Philippines - A framework for economic recovery (Vol. 2 of 3) : Sectoral analysis

Repohl No. 6350-H The Philppines A Framework for Economic Recovery (In Three Volumes) Volume II: Appendix on Sectoral Analysis November 5, 1986 Country Programs Department East Asia and Pacific Region FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be used ty recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  FOR OmCIAL USE ONLY PHI LI PPINES COUNTRY ECONOMIC REPORT: APPENDIX ON SECTORAL ANALYSIS Table of Contents Page No. I. BALANCE OF PAYMENTS ...................... ....,........... 1 A. Background ............,,,.,, ,, . 1 B. The Recent Adjustments in the Balance of Payments, 1983-85o*.#,.*.*.oooo ... , ...,, ,,,,,,,,.,. .... ,,,,.,,, ..., 1 Adjustments in the Current Accounto.,0#.... ".696699*0.. 1 Merchandise Exportso. ...... .......................,. 3 Merchandise Imports...#............................ 4 Services and Transfers...,, ... . .... ...... .. 5 Adjustments in the Capital Account ...................... 6 General Developments ......................0......... 6 Details of the External Debt Restructuring..s,.,,..... 7 C. External Financing for Recovery ................,......... 11 Initial Conditions and Strategy .................. 11 Implications for Creditors and Borrowers................ 13 II. ISSUES IN THE FINANCIAL SECTOR................................ 19 A. Introduction ..... .............I, ..... ..... 19 B. Recent Developments in the Financial Sector ................ 20 Performance in the Seventies......... ... ... 20 The Impact of the Reforms of 1980........ .....0..... 20 The Present Crisis .........so........... ......e... . 22 C. The Impact of Government Borrowing on Interest Rates..... 22 The Evolution of Interest Rates......................... 23 The Increase in Government Borrowing .................... 24 D. The Taxation of Intermediation ............................ . 25 The Growth of Base Money..,..................... .. ... , 25 Reserve Requirements.....q...r e m e nt..................... 26 Agri/Agra Requirements ................ , ...... 28 The Gross Receipts Tax (GRT) .......... ......... 29 The Withholding Tax on Interest Income*......... 29 E. Institutional Reforms., ........... ............. 30 The Crisis of Private Commercial Banks................ 30 Government Financial Institutions (QFIs) ................ 34 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.  - ii - Page No. F. Requirements for Future Growth............................. 36 A Consistent Fiscal and Monetary Stance ................ 37 A Reduction in Reserve Requirements and a Rise in the Interest Paid on Bank Reserves................. 37 The Repeal of PD 717.................................... 38 Eliminating the Gross Receipts Tax ...................... 38 Avoiding an Increase in the Withholding Tax on Interest Incomeo... . . e.e.eee ewe e e ........... . e...... 39 Privatizing the Government-Acquired Banks ............. 39 Allowing Freer Entry into the Banking Industry.......... 40 Strengthening the Central Bank's Supervisory Functions* * . *........ . see...... . . e.. . e . . ... ... .e.... 40 Annex 1: The Impact of Government Policies: An Analytical Framework.. e......oooo o...... . , ,,,,,:, ,,,,e,,e, 41 Annex 2: Calculating the Effects of Changes in Different Taxes on Bank Spreads.................... 46 III. THE PUBLIC SECTOR ................. ...... ......... 48 A. Recent Fiscal Developments, 1979-85........................ 42 National Government Fiscal Developments, 1979-84. ....... 42 Fiscal Developments under the Adjustment Program, 1985., ... , ,, o , , , ,, ,.,... 52 National Government Operations . ..o.,.*....oos.. 52 Nonfinancial Public Corporations............ eec...... cc 55 Social Security Institutions .......................... 55 B. Fiscal Outlook for 1986 and Some Analytical Issues .......... 55 Nonfinancial Public Sector .... eec...... ..... . .. 55 Consolidation of Central Bank Operations into the Financial Operations of the Public Sector,. .......... 58 Indications of the Domestic Components of the Fiscal Deficito...o e.... ...... ...... ,c........ 59 Effects of Exchange Rate Depreciation on the Budget Deficit.... ........ ...... ............... 61 Some Desired Fiscal Adjustments for 1986 ....... o ......... 63 C. Medium-term Fiscal Prospects and Isues .................... 65 Revenue Strategy ..... ...........* .........ec... cc.. e... e. 66 Changes in Tax Administration............... ".........o 66 Tax Reform ........................................... 67 The Revenue Effect of the Proposed Reforms...........o.. 69 Internal Cash Generation of Public Enterpriseso.o..e.e. 71 Expenditure Strategy and Organizational Reforms ..5.... o 71 Composition of Public Sector Expenditure ................ 71 Budgetary Support to GFIs..eo.o..... ................. 72 Medium-term Fiscal Scenarios. ...... e.e....eec ....... 72  -iii - Page No. Annex 3: Structural Aspects of the Expenditure and Tax Annex 4: Fiscal Adjustments Under the Program and their Effects on the Current Account Balance of the Balance of Payments ................. , 81 Annex 5: Medium Term Fiscal Scenarios..enari.....os.......... 83 IV. AGRICULTURE'S ROLE IN ECONOMIC RECOVERY......................0 90 A. Sector Performance, 1980-859... 91 Recent Sectoral Adjustments s..........................,,, 94 B. Agricultural Productivity.o.d.... ..v it..y........... 94 Fertilizers and Che si c a l s 96 Pesticides .., , ,............ 102 Irriga tion .. . , . . ..999 . 103 Proposed Government Strategy...r......... 105 The Coconut Sector ................. . , , , * 105 Rural Infrastructure. ................ o ....... , 107 Research and Extension. 9 , , 109 C. Trade Policy .................... 9 , 99,,., 111 Exchange Rate...... ..... , 113 Export Taxes ........... 99 ,9,,, l9 115 D. Issues of Diversification .................................. 116 Potential for Diversification. ............................. 120 Rice .................... ,,, , 122 The Role of Government ................... ............... 123 E. Institutiona,l Constraints................. .9999 123 V. INDUSTRY'S ROLE IN ECONOMIC RECOVERY.,, 6SOO.4%.4 ...................... , ., 126 A. Background to the Current Economic Crisiss.................. 126 B. Recent Developments in the Industrial Sector..........,., 131 The Record Since 1980. . . 99999999999999999999 131 The Export Sector *........ , ............ 138 El1 c t r on i cs . . . . .... , , . 0 0 9 0 a 0 0 0 a . , , .. a138 Garment s . a a. . . 0 a 0 0 0 0 6 a . , ., a a 0 a a a 0 0 a I a138 'he Policy Environment in the 1980s .... 139 The Trade Liberalization Program., 139 Import Restrictions. , , , 9 9 , 9 140 The Current Situation ..... * ........ , ..... . . 141 Realignment of Indirect Taxes.o ...., .., 142 Industrial Incentives Policy,.,*,y.*,.&.**.... 143 Sector Development Programs.......................... ,, 144 Progressive Manufacturing Pr o g r a m s 145 Direct Government Involvement in Industry ............... 146 C. The Current Situation: Causes of Recent Industrial Contraction..... ........ ,,,,. .... otteete ... ... .......... . 147  - iv - Page No. D. Revitalizing Philippine Industry: Requirements for the Short and Medium Terms .................... . .......... . 152 Constraints to Economic Recovery and Measures in the Short Term.........,.'........................... 153 Business Confidence and Government Action ions......e.... 153 Nonperforming Assets, Government Corporations and Sequestered Assets 154 Demand Stmltionl s t i o 154 Investment Demand and Public Investment...........**6,, 155 Availability of Credit .................. 155 Import Restrictior.s................. ., ,, ....... 156 Domestic Trade Restraints.. ,9*9.* , ,.. , . ..o . .... 156 Industrial Promotion Policies in the Medium Termo..9.... 156 The Expansion of Exports.... ... 9 ............,...... .0. 157 Trade Liberalization,.,............................... 157 Electronics, Garments and the Quota System.............. 157 Export Diversification and Promotion.-...........6.... 158 Structural Constraints and Infrastructure Needs. ........ 163 Productivity and Technical Change.................... ... 164 Likely Sector Response. . . 165 VI. PUBLIC INVESTMENT ............................... 166 A. Trends in "'iblic Investment. 166 B. Public Expenditure Program for 1986-87.,, . .94, 171 C. The Medium Term Public Expenditure Program (1986-91) 172 The New Government's Public Sector Role, ..... ..., 172 Size of the Public I nvestment Program ....... 174 Medium-Term Program for O&M Expenditures 175 D. Composition of the P I P ...................O .... , , ., 176 Population G r ow t h .......... 176 Agriculture, Rural Development and Irrigation .......... 177 Transportation .... O... 180 Energy ..... .... , .,.. , .............. 181 Geotlhermal., .......... ........,,... 182 Power .....,.., ...................... 183 Water... ,.,,.,,,,....... , ......... 184 Telecommunications.., ... .*........................ ,..,. 185 Education and Training ........ ................... , .. . 186 Industry .... , ,, , . 187 Other Major Projects ................................,, 188 TECHNICAL ANNEXES ON MACRO ISSUES Annex 6: The Role of Monetary Policy .............. 189 Annex 7: Inflation in the Philippines ...................... 192 Annex 8: Recent Adjustment Experiences . . .197  I. BALANCE OF PAYMENTS A. Background 1.01 This chapter examines the external balance situation of the Philippines in the context of medium-term recovery. aecause of the current precarious health of the external sector, a sustainable medium-term strategy will require policies aimed at improving the robustness of trade patterns and improving the creditworthiness of the country. 1.02 Structural deficits emerged in the balance of payments by the mid- 19709. The current account was characterized by deficits averaging 5% of GNP between 1975 and 1981 which widened to 8% by 1982-83. Exports remained concentrated in traditional agricultural commodities, mainly sugar and coconut products, and growth in manufactured exports was limited to the rise in importance of two enclave operations, garments and semi-conductor components. High and uneven levels of protection fostered investment in inefficient industries heavily dependent on imported inputs. In addition, a large public investment program unmatched by mobilization of public revenue put further pressure on the current account. These structural problems were combined with markedly worsened external and weather factors in the early 1980s. 1.03 While the current account deficits were matched by inflows of capital in the 1970s, largely from commercial banks, this external financing pattern was not sustainable in light of the structural problems compounded by cyclical developments. Total external liabilities rose to over 350% of exports and 70% of GDP by 1983, and the share of short-term debt rose to almost 46% of the total. Further complicated by political developments, the difficult external position reached crisis proportions in October 1983 and many emergency measures were taken, such as centralizing foreign exchange operations and initiating debt renegotiations. 1.04 Since that time, a degree of normalcy has returned as outlined in the next section on the recent adjustments in the current and capital accounts. However, in recognition of the burden of servicing a large foreign debt acquired over the last decade and the lack of dynamism in the trade environment, the policy section presents the major elements necessary for the external sector to contribute to the overall development :rategy of this report including supportive net foreign savings and measures for rationalizing and stimulating the trade regime. B. The Recent Adjustments in the Balance of Payments, 1983-85 Adjustments in the Current Account 1.05 Over the last couple of years, the current account has evidenced a sharp reversal, from deficits representing more than 8% of GNP in 1983 to a deficit of $1.3 billion in 1984 (4% of GNP) and a small surplus of $8 million in 1985, as indicated by the summary balance of payments, Table 1.1 As detailed in the discussion of the macroeconomic adjustment program, this reflects a dramatic drop in absorption which more than offsets the accompany- ing drop in output. These trends were reflected in a rapid decline in imports of goods and services rather than any export surge. For the most part, the  - 2 - drop in absorption was not accompanied by any real exchange rate deprecia- tion. In fact, in 1985 the rate appreciated 8.3% on average from 1984. Table 1.1: BALANCE OF FAYMENTS /a (in million US$) Z Change x Change 1983 1984 1983-84 1985 1984-85 Merchandise Trade -2,482 -679 -482 Exports 5,005 5,391 7.7 4,629 -14.2 Imports -7,487 -6,070 -18.9 -5,111 -15.8 Non-Merchandise Trade -740 -975 111 (of which interest expense) (1,985) (2,330) (2,208) Transfers, net 472 396 379 Current Account -2,750 -1,268 8 (as Z of GNP) (-8.1) (-4.0) (0.0) Long Term Loans 1,347 258 2,727 Inflow 2,336 1,259 4,181 /b Outflow -989 -1,001 -1,454 Direct Investments, net 112 6 -9 Short-Term Capital, net -618 549 -1,526 /c Net Errors and Omissions, Gold Monetization and Revaluation Adjustments -254 255 771 Capital Account 587 1,068 1,963 Unremittable Arrears/ Adjustments - - 698 Rollover of nonmonetary trade arrears - - 120 Overall Balance -2,163 -200 2,789 Change in Net Inter- national Reserves -1,011 446 991 Change in I;onmonetary Arrears Increase(-)/ Decrease -1,152 -646 1,798 Memo: Rescheduling 3,111 /a Based on IMF concept of arrears. 76 Includes extraordinary financing affecting short-term capital. 75 Before extraordinary financing. Source: Central Bank of the Philippines  -3- Merchandise Exports 1.06 As explored at length in earlier Bank reports, the Philippines experienced a sharp drop in the growth rate of exports in the early 1980s compared with the gains in the 1970s. This is explained by the combination ot the world recession (1980-83), the continuing decline in the terms of trade (1979-82), the drought (1983) and the appreciation of the real exchange rate (1978-1982). While merchandise exports recovered slightly in 1984, they plunged again in 1985, with a breakdown given in Table 2.2. Table 1.2: EXPORTS BY COMMODITY GROUPS (in millions of US$) X Change Z Change 1983 1984 1983-84 1985 1984-85 Traditional 1,545 1,343 -13.1 1,021 -24.0 of which: Coconut 516 580 12.4 347 40.2 Sugar 299 246 -17.2 169 31.3 Logs and plywood 150 144 -4.0 90 -37.5 Manufactures 2,387 2,992 25.3 2,765 -7.6 of which: Electronics 1,053 1,329 26.2 1,056 -20.5 Garments 545 603 10.6 623 3.3 Nontraditional Agriculture /a 982 923 -6.0 791 -14.3 Other 91 133 46.2 52 -60.9 Total 5,005 5,391 7.7 4,629 -14.1 /a Agriculture exports excluding coconut, sugar, forest products, copper and gold exports. Source: Central Bank of the Philippines 1.07 Manufacturing exports led the temporary export recovery in 1984, increasing over 20% in dollar terms to $3.0 billion, due to the performance of export-geared electronics (up 26% to $1.3 billion) and garments (up 11% to $0.6 billion). This was largely the result of economic recovery in the major export markets. In addition, the real effective exchange rate had depreciated slightly (4% on average in 1984 compared to the pre-crisis level in 1983) following large nominal devaluations in October 1983 and June 1984. However,  -4- manufacturing exports registered t decline in 1985 (8% in dollar terms), con- tributing to the overall decline.-/ This was solely the result of the sharp decline in electronics exports, related to the collapse of the market for semi-conductors. The marginal dollar increase in other exports represented a slight real decline mainly due to the real exchange rate appreciation. 1.08 Despite the slump in the domestic markets after two years of deep recession, domestic manufacturers did not turn to foreign markets. This is a strong indication of the weakness of the environment for promoting external competitiveness, which was reinforced by the lack of price incentives as reflected in the appreciation of the real exchange rate, a key but by no means exclusive factor. Another problem was the external markets' perception of unreliable delivery due to the continuing political uncertainty. In the first quarter of 1986, there were no indications of a reversal in manufactured export trends. 1.09 For traditional agricultural exports, the decline continued in 1984 and 1985, by 13% and 24% in dollar terms, respectively. Only prices of coco- nut products exhibited a sharp transitory improvement in 1984 which offset a sharp production decline due to drought. Other major traditional commodities including sugar and forest products showed declines in both price and volume. For other nontraditional agricultural categories, export performance in 1984 and 1985 was mixed, for example, banana and coffee exports increased in 1984 and then fell slightly in 1985 and fish exports declined in 1984 but showed a respectable increase in 1985. Merchandise Imports 1.10 As explored in earlier Bank reports, other than the large increase in the value of oil imports from the 1979-80 oil price shock, the value of imports was quite flat in the early 1980s. However, beginning in 1984, both volume and dollar value of imports dropped precipitously. The austerity measures, quantitative controls and recession in domestic economic activity were the major causes in 1984. As indicated in Table 1.3, the sharpest declines of over 30% were evidenced for capital goods and petroleum imports. The contraction in intermediate goods was greater than that explained by historical price and output elasticities, presumably due to the tightening of quantitative restrictions. The major exceptions in 1984 were the intermediate imports for the garment and electronic industries which showed an increase in line with exports (61% and 5%, respectively) as special mechanisms were set up to facilitate their access to inputs, e.g., allowing consignment arrangements for garments. By 1985, the further depressed economy generated even less impirt demand. Contraction of import demand was reflected in a sharp appreciation of the real exchange rate in the floating market which had been introduced in October 1984. The greatest contraction again was in capital 1/ Based on balance of payments statistics compiled by the Central Bank report.  - 5 - goods imports (32Z), but the imports for the manufacture of electronic exports also experienced declines in line with the poor export performance. Table 1.3: IMPORTS BY COMMODITY GROUPS (in millions of US$) % Change Z Change 1983 1984 1983-84 1985 1984-85 Capital Goods 1,698 1,150 -32.3 788 -31.5 Raw Materials and Intermediate Goods 2,882 2,505 -13.1 2,092 -16.5 Mineral fuels 2,123 1,649 -22.3 1,452 -11.9 (of which petroleum) 1,741 1,472 -15.5 1,277 -13.2 Food 528 425 -19.5 426 0.2 Other 256 341 33.2 353 3.5 Total Imports 7,487 6,070 -18.9 5,111 -15.8 Nonoil Imports 5,746 4,598 -20.0 3,834 -16.6 Source: Central Bank of the Philippines Services and TransEers 1.11 As shown in Table 1.1, shifts in services and transfers can be important for the balance of payments of the Philippines. The services account fluctuated from a $1.0 billion deficit in 1984 to a $0.1 billion surplus in 1985. The most important component is interest expense which increased 17% in 1984 and then declined 5% in 1985 because of the decline in international interest rates. 1.12 Another major component is workers' remittances. The remittances from seamen and contractual workers (personal income) fell 30% in 1984, largely because of the weaker demand for labor in the oil exporting countries reflecting the oil price decline, offsetting the positive effect from the exchange depreciation. Remittances rebounded slightly in 1985, by 5%, partly because of a shift in composition of contractual workers toward the more highly-skilled. Most other service categories also improved in 1985. Inflows from transfers including personal remittances remained virtually flat in 1984- 85.  -6- Adjustments in the Capital Account Ceneral Developments 1.13 The overall balance of payments strengthened in 1984 and 1985 since the improvements in the current account in 1984 and 1985 were accompanied by improvements in the capital account (see Table 1.1). After exceptional financing, the capital account moved from a surplus of $0.6 billion in 1983 to surpluses of $1.1 billion and $2.0 billion in 1984 and 1985, respectively. The overall balance moved from a $2.2 billion deficit in 1983 to a $0.2 bil- lion deficit in 1984 and a '2.3 billion surplus in 1985. This is reflected in a gradual improvement in the net international reserve position in both years. Furthermore, the $1.8 billion in non-monetary arrears that had built up during the 1983-84 foreign exchange crisis moratorium on debt service were eliminated in 1985. 1.14 The 1984 balance of payments deficit and capital account improvement were due to the inflow of new money from (or guaranteed bX) the export credit agencies of the U.S. and Japan and multilateral agencies._ With an increase in confidence in the foreign exchange situation, and with guarantees from the U.S. and Australian export credit agencies, the shorc-term capital position also improved. 1.15 A major contribution to the passage out of the critical phase of the Philippines' foreign exchange crisis was the external debt restructuring agreements with the private commercial bank and official creditors, most of which occurree in 1985. Overall, this involved rescheduling of $6.5 billion over the 1983-86 period, new commercial money of $0.9 billion and a $3.0 bil- lion trade facility. Pending completion of these negotiations, the moratorium on principal repa,'ments on certain maturing obligations to international creditors originall; imposed in 1983 and resulting arrears build-up had remained in effect. Of these amounts, $3.1 billion of the rescheduling and $0.4 billion in new bank money were the critical factors in closing the capital account in 1985, reflected as inflows of long-term loans as seen in Table 1.1. The fall of $1.7 billion in short-term capital in 1985 reflects the lack of demand for short-term trade financing in line with the macro- economic situation rather than the lack of availablility of funding. The $3.0 billion trade facility with deposits at the Central Bank was underutilized. 1.16 While this rescheduling strategy succeeded in moving the Philippines away from a crisis situation, it alone is not a sustainable strategy for the medium-term. As shown by the external debt indicators in Table 1.4, there has been a deterioration in the debt burden relative to GDP and exports. Interest service remains high, although actual debt service payments were reduced in line with the moratorium on principal payments and subsequent reschedulings. These issues are addressed in the last section as part of the strategy for resuming sustainable growth. 21/ Ihe debt restructuring packages were not basically finalized until 1985.  Table 1.4: EXTERNAL DEBT INDICATORS Heavily Indebted Middle Philippines Income Countries a/ 1978- 1978- 1981 1982 1983 1984 1985 1981 1982 1983 1984 Interest/GNP 4.5 6.1 6.0 6.4 6.9 3.0 5.2 5.4 6.0 Interest/Exports of goods and non- factor services 23.3 36.3 30.5 28.7 32.1 20.2 32.6 28.9 30.9 Debt Service/GNP 7.3 8.8 9.1 8.8 7.8 5.9 8.3 7.9 8.6 Debt Service/Exports of goods and non- factor services 37.8 52.5 46.1 39.4 35.7 39.4 51.6 42.8 44.0 Debt/GNP 48.9 61.5 70.0 i7.5 82.3 31.1 45.6 57.3 59.0 (Debt/GDP) (46.5) (60.6) (71.9) (78.7) (80.3) Debt/Exports of goods and non- factor services 254.2 367.2 352.4 346.6 381.9 206.1 283.5 309.2 302.5 /a Sample of 17 countries. Sources: World Bank, Economic Analysis and Projections Department for 1978-84 figures; Central Bank of the Philippines for 1985 figures. Details of the External Debt Restructuring 1.17 The terms of the Philippine debt package negotiated with the banks are r,ot out of line with those obtained by other major debtors although less favorable than the most recett packages negotiated by Argentina, Chile and Mexico (as shown in Table 1.5). The most notable feature is the greater degree of short-term debt that had to be converted to term debt in the case of the Phil:, pines compared to other countries, many of which negotiated for maintenance of short-term faciLities rather than conversion. The restructur- ing agreement with the private banks had five main components: restructuring of public sector, private corporate sector, private financial sector debts, a new money facility, and a short-term trade facility. Agreement was reached in May 1985 except for the private corporate sector where agreement was not reached untiL January 1986. The restructuring period is from October 17, 1983 (when the moratorium was imposed) through December 1986, involving $5.5 billion of a total of $14.5 billion owed the commercial. banks as of the end of  - 8 - 1985. This included not only $2 billion in medium- and long-term debt resche- duled with a 5-year grace period, 10-year maturity, at LIBOR (or equivalent rate) plus 1 5/8x. It also included $3 billion in short-term debt rescheduled with a 4-year grace period, 4-year maturity and an interest rate spread under 2Z. The bulk of the restructured debt ($2.6 billion) was o;-id by the public sector, with an additional $1.7 billion owed by the private financial sector and $1.2 billion owed by the private corporate sector.  - 9 - Table 1.5: TERMS AND CONDITIONS OF RECENT BANK DEBT RESTRUCTURING PACKAGES Interest Date of Amount Grace Maturity (in percent spread agreement Country (US$ billions) (in years) over LIBOR/US Prime) Argentina 8-85 restruturing MLT 13.4 3 10-12 1 3/8 new loan 3.7 3 10 1 5/8 - 1 1/4 new trade credit 0.5 - 4 1 3/8 - 1 trade facility maintenance 1.2 - - 1 1/8 - 3/4 Brazil 1-84 restructuring MLT 4.8 5 9 2 - 1 3/4 new loan 5.5 5 9 2 - 1 3/4 rollover ST 15.8 - - Chile 1-84 restructuring ST 1.2 4 8 2 1/8 11-85 restructuring MLT 6.0 6 12 1 3/8 new loan 0.8 5 10 1 5/8 - 1 1/4 trade facility maintenance 1.7 - - 1 3/8 - 1 1/8, + 1/8 facility fee Mexico 8-83 restructuring ST, MLT 18.8 4 8 1 7/8 - 1 3/4 new loan 6.0 3 6 2 1/4 - 2 1/8 8-85 restructuring ST, MLT 20.1 1 14 1-1/4 - 7/8 Peru 2-84 rescructuring MLT 0.5 5 9 1 5/8 - 1 1/4 (in new loan 0.2 3 8 2 1/4 principle) trade facility 0.3 - - 5/8 + 1 1/2 acceptance commission Philippines 5-85 /a restructuring MLT 2.2 5 10 1 5/8 ST 3.3 4 4 less than 2 new loan 0.9 5 9 1 3/4 - 1 3/8 trade facility 3.0 - - 1 1/4 /a Agreement on rescheduling of private corporate debt was not reached until 1-86. Source and further details: Maxwell Watson, Donald Mathieson, Russell Kincaid and El.iot Kalter, International Capital Markets: Developments and Prospects, IMF, Feb. 86, pp. 106-120.  - 10 - 1.18 Along side of the restructuring of existing debts, the Philippines secured $925 million in new medium-term money to be disbursed in tranches to the Central Bank. Of this amount, $400 million was disbursed in 1985, $175 million was disbursed in first quarter 1986 and the outstanding $350 mil- lion most likely will be disbursed in 1986. Finally, a short-term trade facility of $3.0 billion was set up to replace the existing short-term debt which had been converted to term debt. The funds were placed on deposit at the central bank carrying a spread of 1 1/4% and then made available as required. However, usage has been low. At the end of 1985, $1.7 billion remained unused. 1.19 The other restructuring agreement reached in December 1984 was with the official creditors of the Paris Club, involving about $1.1 billion. This consisted of 100% of principal and 60% of interest due on medium- and long- term credits between January 1, 1985 and June 30, 1986, rescheduled with a 5- year grace period and 10-year maturity and, as standard, bilaterally negoti- ated interest rates. In addition, the outstanding arrears and remaining interest were to be paid over 2 years and 3 years, respectively. 1.20 In the private sector, the process for determining the extent to which the commercial bank restructuring is passed on to the original borrower is taking place currently. For the public sector, the national government does not receive the benefit of the restructuring with the commercial banks since it must pay into a blocked Central Bank deposit according to the original maturities. Except for the government financial institutions which have been exempted, other government corporations are obligated to service their debt on schedule to the Central Bank. 1.21 The private corporate sector has four options foS,repayment to be negotiated by the creditor and borrower by September 1986..- The most common option would be for the corporate borrower to deposit pesos with the Central Bank at the original maturity schedule, resulting in assumption of the corresponding external debt by the Central Bnnk until that debt becomes due according to the same restruicturing schedule as for the public sector debts. Other options include a rescheduling of maturities with final amortization no later than 10 years without forward exchange cover of the Central Bank and with the Central Bank assuming the obligations whenever that schedule is less generous than that for public sector debt; rescheduling with partial forward exchange coverage from the Central Bank; and rescheduling with peso deposits to the Central Bank over 7 years with 3 years' grace with full forward exchange cover and peso interest capitalization features, to be used only in rare cases of corporate financial distress. 1.22 For the external debt of the private financial sector, primarily about $1.6 billion in short-term debt, the creditor can decide on one of three 3/ For further details, see CB Circular No. lO76, August 1985, as amended by CB circular No. 1601 (May 2, 1986).  - 11 - options by September 1986.41 The borrower may be required to deposit the peso equivalent of the debt immediately, may agree to deposit the peso equivalent of the debt as scheduled, or may agree to a bullet repayment in about 4 years. In the first two caqes, the Central Bank assumes the external obligation once the deposit has been made until that debt falls due according to the restructuring schedule. C. External Financing for Recovery 1.23 Reflecting certain unsustainable structural patterns, the balance of payments has been the critical area of concern for policymakers in the recent past. While the problems have by no means been overcome, a number of recent developments favorable to the balance of payments have lightened the adjust- ment and recovery picture. As elaborated on in this section, these include the decline in oil prices, international interest rates and perceived riski- ness of capital. The more optimistic picture offers the Philippines a number of options. This section emphasizes a strategy based on growth and external sector dynamism. At the same time, it dzscusses the status-quo option with less growth but nonetheless a manageable balance of payments picture. 1.24 The external financing stra:egy of the Philippines is crucial in any recovery strategy. Furthermore, it needs to be consistent with the resumption of growth without a further deterioration in the creditworthiness of the country. one first part of this section discusses the appropriate strategy given the existing external debt situation of the country. The second part discusses the specific implications for the relationships with the major creditor groups. Initial Conditions and Strategy 1.25 International capital flows can and have played a useful role in promoting growth in many developing countries. For example, Korea increased its borrowings in the 1960s, initially leading to high-debt ratios but balanced by expanding output and exports. However, borrowing needs to be accompanied by policies consistent with sustainable growth in output and the external sector such as efficient investment and an adequate real exchange rate policy. Otherwise, the external financing strategy can lead to balance of payments crises with enormous real effects, as evidenced in tne Philippines in the early 1980s. 1.26 Even countries which followed consistent policies and managed prudent borrowing strategies have required some access to external financing of the order of 1% to 5% of GNP over extended periods. As long as the Philippines follows a strategy which productively uses capital and gives the 4/ For further details, see Circular No. 1091, January 1986, issued by the Central Bank.  - 12 - favorable signals to the external sector, it is not inappropriate to run small current account deficits over the next five years. 1.27 The new government has the potential to develop a sustainable growth strategy consistent with some reliance on continued external financing. As sho.n in Table 1.4, the Philippines has a sizeable stock of external debt relative to the size of its economy and external sector. The interest servicing on this debt haa represented about 6% of GNP and 30% of exports of goods and non-factor services (gnfs). Even with lower inte97ational interest rates for 1986, the projected percentage is about the same,- which is about the average for highly indebted middle income countries. For a country in the developing stage modest external financing of about 2% of GNP would still require a surplus in the current account excluding interest of about 4%. Thus, the financing strategy has to be accompanied by policies encouraging a healthy, external sector including the real exchange rate, rural development and the gene al trade regime as outlined in the previous sections in order to generate that surplus. 1.28 Another aspect to consider in developing an external financing strategy is the perception of creditors as to the willingness of the borrower to repay, regardless of the optimality of the use of external financing. In any event, once a country has reached a given level of external indebtedness relative to its resources, it is not necessarily in the interest of its creditors to support a current account surplus because a country may rather resist servicing the debt than reduce it. 1.29 As a ratio to resources, the external debt of the Philippines represented about 250% of exports (gnfs) and 50% of GDP in the 1978-81 period when the Philippines had voluntary access to external capital markets and then rose to about 350% of exports (gnfs) and 75% of GDP in the 1983-85 period, slightly more than the highly indebted middle income country averages of about 300% and 60% (of GNP), respectively. While it may not be in the interest of the creditors to force sharp declines in the current relative levels of debt, the Philippines should aim to move back to more comfortable levels so as to increase flexibility and reduce the risk of being again susceptible to a severe balance of payments crisis. 1.30 An improvement in creditworthiness is not inconsistent with increasing external debt as long as it is accompanied by even greater output and export expansion. The alternative strategy of maintaining or reducing the level of external debt may not be able to succeed in establishing growth and therefore an improvement in debt servicing capacity without serious implica- tions for the share of output available for consumption. 5/ Projected interest payments for 1986 are 6.4% of GNP and 33% of exports of goods and non-factor services.  - 13 - Implications for Creditors and Borrowers 1.31 Reaching the satisfactory net foreign savings position outlined above involves new funding as well as possible rescheduling of amortization payments on existing debt. As shown in Table 1.7, tho financing requirements; net of disbursements from morey already committed are in the range of US$2 billion to US$4 billion per year in the base case. This has a number of implications for both the creditors and borrowers. Tables 1.6 presents existing external liabilities of committed external debt in more detail, with breakdowns by creditors and borrowers.  - 14 - Table 1.6: TOTAL EXTERNAL LIABILITIES (in US$ millions) 1985 Item (End of Year) x of Total By Type of Debt 26,252 Medium- and Long-Term 17,679 67.3 IMF 1,232 4.7 Others 16,447 62.7 Short-Term 8,573 32.7 Trade 4,854 18.5 Non-Trade 3,719 14.2 By Borrower 26,252 Non-Banking System 17,376 66.2 Public 12,358 47.1 National Government 5,939 22.6 Government Corporations 6,419 24.5 Private 5,018 19.1 Banking System 8,876 33.8 Central Bank 5,923 22.6 Commercial Banks 2,953 11.2 Government 841 3.2 Branches of Foreign Banks 1,205 4.6 Private domestic 907 3.4 By Creditor 26,252 Commercial Banks 14,474 55.1 Other Financial Institutions 795 3.0 Suppliers 3,264 12.4 Multilateral 4,486 17.1 Bilateral 2,860 10.9 Export Credit Agencies 786 3.0 Others 2,074 7.9 Others 373 1.4 Source: Central Bank of the Philippines  - 15 - Table 1.7: MEDIUM-TERM FINAN(ING REQUIREMENTS (billion US dollars) 1986 1987 1988 1989 1190 1991 Base Case Current Account 0.28 -0.21 -0.66 -0.77 -0.82 -0.90 3cheduled Amortization /a -0.78 -1.87 -2.78 -1.93 -2.39 -2.40 Changes in reserves -1.23 -0.42 -0.12 -0.35 -0,39 -0.30 (- increase) Change in short-term debt lb -0.91/c -0.40 -0.10 -0.50 -0.50 -0.50 Pipeline Disburse- ments -0.85 0.39 0.54 0.38 0.30 0.10 Financing Cap 1.79 2.51 3.12 3.17 3.80 4.00 New official money/d 0.24 0.69 0.98 0.99 1.11 1.16 Other /e 0.12 0.52 0.47 0.52 0.53 0.50 Rescheduling and other new money/f 1.43/c 1.30 1.67 1.66 2.16 2.30 Memo Items: CA/CNP -X) 0.9 -0.7 -1.9 -2.1 -2.1 -2.1 Debt service ratio 45.7 47.5 45.4 41.2 38.0 34.0 Debt/GNP 91.0 85.9 83.3 81.0 78.7 74.0 /a Total maturities falling due, including monetary liabilities except IMF repurchase after 1985 Paris club and commercial bank rescheduling agreement. /b Short-term debt reductions of the amount indicated from 1989 on should be construed as a desirable objective of debt restructuring and not as a projected amount. /c Includes conversion of short-term debt into medium-term obligations. 7r Estimated disbursements from official commitments signed after December 31, 1985. Includes estimates of likely commitment programs for loans not yet identified. /e Includes direct foreign investment, capital not elsewhere included and gcld monetization. /f Residual to be obtained from rescheduling and other new money sources, both private and official. Eligible scheduled maturities are defined as projected maturities of private financial institutions and bilateral official debt. Other maturities and payments may also be rescheduled subject to negotiations. Sources: Central Bank, Bank staff calculations. !  - 16 - 1.32 The government has declared its intent to change the composition of its foreign financing in favor of more concessional official sources. None- theless, because of their existing share of Philippine external debt, that is, 55Z as of the end of 1985, the commercial banks will continue to play a key role in the external financing strategy. The section on debt restructuring gives a complete picture of the agreement reached for harndling the external financing needs of 1983 through 1986, and the government and banks have begun discussions on the approach beginning in 1987. 1.33 Until voluntary lending has been resumed (presumably in line with the gradual improvement in the Philippines' economy relative to its debt), and given the difficulties of transferring gross disbursements of the magnitudes of financing required in both the high and base cases, an important source of financing will remain rescheduling of scheduled maturities on outstanding debt. The maturities on debt not previously rescheduled represent $4.6 bil- lion over the next five years, with an additional $2.3 billion related to the 1983-86 refinancing package coming due in 1990-91, for a total of $6.7 billion representing about 54% of scheduled amortization. 1.34 The decision as to a multi-year rescheduling of bank debt will be related to the speed of instituting policy directions consistent with the high growth strategy. It is widely accepted that multi-year restructurings have a number of advantages over a series of yearly exercises. They can contribute to an improvement in the climate for effective economic decision making by reducing uncertainty, and can eliminate costly and time consuming negotiations with the large number of banks involved. However, the creditors will not choose to lock themselves into a more comprehensive financing package con- sistent with higher growth unless they are convinced that the debtor country is taking the steps necessary to ensure this most favorable outcome for both creditors and the debtor. Thus, it is imperative that the Philippine govern- ment approach the next round of bank debt restructuring negotiations with clear policy directions and evidence of progress in taking necessary measures. 1.35 In regard to the terms of the rescheduling, the Philippines and her creditors can draw on recent trends elsewhere as well as recent favorable political developments in the Philippines in negotiating both longer grace and maturity structures and smaller interest spreads. The projections exercise indicates that debt repayments remain high in the early 1990s. The restruc- turing can avoid postponing the problem by spreading the maturities beyond that period. Reduced spreads also avoid exacerbating the problem by maintain- ing interest payments at comfortable levels. In the base-case projections, given an interest rate of 9% for commercial bank debt, interest expense as a ratio of exports of goods and non-factor grvices and as a ratio of GNP falls to 22.4% and 5.2%, respectively, by 1991.- 6/ Projections also assume 8% interest rate for ODA and IBRD loans.  -17- 1.36 In addition, the banks can be called upon to provide fresh financing, contributing to the financing of the small current account deficits consistent with the growth strategy and the improvement in debt servicing capacity outlined above. As shown in Table 1.7, the source for an additional US$1.3 billion in 1987 and around US$3.4 billion yearly in 1988-91 remains unidentified in the financing requirement. A major portion of this can be expected to come from private sources as a complement to multilateral and bilateral efforts. The same rationale for favorable terms, both maturity structure and interest spreads, applies to new money as well as to the restructuring of existing debt. Also, there is the issue of the ultimate user of these additional resources. While it will be difficult as long as a situation of unvoluntary lending exists, the new money should be channeled as much as possible directly to the investor and producer communities. 1.37 Another important source of financing is official lending. This source is closely linked to the public finances. First, for project related assistance, counterpart funds as well as adequate operating and maintenance expenditures are necessary to make use of these resources. Second, concessional official lending will be crucial in the shorter term to support the budget. This involves identification of the amounts to cover the budget gap in 1986 and 1987 to prevent undue strain on interest rates and inflation from the alternative domestic bond and money financing sources. It also requires a better articulated growth framework in which to present the consistency of the immediate needs. 1.38 A critical component of the fiscal picture is the debt servicing of the government financial institutions. In light of their large portfolio of non-performing assets (estimated at 85% of DBP's assets and 60% of PNB's assets), these institutions are expected to recover only a fraction of the resources needed to service external debt of over $5 billion, includi7g guarantees. Total 1987-91 servicing is estimated at US$3.1 billion.7 The government must move expeditiously in addressing this problem, as explored in more detail in the financial sector chapter. 1.39 The amortization schedule for committed debt from bilateral creditors represents about 7% of the total amortization for 1987-91, plus presumably a large share of the suppliers' credits (6% of scheduled 1987-91 maturities) because of guarantees by official export credit agencies. Although these amounts are relatively minor, the offi.^ial lending community also may be called upon to reschedule obligations. In that case, it would be crucial for the export credit agencies in coordination with their national governments to agree to maintain existing credit lines rather than cut them off as has been the practice in the past. 7/ According to DBP and PNB, DBP had $2.0 billion outstanding end of 1985; PNB had $1.1 billion in direct borrowing and an additional $2.3 billion in guarantees.  - 18 - 1.40 Other major sources of external financing will continue to be the multilateral institutions. An additional $16.6 billion over 1987-91 would need to be secured from the multilaterals, the bilaterals (new money and/or rescheduling) and commercial banks (new money and rescheduling). However, it must be emphasized that this is only a recommended course of action if taken in tandem with the recommended policy actions for strengthening the external sector. Without those measures, a much more conservative external financing picture is called for, consistent with lower growth in output and exports.  - 19 - II: ISSUES IN THE FINANCIAL SECTOR A. Introduction 2.01 The Philippines' financial system is facing a severe crisis which threatens the economic recovery and ma) become a binding constraint on the country's medium- and long-term growth prospects. The crisis started in 1983. Between 1983 and 1985 bank real deposits and loans outstanding fell by 29% and 54X, respectively. The ratio of M2 to GNP fell from 25% to around 15.3%. By early 1986, several government as well as private financial institutions were facing serious liquidity problems. Savings mobilization was at an all time low and credit to the private sector had almost dried up. Real lending rates stood at around 30%. 2.02 The deteriorating macroeconomy after 1983 is partially responsible for the current turmoil in the financial sector. The fall in income led to a decline in financial savings. Severe corporate dis.ress, due to the fall in aggregate demand, had its counterpart in a worsening in the portfolios of financial institutions. 2.03 Government policies made the situation much worse. After 1983, Government increased its implicit taxation of financial intermediation through an increase in the rate of growth of base money and a rise in reserve requirements. Reserve money grew by nearly 50% during the second half of 1983 alone. Reserve requirements were raised from 18% to 24%. Hence, seignorage, government revenue from this implicit taxation of intermediation, rose from 0.3% of GNP in 1982 to 2.7% and 1.6% in 1983 and 1984. This large tax was associated with a doubling in bank spreads. 2.04 Government has increased its borrowing from domestic financial markets. Between September 1984 and December 1985 the real stock of government securities held by the private sector grew by more than 75%. At present, the Government receives around 40% of the total credit generated by the financial system. This rapid increase in government borrowing was one of the causes of the rise in real interest rates. It led to a decline in the amount of credit available for private investment. 2.05 This Chapter proposes specific policy measures that would help reverse current trends. In addition to reducing real interest rates, these policies will help improve the structure of the financial system. Two sets of institutional problems need to be addressed. First, the Central Bank's reaction to the threat of bank failures was to adopt a policy of merging and consolidating banks. This policy may alleviate short-run problems, but it does not address the long-run structural weaknesses of the financial system. An analysis of commercial banks' balance sheets indicates that bigger banks are not necessarily more stable than smaller ones. By reducing competition, current regulations will, in the long run, adversely affect the efficiency of the financial system. Second, the rehabilitation of the two largest government financial institutions (GFIs) is one of the Government's top priorities. Such a rehabilitation should be accompanied by a clear statement of what the public sector's future role in the financial system ought to be.  - 20 - B. Recent Developments in the Financial Sector 2.06 There have been sharp fluctuations in the financial sector's performance during the last 15 years. In the seventies, the sector was heavily regulated. In the early eighties, policy reforms were successful in allowing it to play a more active role in mobilizing domestic resources. Since 1983, the financial system has not mobilized resources adequately. This inadequacy has been at least partially caused by government policies. Imediate action is needed to reverse the trend of the past three years so that the benefits from the reform process which started in 1980 may be reaped. Performance in the Seventies 2.07 Historically, the incentive system in the Philippines was not geared to mobilize domestic financial savings. Nominal interest rates were closely regulated. Hence, real rates were primarily a function of inflation and often negative. Real deposit rates ranged from -5% in 1970 to -18% in 1974, then from 6% in 1976 to -4.7% in 1979. The interest rate structure was also deficient. Differentials between short- and long-term rates did not encourage long-term savings nor term transformation of maturities by commercial banks. 2.08 Furthermore, there were a number of regulations limiting the activities of financial institutions. These regulations impeded institutional development. They led to excessive specialization and considerable fragmenta- tion. Hence, they reduced competition and diminished responsiveness to changing needs and demands. This legacy of intervention seems to have had a negative impact on the financial system's development. Table 2.1 shows that the ratio of M2 to GNP, a commonly used measure of financial depth, in the Philippines has historically been among the lowest in East Asia. This ratio stagnated at around 21-23% during the 70s. It should be noted, however, that although the ratio of financial savings to GNP was stagnant, these savings were actually growing in real terms since GNP was steadily increasing during this period. The Impact of the Reforms of 1980 2.09 In 1980, a comprehensive set of banking and financial reforms were implemented. The most important of these was the progressive lifting of all interest rate ceilings and the introduction of variable rates based upon the Manila Reference Rate (MRR). Regulatory reforms, while not abolishing the specialized nature of the banking system, enlarged institutional functions, made possible greater competition put together between different categories of institutions, and allowed for the evolution of universal banks.- In addition to carrying out the regular activities of commercial banks, universal banks are allowed to extend long-term credits, underwrite securities and make equity participations. 1/ Eight private commercial banks currently have licenses to operate as universal banks.  - 21 - Table 2.1: RATIOS OF M2 TO GNP Country 1976 1978 1980 1982 1984 Philippines 18.8 22.7 20.9 23.5 20.8 Indonesia 17.7 17.9 18.6 21.2 n.a. Korea 30.3 32.7 33.7 38.4 37.8 Malaysia 47.3 48.4 54.8 64.3 64.0 Singapore 64.0 61.3 68.9 73.4 74.0 Thailand 37.4 38.8 37.4 44.3 56.6 Source: IFS 2.10 Initially, the reforms did increase competition and the financial system played a more active rol.e in mobilizing resources. Real deposit rates moved from -4.7% in 1980 to l.51 in 1981 and 4.7% in 1983. The ratio of M2 to GNP rose from around 21% in 198) to 25% in 1983. Data on commercial banks' deposits and credit outstanding shows a steady improvement in the commercial banking sector's performence during the period immediately following the reforms (Tabler 2.2). Between 1980 and 1983 deposits at commercial banks increased by 32Z in real terms. The increase in the volume of deposits was associated with a leng.gthening of their maturity structure. The share of time and savings deposi.s in total bank deposits rose frcm 71Z in 1980 to 83' in 1983. 2.11 The increase in deposit mobiL.zation led to a rise in bank credit and an improvement in its term structure. Between 1980 and 1983 real credit outstanding by commercial balks increased by 6%, and the share of intermediate Table 2.2: COMMFRCIAL BANK DEPOSfTS AND LOANS (P bin, 1978 1vrices/s) 1980 1981 1982 198,37 1984 1985 Total deposits 30.4 34.4 38.1 40.1 30.8 28.4 Share demand 49 22 16 17 13 12 Share time & savings 71 78 84 83 87 88 Loans oucstanding 55C. 55.1 56.7 58.7 40.6 27.1 Share short term 78 73 69 70 61 61 Share medium & long term 22 27 31 30 39 39 /a Deflated by the CPI Source; Central 3ank and TFS  - 22 - and long-term loans in total credit rose from 22% to 30%. The policy reforms were probably the cause of the improved performance of the financial sector between 1980 and 1983. This performance cannot be attributed to fast real growth since real GNP only grew at an average annual rate of 1.5% between 1980 and 1983, down from an average rate of 5.8% during the previous three-year period. ,he Present Crisis 2.12 As shown in lable 2.2, the situation changed dramatically after 1983. Bank deposits tell, in real terms, by 29% betweeni 1983 and 1985. Consequently, real credit outstanding fell by 54% during the same period. The rario of M2 to GNP fell from 25% in 1983 to 21% in 1984 and then to around 15% it.. 1985. 2.13 The present crisis in the financial sector was partly due to the deteriorating macroeconomy. First, the loss in inicome, caused by the real output drop of 1984 and 1985 resulted in a fall in the private sector's demand for firnancial assets. Hence, deposits at commercial banks declined. Second, the reOuction in aggregate demand had a negative effect on firms and many faced financial distress. Therefore, loan demand weakened tremendously. Third, severe corporate distress had its counterpart in a worsening in the portfolios of financial institutions. Several banks, faced with liquidity/solvency crises, reduced their deposit mobilization efforts. Roughly 9% of the 29X decline in Seal holdings of bank deposits may be attributed to the fall in income.-- The remaining 20% are probably due to government; policies. 2.14 Three sets of government policies have contributed to the crisis in the financial sector. First, Government has had to rapidly increase its borrowing from the private financial market. This has led to a fall in the amount of credit available to finance private activities and a rise in its interest cost. Second, there was a rapid rise in the implicit taxation of intermediation via an increase in the rate of growth of base money and a rise in reserve requirements. It lead to an artificial increase in the costs of intermediation and hence in bank spreads. Third, both the Government and the Central Bank failed to resolve some longstanding structural weaknesses in the financial sector which were magnified by the crisis. These included inadequate supervision of private banks and the crisis of government financial institutions. C. The Irrmpact of Government Borrowing on Interest Rates 2.15 The liberalization of interest rates which started in 1981 was an important step towa:ds increasing the efficiency of the financial system, but 2! Estimates of the income elasticity of the demand for real financial assets usually yield a figure of around one.  - 23 - the high levels of real interest rates which prevail at present threaten the economic recovery. Interest rate liberalization ensured that savers would receive a fair return on their assets. Hence, financial savings were encouraged. More resources were made available for investment than would have otherwise been the case, Financial reforms were initially associated with an increase in both bank deposits and loans. However, today given a tight monetary policy and high public sector borrowing requirements, the Government has displaced private investors out of the financial markets and is partially responsible for the prevailing high interest rates. The Evolution of Interest Rates 2.16 The period 1981-86 can be divided into three subperiods with respect to the levels of real interest rates (Table 2.3). The period immediately following the liberalization, 1981-83, was characterized by a fairly stable level of real interest rates. Real deposit and lending rates averaged 1.4% Table 2.3: INTEREST RATE DEVELOPMENTS /a Year Real deposit rate /b Real lending rate /c Inflation rate /d 1981 1.5 4.5 11.7 i982 4.7 7.0 9.2 1983 -2.0 6.0 16.5 1984 -27.2 -19.7 58.; 1985: I -17.9 -5.3 42.4 II -11.1 4.9 33.1 III 1.0 21.7 15.7 IV 4.7 21.1 7.7 1986: I /e 8.9 29.5 3.5 /a Fourth quarter data for 1981-84. All data are period averages. Tb Rate on 61-90 day time deposits. 7-c Rate on 1-2 year secured loans. 7T Calculated using the CPI. 7e January and February averages only. Source: Central Bank and IFS. and 5.8%, respectively. This period was also characterized by moderate rates of inflation which did not accelerate until the fourth quarter of 1983. The second subperiod, 1984 I to 1985 I, was characterized by highly negative real interest rates. Inflation increased from 9.2% in the fourth quarter of 1982 to 60.9% in the third quarter of 1984, following a rise in the rate of growth of base money coupled with a fall in real output. Nominal rates were slow to adjust to this change in inflation. Deposit and lending rates in this period averaged -26.5% and -18.5%, respectively.  - 24 - 2.17 The third subperiod has been one of high real interest rates. Inflation has been falling dramatically since the first quarter of 1985, from an average of around 50% in 1984 to 7.7% in the last quarter of 1985. Again, nominal rates did not adjust fast enough. As a result, real deposit and lending rates averaged 8.9% and 29.5% during the first 2 months of 1986, respectively. By discouraging private sector spending on working capital and investment, these high levels of real lending rates could abort the economic recovery. The Increase in Government Borrowing 2.18 The rapid increase in government borrowing from the domestic sector together with tight monetary policy which occurred in 1985 is partially responsible for the high level of real interest rates. The stock of government securities held by the private sector amounted to P 71 billion in December 1985. Commercial bank loans outstanding stood at around P 95 billion pesos. That is, Government securities' share of total credit generated by the financial system is roughly 43%. Government is the most important borrower in the financial system. It competes with the private sector for scarce financial resources. 2.19 Despite reductions in the fiscal deficit, government borrowing from the domestic private sector increased dramatically starting 1983. During the period 1974-83, the stock of government securities held by the private sector grew, in real terms, at an average annual rate of 15%. The annual growth rate nearly quadrupled between December 1983 and December 1985 to an average 55%. Between September 1984 and December 1985, the real stock of government securities held by the private sector actually grew by 77%. Parallel to the increased borrowing, the budget deticit fell from 4.3% of GNP in 1982 to 1.9% in 1984. 2.20 Government had to increase its borrowing from the private sector in response to two important changes. The first change, a sharp drop in external financing, was out of Government's control. Net external financing fell from 1.4% of GNP in 1983 to 0.4% in 1984. The Government now had to rely more on domestic sources to cover its deficit. 2.21 The second change was a much tighter monetary policy carried out by the Central Bank. The rate of growth of reserve money fell from 47.5% in 1983 to 5.9% in 1985, which meant that government borrowing from CB had to decline significantly. Between September 1984 and December 1985, the stock of government bonds held by CB actually decreased in nominal terms. The real stock of CB securities outstanding rose from P 2.2 billion (1978 prices) in December of 1983 to P 7.1 billion (1978 prices) in December 1985. CB is competing with the treasury in the financial markets. 2.22 In order to attract private savers, it was necessary to raise the return on government and CB securities. Hence, the real interest rate on a 91-day treasury bill rose from -8.6% in December 1984 to 10.9% in December 1985. Faced with increased competition for funds from the public sector, banks had to raise their real deposit rates. These increased from -11.8% in December 1984 to 6.7% at the end of 1985. As a result, real lending rates reached 30%.  - 25 - D. The Taxation of Intermediation 2.23 The high real lending rates observed in the Philippines today are also caused by the excessive taxation of intermediation. Explicit and implicit taxes on intermediation raise bank spreads, and hence are translated into higher lending rates. There are two types of implicit taxes on intermediation in the Philippines: high reserve requirements and forced investment in agrarian reform bonds (agri/agra requirements). An important explicit tax is the 5% tax on banks' gross receipts (CRT). 2.24 Taxes on intermediation have historically been very high in the Philippines, and they were raised dramatically during the 1983-85 period. Much of the financial shallowing which occurred during this period has been due to the excessive taxation of intermediation. For example, spreads averaged 16.4 percentage points in 1985; of which around 7.2 rcentage points resulted directly from the different taxes on intermediation.- 2.25 If all taxes on intermediation were eliminated, real lending rates in 1985 may have been some 7.2 percentage points lower. A substantial reduction in the taxation of intermediation would Lead to a large fall in spreads. Banq will have a greater incentive to expand and more savings will be mobilized.-' Such a policy action will result in higher bank lending and a fall in real lending rates. The Growth of Base Money 2.26 Recent efforts at controlling the rate of growth of base money have greatly reduced the implicit tax on intermediation. Hence, it is expected that once the financial system adjusts to a lower inflation, bank spreads will fall. Changes in inflation have dramatic effects on spreads. In an economy where reserve requirements are the only tax on intermediation and where the banking system is competitive, the relationship between bank spreads and the rate of inflation is described by the following formula: spread = reserve requirement ratio (real deposit rate + inflation rate) 1 - reserve requirement ratio 2.27 Since in the long run the real deposit rate is unaffected by the rate of inflation at any given reserve requirement ratio an increase in inflation will be translated into a greater spread. Table 2.4 presents estimates of how the spread due to the different taxes on intermediation in 3/ The proof of this statement is found in Annex 2 which presents the formula for determining bank spreads in the Philippines. A simplified version of this formula is presented in the text. 4/ See Annex 1 for an analytical proof of this statement.  - 26 - the Philippines in 1985 would have been different under various inflation scenarios. These estimates indicate that changes in inflation have dramatic effects on spreads. The Government reaps seignorage by printing more money and creating more inflation. The burden of this seignorage is shouldered by the financial system. Table 2.4: ESTIMATES OF THE EFFECT OF CHANGES IN THE RATE OF INFLATION ON BANK SPREADS IN THE PHILIPPINES (Z) Inflation scenarios Spread due to various taxes actual 1985:24.7% 7.2 19% inflation 5.8 14% inflation 4.3 9 % inflation 2.8 Source: Bank staff estimates. 2.28 UsualLy, short-run changes in spreads will be lower than the implied by the calculations presented in Table 2.4. This is due to two reasons. First, nominal interest rates do not adjust instantaneously to changes in the inflation rate. The immediate effect of the fall in inflation is a rise in real deposit rates. Second, banks may maintain spreads in the short run by changing their profit margins or operating costs. 2.29 Nevertheless, changes in inflation seem to have had important effects on bank spreads in the Philippines. As inflation rose from an average of 12.5% in 1981-83 to 37.3% in 1984-85, bank spreads rose from an average of 5.4 percentage points to an average of 10.4 percentage points. The opposite occurred when inflation subsided. The fall in inflation from 15.7% in the third quarter of 1985 to 7.7% in the fourth quarter wan correlated with a 4.3 percentage point decline in average spreads. These changes in spreads were not entirely due to changes in the rate of inflation, however. Portions of them resulted from changes in reserve requirements. Reserve Requirements 2.30 The present regulations concerning reserve requirements are responsible for a significant portion of the costs of intermediation. There is room for substantial reductions in these costs through changes in reserve ratios as well as increases in the interest paid by CB on bank reserves. 2.31 The interest rate liberalization was initially accompanied by a decrease in commercial banks' reserve requirements from 20% in 1981 to 18% in  - 27 - 1982. This measure was aimed at reducing the costs of intermediation. Further reductions in reserve requirements were being contemplated. Such reductions together with the other regulatory and institutional reforms were expected to increase the efficiency of the financial system and foster its development. 2.32 However, the Government failed to continue with the reform program as was initially planned and today reserve requirements are even higher than in 1980. The rapid expansion in reserve money during the second half of 1983 was immediately followed by a very restrictive monetary policy. Monetary restraint was partially achieved through higher reserve requirements. Hence, instead of further reducing these requirenients, the Government actually raised them by 5 percentage points to 23% in 1983 and then by an additional percentage point to 24% in 1984. Now that inflation is under control reserve requirements have been reduced but only to 21%, in early August 1986. However, reserve requirements are still high at 3 percentage points above their level in the 1970s. 2.33 The existence of reserve requirements implies that the amount of loanable funds generated by banks will always be lower than the deposits they collect. The difference between these two variables is equal to required reserves. Hence, as long as there is some positive reserve requirement, banks will have to maintain a spread between lending and deposit rates even if they were only to make zero profits. As the formula shows, increases inr reserve requirements will lead to increases in bank spreads. Note, however, that this need not always be true. If CB pays an interest rate on bank reserves equal to the deposit rate, banks can achieve zero profits by setting lending rates equal to those they pay on deposits. In such a situation, changes in reserve requirements will not necessarily have any long-term effects on spreads. 2.34 In the Philippines, the interest rate on bank reserves is equal to 4%, a rate which is much lower than the deposit rate paid by banks. The present high reserve requirements impose high costs on banks which they must cover by charging high lending rates, i.e., maintaining large spreads. 2.35 Of the 7.2 percentage points of spread in 1985 which were due to the different taxes on intermediation, 4.4 percentage points can be directly attributed to reserve requirements. Table 2.5 shows how this spread would have fluctuated in response to changes in reserve policies. The second and third rows show what the spread would have been had reserve requirements been lower. The third row indicates that, had the Government kept these requirements at their 1982 level, 18%, bank spreads, and hence real lending rates, in 1985 might have been around 1.4 percentage points lower.  - 28 - Table 2.5: THE EFFErTS OF CHANGES IN RESERVE RATIOS AND ON INTEREST ON RESERVES ON BANK SPREADS (x) Changes Spread due to various taxes actual for 1985: 24% 7.2 20% reserve ratio 6.3 18% reserve ratio 5.8 with 8% interest on reserves 5.8 with 10% interest on reserves 5.1 20% ratio and 8% interest on reserves 5.2 20% ratio and 10% interest on reserves 4.6 18% ratio and 8% interest on reserves 4.8 18% ratio and 10% interest on reserves 4.3 Source: Bank staff estimates 2.36 The impact of reserve requirements on spreads could be lowered by reducing their opportunity cost to banks by allowing them to earn higher interest rates. Rows 4 and 5 show what the impact of raising the interest on reserves, without changing reserve ratios, would have been in 1985. Row 5 indicates that had CB paid 10% interest on reserves, bank spreads would have been 2.1 percentage points lower. Rows 6-10 show the effects of different combinations of lower reserve ratios and higher interest on reserves. Row ten indicates that had the reserve ratios been kept at their 1982 levels and had the interest paid on these reserves been raised to 10%, which is still much lower in real terms thani the rate paid on reserves in 1982, bank spreads and real lending rates in 1985 might have been some 2.9 percentage points lower. Agri/Agra Requirements 2.37 The repeal of Presidential Decree No. 717 (PD 717) will exert a downward pressure on lending rates without affecting the volume of loans going to agriculture. The program has had no effect on agriculture credit. It has simply been an additional tax on intermediation. 2.38 In 1975, PD 717 was passed. This decree provided that banks should allocate 25% of their net loanable funds generated starting May 1975 for agricultural credit: 15% for general agriculture and 10% for beneficiaries of the agrarian reform program. Instead of actual lending to agriculture, banks may choose to formally comply with this regulation through the purchase of certain eligible securities which carry a 9% coupon rate. Most banks chose to buy these securities rather than lend to agriculture. 2.39 The proceeds from the sale of the securities are not earmarked to agriculture. They simply join the general pool of funds generated by the Government or CB from various sources. The ratio of commercial banks! agricultural loans outstanding to total loans outstanding actually fell after  - 29 - the promulgation of PD 717. It decreased from an average of 23% during the period 1971-74 to an average of 10% during the period 1978-83. Since most of the urban-based banks have no expertise in the area of agricultural lending, they perceive it as being too risky. Many banks are able to comply with the 15% mandatory lending to general agriculture, since agribusiness falls in this category. However, virtually all private banks have to buy securities in order to cover their 10% agrarian reform obligations. 2.40 The agri/agra program has simply been an additional tax on inter- mediation. The yield on agri-agra securities has been consistently lower than the interest on secured loans of similar maturity, and in many instances much lower than banks' cost of funds. With agri-agrt another artificial layer has been added to the costs of intermediation. This additional layer moves up proportionately with interest rates and is ultimately passed on to the banks' borrowers, including those in the agricultural sector, through higher spreads. It is estimated that roughly 1.5 percentage points of spread in 1985 were due to the 10% agrarian reform requirement. The Gross Receipts Tax (CRT) 2.41 In 1985 the GRT was responsible for roughly 1.3 percentage points of bank spreads. This is a tax of 1-5% which is levied on banks' gross receipts. The GRT on interest income is 5% for short-term maturity, not exceeding two years; 3% for medium-term maturity, over two years and less than four years; and 1% for long-term maturity, over four years. Gross receipts are defined as interest times loans. This implies that if a bank charges its borrowers an interest rate of 20%, it actually receives only 19%; if it charges 30%, it receives only 28.5%. Banks reduce the effect of this tax on their profits by charging a higher interest rate to their borrowers, i.e., having a larger spread. The GRT is not only a tax on banks, it also affects and distorts the private sector's investment decisions. 2.42 Although the GRT is easier to collect than other less distortionary taxes (such as the tax on bank profits) its impact on the Government's budget is insignificant. In 1985, it generated only P 746 millicn in revenue or less than one percent of total government revenue. The Withholding Tax on Interest Income 2.43 Savers are also taxed in the Philippines. Currently, there is a final tax of 17.5% on interest income, which is withheld at the source, and it might be increased. Although this tax does not constitute double taxation, it does have an important effect on both deposit and lending rates. 2.44 Increases in the tax on interest income will have a negative impact on financial savings mobilization. Had there been no withholding tax in 1985, the same amount of financial savings could have been mobilized at deposit rates that are on average 3.3 percentage points lower than actual rates. Bank spreads are positively correlated with the deposit rate. It is estimated that this lower deposit rate would have implied an average spread which is around 1.7 percentage points lower. That is, lending rates would have been, on average, five percentage points lower than actual rates.  - 30 - 2.45 Given the present tight fiscal situation a reduction of the withholding tax may not be feasible. This tax is easy to collect and is an important source of government revenue. However, further increases should be avoided, since the concomitant fall in financial savings and rise in interest rates will adversely affect the economic recovery. E. Institutional Reforms 2.46 The present crisis has magnified some long-standing structural weaknesses in the Philippines' financial sector. Some private commercial banks are facing liquidity/solvency problems. CB's reaction to the weaknesses of commercial banks has been to adopt a policy of encouraging bank merger and consolidation. This policy will not have any long term effects on the stability of the financial system. Moreover, by reducing competition it will adversely affect the system's efficiency. PNB and DBP, the two Covernment financial institutions, are facing even more serious difficulties. Past performance by the CFIs seems to indicate that Government should scale down its involvement in the financial sector. The Crisis of Private Commercial Banks 2.47 Private commercial banks are the main institutions responsible for saving mobilization. Several of these banks, specifically government acquired banks, are currently facing financial crises. This is an issue which requires immediate government attention. Thirty commercial banks operate in the Philippines. The largest of these is the government-owned PNB. Of the remaining 29, 4 are branches of foreign banks, 6 are private banks that have been acquired by the Government in the late 1970s and early 1980s when they were in financial distress, and 19 are owned by domestic entrepreneurs, some with foreign participation. Table 6 shows the relative importance of the four types of institutions. It indicates that private domestic banks are by far the most important type of institution, while the acquired banks' share of the market is small relative to their number.  - 31 - Table 2.6: THE RELATIVE IMPORTANCE OF DIFFERENT CATEGORIES OF COMMERCIAL BANKS AS OF DECEMBER 1985 (X of total) Total assets Total deposits Total loans Domestic banks 50.40 68.15 42.74 Foreign banks 15.36 9.99 16.52 Government-acquired 7.58 6.31 12.69 PNB 26.66 15.55 28.05 Source: Published Statements of Condition. 2.48 Most private banks started as closely held family or group-oriented undertakings, fulfilling the financial needs of business activities within the family or business group. This explains the relatively large number of small banks which exist in the Philippines today. Relative to GNP, commercial banks in the Philippines tend to be smaller in size than those in any other East Asian country except Indonesia. Concerned with the stability of the banking industry, as a result of several bank failures, CB has engaged in a policy which aims at reducing the number of banks and increasing their size. No new bank (including foreign banks) is allowed to enter the market, and bank mergers are being actively encouraged. As a result, the number of commercial banks operating in the country has been steadily declining. It fell from 34 in 1983 to the present figure of 30. Yet the private banking industry remains fairly competitive. Table 2.7 shows that, except for Citibank which controls around 9% of the resources of the commercial banking industry, market power is evenly divided among six large private banks with each controlling between four and 6% of the market. The remaining banks' shares of the market are very small; ranging from 3.0% for Allied Bank to 0.61% for Pilipinas. 2.49 The Central Bank's concern with the stability and soundness of the commercial banking system is understandable. Several commercial banks are facing liquidity/solvency problems. In order to avoid a large number of bank failures, CB has extended assistance to failing banks in the form of emergency loans and overdraft facilities. In December 1985 total assistance to private commercial banks amounted to around P 8.75 billion or 24% of the stock of reserve money. Limiting the number of banks and trying to increase their size may reduce the severity of the problem. However, it should be noted that in general there exists a conflict between the objective of financial stability and the goal of having a competitive banking system. Lack of competition does not seem to be an issue of immediate concern for the Philippines. But, once the immediate crisis is resolved, the authorities may wish to consider policy reforms that aim at increasing financial efficiency by allowing freer entry into the banking system.  - 32 - 2.50 Table 2.8 shows some representative financial ratios for private commercial banks as of the end of December 1985. The first of these ratios, the loan to deposit ratio, is a measure of bank stability. It indicates the extent to which a bank overstretches its resources to provide loans. In the US, bank analysts use this ratio to measure the degree of risk that the bank is exposed to, and in Japan banks are required to keep it below 80%. The remaining two ratios, liquid assets to total liabilities and liquid assets to total assets, are measures of bank liquidity. They indicate a bank's ability to adjust its portfolio in response to stocks. These three Table 2.7: THE MARKET SHARE OF THE TOP SEVEN PRIVATE COMMERCIAL BANKS AS OF DECEMBER 1985 (Z share) Bank Assets Deposits Loans Citibank 9.23 7.53 9.46 PCIB 5.78 8.08 5.28 Metrobank 5.73 7.11 5.18 BPI 5.67 8.50 4.53 Cocobank 4.86 7.63 5.13 FEBTC 4.37 5.93 3.20 BA 4.00 1.43 4.00 Source: Published Statement of Condition. ratios are useful tools for analyzing the financial situation of commercial banks. They do point out problem areas. However, it should be noted that they say nothing about the quality of bank portfolios, and hence may be misleading in situations where a bank seems quite liquid, but is holding a large amount of nonperforming assets. Since an in-depth analysis of the quality of private banks' portfolios is beyond the scope of the present study, an attempt will be made here to assess the stability of different banks only using these three ratios. 2.51 From Table 2.8, it is seen that, on average, foreign branches have the highest loan to deposit ratios and the lowest liquid assets to liabilities and to total assets ratios. This is not surprising. These branches rely on resources from their head offices. Since their stability is mainly a function of the mother bank's strength, these ratios do not provide cause for concern.  - 33 - Table 2.8: REPRESENTATIVE FINANCIAL RATIOS OF COMMERCIAL BANKS (DECEMBER 1985) Liquid assets/ Liquid assets/ Loans/Deposits liabilities All assets Foreign banks Average 190.79 23.92 23.72 Covernment-acquired Average 164.98 38.48 37.52 Private domestic Average 50.63 52.68 46.11 Source: Published Statements of Condition 2.52 The situation is different as far as the acquired banks are concerned. Government institutions took over these banks from the private sector, because they were facing financial difficulties. On average, government-acquired banks have remained far less stable than the rest of the banking system. Their average loan to deposit ratio was around 165%; more than double the "normal" level of 80% and more than triple the average for the private banks. Their liquidity ratios are also quite low: the average ratios of liquid assets to total liabilities and liquid assets to total assets for the acquired banks were 73% and 81% of those for private banks. The acquired banks' position has probably deteriorated since December. As government- controlled banks, they were subject co the boycott called for by the opposition after the February elections. Some lost deposits and had to increase their borrowing or sell off their liquid assets. Government institutions acquired these six banks with the aim of rehabilitating them then reselling them back to the private sector. The Government is now considering the reprivatization of these banks. Concrete steps in that direction need to be taken. 2.53 Faced with the crisis which started in 1983, private domestic banks reduced the size of their loan portfolios. Loans outstanding, in real terms, fell at a rate which was double that of the rate of decline in deposits. Instead of lending, many banks preferred to hold government securities. Hence, as Table 2.8 indicates, this group of banks seems to be fairly liquid at the moment. The situation in some private domestic banks has worsened since December. This is the case for banks that were linked to the old regime ("crony" banks). They have been losing deposits since the February elections. Hence, although their December balance sheets show them as being very sound and liquid, their stability is now in question. The Government's position towards these banks is not yet clear.  - 34 - 2.54 CB's policy of merging and consolidating banks may have some beneficial short-run effects. Merging a failing bank with a strong institution may avoid some of the problems associated with the bankruptcy of the weaker bank. However, this approach will have no long-run effect on the soundness of the banking system. Bigger banks are not necessarily more stable than smaller ones. An analysis of individual bank data shows no signifi ant relationship between size and stability. 2.55 The history of the Philippines financial system indicates that bank failures have almost always been associated with mi'smanagement. Increasing bank size will have no effect on the quality of management. In the long run, problems associated with mismanagement can only be avoided if CB effectively carries out its role in supervising banks. New regulations that ensure the soundness of banks need to be introduced, and CB's ability to enforce such regulations need to be strengthened. Government Financial Institutions (GFIs) 2.56 PNB and DBP are the most important of the GFIs. PNB is responsible for 26.7 percent of the total resources of the commercial banking system and 15 percent of the resources of the financial system (excluding CB). The resources of DBP, the government-owned development bank, represent 80% of the resources of all specialized government banks and 14% of the resources of the financial system. That is, together these two institutions represent around one third of the entire Philippines' financial system (excluding CB). They are both experiencing severe financial difficulties. It is estimated that roughly 75Z and 95% of PNB's and DBP's assets, respectively, are non- performing. 2.57 There is a need to re-examine Government's role in the financial sector. The rationale for the existence of GFIs is usually that they provide services which, due to market imperfections, the private sector is unable to provide. Yet, PNB competes directly with private banks. It does not concen- trate its lending to agriculture and industry. Most of its loans are for trade-related activities. Nor does it seem to have a comparative advantage in mobilizing deposits of small savers. About 80 percent of PNB's deposits come from accounts of P 2,000 or more. Similarly, with DBP's performance. Most of its resources came from government or foreign sources. The majority of its loans went to large enterprises who could have probably obtained private- sector funding had their projects been viable. 2.58 These two institutions represent an important drain on Covernment's scarce resources. Government assistance to PNB and DBP in 1986 is expected to be around P 15 billion. In the short run, the main problem facing the Govern- ment is how to deal with these institutions' nonperforming assets. As a first step, it has been decided that they be moved to a newly created Asset Management Company. This Company then bears the responsibility of disposing with them. It is hoped that revenue from the sale of the nonperforming assets will partially offset the huge cost that the Government incurs servicing the GFIs' liabilities. Moving the nonperforming assets out of PNB and DBP implies a sharp reduction in their size. This action will allow the two institutions to return to some semblance of normalcy in the short run, and will emphasize the new Government's commitment to the stability of the financial system.  - 35 - 2.59 Poor performance by the two largest GFIs has been partially due to their undertaking go',irnment-sponsored projects. These "behest" loans constitute a major portion of their portfolios. Around 80 of PNB's top 100 loan accounts fall in this category. Most of these projects have either proven not to ba viable, or are facing protracted delays in implementation. They form the great t,ulk of nonperforming assets. This raises the question of whether any large guvernment-owned bank can function smoothly. 2.60 The argument for the continued existence of GFIs is that due to uncertainty end the private barks' excessive risk aversion, the amount of credit provided to agriculture and to stall- and medium-scale industries is lower than what is deemed to ou socially desirable. Hence, GCIs are needed to provide this type of risky credit during the early stages of the development of the financia. system. In practice, however, neither PNB nor DBP have played this role. 2.61 The two institutions were not active in the area of agricultural lending. Table 2.' shows that agricukltural loans account only for 8.8% and 7.6% of PNB's and DBP's portfolios, respectively. DBP provided more loans to support investment in real estate than it did to Agriculture, and nearly one third of PNB's portfolio consists of trade-related loans. The ratio of agricultural credit to total credit in these two institutions' portfolios is lower than the average for the commercial banking sector as a whole. 2.62 Nor did PNB and DBP cc.rc*ntrace sn lending to medium- and small- scale irdustries. They 'lave been lending mainly large amounts to a few big enterprises. PNB's top 30 loans aLcount for 80% of its portfolio. Similarly, 20 loans account for more than 50% of DBP's portfolio. 2.63 Large enterprises working in industry or real estate usually have little difficulty obtaining credit from private banks if their projects are viable. Nearly all of PN3 s and DBP's big accounts are now nonperforming. The GFIs wcre financing projects tnat private banks would not support, not because these were in risky sectors or they were small in size but because they were not economically feasible. 2.64 Past performance indicates that it may be desirable to at least reduce the size of these two instituticns considerably. An action plan to reduce the scale of government involvement in the financial sector, while minimizing the ir"pqact of such a reduction on Zmployment is being prepared by the new Government. Long-Term Financinr 2.65 An increase in mc.dium and long term lending to finance investment is needed to maintain the econcmic recavery. Since this type of lending is generally riskier than short term lending, which is usually linked to trade and commercial activities, banks are rciuctant to provide it unLess they can earn sufficient risk premia. Hience, the interest rate liberalization which implied an increase in cAie differential between long and short term rates has lead to a rise in the share of long and medium term loans in total loans out- standing. This share rose from 22% in 1980 to 39% in 1984. However, since  - 36 - overall lending was decreasing, due to the financial crisis, this has not been translated into a real rise in the volume of medium- and long-term loans out- standing over this period. Table 2.9: SECTORAL DISTRIBUTION OF PNB AND DBP's LOANS OUTSTANDING (% of total) /a PNB DBP Agriculture 8.8 7.6 Industry /b 39.2 71.4 Trade 29.2 /c Reaj Estate /c 9.6 Other 22.8 11.4 /a 1985 data for PNB and 1984 data for DBP. 7i Includes mining and construction. Th Does not appear as a separate category in bank's classification. Source: PNB and DBP. .66 Measures that would stabilize the financial system such as a reduc- tion in inflation or in reserve requirements would probably lead to a rise in tiiis type of lending. Further steps that aim specifically at increasing term financing need to be considered. These may include redefining the roles of restructured GFIs so that they focus solely on providing this service. Initially, GFIs will not be directly competing with private banks in this area, especially if they focus on lending to small and medium scale enter- prises. Given the constraint on public resources and past performance by GFXs, any action on this front has to be complemented by an increase in private long term lending. The government may wish to consider providing some incentives for private banks to increase term lending. The different types of incentives that should be studied may include differential reserve requirements or special tax breaks. F. Requirements for Future Growth 2.67 The financial sector has an important role to play in any program for economic recovery. Economic recovery will require an increase in private investments as well as expenditures on working capital. Given the constraints oa foreign borrowing, a large part of this increase in private activicy will have to be financed through private resources. Hence, the success of such a recovery program will depend crucially upon the efficiency of the financial system in mobilizing savings and supplying credit to productive enterprises.  - 37 - 2.68 The short-run objective of financial policies in the Philippines should be to increase the volumes of financial savings and credit to the private sector. The achievement of this objective will lead to a reduction in real interest rates or, at least, will avoid any further increases. The increased availability of funds for working capital and new investments, will encourage private sector activity and thus accelerate the pace of economic recovery. 2.69 The long-run objecEive of financial policy should be to improve the institutional structure and increase the efficiency of intermediation. This is necessary to ensure the long-run stability and growth of the financial system. Nine sets of policy actions that would help achieve these goals have been identified. They are described below. A Consistent Fiscal and Monetary Stance 2.70 The main goal of monetary policy should be to ensure price stability. High and variable inflation rates are a primary cause of financial shallowing. Hence, CB's recent success in controlling inflation will have a positive impact on the financial system. The reduction in the inflation tax on intermediation has already lead to a fall in bank spreads. Real rates will decline. They have already fallen from the exceptionally high levels of the first two months in 1986. 2.71 Since neither an increase in real income nor a structural shift in the demand for financial assets are expected in 1986, constant real interest rates imply that the stock of public securities held by the private sector should not increase in real terms. Public securities include treasury bills and notes as well as CB's certificates of indebtedness (CBCIs). With an inflation rate of around 10% in 1986, the sum of new borrowing by both the Government and CB from the private sector should be in the range of P 9-10 billion. Similarly, after 1986, fiscal policy, and hence govern- ment borrowing, has to be consistent with money growth targets (inflation) and with expected changes in real income. A Reduction in Reserve Requirements and a Rise in the Interest Paid on Bank Reserves 2.72 The present high levels of reserve requirements impose a large tax on intermediation. They raise bank spreads and are one of the causes of high real lending rates. The Government's medium-term objective should be to reduce reserve requirements to their 1982 levels -- 18%. If such a reduction had occurred in 1985, real lending rates could have been some 1.4 percertage points lower. A step in that direction was already taken in September 1985, but it is still not sufficient. Reductions in reserve requirements should be gradual to avoid a sharp increase in money supply and prices. In the long run, when the need to resort to the implicit taxation of intermediation is diminished, the Government should consider reducing reserve requirements to below 18%. These requirements are a tax on banks and do not necessarily enhance their stability.  - 38 - 2.73 The gradual reduction in reserve requirements should be accompanied by a rise in the interest paid on bank reserves. A rise in these rates reduces bank costs which are associated with holding reserves, and hence leads to a fall in spreads and real lending rates. The Repeal of PD 717 2.74 This policy change will not have a significant effect on the government's ability to finance its deficit, it will not affect lending to agriculture, but it will reduce commercial banks' spread. The stock of agri/agra bonds outstanding at the end of 1985 was P 4.6 billion or roughly 4.7% of total government bonds outstanding. New issues in 1983 and 1984 amounted to only P 0.6 billion and P 0.18 billion, respectively, and, due to the contraction in loanable funds, no new bonds were issued in 1985. The repeal of PD 717 would imply that no new agri/agra bonds will be issued in the future. Repayments on maturing bonds are to be financed through the sale of treasury bills or notes which bear a market-determined rate of return. By exerting a downward pressure on bank lending rates, the elimination of agri- agra may actually reduce the cost of servicing the overall government debt. 2.75 The mandatory allocation of credit is not an appropriate method of increasing lending to agriculture. Experiences of other countries indicate that such targeted credit schemes rarely produce the desired effects. Instead of taxing financial institutions by forcing them to lend to risky and/or unprofitable agricultural enterprises, Government should undertake policy reforms that would help make agriculture more profitable and less risky. Such reforms will encourage voluntary lending to that sector. Eliminating the Gross Receipts Tax 2.76 The GRT has very little effect on government revenue. However, it was estimated that in 1985 it was responsible for around 1.3 percentage points of bank spreads. This is not only a tax on banks. It adversely affects both depositors and borrowers. The GRT should be eliminated. In addition to increasing the efficiency of intermediation, this action will help achieve the short-run goal of reducing interest rates. 2.77 A policy package consisting of a reduction in reserve ratios to 18%, a rise in the interest paid on reserves to 8%, the repeal of PD 717 and the elimination of the GRT could lead to a sizable redaction in bank spreads and real lending rates. Estimates of the impact of this package on bank spreads,  - 39 - Table 2.10: THE EXPECTED IMPACT OF POLICY PROPOSALS ON BANK SPREADS (X) Spreads due to different taxes on intermediaLion /a With no policy change 5.2 Adopting the entire package 1.5 Eliminating the GRT only 2.9 Raising interest on reserves only 3.8 Reducing reserve requirements only 4.2 Repealing PD 717 only 4.3 a/ Calculated under the assumption of a nominal deposit rate of 15%. Source: Bank Staff estimates. under the assumption that nominal deposit rates will remain at their current levels of around 15%, are presented in Table 2.10. This table shows that if all the recommendations presented here are adopted, bank spreads could fall by as much as 3.7 percentage points. The table also shows the impact on spreads of adopting some portions of the package and not others. In order for this policy to be feasible, Government's need to resort to taxing intermediation should be reduced. Avoiding an Increase in the Withholding Tax on Interest Income 2.78 An increase in the withholding tax on interest income, as is currently being contemplated, would be counterproductive. Such an action will lead to a fall in financial savings and a rise in real interest rates. It may adversely affect the economic recovery. Increased savings mobilization is one of the Government's important goals. A rise in the tax on savers will clearly conflict with this goal. Privatizing the Government-Acquired Banks 2.79 The six government-acquired banks are facing serious financial problems. Government intervention has not helped stabilize these banks. They should be sold back to the private sector since weak and unprofitable banking institutions cannot be indefinitely supported by CB and the Government. Some banks have already attracted foreign bLyers. American Express International, for example, have now bought a 40% share of Interbank. Sales to domestic entrepreneurs are also a possibility. For example, a group of sugar millers and planters are negotiating for the purchase of Republic Planters Bank.  - 40 - Allowing Freer Entry into the Banking Industry 2.80 Present regulations which prohibit entry into the banking industry and limit bank expansion through the opening of new branches reduce the competitiveness of this industry. Hence, they adversely affect its efficiency. In the long run, they will lead to the emergence of a monopolistic financial system. Savings mobilization efforts will be weakened and credit will be restricted. Monopolistic banks tend to set deposit rates that are too low and lending rates that are too high. Therefore, once the intensity of the present crisis is reduced, CB should move towards allowing more competition between banks. The present policy of merging and consolidating banks will not have any long-run effect on the soundness of the banking system. Bigger banks are not necessarily more stable than smaller ones. The stability of the financial system can only be ensured, in the medium and long terms by improving CB's ability to supervise commercial banks. Strengthening the Central Bank's Supervisory Functions 2.81 CB has played an important role in maintaining financial stability during the recent crisis. However, its interventions to stabilize specific institutions have almost always taken place a little too late. This indicates a need to improve its supervisory functions. CB's interventions should occur before an institution is on the brink of bankruptcy and requires emergency assistance. As suggested by the Asian Development Bank, CB should set guidelines to improve the financial conditions of banks. These can take the form of various ratios reflecting a bank's exposure to risk, its liquidity, its solvency and the adequacy of its capital base. If one of these ratios is violated, CB should intervene immediately. It should penalize the violating bank and force it to take prompt corrective actions. A strong CB which effec- tively carries out its role of supervising financial institutions is a prerequisite for the long-run stability of the financial system.  ANNEX 1 Page 1 - 41 - PHILIPPINES THE IMPACT OF GOVERNMENT POLICIES AN ANALYTICAL FRAMEWORK A. Introduction The aim of this annex is to describe the links between the policy tools analyzed in this paper and their effects on the development of the Philippines' financial sector. This is done by presenting a simple intermediate-run model of that sector. The model is used to illustrate some conceptual issues. Despite its simplicity, the model captures some of the important features of the Philippines' financial system. It is a partial equilibrium model which considers the equilibrium conditions in the markets for financial assets and loanable funds. The main actors in that market are: the government who taxes and borrows from the financial system to cover its fiscal deficit and subsidize priority sectors, households and firms who supply financial savings and demand loans; and banks and nonbank financial institutions who mobilize deposits and provide loans. B. The Government In the Philippines, as in other countries, the government needs to extract resources from the financial sector to cover its fiscal deficit. For the purposes of the present exercise, the size of the real deficit is taken as given. Hence, the focus will be on the impact of the various methods of financing any given real deficit on the efficiency of the financial system. This does not mean that the size of the deficit itself does not have an important impact on the efficiency of the financial system, however. The real deficit can be financed by increasing the monetary base (borrowing from the Central Bank) or borrowing from other domestic sources. The revenue accruing to the government from increasing the monetary base is equal to the rate of growth of base money multiplied by real holdings of base money. The demand for real base money is in turn divided into the demand for currency by the nonbank public and for reserves by the commercial banks. These relationships are described by the following two equations: Z = 4M + B (1) M C + kD (2) where we have defined the following variables: Z = real budgetary deficit V = rate of growth of nominal base money M = real monetary base B = real government borrowing on the free market C = real currency outside banks k reserve requirement ratio D real bdnk deposits  ANNEX 1 - 42- Page 2 Equations (1) and (2) imply that: Z - "(C + kD] + B (3) The above equation contains three of the policy instruments analyzed in this paper: the rate of growth of base money, the required reserve ratio and the amount of government borrowing. It shows that increases in the budget deficit necessitate an increased use of these policy instruments which raises the level of the distortions in the financial market. Government policies also affect the financial system through their impact on inflation and the nominal exchange rate. In the long run, the rate of inflation will b; equal to the difference between the rate of growth of base money and the steady state rate of growth of output. In the short and intermediate runs, with which we are concerned, increases in (i) will affect the inflation rate (X), but there will not necessarily be a one-to-one relationship. Changes in w will also affect real output. Hence, we let w be a nondecreasing function of p without specifying an exact functional form: X = 1(u) (4) In a semi-open economy as the Philippines, changes in w will lead to a short-run appreciation of the real exchange rate. Since the Philippines has a flexible exchange rate regime, this implies that a future nominal depreciation occurs moving the real exchange rate back towards equilibrium. That is, the future percentage change in the nominal exchange rate (E) will also be an increasing function of ; E = E[V]. (5) C. Households and Firms Households and firms can hold their savings in the form of any of four assets: foreign financial assets, real assets (inflation hedgers), currency and interest bearing domestic financial assets (real bank deposits). The demand for real deposits is a positive function of their rate of return (i ) and o' wealth (W) and a negative function of the rates of return on otfer assets. The return to real cut:ency holdings is zero by definition. The return to holding real assets is the inflation rate and the return to holding foreign assets is the foreign interest rate plus the future rate of depreciation of the domestic currency, i* + E. Hence, the supply of deposits to the domestic financial syste.n can be written as: Ds = D(i d' , i* + E) W (6) Note that the above function is not homogenous of degree zero in i, i and i t + E. One cannot specify it purely in terms of the real rates of redurn on foreign and domestic financial assets. This is because equal percentage point increases in nominal rates and rhe rate of inflation will still lead to a  43 ANNEX 1 Page 3 portfolio shift out of currency which has no interest rate that can adjust. The demand for unsubsidized loans in the free part of the capital market is divided into demand by the private sector, including households and firms (L), and demand by government. Government borrowing (B) is treated as exogenous. Private demand for loans is a positive function of the inflation rate and a negative function of the lending rate ( it ). That is, we have: Ld L Or, it ) (7) As argued earlier, both the inflation rate and the rate of exchange rate depreciation are functions of the rate of growth of the monetary base. Hence, equations (4) and (5) can be used to rewrite Equations (6) and (7) as follows: Ds D(id, ( i* + E (u)) W (8) Ld = L ((w(), it) (9) D. Financial Institutions Financial institutions (hereinafter referred to as banks) are viewed as profit-maximizing pricetakers. Given the relatively large number of banks in the Philippines and the smallness of their size, the assumption is fairly realistic. Since this is a short or intermediate-run model, bank profits are not assumed to be zero. Due to the existence of regulations pertaining to entry and exit from the banking industry, positive or negative profit rates may be observed. Bank costs can be divided into two components. First, the interest paid on deposits. Second, the capital and labor costs associated with collecting deposits and making loans. ILn the short and intermediate runs, when branch capacity is fixed, these latter costs are an increasing convex function of the volume of deposits (the marginal cost curve is upward sloping). The amount of loans that banks supply in the free market is equal to deposits (D) less required reserves (kD) less mandatory allocations to the agri-agra programs (yD) . Bank revenue is equal to the free lending rate (il) times loans made on the free market plus the rate on agra bonds (it) times their volume, plus interest paid on reserves (ir) times the amount of reserveu. The above discussion implies that profits for the representative bank can be written as follows: profit = i" (I - k - Y) D + i kD + i y D - c(D) (10) I ~ ~~r t Where c(D) is the cost function described abo-e. Maximizing (10), yields the familiar condition chat marginal revenue be set equal to marginal cost: ii (1 - k - y)+ i k + i y - i = c'(D) (li) Holding other factors affecting bank costs (e.g., wages) constant, the assump-  ANNEX 1 - 44 Page 4 tion that the marginal cost curve is upward sloping implies that banks' demand for deposits and hence supply of free loans are increasing functions of the expression on the left-hand side of Equation (11). Dd a f(i [1 - k - r] irk + itY + irk - id) (12) L a (1 - k - Y) f(i (I - k - y] + irk + ity - id) (13) E. The Impact of Government Policies on the Financial System An equilibrium is defined as a situation where both the markets for deposits and loans clear. That is: f(i [1 - k - Y] + ity + irk - id) D(id, r(u), i* + E()) W (14) (1 - k - y) f(i (t - k - J + i ty + irk - id) = L(f(I), i ) (15) We now discuss the effects of changes in government policy on the mobilization of financial resources, or, alternatively, on interest rates. The agri/agra program is addressed first. Equations '14) and (15) indicate that as long as the return on agra bonds is less than the return on loans made in the free market, a decrease in the ratio of loans that banks must provide to the targeted sectors or a rise in their interest rates raises banks' demand for real deposits. Deposit rates will increase, and the volume of savings mobilized through the financial system also increases. Conse- quently, loan supply increases and lending rates decrease. More loans are made available on the free market. An elimination (or reduction) of this program will clearly yield benefits in terms of increased savings mobilization and more loans to nonpriority borrowers. Equations (14) and (15) also indicate that the various methods of raising revenue from the financial system may have different effects on this system's ability to mobilize and allocate credit. The effect of government borrowing from the free market is straightforward. This increases lending rates. Hence banks demand more deposits. Deposit rates rise and resource mobilization increases. Overall lending in the free market rises. However, the volume of credit going to the private sector falls and its cost rises. Some crowding out occurs. RaisinR aovernment reve-nue via higher reserve requirements or via the mandatory sale of government bonds to financial institutions has a stronger negative impact on the financial system. Such a policy leads to a fall in banks' demand for deposits. Deposit rates fall and less savings are mobilized through the financial system. Consequently, a decrease in the supply of loans occurs and lending rates rise. This analysis indicates that it would make sense for the government to lower reserve requirements and/or mandatory purchases of government bonds dnd make up for the lost resources by raising its borrowing from the free market. The viability of this policy option requires a decline in the size of the fiscal deficit. Borrowing today implies future repayment of principai and interest. If the fiscal deficit is  ANNEX 1 - 45 Page 5 not under control, this will necessitate a rise in future financial taxes which will be counter productive. An increase in the rate of growth of base money leads to higher rates of inflation and currency depreciation. Firms and households shift out of domestic financial assets into foreign assets or inflation hedgers. The deposit rate increases, but at the new equilibrium less savings are mobilized by the financial system. Hence, the supply of loans decreases. Lending rates rise, and less credit is supplied by banks. Such a policy change, therefore, imposes an implicit tax on savers, new borrowers and financial institutions.  ANNEX 2 -46- Page 1 PHILIPPINES CALCULATING THE EFFECTS OF CHANCES IN DIFFERENT TAXES ON BANK SPREADS This annex presents the formula used in calculating the impact of changes in different taxes on bank spreads, and describes how it is derived. The first step is to derive an expression for lending rates using the identity that bank net revenues are equal to their costs plus profits. In the Philippines, banks' net revenues (NR) are divided into three components: (a) receipts from lending on the free market which are equal to the lending rate (iL) times the volume of loans (LO) less the gross receipts tax (t); (b) receipts from holding reserves with CB which are equal to the rate paid on reserves (ir) times the amount of reserves (R); and (c) receipts from holding agra bonds which are equal to the yield on these bonds (i ) times their volume (A). That is: NR = (l-t)i LLO + i R - i A (1) L r a The variables R and A are functions of deposits (D), the required reserve ratio (r) and the proportion of loanable funds earmarked to agra credit (a): R = rD (2) A = a(l-r)D (3) That is, NR = [iL(l-t)(l-a)(l-r)+i rr+i aa(l-r)]D (4) In situations where profits and operating costs are zero, the expression on the left hand side of equation (4) has to be set equal to the interest that banks pay to their depositors: NR = [iL(l-t(l-a)(l-r)+i r+i aa(l-r)]D = id D (5) where id, the nominal deposit rate, is defined as being equal to the real deposit rate (d) plus the inflation rate (it). This implies the following expression for lending rates: d+n-i r-i a(l-r) r a L= (l-t)(l-r)(-a)F (6) In practice, however, neither bank operating costs nor their profits are equal to zero. Lending rates also reflect these two variables. There- fore, we add a new term, c, representing per unit profits and operating costs to the right hand side of equation (6) so that: d4,"-i -i a(l-r) r a L = T_1-0(l-rM-a)' + C ~~~~~~~(7)  ANNEX 2 - 47 Page 2 It would not be realistic to assume that c is constant. In fact, one would expect profit margins in banking, as elsewhere, to respond to changes in interest rates. Helnce, c may also be a function of the diffirent taxes on intermediation. For simplicity, however, changes in c are traated as exogenous. We only estimate the impact of various taxes on spreads via their effect on the first term on the right hand side of equation (7). Subtracting a from both sides of equation (7) we obtain an expression for the real lending rate (L). Differentiating chis expresson with respect to n, i , r, i and t, while noting that in 1985: U = .25, d -.06, i r .04, r .23, i .09, a = .09 and t .05, we get: r a OU (-t lr)la = 0.5 (8) SL~ - r 034(9) hi (l-t)(l-r)(l-a) 0.34 r 8L (i aa-ir)[l-t)(1-r)(1--a)j+(1-t)(1-a)(d + fl-i aa(1-r)-i r) _ a - ra = 0.29 Or 2(l-t)(l-r)tl-a)2 (10) 6 (l-t)(l-r)(l-aY = -0.10 (11) a 6L -i (l-t)(1-r) (l-a)+(l-t)(l-r)(d+7-i aa(-r)-i r) =a [(l-t)(1-r)(l-a)] 2 (12 FL (d+n-iaa(I-r)-irr](l-r)(l-a) - = - 0.28 (13) -t [(l-t)(l-r)(l-a)]2 The above results explain the conclusions reached in the text. A reduction in inflation has a strong negative impact on real lending rates, as long as it is not associated with an increase in the real deposit rate. Such reductions in L may also be achieved by raising i and ia or reducing r, a and t. The magnitudes of the effects of marginal changes in the different policy instru- ments on real lending rates are calculated in equations (8)-(13). The results obtained from simulating large changes in these variables are presented in the text.  - 48 - III. THE PUBLIC SECTOR A. Recent Fiscal Developments, 1979-85 3.01 The nonfinancial public sector in the Philippines has been characterized by a structural weakness in revenue collection at the national government level and an inadequate operational surplus to finance its capital expenditures. These structural problems, in combination with recession and countercyclical fiscal stance, increased the overall nonfinancial public sector deficit to 5.5% of GNP in 1981-82, compared with 1.4Z of GNP in 1979 (Table 3.1). At the national government level, the deficit increased due to a considerable weakening in its revenue position and to higher equity contribu- tions to public corporations to cover their widened savings-investment gap. The public corporations grew rapidly due to a large investment program and the acquisition of distressed private companies, without significant improvement in their operating surplus. The deficit was mostly financed through external borrowing, thus contributing to the external debt problem of the country at a time when international interest rates were rising. Since 1983, however, the overall public sector deficit has been significantly reduced, as a part of stabilization policies, through drastic reductions in public investment programs, in national government maintenance and service expenditure, and in subsidies. 3.02 In 1985, the overall nonfinancial public sector deficit is estimated to be around 1.5% of GNP. This improvement is mostly attributable to an improvement (about one percentage point in relation to GNP) in the saving- investment gap of the major government nonfinancial corporations; the operat- ing surplus of public enterprises improved by 0.4% of GNP and their capital expenditure declined to 2.6% of GNP, compared with a peak level of 6.3% in 1982. The deficit at the national government level remained unchanged at 1.9% of GNP as an increase in revenue was offset by increases in interest payments, wages and salaries, and assistance to the government financial institutions (GFIs). The deterioration of the financial position of the CFIs has emerged as a much bigger problem as budgetary supports to the GFIs increased from an average of P 0.5 billion during 1980-83 to more than P 10.3 billion (1.7% of GNP) in 1985. National Government Fiscal Developments, 1979-84 3.03 Relative to GNP, the overall deficit of the National Government increased from 0.2% of GNP in 1979 to more than 4% of GNP in 1981-82 before declining to 1.9% in 1984 (Table 3.2). The widening of the deficit in 1981-82 reflected both a rise in expenditure and a weakening of revenue performance, notwithstanding a series of discretionary revenue measures adopted during the period to improve revenue collection. The declining trend was temporarily reversed in 1983 as receipts from international trade-based taxes rose sharply with the rise in peso value of imports and the introduction of import surcharge in December 1982. The declining revenue trend resumed, and the ratio of revenue to GNP declined to its lowest level in recent years (10.8% of CNP) in 1984, notwithstanding a series of tax increases implemented in late 1983, in April-June 1984, and in August-October 1984 (Table 3.3). The revenue  - 49 - Tahle 3.1: PURLIC FTNANCF OVERVIFW, 1979-R6 (in percent of CNP) 1Q79 I9qO 1981 1982 1R83 1984 1985 1986/a National Covernment Revenues 13. 13.1 11.8 11.4 12.1 10.8 11.6 12.4 Expenditures and net lending 13.7 &72T T