Philippines - Capital market study (Vol. 1 of 2) : Main Report

Report No. 1005:00- :Ph'i'l i 'p1bes iCZapit'al Mark<et Study .; (inTwo.V6lumeqs6},^ Volume1: Main Report MICROFICHE COPY -Ft6ruary 24,1991 Report No. 10053-PH Type: (SEC) ' - ~~~~~~~~~~~~DALLA, I. /X80484 /D 8057/ AS2IE ;.-industry and Energly Division Country Department I - Est Asia Pactfic Region- : FOR. oFFiCtU SE ONLY  CRENY EQUIVALENT Average 1991 - US$1.0 = P 26.7 Average 1990 - US$1.0 = P 24.5 Average 1989 - US$1.0 = P 21.7 Average 1988 - US$1.0 = P 21.1 Average 1987 - US$1.0 = P 20.6 Average 1986 - US$1.0 = P 20.4 ACRONYMS AND ABBREVIATIONS ADB - Asian Development Bank ASEAN - Association of Southeast Asian Nations BIR - Bureau of Internal Revenue BOI - Board of Investment C-BP - Central Bank of the Philippines CSS - Contractual Savings Sector DBP - Development Bank of the Philippines GSIS - Government Service Insurance System CDP - Gross Domestic Product GRT - Gross Receipts Tax LO - International Labor Organization IMF - International Monetary Fund NG - National Government PNB - Philippine National Bank RRs - Reserve Requirements SEC - Securities and Exchange Commission SSS - Social Security System  FOR OFFICIAL USE ONLY PHILIEPIN CAPITAL MRKET ST=D VOLUME I EOR EXEXUTIVE SUMHARY . . . . . . . . . . . . . . . . . . . . . . . i-xviii I. INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . 1 II. MACROECONOMIC AND FINANCIAL DEVELOPMENTS . . . . . . . . . 4 A. Macroeconomic Trends . . . . . . . . . . . . . . . . 4 B. Outlook for the l99Os . . . . . . . . . . . . . . . . 17 III. PHILIPPINE FINANCIAL SYSTEM . . . . . . . . . . . . . . . . 18 A. Financial System ..18 B. Banking System .21 C. Comparative Developments in Financial Market Indicators . . . . . . . . . . . . . . . . . . . . 25 IV. CENTRAL BANK OF THE PHILIPPINES . . . . . . . . . . . . . 28 A. Role in the Financial System . . . . . . . . . . . 28 B. Financial Condition of the CBP: Past and Present . . 32 C. Prospects .... . . . . . . . . . . . . . . . . . . 35 D. Finricial Restructuring of the CBP . . . . . . . . . 40 E. Conclusions and Recommendations . . . . . . . . . . . 42 V. GOVERNMENT SECURITIES MARKET . . . . . . . . . . . . . . . 44 A. Background . . . . . . . . . . . . . . . . . . . . . 44 B. The Primary Market . . . . . . . . . . . . . . . . . 45 C. The Secondary Market . . . . . . . . . . . . . . . . 49 D. Regulatory Framework . . . . . . . . . . . . . . . . 53 E. Conclusions and Recommendations . . . . . . . . . . . 54 This report is based on the findings of a sector mission consisting of Messrs.\Mmes. Ismail Dalla (Task Manager), Deena Khatkhate, Zamir Hasan, Daniela Gressani, and Aldo Baietti from the World Bank, Jian-Hai Lin from the IMF, and five consultants (Ann-Marie Meulendyke, Eli Remoluna, Mukul Asher, Eric Chalmers and Harry Watson). Mr. lyer from the International Labor Organization also participated in the mission. 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. _ ~ ~~~~~~~~~~~~ I._ _ . ... ..  VI. CONTRACTUAL SAVINGS SECTOR . . . . . . . . . . . . . . . . 55 A. Overview . . . . . . . . . . . . . . . . . . . . . . 59 B. Social Security Arrangements . . . . . . . . . . . . 59 C. Private Pension System . . . . . . . . . . . . . . . 69 D. Insurance Industry . . . . . . . . . . . . . . . . . 75 VII. TAXATION OF FINANCIAL INSTRUMENTS AND CAPITAL MARKET DEVELOPMENT . . . . . . . . . . . . . . . . . . . 80 A. Introduction . . . . . . . . . . . . . . . . . . . . 80 B. Country Comparisons . . . . . . . . . . . . . . . . . 80 C. Effective Tax Rates on Financial Intermediaries . . . 84 Banking Sector . . . . . . . . . . . . . . . . . . 84 Insurance Sector . . . . . . . . . . . . . . . . . 86 Pension Fund Sector . . . . . . . . . . . . . . . 87 D. Effective Tax Rates on Real Investments . . . . . . . 88 Corporate Sector . . . . . . . . . . . . . . . . . 88 Individuals . . . . . . . . . . . . . . . . . . . 89 E. Conclusions and Recommendations . . . . . . . . . . . 89 MNEX-Es 1. INTERMEDIATION COST OF COMMERCIAL BANKS . . . . . . . . . . 92 2. STOCK MARKET . . . . . . . . . . . . . . . . . . . . . . . 100 3. REVISED ACCREDITATION CRITERIA FOR GOVERNMEKIT SECURITIES DEALERSHIP, AUGUST 1991 . . . . . . . . . . . 112 VOLUME II - CONTRACTURAL SAVINGS S_TOR A. AN ANALYSIS OF SELECTED ASPECTS OF SOCIAL SECURITY . . . . 1 B. THE INSURANCE INDUSTRY IN THE PHILIPPINES . . . . . . . . . 79 C. PRIVATE PENSION SYSTEM IN THE PHILIPPINES . . . . . . . . . 144  TALEI s IN EX 2.1 Key Macroeconomic and Financial Indicators, 1950-90 . . . . 4 2.2 Main Instruments of Monetary Policy, 1980-90 . . . . . . . 9 3.1 Total Assets of the Financial System, 1980-90 . . . . . . . 19 3.2 Total Assets of the Banking System, 1980-90 . . . . . . . . 21 3.3 Ranking and Selected Balance Sheet Accounts of Individual Banks as of December 31, 1990 . . . . . . . . . . 22 3.4 Commercial Banks' Summarized Consolidated Balance Sheets, 1980-90 .... . 23 3.5 Commercial Banks' Summarized Consolidated Income Statements, as of December 31, 1980, 1985 & 1990 . . . . . . . . . . 24 3.6 Financial Depth Indicators, ASEAN Countries, 1990 . . . . . 25 4.1 Central Bank Deficit, 1986-90 . . . . . . . . . . . . . . . 29 4.2 CPB: Balance Sheets, 1986-90 . . . . . . . . . . . . . . . 33 4.3 CPB: Income Statements, 1986-90 . . . . . . . . . . . . . 34 4.4 Cental Bank Balance Sheets for Selected Asian Countries, 1990 35 4.5 CPB: Major Assumptions, 1991-95 . . . . . . . . . . . . . 36 4.6 CPB's Projected Income Statements, 1991-95 . . . . . . . . 36 4.7 CPB's Projected Balance Sheets, 1991-93 . . . . . . . . . . 38 4.8 CPB: Sensitivity Analyses on Net Income Projections, 1991-95 . . . . . . . . . . . . . . . . . . . . . . . 39 4.9 CPB: Overall Deficits Under Different Scenarios, 1991-95 . 40 5.1 Public Sector Deficits, 1986-91 . . . . . . . . . . . . . . 44 5.2 Outstanding Public Internal Debt Maturity, 1986-91 . . . . 45 5.3 Treasury Bill Issuance at Weekly Auctions, 1986-90 . . . . 46 5.4 Treasury Bill Bid Rates at Weekly Auctions, 1986-91 . . . . 47 5.5 Volume of Secondary Market Transactions, 1987-91 . . . . . 50 5.5 Outstanding Government Securities by Holder, 1986-91 . . . 51 6.1 Profile of the Contractual Savings Sector, 1990 . . . . . . 55 6.2 Assets of the Contractual Savings Sector, 1980-90 . .56 6.3 Swmmary of Investment Performance of CSS, 1986-1991 . . . . 57 6.4 Key Statistics of the Social Security Institutions, 1990 61 6.5 Portfolio of the Insurance Industry, December 31, 1990 77 7.1 Tax Revenue of Central Governments in Selected Countries 81 7.2 Tax Revenue, 1988-90 .... . . . . .... . 82 7.3 Real After-Tax Return on Selected Assets, 1985-90 . . . . . 83 7,4 Effective Tax Rates on Intermediation . . . . . . . . . . . 86 TABLES IN AEXL1 Table 1 Financial Intermediation Costs in Selected Countries, 1987-90 94 Table 2 Effects of Reserve, Liquidity, and Other Requirements on Financial Intermediation Costs in Selected Countries . 95 Table 3 Estimations of Costs to Banks of Reserve Requirements, end December 1990 .... . . . . . . . . . . . . . . . 96 TABLES IN ANNEX 2 Table 1 Market Capitalization, Dec=mber 1990 . . . . . . . . . . . 101 Table 2 Primary Offers of Equity Securities . . . . . . . . . . . . 105 Table 3 Source of Capital for Philippine Firms, 1981-89 . . . . . . 105 Table 4 Number of Listed Companies, 1980-90 . . . . . . . . . . . . 107 Table 5 Comparative Size. and Activity, 1985-91 . . . . . . . . . . 108 Table 6 Comparative Performance, 1985-91 . . . . . . . . . . . . . 109 Table 7 Foreign Portfolio Investment, 1986-90 . . . . . . . . . . . 110  2.1 Investment and Savings, 1950-90 . ... . . . . . . . 5 2.2 Selected ;.nterest Rates, 1980-90 ........ . . . 10 2.3 Portfolio Substitution - H3 and Government Securities, 1957-90 ....................... ....... . . . . 10 2.4 Inflation and Depreciation Rates, 1950-90 ... . .... . 12 2.5 Treasury Bills Rate and 'nflation Rate, 1980-90 . . . . . . 15 2.6 Treasury Bills Rate and Depreciation Rate, 1980-90 ... . 15 2.7 Treasury Bills Rate - Philippines and USA, 1980-90 ... . 16 3.1 Ratio of Domestic Liquidity to GDP, 1970-90 ... . . . . . 26 3.2 Ratio of Domestic Credit to Private Sector to GDP, 1970-90 27  CAPITA MALKET STUDY 1. In 1987, the Bank carried out a Financial Sector Study (FSS) which presented a comprehensive review of the Philippine financial system, with a special focus on the commercial banking system. Given the pLiority accorded the banking system at that time, and owing to the complex nature of capital market issues, the FSS proposed that a further study of the capital market be undertaken to identify constraints and recommend policy measures to promote the development of a robust capital market. The FSS also recommended investigating the role played by non-bank financial institutions, especially contractual savings institutions such as social security organizations, pension funds and insurance companies. Consequently, this study was carried out in June 1991 at the request of the Department of Finance (DOF) and the Central Bank of the Philippines (CBP). 2. The study first provides an overview of developments in the Philippine economy and financial markets during the 1980s. It then focuses on the primary problem confronting the Philippine financial system--the troubled financial condition of the CBP. It is recognized that CB? lossEe. the mek4ness of independent monetary Rolicy mlnagement. a high-financial intermediation cost. and the slow develogment of--the Money and cLtal markts are 1al clasely- ik-ed. The CBP's losses and their impact on the conduct of monetary policy, exchange rate policy and capital market development are discussed. Some proposals for a financial restructuring of the CBP are offered. This is followed by discussions covering the major components of the capital market: (i) the government securities market; and (ii) the contractual savings sector (the social security system, the insurance industry and pension funds). Directly related policy issues are also analyzed, namely: (a) the intermediation cost to the banking system (Annex 1); and (b) taxation on financial instruments. Since the Asian Development Bank (ADB) has taken the leading role on the subject of the stock market, it is not duplicated here. However, Annex 2 provides background information on the stock market in an effort to round out our discussion of capical markets in the Philippines. 3. Capital market development in the Philippines has been profoundly influenced by the macroeconomic and political events of the 1980s. Balance of payment difficulties and overvalued exchange rates led to a decline in the holding of financial assets when measured by a ratio of M3/GDP. In 1990, the M3/GDP ratio for the Philippines was 34.4 percent, compared with 68.2 percent for Malaysia and 74.6 percent for Thailand. Other indicators of capital market development further confirm that the Philippines substantially lags behind its neighbors. In 1990, the ratio of stock market capitalization to GDP for the Philippines of 15.1 percent was one half of the figure for Thailand and one seventh for Malaysia. In the same year, the ratio of credit  - ii to private sector by banking sector to GDP in the Philippines was only 19.4 percent, zs against 67.9 percent for Malaysia and 68.7 percent for Thn'land. 4. At the end of 1990, the total assets of the Philippine financial system amounted to P 1,332.9 billion (US$54.4 billion), divided among the CBP (33.4 percent), banking system (46.4 percent), non-bank financial inter- mediaries, mainly the social security organizations and insurance companies (14.4 percent), aind trust operations managed by the banking system (5.8 percent). In addition, private pension funds had about P 20.0 billion under management. During the past decade, the CBP's proportion of the total "assets" of the financial system increased from 20.9 percent in 1980 to 33.4 percent in 1990, due mainly to the increase of the CBP's losses. (The CBP's Charter does not provide for losses, so therefore its losses are recorded as assets under accounts such as monetary adjustm3nt, exchange revaluation and exchange adjustment). As of December 31, 1990, the CBP's cumulative realized and unrealized losses amounted to P 280 billion, due to the assumption of quasi-fiscal activities (Chapter IV). 5. Several policy measures (i.e., interest rate deregulation, universal banking and new capital requirements) were implemented during the 1980s to deepen and liberalize the financial system. These measures contributed to institutional improvements in the financial system, especially for the private banking system. However, the counter-cyclical fiscal policy implemented subsequent to the 1979 oil crisis was accompanied by liberal lending by the two largest government-owned banks, the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP). Their liberal lending practices (largely influenced by the political condition in the country), precipitated a major financial crisis in 1983. The value added by the financial sector declined by 25 percent during 1L983-85, mainly due to write-offs. Domestic liquidity (M3) declined by almost 7 pertentage points of GDP, and credit to the private sector plunged to less than 14 percent of GDP in 1986 from a peak of 33 percent in 1983. 6. Frompthe__sgtandp_oint of financial-systemg developMent, thfg two mos iMgortant results of the-finaincifil-crisis of 1983 ca be identifie!d as the shift In public deficit financing from external liab_ilities to domestic liabilities adtesharp deterioratilon in the finlancial condition of-the CBP. The drying up of external financing, a high public sector deficit, and the unwillingness of the CBP to monetize these deficits required large sterilization operations to contain inflation. As a result, Treasury bill issues by the NG increased substantially. The CBP also issued large amounts of its own securities during 1984-86. The CBP later suspended new issues of these bills and carried out the bulk of sterilization operations by means of Treasury bill issues and NG deposits. 7. The increase in domestic public debt led to an increase in both the level and the volatility of domestic real interest rates, and to a shift in private sector portfolios away from deposits and into government securities. During 1985-89, public debt outstanding increased from 19 to 25 percent of GDP, and the real interest rate on Treasury bills increased from 3 to 12 percent. 8. The exchange rate management in the Philippines can be described as "managed float". Each maj or devaluation took place only after an external  iii - payments crisis had occurred, A depreciation of the exchange rate causes a proportional increase in peso-denominated interest payments on external .eibt and an almost proportional worsening of the net interest income position of the CBP. Since the CBP has large net foreign exchange liabilitiesl/, it has been very reluctant, to depreciate the exchange rate. This has led to increased interest rate volatility and a loss of competitiveness in the real sector (especially the manufacturing sector) vis-a-vis the nation's maln trade competitors. mes Ga ank of the PhiliCginea 9. IhQ CBis in fit.ancial distnsg. During the period 1986-90, the CBP incurred losses at the average rate of P 18 billion p.a. (excluding maleties and overheada which were approximately P 1 billion p.a.). the losses frm for,En liabilities of the CDP were largest (at e 75.6 billi2n) dUring this MaIj a ll MaJor devaluations during these years were responsible for most of these losses. Losses further resulted from swap and forward cover arrangements, outstanding blocked peso accountsaZ/, open market operatif.ns, and from the realized and unrealized losses in international reserves due to exchange rate depreciations. Open market operations by themselves accounted for losses on the order of P 14.6 billion. Another nractice contributing to CBP losses was the granting of emergency loans to failed or failing financial institutions which later became insolvent. Sources of the CBP's income (except for seignoyage, i.e., normal growth in the money supply) have been limited. Thus far, the CBP has financed its realized losses through: (i) seignorage; (ii) interest free deposits from the NG; (iii) roll-over of swap agreements; and (iv) resched.uling of foreign commercial bank loans. 10. The CBP has basically three instruments of monetary policy at its disposal--loans and advances and tha discount rate, reserve requirements (RRs), and open market operations. Discount window horrowing is initiated by commercial banks and is therefore under their direct control, though the CBP sets the rate and the terms of access to the discount window. However, the discount window as a monetary policy instrument is of minor importance in the Philippines and had been used mainly for directing credit to priority sectors at subsidized rates. This leaves the CBP with only two other instruments-- open market operations and RRs--with which to regulate monetary aggregates with an eye towards containing the inflationary pressures on the economy. inge theb CBP does.not have a sizgable portfolio ofngovetnment seCurities, it, has not been able to _onduct o_en market oDe effectively. Thus, the CBP is left with RRs as its only effective monetary instrument. J/ Unlike most central banks, the CBP contracted (voluntarily and involuntarily) a large amount of foreign exchange liabilities during 1980s. LI These are losses incurred in connection with swap transactions with banks operating in the Philippines. Instead of settling the losses at the end of each contract, the CBP agrees to pay the banks the amount due and an interest rate equivalent to the 90-day Manila Reference Rate plus a spread of 1/8 percent. However, these funds are blocked in an account until the CBP is in a position to pay.  - iv - 11. However, RRs in thie Philippines are very large (25 percent on deposits), and the returns are substantially below market rate (4 percent compared with the current market rate of about en percent). Consequently, RRs constitute a burden to the banking sector by substantially raising the cost of financial Intermediation. TIe tgtal nte=ediation goat ludio prgfit marginl in the PhiLitmines gf abgout Z-