Philippines - Strengthening economic resiliency

Report No. 15985-PH Philippines Strengthening Economic Resiliency November 8, 1996 Country Operations Division I Country Department I East Asia and Pacific Region Docmenmt Of tha* tdBn z ''." '"'''' '',"'f"'.,' ,' ''''''' ' . .  CURRENCY EQUIVALENT Currency Unit - Peso (P) US$ = P 26.2 as of October 31, 1996 FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS BIR - Bureau of Internal Revenue BOT - Build-operate-transfer BSP - Bangko Sentral Ng Pilipinas CPI - Consumer Price Index CPSD - Consolidated Public Sector Deficit DOF - Department of Finance EDA - Export Development Act EVAT - Expanded Value-Added Tax FCDU - Foreign Currency Deposit Unit FDI - Foreign Direct Investment FRCD - Fixed Rate Certificate of Deposit GOCC - Government-Owned Corporation GOP - Government of Philippines GRT - Gross Receipts Tax IMF - International Monetary Fund LGU - Local Government Unit LIBOR - London Inter-Bank Offer Rate MWSS - Manila Metropolitan Waterworks System MBS - Mortgage Backed Securities NG - National Government NIIMFC - National Home Mortgage Finance Corporation NPC - National Power Corporation NSCB - National Statistical Coordination Board ODA - Official Development Assistance Pag-IBIG - Home Development Mutual Fund PHIC - Philippine Health Insurance Corporation SIBOR - Singapore Inter-Bank Offered Rate SMI - Secondary Mortgage Market Institution SSA - Social Security Agency UHLP - Unified Home Lending Program WB - World Bank Vice president: Nicholas Hope (Acting) Director : Javad Khalilzadeh-Shirazi Division Chief/Manager: Kyle Peters (Acting) Staff Member: Sanjay Dhar  PHILIPPINES ECONOMIC REPORT STRENGTHENING ECONOMIC RESILIENCY TABLE OF CONTENTS Pa= Executive Summary ..........................................................i I. Introduction ................................................1 II. Macroeconomic Developments: Emerging Trends and Concerns ..................................... . 3 A. Output, Employment and Prices ......................3....................................3 B. Balance of Payments ...........................................................6 C. Monetary Policy .......................................................... 10 D. Public Finance .......................................................... 12 III. Policy Challenges ........................................................... 15 A. Fiscal Policy .......................................................... 15 B. Monetary Policy, Foreign Currency Deposits and Foreign Borrowing ................... 16 C. Structural Reform ........................................................... 18 IV. Official Development Assistance Requirements . .......................................................... 21 LIST OF TABLES AND FIGURES Tables 1 Selected Economic Indicators, 1991-96 .2 2 Aggregate Demand, 1991-95 .4 3 Balance of Payments, 1991-96 .8 4 External Financing Requirements and Sources, 1994-98 .21 Figures I GDP Growth and Its Components, 1991-96 .3 2 Trade, Current Account Deficits and Worker Remittances, 1991-96 .6 3 Foreign Investment, 1991-95 .9 4 Inflation, Interest and Exchange Rates .11 5 Money and Credit, 1990-95 .11 6 Foreign Currency Intermediation Shares, 1990-95 .11 7 Public Sector Balances, 1991-95 .13 Statistical Appendix ............. 23 This report was task-managed by Sanjay Dhar. Tom Glaessner contributed. Nam Pham provided research assistance and Hedwig Abbey assisted in document processing. We gratefully acknowledge the cooperation of government officials, particularly from the Department of Finance, National Economic Development Authority and Central Bank.   PHILIPPINES: STRENGTHENING ECONOMIC RESILIENCY EXECUTIVE SUMMARY (i) Since 1994, the Philippines has witnessed a significant economic recovery, the nature of which has raised expectations that rapid growth can finally be sustained on a more regular basis. Several factors account for this optimism. A decade of structural adjustment and increasing integration with the international economy-facilitated by trade and capital account liberalization-have reduced economic distortions and fostered greater competition in the domestic economy. In contrast to previous growth episodes, the current recovery has been driven not by fiscal stimulus but by strong export growth and rising levels of private foreign investment. Reflecting the changing pattern of growth, manufactured exports now dominate export composition, while the external debt service ratio fell to below 15 percent in 1995, with a further decline expected in 1996. The increased confidence of foreign investors appears to reflect improved perceptions of political stability in addition to improved economic management. Given the long hiatus of private capital flows prior to the current expansion, the ongoing adjustment in private portfolios could be sustained for an extended period, provided the economic and political environments remain favorable. (ii) By most measures, economic performance has progressed favorably during the current recovery (Table 1 provides an overview): GNP growth has risen to 7.1 percent in the first half of 1996; inflation has fallen back into single digits; the fiscal stance remains restrained, with the consolidated public sector financial position close to balance in both 1995 and 1996; export growth has slowed sharply (from 29 percent in 1995 to 17 percent through July 1996), but this performance still compares favorably with most of the Philippines' wealthier neighbors; and the successful handling of speculative episodes during 1995 has given rise to a period of increased capital inflows in 1996, with sustained intervention by the central bank (BSP) resulting in a stable nominal exchange rate and rising foreign exchange reserves. A. Macroeconomic Policy Challenges (iii) Yet there remain two sets of macroeconomic policy challenges: (i) the sustainability of the fiscal deficit reduction; and (ii) the pace of credit expansion, which reached 55 percent in the year ending July 1996 and was accompanied by a trade deficit that grew to nearly 15 percent of GNP in the first half of 1996. Moreover, while the overall balance of payments position remains strong, the authorities need to be wary of a situation in which undue reliance is placed on surging remittances and capital inflows, particularly if it is accompanied by sustained appreciation of the real exchange rate and widening of the trade deficit. (iv) Fiscal Concerns and Policy. It is clear that there are important unmet needs within the public sector ranging from alleviating infrastructure bottlenecks, addressing pressing rural and human development needs, and improving the attractiveness of civil service employment. At the same time, there is no room for relaxing the fiscal stance-indeed fiscal tightening is more appropriate-in view of the rising trade deficit and pace of credit expansion, the still high level  -ii- of public debt, the prospect of increased costs of central bank sterilized intervention (which are incorporated into the fiscal accounts), and the significant contingent liabilities of the public sector (which are not fully incorporated). (v) Hence needed increases in government expenditures will have to be financed through higher revenues. This points to the critical need to increase tax revenue, particularly since privatization revenue is projected by the Government to decline. Consequently, it is essential to pass and effectively implement the comprehensive tax reform program that has been submitted to Congress and debated for over a year. In addition, efforts to improve tax administration and enforcement need to be intensified, and incentives designed for local authorities to adjust property assessments to realistic levels coupled with the means to enforce collection. (vi) An important additional element of fiscal sustainability is to manage and limit future claims on the budget. The Philippines has been at the forefront of efforts among developing countries to facilitate private investment in infrastructure, a process that will be vital to sustain rapid growth. In parallel, it will be important to reinforce recent progress on developing a framework for managing and accounting for contingent liabilities, in order to improve the incentives for both government agencies and private sponsors to such public-private interface. Strengthening the ability of the banking system to cope with rising capital flows and financial deepening will be essential. Finally, adjustments in the Government's role in social security provision and housing finance will be needed to improve fiscal sustainability, as briefly described below. (vii) Restraining Credit Expansion. The financial deepening that has occurred in recent years fundamentally reflects the improving confidence of both residents and nonresidents in the Philippine economy and banking system. But the recent pace of credit expansion, which has been substantially faster than the growth of M3, also reflects the increased use by banks of foreign borrowing and foreign currency deposit units (FCDUs) as the source for credit expansion. Credit growth at its recent pace, if sustained over an extended period, would not be compatible with maintaining low inflation or a sustainable balance of payments position, and could undermine the ability of banks to adequately manage their loan portfolios. (viii) If measures to dampen credit expansion are needed, the menu could include: tighter overall monetary policy; tighter guidelines for the use of FCDUs; possible taxation of foreign borrowing; and increased capital requirements for banks, which is also advisable from a prudential standpoint and is already under consideration. With respect to FCDUs, the policy options include: imposing a liquidity requirement in foreign exchange; limiting credit use to trade finance; and moving towards a more level playing field in terms of their tax treatment vis- a-vis peso intermediation. Such measures would also be advisable to contain currency substitution over the medium term and to limit foreign exchange risks and maturity mismatches arising from intermediation through FCDUs. B. Structural Reform (ix) The Philippine authorities have appropriately focused their structural reform efforts over the past decade on economic liberalization, privatization, and increasing competition. As the  -iii- beneficial impact of these reforms bear fruit, the need to raise domestic savings to sustain rapid growth has become increasingly evident. In this context, reforms within social security and housing finance can play an important role in raising savings, improving the efficiency of its allocation, and developing the domestic capital market. (x) Social Security Reform. Within social security, some combination of increased contribution rates, increased compliance, and improved investment strategies by the social security agencies (SSAs) is likely to be needed. These reforms would respond to concerns that current contribution rates may be insufficient to finance the prevailing structure of benefits and maintain the present partial funding level of the SSAs, and that below-market returns on subsidized housing or member loans cannot be compensated for indefinitely. Institutional reforms to provide benefits more efficiently would complement such reforms. Liberalizing existing constraints on the substantial long-term resources available to the SSAs for investment would also provide an important boost to the development of the domestic capital market. (xi) Reform of Housing Finance. The costs and contingent liabilities associated with support for the housing sector are significant, involving both off-budget interest rate subsidies and potential stock losses via nonperforming loans. The response to recent institutional problems has been positive thus far. The challenge will now be to build on the Government's recent progress by developing an institutional framework that is grounded in its long-term viability. In such a framework: targeting of housing subsidies would be based on transparent criteria that preserve beneficiaries' and intermediaries' incentives; and a wide array of private financial institutions would play a greater role in financing housing at market rates of interest, even in the case of medium- to low-income clients. Finally, an active secondary market would be developed, which could play a key role in the development of the Philippine securities market.   PHILIPPINES: STRENGTHENING ECONOMIC RESILIENCY I. INTRODUCTION 1. The Philippines in 1996 is well poised to record its fifth consecutive year of rising economic growth. From a period of declining real per capita income in 1991-92, the Government's target of at least 6.5 percent real GNP growth in 1996 appears attainable. 2. The current recovery, which began in earnest in 1994, was sparked by the resolution of the power crisis during 1992-93 through expedited use of private investment and the prospect of greater political stability with the incoming administration of President Ramos. In contrast to past growth episodes, this recovery has been marked by declining public sector deficits, strong export growth, and increased levels of private foreign capital. Following a decade of structural reforms that have reduced distortions and opened the economy to greater competition, expectations have been raised that rapid growth can finally become self-sustaining. Higher growth has also begun to reduce unemployment and poverty. 3. This report confirms the private sector's central role in generating the impetus for growth, and the important role of financial policies in bolstering confidence. At the same time, it assesses a number of emerging concerns that will need to be addressed to solidify growth prospects. In particular, the fiscal improvement that has occurred to some extent reflects increased revenue from privatization and maintenance of public investment at relatively low levels. With deficiencies in infrastructure still apt to constrain growth, the need to strengthen the tax revenue base remains. Notwithstanding the rapid export expansion, the trade deficit has widened and the real exchange rate has appreciated, reflecting surging worker remittances and private capital inflows. Finally, credit expansion to the private sector, while starting from a low base, has been very rapid. In a situation of modest domestic savings and potentially volatile capital flows, these factors imply the need for sustained vigilance over macroeconomic policy. 4. Section II reviews recent macroeconomic developments and elaborates on the above concerns. Section III discusses the policy implications of emerging macroeconomic trends, in particular the requirements for maintaining fiscal sustainability and options for restraining credit expansion. Furthermore, the objectives of raising domestic savings and improving the efficiency of their allocation are examined in the context of options to reform the Government's role in the provision of social security and housing. Finally, Section IV provides projections of official development assistance (ODA) requirements in the context of the Government's public investment program and places these within an overall balance of payments framework through 1998.  - 2 - Table 1: Selected Economic Indicaor, 1991-96 1991 1992 1993 1994 1995 1996 /a (percentage change) Growth and Inflation Real GNP 0.5 1.6 2.1 5.3 5.5 7.1 (Si) Real GDP -0.6 0.3 2.1 4.4 4.8 5.0 (Si) CPI (perod average) 18.7 8.9 7.6 9.0 8.1 9.1 (Jan-Oct) CPI (end period) 13.1 8.2 8.4 7.1 10.9 4.7 (Oct) Unemployment Rate (percent) 10.5 9.8 9.3 9.5 9.5 8.9 (Jan-July) (in percent of GNP) Savings and Investment National Savings 18.2 19.4 18.1 19.0 19.0 19.3 (S I) Gross Investment 20.1 21.0 23.6 23.5 21.6 23.5 (S I) Public Sector National Govemment Tax Revenue 14.5 15.2 15.3 15.6 15.8 16.4 (T) Investment 3.0 3.4 2.5 2.5 2.8 2.9 (T) Balance/b -2.1 -1.2 -1.5 0.9 0.5 0.8 (T) Baiance /c -2.5 -0.5 -0. 5 Monitored Corporations Balance -0.6 -0.8 -1.7 -0.5 -0.2 -1.2 (T) Consolidated Public Sector Balance -2.0 -1.9 -1.7 -0.4 -0.2 0.0 (T) PublicDebt 111.5 118.6 125.6 107.6 101.0 National Govemment Debt 61.5 71.2 85.4 70.7 66.3 (end-year percentage change) Money and Credit M3 15.5 11.0 24.6 26.5 25.3 21.4 (July) Credit to Prvate Sector 7.8 24.6 38.0 27.9 43.5 54.5 (July) Commercial Bank Credit 6.6 24.6 32.7 34.8 38.6 54.1 (July) Balance of Payments (end-year percentage change; $ value) Merchandise Exports 8.0 11.1 15.8 18.5 29.4 17.3 (Jan-July) Merchandise Imports -1.3 20.5 21.2 21.2 23.7 27.0 (Jan-Juty) (in percent of GNP) Trade Deficit 7.0 8.7 11.2 11.9 11.7 14.6 (SI) Current Account Deficit 1.9 1.6 5.5 4.5 2.6 4.2 (S I) International Reserves Gross Official Reserves ($ billion) /d 4.5 5.3 5.9 7.1 7.8 11.5 (Sept) (in months of imports) 3.4 3.3 3.1 3.1 2.6 3.2 (Sept) External Debt Total ($ billion) 30.0 30.9 34.3 37.1 37.8 In percent of GNP 65.6 57.4 62.0 56.4 49.4 Debt Service Ratio (percent) /e 35.1 32.9 23.5 20.2 14.5 12.8 (S I) Exchange Rate (Pesos/$; period average) 27.5 25.5 27.1 26.4 25.7 26.2 (Jan-Sept) Real Effective Exchange Rate (1990=100) /f 99.8 110.9 110.4 117.3 120.3 129.0 (Si) Sources: GOP; IMF, WB staff estimates. a. Latest perod. S I and T refer to first semester and offical target, respectively. b. Excluding central bank restructurng. c. Including central bank restructuring. d. Including gold. e. Before rescheduling, as a percentage of exports of goods and services. f. Increase indicates appreciation.  - 3 - II. MACROECONOMiC DEVELOPMENTS: EMERGING TRENDS AND CONCERNS A. Output, Employment and Prices 5. Supply Factors. Through 1995, industrial expansion was the driving factor behind the current recovery from the supply side, whereas agricultural performance remained disappointing (Figure 1 and Appendix Table 4). Thus despite over 7 percent industrial growth in 1995, real GDP growth was limited to 4.8 percent as agricultural output stagnated due to a serious drought. Manufactured production expanded by nearly 7 percent, aided by rapid export growth within the electronics sector. Figure 1: GDP Growth and Its Components, 1991-96 (percent, at 1985 prices) 8 7. 6 4, 3 2 0 -1 -2 -3 1 991 1 992 1 993 1 994 1 995 1 996(1) OGDP YAgriculture OIndustry OServices a 1996 data refers to first semester. 6. In the first half of 1996, growth rates within manufacturing and overall industrial production slowed to 5.6 percent and 5.9 percent, respectively, reflecting slower export growth and the adverse impact of lower agricultural production in late 1995 on manufactured food production. However, a pick-up of investment in 1996 particularly for durable equipment and the greater buoyancy of the economy in general suggest that industrial growth rates could soon recover to 1995 levels. A strong agricultural recovery in the first half of 1996 and slightly higher growth in services helped to raise real GDP growth to 5 percent. Meanwhile, the differential between GDP and GNP growth rates continued to rise, as surging growth of net factor income from abroad of 77 percent in the first half of 19961 pushed GNP growth to 7.1 percent, up from 5.5 percent in 1995. Discussed under Section IIB below.  -4 - 7. Aggregate Demand. The precision with which demand trends can be estimated is affected to some extent by the significance of informal economic activity and past statistical discrepancies within the national accounts. The rapid growth of net factor income from abroad may also be contributing to measurement difficulties within the balance of payments, given the relative difficulty of tracking expenditures from this source. Notwithstanding these caveats, export and import shares have clearly grown significantly in the 1990s. However, the share of investment in GNP fell appreciably in 1995, reflecting reductions in both public and private investment.3 In particular, investment in durable equipment rose by only 2.2 percent in 1995. This slowdown was primarily due to the completion of major power projects by the National Power Corporation (NPC) in previous years, and the resumption of a more normal pattern of investment in transportation equipment following a jump in such investment in 1993-94 associated with the modernization of air and water transport. Investment in construction and real estate grew at a faster pace than durable equipment through 1995, although as noted durable equipment investment recovered strongly in the first half of 1996. Table 2: Aggregate Demand,1991-96 (in percent of GNP) 1991 1992 1993 1994 1995 Consumption 82.9 83.6 84.8 83.0 82.6 Private 73.0 74.1 74.8 72.5 71.8 Public 9.9 9.5 9.9 10.5 10.9 Investment 20.1 21.0 23.6 23.5 21.6 Private 15.2 16.2 17.9 18.1 17.0 Public 4.9 4.8 5.7 5.3 4.6 Exports 29.4 28.6 30.8 33.0 35.1 Imports 32.4 33.5 39.1 39.1 42.7 Statistical Discrepancy -0.6 -1.5 -1.7 -2.8 0.1 Net Factor Income 0.5 1.7 1.7 2.5 3.1 GNP 100.0 100.0 100.0 100.0 100.0 Memo Items: National Savings 18.2 19.4 18.1 19.0 19.0 Private 14.9 16.5 13.7 16.0 15.7 Public 3.3 2.9 4.4 3.0 3.3 Source: GOP. 2 Efforts are underway to address measurement difficulties; in particular, the central bank is refining its procedures to more accurately estimate items in the services account of the balance of payments. 3 Data in Table 1.2 are ratios of nominal variables; measured as real ratios, the decline in 1995 investment was less significant.  8. The national accounts data also indicate declines in the share of consumption since 1993-along with the virtual elimination of a significant statistical discrepancy in 1995 (Table 2). However, to the extent that at least some of the statistical discrepancy can be absorbed within the consumption data-in most countries, consumption tends to be the least accurate of demand data-the precise trend of the consumption share in GNP between 1994 and 1995 is not clear. Finally, national savings increased gradually through the current recovery (since 1993), although private savings fell slightly in 1995. 9. Employment. The Philippine labor market is characterized by an industrial sector that employs 16 percent of the labor force-a share that has remained relatively stable for 20 years- with agriculture and services accounting for the remainder in roughly equal proportions. While the economy generated nearly two million jobs during 1993-95, the unemployment rate did not decline significantly during this period and stood at 9.5 percent in 1995 (Appendix Table 13), although underemployment has fallen. Job creation in 1995 reflected sectoral trends. Industrial employment rose by nearly 5 percent (implying some increase in labor productivity within industry), whereas agricultural employment declined for the first time in the 1990s reflecting the severe drought. Employment in services expanded by nearly 600,000, comprising over 90 percent of the total employment growth. 10. The pace of job creation increased in 1996, however, aided by the strong recovery in agriculture: the average unemployment rate during January-July 1996 was 8.9 percent, down significantly from 9.9 percent for the same period in 1995, and was accompanied by an increase in the labor force participation rate. Labor productivity of existing workers has also increased in recent years as might be expected during the early phase of a recovery. A sustained period of robust growth might therefore be expected to have a more significant impact on employment and incomes. 11. Inflation. Recent price trends have displayed considerable short-term volatility reflecting the volatility of food prices and their substantial share in the overall consumer price index; non- food price increases for most of the period since the beginning of 1995 have been much more stable, averaging about 6 percent. Through the second half of 1994 and early 1995, inflation4 was on a declining trend reaching a low of 5 percent, aided by an appreciating nominal exchange rate and rising real money demand, and notwithstanding rapid growth in liquidity. The aftermath of the Mexican crisis temporarily reversed exchange rate and money demand trends, rendering the prevailing expansion in liquidity excessive-broad money (M3) growth peaked at 45 percent in April 1995. Monthly price increases rose sharply in mid-95 as rice prices doubled following seasonal shortages and other food prices also increased, notwithstanding a sharp decline in monetary growth to 25 percent by end-95. By September 1995, inflation had reached double digit levels and remained in the 10-12 percent range until May 19965. Nevertheless, with monthly price increases moderating after February, inflation has fallen through most of 1996: the 4 Unless noted otherwise, inflation refers to the widely-tracked year-on-year change in consumer price index. 5 The persistence of this relatively high inflation reflects the fact that rice prices did not fall significantly after their initial increase in mid-95.  -6 - year-on-year CPI had dropped to only 4.7 percent by October, while average inflation during January-October 1996 had also fallen to 9.1 percent. B. Balance of Payments 12. Overview. The pace of international integration has accelerated during the current recovery as trade, remittances, and private capital flows have each expanded rapidly. Within the context of rapid growth of both exports and imports, the trade deficit widened to nearly 12 percent of GNP in 1994-95, and increased further in the first half of 1996. The rising trade deficit was however accompanied by a declining current account deficit through 1995 that reflects a substantial surge in remittances and private transfers (Figure 2). The capital account has witnessed rapid increases in direct and portfolio flows, which on a net basis have exceeded use of medium and long-term loans since 1994. Surpluses in the overall balance of payments position have substantially increased gross reserves, which in late 1996 had increased to over three months of import coverage. Figure 2: Trade, Current Account Deficits and Worker Remittances, 1991-96 /a (in percent of GNP) 10 Trade Deficit 8= 2 0 -- 1991 1992 1993 1994 1995 1 996(SI) a/ 1996 data refers to first semester. 13. Exports have formed a driving factor of the current recovery, aided by the liberalization of trade and foreign exchange regulations and increasing foreign direct investment (FDI), and notwithstanding the approximately 30 percent appreciation of the real effective exchange rate since 1990.6 Merchandise exports in 1995 grew by 29 percent in dollar terms, driven by nearly 50 percent expansion of electronics goods exports, and accounted for 43 percent of exports for the year. Exports such as for semiconductor equipment have benefited from booming trade worldwide and large price increases and by their relatively high import content, which has 6 The real exchange rate nevertheless remains somewhat below its earlier peak in the 1 980s.  provided an effective buffer against real exchange rate movements, but by the same token has limited the beneficial impact of their expansion on the trade deficit. In 1996, however, weaker external demand and stabilizing prices for electronics components are expected to slow the growth of merchandise trade, in common with other countries in the region: through August, export growth had slowed to 17 percent. 14. Although some individual categories such as garments have not participated in the export boom, manufactured exports as a group have continued to increase their share in merchandise exports-from 70 percent in 1990 to nearly 80 percent by 1995-and grew by 23 percent through July 1996. Nevertheless, implementation of the Export Development Act (EDA) in 1996, which provides for certain tax and tariff exemptions on exports with relatively high local 7 content, indicates official concern that profitability of such commodities may be eroding7. Although current plans envisage a modest use of tax and tariff exemptions, it should be noted that legislation such as the EDA is unlikely to be a cost effective means of ensuring export profitability, given its cost in terms of foregone tax revenue. 15. Imports. Merchandise imports more than doubled in dollar terms during 1991-95 and have continued their rapid growth in 1996: in contrast to the export slowdown, import growth rose to 27 percent through July, reflecting the robust growth of the domestic economy. Capital and intermediate goods still form the bulk of imports; the share of consumer goods imports has grown in recent years but still comprises only 11 percent of total imports. Although the import of consumer goods rose by 50 percent in the first half of 1996, this primarily reflected replenishment of rice stocks-excluding rice, the growth of consumer imports was no more rapid than the average of all imports. 16. Workers' Remittances. The reduction of the current account deficit since 1993 is primarily the result of the substantial surge in personal income flows and peso conversions of foreign currency deposit units (FCDUs), which together grew by 66 percent in 1995 reaching nearly $10 billion; by the first half of 1996, services exports were exceeding merchandise exports. Interpreting this data accurately has however become more problematic since residents now hold about 90 percent of FCDUs, increasing the likelihood of misclassifying nonresident flows.8 At the same time, the central bank since 1995 has increasingly required banks to provide more disaggregated information on a more frequent basis, for example on the sources and uses of foreign exchange, that can be used to support existing information on FCDU flows. One interpretation of the recent surge in remittances therefore is that it represents a progressively more accurate picture of the true extent of such flows; and to the extent that these flows are not yet fully captured, the current account deficit may in fact be overestimated. On the other hand, negative errors and omissions in 1995 and the first half of 1996 were larger than the estimated current account deficit during these periods (Table 3). Since these errors and omissions are Similar exemptions by competing countries have also prompted these interventions. 8 Remittances intermediated through FCDUs are recorded as a current account inflow only once they are converted into pesos. A remittance that is unconverted does not enter the balance of payments at all.  -8 - thought to originate in part from the services account (in addition to selected capital account items), the true current account deficit could also be underestimated. 17. Irrespective of measurement concerns is the issue of sustainability. If they accurately portray remittance inflows, recently observed growth rates of such inflows may reflect a portfolio shift among nonresidents in response to improved perceptions of the Philippine economy. Increased confidence in the banking system may also have resulted in greater use of banks in intermediating remittances. While such a shift could continue for several years, the pace of expansion over the medium term is unlikely to be sustained even if perceptions remain favorable (given the more stable stock of workers abroad), stressing the importance of monitoring the trade deficit as an important economic variable. Table 3: Balance of Payments, 1991-96la (in millions of US$) 1991 1992 1993 1994 1995 1996(I) Trade balance -3211 -4695 -6222 -7850 -8944 -5990 (% of GNP) (7.0) (8.7) (11.2) (11.9) (11.7) (14.6) Exports (fob) 8840 9824 11375 13483 17447 9583 Imports (fob) 12051 14519 17597 21333 26391 15573 Services (net) 1515 3020 2507 3964 6084 3913 Receipts 5624 7443 7497 10550 15412 10994 olw Remittances/Private transfers 2515 3485 3956 5824 9649 6288 Payments 4109 4423 4990 6586 9328 7081 o/w Interest 1993 1703 1513 1579 1875 927 Transfers (net) 827 817 699 936 880 351 Current Account Balance -869 -858 -3016 -2950 -1980 -1726 (% of GNP) (1.9) (1.6) (5.5) (4.5) (2.6) (4.2) Foreign investment (net) 654 737 812 1558 2326 1604 Direct Invesment 529 675 864 1289 1125 509 Portfolio Investment 125 62 -52 269 1201 1095 MLT borrowing (net) 922 666 2105 1313 1106 824 Inflows 3613 7436 4853 4369 3803 2484 Outflows 2691 6770 2748 3056 2697 1660 Short-term Capital (net) 349 660 -148 1002 -56 182 Change in Commercial Banks' NFA -181 459 -547 465 1309 4149 ( - indicates increase) Errors and Omissions 584 -360 84 160 -2155 -2624 Others /b 644 188 544 254 81 6 Changes in net reserves Ic -2103 -1492 166 -1802 -631 -2415 (- indicates increase) Sources: BSP; WB. a. 1996 data refers to first semester. b. Includes monetization of gold, revaluation adjustments and $469 million purchase of collateral in 1992. c. Includes net credit of IMF.  - 9 - 18. Capital Flows. The past three years have witnessed rapid growth of foreign investment inflows and a parallel decline in the use of long-term borrowing, reflecting improving investor confidence in the Philippine economy and the reduced borrowing requirements of the public sector, hitherto the principal user of long-term foreign loans. Net foreign investment amounted to $2.3 billion in 1995, split about equally between direct and portfolio flows. This however masks considerably larger gross flows-inflows and outflows summed to $11.3 billion, dominated as expected by the more volatile portfolio flows (Figure 3). Data for the first half of 1996 indicate a continued increase in such flows. While firm data on the destination of portfolio flows are not available, anecdotal evidence indicates that the majority of such flows are directed towards equities. Foreign ownership of domestic stocks is still thought to be low relative to neighboring market economies given that the phenomenon of significant portfolio inflows is relatively recent. Nevertheless, foreign investors appear to be active market participants, making up a significant proportion of the daily turnover of the Philippine stock exchange. Figure 3: Foreign Investment, 1991-95 (in billions of US$) 7 6 Portfolio Investment Direct Investm ant 5 4 3 2 0 1991 1992 1993 1994 1S95 Inflow Outflow Inflow 0uflow Inflow Outflow Inflow Outflow Inflow Outflow 19. The favorable investor responses to two recent transactions-a Brady Exchange Program in September 1996 and the Philippines' first issue of Samurai bonds in 15 years in July 1996- signify the country's improving international creditworthiness. The Brady Exchange Program was only the second transaction of its kind to be executed (following Mexico in May). Under this program, the Philippines was able to retire 39 percent of its outstanding $1.6 billion of Brady bonds for uncollaterized 20-year fixed rate bonds at 225 basis points over the 30-year US Treasury bond rate, benefiting from the transaction through several channels. Financially, the transaction will make available $183 million in cash from the collateral released in the retirement of par bonds; the bond exchange component also reduced the debt stock by $84 million. More importantly, the transaction has created a 20-year borrowing benchmark for the Philippine capital market that should help private companies, government agencies, and infrastructure projects  - 10- better access international capital markets for maturities that match long payback periods. Similarly, the favorable terms received for a dual issue of five and a half and seven year yen bonds on the Samurai market enabled the Philippines to retire more expensive with cheaper debt and develop benchmarks for further borrowings in the Japanese market. 20. Reserve Accumulation. The central bank has used the increase in capital inflows to build reserves. In 1995, the reserve accumulation was hampered by bouts of speculation, the most serious of which followed the Mexican peso crisis. Hence, while net BSP foreign exchange purchases reached nearly $2 billion in 1995, as a share of the rapidly rising import base, gross reserves fell to the equivalent of 2.6 months. Stronger net capital inflows in 1996 have permitted a more rapid accumulation of reserves: gross reserves stood at $11.4 billion in September, rising to about 3.2 months of imports, and exceeding the target for the year end. Import coverage of reserves is however modest by East Asian standards. 21. External Debt. The factors discussed above-rapid growth of exports and remittances and the increased reliance on non-debt creating flows-have combined to reduce the Philippines'external debt burden, especially when measured in flow terms. As of December 1995, external debt stood at $37.8 billion, or 49 percent of GNP, and the debt service ratio was under 15 percent, down sharply from 27 percent in 1990. Short-term external debt stood at $5.3 billion, representing a sharp decline relative to the rapidly growing trade flows. These figures however do not include the foreign exchange liabilities of banks arising from their FCDU holdings, which amounted to $9.1 billion in 1995; loans from this source have accounted for a significant proportion of trade financing, thereby reducing the need for foreign borrowing for this purpose. C. Monetary Policy 22. Monetary policy in recent years has been conducted against a background of rapid financial deepening accompanied by large increases in money demand and rising private capital inflows. Growth of M3 averaged 26 percent during 1994-95, decelerating slightly in the first half of 1996. Credit expansion to the private sector has been even more rapid, averaging 36 percent during 1994-95 and accelerating to about 55 percent by mid-96. As a share of GNP, broad money (M3) rose by 11 percentage points between 1991-95 while the share of private credit doubled to 38 percent (Figure 5 and Appendix Table 8). 23. The significantly faster growth of private credit relative to M3 primarily reflects the increased use by banks of foreign borrowing and FCDUs as the source for credit expansion (and the fact that credit figures include foreign currency transactions whereas M3 data do not). Foreign borrowing by banks rose by $2 billion in the first quarter of 1996 alone. FCDUs have grown as a share of total intermediation (Figure 6), while the loan to deposit ratio of FCDUs has also grown: as of March 1996, for example, while foreign currency deposits had grown by 27 percent over the past year, foreign exchange-denominated credit had expanded by 81 percent over the same period (both measured in dollars), and more than doubled through June 1996.  - 11 - Figure 4: Inflation, Interest and Exchange Rates July 1994-July 1996 (monthly averages) 2 4 .'N ', eso par US doliar (right 0 * -, _ ' I---latlon (yr-on-yr-CPI (I _ts c ala change loft Seal.) 4 -W---