PHILIPPINES QUARTERLY UPDATE Laying Out the Exit Strategies. February 2010

Transcription

1 PHILIPPINES QUARTERLY UPDATE Laying Out the Exit Strategies February 2010

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3 Laying Out the Exit Strategies TABLE OF CONTENTS Executive Summary...3 Recent Economic Developments...4 Output and Demand...4 Employment and Poverty...6 Balance of Payments and External Debt...8 Financial Markets and Corporate Sector...10 Policies Monetary Policy...12 Fiscal Policy PROSPECTS External Environment...15 Output and Demand...17 Employment and Poverty...19 Balance of Payments and External Debt...19 Monetary Policy...20 Fiscal Policy Appendix: Summary Macro and Fiscal Tables...27 Boxes Box 1. Petroleum Taxation in the Philippines...25 Box 2. Philippines: Revisions to the National Income Accounts...26 Figures Figure 1. The economy contracted for two quarters but recovered since...4 Figure 2. GDP per capita declined in /...4 Figure 3. GDP growth rebounded thanks to private consumption...6 Figure 4. Except for agriculture, all productive sectors all posted moderate improvements...6 Figure 5. Strong job creation but not enough to offset rapidly rising working-age population...7 Figure 6. Rising unemployment and under-employment...7 Figure 7. falling hours worked and rising labor force participation...7 Figure 8. Robust overseas deployment partly reflects global staffing restructuring...7 Figure 9. A resilient current account surplus...8 Figure 10. External trade is recovering but remains well below pre-crisis level...8 Figure 11. After a sharper decline, electronic exports are posting a strong recovery...9 Figure 12. Remittances have been strongly countercyclical in real peso terms...9 Figure 13. Reserves have surged by $20 billion since 2008Q4 due to strong BoP...9 1

4 Philippine Quarterly Update - February 2010 Figure 14. The external debt position remains comfortable... 9 Figure 15. Equities have surged past their pre-lehman Brothers level...11 Figure 16. as have spreads on dollar debt Figure 17..and similarly for domestic financing Figure 18. The Peso is rapidly appreciating following a long period of steady depreciation...11 Figure 19. Inflation troughed as the fuel and food price shocks disappeared, core remains subdued...12 Figure 20. Inflation remains within the BSP announced target band...12 Figure 21. BSP s rate cut were initially broadly matched by the banks till April...13 Figure 22. Private credit and bank lending growth are fading but financial assets keep growing...13 Figure 23. Gapping fiscal deficits and rising debt Figure 24. Rapidly declining tax effort, and rising share of interest payments to total revenue...14 Figure 25. A sharply deteriorating structural fiscal BALANCE Figure 26. mostly due to a structural decline in the BIR s TAX EFFORT...15 Figure 27. Consumer sentiment remains cautious Figure 28. Real remittance growth Figure 29. El Niño s impact on Agriculture and GDP Figure 30. Business sentiment is surging Figure 31. Inflation expectations remain well anchored Figure 32. Credit growth lags behind nominal GDP growth over the medium-term...21 Figure 33. National Government debt sustainability prospects deteriorated between 2008 and Figure 34. Philippines: Petroleum Taxation and the Poor Figure 35. Gasoline and Diesel Tax Estimates Around The World, 2008* Tables Table 1. Philippines Stock Exchange Index and Its Components, Table 2. Global Economic Prospects...16 Table 3. Philippines: How does the 2009 Downturn Compare with Past Recessions?...17 Table 4. Philippines: Selected Economic Indicators, Table 5. Philippines: National Government Cash Accounts (GFS Basis),

5 Laying Out the Exit Strategies Executive Summary Contrary to previous official estimates, the economy contracted between 2008Q4 and 2009 but recovered moderately afterwards. GDP grew by 0.9 percent in 2009 but contracted by 1 percent on a per capita basis. On the demand side, private consumption partly driven by strong remittance inflows and robust public spending have been the key growth drivers. Investment and net exports continue to be a drag on growth, but at a decelerating rate. On the supply-side, the typhoons profoundly impacted the agricultural sector in Q while industry is gradually recovering. Amid bright spots, social and labor market indicators remain weak reflecting the series of crises that have hit the country. Unemployment and underemployment are both rising, as is the labor force participation rate as household seek additional income in response to falling real wages and hours worked. OFW deployment remained strong despite rapidly rising global unemployment, reflecting the high demand for and supply of Filipino workers in the global labor market, particularly in the sea-faring industry. However, the incidence of hunger reached record highs in Q4, with Manila particularly hard hit. This partly results from the hardship that typhoon Ondoy brought to the capital region s poor. Despite a series of diverse global shocks, the balance of payments remained strong throughout the past two years, thanks to strongly counter-cyclical workers remittance inflows. The country s robust current account and BoP surpluses have permitted the BSP to accumulate substantial foreign exchange reserves in 2009 ($20 billion), providing ample support to the country s trade and external payments needs. Trade recovered in late 2009 but exports are still at only 2005 levels. As expected, remittances accelerated in Q4, in part due to transfers to typhoon-affected relatives. The countercyclical nature of real peso remittances has been remarkable in the past three years; as the economy recovers, the strength of these remittances is projected to wane in The central bank has begun to implement an exit strategy from the extraordinary crisis-related liquidity-support and monetary easing. As concerns about the liquidity and stability of the financial system have abated, and inflation measures are rising moderately, the BSP signaled in January a measured implementation of its exit strategy by realigning its rediscounting facility rate to the overnight RRP. Subject to fulfilling its inflation target, the BSP is expected to link the pace the monetary policy normalization to the strength of the economic recovery. The largest fiscal easing in over two decades weakened the structural fiscal balance; a clear and credible exit strategy is crucial to enabling a measured unwinding of the fiscal stimulus. Thanks to previous fiscal consolidation efforts, for the first time in recent economic downturns, the government was able to undertake a counter-cyclical fiscal policy. The 2½ percent of GDP in fiscal easing was the largest since 1986 and clearly helped buffer the economy during the global recession. However, it generated a NG fiscal deficit to 4.1 percent of GDP in 2009 (GFS basis), mostly of a structural nature as permanent revenue-eroding and expenditure-increasing measures were introduced. To enable a measured unwinding of this fiscal expansion so as to protect the nascent recovery laying out a specific medium-term plan that takes into account the country s inclusive growth agenda is warranted. Real GDP growth is projected to reach 3.5 percent in 2010 and 3.8 percent in This represents an upward revision from our previous Philippines Quarterly Update that reflects a stronger global outlook, stronger-than-expected OFW deployment in 2009, and a looser fiscal stance in 2010 than anticipated earlier, in part reflecting post-typhoon reconstruction activities. Our analysis shows that, so far, the size and pace of the peak-to-trough and the projected recovery in 2010 is closely aligned with past recessions in the Philippines. However, unless reforms address long-standing growth bottlenecks, the recovery s shape over the medium-term will move from V to \ / ----, i.e., stabilize at a lower equilibrium growth rate. 3

6 Philippine Quarterly Update - February 2010 Recent Economic Developments 1 Output and Demand 1. Revised official GDP data reveal that the economy contracted for two quarters in late 2008/early 2009 and expanded moderately thereafter. Revised GDP estimates show that, contrary to initial estimates, GDP actually fell on a seasonally adjusted basis for two consecutive quarters (2008Q4 and 2009) Figure 1. 2 A soft rebound in the following three quarters pushed the economy out of negative territory. In the fourth quarter of 2009, gains from the global economic recovery and a rebuilding of inventories were offset by agricultural losses caused by the massive typhoons-related flooding in Luzon island (where over two-third of domestic value added is created). 3 On a year-onyear basis, GDP managed to grow by 0.9 percent the slowest pace since the Asian financial crisis in 1998 but on a per capita basis, it decreased by 1 percent (Figure 2 and Table 4). Figure 1. The economy contracted for two quarters but recovered since Figure 2. GDP per capita declined in / in percent Seasonally Adjusted QoQ GDP Growth GDP GnP Private consumption Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 in percent YoY GDP per capita growth Source: National Statistical Coordination Board. Source: National Statistical Coordination Board. 1/ The series contains data breack in both 2000 and On the demand side, the recovery in private consumption and robust public spending have been the key growth drivers. While the drop in private consumption in the first quarter of 2009 led to a temporary contraction in GDP, its recovery in the second quarter helped buoy the economy as private consumption accounts for over 70 percent of GDP. Private consumption has grown more sensitive to shocks since the 2008 global food crisis when it first registered its negative growth since The rebound in private consumption was likely driven by strong remittances inflows (in real peso terms) and improved global outlook. While private spending registered a notable improvement in the Q4 2009, the quality and sustainability of this revival remains unclear as some of this additional spending in late 2009 was related to restoring damaged assets during the typhoons. The government s pump-priming efforts and the BSP s accommodative monetary policy have also been supportive of growth through 2009 (See policy sections). 1 The Philippines Quarterly provides an update on recent economic developments and policies, and presents findings from ongoing World Bank work on the Philippines. The update is produced by a PREM team from the Manila office consisting of Eric Le Borgne (Senior Economist and task team leader), Sheryll Namingit, and Franz Loyola with support from the Philippines country team. Questions can be addressed to David Llorito (dllorito@wordbank.org). 2 In terms of duration, the current technical recession is similar to that of the previous two recessions (2000 Q and Q2), while in terms of depth it falls in between these two (i.e., worse than in 2000/2001 but better than during the Asian Financial crisis). 3 For details on the impact of typhoons Ondoy (Ketsana) and Pepeng (Parma) on the Philippines economic, financial and social sectors, see Box 1 of the November 2009 Philippines Quarterly Update as well as the November 2009 Philippines Post-Disaster Needs Assessment (PDNA). Both reports are at 4

7 Laying Out the Exit Strategies 3. Investment and net exports continued to be a drag on growth, but at a decelerating rate (Figure 3). In the fourth quarter of 2009, capital formation contracted by only 0.8 percent (year-on-year) compared to the double-digit contraction of the previous four quarters, pushing the full year contraction to 9.9 percent in The improved performance was driven by the slowdown in the contraction of durable equipment and inventory re-stocking, motivated in part by a need to replenish low stock levels in light of improved growth prospects as well as the need to replace core equipments and machineries damaged by typhoons Ondoy and Pepeng. However, in the fourth quarter both public and private construction shrank. For the former, the contraction was due to the frontloading of capital spending in the Government s Economic Resiliency Plan; for the latter it mainly stems from oversupply in both residential and commercial real estate (as discussed in our previous Philippines Quarterly Updates). As the global economy recovered, net exports have also increasingly contributed to overall growth since the third quarter of 2009 (See balance of payments section). 4. On the supply-side, the typhoons had a profound adverse impact on the agricultural sector. As estimated in the PDNA report, 4 agricultural production suffered heavily because of weather disturbances especially in the central and northern part of Luzon which are heavy producers of rice. Rice production, which account for 17 percent of the total agricultural production, contracted on a year-on-year basis by 14 percent in the last quarter of This contraction accounts for almost the agricultural sector s entire 2.8 percent decline (year-on-year basis) in that quarter and dragged down the full year growth to 0.1 percent from 2.9 percent in January to September Industry showed signs of a gradual recovery after three quarters of negative year-on-year growth (Figure 4). With global recovery starting to take place, the manufacturing sector posted its first growth in the fourth quarter after three quarters of consecutive contraction. The utilities sector (electricity, gas and water), which is closely linked to manufacturing and commercial sectors, also improved from its negative contribution to growth in the last two quarters. The recent improvement, however, was not enough to prevent the overall industrial sector from contracting by 2.0 percent in The strength of the recovery is still uncertain based on seasonally adjusted growth. 6. The service sector has proved resilient but growth was subdued throughout The services sector slowed down considerably in the first half of 2009 but has started to recover in the third quarter. Its pace, so far, has remained moderate and uneven (Q QoQ sa growth was slower than in the previous two quarters). Early election spending seems to have stimulated the services sectors. For example, private services grew by a robust 6.1 percent in Q4 the highest in eight quarters with recreational services posting double digit growth. 4 Philippines Post-Disaster Needs Assessment (PDNA) report undertaken by the World Bank, other development partners and government agencies. November

8 Philippine Quarterly Update - February 2010 Figure 3. GDP growth rebounded thanks to private consumption Figure 4. Except for agriculture, all productive sectors all posted moderate improvements Contribution to YoY GDP growth and Domestic Demand Growth 12 YoY GDP Growth (Supply side) in percentage points Discrepancy investment Private consumption Dom. Demand g.r. net Exports Govt cons GDP growth Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 in percent Q2 agriculture Services manufacturing Q4 Q2 Q4 industry GDP Growth Q2 Q4 Q2 Q Sources: National Statistical Coordination Board and Department of Budget and Management Employment and Poverty 7. While total employment continued to grow, the labor market continues to weaken. Thanks, in part, to the Government s fiscal stimulus and particularly to the Comprehensive Livelihood and Emergency Employment Program (CLEEP) that employed 389,769 low income Filipinos from October 2008 to January 2010, net job creation remained robust in 2009 (through October), mostly due to the services sector (Figure 5). More generally, despite the rising number of jobs created since 2007, this has not been sufficient to offset the rapid increase in the working-age population and in the labor force (Figure 5). As a result, labor market indicators have worsened since the economy decelerated from its 7.1 real GDP growth rate. These include a steady increase in unemployment and, with a lag, in under-employment (Figure 6), a fall in the share of full time jobs (Figure 5) and in the average hours worked (Figure 7), and a steady increase in the labor force participation ratio (Figure 7). Labor Force Survey data also reveal that daily real wages declined noticeably through the first half of 2009 (latest available data). 8. Robust deployment of workers overseas partly reflects global recession-induced global staffing restructuring and the strong value-proposition of Filipino workers in the global labor market. After posting a strong 17 percent growth in deployment in 2008, deployment growth slowed down but remained robust, at 11.7 percent through November 2009 (Figure 8). This good performance could be partly related to an acceleration of global staffing recruitment towards more cost efficient sources. For example, in the sea-faring industry which has been, and continues to be, sharply affected by the global recession and the collapse in global trade and cruise ship tourism the pressure to drastically reduce costs has led some companies to accelerate their staff sourcing from countries such as the Philippines which has a large pool of comparatively cheap, English-speaking, and well qualified seafarers. As a result, sea-farers deployment increased by about 23 percent in the year through November 2009 (against an average of 14 percent during ). 6

9 Laying Out the Exit Strategies Figure 5. Strong job creation but not enough to offset rapidly rising working-age population Figure 6. Rising unemployment and under-employment thousands 1,606 1,406 1,206 Labor Force Survey (October rounds) Change in potential labor force (pop 15 years and over) change in actual labor force Job creation Share of full time jobs (RHS) Percent Percent Labor Force Survey (October rounds) Percent 22.0 Unemployment Rate (%) Underemployment Rate (% of Employed)--rHS , Figure 7. Falling hours worked and rising labor force participation Figure 8. Robust overseas deployment partly reflects global staffing restructuring Percent 65 Labor Force Survey (October rounds) Percent Total OFW Deployment (Land-based and Sea-based) Millions Land-based Sea-based Labor Force Partcipation Rate (%) Mean Weekly Hours Worked Jan-Nov 2008 Jan-Nov 2009 Source: National Statistics Office, October Labor Force Surveys. Source: POEA 9. Hunger incidence reached record highs in the fourth quarter of 2009; Manila fared particularly badly, mostly on account of the typhoons. A Social Weather Station (SWS) survey showed that hunger reached a record-high of 24.0 percent in December 2009 from 18.8 in October 2009 and from its previous record of 23.7 percent in December A significant rise was noted in Metro Manila. The jump in incidence might seem surprising at first as the impact of typhoons Ondoy and Pepeng (September 26 and October 5) did not have any notable impact on hunger incidence in October.5 A likely explanation for the initial subdued impact on hunger was the large immediate relief operation that was established by the government (561 evacuation camps providing food and shelter to over half a million people at the peak of the crisis including a large share of poor households who were living in the shantytowns; see Box 1 of our November 2009 Philippines Quarterly Update for details). These operations greatly helped struggling households in providing immediate relief but the spike in hunger incidence reveal that several months after the typhoons struck, poor households in Manila have not been able to fully recover. 5 The fourth quarter of 2009 Social Weather Station survey was conducted from December 5 to 10 and asked about the family s experience of hunger, self-rated poverty, and self-rated food-poverty in the last three months. The third quarter survey was conducted from October 24 to 27, three to four weeks after the typhoons. 7

10 Philippine Quarterly Update - February 2010 Balance of Payments and External Debt 10. The overall balance of payments was hardly affected by the global crises despite deep contraction in exports and some capital outflows especially in late 2008 / early The balance of payments remained resilient through the third quarter of 2009 at 2.9 percent of GDP, thanks to a strong current account which stood at 5.4 percent of GDP (Figure 9). The trade sector was hit considerably by the global recession but with the contraction in imports greater than that in exports, the impact on the trade balance through the September 2009 was positive (Figure 10). Moreover, the resiliency of nominal dollar remittances which grew by 5.6 percent in 2009 helped buoy the current account. Strong capital outflows occurred in Q but were gradually reversed and turned positive by Figure 9. A resilient current account surplus Balance of Payments Figure 10. External trade is recovering but remains well below pre-crisis level 6000 Balance of Trade, 3 mma in bln us$ Q2 Q4 others Financial account current account BoP position Q2 Q4 Q2 Q4 Q2 in bln us$ Exports imports Trade Balance (rhs) (0.5) (1.0) (1.5) in bln us$ mar-06 may-06 Jul-06 Sep-06 nov-06 Jan-07 mar-07 may-07 Jul-07 Sep-07 nov-07 Jan-08 mar-08 may-08 Jul-08 Sep-08 nov-08 Jan-09 mar-09 may-09 Jul-09 Sep-09 nov-09 Jan-10 Source:Bangko Sentral ng Pilipinas Source:National Statistics Office 11. Exports are recovering but this reflects base effects as December data are still at 2005 levels. While both exports and imports have been posting strong year-on-year growth in Q4 (e.g., exports grew, on a year-on-year basis, by 24 percent in December and 43 percent in January), this reflects a strong base effect as export had contracted by 40.3 percent in December 2008 and by 40.6 percent in January 2009 (Figure 10). Electronic and semi-conductors exports accounting for about 60 percent of total Philippines exports have posted a sustained recovery (again from a low base) and the industry is confident that the uptrend is no longer due to re-inventory stocking (Figure 11). 12. Remittance growth accelerated in the latter part of 2009, in part due to OFWs sending money to typhoons-affected relatives. Remittances in nominal dollar terms grew briskly in both November to December compared to the rest of 2009 (Figure 12). As discussed in our November 2009 Philippines Quarterly Update, the uptick was expected as remittances in the Philippines act as insurance to households affected by natural disasters. Recent research based on Philippines data shows that an average of 60 percent of household income lost through natural disasters is replaced by remittances (Yang and Choi, 2007). 6 Notwithstanding the resiliency of the dollar value of remittances during 2009, the real peso value of these remittances has steadily (and rapidly in Q4) decreased during the year (Figure 12). 6 Yang, Dean, and HwaJung Choi, 2007, Are Remittances Insurance? Evidence from Rainfall Shocks in the Philippines, World Bank Economic Review, Vol. 21(2), pp

11 Laying Out the Exit Strategies Figure 11. After a sharper decline, electronic exports are posting a stronger recovery than other exports Figure 12. Remittances have been strongly countercyclical in real peso terms in bln us$ Exports, 3 mma non-electronics Electronics total in percent Philippines: Remittance Growth, 3 mma nominal usd nominal Php real Php mar-06 may-06 Jul-06 Sep-06 nov-06 Jan-07 mar-07 may-07 Jul-07 Sep-07 nov-07 Jan-08 mar-08 may-08 Jul-08 Sep-08 nov-08 Jan-09 mar-09 may-09 Jul-09 Sep-09 nov-09 Jan-10 Feb-07 apr-07 Jun-07 aug-07 oct-07 Dec-07 Feb-08 apr-08 Jun-08 aug-08 oct-08 Dec-08 Feb-09 apr-09 Jun-09 aug-09 oct-09 Dec-09 Source: North American Semiconductor Equipment Industry Source: Bangko Sentral ng Pilipinas 13. The Philippines showed a remarkable resiliency during 2009 on the external front. Aside from a balance of payments and current account in surplus, the country s foreign exchange reserves have also continued to rise to record-highs through 2009 and in early As of January 2010, gross international reserves stood at $45.7 billion, thereby providing the country with ample liquidity (GIR can cover 9.3 months of imports and more than four times short-term external debt by residual maturity Figure 13). More remarkable is the $20 billion increase in total reserves (NIR and the forward book of the BSP) from Q to Q (Figure 13). 7 As of November 2009, external debt as a ratio of GDP (BSP definition) rose slightly by more than one percentage point as the public sector tapped global bond markets. This increase notwithstanding, the share of short-term external debt to total debt declined to 10 percent at end Figure 14. Figure 13. Reserves have surged by $20 billion since 2008Q4 due to strong BoP Figure 14. The external debt position remains comfortable in mln US$ nir Foreign Currency Liquidity Forward Book in bln us$ External Debt long-term Short-term St external debt cover (rhs) Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 0 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q Source: Bangko Sentral ng Pilipinas Source: Bangko Sentral ng Pilipinas 7 The IMF s increased SDR allocation, deposits from global bond issuances, valuation gains and loan disbursements from multilateral organizations have been important contributors to the rise in reserves. 9

12 Philippine Quarterly Update - February 2010 Financial Markets and Corporate Sector 14. The impact of the global financial crisis and recession proved short-lived in both the Philippines equities and debt markets (Figures 15 to 18). The Philippines Stock Exchange index (PSEi) continued to surge beyond the 3,000 level through mid February, posting a 79 percent gain from its post Lehman Brothers trough in October As global risk appetite recovered, nonresident net inflows in the first two months of 2010 continued to be positive. Similarly, sovereign spreads have narrowed significantly since Q4 2008, notwithstanding the country s deteriorating structural fiscal balances. They are now lower than prior to Lehman Brothers collapse partly due to temporary supply and demand conditions (a reduction in the aggregate supply of global bonds in East Asia and ample demand for such bonds; the latter stems from the ample global liquidity thanks to central banks large quantitative easing and easy monetary policies, but also reflects the relative better performance of public finances in the region than in other parts of the world). 15. Except for small and medium enterprises, and the property and mining sector, the profitability of the corporate sector continued to improve. 8 Listed companies in the Philippines Stock Exchange posted a robust recovery in profits (through 2009 profits grew by 61 percent year-on-year; Table 1). The financial, industrial, holding firms and services sectors continued to grow their bottom line at double digit rates as both international and domestic conditions normalize. On the other hand, listed SMEs and mining companies posted negative profit growth during the same period. The property sector continued to be loss making as inventories remain large and price pressures have materialized in all segments of the market. Table 1. Philippines Stock Exchange Index and Its Components, Net Income Revenues Jan-Sep 2009 Jan-Sep 2008 % change Jan-Sep 2009 Jan-Sep 2008 % change PSEi , , Financials Sector Industrial Sector Holding Firms Sector Property Sector Services Sector Mining & Oil Sector Small and Medium Enterprises Total , , Source: Philippine Stock Exchange 8 Companies listed on the PSE are not representative of the overall Philippines corporate sector as they are concentrated 10 in a few sectors.

13 Laying Out the Exit Strategies Figure 15. Equities have surged past their pre-lehman Brothers level Figure 16. as have spreads on dollar debt Philippine Stock Exchange Index Sovereign Debt Spread and Foreign Exchange Rate 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 1,500 in basis points PHL EMBI (lhs) Foreign Exchange Rate (Php/USD)(rhs) Foreign Exchange Rate (PhP/Euro)(rhs) Jun-08 Jul-08 aug-08 Sep-08 oct-08 Dec-08 Jan-09 Feb-09 mar-09 may-09 Jun-09 Jul-09 aug-09 oct-09 nov-09 Dec-09 Jan-10 Jun-08 aug-08 oct-08 Dec-08 Feb-09 apr-09 Jun-09 aug-09 oct-09 Dec-09 Source: CEIC database Figure 17..and similarly for domestic financing Source: Bangko Sentral ng Pilipinas, CEIC database Figure 18. The Peso is rapidly appreciating following a long period of steady depreciation 1/ in percent Yield curve (Treasury Reference Rates) Jul-08 nov-08 Feb-09 aug-09 Jan Real and Nominal Effective Exchange Rate Indices (1980=100) Real Effective Exchange Rate (lhs) nominal effective Exchange rate Index (rhs) m 3m 6m 1y 2y 3y 4y 5y 7y 10y 20y 25y 12.0 Jan-08 Feb-08 mar-08 apr-08 may-08 Jun-08 Jul-08 aug-08 Sep-08 oct-08 nov-08 Dec-08 Jan-09 Feb-09 mar-09 apr-09 may-09 Jun-09 Jul-09 aug-09 Sep-09 oct-09 nov-09 Dec Source: Philippine Dealing and Exchange Corporation Source: bsp. 1/ Against major trading partners (US, Japan, European Monetary Union, United Kingdom). 11

14 Philippine Quarterly Update - February 2010 Policies Monetary Policy 16. Overall inflation eased in 2009 but upticks were seen in the latter part of 2009 as recovery gathered pace and the base effects from the 2008 price shocks faded (Figure 19). After average inflation reached 9.3 percent in 2008, it receded to 3.2 percent in 2009, in part driven by a 7.7 percent fall in fuel prices. Core inflation dropped from 6.2 percent in 2008 to 4.1 percent in 2009, following weak domestic and international demand. After bottoming out in August 2009, inflation edged up, partly due to the base effect from the 2008 global food and fuel price shock fading out, but also due to typhoon-induced temporary supply shocks. As a result, year-on-year inflation in December 2009 reached 4.4 percent still within the BSP s target inflation for 2009 of percent (Figure 20). In both January and February, headline inflation decelerated slightly, to 4.3 and 4.2 percent, respectively, due to slower price increases of food, beverage and tobacco, housing repair, and services. 17. The BSP has begun a prudent and paced exit from conditions of exceptional liquidity by raising the rediscount rate. At the height of the crisis, the central bank implemented liquidity-support measures and interest-rate stimulus (see previous Philippines Quarterly Updates for details). As concerns on the financial system and liquidity have eased, the central bank decided in January to increase and realign the rediscounting facility rate (which was reduced by 50 basis points at the height of the crisis) to the overnight RRP rate. However, the BSP kept its policy rates unchanged as economic growth remained weak and well below potential so that inflationary pressures remain manageable, notwithstanding risks of a return to global price shocks (e.g., to rice due to the El Niño phenomenon). It is notable that, while the BSP has aggressively cut rates at the onset of the global recession, banks have only partially passed on the BSP rate cuts (Figure 21). It is therefore unclear how quickly and fully banks would transmit future rate hikes (though experience points to an asymmetry in the response to rate cuts and rate increases). Figure 19. Inflation troughed as the fuel and food price shocks disappeared, core remains subdued Figure 20. Inflation remains within the BSP announced target band 14 Contribution to YoY Inflation Rate 14 Monetary Policy Headline inflation rrp core inflation Discount rates in percentage points Fuel Food core inflation others inflation rate PPi growth in percent Inflation Target Band may-07 Jul-07 Sep-07 nov-07 Jan-08 mar-08 may-08 Jul-08 Sep-08 nov-08 Jan-09 mar-09 may-09 Jul-09 Sep-09 nov-09 Jan Source: National Statistics Office Source: Bangko Sentral ng Pilipinas 12

15 Laying Out the Exit Strategies 18. Bank lending and private sector credit growth is rising again, after a period of rapid deceleration since the onset of the global crisis (Figure 22). From an average growth of 22.6 in August 2008 to January 2009, outstanding loans of universal and commercial banks grew at a slower pace through most of 2009, partly due to tightening of lending standards. However, in late 2009, a temporary recovery in lending emerged, with lending growth reaching double digit again in December. Most of the increase in bank lending was driven by loans for the transportation, storage and communication sector. Meanwhile, construction and manufacturing loans continued to decline on a year-on-year basis, by 27.4 percent and 16.7 percent respectively in December. On the consumption side, the biggest drivers were car financing and credit cards. The January figures reveal, however, that bank lending growth moderated to 5 percent, mainly due to a deceleration of loans to production activities. Figure 21. BSP s rate cut were initially broadly matched by the banks till April Figure 22. Private credit and bank lending growth are fading but financial assets keep growing Cumulative Reduction in Policy Rate and Lending Rate Policy Rate (overnight reverse repo rate) Money and Credit Growth in percentage points Bank lending rate in percent Financial assets m4 Private sector credit Bank lending nov-08 Dec-08 Jan-09 Feb-09 mar-09 apr-09 may-09 Jun-09 Jul-09 aug-09 Sep-09 oct-09 nov-09 Dec-09 Jan-10-8 Jan-08 Feb-08 mar-08 apr-08 may-08 Jun-08 Jul-08 aug-08 Sep-08 oct-08 nov-08 Dec-08 Jan-09 Feb-09 mar-09 apr-09 may-09 Jun-09 Jul-09 aug-09 Sep-09 oct-09 nov-09 Dec-09 Source: Bangko Sentral ng Pilipinas Source: Bangko Sentral ng Pilipinas Fiscal Policy 19. The magnitude of the fiscal stimulus implemented in 2009 was unprecedented in recent Philippines history. The 2.6 percentage points of GDP in fiscal easing of the overall fiscal balance (GFS basis) from 2008 to 2009 was the largest one recorded since the 1986 People Power revolution (Table 5). By comparison, during the Asian financial crisis, the fiscal easing (the second largest after ) amounted to 2.0 percent of GDP. The large fiscal stimulus helped buffer overall economic activity in The large fiscal stimulus, however, pushed the national government s primary fiscal balance (i.e., excluding interest payments) into its first deficit since 2002, the estimated public sector balance into its first deficit since 2005, and led to the first increase in the non-financial public sector debt-to-gdp ratio since 2003 (Figure 23 and Table 5). 9 Such a large counter-cyclical and timely fiscal stimulus contrasts with past fiscal behavior which had been pro-cyclical (Zakharova, 2006; Botman, ). The government was able to launch the ERP thanks to the combination of (1) fiscal space created in previous years and (2) the strong balance of payments position resulting from large and sustained OFW remittances. 9 The National Government debt increased for the second year in a row in Zakharova, D., 2006, Cyclically-Adjusted Balances and Fiscal Sustainability in the Philippines, IMF Country Report No. 06/181; Botman, D., 2009, Fiscal Policy During Downturns and the Pros and Cons of Alternative Fiscal Rules, IMF Country Report No. 09/63. 13

16 Philippine Quarterly Update - February The fiscal deficit reached 4.1 percent of GDP in 2009, the highest level since the implementation of fiscal reforms in (Figure 23). The worsening of the fiscal balance was broadly evenly divided between higher spending (1.4 percentage points of GDP), and lower revenue (1.2 percentage points of GDP). On the spending side, 40 percent of the increase was due to discretionary primary spending (related to the Economic Resiliency Plan) and more than 20 percent due to the increases in the wage bill due to the adoption of the Salary Standardization Law (SSL III). On the revenue side, the decrease stems from a sharp drop in the tax effort (1.3 percentage points of GDP) so that the tax effort is now lower than in 2005 (the year of tax reforms). As a result, indicators of fiscal sustainability, such as the share of interest payments to total revenue is growing rapidly even though the country is currently borrowing at record low rates (Figure 24). Figure 23. Gapping fiscal deficits and rising debt Figure 24. Rapidly declining tax effort, and rising share of interest payments to total revenue Percent o f G D P Philippines: Public Finance Debt and Deficits CPS fiscal balance (RHS) NG fiscal balance (GFS basis) (RHS) ng Debt-to-GDP ratio nfps debt-to-gdp ratio Percent o f G D P Percent Philippines: tax Effort and interest-to-income burden NG Tax collection (RHS) interest payment-to-total revenue ratio (GFS) Percent o f G D P Source: Department of Finance. Source: Bureau of Treasury. 21. The change in fiscal balances from 2008 to 2009 was mostly due to a sharp deterioration of the structural fiscal balance, and structural revenue in particular. While the structural fiscal balance (i.e., excluding cyclical component and one-off items) had significantly improved from 2006 to From 2006 to 2007, the balance remained broadly unchanged. However, in 2009 it deteriorated markedly (Figure 25). Most of the deterioration stems from the revenue side. Since the global food and fuel price shocks in 2008, Government and Congress have responded to the global shocks by introducing permanent tax cuts or exemptions. As a result, a large share of the gains from the 2005 reforms (e.g., evat) has been undone (Figure 26) Recently, cyclical and one-off factors have been more pronounced on the fiscal balance (oil and rice price shocks; financial crisis and recession; typhoons) Figure 25. In 2008, the rapid increases in oil prices has allowed the government to collect a large revenue windfall (notably on the VAT), though some of it was offset by increased rice price support (but only a small part of the fiscal support to NFA is on-budget). The global financial crisis and recession led the government to introduce a temporary fiscal stimulus, the Economic Resiliency Plan. Finally, the impact of typhoons Ondoy and Pepeng on public finances, both revenue and expenditure, will remain noticeable in the short- to medium-term. 11 The most important recent tax eroding measures which have been described in details in previous issues of our Quarterly Update are the following: 0.5 percentage points of GDP originate from the reduction in the corporate income tax (from 35 to 30 percent), 0.3 percentage points of GDP stem from the cut in personal income tax, and 0.15 percentage points of GDP are due to the replacement of the VAT by a lower-yielding franchise tax on power transmission. 14

17 Laying Out the Exit Strategies Figure 25. A sharply deteriorating structural fiscal balance 1/ Figure 26. mostly due to a structural decline in the BIR s tax effort Percent of potential GDP Decomposition Analysis of the NG Fiscal Balance Percent of potential GDP Components of the NG Structural Fiscal Balance total revenues total expenditures Structural fiscal deficit (RHS) Percent of potential GDP cyclical fiscal balance cyclically-adjusted fiscal balance Source: WB staff calculation based on the second method presented in Fedelino et.al., 2009, Computing Cyclically Adjusted Balances and Automatic Stabilizers, IMF, FAD Technical Notes and Manual, Washington DC. 1/ The small share of cyclical factors in the overall fiscal balance is common in developing and emerging markets as automatic stabilizers are rather modest. 23. Notwithstanding weaker public finances and renewed global sovereign risk aversion (Dubai, Greece), the Philippine has accessed global bond markets on favorable terms. Thanks to ample domestic liquidity and continued strong demand for emerging Asia global bonds, the country has been able to tap the markets at record low rates and long maturities (Figures 16 and 17). In particular, the government raised $1.5 billion in global bonds in early January the first Asian issuer in 2010 in two durations: 10 and 25-year dollar-denominated bonds whose yields were 184 and 195 basis points over US Treasuries, respectively. In February, the government issued $1.1 billion worth of Samurai bonds. With these two operations, 40 percent of the total planned foreign borrowing for 2010 has already been accomplished in the first quarter. The remaining foreign financing is planned to come from non-market sources (bilaterals and international financial institutions) though the government has also announced it is preparing to issue its first Diaspora bond (raising $500 million and 100 million) for March PROSPECTS External Environment 24. The global economic recovery though still fragile is on firmer grounds (World Bank, ). After an unprecedented 2.2 percent decline in 2009, global GDP is projected to grow by 2.7 percent in 2010 and is expected to accelerate modestly to 3.2 percent in 2011 (Table 2). As the positive impact of the unprecedented fiscal and monetary stimuli and the inventory cycle wanes, the pace of the recovery is projected to slow down. This is in part because spending is expected to be less buoyant with households and the banking sector in need of rebuilding their balance sheets. Risks to the baseline projection remain substantial, especially on the downside. In particular, a double-dip characterized by a further slowing of growth could materialize if the unwinding of the fiscal and monetary policy is too rapid and forceful. The financial system remains weak in major parts of the world with 40 percent of anticipated write-downs of US-domiciled banks and 33 percent of potential losses in major European banks yet to be recognized and provisioned for (ECB Financial Stability Review, ). 12 World Bank, 2010, Global Economic Prospects 2010, Washington DC, January. 13 European Central Bank (ECB), 2009, December 2009 Financial Stability Review, Frankfurt, Germany. 15

18 Philippine Quarterly Update - February 2010 Table 2. Global Economic Prospects (Percent Change from previous year, except interest rates and oil prices) / / / Real GDP growth 1/ World High income United States Euro area Developing Countries East Asia and Pacific China Memorandum items: World trade volume Commodity prices (US$ terms) Non-energy commodities Oil Price (US$ per barrel) 4/ Oil Price (percent change) Source: Global Economic Prospects 2010, World Bank 1/ Aggregate growth rates calculated using constant 2005 U.S. dollar GDP weights; 2/ Estimate; 3/ Forecast; 4/ Simple average of Dubai, Brent and West Texas Intermediate. 25. Faster economic growth in East Asia will be more likely sustained but compared to recovery from the Asian financial crisis and dotcom bust, the recovery is expected to be more muted, reflecting weaker global demand and less buoyant financial conditions. Continued strong advances in China s domestic demand, and associated imports, should play an important role in underpinning a second export-led revival phase for the remainder of the region. 26. As consumption and investment activity remain vulnerable, world trade will continue to lag behind economic activity (WB s Global Economic Prospects 2010). Global investment activity fell by 9.7 percent in 2009 and is estimated to grow by only 4.9 percent in Given that investment goods are generally heavily traded, world trade will remain depressed until economic recovery picks up. Furthermore, even with trade in goods and service projected to grow by 4.3 percent and 6.2 percent in 2010 and 2011, respectively, overall volume will still be 5 percent lower than its 2008 peak as a result of the weak recovery and base effects. Commodity prices will be relatively stable over the medium term. 27. Crude oil prices are expected to rise only slightly as a result of the large inventory overhang from the huge drop in demand and soft economic recovery. However, prices of major metal commodities, aluminum and copper are anticipated to rise moderately as metal demand expands with the recovery and excess capacity seen during the crisis is reduced. Even with increasing production costs and rising demand for biofuels, agricultural commodities are expected to be steady due to improvements in total factor productivity. Short-term food security concerns have settled down as most countries have reversed restrictive trade policies that followed from the 2008 food price crisis. 16

19 Laying Out the Exit Strategies Output and Demand 28. The Philippine economy is projected to grow by 3.5 percent in 2010, and 3.8 percent in Growth in 2010 is slightly higher by 0.4 percentage points compared to our earlier forecast (November 2009 Philippines Quarterly Update). The upward revision reflects (1) a stronger global outlook, (2) stronger than expected OFW deployment in 2009 leading to an upward revision in our remittance projections (to 6.0 percent), and (3) a looser fiscal stance in 2010 than previously anticipated (in part to reflect additional spending for post-typhoon reconstruction activities). Other important growth drivers for 2010 include a replenishment of depleted stocks, election-related spending in the first half of 2010, and the strong short-term outlook for the Business Process Outsourcing (BPO) sector. The growth uptick from 2010 to 2011 is, however, expected to be moderate given our projected slow global recovery, the projected acceleration of the unwinding of monetary and fiscal policy stimuli, and more binding constraints arising from growth bottlenecks. 29. The magnitude of the current economic downturn and its projected short-term recovery in 2010 is aligned with past Philippines recessions (Table 3). A simple statistical comparison of growth trends around the average of the 1991 and 1998 recessions with the 2009 downturn reveals that the peak-to-trough decline in GDP are similar then and now (6.9 versus 6.2) but the composition differs noticeably. In previous recessions, the Philippines had weaker public finances and a current account deficit (Panels a and b of Table 3). This prevented the use of a forceful fiscal stimulus (-8.6 then, +2 now) and required a stronger domestic adjustment in private consumption and investment. Interestingly, the projected strength of the recovery from 2009 to 2010 is very close to that experienced in past recessions (our 3.5 percent growth projection compares to the simulated 3.4 growth Table 3, panel b). One notable difference concerns the medium-term part of the recovery, with our global prospects projecting a protracted and muted recovery, the recovery in 2011 will not be as strong as during the previous recoveries (the recovery s shape will change from V to square root). Table 3. Philippines: How does the 2009 Downturn Compare with Past Recessions? Average GDP Growth During Crisis Years Projected GDP Growth based on historical (t = 1991,1998) crisis and recovery path (t=2009) t-2 t-1 t t+1 t+2 t+3 Σ peak to trough 1 / Private Consumption Government Consumption Capital Formation Fixed Capital Construction Durable Equipment Exports Imports GDP t-2 t-1 t t+1 t+2 t+3 Σ peak to Actual Simulated trough 1/ Private Consumption Government Consumption Capital Formation Fixed Capital Construction Durable Equipment Exports Imports GDP Source: World Bank staff calculations. 30. Growth in private consumption is projected to hold up well in 2010 but its pace will be slower than in the pre-crisis years. Demand is projected to benefit from increased election spending. Heightened precautionary savings that dampened spending in 2009 will more likely diminish as consumer expectation gradually over the next 12 months improve (Figure 27). The higher marginal propensity to spend is, however, projected to be partly offset by a reduced pace of remittance inflows (in real peso terms 14 ) Figure 28 and continued downward pressure on real wages. 14 While the rate of growth of remittance inflows are projected to increase in US dollar terms, partly on account of still robust deployment of Filipino workers that took place in 2009 (12 percent growth in January to November 2009 compared to 17 percent in 2008) the impact of these inflows on consumers purchasing power will be tempered by the expected higher increase in prices and moderate strengthening of the Peso (compared to 2009). 17

20 Philippine Quarterly Update - February 2010 Figure 27. Consumer sentiment remains cautious Figure 28. Real remittance growth Overall Consumer Outlook: Composite Index current Quarter next 3 months next 12 months Q2 Q4 Q2 Q4 Q2 Q in percent Remittance Growth 1/ nominal $ nominal Php real Php OFW Deployment Source: National Statistics Office Source: Bangko Sentral ng Pilipinas 1/ Growth for OFW deployment for 2009 is only from Jan-Nov. 31. Investment is projected to post a small rebound. Capital formation is expected to remain weak, expanding by 2 percent in While restocking and some reconstruction efforts to restore lost assets during the September-October 2009 floods will provide some support, investment is projected to remain at historically low levels in 2010 as companies will want to (1) have more visibility regarding the sustainability and strength of the recovery; and (2) delay some investment to after the May general elections before committing to long-term irreversible investment plans. On the public sector side, investment will be constrained by the election ban on the inception of new projects. With the Philippines global ranking in Doing Business surveys steadily declining over time, FDI inflow is expected to remain moderate. 32. On the production side, a weak but more-broad based improvement is seen in 2010, as revealed by the overall improvement in business sentiment (Figure 30). Having been devastated by the massive flooding in the last quarter of 2009, the agriculture sector is expected to recover and grow moderately percent in 2010 from 0.1 percent. The slow growth pick up is due to the moderately strong El Niño phenomenon that is projected by the Philippine Atmospheric, Geophysical and Astronomical Services Administration (PAGASA). This will negatively impact agriculture output, and rice production in particular. A rebound in manufacturing worldwide will push overall industrial production to 3.1 percent in Backed by increased demand for transportation, communication and storage, and trade service during the election period, the services sector is projected to grow by 4½ percent this year. Figure 29. El Niño s impact on Agriculture and GDP Figure 30. Business sentiment is surging contribution to growth, in ppt El Nino Phenomenon & Agricultural Production Services industry agri 1998: Severe El nino 2003: mild El nino Business Sentiment current Quarter next Quarter Source: National Statistics Office Source: Bangko Sentral ng Pilipinas

21 Laying Out the Exit Strategies 33. The outlook is subject to El Niño-related downside risk. A worse-than-expected El Niño could significantly pull down the economy s aggregate growth rate. Indeed, the severe 1998 El Niño phenomenon impacted agricultural output so much that the sector s contribution to the drop in GDP was actually larger than the impact of the Asian financial crisis (Figure 29). Production would be further affected if typhoon-damaged agricultural infrastructure were not reconstructed on time. A worse El Niño could also cause supply disruptions and a resurgent food price shock. As in 2008, this could result to an uptick in inflation, reduce real income and increase the losses of the National Food Agency. The latter s loss would be an automatic liability of the public sector. 15 El Niño has already noticeably reduced the capacity of hydroelectric power plants, especially in Mindanao where this has resulted in large scale rotating power cuts. Similar but less extensive power cuts have also taken place in Manila. A worse than expected El Niño phenomenon, through its impact on electricity supply, would significantly affect energy-intensive industry sectors, including electronics and semi-conductors that account for about 60 percent of the country s exports. 34. Upside risks to the outlook include a stronger-than-expected global recovery. This could have a positive impact on the domestic economy via its impact on OFW deployment, remittances and exports which could grow faster than anticipated in our baseline scenario. Employment and Poverty 35. The labor market is expected to improve but its structural weaknesses will remain unless reforms are introduced. Aside from the general recovery in economic activity, the general election campaign will provide temporary employment opportunities especially for unskilled workers. Structural improvements, however, can only occur through structural reforms of the labor market. Overseas working opportunities, while somewhat reduced compared to the pre-global recession period, are projected to continue providing relief to the rapidly expanding domestic labor force. 36. Generating inclusive growth is projected to remain a fundamental challenge for the Philippine economy; poverty incidence is estimated to remain high. The food crisis in 2008, the economic downturn and the recent typhoons have thrown an estimated 1.4 million households into poverty, compared to a no-crisis scenario (See November 2009 Philippines Quarterly Update for details). While the resumption in growth is a necessary condition for poverty incidence to decrease, as the experience between 2003 and 2006 testifies, this is not a sufficient condition. The El Niño phenomenon could, in particular, be a significant source of new duress for poor and near poor households. This could also generate large increases in hunger incidence as 74.8 percent of the poor reside in rural area where selfsubsistence farming is widespread (World Bank, ). Balance of Payments and External Debt 37. The outlook on the balance of payment remains positive with the current account projected to remain in surplus thanks to remittances (Table 4). While it is expected to be lower than the expected surplus of 5.5 percent of GDP in 2009, the current account is projected to post a robust surplus of 3.5 percent of GDP in The strong outlook hinges on the prospect of higher remittances as a result of increased deployment of Filipino workers during the crisis and the recovery in the global economy. The capital account is expected to widen, due to higher external financing needs from the public sector. To date, the issuance of global and Samurai bonds have already boosted the overall BOP balance in Total inflow of foreign direct investment is expected to moderately improve. 15 For an overview of the stark inefficiency of the NFA in providing support to the poor and the large fiscal cost involved, see Box 3 of the November 2009 Philippines Quarterly Update. 16 See chapters 4 and 6 of Philippines: Fostering More Inclusive Growth, World Bank, forthcoming 19

22 Philippine Quarterly Update - February Exports and imports are projected to recover in 2010 but would still remain significantly below pre-crisis levels. Exports are projected to return to pre-crisis level only gradually (by 2012). With nearly 60 percent of the country s exports consisting of electronics and semi-conductors which were traditionally mostly aimed at final consumers in developed countries (the US, EU, and Japan in particular), the country is expected to only benefit moderately from the strong projected growth in the East Asia region. The country s improved ranking in the World Bank s World Trade Indicators, notably in the Logistics Performance Index, is welcome and encouraging. Continued improvement in the overall investment climate would greatly help the country increase capacity and diversify its exports. 39. Continued demand for Overseas Filipino Workers ensures growth of remittances for As deployment of both unskilled and skilled workers like engineers, health workers and teachers remained strong in 2009 (growth of 12 percent through November), workers remittance inflows are projected to continue growing (by 6 percent). Demand for Filipino labor is expected to continue in 2010, albeit at a slower pace than in 2009, as the global recovery is projected to have a low job intensity in Monetary Policy 40. Inflation is expected to accelerate modestly in 2010 but to stay within the BSP s announced target band. Well anchored inflation expectations (Figure 31), a weak labor market, a positive output gap, and a projected modest rise in global commodity prices all point to contained domestic inflation. However, some supply side bottlenecks are expected to drive up inflation slightly (to 4.8 percent in 2010). These include some localized food supply shock stemming from the El Niño phenomenon which is already being felt in 14 provinces and is expected to persist until June 2010 (PAGASA, ). As a result, food prices this year are expected to rise faster than in Also, while electricity supply is constrained by lower water level in hydropower plants/dams, demand for electricity and water are expected to increase due to higher heat levels. Upside risks to our inflation forecast include the possibility, after the general election, of adjustment in politically sensitive administered prices (e.g., utilities tariffs) and in taxes. Potentially higher commodity prices also present an important upside risk. 41. The central bank s exit strategy from the crisis-fighting measures is clearly and coherently articulated. The Bangko Sentral ng Pilipinas (BSP) has clearly and explicitly announced sound principles to guide its exit strategy. First, the discontinuation of liquidity-support measures contingent on the normalization of activity in the financial markets. Second, subject to maintaining the inflation outlook and inflation expectations within the BSP s target band, the central bank will continue its accommodative monetary policy stance until the economic recovery gathers pace and traction. Such a strategy is consistent and aligned with the overarching objective of achieving inclusive and sustained economic growth in the Philippines (MTPDP ). 42. Well anchored inflation expectations and a slow elimination of the positive output gap provide some leeway for the BSP to implement its exit strategy. With inflation expectations well anchored (Figure 31), the BSP has enough room to maintain accommodative monetary policies to support the recovery. In addition, the output gap is projected to remain large and positive in 2010 and to close only in Demand-driven inflationary pressures are, therefore, expected to remain tame for some time. As far as asset-price inflation is concerned, while stock market prices have sharply rebounded and exceed their pre-lehman Brothers level (Figure 15), stock market ownership remains limited in the Philippines (estimated at less than 2 percent of the population) so that they are not expected to have a significant macroeconomic impact on domestic demand conditions. Similarly, while domestic credit growth greatly outpaced nominal GDP growth in 2009, such rapid expansion likely reflects the low base and a catch up effects from years of below nominal GDP growth (Figure 32). 17 PAGASA Advisory no. 6 (February, 2010) 20

23 Laying Out the Exit Strategies Figure 31. Inflation expectations remain well anchored Figure 32. Credit growth lags behind nominal GDP growth over the medium-term Inflation Forecast Performance Forecast Period Expected Inflation (One-year ahead) actual inflation Domestic Credit and Nominal GDP Growth in percent Inflation Target Band in percent Domestic credit nominal GDP Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q4 Q2 Q Source: Bangko Sentral ng Pilipinas Source: Bangko Sentral ng Pilipinas Fiscal Policy 43. Establishing and clearly disseminating a detailed and credible fiscal exit strategy is crucial to enabling a measured unwinding of the fiscal stimulus. While the fiscal stimulus helped buffer the economic slowdown, the structural deterioration in the fiscal balance is not sustainable over the medium-term. A comparison of the prospects for the debt path of the National Government between 2008 and 2009 ( Fan chart of Figure 33, panel a and b, respectively) reveals that probabilistic distribution of debt exhibits a notable upward shift, with far fewer likelihood of the debt ratio going down. 18 A detailed and credible strategy to reduce the large structural fiscal deficit over time is therefore crucial to maintaining investor, entrepreneur, and consumer confidence which is necessary to generate inclusive growth. Such a strategy could, for instance, lay out specific measures that would be used, both on the revenue and the expenditure side to achieve the stated goal of reaching fiscal balance by Some countries have found that pre-announcing the timing of some of these measures can be used both to instill confidence in the exit strategy itself but also to boost current consumption (e.g., this would be the case with a pre-announced increase in taxes on consumption). 44. Nesting the planned unwinding of the fiscal stimulus within a detailed medium-term fiscal framework would enhance credibility. A specific medium-term plan and path for unwinding the fiscal stimulus would minimize a fiscal crisis risk. While the Government aims to achieve an overall fiscal balance by 2013, accompanying this commitment with detailed measures (and their likely timing and yield) and embedding them within a medium-term fiscal framework and a medium-term expenditure framework would be desirable. Undertaking and publishing (say, as an annex of the annual NG budget document) a statement of fiscal risks surrounding the National Government budget would also help in improving the transparency and credibility of fiscal policy For example, as of 2008, the probability that the NG debt-to-gdp ratio would reach or exceed 80 percent by 2013 was a relatively low 15 percent. By 2009, that probability has increased to 30 percent (Figure 33). 19 See the forthcoming 2009 Philippines Development Report for an overview of fiscal risks in the Philippines. 21

24 Philippine Quarterly Update - February 2010 Figure 33. The National Government debt sustainability prospects deteriorated between 2008 and 2009 in percent of GDP DSA based on 2008 data Percentile distribution 90-95th 80-90th 70-80th 60-70th 50-60th 40-50th 30-40th 20-30th 10-20th 5-10th in percent of GDP DSA based on 2009 data Percentile distribution th 80-90th 70-80th 60-70th 50-60th 40-50th 30-40th 20-30th 10-20th 5-10th Source: World Bank staff calculations based on Celasun et al. (2006), Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A Fan-Chart Approach, IMF Staff Papers, Vol. 53(3), pp3-34. The fan chart approach builds on the baseline debt path projected in a standard debt sustainability analysis (using the baseline macroeconomic scenario shown in Table 4) by adding confidence intervals around this central projection (the confidence interval is constructed by drawing on the joint distribution of historical shocks to key macroeconomic variables e.g., economic growth, the exchange rate, domestic and foreign interest rates). The fan chart reveals that while the baseline scenario (50th percentile) projects a debt path that is broadly stable, there is significant uncertainty surrounding this projection. See Chapter 2 of the 2009 Philippines Development Report for further details on the methodology and its application to the Philippines. 45. Creating a strong revenue base is crucial to increasing fiscal space needed to support a sustained and inclusive growth. With no new revenue-increasing policy measures to boost tax collection and a few to erode it, the tax effort is projected to reach 13.0 percent of GDP in 2010, only marginally higher than in 2009 (Table 5). The rebound in the tax effort from high-elasticity taxes such as the corporate income tax is expected to be offset with (1) the loss carry forward stemming from the 2009 economic downturn and the Ondoy and Pepeng typhoons 20 and the new tax eroding measures such as the selective VAT exemption for senior citizens. On the expenditure side, the salaries of government employees will continue to increase (by 50 percent over four years starting in July 2009) as a result of the Salary Standardization Law III (the total cost is budgeted at P125.6 billion or 1.6 percent of 2009 GDP). Capital spending is projected to shrink as a ratio of GDP compared to 2009 as a large part of the 2009 increase was related to the fiscal stimulus plan. The fiscal deficit (GFS definition) is projected to reach 3.8 percent of GDP in 2010 from 4.1 percent in Barring new reform measures, the deficit which is mostly of a structural nature (Figure 26) is expected to remain sizeable over the medium term. 20 The tax impact of the typhoon will also arise from VAT input refunds that companies are entitled to. The extent of the actual refunds is unclear, however, as such refunds are surprisingly low in the Philippines. One reason is that such requests require extensive administrative paperwork and trigger an automatic audit of the company seeking such a refund. The refund process takes several years (far exceeding the legally mandated six months) and, even when granted, the funds would seldom be given in cash but be provided in the form of a tax credit certificate. A lack of a well functioning input credit refund process fundamentally destroys the neutrality and efficiency of the VAT whereas these are precisely the advantages of relying on a VAT. 22

25 Laying Out the Exit Strategies The following measures could be considered to efficiently and equitably strengthen the revenue base: o o Tax policy: (1) A moratorium on new tax eroding policy measures until the tax effort has returned to, at least, its 2008 level, (2) the rationalization of fiscal incentives, which would broaden the base, eliminate tax redundancies (estimated at 1 percent of GDP), improve horizontal equity among firms, not distort capital allocation, and facilitate tax administration and governance, (3) implementation of a law that limits deductions to core business expenses (as provided in some versions of the SNITS), and (4) increased excises on tobacco, alcohol, and gasoline. This last measure has the best revenue potential because it is efficient, highly progressive, and easy to collect; Box 1). Tax administration: such reforms would both help with short-term revenue gains and pave the way for long-term improvement in administrative efficiency. Through improved tax compliance they would also improve horizontal and vertical equity. The renewed focus of the BIR leadership to strengthen its Large Taxpayers Service (LTS) is commendable. At the same time, ongoing tax compliance and collection reform measures need to be pursued forcefully Focus on these compliance-improving measures is warranted by a provision in the 2009 budget to institutionalize the RATE, RATS, and RIPS programs as permanent offices in the BIR, BOC, and DOF respectively. Improving performance monitoring and evaluation in BIR and BOC would help strengthening accountability, professionalism, and transparency of the Bureaus. 47. Rationalizing expenditure, including off-budget spending could also help increase the spending efficiency. To increase fiscal space and make room for more effective and targeted spending, reforms aimed at streamlining costly and nontargeted social spending programs such as the rationalization programs of the NFA and NIA should be a priority. 23 While these programs mostly operate off-budget, they generate losses that affect the public sector fiscal balance. 21 These recommendations are detailed in the 2009 Philippine Development Report (forthcoming) These include expanding the tax base via third party information sharing and strengthening enforcement via the Run After Tax Evaders (RATE), Run After the Smugglers (RATS), and Revenue Integrity Protection Service (RIPS) programs. See the November 2008 Philippines Quarterly Update for details. 23 See Box 3 of the November 2009 Philippines Quarterly Update for a comparison of the efficiency and cost-effectiveness of the NFA and the CCT program as social safety net programs. The analysis concludes that, by reallocating the fiscal transfers from the NFA to the CCT, 100 percent of the poor would receive coverage, against 25 percent, with each poor household receiving 7 times the benefits it receives with the NFA. 23

26 Philippine Quarterly Update - February 2010 Box 1. Petroleum Taxation in the Philippines Tax collection from gasoline and diesel excises has plummeted since 1997; the beneficiaries have been the most well-off Filipinos. From 1997 to 2009, excise collection (in percent of GDP) has been reduced by 1.8 percentage points of GDP. The sum of the annual losses in excise collection since 1997 reaches a staggering 18.2 percentage points of GDP (P1,400 billion; $30 billion) once interest costs are included. 1/ Maintaining the 1997 excise effort level, or the real value of excises, would have resulted in a drastically lower public debt (currently exceeding 60 percent of GDP). Such a relatively high level of debt requires about 4 percent of GDP in annual debt service payment; this money could have been allocated for the much needed priority spending on infrastructure, health, education, and social protection, thereby benefiting the poor. Petroleum excises on gasoline and diesel are among the most progressive taxes in the Philippines i.e., the tax rate increases as your income increases (Figure 34). However, with the real tax rate decreasing steadily over time, this has eroded the effective progressivity of tax system in the country. Hence, the richer the household, the larger the benefit received from lower excises on petroleum products at the expense of the budget. Figure 34. Philippines: Petroleum Taxation and the Poor Source: FIES 2006 and World Bank staff calculations. Gasoline and diesel taxation in the Philippines is low by international standards Rich consumers in most countries pay higher taxes than rich Filipino consumers (especially for diesel) Figure 35. The range of countries with higher petroleum taxation ranges from emerging markets (e.g., Turkey) to low income (e.g., Bangladesh, Mauritania) and developed countries (e.g., Japan, Hong Kong, Korea, Singapore). Figure 35. Gasoline and Diesel Tax Estimates Around The World, 2008* US$/liter 1.60 Gas Tax Estimates Around The World (excl. oil exporting countries, November 2008) US$/liter 1.20 Diesel Tax Estimates Around The World (excl. oil exporting countries, November 2008) Philippines Philippines Jordan lebanon namibia Honduras Guatemala South africa ukraine Bhutan Suriname lao People's Dem.rep chile niger Benin afghanistan, i.r. of armenia New Zealand romania Somalia Fiji Haiti Estonia Kenya Greece Brazil lithuania Grenada mali Zimbabwe albania israel Sweden Bulgaria Poland central african rep. mauritania Korea madagascar Finland Portugal netherlands malawi China,P.R.:Hong Kong Jordan Bangladesh Gambia, the lebanon El Salvador nepal Jamaica New Zealand togo Haiti Singapore lesotho Dominican republic afghanistan, i.r. of niger tajikistan Guinea Brazil Fiji Zimbabwe costa rica macedonia, Fyr Somalia uruguay congo, Dem. rep. of uganda cyprus Slovenia Estonia albania luxembourg Grenada mozambique Korea mongolia madagascar France Portugal Sweden malta turkey Denmark Source: OECD, International Energy Agency, Energy Prices and Taxes. * Excluding oil exporting countries. Data as of November / Since the fiscal balance has been in deficit, the foregone revenue was financed through debt issuance. 24