Philippines - Private sector assessment (PSA) (Vol. 2 of 3) : Main report

Report No. 11853-PH Philippines Private Sector Assessment (PSA) (In Three Volumes) Volume II: Main Report July 12, 1994 Industry and Energy Operations Division. Count;v Department East Asia and Pacific Regional Office Private Sector Strategies Division, Corporate Planning Department International Finance Corporation FOR OFFICIAL USE ONLY Dlocument of the Wor!d Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization  CURRENCY EQUIVALENTS July II, 1994 - Pesos 26.9 Average 1993 - Pesos 27.1 Average 1992 - Pesos 25.5 Average 1991 - Pcsus 27.5 Average 1990 - Pesos 24.3 Average 1989 - Pesos 21.7 ABBREVIATIONS AND ACRONYMS ADB - A,sian Development Bank APT - Asset Privatization Trust ASEAN - Association of Southeast Asian Nations BER - Basic Economic Report BOI - Board of Investments BGO - Build-Operate-Own BOT - Build-Operate-Transfer BSP - Bangko Sentral ig Pilipinas BTO - Build-Transfer-Operate CAB - Civil Aeronautics Board CB-BOL - Central Bank-Board of Liquidators CBP - Central Bank of the Philippines CCPAP - Coordinating Committee for Philippine Assistance Program CEM - Country Economic Memorandum CIB - Credit Information Bureau CISO - Conference of International Shipowners and Operators CMA - Central Monetary Act CMTS - Cellular Mobile Telephone Service COA - Commission on Audit COP - Comnmittee on Privatization CPCN - Certificate of Public Convenience and Necessity CPSD - Consolidated Public Sector Deficit DBP - Development Bank of the Philippines DENR - Department of Environment and Natural Resources DGES - Directorate General of Electricity Supply (Malaysia) DO - Department Order DOE - Department of Energy DOTC - Department of Transportation and Communications DPWH - Department of Public Works and Highways DST - Documentary Stamp Tax DSWO - Department of Social Welfare and Developnment DLI - Department of Trade and Industry ECO - Expanded Cofinancing Operation }IlS - Environmental Impact Statement T () - Executive Order I PR - Effective Protection Rate l i-i - Export Processing Zone > i I/A - Export Processing Zone Authority I:RB - Energy Regulatory Board l:RL - Economic Recovery Loan  FOR OFFICIAL USE ONLY ABBREV'IATIONS AND ACRONYMS (cont.) ESAP - Enrg-v Sector Action Plan ESW - Economic and Sector Work FCDU - Furaign Currency Deposit Unit FDI - Forcign Direct Investment FIA - Foreign Investment Act FIAS - Foreign Inves.nient Advisory Services F1'AA - Financial and Technical Assistance Agreement FSAL - Financial Sector Adjustrnent Loan GATT - General Agreement on Tariffs and Trade GDP - Gross Domestic Product GFI - Government Financial Institution GFS'ME - Guarantee Fund for Small and Medium Scale Enterprises GMCC - Goxernmenc Monitorh.g and Coordinating Committee GMDSS - CGl(>',al aIaritime Distress and Safety System GNP - C(ross National Product GOCC - G(C;o.errrnent-Owned and -Controlled Corporation GRT - Gr - Receipts Tax GSIS - kemrnient Service Insurance System GT - Ci, Tr n IBRD - i:: Litional Bank for Reconstruction and Development IFC - 1:n - :ia-nal Finance Corporation lIvF M - munal Monetary Fund IPO IV al Pubhic Offering IPP ! Pcwaer Producer (Power Sector) IPP I 'nt Priorities Plan ISIC na1 Stardard Identification Code JEXIJM r: \ Im r-liport Bank of Japan KDC h D n lopment Center KLSE - _Kj aLa lumpur Stock Exchange LBP 1 Bnd Bank of the Philippines LGU - L -al Government Unit LIFRB Tfransportation Franchising and Regulatory Board MARINA - V v .2ine Industry Authority MERALCO V' 'Electric Company MICT ': i International Container Terminial MIGA -i: aral Investment Guarantee Agency MKSE - Stock Exchange MMTC N lanila Transit Corporation MSE - Stock Exchange MI'C - ' 'rban Center MWSS hu',Iitan Waterworks and Sewerage Systems MVD'DP - Vehicle Development Program MWN ,.5L att NCSo !. Census and Statistics Office N EA ' nal Electrification Administration NEB ,a;!1 Electricity Board (Malaysia) NED "Iia Economic Development Authority NF F Aal Foo, d Authority NIG i wrnal Government I Ttus Idof .=^;ic !t <a restricted distribution and may be used by recipients only in the performance of their official dite,t . Xotents may not otherwise be disclosed without World Banrk authorization.  ABBREVIATIONS AND ACRONYMS (cont.) NGO - Non-governmental Organization NIA - National Irrigation Administration NPA - Non-performing Assets NPC - National Power Corporation I JSC - National Steel Corporation NTC - National Telecommunications Commission OD - Operational Directive ODA - Official Development Assistance OECF - Overseas Economic Cooperation Fund OMO - Open Market Operations OPSF - Oil Price Stabilization Fund PAL - Philippine Airlines PASAR - Philippine Associated Smelting and Mining Corporation PCGG - Presidential Commission for Good Government PCO - Public Calling Office PHILPHOS - Philippine Phosphate Fertilizer Corporation PIPP - Philippine Infrastructure Privatization Program PLDT - Philippine Long Distance Telephone Company PNB - Philippine National Bank PNOC - Philippine National Oil Company PPA - Philippine Port Authority PSA - Private Sector Assessment PS(C - Public Service Commission PSD - Private Sector Development PSE - Philippine Stock Exchange QR - Quantitative Restriction RR - Reserve Requirements ROR - Rate of Return RSA Revised Securities Act SBL - Single Borrower Limit SEC - Securities and Exchange Commission SEMIRARA - Semirara Coal Corporation SIPF - Securities Investor Protection Fund SITC - Standard Industry Trade Classifications SMC - San Miguel Breweries SME - Small- and Medium-Size Enterprise SOE - State-Owned Enterprise SRRS - Interisland Liner Shipping Rate Rationalization Study TA - Transferred Assets TCC - Traffic Control Center TNB - Tenaga Nasional Berhard (Malaysia) UNDP - United Nations Development Programme USAID - United States Agency for International Development  TABLE OF CONTENTS Page No. 1. A PROFILE OF THE PRIVATE SECTOR ........... ..1............ A. Background .......................................... 1 B. The Structure of Philippines' Business ......................... 4 C. The Effect of Government Enterprises and Public Debt on Private Business ................................... 18 II. REMAINING CONSTRAINTS TO PRIVATE SECTOR DEVELOPMENT 25 A. An Overview .25 B. Macroeconomic Stability and the Business Environment .27 C. Incentive and Investment Regime Constraints .33 D. Infrastructure Constraints .48 E. Regulatory and Legal Constraints ............................ 70 F. Financial Sector Constraints. 84 III. STRATEGY ..104 A. World Bank Strategy .104 B. IFC Strategy .110 Tables in Main Revort 1.1 Investment and Savings, 1988-93 ................................ 3 1.2 Distribution of Corporations with more than 1 Billion Pesos in Assets: 1992 ..... 9 1.3 Employment and Value Added of Manufacturing Establishments, 1988 .... ..... 10 1.4 Total Debt of the Public Sector, Selected Years, 1983-93 ................. 13 1.5 Financial Performance of the Manufacturing Sector, 1979-92 ............... 14 1.6 Distribution of Value-Added Across Manufacturing Subsectors, 1967-93 .... .... i6 1.7 New Equity Listing and Total Capital Raised, 1989-93 ................... 17 1.8 Financial Situation and Financing Requirements of Monitored Government Corporations, 1988-93 ...................... 20 1.9 Companies to be Privatized in the Near Termn ........................ 22 1.10 Status of Remaining GOCCs Targeted for Privatization ................... 23 1.11 Key Privatizations in 1994 .................................... 24 11.1 Revenue Enhancement Measures ............................... 32 11.2 Debt Issuance irn International Capital Markets, 1993-March 1994 .... ........ 33 11.3 Average Effective Protection Rates, 1985, 1990, and 1992 ................ 35 II.4 Different BOT Schemes ...................................... 55 11.5 Telecommunications - Summnary of Physical Targets ................... 61 11.6 Telecommunications Services and Carriers in the Philippines ............... 63 11.7 Priority BOT Projects ....................................... 67 11.8 Firms' Experience with the Legal System ........................... 83 11.9 Gross Domestic Savings, 1991-93 ................................ 85 II.10 Comparisorn -f Bank Reform Bills .88 11.11 Revenue Collected from Taxes on the Financial Sector, 1993 .92 11.12 Market C.apitalization, November 1993 ............................ 96  Figures in Main Report 1.1 Philippines Investment Trends, 1980-1991 .......................... 1.2 , Asset Structure of Top 1000 Corporations, 1990 ./ 11.1 Sununary Constraints to Operations and Growth .26 Boxes in Main Report II. 1 Salient Features of the New BOT Law .. 53 11.2 Power Privatization in Malaysia .57 11.3 Similar Beginnings, Different Endings: A Tale of Two Companies .... .... .. 74 11.4 Barriers to Entry and the Mobility of Resources. 77 MAP IBRD No. 24105R1  Preface The report was prepared jointly by the World Bank and IFC. World Bank inputs to the report were task managed by Mr. Yalcin M. Baran, with contributions from Mr. Martin Edmonds, Mr. Aldo Baietti, Ms. Erika Jorgensen, Mr. Sheyam Khemani, Mr. Robert Pardy, Mr. Mark Shacter, Mr. Peter Smith, Mr. Douglas Webb (Bank Staff), Mr. Roger Boner, Mr. Mario Lamberte, Mr. Peter Wallace, and Mr. Bruce Owen (Consultants). Mr. Peter Cordukes, Mr. John Nash, and Mr. Bjorn Wellenius provided peer review for specific chapters; Messrs. Rolando Arrivillaga, Faruq Iqbal, Andrew Stone, and Michael Walton were the peer reviewers for the whole report. An enterprise survey carried out by Access-Asia and the Pliilippine legal firm, Sycip, Salazar, Hernandez & Gazmaitan also contributed to the report. Ms. Mercedes Pendleton and Ms. Alicia Roaquin assisted in the preparation of the report. IFC inputs to the report were task managed by Mr. Gary Bond, with contributions from Asia Investment Department, Infrastructure Department, and Legal Department. Mr. Hassan El-Rifai (MIGA) and Mr. Boris Velic (FIAS) also contributed to the report. The report was discussed with the Government on June 14-15, 1994. The report was cleared by Mr. Vineet Nayyar, Mr. William McCleary (World Bank) and Mr. Dileep Wagle (IFC).  I. A PROFILE OF THE PRIVATE SECTOR A. Bkground 1. 1 The Philippines is largely a private sector oriented economy, although in many ways (both direct and indirect) the Government plays a key role in shaping business outcomes. The boundary between private and public activity blurred during the Marcos administration. Since 1986, the definition of the boundary has been redefined with more clarity regarding thie role of each sector. However, even today the distinction Letween what is public and what is pr.I/ate is not easy to make. Not only are a number of top corporations publicly-owned, but the Government still owns large shares in "private" companies such as Philippine Airlines (PAL). Other major companies such as San Miguel Corporation have large blocks of shares which were sequestered by the previous administration after Marcos was toppled, but ownership of those companies is not unambiguously clear. In addition, there remains in the Philippines an element of piiolic sector influence over the decision making of some of the larger private companies, and this, coupled with corporate influence at the governmert level, rcsults in private-public transactions not always being dealt with at an arms-length basis. The granting of franchises, the allocation of loans through public financial institutions and the inconsistent enforcement of regulatory mechanisms each have provided examples of how the more established elements within the business sector continue to give as much priority to the relationship s ith the government as to the marketplace as a source of growth. This may explain why those private sector groups witlh large real estate holdings have preferred to expand in the domestic market and. hence, why an "export mentality" prevalent in most Southeast Asian countries has not taken root in the Philippines. 1.2 According to national accounts data, the private se( tor in 1993 accounted for around 72 percent of fixed investment in the domestic economy. hut this share has fluctuated considerably in recent years. As recently as 19S8. private businesses accounted for 87 percent of total investment in the Philippines, but this proportio.; has declined slightly since then because of a drop in private investment. By comparison, the private sector share of total investment in 1990 was 67 percent in Malaysia, 58 percent in Indonesia and 82 percent in Thailand (and on a rising trend in each country). 1.3 Neither real private nor public investment grew significantly over the period 1980-93 (Figure 1.1), leading to low investment rates, poor infrastruca're and rundown private capital. The expansion in infrastructure investment (mainly by the public sector) slowed down once the debt crisis in 1983 unfolded. Similarly. because a significant share of private investment undertaken during the 1970s involved explicit or implicit governmrent subsidies, the deterioration in public finances in the early 1980s also resulted in reduced public sector support for private investment. As the financing of large and growing public sector deficits became difficult to finance, the previous administrations found it increasingly difficult to provide incentives to selected private firms, such as tax write-offs, directed credit, and foreign exchange access. Although some efficient investments were undertaken during this period, a number of inefficient but very large undertakings were also made under the guise of "crony capitalism".' Some of these investments increased private sector capital formation, they also expanded the country's external debt burden. while others only raised the O-kt level without having any appreciable impact on output. Poor private investment performance als-) re2."cts the impact of other policy and infrastructural impediments as well as the conduct of the private sector in trying to protect its market share throuLch various entrv barriers rather than by undertaking necessary investments, as in Some T hl-!n of questionable state loans were made to 419 companies during the Marcos years. The 419 debt . Aere subsequently transferred to the Asset Prnatization Trust (APT) to enable their disposition.  - 2 - telecommunications and transport. It may also reflect the relative attractiveness of financial investments over risky physical investments, given the still high risk-free real T-bill rates (which have come down to 15 percent recently, while real rates have averaged in a range of 5 - 8 percent ainually). Figure 1.1 PHILIPPINES INVESTMENT TRENDS CEILLIONS Of 1985 PESCO, z _ r_ AVATE /NVESTMEN7 .P(XL C IESTMEN Investment and Savings 1.4 Private investment has risen in the last two years to equal 17.2 percent of GNP in 1993 (see Table 1.1). This expansion was fueled mostly by private investments in power and telecommunications. Public investment also rose in the last two years as public current outlays were restrained. The worrisome trend is the declining savings both in the public and private sector alike in 1993. This trend needs to be reversed in the subsequent years for sustained economic growth. In the short-tern, the private investment-savings gap has become the binding gap.' Household savings (including unincorporated businesses), which in the late 1970s up to the mid-1980s was a major source of national savings, has fallen drastically in recent years, even turning negative in 1993. Increased savings would reduce dependence on foreign savings, which rose from 5.9 percent of GNP during 1993. 2 Especial! 'inre foreign exchange and fiscal constraints are being addressed.  -3 - Table 1.1: Investment and Savings, 1988-93w 1988 1989 1990 1991 1992 1993 Gross investment 18.5 22.1 22.4 20.1 21.7 23.6 Public 3.3 4.1 4.9 4.8 5.5 6.4 Private 15.2 18.0 17.5 15.3 16.2 17.2 National savings 17.4 18.7 16.3 17.8 19.8 17.7 Public 0.9 -0. 1 -0. 1 3.3 2.9 2.3 Private 16.5 18.8 16.4 14.5 16.9 15.4 Foreign savingsbi 1.1 3.4 6.1 2.3 1.9 5.9 Public saving-investment gap -2.4 -4.2 -5.0 -1.5 -2.6 -4.1 of which: NG deficit -2.9 -2.1 3.4 -2.1 -1.1 -1.4 Private saving-investment gap 1.3 0.8 -1.1 -0.8 0.7 -1.8 a! Investment and savings adjusted from National Income Accounts. Non-monitored corporations are excluded from the public sector; investment in the Comprehensive Agrarian Reform Program is excluded from public investment. Private shares are calculated as residuals. b/ Foreign savings equal the current account deficit. Source: NEDA, IMF and World Bank staff estimates. 1.5 Investment performance has also been affected by shifting patterns of foreign direct investment (FDI). Following the rise of nationalism in the early 1970s, the framework became more restrictive: Foreign banks had been limited to four until this year, public utilities were mandattd to be 60 percent Filipino-owned, and retail trade was closed to foreign direct investment. After 1972, foreign investment was made only with the approval of the Board of Investments (BOI). Moreover, because foreign investors perceived public policy as inconsistent, foreign capital inflows were limited, especially as compared to flows received in neighboring countries. Most foreign investment in the 1970s was from Japan and other countries in the region; the main recipients we!re vehicle assembly and consumer goods. 1.6 In the 1990s. the stock of foreign investment equaled US$3,303 million, of which US$741 million was in oil and gas, USS431 million was in chemicals and chemical products, USS398 million was in banks and other financial institutions, and US$312 million was in food. In 1991, multinational firms comprised 14 of the top 50, 34 of the top 100, and 115 of the top 500 firns in the country. The Philippines has not attracted significant foreign investment in recent years in comparison with its neighbors. However. there was an increase in FDI inflows after 1987 due to a debt-equity swap program between 1986 and 1988.3 3 The Unmwd `.,!imns estimates that 21 percent of FDI flows to the Philippines from 1985-89 came from debt-equity swaps  - 4 - 1.7 Foreign prrtfolio investment in the Philippines lhas also been erratic. reflecting investors' response to its domestic political problems. Foreign direct investment averaged under USS200 million per year in recent years, compared to US51-4 billion in neighboring countries. From a peak of US$344 million in 1982, fcreign equity investment inflows fell to less than US$100 million in 1987-88, before rising to an average US$328 million during 1990-93. 1.8 The limited attractiveness of the Philippines as an investment site coincided with the emergence in Asia of rapid growth in cross-border capital flows. From the mid-1980s onwards, large volumes of both loan and equity capital was transferred from Japan (and later Korea and Taiwan, China) to the emerging economies of East Asia undergoing rapid transforn,ation and growth. The Philippines remained largely isolated from these capital tlows (due in large part to civil unrest and extemal debt problems) and, as a result, its investment performance lagged further behind that of its neighbors. U.S.-based investment actually fell during the mid-1980s: even in 1990, U.S.-based investment was lower than in the late 1970s. While investment from Japan rose, the Philippine share was much lower than that for Malavsia or Thailand. The last major slump in FDI occurred in 1984, when the inflow of new direct investment fell to USS9 million, though FDI inflows have gradually risen since then. B. The Structure of Philippines' Business 1.9 The private sector in the Philippines is highly segmented. Witliin the private business sector, a substantial amount of economic activity is accounted for by a relatively small number of firms operating across a range of sectors. According to the latest (1988) census, there were 9,141 establishments in manufacturing in the Philippines. Less than 10 percent of these establishments (822 in total) employed more than 200 people, yet they accounted for 64 percent of total manufacturing employment, and 77 percent of manufacturing value added. Food processing and garment manufacturing firms accounted for the largest share of these firms by number. 1.10 Most firms in manufacturing are small and account for only a fraction of the total value added in the sector. Although the micro and small firms seem to compete with each other, they are not necessarily economically efficient; they have been sustained in part by government policies designed to encourage small ente -prises. 1.11 Until recentlv, most industries have been primarily assemblers of imported parts, a reflection of past import-substituting policies. With few exceptions, protectionism has led to mostly inefficient companies manufacturing generally inferior products at relatively high prices. With their domestic markets protected, and given the existence of an anti-export bias, industries are not encouraged to develop products for export, and therefore limit themselves to the relatively small domestic market. The Philippine manufacturing sector is predominantly oriented toward consumer goods, which represent 53 percent of manufacturing value added. Intermediate goods l!sed as inputs in producing petroleum products account for 25 percent of ;alue added, and capital goods, including electronics, account for 22 percent. Within the capital goods sector, electrical equipment and electronics increased its share of manufactured value added to 9.2 percent. The share of transport equipment and other machinery dropped. however, reflecting a move from capital-intensive, mostly inefficient, indu-:2eo toward labor-intensive production of electronic components. The Philippines has comparative aiJ. .:aces in the latter in terms of the cost and qualifications of its labor force.  1.12 The manufacturing sector is also heavily concentrated in the national capital region. The degree of regional concentration, however, has declined in the last decade. In 1980, Metro Manila accounted for nearly 45 percent of gross value added in manufacturing; this share fell to 39 percent by 1992. Correspondingly, there were small increases in the shares of southern Tagalog (near Manila) and central Luzon. Although the Government has provided tax incentives for private firms to locate outside the national capital region, there has been only a limited supply response because of the lack of transportation and commnunication infrastructure in regions away from Metro Manila. It seems that there are still greater benefits to locating near the main centers of demand. 1.13 Dearth of Medium-size Finns. Medium-sized firms, numbering 683, comprised only 0.9 percent of the total. In the footwear industry, for example, only 24 firms (about 5 percent) out of 484 registered companies have more than 50 workers. The lack. of medium-size firms, which tend to be more labor-intensive than large firms, means a reduced capacity to generate employment. The proliferation of small firms, however, has not led to creation of high-productivity jobs. 1.14 At the end of the 1960s, the formal private sector consisted of (a) relatively advanced, oligopolistic and protected family-based conglomerates operating in agriculture, mining, light processing, food processing and real estate; (b) ethnic Filipino-Chinese companies operating in trade, light manufacturing (e.g., textiles), banking, and finance; and (c) multinational firms, predominantly of U.S. origin, engaged in exporting raw or semi-processed goods to the United States or in selling U.S. brands in the domestic market. lhese three groups continue to dominate the formal private sector. At present, multinational firms account for about a fourth of GDP, and family-based conglomerates and Filipino-Chinese together account for another one-fourth. 1.15 Between 1972 and 1986, new groups emerged. These included (a) "cronies" of the Marcos regime, whose success was largely dependent on access to political power and patronage; (b) some small and medium-size firms, which developed as a result of government policies; (c) informal entrepreneurs; and (d) export-oriented firms engaged in the export of such manufactured goods as garments and electronics. 7'hese new groups have not been not able to grow rapidly as a result of a multitude of entry barriers as discussed in Chapter II. 1.16 The persistence of large family groupings in the private sector has significant implications for capital accumulation, asset acquisition, and investment strategies. Family groupings represent a concentration of wealth based on landed estates dating back to Spanish colonial times. Indeed, despite the emergence of other groups, there has not been a significant change in the concentration of wealth in the country over the past three decades. In 1961, the Nation I Statistics Office estimated that 20 percent of the households received 57 percent of the income; in 1988, the same 20 percent received 54 percent of the income. 1.17 The large family groupings continue to maintain significant investments in agriculture - principally sugar, coconut, and forest products. From this foundation, they have diversified into agricultural processing and food industry products, urban real estate (especially in Manila and Cebu), financial services (banking and insurance), and a range of quasi-public services such as transport, telecommunications. and power distribution. Manufacturing (or, more commonly, assembly) has been a peripheral interest of the family groupings; where interest has developed, it has been focused on textiles, home app!ianices, and automobile parts. During the Marcos years, some family groupings lost and others prospered. Since 1986, following the reorientation toward the private sector, traditional family groupings have become stronger. The concentration of wealth among a few families allowed for little domestic or foreign competition. There has been a tendency in family-based manufacturing firms  - 6 - to divert profits to other sectors rather than to reinvest in technological development or other modes of gaining competitive advantage. This is especially evident in the telecommunications sector, but also in some industrial sectors such as in textiles,4 1.18 A major problem in the private sector is the continued dominance of the manufacturing sector by a few large firns. Existence of a multitude of entry barriers (see Chapter 11) led to inefficient and oligopolistic behavior in which the large firrm do not compete vigorously with each other. The foctis of the large Philippine companies on high-profit, low-volume, domestic markets rather than competitive, high-volume, global markets has meant that these companies have not grown as fast as their counterparts in other Southeast Asian economies. It is commron in the private sector to look t) the Government to solve a wide range of problems - from relief from energy costs to protection from foreign competition to suppression of labor agitation. Access to political power is not wvidelv distributed, however, and the beneficiaries of government interventions have tended to be large enterprises and the major family groupings.5 Recent governiment actions indicate an easing in this stance, but the overall regulatory framework has encouraged rent-seeking and collusion to limit competition, and has reduced the need to be efficient. 1.19 The cartel-like structure in most sectors is also found in the financial sector. In the past, loans to directors, officers, stockholders, and related interests encouraged priority lending to enterprises that are interconnected, and curtailed credit to unrelated entities.' This system depressed the financing of efficient private sector investment. In the 1980s, inappropriate insider loans were responsible for all the bank failures, which reduced access to creditworthy borrowers. 1.20 Returns filed with the SEC provide further insight into the st-ucture of business activity. In 1992, the biggest 1,000 corporations had a total revenue of P 951 billion and manufacturing firms accounted for the largest portic-n (almnct 50 percent), followed by businesses in the wholesale and retail trade, and by the financing, real estate, insurance and business services sectors. Applying a value added-to-turnover factor of 0.4 to 0.6 7 indicates that these firms accounted for some 28 to 42 percent of GDP in 1992. The top 50 of these corporations account for around one-fifth of GDP. This degree of concentration is comparable with that in Indonesia (where it has been estimated that the largest 400 companies account for about half of GDP) and in Korea (where the largest 1,000 firms accoulnt for 63 percent of GDP).8 However, as discussed below, the performance of Philippine firms has lagged behind that of their East Asian neighbors; and entrenched entry barriers, which sustain rent-seeking behavior, indicate the main problem is not only high concentration ratios but overall policy inconsistencies and discretionary application of rules on private businesses. 4 Most textile manufacturers did not respond to the enterprise survey undertaken for this report. 5 Bruce Koppel and Manuel F. Montes, Private Goals and Public Means: liberalization. Industrialization and Government-Busmiess Relations in the PhilipDines. 1950-1990, forthcoming. 6 Edita Tan, "Interlocking Directorates. A value added tm turnover ratio of 0.6 was assumed in the case of the Indonesia PSA: the appropriate *alue ot this ratio varies denendilng on the activities in which the corporate groups are engaged. a Given thai a%h.u 10,000 enterprises -mostly inicroenterprises - are created annually and registered with the SEC. and that 1.4 million households operate small business operations. is an indication that the top 1.000 corporations may in fact rep! exent a smaller share of the domestic economy.  - 7 - 1.21 Included in the SEC top 1000 are some 28 Government-owned or controlled corporations, five of which are very large and are presently among the top 25. The largest of these are National Power Corporation (the largest company by asset:-,, PETRON (partially privatized), PNB, PASAR (the largest minerals/metal processing operator), and the National Steel Corporation (which dominates the Philippine iron and steel sector), which is being privatized. in 1992, public corporations accounted for 15 percent of the revenues of the SEC top 1000, but they also accounted for 30 percent of assets and 30 percent of liabilities. These figures indicate that government corporations have a large presence in some key sectors of the economy, such as in power. 1.22 The asset structure of corporations included in the SEC listing provides an indication of the patterns of investment within the business sector in recent years. In terms of total assets, financial sector firms are by far the largest, accounting for half of the SEC top 1000 total assets. Manufacturing sector firms by contrast accounted for only 15 percent of total assets. However, there are substantial differences between firms in different sectors according to the composition of assets. Fixed assets make up only a quarter of the total asset holdings of these 1000 companies, with the balance being classified as "current" or "other". For the business sector as a whole, this indicates that companies may have a strong preference for liquid assets over plant, equipment and other fixed assets. Even in the manufacturing sector, where plant and equipment investment is normally a large component of assets, only one-third of total assets are classified as fixed (see Figure 1.2). Figure 1.2 ASSET STPUCTUPE OF TOP 1000 COPPOPAT IONS (1990 SEC DATA, BY SECTOR) 120 1 100 90 f I XED ASSETS CI URRENT & OTHER ASSETS 1.23 In 1992, some I110 non-financial corporations had assets exceeding P I billion (US$41 million), but more than half of this was accounted for by 19 governrnent corporations (a quarter by NPC alone). Among the private firms, investments of this size provide an indication of the willingness to comrnit funds and, as Table 1.2 indicates, that the sectoral distribution of these large-scale investments has not been even.  - g . 1.24 The sectors which have attracted the most large-scale investments have been mining, food processing, beverages, petroleum refining, utilities, transport and conmmunications. In the petroleum refining sector, state-owned PETRON controls the largest operation with a ne. worth of around USSI billion in 1992 (and is now being privatized), but private sector firms have also committed substantial funds to their operations (equivalent to around US$1.6 billion in 1990).9 In the utilities sector also, governmnent agencies such as NPC and the National Electrification Administration (NEA) account for the largest investments, but private operators such as MERALCO have also made very large comritments. In the communications sector, significant private investments have been mnade in telecommunications (with PLDT being the largest), but in the transport sector, all of the major investments were held by government corporations in 1990 (although a majority shareholding in Philippine Airlines has since been divested). The engineering sector, on the other hand, has not attracted the volume of large-scale and capital intensive investments that are normally associated with efficient operations in this sector. The large textiles sector also reveals a low level of investment. The chemicals sector similarly has attracted only a small number of large-scale investments. With the exception of mining, food processing (which includes sugar) and electrical machinery, few large-scale and capital intensive corporate operations have developed around export activities, while some, such as beverages, have expanded under the shelter of high import protection. 1.25 The SEC top 2,000 includes 342 companies whose ownership includes foreign equity either as sole owner or on a joint venture basis. These foreign-affiliated firms accounted for about one- fourth of total revenue of the top 2,000 companies in 1990, indicating a contribution to GDP in the range of eight to 12 percent. Total assets of the foreign affiliated firms amounted to a 295 billion (US$12.3 billion), more than half of which was in the financial sector, although large holdings also appear in petroleum refining, electrical machinery and chemicals industries. In manufacturing and agriculture, foreign affiliated companies accounted for between one-quarter and one-third of total assets. By contrast, foreign affiliated firms accounted for just five percent of mining sector assets (due par.ly to foreign ownership restrictions in this sector). A significant neA investment in this sector is Shell's US$667 million STAR refining project, the commercial financing for which was successfully completed in January 1993 with assistance from IFC. This was the largest fund-raising exercise invulving the private sector (on a non-guaranteed basis) since the Philippines declared a moratorium on foreign debt payments in 1983.  -9 - Table I.2: Distribution of Corporations with more ban IBilllon Pesos in Assets, 1992 (1) (2) (3) (4) Sect'x Companies Assets held A isets held as a percerd of I> billion (P billion) touai sector assets (%) Agriculture 1 1.5 15.5 Mining 12 50.7 96.4 Manufacturing: Food processing 17 53.6 87.4 Beverages 3 45.4 98.1 Textiles 1 1.6 45.7 Apparel, leather, footwear 0 0 0 Wood products, fumiture 1 1.4 28.6 Paper products 1 1.2 46.2 Industrial chemicals 3 4.2 30.2 Other chemicals 5 10.3 50.5 Petroleum refining 5 88.3 99.7 Rubber goods 6 12.2 77.7 Plastic, pottery, china 0 0 0 Glass products 1 3.6 55.4 Cement 6 12.1 69.9 Iran & steel 4 32.2 84.5 Nonferrous 0 0.0 0 Fabricated Metal 2 4.8 80 Machinery 3 3.3 76.7 Electrical Machinery 10 15,2 64.6 Transport Equipment 0 6.3 0 Electricity, gas, water 4 262.1 99.1 Construction 3 4.9 41.5 Wholesale, retail 4 29.6 24.2 Transport, communication 15 127.7 94.4 Conununity & other services 6 8.8 51.2 Source: SEC, 2000 Top Corporations in the Philippines, 1991 Edition. 1.26 Small and Medium Scale Enterprises (SMEs). Due to various constraints, medium-scale enterprises have never grown in number or expanded to any significant degree. This is largely due to the fact that once firms reach a certain size, compliance with business taxes and minimum-wage laws is more likely to be enforced. At the same time, they do not enjoy enough economic power to circumvent these costs (as do the large establishments) that cut into profits. The sector includes 115,000 establishments (and 60,000 microfirms not registered in official statistics), employs more than three- fifths of the manufacturing workforce, and generates more than one-fifth of manufacturing value added and of manufacturing fixed assets. Micro and small-scale firms account for about 98 percent of all establishments, but employ only 41 percent of the workforce and create about 14 percent of value added. By contrast, large-scale establishlnen.. (employing more than 200 workers) account for three-  - 10- quarters of value added and half of employment in manufacturing, although theN represent only 1 percent of all firms (Table 1.3). 1.27 Of the limited number, most are concentrated around Metro Manila. I ortN percent of the country's industrial firms are located in Metro Manila area and about 23 percent in the nearby central Luzon and southern Tagalog regions.'0 All other regions, including such urbanized growth areas as Cebu, Davao, and Iloilo, accounted for about 40 percent of all SMEs. Larger firms are more concentrated in the Metro Manila area: Over 60 percent of firms with more than 50 employees are in this region. This occurred mainly due to the city's attractiveness as a center of power and therefore essential in terms of lobbying policy makers. Such concentration explains why the rest of the country remained underdeveloped and underscores the need to speed up the Government's plans for decentralization through encouraging the further development of Local Government Units (LGUs). Table 1.3: Employment and Value Added of Manufacturing Establishments (By firm size. 1988) Percentage Percentage V alue Percentage Number of Number of of Total of manuf added of employees firns total employees employment Thou Pesos) manuf. _alue added 0-10 67,147 88.0 234,428 21 8 1.- 3.0 10-99 7,639 10.0 202.910 18 9 51!) 11.4 100-199 680 0.9 97,670 9 1 141.>48 10.9 200 or tnore 822 1.1 542.309 50.2 ' 1'( 74.7 TOTAL 76,288 100.0 1.077,317 100 (1 l3f',M39 8;) 100 0 Source: Census of Establishments, 1988, National Census and Statistics Office (NCSO). Manila 1.28 Large firms provide a significant source of manufacturing jobs in the Philippines. But SMEs take the lead in leather and footwear (80 percent); nonmetal mineral industries. excluding cement (75 percent); metallic and nonelectrical machinery (68 percent), paper. printing. and publishing (63 percent); and chemicals, rubber, and plastics (54 percent). About 57 percent of microenterprise employees were in wholesale and retail trade; 18 percent in manufacturing; 21 percent in personal and financial services; and the rest, about 4 percent, in construction, mining, and transport. Food and beverage retailing represented about one-third of cottage employment. 11 1.29 Government policies have attempted to encourage subcontracting. Promotional policies have included financing programs, such as the Tulong Sa Tao Subcontracting Financing Program, the National Subcontractors' Exchange (SUBCONEX), a registry and placement service for subcontractors. There have also been mandatory local content requirements for cars. motorcycles. trucks. and electronic consumer goods. 0 1983 Census of Establishments. "1 1983 Census.  i.30 Subcontracting is usually more important in labor-intensive components or subassembly sectors, such as garments, wood furniture, transport equipment, scientific instruments, electronics, and nonferrous metals. According to 1983 and 1988 census data, subcontracting in the Philippines is most important for small supplier firms, declining as a share of output as establishment size increases. However, medium-size establishmnents subcontract out a larger share of their work in terms of total cost of production than either snaller or larger firms. The sectors that relied most on subcontracting included garments (19 percent of total costs), printing (7 percent), wood funiture (7.8 percent), nonmetal mineral products (6 percent), wood products (5 percent), fabricated metal products (4 percent), and electronics (4 percent). 1.31 Despite the direct and indirect encouragement given to subcontracting in the Philippines over the past 20 years, it still remains limited to a few subsectors. And although it increased between 1983 and 1988, subcontracting accounts for only a small share of the value of manufacturing output - 2.5 percent in 1988. In Japan, by contrast, purchases of subcontracted supplies account for about 70 percent of total manufacturing costs in the automobile sector. 1.32 Agribusiness makes up a key component of private sector activity in the Philippine economy. Broadly defined to include all production, marketing and processing activities linked to food and fiber conmmodities, agribusiness accounted for about 49 percent of GDP in 1993, made up of primary agricultural value added of 23 percent, agro-industry value added of 13 percent and agribusiness services value added of 13 percent. 1.33 The private sector also includes the small, nonplantation farners who produce food staples, coconuts, and other agricultural products. In the 1950s and early 1960s, absentee landlords and land tenancy were major constraints to agricultural diversification and efficient land use, but during the periods of rapid economic growth in the 1970s, these farmers prospered. During the early part of the 1980s, however, when price controls tended to favor the urban consumer, increased production did not translate into increases in farmers' incomes, so their ability and incentives to undertake investments declined. 1.34 The sector also comprises a small number of very large conglomerates coexisting with a large number of small farmers and processors. Total business activities (agricultural and non- agricultural) of the top 50 agribusiness groups accounted for 11 percent of Philippine's GDP in 1989, but it is within the agribusiness sector itself that concentration is most evident. Government policies which date back to the 1960s have enabled six conglomerates to control a large part of the agribusiness sector. In 1990, these six groups controlled about 80 percent of the commercial poultry market, 93 percent of the dairy market, 60 percent of the animal feed market, 100 percent of coconut oil processing, 90 percent of banana exporting, and 100 percent of tobacco processing. Expansion and diversification of business activity over the past two decades (at times on the basis of favorable franchise, licensing or financing arrangements with Government) have seen some of these groups extend their interests beyond the agribusiness sector. I2 1.35 Since 1989, small farmers have been adversely affected by natural disasters, such as droughts, earthquakes, and t:le eruption of Mt. Pinatubo, in addition to the usual seasonal typhoons and floods. Growth remained stagnant owing to limited scope for production increases in grains and poor market prospects for traditional crops like coconuts and soya. Furtherrnore, the incomplete 12 As an exa.mp!. in 1992, a tobacco-brewing-banking conglomerate associated with Fortune Tobacco financed 40 percent of the US$369 million paid by the PR Holdings consortium for controlling shares in Philippine Airlines.  - 12 - implementation of agrarian reform has created uncertainty and deterred private investment, and so has not had the desired effect of increasing agricultural output. 1.36 The main reason for relatively slow growth in the agro-business (particularl) processing) sector during the second half of the 1980s has been the limited flow of new investments into the sector. This in turn has resulted mostly from the same series of constraints which have had a negative impact on other aspects of sectoral development (a) the Government's indecisive and slow implementation of the agrarian reform program; (b) poor transport, conmmunications and power infrastructure; (c) high real domestic interest rates and lack of sufficient long-term credit. (d) periodic overvaluation of the domestic currency; (e) trade and investment policies which continue to be biased against agriculture and agro- processing; (f) inadequate market information systems, and (g) law and order problems. Somewhat more specific impediments to effective development of modern agro-processing include irregular (quantity and quality) supply of raw materials, excessive cost of packaging materials (due to high protection on these materials), and high minimum wages compared to successful agro-business centers. 1.37 While agro-industry's share of industrial activity has been declining, it still remains an important part of the Philippine economy. In 1993, agro-industry accounted for 52 percent of manufacturing value added, down from a high of 58 percent in 1986. Food processing dominates agro- industry. Beverage manufacturing, tobacco and wood processing industries are the other main components of agro-industry. Nevertheless, food processing has grown slowly in the Philippines because of limited diversification of its raw material base beyond rice. corn, coconuts, and sugar. Unlike some other countries in the region, the Philippines has largely failed to attract significant investment in processing of non-traditional agricultural crops for domestic consumption as well as for exports. 1.38 The manufacturing sector has not performed strongly during the past decade. Total productivity in manufacturing fell. The share of workers in manufacturing has remained at around 11 percent since 1970 -- comipared to one-fourth to one-third of the total labor force in most other ASEAN countries - while manufacturing's contribution to GDP has similarly remained unchanged at around 25 percent. A recovery in manufacturing output in the second half of the 1980s was accompanied by an improvement in measured productivity. but much of the increase in output was due to increased utilization of existing capacity and not associated with any sustained increase in business fixed investment. The growth of output from manufacturing firms fell to only 0.7 percent in 1993. 1.39 An important indicator of the state of private ownership in the manufacturing sector is the low share of manufacturing workers employed in factories. The 1988 census revealed some 2.2 million employees in manufacturing establishments in the Philippines, but almost two-thirds of these (1.4 million) were employed in the household/unorganized labor se.tor (i.e.. outside of factories). Census data indicate a gradual shift toward factory employment ove; the past three decades, but the current structure of employment is still very much concentrated in smaller and unorganized establishments. The productivity of labor within the smaller establishments is believed to be lower than in the organized factory units, which not only, sustains inefficiencies in the manufacturing sector, but also explains the high share of output comiiing from a relatively small number of large establishments. 1.40 As external financing became difficult, domestic debt was substituted for foreign debt in the last part oth 1980s. Since 1988. as external debt declined as a share of GDP. domestic debt's share rose (Tahhe 1 4). While part of this increase was attributable to the continued budgetary deficits, persistent large losses of the CBP were also a major factor accounting for the accumulation of domestic debt. Over the rneriod 1990-92, the GOP issued a large amount of Treasury securities to finance CBP's  - 13 - losses and to assist the CBP in conducting open market operations. Also, the maturity of domestic public debt shortened. In 1983, about one-half of Government securities were in the form of long-term bonds but, by 1992, 95 percent of Government securities were in short-term Treasury bills, mainly 91- day instrunents. This change in maturity reflected concerns over domestic inflation, the continued financing needs of the National Govermnent, and the lack of depth of the domestic financial market. Part of the high real interest rate reflects the risk premium, which should decline over time as the ratio of debt to GDP falls. The burden of domestic debt also grew over time. In 1992, interest expense accounted for six percent of GDP and 31 percent of Government expenditures. The impact of interest rate volatility on the Government budget is very substantial. Therefore, the domestic debt situation in the Philippines requires the GOP's serious attention for a coherent debt management strategy. Table 1.4: Total Debt of the Public Sector, Selected Yeas, 1983-93 (As % of GDP) 1983 1985 1987 1990 1992 1993 Total debt outstanding 62.5 79.2 90.5 75.6 85.9 97.0 Domestic debt 12.5 17.0 22.2 23.0 37.9 49.0 External debt b/ 50.0 62.2 68.3 52.6 48.0 48.0 o/w: NG 20.5 29.3 43.4 46.5 52.5 63.1 Domestic debt 9.2 10.4 20.7 22.3 32.5 43.8 External debt c/ 11.3 18.9 22.7 24.2 20.1 19.2 Central Bank 12.0 23.5 19.6 12.6 15.3 15.7 Domestic Debt 0.0 4.2 0.1 0.2 5.0 5.0 External Debt 12.0 19.3 19.5 12.5 10.3 10.7 Other d/ 30.0 26.5 27.5 16.5 18.1 18.2 a/ As of mid-September. Data includes P 220 billion of Treasury securities issued to the Central Bank. b/ Data for 1992 and 1993 are estimates. c/ IMF. d/ Residual. 1.41 The financial strength of manufacturing firms has, however, irnproved in recent years following depressed earnings during the early to mid-1980s. As shown in Table 1.5, the most significant improvement in the financial condition of the top 1,000 corporations since 1986 has been in the increase in return on equity despite a significant reduction in leverage. These data indicate that, while balance sheet restructuring has improved the overall capability of Philippine corporations to undertake further investment, depressed domestic market activity until last year coupled with a plethora of disincentives to invest in fixed plant and equipment has been a barrier to resumed investment growth (see Chapter II). 1.42 One significant area of adjustment which occurred within the manufacturing sector over the past two decades has been in the composition of exports. In the early 1970s, about 70 percent of  - 14 - Philippine mnanufactured exports came from the food sector but, commencing in the mid-1970s, the Philippines, like many other developing countries, began to shift more into "nontraditional" exports, mostly garments and electrical goods (mainly semiconductor assembly), with low domestic value added. By the mid-1980s, semniconductors accounted for 26 percent and garrnents 15 percent of Philippine manufactured exports. Now, about three product categories account for a significant share of total exports. Nevertheless, the extent of export diversification achieved by Philippine manufactures has been far less than that of successful exporters like Indonesia, Malaysia and Thailand. This is attributable to low investment and the problems of achieving appreciable cost efficiency. The collapse of Philippine footwear exports during the 1980s (at a time when Indonesia, China, and Thailand were increasing their footwear market share) illustrates the extent of this problem. Table 1.5: Financial Performance of the Manufacturing Sector, 1979-92 Net profit Retum on Return on margin assets equity Turnover Leverage Year (in %) (in %) (in %) (ratio) (ratio) 1979 3.00 3.15 9.97 1.05 2.17 1980 1.51 1.60 5.61 1.06 2.51 1981 1.12 1.22 3.87 1.09 2.17 1982 n. a. -0.12 -0.39 n.a. 2.16 1983 n.a. 0.63 2.16 n.a. 2.43 1984 1.26 1.56 6.14 1.24 2.94 1985 0.47 0.59 2.35 1.26 2.98 1986 2.70 3.09 9.84 1.15 2.18 1987 4.07 4.03 13.76 0.99 2.41 1988 5.13 5.73 17.20 1.12 2.00 1989 4.95 5.57 16.03 1.13 1.88 1990 4.44 5.11 14.45 1.15 1.83 1991 4,7 6.0 15.6 1.3 1.0 1992 5.9 6.9 14.5 1.2 1.2 Notes: Net profit margin is after-tax income as percent of gross revenues, Return on assets is after-tax income as percent of total assets. Retum on equity is after-tax income as percent of net worth. Tumover is ratio of net sales to total assets. Leverage is ratio of total liabilities to net worth. Sources: Business Day. 1000 ToD Corporations, 1981, 1982; Philippines SEC, ToD 1000 CorporationS, 1985, 1986, 1990; Mahal Kong Philippines Foundation, Inc. Philiopines' Best 1000 Corporations, 1989; World Bank reports. 1.43 Other factors have also limited Philippine exports. First, manufactured exports did not develop backward linkages and have resulted in a high import content of exports. Second, manufacturing is poorly diversified. The continuing overreliance on two products, garments and electronics, makes exports vulnerable to changes in the international markets. Garments are subject to international quotas and electronics are affected by rapidly evolving technology. Also, Philippine export markets are poorly diversified and this might limit future growth. The country's intraregional trade has been the lowest in Southeast Asia, and 75 percent of its exports go to only three industrial markets: the United States (37 percent), Japan (20 percent), and the European Community (17  - 15 - percent). Most Southeast Asian countries have increased their intraregional trade. For instance, 42 percent of Singapore's exports went to Southeast Asian countries excluding Japan, compared with 7.5 percent for the Philippines in 1991. 1.44 "Nontraditional" Exporters. Of the 330 exporters among the top 1,000 companies, 90 percent are controlled by either conglomerates or multinationals. Another group of domestic companies export both labor-intensive ready-to-wear garments and capital-intensive goods. The owners of some of these firms tend to be ethnic Filipinos, and the managers are relatively young, many with degrees from foreign universities. Some are Chinese-Filipinos. There are also many small handicraft exporters, with an annual export volume of about US$100 million. The financing for non-traditional exporters comes from banks and other formal sources, as well as from savings and extended family relationships. Since these firms have to survive in highly competitive, fast-changing international markets, their main impediments to growth - besides the periodic overvaluation of the currency and the overall anti-export bias of the trade and investment regime - are operational problems such as industrial bottlenecks (in particular power blackouts during 1991-93), the still high cost of finance and a slow-moving government bureaucracy. 1.45 Similar to the situation in Indonesia, there are few inter-firm linkages within the industrial sector in the Philippines, and the linkages that exist between exporting firms and the rest of the economy remain limited. Firms that were established within Export Processing Zones (EPZs) or under bonded warehouse arrangements have tended to focus on export markets exclusively and, as a result, few mixed sales businesses have developed. In 1988, of the top 200 exporters (who provided over two- thirds of export sales), virtually all were 100 percent for export." Since the trade policy framework simultaneously affords protection against imports and, at the same time, provides export incentives such as duty exemptions, it resulted in a dualism within industry whereby a number of export-oriented firms coexist with less efficient domestic-oriented firms. The quality and cost of components and services provided by the domestic-oriented firms are in many cases not up to international standards and, for this reason, exporters make relatively few purchases from domestic firms. As a result, the expansion that has taken place amona exporting firms over the past decade has not had a significant impact on the business opportunities for other firmns. 1.46 While the range of goods being produced in the Philippines gradually expanded during the 1960s (such that textiles, paper, cement, metal products and chemicals joined the traditional industries of wood processing, food and beverages), there has been little change in the overall structure of manufacturing since then (Table 1.6). Even with the reform efforts started in the 1980s, there is little evidence of creation of significant new lines of business - unusual for a country located within the dynamic growth region of Southeast Asia. For example, an attempt to introduce upstream petrochemical capabilities into the Philippines was abandoned in 1991 due to legal entanglements. The circumstances surrounding this legal challenge have been cited by some business groups as one factor contributing to the overall caution of foreign business investors. Although the entry of new firms started accelerating toward the end of 1993, the static structure of industrial output until recently indicates that the incentives structure and enabling environment within the Philippines has not been as conducive to the growth of new enterprises or lines of business as took place in other successful Southeast Asian countries. This is the result of several factors, including macroeconomic problems, continuing anti-export biasZ the trade and investment regime, crowding out of private investment by large public sector horrowigs and, more recently, severe infrastructure limitations. '3 In addition. ot tle top 50 exporters, 20 were majority foreign-owned.  - 16 - 1.47 The Philippine private sector is burdened with cost disadvantages (due to infrastructure inadequacies, high cost of power, labor costs) which make it difficult for them to switch easily from domestic sales to export narkets. Development of new export capabilities will depend on timely removal of the anti-export bias of the trade and investment regime. As discussed in Chapter II, a more concerted export-oriented effort on trade and competition policies to lower the costs of doing business in the Philippines will be needed to stimulate investment-led growth by private business, and current Government plans are in this direction. Table 1.6: Distribution of Value-Added Across Manufacturing Subsectors, 1967-93 (share in %) ISIC codes Manufacturing subsector Average Average Average Average 1967-70 t975-80 1985-91 1992-93 311/12 Food manufactures 46.44 43.91 41.50 37.0 313 Beverage manufactures 2.01 2.29 4.22 3.9 314 Tobacco manufactures 2.37 3.16 3.01 2.8 321 Textile manufactures 5.27 5.19 3.89 3.2 322/4 Wearing apparel and footwear 3.92 4.02 4.89 6.2 323 Leather and leather products 0.17 0.12 0.08 0.08 331 Wood and cork products 4.46 3.71 2.12 1.9 332 Furniture and fixtures 1.93 1.49 1.27 1.2 341 Paper and paper products 0.87 1.09 1.12 1.03 342 Printing and publishing 1.18 1.35 1.37 1.6 351/2 Chemicals and chemical products 3.65 7.04 6.44 6.26 353/4 Petroleum and coal products 11.44 10.86 13.83 17.78 355 Rubber products 1.75 1.81 1.45 1.38 356/61-3/69 Non-metallic mineral products 3.07 2.79 2.29 2.74 371/2 Pasic metal products 1.15 1.55 2.95 2.24 381 Fabricated metal products 2.72 2.24 2.19 2.42 382 Machinery except electrical 1.53 1.25 1.04 1.24 383 Electrical machinery 1.70 1.77 3.66 4.49 384 Transport equipment 3.21 3.24 0.83 1.22 385/6/980 Miscellaneous manufactures 1.17 1.11 1.84 1.86 All Manufacturing 100.00 100.00 100.00 100.oo Notes: Derived from constant price value added. Sources: National Income Accounts, NSCB. 1.48 One important area in which growth has taken place in recent years has been in the equity market as more firms have sought to expand through public listings. The number of listed firms has increased from 130 in 1986 to 186 by mid-1994, and this increase has been accompanied by phenomenal growth in market capitalization from US$2 billion to US$39 billion. The stock market grew by 130 percent in US dollar terms, becoming the best performing stock exchange in 1993. In 1993, initial public offerings (IPOs) of 13 companies reached P 13.7 billion. For the first quarter of 1994, there are already 21 applicants for IPOs filed with the SEC. While the size of the Philippine equity market is still small when compared to the overall domestic economy, as well as to other emerging markets (see section on the capital markets), further growth potential is large. In 1993, the  stock market grew by 154 percent, and large family-owned enterprises have started to go public. Commercial and industrial firms now account for more than 90 percent of the total market capitalization compared to 10 percent six years ago. Recent developments in the nurnber c. new listings and total capital raised are shown in Table 1.7. Table 1.7: New Equity Listing and Total Capital Raised, 1989-93 (USS milons) 1989 1990 1991 1992 1993 Number of new listings 7 9 9 9 13 Total capital raised 103 351 447 408 493 (US$ millions) Source: Manila Stock Exchange. 1.49 Compared with those of its neighbors and countries of a similar size, the Philippine market is small. Also, like many other equity markets in the developing world, the Philippine market is very narrowly based: daily trading value is approximately US$13.5 million, but 85 percent of business by value is accounted for by transactions in only five stocks. 1.50 Most firms are privately owned and want to keep tight corporate control. They are therefore reluctant to provide the information required for registering securities or disclosing material financial information. As a result, they tend to shy away from equity financing. In addition, the beneficial tax treatment of debt and the high real domestic interest rates on goverrament securities have meant that equity offerings are mostly unattractive to investors. With high real domestic interest rates, Philippine firms have generally found it too costly to meet the investor expectations of high returns. 1.51 As a result, the equity market is underdeveloped in terms of both supply and demand (see Chapter II). On the supply side, only a small number of high-grade securities are offered by a small group of listed companies. On the demand side, only a narrow base of investors is actively involved in the stock market. Their limited demand for stocks leads to depressed prices, which in turn limits the incentive for issuers to make public offerings. Although there was a large inflowv of foreign funds into domestic equities in 1993. the size of the market is still small compared to other emerging markets (para. 1.48). Moreover, small individual investors have a limited opportunity to participate in primary offerings of popular shares because stock exchange member firms distribute shares among themselves and to preferred clients. 1.52 Recent growth in the volume of funds raised in the Philippine equity market has maue it a more important source of investment financing than previously. Nevertheless, the amounts raised are not large, neither in relation to alternative sources of company finance nor relative to the overall size of private sector investment."4 One reason is that privatization initiatives, which have been used in other countries to stimulate equity market growth, have for the most part bypassed the stock exchanges in the Philippines. The Government will time further privatization of PNB to avoid adversely affecting its share price. The main exception to this was the listing of l 1.8 billion of shares in Philippine National '' In 1991, tta <:apttal raised on the equities market was equivalent to 6.8 percent of total investment expenditure by the private sector  - 18 - Bank (PNB) in 1989. This underscores the need to expedite the introduction of capital market reformns as discussed in Chapter II of the report. C. lhe Effect d Gof w E i ad Public Debt on Private Busin 1.53 The public sector's direct involvement in the economy increased significantly between 1972 and 1986, with the number of government-owned or controlled corporations (GOCCs) increasing from 75 in 1970 to 301 in 1986. The new GOCCs included corporations nationalized in the early years of martial law, those established by government agencies or subsidiaries created by existing GOCCs, others confiscated from political opponents of the president (sequestered assets), troubled corporations foreclosed by Government financial institutions and those created to advance the political or personal objectives of public officials. 1.54 These GOCCs were engaged in a various activities. More than a third were in finance, housing, and services, and most of the gross value added was in utilities and finance. Their contribution to the overall public sector deficit grew from eight percent in 1975 to 22.5 percent in 1984. Without this burden, the public sector would have had a surplus during this period.'5 1.55 Also during this period, state-owned banks acquired holdings in a large number of corporations through default. The Development Bank of the Philippines (DBP) and the Philippine National Bank (PNB) becarne saddled with nonperforming assets, particularly from 1981 to 1983, due mainly to investments by unethical businessmen and the banks' own faulty credit decisions, often dictated by politics. For example, investments that featured overpriced assets were common and created bloated liabilities and a subsequent loss of equity for these banks. The credit compression exposed financial weaknesses in undercapitalized firms. To prevent large sca'e failures, the Government set up a rehabilitation fund to help financially troubled companies, but this did not prevent many defaults and only increased the DBP's and PNB's nonperforming assets further. By 1986, there were an estimated 399 nonperforming assets on the books of state-owned banks, with an estimated book value of P 132 billion. This figure excludes smaller companies, those with book values of less than P 10 million, whose recoverable value has been estimated at P 24 billion. Thus, the DBP and PNB were in serious technical default whca the new administration took power in 1986. 1.56 Virtually all of the provision of infrastructure services (with the main exception of PLDT - telecommunications - and MERALCO - electricity distribution - both of which are private) in the Philippines has in recent decades been publicly owned and operated. Because of this, and the fiscal crisis that accompanied the economic problemns of the 1980s, there has been a significant reduction in public spending on infrastructure. The public investment program, which peaked at nearly 11 percent of GDP in 1981 (five percent for infrastructure, the rest for capital transfers to other government corporations), had by 1993 fallen to six percent of GDP (with infrastructure accounting for just over half of the total). During 1988-92, public infrastructure spending has averaged at less than two percent of GDP, far below the Indonesian performance of around five percent. In 1993, even including PL.DT's and MERALCO's total capital outlays, Philippine infrastructure expenditures were about three percent of GDP. In recent years, the Government has announced a number of infrastructure spending targets, but a number of problems, including revenue shortfalls, have prevented it from implementing even two-thirds of the planned programs. The Government depends on foreign borrowing (ODA) for Is Manasan and Buenaventura (1985).  - 19 the majority (77 percent in 1992) of its infrastructure investment programn, but the record of implementation has been poor. 1.57 The expansion of the Government sector in the 1970s led to growth in external borrowings. Over the past decade, these public borrowings have been from official aid agencies. The stock of long-term external debt stood at USS8.8 billion in 1980, of which some 72 percent was public or publicly guaranteed. Over the following decade, public long-term external debt grew rapidly, reaching US$29.1 billion by 1993, with official (multilateral and bilateral) agencies being the principal debt suppliers. Private external debt, on the other hand, declined rapidly after the onset of the external debt crisis in 1983. By 1993, private long-term external debt had declined to US$1 1. billion, or just 3.6 percent of total long-term external Philippine debt. 1.58 The accumulation of public external debt during the 1980s was more rapid than growth in the overall economy and has been one of the major contributing factors to the continuing adverse perception of Philippine country risk. In 1982, just prior to the onset of the external debt crisis, the long-term debt-to-GDP ratio stood at 33 percent, but this ratio climbed rapidly to reach 74 percent in 1987 before declining. By end-1993, the long-term debt-to-GDP ratio was 62 percent, still well above the pre-debt crisis level. The external debt service burden followed a similar pattern, partly because of a iarge-shift toward variable interest rate debt (although interest rates have fallen since the early 1980s) and an increasing volume of official debt obtained on concessional terms. The ratio of long-term debt service to exports increased from 26 percent in 1983 to 30 percent in 1987, but then contracted to 20 percent at the end of 1993. The reduction in debt service burden has improved international perceptions of Philippine country risk. 1.59 The management of the Philippines' external debt remains a critical factor in mobilizing finance for efficient private sector development. Reducing the debt-to-GDP ratio will be important to securing an enhanced perception of Philippine creditworthiness, which ultimately means reduced internal debt borrowing costs for private investors as well as better access to external equity and securities markets. Controlling the growth of public and publicly-guaranteed debt will remain a priority issue if private external borrowing is not to be further crowded out (see Chapter II). 1.60 The public sector has also been a major participant in domestic capital markets. The issuance of domestic government securities accelerated in the second half of the 1980s as budget deficits persisted and domestic debt substituted for external debt. Government securities outstanding at the end of 1985 were equivalent to US$4.1 billion, but by 1993 these had expanded to US$25.2 billion, with the private sector and semi-government entities accounting for most of this growth. The holding of Government securities by private firms and individuals has been at the expense of investment in productive capital and other financial and nonfinancial assets. 1.61 Deposit money banks (a major source of finance to the domestic economy) also shifted a significant share of their domestic credit toward the public sector during the past decade. In the early 1980s, the deposit money banks allocated 80 to 85 percent of their credits to private sector borrowers, but with the onset of the external debt crisis this share declined (to a low of 68 percent in 1986) and has remained at around 70 to 73 percent in recent years. By March 1994, these banks provided credit to the public stctor of about US$3.4 billion equivalent in domestic currency. For the whole banking sector, the increased portfolio allocationL toward government paper has followed a .imilar pattem. Between 1987 and March 1994, the banking sector's holdings of securities (mainly goverrunent) rose from US$1.9 billion to US$4.9 billion.  - 20 - 1.62 Part of the Government's extensive borrowing requirements resulted from financing losses incurred by public enterprises. Most stemmed from uneconomic investments and imprudent levels of financial leverage. In 1986, at the end of the Marcos administration, there were some 301 GOCCs, the transfers to which accounted for one-fourth of consolidated public expenditures. The transfers were made to companies such as Manila Electric Company (MERALCO) and Philippine Airlines (PAL) which had been confiscated by the Marcos administration for political reasons and buy-outs (such as that of ESSO) for nationalization objectives. In addition, there were the "nonperforming assets" of Government financial institutions (GFIs) which had previously made "behest loans"" to favored private business groups. Fourteen of the larger public corporations have been singled out for closer monitoring by the Government Monitoring and Coordinating Committee (GMCC), and later by the Department of Finance as part of monitoring the reduction in the consolidated public sector deficit." The overall performance of these companies has shown little improvement since the mid-1980s (see Table 1.8), and because their overall impact on the fiscal balance is still a concern, all are currently being assessed for privatization by the Government. The overall deficit of the 14 monitored nonfinancial corporations is projected to decline to 0.8 percent of GNP during 1994 from 1.7 percent in 1993. All of this reduction, however, is attributable to sales of companies by the APT and the privatization of PETRON. The deficit of other public enterprises, in particular NPC. is expected to remain unchanged. As a result, the aggregate deficit would rise in 1995 to 1.2 percent of GNP, and then stabilize at this level. To achieve even these targets. the Government plans to undertake a substantial restructuring of NPC (see Chapter II). "Table I.8: Financial Situation and Financing Requirements of Monitored Government CorporationLs, 1988-93 (Million Pesos) 1988 1989 1990 1991 1992 1993 Overall surplus (+) deficit (-) a/ 1,300 -7,541 -21,327 -10,767 -12,956 -30,144 Government subsidies 1,644 4,546 2.190 3,369 2,296 4,537 Government equity -2.943 2,078 3,274 2,101 610 5,640 Government lending 4,063 2,174 2,181 4,564 1,330 1,549 Domestic bank credits -1,224 2,236 7,456 -3,668 3,730 1,986 Other domestic financing 34 -6,094 -47 4,240 -1,726 -5,427 a/ Net of subsidies. Source: GOCCs. 16 Loans giveln tm Marcos' "cronies" with political motives. 1 7 Thlest: T i. h11\pkrt Processing Zone Authority. (ii) Local Water Utilities Administration. (iii) Light Rail Transit Audiolrn , Meiro Manila Transit Corporation, (v) Metropolitan Waterworks and Sewerage Systems (MWSS), (vi) Nat. l1l I; i,ipment Corporation (a holding company), (vii) National Electrification Administration (NEA), (viii) Nationa! Fr-d Authority (NFA), (ix) National Housing Administration, (x) National Irrigation Administration (NIA), (xi} Natwnid Power Corporation (NPC), (xii) Philippine National Oil Company (PNOC), (xiii) Philippine National Railway,. and (xiv) Philippine Port Authority.  - 21 - 1.63 Privatization was undertaken in 1986 for economic and political reasons. The rmain economic objective was to reduce the financial burden imposed by GOCCs and nonperforming assets on the public sector finances, and partly to raise the efficiency of the domestic economv. The political objective was to reverse the politically motivated nationalization of particular indust ies in the 1970s. Initial efforts at privatization started prior to 1986, when DBP was forced to dispose of its nonperforming assets. At about the same time, in view of increasing financial difficulties, the Government began to divest itself of some of the GOCCs. 1.64 The previous administration stated its policy on privatization in Proclamation 50 in 1986. The Proclamation outlined the Goverrunent's intention to dispose of GOCCs and nonperforming asse.s to reduce the size of the Governmnent corporate sector (as well as to remove the poor legacy of the p;evious administration), financially rehabilitate PNB and DBP, reduce the consolidated public sector deficit, increase government revenues through rehabilitation of GOCCs and nonperforming assets, and fund the Comprehensive Agrarian Reform Program (CARP) from the expected sale proceeds of privatization of GOCCs. 1.65 The Proclamation also defined the institutional framework for privatization. It led to the creation of the Committee on Privatization (COP) tasked to oversee the Philippine privatization program, setting objectives and policies concerning the divestment of public assets, and the Asset Privatization Trust (APT) as the main implementing body. 1.66 The Prcclamation was later amended by RA 7181, which extended the life of the COP and APT from December 8, 1991 to August 31, 1992, and added certain provisions on the conduct of privatization. The new law mandated that there shall be no dislocation of labor outside boundaries established by existing laws or collective bargaining agreements; assets shall not revert back to previous owners who were found, through appropriate legal procedures, to have mismanaged or diverted resources from the assets. resulting in loss and/or in bankruptcy; at least 10 percent of the assets, in corporate form, shall first be offered to small domestic investors; and a loss recovery provision shall be a condition of sale for any assets below the transfer price. The law also subjected the sale of strategic industries to presidential approval and spelled out the role of the National Economic Development Authority (NEDA) in determining what constitutes a strategic industry. 1.67 Republic Act No. 7661 further extended the life of the COP and APT until June 30, 1995. The same law confirmed the same conditions in the privatization of non-performing assets in R.A. 7181. The initial privatization program focused mostly on the reduction of nonperforming assets and less on the sale of GOCCs. As of December 1993, the APT and the other disposition entities had sold or liquidated 327 out of 419 transferred assets (nonperforming assets transferred to the APT for disposition) and 81 out of 130 GOCCs targeted for disposition. Total revenues amounted to P 77.8 billion, of which P 38.1 billion came from transferred assets, more than originally estimated. 1.68 COP and APT reports on unsold GOCCs and transferred assets define the future direction of privatization. There are still 92 nonperforming assets, and 49 GOCCs that remain to be privatized. The other 179 GOCCs have been slated for retention, abolition and consolidation. In December 1992, President Ramos signed Executive Order 37 which seeks to take the privatization effort further by speeding up the sale of the remaining GOCCs that have been scheduled for disposition and ordering a review of whethL! ilA.re is a need to retain the remaining 81 GOCCs. In 1993, President Ramos identified seven awi: w nal GOCCs for privatization. A discussion of the remaining GOCCs can help to illustrate some oi the issues that will have to be addressed.  - 22 - 1.69 The remaining GOCCs have a book value of P 28.3 billion. Four GOCCs that carry substantial foreign debt account for the largest portion. (Table 1.9 shows companies that are targeted to be privatized in the near term.) Two of these, the Philippine Associated Smelting and Refining Corporation (PASAR) and the Philippine Phosphate Fertilizer Corporation (PHILPHOS), were part of the Government's attempt to pursue industrialization by investing in proiects beyond the means or below the average cost of capital used by the private sector. The Semirara Coa; Corporation was created in this way as part of the country's energy development program. Semirara was intended to produce low- grade coal from the country's largest known reserves for the National Power Corporation's Calaca power plant, but the coal turned out to be unsuitable. Another GOCC, the Metro Manila Transit Corporation, was created by the Metro Manila Commission to ease public transportation shortages in metropolitan Manila. Sales of these four GOCCs have been hampered by large foreign debt, and Semirara is barely operating because existing coal users require coal of a higher grade than it produces. Its excessive leverage reduces the financial viability of the mine. 1.70 Legal impediments, primarily injunctions against the sale of assets initiated by former owners, have prevented the sale of four other GOCCs. with a book value of P 5.9 billion, and of about 20 transferred assets. Although Proclamation 50 specifies that "no court of administrative agency shall issue any restraining order or injunction against the Trust in connection with the acquisition, sale. or disposition of assets transferred to it .., privatization undertaken by "disposition entities" does not have the same protection. Table 1.9: Companiies to be Privatized in the Near Term 1. National Steel Corporation 2. Calinog-Lambunao Sugar Mill 3. Cellophil Resources 4. Manila Gas 5. Nonoc Mining and Industrial Corp. 6. North Davao Mining Corp. 7. Land Oil Resources Source: APT. 1.71 Much progress has been made in disposing of GOCCs and transferred assets, but more needs to be done for privatization to achieve its full potential. Table . 10 shows the status of remaining GOCCs targeted for privatization as of 1993.  - 23 - Table I.10: Status of Remaining GOCCs Targeted for Privatizadon Nwnber Book value of assets Percentage Status of GOCCs (Millions of Pesos) of total With substantial foreign debt 4 12,559.6 44.4 With legal impediments 4 5,907.0 20.9 For dissolution 6 4,783.3 16.4 For marketing action 22 2,791.7 9.8 Ongoing valuation/private study I 1 1,725.4 6.1 Awaiting Commission on Audit 4 530.9 1.9 (COA) clearance 1Total 51 28,298.0 100.0 Source: COP, APT. 1.72 The implementing guidelines to E.O. 37 contain a broad definition of "privatization", encompassing initiatives other than sale to the private sector: "Privatization shall refer to the transfer of government corporations, activities or assets of Government to total, majority or minority private ownership or to private control. It includes sale of shares and physical assets, leasing of assets, management, maintenance and other service contracts or build-operate-transfer (BOT) schemes and other similar arrangements under Republic Act No. 6957." 1.73 This definition of privatization offers considerable flexibility to the agencies responsible for the shares and assets of individual GOCCs. During 1993, the implementing guidelines require that privatization action plans for the 48 GOCCs already identified for privatization by the President be presented to the Committee on Privatization (COP) for approval. Included in this group of companies are the Manila Hotel, PASAR and parts of PNOC. In December 1993, 40 percent of the total shares of PETRON were bought by the Aramco Corporation of Saudi Arabia through a bidding process. Depending on the financial attractiveness of the assets that are brought forward, the divestiture strategy should target increased use of public offerings to develop capital markets and disburse public ownership of the companies being privatized. The IPO of PETRON, covering 20 percent of the firm's shares, planned for July 1994 is a step in the right direction. Another form of encouraging wide dispersion in ownership of public assets for disposition is that approved by the COP for the Metro Manila Transit Corp. (MMTC), which is planned to have a negotiated sale with private organization/cooperative majority owned by former MMTC workers. 1.74 The implement-ng guidelines also required that the remaining 81 public enterprises and assets be assessed for retention or privatization and, upon approval by the President, a privatization action plan be dra'. n up for each corporation by the appointed disposition authority. In May 1993, the National Development Company took this process one step further with advertisements notifying privatization opportunities for the National Steel Corporation, PASAR, PHILPHOS, NDC-Guthrie  - 24 - Plantations, Refractories Corporation of the Philippines, SEMIRARA Coal Corporation, and National Shipping Corporation. 1.75 From 1987 to March 31, 1994, the Philippine Government's privatization program generated P 98 billion cumulative revenues as follows: * P 41 billion from the sale of transferred assets (TAs); * P 42 billion from the privatization of GOCCs; and * P 15 billion the sale of other assets. This includes the sale of the following big-ticket GOCCs: Table 1.11: Key Privatizations in 1994 Proceeds from Sale Degree of Buyer (P Billions) Privatization (% of total ownership) l Petron Corporation 14.8 40 Saudi Arabian Oil Co. Philippine Airlines, Inc. 10.7 67 PR Holdings, Inc. Philippine National Bank 4.6 43 Various Interbank 2.2 100 DBP Consortium Philseco 2.1 87 Philyards Holdings, Inc. Narina Properties 1.8 100 Tan Yu Group of Cos. Phil. Plaza Holdings, Inc. 1.5 100 Allied Kajima Union Bank of the Philippines 1.3 87 Aboitz, Insular, etc. Source: COP. 1.76 Some of the most significant privatization transactions during January to March 1994 were the sale of the following (a) 38.7 million government-owned shares in Meralco to SSS and GSIS for P 13.6 billion; (b) 72 percent government-owned shares in PICOP, the only tirnber and paper product company in the Philippines, to Valderrama Consortium for P 2.4 billion; (c) 87 percent of the sales of stock of Philseco to Philyards Holdings, Inc. for iP 2.1 billion; and (d) 19.4 billion Government-owned shares in Oriental Petroleum Minerals Corporation for P 1.5 billion to an international investor. 1.77 Future privatization activities include the additional 20 percent IPO of the shares of stocks on Petron Corporation and the sale of Government-owned shares in National Steel Corporation. 1.78 During 1994-96, the Government expects to receive about l 78 billion (4.5 percent of GNP) in privatization receipts. The Government plans to reduce domestic debt with part of the expected revenues. 1.79 Fht Government corporations which are to be retained under public control will nevertheless be required to identify specific assets or activities which may be more efficiently handled by the private sector, and to carry out asset sales, leasing, management, service or other arrangements (including BOTs) which will enable private sector efficiency gains to be effectively utilized. These privatization initiatives are potentially important to the development of the Philippines private sector.  - 25 - H. REMANING CONSTRA1INTS TO PRIVATE SECTOR DEVELOPMENT A. An Overview 2. 1 A number of the constraints to private sector development that were identified in Chapter I have been addressed as part of Government reform initiatives in recent years. Chapter 11 reviews these initiatives and highlights the remaining obstacles to efficient private sector development and the unfinished reform agenda. The progress achieved in improving the business climate has vastly improvcd in the last two years: Success in external debt management and macroeconomic stabilitv have enabled the Philippines to move toward voluntary external financing; however, there is still an unfinished agenda of reforms One of the report's main findings is that the private sector needs to be reformed at the sarne time that public sector management is strengthened (especially the regulatory agencies). to improve efficiency. Until recently, the main obstacles were largely a heavy external debt, macroeconomic disequilibria, a restrictive foreign exchange regime, and complete isolation from international capital markets. Changes in these areas will help promote more efficient and more dynamic business investment in the coming years, but completing the unfinished agenda of reform initiatives is key The focus of private sector development for the future should promote greater openness; this should be followed with institutional reforms designed to consolidate the changes, to improve efficiency, and to establish an adequate framework for sustained vrowth in efficient privatc 3ector investment and production. 2.2 An enterprise survey was conducted on small- and medium-scale firms in August: September 1992. The survey covered more than 100 firmns in textiles, food processing. software, and wooden furniture in metropolitan Manila. Cebu, and Mtindanao. Entrepreneurs pointed to macroeconomic and infrastructure constraints as the most handicapping (Figure 11 1 ). They singled out high real domestic interest rates and the uncertainty of the macroeconomic environment (especially the periodic overvaluation of the exchange rate), despite ongoing policy reforms, as well as policy uncertainty and discretional use of regulations. In infrastructure, the major impediments were electric power, transport. and telecommunications, problems that reflect years of neglect, policy distortions, and strategic conduct by monopolies and oligopolies (as in telecommunications and transport, respectively). The tax burden, legal regulations, and compliance costs were not identified as major obstacles, indicating that many firms are able to ciruumvent formal rules and practices. Also, security issues were not cited as a key concem because respondents were selected from among enterprises owned by Philippine nationals. Mission findings indicate that security is an important concern to some foreign investors. Firms located in Cebu ranked all constraints much more severely than did firms in Manila or Davao, perhaps because the firms in Cebu are more export-oriented than the respondents in other regions. 2.3 Respondents were concerned that policies were frequently changed and did not provide a sense of stability. Also. although they ranked regulations as less important constraints, they simultaneously complained of bureaucratic red tape. This seeming contradiction could be explained by the fact that firms have found ways to evade the burdens of regulations by participating in informal systems of rules and practices. If this is indeed the case, then the low constraint scores for regulation indicate that the level of constraint imposed by the regulatory regime is mitigated by the ability of some firms to circumvent the formal system. Evidence from other developing countries suggests that, once . .... . . . . Is Thc jeer , !i cxamnple Because of the long and tedious approval process and the paperwork involved. many ot e.: .i:. Aorked Aithout a license, although chey were willing to pay the appropriate license fees and various required dues. But when the registration process was simplified. many of them registered and paid the approl-ate rI;' tees. This could indicate that front-line gomerrnmenic agencies do not seem to be client-oriented, but raliet ulnrO l- eticd to saitst audit procedures.  - 26 - EF r.ul1: Summary Constraints to Operatos and Growth (Average for AJI rifis) Tax regulations .... . Labor regulations . Import regulations.ML Admin. of Import regulations . . Cost of licensing .... . ........______________ Number of licenses .. Trade/union restictons CQettig producdon llcenses Export regulations Investment regulations Price contols: Inputs _______________ Price controls: cutputs 2 3 Ranking z Small Mecium _,Large M Allfrms NOW Raati ma.d ht b_tn Od frvrn tre hill t 4 raNte m fIt t?e inred of OWOuu aoma.  - 27 - macroeconomic and policy instability issues are addressed, impediments related to bureaucratic red tape are likely to figure more prominently. As the discussion below also emphasizes, the regulatory burdens are not costless and the reform of arrangements which govern business-to-business and business-to- government transactions will be a priority in coming years. Given the recent fall in domestic inflation and interest rates, and some nominal devaluation that has taken place recently, infrastructure constraints are now likely to emerge as binding constraints to private sector development in the short-term. 2.4 One of the major concerns of local and foreign business groups seeking to expand output and improve efficiency was the acute power shortages that adversely affected activities in most of the country, but especially in Luzon and Mindanao. According to a study prepared by Baring Securities Inc. in early 1993, the power crisis was a major constraint to increased utilization of existing plant capacity, in addition to blocking implementation of new investment plans. Also, a survey undertaken by Business International Philippines Inc., 40 multinational companies pointed to infrastructure deficiency as a key factor in reducing the Philippines' attractiveness as a business destination. Business groups also cite many other issues they regard as problematic. Distortions in financial markets (linked in part to macroeconomic problems) make it difficult to mobilize funds for private investment on a large-scale; administrative weaknesses and regulatory controls are delaying private sector project start-ups; well-defined competition policy is virtually non-existent (although the Governrent is taking steps to remedy this problem), particularly where franchising arrangements are operating; the scope and depth of the capital markets are still shallow, despite the recent phenomenal growth; and privatization initiatives have thus far been modest. These types of problems reflect unresolved issues surrounding the public-private interface. Their continued presence suggests that even if problems of a more cyclical nature are addressed, a strong and sustained private sector investment response would be unleashed after the reform effort has been fully consolidated. In part, this will require a change in the regulatory and institutional framework that will need to redefine some of the traditional relationships that have existed between business and Government. B. Mac nomic Stability and the Busineus Environmet 2.5 The macroeconomic situation in the Philippines in 1994 shows substantial improvements in stability: single digit inflation, some capital repatriation, an increase in foreign portfolio investment, a market-determined exchange rate, the restructuring of commercial external debt, and improved access to international capital markets indicate the positive results that has been achieved in the overall business environment. Nevertheless, among domestic and foreign business groups, the Philippine economy is still thought to have a potential for macroeconomic instability, partly due to historical record, but more fundamentally due to weaknesses in public finances which continue to be a major threat to the business environment. Overcoming the fragility within the macroeconomic balances has been an essential requirement to strengthen recovery of business confidence and can be expected to spur private investment over the next few years, esp^cially now that the authorities plan to introduce a stabilization program with IMF assistance (see paras. 2.20 and 2.25). 2.6 Weaknesses in public finances - evidenced by continuing public sector deficits and the mode of financing these deficits - continue to threaten a sustainable macroeconomic environment, and their o, igins go back more than a decade. After a period in the 1970s of expenditure-led growth financed by external debt accumulation, the domestic economy decelerated (in the early 1980s). A series of domestic crises coupled with external shocks led to the worst economic contraction in the post-war years, with GDP plunging by 7.3 percent in 1984 and again in 1985. Per capita income fell even faster, at close to 10 percent for both years. Domestic inflation accelerated to 50 percent in 1984 before slowing to 23 percent in 1985 In the second half of 1983, the authorities initiated a stabilization prograrn to reduce  - 28 - domestic inflation and discourage capital flight. During 1986-88, moderate economic growth took place in response to implementation of economic reforms. 2.7 A series of shocks then hit the economy. In December 1989, an attempted military coup led to a crisis in confidence at home and abroad, and to a period of looser fiscal and monetary management. In July 1990, an earthquake severely damaged infrastructure in central Luzon. This was followed by the Gulf crisis, which sharply raised the cost of oil imports. In November 1990, a typhoon triggered flash floods, killing more than 4,000 people in the Visayas. In June 1991, the eruption of Mount Pinatubo devastated a large area and created a medium-term threat of mud flows. In 1992, American military forces withdrew from the Philippines and their accompanying expenditures ended. 2.8 Macroeconomic management was unable to react effectively to these shocks throughout this period. The most difficult choice appeared to involve adjusting the exchange rate, which would have been useful to restrain import growth. However, this also would have increased public expenditures, especially after the natural disasters (and reveals the problems with regard to policy trade-offs). During the first half of the year, while the current account of the balance of payments continued to deteriorate, the exchange rate was held stable and fiscal policy continued to be expansionary. 2.9 Public borrowing at high nominal and real rates of interest was used to mop up excess liquidity. Domestic inflation fell, as desired, but so did gross domestic investment, which exacerbated the recession. Throughout this period, fiscal decisions became increasingly don inated by debt management concerns, resulting in reduced investment and O&M expenditures and an increasing reliance on short-term fiscal initiatives. It has only been in the past few years that authorities have acted to reverse the growing consolidated public sector deficit and pave the way for more stable public finances. 2.10 Macroeconomic policy has imposed severe constraints on the private sector in the recent past. Financing large p 'olic sector requirements to deal with internal and external disequilibria have resulted in high real domestic interest rates, a periodic overvaluation in the exchange rate, volatile domestic inflation, and insufficient infrastructure services. High and volatile domestic interest rates and an overvalued exchange rate have discouraged long-term investment and led to the misallocation of resources to nontradable sectors. 2.11 However, even in the 1980s, macroeconomic stability never deteriorated to the degree witnessed in other highly-indebted middle income countries (especially in Latin America). In the last three decades, domestic inflation has generally remained at single digit rates, with the GDP deflator exceeding 20 percent in only two years (1974 and 1985). Consolidated public sector deficits and current account deficits in the balance of payments have rarely exceeded 5 percent of GDP. The 1980s was a decade in which repeated stabilization efforts coupled with tight aggregate demand management, aimed at containing domestic inflation and emerging balance of payments deficits in the wake of the debt crisis. 2.12 The Impact of the Public Finance and Foreign Debt Constraints on the Private Sector. Since 1989, basic prices in the economy, interest rates, domestic inflation, and the exchange rate have been driven by the stabilization efforts of the Government. Rising domestic debt has led to higher real domestic interest rates, which have crowded out private investment. High real domestic interest rates resulting from high levels of debt have also made fiscal adjustment more difficult - by raising interest expenditures, by depressing domestic growth and thus eroding the tax base, and by increasing pressures on spending, in particular on subsidies. The result has been monetary policy subordinated to the cash management needs of the National Treasury.  - 29 - 2.13 The Central Bank has favored a strong peso in the past, and with large foreign liabilities on its balance sheet, it took measures to defend the peso and support its overvaluation in the 1980s. Its attempts to achieve a real devaluation of the exchange rate, however, have been less frequent and far less successful than attempts to support the exchange rate. The recent financial restructuring of the Central Bank was completed in December 1993, but took effect as of July 3, 1993 (see paras. 2.226 and 2.227). The new law stipulated the creation of a new Central Bank called "Bangko Sentral ng Pilipinas" (BSP). As part of the restructuring, the National Government (NG) will pay interest to fund the cash needs of the CB-BOL, which will be liquidating the previous external debts over the next 25 years. The financial restructuring involved shifting most external liabilities and non-performing assets to the CB-BOL9 and which were replaced by P 220 billion in Government securities bearing interest at market rates. This operation provided the BSP with a strong balance sheet, including capital of P 20 billion, which is to planned to be raised to P 70 billion in 1995 through a further issue of Government securities. As a result, BSP will be profitable even at much lower levels of reserve requirements (RRs). Moreover, the large portfolio of Treasury bills will enable it to conduct open market operations without financial assistance from the NG. These obligations will increase the Government's interest payments to more than 7.5 percent of GNP. The restructuring resulted in a net positive asset and income position, and it should eliminate incentives for the Central Bank to defend the domestic currency at unrealistic levels. 2.14 Structural Reforms. The reform steps already taken by the GOP to bring about improved macroeconomic stability, and the strategy being developed, have been documented in Bank studies prepared in late 1992 and early 1993.20 Interest rates were deregulated in the early 1980s, two major public banks were rehabilitated in the mid-1980s, and the Central Bank was restructured in 1993 (as mentioned above). Together, these actions made interest rates more market-determined. Regarding the exchange rate, deregulation of foreign exchange is now virtually complete, and the exchange rate is market-determined. Although the Central Bank has continually intervened to prop up the value of the domestic currency in the past, this should be less of a problem in the future (see para. 2.13 above). The 1992 Brady deal has strengthened creditworthiness and reduced pressures on the budget. The budget is now supportive of more public infrastructure investment despite institutional problems, although full and timely execution of the budgeted expenditures, especially capital expenditures, depends on revenue performance and strengthened public institutions. Thus, some of the key macroeconomic constraints on the private sector have been addressed. 2.15 However, even though the current macroeconomic situation is no longer a major constraint on private investment, the long history of macroeconomic volatility has fostered a cautious attitude and uncertainty among investors, both domestic and foreign. This caution can only be overcome through time and a consistent track record of prudent fiscal and monetary management - needed to create credibility in government policies. 2.16 Continuing Issues. A number of macro policy decisions taken in recent years have been unhelpful to business growth. Cutbacks in public investment and reduced operations and maintenance on public works have helped the authorities to contain its deficit in the short-term, but at a high cost in terms of reduced quality and quantity of services to the private sector. Similarly, the reliance on distortionary taxes to supplement government revenues has also added to the cost of doing business in the Philippines. The temporary nine percent import levy introduced in 1991 increased the cost of inputs to industry. This exacerbated already-low levels of private investment activity as has the Gross Receipt 19 The pres ious Central Bank will continue to exist as the Central Bank Board of Liquidators (CB-BOL). 20 See The Philippines: An Onenine for Sustained Growth, World Bank, April 1993.  - 30 - Tax (GRT) on funancial intermediaries (coupled with high reserve requirements), which has raised the costs of mobilizing funds for private production, investment, and exports. 2.17 The impact of monetary policy on exchange rates in 1992 also adversely affected returns to producers in the industrial and agricultural sectors. While domestic interest rates generally eased throughout 1992 (with the 91-day Treasury bill rate falling from 21.5 percent at end-1991 to 14.8 percent at end-1992), the peso appreciated about 12 percent, impairing the competitiveness of tradables. Large capital inflows (partly in response to high domestic interest rates as compared to intemational rates) have been the principal factor behind the real peso appreciation. The continued decline in nominal interest rates in 1993, paralleling reduced domestic inflation, has since resulted in a nominal devaluation of the peso, somewhat improv...g prospects for exporters. However, with an open capital account and a convertible exchange rate, there is a risk of large swings in private capital flows with the attendant impact on appreciating the exchange rate and hence harming export growth. 2.18 From the viewpoint of promoting stronger private investment growth, it is evident that the broad thrust of macro policy should aim at avoiding actions which either impair business competitiveness through distortionary taxes or overvalued exchange rates, or which crowd out private investors through high real domestic interest rates or a large volume of government borrowings. The main requirement is for fiscal policy to shoulder more of the burden of controlling aggregate demand so as to reduce the adverse business impact of tight monetary policy on the exchange rate and on private investment. In short, the focus should be on reducing continued reductions in the consolidated public sector deficit without at the same time impairing business competitiveness. The reduction in the consolidated public sector deficit should be achieved in a sustained and credible way and not through short-term palliative measures. 2.19 To be sustainable, a reduction in the consolidated public sector deficit will need to be achieved by permanently increasing non-distortionary tax revenues and decreasing low priority expenditures. Temporary levies, revenues from the privatization program, and excessive reduction of operation and maintenance spending can all reduce the public sector deficit in the short-term, but cannot yield a lasting improvement in fiscal balances. Although excessive reduction in growth-oriented expenditures - public infrastructure and social services - might be sustained, the resulting reduction in growth will reduce the tax base in the long run and thus undermine fiscal adjustment. Unless the public finance constraint is perrnanently overcome and the burden of both external and domestic public debt reduced to more sustainable leve;s, the economic recovery will remain weak and will continue to be vulnerable to exogenous developments, reducing the country's capacity to successfully confront external shocks in the future. 2.20 Strategies for achieving these outcomes form the basis of ongoing discussions between GOP, the Bank, and IMF. To further reduce the consolidated public sector deficit and achieve a better balance between fiscal and monetary policies, with the thrust of adjustment falling more on fiscal policy, this report recommends continued efforts to increase resource mobilization by strengthening the administration and greater reliance on value-added and income taxes instead of by trade and excise taxes and phasing out tax exemptions. The largest scope for improved revenues comes from more effective implementation of existing taxes; weaknesses in collection have resulted in individual and corporate income taxes yielding only about one-half of their measured potential.2" Public corporations have also been a drain on the 21 Said ditterentd,. businesses are likely to be better off if they pay their tax obligations rather than bear the cost of being crowded out. At the same time, businesses should reasonably expect the Government to cut back on wasteful expenditure and to promote efficiency in public provision of services.  - 31 - budget because of recurring financial losses and a failure to pay taxes in full and on a timely basis. Options for reducing these losses include greater efficiency, improved management, and binding budget constraints, 2.21 A number of new measures are under consideration by the Congress and the Administration, the most important of which are listed in Table 11.1. The minimum three percent import tariff put in place in April 1994 is to be extended to BOI exemptions by narrowing the sectors covered, reducing the length of tax holidays, and by not renewing exemptions nor granting them for plant expansions. More comprehensive tax reforn is also in the works. A new Task Force on Tax and Tariff Reform has been at work since February 1994 to suggest improvements to the tax system and the tariff code. By mid- 1994, it is expected to provide recommendations on a modified income tax for corporations and an asset- based minimum corporate tax (similar to one in operation in Mexico), aimed at increasing corporate tax collections above their current level of two percent of GNP, as well as any further revisions to the VAT. By February 1995, the group is to prepare suggestions on individual income tax revisions, tax incentive restructuring, excise tax simplification, and import tariff changes. 2.22 The Government took action to raise new revenues in the last two years. In 1993, VAT withholding was extended to government contractors and suppliers. In 1994, the Congress broadened the tax base for VAT to cover most previously exempted areas, including telecommunications; road freight and other transportation; lease and sale of real property; restaurants; hotels and motels; and books, newspapers, and broadcasting. Also in 1994, a minimum three percent customs charge was applied by administrative action to all zero-rated goods and certain currently exempt items, to be extended over time to goods imported under projects registered with BOI. 2.23 In addition, the Government is taking action to improve tax collection through a number of measures, including the establishment of separate treatment for large taxpayers and strengthening of penalties for non-payment of VAT. The Bureau of Internal Revenue will begin monitoring the tax returns of large taxpayers; the 1000 largest taxpayers in Metro Manila have been notified and issued Taxpayer Identification Numbers. 2.24 On the expenditure side, the options for reform should focus on public employment and on high priority public investment, since close to two-thirds of National Government expenditures represent wage and interest payment obligations. The Government needs to exercise caution in incurring new debt obligations, including contingent liabilities. In effect, the Government will need to resist borrowing commitments in activities which can be financed and undertaken by the private sector. Given that public sector employment has grown at an annual average of 5.6 percent in recent years, this report recommends continued efforts to streamline public spending, with a focus on privatization and a restructuring of public employment. The Governrnent plans to reduce the number of departments to avoid duplication and the size of the civil service. Also, the Government plans to devolve additional functions and personnel to the LGUs to ensure that their responsibilities are raised to the level of funds being made available to them. While discretionary current expenditure is restrained, interest payments should decline as domestic debt is reduced and domestic interest rates fall in line with reduced domestic inflation and a fall in risk premiums (para. 1.40), creating room for increasing capital expenditure prudently. This should allow the Government to provide the infrastructure necessary to support economic growth. Increasing private sector delivery of public services represents a viable means of achieving the same public purpose with fewer public resources.  - 32 - Table II.1: Revenue Fnhancement Measures (billons of Peos) &bu to lam. Te Ce..ed _ Stu os Emnm d Rvenaue , , . , s9g~~~~~~~~~~~~~~~~~~~l3 W%9 Exewcile Brach Comperindon On going 00 0.0 Investigation and prosecnon of tax evasion and smugling cae On going Tap pnivae sector in disposing goods by BOC/BIR On going Liberalize importation of luxury vehicles On goitg 0.1 0.3 Energy conservaDon and environmental levy EO 115 2.0 0.0 Re-registmtion of imported vehicles deficiency taxes On going 0.1 0.5 Capital gains tax from privatzaoion Pending in Congress 2.2 Excise tax on bottied water Pending 0 0 0.0 Moratorium on new tax exemptioos and review of current exemptions Pending 0.0 0.0 Legislative Branch Consolidation of trust and special funds with the General Fund On going . Strucmtural reforms in VAT RA 7716 0.0 3.0 Administrative reforms in VAT 2 1 0.0 Excise tax on alcohol Pending in Congress 0.0 0.0 Excise mx on cigarettes On going 0.0 2.3 Land conversion tax Pending 0.0 0.1 Measnrs to lcreae Non-Tax Reu Sts Estimated Revenue impact _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 199" 1994 Executive Branch Adjust fees and chu.rges On going 1.7 1.4 Accelerate privatizatJon and extend life of APT/COP RA 7661 0.0 23.9 5 ~~~~~~~Other Rteubmai Measures_ ______ S.atus Eesmaed Revenue __________________________________________________________ ________ _______ t 1993 1994 Executive Branch 8% minimum tariff EO 172 0.0 1.2 Administative measures Being implemented 0.7 Increase in registration fees of motor vehicles Effective on same 0.5 date as increase in PMVT Legislative 2% affluent consumpoon tax Under discussion 0.5 Increase in PMhVT Under discussion 0.1  - 33 - 2.25 Stabilization Program. With IMF support, the Government will start implementation of a stabilization program. The program aims at reducing the share of the consolidated public sector deficit (CPSD) and domestic debt to GNP. The CPSD is to be lowered from 2.6 percent of GNP currently to 0.6 percent in 1996, which should enable the domestic debt/GNP ratio to decline to 41 percent. To achieve these objectives, a significant improvement in the savings/investment balance will be necessary, together with an increase in the efficiency of investment. Under the program, the ratio of national savings to GNP would increase by about six percentage points to 24 percent of GNP by 1996, virtually all of which would come from planned public sector fiscal adjustment. The program would continue to reduce domestic inflation, limit the current account deficit of the balance of payments to prudently financeable levels, and rebuild gross international reserves. 2.26 While the large foreign public debt has made new external borrowings difficult for private firms in the past because it had a negative impact on country risk rating, with the completion of the comprehensive commercial bank debt restructuring in December 1992. the Government decided to seek an investment rating from international credit rating agencies. In July 1993, both Moody's and Standard and Poor's gave the Philippines ratings (Ba3 and BB-. respectively), putting the country on a par with Latin American countries, but lower than neighboring Southeast Asian countries. Since then, external borrowing has exceeded US$1 billion (Table 11.2). One of the reasons for the increased use of external financing by the private sector is the relatively lower interest rates available in international capital markets. Table II.2: Philippines - Debt Issuance in International Capital Markets, 1993-March 1994 Date Issuer Amount Type Maturity Spread Sovereign (IUS$ mil) (years) at Issue Guarantee Feb. 93 Republic of the Philippines 150.0 Eurobond 3 320 Yes Jun. 93 Development Bank of the Philippines 175.0 Eurobond 5 310 No Aug. 93 Philippine Airlines 100.0 Eurobond 3 375 No Oct. 93 Philippine National Oil Company 90.0 Eurobond 5 265 No Nov. 93 Philippine National Power Corp. 200.0 Eurobond 7 225 Yes Nov. 93 Philippine National Bank 150.0 Eurobond 3 220 No Dec. 93 Subic Power 105.0 Eurobond 15 385 No Dec. 93 J.G. Summit 260.0 Convertible 10 No Mar. 94 Philippine National Bank 54.0 Eurobond 3 No Mar. 94 Filinvest 100.0 Convertible 10 No Source: Salomon Brothers and Government of the Philippines, C. Incentive and Investment Regme Constraints 2.27 The emphasis of Philippine industrial policy since the 1950s on high trade protection (to encourage import substitution) and, since the 1970s, on provision of fiscal incentives (to counteract the effects of trade protection and other distortions) had created, by the beginning of the 1980s, a business sector that was high Cost and pursued rent-seeking activities. However, especially in the last five years, the trade and investment regimes have become much more liberal and outward-oriented. Foreign exchange regulations have been lifted. Philippine import tariffs and non-tariff restrictions have steadily fallen. Regulationis on foreign investment have been relaxed. The policy of promoting specific industrial  - 34 - sectors has largely been abandoned. The main area of future reform is the successful coinpletion of the reform in trade and in the foreign investment regime as discussed in this report, 2.28 Liberalization of foreign exchange transactions in the Philippines took place in August 1992 following partial liberalization in December 1991.- The business rcsponse to the liberalization initiatives has been positive, both in terms of portfolio capital inflows and reduced transactions costs for exporters. In the past, proceeds from exports and remittances from overseas workers had to be surrendered to authorized agent banks who were entitled to hold the funds for 30 days before conversion into domestic currency. Repatriation abroad was allowed only for certain forms of foreign investment income such as interest and dividend payments. The controls discouraged both trade and investment. Exporters can now hold up to 100 percent of their export earnings in foreign exchange, thereby saving on conversion margins for inputs purchased from abroad. Repatriation of funds by registered foreign investments can also now be made without prior Central Bank approval (before it used to take three to six months). Short-term loans under the dollar-based FCDU credit facility no", have a ceiling equal to 100 percent of exporters' L/Cs or expected foreign exchange receipts. The transaction volume in foreign exchange markets has increased significantly since 1991. Exporting firms cite these changes as providing a substantial benefit in facilitating business expansion. Foreign financiers also view forex liberalization as a positive factor in their assessment of country risk. The latest liberalization in this area was the lifting on June 17, 1994. bv the Monetary Board of existing restrictions on repayment and repatriationl of foreign investments financed v.v tiansactions using the debt-to-equity scheme. 2.29 The gradual lowering ot' imiport tariff protection will continue through 1995 according to the schedule set out in Executive Order 470 (introduced in July 1991). By the final phase. the P'hilippines will have a nine-hand tariff structure, with items concentrated at 3. 10. 2() and 50 percent tariffs Capital equipment. initially at an average rate of 3() percent. will face a 20 percenit rate if produced domlesticaliv and a 10 percent rate if not Items to remain covered by 50 percent tariffs inclide rice, vegetable oils, sugar, fruits. alcohol. toFbacco and leather goods -- industries wielding political clout. 2.30 Althouglh there was a bias against exportables in general. ancd agricultural and manufactured exports in particular. there was only marginal growth in the ratio of effective protection rates (T PRs) for agriculture to manufacturing between 1985 and 1992. from 0.28 in 1985, to 0.32 in 1990. to 0.34 in 1992 (Table 11.3). (Anniex I contains tables on the trade regime.) 2.31 In general. however, variances between effective protection rates (EPRs) for exportables and importables have been vern wide, between -6.9 percent for exportables and 102.2 percent for importables in 1985, and between -4 I percent and 74.1 percent in 1992. Thus, some categories of importables carry far higher protection than the average, indicating a bias against exportables and in favor of importables. Delays encountered in tihe payment of rebates under the export duty drawback scheme reduce benefits to exports and fail to lesen the anti-export bias of the trade regime. Restrictions on potential export industries and the protection provided to inputs and intermediate products increase the bias. For example, the substantial EPRM on imported paper, rubber. leather, and plastic, which could be inputs to food 22 Only mrni it tt nc (m foreign exchange transactions have been retained: dividends tromn investments in norn-priority sectors un.I 0.- . I- inequity conversion program cannot he repatriated for four y ears fa testriction that the Government plan. t, , 'ii. multiple exchange rates operate for oil imports becauqe of the forward exchange cover ariallort t-. tho te OPSF (which will be eliminated as part of the overall deregulation of the oil sector): and foreien ex( hatize to) service debts may be purchased from the banking system onlv for loans approved hv the RSP (to assht or - tai! authorities in monitoring roreign borrowing). Also. outward investment hy residents of over US$1 million recrr i lHSP approval.  - 35 - exports, penalize downstream industries by increasing costs.23 The protection levels embodied in EQO. 470 are not expected to achieve sector neutrality or to reduce penalties for exports - imposed by the import tariff regime - by the end of the current trade reform program. Several items that will continue to be taxed at 50 percent are necessary inputs to downstream industries. 2.32 In the Philippines, highly protected capital-intensive upstream industries, such as textiles and paper, have usually obtained high import tariff protection, while downstream industries, such as garments and printing (dominated by smaller firms), have received lower protection. To the extent that inefficient upstream industries dominated by large firms survive behind protectionist policies, they reduce the international competitiveness of downstream SMEs. Table 11.3: Average Effective Protection Rates, 1985, 1990, and 1992 (percent) Sector 1985 1990 1992 /a All sectors 49.0 41.8 35.7 Exportables -6.9 -4.1 -4.1 Importables 102.2 75.1 74.1 Agriculture 20.7 18.2 18.1 Exportables -6.6 -0.7 -0.7 Importables 82.2 57.1 59.7 Manufacturing 73.3 57.5 53.4 Exportables -4.4 -1.3 -1.3 Importables 107.3 79.2 77.5 Agricultural EPR 0.28 0.32 0.34 Manufacturing EPR /a - Projected, based on E.O. 470. Source: USAID (1991), Erlinda Medalla (1992). 2.33 Although there was a rapid decline in the proportion of restricted items to total items, and of their value to total import value between 1985 and 1988, the value of restricted imports did not decline in relation to toti imports between 1988 and 1991. Several of the items that remain restricted are essential to support domestic competition and to encourage export growth. These include second-hand trucks and buses, motor vehicle parts, accessories, passenger cars and jeeps, pesticides, fertilizers, and refined petroleum products. In fact, these items accounted for six percentage points of the 13 percent share in 1991. Although the Government agreed to phase out the remaining QRs in 10 years as part of the Uruguay Round:. this report recommends that the remaining QRs on imports be phased out by the end of 1996. 23 IrnporuiVlie- ( as inputs to garments and related industries), however, benefitted from EPRs of 262.3 percent in 1985 adL S7 percent in 1992.  - 36 - 2.34 It is easier for larger firms to obtain licenses and quotas. Licenses are usually allocated to applicants based on criteria related to scale or previous performance, such as capacity, past imports, and value of assets. These criteria have created a bias in favor of large firms and have discouraged the entry of new firms. SMEs without access to imported raw materials or capital goods are forced to procure them from domestic producers, who generally offer lower quality, or from importers, often at a higher markup than their larger competitors pay for direct imports. An example of a policy that gives a clear advantage to larger enterprises is the restriction on the import of used light conimercial vehicles for the transport of merchandise. Conversely, imports of larger commercial vehicles, more likely to be purchased by larger firms, are not restricted. 2.35 Regarding QR elimination, the Government reduced the number of restricted items from 3,000 items in 1980 to 183 items at end-1993. Coverage has been reduced to around five percent in 1993. However, the number of items under QRs increased during 1993 due to the imposition during that year of restrictions on 57 commodity categories, mostly related to grain and livestock products. While only a small number of import items today are subject to administrative restriction, the resulting price distortions impose efficiency costs on some important areas of the domestic economy'. Remaining import restrictions kept domestic agricultural prices hiigh. especiall) for corn. for which the domestic price was more than 50 percent above world levels. thereby hindering the expansion of poultry and other processing industries. 2.36 T'he Government stated its intentiotn to use administrative orders to lift QRs on processed meats and rescind the administrative component of the QR on coal products. A speedy ratification of the Uruguay Round Agreement of the GAT'F and aggressive action to eliminate import restrictions on the broad range of agricultural products negotiated for t:vriffication under the GATT (including all agricultural items except rice) would uniderscore thie Government's commitment on trade liberalization. By end-1996. virtually all QRs will have been eliminated, apart from those needed for reasons of security, health, or safety. The only exceptions will he the QRs on rice and petroleum products, which will be lifted in early 1997; and those under the Motor Vehicle l)evelopment Program (MVDP). which will he phased out by end- 1998. 2.37 While E.O. 470 is a step in the right direction. it is clearly n(ot sufficient to alter the anti- export bias of the trade regime and hence assist the Philippines in catching up withi some other countries that have gone much farther in reducing trade barriers and integrating their economies with world markets. Although the Philippines' current tariff rates are not radically different from some of the other East Asian countries such as Korea. Malaysia, and Thailand. the overall bias of the trade regime is not pro-export. As a result, the "export push" which characterizes those countries is not evident in the Philippines.24 In some last Asian economies - Hong Kong, Malaysia and Singapore - outward orientation reflected neutral trade policies. since those countries largely or entirely eliminated trade barriers. However. sevOral other economies - notably Korea and China (Taiwan) - selectively supported exports withlout dramatically cutting import barriers (see "Foundations of East Asian Success", by Peter A. Petri. 1993) Given the f'iscal conistraints and the decision to join GATT, the latter alternative is not fcoisible t'or the Philippinies. Hence, drastic reduction in import tariffs would remove the anti-export bias of the trade regime. Some of the countries in Latin America that have been most successful in expanding exports in recent years are Colombia, Chile. Argentina. Cost Rica, and Bolivia. These countries ha e all achieved high rates of export growth. following implementation of trade reforms. The import tariff i.,iwc in most of these countries is 5-20 percent. (The exceptions are the top rates in Bolivia and \ ir a 10 percenit and 22 percent, respectively - and Chile's uniform tariff of II 24 East Am>an Nlnaje. World Bank. 1993.  - 37 - percent for all imports.) All have virtually eliminated import licensing and other non-tariff barriers. Based on the success of these examples, most other countries in Latin America and the Caribbean have introduced or are in the process of introducing similar trade regimes. Improving customs administration should generate fiscal revenues which would be needed to offset the expected decline in revenues as a result of reduced import tariff rates. It may also be noted that the cost of distortions (i.e, high import tariffs) is lost output and employment, which the country can no longer afford. This report recommends accelerating trade liberalization and reducing import tariff rates to a range of 5 to 20 percent, with few rates in between, and striving for revenue neutrality in trade reform by phasing out import tariff exemptions, and strengthening customs.' It also recommends phasing out all QRs, except for health considetations, and maintaining the market-determined exchange rate while minimizing Central Bank intervention in foreign exchange markets, except to smooth out high volatility in the exchange rate in line with current policy. This report also recommends introducing net operating loss carry-over and accelerated deprecation over time once public finances stabilize, tax holidays are phased out, and reliance of the tax system shifts from international and excise taxes to VAT and income taxes.26 2.38 The Philippines has made important progress in liberalizing the foreign investment regime. As further administrative efficiencies are gained, the process of business registration should not be an issue for most investors. Rules governing foreign direct investment were substantially liberalized with the Foreign Investments Act of 1991. (Annex 2 provides a summrary of repealed provisions of the Omnibus Investment Code.) Under the new regime, foreigners can invest up to 100 percent of the capital in an enterprise that is not covered by the negative list simply upon registration with the SEC. If they wish to benefit from the fiscal incentives provided under Book I of E.O. 226, they must apply to the Board of Investments (BOI) for approval. Foreigners can own up to 100 percent equity in any enterprise that exports at least 60 percent of its output (rather than the 70 percent cutoff rate under E.O. 226) or in any domestically-oriented enterprise that is not in those sectors included in the negative list. No divestment cf foreign majority control is required. (Annex 3 lists investment areas closed to 40 percent foreign equi;y participation; Annex 4 shows table of nationalized activities and their requirements; and Annex 5 describes citizenship requirements for foreign investment in different activities.) Previously, foreign investors had been required to transfer control to Philippine nationals within 30 years of registration. Corporations with less than 40 percent foreign equity can obtain SEC registration within about nine days; for companies with 41 to 100 percent foreign equity, the processing time is about 24 days. (Annex 6 describes rights provided to foreign investors under the existing laws.) 2.39 The Act does not apply to the banking industry, but in May 1994, a law was passed liberalizing the entry and scope of operations of foreign banks. RA 7721, signed into law in May 1994, allows for entry of up to 10 additional foreign banks and further scope of operation for foreign banks already in the country. The new entrants, six allowed within the next five years and another four upon approval of the President. will be limited to six branches and will require minimum capital of US$7.5 million. No limits were set on setting up subsidiaries in the country or buying into existing domestic banks as long as 70 percent of the assets of the banking sector remain controlled by domestic banks with majority Philippine ownership. Under the new law, a foreign bank may choose one of the following modes of entry (I) by acquiring, purchasing, or owning up to 60 percent of the voting stock of an existing bank; (2) by investing in up to 60 percent of the voting stock of a new banking subsidiary 25 NEDA propo' i in 1994. an acceleration in the reform described in "Guidelines for the Overall Tariff Review" which sets out tr .d,! iheralization targets. The proposal, which is under discussion, is to reduce tariffs gradually to two rates: three pe.; 1 JnJ 10 percent after the last yeir of E0470. By the year 2000, a uniform tariff of five percent is being targeted. The President has yet to approve the guidelines. 26 The Government has already taken steps to shift reliance of the tax system to the VAT (see para. 2.22).  - 38 - incorporated under the laws of the Philippines; or (3) by establishing branches with full banking authority. Regarding the last mode of entry, on ten new foreign banks will be given a license within five years of the effectiveness of the law, but each one of them may have up to six branches. The four existing foreign branches may also open up to six additional branches each. The law stipulates that only those among the top 150 foreign banks in the world or the top five banks in their country of origin as of the date of application will be allowed entry (para. 2.223). According to the BSP, 15 foreign banks have already indicated their intemest in applying for a bank license, most of which prefer to enter as a branch. The passage of this law should help promote competition within the financial sector generally and improve the level of funds mobilization for private investors (see section on finance). 2.40 Other actions have been taken to improve the environment for foreign investors. Full and imrnediate repatriation of dividends, profits, and capital from foreign investment was put into place as part of foreign exchange liberalization in 1992. Streamlining of procedures for obtaining work permits and visas for foreigners also occurred in 1992. In 1993. the maximum length of land leases were extended from 25 to 75 years, giving foreign investors greater securitv of tenure. 2.41 Greater perception of political stability and internal security will likely encourage potential new foreign investors. Most foreign investors decide to undertake investments in a particular countr) based on an overall assessment of risks and opportunities. In this respect, the timely implenmenitation of reforms suggested in this report should lead to higher foreign investment flows to the country, since the expected benefits should alter the balance between risks and opportunities in the Philippines' favor. Equally important is the need to address the issue of legal restrictions prohibiting foreigners from investing in certaiii industries and from owning land. Some sectors, such as retail trade, are completely closed to FDI. Furthermore, tht dilapidated infrastructure in the Philippines also has constrained foreign investment, while economic stagnation in the past several years has deterred increased FIDI flows. 2.42 The first Negative List consists of Lists A. B and C. List A includes areas in which foreign ownership is limited by mandate of the Constitution and specific nationalization laws. List B contains investment areas where foreign ownership is limited tor purposes of public health and safety and to protect small and medium-sized domestic market enterprises, List C includes investnment areas in which existing enterprises are assumed to meet domestic demand. Under the law, inclusion in List C requires a petition by a Philippine national engaged in the area before public hearings may be held. Among the restricted areas in List A are mass media, licensed professions, cooperatives, utilization of natural resources, public utilities. List B includes manufacture of weapons and explosives, dangerous drugs, small and medium scale domestic market enterprises, and small and medium scale export enterprises which utilize raw materials f'rom depleting natural resources. In contrast to the Transitory Negative List, List C in the first Negative List is empty because no petitions for inclusion in said list had been received as of the August 31, 1993 - the deadline set by the implementing Rules and Regulations of the FIA. With the empty List C. new areas will be effectively opened to foreign investments upon the expiry of the trarsitory Negative List on October 24, 1994. Legislation amending the Foreign Investments Act to eliminate Negative List C has already been submitted to Congress. The Government also plans to eliminate the restrictions under Negative List B, limiting the entry of medium-size firms and the ban on foreign retail firms in L.ist A These areas include, among others, travel agencies, tourist lodging services (pension houses and tourist inns), convention and conference organizers, life and non-life insurance business including professional reinsurance services and insurance brokerage. 2.43 '11 (Iwptv List C is considered welcome for the following reasons: (a) "Adequate capacity" is not a sound basis for excluding foreign investments in a particular sectx i A foreign firm would enter if it has something better to offer, and can compete with  - 39 - the incumbent firms by offering quality products at lower prices which would respond to the consumers, and domestic producers as well. (b) Restricting entry into an industry on the basis of "adequate capacity" meanwhile, encouragers existing firms with high-cost production techniques to continue operating at the expense of consumers. 2.44 Foreign ownership restrictions on mining finns remnain a major constraint to mobilizing needed equity investments in this sector (in contrast to Indonesia where foreign investments in mining have been critical to the development of the sector). As a result, the sector has been contracting due to lack of new investment. With the assistance of foreign mining firms, a Financial and Technical Assistance Agreement (FTAA) policy has been drawn up but as yet no specific projects have been authorized by the Government. Under the proposed FTAA, a wholly foreign-owned firm may engage in mining ventures, as a contractor, but must divest 60 percent of its holdings to local investors within 10 years from the recovery of its pre-operating and property expenses. Foreign firms must therefore judge the risk of an adequate return from divestiture against the revenue sharing arrangements under which the Government takes 60 percent of net revenue and the company receives 40 percent.'7 In the shipping industry also, restrictions on foreign ownership are preventing the growth of adequate shipping to meet inter-island commerce needs. Industry estimates indicate that passenger and cargo vessels will need to double (to around 600) in the coming decade, but mobilizing the capital for this expansion will be more difficult if the majority of equity has to remain local. 2.45 On June 2, 1994, the House of Representatives approved on the third and final reading a bill that proposes five major amendments to the FIA, including the (1) reduction in the minimum equity requirement for foreign-owned domestic and export enterprises which use depleting natural resources from US$500,000 to US$150,000; (2) deletion of the three-year requirement before a domestic market enterprise can change its status to export enterprise; (3) repeal of the entire provision on strategic industries in order to include these in the BOI-IPP (Section 10 of the FIA); (4) deletion of all provisions pertaining to Negative List C (Sections 8-c, 9 and 15 of the FIA). These changes will make the country more attiractive to foreign investors. On the other hand, the Senate version which is yet to be discussed by the chamber proposes to modify only the two following major provisions of the FIA (1) repeal of a provision on "strategic industries"; and (2) removal of the three-year requirement before a domestic market enterprise shifts to an export enterprise. 2.46 The Lower House filed a bill in 1993 seeking to liberalize retail trade business. The three major features of the bill include: (a) the retail trade business will be exempted from the FIA; (b) the three levels of capitalization will be a 100 percent foreign ownership for ventures with capitalization of at least US$100 million, a inaximum of 51 percent equity participation for ventures with at least US$10 million worth of investment, and a maximum of 49 percent foreign equity participation for capitalization of less than US$10 million, and (c) enterprises partially or wholly owned by foreigners, involving the establishment of a chain of retail stores, are required to have capital of at least US$10 million for every store or branch established in the country. 2.47 The challenge to the Philippines in attracting manufacturing investment from abroad has become tougher with the emergence of southern China and the expected take-off of Viet Nam as the most 27 Because 1. I kA is designed to circumvent constitutional limitations on foreign ownership (at least in the initial phases of a vcritirt, ' It also carries the risk of a legal challenge. Foreign mining groups are believed to remain cautious about the legal h.i' it this initiative.  - 40 - dynamic growth area in Southeast Asia. Foreign investors in Asia (many of whom are ethnic Chinese) see China as an increasingly preferred investment site, and the recent decision by Taiwan (China) to officially allow Taiwanese (China) firms into China indicates that countries such as the Philippines will have to compete much harder .n the future to attract foreign direct investment.2" Addres; ing infrastructure and capital mobilization issues on a timely basis will remain a priority, as will the need for much greater professionalism on the part of Government officials who deal with business people directly. One issue of importance in coming years will be the need for a coordinated effort from the Export Processing Zone Authority (EPZA) and the Subic Bay Authority in attracting foreign investment. 2.48 As discussed earlier, foreign investors typically are influenced by overall macroeconomic and political stability - areas in which the Philippines has been making good progress recently. Red tape and bureaucracy are still perceived as impeding speedy implementation of projects, particularly at the level of line agencies. However, there are also legal and regulatory impediments which will need to be modified through legal changes. The most important legal constraint is the 40 percent maximum ownership allowed for foreigners in some key sectors. The other restrictions are as follows * Foreign Investment in Land. It is recommended that the nationality requirements be relaxed to allow noncitizens to lease land in industrial estates or export processing zones, as proposed in a legislation presented to the Congress four years ago. It is also suggested that noncitizens be permitted to lease public lands. o Minimum Capitalization. The minimum capitalization requirements (domestic market enterprises not involved in advanced technology or export companies utilizing raw materials from depleting natural resources must have a minimum paid-in equity of US$500,000 if they are more than 40 percent owned by foreign nationals) should be deleted or reduced substantially to attract smaller foreign investment which can grow over time. * Existing Production. Because List C enumerates areas in which foreign investment need not be encouraged, it discourages competition and a healthy private investment environment. It is recommended that List C be deleted from the Negative List. - Import and Wholesale Activities. The language in List C restricts the "import and wholesale activities not integrated with production or manufacture of goods" to Philippine nationals. Thus, foreign enterprises proposing to engage in import and wholesale activities in the Philippines, through a branch, partnership, or majority-owned subsidiary. must manufacture the products to be distributed. Prospective foreign investors who have expressed a desire to engage in such activities without owning a manufacturing facility have been prevented from doing so. It is recommended that restrictions on import and wholesale activities be removed from the Negative List. * Joint Venture. Once a foreign investor enters into a joint venture with a Philippine national. the Philippine partner has a right of veto with regard to any competing activity by the foreign investor in the domestic market. Anti-competitive restraints of this kind entered 28 Wiiiic tt . percent of people in the Philippines are pure Chinese. Chinese-ovwned companies account for two- thirds ut .hL r.ies ot the 67 biggest corporations (The Economist, July 18, 1992). Philippine businesses have yet to exploti tih. eav Chinese business network to the same extent as other Southeast Asian countries such as Indonesia. Thailand, at d Mlalaysia.  - 41 - into by a competitor and a potential new entrant are illegal in most market economies. It is proposed that this restriction be deleted from the implementing rules of the FIA. * Nationality Restrictions. Nationality laws are too restrictive for certain classes of business. These include retail trade, construction, shipping, airlines, mining, travel, media, advertising, utilities, and insurance. Foreign investments can be increased if these restrictions and limitations are relaxed to permit foreign investors to own up to 100 percent equity. 2.49 To attract higher levels of FDI, this report recommends the following legal changes: (a) Phasing out the 40 percent limitation on foreign ownership. (b) Reducing the minimum capitalization requirements for FDI. (c) Allowing foreign ownership in sectors - presently closed to 100 percent foreign ownership - such as retail trade. (d) Eliminating the negative list. 2.50 The investment response since the introduction of the [or n Investment Act has been generally modest. While the Act itself' was an important step to make the ' lippines more internationally competitive in attracting [Il. the realization of these flows has awaited the resolution of other more binding constraints to investment activity (notably political uncertainty before the May 1992 elections, power supply shortages, capital mnobilization difficulties and macroeconomic stability) as well as the factors listed above. Many FDI inflows are accompanied by some type of foreign loans as part of a project financing package, and the reluctance of foreign commercial banks to take on additional Philippine exposure in recent years has been a contributing factor to the muted FDI response. It is for this reason that the recent Brady-type restructuring of foreign commercial bank debt to the public sector and the consequent improved credit rating secured by the Philippines are major positive steps toward regaining the confidence of foreign banks, institutional lenders, and equity investors - an essential step for the resuniption of strong [1)1 growth in the next few years. FEscal Incentives 2.51 Fiscal incentives affect relative factor use because of their effects on relative factor prices. Fiscal incentives also intiluenice the flow of resources across different economic activities by changing re!ative profitability rhic B3oard of Investments (BOI)-administered incentives created biases in market orientation and in interseLioral and geographical distribution of registered activities, thereby adversely affecting resource allocation, (Annex 7 describes BOI incentives.) 2.52 'I'lTe 1301. which was established in 1968, is charged with responsibility for preparing the annual Investment Priorities Plan (IPP), processing applications for registration of enterprises under the IPP and approving incentives, and periodically monitoring compliance by enterprises. (Annex 8 describes thle Investment Pr6intie Plan.) Since the incentives are given selectively, they serve as an entry barrier. In preparingt thc !1' thle B01 was guided by tthe concept of "measured capacity". that is, incentives are not given t ;ippia,tt' it thie BOI decides that the existing capacity can meet domestic demand. Potential entrants arc li,>l riithited t'rom entering the market, but they will no longer enjoy the fiscal incentives. This is infctCli I,t <in id wasteful investment. A study estimated that the fiscal incentives given by the  - 42 - BOI can increase the rate of return of a pioneer firm by at least 12 percentage points and that of a non- pioneer firm by at least 10 percentage points. These generate larger profits that can be used by BOI- registered firrns to defend themselves against new entrants that do not benefit from BOI incentives. In the past, incentives encouraged capital intensive projects in Metro Manila. 2.53 Although some economic activities were added to the IPP list between 1989 and 1992, the number of economic activities included in the IPP list has been declining over the years. (Annex 9 presents a list of preferred economic activities in 1986, 1989, and 1992.) This means that many potential entrants will no longer enjoy the fiscal incentives accorded to the earlier ones, creating a bias against new entrants and favoring incumbents. Fiscal incentives are not believed to have had an appreciable impact on increasing private investment, but have led to higher fiscal expenditures. 2.54 With the approval of the 1994 Investment Priorities Plan, which lists 59 priority areas eligible for BOI incentives, the BOI has already restricted tax and duty free importation of capital equipment and tax holidays to three years instead of five, and excluded expansion projects from eligibility for tax holidays, except for export oriented firms and garment firms exporting under quota. 2.55 The single most important incentive in terms of revenue foregone and, consequently, in terms of benefits to the firms registered with the BOI, is the exemption from paying taxes and duties on imported capital equipment. The Government needs to improve the mechanisms for exemptions and drawback of the duties and taxes on inputs to exports. The BOI-administered tax and duty drawback system was one ot' several such schemes, none of which was effective. However, the establishment of the One-Stop Action Center for Tax and Duty Exemption/Drawback is helping to streamline the exemption/ drawback system until trade liberalization finally makes some of these incentives unnecessary. This is particularly true for the tax and duty exemptions on capital equipment; this means that if the Government later decides to provide incentives for reasons other than to compensate for trade distortions, it will have to use other types ot' incentives. 2.56 By reducing the cost of capital for larger enterprises, fiscal incentives for "priority" areas in the Philippines have discriminated against SMEs. L.ikewise, investment incentives provided by the Government to industries to promote decentralization of economic activities largely benefit large enterprises: (a) One example is the exemption from income tax granted by the BOI to infant industries. lThis policy is neutral between enterprises but not within sectors, since the BOI's designation of areas as "pioneer" involves fiscal incentives. The main criteria for designation as pioneer activities are production of goods not previously manufactured in the country and use of new production technologies. A strict application of these criteria can result in a relative disadvantage for SMEs, since large firms are in a better position to implement new technologies and to move into new areas of production. (b) A cnmparison of incentives available for increasing the use of labor (deduction of labor expenses s with incentives for the use of capital (tax and duty exemption or tax credit) shows a clear bias in favor of capital-intensive firms. Even the 100 percent eligibility for offset agamnst taxable income of additional labor costs (due to new hiring for a project) that is a'. .ifnlT to pioneer enterprises cannot compare with incentives for capital investment. In , n tax relief on labor costs cannot be claimed where the income tax holiday is already rJd This renders this instrument practically worthless as an incentive for highly labor- irncnsive production, in which subsidies for capital investments encourage higher capital  - 43 - intensity. This scheme clearly benefits large and capital-intensive enterprises and discriminates against small and more labor-intensive industries. (c) The tax credit on domestic capital equipment is intended to place purchases of locally produced capital on the same footing as imports of capital goods. An investor purchasing domestic capital goods receives a tax credit for the amount of the import duty that would normally have been due if the capital goods had been imported. But, in fact, parity is not achieved. A tax credit issued for purchases of locally produced capital goods yields a financial benefit only when the enterprise makes a profit. Because SMEs, for a variety of reasons, have poorer access to imported machinery than large enterprises, they are also less able to claim incentives. Although the tax credits are transferable, this is only possible on a limited scale to suppliers of intermediate materials. SMEs are often supplied by marginal suppliers paying no tax or officially exempted from income tax, so, in practice. the benefit of tax credits is limited for them. A background paper prepared for this report showed that most firms which benefitted from the incentives were large-scale, capital-intensive and mostly oriented to the protected domestic market as a result of the biases in the design and irnplementation of fiscal incentives.9 Annex 10 provides tables which show the biases fiscal incentives create as discussed above. This report recommends phasing out fiscal incentives and dropping the IPP in view of the tight fiscal situation which requires cutting all unnecessary spending, the anti-export bias of the incentives, and the general ineffectiveness of fiscal incentives in encouraging private investment in the presence of trade protection and other binding impediments to efficient private sector growth. Regarding the BOI, this report supports the expeditious and successful completion of the transformation of the entity from a regulatory agency to a promotion agency in line with FIAS' IJNDP-financed restructuring program. 2.57 Phasing out fiscal incentives over time will not only help reduce consolidated public sector deficits, but will also remove sormie of the harmful biases of the current investment incentives regime. 2.58 Heavy regulation of the petroleum sector also resulted in price distortions. The Oil Price Stabilization Fund (OPSF) minimized the frequency of domestic price adjustments, but led to large price adjustments in the past. Price increases resulted in popular opposition, delaying adjustments and causing the OPSF to incur deficits at times. In 1993, the authorities took advantage of an OPSF surplus to increase the oil import duty without a corresponding increase in retail prices. However, when the OPSF funds ran out and prices had to be raised by 15 percent in February 1994, widespread public protests forced the authorities to roll hack both the price increase and the related tax. Another problem arising from regulation has been that cross-subsidization of prices within the OPSF, which caused a serious disparity between consumer dernand and refining capacity, especially for low-priced diesel. During 1994, the authorities plan to adopt an automatic mechanism for adjusting petroleum prices. Domestic prices will be reviewed monthly and will be revised whenever movements in international prices and the exchange rate necessitate an adjustment. This should minimize the need for large and politically difficulty price increases in the future. 2.59 Labor costs are a critical determinant of competitiveness for the Philippines. Overall, unit labor costs in the Philippines are low compared with some of its neighbors; the cost of skilled labor, such as foremen. accotmIfl.ts and clerks is still competitive. The legislated minimum wage in the Philippines, a. approximiQo SS't 00 a day (somewhat less outside Metro Manila), is higher than in Indonesia, 29 Rosat Si<, "n Fiscal Incentives in the Philippines," background paper for the PSA.  - 44 - China, and Vietnam. The problem appears to have been political influences on minimum wage legislation until the last few years, which raised the wage floor and compressed wage differentials in the formal sector. This floor erodes the profitability and competitiveness of large firms in the formal sector. which includes foreign-owned firms, and it increases the wage bill for the public sector, where wage levels tend to adjust with changes in the minimum wage. However, the minimum wage does not serve to protect workers because many workers are employed outside the formal sector, as a result, more than two-thirds of all wage earners in industry earn wages below the minimum, Given that the overall productivity of labor is also low, productivity adjusted wages for unskilled labor are even higher than those which do not consider productivity. Alone among its competitors in Southeast Asia. the Philippines faced a significant decline in output per worker during the 1980s. For the period 1980-89, total output per worker declined nine percent for the entire economy and 17 percent for the non-agricultural sector. This report recommends a review of the minimum wage by the Government to ensure that legally mandated increases in minimum wages do not result in slowing down employment growth. 2.60 Legislation in the Philippines is generally pro-labor, in line with the constitutional mandate, although traditional management prerogatives are still recognized and respected, subject to certain limitations. These prerogatives include the employer's right to run the business and to regulate ail aspects of employment, such as hiring. work assignments, working methods, time, place. and manner of work, and dismissal of workers, according to his own discretiotn arid judggment. Also, labor relations have improved since the end of the Marcos regime. The nutimber of strikes has dropped steadily. and the loss in worker-days was reduced by niore than half in recenit years, With regard to labor unioni organiization and labor-management relatiols, the Philippines is riot muich different from other ASEAN nations, although union activity and strikes are somewhat more prevalent in the Pfhilippines than in Singapore or Indonesia. Slightly less tharn one-quarter of the worklforce is unioinized, but the presenice of more than 3,000 unions helps prevenit any one union. particularly a radical organization. from tundamenitally disrupting the labor scene. 2.61 The Philippines has an attractive labor pool. Its labor force is well over 2() million and growing by four percent a year. There is an abundant supply of skilled workers and managers, and English comprehension is widespread among both skilled arid unskilled workers. Thlis particular combination of a large labor supply and a high level of skills and other qualifications is uncommonl. The Thai labor force, tor example. is comparable in size to that of the Philippines, particularly in unskilled labor, but there is a serious shortage of qualified engineers, technicians, and middle managers - a shortage likely to persist in the immediate future and perhaps beyond, In Malaysia. where the labor force is a little over six million and growing at two percent a year, firms generally have no difficulty hiring unskilled and semi-skilled workers, but skilled workers are in short supply. Indonesia's strength is the size of its workforce -- 76 million and growing at three percent a year. Yet, an estimated 70 percent have received only elementary education and familiarity with English is practically nonexistent at lower levels. This has led to a shortage of skilled workers, in particular technicians, engineers, accountants, and managers, at all levels. To maintain its competitive edge in skilled labor, the Philippines needs to focus on improving the quality of education and to encourage further development of management skills training. It is the recomimiendation of this report to upgrade management training. 2.62 Despite the Philippines' relatively skilled labor force, a number of weaknesses are evident. There is a misniatth lhctween secondary arid tertiary education and industry needs; the brightest and most qualified skilled wr 1ikers often choose better-paying jobs abroad: and the apprenticeship schemes do not adequate1 l\ri T tr arinees. Although the country has a hiigh literacy rate. there is apparent evidence that graduates itc '!eill-prepared for the careers they had sought to pursue (those from lesser-known universitieq v,irniallv cannot compete for employment) or are misrnatched against the needs of the job market Tlhert s J lack of good technical and vocational scliools. Institutions offer two-to-three-year  - 45 - technician courses in which students learn theory under controlled conditions and then get only one to three months of on-the-job training. The Government limits apprenticeships to six months, hardly long enough to teach trainees all the skills required by an industry. In most countries, multi-year apprenticeship schemes overcome this problem. The Philippine Government appears to be favorably considering a more realistic apprenticeship scheme. This report recommends that the Government adopt such an apprenticeship scheme. 2.63 Competition policy remains an area of concern. Reflecting the impact of a multitude of entry barriers in over half of manufacturing subsectors, the top four firms account for more than 70 percent of total sales, but due to the protection and other incentive policies of the past, they generally have not had the same outward efficiency incentives as major firms in the successful exporting economies of Southeast Asia. In a number of highly-publicized cases, firms have been able to use the vagaries of the legal system to ward off competitors. High levels of industrial concentration and protection from foreign competition have combined to create very weak pressures for product or market innovation. The gradual removal of trade and industrial policies is starting to break down the concentrated market structures, but the process could and should be accelerated. More determined enforcement of competition policies, now under consideration by the Government, would also encourage greater competition and create pressures to achieve greater efficiency. 2.64 Lack of competition is also a problem in sectors where state-owned enterprises (SOEs) dominate. Within the manufacturing sector, a few SOEs are extremely large and together they account for 15 percent of manufacturing sector revenues. PASAR, which carries out nonferrous smelting, ranks eighth among corporations; National Steel Corporation (NSC), which operates mainly rolling mills, ranks tenth; while Paper Industries Corporation ranks 39th. PASAR, NSC and PETRON (before it was privatized) all dominate their respective subsectors, and their privileged position has not only reduced competition within each subsector but, more importantly, the passing on of their cost inefficiencies has impaired the competitiveness of private sector operators in downstream activities. 2.65 While cross-ownership patterns between larger corporate groups and private banks provide greater ease of access for loans to established groups for expansion or diversification, it is at the aggregate level that the Philippines' financial sector weaknesses have probably had their greatest impact on limiting the growth of firms and the spread of effective competition. A combination of isolation from international capital markets and large government borrowings on domestic financial markets has meant that the domestic financial sector has not developed the range or volume of credit and equity-related instruments that private firms require in order to respond to emerging opportunities. While initiation in liberalization of the trade and investment regimes have been important precursors for a competitive and cost-efficient business environment, high cost and limited access to credit and crowding out has inhibited the pace at which private firms can mobilize the funds needed to make investments and make more effective competition a reality. Reduced public borrowings and substantive financial sector reform will be important in order to realize the investment needed for greater competition and improved cost efficiency. 2.66 Overcoming these barriers to more effective competition will also have important implications for the pace and direction of future privatization activity in the Philippines. As outlined in Chapter 1. the privatization program that has been implemented since 1986 has had a mixed record in terms of enabling the Government to disengage from conmmercial activities, and the stage has now been reached for a hn..nnig of the privatization effort and a shift in the overall strategy of divestiture. (Annex 11 disWlus9\'- issues faced in the early stages of the privatization in the Philippines.) The financial sector weaknesses have inhibited the pace of privatization to date, and have caused the Government to become overdependent on private placements as a method of divestiture. With the exception of PNB and  - 46 - the Union Bank, there has been little effective broadening of the ownership base. Overcoming this problem in the case of the very large assets that have been listed for sale will require a more focused strategy based on capital market initiatives in order to secure a broader ownership base and more effective competition (see section F below). 2.67 Additionally, the Government must capitalize on the momentum toward privatization that had been created since 1986, and learn from past experience. Toward this end, it is recommended that the Government enhance the privatization program through the following actions: * Deline a broader pratization framework. To broaden the scope of privatization, it is reconmmnded that the Government consider: An expanded privatization policy that covers not only the GOCCs and nonperforming assets that are currently targeted, but all GOCCs and government agencies that perform commercial functions. A policy to restrict future public sector involvement in the economy beyond regulatory and enforcement activities. The immediate implementation of this policy would involve minimizing (a) the purchase of GOCCs or shares therein, or government-owned shares in any entity by other state-owned entities; and (b) existing GOCCs and government agencies from taking on economic functions they are currently not performing. - A policy to encourage competition and discourage excessive concentration of market power in any industry by facilitating entry through merger control prior to any privatization. - Continue to contract out private sector delivery of public services through BOTs and Boos. * Dispose of the backlog of GOCCs and transferred assets. The Governrment should seek an early resolution of all accounts on the books of the APT and other disposition entities as of the end of 1994. APT should be given the sole responsibility for disposing of all GOCCs identified for privatization, under the policy direction of the Committee on Privatization (COP). * Expand privatization coverage. In conjunction with expanding the privatization program, the Governrment should establish a mechanism for identifying and evaluating privatization options. Under E.O. 37, the administration has already ordered all Department heads to identify activities and assets that would be better controlled by the private sector. E.O. 37 also seeks to speed up the sale of 50 GOCCs and to review 81 remaining GOCCs. It is recommended that the process for identifying and evaluating attractive privatization targets be introduced on a timely basis, and that the Government expedite the sale, liquidation, and privatization of the remaining nonperforming assets and the GOCCs targeted for privatization.  - 47 - PrkivS Sategy Initves 2.68 To implement the above mentioned objectives, it is recommended that certain initiatives be undertaken as part of a coherent action plan. The legislation should give COP and APT expanded responsibilities for establishing policy and guidelines for implementing privatizatioii. Specifically, the following actions are recommended: * Directing the proposed competition agency to review concentration in selected sectors and to drafting regulations designed to encourage competition in these sectors and in the economy as a whole, and reviewing privatizations to limit market power of individual companies. * Establishing guidelines on the treatment of labor by the new owners of GOCCs and transferred assets. * Extending the life of COP and the APT from June 30, 1995. as needed. The COP should be directed to develop new guidelines under which APT disposes of GOCCs and nonperforming assets. All sales of these assets should be centralized under APT. The guidelines should make it possible to: - Assess the condition of GOCCs and nonperforming assets to determine their liquidation value. The rehabilitation of these assets. particularly the infusion of funds to imnprove their value, should be discouraged. - Expand the options for negotiatinig the dispositiorn ot an asset, while taking account of the asset's condition, its marketability, its realizable value, and the incremental cost to the Government of mnaintaining it. - Establish the conditions under which the assets will he offered for sale on a timely basis. At the end of a certain period, the enterprises should be dissolved and the underlying land and equipment sold as quickly as possible. - Ensure proper management and corporate accountability for firms being privatized. 2.69 The Presidential Commission for Good Government (PCGG) controls "surrendered" assets including large blOcks of shares in PLDT, San Miguel and numerous other companies, as well as some physical properties. These assets are valued at several billion US dollars. The ownership of these assets should be decided expeditiously by a special court. This report recommends that those assets determined to be Government property should be privatized. 2.70 Financing and Securities Markets. The Government should seek to establish creative means by which the securities markets can finance the transfer of Government assets to the private sector. In particular, Section 2(d) of RA 7181, which provides that 10 percent of these assets shall first be offered in corporate form to small investors, including overseas workers, should be complemented by mechanisms that facilitate the entry of small investors into the capital markets.  - 48 - D. Infrastructure Constraints 2.71 Infrastructure bottlenecks have been one of the key Lconstraints to prikate sector development: Power outages were the principal deterrent to new investment until the end of 1993 A number of initiatives have already been taken that will expand supply through BOT and Bo3() schemes. and it is the private sector that has and is expected to plav the key role in these initiatives Beyond these imnmediate steps, however, there exists a broader range of infrastructure issues such as low telecommunications coverage, high cost of transport and inter-island shipping, dilapidated transport infrastructure, all of which adversely affect private sector development, Infrastructure deficiencies have necessitated increased private provision of those services. hence creating new investment opportunities. as well as pressing constraints on private investment and growth. 2.72 The Philippines is now caught in a downward spiral of poor infrastructure services, low resource mobilization, and cutbacks in maintenance and investment resulting in further deteriotation. The costs of starting aDd running a business have increased over recent vears as electricity brow xnouts and other disruptions have risen. Requiring back-up power generation. or waiting moriths or years for telephone connections, being unable to place calls, or having to install a dish for communications, makes doing business costly. Time delays and congestion, and frequent interruptions in production activities. add further to the costs of doing business. The wide range of deficienicies anrd the declinictl level of services have triggered consumers' resistance to price increases But without increas:ng priLes and revenues, the utilities cannot improve services and invest in additiona! capacity. 2.73 The present infrastructure inadequacies can be traced to successive fiscal crises that resulted in a shift in spending priorities toward current expenditures. Budgetary pressures tneant that public funds were not allocated either for new capacity additions or for recurrent maintenance expenditures; even where official loan funds were made available from abroad, the public sector had difficulty utilizirig them according to plan. Fiscal problems also contributed to a rund( V n in operations and mainltenatice activity; a number of government power stations are now running at a fraction of their capacity due to lack cf maintenance. 2.74 While public sector funding shortages are superficially viewed as the cause of the infrastructure crisis, a more fundamental issue lies with concentrated industry structures, domninated primarily by public enterprises and private monopolies. During the last decade. the poor economic performance and weak financial outcome of many public enterprises have seriousiv limited their capacity to maintain and invest in infrastructure systems through internally generated funds This poor performance can, in turn, be traced to structural factors. These include non-commercial rmanagetnent structures, unclear and often conflicting commercial and social objectives, low capitalization and limited accountability for performance. Price controls, inadequate pricing levels and/or tariff structures as well as difficulties in enforcinig revenue collections, further constrain internal revenue generation. As a result, many enterprises have failed both to expand access or to improve quality of services to a growing population. They have also had to increasingly rely on the Government's financial support to sustain their activities. This support. combined with the need to reduce the consolidated public sector deficit. has further diverted already limited financial resources from the priority activities and prevented the Government from undertaking necessary and urgent infrastructure investment. 2.75 In ,,iition. existing and new firms face further disincentives to provide infrastructure and improve the inl it of services These stem from existing industry structures and the regulatory framework WhiLil encourage incumbent firms to focus on lucrative market segments. while presenting significant bAh 1:- to entry by new firms. Such barriers have arisen, for example, through a bundling  - 49 - of commercial and regulatory functions into a single organization (e.g.. the Philippine Ports Authority), thereby creating considerable impediments to competition in the provision of infrastructure related services. In other instances (e.g., power and telecommunications), natural monopoly elements within the various sectors have been bundled together with contestable businesses, thereby frustrating effective competition in supply and reducing incentives to improve quality. Initiatives such as BOT schemes may provide a temporary remedy for some of the more obvious symptoms, but avoiding a recurrence of these problems may require a more fundamental restructuring of the various regulatory frameworks governing the supply of infrastructure services. 2.76 The extent of the infrastructure problem in the Philippines cannot be overstated. Infrastructure degradation is most noticeable in poor highway maintenance. urban traffic congestion, inefficient seaport cargo handling, intermittent power failures, and chronic underinvestment in telecomimunications services, with resulting limited and low quality service. These problems. in turn, raise production costs and lower productivity, which together reduce employment, incomes, and international competitiveness. Difficult communications and inefficient transport reduce responsiveness to clients, lowering demand for Philippine exports. Poor infrastructure also diverts scarce investment funds from productive capital improvements into infrastructure substitutes, and drives foreigni investors to other locations which do not have these problems. 2.77 Because of the loss of confidence in public sector infrastructure rnanagement, and bec:ause of recent trends in privatization. the private and public sectors roles in infrastructure development and management are now being reconsidered. In order to rehabilitate the infrastructure quickly. a strategy has to be formulated based on competitive. self-financing. decentralized, and accountable infrastructure service delivery systerns. including an expanded role for the private management of "natural monopolies with proper public regulation There is still an important role for the public sector under this strategy, but many of the managerial, institutional. and regulatory problems that contributed to infrastructure degradation must be addressed by involving the private sector on a larger scale. 2.78 Experience in the Philippines shows that the concentration of responsibilities into single institutions has not necessarily had the desired effect. Instead, it has often resulted in poor operational performance in most of these agencies. It has also led these institutions to explcit their monopolistic positions by engaging in rent-seeking behavior. i.e., maximizing the benefits to the owners, managers and employees to the detrimiient of the public as a whole. 2.79 Thus, this report recommends the following: * Encouraginig and developing efficient ownership and management of infrastructure systems which are fully accountable and autonomous. * Establishirig ccmpetitive industry structures to attract new fi1rrc and supply infrastructure needs * Fostering an effective and transparent regulatory framework. * Maint;iining stable macroeconomic, legal and political environments to generate confidence i t!- ! :' 'lppine econorny.  - 50 - EALV 2.80 During 1992-93, capacity was so short that Luzon faced brownouts virtually daily; during the hot months of March-June. these averaged seven hours a day. Mindanao also had severe brownouts which reached nearly 12 hours a day for a few months in 1992 as a result of serious drought conditions. However, because of the Government's policy of encouraging "fast-track" projects, power blackouts were eliminated by the end of 1993. 2.81 In the energy sector, the overriding constraint has been serious shortages in power generating capacity. These shortages put a severe brake on economic growth given that prolonged outages adversely affected industrial and commercial activities. Consequently, unemployment and economic losses averaged an estimated US$600-US$800 million per year during 1992-1993.30 There are other estimates which put economic losses at about US$2-3 billion a year.3" 2.82 Sector Structure. Shortly after the inauguration of the new administration, the Energy Sector was reorganized to (a) increase the economy's responsiveness to public policy; and (b) strengthen the Government's capacity to improve the sector coordination. The newly created Department of Energy (DOE) becamne the leading policy body, with the Secretary of Energy becoming the ex-officio chairman of NPC, PNOC. and (unless otherwise agreed) NEA. NPC continued as the main generation and transmission company in the country. Its monopoly over generation was broken by Executive Order (E.O.) 215 in 1987, and an increasing number of private independent producers now seek to sell their output both to the grid and to regulated distribution utilities. PNOC retained its monopoly position in primary fuels. It is also developing generation facilities that are fired by the fuels it produces. Virtually all electricity distribution is provided by private companies. Some 13 are investor-owned; they provide service mainly to urban centers. Distribution elsewhere is provided by 120 member-owned electric cooperatives (they. in turn, obtain their investment funds and technical assistance from NEA, a government-owned corporation). Aside from MERALCO, the distribution utilities are small and relatively weak. Price regulation for all power utilities was assigned to the ERB in 1993. 2.83 Causes of the Crisis. The two main causes of the current power shortage situation include: (a) Limrnited Additions to Capacity. In 1986, NPC had sufficient rated capacity to last until 1991-92. However, only limited capacity was added during 1986-1991. The Bataan nuclear plant - for which about US$2 billion was spent - initially expected to meet demand, was never brought on line due to concerns over safety. As a result, NPC was unable to meet demand in Luzon, especially during the hot months of March through June of last year. Peaking plants, which have low capital costs and high operating costs accounted for virtually all of the limited power capacity that has been added since 1986 to provide a short-term solution to the inmmediate crisis, given the inability of putting base load plants into operation in a short time. This indicates that future efforts will need to focus on building base load plants to address the expected electricity capacity deficit on a lasting basis. 30 Hi. .: ,i-nt 0t a loss of around 1.5 percent of GDP; some business groups estimate economic losses Eo be even AYU trinultants. Manila. Philippines.  - 51 - (b) Aging of Existing Base Load Plants. The age of NPC's base load thermal capacity averages about 23 years. The youngest base load plant in the Luzon grid is 10 years old. Virtually all base load plants have been maintained poorly. During the power crisis in 1992 and 1993, the NPC delayed taking plants out of service for maintenance, thereby running them at high load factors until they broke down. The condition of some of the larger plants is poor; they run at or substantially below their rated capacity, and their rehabilitation is both expensive and left to chance. On one occasion, a large plant failed within a couple of days of the completion of a rehabilitation program. While some blackouts result from the shortage of rated capacity, the severity of blackouts has been seriously exacerbated as a result of the poor working condition that reduces the plants' reliable capacity. This problem further increases the need to add base load plants in the future. [aveustnt Requ _remet 2.84 Investment requirements during 1994-98 for capacity and transmission additions and rehabilitation are conservatively estimated at no less than US$2 billion annually, under a very strong assumption that existing plants will perform up to rehabilitated standards. However, it is more likely that the annual investments will need to be raised, since greater capacity will be needed, given the poor condition of existing plants. Together with the need to provide reserve capacity for independent power producers (IPPs) and the old age of existing plants, NPC will need to maintain a reserve capacity of at least 30 percent. The fast growth of IPPs may reduce NPC's need for future capacity additions and investment requirements as well. This would increase investment requirements still further. Thus, during the rest of the decade, the power sector will require at least US$10 billion (assuming modest economic growth rates) to finance generating capacity, and another US$3 billion for transmission. These investments are needed urgently. Any delays will severely constrain future economic growth. 2.85 The worsening of NPC's finances in the past constrained investments. Borrowing to finance expenditures during the 1970s and early 1980s left the company with an exceptionally high 8:1 debt/equity ratio. Consequently, to fund its operations, NPC relied on the National Government, through equity injections, fuel prices subsidies through the OPSF and, most recently, an exemption from payment of duty on oil imports. While public opposition to price adjustments made it difficult to introduce timely rate adjustments, tariffs have generally been maintained in real terms since 1988. Despite large transfers and relatively high tariffs, the company relies on external financing to fund its investments. The Government has indicated its conmmitment to ensure the financial viability of the NPC. In early 1994, energy pricing was made more flexible with the introduction of a formula that allows the NPC to make regular monthly tariff adjustments to compensate for increases in fuel prices and the cost of electricity purchased from private power producers. A similar formula will be introduced soon to compensate for exchange rate depreciation. which affects debt servicing costs. 2.86 Large investment needs will continue to require financing both from private and official external sources. Private financing, although showing an increasing trend in the last two years, has been constrained in the past as a result of the following reasons (a) commercial lenders do not want to commit funds beyond about US$1 billion a year to both the public and private sector in the Philippines in the short-term (with improved creditworthiness, this amount would likely increase over the years); (b) some credit sources are reaching country risk limits (for example, JEXIM and ADB private financing); and (c) most sources of supplier credit either require government guarantees or are constrained by narrow exposure limits at thlict unguaranteed windows.  - 52 - 2.87 Moreover, NPC, despite having been recapitalized by the Government, still faces important cash constraints because it has been unable to raise investment capital from domestic capital markets, although it borrowed from international capital markets with a Governrment guarantee. To recapitalize, NPC could also privatize some of its viable thermal plants either through outright sale or public offering of stocks. The latter, which is actually reLapitalization by the private sector, would be preterable since it would improve NPC's financial ratios. 2.88 Reforning the energy sector is a high priority of the new administration; as a result, the Goverrnent prepared and approved an Energy Sector Plan (ESP) in January 1993. The ESP recognizes that a coordinated approach to development of the sector requires a framework that emphasizes order and discipline. To that end, the ESP sets out measures in many areas of key concern - particularly sector coordination, regulatory framework, private sector participation, power and oil pricing, environmental management, energy conservation, operational efficiency, and project implementation. Some actions of the ESP have already been implemented, including the establishment in late 1992 of the Department of Energy (DOE). The Government, NPC, and the Bank are engaging in an ongoing dialogue on the implementation of the ESP. As part of that dialogue, the Bank is currently involved in sector work, under whichi it will seek to agree with the Government on a long-termn rational development for the power sector, including an appropriate sector structure and regulatory framework. 2.89 In order to imeet demand, the Government has set the following targets (a) adding generation capacity as quickl' as possible so as to prevent any blackouts; and (b) doubling generating capacity to 8.00() MW by 1998. T'he total power additions to the Luzon grid for the period 1994-98 are about 3,0()0 MW. Introducing expected capacity additions from the IPPs. the capacity is expected to be raised to about 5,67() MW. The Government's strategy is to focus on low-cost generation by greater reliance on comibined-cycle, coal, hydro. geothermal and renewable resource-based generation. The Government will contitiue to rely on greater private sector participation in the development of the sector, Conventional base load supply projects (coal, geothermal, and hydro) require construction times of three to six years, and could not provide relief in the short-term. Therefore, to address the urgent need for additional capacity. the Government has embarked on a "fast-track" generation expansion program that involves the financing. implementation, and operation of several combustion turbine or diesel-engine driven systems. In addition, under the "Electric Power Crisis Act of 1993," the President was given special powers to rewolve the power crisis, including facilitating increases in tariffs as and when needed, and speeding up project approvals. 2.90 The schieduled total power additions to the Luzon grid for the period 1994-98 are about 3,000 MW. Includirng expected actual capacity additions from the IPPs, the capacity is expected to be raised to about 5.67 1 MW. Due diligence should be applied in preparing the expanded program and in considering the entry of distributors to prevent overcapacity. 2.91 Fifteen contracts have already been signed, and several others are under negotiation with private developers for the construction, financing and operation of power plants using Build-Operate- Transfer (BOT) o.r Build-Transfer-Operate (BTO) systems. The total power generation contracted by NPC with the private sector amounts to about 2,700 MW, or 70 percent of the present reliable capacity (of this total. some I.(XK) MW were brought on line by the end of 1993), and the private sector is expected to d've i.'f m iost new power generation in the future. NPC's Board of Directors has decided that it will wk r the private sector to develop practically all new thermal generation plants; most of them u . X! v H )T or BOO projects.  - 53 - Box 11.1: Salient Features of the New BOT Law RA 7718 amending the four-year old BOT law (RA 6957) introduces flexibility in the following areas which created constraints in the last year: * Coverage of the BOT scheme by providing a clear legal basis for BOT variations such as build- own-operate, build-lease-transfer, build-transfer-operate, contract-add-operate, develop-operate- transfer, rehabilitate-operate-transfer aid rehabilitate-own-operate (see Table 11.4). * Government financing by allowing Government financing of up to half of project cost through direct budgetary appropriate and official development assistance (ODA) in the case of "projects which would have difficulty in sourcing funds," * Rate of return by defining a reasonable ROR as "that which reflects the prevailing cost of capital in the domestic and international market", except in tht case of negotiated contracts where the National Economic and Development Authority will set the ROR, which for "public utility projects which are monopolies" should not exceed 12 percent. * Negotiated contracts by allowing direct negotiations in cases where there is only one qualified bidder. * Acceptance of proposals by authorizing the acceptance of unsolicited proposals on a negotiated basis if projects involve a new concept or technology or are not included in the priority list; do not entail any government guarantee. subsidy of equity; and have been subsequently opened to competitive proposals and no other proposal was received. * Contract termination by allowing a contractor to terminate the contract in the event that government defaults on major obligations subject to reasonable government compensation. 2.92 The Government and NPC have arranged for a substantial amount of new generation under the "fast-track" programii. Moreover, NPC is itself developing several large generating facilities. The Philippines has so far signed 35 contracts with the private sector for the construction, financing, operation, and managemetit of power plants, involviiig a total capacity of about 5,000 MW, compared to total existing generating capacity of around 6,800 MW. This program has had the intended effects, with new generating capacity of 855 MW installed in 1993 and rehabilitation of two power plants adding 560 MW more. Through the BOTIBOO schemes, over 6,000 MW have already been contracted through 1998, over half of the total system capacity of 12,000 MW. By the year 2005, the Governrment expects that total system resources would reach 24,000 MW, with much of the generating capacity being undertaken by the private sector. This should help the Government begin to focus its attention on the orderly long-terni development of the sector, rather than the immediate need to add capacity. 2.93 (it \lx 1 S. 1994. a law was passed amending the Republic Act No. 6957 -- known as the BOT law I10 i) iI Law Amendments were designed to modify the existing legal framtework and to encourage it Ian u udturc development by the private sector, which was not satisfactorily achieved by the previous hw A t tnumiber of improvements were put in place, resulting in a substantially liberalized version. R,pubi iu t\ct No, 7718 (see Box 11.1 for the salient features of the new BOT law).  - 54 - 2.94 The most significant changes introduced by R.A. No. 7718 include the following (see the following table for description of different contractual schemes}: (1) Unsolicited Proposals which contain new concepts or technology viewed as desirable bv the GOP may be implemented under the new law. This is seen as one of the landmark provisions, allowing the GOP to harness the creative energies of the private sector. (2) Government Support may be provided to critical infrastructure projects in a variety of ways under the new law: * Credit enhancements refer to the provision of GOP risk abatements to projects, essentially, assisting in creating a financeable project. * Cost-sharing projects with the private sector is another area which has been liberalized. Under the new law. the GOP may provide up to a maximum of half of total project cost. (3) Market-determined Rates of Return. reflecting the cost of capital in domestic and international markets, will he the guiding principle when determining user charges/tariffs. Under the new law, regulatory risk is also substantially decreased from the private sector's perspective because toll increases are implemented automatically. based on predetermined formulas. (4) Streamlining of GOP approvals is achieved by identifying the critical bottlenecks in bidding and award procedures and by providing solutions as needed. (5) The BOT Center is another key initiative of the BOT program, whose establishment will address the need for a one-stop assistance center for both the private and the public sector. This Center will consist of four divisions, namely the (i) Private Sector UJnit; (ii) Public Sector Unit (iii) Training and Conference Management Unit, and (iv) Information and Liaison Unit. 2.95 Even with the active participation of private power producers, the orderly development of the power sector depends on improving the efficiency and effectiveness of NPC, which still owns most of the existing generating capacity and of the transmission network. Current govermnent regulations have caused NPC to follow cumbersome processes with regard to the development of new capacity. Political considerations have prevented it from making timely tariff adjustments, and even from taking plants out of service on schedule for planned maintenance. In short, NPC's management lacks autonomy and cannot operate the company along commercial lines. 2.96 The privatization of NPC will likely take some time and effort. Because of the age and questionable operating condition of most of NPC's plant and equipment, an effort to sell or lease the company's assets is likely to be time consuming. The Government is currently in the process of preparing an action plan to privatize NPC. The Senate passed its version of the privatization study and the Lower llowstr is preparing its version The DOE plans to present to the President a blueprint of a power sect- n,r,tructuring by September 1994. NPC needs to define the separation of power generation and transiTino..-T Junction in view of the complexity and vastness of the operations. Currently. there are three pri',atlzation studies underway. Ridgehome/Lahmeyer has just completed one, RCG/Hagler has presented it~; fir,t draft in June (which is being reviewed by NPC), and the NPC in-house study will soon follow  - 55 - Table 11.4: Different BOT Schemes Build-Own-and-Operate a Private sector finances, constructs, owns, operates and mnaintains facility. Build-Lease-and-Transfer * Private sector finances and constructs facility. * Government leases facility for fixed period. * Government owns facility upon expiration of lease. Build-Transfer-and-Operate 0 Government finances project. * Contractor builds facility. * Contractor operates facility on behalf of Govermnent agency. Contract-Add-Operate 0 Private sector leases existing government facility. * Private sector undertakes expansion/improvement. * Private sector operates the project. Develop-Operate-and-Transfer * Private sector undertakes project. * Project results in higher property values for adjoining property * Private sector obtains right to develop property. Rehabilitate-Operate-and-Transfer * Private sector rehabilitates, operates, and maintains existing Government facility. * Government retains ownership upon expiration of contract. Rehabilitate-Own-and-Operate 0 Privates sector rehabilitates existing government facility. * Private sector operates facility for indefinite period on the condition that it does not violate the terms of its franchise. 2.97 Since competition is possible in generation, it should be vigorously pursued, and there should be no undue legal restrictions on franchising or other types of private sector entry. Merely removing statutory restrictions, however, will not induce the private sector to participate in the power sector. Private firms should be encouraged and protected by a regulatory and legal framework that allows them to assess and undertake reasonable market risks, and permits them to enter into long-term contractual arrangements with the grid operator, as discussed below. Since 1991, when the term of ERB's commissioners became fixed, thereby giving that organization greater autonomy, its effectiveness has improved.32 Its further improvement should be strongly encouraged. 2.98 The Government considers that there is a need to review existing ERB regulations on the IPP purchase power agreements with the energy distributors. It currently allows distributors to enter into private power contracts with IPPs at prices higher than the grid rate. Moreover, the distributor has the option to purchase its own requirement from the IPPs at maximum capacity even at a price higher than the grid rate. This can happen when the distributor is also the owner of the IPP. Safeguards would need to be introduced to assure NPC of a market for its existing and planned generating additions. 2.99 In the next two years, NPC should be transformed into a commercially-oriented power utility. In the immnediate future, NPC should continue to manage the addition of generation capacity, 32 The most recent events raise doubts about ERB's level of autonomy, however. For example, it raised the price of oil products in early 1994; but when opposition surf. ced, it rolled back the price hikes.  - 56 - particularly under BOT/BOO arrangements. At the same time, work should begin on corporatizing NPC and giving its management a clear mandate to function along commercial lines, In the medium-term. once the company has had some experience as a commercially oriented utility, the most desirable approach would be for NPC to move toward privatization. (See Box 11.2 which describes power privatization in Malaysia as an example. Given that some of these privatization experiences are quite recent, a number of experiences will need to be carefully reviewed to select the best formn of privatization for the Philippines.) 2. 100 Regarding transmission, there should not be any structural or legal deterrent to multiple party (public and private) ownership of the transmission system. To prevent a disorderly situation from developing, however, the Government should carefully formulate rules, including principles for the establishment of wheeling charges that would govern the use of the grid for transfers of electricity from suppliers to clients. The Government's main responsibility will be to ensure a level playing field for all participants in the sector and the flow-through to the public of the benefits (if any) of private sector efficiency. In the long-term, the Government's responsibilities in load dispatch and system planning should become the core activities through which it ensures the orderly development of the sector. 2.101 To expand investment financing in the energy sector, the Government has sent the Congress two separate bills: One is to exempt the private sector from the payout of an onerous 60 percent royalty on geothermal production for 10 years, and the other is to enable the Government to penalize theft of electricity. If passed and enacted, the former bill would encourage private investment in geothermal production and the latter would improve NPC's financial ability to rehabilitate the existing power infrastructure. This report supports Government efforts for the passage of both bills. Existing Experience with BOTIBOO 2.102 The Philippines has committed to more capacity additions through BOT/BOO arrangements than all other developing countries combined. The experience so far with such arrangements has been mixed. Several of the existing arrangements involve NPC agreeing to purchase electricity at prices higher than the current grid price. In some instances, these arrangements presumed that a developer would construct a peaking plant and run it at load factors that were more appropriate for base load. The rates of return on equity being sought by the developers have understandably been high, and the Power Purchase Agreements (PPAs) assure the developer of these returns through take-or-pay provisions. In principle, these are justified when developers assume the full project and commercial risks on the power facility (although in the Philippines, they have not). In fact, NPC has assumed the fuel risk and the Government has guaranteed NPC's performance as the purchaser of electricity. 2.103 Within five years, one of the major expenditures of NPC is expected to be purchases from independent producers. NPC has a stated expectation that its tariff, in 1993 constant prices, will increase from US6.2c/kWh to US8.0C/kWh in 1997. This would raise the already high retail rate of electricity from about US13c/kWh, to about US16c/kWh. Already, the Philippines has Southeast Asia's highest rates for medium voltage industrial and commercial end users and rural consumers, while urban residen- tial rates are second only to Japan, and residential rates average about two to three times the norm of the U.S. The existing high tariffs reflect (a) inefficiencies at the generation level; (b) high distribution losses, (c) high priced iTnvestmnents at both levels; (d) the responsibility of distributors to shoulder costs that are either forgiven or covered by the consumer in other countries of the region; and (e) the high real cost of domestic finance. To address the high cost of power, it is suggested that the regulatory agencies require all power producers, public and private, to raise efficiency and cut costs over the medium-term in order to avoid large tariff increases which would adversely affect the international competitiveness of Philippine industries.  - 57 - Box 11.2: Power Privatization in Malaysia 1. The privatization of the major power utility in Malaysia required a number of legal, institutional, and financial changes. After a decision by the Government to restructure the power sector, the laws and regulations were revised, and a regulator was established. The new management was given time to take control of the electricity company and improve its efficiency. Finally, there was a partial sale (23 percent) of the shares of the company, and the private sector was given incentives to participate in generation. 2. The Malaysian National Electricity Board (NEB) was incorporated as a wholly Government- owned company, Tenaga Nasional Berhard (TNB) under the Companies Act in September, 1990. TNB was issued a license to generate, transmit, and distribute electricity as a monopoly, with no competition envisaged initially. While TNB still remains dominant, there are plans to promote the setting up of independent power producers (IPP) over time, so that there will be competition in generation. Prior to the sale of TNB's shares, the Government enacted a new Electricity Supply Act (1990) that established a Directorate General of Electricity Supply (DGES) to issue licenses for electricity supply (at present the only licensee is TNB), set performance standards, recommend prices, and register and inspect electrical installations. 3. In 1992, TNB was listed on the Kuala Lumpur stock exchange (KLSE), and 685 million shares were sold to private investors, including pension funds, banks, employees, and the public. The Govemment of Malaysia still holds about 77 percent of TNB's shares, and the Ministry of Finance retained a "golden share," which gives it substantial control over TNB. The sale of TNB's shares increased KLSE's capitalization by US$1.2 billion, and this was the largest-ever offering on the KLSE. 4. Under the regulations, a licensee has to maintain a separate account for each activity, provide information on operating costs, propose prices according to the a price cap formula, be responsible for rural electrification, and maintain standards for generation security, transmission system design, and distribution. TNB's license can be revoked only with ten years' notice. Apart from reporting to DGES, TNB reports on its performance to its Board and management, shareholders, and extemal lenders. 5. Funher to establishing DGES as the regulator, a number of other steps were taken for the corporatization of TNB. A new charter was prepared for TNB, and a new Board of Directors was appointed. Corporate objectives and performance targets were set, and TNB's internal organization, managers and staff were restructured on a corporate basis, and salaries were adjusted to market levels. The management was focused on decentralized decision-making, enhancing efficiency, and making a profit, though increases in tariffs were prohibited before privatization. In addition, TNB were made subject to taxes. At present. TNB is a financially viable power utility that has been partially privatized. 2.104 So far, DOE and NPC have licensed private producers to sell directly to distribution utilities, even wheeling through NPC's network. Because it appears financially stronger than NPC, or because power sold to the retailer can be priced more expensively than to the wholesaler, a few developers prefet to Ne ll to MERALCO directly. However, none of the other distribution utilities have the strength ot slc tf N\