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p. 31 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia East Asia Southeast Asia Cambodia Indonesia Lao People's Democratic Republic Malaysia Myanmar Philippines Singapore Thailand Viet Nam South Asia Central Asia The Pacific III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia : Southeast Asia

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Philippines

Helped by higher agricultural output, GDP growth picked up to its highest rate in 15 years, but is likely to ease somewhat over the next 3 years. The Government has initiated important reforms in public finance to raise revenues and reduce the budget deficit. Further challenges include unemployment reduction, debt management, power sector reforms, and investment climate improvement.

Macroeconomic assessment of 2004

The economy performed better than expected in 2004: GDP grew by 6.1%, surpassing the government projection. A beneficial international economic situation, favorable weather, and growth in all regions of the country were important determinants. Although remittances by overseas workers rose by 11.8% to $8.5 billion, gross national product (GNP) grew by the same amount as GDP. This was due to increasing external debt service payments, which lowered net factor income growth to 4.9% in 2004 from 17.9% the previous year. Growth in personal consumption expenditure, accounting for about two thirds of aggregate demand, accelerated to 5.9% from 5.3%--higher farm output, stronger remittances from overseas workers, and booming demand for telecommunications services were the largest contributors.

The Government’s cautious cash spending resulted in a further decline of government consumption expenditure by 0.8% in 2004. Growth of fixed capital formation accelerated to 5.1% from 2.9%, due to stronger private investment. Investment in construction expanded by 6.2%, marking a healthy rebound from the decline of 2.9% in 2003. According to the National Statistics Office, total exports increased by 14.0% (4.4% in 2003) as merchandise exports and nonfactor services gained momentum. Total import growth slowed to 6.3% from 10.2%, reflecting decelerating growth in several categories, including transport equipment and manufactured metals. Growth of net exports contributed about 2.6 percentage points to GDP growth, after subtracting from growth in recent years.

On the production side, all three sectors improved growth. Agriculture, which contributes a fifth of the country’s economic output and employs slightly above one third of its workforce, grew by 4.9%, thanks to favorable weather. Industrial growth rose to 5.3%, due to better outturns by manufacturing and construction. Manufacturing, the biggest contributor to the growth of the domestic economy, continued to pick up pace, expanding by 5.0% in 2004. This is a particularly positive development because manufacturing generates flow-on benefits to the rest of the economy. Services continued to improve, by 7.3%, with the top contributors being trade, transportation, communications and storage, and finance.

High unemployment remains the country’s single clearest indicator of a weak economy, averaging 11.8% of the labor force, up from 11.4% in 2003. Likewise, underemployment rose to 17.6% in 2004 from 17.0% the prior year. Adding the number of unemployed to the number of underemployed and dividing it by the size of the total labor force gives an index of “labor underutilization.” In the Philippines, this rate increased from 26.5% in 2003 to 27.4% in 2004. The number of workers joining the labor market in most years exceeds the number of jobs created (Figure 2.10). In 2004, the economy created 977,000 new jobs (67% in services, the rest divided equally between agriculture and industry) compared with 574,000 in 2003, while there were 1.29 million new entrants. This implies that the number of unemployed rose by a further 313,000, and this at a time that GDP grew faster than any year since 1989.

The Government operated under the reenacted 2003 budget for the whole year of 2004. In a favorable development, the full-year deficit of P186.1 billion (3.8% of GDP) was below the programmed ceiling of P197.82 billion (4.2%). Revenue collection rose by 11.4% to P698.3 billion in 2004, with tax revenues up by 11.2% and nontax revenues by 12.6%. However, the revenue-to-GDP ratio declined to 14.4% from 14.6%.

On the expenditure side, the Government maintained fiscal discipline. Its spending rose by 7.0% to P884.4 billion. Mandatory expenditures for interest (30%), personnel (30%), and grants to local governments (20%) constituted 80% of the budget, crowding out urgently needed capital outlays. Total public expenditures have been hovering at about 19% of GDP for many years, below the average of other countries in the region. The lack of financial resources continued to force the Government to borrow to meet its operational needs, and its debt stock climbed to P3.80 trillion in November 2004 from P3.36 trillion a year earlier. Foreign public borrowing reached P1.81 trillion in November, equivalent to 47.6% of total government borrowing.

Inflationary pressures were more pronounced in 2004. The overall CPI rose by 7.9% in December 2004, while the average inflation rate for the year was 5.5%, above the Government’s target of 4.0-5.0%. The acceleration was the result of higher food and fuel prices. The stock market responded to the improved growth rate, with the composite index of share prices increasing by 35%. The peso continued to depreciate, to an average of P56.03/$1 in 2004 from an average of P54.20 in 2003, adding to domestic price pressures. However, the real effective exchange rate index of the peso averaged P54.44 (P56.94 in 2003), indicating that the real extent of the depreciation was smaller in terms of the peso-adjusted inflation-rate differentials, i.e., the Philippines had higher inflation than the countries in the basket used for the index. The upshot is that the peso lost competitiveness.

Domestic liquidity (M3) expanded by 8.2% in December 2004 from 12 months earlier, accelerating from 3.3% in December 2003, with domestic borrowing dominated by the Government, as corporate demand remained subdued. On the credit supply side, although there was a slight decline in the NPL ratio (to 13.6% in November 2004 from 14.1% at end-2003), weak asset quality continued to hamper the commercial banks’ ability to expand operations. The policy rates of the Bangko Sentral ng Pilipinas (BSP)--the overnight borrowing rate and the overnight lending rate--have been unchanged since July 2003, at 6.75% for the former and 9.0% for the latter. Continuing high demand for deficit financing pushed the 91-day treasury bill rates up to an average of 7.3% in 2004.

The current account surplus widened to $2.1 billion in 2004, from $1.4 billion in 2003. The financial account showed a deficit of $1.7 billion, reflecting higher overseas investments by residents than nonresidents’ investments in the Philippines. The balance of payments registered a fall in reserves of $1.6 billion. Gross international reserves decreased to $16.0 billion, which is the equivalent of about 4.1 months of imports of goods and services. The decline came as a result of the debt service payments by the Government.

Macroeconomic policy developments

The major priorities of President Arroyo’s new administration were outlined in the Medium-Term Philippine Development Plan (MTPDP) 2004-2010, unveiled in October 2004. They include an acceleration of growth, job creation, and reform of the energy sector. Fiscal consolidation and achievement of a balanced budget by 2010 have the highest priority. Relieving the Government’s debt burden is a prerequisite for raising more funds to finance development. Power sector reforms, crucially the privatization of the National Power Corporation, are also necessary to cut the debt burden. Given the magnitude of the fiscal pressures, the Government faces great challenges in designing a package of policies and measures that can achieve the key MTPDP targets while maintaining fiscal discipline.

Creating more jobs, arguably the country’s most important task, would greatly assist in reaching the goal of reducing the poverty incidence from 25.5% to about 18.0% by the end of this decade. This will require many more jobs, particularly higher-paid positions in the formal sector, and an increase in agricultural productivity. As reflected in the MTPDP, the new administration has pledged to generate about 1.5 million jobs a year between 2004 and 2010, for a total of about 10 million new jobs (60% in the services sector). Although in the past the economy has created over a million jobs in a single year, generating 1.5 million jobs consistently until 2010 will be hard. Moreover, this may not make much of a dent in unemployment if the number of new jobs is surpassed by entrants into the labor market. The Philippines has about 30 million people under the age of 15, and about 13 million of them are expected to join the labor force over the next 14 years. Hence, the economy needs to create about 1 million jobs a year just to absorb new entrants. But given the current number of unemployed, the unemployment rate in 2010 would still be 8.9% according to the MTPDP. Clearly, sound population control policies are needed to reduce population and labor-supply pressures. This also requires an increase in the rate of capital accumulation and the implementation of policies to achieve full employment. These should go well beyond labor market reforms. The dilemma that the Philippine administration faces on this front is that it cannot use active monetary and fiscal policies; in the former case, because BSP’s policy is anchored in inflation targeting, and in the latter because of the debt and its financing problems.

In the social sphere, policy priorities include improvement of social services and infrastructure, which will require increased financial resources, and the articulation of a population policy to reduce population growth. Improvements to infrastructure would attract more domestic and foreign investment, reduce production costs, and facilitate exports. Channeling more private investment into energy, roads, and water supply would help in this area. Civil service reforms, such as removing functional duplications among agencies, would improve the Government’s ability to implement the MTPDP and attract investment. Governance issues--weak enforcement of the rule of law, and corruption, for example--also require attention because they contribute to the perception that the country is an unattractive destination for foreign investment.

Although the Government maintained fiscal discipline in 2004, the public sector’s deficit remains the most significant macroeconomic imbalance due to its impact on debt sustainability. The system is unable to fully mobilize revenues, whether through taxes, tariffs, fees, or charges. Acknowledging that low revenue collection is a fundamental cause of the budget deficit, the new Government proposed a package of measures to increase tax revenues. A series of bills has been filed with Congress for an increase in the basic VAT rate from 10% to 12%; reimposition of a 3% franchise tax on telecommunications companies; adoption of gross income taxation for corporations and self-employed individuals; rationalization of fiscal incentives for investors; and indexation to inflation of excise taxes on alcohol, tobacco, and petroleum products, among other measures.

The approval by Congress in December 2004 of higher tax rates on alcohol and tobacco should improve the fiscal situation in 2005 by raising an additional P15 billion over the year. However, the Government needs to raise at least P90 billion in new taxes to cut its dependence on borrowing. (In 2004 the Government borrowed P241 billion to meet its financial requirements, equivalent to 28% of total expenditures.) Another advance was the signing in January 2005 of a law that encourages staff of the internal revenue and customs bureaus to be more efficient in collecting taxes. A bill that would overhaul the VAT system was passed by the House of Representatives in January and went to the Senate for discussion.

Increased borrowing during 2004 prompted various international financial institutions and credit rating agencies to urge the Government to significantly raise revenues and control spending. Debt interest payments escalated to 29.5% of total public expenditures in 2004, from 19.5% in 1998. Without appropriate and effective reform, in the next few years the country will face a situation of lower public expenditures, and hence declining public services, and a further deterioration in its credit rating. An increasing debt stock could also trigger a significant depreciation of the peso. Despite efforts from the Government and an appreciation of the peso in early 2005, credit downgrades by Standard & Poor’s and by Moody’s in the first 2 months of 2005 are hurting the economy by increasing its cost of borrowing, given that this cost is already 500 basis points above the US treasury bill rate, and that ratings of neighboring countries are improving. The downgrade will probably also affect the country’s ability to attract greater volumes of FDI.

Another reason for the Government’s fiscal vulnerability stems from the high level of contingent liabilities, primarily for underwriting the finances of government corporations (including some financial institutions) and the public pension system. As the Government continues to guarantee further loans to these corporations, its contingent liabilities reached P821.3 billion in the first 3 quarters of 2004, of which 95% was foreign debt. The National Power Corporation’s liabilities represent about 65% of the Government’s total contingent liabilities. Moving forward with the MTPDP’s measures to privatize state-owned power generation and transmission assets would go some way to overcoming this pressing problem. In addition, the creation of a sound regulatory framework for the power sector is required to attract private investment. Once that has been done, the Government should consider initiating steps to build partnerships with the private sector to address the physical deficiencies in the power system so as to avoid power shortages.

Outlook for 2005-2007 and medium-term trends

The MTPDP forecasts GDP growth rates of 5.3-6.3% for 2005, 6.3-7.3% for 2006, and 6.5-7.5% for 2007. The forecast rate increases to 6.8-7.8% in 2008 and 7.0-8.0% in 2009 and 2010. According to the plan, unemployment will decrease steadily from the current 12% to about 9% in the last 2 years, with elimination of the fiscal deficit by 2010. The key to achieving GDP expansion of 7-8% by the end of the decade is to attain growth rates of the capital stock of at least 10% (in net terms), substantially higher than the current rate (around 3%), as the experience of other Asian economies during their high-growth periods suggests. This requires an extended investment push to create a virtuous cycle of higher rates of productivity, wages, and employment. However, given the current problems with the budget deficit and debt, which affect the Government’s investment capacity, and the poor investment climate, which affects the private sector’s investment willingness, it will be difficult for the capital stock to grow by the pace required to achieve the targeted GDP growth rate.

While raising the investment-to-GDP ratio is important, the variable that matters for growth is the rate of increase in the capital stock, which depends on both the investment-to-GDP ratio and the productivity of capital. Unfortunately, the Philippines has a very low investment-to-GDP ratio (around 20%) and low capital productivity (around 0.35, i.e., 0.35 pesos of GDP is created per peso of capital stock, according to ADB estimates). The MTPDP assumes an increase in the ratio of gross investment to output of 8 percentage points to 28%, by 2010. This effort alone will probably not suffice to lift significantly the growth rate of the capital stock, because it requires an unrealistically high increase in the productivity of capital, of about 50%, in a short period.

With the current level of capital productivity, an investment-to-GDP share of 28% will lead to an expansion of the capital stock of only about 4.8%. The MTPDP’s projected GDP growth rates for 2005-2007 are mainly in the 6-7% range. This requires capital accumulation to increase by 7-8%. But even assuming some gain in capital productivity, this accumulation rate target still necessitates an investment share above 30%. Even if the Philippines manages to increase its investment-to-GDP ratio to 28% in the next 2 years and increase capital productivity by 10%, this would lead to a growth rate in the capital stock of 5.7%, insufficient to achieve the forecast GDP target. Higher capital productivity requires reforms at the industry and company level. A rate of increase in the capital stock of about 5% would contribute about 1.5 percentage points to GDP growth.

This would not be enough to put the country on the virtuous cycle, though. For the Philippines to achieve GDP growth rates of 6-7%, the contribution of capital accumulation to output growth must be in the neighborhood of 2.5 percentage points, or about 40% of total GDP growth.

This analysis leads to the conclusion that the growth targets set by the MTPDP are probably too high. On more realistic assumptions, the growth rate for the next 3 years will hover at around 5%, below the government targets. (Momentum slowed in the fourth quarter of 2004 due to inflation pressures, lower agricultural expansion, higher debt repayments, and low investment.) GNP will grow at approximately the same rate due to high debt service payments. From the high rate in 2004, agriculture is expected to decelerate to about 4.0% in the next 3 years, as a result of less favorable weather that is forecast for this period. Industry growth will also be lower, at around 4%. The services sector is expected to maintain its high growth of close to 7%.

On the expenditure side, it is expected that personal consumption will swell by around 5% over the medium term, and government consumption--helped by revenue increases--by 3.0% in 2005. Gross fixed capital formation is expected to rise at an annual average of 7.5% (public investment by 7.0%). Exports are forecast to grow more slowly, by 7.5%, because of a weaker global economy and strong international competition. Imports are forecast to expand by 6.5% due to a slight rise in the price of imported inputs used in industrial exports. The current account will record a surplus of around 2-3% of GDP.

Given continuing high oil prices, wage rises, and transport cost increases, inflation in 2005 will likely rise to average 6.5%, above BSP’s target (inflation in January 2005 reached 8.4%). Over 2005-2007, unemployment is projected to remain slightly above 11%.

The fiscal situation will continue to be the key factor to be monitored over 2005-2007. The 2005 budget as proposed by the House of Representatives was approved by the Senate without amendments. Revenues are expected to be 15.0% of GDP, edging up to 15.3% in 2006 and to 15.5% in 2007, thanks to the introduction of new taxes over this period. The fiscal deficit is expected to be 3.6% of GDP for 2005, 3.2% for 2006, and 2.8% for 2007. Underpinning the fiscal program are measures to boost the revenue-to-GDP ratio to 18% in 2010, mainly from higher revenue collection efficiency.

President Arroyo has set the tone for her administration’s focus on fiscal consolidation. With the passage of new revenue measures and higher economic growth in 2004, the stock and currency markets rallied. The initial steps have been positive and the MTPDP 2004-2010 provides a platform for the Government to proceed, even though some of the targets are, perhaps, optimistic. The next few years will show if there is the will to put the Philippines on a high-growth path.

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