Philippines - Structural Adjustment Loan Project

Document of ' The World Bank i FOR OFFICIAL USE ONLY Repor No. P-28,72-PH REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMF TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF THE PHILIPPINES August 21, 1980 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 authorization.  CURRENCY EQUIVALENTS Currency Unit = Peso .F 1 = US$0.135 P 1 million = US$135,000 US$1 = P 7.40 ABBREVIATIONS BOI - Board of Investment CB - Central Bank of the Philippines EPZA - Export Processing Zone Authority LIDP - Letter on Industrial Development Policy MOI - Ministry of Industry NACIDA - National Cottage Industry Development Authority NEC - "Nonessential" Consumer Good NEDA - National Economic and Development Authority SAL - Structural Adjustment Loan 51SI - Small- and Medium-Scale Industries UC - "Unclassified" Consumer Good GOVERNMENT OF THE REPUBLIC OF THE PHILIPPINES FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY REPUBLIC OF THiE PHILIPPINES PROPOSED STRUCTURAL ADJUSTMENT LOAN Table of Contents Page No. LOAN AND PROGRAIS SUM1LARY . . . . . . . . . . . . . . . . . . i PART I - THE ECONOMY . . . . . . . . . . . . . . . . . . . . . 1 PART II - STRUCTURAL ADJUSTMENT IN THE ECONOMY AND THE BALANCE OF PAYMENTS . . . . . . . . . . . . . . . . . 7 PART III -THE INDUSTRIAL SECTOR . . . . . . . . . . . . . . . 12 PART IV - THE INDUSTRIAL DEVELOPMENT PROGRAM . . . . . . . . . 17 PART V - THE STRUCTURAL ADJUSTMENT LOAN . . . . . . . . . . . 32 PART VI - OTHER WORLD BANK OPERATIONS . . . . . . . . . . . . . 37 PART VII - LEGAL INSTRUMENTS AND AUTHORITY . . . . . . . . . . . 38 PART VIII -RECOI4ENDATION . . . . . . . . . . . . . . . . . . . 39 ANNEXES I. Country Data II. Status of Bank Operations III. Supplementary Loan Data Sheet IV. Government Letter on Industrial Development Policy V. Selected Documents Available in the Loan File VI. IMF Financial Relations with the Philippines VII. Statistical Appendix 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 authorization.  PHILIPPINES STRUCTURAL ADJUSTMENT LOAN Loan and Program Summary Borrower: Republic of the Philippines Amount: $200 million equivalent Terms: Payable in 20 years, including five years of grace at 9.25% per annum Program The proposed loan would support the implementation of a Description: comprehensive industrial developnent program described in a Letter from the Government to the Bank. The program is designed to accelerate industrial growth, expand employment more rapidly, maintain the rapid growth of nontraditional exports, increase the efficiency of capital use, and stimulate industry outside of the Metropolitan Manila area. To achieve these long-term objectives, actions would be taken, in phases, in the five major areas of export promotion, tariff reform and trade liberalization, investment incentives, industrial restructuring, and major industrial projects. The initial phase of policy reform measures, to be supported under the proposed loan, concentrates on export promo- tion, tariff reform and trade liberalization. Loan Description: The proceeds of the proposed loan would help finance industrial imports and technical assistance during the start of the structural adjustment process. The import component ($195 million) would provide foreign exchange for imports of industrial raw materials, intermediate and investment goods, and spare parts. The Philippine peso counterpart funds generated by the proposed loan would be credited to a special account in the Central Bank and would be used to finance economic development expenditures. The technical assistance component of the proposed loan ($5 million) would finance consultancy services to help the Government formulate and implement industrial policy measures and programs.  - ii - Estimated The import component of the proposed loan would be dis- Disbursements: bursed in two tranches over a period of twelve months. The first tranche of $100 million would be available for disbursement at the time of loan effectiveness. The second tranche of $95 million would be available on January 31, 1981 if progress in liberalizing import licensing and realigning tariffs is satisfactory. The technical assistance component of the loan would be disbursed over a period of four years as expenditures are incurred. US$ million Bank FY81 FY82 FY83 FY84 Annual 195 1 2 2 Cumulative 195 196 198 200 Appraisal Report: None. This is a combined President's and Staff Appraisal Report.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPKENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT LOAN TO THE REPUBLIC OF THE PHILIPPINES 1. I submit the following report and recommendation on a proposed structural adjustment loan to the Republic of the Philippines for the equivalent of $200 million to support its industrial development program. The loan would have a term of 20 years, including 5 years of grace, with interest at 9.25% per annum. PART I - THE ECONOMY 2. An economic mission visited the Philippines in May/June 1979, and its report, entitled "The Philippines: Domestic and External Resources for Development" (No. 2674-PH), was distributed to the Executive Directors under Sec-M79-822 dated November 16, 1979. An industrial sector report, entitled "Industrial Development Strategy and Policies in the Philippines" (No. 2513- PH) was distributed on the same date. A related financial sector report, entitled "The Philippines: Aspects of the Financial Sector" (No. 2546-PH), was distributed to the Executive Directors on October 12, 1979. Introduction 3. Despite the deterioration in the Philippines- terms of trade and the sharp cyclical fluctuations in the international economy during the 1970s, better economic management made possible considerable improvements in the rate and structure of the country's economic growth. The trend growth rate of GNP was accelerated from 5% to 6%. The ratio of fixed investment to GNP was raised from 16% in the early 1970s to nearly 25% at the end of the decade, and the export growth was increased. Although the level of domestic savings rose substantially, high foreign borrowing was still necessary to help finance the acceleration of growth and investment and to provide time for orderly adjust- ments to reduce the large balance of payments deficits experienced after the 1973-74 energy crisis. The public sector played a much more dynamic role in stimulating development in the 1970s, and the perfonrance of the agriculture sector was also quite good. 4. However, some difficult longstanding problems remain to be tackled more intensely in the 1980s, and new development issues are emerging. The most important of these are further slowing of the population growth rate, acceleration of enployment creation, and alleviation of widespread poverty. In addition, the 1979 oil price increase and international recession have significantly tightened the balance of payments constraint facing the Philippines. Hence, a major structural adjustment effort will be necessary if the country is to continue to make reasonable progress towards its development objectives. An increase in the efficiency of investment, reduced dependence on imported oil, and improved performance of the manufacturing sector will be critical to the success of the adjustment process and the development effort.  - 2- Economic Performance in the 1970s 5. More Dynamic Role of the Public Sector. The public sector had historically played a relatively passive role in the development of the Philippine economy and had claimed a much smaller share of national resources than in many other developing countries. In the late 1960s, general govern- ment expenditure averaged only 12% of GNP, public investment was strikingly low at about 2% of GNP, and tax revenues stood at 11% of GNP. Government expenditures were dominated by general administration and social services. 6. The public sector assumed a much more important and dynamic role in the 1970s. Both the overall level of expenditures and the shares going to economic services and public investment were raised dramatically. By the end of the decade, government expenditures reached an estimated 16% of GNP, and public investment equaled about 5.5% of GNP. This expansion brought about badly needed improvements in basic infrastructure particularly in transpor- tation, power, and irrigation as well as the development of more effective programs in the fields of urban and rural development, health and family planning. 7. At present, the size of the public investment program is appro- priate. Its composition is, with a few exceptions, broadly consistent with the countrys development priorities. However, as resource constraints are likely to be tight during the next decade, further strengthening of investment programming and budgeting procedures will be needed to concentrate resources on the highest priority projects. 8. The rapid expansion of public expenditure has been made possible by a program of systematic tax reform to raise the needed revenues equitably and efficiently. The dependence on cyclically volatile taxes on international trade has been reduced, and the proportion of revenue coming from domestic taxes has been increased. The domestic sales tax has been restructured to improve its progressiveness. Numerous increases have also been made in excise taxes, both to raise revenues and increase the progressivity of the indirect tax system. Overall, the tax ratio was raised by more than two percentage points during the 1970s. Although revenue performance was thus quite buoyant, this buoyancy resulted from a series of annual packages of new tax measures and vigorous efforts to improve taxpayer compliance and collection performance. The elasticity of the revenue system to GNP growth is still below unity. Consequently, continuation of a strong revenue effort, both by the Government and government corporations, will be necessary to allow for further expansion in infrastructure and social services. Further tax reforms are needed to raise the tax system-s elasticity, to improve its equity by increasing the proportion of revenue coming from direct taxes, and to reduce distortions in economic incentives. 9. Population. The Philippine family planning program now registers approximately 650,000 new acceptors per year. The estimated proportion of married women of reproductive age practicing family planning increased from 15% in 1973 to 27% in 1978. However, by East Asian standards, this index is  - 3 - still relatively low, and the number of new acceptors has reached a plateau as the program has faced the increasingly difficult problem of reaching rural areas. 10. In part because of the more active family planning efforts during the 1970s, ... population growth rate fell from 3.0% in the intercensal period 1960-70 to 2.8% in the intercensal period 1970-75. It is currently estimated at about 2.5% per annum. Nevertheless, rapid population growth is still straining available land resources, aggravating already serious employment and poverty problems, and burdening the public budget with a high growth rate of demand for basic services. Further reduction of the population growth rate is therefore vital for the country's future economic development. 11. Agriculture and Rural Development. Although there has been con- siderable variation in performance among subsectors, the trend growth rate of the agricultural sector as a whole was about 5% during the 1970s, which by international standards is quite high. Increased support for agricultural production has been provided through improved price policy and credit, exten- sion, and irrigation programs. Expanded rural development programs such as water supply, electrification, and health have also been initiated. However, little progress has been made in raising incomes in rainfed areas, population pressure on the arable land is steadily increasing, and soil erosion in hilly areas that have been logged over or settled is a serious problem. 12. With the spread of irrigation and high-yield varieties, rice produc- tion from irrigated areas has expanded strongly. The Philippines, once a chronic importer of rice, actually exported about 1% of rice production in the last two crop years. With the completion of the large irrigation projects now under construction, continued rice self-sufficiency appears assured for the 1980s. An agrarian reform was instituted in 1972 to transfer holdings of rice and corn land in excess of seven hectares to tenant farmers and to replace sharecropping with leaseholding on remaining tenanted holdings. Production of nontraditional export crops such as bananas and coffee has also expanded rapidly. 13. On the other hand, the development of rainfed agriculture, which is necessary for raising the incomes of the rural poor in nonirrigable areas, has lagged behind. Locally adapted technologies for improving yields of rainfed grains, particularly corn, are still under development. Productivity in the coconut sector is relatively low because of a large number of overaged trees, although a replanting program is scheduled to start in the early 1980s when a sufficient number of high-yielding variety seedlings will become available. Solutions of the interrelated problems of low incomes and soil erosion in the settled hilly areas will require development of new tree cropping and mixed farming technologies, resolution of difficult land tenure questions, and sub- stantial upgrading of the administrative capabilities of the agencies concerned. Although progress in rainfed agriculture is likely to be slow because of the difficult technical and institutional issues that need to be solved, it is essential if the benefits of development are not to bypass a significant percentage of the population.  14. Industry. Two of the economy's critical structural weaknesses are in industry and energy. Despite some improvements in industrial and trade policies in the early 1970s, the rate and pattern of industrial growth has remained unsatisfactory and continues to be a major cause of the Philippines economic problems. Rather than being a dynamic leading sector, manufacturing grew relatively slowly during the last decade at 6.5% per annum, about the same rate as total GDP. The majority of industries are highly protected and produce only for the domestic market. Since the early 1950s, manufacturing employment has grown slowly, instead of providing job opportunities for an increasing share of the labor force, and has remained constant at about 10-12% of total employment. Efficiency of investment is also low, and manufacturing industry is heavily concentrated in the Greater Manila area. 15. Historically, the industrial sector has been a large net burden on the balance of payments, relying heavily on imported equipment and intermedi- ate goods but exporting very little. Successful steps were taken during the early 1970s to promote such nontraditional manufactured exports as garments, electronics, footwear and handicrafts. Nontraditional manufactured exports increased rapidly during the decade and currently account for nearly a third of the country's total merchandise exports. As a result, the rate of employ- men.t creation recently appears to have improved somewhat. However, the export expansion has been concentrated on a few items, and backward linkages with the rest of the economy have been limited. Consequently, the nontraditional manufacturing export sector is an outward looking enclave in an otherwise heavily protected economy. 16. Energy. At the start of the 1970s the Philippine economy was almost completely dependent on imported oil for energy. Since 1974, considerable effort has been made to reduce dependence upon imported oil through both energy conservation and the development of alternative domestic energy resources. Increases in world oil prices have been fully passed on to consumers, and gasoline taxes and electricity tariffs have been raised to restrain demand. Consequently, the growth rate of energy consumption has been held two percentage points below that of GDP. Measures to diversify energy supply have included the development of hydroelectric, geothermal, coal, and nuclear energy. More importantly, limited domestic petroleum production was started in 1979. However, due to the long gestation period of energy projects, total domestic energy production still constituted only 15% of total commercial energy consumption at the end of the decade. 17. Savings and Financial Sector Development. Both public and private savings performance improved considerably during the last decade. Gross domestic savings expanded from 20% of GNP in the early 1970s to the present leve!l of 25% of GNP, financing about 80% of total investment, with the balance coming from foreign savings. The Philippine financial system is relatively well developed and in recent years has become increasingly sophisticated. Significant improvements have been made in financial policy to increase the efficiency of financial markets in intermediating between savers and invest- ors. The banking system was strengthened by increases in capitalization; interest rates were realigned to encourage a greater flow of financial savings into time and savings deposits relative to short-term deposit substitutes and  - 5 - to reduce the spread between borrowing and lending rates; and special credit programs were introduced to expand lending to the credit-short agricultural sector and rural areas and to serve the needs of medium- and small-scale industries. 18. However, some important issues concerning the mobilization and allocation of financial resources remain to be tackled in the 1980s. Buoyant private savings will continue to be the primary source of financing for investment. The level of domestic savings will need to rise by 2-3% of GNP over the next decade in order to maintain the level of investment while simultaneously reducing the current account deficit and the country's reliance on foreign savings. Industry relies heavily on foreign financing, and more domestic finance needs to be made available on longer terms. Financial policy, especially with regard to interest rates, will also need to encourage greater efficiency in capital use and to allocate resources more effectively to priority development needs such as labor-intensive and export-oriented industries. Development Strategy and Key Issues for the 1980s 19. The Philippines development strategy was set out in a Five-Year Development Plan for the period 1978-82. The Plan's major objectives are (a) to accelerate the rate of growth first to 7% and then to 8%; (b) to generate sufficient productive employment opportunities for the rapidly growing labor force; (c) to provide for the basic needs of the population; and (d) to reduce social, regional, and economic disparities. The Plan-s agricultural strategy emphasizes food production, agricultural diversification, and stronger linkages between agriculture and industry. Its industrial strategy calls for further processing of domestic raw materials, accelerated employment generation by small- and medium-scale industries, and selected large-scale projects. The projected current account deficit is to be restrained to managable levels by inter alia aggressive export expansion and domestic energy development. The Plan also includes social development targets in education, housing, health, and family planning. 20. The Plan's objectives and strategy are still broadly appropriate, and its quantitative targets were reasonable given the assumptions about the external environment prevailing at the time of its drafting. However, in light of adverse external developments, the growth targets subsequently had to be revised downwards, and adjustment policies need to be strengthened. Furthermore, the Philippine economy still suffers from a number of fundamental longstanding development problems which need to be addressed during the 1980s. Efforts to improve economic performance will need to concentrate upon employ- ment creation, poverty alleviation, and the efficiency and labor intensity of investment. 21. Fmployment Creation. The economy has not generated sufficient pro- ductive employment opportunities for the labor force which is growing at 4% per year. Due to the slow expansion of industrial employment, an excessively high proportion (85%) of additional labor has been absorbed by the agriculture and service sectors. This resulted in a low or even declining value added per  - 6 - worker in some areas and subsectors and has held down the overall growth of labor income since manufacturing employment is, on average, much more pro- ductive than that in other sectors. With the exhaustion of most new land resources suitable for cultivation and the exploitation of the most irrigable areas, the agriculture sector will be able to absorb only about 40%, or 250,000, of the 600,000 annual entrants to the labor force in the 1980s. Manufacturing will have to provide employment for at least 150,000 of the other 350,000 new workers, a sharp contrast to the annual average of only 40,000 jobs created in the manufacturing during the 1970s. 22. Poverty Alleviation. For historical reasons, income distribution in the Philippines is highly skewed, and there is a small elite which is conspic- uously wealthy. The incidence of poverty has remained high, at 40-45%, in both rural and urban areas, and malnutrition is widespread. Regional dispari- ties are also pronounced, with the incidence of poverty reaching up to 60-70% in the least developed regions. During the last two decades, population pres- sure has led to an increasingly unfavorable man/land ratio and an expansion of cultivation into marginal lands with lower productivity. It has also in- creased landlessness and accelerated migration into urban areas. Both of these factors, in combination with the limited productive employment opportu- nities in the modern sector, have put downward pressure on urban and rural real incomes. Real wages fell at the start of the decade as part of an ad- justmlent necessary to restore external balance and have been held down since then because of the deterioration in the external terms of trade and inade- quate employment creation. Hence, despite relatively high overall economic growlh of 6% per annum, no significant reduction was achieved in the incidence of poverty during the last decade. The key elements in an attack on the country-s poverty problem will be a rapid expansion of manufacturing employment, development of rainfed agriculture, continued improvement in basic public services, and a further reduction in the population growth rate. 23. Efficiency and Labor Intensity of Investment. Private and public investment have risen sharply during the last decade, and both are now at levels appropriate for a country with the Philippines' per capita income and resource endowment. The expansion in the economy's real output has, however, been low relative to the high level of fixed capital formation in the 1970s. The E'hilippines has an incremental capital/output ratio about 35% higher than neighboring Asian countries which have roughly comparable patterns of investment. In addition, as noted earlier, the rate of nonagricultural job creation has been inadequate, indicating that, overall, investment has not been labor-intensive enough. 24. Consumption needs to grow moderately rapidly if the poverty problem is to be addressed and continuation of the prolonged containment of real wages is not to generate unbearable social stress. Hence, the scope for generating additional domestic savings by constraining consumption growth is limited. Since reliance on foreign savings needs to be reduced, it is not realistic to aim at further substantial increases in the investment rate. Consequently, it will be the efficiency of investment (output per peso invested) and the labor intensity of investment (employment per peso invested) that will be the critical determinants of the growth in output and employment. A primary cause of low investment efficiency and low labor intensity has been  - 7 - the distortive effects of past trade, industrial, and financial policies on the allocation and use of capital by domestic market-oriented manufacturing and service industries. Furthermore, as the public investment program rises during the next decade to levels at which resource constraints become increasingly important, greater attention will have to be devoted to questions of the efficiency of infrastructure investment. PART II - STRUCTURAL ADJUSTMENT IN THE ECONOMY AND THE BALANCE OF PAYMENTS 25. The Philippines experienced chronic external deficits during the 1960s, and at the start of the last decade the structure of the balance of payments was very weak. The structural balance of payments problem was aggra- vated by the 1.973/74 oil price increase and the subsequent collapse in commod- ity prices. In the second half of the decade, substantial progress was made in effecting the necessary adjustment in the balance of payments. However, the 1979 oil price increase has offset the recent gains and necessitated a second major structural adjustment effort. Improved efficiency of resource use in the industrial sector and maintenance of the rapid growth in nontradi- tional exports will be critical to the success of the adjustment effort. Response to the First Energy Crisis 26. The Government responded to the first oil price increase by continuing its efforts to improve the basic structure of the balance of payments, while simultaneously undertaking a large foreign borrowing program to maintain the growth of output and investment in the interim. At the start of the 1970s, export earnings came largely from a group of traditional primary commodities with relatively unattractive long-term price prospects. During the decade exports were diversified and earnings performance strengthened through development of nontraditional products and increased processing of primary commodities. Earnings from nontraditional manufactured exports increased dramatically from around $50 million at the end of the 1960s to $1.5 billion in 1979. The trend growth rate of exports accelerated from the 5% rate of the late 1960s to 7% during the 1970s. The growth of imports was also slowed by constraining energy demand, accelerating domestic energy production, expanding rice production to eliminate food grain imports, and restraining the growth of consumption through effective demand management policies. 27. To finance the imports to sustain growth and investment levels, gross disbursements from medium- and long-term external borrowing was expanded from $400 million per year prior to the first energy crisis to over $2 billion per year at the end of the decade. Good external debt management policies were pursued throughout the decade, with favorable market opportunities being utilized to improve the maturity structure of the debt. Accelerated inflation also tended to erode the real burden of the external debt and hold down the debt service ratio. 28. The above adjustment policies were supported by a series of IMF programs, including a three-year extended financing arrangement during 1976-78  - 8 - and a one-year standby in 1979. The policies enabled growth and investment rates to be maintained by the high level of borrowing, while the current account deficit was stabilized at about $1 billion in nominal terms and was reduced from a peak of 6% of GNP in 1975-76 to 4.5% of GNP in 1977-78. Impact of the 1979 Oil Price Increase 29. The improvement in the balance of payments was, however, reversed by the 1979 oil price increases. Since the Philippines imports about 80 million barrels of oil annually, the increase in oil prices from $13/barrel in 1978 to an estimated $29/barrel in 1980 has added about $1.3 billion (3.5% of esti- mated 1980 GNP) to the import bill. Although a recovery in the prices of some primary commodities contributed to a large increase in nominal export earn- ings, the current account deficit nevertheless widened to $1.6 billion (5.4% of GNP) in 1979 and is expected to reach $2.2 billion (or 5.8% of GNP) in 1980, 30. The increase in oil prices has adversely affected the Philippines' overall economic growth and rate of inflation as well as the balance of payments. Instead of accelerating to 7% in 1979 as targetted in the DeveLopment Plan, real GNP growth slowed from 6.3% in 1978 to 5.8% in 1979. Real growth is likely to be 5-6% in 1980. Although agriculture has continued to perform well, the recessionary effect of deteriorating external terms of trade has slowed industrial growth, employment, and investment. 31. The rate of inflation, which had averaged about 7% annually during 1976-78, accelerated to 19% in 1979. This increase resulted largely from higher energy costs, abolition of price controls in June 1979, and adjustment in other prices to reflect the higher cost of imported oil. In order to maintain the real income of workers, which had been considerably eroded in earlier years, the Government increased minimum wages and allowances substan- tially in mid-1979. This adjustment further intensified cost push inflation- ary pressure. Consequently, in February 1980 the Government found it neces- sary to temporarily reverse its policy of price de-regulation and impose a three-month freeze on the prices of nine important food items. The rate of inflation is likely to decelerate only gradually in the course of 1980. The Adjustment Problem and Policy 32. The recent oil price increase has considerably tightened the long- term balance of payments constraint facing the Philippines. Moreover, despite the policy improvement of the early 1970s, the balance of payments still re- flects a number of underlying structural problems. The country still relies on traditional commodity exports for more than two-thirds of its foreign ex- change earnings, and the industrial sector is still too great a net burden on the balance of payments. More than 80% of the economy s energy is supplied by imported oil, and its rising price has raised oil