Report No. 39226-PH Philippines Invigorating Growth, Enhancing Its Impact May 18, 2007 Poverty Reduction and Economic Management Unit East Asia and Pacific Region Document of the World Bank Philippines: InvigoratingGrowth. Enhancingits Impact Table of Contents Executive Summary ................................................................................................................. 111 ... IRecentEconomicDevelopments.......................................................................................... . 1 I1. How RobustI s PresentGrowth?......................................................................................... 8 I11.Invigorating Growth, Enhancing Its Impact ..................................................................... 13 A. Fiscal Ref0rm.................................................................................................................... B. Strengthening Public Expenditure Management............................................................... 14 15 C. Improving the Investment Climate................................................................................... 17 17 21 3. Reforming the Maritime Sector .................................................................................. 2. Enhancing Competitiveness in the Cement Sector ..................................................... 1.Power Sector: ReformProgress and Priorities............................................................ 25 4.Enhancing Competition inthe Aviation Sector .......................................................... 28 Poor................................................................................................................................. 5. Reducing Agricultural Protection to Improve Competitiveness and Benefit the D. Maximizingthe Benefits of Growth for the Poor............................................................. 32 36 Statistical Annex ..................................................................................................................... 38 References ............................................................................................................................... 46 Boxes Box 1:Telecommunications Reform in the Philippines: Impact and Lessons....................... 13 Text Tables 1 Selected Economic Indicators................................................................................................ 2 2 Cement prices inEast Asian MICs ...................................................................................... 22 3 Per Capita Cement Consumption inEast Asian MICs ........................................................ 23 4 Cement: Capacity Utilization and Imports .......................................................................... 5 Infrastructure Ranking in the Global Competitiveness Report............................................ 23 25 7 Proposed PPA Amendments................................................................................................ 6 Economic Impact of RO-RO ............................................................................................... 26 27 Text Figures 2 Employment Growth Remains Modest.................................................................................. 4 1 Growth Driven by Consumption and Exports. not Investment.............................................. 3 3 Self-Rated Poverty andHunger ............................................................................................. 5 4 Public Sector Deficits & DebtDecline, Revenue Increases .................................................. 5 5 Balance of Payments- Strength Global Liquidity Boost Financial Market .......................... 7 6 Philippines Wages, Capital and Labor ................................................................................ 11 7 Domestic & World Rice Prices............................................................................................ 33 i ACKNOWLEDGMENTS This report wasprepared by a team led by Sanjay Dhar and comprised Jehan Arulpragasam, Karl Chua, Victor Dato, Ben Eijbergen, Awind Gupta, Alessandro Magnoli, William Mako, Yasuhiko Matsuda and Sergiy Zorya. The report utilizes background papers by: Enrico Basilio, Gilbert Llanto, Cherry Rodolfo (Transport Infrastructure) and Mary Mirandilla (Telecommunications). Gloria Elmore and Necitas Garcia provided administrative assistance. Commentsfrom Philippine Government officials, representatives of Philippine industry, IMF and WorldBank staff are gratefully acknowledged. An earlier version of this report was preparedfor the Philippines Development Forum, held in Cebu City on March 8-9, 2007. ii EXECUTIVE SUMMARY Major fiscal adjustmentduring2005-06, aided by abundant globalliquidity,has turned around marketsentiment on the Philippines. Stocks, the peso and reserves have all risen significantly, as have foreign direct investment and portfolio inflows, while interest costs and spreads for government borrowing have fallen along with inflation. Real GDP grew by 5.4 percent in 2006 and real GNP by 6.2 percent, marking the first time that three consecutive years of growth of 5 or more percent was recorded since the 1970s. Strong growth in business process outsourcing, electronics exports and remittance-driven consumption served as important props for higher growth. The financial market turnaround has yet to translate into higher overall investment, which has been stagnant in real terms and has declined as a share of GDP to below 15 percent. This is of concern since higher economic growth is needed to generate more jobs and reduce poverty more rapidly, and it i s difficult to see how sufficiently robust growth can be sustained at present levels of investment. Moreover, the labor market response to the growth that has occurred has been insufficient to reduce unemployment significantly. The strategy to accelerate growth and enhance its impact involves four elements: A. Fiscal policy must continue to lower the public debtIGDP ratio, which, although significantly reduced since its peak in 2003, remains high. Policy credibility has improved with both the extent of fiscal adjustment-about 5 percent of GDP during200506, and the fact that successful implementation of the VAT reform helped to reverse an extended deterioration in the tax effort dating from the 1997 Asian crisis. Credibility would be strengthened further by meeting the government's medium-term fiscal targets that include a balanced budget by 2008 and further increases in the tax effort in both 2007 and 2008. To reduce public debt and reverse chronic under-spending of public resources, the tax effort will need to continue to improve: for which more effective tax administration i s essential, but tax policy adjustments will also be needed. B. The growth impact of public expenditure can be enhanced by increasing public investment, shifting expenditure to support more growth-oriented public policies, strengthening spending agencies' capacity for executing the budget, and minimizing corruption and other forms of resource leakage. C. Improvingthe Investment Climate. The Philippineslow rankings in competitiveness surveys, infrastructure comparisons, and educational achievement has appropriately stimulated efforts to simplify approval procedures and upgrade infrastructure and skills. This report offers suggestions for reform in a few specific areas-where the payoff in terms of unleashing investment and job growth through opening markets to greater competition i s judged to be significant: ... 111 0 Accelerating Privatization and Enhancing Regulatory Capacity in the Power Sector. Considerable progress has been made on an ambitious reform agenda for the power sector, and PSALM'S financial position has clearly improved. But faster progress on the Government's privatization agenda i s needed to promote competition in the wholesale electricity market, augment long-term power supply capacity, enhance operational efficiencies, achieve financial viability for PSALM, and strengthen government credibility given the major delays that have occurred to date. Commensurately, regulatory capacity needs to be enhanced to encompass market supervision from the current focus on price regulation. The implementation of the universal charge for stranded cost and stranded debt would strengthen the long-term financial viability of the sector and would facilitate electrification into rural and remote areas. Reforming the Cement Market. Philippine cement prices are higher than in a number of other middle income Asian countries, a relatively small number of firms account for the bulk of domestic production, and imports constitute an insignificant portion of total .demand. In a scenario of rising investment and growth, domestic price pressures could therefore intensify, and it would be important to ensure a competitive production and price structure for cement. To promote such competition, greater reliance on imports could be considered, including by floating a global tender for purchase of cement for public infrastructure projects. New foreign and domestic entrants could be encouraged by simplifying and expediting the numerous regulatory, land, quarrying and environmental clearances associated with setting up of a cement plant (without diminishing the substantive environmental assessment). And the Government's oversight capacity to ensure that competitive conditions prevail in the cement market could be strengthened. Opening the maritime sector to more competition would reduce trading costs and boost agriculture. Despite some recent reform in the maritime industry, high costs undermine competitiveness. For example, the cost of exporting a 20-foot container from the Philippines i s significantly higher than in other Asian countries. High impact reform priorities include: amendments to the Philippines Ports Authority (PPA) Charter to separate the development and regulatory functions of PPA and redress conflicts of interests in its mandate; privatization of the Manila North Harbor; full competition in foreign containerized cargo operations; and expansion of the Strong Republic Nautical Highway. For the credibility of the maritime sector as a whole and for the Government agency involved in this sector, it i s important to be seen as pursuing fair, transparent and competitive bidding processes for the privatization of the Ports of Subic, Batangas and North Harbor. Faster liberalization of the Philippine aviation sector would benefit overseas workers, boost tourism and spur economic development. There i s a significant opportunity to enhance competitiveness if the air transport industry i s deregulated, and regulators act to foster competition and reduce their influence on market forces. Easier market entry will increase competition, reduce airfares, and increase the number of foreign visitors. After low-cost airlines were allowed into Diosdado Macapagal International Airport, for instance, passenger traffic grew from less than 50,000 in 2004 to more than 470,000 in 2006. Such traffic growth could provide a iv powerful stimulus for emerging sectors, such as leisure and medical tourism. Since 70 percent of the air cargo moving through a logistics hub typically goes via passenger aircraft, increased passenger traffic may also facilitate high-value exports and the development of local logistics hubs. Development of supporting services at airports (e.g., customs, maintenance) and other policies (e.g., on M&A, collusion) to encourage competition would also be useful. 0 Reduced protection of agricultural commodities, in particular rice, through lower import protection and devolving the National Food Authority's trading functions to the private sector. This would enhance labor market competitiveness since food-and rice in particular-comprises a large share of the consumption basket of low income workers. It would improve competitiveness in the food processing and livestock industries. It would increase disposable incomes particularly for the poor, and it would reduce hunger. The potential for rapid growth from successful reform is illustrated by the experience of deregulating telecoms in the 1990s: which not only transformed the industry-from single operator dominance to one of competition, dynamism and vastly improved service-but has also facilitated growth in call centers, BPO, and other IT-enabled services. D. Maximizing the Benefits of Growth for the Poor. There are four areas where policy attention i s needed: (i)growth needs to be unleashed in sectors from which the poor derive their incomes, most notably agriculture, through enhancing access of the poor to assets, markets, and income; (ii)the gains from fiscal reforms need to be directed at public spending that improves the human capital of the poor; (iii)the development of a coherent social protection strategy would reduce the risk of impoverishment of the vulnerable, but could also assist in securing gains in fiscal efficiency; and (iv) to improve both efficiency and equity of pro-poor spending, the Philippines needs to put in place a system to better target the poor Conclusion The Philippines has achieved unprecedented success in fiscal policy in a difficult political environment. If the same determination can be applied to strengthening the investment climate and competition, while sound fiscal policy i s maintained, higher economic growth would be more likely, and its impact on the labor market and poverty reduction would be more beneficial than witnessed to date. V I.RecentEconomicDevelopments Strong fiscal adjustment and a favorable global environment have benefited the Philippine economy-but investment and employment have yet to respond Growth over the past three years has been well above historical trend (Table l), even as significant fiscal adjustment has sharply reduced public sector deficits and debt. As a result, previously prevalent concerns about financing difficulties for the public sector, have given way to optimism in the financial markets characterized by rising capital inflow, equity prices approaching their pre-Asian crisis highs, and a significantly reduced, though still high non-financial public debt/GDP ratio of about 77 percent. It i s worth noting though that this improved performance has occurred in an environment in which average growth among all developing countries rose to about 7 percent in 2006 (5.5 percent excluding China and India); in the global context therefore, Philippine growth was no higher than average, though a redeeming feature i s that it occurred in the midstof a major fiscal adjustment. Growth in 2006 was driven by double-digit export growth and private consumption: the former driven by the electronics sector; the latter aided by robust growth of remittances. Public consumption also recovered in 2006, despite a reenacted budget, attributed to first quarter pump priming and fourth quarter spending on account of the supplemental budget. Domestic investment has been on a declining path, however. Investment grew marginally in 2006, and continued its decline as a share of GDP to below 15 percent. Moreover the slight increase in investment was biased towards public construction, while private construction and acquisition of durable equipment contracted. Investment in durable equipment fell to 6 percent of GDP, its lowest share since 1985. Figure 1 indicates that real fixed investment has not increased in the Philippines since 2002, in contrast to neighboring countries. Private investment has yet to respond to the higher growth rates of recent years, and has not been helped by the political instability and uncertainties of recent years. Despite ample liquidity, banks have remained cautious in their lendingto the private sector, preferring to finance the government in local as well as foreign currency, and government securities now comprise about a third of the banks' portfolio. Private sector credit as a share of GDP fell by some 40 percent between 2000 and 2005, although bank lending, to the private sector began to pick up in late 2006. Public investment, averaging only 2.5 percent of GDP in 2004-06, has been limited by fiscal constraints, and deficiencies in infrastructure appear to be a major drawback to increased private investment. On the supply side, 6.3 percent growth in the service sector was again the leader, boosted in particular by the financial sector and private services such as business process outsourcing. Agricultural output rebounded by 4.1 percent in spite of two severe typhoons in the last quarter of 2006. Manufacturing output continued to grow on pace with GDP but, in contrast to recent years, mining witnessed a contraction. 1 Table 1. Selected Economic Indicators 2000 2001 2002 2003 2004 2005 2006 Growth, inflation and unemployment (percent) Grossnational product 7.1 2.3 4.2 5.9 6.7 5.6 6.2 Gross domesticproduct 6.0 1.8 4.4 4.9 6.2 5.0 5.4 Inflation (periodaverage);2000 base year 4.0 6.8 3.0 3.5 6.0 7.6 6.2 Inflation (endperiod);2000 base year 6.5 4.5 2.5 3.9 8.6 6.6 4.3 Unemployment/1 11.2 11.1 11.4 11.4 11.8 11.3 11.0 Savings and investment (percent of GDP) Gross national savings 18.2 16.5 17.3 17.2 18.7 17.2 19.1 Grossdomestic investment 21.2 19.0 17.7 16.8 16.8 15.1 14.8 Public sector (percent of GDP) Nationalgovernmentbalance -4.0 -4.0 -5.3 -4.6 -3.8 -2.7 -1.1 Total revenue 15.3 15.6 14.6 14.8 14.5 15.1 16.3 Tax revenue 13.7 13.6 12.8 12.8 12.5 13.0 14.3 Total spending 19.3 19.7 19.9 19.5 18.4 17.8 17.4 Consolidatedpublic sector balance -4.6 -4.8 -5.6 -5.1 -4.9 -1.9 0.1 Nonfinancialpublic sector debt 88.1 87.4 93.7 100.8 95.4 86.8 75.0e Nationalgovernment debt 64.6 65.7 71.0 77.7 78.5 71.8 64.8 Money and credit (year-end percent change) M 3 4.6 6.8 9.5 3.3 9.2 9.0 22.3 Credit to the private sector 8.1 -3.0 1.2 1.8 4.6 -1.5 6.0 I Balance of payments Merchandiseexports (percent change) 9.1 -16.2 9.9 2.7 9.8 3.8 14.6 Merchandiseimports (percentchange) 7.7 -13.3 6.3 3.1 8.0 8.0 10.6 Current accountbalance (percentof GDP) -2.9 -2.4 -0.4 0.4 1.9 2.1 4.3 Internationalreserves Gross official reserves(billions of dollars) 15.1 15.7 16.4 17.1 16.2 18.5 23.0 Gross official reserves(months of imports) 4.2 4.6 4.7 4.2 3.7 3.9 4.4 External debt Total (billions of dollars) /2 51.2 51.9 53.6 57.4 54.8 54.2 53.4 Total (percentof GDP) /2 67.5 72.9 69.8 72.1 63.3 55.1 45.6 Debt service ratio (G&S andincome)/2 13.0 15.7 17.1 16.9 13.8 13.5 12.0 Exchangerate (peso/dollar,periodaverage) 44.2 51.0 51.6 54.2 56.0 55.1 51.3 Real effectiveexchange rate (2000 = 100) 100.0 95.6 96.2 89.1 86.2 92.3 102.5 Memorandum items Nominal 2006 GDP: USD 116.9billion 2006 population: 84.5 million Source:COP, World Bank, IMF e/ Estimate 11Annual average; usingold definition. Unemployment rate for 2005 and2006 under new definition are 7.7% and 7.9% respectively. 2/ Reportedby BSP 2 Figure 1:Growth Driven by Consumption and Exports, not Investment Growth of Selected Expenditure 20.0 , Classes 6.0 n 5.0 . / 4.0 3.0 2.0 1.o -10.0 J 0.0 2002 2003 2004 2005 2006 2002 2003 2004 2005 2006 --tPersonalconsumption Agriculture, fishery and forestry Industry Service 1 +Capital formation --tEqorts Source: NationalStatisticalCoordination Board J Source: NationalStatistical Coordination Board 35.0 Investment(%of GDP) 1 7 25 0 20 0 150 100 5.0 0.0 1980 1983 1986 1989 1992 1995 1998 2001 2004 oConstructonIDvrableEquipmento Others Source: NationalStatisticalCoordinationBoard Falling inflation has permitted an easing of monetary policy. Notwithstanding the VAT adjustment and higher oil prices, inflation has been on a downward trend, falling to 4.3 percent by year end, and to 2.3 percent by April 2007, aided by the stronger peso and stable food prices. Average inflation in 2006 fell to 6.2 percent from 7.6 percent in 2005. The central bank (BSP) did not explicitly lower its overnight rates but instead reintroduced a tiering scheme in November whereby bank deposits placed at the BSP receive progressively lower rates on balances above P5 billion and PI0 billion than the 7% basic rate. Meanwhile, market rates for government securities have fallen significantly: the benchmark 91-day Treasury bill averaged 5.4 percent in 2006 had fallen below 3 percent by February 2007. Sovereign spreads declined by 100 basis points in 2006 reflecting both lower public deficits and the falling spreads for emerging markets in general. Higher economic growth in the last three years has elicited a disappointing response in the Philippine labor market (Figure 2 & Annex Table 9). Average employment growth in 2006 slowed to 2 percent, less than the growth of the working age population. The growth of wage and salaried workers was higher, at 2.9 percent, but their share of total employment i s still only about 50 percent, and fell relative to 2004. B y contrast, the 3 proportion of unpaid family workers, prevalent in agriculture and private households, increased. Under the old (comparable) definition, the unemployment rate had dropped slightly to 11percent as of October 2006, but this was in part due to a decline in the labor force participation rate. Underemployment, however, grew to 22.7 percent from 17.6 percent two years ago. About 1.1million Filipino workers are estimated to have left the country in 2006 for employment overseas, which in part reflects the lack of domestic employment opportunity, though higher wages abroad may be the dominant pull factor. About 8Y2 million workers, nearly a quarter of the domestic labor force, are estimated to work abroad.' Given the extent of labor underutilization, reflected in high unemployment, underemployment and share of workers that are not in the formal sector, employment growth needs to be boosted substantially. Figure 2: Employment Growth Remains Modest Share of employed ~ 120.0- 100.0- nUnpaidiamily workers 80.0 - IOwnaccount 60,o - oWaqe andsalaried 40.0 - 20.0 1 0,o - +-Employment growth +GDP growth 1 1996 1998 2030 2002 2004 2006 Source: National Statistics Office Source:NalionalStatistics Mice ~ Surveys on poverty and hunger indicate mixed results in the past three years notwithstanding higher growth. As reported by the Social Weather Station, self-rated poverty had fallen considerably as of early 2004, but since then was on a gradually rising trend until mid-2006, after which it fell (Figure 3). Self-rated hunger hit a record high in 2006 before declining in the most recent survey results. Official poverty figures (based on the Family Income andExpenditure Survey) are not available beyond 2003. I The Government estimates the stock of overseas Filipinos at 7.924 million in 2005. This includes permanent residents abroad, those with temporary status (3.652 million), and estimated irregular/undocumented workers (0.881 million). The Government has taken a proactive stance towards the protection and welfare of overseas migrants. 4 Figure 3: Self-Rated Poverty and Hunger Trends Self-rated poverty incidence , Degree of Hunger 70 20.0 7 16.0 12.0 8.0 40 30 1 D 4.0 D I 1--eSelf-ratedpoverty+Official poverty incidence +Overall Hunger -c-tvbderateHunger Source: Social Weather Station Severe Hunger Source.Social Weather Station A Major Fiscal Turnaround The fiscal adjustment in 2005-06 was stronger than targeted, at about 5 percent of GDP, with the consolidated public sector balance estimated to have shifted to a slight surplus in 2006 from a deficit of 4.9 percent in 2004, implying a primary surplus in 2006 of about 6 percent. Together with steady real growth and an appreciation of the peso in real terms, the non-financial public debt/GDP ratio fell from over 100 percent in 2003 to an estimated 75 percent in 2006. Figure 4: Public Sector Deficits & Debt Decline, Revenue Increases NG and CPS deficit (YOof GDP) 110, NG and NFPSdebt (Yoof GDP) -5 60 - -7 J 2002 2003 2004 2005 2006 i --t CFS def icit --ab- NG def icit 1 --tConsolidatednon-financialpublicsectordebt +National government debt Source: DOF a- Revenue and Taxes Efforts 17.0 7 16.0 - 120 - d&-.-*--a E:, 15.0 - - - 100 - 8 0 - 12.0 10.0 ll.O i 0.0 I 2000 2001 2002 2003 2004 2005 2006 2000 2002 2004 2006 ---tRevenue--&-Tax revenue --tCapital--c.Interest +Rimary Source: Departmnt of Rnance Source: Department of Finance, Bank Estimates 5 A falling GOCC (Government Owned and Controlled Corporations) deficit, continued surpluses in the two major pension funds, and a rising surplus for local governments also contributed to the consolidated deficit reduction (Annex Table 7). In particular, the deficit of the National Power Corporation, traditionally the largest GOCC deficit contributor was held in check, reflecting tariff increases in 2004-05 and aided by recent peso appreciation (given its large external debt). B y contrast, the National Food Authority's (NFA) deficit increased to be the largest single contributor to the GOCC deficit (0.4 percent of GDP). The elimination of the consolidated public sector deficit (CPSD) in 2006 was primarily due to a cut in the National Government deficit. The NG deficit, targeted for balance by 2008, was reduced to P65 billion (1.1percent of GDP) in 2006 from 2.7 percent in 2005. In contrast to the 2002-05 period, when NG deficit reduction (as a share of GDP) was driven primarily by expenditure compression, in 2006, the bulk of the adjustment was due to implementation of the VAT reforms which raised tax revenue by 22 percent, increasing the tax/GDP ratio from 13 percent in 2005 to about 14.3 percent in 2006-marking the first significant increase in tax effort since the post-Asian crisis collapse of tax revenue. O f the 0.5 percent of GDP spending contraction, lower interest payments accounted for 0.3 percent limiting the primary expenditure cut relative to past years. With Congressional approval in January of the 2007 budget, non-interest spending i s slated to increase as a share of GDP after continuous compression since 2002. In the first quarter of 2007, the budget deficit reached P52 billion, below its level in the first quarter of 2006, but slightly above target, reflecting lower than targeted tax revenue, and notwithstanding a boost to overall revenue by the proceeds from the P25.2 billion sale of the Government's stake in Philippines Telecommunications Investment Corp. ImprovingBalanceof Payments The strong performance of electronics exports and remittances far outweighed the impact of higher imported oil prices on the current account-the current account surplus in 2006 jumped to $5 billion from $2 billion in 2005-while rising foreign direct and equity investment also contributed to gross reserve accumulation to $25 billion by April 2007, from $18.5 billion at end-2005. Net FDI inflow rose to $2.35 billion in 2006, nearly double the 2005 level, and net portfolio inflows also accelerated following the May-June sell-off. A 20 percent increase in remittances to $12.8 billion in 2006 underscores the vital role of remittances and transfers for the balance of payments: through these flows, which together account for over 13 percent of GDP, large trade deficits have been transformed into current account surpluses, which in 2006 grew to 4.3 percent of GDP. Boosted by foreign capital inflow, the Philippine stock market was among the top East Asian performers in 2006, and rose to pre-Asian crisis highs by May 2007- notwithstandingthe global correctionof equity prices that began in the last week of February 2007. The peso appreciated by about 7 Vi percent against the U.S. dollar in 2006, and strengthened further through May 2007 even as the BSP continued to build reserves as a net buyer of foreign currency. Interest rates in the peso market and Philippinespreads in the global market also fell substantially, with the former prompting more investment into equities (Figure 5). 6 Foreign currency borrowing from the capital markets by the public sector (includingBSP) in 2006 was about $4 billion, although net borrowing on this basis was negative reflecting both scheduled amortization and pre-payments. Gross borrowing from the capital markets i s projected to decline in 2007, given lower public sector borrowing requirements and the Government's intention to rely to a larger extent on borrowing in local currency and from official sources. In January 2007, the national government issued a $1billion 25-year bond at a yield of 6.55 percent. This issuance completed the national government's commercial borrowing for 2007. Resort to budget support loans from the Asian Development Bank and the World Bank was also significantly increased in late 2006/early 2007. Figure 5: BOPStrength, Global Liquidity Boost Financial Markets Eternal sector (in billions USD) Inflation and T-bill Rates 60.0 7 6.0 9, I 8 - 40.0 7 - U E 30.0 6 - + 20.0 0.0 E 5 - 10.0 4 0.0 -4.0" 3 ) is.c.l~ 2000 2002 2004 2006 Jan- Apr- Jul- Oct- Jan- Apr- Jul- Oct- -8- &ports 05 05 05 05 06 06 06 06 -k-lnports --tCurrentaccountbalance l+hflation -e-Sl~DayT-bilI Source: Central Bank of the Philippines Source: Central Bankof the Riilippines 700 Bond spreads Market Indicators 3300 -5 Q) 2800 2300 %gig 400 300 -1 5 50.0 p2 *8 1800 1300 55.0 0 1 ' 800 60.0 2000 2001 2002 2003 2004 2005 2006 -+-China Malaysia 2000 2002 2004 2006 +Fhilippines -s- Thailand 1-m- Stock index -+- Exchange rate ~ Source: World Bank Source: CentralBank of the hilippines 7 A Gradually Strengthening Banking Sector Considerable progress has been made in recent years to address banking sector vulnerabilities. The regulatory framework for the effective conduct of banking supervision has been strengthened, and efforts to strengthen corporate governance, risk management, and capital adequacy in commercial banks have also progressed. Regulations are now in closer alignment with international standards and regulatory policies are more responsive to the growing sophistication and globalization of the banlung industry. Strengthening legal protection for bank supervisors, as intendedin the amendments to the BSP Charter, i s needed to boost supervisory credibility, but this bill has continued to languish in Congress. While asset quality i s still below regional and world standards, significant progress in asset resolution has been achieved. Capital adequacy i s above the minimumnorms under BIS. In addition to reducing bad loans and non-performing assets from their balance sheets in response to regulatory pressures and changes, large domestic banks have focused on strengthening their capital base by raising tier-2 bonds in recent years. BSP has encouraged such capital-raising by issuing guidelines relating to issuance of Hybrid Capital Instruments. Improvements in asset quality are due in part to enactment of the Special Purpose Vehicle (SPV) Act, which was an important catalyst in reducing banking sector vulnerabilities via the take out of non-performing loans and assets from commercial bank balance sheets. After a slow start, by end 2005, about P97 billion worth of NPAs were sold through transactions under the SPV Act, reducing by about 19 percent the stock of NPAs in the banking system. In early 2006, the SPV Act was extended by a period of another two years. This enabled (mainly) universal and commercial banks to reduce their stock of NPLs by another 18 percent in 2006. BSP expects an additional PlOO billion of NPLs/NPAs would be taken out from bank balance sheets during2007. 11. How Robust I s Present Growth? Notwithstanding the positive developments with respect to growth, fiscal policy, financial markets and the balance of payments, two longstanding-and related-concerns remain: the low and declining share of investment in the economy; and the weak employment response to higher recent economic growth. These disappointing responses may in part represent understandable lags in investor/employer behavior in the face of the relatively recent improvement in macroeconomic performance amidst the long history of macroeconomic volatility-and the still unsettled political climate. If investors need more time to commit increased resources within the Philippines, an important policy implication would be to maintain the momentum of fiscal adjustment. This would continue to ease concern about macroeconomic instability, which has been of paramount concern among investors in the past; with declining deficits and present growth rates, public debt/GDP would continue to decline briskly, further easing such concerns, and increasing the scope for public investment. Moreover, there are a number of positive factors in play that would support the view that growth could at least be maintained at its recent pace: 8 0 Corporate profitability has increased in recent years, indicating that intentions to expand investment may be in process. 0 The cost of financing new investment has declined as a result of the increase in equity prices and the easing credit environment. Bank lending to the private sector appears likely to grow from the depressed levels of the past given lower public financing needs, lower interest rates on government securities, and the gradual strengthening of bank balance sheets. 0 With remittance-assisted personal consumption growing by more than 5 percent, f i r m s would eventually need to increase investment to fulfill this demand; average capacity utilization rates are a relatively high 80 percent. Moreover, consumer imports comprise less than 4 percent of GDP, whereas personal consumption accounts for 78 percent, indicating that the bulk of the increasing demand can be expected to be suppliedby higher local production. 0 FDIhas grown significantly though from a small base, and now forms a growing share of overall private investment (14 percent in 2006). 0 Confidence improved in recent months as indicated by BSP's December 2006 Survey of Business and higher scores for the overall business confidence index in early 2007. Approved project investments in the industrial export zones in 2006 increased by 25 percent over 2005. 0 Private services, particularly voice-based BPO sectors such as call centers, continue to grow rapidly. Overall, services account for more than 50 percent of GDP. Knowledge process outsourcing (KPO), medical services, tourism and mining are sectors that provide considerable untapped potential. The Supreme Court's declaration of the Mining Act as constitutional in 2004 increased investor interest, and FDIin miningi s expected to increase. 0 There i s already some room to increase public investment. Falling interest payments/GDP would allow for rising public investment within a balanced budget framework. If tax collection continues to improve, the scope for increasing public investment would become more significant. To the extent this alleviates bottlenecks for private investment, the latter may also increase. 0 With services becoming the dominant component in GDP-both in terms of their share and relatively rapid expansion, the nature of growth may be becoming less investment-intensive-so that robust growth may be compatible with lower investment rates than implied by historical data, as the service sector i s less investment-intensive than industry. An alternative, less optimistic, view is that private investment is constrained by a number of institutional factors that may be difficult to address and require significant policy adjustments. One such factor relates to competitiveness in the labor market: the Philippines has found it difficult to compete with lower wage Asian economies at the unskilled end of manufacturing due to its higher wage structure, whereas unit labor costs appear to be comparatively higher in the Philippines for a broad range of manufacturing activity. This also reflects markedly lower growth of output per worker relative to other East Asian 9 countries.2 Hence the dynamic growth areas have been relatively limited and have not provided adequate employment opportunity for the population at large. A closer look at wage rates across low and middle income Asia suggests that wage rates in the Philippines indeed tend to be high, particularly for basic workers, and particularly in relation to per capita income (Figure 6). Measured over the past several decades, the growth of both physical capital and total factor productivity (TFP) was much lower than in the rest of East Asia (World Bank, 2005a), and the marginal product of capital-as estimated in recent empirical work-has also been But during2004-06, TFP growth picked up significantly (Figure 6). This could inpart reflect the short time span-capturing, for example, cyclical effects such as in capacity utilization. But it may also be the lagged effect of higher growth from past structural reform^.^ Notwithstanding possible disadvantages in the labor market, dynamic growth has occurred in a few specific sectors such as electronics components and voice-based BPO. But why has such growth not spread to more sectors? Longstanding impediments to invest include poor infrastructure which in turn reflects decades of fiscal constraint and ineffective delivery caused in part by governance shortfalls, and the high cost of certain inputs, such as electricity. Similar constraints have undermined education quality, which used to be a point of strength. The Philippines thus continues to receive low rankings in 2006 international competitivenesssurveys, including those of the World Competitiveness Yearbook (4gthof 61), the World Bank (113`hof 155), and World Economic Forum (77`h of 120). The concentrated ownership structure of corporate conglomerates creates barriers to investment: many corporate insiders are comfortable investing only a portion of their funds in-country, and invest considerable portions offshore. Given corporate ownership of most major banks, the latter are more inclined to provide financing within their conglomerate rather than to unconnected parties. Laws that prevent foreigners from owning land limit the ability of foreign banks to lend, since they cannot collateralize their loans competitively. Competition i s also undermined by regulatory capture of major agencies, in which regulatory decision making i s unduly influenced by the major player or players in the industry being regulated. In such cases, regulatory decisions can be biased to benefit the major players to the detriment of the consumer, small firms or potential entrants. They can also increase unpredictability in regulatory policy, adding to investor uncertainty. Thus, the incentive for firms that are not insiders may be to stay small and informal, ' 1percent per annum average growth inoutput per worker inthe Philippines during 1961-2003 versus 4.4 percent in neighboring economies (World Bank, 2005a). Aquino (2003) calculates Tobin's Q (market value/asset value) of the Philippine corporate sector. A low Tobin's Q-indicating a low marginal productivity of capital and hence a lack of profitable investment opportunities-can explain the stagnancy of fixed investment. Indeed, while firms with a higher Tobin's Q can more easily and less expensively finance their investments, firms with a low Q are considered to have lower growth potential and the market might require higher premiums in raising funds. This analysis was undertaken when equity prices were considerably lower than current levels, however. Work by Cororaton and Cuenca (2002) and Banados (2005) indicate that the TFP trend started to improve as early as 1998. 10 whereas for the large incumbents, it may be quite rational to restrict production below the Monthly Wages in Low and Middle Income Asia 1800 _------ (November 2005. In US Dollars) 5000 - Malaysia, xII"l "I Source JETRO16th 4500 - SurvWof I-NEsiKm 0 1500 .-widcost--- - - - -Kuala-Lunpur- - - - - - -- - - - - - 4000 - 5m Conparison InMajor g - 1200 _ _ Citiesanjregiormn- - - - - - - - Shanghai !5'! March_2006 - - - - - - - - e 3500 0- 3000 - 0 2500 - Thailand, T2 E $900 0 _" 2000 - 1 .-__________________________ Q,ngdas Shenzen Bangalore $ 1500 - China 5E "600 _ _ _ _ _ _ _ _ _ _ _Jakar20 0 - 00--@r!Ia_ ,+ _ _ - - 1000 - Indonesia+ m Bangladesh , +Philippines E Hanoi Bangkok 500 - ' Vietnam India a !! 300 ._____ 0Dh& _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 0 - 0 50 100 150 200 250 0 7 1 0 50 100 150 200 250 Average monthlywageworker in USD Average monthly wage worker in USD Source JETROWIhSurveyof InvestmentRelaledCoslandWorldBank The combination of entry barriers and underinvestment by incumbents may I Growth accounting be contributing to low investment, with adverse repercussions for the labor 1 4.0 1 market: conglomerates limit domestic U investment; smaller firms face disincentives as well as undue -2.0 - constraints to investment; the formal -4.0 - labor market i s protected and suffers -6.0 - from competitiveness problems driven -8.0 - by policy, institutional features, and a Contribution to growth lack of resources for education and RysicalK 0 Human K 0 TFP training; thus the growth of the formal - - labor market remains constrained, with emigration and informal activity remaining major outlets for the growing working age population.' Such structural impediments to investment, coupled with the investment hangover from the Asian crisis that was common to other East Asian countries as well' has lowered investment to historically low shares in the Philippines. There i s also the possibility that private capital inflows would continue to strengthen the real exchange rate, undermining the profitability of investment in traded goods and services. Monopolists produce where marginal revenue equals marginal cost, and not where average revenue 'equalsmarginal cost. This situation displays characteristics of the so-called 'Low-capital Nash Equilibrium', in which no Player with rational foresight gains by changing strategy unilaterally (and could bear a short-term cost). On the latter, see IMF(2006a) and World Bank (2006a). 11 Reforms in the following areas would be important to respond to the concerns about low investment: Increase competition in protected sectors: Telecoms reform in the Philippines illustrates the potential for unleashing investment and employment, see Mirandilla (2007), and Box 1below. Upgrade infrastructure and skills which will take time and resources but i s essential for future competitiveness. Improve the return and risk factors for private investment ininfrastructure. Ensure that the financial sector can support the needed increases in investment. Adequate supply of credit, development of capital markets, and access to finance by the poor are each relevant in this context. Reduce the cost of doing business through simplification of approval procedures. There has been much discussion of these topics in the Philippines. In 2005, the World Bank issued two reports whose recommendations remain largely relevant today8- although the scope for public investment to address infrastructure impediments has improved with the fiscal position. To address the lack of infrastructure, the Government i s embarking on an infrastructure program amounting to P372 billion for 2007-2010 and beyond, consistent with its deficit reduction program for the medium term. In recent months, the National Competitiveness Council has developed specific proposals across a range of areas to reduce the cost of doing business and enhance competitiveness. Rather than summarizing the recommendations of past or ongoing work, this report offers suggestions for reform in a few specific areas (from item 1above)-where the payoff in terms of unleashing investment and generating job growth through opening markets to greater competition i s judged to be significant. World Bank 2005b and 200.5~. 12 Box 1: TelecommunicationsReforminthe Philippines:Impactand Lessons The Philippine telecoms sector shows how regulatory reform can spur rapid growth. Telecommunications policy reforms in the 1990sled to major gains in investment andjob growth. Telecommunicationsis one of the most dynamic sectors in the Philippines today. From a tele-density of 1 per 100 persons in 1990 and a single dominant operator that took years to install a line, tele-density climbed to 7.7 in 2006 and the waiting time to apply for phone service is now measured in days. Telecommunications service grew to a $3.3 billion revenue market in 2004. B y 2005, the sector accounted for almost 5 percent of GDP, and corporate profits inthe sector have increased exponentially. Liberalization changed the structure of the telecommunications industry. Opening the market on fixed-line growth introduced new investors and reinvigorated the incumbent PLDT, which still held more than half of local line subscribers as of end-2000. I t paved the way for other players to provide access in areas that the dominant players sidelined. The result was a hugejump in installed tele-density. As of 2005, there were 6.5 million fixed lines installed. Mobile penetration grew exponentially from 3 million mobile phones in 1999 to over 35 million in 2006. In2005, there were 73 local exchange carriers, 11international gateway facilities (IGFs), 7 mobile telephones, 14 inter-carriers, and 388 value-added service (VAS) providers. Telecommunicationshas had a major impact on creatingjobs and supporting emerging industries. There are more than 20,000 people employed directly in the telecommunications industry. The Philippines i s now an important location for call centers, business process outsourcing, and other IT-enabled services. An estimated 235,000 jobs as of end-2006 are found in industries that have directly benefited from the telecoms reforms such as business process outsourcing, mostly from medical transcription and call centers. The BPO sector's value reached $3.4 billion in 2006 and it has grown at an annual rate of 43 percent. In the call center business, the Philippines has the fourth largest industry, surpassed only by Australia, India and China. Telecommunications is also reducing transactions costs for remittances. For example, remittance charges through mobile phones are only 1 percent of the average remittance value compared to banks that charge up to six times more. A word of caution on deregulation. The Philippine experience with telecoms reform highlights that deregulation in a market lacking sufficient competition undermines the positive impact on the economy and hampers full competition. The Philippines underwent a period of "re-regulation" that ushered in more robust competition. Details may be found in a draft paper by Mary Grace P. Mirandilla, "Competition, Regulation and Re- Regulation: Development of Telecommunications in the Philippines ". The paper includes a section on remaining regulatory issues for the sector, including the need for more competition. 111. InvigoratingGrowth, EnhancingIts Impact Irrespective of the weight one places on the factors constraining investment, the following policy goals are essential to turning around investment, accelerating growth and enhancing its impact: Maintain sound fiscal policy to continue lowering public debt and ensure priority expenditure can be fundedin a sustainable manner; Enhance growth impacts of public expenditure by increasing public investment, shifting expenditure to support more growth-oriented public policies, strengthening spending agencies' capacity for executing the budget, and minimizing corruption and other forms of resource leakage. Improvethe InvestmentClimate. This report discusses the following areas: 13 o Accelerating privatization and enhancing regulatory capacity inthe power sector o Enhancing competition incement, the maritime sector and aviation o Increasingcompetitiveness by reducing agricultural protection 0 Maximize the benefits of growth for the poor by enhancing the ability of the poor to participate in a broad-based growth process, and ensuring that the fiscal dividend of growth i s appropriately channeled to programs that benefit the poor. A. FISCAL REFORM Present deficit and growth levels already suffice to lower public debt ratios further. But public resources for growth-enhancing expenditures need to be raised; hence the need to increase revenue and improve spending efficiency. Priorities include: Improving Tax Administration. The significant increase in the 2006 tax effort reflected implementation of the VAT reforms, as VAT collections in 2006 indeed expanded approximately as targeted. Growth of the tax base and higher oil prices also boosted tax revenue. Yet collection of personal income taxes and excise taxes was lower than target. Excise tax collection actually fell in nominal terms due to the cut in the excise tax rate on petroleum. It i s acknowledged that there is substantial scope for increasing tax collection through improved administration in areas of compliance and enforcement such as: accelerating the pace of work on cleaning the taxpayer register, auditing tax arrears and stop-filers, and developing national audit plans and industry- based audit manuals. Linking Taxpayer Information Across Government Agencies. The scope for improving the integrity of the taxpayer registry and reducing tax evasion would be enhanced by linking the BIR taxpayers' database with the databases of other selected agencies. For example, linking BIR to the database of the Social Security System (SSS) can incorporate information on large numbers of workers who are not in the BIR database. Linking the BIR database with those of the Securities and Exchange Commission, Land Registration Authority and the Land Transportation Office would help to ensure that self-employed, professionals and small enterprises are better c ~ v e r e d . ~ While there may be technical issues impeding this objective, the first step to resolving these i s a government decision to collect taxes on the basis of a more comprehensive taxpayer information database than i s presently available. Other priority areas include: Enhancing taxpayer services, such as expanding the electronic filing and payment system and other electronic services. Identifying a strategy for cleaning up the database for large corporations and businesses, and improving the tax remittance system from authorized agent banks (AAB) and from other government agencies (by means of the tax remittance advice). Social security membership is mandatory in the Philippines but there is less than full compliance in registrationand payment of social security contributionsamongst the self-employed. 14 Complementary human resource development and management as well as change management in the tax bureaus to boost morale and provide better incentives for BIR andBOC employees to improve performance. Institutionalization of reforms in BIR. BIR has recently created a Tax Reform Administration Group (TRAG) to manage the Bureau's reform program. In addition, a reform steering committee composed of the Commissioner and top management of BIR with representation from DOF has been formed and regularly meets to discuss reform strategy and priorities. Seven task forces (one for each priority reform action plan) were also created to operationalize the reform priorities: Registration Filing and Payment; Taxpayer Service and Compliance; Audit; Organization and Management; Legal and Enforcement; Nationwide Rollout of Computerized System; and Collection, Enforcement and Arrears Management. Institutionalizing the TRAG as a permanent department in the tax bureau would help to maintain the reform momentum. Adjusting ExciseTaxes and Indexingto Prevent Erosion. Excises on alcohol, tobacco and fuel have declined significantly in real terms since the comprehensive tax reform of 1997, and are low by international standards. The sin tax law passed in 2004 did little to stop the erosion of excise collections. Excises therefore need to be adjusted and then indexed to inflation. Indexation offers the best way to ensure that revenue from this source does not decline in real terms, and once such a reform i s legislated, it removes the need to debate discretionary adjustments on an ongoing basis. Reform of Tax Incentives for Investment is also an important potential means to limit revenue losses. Conservative estimates place the loss due to redundant incentives at about 1 percent of GDP in 2004.'0 Moreover, fiscal incentives have often failed to spur investments, as many investment approvals have not translated into actual flows. Targeting of investments i s also weak and has resulted in uneven regional development. Rationalizing tax incentives thus has the potential to improve both investment outcomes and fiscal policy. Tackling rising NFA deficits. A review of the operations of the National Food Authority i s underway. Tackling NFA's deficits would best be undertaken in the context of a reform of the process through which agricultural production i s protected, as discussed in Section 1II.C. B. STRENGTHENING PUBLICEXPENDITURE MANAGEMENT Inenhancing the growth impact of public expenditure, several challenges remain. First, in spite of the expected increase in public spending in 2007, the Philippines still spends too little in a number of critical areas, because of the years of weak revenue performance and expenditure compression. Under-spending in infrastructure has been noted, but the same applies to health, or even to education, which, in spite of receiving the lion's share of the available budget, has seen its spending level decline in recent years both as a share of GDP and on a per capita basis. Second, there i s evidence that the scarce available resources are not always allocated to expenditure items with the greatest growth impact. Thus, roads maintenance, an loSee Reside (2006). 15 item known for its high economic return, i s chronically under-funded, while some of the budget for new infrastructure construction i s dispersed over a large number of small projects and/or allocated to projects of questionable economic viability or implementation readiness.l1Similarly, a large share of the agriculture budget i s tied to supporting`the rice self-sufficiency policy which i s problematic on several grounds.l2 Third, capacity constraints within the bureaucracy limit its ability to absorb much larger amounts of budgetary resources and execute them efficiently. The same institutional weaknesses prevent the government from conducting thorough monitoring of the implementation of funded activities and prevent leakage of funds due to mismanagement or corruption. Corruption i s another reason why allocated resources do not always result in expected expenditure outcomes. The large funding needs and the limited absorptive capacity mean the government will need to make hard choices in prioritizing some sectors and programs over others in its budget allocation decisions. With the incipient medium-term expenditure framework, the government has been developing institutional mechanisms for letting explicit policy decisions guide resource allocation within a hard budget constraint. It i s critical to continue and deepen this reform and gradually improve efficiency of the budget composition. While an effective institutional framework for better expenditure prioritization i s being de~eloped,'~the government would also benefit from developing a short list of implementation-ready, high impact projects, especially in the area of infrastructure investment. Efforts to strengthen the government's monitoring capacity could be focused initially on these priority projects. Deepening implementation of the procurement reform, which has already produced promising initial results, for example in reducing the cost of textbook procurement while improving the quality of the procured books, would support the strengthening of agencies' implementation capacity to the extent the reform limits the extent of resource leakage from corruption. A key cross-cutting reform that can reinforce the entire cycle of public expenditure management-from planning and budgeting to accounting and procurement-is enhancement of budget transparency. Here the agenda i s broad. The ongoing Organizational Performance Indicator Framework (OPIF) initiative contributes to this agenda by clarifying what outputs government expenditure i s intended to produce. Other possible reforms include redesign of the format in which budget appropriations are presented in the Government Appropriations Act. Tracking and reporting on budget execution-such as the specific amounts released by the DBM to the line agencies and the exact use of these released funds by the line agencies-will therefore be important. Over time, these budget execution data should be accompanied by information on the physical output production. However, the government's existing information management capacity i s inadequate for such systematic budget reporting across the board. The COA has been leading a roll-out of its new electronic accounting system, e- l' World Bank (2006b). See Section III.C.5 below and World Bank (2007). l3 Necessarily, such a framework would involve improved coordination and harmonization among key oversight agencies, NEDA, DBM and DOF as well as relevant line agencies in expenditure planning and prioritization. 16 NGAS. This i s a highly valuable initiative, but progress to date has been slow. Furthermore, the inconsistency between the accounting format and the budget reporting structure diminishes e-NGAS's value as a tool for monitoring budget execution as it i s not possible to use e-NGAS to identify exactly how the budget, as appropriated, i s executed. Investing in the development of an integrated financial management system will be needed in order to make significant progress on the Government's budget transparency agenda. c. IMPROVINGTHE INVESTMENTCLIMATE 1.POWERSECTOR: REFORMPROGRESSANDPRIORITIES Strong Response to a Legacy of Losses The Electric Power Industry Reform Act (EPIRA) of 2001 outlined an ambitious framework for restructuring the power industry in the Philippines. I t s major objectives were to ensure the quality, reliability, and security of the supply of power, and transparent and reasonable prices of electricity in a regime of free and fair competition. It also aimed to enhance the inflow of private capital and broaden the ownership base in the sector. EPIRA provided for: Unbundling the sector into generation, transmission, distribution, and supply; the generation and supply businesses are intended to be open and competitive Creation of National Transmission Corporation (Transco) to assume the transmission assets and functions of the National Power Corporation (NPC), and Creation of the Power Sector Assets and Liabilities Management Corporation (PSALM) to own Transco and other NPC assets, and assume all the liabilities of NPC, with a mandate to privatize the Transco concession and to dispose, sell and privatize NPC's generation assets, IPP contracts, real estate and other disposable assets Creation of a wholesale electricity spot market (WESM) A universal charge for recovery of stranded costs for power purchase and NPC stranded debt beyond government absorption of NPC debt Promotion of rural electrification and provision of a subsidy mechanism for missionary electrification Replacement of the Energy Regulatory Board (ERB) with the Energy Regulatory Council (ERC) The motivation for reforms in the power sector was in large part a response to the serious financial difficulties that had rendered the government-owned power sector insolvent. This reflected: (i)a legacy of take-or-pay financial obligations to independent power producers (IPPs) that addressed the power crisis of the mid-l990s, but at the cost of massive contingent liabilities due to lower than anticipated ex-post demand; and (ii) external financing of the power sector's chronic deficits, with NPC's debt burden aggravated by the depreciation of the peso and weak demand following the Asian crisis. This has also resulted in ongoing tension in apportioning costs: to the consumer-which 17 i s detrimental to competitiveness-versus the taxpayer-which i s problematic, given a history of weak tax collection and high fiscal deficits. As discussed below, several of the institutional reforms foreseen by EPIRA have been implemented. Moreover, the financial situation o f consolidated PSALM improved significantly in 2005-06 following large tariff adjustments in 2004/05, a transfer of P200 billion of NPC debt to the National Government, and a reduction of debt service costs as a result of peso appreciation. However, the original privatization schedule for generation companies (GENCOs) and the transmission company (Transco) has been considerably delayed-11 percent of power generation capacity had been privatized as of end-2006 versus an original target of 70 percent, which in turn has undermined the objective of enhancing competition and private investment. Market Reforms The introduction of a competitive wholesale market is at the core of the reform program in the power sector. Under WESM, buyers and suppliers are to trade electricity as a commodity. While the overall balance o f supply and demand will be an important factor in the level and volatility of pool prices, another key factor will be the capacity of the transmission system. Where there are constraints on power transmission, spot energy prices are to be set by the local balance of supply and demand rather than the system-wide position. If the market functions well, the average market price i s assumed to approximate the average cost of new generation capacity in the long term. The commercial operation of WESM in Luzon was started in June 2006, after a four-year process of collaborative work among the power industry stakeholders to set up the necessary infrastructure. In April 2006, ERC issued a new timeline for retail competition, defining the commencement date of open access, as follow^:'^ (a) Open access and retail competition to commence by July 1,2007, in the Luzon grid for end-users with monthly average peak demand of at least 1 MW for the last 12 months. (b) Beginning July 1, 2009, the threshold level for the contestable market will be reduced to 750 kW; at this level aggregators will be allowed to supply electricity to end-users whose aggregate demand within a contiguous area i s at least 750 kW; and (c) Beginning July 1, 2011, if the ERC deems as realistic, the contestable market will cover end-users at the household level. Policy Issues Ensuring New Investment There i s no immediate risk of countrywide electricity supply shortages of the kind experienced in the early 1990s (see annex below), but consistent with EPIRA's objectives the government's responsibilities for funding capital expenditures and taking on industry risk need to be reduced. Hence the business environment in the power sector needs to improve to ensure that adequate private investment will meet future capacity needs in a timely manner. l4 This timeline may be further postponed given interim delays inprivatization and the current privatization schedule. Increasing Private Participation The Government's intention to accelerate privatization of GENCOs is consistent with the objectives of promoting competition in W E S M and augmenting long-term power supply capacity, and yielding operational efficiencies. B y contrast, the rationale for privatization of Transco i s primarily to raise revenue; and to improve credibility, as there have been several aborted bids (to privatize Transco's operations through a 25-year concession). If privatization i s indeed to be accelerated to meet the government's revised timetable (below), a careful assessment of the reasons for the slower than targeted progress needs to occur, followed b y corrective actions. Given the difficulties faced in privatizing generation, priority needs to be given to contracting out the trading functions and establishing the IPP Administrators to increase competition, improve the performance of the critical trading and dispatch function, and reduce the Government's risks. I Timeline Privatization Targets for Generating Assets I Targets, in % I Targets inMW I By mid-2007 10-15 437-650 By end-2007 45-50 1,951-2,168 I 2008 I 70-75 I 3.035-3.252 I Zmproving Regulation Two key concerns that are common across the experience of different countries in the introduction of competitive markets are: Price volatility in the wholesale market, and the financial risks and retail price implications of this volatility Security of supply and investment in new generation and investment in new generation and network capacity Strengthening ERC's capacity is thus needed to reduce perceived regulatory risk. The market supervision role will be particularly challenging as the skills and knowledge required are very different from those necessary for price regulation. Achieving and sustaining financial viability for NPC and P S A L M Notwithstanding the turnaround in the NPC's financial performance, consolidated P S A L M remains vulnerable to shocks, notably higher oil prices and exchange ratehnterest rate risks, while debt service payments are projected to spike sharply in 2009-10. Additional critical factors thus include: the timing and amount of privatization proceeds, the market share of NPC, the volatility of spot power prices, and adequacy of the universal charge for recovery of stranded NPC contract costs and debt (as yet to be approved by ERC). In the next few years, comprehensive liability management at PSALM will be an important part of the government's public debt and risk management. 19 ANNEX: BACKGROUND INFORMATIONONPOWER" ExistingInfrastructure The country has three high-voltage grids in Luzon, Visayas, and Mindanao, with the Luzon and Visayas grids being interconnected. In addition, there are numerous remote communities and small islands that are off the main grids. As of 2005, the total installedpower generation capacity inthe maingrids is 15,619 MW, consisting of: coal-fired plants, 25.4 percent; oil-fired, 23.4 percent; hydro, 20.6 percent; natural gas, 17.7 percent; and geothermal, 12.7 percent. The Philippines' aggregate dependablecapacity in 2005 was 13,595 MW. A total of 20,236 circuit-kilometers (ckt-km) of transmission and sub-transmission lines comprised the main grids, broken down as follows: Luzon, 9,881 ckt-km; Visayas, 4,807 ckt-km; and Mindanao, 5,547 ckt-km. The combined substation rated capacities rose to 24,607 megavolt amperes (MVA) in 2005. In total, there were 800 megavolt ampere reactive (MVAR) capacitor banks installed in 2005. Out of 41,945 barangays in the country, 39,381 have access to electricity, for a barangay electrification level of almost 94 percent. Market Structure and Ownership The electricity market i s dominated by three large companies: NPC which i s the major generator and power purchaser, Transco, which i s the transmission service provider and system operator, and Manila Electric Company (Meralco), a listed company in the Philippine Stock Exchange, which is the distributor in Metro Manila and neighboring areas. NPC, through its Small Power Utilities Grid (SPUG) also supplies electric cooperatives that are off the main grid in islands and remote areas. In 2005, NPC's plants and contracts with lPPs accounted for around 70 percent of total electricity generation. Most of the balance was produced by IPPs selling to Meralco. Around 90 percent of NPC power sales are for distributionutilities, while the rest i s for direct sales to a range of industrial and commercial users, and miscellaneous customers. In addition to Meralco, there are 17 private distributors connected to the transmission or sub-transmission systems. There are 120 electric cooperatives, most of which are supplied from the grid. Power Demand-Supply Trends. In 2005, the country's highest demand was recorded at 8,559 MW, 1.2 percent higher than the previous year's demand of 8,455 MW. On a per grid basis, Luzon and Visayas recorded an increase in peak demand, while Mindanao peak demand was lower than the previous year's. Although peak demand increases annually, actual peak demand l5 Sources for this section include: DOE PEPPDP Supplement, available at the DOE website (www.doe.gov); and Philippines: Meeting Infrastructure Challenges, World Bank, 2005 20 growth rate i s relatively lower than projections. This has been the trend for the past two years. Similarly, the demand growth rate has been continuously decreasing since 2000. Total power generation in 2005 was 56,568 GWh, up by 1.1percent from 55,927 GWh in 2004. The loss of share in power generation by oil-fired plants (from 15.2 percent to 10.9 percent) was basically taken up by natural gas-fired plants (from 22.1 percent to 29.8 percent) in 2005. The share of hydro and geothermal was 32.3 percent in 2005. Outlook. Over the period 2006-2014, energy consumption i s estimated to increase annually at an average of 4.2 percent to 4.6 percent in Luzon, 6.1 in Visayas, and 6.3 to 6.7 percent in Mindanao. Energy forecasts were calculated from the aggregated projected energy sales of all distribution utilities, directly connected customers, and embedded generators. The range in estimates reflects the variances between DOE, NPC and Transco forecasts. To cope with this demand growth, a total of 3,917 MW needs to be added to the system. O f this, around 13 percent or 517 MW will be provided by committed power projects. The government targets to energize the remaining2,564 barangays by 2008. Investment Requirements Power generation projects for the period 2006-2014 will require a total investment of about P227 billion. Of these, 22 percent or P51.1 billion i s already committed by private proponents. 2. ENHANCING COMPETITIVENESSINTHE CEMENT SECTOR The cement sector in the Philippines has displayed a number of characteristics that are symptomatic of the investment climate concerns raised in Section I1 of this report. On the one hand, capacity utilization in the industry averaged only about 60 percent over the past five years, cement demand for most of this period was relatively stagnant, and per capita consumption remains comparatively low. These factors and relatively high energy input costs contributed to losses for the industry during 2001-03. Since then, however, industry profits have recovered and have been relatively buoyant in recent years. Although cement prices at the retail level have not kept pace with price increases since 2000 of key inputs such as oil and electricity, they remain higher than in a number of other middle income countries of the region. A relatively small number of firms account for the bulk of domestic production, while imports constitute an insignificant portion of total demand, even though import prices appear competitive with domestic prices. In a scenario of rising economic growth and investment, a competitive production and price structure for cement would be of growing importance. This section of the report provides an overview of sectoral characteristics and discusses policy directions the Government may wish to consider. Context Numerous investor surveys have identified inadequate infrastructure as a major constraint to growth and competitiveness. In response, and in the context of an improved fiscal situation, the government i s now planning a significant step up of public investment in 21 infrastructure. The goal i s to increase public infrastructure spending from about 2 percent of GDP to 4.5 percent of GDP by the end of the current Medium-Term Philippine Development Plan (MTPDP). A four-year 1-7-trillion Peso infrastructure investment plan has been prepared. The infrastructure investment plan i s anchored in a significant expansion of investment in transport infrastructure, especially roads. The objective i s to reduce transport costs, enhance inter-island movement of goods, and link farms to markets. Twelve major road projects with a total length of about 1,400 kilometers are envisaged. Based on standard industry norms these major projects alone would need about 1million tons of cement. Planned expansions in airport and airfield capacities would also lead to significant increases in cement demand. Rapidly expanding housing construction sectors would also add to the demand for cement. The MTPDP supply-demand forecast for 2005 to 2012 projects a "supply deficit" of 29 million bags in 2011 and 88 million bags in 2012. To facilitate the envisaged expansion of infrastructure investment, the Government i s implementing measures to address policy and regulatory constraints in order to lower the costs and uncertainty associated with investing in infrastructure. While the legal, regulatory and contracting frameworks are fundamental determinants of infrastructure investment decisions, other measures to reduce costs could also play a supportive role. In this context, a competitive and dynamic cement sector could play such a role. CurrentSituation Cement Price (US$ per tonne, 44 2006) China 35 Malaysia 49 Thailand 50 Vietnam 65 Indonesia 69 Philippines 72 l6 Low consumptioninthe Philippinesreflects a number of factors other than price, includinga low investment/GDP ratio. 22 Per Capita Consumptionof Cement in 2005 (kgs) China 750 Malaysia 477 Thailand 450 Vietnam 316 Indonesia 144 Philippines 128 The industry structure is concentrated. The top three firms account for nearly 90 percent of installed clinker capacity of 22 million tones. The remaining 10 percent i s in the hands of four small independent producers. This contrasts to the situation prevailing at end-1999 when more than 15 firms were operating in the market. Despite the fact that installed capacity was only 57 percent in 2006 and has averaged about 60 percent since 2002, retail prices increased by about 67 percent during 2002-06 (after falling by about 21 percent in 2002). A number of factors appear to be driving price increases. According to the manufacturers, the initial increase in ex-plant price was to offset losses made in the early years of the decade. Inthe past two years, ex-plant price increases have been more moderate, and the 39 percent increase in price between 2000 and 2006 was less than the CPI increase. However, retail prices still remain high. A Department of Trade and Industry August 2006 report on the cement industry indicates that cement prices increased from PlOO per 40-kg bag in 2000 to P165 per bag in 2005 even though demandfell. Supply chain inefficiencies and insufficient competition in the supply chain infrastructure appear to be among the contributory factors. The price situation i s also not helped by the fact that electricity costs in the Philippines are much higher than elsewhere in middle income Asia, and relatively high costs of other inputs may also have undermined profitability. Another element in price determination may be the lack of significant competition from imports. Price competition from imports has not been a factor in recent years-the share of imports in total demand has declined even though tariffs at 5 percent are not high. In 2001-02, an influx of cheap imported cement caused prices to drop sharply. The industry then managed to secure an approval from the Government to enforce a temporary safeguard duty. While this was lifted in end 2004, import shares have not recorded a significant increase despite a comfortable supply situation within the region (Table 4). 1 Table 4: Cement: Capacity Utilization and Imports Capacity Utilization 1 Change inCement IShare of Imports (% ofI (%) Price(%,Y/Y) demand) 2002 61 - 21.3 3% 2003 60 5.O 0% 2004 56 30.5 0% 2005 55 13.9 1% 2006 II 57 7.1 n.a. 23 Policy Directions The use of cement in a wide range of infrastructure investment and housing, and the prospect of higher cement demand if investment and growth increase as policymakers anticipate, indicate that the availability of cement at competitive prices would be of growing importance for Philippine competitiveness. Consequently, the Government may wish to consider the following options to enhance competition. Imports could be used as the basis for containing pricing pressures. It should be noted that although import tariffs for cement are moderate, non-tariff barriers to limit imports may be undermining the objective of inducing greater price c~mpetition.'~To ensure that cement for government projects i s procured at competitive prices, the Government could float a global (national and international) tender for purchase of cement for public infrastructure projects. New foreign and domestic entrants could also be encouraged. The preferred option would be to focus on simplifying and expediting the numerous regulatory, land, quarrying and environmental clearances associated with setting up of a cement plant (without diminishing the substantive environmental assessment). Given expected increases in demand, the market should be attractive to new entrants without special incentives. The Board of Investment (BOI) has formulated a sector specific fiscal incentives package. Using these incentives, two domestic business conglomerates are planning to set up cement factories with annual capacity of one million metric tons each. In return for the fiscal incentives, the firms have to agree to adhere to the selling prices proposed in their proposal. In order to retain the incentives the firms are prohibited from selling a majority of the promoter shares for a period of four years. While this measure may induce new entry, it entails fiscal costs and administrative and enforcement complexity. Moreover, administered prices are not effective in creating a competitive market. The proposed arrangements also run contrary to the government's stated policy intention of simplifying the investment incentives regime and shifting away from sector specific investment incentives. The government could also consider strengthening its oversight capacity to ensure that the cement market remains competitive. Given the strategic importance of cement it would be important to put in place a mechanism to monitor demand and supply, price trends and industry practices with a view to maintaining competitive conditions. A l7 Under the Bureau of Product Standards (BPS) Product Certification Scheme, manufacturers and importers of cement are required to have their products tested. The tests must follow the requirements of relevant standards at the BPS Testing Center or any BPS-accredited or BPS-recognized laboratory prior to sale. Only those manufacturers or importers whose products pass the tests are issued the Philippine Standard (PS) License and the Import Commodity Clearance (ICC), respectively, and are authorized to stamp or affix the PS or ICC mark in their products as a guide to the public. While the standards embodied inthese requirements may be important to maintainquality control, they may need to bereviewed to ensure they are not used to inadvertently restrict imports. 24 periodic review of administrative, procedural, regulatory hurdles and industry practices could be undertaken. 3. REFORMINGTHE MARITIME SECTOR" Increased investment in infrastructure coupled with measures to improve price- quality levels could enable the Philippines to become more competitive in the global economy. Based on the competitiveness ranking of the World Economic Forum on basic infrastructure, the Philippines placed 89thout of 102 countries surveyed. Compared with other Asian neighbors, the country i s in the bottom in most of the categories-railroads port, and air. In particular, Philippines' ports are now rated as the least competitive among those in eight major Asian countries (Table 5). Table 5: InfrastructureRankinginthe Global CompetitivenessReport Country Overall Railroad Port Air Electricity Telecoms Infra China 3.5 3.1 3.1 3.9 4.2 5.4 India 2.9 4.1 3.2 4.8 3.0 6.0 Indonesia 3.1 3.2 3.1 4.1 3.6 3.9 Korea 5.2 5.4 5.3 5.1 6.1 6.5 Malaysia 6.1 4.9 6.1 6.2 5.9 6.0 Thailand 4.9 3.7 4.5 5.6 5.3 6.1 Vietnam 2.1 2.8 3.1 3.9 3.4 4.9 Philippines 2.3 1.5 2.4 3.9 3.6 4.8 Ranking 8 out of 8 8 out of 8 8 out of 8 6 out of 8 5 out of 8 7 out of 8 Source: World Economic Forum, "The Global Competitiveness Report, 2003-2004" Legend: I= poorly developed and inefficient, 7 = among the best in the world According to the World Bank's Doing Business Indicators (Cross-Border Trading, 2006), it costs 60-300 percent more to export a 20-foot container from the Philippines than from China, Singapore or Thailand.19 Incomplete reforms have constrained efficiency and discouraged investment Prior to initial reforms in the 1990s, ports development and operation was a government monopoly. Very few private ports were allowed to operate commercially. Highly centralized administration under the Philippines Ports Authority (PPA) encouraged inefficiency. EO 212 (1994) was an attempt to liberalize and deregulate the ports sector through the privatization of public ports. Because of the possibility that port workers would be laid off, however, EO 212 was never implemented. In 1997, EO 410 rescinded EO 212. EO 59 (1998) attempted to transfer the government's port monopoly' to a private consortium, without any public bidding. With the business community opposing '*19Adapted from Basilio, Llanto and Rodolfo (2007) $1,336 in the Philippines versus $848 in Thailand, $382 in Singapore, $335 in China. These costs include several itemskharges: documentation, inland transportation, customs clearance and technical control, ports and terminal handling, but not ocean freight. It should be noted that Philippine survey respondents report a relatively wide range of costs, and further work may be needed to derive more accurate estimates. 25 implementation of this initiative, EO 308 (2000) rescinded E O 59 and mandated competition in the privatization of Manila's North Harbor. Some other independent port authorities (IPAs) have emerged-e.g., the SBMA (Subic Freeport), CEZA (Port Irene), BCDA (Poro Point), CPA (Cebu), RPMA (ARMM ports), and Phividec (Mindinao Container Port Terminal). These IPAs offer little competition to the PPA, however, and in many cases simply follow or adopt PPA rates and policies. EO 170 (2003) promotes private sector investment in the operation of RO-RO (roll on- roll off) ships as well as development of RO-RO terminals (ports) as part of the Road- RO-RO Terminal System (RRTS). Since 2003, more RO-RO ports have been developed. An initial economic impact assessment indicates that the RO-RO program has increased transport efficiency, reduced transport costs, promoted tourism and regional trade, enhanced agricultural productivity, and catalyzed regional development.20 For instance, since opening in 2003, the Roxas-Caticlan RO-RO operation has facilitated dramatic increases in passenger traffic, cargo traffic, bus operations, and new business establishments (Table 6). Table 6: Economic Impact of RO-RO (Roxas-Caticlan Route) 2003 2005 Year RORO was introduced Ship calls 818 1,959 ShippingOperators 1 3 Number of Ships 1 5 Passenger Traffic 130,199 588,150 Cargo Traffic 31,309 157,265 Number of Bus Operators 6 Number of Buses 51 BusinessEstablishments 690 859 Source: E. Basilio. Economic Impact of RORO on the Municipaliry of Roxas, Oriental Mindoro (UA&P 2006) The Philippines presently has more than 100 public ports. However, cargo traffic i s substantial at only a few (e.g., North Harbour, Cebu, Batangas, Cagayan de Oro, Illoilo). Most of the smaller ports are feeder or RO-RO operations handling small volumes of cargo and passengers. The Philippines currently has only two terminal operators. Asian Terminals Incorporated (ATI), in which Dubai Ports owns an equity stake, operates South Harbour. International Container Terminal Services Incorporated (ICTSI), which operates the Manila International Container Terminal (MICT) also has overseas operations, for instance in Brazil and Madagascar. New ports have been or are being developed-Batangas International Port and Mindinao Container Port terminal, as well as the soon-to-be-competed Subic Bay Freeport Terminal 2. Operation of these terminals i s up for bid, and should include foreign participation. The sector suffers from a lack of credibility in pursuing open and fair competition between ports and among port operators. The Government has a key and leading responsibility in setting the rules for open, fair and competitive bidding processes for the privatization of the ports of Batangas, Subic and North Harbour. Regrettably, the first 2oAn Assessment of DBP's IndustrialRestructuringProgram, CRC, 2006. 26 steps towards privatization appear rather confusing and do not show full commitment to the objectives of good governance and competition. ReformPriorities Thus, there has been too little improvement in Philippines port operations. As evident from Tables 5 & 6, much more can be done to improve competitiveness. The four reforms recommended below contemplate the following: (a) Separate PPA's development/operating and regulatory functions Major flaws in the charter of the Philippine Ports Authority are summarized in Table 7- and will require Congressional action to rectify. In essence, there i s an immediate need to separate ports regulation from PPA's port development and operations activities- particularly in light of the ongoing and upcoming privatization of the Ports of Batangas, Subic and North Harbour. A certification from the President (as urgent Bill) would facilitate the enactment of the proposed amendments to the PPA Charter. Table 7: ProposedPPA Amendments Issue ProposedAmendment Conflict of Interest: Emanating from the fact that Separate the development and regulatory functions PPA is the owner, developer, operator and regulator of PPA. of ports. In many cases, PPA uses its regulatory powers to prevent competition in order to protect its PPA can develop and operate the ports but a new own interest even at the expense of the public regulatory agency must be created to address the interest--e.g., non-issuance of permits to private "conflict of interest". operatorh serve as entry barrier PPA i s allowed to share at least 10% from cargo Deletehemove this provision handling revenues. There i s an economic incentive for PPA to increase cargo handling rates-a case of the regulator benefiting from its own regulation. (b) Privatizationof the Manila North Harbour In 2000, President Estrada issued EO 308 which called for competition in the privatization of the Manila North Harbour by: (i) having two competing terminals (split the North Harbour into two packages); and (ii)subjecting the process to competitive public bidding. The private sector (PCCI, PFI, DMAP, Philexport) in general supports this position. However, after 6 years of non-implementation of EO 308, the PPA submitted for approval to NEDA-ICC a draft Bid Terms of Reference (TOR) that calls for a single terminal operator for North Harbour (monopoly), in disregard of concerns raised by the private sector on the draft TOR-i.e., one contractor, non-competing terminals, protection from competition, inclusion of the port workers separation benefits in the project cost, etc. Apparently unwilling to wait for the action of the NEDA-ICC on the BidTOR, the PPA meanwhile announced it will pursue on its own the privatization of North Harbour. (c) Competition inForeign Containerized Cargo Operations Among Manila's ports, there i s still a lack of competition in the most lucrative market segment - foreign containerized cargo operations. This explains, to a large extent, the 27 high cost of exporting a container from the Philippines. In 2003, when PPA allowed Harbour Centre (HCPT) to handle foreign break-bulk cargoes, a large part of break-bulk cargo shifted to Harbour Centre due to higher efficiency and lower (by about 40 percent) lower costs. There i s some competition between M I C T and South Harbour on foreign containerized cargos. HCPT, however, does not yet have a permit to enter this market. It i s expected that HCPT's entry into the foreign containerized cargo operations would improve competition and efficiency. (d) Expansion of the Strong Republic Nautical Highway (SRNH) Since the signing of EO 170 in 2003, more than 20 RO-RO links have been established throughout the country as part of the SRNH. JICA recently completed a RORO master plan study indicating various RORO routes that still need to be established. To speed up the establishment of these routes, the following improvements are possible: Provide the private sector the "right of first refusal". EO 170 speaks of "encouraging private sector investment in RORO. The PPA could allow the private sector to participate in RORO terminal development. The financial institutions will ultimately judge whether a route i s financially viable or not. The PPA could focus on routes where the private sector i s not willing to invest. 4. ENHANCING COMPETITIONINTHE AVIATION SECTOR21 The current administration envisions the Philippines as a transport and logistics hub in the Asia-Pacific region. The experiences of regional hubs reveal that the availability of an efficient network of air transport services to move goods and people i s a major attraction for investment in high value production and in service-oriented facilities. The air transport sector's critical role in realizing this vision cannot be understated. About 70 percent of Philippine exports, by value, move by air. 98 percent of visitor arrivals arrive by air. The country has an existing and extensive network of international and domestic airports, most of which remains underutilized. Development of the Philippines' civil aviation sector i s caught between the legacy of a dominant national flag carrier and limits on Philippine carriers from existing bilateral air service agreements (ASA) and the lure of cost savings, service improvements, and economic development gains expected from prompt liberalization of entry by foreign carriers into the Philippines market. Originsof Legacy Issues The 1952 Civil Aeronautics Act of the Philippines established economic regulation of civil aviation by the Civil Aeronautics Board (CAB) and technical regulation by the Civil Aeronautics Administration. In June 1959, the government passed the Republic Act No. 2232 that designated Philippine Airlines (PAL) as the national flag carrier of the country. In 1973, the Marcos administration established a one-airline policy in both the domestic and international routes with the passage of the Letters of Instruction No. 151 and 151A. 21Adapted from Basilio, Llanto and Rodolfo (2007) 28 Bilateral ASAs regulating air service between country-pairs in the region generally served to consolidate the dominance of PAL. Ebb and Flow of Reform The monopoly of PAL was challenged with the issuance of Executive Order (EO) No. 333 by the Aquino administration. Under the Ramos administration, the CAB started to introduce competition into international routes by negotiating capacity expansion. The government further declared plans for the Bases Conversion Development Authority (BCDA) to transform the former Clark air force base into a major international passengedcargo terminal and the former Subic Naval Base into a special economic and free port zone. Under EO No. 80 (series of 1993) the government established the Clark Development Corporation and the Board of Directors of the BCDA has promulgated a policy of expanding air services to the airport through its development as a major cargo hub for the Asia-Pacific region. On April 28, 1994, it issuedEO No. 174 designating the Clark Special Economic Zone as the site of the future premiere international airport. All these policies aimed to realize the development agenda of the administration to position the Philippines as the hub for tourism and transport. However, it was the issuance of EO No. 219 (series of 1995) that paved the way for this vision to become a reality. The entry of competitors like Cebu Pacific, Asian Spirit and Air Philippines challenged PAL'Sposition in the industry. The major beneficiary of the policy was the domestic passenger market, as evidenced in wider range of choices (e.g. airlines, flights, fares) and growth in traffic.22 The same policy provided the opportunity for the new local carriers to be designated as official carriers in international routes. However, it did not completely create an enabling environment for them to easily secure additional traffic rights negotiated by the C A B or to use existing entitlements. The use of the grandfather clause tends to deprive new entrants of the chance to compete. Furthermore, the government was not pursuing bilateral agreements revenue-generating markets. The delay in the promulgation of the Implementing Rules and Regulations did not secure the spirit and benefits of the liberalization policy.23 Starting in 2001, the CAB initiated improvements in the air access infrastructure between the major markets and the Philippines, particularly the gateways of Cebu, Davao and the Diosdado Macapagal International Airport (DM1A)-the former Clark air base.24 EO No. 253 (2003) provided for the expansion of air services to the DMIA and the Subic Bay International Airport (SBIA). This policy opened up the DMIA and the SBIA to international air cargo operators and regarded the increase in commercial air cargo as an enhancement of trade and investment opportunities for the phi lip pine^.^^ The 22Some routes are served by only one niche carrier since the larger carriers concentrate in the trunk routes. 23This was evidenced in the abrogation of the W-Taiwan (China) agreement in 1999.The rules and regulations were finally passed in 2001. 24The CAE3 negotiated for higher capacity between the Philippines and countries such as South Korea, Japan, Singapore, China, Vietnam, Qatar and United Arab Emirates. 25Air access to the DMIA and SBIA is declared as a development route. The authority to operate such route may be granted unilaterally without any restriction or limitation on capacity, type of aircraft and non- cabotage traffic rights other than those that may be required by considerations relating to airport security and 29 IRRs were approved and issued in March 2005 and amended under CAB ResolutionNo. 16 (series of 2005). The liberalized charter policy under CAB Resolution No. 23 (series of 2005) aimed to enhance the development of the regional gateways. This enabled Asiana Airlines to develop the Korean tourism market and low cost airlines like Air Asia and Tiger Airways to create new markets and provide alternatives to passengers. On June 2005, President Arroyo declared the development of the Clark-Subic corridor as part of her ten-point legacy agenda. The benefits created by this liberalized charter policy for the DMIA became the basis for the issuance of Executive Order No. 500 (series of 2006). As a result of this liberalization, DMIA became an international gateway. Asiana Airlines and UPS started to operate out of DMIA in 2003, and Air Asia (Malaysia) and Tiger Airways (Singapore) began using DMIA. DMIA's traffic grew from 453 international flights in 2004, to 2,373 flights in 2005, and to 4,130 flights in 2006. DMIA's passenger traffic increased from less than 50,000 in 2004 to more than 470,000 in 2006. The two low-cost carriers (LCAs), Air Asia and Tiger Airways, accounted for 83 percent of the,2006 passenger traffic. Philippine carriers challengedEO 500 on three grounds: 0 A lack of reciprocal entry into key regional markets, e.g., Singapore, Malaysia, South Korea; A contention that unlimited traffic rights for foreign airlines flying into DMIA and SBIA would hurt development of Philippine's aviation sector; and Additional risks to passengers flying on "non-designated" carriers. Six months later, in August 2006, EO No. 500-A (series of 2006) was issued. While E O 500-A may have addressed the objections raised (Basilio et.al, 2007), it also appears that EO 500-A will constrain air traffic and economic growth inseveral ways. First,LCAsnot included as an "officially designated" carrier inan existingbilateral ASA may have to curtail or cease flights into DMIA or SBIA?6 All but one of the airlines operating at DMIA are "non-designated" carriers. Since experience at logistics hubs indicates that about 70 percent of air cargo i s carried in the bellies of passenger aircraft, curtailment of L C A passenger traffic pending the renegotiation of ASAs jeopardizes development of DMIA and SBIA as both passenger and logistics hubs. EO 500 was originally intended as a unilateral policy to accelerate development of Clark and aviation safety. This authority shall be granted without prejudice to any right or privilege of the applicant under Philippine law, including any Air Services Agreement (ASA) or similar air services arrangement. Foreign air carries designated by states with an ASA with the Philippines that already grants such carriers the right to operate air cargo services to and from the DMIA and SBIA may apply for a waiver of any restriction or limitation on capacity, type of aircraft or non-cabotage traffic rights imposed by the relevant ASA on their right to operate such air services. Such waiver shall be granted provided its scope does not extend beyond the commercial and technical requirements for the operation of air services to and from the DMIA and SBIA. 26 Designated carriers are those entitled to exercise the international route and traffic rights under bilateral air transport agreements exchanged between governments. Designation has two purposes: to maintain the responsibility o f States for the safety o f aircrafvair carriers registered in the State and to ensure that the "legitimate" share o f each State in the air traffic market is protected. 30 Subic by exempting them from bilateral ASA restrictions. The spectacular 2004-2006 growth in traffic underscores the economic benefit of this policy. Second, EO 500-A stipulates that CAB shall renegotiate ASAs with Malaysia, Thailand, and Singapore within 20 months of its effectiveness (e.g., by about March 2008) rather than within 12 months of EO 500's effectiveness (Le., during 2006). Meanwhile, users are deprived from enjoying the benefits of the low-cost business model. This i s where the value of economic integration such as the ASEAN comes in. Regional agreements that will open up the skies not only reduce the costs of negotiation but have the potential to attract new entrants and use the infrastructure that i s already in place. Third, the actual implementation of ASAs often works to the benefit of legacyhncumbent carriers rather than to start-up LCAs. Bilateral ASA reciprocity typically requires that the airline(s) of one nation receive an equal share of the market with the airline (s) of the other nation. Confidential memoranda of understanding (MOUs), by which ASAs are implemented, are often more restrictive than the published ASAs. These ASA MOUs may constrain business development by mandating reciprocity in outcomes rather than in opportunitie~.~~ASAs may allow designated carriers to "hoard" traffic rights entitlements and limit entry by new carriers due to an alleged lack of capacity. This political ploy may even disadvantage smaller designated carriers, since there i s a tendency for the government to allocate rights according to "airline size" and not to airline business needs. In most ASA's the doctrine i s that all international commercial air transportation i s forbidden except to the extent they are permitted. This issue then becomes more political than commercial. Policy Challenges LCAs are challenging legacy carriers to compete and become profitable. This has variously involved the creation of new subsidiaries, tougher negotiations with suppliers, reliance on internet marketing, and unbundled menu-driven price reductions. Inmany cases, however, restrictive bilateralASAs still constrain the ability of LCAs to add capacity. The need to pro-actively negotiate for higher entitlements and deregulate the international air services market i s aligned to the goal of the government to become a competitive destination for medical tourism and retirement. The high costs of travel and lack of access to and from the Philippines from target markets in Northeast Asia, the U S and South Asia reduce the competitiveness not only of medical facilities in Metro Manila, but also of destinations like Cebu, Davao, Clark and Subic. Alignment of action plans i s vital at this point-when the government i s accelerating its marketing and promotion efforts in those sectors. I t may also be difficult for LCAs to find secondary airports that meet international standards.2sThe Philippines i s well-positioned, however, to meet this need as a result of past investments in airport development. Recovering the costs of these investments 270umand Yu, Shaping Air Transport in Asia-Pacific," Ashgate Publications, 1999. " 28 The only way LCAs can survive is to price flexibly according to market demand. To maintain this flexibility, LCAs need a low cost structure. Costs can be better-controlled at non-congested airports. Unreliable flight dispatch raises costs and reduces revenue. 31 should challenge airport authorities and local government units to negotiate for representation in how the air transport policies are developed. DMIA i s well-suited for L C A operations in terms of cost reduction and revenue maximization opportunities. Other secondary gateways may also have potential. Hence, infrastructure development is another priority. This encompasses airports (particularly the secondary ones), accommodation, land transport and human resources for the air transport and its allied sectors like tourism and trade. Implementation of the Roadmap for ASEAN Competitive Air Services Policy will allow PAL and Cebu Pacific to develop the ASEAN markets, particularly for tourism and trade. The other ASEAN airlines can contribute to capacity expansion and potentially reduce the costs of travel. The Ninoy Aquino Terminal 3 should be operational to meet the demand of these regional airlines by 2008. Airports play a crucial role in all of these developments. They need to create value for the airlines, passengers, and shippers. Together with other service-oriented agencies, airports are now challenged to make the business environment more competitive in order to grow their passenger traffic, revenues from airline operations, and non-airline (e.g., retail, ancillary services) revenues. Key government services-Customs, Immigration and Quarantine-are part of the total competitiveness package. Competition policies are needed to address domestic and international issues such as ownership, mergers, acquisitions, allocation of airport slots, state aid and subsidies, collusive behavior and predatory behavior among others. Consumer protection rules must be defined.29These issues are of concern to ASEAN, given directions by ASEAN leaders accelerate the integration of air transport and tourism. The lack of competition policy will reduce the potential benefits from liberalization of the air transport sector. The Philippines also has potential (e.g., at Clark or Subic) to service more of the maintenance, repair, and overhaul (MRO) needs of Asia-Pacific airlines and thereby stem emigration by Filipino technicians. 5. REDUCINGAGRICULTURAL PROTECTION TO IMPROVECOMPETITIVENESSAND BENEFITTHE POOR~O The Philippine labor market has been less than conducive to facilitating domestic job creation notwithstanding the recent increase in economic growth, as discussed above. There are many contributing factors, such as the lack of resources available for both basic and higher education resulting in poor mathematics and science scores in international comparisons, and indications that proficiency in English may be declining. These shortcomings can be addressed as resources for education are increased and delivery systems are improved. Externalities, arising from possible under-provision of training by the private sector, also need to be assessedand addressed. 29 See the Regional Economic Policy Support Facility Reports 02/008 (Peter Forsyth et a1 "Preparing ASEAN for Open Sky") and 04/008 (Christopher Findlay et a1 "Strategic Directions for ASEAN Airlines in a GlobalizingWorld) commissionedby the ASEAN Secretariatand the AusAid. 30 The materialinthis sectiondraws primarily from the World Bank's AgriculturePublicExpenditure Review,currently indraft. 32 There is also a need to re-assess policies that raise food prices and underminelabor competitiveness through their impact on wages and the competitiveness of agricultural products and food processing. It i s instructive to begin with a few observations which stem from the fact that domestic rice prices have consistently been kept above the world price (Figure 7). This has had the following repercussions: It has disproportionately burdened the poor who spend the highest proportion of their incomes on rice. The poorest 30 percent of Philippine households spend 27 percent of their food expenditure and 17 percent of their total expenditure on rice. If the rice price in the Philippines was equal to the border price, incremental saving by the average family would have been P3,400 per year during2000-2005, the poorest 30 percent would have saved 10percent of their food expenditures, and hunger amongst such families would have correspondingly declined. It has reduced rice consumption. At lower prices, rice consumption would have increased in the Philippines: in 2004, per capita consumption was less than half Vietnam's, slightly over half Indonesia's, and less than Thailand's. It has increased income disparity within agriculture. The wealthiest rice farm households receive the bulk of the benefits of these policies: about 40 percent of rice farm households account for two-thirds of the marketed domestic rice, with relatively little accruing to poor rice farm household^.^^ Meanwhile, landless laborers, who constitute the poorest members of the rural community, as well as the urbanpoor, are both harmed. Figure 7: Domestic Rice Prices Consistently Above World Prices Domestic and World Rice Prices 3' Dawe(2006). 33 0 I t has retarded crop diversification. This is the result both of the protection granted the sector as well as the rice sector bias of public expenditure, which together have discouraged the expansion of high-value commodities that market- determined relative prices would otherwise have signaled as more rem~nerative.~~ 0 I t has lowered Philippine wage competitiveness. Since rice alone accounts for 20 percent of the food component of the CPI, its high price places upward pressure on wages. Among unskilled workers in the formal sector, the cost of living i s an important determinant of wages. In the Philippines, the minimum wage i s significantly and negatively correlated with employment, especially in the agriculture and service sect01-s.~~ A 10 percent increase in real wage is correlated with a 4.3 percent decline in agricultural employment and a 2.8 percent drop in services employment. The minimumwage, in turn, i s reported to be significantly influenced by inflation: a 10 percent increase in the CPI induces a 12 percent increase in the minimumwage. 0 It has been costly fiscally. Between 2000 and 2005, about 60 percent of the consolidated AFMA (Agriculture and Fisheries Modernization Act) budget of the Department of Agriculture was allocated to the rice sector. In addition, the NFA receives transfers for stabilization and tax subsidy, and has incurred increasing deficits (which, in 2006, comprised about two-thirds of the GOCC deficit) to finance its mandate of being the monopoly rice importer and distributor of rice subsidies. Adding the NFA costs to the AFMA budget spent on rice brings the annual average of the total budget expenditure for the sector to be 0.26 percent of GDP between 2000 and 2005, 0.46 percent in 2005, and higher in 2006 based on preliminary estimates. The current rice polic has thus proved costly, not only for agriculture, but for the economy as a whole. 3 1 It i s counterproductive to raise prices for the main commodity consumed by laborers in a situation where higher employment demand in the non-farm economy i s essential for poverty alleviation, and when neighboring countries enjoy a competitive advantage of lower rice prices that translate into more competitive wages and higher consumption. Indeed, the pace at which the Philippines i s able to bring down its food prices, and thereby enhance labor competitiveness, will have a bearing on its capacity to expand into any internationally competitive, labor-intensive activity. Other commodities such as corn and sugar tend to receive higher levels of protection than rice. Corn i s a subsistence crop among upland farmers in the south and a food staple for 10 to 15 percent of the population, as well as a major feed ingredient. Such protection can thus add significantly to costs for poultry and the livestock industry, 32 Itcan be argued that production subsidies of agricultural commodities by some OECD countries distort world relative prices. However,Philippine wholesale prices for major agriculturalcommodities were 50-70 percent above the border price during 2000-2005; Le., well above distortions caused by OECD subsidies, certainly for rice. 33Brooks, R. (2002):Why I s Unemployment High in the Philippines?IMFWorking Paper No. 02/23. 34 The average annual net welfare loss of rice policy in the Philippines,combiningchanges inproducer surplus, consumer surplus, and budget surplus, is estimated at P50billion or 1.2percent of GDP during 2000-2005 (World Bank, 2007). 34 which also receive high levels of protection, in part as compensation to offset the high corn prices. High tariffs for sugar penalize the processed fruit industry. Thus, separately from the aforementioned impact on the labor market, competitiveness in food processing and livestock i s undermined by a policy that raises food prices. I t i s therefore not surprisingthat welfare impact assessmentsof agricultural trade liberalization consistently report positive effects.35 The evolution of policies to protect agriculture i s rooted in the skewed land distribution stemmingfrom the colonial period coupled with strong sentiments for the enduring (but unrealized) goal of food self-sufficiency. Shifting from a goal of food self-sufficiency to greater food security at the household level would be an important component of a reformstrategy. Key elements of such a shift are outlined below (and elaborated on in the World Bank's forthcoming Agriculture Public Expenditure Review): Gradual reduction of import protection to allow rice prices to adjust towards the border price. This would benefit the majority of the population, especially the poor. The reduction in import protection i s also the only means to cut some marketing costs (e.g., working capital requirement for traders and millers, storage costs) and production costs (e.g., wage costs), which would raise farm incomes and at least partially offset the impact of lower prices on rice farmers. Target public investment to reduce marketing and production costs. Currently Thai rice farmers receive 81 percent of the wholesale price, whereas Filipino rice farmers receive 74 percent, due to larger marketing costs and margins. Public investment in roads, R&D, extension, and food quality and safety would reduce farmers' transaction costs. Investment in wholesale markets for palay would reduce the large number of intermediaries. Such commodity-neutral agricultural policy i s an important prerequisite for ensuring higher returns to public investment in agriculture and diversified agricultural growth. Change the NFA's core mandate. Under the above scenario, the NFA would focus on rice market regulation while devolving its trade functions to the private sector. It could still be responsible for managing buffers for emergency reasons and for protecting consumers against very high international prices. The purpose of stabilization would be to insure against the risks associated with sharp international price movements. Just as insurance i s only taken out to guard against serious risks, so the stabilization system would only be used to reduce the largest price fluctuations and to stabilize domestic prices around the world market price. This would be the most effective means of tackling NFA's rising deficit. As experience from other Asian countries indicates,36 the changed NFA mandate towards buffering around reference border prices and shifting trading functions to the private sector would be the most effective way of reducing fiscal costs and resource misallocation. 35See David, Intal and Balisacan (2007). The authors cite studies by Habitoand Cororaton(2000), Cororaton (1998) and Clarete (1991) on the positive impact of trade liberalization. 36Gummings, R.,R. Shahidur and G. Ashok (2006) 35 Over time, rice production in the Philippines could become more competitive even at lower market prices, while crop diversification would be encouraged. Under this scenario, the key task for the government in the transition period would be to begin increasing the role of private traders and tackling structural problems in the food supply chain to increase the share of the farm-gate in consumer prices, and to reduce production costs. Thus, it would be possible to increase farm incomes, enhance crop diversification and improve the allocative efficiency of public expenditures while also reducing the prices paid b y consumers. D. MAXIMIZING BENEFITSOFGROWTH THE FOR THE POOR Poverty in the Philippines declined at a relatively slow pace through 2003: FIES results indicate a poverty incidence of 30 percent in 2003. With stronger growth in the interim period, poverty incidence i s estimated to have declined further, but official estimates usingthe 2006 FIES will not be available until 2008. Ensuring that higher growth is shared and broad-based will be pivotal to the Philippine's success in reducing poverty and reaching its MDG targets. This i s also important for the sustainability of the growth process. There are four broad areas where attention i s required. First, growth needs to be unleashed in sectors from which the poor derive their incomes. For example, with about 60 percent of poor households deriving income from the agricultural sector, reforms aimed at stimulating growth in this sector will be important for reducing poverty. Policies that increase access of the poor to assets (such as the comprehensive land reform program, CARP), and to markets (such as developing and maintaining the rural road infrastructure and improving the access of the poor to finance) would thus be critical to poverty reduction. Helping to enhance livelihoods and generate rural off-farm employment in the service sector will also be important. More broadly, addressing the impediments to investment that constrain the income earning capacity of the poor should be an important agenda item going forward. Second, the gains from fiscal reforms need to be directed at public spending that improves the plight of the poor by improving their humancapital. Investing more in human capital will not only be critical for achieving key MDG targets, but has fundamental ramifications for enhancing the competitiveness of the labor force. As a share of GDP, central government expenditures on education fell from 4 percent in 1998 to 2.4 percent in 2005; central government expenditures on health fell from 0.5 percent in 1998 to 0.3 percent in 2005. The increased allocation in spending for education in the 2007 budget i s a step in the right direction. The proposed 2007 budget allocates substantial real increases for the public school system, including increased allocations for teacher recruitment, textbooks and school buildings. Sustained increases in allocation to the social sectors (consistent with fiscal objectives) would be required to reassert the standing of the Philippines with regard to its human capital outcomes. This would need to be complemented by reforms that improve the quality of spending to concentrate on pro-poor outcomes. In education, maintaining the medium-term focus on quality, school completion and achievement rates will be essential. In health, it will be important to successfully implement plans to increase the equity, sustainability and quality of health service delivery for the poor, as well as to achieve the health related MDGs (such as 36 women and child services and intensified disease control programs for tuberculosis, malaria, and HIV/AIDS). Improving the access of the poor to health insurance, through expanding enrollment of the poor in the PhilHealth indigent program-in conjunction with needed improvements in targeting to the poor (see fourth point below)-as well as revision of the PhilHealth benefit package to improve protection against catastrophic health expenses for the poor, are thus also a key reform in this regard. Third, the development of a coherent social protection strategy would reduce the risks of impoverishment of the vulnerable, but would also assist in securing gains in fiscal efficiency. Currently the Philippines i s characterized by a diversity of disparate programs aimed at helping the poor and vulnerable. A recent study estimated that only some 0.2 percent of GDP was allocated to social protection programs in the phi lip pine^.^^ Matching an assessment of these programs up against an analysis of the actual risks and vulnerabilities faced by the poor would be an important next step. Social insurance and health insurance should be viewed as key elements in the broader menu of social protection in this regard. As discussed earlier, present implementation of policies towards rice production and imports, which entail significant economic costs, do not appear the most effective in terms of tackling the risk of hunger and poverty. Finally, it would be useful to develop an empirically based social protection strategy that addresses the major risks to the vulnerable and poor. Ideally such a strategy would lead to sector- wide multi-year programming and financing. Fourth, to improve both efficiency and equity of pro-poor spending and to strengthen social protection, the Philippines needs to put in place a system to better target the poor. With the scope for increasing pro-poor spending, the imperative to ensure that targeted programs actually reach the poor becomes all the more critical. Currently different targeting schemes are used for different programs. The assessments that exist of these schemes show high leakage rates (to the non-poor) and under-coverage rates (of the poor) (Manasan, 2006). Whether for targeting of rice, of health insurance, or of scholarships, there i s an increasing demand for an accurate, objective, transparent, and technically sound system to target the poor. The Philippines already has in place some of the elements needed for a state of the art targeting system-namely accurate poverty maps for geographic targeting. To develop a household targeting system would in addition call for using a proxy means test on appropriate survey data. Despite the up- front costs of developing such a system nationally, the fiscal gains of improved targeting over time will be significant, as will be the improved effectiveness in reaching the poor. 37 Manasan (2006). 37 STATISTICALANNEX Table 1. Summary Indicators 2002 2003 2004 2005 2006 Nationalincome(growth rates) Gross national product 4.2 5.9 6.7 5.6 6.2 Gross domestic product 4.4 4.9 6.2 5.0 5.4 Prices Consumer prices (period average)/l 3.0 3.5 6.0 7.6 6.2 Exchange rate (period average) 51.6 54.2 56.0 55.1 51.3 Savingsand investment(percent of GDP) Gross national savings/2 17.3 17.2 18.7 17.2 19.1 Gross domestic investment 17.7 16.8 16.8 15.1 14.8 Resource gap -0.4 0.4 1.9 2.1 4.3 Publicsector (percent of GDP) Consolidated public sector balance -5.6 -5.1 -4.9 -1.8 0.1 National government balance -5.3 -4.6 -3.8 -2.7 -1.1 Revenue 14.6 14.8 14.5 15.1 16.3 Expenditure 19.9 19.5 18.4 17.8 17.4 Monetary and financial sector Broad money (growth rate) 9.5 3.3 9.2 9.0 22.3 Private sector credit (growth rate) 1.2 1.8 4.6 -1.5 6.0 91-day treasury bill rate 5.4 6.0 7.3 6.3 5.4 PSE composite index (year end) 1,018 1,442 1,622 2,067 2,983 Externalsector (billions dollars) Current account balance -0.3 0.3 1.6 2.0 5.0 Percent of GDP -0.4 0.4 1.9 2.1 4.3 Merchandise exports 34.4 35.3 38.8 40.3 46.2 Growth rate 9.9 2.7 9.8 3.8 14.6 Merchandise imports 39.9 41.2 44.5 48.0 53.1 Growth rate 6.3 3.1 8.0 8.0 10.6 Externaldebt/2 Total external debt (billions of dollars) 53.6 57.4 54.8 54.2 53.4 Percent of GDP 69.8 72.1 63.3 55.1 45.6 Debt service ratio (G&S and receipts) 17.1 16.9 13.8 13.5 12.0 Social sector Population (millions) 78.7 80.2 81.6 83.1 84.5 Poverty incidence (PPP $1 a day) 12.4 13.1 11.5 10.8 9.6 Per capita GNI, atlas method 1,030 1,080 1,200 1,290 1,420 Source: Government of the Philippines, World Bank e/ Estimate I/Baseyear: 2000 2/ Reportedby BSP 38 Table 2. National Accounts 2002 2003 2004 2005 2006 (Growth rates) Gross national product 4.2 5.9 6.7 5.6 6.2 Gross domestic product 4.4 4.9 6.2 5.0 5.4 By industrialorigin Agriculture, fishery and forestry 4.0 3.8 5.3 1.8 4.1 Agriculture and fishery 4.1 3.7 5.1 2.0 3.9 Forestry -27.5 24.3 53.2 -31.3 59.8 Industry 3.9 4.0 4.7 4.9 4.8 Mining and quarrying 51.O 16.8 2.6 9.3 -6.0 Manufacturing 3.5 4.2 5.1 5.6 5.4 Construction -4.0 -0.8 3.4 0.9 4.6 Utilities 4.3 3.2 4.2 2.5 6.4 Service 5.1 6.1 7.6 6.4 6.3 Transport, storage, communication 8.9 8.6 11.2 7.2 6.7 Trade 5.8 5.7 6.8 5.6 5.5 Finance 3.4 5.9 9.9 13.6 9.5 Real estate 1.8 4.0 5.3 5.4 5.8 Private services 5.5 8.1 10.1 5.5 6.8 Government services 1.3 2.9 0.5 1.9 3.9 By expenditure class Personal consumption 4.1 5.3 5.8 4.9 5.5 Government consumption -3.8 2.6 1.4 4.0 5.7 Capital formation -4.3 3.0 7.2 -6.0 2.1 Fixed capital 2.1 3.8 1.3 -3.9 0.6 Construction -0.7 -1.2 -0.8 -0.9 2.8 Durable equipment 4.8 9.2 3.2 -7.1 -1.4 Breeding stock & orchard development 3.3 -0.5 0.9 0.8 0.0 Changes in stocks -109.3 141.7 -444.1 -54.2 76.5 Exports 4.0 4.9 14.4 4.2 12.1 Imports 5.6 10.8 5.8 2.4 2.5 Statistical discrepancies -432.0 131.2 -50.9 52.2 -99.4 Memorandum items GIR (billions of dollars) 16.4 17.1 16.2 18.5 23.0 Exchange rate (period average) 51.6 54.2 56.0 55.1 51.3 Tax effort (percent of GDP) 12.8 12.8 12.5 13.0 14.3 Deficit (percent of GDP) -5.3 -4.6 -3.8 -2.7 -1.1 Non-performing loans ratio 15.0 14.1 12.7 8.2 6.0 Nominal GDP (billions of pesos) 3964 4316 4859 5419 6000 Sources: -National Statistical CoordinationBoard, Central Bank of the Philippines,Bureau of Treasuiy 39 Table 3. Inflation Rates 2002 2003 2004 2005 2006 (Percent per annum, average) All items 3.0 3.5 6.0 7.6 6.2 Food, beverages and tobacco 2.3 2.2 6.2 6.4 5.5 Clothing 3.5 3.4 2.7 3.5 3.0 Housing and repairs 4.8 4.3 3.8 4.5 3.9 Fuel, light and water 2.5 6.3 7.4 18.1 12.9 Services 4.3 5.6 9.2 11.8 8.9 Others 1.8 1.9 2.2 3.2 3.0 Source: National Statistics Office Table 4. Monetary Survey 2002 2003 2004 2005 2006 (Billions of pesos) Total liquidity 2,351 2,474 2,711 2,887 3,397 Broad money (M3) 1,670 1,725 1,884 2,053 2,511 Narrow money 470 510 556 605 753 FCDU deposits 628 676 766 762 818 Other liabilities 53 73 62 72 68 Net domestic assets 1,799 1,801 1,985 1,925 2,011 Net domestic credit 2,207 2,313 2,533 2,428 2,593 Public sector 727 807 956 875 947 Private sector 1,480 1,507 1,577 1,553 1,646 Net other items -408 -513 -548 -503 -582 Net foreign assets 551 673 727 961 1,386 Central bank 548 637 690 846 1,075 Deposit money banks 4 37 37 115 311 (Percent of GDP) Total liquidity 59.3 57.3 55.8 53.3 56.6 Broad money (M3) 42.1 40.0 38.8 37.9 41.8 Narrow money 11.9 11.8 11.5 11.2 12.5 FCDU deposits 15.9 15.7 15.8 14.1 13.6 Other liabilities 1.3 1.7 1.3 1.3 1.1 Net domestic assets 45.4 41.7 40.8 35.5 33.5 Net domestic credit 55.7 53.6 52.1 44.8 43.2 Public sector 18.3 18.7 19.7 16.1 15.8 Private sector 37.3 34.9 32.4 28.7 27.4 Net other items -10.3 -11.9 -11.3 -9.3 -9.7 Net foreign assets 13.9 15.6 15.0 17.7 23.1 Central bank 13.8 14.8 14.2 15.6 17.9 Deposit money banks 0.1 0.8 0.8 2.1 5.2 Source: CentralBank of the Philippines 40 Table 5. NationalGovernmentOperations 2002 2003 2004 2005 2006 (Percent of GDP) Total revenue 14.6 14.8 14.5 15.1 16.3 Tax revenue 12.8 12.8 12.5 13.0 14.3 Bureau of Internal Revenue 10.2 9.9 9.7 10.0 10.9 Net income & profits 5.7 5.7 5.7 6.0 6.2e Excise tax 1.4 1.3 1.2 1.1 1.Oe Sales taxes & licenses 2.3 2.3 2.2 2.3 3.0e Other domestic taxes 0.7 0.6 0.5 0.6 0.7e International trade taxes 0.0 0.0 0.0 0.0 O.Oe Bureau of Customs 2.5 2.7 2.6 2.9 3.3 Other offices 0.1 0.1 0.2 0.2 0.1 Nontax revenue 1.8 2.0 2.1 2.0 2.0 Bureau of Treasury 1.2 1.3 1.3 1.3 1.2 Fees & charges 0.6 0.4 0.4 0.4 0.3 Privatization 0.0 0.0 0.0 0.0 0.1 CARP 0.0 0.0 0.0 0.0 0.0 Others 0.0 0.3 0.2 0.2 0.2 Marcos wealth 0.0 0.0 0.2 0.1 0.1 Grants 0.0 0.0 0.0 0.0 0.0 Total expenditure 19.9 19.5 18.4 17.8 17.4- Allotment to LGUs 3.5 3.4 3.0 3.0 2.9 Interest payment 4.7 5.2 5.4 5.5 5.2 Tax expenditures 0.1 0.3 0.1 0.2 0.3 Subsidy 0.2 0.3 0.3 0.2 0.2 Equity 0.0 0.1 0.0 0.0 0.1 Net lending 0.1 0.1 0.1 0.0 0.0 Others 11.3 10.0 9.5 8.8 8.7 Personnel services 6.7 6.4 5.8 5.5 5.4 MOOE 2.1 1.8 1.7 1.6 1.7 Total capital outlay/l 3.1 2.6 2.7 2.4 2.3 Balance -5.3 -4.6 -3.8 -2.7 -1.1 Primary balance -0.6 0.6 1.5 2.8 4.1 Financing 6.7 6.6 5.0 4.4 1.8 Net domestic 3.9 3.3 3.3 2.6 -0.2 Net foreign 2.8 3.3 1.7 1.7 2.0 Source: Bureau of Treasury, Deparfment of Budget and Management, World Bank estimates 1/ Includes capital allotments to local government units 41 Table 6. Consolidated Public Sector Debt 2002 2003 2004 2005 2006 (Percent of GDP) Consolidated public sector balance -5.6 -5.2 -4.8 -1.8 0.1 National government balance -5.3 -4.6 -3.8 -2.7 -1.0 Consolidated public sector debt 110.2 117.6 109.0 93.4 82.0e Domestic 34.4 35.5 35.2 32.2 Foreign 75.9 82.1 73.9 61.2 Financial public sector debt 34.0 33.9 27.4 19.4 Domestic 19.8 20.1 16.4 11.3 Foreign 14.2 13.8 11.0 8.1 Consolidated non-financial public sector debt 93.7 100.8 95.4 86.8 75.0e Domestic 32.0 32.4 32.6 33.7 Foreign 61.7 68.3 62.9 53.1 GOCC debt 34.7 38.4 32.0 29.0 Domestic 6.1 6.5 6.4 8.5 Foreign 28.6 32.0 25.6 20.5 Consolidated general government debt 67.0 71.7 69.3 62.0 Domestic 31.4 32.0 31.1 29.5 Foreign 35.6 39.6 38.2 32.5 National government debt 71.0 77.7 78.5 71.8 64.8 Domestic 37.1 39.5 41.2 39.9 Foreign 33.9 38.3 37.3 31.8 Source: Department of Finance e/ World Bank estimates 42 Table 7. Consolidated Public Sector Fiscal Position 2002 2003 2004 2005 2006 (Percent of GDP) Consolidated public sector balance -5.6 -5.1 -4.9 -1.8 0.1 Public sector borrowing requirements 6.8 6.4 5.9 3.4 1.3 National government -5.3 -4.6 -3.8 -2.7 -1.1 CB restructuring -0.4 -0.4 -0.4 -0.3 -0.2 Monitored GOCCs -1.2 -1.5 -1.9 -0.4 0.0 OPSF 0.0 0.0 0.0 0.0 0.0 Adjustment of net lending and equity to GOCCs 0.1 0.1 0.2 0.0 0.0 Other adjustments 0.0 0.0 0.0 0.0 0.0 Other public sector 1.2 1.2 1.o 1.6 1.4 SSS/GSIS 0.6 0.4 0.5 0.9 1.o BSP 0.0 0.2 0.1 0.1 0.0 GFls 0.1 0.1 0.1 0.1 0.1 LGUs 0.4 0.5 0.3 0.4 0.4 Timing adjustment of interest payments to BSP 0.0 0.0 0.1 0.1 0.0 Other adjustments 0.0 0.1 -0.1 0.0 -0.1 Source: Department of Finance 43 Table 8. Balanceof Payments 2002 2003 2004 2005 2006 (Billions of US dollars) Current account balance -0.3 0.3 1.6 2.0 5.0 Trade Balance -5.5 -5.9 -5.7 -7.8 -7.0 Exports 34.4 35.3 38.8 40.3 46.2 o/w manufacturing 31.6 32.0 35.5 36.9 41.1 o/w electronics 25.1 25.0 27.9 28.5 31.1 Imports 39.9 41.2 44.5 48.0 53.1 o/w oil and petroleum products 3.3 3.8 4.7 6.3 8.1 o/w electronics parts 12 15.9 15.9 17.4 18.2 20.7 o/w capital 8.4 8.8 8.7 8.9 9.1 Services -2.0 -2.0 -1.a -1.3 -0.7 Receipts 3.4 3.4 4.0 4.5 5.4 Payments 5.4 5.4 5.8 5.9 6.1 Income -0.4 -0.3 -0.1 -0.2 -0.5 Receipts 3.3 3.3 3.7 3.9 4.4 Payments 3.7 3.6 3.8 4.2 4.9 o/w interest payments 1.2 1.3 1.3 1.5 1.6 Transfers 7.7 8.4 9.2 11.4 13.2 Receipts 7.9 8.6 9.4 11.7 13.5 Payments 0.3 0.2 0.3 0.3 0.3 Workers' remittances 6.9 7.6 8.6 10.7 12.8 Capitaland financial account 1.1 0.7 -1.6 2.2 -1.7 Capital account 0.0 0.1 0.0 0.0 0.1 Financial account 1.0 0.7 -1.6 2.2 -1.9 Direct Investment 1.5 0.2 0.1 1.7 2.2 Portfolio Investment 0.7 0.6 -1.7 3.5 2.7 Other investment -1.2 -0.1 0.0 -3.0 -6.8 Errorsand omissions 0.0 -0.9 -0.3 -1.9 0.5 Balanceof payment 0.8 0.1 -0.3 2.4 3.8 Source: Central Bank of the Philippines 1/ 1999-2005revised 2/ MaVAcc for the mftr. of elect. eqpt. 44 Table 9. Labor and Employment Indicators/1 2002 2003 2004 2005 2006 (In thousands) Population 78,705 80,166 81,617 83,054 84,476 Growth rate 1.9 1.9 1.8 1.8 1.7 Working age population 50,344 51,793 53,144 54,388 55,626 Growth rate 2.9 2.9 2.6 2.3 2.3 Labor force 33,936 34,571 35,862 36,439 37,050 Labor force participation rate 67.4 66.7 67.5 67.0 66.6 Employed 30,062 30,635 31,613 32,313 32,963 Employment growth 3.1 1.9 3.2 2.2 2.0 Wage and salaried 14,653 15,354 16,472 16,316 16,789 Percent of employed 48.7 50.1 52.1 50.5 50.9 Own account 11,399 11,517 11,614 12,104 12,134 Percent of employed 37.9 37.6 36.7 37.5 36.8 Unpaid family workers 4,009 3,765 3,527 3,893 4,040 Percent of employed 13.3 12.3 11.2 12.0 12.3 Unemployed /2 3,874 3,936 4,249 4,126 4,088 Unemployment rate /2 11.4 11.4 11.8 11.3 11.0 Underemployed 5,109 5,221 5,575 6,785 7,470 Underemployment rate 17.0 17.0 17.6 21.o 22.7 Source: National Statistical Coordination Board. 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