Philippines - Recent macroeconomic developments and reform efforts

Report No. 13109-PH Philippines Recent Macroeconomic Developments and Reform Efforts June 30, 1994 Country Operations Division Country Department I East Asia and the Pacific Region FOR OFFICIAL USE ONLY ~. - ~ ~ ~ * . A . , . -* d-* . 5e. Document of the World 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 EOUIVALENT Currency Unit - Peso (P) USS - P27.5 (as of December 1993) ABBREVIATIONS AND ACRONYMS ASEAN - Association of Southeast Asian Nations BOI - Board of Investments BOT - Build-Operate-Transfer BSP - Bangko Sentral ng Pilipinas CARP - Comprehensive Agrarian Reform Program CPIP - Core Public Investment Program zO - Executive Order IRB - Energy Regulatory Board mRP - Effective Rate of Protection SOCC - Government Owned and Controlled Corporation HCV - Home Consumption Value IMF - International Monetary Fund LIBOR - London Inter-Bank Offer Rate MITI - Ministry of International Trade and Industry NFDA - National Economic and Development Authority NPC - National Power Corporation NSCB - National Statistical Coordination Board OPS? - Oil Price Stabilization Fund PLDT - Philippine Long Distance Telephone Company QRS - Quantitative Restrictions RA - Republic Act VAT - Value Added Tax FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY PHILIPPINES RECENT MACROECONOMIC DEVELOPMENTS & REFORM EFFORTS Country Economic Memorandum Table of Contents Paae No, Executive Summary .j.. . . . . . . . . . . . . . . . . . . . . I. RECENT MACROECONOMIC DEVELOPMENTS . . . . . . . . . . . . . . .1 Overall Growth Performance ... . . . .. 1 Investment and Savings ... . . . . .. 5 The Labor Market, the Exchange Rate, and Competitiveness . . . 7 Fiscal and Monetary Developments . . . . . . . . . . . . . . . 11 The External Sector ... . . . . . ..... . . . . . . . . . 18 II. CONTINUING STRUCTURAL REFORMS . . . . . . . . . . . . . . . . . 25 Revenue Generation and Fiscal Improvements .. .... . . . . 25 Economic Liberalization ... . . . . ..... . . . . . . . . 28 III. MEDIUM TERM PROJECTIONS AND AID REOUIREMENTS . . . . . . . . . 37 Assumptions Behind the Projections ..37 Projected Outcomes . . . . . . . . . . . . . . . . . . . . . . 39 Financing Requirements. 41 Text Tables 1.1 Macroeconomic Indicators (1970-93). 2 1.2 Real Output Growth (1986-93). 4 1.3 Investment and Savings (1988-93). 6 1.4 Employment, Wages and the Exchange Rate (1988-93). 8 1.5 Structure of the Labor Force in 1980 and 1993. 9 1.6 National Government Cash Budget (1990-93) .14 1.7 Consolidated Public Sector Deficit (1986-93). 15 1.8 Monetary Indicators (1986-93) .17 1.9 Current Account Indicators (1986-93) .19 1.10 Capital Account Indicators (1989-93) .20 2.1 Main Revenue Generation Measures (1993-94) .26 2.2 Trade Policy Indicators (1980-95) .32 3.1 Macroeconomic Indicators (1992-97) .40 3.2 Financing Requirements (1992-97) .42 3.3 Official Development Assistance (1986-93) .43 Tlhis document has a resticted distribution and may be used by recipients only in the performance of their |official duties. Its contents may not otherwise be disclosed without WoTld Bank authorization.l  Text Figures 1 Real Income Growth (1950-93) . . . . . . . . .1 2 Power Shortages in Luzon, (1992-93) . . . . . .5 3 Real Effective Exchange Rate (1979-93) . . . .10 4 Import Content of Exports . . . . . . . . . . .22 STATISTICAL APPENDIX . . . . . . . . . . . .45 IBRD MAP No. 24105R1 This report was prepared by Erika Jorgensen (Task Manager) with the assistance of Nam Pham (statistics), Lani Azarcon (background data), and Dharshani de Silva (formatting and editing).  THE PHILIPPINESt RECENT MACROECONOMIC DEVELOPMENTS AND REFORM EFFORTS EXECUTIVE SUMMARY i. After 10 years of stagnation or minimal growth--so that real per capita income in 1993 was lower than in 1977--the Philippine economy started a significant upward trajectory in 1993. An increased rate of investment and continued capital inflows from abroad signal strengthening private sector confidence. Moreover, new efforts to raise revenue have resolved much of the uncertainty over fiscal balances. The indications are that the economic policy reforms that the country has instituted together with the decisive beginning on infrastructure improvemento (particularly in power) could have significant effects in sustaining growth in the medium term. However, this will depend crucially on continuing measures to keep public finances sound, to stimulate capital formation, to maintain competitiveness by liberalizing the economy, and to secure necessary financial support from international donors. Economic Performance in 1993 ii. While the economy has generally seemed poised for growth for well over a year, persistent power shortages through 1992 and most of 1993 and continuing uncertainty engendered by a decade of "stop and start" implementation of policy reform undermined economic performance until mid-1993. output and income began a gentle recovery in 1993, ending the year 2.4 percent higher. Investment strengthened to almost 24 percent of GNP, as capital spending by both the public and private sectors on power generation soared. Exports of manufactures boomed by 20 percent in dollar terms, fostering total merchandise export growth of 16 percent. Import volume surged by 21 percent, driven by a 40 percent increase in imported capital equipment, especially power generators. The consequent deterioration of the current account was financed by new borrowing. in international capital markets and increases in portfolio and direct foreign investment inflows. iii. Capital spending by the public sector, especially because of heavy outlays by the National Power Corporation on power generation capacity, pumped up public investment to 6.0 percent of GNP in 1993. As a result, while the National Government held its deficit to 1.4 percent of GNP, despite higher allotments to local governments, the deficit of the consolidated public sector rose to 2.7 percent of GNP (from 1.9 percent in 1992). As a complement to the "pump-priming" impact of greater public investment, the Government also used monetary policy to spur growth through the first half of the year, but the authorities reasserted stability when increased liquidity began to feed inflationary expectations and interest rates began to rise again. iv. Overall, 1993 witnessed a number of positive developments with implications for medium-term growth. The electricity shortages that have plagued the country for years appear to have been brought under control. Significant new revenue measures have been put in place. Inflation remains reasonably low; and an autonomous Central Bank has been established. After a decade of exclusion, the country obtained an international credit rating and returned to borrow in international credit markets. Capital inflows continue, although foreign direct  - ii - investment has not yet responded strongly as in other East Asian countries; and stock market performance in 1993 was the best in Asia, signalling private sector confidence that a sustained recovery is under way. v. Sustained higher growth will require that competitiveness of the economy be the centerpiece of economic policy making, with due attention paid to coordination of policy. For example, appreciation of the real exchange rate and increases in the minimum wage are gradually pricing the Philippines out of unskilled labor intensive manufactures, despite historically high levels of literacy and educational attainment relative to its per capita income. Another policy area important for long term competitiveness is external debt management, which needs to be especially prudent now that access to international markets has been reestablished, balancing investment needs today against possible threats to the public purse in the future. Sustainability of growth will also require the development of the rural sector and more robust performance of agriculture as well as further diversification of exports. Thus, despite the clear improvements ln economic performance in 1993, and the indications of strong outcomes so far in 1994, some caution about prospects is still warranted. Continuing Structural Reforms vi. The severe power outages in 1993 were the most immediate cause of slow recovery in that year; but hesitation by domestic and foreign investors to commit sufficient resources to the economy could threaten growth prospects for the rest of 1994 and beyond. The improvement in investment rates in 1993 is fully accounted for by power sector projects alone. For the recovery to strengthen, investors must commit to projects spread across the economy. The bolstering of private sector confidence by continuing the program of macroeconomic stability and economic liberalization is therefore crucial. vii. The Government's recent efforts to complete the missing elements of its program of structural reforms should go a considerable way towards dissipating investors' doubts. The Government has taken important strides in improving revenue generation and in enhancing economic liberalization. The Congress has recently broadened the value-added tax to cover service sectors, and additional tax reform is being examined by a new task force; it is expected that this will lead to recommendations on new taxes on corporate and personal incomes and to further rationalization of the tariff structure. The exchange rate has boen almost completely freed of restrictions, foreign investment has been further encouraged by shortening the list of excluded sectors and by opening the banking sector to foreign investors, and private investment has been facilitated through the introduction of Build-Operate-Transfer and other arrangements for private sector participation in infrastructure. Thus, the improvements in macroeconomic management, the decisive start towards easing power shortages and other infrastructure constraints, and the increased recognition of the private sector as the engine of economic growth should have laid a solid basis for development over the medium-term.  - iii - Aid Reauirements viii. The prospects for medium term growth of GNP above 5 percent per annum are good. The responsiveness of private investment is expected to prove more supportive of sustained recovery than in past upturns; and trade and foreign exchange liberalization have reduced the danger to growth poised by surging imports. The hard-won confidence of the private sector should continue to grow, unless the Government fails to sustain and strengthen the current posture of openness and competitiveness. The projections of growth and the related external financing requirements assume that the Government implements sound macroeconomic management, especially fiscal improvements and continued economic liberalization to improve the business environment. Continued improvements of the tax, trade and foreign investment regimes and of domestic competition will be key. ix. In the absence of any serious policy reversals, more efficient investment and strong export growth, led by manufactures and not swamped by import surges, will lead the economy to sustained annual GNP growth above 5 percent. The growth path projected for 1994-97 will create sizable external financing requirements. While foreign investment will contribute to flows, aid commitments and disbursements at least as generous as in the recent past will be needed to finance this path. For 1994, some exceptional financing is likely necessary to cover the greater than $600 million remaining gap that has been projected without any 1994 Paris Club rescheduling. For 1995-97, annual new commitments of around $2.5 billion may be needed, of which around 20 percent should be fast disbursing on average.   I. RECENT MACROECONOMIC DEVELOPMENTS Overall Growth Performance 1.1 From the 1950s through the 1970s the Philippines sustained economic growth rates consistently above 5 percent per annum. However, growth was always fragile, and periods of rapid growth were generally brought to a halt by foreign exchange crises. This pattern of relatively moderate cyclical movements was broken by an episode of unprecedented severity in the mid-1980s in the wake of the international debt crisis. The harshness of the collapse of income in these years, and therefore the amount of ground that needed to be made up, is clear from Figure 1. The structural reforms of the 1980s and 1990s--most importantly, trade and foreign investment liberalization and reform of the financial sector and the tax system--have succeeded in reducing the risk of balance of payments emergencies; but a new obstacle to growth emerged by the mid-1980s. Public finance pressures became severe as a result of the twin burdens of servicing massive foreign debt held or guranteed by the public sector and financing fiscal expenditures from domestic sources alone. In recent years, the impact of tax reform, privatization, and effective debt management have begun to improve the fiscal situation; and after three years of frustration, 1993 registered modest recovery of real income growth. Still, sustaining the hard-won advances in revenue generation and economic liberalization over the medium term remains the primary challenge to attaining a higher growth path.' Fig.1: Real Income Growth (1950-93) chanwg contnt price GNP) 15 10 ......... - - - - - - ...................... 5. ..... 0 -10I 505254565860624 66687072747878808284808890 93 Sourso: Nado Inoon. Aeoounts, Ndonal IaUtca Coordzwton Bowd. For detailed analysis of the long-term performance of the Philippine economy, see World Bank, The Philippines: An Opening for Sustained Growth, Report No. 11061-PH, April 1, 1993.  - 2- 1.2 Intensified structural reform since 1986 had, by 1989, eliminated most price distortions and improved resource allocation. As a result, the Philippines had been expected to continue the robust growth of 1986-89 through the early 19909. Instead the economy experienced a ragged start to the decade. Economic performance deteriorated in 1989, triggered by worsening terms of trade, an increase in international interest rates, and high import growth that outpaced exports. Policy response to these developments was delayed: the Government did not let the exchange rate depreciate for fear of jeopardizing the fiscal balance (through the impact on external debt servicing) nor did it adjust domestic oil prices to fully reflect international prices for fear of political repercussions. Stabilization remained out of reach through 1989 and 1990, partly because of continued political unrest and a series of natural disasters but primarily because of swings in Government macroeconomic policies. Starting in 1991, however, the Government managed to squeeze the National Government deficit--from 3.4 percent of GNP in 1990 to 1.2 percent in 1992 while CPI inflation fell from 18.7 percent in 1991 to an average 7.6 percent during 1993 (see Table 1.1). But the cost of sustained fiscal and monetary tightening, together with growing shortages of power, was the continued stagnation of economic activity--GNP expanded by only 0.4 percent in 1991 and 1.0 percent in 1992. As a result, real per capita incomes were lower in 1993 than they had been in 1977. Table 1.1: Macroeconomic Indicators (1970-93) 1970-80 1981-85 1986-89 1990-92 1993 (percent) Real GNP growth 5.8 -1.7 5.6 2.2 2.4 Real GDP growth 5.7 -1.1 5.2 0.9 2.0 Inflation (% change in CPI) 14.5 18.2 5.9 13.9 7.6 Export growthb 11.3 -2.0 12.2 3.6 9.0 (as percent of GNP) Current account deficit -2.7 -5.4 -0.7 -3.4 -5.9 National government deficit n.a. -2.9 -3.1 -2.2 -1.4 Gross domestic invcstment 27.3 24.8 18.7 21.4 23.5 National savings 25.9 20.6 18.0 18.0 17.7 a. 1973-80. b. Expots of goods cad non-factor ervices in consant pesos. Source: National Statistical Coordination Board; Bangko Sentral ng Pilipinas; World Bank suff ertinates. 1.3 Macroeconomic management remained a challenge through 1992 and 1993. Liberalization of foreign exchange transactions in 1992 led to a surge of inflows of foreign resources attracted by high domestic interest rates and improved political and policy stability. These inflows led to an appreciation of the peso, hurting the export industry and growth. Despite these difficulties, the impact of accumulated policy reform was starting to be realized towards the end of 1992. A Brady-type commercial bank debt restructuring was successfully completed in December 1992, significantly reducing the Philippines' external debt burden, and allowing a return to voluntary borrowing in the international capital markets in 1993. Furthermore, in March 1993, the Philippines successfully  - 3 - completed an IMF Standby Arrangement. However, two factors dampened investment and growth--electricity shortages and uncertainty about revenue mobilization sufficient to finance much-needed infrastructure inveztment lingered through most of 1993. It was not until a1r,:_t the end of 1993 that the government and the private sector's concerted efforts to augment power generation capacity finally alleviated the electricity supply problem, while it has only been in the first quarter of 1994 that the Government has put in place measures to enhance revenue generation that substantially reduce the risk that future fiscal gaps may jeopardize sustained growth. 1.4 Performance in 1993. The economy gained strength through 1993. The depreciation of the exchange rate since August 1992 and the alleviation of electricity shortages by end-1993 nourished modest output (GDP) growth of 2.0 percent last year which, when supplemented by inflows of remittances, yielded overall GNP growth of 2.4 percent. This modest pickup in output in 1993 after several years of stagnation intensified demand pressures in the second half of the year. Inflation worsened slightly, to end the year at 8.4 percent (December 1992 to December 1993 rate). Interest rates also increased, and the 91-day Treasury bill rate, which had dipped below 10 percent in June 1993, rose above 16 percent by December. Over the same period, the current account deficit widened sharply, from less than 2 percent of GNP in 1992 to almost 6 percent of GNP in 1993. Concern about the steadiness of macroeconomic policy was reignited, especially because of the extended and continuing struggle to fill the fiscal gap, spurring the Government to tighten monetary policy, improve prospects for revenues, and conclude negotiations on a new program with the IMF. 1.5 Growth in 1993 was driven by higher fixed capital formation, at 23.5 percent of GNP, which contributed to strong expansion of the construction sector, and export growth of 9 percent in volume terms. As power shortages finally abated, manufacturing output began to increase late in the year, but only enough to fuel growth of less than 1 percent in the sector (see Table 1.2). Manufacturing was led by transport equipment, chemicals, non-metallic mineral products, wood products, and footwear and wearing apparel, and driven generally by robust expansion of export production. However, the food and beverages subsector, constituting almost half of all manufacturing, responded only slowly to the improving power situation, posting a 2 percent contraction for the year. Construction expanded strongly, reflecting the rush of investments in power generation and in telecommunications, as new entrants to the sector provided additional telephone lines and cellular services. Agriculture, which had performed strongly in the first half of the year (compared to the drought conditions of 1992), suffered setbacks to finish the year with 2.0 percent growth. Its growth was moderated by a contraction in output of corn, coconut, and bananas in the third quarter driven by the prolonged dry season, although livestock and poultry posted a 5.6 percent gain for the year.  -4- Table 1.2: Real Output Growth (1986-93) (percent) 1986-89 1990 1991 1992 1993 GDP 5.2 2.7 -0.2 0.3 2.0 Agriculturc 3.3 0.5 1.4 0.4 2.0 Industry 5.6 2.5 -2.6 -0.5 1.8 Mining & Quarrying -0.9 -2.6 -2.9 6.7 0.7 Manufacturing 5.7 2.7 -0.4 -1.7 0.7 Construction 8.5 5.0 -15.7 2.8 6.7 Services 5.9 4.0 1.0 1.0 2.1 a. 1986 not available. Source: National Income Accounts, National Statistical Coordination Board. 1.6 A determining factor in the Philippines' recent economic performance has been the electricity situation, which has affected output, employment, investment, exports, and government revenues. Electricity shortages began in 1990 and worsened through 1992 and the first semester of 1993. Record droughts in Mindanao which devastated hydropower production compounded the shortage of generating capacity resulting from delayed construction of new plants and the mothballing of the 605 megawatt (MW) Bataan nuclear plant. The impact on output was most severe in the first quarter of 1993 because the brunt of shortages in that year were borne by Luzon, which produces 65 percent of national output, while Mindanao was hardest hit in 1992. During January to March 1993, brown-outs in Luzon averaged six to nine hours as compared to an average one hour during the same period of 1992. (See Figure 2.) The adverse effect on 1993 output has been roughly estimated at around 1.5 percent of GNP.2 2 World Bank staff have estimated output losses at around 1.5 percent of GNP. The National Economic Development Agency (NEDA) calculated a similar magnitude of 1.3 to 1.6 percent of GNP, while the Philippine business community had higher estimates of 1.8 to 2.4 percent of GNP.  - 5 - Fig. 2: Power Shortages In Luzon, (1 992-93) (average daily hours of brownout each month) 10 4 .......... ... .. //..... .. ....... 2 --....--..........-..--........-. -. -. 0 JFMAMJJASONDJFMAMJJASOND Sourme: Nalondl Power Copoxdon, PtNllppk*s 1.7 To address the crisis, the Government brought the private sector into a "fast-track" power generation program. Using Build-Operate-Transfer (BOT) and related innovative financing arrangements, the Philippines, a pioneer in this area, has so far signed 26 agreements with the private sector for the construction, financing, operation, and management of power plants, involving a total capacity of 3660 MW, compared to total existing generating capacity of around 6,800 MW. This program has had the intended effects, with new private generating capacity of 1300 MW operational by the end of 1993. With a reported reserve level of about 100 MW, the National Power Corporation (NPC) announced the power crisis officially over in January 1994. Nevertheless, reserve capacity still remains low: NPC estimates that over the next 5 years, generating capacity will need to double to avert a recurrence of the power crisis. Investment and Savinos 1.8 Gross domestic investment levels in the Philippines have been steadily improving. Despite electricity shortages, 1993 registered total investment of almost 24 percent of GNP, as compared with the average level of 19 percent during the 1986-89 boom. Investment has not yet regained the high average 27 percent of GNP of the 1970s, but its modest upward trajectory for the last two years has been fostered equally by gains in public and private investment. Public  investment in 1993 attained a level of 6.0 percent of GNP while private investment equalled 17.5 percent of GNP (see Table 1.3). Table 1.3: Investment and Savings (1988-93) (as percent of GNP) 1988 1989 1990 1991 1992 1993 Gross investment 19.0 22.4 24.7 19.9 20.8 23.5 Public 3.2 4.1 5.4 4.8 5.5 6.0 Private 15.8 18.3 19.3 15.1 15.3 17.5 National savings 18.0 18.9 18.6 17.7 19.0 17.6 Public 0.5 0.9 1.1 4.1 4.3 3.9 Private 17.5 18.0 17.5 13.6 14.7 13.7 Foreign vingsb 1.0 3.5 6.1 2.2 1.8 5.9 Public uving-investment gap 2.7 3.2 4.3 0.8 1.2 2.1 of which: National Govt. deficit 2.9 2.1 3.4 2.1 1.2 1.4 Private sving-investment gap -1.7 0.3 1.8 -1.5 0.6 3.8 a. Investment nd savis adjusted from National Income Accounts. Non-monitored corportions are excluded from the public ector, investment in the Comprehensive Agarian Reform Progrm is excluded from public invesment. Private shares are calculated as reiduals. b. Foreign savings equal the curmnt account deficit. Sown.: National Economic and Development Authority. 1.9 Public investment, which has been edging up for the last five years, has been primarily driven by government efforts to leave more room in the budget for capital expenditures. Having been pumped up to unprecedented levels by the government through the 1970s, public investment collapsed when the private external flows with which they had been financed evaporated after 1983. Since 1989, the government has struggled to increase funding for public investment, with some success. The expansion of public investment in 1993 emanated from higher capital spending by government corporations (particularly by NPC whose capital expenditures increased from 0.7 percent of GNP in 1991 to 2 percent of GNP in 1993 as it responded to electricity shortages). Since public savings fell slightly in 1993, higher public investment enlarged the public savings-investment gap to 2.1 percent of GNP, matched by sharply higher foreign financing. 1.10 Private investment has been on the rise for the last two years and expanded to 17.5 percent of GNP in 1993. The expansion was led by power sector investments in the form of BOT arrangements with the government, which are estimated to have amounted to more than 1 percent of GNP last year. While private investment outside the power sector has not yet picked up appreciably, it is expected that new private investment will create greater expansion of output than in the past, in response to the more competitive and open environment fostered by structural reforms--the incremental capital output ratio is expected  to decline to more normal levels from its unusually high past levels, often exceeding 10. The behavior of private investment, which has generally claimed around three-quarters of total investment spending, has in recent years been primarily a reflection of the confidence of the business community in policy Btability. For example, private fixed capital formation was discouraged until last year by high real interest rates, driven partly by large public sector deficits and the resulting uncertainty about future policy direction. Higher volatility of interest rates, inflation, and the exchange rate since the early 1980s has also likely dampened investment. Foreign investment3 has been depressed by political as well as macroeconomic instability, and so has not yet contributed a large share of private investment in the Philippines, in stark contrast to other ASEAN countries. These negative influences are recently on the wane, and investor confidence is slowly strengthening. 1.11 National savings continues to be low at 18-19 percent of GNP in 1991- 93, as compared to its ASEAN neighbors and as compared to its own past performance (e.g., 26 percent of GNP on average in the 1970s). Even though gross national savings have been augmented in recent years by increased flows from abroad of worker remittances and transfers, it was solely larger foreign savings that financed expanded investment last year. It should be noted, however, that the distinction between foreign and domestic savings is now somewhat blurred because of the degree of openness of the capital account, with some substantive part of foreign savings consisting of return capital flight. Moreover, while national savings needs to be increased significantly over the medium term, the recent high level of foreign savings is not the suspect phenomenon it was in the late 1970s, when large current account deficits were matched by government borrowing on international capital markets and the funds were used to finance an ambitious but inefficient public investment program. Instead, about 40 percent of foreign savings in 1990-93 consists of direct and portfolio investment, much of which could be considered reverse capital flight, especially by overseas Filipinos, and a sign of improved private sector confidence. The Labor Market. the Exchange Rate. and Comvetitiveness 1.12 Emvloqment Performance. In 1992, the labor market began to recover from the impact of economic recession and natural disasters of the preceding two years. Unemployment, at 10.6 percent in 1991, was on a downward trend by the second quarter of 1992. Despite the severe power shortages in 1993 which weakened the recovery of employment, unemployment continued to decline to 9.4 percent of the labor force (see Table 1.4). Employment growth was led by the informal services sector, as workers were pushed into self-employment, and by agriculture, which was recovering from drought. Job expansion in the industrial sector, which had been strong through 1991 and 1992, evaporated in 1993 in the wake of worsening electricity shortages. The National Economic Development Agency (NEDA) estimated power shortfalls to have affected over 40 percent of workers in the National Capital Region and over 5 percent of workers outside Metro Manila, especially those in power-intensive industrial sectors and those employed by small and medium firms less able to cope with outages. Most of the adjustment by labor has occurred as reduced work hours rather than lay-off., 3 See paras. 1.42 to 1.44 below.  nudging the underemployment rate up slightly to almost 22 percent from its already high level of near 21 percent in 1992. Table 1.4 Employment, WN ages and the Exchange Rate (1988-93) (percent, except as noted) 1988 1989 1990 1991 1992 1993 Employment Overall growth 5.8 3.3 1.4 3.2 3.4 2.9 Agriculture 1.9 -0.2 0.8 3.1 4.2 3.9 Industry 15.4 7.7 -2.3 6.1 5.3 -0.5 Manufacturing 14.8 5.9 -3.4 6.2 6.3 -2.6 Construction 18.6 15.1 4.0 5.2 4.3 4.5 Services 7.1 5.7 3.7 2.1 1.7 3.2 Unemployment rate 9.6 9.1 9.4 10.5 9.8 9.3 Underemployment rate 23.5 23.2 22.4 22.5 20.5 21.7 Minimum wazesh Metro-Manila 7.2 8.6 3.7 6.6 -10.9 -8.4 Outside Metro-Manila 10.5 5.2 3.8 -9.7 -6.9 -5.4 Exchanue rte Nominal (PesosfUSS) 21.1 21.7 24.3 27.5 25.5 27.1 Real effective (index, 1980=100) 68.2 73.2 71.2 70.3 78.0 76.1 a. Percent of erployed workers wanting additional hours. b. Growth in non-rgriculture minimum wage deflated by CPI. c. Nominal rate is annual average Pesoa/USS. Real effective rate is annual averpg trade partner-weighted adjusted by CPI; increase indicates appreciation. Source: Philippines Statistical Yearbook; National Economic and Development Authority; World Bank stff esimates. 1. 13 The Philippine economy has failed over the last two decades to provide sufficient numbers of wage-paying jobs in the modern sector for its growing labor force. Sectoral shares of employment have changed only slowly, and the small *hifts that have occurred have been primarily from informal agriculture to informal urban services. Agriculture overall has gradually lost employment to the services sector, declining from almost 60 percent share of the labor force in 1970 to 49 percent in 1980 and 41 percent in 1993. However, the share of labor employed in manufacturing, where labor productivity is five times the level in agriculture and three times that in services, has hovered at 10-12 percent for thirty years (see Table 1.5). Without sufficient absorption into high productivity areas, incomes have been relatively stagnant, and the growing population has created an elastic supply of unskilled labor in agriculture and services and encouraged workers to look overseas for employment. Overseas contract workers have constituted a fairly steady 2 percent of the labor force since 1985.  - 9 - Table 1.5: Structure of the Labor Force in 1980 and 1993 1980 1993 Labor force (thousands) 17,308 26,879 As % of labor force: Employed 95.0 90.7 Agriculture 48.8 41.4 Industry 14.5 14.2 Manufacturing 10.5 9.1 Construction 3.4 4.1 Services 31.7 35.1 Unemployed 5.0 9.3 Memo item: Overseas contract workers (thousands) 214.6 686.5a (as % of labor force) 1.2 2.6 a. 1992. Source: Philippine Statistical Yearbook; Labor Force Survey, National Statistical Office. 1.14 Wages. Between 1988 and 1991, unskilled industrial wages were pushed upwards by increases in the legislated minimum wage, which was set at roughly double the average rural wage in the Philippines and above minimum wage levels in Thailand, Indonesia, and Malaysia. Although compliance is far from universal, employment expansion suffered in the modern industrial sector, in bigger companies and in foreign owned firms, where payment of the minimum wage is more likely to be enforced. After rising strongly in real terms through 1991, the real value of daily minimum wage rates declined through 1993 as minimum wage rates were on average held more or less constant (see Table 1.4). Despite much political attention to the erosion of the minimum wage, the Administration resisted pressure to legislate minimum wage increases and continued to support the existing regionalized wage setting mechanism. However, in response to persistent political demands, the regional boards, in charge of wage setting since 1990, granted increases in December 1993 that varied by region and by industry but roughly averaged 13 percent in nominal terms overall and 16 percent for Metro Manila. While insufficient to make up for the erosion in real value since 1991, these wage increases do discourage foreign investors from labor intensive production in the Philippines--the minimum wage has risen by over 13 percent in dollar terms since 1991 for the country as a whole and by almost 18 percent in dollar terms for Metro Manila. 1.15 Exchange Rate Movements and Competitiveness. Aggressive minimum wage policy in the late 1980s which was not countered by real exchange rate depreciation has left the country with relatively high costs for unskilled labor, compounded by low productivity compared to the rest of the region. The nominal peso-dollar exchange rate appreciated 7 percent from end-1991 to August 1992,  - 10 - prodded upwards by large portfolio investment inflows, but then fell by 12 percent during 1993, spurred by increased import demand and non-trade payments and lower interest rates on peso-denominated assets, as shown in Table 1.4. Nevertheless, Figure 3 illustrates the modest appreciation of the real effective exchange rate that has been accumulating since 1988, undermining the price competitiveness of Philippine exports, especially in comparison to the real depreciation over the same years experienced by Malaysia, Indonesia, and China. Stability of nominal wages through 1990 and 1991 (determined by the minimum wage) at least prevented further deterioration in competitiveness of the unskilled wage, but the situation worsened again with the minimum wage increases of 1993. While the Government should be aiming to link wage setting to labor productivity, maintaining the current decentralized determination of the minimum wage is a reasonable compromise that tends to diffuse pressures to increase real wage levels by mandate. Fig. 3: Rea Effective Exchange Rate (1979-93) /a 120 . , .................................................................... 1 0 0 ..... ................................... 70 .:...... eo- 79 80 81 82 83 84 85 88 87 88 89 90 91 92 93 .1 IuM-IMo hainaa kndodh wmdaIon REI in bede-alnar wu.dd &Wa a4ua*d by CPL @oum: tsInd Flnwc SWON, IRAF 1.16 An additional issue affecting the prospects for Philippine industry and the attractiveness of the country to foreign investors is that even for skilled labor, a factor for which the Philippines had long enjoyed a comparative advantage, the country is losing its cost competitiveness. Labor costs in 1992 for unskilled workers, for managers, and for engineers in the Philippines  - 11 - averaged below those in Malaysia and Thailand but above those in Indonesia, China, and Viet Nam.4 A rough indicator of overpriced industrial labor is that the manufacturing wage to GDP per capita, a ratio which captures whether returns to labor in manufacturing are excessive compared to opportunities elsewhere in the economy, is quite high in the Philippines--all the successful exporters in East Asia had ratios close to 1.5 in the late 1980s while the Philippines' ratio was 2.7 in 1988. Thus, some modest real depreciation would improve cost competitiveness. Fiscal and Monetary Developments 1.17 Macroeconomic management, while accumulating successes since the consolidated public sector deficit peaked at 4.9 percent of GNP in 1990, remains a delicate balancing act in the Philippines. A high level of foreign borrowing and poor management of public expenditure in the late 1970s left a costly legacy of public external debt. AB in many other highly indebted countries, heavy external debt was transformed into sizable domestic debt in the years after the international debt crisis, as domestic borrowing filled a fiscal gap worsened by external debt servicing; insufficient fiscal adjustment forced monetary policy to center stage in the ensuing attempts at stabilization. The burden of debt service, both foreign and domestic, on public finances continues to be heavy, and the vulnerability of fiscal balances to interest rate and exchange rate shocks has been only partly mitigated by recent rescheduling of external debt and Improved fiscal management. The sizable demands of infrastructure investment on expenditure levels and the management of large capital flows in a liberalized foreign exchange environment continue to challenge policymakers. With some additional strengthening of revenue generation and expenditure management, the fiscal constraint to growth may finally be relaxed.5 1.18 Fiscal Revenues. The Philippines has improved its revenue performance over the last few years, showing a steady rise in the ratio of tax revenues to GNP from 11.4 percent in 1988 to 15.3 percent in 1993. This achievement has gone a long way to bringing the country's tax effort more into line with its ASEAN neighbors' but further progress is necessary to cover the Philippines' unusually high debt servicing and its substantial need for infrastructure investment compared to its neighbors. In 1993-94, numerous new revenue measures, both legislative and administrative, have finally brightened the fiscal picture, as 4 See Osamu Kawaguchi, Foreign Direct Investment in East Asia: Trends. Determinants, and Policy Implications, Internal Discussion Paper Report No. IDP- 139, East Asia and Pacific Regional Series, World Bank, April 1994. S For further analysis of the fiscal situation, see World Bank, The Philippines Country Economic Report: Public Resource Mobilization and Expenditure Manacement, Report No.10056-PH, February 20, 1992. 6 On average for 1977-88, the Philippines collected the least tax revenue as a share of GNP of any ASEAN country, obtaining only 11 percent of GNP in tax revenues while other ASEAN countries ranged from Thailand at 14 percent to Malaysia at 22 percent.  - 12 - detailed in Chapter II although further follow-through is needed to guarantee public finances over the medium term. 1.19 Historically, the bulk of tax revenues have come from indirect taxes, accounting for about two-thirds of total tax revenues: the key contributors have been import duties, license and business taxes (including VAT since its inception in 1988), and excise taxes, each accounting for about one-fifth of tax revenues. Direct taxes have raised only about one-third of revenues,' performing far below potential because of low collection rates. Categorized differently, about two- thirds of taxes arises from domestic taxes and one-third from international trade taxation. Lastly, non-tax revenues have contributed another 2-3 percent of GNP to total revenues, of which privatization has been an additional modest resource for the National Government in recent years, yielding P1.9 billion in 1992 and P1.7 billion in 1993. For 1994, privatization sales are expected to yield much larger income--of at least P25 billion for the National Government (or around 1.5 percent of projected GNP). Importantly, rather than treating these receipts as revenue, the Government is applying much of them to amortization of domestic debt, as is appropriate for asset sales. 1.20 The tax structure has been changing only slowly since the tax reforms of 1986-88. Import duties are declining in importance, having provided over one- quarter of taxes at the beginning of the 1980s, as other taxes gain importance and as trade liberalization reduces the average duty rate. Much of the Improvement in tax effort, however, has originated from distortionary financial taxes (such as the Gross Receipts Tax on financial intermediaries and other documentary taxes on financial transactions), which have grown to almost 10 percent of taxes from a negligible level in 1986 and from taxes for which the tax base has expanded rapidly in recent years, such as imports and interest income. Various administrative reforms and the recent move towards computerization of the Bureau of Customs and the Bureau of Internal Revenue are expected to improve collections of income tax and VAT especially, which will allow movement away from distortionary taxes. 1.21 Revenue collections in 1993, at 17.3 percent of GNP, slightly down from the preceding two years, were dampened by the abolition of the special import levy in 1992 and by diminished loan repayments from government-owned-and- controlled corporations (GOCCs). The Government pursued its revenue targets through an accelerated privatization program, a new law increasing cigarette taxation, increases in other taxes, and further administrative improvements. To fill the fiscal gap for 1994 and beyond, the Energy Conservation and Environmental levy of P1 per liter of imported oil was implemented in August, and the payments to the National Government began out of the surplus in the Oil Price Stabilization Fund (OPSF). Given the large accumulated surplus in the OPSF, funds were not exhausted until end-year despite the flow deficit. The Government then increased retail petroleum product prices, in February 1994, by an average 15 percent (but as much as 100 percent for some products), but widespread political protests persuaded the Government to roll back the retail price increases and withdraw the special levy. The estimated PIO billion of annual 7 Of which individual and corporate income taxes constitute another fifth of total tax revenues.  - 13 - revenues lost have now been replaced by alternative measures put into place in 1993-94, as discussed in Chapter II below, which place the country closer to its goal of continuing to increase revenues by around 0.5 percent of GNP each year. 1.22 Fiscal Expenditures and Deficit. The National Government has cut its deficit by more than half since 1990, from 3.4 percent of GNP to 1.4 percent, with the adjustment falling on current expenditures. Savings in domestic interest payments generated by a steady decline in interest rates and continued compression of operations and maintenance expenditures were only somewhat offset by an expansion equal to almost 1 percent of GNP in allotments of revenue to local government units, as shown in Table 1.6. The structure of fiscal expenditures remains quite inflexible, with debt service still absorbing almost 30 percent of National Government expenditure (compared to closer to 5 percent of expenditure in 1980); three-quarters of interest payments are on domestic debt. Salaries and wages claim close to another 30 percent, leaving public investment by the National Government with only a one-sixth share of the budget (or about 3 percent of GNP). Transfers of more revenue to local governments in 1993, amounting to almost 10 percent of total expenditure--a pattern which is to continue into the future as decentralization is fully implemented--add to inflexibility. With the investment and operations and maintenance budgets in need of expansion to foster private sector growth, further expenditure cuts must likely look to reduction of the wage bill (through streamlining of the civil service) and declines in domestic interest payments (through reduced fiscal deficit levels, and, in the short run, careful monetary management that minimizes the risk premium component of domestic interest rates).  - 14 - Table 1.6: National Goverrunent Cash Budget (1990-93) 1990 1991 1992 199? As % of GNP Revenues 16.8 17.5 17.6 17.3 Tax Revenues 14.1 14.4 15.1 15.3 Bureau of Intemal Rcvenue 9.6 9.2 9.7 9.7 Bureau of Customs 4.3 5.1 5.3 5.4 Non-TaJx Revenues 2.7 3.1 2.5 2.0 Asset Sales & Privatizationb 0.3 0.3 0.4 0.2 Expenditures & Net Lendine 20.2 19.6 18.8 18.7 Currcnt Operting Expenditures 16.5 15.6 15.6 14.9 Personnel Services 5.8 5.7 5.4 5.3 Maintenance and Operations 2.8 2.9 2.4 1.9 Interest Payments 6.6 5.9 5.8 5.2 Foreign 1.7 1.5 1.2 1.4 Domestic 4.9 4.5 4.6 3.8 Othee 1.3 1.0 2.1 2.5 Capital Expenditures 2.9 3.2 3.6 3.2 Equity and Net Lending' 0.8 0.8 -0.4 0.7 Deficit (-) -3.4 -2.1 -1.2 -1.4 In billion pesoS Ftmancing Deficit 37.2 26.3 16.0 20.6 Net External Financing 4.1 6.9 14.4 11.2 Gross External Financing 24.4 23.1 34.1 36.8 Less: Amortization 20.3 16.2 19.7 25.6 Net Domestic Financing 33.1 19.4 1.6 9.4 GNP (billions of pesos) 1,078.4 1,262.5 1,377.9 1,501.2 a. Prelirninary. b. In 1992, P10.4 bilion of privetizstion proceeds is included as negative lending rather than as revenue. c. Icludes subsidies, tax expenditures, allotments to local govermnents and transfers to the Oil Price Stabilization Fund. d. Includes outlays for Comprehensive Agarian Reforn Program land acquisition and credit; for 1992, P10.4 billion of privatization proceeds included as negstive net lending. Source: Department of Budget and Managernent.  - 15 - 1.23 Movements in the deficit of the consolidated public sector, reduced by one-third since 1990, have been determined not only by National Government balances but also importantly by three other sources of imbalance: (i) losses by the Central Bank, until its restructuring in 1993; (ii) deficits in the oil Price Stabilization Fund, a problem now on its way to resolution; and (iii) the financial situation of the GOCC9, an ongoing issue (see Table 1.7). Table 1.7: Consolidated Public Sector Deficit (1986-93) (as % of GNP) 1986 1987 1988 1989 1990 1991 1992 1993 Public sector deficit -5.91 -1.8 -3.3 -3.8 -4.9 -2.0 -1.9 -2.7 Non-financial public sector deficit -4.3 -1.3 -2.1 -2.8 -4.2 -1.3 -1.5 -2.9 National governmnent -5.2 -2.5 -2.9 -2.1 -3.4 -2.1 -1.2 -1.4 Monitored nonfinancial corporations -1.1 0.0 0.4 -0.3 -1.8 -0.6 -0.8 -1.8 Oil Price Stabiization Fund 0.0 0.0 0.0 -0.9 -0.1 0.8 0.4 -0.5 Adjustmnents for intra-govemment transfers 2.1 1.1 0.5 0.6 1.2 0.6 0.1 0.8 Centml Bank income -3.1 -1.6 -2.1 -2.3 -2.0 -1.7 -1.6 -1.1 Governmnent financial institutions -2.1 0.1 0.2 0.3 0.3 0.2 0.3 0.4 Adjustments and other' 3.5 0.9 0.7 0.9 1.0 0.8 0.9 0.9 a. Includes ocial security institution surpluses, local government surpluses, and intr-public sctor tansfen. Sowre: Departmenl of Fnance. 1.24 Losses of the Central Bank, averaging about 2.3 percent of GNP since 1983, have been an important element in the overall public sector deficit. The servicing of considerable foreign exchange liabilities assumed from government financial institutions in the wake of the debt crisis created large and growing deficits for the Central Bank. These deficits both depleted the revenues of the National Government which had to cover the losses and limited monetary policy options. The financial restructuring of the Central Bank in 1993 (discussed in Chapter II) greatly benefitted monetary management through augmentation of its financial strength and independence. 1.25 The OPSF has at times been a major drain on fiscal revenues, for example, in 1989 when its deficit exceeded PS billion. The Fund was intended to smooth adjustment to changes in world oil prices. Since it has proved quite difficult politically to raise oil prices, it has tended to run excessive deficits as world oil prices rise. This potential drain on public sector coffers is being stemmed by ongoing energy pricing reforms (described in Chapter II) geared to depoliticize pricing by putting in place automatic oil price adjustments which will restrict the accumulated gains or losses of the OPSF to levels that will not have macroeconomic impact.  - 16 - 1.26 The consolidated deficit has also been affected by the spending patterns of the GOCcs, dominated by NPC. Despite large transfers from the Nationai Government and high power tariffs, NPC has run large deficits of as much as 1.5 percent of GNP in recent years. A spurt of capital spending in 1993 to add new capacity and relieve the power crisis was the main contributor to the widened GoCC deficit. continued high investment levels by NPC for the next few years will continue to contribute to the consolidated public sector deficit although internal cash generation should cover more of NPC outlays than in the past. 1.27 With public funds scarce into the foreseeable future, and with investment needs in power generation alone estimated at $1.3 to S2.0 billion per year, the Government has turned to innovative arrangements with the private sector to finance infrastructure needs. The Philippines has been a pioneer in Private sector participation in power generation, already contracting through Build, Operate and Transfer; Build, Transfer, and Operate; and other schemes for investments that will almost double existing generation capacity. Financing arrangements of these sorts are being pursued now in other infrastructure areas, with great potential to relieve some of the pressure on public investment. 1.28 For the investment expenditures that remain with the public sector, a fundamental ongoing issue is the timeliness of proiect implementation. The Government planned to frontload its investment spending for 1993, in what it termed its "pump-priming program," so that public investment could have maximal impact on demand and encourage an earlier economic recovery. Capital expenditures of P50 billion by the National Government and P77 billion for GOCCs were identified. As it turned out, actual capital expenditures, at P96 billion, fell below the original programmed level of P127 billion, although public investment still expanded from 5.5 to 6.0 percent of GNP from 1992 to 1993. The Government has assessed that implementation problems arose from a number of sources: slow releases of advice of allotment and of notice of cash allocation, problems with bidding procedures, poor performance by contractors, right-of-way difficulties, and the presence of squatters on some project sites. The Governemnt is exerting efforts to resolve these problems. 1.29 Given the experience with "pump-priming" during 1993, a Core Public Investment Program (CPIP) for 1994 has been approved by the NEDA Board to assure adequate and timely funding for priority public investment projects. The CPIP lists projects in power generation and transmission, water supply, basic education, housing, social services, disaster mitigation, and irrigation that will be protected from any budget cuts that may become necessary during the fiscal year. It will cover around two-thirds of the capital outlays planned by the National Government; and for these projects, 60 percent of budgetary requirements are to be released in the first half of 1994. 1.30 Monetary Management. The volatility of inflation has reemerged as an issue in macroeconomic management since 1991. Expanded fiscal deficits in 1989- 90, peso depreciation in 1990 and 1992-93, and minimum wage increases in 1991 and 1993 have aggravated inflation. Monetary management of these events has been complicated by foreign exchange liberalization and the return of substantial flight capital since 1991. International reserves have mounted, and sterilization of these inflows has increased domestic interest rates, attracting  - 17 - further portfolio investment. As has been true since 1983, in the absence of sufficient fiscal adjustment, monetary policy has had -^ czmpensate by being more restrictive, which tends to drive up interest r-tes and F-preciate the exchange rate. 1.31 The Government hoped to spur long-awaited growth in 1993 by "pump priming" or front-loading public investment, as discussed above. Monetary policy was also expansionary, as the authorities lowered the amount of Treasury bills auctioned to increase liquidity in the economy. This measure, taken early in 1993, immediately lowered interest rates and initially tended to reduce the Government deficit, increase credit to the private sector, and reduce the pressure on the peso to appreciate. Between April and June, the T-bill rate fell by 1.5 percentage points to 10 percent, the lowest level for a decade. However, by increasing broad money growth to an annual average of 25 percent (as compared with an average of 15 percent during the previous three years) (Table 1.8), this policy also raised inflationary expectations. Increased uncertainty about macroeconomic policy caused the movement of interest rates to reverse course; and the peso suffered a speculative attack at end-September during which it lost about 7 percent of its value in a few days. To reassert stability, the Government took several measures to reduce liquidity in the economy, including increasing the auction of T-bills and imposing 10 percent reserve requirements on common trust funds (off-balance sheet items of commercial banks). Gross international reserves grew modestly through 1993, from $5.2 billion to $5.8 billion, representing 3 months of imports and sufficient funds for the central bank to calm the foreign exchange market, if necessary. Table 1.8: Monetary Indicators (1986-93) (percent, except as noted) 1986-89 1990 1991 1992 1993 Broad money growth 19.0 18.4 15.5 11.0 24.6 Inflation (% change in CPI) 6.4 14.2 18.7 8.9 7.6 Treasury-bill rate (91-day) 15.2 23.7 21.5 16.0 12.4 Commercial lending rate 16.5 24.1 23.1 19.5 14.7 Gross ofricial rcserves (S million) 2,200 1,993 4,470 5,218 5,801 (mos. of imports of goods & services) 2.5 1.5 3.3 3.3 3.0 a. End-of-period M,. Source: International Financial Statistics, IMF; Bangko Sentral ng Pilipinras. 1.32 Since 1991, when prices rose by 18.7 percent, consumer price inflation has moderated. The year 1992 saw increases of only 8.9 percent, squeezed further to 7.6 percent overall for 1993. Monthly inflation in 1993 followed a downtrend  - 18 - until June, when it hit an historic low of 6.6 percent (12 month rate), aided by slack domestic demand. Inflation edged up through the second half of the year, aggravated by the 18-centavo per kwh increase in rNPC's electricity tariffs implemented in May 1993 and boosted by higher food prices from July through Ncve.bcr. An increase in the minimum wage at the end of 1993 also added to inflationary pressures at the start of 1994. Overall, the rising domestic liquidity discussed above allowed inflation to accelerate through the second half of 1993, ending the year at 8.4 percent and rising to 10.5 percent in February 1994. However, the tightening measures put in place and the projected tight fiscal stance for 1994 are expected to reduce inflation to 8 percent by the end of the year. 1.33 Despite the pressures nudging interest rates upwards again over the last year or so, real ex post returns on Treasury bills fell from 6.5 percent in 1992 to 4.5 percent in 1993, having exceeded 8 percent during 1986-90. Underlying this improvement has been the steady reduction in public sector borrowing and increasing private sector confidence in macroeconomic stability which has reduced the risk premium while a more stable exchange rate has reduced the depreciation premium demanded by investors. Commercial lending rates also became more favorable for borrowers, who had paid over 9 percent in real terms during 1986-90 and in 1992; rates dipped below 7 percent in real terms for all 1993 (based on an average nominal rate of 15 percent). 1.34 The closely intertwined behavior of money, inflation, interest rates, and the exchange rate in 1993 reflects the increased complexity of monetary management in the Philippines. With liberalized interest rates and foreign exchange transactions, the stance of monetary policy is closely and explicitly linked to the levels of interest and exchange rates: influencing one largely determines the other two. Part of the impetus for restructuring of the Central Bank in 1993 (discussed in Chapter II) was to equip monetary policymakers with financial assets and independence so that they could carry out effective market oriented monetary policy that takes these interdependencies in the economy into account. The External Sector 1.35 Since the 1960. at least, periods of strong growth in the Philippines have most usually been halted by a foreign exchange crisis brought on by surging imports. High import intensity during past growth episodes was encouraged by sustained overvaluation of the exchange rate during the 1970. and tariff exemptions for imports by priority sectors. However, the combined long-term impact of the promotion of a modern export sector and the structural reforms of the 1980s and 1990s has improved the potential for sustained growth without balance of payments crises. Trade and financial sector liberalization, privatization of government-owned corporations, and most recently, the move to a market-determined exchange rate have diminished import intensity. 1.36 In 1993, the current account deteriorated dramatically, from a level of 1.8 percent of GNP for 1992 to 5.9 percent for 1993 after having improved through 1991 and 1992 (see Table 1.9). This worsening can be traced to a widening trade gap, as healthy export growth of 15.8 percent in dollar terms was outstripped by an 21.2 percent upsurge in imports. Net service receipts  - 19 - experienced a modest decline in 1993, after doubling between 1992 and 1993, driven by worker remittances, which stabilized in 1993 as lower domestic interest rates proved less attractive, and by insurance and freioht payments, which rose with imports. Net transfers also fell slightly in 1993, further worsening the current account balance. Table 1.9: Current Account Indicators (1986-93) 1986-89 1990 1991 1992 1993 Current account balance (in S million) -334 -2,695 -1,033 -999 -3,289 Current account balance (% of GNP) -0.7 -6.1 -2.2 -1.8 -5.9 Merchandise exports (in S million) 6,364 8,186 8,840 9,824 11,375 Merchandise export growth (in %)' 14.2 4.7 8.0 11.1 15.8 Traditional exportsb 4.1 -13.8 -7.3 18.0 -12.5 Non-traditional exports' 17.0 8.4 10.4 10.2 19.8 Merchandise imports (in S million) 7,590 12,206 12,052 14,519 17,597 Merchandise import growth (in %) 20.3 17.2 -1.3 20.5 21.2 Capital equipment 34.1 28.8 -5.3 36.1 39.4 Raw materials and intermediatc goods 23.2 7.8 0.7 15.6 16.2 Overseas worker remittances (growth in %)d n.a. 7.6 26.3 37.2 1.9 Interest payments (in $ million) 1,843 2,154 2,157 1,898 1,822 a. Growth of S value. b. Coconut, sugar, pineapple, and bananM products; abaca fibers; logs and lumber; copper concentmtes; and gold. c. All other exportu, including nanufactures. d. Growth in S value of personal income component of factor receipts and worker remitance component of transfen. Source: Balance of Payments, Bangko Sentrl ng Pilipinas; Teriff Commision; World Bank atff esnimates. 1.37 The current account deficit in 1993 was financed by almost $900 million in commercial borrowings from the Euromarkets and over $800 million in debt rescheduling; net foreign investment flows of around 5600 million; other borrowings; and a modest drawdown of net international reserves of the Central Bank. The caDital account records overall net foreign investment (direct and indirect) for 1993 at $599 million, 17 percent below 1992 levels (see Table 1.10). Net direct foreign investment was recorded in the balance of payments at $763 million, with large outflows dampening the strong inward surge. Portfolio inflows boomed to $2.3 billion in 1993, attracted by the bullish local stock market and rising domestic interest rates. However, portfolio investment outflows increased sharply in 1993 to $2.4 billion, creating a small net portfolio outflow as non-resident investors took profits from earlier investments and as resident investors (whose outward portfolio investments jumped by over $1  - 20 - billion) responded to relaxed rules for outward investment.' For non-residents alone, net portfolio investment inflows totalled $897 million for 1993, up from $155 million in 1992. Table 1.10: Capital Account Indicators (19S9-93) (in $ millions) 1989 1990 1991 1992 1993 Total net foreign investment 843 480 654 737 599 Net direct foreign investment 566 532 544 697 763 Inflows' 575 554 571 798 1,137 Outflows 9 22 27 101 374 Net portfolio investment 277 -52 110 40 -164 Inflows 386 152 227 566 2,257 Outflows 109 204 117 526 2,421 Net long-term disbursements& 604 1,225 1,186 812 2,202 Net short-term capital' 309 945 948 1,139 320 Increase (-) in net reservesd -300 45 -1,755 -1,689 168 Memo items Total external debt' (S billion) 28.5 30.4 32.2 32.4 35.9 (% of GNP) 67.8 68.6 70.1 60.2 64.9 Total debt servie'J (% of exports of goods & services) 30.9 29.1 23.6 29.9 19.7 a. Includes debt conversion. b. Includes implicit inflows from Paris Club and commercial bank rescheduling. c. Icludes errors and omissions and balancing item; for 1992 includes $469 million for purchase of collateral. d. Reserves of central bank only; includes net credit from IMF. . Includes private non-guaranteed debt, IMF credit, and short-term debt; from Debtor Reporting System. f 1992 debt service reflects payments connected to commercial bank debt restructuring. Soure: Balance of Payments, Bangko Sentral ng Pilipins; Debtor Reporting System, World Bank. 1.38 Imports. The removal of a temporary import surcharge in May 1992 and the demand for equipment to battle the worsening power outages stimulated imports through 1993. Import growth was dominated by arrivals of capital goods (contributing half of import growth), in particular power generating sets and aircraft (for newly privatized Philippine Airlines and others) which should be considered one-time adjustments and lumpy purchases respectively. Power 1 CB Circular 1389 (April 1993) removed the need for Central Bank approval for many such transactions.  - 21 - generator equipment and aircraft constituted 16 percent of overall imports in 1993; these categories alone equalled the total increase in imports from 1992 to 1993. Imports of raw materials and intermediate gczSs also expanded strongly (contributing another third of import growth), in anticipation of rising demand for production of electrical equipment, metal products, and chemicals. Finally, consumer good imports boomed by 28 percent but constitute only 9 percent of total imports. Thus, a good part of the trade deficit can be attributed to fixed investment and inventory restocking in preparation for a recovery of output. 1.39 Exports. Merchandise export growth in dollar terms has risen dramatically, from 4.7 percent in 1990 to 15.8 percent in 1993, led by non- traditional exports, especially manufactures. The real appreciation of the exchange rate in 1992, propped up by sterilization of large foreign exchange inflows, severely undercut the profitability of Philippine exporters and dampened growth in that year, more than countering some improvements in the policy environment for exporters (discussed in Chapter II). With a correction in the value of the peso since mid-1992 and the gradually improving power situation, exports surged in 1993, led by manufactures, sugar, and fish products. However, in the past, high export growth has been virtually matched by high imports of raw materials and intermediate goods, leaving net exports too small to provide impetus to the economy. During 1986-89, merchandise import growth exceeded merchandise export growth by over 6 percent on average. This gap has narrowed from 1992 to 1993; and the dominance of import composition and growth by capital goods improves the likelihood that imports will add to growth rather than threaten it. 1.40 The import intensity of Philippine exports has always been high, especially for its two big merchandise export earners--electronics and garments. But the cumulative impact of reforms of the past decade--trade, financial, and foreign exchange liberalization and privatization--is beginning to be felt. The average import content of electronics and garments exports, the two biggest merchandise export earners, for the period of 1977-85 was 75 percent and 60 percent respectively; this ratio has gradually diminished, to average 58 and 55 percent for the period 1986-93. Thus, it is not unrealistic to expect net exports to grow concomitantly with gross exports over the next few years.  - 22 - Fg9.4: Import Content of Exports (1977-93) 0.9 0.8 . . .. .. ... .......... ....................... ............... - Eleotronics 0.7- X .. .. ....vV..A..+Canars 0.5 77 78 79 80 81 82 83 84 85 88 87 88 89 90 91 9-2 93 Sowos: Bawi ol Payqmrro, BSP 1.41 An important addition to revenues from merchandise exports for the Philippines has always been the earnings of migrant labor. Total overseas workers' remittance' remained stable in 1993 at $2.6 billion, after surging by 37 percent in dollar terms in 1992. The 1992 jump was somewhat exceptional and resulted from greater confidence of overseas workers in the domestic banking system, following the foreign exchange liberalization of 1992, and improved mervices by Philippine banks to overseas workers. 1.42 Foreign Direct Investment. Between 1986 and 1992, the Philippines received $3.2 billion in foreign direct investment, only 5 percent of the total foreign direct investment flows to East Asia (including China). The United States was the source of 38 percent of these flows; Japan provided 26 percent; 12 percent originated in Europe; and 10 percent flowed from Hong Kong. Clearly, the Philippines needs to attract a larger share of the total investment flows to the region, since foreign direct investment is seen as the conduit for technology and managerial know-how as well as providing capital for investment. ' Including the personal income component of total factor receipts and the personal remittance and migrant transfers portions of total transfers in the balance of payments.  - 23 - 1.43 In 1993, foreign direct investment inflows surged above $1 billion, beyond the record level achieved in 1988, but net foreign direct investment (adjusted for outflows) expanded by a modest 9 percent.10 This response in 1993, following the 28 percent increase in net direct investment flows in 1992, constitutes evidence that the Government's efforts to improve the investment climate are beginning to have an impact; but so far, net investment flows remain well below what is required for growth of East Asian proportions. In particular, the lifting of restrictions on foreign ownership and simplification of bureaucratic processes set out in the Foreign Investment Act (Republic Act or RA 7042 of 1991) have not yet elicited enough of a positive response from foreign investors. NEDA attributed the somewhat disappointing net flows in 1993 to continued recession in source countries, the power crisis and other inadequate infrastructure services, and the continued perception of law and order problems. 1.44 Recent cross country analysis by the World Bank has identified the three most important longer-term determinants of foreign direct investment in East Asia to be stability and size of the domestic market, labor cost, and foreign investment policy. Improving the environment for private investment in general--through consistent macroeconomic policy, development of infrastructure and human resources, and liberalization of trade and investment regulations--was found to be far more effective than special policies focussed on attracting foreign investment. It is clear that the Philippines must continue to reinforce these areas. Surveys of Japanese investors by the World Bank and by Japan's MITI reveal that the priority policy areas for the Philippines to attract more Japanese investment are to persuade investors that political risk has diminished, that economic growth and stability will be maintained, and that improved infrastructure will contribute to the reduction of business costs." In the short term, a targeted approach such as the promotion of the Subic Bay Freeport may help to restore investor confidence. 1.45 External Debt. Total external debt of the Philippines rose from $2.3 billion at end-1970 to $17.5 billion at end-1980 and stood at $35.9 billion at end-1993 or 65 percent of GNP. High levels of foreign debt are the legacy of the government's access to easy international borrowing in the 1970s to expand its public investment program and have rendered the country and the public purse vulnerable to changes in international interest rates. Further, with most of the debt publicly guaranteed, public finances became sensitive to exchange rate movements. Initial efforts to reduce the Philippines' debt burden, which by 1986 had risen to a peak of 93 percent of GNP"2, focussed on debt service reduction 1