Philippines - Growth with equity : the remaining agenda - a World Bank social and structural review

Report No. 20066-PH Philippines Growth with Equity: The Remaining Agenda A World Bank Social and Structural Review May 3, 2000 Poverty Reduction and Economic Management Sector Unit East Asia and Pacific Regional Office u Document of the World Bank  CURRENCY EQUIVALENTS (As of May 3, 2000) Currency Unit Peso $1.00 , = 41.27 pesos 1.00 peso = $ 0.024 FISCAL YEAR January 1-December 31 ABBREVIATIONS AND ACRONYMS ACEF Agricultural Competitiveness Enhancement Fund ADB Asian Development Bank AFMA Agriculture and Fisheries Modernization Act AFP-RSBS Armed Forces of the Philippines Retirement and Separation Benefits System AFTA ASEAN Free Trade Area APEC Asia-Pacific Economic Cooperation APIS Annual Poverty Indicator Survey APT Asset Privatization Trust ASEAN Association of Southeast Asian Nations B.P. Batasang Pambansa BIR Bureau of Internal Revenue BOC Bureau of Customs BOT Build-Operate-Transfer BSP Bangko Sentral ng Pilipinas BTr Bureau of Treasury CAMELS Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity CARP Comprehensive Agrarian Reform Program CB-BOL Central Bank-Board of Liquidators CEPT Common Effective Preferential Treatment CES Career Executive Service CESO Career Executive Service Officer CMDC Capital Markets Development Council COA Commission on Audit CSC Civil Service Commission CTRP Comprehensive Tax Reform Program Vice President Jemal-ud-din Kassum, EAP Country Director Vinay Bhargava, EACPF Sector Director Homi Kharas, EASPR Task Manager Bernard Funck, EACPF  CYFP Children and Youth Foundation of the Philippines DAR Department of Agrarian Reform DBM Department of Budget and Management DBP Development Bank of the Philippines DND Department of National Defense DOH Department of Health DOSRI Directors, Officers, Stockholders and Related Interests DPWH Department of Public Works and Highways DSWD Department of Social Welfare and Development EO Executive Order EPR Effective Protection Rate FDI Foreign Direct Investments GAAM Government Accounting and Auditing Manual GAAP Generally Accepted Accounting Principles GDP Gross Domestic Product GNP Gross National Product GOCC Government Owned or Controlled Corporations GOP Government of the Philippines GSIS Government Service Insurance System HIGC Home Insurance and Guarantee Corporation HPA Hanoi Plan of Action HT High Technology ICRG International Country Risk Group IFAC International Federation of Accountants IMF International Monetary Fund INTOSAI International Organization of Supreme Audit IPOs Initial Public Offering IPP Independent Power Producers IRA Internal Revenue Allotment IT Information Technology ITCs Investment Trust Companies LBP Land Bank of the Philippines LGUs Local Government Units LWUA Local Water Utilities Administration MAV Minimum Access Volume MFIs Microfinance Institutions MLT Medium and Long-Term Loans MNCs Multinational Corporations MTDP Medium-Term Development Plan MTPDP Medium-Term Philippine Development Plan NAFTA North American Free Trade Agreement NAPOCOR National Power Corporation NCC National Credit Council NDHS National Demographic and Health Survey NEA National Electrification Administration NEAT National Education Achievement Test NFA National Food Authority NG National Government  NGOs Non-Government Organizations NHMFC National Home Mortgage Finance Corporation NIC Newly Industrializing Countries NPC National Power Corporation NPLs Non-Performing Loans NSCB National Statistical Coordination Board NSO National Statistics Office OCW Overseas Contract Workers ODA Official Development Assistance OECD Overseas Economic Cooperation and Development OPP Private Occupational Pension Plans Pag-IBIG Home Development Mutual Fund PAYG Pay-As-You-Go Systems PCFC People's Credit and Finance Corporation PCIC Philippine Crop Insurance Corporation PD Presidential Decree PDIC Philippine Deposit Insurance Corporation PECC Pacific Economic Cooperation Council PEZA Philippine Export Zone Authority PHIC Philippine Health Insurance Corporation PICPA Philippine Institute of Chartered Public Accountants PIDS Philippine Institute for Development Studies PMO Project Management Office PNB Philippine National Bank PPI Private Provision of Infrastructure PSE Philippine Stock Exchange QRs Quantitative Restrictions R&D Research And Development RA Republic Act RIC Presidential Retirement Income Commission SAS Service Area Scheme SEC Securities and Exchange Commission SSL Salary Standardization law SSS Social Security System ST Short-Term T-bills Treasury Bills TFP Total Factor Productivity TWG Technical Working Group UNDP United Nations Development Programme USAID U.S. Agency for International Development VAT Value Added Tax WTO World Trade Organization  TABLE OF CONTENTS EXECUTIVE SUMMARY .............. ......................i Structural Transformation ................................... . ii Governance ....................................v Vulnerability \ Sustainability ................................ ..x PROLOGUE ....................................2 1. Poverty Reduction and Economic Performance ..................................6 A. Introduction ....................................6 B. Trends in Growth and Poverty Reduction ....................................6 C. Sources and Patterns of Growth ................................... 10 D. The Asia Crisis and Beyond ................................... 27 E. Lessons and Challenges for the Medium-Term ................................... 29 F. Conclusions ................................... 39 2. Challenges for the Private Sector .. ................................. 40 A. Strengthening Corporate Governance ................................... 41 B. Broadening Access to Land ................................... 54 C. Opening Up and Leveling the Playing Field ................................... 58 D. Conclusions ................................... . 65 3. Finance for Development .................................... 67 A. Introduction ................................... . 67 B. Overview of the Financial Sector .. ................................. 68 C. The Legacy of Early Financial Reforms ............... .................... 70 D. The Asia Crisis and Its Aftermath .. ................................. 72 E. Key Challenges for the Future ................................... 76 F. Conclusions ................................... 82 4. The Business of Government .............. ..................... 84 A. Introduction ................................... . 84 B. Providing Public Goods .............. ..................... 84 C. Delivering Effective Justice .............. ..11................... I D. Improving Revenue Performance ............. .. .................... 115 E. Conclusions ................................... . 119 5. Vulnerability / Sustainability .. ................................. 122 A. Introduction ................................... . 122 B. Limiting Vulnerability .................................... 122 C. Domestic Savings Mobilization .............. .. ................... 126 D. Resuming Fiscal Consolidation .............. .. ................... 130 E. Requirement for Foreign Assistance ............... .................... 133 BIBLIOGRAPHY ................................... . 136 Statistical Annex ................................... . 144  Tables 1.1: RECENT EVOLUTION OF POVERTY, 1985-97 ........................................................... 7 1.2: POVERTY REDUCTION IMPACT OF GROWTH FOR SELECTED COUNTRIES .......... ........... 7 1.3: INFLOWS OF FOREIGN SAVINGS, 1992-99 ........................................................... 8 1.4: POPULATION AND GDP PER CAPITA IN SELECTED COUNTRIES ................. .................... 9 1.5: GROWTH RATES IN SELECTED COUNTRIES ........................................................... 10 1.6: ELASTICITY OF POVERTY TO GROWTH . ........................................................... 0 1.7: EVOLUTION OF SOURCES OF GROWTH OVER TIME ..................................................... 1 1 1.8: SOURCES OF GROWTH: AN INTERNATIONAL COMPARISON .................. ..................... 12 1.9: SOURCES OF GROWTH BY SUB-PERIOD ........................................................... 12 1.10: EFFECTIVE RATE OF PROTECTION, 1990-2000 ........................................................ 13 1.11: NOMINAL PROTECTION RATES OF MAJOR AGRICULTURAL COMMODITIES .............. 15 1.12: WAGE COSTS IN MANUFACTURING ............................... ............................ 15 1.13: SOURCES OF SECTORAL GROWTH BY SUB-PERIOD ..................................... ............. 16 1.14: EAST ASIAN EXPORT SHARES IN INTERNATIONAL IMPORT MARKETS .......... ........... 17 1.15: MANUFACTURING EXPORTS OF SELECTED DEVELOPING COUNTRIES .................... .. 18 1.16: COMPOSITION OF OUTPUT IN SELECTED COUNTRIES, 1992-98 ................................ 20 1.17: EMPLOYMENT BY SECTORS, 1980-98 ........................................................... 21 1.18: COMPENSATIONS BY SECTORS, 1991-97 ........................................................... 21 1.19: EMPLOYMENT BY SECTORS IN SELECTED COUNTRIES ......................... .................... 21 1.20: EVOLUTION OF POVERTY BY SECTOR OF EMPLOYMENT, 1985-97 ........................... 22 1.21: SECTORAL PROFILE OF POVERTY, 1997 ........................................................... 22 1.22: EDUCATION ENROLLMENTS AT THE TERTIARY LEVEL, SELECTED COUNTRIES ....... 24 1.23: POVERTY AND EDUCATIONAL ATTAINMENT ........................................................... 25 1.24: DISTRIBUTION OF INCOME AND CONSUMPTION IN SELECTED COUNTRIES ............... 27 1.25: DEMOGRAPHIC SCENARIOS ............................................................30 1.26: POVERTY AND FAMILY SIZE ........................................................... 30 1.27: FEMALE EDUCATION, FERTILITY AND LABOR FORCE PARTICIPATION ..................... 31 1.28 GOVERNMENT AND DONOR SHARE IN FUNDING FOR SELECTED PROGRAMS, 1996 ........................................................... 32 1.29: GROWTH PROSPECTS ........................................................... 33 1.30: FOREIGN INVESTMENT INFLOWS TO EAST ASIA ....................................................... 36 2.1: GROWTH AND FINANCIAL PERFORMANCE OF TOP 1 000 CORPORATIONS BY CORPORATE CONTROL STRUCTURE ........................... ................................ 42 2.2: OWNERSHIP CONCENTRATION AND LEGAL FRAMEWORKS ................... ..................... 43 2.3: MARKET SHARE OF GROUPS OF COMPANIES IN SELECTED INDUSTRIES, 1991-97 ..... 46 2.4: VARIABLES AFFECTING THE ENFORCEMENT OF INVESTOR RIGHTS ............ ............... 48 2.5: MEASURES FOR PROTECTING CREDITOR RIGHTS ....................................................... 50 2.6: DURATION OF DEBT SUSPENSION PROCEDURES ......................................................... 51 2.7: SIZE AND CHARACTERISTICS OF DIFFERENT LAND REFORMS ................. ..................... 55 2.8: LAND DISTRIBUTION UNDER CARP STATUS BY LAND TYPE AND MODE OF COVERAGE, 1972-97 ........................................................... 56 2.9: IMPACT OF LAND REFORM ON BENEFICIARIES .......................................................... 57 2.1 0: EVOLUTION OF EFFECTIVE RATES OF PROTECTION ..................................... ............ 59 2.1 1: AVERAGE MFN RATES OF SELECTED ECONOMIES .................................... .............. 60  2.12: IMPACT OF TARIFF REFORMS .......................................................... 61 2.13: IMPACT OF TARIFF REFORMS .......................................................... 62 2.14: SHARE OF FOOD IN CONSUMPTION BY DECILE ......................................................... 63 3.1: FINANCIAL DEPTH AND INDEBTEDNESS IN SELECTED EAST ASIAN COUNTRIES ........ 70 3.2: NPLS AND FINANCIAL RESTRUCTURING IN SELECTED EAST ASIAN COUNTRIES ....... 73 3.3: VOLUME OF GOVERNMENT SECURITIES: 1990-97 ..................................................... 75 3.4: OVERHEAD COSTS OF BANKS: 1992-97 .......................................................... 77 3.5: NET INTEREST MARGINS OF BANKS: 1992-97 .......................................................... 77 4.1: GOVERNMENT EXPENDITURES BY FUNCTION IN SELECTED COUNTRIES .......... .......... 85 4.2: GOVERNMENT EXPENDITURES BY NATURE IN SELECTED COUNTRIES ........... ............ 86 4.3: SIZE OF THE CIVIL SERVICE IN SELECTED COUNTRIES ............................................... 86 4.4: EVOLUTION OF THE CIVIL SERVICE, 1970-97 .......................................................... 87 4.5: ACCESS TO EDUCATION, 1998 .......................................................... 88 4.6: ACCESS TO HEALTH, 1998 .......................................................... 88 4.7: SELECTED HEALTH INDICATORS BY LEVEL OF INCOME, 1998 ................................... 89 4.8: QUALITY OF INSTITUTIONS IN VARIOUS COUNTRIES .................................................. 90 4.9: SELECTED CONTINGENT EXPOSURESa .................................. ........................ 92 4.10: RULE OF LAW RATINGS FOR SELECTED EAST ASIAN COUNTRIES, 1988-98 .......... 112 4.11: CASE BACKLOG IN PHILIPPINE COURTS .......................................................... 113 4.12: MAJOR FISCAL INCENTIVE SCHEMES IN THE PHILIPPINES ...................................... 116 5.1: DOMESTIC SAVINGS RATES .......................................................... 127 5.2: INVESTMENT-SAVINGS BALANCE, 1997-2010 ......................................................... 129 5.3: PUBLIC DEBT IN SELECTED COUNTRIES .......................................................... 130 5.4: FISCAL DEVELOPMENTS UNDER VARIOUS SCENARIOS, 1997-2010 ......................... 133 5.5: EXTERNAL FINANCING REQUIREMENT, 1998-2010 ................................................. 134 Figures 1: FARM AND NON-FARM COMPONENTS OF GDP .2 2: DESEASONALIZED GDP DEVELOPMENTS, 1998-99 .2 3: GROWTH IN EMPLOYMENT .3 4: KEY RATIOS OF THE BANKING SYSTEM (percent) .3 5: UNEMPLOYMENT RATE .3 6: SELF-RATED POVERTY INCIDENCE (percent) .3 7: NATIONAL GOVERNMENT CUMULATIVE SURPLUS/DEFICIT .4 8: NATIONAL GOVERNMENT REVENUE AND EXPENDITURE .4 9: PRIME RATE AND INFLATION .4 10: NET DOMESTIC CREDIT GROWTH ..................................................4 11: CORE AND HEADLINE INFLATION ..................................................5 12: MERCHANDISE TRADE ...................................................5 1.1: GDP GROWTH RATES IN SELECTED COUNTRIES, 1960-98 ..........................................8 1.2: INCOME AND CONSUMPTION PER CAPITA ...................................................9 1.3: CAPITAL/LABOR RATIO ................................................. 11 1.4: LABOR FORCE PARTICIPATION AND UNDEREMPLOYMENT, 1971-99 ......................... 11 1.5: SECTORAL PRICE DEVELOPMENTS .................................................. 14  1.6: REAL EXCHANGE RATE INDEX ....................................................... 14 1.7: HIGH-TECHNOLOGY EXPORTS IN SELECTED COUNTRIES ........................... ................ 19 1.8: GROSS SECONDARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES ........... 23 1.9: GRoSS TERTIARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES ................ 24 1.10 DISTRIBUTION OF THE GROSS NATIONAL DISPOSABLE INCOME ................................ 26 1.11: POVERTY, DISPOSABLE INCOME, AND FAMILY CONSUMPTION ................................ 26 1.12: EVOLUTION OF INCOME BY QUINTILE ....................................................... 27 1.13: CONTRIBUTIONS TO FINAL DEMAND ........................................................ 28 1.14: CONTRIBUTIONS TO GROSS DOMESTIC PRODUCT ..................................................... 28 1.15: STRUCTURE OF OUTPUT ....................................................... 33 1.16: STRUCTURE OF EMPLOYMENT ....................................................... 33 2.1: CORPORATE LEVERAGE IN SELECTED COUNTRIES ..................................................... 49 2.2: EFFECTIVE PROTECTION RATES FOR MANUFACTURING AND AGRICULTURE ............. 60 2.3: AGRICULTURAL EXPORTS ........................................................ 63 2.4: PRICE OF RICE IN SELECTED COUNTRIES ................................. ...................... 63 3.1: RATIO OF DEPOSIT MONEY BANK ASSETS TO TOTAL FINANCIAL ASSETS ......... ........ 69 3.2: STOCK MARKETTURNOVER ....................................................... 80 4.1: EVOLUTION OF NATIONAL GOVERNMENT EXPENDITURES, 1994-99 ......................... 87 4.2: WAGE COMPRESSION RATIOS IN SELECTED COUNTRIES .......................................... 101 4.3: TRANSPARENCY INTERNATIONAL CORRUPTION PERCEPTION INDEX (CPI) ............. 108 5.1: CURRENT ACCOUNT BALANCE, 1996-2010 ........................................................ 123 5.2: FOREIGN RESERVES, 1996-2010 ....................................................... 124 5.3: EUROSPREADS, SELECTED COUNTRIES . ........................................................ 124 5.4: NATIONAL GOVERNMENT EXPENDITURE ..................................... .................. 125 5.5: STOCK EXCHANGE DEVELOPMENTS IN SELECTED COUNTRIES ............... ................. 126 5.6: FAMILY SAVINGS RATES BY LEVEL OF INCOME .......................................1 128 5.7: GROSS NATIONAL SAVINGS BY SECTORS ....................................... 128 5.8: EVOLUTION OF NATIONAL GOVERNMENT AND PUBLIC SECTOR GOVERNMENT BALANCES ....................................... 131 5.9: EVOLUTION OF NATIONAL GOVERNMENT REVENUES ....................................... 131 5.10: ODAUTILIZATIONRATEa/ ..................... 135  Boxes Box 2.1: EXAMPLES OF BEST PRACTICES IN CREDITOR PROTECTION . . 50 Box 3.1: WHY DOES FINANCE MATTER? .......................................... 68 Box 3.2: THE PHILIPPINES' 1980s CRISIs ......................................... 71 Box 3.3: PROMOTING RuRAL AND MICRO FINANCE ......................................... 79 Box 4.1: FIRST THINGS FIRST IN BUDGET REFORM .......................................... 105 Box 4.2: REPRESSION OF CORRUPTION IN HONG KONG AND IN THE PHILIPPINES .109   FOREWORD This report has been prepared by a core staff team comprising Bernard Funck (main author), Rajashree Paralkar, Joven Balbosa and based, among others, on valuable contributions by Ceasar Cororaton and Janet Cuenca (sources of growth, impact of trade liberalization), Charles Woodruff (corporate governance), Rick Messick (judiciary); MacDonald Benjamin (financial sector), Cecilia Vales (procurement), Dana Weist (tax administration), Leonora Gonzales and Angelina Ibus (civil society). The team drew upon a number of background studies, including by Arsenio Balisacan (poverty profile), Mike Alba (incidence of public expenditures), Klaus Deininger et al. (land reform), Aldo Baietti et al., Gilbert Llanto et al. (private provision of infrastructure), Ma. Joy Abrenica (telecommunications), Leonard Early and Sylvie Trosa (budget and performance management), Denis Ives, David Steedman (civil service), Subrahmanya Ramamurthy (budget execution and accounting), Kenneth Dye (audit), Vinay Bhargava et al. and Robert Beschel (anti-corruption). The team gratefully acknowledges its indebtedness to the analytical work produced by the Philippine Institute for Development Studies; under the AGILE project of USAID-particularly the studies of Rosario Manasan (trade liberalization), Ramon Clarete (food policy) and Kevin Fogarty (corporate governance); as well as to research supported by the Asian Development Bank-in particular by Cesar Saldafia (corporate governance), by the International Monetary Fund, as well as various United Nations agencies. A complete bibliography is attached at the end of the report. The team also received useful input and advice from a number of reviewers within the World Bank, including Masahiro Kawai, Homi Kharas, Sanjay Dhar, Daniela Gressani and Milan Brahmbhatt. Eduard Bos produced the demographic projections used in this report, and Rosalinda Dacumos helped with the macroeconomic simulations. The production of the report would not have been possible however without the logistical support of Araceli Tria , Myla Grace de Guzman and Lily Tsang.   EXECUTIVE SUMMARY 1. The following facts command attention: (a) Poverty incidence dropped by about 15 percentage points between 1985 and 1997. When growth exceeded 5 percent prior to the Asia crisis, the pace of poverty reduction accelerated to 2 percentage points per year. (b) With the share of government corporations in the sales of the top 1000 firms shrinking from close to 20 percent in the mid-1980s to about 6 percent at present, the private sector has been the main engine of growth. (c) With export growth accelerating from an average 4 percent in the 1980s to 16 percent in 1990-98, the country doubled its share of world markets. (d) The Philippines was among the first countries directly affected by the Asia crisis to regain (and exceed) pre-crisis levels of economic activity. 2. For anyone familiar with the country's history, these are encouraging signs that a new Philippines has begun to emerge. 3. With the Asia crisis receding, the question facing the authorities is how to sustain this achievement and bring back growth to a pace healthy enough to make a serious dent into poverty. The concern is real: the recovery has been hampered by a wider fiscal deficit, slow progress in implementing structural reforms in the last two years, and governance concerns. On financial markets, widening spreads on foreign borrowing and a poor stock market performance are current areas of concern. For the man on the street, the perception is that poverty is no longer declining. 4. This report highlights how much recent achievements in terms of growth and poverty reduction owe to the progress the country has made on a broad front of policy issues, ranging from openness to trade, investment and competition, to education, and from governance and empowerment to financial regulation. 5. But it is also the case that progress has been uneven in many areas, leaving enough of a remaining agenda to support growth and poverty reduction efforts over the medium term. The report outlines this agenda, some of the key elements of which are: (a) Intensifying trade liberalization and domestic competition. (b) Strengthening standards of governance across financial, corporate and public sectors. (c) Broadening asset ownership, and the poor's access to tangible assets (e.g., land) and intangible ones (e.g., education). (d) Nurturing domestic savings, in the public sector to start with.  -ii- 6. On that basis, this report envisages that GDP growth would pick up in 2000 from the 3.2 percent recorded in 1999, and again cross the 5 percent threshold, as needed to meet the Government's target for poverty reduction under the medium-term development plan for 1999-2004. STRUCTURAL TRANSFORMATION 7. Following the crisis of the 1 980s, two major factors helped revive growth: (i) the structural reforms undertaken to move from the import substitution industrialization policies of the previous decades to a more balanced development strategy; and (ii) the restoration of orderly relations with the country's creditors following the debt restructuring agreement of 1992. 8. The country's shift from inward to an outward orientation not only permitted a world-class export industry to finally emerge in the Philippines, it also succeeded in making growth more beneficial to the poor by: (a) Making growth more labor-intensive, allowing comparatively modest growth performances to translate into relatively large drops in poverty incidence. This resulted at least as much from changes in the composition of output in favor of more labor-intensive activities (particularly in non- tradable sectors) as from a change in factor intensity within sectors. Employment in construction and services thus opened a main escape route out of poverty, poverty reduction being faster and deeper for those engaged in these sectors. (b) Forcing a relative desegmentation of the labor market under the pressure of competition. The resulting convergence of wages across sectors helped spread the benefits of growth across the economy. (c) Causing a redistribution of the national income in favor of households and consumers, reflecting not only a rising share of labor in the national income but apparently also a redistribution of the previous rents to the consumer as a result of trade liberalization and de-monopolization. 9. This process, however, left a number of issues outstanding. First, what did not improve is income inequality among families. The fact that lower income groups also enjoyed unprecedented poverty reduction may have made growing inequality more socially acceptable. But, this may change in a slower growth scenario. 10. Second, a shift in the domestic terms of trade against tradables in the run-up to the Asia crisis-linked in part to the uneven progress of competition across sectors- indicates that rigidities persist which stand in the way of sustaining rapid growth. As mounting inflows of foreign savings fueled domestic demand, the related pressure applied differently across the economy, causing prices to rise in sectors less exposed to competition, and factors to shift towards those sectors. Conversely, where international competition limited price adjustments, the same demand pressures caused the current account deficit to expand, leaving the country exposed to volatile market sentiments.  -iii- 11. An attempt to maintain the country's self-sufficiency in food actually exacerbated the problem for the rest of the economy. While other tradables were exposed to higher competition, the effective protection granted to key food items (mainly rice, corn, meat, and sugar) increased until 1997. The ultimate result of this policy was to drive up wages to levels considerably higher than in neighboring countries at comparable levels of development. This hindered the capacity of the tradable sector to adjust to the shift from inward to outward orientation and limited its capacity to create jobs in activities where the value added per worker was sufficiently high to make up for high wage costs, i.e. relatively high skilled jobs, such as in electronics. As a result, industry's contribution to the national output shrank through the 1 990s in contrast to neighboring countries. 12. Agriculturalperformance also remained weak, special protection notwithstanding: not only is agriculture the sector where poverty is highest (over 40 percent of the people engaged in agriculture), but it is also the sector where the pace of poverty reduction has remained the slowest. One can hardly avoid the proposition that the protection granted to the sector in the name of food self-sufficiency actually served to retard a process of structural transformation which would otherwise have benefited the poor, had it been allowed to unfold more freely. 13. To regain the higher growth rates needed for rapid poverty reduction, it will be necessary to arnplify the process of structural transfornation by which factors of production, particularly labor, shift to higher productivity activities. The word "industrialization" could be used in this context if it encompasses those services which are quickly "industrializing" as a result of the IT revolution, and in which the Philippines is already showing good potential. A key condition will be to restore a more balanced structure of incentives across sectors, including by (a) Aligning the pace of trade liberalization across tradables. While the county forges ahead with cutting down the average tariff to 5 percent by 2004, it is also essential to bring the so-called "sensitive items" into the fold, as indeed contemplated under the Hanoi Plan of Action under AFTA. The devaluation of the peso was actually instrumental in setting that process in motion: as a result of it, the implicit rate of protection dropped in the case of rice from about 80 percent to about 35 percent between 1997 and 1998. It would be important to stay on this trajectory. Indeed, the pace at which the country is able to bring down its food prices, and thereby enhance labor competitiveness, will have a crucial bearing on its capacity to expand into any internationally competitive, labor-intensive activity in any sector and to seize the opportunities which world trade expansion offers beyond the confines of electronics. Feeding a growing population will in any case require a different concept of food security than the ideal of food self-sufficiency, which underpins current policies. With cultivated areas constrained and cereal yields sluggish, there is little prospect that the sector could feed 15 to 20 million more mouths by 2010, without putting further pressure on food prices,  -iv- further straining household budgets and hampering growth. Trade is a better way of achieving both the objectives of growth and food security. (b) Fostering competition in services. The case of telecommunications vividly illustrates the potential benefits from opening up service sectors to heightened competition. Early gains from the liberalization of the telecommunication industry in the early 1 990s-together with the development of an electronic industry-have positioned the country well to participate in the global information revolution (e.g., Internet-based back-office functions, e-commerce). It is now important to consolidate this advance by removing remaining policy bottlenecks in the sector, and, emulating its example, to extend the process to other service sectors, where competition remains stifled (e.g., ports, inter-island shipping). 14. Transforming economic structures is obviously not just a matter of price incentives. Sectoral interventions are also critical in the fields of (i) education and skills development; (ii) population; (iii) urbanization; and (iv) agricultural modernization. Education and Skills 15. The Philippines might not have benefited as much from the process of structural transformation described above, had it not been for its long-standing effort in favor of education. Thanks to this, enrollment in primary education has become almost universal, secondary education has reached the level of "mass education," and even at the tertiary level, enrollment compares to levels found in developed countries. This investment in human capital made it possible for labor to gradually shift towards higher productivity activities and offer sufficient skills to make up for comparatively high wage cost. 16. Quality and relevance have, perhaps inevitably, not always kept up with quantitative achievements: dropout rates are stubbornly high, mean achievement scores remain well below target, and in higher and vocational education, low quality state universities and colleges are displacing private institutions. Whereas more than half of the non-poor proceed beyond primary education, only a quarter of the poor do so. The measures proposed to improve the effectiveness and efficiency of education, and its accessibility to all, include: (i) increase the relative allocation for instruction material (as opposed to wages and buildings) and better target investments in basic education to benefit under-served areas and groups; (ii) implement a comprehensive teacher training (both pre- and in-service) and deployment program; and (iii) reverse the haphazard expansion of low quality post-basic public education, wean them from public funding, and develop accreditation systems applicable to both public and private institutions. Population 17. Curbing population growth would make the task of lifting people out of poverty that much easier. At 95 million by 2010, the population will be 9 million larger than it would have been, had women had as many children as they wished since 1990. For education, for instance, this means attending to 7 million more children and youth than would otherwise have been the case. With such numbers, the ambition of reaching the  poor becomes even more daunting. Conversely, the persistence of this discrepancy between actual and desired maternity points towards the scope for more vigorous population policies, starting with a better funding ofpopulation programs. Urbanization 18. If cities are to play host to the process of structural transformation, the country will need to step up its investment in urban and inter-urban infrastructure (particularly in the completion of the country's arterial road network). The resources required to bring cities up to par and to operate the related services efficiently extend far beyond the government's own capacity. Hence the need to tap private investment. Whether these materialize-and the cost at which they do-depends in large measure on whether credible regulatory frameworks are established (see below). Agricultural Modernization 19. Considerable effort will need to go into agriculture to help the sector adjust to trade liberalization and seize the opportunities offered by the opening up and expansion of markets along the entire western Pacific Rim to diversify into internationally competitive crops (tree crops, for instance). To see the sector through the transition, there will be a need for a strategic (public and private) investment into land, facilities and infrastructure, as well as for research and extension services to develop and spread alternative farming packages to the farmers. This should be the main thrust of the implementation of the Agriculture and Fisheries Modernization Act. GOVERNANCE 20. Given the Philippines' open economy and heavy reliance on trade and capital flows, strengthening investor confidence will be vital to sustain a higher growth path. This objective in turn will be best served by undertaking a concerted effort to raise standards of governance in public institutions and the private sector. Much has been achieved since the return to democracy in 1986-ranging from devolution to banking regulation. Yet the remaining agenda is also large. Raising Standards of Government 21. The Philippines has taken important strides since the people power revolution of 1986 towards stamping out rent seeking and patronage from government. Witnessing this, international surveys report a steady improvement in perceptions of corruption and in the prevalence of the rule of law since the late 1980s. While recognizing this progress, the same surveys also confirm that much remains to be done for a culture of performance and accountability to set in. Indeed, the Philippines' ranking in terms of bureaucratic and judiciary effectiveness is low, while corruption indicators remain uncomfortably high. This report (as well as the 9-point action plan put forward by the World Bank to fight corruption) highlights the need to get some of the basics in place, including:  -vi- (a) A meritocratic civil service. At present, public employment remains heavily politicized and poorly motivated. By any standard, an extraordinary number of positions at all levels of government remain filled through political appointment. As a result, less than 40 percent of the senior executive positions are currently filled by fully qualified career officers. Even within the career service, appointment and promotion is only loosely linked to merit, and performance evaluation and rewards systems have been debased. Moreover, while the salaries of the rank and file have been adjusted to market levels under the Salary Standardization process, those of senior executives lag behind, creating crippling problems of retention, morale, and perhaps even public morality. Two priorities emerge. The first one is to professionalize the service. This is one of the objectives of the revised Civil Service Code, which is before Congress. The second is to revamp the pay and grading system with a view to better motivate and retain senior career officers. This would also be the opportunity to initiate a long-term reflection on the proper scope of the civil service code. (b) Reliable financial management systems. In recent years, a number of countries have blazed new trails in using budget reform to improve public service performance. A prerequisite, however, is to create a culture that expects performance and demands accountability. The main issue at present is not so much with the way the budget is put together (which is being improved), but with the way it is spent and accounted for. Sophisticated accounting and monitoring systems do exist, but they are too unwieldy to produce much that is of use in day-to-day management. Because of these defects, fiscal and department managers are too often left groping in the dark when trying to pilot the execution of the budget, a situation unlikely to foster performance, ... or probity for that matter. Much of the burden in this respect has historically rested on the Commission on Audit. In addition to external audit, it has traditionally performed many accounting and most internal control functions. But, in line with international practices, the Commission is gradually disengaging from non-audit responsibilities, leaving a vacuum where the executive branch needs urgently to step in, with two priorities: bringing accounting in line with international standards and developing internal control. (c) A foolproofprocurement system. Although current systems espouse the principles of competition, economy, efficiency and transparency, practices are known to be riddled with fraud and inefficiencies. The heart of the problem is not the lack of rules, but rather an excess of inconsistent ones, which have proliferated over the years, as piecemeal responses to recurring leakage. Much gain could come from (i) consolidating existing rules in a harmonized procurement code; and (ii) developing standardized forms and fornats, the use of which would limit discretion, streamline the approval process, and facilitate contract monitoring and audit.  -Vii- (d) An effective judiciary. There is widespread concern, domestically and internationally, that Philippine courts do a poor job of upholding the "rule of law," and thereby debilitate efforts to improve the development policy framework. Laws might, for instance, be more effective at stamping out corruption if courts were more diligent in sanctioning the culprits. On the face of it, the Philippines has a full arsenal of rules and institutions to identify and suppress the syndrome. But comparison with Hongkong indicates why this does not happen: only 1 in 10 prosecuted cases result in a sustained conviction, while the ratio is 8 to 10 in Hong Kong. Two issues first warrant attention: (i) lengthy delays in resolving civil and criminal cases (the court backlog has increased from about 300,000 to about 650,000 cases between 1992 and 1998); and (ii) unpredictable results when a decision is finally reached. Improving procedures for transparent, merit-based judicial appointments and rooting out corruption in the judiciary would help in both respects. Devolution and Empowerment 22. With the 1986 revolution, the country has also moved away from the view that the state must or can itself address all the legitimate demands from society, and learned that, in many cases, citizens are often willing to pay or contribute their time and energy to the fulfillment of social needs that they care about. In those cases, the Philippines has learned that it is often best for the state not to abdicate but to focus on providing the enabling environment in which private and local initiatives will flourish. (a) Although it has caused an uncomfortable accumulation of contingent exposures, there is no question that the option in favor of private provision of infrastructure has, on balance, served the country well and will remain irreplaceable for unlocking the growth potential of the economy. (b) Another important initiative has been to bring government services in closer contact with users and more responsive to their needs, under the devolution of the 1991 local government code. Devolution, it was also hoped, would put local government at the forefront of the fight against poverty. How much of that has been achieved is unknown. It is now time for such stocktaking to take place, based on a rigorous data investigation. (c) In the same spirit, the growing participation of non-government organizations (NGOs) in public affairs, although of a different nature and scale, has been one of the greatest successes of the decade. 23. This blooming of civil society initiatives offered a fertile ground for broader approaches to poverty alleviation to emerge. Under these approaches, the poor have come to be seen not merely as recipients/beneficiaries of government programs or policies, but as agents of their own destinies. Through the nineties, a new consensus began to form around the need to empower the poor, including by securing the rights of poor communities and individuals and their equitable access to assets.  -viii- 24. Two of the most important programs to help lower income groups get access to tangible assets have been: (i) the National Shelter Program (NSP) of 1986 for housing; and (ii) the Comprehensive Agrarian Reform Program (CARP) of 1988. The former unfortunately failed. Although it has involved great expenses (pensioners' money, essentially), there is little evidence that, aside from a few remarkable exceptions (such as the Community Mortgage Program), the NSP made much of an impact on the housing conditions of the poor. There is now growing recognition that: (i) public funding on its own cannot solve housing problems; (ii) to bring in commercial-based financing, low income housing loans need to be at market rates of -interest; and (iii) ensuring affordability for the poor could best be achieved through a carefully targeted and transparently budgeted up-front subsidy program. This vision, cast by the Medium-Term Development Plan for Shelter, remains to be acted upon. 25. There is better evidence of success in the case of the agrarian reform program. Although its implementation is lagging behind schedule, fresh data presented in this report confirm the intuition that access to land ownership gave the leg up to those who benefited from the program. But what about the many more who did not? It also appears it has become harder for the landless to access land, and that this may be due to the restrictions to the operation of the land market (particularly land rental), which agrarian reform introduced. If further research confirms these preliminary findings, it might be justified to target CARP implementation more toward landless; and to identify which CARP-induced land market restrictions could be relaxed to give a better chance to non- beneficiaries to access land outside of the program. By driving down land prices, food trade liberalization would further help. In the meantime, a more effective collection of existing land taxes would increase the efficiency of land use. In addition, it would be worth piloting mechanisms to fund poor communities directly to purchase CARP land on a mutually agreeable basis to supplement existing compulsory CARP arrangements, and speed up land transfers in areas where landlord resistance is fiercest. Corporate and Financial Sector Framework 26. The newfound financial resiliency of Philippine banks and corporations in the face of the Asia crisis similarly bears testimony to the progress achieved in the area of corporate and financial sector governance. At the same time, market reactions to a recent spate of stock market scandals and murky corporate maneuvers point to the magnitude of the unfinished agenda, as well as to the urgency of tackling it to restore confidence. 27. Another telltale sign of an underlying problem is the concentration of ownership around family-based conglomerates. Not only is it high by regional standards, this concentration also rose in recent years. In the current environment, the limited scope for outside creditors or minority shareholders to discipline corporate insiders also constrains the capacity of firms to raise external finance. To this, ownership concentration and conglomerate structure offer the palliatives of stronger internal control and internal capital markets. The success of this corporate structure potentially poses two major risks to the economy, which the country has begun to address: (a) Group-based companies might abuse dominant market positions to extract monopoly rents. With the opening up of the economy to trade and  -ix- investment, these positions have begun to erode. But further efforts to stimulate competition will be required to put this concern to rest. (b) Corporate groups might use their ownership of banks for connected lending purposes, undermining the stability of the banking system. After a history of banking turbulence often caused by such poor lending practices, vigorous reforms efforts since the late 1 980s have made considerable headway toward strengthening the regulation of the sector, in part by elevating the independence and authority of bank regulators. These reforms proved their worth when the Asia crisis struck. It then appeared that the comparatively better regulated (and also more fragmented) banking industry of the Philippines had been less prone to take on unduly large risk exposures. Furthermore, fresh memories of the 1980s' debt crisis served to cool the appetite for risk of many corporations and banks, while an only recent reentry into international capital markets inhibited the more adventurous from turning to those to circumvent domestic constraints. Banking regulators will not have the luxury of resting on their laurels. First, recurring abuses of connected lending limits signifies the need for continued supervisory vigilance in this respect. Furthermore, the ongoing consolidation of the banking industry will also (i) relax the constraints which connected lending ceilings had so far been placing on individual exposures; and (ii) increase the scope for oligopolistic behaviors on the part of remaining banks. To obviate the related risk, banking sector consolidation will need to go hand in hand with fresh efforts to improve bank governance; enhance contestability; further strengthen supervision; as well as to ensure prompt resolution of distress cases, should any arise. 28. If the country is to generate the external finance which its corporations need to grow, a more direct effort will be required to tackle, not only the symptoms and side- effects of corporate and capital market governance weaknesses, but also their more deep-rooted causes. Such effort should involve, inter alia, reinforcing the protection of minority shareholders and creditors vis-a-vis corporate insiders (i.e., majority shareholders and managers); straightening out the governance and regulation of markets and institutional investors; and elevating the independence and authority of regulators vis-a-vis market participants (particularly that of SEC and PSE), in a similar fashion as was done for the banking industry. An early approval of the proposed Securities Act by Congress, and of effective debt resolution procedures by the Securities and Exchange Commission would considerably improve the formal framework. 29. Little would have been accomplished however unless the rules which are on the books are more deliberately enforced (e.g., integrity of regulatory, accounting and auditing practices; compliance with disclosure requirements). For market participants, this will be the litmus test that the rules of business are indeed changing.  VULNERABILITY \ SUSTAINABILITY Sources of Vulnerability 30. Resuming growth is one thing. The country just experienced how essential proper financial regulation was in sustaining it. A lack of savings also leaves the country more exposed than most to shocks and turbulences. As a nation, the Philippines has one of the lowest domestic savings rates in the region. Thus, any spur of development energy rapidly threatens its external balance. 31. The same goes for low-income groups: taken together, the lower three income deciles of the population do not save. They have therefore little cushion to fall back on in hard times, or capacity, even in good times, to access formal credit markets or makes the most basic investments. As a result, they are the ones who can least afford economic shocks, as research on the impact of the recent crisis confirms. 32. To sustain the level of growth required for rapid poverty reduction, while keeping the country out of future financial troubles, the investment-savings coverage ratio will need to rise over time. A number of factors could contribute to lifting private savings: (i) maintaining confidence in the country's banks and currency will remain central; (ii) diversifying savings instruments and broadening the coverage of contractual savings schemes; (iii) bringing down food prices through trade liberalization; (iv) accelerating the decline in the age dependency ratio (through more vigorous population policies). Sustaining faster growth may further induce a virtuous circle of higher private saving. Fiscal Consolidation 33. One needs to recognize that private saving has a high degree of inertia and that sustained changes tend to materialize only over the long term. For a more immediate impact on aggregate savings, a resumption of fiscal consolidation is needed. After the fiscal deficit widened beyond target in 1999 (to 3.6 percent of GNP), government should be steadfast in its resolve to bring the deficit down to 1.9 percent of GNP this year. 34. The main instrument of fiscal consolidation should be to reverse the recent losses of revenues (down from 18.5 of GNP in 1997 to 15.2 of GNP in 1999). Anticipating the impact of trade liberalization, the Philippines tax system underwent a fundamental overhaul under the three rounds of the Comprehensive Tax Reform Program in a bid to make taxation more buoyant, remove distortions in incentives, and reduce corruption by streamlining tax provisions, closing loopholes, and generally limiting the room for discretion. This tax reform needs to be brought to closure, including by streamlining the many tax incentives, which continue to puncture tax collection efforts. 35. Beyond this, all efforts should turn to revenue collection. To start with, the pattern of tax amnesties should be stopped, and the government should distance itself from the various efforts currently afoot in Congress in favor of a new one. Second, the Commission on Audit must be authorized to extend its oversight to the Bureau of Internal Revenue, to help root out allegedly endemic corruption in revenue collection. Third, the  -xi- recently decided restructuring of the Bureau from a functional to a client-based organization needs to proceed, and underpin more forceful audit efforts. 36. The biggest threats to fiscal stability, however, often arise, not from the mainstream of budget operations but from off-balance sheet risks, such as the performance guarantees embedded in PPI contracts. Large as those might be, they do not constitute the only form of contingent exposure. There is also a well-established tradition in the Philippines for the government to use off-balance sheet mechanisms to meet social needs (e.g., local water, rural electrification, housing, deposit insurance). These arrangements also create considerable-and in some cases, much less contingent- exposures. Going forward, a more careful use of guarantees and a better monitoring- and pricing-of the risks involved will be in order (e.g., when capitalizing the Home Insurance and Guarantee Corporation). 37. Even if the Philippines succeeds in cutting back its investment/savings gap substantially over this decade, as this report anticipates, the Philippines will continue for some time to come to require official development assistance to meet its development priorities. For this assistance to be forthcoming, however, the country will need to restore its record of aid utilization, which has deteriorated sharply in recent years.   -2- PROLOGUE The Philippines was among the first countries directly affected by the Asia crisis to regain (and exceed) the level of activity achieved before the crisis. The pace of the 1999 recovery may have been milder than in other crisis-affected country (3.2 percent GDP growth in 1999), but so was the previous contraction (see Figure 1). Indeed, were it not for the impact of El Nifo (which caused rice and corn production to contract by 19 percent and 13 percent in 1998, respectively), the economy would likely have avoided a recession. In fact, GDP shrank somewhat (-0.5 percent in 1998), but growth of nonfarm output remained positive (+1.1 percent in 1998). Figure 1: FARM AND NON-FARM Figure 2: DESEASONALIZED GDP COMPONENTS OF GDP DEVELOPMENTS, 1998-99 (percent year on year) (percent, annualized quarterly growth rate) 350 -5.0 _ R _ _ > | 5 9 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~2.0 -25l01 Q2 03 Q4 Q1 Q2 03 04 ~~ -GDP ----- Farm -Nonfarm F-~GOP -~Agricuhue Industry :se~c:s Source:NSCB Source: NSCB Similarly, employment has risen by 4 percent since 1997 (see Figure 3), limiting the social impact of the crisis. Furthermore, Philippines banks have remained capitalized considerably beyond Basle-standards with an average capital adequacy ratio at 17.6 percent. The question now facing the authorities is how to bring back growth to a pace strong enough to make a serious dent into poverty.  -3 - Figure 3: GROWTH IN EMPLOYMENT Figure 4: KEY RATIOS OF THE BANKING (percent year on year) SYSTEM (percent) &g=1~~ Farpo<-,nm ----oo (ft) V4Wi Source: NSO Source: BSP The concern is real. With the technical rebound of agriculture, growth did bounce back in 1999. But nonfarm activity remained sluggish (+2.4 percent in 1999). Furthermore, on a deseasonalized basis, growth has actually been decelerating (see Figure 2), and might already be too slow for unemployment to come down further (see Figure 5). In this context, the public perception is that poverty is not any longer declining (see Figure 6). Figure 5: UNEMPLOYMENT RATE Figure 6: SELF-RATED POVERTY (percentage point difference, year on year) INCIDENCE (percent) 3% 69 2% 67 1%/ 63 0% 61i. -2% 57 Jan July Jan July Jan July Jan 55 97 97 98 99 00 1994 1995 1996 1997 1998 1999 Source: NSO Source: Social Weather Station The authorities' attempts at reviving demand have met with only mixed success. Of course, growth might have been weaker, had fiscal and monetary policies not been relaxed. And fiscal expansion may have helped to maintain essential expenditure programs. But, with the fiscal deficit well beyond original targets (from an initial target of 0.6 percent for 1999, the national government deficit widened instead to 3.6 percent of GNP, (see Figure 7), with revenue losses (down from 18.5 of GNP in 1997 to 15.2 of GNP in 1999, (see Figure 8), policy credibility has suffered and the policy of fiscal stimulation has run its course before private demand could gain much momentum. Investment continued to contract and private consumption decelerated in 1999. Concerned to limit pressures on interest rates (see Figure 9), the government is now actively trying to reverse the fiscal trend (see Figure 7 and Figure 8), in the hope of bringing the deficit down to 1.8 percent of GNP this year.  -4 - Figure 7: NATIONAL GOVERNMENT Figure 8: NATIONAL GOVERNMENT CUMULATIVE SURPLUS/DEFICIT REVENUE AND EXPENDITURE (billions of pesos, 12-months moving sum) (percent year on year, 3 months moving average) ~ yA t ~~~~~~~~__ * _ , __ = to -Revenue --Eq~nditureK Source: Department of Finance Source: Department of Finance Similarly, a steady relaxation of monetary policy and the ensuing fall in interest rates since the Spring of 1998 (see Figure 9) may have saved banks and corporations from more serious stress, but they have so far breathed little new life into private credit demand (Figure 10). Lower interest rates notwithstanding, the Philippines stock exchange has also had one of the least inspiring performances among major Asian stock markets since they hit bottom in late Summer 1998. Figure 9: PRIME RATE AND INFLATION Figure 10: NET DOMESTIC CREDIT (percent year on year) GROWTH (at constant exchange rate, percent year on year) ) a WI SS 41 * / \'/ rE- `77`;1 7-77 t;'n Difference (rts) CPI (llhs) -Prime Rate (Iha Total (Ihs) -Priv_Sect._(rhs): Source: BSPa NSO Source: BSP The combination of an ever widemng fiscal deficit inconsistent structural policy signals, and repeated allegations of cronyism have created a malaise strong enough to blunt the economy's response to the stimulus provided. Things do notwneed to be that way. With stronger confidence, there are many reasons to believe that the country could afford to pick up the pace of growth without major immediate financial risk. Weak domestic demand has helped bring down core inflation from 12 to 8 percent between 1998 and 1999 (the impact of the bumper crop  -5 - temporarily brought headline rate further down below 3 percent in early 2000, (see Figure 11) and put the country's external accounts in a position of rare strength. Spurred by relentless growth of electronics exports, the trade account swung into surplus (about 5 percent of GDP in 1999) for the first time in 26 years (see Figure 12) and drove the current account to a record surplus. Heavy sovereign borrowing (US$4.4 billion in 1999) to meet the public sector financing requirement have helped boost reserves to historically high levels (about US$15 billion at the end of 1999); though reserve accumulation was at the same time limited by the unprecedented level of unexplained outflows. With subdued demand from other sectors of the economy, the country's external debt remained relatively stable at US$48 billion as of June 1999. Furthermore, most of it (86 percent) is for medium to long-term maturities, while short-term obligations now fall well below the level of external reserves. Figure 11: CORE AND HEADLINE Figure 12: MERCHANDISE TRADE INFLATION (percent year on year in US$ million) (percent year on year, 1994=1 00) -GPI - PI x fod & utlities Tradebalanice (rhs) -E,qports (fth) - linwots (us) Source: NSO Source: NSO With the impact of the Asia crisis receding, it is therefore time for policy-makers to train their sights again on the structural challenges of the medium term. The main priority in the view of this report is to set the country on target towards the international objective of reducing absolute poverty by half by 2015. The past decade saw the country make unprecedented progress in that direction. To be able to pick up the pace again, it is useful to reflect on the lessons learned from both recent successes and disappointments. The chapters that follow contribute to this reflection.  -6 - 1. POVERTY REDUCTION AND ECONOMIC PERFORMANCE A. INTRODUCTION 1.1 The Philippines' shift since the mid-1980s from inward to outward orientation changed the nature of growth, making it more labor-intensive and more beneficial to the poor. Thanks to a long-standing effort in favor of education, larger numbers were able to contribute to the structural transformation and share in the benefits of growth. A redistribution of the national income in favor of households and a convergence of earnings across sectors further helped spread the benefits of growth. Unfortunately, the period also coincided with a series of shocks-largely exogenous to the structural transformation itself-which limited the duration of the growth years and hence, the full impact on poverty. 1.2 During the run-up to the Asia crisis, moreover, the macroeconomic foundations of growth became more fragile. With the prior appreciation of the currency, the domestic terms of trade increasingly tilted towards nontradables (e.g., real estate, services), while rising food protectionism further hindered the development of sectors more open to international competition. Booming exports notwithstanding, this powerful undertow eventually destabilized the external account, exposing the country to the reversal of market sentiment throughout the region. These developments are discussed in the second section of this chapter. 1.3 As described in the prologue, the country succeeded during 1998-99 in restoring its external financial situation at a much lower social cost than its neighbors more severely affected by the Asia flu. The issue now is how to rekindle growth and put poverty reduction back on track. The final section discusses some of the main challenges involved: (i) containing population growth while dealing with its implications; (ii) resuming faster, labor-intensive, but also better balanced growth; and (iii) managing the rapid urbanization which will necessarily accompany the needed structural transformnation3 of the economy. B. TRENDS IN GROWTH AND POVERTY REDUCTION 1.4 By all accounts, the policies pursued since the return of democracy have been good to the poor (see Table 1.1). Not only has the number of people living below the poverty line fallen steadily in relation to the population (from 41 percent to 25 percent '"The potential of the concept of structural transformation to unify the study of various aspects of development is demonstrated by the use of such terms as agricultural transformation, industrialization, demographic transition, and urbanization, each of which describes one or more dimensions of the overall transformation process.... What are the main features of the transformation that affect the ways in which economies grow and that distinguish developed and developing countries? ... * Engel's law of the declining share of food in consumption