Philippines - A framework for economic recovery (Vol. 1 of 3) : The policy agenda

Report No. 6350-P The Philppines A Framework for Economic Recovery (In Three Volumes) Volume l: The Policy Agenda November 5, 1986 Country Programs Department East Asia and Pacific Region FOR OFFICIAL USE ONLY Document of the World Bank This report has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS October 1986 - US$1.0 = P 20.4 - P 1.0 = US$0.05 Average 1985 - US$1.0 = 18.6 - P 1.0 = 0.05 Average 1984 - US$1.0 = 16.7 - P 1.0 = 0.06 Average 1983 - US$1.0 = 11.1 - P 1.0 = 0.09 ACRONYMS CB - Central Bank CPI - Consumer Price Index CRC - Capital Recovery Component DBP - Development Bank of the Philippines EPR - Effective Protection Rate CDr - Gross Domestic Product GFI - Government Financial Institution gnfs - Goods and non-factor services GNP - Gross National Product CRT - Gross Receipts Tax ha - hectare h.c.v. - Home Consumption Value H.Y.V. - High Yield Varieties ICOR - Incremental Capital Output Ratio IFS - International Financial Statistics IMF - International Monetary Fund ISF - Irrigation Service Fees LBP - Land Band of the Philippines LIBOR - London Inter-Bank Offering Rate MAF - Ministry of Agriculture and Food MOE - Ministry of Energy MRR - Manila Reference Rate MT - metric tons NEC - Non-essential consumer NEDA - National Economic and Development Authority NFA - National Food Authority NFPE's - Non-financial Public Enterprises NIA - National Irrigation Administration NPA's - Non-performing Assets NPC - National Power Corporation O&M - Operation and Maintenance PCA - Philippine Coconut Authority PGC - Philippine Export and Foreign Loan Guarantee Corporation PIP - Public Investment Program PNB - Philippine National Bank PNOC - Philippine National Oil. Company UC - UJnclassified Consumer WPI - WhoLesale Price Index  FOR OmCAL USK ONLY PHILIPPINES COUNTRY ECONOMIC REPORT: A FRAMEWORK FOR ECONOMIC RECOVERY VOLUME I: THE POLICY AGENDA Table of Contents Page No. SUMMARY AND CONCLUSIONS ...................................... * * * * * * * * * I. MACROECONOMIC OVERVIEW .......................... 1 A. Macroeconomic Developments: 1970-85 ..................... 1 The Building of a Crisis: 1970-82 ....................... 1 The Years of Stabilization: 1983-85...................... 4 B. Macro-Adjustment for Growth............... .............. 7 Recent Developments ..................so ...... 7 Recovery Prospects ................ 9 Medium-Term Prospects ...... .............................. 12 II. RESOURCE MANAGEMENT .......................................... 16 Ao The Balance of Payments ... ........... .................. 16 Recent Adjustments............ 16 Policies for Recovery................ .oo 19 Exchange Rate Policy ........... ..*..... .19 External Debt Strategy... ...... .... ................. ...o . 21 Implications for Creditors and Borrowerso................ 22 B. The Financial Sector............... ........ ............ 24 Recent Adjustments.................. . ... ... * 25 Requirements for Achievement of Sustainable Growth ....... 27 Lowering Spreads and Real Interest Rates ................. 28 Government Financial Institutions (GFIs) .................. 30 Crisis of Commercial Banks............................... 32 Strengthening the Central Bank's Supervisory Functions ......... ....... o.0466 ..s. 33 This report presents the findings of a mission which zisted Manila in April 1986. The mission consisted of Isabel Guerrero (Leader), Vittorio Corbo, Israel German, Hafez Ghanem, Kathie Krumm, Ahsan Mansur, Rakesh Mohan and Goran Segerlund. The report was updated and discussed with the Government in October 1986... This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Page No. C. The Public Sector ........**......*.. * ............ 34 Recent Developments and 1986 Outlookt..... 34 Consolidation of Central Bank Operations into the Financial Operations of the Public Sector tor......... 37 The Domestic Components of Fiscal Deficiti............... 37 Structural Aspects of the Expenditure and Tax system ~~~~~~~~~~~~40 Public Sector Expendiure. 42 Elements of a Revenue Strategy for the Medium Terms m****. 43 Changes in Tax Administrationsti............ on...... 43 Tax Reom43 The Public Investment P ro g r a m 44 Recent Developments.. *... ........**o***o. ... 44 III. THE PRODUCTIVE SECTORSE C T O RS............ 48 A. Agriculture .... 48 Requirements for Resumption of Sustainable Growtht....... 50 Rural CTesit............................................. 50 Tradte Polce SO .. Exchange Rt .... ,,51 Export Taxex... 52 Agricultural Productivityo... 52 Fertilizers ......... 'f ...$ .... 54 Irrigtin....a t i on00 ...... 55 Proposed Government Strategy............................. 55 Rural Infrastructure.................................. 56 Research and Extension................................... 57 Revitalizing Philippine Industry.d.u..s t ry.............. 59 The Expansion of Exports.................. o.t . . 61 Trade Liberalization.. 0 0 000 0 0 .00 00 00 00. 61 Electronics, Garments and the Quota System t.......... 61 Export Diversification and Promotion..................... 62 The Trade Reforms... .... .64 Removal of Quantitative Import Restrictions........ 0 65  WORLD BANK REPORTS ON THE PHILIPPINES, FY85/86 A. Sector Reports and Special Economic Studies Agriculture: Issues in Pricing Policy, No. 4845, July 1984 Public Expenditures and their Financing, No. 4919, September 1984 A Review of External Debt, No. 4912, November 1984 An Agenda for Adjustment and Growth, No. 5258, November 1984 Recent Trends in Poverty, Employment and Wages, No. 5456, June 1985 Food Processing Sector: Development Potential and Constraints, No. 5503, July 1985 Sugarlands Diversification Study, No. 6042, May 1986 B. Appraisal Reports Agriculture Agricultural Credit, No. 5514, May 1985 Transporation Second Rural Roads Improvement Project, No. 5971, May 1986 Water Supply Metropolitan Manila Water Distribution, No. 5903, February 1986 a7 The previous economic report "The Philippines: An Agenda for Adjustment and Growth," No. 5258-PH, November 1984, lists World Bank reports on the Philippines distributed in FY1983/84.  SUMMARY AND CONCLUSIONS At the time of the last Country Economic Memorandum on the Philippines, stabilization was the central issue that policymakers needed to address. Today, the main objectives of economic stabilization have been achieved. The new Government now has to focus on increasing output, employ- ment, and living standards within an environment of constrained resources, both domestic aid foreign. Although the Philippine economy is well endowed with natural and humqn resources, recovery will not be an easy task. Underly- ing weaknesses in the economy will inhibit the recovery effort. These include the biases against agriculture and export production, low productivity in industry, weaknesses in the financial system, low public-sector savings and the overhang of accumulated foreign debt. The main challenge for policymakers today is to design a program for economic recovery which is consistent with the objectives of the new Government's development strategy and addresses the country's fundamental structural problems. The Recent Adjustment The stabilization of the external account imbalance has been achieved but at the expense of a sharp drop in economic activity. The current account deficit, inflation, and the government deficit have all been substan- tially reduced in the last two years. The current account deficit was reduced and then shifted from 8% of GNP in 1982 to a small surplus in 1985. Inflation was reduced from a peak of 50% in 1984 to a rate of 2% in the first quarter of 1986. The consolidated public deficit was reduced from 5.8% of GNP in 1982 to 1.5% in 1985. At the same time that aggregate demand was controlled, overall output was also contracting and real interest rates were rising to unprecedented high levels. For the past two years, GDP growth has been negative, unemployment has increased, income per capita has declined to 1975 levels, and capacity utilization has dropped dramatically. The expenditure-output gap was reduced through a drop both in the level of domestic demand and aggregate supply, thus stabilizing the economy at a lower income level. Investment, both private and public, contracted more sharply than consumption. Reduced real income brought about a decline in imports, which had to offset not only the initial balance of paymei s deficit but also a significant decline in export earnings. The public sector's borrowing requirements combined with the monetary squeeze, contributed to high interest rates and to crowding out of the private sector. On the expenditure side, after the Government reduced public investment by more than half in two years, a large part of the deficit was due to foreign obligations of unprofitable private sector projects that the Government had to assume. On the financing side, tax collection was falling throughout the adjustment program, and foreign financing had sharply dropped. Thus, the Government had to resort to domestic financing to meet its borrowing requirements. Given the restrictive monetary policy in place, this borrowing was translated into very high real interest rates and a drop in private investment. Real interest rates reached a peak of 29% in the first quarter of 1986 while private investmlent dropped from 21% of GNP in 1982 to  - ii - 12.61 in 1985. The private sector financed the public sector investment- savings gap, as vell as the surplus in the current account in 1985. In hindsight it appears that adjustment could have been both less painful and more structural if it had been done more through shifts in the composition of expenditures and output rather than exclusively through expenditure reduction. Although some drop in absorption was necessary, it could have been combined with a number of expenditure-switching policies such as appropriate exchange rate policies, tariff reform and removal of import restrictions, elimination of export taxes, and export promotion measures. These policies, by achieving An increase in the relative prices of tradables versus nontradables, could have shifted resources from the nontradable goods sector, where there was excess supply, to the tradables sector. Thus the external imbalance could have been closed by an increase in exports rather than exclusively through a decline in overall output. Instead, the real exchange rate remained stable in 1984 and it even appreciated in 1985 with the drop in economic activity. Stabilization was4achieved without addressing the fundamental trade distortions which were partly responsible for the 1983 crisis. In fact, a number of stabilization policies, such as import restric- tions, increased import duties and increased export taxes, were at cross pur- poses with the medium term adjustment requirements of the Philippine economy. Mascroadjustment for Growth At present, public sector resource mobilizationeremains inadequate, external debt continues to be large, and the financial sector remains weak. Without fundamental structural reforms, external imbalances are likely to reappear, once recovery is under way. Given that abdorption has already been reduced, further adjustment should be done through both a switch in expendi- ture and through supply oriented policies. Growth oriented policies include increasing efficiency of domestic production, shifting expenditure composition (both private and public) towards maintenance and investment activities, increasing domestic savings, allowing for adequate government expenditures, and removing the constraints to expanding production in agriculture and industry. In the short run, the main constraint to economic recovery is the public finance problem. Through the rescheduling, external debt has now been transformed from a balance of payments to a fiscal problem. Since government expenditures have been significantly reduced, the only viable way to reduce the budget deficit any further is to cut transfers and improve tax collections. These two measures, however, are unlikely to lead to an immediate increase in fiscal resources. In the meantime, given the size of external obligations--more than half of the assistance to government financial institutions is foreign-based--actions to cut the deficit will still leave an unfinanced gap. Financing such a gap domestically would either lead to an acceleration in inflation or to a significant further crowding out of much needed private investment. This is why external financing of the deficit will be essential while structural changes are being implemented to reduce the consolidated deficit.  - iii - There are a number cf positive developments which, if capitalized on, could significantly ease the adjustment and recovery process. First, the drop in international oil prices will reduce the import bill by close to 10X. Second, lower international interest rates will heip alleviate the external debt burden. Third, although some industrial restructuring still has to take place, much of the painful adjustment in the manufacturing sector has already been undertaken as a result of the ongoing recession. Fourth, the change in economic and political conditions is likely to lead to an increase in investment in the next few years. Fifth, a number of reforms, especially in the agricultural sector, are in place and have not had a chance to show their impact, given the depressed level of economic activfty. Last, the philosophy of the new Government is more clearly concerned with supporting activities such as agriculture, small producers and exports which have been discriminated against in the past. To capitalize on these positive developments, however, the Govern- ment should be carefl. lo avoid some policies which are popular in urban areas but which go against the objective of agricultural and export development. The overvaluation of the exchangc rate, negative effective protection for agriculture and export activities and price controls on agricultural products are all policies which benefit urban producers or consumers at the expense of rural development and export profitability. Trade Policies Given the existing recessionary conditions the sequencing of trade policies should start with export promotion measures, together with the removal of import restrictions on raw materials and intermediate products. Maintenance of the present flexible exchange rate system is a crucial element of this strategy. This will ensure that the exchange rate adjusts to a level consistent with a recovered and liberalized economy. Other export promotion measures include quality control, duty-free inputs for export production, and negotiations for enlarged access to restricted markets. Import restrictions on raw materials and intermediate products also need to be removed immediately so that user industries are no longer penalized by the ewistence of these restrictions and can have an pportunity to become more efficient when they have to start competing with foreign products. The Government has already undertaken measures in this direction such as the removal of export taxes and the elimination of restrictions to a number of imported raw materials. Although further tariff reform can begin to be implemented after the mentioned policies are in place, it is crucial that the signals for future investment be consistent today with the Government's medium-term thrust. What is important on the trade front now is a clear commitment from the Government to a policy of trade liberalization and to the elimination of import restric- tions and all impediments to export expansion. This will require a clear statement on the goal of liberalization, its underlying rationale, and a timetable for implementation. The preannouncement of a schedule for liberali- zation, including an indicative schedule of tariff reduction, before new investments takes place will also make the adjustment easier for firms already in operation.  - iv - The Balance of Payments The balance of payments is going to be a focal point in the next five years. On the financing side, the current high debt obligations will constrain economic recovery so debt rescheduling will be at the center of the new government's policy agenda. On the real side, efficient import substitu- tion and export growth are essential components of a sustainable growth stra- tegy. Competitiveness of the Philippine economy must be improved through the trade weakness summarized above so that sufficient foreign exchange is generated to finance the imports complementary to investment and output growth and also to meet the debt payment obligations. Although the balance of payments crisis has been reversed both in the current and the capital account, the reversal might not be sustainable. The current account improved mainly through a reduction in imports which will need to increase once recovery is underway. The capital account improved through the rescheduling covering only the October 1983 to December 1986 period. The new government has the potential to develop a sustainable growth strategy consistent with some reliance on continued external financing. As long as capital is used productively and favorable signals are given to the tradable producing sector, the Philippines can run small current account deficits over the next five years. An alternative strategy of maintaining or reducing the level of external debt is not compatible with substantial growth. As long as the growth in debt is slower than the growth in GNP and exports, the relative debt burden will be gradually reduced. Nonetheless, the extra financing requirements for this growth oriented strategy are large. A substantial portion of these financing requirements will have to be met through concessionary loans and additional debt relief. Multi-year debt rescheduling would allow the government some time to implement the policy reforms necessary for sustained economic growth. The Financial Sector The success and sustainability of the recovery will hinge on the financial system's capacity to mcbilize domestic savings and supply credit for productive activities. Although the 1980 financial reforms were successful in mobilizing resources, the financial system now faces severe problems stemming from the recent crisis and the economic recession. The agenda for policy actions in the financial sector should address a number of shortcomings present in the sector today. The shortcomings include high real interest rates, high cost of intermediation, strong government presence in the financial institutions, and the present crisis of commercial banks. There has been a decline in the volume of credit available to the private economy as a result of the Government's need to source its financing domestically within tight monetary conditions. Taxes on intermediation have also increased and have then resulted in higher spreads between lending and deposit rates In the short run, a lower level of domestic financing of the deficit combined with the removal of some taxes on intermediation will help to bring real interest rates down to a level consistent with economic recovery. In the medium term, the role of the Government in the financia' sector should be reduced and focused on functions which the private sector fails to perform adequately, such as lending to agriculture and small scale industry. To the  extent that it is not a result of private competition, merging of commercial banks should not be encouraged as a means of solving the present crisis of some formerly private banks now acquired by the Government. The role of the Central Bank should be limited to traditional functions with considerably strengthened supervisory capabilities. The Government is presently consider- ing reforms in this area in order to reorganize and demarcate the future role of government financial institutions. The Public Sector The size of the public sector in the Philippines is structurally bounded by an exceptionally low tax ratio. To address this problem, the Government needs to increase its revenue generation capacity to continue building and maintaining basic infrastructure facilities and services needed for productive activities. Although the tax system is comprehensive, tax collection efficiency needs to be improved together with the removal of distortionary effects of the prevailing system. A substantial tax reform has recently been implemented which addresses both collection inefficiencies and distortionary effects on resource allocation. However, the benefits of the reform will not have their full impact on revenue generation until 1987. In the interim, expenditure levels for 1986 should allow for higher capital outlays, maintenance and budgetary assistance for the government until 1987. In the interim, expenditure levels for 1986 should allow for higher capital outlays, maintenance and budgetary assistance for the government financial institutions. Also, expenditure priorities will have to be reoriented towards developing agrcuilture infrastucture, and provision of services in health and education. The medium-term expenditure strategy should aim at increasing the share of capital and maintenance in total public-sector expenditure while limiting the growth of statutory obligations such as public and publicly guaranteed debt. Cash generation of public enterprises should also increase through improvement in their management, cost-recovery efforts, divesting of those enterprises which can be operated by the private sector, and liquidation of unviable operations. In the short run, given the size of the deficit, some increase in external budget support may be necessary. The Agriculture Sector The overall incentive system in the agriculture sector has significantly improved after a number of reforms which have been recently implemented. Subsidies and directed credit to agriculture have been removed; price controls on agricultural products have been liberalized; export taxes have been eliminated with the exception of those in place for conservation purposes; the importation of inputs to agriculture, such as fertilizers and animal feeds has been liberalized; and the range of nominal tariffs has been reduced. In addition, monopolies in sugar and coconut trading are being dismantled and the institutional structure in these subsectors is being rationalized. However, the macroeconomic framework still discriminate against agriculture. A protected manufacturing sector has made investment in agriculture relatively unattractive and resources have continued to move out of this sector. Effective protection rates are still negative for agricul-  - vi - tural activities as a result of the current tariff and tax structure. In addition to a discriminating macroeconomic framework, there are number of institutional constraints which prevent producers from responding to the new set of incentives following the recent reforms. These constraints have resulted in a low, and sometimes declining, productivity in the agriculture sector. Elements of a strategy to increase productivity include greater incentives for fertilizer use through reduction in taxation and improvement of the physical distribution system; improvements in irrigation services through substantial increases in the level of operation and maintenance expenditure; increased government expenditures on rural infrastructure, research and rationalization and strengthening of the extension system. Finally ration- alization of existing agriculture institutions, in particular the area of planning and policy formulating is another important requirement for agricultural development. Industry The recent collapse in economic activity has in some respects made it easier to develop a competitive industrial structure more suited to Philippine comparative advantage. Many of the most uncompetitive industries and firms have already ceased operations. Industry can now contribute in large measure to future growth given the right and timely policy measures. A recovery program for industry will have to address the present low final demand, high credit cost, and import restrictions. Urgent action is aiso required on nonperforming apoets and will do much to revive business confi- dence. The more growth oriented macro-economic environment and appropriate real exchange rate polic;es will need to be bolstered by further action in the regulatory environment, r.ew industrial promotion measures, and changes in the incentive system. On the regulatory environment it is necessary to liberalize domestic trade restraints ano review the role of fiscal incentives. Changes in the trade environment include immediate lifting of import restriction on raw materials and intermediate goods, and a preannounced program for further rationalization of tariffs along with implementation of antidumping measures. The implementation of export promotion actions will allow Philippines industry to seize the emerging set of opportunities, as many of its competitors in the region shift their activities out of labor-intensive industries in response to their rising wage levels. A substantial wage differential between the Philippines and other East Asian competitors has opened up in recent years, as real wages have remained constant in the Philippines, while they increased in the other countries. Domestically, the recovery of the public investment program will help in reviving demand, in particularly for the construction sector. In the medium term, a major outstanding issue will be the provision of industrial term credit.  PHILIPPINES COUNTRY ECONOMIC REPORT: A FRAMEWORK FOR ECONOMIC RECOVERY I. MACROECONOMIC OVERVIEW A. Macroeconomic Developments 1970-85 The Building of a Crisis: 1970-82 1.01 Although the Philippine case was generally perceived as a success story during the seventies, the seeds of the 1983 crisis were already being planted. GNP growth rates were quite high, but manufacturing expansion largely occurred in highly protected sectors. Export growth rates were also quite high, but the incentive system was not conducive to a broad-based export expansion. The peso was adjusted periodically, but the structure of tariffs, import restrictions, and export taxes allowed the peso to be overvalued by around 30% during the seventies. Investment rates were about 30% of GNP, but these resources were not productively used and responded to a distorted set of incentives. To sustain a high rate of growth under these conditions, the Government increased its reliance on external sources of finence. 1.02 The deterioration in terms of trade in the late 1970s, followed by rising interest rates in the early 1980s, brought into the open the underlying structural v:eaknesses of the economy. The faltering growth psrformance in the early 1980s ended up in an open crisis situation in 1983. BeLause of falling terms of trade and an inefficient industrial structure, growing import requirements were not met with commensurately higher export receipts. The current account deficit increased from an average surplus of 0.7% of GNP in the 1970-74 period to a deficit of 4.6% in 1975-80 and 7.6% in 1982. As most of the deficit was financed with foreign borrowing, total external debt increased from $4.9 billion at the end of 1975 to $13.4 billion at the end of 1979, an average rate of 28.6% per year during this period (see Table 1.1).  - 2 - Table 1.1: SELECTED MACROECONOMIC INDICATORS, 1970-85 1970-74 1975-79 1980 1981 1982 1983 1984 1985 Real GNP Growth Rate (x) 6.1 6.4 5.0 3.4 1.9 1.1 -6.8 -3.8 Inflation (yearly averages) Consumer prices (CPI) (2) 18.9 9.9 18.2 13.1 10.2 10.0 50.3 23.1 GNP Deflator (x) 16.8 9.8 15.6 11.0 8.4 10.1 49.1 17.6 Net Terms of Trade (Index 1972=100) 125.5 79.4 68.6 60.4 58.7 61.3 59.8 55.0 Current Account Deficit/ GNP (X) ( ainus = deficit) /b 0.7 -4.6 -4.9 -5.1 -7.6 -7.1 -2.7 0.1 Real Exchange Rate /a (Index 1980=100) 97.8 103.1 100.0 96.2 91.0 105.7 105.0 96.3 External Dqbt US$ billion n.a. 8.76 17.4 20.8 24.2 23.9 24.4 25.2 Consolidated Public Sector Deficit/GNP (x) n.a. n.a. 3.0 5.1 5.8 4.2 3.0 2.6 /a A higher number means a depreciation, Calculated on a trade based average using 1980 shares of the main trading partners. /b Derived from national accounts; differs slightly from balance of payment estimates. Sources: National Accounts. Central Bank, Statistical Bulletin. World Bank, World Tables, 1985-86. 1.03 Another cause of the 1983 crisis was a growing public sector gap as increased public sector investment and government consumption was not offset by increased public sector savings (see Tabie 1.2). The larger deficits reflected an attempt by the Government to implement a countercyclical expan- sionary policy rather than adjusting to the drop in terms of trade and the accumulating debt.  - 3 - Table 1.2. PRIVATE AND PUBLIC SECTOR RESOURCE ABSORPTION (percentage of GNP) Private sector /a Public sector /b Surplus/ Surplus/ Year Investment Savings deficit /c Investment Savings deficit Deficit Ic 1978 22.4 20.2 -2.2 6.6 3.5 -3.1 -5.3 1979 25.0 21.0 -4.0 6.0 4.6 -1.4 -5.4 1980 22.8 20.1 -2.7 7.9 4.9 -3.0 -5.7 1981 22.0 21.1 -0.9 8.7 3.6 -5.1 -6.0 1982 21.8 19.1 -2.9 7.0 1.2 -5.8 -8.5 1983 19.4 15.4 -4.0 7.7 3.5 -4.2 -8.2 1984 14.6 15.0 0.4 4.6 1.0 -3.0 -2.6 1985 12.6 14.6 2.0 3.6 1.0 -2.6 -0.6 /a Private seotor and others is computed as residual. 7r Public sector includes National Government and nonfinancial corporations. ic Minus = deficit; equals current account balance less transfer; derived from national accounts. Source: NEDA, National Accounts Staff. 1.04 In addition to internal structural weaknesses, the external environ- ment of the late seventies made adjustment even more urgent. The sharp dete- rioration in the Philippines' terms of trade, the increase in international iziLerest rates, and the drying up of medium and long term international capital markets called for moderate fiscal and monetary policies and a real devaluation in the early eighties. However, even after the substantial contraction in medium and long term international financial markets following the Latin American debt crisis, the Philippine authorities continued postponing the needed adjustment measures by increasing short-term debt. When a political crisis developed following Aquino's assassination, the external debt problem came into the open, as commercial lenders refused to roll over short-term credits or extend new medium- and long-term loans. 1.05 The debt problem in the Philippines was a result of misdirected investment in the seventies. The fact that investment resources were not pro- duccively used, together with rising real interest rates, turned what could have been a liquidity crisis into one which has imposed tremendous longer run costs to the economy. The debt crisis in other countries occurred as a conse- quence of exchange rate mismanagement and following capital flight (Latin America), or overconsumption both private (Israel) and public (Mexico). In the Philippines, the large accumulation of foreign debt did not result in a major real appreciation of the exchange rate since the investment had a large import component. This investment surge occurred in both the public and pri- vate sectors, but much of the private investment took place with guarantees or loans from government-owned banks. While a large portion of the public sector  investment helped reduce petroleum imports by developing indigenous energy sources, much of the investment financed during this period was ill-conceived, overpriced, or proved unprofitable in a rapidly changing international environ- ment. When these private investments proved unprofitable, they became a public liability through their financial links with government banks. The Years of Stabilization 1983-85 1.06 During the second half of 1983, when international banks stopped lending to the Philippines and called their maturing loans, the country's critical balance of payments position was exposed. By late 1983, the option of continuing to postpone adjustment by further increases in external debt was no longer available. The capital flight that followed the political crisis of the second half of 1983 exacerbated the emerging balance of payments problems; it was becoming increasingly difficult to get external financing for a current account deficit equal to 7.1% of GNP. 1.07 TI.e Philippines started a stabilization process in late 1983 and brought under control the short run external imbalances. The turnaround in the cyrent account deficit has been achieved through a drop in real absorp- tion - and a sharp output contraction. Lowering of imports has been achieved through a contraction in productive activity, and as a consequence exports have also dropped substantially. In the absence of foreign financing some cut in real absorption was inevitable but in order for the stabilization effort to represent a structural adjustment conducive to longer-term sustainable econo- mic growth, it should have been accompanied by an appropriate realignment of relative prices. This in turn would have required a medium-term perspective in stabilization policy formulation, which was Lacking. Drastic cuts in public expenditures and restrictive monetary policies, which were the primary instruments used by the Philippine Covernment to stabilize the economy, were appropriate ones. There is room for argument, however, about the extent of the monetary and fiscal restraint during some episodes of the stabilization period. Moreover, the balance of payments management which relied, initially at least, on restraining imports rather than on adequate exchange rate adjustment, may have prevented a more buoyant export response which would have enhanced the sustainable growth prospects of the economy. 1.08 Some of the Government's stabilization policies during the 1983-85 period were not appropriate for the medium-term adjustment needs of the Philippines economy. Quantitative import restrictions, increases in import duties, and taxes on exports introduced as part of the stabilization program were at cross purposes with medium term requirements. For the medium term, the deterioration in the terms of trade and the reduction in international bank lending required new incentives to promote export oriented activities and efficient import substitution. In reality, however, the net effect of the trade measures actually implemented after 1983 was to reduce the incentives for export-oriented activities relative to highly inefficient import competing activities. 1/ Real absorption is defined as total consumption plus total investment.  -5- 1.09 The Government's initial reaction to the economic crisis in 1983 was to devalue the peso and then close the economy. The government undertook a series of nominal devaluations to reverse the 1978-82 appreciation. The first of these, in June 1983, was too small (7.8%) to reverse the appreciation of the currency in the 1978-1982 period (Table 1.1). Furthermore, the suspension of international bank lending to the Philippines required a much heavier devaluation. When the political situation started to unravel in late 1983, it led to substantial capital flight. A second, sharper devaluation, of 27.3% occurred in October 1983. The net effect was a real devaluation of 16% between 1982 and 1983. 1.10 In October 1983, the Philippine authorities imposed foreign exchange rationing and as a result a wide range of imports was prohibited and the import liberalization program was halted. The program to remove import restrictions, which started in 1981, had been designed to complement the tariff reform program. Although the tariff reform was not abandoned during the stabilization, its effect was offset by the increase in nontariff controls and the imposition of an import surcharge. Furthermore, taxes were imposed on both traditional and nontraditional exports. 1.11 In 1983, the intensification of import controls at the time of the devaluations, complemented with accomodating monetary policy, resulted in an acceleration of inflation which eroded part of the effect of nominal devalua- tions on the real exchange rate. Inflation surged from 10% in 1983 to 50% in 1984. Previous devaluations were followed by another 28.6% devaluation in June 1984 and a managed float was implemented starting in October 1984. How- ever, the real exchange rate remained constant in 1984. (Table 1.1, line 5.) 1.12 The stabilization measures, which were introduced only in the second half of 1983, became effective in 1984 and were later supported by an IMF standby agreement. Real absorption in fact increased 0.2% in 1983, and only started falling by 5.6% in 1984. As a result of import restrictions, a depre- ciated currency and the cut in real absorption, the current account deficit as a share of GNP was dramatically reduced in one year from 7.1% in 1983 to 2.8% in 1984. 1.13 Although by 1984 the contractionary effects of the macroeconomic adjustment were already apparent, the Government's monetary policy continued to be restrictive in 1985. As a result, inflation continued to drop together with GNP and the real exchange rate appreciated. By 1985 the government's stabilization policies produced a further drop of 1.9 percentage points of GNP. However, concern about the sharp increase in inflation during 1984, together with the need to control the deficit of the Central Bank, led to a monetary policy aimed at slowing down the rate of nominal devaluation. Indeed, the nominal exchange rate appreciated 4.8% between December 1984 and December 1985, while in the same period CPI inflation dropped to 5.7%. lhe resulting real appreciation further penalized export oriented activities when, in fact, a substantial real depreciation was required. In spite of the real appreciation the further .eduction in real absorption in 1985 led to a small current account surplus. inflation, in fact, was sharply reduced but GNP, which had already dropped 6.8% in 1984, fell by an additional 3.8% in 1985. -The December-December Wholesale Price Index (WPI) inflation rates went from  47.4% in 1983, to 52.4% in 1981 and -0.8% in 1985; CPI inflation dropped from 50.8% in 1984 to 5.7% in 1985.- 1.14 The contraction in aggregate demand took place largely through a drop in investment, both private and public. Total investment dropped from 27.1% of GNP in 1983 to 16.2% in i985. Public investment dropped from 7.7% of GNP in 1983 to 3.6% in 1985 (Table 1.2). Private investment contracted by around 6.8% of GNP during the period. 1.15 The fact that private consumption levels as a share of GNP were maintained during the 1983-85 period shows that the burden of the adjustment was mainly borne by the productive sector and by the government. National accounts estimates show that the Philippine adjustment was an exception to stabilization experiences in other countries in that private consumption levels in the Philippines have been safeguarded and have even increased as a share of GNP (Table 1.j). Private consumption levels were kept by sacrificing personal savings. The share of private savings as a share of GNP fell from 19.1% in 1982 to 14.6% in 1985. In part, this could represent the perception by the private sector that the crisis was temporary, and reflects consumer behavior compatible with a longer-term view of income and consumption. This particular development gives an advantage to the recovery process since there will not be pressure to recover historical private consumption levels. However, since both savings and investments fell, it will be important to ensure that investment recovers and private savings get back to precrisis levels. This implies that the propensity to save out of income will have to return to the 23-25% level. 2/ These end-of-the-period figures are different from the yearly averages used in Table 1.1. The end-of-year figures reflect more accurately the rapid drop in inflation rates than do yearly averages.  -7 - Table 1.3: ABSORPTION, OUTPUT AND THE CURRENT ACCOUNlT (Percentage of GNP) Gross Statistic Net trans- Current Consumption capital dis- Total fers from account Private Public Total formation crepancy absorption abroad deficit (1) (2) (3) (4) (5) 6=(3)+ (7) (8) (4)+(5) 1978 67.1 9.1 76.2 29.0 0.1 105.3 1.1 4.2 1979 67.2 8.4 75.6 31.0 -1.3 105.3 0.8 4.6 1980 67.3 8.0 75.3 30.7 -0.3 105.7 0.8 4.9 1981 68.2 8.2 76.4 30.7 -1.0 106.1 0.9 5.1 1982 69.9 8.7 78.6 28.8 1.1 108.5 0.9 7.6 1983 70.8 7.8 78.6 27.1 2.6 108.3 1.1 7.1 1984 76.9 6.8 83.7 19.2 -0.2 102.7 -0.1 2.7 1985 81.7 7.1 88.8 16.2 -5.5 99.5 0.5 -0.1 Note: Total Absorption = Consumption + Investment + Statistical Discrepancy Current Account Deficit = Absorption - GNP - Net Transfers from Abroad. Source: NEDA, National Accounts and National Accounts Staff. 1.16 In 1985, private savings financed the public sector investment sav- ings gap as well as the surplus in the current account. The monetary squeeze and the sharp increase in real interest rates both contributed to crowd out private investment. The overall government deficit as a share of GNP was reduced from 5.8% in 1982 to 2.6% in 1985 (see Table 1.1, line 1, In terms of sectoral absorption of resources, the national government and the 15 largest non-financial public corporations reduced their investment-sa'ings gap as a percentage of GNP from 8.9% in 1982 to 3.2% in 1985. At the same time, the investment-saving surplus of the private sector increased from-2.9% of GNP in 1982 to 2.0% of GNP in 1985. 1.17 The restrictive monetary policy that the Government followed in 1985 produced not only a nominal currency appreciation, but also a significant appreciation in real terms. In addition, given the rigidity in the already reduced government borrowing requirements, the stock of credit to the private sector decreased by 54% during the adjustment period. Our estimates indicate that monetary policy was overly restrictive by 6% and 9Z in 1984 and 1985, respectively. B. Macroadjustment for Growth Recent Economic Developments 1.18 After two and a half years of stabilization, the Philippines has eliminated the current account deficit and controlled inflation, but GNP has  -8- dropped for two consecutive years and no substantial growth, if any, is expec- ted in 1986. As we saw in the previous section, stabilization was achieved through reduced income and without addressing the medium term needs of the Philippine economy. Furthermore, the decrease in imports was initially made possible by import controls and later by declining output, not by a change in relative prices. 1.19 Deflationary trends continued during the first part of 1986: GNP, which declined 3.8% in 1985, only slightly recovered in the first quarter of 1986. GNP per capita is now slightly below 1975 levels in real terms. The achievements of the rapid growth period of the seventies have been lost in two years. Unemployment in Metro Manila has increased from 11% in 1980 to 22% in 1985. For the current year there is little sign of recovery by the private sector, and private investment remains depressed because of slack demand, high levels of unused capacity, and high interest rates. A growth rate of GNP of no more than 1% can be expected for this year. Thus, it is extremely import- ant that the appropriate mix of fiscal, monetary and exchange rate policies be put in place to facilitate a major recovery of the economy in the short term, without losing the gains of the past stabilization period. 1.20 The drop in GNP per capita, and its socioeconomic implications, are even more pronounced if we take into account the recent population estimates and trends. Population growth in the Philippines is now estimated to be in the range of 2.7-2.9%, which is higher than the 2.5% now officially used for planning purposes. As a result, the Philippine population growth rate is the highest among major Southeast Asian countries. Assuming a 4 to 5% average GDP growth from 1987 to 2000, 1983 per capita GNP will not be regained until the year 2000. Present schooling requirements, the demand for health and other social services, and the need for future job creation are probably underesti- mated with the current official population growth rate. 1.21 As a result of election spending, the budget deficit in the i'irst quarter of 1986 amounted to 10 billion pesos. This represents a large increase with respect to the same period in 1985 when the deficit for the whole year was 11 billion pesos. Preliminary estimates suggest a budget deficit of 35 billion pesos for 1986. The expansion in government spending during the first quarter of 1986 was not translated into higher economic activity. The reason for this is that the Central Bank undertook open market operations to offset the increased liquidity by issuing special Central Bank bills. Reserve money which had reached a peak of P 44 billion in February was reduced to P 40 billion by the end of March. Inflation has been kept under control with the consumer price index increasing only at an annual average rate slightly above 3% during the first quarter of the year. However, interest rates increased dramatically to a peak of 30% at the end of February from 16% in mid-January. 1.22 The public perception was that the monetary authorities were reacting, not only to the possible inflationary impact of increased spending, but more importantly to the depreciating pressure on the nominal exchange rate. There was upward movement in the exchange rate which was then con- trolled through contractionary monetary policy. With the improvement in the overall political climate and the reversal of capital flight, the exchange  - 9 - rate returned at the end of the first quarter to its January level of about P 20.5 to $1. At the same time, overall gross foreign exchange reserves of the Central Bank increased over their end-year position, rising from $1.1 bil- lion to $1.5 billion. 1.23 Although the adjustment program has created a current account sur- plus, this is unsustainable given the need for GNP to recover. Without an expansion in exports any GNP recovery will increase the current account deficit through higher import requirements. For the Philippines to achieve acceptable growth with a sustainable current account position it is necessary to expand exports and efficient import competing activities. In the medium term, the export expansion should be sufficiently large to finance iinports at a higher level of output and to leave a surpl-'s to finance net factor pay- ments. Such a strategy for export-oriented growth will require an adjustment effort that should start to be inkplemented now. Some of the key components are outlined in Chapter II. Recovery Prospects 1.24 Export-oriented medium-term adjustment will require the Philippines initially to increase investment in export oriented activities and in branches of manufacturing that, after some initial restructuring, can become competi- tive with imports on the basis of relatively low tariffs. A return to the saving rates of the 1972-81 period, averaging 24 to 25%, would be sufficient to finance the investment requirements of the export-cum-efficient-import- substitution strategy. With a more stable economic environment and appro- priate incentives for export expansion, the Philippines should be able350 return to these savings rates, which are comparable to those of Korea.- In the short run, the investment requirements in the tradable sectors will have to come from reallocation of investment away from non-tradables and highly protected import competing activities and towards export-oriented activi- ties. This reallocation will have to be complemented with a increase in foreign savings for a period of time. The current account could be allowed to rise to about 2% of GNP for the next five years. Once GNP growth gets under way, however, foreign savings should be gradually replaced by national savings and the current account deficit should be reduced. 1.25 In addition, a consistent adjustment program that is perceived as sustainable should help the Philippines to attract foreign direct investment, and should encourage repatriation of some of the capital that left the country earlier. The best way to attract these kinds of inflows is to provide an environment conducive to medium term growth with a stable real exchange rate-- which is also a pre-condition for moving towards export-oriented growth. 1.26 The Philippine Government can now address the structural adjustment problem directly without simultaneously facing the problem of stabilizing the economy. One of the main achievements of the recent adjustment was to elimin- 3/ See Vol. II, Annex 8 for recent successful adjustment experiences in other countries.  - 10 - ate the heavy inflation of 1983-84, and this substantial gain made on the stabilization front should be safeguarded. 1.27 Sources of Recovery. Apart from the need to put together a consistent medium-term strategy, the most urgent issue now is how to start the recovery process. The absence of recovery in economic activity in spite of the change in government and greater confidence, reflects primarily a lack of final demand, but possibly, also insufficient clarity in the public about the nature, continuity and sustainability of future courses of policy. 1.28 There is no single reciepe for short term recovery. A set of measures are required to stimulate activity in the private sector. The pack- age should consist of a combination of relaxation of import controls, money supply expansion, government spending and increased foreign borrowing. In addition, the short-term recovery effort needs to be defined within a broader medium term strategy. Therefore, structural issues should be a vital compo- nent of this short run strategy. The Government has initiated or is in the process of elaborating policies on a number of these issues which need to be tackled as a precondition for a healthy recovery. 1.29 Short-term recovery will require a higher level of government spending. This would allow for higher operating and maintenance expenditures and to shift resources to agriculture. The deterioration of public sector infrastructure is beginning to pose a real obstacle to economic recovery. Changes in the budget composition could also have an expansionary effect in the economy, and help raise the level of aggregate demand. The size of the deficit, however, should be one which does not crowd out private activity, leading to an increase in inflation or in real interest rates. There is now some leeway for aggregate demand expansion because of existing excess capacity and very low annual inflation. However, support from foreign sources will be crucial given the existing level of foreign obligations that have to be paid by the Government in 1986. 1.30 Short-Term Issues. The recovery program needs to face squarely the fiscal difficulties that have developed as part of the problem of servicing external debt. The external debt problem has now been transformed into a fiscal problem. Two and a half years of recession have led to a further dete- rioration in the domegtic assets of government financial institutions (GFIs) putting additional pressure on the government budget. Support to the GFIs is conservatively estimated to require P 20 billion in 1986, an amount equal to the total capital expenditure of the national budget, and a significant factor explaining the projected budget deficit. As government expenditures on goods and services have already been reduced significantly in the last two years, and the Government needs to increase social expenditures and infrastructure rehabilitation, the most promising ways of reducing the public sector deficit is to cut transfers and improve tax collection in the medium term. The recent tax measures taken by the government greatly improve the prospects for higher revenue performance. 1.31 In the meantime, given the size of the GFIs' external obligations, all feasible actions to cut the consolidated public sector deficit will still leave an unfinanced gap. The problem then becomes one of financing the defi-  - 11 - cit without an acceleration in inflation and/or crowding out much needed private investment. Indeed, with an annual inflation rate below 8%, and allowing for some noninflationary increase in the monetary base, seigniorage can contribute no more than 1% of GNP to the financing of the consolidated public sector deficit. 1.32 Therefore, some external financing of the deficit will be essential while structural measures are taken to reduce the consolidated deficit. However, for the external savings to be actually absorbed, they must be transformed into actual imports of goods and services. This is, in part, why a reform of the trade regime is a crucial component to achieve sustainable growth. For the country to succeed in having a more open and competitive economy, the key question at this stage is the timing and sequencing of trade reform. One possibility is to start with the liberalization of imports allowing for exports to become profitable once the economy is more open and the exchange rate adjusts to the new protective environment. Another alter- native is to start promoting exports and then undertake trade liberalization. Given that the economy is in a depressed situation, there is here something to be said for a policy that leads to an accumulation of reserves in advance of the liberalization process. This sequencing, as opposed to liberalizing and then allowing the exchange rate to adjust, has the advantage of stimulating aggregate demand. In addition, the cushion of reserves is needed since the export response will lag behind the increase in imports once the economy is opened. 1.33 Since delaying the tariff reform preserves the disincentive to greater efficiency and gives the wrong signals for resource allocation, a strong and credible commitment should be made for further reform. This would mean clearly stating the goal of liberalization, the underlying rationale and the time table for implementation. Removal of import restrictions should be the first priority, with a gradual scheduled adjustment of tariff rates to follow. The change in the tariff structure should be ideally carried out in the context of multilateral trade negotiations. The process of tariff adjustment could be done over a period of five years where the end rates would be uniform at 20% or 30%. 1.34 Complementary measures should be the maintenance of a competitive exchange rate as the reform and larger imports take place, changes in the sales and excise tax rates, and removal of all export taxes. The Government has recently removed taxes on all exports with the exceptioI of those in place for conservation purposes. During the adjustment to the change in incentives, which should start as soon as the trade reforms are announced, firms who are uncompetitive due to the protective system should get some temporary assistance in the transition to a more open system. This assistance should be clearly stated as temporary so that there would be an incertive to replace capital or encourage new investment.  - 12 - Medium-term Prospects 1.35 The medium-term scenario and the corresponding financing require- ments have been projected taking into account different assumptions on policy changes. Assuming that a turnaround in economic activity will be brought about by the appropriate short term policies discussed above, the most important issues are in the sustainability of recovery over the next five years. Our projections are therefore concentrated on the 1987-91 period. It is important to bear in mind that projections are quite speculative at this time. In addition to the standard sources of uncertainty are the developments in the world economy, particularly in commodity price and trade volume prospects. There is additional uncertainty over the timing and pace of the recovery of the Philippine economy from its current depressed level. Furthermore, in the wake of the substantial structural adjustment measures undertaken, it remains to be seen how much existing productive capital can be reoriented towards profitable use and how much must be considered as obsolete in the new environment. 1.36 The projections assume a relatively favorable world economy in the next five years as a result of the recent decline in oil prices and real interest rates. Industrial countries' CDP is projected to grow around 3.5% per year, international inflation remains low, and real interest stays at current levels. Global manufactured exports are projected to grow at aruund 7.5% and energy prices are projected to increase by 18% from 1986 levels by the year 1990. 1.37 Given this external environment, two possible paths for the Philippine economy during the next five years are described. The base case is wh'at was covsidered as the most likely scenario. It anticipates a recovery in '87, led by industrial growth, that results in a real GDP level 5% above 1986. This can be achieved if existing capacity is more effectively uti- E lized. In 1988 and beyond, GDP growth would be sustained at around 5% as in- vestment and exports continue strong growth and new projects srate to yield returns. The high case is what the recommended agenda might bring about if adequately implemented, and if private sector confidence is rapidly rebuilt. If next year's recovery is stronger than in the base case in all segments of the economy, growth in the range of 6-7% of GDP could be achieved. For this to be sustained over the next five years strong investment and export perfor- mance will be required. The policies envisioned in agriculture for the high case include significant improvements in irrigation services through increas- ing O&M expenditure on irrigation infrastructure; increase in fertilizer and pesticide use stimulated mainly by reduction in taxation levels; improved farm-to-market roads and general improvement in rural infrastructure; and effective price stabilization for rice and corn. On trade policy it is assumed that export taxes will not be reimposed and an appropriate exchange rate policy will be pursued. Under this case the agricultural sector is projected to grow at a rate of 3.9% p.a. In the industrial sector, growth will need to be about 10% per year to reach 1981 per capita value-added levels by 1990. This growth, which is higher than that achieved in the second half of the seventies through heavy government investment, can be achieved now only through private-sector responses to a considerably improved environment. Growth will depend on a sharp reduction in the bias of the protective system  - 13 - against export and efficient import substitution activities. The high case also assumes that macroeconomic policies will be directed to secure domestic financial stability and external competitiveness. 1.38 How feasible is it for the Philippines to increase the ratio of its current account deficit to GNP? Of the 17 most heavily indebted countries, only five had a current surplus in 1985. Among the remaining 12, the current account deficit ranged from 5 to 11%. A well structured adjustment program should allow the Philippines to get access to external financing for invest- ment with a high and sustainable return. Naturally, the higher the proportion of this financing that is provided on concessional terms, the better. 1.39 The key to future growth, in a macroeconomic sense, will be to achieve the right balance of savings, investment and consumption that will permit both the higher investment rates necessary to accelerate the rate of growth, and also provide for sufficient growth in consumption so as to allow some increase in per capita living levels. Because of the already high debt overhang, the financing of a very large portion of the investment program through foreign savings is neither practical nor possible. On the other hand too great a reliance oU domestic savings could obviate the required growth in consumption levels and restrict domestic investment. New foreign capital inflows can help facilitate the recovery process. In the base case, non-grant foreign financing would be a modest 2% of GNP. In the high case, foreign financing needs could be greater, at 3 to 4%, because of the substantially higher investment levels. 1.40 To a large extent, the debt expansion necessary to support growth depends on the exchange rate policy pursued, and on the resulting impact on trade. The scenarios presented have assumed growth oriented real exchange rate policies will be followed. Additionally the relative cost of Philippine labor has been decreasing with respect to other East Asian countries. These would boost exports, especially in nontraditional categories. Based on estimates of export functions, manufactured exports in the high case should be able to increase their share in world markets and grow around 11% in real terms assuring other export constraints are removed and markets are penetrated. In the base case exports will merely keep their international market share. 1.41 Imports of goods and nonfactor services are expected to increase by 9 to 10% after 1987 in the high case. The decline in oil imports is expected to be offset by the expansion of intermediate inputs as growth resumes. However, greater emphasis on rural development and improved capital efficiency should reduce the import intensity of growth. Imports will grow between 6 and 7% in the base case, largely due to lower intermediate and capital equipment requirements. 1.42 In sum the Philippines cannot be a capital exporter and still have substantial growth during the next decade. To support a growth oriented strategy total debt outstanding is likely to increase. However, if the growth in debt is less rapid than the growth in GNP and exports, the relative debt burden is gradually reduced. (See Table 1.5) Debt outstanding as a share of GNP can be expected to decline from 91% in 1986 to 75% by 1991. Thus, the  - 14 - Philippines should attempt to "grow out" from under its debt burden, as higher output and exports eventually ease the problem of debt repayment. Table 1.4: COMPARATIVE REAL GROWTH RATES FOR THREE POLICY SCENARIOS (percent) 1986 1987 1988 1989 1990 1991 GDP High 0.5 6.0 6.4 7.0 7.0 7.0 Base 0.5 4.9 4.5 4.9 5.3 5.4 Agriculture High 2.3 3.9 3.9 3.9 3.9 3.9 Base 2.3 3.0 3.0 3.0 3.0 3.0 Industry High -1.2 9.0 9.8 10.8 10.7 10.6 Base -1.2 7.3 6.3 7.1 8.0 8.0 Investment High 2.6 41.9 19.1 16.3 7.2 7.2 Base 2.6 33.2 8.5 12.8 9.4 5.7 Consumption /a High 2.0 1.9 4.0 4.5 7.2 7.2 Base 2.0 2.0 4.1 3.0 4.5 5.5 ExDorts (GNFS) High 2.4 2.6 4.8 7.6 8.0 8.2 Base 2.4 2.6 3.4 5.6 5.8 6.0 Manufactured High 5.0 8.6 9.5 11.0 11.0 11.0 exports Base 5.0 8.5 7.0 7.5 7.5 7.5 Imports (GNFS) High 11.3 17.2 10.0 10.6 8.8 8.9 Base i1.3 14.5 5.9 6.9 7.1 6.8 /a These aumbers are just illustrative. It might be difficult to compress consumption in 1986 and wait for the resumption of growth in the rest of the period.  - 15 - Table 1.5: PROJECTED RESULTS OF THE THREE RECOVERY SCENARIOS 1986 1987 1988 1989 1990 1991 Investment High 17.3 23.3 26.0 28.3 28.3 28.4 (X of GDP) Base 17.3 21.5 22.3 24.0 24.9 25.0 Curr(nt account deficit High -0.9 1.3 3.1 3.6 3.1 4.0 (Z of GNP) Base -0.9 0.7 1.9 2.1 2.1 2.3 Debt out- standing High 91.0 85.0 82.6 80.4 78.5 75.3 (Z of GNP) Base 91.0 85.9 83.3 81.0 78.7 74.9 Debt service ratio /a High 45.7 47.5 45.1 40.6 37.4 38.5 (DS/XG 25) Base 45.7 47.5 45.4 41.2 38.0 34.9 /a Percent of exports of goods and services. Does not include further rescheduling after 1986.  - 16 - II. RESOURCE MANAGEMENT 2.01 The management of the external, financial and fiscal resources will be critical in various ways for the gchievement of a sustainable medium term strategy. The balance of payments, although no longer in a crisis situation, will continue to reflect the presence of unsustainable structural patterns in the Philippine economy until adequate measures are implemented. Only then will the external sector be able to provide a basis for continued growth while also achieving an improvement in creditworthiness. While clearly external resources are needed to spur recovery in the short run, in the meditum term growth will have to be financed through domestic savings. Therefore, the success of the recovery will also hinge on the financial system's capacity both to mobilize domestic savings and to supply domestic credit for productive activities. Finally, fiscal resources will be necessary to provide the private investors with the adequate support for productive activities. This will require the implementation of policy measures which will eventually result in a self-sustaining public sector which does not displace but rather supports private initiative. A. rhe Balance of 'pSments 2.02 The balance of payments is going to be a focal point in the next five years. On the financing side, the current high debt obligations will constrain economic recovery so debt rescheduling will be at the center of the new government's policy agenda. On the real side, efficient import substitu- tion and export growth are escential components of a sustainable growth stra- tegy. Competitivene3s of the Philippine economy must be improved so that sufficient foreign exchange is generated to finance the imports complementary to investment and output growth and also to meet the debt payment obligations. Recent Adjustinents 2.03 Although the balance of payments crisis has been reversed both in the current and the capital account, the reversal might not be sustainable. The current account moved from a deficit of 8X of GNP in 1983 to a small surplus of eight million dollars in 1985 but mainly through a reduction in imports vnich will, need to increase once recovery is underway. The capital account improved through the rescheduling covering only the October 1983 to December 1986 period.  - 17 - Table 2.1: IMPORTS BY COMMODITY GROUPS (US$ million) Z Change % Change Item 1983 1984 1983-84 1985 1984-85 Capital goods 1,698 1,150 -32.3 788 -31.5 Raw materials and inter- mediate goods 2,882 2,505 -13.1 2,092 -16.5 Mineral fuels 2,123 1,649 -22.3 1,452 -11.9 (of which petroleum) 1,741 1,472 -15.5 1,277 -13.2 Food 528 425 -19.5 426 0.2 Other 256 341 33.2 353 3.5 Total Imports 7,487 6,070 -18.9 5,111 -15.8 Nonoil Imports 5,746 4,598 -20.0 3,834 -16.6 Source: Central Bank of the Philippines 2.04 Imports in most areas dropped sharply, both in volume and in value, initially through quantitative controls on imports, and later through the drop in domestic activity. Overall, the volume of commodity imports declined 36% between 1983 and 1985. The sharpest decline was in the import value of capital goods which dropped by 54% and petroleum which dropped 27%. (See Table 2.1) The contraction in intermediate goods was greater than that explained by price and output elasticities, mainly due to the tightening of import restrictions. Major exceptions to the import decline were inputs to garments and electronic exports which continued growing in 1984. However, by 1985 these imports also dropped in line with the poor export performance. (See Table 2.1.) 2.05 Exports growth rate dropped in the early eighties as compared to the seventies. In volume terms, exports declined 5% between 1983 and 1985, or 7.5% in value terms. In particular, a,raditional agricultural exports dropped by 13% and 24% in dollar terms in 198 and 1985. This was due to a combination of unfavorable prices and a domestic drought. Growth declined because of a combination of world recession, continuing decline in terms of trade and an appreciation of the real exchange rate. Although manufacturing exports were sheltered during the 1983 crisis, they did start falling during the stabilization program as a result of the appreciation of the peso and the downturn in the electronics world market. (See Table 2.2). 2.06 Overall, services and transfer accounts slightly worsened during the period. Services fluctuated from a deficit to a surplus reflecting the decline in international interest rates, and declining tourism earnings. Invisible receipts in the form of workers remittances, fell in 1984 reflecting the decline in construction activity in oil-producing countries. Remittances rebounded slightly in 1985 because of the shift in composition of contractual  - 18 - workers and changing devaluation expectations. As the economy stabilized, more remittances came through official channels since devaluation expectations were reversed. Table 2.2: BALANCE OF PAYMENTS (US$ million) Item 1983 1984 1985 Merchandise trade -2,482 -679 -482 Exports 5,005 5,391 4,629 (growth rate) (7.7) (-14.2) Imports 7,487 6,070 5,111 (growth rate) (-18.9) (-15.8) Non-merchandise trade -740 -975 111 (of which interest expense) -1,985 -2,330 -2,208 Transfers, net 472 386 379 Current account -2,750 -1,268 8 (as % of GNP) -8.1 -4.0 .03 Long term loans 1,347 258 2,727 Inflow 2,336 1,259 4,181 Outflow 989 1,001 1,454 Direct investments, net 112 6 -9 Short-term capital, net -618 549 -1,526 Net errors and omissions, gold monetization and revaluation adjustmernts -254 255 771 Capital account 587 1,068 1,963 Changes in net international reserves -1,011 -646 1,798 Source: Central Bank of the Philippines. 2.07 Improvements in the current account were accompanied by improvements in the capital account. About $5.6 billion in external debt was rescheduled in 1985 and succeeded in moving the Philippines away from a crisis situation. The most notable feature of the rescheduling is the large proportion of short- term debt and arrears that were converted to long-term debt. As a result, it eliminated about $1 billion in debt payments in both 1985 and 1986. However, repayments of the rescheduled debt during the 1989-95 period will add to an already heavy debt burden in the period and may necessitate further reschedL'1ings.  - 19 - Policies for Recovery 2.08 A program of adjustment for growth requires reversing the current bias against export oriented and efficient import competing activities other- wise output growth will continue to be bounded by current account deficits. This will require changes in the trade regime, export promotion measures and exchange rate adjustment. As noted above, changes in the trade regime, should give a clear signal that the profitable sectors in the medium-term will mostly be export oriented and efficient import competing activities. Before starting tariff reduction an explicit export promotion program should be implemented including: (a) speedy access to export financing at internationally competi- tive interest rates; ' ! availability to exporters of tradable inputs at international prices; (e an appropriate mechanism for ensuring quality control of exports; and d) provision of information on external markets to exporters. Together w.-h these changes, the nominal exchange rate should be allowed to adjust to deal with the potential trade balance problem. The value of the real exchange rate will need to be such that new export activities and efficient import competing activities should become profitable. Exchange Rate Policy 2.09 In the Philippines, the nominal exchange rate is flexible and determined by the daily transactions in the foreign exchange market. This mechanism, which is appropriate for the current and likely future needs of the economy, allows for an interaction of demand and supply for foreign exchange and prompts the necessary adjustments. This, however, needs to be seen in the light of other policy developments in the economy to ensure that competitive- ness will be restored and maintained. The determinants of the demand and supply of foreign exchange cover virtually the entire range of macro-economic policy choices. Some variables, however, have a more direct and immediate bearing on the exchange rate policy outcome and should therefore be more particularly monitored by the Government. For instance, restriction on certain imports and limitations on the capital account flows may result in unintended outcomes in the exchange policy area. Foreign reserves management and external borrowing policies should, of course, be considered in this perspective. 2.10 Exchange rate policy in the Philippines has proved to be, in the past, a powerful instrument for structuring the economy. In this respect it is important to bear in mind that what determines the behavior-of economic agents is the real exchange rate in its actual and expected path. In most countries, but certainly in countries with less developed financial markets like the Philippines, individual producers and consumers will not have, as a rule, the financial resources necessary to base their decision-making on long- run considerations. In such situations, Government must recognize that the equilibrium rate will change over time in the presence of structural change and evolving structural preferences, and in response to Government's own policies with respect to foreign borrowing, reserve accumulations and expenditures.  - 20 - 2.11 Despite technical difficulties, it is possible to estimate in rough orders of magnitude how the real equilibrium exchange rate for the Philippines evolved even for the period before floating rates were instituted. This rate is found after making the necessary allowance for structural developments in the period 1972-86. The relevant adjustments made for the Philippines are for changes in terms if trade policy, productivity and build-up of external debt. The results cf such calculations indicate that the Philippines peso appreciated during much of the 1970s and 1980s. However, the significant real depreciation of the peso during early 1986 (in tandem with the depreciating US dollar) helped restore the competitiveness of the peso. 2.12 The competitiveness of the Philippine peso was also calculated in relation to its dynamic East Asian neighbors. According to this indicator the Philippines since 1980 has seen an erosion of its competitive position, since its real exchange rate has depreciated less than the exchange rates of the competitor countries. Especially since 1984, the currencies of most major East Asian competitors, have steadily depreciated in real terms. For the Philippines, the real depreciation has been a more recent trend and the passive result of the depreciation of the dollar vis a vis the yen and other currencies. 2.13 For the future, two considerations are relevant for the management of the country's real exchange rate. First, as the economy moves out of the current recession, and with the implementation of a program of trade liberal- ization, one would expect the demand for foreign exchange to pick up. Since the equilibrium exchange rate would then also change along with the changed structural conditions of the economy continued, flexible management of the exchange rate is an appropriate response and would contribute to ensure an improved competitiveness of Philippine exports in international markets. 2.14 Second, in the short term there might well arise a surge of capital inflows which are not matched by a commensurate increase in the demand for foreign exchange, for example, a capital reflow as a result of increased investor confidence in the economy. These capital flows would put upward pressure on the exchange rate causing it to move away from its long run equilibrium, thus harming the country's international competitiveness and chances for recovery. In this case, accumulation of foreign reserves by the central bank, or repayments of short term debt would be an appropriate response in order to prevent an appreciation of the real exchange rate. Exchange rate management could also be complicated in the medium-term if real interest rates were to remain high because of large borrowing requirements of the public sector and the Central Bank.  - 21 - External Debt Strate8y 2.15 As long as the Philippines follows a strategy which productively uses capital and gives the favorable signals to the external sector, it is not inappropriate to run small current account deficits over the next five years. Even countries which followed consistent policies and managed prudent borrowing strategies have required some access to external financing of the order of 1% to 51 of GNP over extended periods. The new government has the potential to develop a sustainable growth strategy consistent with some reliance on continued external financing. As shown in Table 2.4, the Philippines has a sizeable stock of external debt relative to the size of its economy and external sector. The interest servicing on this debt, about 6% of GNP and 301 of exports of goods and non-factor services (gnfs), is about the average for highly indebted middle income countries. As a ratio to resources, the external debt of the Philippines represented in 1984 about 350% of exports (gnfs) and 77Z of GNP, which is above the average for all highly indebted middle income countries (see Table 2.4). Table 2.4: EXTERNAL DEBT INDICATORS Heavily Indebted Middle Philippines Income Countries /a 1978-81 1982 1983 1984 1985 1978-81 1982 1983 1984 Interest/GNP 4.5 6.1 6.0 6.4 6.9 3.0 5.2 5.4 6.0 Interest/Exports of goods and non- factor services 23.3 36.3 30.5 28.7 32.1 20.2 32.6 28.9 30.9 Debt Service/GNP 7.3 8.8 9.1 8.8 7.8 5.9 8.3 7.9 8.6 Debt Service/Exports of goods and non- factor services 37.8 52.5 46.1 39.4 35.7 39.4 5i.6 42.8 44.0 DebL/GNP 48.9 61.5 70.0 77.5 82.3 31.1 45.6 57.3 59.0 Debt/Exports of goods and non- factor services 254.2 367.2 352.4 346.6 381.9 206.1 283.5 309.2 302.5 /a Sample of 17 high debt countries. Sources: World Bank, staff estimates, Central Bank of the Philippines for 1985 figures. 2.16 The Philippines may prefer to move gradually back to the more com- fortable debt levels of the late 19709 so as to increase flexibility and re- duce the risk of being again susceptible to a severe balance of payments cri- sis. This improvement in creditworthiness is consistent with increasing ex- ternal debt as long as it is accompanied by even greater output and export expansion. For example, a 800-990 million annual increase in external debt  - 22 - matched with GNP growth of about 5% would move the Philippines gradually towards more comfortable relative debt levels. With these feasible growth rates, by 1991 debt relative to output and exports would reach 75%. An alternative strategy of maintaining or reducing the level of external debt may be possible only by reducing per capita consumption levels. 2.17 In the high case presented in the previous chapter the external financing needed is large, but because of more rapid growth, relative debt changes in a similar fashion to that described for the base case. The current account deficits rise from $0.4 billion in 1987 to $1.8 billion by 1991. A substantial amount of the resulting capital requirements will have to be met through concessionary official loa,s and from additional debt relief arrangements, particularly from private sources. Additional debt relief should be on a multiyear basis, .n order to prevent the need for repeated rescheduling, and to give the Government some breathing space within which it can enact policy reforms, and reap their benefits. In addition, these reschedulings should be on as favorable terms es possible. Annual interesc payments are already a burden on the economy, and could be $2.2 billion by 1991. A large part of these payments are being met by a resource transfer out of the economy, since there is a positive resource balance (exports minus imports). These debt service projections are dependent on the assumed terms for new capital inflows and/or debt rescheduling. The projections in Table 2.5 assume that new capital flows are available at an interest rate of about 9.0%. Implications for Creditors and Borrowers 2.18 Reaching the satisfactory net foreign savings position outlined above involves new funding as well as possible rescheduling of amortization payments on existing debt. As shown in Table 2.5, the financing requirements, net of disbursements from money already committed are in the range of US$2 billion to US$4 billion per year in the base case. This has a number of implications for both the creditors and borrowers. 2.19 The government has declared its intent to change the composition of its foreign financing in favor of more concessional offic:al sources. None- theless, commercial banks will continue to play a key role in the external financing strategy since they represented 55% of Philippine external debt, as of the end of 1985. Until voluntary lending has been resumed, an important source of financing will remain rescheduling of scheduled maturities on out- standing debt. 2.20 A possible multi-year rescheduling of commercial banks' debt will be a major issue in the coming months. On the one hand, it is widely accepted that multi-year restructurings have a number of advantages over a series of yearly exercises. They can contribute to an improvement in the climate for effective economic decision making by reduc.ng uncertainty. They also eliminate costly and time consuming negotiations given the large number of banks involved. On the other hand, the creditors may not choose to lock themselves into a more comprehensive financing package consistent with a higher growth strategy unless they are convinced that the debtor country is taking the steps necessary to ensure this outcome. The Government will there-  Table 2.5: FINANCING REQUIREMENTS: BASE CASE /a (Current US$ billions) Base case 1986 1987 1988 1989 1990 1991. Current account 0.28 -0.21 -0.66 -0.77 -0.82 -0.90 Scheduled amortization /b -0.78 -1.87 -2.78 -1.93 -2.39 -2.40 Changes in reserves (- increases) -1.23 -0.42 -0.12 -0.35 -0.39 -0.30 Changes in short-term debt /c -0.91/d -0.40 -0.10 -0.50 -0.50 -0.50 Pipeline disbursements 0.85 0.39 0.54 0.38 0.30 0.10 Financing Gap 1.79 2.51 3.12 3.17 3.80 4.00 New official money /e 0.24 0.69 0.98 0.99 1.11 1.16 Other /f 0.12 0.52 0.47 0.52 0.53 0.50 Rescheaiiling and other new money Aj 1.43/d 1.30 1.67 1.66 2.16 2.30 Memo items: CA/GNP (%) 0.9 -0.7 -1.9 -2.1 -2.1 -2.1 Debt service ratio 45.7 47.5 45.4 41.2 38.0 34.0 Debt/GNP 91.0 85.9 83.3 81.0 78.7 74.0 /a This table is consistent with the base case presented in Tables 1.4 and 1.5. /b Total maturities falling due, including monetary liabilities except IMF repurchases, after 1985 Paris Club and commercial bank rescheduling agree- ment. /c Short-term debt reductions of the amount indicated from 1989 on should be construed as a desirable objective of debt restructuring and not as a projected amount. /d Includes conversion of short-term debt into medium-term obligations. 7e Estimated disbursements from official commitments signed after Decem- ber 31, 1985. Includes estimates of likely commitment programs for loans not yet identified. /f Includes direct foreign investment, capital not elsewhere included and gold monetization /g Residual to be obtained from rescheduling and other new money sources, both private and official. Eligible schedled maturities are defined as projected maturities of private financial institution and bilateral offi- cial debt. Other maturities and payments may also be rescheduled subject to negotiation. Sources: Central Bank, Bank staff calculations.  - 24 - fore enhance its chances of obtaining multi-year rescheduling by pursuing a clear policy direction and implementing the corresponding measures. 2.21 In regard to the terms of the rescheduling, the Philippines and her creditors can draw on recent favorable trends in the international market and political developments in the Philippines in negotiating both longer grace and maturity structures and smaller interest spreads. Since the projections exercise indicates that debt repayments remain high in the early 1990s, the restructuring should aim to extend the maturities beyond that period. Reduced spreads also avoid exacerbating the problem by maintaining interest payments at manageable levels. 2.22 In addition, banks can be called upon to contribute with fresh financing to the current account deficits consistent with the growth strategy and the improvement in debt servicing capacity outlined above. As shown in Table 2.5, the source for the additional US$1.7-2.3 billion in 1988-91 remain unidentified. A major portion of this can be expected to come from private sources to complement multilateral and bilateral efforts. The same rationale for favorable terms, both maturity structure and interest spreads, applies to new money as well as to the restructuring of existing debt. 2.23 Another important source of the US$2-4 billion yearly new money re- quirements is official lending. This source is closely linked to public finances. First, for project related assistance, counterpart funds as well as adequate operating and maintenance expenditures are necessary to make use of these resources. Second, concessional official lending will be crucial in the shorter term to support the budget. This involves identification of the amounts to cover the budget gap in 1986 and 1987 to prevenL undue strain on interest rates and inflation from the alternative domestic bond and money financing sources. A critical component of the fiscal picture is the debt servicing of the government financial institutions for the 1987-91 period. 2.24 The amortization of debt already committed from bilateral creditors represents about 7% of the total scheduled 1987-91 maturities. A similar share is covered by suppliers' credits with guarantees by official export credit agencies. Although these amounts are relatively small, the official bilateral lending community also may be called upon. to reschedule obligations. In that case, it would be crucial for the export credit agencies in coordination with their national governments to agree to maintain existing credit lines rather than cut them off as has been the practice in some cases in the past. B. The Financial Sector 2.25 As a result of the recent crisis, the financial system currently faces severe problems. Credit supplied to the private sector has declined sharply, together with a rapid increase in real interest rates. Two factors seem to have been at least partially responsible for high lending rates. First, government has been forced to increasingly source its financing domes- tically. Since much of government borrowing is to finance debts originally incurred by the private sector, this is not strictly a case of the public sector crowding out the private sector. Nevertheless, there has been a  - 25 - decline in the volume of credit available to the private economy for new and replacement investment, which then contributed to the rise in lending rates. Second, the increase in taxes on intermediation, which is translated into higher spreads, has lead to a further increase in lending rates. 2.26 The present crisis has also magnified some long-standing structural weaknesses in the financial sector, which could seriously impair its future development. Partly as a result of weakened economic activity, some private acquired banks are facing liquidity/solvency crises. In addition, stemming from longer term deficiencies, government financial institutions are facing even more serious solvency problems. To deal with the private banks crisis, the Central Bank has been forced to increase emergency assistance and is en- couraging mergers of commercial banks. By the end of last year, emergency assistance represented already 242 of the stock of reserve money, or P 8.8 billion. 2.27 Another structural weakness, and one of the most disturbing features of the Philippines financial sector, are the large spreads between commercial deposit and lending rates. Spreads in the Philippines are in the range of 161 while in most countries spreads are much lower, around 3-4%. These large spreads stem from high intermediation costs, mainly in the form of taxes and probably do not contain significant rent elements. Recent Adjustments 2.28 The financial reforms which started in 1980 were quite successful in mobilizing savings before the economic crisis started. The reforms included liberalization of interest rates and lifting restrictions on commercial banking activity. The volume of savings mobilized by the financial system rapidly increased during 1980-83. After stagnating for more than a decade, the ratio of M2 to GNP increased from 21% in 1980 to 25% in 1983 (see Table 2.6). Commercial banks' deposits and credit outstanding increased and there was a significant lengthening of loan maturities.  - 26 - Table 2.6: COMPARATIVE FINANCIAL DEPTH: RATIOS OF M2 TO GNP tZ) Country 1976 1978 1980 1982 1983 1984 1985 Philippines 18.8 22.7 20.9 23.5 25.5 20.8 15.3 Indonesia 17.7 17.9 18.6 21.2 21.7 n,a. n.a Korea 30.3 32.7 33.7 38.4 39.3 37.8 n.a Malaysia 47.3 48.4 54.8 64.3 64.4 64.0 n.a Singapore 64.0 61.3 68.9 73.4 74.0 74.0 n.a Thailand 37.4 38.8 37.4 4.3 49.6 56.5 n.a Source: IFS 2.29 However, after 1983 the economy has undergone a period of consider- able financial shallowing. By 1985, the ratio of M2 to GNP had dropped to 15.3%, bank real deposits and loans outstanding fell by 29 and 54% respectively. (See Table 2.7) Saving mobilization is at an all time low, credit to the private sector has severely contracted and real lending rates increased to about 30% in the first quarter of 1986. The present setback in the financial sector's ability to mobilize domestic resources seriously threatens both short- and medium-term recovery possibilities. Table 2.7: COMMERCIAL BANK DEPOSITS AND LOANS (billions of 1978 pesos /a) 1980 1981 1982 1983 1984 1985 Total Deposits 30.4 34.4 38.1 40.1 30.8 28.4 % Share demand 4 29 22 16 17 13 12 Z Share time and savings 71 78 84 83 87 88 Loans Outstanding 55.6 55.1 56.7 58.7 40.6 27.1 x Share short term 78 73 69 70 61 61 x Share medium and long term 22 27 31 30 39 39 /a Deflated by the CPI. Source: Central Bank and IFS 2.30 The domestic recession is partly responsible for this rapid financial shallowing. The fall in income resulting from the contraction in economic activity led ill itself to a decline in the level of financial sav-  - 27 - ings. In addition, the portfolios of financial institutions, both private and public, worsened as a result of corporate distress in the productive sectors. 2.31 Direct government intervention, through reserve money expansion and higher reserve requirements, made the situation even worse. Reserve money expanded by nearly 50% during the second half of 1983 alone, and reserve requirements increased from 18% to 24%. Government revenue from this implicit taxation rose from 0.3% of GNP to 2.7% in 1983 and 1.6% in 1984. As a result of this increased implicit taxation, bank spreads doubled thus contributing to the increase in real lending rates. The Government decreased reserve require- ments in August 1986 but only to 21%, which is still high. 2.32 In addition, government led the increase in real interest rates through increased domestic oorrowing. In order to meet its monetary targets, given its borrowing requirements and the lack of foreign financing, the government had to borrow from the private sector. The real stock of govern- ment securities held by the private sector increased by more than 75% between September 1984 and December 1985, and the government received around 40% of the total credit generated by the financial system by the end of last year. Requirements for Achievement of Sustainable Growth 2.33 The analysis of the recent adjustment brings us to the importance of consistent macroeconomic policies. As stated earlier, monetary policy should ensure price stability. However, more importantly, fiscal policy has to be consistent with monetary targets in order to keep the government from crowding out the private sector. During the recovery, the stock of public securities held by the private sector should not increase any further in real terms. With a 10% inflation, government borrowing from the private sector should not be above 9 to 10 billion pesos. Otherwise, real interest rates will continue to be so high that few productive investments will be profitable. 2.34 Financial policies should be designed with both long and short run objectives in mind. In the short run, financial policies should assist economic recovery through increasing the volume of financial savings and credit available to the private sector. lncreased credit availability will help to achieve a reduction in real interest rates which is a vital component required to encourage productive activity. In the long run, the objectives are to improve the institutional structure of the financial sector, and to increase the efficiency of intermediation. Since developing the financial sector will mobilize the resources necessary for new pro,A-ctive activities, the achievement of these long run objectives is crucial for economic growth to be sustained. 2.35 The following agenda for policy actions addresses a number of short- comings present in the Philippine financial sector today. The shortcomings include high real interest rates, high cost of intermediation, strong govern- ment presence in the financial institutions, and the present crisis of commer- cial banks.  - 28 - Lowering Spreads and Real Interest Rates 2.36 Starting in 1985 real interest rates have been so high that they seriously threaten economic recovery (see Table 2.8). High real rates are a result of falling inflation, high intermediation costs, and the high level of government borrowing. As inflation started to fall, nominal rates did not adjust fast enough so real rates were high in part because of this lagged adjustment. Table 2.8: INTEREST RATE DEVELOPMENTS /a (period averages) Year Real Deposit Rate Real Lending Rate Inflation Rate 1981 1.5 4.5 11.7 1982 4.7 7.0 9.2 1983 -2.0 6.0 16.5 1984 -27.2 -19.7 58.1 1985: I -17.9 -5.3 42.4 II -11.1 4.9 33.1 III 1.0 21.7 15.7 IV 4.7 21.1 7.7 1986 I 8.9 29.5 3.5 a/ See Table 2.3 in Chapter II, in the Appendix for details on data specification. Source: Central Bank and IFS. 2.37 The main cause of high intermediation costs is the high, and increasing, taxation on financial intermediation. In the Philippines there are implicit and explicit taxes on intermediation. The implicit taxes are high reserve requirements, forced investment in agrarian reform bonds, and inflation. There is also an exzlicit tax of 5Z on 2ross receiDts and a tax on  - 29 Tahle 2.9: THE EXPECTED IMPACT OF POLICY PROPOSALS ON BANK ';PREADS (percentage points) Loss in Revenue Resulting spreads /a (billiorn in pesos) With no policy change 5.2 Adopting the entire package 1.5 2.1 Eliminating the GRT only 2.9 0.8 Raising interest on reserves only /b 3.8 0.7 Reducing reserve requirements only 7c 4.2 0.6 Repealing PD 717 only (agri-agra) 4.3 0.0 /a Calculated under the assumption of a nominal deposit rate of 15Z. __ A 42 increase in interest has been multiplied ,y the amouiit of reser%es available on December 1985. /c Reserve money has been assumed to initially fall to compensate by the fall of reserve money demand by commercial banks. 15% growth has been assimed thereaftet Source: Bank Staff estimates. 2.38 High spreads get passed on by commercial banks to their borrowers in the form of higher interest rates. In order to reduce spre'ads several policy options are available, without significant decreases in revenues (see Table 2.9). These include the reductioon of reserve requirements, irf1easing interest paid on reserves and eli ination of Agri-agrA reqjirmene.s - and the Gross Receipts Tax. 2.39 Reserve requirement regulations are responsible for a significant portion of the costs of intermediation. As a reaskir of the recent adjustment, in which they were used as one of the instruments for monetary contraction, reserve requirements are higher today than before the financial reform. Since the interest paid on reserves in the Philinpines is much lower than commercial rates, reserve requirements represent a cost to the barks while riot necessari- ly having the benefit of increasing financial stability. With an easier mone- tary policy there will be room tor substantial reductica in intermediation costs through changes in reserve ratios. Intermeeiation costs could also be reduced through increases in the interest paid by CB on bghk reserves. Reserve requirements should be decreased fron 212 to 18I in order to reach 1982 levels. This should be done gradually and coordinated with money supply targets. 4/ Agri-agra are securities which carry a 9A coupon raite that banks can hold to meet their agriculture lending ieaal eq.iieemenEs. The proceedi are not earmarked for agriculture.  - 30 - 2.40 The Agrarian reform requirement, agri-agra, should also be eliminated since it does not affect lending to agriculture, is not an impor- tant source of revenue, and its removal would reduce bank spreads. Since 1975 banks have had to allocate 251 of their net loanable funds to agri-agra securities or to direct lending to agriculture. However, this program has had no effect on agricultural credit and the share of loans to agriculture actually fell after 1975. Furthermore, in 1985, 1.5 percentage points of the spread were due to the 101 agrarian reform requirement. rhe agri-agra program has simply been an additional tax on intermediation since the yield on agri- agra securities has been consistently lower than alternative loans, some times it was even lower than the banks' costs of funds. The repeal of the agri-agra requirement would help reduce lending rates without affecting the volume of loans going to agriculture. 2,41 The Gross Receipts Tax (CRT) should be eliminated and taxation to the banking system should be achieved exclusively through the existing profit tax. A tax of 5% is levied on banks gross receipts. In 1985, the CRT was responsible for roughly 1.3 percentage points of bank spreads. Although this tax has the advantage of bei-ng easy to collect, it adversely affects both depositors and borrowers, 2.42 Other featUres of the tax system also discourage resource mobiliza- tion such as the withholding tax on interest. income which represents a tax on savings. Further increases in this tax might discourage savings and should be avoided. Had there been no withholding tax in 1985, the same amount of financial savings could have been mobilized at 3.3% lower deposit rates, on average. It is estimated that this lower deposit rate would have implied an average spread 1.7 percentage points lower. Lending rates would have been on average 5 percentage points lower. 2.43 The growth in base money, by generating inflation, increases bank spreads. The government reaps seignorage by printing more money and creating inflation. Since the burden of this seignorage is shouldered by the financial system, it is then translated into higher spreads. Controlling base money also reduces the implicit tax on intermediation through lower inflation. Changes in inflation have dramatic effects on spreads. In spite of the fact that usually spreads take some time to adjust to lower inflation, changes in inflation seem to have had an important effect on bank spreads in the Philippines in the past years. Government Financial Institutions (GFIs) 2.44 The poor performance of the two largest public financial institu- tions, Philippine National Bank (PNB) and Development Bank of the Philippines (DBP), raises questions about their role in the financial system, and suggests that it may be desirable to reduce their size and functions considerably. This is a crucial area for action since government assistance to PNB and DBP in 1986 alone is expected to be around 15 billion pesos and these two institutions together represent around one third of the Philippines financial system, excluding the Central Bank. The governmnent's role in the financial sector needs to be reexamined. The economic rationale for the existence of CFIs in the Philippines is that they provide services which, due to market  - 31 - imperfections, the private sector is unable to provide. Specifically because of uncertainty and the private banks' excessive risk aversion, the amount of credit provided to agriculture and to small- and medium-scale industries is lower than what is deemed to be socially desirable. Hence, GFIs are needed to provide this type of risky credit. Therefore, in the transition to a more developed financial system, the government should focus on lending to small- and medium-scale industries and in providing credit to small farmers. 2.45 However, in practice PNB and DBP have competed in functions with private institutions and might have even hindered their development. Most of PNB loans are for trade-related activities. In addition, PNB does not seem to have a comparative advantage in mobilizing deposits of small savers since about 80% of its deposits come from accounts of two thousand pesos or more. Similarly, most of DBP's resources did not come from mobilizing small savers and the majority of its loans went to large enterprises which could have probably obtained private-sector funding had their projects been viable. 2.46 Furthermore, the two institutions did not succeed in providing significant amounts of additional cisky credit for agriculture nor medium- and small-scale industries. Table 2.10 shows that agricultural loans account for only 8.8% and 7.6% of PNB's and DBP's portfolios, respectively. DBP provided more loans to support investment in real estate than it did to agriculture, and nearly one-third of PNB's portfolio consists of trade-related loans. The ratio of agricultural credit to total credit in these two institutions' portfolios is lower than the average for the commercial banking sector as a whole. In addition, these institutions have been lending mainly large amounts to a few big enterprises. PNB's top 100 loans account for 80% of its portfolio and 20 loans account for more than half of DBP's portfolio. By and large, GFIs were not financing projects that private banks would not support because these were in risky sectors or they were small in size. Unless their lending can be redirected in the future, there is little rationale for their existence as public entitites. Table 2.10: SECTORAL DISTRIBUTION OF PNB AND DBP LOANS OUTSTANDING (% of total) /a PNB DBP Agriculture 8.8 7.6 Industry /b 39.2 71.4 Trade 29.2 /c Real Estate /c 9.6 Other 22.8 11.4 /a 1985 data for PNB and 1984 data for DBP. rb IncLudes mining and construction. 7C Does not appear as a separate category in bank's classification. Source: PNB and DBP.  - 32 - 2.47 In order to prevent the recurrence of past problems primary reliance for financial intermediation should be placed on the private sector, and the Government's participation in the financial system should not replace nor unfairly compete with the private sector, The restructuring of existing GFIs should reflect this objective, while the creation of any new government banks should be generally avoided unless there is a need to fulfill a clearly defined function which the financial system otherwise could not meet. In that case Government banks should operate under the same rules and regulations as private sector counterparts. 2.48 Government banks should be financialLy viable without need for continuing government financial support and special privileges, including special tax treatment and access to government deposits above working balances. Similarly, they should not support directed and subsidized credit programs without explicity off-balance sheet funding from the Government. Government banks should be subject to regular audits by independent private firms, in addition to government audits, to ensure public accountability. These principles have recently been adopted by the Government and measures aimed at implementing them are currently under preparation. Crisis of Commercial Banks 2.49 Several government-acquired banks are currently facing liquidity and/or solvency problems. As shown by the loan to deposit ratios presented in Table 2.11, several banks have overstreched their resources to provide loans and are now facing stability problems. The two other ratios in the table indicate a bank's ability to adjust its portfolio in response to shocks. In the case of foreign branches low liquidity ratios are not a cause for concern since they rely on resources from their head offices. However, the acquired banks do have a problem of liquidity in addition to a problem of stability. Table 2.11: REPRESENTATIVE FINANCIAIL RATIOS OF COMMERCIAL BANKS (DECEMBER 1985) (in percentage) Loans/ Liquid assets/ Liquid assets/ deposits liabilities all assets Foreign banks 190.79 23.92 23.72 Government-acquired 164.98 38.48 37.52 Private domestic 50.63 52.68 46.11 Source: Published statements of condition. 2.50 Government institutions took over these banks from the private sector because they were facing financial difficulties. This intervention,  - 33 - however has not been successful, since they are much less stable than the average. Ratios of liquid assets to total liabilities and liquid assets to total assets for the acquired banks were 73 and 81X of those for private banks. Only two of these banks have a loan to deposit ratio which is less than one; and for one of them the relatively low loan to deposit ratio is off- set by below average liquidity ratios. The acquired banks' position has probably deteriorated since December. As government-controlled banks, they were subject to the boycott called for by the opposition after the February elections. Some lost deposits and had to increase their borrowing or sell off their liquid assets. Government institutions acquired these sick banks with the aim of rehabilitating them and then reselling them back to the private sector. The rehabilitation effort has so far not been a success. Problems at the government-acquired banks affect the stability of the entire banking system. The Government is now considering the reprivatization of these banks. Concrete steps in that direction need to be taken. 2.51 In general, private banks, although affected by the crisis in the real economy, are financially stable. Faced with the crisis which started in 1983, private domestic banks reduced the size of their loan portfolios. Loans outstanding, in real terms, fell at a rate which was double that of the rate of decline in deposits. Instead of lending, many banks preferred to hold government securities. Hence, as Table 2.11 indicates, this group of banks seems to be fairly liquid at the moment. 2.52 CB's policy of merging and consolidating banks may have some benefi- cial short-run effects. However, the risk of encouraging further consolida- tion of commercial banks is that it might lead to an uncompetitive financial system in the long run. Merging a failing bank with a strong institution may avoid some of the problems associated with the bankruptcy of the weaker bank. However, this approach will have no long-run effect on the soundness of the banking system. Bigger banks are not necessarily more stable than smaller ones. An analysis of the data shows no significant relationship between size and stability. Strengthening the Central Bank's Supervisory Functions 2.53 The history of the Philippines financial system indicates that bank failures have almost always been associated with mismanagement. Increasing bank size will not necessarily improve the quality of management. In the long run, problems associated with mismanagement can only be avoided if CB effec- tively carries out its role in supervising banks. New regulations that ensure the soundness of banks need to be introduced, and CB's ability to enforce such regulations need to be strengthened. 2.54 CB has played an important role in maintaining financial stability during the recent crisis. However, its intervertions to stabilize specific institutions have always taken place only after the crisis is well underway. It would be better if interventions by the CB could occur before an institu- tion is on the brink of bankruptcy and requires emergency assistance. As suggested by the Asian Development Bank, CB should set guidelines to improve the financial conditions of banks. These can take the form of various ratios reflecting a bank's exposure to risk, its liquidity, its solvency and the  - 34 - adequacy of its capital base. If one of these ratios is violated, CB should intervene immediately. It should penalize ti?e management of the violating bank and force it to take prompt corrective actions. A strong CB which effec- tively carries out its role of supervising financial institutions is a prere- quisite for the long-run stability of the financial system. C. The Public Sector Recent Developments and 1986 Outlook 2.55 Since 1983 the overall public sector deficit has been significantly reduced, as a part of stabilization policies, through drastic reductions in public investment programs, in national government maintenance and service expenditure, and in subsidies. The overall consolidated public sector deficit had reached 5.8% of GNP by 1982, compared with 1.4% of GNP in 1979 (Table 2.12). This widening deficit was temporarily reversed in 1983 as receipts from international trade-based taxes rose after the introduction of an import surcharge in December 1982. However, revenue in relation to GNP declined to its lowest level (10.8% of CNP) in 1984, notwithstanding a series of tax increases implemented in 1983 and 1984. The drop in revenue mobilization was associated with the decline in economic activity and export prices, tax administration problems and some changes in the tax system which reduced the buoyancy of the system.  - 35 - Table 2.12: PUBLIC FINANCE OVERVIEW, 1979-86 (1 of GNP) 1979 1980 1981 1982 1983 1984 1985 P 1986 E National Government /a Revenues 13.5 13.1 11.8 11.4 12.1 10.8 11.6 12.4 Expenditures and net lending 13.7 14.4 15.8 15.7 14.0 12.2 13.5 17.9 Deficit -0.1 -1.3 -4.0 -4.3 -2.0 -1.9 -1.9 -5.5 Major Nonfinancial Govt. Corporations Investment-saving gap -3.6 -4.3 -4.6 -3.3 -3.6 -2.3 -1.4 -2.2 Local Government Surplus 0.1 0.2 0.1 0.1 0.1 - 0.1 - Social Security Institutions Surplus 0.8 0.8 0.8 0.9 0.8 0.6 0.8 0.9 Consolidated Public Sector Deficit /b -1.4 -3.0 -5.1 -5.8 -4.2 -3.0 -2.6 -5.0 Memorandum items: Government current expenditures 10.4 10.2 9.7 10.2 10.0 8.6 9.9 11.0 Public fixed investment 6.9 8.5 9.9 9.5 7.8 4.6 3.7 4.8 Note: Totals may not add up due to rounding. /a Includes assistance to the GFIs. /b Sum of the four fiscal balances (national government, government corporations, local government, and social security institutions), less national government equity contributions and net lending to the major government corporations. 2.56 In 1985, the overall nonfinancial public sector deficit was esti- mated to be around 2.6% of GNP. This reflects in part an improvement of about 1 percentage point in relation to GNP in the saving-investment gap of the major enterprises. The deficit at the national government level remained unchanged at 1.9% of GNP. The increase of 0.8% of GNP in revenue was offset by increases in interest payments, wages and salaries, and assistance to the government financial institutions (GFIs). The deterioration of the financial position of the GFIs has emerged as a much bigger problem as budgetary sup- ports to the GFIs increased from an average of P 0.5 billion during 1980-83 to over P 10.3 billion (1.7% of GNP) in 1985.  - 36 - 2.57 The overall deficit was entirely financed from domestic sources as net external financing waa marginally negative. Although the deficit appears to be low, given the monetary targets financing of the deficit through Treasury Bills contributed to higher domestic interest rates. 2.58 Without any new fiscal measures the consolidated public sector defi- cit is projected to be 5% of GNP in 1986.5 This deterioration reflects a sharp increase in the budgetary support to the financially troubled GFIs, increased provisions for operations and maintenance (O&M), and higher capital expenditure. 2.59 Assistance to the GFIs is estimated to more than double to P23 bil- lion mostly because of the deteriorating cash-flow position of the Philippine National Bank (PNB) and the Philippine Export and Foreign Loan Guarantee Corporation (PGC). PNB had a net loss in deposits due to withdrawals by individuals. In addition original estimates have been revised to incorporate assistance from either public institutions and the Central Bank to the GFI's. 2.60 The deficit of the nonfinancial public enterprises is projected to almost double to 2.2% of GNP in 1986 due both to a reduction in their operat- ing surplus and to a higher level of planned capital expenditure. Their internal cash generation deteriorated mostly because the National Food Admini- stration will incur a loss of more than P 1 billion due to the abolition of its wheat import monopoly and debt service on past loans. In addition, the operating deficit of the National Irrigation Administration is projected to deteriorate further, reflecting problems in collection of service charges. Total capital expenditure of the NFPEs is also expected to increase by more than 28%, mostly due to planned increases in capital outlays of the NPC and the Metropolitan Water and Sewerage System. 2.61 Through a combination of expenditure measures and revenue effects, the overall deficit of the National Government in 1986 should be reduced to around P 25 billion or 4.1% of GNP. The overall deficit on account of the financial operations of the major nonfinancial public expenditures should be reduced to around P 10 billion from the currently projected level of more than P 14 billion. In addition to fiscal measures, some tax reforms will be implemented. The authorities have adopted a comprehensive tax reform plan for 1986 which includes some revenue-losing measures designed to improve equity and allocational efficiency, and some revenue-enhancing measures directed at expanding the tax base. (details in Appendix, Chapter 3). 5/ Covers the nonfinancial public sector, but includes government assistance to GFIs.  - 37 - 2.62 Even if all measures suggested above are implemented immediately, the deficit will remain too high to be entirely financed from domestic sources without having undesirable effects on the interest rate, or inflation. Consequently, the availability of transitory external budgetary support would be highly desirable. Consolidation of Central Bank Operations into the Financial Oerations of the Public Sector 2.63 Given the fact that the Central Bank in the Philippines has gone beyond its traditional monetary functions, it should be considered within the fiscal picture. The deficit of the Central Bank is expected to range between P 15 to P 20 billion for 1986 alone. This deficit is mostly attributable to interest payments on bonds issued by the Central Bank to achieve the monetary targets under the adjustment program, interest payments on external obligations, and exchange losses on account of deposits held in blocked accounts. 2.64 During the period 1983-1985, the losses of the Central Bank were higher than the consolidated losses of the nonfinancial public sector. The relative significance of the main sources of losses shifted in recent years. During 1983-84, losses were incurred mostly due to forward cover and swap operations. Since then, interest payments on the growing stock of oustanding Central Bank securities and on Central Bank foreign liabilities rose sharply, and are expected to remain as the major sources of the Central Bank's overall deficit. The Domestic Components of Fiscal Deficit 2.65 The consolidated budget deficit which includes both domestic and foreign-based expenditures and payments of the principal, measures the effect of public sector operati-ns on the monetary accounts and the rest of the economy. However, the cash basis fiscal deficit does not adequately show the thrust of public sector operations on domestic demand when a significant proportion of the public sector outlays are on account of foreign obligations. To the extent that a component of the total expenditure is paid abroad, this does not exert any effect on the domestic aggregate demand. Thus, the mone- tary effect of fiscal deficit may not parallel the direct thrust on domestic economic activity originating from the fiscal operations. 2.66 This dIfference is important in the caqe of the Philippines where a significant proportion of the total expenditure is on account of foreign obligations. At the national government level, out of the total projected deficit of P 34.8 billion in 1986, about P 24.7 billion (3.8% of GNP) is attributed to external sources (Table 2.13). Foreign-based expenditure is mostly due to interest payments on foreign debts. External interest payments on behalf of the GFIs and the public corporations are shown as part of the equity and net lending operations of the National Government. 2.67 The domestic-based deficit indicates that the contribution to domestic demand arising from the national government operations will be about 1.6% of GNP, compared with the overall cash deficit of 5.5% of GNP. Therefore  - 38 - in 1985 when the overall deficit was 1.9% of GNP, given that external payments obliga ions fulfilled, the fiscal policy was contractionary in its effect on domestic demand. The domestically based surplus contributed to the sharply improved current account position of the balance of payments (see Appendix, Chapter III, Annex 4 on the effects of fiscal adjustment on the current account developments in the Philippines).  - 39 - Table 2.13: PHILIPPINES: DOMESTIC AND FOREIGN-BASED COMPONENTS OF THE NATIONAL GOVERNMENT BUDGET DEFICIT, 1986 /a (P bln) Foreign- Domestic- based based Total Revenue 4.10 76.20 80.30 Domestic-based taxes -- 49.00 49.00 Income and profit (-) (19.00) (19.00) Excises (--) (13.80) (13.80) Sales and licenses (--) (14.40) (14.40) Other (--) (1.80) (1.80) International trade taxes -- 20.00 20.00 Import duties and taxes (--) (18.80) (18.80) Export taxes (--) (0.90) (0.90) FOREX taxes (--) (0.30) (0.30) Nontax revenue 4.10 7.10 11.20 Of which: Economic Support Fund (4.00) () (4.00) Expenditure and Net Lending 28.82 86.31 115.13 Current operating expenditure 6.85 60.25 67.10 Personal services (0.05) (25.55) (25.60) Maintenance and operating (1.20) (17.60) (18.80) Interest payments (5.60) (12.70) (18.30) Subsidies (--) (0.90) (0.90) Allotments to local governments (-) (3.50) (3.50) Other (- -)(- Capital outlays 3.19 10.71 13.90 Infrastructure (0.69) (5.21) (5.90) Other capital outlays (2.50) (5.50) (8.00) Equity and net lending 18.78 15.35 34.13 Of which: Assistance to GFIs (12.00) (10.90) (22.90) DBP /5.70/ /4.30/ /10.00/ PNB /4.70/ /5.90/ /10.60/ PGC /1.60/ /0.70/ /2.30/ 15 government corporations t (6.78) (4.45) (11.23) Other government corporations t Deficit (-) -24.72 -10.11 -34.83 Percent of GNP (-3.8) (-1.6) (-5.4) /a Unde7 unchanged fiscal policies. Sources: Data provided by the Philippine authorities; and staff estimates.  - 40 - 2.68 Both concepts of deficit, cash-based and domestic-based deficit, are important for the purpose of policy analysis in the case of the Philippines. In situations where domestic demand is slack and other sectors of the economy are not expected to pick up, fiscal policy may play some temporary stimulatory role, and the concept of domestic-based deficit may be useful for that purpose. The cash-based deficit, on the other hand, would highlight the financing problem which will persist in the medium-term. Structural Aspects of the Expenditure and Tax System 2.69 In addition to the current debt constraints on public finances, the size of the public sector in the Philippines is structurally bounded by an exceptionally low tax ratio. The size of the public sector is small relative to most of its regional comparators. Total expenditure (excluding net lend- ing) at the central government level was less than 12% of GNP in 1983. This is the lowest in the region where central government expenditures range from 18.2% of GNP in Korea to 40.8% of GNP in Malaysia (Table 2.14). The tax ratio in the Philippines in proportion to GNP is one of the lowest in the world. Among the regional comparators, the Philippines has the lowest tax to GNP ratio, 10.4 Z of GNP. This does not mean, however, that the Philippines has to reach much higher expenditure to GDP ratios. The private sector is an important agent in providing services which are provided by the government in other countries. A low level of expenditures relative to other countries suggests that expenditures should not decrease any further and that the public sector gaps should be closed through increased revenue generation.  - 41 - Table 2.14: COMPARATIVE TAX AND CENTRAL GOVERNMENT EXPENDITURE DATA, SELECTED YEARS (in percent of GNP) Philippines Indonesia Malaysia Thailand Korea (1983) a/ (1983) (1981) (1984) (1984) Tax revenue 10.4 20.3 24.2 14.0 17.0 Taxes on income and profits 2.3 16.7 10.7 3.2 4.4 Domestic taxes on goods and services 4.5 2.4 2.6 6.9 8.6 Taxes on international trade 3.2 1.0 8.1 3.6 2.9 Other taxes 0.4 0.2 2.8 0.3 1.1 Total expenditure 11.9 24.0 40.8 19.8 18.2 Current expenditure 9.1 12.3 25.2 16.3 15.6 Capital expenditure 2.7 11.7 15.6 3.5 2.5 Net lending 2.1 1.5 4.2 -0.1 2.4 Overall deficit 2.0 2.8 15.8 3.8 1.3 /a Figures may not be exactly comparable with other tables because of classification discrepancies. Sources: IMF, Government Finance Statistics, and International Financial Statistics. 2.70 The low buoyancy and low elasticity of the Philippine tax system creates serious difficulties for policymakers as it requires continuous legis- lative changes to prevent a fall in the ratio of revenue to GNP. In fact, in recent years revenues fell despite many discretionary revenue raising measures that the Government adopted. This is a clear indicativ that the underlying buoyancy and elasticity of the tax system is very low, Buoyancy calculations indicate that the problem has become more serious in recent years, particularly before the introduction of the 1985 tax reforms (Table 2.15). 6/ Buoyancy estimates the responsiveness of the yield of a given tax to changes in some relevant aggregate variable without any correction for discretionary (statutory) tax changes. An elasticity measures that responsiveness after correcting the tax revenue series for such discretionary changes.  - 42 - Table 2.15: ESTIMATES OF BUOYANCY AND TAX ELASTICITIES, 1978-85 Buoyancy Estimates Elasticity Estimates a/ 1978-80 1980-85 1978-85 Tax revenue 1.0 0.8 0.5 Taxes on net income and profits 1.3 0.8 0.8 Taxes on domestic production and consumption 0.9 0.9 ... Sales and business taxes (1.2) (0.4) (0.4) Excises (0.8) (1.2) (0.3) Taxes on international trade 1.0 1.0 0.6 Nontax revenue 0.4 0.7 . /a An elasticity of at least one in a basic prerequisite for a healthy tax system. Source: Staff Calculation. 2.71 The existing tax system may be affecting a broad range of economic decisions while raising relatively little revenue. Economic decisions of tax- payers may be influenced by the relative ease with which taxes are evaded. For example, the prevailing schedular nature of the income tax may well encourage better-off taxpayer7 to diversify their activities across the various income tax schedules.- Public Sector Expenditure 2.72 Total nonfinancial public sector expenditure as a proportion to GNP is low in the Philippines compared to most countries of comparable income levels. Among other things, this results from very low revenue collection. Inadequate revenues constrain the government ability to provide adequate public economic and social infrastructure and for maintenance expenditures. In the medium term, any significant increase in public sector expenditure, in 7/ The income tax system is defined as schedular since it has different tax rates for different sources of income. Income from interest, dividends, royalties and government compensation have different rates in the Philippines.  - 43 - line with the authorities' desired objective, will continue to be constrained by the revenue collection efforts. 2.73 Apart from the lower level of expenditure, the composition of public sector expenditure has also shifted to an undesirable direction in recent years. At the national government level, capitil expenditure, and expenditure on goods and services (mainly on account of operations and maintenance) rapidly declined in relation to both total expenditure and CNP. The share of capital expenditure in total expenditure declined from a peak of more than 26% in 1981 to 11% in 1985; and from 4.2% of GNP in 1981 to 1.5% in 1985. Expen- diture on goods and services declined from 4% of GNP to 2.2% in 1985. Expen- ditures on wages and salaries, interest payments, and assistance to CFIs increased rapidly in recent years both as a percent ot total expenditure and in relation to GNP. The increase in the wage bill occurred, rotwithstanding a decline in real wages in the public sector, and may be attributable to addi- tional hiring. 2.74 The two debt components of national government expenditure, have introduced additional inflexibility in the budgetary operations. Interest payments on account of national governmetit debts and transfers to CFIs to service their maturing liablities have also re4ched alarming ptiportions and will continue to remain high in the medium term. Elements of a Revenue Strategy for the Medium 'erm Changes in Tax Administration 2.75 There is a considerable gap between revenue potential ai,d actual collection in the Philippines. Ihe main shcrt.all in revenues is due to poor compliance and needs to be tackled through adminisLrative reforms. Some changes are already starting to he implemented in Internal i'evenue. Personnel changes and administrative reorgPnization are underway in the Bureau of Internal Revenue to increase collecciorL efficiency. Tax Reform 2.76 The new administration has adopted a major Tax Reform Program that took effect in July 1986. The package has been d2signed to 'ecireas the tax system into a more efficient instruwient lor revenue generation, resource allocation and redistribution. The major elements to improve the revenue elasticity of the system include a par;ial shift to global taxation, a shift to a fully and valorem basis and iiicrease in rates for excise taxation of cigarettes and licor, and abolitior. of most exemptions from direct and indirect income tax. The Government has also decided to is-titute a full- fledged value-added tax in place of a complex and poor revenue performing sales tax, effective January 1988. 2.77 In order to improve resource allocation the package include measuves to rationalize trade taxes and margiz-al income tax brackets. A tariff reform of import taxes include establishmenr of a rrini,r.um 10% luty on presently zero- rate imports, selective lowering of certa'n high rates, ard A shif, tD a CIF basis of import taxation. With respect to export taxes, the Go..'ernment has  - 44 - abolished export duties that have penalized exporters in present commodity market conditions. To boost incentives and reduce evasion the highest marginal rate has been unified as a substantially lower level of 35% (compared with the previous 60%). 2.78 To enhance the redistrictive impact of the tax system the measures include increase of personal exceptions under income tax so as to exclude all households below the poverty line. The decision to reassess taxable values of properties represent an important step in providing for a more equitable distribution of the tax burden. 2.79 In total, the net revenue yield of the tax package for 1986 is estimated at P 3.5 billion and, for 1987, at P 13.4 billion. Included in these estimates (P 1.6 billion and P 6.5 billion for 1986 and 1987 respectively) is the effect of the withdrawal of exemptions to the nonfinancial public corporations which, for the time being, will be balanced by explicit budgetary subsidies, thus making transparent, traditional implicit subsidies on the operation of these corporations. The Public Investment Program 2.80 During the 1970s the public sector gradually increased its invest- ment rate from a low level of 1.5% in 1970 to 6% of GNP by the end of the decade to meet the infrastructural requirements of a rapidly growing economy. After 1979, however, there was a pronounced acceleration in the public investment rate to counter cyclically offset the then deepening world recession and to fund investments in the energy sector that would help reduce the heavy dependence on imported petroleum. In addition, a major program of industrial investments was launche,d to save foreign exchange through import substitution. As a result of this effort the overall public investment rate increased to a peak of about 9% in 1981. Recent Developments 2.81 Most of the fiscal austerity measures were aimed at reducing the Public Investment Program (PIP). As a result the PIP was cut, in real terms, by almost 50% during Lhe stabilization period (See Table 2.16). Reductions were particularly severe in such areas as transport/communications (-80%), industry (-83%) and energy (-54%). While there has been a sharp reduction in new projects, there have also been considerable delays experienced in comple- tion of ongoing projects. 2.82 A substantial reordering of Lhe public investment program took place in 1984/85 to scale back the budgetary ,teficits and public borrowing require- ments. Overell, the Bank's Public Investment Review (August 1985) concluded that the reordering of the investmenr program appeared appropriate. The restructured investment program showed a substantial increase in agricultural investments in line withi the previous Government's announced policy of shift- ing to balanced Agro-Industrial Development. In light of the constrained resource situation many large capital intensive projects in energy, irrigation and industry were either deferred or deleted from the program. The report also concluded that investments in transportation had already suffered from  - 45 - considerable reductions in the recent past and further cuts were likely to have serious consequences for future economic development. Table 2.16: PUBLIC SECTOR INVESTMENT (P bin) 1977 1979 1981 1982 1983 1984 1985 1986 1987 National Government 3.2 5.0 12.7 10.0 10.4 9.8 8.8 14.6 20.2 Public corporations 4.8 7.6 12.9 12.9 18.1 12.7 11.1 15.4 15.7 Local government 0.4 0.5 0.7 0.7 0.7 1.5 1.4 1.4 1.5 Total 8.4 13.1 26.3 23.6 29.2 24.8 21.3 31.4 37.4 X of GNP 5.6 6.0 8.7 7.0 7.7 4.6 3.6 5.0 5.5 Sources: NEDA 2.83 Although public investment cuts were largely appropriate, the cut in Operation and Maintenance (O&M) has been counterproductive. O&M expenditures have been cut by about 50% in real terms compared with 1982. (See Table 2.17) Cuts have been particularly serious in irrigation where O&M has fallen 40Z in real terms since 1981. The underfunding is also substantial in the various public corporations. Table 2.17: NATIONAL GOVERNMENT BUDGET: MAINTENANCE AND OPERATING EXPENDITURES (million pesos, 1972 prices) 1977 4,973 1979 3,592 1981 3,551 1982 3,611 1983 3,109 1984 2,160 1985 1,871 Source: NEDA 2.84 The national government budget for 1986 restores capital spending to about the same level as in 1979, through a doubling of the investment program. For the entire public sector, investment would rise from 3.6% last  - 46 - year to about 5% of GNP. The target increase in the national budget are in areas that will support employment oriented rural works projects. The investment program for the corporations calls for a fairly substantial increase for NPC from P 4.9 billion to P 8.8 billion this year. This increase is the result of two factors: the final payment of the nuclear power plant of P 2.6 billion, and increased expenditures for the rehabilitation of existing oil-fired plants of P 2.0 billion. 2.85 The 1986 national budget also calls for a substantial ncrease in O&M expenditures by 62%. This increase redresses the past trend of declining levels of O&M expenditures which have fallen 50% since 1982, despite an expanding capital base. The current total increase would raise the level to about 80% of the 1982 level. The restoration effort would be even larger for economic and social services reaching about 95% of the 1982 level. 2.86 To stimulate aggregate demand in the short term and to provide for adequate structural support of private sector development in the medium term, it is recommended that the Government as a minimum maintain a public invest- ment program of about 5-5.5% of GNP which represents more of a restoration of the investment level to the 1976-77 period (5.4% of GNP). A 5% public investment program would still represent a substantially lower public investment program than in a number of lower/middle income LDCs, such as Turkey (11%), Morroco (10%), Tunisia (15%), Ecuador (8.6%), Portugal (7.1%), Pakistan (9.2%) and Jordan (14%). The above proposed minimium public investment program of 5-5.5% is based on a number of factors including the above-mentioned "bottom-up" sectoral investment analysis and "top-down" ICOR and capital depreciation assumptions. 2.87 The new government wants to encourage private initiative, reduce government intervention end eliminate favoritism. Under the new investment guidelines the government would basically function as a provider of public goods, rather than as a direct producer, in areas in which market failure, externalities, or social objectives do require intervention. This is in fact one of the major changes from the past decade. In this context public sector participation will be concentrated in development of rural and urban infra- structure, encouragement of small farmers, and provision of services in health and education. 2.88 In line with this new role, privatization of public corporations is now one of the most urgent concerns of pulicy making. The government wants to privatize an important number of public corporations including the Philippine National Oil Corporation (PNOC), the National Food Authority (NFA), the National Development Corporation (NDC), and Philippine Airlines. In the case of PNOC, the first step is to decentralize and privatization will start to be considered only when the subsidiaries are independent. In addition, nonperforming accounts of the various GFIs will be transferred to a separate entity which will manage the disposition or rehabilitation of these assets. 2.89 Sectoral requirements for public investment are analyzed in detail in the public investment annex of this report. Following the recent cuts the high priority sectors for public investment are agriculture, transportation, water supply and telecommunications. Efforts should be concentrated in these  - 47 - areas since any medium term strategy which pursues agricultural and export development will hinge on infrastructure, which at this point is largely inadequate in all of these four sectors. 2.90 In agriculture, public investment should be limited to research and extension, and investment in rural infrastructure, but not commodity produc- tion. On rural infrastructure, the most urgent problem in irrigation is the severe underfunding of O&M which in 1986 is one third below the desirable level. Deferred O&M may result in accumulated rehabilitation investment needs of P 8.7 billion by 1995. 2.91 In the industrial sector, the governments strategy is to start divesting public firms most of which are now under NDC. As mentioned before, the major industrial projects have been completed or cancelled and the NDC is starting to be privatized. Therefore, the PIP does not contain any projects in industry, since all productive activity in this sector will clearly be left to the private sector. 2.92 The ongoing transportation investment plan has high priority, with high rates of return, and considerable social benefits. While the road net- work is adequate in location and extent, in reality an important part is in very poor conditions. Only 13% of the network is paved, and the conditions of many roads are poor in terms of deficient design and construction, lack of maintenance, and damage from overloaded vehicles. The usefulness of the existing network is significantly diminished by missing or weak bridges and the scarcity of access roads in remote areas. In the PIP the emphasis of investment in transport has shifted away from new construction to maintenance, rehabilitation and improvements. Increased attention is also being given to rural roads. 2.93 The country's economic situation, growth in power demand and falling oil prices have affected proposed investments in the power and energy sector. While geothermal energy sources are still competitive with alternative fuels, many proposed coal projects, which were already marginal investments before the change in oil prices, are probably no longer viable investments, and need to be carefully re-examined. 2.94 NPC has developed a tentative investment program for Luzon, assuming the nuclear plant is "mothballed" indefinitely, which ca'ls for rehabilitation of Sucat 1 and 4 (1989 and 1991 respectively) and commissioning of Calaca II (1991) and Bacon-Manito I (1991). This sequence is justifiable given the present distorted pricing of steam. However, it is questionable whether in economic terms this sequence (Calaca to be commissio:ned at the same time as Bacon-Manito I) represents a least cost power investment program, particularly given the sunk costs already invested in Bacon-Manito I. Geothermal could potentially represent lower cost options for power supply in the 1990s and therefore warrant further consideration/investigation.  - 48 - III. THE PRODUCTIVE SECTORS 3.01 With an adequate macroeconomic environment and the appropriate incentive structure, it is the productive sector which will provide the real resources to supply domestic demand and to pay for import needs. During the past few years there has been little new private investment because of uncertain economic and political conditions. Policy makers have had to focus on stabilizing the economy in the short run. Having achieved that, attention must now turn toward the launching of medium-term economic planning. Given new political conditions and the likelihood that private investment will eventually resume, the incentive structure should promote growth along the lines of Philippine comparative advantage and away from a highly distorted output pattern. 3.02 The stabilization, although dramatic in terms of output drop, has probably left a healthier productive base than before the crisis. As a result of the economic crisis and the adjustment that followed, competitiveness and efficiency in industry might have improved since those firms that were able to survive despite the recession are probably the most competitive in the sector. In addition, there are significant amounts of unutilized capital. Therefore, industrial output can expand in some cases with little new investment given an increase in demand and the appropriate signals, it can start to contribute to economic growth. For agriculture, a number of reforms are in place which will support the sector's development once growth is resumed. A. Agriculture 3.03 Agriculture has been the only sector which has kept positive growth rates in the past two years, but output has been growing at lower than histo- rical rates. Production of a number of basic food commodities and commercial crops, labor productivity, real wages, and employment have all declined. Although the sector has been affected by the 1983 foreign exchange shortage and the credit constraints during the stabilization program, macro policies have systematically discriminated against agriculture for a long time. However, agriculture still remains a dominant sector: it is the most important employment generator, represents 26% of total value added, and over a third of export earnings.  - 49 - Table 3.1: GROWTH AND STRUCTURE OF THE AGRICULTURAL SECTOR 1972-85 Growth rates (real value added, X p.a) Percentage share 1972-82 1983 1984 1985e 1972 1980 1985 Palay (rice) 4.7 -13.3 7.7 4.1 17.1 14.7 18.1 Corn 3.8 -6.7 7.1 15.5 6.3 5.6 6.5 Coconut (incl. copra) 1.4 -9.0 -21.3 27.6 7.2 4.9 4.5 Sugarcane 2.2 -14.3 17.6 -39.8 6.6 4.3 3.1 Banana 13.0 4.3 .6 10.8 3.7 7.8 9.2 Other Crops 6.5 4.3 3.9 2.80 14.2 21.3 20.8 Livestock 1.0 10.0 -.4 -2.2 10.9 6.2 8.1 Poultry 10.9 13.6 4.4 -0.5 4.5 5.9 10 Fishery 4.7 2.3 -1.8 2.2 16.7 18.1 16.9 Forestry -6.9 -16.6 -6.6 -7.7 12.5 10.9 2.7 Total Sector 4.2 -2.1 2.27 2.37 100.0 100.0 100.0 e - Bank estimates. Source: Derived from National Accounts Staff, NEDA. 3.04 Following the historical trend, resources have continued to move out of this sector because of a policy environment which resulted in a set of incentives that made production in agriculture relatively unprofitable. Macro policies have discriminated against agriculture through price controls, an overvalued exchange rate, export taxes, marketing monopolies, and negative effective protection for agricultural products. Many of these policies were the result of piecemeal decisions addressing a whole range of needs such as quick revenue generation, protecting the urban consumer and protecting industrial producers. The resulting set of incentives was one in which the profitability of agricultural activities declined steadily as both the external and internal terms of trade of agriculture have declined. 3.05 Today, after a number of reforms, the incentive system in agriculture is much improved. Major sector-specific reforms have been undertaken which have considerably reduced the anti-agricultural bias. With the exception of the protective system which still favors manufacturing production, other price distortions have been largely eliminated. Producer prices of pork, eggs, and poultry have been liberalized and the price ceiling on milled rice has been removed; the overall range of nominal tariffs has been narrowed and the importation of animal feed, wheat, and fertilizer has been liberalized; subsidies and directed credit to agriculture have been removed. In addition, monopolies in sugar and coconut trading are being dismantled and the structure of the institutional set-up in these subsectors is being rationalized.  - 50 - Requirements for Resumption of Sustainable Growth 3.06 In addition to providing agriculture with the appropriate macro- economic framework, the government still needs to remove some institutional constraints which might prevent producers to respond to the new set of incen- tives. Specifically the government should address two interrelated issues in agriculture: the low productivity of the sector, and the sector's concentration in a few crops. Both issues face similar constraints which hinder the development of activities in which the Philippines enjoys comparative advantage. Rural Credit 3.07 Significant factors in the relatively weak performance of agriculture in recent years have been the sharp contraction in the supply of credit and, more recently, the severe inadequacy of existing channels for the delivery of rural credit. The flow of institutional credit for farm production and seasonal production loans have declined drastically in recent years. Efforts by the Central Bank to direct credit into agriculture as a preferred area have failed and the share of agriculture in total credit outstanding by commercial banks declined from 16% in 1980 to 8% in 1984. Structural problems in the banking system and financial weaknesses of individual institutions currently constrain the flow of formal credit to agriculture, limit the range of services offered, and lead to increased transaction costs. Massive arrearages in the rural banking system pose serious problems to the efficiency and viability of both government owned or supported financial institutions as well as private rural banks. Out of 904 rural banks, 119 have closed and in the remaining banks more than 50% of total loans are now performing. The private rural banks suffer from subloan arrearages, low capitalization and limited deposit mobilization. As a result, the rural banking system cannot adequately supply the needs of agriculture and the rural sector. A major thrust, therefore, in agricutlure must be the development of an efficient delivery system for rural lending. Government should embark on a comprehensive plan which should include selective rehabilitation of rural banks, mobilization of rural savings, reduction of intermediation costs, and simplification of loan procedures. Trade Policies 3.08 It has been calculated that a real depreciation of the peso of 5% will lead in the long run to a 3% increase in agricultural income. Furthermore, a relatively less protected industrial sector is a crucial requirement to make investment in agriculture more attractive. In spite of the tariff reform program, overall agricultural activities have negative effective protection rates of around -2X while manufacturing activities are protected by about 20% (see Table 3.2). The tariff reform program reduced the negative EPRs in the agricultural sector for a number of agricultural products. However, for some products protection became even more negative because of the imposition of export taxes, as a revenue measure, following the 1983 crisis. Today, effective protection rates for the agricultural sector are still negative while remaining positive for import-substituting manufactured products. Historically negative EPR's help explain the fact that  - 51 - resources have moved out of agriculture and into industry. Over time this has lowered agricultural production and export earnings, provided significant income transfers from the rural to the urban population, and resulted in a level of national output below that which would have existed under a more neutral environment. 3.09 The gradual reduction in the level and dispersion of the tariff rates is a necessary but not sufficient condition to remove the anti- agricultural bias of the existing trade regime. The elimination of import restrictions now being implemented should continue and export taxes should not be reimposed. Lowering tariffs and narrowing the rates to the 10-30% range would not reduce importantly the negative EPR's of the major agriculture products. Quantitative restrictions and import controls on agricultural commodities and inputs should also be eliminated. Specifically, the ban on importation of yellow corn imposed in October 1985 should be removed since it penalizes the feed meal industry for which yellow corn is an important input. The import duty on yellow corn is already a very high 50%, and the government should even consider lowering the duty to the 20-30% range. Other commodities and inputs that are subject to import licensing and control are meat and meat products, and tin plates, (which are used in food processing for canning). For agricultural exports in general the Government should also address the high tariffs on packing materials, and delays in obtaining permits in fish importation. Table 3.2: EPR ESTIMATES (X) Sector 1979 1985 Corn Unmilled 9 9 Milled 11 11 Rice, milled 11 11 Coconut, including copra -8 -16 Sugar, milled and refined -6 0 Banana -6 -4 Commercial fishing Exportable -4 -3 Importable 8 9 Primary and agricultural sectors -2 -5 Manufacturing sectors 27 20 Source: PIDS. Exchange Rate 3.10 The penalty of an overvalued peso has been shown to be a powerful disincentive Lo agriculture--and to agricultural exports in particular.  - 52 - Although the peso was adjusted periodically to reflect market conditions, the structure of tariffs, quantitative controls on imports, export taxes and currency restrictions have allowed the peso to maintain an artificially high value throughout most of the postwar era. In the Philippines the overall impact of the overvaluation of the effective exchange rate between 1969-80 was to reduce the price of agricultural exports relative to the prices of indus- trial exports, import-competing goods, and home goods by 11.3%, 6.6% and 3.2%, respectively. Thus, agricultural export production was discouraged in favor of industrial exports, import-competing products, and home goods. The annual cost of the overvalued exchange rate has been estimated to include foreign exchange losses on the order of P 5 billion, employment loss for around 126,000 workers and welfare loss to producers of P 1.8 billion. The off- setting welfare gain to consumers of P 2.9 billion can be largely translated as welfare transfer from the rural to the urban areas. The competitiveness of agricultural exports further deteriorated in the past two years as the real effective exchange rate appreciated. The international competitiveness of Philippines rice, corn, coconut oil, sugar, coffee, banana and tobacco has declined mainly because of the exchange rate appreciation. 3.11 The overvalued exchange rate has had a more negative effect on agriculture exports than on manufactured exports. In the case of industrial exports, the existing biases of the tariff structure and indirect taxes have been partly offset in the seventies, by fiscal and financial incentives provided under the investment codes, as well as the development of export infrastructure specifically directed toward labor-intensive manufactured products. E_pyot Taxes 3.12 Export taxes in the Philippines have been the main factor explaining negative effective protection for a number of products. Export taxes have been levied until July 1986 on 10 traditional export products with rates rang- ing from 2% to 20%. Although export taxes were recently eliminated, through- out most of the past two decades the overall implicit export tax on agricul- tural export was close to 16%. These taxes were originally imposed in order to encourage domestic processing and manufactured exports and to generate government revenue. However, export taxes effectively increase the relative protection to manufacturing industries and benefit consumers and Government. They represent once again a transfer of wealth from agricultural producers to the urban sector. Furthermore, it has been shown that export taxes r,lso represent a deadweight efficiency loss to the economy since producers lose more than consumers and government gain. Finally, the reverue generated from export taxes was only 3% of total government revenues. For all these reasons, the recent elimination of export taxes is an important step towards improving the competitiveness of agricultural exports. With the exception of the export tax on logs imposed for conservation purposes, export taxes should not be reimposed. !gricultural Productivity 3.13 The ability of the agricultural sector to significantly contribute to economic growth has been hindered by the present low, and in some places  - 53 - declinin:1, pr,ductivity. Unlike Malaysia and Indonesia where new lands are still avai.able, Philippines has very limited potential farmland, so future increases in production will have to come from higher yields on existing crop land. 3.14 Crop yields in the Philippines are quite low by international standards. (See Table 3.3). In rice, for example, the yields in Asia average about 3.3 MT/ha, while in the Philippines they were only 2.5 MT/ha. The yields of rice per hectare were 2.9 MT/ha in Indonesia and 6.5 MT/ha in Korea. Yields in the Philippines are also lower than the international and regional averages for maize, sugar, copra and tobacco. Low corn yields are a result of the unavailability of disease resistant high yield varieties (HYVs), the lack of drying facilities, inadequate seed control and low level of fertilizer and pesticide use. Sugar yields on the other hand, suffer from the spread of production to marginal areas, and the deterioration of cane varieties. Table 3.3: YIELD COMPARISONS FOR MAJOR CROPS, 1984 /a (Metric tons/ha) International Philippines Asia South America average Rice (paddy) 2.5 3.3 2.1 3.2 Maize 1.0 1.5 2.0 3.4 Sugar (cane) 48.1 53.0 63.0 58.0 Tobacco 1.1 1.4 2.1 1.5 /a As the area compared is heterogeneous, this is only a rough comparison of yield. Source: FAO Production Yearbook. 3.15 Given the important linkages with other productive sectors, an increase in agriculturai productivity would have beneficial economy-wide effects through price and quantity adjustments as well on the rural and households' income generation and consumption patterns.- Thus, a major component of a long-term strategy in the agricultural sector should be the improvement of the productivity of the sector. 8/ For a quantitative analyses of the effects of an increase in productivity in Philippine agriculture see Bautista R.M. "Effects of Increasing Agricultural Productivity in a Multisectoral Model for the Philippines." IFPRI, July 1985.  - 54 - 3.16 Elements of a strategy to increase productivity include inducement to use of fertilizers through reduction of taxation and improvement of the physical distribution system; improved irrigation services through substantial increases in the level of O&M expenditures in irrigation systems; increased Government expenditures on rural infrastructure; increased budgetary alloca- tion for research and extension; and rationalization and strengthening of the extension system. Fertilizers 3.17 Despite the major role fertilizers have played in improving agricul- tural productivity, the Philippines is still a low level user of fertilizer. Furthermore, the use of fertilizers in the Philippines has been economically suboptimal. Government pricing policies,the high cost distribution system and technical problems associated with water supply and extension services have all contributed to low levels of application. The high fertilizer/crop price ratios, the foreign exchange shortages in 1983-84 and the credit shortages especially starting in 1983, have caused a significant decline in fertilizer consumption in recent years. Fertilizer use has declined from a level of 846,000 MT in 1982 to 701,000 MT in 1985--a level comparable to 1977 consump- tion levels. As a result, the average use of fertilizer per ha declined significantly and the nitrogen use per ha in the Philippines is one of the lowest in Asia (38.5 kg per ha compared to 57 kg and 45 kg in Indonesia and Malaysia, respectively). In order to increase the use of fertilizers, the Government should initiate policies to reduce the cost of fertilizer and reduce the risk associated with the use of agrochemicals by farmers. This should include the complete elimination of the fertilizer levy; improving the physical distribution system; providing adequate extension services; improving the supply of water and stabilizing rice and corn prices. 3.18 The major problems affecting fertilizer consumption in the Philippines is government pricing policies which lead to high fertilizer/crop price ratio. These ratios in the Philippines for rice and corn are amongst the highest in Asia. Past government policies have protected fertilizer producers from foreign competition through import restrictions and import duties. Farmers were thus bearing the burden of an inefficient fertilizer industry. Import restrictions were removed in August 1984. However, ex- warehouse prices of most fertilizers remained higher than world prices because of high levels of taxation and high physical distribution costs. In the last quarter of 1984 urea prices, for example, were 28% higher than world prices. Recently, the domestic price of fertilizer declined significantly after the decline in world prices and, in addition, fertilizer importers were practi- cally exempted from the 20% tariff. However, the farmgate price of urea in April 1986 was still 10% higher than world prices. The main distortion in fertilizer prices was caused by the capital recovery component (CRC) which is a levy of P 10 per bag of fertilizers, imposed in order to pay for nonguaran- teed private debt, which adds about 6% to the farmgate price. The GovernmenIL is currently reviewing the CRC in view of the disincentive created for farmers and as of July 1986 importers and distributors have discontinued paying the P 10 tax. It is recommended that after the review by Government the CRC would be abolished completely.  - 55 - 3.19 Even after taking into account the negative effect of higher prices on fertilizer consumption, the use of ferttlizers in the Philippines is econo- mically suboptimal. In all regions, in irrigated and nonirrigated areas, farmers produce at levels at which the value of the marginal product of ferti- lizer exceeds the price of fertilizers. The main factors explaining subopti- mal fertilizer application are: (a) the instability of output prices; (b) un- certainty and inadequacy of water supplies; (c) lack of sufficient knowledge on fertilizer application techniques; and (d) the high probability attached t.o losing the crop through natural disaster. Apparently the most important fac- tor in the farmer's decision as to the applications of fertilizer hias to do with the price of the crop. The absence of an effective price stabilization system for rice and corn is translated into a lower expected value o,t narginal product. Combined with the risk factors involved in uncertain water supply and uncertain yields, the result is lower application of fertilizer. rr .g at Lo't 3.20 Inefficient and Unproductive use of past investment .n the igr'cui.- tural sector is also a major reason for the low produtctivity of the sect;rl In spite of the massive investment in irrigation infrascructuire undertaken in the last two decades, frequently less than two thirds of the plannied servine area are effectively irrigated because of inadequate operation anci jiairi- tenance. Operation and Maintenance (O&M) expendituires at the system l.eveL declined in real terms from P 189/ha in 1981 to P 117/ha in 1984. The conse- quences ale a steady decline in system's efficiency, and premature deteriora- rior- Gf past investments. The decline in service area is estimated at 1.5-2%, per year with a corresponding decline in yield and production. 3.21 Ihe inadequate funds allocated for O&M are a result of the Low Leve(.s and poor collection of Irrigation Service Fees (ISF) and the decline in Goverrnmernt equity contributions for irrigation investment. Current I F l' evels ,are, on average, 50% lover than the rates required to cover total investment costs and the desired level of O&M expenditures. The present levels are / inadequate even to recover only the direct irrigation crnst.ruction tosts.- rhere is, therefore, a circular problem in which poor O&t. result in poor serv;ce. This in turn helps to explain the low collecr.ion oi fees s.nce farmer do nOL want to pay for poor services. Finally, the reduced resour-ces r2sulting from low colLection wil.l impLy a lower level, of O&M than. requirE,d. 3.22 Proposed Covernment Strat ey. High priority sh)uld be givern by tihe Government to a substantial increase in expenditures for opr}ation, maintenance, and rehabilitation, of existing irrigation works, and conplet,lon of on-going irrigation projects. This should be financed by an enlarged p-ublic exrenditure program for irrigation and recovered thro.gh better wate? chiarges collection and more appropriate rates. O&M expenditures should be increased to the level of P 400/ha (in 1985 prices), and greater emphasis sho':id be gi:en to the creatitcn of Irrigator Associations to encourage direc:: n.o.vemernt of farmers' in the operation arnd maintenance, and tne developmenr f smai-iscale Irrigatlon prolects. 9/ ;fined is the or, sut LJ ioll c-st of -' ifr gt r lin % ., exclu&l ng road(is and suppo: Krg LnfrAFrruiui...  - 56 - 3.23 Concurrent with the improvement in irrigation services to the farmers, new strategies to increase the collection and level of 1SF should be initiated. Measures to increase collection should include improvement of the billing system, updating of irrigation fee registers and parcellary maps, strengthening NIA's legal capacity of enforce fee collection and punish delin- quent farmers, and enabling NIA to negotiate with farmers the payment of past accounts. Beyond improving collection, there is also a clear need to increase ISF level particularly for the reservoir systems. However, gradual increases in ISF level should be initiated only after irrigation services to the farmers are substantially improved and an effective collection mechanism is firmly in place. Rural Infrastructure 3.24 The deterioration of the rural infrastructure is a major constraint on a susLained recovery of the agricultural sector. The condition of most of the rural road network is in very poor condition because of deficiencies in design and construction, lack of maintenance, and damage from overloaded vehicles. Missing or weak bridges diminish the usefulness of many existing roads and in remote areas access roads are scarce. Most of the lower standard roads are impassable during the rainy seasons, and a number of fertile upland and soastal regions are practically inaccessible in any season. The stock of transportation equipment has deteriorated drastically in recent years, making transportation and distribution of produce and inputs unreliable, time consuming and expensive. As a consequence, vehicle operating costs are very high, significantly increasing the tiansportation costs of agricultural products. Inappropriate rural infrastructure has increased farmers costs in real terms by approximately 30% from 1980 to 1985. 3.25 Transport inve,tments that support agricultural production should be given high priority in the investment program. While construction of new roads is still necessary, the emphasis should shift toward maintenance, reha- bilitation and improvements of existing infrastructure. Through improved maintenance the economic life of existing assets would be extended as well as transport costs would be reduced. Rehabilitation should be undertaken when regular maintenance is no longer effective, in order to avoid costly replacements. 3.26 In the Philippines postharvest facilities, especially drying and storing, are very inadequate. In 1985, the drying capacicy in the Philippines covered only 23% of total corn production; storing capacity covered 55% of total production. This bottleneck to increased crop production breaks the potential linkages between producers and processors and compels farmers to sell wet produce at depressed prices rather than facing total crop spoilage. There is a wide gap between post harvest facilities and corn production, particularly for driers since they are used for both paddy and corn. 3.27 Investment in postharvest facilities is and should continue to be a private activity. The recent liberalization of grain prices and trade should provide incentives for the private sector to invest in economically viable facilities. Government involvement could complement private initiative through provision of facilities on a lease basis with provision of option to  - 5/ - buy or by facilitating long-term credit, and throu-h effective price stabilization for rice and corn. Research and Extension 3.28 Although the Philippines has one of the oldest rese.arch and ext.?n- sion system in Asia, the support provided by the existing system is inade- quate. In additiotn to insufficient research funds there is .-o c:lear link between agricultural research and extension work; and the extension system is diffused, undertrained and underfunded. For example, the agronomic efficiency of fertilizers currently used in the Philippines is so poor that the farmer benefits from no more than 40% of the nitrogen applied to rice crops, while the rest is lost through improper use. 3.29 Operating and capital expenditures devoted to research and extension should increase in real terms to more adequite levels of about 1% of agricul- tural value added. Current operating expendituires of the three ministries responsible for research and extension in agriculture have fallen both in nominal and in real terms, between -'q8l and 1%4. The exterision staff lack fuel, vehicles, spare parts and other essentials to perform their duties. Furthermore, international comparisrn of agricultural research expenditures as a percentage of agricultural value added qhow that already in 198U the Philippines level was amongst the lot,iest i Asi.a (0.16%). 3.30 The fact that the existing Ex-ension system is extrLmely ciiffused limits the efficiency of the seivicev provided -c fat;,.rs. About )5 govern- ment ministries and agencies provide varying forms of trral extension. Agri- cultural extension has developed along commodlcy lines and each major crop has its own research and extension apparatus. For example, coconuts are handled by the Philippine Coconut Authority (PCA), cugar by Philsucom, cotton by Philcotton, tobacco by Philippine Tobacco Administration and Philippine Virginia Tobacco, rice and corn by Bureau of Agricultural Extension and animal protection is serviced by the Bureau of Anirnal. indust-y. With so many agencies involved in extension, overiaps and ineffic ncies are bound to exist. In the case of multicrop farming the same group cf farmers must deal with at least three agencies and z<r times with up to eight. Ciearly there is a need to rationalize the structure of the extension system, reduce the number of bodies dealing with extension and assemble the rcior responsibility under one roof, preferably the Ministry of Agriculture. i"'is will also help to strengthen the link between the researct; side and the extension as at present there is no clear line of commant frorn the national level downi to the field. B. Industry 3.31 The recent col.lapse in econcmic activity particu'arly affected the industrial sector which had alFtady s.arted to contract af:er the second oil shock. However, the adjustment has left a more competiti-i!. industrial struc- ture in place. Therefore, given the right policy measures, the sector has the potential of importantly contributing to future growth. 3.32 Table 3.4 is quite graphic in clescribing the depr~