Philippines - Industrial development strategy and policies (Vol. 2 of 3) : Main report

Report No. 2513-PH Industrial Development Strategy and Policies in the Philippines FILE COPY Volume 11: The Main Report October 29, 1979 Country Programs Department East Asia and Pacific Regional Office Industrial Development and Finance Department FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official dtities. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1.0 = P 7.40 P 1.00 = US$0.135 P 1 million = US$135,135 P 1 billion = US$135 million ABBREVIATIONS ADB - Asian Development Bank AIIA - Agricultural Investment Incentives Act (R.A.) ASE - Annual Survey of Establishments BFAR - Bureau of Fisheries and Aquatic Resources BOI - Board of Investment CB - Central Bank of the Philippines COE - Census of Establishments CSMI - Commission on Small and Medium Industries DAP - Development Academy of the Philippines DBP - Development Bank of the Philippines DCP - Design Center of the Philippines DLC - Department of Loans and Credit (of CB) ECA - Economic Cooperation Administration (of the US) EPZA - Export Processing Zone Authority FCDU - Foreign Currency Deposit Units FDA - Food and Drug Administration, Ministry of Health FNRI - Food and Nutrition Research Institute FORPRODICOM - Forest Products Research and Industry Development Commission FRR - Financial Rate of Return FTI - Food Terminal Incorporated IDRC - International Development Research Center IED - Institute of Export Development (of BOI) IGF - Invention Guarantee Fund IGLF - Industrial Guarantee and Loan Fund IPP - Investment Priorities Plan IPPP - Industrial Promotion Policy Project at the University of the Philippines IRRI - International Rice Research Institute ISEC - International Services Executive Corporation MASICAP - Medium and Small Industry Coordinated Action Program MOA - Ministry of Agriculture MIA - Maritime Industry Authority MIRDC - Metals Industry Research and Development Center MOI - Ministry of Industry MSI - Medium-Scale Industries NACIDA - National Cottage Industry Development Authority NBFI - Non-Bank Financial Intermediaries NCSO - National Census and Statistics Office NEDA - National Economic and Development Authority NFFA - National Federation of Fishing Association NIST - National Institutioni of Science and Technology NPCC - National Pollution Control Commission NSC - National Steel Corporation NSDB - National Science Development Board OBU - Offshore Banking Unit  - ii - FOR OFFICIAL USE ONLY OIA - Office of the Internal Audit (of CB) PCFM - Philippine Chamber of Food Manufacturers, Inc. PCHI - Philippine Chamber of Handicraft Industries PCMP - Progressive Car Manufacturing Program PD - Presidential Decree PDB - Private Development Bank PDCP - Private Development Corporation of the Philippines PEC - Philippine Export Council PFFPI - Philippine Federation of Food Processing Industries PFCA - Philippine Fish Farmers Association PFPA - Philippine Fruit Processors Association PISO - Philippine Ihvestments Systems Organization PNB - Philippine National Bank PSTC - Philippine Shoe Trading Corporation PSC - Price Stabilization Council PTNP - Progressive Truck Manufacturing Program PTPEA - Philippine Tuna Producers and Exporters Association PTRI - Philippine Textile Research Institute RA 5186 - Republic Act 5186: Investment Incentives Act RA 6135 - Republic Act,6135: Export Incentives Act RC - Review Comiittee.(of IGLF) SBAC - Small Business Advisory Centers SMI - Small and Medium Industries STD - Special Time Deposits TAC - Trade Advisory Councils TCNAP - Tin Can Manufacturers Association of the Philippines, Inc. TDC - Technology Development Center TRC - Technology Resources Center UNIDO - United Nations Industrial Development Organization UP - University of the Philippines UPISSI - University of the Philippines Institute for Small-Scale Industries USAID - United- States Agency for International Development FISCAL YEARS July 1-June 30 (up to June 30, 1975) July 1-December 31, 1975 (interim) January 1-December 31 (from January 1, 1976) This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authoriation.   - iii - Page 1 MANUFACTURING: BASIC DATA Annual Rate of Growth (%) 1970 1977 1970-76 GDP (billion pesos, 1972 prices) 51.0 78.0 6.2 Manufacturing Gross Value Added 11.8 18.6 6.7 (billion pesos, 1972 prices) Foodstuffs, beverages, tobacco 4.9 7.4 6.1 Textiles, clothing and footwear 1.1 1.8 7.3 Wood and furniture 0.5 0.8 7.0 Chemicals, rubber, oil & coal products 2.0 4.1 10.8 Nonmetallic mineral products 0.5 0.6 2.6 Basic and metal products, mechanical & electrical machinery, transport equipment 1.9 2.8 5.7 Other 0.9 1.1 2.9 Investment as % of GDP (1975) 1970 1975 Manufacturing Investment 2.4 2.1 4.71 2.86 (billion pesos, 1972 prices) Labor Force Total (in thousands) 10,729 14,663 5.3 Manufacturing (in thousands) 1,323 1,680 3.1 % of labor force 12.3% 11.0% Factory (in thousands) 404 630 7.6 % of manufacturing 30.5% 37.5% (1974) Shares in Factory Labor Force Foodstuffs, beverages, tobacco 13.2 17.0 Textiles, clothing and footwear 55.0 38.4 Wood and furniture 9.8 8.7 Chemicals, rubber, oil & coal products 2.2 5.2 Nonmetallic mineral products 1.8 2.7 Basic and metal products, mechanical & electrical machinery, transport equipment 13.8 16.8 Other 4.2 11.2  - iv - Page 2 Annual Rate of Growth (%) (Current prices) Exports (Million US$, 1973 1975 1977 1973-77 current prices) Total Exports 1,886.3 2,294.5 3,150.9 13.7 Traditional Exports 1,543.9 1,769.4 2.085.1 7.8 Sugar 293.6 614.6 532.2 16.0 Coconut 373.6 466.4 761.0 19.4 Minerals 334.3 255.8 302.3 -2.5 Forest products 416.5 225.2 261.5 -11.0 Fruits & vegetables 25.1 45.2 74.8 31.6 Other 100.8 162.2 153.3 10.9 Nontraditional Manu- factured Exports 226.8 374.3 717.0 33.3 Garments 58.0 107.0 250.2 44.3 Handicrafts 27.4 78.2 84.1 32.6 Electrical & electronic equipment & components 11.3 47.3 124.3 82.0 Non-metallic mineral manufactures, particu- larly cement 25.2 32.2 38.7 11.4 Chemicals 10.6 22.1 54.6 50.9 Wood manufactures, excl. plywood, veneer & lumber 17.2 16.9 35.6 20.0 Food products & beverages 15.0 14.7 30.7 19.5 Machinery & transport equipment 3.4 9.5 27.3 68.2 Textile yarn, fabrics & other related products 17.3 8.7 12.5 -22.1 Cordage, cable, ropes & twines 4.6 7.6 12.5 28.4 Other 36.8 30.1 46.5 6.1 Nontraditional Products (Unmanufactured) 55.4 135.5 323.7 55.5 Special Transactions & Re-Exports 60.2 15.3 25.1 -19.6  - v - Page 3 1977 Direction of Exports US$ million % of total World 3,150.9 100.0 United States 1,102.6 35.0 Japan 726.9 23.1 Netherlands 281.8 8.9 Germany 137.6 4.4 Union of Soviet Socialist: Republics 130.1 4.1 People's Republic of China 108.0 3.4 United Kingdom 70.7 2.3 Singapore 64.5 2.1 Australia 60.4 1.9 Other 468.3 14.8   - vi - PREFACE This report presents the findings of an Industrial Sector Mission which visited the Philippines in February 1979 to review industrial strategy and policies, including rehabilitation and other programs toward further development and greater efficiency in a number of specific industries. The Report is in three volumes: One, The Summary Report; Two, the Main Report; and Three, the Statistical Appendix and Annexes with more detailed data. The scope of the Mission has been sketched in Chapter 1 of the Main Report. From the very start the work of the Mission was conceived as a joint Philippine/World Bank effort. Without the close cooperation and assistance of Philippine officials, the Mission could not have undertaken its task. After a preparatory visit by the Mission Chief in November 1978, the Minister of Industry arranged for several industry studies which were made available to the Mission on its arrival. The Minister also appointed a Coordinating Committee chaired by Rafael A. Sison, Deputy Minister and Conrado Sanchez, Jr., Supervising Governor, Board of Investments. The Mission members conducted all their field work with the help of Philippine counterparts. Further, in areas outside the purview of the Ministry of Industry and the Board of Investment, the Mission was guided by an inter- agency committee composed of representatives of NEDA and the Tariff Commis- sion, the Ministry of Finance, the Ministry of Natural Resources, the Central Bank, the Development Bank of the Philippines and the Metals Industry Research and Development Center. The Philippine counterpart committees and working groups are listed in Annex 1-1. The Mission has benefitted from several earlier studies of Philippine trade, industry and employment problems, notably Vicente B. Valdepenas, Jr., "The Protection and Development of Philippine Manufacturing" (1970); John H. Power and Gerardo P. Sicat, "The Philippines: Industrializa- tion and Trade Policies" (1971); "Sharing in Development, a Program of Employment, Equity and Growth for the Philippines" (ILO, 1974);) and Robert E. Baldwin, "Foreign Trade Regimes and Economic Development in the Philippines" (1975). The Mission has also drawn frequently on the Working Papers of the Industrial Promotion Policies Project conducted in 1978 at the University of the Philippines under the direction of Romeo M. Bautista and John H. Power, and the NEDA/UNDP Export Promotion Project. Several World Bank reports have aided the Mission's analysis: "The Philippines: Priorities and Prospects for Development" (1976); "Staff Appraisal Report on the Second Small and Medium Industries Development Project" (Report No. 2417-PH, March 30, 1979); "Staff Appraisal Report on the Development Bank of the Philippines" (Report No. 1972-PH, April 21, 1978); "A Development Strategy and Investment Priorities for the Central Visayas (Region VII)" (Report No. 2264-PH, January 4, 1979); "An Overview of the Small and Medium Industry in the Philippines," a draft consultant report; and preliminary papers from the Bank's research project on small enterprises (RPO 67-159).  - vii - The Mission was composed as follows: Barend A. de Vries - Chief of Mission Christiaan J. Poortman - -Economist (Export and Employment Policies) William G. Tyler (Consultant) - Economist (Incentives) Maurice J. Joyce - Industrial Economist (Regional Dispersion, Garment and Cement Industries) Jacob Levitsky - Operations Adviser (Small Industry, Footwear and Furniture Industries) William P. O'Neil - Industry Expert (Steel Industry) Yung Whee Rhee - Economist (Mechanical Engineering Industry) Harry Y.H. Choi (Consultant) - Industry Expert (Mechanical Engi- neering Industry) Harold Catling (Consultant) - Industry Expert (Textile Industry) John P. Allchin (Consultant) - Industry Expert (Food Processing Industry) Kerry B. Busteed (Consultant) - Statistician Carlos F. Singer - Research Assistant The Mission Report was discussed with the Government in August 1979 by a World Bank team composed of Messrs. Stanley Please, Barend A. de Vries, Hedayat Amin-Arsala, Lawrence E. Hinkle and Khalid Siraj.  INDUSTRIAL DEVELOPMENT STRATEGY AND POLICIES IN THE PHILIPPINES THE MAIN REPORT TABLE OF CONTENTS Page No. GLOSSARY OF ABBREVIATIONS ...... .................. i BASIC DATA ... ..................................... iii PREFACE V.... . vi CHAPTER I: INTRODUCTION-AND OVERVIEW. 1 A. Introduction. 1 B. Structure of Philippine Manufacturing 2 1. Historical Performance. 2 2. Structure of Growth. 4 3. Composition of Manufacturing Investment 6 4. Factor Intensities and Productivities 6 5. Relative Importance of Industrial Exports and Imports. 8 C. Manufactured Export Performance and Prospects. 9 1. Recent Developments ...................... 9 2. Prospects ................................ 11 D. Employment ................ .. ................. 13 1. Structure and Growth .... ................. 13 2. Employment Creation (1977-85) .... ........ 15 3. Employment in Small-and Medium-Scale Industries ............................... 17 E. Competition in the Private Sector ............ 18 CHAPTER II: INCENTIVE SYSTEM AND POLICIES .... ................ 20 A. Overall Effects of Protection .... ............ 20 B. Components of the Incentive System .... ....... 26 C. 1. Customs Tariffs .......................... 26 2. Import Licensing ......................... 27 3. The BOI Incentives ....................... 28 4. The Administrative Impact of the BOI ..... 32 5. Export Incentives ........................ 34 C. Recommendations ............. .. ............... 36 1. Reduction in Protection and Liberalization in Import Restrictions .... 36 2. Changes in the Export Incentive Regime ... 38  TABLE OF CONTENTS (Continued) Page No. CHAPTER III: SMALL AND MEDIUM INDUSTRIES ...................... 41 A. The Cottage Sector .......................... 41 B. Growth of SMIs .............................. 43 C. Labor Intensity and Capital Efficiency ...... 44 D. Subcontracting .............................. 45 E. Technology and Assistance Programs .......... .46 CHAPTER IV: THE REGIONAL DISPERSAL OF MANUFACTURING .50 A. Present Concentration .50 1. Reasons for Concentration .51 2. Effects of Concentration .52 B. Present Strategies and Policies . . 52 1. Planning ................................ 52 2. Incentives ....... ....................... 53 C. Future Steps ................. ............... 54 1. Infrastructure ...... .................... 54 2. Incentives ....... ....................... 56 3. Regional Industrial Promotion .... ....... 58 4. Finance and Credit Policy ...... .......... 58 5. Other Policies ...... .................... 59 6. Regional Project Promotion .... .......... 60 D. Summary of Recommendations . . 60 CHAPTER V: THE STEEL INDUSTRY .61 A. Structure and Organization . . .61 B. Operations . . ..................-. 64 1. Labor ................... 64 2. Performance .............................-65 3. Quality - Flat Products ......... ........ 66 4. Quality - Non-Flat Products ............. 67 C. Protection . ............................... 68 D. Steel Expansion Plans . . .69 1. Cold Mill Expansion . .70 2. New Integrated Steel Project .70 (a) Design .71 (b) Benefits .72 CHAPTER VI: THE MECHANICAL ENGINEERING INDUSTRY .75 A. Overview .75 B. Comparative Advantage and Incentives 76 C. Consumer Durables .79 Ancillary Industries .................... 80 D. Capital Goods ................ 82 E. Conclusions and Recommendations .... ......... 84  TABLE OF CONTENTS (Continued) Page No. CHAPTER VII: THE TEXTILE INDUSTRY ............................. 86 A. Introduction .86 B. Present Structure and Performance .... 86 1. Processes . . 86 2. Capacity and Size . . 87 3. Organization . .88 4. Management . .89 5. Performance. 90 6. Profitability . .90 7. Supply of Capital Equipment . .91 8. Availability of Raw Materials . .91 9. Technology . .92 10. Labor . . 93 C. Issues of Current Operations and Expansion - 94 1. Integration .94 2. Rehabilitation .94 3. Protection and the Textile Industry 95 4. Effects of Tariff Cuts .98 5. Expansion .98 6. Exports .99 7. Location of Industry ................... 100 I CHAPTER VIII: THE FOOD PROCESSING INDUSTRY .102 A. Overview ................................ 102 B. Performance and Growth Constraints .105 C. Incentives ................................... 110 b. Investments and Prospects .................... 112 E. Recommendations .114 CHAPTER IX: OTHER INDUSTRIES .........................-.-. 116 A. The Cement Industry ........................ I - 116 1. Technical Problems .............. 117 2. Pollution Control .............. 117 3. Coal Conversion ................ 117 4. Future Action . .119 B. The Clothing Industry ................ 121 1. The Domestic Market ............. 122 2. The Export Market ............... 122 3. Direction of Trade ...................... 124 4. Technical Performance . ........... 125 Issues . .125 5. Export Promotion . .127 6. Tariffs and Incentives . .128  TABLE OF CONTENTS (Continued) Page No. C. The Furniture Industry ..... .................. 129 1. Recent Performance ..... .................. 129 2. Supply of Raw Materials and Components ... 130 3. Export Problems and Prospects .... ........ 131 4. Recommendations ....................--.-. 132 D. The Leather and Footwear Industry .... ........ 134 1. Raw Materials ................ 134 2. Labor Productivity and Capital Intensity .135 3. The Export Industry .135 4. Domestic Sales .136 5. Recommendations .137 TABLES IN TEXT Table No. Page No. I-1 Shares in Employment and Value Added, 1960-74 .... ....... 4 I-2 Summary of Plants Visited By Mission .................... 7 I-3 Sources of Growth in Manufacturing, 1970-77. I-4 Rates of Employment Growth in Philippine Manufacturing .. 14 I-5 Employment Growth in Philippine Manufacturing, 1970-85 .. 16 II-1 Effective Rates of Protection for Major Product and End Use Groups ........................................ 21 II-2 Spearman Rank Correlations with Domestic Resource Costs (DRCs) and Effective Rates of Protection (ERPs), 1974 . 23 II-3 Average Effective Protection for Manufacturing in Selec- ted Developing Countries .............................. 25 II-4 Penalty on Export Through Credit System .... ............. 35 IV-1 Regional Spread of Manufacturing, 1975 .... ............... 50 V-1 The Structure of the Philippine Steel Industry .... ...... 62 VI-1 Structure of Protection in the ME Sector (1974) ......... 78 VII-1 Imported and Domestic Fabric Relative Prices .... ........ 96 IX-1 The Clothing Industry, 1975 ............................. 121 IX-2 Philippine Exports of Garments, 1970-77 .... ............. 123 IX-3 Destination of Garment Exports, 1974-77 .124  CHAPTER I INTRODUCTION AND OVERVIEW A. Introduction 1.1 This report studies the contributions which Philippine manufac- turing can make to the principal objectives of the country's development policy - the improvement in living standards and greater equity among popu- lation groups and geographic regions, the creation of jobs and the generation of additional resources for investment through higher export earnings. Industrial strategy has an immediate bearing on several of the Government's policies in international trade and finance, regional develop- ment, the financial system and the provision of employment. Hence, the Mission, in assessing the role of industrial growth at the present juncture of Philippine development, investigated in detail several aspects of manufacturing policy. As a starting point, it analyzed the various; elements of the Government's incentives for industry -- a broad range of measures including import tariffs, investment and export incentives as well as Central Bank licensing and credit policies (Chapter II). 1.2 A number of new initiatives in Government policy, starting with the 1970 devaluation, marked a move toward a more export-oriented industrial policy in the Philippines. However, a full turn-around toward a mcre outward-looking and labor-intensive strategy, in line with Governmetnt's development objectives, will require further adjustments in the incentive system, notably a reduction of import protection and a broadening of export promotion measures. These adjustments would aim at improving the performance of the industries at present producing mainly for the home market (mainly through changes in import tariffs and investment incentives) and sc,lidifying and broadening the manufactu,red export drive. 1.3 Further liberalization of import policies cannot take place in a vacuum. It has to build on the present industrial structure and in several ways it must be accompanied by investment and rehabilitation measures to make possible more competitive and efficient industrial production. For this reason -- and in this light -- the Mission took a close look at several industries because of their key importance in further manufacturing growth - as for example the steel, mechanical and the food processing industries -- and because conditions in the industry would have to improve substantially before policies can be significantly liberalized. This latter factor is particularly important in the textile industry, much of which at present is high-cost and cannot supply the rapidly growing garment export industry at competitive prices. The Mission also studied several of the more labor intensive industries (garment, furniture and footwear) in which small- and medium-sized firms provide the larger share of output and employment and which are of importance in the country's export drive. 1.4 In its industry reviews (Chapters V through IX) the Mission sought to identify the steps to be taken toward further technological development, greater efficiency and competitiveness, which would help manufacturing  over-all to create more productive jobs and help the Philippines to become more integrated with the regional and international economy. At the same time, the Mission explored ways in which the Government's regional dispersion policies can be applied to manufacturing, and how industrial incentive policies can contribute to regional development (Chapter IV). Finally, because of the importance of cottage and small scale industries in employment generation and export development, special attention was given to policies for these industries (Chapter III). 1.5 The current and prospective policies for manufacturing development must be seen against the shifts in the Philippine industrial structure which have taken place since World War II. This Introductory Chapter briefly discusses the changing structure of Philippine manufacturing, and particularly its present and prospective role in export growth and employment creation. B. Structure of Philippine Manufacturing 1. Historical Performance 1.6 The postwar development of the Philippine manufacturing industry is well documented./1 Starting in the 1950f, import substitution of consumer goods became the principal policy instrument to promote industrialization. Initially, the manufacturing sector responded favorably, with output growing at an average annual rate of over 12% from 1950 to 1957. However, by the late 1950s, the domestic market started to impose a limitation on the expansion of the sector and output growth fell to an average level of 5% per annum. The sector was no longer in the lead of Philippine development. Government policies concentrated on relatively capital intensive projects oriented on the home market or the processing of primary products for exports. 1.7 Although the strict import restrictions prevailing in the 1950w were gradually decontrolled in the early 1960s, they were replaced by a highly protective tariff system (instituted in 1957). Policy reform in the 1960s therefore did not alter the bias of the incentive system in favor /1 See, amongst others, J. Power and G. Sicat, "The Philippines: Industrialization and Trade Policies" (1971), and R. Baldwin, "Foreign Trade Regimes and Economic Development: The Philippines" (1975).  of import substitution. Manufacturing was limited in its backward integra- tion and in developing new exports. Since 1956, total employment in the manufacturing sector remained virtually constant at 10-12% of total employ- ment, growing at an average rate of less than 3% per annum. 1.8 By 1970 a number of new measures started a reorientation of Philip- pine manufacturing strategy which in the second half of the decade resulted in substantially greater earnings from manufactured exports and in increased employment creation. The 1970 measures included a devaluation of the peso by more than 60%, the promulgation of the Export Incentives Act, and the introduction of various arrangements for duty free importation of raw materials used in export production (see Chapter II). Further, the Philip- pines established an export processing zone (EPZ) at Bataan. Preferential Central Bank rediscount facilities were made available for export financing with special emphasis on the promotion of nontraditional exports. More recently, the Philippine Exp:ort Council was created to serve as the main body for Government and private slector cooperation in the expansion of exports. 1.9 The Government also made an initial start at correcting tariff distortions by simultaneously reducing the number of items subject to the highest protective rates and limiting the granting of tariff exemptions. In response to these measures, industries producing nontraditional, labor- intensive, products /1 expanded rapidly from a low base as their exports increased more than fivefold' between 1973-1977. The average annual growth of manufacturing production accelerated to 13% in the "factory" sector although it remained stagnant in the "cottage" sector; taking the two combined, total manufacturing grew by 6.5% during the 1970s./2 /l Major nontraditional manufactured exports are: garments, electronic components, handicrafts, cement, chemicals, wood manufactures, food products. /2 The "factory" or "organized" sector is defined as those manufacturing establishments employing five or more workers. The "cottage" or "'unorganized" sector consists of establishments with less than five workers.  -4- 2. Structure of Growth 1.10 The Philippine manufacturing structure is highly dualistic. The distribution of both employment and value added has a very pronounced skewedness. "Unorganized" manufacturing employs nearly two-thirds of the manufacturing work force, but produces only a small fraction of total value added in manufacturing, the precise magnitude of which is difficult to determine since available estimates are residuals (Table I-1). However, it is clear that the "organized" sector produces most of the value added in manufacturing. The unevenness between shares in value added and employment is even more marked for the large establishments (with over 200 workers each) and has become increasingly pronounced over time. Chapter III pays special attention to the problems in the cottage and small business sectors. 1.11 The share of manufacturing in GDP increased from about 18.9% in 1960 to 21.2% in 1967, to approximately 24% in 1977. The composition of manufacturing value added has changed relatively little over the last ten years. Food processing, including beverages and tobacco, has consistently contributed well over one-third of total manufacturing value added. The contribution of the chemical industries, including rubber and products of petroleum and coal, steadily increased in relative importance, while the Table I-1: SHARES IN EMPLOYMENT AND VALUE ADDED, 1960-74 Size Employment Value added (employment) (percentage) (percentage) 1960 1974 1960 1974 1 - 4 76.0* 62.6* 17.7* 3.4* 5 - 19 4.8 5.5 6.1 2.2 20 - 99 5.3 5.8 13.0 9.6 100 - 199 2.9 3.8 10.0 9.8 200+ 11.1 22.3 53.2 75.0 * residual estimates Sources: NCSO Annual Survey of Establishments; NEDA National Income Accounts  - 5 - relative shares of all other industries fell gradually over time. As expected under the prevailing tariff and trade regime, consumer goods constituted about 55% of manufacturing value added until 1970. But its share fell to 47.9% in 1977 mainly as a result of the rapid increase in the production of intermediate goods, particularly chemicals (see Table 1.1)./1 1.12 A comparison of the structure of Philippine manufacturing and that of other major East Asian countries is given in Table 1.2. A further compa- rison can be made on the basis of a 93 cross-country regression analysis aimed at determining the average, or "norm", industrial structure at different levels of development and according to country size. The analysis compares structural "norms"', predicted on the basis of the regressions, with the historically observed or actual structural shares in Philippine manufacturing for 1973 (Table 1.3)./2 It shows that the Philippine manufacturing sector as a whole is relatively larger (measured as a percentage of GNP) than one;would expect on the basis of the cross-country norm, while its services sector is relatively smaller. Within the manufacturing sector, this seems to be mainly the result of the relatively large size of resource-based industries (food and wood) and to a lesser extent of the chemical industries. On the other hand, the textiles, clothing and metal industries appear to be considerably smaller than expected from internationaL comparison. 1.13 Philippine manufacturing structure may further be compared with that in Korea, Taiwan and Mexico (Table 1.4). The first two countries are representatives of a group of countries which adopted an outward-looking policy oriented towards the exportation of labor-intensive products after a first stage import substitution of mainly non-durable consumer goods was completed. Mexico, on the other hand, is an example of a country which placed relatively more emphasis on import substitution beyond the completion of the first, relatively easy, stage./3 Such a comparison, again, shows the large size of the Philippine food industry relative to Korea and Taiwan in particular. It also shows the relatively small size of Philippine textiles, clothing and metal products industries, the latter even in comparison to Mexico. Overall, the size of the manufacturing sector in the Philippines /1 The Statistical Appendix (Volume III) starts out with a comment on the quality and reliability of Philippine industrial statistics. Annex I-4 "Industrial Statistics in the Philippines" deals in more detail with statistical reporting and reliability in a special report prepared at the request of the Minister of Industry and discussed with P?hilippine officials while the Mission was in Manila. /2 Methodology adopted from Chenery and Syrquin, Patterns of DeveLopment, 1950-70 (1975). Analysis conducted (on the basis of a 93 country sample) under a World Bank Research Project. 3 Export Incentives and Export Performance in Developing Countries: A Comparative Analysis: IBRD/SWP 248 (1977).  -6- is slightly smaller than in Korea and Mexico, but considerably smaller than Taiwan. In this comparison raw material processing (e.g., sugar and coconut related industries) are included in manufacturing output; however, these pro- ducts are excluded from nontraditional manufactured exports. 3. Composition of Manufacturing Investment 1.14 The food and textile industries received the major share of manufacturing investment during the 1960-75 period, closely followed by such other capital-intensive sectors as chemicals, oil and coal products, non-metallic minerals and basic metals (Table 1.5). This investment pattern did not change significantly between 1960-69 and 1970-75 despite the tariff changes and export promotion measures taken in the early 1970s (Table 1.6). 1.15 The share of investment in industries with relatively low capital- labor ratios remained constant between 1960-69 and 1970-75. Yet both out- put and employment growth in these industries accelerated sharply during the 1970-75 period (Table 1.7). Average annual growth of output in industries with relatively higher capital-labor ratios, /1 on the other hand, fell considerably during 1970-75 while their employment growth stagnated. There is thus a reasonable indication that recent investment was channelled into comparatively more capital-efficient production processes with lower capital-labor ratios, i.e.ja relative reduction of the pronounced bias in favor of capital intensity prevailing in the two previous decades. 4. Factor Intensities and Productivities 1.16 Average capital investment per unit of labor employed tends to rise with the size of establishment, except in the case of the furniture industry. Capital efficiency (as indicated by value added per unit of capital) shows considerable variation among establishment sizes in different industries. Small establishments are more efficient in their use of capital than larger scale enterprises in such industries as tobacco, textiles, wood manufacturing and miscellaneous, mainly light, industries, e.g.9rubber shoes, foundries and metal working plants. (See also Chapter III). On the other hand, larger scale establishments appear to be more capital efficient in the food and beverage industries, furniture manufacturing and in such capital intensive industries producing chemicals, oil and coal products and transport equipment (Table 1.9). /1 Due to the distribution of capital intensity over Philippine manufactu- ring-branches, industries such as textiles, beverages, printing are shown in Table 1.7 as industries with a below average Kb/N ratio (Table 1.8).  - 7 - 1.17 The Mission in its visits to some 100 plants, paid special attention to the extent to which capital intensive technology was employed. Although the Mission did not undertake a comprehensive review of this question, it would seem that Philippine manufacturing usually employs relatively labor intensive methods. The Mission encountered few, if any cases, of excessive capital intensity. Economic data on 44 plants are given in Annex I-2 and summarized in Table I-2 below. Export oriented firms had a capital investment per worker of $2,800 and firms with predominantly domestic orientation, $22,000. The recent growth of relatively labor intensive industries in the organized sector has thus significantly enhanced the contribution of manufacturing to Philippine employment (Section D). Table I-2: SUMMARY OF PLANTS VISITED BY MISSION All Export Nonexport Per plant data firms firms firms Investment ($ million) 14.6 3.0 22.2 Number of jobs 1,033 1,083 1,002 Sales ($ million) 17.3 4.5 22.0 Exports ($ million) 7.1 6.0 8.5 Value added ($ million) 8.2 1.2 10.6 Investment per job ($) 14,114 2,764 22,111 Value added/sales (x) 47 26 49 Export/sales (%) 41 71 37 BOI benefits/sales (%) 7.8 6.8 8.9 Source: Annex I-2.  5. Relative Importance of Industrial Exports and Imports 1.18 With the increase in manufactured exports, their share in total manufacturing output increased from 12.9% in 1970 to 15.3% in 1977. Their share in incremental output during 1970-77 amounted to nearly 20%, with traditional and nontraditional exports each contributing half. The large relative contribution of the nontraditional exports are a good indication of the rapid growth that took place in response to the various export promotion measures taken in the early 1970s (Table I-3). Table I-3: SOURCES OF GROWTH IN MANUFACTURING, 1970-77 (billions of pesos/1977 prices) Output Incremental Output 1970 1977 1970-77 (%) Manufactured Export Sector 10.2 (12.9) 19.3 (15.3) 19.4 Traditional 9.3 13.9 9.8 Nontraditional 0.9 5.4 9.6 Domestic-Market Oriented Industries 68.8 (87.1) 106.7 (84.7) 80.6 Total Manufacturing 79.0 (100.0) 126.0 (100.0) 100.0 Source: Appendix Table 1.18. 1.19 Among the leading manufactured export sectors in 1974 were sugar milling, coconut oil, wood products, furniture and cement. These all exported more than 20% of their output, with the first two industries exporting more than half. For the manufacturing industry as a whole, exports amounted to about 14% of total output (Table 1.10). 1.20 The Philippine manufacturing sector's total direct import require- ments amounted to only 17% of output in 1974. Import dependence is relatively low due to the importance of resource based agro-processing industries. The direct import content was the highest in such capital intensive industries as basic metals, chemicals, oil and coal products, textiles and rubber. Although the nontraditional export sector is dependent, to a considerable extent, on imported inputs (para. 1.27), its volume was still small in 1974 (see Table 1.11).  -9- 1.21 The composition of imports by end-use reflects the basic structure of industry resulting from the Government's industrial policies (Table 1.12). Capital goods industries are relatively underdeveloped and their products make up 30% of total imports (seelChapter VI). On the other hand, consumer goods, of which the importation is restricted through various controls, -'Knstitute less than 10% of total imports. Imports of raw materials and intermediate goods make up nearly 40%, confirming the high import dependency of such industries producing chemicals, metals, textiles'and garments. C. Manufactured Export Performance and Prospects 1. Recent Developments 1.22 The'1970 export promotion measures - in particular the facilities under which selected export firms can import inputs free of duty - caused a spectacular increase in non-traditional manufactured exports./l They increased at an average real'rate of 30% per annum from $116 million in 1972 to $1,045 million in 1978, or approximately 30% of total exports (Table 1.13). In the initial years of the export promotion effort, the Philippines benefitted from the relatively favorable demand conditions in the OECD countries. Subsequently, the Philippines have benefitted from its own measures putting export firms on a free-trade basis, its relatively favorable labor productivity in export plants, and the fact that its labor ccsts are low and declined relative to those of its competitors, e.g. Korea and Taiwan, some of which had filled their quotas in major markets for relatively simple products. 1.23 The impetus for the nontraditional export growth has come primarily from three categories of manufactured exports, i.e., garments, electrical and electronics equipment and handicrafts,'together accounting for two-thirds of total nontraditional manufactured goods in 1978. Garment exports, constituting one-third of the total, comprise a number of articles ranging from embroidered cloth to gloves and ready-made apparel, over half of which are manufactured on a consignment basis. The electronics industry, the second largest nontraditional exporter (25%),manufactures mainly semiconductors on a subcontracting basis with corporations in the US and Japan. Handicraft exports, amounting to 10% of nontraditional manufactured exports in 1978, consist of a large variety of articles mostly madet from local raw materials. Other leading nontraditional exports are chemical products (chemical elements and compounds, pharmaceutical products, resins, plastic materials, explosives), nonmetallic mineral products (mainly cement) and wood manufactures (mainly furniture made of wood and rattan). As a share of total nontraditional manufactured exports, however, each of these product groups accounts for less than 6% (Table 1.14). /1 These are manufactures of which exports were less than $5 million in 1968. Traditional manufactured exports are mainly processed primary products (e.g.,sugar, coconut oil, copper concentrates, lumber and plywood). The production of many of these items is relatively capital intensive.  - 10 - 1.24 The uptrend in Philippine manufactured exports also means that its performance is improving relative to that of other countries in the region. Tables 1.15 and 1.16 compare Philippine manufactured exports with those of Korea, Malaysia, Thailand and Indonesia during 1967-75./i In 1967, Philippine manufactured exports were comparable to those of the other countries in the East Asian region (except for Indonesia). In subsequent years, however, the Philippines fell behind: both in growth and absolute value Philippine exports in 1975 were, after Indonesia, lowest in the group. However, processed food exports in 1975, as a percentage of manufactured exports, were higher in the Philippines than in the other countries. 1.25 In contrast with primary export product processing, Philippine nontraditional manufactured export industries are relatively labor- intensive. Many of the export processing firms visited by the Mission had a capital investment per worker of less than $2,000; the average was $2,800 (see Table I-2). UP studies suggest that the average capital /2 labor ratio in the sector is P 20,000 or $3,000 compared with P 81,000 for manufacturing as a whole./3 The investment per worker ranges from P 6,500 in the leather footwear industry to P 8,500 in the manufacture of wearing apparel/garments to P 15,000 in the wood and rattan furniture industry (1974). 1.26 There is considerable variation in the size of export producing firms. Many embroidery and handicraft exports are produced in the cottage sector in firms with less than 20 workers. On the other hand, the typical export processing firm has 200 or more workers and cannot be regarded as small or medium sized. UP studies /4 suggest that the majority of establish- ments in such industries as handicrafts, garments and wood manufactures have a replacement value of fixed assets of less than P 4 million. However,. the cement, chemical and electronics industries are generally large scale operations with a capitalization of over P 4 million. /1 For the purpose of this regional comparison, manufactured goods are defined as SITC - categories 0-8, i.e, excluding mineral and agro- processing industries. Data for period after 1975 were not available. /2 Defined as the replacement value of fixed assets, expressed in 1974 prices. /3 Cf. E.A. Hife, Factor Productivity and Intensities in Philippine Manufacturing, 1974 (IPPP Working Paper No. 10). /4 Hife, op. cit.  - 11 - 1.27 Unlike the processing of primary exports, nontraditional export manufacturing is largely dependent on imported materials and has only few linkages with the domestic manufacturing sector. Handicrafts and wood manufactures, on the other hand, use local inputs. However, plant visits have indicated that industries involved in the production of such leading nontraditional exports as electronics, watches, leather shoes and garments import between 35-60% of their inputs. Value added is only about 25%. The contribution of nontraditional manufactured exports in terms of net: foreign exchange earnings is limited to about 40% of gross earnings. 2. Prospects 1.28 In the next eight years or so (1978-85) Philippine nontraditional manufactured exports can grow by 18% per annum if the Government continues to take effective export promotion measures and there are no major setbacks in the markets for Philippine products. To sustain this vigorous growth rate the Philippines will have to introduce several reforms in its incentive system as recommended in Chapter II. Rapid growth is essential to main- tain a viable balance of payments position because of the recent slow-down in traditional exports. 1.29 On this basis, nontraditional manufactured exports would amount to close to $3 billion (in 1977 prices) in the mid-1980s, with garments and electronic items each amounting to around $750 million (Table 1.17). Nontraditional export output would contribute 15% to the increase in total manufacturing output, assuming the latter would grow by 8% per year in 1977-85 (Table 1.18). The strongly increasing earnings and output from manufactured exports would also have a profound impact on the struc- ture of the Philippine manufacturing sector. An increasingly larger share of the sector would be labor intensive, with nontraditional manufactured exports increasing from 1% of gross value added in manufacturing in 1970 to 4% in 1977 and over 7% in 1985 (Table 1.19). Investment in nontra- ditional export industries would be relatively small but employment creation large: % of total in 1977-85 Investment New employment Domestic manufacturing & traditional manufactured exports 90.4% 60.8% Nontraditional manufactured exports -9.6% 39.2% Source: Appendix Table 1.19.  - 12 - 1.30 The Philippines has at present a strong competitive position in labor intensive manufactured exports. Labor productivity in export processing plants compares favorably with that in Korea and Taiwan. Philippine workers are literate in English and easily trainable; management in the export industries is up to international standards. At the same time Philippine wages have, since 1972, come down relative to those in several competing LDC's and industrial countries: by more than 50% relative to wages in Japan and Korea, 46% to those in Germany and 17% to wages in the US (see Table 1.20)./1 While productivity in nonexport industries has lagged, productivity in Philippine export industries improved by 13% between 1969-74, thus keeping pace with manufacturing productivity in such countries as Korea, Japan, the US and Germany (see Tables 1.22 and 1.23). At present, Philippine wages are about half of those in Taiwan, Korea and Hong Kong. A survey of labor costs in Southeast Asian electronics factories, for - instance, showed that in 1977 Philippine wages were only 60% of the wages paid in Taiwan, 50% of those in Korea, 40% of those in Hong Kong and 10% of the wages paid in Japan. 1.31 The medium term outlook, therefore, is for a strong competitive advantage in those industries which are intensive in the use of unskilled and semi-skilled labor. In fact, present productivity levels and range differentials would permit Philippine wages to increase without endangering the export drive. Besides garments and electronic components, this means a considerable export growth potential in industries such as wood manufactures, footwear, watch assembly, toys, artificial flowers, travel goods, etc., and for those industries such as handicrafts, chemicals and food products which have an (added) comparative advantage because of their natural resource base. 1.32 Exports of Philippine manufactured items are likely to benefit from structural changes in competing countries. Major international competitors in such areas as garments, electronic components, watch assembly, etc. are experiencing labor shortages and rapidly increasing wage costs and there is evidence that some of these labor intensive industries have in fact been moved to the Philippines. 1.33 Market Access and Diversification. Continuation of the present momentum in nontraditional manufactured export growth will require development of new products and new markets. It is important that Philippine products enter higher quality markets. A broadening range of Philippine products are subject to various kinds of quota restrictions and marketing arrangements: garments (Australia, EEC, US and Canada), footwear (Canada and Japan), fruit juices (France, Germany, UK), ceramics (Australia), and wood products (Australia and New Zealand) (see Annex I-3). To counter these protectionist measures and any further restric- tions that may come about in the future, the Government will need to /1 Reflecting in part the effect of the 1970 devaluation, over a longer period - 1966-77 - Philippine wages have come down even more: roughly 50% relative to wages in the US and Korea, and almost 75% relative to Germany and Japan (see Table 1.21).  - 13 - embark on a more aggressive strategy to diversify into new or related manu- factured export items. At the same time, efforts should be made to open up new markets for existing products in countries with which the Philippines have had no or only minimal trading relations. 1.34 In some items, notably garments and footwear, customer countries have relatively ample quota arrangements and some quotas have not been filled for Philippine products. Some plants were started by entrepreneurs from competing countries where quotas were exhausted. There are considerable opportunties to develop new, higher quality items not subject to quota arrangements. 1.35 For the nontraditional manufactured exports as a group, substan- tial market diversification and expansion should be possible. Although the major export markets for these products are obviously concentrated in the US and Western Europe, lucrative markets are also available in the EFTA countries, Japan and the Middle East. An integrated marketing plan including a trade information network, a market development and promotions program and an export publicity campaign has been proposed under the Philippine National Export Strategy for 1978-82 and is now being implemented. 1.36 Against the background of the recent protectionist measures taken in customer countries, there is a strong movement in the Philippines towards greater and more active intra-regional trade with neighboring ASEAN countries. However, the economies of the member countries are only partly complementary and intra-ASEAN trade has so far been limited; only 3-5% of total trade in the case of the Philippines. An initial step to further intra-ASEAN trade was taken in 1978 when a Preferential Trading Agreement was signed whereby over 800 commodity items of ASEAN member countries were accorded lower tariff duties; since then this list has been expanded to include 1,200 items. However, the impact of the tariff agreement on intra-regional trade is likely to remain small until the ASEAN industrial complementation program gets underway. D. Employment 1. Structure and Growth 1.37 Manufacturing employment in the Philippines - which doubled from 837,000 in 1950 to about 1.6 million in 1976 - falls into two distinct categories: employment in the "unorganized" or "cottage sector" and "factory" employment in enterprises with five or more workers. In 1976 there were about 630,000 jobs in factories and roughly one million in the cottage industries (Table I-4). 1.38 Employment in the cottage industries has increased relatively slowly (1.7% per annum) and, providing about two-thirds of total employment, this sluggishness has dampened the contribution of total manufacturing to Philippine employment (7% in 1956-77, as against 47% for agriculture and 38%  - 14 - for services, see Table 1.25). In recent years, employment in the manufac- turing sector declined as a share of total employment and grew by only 2.8%, creating a mere 40,000 jobs annually. During the same period, total employ- ment in the economy as a whole grew at a rate of 5.2% or 660,000 jobs per annum (Table 1.26). 1.39 Factory employment, on the other hand, has increased rapidly rising from 206,000 to 1956 to 630,000 in 1976, or more than twice the rate of total manufacturing employment including the cottage industries. Employment in factories with over 20 workers increased even more rapidly at a rate of 6.7% p.a., accounting for nearly 56% of incremental employment growth in total manufacturing (see Table I-1). With a low starting base, the contribution of the factory sector to total Philippine employment was only 4.3% in 1976. Table I-4: RATES OF EMPLOYMENT GROWTH IN PHILIPPINE MANUFACTURING, 1956-76 Annual Incremental Employment growth growth Size (employment) 1956 1976 1956-76 1956-76 '000 % '000 % (%) (%) Organized (factory) 5-19 55 5.7 80 4.8 1.9 3.5 20+ 151 15.7 550 32.7 6.7 55.6 Subtotal (206) (21.4) (630) (37.5) (5.8) (59.1) Unorganized (cottage industries) 1-4 756 78.6 1,050 62.5 1.7 40.9 Total 962 100.0 1,680 100.0 2.8 100.0 Sources: Appendix Tables 1.27 and 3.4. 1.40 Clothing and footwear has consistently had the largest share (25-40%) of total employment in the manufacturing sector during the period 1960-75, followed by textiles and food (each with 12-16%) and wood products (6-7%). In the organized sector, however, the food industry has always had the largest relative share of employment (see Table 1.28). Compared with some other countries in the East Asian region, the Philippine performance in manufacturing employment generation has tended to lag: in 1963 for example it was considerably higher than in the other countries (as a share of total employment) but by 1975 this was no longer so and it had been by-passed by Korea (Table 1.29).  - 15 - 1.41 The limited labor absorption of Philippine manufacturing stems from a complex of causes. The most labor-intensive sector, the cottage industries, has remained the most important in employment provision but, in terms of employment growth, has steadily lagged behind the relatively more capital-intensive factory sector. Within the factory sector, the Government had a considerable influence on the composition of new industries and the choice of technology through the provision of official credit and investment incentives. In the 1960s, output and investment in industries with relatively higher capital intensity grew more rapidly than in relatively more labor-intensive industries. Investment incentives went predominantly to capital intensive industries producing for the home market and processing primary exports. These incentives themselves had a pro-capital bias and the pricing of capital goods in the economy reinforced the capital-intensive bias in the factory sector. With the growth of labor- intensive nontraditional manufactured exports after 1970, however, labor absorption of Philippines manufacturing has improved. As can be seen from Table 1.18, employment elasticity during 1970-77 in nontraditional manufacturing was 1.0 as against 0.6 for processed primary exports as 0.32 for industries producing for the home market. Consequently, exports of nontraditional manufactures accounted for more than 30% of manufacturing employment creation during 1970-77 while accounting for less than 8% of manufacturing investment. 2. Employment Creation (1977-85) 1.42 Continued growth in labor-intensive manufactured exports will bring about dynamic changes in the composition of manufacturing employment and its contribution to new employment creation in the economy. Moreover, as the domestic industry becomes a more efficient producer of intermediate inputs, the linkages between the export sector and the domestic economy can be strengthened. Manufacturing growth, and particularly the growth of manufactured exports, will also be a very substantial provider of employment in both the service sector (transportation, finance, procurement, marketing) as well as in the construction industry. 1.43 Based on the Mission's projection of nontraditional manufactured export growth of 18% p.a. and overall manufacturing growth of 8% p.a. in 1977-85, the manufacturing sector as a whole would create close to one million (i.e., 960,000) new jobs, i.e.#120,000 jobs per year, which is more than one-fifth of the growth in the labor force (600,000 per year) (Table 1.18). In recent years, new employment creation in the manufacturing sector was only 40,000 jobs, or less than one-tenth of the increase in the labor force. In all, manufacturing employment is expected to grow at an average annual rate of 5.9% (or about twice its historic rate) and reach ,2.6 million in 1985. At the end of the eight year period, its contribution to the total employment in the economy would reach about 15%. 1.44 Direct employment creation as a result of the continued rapid growth in nontraditional manufactured exports would be around 360,000 new jobs during 1977-85. This compares with a totai of 320,000 jobs generated by the manufacturing sector as a whole during 1970-77. Its average annual increase of 45,000 jobs would account for more than one-third of the yearly  - 16 - addition to the manufacturing work force. Moreover, its share in total manufacturing employment would double from about 8% in 1977 to over 19% in 1985. On the other hand, the share of traditional export industries would remain constant at 7%, while the share of the domestic market-oriented industries in total manufacturing employment would fall from over 90% in 1970 (and about 85% in 1977) to less than 74% in 1985, mainly as a result of its relative capital intensity and its lower output growth (Table I-5 below). 1.45 The projected changes in manufacturing employment will change its structure in favor of factory employment. Employment in the factory sector would more than double between 1977-85 and its share in total manufacturing employment would increase from 30% in 1970 and about 40% in 1977 to over 55% in 1985. On the other hand, the cottage sector would continue to decline. At its historic annual growth rate of 1.5% it would contribute less than one- fifth to incremental manufacturing employment in 1977-85. Table I-5: EMPLOYMENT GROWTH IN PHILIPPINE MANUFACTURING, 1970-85 Employment (percen- tage distribution) Annual growth (%) 1970 1977e 1985p 1970-77e 1977-85p Traditional manufactured exports 7.0 7.1 6.9 3.9 5.2 Nontraditional manufactured exports 1.5 8.3 19.2 32.0/a 17.0 Domestic market-oriented industries 91.5 84.6 73.9 1.9 4.2 Total 100.0 100.0 100.0 3.1 5.9 Of which: Factory sector 30.5 37.5 55.4 7.1 10.4 Unorganized sector 69.5 62.5 44.6 1.1 1.5 /a Growth rate inflated due to low base. e = estimated. p = projected. Sources: Appendix Tables 1.18 and 1.19. 1.46 The employment projections assume that investment per job will be $20,000 in home industries and $3,600 in nontraditional manufactured export industries (estimates based on the IPPP studies; the Mission's findings suggest investment per job may be lower, perhaps closer to $2,800 or even lower; see Table I-2 and Annex I-2). These projections imply a decrease in the capital-labor ratio from $30,000 (in 1970-77) to $20,000 and an increase  - 17 - in the employment elasticity of manufacturing output in home industries from 0.32 in 1970-77 to 0.57 in 1977-85. Such changes can be expected to materialize provided greater attention is given to employment effects and capital efficiency in investment decisions; better capital utilization will increase employment while output is accelerating. Should the Gove!rnment not adopt the various policy recommendations of the Mission, the employment elasticity would not improve and output growth may likewise be lower - perhaps at 6% or less instead of the 8% assumed earlier. This would mean that employment in home industries would continue to increase by only 1.9% (instead of 4.2%), reaching' 1.6 million in 1985 (instead of 1.9 million). If, in addition, nontraditional exports were to increase at a slower pace - assume 12% - than the 18% indicated before, the cost in terms of jobs lost would be another 160,000 jobs per year by 1985. In total, the loss in new job creation resulting from slower growth and greater capital intensity would be 450,000 - 500,000 jobs by 1985. 1.47 The acceleration in manufacturing emloyment and changes in structure are conditional upon the recommended improvements in the incentive system and the continued growth of manufactured exports. The projected changes in employment are not out of line with those observed in other countries in the region. rhe Philippines' projected growth in manufacturing employment of 5.9% p.a. for the period 1977-85 is less than what was achieved by Korea (15.2% p.a.) in 1970-75 and also Malaysia (6.6% p.a. starting from a low base). In Korea, in 1960-70, manufactured exports contributed 38% to employment growth in manufacturing and 33% in the economy (including indirect employment generation); in 1970 exports accounted for one-quarter of manufacturing employment. As manufactured exports became more important in Korea and.Taiwan, the cottage sector also declined in relative importance. 3. Employment in Small-and Medium-Scale Industries 1.48 Because of its large relative share in total manufacturing employment and its inherently labor-intensive character, promotion of small- and medium-scale industries should also play an important role in improving labor generation in the manufacturing sector. Besides the need for improve- ment in labor productivity of small manufacturing activities (discussed in Chapter III), participation of small industries in export development should be encouraged. 1.49 Given a policy environment free of factor price distortions, small- and medium-scale industries in the Philippines should be able to exploit their comparative labor advantage and contribute a substantial part of manufactured exports. Processed foods, apparel, musical instruments, wooden furniture, and footwear are,promising areas in this respect. Improvement in quality standards, however, is a necessary condition for a successful performance in the export market and technical assistance at the production level will be required. Since direct penetration of the export markets is intrinsically difficult for small manufacturers, forward linkages with larger scale industries should be developed. Present arrangements seek to accomplish this through internal subcontracting and the help of trading companies.  - 18 - 1.50 However, it should be realized that the product markets for small- and medium-scale industries are, and will remain, predominantly domestic, supplying consumer goods and services to low-and middle-income groups. The level of demand and thus the possibility of a rapid expansion of output in such commodities as processed foodstuffs, beverages, utensils, shoemaking, and ceramic products is dependent on the purchasing power of these income classes. Indeed, the present distribution of incomes in the Philippines seems to be at least a partial explanation for the poor labor absorption performance of the small-scale manufacturing sector during recent years, Wider income redistribution, including increased employment opportunities in rural areas should therefore be considered a major policy measure to stimulate the demand for locally-produced, labor-intensive consumer goods and thus increased employment generation. E. Competition in the Private Sector 1.51 Most of the measures discussed in this report fall in the public domain. Yet it is well to realize that in the end it will be the private sector which must take action to achieve greater competitiveness and growth. With the exception of the National Steel Company, the industries reviewed by the Mission are all in the private sector. The attitude of private management toward industrial development, employment creation and Government initiatives are of crucial importance for the future course of Philippine manufacturing. 1.52 Private managers generally feel that administrative simplification will be a boon to future growth. There is also concern that a reduction in Philippine protection will endanger business in certain sectors and that, moreover, protection in customer markets increasingly handicaps export growth. However, the Mission observes that, while recognizing the real obstacles imposed by the "new protectionism" in industrial countries, Philippine exporters still have numerous opportunities in widening their markets (paras. 1.33 and 1.34). At the same time the Philippines can still go a long way toward removing the penalty on its own exports imposed by the present Philippine incentive system -- at least 30% gross and 20% net (after special export benefits). 1.53 Increased competition in industry and banking should have wide- spread benefits and would be enhanced by the reduction in tariffs recom- mended by the Mission. It is difficult to generalize about the state of competition in Philippine manufacturing. Like in other countries, certain industries (e.g., food-processing and mechanical engineering) are charac- terized by a few dominating firms and a host of smaller entities (often using less sophisticated technology). Many businesses are family-held and are not run on modern management principles. It is not easy generally to attain greater competition, and where new investments and modern management inputs are needed, it may not be desirable to force competition before corrective steps are taken. Yet, greater competition will benefit development in most industries, improve capital utilization and product quality and lower costs. Competition is likely to increase with the greater integration of Philippine manufacturing with the international economy which can be expected from continued manufacturing export development.  - 19 - 1.54 Greater competition and eagerness to provide service to industry would also improve the performance of commercial banking, which is one of the main subjects of a parallel Bank mission on issues in the financial system. Increased commercial bank activity is especially important for .industrial development outside Metro Manila and for the financing of small export firms. The Mission has dealt with financial issues in Volume Two, Chapters III and IV, and in the discussion of financing of export industries (paras. 34 and 35).  - 20 _ CHAPTER II INCENTIVE SYSTEM AND POLICIES 2.01 This chapter discusses the major elements in the Philippine incentive system: the customs tariffs and import licensing, the BOI invest- ment and export incentives and the other export promotion measures including certain export credit facilities. It has been well documented in the literature that the system had an impact in orienting industrial development toward the home market, and in giving an advantage to relatively capital- intensive production. The industrialization pattern tended to reinforce regional and income disparities and its effect in raising employment and hence income in the poorest population strata was small. Since 1970 a major reorientation toward labor-intensive export growth has been under way. In addition,the Government has been giving increased attention to small industries (Chapter III). In the final section, the Mission makes a number of recommendations as to how the system might be adapted to the requirements of broader and continuing employment and export growth. The chapter starts out with a discussion of the overall impact of protection, based on the Mission's field work and the UP studies. A. Overall Effects of Protection 2.02 The key element characterizing Philippine industrial policy since the early 1950s has been the protection of the domestic industrial sector from import competition. The level of protection for the domestic market is high and has remained so since the mid-1960s. The average level of effective protection for the entire economy in 1974 has been estimated at 54% (IPPP, 1979). For manufacturing the average level of effective protection increased from 51% in 1965 to 125% in 1974 (Table II-1). A major cause was the increase in effective protection for consumption goods which reached an average of 247% in 1974. As such, the cascading structure of protection in the Philippines, so frequently observed in developing countries, has increased markedly. The increase in the cascading structure is further evidenced by the decline in effective protection afforded to the capital goods sector (34% in 1965 vs. 18% in 1974). The capital goods sector is underprotected (see also Chapter VI). The export sector is penalized where producers are subject to taxes, in particular on their inputs. In practice, under the Export Incentives Act, many export firms have, since 1970, been put on a free-trade basis. Since 1974 a number of tariff items have been reduced, but the 1974 estimates still correctly reflect the overall tariff structure and level.  - 21 - Table II-1: EFFECTIVE RATES OF PROTECTION FOR MAJOR PRODUCT AND END USE GROUPS 1965 !174 (x) (%) Exports -19 -16 Manufacturing 51 125 Capital goods 34 18 Intermediate goods 65 - 23 Consumption goods 86 247 Sources: 1965 estimates are from John H. Power and Gerardo P. Sicat, "The Philippines: Industrialization and Trade Policies" (New York, Oxford University Press), 1970; p. 99. The 1974 estimates are those of Norma A. Tan, "The Structure of Protection and Resource Flows in the Philippines, 1974," IPPP, University of the Philippines, Ph.D. dissertation, 1979. 2.03 A striking feature of the Philippine protection system is the unevenness of effective protection over different industries. Such unevenness has the effect of channeling resources into those sectors with higher levels of effective protection. The food products sector, for example, possesses many inclustries which receive excessively high levels of both nominal and effective protection. Among these industries are flour milling products, bakery products, candy, cocoa and chocolate products, starch products, and vegetable lards (Table 2.1). Some other industries receiving inordinately high levels of effective protection include distilled liquors, wines, cigarettes, textile mill products, paper products, tanning and leather finishing, rubber footwear, tires, cosmetics, metal cans, household appliances, motor vehicles and fabricated plastic products. 2.04 In contrast, exported products (not benefitting from the Export Incentives Act) frequently receive negative effective protection. Fish canning, leather products, cigars, and embroidered products are but a few examples. That these products are exported at all is a reflection of the strong comparative advantage that the Philippines has in those products and the extension of free-trading regimes to the inputs of exported products. Through drawback schemes and the like, manufacturing exporters can import inputs for their exported.products, thus bypassing the ill effects of cdiscrimination-by which Philippine-commercial policy has-raised the prices of tradable intermediate-goods (Section B5).- The estimate of negative protec- tion for export industries in Table II-1 does not apply to firms enjoying a f-ree-trade regime. These firms receive in effect a subsidy which offsets the effect of protection on,inputs. In the garment industry, this "subsidy" is equivalent to 37% of export value and 150% of value added; assuming all inputs are imported, value added is 25% of output and the tariff on inputs is 50%.  - 22 - 2.05 The effect of the protective system has been to allocate resources out of those industries in which the Philippines has a comparative advan- tage and into those industries where it has, at least, a static comparative disadvantage. An analysis of domestic resource costs in the Philippines (IPPP, 1978) has identified those industries where Philippine domestic resource costs are the least, i.e., where its comparative advantages are the highest (Table 2.1). These industries are frequently those which are exporting. Conversely, industries with the highest domestic resource costs (DRCs) are generally those with the highest levels of effective protection. Statistical tests have demonstrated the strong, statistically significant positive relationship between DRCs and effective protection rates over industries (Table II-2). These same tests also suggest that there has been excessive import substitution in the Philip- pines. The highest DRCs are for those industries where the ratio of imports to total available domestic supply is the lowest./l 2.06 The greatest Philippine comparative advantages lie in labor- intensive and resource-based products. This is suggested by the positive relationship between DRCs and capital- intensity (Table II-2). That this relationship is not even stronger reflects the fact that some primary export processing is relatively capital-intensive. Similarly, as noted above, the system of protection discriminates against those industries where the Philippines possesses the greatest comparative advantages./2 2.07 The incentive system overall has imparted a capital-intensive bias in the economy. The customs structure favors import substitution activities which are relatively more capital-intensive than export industries (other than primary processing), and moreover, capital goods received relatively low protection. The bias of the customs structure is reinforced by the nature and the administration of investment incentives under the BOI. As discussed in Section B3, investment incentives are largely tied to capital equipment, while the firms receiving the benefits have tended to be the larger and more capital-intensive ones in their industries. Further, BOI sanction usually facilitates the allocation of investment credits by official agencies. In short, the effect of the various measures has been /1 The actual tests carried out were done with Spearman rank correlations (Table 2.2). /2 The rank order relationship between effective rates of protection and capital-labor ratios is positive but not statistically significant (Table II-2). Removing natural resource processing industries, and other related attempts involving exports, improved the positive statis- tical relationship but never beyond the 10% level of significance.  - 23 - Table II-2: SPEARMAN RANK CORRELATIONS WITH DOMESTIC RESOURCE COSTS (DRCs), AND EFFECTIVE RATES OF PROTECTION (ERPs), 1974 Manufacturing less All manufacturing natural resources industries processing industries (76 industries) (54 industries) Domestic Effective Domestic Effective resource rates of resource rates of costs protection costs protection (DRCs) (ERPs) (DRCs) (ERPs) Effective rates of protection (ERPs) 0.654a -- 0.648/a -- Ratio of imports to total available domestic supply (M/Z) -0.189 2 -0.005 -0.138 0.014 Capital-labor ratio (K/L) 0.245/a 0.083 0.354/a 0.164 /a Denotes significance al: the 5% level. Source: IBRD staff calculations from IPPP data. Some of the data appear in Tables 2.1 and 2.2. to lower the effective price of capital goods in the economy. However, since the 1970 devaluation and the granting of incentives to labor-inten- sive export industries, the capital-intensive bias has been lessened. While the Mission has not made a comprehensive review of capital intensity in industry, it did not, in its field visits, encounter cases of excessively capital-intensive production, and in fact in many instances the Mission calls for selective improvements in capital equipment through modernization, rehabilitation (e.g., the textile industry) or expansion or new investment (e.g., in the mechanical and food processing industries). On the other hand, even during the 'seventies manufacturing investment did not change materially in composition and continued to emphasize capital-intensive industries. 2.08 A comparison with other countries further emphasizes the high levels of effective protection for the Philippines (Table II-3). This is particularly the case when the comparisons are made with those countries that have enjoyed considerable success in promoting their manufacturing  - 24 - exports and achieving high rates of economic growth in recent years. For example, after an import substitution phase Korea adopted more liberalized trading policies and by 1968 it has been estimated that the average level of effective protection for manufacturing was -1% (IBRD, 1977). 2.09 Countries which have experienced very poor performance with respect to economic growth and export growth have frequently possessed high rates of effective protection. For example, Chile and India have been among the developing countries most heavily protecting their industrial sectors (Table II.3). Their average annual total export growth rates for 1966-73 have been a slow 5 and 8%, respectively; manufacturing exports grew not at all in Chile and at 7% annually for India./l In addition to the associa- tion between low rates of effective protection and high rates of manufac- turing export growth, reductions in high rates of protection are frequently associated with an acceleration in industrial export growth. In South Korea, Taiwan, Thailand, Argentina an Brazil substantial growth in manufac- tured exports accompanied import liberalization measures. 2.10 The effect of the protection system in the Philippines is to impose the equivalent of a tax on the export sector, the magnitude of which is roughly reflected by the average level of protection. Estimates of the distortions imposed on the economy range from 19 to 34% (IPPP, 1979). The higher estimate, based on the UNIDO procedure, assumes the existing protective structures. The actual price effect in case of full removal of protection might, of course, be smaller, depending on the accompanying adjustments in the balance of payments, in particular the increase in exports which would be associated with a change in protection policy. Al- though these estimates were made for 1974, the lack of substantive changes in either the protection system or in the real purchasing power parity exchange rate since 1974 suggests that they retain their applicability for 1979. 2.11 Since 1974 the nominal peso-dollar exchange rate has varied little. The depreciation of the dollar in relation to the Japanese yen and European currencies has resulted in a slight real depreciation of the peso since 1974 (Table 2.3). /1 See Bela Balassa, "Export Incentives and Export Performance in Develop- ing Countries: A Comparative Analysis," Weltwirtschaftliches Archiv, Volume 114, No. 1 (1978), pp. 24-61.  - 25 - Table II-3: AVERA(GE EFFECTIVE PROTECTION FOR MANUFACTURING IN SELECTED DEVELOPING COUNTRIES Average rate of effective protection in manufacturing Country Year (%) Argentina 1958 162 1969 89 1977 39 Brazil 1966 181 1967 76 1973 47 Chile 1961 182 Colombia 1969 29 India 1961 313 Malaysia 1965 6 Mexico 1960 27 Pakistan 1964 271 Philippines 1965 51 1974 125 South Korea 1968 -1 Taiwan 1965 33 Ihailand 1969 50 1971 40/a /a Thai estimates are tor the import competing manufacturing sector only. Sources: Bela Balassa and Associates, The Structure of Protection in Developing Countries (Baltimore: Johns Hopkins Press, 1971), p. 54; Ian Little,. Tibor Scitovsky, and Maurice Scott, Industry and Trade in Some Developing Countries (London: Oxford lJniver- sity Press, 1970), p. 174; Larry E. Westphal and Kwang Siuk Kim, "Industrial Policy and Development in Korea," World Bank Staff Working Paper No.i263, August 1977, p. 3-10; Thomas L. Hutcheson, "Incentives for Industrialization in Colombia," Ph.D. Disserta- tion, Unversity of Michigan, 1973, p. 68; William G. Tyler, Manufactured Export Expansion and Industrialization in Brazil (Tubingen: J.C.B=. Mohr, 1976); IBRD,"Thailand's Industrial Sector: The Changing Role of Policies," East Asia and Pacific Regional Office, November 1978, p. 88; and IBRD, "Argentina: Structural Changes in the Industrial Sector," Latin America and the Caribbean Regional Office, March 30, 1979.  - 26 - 2.12 The international competitive position of the Philippines during recent years has also improved as a result of a decline in wages relative to those in both competing and customer countries (see Chapter I). In any case, wage levels in the Philippines remain low relative to other countries (Table 2.4), reflecting Philippine comparative advantage in labor-intensive products. B. Components of the Incentive System 1. Customs Tariffs 2.13 Present tariff rates range from 10 to 100%. The 10% tariff is considered a revenue tariff and is levied on all imports unless specifically exempted under an incentive program. The tariffs increase in 10% increments up to the maximum of 100%. 2.14 In addition to the tariff there is a compensating sales tax which is levied in such a way that the effective rate is slightly higher than that assessed on a comparable domestically-produced product. 2.15 The tariff rates as a whole are high. The (unweighted) average over all items is 46%. For agricultural and agriculturally-based products the average tariff is 66%, while for industrial products the average is 39% over the total number of items included. While these averages appear high, they may in fact be deceptively low because some very important single tariff items, such as automobiles and cotton textiles, have very high tariffs. Moreover, there is great unevenness in tariff rates among products and categories (Table 2.5). 2.16 The underlying economic rationale of the observed high tariff levels is the protection of domestic industry. Yet, in many instances, this rationale appears to be inconsistent with actual protection. For example, there is evidence of considerable tariff redundancy, e.g.fbeer, apparel and footwear. While firms producing these products could successfully compete with imports with much lower tariffs, the redundant tariff levels have an important quantity effect by assuring the domestic market or, as frequently is the case, reserving the entire market for domestic producers. 2.17 In addition to widespread tariff redundancy, the Philippine pattern of tariff protection provides rather high tariffs on products not produced in the Philippines. Products such as sheepskin leather, metallized yarn, woven fabrics made with metallized thread, rubberized textile fabrics, nuts and bolts, and screws are a few examples of those goods not produced in the Philippines but subjected to tariffs of 50 to 100%.  - 27 - 2.18 Changes in tariff levels are the administrative responsibility of the Tariff Commission, which is charged with making studies of the tariff system and conducting hearings. The Tariff Commission makes tariff policy recommendations through an inter-ministerial Sub-Committee on TariEf Matters. Recommendations are passed on to a ministerial level Board on Tariff Policy which in turn presents decisions for presidential approval. Since the last major revision of the tariff system in 1973, some further reductions in tariffs (e.g.)on tires, cotton yarn, musical instruments, and electric hand tools) have taken place. 2.19 One significant proposal still being considered involves a reduction of tariffs on 77 textile items. This proposal grew out of a report by the Tariff Commission in March 1978. Action on this proposal was still pending at the time of the Mission's visit. The delay in acting on this proposal illustrates the importance of appropriate governmental agency coordination on tariff questions, and the need to coordinate tariff action with necessary rehabilitation of the industry (see Chapter VII). 2.20 One consideration in tariff reduction stems from the importance of tariffs as a means of collecting tax revenues. In 1977 tariffs accounted for 18% of the national Government's total revenues. To the extent that there are presently prohibitive tariffs, tariff reduction could actually increase tariff revenue by increasing imports by more than the commensurate offsetting decrease in tariffs. It depends upon the elasticity of import demand with respect to price changes brought about by the tariff changes. It is clear that a careful fiscal assessment of tariff policies is desirable. In certain cases (especially luxury goods) tariffs could be replaced by sales taxes. 2. Import Licensing 2.21 In order to import certain types of products the approvaL of the Central Bank is necessary. The requirement for Central Bank approval has an effect similar to import liclensing. The system applies mostly to commodity categories classified as "non-essential" and "unclassified" consumer goods. All goods in these classes are restricted and therefore require Central Bank authorization for importation which, if granted, allows importation with the payment of the import taxes. These two restricted categories total 670 out of some 3,500 items in the Philippine tariff schedule. They include such products as canned meats and fish, fresh and preserved fruits, cigarettes, alcoholic beverages, paper, kitchen utensils, television sets, household appliances, automobiles and apparel. Many of these items are exported or are potential exports. 2.22 In addition to import licensing for the "non-essential" and "unclassified" consumer goods categories, the Central Bank also restricts  - 28 - the importation of a small number of intermediate goods consisting of yarn, textiles, and steel plate. These products are inputs into export production (e.g., garments) or inputs into products used in export production (e.g., cans used in the food processing industry). While imports are supposed to be freely allowable without taxes for a number of export production schemes, in practice there appear to be delays and difficulties in obtaining the import licenses. 2.23 The licensing system appears to be an element in balance of payments management. Nevertheless, the system can be expected to impart a protection element. One attempt (IPPP, 1979) to assess the importance of quantitative restrictions on imports, made direct price comparisons between Philippine prices and international prices for some 200 six-digit SITC commodity groups. The findings were that !'in no instance was there a plausible price comparison that suggesed an implicit tariff higher than what is estimated from the tariff and tax system." As such, this study minimizes the importance of quantitative import restrictions. In plant visits, how- ever, the Mission found several instances in which the import licensing system is an obstacle toward product improvement, greater competition, and the provision of intermediate goods for export industries and firms. In some cases (e.g., steel products) price controls keep down the prices of licensed products; this has at times aggravated supply problems and further contributed to plant inefficiency. The restriction of competition from imports has enabled a number of firms (e.g., in the textile and steel-rolling industries) to operate at uneconomic levels of capacity utilization and costs. Furthermore, there are frequently important quality differences between domestic and imported consumer goods. Tastes for such goods also frequently favor the imported product. Without import licensing there would unquestionably be greater imports of luxury consumer goods. 2.24 The Central Bank also administers exchange controls related to capital movements, service payments, and foreign travel. Restrictions on foreign exchange purchases for travel abroad have been detrimental to Philippine export marketing efforts and, as a result, to export growth. Exporters often experience difficulty in arranging travel abroad to market their products. 3. The BOI Incentives 2.25 In the past decade a new form of industrial policy has emerged in the form of a system of fiscal incentives administered by the Board of Investment (BOI). With the implementation of the Investment Incentives Act (R.A. 5186) in 1967 a series of fiscal incentives was established to attract investment into activities deemed to have priority and to be consistent with national economic development objectives. Both new and established firms are eligible in the preferred industries for the incentives. A so-called "ipioneer" project, involving either new products or processes, is eligible for additional benefits. The intention of the legislation was to provide  - 29 - incentives to both projects where domestic capacity was estimated to fall short of domestic demand and to projects with an export potential. In practice, the emphasis under this Act tended to be on import-subst:Ltution type of activities. In exports, the emphasis was initially on relatively capital-intensive processing of primary products rather than labor-intensive manufactured exports. 2.26 To offset this deficiency and provide a promotional thrust to manufactured export activities, the Export Incentives Act (R.A. 61:35) was passed in 1971. While most of the incentives under the two incentLves acts are quite similar, the Export Incentives Act offers some additionaL benefits to export-oriented firms. The restrictions on foreign ownership are waived for firms exporting more than 70% of their output, and there are a few extra fiscal benefits, involving mainly the possibility of operating a bonded manufacturing warehouse for the duty-free importation of intermediate goods used in the production of exports. As a result of the Export Incentives Act an increasing proportion of incentives granted by the BOI is now extended to nontraditional manufactured;exports. In 1977 34% of total BOI benefits were extended under the Export lncentives Act. It should be realized, of course, that many projects benefitting under the Investment Incentives Act are also export producers (largely primary product processing, both agricultural and mineral). In 1977 Investment Inc -ntives Act benefits went to firms producing $875 million in exports, while firms receiving Export Incentive Act benefits produced exports of $715 million (Tables 2.6a and 2.6b). 2.27 Of the varied incentives described in detail in Annex II-1, there are several that predominate (Table 2.7). For projects registered under the Investment Incentives Act, the exemption of import taxes on imported capital equipment and the accelerated depreciation allowance amounted to 40% of the total value of the incentives granted in 1977 (65% in 1975). Both of these incentives, along with a few others, are subsidies on the use of capital. 2.28 While these incentives are also significant for export projects, other incentives, not invo]ving' a subsidy on capital usage, emerge as the most relevant. In particu]ar, the provision allowing for the deduction from taxable income of an amount related to labor costs and indigenous raw materials expenditure accounted for 53% of the value of the incentives to export-oriented BOI-registered firms in 1977. The tax credits for import taxes on products used in export production accounted for an additional 21%. Tariff exemptions on imports used in export production are permitted under three additional programs: (i) the permission for some BOI-registered firms to operate bonded manufacturing warehouses; (ii) the drawback scheme, which refunds the tariffs paid; and (iii) export processing zones (see Section 5). 2.29 The protection from dumping, however defined, and the possibility of receiving additional tariff protection in the domestic market up to a  - 30 - tariff level of 50% are potentially important protective instruments. Under the Industrial Incentives Act legislation the BOI is empowered to recommend the postoperative tariff increases to the Tariff Commission. In practice, the authority has been used quite sparingly, perhaps because tariffs in many instances already approach, or exceed, the 50% limit. 2.30 The effect of the BOI fiscal incentives for import-substitution projects is to complement the incentives for domestic market production provided by the tariff and import licensing system. Home market protection is increased. The additional protective effect afforded by the BOI incentives appears rather modest in the aggregate, although for individual firms it can be significant. Incorporating the BOI incentives into estimates of effective rates of protection does not appreciably change the level of effective protection for most industries /1 (Table 2.8). Only in a few industries is there more than an increase of a couple of percentage points. Although tariff rates averaged 38.9% in 1974, it has been estimated that the tariff equivalent of tax subsidies averaged only 1.4% (IPPP, 1979); the reason for this relative insignificance at the aggregate level is that the BOI incentives and the output of BOI-registered firms are quite small in relation to output for the entire industry. 2.31 Seen from the point of view of the individual firm, BOI benefits can be an important factor in its profitability. Measured as a percentage of sales, the benefits frequently do not exceed the equivalent of more than 2 or 3%, but sometimes range up to 25 or 30% (cf IPPP Working Paper No. 16, Table 1). Annex T-1, based on Mission firm interviews, shows estimates ranging up to 11 or 12% of sales in the textile and garment industries, 29% in canned beef and 23% in the mechanical engineering industry. 2.32 If the magnitude of the BOI incentives for domestic market production are seen to be quite small in the aggregate, the same is the case for the incentives for exports. Yet the aggregate are not the most relevant measures. What matters are the effects that the incentives have on individual firm profitability. The BOI incentives can reach considerable magnitudes, especially if large investments are being made. On an operating /1 There are two features in these estimates that overstate the additional protection in the domestic market afforded by the BOI incentives. First, the incentives themselves have been overstated. The full amount of a deduction from taxable income is considered as the amount of the incentive rather than only that amount times the corporate income tax. Second, no distinction is made between incentives awarded for home mar- ket production and those related to exports. The latter should be ex- cluded.  - 31 - and production basis, there, are some limits imposed on the effective subsidies provided to export activities. In practice, the most important BOI incentive for export has been the tax deduction for labor costs and local raw material purchases up to 25% of the firm's export sales. Assuming the firm is exporting all its output and has sufficient labor and local raw material costs, the maximum that this incentive can reach in value to the firm is 8.75% of the value of its output./I Depending upon the circumstances of the individual BOI-registered firms, the actual magnitude of the incentives provided to different incentives varies widely. 2.33 For the aggregate of all recipient firms in 1977, the total subsidies and rebates received under the Export Incentives Act amounted to 9% of their export sales (Table 2.9). This amount has increased in recent years; in 1973 it was only 3%. Of the BOI-registered firms interviewed, most indicated that their current BOI benefits received ranged from 2-12% of their export sales value. One firm, manufacturing sports shoes, indicated that it was receiving about: 20% of its export sales in BOI benefits. Even for such a firm fortunate enough to receive the full complement of BOI incentives, these incentives are still not of such a magnitude to offset the distortions imposed by tariffs and government commercial policy. And most firms do not receive the full complement of BOI incentives. 2.34 In addition to being eligible to receive the BOI fiscal incent- ives, there are several other, more intangible benefits for a firm in being registered by the BOI. BOI registration in effect constitutes a govern- mental recognition and tacit approval of the firm and its activities. On the basis of this recognition, the firm's dealings with other parts of the Government may be facilitated. For instance, with a letter of endorsement from the BOI it is easier for a firm to obtain foreign exchange for marketing efforts abroad. In addition, the Central Bank is also said to treat a firm's requests for import licenses more expeditiously if it is a BOI-registered firm. Finally, BOI registration may facilitate access to long-term credit from official financial institutions such as the DBP. 2.35 A wide range of industries have received benefits from t'he BOI. Under the Investment Incentives Act the industries that have received the most benefits are copper smelting and refining (36% of total benefits in 1977), pulp and paper (16% of 1977 total), chemicals and chemical products, and synthetic textile fibers. For the export projects those industries which have received the most BOI attention and benefits include chemicals and chemical products, fiber products, garments and textiles. /1 This incentive may in fact be very important for the profitability of the firm. Through this'incentive some export-oriented producers produc- ing goods with a high domestic raw material content escape national in- come taxation altogether.  - 32 - 2.36 Benefits under the Investment Incentives Act have tended to go to the larger and more capital-intensive firms, both firms producing for the home market and primary export processing firms. (In 1977 some 62% of benefits went to firms in industries with above average capital intensity. See Table 2.10). A relatively small portion of the benefits went to smaller firms (e.g., with fixed assets of less than P 5 million, as shown in Table 2.11). On the other hand, benefits under the Export Incentives Act have been more evenly distributed over firms of varying size and have gone to more labor-intensive firms (Table 2.12). Export-oriented firms have received benefits under both Acts, with the benefits under the Investment Incentives Act going to relatively more capital-intensive firms than those under the Export Incentives Act (Table 2.12). Finally, the capital intensity of BOI preferred projects were generally higher than industry averages while capital efficiency estimates were lower (Table 2.13). 4. The Administrative Impact of the BOI 2.37 The BOI plays a key role in Philippine industrial policy through its administration of a complex set of incentives. As the manufacturing sector grows, the administrative burden and responsibility placed upon the BOI, under present arrangements, will increase. Reducing the administrative complexity of the incentive system and facilitating its administration will become increasingly important if the system is to function-smoothly in an expanding economy. 2.38 As noted, the BOI operates within the priority plans, worked out in collaboration with the NEDA. In determining priorities, the BOI does not have at its disposal an overall strategy for the development of key subsectors. The Mission recommends that more work be undertaken on a strategy for the mechanical and food processing industries, which must necessarily play a critical role in the country's economic objectives in coming years. 2.39 Once a priority subsector is identified, all firms in that sub- sector are eligible for the relevant incentives. However, on the firm (project) level there is some unevenness in the way in which the incentives are in fact applied. In particular, given the administrative requirements imposed by the BOI on firms, only the larger firms can effectively benefit from the incentives. In other words, the system de facto discriminates against small- and even medium-sized enterprises. Moreover, there is an element of regional discrimination present as well. The BOI maintains its only office in Manila, and to deal with the BOI it appears a firm must either be located in Manila or send representatives to Manila frequently. The answer to this particular problem is not to create regional offices but rather to streamline and simplify the process regardless of firm size or  - 33 - distance from Manila. In other words, greater automaticity should be introduced into the BOI system. A simplification of BOI rules and procedures would promote both SMI development and regional diversiL-ication. 2.40 In some situations the BOI rules may well tend to penalU-:e mana- gerial efficiency by placing limits on firm profitability. BOI rules stipulate that firms with a rate of return on equity over 20% are not eligible for the BOI incentives applied to capital equipment. Sim:Llarly, if a firm with benefits earns more than 33% for two consecutive years, the rules state that the BOI must terminate benefits. If the Government decides to encourage the development of a particular industry, equal treatrnent of all firms in the industry would avoid putting a penalty on good management and efficiency. 2.41 Future BOI efforts to simplify procedures could involve several elements. Certain incentives could be applied to all industry and not be subject to administrative discretion. For example, consideration might be given to including extra tax incentives for labor and local raw material cost in the fiscal system. :Subsectors eligible for BOI incentives would be determined in advance on the basis of economic appraisal and special strategy studies. 2.42 Within the BOI system, the following might be considered: First, after a subsector has been deemed to warrant support, granting benefits to all firms in that industry would serve to reduce distortions and improve resource allocation, as well as reduce administrative burdens on the BOI. Second, general guidelines for the amount of incentives a firm could receive in a certain industry could be established from time to time. Within those guidelines, no separate BOI examination should be required, except for very large projects. The firm would be able to avail itself of incentives automatically up to the limits set by the guidelines. 2.43 A third means of simplifying BOI procedures could involve the "expansion plan" process. At present, firms are registered with the BOI for a certain capacity; expanding beyond that capacity requires BOI approval. If BOI incentives could be extended to plant expansion beyond the size originally approved, the detailed examination of extensive "expansion plans" by the BOI could be avoided. The government is, of course, interested in avoiding excessive capacity build-up within an-industry (as happened in cement and-coconut processing). The credit system could possibly become more effective in avoiding such excess capacity situations by being more restrictive in its willingness to refinance corporate failures. Until this happens the Government may have to continue exercising some check on excessive plant expansion. 2.44 Simplification of the procedures for granting incentives will require close coordination with other government agencies such as the Bureau of Internal Revenue and the! Customs Service. The Mission feels that an increased emphasis on the economic analysis of projects would assist in streamlining the evaluation 'process.  - 34 - 5. Export Incentives 2.45 Export incentives have been instrumental in expanding and diversifying manufactured exports. Continued export growth will require simplification in the administration of export promotion measures. To the maximum extent feasible export producers, large and small, should have duty-free access to raw material inputs. Domestic supplies to the export industries should also be eligible for duty-free imports of their own inputs. Finally, small producers need help in maintaining uniform quality production standards, marketing, procurement and obtaining finance. 2.46 Import and Export Procedures. The various methods under which duty-free importation is currently approved are subject to administrative decision and often require considerable time for the entrepreneur, tie up working capital, or the eligibility rules are too restrictive. The marginal deposit scheme requires the local purchaser of imported materials to place a deposit, often up to 50% of the purchase price or more, with a commercial bank. Deposits may be tied up for several months, thus raising the cost of working capital finance./I 2.47 Duty-free importation of inputs is effected through the drawback system or bonded warehouse arrangements. The drawback system involves many steps of documentation and approval before a refund of the deposit (equal to the full value of import duty required) takes place. The duty is frequently returned only after several months and is partly in the form of tax credits. 2.48 The credit of the marginal deposit scheme and the drawback may add more than 5% to the export costs (Table II-4). 2.49 The bonded warehouse system enables the exporter to store imported materials for a longer period without having to pay duties and thus cuts back the time in which working capital is tied up in import duties. The bonded manufacturing warehouse system, or "manufacture-in-bond", permits export industries to operate on a truly free-trade basis without being physically located in an export-processing zone. This system is currently only available to exporters specifically "endorsed" for this purpose by the BOI and employing at least 150 workers in the case of an existing company or 600 workers in the case of a newly established manufacturer. An additional requirement is that at least 70% of the output is to be exported and strict conditions are set in terms of minimum domestic value added, the quality of the company's management and its financial position. As a result, the bonded manufacturing warehouse facilities are only available to well-established, larger scale, export industries. /1 Producers in EPZs are exempt from this requirement.  - 35 - Table II-4: PENALTY ON EXPORT THROUGH CREDIT SYSTEM % of export value Drawback 6 months 2.00 3 months 1.00 Marginal deposit 6 months 3.75 4 months 2.50 Total penalty 3.50-5.75 Assumptions: interest rate is 15%; raw material imports are 50% of export value; duty is 50% of c.i.f. price of raw materials. 2.50 Paperwork and procedures required by government agencies appear to present a genuine obstacle to many export producers, especially the smaller ones. A recent Presidential Decree (No. 930) has already cut the required export documents from 13 to 6 and instituted exemptions for holders of periodic clearance certificates. It would seem appropriate to consider further simplification, in particular the creation of a "one-stop export office" to which every exporter would submit a single set of documents. Such an export office would have the responsibility of circulating papers among the various agencies and return them to the exporter within a prescribed time frame. The more individual authority this "export office" would have, the quicker the clearance process could be completed. 2.51 Export Financing. The Central Bank has a special rediscount faci- lity (at a rediscount rate of 4%,recently reduced to 3%) for financing of exports./l The present facility is split into financing of traditional manufacturers and nontraditional manufacturing exports. The latter has been underutilized (71% of the amount set aside has been taken up during the last three years), even though the borrower pays 10% (including 1% commission) as against the commercial rate of 16%. Exporters consider the percent preferen- tial rate high in relation to the rates available to their competitors in other countries. Further, smaller producers find it difficult to make use of the facility. /1 The value of eligible loans has been raised from 80% to 100%.  - 36 - C. Recommendations 2.52 Any changes made in the Philippine system of incentives should be discussed and undertaken in the context of certain overall objectives of industrial policy. These objectives are: (a) Facilitate export growth, particularly of labor-intensive indus- tries. (b) Increase the linkage between manufactured export development and the rest of the economy, mainly through increased domestic procurement of raw materials and components at economic prices. (c) Encourage the economic development of manufacturing for the home market, particularly strategically placed but lagging sectors, and industries which can become more efficient through rehabilitation and renewal. 2.53 A rationalized system of incentives for the Philippines would consist of two principal elements. They are: (a) The reduction and evening out of tariffs and other forms of protection for domestic market production; and (b) The provision of greater incentives for export, especially of manufactured products. 1. Reduction in Protection and Liberalization in Import Restrictions 2.54 The average level of tariff protection is excessive and should be reduced. A gradual reduction in overall tariff levels will make the economy more efficient and competitive, support manufacturing export development, and help spread its effects to the rest of the economy. 2.55 Modifications in the existing custom tariff structure should be aimed at progressively evening out the structure, while still providing for a flexible response in the demonstrated presence of dumping. The reordering of the customs tariff should possess the following elements. In introducing lower and more even protection, the Government should follow the course of expeditious across-the-board action, except in selected cases where specific industry programs are mounted to establish more competitive conditions through modernization, renovation and new investment. These selective programs will go hand-in-hand with the lowering of tariffs to levels suggested by the Mission (usually 20-30%). Across-the-board action can be taken in the short- run: this is true for the steps recommended under (a), (b), and (c). On the other hand, the establishment of protection levels tailored to specific industry conditions and programs may require a longer period of time (the steps recommended under (d), (e), and (f)).  - 37 - (a) The lowering of peak rates. There are many products with very high rates of nomiiial and effective protection. Included are such industries as cotton textile fabrics, paper products, bakery products, rubber footwear, paints and varnishes, household appliances, and fabricated plastic products. An acceptable rule of thumb would be to gradually, but very explicitly, lower all tariffs falling in the 70-100% range. (b) The lowering of tariffs to remove redundancy. In instances where there is redundancy in tariffs, the tariffs serve no positive economic purpose and should be reduced. Candidates for such tariff reductions :[nclude apparel, beer, furniture and pineapple products. (c) The lowering of tariffs for products not produced in the Philippines. There is no economic rationale for such protection. If tax revenue is to be raised by taxing such items, a general excise tax, applicable to both imports and any domestically- produced products, is the appropriate instrument. (d) The lowering of tariffs for those industries where studies have identified possibiLities of achieving greater productive efficiencies through rehabilitation, restructuring and renewal. This is the case for textiles and steel products. Industries which supply inputs to export industries should receive special attention. (e) The use of tariff protection for infant industries possessing strong potential comparative advantages. If economic analysis indicates the possibility of economic import substitution, tariff protection should be employed during an initial period to promote that industry. Similarly, export subsidies can serve the same purpose. It is clear, for instance, that the Philippine capital goods industries are "underprotected" by commercial policies. Yet, as discussed in Chapter VI, there are very strong potential comparative advantages in some of those industries. In fact, the existing domestic resource cost estimates by and large demonstrate that the capital goods industries possess present comparative advantages as well. These industries should be actively promoted by gov\ernment policy. As a rule, as viable projects are presented, tariffs on capital goods may be brought in line with the general tariff level, and exemptions from such tariffs, as allowed by the BOI for import substitution projects, should be selectively curtailed. (f) The linking of tariffs with export performance. The provision of protection in the domestic market in selected situations should be made conditional upon export performance. This amounts to a cross-subsidization of manufactured exports. Experience elsewhere  - 38 - has demonstrated that such a scheme, if properly applied, can be highly instrumental in promoting exports. The cross-subsidization system works by requiring that a minimum proportion of sales be exported in exchange for retaining tariff protection in the domestic market. The export percentage can be implemented gradually and set in cooperation with the industry producers' associations. Selected new projects receiving BOI investment incentives could have export targets expressed as a condition for receiving the incentives. While many industries should fall under this type of arrangement, some leading examples are automobiles, consumer durable products, chemicals and textile rehabilitation projects. (g) The overall reduction of tariff levels should be accompanied by a concomitant winding down of the import licensing system. Without the concerted reduction of import licensing, tariff reductions would result in a possible expansion of the restrictions imposed by the import licensing system and an increase in the windfall profits for those importers fortunate enough to secure import licenses from the Central Bank. Consequently, for tariff reductions to be eco- nomically effective, the import licensing facility should be phased out, products effected. To ward off untoward events in a balance of payments crisis, an office in the Central Bank could be established to monitor imports and impose quantitative restrictions for balance of payments purposes under emergency circumstances. 2. Changes in the Export Incentive Regime 2.56 Providing greater incentives for exports should include the estab- lishment of free trading regimes for manufactured export industries to the maximum extent possible. This involves: (a) duty-free importation of raw material and components; and (b) providing additional assistance to help industries overcome the disadvantage of operating in an economy with high protection. While duty-free importation of inputs used in export production is currently allowed under a number of schemes, the machinery needs to be strengthened and effectively extended to small firms. The drawback scheme, for instance, reportedly works poorly./l These schemes should be simple, automatic, fast and entirely certain. 2.57 Even with perfectly functioning drawbacks and tariff exemptions, the present system is restricted to firms engaged in direct export manufac- turing. "Indirect exports" are placed at a disadvantage; in fact under /1 One firm with frequent drawback dealings reported that it had never received the full amount it was entitled to under the drawback.  - 39 - present policies, given tariff protection, domestic suppliers to export firms are discriminated against. The extension of free trading regimes to all inputs for export production presents a danger of providing further discri- mination. Care must be exercised not to discriminate against locEil producers supplying intermediate inputs. 2.58 Steps toward more effective export procedures and financing might appropriately.start with the introduction of a special facility for the fi- nancing of inputs into export production. Such a facility could, of course, be introduced only if it fitted into the country's overall financial policy. On the basis of export orders, producers would be able to obtain low-cost financing (letters of credit) for raw material and component purchases (both imports and domestic procurement). The letters of credit, subject to special Central Bank rediscounts, would also make the import eligible for duty-free entry. In the case of local procurement, the domestic producer could use the local letter of credit for duty-free importation of his requirements. This system has two advantages over present arrangements: (i) it provides special financing for raw material imports which are not covered by the present Central Bank facility, and (ii) it makes duty-free import of exporter requirements more general and automatic. Thus, it would extend the free trade regime for exporters, make the present arrangements (described in Section B5) more automatic. Under such a system the present Export Incentives Act would play a less important role. 2.59 If the proposed credit-cum-duty-free entry arrangements could not be adopted, several other Steps should be considered as a next best solution to make the present system more effective: (a) reduce the delays in refunding deposits of import duties in the case of the drawback and bonded xwarehouse systems; (b) refund duty payments instead of providing tax credits and (c) relax the stringent: requirements for the operation of bonded manufacturing warehouses and make the system more easily available to both small entrepreneurs and new export industries./l /1 In this connection, attention should also be given to a wider applica- tion of Customs Administrative Order No. 3-78. This CAO provides for the release from customis custody (without payment of duties and taxes but under bond) of imported materials to be processed into export pro- ducts by small-scale industries which do not have the financial capa- city to make prior payments of duties or to operate a bonded warehouse. A certified copy of a valid and subsisting contract between the local firm and the foreign buyer is required. Small-scale industry under this Order is defined as having an authorized capital stock of less than one million pesos. The present CAO is limited to imports under consignment and it might usefully be liberalized to include imports on own account.  - 40 - In the longer run, consideration should be given to the establishment of a network of regionally dispersed mini-industrial estates which should include bonded export processing facilities. This will enable small-scale producers, in particular, to participate in export production, possibly on a cooperative basis. 2.60 Commercial banks can improve their service to export firms, particularly the smaller and newer ones, by setting up special "export departments," staffed with experts to assist and encourage potential or existing exporters to make use of the export financing facilities. Export loan application procedures could be simplified and made more com- prehensible to small businessmen. Further, the absence of an export credit guarantee scheme limits export development. Action should be taken to establish an export credit insurance and guarantee scheme which would mini- mize credit risks in export transactions. A Philippine Export Credit Insu- rance and Guarantee Corporation was created in March 1972 but is still not operating. 2.61 Small exporters initially lack the essential production, marketing and quality control skills to produce a consistently competitive export com- modity and are, therefore, considered high risk clients by the commercial banks. Close supervision and technical assistance at the production level are required to make such small exporters more creditworthy. Efforts should, therefore, be made to establish a form of "supervised credit," either through collaboration between the commercial banking institutions and the existing small business advisory organizations or through the closer liaison with cooperative bodies as is currently under experimentation in the shoe industry. Such a system might be eventually considered for all SMI operations. 2.62 The "Accredited Trading Companies" (ATCs), which the Government recently decided to promote, could potentially play an important role in this respect. P.D. 1319, which became effective at the start of 1979, provides very sizable incentives for ATCs in terms of access to favorable rediscounting privileges, liberal export payment terms and access to the incentives under the Export Incentives Act. These private trading companies are expected to (a) assist in marketing of the products of small-scale exporters, (b) enforce quality control through technical assistance, and (c) provide export financing. So far, however, the response from the private sector to the new legislation has been negative. While the incentives are generally perceived as advantageous, the eligibility requirements with res- pect to minimum net worth, minimum export sales, range of export products, number of overseas representatives, etc., are considered too restrictive. A relaxation of these conditions is therefore recommended.  - 41 - CHAPTER III SMALL AND MEDIUM INDUSTRIES 3.01 Small- and medium-sized industries (SMIs) employ, together with the cottage sector, close to 80% of the work force in manufacturing and produce only 25% of value added. While these data are highly tentative, they do illustrate the low output per worker, particularly in the smaller-sized firms. The low labor productivity is in part caused by limited use of capital equipment - in many cases perhaps even more limited than is indicated by the low level of labor costs. 3.02 Small-scale enterprises are concentrated in those industries which have been reviewed in Chapters VI and IX of this report: mechanical engineering, garments, footwear and furniture. SSI accounts for more than half of value added or employment in these industries. The role of SSI in food processing is also large, but it has been declining (see Chapter VIII). 3.03 Like large-scale manufacturing (in enterprises with 200 workers or more), SMIs are heavily concentrated in Metro Manila and the surrounding central regions (see Chapter IV). However, the cottage industries are less so concentrated. 3.04 Since the early 'seventies the Government has been giving increasing attention to the role of SMIs in Philippine development, and as part of this effort, the sector has been receiving larger amounts of technical assistance and finance. NEDA identifies the SMI sector as of strategic importance in employment creation and regional dispersion. To improve understanding of the needs of the sector, several studies have been undertaken or are under way. The Mission has drawn on these studies. 3.05 In dealing with the SMI policies, one must necessarily allow for the effectiveness of present SMI assistance measures as well as for the impact which general industrial policies have on small-scale ente-rprises. The small size of enterprises and their dispersion puts them at a disadvantage vis-a-vis the large-scale enterprises. With the exception of programs specially designed to deal with SMIs, the Government's general programs for industrial development, e.g., those embodied in the incentives administered by the BOI, are mostly geared to the larger enterprises. A. The Cottage Sector 3.06 Most of those employed in the manufacturing sector work in very small enterprises (less than 20 workers) are usually referred to as cottage industries. The cottage or unorganized sector employs over one million workers, about two-thirds of the total number employed in the manufacturing industry as a whole. This group includes many very small service workshops and some producers of low quality utilitarian goods such as footwear, furniture and garments which find a market among the poorer consumers of the domestic market. The overwhelming majority are engaged in what may be termed cottage or household craft industries (see Tables 1.28 and 1.29).  - 42 - 3.07 Cottage industries are relatively more important in the Philippines than in many other industrializing countries. In the mid-1970s about 2.5% of the total Philippine population were engaged in household and cottage industries against a percentage of as low as 0.2% in Brazil. 3.08 Cottage industries, registered with the National Cottage Industry Development Authority (NACIDA),are exempt from sales or other taxes and from minimum wage legislation. To be eligible,firms must have fixed assets below P 100,000 and sales below P 400,000. In 1978 some 86,000 firms were officially registered with NACIDA (Table 3.1). Firms manage to continue their NACIDA registration even after their asset value has outgrown the legal limits. Others reorganize the enterprise under a new name after an initial year and thus are able to start a new NACIDA registration. 3.09 Cottage industries are so organized that for each directly employed worker there are 3 to 4 "indirect workers" engaged in their own households for the cottage enterprises. 3.10 Cottage industries make a significant contribution to the Balance of Payments. Exports of craft industries grew from US$27 million in 1973 to US$84 million in 1977 (an annual growth of 33%) (Table 3.2). Only the garment industry and a few special categories (e.g., rattan furniture) have been able to show similar growth rates in manufacturers'exports. In addition a large part of the output of the cottage industries is sold to tourists and foreigners residing in the country. As tourism has grown substantially since 1975, the sales within the country of local handicrafts has increased also. In addition, domestic value is relatively high since virtually all the cottage industries work with local materials such as wood, rattan, bamboo, wicker, leather, shells, and local fibers and cloths. 3.11 Most cottage industries sell through private traders who, although take large profit margins, are the main organizers of handicraft export trade. NACIDA itself has some large stores, mainly in Manila, but the cottage industries claim they do not show aggressive marketing, and they take goods only on consignment. Many cottage enterprises prefer to use private trading channels. 3.12 NACIDA has developed programs for providing assistance in training and, together with the Design Center, has also helped in improving designs. The Design Center of the Philippines has made assistance to craft enterprises the major focus of its work. The technical assistance program of the Ministry of Industry - through the SBACs and MASICAP - has also given considerable assistance to cottage industries in the regions. In fact, in some areas the major beneficiaries of both these programs have been in the cottage industry category. 3.13 The cottage industry sector in the Philippines will continue to play a significant role in employment and exports, and deserves continued support from the Government. Employment is provided at times and in regions where it can complement the seasonality of agricultural demand for labor.  - 43 - However, more effort must be made to integrate the activities of the sector within the general programs of industrial development. For this reason, NACIDA needs to upgrade it:s staff and be integrated more with the programs of the Ministry of Industry. At present, NACIDA activities depend on the Ministry of Trade, and there is little relationship with the Ministry of Industry which has the primary responsibility for industrialization and exports. 3.14 Technical assist:ance is needed primarily in marketing, skill upgrading and design. This is particularly important in those cottage industries which sell in competition with large-scale industries such as footwear, furniture, garments, ceramics and some metal and food items. 3.15 The present system of providing support through tax exemptions may, in many cases, act as a deterrent to growth of some enterprises for fear of losing these privileges. Further, more financial resources need to be made available. The cottage industries still depend to a great extent for working capital on short-term, high-interest financing from traders, as the amounts made available through the commercial banking system are inadequate. According to Central Bank records, only 2% of the portfolio of commercial banks at the end of 1977 was in credit to cottage industries and the overwhelming majority of this was in the Metro Manila area in the form of short-term working capital loans. (See Table 3.3.) 3.16 As the organized sector grows, it may increasingly draw labor away from the cottage sector. However, as long as opportunities for industrial employment remain limited outside the Metro Manila area, and wages in the organized sector remain low, cottage industry as a source of income for the rural labor force, will continue as a reasonable - and in many cases as the only - alternative. Government efforts should therefore be directed both at assisting the modernization of these activities (transformation into SMIs), and improving incomes for those who continue to be engaged in cottage industries. B. Growth of SMIs 3.17 Between 1968 and 1977 some 11,000 new SMI firms were established. The annual birth rate over the 25 year period 1951-1977 was 560, but this increased to over 1,000 in the 1968-77 period (see Table 3.4). 3.18 Failures among SMI firms are relatively high. The causes have not been studied in detail, but excessive competition, inadequate finance and poor management are important contributory factors. Usually the Government permits market prices to operate and does not help out small fail:Lng enter- prises, as it often does with larger firms (or as is done in some other developing countries). 3.19 The Mission projects manufacturing employment to increase by some 120,000 jobs per year in the next several years (Chapter II). Labor-intensive industries are likely to be major providers of new employment. Most of these  - 44 - are likely to be labor-intensive export industries operating through large- scale firms. If the SMIs are to expand and contribute to new employment, they will have to become more efficient and be more closely integrated with large-scale manufacturing. As recommended in the chapters dealing with specific industries, steps toward greater efficiency and rationalization will need to be bolstered by increased access to both short-and long-term finance. 3.20 Additional efforts may best be concentrated on existing, relatively more efficient firms rather than creating new enterprises. To some extent this is happening already. It appears to be the approach followed by PDCP in the allocation of investment credits. Further, in the Cebu area, there appeared to be stagnation among firms with less than nine employees, while employment in the large firms increased by 11% in 1975-78. 3.21 Special efforts are called for to help disperse SMIs to the outer regions. Concentration in and around Metro Manila has been strong. From 1967 to 1972 small- and medium-scale industries with 10 to 199 employees in Metro Manila and its adjacent areas of central and southern Luzon increased from 61.3% of the total number of SMIs in the country to 69.9%. In 1972-75, after some measures to restrict further development in the capital and some incentives and assistance programs had been initiated in the outer regions, the concentration remained almost unchanged. In 1975, 69.2% of SMIs were located in the central areas around Metro Manila. Although the increase in concentration around Manila was halted, only 32.5% of new SMI firms were established outside the central regions in 1972-75 and in 1975, 47.3% of Philippine SMI firms were still located in Metro Manila. C. Labor Intensity and Capital Efficiency 3.22 Smaller firms are generally more labor-intensive than larger enterprises. The following table (taken from an UP-ISSI sample study) gives the book value of assets (in thousands of current pesos) per worker: Year SSI MSI LSI Total 1968 6.5 14.9 13.2 11.0 1970 6.9 15.2 18.2 14.2 1973 8.0 18.4 26.3 19.9 1974 8.5 19.7 25.8 19.1  - 45 - 3.23 The upper limit in the DBP and IGLF financing program guidelines for SMIs has been P 30,000 (more than $4,000). A Presidential Decree (No. 1123, dated June 1976) defined labor-intensive industrial activities as those with capital-labor ratios of not more than P 30,000 in capital assets per unit of labor (about US$4,000). 3.24 The Mission is not in a position to arrive at any general conclusion about the capital efficiency in Philippine manufacturing. Within some industries small-scale firms are the more efficient users of capital (as estimated by data on the value added per unit of capital). Where this is true (as for example in rubber shoes, foundries, fabricated metal products) there may be a strong basis for productive technical assistance. Some studies suggest that in manufacturing as a whole capital efficiency is generally larger in the relatively more labor-intensive industries. /1 D. Subcontracting 3.25 Both the efficiency and quality of small-scale enterpriSe could be helped through subcontracting by the larger enterprises. However, this in- terrelationship between SMIs and large manufacturers is not yet well devel- oped in the Philippines. The larger industries lack confidence in smaller suppliers, particularly with regard to quality and delivery. A sample survey conducted by the UP/ISSI in 1974 found that 16% of the SSIs sampled were en- gaged in some form of subcontracting work to fill orders by larger industries. This may be compared with 60%, estimated to the proportion of SMTsin Japan engaged in subcontracting in 1976. In the automobile industry procure- ment from smaller firms was an element in the PCMP, but for several reasons this has been achieved only to a limited extent (paras. 6.23-6.271). Similar efforts are contemplated in the production of trucks and other products. 3.26 More generally, the main reasons for the low level of subcontracting in the Philippines are: (a) The relative underdevelopment in manufacture of parts of- machinery, appliances, transport and electrical equipment, etc., where most subcontracting could develop; /1 A UP study that ranked industries by capital intensity found that 9 out of the 10 most labor-intensive industries with less than P 5,000 unit per worker are also those with the highest value added per unit of- capital. Only 4 out of the 72 industries that had a lower than average capital efficiency were labor-intensive industries according to this study. The labor-intensive industries that were inefficient in the use of- capital were leather and leather products, wood furniture, and knitting (Table 3.5). Cf. "Factor Productivities and Intensities in Philippine Manufac- turing with Emphasis on Establishment Size, 1974" (IPP Working Paper, UP, June 1978).  - 46 - (b) The inadequate capacity and capability of SMIgto undertake subcontracting work at the level required; (c) The insecurity and financial problems felt by SMI entrepreneurs in relying too much on subcontracting; (d) The inadequacy of assistance available to the SMI subcontractors either from large industry or from institutions to help them to meet quality and delivery requirements; (e) Ignorance on the part of the large-scale industries of where and who in the SMI sector has the capability and facilities for carrying out subcontracting orders. 3.27 It can be expected that, as discussed in the case of the mechanical engineering industry, these problems will be overcome as the individual industries themselves improve their technical capability. To a large extent this can be facilitated by large-scale firms and large users of industrial products (e.g., the Government). In this process the specialized technical institutes (e.g.,MIRDC) can play a crucial role. The Ministry of Industry can help by giving advice on subcontracting under its SMI assistance program. The Government could provide incentive to subcontracting through public procurement favoring suppliers who subcontract substantial parts of orders to SMI, and through encouraging bidding for Government contracts of groups of larger- or medium-sized enterprises together with a number of smaller sub- contractors. Over time regional subcontracting offices could become clearing houses for the provision of advice *and information on major procurement activities of Government agencies and larger enterprises. 3.28 In some situations subcontracting has been used as a means of avoiding the minimum wage legislation (e.g., in the furniture and garment industries). While the desirability of minimum wage legislation should be studied fully, there is a case for legislation, as has been enacted in Japan, to prevent abuses through subcontracting. E. Technology and Assistance Programs 3.29 There are big variations in technology employed by different industrial enterprises in the Philippines. Most large-scale (and some medium- scale) enterprises resort to links with foreign firms to obtain technological guidance. Usually this is through technological licensing schemes. The Philippines spends tens of millions of dollars each year in payment of royal- ties for patents and licensing agreements. This is now supervised by the Technical Transfer Board in the Ministry of Industry. MOI scrutinizes tech- nology agreements to ascertain that payments are not excessive and are for appropriate purposes. 3.30 Smaller- and medium-sized enterprises tend to use simple, even primitive technologies. Much of their equipment is either of a basic or obsolete type. This inadequate equipment, compounded at times with outdated  - 47 - technological knowledge, helps to explain the low levels of labor productivity in many countries. The low wage level has, of course, contributed at times to poor labor utilization. 3.31 Some efforts are now being made to develop the use of indigenous technologies. An Invention Guarantee Fund (IGF) has been set up t:o provide financial assistance to invention projects, without the necessary collateral to obtain DBP or commercial bank financing. In such cases, the IGF will provide a guarantee and may thus provide some help and stimulate the growth of local innovation. 3.32 Several specialized institutions are engaged in the provision of technical advice and training for individual industries, e.g., textiles, mechanical engineering, food processing and forest products. As cliscussed in the individual industry chapters of this report, these institutions could become more effective through more active field work and stronger relations with finan- cial and business advisory organizations. Most of these technicaL institutions require more budget assista:nce and some should be represented in the industrial- izing outer regions. (See Annex III-1.) 3.33 The major programs of the Ministry of Industry are the Medium- and Small-Industries Coordination Program (MASICAP), providing assistance in formulating SMI projects, and the Small Business Advisory Centers (SBAC) operating outside the central regions. Their activities and those of other Government agencies interested in SMIs have, since 1974, coordinated through the Commission for Small and Medium Industry (CSMI). In practice, the effectiveness of the CSMI has been limited by the diversity of its task and the multiplicity of the agencies represented. 3.34 There is an urgent need for strengthening vocational training, apprenticeship, and technical training throughout the Philippines, and particularly in the outer regions. The lack of skilled workers will soon become a major bottleneck to industrial development. Several industrialists, particularly in such fields as shipbuilding, furniture making, machine construction and maintenance, are already complaining of the difficulties of finding suitable skilled workers and retaining them. The Ministry of Industry, in part acting through the specialized technical institutes, might best take the lead in mounting a more effective program of vocational training for industry. 3.35 In all, Government budget outlays for the SMI assistance programs have been only P 8 million (Table 3.6). They could be made more effective by tackling some of the following shortcomings: (a) The lack of experience of the very young professionals (average age 24) who man the SBACs, and even younger in the case of MASICAP. *(b) The poor coverage due to manpower constraint, high proportion of travel time, immersion in somewhat theoretical plant surveys involving 1 to 3 months consultant time and leading to limited recommendations.  - 48 - (c) Inadequate familiarity with and acceptance by local business and financial representatives. (d) Lack of adequate help and support to the centers from head- quarters and technical institutes to whom referrals are made. (e) Too high staff turnover and staff movements due to poor salaries and difficult working conditions. Turnover which reached 42% (there is reason to believe the most competent and dynamic left) in 1977, dropped considerably in 1978 due to commitments of staff to serve a period after initial training. 3.36 MASICAP suffers from similar difficulties as the SBACs; but, as its role is more limited, it has more easily a'djusted to staff limitations. MASICAP's inexperienced staff has generally dealt with only small projects - 42% of MASICAP's projects to the end of 1978 involve loan requests for less than P 50,000, and 70% for less than P 150,000, the upper limit of DBP branch manager's authority. There are two disturbing features that should be mentioned regarding MASICAP's performance: (a) The drop in number of MASICAP projects prepared despite staff increase (from 1,525 projects prepared in 1976 to 1,050 in 1977, and from 695 actually financed in 1976 to 544 in 1977). The full significance of this drop is difficult to assess since it may indicate a greater selectivity in the projects assisted and may also reflect the changed policies of the financing institutions. (b) The relatively high rate of arrears and failures in MASICAP projects realized. Somewhere on the order of 50% of all MASICAP prepared projects are in arrears, or have failed completely. 3.37 MASICAP and SBACs must be judged as a low cost program to reach out to the SMIs in the regions. More experienced personnel, available for consultation with younger staff, would be able to enhance the effectiveness of the advice given by SBACs and also the calibre and complexity of the projects prepared by MASICAP. Despite shortcomings, both programs have made contributions toward helping the sector and have created what may in the future develop into an important case of motivated extension workers for the SMI sector. 3.38 Some possible lines along which the assistance program may be strengthened are: (a) Organizing a group of more experienced older part-time technical consultants to help the SBAC and MASICAP group at each location drawn from large and medium industry, academic institutions, consultants, and - if such exist - retired professionals. (b) Encouraging the development of more field offices of technical institutes and close coordination of SBAC, MASICAP with this staff, and where feasible directed by regional offices of the MOI.  - 49 - (c) Building up groups of more experienced technical sectoraL specialists at the regional level. (d) Organizing more advisory services at a group level thrc--:h preparing modular materials, e.g., costing systems, planning and control, layouts for furniture, garment factories, machine shops, etc. (e) More reliance on technical information and quicker advice limiting assistance to no more than 4 or 5 days per firm to increase coverage. (f) Closer coordination of SBACs with financial institutions and training programs. 3.39 Bigger budgets, increased staff, some improvement in salary scales, travel allowances, and provision of more vehicles would probably help not only to raise quality of performance, but also improve morale and efficiency. A career development program for MASICAP staff members, including two years in industry after their MA'SICAP period, further advanced training, and then returning to work a number of years in SBACs might also help to improve staff performance levels. 3.40 A strengthened program of technical help for SMI will need to be reinforced by increased financial assistance. Commercial banks at present limit themselves essentially to short-term finance and are heavily concen- trated on Metro Manila and the central regions. The DBP and the special rediscounting by the Central Bank through IGLF are the only programs, with external assistance, for investment finance available to SMIs. It seems clear that if the more efficient subsectors of small industry are to make a greater contribution to employment creation, and if their integration with modern manufacturing is to be accelerated, they will require more financing. The Mission has made some specific recommendations about the financing of small export firms (see Chapter II). One would hope that the activities of financial institutions be more closely integrated with the technical assis- tance programs for SMIs. They could also fruitfully focus on programs for specific industries (e.g., furniture or footwear, reviewed in Chapter IX). These observations are of particular importance for long-term finance and all types of credit provision iii the outer regions. In addition, means should be explored for providing more equity finance to'SMIs. (See Annex III-2).  - 50 - CHAPTER IV THE REGIONAL DISPERSAL OF MANUFACTURING A. Present Concentration 4.1 Industry /1 in the Philippines historically has been concentrated in Manila. In 1975, some 73% of manufacturing value added and 65% of em- ployment was located in Manila and the surrounding provinces. This represented a surprisingly small change from the 67% of value added in 1971. Table IV-1: REGIONAL SPREAD OF MANUFACTURING, 1975 Manufacturing Value Added Employment P Million % No. % Manila 8,472 51.2 732,353 45.3 Central Luzon and Southern Tagalog 3,524 21.3 312,143 19.3 Other 4,541 27.5 571,331 35.4 Total 16,537 100.0 1,615,827 100.00 Note: More detailed statistics are included in Tables 4.1-4.5. Source: NEDA. 4.2 The only industries in which there is any degree of dispersion are the resource-based food and wood industries. If these industries were ex- cluded, the 1975 proportion of manufacturing value added in Manila and environs would have risen to 87%. This is a striking figure. It means that virtually all manufacturing industry, outside of some resource-based industry and some small industry serving local markets, is based in Manila. Certainly all the labor-intensive industry, on which the successful export drive has been based, is in the Manila area. (For example, 91% of the clothing and footwear industry and 95% of electrical equipment.) 4.3 Most of the larger investment projects are also concentrated in and around Manila (Table 4.6). Up to the end of 1977, 275 of the 515 projects registered under the Investment Incentives Act were in Manila and environs./2 The projects registered under the Export Incentives Act were even more concentrated with 132 of 160 projects in Manila and Central Luzon. The industry that is located outside of Manila is, in turn, located mainly in /1 This chapter considers only manufacturing industry. The mining sector is regionally diverse, but is concentrated in several large projects and its inclusion would distort the presentation. /2 This figure includes mining projects.  - 51 - the industrializing regions of the Western Visayas, Central Visayas and Northern and Southern Mindanao. These areas accounted for 19% /1 of 1975 manufacturing value added, leaving only 8% for the remaining non-industrial regions. These remaining regions are overwhelmingly rural'and agricultural and are not likely to industrialize rapidly in the next decade. Regional development, if it is to be cost-effective, should concentrate on agriculture in these regions, whereas i:ndustrial development efforts should be directed to the industrializing regLons of the Visayas and Mindanao, referred to above. Additional efforts to encourage industry in the Central Region to ease the increasing population pressure are also warranted, including possibly a satel- lite cities strategy for Central Luzon and Southern Tagalog. 1. Reasons for Concentrat:lon 4.4 The heavy concentration of industry in Manila has arisen for a number of reasons: political, social and economic. The policies followed during the import substitution drive of the 1950s and 1960s depended on the availability of imported materials and intermediate goods. The natural location of these Lndustries was near the major port of Manila. In addition, the major consumer market was in Manila. At the same time, the Government licensing system that arose to administer the imported materials was centralized in Manila. 'Industries in the regions that relied on domestic resources did not get the same impetus from the Government's policies and, consequently, grew slower. The proportion of gross value added in manufacturing in Manila increased from 50% to 64% between 1948 and 1961. These pressures were reinforced by the lack of industrial infrastructure in the regions. Without adequate telephones, power, roads and water supply, modern industry will not develop. Some efforts, of course, are being made, for example through the National Electrification P?rogram, but in many major regional cities, power is still expensive and subject to frequent interruptions, roads are congested, telephone service is poor, ports are crowded, and water is scarce and delivered at low pressure. The infrastructure problems, in turn, are worsened through the natural difficulties arising from the geographic isolation of many areas in the P'hilippines, with the accorapanying need for more efficient inter-island transport. 4.5 Further constraints to the development of industry in the regions have arisen through the concentration of Government decision-making in Manila. Some organizations, such as NEDA, have regional staffs, but the BOI and the MOI have only one office in Manila.. This has made it more difficult for entrepreneurs in the regions to avail themselves of the incentives offered for industry. The Mission believes that the correct approach to this problem is to restructure and simplify the incentives system and make it more automatic in its application (as discussed in Chapter II). This would help in making investment incentives more easily available for regional industry than at present. Li Including the metal fabrication facilities in Iligan City which is classified as Central Mindanao.  - 52 - 2. Effects of Concentration 4.6 The Government has been keenly aware of the regional disparities in industrial growth and investment and has sought to divert industry to the regions. The main concerns have been the desire to ease the overcrowding in Manila with its consequent economic and social costs, and to ease the problems of unemployment and outmigration in the regions. The problems in Manila with its congested roads and urban slums are obvious, yet Manila is still attracting more people each year. The 1975 Population Census recorded that the proportion of the population that had immigrated to Manila from other provinces between 1971 and 1975 was 8.3%; this compares to 3.1% for the rest of the country./l This immigration pattern reflected closely the high and growing incomes in Manila compared to other regions (see Annex Table 4.7). For example, in 1975 per capita GDP in Manila was P 4,529 (1972 pesos) compared to P 1,625 for the whole country. 4.7 The most efficient way, in the long term, to tackle the problems of regional disparities is to increase incomes and provide infrastructure and key industrial services, including finance in the already industrializing regions outside Metro Manila. The key to increasing incomes lies in industrial investment leading to increased manufacturing output and absorbing work force increases that cannot be handled by increasing agricultural production. B. Present Strategies and Policies 1. Planning 4.8 The Government, through NEDA and assisted by UNDP and the Bank, has devoted much effort to regional planning. The 1978-1982 Development Plan,/2 inter alia, pointed to regional income disparities and stressed the Government's objective of making depressed regions grow faster than the richer, more developed regions. This would be achieved through an integ- rated approach to each region's development, highlighting the expansion of agricultural production, together with improvements in the distribution and marketing systems. At the same time, industrial development, particularly small and medium industries, would be encouraged and infrastructure support and social services provided. In general, industrialization is envisaged as the long-term output of the program and the key to providing productive /1 The only other egions with relatively high immigration ratios were Northern Mindanao, 6.1%, and Southern Mindanao, 6.0%. /2 Five-Year Philippine Development Plan, 1978-1982, Manila, September 1977. In addition, a separate Plan has been prepared for each region.  - 53 - employment. Under the Plan, the regional cities are to serve as the basic providers of services and facilities to the disadvantaged areas and as links between such areas and the national economy. 4.9 The Bank, in it; role as Executing Agency for the NEDA/UNDP Regional Planning Project, has assisted NEDA in developing regional plans. /1 Regional investment programs will be prepared for each region during 1979, consisting of programs and project packages, to translate into action the objectives and strategies of the regional Five-Year Plans. This emphasis on project implementation cainot be stressed too much. Sufficient broad planning has been done and the efforts of the Government should turn towards the more difficult practical problems of designing and executing projects to increase income and thus lessen regional inequalities. Project implementa- tion is discussed below. 2. Incentives 4.10 Industry in the Philippines operates under a comprehensive and complicated system of tariffs, import licensing and fiscal incentives (see Chapter II). In themselves the tariff system and most of the investment incentives are meant to be neutral in their regional impact, although to the extent that they disadvant:age small and medium industry or labor-intensive industry, they indirectly discourage regional dispersal, since these are the industries that, ceteris paribus, might be expected to locate outside Manila. The industries that by and large have been encouraged in the regions are relatively capital-intensive primary-product processors located near supply sources. To the extent that the incentive system has encouraged relatively more capital-intensiye import substitution industries, they have tended to locate in or near Manila. 4.11 The most direct policy designed to assist dispersal from Manila is the ban on new non-export projects within a 50 km radius of Manila. This ban, however, has meant simply that industry has grouped just outside this limit, particularly in Cavite and Laguna provinces. While this has helped ease the congestion in the heart of Manila, it has not helped the more remote regions. The 50 km ban has recently been relaxed following complaints about the difficulties it caused. Another discretionary policy influencing location is BOI's practice of negotiating the location of projects at the application stage. A large electronics factory is planned for Baguio, and a watch factory for Cebu. This practice is a step in the right direction, but /1 The Bank also studied in detail a regional strategy for Region VII. See Report No. 2264-PH., "The Philippines: A Development Strategy and Investment Priorities for the Central Visayas (Region VII)", January 4, 1979.  - 54 - broader and more specific measures to assist industrial relocation are necessary if any real progress is to be achieved. Policy measures are discussed in paras. 4.19-4.25 below. 4.12 The only investment incentives specifically directed towards assisting regional dispersal are the deduction of twice labor cost plus local raw material cost from taxable income up to a maximum of 25% of export revenue, and a tax credit of 100% of infrastructure works undertaken by an export firm in the provinces. These incentives, however, have had a minimal impact on regional dispersal. Studies undertaken in the UP Study /1 found that firms did not regard them as significant. Since any registered firm can claim a labor cost plus local raw material deduction, the extra labor cost deduction is worth something only to firms with labor cost and raw materials less than 25% of export revenue; this severely limits the value of the incentive. The other incentive, the tax credit on infrastructure, amounts to a substitution for adequate public infrastructure expenditures, and many firms are not prepared to incur such heavy front-end infrastructure costs, even if they may eventually receive a tax credit, and then only if their project is profitable. C. Future Steps 1. Infrastructure 4.13 The crucial bottleneck is in infrastructure, and this problem should be addressed as a matter of priority. The major regional cities need main infrastructure such as water, power, telephones and inter-island transport; and the Government's-plans for provision of such infrastructure should continue to be given high priority. Experience in other countries has shown that industrial estates can be an efficient way to package infrastructure for industry at reasonable cost. In present circumstances, prepared industrial sites for the outer regions with available water, power, roads, telephones and other necessary services are a key prerequisite to regional industrial growth. Provision of such sites, of course, should usually follow delivery of the main infrastructure. NEDA and the Planning and Project Development Office of the Department of Public Works, Transport and Communication have drawn up plans for regional industrial estates. The problem is how to implement the estate program. 4.14 The industrial estate program, as outlined in the Five-Year Develop- ment Plan envisages estates in major regional cities, such as Davao and Cebu, but also proposes estates in the more depressed regions such as Albay and Northern Luzon. Such estates in depressed parts of the country are intended to ease the social problems arising from chronic unemployment and outmigra- tion. While these objectives must be encouraged, the Mission questions whether providing industrial sites is an efficient way to achieve them. In /1 Working Papers Nos. 4 and 23.  - 55 - remote areas, where indusl:ry is minimal, agricultural development will be more effective than industrial sites in increasing income. The absence of industrial sites and services is only one of the factors inhibiting industrial growth in the depressed regions. The absence of skilled labor, remoteness from markets, or lack of experienced entrepreneurs are likely to be stronger reasons for the lack of industry. By contrast, in the major regional centers, where industry is, at least to some extent, growing naturally, such factors are less important, and the infrastructure problem becomes of prime importance. Consequently, industrial estates, with the support of external infrastructure, should be focussed on major regional cities as growth poles. 4.15 Such a focus is also indicated because the resources, both finan- cial and managerial, that can be devoted to estate development are limited, and their dispersal over many cities would only lessen the chance of quick, tangible results. To minimize initial costs, areas must be chosen which already have significant natural growth and future potential. This would ensure that the investments have the quickest and largest impact. Obvious cities for estates are Cebu, Davao, and perhaps Iloilo or Bacolod. These estates could handle medium-sized labor-intensive industries. The Cagayan de Oro/Iligan corridor, with its cheap power and deep water ports, is the obvious place to serve heavy industrial development. Other estate sites may be viable in the longer term, but should probably be developed only after the above projects have been proven successful. The estates should be developed in or near the existing towns, since their probability of success will decrease the further they are from the natural growth centers. 4.16 In addition to these projects, Central Luzon and Southern Tagalog, the most populated of the regions outside Metro Manila, must necessarily be developed as a major industrial center and as such, action should be taken to locate suitable industries in designated parts of this region. Such action would help provide an alternative pattern of industrial location, supplement- ing any restriction on industrial development in Metro Manila as discussed in para. 4.23 below. 4.17 While NEDA has drawn up the industrial estate program, the Mission feels that the responsibility for coordinating the program's implementation should rest with a line agency, preferably the Ministry of Industry. At the same time, actual project implementation should be carried out at the regional level, either by public or private companies. If necessary, regional develop- ment corporations could be established to operate estates. 4.18 The Government, through the Export Processing Zone Authority,(EPZA) has built an Export Processing Zone at Bataan and is constructing another on Mactan Island near Cebu. The Bataan Zone has been a great help to industries located there in simplifying import and export procedures. The Zone employs over. 20,000 people and had gross exports of IJS$44.8 million in 1977. However, the Zone was built in a remote area with consequent heavy costs which cannot be recovered. In the future, the EPZA intends to construct such zones in places where population and some infrastructure already exist. These zones will help exporters move to the regions. In addition, the regional  - 56 - industrial estates should contain bonded warehouses for individual businesses or serving groups of smaller entrepreneurs to facilitate export. At present, bonded warehouses must belong to one firm and are allowed only to BOI-registered companies. 4.19 The Mission feels that industrial infrastructure in place, as discussed above, will substantially reduce the current bottlenecks. However, efforts will also have to be made to press ahead with plans for improving inter-island transport to link the major industrial centers with raw material sources and with markets. Such transport is crucial, given the geography of the Philippines, and without it industry will develop to serve local areas but will not reach the full potential that could arise through an efficient linking of the country's major commercial centers. 2. Incentives 4.20 It is clear that incentives should play a greater role in assisting regional decentralization, if the Government's objectives are to be achieved. Along with infrastructure development, appropriate incentives and credit provisions are the most effective tools to ensure that industry will move away from Manila and the Center (i.e., Central Luzon and the Southern Tagalog provinces adjacent to Manila). 4.21 Given positive steps to improve infrastructure and other essential services such as credit, a positive incentive policy would induce industries to locate away from the Center and make the best use of the advantages being offered in the outer regions. In particular, those regions which already have some industrial base (Western and Central Visayas and Northern and Southern Mindanao) have economic advantages (e.g., lower wage costs, lower construction costs in some cases, and less congestion) which entrepreneurs should be encouraged to exploit through proper incentives. A positive incentive policy would encourage regional dispersion by: (i) discouraging industry in Metro Manila; (ii) giving neutral treatment to investment in the growth region surrounding Manila; (iii) encouraging the outlying regions by giving them preference in the adminstration of a simplified incentive system; and (iv) avoiding excessive fiscal costs. 4.22 Further, export incentives would aim at putting all export producers on a free-trade basis, permitting duty-free imports of raw materials and other inputs into export industries, and providing preferential credit for working capital. The simplified system recommended in Chapter II would be easier to administer and give firms in the outer regions the same advantage enjoyed by those in the Center. 4.23 Until recently, industry in Manila was limited by the 50 km ban on non-export oriented projects. However, such a ban may be too restrictive in that it may not be practical for certain industries, say, for market or supply considerations, to locate outside of Manila. A more efficient way to discourage industry in Manila would be to levy an increased industrial property tax in Metro Manila and encourage, through a simplified incentive system, the establishment of larger projects outside the Center. For this  57 - purpose the Center would include, in addition to Metro Manila, the Central Luzon Region and the Southern Tagalog Provinces adjacent to Manila. The objective would be to induce location of new major industries outside the Center, but still to allow those firms that had a sufficient need to be in the Center. Conditions in Manila could also be helped through more comprehensive locational planning to smooth traffic flow and ease industrial crowding. Another way to avoid congestion in Manila would be for the BOI, as a general policy, not t.o extend investment incentives in Manila, except in those special cases that fitted in with locational planning or could show that they did not add. to congestion. 4.24 A property tax surcharge on industrial sites in Manila would lead to accelerated growth in the central region just outside Manila. Such development should be encouraged, but should occur naturally without special incentives. For.the remainder of the country, special encouragement should be given, particularly to the larger projects. The Board of Investment can encourage the location of large economically viable projects in the outer regions by direct negotiations. The incentives, as discussed in Chapter II, should be simple to operate and administer and apply equally to all firms within the industries being encouraged. In administering them, special attention should be given to the economic rate of return, the protection required and the employment effect. Of special importance in the outer regions.would be tax credits or subsidies for labor training, deductions of labor cost from taxable income, and tax credits for necessary infrastructure development. Further, in the outer regions, a somewhat lower rate of return might be tolerated in order to allow for any disadvantages of locating in the outer regions and the external benefits from easing congestion in Manila. For example, if in the Center the cut-off rate of economic return were 15%, it might be 10% in the outer regions. The extent of preference given is difficult to determine a priori but should be related to the additional costs of locating outside the Center. The Government could study these costs to obtain some idea of appropriate incentive levels. These recommendations, if adopted, would mean that the incentives system would have a much sharper focus in encouraging regional dispersal than is now the case. 4.25 The current BOI practice of regional promotion through negotiation on individual project location should be continued, particularly with respect to large capital-intensive projects. If such projects are economically justified, they should be directed to the regions where they would also be instrumental in attracting ancillary industries, often-smaller and more labor- intensive. 4.26 It must be stressed that, without adequate infrastructure, such an incentive policy will not work. Industry will continue to group in and around Manila and additional taxes will only add to costs and prices. A dual policy of infrastructure and incentives is the key to a successful dispersal of industry.  - 58 - 3. Regional Industrial Promotion 4.27 Some decentralization of Government decision-making for industry is necessary. In many cases, businessmen have to be in close contact with government institutions and regional businessmen may be disadvantaged when they have to deal with Manila all the time. How much decentralization is necessary? Too much centralization will disadvantage regional entrepreneurs, but, on the other hand, too much decentralization will increase bureaucracy and impose additional burdens on the Government's already limited staff resources. 4.28 Currently, the planning function is regionalized through NEDA, but industrial policy decisions by the MOI and BOI are centralized in Manila. The small industry programs, such as MASICAP and SBAC.are regionalized and. in fact, MASICAP operates only outside Manila. At present, businessmen in the regions, especially the smaller ones, are handicapped by having to deal all the time with Manila in the complex and lengthy process of obtaining BOI registration and incentives. However, if incentives were simplified and the outer regions given preference, there might be fewer problems in dealing with Manila. The BOI Governors are making increasing efforts to represent their policies to the outer regions through personal visits and seminars. Further action in this complicated task may well be worth considering. For example, there might be some advantage in having one BOI officer stationed in major cities such as Cebu and Davao, to explain BOI procedures and help firms in applying for incentives. Regional industrial development would also be helped substantially through a strengthening of existing regional administration, in the cities and provinces and in the main line agencies. Proposals to streng- then regional administration should receive the wholehearted support of the Government and should be included in a program of strengthening industrial support services in the outer regions. 4. Finance and Credit Policy 4.29 Adequate industrial finance is another key prerequisite to a successful dispersal policy. The regions are presently served by branches of most major Philippine banks; development finance for industry is provided mainly through branches of DBP and through private development banks (there are 35 such banks spread throughout the country). IGLF funds are also available for SMI in the regions. Despite such services, businessmen in the regions continue to complain of difficulty in obtaining sufficient finance, particularly working capital finance. 4.30 The Government, attempting to make finance more readily available to regional industry, has directed that DEP and IGLF aim to channel 60% of their lending to areas outside Metro Manila. In fact, over the past three years, 59% of IGLF's loans and 71% of DBP's industrial loans have been made outside Manila, with 29% and 22% respectively in Central Luzon and Southern Tagalog. The commercial banks directed most of their industrial operations to Manila, and by March 31, 1978, 92% of total private commercial bank credits out- standing in manufacturing were in Metro Manila. Hence, there is no doubt that the commercial banks - and the financial community in general - should make a much greater effort in assisting--industrial investment and production -in the outer regions. Clearly, Government action in infrastructure and industrial  - 59 - incentives should be supplemented by greater private financial support. Without more financial cooperation, regional industrial development will continue to suffer. 4.31 Businessmen in the regions also complain about the excessive time taken for DBP to process loans. One procedure that does delay processing of loans through DBP is that loans over P 150,000 must be approved by the head office in Manila. DBP's management restrictions, however, are necessary at this stage to ensure the quality of its loan portfolio in the regions. W4hile it is necessary to continue improving project appraisal and supervision capabilities of branch staff, some restrictions are likely to be necessary to cut down on future arrears. Nevertheless, it is important that DBP make continued efforts to increase the supply of funds and reduce processing times, at least in the more rapidly growing industrial areas. This could be approached by finding ways to give more autonomy and incease staff capabili- ties in the larger branches. As an alternative, regional development banks could be considered for the more rapidly growing outer regions. 4.32 There are signs that project finance is becoming more readily available in the regions. PDCP now has 5 regional branches and has plans for one new branch per year. The private development banks are under review for increased financing through a rediscount facility with DBP, and DBP has established a training institute for staff of private development banks to up- grade their development banking skills. In the future, such banks may become an efficient channel for financing investment in the outer regions from official sources. Furthermore, the proposed extension of IGLF facilities to medium industries and the increased margins for banks using IGLF should increase the credit supply in the regions.- Further impetus could be supplied if the Government were to consider favorably applications for new banks headquartered outside of Manila. In the final analysis, however, increased credit will come most readily with an increased pipeline of bankable projects and i:his will occur only if the Government introduces the correct policies to reduce the regional disadvantages described in this chapter and if more effective technical assistance is given to SMIs. 5. Other Policies 4.33 Many other Government policies will have an impact on regional industrial dispersal. The export policies, including trading houses and free zones (discussed in Chapter II), will certainly help the growth of export industries to use the low labor costs outside of Manila. Any strengthening of the MASICAP and the SBAC programs will directly help regional SMIs, since these programs are already directed away from Manila. Similarly, policies such as labor training and industrial extension services in the engineering industries will have a direct effect on SMI in the regions. In particular, there is a shortage in many areas of adequately trained skilled labor, and labor training in the regions should be given increased emphasis.  - 60 - 6. Regional Project Promotion 4.34 The projects that could feasibly be initiated in the regions fall into three main groups: (a) industries relying chiefly on cheap labor and infrastructure, such as garments, electronics, and footwear; (b) large capital- intensive projects, such-as the proposed iron and steel complex; (c) projects based on domestic raw materials, such as in the food processing sector. 4.35 The analyses of individual industries (Chapters V-IX) give examples of branches that might have special advantages in the outer regions. Besides the leather and furniture industries, special mention might be made of the possibilities of locating food processing industries away from Manila (e.g., an integrated sardine project in Palawan). The suggested small power loom weaving project (Annex VII-2) would also be suitable for development in the regions. Certainly economically viable capital-intensive projects should be directed to the regions, where their linkages would create much needed employment and improve regional incomes. 4.36 Further project promotion and preparation work will result from the current phase of the NEDA/UNDP/IBRD Regional Planning Project. The outcome of this work should form the basis for a ranking of viable projects in accor- dance with resource availability. Accompanying such project preparation, regional and local government administration capabilities should be improved so as to ensure that the identified projects can be quickly and smoothly implemented. D. Summary of Recommendations 4.37 In summary, the Mission recommends the following steps to assist in regional dispersal of industry: (a) Emphasis on infrastructure improvement, particularly on industrial estates in selected areas of the country with high potential for industrial growth; (b) Simplification of investment incentives and hence no large-scale decentralization of BOI; (c) In administering investment incentives, the outer regions would be given preference, especially for larger projects, and location in Metro Manila would be discouraged through an increase in indus- trial real estate tax and unavailability of investment incentives except in special cases; (d) Improved planning of locating suitable industries in Metro Manila, Central Luzon and Southern Tagalog; (e) Increased commercial bank financing of industry in the outer regions; and (f) Increased investment finance through existing institutions and expansion of the private development banks in the outer regions.  - 61 - CHAPTER V THE STEEL INDUSTRY A. Structure and Organization 5.01 Philippine steel making dates back to 1951 when a rolling mill for bar products was first started. Since then, it has developed into an industry with some 50 firms, with a rated (rolling) capacity of over 2 million tons per year (t:py). Sub-sector Number of firms 1974 1978 1. Melting and rolling plants 29 31 2. Sheet rol:Ling mills 1 1 3. Tinning p:Lants 1 1 4. Sheet - galvanizing plants 9 10 5. Tube and pipe mills 5 7 Total 45 50 5.02 As summarized in the following table, the structure c,f the Philippine steel industry differs from that of many other steel. producing countries in that indicated capacity for rolling and finishing (over 2.0 million tpy) is large in relation to market demand (about 1.05 million tpy), and especially in relation to its very low rated raw steel capacity (about 450,000 tpy).  Table V-1: THE STRUCTURE OF THE PHILIPPINE STEEL INDUSTRY Indicated Steelmaking 1977 Actual % Product Number of Typical Rolling/Finishing Capacity Production Capacity Group Plants Products Capacity (tpy) (tpy) (tpy) Utilization 32 Wire rod/bar, 1,250,000 (Below) 472,000 38% Non Flat Reinforcing bar, Products small sections (10) (Of which have (458,000) (234,000) 51% steelmaking capacity) Flat Products 1 Hot rolled coil, 500,000 /a (None) 110,000 lb 22% plate + sheet 2 Cold rolled coil 300,000 la 193,000 /b 64% and sheet Coated 1 Tinplate 130,000 82,000 68% and 9 Galvanized sheets 395,000 102,000 26% Other 5 Pipes and tubes 130,000 40,000 31% Products Totals 50 2,700,000 /a 458,000 37% /c (Appx) /a Not all is available for sale, i.e., some hot rolled product is used for cold rolling and pipe, some cold rolled is used for tin and galvanized, etc. /b 1978 data. /c Composite, including steelmaking.  - 63 - 5.03 National Steel Company, the main producer of flat products, has fairly modern (but low capacity) rolling mills for plate. hot rolled coils /1 and sheet, and cold rolled coils and sheet. It has no primary steelmaking capacity for flat products, but instead utilizes semi-finished products (mainly slabs, and some hot rolled coils /2) purchased mostly from Japan and Australia as its raw materLal. 5.04 In non-flat products, the industry is characterized by a large number of small rolling mi:Lls (primarily for reinforcing bar and vwire rod) which are based mainly on use of purchased billets as raw material. However, several plants for non-flal products have their own small electric furnace and/or open hearth steelmalcing shops which produce "billet-sized" ingots for rerolling. Almost half of the billet equivalent tonnage is locally produced. One firm (PBM) has a modern continuous casting machine for the production of continuous cast blooms for subsequent rolling. The range of production equipment runs from modern and efficient /3 electric arc furnace shops with modern rolling mills (i.e., Armco - Marsteel) to older bar mills using much rnanual labor, and old, higl -cost open hearth steelmaking furnaces (PBM). Although continued operation of several parts of the non-flat steel producing sector may not be economic:, the older (often almost fully depreciated) plants may still be able to compete in their own local markets with freer selling prices and less tariff protection. High production costs (especially with increasing costs of energy) may lead to shutdown of the least efficient facilities. 5.05 Given the structure of the industry, there is much competition among the firms in non-flal:products, as well as in galvanizing. There is, however, only one firm now involved in the production of hot and cold rolled sheets and one other firm which manufactures tinplate. 5.06 Location. Over 80% of the individual steel producing firms in the 1]hilippines are located in the Metropolitan Manila area. Most of the firms based in Manila are smaller producers of non-flat products, while the one large flat products producer is located in Mindanao./4 /1 See para. 5.16 for description of limitations of National Steel's hot rolling mill. ,/2 It also utilizes some CR coils to balance and make best use of its facilities. /3 "Efficient" in terms of utilization of raw materials, fuels, labor and other inputs, and quality of output. /4 National Steel's main facilities are located in Mindanao, but the Company has recently acquired a smaller cold rolling mill in the Manila area.  - 64 - Installed Employment Region Capacity (M) (%) 1. Metropolitan Manila 73 87 2. Luzon 1 1 3. Visayas 2 2 4. Mindanao 23 10 Source: MIRDC, February 1979. B. Operations 1. Labor 5.07 The labor force in the industry has increased from 10,800 in 1974 to 12,700 in 1978. There is an abundance of unskilled workers as well as graduate engineers. On the other hand,it is difficult to obtain, train and retain the many skilled and semi-skilled workers needed for an efficient steel industry. The education system is not well-matched to the requirements of the steel industry. Recently, the shortage of skilled workers has been aggravated by emigration of technicians to the Middle East for higher wages. 5.08 The Metals Industry Research and Development Center (MIRDC) has a good comprehensive program for training the required types of workers, but its capacity should be expanded to increase the number of workers it can train. Additional training - by industry itself - will also be needed, since MIRDC cannot but meet part of industry's requirements. 5.09 Labor costs are a small fraction, often 5% or less, of total pro- duction costs. This is because purchased materials represent the greater portion of costs (especially in non-integrated plants), while wage levels are low (often about US$0.50/hr equivalent). Some plants use incentive pay systems, with a favorable effect on productivity (and overall machine capacity). Wages in the Philippine steel industry have risen more slowly than those in neighboring steel producing countries, giving the Philippines an advantage in cost per man-hour.  - 65 - 2. Performance 5.10 Operational performance of the industry has not been favorable over the last few years. Several factors besides domestic market limitations and excess capacity contribute to low productivity, quality problems, and poor overall utilization of installed production capacity: (a) Severe maintenance problems; causing breakdowns, long down time and equipment outages, and also some problems with consistent product quality, (b) Lack of preventive maintenance, and maintenance plannning; (c) Long periods without adequate spare parts; (d) Frequent power outages, low line voltage, or frequency problems; (e) Lack of adequately trained personnel in operations and main- tenance, contributing to breakdowns; (f) Difficult climatic conditions in some areas - constant high temperature and humidity, with occasional floods; (g) inadequate communication facilities, as needed to promptly correct difficulties. These problems have often resulted in high production costs. 5.11 Most managers feel it will take many years to overcome these difficulties and to start matching the levels of machine productivity and material yields being achieved in developed countries. 5.12 As indicated in the Table on page 2, the industry suffers from generally low capacity utilization. Field visits suggest capacity utili- zation rates of 50 to 60% were typical in 1978. Some improvement was expected in 1979. 5.13 Some of the problems of low productivity and high production cost are related to the use of older, less efficient equipment and facilities. For example, the small (40 ton), old open-hearth furnaces at the Philippine Blooming Mills are likely to have high fuel consumption and low productivity, and thus to yield high cost steel. Other furnaces of very small capacity (approximately 3 to 10 tons/heat) and older small rolling mills oif less than 50,000 tpy capacity may be high cost producers when making plain carbon steels. However, some of the products being manufactured are very simple, and with low capital charges, and very low labor costs, the continued operation of smaller ("manually fed") rolling mills should not be ruled out categorically - especially where they adequately serve a small regional market, (and in cases where they do have furnaces to make their own raw steel, they may have a low cost scrap supply.) 5.14 In any case, increased freedom of competition - with gradually reduced tariff levels - would be the best means by which the truly high cost producers could be gradually phased out. Some of the more modern electric arc furnace operations, continuous casting, and rolling mills should be able to produce non-flat steel products at competitive costs if supplied with economic raw materials /1 and are properly operated and maintained. /1 There is some risk of high costs due to dependence on (imported) scrap which is subject to major variations in availability and cost.  - 66 - 5.15 In the flat products sector, machine productivity and overall utilization of installed capacity also appears to have been low in recent years. The key individual units involved (involving large capital investments) are the hot and cold rolling mills of National Steel Co. - which appear to have been utilized at only about 50% capacity (or less). Reasons are numerous: operational problems, maintenance problems, change of company management, market demand, quality, and other factors. In any case, the same equipment has achieved more favorable performance levels in other locations, and there is potential in the Philippines for increased production, higher quality, and lower costs of flat products. 3. Quality - Flat Products 5.16 One company, National Steel Co., produces flat products; several other firms, (especially coil galvanizing, and a tinplate producer) are in- volved in subsequent operations utilizing the flat products produced by National Steel Co. as well as imported steel. The major production facili- ties of National Steel include slab reheat furnaces, conventional roughing mill, reversing hot strip mill /1 (steckel) and pickling, cold rolling, electrolytic cleaning, annealing, temper rolling, shearing and finishing facilities. These facilities were considered up-to-date and reasonably modern in the late 1960s and utilize similar technical processes as being used today, but without the latest advances and refinements. They should be able to produce steel products of acceptable quality, if properly operated and carefully maintained. 5.17 In subsequent operations after the steel plant, consumers should have no major problems in galvanizing or in using hot rolled plate. Product quality of cold rolled sheets should be acceptable to appliance makers, the automotive industry and other users, although there may be some surface problems in the more critical applications, due to annealing and hot rolling limitations. Some deep drawing qualities and other specialized steel grades are not now available in the Philippines, and will probably continue to be imported. 5.18 Significant problems have, however, been experienced with quality tinplate production at reasonable costs. Can manufacturers complain about high costs, low quality, and lack of adequate sppplies of locally produced tinplate./2 Domestic tinplate prices are now approxiately 28% higher than /1 Includes reversing steckel mill - which is known to have some inherent problems with off guage material at coil ends, and other moderate problems with temperature control, and control of mill scale (surface). /2 Imports have averaged some 40% of total consumption in recent years.  - 67 - corresponding "World" prices, and the one company involved in tinplate production (Elizalde Company) has been incurring substantial losses, even with its rather high selling prices. Reported overall product yields at Elizalde have been as low as 60% in some cases, with yields on prime products sometimes in the neighborhood of 35 to 40%. IJnder these conditions tin- plate could not be produced at reasonable costs. 5.19 The main cause of low yields and poor quality of tinplate lies with the raw material, black plate. The most serious problem seems to be surface rusting, a problem which has been aggravated by the recent physical separa- tion /1 between National Steel's cold rolling operations (conducted in Mindanao) and Elizalde's electrolytic tinning operations (conducted in Manila).The difficulty of packaging and transporting the steel coils for tinning includes a trip of about ten days involving multiple handLing, high temperatures, and humid conditions. There are also believed to be some problems with operating practices and/or installations in the electrolytic tinning line itself, which are being analyzed and corrected by Elizalde. 5.20 Close attention to quality control in the production of black plate, especially in modified practices of electrolytic cleaning and annealing, will be needed. Also better packaging (at additional cost) and carefuL handling by truck, crane, and barge will be beneficial. In addition to the tin line modification being handled by Elizalde, these steps should result in signi- ficant improvements in product quality and some reductions in cost of tin- plate production. Further, more careful control of operating practices, quality, and equipment maintenance will be required to achieve reasonable production levels and product cost. Quality - Non-Flat Products 5.21 Some of the rolling mills used for production of non-flat products, especially reinforcing bars,, may not achieve the close tolerances typical of most modern rolling mills. However, this is not believed to be a serious problem for the relatively simple rod and bar products produced in the Philip- pines. The physical quality of most of the products rolled from imported billets is believed to be suitable for the application involved. Complaints about product quality involving non-flat products are not believed to be a major problem. However, continuing small investments/replacements/refinements will be required in the future in order to keep abreast of a continuing trend toward higher quality products being produced in the world steel :Lndustry. /1 Electrolytic tinning operations were originally done at the same location as cold rolling, but for unknown reasons the tinning line was moved to Manila in early 1970's.  - 68 - C. Protection 5.22 The structure of protection in the steel industry is highly uneven among different branches. It is governed by these factors: (a) Nominal import duties on inputs are low -- viz, 10% on scrap, billets, slabs and hot rolled coil. However, cold rolled coil, an input for galvanizing and blackplate used in electrolytic tinning, has a 30% duty. Outputs, viz tinplate, galvanized sheets and bars and rods, are subject to a 50% duty. (b) In bar, rod and sheet production the raw material input accounts for a high proportion (60-80%) of total cost. Hence, small changes in raw material costs markedly affect the protection on value added. (c) Imports of inputs are also governed by licensing, and domestic prices are set by official agencies. Thus, the domestic price of rods and bars is 23% above international levels, making the tariff redundant. Protection % On Value Item Nominal Actual Added Tinplate 50% 14% -23 14% 92 /a Galvanized Sheets /b - 60% 150 Rods and Bars 50% 283 23% 103 /a Assuming duty-free imports of raw materials (coils). /b Assuming indusry uses domestic coils which cost 54% above international level. Source: See Annex V-4.  - 69 - 5.23 The 32 rod and bar mills, production of cold rolled finished products by National Steel, and most galvanizing plants receive effective protection, (i.e., on value added) over 100%. The effective protection on rods and bars (103%) would be even higher (283%) if domestic prices were not controlled. 5.24 Tinplate production is put at a disadvantage because of domestic price controls. Government controlled prices for tinplate (especially tinplate used for the canning of milk) are not set high enough to offset the high cost of local inputs and otherwise high production costs. As a result, tinplate production normally receives negative protection. In 1979 the Government is permitting duty-free imports of 60,000 tons of cold rolled coils for tinplate, making domestic tinplate production profitable (effective protection 92%). 5.25 Protection policy has been partly responsible for low capacity utilization (often below 50%) and high costs in the industry. Despite high prices, profits and return on investment are unsatisfactory. 5.26 High levels of protection (through tariffs and import restrictions) have provided financial incentives conducive to premature investment in facilities (mostly in rolling mills). They have also relieved necessary pressure on many important parts of the industry to improve its basic performance and achieve reasonable levels of production costs. Lower levels of protection would have been conducive to more rational facility planning (new plants/expansion) in tune with realistic market estimates, and to higher standards of operating performance than have actually been achieved. 5.27 A rational realignment of tariff on various steel produc:ts would help the industry in improving its performance while increasing competitive pressure for modernization and better planning of facilities. This would require a review of individual product cost structures, and calculation of protection levels which individual branches (i.e., products) require to attain a reasonable return on capital investment. It would involve several changes from the present structure, with fully-finished products (tinplate, galvanized sheets) receiving protection below the present 50% (probably closer to 30%). Reduction in actual tariff rates would have to be accom- panied by relaxation of restrictions (licensing) if it has to have a full effect on industry operations and prices. D. Steel Expansion Plans 5.28 A number of rolling mills, particularly the larger ones, can be operated economically. Some of these mills require modernization and rounding out.  - 70 - 1. Cold Mill Expansion National Steel's cold rolling mill, for example, has basic equipment (Tandem Mill) with an ultimate potential to produce about 700,000-800,000 tons per year (tpy), but at present has a capacity of at most 300,000 tons./1 Expansion (a pickle line, tandem and temper mill modifications, annealing, and auxiliary facilities) at a cost of about $70-100 million should enable its capacity to be increased from its present level to about 700,000-800,000 tpy. This investment would permit the company to increase productivity, improve quality, lower costs of production, and ultimately to lower prices -hence make possible lower protection (as recommended in the previous section) -- and still obtain a reasonable economic return (roughly estimated at 15%) of the new investment. 2. New Integrated Steel Project 5.29 The Government and National Steel Company now have under study a major proposal for an integrated steel facility which would supply approximately 1.5 million tons per year of semi-finished products for home consumption. The cost would be approximately $1.3 billion and the project could be operational five years after it gets underway. A revised feasi- bility study /2 is currently under preparation. 5.30 The size of the integrated mill would, of course, critically depend on the prospective market. The present market is about 1.3 /3 million tons (raw steel equivalent; see Annex V-2). Total projected demand which could be met by the proposed new integrated steel works would approach 1.5 to 1.6 million tons in 1985. This estimate assumes: (a) a 7%/yr compounded growth rate starting in 1978; (b) some expansion of existing steel producers; and (c) approximately 20% of domestic steel demand to be met by imports and steel producers other than the new integrated plant. /1 Depending on product mix, which is somewhat unfavorable in the case of National Steel at the present time. /2 The original Japan International Cooperation Agency (JICA) "Pre-feasibility Study" covered a plant producing 1.0 million tpy; the size of this plant was increased tentatively to 1.5 million tpy at the same time as the Bank Mission, in February 1979; final size of the project will be determined this year. /3 This gives only about 31 kg annual per capita consumption or about 5% of consumption in highly developed countries.  (a) Design of the New Integrated Steel Project 5.31 Project design, Tnakeup of production facilities, capital costs, production costs, sales revenues, and other factors influencing feasibility of the project all depend on the product mix and flow process assumed for the proposed new project. Thus, a new plan based on a larger project, say 1.5 million tpy instead of 1.0 million tpy (or possibly higher if deemed economic by other considerations), will require a detailed study including a re-evaluation of practical alternative flow processes and production plans. 5.32 In order to produce steel at reasonable costs, both the primary facilities (coke plant, blast furnace, basic oxygen vessels, and continuous casting) and also the individual rolling mills /1 (if any) must be of economic size (scale); if this is not the case, unduly high capital cost and operating cost would make Philippine steel less competitive than desired. 5.33 For the new proposed plant (at least 1.5 million tpy), the primary facilities, up through steelmaking, could be expected to be reasonably com- petitive in capital and operating costs if operated efficiently, and if sinter is made available from the Kawasaki (Japan) sinter plant to the blast furnace at a (negotiated) price close to its actual cost. (Use of advanced Japanese operating and raw material purchasing know-how, and existing large port and ore/coal vessels -- up to 250,000 tons - together with the 5 million tpy sinter plant, should be of significant advantage and help in achieving reasonable production cost for primary iron; cost of primary iron is one of the most important single factors in overall cost of steel products). 5.34 However, the product mix of rolled products for the proposed plant (meeting the specific needs of the domestic market) may present some diffi- culties with respect to (a) size and cost of hot strip rolling capacity; (b) related size of continuous casting machines for slabs, and for blooms; (c) timing of installation, and economic utilization of installed capacity (in early years 1984-86). 5.35 Based on estimated market demand and specific product mix, the total requirement for hot rolled flat products (hot rolled coil, sheet and plate) could be expected to be about 1.0 million tons in 1985. Non-flat product tonnage would make up the remaining market to total about 1-1/2 million tons of raw steel equivalent in 1985. /1 The original plan evaluated by JICA called for a (small) billet mill producing 199,000 tpy of billets; for flat products it would utilize modified NASCO hot rolling capacity of 667,000 tpy; a new hot rolling mill was also being considered. In addition, all downstream rolling mills must be reviewed to assure technical compatibility with products of the new integrated plant; economic replacement/additions will also be-reauired in the case of certain mills.  - 72 - 5.36 The capacity of the existing hot strip (steckel) mill (leased to National Steel Company) is about 500,000 tpy. However, that capacity has never been attained in practice due to continuing operating problems. Thus, if the existing slab mill/hot steckel mill /1 were utilized at fuii capacity, the remaining volume of tonnage for a new hot strip mill (if in- cluded as part of the integrated mill) would be small, and probably would not support economic levels of production for several years. Alternatively, the existing steckel mill, which is still usable, could be taken out of service and higher tonnages allocated to the new hot strip mill. Even if this were done, economic cost levels for hot strip production may not be achieved until after 1990 or until production levels could approach 1-1/2 to 2 million tpy. The economic solution to the problem, however, may be to delay building the integrated plant by about 4-5 years, or at least change the time phasing of some plant facilities, for example delaying acquisition and startup of a second slab casting machine, and a new semi-continuous hot strip mill and related facilities. Such delay would achieve a closer match between market growth and installed capacity, and permit a reasonably high degree of capacity utilization even in the earlier years of plant operation. Thus, the economic rate of return on invested capital could be improved (See Summary, para. 11 for additional details.). 5.37 Any proposed project should be evaluated objectively, with allowance being made for significant risks associated with past problems of low capacity utilization/low productivity, low product quality, and associated high over- all production costs. If effective use is made of competent technical assistance from an efficient operating steel company (possibly also with an equity interest in the project), such risks could be reduced significantly. (b) Benefits of the New Integrated Steel Project 5.38 Based on an expanded project, producing about 1-1/2 million tons/yr in raw steel equivalent, the projected employment might be 4,100 new jobs and foreign exchange savings at full operating levels would be about $ million per year./2 This savings results primarily from the costs which would be incurred to purchase semifinished steel products for Philippine market requirements if the project were not completed, as compared with the normal foreign exchange costs associated with the operation of the proposed plant (plus debt service) if it were to be built. /1 May include some modifications to increase capacity and quality. /2 The indicated foreign exchange savings would increase rapidly with increases in steel product selling prices, which could occur during periods of world steel shortages - as in 1974. During such shortages, selling prices could increase the equivalent of 20% or more over the full year. Annual foreign exchange savings associated with the opera- tion of the integrated steel plant could then easily double to about $140 million per year.  - 73 - 5.39 The projected foreign exchange savings are relatively low in com- parison to other Bank steel projects for the following reasons: (a) Main raw materials required to operate the plant (coal, iron ore, some fuels, and scrap) would be imported; (b) The foreign exchange cost of the products to be produced (mainly slab and billets) would be less than the foreign exchange cost of fully-fiinished products normally produced by a steel plant. 5.40 If the technical .and operational issues mentioned above are resolved to a reasonable degree, the prospects for economic basic steel production in the Philippines would be influenced appreciably by how well the following business conditions are satisfied: (a) The existing world excess of steel supply over steel demand will be diminished significantly by the mid-1980s; (b) The availability of semi-finished products - billets, blooms, slabs for rerolling (also to a smaller degree, hot rolled coil) will become less certain, and supply of such items will be subject to increased price volatility; (c) Prices of semi-finished and finished steel products will strengthen relative to prices of major inputs (especially ore, coal, other energy, labor) by the mid--1980s; and (d) Relative prices of steel plant capital equipment are likely to rise. 5.41 Based on information available now, the economic rate of return for a smallS to medium-size integrated greenfield steel project in the Philippines, if it can be operated with reasonable efficiency, may well be in the 7-11% range./l The project would also contribute to the regional development, growth and diversification of the Northern Mindanao economy, including related industries such as refractories, rolls, castings, trans- port, other supplies and services; and it would also provide other indirect benefits such as technology transfer, improved management techniques and practices, advanced training in fields of mechanical/electrical/hydraulic equipment operation and maintenance. All of the above could contribute substantially to indirect employment in the long-term future. /1 This range would be about equal to other conventional small- to medium- sized new steel projects which cannot rely on significant natural advan- tages. The final return may be slightly lower than new conventional or direct reduction steel plants located in areas where low-cost energy is available. Of course. the return on all steel projects could improve if there is a general increase in selling prices associated with possible shortages in the mid-1980s.  - 74 - 5.42 The rate of return indicated above may well be considered sub- marginal - particularly when considered in relation to alternative investments available to the Philippines (see Summary Report). A moderately higher return would be obtained on a larger integrated plant project - say about 2.5 to 3.0 million tons - particularly since it could be combined with more economical production of hot strip mill products (e.g., of 1.5-2 million tpy). The larger, better balanced capacities (2.5 to 3.0 million ton raw steel capacity and 1.5 to 2 million ton hot strip mill, as suggested in para. 5.36), would be justified by about 1991 and should produce a somewhat higher rate of return than the 1.5 million ton plant now being considered. Apart from the difficulty of arranging a larger amount of financing, such a postponement would, however, entail certain risks to the Philippine economy if serious shortages were to develop by the mid-1980s. and if such shortages were to raise world steel prices even above the cost level at which a 1.5 million ton plant can operate. In such a shortage situation, the price of semi-finished products (on which the Philippines would be dependent) could be particularly volatile, and supply conditions, especially for those products, could be sporadic, possibly placing the Philippines in a somewhat vulnerable situation with respect to steel supply. 5.43 In any case, further work on any Philippine steel project should be directly linked to additional effective technical assistance to assure improvement in operating practices, in order to achieve acceptable levels of utilization of installed plant capacity.  - 75 - CHAPTER VT THE MECHANICAL ENGINEERING INDUSTRY A. Overview 6.01 The mechanical engineering industry assumes an important place in the economy: (a) it made up over 40% of gross domestic capital formation in manufacturing over the past decade; and (b) imports of capital goads made up at least one-third of total imports. However, the growth of the industry has fallen behind that of manufacturing generally; its share of value added in manufacturing fell fromt 12.6% in 1967 to 10.8% in 1977. As a result of the slow growth of the mechanical industry, the country has become relatively more dependent on imports,.and it has had less opportunity to build "techno- logical capacity" of industries other than consumer goods. Total imports of products of the mechanical engineering (ME) industry were over $1.2 billion in 1976, of which $652 million in non-electric machinery, $201 in electrical machinery and $313 million,in transport equipment. Exports totalled $24 mil- lion in 1976 and $53 million in 1977 (see Annex VI-2). 6.02 The size distribution of firms in the industry is characterized by a few large companies (assembling cars, making sewing machines and house- hold goods and two jobbing enterprises) and many very small companies. There are relatively few medium-sized companies (including production of motorcycles, appliances, metal containers and one shipyard). The follow- ing shows the relative importance of firms in the industry: Firm Size % of Firms Large 11 Medium 13 Small, 76 6.03 In the formal ME: sector, the average capital-labor ratio is only one-half of the industry average. However, the share of ME sector in total manufactuing employment is,only slightly above one-tenth, since investment in the ME factory sector has been low. However, in the informal ME sector (i.e., in enterprises with less than five workers) employment is more than three times that in the factory sector, and its share in manufacturing is also much higher than that in the factory sector. 6.04 In the present stage of Philippine development the industry uses relatively labor-intensive technology. In its plant visits the Mission did not encounter examples,of excessive capital intensity. There is widespread use of general purpose machinery and second-hand equipment. This has meant that manufacturers have frequently tended to substitute labor for capital. While it is desirable not to rely heavily on highly automated or special purpose machines at this stage of development, there appears to be need  - 76 - for selective modernization and quality-upgrading in certain subsectors. Further, worker training could be substantially improved in order to up- grade skills. Management efficiency should be stressed in order to improve production planning and control. Capacity utilization in the ME sector is perhaps better than in other sectors, although there are many cases of underutilization. 6.05 The Mission covered: (a) the auto ancillary and foundry indus- tries - activities that comprise the major elements of local industrial in- puts; and (b) heavy equipment manufacture - an activity in which the country can potentially achieve a comparative advantage. In addition, the state of the machine tool, the hand tool, the metal container (food cans), and the consumer goods (sewing machine and home appliances) industries were exam- ined. Summary comments on each industry are given in Annex VI-1. B. Comparative Advantage and Incentives 6.06 The ME industry can conveniently be split into two major sub- groups: consumer products including cars and durables, and producer goods including capital goods. Philippine comparative advantage lies more in producer goods than in production of consumer items - this is evident from the Mission's plant observations (Annex VI-1), the difference in labor- intensity of the two major branches, and from computation of domestic resource costs (Table VI-2). While consumer goods industries are rel- atively less efficient, they have received higher levels of protection than producer goods industries. In the interest of efficient longer-run develop- ment, producer goods industries should receive greater assistance from the Government's incentive policies. 6.07 Protection in the ME industry is generally less than in manufac- turing as a whole, although automobiles and consumer durables (refrigerators, etc.) receive high levels of effective protection. 6.08 Tariff rates for the major ME products can be classified into three groups (see Annex VI-2): (a) 10% to 20% - Producer-type ME products (such as industrial machinery and agricultural machinery) (b) 30% to 50% - Intermediate-type ME products (such as tubes, pipes, and bolts) (c) 70% to 100% - Consumer-type ME products (such as household elec- trical appliances) 6.09 The current tariff rates appear to be mainly based on the end use and degree of necessity of commodities rather than the static or dynamic comparative advantages of producing them. Protection of capital goods  - 77 - (usually 20% or lower) is below the total price effect of the overall protec- tion system (at least 30%). Hence, compared with international prices, domestic prices for capita:L goods are below those of other goods in the economy. 6.10 Effective protection of producer goods is one-fifth that of con- sumer goods (Table VI-1). The disparity is caused by the fact that while nominal rates on producer goods are less than protection of inputs, the reverse is true for consumer goods. 6.11 BOI incentives extend exemptions from duty and compensation taxes on imported capital equipment, and tax credits on domestically-produced equipment. Given a strong preference for imported equipment and the small size of domestic production the value of BOI tax credits (on domestic items) is small (less than 7% in 1977) in relation to tax exemptions on imports. These tax exemptions further lower the protection of producer goods in re- lation to consumer goods. In practice, the BOI has seldom been able to enforce the requirement that no incentives be granted to importation of capital equipment which can be produced locally. This requirement should, of course, not be applied to export industries, which the Mission recommends be permitted to import free of duty. 6.12 The ME sector has received relatively little investment credit from official sources. For example, in relation to value added, DBP credits to ME industries were only one-fifth of credits to manufacturing as a whole (P 11 per P 1,000 value added in ME, compared with P 49 in manufacturing as a whole). Further, unlike their foreign competitors, domestic machinery producers do not have low-cost' credits to finance their sales. Increased export and local use of the domestically produced plant equipment can hardly be expected unless long-term capital funds with a low interest rate is available to the purchasers. 6.13 If the ME sector is to expand exports, it will be mainly through a gradual increase of export sales by firms initially producing for the home market. In the ME industry it is therefore particularly important that export incentives are applied in such a way that in effect all export production is on a free trade basis. In this way the many firms with initially relatively small export volumes can benefit. However, at present export incentives, in particular duty-free importation of inputs and capital equipment, is only granted to selected firms approved by the BOI.. Usually only firms with exports over 50% of sales can import inputs and capital equipment duty-free (Chapter II). 6.14 There are at preSent some ME export producers which do not bene- fit from the BOI incentiveS. Thus, one firm, which has been exporting diesel engine components since 1973, has not been able to obtain tariff and tax rebates for their imported material inputs (which are about 70% of total material inputs), since it is not registered with the BOI and does not export more than 50% of its products.  Table VI-1: STRUCTURE OF PROTECTION IN THE ME SECTOR (1974) Input-Output Average Nominal Average Effective Major Categories Industry Groups Sector No. Protection Rate /a Protection Rate /a (%) (%) A. Producer Goods 29 18 (1) Agricultural and industrial machinery 129-131 18 8 (2) Basic metal products 120-121 23 14 (3) Motor vehicle components and other transport equipment 144-147 60 16 (4) Shipbuilding and repairing 142 17 26 (5) Electrical machinery and equipment 132-135 29 27 B. Consumer Durable Goods 67 90 (1) Hand tools 123 39 34 (2) Electrical products 136-138 45 50 (3) Motorcycles and bicycles 146 50 52 (4) Fabricated, structural and stamped metal products 122, 124 - 128 51 75 (5) Motor vehicles assembled 143 93 127 (6) Jewelry 148 91 133 (7) Household electrical applicances 139-141 100 167 /a Unweighted average computed from the estimates in Annex VI-2, Table A.2-1 (on page 258).  - 79 - 6.15 Impact of Incentives. The prime targets for the Philippine policy of import substitution have been non-durable and durable consumer goods. It might have been expected that this strategy would in time lead to the cre- ation of the capital and intermediate goods industries through backward linkage of demand from the final consumer goods industries. However, the :Lncentive structure has failed to provide an infant industry protection to the capital good industries, required to build technological capacity in competition with capital goods imports. While the consumer durable goods industries have supplied the major part of the domestic market, the domestic demand for capital goods haVe been met almost entirely by the imported capital equipment. Further, high protection has been associated with overcrowding. Of a total 36 overcrowded industries more than one-third are in the ME sector, and most of them are consumer durable goods industries (Annex VI-2). 6.16 Comparative Advantage. Relatively higher domestic resource cost (DRC) estimates for consumer durables suggest that the Philippines have rela- tively less comparative advantage than in producer goods (see Annex VI-2, Table 4-3). Protection is relatively higher in ME industries with higher DRCs and may itself have fostered inefficiency. The strong positive correlation between effective subsidy rates and DRCs observed in the ME industries also suggests the specific direction of incentive reform: to reduce the effective subsidies of the industries with high DRCs and to increase them in industries with low DRCs. In the Investment and Export P'riorities Plan (Table 4-3 of Annex VI-2) the Government envisions more active export promotion and;import substitution for most of the ME items for which it has a comparative advantage. For those ME items listed in the plan but for which the country does not have a comparative advantage now, more careful evaluation appears to be needed in order to ascertain the existence of dynamic comparative advantage. A more refined analysis to determine the social profitability of BOI projects is needed. This might be undertaken in the context of more detailed ME sector planning recommended at the end of this chapter. C. Consumer Durables 6.17 Much of the increase in ME output over the past 4 or 5 years was in consumer goods, led by auto assembly and home appliance manufacture, both high-cost operations serving exclusively the home market. A key development issue regarding these industries concerns their ancillary industries which are examined in paras. 6.22-6.28. 6.18 The appliance industry is relatively well established, with out- put more than doubling fromt $30 million in 1972 to about $70 million in 1977. This industry is characterized by a high direct local content of its products (average of over .80% for its major lines of refrigerators, air- conditioners and sewing machines) achieved through vertically integrated manufacturing operations. With improvements in production structure and fa- cilities, this industry has a potential to export, and this factor should probably be a central consideration in its development planning. In this  - 80 - connection, the product strategy can be crucial. Present products are older US models that should be difficult to export in competition with the prod- ucts of the multi-nationals. As opposed to moving up to more advanced or sophisticated models, the industry might consider moving down to a more basic low-cost line of products not made in the industrialized countries, but a demand for which may be presumed to exist in the poorer countries. 6.19 Typical of products now made in the Philippines that have special export implications are food cans, hand tools and sewing machines. There has been some limited export of general-line cans to the regional market, but the importance of the can-making industry is as a supplier to food processing for export. Production of metal cans, mainly food cans, exceeded $40 mil- lion in 1977. Excepting milk cans, whose production is integrated with milk processing, food can fabricators are operating at substantially below 50% capacity because of an apparent inability to supply products of accept- able quality and cost to the canning industry. In fact, some export food processors import empty cans. It is important that export producers are able to obtain tin cans at international costs and quality (see also Annex VIII-2). 6.20 The production of items such as hand tools and cutlery tends to favor low-wage countries because they are labor-intensive and the technol- ogy is relatively simple. However, in the Philippines they have a very high DRC. At the moment, hand tools are made by one large unit, but while it operates at well below capacity, imports totalled about $10 million (1977). The industry feels that locally-made tools cannot compete quality-wise against imports at the high end of the market, and costagainst imports from other low-wage countries at the low end of the market. A reassessment of product and marketing strategy is indicated. 6.21 In sewing machines, the local industry produced about 85,000 units (1977) valued at under $10 million. All are foot-operated models, produced with about 50% local content or less, depending upon whether the machine heads are imported or locally assembled. There is no supplier of precision components in the country. The development strategy for this industry might consider local production of industrial-type machines of simple de- sign, thereby linking this industry with garment-making in the SMI sector. Also, the export of cabinets (linked to the local wood industry) and stands (linked to the foundry industry), presently estimated at below half a mil- lion dollars, could be more aggressively promoted. Ancillary Industries 6.22 With the automotive industry assembly-oriented and the appliance manufacture vertically-integrated, there has not been much opportunity for their ancillary areas to develop. The ancillary industries, as they exist in the country today, consist mainly of small units equipped with general- purpose machines serving the repair and replacement needs of the automotive as well as the non-automotive markets.  - 81 - 6.23 The Progressive Car Manufacturing Program (PCMP) created four key ancillary units within the automotive industry: one engine plant, two trans- mission plants and one body stamping plant. The program was of key importance in that it avoided the establishment of many additional automotive producers and encouraged both domestic production and exports of key components. In 1977 domestic component production was about 53% of car output, with exports of components by PCMP participants adding a further 12%. Yet the achievements of the program should be measured against the unavoidable limitations of a small domestic market. With sales of only 32,000 units divided among 5 major producers (and 15 different models) few economies of scale could be achieved and, in fact, the participants in the program suffered a combined loss in 1977 of P 53 million. Capacity utilization in the 5 major plants producing key components was less than 50'% in 1976 (see Annex VI-2). 6.24 The PCMP program has received protection of close to 100% on final products (through tariffs and tax exemption) resulting in effective protec- tion of over 300%. The Mission estimates the domestic resource cost of ag- gregate PCMP production (based on book values) will range from at least 16 to 52 pesos per dollar (depending on whether BOI or AMII data are used). The incentive scheme has encouraged in-house production of components by PCMP participants rather than subcontracting. 6.25 Increased production of automotive components might involve larger sales abroad and/or more procurement from domestic ancillary firms for con- sumption at home. Either form would require changes in the incentive system. Additional exporl: incentives could be required (even for PCMP pro- ducers), since sales in the protected home market may be more remunerative than exports. For the further development of the ancillary industries, they should receive the same incentive treatment as the PCMP participants. This will require technical assistance and investment credit from official sources. Once items for additional economic domestic production are iden- tified they should receive the same protection as is awarded to PCMP participants. 6.26 With rules for incentives for ancillary production established, the specification of domestic procurement content need no longer play the same regulatory role as at present. Instead it would be better to consider the DRC of net foreign exchange savings or earnings under the PCMP program, and as already suggested, consider appropriate incentives to achieve them. 6.27 Further study is required to identify the products which could be manufactured at reasonable cost. Increases in the domestic requirement would easily lead to an excessive rise in automotive production cost./1 The auto- motive parts industry is composed largely of makers of non-metal parts such as /1 The foreign exchange savings achieved by the domestic procurement are smaller than the 53% obtained in 1977; allowing for import requirements of part production may cut savings in half (see Annex VI-2).  - 82 - rubber, plastic and glass items and includes relatively few makers of mechan- ical items. Metal items are mostly simple fabricated and pressed parts that do not require costly specialized tooling. Further progress in the local supply of original equipment parts would require that engine and driveline parts and other sophisticated mechanical components be produced locally, but new investments to produce them appear not feasible under present market conditions. As a strategy to develop the ancillary industries, it is there- fore suggested that consideration be given to their independent development as efficient local suppliers of simple parts and as exporters. In world trade, the manufacture and supply of parts and accessories have developed into separate production and marketing activities of their own, quite independent of firms manufacturing the end products. One of the factories visited by the Mission appears to have successfully applied this strategy to accomplish a small but significant export of diesel engine replacement parts to the United States. 6.28 In developing a strategy for the sector, the possibility of com- plementary production of parts in other ASEAN countries could be more actively pursued. The Automotive Complementation Scheme deserves further detailed and analytical study to identify alternative economic production possibilities in the ASEAN region (see Annex VI-2). D. Capital Goods 6.29 While growth has largely occurred in consumer goods manufacture it would appear that, in light of the Philippines' comparative advantage emr phasis be given to a systematic buildup of capacity in capital goods. At present, capital goods manufacture is largely confined to jobbing operations supplying repair and replacement parts for mining and other industries, the production of a few lines of fabricated items and an infant machine tool industry: Mining machinery - only some replacement parts are made. Construction machinery - local production limited to concrete mixers and tractor parts. Food processing equipment - some replacement parts are made, mainly parts for bakery equipment. Sawmills - manually-operated sawmills are produced, plus repair parts. Other plant equipment - some simple vessels, tanks, structural units are made and centrifugal pumps are produced but otherwise local production is limited to small replacement parts. Total output of this subsector is estimated at $70 million (1977).  - 83 - 6.30 In machine tools, there is one unit producing center la:hes under Indian license, several units producing simple mechanical presses plus a large number of rebuilding and service establishments. Total estimated out- put of $8 million (1977) reported for this industry actually includes, in large part, tools, dies and molds made by small jobbing establishments. While the capacity of this subsector is very limited, there is a Large and growing market for low-cost standard machine tools (vocational schools, training centers and small shops) that domestic manufacturers can poten- tially supply. 6.31 Given proper stimulation and support, the ME industry c<n achieve economic import substitution of simpler capital items that comprise a sub- stantial proportion of the import bill, and have relatively low DRCs, for example, material handling equipment, road rollers, bakery equipment, some foundry equipment, and heat exchangers, among others. *With reference to the 1977 statistics, a modest 30% rate of import substitution translates to a capital goods market of more than $100 million. In addition, export of foundry products, fabricated equipment and structural items should be possible. 6.32 The Foundry Industry Is comparatively large - some 180 units with an installed capacity of 150,000 tons. The majority are small Uliti tio ,! the industry suffers from excessive fragmentation and competition. Although it is labor-intensive and the Philippines should be able to achieve a low DRC, the Philippines'foundries are not at present competitive. Wi'th suffi- cient market prospects, at home and abroad, it would be worthwhile to mount a comprehensive assistance program for the many small, independeni: found- ries in the country, covering raw material supply, technical assistance, testing services and training. MIRDC would be an appropriate agency to formulate and implement such a program (see Annex VI-3). 6.33 Investments in expansions or new capacities in the capital goods subsector will be costly, and in fact, any substantial commitment by the country to undertake capital goods manufacture will probably require a minimum investment on the order of $100 million over the next few years to cover modernization and expansion of some existing capacities and possibly one or two new projects. Areas of immediate opportunities could be: (a) mining, construction and material handling-equipment where the country has some con- siderable experience in parts production. Investments here will 'Largely be expansion and modernization of selected existing capacities towards the pro- duction of some standard lines of machinery. Foundries, fabricati'on shops and machine shops will all require some new tooling and improved plant layout; and (b) plant equipment which links with growing activities by local firms in plant construction, domestic and overseas. There is no appropriate existing capacity in this area. One large or two complementary smaller projects might be considered, possibly as joint ventures with established foreign makers, designed for efficient heavy fabrication, machining and assembly of selected lines for plant equipment. In addition, there is a need for upgrading operat- ing practices within existing plants, product planning, process control and maintenance, as well as an expansion of training programs, especially for shop  - 84 - supervisory personnel. Since at present the Philippines has limited design capability, external assistance would be useful either direct, through joint ventures, or by assisting MIRDC. E. Conclusions and Recommendations 6.34 The ME industry is heavily concentrated on consumer products and has at present little capacity in capital goods production. About half of the output of ME industries consists of motor vehicles, home appliances, mining and construction of machinery spares. Another 40% constitutes manufac- ture of various small metal products. 6.35 The most crucial and perhaps most difficult task in manufacturing development will be the strengthening of the ME sector. This will require special assistance for stronger infrastructural linkages and improved tool- ing, design and production technology. It will be necessary to determine more carefully in which product lines, especially in capital goods, the Philippines has a comparative advantage and what type of assistance is most called for to help them get established. The most urgent problem areas in the industry are: (a) Raw materials - there are across-the-board problems with avail- ability, quality and cost of local raw materials, notably scrap, tinplate and steel sheets. (b) Plant - constraints in investment and financing are reflec- ted in crowded shops, frequently antiquated tool- ing, costly down time and obsolete methods of pro- duction. Further, capacity is often underutilized and productivity is low. (c) Manpower - there is a serious shortage of experienced shop supervisory personnel and skilled workers, yet very few plants have formal in-house training programs. (d) Technology - deficiencies in product design and enforcement of standards limit production largely to low- value items, and technical services by organi- zations such as MIRDC are severely constrained by lack of funds. 6.36 Emphasis will initially have to be on economic import substitution, e.g., in producer goods or items such as material handling and construction equipment, food processing machinery, heat exchangers, and some foundry equipment. In exports, electronic products and auto parts have been the most important items. Main opportunities to develop new exports should lie in: (a) relatively simple and labor-intensive items such as hand tools, cutlery, foundry products, auto parts and machinery replacement parts (for mining machinery); and (b) metal products that are linked to other export  - 85 - sectors such as overseas construction and food processing for expcrt. Further it may be possible that, under present levels of protection, the producers of consumer durables and participants in the PCMP can be encouraged to increase their exports of finished products and/or parts. The foundry industry also merits priority attention. A basic need is selective modernizaticin and upgrading of foundries to achieve production specialization by type and weight of castings. 6.37 In Research and Development, the country might get into the develop- ment of some standard products, redesigned and adapted for the ASEAN market. This has been done for some agricultural machinery (IRRI tiller) and in connection with the Asian utility vehicle. Among the possibilities are basic, low-cost lines of appliances for the local and regional markets. 6.38 Incentives are provided through technical assistance, credit, pro- tection and elimination of duty-free importation of capital goods in non-export industries. At present producer goods industries tend to receive less incen- tives than other industries. It is desirable that the Government establish a more even level of incentives: narrowing the present disparity between effective incentives in the ME sector and manufacturing in general, and, within the ME sector itself, between underprotected producer goods and over- protected consumer items. Adjustments in tariff rates may best be put into effect gradually as capacity in specific product lines is improved. 6.39 In the administration of incentives, improved capability of small- and medium-sized producers deserves primary emphasis. They need assistance in raw material supply, layout and tooling, production problems, product testing and training of shop personnel. Organizations like MIRDC will require substantially increased resources to render broader and more effective service to the industry. Substantially larger investment credits should be made available for increasing capacity. 6.40 These actions should be guided by more specific product planning within a comprehensive strategy for the sector. Active Government: support is warranted for MIRDC's effort to initiate such a planning exercise. It will have to address the major problem areas listed in para. 6.35e  - 86 - CHAPTER VII THE TEXTILE INDUSTRY A. Introduction 7.01 Until the mid 1950s the textile industry /1 was of negligible size and importance. The pattern of growth from 1955 to 1978, as indicated by num- bers of spindles and looms, is shown In Table 7.1. The industry grew very rapidly to reach roughly two-thirds of its present size during the first ten years. Thereafter, growth hardly kept pace with the deterioration of the older equipment, some of which was of pre-war vintage bought second-hand from the United States. Since 1965 the growth rate in numbers of spindles has been only 3.2% p.a. and in terms of numbers of weaving looms barely 1% p.a. Since 1974, the growth rate of spinning capacity has been slightly more than 2% p.a. 7.02 A complementary view of industry growth is given by Table 7.2. Based on NCSO Annual Surveys, this gives employment, value added and value added per employee figures for woven and knitted textiles for selected years from 1956 to 1974. In terms of employment and value added, the woven textiles sector has been very much more important than the knitted textiles sector throughout the period covered. Initially, knitting was the more rewarding in terms of value added per employee, but since 1960 has always shown a lower ratio and in 1974, the last year of the series, value added per employee in woven textile manufacture was 38% higher than in knitted textile manufacture. B. Present Structure and Performance 1. Processes 7.03 The industry is fully up-to-date so far as its range of processes and products is concerned. Possibly spurred on by the fact that cotton is not yet grown in substantial quantities in the country (in 1977 a little over 2% of consumption was domestically-produced), the industry is making exten- sive use of the whole range of man-made fibers now available in both staple fibre and continuous-filament form. In the absence of a sufficient supply of home-produced cotton, this is fully justified by the generally high durability and low real cost of man-made fibers, particularly the synthetics. The processes used in the conversion of raw materials of the industry into sale- able fabric are thus: (a) conventional spinning of man-made and natural fibers; (b) texturing of continuous-filament yarns (principally synthetics); (c) weaving of both spun and filament yarns; (d) knitting of both spun and filament yarns. and (e) finishing (bleaching, dyeing and printing). J1 This chapter discusses textiles, yarns and fabrics; clothing is discussed in Chapter IX.  - 87 - 7.04 The relationships between these processes is shown in the basic flow-chart (Annex VII-4). Table 7.4 indicates the relative importance of each process in terms of the employment which it provides. At the present time, the number of employed in weaving is disproportionately high for an industry with fairly modern equipment. The reason is that many oE the older looms, although nominally automatic, are not being used as such. This is because they incorporate a now obsolescent shuttle replenishment mechanism, of Japanese marLufacture, for which important spares are no longer available and it is therefore necessary to replenish the shuttles of these looms manually. Very little has been done by way of updating or renewing early installations and in consequence the present equipment of the industry is predominantly middle-aged, if not actually elderly. The situation of spinning is typical of the industry as a whole. Of a total of around one million spindles, the age distribution is: Pre-1945 (bought second-hand) 11% Period 1946-55 6% Period 1956-70 60% Period 1971-78 23% Total 100% Of these, only the post-1970 spindles can be regarded as fit for further service without some measures of reconditioning. The remaining 77% of the total require either complete replacement or substantial renovation and some updating. 2. Capacity and Size 7.05 The industry is now of the right order of size to be able to cater completely to the demands of the home market and have a little spare capacity for export. Although of adequate potential size, the industry does not in fact manage to meet even domestic demand. During 1977, the last year for which the figures were available, approximately 73,000 tons of yarn were produced and 23,000 tons were imported. Of this total 96,000 tons of textiles, almost all was consumed by the home market. Only 5,000 tons was exported and that mostly :Ln the form of garments. There is also believed to be a substantial amount of smuggled textiles taken up by the home market but there are, naturally, no hard figures to support this belief. 7.06 There are no really large mills and no very small mills. In other words the range of sizes met with in the Philippines is not great and, as most mills are very near the optimum size, no real effect of size was seen. In this connection, it is pertinent to note that in general there are no substantial economies of scale per se for units appreciably larger than those at present existing in the Philippines.. The yarn count has some bearing on the optimum size of a mill but size is never a very critical element. It is generally worthwhile to increase size up to 40,000 spindles in a spinning  - 88 - unit and up to about 500 conventional automatic looms (or the equivalent capacity in multi-width shuttleless looms) in a weaving unit. Above this size the benefits of more efficient machine utilization tend to be offset by logistic and management communication weaknesses. 3. Organization 7.07 The organization of the central core of the Philippine textile industry is essentially "vertical", i.e., there is little specialization in the major subprocesses of yarn manufacture, cloth production and finishing. Of the 32 mills which engage in the manufacture of spun yarn, only four re- gard yarn as their end product. On the scale practised in the Philippines, this form of organization is generally uneconomic and can thrive only in a protected home market. Its strength is flexibility in regard to end-product attributes but, except when practised on the largest scale (e.g., in the USA), this is achieved only at the expense of high production costs. The diametrically opposed alternative of "horizontal" organization, i.e., high specialization in single subprocesses, is a means whereby production costs can be substantially reduced and fabric quality (in the sense of freedom from defects) dramatically raised. The result is cheaper fabric and greatly reduced costs in garment making as a result of the reduction in the frequency of fabric faults. 7.08 The lack of specialization means that the Philippine textile indus- try is an inefficient producer. At the whole-world average rate of production per installed spindle, the million spindles of the industry would have pro- duced 135,000 tons of yarn in 1977 - more than double that actually produced during that year. The basic reason for this very poor performance appears to be a lack of specialization by both process and product. Table 7.3 shows the degree of specialization existing in the spinning sector. Of total spinning capacity only 20% is in specialized mills, with the remainder integrated with fabric production and also, for the most part, with finishing. It is no coincidence that the productivity figures given in the table show the average per-spindle productivity of the specialist spinners to be 35% higher than that of the non-specialists; it is well documented that high process specialization increases productivity and, even more strikingly, reduces cost./1 This being so it is clear that, over all, the Philippine nation, with 80% of its spinning capacity non-specialist, is paying a high price for the somewhat illusory feeling of independence which integration gives to individual textile manufacturers. The situation is even worse in other sectors of the industry. Only 3% of the weaving capacity is with specialist companies and 77% is with companies which also have "in house" spinning and finishing. There are no specialist finishers and as a result there is a gross excess of finishing capacity. 7.09 However, integration is not wholly to be condemned. Combined with a sufficiently high degree of product specialization, integration can be very rewarding, particularly in the marketing advantages which it can give. /1 Annex VII-1 gives an example of the effects of specialization.  - 89 - In the circumstances of the Philippines, vertical organization (or "inte- gration" as it is called locally) is justified in a small number of special cases. For example, there is a large mill producing only heavyweight denim (itself a highly specialiaed product) with complete integration of all processes from baled fiber to preshrunk fabric. Technically, this is a good operation producing denim (for blue jeans) as economically as is possible. A second example is in the making of sewing thread. Special properties are required of the yarn from which sewing thread is made and the subsequent processes are almost wholly unique to thread manufacture. These factors, together with the very narrow end-product range involved, fully justify the use of the integrated system of organization. By and large, however, it is true to say that the many "integrated" textile plants of the country are adding substantially to the cost of textiles. 4. Management 7.10 The quality and performance of general management is good when viewed in relation to the conditions prevailing in the Philippines. Given a substantially integrated Lndustry operating in a protected sellers market, it would be unrealistic to expect general management to be desperately concerned about production costs or to venture into the large-volume export markets. They could not hope to succeed in the latter because they are, for the most part, vertically organized and equipped for exploitation of the relatively lucrative domestic market. To succeed in the hard world of international "main line" textiles, they would need specialist equipment and an organization geared to the super-effic:Lent production of long runs of a much narrower range of products than is now usual. Nevertheless, a number of companies contrive to do some export business, but this is largely confined to fringe interests of the textile market such as nylon tricot fabric, ramie tops and textured heavy denier filament yarn, and cannot be regarded as a foundation on which to build a major textile export industry. 7.11 The quality and performance of technical management varies greatly indeed. At its best it is good by world standards. In these mills the record of innovation in regard to both equipment, operating procedures and production control techniques is commendable. It is common to find expatriate technologists, often with a Hong Kong or Taiwan background, whose whole motivation appears to be a belief that a well-run mill is a thing of beauty and a worthwhile end in itself. These people have made their plants into almost show-place mills which are, within the limitations discussed above, efficient producers of good quality textiles. Regrettably, there are other companies operating old, worn-out machinery in a desultory fashion under deplorable working conditions. This may well be the most profitable short-term use of company resources as labor costs in these mills are low, virtually nothing is being spent on maintenance-and renewals, and the products, poor as they are, are saleable on the protected domestic market. This is not, however, in the best interests of the industry as a whole nor even in the longer-term interests of the individual companies concerned.  - 90 - 7.12 The real cost of this mode of operation may be seen by a direct comparison of one such ill-run mill (Mill A) with a well-run mill (Mill B). Mill A was fully integrated and had a total of 100,000 spindles; Mill B was a specialist spinner with 40,000 spindles. Using directly comparable in- dices of productivity the relative performance was: Mill A Mill B Per spindle productivity 1 2.6 Per worker productivity 1 8.3 Yarn fault rate 1 0.09 This is not to say that all old mills are run inefficiently. Several mills with mostly pre-1965 machinery were seen to be run in an exemplary manner, with performance indices exceeding 80% of those of completely modern mills. 5. Performance 7.13 In view of the fact that the present organization of the industry precludes high product-specialization, the performance of the industry as a whole may be considered as being reasonably satisfactory. Over the past five years output has increased more rapidly than has the spindle population. The reason for this is that the new spindles introduced during this period are inherently more productive than the average of existing spindles. Most sound machinery in the industry is operated on three shifts, six days per week, which compares well with most other countries. Of the total installed capacity in 1978, 43% was operating at speeds below 7,000 revolutions per minute but almost all new spindles are suitable for speeds of 12,000 revolutions per minute or more. 6. Profitability 7.14 Table 7.3 shows that profitability is generally low. Even in 1973, a world-wide boom year for textiles, the return on total assets employed was only 4.5% and in 1976, the latest year for which the figureshave been issued, it became a loss of 0.3%./l However, these are average figures, and disguise a wide range of profits, with many efficient firms obviously making high profits. The returns on equity are particularly interesting in that the information available makes it possible to compare the performance of special- list and non-specialist firms. In the boom year of 1973, the specialist mills returned 28.0% against the non-specialists figure of 15.4% and in the slump year of 1976, when the non-specialists returned a loss of 2.7% on equity, /1 These figures are taken from a survey carried out by DBP for the Govern- ment's Textile Study Group.  - 91 - the specialists made a profit of 8.7%. These differences are substantial and support the comments made above on the need for more specialization in the industry. They are too great to be explained away by the relatively small differences in capital structure which exist. 7. Supply of Capital Equipment 7.15 Virtually no major items of capital equipment for the textile indus- try are made in the Philippines. The machinery of today is so highly specia- lized and requires so high a degree of accuracy of manufacture in relation to the size of the total world market for textile machinery, that there has been a dramatic worldwide reduction in the number of companies engaging in the business during the past ten years. It is not surprising, therefore, that all machinery is imported. The choice of country of origin is generally unimportant in relation to technical aspects, and purchase decisions tend to be made on the basis of price, exchange rate and credit facilities. 8. Availability of Raw Itaterials 7.16 Increased use of synthetic fibers, both as continuous filaments and as staple fiber (particularly polyester staple blended with cotton or wool worsted), has had an important impact on the world textile scene. Originally introduced as expensive, premium fibers, the synthetics have come down in price to such an extent that, even on a weight basis, they are cheaper than cotton and very much cheaper than wool. Over the past ten years synthetic fiber makers and natural fiber producers have overreacted (in opposite direc- tions) to the changing situation. As a result, we are now in the position of having a world surplus of capacity for the production of synthetic fibers and a shortfall of the availability of natural fibers, cotton in particular- 7.17 The Philippines has sensibly decided to reduce the real cost of textiles by encouraging the use of synthetic fibers to increase durability. As part of this program, synthetic fiber plants have been set up with Japanese participation. The present capacity of these plants is rather less than the requirement of the textile industry and further investment in synthetic fiber manufacture is proposed. Unfortunately, there is a world-wide over-supply of all synthetic fibers and currently it is cheaper to shop around buying fiber at prices based on marginal costings than to set up a plant to make it oneself. If is, of course, difficult to say for how long this situation will continue, but it is clear that now is not a propitious time for further expansion. of so capital-intensive a sector of the industry. 7.18 Ramie is a natural fiber which grows well in Mindanao and is currently being used in s-ignificant quantities both alone and in blends with polyester staple. Dur-ing 1977, the weight of spun ramie was a little over 2,000 tons against a totaLof 20,000 tons of imported cotton and 437 tons of domestically-produced cotton. There is a strong possibility that a useful textile export industry could be based on ramie as the fiber, in its finished  - 92 - form, has many of the attributes of linen and linen production in Europe has almost ceased, not because of lack of demand for the product, but because flax is no longer available in sufficient quantity. 7.19 Expansion of ramie growing and processing could be rewarding. It is a readily exportable end-product which would not be excessively capital- intensive. There is a bonus to ramie growing in that a by-product of ramie fiber production is considerable quantities of a feed suitable for commercial hog-raising. This is already being exploited in Mindanao. 9. Technology 7.20 Textile manufacture is no longer a craft dependent on direct workers who have served an apprenticeship or undergone a long period of training. The staff of a modern mill may be divided into three categories: (a) technolo- gists; (b) direct operatives; and (c) technicians (i.e., mechanics, elec- tricians, etc.). 7.21 The quality of the technologists (with regard to both knowledge and diligence), is crucial to operational efficiency, but the number involved is very small. A large spinning mill, for example, might operate with only four - a chief and three assistants. As has been noted earlier, technologi- cal management in most of the mills visited was excellent but was provided mainly by expatriates from such places as Hong Kong, Taiwan, Japan and India. While no facility exists within the country for full technological training, this is not important. The number of such technologists needed is very small and there are many excellent technical colleges and universities in the world at which suitable personnel can conveniently be trained. It may even be argued that training abroad is to be preferred because it avoids the dangers of in-breeding. The award of fellowships to enable four or five suitably-qualified Filipinos each year to go abroad for training periods of up to three years duration would fairly quickly reduce the dependence of the industry on expatriate technologists. 7.22 Although there is no textile technical college, there is the Philippine Textile Research Institute which could be a useful organ through which the industry could be kept in the forefront of development and which could help in the solution of problems inherent in the local industry or in particular mills. PTRI is wholly funded by the Government and is subject to the general supervision of the National Science Development Board. It has reasonably equipped work rooms in which a small amount of operative training is done, but discussions with the staff suggested that they had very little rapport with the industry. Discussions with members of the industry left the impression that PTRI was regarded as a remote, inward-looking organization of no direct value to the industry. This is an unfortunate situation which could be remedied by establishing better channels of communication between PTRI and the trade association of the textile industry. Whether or not PTRI could contribute usefully to the post-graduate training of technologists depends  -93 - very much on the mutual willingness of the two parties to cooperate in this sort of activity. If such willingness could be developed it would materially advance the technology of the industry as a whole. 10. Labor 7.23 In the view of the technologists met, and on the evidence of the operation of machinery seen in the mills visited, it is clear that: the available labor (at least around Metro Manila) is entirely adequate. It is easily trained and, subject' to technological supervision, fully competent. Manning levels needed are much higher than in America and Europe (although very much lower than in India) but this does not seem to be the re!sult of inadequate training. It is rather the lack of a sense of urgency and dedication to the efficient performance of one's duties which is such a marked feature of workers in such disparate, but equally highly competitive, textile producing countries as the USA, Germany, Hong Kong and Taiwan. At: the wage levels prevailing in the Philippines, however, this situation gives no cause for alarm. Some relevant comparative labor productivity figures for 1977 are: Labor productivity in Spinning Weaving USA 100 100 EEC 72 49 Turkey 37 26 Philippines 31 24 Pakistan 15 9 7.24 It would be unrealistic to aspire to the American figures, which are a reflection of the very high degree of product specialization which is possible in that country. A reasonable target for the Philippines would be a performance between that of Turkey and that of the countries of the EEC, say 55 in spinning and 40 in weaving. 7.25 Technicians, particularly mechanics and electricians, are a very different matter. Modern textile machinery can only work well when in first- class condition and, although the technologists are able to define setting requirements, they are very' dependent on the services of technicians for the achievement and maintenance of these settings. Labor turnover of technicians is very high indeed and the quality of technicians available has been harshly condemned by management. This suggests at least a shortage of adequately trained technicians willing to work in the textile industry. A common complaint of management is that after being trained in the mill as a techni- cian a man is very likely tb go away and use his newly-acquired skills either as a freelance or in a post offering higher remuneration as an auto- mobile mechanic or electrician. This weakness is not confined to the textile industry and may well be an indication that industry generally is paying insufficient attention to the training of technicians.  - 94 - C. Issues of Current Operations and Expansion 1. Integration 7.26 As discussed in B-3 above, there are general operating inefficien- cies introduced through the lack of specialization in the textile industry. Vertical organization (integration) is indeed the norm and there is no doubt that most of the industry's leaders wish it to remain so. The reason for this is that an entrepreneur with an integrated mill believes that he is much more the master of his own destiny. With a specialist-function mill he is but one link in a rather tenuous chain. In support of this preference to remain vertical, he will advance the argument that the closer contact and intimate liaison between the specialist subprocesses leads to true optimization of all intermediate product parameters and hence more efficient production. Worldwide experience has shown that this argument is fallacious except when associated with very high product specialization -- a condition applying to only a small minority of mills in the Philippines although, because of the much larger home market, not uncommon in the USA. It is difficult to assess precisely the extra cost which integrated working entails in the Philippines. A tentative estimate is that the overall cost could be reduced by about 40% by rationalization and efficient horizontal (i.e., specialist) organization of the industry. At this level of performance the industry would be able to compete internationally with such countries as Hong Kong, Korea and Taiwan. 2. Rehabilitation 7.27 Only about one-quarter of the existing equipment of the main line industry (conventional spinning, weaving and finishing) is less than ten years old and much of the remainder is about twenty years old. This old machinery is in need of substantial renovation and, in many cases, renewal. Lack of necessary renovation and renewal combine to give the industry a per spindle productivity performance about 40% lower than one might easily tolerate. A conservative estimate of the cost of rehabilitation in spinning alone, at 1979 prices, is $100 million. Detailed estimates of the requirement of other sectors of the industry have not yet been made, but it seems likely that the total cost of rehabilitation of the whole industry will be about $250 million. The effect of rehabilitation would be to reduce operating costs (but at the same time incurring a considerable capital liability) and to increase productive capacity by about 25%, assuming there is no increase in size of the industry in terms of numbers of spindles and looms. There would also be some quality improvement. 7.28 Without rehabilitation some of the older mills will cease to be operable while others will suffer a decline in productive capacity and a rapid increase in costs per unit of production. In fact, the rehabilitation program would involve phasing out some plants which, even after new capital outlays, could not be competitive at the proposed lower tariff protection. Renovation of the machinery is a relatively straightforward task in technical terms. The present need is to evolve a strategy of rehabilitation, by means  - 95 - of which greater specialization may be introduced and productive efficiency thereby increased. A survey of the present position and rehabilitation needs of the equipment of the industry is underway through a subcommittee of the Textile Industry Inter--Agency Committee. So far, only the spinning and yarn texturing sectors have been completed. It is a thorough and extremely competent piece of work on which a master-plan for rehabilitation could be made with confidence in its technical soundness. It does not, however, give any attention to the matter of specialization vs. integration. It would be a step towards operating-cost reduction if the ground rules for rehabilitation loans were so framed as to encourage process and/or product specialization. 3. Protection and the Textile Industrv 7.29 The textile industry currently receives substantial protection against imports with nominal tariff rates increasing as the stage of processing progresses from fiber through to finished cloth. The tariff rates are summarized below: Tariff rate /a (%) Cotton 10 Staple fiber 30 Yarn, filament or cotton 50 Woven fabric 70 Clothing, finished fabrics 100 /a There is a:lso a sales tax that must be paid on imports which is set at a slightly higher level than the tax on domestic production. 7.30 In addition to the tariffs, most textile and clothing items are included on the Central Bank's restricted lists and consequently these items are subject to quantitative restriction as well as tariffs. In practice, however, the import restrictions do not usually raise domestic prices of yarn and cloth above the duty-paid price of comparable imports. Thus, domestically produced synthetic yarn is priced at around 50% higher than the c.i.f. price of equivalent imported yarn, and fabric prices are generally some 40-80% higher than equivalent import prices.  - 96 - Table VII-1: IMPORTED AND DOMESTIC FABRIC RELATIVE PRICES Import Domestic Varia.ace ----- (Pesos) ------ (%) Polyester/cotton (yd) White (polyester) 4.35 6.58 51 White (cotton) 4.58 6.41 40 Plain, dyed (polyester) 4.80 9.17 83 Plain, dyed (cotton) 4.54 7.20 40 Cotton denim (sq yd) 10.73 18.54 73 Source: BOI. 7.31 The effect of escalating tariff levels is to provide high rates of effective protection on the value added in each process in the textile manufacturing chain. In spinning and weaving, where the value added at international prices is about 33% of the value of output, effective protec- tion available is of the order of 90-110%. 7.32 These effective rates of protection are those available to effi- cient firms and give scope for very high profits, since given the low labor costs in the Philippines, profits are a large part of value added; less effi- cient firms, with higher costs and lower profits, will have less effective protection. At the margin, the high effective protection means that some badly-managed, high-cost firms can still survive, even though they are inefficient both by Philippine and world standards. Efficient firms operating side-by-side with high-cost firms have a comfortable life and are given no incentive to further reduce costs or increase productivity. 7.33 The high protective levels, as well as permitting efficient firms to make excess profits and high-cost firms to survive, lead to high prices for textile fabrics with consequent disadvantages to the domestic cost level and the price of clothing consumed by all levels of the population. A further damaging effect of the high cost of domestic textiles is that they cannot be used in the export clothing industry but are limited to the domestic market. As a result, an important opportunity for increasing value added and employment in the export industry is being missed. 7.34 While the present tariff levels may have been justified in the past as necessary to protect an infant textile industry, there is little case now for such high levels. The Government is particularly aware of the problems posed by the textile tariffs, and, in recent months, the Minister of Industry has stated the Government's intention to reduce tariffs on fabrics from 70% to somewhere around 30%, with concomitant decreases in fiber tariffs. The President has supported these proposals in a recent speech to the Textile and Garment Manufacturers Association.  - 97 - 7.35 The Mission agrees that textile tariffs should be substantially reduced. The final level of the tariffs should be designed to give roughly equal protection, in effective terms, to each stage of production, and should also bear some reference to tariff rates in other sectors of the economy to ensure that the textile industry is not given relativeLy less protection than other industries. The rates would also have to provide sufficient protection to the industry against dumping. The following schedule presents a set of tariffs that would broadly fulfill these objec- tives even though the new effective rates still show considerable variation. These tariffs are indicative only, and the exact levels of any reduction would, of course, have to be decided by the Government after appropriate analysis and consideration. Effective Suggested protection revised Before After Product Present: tariff tariff reduction reduction Cotton 10% 10% 20% 20% Staple fiber 30% 10% 90% 30% Yarn i0 % 20% 90% 40% Fabric 70% 25% 110% 35% Clothing 1(0% 30% 170% 42% 7.36 To give the industry time to adjust, these reductions could be phased in over 2 to 3 years as rehabilitation of less efficient firms pro- ceeds. At the same time, the import restrictions would have to be phased out, if the tariff cuts were to have their full impact. This would require the coordination of the Tariff Commission, the Central Bank and the Ministry of Industry. If the import restrictions remain, the price of textiles could still be maintained at their existing levels and any tariff reduction would only result in a transfer of income from the Government to manufacturers with no benefit to consumers. 4. Effects of Tariff Cutsi 7.37 The proposed tariff cuts would lower the excessively high rates of protection presently given to fibermaking, spinning and weaving, and would even out the protection given to each stage of production. The cuts would increase the competitive pressures in the industry, but efficient well- managed firms would have little trouble coping with them, (see Annex VII-2) especially if they increased their product-line specialization. Many marginal firms, however, would not survive under the new regime unless they replace obsolete equipment:, improve management and increase overall efficiency; even then some plants will have to be phased out. Funds for rationalization should be hand-in-hand with the lowering of tariffs and  - 98 - easing of import restrictions, and this will help firms wishing to modernize or streamline their production. 7.38 There is unlikely to be any long-term impact on employment as a result of the proposed policy changes. Textiles are not likely to be imported to any extent behind the proposed tariff levels (although there will, of course, be an increased possibility of import), and, in fact, the domestic market will increase in size in response to the expected price reductions thus increasing employment in the industry. Further gains in total employment will also arise if the lower prices and increased efficiency in the industry means that domestic textiles can be used more in the export garment industry. 7.39 While aggregate employment will not be affected negatively, some of the less efficient mills will have to close down and this would put the employees of these mills out of work. These jobs will be replaced as other mills expand output and as the market grows. Nevertheless, inasmuch as the new jobs are in different locations, this will disadvantage the displaced workers. Every effort will have to be made by the appropriate Government agencies to encourage other firms to use the buildings vacated by firms that go out of business and to assist workers who have to travel to other textile firms. Fortunately, any dislocation will take place in Metro Manila-and so resettlement of workers will be unnecessary. 7.40 A planned program of tariff cuts and import liberalization is an essential prerequisite of any program to make the textile industry more efficient and competitive. The Government has expressed its desire that textile tariffs should be reduced, and such a reduction should be given high priority in any overall plan for tariff rationalization. 5. Expansion 7.41 Meanwhile, as the subcommittee continues to study rehabilitation needs, many companies within the industry are taking steps to increase their capacity. During 1978 a total of 72,000 new spindles were installed and in January 1979 nine new investment proposals received the approval of the BOI. These proposals are for an increase in industry capacity of 227,000 spindles, i.e., roughly a 25% increase. The Board has given approval subject to the condition that 69,000 of the new spindles will be used exclusively for the production of goods for export. In addition-to these firm approvals, the Board has registered Letters of Intent from fourteen other companies for installation of a further 386,000 spindles. At present, these figures are merely approvals and statements of intention - that they will shortly become spindles and looms is by no means certain. A decision by Government to reduce the tariffs on imported textiles would probably cause some, if not all, of these plans to be abandoned. 7.42 The case for expansion of the industy is weak. An industry of the present size, in good condition and efficiently run, is sufficient to provide all the immediate and near-future needs of the country. Under the  _ 99 - export requirement policy in present and foreseeable future circumstances, it may not, in general, be possible to export textiles directly from the Philippines without the aid of some subsidies, either direct or indirect, through additional protection of the domestic market. On the other hand, some export or exposure to international markets will help the industry to be efficient and competitive. 6. Exports 7.43 The export of textiles can be a useful contribution to the eco- nomics of a developing country but it must be appreciated that the export market is a hard, keenly contested market. As presently organized,the textile industry of the Philippines is ill-fitted to enter the international arena and compete in the very substantial market which exists for standard textiles, i.e., shirtings, bed sheets, drapes, napery, etc. It would be wholly unrealistic to expect to succeed in this market by syphoning-off a fraction (even a large fraction) of the output from integrated mills, essentially geared to the relatively high variety demands of the domestic markcet. Success in the highvolume, low fault-rate international market requires the setting-up of large specialist mills designed and staffed for the efficient production of a small number of standard cloths. This could be done relatively cheaply by attracting major international companies of proven capability, andl who would initially provide some capital and expatriate general and technical manage- ment, to operate in the Philippines under mutually profitable conditions. An alternative approach to the exporting of textile products is to concentrate on low volume, high value and relatively high profit 'premium' textiles, particularly in the form of garments or other made-up goods. Such an approach is discussed in Chapter IX-B. 7.44 The use of ramie as a textile fiber has already been discussed under the heading "Availability of Raw Materials" in Section B-8 above. Alone, or in blends with polyester, ramie could substitute for linen, now becoming a premium textile material, partly because of its crisp handle combined with high absorbency and also because of the very limited amount of flax now available. Ramiet fabrics could become a valuable export, both in fabric form and even more so in the form of garments and made-up goods. 7.45 Although most t:extile processes are heavily capital intensive, the making of fully fashioned knitwear is an exception and this activity could well be expanded as an export industry. Other countries, notably Taiwan, Hong Kong and Korea, are already exporting substantial quantities to the USA and Europe but they have, so far, produced only for the lower end of the market, employing low specification yarns and constructions. It is very likely that an up-market approach using higher specification yarns and superior knitting constructions (i.e.,higher stitch densities) would be successful and extremely profitable.  - 100 - 7. Location of Industry 7.46 The industry is presently concentrated in the Metro Manila area (see Chapter IV). However, there are severe impediments to setting up substantial mills for spinning, weaving or knitting in other parts of the country. Such mills require: (a) A pool of labor from which a machine operating force of 500 to 1,000 people, trainable and not adverse to factory life, can be drawn and a slightly smaller number, say 300, be available for the provision of infrastructure support; (b) Road, rail or some other efficient transport facility for the delivery of raw materials and the distribution of finished goods without undue delay or expense; and (c) An adequate power supply. A modern 50,000 spindle spinning mill will impose a steady demand, day and night, of about 4 megawatts plus a varying amount of power for air conditioning. During hot and humid weather a further 3 megawatts may occasionally be needed for this purpose. Alternatively, the mill may be provided with its own power supply from diesel, steam turbine or gas turbine equipment. 7.47 As described in Chapter IV, infrastructure such as transport and power may not, at this stage, be adequate to support very large mills. There are, however, some important textile operations which can be carried out reasonably efficiently wherever there is a supply of willing labor available. In spinning there is no viable alternative to the use of fairly sophisti- cated, modern machiner.y located in large mills. In weaving, however, small- to medium-sized units, based on the use of simple power looms without automatic weft replenishment facilities, can be used. Such looms are not suitable for use in large mills on account of logistic and personnel management considerations, but they are capable of producing high quality fabrics economically. Because of the smaller unit size, such a system affords scope for regional dispersal and has the advantage of being much less capital-intensive than is mill-scale weaving. It reduces the amount of fixed capital per employee from about $27,000 per person, for mill-scale weaving on pirn changing automatic looms, to $1,500 per person for small-scale power loom weaving on 'Lancashire' looms. The capital cost per unit of production is reduced by a factor of about 9:1 under conditions conducive to intensive operation.  - 101 - 7.48 Typical units would be equipped with from 10 to 40 looms, would give direct employment to 15 to 60 people and would require a power supply of about 500 watts per loom. This alternative to mill-scale weaving is discussed in greater detail In Annex VII-3 "Low capital-cost weaving in small units." The product would be indistinguishable from more typical mill-woven fabric, and is different from craft weaving (such as is carried out in Baguio and other places) for the production of such things as runners, place mats and Roman shades.  - 102 - CHAPTER VIII THE FOOD PROCESSING INDUSTRY A. Overview 8.01 The food industry occupies an important place in Philippine manufacturing. It produces about one-fourth of value added in all manu- facturing and employs one-fifth of the total manufacturing labor force. Some 450 establishments, employing more than 20 workers, produce approxi- mately 26% of the value added by all manufacturing enterprises of that size. About two-thirds of these larger establishments are located in Metro Manila and surrounding regions. Employment and value added by small and cottage establishments in food processing (with less than ten workers) represent around 40% of the small scale and cottage sector in all manufacturing; they are more evenly spread throughout the country than the large establishments. Capital-labor ratios in the food industry average somewhat above those for manufacturing as a whole, but capital efficiency and value added per worker also tend to average higher. The employment effects of food processing should take into account employment in ancillary activities (storage and transport) as well as agriculture and fisheries; this indirect employment could be as much as ten times the direct. (See Tables 8.1, 8.2 and 8.3.) 8.02 The Mission focussed on processing of fruits and vegetables, fish and meat, which in value added, represent about 27.0% of total food manu- facturing. Important processing /1 activities not covered by the Mission include sugar production, coconut products, edible oils and fats, dairy products, and grain milling. 8.03 Some 53 firms produced around 80% of the output and virtually all of the exports of processed fruits and vegetables, fish and meat. They provide some 50% of the employment of the sub-sector. The Mission's analysis is based on discussions with 21 large firms and a number of /1 The BOI staff defines food processing as "converting raw material into marketable form by a special treatment or series of actions that result in a change of the nature or state of the products, such as by slaughter- ing, milling, pasteurizing, drying or desiccating, quick-freezing.and the like. Merely packing, packaging or sorting out and classifying shall not, by themselves, constitute processing." This definition does not differentiate between either scale or degree of sophistication in transforming/converting processing operations. It is frequently con- venient to distinguish between "primary" and "secondary" processing. Operations of cleaning, inspection, packaging and storage under regulated conditions are also normally reported as "processing" - albeit at the "primary" level.  - 103 _ trade associations and Government agencies which are listed in Annex VIII-1./l Detailed data from selected firm interviews are given in Annex I-1. 8.04 The sub-sector la has grown considerably in 1965-74: - - - - - - - in millions of constant 1972 Pesos - - - - - - - - Annual growth rates Processing 1965 1969 1974 1965-1974 category Output V.added Output V.added Output V.added Output V.added Fruits & vegetables 144 64 356 115 400 149 12.01 9.83 Fish NA NA 15 5 40 13 21.67 21.06 /a Processed meat and poultry are not included because statistics aggregate slaughtering with fresh and processed meat. A The lower limit for "large" firms is total assets of P 4 million. The The firms interviewed by the Mission had capital assets over iP 20 million. The definition employed by the Government includes land and buildings, which might. better be excluded for the purpose of the present analysis.  - 104 _ 8.05 Overall growth has continued steadily since 1974, being particularly marked for-processed pineapples, mangoes and marine products - all based on domestic raw materials - as well as for juices, nectars and meats using both domestic and imported raw materials. In the last seveial years there has been no significant increase in new undertakings; rather the more established firms tended to consolidate and strengthen their market posi- tion. To overcome frequent difficulties in obtaining their raw material supplies, large firms are seeking to establish their own production 0 sources. Such integration reinforces the consolidation of established firms and puts the small processors and producers at a disadvantage. If left unchecked, this trend could also have far-reaching implications for the distribution of ownership in agriculture. 8.06 The industry has an important role to play in the improvement of nutrition of the lower income groups of the population. At least one-fourth of the Philippine population has an inadequate dietary intake. For some other parts of the Philippines, deficiencies may be more pronounced. Most of the food intake by the poorer classes is in the form of fresh products, but manufactured and processed foods should be expected to make an increasing contribution. Canned sardines and mackerel could provide a useful source of high protein food from domestic sources at relatively low prices. 8.07 Management. Senior management (frequently one or more members are substantial shareholders, especially with family-owned companies) is competent and appears to operate successfully. In general, its members are fairly young and many possess overseas training. In some firms, the middle cadre and supervisory staff gave the impression of superficial experience and a reluctance to accept responsibiity; on-job training programs and profit sharing schemes might justify examination. 8.08 Workers. On the whole, factory workers were found to display a disciplined attitude to their duties and to evidence good productivity. One manager reported that, after a mere three months' on-job training, female labor in his firm gave a 40% greater productivity than similar workers at a comparable plant in a developed country. Many firms furnish on-job worker training but very few consider incentive payment schemes to be warranted. Worker turnover was reported as extremely low, as was absenteeism. 8.09 Facilities. Factory design and construction are generally suitable. With the exception of simple fabricated items, most plant and equipment are imported, principally from the USA. Some sophisticated plant (e.g., automatic can seamers) is supplied from Taiwan. A local company has recently begun to fabricate stainless steel. However, imports of more complex plant items as required by large firms will tend to persist because of: (a) their specialized character; (b) the reluctance of processors to risk teething troubles with local prototypes; (c) the high cost of producing custom-built items; and (d) the ready availability and low tariff of new (as well as modern second-hand good condition) imported plant and equipment.  - 105 - 8.10 Technology. Having regard to the number, types, sizes and the short runs of many products, the level of technology and process operations is considered satisfactory and appropriate. Most firms have direct linkage or back-stopping arrangements with sources of overseas expertise, ensuring ready access to technological advances, engineering and process guidance, senior personnel training, etc. The Mission did not encounter investments in unnessarily sophisticated technology. Given higher volume throughout and :Longer runs on individual products and sizes, greater mechanization would be justified, for example, in handling of raw materials and finished goods, materials' preparation and filling into containers, automatic check-weighing, high-speed labelling and automatic casing. All firms seemed extremely alive to the importance of assuring consistent quality appropriate to market requirements and appear to be devoting much effort to that end. The larger Eirms themselves possess and/or are able to utilize facilities of testing, investigation, research and'development; consequently, there is little demand for such services from official sources. 8.11 Most firms' sales are predominantly in the home market; however, many are developing export business which is usually more profitable. A few firms process either fruit or seafood almost exclusively for export and have little or no dependence on the domestic sales. 8.12 Because of the relatively low level of domestic demand and keen inter-company competition, the sub-sector's profits on home sales are said to average below 10% while trade margins are themselves very slender (see Annex VIII, Table 4). Statistical information on total family income and the class- ification of family income (see Table 8.5) show that the low income group, defined as families earning less than P 6,000 p.a., is currently estimated to account for some 60% of rural families. Persons in this group are regar- ded as occasional consumers of processed foods and, even then, they tend to be purchasers of low-price items. 8.13 Of total direct cpst (excluding returns to capital) in the processing industry, some 60% represents material inputs, 35% packaging and only 5% direct labor cost (see Table 8.6). The low proportion of direct labor cost is explained by the relative importance of capital equipment used in processing. Labor cost in the small and cottage industries can be expected to represent a considerably larger proportion. B. Performance and Growth Constraints 8.14 The Fruit and Vegetable Industry is the most developed component of the sub-sector. The constituent firms have good operational efficiency. In summary, some features of the industry are:  - 106 - Principal Raw materials Processed form outlets Orange /a Concentrate Canned and Tetrapak Domestic Grape /a Concentrate Canned and Tetrapak Domestic Beans and Tomato /a Canned Domestic Mango Canned and Tetrapak Domestic Mango Canned Export Fruit Purees Bottled Domestic Banana Pulp/Puree Export Pineapple Canned Export /a Imported; all others indigenous. 8.15 Various other indigenous raw materials including papaya, mixed tropical fruits, peas and sweetcorn, are processed, albeit on a minor scale. Pineapple is the preeminent raw material in terms of weight and value. The two firms specializing in the export of processed pineapple also engage in its production. Throughout the Philippines, some 30,000 ha are under pineapple cultivation; good yields are obtained due to favorable climatic and soil conditions, especially in the areas of Mindanao and Davao. Of total Asian production in 1975 (about 1.9 million MT), Taiwan was in first place with 27% and the Philippines in second, accounting for 19% of total production. Excepting the two firms with integrated producing/processing operations for pineapple, others obtain the larger proportion of raw material inputs from independent growers and markets. Reported problems include: little or no grading, varietal variations, uncertainty of supply, and rapid upward price increase outside the glut periods. On this account, some firms are moving into raw material production. 8.16 The Philippines has no domestic producer of tomato paste (30/32%), which is imported from Taiwan and Europe. At least one firm produces tomato puree whilst another repacks imported paste into consumer-size cans. Examination of fresh tomatoes (Roma-type variety) in the San Andres market would suggest that tomatoes suitable for paste can be grown at a price to warrant consideration of processing; accordingly, investigations would be necessary to determine whether: i) more than one crop per year can be harvested, and ii) demand would justify the sizeable investment in a modern vacuum concentration plant. 8.17 The Seafood Processing Industry. Some characteristics are listed in the following tabulation:  - 107 _ Raw materials /a Processed form Outlet Sardines Canned Domestic Mackerel Canned Domestic Tuna Frozen and Canned Export Shrimps Frozen and Canned Export Cuttle Fish Frozen Export Abalone Frozen Export Lobster Frozen Export /a All indigenous. 8.18 Most factories/firms process seafood exclusively. However, a few process other commodities as production fill-in when no seafood is available. Raw material is derived principally from commercial fishing operations - either independent or under the processors' control - and, to a lesser extent, from municipal fishermen. The country's main fishing port and fish market is at Tagnig, Metrco Manila, in which area most of the country's cold storage facilities are located, notably those of the Government-olwned Food Terminal, Inc. A major obstacle to the industry's progressive expansion is the assured consistent supply of raw material for the maximum period, at a price and of a quality which makes processing rewarding. To this end: (a) Processors are locating and expanding operations outside the Metro Manila zone, at the same time developing their own fishing operations as well as organizing peasant fishermen as suppliers; (b) Government is launching a program for fisheries' development; and (c) The Fisheries Industry is listed as a "preferred area" under the Act for Investment Incentives for Agriculture (Agri- Business Unit). 8.19 Raw material should permit a "several-fold" /a increase in the fish catch within territorial waters. Nevertheless, it would appear prudent for appropriate survey investigations to be undertaken during the coming decade so as to preclude any irreversible depletion of this renewable resource - as in fact has happened with over-exploited fisheries in other parts of the world. /1 Expression used by the Bureau of Fisheries and Aquatic Resources.  - 108 - 8.20 The Meat Processing Industry. From a modest base at the start of the present decade, the industry's output has steadily increased. Using modern processing systems, the firms inspected are achieving good effi- ciency. The industry's principal raw materials are: local cattle which are being upgraded through improved selection; imported beef, pigs and poultry raised by both the processors and contracted producers. The main products are open-pack meats, especially sausages of various kinds, corned beef and dressed frozen poultry. Sales focus on the home market; however, export business is being successfully built up for frozen poultry. The industry's growth is conditional on the price of raw material inputs in relation to both domestic purchasing power and the products' competitiveness in the export market. Thus, livestock improvement, better animal husbandry practices and access to keenly priced feedstuffs are all mandatory in assuring the industry's sound expansion. With the industry's further growth, consideration could be given to the local manufacture of protein- rich materials of vegetable origin to be used in part as substitution of meat in sausage products. 8.21 Sub-sector's performance is good, particularly so taking into account the constraints discussed below. The Philippines compares well with developing countries at a similar stage of industrial development. Individual firms could, however, make several improvements, e.g., (a) make more use of process instrumentation; (b) give more attention to product diversification so as to lower unit costs by increased throughput; (c) up- grade product presentation; (d) be more aggressive in promoting sales; and (e) secure higher productivity from their office staff. 8.22 Assured access to raw material inputs - as to quality, quantity, price and reliability of supply - probably constitutes the major obstacle to expansion of the sub-sector. This is true for both domestic and export production but measures to overcome this constraint are crucial if the Philippines is to expand exports of food products. Many firms are consider- ing or are already implementing a "backward integration" policy whereby they undertake fishing, poultry and cattle-raising, horticulture, etc. Such trends (if not checked) can but diminish the participation of independent producers, especially the small-scale, in the industrial economy. 8.23 Cans. Because of their general use throughout the sub-sector, round cans ("open-top" or "sanitary" in trade terminology) feature as a key input. Domestic production of both electrolytic tin plate and its precursor, black plate, is quantitatively insufficient - reportedly due to malfunctioning of manufacturing facilities rather than to intrinsic capacity deficiency. Domestic plate quality varies considerably and is inferior to that manufactured abroad. Hence, to obviate difficulties with their buyers, processors of export lines pack in duty-free imported cans or, if they themselves fabricate cans, use duty-free imported first-grade tin plate. Although the shortfall of can fabricators' requirements is made up by importing, in practice licenses are almost invariably issued for second-  - 109 - grade plate. Imports of tin plate are taxed at some 80% of the pLate's c.i.f. value; however, black plate, the raw material for tinning, is sometimes brought in free of duty on an ad-hoc basis. Should the resultant cans be exported, processors say that no mechanism exists for a tax drawback. To combat the uncertain supply situation, fabricators are obliged to carry high inventories. Three fabricators, operating continuous automatic lines, plus six others with restricted mechanization and process control, sell to processors. Due to the diversity of sizes in demand, short production runs followed by machinery size! change-overs are characteristics of the Philippines' open top can-making industry which reports utilization at 60%-70% of installed capacity. (See Annex VIII-2, Table 8.7 and Chapter V, paras. 5.18-5.20.) 8.24 Regulations. The Food and Drug Administration (FDA) of the Ministry of Health prescribes standards for the food industry. The large firms incur the extra costs (usually passed on to the consumer) in satisfying FDA re- quirements. The FDA has inadequate resources to enforce the requirements; thus, the small and cottage-type establishments receive scant control. Because many home market consumers are extremely price conscious, they there- fore tend, when price disparity occurs, to purchase products made by small and cottage-type establishments which are frequently of inconsistent standard. This situation renders market penetration more difficult for the reputable processors and serves to perpetuate preference for the imported products. Widespread enforcement of realistic standards would be in the interest of the industry and of health conditions generally. 8.25 Operations of Food Terminal, Inc., which furnishes cold storage for raw materials and frozen foods, could be improved. At present, it suffers from deficient handling arrangements, delays in moving into storage, temperature variations, high charges, and remote location. The Terminal's Food Processing Department has the objectives of: (a) generating income from processing and research services; (b) developing and maintain- ing technical and manpower capability; and (c) establishing methods for minimizing post-harvest and storage losses. The Department needs more laboratory equipment and pilot-type plant, etc., to make its performance more effective. With improved facilities, the Department could undertake a valuable function in conducting developmental work designed to promote new processing opportunities. 8.26 There is at present no association of the industry as a whole which can bring industry-wide problems to the attention of the Govern- ment. The sub-sector has four trade associations; either these individually, or even single firms, make submissions to public agencies. Major matters of industry-wide concern would better be reviewed through a wider association such as the Philippine Federation of Food Processing Industries (PFFPI), which was formally organized in July 1977 to act as a single body to address shared problems of the entire food processing in- dustry in relation to the ASEAN Federation of Food Processing Industries.  - 110 - C. Incentives 8.27 Tariffs on food products show very considerable variation. Data in the UP study suggest that export products generally have low or negative protection. On the other hand, processed food and beverage products for the home market receive high protection; for example: a group of processed food products for which calculations were made in the UP study received tariff protection (with subsidies) at a level of over 80% (nominal) and 400% (effective)./1 Bakery products receive nominal protection of 110%. Commer- cial fishing receives over 100% (nominal) and 116% (effective) according to the UP study; the tariff on canned mackerel and sardines is, however, only 10%, and hence the effective protection is below that of other fish products. 8.28 Given the relative favorable performance of the food processing industry, the present protection levels would seem to be on the high side. Some nominal protection of finished products may be justified where inputs are subject to protection or where the cost of domestic inputs are above international levels. Where the Government wants to restrict luxury foods consumption it might be more appropriate to increase domestic sales taxes, so that the commercial policy can be consistent with development of a rational and efficient industry structure. 8.29 The domestic sardine and mackerel industry could become a more important source of relatively low-cost high-protein food. At present, some $25 million of this fish food is imported in canned form (300 million cans in 1978). The product is subject to a 10% customs tariff which may be. justified (and sufficient) in light of the duties imposed on imported cans and tomato paste. The local product, considered by some as being of lower/2 quality, is priced more than 10% below the import. However, larger and more consistent domestic production of canned fish could come about with improvements in the supply of cans (see Annex VIII-2) and other steps to help develop the fishing industry; this should not involve any permanent increase in tariff protection. Food products of which the Philippines can potentially expand exports should, in general, not require high levels of protection. /1 For input-output sectors 40, 41, 45 and 46. /2 But domestically-canned samples examined by the Mission were considered to be of equivalent standard.  8.30 BOI Operations. Fish, meat, fruits and vegetables are all eligible for BOI incentives under the 1978 Investment and Export Priorities Plans. Furthermore, under Presidential Decree No. 1159 of June 1977, investment incentives for agriculture are now operative. This decree, unlike the Investment Incentives Act (R.A. 5186) and the Export Incentives Act (R.A. 6135), not only incorporates all the applicable guarantees provided by the two Acts but also adds new incentives, taking into account the unique bottlenecks and problems of investing in agriculture. P.D. 1159 has for its spring board a new dimension in agricultural development - the agri-business approach. 8.31 In the agro-based industries the greater part of BOI incentives have gone to products other than fruits, vegetables, meat or fish products. Food processing, in fact, has received only 2% of benefits in agro-based industries under R.A. 5186 and 14% under R.A. 6135 (export promotion) in 1975- 1977. (See Table 8.8.) I]n all, some 37 firms (most of them large) benefited during 1971-78: Processing category Number of firms R.A. 5186 (Domestic) Seafoods 3 Fruits and vegetables 6 Meat 5 Total 14 /a R.A. 6135 (Export) Seafoods 16 Fruits and vegetables 7 Meat 1 Total 24 lb /a Of a total of 118 firms in BOI's global category of "Processed Foods." /b Of a total of 40 firms in BOI's global category of "Food and Beverage Products." 8.32 Most firms receiving benefits consider them "quite material" in facilitating their position, and they regard duty-free imports and tax credits as particularly important. However, some firms regard the incentive effect minor in the case of intrinsically sound and viable projects.  - 112 - 8.33 The Mission finds the food processing industry to be well- established and operating profitably. Extension of BOI benefits for expansion projects will usually not be required; rather, it would have the effect of further consolidating the already strong position oL well- established companies. Instead, benefits might advantageously be extended for new products or processes and for "newcomers" to the industry. In any case, all processors should be encouraged to procure a portion (say, 30% depending on local conditions) of their requirements from small growers. The Mission feels that the Agricultural Investment Incentives Act should be administered with caution especially in cases where benefits for back- ward integration by large processors would endanger the small growers. 8.34 There is not at present a systematic effort towards developing specific project opportunities in food processing. Project studies, even if in preliminary form, could guide the Government and the BOI in their administration of benefits. The Mission considers that Government, in concert with the private sector, should draw up a systematic development plan for the food processing industry. D. Investments and Prospects 8.35 Most of the new investment proposals encountered by the Mission envisage expansion of existing products. In all, the sub-sector may plan new investments of at least $30 million in 1979-83, mostly for marine and fruit products. In addition to these industrial investments, the larger firms may enter into agricultural and fisheries investments. 8.36 Among the larger new projects is a third pineapple producing and processing undertaking scheduled to commence commercial operations in 1980. The project, located in Davao, would produce $13 million in exports, employ some 2,000 workers and involve a capital outlay of some P 70 million. Aside from still further emphasizing the export potential for pineapple processing in the Philippines, the project illustrates that, given suffi- cient perishable raw material production, it is preferable for the processing plant to be adjacent to its source. Consequently, as general infrastructural betterments proceed throughout the Philippines, processing activities may increasingly tend to become located near major production areas. 8.37 Of special interest is a possible project which would integrate fishing and canning of sardines and mackerel. It might be located in Northern Palawan, thus helping to create jos in a depressed area and, at the same time, provide essential food at lower pries. Some suggested characteristics of the project are: (a) fishing performed by domestically- constructed purse seiners; (b) incorporation of highly efficient handling and production systems in the cannery; (c) acquisition of modern good- condition second-hand plant, as available overseas where fish supply has  - 113 - failed (due to uncontrolled'fishing); (d) cannery capacity of 150,000 cans (202 x 308) per 8 hour shift; and (e) work-up of fish waste into high grade fishmeal. Preliminary calculatLons suggest the project would have a reasonable economic return and might help in reducing domestic prices. It warrants further study. If accepted, it might perhaps be realizecd with participation by local fishermen, thereby serving as a demonstration model for linking small producers with the 'industrial operations to which their raw material gives rise. 8.38 The Food and Nutrition Institute is conducting investigative and pilot plant work to evolve highly nutritional low-cost food ingredients/ preparations using legumes -- notably the mungo bean (Vigna radiata), animal blood and other indigenous materials. A possible project for utilizing echinoderms (sea cucumbers) as a source of low-cost protein is described in Annex VIII-3. Projects for highly nutritional low-cost food will probably be perfected for manufacture in the Philippines on an industrial scale, such as has resulted in Mexico /1 and Guatemala./2 The Mission considers that, for the resultant materials to be widely consumed by the poor, a significant amount of subsidy will be necessary; in such event, it should be applied preferentially to the raw material component(s) rather than to the manufacturing operations. Furthermore, the Mission would stress the importance of assuring the'end product's acceptance as attractive food rather than of promoting it for its nutritional qualities alone. 8.39 Exports were US$88 million in 1976, against imports of US44 million (see Table 8.9). Preliminary data indicate that exports in 1978 were slightly above US$100 mil:Lion. Given present constraints, sustained export growth will require action:on improving raw material inputs. Assuming corrective action is taken expeditiously, exports could reach US$500 million p.a. by 1987. 8.40 Growth of home sales depends on the overall increase in purchasing power and the ability of firms to minimize an upward movement in their products' prices. Given adequate promotion, especially-good prospect is envisioned for fruit juices/nectars which should capture some of the market for carbonated beverages., with concomitant betterment of nutrition. /1 Fortified tortilla flour - developed by Instituto Mexicano de Investigaciones Tecnologicas. /2 "Incaparina" - developed by Instituto de Nutricion de Centroaimerica y Panama.  - 114 - E. Recommendations 8.41 Raw Materials. Consideration should be given to adopt the policy whereby, within a determined period of, say five to ten years, all large processors procure not less than 30% by value of their domestic inputs from independent suppliers - preference being given to small growers and fisher- men, formed into associations or cooperatives with which the large processors would contract. 8.42 An inter-agency commission, to function at two levels - policy and operational - should address the problems of raw materials, with special attention to production, storage and marketing in relation to requirements of both existing processor and the envisioned new opportunities. 8.43 Cans. Steps should be taken to improve the domestic can supply. Domestic can fabricators should be helped to operate their facilities more economically by more adequate /1 supplies of tin plate. As discussed in Chapter IV, the Government would be well-advised to permit freer imports at low duties of black plate and tin plate until domestic production of these imports can be increased to meet domestic requirements. Export industries would be able to obtain their can requirements at international prices and quality. 8.44 Tariff System. Given the relatively favorable performance of the food processing industry, protection is generally warranted only where it is needed to compensate for input prices over international levels. Hence, a phased reduction of tariffs could be effected. Concomitantly, a mechanism might be considered for imposing a sales tax on those products destined for the luxury (high-income group) market. 8.45 Incentives. (i) It is proposed that a shift in emphasis be made so as to accord yet further importance to raw materials production and their effective marketing; (ii) To facilitate small producers' access to incen- tives, BOI and the Ministries. Agencies directy concerned should set up arrangements so that intending applicants are assisted in formulating both their projects and applications; and (iii) Since incentives are no longer a determinant factor for existing large firms in expanding their present facilities to augment current output, it is proposed that incentives should be preferentially available to encourage existing large firms to diversify into new products and to adopt innovative process technologies. Newly-established undertakings should, however, be entitled to all pertinent incentives, given the firms' compliance with requirements. /1 As to price, quantity and quality.  - 115 - 8.46 Accredited Trade Entity. Many important issues - finance, tariffs, incentives, inputs, effects of FDA regulations, etc., - are of general con- cern to the food processing industry as a whole. With this in mind, the Ministry of Industry, in concert with the existing trade associations for food processors, might give de facto recognition to one overall entity (perhaps PFFPI) accredited for dialogue and negotiation with the Government agencies concerned. 8.47 Contacts at the Factory Level. It is appreciated that official agencies and Government-sponsored institutions experience constraints, for example: on the travel of their personnel. However, the Mission considers that increased contacts at the factory level, especially by technical and regulatory staff, should prove mutually beneficial. 8.48 Food Processing Opportunities. In recognition of the important role of food processing in furthering national aims through: (i) providing employment, particularly in the production of its raw material inputs; (ii) expanding exports; (iii) substituting for imports of semi- and processed foods; and (iv) raising the nutritional level of the poor, it is proposed that one specific-entity on Government's part should be responsible for developing food processing "opportunitieslt. This is seen as including identification and formulation of feasible projects as well as their pro- motion and realization by appropriate parties. The DBP could play an essen- tial role in project identification and promotion. 8.49 Although the analysis in this chapter is based on the experience of the large firms, the identification, work-up, promotion and realization of opportunities for smaller-scale processing projects should receive attention. Potential exists both to improve existing small-scale operations and to establish new processing activities (especially of the "primary" type) adjacent to areas of' production, such as might be developed though growers' associations and cooperatives.  - 116 - CHAPTER IX OTHER INDUSTRIES A. The Cement Industry 9.1 The cement industry in the Philippines currently consists of 18 plants, operated by 16 companies, producing cement by wet, semi-dry and dry processes. The plants vary in rated capacity from 122 thousand m tons of clinker per year to 739 thousand m tons. Total rated capacity in the industry is 7.4 million m tons, but, in practice, this capacity is not attainable because of electricity supply problems, the impact of adverse weather, and the widespread operating problems described below. The actual present capacity has been reliably estimated at 4.6 million m tons. Current domestic demand is about 3.4 million m tons and exports about 300,000 to 800,000 m tons per year. So, in fact, the industry is operating near its present actual capacity. The industry is located near markets and/or raw material sources throughout the country with 11 plants in Luzon, 2 in the Visayas and 5 in Mindanao. 9.2 Until the late 1960s, the cement industry operated efficiently and profitably. Cement consumption was increasing and the firms in the industry enjoyed high profit margins. However, the high profits and ready finance available from the Government attracted new firms to the industry, almost doubling the capacity in two years from 3.6 million m tons in 1969 to 6.4 million m tons in 1971. Consequently, capacity utilization rates dropped from around 82% in 1969 to 43% in 1971 and have remained low ever since (with respect to rated capacity). 9.3 At the same time as the industry was hit by excess capacity, the peso devaluation of 1970 caused severe problems. The cost of inputs, especially oil, increased substantially and the industry's heavy debt obligations, much of it in foreign currency, increased correspondingly. The oil price increases after 1973 have also increased the pressure on the industry. 9.4 The combination of a depressed market, increasing costs, large debt burden, and severe underutilization of capacity led to large losses by most firms in the industry. Consolidated losses were P 62 million in 1973, P 75 million in 1974 and P 97 million in 1975. These losses have continued through to the present. The lack of profits meant that working capital for plant maintenance was insufficient with a consequent rundown of plant facilities. Debts due could not be repaid and in many cases were refinanced, especially by DBP, but even the refinanced loans quickly ran into arrears. Current debts continue to be heavy and cannot be repaid by many firms under existing arrangements.  - 117 - 1. Technical Problems 9.5 In addition to the financial difficulties outlined above, much of the industry has severe technical problems. In a significant number of plants, maintenance of equipment is poor because of bad management: and lack of spare parts; production is constantly interrupted by erratic electricity supply and extreme weather conditions; operating staff are inexperienced and supervision is lacking; ancillary machines and instrumentatioII are inadequate or in poor condition; some plants are dirty with consequent problems from breakdowns and poor employee morale. These difficulties have led to low operating efficiency with higher costs and lower output. A technical consulting group, comprised of British and French engineers, recently undertook a thorough review of the industry and recommended, inter alia, more expenditure on spare parts and equipment to rehabilitate the plants, together with a serious effor,t by the industry to set up training facilities for management and workers, research laboratories to investigate process control, and a control instrument workshop to provide the whole industry with adequate control instruinents. There is also an urgent need for the upgrading of management skills, and a change in management: in some of the firms. 2. Pollution Control 9.6 As well as the need for drastic measures to rehabilitate the industry, pollution control is also a problem. The National Pollution Control Commission (NPCC) has set stringent conditions for the dust in emissions from the cement plants, and has required the plants to reach these standards, which are in some cases stricter than those set when the plants were first constructed. The consultants found that significant decreases in dust pollution control could be obtained by simply cleaning the plants and spending relatively small amounts on repairs of existing anti-pollution equipment. The upgrading and replacement of existing equipment to meet the NPCC standards would involve, in many cases, high costs in equipment and production loss while the equipment was being installed. This would add further to the industry's current burdens. The cement industry should agree with the NPCC on a feasible plan for reducing exhaust dust, given the costs involved and the equipment already installed, and the current problems faced by the industry. This plan should be tied in with a program for the rehabilitation and rationalization of the industry. 3. Coal Conversion 9.7 For some time, discussions have been taking place between the cement industry and the Government on the conversion of cement plants from oil to coal firing. The aim of this conversion is to save foreign exchange by using domestic coal in place of imported oil, and to help the country's coal  - 118 - development program by increasing the market for domestic coal production. In July 1978, the President appointed a high-level committee L to study the conversion, and following this committee's report, issued a Letter of Instruction requiring that four cement plants be converted by 1981, five the following year, and the other five converting after individual feasi- bility studies were carried out by DBP. DBP has been directed to supply the finance for this conversion. 9.8 The Ministry of Energy has undertaken to ensure the availability of coal of adequate quality. The coal supply will be part of an ambitious program to increase coal production from 426,000 m tons in 1978 to 1,185,000 m tons in 1980, 2,430,000 tons in 1983, through to 5,400,000 tons per year in 1987, i.e., a 33% annual increase. In addition to the cement plants, this coal will supply the new thermal power plants planned by the National Power Corporation over the next decade. The Ministry of Energy has also undertaken to supply the infrastructure for the delivery of coal to the cement plants. This will entail purchasing barges and completing three bulk terminals by mid-1982. ' 9.9 The cement industry naturally is concerned about the Ministry of Energy's ability to deliver both the coal and the infrastructure on schedule. To overcome this concern, the Government has guaranteed that it will supply coal of minimum quality at a price not greater than 70% of the equivalent oil price. It has also agreed to provide 100% financing for the conversion through DBP, and to allow the duty-free import of all conversion equipment. 9.10 This program raises some questions. First, the coal mines and the necessary delivery infrastructure have not yet been developed. It can be argued that there should be some progress made in this, before the cement plants are required to convert to coal. Otherwise, coal inputs may have to be imported and there would simply be a substitution from imported oil to imported coal plus conversion costs with the attendant disruptions to pro- duction. If, in turn, the infrastructure is not ready on schedule, the coal will not be able to reach the cement plants. 9.11 Second, the conversion may not be as technically simple as the Government's technical studies assume. There are potential difficulties in the conversion. These include the need to control the amount of ash in the coal by homogenizing the coal before delivery. With such potential problems /1 Consisting of the Ministers of Energy, Economic Planning, Industry and the Chairman of DBP.  - 119 - in mind, it is important to start feasibility studies for conversion of the most efficient and smooth-running plants. Certainly, with appropriate technical expertise, good schemes will emerge for conversion to coal-firing in a select number of firms over the next two to three years with further plants following later. 9.12 Third, the conversion program assumes that all 14 oil-fired plants will be converted to coal-firing. However, some of the older, less effi- cient plants may be phased out of production within the next few years and it may not be worthwhile to convert these plants. 9.13 Fourth, the Government's commitment to supply coal at 70% of the equivalent oil price may lead to problems if the coal proves more expensive than currently projected. 'If the coal price is above 70% of the equivalent oil price, the Government has given an open-ended commitment to subsidize the difference. Some hard analysis has to be done on prices and the relative heating power of oil and coal to ensure that the chance of large budgetary payments is minimized. 9.14 A blanket conversion program should be approached with caution. The industry has many problems to overcome and an immediate conversion program will compound these difficulties. The house should be put in order before conversion begins and then conversion should take place gradually in effi- cient firms after careful technical study. This would, of course,, mean a slower, more selective, conversion program, but in the long run, there would be a better chance that the coal industry would have a healthy cement market. If the coal production does go according to schedule and a surplus results, this could be exported, until the cement plants were finally converted to coal. 4. Future Action 9.15 It is apparent that some rationalization is needed in the industry. Some obsolete plants will probably have to be phased out over the next few years. At the same time, new efficient plants must be constructed to meet increasing demand; if the industry continues to grow at 7 percent per annum, demand will reach 5.7 million m tons by 1985 and 8 million m tons by 1990. This would mean an addition of at least: 4 million tons over the next ten years. In practice, this would be closer to 6 million tons as older plants were scrapped. New large-scale plants are needed to meet this demand.  - 120 - 9.16 The industry and the Government need to draw up a plan for rationalization, including plants to be phased out (or at least not to be rehabilitated) and new plants to be built. This plan could also include merging some of the existing firms with revamped management. Furthermore, details of a sensible program for anti-pollution equipment and cement conversion should'be worked out. The needs of the industry for technical assistance and training must also be met. If such an overall program is not developed, the industry's situation will not improve and any further money spent may be wasted. Currently, there are many groups involved in one way or another in the cement industry, but their initiatives are not coordi- nated. The Cement Industry Authority and DBP are the obvious bodies to control the rationalization and rehabilitation program, and they should set up an official joint body to administer it with qualified full-time staff. 9.17 The first step in such a program may involve an investment of $220-280 million. This would include anti-pollution equipment of about $30 million, coal conversion at $30-$50 million depending on whether or not old plants are converted, plus plant rehabilitation at a further $60 mil- lion, and could also include one new plant at $100-$150 million. Over the next ten years, investment in new plants might total $1,100 million (at 1979 prices). The key financing agent for the program is DBP. Cement prices were recently increased by P 5.65 to P 20 per 40 kg bag); of the increase, P 1.35 is being set aside in a rehabilitation fund and P 1.84 for amor- tization of debt to the DBP. Domestic cement prices are in line with international prices, and rehabilitation and new capacity would permit continuation of exports while increasing domestic demand is met. 9.18 The most efficient way to provide financing is through private direct investment and /or a line of credit specifically for cement, available to any firm with proposals that fit in with the long-term rationalization plan. Proponents should be required to put in additional equity before funds would be available. The technical merit of project proposals should be assured by requiring their review by impartial consulting engineers assisting the program administrators. Where necessary, management changes could be required as loan conditions. 9.19 The cement industry is now at the crossroads. If the correct hard decisions are made, its efficiency will improve through plant upgrading and mergers. If these decisions are not made, the debt situation will become worse, costs will increase with consequent disruption to the vital construction industry, and the Philippines may even become a net importer of cement, despite its abundant raw materials.  - 121 - B. The Clothing Industry 9.20 The clothing industry is the most dynamic industry in the Philippines. It has evolved since the 1950s from small tailoringx and dress shops making clothing-to-order, to a multi-million dollar business with exports of over $300 million in 1978, of which around $120 million is net of imported fabrics. The export garment industry provides a striking example of what can be achieved by a combination of entrepreneurial talent and supportive Government policy taking advantage of the Philippines' low labor costs and high quality work force. - 9.21 The garment industry has grown at 5% per annum over the past few years, with gross value added at constant prices increasing from P 533 mil- lion in 1973 to P 657 million /1 in 1977. In 1975, some 106,000 employees in 28,000 establishments produced clothing (see Table IX-1) in the organized sector, and many others undertake part-time commission work in homes and small shops. The reliance of modern clothing production on relatively cheap Table IX-1: THE CLOTHING INDUSTRY, 1975 Size of establishment No. of No. of Value by no. of workers establishments workers added (F ' 000) 1-9 27,014 73,099 241,631 10-19 428 4,277 15,988 20-49 80 2,160 17,905 50-99 30 2,019 20,428 100-199 19 2,693 17,186 200-499 11 3,354 46,898 500 + 8 18,409 94,823 Total 27,590 106,011 454.859 Source: NCSO, Census of Establishments, 1975. /1 Including footwear which comprises around 10% of the total.  - 122 - sewing machines means that garments can be produced efficiently by small industry, and in fact most of the industry's establishments are small cot- tage-type units providing half of total industry value added. The export sector, on the other hand, is based on larger firms catering to high-volume overseas orders. Of the 169 larger clothing firms registered with the BOI, only 17 can be considered as major exporters. The BOI currently has 8 project proposals under review with total investments of $4.1 million. Those projects are expected to generate 2,283 jobs at an average cost of $1,790 per j ob. 9.22 Around 53% of garment manufacturing establishments with over 9 workers are in Metro Manila or surrounding regions. By value, this con- centration is much more marked, with 91% of 1975 value added in Metro Manila and its environs. This indicates the heavy concentration of the larger apparel firms in Manila. 1. The Domestic Market 9.23 The domestic market is estimated at about P 600 million, i.e., less than one-third of the export market in 1978, and has grown at around 5% annually over the past four years. Demand will continue to grow, through natural population growth as well as through consumers' upgrading their clothing requirements as they become more affluent. Lower income families will switch more into cheaper ready-to-wear clothing and middle-class consumers will move away from dressmakers and tailors as ready-to-wear quality and styling improve. These factors could help increase the domestic market growth for garments to around 7% per annum over the next five years. 2. The Export Market 9.24 From 1970 to 1978, clothing industry exports, based on imported fabrics, grew from US$36.2 million to more than US$300 million. Garments have been the cornerstone of the remarkable growth in non-traditional exports witnessed through the 1970s. The trend in garment exports is shown in Table IX-2.  - 123 - Table IX-2: PHILIPPINE EXPORTS OF GARMENTS, 1970-77 (US$ million) Total nontraditional manufactured Total Garments exports exports % % (1) (2) (3) (1)(2) (1)(3) 1970 36.2 94.5 1,062 38.3 3.4 1973 57.9 226.8 1,871 25.5 3.1 1975 107.0 374.2 2,263 28.6 4.7 1976 184.9 545.9 2,516 33.9 7.3 1977 250.2 717.0 3,076 34.9 8.1 9.25 Garment exports increased at an annual compound rate of 32% over this period and more than doubled their share of total exports. These exports covered most types of clothing for men, women and children, with a heavy emphasis on embroidery (54% of 1977 exports) and on high-volume lines, such as standard suits and trousers for customers such as K-Mart or Sears. This dynamic market development reflects the Philippines' wage cost advantages in this highly labor-intensive industry./l In addition to cheap labor, an important factor contributing to the export development has been the Government's policy of allowing the unrestricted and duty-free import of fabric under bond for making up into clothing for export. While it would, of course, be preferable if domestic fabrics could be used to make up into garments for export, this is not practical in most cases at present (see Chapter VII) on price or quality grounds. The policy of allowing imported fabrics to be used in making garments for exports has overcome the problems that would be caused if exporters were required to use domestic fabrics and has permitted the development of the exPort sector with the resulting employment and other spin-offs such as labor and management training. 9.26 The export growth has led to 70,000 new jobs in the past eight years, and, based on current projections of $600 million in garment exports by 1983, another 70,000 jobs will be added over the next five years. While most of the increased employment will lie in larger factories producing for high-volume customers in Europe or the United States, a significant proportion will be in smaller businesses, particularly in the subcontracting /1 Some manufacturers complain that the low wages are offset by low produc- tivity. This is true in some factories but others have productivity just as high as in other exporting countries in the East Asia Region. Productivity is mainly a function of management and factory conditions.  - 124 - of embroidery or knitting. Sub-contracting and the use of outworkers are growing and are excellent ways to encourage small industries, particularly outside Manila. The exact extent of such sub-contracting is unknown, but it is without doubt significant./l In one firm visited by the Mission, some 3,500 outworkers were involved in hand embroidery and in knitting sweaters with mechanical knitting machines (at a cost per job of only $650). 3. Direction of Trade 9.27 The garment exporters have traditionally relied heavily on the US, which took as much as 74% of clothing exports in 1975. But, spurred by the 1975 imposition of quotas on certain lines by the US, the industry has diversified its markets. In 1974, less than 5% of garment exports were destined for Europe, but this had grown to 24% by 1977, with Germany, the Netherlands and the UK the big customers. The geographic distribution of exports is shown in Table IX-3. The US is still by far the most important destination, particularly for embroidery products. The growth in the European markets has been mostly in standard ready-to-wear clothing. Table IX-3: DESTINATION OF GARMENT EXPORTS, 1974-77 (US$ Million) Country of destination 1974 1975 1976 1977 United States 74.0 79.1 110.2 156.7 Europe 4.3 8.0 41.9 59.9 Germany 1.5 3.3 15.5 23.5 United Kingdom 0.7 2.3 10.8 11.0 Netherlands 0.5 0.7 4.2 8.2 Other 1.5 1.7 11.4 17.3 Australia 3.6 4.8 6.5 8.0 Canada 2.3 4.2 6.9 4.6 Japan 4.0 3.3 7.9 4.6 Others 5.9 7.7 11.3 16.0 Total 94.1 107.0 184.7 249.7 Source: Board of Investment. /I One estimate has been given of 450,000-500,000 workers, but this may be an overestimate. At best, such a large number of workers would devote only a small part of their time to making clothes.  - 125 - 9.28 The quotas placed on imports of garments from the Philippines by the US, Australia, the EEC and Canada give the industry cause for concern. In past years such quotas, overall, have not been a limiting factor. In fact, quotas have actually increased the Philippines' exports as production has shifted from previously successful exporters, such as Taiwan and Hong Kong, who have been restricted by earlier quotas. However, as the Philippines' exports expand, the pressure of quotas will undoubtedly become more severe. Europe, the growth segment of the market, is moving in the direction of imposing more quotas. 9.29 The business community is becoming increasingly concerned about the future impact of quotas;, and this concern was frequently voiced to the Mission. By and large, the problem is beyond the control of the domestic industry and must be handled at a broader policy level. There are, how- ever, several practical steps to take to minimize the impact of future quotas. The industry must be able to diversify its product lines, so as to have the flexibility to shift productions to lines unaffected by quotas. It must also try, wherever possible, to upgrade quality standards so as to avoid competition at the low end of the market. For this purpose., the industry needs to know precisely the fashion and market situation in other countries. Incentives must be provided to help Filipino entrepreneurs to travel overseas on business and/or to retain agents in other countries for feedback trends. These incentives could take the form of tax credits or deductions from taxable income of a given percentage of overseas promotional expenditure incurred. The question of minimizing the impact of quotas is tightly linked with that of export promotion, discussed below. 4. Technical Performance 9.30 The Mission found the technical performance of the industry entirely satisfactory in one or two large units. In all the small and medium fac- tories, operations are very primitive. This causes few problems in the smallest rural units, but in the medium to large factories, productivity and quality could be improved by a little low-cost automation. Simple jigs for more accurate sewing of pockets, collars and cuffs, the use of lay planning and pattern "grading" (i.e., making patterns of a whole range of sizes from a master pattern), and the use of some of the simple sewing machine accessories that are. now becoming both cheap and widely used, would all increase efficiency. If garment manufacturers sent technical staff abroad on short, practical courses, the payoff would be substantial. Issues Use of Domestic 4Materials. The export garment industry relies almost entirely on imported raw materials, mostly fabric. In general, domestically-produced fabrics are considerably more expensive than imported fabrics, and in many cases their quality is inferior. The only cases the .Mission found in which domestic material was used in garments for export  - 126 - were some T/C shirting fabrics, nylon tricot fabrics and acrylic yarn for sweaters. In most cases, however, the garment industry imports fabrics from Hong Kong, Japan, Thailand, Taiwan, Malaysia and South Korea. Accessories such as zippers, buttons, labels and lace are also mainly imported. 9.31 These materials are imported for re-export duty-free through bonded warehouses or the Export Processing Zone at Bataan. This policy of free import has minimized the problems the garment industry would face if it had to rely on domestic fabrics under the present tariff system. In fact, the textile and the export garment industries are, for all practical purposes, two separate industries, with the textile industry operating under a high tariff regime and the garment industry at free trade prices. This is illustrated by the case of a big textile firm that produces fabrics for the domestic market and also operates a large export clothing firm based entirely on imported fabric. Other domestic garment manufacturers, who have applied for BOI registration as exporters, have indicated that they will shift to imported fabrics through bonded warehouses as soon as their applications are approved by the BOI. 9.32 While the free import of fabrics and accessories has helped the garment industry, it also means that a large potential market (some $180 million in 1978) for the textile industry has gone begging. A crucial issue is what can be done to ensure that domestic textiles can be used more in the export garment industry. As long as the existing system of high tariffs and import restrictions supports the domestic textile industry, there is no incentive to produce textiles for export. Inefficient firms cannot meet the low prices needed to be competitive in export markets,,and efficient firms comfortably make high profits on the domestic market. As the protection is reduced, however, the export market will appear relatively more attractive than at present, and the more efficient textile producers will be better prepared to make the effort needed to meet the price and qualities necessary for export. Garment manufacturers would be more than willing to use competitive domestic textiles to avoid the costs and delays associated with importing raw materials. (It may take up to three months to go through all import procedures before raw materials finally arrive at the plant.) By the same token, even though a reduced tariff would mean that the textile industry would have increased incentive to sell to the export garment industry, there will still be a price advantage on domestic sales (for example, a 25% fabric tariff would mean domestic prices could be some 25% higher than c.i.f. imports). This difference will not be as great as now, and there will be more reason to expand output and profits through sales destined for export. 9.33 Another step that the Government could take to increase fabric exports would be to ensure the wide availability of drawback of tariffs paid on inputs of textile firms which sell fabric to the garment industry for eventual export. There is provision for such indirect drawback for BOI registered firms, but the paperwork is complicated, and many firms do not attempt to get such drawback even when they are entitled to it. Such  -127 - drawback should be available to any firm, not simply to those registered with the BOT, and the administrative procedures for claiming it shiould be simplified. In addition, the import restrictions on yarn should be lifted if such yarn is destined for export. A weaver, even if efficient., will find it hard to export directly or indirectly if he must purchase higher-cost domestic yarn. In effect, drawback combined with unrestricted import of y.arn used in weaving for t'he export garment industry would put the weaving industry on a free-trade basis for export, in the same manner as t:he garment industry currently operates,. This, combined with increased efficiency in the textile industry through reduced tariffs and rehabilitation, would ensure that the textile industry expands rapidly into exports. 5. Export Promotion 9.34 The success of garment exporters speaks for itself and niot a great deal of promotion is needed. Overseas buyers now actively seek outt Philippine suppliers with large orders, and promotion is not as necessary as in other industries that have not developed their e-xport potential. Nevertheless, export promotion could pay dividends in two areas: (a) encouraging smaller industry, particularly in the regions, to enter the export market, and (b) sear'ching for opportunities to upgrade the quality of garment exports to help the industry break into higher priced markets and thereby maintain the impetus of the export drive. 9.35 The BOT already a! ssists small exporters on an ad hoc basis through seminars, conferences and briefings, but a more systematic approach is warranted. This would include an information system to notify small pro- ducers'of export opportunities, explain export procedures and introduce them to foreign buyers visiting the Philippines. In addition, to ensure that small producers have access to imported fabric and are not solely dependent on domestic textile mills, a system of bonded warehouses that could be shared by a number of smaller producers should be introduced. This would overcome the present disadvantage suffered by small producers who cannot afford a bonded warehouse solely for themselves, and would also inicrease the efficiency of use of the bonded warehouse system. 9.36 In general, most of the garment exports are in standard, low-priced categories and are thus subject to competition from other developing countries. Such competition will probably become more severe as China enters more deeply into world markets. There is no reason why the Philippines cannot aim an increasing proportion of its exports to a higher market level. In some casels, this has already been done. One manufacturer visited by the Mission is selling nightwear to quality stores in 'Europe, the US and Australia. T-he key- to such upgrading is quality control a-nd design. Design is something that a. government cannot directly help with to any great extent, as it depends largely on individual talent. But the government can give indirect assistance through market information and tax assistance for overseas travel, as discussed above.  - 128 - 6. Tariffs and Incentives 9.37 The main incentives assisting the domestic clothing industry are the tariffs and restrictions on clothing imports. The most important incentive available to the export industry, by contrast, is the free entry of raw materials. The domestic Industry is protected by a tariff of 100%. This is higher than the 70% tariff on fabrics, and results in an available effective rate of protection on the order of 175%. In practice, compe- tition coupled with the relatively low level of domestic purchasing power and, in some cases, the lower quality of garments produced for the domestic market, mean that domestic prices are not set as high above c.i.f. import prices as the tariff would allow. Nevertheless, domestic prices are still considerably higher than export prices, primarily because material costs are higher (see Chapter VII), and also because profits on the protected domestic market are higher. In fact, all garment manufacturers seen by the Mission, who sell both domestically and for export, stated that profits per unit on the domestic market were higher than on the export market (see Annex IX-1). 9.38 Those garment manufacturers that are registered with the BOI are entitled to the normal range of fiscal incentives available to registered firms. In practice, however, these incentives mean less to the garment industry than to many other industries. Capital cost in garment manufacture is low and hence the incentives for expansion reinvestment, accelerated depreciation and exemption from duties on capital equipment are not so important. In a typical clothing factory, the latter two incentives would amount to less than 1.2% of annual output. The incentives allowing deduction of labor training expenses from taxable income has been useful to many garment firms, as has the deduction of direct labor cost from taxable income within certain limits. To profitable firms, this is worth about 2.5% of each year's sales. In conclusion, the best incentives that the garment industry can have are the continued absence of tariffs and import restrictions on inputs for all sections of the export sector, and for the domestic sector, a reduction in price of textile fabrics through lower domestic costs and reduced tariffs on textile inputs.  - l?9 - C. The Furniture Industry 1. Recent Performance 9.39 Wood is one of the primary resources of the Philippines. In 1977, the export of logs earned. the country US$133 million (the 5th most important export item). Exports also carried US$66.6 million in sawn lumber, and US$40 million in plywood. 9.40 Nevertheless, the woodworking industry is relatively undeveloped, and there are few modern furniture factories. More than 95% of the furniture making firms are small-scale by any standard. Precise figures oln the number of firms and the employment in the industry are not available since a large part of the furniture is manufactured in the Philippines by artisans and household carpenters. In the NACIDA registrations of November 1978, there were 8,125 "woodcraft" registered cottage firms employing 33,915 workers. There may be three times that number engaged in wood carving or woodworking "outside" as household workers. 9.41 Other estimates state that in 1977 there were 15,000 separate "manufacturers of furniture." This probably includes makers of rattan and "buri" (wicker) furniture,' of which there were 2,300 separate NACIDA cottage industries registered, employing 9,297 workers. 9.42 The overwhelming majority of the furniture manufacturers - even those that are above the cottage and artisan level - use very little machinery, and have fixed assets of not more than P 200,000 (US$30,000). A handful of firms, primarilyeexporting, have fixed assets above the range of P 4 to P 5 mil- lion (US$500,000 to US$700,000). 9.43 A study of the furniture industry in 1974 by UP/ISSI found that at that time most of the small furniture firms had an annual production of between P 200,000 and P 500,000 (US$30,000 to US$70,000). With very few exceptions, furniture industries in the Philippines were family concerns, single proprietorships without any expertise participation; and, they are still so today. 9.44 In general,.local home demand for furniture is low; and, the most successful enterprises tend to be those that produce office furniture, for which there is-great demand during business construction booms, or furniture for hotels. There was a rapid growth in the-latter during the big hotel construction program of 1.975-76. The smaller furniture manufacturers very often sell their custom-built items directly to customers from their own showrooms or stores. 9.45 The last few years have seen a significant increase in the export of furniture even though the total figures still'remain modest. The increase in rattan furniture exports has been impressive, and there has also been some significant increase in the export of "buri" and wood furniture. The total value of furniture exports of all types amounted to only US$854,000  - 130 - in 1968 as against US$21.7 million in 1977. It is estimated that furniture exports in 1978 exceeded US$25 million. While this is impressive, furniture represented less than 1% of all Philippine exports, and it is a relatively small amount compared with Taiwan's furniture exports to the US of US$152 mil- lion in 1977. 9.46 More than half of 1977 exports, or US$11.4 million, was of rattan furniture. This is a spectacular increase from the US$2.8 million as recently as 1975. US$6.9 million represented the export of "buri" furniture in 1977, also a spectacular increase from less than US$1 million in 1975. Wooden furniture, also increasing rapidly, was US$1.59 million in 1977 (and is expected to rise to close to US$2 million in 1978). 2. Supply of Raw Materials and Components 9.47 A major problem preventing the development of furniture for export is the availability of suitable raw materials. Despite large forest reserves in the Philippines, supplies of the attractive "narra" hardwood are becoming scarce. Large forest areas have been depleted, and the Government decided to impose severe restrictions on the amounts of this hardwood that can be felled, and banned its export. Furniture manufacturers complain that this ban made it very difficult for them to obtain "narra" wood, and has made it very expensive. 9.48 So far manufacturers are convinced that only the "narra" wood is suitable for export furniture. Experts at the Forest Products Research Institute (FORPRODICOM) in Los Banos claim that they are working on substitutes for "narra." This institute might give more direct assistance to the furniture manufacturers who complain they get little help from it. There is no doubt that more could be achieved using other species of timber available in the Philippines, and the overreliance on "narra" is due more to prejudice and lack of technical information. 9.49 Even more difficult is the supply of raw material for the rattan furniture industry. Exports are growing at a fast pace, which is straining the supply of raw materials. A ban has been placed on the exports of rattan poles, but this is being circumvented in all sorts of ways. Rattan manufac- turers complain that they are only able to obtain rattan poles with great difficulty and at a very high price; and, that this now has become a serious constraint on the expansion of the export of rattan furniture. Daily, new buyers arrive and offer attractive orders, but the manufaturers are reluctant to take on these orders for lack of raw materials. A study is now going on as to whether there is need to allow the import of more rattan poles from Indonesia, and whether more suitable poles can be obtained. 9.50 Raw material is available for "buri" furniture. Although there has been a dramatic rise in the export of "buri" furniture, there are many in the industry who feel that the quality levels and design standards are being lowered by cut-throat competition, and that Philippine "buri" furniture may suffer from bad reports overseas on the quality of the products exported.  - 131 - 9.51 Apart from the availability of hardwoods, there is the serious technicaliproblem of the proper seasoning of timber used in furniture for export to different climatic conditions. Most of the "narra" wood arrives from the forests with high moisture content and primitive kiln drying, or prolonged air drying, usually lowers the moisture content to only about 14%. However, a moisture content of 8% is needed for export furniture and for this, modern kilns with instrument-controlled drying programs are needed. Only a few of the larger modern factories have such kiln drying equipment, which is far too expensive for the smaller factories. The only solution would be the establishment of centralized kiln-drying facilities which could be used by the smaller factories. Some timber dealers are able to provide woods that have been dried to the required moisture content, but charge very high prices. 9.52 Apart from the wood, practically all the accessories and hardware used for exports, and in better-quality furniture for the domestic market, are imported. This applies not only to the metal accessories, but also to stains, varnishes, adhesives, and sometimes upholstery items, etc. It is difficult to see why the Philippines.is not able to manufacture these items; and, efforts should be made to have local industries manufacture these accessories of sufficient quality and reliability (see Chapter VI). Meanwhile, the import of these items poses problems for the small- and medium-scale manufacturers who, until now, have had to tie up considerable quantities of working capital to pay the duties and tariffs (see Chapter II). A few larger firms have made arrangements for a bonded warehouse, but the cost of maintaining such a warehouse is too high for a single small or medium manufacturer. Again the solution could be in grouping. The recent Customs Administrative Order No. 78-3 allows small firms with authorized capital below P 1 million to import items under bond without the need to operate a bonded warehouse; but, it seems that few of the small manufacturers avail themselves of this possibility either through ignorance of its existence, or because of bureaucratic problems. 3. Export Problems and Prospects 9.53 The number of firms actually engaged in exports are few. A recent report /1 mentions 64 manufacturers in Manila and Cebu who belong to the Chamber of Furniture Industries of the Philippines (CFIP) and who are oriented in any measure towards exports. Apart from the technical problems and raw material availability, investment financing is a primary problem. Most small firms are severely undercapitalized, and the furniture manufacturers are unable to meet the collateral requirements of the financing institutions to obtain loans for new equipment. 9.54 Exports of both wood and rattan furniture have gone primarily to the US, and to a much lesser extent, Australia and Japan. While there is no shortage of orders for rattan furniture, more effort will be needed if the industry is to expand substantially the export of wooden furniture. In addition, there seems to be difficulty in financing participation in inter- national exhibitions, travelling expenses for salemen, and even the high costs of freight (particularly of some items from places like Cebu, one of the centers of furniture manufacture). /1 Studies on Philippine Industries; Number 21: "The Wooden and Rattan Furniture Export Industry", PDCP, August 1978.  - 132 - 9.55 Another difficulty facing the furniture industry is the depletion of skilled manpower. One cause is the migration of skilled workers to the Middle East. Another reason given is the inadequacy of training facilities so that not enough skilled carpenters and woodworkers enter the industry. The salary structure does not provide adequate rewards for skilled manpower to encourage the investment in training. This has led some firms to try to invest in machinery, and thus reduce the dependence on skilled workers. 9.56 A survey of manufacturing costs in a number of woodworking firms shows that labor accounted for 20% to 30% and materials for 50% to 60%. The same survey revealed that half of the workers were skilled. In rattan manufacture the number of skilled workers is higher. In the most modern furniture factory, developed exclusively for export as a joint venture with Danish manufacturers, the total cost fell below 15%, and the number of skilled workers required was substantially lower. In general, rattan furniture manufacture is more labor-intensive but, due to the ever rising costs of the rattan poles, the proportionate cost of the material remains high. 9.57 Capital investment in small or medium mechanized furniture factories is on the order of P 10,000 (or between US$1,000 and US$2,000) per worker. One of the most modern furniture factories in the Philippines had an investment of between US$4,000-5,000 equivalent per worker. Most rattan factories operate quite efficiently with investments around P 5,000 per worker (less than US$1,000). Rattan manufacture tends to require more space, and the bigger part of the investment is in factory accommodation. 9.58 There is great potential for growth in furniture, both of wood and rattan, for increased domestic demand and for exports. More export assistance is needed - possibly along the lines already started in the footwear industry - e.g., through the creation of a Furniture Trade Exporters Corporation. There might be a case for such a corporation relocating and regrouping its members on a type of industrial estate which could have common central kiln drying facilities, and might encourage the development of accessories manufacture. 9.59 Some assistance is needed also in design since, until now, most of the designs are provided by the importers who give the orders, or copied from foreign design for the domestic market. The Design Center of the Philipines (DCP) has not provided any assistance in furniture design, and should be encouraged to work in this field. 9.60 Above all, a way must be found to make available adequate supplies of suitable timber and rattan poles - either through regulating the flow of wood from the forests, or through liberalizing imports if this proves necessary. 4. Recommendations 9.61 In conclusion, the following measures for the development of the furniture industry are recommended:  - 133 - (a) Expanding the availability of suitable woods, rattan poles, and other materials through a better controlled reafforestation, felling, and distribution program coordinated with the manu- facturers, and a research program of FORFPRODICOM, and with liberalized imports where needed to maintain supply and reasonable price levels; (b) More training, and the introduction of a wage structure to encourage skill development; (c) More finance for equipment, working capital, and export promotion; (d) Establishing a Furniture Trade Exporters Corporation, with part public capital, to help in export marketing, common materials procurement and seasoning, relocation and training programs; (e) Involving the Design Center in improving furniture design; and (f) Search for new export markets, e.g., Europe, the Middle East and Asian countries, especially for wooden furniture made from timbers other than "narra".  - 134 - D. The Leather and Footwear Industry 9.62 In the last ten years the industry has grown considerably in response to both domestic and export demand. Total footwear production of all types was estimated to be 32 million pairs in 1976, of which 6.7 million pairs were of leather. Most of the shoe manufacture is carried on in small cottage-type industry. There were over 2,700 leather shoe manufacturers in 1978, with over 20,000 workers in total. In addition, there were a few large manufacturers of rubber shoes, employing about 10,000 workers and using local raw material. In all, about 125 plants had over 50 workers in 1977, and only 7 had over 200 workers. 9.63 The industry has substantial potential for further expansion. At present, only 20% of Filipinos possess a pair of leather shoes. Some five million pairs of shoes were imported in 1976, despite high protection. Export demand is strong at present price-cost relationships. However, the industry must overcome a number of problems, especially raw material supply and productivity. 1. Raw Materials 9.64 Tanneries: Most tanneries are primitive and produce low quality leather. The Philippines does not produce hides in sufficient quantity or quality, the reason being the type and size of the cattle population, the manner of slaughtering, and the poor skills in flaying and preserving the hides. The tanning industry, therefore, relies to a great extent on imported hides - at least for production of better-quality leather. 9.65 Even with imported hides, the quality of finished leather from Philippine tanneries is low. A consultant study of leather production in the Philippines 1/ concluded that only 3 tanneries were producing leather of export quality; their costs were well above international levels. Even for the few tanneries that produced high-quality leather, all the hides and chemicals were imported, and the added value was low. Only 1,000 people were employed in all the mechanized and partially-mechanized tanneries - less than half of these full-time. 9.66 A major long-term technical assistance program would be needed to bring locally-produced leather to quality standards. It would have to extend from cattle raising, the slaughtering of animals, and the treatment of hides to the equipping of tanneries and the training of technicians and skilled workers. /1 Feasibility study of "Integrated Program for the Philippines Leather and Footwear Industry" - ITALMACCHINE PLANTS S.P.A., Milan, Italy - October 1978.  - 135 - 2. Labor Productivity and Capital Intensity 9.67 Productivity in export firms is sufficient to permit further expansion of sales. A few factories reach a productivity of 7 shoes per worker per day. This compares with 10 to 15 in Italy. Philippine companies compare favorably with India where two to three pairs per worker daily is not uncommon in the smaller factories. 9.68 Low productivity is explained by low mechanization and poor skills. Further, there is virtually no footwear component manufacturing in the Philippines, so that each shoe manufacturing firm has to produce - or import - all parts of the shoe. 9.69 Even where the footwear industries have been equipped with modern machinery, the capital cost per worker remains low. One of the most modern shoe manufacture factories in the Philippines, in the Bataan export zone, produces over 2,000 pairs a day with 280 workers at a capital cost per worker of less than US$3,000. In the rubber shoe manufacturing industry, capital costs are nearer US$1,000 per worker. 9.70 Wage rates in the shoe industry are generally low,on the order of E 12 (i.e., US$1.60 per day), but most firms work on a combination of day rates and piece work so that good workers with high output can earn up to P 17-18 (i.e., US$2.30) or higher. Due to the high cost of leat:her and poor utilization of materials, labor costs represent only 16% to 18% of the total manufacturing costs in leather shoe factories. In the more efficient, larger exporting firms, Labor costs are below 15% and the import: content of the finished shoe is on the order of 65%. 3. The Export Industry 9.71 Exports have increased steadily since 1970 and reachecl 12 million pairs of shoes in 1978, 8 to 9 million of which were rubber. There has been a significant proportionate increase in the amount of leather arid synthetic non-rubber footwear exported. The export industry uses mostly imported raw materials. The only exception to this is the case of one or two factories that have been very successful in exports of snakeskin sandals from local materials. 9.72 Most of these export items are relatively inexpensive shoes. In the US, the major market (70% of all leather footwear exports), Philippine shoes averaged $4.45 as against $9 for European shoe imports into the US. A few major exporters are able to get $7 per pair. 9.73 Original designs of footwear in the Philippines are virtually unknown. Buyers usually present samples, and offer to order substantial quantities of these shoes for delivery at certain dates for an agreed price.  - 136 - Many such buyers arrive and are prepared to offer substantial orders; but in many cases, the factories are unable to produce and supply in time, and at the required quality. In some cases the price offered is considered inadequate. 9.74 The Ministry of Industry has made progress in organizing the shoe manufacturing sector. The Shoe Trade Commission centered in Marikina (Metro Manila) was set up in 1977, but so far has progressed little in organizing training or services. The Philippine Shoe Trading Corporation (PSTC, set up in 1978 with 50% of the capital provided by the Government and 50% by a small group of shoe manufacturers) has already undertaken some export orders, and has subcontracted some of these orders out to smaller firms. Most larger exporters have until now claimed that they cannot subcontract export orders for fear of jeopardizing quality standards. The new Corporation's subcontract arrangements could constitute a promising development and provides the main hope for upgrading the better of the smaller and medium industries. Through PSTC the smaller firms together can operate a common bonded-materials warehouse, thus enabling them to import duty-free quality leather for re-export in shoes. The PSTC can also arrange the refinancing of foreign letters of credit through the special Central Bank scheme for providing export credits. This grouping, together with the Corporation, can also make contacts with additional buyers from new countries and may, in the course of time, help solve the problem of the lack of training facilities for skilled footwear technicians. 9.75 Technical Assistance. There is as yet no technical institute to assist the shoe industry. Such an institute could be of assistance in improving the quality of indigenous materials - both natural leather and synthetic - as well as such items as the use of plastics, rubber components, adhesives, and finishing materials. A center might also assist in creating original Philippine designs, possibly together with the Design Center of the Philippines. As a long-term aim, a leather and footwear development center might also develop some locally-made shoe manufacturing machinery. 9.76 Prospects. There is an increasing interest by foreign and local investors in footwear manufacturing projects in the Philippines. Six of the larger existing firms have already applied to the BOI for expansion geared to the export market. Twenty-four firms have submitted new investment proposals. If all these projects were implemented, this could add further capacity for over 60 million pairs of shoes, which would have to go primarily to export. This would amount to increasing present capacity by a further 150%, and could create more than 15,000 new jobs; but, there might be some marketing problems. 4. Domestic Sales 9.77 For the home market, lower quality shoes are considered adequate. Smaller factories supply this market with designs copied from magazines or imported products.  - 137 - 9.78 Upgrading quality and productivity of the smaller factories would require substantial financial and technical assistance. Most of the manufac- turers are severely undercapitalized. Although some of the Marikina (Metro Manila) medium-sized factories have managed to obtain DBP and IGLF loans, the lack of adequate collateral has prevented most of these firms from availing themselves of these lines of credit. Several smaller shoe manufacturers stated they still had to obtain working capital finance from traders at 3% per month. 5. Recommendations 9.79 To achieve its full potential and sustain the present momentum of the industry, more comprehensive assistance is needed: (a) Expansion of the scope and activities of the Philippine Shoe Trading Corporation. All export firms, including small ones, should be permitted to import raw materials duty-free; (b) More finance must be made accessible to the smaller firms for working capital and equipment; (c) A Leather and Footwear Development Center, jointly operated by the industry and Government, should be set up; and (d) A long-term (10.-year) program for developing a high quality leather tanning industry is needed.