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Wednesday, November 19, 2008

How RP Can Weather the Crisis

Taken from a paper from the World Bank


Philippine economic performance has decelerated in 2008. Growth in the first
half slowed to 4.6 percent from over 7 percent last year. Higher food and fuel prices have
caused real household income to decline, pushing private consumption growth to its
lowest level in years. Public sector consumption and investment spending were even
weaker, contracting in real terms. Similarly, the services sector also slowed. Growth to
date has been buoyed instead by private investment and non-factor service export on the
demand side and agriculture and manufacturing on the supply side.
Rising inflation has brought significant hardships to the poor. Monthly
headline inflation since June have risen to decade-high levels, and the inflation faced by
the poor is rising even faster given the large share of food in their consumption basket.
The government has responded by postponing its balance budget goal this year to allow
for spending increases in infrastructure, social protection, and subsidies.
In addition, the recent global slowdown arising from the financial turmoil
has also taken its toll on the performance of the external sector, notably through
merchandise exports and foreign investment inflows. Slower growth in partner
countries and higher oil and food prices have bloated the trade deficit. Remittances,
however, have remained robust, and have kept the current account in moderate surplus.
Direct investment inflows have diminished but remain positive so far. Portfolio
investment has been more adversely affected by the financial market turmoil and global
risk aversion. Nonetheless, the overall balance of payments has remained in surplus and
enabled the country to continue to accumulate international reserves.
Despite the twin challenges of slower growth and higher inflation, the
situation is expected to remain manageable. The Philippines is in a better position to
weather the uncertainties brought about by the recent global slowdown and escalating
fuel and food prices given the fiscal and other reforms it has undertaken in the last several
years. With the appropriate fiscal and monetary policies, short-term growth prospects can
be improved while inflationary pressures contained. Nevertheless, a significant slowdown
in the economy is likely, and growth is projected to slow to 4-4.5 percent this year, and 3-
4 percent next year.
It is in this light that the Philippines must consolidate its fiscal position and
improve revenue efficiency so as to limit fiscal risks and increase the quality of
spending. Increasing tax revenues remains the key immediate challenge. Without it, the
budgeted higher infrastructure, social services, and social protection spending may not be
feasible. New tax policies and better tax administration are needed to raise revenues to
more sustainable levels. In the area of tax policy, improving the structure and rates of
tobacco excises and rationalizing fiscal incentives can boost revenues and have social and
economic benefits. Institutionalizing third party data sharing with the BIR and enhancing
tax enforcement activities can have a significant and immediate impact on compliance.
On the expenditure side, improving spending quality and its composition—and in
particular the targeting of the social safety net, and capital spending efficiency—are
Recent Economic Developments
Philippine economic growth has decelerated in 2008. Higher food and fuel prices
have caused real household income to decline, pushing private consumption growth to its
lowest level in years. Public sector consumption and investment spending were even
weaker, contracting in real terms. Rising inflation has brought significant hardships to the
poor. The government has responded by postponing its balance budget goal this year to
allow for increases in infrastructure and social protection spending and subsidies to the
poor. The recent global slowdown has also taken its toll on the performance of the
external sector, notably through merchandise exports and foreign investment inflows.
Despite these challenges, the economy is expected to remain resilient and manageable. In
the short-term, the Philippines is expected to weather the crisis but growth will
nevertheless slow down significantly. In the long-term sustainability of growth remains
dependent on improvements in the investment and governance climate.
Real sector performance
Economic growth decelerated in 2008, after posting the strongest growth in
three decades last year. From 7.2 percent in 2007, GDP growth slid in the first quarter
to 4.7 percent and again in the second quarter to 4.6 percent.1 The slowdown in the
second quarter was rooted in rapidly rising inflation which reduced household real
income, and to some extent last year’s high GDP base due to higher government
spending.2 As oil and food prices soared worldwide, domestic household consumption
grew at a slower rate of 3.4 percent in contrast to its average growth of 5.4 percent in the
previous 21 quarters. Growth in the consumption of almost all commodity groups
weakened and has been most pronounced in food consumption which grew at a much
slower rate of 2.7 percent from 4.9 percent in the first quarter and 6.3 percent last year.
Households also consolidated their spending on fuel, light, and water which dropped by
1.3 percent. Government spending was even slower despite earlier pronouncements by
the administration to pump-prime the economy and increase spending for infrastructure
and social protection, and subsidies to the poor. Public consumption and investment
contracted by 5.9 and 6.4 percent respectively in real terms. Expansionary fiscal policy,
as a means to stimulate the economy, was therefore underutilized and contributed to the
lackluster performance of the economy. In the third quarter, government spending has
picked up, and government reported a higher deficit in the months of August and
Unexpectedly, higher growth of capital formation and exports cushioned
overall growth. Capital formation grew at a respectable rate of 14.7 percent in the
second quarter as private construction and investments in durable equipments held up
well despite the weakening economic environment. Private construction, mainly
residential and office buildings grew by a hefty 25 percent in the second quarter, tracking
higher growth in the real estate sector and lifting first half growth to 21.7 percent. The 4
percent growth in durable equipment spending was driven by investments in vehicles,
mining and construction machineries, and other specialized machineries. Changes in
stocks have turned positive from negative last year and while it has the effect of pulling
up investment growth, it nevertheless reflects the slowdown in economic activity.
Exports of goods and services rebounded in the second quarter, growing by 7.7 percent,
from a slump in the first quarter. As expected, non-factor services, which include the fast
growing business process outsourcing industry, grew by 18.3 percent, driving growth in
external demand (Figure 1).
On the production side, growth was buoyed by better than expected crop
harvest and higher production in the manufacturing sector. Gross value added in
agriculture expanded by 4.9 percent in the second quarter, the highest growth among the
three sectors. Encouraged by higher commodity prices, domestic production of rice, corn,
and banana registered double-digit growths while sugarcane production was
exceptionally strong with a growth of 111 percent. The manufacturing sector
unexpectedly grew at a higher 6.1 percent, the highest in 13 quarters, and was supported
by strong growths in food manufacturing, and to a lesser extent, beverage, basic metals,
chemical and chemical products, and footwear and apparel manufacturing. Productivity,
however, remains low.
The services-led growth story in the last seven years appears to have taken a
backseat. The services sector, which comprises more than half of GDP and employs
more than half of the total workforce, posted its weakest growth in the second quarter—
4.3 percent compared to 4.9 percent in agriculture and 4.8 percent in industry (Figure 2).
Only the real estate and private services sub-sectors, which include the fast growing
business process outsourcing (BPO) industry, posted higher than average growth in the
second quarter. The rest of the services sub-sectors, most notably trade and
transportation, communication, and storage were adversely affected by subdued demand
because of higher prices. The much slower growth of the financial sector at 2.4 percent
deserves some mention, as it has been one of the fastest growing sub-sectors in the last
five years—with double-digit growth in 13 out of 18 quarters. The decline in financial
sector profits, in particular treasury earnings, has begun to eat up the gains posted in the
previous quarters given higher risk aversion and tightening of global credit markets.
The slowdown in the economy has begun to affect the labor market. Although
the rate of unemployment improved in the first three quarters of 2008 to 7.6 percent—
slightly lower than last year’s 7.7 percent—the bulk of the improvement is traced to the
contraction in the labor force participation rate, from 64.3 to 63.3 percent, and the
increase in the number of unpaid family workers, which comprised 11.2 percent of total
employment and is prevalent in agriculture and private households. Moreover, the high
value-added manufacturing sector shed some 130,000 jobs. The good news, however, is
the underemployment rate improved to 19.9 percent from 20.8 percent last year.
Inflation and monetary conditions
After a period of falling inflation in the last three years, rapidly accelerating
inflation resurfaced this year. Higher food and oil prices were initially muted by the
strong peso which appreciated by nearly 20 percent in 2006-07. In early 2008, inflation
breached the central bank’s 4-5 percent target as world food and oil prices surged.
Inflation continued to escalate, reaching double digit levels by June. In August, inflation
reached a peak of 12.5 percent before falling in September to 11.9 percent, bringing yearto-
date inflation to 9.2 percent (Figure 3).
The decade-high inflation is primarily traced to escalating food prices. Food
comprises about half of the CPI basket and thus has a strong impact on headline inflation.
Food prices have increased at double digit rates since April, triggered primarily by the
steep increase in the international price of rice. The government’s now-abandoned
practice of announcing large tenders of rice imports may have also contributed to the
spike in the international price of rice. At the local level, there were reports of domestic
rice hoarding and speculative pricing by traders, more prevalent in areas outside the
National Capital Region, which have contributed to higher retail prices. At its peak, rice
price increases reached 50 percent in July before descending to 45 percent in August and
37 percent in September.
At the same time, fuel prices, especially diesel oil, increased sharply in the
second quarter and have brought significant hardship to the transport sector and
commuters. To mitigate the rise in fuel prices, the government gradually removed the
tariff rate on oil and asked oil companies to cross-subsidize diesel oil, which is the
dominant fuel used by public transport. An increasing number of public vehicles have
converted to the cheaper liquefied petroleum gas (LPG). Buses powered by compressed
natural gas (CNG) have also begun service. Falling fuel prices since the beginning of
September has offered some relief and enabled the government to resume levying the
tariff on imported fuel in October.
As inflationary pressures mounted, core inflation has doubled since the start
of the year. Without respite from the rising prices of basic commodities, prices of other
goods have also risen rapidly, pushing up core inflation from less than 3 percent in 2007
to 7.5 percent in September 2008. In an effort to control spillovers, the central bank
increased policy rates thrice since June (see discussion below).
In line with the rising consumer price index, nominal wages have increased.
As of June, all 17 regions have been granted wage hikes by the regional boards of the
National Wages and Productivity Commission. The increases in the regional minimum
wages, however, have been less than the increases in regional year-to-date inflation,
resulting in a decline in the minimum wage rate in real terms. For instance, the National
Capital Region (NCR) was granted a 6 percent increase in June, but this was lower than
the September year-to-date inflation of 7.2 percent. And since minimum wages cannot be
increased more than once in a year (barring exceptional circumstances), higher inflation
in the succeeding months, averaging close to 9 percent between June and September, has
further eroded real wages.
Production costs have also picked up. Growth in the producer price index (PPI)
of the manufacturing sector had remained almost flat in the first four months of the year
but rising input prices on the international market and rising nominal wages have filtered
into the production sector, giving rise to higher PPI inflation beginning May. From less
than 1 percent between January and April this year, PPI inflation jumped to 5.8 percent
year-on-year in July and August. In particular, manufacturers of food, petroleum
products, basic metals, iron and steel, and non-ferrous metals had to grapple with fastrising
production costs. Similarly, the construction materials wholesale price index
started to pick up in April (Figure 4). The August year-to-date construction wholesale
price inflation in NCR reached 12.7 percent compared to an average of 4.4 percent in
2007 as the prices of fuels, lubricants, and steel increased.
With inflation breaching the central bank’s original and revised targets,
policy rates were hiked to contain inflation. From a relaxed monetary stance last year
to mitigate the expected slowdown in growth following the onset of the subprime crisis,
the Monetary Board hiked the 7 percent policy rate by 25 basis points on June 5, 2008
after seeing the May inflation of 9.5 percent, a nine-year high. The hike in policy rate was
initially modest given expectations that upside inflationary risks would be tempered by
the global economic slowdown. However, further increases in the inflation rate in the
succeeding months prompted a second hike in policy rates by 50 basis points on July 17
and another 25 basis points on August 28. In October, the Monetary Board left key policy
rates unchanged after considering the improved inflation outlook and developments in the
global financial market.
Monetary growth has slowed in 2008. Growth in M3 (broad money) slowed to
9.8 percent in August from 11 percent in 2007 and over 23 percent in 2006. The
authorities had used various tools since 2006 such as special deposit accounts to mop up
excess liquidity. At the same time, banks have been encouraged to lend more and reduce
their holdings of government securities. In addition, the government has cut down on the
issuance of securities following improvements in its fiscal position. Also, holding of
government securities will eventually have higher risk weights under Basel II. Relatively
low lending rates, despite the hike in policy rates, have also helped increase lending
activity. Growth in loans outstanding of universal and commercial banks (net of RRPs3)
rose gradually in the last 12 months, reaching 22.1 percent in June with significant
increases in both commercial and consumer lending. Lending to utilities, trade, and the
transportation, communications and storage sectors comprises 60 percent of new
commercial net lending in the year ending August while credit card loans comprised 80
percent of the increase in consumer lending. The rapid growth in credit gives some
reason for concern, as credit growth during a period of economic slowdown could lead to
higher defaults in the future.
Fiscal performance
Tax effort, which fell below expectations in 2007, improved significantly in
the first half of 2008. The VAT reform had boosted tax effort to 14.3 percent of GDP in
2006 from 13 percent in 2005. Weaker tax administration and macroeconomic
developments such as a stronger currency, however, pushed back tax effort to 14 percent
of GDP in 2007 and cast some doubt on the sustainability of the government’s fiscal
program. In late 2007, both the Bureau of Internal Revenue (BIR) and the Bureau of
Customs (BOC) began to focus on the reforms in addition to meeting monthly collection
targets. These reforms included scaling up the use of third party information to detect tax
evaders and non-registrants, and the control of smuggling, in particular petroleum and
cars. As a result, tax effort improved in the first quarter of 2008, and continued to
improve in the second quarter, although higher prices, notably for oil appear to have been
the main driver of the second quarter results. Tax effort in the first half is estimated at
14.6 percent of GDP from 13.8 percent a year ago.
At the same time, government spending was lower than planned, and helped
keep the deficit in check. The late passage of the budget as late as April, low absorptive
capacity of several agencies, and the pending rationalization plan, which generally
prohibits the hiring of new staff all contributed to the slow growth in government
spending.4 In the first half, primary spending grew by 6 percent while interest payment
grew by 8.7 percent given higher borrowing spreads and interest rates. Total spending
grew by only 6.7 percent versus a tax revenue growth of 18.5 percent. Consequently, the
deficit in the first half was well contained at P18 billion and was equivalent to less than
0.2 percent of estimated GDP for the whole year.
The hike in food and fuel prices and slower growth has prompted the
government to increase spending. In May 2008, the government announced that it was
prepared to provide as much as P93.6 billion (1.3 percent of GDP) in additional spending
to help the poor cope with rising fuel and food prices. The additional spending for
infrastructure, subsidies, and social protection are to be financed by higher tax revenues
and new borrowings. Of the P93.6 billion in additional spending, P18.6 billion is
expected to be sourced from ‘windfall’ revenues from the VAT on oil, which as of July
amounted to about P9.2 billion. The remaining P75 billion which is equivalent to 1
percent of GDP would be sourced from additional borrowings. A portion of the new
borrowing requirements was financed from the July retail treasury bond offer, which
amounted to P70 billion (0.9 percent of GDP). The remaining balance of $500 to $750
million is expected to be sourced from a combination of official development assistance
and bond offering. Earlier in the year, the government raised $500 million in ROP bonds
which completed its external borrowing requirements net of ODA under the original
balance budget framework.
The latest fiscal accounts have begun to show higher overall spending.
Consistent with the government’s plan to increase spending, primary spending grew by
21 percent in the third quarter (Figure 5). Tax revenues, however, grew at a much slower
pace of about 10.6 percent given lower collections by the BIR (Figure 6). Collections
from the BOC, however, remain strong, aided in part by higher oil prices. Lower than
programmed tax revenues are expected in the second half from the implementation of
Republic Act (RA) 9504 which increases personal and additional exemptions of
individual taxpayers and exempts minimum wage earners from the personal income tax.
With total revenue growth easing to 2.6 percent in the absence of new privatization
receipts, P35.3 billion was added to first half deficit, bringing the September year-to-date
deficit to P53.4 billion or P18.3 billion higher than program (0.7 percent of full year
GDP). Privatization receipts for the year are estimated between 0.2 and 0.4 percent of
But disbursements on short-term mitigating measures have been slow so far.
Of the P18 billion allocated to social protection and subsidies from the “Katas ng VAT”
program, only about P4 billion has been released for the following projects: 1) P2 billion
in cash transfers to electricity lifeline users (i.e. consumers of less than 100 kwh of
electricity per month); 2) P1 billion in scholarship grants and interest-free loans to poor
students; and 3) P1 billion for demand-side management programs such as the conversion
into energy-efficient light bulbs and provision of low interest loans to jeepney drivers
who wish to convert their engines into the cheaper and more environment-friendly LPGfired
engines. Two other tranches of P4 billion each to be spent on subsidies for small
power users, rehabilitation of infrastructure affected by typhoon, livelihood and loans to
families of transport operators, cash assistance to senior citizens not covered by pension,
upgrade of provincial hospitals, and financial assistance to small farmers, have yet to be
released in full.
External sector performance
Though clearly hit by the global slowdown, the external sector remained
resilient. In the first half of 2008, a BOP surplus of $1.9 billion was recorded. The
current account also remained in surplus at 2 percent of GDP. Although the trade deficit
was much higher at about 6.9 percent of GDP, rapid growth of remittances kept the
current account balance in check. The capital and financial accounts maintained a
respectable surplus despite net outflows of portfolio investment following the increase in
market volatility.
Foreign trade performance has been hit by the global slowdown and rising
prices. The first half trade deficit ballooned to $6.4 billion from $3.2 billion in the same
period last year. Nominal imports, in dollar terms, expanded at a fast rate of 15.5 percent
in the first half, with significant contributions from oil, cereals, fertilizers, and iron and
steel imports. The increase in cereal imports reflects the rapid inflation of food prices and
the government’s move to stock up more rice in view of the food crisis felt earlier this
year. Demand for fertilizers was also propped up by the government’s intensified support
to the agriculture sector through the FIELDS program, which provides for bigger
fertilizer subsidy to farmers. Higher demand for office and residential buildings has
continued to push up iron and steel imports, although the large increases in international
prices posed concerns for the construction and real estate industries going forward.
Consistent with the experience of other countries, export growth in the first half
moderated to 4.1 percent from 7.1 percent last year. While preliminary export data for
July-August indicate an uptick from 1 percent last year to 5.4 percent, the country’s top
export, electronics, remained sluggish as demand for high tech products fell worldwide
and as competition intensified among global manufacturers of semiconductors, reflecting
falling Philippine export productivity. Export of garments also dropped with increasing
competition from other low-cost manufacturers after the US lifted the quota. The
depreciation of the peso by about 18 percent between January and October this year has
been a relief to exporters and has helped bigger exporters cope with falling demand but
has yet to encourage smaller exporters that have closed shop last year to reopen.
Inflow of remittances remains strong although the pace of growth has
slowed. Notwithstanding the global economic slowdown, the country continues to deploy
overseas workers at astonishing speed. In the first eight months of the year, deployment
rose by 26.4 percent to more than 884,000 as demand persists, especially in sectors like
education and health. Moreover, the destination of overseas workers has become more
diversified. Recent bilateral talks with host countries have also opened up new
employment opportunities abroad for Filipinos. The rapid growth of overseas Filipinos
and the huge amount of remittances they send back has encouraged more local banks to
expand their international presence. These expansions have also brought more overseas
Filipinos into contact with various financial products, thereby increasing the share of
remittances channeled to investments. It is estimated that about 30 percent of remittances
are now being invested in housing.5 Against this backdrop, the central bank recorded the
highest monthly inflow of remittances in June, $1.5 billion or 30 percent higher than last
year. However, in the succeeding months remittances started to register slower growth,
from 24 percent in July to 10 percent in August. This brings the August year-to-date
inflows to $10.9 billion or 17.2 percent higher relative to the level a year ago.
Total capital inflows remain solid even as foreign investors turned cautious.
Net direct investment in the first half stood at $742 million and is much higher than the
$1.4 billion in net outflows recorded in the same period last year.6 Although net inflows
were higher, direct investments by non-residents declined by 57.9 percent to $813 million
from $1.9 billion in the same period last year. The decline was even more pronounced in
July as direct investment inflow dropped by 70 percent. Net placement of equity capital
accounted for about 94 percent of total net inflows in January-July. Several sectors, such
as financial intermediation, hotels and restaurants, real estate, and construction appear
more upbeat with greater net equity investment inflows this year compared to last year,
although the sustainability of their growth is doubtful. Portfolio investment was more
adversely affected by continuing risk aversion, recording a net outflow of $520 million in
the first nine months, a trifle compared to $3.4 billion in net inflows last year. Placements
in the stock market, peso denominated government securities, and money market
instruments were offset by higher outflows from peso bank deposits amounting to $2.3
billion. The other investment account turned positive in the first half to $643 million from
a deficit of $632 million last year as residents pulled out their investments abroad.
The BOP surplus has contributed to a higher reserve position. Gross
international reserves rose to $36.7 billion in June from $33.8 billion in end 2007. In
July, reserves had inched up to $36.9 billion before falling back to $36.7 billion in
August and September following some devaluation in gold reserves, the peso defense
notwithstanding. The latest GIR level can cover 5.8 months of imports of goods and
payments of services, and income and is also equivalent to 4 times the country’s shortterm
external debt.
Financial markets
Domestic financial markets have been resilient despite the turbulence in the
international financial markets. With the exception of a handful of banks, the banking
system as a whole was mildly affected by the financial turmoil. At any rate, the
Philippine banking system remained adequately capitalized as of June 2008 with a capital
adequacy ratio (CAR) of 15.5 percent on a consolidated basis.7 Total assets increased to
over P5 trillion with a notable increase in cash—seen as a buffer to market volatility.
Investments, however, declined with lower investments in government securities because
of lower issuance of government bonds and the higher risk weights that below investment
grade foreign currency denominated government securities will carry under Basel II.
Non-performing loans have fallen to below 5 percent in end-2007 and continue to drop
towards its pre-crisis level of about 3 percent.
The impact of the global financial turmoil on the Philippines has been seen
mainly in the decline in stock market and asset prices, a rise in the spreads on its
international bonds, and some depreciation of the peso. Following the strong
appreciation of the peso in 2007, the currency depreciated by about 18 percent year to
date against the US dollar. However, the depreciation masks some of the pressures on the
exchange rate as the authorities have also been intervening in the foreign exchange
markets—notably in the swap markets—to support the peso. Stock market prices have
declined by 45 percent since the end of 2007; a decline that is comparable to other East
Asian economies. The October auction of the benchmark T-bill saw rates jump by 150
basis points from the last auction in July (the July auction saw a 200 basis points increase
in rates). Borrowing spreads, which had fallen below 200 basis points last year, jumped
to over 800 basis points in October.
As in other countries in the region, the Philippines has implemented
measures to deal the pressures in the domestic financial markets. In particular, the
Philippines has approved a circuit breaker rule to halt trading in the stock market if the
benchmark index drops by 10 percent from the previous day and is considering
quadrupling the deposit insurance threshold combined with a capital injection (of P45
billion) into the deposit guarantee fund. On its part, the central bank has allowed a change
in accounting rules to enable banks to avoid mark-to-market losses on their government
bond holdings, eased its rules on the 100 percent asset cover of bank’s foreign currency
deposit units, and opened an inter-bank dollar-denominated borrowing and lending
facility to manage liquidity constraints of banks. The Bankers Association of the
Philippines has also come out with self-restraining measures to help the central bank
manage the shock to the domestic financial system.
For emerging markets like the Philippines, there are several potential
channels of vulnerability through which they could be affected by the current
turbulence in the global financial markets: a) Direct exposure to sub-prime related
distressed credit products of the US and Europe, or to other structured credit and other
related derivatives, or direct exposure to troubled US or European banks; b) Exposure to
increased investor risk aversion leading foreign investors to move to cash and safer fixed
income positions. Countries that are especially vulnerable include those with: high
external debt burdens, high foreign participation in local debt and equity markets and
more generally large current account deficits; c) Fundamental factors associated with
external financing needs—whether reflecting sovereigns with large and rising external
financing needs, banks with large (short-term) external funding needs or corporations
reliant on external funding for refinancing debt coming due or to fund planned growth
and possible repercussions on the domestic economy arising from these; d) Exposure to a
slowdown in global economic growth—developing countries with high-income country
trade orientation and or reliance on workers’ remittances inflows are particularly

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