Philippines - An opening for sustained growth (Vol. 1 of 3) : Overview and part I : growth with stabilization and structural reforms

Report No. 11061-PH The Philippines An Opening for Sustained Growth (In Three Voltumes) Volume 1: Overview and Part 1: Growth with Stabilization and Structural Reforms April1, 1993 Country Oferations Division Country Department I East Asia and Pacific Region FOR OFFICIAL USE ONLY Document of the Worl Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. PHILIPPINES FOR OFFICIAL USE ONLI BASIC ECONOMIC REPORT THE PHILIPPINES: AN OPENING FOR SUSTAINED GROWTH Table of Contents Volume I Executive Summary, Overview, and Recommendations EXECUTIVE SUMMARY ....................................... . I. DEVELOPMENT ISSUES AND PROSPECTS: OVERVIEW, ASSESSMENT, AND RECOMMENDATIONS ....................................... I A. Overview and Assessment of Development Issues and Policies ............... 2 B. Development Strategy ....................................... 21 II. INTRODUCTION: STRUCTURAL CONNECTIONS IN ECONOMIC POLICY REFORMS ................................................. 29 PART I Growth with Stabiliztion and Structural Reforms: Macroeconomic Performance and Prospects III. GROWTH AND CONSTRAINTS TO GROWTH: FORFIGN EXCHANGE AVAILABILITY AND PUBLIC SECTOR FINANCES ................... 33 A. Growth under Foreign Exchange Constraints ......................... .34 B. Growth under Public Finance Constraints ........................... . 47 C. The Pursuit of Structural Adjustment ........ .................... ...51 IV. GROWTH AND FISCAL ADJUSTMENT ............................ 58 A. Fiscal Adjustment and Debt Stabilization, 1986-91 ..................... 59 B. Composition of Fiscal Adjustment ............................... 69 C. Fiscal Adjustment in a Growth-oriented Strategy ...................... 80 V. PROSPECTS FOR GROWTH: FISCAL POLICY, STRUCTURAL REFORMS, AND MACROECONOMIC PERFORMANCE ......................... 82 A. Quantifying Fiscal and Monetary Policy Tradeoffs .................... 83 B. Growth with Adjustment .................................... 91 This document has a restricted distribution and may be used by recipients only in the performance of their offcial duties. Its contents may not otherwise be disclosed without World Bank authorization. Pat VI. ACHIEVING POLICY OBJECTIVES: ISSUES IN THE DESIGN AND IMPLEMENTATION OF POLICY ........ 101 A. The Roles of the Executive and Legislative Branches .................. 1)2 B. Monetary Policy ......................................... 104 C. Fiscal Policy ........................................... 108 D. Conclusions ............................................ 120 LIST OF TABLES. FIGURES. AND BOXES CHAPTER II FIGURES 2.1 Linkages Among the Philippines' Economic Structures ..................... 30 CHAPTER.1I FIGURES 3.1 Foreign Currency Constraint on Growth .............................. 36 3.2 Primary Commodity Prices and GDP Growth........................... 36 3.3 Traditional Exports and Merchandise Imports ........................... 38 3.4 Traditional and Non-traditional Exports .............................. 38 3.5 Trade and Current Account ...................................... 41 3.6 Ratio of Total ExternalDebt to GDP ................................ 41 3.7 Gross Domestic Investment ...................................... 44 3.8 Gross Domestic Savings and Investment .............................. 44 CH APTER11V TABLES 4.1 Foreign Debt ............................................... 61 4.2 Domestic Public Debt ......................................... 61 4.3 Public Sector Deficit .......................................... 70 4.4 National Government.......................................... 71 4.5 DirectandlndirectTaxes ....................................... 75 4.6 Buoyancy and Elasticity of Major Taxes .............................. 75 4.7 Government Tax Revenues ...................................... 76 4.8 Monitored Government Nonfhmancial Corporations ........................ 78 4.9 Central Bank ............................................... 79 FIGURES 4.1 Public Debt ........................................ ...... 60 4.2 Ratio of Public Debt to GDP (1990) ................................ 60 4.3 TreasuryBillPate............................................ 63 4.4 Ex-Post Premium on Domestic Securities ............................. .63 4.5 National Government Balance .................................... 73 4.6 Capital Expenditures of the National Government ........................ 73 4.7 Inflexibility of National Government Expenditures ........................ 74 BQXES 4.1 Budgetary Effects of Exchange Rate Depreciations ........................ 64 4.2 External Debt Management ....................................... 68 CHAPTER V TABLES 5.1 Fiscal Expansion Financed by Domestic Debt Accumulation .................. 85 5.2 "Balanced" Increase in Growth-oriented Expenditures ...................... 87 5.3 "Aggressive" Exchange Rate Management ............................. 89 5.4 Macroeconomic Outcomes .......................................95 5.5 Financing Growth ............................................ 96 5.6 Financing Requirements, 1992-97 .................................. 97 5.7 Summary Balance of Payments Statistics, 1992-97 ........................ 99 CHAPTER VI TABLES 6.1 Public Sector Costs and Priority Actions in the Philippines ................. 109 6.2 Lumpy Infrastructure Investment Projects ............................ 110 IBRD MAP No. 24105R * Volumes II and III bound separately. Volume II: The Real Economy and The Correlates and Determinants of Poverty Volume I: Statistical Appendix This report was prepared by Mr. H. Kharas (Mission Leader), Ms. D. Gressani (Macro), Mr. R. Faini (Consultant, Macro), Mr. J. Balkind (Budget Implementation), Ms. E. Jorgensen (Real . Economy), Mr. T. Wiens (Agriculture), Mr. S. Shah (Industrial Structure), Mr. A. Mody (Export Competitiveness), Mr. D. Lindaner (Consultant, Labor Markets), Mr. S. Hossain (Education and Health), Mr. J. Behrman (Conrltant, Poverty), Mr. L. Hakim (Poverty), Mr. S. Devarajan * (Tax/Expenditure Incidence), Ms. R. Hall (Statistics), Mrs. H. Abbey (Formatting and Typing). EXECUTIVE SUMMAY Staanation in the 1980s 1. More than a decade after the Philippines initiated its structural adjustment program, sustained development remains elusive. Real per capita income in 1992 was 7.2 percent below its 1980 level. Changes in other indicators of development have been equally disappointing: savings and investment as a percent of GDP have been on average one-quarter lower than their 1980 average; export growth has been half that in the 1965-80 period; external and internal public debt combined have doubled as a share of GDP; inflation has been higher by around five percentage points per year; and the absolute numbers of the poor continue to rise. This performance stands in sharp contrast to that of neighboring East Asian countries where economic "miracles" have spread from the original four "tigers" to Malaysia, Thailand, and Indonesia. And other East Asian countries have been able to attract sizeable levels of foreign resources from private investors and creditors, while the Philippines has continued to rely on exceptional financing from official creditors over this period. Yet, although stagnation appears to be deeply rooted in the Philippines when viewed in this fashion from the perspective of over a decade, the potential for rapid development has also been displayed: strong growth during 1986-89 averaged over 6 percent; manufactured exports have regained their world market share and more recently, along with improved macroeconomic balances, there are signs of improved microeconomic fundamentals which augur well for future growth-high corporate profitabiliry and reduced leverage, greater dynamism by small and medium enterprises, a tighter labor market, and some improvement in poverty incidence. 2. The pattern of development in the 1980s, with episodes of rapid growth followed by periodic crises and periods of consoliastion, is characteristic of the country's economic history since independence. In an effort to break out of such cycles, the Philippines launched a program of structural adjustment early in the 1980s, and since then has pursued reforms across a broad range of areas. But the response to these openings has not yet been as fruitful as in other reforming high-debt countries and it is the disappointment with the results of structural reforms (which have been the cornerstone of the growth strategy since 1980), that causes concern that the performance gap between the Philippines and its neighbors may continue to exist for some time. 3. This concern may be misplaced. The failure to sustain high growth in the 1980s can be attributed to a number of factors discussed below including: (i). policy slippage, especially in macroeconomic management, which was complicated by the high foreign debt of the country and by the need to manage an unprecedented series of natural disasters and external shocks; (ii) a slow private sector response to a reformed incentive structure, partly associated with prolonged domestic political turmoil; and (iii) a sizeable poverty problem which has encouraged a short-term horizon in public revenue and expenditure decision-making. Lessons learned from this experience could avert prolonged crises in the future. Two essential ingredients, which have been stressed in other East Asian countries but which have been lacking in the Philippines are consistency of policy implementation and a sense of national purpose. Financial, managerial and technical weaknesses in several key public institutions, along with resistance to some policy changes, have stood in the way of transisting the Government's policy agenda into results. Sustained growth at even the moderate rates indicated in this report of 5-6 percent depends on an improvement in governance-both with regard to the delineation of governmental roles and the effective functioning of institutions on a broad front. T1erPcd! Agenda for the 1990s 4. The diagnosis of the pitfalls of the 1980s points to the key policy agenda for the 1990s. First, the emerging track record of decisive macroeconomic management must be reinforced. Second, incentive reforms need to be sustained and deepened into new areas. At the same time, other measures to strengthen the private investment response to reforms are required. Improvement in law and order is one such measure. Another is provision of infrastructure services. This requires a renewed focus by the government on strengthening public infrastructure agencies to ensure that public spending is carried out efficiently, to mobilize public resources to increase the level of infrastructure spending, and to develop the regulatory environment for private involvement in infrastructure. Third, more emphasis needs to be placed on the sustainability of development, particularly with respec: to envirommental and social consequences. MaCrQ_ c__Mi-_ _ a__ axEsent ? 5. Macroeconomic policy has evolved significantly over the course of the 1980s. In the aftermath of the debt crisis of 1983, the key concern was to restore the viability of the balance of payments: tight monetary policy, along with exceptional financing from official creditors and debt reschedulings formed the core of the strategy. More recently, fiscal adjustment has been the key to a stable macroeconomic framework. However, fiscal deficit reduction compatible with growth has proven difficult to sustain. Measures taken to reduce the deficit have also draged down growth: ad hoc taxes, such as the temporary import levy, the gross receipts tax on financial intermediation and various stamp taxes and fees, were imposed; public infrastructure and maintenance expenditures were slashed; public wage restraint, which temporarily improved public finances in the mid-1980s, had to be abandoned later in the decade when the public-private wage differential widened to unsustainable levels; and the exchange rate was allowed to appreciate in real terms to reduce the cost of servicing external debt. As a result, fiscal and monetary policy have swung between contractionary and expansionary modes to mect either stabilization or growth objectives. 6. Macro-management was complicated by the presence of high external debt. Debt service peaked at 44 percent of exports of goods and services in 1982, and since then has been reduced through a combination of reschedulings and debt and debt service reduction operations with official and commercial creditors. The debt burden prevented the consolidated public sector deficit from being reduced more rapidly and high external debt service obligations have been responsible for large recurrent deficits of the Central Bank. The susceptibility of Central Bank net income and balance sheet to exchange rate movements reduced the effectiveness of monetary management. These pressures were especially important when external shocks and natural disasters required timely macroeconomic policy adjustments. Delayed responses, for example to the rise in oil prices and fall in worker remittances following the Gulf crisis in 1990, and policy slippage were costly in the short run to the stabilization effort and had further long run consequences of lowering the credibility of the Government to maintain a sound macroeconomic environment. As in other countries, macroeconomic management was also complicated by political pressures (including a series of coup attempts) and by the fragmentation of both policy making and implementation, in the prer nce of active roles played by the legislature and the judiciary. 7. Structural adjustment has slowly changed the parameters of the macroeconomic equations, allowing the authorities more room to maneuver. Tax buoyancies and elasticities have been raised; significant external debt reduction achived; subsidies reduced to low levels, especially to government corporations; important public assets and corporations have been privatized; greater control established * Stt - over public expenditures; and the exchangt rate mechanism has been largely freed from direct controls and interventions. Despite the fact that more could have been done, these accomplishments are significant. They are already reflected in the far sounder economic base inherited by the Ramos administration compared with that available to its predecessor. Foreign exchange reserves are at comfortable levels, single-digit inflation exists, and the external debt of commercial banks has been restructured on terms favorable to the Philippines. In addition, the stock-market boom and the return of * substantial amounts of capital that had fled the country earlier suggest that investors are increasingly confident after the successful political transition from President Aquino to President Ramos. One conclusion of the report is that major macroeconomic impediments to sustained medium-term growth need * not arise (financial prudence can be maintained and public revenue increased. 8. Four key issues shape the remaining macroeconomic policy agenda. * Although the fiscal deficit is currently at a sustainable level, the composition of public finances is cause for concern. To spur growth, the nation must increase public investment and maintenance (especially of the road network) and allow the real exchange rate to depreciate, both of which will make the measured deficit rise. Yet the deficit must not rise too far, given its implications for public-sector debt and fature budget stability. Thus, one of the paramount renmmendations in the report is that public revenue be increased. Focusing on the evolution of debt, both domestic and external, relative to GDP, rather than on the deficit, is appropriate for medium-term budgetary planning, to avoid growth-reducing actions under the guise of budgetary control. The growing crisis with public infrastructure cannot be resolved simply by expanding the deficit, even when foreign creditors are willing to provide a high percentage of total project costs. Deficit exparion would crwwd out private investment by fueling aggregate demand and inflation, appreciating the real exchange rate, and, correspondingly, increasing real domestic interest rates. However, given the breathing room afforded by better-than-targeted public deficits in 1992, some increa: in the deficit can be tolerated in the short term to accommodate the backlog of public investment needs, especially in power. To ensure sustainability, the government must accompany the deficit increase with a concerted revenue effort, encompassing improved tax collection efficiency, new taxes, user fees, and other public revenues, such as social security contributions. Interest and personnel expenses as a percentage of total goveiment expenditures have soared, and the budget has become increasingly inflexible. The government has also been forced to become the financier of public corporations, in the form of equity, subsidies and loans, and of the central bank, in the form of deposits.' The amount of real fixed-capital formation that is allocated through the budgetary process and which is thus subject to social priorities has been reduced correspondingly. Painful but sustainable fiscal adjustment measures-reducing the number of public employees and improving the productivity of publicly provided services, both within the administration and in public enterprises-have yet to be undertaken. The cost of maintaining the numbers on the public payroll has thus been jobs lost in reduced public investment projects, often in poorer, rural provinces. Because the burden of stabilization has fallen disproportionately on monetary policy, inflation, interest-rate, exchange-rate and foreign-reserve targets cannot be met simultaneously. At the same time, the practical conduct of monetary policy has been - iv * compromised by the persistent deficit of the central bank and the complex interaction between the central bank and the national Treasury. Restoring the independence of the central bank is a priority. The Real Egonomy and Business Competitivenes 9. By the end of the 1970s, significant defects in the growth process were apparent. The public corporate sector was expanding into high risk, capital intensive projects. Foreign capital was being intermediated into private investments through public financial intermediaries without adequate supervision or assessment of project risk. And industrial sector growth was increasingly riding on construction in the nontraded goods sector, rather than on further manufacturing growth. The identified problem was to raise the efficiency of investment through an adjustment of incentives, covering agriculture, industry, trade, the financial sector and energy pricing. 10. In spite of several ups and downs, the Philippines has progressed significantly in implementing this adjustment program. Reforms in agricultural pricing and marketing, the financial sector, privatization, trade and tariff liberalization, direct and indirect taxes, and investment incentives have been undertaken, along with procedures to set priorities for public investments. Sugar and coconut monopolies have ben disbanded, interest and exchange rates are now determined by market forces, the bias towards capital intensity in investment incentives has been effectively removed, the Board of Investments has streamlined procedures and taken on a more promotional role, a value added tax and improved income tax measures have reduced tax distortions, and trade reform has been pursued. Taken together, these measures have substantially opened the economy to competition and corrected major policy-induced internal distortions. If plans for extending these reforms into maining areas-transport, energy, capital markets and wage setting-are realized and a track record of implementation follow- through is effectively develcped, the incentive system in place can support rapid medium term growth. 11. To date, structural reforms have elicited only a slow respoy n from the private sector, despite the fact that the reforms have been comparable in scope and speed to those undertaken in successful adjustment countries such as Mexico and Indonesia. Although it is true that initial expectations of speedy reforms in the Philippines have not been realized, the accumulated impact over time has been significant. The slow supply response has stemmed in part from initial conditions that were worse than in other countries, because of deep-rooted oligopoly and structural poverty, and low private savings and investment rates. 12. A key impediment to the supply response has been the resiliently dualistic nature of the economy. Even during the period of rapid economic growth in the 1970s, key measures of dualism showed little improvement. In the rapidly growing East Asian countries, the share of labor engaged in wage-paying occupations increased substantially; in the Philippines, the main transformation was from unpaid family and own-account workers in agriculture to the informal services sector. The rural-urban mean income diffeteial has remained constant at around 0.47 for thirty years, well below any cost-of living differences between rural and urban areas. The wage in manufacturing relative to GDP per capita (a proxy for opportunities elsewhere in the economy) has reached a level of around 3, the same as at the start of the 1970s; for other rapidly growing developing countries, this ratio is closer to 1.S. Industrial unskilled labor still commands a wage premium over 4ricultural unskilled labor of around 100 percent. Migration, both internal and external, remains high. *V*. 13. Recently however, there are encouraging signs that reform of incentives is starting to changt old economic structures and behavior at a microeconomic level. Exporters are rebuilding market share through lowering unit values relative to their regional competitors. Since 1985. the trend toward ever larger establishments has reversed and small and medium firms have expanded their share of value added, employment and exports. Total profitability of industrial firms has returned to levels well above those of the early 1980s and balance sheets have been rebuift with lower debt and more equity. 14. Overall, the report concludes that the Philippines has made significant progress toward neutrality in industrial, trade and investment policies. While policy neutrality is widely regarded as a necessary condition for competitive success, East Asia in particular has emphasized other, more activist measures of export and foreign investment promotion, and marketing, technological and infrastructural partnerships between the public and private sectors. The report stresses the elements below as key components of this strategy: " Deficiencies in infrastructure are the most serious current bottleneck to rural and industrial growth; policies, institutions and investments are all weak. Although the government has just recently announced reforms in energy pricing and sectoral policies, implementation problems continue to delay rtsolution of the short-term crisis in power and threaten medium term growth as well. The dimensions of the energy problem are enormous; physical needs of about 700 megawatts a year, costing almost $2 billion per year (including private sector contributions) for generation, transmission and distribution. Implementation of such plans requires strengthening of the technical, managerial and financial capacities of key public power agencies, as well as streamlining of procedures for encouraging private participation. " Apart from the recent power shortage, infrastructure problems remain the most serious obstacle for rural development, although they have not yet reached crisis proportions for industry. Charges for most services approximate international norms, but access and reliability are more pressing issues. The private sector has responded by providing services itself (from energy to services that speed transit through ports) at a relatively-modest cost premium. Private industrial parks, coordinated with officially designated growth poles, also help achieve economies of scale in the provision of infrastructure. However, industry has been living off previous investment. The failure to add substantively to infrastructural capital over the past six years and the deterioration caused by inadequate maintenance threaten to produce a crisis in the medium term, especially in water, roads and ports. In each of these sectors, responsibilities for owning, operating, regulating and financing the infrastructure are vested in a single public sector institution, creating a web of inefficient cross-subsidies that mitigate against cost-effective and high-quality services. This crisis can be overcome by building up the financial and implementation capacities of public agencies and developing clear regulatory structures to facilitate the participation of the private sector in providing the infrastructure. " A amaor outstanding issue is the extensive oligopolistic structure of industry and agribasiness; in over half of manufacturing subsectors, the top four firms account for more than 70 percent of total sales, a level that is high relative to the level in other industrialized and Jeveloping countries. Unlike other East Asian countries, in which the size of firms is positively related to efficiency, large firms in the Philippines have developed in order to take advantage of fiscal incentives and other publicly provided protection, rather than in response to market conditions. With domestic industrial concentration and protection from - vi - abroad, competitive pressures have been weak and productivity growth ow. Although this oligopolistic structure appears to be breaking down slowly with the removal of trade and industrial policies biased toward large firms, the process could be accelerated by enforcing anti-monopoly regulations more strictly and by implementing policy reforms to avoid special incentives for large and small firms. These measures would help medium-scale firms introduce greater competitiveness into domestic markets and reverse the low productivity growth of the past. Other countries in Asia have launched manufactured export growth by targeting real exchange rates. The lack of such a policy in the Philippines is only one, perhaps a small, reason for its poor export performance. Overall, unit l-hor costs in the Philippines are low relative to those of its regional competitors, since, until recently, the real wage has declined despite the real appreciation of the currency. However, the unit labor-cost advantage enjoyed by the Philippines comes from the relative cheapness of skilled labor, such as foremen, accountants and clerks, thus offsetting expensive unskilled labor. The real problem appears to be a political use of minimum-wage legislation, which has driven up the wage floor and compressed wage differentials in the formal sector. The minimum wage does not protect workers; the wages of fewer than one third of all wage earners in industry are at or exceed the minimum. Minimum-wage coverage is limited to the formal private sector and the public sector, and its effective indexation to the nominal exchange rate limits the growth of these sectors just at a time when conditions are propitious for both to expand investment. If this issue is not resolved, efforts to use a nominal exchange-rate adjustment to improve competitiveness will be fruiless. The only result will be a burst of inflation, as in 1990-91. The manufacturing subsectors whose export performance has been the poorest are those in which international competitiveness is decided not just by price but also by quality. The Philippines has yet made little progress at improving quality, and the export promotion effort should focus on this process. Several policies could be implemented to improve quality: fostering an export culture; promoting foreign investment; acquiring technology; setting and enforcing standards by industry groups and government agencies; facilitating the flow of information on domestic and international market conditions and least-cost production techniques; encouraging specialization; providing direct and indirect exporters with access to duty-free intermediate inputs; and pursuing technology diffusion through subcontracting activities. PErty Alleviation and Su&Inable DeveLopmen 15. While poverty remains an ovetarching issue in the Philippines, poverty incidence appears to have been steadily, if undramatically, reduced since 1971. This pattern is borne out by income, education, health -and nutrition indicators, although there is some concern that the declining trend may have flattened out in the mid-1980s as a consequence of overall economic stagnation. In addition, the poorest of the poor have registered the strongest gains; the distribution of income of those below the official poverty line seems to have improved. The high reported rate of poverty in the Philippines (60 percent of individuals below the poverty line in 1988) partly reflects continuous adjustments in the official poverty line, making comparisons over time and comparisons with other countries unreliable. Compared to the official figure, a more realistic internationally comparable estimate of poverty in the Philippines is 35 percent of individuals in 1988. - vii - 16. Having reached an effective land frontier in the mid-1970s, poverty in the Philippines has had new consequences. In rural areas, poverty has created environmental problems, with encroachment into marginal lands, overfishing in coastal waters, and the logging of old growth forests. In urban areas, a large number of urban poor have emerged, earning their way in low-skill, part-time service occupations. These groups often face specific health hazards from the deteriorating urban environment. However, absolute poverty is still largely a rural phenomenon, due in part to the growth in transfers from abroad that largely benefit the urban population. It is still the case that 80 percent of those who fall below the official subsistence line are located in rural areas. 17. In general, the poor have been protected against the weak economic performance of the 1980s, and public sector efforts to reduce poverty have continued, albeit at a slow rate. This represents a significant accomplishment. Amounts spent on social services, particularly educat, a and health, have been protected from the budget cuts imposed on other sectors. But certain priority programs, such as women's health, family planning and nutritional supplements have not been adequately funded and malnutrition remains a serious problem. Because the poor rely heavily on the production of tradable agricultural commodities, and, in urban areas, on rendttances from abroad, they have benefitted from many of the structural adjustment measures to open the economy, such as reduced agricultural taxation, trade liberalization and foreign exchange reforms, all of which have contributed to a more market- determined exchange rate. 18. The structure of public expenditure appears to L e quite progressive and, given the neuial incidence of the tax system, public tax/expenditure policy has, in net terms, had an important redistributive effect. This could be made even stronger by a greater emphasis on income tax collection. By itself, however, this is unlikely to yield sufficient revenues to finv ce both the infrastructure and human resource development expenditures that are required for an effective anti-poverty strategy. Unfortunately, the negavve effects of tax incidence on the poor have been overemphasized, without adequate discussion of how expenditures could benefit the poor. Thus, the tax effort has been weakened in the guise of protecting the poor. This is however too short-term and narrow a perspective. Without being able to earn positive returns on financial sarings (due partly to the taxation of financial intermediation), to earn high returns on human capital (due to the shortage of job creation), and to have access to land (due to financial constraints and legal delays in implementing the Comprehensive Agrarian Reform Program), most people in the Philippines have faced an uphill battle against poverty. 19. The agenda for the anti-poverty programs must emphasize selected interventions where the case for a public role is clearly established, focus on key at-risk groups, and mobilization of greater resources from all sources. The report recommends attention be paid to the following: The official measure of poverty is too broad to be used effectively as a measure of poverty or as a guide for policy; the methodology needs refinement to become operationally relevant. The poor must be distinguished more effectively so that programs can be better targeted to their needs. Given budgetary shortages, targeting is necessary to support cost- effective government programs. The report suggests that, at minimum, four groLps must be identified: those who are truly indigent, for whom subsidies may be appropriate; those who benefit directly from faster growth, for whom increased access to land, capital and education may be more valuable that income support; those at risk of deteriorating income due to the exploitation of natural resources or to natural calamity; and those at risk from environmental pollution, infectious diseases and other causes. -viii * The Philippines' record with human-capital accumulation continues to be good and provides the basis for projecting a broad-based distribution of the gains from growth, especially if formal wage-paying jobs are created during a recovery. Th. evidence suggests that the poor have gained from aggregate economic growth, and that the growth strategy outlined in the report would support a substantial reduction in poverty given existing conditions. Reforms in the institutional process of wage determination and closer links between labor-market needs and the educational system would tighten the relationship between poverty reduction and aggregate growth. * The welfare of the poor depends critically on transfers-in cash form through extensive private-sector networks that have evolved as insurance against certain types of problems (unemployment, retirement, the absence of the husband, and school-age-child expenses), and in kind from the public-sector in the form of education, health, and other services. For the poorest quintile, these transfers allow actual consumption to be more than double earned income. Thus, the focus of public interventions on raising earned income addresses only one component of the overall welfare of the poor. More effective targeting of public benefits, and efforts to identify the most vulnerable groups (including those who do not have access to extensive private networks), can add to the efficacy of the anti-poverty strategy. * Tit cadence of taxes across deciles is broadly neutral, but they should and could be made more progressive by improving the efficiency with which personal income and business taxes are collected-poor .ax administration now robs the government of almost three- quarters of income taxes oue from the top decile. Indirect taxes, too, are effectively neutral. The structure of expenditures, especially in education, health and infrastructure, is well designed from an equity viewpoint. Thus, the priority for both growth and equity must be to increase public spending in infrastructure and health. As long as local government expenditures share the same distributive goals as government expenditures, higher tax collection, coupled with higher public spending, would benefit the poor tremendously. However, local governments have few incentives to target their expenditures at the poor. Based on international experience, the Philippines must exercise great care in devolving spending responsibilities to local governments, in order to keep the social safety net and other public anti-poverty programs intact. * The initial effect of land reform has been to change tenancy arrangements for rice and corn lands and to give illegal squatters on public alienable lands the rights to continue their cultivation. Thus, in contrast to other countries, Philippine land reform has not been a major instrument for distributing land to landless laborers and those without prior access. This could change in the next phase of land reform, although the report notes two issues which are likely to reduce the redistributive consequences of the CARP. First, budgetary problems may slow down the speed of implementation, especially if the accompanying infrastructure and support services to beneficiary farmers are to be expanded at the same time. Second, land reform has historically generated gains for beneficiaries through an increase in land prices subsequent to the adoption of new technologies. At present, the scope for such technology improvements appears dim. Thus, there is no assurance or prospect that fair-value land transactions will yield high returns to the purchaser. * Efforts to promote rural development will be key in ensurik the sustain- iity of growth. Problems of natural resource degradation have been rooted in high population growth, -ix - which has forced more cultivation of upland areas, contributing to deforestation, soil erosion and reduced productivity in lowland areas as natural watersheds are changed. Effective policies, such as the creation of the Integrated Protected Areas System. have been introduced to mitigate these consequences and promote sustainable development. Valuable lessons have also been learned, through pilot projects, about how community responsibility for commonly accessible natural resources can be developed. Development of new programs, such as for family planning, implementation of existing policies for environmental protection, and proper charges for pollution and natural resource use (for example, through higher energy taxes, mining royalties and mangrove and pasture leases) are major components of development sustainability. StMngthening Policy Implementation 20. The policy agenda outlined above shoula nable the Philippines to achieve macroeconomic stability, open trade, integrated domestic and international markets, and rapid poverty reduction, by following the same strategies implemented successfully by other countries in the region. Such a strategy calls for active policies to promote private industry, export activities and foreign investment, the deregulation of the industrial and agribusiness sectors, federal partnerships with private companies and nongovernmental organizations (NGOs), environmental management, and more effective targeting of social programs. These policies are not new to or untried in the Philippines. In the 1950s, 1960s and 1970s, the government implemented reform policies to expand the economy, but, when the economic and political structure failed to respond adequately to the reforms, a series of economic crises ensued, forcing the government to abandon the policies. To ensure that recent structural reforms do not suffer the same fate in the 1990s, actions to strengthen policy implementation are required. 21. Democratization and devolution, structural reforms, and the processes of urbanization, demographic change and remittances from abroad have reinforced the confidence and capacities of the middle segments of Filipino society-an encouraging sign that makes prospects of sustained reform far better today than at any time in the past decade. Several actions are required to make the reforms take hold. First, the government must build a critical mass of support for reforms by articulating an overall vision of how an export-oriented, labor-intensive approach can meet the demands of different groups for welfare improvement. The removal of protectionist legislation on external trade is one step in the right direction, but pressures for protection against competition will inevitably arise in other areas. Unions and populist politicians may push for minimum-wage increases; businesses for more tax advantages; and, without money to spend, legislators and bureaucrats are exerting their power by legislating that the private sector meet social priorities in, for example, housing development, assistance for small farmers and credit programs. Similarly, legislation to build ten-bed hospitals would be inconsistent with the need for greater efficiency in hospital care. These are all examples of areas in which strong pressures to oppose liberalization currently exist and must be resisted. Forming coalitions to support the reforms would be useful (a formal pact with labor, a working coalition with Congress, and business support for the Development Plan) until the benefits become apparent and a consensus emerges. This requires strong leadership. Above all, divisive political action must be replaced with a common sense of purpose toward a development program, a mindset that has proved effective in the rest of East Asia. 22. Second, given the imperatives of consensus building and multi-level actions, difficult tradeoffs must be made to maintain the integrity of public finances, requiring that the various interest groups eschew their narrow self-interests. The report calculates that the cost of critical actions that "must" be taken by the government within the next couple of years amounts to over $6 billion on an annual basis, or about 14 percent of GDP. These actions include incremental public irtastructure spending on energy and transport (even after major private participation in build-operate-transfer (BOT) type schemes is accounted for); spending on land reform; and increased social sector spending. They also include tax reforms to enhance efficiency, such as the removal of taxes on financial intermediation and corporate deductions and exemptions to bring foreign and domestic investment incentives in line with other countries in the region. While all these and other actions are appropriate, they cannot be pursued simultaneously while maintaining the necessary discipline in managing public finances. Thus, revenue mobilization, on the one hand, and expenditure prioritization and phasing, on the other hand, are critical to designing an affordable development program. 23. Third, the Philippines must modify some of the institutional structures of government. The current institutions were established to handle a system that was more dirigiste than the one that prevails today and one that was concerned more with the mobilization of resources than with the efficiency of how they were spent. Given that the effectiveness with which the development program is implemented will be one yardstick by which domestic and foreign investors will measure the strength of the government, the Philippines must enhance its institutional capabilities to resolve problems in such areas as project implementation, the collection of user fees, and the development of market-oriented regulations and approaches. The report provides several examples of types of administrative change that are required: transforming the Board of Investments from a regulatory to a promotional agency; rethinking the functions of the central bank's import monitoring and exchange control staff; making public corporations more accountable for financial and operational performance; and increasing project monitoring and accountability by line agencies, so that the sectoral allocation of actual public investment can be compared with budgetary authorizations. These reforms in administrative structure are a prerequisite for sustaining growth beyond a short-term macropolicy-induced boom. 24. Fourth, the legal setting must also be modified. For example, efforts to improve the efficiency with which taxes and user fees are collected are hampered by the absence of special tax courts and by difficulties in obtaining convictions. Similarly, the collection of user fees and a reduction in pilferage from public corporations are affected by weak laws. To be successful, the Philippines must strengthen its judicial system to allow the development program to be effectively implemented. 25. Finally, private sector resources must be mobilized. One way to finesse the budgetary squeeze is for the private sector to become the implementing agent for development programs, and this avenue is actively being explored. In the process, the public sector often acquires contingent liabilities, rather than direct liabilities. Proposals for advancing further down this road are being voiced: amending the Foreign Borrowing Act, to grant government guarantees to the private sector, and creating special funds to encourage the private sector to undertake "social priority activities. However, many dangers lurk along this route, and previous experience with socialized losses of rural and industrial credits and agricultural marketing arrangements must be kept in mind. Dangerous levels of contingent liabilities are already being incurred through the social security system, land reform credits, and take-or-pay privatization contracts in energy. Without great care, these conditions could evolve into a future crisis in public finance, especially if external shocks derail growth from its smooth projected path. Medium Term Prspct 26. The challenge of implementing policy reform simultaneously across all the areas outlined above is daunting. Yet now a window of opportunity-opened by the improved macroeconomic base and the reformed incentive structure-exists for the new Government. Another favorable factor is a growing -xi - consensus on reforms established through public hearings and local community involvement, which. although sometimes responsible for implementation delays. reinforces the sustainability of those same reforms. Finally, the regional situation offers opportunities, despite the prospects of less rapid growth in international trade in the 1990s than in the 1980s. Korean, Taiwanese (Chinese) and Japanese companies are rethinking regional strategies, and although Viet Nam and the provinces of southern China are formidable competitors for low-cost labor industries, the quality of Philippine workers and managers is such that the government can effectively attract foreign investment and promote exports. 27. Based on these factors, the assessment in this report is that the Philippines now faces its best prospect for sustained development in almost two decades. Having been overtaken by both first and second generation industrializers in the region, the Philippines now faces a challenge not to remain a perennial underachiever. Circumstances are now favorable for moving to growth of at least 5.5 percent per year over the medium term, consistent with a graduation from exceptional balance of payments financing arrangements within three years. In contrast to previous growth spurts where public consumption also increased, future growth would be supported by higher amounts of public infrastructure investment, complemented by large private investments in such sub-sectors as telecommunications, energy and air and sea transport. In the medium term, other private investments and exports would be the engine of growth. Already, the structure of exports has changed over the 1980s; the manufacturing share of exports has risen from 50 percent in 1980 to the current level of 80 percent. While the prospects for primary commodity exports remain poor given quota-driven sugar exports, banned logging and declining coconut exports, robust growth in non-primary exports could be realized. Furthermore, although near term non-factor service receipts may decline once interest rate differentials have reduced the incentive to shift from foreign currency into peso denominated accounts, these receipts should pick up again over the medium term. Thus, import growth above the rate of GDP growth can be accommodated with current account deficits averaging less than 3 percent of GDP. 28. Although the projected current account deficits ate modest compared to the past, given sizeable principal repayments falling due through 1997, the Philippines will need to continue to rely heavily on new foreign savings. But whereas in the past foreign savings had been required to fill a public sector deficit, and had been mobilized through rescheduling of principal and interest on Paris Club debt, and quick-disbursing official loans, such assistance should be phased down as public finances recover their strength. In the future, with the rapid forecast increase in private investment, including on major infrastructure projects, it is the private sector that is projected to have the more significant resource gaps. Foreign direct and portfolio investment, and project-based commercial credits will have to be mobilized. Already, with the removal of the external debt overhang, blue-chip Philippine companies have been able to tap project financing from abroad on their own account without Government guarantee. 29. Thus, a solid foundation of growth with low inflation and low foreign public borrowing appears feasible, provided that all parties are committed to a common program. A consensus between government and business, the executive branch and the legislature, and local governments and NGOs is necessary to support consistent policy implementation. The government could then take the high-visibility actions necessary to demonstrate a new national resolve for economic development-from convicting large tax evaders to providing export success awards, and even to making garbage collection more effective. In pursuing an agenda of mobilizing domestic and foreign resources, implementing administrative, regulatory and further structural reforms, providing a strong infrastructure, and targeting more and better services at the poor, the government must recognize and accept the challenge to streamline its operations, reduce its overall size, and increase its effectiveness. I. DEVELOPMENT ISSUES AND PROSPECTS: OVERVIEW, ASSESSMENT, AND RECOMMENDATIONS 1.1 Since the Philippines achieved independence in 1946, its economic growth has been interrupted by a series of crises-in 1962, 1972, 1983, and, most recently, in 1990. These crises severely disrupted the momentum of growth, limiting cumulative gains and stagnating development over a prolonged period of time. One of the leading economic indicators-aggregate output-fell by 14.1 percent in 1984/85, and this is largely responsible for the fact that overall per capita income in 1991 was 7.2 percent below its 1980 level. But the crises have also exposed underlying structural weaknesses in a complex develonment process that extends well beyond the aggregate growth numbers. Other indicators of economic development have shown a consistently more dismal picture of an economy that has stagnated over the past 25 years. Unemployment and underemployment, the real wages of unskilled laborers in agriculture and industry, the share of wage-paying jobs in both the public and private sectors and the percentage of people who live below the official poverty line have remained almost unchanged. 1.2 The past ten years amply illustrate the unsustainability of the developmental push of the 1970s and the fragility of the modern economic base. It is during this period that the Philippines systematically lost ground to other countries in the region. On average, the Asian "tigers" and "tiger cubs" grew by 6.9 percent during the 1980s; the Philippines grew only by 0.9 percent. Moreover, the adaptability of the other economies, the growth of their manufacturing exports and the entry of more competitors, such as the coastal provinces of South China, suggest that the performance gap between the Philippines and its neighbors may continue to exist for some time. 1.3 The poor growth performance of the 1980s is all the more surprising given that the Philippines was one of the first nations to pursue structural adjustment, and that it has implemented reforms in a broad range of areas: taxation, agricultural marketing, trade, foreign investment, the financial system, industrial incentives, public corporations, and foreign-exchange management." However, the response to the openings created by these policies and reforms has not yet been as fruitful as in other reforming high-debt countries, such as Chile, Turkey and MexicoY In part, the muted response can be attributed to the special circumstances faced by the Philippines: frequent coup attempts and rampant violence in urban and rural areas have dampened the enthusiasm of investors; and a series of natural calamities, including a drought, earthquake, typhoons, and the eruption of Mt. Pinatubo, have left damage that has been felt at the macroeconomic level. ' The first World Bank Structural Adjustment Loan to the Philippines was made in 1980. Since then, nine structural and sectoral adjustment loans have been made, totalling $2,076 million. The Philippines is also in the midst of its eighteenth IMF program, with the first dating to 1960 and with almost uninterrupted annual coverage since 1970. F Global competitiveness rankings of the Philippines has been high for some time. For example, in the 1983 "World Development Report" of the World Bank, a ranking of 31 developing countries by the degree of growth-affecting distortions placed the Philippines at third least distorted, equal to Malaysia and Korea. -2- 1.4 Against this economic and political backdrop, this report assesses the impact of structural adjustment on economic structures in the Philippines in the past decade, and, based on this assessment. provides a set of recommendations for creating and sustaining growth over the medium term. One thrust of this report is to call for a more proactive policy of development across a range of areas that would culminate in improved economic incentives, more effective institutions and greater investment. In the past, the government has emphasized a process of structural reform to establish incentives to induce growth led by private sector investment in response. But structural reform has yet to be translated into sustained growth: macroeconomic stabilization has kept real interest rates high; a large debt burden has encouraged the government to pursue an overappreciated exchange-rate policy to keep fiscal balances in check; and real minimum wages have been raised through legislative action. At the same time, an inability to raise or collect user charges, as well as other financial and managerial shortcomings, have weakened public institutions. Consequently, private investment and hence the supply response to structural reform, have been low. Slow response by the private sector also stems from preexisting economic conditions in the Philippines that, given deep-rooted oligopoly and structural poverty, low private savings and investment rates, a narrow tax base and an import-intensive industrial structure, were more severe than the economic conditions in many other countries where recovery has quickly followed on the heels of structural reforms. 1.5 The report calls for public-sector action in ten specific areas to enable the Philippines to achieve sustained growth: (i) public finances and the evolution of public debt; (ii) external balances and the composition of debt financing relative to nondebt financing; (iii) domestic financial stability and the deepening of the capital markets; (iv) natural resource use; (v) private-sector-led growth, based on internationally competitive production; (vi) infrastructural development; (vii) a broad-based distribution of growth and poverty alleviation; (viii) the adequate provision of land and associated rural development services; (ix) expanded opportunities for human-capital development and improved access to and higher- quality social services for all groups; and (x) fairness in domestic public-tax-expenditure policy. Several factors now create the opening for sustained growth in the Philippines-a reduction in political tensions, an improved macroeconomic situation, emerging confidence among investors, the resolution of the commercial bank debt issue, and an improved working relationship between Congress and the executive branches. The report describes how a package of measures that encompass the ten specific elements can be designed and implemented to balance competing objectives and synthesize them into the overriding goal to achieve high, sustainable growth. A. Overview and Assessment of Develooment Issues and Policies 1.6 In the early 1980s, the economic problems of the Philippines could be characterized as a seamless web that emanated from three nodes: macroeconomic balance, business competitiveness and household poverty. (Figure 2.1 in Chapter 2 illustrates the configuration of this web.) This introductory section of Chapter I discusses each of these three structural components of economic policy. For each, the text first provides an overview of the issues that shape the component, and then assesses the policy progress that har been made. The Macroeconomy: Issues and Policies 1.7 The macroeconomic climate in the Philippines in late 1992 is much sounder than the one inherited by the Aquino administration. Single-digit inflation, the return of flight capital, foreign- exchange reserves at record levels, a comprehensive restructuring of medium-term commercial bank external debt, new all-time highs in the stock market, and the capture of ever-increasing remittances by -3- the banking system are all indicators of an economic base on which growth can be sustained if remaining constraints can be removed. 1.8 Since the onset of the debt crisis in 1983, it is clear that the Philippines has evolved from a country in which foreign exchange was the binding constraint against growth into one in which public finances are the binding constraint. One practical manifestation of this evolution is that, despite its ability to mobilize a significant amount of foreign aid (and most recently returning flight capital), the country has not been able to translate this opportunity into growth because contractionary fiscal expenditure cuts have been made in response to weak public revenue collection. Foreign assistance can solve a short-term balance-of-payments need, but it does nothing to resolve the fundamental problem of public-sector insolvency unless it is invested in projects that generate a high return to the government, either directly or indirectly through buoyant taxes. 1.9 The public finance constraint has emerged from a strategy of rapid external-debt accumulation, which was pursued in the 1970s to relax the foreign-exchange constraint temporarily, but which culminated in a major balance of payments crisis in 1983. When the debt burden rose, an adjustment strategy was initiated, but it faced not just rising interest payments, but also a deterioration in global economic conditions in the early 1980s-specifically, the sudden rise in real interest rates and reductions in growth. As soon as real interest rates exceeded the rate of growth, the quality of the investments financed by debt suddenly became the critical concern. General growth would no longer provide sufficient financing to cover interest obligations, and persistent non-interest fiscal deficits would lead to an exploding public-debt/GDP ratio. The government and its multilateral, bilateral, and commercial creditors understood that fiscal control would be necessary to support the resumption of long- run growth. 1.10 Although the fiscal adjustment has addressed the deficit problem in the short run, fiscal balances will not yet lead to sustained development in light of three factors: (i) distortionary taxes, such as the temporary import levy of 1991, the gross receipts tax on financial intermediation, high reserve requirements on deposits, and various stamp taxes and fees; (ii) inadequate public infrastructure and maintenance expenditures; and (iii) an appreciated exchange rate, which reduced the cost of external debt service and of domestic subsidies to public corporations that depend on imported raw materials or capital equipment. Yet, as these short-term measures are abandoned in an effort to restart growth, the deficit problem could again become a serious constraint unless additional taxes are mobilized. 1.11 Initially, the burden of adjusting to the balance of payments crisis fell to monetary policy. Credit to the private sector declined by 64.5 percent in real terms between 1983 and 1986-which, when coupled with a switch in the direction of fiscal financing toward domestic debt, generated higher domestic interest rates and reduced growth, exacerbating the poor macroeconomic situation. Meanwhile, fiscal adjustment sought to reduce real wages in the public sector, but, in the absence of similar measures targeted at the private sector, the gap between public and private wages widened to unsustainable levels, and the government was forced to grant catch-up wage increases in 1988. At the same time, the government slashed investments and operational and maintenance expenditures. Thus, fiscal adjustment has yielded poor results; wage freezes, lower public investment and reduced operational and maintenance expenditures are band-aids not cures. The latter two have reduced returns for private investors, and the negative effects on growth again lowered the revenue base in ensuing years. Thus, the fiscal adjustments that have actually been implemented have continually fallen short of the fiscal adjustments that are necessary, and this vicious circle has perpetuated the stagnant macroeconomy. -4- 1.12 One alternative to this cycle-cuts in public growth-oriented expenditures, stagnation, and then a decline in the revenue base-is to rely more heavily on exchange-rate adjustment to encourage expenditure switching and to generate growth, and thus tax revenue, from exports. Such countries as Malaysia and Indonesia, which rely heavily on taxes from natural resources, have used the exchange rate as a policy instrument to strengthen growth, the balance of payments, and fiscal balances simultaneously. However, the underlying economic structure of the Philippines has limited the scope for applying this option. An exchange-rate depreciation would have had immediate short-term negative consequences on the fiscal deficit, since fiscal subsidies (especially for oil and energy products, and as transfers to corporations too slow to raise user fees) would rise along with foreign debt service obligations and the cost of imported capital goods. Conversely. the revenue gains from depreciation-largely in the form of higher tariff collections-would not have been sufficient to overcome the effect on expenditures. This was in fact the case through the mid-1980s, due partly to a weak tax effort and little tax buoyancy, and partly to tariff reductions and low Bureau of Customs collections. Thus, any depreciation would have led to a net drain on the budget. Without offsetting revenue items, and with large foreign debts and other foreign exchange obligations, the central bank was particularly vulnerable to depreciations. In fact, despite the fiscal consequences, the government was forced to engineer depreciations in 1986 and 1990 to restore a balance-of-payments equilibrium. The net result of these monetary and exchange-rate policies has been to stabilize the macroeconomy, but not to support sustained growth. 1.13 Structural reform and debt management have now changed the parameters of this macroeconomic equation somewhat, giving the current administration more room to maneuver. The tax effort and tax buoyancy have increased, subsidies have been reduced, and energy-pricing policies are now being implemented to ensure that administered prices follow international price and exchange-rate movements. External debt reduction and the unwinding of central bank foreign currency swaps have reduced the impact of the exchange rate on debt-service obligations. Meanwhile, the experience of late 1990 has shown that exchange-rate depreciation has in fact had a beneficial impact on domestic interest rates (by lowering the risk premium demanded by investors for holding peso debt), an impact that has become more significant with the rise in total outstanding domestic debt. Conversely, the need for continued monetary tightness to keep inflation down has raised domestic interest rates and led to an appreciation of the peso. However, as financial stability is restored to the system, interest and exchange rates should reverse direction. Thus, conditions for restoring a sound macroeconomic framework, including public financing consistent with investment expenditures and exchange rates that support growth, are much more favorable at present than in the recent past. 1.14 Although it may now be easier to design a macroeconomic program that supports rapid growth and low inflation while maintaining fiscal and external balance, implementing the program successfully will not be easy. The actual evolution of tax receipts, public expenditures and monetary variables munst be controlled in a narrow range around the programmed levels-or else there is a danger of overheating and a rekindling of inflation, if the macroeconomic stimulus is too large, or of a renewed stagnation and loatW investor confidence if macrocontrols are kept too tight. In the past, on both fiscal and monetary sides, the inability to achieve program targets has consistently added to economic problems. For example, in 1990, policy slippage alone would have caused the economy to deteriorate rapidly,y even though exogenous shocks-including the most serious coup attempt against the Aquino government, the Gulf Crisis, drought, typhoons and a major earthquake-undoubtedly compounded the difficulties faced F See the Chairman's report to the Consultative Group Meetings in Hong Kong, February 1991. -5- by the authorities. Consistent and coordinated policy implementation in the ASEAN (Association of South East Asian Nations) mode is now necessary. Macroeconomic Stability: Assessment of Policy Progress 1.15 Despite the fact that more could have been done, the report acknowledges major accomplishments by the public sec:or, especially in fiscal adjustment, debt management, monetary management. and exchange-rate management. These have provided more room for maneuver on the macroeconomic front as well as a more responsive economic structure than at any time since 1983. Fiscal Ajustment 1.16 Revenue. Since the mid-1970s, government spending has outstripped revenue, leading to an accumulation, first, of external debt and, more recently, of internal debt. By 1986, the ratio of total public debt to GDP had reached 0.9, high even by the standards of other highly indebted countries. Under the Aquino administratio. the public indebtedness ratio appears to have stabilized, a considerable achievement in light of exchange-rate devaluation (which raises the burden of external debt even in the absence of new flows) and low growth. The consolidated public sector deficit has been reduced to below 3 percent of GDP; adjusting interest payments to remove the effects of inflation shows an even more significant adjustment to a real surplus. Over time, and as actual inflation slows, maintaining this adjusted surplus will automatically reduce the ratio of debt to GDP further. 1.17 Although important elements of tax reform to improve fairness and efficiency have been completed-covering both direct taxes and indirect taxes (including the introduction of the value-added-tax (VAT))--they have not yet yielded much in terms of revenue, due partly to collection weaknesses and partly to low growth, which has reduced the benefit of higher tax buoyancy created by the reforms. Thus, the burden of fiscal adjustment has fallen disproportionately on public expenditures. 1.18 The government's highest priority now is to increase public-sector revenue. The report suggests that overall public-sector revenue be raised by at least one half of one percentage point of GDP a year for the next five years (1993-1997). This target is a bold one, considering that several existing taxes are to be reduced, including tariffs and the Gross Receipts Tax. Tariff rates are already bound by the schedule adopted in EO 470, and, if feasible, the reduction in rates could be accelerated and deepened. Nevertheless, given the buoyancy of the tax structure now in place, the target can be reached in a recovery situation. The greatest opportunity for expanding revenue comes from high#-- tax collections from the VAT, individual taxes, and corporate income taxes which currently yield only about one-half of their measured potential. Yet, although aggressive collection would both serve revenue requirements and help make the actual system more progressive, it is unlikely to be sufficient in itself. A concerted effort to raise fresh revenue by introducing new taxes is essential in the medium term. Several promising avenues could be explored: the VAT could be refined, ceilings could be imposed on eligible deductions for business taxes, taxes on energy and other excises could be increased, and natural resource taxes could be imposed (mining royalties and mangrove and pasture leases). 1.19 The government on its own cannot bear full responsibility for raising public revenues-the task is too great. Three other groups can and should increase their contribution to public revenue: local ' See Krugman et al., Transforming the Philippine Economy, NEDA/UNDP, June 1992. -6- government, public corporations, and social security institutions. Locally generated government revenue fell by one-third in real terms in the 1980s, with yields from the largest component-property taxes- falling in the face of deferred assessments, poor administrative records and lack of political will.This situation could be rectified if the government: set nationwide criteria for local assessors to use to develop systematic, market valuation; regularly developed detailed tax maps; set quantitative targets for increasing property tax collection rates; and focus on collections due on idle land, real estate and agricultural lands where no alternative taxes are imposed. 1.20 Public corporations have also been a drain on the budget. They can help increase revenue by paying all required tariffs and income, withholding, sales and real estate taxes; increasing their dividends from 10 percent to 15 percent of net income (the average for private listed companies); and improving internal cash generation by imposing appropriate user charges. User fees can be expanded in several sectors, including hospital care and secondary and higher education. But user fees can also be collected more effectively. Agencies should be allowed to retain a portion of fees as an incentive to increase their diligence in collecting them; they should not be required to transfer the full amount to the Treasury. At the same time, the regulatory framework must be adjusted whereby agencies have the operational flexibility necessary to adjust user fees to changing costs, particularly for energy and power. In other cases, the cost-accounting basis for establishing user fees is weak and must be improved by the Commission on Audit. 1.21 Given the size and revenue potential of the social security funds, improving how they are managed and allocated would enhance overall public finances and deepen domestic capital markets. The government could improve the return on assets of both the Government Service Insurance System (GSIS) and the Social Security System (SSS) by reducing member loans, which effectively provide subsidies to middle-class families, and by implementing a more professional investment strategy. The SSS should also strive to increase its member participation rate; in 1990, only 4.8 percent of total eligible members, and only 22 percent of total registered members, actually contributed to the fund. If these ratios could be raised, the resulting surplus in the SSS could be used for investment purposes and to develop the capital market. 1.22 Expenditures. In order to maintain financial stability, the government must reduce the overall public-sector deficit to a point at which the overall public debt burden starts to fall. Doing so implies that expenditures be tied closely to public revenue. The government has already introduced a cash management system that has successfully maintaind this link, thereby preserving the macroeconomic integrity of public finances. However, as a result, actual expenditures have deviated significantly from budgeted expenditures, and the priorities that have been worked out so carefully in the budget are not necessarily respected in the actual erpenditure programY The cash management system has imposed other costs. For example, some programs that require funding consistency in order to be effective, such as malaria control, have faced a shortage of funds in some years, reducing the successes of previous years. Within dtloastse of the year, as well, the tight linkage between revenue and expenditures leads to inefficiencies, asthe seasonality of expenditures, linked to the construction season, deviates from the M' The project evaluation process must be streamlined: economic profitability is only I of 31 criteria used to rank projects and has a weight of only 4.4 percent of the total. This said, however, most public projects are carefully vetted by foreign donors, limiting the danger of "white elephants" in the public investment program. -7- seasonality of revenues. One recommendation in the report is that the government identify a core set of activities and projects that are protected against short-term financing restrictions. 1.23 In a system in which budget stringency is paramount, funds must be allocated effectively. The first step in doing so is to increase the amounts that are subject to discretionary allocation procedures. At present, over two-thirds of total government expenditures are fixed in the sense that they represent contractual wage and interest payment obligations. The governmeat has made significant strides toward reducing the burden of interest payments on external debt. and further progress on this front will be limited. However, both public wages and the number of public employees must be scrutinized if an effective and sustainable fiscal adjustment is to be made. Present efforts to streamline the bureaucracy are welcome first steps. It must be remembered that any reduction in public employment will not contribute to a loss of jobs in the economy; the revenue freed up by restructuring would be allocated to public investment projects that would add to jobs in the private sector. In terms of wages, the experience of the early 1980s must be remembered. At that time, a freeze was imposed on public w?ges-a policy that was unsustainable when a sizable wedge between public and private wages ensued. Public-sector wages cannot be tackled in isolation from private-sector wages, and the dominant issue here is the political one of minimum-wage levels. 1.24 A significant component of the expenditure-allocation aspect of fiscal adjustment remains untackled-employment and productivity in public services. The number of public-sector employees has increased steadily over the years, at an average annual rate of growth of 5.8 percent. Astonishingly, this increase has been sustained even during crisis periods. Although the Philippines does not have a large public sector by international standards, the network of private-sector involvement in public-service activities, from NGOs to private schools and clinics, is more extensive in the Philippines than in most other countries. Thus, the public sector in the Philippines should be smaller. Thus, to restructure public employment in an effort to allay fiscal pressures, the government must first define the respective roles of the national and local governments, public agencies, NGOs, private practitioners, and employers in financing and delivering services, and then overhaul regulatory practices. In the social sectors in particular, private-sector participation is fundamental to the overall delivery of services and must be factored into the budget allocation decisions of the government. For example, some parties have assumed that the constitutional provision to provide universal secondary education implies that the government should direct more of its education budget toward secondary schooling. But the ambiguity of the provision calls into question whether, for instance, additional public secondary schools should be constructed in an environment in which private secondary schooling appears to be more cost effective. Similarly, for hospitals, higher education and other services, the absence of a clear policy on public and private roles hinders effective budgetary allocations for the social sectors, as well as rigorous assessments of financial viability and financing of the private sector. 1.25 Increasingly, this division of responsibility also pertains to the infrastructure sectors with the emergence of build-operate-transfer (BOT) schemes. Almost one-half of energy-related investment is expected to come from the private sector over the next six years, and an additional large amount of private-sector funding for telecommunications and urban transport is expected. However, the aggregate potential for BOT schemes, both domestically and from abroad, must now be assessed. On the one hand, the recent Brady agreement and the freeing of the exchange rate should allow interested foreign investors and large domestic companies, such as the Philippine Long Distance Telephone Company (PLDT) and the Manila Electric Company (MERALCO), to obtain private external financing without the "country -8- risk" overhang of the past." On the other hand, official assistance often provides the most suitable maturities for long- gestation infrastructure projects, and can be catalysts for mobilizing additional private financing. This factor may provide a rationale for the on-leading of official resources for specific infrastructure projects. In order to incorporate these government liabilities into the debt management strategy, the report recommends that guaranteed loans be treated the same way as public expenditures for the purpose of setting aggregate spending ceilings, even if the funds are on-lont to the private sector to implement projects. Debt Manaremmt 1.26 The burden of public domestic and external debt is heavy. For example, the public debt to GDP ratio, at 83 percent. is still well above the 60 percent target proposed by the EC Commission for countries to join the European Monetary Union; the disparity indicates that the debt burden may be too heavy for the Philippines to attain the inflation levels of industrialized countries in the medium term. Of course, debt would not have been a problem if the resources that had been borrowed were invested profitably; had returns on investment of even 10 percent been achieved, the incremental revenue flow to the government would now be around 9 percent of GDP. Even if the returns had not been captured directly by the government but had gone into society at large, the government should have been able to capture a significant portion through the tax system. Unfortunately, much of the debt was dissipated in consumption, capital flight and unproductive investments?11 Thus, there was little return to cover the costs of future debt servicing. Other revenue sources also did not grow to cover debt service, given that taxes in the Philippines have been quite inelastic, and that the overall tax effort has averaged only 10 to 12 percent of GDP over the past 20 years. 1.27 Yet the Brady plap, introduced in 1989, has snifted the debt strategy from one that emphasized cash-flow relief, relying on reschedulings, to one that emphasizes reducing the debt. The Philippines has managed to reduce its external commercial bank debt by more than $4.6 billion through various means, including debt buybacks amdebt-equity swaps. The fixed-price, below-market interest rate on debt exchange bonds may yield alkeffective additional debt reduction of $0.5 billion. With the 1992 second-stage Brady agreement, the Philippines can put behind it the-politically contentious external debt issue. 1.28 Da)mestic real interest rates are also high, as is typical for a highly indebted country, and are likely to remain at high levels as investment demands in a growing economy will pressure local Most export credit agencies require government guarantees to ensure convertibility into foreign exchange for servicing on their debt. With foreign exchange now being liberalized, convertibility is no longer an issue and several official export credit agencies are making loans directly to the private sector without any goverment guarantee, a welcome innovation in development financing for the country. The Philippines' pubic external debt was not due to an excessively large public sector. Rather, it reflected the social subsidization of private-sector losses; the nonperforming assets of public financial institutions, which continued to lend to private firms in an ultimately unsuccessful bail-out; ex post depositor guarantees on failing commercial banks; and efforts to buttress the currency. These debts, amounting to perhaps $10 billion (and the Nuclear plant related claims), have had only minor counterpart assets. They essentially were transfers to the private sector. -9- capital markets. Interest paid by the government accounts for 6 percent of GDP (30 percent of the budget) and is higher than new public fixed investment. Yet, here, too, there is room for maneuver to take advantage of specific market opportunities.for relatively cheap borrowing. Since external debt reduction and tax reform have made public finances less affected by a depreciation, the government can safely consider a broader ra,ge of firiancing options. It is important that the public debt management strategy maintain this posture of neutrality vis-a-vis the exchange rate. 1.29 One component of debt management is to shift the burden of public deficits to different public entities. But the shift must be made judiciously and soundly. The surpluses of the social security institutions are illustrative. Although the surpluses are an important reason for the low reported consolidated public deficit, it should be remembered that the liabilities of these agencies are guaranteed by the government. To the extent that the social security institutions are actuarially in balance, their surpluses should rot be counted as offsetting the public-sector deficit, since they are accompanied by equivalent future liabilities. Given current accouiting practices, it is very difficult to identify the extent to which the social security system presently adds to or subtracts from the long-run fiscal deficit. Thus, the actuarial value of the schemes should be computed under different assumptions about growth rates, benefit-level adjustments, salary increases and the like, thus providing a sound basis for assessing the potential risk to the budget imposed by the government's guarantee of future liabilities. Monetary Management 1.30 Although inflation had been brought under control during the mid-i980s, it has re-emerged as an important constraint on growth in the past few years; in 1991, the CPI grew by 17.7 percent, yet is has recently retreated to single-digit levels. This volatility can be traced to several causes: an expansion of fiscal deficits in 1989/90 .d their monetization; cost-push effects from the nominal peso depreciation of late 1990; strategic pricing behavior after the imposition of the import levy in 1991; and legislated wage increases after energy-price increases in 1991. The increase in inflation and its volatility over time-and hence its effect on the stability of real interest and exchange rates-are worrisome issues that require further attention. 1.31 The efforts of the central bank to control inflation have been undermined by two important developm ents. First, with the liberalization of exchange-rate management and renewed confidence in the Philippines, there has been a substantial return of flight capital; the central bank has been able to purchase a net amount of over $3 billion in foreign exchange markets since January 1991, an unprecedented amount for a country which has historically had a dollar shortage. To maintain control over base money, the government has sterilized these inflows, but at a cost of higher domestic interest rates that have encouraged further capital inflows and larger central bank losses. The most pressing issue facing the central bank is whether, given the new exchange-rate regime, monetary policy should target base money or domestic credit and interest rates. 1.32 The second key development in the fight against inflation has been the deterioration .f the central bank income position. With more debts than interest-earning assets given the quasi-fiscal activities it has undertaken, the central bank has suffered large losses since 1986. These losses have been financed in a variety of ways: government and public corporation payments to the central bank for external debt service that, following rescheduling agreements, would become due only at a later date; a buildup of interest-free deposits by the government; and a rollover of obligations due to other creditors through blocking accounts. These measures have been effective at precluding the monetization of central bank deficits, but they have effectively placed monetary control in the hands of the Treasury (given its ability - 10 - to manipulate deposits) rather than the central bank. Restoring the central bank to a position of dominance in monetary policy implementation is a priority. Exchange-Rate Mana&ement 1.33 The peso has appreciated in nominal and real terms relative to late 1990, and it has done so largely as a result of market forces. Thus, the oft-stated desire for a more "competitive" real exchange rate is clearly not something that can be achieved readily with nominal exchange-rate policy alone, especially when tight monetary policy acts in a countervailing direction. Also, the real exchange rate is influenced as much by the political expediency of wage legislation as by nominal exchange-rate movements. Thus the critical objective for exchange rate management should be to ensure that the rate is determined by market, not political, forces. 1.34 Prior to 1991, administrative controls imposed on the prchase and sale of foreign exchange were too numerous to establish what a market rate might be. In this context, exchange-me liberalization was a priority action. In 1992, the government took several extraordinary steps to deregulate the foreign exchange market: increasing foreign currency retention amounts for exporters to 100 percent of revenue, with free disposal of such amounts; eliminating surrender requirements for export receipts; eliminating or liberalizing restrictions on the use of foreign exchange for both current and capital account purposes; liberalizing access to dollar loans sourced from off-shore foreign currency accounts; and broadening the market by redefining the exposure limits of banks, lifting restrictions on off-floor trading and extending trading hours. These measures have already gone a long way toward establishing a true market- determined rate for foreign exchange, and the Philippines now joins other ASEAN countries in allowing an essentially free foreign-exchange market. The government could institutionally safeguard this market- determined rate by accepting the obligations under Article VIII of the IMF's agreement. At present, the Philippines is the only ASEAN country that has yet to accept them. The Real Economy: Issues and Policies 1.35 The Philippines is still largely an agricultural economy. Although the national income accounts suggest that the importance of agriculture has declined to 22 percent of value added in 1991, a lIrge array of industrial and service output is also related to the agricultural economy, creating a block that accounts for half of total output. Almost one-half of manufacturing is in food processing, and an estimated 13 percent of trade, transport and finance services are linked to agriculture. Hence, the performance of and prospects for the economy cannot be divorced from agriAiture. 1.36 Agricultural performance over the past decade has slowed, due to several negative factors. First, the easy gains of yield improvements in traditional crops appear largely to have been exhausted. In the rice subsector, the most promising sites (particularly in Luzon) have already been put under irrigation; most farmers have adopted '-igh-yielding varieties (87 percent in 1988) and are achieving good yields relative to their potential. Second, much of the natural resource base has been fully exploited. The fish catch has reached or exceeded sustainable levels, and logging in old-growth forests has been declared illegal. Third, traditional cash crops-sugar and coconut-face poor external demand, and copra could be affected further by new EC health regulations on aflatoxin. Fourth, the relative price of rice and corn to fertilizer is expected to decline in the medium term. The only brig' spots pertain to pork - 11 - and poultry and horticulture, but growth in these sectors depends on aggregate economic growth, on improvemenu in the efficiency of internal trade, and on increased private and public investment in the rural economy. 1.37 The low growth in agriculture is reflected in the structural transformation of the labor force in the Philippines. In most rapidly developing countries, the labor force is making the transition from unpaid family and own-account workers in agriculture, where productivity is low, to formal wage-paying jobs in industry and service sectors, where productivity is higher. This transition has not yet occurred in the Philippines. The share of labor engaged in wage paying-jobs across the economy has increased only by 4 percentage points over the past 20 years, and one quarter of this increase was in agriculture, due to the technical change wrought by the Green Revolution. The main transformation of the Philippine labor force has been from low productivity jobs in agriculture to low productivity jobs in the informal service sector. The sari-sari store and domestic household help have become the refuge of surplus agricultural labor. 1.38 Typically, employment restructuring occurs with rapid economic growth. Yet, even during the high growth years in the Philippines between 1965 and 1982, the structure of employment changed little. The absence of change can be attributed largely to the persistence of a dualistic economy. The formal modem sector provided output growth, but not jobs; especially in the late 1970s, the sector was driven by high rates of investment in capital-intensive production. During this period of output growth, large firms prospered, while small and medium enterprises were squeezed out. Rural nonfarm enterprises, which have played such a crucial role in Taiwan, Indonesia, and Malaysia, fared poorly in the Philippines. Consequently, key measures of dualism show little improvement. The rural-urban mean income differential has remained at 0.47, well below any cost-of-living differences between rural and urban areas. The wage in manufacturing relative to GDP per capita (a proxy for opportunities elsewhere in the economy) has reached a level of around 3, the same as at the start of the 1970s; for other rapidly growing developing countries, this ratio is closer to 1.S. Industrial unskilled labor still commands a wage premium over agricultural unskilled labor of around 100 percent. Migration, both internal and external, has been high. 1.39 Dualism and the existence of a labor surplus are often perversely associated with a capital- intensive modem sector. Much has been written about the bias toward capital intensity in the Philippine manufacturing sector during the 1970s. Trade restrictions, investment incentives and foreign borrowing made cheap in real terms by an appreciating peso all contributed to the rapid expansion of capital goods sectors, such as cement, glass, textiles, and chemicals. Many of these projects proved unprofitable at more realistic exchange rates, and have left the country with a heavy debt burden. But similar costs were suffered by several other countries, including Malaysia and Korea, that attempted a similar strategy of import-substitution in capital goods industries. The projects should not have reduced the rate of manufacturing growth in the Philippines, especially when the capital-favoring distortions were addressed, as they were with financial deregulation in 1980 (which freed up domestic interest rates), a change in investment incentives and the cut-off from foreign loans in 1983, and substantive trade reform and subsequent exchange-rate depreciation in 1986. 1.40 Less often remembered is that many labor-intensive manufactured export items were also developed during the 1970s. Between 1970 and 1984, the Philippines increased its market share in world manufactured exports from 0.24 percent to 0.4 percent and also considerably diversified its mix of export products, which should have put the Philippines in a strong position for future expansion. However, just . 12 - between 1984 and 1988, substantial export market share was lost, and recovery since then has only begun to recapture this ground. 1.41 It is worth recalling that, until 1984, the Philippines had a larger world market share of manufactured exports than Thailand or Indonesia. Today, its share is less than half that of Thailand, and slightly lower than that o' Indonesia. It is this rapid loss of market share that could wreak the greatest damage on Philippine prospects for manufactured export growth. The problem is not insurmountable: Malaysia experienced a similar decline between 1984 and 1986; Korea and Taiwan exhibited much larger declines between 1988 and 1990, and 1986 and 1990, respectively. But the specific reasons for the slowdown in exp,rts in these countries could easily be identified and remedial measures taken. In the Philippines, implementing classical remedies-a real depreciation of the exchange rate and productivity enhancements through investment-has been much more difficult. Despite nominal peso depreciations in 1986 and 1990, the real exchange rate quickly returned to predepreciation levels, and private capital investment has remained low because of high domestic interest rates. The report links the absence of supply response by exporters, and by manufacturers in general, to the dominance of inflexible large firms and the lack of domestic competitivenes 1.42 Not all segments of manufacturing exports have fared poorly, and it is instructive to examine successful cases, such as garments. This subsector has good institutional backing and extensive contacts with foreign purchasers. But it is also a subsector that has been protected, by the international system of quotas, against competition from other countries, and is one in which reasonable demand growth has been coupled with little change in quality, or quality-based competition, over time. In other subsectors, such as leather shoes, where price and quality competitiveness has been fierce, the Philippines has lost out. Other indicators also suggest that the real appreciation of the peso should not be overemphasized. Despite exchange rate developments, some regions, such as Cebu, have successfully expanded manufacturing exports by adopting a closer partnership between the local administration and private business, ensuring that business-related problems associated with infrastructure, access to incentives, international marketing and customs are handled quickly. This experience shows that opportunities exist in the current macroeconomic climate for vigorous growth in manufactured exports. 1.43 There are some positive signs that the reforms in the industrial sector are starting to yield the desired supply response. The time horizon of producers, as measured by their strategic pricing behavior, has lengthened. In 1978, danger signs already existed in the Philippines that exporters were focusing more on reaping rapid profits by retaining high unit value for exports relative to their regional competitors than on building market share with aggressive pricing behavior. By 1988, this indicator had been reversed. Evidence also exists that the trend established during the 1970s and early 1980s toward an increased importance of large establishments has significantly reversed. Since 1985, small and medium-size firms have expanded their share of value added, employment and exports, while the policy bias toward large firms has declined auguring well for a more adaptive export sector, positioned to respond much more rapidly to changes in relative prices than in the past. Meanwhile, profits have returned to levels well above those of the early 1980s, and balance sheets have been rebuilt with lower debt and more equity. 1.44 These examples suggest that the potential for solid manufacturing growth is now in place. But the Philippine government must address many dimensions to foster an export culture successfully in the country. The most pressing need is to restore infrastructure services, which pose a significant potential threat to sustained growth. Since the beginning of stabilization in 1983, public investment has been slashed. With the exception of power, these cutbacks have not yet become a major drawback to - 13 - inaustry, given the long lead time in infrastructure projects and the limited growth in demand that accompanied the weak economic performance during this period. But power, telecommunications, water, urban sanitation and transport and rural infrastructure have all been badly neglected for several years and must be addressed soon to support sustainable growth. Current trends whereby industrial parks are being developed by the private sector in selected regional growth poles, where infrastructure can be provided in a comprehensive and cost-effective fashion, are encouraging and could be bolstered by new modalities to give the private sector access to Official Development Assistance. But the public sector must redirect its expenditures from inflexible categories, such as debt and personnel payments, toward more discretionary categories covering capital investment. Creating Competitive Econonic Structures: Assssment of Policy Progress 1.45 The report concludes that the Philippines has made significant progress toward neutrality in industrial, trade and investment policies, already yielding an industrial structure whose size is more balanced, a greater adaptability of exports, and greater efficiency through subcontracting and the acquisition of technology. While policy neutrality is widely accepted as a necessary condition for competitive success, East Asia in particular has emphasized other, complementary measures of export and foreign investment promotion, and marketing, technological and infrastructural partnerships between the public and private sectors. These elements are stressed in this report as key components of Philippine policy. 1.46 Agriculture. Under the Aquino administration, the Department of Agriculture pursued a profit- and market-oriented approach, reducing controls and regulations, and encouraging the private sector to assume functions that are performed poorly by the government. Monopolies in sugar and coconut marketing have been eliminated, and competition in the milling industry has been introduced. Import controls on agricultural inputs were eliminated, export taxes removed in 1984, and most producer price interventions removed. The benefits of macroeconomic reforms that have promoted tradables-such as exchange-rate and tariff reform, and reduction of subsidized creditf-have accrued largely to the agricultural sector, although it will still enjoy less protection than manufacturing when E%) 470 is fully implemented. In certain important areas, such as pork and poultry and fisheries, the potential for agricultural production and exports is still adversely affected by the high cost of intermediate inputs (corn and packing materials, respectively), but few other major policy-induced distortions remain. 1.47 Public spending on rural development must be reviewed. In recent years, subsidies extended through the National Food Authority's rice and corn trading or the Agriculture Department's two-for-one fertilizer distributionprogram, as well as the escalating costs of land reform-including payments for land, credit for input purchases and expanded staff to administer the program-have consumed public resources for activities that are at best weakly linked to increased productivity. These measures could otherwise have been invested in agricultural research, irrigation, roads and other rural infrastructure. Public spending on these infrastructure projects should also be based on economic efficiency criteria; for example, in irrigation, the large national projects offer increasingly marginal returns, whereas good smaller projects can be more cost effective. Less expensive strategies for meeting national objectives Most of the bias against agriculture was due to the indirect effects of macroeconomic policies (see Intal and Power in Krueger et al, The Political Economy of Auricultural Pricin Policy, Johns Hopkins for the World Bank. 1991). -14 - should also be considered, such as implementing trade reform that substitutes partially for investment in irrigation as an instrument to ensure food security and to generate foreign exchange. 1.48 Natural Resources. The government has introduced both administrative and legislative proposals to respond to key environmental issues in forestry and fisheries-the integrated protected areas system, the master plan for forestry and fish conservation, and protection measures.2' Actualizing these policies is now the most pressing issue. By implementing pricing and taxing natural resources adequately- -going beyond forestry charges to include mining royalties, land and license fees for pasture and mangrove leases-the Philippines would meet both conservation and public finance objectives. 1.49 Trade Policy. With the removal of most quantitative restrictions and the adoption of EO 470 (the tariff reform program of July 1991), the Philippines has created a trade regime that is comparable to the regimes of most other countries in the region, with average nominal tariffs due to fall below 20 percent and with import restrictions imposed on less than 5 percent of all items. The effective protection rate on manufacturing will be reduced from the present level of 33 percent to 28 percent by 1996, lower than Indonesia (59 percent) or Thailand (51.2 percent). While the tariff structure can still be rationalized in some areas, significant openness has been achieved overall. Importantly, tariff reforms have also been accompanied by measures to simplify and streamline customs procedures. In Addition, the tax and duty-drawback system for exporters has been improved, although indirect exporters still find it difficult to access such concessions. 1.50 The Philippines exhibited similar openness during the 1960s, followed by a reintroduction of restrictions. Thus, this historical experience tempers the credibility of the current reform program. Efforts to accelerate the tariff-reduction process, provided that doing so is warranted by revenue considerations, would bolster credibility. Pursuing intra-ASEAN liberalization goals is also important, because, in addition to contributing to openness, they would help create an institutional lock on the current reforms. 1.51 Expr DeveLopM . Three basic issues must be addressed to turn export-led growth from a slogan, which was already adopted in the Philippines in 1967, into reality. First, the macroeconomic environment must be stabilized. The report concludes that the variability of the exchange rate is a significant problem facing exporters. As the economy recovers a4 inflationary expectations are broken, the current appreciation of the peso should reverse itself and stabilize around a viable market-determined level. Avoiding future variability is an important issue for exporters. In an economy where the exchange rate floats, variability in the nominal rate can best be controlled by smoothing fluctuations in interest rates through domestic credit policy. Second, exporters must have access to physical and financial inputs at world prices. Exchange-rate liberalization has effectively fulfilled the latter criterion. But the duty drawback and exemption schemes that are in place to remove the anti-export bias of the tariff system work only selectively (as is true in most countries). Reducing tariffs is the only realistic foundation for a broad-based pro-export policy. Third, strong institutional support for exporters must be developed. The Philippine Export and Investment Development Council is one such initiative that gives prominence to the export drive But pro-export bureaucratic structures must be developed within agencies, from 2' The basic strategy is outlined in the Department of Environment and Natural Resources' 1989 Action Plan, "Philippines Strategy for Sustainable Development." - 15 - requiring that the central bank monitor exports to transforming the Board of Investments from a regulatory body to a promotional body, to soliciting foreign investment, setting standards and quality norms to promote cost-effective specialization in component manufacture, and linking export promotion to labor-force training programs. Some promotional programs have been implemented successfully, such as the Product Specialist Program; such programs should be reviewed to ascertain whether they could be broadened in scope and developed onto a sustainable financial base through user fees. Other quality- enhancement programs should also be developed, such as market-driven technology institutes to help small and medium-size firms, for which information costs are high, identify, acquire, adapt and adopt high-quality foreign and domestic technologies. 1.52 Industrial Policy. The broad interventionist programs of the 1970s have widely been eliminated. First, a program of privatization has been implemented successfully, with more than 60 percent of public assets identified for the first-stage of privatization having already been offered for sale. Second, the incentives offered through the Board of Investments have been restricted; they have been made less discretionary and are based on criteria that are more transparent and no longer biased toward capital. Thus, the board has assumed a more promotional role, establishing country-specific desks to target information and assistance to identified foreign investor groups. It also provides a valuable function in coordinating with other regulatory agencies, to hasten clearance procedures for businesses. Third, the Investment Priorities Program has been shrunk systematically to cover 53 sectors in 1992, far fewer than the 261 in 1990. Fourth, a program of regionalization has reduced the dominant contribution of metropolitan Manila to total investment. Fifth, a new Foreign Investment Act that compares favorably with others in Asia has been implemented. Taken together, these reforms suggest that most policy- induced distortions that influence the industrial sector have been removed. 1.53 Infrastructural Policies. Deficiencies in infrastructure are the most serious current bottleneck to rural and industrial growth; policies, institutions and investment are all weak. Although the government has just recently reformed energy pricing and established more flexible guidelines for fare setting in the transport sector, these initial policy thrusts remain partial and tentative. The infrastructure of ports, water and other areas is a noteworthy difficulty, because in each sector responsibility for vwning, operating, regulating and financing this infrastructure on behalf of the public sector is combined in a single institution, creating a web of inefficient cross-subsidies that mitigate against cost-effective and high-quality services. 1.54 In Mba areas, budgetary spending must be increased to avert a serious breakdown in urban services. Urban transport, water, sanitation and solid waste disposal must be expanded. In particular, water shortages could develop into crises in the medium term unless swift action is taken. In each of these areas, resources from user fees must be mobilized and should provide the bulk of operating expenses. However, several of the urban-sector institutions, such as the Local Water Utilities Authority, have deep-rooted financial problems and should be restructured before they receive further funding. Again, institutional deficiencies, rather than "need* or financial constraints, are the most pressing problems in the sector. 1.55 The road network has suffered from a lack of expenditures for maintenance, and spending must be more than doubled. In particular, rural and provincial roads have been neglected. A road rehabilitation program, linked to institutional reforms in road management, must receive increased financing. As land and sea transport policy is liberalized, the private sector is expected to provide the resources necessary for upgrading the nation's trucks and fleet. The private sector could also contribute - 16 - more significantly to financing and managing common user ports if the role of the Philippine Ports Authority as owner, operator, regulator and financier on behalf of the public sector is decentralized. 1.56 In ecergY, a major expansion in electricity generation and distribution is necessary, yet on a scale that takes into account three perspectives. At the national level, energy supply and demand calculations show what is desirable: about 700 megawatts a year, costing almost $2 billion a year (including private sector contributions) for generation, transmission and distribution. This amount is required to compensate for previous years when investment was too low. However, from the perspective of the principal energy institutions, the government must ascertain what these bodies can reasonably finance without falling too heavily into debt. Moreover, institutional capacity for expansion must be considered in order to minimize waste. The key national-power spending decisions must be compatible with a reasonable financing plan and program for efficiency improvements for the National Power Corporation and other institutions in the power sector. 1.57 One already successful infrastructure-related strategy is the increased participation of the private sector. The government has introduced new laws and programs governing build-operate-transfer type schemes, and the Philippines is one of the pioneer developing countries in implementing several projects contracted under such schemes. The development of industrial parks by the private sector in areas designated as "growth poles" has also proved to be more successful than earlier public-sector experience with export processing zones, and has achieved economies of scale in an environment of scarce resources for infrastructure. These measures have helped reduce the immediate costs of deficient services and declining urban environments, but a more comprehensive infrastructural strategy is urgently required to address problems before further crises develop. Poverty: Issues and Policies 1.58 While poverty remains an overarching issue in the Philippines, poverty rates have improved steadily, if undramatically, since 1971, according to several indicators, including income, education, health and nutrition. Although official statistics suggest that 54 percent of families and 60 percent of individuals live below the poverty line, these figures bear little resemblance to poverty measures used by other countries in the region or, indeed, given continuous adjustments in the official poverty line, to those used by the Philippines in earlier years. A more realistic internationally comparable estimate of poverty is 35 percent of individuals. In addition, indicators of poverty that are sensitive to the distribution of income below the poverty line show a stronger reduction in poverty than the simple headcount index. However, the basic profile of the poor has not changed much; despite the increase in urban populations, poverty is still a largely rural phenomenon in the Philippines, due in part to sizable transfers from abroad that largely benefit the urban population. The composition of the truly poor-those under the official subsistence line-is still 80 percent rural. These facts, and more detailed analysis of the causes and characteristics of the poor, provide a solid basis for the claim that conditions are now ripe for a major reduction in poverty if sustained growth can be achieved. In other Asian economies, experience has shown that the incidence of poverty has been halved each decade over prolonged periods, and this should be the minimum target for the Philippines. 1.59 Having reached an effective land frontier in the mid-1970s, poverty in the Philippines has had new consequences. In rural areas, poverty has created environmental problems, with encroachment into marginal lands, overfishing in coastal waters, and the loggig of old-growth forests. In urban areas, a large number of urban poor have emerged, earning their way in low-skill, part-time service occupations. As these groups place pressure on the urban labor market, those with wage-paying jobs - 17- have sought to protect themselves through trade unions and other political activity, leading to extensive labor-market interventions. There are clear signs that urban labor markets rely too heavily on the credentials of the workers-educational systems, particularly in technical institutes and colleges, focus more on finding jobs for their students than on raising skills. In fact, real social rates of return to education have fallen below the official discount rate, and the quality, rather than the quantity, of education is increasingly the critical issue for policy. 1.60 In both rural and urban areas, the single most important determinant of poverty is the degree of underemployment. Creating permanent jobs, not higher wages, improves the conditions of the poor. But the demand for labor has been dampened by minimum-wage legislation, whose compliance is backed up by a force of over 200 labor inspectors; Manila, with minimum wages of $4.25 per day (plus another $1 in non-wage benefits) has unskilled wage rates comparable to Bangkok (where the labor market is much tighter) and higher than in Jakarta or Kuala Lumpur. But the minimum wage is an ineffective instrument for alleviating poverty in the long term. In addition to redistributing income between profits and wages (offset by capital intensification), the minimum wage redistributes income between those with formal-sector jobs and those without. Increasingly, the more serious problem in the Philippines is finding ways to reach those who are outside the formal sector. 1.61 The Philippines has had a creditable record in social service delivery and has protected social expenditures throughout its adjustment period. Educational enrollment and literacy rates are high, and the basic structure of public expenditures on education is progressive, given the dominant public- sector influence in primary education and the dominant private-sector influence in tertiary education. Nevertheless, richer regions have higher-quality schools, and the poor, given high grade-recidivism and dropout rates, do not have the same rate of return to education as those from richer families. 1.62 A much more modest amount is spent on health. The government has a strong bias toward allocating health funds to poorer regions, but the effectiveness of its targeting effort has yet to be felt, and disparities in infant mortality rates across regions continue to be considerable. The capability of the health system to deliver scrvices to the poor has also been undermined by decisions to allocate a growing proportion of funds to public hospitals and administration rather than to preventive services. Thus, certain priority programs, such as women's health, family planning, and nutritional supplements, have not been funded adequately. Malnutrition remains a serious problem in the country. Health needs are shifting in response to demographic changes and migrPtion. Althoug, a sharp reduction in the aggregate population growth to 2.3 percent is a positive development, urban populations continue to grow rapidly, and health problems in slums are spreading. Moreover, water quality is a major issue, as pollution from untreated sewage and the clogging of waterways and canals with uncollected solid waste grow more serious. And air quality is also declining in metropolitan Manila, due to concentrated vehicle emissions. Thus, pollution issues threaten rich and poor alike. 1.63 Public spending has important redistributive effects--the lowest-income decile receives public services that cost an average of about 45 percent of their gross income, for which they pay about 20 percent in the form of indirect taxes. Despite the growing reliance on indirect taxes, the report suggests that overall tax policy reforms have been progressive. For direct income taxes, both the final tax on passive income and the increased personal exemption levels tended to enhance progressivity, which could in turn be improved by making income tax collection more efficient. For indirect taxes, their incidence is more complicated. However, the report finds little evidence that the VAT, energy or other "sin" taxes have been regressive, due largely to the secondary effects of these taxes on the prices.of final-goods substitutes. The pass-through of indirect taxes on intermediate goods into the prices of final goods also - 18 - shifts the incidence of indirect taxes progressively. Overall, the tax structure appears to be broadly neutral. 1.64 If the value of the services consumed by the poor is truly represented by the government's cost to provide these services, the net benefits from public tax/expenditure policy to the lowest decile is about one-quarter of their income. By international standards, the structure of both education and health expenditures in the Philippines is progressive, although more emphasis on preventive rather than curative health would enhance the progressivity of public health financing. Infrastructure spending, too, has been oriented toward poorer regions, reducing econo'my-wide inequality. 1.65 If public policy toward the poor is to be made more effective, tax and expenditure policy in the Philippines must be reformed. Policy makers overemphasize the negative effects of tax incidence on the poor, and the debate ensues in the absence of methodologies for measuring final tax incidence and without adequate discussion of what is to be done with the money. Thus, in the name of protecting the poor, the tax effort has been weakened. This effect has been particularly hard felt with indirect taxes, which are administratively easiest to collect-the value added tax, excises on tobacco and alcohol, and energy-related taxes and tariffs. At the same time, the demand for social services and growth-related infrastructure, from which the poor benefit disproportionately relative to their income, has expanded. Without being able to earn positive returns on small financial savings (due partly to the taxation of financial intermediation), to earn high returns on human capital (due to the shortage of job creation), and to have access to land (due to financial constraints against implementing the Agrarian Reform Program), most people in the Philippines have faced an uphill battle against poverty. Poverty Reduction: Assessment of Policy Progress 1.66 The report finds that much more progress has been made at reducing the number of families below subsistence than the number of families below the poverty line. In part, this targeting is due to government policie* that have focused on the poorest of the poor. Although poverty remains a crushing burden, success at protecting the poor from the weak economic performance of the 1980s has been a significant accomplishment. 1.67 Macroeconomic Policies. For the most part, the poor have not been hurt by the macroeconomic adjustment measures implemented. The report finds that the economic structure of the Philippines does channel the gains from growth progressively, and the single most effective policy for alleviating poverty has been growth. The poor have benefitted from agricultural marketing, taxation and foreign-exchange reforms, given the presence of transfers from abroad and self-employed income from crop farming and other produced tradables. Although household income indicators are not available to track the 1980s precisely, other measures of poverty have declined over the past decade, indicating that the poor have been protected. However, the sharp measured decline in some poverty indicators between 1985 and 1988 underscores the extent to which the poor depend on macroeconomic cycles. Thus, the current stagnation may have reversed earlier trends in the reduction of poverty. 1.68 Access to Land and Other Natural Resources. The Agrarian Reform Program has gone well beyond earlier land transfer programs by encompassing all agricultural lands, regardless of the type of crop or tenancy arrangement. Actual land reform has proceeded more slowly than anticipated, with about 1.73 million hectares having been distributed to 874,326 farmer-beneficiaries between July 1987 and September 1991. In this first phase, however, the primary effect of land reform has been to change tenancy arrangements for rice and corn lands and to give illegal squatters on public alienable lands the -19- rights to continue their cultivation. Thus, in contrast to other countries, Philippine land reform has not yet been a major instrument for distributing land from landowners to landless laborers and those without prior access. 1.69 Although land reform has been emphasized as a mechanism for alleviating rural poverty, the report introduces a note of caution about what can realistically be expected. Two difficulties are associated with land reform. First, budgetary problems may not Alow the comprehensive Agrarian Reform Program to proceed as rapidly as programmed, especially with the accompanying infrastructure and other support services to beneficiary farmers. Second, land reform has histo;ically generated gains through a subsequent increase in land prices after the adoption of new technologies. At present, the scope for such technology improvements appears to be dim. Thus, there is no assurance or prospect that fair- value land transactions will yield high returns to the purchaser. 1.70 Land reform is only one component of efforts to promote rural development. Population growth has been forcing more cultivation of upland areas, contributing to deforestation, soil erosion and reduced productivity in lowland areas. Effective policies have been introduced to mitigate these consequences and promote sustainable development, such as the creation of the Protected Areas System, and valuable lessons have been learned about how community responsibility for commonly accessible natural resources can be developed through pilot projects. 1.71 Human Resource Development. Per capita spending on education and health has been restored to pre-economic crisis levels of the 1970s, sparing the poor from bearing the full burden of adjustment. In education the principal thrust toward primary education must be reinforced, with a closer examination of secondary and higher education. Education spending has evened out regional inequalities in secondary-school enrollment rates, and per capita public spending on primary education has also been even across regions. Yet, despite the successful mobilization of resources for education, much of this increase has gone into teachers' salaries; the composition of public spending must be adjusted from teacher salaries to textbooks and other material inputs in order to improve the quality of education and reduce drop-out and grade-recidivism rates among the poor. In higher education, unit costs can be brought down by consolidating small-size schools. The costs of secondary education in the public sector are also higher than those in the private sector, without evident differences in educational quality; thus, the relative roles of costs and quality must be reconsidered to justify expanding public secondary school budgets. 1.72 elthg initiatives by the Aquino administration to improve the coverage and utilization of services, lower costs and improve cost recovery in specialized hospitals have had positive effects on the health status of the Philippine population. Among these initiatives were the following: an increase in public funding for health; a focus on the health aspects of family planning; the adoption of the generic drug law; a strengthening of major disease control programs, including those for malaria, tuberculosis, diarrheal disease and preventable childhood disease; outreach programs for the urban poor; and a more effective allocation of funds according to poverty status and health risk through provincial health planning processes. 1.73 The basic commitment to primary and preventive public health programs has been a significant and positive development that should be preserved and reinforced at the local government level, where many of the health spending allocations will now be decided. Other programs, such as family planning, must be taken up as priorities by the national and local governments. Major spending decisions about hospital-based services must be made, for which a rationalized system can yield - 20- substantial gains in internal efficiency. Given the demonstrated willingness-to-pay for health services, and a preference for the private health system over the public system (except in emergencies), the scope for mobilizing other resources, including those from private employers and NGOs, is considerable. 1.74 geingfi Policies. The government has implemented a variety of livelihood projects, food assistance and public employment programs to form a safety net under the poorest groups. It appears that these programs have reached their target beneficiaries much more effectively than did previous programs of integrated rural development. The poor have also developed complex networks of private transfers in response to unemployment, expenses associated with school-age children and the absence of retirement income. Thus, the effectiveness of public safety nets depends on whether they can complement private structures; the most vulnerable groups may not necessarily be the poorest, but those without the necessary support structures. 1.75 Target groups must be identified more consistently to reduce leakages in public spending on social services. Each anti-poverty program in the Philippines appears to use different definitions of eligibility. In slum community upgrading projects, the eligibility is sometimes related to housing ovwership rather than to income. For livelihood projects, the eligibility is defined in terms of an income threshold. In nutrition, program implementation is geared toward the bottom 30 percent of the population. For employment programs, the National Manpower and Youth Council and the Department of Labor and Employment target beneficiaries according to their occupation (rural workers, marginal fishermen, unemployed and underemployed). In education, different family income cutoffs are used for scholarships and other support. Subsidized interest on housing depends on the size of the loan rather than on the characteristics of the beneficiary. Energy pricing is differentiated on the basis of expenditure survey data to subsidize those products consumed directly by the poor. In short, the multitude of government programs all use different criteria for identifying target groups and defining eligibility. 1.76 One reason for the range of eligibility criteria may be thAt the official definition of the poor- -those whose income places them below a given poverty line-is inadequate for targeting purposes; clearly target criteria should be defined more narrowly. This report suggests that, at a minimum, a distinction should be drawn between four groups: * Those who are truly indigent by international standards, for whom price and income subsidies may be appropriate: the overall size of this group probably does not comprise more than 10 percent of individuals. * Those who would benefit from a more effective overall growth and development strategy, for whom increased access to capital and markets may be more valuable than income support. In most instances, the purpose of distinguishing this group is to identify high- return projects that would benefit them to the greatest extent, such as improvements in the quality of primary schooling and of rural roads. * Those who are at risk of deteriorating income due to natural resource degradation or natural calamity. * Those who are at risk in the presence of environmental pollution, infectious disease or other health hazards. - 21 - 1.77 The concept of targeting by risk factor rather than by income or some other identifiable characteristic should be considered in the Philippine context. Private transfers among househoMls are extremely well developed, and their size indicates that families have developed protective structures independent of the government. However, the pattern of transfers suggests that in reality they are within- family reallocations that are not captured properly in surveys that define households according to residence in a single unit. Educated but unemployed female-headed households are the largest transfer recipients. Analysis of data on transfers indicates the dangers of using household income as a targeting threshold for defining poverty. While many of the transfer recipient households are "poor" (in the sense that they have no visible sources of income) underlying family income is not being captured given the physical absence of the principal earner. 1.78 The analysis in this report also suggests that private transfers respond positively to the need for certain family expenses, such as those related to school-age children, unemployment and retirement. If public interventions atte- t to provide similar support to these "measured low-income" families, the likely result is that private transfers would simply decline. In this case, the government's money is not really benefiting the intended direct recipient, but the potential private donor. Statistics on the characteristics of donors indicate that they are much wealthier than the average household. Thus, because of private transfers, public income support based on income or on certain perceived problems of the poor could end up being misdirected to those receiving private transfers. The implication is that transfers targeted according to risk-that is, at those families with little network connections-would be more cost- effective in raising the living standards of the poorest groups in the country. 1.79 Identifying at-risk groups requires special data collection instruments that focus on specific population subgroups and the services that are most appropriate for them. For example, a special matching survey was fielded to yield the information necessary for linking parental education with dropout rates. The data supported identifying the group at greatest risk of being ill-served by the primary education system. Similarly, children aril lactating mothers have been found to be at greatest nutritional risk and can be treated through interventions that encompass outreach services at the barangay level. A "birth-based" service delivery framework is a promising avenue for implementing targeting effectively. As another example, the risk approach to targeting in urban areas must be accompanied by significant outreach and education programs. Investments in sanitation and solid-waste management and the establishment of designated sites for garbage disposal are required before the private sector and local communities can be mobilized. Establishing the scope of areas affected by given pollution sources is a precondition for linking program expenses with beneficiaries in a targeted way. Typically, doing so requires collecting detailed health information at.the barangay level. B. DevlopM Sta The Develoment ADDroach 1.80 One reason for the difficulty in generating sustained medium-term growth in the Philippines is that macroeconomic, business competitiveness and poverty issues are so closely linked that progress on all fronts must be made simultaneously. As argued earlier, the basic strategies of sound macroeconomic balances, policy neutrality in business incentives along with proactive promotional programs, and more social sector spending with significant reallocations to protect the poor are now in place, although room for improvement in these areas is still considerable. - 22 - 1.81 The East Asian characteristic of an export-led, labor-intensive developmental strategy provides the model for the Philippines. Although some have argued against this strategy on the grounds that most of the poor continue to live in rural areas, this argument is not a rationale for an alternative Philippine path to development. A high correlation exists in East Asia between export growth rates and the rate of reduction in rural poverty, and there is good reason to expect that the same phenomenon applies to the Philippines. Part of the reason is that in the Philippines, as elsewhere, rural incomes are well diversified. The concern that rural traditional handicrafts would be wiped out by modem, competitive industrial imports, thereby exacerbating rural poverty, has proved unfounded. Rural employment in agriculture has declined steadily over time, and thus rural income from manufacturing, trade and other nonfarm entrepreneurial activities and from nonagricultural wages has been growing. Given the limited potential for further productivity growth from staple agricultural crops, this process of rural diversification offers the best hope for reducing poverty. 1.82 Although the Philippines has previously enjoyed periods of rapid agricultural growth and has officially espoused the idea of rural-based industrialization, these business-induced developments have not had the desired effect at generating a structural transformation of the labor force, for several reasons. First, the presumption has been that the initial step must come from an increase in the productivity of existing occupations. Thus, public programs have been weighted heavily toward irrigation, research and extension and, more recently, land reform. The approach suggested here would emphasize the gains from encouraging a change in occupations. Occupational adjustments require more investment in human development to facilitate entry into new jobs, basic rural infrastructure such as farm-to-market roads to facilitate the introduction of new crops and products, and transport deregulation to integrate the domestic economy. Second, the presumption has been that rural nonfarm enterprises would evolve to serve rural domestic demand. In an open economy, this need not be true. Rural nonfarm enterprises have ample scope to serve both the urban and the export sectors. The labor force in rural areas is we!l educated, and, although infrastructure is lacking, it could be readily developed around peri-urban areas if the incentive structure were correct. Recently, with the reduction in trade and investment-related incentives biased toward large firms, regional growth poles have shown signs of dynamism that could become the engine for rural growth in surrounding areas. 1.83 The adjustment policies that would have the greate4t effect on alleviating poverty are those that would encourage a structural transformation of the labor force into wage-paying jobs and away from informal, low-productivity occupations. Implementing these policies would necessitate reducing the protection afforded to the manufacturing sector and opening the economy through aggressive trade and exchange-rate policy. In the short term, unskilled wages in manufacturing would likely decline, while rural wages would remain stable until surplus labor was absorbed. But eliminating the wedge that currently exists between rural and urban wages would provide a strong stimulus to developing small, labor-intensive rural nonfarm enterprises. The essence of the strategy is to create new permanent jobs, not to protect wages, meaning that successive Philippine administrations have put the cart before the horse. The Strategy for Growth 1.84 Previous Philippine growth strategy emphasized restoring macroeconomic balances, while getting incentives right. The expectation has been that private-sector investment, buoyed by a solid macroeconomic base, would lead to growth and indeed sustain it by efficiency gains developed through a close link between domestic and world prices. The actual experience of the past six years has shown how difficult it is to realize the gains from adjustment in an environment in which macroeconomic - 23- stability must be reinforctt. Currently, structural reforms, while ensuring market-clearing prices, have not yet translated into proper long-run prices that guide resource allocation, given the continued uncertainty of the macroeconomic environment. Thv- the government has been forced to implereent tight monetary policies with high interest rates and appr lated exchange rates. At the same time. wages have been legislated to levels above those required to clear markets. Only when macroeconomic conditions return to normal, which first and foremost requires greater revenue mobilization, will the proper incentives be in place. With stability in place, interest-rate reductions and, hence, exchange-rate depreciation will follow, allowing appropriate relative prices to evolve. Maintaining these incentives will be a major undertaking, requiring that structural reforms be extended to further areas-transport, energy, capital markets and wage setting-as planned, and also requiring that other reforms that have recently been proposed be implemented effectively. 1.85 Clearly, adjustment-or "getting the incentives right"-is a necessary condition for sustained growth, but one which is unlikely to be sufficient given the long history of disappointing performance in the Philippines. Restoring the confidence of investors and ensuring sustained growth will increasingly depend on three factors: investments, institutions and the effectiveness of implementation. These three elements are closely related: investments on a substantial scale will be justifiable only if the institutional capacity of public agencies and corporations to finance and undertake infrastructural improvements is developed, and only if the effectiveness of the public sector at implementing projects (necessary to mobilize foreign funds) can be improved. 1.86 Investments. The central issue associated with embarking on a new growth-oriented strategy is the speed with which public investments can be increased without jeopardizing macroeconomic stability or straining the institutional capacities of the agencies. Infrastructure needs are enormous, due in part to the low investments of the past decade. Growth cannot be sustained without expanding these investments. However, while these needs are immediate, the prospects for raising taxes or other public revenues at the same rate are small, particularly because certain tax rates (import tariffs and taxes on financial intermediation) must be brought down to reduce distortions in the system. Some savings can be realized by reducing and reallocating public expenditures in areas that do not increase growth directly, but again the prospects for immediate savings from such measures are not favorable. Thus, the consolidated public-sector deficit must be allowed to increase temporarily; yet, at the same time, not all expenditures that are deemed desirable can be implemented in the medium term. Phasing and prioritization are essential. 1.87 A moderate, temporary increase in the public-sector deficit will not generate domestic financial instability as long as the funds are being used efficiently for high-return investment; the deficit is financed with loans from abroad; and a credible plan of tax and revenue mobilization and expenditure control is in place to ensure that the deficit will be brought back down to long-run sustainable levels when the pent-up demand for infrastructure has been met. These elements are included in the strategy outlined in the report. 1.88 The macroeconomic consequences for interest and exchange rates depend on the overall performance of the public sector. However, the efficiency of investment depends critically on how the deficit is apportioned between the national and local governments and key agencies. To date, the government has had to bear the burden of maintaining an adequate macroeconomic framework by reducing its expenditures whenever other agencies overshot; but it has done so at the expense of key activities. Broadening the base of resource mobilization to include entities other than the government will - 24 - be a prerequisite for success. As in other ASE *N countries, public monopolies must contribute to the national budget, not be a drain on it. 1.89 The report envisages a macroeconomic scenario for growth that would permit a recovery in GDP growth to around 5 to 6 percent a year, or over 3 percent in per capita terms; maintain inflation at single-digit levels; reduce the incidence of poverty in half over a decade; bring down public-debt/GDP ratio from 0.8 to 0.7 over six years; increase public investment by 2 percentage points, to an average 6.5 percent of GNP; increase the share of exports and imports in GDP from 25 and 30 percent to 30 and 35 percent, respectively, by 1997, implying a growth of 6 percent a year in each; support a depreciation of the real exchange rate by about 4 percent a year over the next five years; reduce real interest rates to about 6 percent; and allow international reserves to be built up to three months of imports, or by over $6 billion by 1997. Unlike previous expansions, which were cut short by balance-of-payment constraints, the projected scenario should be sustainable because a large part of new investment will be undertaken by the private sector with pre-identified financing-such as build-operate-transfer. Thus, current account deficits will be offset by matching equity and loan inflows. 1.90 Institutions. The pace of institutional reform in the Philippines has not kept up with the structural reform program, and institutional weaknesses in four key areas still must be addressed. First, given the tightness of the public finance constraint, institutions must become part of the resource mobilization effort of the public sector and be given a financial structure on which true operational autonomy can be based. Second, they must also be made more accountable for internal efficiency. Third, they must accommodate the growing need for a public/private partnership across the board. Fourth, they must be oriented toward export promotion. 1.91 Public institutions in the Philippines have long required periodic financial rescue by the government. The rehabilitation of the public financial institutions is one success of the Aquino administration. But these reforms left the central bank untouched. The central bank deficits, brought about by quasi-fiscal activities undertaken during the Marcos era, have been compounded over time by interest due on debts. For the most part, the potential inflationary consequences of the central bank have been averted by various types of noninflationary financing: blocked accounts; peso payments received on restructured foreign obligations from the government, corporations and private companies in exchange for the assumption of liability for the rescheduled amounts; the issuance of interest-bearing central bank bills; and the expansion of interest-free government deposits. However, all of these measures are temporary, and rely on close cooperation between the Treasury and the central bank for the daily conduct of monetary policy. This management reduces the operational independence of the central bank and is institutionally unstable. Restructuring the central bank to permit it to restore its financial viability is a priority which, from the standpoint of aggregate public finances, is costless, even though it would add to the national government deficit. 1.92 Many of the public nonfinancial institutions also remain in financial distress, with high debt levels and little equity, causing periodic deficits. Net of subsidies, the financial performance of the 14 monitored corporations has only improved slightly; deficit reduction has occurred in the face of falling capital expenditures and falling revenue as a percent of GDP. Among the largest public enterprises, financial restructuring and workout plans for the National Power Corporation, the Local Water Utilities Authority, the National Electricity Authority, the National Irrigation Authority, the National Home Mortgage Finance Corporation and the National Housing Authority must be implemented immediately. - 25 - 1.93 The financial deficits of corporations are closely linked to their internal inefficiencies. The government has set up a Performance Evaluation and Incentive System (PEIS) to track both financial and operational indicators. Yet, although this system has been extended to 34 corporations providing a renewed focus on productivity and cost considerations which had previously been ignored, it has yet to produce a dramatic turnaround in public enterprise performance, the rate of success at meeting performance criteria has rarely exceeded 50 percent. The PEIS would be more effective if it formed the basis of an incentive system to reward public enterprise managers, and if it led directly to a greater "corporatization" of public companies in which managers would have greater operational flexibility to develop the services they provide. To do so, managers must develop corp-rate plans and public accountability principles. They must also have the freedom to adjust fees, and explicitly charge any noneconomic services provided for social reasons to the budget, so that they can be evaluated against other public transfer mechanisms. Last, managers require greater control over operational matters, including wages and employment, the use of consulting services and bidding procedures. Thus, corporations with established track records in meeting PEIS targets should be exempted from the Public Services Act. 1.94 Developing an effective public/private partnership requires reformulating the roles of public institutions. In particular, public regulatory authority should be established to provide clear "rules of the game" to govern both public and private agencies. The regulator cannot also be an implementing agency, as is the case with the National Power Corporation, when it negotiates build-operate-transfer contracts; the Local Water Utilities Authority, which both functions as a regulatory agency and designs, constructs and finances complete water system improvements, tha* are then turned over to Water Districts for operation and repayment; and the Philippine Port Authority which, in meeting revenue objectives, capacity utilization for its own-administered ports, price setting and entry restrictions, has few incentives to promote private-service improvements. 1.95 As deregulation extends into new areas with fewer market participants, the regulatory framework must be prepared to handle monopoly issues. Existing laws on monopoly and unfair competition fail to provide easily enforceable definitions of prohibited actions, and the prosecution of monopoly practices under these laws has been a low priority. Comprehensive legislation to prohibit price fixing, market division and boycott agreements must be enacted and enforced by a strong central anti-trust agency. 1.96 Imolemenion. Despite the mobilization of significant pledges of foreign assistanco, the Philippines has yet to be able to translate these pledges effectively into actual project investments. To some extent, this implementation weakness has been systemic; weak institutional capacity, delays in obtaining agreement within government and the lack of counterpart fundsMIF are commonly cited. But such explanations do not provide the complete story. For example, in the aftermath of the Gulf Crisis, many donors reduced counterpart funding requirements and yet saw no visible improvements in project performance. The National Economic and Development Authority has now established a disbursement monitoring unit to troubleshoot problematic, long-delayed projects. A remaining priority is to improve audit and accounting functions (as recommended in the draft Omnibus Accountability Code for Government Assets, Liabilities and Equity), which would seek to streamline the review of contracts, the Counterpart funds are not the real issue. The problem is the tightness in Government expenditures required to bring debt down to manageable levels. .26 - inspection and appraisal of infrastructure projecL. the checking of materials pricing and the countersigning of disbursement checks. 1.97 While the government has undertaken many reforms successfully to improve the effectiveness with which projects are implemented, the adoption of the Local Government Code provides both opportunities and risks for further gains. Technical capabilities among local government units vary greatly; many municipalities have few technical personnel and limited experience in tendering or supervising contracts. Planning and administrative capacities are also lacking. With devolution, expenditures, personnel and revenues are expected to double, placing a considerable burden on local administrative structures. 1.98 The effectiveness of the public sector will be measured in terms of six indicators: * The ability to forge a close working relationship among different arms of the government, to develop strategies for sustainable growth that govern short-, medium- and long-term issues in macroeconomic control, infrastructure management, poverty alleviation, environmental degradation, and population growth, and to convert these elements into specific action programs by adopting priority legislation. * The time taken for implementing projects and programs from their approval to their completion. * The degree to which the tax effort can be improved through greater collection efficiency. * The speed of response to external shocks and natural disasters. * The ability to develop and maintain satisfactory monetary targets. * The internal efficiency of the public corporations and government departments. 1.99 Improvements in all these areas will enable the country to develop a reputation for consistent economic policy management and overcome international perceptions of the Philippines as a reform laggard. Building a Coqn us 1.100 Many voices have advocated a market-friendly approach to development in the Philippines, but the national commitment to any specific approach has often been questioned. This cannot be ascribed solely to the costs of an open democratic system, as some would have it. In the Philippines, "people empowerment" through public hearings and other mechanisms is a strong force behind legitimizing reform measures. The "two steps forward, one step back" characterization of policy-making stems instead from differences among narrowly based interest groups. However, reforms have been undertaken in the face of vigorous opposition. The debt strategy, trade liberalization and the privatization of profitable assets have all been questioned by selected interest groups.1' The Medium-Term -' Address by Secretary of Finance, J. P. Estanislao to the March 1992 Consultative Group meeting. -27 - Development Plan must provide a vision of broad-based economic growth and a sense of how the national and local governments, public and private corporations, NGOs and community groups must all contribute to a national partnership. 1.101 Building a consensus will be more difficult because it must occur in an environment of tight public resources. Tax increases and the prioritization of public expenditures are never popular. One approach is to consider earmarking specific funds for associated expenditures. While some conceptual appeal is associated with the idea that earrnrking can facilitate political agreement on increasing both revenue and expenditures, and can protect high-priority programs from shifts in political priorities, the experience in other countries is that earmarking has not worked very well.2 In practice, if the political support does not exist for a program, governments have found ways to tap into earmarked funds. And the danger of over- or underspending on general programs (such as fuel taxes financing highway expenditures) is significant when the levels of revenue and of spending have no direct relationship. However, earmarking has worked more effectively at a municipal level, where beneficiaries from a discrete spending program (such as a road improvement) can clearly be identified, and where cost-benefit considerations allow the taxes that are paid to be tailored to the benefits that are received. In such cases, a specific cut-off date for the taxes also exists when the spending program is fully implemented. 1.102 One theme for which unanimity has been reached, if not a strategy articulated, is the alleviation of poverty. Poverty reduction must be treated as a vital component of a growth strategy. It can no longer be treated as an isolated phenomenon, affecting a group called the poor, while leaving untouched the group called the noopoor. Without anti-poverty measures, medium-term development in the Philippines will be unsuccessful, and without medium-term development a reduction in poverty will not occur. This link occurs through several channels. First, on a purely social level, implementing a consistent set of policies within which growth can prosper will be difficult unless all groups benefit from development. The prospect of backtracking under pressure from some disadvantaged group will always be present. Second, the poor are increasingly affecting the capacity of metropolitan Manila to deliver the normal advantages of urbanization and agglomeration that typically accompany development. By tapping into public utilities, slum dwellers are constraining the financial and technical capacity of urban utilities to deliver services. By contributing to waste, the poor are affecting the overall quality of air and water. The nonpoor are no longer protected from these effects, and indeed some of the worst air pollution exists in the wealthiest parts of metropolitan Manila. Third, the ability to attract foreign direct investment also increases as the general level of education of the poor rises, increasing productivity and reducing the potential for civil disorder and insecurity. 1.103 The poor are often called upon for sacrifice in the name of overall economic growth. A clear case in point is the tradeoff between environmental protection and energy or other industrial development. Without a linkage between those who benefit and those who are hurt, public hearings on environmental assessments have no built-in procedures to arrive at a socially acceptable solution. The present system is acrimonious and time-consuming, with the costs of decision-making so high that they outweigh the potential benefits of progress. ' See William McCleary, The Earmarking of Government Revenue: A Review of Some World Bank Experience," The World Bank Research Observer, vol. 6, no. 1, January 1991. - 28 - Principal Obstacles and Risks 1.104 Implementing the policy package delineated in this chapter will not be easy. Economic pol*.;iaki-!z in the Philippines is a hotly contested public issue, and success will d pend on whether the debate is depoliticized and on whether a more technocratic approach to economic discussions is adopted. External debt, energy pricing, wage setting, agricultural reform (including corn pricing and the Comprehensive Agrarian Reform Program), environmental assessments, and even foreign investment location and banking supervision have been areas of judicial and legislative challenge. As the reform process strips interest groups of legal protection and as the opportunity for exploiting economic rents is reduced by competition, the pressure to use other tactics for narrow economic advantage will mount. 1.105 The public at large still perceives graft and corruption as the number one economic problem facing the country.2 The support generated by anticorruption candidates in the general elections is further testament to the degree of this problem. Smuggling to evade tariffs and tax evasion are also prevalent; moreover, apprehensions reach only 2 to 4 percent of the total estimated value of smuggled goods. Such corruption and illegality have a strong influence on the investment climate, the ability to attract foreign investors (except in joint ventures with local partners), and the efficiency of competitive markets, and must be dealt with severely in order to support sustainable recovery. 1.106 As budgetary pressures mount, nonbudgetary solutions to problems may be adopted as expedient measures. In the Philippines, the amount of contingent liabilities being incurred by the government to limit using its own resources at the current moment is growing rapidly. Among the largest of these liabilities are social security obligations, debts incurred for implementing land reformw and privatization contracts in energy. The on-lending of Official Development Assistance (ODA) to private- sector implementing agencies, or the relaxation of the Foreign Borrowing Act to permit direct lending to private companies with government guarantees, is another example of expanding contingent liabilities. These must be carefully controlled, else the public sector will be unable to place its finances on a sustainable basis and the economy will continue to be subjected to macroeconomic shocks. 1.107 The other avenue for bypassing the limits on public funds is to pass legislation to force the private sector to perform "socially useful" activities. The new Urban Development and Housing Act would encourage developers to set aside a portion of each subdivision (20 percent of the area or cost) for socialized housing as a condition for obtaining zoning permission to proceed with development. Another recent law establishes fixed proportions of credits that banks must make to small and medium enterprises; the agri-agra law already has similar requirements for agricultural loans. As compensation, such laws often incorporate tax breaks or other future financial benefits to reduce the immediate financial burden on the private sector. However, the major effect is to introduce distortions into the system that work against the poor. As indicated by the experience of Kalakalan 20, the poor benefit most from an environment free from government regulations, not from one in which additional regulations are introduced, even when they are purportedly in their interests. Poverty reduction cannot be mandated by the government, and is best addressed through growth, not through regulation. 1 As indicated by surveys of voters undertaken by Social Weather Stations. -01 Although land reform also involves offsetting assets-in the form of loans to beneficiary farmers- the ability and willingness to collect on these loans, especially in poor economic times, has yet been tested. * 29 - II. INTRODUCTION: STRUCTURAL CONNECTIONS IN ECONOMIC POLICY REFORMS 2.1 In the early 1980s, the economic problems of the Philippines could be characterized as a seamless web connecting three nodes: macroeconomic balances, industrial competitiveness, and household poverty. As shown in Figure 2.1, none of these nodes can be independently described as the root cause of Philippine economic problems because they are closely linked. Macroeconomic problems prevented the government from spending on social services amounts that could significantly have alleviated poverty and helped to create a middle class. Without the emergence of a middle class, the size of the domestic market remained small, and businesses were unable to achieve minimum efficient scale or take advantage of shifts in the pattern of demand that higher income levels could have brought. Hence, there was little spending on research and development to develop new products and processes and there was little productivity growth. Instead, formal industry sought to buttress its position through various tactics to restrict new entrants-capital-intensive plants and captive marketing and financial channels. Industry also looked to the government to provide subsidies and tax breaks as well as protection against imports and foreign investors, thus reinforcing fiscal problems. 2.2 Feedback was also generated in the other direction. Fiscal problems were reflected in reduced infrastructure spending and in high rates of interest on bank loans (because of high public borrowing and taxation of financial intermediation). They were also reflected in appreciated real exchange rates as the government strove to minimize the costs of its external debt service burden. These characteristics hurt business and encouraged it to turn inward to the domestic market and to rely on internal revenue generation for expansion. As a consequence, few formal sector jobs were created and the internal terms of trade were shifted away from the tradable agricultural sector toward a protected manufacturing sector. Both of these developments impinged on the poor, who received less for their primary products and who were forced into self-employed, low-skill informal sector jobs. With mounting poverty, the scope for more direct and indirect taxes shrank, amid increasing demands for more social services and provision of a safety net. Meanwhile, the public sector's ability to extract rents from the country's diminishing natural resource base was also reduced. 2.3 Because different components of policymaking are so closely intertwined, it is difficult to coordinate, sequence, and phase all the elements in an optimal fashion. Policymaking in the Philippines over the past few years has accordingly had stop-go phases when one area or the other appeared to be falling behind and in need of special attention. Agrarian reform and antipoverty programs, tax reform and macroeconomic stabilization, and trade reform and competitiveness building have each moved cyclically from policy limelight to the shadows. While it is perhaps inevitable that implementation of a complex package of measures is uneven, it is also the case that consistency is necessary for effective policy implementation. ' In a recent pamphlet (Krugman and others, Transfomin the Phii EAmy. NEDA/UNDP, June 1992), Krugman gives the example of car manufacturing: in 1988, two producers sold 10,800 vehicles. In Malaysia, an economy of similar aggregate size as the Philippines, the prevalence of a middle class allows the main producer (Proton) to sell up to 80,000 vehicles annually during good years. Figure 2.1: Linkages Among the Philippines' Economic Structures Macroeconomic Imbalance . Fiscal Deflcit . High Debt . Periodic Payment Crisle . Fractious Government . High Wages " Lo TaxBassSocial Services .Low Tax Base . Low Spending on . Deaad for Subsldies SlowoLand eriob and Protection . Slow Land Reform . Low Export and High import . Low Depost Rat Input Requirements . Minimum Wage Law .L Income and . Poor Inastr tre Indir at Tax Base . High Inter Rates . Dem for Safety Net and and Spree n Anti-P erty Program . Uncompe Iv Exchange Rate . Natural soure Overexploitation Uncompetitive industry Growing Poverty u n c mp tit ive In d s tryo m High Poverty incidence . Capital abalance . Low Formal Employment Growth. Deteriorating Environment . No TFP Growth . Anti AgrlouRture Blue. Urban Poverty . Low Oually No Middle Clas . Low Expert Growth Rising Unemployment . OlgaoPistle Falling Skel . Large inbermal Sector * . Low Skills Investment . Low Financl Savinge . nelder Protection of Workforce . Small Domestic Market -31 - 2.4 To be fair, the task of attempting structural adjustment and macroeconomic stabilization at the same time is daunting. Many structural reform efforts, such as tariff reduction, exchange rate liberalization, and tax reform, can have negative short-run effects on the budget. Indeed, the vulnerability of the budget, both to the effects of structural reform and to external shocks, has been one of the central problems dictating the speed of reform. For example, in 1983 there was a reversal in the . trend toward trade liberalization as a result of the debt crisis, which left a large unfinanced gap in the fiscal accounts, thus necessitating the imposition of an across-the-board import levy. More recently, an import levy was again imposed in February 1991, further increasing trade protection. But such examples of backtracking are few and are imposed only for preannounced limited periods. 2.5 The more general difficulty, then, has not been one of backtracking but of slowness in implementation. Tax reform and agrarian reform have been far slower than announced. The schedule for trade liberalization has been drawn out over a much longer period than anticipated. Energy pricing mechanisms remain under study; and increases in administered prices in response to international price changes are tortuous and, recently, were delayed so long as to create large subsidies with serious macroeconomic consequences. In each case, interest groups committed to the announced plan of action have been disappointed. Similarly, the government has always presented rosy outlooks on the economy, even when it was clear that a period of austerity was inevitable as in 1986 and 1991. More than anything, this cycle, in which expectations are raised by initial pronouncements of government intentions, and then dashed by actual results, is responsible for a lack of confidence in the economy and for a pervasive atmosphere of uncertainty. Because of continued uncertainty, the behavior of firms and households and their expectations about the future-particularly with regard to investment and savings- have been slow to change, increasing the difficulty of the adjustment task. Turning around the wait-and- see attitude of investors and reducing the peso/U.S. dollar risk premium on borrowing are two major tasks facing the Ramos administration. 2.6 In addition to the content of the policy reform process, the perception of progress is important, especially in attracting foreign investment.A The Philippines was one of the first developing countries to enter into formal structural adjustment programs and has significant accomplishments to show for its efforts. When compared with two widely acknowledged successes, Indonesia and Mexico, the speed and depth of reform in the Philippines along key dimensions has been very similar if not superior. Yet the overall perception of progress is unquestionably much lower. 2.7 The principal task of adjustment and stabilization has been to develop a policy package where actions in different areas reinforce each other. This has been complicated by the fact that the need for constant crisis management in the Philippines has often required unpleasant measures to improve the immediate situation-measures that rim counter to longer-term objectives of growth. The recently removed import levy is an example of such a policy measure, which, although it resolved fiscal problems for a year, constrained growth and hence future fiscal revenues. Reduction in maintenance and investment expenditures is another example. It is evident that such measures cannot be sustained The Philippines may also suffer from unrealistic expectations, which, when not met, produce disappointment. Mexico, which is widely perceived as a star performer, has had a growth of only 0.1 percent in manufacturing industries since 1987, and labor-intensive industries have recorded net losses in output and employment. But Mexican exports have soared, providing the balance of payments financing for significant expansion in no m fa sectors of the economy. - 32 - indefinitely, and in any analysis it is critically important to go beyond the aggregate numbers and focus on the quality of the adjustment effort. 2.8 The remainder of this report is divided into three parts, each corresponding to one of the areas identified in Figure 2.1, although it must be stressed that these are closely related to each other. Part I deals with macroeconomic issues. It traces historical developments and, using a model developed for this purpose, attempts to provide a quantitative picture of the principal macroeconomic tradeoffs facing the country. Specifically, the links between growth, deficits, interest and exchange rates, and public investment are quantified in both the short and medium run. The key questions addressed by this part of the report deal with the growth strategy and the public sector's role in bringing this about. Issues such as whether business is better served by more taxes to bring down the deficit, reductions in distortionary taxes, or more taxes coupled with infrastructure spending are addressed. The tradeoff between high domestic interest rates to control inflation versus a depreciated peso to boost exports is also reviewed. 2.9 Part U describes the real economy, relating its performance to structural policies *nd the overall business environment. It touches on prospects and constraints in each of the major sectors of the economy. A significant analytical innovation in this section is the detailed analysis of efficiency and firm size. These are related to broader themes having to do with competitiveness in Philippine industry. Competitiveness has been lacking, partly because of protection from abroad and partly because of an industrial structure with heavy concentration among the largest firms, a preponderance of small firms, and very few medium-size firms. This "missing middle," however, has been showing signs of responding to the opening of the economy to foreign competition. The analysis sheds light on the degree to which the private sector can respond to government changes in the incentive structure and looks at what complementary policies might be needed. 2.10 Part M reviews the effects of growth and adjustment policies on households and on poverty. It focuses on methodologies for measuring poverty, as these data are of concern to policymakers and have far-reaching impact, yet are not well understood. Some apparent anomalies arise: poverty reduction in the Philippines has been accomplished despite stagnant or negative per capita household income growth, and despite a fall in real wages for unskilled industrial workers. The report lays some stress on the prevalence of private transfers, which have become an important source of income for the urban poor in particular, and on the implications of such networks for public policymaking. The last chapter of the report analyzes the distributional effects of public taxes and expenditures. It introduces a general equilibrium methodology to assess incidence and finds that this refinement points to a substantive difference to the general perception that the tax burden in the Philippines is unequal. It also shows that the way public money is spent is the most important determinant of whether the growth strategy pursued is also consistent with reducing poverty. THE PIUFINFS.: AN OPENING FOR SUSTAINED GROWTH PART I: Growth with Staxation and Struckual Reform: Macreeconomile Perforaance and Prospects - 33 - III. GROWTH AND CONSTRINTS TOQ gROWTH: FOREIGN EXCHANGE AVAILABILITY AND PUBLIC SECTOR FINANCES 3.1 Several times in the past (1962. 1970, 1983) and again in 1990, periods of relatively high growth have come to an abrupt stop because of a foreign exchange constraint. This point has long been recognized in the Philippines: "the record has shown that as long as the foreign financing constraint is not set too low, the Philippine economy can manage to exhibit growth, but little in the way of strengthening the capability of the economy to withstand international shocks."' 3.2 To design the strategy for future growth, it is crucial to establish whether the structural reforms of the 1980s have succeeded in overcoming this foreign exchange constraint. If foreign exchange available to finance imports is generated largely by primary exports, the growth rate will be determined by international demand; an appropriate strategy would rely on promoting import substitution and developing nonprimary exports while borrowing internationally to relieve the balance of payments constraint. This view appears to be shared by several observers of the Philippine economy, but is only one part of the explanation for sluggish growth over the 1980s. 3.3 The analysis in this chapter suggests that measures aimed at promoting the development of a modem export sector and the structural reforms aimed at reducing the high import elasticity of domestic supply have succeeded in relaxing the foreign exchange constraint that has limited growth potential in the Philippines in the 1960s and 1970s. On the export side, manufactured goods exports and service exports- -most importantly remittances of contract workers-have far outpaced primary exports and continue to grow. On the import side, the excessive import elasticities of domestic production Lve been reduced by trade and financial liberalization, a more flexible exchange rate management, and privatization of the public corporate sector. This conclusion has important implications for policymaking: the emphasis should be on maintaining a macroeconomic framework supportive of growth, not on targeting industrial policy interventions to specific sectors. Such a supportive framework should include relative prices free from distortions, an exchange rate policy responsive to international competitiveness concerns, and a macroeconomic program consistent with maintaining inflation and interest rates at levels not too far from those prevailing in international markets. 3.4 The removal of the foreign exchange constraint can set the stage for the resumption of growth and ensure its sustainability %aly if consistent macroeconomic policies are in place. The history of the Philippine economy clearly indicates that several attempts at structural reforms have been abandoned and even reversed when they have resulted in balance of payments crises because of inadequate m- c management. Recent history also shows that stabilization-managing the balance of paymenots-and structural reform-relaxing the constraints on growth-are mutually reinforcing, but episodes of unsuccessful stabilization threaten the progress of reform. These experiences illuminate the importance of policy consistency in shaping expectations: a long track record of slippage contributes If Montes, M.F., "The Possibilities of Sustainable Growth in the Philippines: A Three Gap Analysis" (1989), unpublished. Z Cf. for instance Krugman and others, Trnsminm the Philionine EnmMX. NEDAIUNDP, June 1992. - 34 - to destabilizing behavior because of anticipation of policy reversals and makes stabilization efforts more difficult by exacerbating the business cycle. 3.5 The conclusion that the foreign exchange constraint has been overcome and that the Philippines is now ready to recover the ground lost relative to its neighbors has to be tempered with the recognition that a new constraint to growth, which emerged in the 1980s, remains to be dealt with. Financing rapid import-intensive growth in the 1970s in spite of limited export revenues led to overborrowing by the public sector, and lack of adequate management of public expenditure and lending led to little lasting benefits from the debt accumulated in that period. Insufficient fiscal adjustment in the aftermath of the international debt crisis transformed external debt into domestic debt and only recently has progress been made in stabilizing the burden of public debt. As a result, a large share of public sector resources continues to be absorbed by debt service, and fiscal balances continue to be vulnerable to shocks in interest and exchange rates. 3.6 The analysis below indicates that although tax reform, privatization, and effective debt management have helped relax the public finance constraint on growth, the Philippine economy will have to continue to live with it for a long time. A strategy to manage fiscal adjustment consistent with growth and inflation objectives is elaborated in Chapter IV. The main conclusion to be stressed here is that a growth-oriented strategy can only be afforded if public debt can be reduced to a sustainable level. A. Growdunder.EMM E&ca= Constraiars 3.7 During the 1950s and 1960s, the Philippines enjoyed high but variable growth, limited by foreign exchange receipts obtained largely from commodity exports. Commodity booms led to periods of very high growth, accompanied by import surges, foreign exchange crises, and deceleration of growth. The high correlation between growth in commodity exports and growth of GDP and the high income elasticity of imports drove these cycles throughout the period. 3.8 The recognition that new sources of growth were needed led in the early 1960s to an experiment of trade liberalization, soon abandoned in favortof quantitative import restrictions and selective tax and tariff exemptions. By the early 1970s, a system characterized by a separate productive area-one with few or no trade barriers and price distortions, where nontraditional exports could grow successfully-had been established. 3.9 Substantial progress was made during the 1970s in developing a modern export sector. In spite of this important step toward relaxing the foreign exchange constraint on growth, high elasticities of imports with respect to domestic production were reinforced by the maintenance of an overvalued exchange rate throughout the 1970s, which amounted to a subsidy to imports and thus biased the allocation of investment toward the nontraded sector. Unlike the previous period, however, in the 1970s growth could be sustained-despite widening current account deficits-through extensive external borrowing. 1950-70 Dependence on Primary Commodities 3.10 Immediately after independence in 1946, the Philippines experienced a short period of high growth rates and declining prices, brought about by the availability of large subsidies in the form of funds - 35 - for reconstructionl' and the maintenance of the prewar parity of the peso with the U.S. dollar. This short period came to an end with the drop of foreign exchange reserves in December 1949, when the peso/S rate was devalued to 2 and extensive import and foreign currency constraints were introduced. 3.11 This episode resembled in many aspects several external payments crises that followed. Short periods of high growth rates were accompanied by surges in imports, depletion of foreign currency reserves, large depreciations of the exchange rate, and the arrest of growth. Figure 3.1 shows the correlation between the level of gross international reserves of the central bank-expressed in months of imports-and the growth rate of real GDP since 1950. 3.12 This correlation, for the period 1950-70, arose from the dependence on primary commodity exports as the preponderant source of foreign exchange revenues. Coconut, sugar, logs, and copper accounted for about 70 percent of current account receipts. The highly restrictive trade and foreign exchange regime established after the 1949 crisisV, V was meant to protect foreign exchange reserves by providing a high degree of protection for the domestic market of manufactured consumer goods. 3.13 The consequences of this regime were that growth potential was limited by the low income elasticity of primary commodities in world markets and was highly sensitive to international price shocks. Figure 3.2 shows both the declining trend in ODP growth (between 1950 and 1970), and the strong correlation between the price of the two most important commodity exports-coconut oil and sugar-and growth. The growth rate of GDP averaged 6.3 percent for the period 1950-60, and declined to 4.5 percent during 1960-70. ' The Philippine Rehabilitation Act of 1946 provided for payment by the United States to the Philippine government of $620 million for war damages. Cf. G.M. Jurado, "Foreign Trade and External Debt," in J. Encarnacion and others, ftftiaDEnrnicrem s inM (University of the Philippines, School of Economics, 1976), p.275. Inflows of foreign exchange during the 1946-49 period however are estimated as high as $2 billion by A.A. Castro-G.M. Jurado-R.S. Mariano, "The Philippines," in S. Ichimura (ed.). The Economic De M t of South and Southet (University Press of Hawaii, 1975), p.181. V Restrictions on imports of luxury and nonessential goods were introduced for one year in January 1949 and then extended for four months; in May 1950 the Import Control Administration was created to allot import quotas (with preferential treatment given to Filipino-majority enterprises); the Import Control Commission was created in its place in 1951, following evidence of corruption; after presidential elections in 1953, import restrictions were administered through the central bank's control over foreign exchange. Cf. J.H. Power-G.P. Sicat, Tle Phili (Oxford University Press, 1971), pp.8889. F In addition to the introduction of a restrictive trade regime, over-reliance on primary commodity exports was encouraged by the prohibition agains export taxes and the maintenance of the prewar exchange rate with the U.S. dollar. The former policy-in force between 1946 and 1956 under the Philippine Trade Act of 1946-generated a strong bias in particular toward the sugar sector, which also enjoyed high export prices to the United States. Concerning the latter policy, to quote Power-Sicat (1971, p.31), "rapid reconstruction ... under a more realistic exchange rate ... would have redirected consumption to investment and set Philippine industrial growth on a more promising path." 刈はd上． Orカ皿Fwt. 加編－100 ・1馴一国， ら 田． いか， .37- 3.14 Concerns over the deceleration of growth and the gradual removal of tariff preferences with the United States-01 led to a reconsideration of the trade and foreign currency regime. In 1957 a tariff law was enacted, and quantitative controls were phased out between 1960 and 1962. No adjusunent of the exchange rate took place until capital outflows led to a steep decline of gross international reserves, in January 1962. As a new administration came into office, the exchange rate was allowed to float, resulting in a devaluation of the peso fkom a rate of 2 to 3.9 with the U.S. dollar. 3.15 This early attempt at trade liberalization had very limited implications for the development of the nontraditional export sector. The elimination of quantitative restrictions and the introduction of tariffs did not reduce effiective protection and did not lessen the bus toward import substitution and against exports and backward lWage in --f- - ---ing. Neither the structure nor the It-urel of effective protection changed substantially as a result of the changes in the trade regime: the average tariff rate for goods incmased from 46.2 to 50.8 percent, and consumption goods remained the most protected within the manufactured sector.21 As a result, as shown by Figures 3.3 and 3.4, connodity exports continued to be the main source of foreign exchange. aW the performance of exports did not show any substantial reaction to these policy changes. 3.16 Just as the elimination of import restrictions did not substantially change the bias of the trade system the devaluation of the peso in 1962 did not substamiafty change the exchange rate regime. First, the devaluation was accompanied by the introduction of a two-tier system. in which the "offlcial* exchange rate remained at two pesos per U.S. dolW until November 1965, while the *unofficial* me fluctuated around P3.9. The transactions subject to surrender at the official exchange rate-most notably, the conversion of 20 percent of export rewenues-were thus efttively taxedY Second, the timing of the devaluation-not accompanying trade liberalization but rather following a crisis-apin confirmed that the maintenance of a fixed exchange me was a policy objective independent of trade policy ns and subject only to the coma-aim imposed by the level of foreign currency reserves. 3.17 Toward the and of the 19ft, it beam apparent that neither the changes in the trade regime nor the devaluation of 1962 had succeeded in overcoming the domestic market bias of the industrial structure or in stimulating nomraditional exports. Lack of supply response by the f Miring sector led to a reconsideration of policies in the latter half of the 1960s. The new strategy aimed at stimulating industrial growth-in exports in parficular-dwou& incentive V The Philippine Trade Act of 1946 provided for eight years of free trade between the United States and the Philippines, to be followed by gradual removal of the preferential tariff system during the following twenty years. Cf. Power-Sicat (1971). p.31. Mie Laurel-Langley Agreement of 1956 spelled out this transition. a. Power-Sicat (1971), p.93. Cf. Power-Sicat (1971), p.93. Cf. Power-Sicat (1971), p.92. 奉二。， 寫「一不不森方不1軾「一一兀疋彎－刁 糾。計u上廷綺l實霆―。。神··土至華―! 耳―m藝l}-―荊震――症―薑11-―甲 暴―-i-，】＼-―江鳥――莖―日1\-―變 ‘〕i！際．：〕〕｛‘〕i!―狗〕〕〕’ 匕生旦〔’墜生呈少 .39- policiaY Although the establishment of incentives for selected industries dated back 10 1946, it was during 1%7-70 that a widespread regime of investment and export WCOOtives was established. While dim are questions about the effects of these incentives on capital intensity bin and allocauve efficiency within the industrial sector, they resulted in substantially lower tax rates and import tariffs for exports and selected sectors and set the stage for their rapid growth in the 1970s. 3.18 The combination of selective tariff exemptions and investment incentives. on the out band. and the fiscal and monetary expansion accompanying the presidential election of 1969, on the other. led to a sharp deterioration of the current account balance. This resulted mostly from the rise of imports-m particular of capital goods and raw materials-while exports failed to keep pace. The current account deficit was in part financed by a rise in capital inflows, reflected in an increase of external debt from $0.5 billion to $2.3 billion between 1965 and 1970. Thm inflows, however, were insufficient to avoid substantial stress on intemational reserves.2 3.19 As in the previous experiment with trade liberalization. the exchange rate was w.. allowed to depreciate in response to the change in the policy regime- Mw central bank tried to stem the decline of international reserves by imposing restrictions on foreignt mmwy transactions Md imports. In February 1970, as foreip exchange losses became unsustainable, the exchange rue was allowed to float and, by the end of the yen. reachW P 6.4 per U.S. dollar. a devaluation of about 65 Percent. As in 1962, the crisis of 1970 was WOW by inconsistency between =6 policy and exchange rate management leading to an overvguation of the exchange rue. loss of international reserves, and a large step devaluatiaL The chronology of incentives laws, from 1946 to 1970, iticludes: Republic Act 35 of 1946 (grantin the exemption of new and necessary industries from the payment of MtMW revenues taxes for the first four years of operation); Republic Act 901 of 1953 (granting the memption of now and messary industries fim payment of all am, that is, internal revenue taxes as well as import duties. until December 1958, with transitory provisions thmafter); Republic Act 3127 (Basic Industries Act) of 1961 (panting the exemption of basic, instead of new, Wdustries ftm payment of import-related taxes); Republic Act 5186 (Investment Incentives Act) of 1967 Wanting the exemption of pioneer or preferred mdustries from tam, provision of Witional tariff protection. specW tax credits and deductions from taxable income, admWuered by the Board of Investments); Republic Act 5455 of 1968 (setting the legislative framework for foreign investment); and Republic Act 6135 (Export Incentives Act) of 1970 1 - . - the exemption of Wort-onented enterprises fim payment of export taxes and import duties on imported capital goods and inputs. the reduction of income taxes; and the provision of tax cnft)- Cf. Power-Sicat (1971) and JmvAo (1976). 1W The service balance also deteriorated beginning m 1968. Mus deterioration does not appicar to have ban csgsed by interest payments on external debt in 1968 and 1969; beginning in 1970, however, this component increased substantially, as a result both of higher U.S. dolla interest rates and Of the of some extemal, liabilities in that yea, wiose consolidation resulted in an increase of $140 million in external debt. Cf. M. Thompson-G.W. Slaytm -An Essay on Credit P_ n 1 ___1 F -- t between the DAF W -be Republic of the M ippines: 1970-1983.- FWjM* of Ecommics and Rusiness, Vol.XXII p.63. -40- 1970-80: Dependence on Debt Accumulation 3.20 The crisis of 1970 inaugurated a new phase in Philippine policymaking. In the first place, policy was designed to affect resource allocation directly, through incentives for priority sectors chosen by the Board of Investment. Second, these incentives substituted for. rather than complemented, trade and exchange rate policy. With selective interventions, the degree of protection varied substantially across sectors, and only direct exporters benefitted from tariff exemptions. Third, industrial growth remained very import-intensive: overvalued exchange rates, investment incentives, and low tariffs on capital imports stimulated a concentrated, low value added export sector but did not encourage the development of export industries with extensive backward linkages. Fourth, the strategy emphasized rapid industrialization led by state enterprises and financed by foreign borrowing. 3.21 The introduction of investment and export incentives in the late 1960s and the devaluation of 1970 had a significant impact on industrial value added and nontiaditional exports. Industrial growth rates averaged 7.7 percent and the value of nontraditional exports grew at an annual rate of 34 percent in the 1970s.' The effective removal of trade barriers by the provision of selective exemptions to tariffs and taxes was starting to prove effective, though in limited productive areas. 3.22 These positive developments-together with the restrictive effects of the IMF-sponsored stabilization program of 1970-led initially to an improvement of trade and current account balances. As growth resumed, however, this improvement could not be sustained, and a sharp worsening of external accounts followed, beginning in 1974, as shown in Figure 3.5. 3.23 While the current account deficit in 1974 can be explained to a large extent by the oil price shock and the resulting general increase in international prices, the continuing worsening of the current account balance reflected sustained high import dependency, in spite of the pass-through of the oil price increase domestically and the reintroduction of quantitative restrictions. Merchandise imports increased at an annual rate of about 20 percent during the second half of the 1970s, encouraged not only by tariff exemptions under the incentive programs but also by the sustained overvaluation of the exchange rate after 1973. In spite of the nominal introduction in 1970 of a regime of managed floating and the permanent terms of trade deterioration caused by the oil shock, the exchange rate was maintained substantially stable by recourse to foreign borrowing: between end-1970 and end-1980, the peso devalued cumulatively by only 23 percent vis-a-vis the U.S. dollar, while domestic prices rose by 250 percent-or at an average annual rate of 12.5 percent-during the same period, leading to a real appreciation in excess of 40 percent. 3.24 The improvement of manufactured expert performance in the 1970s was a substantial step toward relaxing the foreign exchange constraint that had limited growth in the 1960s. Export growth, however, was concentrated in selected sectors, and a strong bias toward nontraded sectors continued to be fostered by the maintenance of an overvalued exchange rate and widespread import restrictions. The removal of these distortions could have built on the progress achieved on the export side, by reducing the income elasticity of imports and by widening the tradable sector. Instead, the steady growth of imports was financed by external borrowing and this transformed the foreign exchange constraint into a public finance crisis. 8' Price and volume indexes-at the level of disaggregation relevant here-are not available until 1985. ！鄴「可不不可刀鄴「可不不邢一司 ,!―祇瞭→→州―實I―祈諍旦匹綺―. 藝I呂1洛11妝瞥11露l造1 111! 邑―一l才――寡配――奮―薑1股――妝 暴―糾文――參乞―-&―馴C-―寥 邑―:1入――響量――」計＇卜――鳥今 邑―&-\\-―豐霆―-l-:―夕―-―藝 l-&―洛―}!i―圍；―《州」―l 谷―。1一一＿r_-,l寫響―。仁〈望f劉I 亂L二二二二二」買匕么二二二二－」 .42- 3.25 Total foreign debt rose from $2.3 billion at end-1970 to $17.3 billion at end-1980, as shown in Figure 3.6. During the same period, gross international reserves of the central bank rose from $250 million to $2.9 billion, and the net foreign asset position of the central bank improved-in spite of extensive foreign borrowing by the central bank-ftom negative $81 million to $456 million. 3.26 Several factors contributed to allowing the Philippines to accumulate so much debt so quickly. First, the emergonce of large surpluses in oil-exporting countries following the 1973 oil price shock led to a large increase in the supply of international loam. Second. the policy of promoting industrialuation by mearis of a large public Investment program gave rise to an secedented increase in demand for foreign loans by institutions carrying goverriment guarantees and thus appeanng to be excellent cr"t risks. 7bW, the involvement of both the RAF and the World Bank-the former endorsing macroeconomic policies with craft arnmSements covering every year in the 1970s, and the laner coordinating official aid tb=gh thC establislunent in 1971 of the Consultative Group for the Philippines- facilitated access to borrowing from official sources, export credit agencies and commercial lenders. 3.27 17he increased, direct prosence of the government in the economy took die form of acquisition or establishment of financial and nonfinancial corporations. Although the Phil' i government had owned corporations even prior to independenceP between 1970 and 1980 the number of govertiment-owned. corporations almost trebled, fiom 75 to 207, with the largest nonfinancial corporations concentrated in transport, water, and energy. 3.28 The role of the government increased substantially not only in hidustry but also in the financial sector. Ihe two largest government-owned banks, the Development Bank of the Philippines (DBP) and the Philippine National Bank (PNB), had been established in the 1950s. but starting in the mid-1970s increased their lending substantially, both to public corporations and to die private sect". 3.29 The incrom in investment stands out as the most significant development on the aggregate demand side. Govenimm-owned corporations carried out the bulk of the public investment program in the second half of the 1970s. Total. public hivestment surged from an average of 1.7 percent of GDP to about 8 percent during 1975-80, while private Investment rose from an avenge of 20 percent of GDP to 23 percent. Gross domestic savings increased during the same period, from an avenge of 20 percent of GDP to around 24 percent, but increments' financing for public investment can mostly from foreign savings in the form of external debt accumulation (Figures 3.7 and 3.8). IV The number of government-owned coWtations, including parent companies and subsidiaries, grew as follows: ............................................................................................................... 19" 1945 IM Ms MO 1965 IM IM 1980 IM 1"I ............................................................................................................... Parent 14 22 22 29 33 ST 72 90 93 n.e. Subsidiarfes 2 3 6 a 10 Is Is so 117 203 n.o. Totat 16 25 as 37 43 75 122 207 296 171 ............................................................................................................... Source: for 1935-80, World Bank PWIWRim: Key Issues in the Nonfinancial Public QMMI-e S (1986); for 1995, World Bank. President's Report: Philippine Reform Program for Government Corporations (1988); for 1991. GOP. Project Completion Report: Philippine Reform Program for Government Corporations (IM), draft. -43 - 3.30 The effect on the economy of the relaxation of the foreign exchange constraint by means of international loans-together with the rising stimulus from the public sector-was a decade of high growth, averaging 5.6 percent a year in spite of the 1973 oil shock and the ensuing world recession.A This was accompanied, however, by a gradual rise in domestic inflation, averaging 15 percent a year and reaching a peak at 28 percent in 1974. The 197C devaluation and the 1973 oil shock were only partly to blame: these were estimated to have caused respectively a 12 percent and 22 percent increase of household consumption prices, on the basis of input-output estimates of total import content.1 Since the cumulative increase in the GDP deflator between 1970 and 1975 was about 140 percent, less than one third of it could be attributed to "imported inflation"; external factors were also unlikely to explain the persistence of inflation after 1975. 3.31 Domestic fiscal and monetary developments were mostly responsible for the rise in domestic inflation. The effect of fiscal policy on inflation is hard to quantify, as reliable public finance data-in particular for government-owned corporations-are not available for the 1970s, and data on the financing by the banking syst to the public sector show only a moderate increase in net claims on the public sector.1V At the same time, however, the growth rate of monetary aggregates accelerated substantially: reserve money grew at an average annual rate in excess of 17 percent; domestic liquidity-defined to include currency, deposits, and "deposit substitutes"-more than doubled in constant prices between 1970 and 1980 and, as a share of GDP, rose from 23 percent to 28 percent. 3.32 At the end of the 1970s, after a decade of sustained GDP growth and the accumulation of an additional $15 billion of external debt, the Philippines was facing new constraints without having overcome the old ones. In the first place, the foreign exchange constraint that had limited growth potential in the 1950s and 1960s had not been relaxed. Import growth had outpaced export growth, as a result of an incentive policy that reduced substantially imported input costs for selected sectors, an exchange rate policy that allowed devaluation rates well below inflation differentials, relative to both trading partners and competitors, and a public investment policy engaged more in industrial activities than in infrastructure development. In the second place, an external debt stock amounting to $17.5 billion-of which, $12 billion on variable interest rateew-had made the current account vulnerable to changes in international interest rates. Third, public finances had become vulnerable to exchange rates and interest I Cf. W.G. Nuqui-N.B. Bernal-V.V. Quimbo-P.M. Tayzon, "The Philippines: External Shocks, Adjustment Policies and Impact Selected Developnent Concerns, 1973-1985," Journal of Philippine Develmant. Vol. XIV (1987). W These estimates are from RM. Bautista, "Inflation in the Philippines, 1955-74," in J. Encarnacion and others (1976). "I According to the Central Bank of the Philippines, net claims of the banking system on the public nonfinancial sector rose from P3.7 billion in 1970 to P7.7 billion in 1980; the latter amount includes PS billion in net claLus of the central bank on the national government; cf. Central Bank of the Philippines, Selected EconoMic_Indicators (1989). According to the IMF, not claims on the government rose from P2 billion to P7.8 billion, and gross claims on public enterprises rose from P2 billion to P8 billion during the same period; ct. IMf, In= mLEinanial Satii (various issues). N Total external debt grew from $2.3 billion at end-1970 to $17.5 billion at end-1980, according to central bank sources; according to the World Debt Tables, in 1980 short-term debt and variable-interest long-term debt amounted to $7.6 billion and $4.4 billion, respectively. ;！馴合 (．闖”．評點視吋dC。妒．“平（．闖pd秤“風力纏C。夠．。甲 藝 -45- rate shocks: the fiscal expansion had occurred without a corresponding expansion of the revenue base, the revenue base itself had been eroded by growing exemptions and rising external debt service obligations had decreased the flexibility of public sector expenditures. Finally. the rapid expansion of public corporations and financial institutions had led to their dependency, respectively, on transfers from the national goverment and on government deposits and central bank financing, further constraining fiscal and monetary policy. 1980-84: Structural Adiustment without Stabilizatio 3.33 At the end of the 1970s, concerns about allocative inefficiencies-revealed by excessive capital intensity and import intensity of domestic production-led to the introduction of selected reforms aimed at liberalizing the financial system and the trade regime. These reform were supported by conditionality-often joint-attached to World Bank loans and IMF credit arrangements. Several institutional reforms were introduced in the financial sector, involving the defimuon of the functions of different financial intermediaries, their regulatory framework, and the supervisory responsibilities of the central bank, The main innovations were the introduction in 1980 of *universal" banks following the Getman model and the gradual liberalization between 1980 and 1983 of interest rates, which had beeri regulated by the central bankAl' Reforms ut trade policy, introducaid in 1980, involved a substantial reduction of tanff rates-m particular at the higher and of the spectrtm where the highest duty was reduced from 100 to 50 percent. But no significant changes were implemented in licensing and other administrative restrictions on imports.0 A . . of invesunent incentives in 1994 attempted to reduce their capital-imensity bias and to harmonize them with policies foUowed in competing countries. 3.34 Financial sector rdorms, aimed at improving savings mobilization by the banking system and reducing its had little immediate effect on the performance of the sector, which was soon shaken by the Dewey Dee crisis and its ramifications-Z The problems that were rapidly building up at that time-the dommance of government-owned banks, the deterioration of their portfolios, and the impendmg implications of this deterioration for public finances-were not addressed. The rtAuction in U/ Cf. World Bank, Philinines Financial Sector SU& (1988) and BE/World Bank. Mw MWRim- An= of the Financial Swor (1979). Z The trade reform program included the removal of a&MnWrative restrictions on 960 of 1,304 regulated items. The removal was initiated but not completed and was soon reversed to a large extent, as balance of payments difficulties mounted in 1982-83. Cf. World Bank, Philippines Strictural Adjustment Loans I and H: Program Completion Report (1984). L91 Dewey Dee. a textile entrepreneur, defimW and left the country. This &*fault shook the financial system and led to the bankruptcy of several financial institutions; the crisis required the intervention of the central bank, whose emergency loans to commercial banks increased fduffold to P3.7 billion, and led to the acquisition of four additional commercial banks by the pOic sector in 1981-82. The commercial barib acquired in this period are International Corporate Bank and Union Bank in 1981. and Associated Bank and Commercial Bank of Manila in 1982. a. R.S. Dohner-P. Intal Jr., "The Marcos, Legacy: F r r n 1 lid-, Policy and Foreign Debt in the Phfltqftu.* in J.D. Sachs4-M- CoHins (eds.), DevAceing Country Debt and -Economic (NBER, 1989), Vol. 3. p.498. -46- tariff rates, on the other hand, had inmediate negative implications for fiscal balances, as it was not accompanied by adequate measures to compensate for the revenue losses that it causedA2' 3.35 Macroeconomic management was again inconsistent with structural reform efforts. The domestic policy response to the 1979 oil shock and ensuing world recession was a further substantial increase in public sector spending. Public investment alone increased by 3.5 percentage points of GDP in 1980-81, and the deficit of the national government increased by a comparable amount. As had happened with the first oil shock, this response succeeded in softening the initial impact of the shock on GDP and in maintaining a stable exchange rate; in addition, no acceleration in domestic inflation followed this shock, unlike the previous one. The cost of this 'countercyclical maneuver--as it was defined by poicymakers at the time-was an additional $3.6 billion in external debt and $0.8 billion reserve loss by the central bank in 1981 alone. 3.36 The unsustainability of this policy course was imnediately apparent. The expansion by the public sector was accompanied by an opposite response on the part of the private sector; private investment declined by 5 percentage points of GDP in 1980-81. more than compensating for the increase in public investment. Gross domestic savings declined by 4 percentage points of GDP during the same period. Interest payments contined to grow, in level and as a share of export revenues, as external debt and international interest rates rose steadily. Flight capital totaled more than $2.5 billion in 1980-81 .l 3.37 The lack of effective s o mc management to stem the impending crisis became apparent in 1982, as the Philippines failed to reach an agreement with the IMF; 1982 was the first time since 1970 that the Philippines had not had in place a stabilization program sponsored by the IMF. The Stand-By finally concluded in February 1983 was interrupted in the summer of the same year.W 3.38 The failure to reach an agreement with the IMF further reduced access to foreign credit. In 1983, as external financing was drying up and in spite of efforts to increase tax revenues,P the central bank expanded its financing of the fiscal deficit. Reserve money increased dramatically, mostly during the second half of 1983, and was 50 percent higher at end-1983 than at end-1982. In addition. The effective tax rate on merchandise imports-including import duties and excise taxes--on merchandise imports declined from an average of 16 percent during 1975-79 to 12 percent in 1980-81. 1 Cf. I.T. Sicat, 'Capital Flight: The Philippine Case,' C Review (May 1990). Capital flights are defined by Sicat as the residual change in external debt, after accounting for direct investment, current account transactions, change in official reserves, gold monetization, allocation of SDRs, and revaluation of external debt stocks due to exchange rate changes. SCf. ThompomSlayton (1985). W An additional 3 percent import duty--aimed primarily at increasing government revenues-was introduced in December 1982 and raised in stages to 10 percent by 1984, raising the effective tax rate on merchandise imports to about 18 percent. Two extraordinary trade taxes were introduced in June 1984, at the time of the second steep devaluation that occurred during the crisis: a 10 percent tax on foreign exchange for nn-merchandise transactions and a windfall tax on traditional exports. Cf. R.S. Dohner-P. Intal Jr. (1989), p.534. -47 - the inability of the central bank to sterilize losses on swaps and forward cover contracts contributed to the rise in money supply. 3.39 The eruption of the crisis-with the announcement of a ninety-day moratorium on external debt amortization in October 1983-was brought about by the depletion of international reserves, as short- term credit lines could not be refinanced and last-ditch efforts to access foreign exchange through swap operations proved insufficient. The crisis was accompanied by a sharp devaluation, a surge in inflation, the introduction of extraordinary measures to control imports and allocate foreign exchange, and unsuccessful attempts to reach an agreement with the IMF and with commercial banks. 3.40 Although underlying disequilibria were building up for almost a decade prior to the crisis and adverse external events played an important role in its onset, the expansionary maneuver of 1980-81 and the avoidance of the necessary exchange rate adjustment after the second oil shock were directly responsible for the capital flight and the overheating of the economy that precipitated the crisis. First, the combination of the fiscal expansion and the overvalued exchange rate, in addition to boosting the level of demand, had perverse effects of shifting resource allocation toward nontradables and reinforced the effect of the oil shock on the current account balance. Second, had the excessive fiscal expansion of 1980-81 not taken place, the inflationary surge of 1984 and the subsequent overreliance on monetary adjustment in 1984-85 could have been avoided. Third, in the same way, had the exchange rate not been supported at a too appreciated level, capital flight on the scale observed in 1981-82 would not have oc- curred and the last round of external debt accumulation-in particular by the central bank-could have been avoided. B. Growth under Publicinan C anMs 3.41 The foreign exchange constraint that had limited growth in the 1950s and 1960s and that had been relaxed by borrowing in the 1970s and early 1980s was again suddenly binding with the eruption of the international debt crisis. The Philippines found itself at a very difficult juncture, when extensive structural adjustment had to be undertaken at the same time as macroecoiomic stabilization. 3.42 The sustainability and the fruition of structural reforms depended crucially on the success of stabilization, and in turn the effectiveness of macroeconomic management needed to be strengthened by structural reform. Both stabilization an; adjustment needed to focus on public finances, which were in a deep crisis because of the virtual disappearance of foreign financing, the increasing share of resources absorbed by debt service, the realization of contingent liabilities, and the collapse of growth. Finally, sequencing of reforms and consistency of stabilization polices were also crucial for the two to be mutually reinforcing. 1984-86: Crisis Manaement 3.43 The immediate consequences of the 1983 crisis-following the unavailability of external financing, the depletion of international reserves, and the announcement of the moratorium of principal repayments on foreign debt-were a large devaluation and the acceleration of inflation. These were followed by orthodox stabilization measures-most importantly, a drastic reduction in monetary aggregates-that were extremely successful at preventing the entrenchment of inflation and at stabilizing the exchange rate, unlike what happened in the majority of highly indebted countries at that time. Monetary policy, which bore the brunt of the stabilization burden. changed course decisively in 1984, -48 - shifting the composition of the financing of the public sector deficit away from money to domestic securities, raising reserve requirements, and reducing the growth of money supply. 3.44 Monetary policy became restrictive very rapidly. The monetary contraction was accomplished by open market operations (issuance of treasury bills and central bank securities) and an increase in reserve requirements: public domestic debt rose from 16 percent of GDP at end-1983 to 20 percent at end-1984, to 24 percent by end-1985; reserve requirements were increased in steps from 19 percent before the crisis to 24 percent in April 1984. As a result, domestic liquidity dropped from 31 percent of GDP at end-1983 to 23 percent at end-1984, and remained stable around this mark during 1985-86. This succeeded in bringing down inflation from levels approaching 50 percent in 1984 to 5.5 percent by December 1985, to -1.8 percent by December 1986; it also led to a dramatic reduction in credit to the private sector, from 35 percent of GDP at end-1983 to 14 percent at end-1986. 3.45 The extent of the monetary contraction during 1984-86-a drop in the domestic liquidity to GDP ratio of 7.5 percentage points and a drop in credit to the private sector of 20 percentage points- together with the rationing of foreign exchange led to an unprecedented fall in income. GDP declined by more than 7 percent a year in 1984 and 1985, and in 1986, in spite of the beginning of a recovery, it was still one-tenth lower than in 1983. On the supply side, value added in industry accounted for most of the contraction, and on the demand side gross investment declined to 16 percent of GDP in 1985-86, the lowest level in the entire postwar period. However, unlike other highly indebted countries, consumption levels were maintained during the recession.-W 3.46 Meanwhile, fiscal adjustment lagged behind. The public financial sector experienced a widening of its deficit during this period. Losses by government financial institutions-including Philippine National Bank (PNB), Development Bank of the Philippines (DBP), and Philguarantee- increased from 1.5 percent of GDP in 1983 to 3.3 percent in 1985; these losses were financed both by transfers from the national government and by emergency assistance from the central bank. The central bank itself experienced large losses, in particular in 1984, when they reached the record level of P27.6 billion-5.4 percent of GDP. While the losses by the government financial institutions were caused by bad loans to private corporations, those of the central bank resulted to a large extent from operations in foreign currency, mostly forward cover arrangements with public corporations and swaps with commercial banks.& 3.47 The public nonfinancial sector-including the national government and the monitored public corporations-initially succeeded at reducing its consolidated deficit, as a share of GDP, from 5.3 percent in 1983 to 2.7 percent in 1985. This improvement was achieved mostly by means of extraordinary levies and by reducing Operations and Maintenance (O&M) and investnent outlays. By 1986, however, the increased burden of interest payments-due to the devaluation of the exchange rate and the increase in domestic nonmonetary financing-and the pressure caused by transfers to government financial institutions led again to a widening of the deficit. & Personal consumption expenditure experienced a modest decline only in 1985, when it decreased 1.1 percent in constant 1985 prices. This is the only postwar year in which a decline in personal consumption expenditure is recorded. Cf. R.S. Dohner, "The Central Bank Deficit" (July 9, 1990), unpublished. -49- 3.48 Despite fiscal slippage, the external payments position improved dramatically. From a current account deficit of 8.3 percent of GDP in 1983, a surplus of 3.2 percent was recorded in 1986. The adjustment was borne to a large extent by imports of merchandise, which dropped by one-third during the period. The service account also improved dramatically-by $1.5 billion-in spite of substantially unchanged interest payments. 3.49 Adjustment of this magnitude was necessary because of the difficulties in managing the capital account. Given the severely damaged relations between the Philippine government and the IMF,W the resumption of dialogue r-quired substantial prior actions. The successful management of the crisis-in terms of reduction of inflation, stabilization of the exchange rate, and improvement of the current account-allowed the Philippines to conclude a new Standby arrangement with the IMF, a rescheduling agreement with Paris Club creditors in December 1984, and a financing package-including a rescheduling agreement and new money-with commercial banks in May 1985. 3.50 The stabilization after the crisis had been accomplished by temporary or unsustainable measures-extraordinary levies and deep cuts in O&M and investment expenditures-that did not address the new fiscal constraint. The task ahead required a substantial change both in the orientation of the productive system and in the structure of the public sector. The successful management of the crisis set the stage for the resumption of aid lows, and this in turn allowed the Philippines to obtain the "breathing period" and the resources to undertake the reforms that were necessary to resume growth on a sustainable path. 1986-92: Emerging Growth Trend 3.51 The recovery started in 1986. It is extremely difficult to disentangle the many internal and external factors that contributed to the beginning of the recovery. In the first place, the February 1986 election was accompanied by an increase in public expenditure in late 1985 and early 1986; second, the peaceful "People's Power Revolution" brought back a democratic regime and rekindled both domestic and international confidence in the Philippine government; third, the oil "counter-shock" almost halved international oil prices; fourth, in addition to comprehensive rescheduling agreements, the Philippines obtained substantial inflows of new money from multilateral, bilateral, and-though to a smaller extent- commercial lenders.' 3.52 The recovery was accompanied by the introduction of numerous policy reforms in 1986-88. As it negotiated a new Standby Arrangement with the Fund and an economic recovery loan with the Bank, the new administration set out to change its way of operating in the economy from direct intervention-setting the prices and the quantities-to setting the rules. The scope of these reforms was -6 In December 1983, in the midst of negotiations for the IMF program and the rescheduling agreement with commercial banks, it was discovered that the central bank had overstated its international reserves level by as much as 50 pt As a result, rescheduling negotiations broke off, the central bank governor was replaced, and ement with the IMF was postponed by one year, to December 1984. Cf. R.S. Dohner-P. Intal Jr. (1989), p.533. ' Gross disbursements of public and publicly guaranteed medium- and long-term loans averaged $1.5 billion a year during 1986-90. This did not prevent net inflows from declining sharply, in particular in 1986 and 1987. - so - far-reaching by international standards, but the intensity of the effort was uneven, as was institutional capacity in different sectors of the government. The results of this reform effort differed across policy areas, with taxation, reform of financial institutions, and privatization recording much more progress than trade and industrial policy. 3.53 These reforms accomplished a major restructuring of the Philippine economy by eliminating most price distortions and by improving the working of the government. As a result, the recovery that started in 1986 was led by private sector activity and based on a more efficient allocation of resources. The most dynamic component of demand was not personal consumption but private investment and exports of nontraditional goods; between 1986 and 1989, real private investment grew in excess of 13 percent a year, on average. The value of nontraditional exports grew in excess of 23 percent during the same period, while traditional exports grew a modest 6 percent a year. Industrial output recovered quickly, due to large spare capacity after the collapse of production in 1983-85, and agriculture and services returned to prerecession growth rates. 3.54 Starting in 1989, however, economic performance worsened, with external imbalances increasing and growth decelerating. Policy response to exogenous events in 1989, which was neither timely nor adequate, exacerbated the business cycle instead of dampening it. The worsening of growth and external balances was accompanied by a deceleration of the pace of structural reform. 3.55 The widening of the current account deficit in 1989 was brought about by a combination of demand outpacing output, a moderate worsening of the terms of trade, an increase in international interest rates, and insufficient adjustment in exchange rates. The current account deficit increased from a financeable level of 1 percent of GDP in 1988 to 3.4 percent: once again, the worsening was due mostly to a surge in merchandise imports that more than offset the increase in exports. The increase in imports of capital goods and intermediate inputs was accompanied for the first time by a sharp rise in imports of consumer goods, as a result of trade reform. Lumpy investment expenditures by public corporations in energy and transport also contributed to the increase in imports. Policy response to this deterioration was inadequate: the domestic price of oil products was adjusted belatedly and insufficiently to a rise in import prices, leading to a deficit of P9 billion in the Oil Price Stabilization Fund (OPSF). Failure to increase the price of oil products to fully reflect international prices inhibited demand response to higher prices and resulted in a subsidy of 1 percent of GDP to oil and energy consumers, while the economy was over-heating and imports were rising. 3.56 The worsening of external accounts was also compounded by a sharp rise in real wages,-13 percent in 1989-for the first time since 1980-81. The increase in real wages was the result of minimum wage legislation and a civil service salary standardization program, rather than labor demand pressures.A Wage increases worsened competitiveness at a crucial time: the strong economic recovery, renewed confidence in the government, and new initiatives to reduce the external debt overhang were starting to attract new foreign investment. The increase in real wages also worsened fiscal balances, at a time when high domestic and international interest rates were exerting pressure on the budget. 3.57 The rapid deceleration of growth was brought about by high real interest rates and by an unprecedented sequence of adverse shocks. Domestic interest rates rose in response to sustained domestic The unemployment rate peaked at about 11 percent during the recession and fluctuated between 8 and 9 percent after 1987. - 51 - borrowing by the public sector and an appreciating real exchange rate, resulting in zero growth of private investment in 1990. A series of shocks then hit the economy: in December 1989, a serious military attempt to overthrow the government took place, leading to a crisis of confidence both internally and externally, and was followed by a period of looser fiscal and monetary management; in July 1990, an earthquake severely damaged infrastructure in central Luzon; this was followed by the Gulf crisis, which sharply increased the oil import bill and decreased remittances of contract workers; in November 1990, a typhoon triggered flash floods killing more than 4,000 people in the Visayas; and in June 1991, the eruption of Mount Pinatubo devastated a large area and created a lasting threat of lahar flows. 3.58 Macroeconomic management continued to be unable to react effectively to these shocks throughout the period. The most difficult choices appeared to involve adjusting the exchange rate- because of its fiscal implications-and domestic oil prices-in spite of the small incidence of these products on consumption baskets. Two serious instances in 1990 clearly revealed these difficulties. During the first half of the year, while the current account was continuing to deteriorate, the exchange rae was held stable and fiscal policy continued to be expansionary. After the sharp rise in international oil prices following the Gulf crisis in August 1990, domestic oil prices were adjusted only partially in September, the exchange rate was not allowed to depreciate until October, ard only in December-with a concurrent reduction in excise taxes-were domestic oil prices fully adjusted to reflect higher international prices and higher exchange rates. 3.59 Unlike previous episodes, the deterioration of 1989-90 was driven by the business cycle rather than by fiscal policy; however, lack of timely and effective macroeconomic management allowed the business cycle to feed back on to fiscal balances. In particular, insufficient exchange rate adjustment resulted not only in larger than necessary trade deficits and consumption, but it also caused higher interest rates, raising the public sector interest bill and depressing investment and growth. 3.60 The deterioration of 1989 and 1990 required a sharply restri. tive maneuver in 1991, which led to negative GDP growth of 1 percent. As in previous episodes, the mcnetary maneuver was stronger than the fiscal one, with the result that domestic debt increased substantially in 1991. Unlike in previous episodes, however, the economy responded quickly to the change in policies, and by the fourth quarter was already starting to recover while external balances continued to hold. 3.61 The characteristics of the recovery since 1986-as well as those of the brief slump in 1991- point to a new growth trend emerging from the reorientation of the economy, rather than to a cyclical recovery. Growth since 1986 has been driven by private investment and nontraditional exports, and it has been accompanied by remving distortionary intervention and uncompetitive arrangements from domestic markets and by opening them up to International competition. The structural adjustment process initiated in 1980 and intensified since 1986 has led to enormous progress, in particular by allowing relative prices to reflect relative scarcities, and has enhanced the efficacy of macroeconomic management. Macroeconomic management, however, has not been sufficiently prompt and decisive, and thus has failed to bring to full fruition the benefits of the reforms. C. The Pursuit of Structural Adiusmnt 3.62 Since 1986, there has been not only the imensification of the reform effort in selected areas, but also the emergence of a consistent vision of a more open, competitive, and accountable economic system. In spite of the difficulty of undertaking structural adjustment at the same time as macroeconomic - 52 - stabilization, the Piiippines has been more successful than most highly indebted countries in implementing structural reforms and maintaining a stable macroeconomic framework. 3.63 The first objective of the reforms introduced in this period was to improve allocative efficiency and strengthen private sector initiative. By substantially reducing government intervention and opening the economy to competition internally and internationally, the reforms led to realignments in relative prices to reflect relative scarcity and in resource allocation to reflect comparative advantage. As a result, growth could resume with a stronger export orientation and with lower import-imensity. In addition, trade and financial liberalization have enabled the private sector to respond more flexibly and rapidly to changes in market conditions and has thus improved the effectiveness of macroeconomic policies. 3.64 The second objective was to relax the constraint imposed on public finances by the debt burden. To this end, in addition to the restructuring and privatization of government financial and non- financial corporations, several measures were introduced to strengthen public resource mobilization and to restructure the public expenditure system. External debt management and financial sector deepening also contributed to reducing the vulnerability of public sector balances to interest and exchange rate shocks. 1986-92: Intensification of the Structural Reform Effort 3.65 In the immediate aftermath of the 1983 crisis, several actions had been taken to undo the distortionary measures introduced in the heat of the foreign exchange crisis-' Starting in 1986, these actions were followed by the introduction of reform initiatives across a range of sectors. 3.66 Trade Roliev was liberalized, as the new administration completed in 1988 the program negotiated by the previous government with the Bank and the Fund, requiring the elimination of quantitative restrictions (Qrs) on capital and intermediate goods. (QRs and other administrative restrictions were left in place for selected consumer durables.) These measures resulted in a sizable decline in effective protection rates in manufacturing' and the reduction of disincentives to exporters. The issuance of E0470 in July 1991 has further rationalized and simplified the tariff code, and will gradually reduce tariff rates through June 1996. Remaining QRs were eliminated in 1092,' with the exception of a few agricultural items-which require legislative approval-and automobiles, where incentive to local manufacturers include restrictions on competing imports. A comprehensive import surveillance system at ports of shipment was also established in 1992, to improve the functioning of customs. 3.67 Agricultural pricin and marketina arrangements were liberalized in stages after the 1983 crisis. Regarding the trade and the tax regime, export surcharges introduced in the midst of the foreign exchange crisis were removed in 1984; during 1986-87, import restrictions on agricultural inputs-most ' Cf. R.S. Dohner-P. Intal Jr. (1989), pp. 536-40. ' Cf. J. Power - E. Medalla, Trade Liberalization in the Philionines: Assessment of Progress and Agenda for Future Reform (1986), World Bank Internal Monograph. ' Restrictions on certain items continue to be applied for health and safety reasons. - 53 - importantly fertilizers-were eliminated, wheat imports were liberalized, and the ban on corn import was removed (although administrative restrictions on corn imports remain to date). The abolition of marketing monopolies also occurred in the mid-1980s: the sugar monopoly was privatized in 1985 and in 1986-87 the sugar and coconut marketing monopolies were abolished. Price intervention in the food sector was also reduced substantially, with the liberalization of most producer prices. 3.68 Industrial iolicy--the provision of incentives-was not substantially changed by the new administration as an earlier reform, in 1983, had corrected biases of limiting competition, import- substitution, and capital cheapening that characterized the policies governing industrial development in the 1970s. The Omnibus Investment Code of 1987 mostly collected the preexisting legislation and reduced the administrative complexity of the legislation.-I The policy regime cominued to be character- ized by a substantial degree of discretion in establishing eligibility to different subsidies, lack of monitoring of cost-effectiveness of subsidies, and a dirigiste attitude on the part of the Department of Trade and Industry. 3.69 A set of reforms on direct income taxation were introduced in 1986; they included the globalization of taxable income, with the exclusion of interests and dividends, which were subject to withholding tax; the increase o minimum taxable income and personal deductions; and the reduction of the number of tax brackets and of the highest marginal tax rate. These legislative reforms improved the fairness, efficiency, and buoyancy of direct income taxation, although yield and elasticity failed to increase as quickly as expected. This resulted mostly from institutional weaknesses in tax administration, including failure to collect taxes where due, to establish evasion, and to prosecute tax evaders.41 3.70 In addition to direct income taxation, indirect taxation was also reformed. Sales taxes were replaced with a value added tax, covering most agricultural and industrial products but excluding public utilities and services. The introduction of legislation ran ahead of implementation capacity and for the first two years the value-added-tax (VAT) generated lower revenues than the sales taxes it replaced. In addition, extension of the VAT base to include remaining products and services has not progressed, limiting the accomplishment of the reform. 3.71 Several measures to strengthen planning, monitoring, and auditing were introduced in the national government and public corporations, resulting in an overall improvement of pvbiklc enditure control. In addition, the vublic investment program was completely reconsidered and reoriented, with the elimination of the large capital-intensive industrial projects that had characterized public investment in the 1970s and early 1980s and with a new emphasis on provision of infrastructure to complement private sector activities.A - Cf. P.S. Intal Jr.-J.H. Power, "Trade, Exchange Rate, and Agricultural Pricing Policies in the Philippines" (1990), unpublished. LF Cf. World Bank, "President's Report for the Philippine Economic Recovery Program" (1987), p.6-8. & Cf. World Bank, Philinines: Issues and Policies in the Industrial Sector (1988). ' Cf. World Bank, Public Sector Resource Mobilization and Exenditure Manaement (1992). SCf. World Bank, The Philioines: Issues and Policies in the Industrial Sector (1987), and World Bank, The Philinpines: Selected Issues in Public Resource Manaement (1988). -54- 3.72 Prerequisite to progress on financial reform was the restructuring of the PNB and the DBP, the two largest government-owned financial institutions, technically bankrupt and causing a serious drain on the budget. Reform of these two institutions started in 1986; their organizational structure and legal framework were reformed, their nonperforming assets and most of their liabilities were transferred to the government and the central bank, and the Asset Privatization Trust was established to liquidate the nonperforming assets transferred to the government.2' The restructuring was successful in turning both institutions into profit-making banks with responsible credit policies and in reducing the size of the government in the financial system. Both achievements, in turn, set the stage for privatization of the PNB, the growth of private banks-which recorded spectacular profits during the recovery-and further opening and reform of the banking system. 3.73 The most important area of reform involved reducing direct aovermnent intervention in the economy and establishing market discipline for remaining public enterprises. The reorganization and privatization of public nonfinancial corporations started in 1987. The privatization program has proceeded slowly but steadily and it is still not complete, with 85 of 122 corporations offered for sale to the private sector and 266 of 399 nonperforming transferred assets actually sold to dateA' Progress was impeded mostly by lack of a central authority in charge of privatization and by limited absorptive capacity on the part of domestic financial markets. Privatization was also constrained by legal issues, concerning disputes over the acquisition of corporations by the public sector, and valuation issues, involving discrepancies between market value and book value as established by the Commission On Audit (COA). These difficulties in implementation should not detract from the accomplishments of the program, which radically changed the government's role in the economy. The restructuring program has also made progress; most companies remaining in the public sector are being restructured, with new planning, performance, and monitoring procedures established. One notable exception is the National Power Corporation (NPC), whose pricing policy is still highly politicized, leading to inadequate rates of returnon assets, arrears with the central bank under the debt rescheduling programs, and transfers from the government. Overcoming the Foreign Exchange Constraint 3.74 The structural reforms of the 1980s have completed the removal of the foreign exchange constraint that had been a crucial limiting factor on growth potential in the Philippines. While the development of a nontraditional export sector had already successfully started in the 1970s, the structural distortions that fostered excessive import intensity were substantially removed with the last bout of the trade liberalization effort. The harmonization of tariff rates currently in progress-following the gradual removal of administrative import restrictions in 1987-89-will need to be complemented by flexible 22' In addition, the program included the privatization of six other government-owned banks, which had been acquired because they were insolvent. Two additional government-owned banks-Land Bank of the Philippines and Amanah Islamic Bank-were not included in the financial reform program. ' The program involved a total of 301 corporations. To date, decisions have been for the disposition of all but four corporations, requiring retention of 78 corporations by the government, privatization of 122, liquidation of 59, transformation of 6 into private foundations, and merger of the remaining corporations with other existing government corporations or with government agencies. Cf. World Bank, "Philippines - Reform Program for Government Corporations: Release of the Third Tranche of the Loan" (1992). -55 - exchange rate management, in order to avoid the consequences that previous episodes of trade liberalization have produced: worsening of the external accounts, foreign exchange crisis, and reversal of trade reform. 3.75 Overcoming the foreign exchange constraint does not eliminate the need for foreign resource utilization. The Philippines is expected to continue to run current account deficits because of large external interest payments and pressing investment needs, as will be discussed in Chapter V. The reforms implemented in the 1980s have removed the main distortions in relative prices that had led to a bias toward the nontraded sector and that had hindered the development of a modem, labor-intensive export industry. These reforms, if complemented by a stable macroeconomic environment and a market- determined exchange rate, will allow growth to be based on more efficient resource allocations. 3.76 In spite of substantial growth in selected productive activities, nontraditional exports will need to diversify further, to keep pace with world demand. Further growth in the nontraditional export sector will also benefit from the recently liberalized foreign exchange market. In addition, the expansion of the export base will profit from a shift away from selective, discretionary incentives that rely on the wisdom of bureaucrats to pick winning industries, toward more general measures, such as duty drawbacks. A shift from selective to general incentives would necessarily sacrifice their generosity, in order to keep their cost within feasible fiscal programs, but would allow the development of new export industries. Overcomine the Public Finance Constraint 3.77 The structural reforms of the 1980s-in particular the reforms of taxation and government financial and nonfinancial corporations-have also substantially relaxed the public finance constraint, by increasing the yield and the elasticity of fiscal revenues and by reducing the drain on public resources caused by an inefficient public enterprise sector. The burden of external and domestic debt and the narrow tax base will, however, continue to impose strict limits on the availability of public resources to finance growth-oriented expenditures in infrastructure and social services. In spite of the success of recent foreign debt reduction initiatives and continuing efforts to deepen domestic capital markets, further reduction of public sector debt will require further reduction in public sector deficits. 3.78 In order to be sustainable, the reduction in public sector deficits will need to accomplish a permanent increase in revenues and a permanent decrease in expenditures. Temporary levies, revenues from the privatization program, and excessive reduction of O&M causing faster depreciation of public infrastructure-all are measures that can reduce the deficit in the short term but cannot yield a lasting improvement in fiscal balances. In addition, excessive reduction in growth-oriented expenditures-public infrastructure and social services-may be sustained but the resulting reduction in growth will in the long run reduce the tax base and thus undermine fiscal adjustment through that route. 3.79 The need to overcome the public finance constraint by further fiscal adjustment and the means to achieve it without condemning the Philippines to stagnation or sustained inflation will be discussed in detail in Chapter IV. It should be emphasized at this point, however, that unless this constraint is overcome and the burden of public debt-both external and domestic-is reduced, the economic recovery will remain weak and will continue to be extremely vulnerable to exogenous developments. - 56- Leagthenina the Planning Horizon.of Macroeconomic Manaaement 3.80 Although there remain unfinished structural reforms, the conclusion that most policy-induced distortions have been removed and that overcoming the public finance constraint rests on balanced fiscal adjustment shifts the emphasis of policy recommendations toward improving macroeconomic management and strengthening institutional capacity to implement and sustain higher investment volumes. 3.81 Macroeconomic management has benefitted directly from structural reform and will improve further as unfinished reforms are completed. As a result of privatization and liberalization, the emphasis of macroeconomic management has shifted away from direct, day-to-day intervention in pricing and production decisions, and the economy has become more responsive to changes in policy as well as in market conditions. This has allowed policymakers to focus on longer-term issues, and to shift from managing the crisis to managing the economy. 3.82 As prices are now free to reflect relative scarcities and economic policy has acquired new strengths, two fundamental prices-the exchange rate and the wage rate-remain far from their long-run equilibrium levels. This is caused by short-term pressures induced by restrictive macroeconomic policies and by legislative protection of the formal sector, not by structural impediments. This conclusion reinforces the view that mcoomc management, rather than further structural reform, is the key to addressing remaining imbalances. 3.83 Macroeconomic management has consistently relied on monetary policy more than on fiscal policy because of the relative inflexibility of the latter. However, overreliance on monetary policy as a means of macroeconomic control, on the one hand, andoverreliance on public investment cuts as a means of fiscal control, on the other, have reduced the flexibility of both monetary and fiscal policy. 3.84 The flexibility-and the effectiveness-of monetary policy has been gradually eroded by the worsening financial condition of the central bank. The central bank of the Philippines had accumulated large domestic and foreign liabilities, as a result of assistance to private and public financial institutions, quasi-fiscal activities carried out prior to the crisis, misguided foreign exchange interventions during the crisis, and the large open market operations conducted in 1984-85 to reduce liquidity in the midst of a recession. As a result, the central bank has incurred rising losses on account of debt service and has increasingly needed support from the government to sterilize them. To this end, open market operations have operated through issuance of interest-bearing obligations by the central bank itself and through issuance of domestic debt by the national government and transfer of corresponding proceeds, in the form of deposits, to the central bank. As a result, domestic debt service is using up a large share of public sector resources, reducing the flexibility of monetary policy and of fiscal policy. 3.85 Effective external debt management has to some extent compensated for the negative implications of the choice of policies on the overall flexibility of macroeconomic management. Extensive rescheduling on favorable terms and a consistent effort to take advantage of market opportunities-through debt-equity swaps and debt buybacks-to reduce commercial debt have substantially decreased the burden of external debt. A new Brady initiative-involving the conversion of restructured medium- and long-term commercial debt into collateralized bonds-will not only result in savings on debt service, but has also allowed predetermination of debt service flows by fixing interest rates on a substantial portion of new bonds. - 57. 3.86 Episodes of tentative macroeconomic management imperil not only the economic recovery but also the progress of structural reform. Overreliance on monetary adjustment to compensate for insufficient fiscal adjustment-most apparent after the 1983 crisis but characteristic of the entire period- has made trade reform costlier and privatization harder by supporting higher interest rates and a more appreciated exchange rate. In addition, overreliance on public investment cuts rather than revenue increases and cuts in subsidies has led to lower growth that would have been otherwise possible, and thus made public opinion toward structural reforms less favorable. 3.87 Finally, full fruition of reforms and effective implementation of macroeconomic policy will depend on i i R natenin in the public sector as well as further development of private sector structures. Programs to revamp tax administration, involving rationalization and computerization of direct, indirect, and trade taxation are now in place, and will need to be implemented quickly and effectively. Programs to strengthen the management as well as the financial condition of the central bank are also being elaborated and will need to receive utmost attention. The Unfinished Structural Reform A,enda 3.88 Although the most important reforms have been introduced and are gradually producing the expected result:., the structural reform agenda has not been fully implemented. First, as discussed above, progress in riatization and restructuring of public corporations will ned to be advanced and consolidated. Second, certain sectors of the economy remain very heavily regulated, most notably labor markets, the transportation sector, and energy and oil products. Government intervention in these areas has often been misguided, and major benefits could be obtained from their liberalization. In particular, minimum wae Ieislation and its strit enforcement in the formal sector have increased the segmentation of the labor market, which is manifest both in the large disparities between formal and Informal wages and in the limited employment generation in the formal sector. Similarly, tariffs and overregulation of entry in the trucking and shipping industries have resulted in an inefficient, overpriced, and uncompetitive transportation systm Although recently decrees have been issued liberalizing entry and exit and rate and fare setting. Third, the supply and pricing of OnrM andLoil products have been affected by the government's inability to resolve the precarious financial situation of the quasi-monopoly producer of electricity, the National Power Corporation. This has led to frequent disruptions of energy supply due to breakdowns in inefficiently maintained and operated plants, large subsidies to consumers, and manipulation of relative prices of oil products, of indirect taxation. and of the function of the Oil Price Stabilization Fund, with large costs to the government budget. Finally, the structure of inve-nt incentive will need to be carefully reconsidered not only on the basis of the relative position of the Philippines vis-a-vis its competitors but also on the basis of the effectiveness of various incentives and their fiscal costs. - 58 - IV. GROWTH AND FISCAL ADJUSTMENT 4.1 By the mid-1980s, the long-standing foreign exchange constraint limiting growth potential in the Philippines had been overcome with the restructuring of the productive system gradually brought about by trade reform, price liberalization, and reorientation of the government role in the economy. These reforms substantially removed the bias toward the nontraded sector and set the stage for economic growth led by the private sector and based on labor-intensive traded goods. Excessive external borrowing, undertaken in the 1970s and early 1980s to sustain high growth and relax the foreign exchange constraint, had in the meantime imposed a new constraint on the economy: the absorption of large resources to service public debt severely limited the flexibility of government expenditures. The stabilization program in response to the 1983 crisis further tightened this public finance constraint, as adjustment was carried out more by changing the composition of deficit financing than by reducing the level of the deficit: increased domestic borrowing to finance the public sector deficit and reduce the monetary base raised real interest rates and crowded out private investment. In addition, the sudden realignment of the exchange rate in the mid-1980s had a large impact on foreign debt service. 4.2 Under the external borrowing constraint imposed by the debt crisis, some fiscal adjustment has been carried out between 1983 and 1986, and has further accelerated since then. The deficit of the nonfinancial public sector has been reduced from 5 percent to 2 percent of GDP, the losses of the central bank declined from about 3 percent to less than 2 percent of GDP, and the government financial institutions have been turned around and are generating surpluses. As a result of fiscal retrenchment and careful external debt management, public debt as a ratio to GDP, has substantially stabilized since 1989. 4.3 Fiscal adjustment has occurred at high cost in terms of foregone growth. The reduction of the fiscal deficit has been accomplished mostly by reducing growth-oriented expenditures-public investment and O&M. At the same time, high interest rates have sustained an appreciated exchange rate, discouraging private investment and depressing exports. Fiscal adjustment has also resulted in increased inflexibility of public expenditure. Contractual expeditures-salaries and interest payments-absorbed two-thirds of the national government (NG) revenues in 1991. These developments have in turn made further fiscal adjustment harder. As a result, there appears to be a resistance level below which the nonfinancial public sector deficit and, even more seriously, the losses of the central bank cannot be reduced. 4.4 This chapter evaluates the extent to which the public sector has adjusted and what remains to be done to eliminate the constraint currently imposed on growth by low public sector expenditures. Two main conclusions are reached. First, further substantial fiscal adjustment is necessary in order to bring down public debt, and thus interest rates. Second, the quality of the adjustment will be crucial to its persistence and to future growth. 4.5 In addition, the next phase of fiscal adjustment will need to go beyond the national government and involve other public sector agencies. Social security institutions will need to improve collection of member contributions and the quality of their portfolios; local government units, in line with their increased responsibilities under the Local Government Code, will need to strengthen resource mobilization, especially property taxes; and public corporations will need to increase internal cash generation to finance priority investments by increasing collection of user fees. *59 - A. Fiscal Adjustment and Debt Stabilization. 1986-91 4.6 The most important indicator of the extent to which fiscal adjustment has been accomplished is the debt to GDP ratio.Y V Total-external and domestic-public debt peaked at 93 percent of GDP in 1986, and has since declined to an average of about 81 percent (Figure 4.1). While this level is still extraordinarily high, even in comparison with other highly indebted countries (Figure 4.2), and is certainly not sustainable given the current levels of growth and real interest rates, the size of the adjustment has been more than 10 percentage points of GDP in five years. 4.7 The reduction in total debt has been accompanied by a change in composition between foreign and domestic components, which has had important implications for the sensitivity of public sector balances to changes in the exchange rate and the interest rate. External public deta' has declined from a level of about 70 percent of GDP at end-1986 to about 54 percent at end-1991. Domestic public debt, on the other hand, has increased from 24 percent in 1986 to almost 28 in 1991-after having already increased by 7 percentage points of GDP between 1983 and 1986 (Tables 4.1 and 4.2). Although the increase in domestic debt has been substantially smaller than the decrease in external debt, it had sizable effects on the shallow domestic financial markets. 4.8 The decrease in external debt burden has been accomplished both by a decline in net foreign loan inflows and by debt reduction initiatives. Net flows to the Philippines have been substantially smaller than in the early 1980s; they have, however, remained positive on average, as a result of sustained disbursements and extensive rescheduling of principal repayments. Since 1986, debt reduction initiatives in the form of debt conversion programs-debt for equity, debt for assets, debt for debt-and debt buybacks have reduced the stock of external debt by around $4.4 billion as of end-1991, and by an additional $1.5 billion in the first six months of 1992. 1' Total public debt includes domestic and external debt of the public sector, defined as debt issued by the national government, the central bank, government nonfinancial corporations and local government units. Government financial institutions are not included in the public sector as data on their debt are not complete; however, both their domestic and external debt are relatively small. All debt data used in this chapter are from the Central Bank of the Philippines, except where noted. a The external debt data from the World Bank's World Debt Tables have differed by approximately $1 billion ir. recent years, mostly as a result of differences in the treatment of about $1.2 billion debt included in the 1987 commercial bank rescheduling. The larger difference for 1990 refle-ts preliminary figures and is likely to be subject to revision. Total Externel Debts Cuaeismen between Date from the Werld Debt Tables and Central Bank 1980 1961 19 196 196 1985 1966 1987 198 1969 1990 Central sank 17252 20893 24677 24816 S418 26252 28256 2649 27915 27616 28549 World Debt Tables 17422 2081 2462 24395 24355 26946 28519 29603 2972 2846fM 30456 Difference 170 -12 -215 *421 -1063 64 263 1154 1057 852 1907 Source: Central bank (CB). Selected Ecanamic indicatort; World Bank, World Debt Tables. ' If the discrepancy between CB data and World Debt Tables data is taken into account, the reduction of public external debt-and thus of total public debt-is equal to 15.5 percentage points of GDP, or approximately 2.5 points smaller. -61 - Tabe 4.1: Foreign Debt 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Total (mi lt ion S) 17252 20893 24677 24816 25418 26252 28256 28649 27915 27616 28549 29956 Pb ic Sector 9510 11920 14455 16730 17548 19122 21829 22751 22668 22222 23052 24116 Public Nonfinancial 7034 8980 10120 12759 13432 13199 14668 16247 16504 16793 17571 18791 Central Bank 2476 2940 4335 3971 4113 5923 7161 6504 6164 5429 5481 5325 Private Sector 7742 8973 10222 8086 7870 7130 7462 5898 5247 5394 5497 5840 Total (share of IP) 53.2 58.6 66.4 74.7 80.9 65.4 94.6 86.0 73.4 64.9 64.6 66.5 Public Sector 29.3 33.4 38.9 50.0 55.9 62.2 73.1 68.3 59.6 52.4 52.6 52.9 Public Nonfinancial 21.7 25.2 27.2 38.4 42.8 42.9 49.1 48.8 43.4 39.6 40.1 41.3 Centra( Bank 7.6 8.2 11.7 12.0 13.1 19.3 23.9 19.5 16.2 12.6 12.5 11.7 Private Sector 23.9 25.2 27.5 24.4 25.1 23.2 21.5 17.7 13.8 12.7 12.5 12.8 Source: Central Bank of the Philippines, Selected Economic Indicators, various issues. 4.9 The increase in domestic debt, on the other hand, has been caused by the continuation of the stabilization policies of the period immediately after the 1983 crisis, which have been overreliant on monetary control; domestic debt has been issued to reduce liquidity. Stronger fiscal adjustment would have been necessary to prevent the rise in domestic debt. In particular, the increase in domestic and foreign interest payments was not accompanied by an adequate increase in revenues or reduction in expenditures. Not only was the reduction in the deficit of the national government and public corporations insufficient and erratic, the income losses of the central bank have also remained consistently high, as a result of interest payments on its large external debt and the rising sterilization requirements. In addition, the restructuring of government financial institutions (GFIs) in 1986-87 led to substantial transfers of external debt and domestic nonperforming asses from the GPIs to the NG-in addition to large write-offs and a decline in total domestic credit-further encumbering the financial position of the NG. Table 4.2: Damestie Patfc Dbt 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Total (million Pesos) 41183 49365 57561 61116 84146 116286 144351 161101 207179 236602 254253 340801 National Government 21876 28657 35344 41842 57735 75972 108085 150751 195015 224334 243793 286590 Central Bank 13992 13690 11932 6736 13031 26128 23694 920 3966 6043 4028 47510 GOCCs 4979 6656 9856 12157 13206 14004 12411 9314 8082 6109 6432 6701 LGUs 336 362 429 381 174 182 161 116 116 116 0 0 Total (as a % of GDP) 16.9 17.5 16.1 16.6 16.0 20.3 23.7 23.5 25.8 25.6 23.7 27.5 National Goverment 9.0 10.2 11.1 11.3 11.0 13.3 17.8 22.0 24.3 24.2 22.7 23.1 Central Bank 5.7 4.9 3.8 1.8 2.5 4.6 3.9 0.1 0.5 0.7 0.4 3.8 GOCCs 2.0 2.4 3.1 3.3 2.5 2.4 2.0 1.4 1.0 0.7 0.6 0.5 LOUs 0.1 0.1 0.1 0.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Source: Central Bank of the Philippines, Annual Report, various issues. -s sno iiodg jenuuy 'ua*sdd!p%q apo ng meisoj :3mos -ae qp.aWe ( Usas eSu- es..- we £ &ms- or e- 06 ot 09 0L 08 06 i, s s es~ssa m ~ sazu ass noJ roi roi ro ro¥ -09- -62 - Debt. Fiscal Policv. and Interest Rates 4.10 The crisis of 1983 was followed by a large increase in real domestic interest rates as well as in the differential between domestic and international interest rates. These developments were connected to both the level and the composition of debt. The high level of total public debt, by increasing the likelihood of default-which, in the case of public debt, can be accomplished both directly and indirectly, by means of excessive inflation, exchange rate depreciation, or taxation-has raised the risk of holding public securities and thus their required real rate of return. In addition, the increase in the domestic financing of the public sector has placed substantial pressure on a shallow and highly imperfect capital market. 4.11 These trends can be seen both by looking at the real interest rate on treasury bills (Figure 4.3) or at the premium required in excess of international interest rates to hold domestic securitits (Figure 4.4). The former is defined as the nominal treasury bill rate, deflated with the twelve-month CPI index; the latter is the difference between the nominal treasury bill rate and the U.S. Treasury bill rate adjusted for the rate of depreciation of the nominal exchange rate. 4.12 Prior to 1987, movements in real interest rates were obscured by large unexpected changes in inflation, which fluctuated between 47 percent in 1984 and -0.4 percent in 1986: during the 1983 crisis and the period immediately following it, inflationary expectations had widely undershot at first and later overshot, causing a large swing in real rates. Starting in mid-1987, in spite of the stabilization of inflation and thus presumably of inflationary expectations, real ex-post rates increased steadily. From mid-1987 to mid-1989, real ex-post treasury bill rates averaged 7 percent, and rose to 9 percent from mid-1989 to mid-1990, as domestic debt was rising. During the first half of 1991, real rates declined temporarily, again because of undershooting of inflationary expectations, and have since recovered. At the same time, the difference-adjusted for the exchange rate depreciation-between domestic and international interest rates has followed a similar pattern (Box 4.1). Starting in 1987, this premium has been fairly stable, averaging about 6 percent. As for the domestic real rate, the premium has declined temporarily in 1991, possibly as a result of unanticipated appreciation of the exchange rate. 4.13 High real interest rates resulting from high levels of debt have made fiscal adjustment harder: by raising interest expenditures, by depressing domestic growth and thus eroding the tax base, and by increasing spending pressures, in particular on subsidies. As a result, the level of the public sector deficit financeable without adding pressure on financial markets-that is, without increasing domestic and foreign debt and without increasing inflation-has declined. 4.14 The level of the deficit that can be financed without increasing the debt to GDP ratio and without increasing inflation depends on the initial levels of debt and on four crucial parameters: the growth rate, the domestic real interest rate, the international real interest rate and the rate of depreciation of the real exchange rate.F The higher the growth rate, the larger the financeable deficit, because of the larger resource base; the higher the real domestic and foreign interest rate, and the higher the rate of real depreciation of the exchange rate, the lower the financeable deficit, because of the higher cost of borrowing domestically and internationally. & For a formal derivation, see for instance R. Anand-S.Vat Wijabergen, "Inflation and the Financing of Government Expenditure in Turkey," World Bank Economic Review (1989). 16 8 • - 8 . ............ ....... ....... ...... : 1 Oaa 3 -- 5 . ..... . . i:....... . ... .. ... . ..... . ................. ................. ...........................4V . * * * * ................... ........ ...... ............................ . . ........... .. . . . . . . . ................. ........... ..... -- 'il 5 5 -64- Box 4.1: Budgetary Effects of Exchange Rate Depredations A change in the nominal exchange rate affects revenues and expenditures of the public sector in a variety of ways. The largest foreign currency denominated revenue items are import taxes. for the national government (NG), and interests on international reserves, for the central bank (CB). The largest foreign currency denominated expenditures are interest payments on foreign debt; in addition, most budgetary transfers of the NG to government. owned and controlled corporations (GOCCs) are also affected by exchange rate depreciations. because of the high import content of investment and operating costs being financed. In the early 1980s. the effect of an exchange rate depreciation was to increase the consolidated public sector deficit. Several of the reforms introduced in the 1980s have reduced the sensitivity of public sector balances to changes in the exchange rate and today there is almost no net effect on the deficit of exchange rate changes. Trade reform initially reduced the importance of trade taxes by reducing average tariff rates but as imports have grown, customs duties have more than recovered previous levels; the restructuring and privatization of GOCCs has increased their reliance of internal cash generation to finance investment and has thus reduced capital transfers from the MG: and external debt reduction initiatives have reduced interest rates and foreign debt. Imort taxes represented a major source of tax revenues in the past but have gradually declined in importance during the 1980s. as a result of trade reforms that have steadily reduced average tariff rates and eliminated export taxes, and of tax reforms that have increased reliance on direct income taxes and the VAT. Collection efficiency has, however, improved with the introduction in 1989 of a limited import surveillance system, and was expected to increase further as the system became comprehensive in 1992. Finally, several reforms undertaken in the 1980s have increased the elasticity of import demand to real exchange rate, thus limiting the effect of a real devaluation on import taxes. Table 4.5 shows the evolution of import taxes in the 1980s; it should be noted that data for 1991 are affected by the imposition of a temporary tariff surcharge on imports. hterest naments on gross iternational reserves have been a modest component of central bank income, as a result of both low levels of reserves and low rates of return. A9er allowing for the fact that a large part of gross reserves-gold and currency-earns no return, average rates of return on other international reserves has averaged 6.8 percent, in U.S. dollars. during 1988-91. Interest payments on foreign debt are the largest expenditure item of the public sector that is denominated in foreign currency. In the past five years, total interest payments on foreign debt by the NG and the CB amounted to more than 3 percent of GDP on average. A real devaluation of the exchange rate increases the share of resources absorbed by interest payments on foreign debt, by increasing in real terms their domestic currency equivalent. Declines in real international interest rates as well as debt restructuring initiatives that have reduced die spread of interest rates on Philippine foreign debt over LIBOR and the level of foreign debt through boybacks and debt-equity swaps (cf. Box 4.2) have contributed to reducing both the debt burden and the sensitivity of fiscal balances to changes in real exchange rates. Most current and caial tanf of the NG to GOCCs are highly sensitive to exchange rate fluctuations as they subsidize current and capital expenditures with a very high import content. Payments to the Oil Price Stabilization Fund (OPSF) depend on the difference between international and domestic oil prices; an exchange rate devaluation that is not accompanied by a proportional increase in domestic oil prices will increase subsidies and correspondingly transfers from the NG to the OPSF. Similarly. capital transfers of the NG to GOCCs for the most part finance expenditures on imported goods, and thus increase with exchange rate devaluations. Finally. current transfers to GOCCs also respond to depreciations, because of the large import content of the operating expenses of public corporations such as the National Power Corporation (NPC). It should be noted that the sensitivity of NG transfers to exchange rate depreciations is the consequence of the unwillingness to raise prices and user fees charged by the public sector in response to cost increases. In the case of OPSF and NPC, it is the willingness to allow domestic prices to be lower than international prices-not the nominal depreciation of the exchange rate-that results in higher transfers. -65 - 4.15 The stabilization of total debt that occurred during the past four years has been accompanied by the nintenance of a primary surplus (revenues less non-interest expenditures) of about 6 percent by the consolidated public sector. This accomplishment however. has been facilitated by higher than desirable inflation and, most recently, by a substantial real appreciation of the exchange rate. While increasing the financeable deficit in the short run, inflation and appreciated exchange rates will reduce growth over the medium term, and thus reduce the financeable deficit. Thus, in the Philippines, given the very high levels of domestic and foreign debt, and given the high domestic real interest rate, a sizable surplus of the noninterest deficit will continue to be required in order not to increase public debt. This conclusion is reinforced by the fact that a real depreciation of the exchange rate is also necessary to restore the exchange rate to a sustainable level, after the real appreciation of 1991 and 1992. 4.16 All highly indebted countries have been characterized by high real interest rates because of debt overhang and have experienced serious difficulties in implementing fiscal adjustment because of high real rates. The Philippines has experienced the same phenomenon, although with lower intensity: it has had much lower real interest rates than other countries-Chile, Turkey, and Mexico most notably-in spite of a substantially larger debt burden, resulting both from comparatively smaller initial fiscal and external disequilibria and from lower monetization, which have led to less volatile expectations of inflation and depreciation. Interest rates have, however, been sufficiently high to hinder fiscal adjustment by absorbing an annual average 5.5 percent of GDP from the national government and 2 percent from the central bank between 1986 and 1991. 4.17 High real interest rates can thus be expected to prevail in the Philippines until public debt can be reduced to sustainable levels. In the meantime, the Philippines will have no alternative but to pursue further fiscal adjustment as the priority for macroeconomic management. Debt. Monetary Policy. and Exchane Rates 4.18 High interest rates not only have made fiscal adjustment harder, they have also made monetary policy harder. In the first place, low growth decreased seignorage revenues. Second, high interest rates made sterilization operations more expensive: there have been periods-in 1989 and 1990- in which the accumulation of international reserves and the implementation of debt reduction operations have been limited by concerns over the high cost of sterilizing resulting money creation. Third, high interest rates had a direct impact on money creation, as the central bank had sterilized excess monetary growth by direct issuance of interest-bearing securities whose service in turn amounts to money creation.y 4.19 The persistence of high real interest rates-together with the maintenance of a conservative monetary policy aimed at keeping inflation at moderate levels-stimulated capital inflows that supported a more appreciated exchange rate than would have been necessary to keep in check foreign trade imbalances and to stimulate growth. According to the central bank data,Y the Philippines has experienced capital flight reflows in each year from 1987 to 1991; during the period 1987-90, in spite Cf. G.A. Calvo, "The Perils of Sterilization," IM Staff Pe Vol. 38, No. 4, December, 1991. Cf. I.T Sicat, "Capital Flight: The Philippine Case,* CB Review. May 1990, and unpublished update from DER-D. -66- of widening current account deficits, the real effective exchange rate of the Philippines vis-a-vis its regional competitors has remained unchanged, and it has appreciated substantially in 1991. 4.20 In the short term, an appreciated exchange rate has tended to reduce the impact of high real interest rates on fiscal balances and monetary policy. A more appreciated exchange rate has reduced the domestic currency equivalent of interest payments on foreign debt, thus reducing the deficit of the national government and the central bank. Moreover, a more appreciated exchange rate has reduced subsidies, investment expenditure, and capital transfers of the NG, which have a very high foreign exchange content. In the longer term, however, a more appreciated exchange rate has effectively subsidized imports, depressed exports, discouraged private and foreign investment in export-oriented activities, reduced growth, and thus eroded the base for tax revenues and seignorage. In addition, an appreciated exchange rate has fed back onto domestic interest rates: investors have been requiring higher interest rates to hold domestic debt, as the difference between actual and expected exchange rates has been rising. 4.21 The short-term benefits-accruing mostly to the central bank (CB)-of an appreciated exchange rate have induced the CB to influence the exchange rate on several occasions throughout the 1980s. Since 1986, attempts to influence the exchange rate have seldom taken the form of direct sales of foreign exchange by the central bank on the foreign exchange market-and never the form of swap arrangements-unlike the previous period. Selected monetary policy interventions-such as increases in reserve requirements, restrictions on the net foreign asset position of domestic commercial banks and on the uses of foreign currency deposits held by residents, and use of the revolving trade facility to supplement gross international reserves-have, however, performed the function of supporting the exchange rate. As a result, since the 1983 crisis, the black-market premium has seldom exceeded the official exchange rate by more than 10 percent. 4.22 Attempts by the CB to achieve a real devaluation of the exchange rate have been less frequent and far less successful than attempts to support the exchange rate. Both in 1986 and 1990, large nominal devaluation driven by the central bank had very short-lived effects on the real exchange rate. To a large extent, this failure was not caused by accommodating monetary policy but rather by cost-push inflation due to the effective indexation of wage rates to the exchange rate. 4.23 The perverse relationship that leads from domestic debt accumulation to high interest rate and appreciated exchange rate, to worsening fiscal balances, and back to domestic debt accumulation, had turned into a vicious circle in the Philippines between 1987 and 1989. Several initiatives have since been taken to break this vicious circle: some have had dubious results-most notably the issuance of interest- bearing securities by the CB and the issuance of special series treasury bills to be held by social security institutions and government corporations; other measures can be expected to have more permanent and desirable effects-in particular the intensification of efforts to reduce external debt (see Box 4.2) and the new tariff code. Additional initiatives that will make the exchange rate more market-determined have recently been undertaken through a program for the liberalization of capital account transactions and the opening of the foreign exchange market to non-bank financial institutions implemented in September 1992. Debt. Stabilization Policy. and Growth 4.24 It was not only high interest rates and appreciated exchange rates that contributed to the slow fiscal adjustment of 1986-91; rather, the composition of fiscal adjustment has had negative implications - 67- for growth. Failure to increase government revenues adequately in spite of important reforms in direct and indirect taxes placed the burden of adjustment disproportionately on expenditures; failure to control the civil service wage bill and subsidies in a permanent way and increasing interest expenditures led to excessive cuts in growth-oriented expenditures, mostly investment and O&M. 4.25 The impact on GDP of these adverse domestic developments began to appear in late 1989. Until then, GDP had been growing at impressive rates from the deep recession of 1984-85, benefiting from large excess capacity and the depreciation of the exchange rate. Starting in late 1989. however. GDP growth decelerated, as a result of capacity constraints, exogenous shocks that shook confidence at home as well as internationally, and inappropriate policy response. In 1990 and 1991, again, a series of adverse exogenous shocks met by inadequate policy response finally led to a recession. 4.26 The pattern emerging in 1989-91 can be characterized as one in which concern over high interest rates led to weaker monetary discipline and concern over growth prospects led to weaker fiscal discipline. The interaction of these two behaviors caused higher inflation, higher fiscal deficits, and higher current account deficits. In addition, politicization of energy pricing resulted in belated and inadequate adjustments, large subsidies to domestic consumers, and thus higher fiscal expenditures; subsidized energy consumption in turn exacerbated the pressure on external accounts and delayed the necessary quantity response to higher international prices and exchange rates. 4.27 These events indicate very clearly that a structural reduction of fiscal imbalances and macroeconomic stabilization are not separate exercises but need to be part of an integrated and continuous effort. Without a reduction of public debt, the economy cannot benefit from the gains obtained from structural reforms nor engage in a growth-oriented strategy. Gains from external debt workouts have already been reaped, in particular with the 1990 and 1992 debt buybacks. Further reduction in public debt requires, in the first place, a reallocation away from those public expenditures least beneficial to growth and toward growth-oriented expenditures. Second, since reallocation of public expenditures can only have limited effects on the level of the deficit in the short run, further reduction in public debt needs to be accomplished by a balanced increase in tax revenues. In addition, fiscal adjustment needs to be supported by conservative monetary policy to control inflation and by flexible exchange rate management, to reduce the overall risk borne by holders of domestic securities. Finally, fiscal adjustment can benefit from the deepening of domestic capital markets, more specifically a more extensive participation of social security and insurance institutions-to increase the size and lengthen the maturity structure of the market- and small investors-who are still marginally involved and whose supply of funds could respond positively to access to higher returns. 4.28 The macroeconomic environment will continue to be fragile because of this fiscal constraint, inherited from years of excessive debt accumulation. Other disturbing features of the economy will also need to be addressed, as will be discussed in Chapter X, in particular the remaining protection of selected productive sectors and the effective indexation of minimum wages to the exchange rate. These characteristics of the economy continue to hinder the ability of policymakers to effect a real devaluation in response to adverse international events. Until the burden of public debt is reduced and these constraints are overcome, stabilization policy will have to walk a very narrow path between overheating and "overkilling". - 68 - Box 4.1: External Debt Management After the debt crisis, the Philippines pursued an external debt strategy aimed at obtaining cash flow relief by means of rescheduling and new money. Two rescheduling agreements were reached in 1984 and 1986 from the Paris Club and provided about $1.2 billion in cash flow relief by rescheduling of principal amortization. An additional agreement reached in 1989 and subsequently extended to March 1993 provided approximately $3.8 billion in cash flow relief over the period 1989-92, by rescheduling principal as well as interest payments. This most recent agreement also provided an improvement in the terms of the rescheduling, which involved longer grace and repayment periods and lower interest rates. Two reschedulings were agreed with the private commercial banks. The first of these, agreed in 1985, rescheduled about $6 billion in repayments and arrears from 1983 to 1986; the second rescheduled $9 billion in repayments due over the 1987-92 period. With the launching of the Brady plan in 1989, the Philippines has shifted its external debt strategy toward seeking a comprehensive resolution of its commercial debt overhang. Agreement on a financing packa? from commercial bank creditors was reached in October 1989. The agreement, which was voluntary and market-based, had three main components: new money, debt and debt service reduction, and restructuring of existing bank debt. As a result, in 1990 $1.3 billion of commercial debt was repurchased at 50 percent discount; the interest rate spread over LIBOR on the remaining commercial debt was reduced marginally by one-sixteenth of 1 percent; and new money of about $700 million was provided by commercial banks. The Bank, the Fund, and other official lenders supported the debt buyback component of the package. Under the provisions of the 1989 financing package, a second buyback was conducted in May 1992; $1.4 billion of commercial bank debt was repurchased at a 48 percent discount. Agreement was reached with commercial banks on a second-stage comprehensive debt and debt service reduction operation. An estimated $3.3 billion of previously rescheduled commercial bank public and publicly guaranteed external debt was restructured in December 1992. Commercial banks have selected from a men comprising a new money option as well as collateralized temporary interest reduction and principal collateralized bonds. Cash flow relief from this operation (including the May 1992 buyback) is expected to amount to approximately $2.7 billion between 1993 and 1998; in addition, interest rates will be fixed and lower than current LIBOR for a six-year period. Debt conversion programs have also contributed, in addition to buybacks, to reducing the stock of external debt. Between 1986 and 1991, these programs have reduced external debt by approximately $2 billion, and it is expected that an additional $300 million in debt reduction will be carried out during 1992. -69 - B. Composition of Fiscal Adjustment 4.29 The amount of adjustment carried out since 1986 has varied measurably between different public sector agencies, as can be seen from Table 4.3. The national government and the nonfinancial government corporations have reduced their deficit substantially, though to a larger extent by cutting investment expenditures than by improving revenues and internal cash generation. The government financial institutions have been successfully restructured and partly privatized, but only after transferring their liabilities to the NG. Finally, the central bank has suffered a continuous deterioration of its balances, with potentially severe negative implications (fortunately not yet fully realized) for stabilization policy. National Government 4.30 The national government0 (NG) has undertaken substantial efforts to reduce its imbalances since 1986, by restructuring both its revenues and its expenditures (Table 4.4). Achievements on the revenue side have, however, been limited by institutional weaknesses, partizlarly in tax administration. On the expenditure side, much of the progress has been accomplished by compressing growth-oriented expenditures-infrastructure investment and O&M-at a very high cost for current and future growth. In addition, excessive cuts in these expenditures have been unsustainable: by leading to deterioration and eventually breakdown of necessary infrastructure, they ultimately resulted in higher expenditures at a later date. Similarly, attempts at reducing personnel expenditures by compressing wages and salaries in 1984- 86 have been unsustainable and have been followed by substantial increases in real terms. The overall adjustment by the NG has been slower than was necessary in order to reduce public debt to levels that can be borne without constant danger of stagnation or runaway inflation. This has been in part a consequence of the continuing burden imposed on the NG by financial difficulties in the rest of the public sector and the assumption of liabilities from other agencies. 4.31 The overall deficit of the NG has been reduced from the peak reached in 1981-82 during the "counter-cyclical maneuver" implemented by the government to stem the recessionary effect of the international oil shock-to levels closer to those prevailing in the 1970s, that is from 4.5 percent of GDP to 2.5 percent. This pattern shows an exception in 1986-when capital transfers to restructure the two largest GFIs absorbed more than 3 percent of GDP-and in 1990-as a result of higher interest payments on domestic debt and higher investment. The adjustment of the primary balance of the NO was, however, much larger: excluding interest payments, since 1987 the NG has recorded a surplus averaging more than 3 percentage points of GDP. This fact illuminates the role played by debt accumulation and high real interest rates in making fiscal adjustment harder. F The natioral government comprises the central operations of the executive branch and includes the following departments: (i) Agrarian Reform, (ii) Agriculture, (iii) Budget and Management, (iv) Education, Culture, and Sports, (v) Environment and Natural Resources, (vi) Finance, (vii) Foreign Affairs, (viii) Health, (ix) Justice, (x) Labor and Employment, (xi) Local Government, (xii) National Defence, (xiii) Public Works and Highways, (xiv) Science and Technology, (xv) Social Welfare and Development, (xvi) Tourism, (xvii) Trade and Industry, (xviii) Transportation and Communications, and (xix) National Economic and Development Authority (Planning). -70- TaM 4.3: PRMic secto aeficiteb 1980 1981 1982 1983 194 1986 1987 198 1989 1990 1991 Public Sector Deficit <mitlion pesos> -37066 •44527 -37729 -39597 -16697 -32516 -36034 -73599 -42793 National Govertuent -3387 -12146 -14404 -7431 -10065 -11141 -31252 -16693 -23206 -19568 -37194 -26330 monitored monfinancial Corporations -10918 -15216 -15333 -1675 -11662 -7882 -6779 245 2944 -2995 -19137 -1412 Transfers frm National Governeent 5000 5500 5000 5700 3994 8942 8890 1120 4251 2432 6249 Consotidated konfinancial Putic Sector -22362 -24237 -19166 -16027 -15029 -29089 -7557 -19141 -18312 -53899 -21493 Centra( Sank Incom •300 -1000 •7200 -13800 -27600 -15500 -18208 -10740 -16875 20922 -21900 -21200 Government Financial Institutions -5300 -8500 -18500 -12000 1300 2100 3300 1400 -100 Transfers frm ational Governmnt 1200 7600 11300 19700 300 1400 *100 800 0 Consolidated Financial Public Sector -17900 -28500 -22700 -10508 -9140 -13375 -17722 -19700 -21300 P~Lic Sector Deficit (as a percentage of DP> -10.0 -8.5 -6.6 -6.5 -2.4 -4.1 -3.9 -6.9 -3.5 Mationät Government -1.4 -4.3 -4.5 -2.0 -1.9 -1.9 -5.1 -2.4 -2.9 -2.1 -3.5 -2.1 Konitored Konfinncial Corporation. -4.5 -5.4 -4.8 -4.5 -2.2 -1.4 -1.1 0.0 0.4 -0.3 -1.8 -0.1 Transfers from Mtionet Governsent 0.0 1.8 1.7 1.4 1.1 0.7 1.5 1.3 0.1 0.5 0.2 0.5 Consolideted Nonfinancial Public Sector -7.9 -7.6 -5.2 -3.1 -2.6 -4.8 -1.1 -2.4 -2.0 -5.0 -1.7 Central Bank Incom -0.1 -0.4 •2.3 -3.7 -5.3 -2.7 -3.0 -1.6 -2.1 -2.3 -2.0 -1.7 Government Financist Institutions -1.4 -1.6 -3.2 -2.0 0.2 0.3 0.4 0.1 -0.0 Transfers from National Governwant 0.3 1.4 2.0 3.2 0.0 0.2 -0.0 0.1 0.0 Consolidated Financial Ptlic Sector -4.8 -5.4 -4.0 -1.7 -1.3 -1.7 -1.9 -1.8 -1.7 INF definitiond (mil ion Pesos) -34100 -43000 -35400 -29600 -18600 -25000 -41000 -58500 -34600 INF definition* (as a percentage of CDP) -9.2 -8.2 -6.2 -4.9 -2.7 -3.1 -4.4 -5.4 -2.8 a. Data for 1991 are preliminary. b. Excluding non-maonitored public corporation and social security institutions. Pay~ets to OPWF are inctuded in the Kational Governnent starting in 1990. c. INF definition inctudes non-monitored public corporations, social security institutions and paymnts to OPSF since 1989 Source: Kational goverment: D8N, Fiscal statisties Uanok (1989), and tpf~ihed ~ed.tes; governent corporations: GCMCC, Statement of Financial Operations of the 14 Major Konfinencial Government Corporations; Central Sank: CDP-DERD. (pi~shed data. - 71 - Tabte 4.4: vationst sovenment (as a percentage of GDP) 1980 1981 1982 1983 1986 1985 1986 1987 1988 1989 1990 1991 Revenues 14.2 12.8 12.0 12.4 10.8 12.1 13.0 15.1 14.1 16.5 16.8 17.8 Tax Revenues 12.5 11.2 10.7 10.8 9.6 10.7 10.8 12.5 11.3 13.2 14.1 14.7 Doestic 7.8 7.2 6.8 6.3 6.3 7.8 7.9 8.7 8.1 9.1 9.8 9.5 International 4.8 4.0 3.8 4.5 3.3 2.9 2.9 3.8 3.1 4.1 4.3 5.2 Mon-tax Revenues 1.7 1.6 1.4 1.6 1.3 1.3 2.3 2.5 2.8 3.2 2.7 3.1 Current Expenditures 10.1 9.4 10.0 9.4 8.2 9.7 11.0 13.7 14.0 15.4 16.6 15.7 PersonneL 3.8 3.8 3.4 3.8 3.2 4.0 4.1 4.7 5.1 5.6 5.8 5.8 AK 4.4 4.0 4.2 3.2 2.4 2.3 2.5 2.8 2.4 2.9 2.8 2.9 Interest Paymnts 0.9 0.9 1.1 1.4 2.0 2.6 3.5 5.4 5.7 5.9 6.6 6.0 Domestic 1.2 1.8 2.5 3.5 4.0 4.4 5.0 4.5 Foreign 0.8 0.7 1.1 1.8 1.7 1.5 1.6 1.5 Transfers to LOUs 0.6 0.5 0.7 0.7 0.5 0.6 0.6 0.4 0.4 0.4 0.4 0.2 Otherb 0.3 0.2 0.6 0.3 0.1 0.2 0.3 0.4 0.4 0.7 0.9 0.6 Savings 4.2 3.4 2.0 3.0 2.7 2.4 2.0 1.3 0.1 1.0 0.3 2.1 Capital Expenditures 5.6 7.7 6.6 5.0 4.6 4.3 7.2 3.8 3.0 3.2 3.7 4.2 Own Investment 3.4 4.5 2.9 2.8 1.9 1.5 1.9 1.8 1.9 2.3 2.7 3.4 Capital Transfers' 2.1 3.2 3.7 2.2 2.7 2.8 5.2 2.0 1.1 0.9 1.0 0.8 Deficit -1.4 -4.3 *4.5 -2.0 -1.9 -1.9 -5.1 -2.4 -2.9 -2.1 -3.5 -2.1 Primary Deficit -0.4 -3.5 -3.4 -0.7 0.1 0.6 -1.6 3.0 2.8 3.8 3.2 3.9 Financing 1.4 4.3 4.5 2.0 1.9 1.9 5.1 2.4 2.9 2.1 3.5 2.1 Net Domestic 0.4 2.2 3.1 0.5 1.5 2.0 4.5 1.4 2.4 1.2 3.1 1.6 Net Foreign 1.0 2.1 1.4 1.5 0.4 -0.1 0.6 1.0 0.5 0.9 0.4 0.5 a. Data for 1991 are preLiminary. b. IncLuding subsidies, tax expenditures and, starting in 1990, payments to OPSF. c. Including net Lending, equity, capital transfers and contributions to CARP. Source: National Govermeent Cash Operations. Department of Budget and Management. 4.32 While the deficit level appears to be dominated by interest expenditures, its variance appears to be dominated by capital expenditures, as can be seen by comparing Figures 4.5 and 4.6 below. In 1981-82 and then again in 1986, it was a sudden increase in capital outlays that led to a deterioration of fiscal balances; much of the retrenchment since the 1983 crisis has also been caused by sharp reduction in capital outlays, especially in own investment. Capital outlays of the NG include, in addition to own investment in infrastructure and other activities, capital transfers to government financial and nonfinancial corporations and-to a smaller extent-capital transfers to local government units and outlays under the comprehensive agrarian reform program (CARP). To a large extent, these transfers are determined by the realization of contingent liabilities of the NG, such as recapitalization of ailing public corporations or debt restructuring to allow for privatization. The increase in capital transfers to GOCCs in 1982 and 2' Capital transfers of the NG include the following items, as classified by DBM: corporate equity, capital transfers to LGUs, capital transfers to PNB and DBP, CARP land acquisition and credit, and net lending. - 72 - to Government Financial Institutions in 1986 can by traced to a sudden deterioration of their financial condition, which the NG absorbed. Since 1987, capital transfers have been reauced substantially- although they still amount to about 1 percert ef GDP-but potential for future increases remains difficult to control, as contingent liabilities of the NO on account of public corporations and social security institutions continue to be high. 4.33 While interest payments experienced the largest increase and investment expenditures the largest decrease during 1986-91, other disturbing developments affected non-interest current expenditures. First, the wage bill of the NG-which had been severely compressed in 1984-86-not only recovered but also increased substantially relative to precrisis levels. The increase was brought about by the Salary Standardization Act as well as by rising employment.- Second, O&M expenditures contracted severely during the crisis and never recovered their precrisis levels, fluctuating between 2.5 and 3.0 percentage points of GDP since 1986. Third, current expenditures classified as "Other*-mostly subsidies to GOCCs-have increased steadily and currently absorb between 0.5 and 1.0 percent of GDP.!' 4.34 This composition of the adjustment accomplished since 1986 on the expenditure side has damaged future growth prospects and cannot be sustained. The heavy and rising burden of interest payments crowded out those expenditures-infrastructure and its maintenance-that are necessary to sustain private sector growth; other expenditures-wage bill and subsidies-have risen instead. In addition, the overall flexibility of public expenditure has been reduced (Figure 4.7). Inadequate infrastructure and wage pressure originating from the public sector have already had negative consequences on private investment and thus on the future base for tax revenues. 4.35 Some adjustment took place on the revenue side, as a result of the important reforms of direct and indirect taxation introduced in 1986-88.2 During this period, personal income taxation was globalized-with the exception of interest and dividend income, which remains subject to separate taxation-personal exemptions were increased, the number of tax brackets was reduced, and the marginal tax rate was lowered. Corporate tax was rationalized, with the introduction of a flat 35 percent rate. Sales taxes on most products and selected services were replaced with a flat-rate value added tax. Other reforms involved the conversion of excise taxes from specific to ad valorem basis and the abolition of export taxes-with the exception of logs. -W Personnel employed by the national government increased more than 60 percent cumulatively between 1980 and 1990, from 519,000 to 843,500 thousand; during the same period, personnel costs of the national government increased from 3.8 percent of GDP to 5.8 p-rcent. U11 The importance of clearly identifying hidden subsidies-such as tax exemptions to GOCCs-as government expenditures and the progress made in this respect by current budgetary practices in the Philippines should be acknowledged. 1' Cf. World Bank, The PhiliMines - Country Economic Reort: Public Sector Resource Mobilization and Expenditure Manaiement (1992, Report No. 10056-PH). hwef 8 d~. et oc~ DR i 2 0000 ~ li ti I- *1 li *1' I is i; I ti 'i I j I: fJ g ____ __ 1* _____ g __ -74- Igure 4.7 Iak3dlbgky of Nadm Government Espenditu 0.13 0.12 0.11 * 0.09 U0.08 0.07 0.06 0.035-I as as ak ea 64 is as 7 3 is 6o 91 Source: Nasionl Govanma Cash Operations, Deparnent of Budget and Mangement. 4.36 Tax effort increased gradually since 1986, from about 11 percent of GDP to more than 14 percent in 1990 and 1991 (Table 4.5). The steady progress of tax revenues was interrupted only in 1988, when the elimination of most sales taxes was not fully compensated by the introduction of the VAT. It should be noted, however, that much of the increase in tax effort has originated from highly distortionary taxes-such as the Gross Receipt Tax on financial intermediaries and other documentary taxes on financial transactions-and from taxes whose yield has risen because of extremely rapid growth of the corresponding tax base, most notably im; rts and interest income. 4.37 The achievements of the tax reform program, however, have been limited by institutional weaknesses that continue to afflict the two main agencies in charge of tax collections, the Bureau of Internal Revenues and the Bureau of Customs. Various estimatesW place collections at about 50 percent of potential revenues for personal income tax, 60 percent for corporate income tax, and 50 percent for VAT. The reforms were successful, however, at increasing elasticity and buoyancy,- both for direct and indirect taxes, as shown in Table 4.6 below. JF Cf. Word Bank, The Philinines - QM omic a=: Public Sector Resource Mobilization andE nditure Managm (1992). SElasticity is defined as the increase in revenues from a tax resulting from a 1 percent increase in the corresponding tax base, for a given underlying tax policy. Buoyancy is defined as the increase in revenues from a tax resulting from a 1 percent increase in the corresponding tax base, including the effect of intervening changes in tax policy. - 75 - Table 4.5: Direct am Indirect Teaes (as a percentage of GDP) 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 Direct Taxes 3.5 3.3 3.2 2.9 2.9 3.4 3.4 3.6 3.7 4.4 5.1 5.2 Income Tax on Business 1.3 1.2 1.4 0.8 1.2 1.4 1.4 1.9 1.9 1.7 1.8 2.1 Income Tax on Individuals 1.0 1.6 1.2 1.5 1.1 1.0 1.0 1.1 1.0 1.2 1.6 1.7 Other Direct Taxes' 1.1 0.6 0.6 0.6 0.6 1.0 1.0 0.7 0.8 1. 1.7 1.5 Indirect Taxes 8.5 7.9 7.9 8.1 7.4 7.3 7.5 9.0 7.4 8.9 9.4 9.5 Taxes on Business & Occupation 2.5 2.6 1.4 1.0 0.9 0.6 1.8 0.9 0.6 0.6 0.9 1.1 Excise Tax on Domestic Product 1.2 1.8 2.2 2.1 1.9 2.4 1.6 3.2 3.1 3.3 3.6 2.6 Excise Tax on lports 0.0 0.0 1.1 1.0 0.6 0.5 0.6 0.2 0.2 0.2 0.3 0.2 Export duties 0.2 0.1 0.1 0.1 0.3 0.2 0.1 0.0 0.0 0.0 0.0 0.0 Iport duties 3.0 2.5 2.7 3.4 2.7 2.4 2.1 3.6 2.9 3.9 4.0 4.8 Other indirect taxes 1.6 0.8 0.4 0.6 1.0 1.2 1.3 1.1 0.6 0.9 0.7 0.7 Total Taxes 12.0 11.2 11.1 11.0 10.3 10.8 10.9 12.7 11.1 13.4 14.5 14.7 Nemo: Import taxes (share of GDP) 3.1 2.6 3.8 4.4 3.3 2.9 2.8 3.8 3.1 4.2 4.2 5.0 laport taxes (share on iuports) 12.9 11.5 18.5 19.7 17.1 17.4 16.5 18.8 14.6 17.0 15.3 18.9 a. Ninor discrepancies between this table and the table of the NO deficit reflect different sources. b. Includes taxes on interest and dividends, property taxes, mnotor vehicle fees and minor items. Source: Economic and Social Statistics Office, National Statistical Coordination Board, revised NIA, February 1992. Table 4.6: Ou"ony ad Elasticity of Major Taxes MRS 1986-90 1986-1990 Buoyancy Elasticity Buoyancy Elasticity All Taxes 0.89 0.53 1.33 1.06 Personal Income Tax 0.62 0.54 1.58 1.22 Corporate Income Tax 1.03 0.85 1.18 1.10 Excise Taxes 0.96 0.32 0.78 0.77 Susiness Taxes 0.79 0.59 1.41 1.07 Import Duties 0.86 0.50 1.52 1.37 Source: National Tax Research Center; reproduced from World Bank, "The Philippines - Country Economic Report: Publi n toresece Nabiliation and ExaditVe Nanasementu. 1993 (Report No. 10056-Pm). 4.38 In spite of these outstanding concerns with revenue collection, the tax reform package of 1986-88 has finally brought the tax effort in the Philippines closer to the average tax effort of other countries in the region (Table 4.7). The tax to GDP ratio in the Philippines still significantly lags behind Thailand and Malaysia, but is now comparable to that of Singapore, Korea, Indonesia, and Pakistan. Further progress in the tax effort in the Philippine- will continue to be necessary, however, as tax revenue needs are higher in the Philippines than in other countries in the region, because of higher debt service and higher public investment requirements. . 76- Tablte 4.7: overment tax aevemes (as a percentage of GDP) 1985 1966 1987 1968 1989 1990 1987-90 Philippines 10.8 10.9 12.7 11.1 13.4 14.5 12.9 South East Asia Indonesia 18.3 14.6 15.1 15.1 16.0 14.1 15.1 Lao POR 1.7 1.5 1.4 10.6 7.6 7.6 6.8 Malaysia 23.1 20.5 15.7 16.2 15.9 16.3 16.0 Thai land 14.3 14.1 14.8 16.0 16.9 17.1 16.2 Viet Nam SR 3.4 4.1 3.2 4.1 5.7 5.2 4.6 MiCs Hong Kong 10.6 10.5 11.2 11.1 11.0 11.4 11.2 Korea 15.0 14.9 15.4 15.9 13.7 14.0 14.8 Singapore 17.3 13.1 13.6 14.0 14.3 14.3 14.1 South Asia Bangladesh 8.2 6.9 6.9 7.0 7.3 7.7 7.2 India n.e. n.e. 7.8 8.5 8.5 V.0 8.5 Nyamer 8.3 7.4 6.4 4.6 4.0 3.9 4.7 Nepal 7.1 7.3 7.4 8.3 8.1 8.6 8.1 Pakistan 11.9 12.3 14.5 13.8 14.3 13.8 14.1 Sri Lanka 19.3 18.1 18.6 16.4 19.6 n.e. 18.2 Source: Philippines: Economic and Social Statistics Office, National Statistical Coordination Board, revised NIA, February 1992; other countries: ADB, ASIA Devloment OutLook 1991 table AZB. 4.39 The reduction of the NO deficit has been accompanied by a reduction in the share of net foreign financing and an increase in net domestic financing, mostly in the form of treasury bills. Net foreign financing remained substantial in 1987-89, due to fast-disbursing loans in support of structural reforms, but declined to about 0.5 percent of GDP in 1990-91. This level is not likely to be exceeded in the future, given the current external indebtedness and the resulting borrowing constraint; domestic financing will thus continue to be the largest source of funds for the government deficit. 4.40 On several occasions since 1986, the issuance of Treasury bills has exceeded the not domestic financing of the NO deficit, as a result of transfers in the form of deposits from the NO to finance the central bank losses. The stock of deposits of the NO at the central bank has increased continuously between 1985 and 1989, when the central bank resumed issuance of its own securities; the increase in NG deposits during that period exceeded P60 billion, equivalent to about 40 percent of the total increase in the domestic debt of the NO. The external debt of the NO also increased in excess of cumulative net foreign financing flows since 1986, as a result of the assumption by the NO of external debt of the Philippine National Bank and the Development Bank of the Philippines at the time of their restructuring. 4.41 This trend toward increased reliance on the NG as the financier of last resort for other public sector entities, which will continue until the restructuring of public corporations is complete, could be exacerbated in the meantime, most notably if the worsening of the financial conditions of the central bank is not reversed. The government thus faces the following alternatives: either to further reduce the deficit, by means of higher revenues or lower expenditures, or to live with high domestic interest rates, by continuing to absorb the largest share of domestic savings and crowding out private credit. The future growth path of the economy will depend on this choice. Only a balanced reduction of the fiscal deficit, to be achieved by increasing tax revenues and growth-oriented expenditures, can support long-term -77- economic recovery and eliminate the danger of inflation. These alternatives will be investigated in detail in Chapter V. Public NOfiania Cor=rations 4.42 The adjustment undertaken since 1986 by the public nonfinancial corporate sector has involved not only its financial performance but also its structure. The large and financially weak public nonfinancial corporate sector has been rationalized and gradually reduced in size. In 1987 and 1988 several actions have been taken to strengthen the legal and institutional framework for the sector, to improve its monitoring and the coordination of its activities by the Government Corporate Monitoring and Coordinating Committee (GCMCC), and to reduce its size by privairization or liquidation of selected corporations. While privatization of the 122 corporations slated for sale has not been completed yet, the 78 corporations to be retained in the public sector have substantially improved management and supervision practices as well as financial performance. One notable exception is the National Power Corporation, which has failed to achieve adequate rates of return on its assets and to establish effective planning and implementation procedures for investment and maintenance activities. 4.43 Fourteen major public nonfinancial corporationsh' have been subject to closer monitoring and performance evaluation by the GCMCC, and detailed information on their income-beginnn with 1985 data-is available. As in the case of the national government, these corporations have also accomplished a substantial reduction of their deficit, to a large extant by reducing their investment expenditures. Their internal cash generation has also improved, in spite of a substantial decline in non- subsidy revenues; GOCCs have not been affected by a surge of interest payments as has the NG, because part of their financing is obtained from the NO at low or no cost. In addition GOCCs continue to receive from the NG a significant component of their receipts as subsidies (Table 4.8). 4.44 As in the case of the NO, the improvement in the internal cash generation of major public corporations has not been sufficient to support their investment programs, in spite of the drastic reduction in the latter. As a result, the average annual deficit acmmulased during 1986-91 amounted to 0.5 percent of GDP. Although this was a remarkable improvement from the early 1980s-the deficit averaged 3.8 percent of GDP in 1980-85-it still required large capital transfers from the NG. Overall support by the NG, in the form of both current and capital transfers to the fourteen corporations mentioned above, averaged almost I percent of GDP during 1986-91, more than half of total transfers by the NG. In addition, many of the corporations-most notably NPC. NEA, MWSS, and NIA-will need to resume investment on a larger scale but will be unable to do so without further substantial improvements in their internal cash generation. While external financing might be available for selected investment projects in these critical areas-energy and water-cost recovery and efficiency will need to increase for such projects to be financeable. L Cf. World Bank, President's Report of the Reform Program for Government Corporations (1988, Report No. P-4469-PH). W These are: (i) Export Processing Zone Authority, (il) Local Water Utilities Administration, (ii) Light Rail Transit Authority, (V) Metro Manla Transit Corporation, (v) Metropolitan Waterworks and Sewerage Systems, (vi) National Development Corporation (a holding company), (vii) National Electrification Administration, (viii) National Food Authority, (x) National Housing Administration, (x) National Irrigation AdminsAt (x) National Power Corporation, (xii) Philippine National Oil Company, (xiii) Philippine National Railways, and (xiv) Philippine Port Authority. -78 - tom* 4.aM .,ftra sew t n n ine~o at Coportions (es parcentege of OP) 1980 INi 1982 1985 1986 1985 1986 19s? 198s 1989 1990 1991 Reu,s 9.8 6.4 7.3 7.5 6.2 7.1 7.9 Stdio 0.0 0.0 0.1 0.2 0.5 0.2 0.3 curront EapenItur*§ 9.1 6.3 6.3 6.0 4.9 6.4 6.4 Interest Pauynts 0.5 1.6 1.5 1.3 1.1 0.8 0.8 Savins 0.1 0.0 -0.1 0.7 0.5 0.8 0.1 1.0 1.5 1.3 0.7 1.5 capitat EXptndturem 4.5 5.4 4.7 5.3 2.7 2.2 1.2 0.9 1.1 1.6 2.5 1.6 Doficit •4.5 -5.4 -4.8 -4.5 -2.2 -1.4 -1.1 0.0 0.4 -0.3 -1.8 -0.1 Primry Doficit -0.9 0.5 1.6 1.7 0.8 -1.0 0.6 Net Finmig -1.4 -1.1 0.0 0.4 •0.3 -1.8 -0.1 Externat -0.4 -0.9 0.0 -0.4 0.3 0.6 0.0 O 10stic 1.8 2.0 -0.1 -0.0 0.0 1.2 0.1 Capitet Transfers fre ng 1.8 1.7 1.4 1.1 0.7 1.5 1.3 0.1 0.5 0.2 0.5 Soure: 0CNC, stement of Finnfal ~eratona of the 14 Major Nmnfancial Goermit Corporatfons. 4.45 The central bank of the Phillppis has been a major contributor to the overal public sector deficit since the early 1980s, and in spite of some adjusatment it has incurred losses averaging 2 percent of GDP since 1986 (Table 4.9). The financial condition of the central bank is of particular concern as It costrains monetary policy and extenal debt managment and provides incentives to manipulate the exchange rate and incree the money supply. 4.46 The central bank losse arise fram inter payments on large negative net foreign assets. Foreign debt was estimated at $5.3 billion at end-1991 and nat international reserves at $2 billion-and on steriition io goverfrnhnt depasits and central bank notes. Unlike central banks in most other highly innted countries, the central bank has not resorted to inflation tax to finane interest paymnts on its foreign dek it has intad b~ accmlatad domestic interest-bearing liabilities, received transfers fram the NO in the forn of interest-free dpsits, and obtaine cash flow relief by rescheduling public ~eennt debtW and by freezing U.S. dollar-denominated domestic liabilities assed during the 1983 crss.JV Sterit~on has been ~ned mostly by ma of transfers from the NG, in the form of deposius, and årne= of own securities, firt during 1984-86 and more recently ' Under vauMous debt rue~naring agruamen, the central bank (CB) acquires restructured exernal liabilities of public and privat institutions, when they ma~ur. on the basis of their original repayment 8e6de; the corresponding repayment is made in local currency to the CB. The CB holds these funds in *blocked peso deposits. This process is equivalent to the CB cnding forward exchange cover on the raweue maturftiå whiLe receivig interest on their domestic currency equivalent. ~ oreign cuMcy waps for approfimalely $960 mi~on were contracted by the CB in 1983 from domestic banks. These swaps have been rolled over and resuing exchange rate losses and interest pay nts have been accrued to blockcd ccunts until 1992 when the swaps were unwound. -79- Table 4.9: Centrat Bank (as a percentage of GDP) 1980 1981 1962 1983 1984 1985 1986 1987 1988 1989 1990 1991 Income Accounts 1.4 1.7 1.6 1.4 1.5 1.6 1.4 1.2 0.9 0.7 0.7 0.8 Loans and Advances 1.1 0.7 0.6 0.5 0.5 0.5 Overdrafts 0.0 0.0 0.0 0.0 0.0 0.0 Domestic Securities 0.1 0.1 0.1 0.1 0.1 0.1 Foreign Assets 0.S 0.7 0.5 0.3 0.1 0.2 0.2 0.3 0.2 0.1 0.1 0.2 Interest Expense Accounts 1.5 2.1 2.3 2.0 3.1 4.3 4.5 2.7 2.9 2.8 2.4 2.7 Legal Reserves 0.1 0.1 0.1 0.1 0.1 0.1 0.2 SCocked Peso Differential 1.2 0.3 0.1 0.2 0.2 0.2 0.3 NG Deposits 0.0 0.0 0.3 0.6 0.6 0.4 0.5 Open Market Instruments 0.9 1.4 0.2 0.2 0.2 0.2 0.4 Foreign Liabilities 1.0 1.7 2.0 1.8 2.1 2.1 2.6 2.0 1.8 1.7 1.4 1.4 Net Interest income -0.1 -0.4 -0.7 *0.5 -1.6 -2.7 -3.0 -1.5 -2.0 -2.2 -1.7 -1.9 Net domestic interest 0.3 0.6 0.8 0.9 0.4 *0.8 -0.6 0.2 -0.4 -0.6 -0.4 -0.7 Net foreign interest -0.5 -1.0 -1.5 -1.5 *2.0 *1.9 -2.5 -1.7 -1.7 -1.6 -1.3 -1.2 Forward Cover Loss -0.4 -1.8 -2.7 1.4 -0.1 -0.0 -0.0 -0.0 -0.0 -0.0 Swap Cover Gain/Loss -1.2 -1.4 -1.0 -1.3 0.2 -0.1 -0.1 -0.1 -0.3 0.2 Net Income -0.1 *0.4 *2.3 -3.7 -5.3 -2.7 -3.0 -1.6 -2.1 -2.3 -2.0 -1.7 Source: Central Bank of the Philippines, DER-Domestic, unphalished. since 1989. Thus, as domestic interest rates have risen, the CB itself has experienced a rise in interest payments on these instruments. 4.47 Interest on external debt has consistently been the largest expenditure item in the CB income statement. It has however declined after the peak reached in 1986, mostly as a result of external debt restructuring. Since 1986, in fact, the CB has taken several initiatives to reduce the stock and the interest rate on its external debt. New external borrowing has been limited to new money and trade finance obtained under debt restructuring agreements with commercial creditors, and the stock of external debt has been reduced by means of debt-equity conversions and buybacks. Debt rescheduling agreements have led, however, to the assumption of foreign debt of other agencies for approximately $3 billion, as of end- 1991. The net effect of these operations on outstanding CB external debt amounts to a reduction of approximately $1.8 billion between end-1986 and end-1991.A 4.48 The recurrent losses of the central bank are of serious concern not only because of their public finance consequences but also for their implications for monetary policy. In the first place, financing interest payments on external liabilities by domestic borrowing has raised interest rates, crowded out private credit, and appreciated the exchange rate. By reducing growth, these in turn have decreased seignorage revenues to the central bank, thus leading to higher future financing requirements. Second, high interest rates have increased the cost of sterilization operations, thus providing a powerful incentive for excessive monetary creation and discouraging those external debt initiatives-debt-equity swaps-that involve money creation but would be extremely beneficial to the CB through their reduction of its future foreign interest obligations. Third, the preoccupation with large financing requirements has distorted the appropriate use of instruments of monetary policy, which are being employed for revenue generation instead of monetary control or developmental objectives. As a result, the level and interest 1-9 Further reductions resulted from the May 1992 buyback ($600 million) and debt-equity conversions in the first half of 1992 ($150 million). - 80- rate of reserve requirements are being set with cash flow in mind, as are other regulatory activities, such as the awarding of retail bianch licenses to commercial banks. 4.49 For these reasons, the elimination of the deficit of the CB is particularly urgent. Since the central bank does not have taxing power except by issuing money, and since such taxing power should be limited to the normal growth of monetary transactions in order not to be inflationary, eliminating the CB deficit will require the transfer of its liabilities to the national government, which is the institution that can tax in the least distortionary manner. C. Fiscal Adiustment in a Growth-oriented Stratev 4.50 While the stabilization of the debt to GDP ratio since 1989 is an encouraging development, its level is still too high and hinders the pursuit of a growth-oriented strategy, that is, a strategy in which private sector development is stimulated and supported not only by a stable macroeconomic environment but also by adequate pro ision of infrastructure investment by the public sector. A shift from the strategy undertaken in 1986 to 1991, which was centered on stabilization and the maintenance of a stable macroeconomic environment, to a growth-oriented strategy for the 1990s will require further fiscal adjustment to reduce public debt-foreign and domestic-and thus real interest rates. 4.51 Shifting to a growth-oriented strategy does not make stabilization less important: on the contrary, without a stable macroeconomic environment a growth-oriented strategy will not be feasible that is, it will neither be financeable nor will it generate an adequate response by the private sector. The two most critical elements of stabilization will continue to be a conservative monetary policy to control inflation and flexible responses to market-determined exchange rates. Both will be necessary to bring down real interest rates, by reducing the level and the variance of inflationary and depreciation expectations. A reduction in domestic interest rates will require flexible managemen. of the exchange rate, in order to avoid creating an expectation of large and sudden devaluations, which might drive up the premium demanded by investors to hold domestic securities. 4.52 The composition of fiscal adjustment will be crucial, and growth prospects will depend as much on its quality as on its size. There is in fact a large body of evidence-for the Philippines specifically as well as for other countriesW-indicating that the composition of public expenditure has important implications for private investment and thus for growth. Public investment in infrastructure tends to complement private investment, while public investment in productive activities-typically by public corporations attempting to exploit returns to scale or to develop strategic industries-tends to compete with and thus depress private investment. In addition, public investment in human capital-health and education-appears to complement private sector development. Progress in reducing the public debt burden will thus need to be accompanied by an improvement in the distribution of public expenditures toward those that most effectively complement private sector development. 4.53 It should be recognized that sustaining growth-oriented expenditures and at the same time reducing the debt burden can only be accomplished by a combination of revenue increases and selected expenditure cuts. As argued earlier in this chapter, the tax system has been much strengthened by the reforms introduced in 1986-88, but tax administration still needs to be improved to increase the tax yield, which remains much below its potential. In addition, the tax system could benefit from broadening the application of the value added tax to sectors still subject to sales tax, as argued in detail in an earlier V Cf. Chapter V below for a discussion of the Philippines, and A. Chhibber-M. Dailami, Fiscal Policy and Private Investment in Developing Countries: Recent Evidence on Key Selected Issues," W_g Bank Workging PEr (1990). - 81 - World Bank report .' On the expenditure side, a substantial improvement could be accomplished by eliminating subsidies to government corporations tad to energy consumers. In addition, the civil service appears to have grown excessively and a serious review of its structure and function should be undertaken, with a view to reducing its size in line with the goal of a smaller and more focused role for the government in the economy and in society in general. & Cf. World Bank, The Phili=ines - Country Economic Renort: Public Sector Resource Mobilization and Expniture Manaeement (1992). . 82 - V. PROSPECTS FOR GROWTH: FISCAL POLICY. STRUCTURAL REFORMS, AND MACROECONOMIC PERFORMANCE 5.1 Over the past decade, the Philippines has relied heavily on monetary tightness to achieve stabilization and on structural reform to increase growth and productivity. This strategy has not been as successful as hoped. Monetary tightness has raised domestic interest rates and appreciated the real exchange rate, depressing private investment. Without private investment, structural reforms have not been able to deliver growth on a scale necessary to improve fiscal balances and relieve the pressure on the monetary authorities. Clearly, the current strategy needs to be modified. 5.2 There are three options open to the government to generate growth. First, the deficit could be allowed to rise from current levels, with the hope that this stimulus would jump-start growth and result in sufficient expansion of the underlying tax base to increase future revenues. Under this scenario, there is little pain to be borne in additional fiscal adjustment. The deficit would automatically close in the future. The danger, of course, is that inflation and nominal interest rates could rise, offsetting any stimulus to private investment. Growth would be short-lived and the fiscal situation more precarious than before. This was indeed the experience during 1986 to 1989. Another danger is that the wrrent account might expand to unsustainable levels. 5.3 The second option is to finance an increase in public expenditures through additional revenue mobilization efforts or through a reorientation of public expenditure, away from low-productivity budget items. Some personnel expenses might fall into this category. The problem with this option is one of timing. Realisically, revenues cannot be raised rapidly enough, nor expenditure adjustments made quickly enough, to accommodate the significant amounts of public expenditure that are required. Even the prospect of mobilizing significant resources for infrastructure through private sector, Build-Operate- Transfer type contracts cod not negate the major public infrastructure spending increases that are now required. 5.4 The third option is to loosen monetary policy in an effort to lower domestic interest rates. The savings on public domestic debt servicing could be reallocated to investment. At the same time, the real exchange rate would depreciate, stimulating exports. Higher export demand and lower domestic interest rates should offset any increases in the cost of investment resulting from the higher prices of imported capital equipment that follow a depreciation, so private investment would react positively to this policy. The danger of overreliance on tnis option is that exchange rate depreciation might widen the fiscal deficit, crowding out private investment. It might also feed back into domestic real interest rates and inflation, as happened in 1991. 5.5 In the end, the new growth strategy adopted by the government must incorporate a balance of each of these options. Where that balance lies depends essentially on the quantitative dimensions of the trade-offs under each of the options. This chapter first assesses the trade-offs through a simulation exercise that captures the key structural elements of the Philippine economy and then develops a medium- term scenario that balances the competing objectives of sustained growth, inflation, and financeable current account deficits. The existence of such a scenario is a positive reflection of the success of the Aquino administration in changing the structural parameters of the economy, thereby permitting more room for pursuit of balanced macroeconomic policies. - 83- A. Ouantifying Fiscal and Monetary Poliey Tradeoffs The Simulation Modell' 5.6 To capture the complex links between fiscal policy and macroeconomic performance, an econometric model of the Philippine economy was estimated over the neriod 1970-90. The model was specified so tnat it could describe the main trade-offs facing policyrsakers in the design of fiscal and monetary policy. The model emphasizes the evolutita of prices, interest rates, and exchange rates as well as the relationship between fiscal policy and growth. It includes a supply block where installed productive capacity-potential output-is a function of private and public infrastructural investment and the wage rate. Private investment in turn depends on output, through a standard accelerator mechanism, and the cost of capital. Output is determined on the demand side, as the sum of consumption, investment, government expenditures, and net exports. Firms are assumed to determine prices as a function of capacity utilization. Prices are also found to depend on the evolution of the exchange rate and money supply. 5.7 The exchange rate is set by monetary authorities as a function of the macroeconomic environment. In the model, an exogenous increase in demand will lead to higher capacity utilization, thereby fuelling inflation and prompting a nominal devaluation. The public sector is described in detail, with a distinction being made between national government, public nonfinancial corporations, and the central bank. A separate budget identity is specified for each of these entities. Budgetary balances in turn determine the evolution of outstanding stocks of domestic public debt. The equilibrium in the money market, as a result, depends on both monetary policy-which sets the evolution of high-powered money- and fiscal policy-through its effects on domestic public debt. The equilibrium interest rate in turn affects, through its impact on the cost of capital, the behavior of investment. 5.8 The estimation of the various behavioral equations, yields interesting insights into the working of the Philippine economy. First, the import content of growth was found to be lower than what sometimes has been asserted. The long-run output elasticity of imports was estimated to be equal to 1.35. In the short-run, though, an acceleration of growth would lead to a larger increase in imports, because of lags in the response of private investment and productive capacity in import-substitution activities. The short-run coefficient is indeed equal to 1.97. Seen in this light, the spurt in domestic imports following the economic recovery after 1985 is not surprising, and can be expected to even out. Second, both imports and manufacturing exports were found to respond significantly to the real exchange rate. The long-run price elasticity was estimated to be -0.8 and 0.7 respectively. Exchange rate policy, therefore, can be expected to play a crucial role in determining the external balance. 5.9 Third, the behavior of monetary authorities in setting the nominal exchange rate was fairly accurately described by a simple reaction function, which included among its arguments the price level, the level of gross international reserves of the central bank, and the stock of external debt. This implies that monetary authorities allow the real exchange rate to become more depreciated the lower the level of 1' A detailed description of the model is given in R. Faini- D. Gressani (1992), "Exchange Rate Management, Fiscal Policy and the External Debt Burden," unpublished. 21 See for instance P. Krugman and others, Transformin the Philippine Economy, (1992, APO Production Unit Inc.). -84- reserves and the lower the level of international debt. That is, lower reserves as well as lower external debt were found to be conducive to a more aggressive, nominal exchange rate policy. These findings confirm that monetary authorities have been concerned that a devaluation, in the presence of a large stock of foreign-denominated debt, might lead to a significant deterioration in the public sector accounts, and have followed a more conservative exchange rate policy than would have been appropriate otherwise. Finally, expectations about future exchange rates were shown to play a substantial role, in addition to monetary and debt aggregates, in influencing the behavior of interest rates. More specifically, the interest rate on treasury bills was significantly affected by the return on foreign assets, with the latter being measured by the sum of LIBOR and expected devaluation, as predicted by the reaction function. This fact highlights the significant link between exchange rate policy and foreign and domestic interest rates. Simulating the Effects of Alternative Policy Packaes 5.10 The model described above was first used to replicate the evolution of the Philippine economy between 1985 and 1990, and was found to adequately represent it. Three features of the actual policy strategy were identified: (a) Tight monetary policy, together with an appreciated exchange rate, was made compatible with low inflation and high fiscal deficits, but at the cost of growing debt accumulation. This strategy, however, led to high domestic interest rates, which reduced growth and thus fed back onto higher fiscal deficits. (b) Fiscal adjustment was carried out by cutting growth-oriented public expenditures. This depressed private investment and growth. The short-run improvement in the fiscal deficit was therefore not sustainable, as the negative impact on growth reduced the base for future public revenues. (c) An appreciated exchange rate led in the short run to improved fiscal balances. Econometric estimation of the exchange rate reaction function showed indeed a reluctance to devalue in the presence of a large stock of external debt. Yet, the real appreciation induced a deterioration of both the capital and the current account, leading to a loss in reserves and forcing monetary authorities to undertake belated major devaluations. Furthermore, the expectation of a future devaluation has introduced a sizable premium into real domestic interest rates over foreign rates. This in turn has discouraged investment and growth and has dissipated the fiscal benefits of an appreciated exchange rate Fiscal Policy and Interest Rates 5.11 The combination of tight monetary policy and still significant budget imbalances means that economic policymaking in the Philippine is like walking on a tightrope. The benefits of low inflation come at the expense of high interest rates, which in turn compound the budgetary problem. Even a limited budget deterioration, due for instance to a lapse in fiscal discipline or to unforeseen shocks, may have far-reaching consequences on macroeconomic performance. In fact, this is precisely what aborted the expansion of 1987-89. 5.12 To illustrate the economic forces generated by an expanded fiscal deficit, the econometric model is used to simulate the impact on the economy of a modestly more expansionary fiscal policy. Between 1986 and 1990, current non-interest government expenditures were increased by P6 billion- - 85 - approximately one percent of GDP at constant 1985 prices. Table 5.1 reports the behavior of some key economic variables, as deviatioLs from the base-run historical simulation. The results immediately show that the concern about the fiscal balances is not misplaced. Table 5.1: Fiscal Empnisien F1an,ged by Doestic Debt Acemaltion (deviations from historic simutation, percent) 1985 1986 1987 1988 1989 1990 GOP Growth Rate 0.0 2.0 0.6 0.8 0.6 0.8 Inflation Rate 0.0 2.0 2.1 4.0 4.0 5.6 Nominal Interest Rate 0.0 1.4 2.4 4.0 5.2 7.5 Cost of Capital 0.0 1.3 2.6 5.2 8.8 15.5 Devaluation Rate 0.0 1.1 3.3 S.3 5.6 3.9 Reat Exchange Rate Index 0.0 *1.1 0.4 1.8 3.2 2.0 Private Investment 0.0 0.3 0.0 -0.4 *1.0 -1.7 Manufactured Exports 0.0 *0.0 0.1 0.2 0.1 -0.3 Inports of Goods and NFS' 0.0 0.6 0.5 0.3 -0.0 *0.5 Current Account Batanceb *0 -192 -109 .84 160 437 Domestic Public Debt* -0.0 1.3 2.9 5.8 9.7 17.5 a. Difference expressed as percentage points of siaulated GP. b. Difference expressed in current S millions. 5.13 On balance, the short-run effects of a fiscal expansion are positive. Larger aggregate demand stimulates output and, through the accelerator effect, also investment: the economy enjoys a short-ni boom. But higher aggregate demand leads to higher capacity utilization, which in turn boosts inflation and induces an increase in interest rates. Nevertheless, private investment rises due to the strength of the accelerator effect, which more than offsets the impact of a higher cost of capital. The only somber notes in the short run are represented by the deterioration in the current account and in fiscal balances, shown as an increase in domestic public debt. 5.14 In the medium run, however, the costs of the fiscal expansion become more and more manifest. A worsening current account leads to a loss of reserves, which, together with higher inflation, prompts a larger devaluation of the exchange rate as monetary authorities attempt to stem incipient outflows of foreign exchange.y The devaluation then further adds to the strength of inflationary pressures. No relief comes from the supply side: in 1986 the accelerator effect is strong enough to sustain the increase in investment and thereby in productive capacity, but in the following years the evolution of private investment is dominated by the rise in the cost of capital. As a result, already in 1987 investment is back to its base-run level, and from 1988 onward it falls well below it. The resulting decline in productive capacity adds further pressure to inflation, which by 1990 is 5.6 percentage points higher than in the base run. The steady rise in inflation together with the widening budget deficit are in turn associated with a steep increase in the level of interest rates: in 1990, the nominal interest rate on treasury bills is 7.5 points higher than in the base simulation. The exchange rate, however, depreciates sufficiently to bring about a real devaluation, and this leads to an improvement of the current account 2' Monetary authorities were found to react with a one-period lag to the loss of foreign exchange reserves. - 86- relative to the base run. Finally, in 1990 domestic debt is 52 percent larger than in the base run, equivalent to about 17 percertage points of GDP. 5.15 The crucial implication of this simulation is that the short-term gains in GDP from a fiscal expansion financed by domestic borrowing are quickly dissipated as higher interest rates lead to lower private investment and thus, in the medium term, lower growth. The growing increases relative to the base values of inflation, devaluation rates, and interest rates further confirm that growth based on an expansion in the fiscal deficit is indeed not sustainable. Public Investment and Growth 5.16 Since 1983, fiscal retrenchment has typically been associated with cutting public investment. The difficulties in compressing current expenditures and a low-yield tax system in the past have meant that public investment has had to take the brunt of fiscal cuts. Yet, the macroeconomic outcome of fiscal policy depends on the composition as much as on the level of fiscal adjustment. An excessive reduction in public expenditures (such as public infrastructures and public investment in human capital) that are complementary to private investment and/or have a high social return is detrimental for growth. Admittedly, a clear-cut distinction between productive and unproductive public spending is not easily made. As in other countries, however, there is evidence that infrastructure investment in the Philippines is complementary to private investment, and the estimated productive capacity equation and private investment equation found evidence of this. 5.17 One of the policy options is to reallocate public expenditures toward productive items. To illustrate the issues involved at a macroeconomic level, the impact of changimg the composition of public spending has been examined using the econometric model. The results are reported in Table 5.2. It is assumed that, starting in 1986, public infrastructural investment increases by P3 billion in constant 1985 prices-approximately equivalent to one half of one percent of GDP-while current government expenditure is cut by an equivalent amount. Initially, therefore, the fiscal balance is unchanged. 5.18 In this scenario, the increase in public investment has an immediate positive effect on private investment. This stimulates aggregate demand with a consequent short-term increase in prices and, as a result, in the interest rate. The real exchange rate appreciates. The effects on inflation, devaluation, and interest rates, however, are much more limited than in the previous case, where the fiscal expansion was financed by domestic debt accumulation. This is as expected, given that the aggregate stance of fiscal policy is unchanged. Interestingly enough, because of larger tax receipts induced by output growth, fiscal balances improve and domestic debt declines, relative to the base case, in absolute levels as well as in proportion to simulated GDP. 5.19 In the medium run, increases in public and private investment each contribute to expanding potential output. In turn, this larger productive capacity relieves the pressure on prices. Table 5.2 shows that, starting in 1987, inflation is consistently lower than in the base run. The behavior of interest rates mirrors that of prices, with some lags. Initially, interest rates are higher than in the base case, mostly because of a more sustained output growth, though starting in 1989 they decline with respect to the base case. Finally, the increase in productive capacity raises export supply, leading to a sustained expansion in manufacturing exports which, from 1989 onward, more than offsets the increase in imports. The improvement in the current account allows monetary authorities to pursue a somewhat less aggressive exchange rate policy with a beneficial impact on domestic inflation. - 87 - Table 5.2: saWnsd Icrease in Grauth-oriented Expditures (deviations from historic siluation, percent) 1985 1986 1987 1988 1989 1990 GDP Growth Rate 0.0 1.4 1.2 0.6 -0.6 -1.2 Inflation Rate 0.0 1.5 *0.5 *0.2 *0.3 *0.3 Nominal Interest Rate 0.0 0.8 0.4 0.5 0.0 -1.0 Cost of Capital 0.0 0.? 0.7 1.0 0.4 -1.1 Devaluation Rate 0.0 0.8 1.3 2.2 1.3 -1.2 Real Exchange Rate Index 0.0 -0.8 1.1 3.1 4.4 3.6 Private Investments 0.0 0.9 1.5 1.5 1.1 0.9 Manufactured Exports 0.0 0.2 0.7 1.3 1.9 2.4 Imports of Goods and UFS' 0.0 0.6 1.1 1.5 1.7 2.1 Current Account Balance .0 *119 -100 -25 150 222 Domestic Public Debts -0.0 -0.1 -0.6 -1.3 -2.3 -4.2 a. Difference expressed as percentage points of simulated GP. b. Difference expressed in current U.S. dollars. 5.20 The balanced budget expansion in infrastrucuire leads to higher GDP, lower inflation, lower interest rates, and lower debt accumulation than in the base run. With the same tax effort, however, a fiscal surplus is rapidly incurred and toward the end of the simulation period, the growth rate of income declines below that experienced in the base case. This is, however, a case of an embarrassment of riches. In reality, the improved fiscal balance could be translated into higher expenditures, which would sustain the growth momentum. 5.21 The results presented in Table 5.2 show how well-designed fiscal policies could provide a crucial contribution toward noninflationary sustained growth. The shift in the composition of public expenditure is initially less expansionary than the increase in current expenditure examined in the previous scenario. But this is only a short-run effect. The increase in public infrastructure leads to a sustained increase in productive capacity, paving the way for steady output growth with little inflationary impact and an improvement in both fiscal and external balatces. In contrast, an expansion in current expenditure was shown to lead to a continuous and possibly unsustainable increase both in the public sector and in inflation. A recent independent report-4 on the Philippine economy argues for more public investment on the ground that existing infrastructures are being dangerously depleted. These simulations provide a quantitative assessment of the beneficial impact of such strategy. Of equal relevance is the simulated effect on inflation. A high-growth strategy driven by public and private investment and greater productive capacity can help considerably in the fight against inflation. This is yet another reminder of the close interaction between stabilization and structural policies. Exchane Rate Policy and Fiscal Outcomes 5.22 The exchange rate devaluations of 1986 and 1990 had a negative impact on fiscal balances to the extent that they increased the local currency value of debt service, expenditures or, foreign capital ' P. Krugman and others, Transforming the Philippine Economy (1992). - 88 - goods, and subsidies on imported goods by a larger amount than they increased the local currency value of international trade taxes, foreign grants, and other foreign sources of government finance. This may explain the reluctance of monetary authorities to devalue the exchange rate in the presence of a large stock of outstanding external debt. At the same time, though, an overvalued exchange rate may have a destabilizing effect on th, economy by subsidizing imports, taxing exports, fostering capital outflows, and discouraging workers' remittances. Many analysts have argued that the Philippines should pursue a much more aggressive exchange rate policy (accommodated by relaxing money supply targets) as a centerpiece of a new growth strategy. It is often hoped that this would relieve the balance of payments constraint and permit a more expansionary fiscal policy as in the first simulation. To assess the trade-offs involved in implementing such a recommendation, a counterfactual simulation was used where exchange rate policy was assumed not to depend on the stock of external debt. In addition, as in the first scenario, current government expenditure is increased by P6 billion, in 1985 constant prices, starting in 1986. -'.23 A comparison between Table 5.1-where the exchange rate is set according to the estimated reaction function-and Table 5.3-where the modified reaction function is used-is quite revealing. Without having to consider the burden of high external debt, the monetary authorities respond to reserve losses with a more aggressive exchange rate policy. The faster rate of devaluation and inflation feed back on the public sector deficit, which is already strained by the expansionary maneuver: foreign currency denominated expenses rise when measured in local currency terms, and higher prices with an unchanged monetary stance push up interest rates and the interest payments bill on domestic public debt. The overall effect of the depreciation on fiscal accounts is on balance negative, so that domestic debt is higher than in the first simulation, though not dramatically so: by the end of the simulation period, domestic debt is about 3 percentage points of GDP higher than it would have been under more conservative exchange rate management. The overall effect of the expansionary fiscal policy on GDP is strengthened by exchange rate depreciation, as is the improvement in the current account deficit. Because of the high import content of capital investment and the effect of the depreciation on domestic real interest rates, there is a minor negative effect of this policy on private investment. Nevertheless, overall GDP growth is boosted because of a strong import-substitution response to the depreciated exchange rate. For example, locally grown and consumed agricultural goods would benefit significantly from the exchange rate movement. 5.24 The main insights of this scenario are as follows: a more aggressive exchange rate policy can have distinct benefits for growth and external accounts, and only modest costs for fiscal policy. It cannot, however, be seen as a substitute for fiscal discipline: the simulation clearly shows that a fiscal expansion financed by domestic debt accumulation continues to be destabilizingoven in this scenario. Policy Implications 5.25 The simulation exercises show that macroeconomic policy in the Philippines has had to walk an extremely narrow path. The risks of zero growth resulting from excessive reliance on cutbacks in discretionary public spending on investment and O&M and on sudden hikes in import levies, have had to be balanced against equally great risks of higher inflation, rising nominal and real interest rates, and falling private investment from too loose a fiscal and monetary policy. Given the structure of the economy, there has been little room for maneuver. - 89 - Table 5.3: *Aggressivew Exchan Rate anaeme (deviations from historic siLtation, per-ent) 1985 1986 198? 1986 1989 1990 GOP 0.0 2.2 0.5 1.2 0.7 0.7 inflation Rate 0.0 2.6 2.2 5.5 SA 6.2 Nominal Interest Rate 0.0 1.9 2.5 5.2 6.6 8.5 Cost of Capital 0.0 1.9 2.9 6.8 11.5 18.9 Devaluation Rate 0.0 2.5 3.1 8.3 7.3 1.8 Real Exchange Rate Index 0.0 -0.3 0.8 3.5 5.1 1.8 Private Investment* 0.0 0.2 -0.0 *0.5 -1.3 *2.2 Manufactured Exports* 0.0 0.0 0.1 0.2 0.2 -0.6 Imports of Goods and NFS" 0.0 0.6 0.4 0.3 -0.2 -0.9 Current Account Salance' -0 *198 -95 -68 260 550 Damestic Public Debt 0.0 1.4 3.2 6.6 11.S 20.7 a. Difference expressed as percentage points of siulated GDP. b. Difference expressed in current S millions. 5.26 Policy reform has broadened the macroeconomic options facing the government in four important ways. First, reforms in direct and indirect taxation have substantially increased the buoyancy and elasticity of taxation. This makes any future growth-promoting strategy less costly in terms of public finances. Considerable follow-through is still required as collection continues to lag behind potential. By most estimates, no more than 60 percent of potential revenues is captured by the tax administration institutions. This is damaging not only to fiscal r-3licy, but to the fairness of the system and thus to future compliance as well. Institutional building in the tax system is an area where major gains could be obtained at relatively small up-front financial costs; however, the process can be expected to require time and persistence to be successfully implemented. A buoyant tax system is the simplest way of ensuring that general government expenditures on road maintenance, for example, can be sustained without resort to ever-expanding deficits. 5.27 Second, the simulations clearly show the limits in the past to th: effectiveness of the exchange rate as an instrument for growth because of the negative implications on ti consolidated public sector deficit. A substantial reduction of the fiscal impact of a devaluation will be accomplished by the recent debt buyback and by the Brady deal. In addition, in order to disentangle exchange rate management from fiscal constraints, deeper fiscal adjustment will continue to be needed, so that a devaluation need not lead to an increase in domestic borrowing and thus interest rates. Guarding the overall public sector deficit against the effects of depreciations still needs attention. It is one reason for stressing the importance of marginal cost pricing in setting tariffs for public utilities. It provides a rationale against using the opportunity afforded by the debt deal to resume foreign borrowing on an excessive scale. It demonstrates the value of debt-equity swaps and privatizationas important components of structural reform. And it reinforces the emphasis that needs to be placed on indirect tax collections that respond most rapidly to exchange rate changes. 5.28 Third, the problems associated with high public sector debt emerge. Clearly, it is high public debt that is responsible for the close interaction between exchange rate policy, monetary policy, and resources available for discretionary public expenditure. High public debt also generates a close link .90- between fiscal policies and their financing and the behavior of domestic private investors. It has been argued that the Philippines does not face as serious a fiscal constraint as other highly indebted countries, because of much smaller public sector deficits. While this was true at the onset of the international debt crisis, it is much less true now, ten years later. Starting with smaller fiscal imbalances, the Philippines has also carried out much smaller fiscal adjustment. This, together with the anti-inflationary stance followed by the Philippine monetary authorities, has now resulted in a much larger public debt burden that mos. other highly indebted countries. 5.29 In order to lessen the impact on interest rates of an increase in the public sector borrowing requirement, continued financial liberalization is important. Improved efficiency and competition in domestic financial markets need to be actively fostered. In the Philippines, excessive taxation of financial intermediation-both by means of high reserve requirements and high indirect taxes-has been accompanied by tolerance for the very high spread charged by banks and limited competition within the sector. These have taken the form of various restrictions to entry in the financial sector, in particular with regard to branching and to entry by foreign banks. In addition to affecting domestic interest rates by widening the spread between deposit and lending rates, these trends have caused a decline in financial intermediation, which has direct efficiency costs, limits the pool of financial savings out of which public borrowing requirements are financed, and reduces the financial tax base.F 5.30 The spread between domestic and international interest rates can also be reduced by adopting a more flexible exchange rate management policy and by integrating domestic with international capital markets. The difference between domestic and international interest rates is in fact the reflection of the risk that a sudden devaluation might result in capital losses on holdings of Jomestic securities, as well as the risk that the high burden of external and domestic debt might lead to some form of default on public debtY A strong commitment to fully market-determined exchange rates, as reflected in recent reforms, would contribute to reducing the fear that a period of overvalued exchange rat-s would be followed by large and sudden depreciations. Similarly, progress on extnal debt management-more specifically debt reduction-and progress on domestic debt management-lengthening maturities and indexing interest rates-will decrease the danger of default on public debt. These policies should be aimed both at reducing the spread between domestic and international interest rates and at eliminating-through the deepening of domestic capital markets and their international integration--the Philippine-specific risk premium and eventually should restore full creditworthiness for domestic borrowers. 5.31 Fourth, reforms to increase the price sensitivity of both exports and imports will contribute to lessening the risk that disequilibrium in the balance of payments will halt growth. Although major steps toward stimulating the development of the tradable sectors have been successfully taken by removing price distortions and liberalizing international trade, there remain important regulatory obstacles to competition, partly because of the nature of incentives to both large and small (but not medium) V For a detailed analysis of the issues pertaining to financial sector liberalization and capital market development, cf. World Bank, PhiliiMines - Capital Market Study (1992, Report No. 10053). V Although the Philippines has not defaulted on foreign or domestic debt even the midst of the debt crisis, the experience with highly indebted countries indicated that arbitrary measures aimed at "expropri- ating" public debt holders have been common: introduction of dual exchange rate regime, consolidation of domestic debt into longer maturities, and extraordinary taxation of financial assets have been among the most common devices. - 91- enterprises, and partly because of barriers caused by inadequate access to infrastucture, especially transport services, which are only now being liberalized. These obstacles tend to bias domestic investment toward local markets, and thus effectively limit the allocation of resources in export-oriented activities. Given the relative price structure in the Philippines, this leads to shifting resources away from labor-intensive to more capital-intensive activities, which in turn leads to higher import content of domestic production. The capital intensity of domestic production, linked to the structure of protection and investment incentives, is also a barrier to a quicker supply response to a depreciation. 5.32 Much has been done already in each of these four areas, and there is a commitnent to further strengthening these efforts. These set the stage for sustaining growth through a more expansionary policy package consisting of higher public investments and O&M spending, financed partly by new taxes, partly by expenditure reallocation, and partly by an expanded deficit; a more aggressive exchange rate policy based on market-determined rates and implemented through reserve accumulation policies; and continued tight domestic credit policies to maintain inflation in check. The next section expands on the quantitative dimensions of this package. B. Growth with Adustment 5.33 The Philippines can realistically aim for a target growth of GDP of around 5.5 percent a year. Growth momentum should build in the latter half of 1992 and, by 1993, carry through into a full- fledged recovery that can be sustained thereafter. Given important demographic changes, with population growth now projected at 1.8 percent a year over the next decade, this represents a significant increase in income per capita. Both per capita private consumption and savings could increase with growth at this rate. Although it is hard to project the new employment that would be created by such growth-there are uncertainties over how wages will react in the Philippine context, where institutional factors rather than market forces play a key role in formal sector wage determination-it is saft to say that a significant dent would be made in unemployment and underemployment. The growth scenario presented below is built around an expansion of public and private investment, which would stimulate the labor-intensive construction industry, and around a steady increase in competitiveness through real exchange rate movements that should give a marked boost to the rural economy. Thus, the projected scenario should prove to be socially acceptable. The Global Environment 5.34 The outlook on the global environment is not very favorable. Growth in the industrialized countries is expected to be sluggish in the short term and to recover only gradually. From the point of view of the Philippine economy, on the positive side, the growth rate of world trade in volume should pick up to about 6 percent after two years of low 4 percent growth, presenting an opportunity for expanding the market share of manufactured exports. At the same time, limited opportunities domestically are encouraging developed country firms to rethink locational strategies, and prospects for direct foreign investment in the Asia region remain promising. Given the significant interest in build- operate-transfer (BOT) type infrastructure projects, more than $1 billion of direct foreign investment a year could be attra:ted to the Philippines. 5.35 On the negative side, international interest rates are expected to rise from the present low levels as the world economy recovers. In spite of the large external debt, however, the Philippines is expected to be largely protected from the effects of this by the recent Brady restructuring of commercial bank debt. Fixed interest provisions on the new debt exchange bonds provide a valuable cushion for the -92 - country over the medium term. The outlook for the major primary commodity exports is one of stability rather than growth. Sugar quotas for the U.S. market should recover somewhat from their precipitous decline (-44 percent) in 1992. as the U.S. market returns to normal conditions, but prices arm unlikely to change even in nominal terms. Prospects for coconut oil and copra are also not encouraging. Prices could show some short-term weakness before recotering in 1995 and thereafter, while volumes cannot realistically be expected to grow in present market circumstances. After a good year in 1992, copper concentrates cannot sustain additional volume growth in the near term and here, too, world prices could weaken before recovering in the latter part of this decade. Following a congressional ban on logging, timber exports are projected to fall off completely. Overall, then, the pattern of the global outlook is similar to that of the past ten years: a decline in the relative importance of primary commodities, but a positive environment for manufactured export growth. Policies Underlving the Projections 5.36 In the scenario it is assumed that the recovery is initiated by the public sector with an increase in growth-inducing spending in infrastructure and maintenance. The first steps of this strategy have already been taken, with the increase of public investment in infrastructure construction in 1992. The primary instrument of this increase will be the state enterprise sector, particularly public utilitiss. Because of the neglect of capital investments in the past, the current requirements for infrastructure spending are enormous and cannot be postponed any longer. 5.37 The growth scenario envisages that stm mLMf investment will reach 4.6 Oiercent of GDP by 1994, more than double the 2.2 percent level projected for 1992, and, after reaching this peak, will decline to a sustainable level of around 3 percent of GDP by 1997. While falling well short of the needs identified in Chapter VI-and unlike those needs-the increase in investment in the scenario is financeable under the projections for resource mobilization discussed below. 5.38 The biggest absorber of infrastructural finances is the power sector. Even with significant participation of the private sector, particularly in generation, the public energy sector investment plan is expected to be the largest component of the expenditure program. Even though needs are projected to taper off after the hump in 1993-95, as the backlog of unmet energy demand is reduced, a sudden increase in infrastructure spending of the magnitude proposed above is anticipated to strain the absorptive capacity of the economy and to worsen substantially the import bill. Institutional strengthening and careful management of external payments will be necessary complements to the increase in public infrastructure investment. In addition, state enterprises will need to maintain user fees at levels sufficiently high to finance at least 25 percent of their investments by internal cash generation. This will require close attention to the level of utility tariffs and collection efficiency. 5.39 The contribution of the national government to the increase in public investment is forecast to be smaller, with national government infrastructure investment averaging 2.5-3.0 percent of GDP. To accommodate this increase in capital expenditure, the national government deficit is forecast to reach 1.5-2.0 percent of GDP in the short run. In the longer run, as the government increases its tax revenues and reallocates its expenditures toward growth-oriented investment and maintenance, the national government will move toward a balanced position, in order to bring down the overall public sector debt. 5.40 The tax effort all be the focal point of fiscal policy. Overall, the scenario assumes that taxes can be raised by one-half of one percent of GDP a year over the next four years. Underlying this net figure, revenue losses from reductions in customs tariffs under E0470 and declines in revenues from * 93 - privatization sales are forecast to be more than compensated by an incremental tax effort of close to 1.5 percentage points of GDP a year. Of this increase, a small part will come simply from growth, given the renewed buoyancy of the tax system; the remainder is projected to arise from a concerted effort to broaden the tax base-in particular with the introduction of ceilings on deductions and with the expansion of the VAT base-and increased collection efficiency-with initiatives to extend import surveillance. streamline tax procedures and strengthen administration and enforcement. As a result of continuing discipline on the current expenditure side and of rising tax effort, the national government is projected to increase its savings by 1 percentage point of GDP-from 3 percent to 4 percent-over the projection period. 5.41 The reorientation of government expenditures will also contribute to containing the national government deficit and increasing the flexibility of budgetary expenditures. The increase in non- discretionary expenditures-interest payments and the wage bill-is projected to be reversed. First, the Debt and Debt Service Reduction (DDSR) deal currently in progress is forecast to reduce directly interest payments on external debt of the national government, though only to a small extent, as most external commercial bank debt is held by the central bank and government corporations; national government support to these agencies on account of their debt service will also decline. Second, interest payments on domestic debt are forecast to decline with domestic interest rates, as a result of the reduction in foreign exchange risk resulting both from the DDSR and the liberalization of foreign currency transactions. Third, the streamlining of central agencies announced by the current administration and the implement4. tion of the Local Government Code are projected to reduce the share of expenditures absorbed by personnel costs. 5.42 The cnoiaeM i (excluding surpluses ot social security institutions and profits of government financial institutions) is forecast to rise to more than 3 percent of GDP in the short run, in spite of growing public sector savings, as a result of higher investment by state enterprises and continued losses of the central bank. Financing of these deficits will involve a balance between domestic and foreign borrowing. In order to reduce crowding-out of private investment, total domestic public debt is projected to stabilize at around the current levels of 28 percent of GDP in the near term, before declining in the mediun term. Because of the long maturities desired for financing infrastructure projects, the pattern of the past eight years of substituting domestic for foreign borrowing cannot b4 continued. As a percentage of GDP, foreign debt can now be stabilized at present levels. 5.43 The growth strategy is predicated on a recovery of private investment, both foreign and domestic. In addition to adequate complementary public infrastructure, a stable financial environment is a prerequisite for this to occur. Inflation in the CPI is projected at a level of around 7 percent. This will require maintenance of a goliev of tight domestic credit, especially as inflationary pressures might build in the early stages of recovery when aggregate demand growth could outstrip the rate of capacity expansion. Moneta glie. on the other hand, is forecast to be more flexible, depending on portfolio shifts between peso and foreign currency denominated instruments. In the liberalized capital account environment that the Philippines will face, following the removal of toreign exchange controls and the establishment of market-determined exchange rates, pursuit of interest and exchange rate stability to avoid large speculative flows of funds will become important ingredients of money and credit policy. Given the sensitivity of capital flows to interest rate differentials that has been observed, especially during the past two years, monetary policy is projected to remain tight enough not to allow domestic interest rates to fall below 15 percent, or about 7.5 percent in real terms, in order to sustain inflows of capital and worker remittances. In the newly liberalized foreign exchange market, it is forecast that pressures -94- originating fiom the recovery of imports will lead to a gradual depreciation of the nominal exchange rate sufficient to offset the real appreciation that has occurred since the bcbinning of 1991. Medium-Tr Pojon 5.44 A summary of the medium-term outcomes is shown in Table 5.4. Real GDP growth of around 5.5 percent would be driven by investment and manufactured exports. Consistent with these aggregate demand developments, the sectors that are forecast to grow faster in the scenario are manufacturing and construction. Transitional sectors, such as agriculture and mining, are expected to grow only moderately. Initially, both the public and private sectors would participate in the investment drive. In 'he medium term, it would be the private sector that would sustain the momentum of growth while the ublic sector phased back infrastructure spending. 5.45 In many respects, the projected recovery in the next three years is similar to the boom enjoyed by the Aquino administration in its early years. Growth, investment, and inflation are all comparable. But there are important differences that would make this recovery sustainable where the other was not. Table 5.4 shows that the recovery of the late 1980s was accompanied by an expansion in real public cor -Ntion, associated with increases in wages for public sector employees. The incipient recovery must ..g this; the increases in public consumption activity underlying the projections are to be more for road maintenance than for wages. 5.46 A second major difference lies in the behavior of the current account. In the projections, the current account deficit is allowed to widen significantly; these external deficits are for investment, not for consumption or interest payments as in the past. These investments provide the capacity growth that helps keep inflation low. The boom during the Aquino administration ran out of steam because aggregate demand quickly outstripped new capacity growth. In addition, a large part of new investment underlying the widening of the current account is undertaken by the private sector under various arrangements-such as BOT-that include pre-identified private financing and are thus accompanied by matching exports and loan inflows in the capital account. Hence, the widening current account deficit shown in the projections is expected to be sustainable. 5.47 Third, the tax effort is higher and psblic sector debt lower than in the past. Although the size of the deficit does not quickly contract in the projections, in qualitative terms the projected deficit is far superior to that registered in the Aquino years. The latter was artificially reduced by low ex-hange rates and cuts in public investments, whereas in the projected period both of these are at levels compatible with sustainable growth. 5.48 LAst, with a different exchange rate and trade policy, the explosion in imports that accompanied the previous boom should be avoided this time around. Imports are still forecast to rise faster than GDP growth, but the pressure to import excessively has been eliminated under the projected policies, with greater credibility in fiscal and monetary policy, with phased tariff reductions, with exchange convertibility, and with the potential to speculate on peso movements in financial assets-thus removing the incentive to speculate through inventory accumulation. * 95 - Table 5.4: Mtesteenoo mic o commas (percent) 1986*90 1990-92 1992-95 1995-98 Compound Growth Rates Reot GDP Grouth 4.9 -0.3 4.9 5.S Consumption 5.4 2.3 3.2 5.7 Private 3.5 2.0 2.7 S.7 Public 20.1 5.0 5.9 5.5 Gross Domestic Investment 14.4 -3.8 16.0 4.5 Fixed Investment 12.0 -2.2 15.7 4.5 of Wich: Public 22.5 2.6 11.8 0.1 Exports of Goods and Services 8.2 11.9 3.8 6.1 Manufactured Exports .. 9.0 8.1 8.2 Imports of Goods and Services 18.2 5 8.0 5.0 Period Averages Inflation 7.6 13.7 7.4 7.0 Current Account/GDP -1.7 *3.1 -2.6 -3.1 Foreign Interest/Exports GNFS 20.9 16.8 11.6 9.6 ReaL Exchange Rate Depreciation .. -3.3 0.5 4.0 Total Pubtic Sector Debt/P 85.8 80.4 85.1 82.1 Public Sector Foreign Debt/UP 61.3 53.8 51.4 47.7 Cons. Putic Sector Deficit/GDP 4.9 4.8 4.6 3.3 Tax Effort 12.4 14.4 16. 17.1 Source: Philippine Statistics and gank Staff Projections. 5.49 Einn Growth. The increase in public infrastructure investment together with the recovery of private investment is projected to lead to gross total investment that, at around 27 percent of GDP, will be at levels significantly higher than any over the past ten years. By 1994, investment is forecast to be more than 6.5 percentage points of GDP higher than 1992 levels. Of this increase, despite the renewed interest of foreigners in the Philippines. less than 2.5 percentage points are projected to be financed through higher foreign savings (Table 5.5). The remainder must be financed through higher domestic savings. 5.50 Most of the increased dmesticuLn will be from the private sector. Over the past two years of sluggish growth, private savings have been run down to maintain consumption. As the recovery materializes, private savings are forecast to increase. As measures to reduce the taxation on financial intermediation are introduced, and with a deepening of the government securities market to favor small, noncompetitive bids, the tendency for private savings to rise in the upswing of the boom can be strengthened and sustained. Even with these measures, the scenario conservatively estimates a recovery of private savings to levels below those historically observed in periods of sustained growth. 5.51 The other element of domestic savings, as mentioned earlier, is related to the efforts of the national government and state enterprises to increase revenues and hold expenditures in check. The dynamics of debt service payments is now moving in favor of the public sector: lower interest rates and -96- lower deficits, allowing the growth of debt to be below GDP growth, mean that interest expenses will no longer increve as fast as revenues and thus that public savings will rise. 5.52 The need to rely heavily on foegn sav-ias implies that the Philippines is still far from a full recovery from its debt crisis. The recent DDSR operation was, however, the final step in the Brady strategy of the Philippines. The operation included $4.6 billion of previously rescheduled medium and long-term commercial bank loans, which constitute the total debt eligible under the Brady initiative. The operation consisted of the following: a cash buyback of $1,263 million at 48 percent discount; the conversion of $1,894 million in Principal Collateralized Interest Reduction Bonds at par; the conversion of $757 million in Interest Reduction Bonds at par; the issuance of $138 million in New Money Bonds and $559 million in related Conversion Bonds. Cash flow savings from the operation, shown in Table 5.6, are projected to amount to about $300 million in interest and $400 million in amortization a year during the projection period. 5.53 Even after the DDSR operation, amortization payments due over the next five years average about $2 billion a year. With debt service obligations, resource gap, and foreign exchange reserve accumulation to be financed, the Philippines must mobilize approximately $5 billion in gross capital inflows (or reschedulings) a year to meet the projected external financing schedule (Table 5.6). About $2 billion of this can be raised without increasing public sector indebtedness: official grants; direct foreign investment; new private sector short-term credits to finance trade expansion and other capital. The remainder must be raised by the public sector through external borrowing. Table 5.: Fimming arvth (as a percentage of SDP) Average 1986-91 1992 1994 1996 Total Investment 19.4 20.4 28.3 28.2 Domestic Savings 15.9 16.5 21.9 22.3 Foreign Savings 3.2 1.0 3.1 2.9 of which: DFI 1.5 1.7 1.5 National Goveranment Investment 2.3 3.4 2.9 3.0 Savings 1.1 3.2 3.7 4.0 State Enterprises Investment 1.5 2.1 4.0 3.0 savings 1.0 1.0 1.2 1.2 Private Sector Investment 16.1 15.0 21.4 22.1 Savings 17.5 11.3 15.7 15.9 Other Savings -3.4 1.0 1.3 1.2 a. Includes central bank, deposit money banks, and a statistical residual in history. Source: World Bank staff projections 5.54 Gross disbursements on new public debt have amounted to around $2 billion in recent years. In order for this to continue at levels at Iast as high, the disbursement rate on Official Development - 97 - Assistance, particularly for traditional projects, must be raised. Even so, an average financing gap of about $1 billion a year is expected for the next few years. of which a significant amount reflects principal payments falling due under Paris Club debt eligible for rescheduling. Continued reschedulings, therefore, are likely to form an important component of the overall financing plan. 5.55 In the projections, it is assumed that the government acts as the main mobilizer of additional foreign savings. It is the private sector, however, that will have the most significant resource gaps. For some large infrastructure projects, the domestic banking system might not be able to handle private sector project finance needs. In the long run, as the external debt overhang is removed, important blue-chip companies in the Philippines, such as PLDT and MERALCO, can raise project financing from abroad on their own account; this is already happening in other high-debt countries, such as Chile and Mexico, where the private sector is now able to tap into foreign private financing. In the short run, however, this will be difficult, as commercial bank provisions on exposure in highly indebted countries still add to the cost of financing and make access to funds less readily available for the Philippine private sector. Toe 5.6: Fimtg baspa vsm 19R-9 (S mitions) 1992 1993 1994 1995 16 1997 Gross Financing Requirements 3660 4406 3858 4341 4242 4728 Non-Interest Current Accoumt 1374 181 133 39 171 *3 Debt Service Due 4359 3675 3832 3875 3882 40468 A. Interest 1905 1804 1794 1833 1929 2034 a. Amertization 2454 1871 2038 2042 1953 2014 of which: Buyback 1263 Increase(-) in Gross Reserves -676 -912 -161 -505 *531 -677 Purchase of Cot lateral' 469 Uwinding of Susps' 400 Sources 3660 4406 3857 4341 4242 4728 Foreign Investment 769 1238 997 941 966 994 NLT Gross Disbrsements 2661 2839 2829 3428 3122 3515 Net Short-Term Capital -212 300 300 300 300 300 Capital, NEI 388 0 0 0 0 0 Net IMF Purchases 54 29 .269 *328 -146 *81 Nemw IteM Paris Club Rescheduling 915 267 0 e 0 0 Conmercial Bank DDSR Savings 30 286 706 674 638 602 Amortization 0 0 420 420 420 420 Interest (Gross) 30 286 286 254 218 182 Unidentified Sources 0 210 796 1361 931 1213 Paris Club Eligible 1069 1213 1281 1211 859 Amortization 746 940 1074 1069 751 Interest 322 273 208 142 88 e. Balance of paymnts projections are after 1992 DOSR operation. b. Debt service after Paris Club rescheduting through end-1992 and 1992 DOR operation. c. Purchase of principal and interest collateral for 1992 0DSR operation. d. Foreign currency swaps contracted by the central bank in 1983 and subsequently rotted over. Source: World Bank staff projections 5.56 There might be some scope for temporary new mechanisms that could take advantage of the public sector's ability to mobilize foreign assistance to help meet the private sector's perceived need for - 98 - long-maturity financing for infrastructure projects. However, the potential benefits of such a facility must be carefully weighed against possible costs. In the Philippines, the costs include the mixed message that would be sent to the private sector about the government's noninterventionist role; the possibility of diverting funds to politically motivated projects or regions on the basis of social needs that fails to meet the commercial tests of the market; and the danger of rekindling a process that, in somewhat different guise, led to the emergence of the debt crisis in the early 1980s. 5.57 Balance of Payments. As discussed earlier, the projections envision a widening of the current account deficit, relative to the period 1986-92. A strong import recovery is forecast, driven by public and private investment. As shown in Table 5.7, the merchandise trade deficit is projected to grow. as imports initially outpace export growth rates. The pattern of merchandise exports reflects stagnant commodity exports and a moderate growth of manufactured exports. 5.58 The scope for a significant increase in the current account, however, is limited. The overall current account is maintained within financeable limits by the sustained surplus on. non-factor and factor services accounts around current levels. In the near term, the growth of non-factor services reflects the conversion into pesos of foreign currency deposit accounts held by residents- deposits that are classified as non-factor service exports; already in 1992. the effects of exchange rate liberalization has boosted these receipts significantly. In 1993 and thereafter, however, the projections incorporate the assumption that, once accumulated foreign currency accounts have been shifted into peso accounts, new inflows will start to diminish. 5.59 The factor services account is kept more or less balanced-in spite of the large, outflows on account of interest payments on external debt-by sustained receipts of contract workers incomes. Since 1991, receipts of contract workers' incomes have been boosted by measures streamlining remittance deliveries by the banking sector; since 1992, these receipts have been stimulated further by the foreign exchange liberalization, as in the case of non-factor service receipts. 5.60 Interest payments on external debt will continue to put pressure on the balance of payments even after the DDSR operation. Interest payments are projected to stabilize at around $2 billion a year- about two-thirds of the projected current account deficit. In 1992, interest expenses have been reduced by the decline of international interest rates and, most importantly, by favorable terms on rescheduling of Paris Club debt, which included a deferment of interest due. With the expiration of the current Paris Club agreement at end March 1993, interest payments are forecast to increase again. The savings from the DDSR operation are projected to help keep interest costs stable even though total debt is rising in projections. -99- table 5.7: samry Satence of Pamnts statistics, 1992-9 (S millions) Actual Prelim. ******-*********Projected***********d**-* 1990 1991 1992 1993 1994 1995 1996 1997 Merchandise Trade -4020 -3213 4516 -5142 -S496 -5672 %60 -5949 Exports 8186 039 9728 11046 12095 13432 14964 16678 Imports 12206 2052 142"4 16188 17591 19104 20624 22627 Services 527 1422 3065 2562 2860 2877 2868 2841 Non-Factor Service Expcrts 2915 3375 4667 3940 4294 456 4813 5096 Man-Factor Service imports 1626 1667 2169 2245 2409 2608 2842 3109 Factor Income 1843 2320 3007 3266 3465 3553 3688 3835 Interest on Reserves 60 110 191 254 352 364 401 440 Factor Payments 2605 2626 2440 2399 2490 2614 2791 2981 Total Intereste 2154 2157 1904 1805 1794 1833 1929 2034 Profit Remittances 283 269 363 414 513 593 668 746 Net Current Transfers 793 885 921 956 974 1000 1034 1072 Current Account Batance *2695 -1035 -S31 -1694 -1661 -1794 -1758 -2195 Capital Account 2233 2262 1152 2506 2088 2626 2435 2795 Foreign tnvestaent 469 654 769 1238 996 941 966 994 Total Net LT Disbursements 900 439 20? 968 792 1385 1169 1501 Gross Disbursments 1906 2661 2839 2829 3428 3122 3515 Amortization" 1098 2454 1871 2038 2043 1953 2014 Net Short-Term Capital* 277 1320 -212 300 300 300 300 300 Capital Flows, NEt 0 0 388 0 0 0 0 0 Errors and Omissions 587 -151 0 0 0 0 0 0 Financing Increase(-) in Net Reserves 45 -1755 -622 882 -431 -883 -677 -757 Memo Items Paris Club Extension 692 915 267 0 0 0 0 Conertal Bank DDSR Savings 30 286 706 674 638 602 Amortization 0 0 420 420 420 420 Interest (Gross) 30 286 286 254 218 182 Unidentified Financing 0 210 796 1361 931 1213 Paris Clh Eligible 1069 1213 1281 1211 839 Amortization 746 940 1074 1069 751 Interest 322 273 208 142 88 a. gaP projections are after 1992 DDS operation. b. Debt service due after reschedulings through March 1993 and 1992 DDSR operation. c. IncluJes the unwinding of amps, Wich are reported separately in Table 5.6. d. Includes the purchase of principal and interest collateral for the 1992 DSR operation, ahich is report- ed separately in Table 5.6. Source: Central Bank, World Bank staff projections -100- Conclusions 5.61 The potential for sustainable, broad-based growth of around 5.5 percent a year now exists. This potential has been created by structural reforms that have given the authorities more scope for policy action by changing the relationship among fiscal deficits, domestic interest rates, and exchange rates. In line with stated government principles, growth would be led by exports and private investment. Yet, in the past, both exports and private investment were choked back by extensive monetary contraction that was imposed to achieve stabilization objectives. In the future, fiscal policy must bear more of the stabilization burden to open the door for private investment and exports. 5.62 Higher public investment expenditures financed by greater revenue collection, a reallocation within the budget, and an expansion of the deficit is central to the growth scenario. A balance among these elements must be achieved to keep inflation, nominal interest rates, and the current account deficit in check. When growth starts, the real exchange rate could depreciate, reducing the size of the merchandise trade deficit that must be financed. Savings from the DDSR operation will help keep foreign interest payments in check. Yet the current account deficit is likely to rise significantly. The financing of growth relies heavily on maintaining worker remittances at elevated levels; mobilizing additional foreign investment for private-sector BOT infrastructure projects; increasing disbursement rates on foreign official assistance; and rescheduling large principal payments that will fall due on bilateral debt over the next few years. - 101 - VI. ACHIEVING POLICY OBJECTIVES: ISSUES IN THE DESIGN AND IMPLEMENTATION OF POLICY 6.1 In the 1980s the Philippines has experienced poor economic performance, as compared with other East Asian countries and as compared with its own record in the 1970s. Yet, unlike other developing countries, the Philippines is no latecomer to the current themes of export-oriented, private sector led development in an open, stable economic environment. Indeed, over the past ten years, it has been pursuing policies of macroeconomic stabilization, liberalization, and deregulation at a pace that, although surely slower than desirable, has 1en on a par with other countries. The Philippines also meets many of the criteria for rapid progress that the World Bank has culled from its broad experiences with developmenti: investing in people; making markets work; opening up to trade and technology flows; and fostering macroeconomic stability. 6.2 In each of these areas, the Philippines appears to have performed well enough to belie its poor overall growth performance. Illiteracy rates, at 10.3 percent, are lower than in countries with much higher incomes and growth rates (such as Malaysia), and female education levels and labor force participation rates are particularly high. Markets have been generally free to work, with public ownership moderate and public employment also below comparator countries. Concerning infrastructure, the record is mixed but not abysmal: hard infrastructure (power, telecommunications) has been in short supply recently, but other forms of market infrastructure, such as financial markets, the regulatory environment governing entry and exit, labor rules, and legal protection of property rights and contract enforcement are generally good. Regarding openness, the Philippines has one of the most liberal policies toward foreign investment, quantitative restrictions on imports have been largely lifted, and tariffs are reasonably low by international comparison. Indeed, a World Bank report in 1987 claimed that the Philippines had already become a relatively open economy, and progress on the policy front since then has reinforced this view. Last, the Philippine record on macroeconomic stability, although at times inconsistent, has never been poor. There have been only two years (1974 and 1985) with inflation higher than 20 percent over the past three decades, and only thirteen years with double digit inflation, often related to external shocks. Public sector deficits and current account deficits have rarely exceeded 5 percent of GDP. 6.3 With this as background, the most compelling question for policymakers is why performance over the past ten years has not been more impressive. There are t4see mainstream explanations. First, the past decade has been one with high political tensions; frequent coup attempts and high levels of urban and rural violence have dampened investor enthusiasm for the Philippines. Second, policy adjustments have not addressed deep-rooted structural issues of oligopoly and poverty, of low private savings and investment rates, and of a narrow tax base. Third, the pace of reform in the Philippines has been slower than in other successful countries. 6.4 The latter explanation is discussed in detail in this chapter. The analysis of economic performance in the preceding chapters has indicated that the poorer economic performance of the 1' Cf. World Bank, World Develooment Report 1991: The Challene of Develooment (1991, Oxford University Press). F Cf. World Bank, Issues and Policies in the Industrial Sector (1987, Report No. 6706-PH). - 102 - Philippines, as compared with other East Asian countries, was caused not only by more difficult initial conditions-in particular, the burden of external debt-but also by shortcomings in the formulation and the implementation of policies. In addition, the gradual approach to economic reform that the Philippines has followed-together with indecisive response to exogenous events-has affected negatively the perception of the reform effort. 6.5 The spectacular success of other East Asian countries in attracting direct foreign investment over the past five or six years, as compared with the Philippines, has been associated with a more positive perception of those countries' reform programs-especially on implementation aspects-and has then contributed to their reform effort, however, by supporting higher growth. The perception of the Philippine reform effort has been more negative, even though the record of actual reforms appears reasonably strong on paper: since 1986 the Philippines has pursued more far-reaching reforms than Indonesia, for instance, yet it has received smaller investment flows. To a large extent, this perception of inadequate reform effort in the Philippines-in spite of important measures to simplify the investment framework, remove distortions in the trade regime, and liberalize the system of foreign exchange management-originates from concerns over the actual implementationof reforms and the possibility that they might be reversed. 6.6 The international donor community has been more willing than private investors to recognize the progress made by the Philippines on the policy front, and has put forward an extensive program of development projects.-F Difficulties with the implementation and thus the disbursement of these large development assistance programs have arisen, however, and to some extent have confirmed that the problem is not with perception alone. A. The Roles of tht iixecutive and Leislative Branches 6.7 The formulation of economic policy in the Philippines is a responsibility shared by the executive and the legislative branches of government. Most economic legislation is initiated by Congress with an explicit endorsement by the executive branch. The most notable exception is the Appropriation Law, which is drafted by the Department of Budget and Management on the basis of the public investment program prepared by the National Economic Development Authority (NEDA) and in consultation with the other departments. In addition, the president can issue executive orders that have the force of law, in certain economic areas-such as trade and taxation-and only when Congress is not in session. Finally, the issuance of Implementing Rules and Regulations to complement economic legislation-for instance, on foreign investment legislation, Build-Operate-Transfer (BOT), and so on-falls under the responsibility of the relevant departments. 6.8 Other branches of government also have substantial regulatory responsibility. The Monetary Board-which is chaired by the governor of the central bank-is responsible for the conduct of monetary IF At the Consultative Group meetings that were held in Tokyo and Hong Kong in July 1989 and February 1991, respectively, $3.5 billion and $3.3 billion were pledged in economic aid for the Philippines, largely in response to the success of the economic recovery at the time and the belief that the policy processes, in terms of both formulation and implementation, were sufficiently strong to achieve the objectives of such large official assistance programs. - 103 - policy and exchange rate management. In addition, it regulates administrative aspects of international trade, credit, and foreign exchange markets. 6.9 The process of policy formulation in the Philippines also involves the private sector. Several branches of government-most importantly, the Monetary Board-include private sector representatives. Public hearings are held on issues concerning different interest groups. both for legislative measures-for instance, the foreign investment bill-and for executive measures-for instance, changes in oil prices, implementing rules for BOT, and so on. This process, although often lengthy and controversial, has proved crucial to forging consensus on important economic policy issues, such as the 1991 revision of the tariff code. 6.10 The perception that the reform effort has been less decisive than in other East Asian countries has often originated from long, drawn-out deliberations in both houses of Congress, difficulties in reaching agreement within the Executive branch, and acrimonious discussions between the administration and the Congress. There have been several instances of members of the administration or members of Congress-and naturally also influential members of the public at large-questioning the merits of a particular action after it has been taken and suggesting its roll-back. This has often undermined the very intent and reason for the action and has exacerbated the credibility problem of the Philippines. 6.11 In many instances, these reactions have stemmed from lack of adequate exchange of information as to the rationale of a particular course of action. Clearly, greater consensus is needed, both within and outside of the administration, on the key policy actions required to keep the economic reform program moving forward, and the establishment-and use-of appropriate channels of communication and consultation can help this process. In this regard, the public announcement by the newly elected president of the legislative agenda that was submitted to Congress on July 23, 1992, is a promising first step. However, it is most unlikely that unanimous agreement can be reached on the reform process, and lack of unanimity should not be allowed to derail it. Greater consensus can be forged by strong leadership and a clear vision of the benefits of reform. Successful reform will itself engender support for further progress. 6.12 The need for greater consensus between the executive and legislative branches on the formulation of the country's reform agenda has to be achieved without compromising either the ability of the Congress to process legislation rapidly and effectively or the ability of the government to respond swiftly and flexibly to unforeseen events. There appears to be scope for streamlining the submission of legislative initiatives in the two chambers of Congress, reducing the considerable overlap between the two houses on economic matters and simplifying the bill-reading process. In addition, the executive branch neefs to retain and consolidate its ability to take actions independently of legislative approval in those areas in which it is its constitutional mandate and in which rapid respone is necessary to the effectiveness of economic management. 6.13 There have also been several instances in which government action has been delayed by conflicts over responsibility, within the executive branch as well as between the executive and legislative branches. These conflicts have characterized the adjustment of oil prices, the allocation of the balances of the Oil Price Stabilization Fund (OPSF), and the taxation of energy products. In addition, conflicts of competence have also extended to the judiciary branch, most notably in the very controversial cases regarding the location of a foreign investment and the liquidation of a private bank by the Monetary Board. -104- 6.14 The Philippine system of government is relatively young and has undergone substantial re- structuring since 1986, in particular with the progressive devolution of functions from the Office of the President and the core departments to the line agencies. In addition, the system is likely to experience further reorganization under the current administration, which has drawn plans to reduce the number of departments by consolidating their functions and to reestablish the Department of Energy. Under these circumstances, conflicts of competence naturally emerge. It is necessary, however, that consensual mechanisms be in place to resolve these conflicts quickly and decisively by establishing and enforcing the appropriate assignment of competence, in order to avoid their continuous recurrence weakening the functioning of government. B. Monetary Poliy 6.15 Monetary policy has carried a disproportionate share of the burden of stabilization. In the immediate aftermath of the 1983 crisis, a rapid contraction in the quantity of money-and even more dramatic contraction in credit to the private sector-successfully prevented the entrenchment of inflation in spite of limited fiscal adjustment. Since then, whenever fiscal adjustment has not proceeded with necessary speed, monetary policy has compensated by being increasingly restrictive. Imnlication of Overreliance on Monetary Policy 6.16 The consequences of this overreliance on monetary policy, as discussed in Chapter IV, have been high in terms of foregone growth. Restrictive monetary policy, together with large fiscal deficits, has resulted in high real interest rates and appreciated real exchange rates; while this had initial beneficial effects on fiscal balances by reducing interest payments on external debt, over time it has had increasing negative effects, because of the impact on interest payments on domestic debt and the reduction of growth. 6.17 Overreliance on restrictive monetary policy has also had negative consequences for external debt management and accumulation of international reserves. Debt reduction initiatives that have a direct impact on money creation, such as debt-equity swaps, have been limited by preoccupation with monetary targets; in particular, the debt-equity swaps program was suspended in 1989 and reintroduced in 1990 under annual conversion ceilings, precisely to maintain narrow money targets. This example underscores the high costs of inadequate fiscal adjustment: insufficient fiscal adjustment, compensated by tight money, required forgoing potential debt reduction and foreign investment inflows. 6.18 The need to maintain a tight monetary policy has also led to narrowly defined targets, based on growth of reserve money. As a result, short-term or seasonal fluctuations in money demand have not been accommodated, leading to large swings in real interest rates that could have been avoided with a more flexible monetary policy. In addition, the growth of credit has received little or no consideration in spite of its relevance for economic activity. The Central Bank 6.19 The conduct of monetary policy has been affected not only by the skewed choice of instruments but also by the financial condition of the central bank (CB). As discussed in detail in a - 105 - previous World Bank report.f assumption of quasi-fiscal activities, bailing out of ailing banks and the Philippines Deposit Insurance Corporation, and misguided foreign exchange laterventions in the late 1970s and early 1980s led to the accumulation of sizable foreign liabilities and nperforming domestic assets. The resulting negative not worth position of the CB and its continuing posting of large income losses has further limited the flexibility of monetary policy and caused great concern for its future course. 6.20 To maintain a tight monetary policy to control inflation while financing its income losses, the CB has had to resort to using revenue generation tools designed for monetary control and to borrow extensively from the Treasury and the private sector. This created distortions in the financial system and exacerbated several fiscal problems. 6.21 The financial sector bears a large tax burden in the form of distortionary taxes such as the gross receipts tax and various documentary and stamp taxes on financial transactions. In addition, reserve requirements have been set at levels-currently 25 percent of all deposits-higher not only than those in comparable countries, but also higher than monetary policy considerations alone would require. Other decisions-for instance, the awarding of commercial branch licenses by auction-have been dictated more by revenue considerations than genuine concern over efficiency. 6.22 Excessive explicit and "indirect" taxation of the financial sector has led to growing disintermediation as banks have shifted toward undertaxed and fee-generating off-balance sheet activities, while extremely high maipns between lending and deposit rates have discouraged mobilization of domestic financial savings. These developments, in turn, have reduced the revenue base for financial sector taxation, discouraged access of small savers to financial markets, aid contributed to high real interest rates. 6.23 The CB has also borrowed extensively from the Treasury to finance its income losses. Between end-1983 and end-1991, national government deposits at the CB increased by P 40 billion, and the increase in deposits since 1990 has been at zero interest. In this way, the CB has extracted a subsidy from the national government and has also exacerbated the problem with the timing of budgetary cash releases, discussed later in this chapter, by transferring part of the seasonality in money creation to the national government budget. 6.24 Increasing reluctance on the part of the national government to subsidize the CD and further reduce already limited budgetary flexibility has forced the CB to resort to borrowing directly from fhe private sector by issuing its own interest-bearing securities. The central bank of the Philippines has a long record of issuing its own securities and experienced a sharp deterioration of its financial condition when, in 1984-86, it financed large deficits by issuing "Jobo Bills." The more recent recourse to CB bills will prove at least as costly as the previous episode, given the current level of real interest rates. In addition, by increasing the sensitivity of the CB income losses-already directly linked to foreign interest rates and to the exchange rate by the external debt burden-to domestic interest rates, the existence of a large domestic debt of the CB will introduce a further constraint on the conduct of monetary policy. ' World Bank, Phil=i SCa ar Study (1992, Report No. 10053-PH). As of end-1991, foreign currency liabilities of the CB amounted to S5.3 billion in loans and bonds and $1 billion in swaps; domestic nonperforming assets amounted to P13.3 billion in overdrafts and P1.9 billion in emergency loans. -106- 6.25 The deteriorated financial condition of the CB has potentially severe inflationary implications. Although the CB has been successful in preventing the transformation of the international debt crisis into persistent high inflation-unlike what was experienced by all Latin American highly indebted countries-continuing income losses are providing the CB a powerful incentive to resort to inflation tax, the only tax that the CB has in its control. In addition, the perception that the financial difficulties of the CB might lead to a sudden acceleration of inflation and depreciation has contributed to the high premium-in excess of international interest rates-required by investors to hold Philippine securities. 6.26 For these reasons, the financial condition of the CB must be addressed. The most important element of a strategy to restructure the CB is the restoration of a positive net foreign asset position. Important steps in this direction, limited to commercial bank debt, have already been taken: the debt- equity swap program and two buybacks-in January 1990 and May 1992-have reduced external debt of the CB by $2.3 billion.-' The unwinding of foreign currenc swaps in 1992 also eliminated $960 million of foreign currency liabilities to domestic commercial banks.' Finally, the Brady deal recently approved-involving the transformation of previously rescheduled medium and long- term loans to foreign commercial banks into collateralized loans at fixed or discounted variable interest rates-has result in a combination of benefits including reduction in interest payments on external debt, postponement of principal repayments until 1998, and predetermination of interest payments. 6.27 As the new Brady deal provides the CB-and in general the Philippines-with the opportunity to put behind the commercial bank debt problem, extreme attention should be paid to preventing the foreign asset position of the CB from deteriorating again in the futureY The introduction of a bill in congress to create a new Central Monetary Authority offers an extremely important opportunity to define clearly the functions of this institution with regard to the assumption of contingent liabilities, in particular in foreign currency. The challenge for the legislators will be to forge a law that gives the new Central Monetary Authority enough power to set monetary policy to achieve growth with price stability, enough flexibility to cope with financial perturbances, and enough fiscal responsibility to avoid assuming or financing long-term losses of financial institutions, whether public or private. The Central Monetary ' Since 1986, the debt equity program has eliminated $1.2 billion of the central bank (CB) external debt; the January 1990 buyback has repurchased at 50 percent discount $1.3 billion, of which $0.5 billion of CB debt; the April 1992 buyback has repurchased at 48 percent discount $1.4 billion, of which $0.6 billion of CB debt. 1' Of the total $960 million in swaps, $700 million were repaid in May 1992, and the remaining $260 million were unwound by end-1992. ' Under the terms of the current rescheduling agreements with the Paris Club and commercial bank creditors, the central bank (CB) assumes rescheduled maturities of public and publicly guaranteed debt as they come due on the basis of original repayment schedules and as original borrowers remit the corresponding principal repayment to the CB. This arrangement provides cash flow relief to the CB in exchange for the assumption of foreign exchange risk on rescheduled debt. This should be the only mechanism through which the CB assumes foreign debt in the future. To end-1991, $3 billion in foreign debt had been assumed by the CB through this channel. - 107 - Authority should be the guarantor of the efficient functioning and development of the financial system. but should not provide blank checks to institutions that fail to pursue sound borrowing and lending practices. Foreian Exchange Liberalization 6.28 It has been argued several times in this report-as well as in an earlier repor-'that the large external debt of the Philippine public sector and the CB in particular provided a powerful incentive to support a more appreciated exchange rate than would have been necessary to stimulate growth and hold external trade transactions in balance. The means to support a more appreciated exchange rate has been higher interest rates, caused by tight monetary policy. In addition. a complex system of foreign exchange restrictions and a narrow market where the exchange rate is determined have contributed to the maintenance of an appreciated exchange rate. 6.29 The gradual elimination of the external debt of the CB will effectively remove the most important incentive for the CB to support an overvalued exchange rate. The liberalization of foreign exchange transactions currently in progress will then reduce the ability of the CB to control the exchange rate, by allowing for a transparent and competitive foreign currency market and by removing the restrictions on uses of foreign currency both by flnanc's' institutions and individual investors. 6.30 The program of foreign exchange liberalization initiated in 1992 involves the elimination of the requirement that exporters remit their foreign exchange receipts, the replacement of the requirement that commercial banks balance their not foreign asset with prudential limits on their exposure in foreign currency, the liberalization of holding of foreign currency deposits by residents, and the liberalization of the investmuent of these deposits by banks receiving them. In addition, new regulations allowing broader access to foreign currency markets and the regularization of off-floor transactions will effectively unify the official and informal market and increase its competitiveness. 6.31 The liberalization of foreign exchange regulations will have several beneficial effects on the effectiveness of macroeconomic policy, by increasing the international integration of domestic capital markets. First, by effectively broadening these markets, foreign exchange liberalization will provide a strong stimulus to their development. Second, by increasing openess and competitiveness of domestic capital markets and by increasing confidence in the market orientation of exchange rate management, it will reduce the domestic securities premium over international interest rates. Third. by eliminating restrictions on foreign currency deposits and loans, it will increase the mobilization of foreign income remittances of contract and long-term workers by official institutions and will increase the access-at internationally comparable costs-to foreign exchange financing for exporters and importers. This structural change will require a shift in the role of the Ce in foreig i exchange markets, from major player in the market to a supervisory agency. ' World Bank, Philipgine - Issues in Adjustment and Comnetitiveness (1990, Report No 8933-PH). -108- C. Fiscal Policy 6.32 Fiscal adjustment has been-and will continue to be-the most critical imperative of economic policy. As argued in Chapters IV and V, domestic deficit financing above current levels is inconsistent with a reduction of public debt and interest rates, and is also an impediment to improving international competitiveness. At the same time, the need to support private sector growth by providing public investment in infrastructure and human resources greatly exceeds the financing and institutional capacity of the government. 6.33 In order to accomplish the needed fiscal adjustment without condemning the Philippines to stagnation, fiscal policy will need to concentrate on two objectives: first, increase resource mobilization to finance public investment without exacerbating the burden of debt; second, increase the productivity of public expenditures by eliminating unnecessary expenditures and investing in the projects with the highest economic and social returns. 6.34 Both tasks require making hard choices between competing deserving needs. Table 6.1 below compares the cost-measured by foregone revenues-of implementing the most important efficiency- enhancing reforms in taxation and trade wih the cost-measured by cash expenditures-of undertaking critical public investment projects and social expenditures. Adding up the costs, implementing these priority measures alone is estimated to require, on an annual basis, budgetary outlays of about $6.5 billion over and above the 1991 expenditures. 6.35 Clearly, these priority measures cannot be implemented under any feasible fiscal and external scenario. Financing an increase in expenditures of this order of magnitude would require increasing total public debt by 14 percent of GDP, or doubling the tax effort. A change in the composition of expenditures alone could not finance these priority measures, given the large share of "contractual" expenditures in the government budget. Of total expenditures by the national government in 1991, about 30 percent was absorbed by interest payments and an additional 30 percent by civil service wages. N-ither of these expenditure components can be quickly compressed, although long-term measures should be taken-as discussed in Chapter IV-to permanently reduce them. 6.36 Policymakers need to reassess priorities for reform and investment in order to define a set of measures that can stimulate growth and be financed within the feasible resource envelope. They should alo) consider the risks implied by an excessive concentration of resources on a single, large project or on a single sector, to avoid the possibility that one single failure may have severe repercussions throughout the economy.1w Many of the necessary investments in infrastructure are however "lumpy" by nature, and their indivisibility neds :o be addressed by careful phasing of their implementation. Table 6.2 shows how much it would cost to implement these necessary but lumpy projects at the same time. MY The Bataan nuclear power plant is an example of the risks associated with undertaking one extremely expensive project. The Bataan plant has never been in operation and has burdened the energy sector with more than $2 billion in foreign debt. Table 6.1: Public Sector Costs and Priority Actions In the Philippines ($ millions: annIal) Expectd Cost Acdon Increment Ratfonate Tax Revenue Losses Tariff Reduction. E.0.470 700 - 1,0000 Promotion of competition: reduction of distortions Accelerated Depreciation 160 - 435t Priority foreign investment incentive Net Operatig Loss Carry-Over 17- 230 Incentive for start-ups Universal Duty Exemption on Imported Capital Equipment 370 - 42? Reduction of tax or investment Abolish Gross Receipts Tax 100 Abolish Documentary Stamp Tax 125e )Reduction of tax on financial intermediation Market Interest Payments on Reserves 200s Public Sector Expenditures Public Investient Requirmnits 1.240 Reach Target O&M Levels 200' Remedietion of infrastructure shortages LarA reform expenses 900' DeterioL .-n of road network Achieve UNDP Human Resources Target 2,200 Purchases of land Human development priority Total 6,200 - 6,800 a. Cost incremeat is relative to 1991 budget situation. b. Incudes losses on dutiable imports and VAT losses applied to reduced base. c. Assumes dot 801-registered firms are not eligible. Depreciation is straight line with 30 percent shorter useful life; 20 percent nominal investment growth; learning curve for applications Is applied. d. Comparison with 1990 actuals. Assumes market interest of 10 percentage points above actual RR interest paid. e. See Table 6.2 for details. f. Estimate to bring real maintenance on road network per kilometer back to 1980-82. Increment over 1990 actual spending. g. Includes support services accompanying land refomn. About 40 percent of budget is for landowners' compensation. See Chapter XIV. b. Based on recommendations made in UNDP Human Develooment Report 1991. as applied to the Philippines by the UNDP Res. Rep. at 1992 Consultative Group Meeting. Note: Ranges refer to 1995 cost and longer-run cost. Source: Staff estimates. -110- Table 6.2: LAmpy Infrastructure Invesne4nt Projects ($ million; annual average) Average 1990-92 Proposed 1993-95 Increment Public Private Public Private Public Private Power: Generation 330' 70' 990' 490b 660 420 Distribution 105' 70' 300' 135' 195 65 Telecommunications n.A. 360' 0.a. 650' 290 Water, Sanitation 85' - 230' - 145 Air n.a. - .a. 300i n.a. 300 Urban Transport a.a. n.a. 110' 1108 110 110 Roads and Bridges 250' n.a. 300h n.a. 50 n.a. Sea 201 1001 10 80 160 Total 790 500 2.030 1.845 1.240 1.235 a. NPC. b. BOT operations including projected disbursements on new contracts. c. NPC plus NEA. d. MERALCO. e. PLDTandoter m f. MWSS plus LWUA; proposed level from the 1988-2000 Master Plan. g. Assumes 49 percent public and S1 percent private DOT funding. Includes urban mlegaprojects: LT and Metro Manila Epressway. b. 1989 Actual; proposed from 1990 Medium-Term Public hrvestnent Program. i. Presumed needed invesanent in new planes. j. PPA; proposed assumes completion of projects in 1990 Medium-Term Public Invesunent Program. k. Presumed needed investment in shipping. SrMe: Staff estimates. 6.37 While constrained in the short term by available resources, policymakers should concentrate on the need to expand the resource envelope by increasing revenue mobilization and eliminating unproductive expenditures. These are long-term undertakings, and measures need to be put in place now in order to generate permanent improvements. On the revenue side, temporary increases, such as those that may arise from fast-tracking privatization, should not distract from the effort to increase tax collections by expanding the tax base and improving compliance. Similarly, on the expenditure side, policymakers should avoid short-term compression of necessary expenditures and pursue instead permanent reductions in those contractual categories-interest payments and the wage bill-that are both very large and extremely hard to control over the business cycle, thus reducing the resources for growth- oriented expenditures and the flexibility to respond to shocks. 6.38 A feasible-though less ambitious-scenario in which selected measures from Table 6.1 are . Implemented and financed through a moderate increase in the fiscal deficit and in tax revenues is discussed in Chapter V. To reach such a feasible scenario, however, will require further careful implementation and phasing of selected actions. The scenario presented in Chapter V assumes that - 111 - approximately two-thirds of the incremental public investment requirements and one-fourth of the incremental tax revenue losses presented in Table 6.1 are implemented. Concerning the remaining incremental expenditure items in Table 6.1. a moderate increase in O&M is forecast. Other expenditures can be accommodated only to the extent that savings on other current items will materialize. Resource Mobilization 6.39 Tax Revenues. As discussed in Chapter IV, the tax system in the Philippines has undergone important reforms during 1986-88 that have substantially enhanced its yield and flexibility. Collections remain much below potential and measures are being taken to improve compliance in direct and indirect taxation-through streamlining, computerization, and homogeneous identification of taxpayers-and in trade taxes-with the globalization of the import surveillance system. 6.40 Given the large estimates of evasion and avoidance, improved collection appears to be the most promising source of tax revenues for the government. In addition, improving collections would improve morale, fairness and compliance across the board. Improvements in collections, however, will require substantial institutional building in the Bureau of International Revenue (BIR) and Bureau of Customs (BOC), as well as education of the public at large to their responsibility as taxpayers and their risks as tax evaders. Changes in institutions and changes in behavior will require time, and today's uncollected taxes will not transform into revenues for some time. Precisely for their long-term nature, these institutional gains need to be pursued consistently. 6.41 Experience from other countries suggests that improved tax collection efforts often promise more than can later be delivered. New tax measures will need to supplement collection efficiency. The most promising avenues include: structural and administrative reforms in VAT; establishment of large taxpayer units; adjustment in excise taxes on cigarettes and liquor; excise taxation of non-essentials; creation of criminal tax courts and imposition of an affluent consumption tax. 6.42 Although a large portion of good taxes go uncollected, substantial revenues are obtained from highly distortionary taxes, in particular on financial intermediation. The gross receipts tax on financial institutions and several documentary stamp taxes have contributed to financial disintermediation and retarded the development of capital markets. Yet these two levies amount to 5 percent to 6 percent of total tax revenues. There is a clear trade-off between the need to mohilize revenues to finance priority investments and the efficiency costs imposed by these taxes on financial markets. Policymakers need to evaluate these trade-offs carefully, and carefully match the removal of these distortionary taxes with compensating new tax measures. 6.43 Unlike other countries, the Philippines has not experimented with earmarking the revenues from specific sources to specific uses. While there are pros and cons to earmarking-most notably, the advantage of creating a constituency for a tax and the disadvantage of reducing budgetary flexibility-the experience in other countries has in general been unpromising.A In practice, if political support does not exist for a program, governments find ways of tapping into earmarked funds; in addition, there is a significant danger of over- or underspending on programs where the level of revenue and the level of spending have no direct relationship (for example where fuel taxes finance highway expenditures). The II Cf. W. McCleary, "The Earmarking of Government Revenue: A Review of Some World Bank Experience," The World Bank Research Observer, Vol.VI (No.1, January 1991). - 112 - most successful instances of earmarking have been at the municipal level, where beneficiaries are more clearly identified and taxes paid can be tailored more closely to benefits received. Given these lessons, there might be scope in the Philippines for earmarking special or temporary taxes. These measures could be aimed at financing emergency requirements (such as overcoming the current energy crisis) or at financing infrastructure projects that have a clearly identified set of beneficiaries, such as the construction of a port. 6.44 Mobilization of Domestic Financing. There is scope in the Philippines for the government to improve the cost and composition of its domestic financing. The largest improvements can come from progress in macroeconomic adjustment and external debt management leading to lower interest rates and lower debt, as argued in Chapters IV and V. However, domestic savings could be mobilized more efficiently by deepening capital markets, and in particular the government securities market.1 Issuance of smaller denomination treasury bills, rationalization of taxation affecting secondary market transactions and capital gains, and indexation of longer-term securities to short-term interest rates would be necessary initial steps in this direction. 6.45 The social security institutions could also play a more important role in the mobilization of domestic financing. The government has taken advantage of the tax-exempt status of these institutions by allocating more than 20 percent of public domestic debt with them at below-market interest rates. Although these expedients have reduced the interest bill of the government, the net effect on the budget is likely to be zero. A more effective way of increasing the role of the social security institutions in mobilizing domestic financing for the public sector-as well as for the private sector-would be to improve their management and regulatory framework. While individuals insured by social security institutions represent more than 65 percent of the employed, only 20 percent are active contributors. Loans to members-often for consumption purposes and at below-market interest rates-contribute an excessive portion of their investments. Several tax privileges could also be rationalized.A Thus, an increase in collection rates-through better record keeping and enforcement-an improvement in financial practices- through the introduction of minimum return on reserve funds, limits on member loans, lengthening of the maturity structure of investments to better match liabilities-and the rationalization of the regulatory and tax framework could help achieve this objective. 6.46 Improving collection rates of the social security institutions would help create a larger domestic capital market, from which both the government and the private sector could obtain long-term finance. This is particularly important for a country with a growing population and thus a growing work force. In addition, the specter of future bailing-out on the part of the government would be reduced if the social security institutions held portfolios commensurate with their future liabilities. Identification of Budgetary Priorities 6.47 The most important act of government in managing the economy is the issuance of the national budget. This law is the result of a joint effort by the executive and legislative branches. The priorities for the public expenditure program are identified through a complex and decentralized process of consultation that involves the private sector. The framework within which the annual national budget S Cf. World Bank, Philippines - Capital Market Study (1992, Report No. 10053-PH). Chapter V. D31 Cf. World Bank, Philippines - Capital Market Study (1992), Vol. II. - 113- is designed is the Medium Term Philippine Development Plan, a policy document that spans the life of an administration and sets out its main goals.L 6.48 The annual national budget draws on several planning documents to allocate resources to priority expenditures, and *t is thus the most important in shaping actual expenditures. The national budget reconciles the priorities identified by the medium-term development program with the aggregate resource envelope in conformity to the government stabilization program, which is currently supported by an IMF Standby Arrangement. The responsibility for preparing this macroeconomic framework is vested in four agencies: NEDA, the Department of Finance, the Department of Budget and Management, and the central bank. 6.49 The elaborate process leading to the formulation and approval of the national budget did not originate with the Aquino administration, although it has been pursued with greater rigor in recent years. This has been part of the ongoing efforts to increase transparency and improve communication between different branches of government, and also between the government and the donor community. Transparency, consistency, and accountability in the public expenditure management process have been necessary to foster constructive relations with donors, which currently finance a large part of the public expenditure program. 6.50 The allocation of investment expenditures is carried out on the basis of the Medium-Term Public Investment Plan, a five-year program that is updated annually. The preparation of this document is the responsibility of NEDA, which carries out extensive consultation with local government units, public corporations, the regional development councils, and foreign donors on the sectoral and regional allocation of investment projects, their phasing, and the composition of their financing. 6.51 To prioritize projects for the Medium-Term Public investment Program, NEDA uses thirty- one criteria, each of which hs several subcategories. Economic profitability has a smaller weight-4.4 percent of the total-in ranking projects than other characteristics, such as location in poor rural areas or employment generation. As a result, a project with an internal rate of return of 50 percent can be ranked below a project with no estimated rate of return and poor potential, but located in rural areas and using labor-intensive production methods. The list of criteria used by NEDA is too long and should be reduced. NEDA should also increase reliance on cost-benefit analysis and correctly include the impact of a project on employment or foreign exchange use by using shadow wages and exchange rates in cost- benefit analysis. 6.52 In spite of these limitations, the current management of public investment has been successful in selecting higher return projects, avoiding the occurrence of "white elephants." and improving the regional allocation of expenditures. In addition, mechanisms have been put in place to integrate the planning process with the implementation and monitoring phase, as will be discussed below. 6.53 Although the planning process for investment expenditures has been considerably strengthened, the planning process remains weak on the financing side, and it does not in general stretch 4' The Medium Term Development Plan of the Aquino administration, covering the period 1987-92, emphasized three key objectives: greater attention to poverty alleviation and social justice; acceleration of growth and increase in economic efficiency; and reduction of government involvement in the economy and emphasis on private sector initiative. - 114- beyond one year, the time horizon of the national budget. The Medium Term Financial Plan is prepared every three years and is meant to provide financial scenarios for the preparation of the annual national budget, but is not currently integrated into the formal programming process. Given the pressing macroeconomic and funding problems facing the government, the Medium Term Financial Plan should take on a special role in the planning of borrowings and of debt service payments over a medium-term horizon; in recent years, however, the immediate effects of large fiscal deficits and high debt service * payments-aggravated by unanticipated new borrowings to meet the expenditure costs of disaster-related reconstruction efforts-have tended to limit the financial planning horizon to the next twelve months. * 6.54 The lack of integration between the public investment program and medium-term financial planning has systematically resulted in unrealistic public investment projections. The investment targets presented in past Medium Term Public Investment Plans (MTPIPs) have never been met, and future MTPIP targets are unlikely to be met either. For the period 1990-94 the investment program envisages a cumulative public investment of P592 billion, approximately $20 billion, which translates into an annual average public investment rate of 9 percent of GDP. This would amount to more than doubling the public investment rate relative to the period 1985-89, and is probably unrealistically high. 6.55 A new budget-based, public investment programming approach is expected to address this concern. The new approach considers: (i) sectoral ceilings; (ii) projected budget situation over the next five years; (iii) infrastructure needs; and (iv) devolution to LGUs. The system is still, however, susceptible to optimistic growth, and hence public revenue and expenditure projections. 6.56 Finally, very limited improvement has been achieved in the efficiency of the planning process for recurrent O&M expenditures that are necessary to maintain public investment. Despite World Bank loans having focused on the insufficient allocation of resources to O&M-the 1987 Economic Recovery Loan-and also on their inefficient targeting-the 1989 Debt Management Loan-this improvement has not occurred. O&M continues to be well below the level prevailing in the early 1980s, contributing substantially, together with low investment rates, to the weakness of public infrastructure.A 6.57 In the future, the vehicle by which the process of planning and budgeting is to be pulled into a formal and detailed system of planning, approval, implementation, and monitoring is the Synchronized Planning, Programming and Budget System (SPPBS). This system, devised by the government, was formally introduced in May 1990 but has not yet been implement4. The SPPBS is intended to consolidate the formulation, integration, review, and approval of the above plans and documents and to strengthen decision making by explicitly linking the decision- making process among central agencies as well as between central, regional, and district agencies. 6.58 The introduction of the SPPBS is expected to improve interagency coordination in the phase of expenditure planning, strengthen the monitoring of actual implementation of the program, and feed back to the planning stage the lessons learned in the course of implementation by establishing performance 1M' The World Bank has identified specific and serious instances of poor maintenance levels and standards in public infrastructure projects, in particular in the supervision of the Rural Roads Project, the Highways V Project, and the Earthquake Reconstruction Project. The capacity in the relevant line agencies to identify O&M requirements, to effectively enforce technical standards, and to ensure quality control has been faulted. - 115- indicators for individual expenditure programs. It should make more explicit the linkage between planning, programming, budgeting and monitoring. 6.59 While a full assessment of the benefits and pitfalls of the SPPBS cannot be undertaken until it is implemented, there appears to be a risk that it could add to the formality and rigidity of the planning process. In addition, the system is designed to focus on capital expenditures and does not direct specific attention to recurrent expenditures of the budget. Finally, in order for effective monitoring procedures to be put in place, the functional, regional. and "special emphasis" classification of expenditure programs needs to be harmonized with that adopted in the various medium-term planning documents. 6.60 Although no substitute for the hard choices that need to be made in designing the expenditure program, strong institutions and effective processes are necessary to implement economic policy. As the new administration approaches the task of policy formulation, three keys issues should receive careful consideration in the context of the current economic environment. First, the government needs to integrate the process of planning expenditures with its stabilization objectives not only in the immediate future but also in the medium term. In order to achieve this goal, the financial planning process needs to be strengthened. Second. the government should identify a set of investment expenditures that has priority within the plan, in order to ensure that critical projects remain protected in the event that extraordinary expenditure needs or revenue shortfalls require a re-direction of expenditures at mid-course. The identification of such a "core" investment program would also protect a minimum level of public investment and would clearly indicate to public sector agencies and foreign donors which are the government's priorities for projects under preparation. Third, planning of investment expenditures should be integrated with the planning of supporting O&M activities. This requires not only providing that financial resources are available for O&M, but also ensuring-or if lacking, developing-the necessary technical and administrative skills. Imnlementation of the Expenditure Prom 6.61 Budgetary Releases. The past three years have witnessed difficulties in the release of budgetary appropriations by the Department of Budget and Management to the line agencies in charge of physical implementation of expenditures. These difficulties are due both to weakness of the disbursement process and to a particularly rigid application of ceilings on disbursements, as the government has struggled to keep actual expenditures within targets. Cash release problems stem from: (i) the inflexibility posed by monthly, as opposed to quarterly, deficit targets; (ii) the inaccuracy of revenue projections and consequent revenue shortfalls; (iii) the poor reporting and monitoring system of government expenditures. 6.62 The budget system has been modified on several occasion during the past few years, most recently in 1989. Under the modified disbursement system currently in place, DBM indicates to implementing agencies the amount and the purpose of cash releases on a monthly basis. This is meant to ensure that the aggregate monthly expenditure is consistent with actual monthly revenue receipts and deficit target limits. In addition, in order to meet the annual target for aggregate public expenditure, monthly releases are set lower than what is implied by the annual budget to allow for end-year slippage: in fact, releases can contain cash expenditures within specified limits, but they do not limit the level of commitments or build-up of arrears, which is not under the control of DBM but rather of the spending agencies. The need for cash releases to eventually match spending commitments-in order to avoid - 116- having line agencies accumulate arrears-leads to occasional spurts of expenditures, with disruptive consequences for overall budget management.-L' 6.63 In addition to the limits faced by DBM in enforcing spending limits, the programming of monthly cash releases is inefficient in that it follows closely available monthly resources rather than matching the appropriate implementation schedule of budgeted expenditures. The timing of several expenditures is in fact crucial to their effectiveness. For instance, insufficient cash releases to finance antimalaria crop spraying this season also eliminates the beneficial effects of last season's spraying. Similarly, insufficient cash releases to finance construction during the dry season might delay implementation by as much as one year. 6.64 Although the system currently in place is effective in ensuring short-term compliance with aggregate deficit targets, it does so by distributing spending cuts irrespective of the priority of any given expenditure, its appropriate phasing, and the costs of postponing its implementation. In addition, by allocating cash releases on the basis of available monthly resources, the system does not allow line agencies to predict releases and thus program the implementation of expenditures. Finally, the current system is unable to control either commitments, whose responsibility rests with the line agencies, or arrears. 6.65 In June 1991 the World Bank, in conjunction with the IMF, reviewed the budget allocation and cash release system and found that the budget process system was, on the whole, sound but that its effectiveness was undermined by the problems afflicting the cash release system, most importantly inadequacy in securing the timely release of cash authorizations1 6.66 The current cash release system has also resulted in delays in the implementation of foreign- assisted investment projects. Lack of even modest counterpart funds-most foreign-assisted projects in the Philippines finance 100 percent of foreign currency costs, or about 70 percent of total costs-has also caused donors to reconsider their original decisions regarding the size of assistance, the implementation timetable of projects, and the likelihood that projects under preparation could indeed be implemented. 6.67 It should thus be recognized that the imposition of arbitrary, across-the-board expenditure ceilings is extremely damaging, in particular if such ceilings are not temporary measures. If these ceilings are a permanent feature in the programming of cash releases, clearly there is a failure to effectively program expenditures, not releases. This problem needs to be addressed by establishing layers of priorities within programmed expenditures, so that core expenditures can be protected from the unpredictability of revenue shortfalls and extraordinary requirements. The identification of core expenditures should carry over to the cash release system, so that cuts can be applied on the basis of priorities rather than across the board. by As an example, in the first half of 1990 overall commitments were allowed to expand to the point that, by September 1990, expenditure targets were substantially exceeded. This contributed to the suspension of the program agreed with the IMF, with negative consequences for the entire stabilization program. LZ' Cf. World Bank, Philinoines: Public Sector Resource Mobilization and Expenditure Management (1992), p. 68. - 117- 6.68 A possible approach to this problem would be to resort to NEDA's existing system of ranking projects and use it to protect those projects that are top ranked--say the top twelve-from budgetary cuts. This would amount to the adoption of a core investment program concept both in programming expenditures and in effecting cash releases. The ranking of the core expenditures should be consistent with the overall development program and its sectoral priorities. To achieve this goal. the current ranking system followed by NEDA could benefit from greater flexibility, as it now appears to give too much weight to the availability of foreign financing. 6.69 Finally, greater attention needs to be given to the possibility of alternative forms of financing before relying on counterpart funding. In particular. the possibility of increasing cost recovery should be further extended, not only to current expenditures but also to infrastructure projects. 6.70 Institutional Capacity. Government line agencies in charge of actual implementation of expenditure programs have been hard pressed for financial resources and for technical and administrative skills. Not only is the pool of human resources available in the line agencies extremely limited, the organizational arrangements are often inadequate. The appointment of new managers and heads of depa-tments at the outset of the new administration's tenure provides a fresh opportunity to look anew at issues of institutional reform and for the government to streamline and strengthen functions and personnel in the civil service and public corporations. Of course, enhancing public institutions requires resources to attract and retain quality personnel and to develop and install effective management information and data systems. 6.71 Institutional capacity could be strengthened in developing and implementing projects in the areas of poverty, environment, land reform, and population by drawing on expertise and resources in the nongovernmental organization (NGO) sector. NGO involvement has already contributed substantially to the implementation of selected projects, for instance, the World Bank Central Visayas Regional Project, and more extensive participation could be designed on the basis of lessens learned, in particular in those areas where the expertise and the reach of NGOs is strongest, such as in the social sectors and in the outlying regions and rural areas. 6.72 Use of Consultants. Institutional weaknesses have often been compounded by difficulties in the use of consultants. Regarding the technical assistance activities associated with the design or implementation of investment projects, delays in identification and selection of consultants has been a common problem. Amended Guidelines for Recruitment of Consultant Services were issued in 1991; under the revised rules, line agencies have now been delegated the authority for tmaking selection decisions and clearer criteria have been adopted for consultant screening o.. development projects. In the future, greater attention will need to be paid to the effective selection and use of consultants, and the donor community will need to participate in this effort by tracking more closely the effectiveness of consultants. 6.73 External Aid Utilization on Investment Projects. An issue related to the implementation of government expenditure programs is the securing of external financing for selected investment activities. The aid pledges by bilateral and multilateral donors need to be translated into actual commitments for specific projects; bidding documents have to be prepared for the projects, contracts awarded for their physical implementation, and actual execution monitored. 6.74 Although data from the Coordinating Council for the Philippines Assistance Program show a fairly good picture in terms of conversion of aid pledges into specific project commitments, donors - 118 - remain worried about the slow pace of aid utilization.2' Delays in preparing bidding documents and in awarding contracts were among the most common reasons given for project slippages, and these delays are usually due to the limited technical and adninistretive skills in the line agencies. These difficuiies on account of institutional weaknesses have compounded the problems caused by insufficient counterpart funds and unpredictable cash releases and have caused a serious slowdown in aid utilization. This problem, if uncorrected, is likely to lead to a decline in official development assistance, as it has already been argued that the aid pledges made in 1989 and 1991 were too large in relation to the actual institutional and financial constraints in the Philippines. This is a fundamental issue and one to which the new administration needs to give the highest priority. 6.75 Procurement of Public Contracts. One of the issues that has limited the quality and timeliness of implementation has been inadequate procurement procedures. This issue has been particularly contentious for foreign-assisted projects, which have often been held up for this reason. 6.76 In 1990 procurmtaent procedures for civil works were revised to incorporate new clauses aimed at improving efficiency and transparency of procurement. The innovations regard cost escalation formulas, prompt payment of claims, elimination of advance deposit requirements for contractors and establishment of bid-to-awards time limits. Standard bid documents have also been compiled for both international and local bidding. The revised guidelines provide for greater delegation of authority to line agencies, by effectively eliminating the limit on the authority of line agency heads to approve the award of publicly bid contracts and by raising the ceiling for award approval of negotiated contracts. These actions have eliminated a major impediment to sensible contract groupings and size and have resulted in much speedier approval of contracts by line agencies. Regarding procurement of goods, new guidelines for local procurement have been drafted by NEDA, but remain to be implemented. 6.77 Despite the progress made in improving procurement procedures, continuous attention needs to be devoted to improving procurement prttices. Among actions under consideration, the Disbursement Monitoring Unit to be established within NEDA, in charge of troubleshooting projects experiencing difficulties in implementation, should also cover procurement aspects. Since NEDA is already responsible for review and monitoring of the overall development program, the addition of the Disbursement Monitoring function should be integrated with these functions. Monitoring and Reportinj 6.78 In contrast with the wealth of data on the expenditure program, there is insufficient reporting of its actual implementation. Although planned investment expenditures are published in detail- disaggregated by economic classification, region, and even project-actual investment expenditures are not even classified by sector; thus data on, for instance, investment in agriculture are available only on an obligation basis. The large divergence in aggregate between cash-based and obligation-based data indicate that large differences are likely also to arise at sectoral and regional levels. Commitment data from Coordinating Council for the Philippines Assistance Program (CCPAP) show that as of December 31, 1991, $3.1 billion (89 percent) of the aid pledges received at the 1989 CG meeting and $2.6 billion (79 percent) of the aid pledges received in 1991 had been converted into commitments. While these appear to be satisfactory rates of availment, data on disbursements show much lower rates of utilization. - 119- 6.79 The usefulness of the current reporting is further limited by differences in the classification and disaggregation criteria adopted by various agencies. For instance, O&M as reported by NEDA includes interest payments, which are not included in the aggregate for O&M as reported by DBM. Finally, discrepancies exist between the data on government consumption. investment, and tax revenues reported by DBM and those published by the National Statistic Coordination Board, due mostly to different definition of which agencies are part of the government. 6.80 Inconsistencies in classification and insufficient detail in reporting limit the ability to monitor the expenditure program and its effectiveness. Without adequate data on actual implementation of the expenditure program, it is impossible to evaluate to what extent original objectives have been met and to program future requirements. Although human and financial resources assigned to monitoring and reporting activities are as limited as those assigned to planning and implementation, a careful review of these activities should be conducted with the objective to coordinate them, standardize their output, and target the information collected to be more directly relevant for planning and implementation purposes. Audit 6.81 The Commission on Audit (COA), a quasi-judicial body that reports directly to the president and Congress, is the sole auditor of the public sector's programs and projects. In this role, COA has to date effectively vetoed internationally certified accounting firms from auditing public corporations, with serious damage not only to their image but also to their ability to access international capital markets. 6.82 COA procedures tend to focus more on detailed certification of records than on substantial evaluation of balance sheets. For example, in agriculture projects, COA has established procedures to establish the authenticity of records about deceased animals; at the same time, COA has tolerated for a decade that the balance sheet of NPC did not revalue assets and thus grossly overstated the rate of return of the corporation. 6.83 For these reasons, and for the self-inflicted exclusion of COA from every attempt at institutional reform, all efforts to improve the audit function have been concentrated in other quarters. In mid-1990, a technical committee organized by the Congress s*-bmitted to the Department of Justice an Omnibus Accountability Code for Government Assets. Liabilities, and Eauity. This would transfer out of COA various accounting functions and would integrate other auditing functions, such as review of contracts, inspection and appraisal of infrastructure projects, verification of prices of materials, and countersigning of disbursement checks. The code would also provide for the reorganization of the Accounting Group in DBM, invested with the technical supervision of accounting and internal audit functions. Some of the provisions of the code were adopted in a DBM circular in September 1990. The proposed code was submitted to the Senate in December 1990 but not acted upon, and it is expected that it will be considered by the new Congress. Decentralization 6.84 One of the main objectives of the Aquino government's development program was to provide for the decentralization of much governmental activity to local units, and this goal was achieved with the enactment in October 1991, with broad support by Congress, of the Local Government Code. - 120 - The Code provides for substantial devolution of resources and responsibilities from the national government to local government units (LGUs)A9' 6.85 Under the system of funds allocation introduced by the new Code, the LGUs in aggregate will receive a share of internal revenues collected in the third fiscal year preceding the current fiscal year. rising from 30 percent in 1992 to 40 percent from 1994 onward. Of this aggregate, the portion received by individual LGUs is determined by a formula based on a minimum allocation, population, and land. LGUs will also be allowed to borrow external funds, with national government approval, and to levy and retain selected taxes on property and business. 6.86 Under the Code, the LGUs will be responsible for a large number of expenditure programs previously managed by the national government. This is expected to require extensive transfer of personnel from the central agencies to the LGUs, in particular in areas such as public works, health, and education. 6.87 The precise atrangements for the transfer of power and responsibility from central agencies to LGUs has not yet been finalized, nor has the relation between delegation of administrative responsibility and devolution of financial resources. In any event, this transfer will certainly need to be complemented by substantial support for institutional strengthening. The vast majority of LGUs have had no experience in managing development programs and their administrative experience has also been limited to few local activities, since most central agencies have regional branches to carry out area- specific programs. 6.88 Several issues also remain to be resolved at the central level. The Code represents a major change in fiscal arrangements, and its impact on the ability of the national government to carry out macroeconomic management could be substantial.& The decentralization process will need to be closely monitored, so that excessive expenditure pressures do not arise and the needs ot the local communities are adequately served by LGUs that are stronger not only in resources but also in administrative skills. D. Conclusions 6.89 Although stabilization policy options will continue to be constrained by high public domestic and foreign debt, their effectiveness can be improved through consistent implementation and institutional strengthening. In order to benefit fully from the progress already made in structural reform, the Philippines must not only make the right choices, but must also implemem them quickly and consistently. ' Cf. World Bank, Philipines - Fiscal Decentralization Study (1992, Report No. 10716-PH). Many countries that have experimented with decentralization have witnessed the largest and best organized municipalities going on major spending binges. For instance, in Turkey in 1985-86 the government delegated to local units the control of local expenditures and of the tax base for selected revenue programs; in 1988-89 the government had to rein in some of the previously delegated powers because of substantial overspending. - 121 - 6.90 Strengthening policy implementation requires strengthening public institutions. Three of the most important macroeconomic agencies--the central bank. the bureau of internal revenue (BIR) and the bureau of collections (BOC)-are hamstrung. The central bank has become financially dependent on treasury support, which limits its independence. The BIR and BOC suffer from legal hurdles (little ability to prosecute tax evaders and smugglers) and internal inefficiencies which have contributed to low collection rates. 6.91 With the reform process, the role of the government has changed profoundly--from one in which it was involved in production, distribution, and price setting to one in which it sets the rules and supervises the functioning of th,; markets. Transport, foreign exchange, oil pricing, trade, and investment policy are examples of areas that have been deregulated and liberalized, effecting a significant change in the institutional functions of government agencies. The introduction of the new local government code will also require that central agencies be substantially reoriented and local government units strengthened. In this context, civil service reform-which should address the function, staffing, and remuneration of public agencies-is a priority. 6.92 Implementing policies effectively and consistently will not eliminate the need for tough choices. The most difficult policy decisions will continue to pertain to fiscal policy. As argued earlier in this chapter, a vast gulf exists between needs-estimated at $6.5 billion on an annual basis, in addition to the present level of expenditures-and the resources available to meet these needs. The dilemma posed by competing and deserving needs must be resolved according to their budgetary costs and social benefits, lest growth remain trapped under the burden of public debt and high interest rates. In this regard, the current procedures for allocating expenditures should be reevaluated. In terms of selecting projects, cost- benefit considerations must be emphasized, rather than less quantifiable-and thus more arbitrary-criteria (such as linkage with rural activities); similar criteria must be adopted for selecting priority recurrent expenditures-in particular in O&M. Finally, the issues underlying the increased inflexibility of budgetary allocations must be addressed, especially as they pertain to wage expenditures and an overall civil service reform. 6.93 An increase in public infrastructure investment, which is now necessary to sustain the recovery of private investment, will continue to require substantial efforts to increase resource mobilization, both domestically and externally. Expenditures must be reallocated within the current levels, but doing so will not provide sufficient savings in the short run to support a substantial increase in investment. For this reason, the tax effort must be increased quickly and in an equitable and non- distortionary fashion. 5.94 Foreign resources will also be necessary for financing an investment-led recovery. Private external sources and non-debt forms of financing should be sought, to avoid a deterioration in the public debt burden. In this regard, BOT and build-operate-own (BOO) forms of private infrastructure investment are a promising complement to public investment. However, funding for the latter will continue to require sustained support by the international donor community. The Aquino administration successfully mobilized considerable foreign resources, but was less successful at translating these commitments into projects on the ground. The institutional capacity of the government to utilize official development assistance resources efficiently, even in a tight budgetary situation, must be improved to respond to the concerns of donors about disbursements, especially in times of increasing global demands on aid. 〕叩