framework for corporate bankruptcies, whichdeprives secured creditors of their contractual rights but is largelyineffective in rehabilitating distressed firms.

* A collateral regime that is overly restrictive as to the type of assets whichcan be used as security for loans, and thus limits the amount of bank creditavailable particularly to SMEs.

* Loose accounting and disclosure standards and lack of enforcement, whichadd to the risk of lending to or investing in Filipino firms; and

* A lack of financial discipline and the moral hazard represented by largeloss making state-owned enterprises (GOCCs), which can continue totrade and accumulate debt after they have become insolvent.

2.2 Section B of this chapter provides an overview of the corporate sector's size andownership structure and assesses the impact of the crisis by reviewing its financialperformance through 1997 and the preliminary results from a survey of manufacturingfirms conducted in late 1998. Section C analyzes the major impediments to corporaterecovery, categorizing these into issues of credit access, accounting and financialdisclosure, and the existing framework for debt resolution. The final section identifiespolicy reform objectives and specific actions to address each of these issues.

B. STRUCTURE OF THE CORPORATE SECTOR

2.3 Size Structure. The most striking feature of the corporate sector is itsdomination by a small number of large enterprises, many of which are owned by a fewlarge industrial/financial groups. It has a surprisingly small SME sector and a hugenumber of micro enterprises: about 98 percent of the more than 220,000 firms in 1993consisted of micro enterprises (with assets of less than P150,000). In 1997, there were

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4,536 small, medium and large non-financial enterprises, of which only 1,536 areclassified as SMEs. The remaining 3,000 are medium or large enterprises, which in1997 accounted for 98.8 percent of the assets of small, medium and large enterprises.Among the large enterprises, there is an even greater concentration within the sevenlargest. The seven, which were either utilities or public enterprises, accounted for 27.2percent of total assets of the 4,536 enterprises.

2.4 While SMEs and micro enterprises control only a small share of total corporateassets, they are extremely important providers of employment. For example, in 1993,they comprised 20 percent and 55 percent, respectively, of the total employment providedby all types of business establishments, demonstrating their ability to leverage smallamounts of capital in order to create large numbers ofjobs.

2.5 Ownership Structure. As in other East Asian countries, the Philippine corporatesector is dominated by a relatively small number of large groups and ultimate control ofthe corporate sector rests in the hands of a relatively simall number of families. Inaddition to owning and controlling major sectors of manufacturing and services, thesegroups/families also control most of the major banks. The Philippine Stock ExchangeInvestment Guide shows that 60 to 90 percent of most publicly listed companies areowned by the top 20 stockholders, with the top 5 shareholders owning more than 50percent. In addition, the degree of cross-shareholdings is extensive. For instance, the top100 corporate borrowers account for $10.7 billion or 30 percent of corporate loansoutstanding from the banking system.

2.6 Only 221 out of the top 1,000 Filipino corporations are publicly listed on thestock exchange, which has a total market capitalization of P1I.4 trillion (50 percent ofGNP). The relatively small size of the stock market reflects the reluctance of familyowned firms to go public as most prefer to rely on internal financing sources rather thanraising equity or debt from the capital markets.

2.7 Financial Performance and Indebtedness in 1997. In 1997, the 4,536 non-financial small, medium and large enterprises earned a total net profit of P72 billion or2.9 percent of GDP. As shown in the table below, about 76 percent of firms wereprofitable, and profitable enterprises clearly had much lower levels of indebtedness thanloss makers as measured by their debt-equity ratios. Those companies which managed toearn higher profits in 1997 than 1996 entered the crisis period with particularly low levelsof indebtedness. Their average debt-equity ratio was only 1.03 at the end of 1996 and ithad increased to only 1.26 by the end of 1997. That the least indebted companies faredbetter is not surprising, given that prime lending rates, which averaged 13 percent beforethe crisis, rose to as high as 35 percent during the third quarter of 1997 before dropping tothe current 14-20 percent range.

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Table 2.1. Corporate Sector Profitability and Level of Indebtedness in 1997

Type of Enterprise No. of Proft (Loss) in P Billions Debt to Equiy RatioEnterprises

1997 1996 1997 1996Profitable in 1997 3436 145.9 n.a. 1.53

of which:- more profitable than in 1996 1536 92.11 64.17 1.26 1.03- less profitable than 1996 973 39.08 76.91 1.68 1.49

Loss making in 1997 1100 (74.0) n.a. 5.45 n.a.Of which:- solvent 771 (39.9) n.a. 2.49 n.a.- insolvent 329 (34.1) n.a. n.a. n.a.

Loss making in both 1996 and 1997 411 (46.53) (8.58) 2.52 1.71

2.8 Concentration of Losses. Losses were relatively concentrated. The top 100 lossmakers accounted for 71 percent of total losses and about 18 percent of corporateliabilities. Within this group, the top 20 loss makers accounted for 52 percent of totallosses and 12 percent of corporate liabilities, while the top ten loss makers accounted for42.5 percent of losses and 8 percent of liabilities.

2.9 Insolvent Loss Makers. About 30 percent of the loss makers, numbering 329,were insolvent and account for 46 percent of total losses. Their liabilities account for 7.4percent of total corporate liabilities or 7.3 percent of GDP. Again there is considerableconcentration with the largest 20 insolvent loss makers accounting for 33.7 percent ofcorporate sector losses and 1.4 percent of corporate sector liabilities while the top 10insolvent loss-makers accounted for 30 percent of total losses and 1.3 percent of totalcorporate liabilities. The two largest loss making and insolvent corporations were state-owned, namely the Philippine Phosphate Fertilizer Corp., and the Philippine AssociatedSmelting and Refining Corp. Their combined capital deficit was P41 billion, or 1.6percent of 1997 GDP.

2.10 Permitting firms to continue trading after they have become insolvent underminesfinancial discipline. In many countries, the officers and directors of such firms can beheld personally liable for any losses sustained by creditors as a result of trading whileinsolvent. In the case of GOCCs, there is a also moral hazard if creditors expect theGovernment to ultimately ensure that their claims are satisfied.

2.11 National Power Corporation (NPC). NPC is the largest Philippine state-ownedcorporation, whose already weak financial position has been exacerbated by the crisis,particularly the exchange rate depreciation. At end-1997, NPC reported long-termliabilities of $10.7 billion, largely denominated in foreign currency including foreignloans of $4.2 billion plus BOT lease obligations of $6.4 billion. Moreover, in the absenceof remedial measures, NPC's foreign currency liabilities will increase sharply when the1,000 MW Sual BOT power project comes into operation and as the $4 billionMalampaya gas project is completed. The Government is exposed to a heavy burden ofcontingent liabilities in foreign currency from its guarantees for NPC's performance

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under both the IPP contracts and the Malampaya gas project. In sum, NPC's heavyreliance on foreign debt financing and its deteriorating finances, if unattended, wouldhave a significantly adverse macroeconomic impact. A reform program for NPC hasbeen initiated, buttressed recently by an ADB loan. Completion of the unbundling andprivatization process however requires approval of the Omnibus Energy Bill pending inCongress for three years and government approval of the privatization plan.

Preliminary Findings of a 1998 Survey

2.12 The World Bank, in collaboration with NEDA and the NSO, is collecting detailedresponses from 800 firms in the manufacturing sector. The aims of the survey are tolearn more about the impact of the crisis at the firm level and to study issues of longer runcompetitiveness. The study represents part of a larger regional initiative; comparablesurveys are also being undertaken in Indonesia, Korea, Malaysia and Thailand. This willallow for informed regional dialogue and benchmarking of performance. The followingpreliminary findings are based on the initial 200 interviews conducted in the Philippinesduring October and November 1998. The firms were selected randomly from amongthose with 20 or more employees.

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Box 2.1 "Survey of Pbilippine Industry and the Asian Financial Crisis": Preliminary Results

The capacity utilization of firms has fallen in most sectors except electronics. Relative to itsneighbors, however, the declines in capacity utilization have been small. On average, firms areoperating at 65% of capacity utilization, relative to 55% in Thailand and 60% in Malaysia.

* Approximately one third of Filipino firms have reduced their number of employees. This compares tonearly 60% of Thai firms and 75% of Korean firms. Smaller firms, local fims and those producing forthe local market are more likely to be employing fewer workers.

* While only one third of firms have actually laid-off any workers, close to two-thirds are not fillingvacancies. The group of employees most affected is those under 30 years of age with 1-3 years ofexperience. Three-quarters of the decline in employment is accounted for by production workers and10% by technicians or engineers.

* Two-thirds of the fmns have not reduced the number of hours being worked.

* 30% of firms report a freeze on the wages of production workers and 30% are freezing the wages ofmanagement. (The overlap between the two groups is substantial, but not complete.)

* Of the five countries, firms in the Philippines appear most likely to borrow in foreign currency. Aselsewhere, the firms most likely to do so are large, exporting firms with ownership links to foreignfirms. The foreign borrowing is likely to be short-term.

* While many firms have exposure to foreign exchange rate risk, only one quarter hedged their position.Of those that did hedge their exposure to exchange rate risk, the hedging was far from complete, onaverage less than half the exposure was covered.

* Depreciation, having raised the costs of inputs, is the single biggest complaint reported by firms whenasked about the sources of current difficulties. Declines in demand, one of the most commoncomplaints in other countries, does not stand out as much in the Philippines.

* High rates of interest was one of the chief sources of current difficulties reported by firms. In contrast,few firms rated restricted access to credit as important. These findings suggest that credit is availableif firms are willing to meet the interest rates; that the demand for credit is down rather than supply ofcredit being rationed. While some firms may be credit constrained in the sense that viable projects aregoing unfunded, the survey results do not indicate a widespread difficulty with credit availability.

* Just under one quarter of the firns report experiencing inadequate liquidity to finance operations.Most attribute this to a decline in revenue, although over a third report a decline in working capitalloans (a decline attributed equally to high interest rates as to constrained access to loans).

* The number of firms that have been refused a loan has almost doubled, from just under 7% betweenJanuary and June 1997 to 13.5% of finrs in 1998.

* Four out of five firms do have their accounts audited, although only two-thirds report that auditedstatements are required by their bank for a loan.

* Firms also report that labor costs are a significant source of difficulty -- particularly for exportingfirms. This is true even after the depreciation of the. Further analysis is needed to examine the linkbetween wages and productivity of various groups to test the legitimacy of this complaint.

* Of various infrastructure services, waste management is the one that received the most complaints andtelecommunications received the fewest.

* Telecommunications, followed by power, were seen as the areas where the quality of infrastructureservices have improved the most.

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C. IMPEDIMENTS TO CORPORATE RECOVERY AND GROWTH

Access to Credit

2.13 While real interest rates on loans to highly creditworthy borrowers have returnedto pre-crisis levels, bank lending to the private sector has fallen drastically-from 52percent growth in 1996 to about zero growth in 1998.

2.14 Even when overall bank lending was growing rapidly, SMEs and microenterprises received only a small share. For example, for the 5,000 firms in 1997representing all but the micro enterprises, the liabilities of the 1,536 SMEs accounted forless than 1.5 of the total liabilities for the 5,000 firms and their share of bank loans wouldlikely be even smaller.

2.15 The data indicate that numerous interventions by government aimed at directingcredit to the SME sector have not had the desired effect, suggesting a critical constraintfor credit access may be the poor quality of collateral available to secure SME loans. '

2.16 A typical SME owns inventory, accounts receivable and a few fixed assets alloften housed in leased premises. However, since the banks cannot effectively usepledges secured by inventories and accounts receivable as collateral, they normally onlylend against land and other immovable assets.

2.17 Even if the law did permit the creation of collateral instruments such as floatingcharge debentures, their value would be diminished by the absence of a central registryfor such claims; and by the provisions, under Articles 2241 and 2242 of the Civil Code,which in a liquidation allow unsecured creditors such as employees and certain suppliersto take priority over a secured lender with respect to claims on inventories and accountsreceivable.

2.18 In addition to the problem of securing loans with working capital assets, thewillingness of banks to extend loans to the corporate sector is also negatively affected by:(i) the often poor quality of borrower financial information; (ii) the inability of lenders toseize the collateral pledged by a defaulting debtor in cases where a suspension ofpayments has been granted by the SEC; (iii) the use of proceeds of collateral pledged tolenders by companies in suspension of payments with no compensation given to thesecured lender; (iv) a requirement that seized collateral be held for one year in order togive the debtor the possibility to repurchase it; and (v) the requirement, immediately uponseizure of collateral, for the lender to pay a 6 percent transfer tax and a 1.5 percentdocumentary stamp tax.

1 To improve SME access to credit, in May 1997, the Government adopted legislation which: (i) createdthe Small Business Guarantee Finance Corporation (SBGFC) which can guarantee up to 85 percent of theloans obtained by qualified SMEs; and (ii) required all lending institutions to allocate at least 8 percent oftheir total loan portfolios to SME lending. In addition there are about 111 Government sponsored creditprograms to support SMEs

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Accounting and Financial Disclosure

2.19 According to users of financial statements, including banks and investment banks,accounting and disclosure regulations/standards in the Philippines compare favorablywith those in many Asian countries. However, the same users report that enforcement byregulators is weak and that auditors seldom issue caveats which might raise questionsabout the reliability of the information contained in client financial statements. Also,there is no tradition of legal actions by investors and lenders against company officers orauditors in connection with cases of deficient or misleading financial reporting. Hence,the true financial state of the companies may not be known sufficiently in advance toarrest a potentially serious deterioration in performance

2.20 Accounting Standards. Philippine accounting standards, including those dealingwith consolidation, are comprehensive and appear to adequately cover all basicaccounting principles. Statutory financial statements include the balance sheet andstatements of income and cash flows along with the general notes to the financialstatements. Moreover, the rules require disclosure of all matters which might affect thedecision of an investor to buy or sell the securities of the company. All companies withquarterly sales in excess of P100,000 must have their financial statements audited andsigned by a Certified Public Accountant.

2.21 Until the early 1990s, Philippine accounting standards (PAS) were based on U.S.Generally Accepted Accounting Principles (USGAAP) as they existed in the 1970s.Rather than updating the PAS in line with changes in USGAAP, which were consideredtoo complex in the Philippine context, it was decided to adopt the standards establishedby the International Accounting Standards Committee (IASC). At present, for all intentand purpose PAS, as defined by the SEC/BOAs' statutory "Rules and RegulationsCovering Forrn and Content of Financial Statements," is based on IASC.

2.22 There are, however, important differences between PAS/IAS and USGAAPwhich are relevant, given the large depreciation of the peso since mid-1997. Forexample, under USGAAP, an increase in unhedged foreign currency liability, caused bydevaluation, creates an equivalent loss when reporting income for the year. UnderPAS/IASC, increases in such liabilities can be capitalized (i.e. offset by revaluationgains) if they are related to the acquisition of fixed assets, or, alternatively, they can beamortized over the remaining life of the debt in question. Most companies have opted for

2capitalization or amortization of increases in foreign debt.

2.23 Accounting Profession. There are around 80,000 Chartered Public Accountantsin the Philippines. Each year around 10,000 aspirants write examinations organized bythe Institute of Chartered Accountants, which only about 20 percent pass. The BOA hasthe power to suspend or revoke an accountant's certification. In fact, these powers are

2 In addition, while USGAAP requires that all fixed assets be valued at their historic cost, net ofdepreciation, PAS/IASC permits enterprises to reappraise their fixed assets, a feature that allows inflationto be taken into account periodically. Thus, with the approval of the SEC, companies can improve theappearance of their balance sheets by using the gains created by the revaluation of fixed assets to wipe out aretained earnings deficit. This practice is commonly known as "Quasi Reorganization".

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seldom exercised and, when they are, the reasons are usually related to unprofessionalconduct rather the failure to properly execute the duties and responsibilities of an auditor.

2.24 Credit Information Bureaus. In addition to published audited financialstatements, banks can obtain credit information from a credit bureau operated by theBAP. There is also the Credit Information Bureau Inc. (CIBI) which was established in1982 by the BSP, SEC and the Financial Executives Institute of the Philippines.Currently CIBI rates about 12 issuers of short-term commercial paper and 31 issuers oflong-term commercial paper. It also prepares credit information reports on firms. Banks,which once accounted for about 60 percent of the demand for CIBI's credit reports, nowaccount for only about 30 percent, with the remainder coming from industrial andcommercial clients. CIBI has access to all the statutory financial statements filed withthe SEC as well as information concerning non perforning loans filed with BSP.

2.25 Regulation. The provisions relating to disclosure and enforcement of disclosurecontained in the Securities Act (submitted to the new Congress in 1998) appearsatisfactory. Financial and other disclosure requirements are to apply, with someexceptions, to all securities sold or offered for sale or distribution within the Philippines.Hence, it will be important that these provisions are not weakened in the final version ofthe Act. While the Act, as presently drafted, should provide adequate protection toinvestors in and lenders to companies whose shares or debt instruments are offered to thepublic, it will not provide any additional protection to the creditors of the vast majority ofclosely held private companies.

Insolvency and Debt Resolution

2.26 A review of a large sample of 1997 corporate financial statements, concluded thata number of firmns would find it difficult to honor their maturing obligations.3 In similarsituations in the past, default was avoided when banks passively restructured loans bysimply rolling over the current portion of loans due from distressed borrowers. However,in many cases, such forbearance, only increased the problem and eventually led to greaterlosses for the banks. To deal with this problem the BSP has adopted stricter rules forloan provisioning. However, recently, these rules were somewhat relaxed in order to givethe banks a strong incentive to pla4y an active role in restructuring or collecting the debtsof distressed corporate borrowers. Debt restructuring is usually enacted on an informalbasis, or, when this is not possible, it is carried out formally according to proceduresdictated by the existing legal framework for insolvency. However, both approaches canbe problematic.

2.27 Informal Resolution. Banks are working with their distressed borrowers torestructure loans. For a number of borrowers with sound core businesses, financialdistress was due to investments in non-core activities such as real estate development.Many borrowers have hence sold non-core businesses or transferred real estate assets to

3 The analysis attempted to determine if the total cash available for debt service over the next 12 monthswould be sufficient to cover bank loans shown as current liabilities and the current portion of long-termdebt.4 Provisions on nonperforming short-term loans can be reversed if such debt can be restructured intolonger maturities, or alternatively loans can be recovered through foreclosure actions.

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banks in order to repay or reduce their debt. As holding real estate does little to improvethe liquidity of the banks, they are required to maintain in their provisions for loan lossesan amount equal to 25 percent of the transfer value of such real estate assets. This givesthem a significant incentive to sell such assets. However, a possible disincentive to suchtransactions is the need to pay, in cash, at the time of the asset transfer, a 6 percenttransfer tax and a 1.5 percent documentary stamp tax.

2.28 Debt restructuring negotiations can fail for a number of reasons: (i) the parties tothe negotiation might simply refuse to act in good faith; (ii) the borrower is so distressedthat liquidation is the only solution; (iii) banks may decide that continuance of the debtorcompany's operations, under current ownership/management, would be detrimental tolenders' interests; or (iii) one of the creditor banks refuses to support a restructuring plansupported by the other banks. The outcome of debt negotiations can also be influencedby the fact that a lender and a borrower might belong to the same holding group,preventing liquidation of an otherwise non-viable business.

2.29 Formal Resolution. When informal debt resolution proves impossible, adistressed corporate may petition the SEC for protection from its creditors. In 1976, theSEC replaced the court system as the formal venue for resolving the debts of distressedcompanies. It is now the SEC which has the power to impose stays of actions bycreditors against corporate debtors, permit debtors to suspend payments to their creditors,decide whether a debtor should be liquidated or be permitted to attempt rehabilitation,liquidate debtors and appoint receivers, members of management committees andliquidators.

2.30 Between January 1997 and October 1998, 52 firms with liabilities of P123 billionpetitioned the SEC for suspension of payments. The 32 petitions received in 1998included one from Philippine Airlines (PAL), which had debts of over P85 billion(primarily owed to foreign creditors). When compared to previous years, this representsan unprecedented increase in the number of cases under SEC jurisdiction.

2.31 The manner in which cases are handled by the SEC appears highly prejudicialagainst the interest of creditors and seldom leads to the rehabilitation of distressed firms.For the 35 cases filed during 1982-96, 14 were dismissed or withdrawn, 6 resulted inliquidation, including 2 where permission to attempt rehabilitation had originally beengranted, 3 cases of rehabilitation, including one dating back to 1982 were ongoing, and11, including one dating back to 1991 have not been resolved, implying that the debtorsremain under suspension of payments with actions by creditors stayed.

2.32 Of the 52 cases filed since the beginning of 1997, 20 have been dismissed or werewithdrawn, 30 remain unresolved and under suspension of payments, and liquidated wasdecided in two cases. The poor performance, to date, is due to a number of problemsassociated with the quasi-judicial process itself and the way that it is administered. Thefollowing problems need to be addressed.

* Without due process or indemnification against loss, secured creditors areprevented from exercising their contractual rights.The process lacks clear and coherent rules and time bound procedures.

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There is no prohibition against assigning fiduciary powers andresponsibilities for the management of distressed enterprises to individualswho have serious conflicts of interest.

* No standards exist defining the minimum qualifications of individualsappointed as receivers or management committee members.

* The process is highly litigious and the main players are lawyers rather thanbusiness professionals.

* Implementation of rehabilitation plans often requires the infusion of cashinto the business, but there is no means of granting preferred repayment tolenders willing to provide such cash.

* The inability to obtain fresh funds often obliges firms under SECprotection to illegally use sales covered by trust receipts to financecontinuing operations, rather than repaying the creditor whose loan wassecured by the receipts.

* Some SEC Hearing Officers allegedly render favorable rulings inexchange for payoffs.

Perhaps the largest flaw in the current system relates to the freezing of creditorrights indefinitely. Suspension of creditor rights, including secured creditors, isjustifiable for a short period to allow the debtor to demonstrate that it is viable and toprepare a rehabilitation plan. But once that period is over, secured creditors need to beable to enforce their collateral and to be compensated for any loss caused by the delay.

2.33 The most sustainable response to the current problems within the SEC is expectedto be to transfer responsibility for dealing with corporate insolvency back to the courts(see Section D below). But in view of the time required to build effective judicialcapacity, the Government has opted to try and improve the SEC administered processwithin the existing legal framework. There are 43 cases pending which need to be dealtwith on an urgent basis and the number could increase dramatically given the much largernumber of loss making enterprises with insolvent balance sheets at the end of 1997.Indeed, as already indicated, the deficiencies within the formal resolution framework areconstraining its greater utilization as banks try to avoid the protracted SEC procedure.

2.34 The Government has responded by adopting a policy statement which will guidethe creation of a new set of rules and time-bound procedures to be followed by the SECin dealing with insolvent enterprises (Box 2.2).

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Box 2.2 Policy Framework for Suspension of Payments

SEC will regulate the process but it will be guided by the corporate debtors and their creditorsaccording to a clearly defined set of rules and time-bound procedures within the legal framework.

The process will continue to provide for the possibility of provisional suspension of payments,normally 30 days, in order to provide time, inter alia, for finalization of rehabilitation proposals orproposals to deal with temporary illiquidity. However, provisional suspensions will be accorded only whenthere is an urgent and compelling reasona to do so after due notice and hearing. Any extension to aprovisional suspension would be granted only after another hearing has been held to seek the views ofcreditors and only after the SEC has determined that the debtor or creditor would not be materiallyprejudiced by the extension. The extension would not, in any case, exceed 30 days; up to a maximum offive extensions could be allowed.

Creditors would be permitted to vote on any proposals for debtor rehabilitation or measures fordealing with temporary insolvency. However, prior to the vote, the SEC would hold a hearing where theviews of creditors would be heard. Following the hearing, secured and unsecured creditors would voteseparately on the proposals. In decidinig whether to accept or reject the proposals, the SEC will be guidedby, among other things, the outcome of the vote. A majority specified voteb by both groups of creditorswould nonnally indicate that the proposals are acceptable to the creditors.

Persons selected as provisional receivers, rehabilitation receivers or members of the managementcommittee would meet qualification standards set by the SEC, would have no conflict of interest with thedebtor, and would be governed by receivership orders and a professional code of conduct.

a. The SEC should be satisfied that (a) the debtor, its officers, and directors, have been acting in good faithand with due diligence; and (b) the debtor would likely be able to make a viable proposal acceptable to thecreditors.

b. In terms of the number of creditors and amount of exposure of each creditor

D. CORPORATE SECTOR REFORM AGENDA

Strengthening the Debt Resolution Framework

2.35 It is clear that the system for addressing corporate insolvency needs a majoroverhaul.- In the short term, given the heavy backlog of existing cases, there may be noalternative but to augment SEC's capacity. The above policy framework (Box 2.2) couldbe made more credible by forming a high-level debt resolution committee (DRC)consisting of the SEC, members of the judiciary, experienced business leaders andinternational insolvency practitioners with the objective of developing a more predictableand efficient debt resolution framework, including rules on priority of claims and votingprocedures applicable to different classes of claim holders. To enforce the new system ofpriority claims, the terms of the Presidential Decree of 1976 transferring corporateinsolvency jurisdiction to the SEC may need to be amended.

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2.36 Whatever the mechanism for strengthening the SEC (whether or not byestablishing a high level committee), a revamped SEC cannot be allowed to become anobstacle to the transfer of corporate insolvency jurisdiction back to the courts. Anystrengthening of the SEC should therefore be conducted in the context of a time-boundtransition of this function to a court administered system.

2.37 The Philippines is one of very few countries that relies on an administrative bodyto manage insolvency cases, and recent events have indicated the practical drawbacksencountered in such a system, implying that the adoption of a modem bankruptcy law(the existing bankruptcy law dates back to 1909) and the training of judges to implementthe new law is of the utmost priority. Since building effective capacity of the courts is asubstantial task which will take time, one means of expediting the shift to a courtadministrated system would be to create a special bankruptcy court with a small numberof full-time judges. Needless to add, the pitfalls experienced by neighboring countriesneed to be properly evaluated while drawing up a legislative agenda to modernize thebankruptcy law.

2.38 Specific actions are identified for addressing each of the issues raised above. Box2.3 summarizes the objectives of reform, the issues to be addressed and the sequentialactions required, identifying those where supporting technical assistance may be needed.

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Box 2.3 Proposals for Corporate Sector Reform

Issue ProposedAction

I. Strengthen financial discipline in the corporate sector

A. Creditors usually suffer greater losses when Prepare and adopt legislation to enable sanctions ofcompanies continue to trade after they have become directors and officers of companies which continueinsolvent. to trade after they have become insolvent (TA

required).

B. When GOCCs trade while insolvent a moral Prepare and implement plans for privatizing orhazard is created. liquidating insolvent GOCCs (TA required).

II. Improve access of corporate sector to debt and equity financing by removing barriers to lendingand investing

A. SMEs cannot use their primary assets, such as Create within the Civil Code, securityaccounts receivable and inventories, as collateral to documentation for accounts receivable andsecure bank loans. inventories such as an assignment of book debt or

floating charge debenture (TA required).

Create a national system of collateral registration toidentify and protect priorities of security (TArequired).

B. Articles 2241 and 2242 of the Civil Code allow Prepare and adopt legislation to amend or rescindunsecured creditors such as employees and certain the two articles to protect secured creditors (TAsuppliers to take priority over a secured lender with required)respect to claims on inventories and accountsreceivable

C. Seized collateral must be held for one year in Prepare and adopt legislation to reduce holdingorder to give the debtor the opportunity to period to 60 days.repurchase it.

D. Immediately upon seizure of collateral, the Prepare and adopt legislation to exempt from taxes,lender must pay a 6 percent transfer tax and a 1.5 the asset transfers to banks or other lenderspercent documentary stamp tax associated with debt resolution actions.

E. Accounting and disclosure standards need to be Adopt the proposed Securities Act of 1998.strengthened and enforced.

BOA to reexamine existing practice for revaluationof fixed assets.

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III. Reform the Policy and Administrative Framework for Insolvency and Debt Resolution

A. There is no overall policy framework or specific Adopt policy statement under consideration; seerules and time-bound procedures governing the also proposed improvements discussed above.SEC's quasi-judicial process for dealing withdistressed companies. Adopt a set of rules and time-bound procedures (TA

required).

B. Fiduciary powers and responsibilities for the Adopt rules prohibiting the appointment asmanagement of distressed enterprises are routinely receivers, liquidators or management committeeassigned to individuals who have serious conflicts members, persons with any conflict of interest (TAof interest. required).

C. No standards exist defining the minimum Establish minimum qualifications and code ofqualifications of individuals appointed as receivers conduct for Receivers, Liquidators and managementor management committee members. committee members (TA required).

D. Implementation of rehabilitation plans often Provide, within the Civil Code, for the seniority ofrequires the infusion of cash into the business, but claims arising from loans to a distressed enterprisethere is no opportunity of granting repayment which is attempting to implement a rehabilitationpriority to lenders willing to provide such cash. plan (TA required).

E. SEC staff may have difficulty implementing new Implement an institutional development program forrules and procedures. SEC including staff training and the preparation of

operating manuals (TA required).

F. Ethical violations against SEC Hearing Officers i1 Investigate alleged violations.alleged.

* Implement corrective actions.

Develop enhanced governance framework (TArequired).

IV. Transfer to Court System Responsibility for dealing with corporate insolvency

A. Develop a time-bound transition to a court * Prepare and adopt a modem bankruptcy lawadministered system for corporate insolvency. (TA required).

* Prepare for effectiveness of new law bytraining judges and trustees (TA required).

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3. FOSTERING FINANCIAL SOUNDNESS ANDGROWTH

A. INTRODUCTION

3.1 The regional crisis has interrupted what was a rapid expansion of the Philippinebanking system, one which had been gaining speed in 1995-96. The ratio of broadmoney (M3) to GNP increased from 28 percent in 1992 to 42 percent in 1997 and theshare of private bank credit to GNP grew even more rapidly from 22 percent to 57percent during the same period. Capital market deepening was more modest: though theaverage and longest maturity of Treasury paper had risen (the latter to ten years), theliquid market for Treasury paper still extends only to the 91-day Bill, the yield curve onGovernment bonds does not extend beyond one year, and corporate bond and annuitiesmarkets are very limited. Equity markets and markets for contractual savings productsare maturing but still have considerable potential for further development.

3.2 The crisis has clearly placed the financial system under considerable stress.Central to a successful resolution of the crisis is to address the challenges presentedwithin the banking system, which remains the dominant vehicle of financialintermediation. Section B summarizes the stress created in the banking system, thepolicy responses and challenges ahead.'

3.3 An important dimension of the recent crisis lies in the over-reliance on foreign asopposed to domestic financing, and excessive dependence by enterprises on short-termbank debt as opposed to long-term debt and equity finance. This suggests that structuralreforms are warranted to support the development of capital markets and promote long-term domestic savings. Over the medium term, such reforms would reduce pressures onthe banking system, lengthen the maturity of debts, provide more equity-based financingfor enterprises and reduce incentives for speculative investment in real estate. Moredeveloped capital markets, including efficient housing finance and well-functioningcontractual savings institutions, could also contribute importantly to fiscal sustainabilityand labor market flexibility. Sections C through E provide overviews of developmentsand policy priorities of the following topics, respectively: capital market deepening;developing long-term domestic savings through reforms in the policy and regulatoryframework for pensions and insurance; and the related objective of placing low incomehousing finance on a more sustainable and transparent footing. Section F concludes witha discussion of the issues and constraints to further developing rural, micro and smallenterprise finance.

1 See World Bank (1998b) for a detailed discussion of the banking reform program initiated.

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B. IMPLEMENTING REFORMS IN THE BANKING SYSTEM

3.4 Philippine banks have weathered the regional crisis better than severalneighboring countries, avoiding major bank failures or a systemic crisis. Nevertheless,they have been weakened by the downturn. Lending has stagnated, both reflecting theeconomic slowdown and accentuating it. The authorities have responded by initiating asignificant reform program to strengthen the prudential framework, incentiveenvironment and failure resolution strategy. The ability of the banking system tocontribute strongly to the economic recovery will depend on a thorough implementationof the reforrn program that has been initiated.

Stress in the Banking System

3.5 The sharp increase in the share of non-performing loans is one indication of thestress faced by banks. This share was at 4 percent at mid-1997 but had risen to 12.5percent in October 1998 before falling to an estimated 11 percent by December 1998.Among bank categories, thrift and rural banks, which together account for about 10percent of bank loans are under far greater stress than commercial and universal banks;the NPL ratio for the latter category at end 1998 is estimated at 10.4 percent. The NPLratio continued to rise through most of 1998 as stress among corporate borrowers grewfrom the accumulated burden of high interest rates, the weaker peso and falling real estateprices, as well as lags in loss recognition. The decline in NPLs between October andDecember was due in part to an increase in restructuring of past due loans as well as anupturn in lending in the month of December. The trend of NPLs in 1999 is subject tosome uncertainty, and will depend on the vigor of economric recovery. But not all NPLswill be unrecoverable and, fortunately, most major banks entered the crisis with very highcapital and reserves in their accounts-the capital to risk assets ratio averaged some 17percent for the banking system as of mid-1998. Such high capitalization represents acushion against losses, protecting depositor funds.

3.6 Banks have responded to the crisis by increased caution in lending, and haveraised provisions against future loan losses. These increased provisions (mandated by theBSP) include higher general as well as specific loan-loss provisions. With theoutstanding stock of bank lending flat in 1998 (after increasing by some 50 percent in1996), banks' operating profits have also been squeezed, even before application of theincreased loan-loss provisions. In aggregate, the banks are not constrained by capitaladequacy requirements, and after a very tight period in ear]Ly 1998, they again hold excessliquidity (despite reduced reliance on foreign financing and a slowdown in depositgrowth). But increases in minimum capital requirements and stricter provisioning,coupled with rising stress, have already prompted a number of bank mergers and furtherconsolidation appears likely. This is desirable given the large number of banks in thesystem and the strain this poses for supervision. And banks are reported to have beentightening lending criteria. Even in the absence of tighter criteria, there would have beena credit slowdown reflecting a contraction in the demand for bankable credit.

2 There are nearly a thousand banks in the system including some 826 rural banks, 116 thrift banks and 53universal and commercial banks; the latter (universal/commercial) account for over 90% of banking assets.

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3.7 Since the start of the crisis, 43 banks-a small commercial bank (Orient Bank),seven thrift banks, and 35 rural banks-accounting for less than one percent of bankingsystem assets, have been closed, compared with an annual average of 15 banks in recentyears; and the BSP has provided increased liquidity support on a selective basis. Whilethe level of insolvency is on a different scale than in other crisis-impacted countries, thedifficulties associated with failure resolution, particularly for commercial banks, cannotbe underestimated.

3.8 The example of Orient Bank, a systemically insignificant and recently-licensedcommercial bank, provides a case in point. Orient unilaterally declared a "holiday" inFebruary 1998, being unable to pay depositors in the face of a 75 percent NPL ratio.Despite the need for prompt action to conserve the value of the bank's remaining assetsfor the benefit of the depositors and PDIC resources, Orient was allowed to remain in thisunorthodox limbo for about eight months. In October, it was finally placed intoreceivership but as of late February 1999, it had yet to be liquidated by the PDIC. Bestpractice in the face of a bank declaring a holiday would have called for the immediateappointment of a receiver, or at least of a conservator.

3.9 Orient's difficulties appear to have stemmed from excessive insider lending.Though long-prohibited by Philippine banking regulations, excessive lending to bankinsiders and their associates remains a common cause of failure. The long delay inresolution action in this instance was attributable mainly to the owner's reluctance toacquiesce in the closure, buttressed by organized opposition to closure by largedepositors. Upon its placement under receivership, senior BSP officials became thetarget of a lawsuit alleging "undue haste" in closing the bank. The long-drawn (andunfinished) saga of Orient's demise is indicative of the practical obstacles to prompt andeffective implementation of the existing regulatory structure. It underlines the need for aspeedier resolution of identified banking failures.

3.10 The obstacles to obtain legislative backing and legal protection to adequatelysupervise and enforce bank regulations are complex. Vexatious litigation againstregulators and political pressure on congressional representatives have in the pastcombined to constrain legislation and policy implementation. A contributing factor maybe the large number of banks, which creates a significant lobby of bank insiders whoseobjectives do not always coincide with the wider public interest. Fears of depositorreaction have prevented regulators from having the sort of access to depositorinformation considered a routine requirement for effective supervision elsewhere.

The Regulatory Policy Response and Challenges

3.11 The recent crisis has highlighted the vulnerability of small open economies tocapital flow shocks. Ensuring that bank owners are adequately capitalized and subjectedto effective supervision and market discipline should remain an ongoing area for policyfocus. With the economy heavily dependent on the banking system for its financing, theshort-term policy requirements are to ensure that bank capital is not too severely eroded,that banks can quickly recover the loss in profitability without increasing vulnerability toshocks and that they retain the confidence of depositors. This will require prompt

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resolution action (in the absence of systemic risk) and an end to the excessive delays thathave characterized policy in the past.

3.12 Supported by a Banking System Reform Loan (BS]RL) from the World Bank andin line with an IMF Stand-by Arrangement, the authorities have acted to strengthen thepolicy environment on a broad front to help achieve these goals. The medium-ternobjective of the reform program is to promote a system in which bank owners, facingappropriate incentives from regulators, market participants and the tax structure, will bemore discriminating in intermediating financial flows particularly as they involve foreigncurrency or lending to volatile sectors such as real estate.

3.13 In addition to the higher minimum capital and stricter provisioning requirementsalready referred to, the banking reform program includes: stricter qualification andcompetency criteria for granting new banking licenses; additional incentives for foreigninvestment in the banking system including 1]00 percent foreign ownership of troubledbanks; stronger disclosure requirements; intensified supervision and monitoring; explicitrules establishing graduated sanctions and regulatory responses to capital shortfalls;enhanced legal authority for the BSP to close insolvent institutions and the PDIC toresolve closed banks more promptly (which, inter alia, would prevent the forbearancedisplayed towards Orient Bank); stronger enforcement of existing rules backed bytougher penalties for noncompliance; and measures to reduce intermediation costs andregulatory arbitrage. While much is being accomplished through regulatory action,Congressional support for legislative measures to enhance supervisory and enforcementauthority towards international best practices will be essential to complement theregulatory measures.

3.14 Enhanced supervisory procedures and intensified supervisory inspection have alsobeen introduced to better ensure compliance with existing prudential norms. In assessingthe condition and prospects of the banks, BSP supervisors are now relying more heavilyon forward-looking indicators of trouble to complement the traditional backward-lookingverification of loan quality. The assessment now pays more attention to the quality ofrisk management systems, liquidity and funding risk and especially to the level andquality of capital: hence, no bank is to be given an overall quality rating higher than thatassigned to its capital position.

3.15 In addition, the Government has initiated a process to strengthen the PhilippinesNational Bank (PNB)-the second largest bank in the country which among the majorbanks has suffered disproportionately from the crisis-and sell its controlling interest to astrategic private investor, and has enlisted specialized advisors to facilitate this process.The ultimate objective of this exercise is to provide PNB an ownership and incentivestructure that will guide it back to a position where it can effectively compete with the toptier private banks in the country.

3.16 Establishing an Asset Management Corporation (AMC). There has beensome discussion in the Philippines of establishing a privately managed AMC to purchaseNPLs from banks to complement existing efforts dealing with banking and corporatestress. Most countries where centralized AMCs have been established-including

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neighboring countries during the current crisis-have experienced systemic financialcrises; i.e. of a different order of magnitude than the Philippines situation to date. Suchcountries as a rule also lacked established institutions for deposit insurance and corporatedebt resolution that the Philippines already possesses. Moreover, serious problems ofgovernance and moral hazard have tended to plague most efforts thus far. Given themore manageable scale of financial stress in the Philippines, the mixed experience ofother countries, the possibility that a new AMC could complicate coordination withexisting institutions, and the risk that establishing an AMC for the system as a wholecould be viewed as a negative signal to investors that currently distinguish the Philippinesfrom the more serious cases of financial distress, a centralized AMC does not appearwarranted at this point.

3.17 Nevertheless, a decision to establish a centralized AMC will need to be evaluatedagainst the evolution of financial stress and the performance of existing institutions todeal with it. In the meantime, the priorities are to enable existing institutions to dischargetheir responsibilities effectively, backed by an improved legal framework, as is in anycase intended. At the same time, banks could be encouraged to establish their own assetmanagement units while a secondary market for bank assets could be promoted.

3.18 Legal Protection. Although some legal protection has been provided to banksupervisors in the conscientious performance of their duties, more is needed. Legislatorsand the judicial system need to become more aware of the wide economic and socialdamage that the owners and managers of insolvent or poorly-run banking institutions cando. The past two years in the region confirms earlier experience worldwide that poorlyregulated banking systems drag the economy down with them during a crisis. Because ofthe wider social implications, banking must be seen as a privilege, rather than a right. Areasoned decision by the prudential regulators to withdraw this privilege in the publicinterest must be adequately protected by the judicial system. In the context of the recentBSRL, the means of providing adequate protection to banking regulators is underconsideration.

Taxation of Financial Intermediation

3.19 The banking system should, of course, pay its fair share of taxation. But asimportant as the overall tax take from banking is the structure of taxation; distortions instructure can become particularly acute when nominal interest, rates are high, as was thecase in late 1997-early 1998. The incidence of taxes such as the gross receipts tax (GRT)and documentary stamp tax (DST) as well as reserve requirements tend to falldisproportionately on the small depositor and the small borrower through the effect ondeposit and lending interest rates, more than on the shareholder or larger customer of thebanks. A government task force is examining options to reform the taxation of financialinstitutions to enhance efficiency in a revenue neutral manner. In such a reform, the DSTand GRT would likely be replaced by a VAT-like charge based on banks' profits andsalaries.

3.20 Consistent with fiscal targets, the authorities intend to begin allowing specificloan-loss provisions to become deductible for income tax purposes; they have also

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introduced a withholding tax on interest paid by banks on foreign-currency denominateddeposits. Although having opposite effects on the flow of tax revenue, both moves are inthe right direction. Allowing deductibility of realistic (specific) loan-loss provisions isnot much of a concession to the banks: it simply recognizes promptly a future reductionin income. As such, introducing tax deductibility is highly recommended as anencouragement for banks to recognize the true quality of their portfolio as early aspossible. Likewise, reducing the tax advantage of foreign currency deposits reduces theartificial incentive to foreign currency business that still exists. As financial marketsstabilize, additional measures towards leveling the playing field between peso and foreigncurrency intermediation will be needed, particularly if the latter resumes its pre-crisisincrease as a share of overall intermediation.

C. DEEPENING CAPITAL MARKETS

3.21 The capital market comprises markets for equities, Government securities andother domestic debt. It is regulated principally by the SEC, which is also responsible forauthorization/licensing of companies, ensuring information disclosure, enforcing anti-fraud measures and prudential regulations, and determining whether distressed firmsshould be granted payment relief from creditors or forced into liquidation.

3.22 Equities are traded on the Philippine Stock Exchange (PSE), which had 185member firms, 221 listed companies and a market capitalization of P1.4 trillion as ofDecember 1998. Both listed and member companies have been severely affected by theregional crisis, due to decelerating economic growth, declining profits, substantialwithdrawals by foreign investors in B class shares, sharply reduced trading volumes andenormous volatility in share prices.

3.23 Government securities are the backbone of the Philippine debt market. TheNational Government's debt in 1998 amounted to P1.8 trillion or 65 percent of GNP, ofwhich P870 billion was domestic debt. Trading volumes have increased significantlywith the creation of the Bureau of the Treasuiy (BTr) in 1995, which has regularized thesecurities issue schedule and introduced longer maturity (2, 5 and 7, and 10-year) fixedrate instruments. Bonds other than national government securities are very limited, withonly a few Government-owned or controlled corporations (GOCCs) and LocalGovernment Units (LGUs) issuing bonds-most LGUs rely on the government banks andon the Municipal Development Fund (MDF) established within DOF to obtain loans andgrants. Private corporate bonds are almost non-existent, due to tax and regulatoryrestrictions, however trade in both short- and long-term commercial paper was fairlyactive prior to the crisis. Mutual funds have recently been reintroduced after aconsiderable hiatus and their total asset value remains small.

3.24 The Philippines' capital markets, particularly the equity market, have madesignificant progress thanks to the coordinated efforts of the Government and privatesector. Nevertheless, a broad set of reforms is still warranted in order to tap the largegrowth potential for these markets. Perhaps the most serious impediment to furtherdevelopment of debt and equity markets is the distorted system of capital income andtransaction taxation. The blend of capital gains taxes, transfer taxes and the DST

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prevailing encourages tax arbitrage and does not ensure a level playing field acrossdifferent types of instruments, issuers and investors. As indicated, the Government ispreparing a set of financial sector tax reforms designed to streamline taxation ofsecurities transactions, substantially reduce tax arbitrage loopholes and introduce a morelevel playing field across instruments and institutions.

3.25 A second key area for reform is promoting increased information disclosure byissuers of debt and equity instruments, (for example adoption of International AccountingStandards, including mark-to-market accounting, and increased disclosures on assetquality and on ownership structures). This has been difficult as Philippine firms are notused to complying with disclosure requirements, however it is essential for educatedinvestors to apply market discipline to firms. More generally, investor education isneeded to motivate self-regulation from the bottom, as well as to mobilize a greateramount of equity capital in the domestic market. Important steps to enhance transparencyhave been proposed in amendments to the Revised Securities Act and the InvestmentCompanies Act that are currently being considered by Congress. Moreover, severalmeasures have been taken to upgrade the SEC, with support from the ADB. Forexample, the SEC is now equipped with a stock watch system linked to the marketsurveillance system of the PSE to facilitate detection of potential malpractice in themarket.

3.26 With regard to the equity market, the immediate challenge is to ensure soundimplementation of SRO-status for the Philippine Stock Exchange. Other issues to beaddressed include: integration of the Philippine Central Depository, the SecuritiesClearing Corporation of the Philippines and share registrars to integrate securitiescustody and transfer functions with clearing, settlement and guarantee functions; gradualopening of the equity market (since A shares are offered directly only to local investorsand B shares to foreign investors); expanding activities to include securities lending andborrowing services; the creation of markets for options, warrants and rights, and equityindex futures; and operationalization of the SME Board on the PSE.

3.27 With regard to debt instruments, there is a need to permit increased participationof foreign broker-dealers and investment banks in underwriting of securities so as topromote competition. Other impediments to the development of the domestic bondmarket include insufficient capital requirements for domestic broker-dealers (B/Ds) toengage actively in dealing activities, as well as restrictions on B/Ds from borrowing frommore than 19 creditors. An enhanced infrastructure for securities lending and borrowingservices and for repurchase agreement transactions, as well as development of interestrate futures (or long-term government bond futures after liquidity is regained) would alsoserve to increase investment in long-term instruments and generate greater liquidity in thesecondary market. The current, one-year term structure on (government securities)interest rates is based on primary auction yields rather than secondary market trading.Therefore it is important to enhance secondary market trading and information systems aswell as the configuration of the secondary market as a whole. Seamless systemsintegration between BTr's registry-depository system for government securities andBSP's payments/large value transfer system is also essential. The Government has

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approached the ADB for a second capital markets development loan that would focus onthe debt market and serve to introduce these reforms.

3.28 Finally, in the area of municipal finance, the key challenge is to operationalize thepolicy framework for LGU financing developed with Woild Bank support and presentedto the donor community in December 1996. This framework defined roles for variouspublic and private LGU financiers with a view to increasing LGU access to finance andto graduating creditworthy LGUs to direct participation in the private capital market.This includes increasing LGU use of build-operate-transfer schemes, developing theLGU bond market and other sources of private finance, optimizing the involvement of thedevelopment banks (DBP and Land Bank) in municipal finance, and transforming theMDF into a full-fledged financial intermediary.

D. DEVELOPING LONG-TEIRM DOMESTIC SAVINGS

3.29 The contractual savings sector (CSS) includes private and public pension funds,life insurance, and pre-need plans. Public pension funds, comprising the Social SecuritySystem (SSS), the Government Service Insurance System (GSIS), the HomeDevelopment Mutual Fund (Pag-IBIG), and the Armed Forces of the PhilippinesRetirement and Separation Benefits System (AFP-RSBS), mobilized over 60 percent orP315 billion of the P484 billion in Philippine contractual savings as of December 1997.Life insurers account for the next largest share, with 27 companies holding around P90billion in assets (heavily concentrated in three foreign-owned firms), followed by privateoccupational pension plans (OPPs) with assets of P68 billion and pre-need plans withassets estimated at P12 billion at end-1997.

3.30 The SSS, GSIS and AFP-RSBS plans are defined benefit plans and offerretirement, survivor and disability benefits to their members. Pag-IBIG is essentially adefined-contribution, mandatory provident fund for housing, allocates 70 percent of itsresources to housing finance, and makes account balances available to members upondeath, disability, retirement or after 20 years of contributions-as it was launched in1981, Pag-IBIG will begin making substantial pay-outs in 2001. Private occupationalpension plans (OPPs) are voluntarily established, typically defined benefit plans, whosebenefits (retirement, separation, disability and death benefits) meet or exceedrequirements set out in the Mandatory Retirement Pay Act (R.A. 7641).

3.31 The public pension plans do not report to an external prudential regulatory andsupervisory agency, except for SSS and GSIS insurance activities, which were recentlybrought under supervision by the Insurance Commission (OIC). Private OPPs areequally unregulated from a prudential perspective; their oversight is limited to a Bureauof Internal Revenue (BIR) review of their tax compliance. For term insurance products,there is a marked difference in the level of regulation and supervision of the pre-need andlife insurance industries, with considerably tighter oversight of insurers by the OIC thanof pre-need plans by the SEC. This has led insurers to establish affiliated pre-need firms.Actuarial standards for the valuation of pre-need plans have been developed by theActuarial Society of the Philippines.

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3.32 The main challenge to be addressed is the gradual drift towards Pay-As-You-Go(PAYG) systems for both SSS and GSIS. For example, despite a fairly high assets-to-expenditure ratio for SSS in 1997 (590 percent), its fund is projected to be depleted by2026 unless pre-emptive reforms are undertaken. The viability of the AFP-RSBS hasalso recently come into question, in spite of annual budget appropriations designed toallow it to build up a self-standing reserve fund. Generous benefits, relatively lowcollection efficiency in SSS's case, and low returns on investments explain the actuarialdeficits prevailing in the three public pension plans.

3.33 The potential costs of delaying reforms are substantial; for example, in the case ofSSS, just to maintain benefits at current levels in the absence of reforms, the totalcontribution rate would have to rise from the current 8.4 percent to 12.8 percent in 2020,16 percent in 2040 and 28 percent in 2060. There are three important measures to whichGOP should give priority in the contractual savings sector, so as to put in place an overallpolicy structure and strengthen the two largest pools of long-termn funds (SSS and GSIS).First, it is essential to develop a policy about the desired combined level of earningsreplacement and benefit distribution across the various mandated pension programs, andput in place a mechanism for generating coordinated projections of the costs and benefitsof the various parts of the retirement income system. Second, measures are required toimprove incentives and administrative procedures so as to promote increased complianceand collections at SSS and Pag-IBIG, including the possible introduction of a centralcollection system. Third, on the investment side, the key priority is to improve themanagement of reserves of the SSS and GSIS by assuring that investments are sound,liquid, earn market rates of return, and that they support financial sector development.Increased transparency is also required in financial transactions between Government andSSS, GSIS and Pag-IBIG. Finally, improved actuarial disclosures and monitoring isrequired for all the pension plans.

3.34 Private occupational pension plans are also characterized by substantial unfundedor underfunded pension liabilities, due to lack of regulatory oversight and to the fact thatemployers are not required to pre-fund the benefits, or to treat pension claims as priorityclaims against assets in the event of bankruptcy. Therefore improved regulation andsupervision of these plans is needed. Moreover, both private and public pension planbenefits are predominantly paid out in the form of lump sums, due to the underdevelopedannuity market. Measures to promote an annuity market could result in improved riskand resource allocations and help to preclude premature disposition of assets by retirees.

3.35 Key challenges in the area of life insurance include increasing competition in theindustry by shifting from fairly rigid premium and product controls to a system ofsolvency monitoring and strictly enforced capital requirements. Restrictions on foreignholdings of real property and common shares impede competition in certain forms ofadmitted assets. The tax regime is also particularly onerous on life insurance products asa whole, relative to pension and pre-need plans, warranting measures to ensure a morelevel playing field across these contractual savings industries. With regard to pre-needplans, improved disclosure, stricter solvency standards and actuarial supervision underthe OIC are warranted to protect consumers and develop the industry.

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3.36 The Government has recognized the need for reforn in the area of contractualsavings and has already taken several steps to improve the retirement income system.Two major pieces of reform legislation were enacted in 1997, the Social Security Act of1997 (RA 8282) and the Government Service Insurance System Act of 1997 (RA 8291),which should strengthen their financial status. In the area of life insurance, GOP hasincreased capital requirements and sought ADB assistance to strengthen the InsuranceCommission, although further reforms are needed to develop the potential for lifeinsurance and the related pre-need industry. The Government is exploring assistancefrom the World Bank to strengthen public pension agencies' collection efficiency andfinancial soundness; develop a stronger planning and prudential framework for theretirement income system; improve supervision and actuarial monitoring of private andpublic pension plans, pre-need plans and life insurance agencies; and establish a levellegal, regulatory and fiscal playing field that engenders greater competition in thecontractual savings sector.

E. REFORMING HOUSING FINANCE

3.37 While the volume of public versus private sector mortgage lending is not welldocumented, it is estimated that total loans for construction and real estate amount toaround P320 billion. Philippine commercial banks and thrifts account for P200 billion(equal to 12 percent of total bank lending).3 Private insurance companies account for P13billion, while the Government accounts for P105 billion in housing loans through theNational Home Mortgage Finance Corporation (NHMFC), SSS, GSIS and Pag-IBIG. Inaddition, the Home Insurance and Guaranty Corporation (HIGC) has commitments whichexceed its existing guarantee limit of P62.8 billion for retail and developmental loans (ofwhich P37.4 billion was availed as of November 1998, primarily by private commercialbanks); hence, total publicly held mortgages and guarantees are equivalent to a littleunder half of all lending for construction and real estate. While private lenders fall underthe supervision of BSP or the Insurance Commission, there is no prudential regulatoryand supervisory oversight of the publicly owned or controlled housing agencies(NHMFC, Pag-IBIG and HIGC).

3.38 Important weaknesses have emerged in the housing finance market, includingmarket segmentation, poor primary mortgage asset quality in the low-income marketsegment, large and inefficiently targeted housing subsidies, and declining publicresources to meet national shelter objectives. The NHMFC reports a 51 percent recoveryrate on the Unified Home Lending Program (UHLP), which accounts for the bulk of itsP42 billion in assets. Pag-IBIG's recovery performance is much stronger, althougharrears have increased since 1997, due in part to portfolio transfers from NHMFC. Thecrisis has also led to a sharp increase in calls on HIGC guarantees. Of particular concernfor GOP and for the public pension agencies (SSS, GSIS and Pag-IBIG), is thecontinuing weak collection efficiency on loans channeled through NHMFC. AlthoughNHMFC has focused exclusively on improving collections, there has as yet been nomeasurable improvement in collection efficiency during the past two years, which

3 Banks have funded an additional, indeterminate amount of housing finance through their trust funddepartments.

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suggests that potential loan losses for NHMFC and its pension fund creditors may besubstantial. Measures are urgently required to collect on/dispose of these assets andreview NHMFC's future.

3.39 To date, GOP has relied heavily on the public pension agencies to bear the costsof below-market interest rate loans to low-income homeowners. Subsidized lendingprograms have been at the heart of the Government's National Shelter Program, which isdesigned to meet substantial un-fulfilled demand for housing. However, the capacity ofthe SSS, GSIS and Pag-IBIG to bear the cost of subsidizing these loans has been strainedand public funding for low-income housing has consequently been restricted. Indeed,SSS has terminated its preferential rate lending and GSIS has suspended all housingfinance as it tries to reformulate its lending program. This has placed considerable strainson Pag-IBIG, the remaining window for below-market rate loans, and resulted in largeback-logs which Pag-IBIG is under pressure to finance. An analysis by researchers at thePhilippine Institute for Development Studies suggests that the interest subsidies (andrelated non-payments on housing loans) have not achieved affordability objectives fortarget populations at low cost; have not addressed the underlying causes of affordabilityproblems (e.g. distortions in land markets); have resulted in large leakages to non-targetpopulations; and have resulted in vast fiscal and quasi-fiscal costs to government.4 Thedeclining public resources have also had adverse effects on private developers servingthis market. Private funding of low-income mortgages and integration of this marketsegment into the broader financial market is not possible unless a policy of market rateson housing loans is introduced. Such a policy would need to be complemented bytransparently budgeted, up-front subsidies to assist carefully targeted beneficiariesachieve home ownership. The required reforms point to the need to redefine the role ofGovernment in housing finance and to support home ownership-and shelter moregenerally-through more efficient and sustainable means.

3.40 In 1996, the Government resolved that "an appropriate, time bound, transparentand well-targeted mechanism will be formulated to replace the credit subsidies currentlyin place."5 The new Administration has taken up this commitment and is developingproposals for budgeting this assistance. It is also reviewing housing finance policiesmore broadly with a view to redefining public and private sector responsibilities andrisks. A program of reforms is being developed with assistance from the World Bankthat should result in an enhanced framework for mortgage loan origination, underwriting,servicing, enforcement and securitization; increased transparency and efficiency inhousing subsidies; resolution of non-performing assets at NHMFC; improved asset-liability management and institutional strengthening at both HIGC and Pag-IBIG; andstrengthened policy formulation capacity at the Housing and Urban DevelopmentCoordinating Council (HUDCC). The ultimate goal is to achieve a higher proportion andvolume of privately funded low- to middle-income housing loans, reduced delinquencies

4 Llanto, Orbeta, Sanchez and Tang (1997): "A Study of Housing Subsidies in the Philippines," Reportprepared for the World Bank and the Housing and Urban Development Coordinating Council.5 See the Memorandum of Agreement on Housing Finance, signed 12th June, 1996, by representatives ofDOF, the Department of Budget and Management (DBM), SSS, GSIS, Pag-IBIG, NHMFC, and theHousing and Urban Development Coordinating Council (HUDCC).

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on mortgage lending, greater liquidity in housing markets through more prevalentsecuritization, and improved access to shelter for Filipino families.

F. ENSURING ACCESS TO RURAL, MICRO AND SMALL

ENTERPRISE FINANCE

3.41 Comprehensive data are not available on the overall level of rural, micro andsmall enterprise finance and on the number of providers and clients. The Land Bank isthe main wholesaler of funds for agricultural and rural credit, with available resources ofP168 billion as of March 1998. These funds are channeled primarily through rural banksand cooperatives to small farmers, fishermen, and non-farm rural enterprises. The ruralbanks and cooperatives have consistently been numerous, undercapitalized and weak, andLBP is encouraging a process of consolidation among cooperative lenders. Privatecommercial bank lending for agriculture, fisheries and forestry is relatively limited,amounting to around 6 percent of their loan portfolios.

3.42 The DBP has provided similar second-tier funding to Land Bank's to interestedfinancial intermediaries for SME finance. It provides medium and long-term agriculturaland industrial finance, with an emphasis on SMEs. DBP had a portfolio of P65 billion(as of end-1997), of which about half is lent on a retail basis and the other half isallocated to rediscounting of SME credits by banks and other financial intermediaries.Banks are required to make 5 percent of their loans available to small enterprises, and theBAP has established a BAP Credit Guarantee Corporation to channel resources throughcredit-granting NGOs to such enterprises. Due to the crisis, retailers of SME funds haveexperienced rising arrears, and have both stepped up foreclosures and repossessions onloans as well as sharply curtailed additional lending to this sector during the past year.

3.43 Microenterprise credit is provided by a variety of formal, semi-formal andinformal financial intermediaries, including rural banks, cooperatives, credit unions, anestimated 500 credit granting NGOs. In addition, over 7000 registered pawn shopsprovide small-denomination loans under BSP supervision. Leading NGO providers ofmicrofinance have begun to establish performance benchmarks as a precursor toestablishing a self-regulatory status for the industry. The Government has alsoestablished a People's Credit and Finance Corporation (PCFC) to wholesale resources tocredit-granting NGOs that follow the Grameen Bank model of providing microfinance.PCFC had resources amounting to P350 million as of March 1998.

3.44 The principal challenge for rural finance is to ensure that small farmers haveaccess to financial services. This can only be done on a sustainable basis if the provisionof rural financial services is viable for lenders. Most LBP lending for agriculture is oncommercial terms. However, LBP has come under considerable political pressure toprovide loans to agrarian reform beneficiaries at subsidized rates of interest. Current on-lending rates are 12 percent for short terrn lending, which constitutes 95 percent of

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agrarian reform loans. This rate is not sufficient to cover administrative costs andadequate prudential loan loss provisions. Not surprisingly, agrarian reform loans havedeclined as a share of Land Bank's portfolio during the past five years, as LBP hasattempted to minimize the need to cross-subsidize this nonviable line of activity. It istherefore essential to reconsider the subsidized, directed credit policy as it has sharplycurtailed agrarian reform beneficiaries' access to financial services.

3.45 In the area of micro and small enterprise finance, the key challenge is to upgradethe institutional capacity of financial intermediaries serving this market segment. In thepast, there have been numerous lines of directed credit at subsidized rates. However,following the signature of a Social Pact on Credit in 1993 and the subsequent creation ofa National Credit Council, measures have been taken to rationalize government-basedcredit and guarantee programs and encourage greater private participation in creditdelivery. Thus PCFC loans to microfinance institutions (MFIs) are made at market rates,as are advances from the BAP's Credit and Guarantee Corporation, and market rates areconsequently applied on sub-loans to low-income entrepreneurs. However, PCFC's ownperformance is currently weak, because of high operating costs relative to apexmicrofinancers in other countries, while most MFIs have limited outreach and fall belowproposed performance standards in terms of outreach, portfolio at risk, and financial self-sufficiency.

3.46 The Government's immediate priority is to ensure that viable rural and urbanenterprises are not put out of business for lack of access to credit. Thus GOP hasapproached the Bank for lines of credit to support long-term investments by agriculturalproducers and urban SMEs. GOP still operates a series of lines of credit through variousdepartments (Trade and Industry, Social Welfare and Development, Agriculture) and aNational Livelihood Support Fund administered by LBP. While GOP has expressed itsintention to rationalize these and increase their effectiveness, further institutionalproposals have also been tabled, including establishing a Private Guarantee Fund forMicro- and Cottage Industries, as well as a People's Development Fund for capacitybuilding. The principal policy thrust in the area of microfinance has however been tobreak the perceived link between microfinance and welfare/interest subsidies, and toencourage active networking among MFIs, development of performance standards,linkages between formal and informal sectors, and mobilizing local resources formicrofinance. In this regard, GOP has sought USAID support since 1997 for a CreditPolicy Improvement Program.

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4. EXPORT PERFORMANCE AND COMPETITIVENESS

A. INTRODUCTION

4.1 Philippine manufactured exports have expanded vigorously in recent years. The compoundannual growth rate (in current dollar values) reached 20 percent during 1990-97, a massiveimprovement over the 9.6 percent rate during the 1980s. More exceptionally, exports havecontinued to perform strongly during the crisis, when those of its traditionally more dynamicneighbors have flagged. While there are some signs of falling off in the rate of growth in the pasttwo months, growth continues to be at double-digit rates and it may be that the slowdown is ashort-term cycle. Philippines has overtaken its main (and much longer established) competitor inthe region, Malaysia, in semiconductors, its main export product. This export is well-positioned interms of growth prospects, and is handled entirely by leading global companies, ensuring access totechnology and markets. The particular products made in the Philippines are less susceptible toprice falls than more standard memory chips. This augurs well for its export competitiveness.

4.2 Nevertheless, it is not clear how sustainable this export growth is. An overwhelmingreliance on one subset of products, however dynamic and globalized, is risky. In this product,recent export growth appears to be due mainly to new investments by multinationals; if so, it willslow once capacity constraints are reached, unless new facilities are built up with additional FDI.Other exports, including labor-intensive ones like clothing where the country should have a strongcomparative advantage, are doing badly (and have been even before the crisis). Philippines is notutilizing its competitive edge in its cheap skilled labor force fully. Even the skill base suffers fromproblems of quality and relevance-these will loom larger as industry moves into more complexproducts. It suffers from other competitive handicaps, in particular in its infrastructure and the lowlevels of capability of domestic firms (which deter greater local content in sophisticated exports).Technological and design activity is very low and FDI policies lag behind best practice in theregion in effectiveness. It is imperative for the country to diversify its competitive base, deepen itsadvantage in its main export activities and strengthen local enterprises. This chapter considers themain policy issues that arise in this context.

B. RECENT EXPORT PERFORMANCE

Growth Rates

4.3 The Philippines is not a large exporter by regional standards. The value of its manufacturedexports was $17.6 billion in 1996, the smallest of its export-oriented neighbors. The mainexporters were China ($130.3 billion), Korea ($111.2 billion), Taiwan (China) ($108.5 billion) andSingapore ($59 billion of own exports). Its ASEAN neighbors were also much larger exporters:Malaysia $67 billion, Thailand $43 billion and Indonesia $29 billion. Philippines' growth was

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robust over 1990-95, a vast improvement over the 1980s, but several neighbors did better (fromlarger bases). From 1995 onwards, however, Philippine exports outpace the others and continue todo so into 1998.

Table 4.1 Annual Growth Rates of Merchandise Exports (% pa)

1980-90 1990-95 1996 1997 1998 1998Jan-Nov 1 quarter 2 quarter 3 quarter

Philippines 4 16 18 23 17 24 15 19Korea 14 14 4 5 -12 9 -2 -10

Taiwan (China) 13 11 4 5 -9Singapore 11 18 6 -1 - -7 -9 -8Malaysia 9 20 5 1 -4 -9 -11 -

Indonesia 2 12 10 7 -6 (a) 1 -8 -

Thailand 14 21 -1 3 -14 (a) -3 -5 -9China NA 19 2 21 -0.2 13 3 -2World 7 7 4 3 - -1 -2 (b) -

Sources: UN Contrade, WTO Annual Report 1998, IMF IFS October 1998, national statistical offices on theinternet.Notes: (a) January-September. (b) Exports by industrial countries only; imports by industrial countries werestagnant in this period.

4.4 Table 4.1 shows the growth of merchandise exports through late 1998. In 1996, when adrop in world trade growth caused a sharp deterioration in regional export performance, Philippineperformance proved more resilient. In 1997, the rate growth accelerated further; only Chinarecorded a comparable (but lower) rate. In 1998, Philippine export growth slowed, but to ahealthy 17%. In contrast, rates for all its neighbors turned negative, even in those such as Chinaand Taiwan (China) not directly involved in the crisis. The regional slowdown had a progressiveimpact on these countries, while Philippine export growth revived in the third quarter to 19%.While export growth in the fourth quarter slowed, Philippine exports have escaped the regional'contagion', and their performance matches that of the most dynamic countries before the crisisstruck. Its main export product continues to thrive (below). Its main market, the United States(taking 34% of its exports in 1998), is importing more from the Philippines. While total USimports of electrical machinery (Philippines' main manufactured export) fell by 0.6% in January-September 1998, its imports of machinery and transport equipment from the Philippines rose by21%.

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Table 4.2 Philippine Manufactured Export Performance 1991-1998

Products Value (US$ millions) Growth rates (%op a.) Distribution (%)1991 1997 Jan-Sep 97 Jan-Sep 98 1991-97 1991-93 1995 1996 1997 1998 (9 mths.) 1991 1997

Total manufactured exports 6,914.9 22,069.4 16,045.8 19,350.4 21.3% 14.8% 30,2% 22.1% 25.6% 20.6% 100% 100%

Consumer Manufactures 3,336.8 4,683.1 3,544.3 3,442.5 5.8% 10.0% 7.7% -1.1% 0.7% -2.9% 48.3% 21.2%

Garments 1,740.3 2,249.5 1,696.5 1,730,5 4.4% 10.7% 8.9% -4.6% -2.4% 2.0% 25.2% 10.2%

Textile yarn, fabrics 72.4 253.4 196.7 157.8 23.2% 13.8% 19.6% 22.0% 16.8% -19.7% 1.0% 1.1%

Gifts, toys, hardware 337.0 473.9 370,2 355.0 5.8% 9.2% 12.8% -1.4% -2.1% -4.1% 4.9% 2.1%

Leather, fashion accessories 256.1 339.7 250.2 264.9 4.8% 10.2% 1.4% -14.4% 12.3% 5.9% 3.7% 1.5%

Fumiture 177.2 321.9 243.5 241.2 10.5% 7.1% 15.0% 6.0% 9.9% -0.9% 2.6% 1.5%

Footwear 141.1 193.7 145.3 117.5 5.4% 9.2% -1.3% -18.1% 13.9% -19.1% 2.0% 0.9%

Processed foods 518.8 645.7 481.5 435.2 3.7% 6.6% -4.4% 10.7% 2.3% -9.6% 7.5% 2.9%

Other 93.9 205.3 160.4 140.3 13.9% 18.6% 24.3% 18.8% -16.8% -12.5% 1.4% 0.9%

Industrial Manufactures 3,578.1 17,386.3 12,501.5 15,907.9 30.1% 19.2% 44.9% 33.3% 34.6% 27.2% 51.7% 78.8%

Electronics 2,239.1 14,961.9 10,718.4 14,442.9 37.2% 25.3% 54.6% 40.4% 41.0% 34.7% 32.4% 67.8%

oAvsemiconductors 1,767.3 11,495.2 8,193.3 11,416.2 36.6% 23.0% 60.8% 39.7% 35.7% 39.3% 25.6% 52.1%

Construction materials 111.7 111.0 82.9 71.3 -0.1% -3.9% 0.2% 28.9% -29.1% -14.0% 1.6% 0.5%

Metal products 356.2 485.1 371.2 262.6 5.3% 9.7% 33.8% -9.8% -7.0% -29.2% 5.2% 2.2%

Chemicals 305.0 383.5 279.0 244.5 3.9% -6.7% 10.6% 2.8% 8.7% -12.3% 4.4% 1.7%

Machinery, trans. equipment 256.5 942.2 681.8 626.2 24.2% 27.9% 12.5% 14.3% 22.2% -8.2% 3.7% 4.3%

Non-met. minerals 26.4 19.9 15.4 13.8 -4.6% -7.3% 3.0% -40.9% 22.8% -10.2% 0.4% 01%

Petroleum products 232.2 349.4 258.8 122.9 7.0% 6.1% 17.7% 31.6% -8.6% -52.5% 3.4% 1.6%

Other 51.0 133.3 94.2 123.7 17.4% 13.4% 48.4% 8.5% 22.3% 31.4% 0.7% 0.6%

Totalexcluding electronics 4,675.8 7,107.5 5,327.5 4,907.5 7.2% 9.4% 10.8% 1.8% 2.1% -7.9% 67.6% 21.2%

Source: Based on data from the Department of Trade and Industry, Governmerit of Philippines

Manufactured Export Structure

4.5 Manufactured products have steadily increased their share of the total, and now account forover 80% of Philippine merchandise exports. In recent years, their growth has accelerated morethan for total exports; the rate of growth achieved in 1994-97 has been over 11 percentage pointshigher than in 1991-93. Despite a slowdown in the first three quarters of 1998, the growth ofmanufactured exports continues at over 20%. However, the pattern is highly skewed (Figure 4.1).Over 1991-97, 84% of the rise in the value of manufactured exports comes from electronics, withone group of electronics, semiconductors, accounting for 64% (Table 4.2). The correspondingfigures for the first 9 months of 1998 are 113% and 98%. This pace of growth more than doublesthe share of electronics, from below one-third to over two-thirds; semiconductors alone contributeover half of the total in 1997 and nearly 60% in January-September 1998. The only other majorproducts with substantial (20% plus) growth over 1991-97 (textiles and machinery/transportequipment) are relatively small, contributing only 5% of the total in 1997.

Figure 4.1 Value of Major Categories of Philippines Manufactured Exports (Sm)

2 - 0 - - Consumer Manufadures

. -4* Industrial Manufactures

18,00c ELECTRONICS

16,000 -

14,000

10,000J

8.000-

4s,000 ** 4,000

2,D00

1991 1992 1993 1994 1999 1993 ¶997

4.6 If electronics are excluded, Philippine export performance is more modest, and deterioratesfrom 1996 onwards, presumably because of the financial crisis. The growth of consumermanufactures falls from 10% in 1991-3 to negative between 1996 and 1998. This is due mainly tothe poor performance of garments, Philippines' main traditional export, but many other consumerproducts-footwear, toys, and leather goods-also do badly. Some fare poorly even before thecrisis: the value of garment exports has been virtually stagnant over 1994-97, and their growthduring (pre-crisis) 1990-95 lower than for its ASEAN neighbors and China.' Since Philippinegarment wages are lower than in Malaysia and Thailand (though higher than in Indonesia andChina), this suggests a weak competitive base in this major labor-intensive export. The recentperformance of garment exports in non-quota markets, which face the most intense opencompetition from lower-wage countries like China, Sri Lanka and Bangladesh, has been evenworse. This reinforces the impression that the upgrading of quality and technology among

l The annual rate of growth of garment exports from the Philippines in 1990-95 was 7.7%, compared to 11.5% forMalaysia, 12.3% from Thailand, 15.7% from Indonesia and 20.1% from China.

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Philippine exporters is lagging. Other labor-intensive products like footwear, toys and leathergoods also perform poorly, with annual growth rates of below 3% during 1994-97. The crisistherefore is only partly to blame for this. The most important resource-based export, processedfoods, shows a generally weak and cyclical growth performance.

C. STRUCTURAL COMPETITIVENESS

Positive Aspects

4.7 A narrow range of products, electronics, drives the outstanding export record of thePhilippines. Within electronics, one product, semiconductors, dominates. Other countries in theregion also export semiconductors, but its growth from the Philippines has been much faster(below).

Table 4.3 Evolution of World Manufactured Exports by Technological Categories (1980-96)

Shares (%o)

1980 1985 1990 1995 1996Resource based 19.5 19.3 15.5 14.0 13.7Low tech 25.3 23.4 23.7 22.0 21.3

Medium tech 38.6 37.3 38.5 36.9 37.2High tech 16.5 20.1 22.2 27.1 27.7

Rates of Growth fl% p.a.)

1980-85 1985-90 1990-95 1995-96 1980-96Resource based 2.0 10.1 6.4 -0.2 5.7

Low tech 0.7 15.3 6.9 -0.9 6.9

Medium tech 1.6 15.7 7.7 3.0 7.8

High tech 6.3 17.4 13.0 4.5 11.6

Total 2.3 15.0 8.6 2.1 8.1

Source: Calculated from UN Comtrade data

4.8 The 'high technology' products that dominate Philippine exports comprise the mostdynamic group in world trade. Table 4.4 shows the evolution of world manufactured trade for fourtechnological categories 2. There is a clear long-term tendency -for the composition of trade to shiftfrom technologically simple to complex products. Over 1980-96, resource-based exports havegrown the slowest (5.7%) and high-tech exports the fastest (11.6%). From being the smallest

2 Resource-hased products are mainly processed foods and tobacco, simple wood products, refined petroleumproducts, dyes, leather (not leather products), precious stones and organic chemicals. Low technology products aretextiles, garments, footwear, other leather products, toys, simple metal and plastic products, furniture and glassware.Medium technology products are mainly automotive products, most industrial chemicals and industrial machinery, andsimple electrical and electronic products. High technology products are fine chemicals and pharmaceuticals, complexelectrical and electronic machinery, aircraft and precision instruments. For a more detailed analysis see S. Lall,'Exports of manufactures by developing countries: emerging patterns of trade and location', Oxford Review ofEconomic Policy, 1998, pp. 54-73.

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category in world exports in 1980, high-tech products surpass resource-based products by 1985and low-technology products by 1996. At present rates of growth, high-tech will soon be thelargest single group. There are many reasons for their rising importance in trade (and production):the rapid introduction of new high value products, the income elasticity of many technology-intensive products (and related services), and their sharply falling costs because of new processes.Moreover, the presence of high-tech manufacturing activities tends to generate advanced skills andhave beneficial spillover effects on related activities. A specialization in high-tech products is thusthe best 'positioning' for exports.

Table 4.4 Technological Structure of Manufactured Exports, 1996(% of each country's total manufactured exports)

Resource Based Low Technology Medium Technology High TechnologyPhilippines 5.9 19.1 7.2 67.8Hong Kong 4.4 52.7 14.0 28.9Singapore 12.7 7.9 14.0 65.4Korea 9.4 28.4 26.6 35.7

Taiwan (China) 5.1 33.9 20.2 40.9Indonesia 34.9 41.9 8.5 14.7Malaysia 17.8 13.1 8.7 60.4Thailand 14.5 35.6 13.5 36.3China 9.8 56.3 13.4 20.6Mexico 7.1 20.9 35.2 36.9World 13.7 21.3 37.2 27.7

Source: Calculated from UN Comtrade and Philippine DTI data.

4.9 Table 4.4 shows the technological structure of Philippine exports in relation to itsneighbors (and to Mexico, the most dynamic exporter to the US since NAFTA). The Philippinestructure is now more 'high-tech' than that of Malaysia and Singapore, which are longer-established and larger exporters of electronics and are specialized (like the Philippines) inmultinational production networks. It is far more so than countries like Korea and Taiwan (China)

w which have considerable indigenous technological capabilities in these sectors but retainsubstantial low-technology exports and are significant exporters of medium-technologyengineering goods. Other countries in the region lag the Philippines in technological sophisticationof exports. In fact, the Philippines may have the world's most 'advanced' export structure by thismeasure.3

3 The largest exporters, the mature industrial countries where the technologies originate, have more diversifiedexport structures. For instance, high-tech exports accounted for 28% of total exports for the USA in 1995, 27% inJapan and 25% in the UK. Data from Appendix Table 6.5, National Science Foundation, Science and EngineeringIndicators 1998, US Government, Washington DC.

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Table 4.5 Philippine Electronics Exports ($ million)

1991 1993 1995 1996 1997 1997 1998

(9 months) (9 months)Semiconductor devices 1,767.3 2,674.9 6,060.1 8,468A 11,495.2 8,193.3 11,416.2Electrical machinery 42.9 98.1 214.7 206.2 280.8 215.1 351.5Telecom/sound apparatus 220.0 369.7 550.4 746.9 831.7 624.6 517.5Office, data processing mach. 106.9 215.0 440.9 878.5 2,101.1 1,502.6 1,922.3Consumer electronics 102.0 160.3 290.8 310.1 253.1 182.8 235.5o/w Audio visual products 86.2 136.6 257.8 270.8 214.8 151.3 208.9

Household appliances 13.4 19.5 26.8 31.6 34.4 27.9 25.6Other consumer products 2.4 4.2 6.2 7.8 3.8 3.6 1.0

Total 2,239.1 3,518.1 7,556.9 10,609.9 14,961.9 10,718.4 14,442.9

Source: Department of Trade and Industry

4.10 Philippines' specialization within 'high-tech', predominantly (80 percent) semiconductors(Table 4.5) is even more desirable. The product group in which it falls (SITC 776, 'Transistors,valves, etc.') is the largest and fastest-growing of tfhe fifty most dynamic exports in the world in1980-95. The total value of exports in 1995 under this group came to $171 billion (7% of totalworld manufactured exports). Its rate of growth over 1980-95 was 18% per annum, compared to12% for the 50 dynamic products and 9% for all manufactured exports. Moreover, thesemiconductor products assembled in the Philippines, mainly microprocessors and specializedchips, are less prone to price fluctuations than standard DRAM chips made by Korea. For instance,between 1997-98 the price of 64-M DRAM chips fell from $16 to $9 each and of 16-M DRAMfrom $3 to $1.8. The breakeven prices for these chips are $14 and $3 respectively.4 These massivefalls were one of the main causes for stagnating Korean export earnings; the differentspecialization led Philippine semiconductor exports to continue growing. Moreover, much ofPhilippine manufacturing is 'contract manufacturing', where wafers are supplied by foreigncustomers (including the parent companies of MNCs) to be assembled into individual chipsaccording to buyers' specifications. This reduces inventory-holding requirements for Philippineproducers and ensures that capacities are booked well in advance (typically one year). Thisarrangement may explain the far better performarnce by Philippine as compared to Malaysianexporters of semiconductors (below).5

4.11 The nature of electronics exporters is another important asset. Practically all exports comefrom affiliates of multinationals. In 1996, there were 118 Japanese, 38 Korean, 29 US, 18Taiwanese and 11 German subsidiaries in this activity, as well as some smaller foreign companies.All were producing for export under facilities offered by the Board of Investments or thePhilippines Export Zone Authority. Table 4.6 gives the names of the leading 50 exporters fromthe Philippines. The list contains most major electronics firms in the world. New investment inelectronics has grown steadily in the 1990s. In 1998, $450 million of FDI was directed into the

4 Korean Herald, May 28, 1998.5 Most recently, electronics production is shifting to turnkey arrangements whereby orders are specified to

contractors who draw from the warehouses of their own suppliers.

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electronics export industry. The Philippine Economic Zone Authority (PEZA) reports thatinvestment in ecozones rose by 18% in 1998. Among the leading investors were SMI-EDPhilippines Technology Inc. ($150m semiconductor plant), Fujitsu (second semiconductor plantfor $140m), NEC (second semiconductor plant for $137m) and GNF ($61m semiconductor plant).fWhile fears have been expressed of a decline in FDI inflows, which would damage exportprospects, available data do not yet suggest that these have a strong foundation.

Table 4.6 List of Leading 50 Philippines Exporters in 1996(in descending order of export earnings)

1 Intel Philippines 11 Philips 21 National 31 San Miguel 41 NEC TechnologiesSemiconductors Semiconductors

2 Texas Instruments 12 Hitachi Computer 22 Asahi Optical 32 Philippines Phosphate 42 EDS Manufactuning

3 Amkor/Anam 13 Laguna Electronics 23 Uniden Philippines 33 Petron Corporation 43 Team Pacific

4 Ionic Circuits 14 Matsushita 24 Analog Devices 34 Phil Intematonal 44 Best ElectronicsTrading Corporation

5 Phil. Associated 15 Acer Inforrnation Prods 25 Fujitsu Computer 35 Cargill Philippines 45 Legaspi Oil CompanySmelting and Refining Products Corporation

6 Integrated Microcircuits 16 Uniden Phils. Laguna 26 T M X Philippines 36 Intemational Wirng 46 United TechnologiesSystems

7 Cebu Mitsumi Inc. 17 Motorola 27 Shell Petroleum 37 International Copra 47 Benguet CorporationExport Corporation

8 Automated Micro- 18 Yazaki-Torres 28 Amencan 38 Dole Philippines 48 Del MonteElectronics Manufacturng Microsystems

9 Electronic Assemblies 19 Rohm Electronics 29 Maxon System 39 Kita Corporation 49Tsukiden ElectronicIndustnes

10 Telefunken 20 Zilog Philippines 30 Shell Gas 40 Best Electronics and 50 Philippine SinterSemiconductors Components Corporation

Source: Export Development Council, Government of the Philippines

4.12 A comparison of semiconductor exports by Philippines and other countries is instructive(Table 4.7). However, the data should be treated carefully. Product composition differs betweencountries: Korea is specialized in D-RAM chips, while Philippines and Malaysia specialize inmicroprocessors. Singapore makes a range of advanced semiconductor devices and is an importantre-exporter for other countries in the region. Taiwan (China) makes application specific chips.The level of technology and local content involved also differ. Philippines, Malaysia, Thailand,China and Mexico are mainly in the final assembly and testing stages.

6 Philippines Daily Inquirer, January 7, 1999.

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Table 4.7 Comparative Exports of Semiconductors

($m. and %)

1991 1993 1994 1996 1997 1997(9 months) 1998(9 months)

ValuesPhilippines 1,767.3 2,674.9 3,767.9 8,468.3 11,495.2 8,193.3 11,416.2Malaysia 4,744.3 7,289.3 9,512.1 13,993.1 14,569.6 11,003.7 10,533.8Thailand 1,121.0 1,708.9 2,242.1 2,956.0 3,376.4China 184.0 359.9 614.4 1,476.9 1,945.7Singapore 4,586.7 6,852.6 12,053.9 19,751.2 20,519.3Korea 6,645.2 8,078.3 11,848.0 17,305.2Taiwan 2,759.7 4,187.5 5,691.8 9,553.1(China)Mexico 45.0 671.1 916.0 1,875.0 1,869.3Total above 21,853.3 31,822.5 46,646.2 75,378.8 53,775.6

World Market sharesPhilippines 2.7% 3.0% 3.1% 4.9% 8.4%Malaysia 7.2% 8.2% 7.9% 8.0% 10.6%Thailand 1.7% 1.9% 1.9% 1.7% 2.5%China 0.3% 0.4% 0.5% 0.8% 1.4%Singapore 7,00/% 7.7% 10.0%10 11.3% 14.9%Korea 10.1% 9.0% 9.8% 9.9%Taiwan 4.2% 5.6% 4.7% 5.5%(China)Mexico 0.1% 0.8% 0.8% 1.1% 1.4%

Total above 29.0% 30.9% 38.5% 43.3% 39.1%

Source: UN Comtrade, national sources.

4.13 Malaysia, the nearest direct competitor to the Philippines, has much longer experience ofsemiconductor production and exports. Many of the same global companies are present there, andover time have made massive investments in physical facilities, training and technological activity(Intel has recently doubled its production capacity in Penang). Affiliates in Malaysia have beeninvolved in process design and development for new products. In view of this, it is remarkable thatPhilippine semiconductor exports exceeded Malaysian in the first 9 months of 1998, when theywere only 40% of Malaysian export values in 1994.

4.14 It is vital to Philippines' export prospects to understand if this is a temporary or longer-term trend. If temporary, Malaysian exports may revive and other production sites may grow morerapidly: the main engine behind Philippine export growth will then slow or stagnate. If longer-term, prospects for future growth seem very bright. There are arguments on both sides. On thepessimistic side, the surge in Philippine exports may be temporary if it only reflects the contractingof new facilities. Philippines has enjoyed a surge in electronics investments in the past 4-5 years;once new capacities are fully used, the rate of growth will moderate and over time other sites willcatch up.

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4.15 On the optimistic side, however, there are reasons for the surge to continue. New FDI isflowing into the industry. The main competitive strength, its relatively skilled, English-speakingworkforce, is lower cost than in Malaysia. Shop floor wages are $200-250 per month, comparedto $300-350 in Malaysia. A new graduate engineer is available at $400-500 in the Philippines,compared to $800-1000 in Malaysia, a production manager at $1000-2000 compared to $3600, aproduction supervisor at $500-600 compared to $1300.7 Moreover, the availability of engineers inthe Philippines is much better than in Malaysia, where companies have to use (expensive)expatriate technical staff. This is a critical factor in a highly skill-intensive industry. Some MNCsare using the Philippines for more technology-intensive jobs. Labor turnover rates are lower in thePhilippines than in Malaysia, conducing to greater skill formation in the former. Japaneseinvestors regard the discipline, trainability and loyalty of Filipino workers very highly; some haverated the workforce as the 'best in the world'.

4.16 The educational base in the Philippines compares well with many neighboring countries.Table 4.8 shows general educational enrollments as well as tertiary level enrollments in technicalsubjects in the Philippines and other countries. The last column is perhaps the most relevant forhigh-tech industries: the numbers of scientists, engineers, mathematicians and computerspecialists. Here, the Philippines scores better than all the other countries in the region except forKorea, Taiwan (China) and Japan, and is not too far from the advanced industrial countries. Givenits long lag in industrial and export development behind the 'new Tigers', it has excellentprospects for promoting export-oriented manufacturing and services based on its lead in education.

Negative Aspects

4.17 This section highlights some of the main structural weaknesses in the competitive andexport structure of the Philippines. It focuses on human capital and technology, and on the twomajor export activities, clothing and electronics. The most obvious weakness, touched on already,is the level of concentration of exports as such. This high dependence on one activity to drivenational exports is inherently risky. Any downturn caused by a slackening of FDI or atechnological shift that affects costs or productivity in the Philippines can be disastrous. The veryfact that the activity is so technologically dynamic and globalized in production increases the risk.Skill and technical requirements are changing constantly. All industrializing countries are tryinghard to attract electronics multinationals, and keeping ahead of the rest is likely to be a verydemanding task.

4.18 The risk of dependence on semiconductors is exacerbated by the anemic performance ofother products. Exports of labor-intensive consumer products show unexpected competitiveweaknesses, both against higher wage economies like Malaysia and Thailand as well as lowerwage economies like China and those in South Asia. Given the skill base and openness to FDI, itis not clear why garments and similar products are performing so poorly. As noted, the financialcrisis only provides part of the explanation-there are evidently lags in upgrading of processtechnology and product quality. Relative to most of its neighbors, the Philippines still has a strongunderlying advantage in labor-intensive exports, but maintaining this advantage requires sustainedupgrading as cheaper competitors emerge in China, South Asia and Vietnam.

7 Wage data are for 1995.

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Table 4.8 Educational Enrollments

(latest available year)

Enrollment Ratios Technical Enrolmerds at Tertiary Level (Numbers & % Population)

Secondary Tertiary Natural Science Math's & Computing Engineering Total Technical subjects

% Age Group Numbers % Numbers % Numbers % Numbers %Philippines 79 27.4 27,200 0.040% 121,000 0.178% 225,700 0.333% 373,900 0.551%Hong Kong 75 21.9 13,400 0.219% 16,600 0.271% 30,000 0.490%Singapore 62 33.7 1,300 0.039% 1,400 0.042% 13,000 0.391% 15,700 0.472%Korea 101 52.0 163,700 0.365% 577,400 1.286% 741,100 1.650%Taiwan 88 38.0 16,800 0.078% 32,800 0.153% 179,100 0.834% 228,700 1.065%(China)Indonesia 48 11.1 25,100 0.013% 128,000 0.065% 293,900 0.149% 447,000 0.226%Malaysia 58 10.6 8,800 0.044% 4,600 0.023% 12,700 0.063% 26,100 0.130%Thailand 55 20.1 22,500 0.039% 27,100 0.047% 58,700 0.101% 108,300 0.186%China 69 5.7 167,700 0.014% 99,400 0.008% 971,000 0.080% 1,238,100 0.101%

Memo Item: Some industralized countrfesFrance 111 49.6 304,100 0.523% 50,800 0.087% 354,900 0.611%Germany 103 42.7 142,400 0.175% 116,700 0.143% :371,600 0.455% 630,700 0.773%UK 134 48.3 120,700 0.208% 98,300 0.169% 216,200 0.372% 435,200 0.749%Japan 99 40.3 805,800 0.644% 805,800 0.644%Canada 106 102.9 47,200 0.161% 52,800 0.180% 103,500 0.352% 203,500 0.692%USA 97 81.1 496,400 0.186% 525,100 0.197% 801,100 0.300% 1,822,600 0.682%

SOURCE: UNESCO, Statistical Yearbook 1997, and national sources for l'aiwan, China.

Human Capital

4.19 Despite its good enrollment record, the Philippine education and training system facesproblems of quality and relevance. There is a 40% dropout or failure rate at universities andcolleges. The school cycle is shorter than in most other countries, so that higher educationinstitutions have to spend more time bringing entrants up to required levels. The curriculumappears less geared to modem technological needs and there appears to be less continuousinteraction between the providers and users of higher education in comparison to many competitorcountries. Standards in many higher education institutions are below international levels. In anexercise ranking 105 state and over 1000 private colleges into four categories (the highest beinglevel 4, equivalent to a good foreign university), the Commission for Higher Education found in1996 that only 2 institutions achieved Level 4. The vast majority clustered in the two lowestlevels. The Commission identified 18 Centers of Excellence, to be given special assistance toupgrade faculties and equipment. However, the bulk of the higher education sector is turning outgraduates of variable, rather indifferent, quality.

4.20 Technical education and training for industry also suffers from widespread qualityproblems. In 1992, the Educational Commission found that the technical training system to be ill-managed and under-financed: it had the lowest per capita expenditures in the region (onlyBangladesh was lower). There is a significant mismatch between the skills provided by the systemand those needed by employers, resulting in large numbers of unemployed trainees. Most largemanufacturing firms, especially foreign affiliates, invest significantly in employee training, but todate no systematic survey has been made of industrial training. However, without a comprehensiveand continuous monitoring of industrial training, the government cannot systematically encourage

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it. A government levy to promote employee training (the TESDA FUND) has not yet beenimplemented (as private contributions have not been forthcoming); such levies exist in mostneighboring countries, along with other schemes to encourage firms to invest in upgradingemployee skills. SMEs invest little or nothing in formal training of their workforce, and arelargely unaware of the need for this: special schemes are needed to upgrade their human capital.

Technological Activity and Support

4.21 The technological system in the Philippines is at an early stage of development, making fora striking mismatch between local technological effort and the high-tech structure of exports.Overall levels of R&D are low, especially that financed by enterprises (Table 4.9). The publicsector dominates R&D, with poor quality R&D management and institutions delinked fromproductive activity. While this is also true of some countries in the region (e.g. Indonesia andThailand), it is not typical of the technology-oriented NIEs like Singapore, Korea and Taiwan(China) .

Table 4.9 R&D Employment and Expenditures

R&D Personnel R&D ExpendituresYear Scientists & Engineers in R&D Total R&D as % Productive enterprise

GNP flnancedPer m. pop. Numbers R&D % GNP

Philippines 1992 157 9,960 0.20 0.05Hong Kong (China) 1995 98 574 0.30 0.01Singapore 1995 2,728 7,695 1.10 0.69Korea 1994 2,636 117,486 2.80 2.35Taiwan (China) 1995 3,022 63,457 1.80 0.99Indonesia 1995 0.10 0.08Malaysia 1992 87 1,633 0.40 0.17Thailand 1995 119 6,899 0.10 0.01China 1995 350 422,700 0.50

Source: UNESCO, Statistical Yearbook 1997 and national sources for Taiwan (China).

4.22 Such low technological effort may not matter as long as enterprises can remain competitivewith heavy reliance on imported technologies. This is adequate for export activity when onlysimple assembly is involved and MNC participation ensures the continuous inflow of new know-how and components. However, the lack of local technological effort starts to constraincompetitiveness as wages rise and more complex, value-added activities have to be undertaken.R&D becomes necessary, not to replace imported technologies, but to use them more effectivelyand to go back in the value chain from assembly into design and manufacturing. In Malaysia,electronics MNCs have gradually raised the technological level of activity and several now useR&D by local affiliates to design and develop new versions of mature products (mainly inconsumer products). In both Malaysia and Singapore, much of the enterprise-financed expenditureshown in the table comes from foreign affiliates. Outside MNCs, R&D capability is increasinglyneeded to promote the growth and competitiveness of local suppliers and subcontractors.

4.23 A weak technological support structure, manifested in low public R&D, reduces the abilityof smaller enterprises to innovate and raise productivity. This is why the NIEs invested heavily in

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promoting R&D, both in public institutions and, more importantly, in private industrialenterprises, while encouraging the import of new technology from advanced countries.8 Singapore,a highly MNC-based economy, targeted MNCs for particular activities (most recently, into R&Ditself) and induced existing investors to upgrade their technological levels over time. It providedcomprehensive technical and financial support for local SMEs, an essential means of enablingthem to subcontract to MNCs and so benefit from technological spillovers. Taiwan (China) alsomounted a broad array of technology support measures aimed largely at its SMEs, with publicprovision of technological support and a pro-active system of extension and contract research.

4.24 Philippine policies have neglected private R&D. Its trade and industrial regimes havefailed to foster an autonomous technology culture, and its SME support system is weak. Despite itsambitious Science and Technology Agenda for National Development (STAND), much of theeffort remains on paper. Technology finance is weak and there is little effort to raise an awarenessof the need for technological effort among private enterprises. The Department of Science andTechnology system is large. It encompasses the National Academy of Science and Technology andthe National Research Council, as well as five research Councils. It also contains 7 researchinstitutes-for industrial technology; metal industry; nuclear power; textiles; advanced science andtechnology; food and nutrition; and forest products-and 6 other institutes, for science education,technology information, technology application and promotion, atmospheric geophysics andastronomy, seismology and a science high school. However, its practical relevance for industrialtechnology development is limited. Only 2% of DOST staff in 1995 had doctorates, and another9% masters' level qualifications. Staff are poorly compensated and often tend to be out of touchwith international scientific trends and research being done by counterparts overseas. 9 There hasbeen relatively little direct interaction with, or contract research from, the private industrial sector(the whole system had 23 contract research projects from private industry in 1995). Few of thetechnologies created are in commercial production. R&D into designated 'export winners' has yetto yield tangible benefits, and its focus does not seem directly relevant to areas of dynamiccompetitive advantage to the Philippines.'0 DOST also provides a number of industrial testing andlaboratory services; these account for most of its budget and employment.

4.25 The Bureau of Product Standards provides testing facilities, promotes quality standards,and accredits independent laboratories. It has been promoting the spread of ISO 9000 standards inthe Philippines, but cannot offer any incentives to firms to adopt ISO 9000 standards. This mayhold back the spread of an important competitive tool among smaller local enterprises in thecountry (many countries offer subsidized consultancy services to firms seeking ISO certification).The Bureau has no financial autonomy and its salaries are dictated by government scales. Thismakes it difficult to recruit and retain good technical graduates. Its testing facilities are limited by

8 See Sanjaya Lall, Learning from the Asian Tigers, London: Macmillan, 1996.9 Jose A. Magpantay, 'Streamlining the Science and Technology Sector for the Country's Development Goals',Report to the Department of Budget and Management, Philippines Institute of Development Studies, 1993.10 The major activities under the 'export winners' scheme as of 1995 include glass from processed 'lahar', low-sugar

mango product, bamboo products, human identification systems, waxing technology, para-rubber, stripping machineryand calcinated marble dust.

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its equipment, and many exporters, in particular smaller companies that cannot afford in-housefacilities, have to use expensive tests abroad.

4.26 In general, while the technology system in the Philippines has the necessary ingredientspresent on paper, its effectiveness is poor. There are many institutions with different programs andobjectives, itself a source of weakness. The management and funding system does not conduce toeffective operation or to close linkages with industry. To quote, "Most institutions involved aresignificantly under-funded for the scale of tasks to be accomplished. Many companies complainedof the difficulty and delays involved in obtaining basic services such as equipment calibration ...Most institutions appeared to be taking a passive role in working with firms rather than proactivelyseeking opportunities to initiate upgrading programs. There also appears to be a serious difficultyon the part of the institutions in retaining skilled people because wages are too low.""iGovernment programs to help SME technology suffer from similar problems: they are "toounorganized, weakly motivated, and under-funded, and have too many different objectives,. 12 Thefinancing of SME technology upgrading is a serious problem; technology finance for all sizes ofenterprises is still in its infancy. The technology informnation system is not very helpful to privatefirms who need to locate and buy new technologies from abroad.

Figure 4.2 Hourly Labor Costs in the Apparel Industry (US)

Taiwan

Hong Kong

Singapore

Korea

Costa Rica

Mexico _

Malaysia_

Domin. Rep. _ =

El Salvador _

Guatemala 1o1990|Thailand 0 S u l 21995

Philippines

Sri Lanka_

Indonesia

Vietnam

Pakistan

India

China

Bangladesh _

0.0 1.0 2.0 3.0 4.0 5.0 6.0

"Foreign Investment Advisory Service, The Philippines: Promoting Backward Linkages: A Pilot Program for theElectrical Appliance and Electronics Industry, World Bank, 1995, p. 16.

12 Ibid. p. 19.

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Garments

4.27 Philippines has no comparative advantage in low-wage garment exports. Its labor costs areconsiderably higher than China or South Asian exporters (Figure 4.2), though they are still belowthose in ASEAN competitors like Malaysia and Thailand. The cost of semi-skilled labor is mostimportant at the low quality, mass-produced end of the garment industry; as wages rise they haveto be offset by improvements in quality, productivity and flexibility. Philippine wages are lowerthan in Malaysia and Thailand, but these countries have expanded their garment exports faster.China has about the same hourly wages as India and Pakistan but its exports have grown overtwice as fast. Latin American exporters have considerably higher wages but their competitiveposition has been transformed by the entry of US producers and their privileged access to the USmarket. Italy remains one of the world's leading clothing exporters despite very high wages ($14per hour in 1996). Other factors explain the evolution of competitiveness in this industry.

4.28 Market access, the operations of multinational producers, and the allocation of quotasunder the MFA are significant influences on the pattern of garment exports. In Asia, the exportthrust has come mainly from local (and regional) firms, while in Latin America foreign(particularly US) affiliates have been predominant. The MFA has long dictated the location ofgarment exports, and has sheltered many quota holders from the full force of competition. Itsabolition by 2005 will lead to a massive 'shake-out' in all exporting countries. The OECD markethas been moving to higher quality products, where the cost of labor per se counts for less. Wageswill remain the overwhelming consideration for the slowly diminishing segment of the lowestquality products. In others, technology, specialization, design, marketing and flexibility will be thedominant competitive factors. The future of Philippine clothing exports will depend on qualityupgrading. This will depend in turn on the use of new technologies, better access to the bestfabrics and other inputs (a strong domestic textile, dyes and accessories industry), advancedtechnical, management, design and marketing skills, and timely delivery and flexibility. Highdegrees of vertical integration, needed in the past to ensure reliable quality and delivery, will beless of an advantage: higher quality products tend to require smaller firms and greater inter-firmspecialization and subcontracting.

4.29 The garment industry has reasonable human capital, especially in fine embroidery(important for infant wear and certain dresses where the Philippines has a leading position in USmarkets). However, it is weak in several specialized technical skills (pattem making, draping anddesign). Worker productivity is variable, but there have been few attempts to raise productivity bybenchmarking. Small producers are the furthest behind world 'best practice', but several largeproducers have also not introduced appropriate process and quality management techniques. As faras equip-ment is concerned, investments and FDI in the industry have fallen behind those in otherindustries. Imports of textile machinery grew at 6% per annum during 1990-95 as compared to thegrowth of total machinery imports of 23% (and of electrical machinery by 24%) per annum.Investment in clothing fell from 6% of total investment in the Philippines in 1987 to 0.09% by1995; foreign investments in the industry fell from 7% (of total foreign investments) to 0.11%

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over this period.'3 Some large exporters have invested in CAD/CAM equipment, containerizationof shipments and advanced process systems, and so improved their quality and turnaround times.However, the bulk of the industry remains uncompetitive by best practice standards.

4.30 Design capabilities in the Philippines clothing industry, while growing, remain weak.Existing design schools are inadequate and firms often hire expensive foreign designers. Designweaknesses hold back quality upgrading, since producers are unable to offer buyers their owncollections and find it more difficult to 'shop around' for different, more rewarding, markets.Delivery times by Philippine exporters are variable: good firms can deliver products to the EC in30-40 days, but most need 60 days for repeat orders. While this is better than the regional average(for South Asia, China, Indonesia or Thailand) of 90 days, it does not match East Europe orTurkey's 21-40 days, or West Europe's 14-28 days. In terms of quality as shown by average unitprice, Philippine garments fetch lower prices than those from Hong Kong, Korea, Malaysia, India,China, Thailand, Indonesia, Mexico or Turkey. The industry suffers from weaknesses in theupstream local textile industry, which has poor dyeing and finishing capabilities. This forcesgarment producers to rely heavily upon imports, often adding to their lead times. Moreover, therehas been a decline of textile production, possibly weakening the downstream industry: arestructuring and upgrading of the textile industry would greatly help the competitive position ofclothing exporters. The recent growth in textile exports is encouraging, though these may be fromplants that do not serve local garment producers.

4.31 Subcontracting is widely used in the Philippines. It involves large firms 'putting out' theassembly of garments to small assemblers rather than the specialized, integrated fashionproduction characteristic of advanced producers (as in the 'industrial districts' of North Italy).Filipino subcontractors tend to remain in low-skill, low value activities and there is a risk that theywill suffer as the MFA goes and competition intensifies. These firms find the greatest difficulty infinding the financial, human and technological resources to improve their technology. It isimportant to strengthen their competitive base at all levels: improving training facilities foroperatives; creating and improving training facilities for garment design, pattern making, drapingand other advanced skills; benchmarking technical efficiency; assisting firms with productivity-raising measures and in-house training; improving the competitive position of the upstream textileindustry; and encouraging the formation of specialized 'clusters' where firms share facilities,information, technology and skills.

Electronics

4.32 The main weaknesses arise from the low technological and local content levels inelectronics production in the Philippines. Much of the activity in MNC affiliates is still at thesimple assembly and testing level (despite the fact that a few MNCs are using local engineers formore advanced activities). This may not constrain exports for the time being, but the capabilitiesdeveloped for low level assembly may not automatically grow into those needed for moreadvanced products and processes. Yet these advanced technologies will be increasingly needed ifgrowth is to be sustained in the future. Semiconductor technologies are subject to rapid change,and without a flexible and advanced base the Philippines may not be able to compete with lower

13 M. S. Austria, The Effects of the MFA Phase Out on the Philippine Garments and Textiles Industries, PhilippineInstitute for Development Studies, Manila, 1996, Discussion Paper Series No. 96-07.

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cost competitors. There is also the possibility that new technologies will not be sensitive to laborcosts, but seek locations that offer advanced production, design and supply capabilities despitehigher wages.

4.33 Low local value added in the Philippines is another reflection of its weak technologicalcapabilities. Average local content is only 20% in semiconductors. It is higher, 25%, in simpleitems like printed circuit boards and lower, 10-15%, in complex products like microprocessors(made by companies like Intel), below the average levels reached in Malaysia (around 45%) andTaiwan (China) (75%). However, a rough indicator of local content (exports divided by imports)suggests that it has been growing over time (Table 2. 10). However, this is a very rough indicator -it is possible that many exports and imports are unrelated to each other. It is widely acknowledgedthat local supplier capabilities (especially among SMEs) are weak; they need to be strengthened iflocal content is to keep rising. There are practically no local producers with the capability to takeon 'original equipment manufacture' (OEM), which was one of the main arrangements used byfirms in Korea and Taiwan (China) to access new technologies and export advanced electronicsproducts.

Table 4.10 Exports as Percentage of Imports in Philippine Electronics Industry

Products 1991 1992 1993 1994 1995 1996 AverageSemi-conductor devices 106.0 105.0 108.5 104.1 124.2 131.6 117.9Electrical machinery 11.0 11.3 13.5 20.1 21.5 14.8 16.2Telecom/sound apparatus 70.9 71.3 67.1 58.6 48.5 48.7 55.8Office, data processing mach. 77.9 54.9 85.5 75.0 89.1 105.7 86.9Consumer electronics 251.9 290.8 232.0 214.3 163.3 177.6 200.3

Audio visual products 319.3 367.2 309.0 263.4 205.3 261.9 262.2Household appliances 112.6 171.8 92.0 90.7 57.8 48.5 76.1Other consumer 150.0 48.5 113.5 151.4 101.6 130.0 113.6productsTotal 87.6 82.8 86.6 85.9 98.3 102.3 93.7

Source: DTI data

D. IMPLICATIONS

4.34 The most important export issue facing the Philippines in the present context is whether theboom in electronics exports will be short lived or sustainable in the medium term. However, thereare other important, longer-term, strategic issues related to export competitiveness: theoverwhelming dependence on one activity is risky; labor-intensive exports show disturbing signsof declining competitiveness; and institutional support for the upgrading of enterprise capabilitiesremains inadequate.

4.35 It is not possible to give an unequivocal answer to the issue of electronics exportsustainability. The critical factor is the international sourcing pattern of leading US and Japanesemultinationals, and these are based on economic as well as other factors (including corporatestrategies). It is not immediately obvious why there has been a regional shift in sourcing ofsemiconductors towards the Philippines from traditional centers like Malaysia. The maineconomic advantage of the Philippines appears to lie in its relatively cheap and plentiful technical

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labor, but it has to be established whether this is the driving force behind recent FDI and sourcingpatterns. If it is, the Philippine advantage is a genuine one and all efforts should be made tomaintain and improve it. If it is not, and the sourcing simply reflects the timing of newinvestments, the boom may fade as new plants approach full capacity.

4.36 It is imperative for the Philippines to strengthen its competitiveness in other activities. Notonly is it necessary to diversify the export base (and so reduce the risk inherent in the present levelof product concentration), it is inappropriate for labor-intensive exports to lose their internationaledge at this stage of development. To revive their competitiveness, the Philippines needs toformulate and implement strategies aimed specifically at skill, technology and marketingweaknesses in a range of manufacturing activities. The government appears fully aware of theseneeds, and has mounted a comprehensive response-unfortunately, much of this remains on paper.There are widespread institutional weaknesses in the major support institutions that need to betackled, backed by efforts to benchmark and raise enterprise level productivity.

4.37 While the Philippines' most valuable resource is its human resources, it needs to undertakesweeping improvements at all stages of the education and training system. Quality, relevance andcompletion rates need to be raised, the length of schooling brought into line with internationalnorms, and access among the poorer sections of the population improved. The quality of highereducation institutions is highly variable and there are few centers of excellence by internationalstandards: a broad improvement of teaching standards and equipment is needed to create the highlevel technical and management skills that competitiveness will require. Employee training byfirms is undertaken mainly by large firms, but smaller firms invest little in upgrading skills ofworkers. There are no studies of how much training is being provided and by whom, so thatappropriate policies cannot be undertaken.

4.38 The technology support system has all the necessary elements but lacks implementationand coherence. There is no systematic analysis of the technological needs of the country and howto achieve them: current plans are too broad and general. The private sector invests little intechnology development, and there is no program to stimulate technological activity in industry.There is a need for a 'technology foresight' exercise of the type being undertaken in most OECDcountries to involve industry, technology institutions and academia in evaluating the most pressingtechnological needs facing the Philippines. This would involve all concerned sections of thepopulation in understanding the implications of technological change and gearing up to meetevolving needs effectively.

4.39 The technology infrastructure is not able to provide effective support to private industry.Its salary structures and management are not conducive to actively seeking out and helpingenterprises with technical problems and upgrading. There is too much attention to routine testingand laboratory services, which could be placed in the private sector, and not enough to true publicservices like basic or contract research, information collection and dissemination, and extensionservices to SMEs. The large number of institutions in place may need to be rationalized and betterstructured and funded. A thorough analysis needs to be carried out of DOST's functions, structureand management, and measures undertaken to link it more tightly to the productive structure. Moregenerally, there is a need for launching consultancy and productivity raising measures for industry,using benchmarking techniques and drawing upon the experience of countries like Taiwan (China)that cater to large numbers of export-oriented SMEs.

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4.40 Finally, the specific needs of the major export industries have to be addressed. Theelectronics industry is growing rapidly but not deepening sufficiently. The garment industry isfalling behind relative to both higher and lower wage competitors, and needs to upgrade itsproduct range and quality. Strategies for restructuring and upgrading may be needed for these andother important activities. These are not being devised adequately by the EDC but there is noother institution present charged with this function. Industry associations themselves do notconduct the kind of analytical work needed to influence policies on competitiveness: catalyzingsuch work may be fruitful.

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5. ECONOMIC SLOWDOWN AND THE POOR

5.1 The Philippines was less successful than its faster growing neighbors in reducingpoverty during the decades prior to the current crisis, but the initial impact on the poor ofthe current slowdown appears to have been less adverse than in neighboring countries.This chapter reviews trends in poverty and inequality prior to the slowdown, assesses theimpact of the slowdown on the poor (to the extent possible with available information),and outlines the priorities for social protection to deal with the possibility of greaterhardship to come. A more extensive assessment of the impact of the crisis on the poor isplanned. once the results of the just completed 1998 household survey become available.

A. PROGRESS TILL 1997: DECLINING POVERTY BUT URBAN BIASED

5.2 The proportion of households living below the poverty line declined during the1990s. This ratio fell from 40% in 1991 to 32% in 1997 (Table 5.1). A similar trend isevident in the proportion of the population below the poverty line.

Table 5.1 Indicators of Poverty Incidence

Total Urban Rural

Indicator 1991 1994 1997 1991 1994 1997 1991 1994 1997% of 39.9 35.5 32.1 31.1 24.0 18.5 48.6 47.0 44.4Families% of 45.3 40.6 37.5 35.6 28.0 22.5 55.1 53.1 51.2population

Source: Family Income and Expenditure Surveys, 1991, 1994,1997. Data for 1997 are preliminary.

5.3 Most of this decline was in the urban areas, where the ratio of poor people in thepopulation declined sharply from 35.6% in 1991 to 22.5%. In rural areas, there was onlya small decline. Indeed, while there was an absolute decline in the number of peopleliving in poverty in urban areas, particularly outside Manila-from 11 million in 1991 to7.8 million in 1997, the number of poor people in rural areas increased (Table 5.2).

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Table 5.2 Number of Poor People (million)

Total Urban Rural

Region 1991 1994 1997 1991 1994 1997 1991 1994 1997

Philippines 28.1. 27.3 27.3 11.0 9.4 7.8 17.1 17.9 19.5NCR 1.4 1.0 1.0 1.4 1.0 1.0AONCR 26.7 26.3 26.3 9.6 8.4 6.8 17.1 17.9 19.5

Source: As in Table 5.1.

5.4 How does this pattern of poverty reduction compare with that of other countries inthe region? Table 5.3 provides an international comparison for the decade 1985-95. Inorder to eliminate differences in measurement that occur because countries definepoverty lines differently, a uniform poverty line of $1 per capita per day has been appliedto expenditure data for all the countries listed in this table. As can be seen, povertyreduction in Philippines has been impressive, but less so than many of the other countriesin the region, primarily reflecting lower growth in the Philippines. This is particularlyevident in the first two columns: every country in the region except the Philippinesmanaged to reduce the absolute number of people living in poverty. The data in Table5.3 suggest that the number of poor began to decline in the 1990s, but this reduction waslimited to the urban areas.

Table 5.3 Poverty in East Asia, Summary Statistics: 1975-95

Number ofpeople in poverty Head-count index (percent) Poverty gap' (percent)(million)

1975 1985 1995 1975 1985 1995 1975 1985 1995East Asiaa 716.8 524.2 345.7 57.6 37.3 21.2 n.a. 10.9 6.4East Asia 147.9 125.9 76.4 51.4 35.6 18.2 n.a. 11.1 4.6(exc.China)Malaysia 2.1 1.7 0.9 17.4 10.8 4.3 5.4 2.5 <1.0Thailand 3.4 5.1 <0.5 8.1 10.0 <1.0 1.2 1.5 <1.0Indonesia 87.2 52.8 21.9 64.3 32.2 11.4 23.7 8.5 1.7China 5 6 8 .9 b 398.3 269.3 59.5b 37.9 22.2 n.a. 10.9 7.0Philippines 15.4 17.7 17.6 35.7 32.4 25.5 10.6 9.2 6.5Papua n.a. 0.5 l0c n.a. 15.7 21.7c n.a. 3.7 5.6cNewGuineaLao PDRd n.a. 2.2 2.0 n.a. 61.1 41.4 n.a. 18.0 9.5Vietnam n.a. 44.3e 31.3 n.a. 74.Oe 42.2 n.a. 28.0 11.9Mongolia n.a. 1.6 1.9 n.a. 85.0 81.4 n.a. 42.5 38.6n.a.: not available.Notes; All numbers in this table (except for Lao's People's Democratic Republic) are based on theinternational poverty line of US$1-a day per person at 1985 prices.a. Includes only those countries presented in the table.b. Data relates to 1978 and applies to rural China only (World Bank 1996d).c. Data relates to 1996.d. Available data on PPP exchange rates and a various price deflators for Lao People's DemocraticRepublic (LAO PDR) are not very reliable and lead to anomalous results. The poverty numbers for LaoPDR in this table are based on a national poverty line which is based on the level of food consumption thatyields an energy level of 2,100 calories per person per day and a non-food component equivalent to thevalue of non-food spending by households which are just capable of meeting their food requirements. The

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US$1-a-day poverty line is based on characteristic poverty lines in low income countries that havecomparable basis in food and non-food consumption needs; the poverty numbers for Lao PDR are,therefore not strictly comparable to those for other countries.e. The figures refer to 1984. "Household Welfare in Vietnam's transition" in Macroeconomic Reform andPoverty Reduction, edited by D. Dollar, J. Litvack, and P. Glewwe. World Bank Regional and SectoralStudy, 1998.

Source: Everyone's Miracle?, World Bank, 1997.

Increased Income Inequality

5.5 The mid-1990s witnessed a significant increase in income inequality with the ginicoefficient increasing from 0.45 to 0.5 in three years (Table 5.5). There are severalfactors underlying this increase. First, the data indicate that only the top decile increasedits share of total income and the first to ninth deciles lost income shares. In other words,the incomes of the richest ten percent of the population grew faster than the incomes ofthe rest of the population. Second, "core" poverty in rural areas appear to have beenlargely untouched. Six rural regions of the country accounted for about 60% of ruralpoverty in 1991, and had poverty incidence ratios well above the national average, i.e., inthe range of 50% to 60%. Except for S. Tagalog (which has developed strong links toManila), these regions have seen little or no improvement in the incidence of poverty(Table 5.4). In one case, there has been a reversal of the improvement achieved during1991-94.

Table 5.4 Persistent Poverty in Certain Rural Regions

Percentage of Poor

Region 1991 1994 1997S. Tagalog 52.5 46.9 42.1

Bicol 60.0 66.9 63.0

W. Visayas 60.3 58.8 57.4

C. Visayas 58.3 43.9 53.6

N. Mindanao 64.3 62.0 61.9

S. Mindanao 55.9 57.0 52.1

Source: As in Table 5.1

5.6 Third, urban-rural differences in standard of living have widened (Table 5.5). Inthe past, location, i.e. whether a person was living in urban or rural areas, did notcontribute significantly to overall inequality (Balisacan 1997)-this factor accounted forabout 20% of total inequality. A more important factor was the level of educationalattainnment, which accounted for about a third of inequality. But the sharp increase in theratio of average family income in urban areas to that of rural areas suggests that at leastbetween 1994-97, the increase in the gini coefficient may be attributable to the increasein rural/urban income inequality, although this needs to be verified with further analysis.Thus while industrialization and urbanization may well have contributed to a decline inpoverty, they may also have contributed to increased inequality.

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Table 5.5 Indicators of Income Inequality

Indicator 1988 1991 1994 1997Ratio of Average Urban to Rural 2.1 2.2 2.1 2.44IncomeGini coefficient of income 0.44 0.47 0.45 0.50

Source: As in Table 5.1

Social Indicators: Some Progress

5.7 The Philippines achieved near universal primary education enrollment by 1970and by 1995, the net secondary enrollment rate had increased to 62.3% from less than50% in 1980. Infant mortality is currently about 44 per 1,000 live births; the under-5mortality rate in 1995 was 67. Educational achievements at the secondary and tertiarylevel are second only to Korea, although there is evidence that the quality of educationhas declined-only two thirds of Filipino children who enter first grade complete theentire elementary cycle, compared to 97% of Korean children. The national average,furthermore, masks wide variations between urban and rural areas: completion ratesrange from nearly 87% in Manila (in 1995) to barely 30% in the poorest provinces. Childhealth indicators are ahead of Indonesia, but behind those achieved in Thailand andMalaysia. In particular, there are large provincial differences in health status, and aresurgence of some serious diseases, notably tuberculosis.

B. THE ECONOMIC CRisIs: RELATIVELY LITTLE IMPACT SO FAR

5.8 The recent slowdown in economic activity and uncertain prospects for robustrecovery indicate that the relatively favorable poverty trends in the nineties could beadversely affected. However, several factors have combined to limit the initial damage.First, private consumption held up strongly through much of 1998, with per capitaconsumption growing by 1.3%. In the absence of household expenditure survey data, itis impossible to say whether the growth in consumption reflects on the welfare of thepoor or the better-off. But households tended to protect expenditure on basic necessitiesand forego spending on durable and luxury related expenditures. This would suggest thatexpenditure cuts were proportionately larger among the middle-class and wealthy,whereas the poor and near-poor were better able to maintain basic expenditure.Continued growth of worker remittances may have helped to maintain such consumption.Finally, while the sharp fall in agricultural output in the first half of 1998 and typhoonrelated damage in the fourth quarter have hurt the rural poor, agricultural recovery to amore normal year in 1999 would be ameliorative.

But Signs of Hard Times Ahead?

5.9 Nevertheless, the crisis may have a stronger impact over time. While the rainshave come in abundance now, a prolonged rainy season could adversely impact crops inparts of the country. And a sustained recovery in non-agricultural GDP is not assured:

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data through end-1998 point to continued weakness in the industrial sector includingmanufacturing and construction. As manufacturing output declined in the second quarter,the expansion of non-farm employment came to a stop; in the third quarter it actuallydeclined. And the rate of open unemployment increased to 10.1% in 1998, from 8.7% ayear earlier. The annual round of wage adjustment implemented in February 1998remained moderate, and, as it turned out, below inflation. The real minimum wagetherefore adjusted to the deteriorating labor market situation, and labor absorbeddownward adjustments in real income. Informal sector real wages are therefore alsolikely to have declined. (These adjustments however followed significant real wageincreases in 1997.)

5.10 While one cannot be precise about the intensity with which these factors will playout, it would be prudent to prepare for the contingency of further deterioration in theirimpact on the poor. In the Philippines, as in other countries of the region, a large numberof people are living just above the poverty line-the so-called near-poor. It would take arelatively small decline in their income to push them into poverty.

C. A STRATEGY FOR SOCIAL PROTECTION

5.11 How best to prepare for the possibility of greater hardship in the coming year?Perhaps the most distressing part of the experience of other countries in the region, whichhave by now experienced a year or more of severe recession, is that they were caught off-guard, both in terms of not knowing who was affected most, and in terms of not havingsuitable safety net programs on the shelf. In the event, Thailand, Indonesia and Koreahurriedly put in place programs of social protection and safety nets which includedexisting programs extended to cover the vulnerable population, and, a few new programs.The Philippines can take advantage of the experience of these countries by identifyingthose policies and programs that are likely to be most effective from its existing portfolio,and plan to expand them as needed.

5.12 Needless to say, the Department of Social Welfare and Development (DSWD)including the Comprehensive and Integrated Delivery of Social Services (CIDSS) shouldform the front-line to shield the most vulnerable groups from social hardship. The mostdisadvantaged groups such as poor women, the elderly without support, abandonedchildren and adults who are unable to work are DSWD's primary targets and willcontinue to need assistance. But there would be a new group of poor as a result of anintensified crisis, i.e. people who have become newly disadvantaged. Further, there areother instruments as well such as food policies and human capital spending that need tobe considered as indicated below. In terms of monitoring the situation, the just-completed Annual Poverty Indicators Survey (APIS) should provide the Governmentwith critical information.

5.13 What are the broad principles which might guide the selection of social protectionprograms and policies? Before discussing these issues, it may be useful to address theextent to which private transfers can provide an adequate safety net in the Philippines.Foreign and domestic transfers together account for about 10% of household income.However, international transfers tend to accrue to the upper income deciles, and to the

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urban and more developed areas (with the exception of Illocos, a poor region).' If theeconomic crisis results in higher unemployment and lower real wages of the better-off,then international remittances can indeed be expected to provide a cushion, as theyalready have. Domestic transfers on the other hand, are more biased towards the poor.Research conducted on data from other countries however indicates that in times ofwidespread economic slowdown, private domestic transfers tend to shrink as all segmentsof the population, including the providers, are affected.

Improving Food Price Affordability for the Poor

5.14 A participatory study on the socioeconomic impact of the financial crisis as ofFebruary 1998 found that in many localities people were facing much higher prices forfood long before this could be detected in official statistics (reflecting the early impact ofEl Nino). It is therefore important to monitor the food situation carefully, in view of theof La Nina's potential impact. The poor spend a larger portion of their income on foodthan do the non-poor. The bottom 25% of the population spends, for example, 21% of itsincome on rice and another 8% on corn and other cereals. The top 25% of the populationspends only 5% of its income on rice and 3% on corn and other cereals. In relative terms,therefore, a given increase in the price of basic foods, particularly rice, would reduce thereal income of the poor more in percentage terms. The groups that are likely to be mostaffected by sharp increases in the price of food are the urban poor and near-poor, and,the asset-less poor in rural areas, i.e. landless laborers, fishermen and forestry workers inrural areas.

5.15 In the long-term, the interests of the poor would be best served through a system ofliberalized rice imports-i.e., replacement of the quantitative restriction on rice with amoderate tariff, coupled with adequate government stockpiling and effective targetingtowards the poor. This is the case since domestic rice prices have historically beensignificantly higher than international prices.

5.16 It is however recognized that shifting to such a policy may not be feasibleimmediately-more work may be needed on alleviating transition costs. In the shortterm, therefore, the primary food policy instrument in the Philippines remains the pricestabilization carried out by the National Food Authority (NFA). By selling rice at lower-than-market price, the NFA is expected to moderate domestic price increases. During1998, the NFA succeeded in moderating the increase in rice prices caused by El Ninothrough the distribution of large imports (1.6 million tons). If the financial crisisintensifies, and concurrently, the impact of La Nina is severe, it may become necessarynot only to import and distribute more rice than normnal, but also to target the rice to thepoor, including those who have newly become poor. Geographical targeting, income-based targeting of food coupons, as well as targeting by subsidizing the lower qualities ofrice, are all options to be considered. Administering a more targeted food distributionsystem to replace the current costly and poorly targeted system, however, requires anenhanced ability to identify the poor and their location.

1 Based on 1991 data. See World Bank (1996), Philippines: A Strategy to Fight Poverty.

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Maintaining Purchasing Power of Poor Households

5.17 Labor intensive public works programs can create productive assets and transferincome to the poor if designed well. Many of the countries in crisis today areimplementing employment programs as a safety net measure. The Philippines has morethan two decades of experience with labor-based works programs, including theCommunity Employment and Development Program which operated during 1986-87, theKabuhayan 2000, and more recently, several employment programs of the DSWD. Butthere is little evaluation of this experience in terns of cost effectiveness and whether theyactually reach the poor. For employment programs to work as a safety net, the wage rateshould be set below the market rate so that workers are not attracted out of otherproductive activities. They should have a high labor content and be situated in areasexperiencing stress. The last issue, i.e. location of the programs will be quite critical. Ifthe crisis intensifies in the non-agricultural sectors, the immediate and the largest impacton incomes will be mainly in urban areas, as appears to be the case in Indonesia and inThailand. The latest LFS data seems to indicate that this might be the case in Philippinesas well-the NCR registered an unemployment rate of 15. 1% in October 1998. If on theother hand, the effects of La Nina are significant, then there would be need for locatingsuch programs in affected rural areas as well.

Maintaining Public Expenditures for Health and Education

5.18 A sharp fall in income not only affects current consumption but also futureincome earning capacity by impeding the education and harming the health of thoseaffected. Since the decision to drop out of school is nearly always permanent, a newgeneration of under-educated adults may well result. Much the same applies to basichealth-if primary care, including public health interventions are underfunded, there is along-lasting effect on the quality of human capital.

5.19 There seems to be full awareness of this in the Government. Despite the initialcut of 25% of the 1998 appropriation, the social sectors were comparatively protected:the share of social services in National Government expenditure is expected to rise to42% in 1998 from 39% in 1997 and 32% earlier in the decade. This trend shouldcontinue in the 1999 budget, with particular emphasis on protecting certain programs. Ineducation, there has been a delay in placing textbook orders, which should beimmediately remedied, and the textbook appropriation in the 1999 budget should beincreased. The school construction program should be put back on track. In the healthsector, the decrease in the coverage of public health programs (malaria control,shistosomaisis, and TB control), and immunization programs should be reversed. At thesame time, it is equally important to restrain expenditures in certain areas. Any newhiring of teachers should be put off until all possibilities for teacher redeployment areexhausted. All new funding for state universities should be vetoed, and an immediatereview of policies regarding State Universities and Colleges and the poorly targetedscholarship program Government Assistance to Students and Teachers in PrivateEducation (GASTPE) should be reviewed. The re-nationalization of two devolvedhospitals and upgrading of five others should be cancelled and the resources reallocatedto primary health programs.

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Livelihood/Microfinance Programs

5.20 Public resources being scarce, other instruments will also need to be relied uponto reach out to the poor. Microfinance can be one of them. Microfinance programs thathave the greatest outreach and that reach the poorest segments of the population tend tobe those that are neither administered by, capitalized by, nor otherwise controlled bygovernments. But in the Philippines, there are over 100 credit programs (livelihoodprograms) run by the Government, providing credit at extremely low interest rates so thatrecipients consider them one-time grants, resulting in a high default rate. Only a few areknown to reach the poor and the ultra -poor, the DSWD's Self-Employment AssistanceProgram, and the Grameen Bank replication program run by the Department ofAgriculture. Even these have problems: in the forner, loan size is too small, and loansare often viewed as grants; in the latter, costs are very high. At the same time, a fewNGOs have successfully run micro-credit programs, although their outreach is quitesmall. The Government therefore needs to evaluate which programs are most efficient atreaching the poor, and how they may be expanded.

Monitoring the Crisis

5.21 The Philippines is ahead of the other countries in the region in that it has alreadyfielded a national survey-the APIS-to capture the impact of the crisis on households.The need for quickly analyzing the APIS and FIES 97 data, as soon as they becomeavailable in January 1999, cannot be overemphasized. Such analysis will provide theGovernment and the donor community with the first really sound evidence on the extentof the impact, the characteristics of the households affected, their location and othercharacteristics, and even some data on the coping mechanisms they are using (specialquestions were built into the APIS questionnaire for this purpose). Complementary datawill also be available from the regular labor force surveys. If the analysis of these twosources reveals the need for more detailed investigation into certain groups or areas,further work will need to be undertaken, including participatory assessments.

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6. ENVIRONMENTAL CHALLENGES AND STRATEGY

A. INTRODUCTION

6.1 The Philippines faces two broad environmental challenges as it strives forsustainable development. The first is to reduce the negative public health, ecological andaesthetic effects associated with industrial and domestic air and water pollution. Thesecond is to reverse the rate of natural resource degradation associated with unsustainableexploitation and conversion of forests and other biologically sensitive areas foragricultural, industrial, infrastructure and settlement purposes. While each of theseproblem areas are confronted by a range of distinctive issues, efforts to address themshare common policy and institutional constraints.

6.2 The driving forces of environmental problems in the Philippines include rapidpopulation growth, high levels of poverty, fiscal and macroeconomic policies whichcreate disincentives for sustainable environmental management, lack of secure land andresource tenure, and inadequate environmental safeguards and enforcement tools.Environmental problems in the Philippines have a social dimension as it is often the poorwho are more adversely affected by environmental degradation. Reducing the effect ofthese underlying causes requires a multi-dimensional approach. The principalcomponents of such an approach include: the continual evolution and refinement of theregulatory and legislative framework; the use of alternative market-based mechanisms toencourage private investment in environmental protection; greater reliance oncommunities in formulation of local level environmental initiatives; and theestablishment of an effective system of environmental governance.

6.3 The Government recognizes the economic, social and ecological importance ofmanaging its water, air and natural resources, but faces a deep legacy of poorenvironmental decisions to overcome. The nation has embarked upon a number ofambitious initiatives and has aggressively developed national legislation to back up itspolicy goals. Environmental priorities are most clearly stated in the landmark publicationPhilippines Agenda 21 (PA 21), which describes the main thematic priorities andidentifies specific regional priorities as well. The document is significant because it hasbeen endorsed at the highest level of government and represents the outcome of a highlyparticipatory process.

6.4 The following sections, provide an overview of the Philippines' major urban andnatural resource based sources of environmental degradation, assess the impact of theeconomic crisis on the environment, and examine implications and policy priorities inlight of current institutional weaknesses.

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B. SOURCES OF ENVIRONMENTAL DEGRADATION

Urban Air and Water Pollution

6.5 Poor air quality is an important problem primarily in Metro Manila. The mostsignificant air pollution problems are suspended particulate matter and lead. The problemis most acute in Metro Manila where measurements of Total Suspended Particles (TSP)and PM-10 frequently exceed relevant national air quality standards as well as WHOguidelines. The main source of air pollution is from vehicles followed by power plants,both small and large scale manufacturing facilities, and burning of garbage. One of thelargest contributions of particulate emissions comes from the resuspension fromroadways and construction sites as well as cornbustion of diesel fuel. The sole source oflead emissions comes from combustion of leaded gasoline., Numerous factors contributeto the growing transport related pollution levels. These include the rapid increase in thenumber of vehicles; lack of adequate road capacity leading to congestion; lack ofalternative public transportation; and low fuel prices.

6.6 Power generation is a source of other important air pollutants such as CO, NOx,and SO2. Power generation contributes approximately 85% of the total SO2 and about15% of the NOx but less than 5% of TSP and 10% of PMIO. Industrial facilities arerelatively smaller but nonetheless important sources of air pollution. According to dataavailable from the DENR-NCR, the main polluting industries include textile mills (S02);food and related products manufacturing (S02); paper and related products (PM);petroleum and coal products (PM); and fabricated metals (PM).

6.7 The economic impact of air pollution include adverse health effects, increasedhealth costs and lost worker productivity due to illness, physical damage to habitat anddeterioration of buildings and other structures. In 1995, dose-response equations used forvaluing health impacts revealed that PM-10 was estimated to cause 1,545 excess deathsannually and 41.8 million respiratory symptom days at a total cost of 5,373 million pesos.There is no reason to suspect that these numbers have been reduced significantly sincethat work was carried out.

6.8 The major sources of water pollution are waste from domestic and industrialsources. Many rivers, lakes and coastal areas are already polluted to levels that posesignificant public health and ecological risk. The impacts of water pollution has been feltmost acutely in urban areas that have high concentrations of domestic and industrialwastewater sources. This is exacerbated by inadequate investment in sewerage andwastewater treatment infrastructure. Most water bodies are recipients of substantialamounts of non-point source surface runoff containing sediment from eroded uplandareas, nitrogen and other agricultural chemicals. Suspended sediments in water bodies-

A recent executive order bans leaded gasoline in Metro Manila in 2000 and in the rest of the countryin 200 1.

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resulting from soil erosion associated with uncontrolled land development, poor roadconstruction and natural disasters-are also important pollutants in some areas.

6.9 Solid Waste Management in the Philippines is also seriously deficient. With fewalternatives available, garbage is routinely dumped in the streets, waterways or vacantareas. Inadequate waste disposal infrastructure and weak institutions contribute toineffective solid waste management programs. It is estimated that less than 15% of thenation's daily waste generated is disposed of in an appropriate manner. Rapid urbangrowth in the absence of upgrading of current waste collection systems indicates thatmuch of the incremental growth in solid waste generation will go uncollected.

6.10 Urban based pollution has been poorly managed and the situation is getting worse.In the medium term, GOP needs to formulate a comprehensive, multi-sector approach.Improvements to air quality could be achieved through a variety of inter-related measuresincluding: improvements in fuel quality (especially diesel); improved inspection andmaintenance of vehicles; improved vehicle emissions standards, technologicalimprovements in emission controls; incentives for fuel switching; traffic management;more effective provision of public transport; and awareness raising. According to theURBAIR report of 1996, the benefits of such measures are substantial, and generallyoutweigh the costs. In the short term, GOP needs to recognize two key issues requiringurgent policy intervention: (i) establishing robust financing mechanisms involving a mixof grants and loans for waste disposal; and (ii) establishing incentives for LGUs to investin environmental improvement facilities.

6.11 Some possible solutions appear well understood but practical action is technicallyor politically difficult. Regarding fuel pricing, for example, the URBAIR report (the lastmajor piece of Bank strategic work on air quality management) recommended thatgovernment support cleaner fuels. Specifically, this means that the subsidy for diesel fuelmust be reduced in order to narrow the existing pricing differential between gasoline anddiesel. Establishing a system of tradable pollution permits may be a feasible approach,but can only be effectively implemented if the receiving ecosystem is already wellstudied. The carrying capacity of a given air shed or water body must be wellunderstood. This is not yet realistic in the Philippines since this condition does not yetexist and monitoring data are not reliable.

6.12 Financed with ADB support, the DENR has embarked upon a major new airquality improvement program (AQAP). The objective of this program is to reduce thelevel of air pollution in Metro Manila from both point and mobile sources. Air pollutionreductions will be addressed through several mechanisms. These include: strengtheningthe capability of the DENR in air quality monitoring; strengthening MMDA in trafficmanagement and enforcement; providing a window with the Land Bank where privatefirms can borrow money for air pollution control devices or for cleaner technologies;assisting the LTO and strengthening its capability to bid, monitor and supervise privatecontractors who will invest in accredited MVIS. The project will also look into cleaner

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fuels with the DOE as well as health impacts of air pollution with the DOH and willinclude a major component to enhance public awareness.

Natural Resource Degradation

6.13 A second important set of environmental problems facing the Philippines relatesto natural resource degradation, which is a long-tern problem threatening thesustainability of agricultural, fishery and forest based production. Degradation hasalready undermined the long-term value of forest resources and has reduced the value ofthe Philippines' biological heritage for both present and future generations. As with urbanpollution, it is the poor who suffer disproportionately from declining productivity offorests, soils, and fisheries.

6.14 Actual forest cover is estimated to fallen to 18%, at least half of which isestimated to consist of degraded forest. The biological diversity of the Philippines is stillrich but is threatened by severely denuded natural vegetation, weakness of existingprotected areas system, population pressure and weak law enforcement. The present rateof irreversible loss of bio-diversity is probably higher in the Philippines than any othercountry in East Asia. While at least 59 national parks have been created since 1900 theyprovide little effective protection for the country's terrestrial environment. Virtually noneof these protected areas would satisfy international protected area standards.

6.15 Upland areas contain most of what remains of the Philippine's biologicallyimportant forests. These areas are subject to constant pressure from growing demands ofrural communities and commercial logging interests. Hunting and regular burning ofupland areas for agricultural purposes constitutes an ongoing threat to remaining uplandresources. In some areas, the upland population has grown even more rapidly than thecountry's total population due to continual in-migration. New road construction, oftenusing questionable siting and construction techniques, continues to open up inaccessibleupland areas. If not carefully planned this type of infrastructure development can alsocontribute to degradation pressures.

6.16 Coastal areas are exposed to various forms of direct and indirect degradationespecially pollution resulting from land based industry, waste disposal and domesticsewerage. The coastal zone includes some 70% of the municipalities of the Philippines,including many of the largest cities. Marine resource degradation resulting frommangrove clearance, coral blasting, over fishing and excessive fish collection foraquarium trade, and hunting of other marine wildlife is significant. Ship waste disposaland oil spills are also a common problem.

6.17 The economic and ecological importance of mangroves can be substantial butthese also face severe degradation from legal and illegal conversion. There is often astrong correlation between productive coastal fishing grounds and their proximity tomangroves. The remaining mangroves are scattered but some concentrations still remainin Palawan, Mindanao, and Eastern Visayas. Significant mangrove destruction has

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resulted from conversion to aqua-culture. According to the 1989 FFARM Study, about95% of the fishpond area was derived from conversion of mangroves. In addition,removal of mangroves for industrial wood supply, charcoal and fuel wood, and otherforms land reclamation have contributed to the overall decline.

6.18 The increased demand for fish from a rapidly growing population and increasingexports, has increased fishing pressure on the marine fisheries and coastal resources in thepast two decades. Declining fish yields result from over-fishing in open access fisheries,siltation of inshore reefs, and poor fishing techniques. Establishing a sustainable marinefishery will require multiple initiatives including reduced fishing effort, more selectiveharvesting, and greater attention to community led efforts to manage and control access tothe fishery.

6.19 The quality of the country's coral reefs is rapidly deteriorating. Studies as earlyas 1978 showed that as little as 5% of the country's reefs could be considered to be inexcellent condition. Even with such widespread destruction, the Philippines coral reefsremain unique on a world scale for their diversity and deserve special attention. As withother coastal problems, coral reefs are often endangered by threats that arise on land,often in areas far from the reefs themselves. Siltation and other forms of pollution aregreatly affecting the viability of the nation's coral resources. These threats work intandem with other agents such as over-fishing, destructive fishing techniques (blastfishing and cyanide poisoning), reef predators and catastrophic stormns that inflict majordamage. Trade in fish and other aquarium collectibles is also an important driving forcein the Philippines as are the large numbers of foreign vessels and fleets of commercialfishermen working in Philippine waters.

6.20 The mining industry has recently become a new symbol of environmentaldestruction in the Philippines. Mineral depletion has not been a significant concern in thepast because of the relatively unexploited and undeveloped mineral resources, but this ischanging. Opening the mining industry to foreign investment without an appropriateenvironmental protection regime for the sector that discourages excessive mineralextraction rates and tolerates excessive pollution from mine tailings will lead toworsening environmental problems and inevitable conflicts over land utilization.

6.21 Many of the nation's natural resource problems result from the same underlyingproblems-lack of alternative livelihoods for the rural poor who depend on the resourcebase for subsistence and rent-seeking, encouraged by inappropriate resource pricing. Anessential component of any approach to improved natural resource management in thePhilippines, therefore, is to formulate programs which improve rent capture andencourage resource productivity and efficiency.

6.22 To address resource degradation issues, GOP must support improved area-basedplanning and program implementation that stresses the importance of community ledproblem solving and which addresses land and resource tenure concerns. Fundamental tothis is the need for well functioning property rights regimes. Watershed management and

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Integrated Coastal Zone Management (ICZM) are two approaches which can addressthese issues. DENR has expressed its strong interest in pursuing both watershedmanagement approaches to natural resource management especially in the area of water,forestry and bio-diversity conservation. There is also substantial scope for initiatingIntegrated Coastal Zone Management (ICZM) approaches.

C. IMPACT OF THE CRISIS ON THE ENVIRONMENT

6.23 The effects of the recent crisis will affect the environment in a number of ways,whose short-term net impact is however difficult to quantify. Urban pollution levels maytemporarily benefit from reduced industrial activity, and the demand for certain naturalresource products may also ease. However, degradation pressures in the countryside mayrise from the pressure of increased poverty, and natural resource extraction rates couldrise as communities develop alternative means of livelihood-possibly in a haphazardmanner, if pressures from the crisis are acute. Finally, reduced resources within firms forenviromnental compliance and investment in environmental protection, and reducedbudgets for public agencies to develop, monitor and enforce environmental prioritiesremain serious areas of concern. Adverse budgetary implications could threatenimportant investments such as operating and maintenance for water and sanitation,natural resource management programs, and expenditures for environmental protectionand conservation programs that would especially benefit the poor could be at risk.

6.24 The crisis therefore increases the urgency of developing alternative financingsources for environmental initiatives. This is particularly important in light ofgovernment's desire to devolve significant responsibility for environmental managementto LGUs. Protecting fiscal resources for essential environmental objectives thereforemerits policy attention.

6.25 The crisis also offers an opportunity to introduce environmental safeguards intoadjustment programs to minimize environmental risks and focus more on measures toestablish long-term enviromnental sustainability. The critical question for theenvironment arising from the crisis is whether resumed growth will be "business asusual", or whether it will reflect fundamental changes that better integrate environmentalconcerns into economic policymaking.

D. CHALLENGES: IMPROVING GOVERNANCE AND COORDINATION

6.26 The Govermrnent has yet to implement an effective system of environmentalgovernance. Roles and responsibilities among the different agencies involved inenvironmental planning, management and oversight are not clearly defined.Environmental institutions have limited capacity to implement and supervise programs.DENR bureaus lack adequate and secure financial resources. LGUs are even lessequipped to carry out their responsibilities. In its efforts to formulate a more effectivesystem of environmental governance, the Government should focus on three key issues:decentralization; compliance monitoring and enforcement; and

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6.27 Decentralization. Following the enactment of the Local Government Code,LGUs now have a substantive mandated role in the control of development, execution ofenvironmental regulatory functions, provision of services and in mobilization of financialresources to address environmental management problems. In some areas, the lines ofresponsibility are blurred and there is an immediate need for harmonizing thedecentralization process of DENR with that of the Local Government Code. The existingcapacity of most LGUs to carry out this mandate is weak and will require significanttraining and human resource development efforts to improve the situation. LGUs facechallenges of securing financing resources, weak capacity in delivery of environmentalservices, and incomplete information to monitor LGU environmental performance. Atthe same time, GOP should not lose sight of the need for a strong core agency. TheDENR should continue to be the key agency for environment in the country and shouldtake the lead in guiding and assisting in the decentralization process of environmentalfunctions. DENR should take leadership in framing policies and overseeing thecompliance and monitoring programs, while LGUs become responsible for theirimplementation.

6.28 Compliance and enforcement. GOP should continue to modernize availableregulatory instruments and its technical capacity for enforcing environmental compliance.GOP compliance enforcement efforts are constrained by a lack of adequate monitoringsystems and lack of basic capacity to manage information which would help establishenvironmental priorities. Several successful pilot initiatives have been undertaken thatpromote community participation in compliance enforcement and such programs need tobe expanded. The ability of government to deal with environmental compliance issueswill be seriously constrained for the foreseeable future. GOP recognizes that it cannotrely solely on a command and control approach; nor can it function as the sole financieror champion of environmental initiatives. GOP must seek ways to promoteenvironmental protection through mechanisms other than regulation, compliancemonitoring and enforcement alone.

6.29 A promising approach is to create enabling conditions for private sectorenvironmental action through market based mechanisms and other economic policyinstruments. Market based instruments include the removal of price distortions such assubsidies and import protection that encourage pollution. Approaches to promoteindustrial efficiency and adoption of cleaner technologies also need to be evaluated.Interesting pilot initiatives and experiments with promising market based policyinstruments such as the environmental user fee in Laguna de Bay, ECOWATCH andenterprise level pollution prevention efforts have been tested. As GOP seeks to increasedirect foreign investment in controversial sectors such as mining, it must seekopportunities to work more closely with companies who may be involved in activitieswhich damage the environment. A more pro-active approach to public-private

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partnerships in the provision of environmental services needs to be encouraged through aprogram of incentives and guarantees. 2

6.30 Community-Based Initiatives. Virtually all enviromnental initiatives requirecommunity support to succeed. The use of communities groups as a way to complementand supplement government action in the Philippines initiatives cannot be under-estimated. The evolving grass roots environmental movement provides an excellentopportunity to allow NGOs and other community groups to work side-by-side withLGUs. NGOs have proven their potential effectiveness as advocates for change,facilitators of dialogue, service providers and supporters of micro-enterprises. GOPshould continue to develop programs which utilize the skills of community-basedorganizations (CBOs). NGOs and CBOs could also become effective partners inmonitoring environmental compliance, facilitation of broad acceptance of environmentalpolicy through multi-party dialogue, environmental awareness raising and environmentaleducation at the grass roots level.

Institutional Integration and Sectoral Priorities

6.31 Government support for environment protection has primarily been pursuedthrough the programs of the DENR. The DENR has taken the lead on most initiatives butits programs have been heavily oriented toward natural resource issues. Often othernodal agencies and their line bureaus simply assume that the DENR should be fullyaccountable for environmental protection. Many nodal agencies have not traditionallypursued formulation of explicit environmental prograrns despite playing important rolesin achieving national environmental objectives. For example, as project sponsors, leadagencies have a critically important role to play in environmental impact assessmentprocedures. In addition, other sector agencies could take the lead in sector specificanalysis of environmental policy and investment options available to them.

6.32 In collaboration with DENR, each lead agency needs to become more pro-activein formulating its own environmental objectives and work programs. The progress ofagencies in addressing specific environmental concerns varies considerably. Forexample, the rural and urban development agencies are actively pursuing specific sectorwork and lending operations in support of environment goals. However, energy andtransport could do more to formulate substantial environmental objectives. The healthsector, which arguably must bear the cost of environmental degradation, should also domore to establish explicit programs to address the public health impact of environmental

2 The seminars, workshops and education initiated by MEIP and the Brown Fund (World Bank projects)through public-private partnership in self-regulation and monitoring for the private sector will be expandedthrough EDI sponsored events, in collaboration with Philippines Business for Environment. Other potentialopportunities are also available in the Bank's current project pipeline. For example, the recent PrivateSector Credit project includes an environmental training component that equips the Development Bank ofthe Philippine and other on-lending institutions to screen industrial sub-loans. A study to assess furtheropportunities for private sector participation in environmental management is also planned.

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degradation. And the Government should support units within each agency to analyze theeffectiveness of measures taken to date. Such analyses would evaluate the costs andbenefits of alternative measures, as a basis for prioritizing future action, and would helpevaluate the instruments and institutions that could be used. In particular, the Governmentshould focus on establishing clear environmental goals in the energy, transport and healthsectors.

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STATISTICAL ANNEX

Table 1: National Accounts, 1990-98 (as percentage of GNP)

Table 2: National Accounts, 1990-98 (growth rates)

Table 3: Consolidated Public Sector Financial Position, 1993-98

Table 4: Outstanding Public Sector Debt, 1993-97

Table 5: National Government Financial Position, 1992-97

Table 6: Monetary Survey, 1993-98

Table 7: Exchange Rates, Inflation and Selected Interest Rates, 1996-98

Table 8: Balance of Paymexts, 1993-98

Table 9: Exports and Imports by Major Commodity Group, 1990-98

Table 10: External Debt, 1993-98

Table 11: Loans Outstanding of Commercial Banks, 1993-98

Table 12.: Labor Market Developments, 1993-1998

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Table 1: National Accounts, 1990-98(as percentage of GNP)

1990 1991 1992 1993 1994 1995 1996 1997 1998

GDP at market prices 100.5 99.5 98.3 98.3 97.5 97.3 96.2 95.9 95.5

Net Indirect Taxes 8.2 9.1 9.7 10.0 10.4 10.6 10.0 9.4

Indirect taxes 9.4 9.8 10.1 10.4 10.8 11.0 10.3 9.9

Subsidies 1.2 0.7 0.3 0.4 0.4 0.4 0.3 0.5

GDP at factor cost 92.3 90.4 88.6 88.3 87.1 86.7 86.2 86.5

Agriculture 22.0 20.9 21.5 21.2 21.4 21.0 19.8 17.9 16.1

Industry 34.7 33.8 32.3 32.1 31.7 31.2 30.8 30.9 30.2

Mining and quarrying 1.6 1.4 1.2 1.1 1.0 0.9 0.8 0.7 0.7

Manufacturing 25.0 25.2 23.8 23.3 22.7 22.4 21.9 21.4 20.9

Services 43.9 44.8 44.6 44.9 44.3 45.1 45.4 47.1 49.2

Imports of GNFS 33.5 32.4 33.5 39.1 39.1 43.0 47.3 56.9 57.2

Exports of GNFS 27.7 29.4 28.6 30.8 33.0 35.4 38.9 47.0 53.1

Total Consumption 81.8 82.9 83.6 84.8 83.0 83.2 82.0 82.2 83.7

Public 10.2 9.9 9.5 9.9 10.5 11.1 11.5 12.5 12.7Private 71.6 73.0 74.1 74.8 72.5 72.1 70.5 69.7 71.0

Statistical discrepancy 0.3 -0.6 -1.5 -1.7 -2.8 0.1 -0.6 -0.2 -3.5

Gross domestic investment 24.3 20.1 21.0 23.6 23.5 21.6 23.1 23.8 19.3

GDFI 23.2 19.9 20.6 23.4 23.0 21.6 22.5 23.5 20.3Nonfinancial Pub. Sector 4.2 4.1 4.8 4.9 4.8 4.5 4.4 3.5

Private Sector 19.0 15.8 15.7 19.0 18.2 17.2 18.1 20.0

Changes in stocks 1.0 0.2 0.4 0.2 0.4 0.0 0.6 0.3 -1.1

Net factor income -0.5 0.5 1.7 1.7 2.5 2.7 4.0 4.1 4.5

GNP (million pesos) 1,071,433 1,254,562 1,374,838 1,500,287 1,736,382 1,958,932 2,282,958 2,526,900 2,789,312

Source: NSCB

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Table 2: National Accounts, 1990-98(growth rates)

1990 1991 1992 1993 1994 1995 1996 1997 19981e

GDP at market prices 3.0 -0.6 0.3 2.1 4.4 4.8 5.7 5.2 -0.5Net Indirect Taxes 3.0 10.1 6.0 4.9 6.5 9.1GDP at factor cost 3.0 -1.6 -0.2 1.8 4.2 4.3

Agriculture 0.5 1.4 0.4 2.1 2.6 0.8 3.8 2.9 -6.6Industry 2.6 -2.7 -0.5 1.6 5.8 7.0 6.2 6.1 -1.7

Mining and quarrying -2.6 -2.9 6.7 0.7 -7.0 -0.8 -4.8 1.7 1.8Manufacturing 2.7 -0.4 -1.7 0.7 5.0 6.8 5.6 4.2 -1.1

Services 4.9 0.2 1.0 2.5 4.2 5.0 6.4 5.5 3.5

Imports of GNFS 10.0 -1.1 8.7 11.5 14.5 16.0 16.7 14.4 -10.4Exports of GNFS 1.9 6.3 4.3 6.2 19.8 12.0 15.4 17.5 -11.4

Total consumption 5.5 1.8 2.9 3.3 3.9 4.0 4.6 4.7Public 6.8 -2.1 -0.9 6.2 6.1 5.4 3.9 2.0 0.8Private 5.4 2.3 3.3 3.0 3.7 3.8 4.6 5.0 3.5

Gross domestic investment 15.8 -17.3 7.8 7.9 8.7 3.0 12.4 11.7 -17.1GDFI 15.0 -14.2 6.4 8.7 7.5 4.7 12.0

Gross national product 4.0 0.5 1.6 2.1. 5.3 5.0 7.2 5.3 0.1

e. preliminary estimateSource: NSCB

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Table 3: Consolidated Public Sector Financial Position, 1993-98

June(in billion pesos) 1993 1994 1995 1996 1997 1998

National Government -21.9 16.3 11.1 6.3 1.6 -24.0Monitored GOCCs -25.6 -9.7 -1.3 -11.2 -17.2Central Bank Restructuring -15.1 -24.3 -20.0 -13.8 -25.7Oil Price Stabilization Fund (OPSF) a -7.9 2.6 -9.2 4.8 -0.8Adjustment to GOCCs b 11.9 7.6 2.8 1.5 2.5Other Adjustments c 2.8 0.0 0.0 0.0 0.0

Public Sector Borrowing Requirement -55.8 -7.5 -16.7 -12.4 -39.6 -60.4(PSBR)

SSS/GSIS 11.7 -12.0 0.0 8.5 3.9Bangko Sentral ng Pilipinas -1.0 5.3 3.6 -2.3 2.2Government Financial Institutions 6.1 3.1 5.0 8.4 4.3Local Government Units 5.9 5.0 1.9 5.7 4.2Time Adj. of Interest Payments to BSP 7.0 -2.3 1.5 -0.7 2.3Other Adjustments 0.3 0.1 0.6 0.0 0.0

Consolidated Public Sector (CPS) -25.8 -8.3 -4.0 7.3 -22.7 -33.6

(in percent of GNP) 1993 1994 1995 1996 1997

National Government -1.5 0.9 0.6 0.3 0.1Monitored GOCCs -1.7 -0.6 -0.1 -0.5 -0.7Central Bank Restructuring -1.0 -1.4 -1.0 -0.6 -1.0Oil Price Stabilization Fund (OPSF) a -0.5 0.1 -0.5 0.2 0.0Adjustment to GOCCs b 0.8 0.4 0.1 0.1 0.1Other Adjustments c 0.2 0.0 0.0 0.0 0.0

Public Sector Borrowing Requirement -3.7 -0.4 -0.8 -0.5 -1.6(PSBR)

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

Consolidated Public Sector (CPS) -1.7 -0.5 -0.2 0.3 -0.9a. Includes OPSF balance, transfers between NG and OPSF, and adjustments for PNOC share of OPSF balance.b. Includes NG transfers to monitored corporations, NPC transfers to NG, NG transfers to PNOC and PNB transfers to NG.c. Includes adjustments for net lending for debt buyback, reconciliation of cash accounts with bank data and other adjustments.Sources: DOF, IMF

88 -Table 4: Outstanding Public Sector Debt, 1992-97

(year end, in billions of pesos)

1992 1993 1994 1995 1996 1997*

Total Public Sector 11 1733.8 1810.9 1863.9 2149.5 2177.6 2313.0Domestic 1233.5 1158.6 1170.1 1432.7 1467.1 1260.7External 500.3 652.3 693.8 716.8 710.5 1052.3

(US$ billion) 19.8 23.9 28.4 27.3 27.0 26.3

National Government 2A/ 976.3 1268.2 1227.5 1313.3 1331.1 1623.6National Government 2B/ 826.8 1074.2 1081.2 1163.8 1155.2 1350.1

Domestic 21 502.9 682.1 670.6 729.0 748.3 755.7External 3/ 473.4 586.1 556.9 584.3 582.8 867.9

(US$ billion) 18.7 21.2 22.8 22.3 22.2 21.7

13 Monitored GOCCs 4/ 188.2 242.2 228.9 343.1 358.5 402.4Domestic 89.7 87.0 77.9 205.9 204.8 203.8External 98.5 155.2 151.0 137.2 153.7 198.6

(US$ billion) 3.9 5.6 8.2 5.2 5.8 5.0

Central Bank/CB-BOL 5/ 560.6 59.6 81.1 82.6 77.1 112.0Domestic 502.3 14.9 40.4 42.1 37.0 31.4External 58.3 44.7 40.7 40.5 40.1 80.6

(US$ billion) 2.3 1.6 1.7 1.5 1.5 1.5

Bangko Sentral 5/ 209.3 240.9 253.8 330.5 338.6Domestic 173.6 183.9 185.8 262.8 199.5External 35.7 57.0 68.0 67.7 139.0

(US$ billion) 1.3 2.3 2.8 2.8 3.5

Government Financial Institutions 158.2 234.6 231.1 306.1 256.6 110.0Domestic 143.6 205.3 202.2 276.1 220.8 58.0External 14.6 29.3 28.9 30.0 35.8 52.0

(US$billion) 0.8 1.1 1.2 1.1 1.4 1.3

Less: GOCC Debt Onlent orGuaranteed by NG 6/ 149.5 194.6 146.5 149.4 176.6 273.4

Domestic 5.0 5.2 5.8 6.2 6.2 7.6External 144.5 189.4 140.7 143.2 170.4 265.8

(US$ billion) 5.7 5.8 5.8 5.5 6.5 6.6

MEMORANDUM ITEMSExchange Rate (P/US$1)

End of Period 25.3 27.7 24.4 26.2 26.3 40.0Average 25.5 27.1 26.4 26.7 26.2 30.0

NG Debt Stock/GNP 60.1% 71.6% 62.3% 59.4% 51.1% 53.4%NG Domestic Debt 36.6% 45.5% 38.6% 37.2% 33.1% 29.9%NG External Debt 34.4% 39.1% 32.1% 29.8% 26.8% 34.2%

Public Sector Debt Stock/GNP 1/ 126.1% 127.4% 109.4% 109.7% 96.3% 91.5%Public Sector Domesfic Debt 1/ 89.7% 77.2% 57.4% 73.1% 64.9% 49.9%Public Sector External Debt 1/ 39.4% 44.1% 40.0% 36.6% 31.4% 41.6%

11 Includes National Govemment, 14 monitored GOCCs, CB/CB-BOUBSP & GFls

21 Includes direct, assumed & contingent liabilities

2A/ Includes direct, assumed & contingent liabilties

2B/ Excludes onlent and contingent/guaranteed liabilities which have not been assumed

3/ Includes direct, guaranteed and assumed liabilities

4/ Includes borrowing relent/guaranteed by NG

5/ Liabilities less currency issue and intergovemment accounts

6/ Includes relent guaranteed and contingent liabilities

1 Unaudited; as of December except for the NPC, and the NFA (November), the Philippine Economic Zone Authority (October), The Philippine National Railways(September) and the National Irrigation Admin (June).

Source: DOF

- 89 -Table 5: National Government Cash Operations (1993-97)

(in million pesos)

1993 1994 1995 1996 1997

Total Revenue 260,405 336,10 361,220 410,449 471,843

Tax Revenue 230,170 271,304 310,517 367,894 412,165

Bureau of Intemal Revenue 145,927 187,445 210,105 260,774 314,697

Bureau of Customs 81,971 81,610 97,691 104,566 94,800

Other Offices 2,272 2,249 2,721 2,554 2,668

Non-Tax Revenue 30,235 64,856 50,703 42,555 59,678

Total Expenditure 282,295 319,874 350,146 404,193 470,100

Current Expenditure 226,618 267,813 277,265 318,462 370,900

Personnel Services 78,696 92,678 109,074 135,406 172,800

Maintenance and Operations 34,565 46,837 46,950 48,702 51,800

Subsidies 5,147 7,021 3,580 5,862 5,900

Allotment to LGUs 27,773 37,753 41,394 45,275 56,400

Interest Payments 76,491 79,123 72,658 76,522 78,000Tax Expenditures 3,946 4,401 3,609 6,695 6,000

OPSF 10,000

Capital Expenditure and Net Lending 55,677 52,061 72,881 75,731 99,200Capital Expenditure 44,773 43,068 64,461 69,628 93,600

Infrastructure and Other Capital Outlays 37,830 33,606 52,673 57,547 79,100

Transfers to LGUs 6,943 9,462 11,788 12,081 14,500Equity and Net Lending 9,402 8,993 8,420 3,176 5,600

CARP Land Acquisition and Credit 1,502 0 0 2,927 0

Overall SurpluslDeficit -21,890 16,286 i 1104 6,256 1,743

Financing 21,891 -16,286 -11,074 -6,256 -27,113

Net Domestic Financing 8,979 -4,709 2,272 -348 -20,295

Net Foreign Financing 12,912 -11,577 -13,346 -5,908 -6,818

Memo Items: (in % of GNP)Total Revenue 17.4 19.4 18.4 18.0 18.6Tax Revenue 15.3 15.6 15.9 16.1 16.1

Current Expenditure 15.1 15.4 14.2 13.9 15.6

Capital Expenditure and Net Lending 3.7 3.0 3.7 3.3 3.9

Overall Surplus/Deficit -1.5 0.9 0.6 0.3 -0.1

Source: Bureau of Treasury

- 90 -

Table 6: Monetary Survey, 1993-98

October1993 1994 1995 1996 1997 1998

(in billions of pesos)

Total Liquidity 499.4 630.8 786.4 913.9 1174.4 1142.6Broad Money 480.3 607.6 761.4 881.4 1066.0 1073.2Other Liabilities 19.1 23.2 25.0 32.5 108.4 69.3

Net Foreign Assets 104.6 123.6 117.9 69.9 -76.9 -1.4o/w Central Bank 56.8 91.8 118.4 232.7 211.9 331.5

Deposit Money Banks 47.9 31.8 -0.5 -162.4 -288.8 -228.3

Net Domestic Assets 394.8 507.1 668.5 843.7 1251.3 1144.0Net Domestic Credit 682.1 821.5 1084.0 1507.8 1922.9 1833.1

Public Sector 274.1 299.8 335.3 377.2 468.2 439.8Private Sector 408.0 521.7 748.7 1130.5 1454.7 1393.3

FCDs, residents -136.2 -158.8 -206.7 -317.6 -433.4 -460.1Other Items (net) -151.1 -155.6 -208.8 -346.5 -238.2 -228.9

(percentage change; end of period)

Broad Money 24.6 26.5 25.3 15.8 20.9 7.5Net Domestic Assets 146.2 20.4 32.0 39.1 48.2 -0.1

Private Sector Credit 38.0 27.9 43.5 51.0 28.7 0.3

(in percent of GNP)

Broad Money 32.0 35.0 38.9 38.6 41.6Net Foreign Assets 7.0 7.1 6.0 3.1 -3.0Net Domestic Assets 26.3 29.2 34.1 37.0 48.8

Private Sector Credit 27.2 30.0 38.2 49.5 56.7

Sources: BSP, IMF

- 91 -

Table 7: Exchange Rates, Inflation and Selected Interest Rates, 1996-98

1997 19981996 1997 1998 QI Q2 Q3 Q4 Q1 Q2 Q3 Q4

Exchange Rates:Period Average (Pesos/$) 26.2 29.5 40.9 26.3 26.4 29.8 35.4 40.7 39.4 42.9 40.6

End of Period (Pesos/$) 26.3 40.0 38.8 26.4 26.4 33.9 40.0 37.1 42.1 43.8 39.1

Real Effective(1990=100) 129.8 128.7 104.7 137.5 139.3 126.9 111.3 102.7 109.1 102.3

Inflation:CPI (1990=100) 177.8 186.7 204.8 182.9 185.1 188.1 190.9 195.6 201.7 206.2 210.4

Year change (%) 8.4 5.0 9.7 4.8 4.5 4.8 6.1 6.9 9.0 9.6 10.2

Interest Rates:(period average) (end of period)

Manila Reference Rates:All Maturities 11.6 17.9 13.6 10.4 10.2 14.9 17.9 18.4 15.3 14.1 13.6

Bank Lending Rate (all maturities) 14.8 20.4 16.1 13.7 13.3 18.2 20.4 20.1 16.0 14.6 16.1

Prime Rate (Metro Bank) .. 17.8 .. 14.0 19.0 25.0 17.8 15.5 15.5 15.8

Time Deposits:Short-Term ( < 1 yr) 10.5 15.9 12.5 9.2 8.2 12.8 15.9 13.9 11.6 11.1 11.5

Long-term ( > 1 yr) 11.1 14.7 12.2 8.6 9.3 13.2 14.7 11.2 12.4 13.6 11.3

91-dayTreasury Bill Rate 11.5 17.7 15.3 10.1 10.5 15.3 17.7 16.6 14.0 13.8 13.5

Reverse RP Rate 11.1 12.0 14.3 10.2 10.5 13.9 12.0 16.1 14.5 13.9 13.5

Repurchase Rate .. .. 15.8 .. 15.4 15.0 15.1 18.0 15.4

Interbank Call Loan Rate 11.2 13.6 13.6 10.2 14.4 15.7. 13.6 13.3 13.2 15.9 14.0

Sources: BSP, IMF

- 92 -

Table 8: Balance of Payments, 1993-98(in millions of US$)

Jan-Sept

1993 1994 1996 1996 1997 1998

Trade balance -6222 -7850 -8944 -11342 -11127 -824% of GNP -11.2 -11.9 -11.7 -13.0 -12.8

Exports (fob) 11375 13483 17447 20543 25228 21845Imports (fob) 17597 21333 26391 31885 36355 22669

Services (net) 2507 3964 4765 6839 5696 750Receipts 7497 10550 14374 19006 22835 10466

o/w Remittances/Private transfers 3956 5824 8696 10169 11748 6208Payments 4990 6586 9609 12167 17139 9716

o/w Interest 1513 1579 2179 2167 2567 1923

Transfers (net) 699 936 882 589 1080 407

Current Account Balance -3016 -2950 -3297 -3953 -4351 333% of GNP -5.5 -4.5 -4.3 -4.6 -5.0

Foreign investment (net) 812 1558 1609 3517 766 873Direct Invesment 864 1289 1361 1338 1125 717Portfolio Investment -52 269 248 2179 -359 156

MLT borrowing (net) 2455 1313 1276 2841 4824 2565Inflows 4853 4369 3927 6540 7724 4477Outflows 2748 3056 2651 3699 2900 1912

Short-term Capital (net) -148 1002 -56 540 493 -990Trading in bonds in

secondary market .. .. -37 -676 -503

Change in Commercial Banks' NFA -299 674 564 4211 1191 -268(- indicates increase)

Errors and Omissions -514 -49 454 -3007 -5250 -258

Others /a 544 254 81 -5 -360 96

Changes in net reserves /b 166 -1802 -631 -4107 3363 -1848(- indicates increase)a. Includes monetization of gold, revaluation adjustments and $469 million purchase of collateral in 1992.b. Includes net credit of IMF.Source: BSP.

- 93 -Table 9: Exports and Imports by Major Commodity Group, 1990-1998

(in millions of US$)Jan.-Sept

1990 1991 1992 1993 1994 1995 1996 1997 1998

Coconut Products 503 447 643 532 639 989 730 835 701

Sugar and Products 133 136 110 129 77 74 140 99 98

Fruits and Vegetables 326 393 371 439 429 458 486 459 329

Other Agro-Based Products 431 503 432 476 530 575 506 506 344

Forest Products 95 73 57 45 26 38 42 45 18

Mineral Products 723 581 633 686 780 893 772 764 473

Petroleum Products 155 175 150 136 132 171 273 237 100

Manufactures 5,706 6,432 7,293 8,720 10,615 13,868 17,106 21,642 19,177

Elect. & Elect. Equipment 1,964 2,293 2,753 3,551 4,984 7,413 9,990 13,199 12,665

Garments 1,776 1,861 2,140 2,272 2,375 2,570 2,423 2,349 1,801

Others 114 100 135 212 255 381 488 641 604

Total Exports 8,186 8,840 9,824 11,375 13,483 17,447 20,543 25,228 21,844Jan.-Sept

1990 1991 1992 1993 1994 1995 1996 1997 1998

Capital Goods 3,122 2,952 4,023 5,610 6,868 8,029 10,472 13,951 9,440

Raw Materials & Intermediate 5,808 5,851 6,769 7,855 9,606 12,174 14,058 14,630 8,895Goods

Unprocessed Raw Materials 862 841 947 961 1,278 1,562 1,720 1,645 895

Semi-Processed Raw 4,946 5,010 5,812 6,874 8,328 10,612 12,338 12,985 7,999Materials

Manufactures 1,794 1,714 2,139 2,590 2,893 3,572 3,948 3,981 2,242

Embroideries 426 514 502 468 411 472 349 356 265

Materials for Elect. Equipt. 1,106 1,208 1,401 1,808 2,711 3,772 5,130 5,406 3,494

Mineral Fuels and Lub. 1,842 1,784 2,050 2,016 2,040 2,461 3,008 3,073 1,587

Consumer Goods 1,061 990 1,241 1,687 2,109 2,784 3,331 3,091 1,942

Durable 392 478 620 842 1,124 1,459 1,653 1,515 674

Non-durable 669 512 624 745 985 1,325 1,678 1,576 1,268

Others 373 474 436 529 710 943 1,016 1,190 943

Total Imports 12,206 12,051 14,519 17,697 21,333 26,391 31,885 35,935 22,807

Source: BSP, National Statistics Office

- 94 -

Table 10: External Debt, 1993-98 11(in millions of US$)

June

1993 1994 1995 1996 1997 1998

By ype of Debt 34,282 38,723 39,367 41,875 45,433 45,777

Medium and Long-Term 21 29,247 33,526 34,088 34,668 36,994 37,614

Short-Term 5,035 5,197 5,279 7,207 8,439 8,162

Trade 3,495 3,401 2,674 4,096 4,157 3,340

Non-Trade 1,540 1,796 2,605 3,111 4,282 4,822

By Borrower 34,282 37,079 39,367 41 ,875 45,433 45,777

Banking System 31 2,403 3,027 5,452 8,632 10,664 11,404

Central Bank

Bangko Sentral 1,288 855 1,212 1,415 2,499 3,931

Commercial Banks 1,115 2,172 4,240 7,217 8,165 7,473

Public and Private 31,879 34,052 33,915 33,244 34,768 34,373

Public 26,583 27,193 26,664 24,132 22,271 21,848

Private 5,296 6,859 7,251 9,112 12,497 12,525

By Creditor 34,282 37,079 39,367 41,875 45,433 45,777

Comm. Banks 5,682 4,688 5,106 7,415 8,872 8,622

Other Finan. Inst. 303 841 1,239 958 1,304 1,001

Suppliers' Credits 3,185 3,549 2,587 2,588 2,359 2,273

Multilateral 7,949 8,216 9,617 8,634 8,638 8,662

oSw IBRD 3,936 3,985 4,995 4,676 4,146 3,944

ADB 2,300 2,558 2,643 3,117 3,091 2,962

IMF 1,312 1,139 814 405 889 1,124

Bilateral 13,369 15,033 14,393 13,439 13,307 12,741

Export Agencies 3,997 4,487 3,939 4,677 4,720 4,530

Others 9,372 10,546 10,454 8,762 8,587 8,211

Others 3,794 4,752 6,425 8,841 10,953 12,477

Memo Items:

Debt service 4S 3,229 4,188 5,032 5,026 5,440 3,414

Debt service/ Exports 17.1 17.4 15.8 12.7 11.3 13.6

Total external debt / GNP (%) 64.2 58.9 51.7 48.1 53

Total external debt/Exports(%) 181.7 161.1 123.7 105.9 94.5

1/ Excludes liabilities of foreign banks in the Philippines to their headquarters, branches, and agencies, some extemal debt notregistered with the central bank, and private capital lease arrangements.21 Includes cumulative foreign exchange revaluation of US$-denominated multi-currency loans from the World Bank andAsian Development Bank of $433 and $384 million, respectively, for end-1 996.31 Effective July 3, 1993, accounts of old CB were split between Bangko Sentral ng Pilipinas and Central Bank - Board ofLiquidators.4/ For 1993-94, figure represents debt service after rescheduling. 1998 debt service as of July.

Source: BSP

- 95 -

Table 11: Loans Outstanding of Commercial Banks, 1993-98

Sept.1993 1994 1995 1996 1997 1998

ECONOMIC ACTIVITY

Growth rates (% on year earlier)Agriculture, fisheries, & forestry 19.1 8.1 19.6 6.4 11.5 -8.2

Mining and quarrying 56.9 -48.1 55.9 9.4 70.3 19.5

Manufacturing 26.9 32.5 33.9 42.5 17.3 -5.2Electricity, gas & water 159.5 25.7 24.7 90.6 34.0 47.5Construction 65.3 32.3 37.4 74.2 19.6 25.2Wholesale & retail trade 27.8 39.8 37.3 38.1 28.0 -4.1

Transportation, storage & communication 52.8 53.8 72.0 53.3 47.7 5.0

Fin. inst., real estate & business services 10.1 37.4 24.8 97.2 42.6 -5.7

Community, Social & Personal services 92.1 -10.4 61.8 57.6 11.4 15.0

TOTAL 32.2 25.4 35.8 51.9 26.5 0.2

Share of Total Loans (%)

Agriculture, fisheries, & forestry 10.6 9.2 8.1 5.7 5.0 4.4

Mining and quarrying 2.5 1.0 1.2 0.9 1.1 1.6

Manufacturing 33.0 34.9 34.4 32.3 29.9 28.1

Electricity, gas & water 2.4 2.4 2.2 2.8 3.0 4.1

Construction 3.1 3.3 3.4 3.9 3.6 4.4

Wholesale & retail trade 15.7 17.5 17.7 16.1 16.3 15.4

Transportation, storage & communication 3.9 4.8 6.1 6.1 7.1 7.7

Fin. inst., real estate & business services 16.7 18.3 16.8 21.8 24.6 23.7Community, Social & Personal services 11.9 8.5 10.2 10.5 9.3 10.7

TOTAL 100.0 100.0 100.0 100.0 100.0 100.0

Source: BSP

- 96 -

Table 12: Labor Market Developments, 1993-1998

1993 1994 1995 1996 1997 1998(in thousands of persons)

Population / a 67093 68661 70267 71899 73449 74967Total Labor Force 26879 27654 28382 29733 30355 31055Unemployed 2497 2622 2704 2546 2640 3144Unemployment Rate (%) 9.3 9.5 9.5 8.6 8.7 10.1

Total Employed 24383 25033 25677 27187 27716 27911Agriculture 11139 11286 11147 11645 11314 10933Industry 3804 3948 4139 4430 4631 4583

Mining and Quarrying 135 111 100 113 130 119Manufacturing 2457 2538 2696 2696 2732 2716Construction 1110 1187 1230 1504 1637 1605Utilities 102 112 114 118 132 142

Services 9440 9799 10392 11112 11771 12394Transport and 1291 1393 1487 1631 1742 1849

CommunicationsTrade 3389 3520 3790 4013 4138 4311Finance 503 490 534 615 688 672Government Services 4244 4386 4569 4850 5196 5555Other 13 10 12 4 6 6

(as percentage of total employment)Total Employed 100 100 100 100 100 100Agriculture 45.7 45.1 43.4 42.8 40.8 39.2Industry 15.6 15.8 16.1 16.3 16.7 16.4

Mining and Quarrying 0.6 0.4 0.4 0.4 0.5 0.4Manufacturing 10.1 10.1 10.5 9.9 9.9 9.7Construction 4.6 4.7 4.8 5.5 5.9 5.8Utilities 0.4 0.4 0.4 0.4 0.5 0.5

Services 38.7 39.1 40.5 40.9 42.5 44.4Transport and 5.3 5.6 5.8 6.0 6.3 6.6

CommunicationsTrade 13.9 14.1 14.8 14.8 14.9 15.4Finance 2.1 2.0 2.1 2.3 2.5 2.4Government Services 17.4 17.5 17.8 17.8 18.7 19.9Other 0.1 0.0 0.0 0.0 0.0 0.0

a. 1998 estimateSource: GOP

- 97 -

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Austria, M.S., The Effects of the MFA Pase Out on the Philippine Garments andTextiles Industries, Philippine Institute for Development Studies, Manila,1996, Discussion Paper Series No. 96-07.

Dollar, D., Litvack, J., and Glewwe, P., 1998. "Household Welfare in Vietnam'sTransition", in Macroeconomic Reform and Poverty Reduction, World BankRegional and Sectoral Study.

Foreign Investnent Advisory Service, The Philippines: Promoting BackwardLinkages: A Pilot Program for the Electrical Appliance and ElectronicsIndustry, World Bank, 1995, p. 16.

Lall, S., Learningfrom the Asian Tigers, London: Macmillan, 1996.

Exports of Manufactures by Developing Countries: Emerging Patters ofTrade and Location. Oxford Review of Economic Policy, 1998.

Llanto, Orbeta, Sanchez and Tang, 1997. A Study of Housing Subsidies in thePhilippines. Report prepared for the World Bank and the Housing and UrbanDevelopment Coordinating Council.

Magpantay, Jose A., Streamlining the Science and Technology Sectorfor theCountry's Development Goals, Report to the Department of Budget andManagement, Philippines Institute of Development Studies, 1993.

Memorandum ofAgreement on Housing Finance, 1996. Signed by representatives ofDepartment of Finance, Department of Budget and management, SSS, GSIS,Pag-IBIG, NHMFC, and the Housing and Urban Development CoordinatingCouncil (HUDCC).

National Science Foundation, Science and Engineering Indicators, 1998, USGovernment, Washington D.C.

World Bank, 1995. Philippines: A Strategy to Fight Poverty.

1997. Everyone's Miracle?: Revisiting poverty and inequality in EastAsia.

1997. Philippines: Managing Global Integration, Country EconomicMemorandum, Volumes I & II. Report No. 17024-PH.

1998a. Philippines: Promoting Equitable Rural Growth, Report No.17979-PH.

1998b. Philippines: Report of the President: Banking System ReformLoan, Report No. P-7235-PH.

_ 1998c. Philippines: Social Expenditure Priorities, Report No. 18562-PH.