Philippines - Private sector assessment (PSA) (Vol. 1 of 3) : Executive summary

Report No. 11853-PH Philippines Private Sector Assessment (PSA) (In Three Volumes) Volume l: Executive Summary July 12, 1994 Industry and Energy Operations Division, Country Department I East Asia anoi Pacific Regional Office Private Sector Strategies Division, Corporate Planning Department International Finance Corporation FOR OFFICIAL USE ONLY ERepolDrt. t1:: iia,: r. Type: ,E, Document of the World 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  FOR OFFICIAL USE ONLY PHILIPPINES PRIVATE SECTOR ASSESSMENT EXECUTIVE SUMMARY Table of Contents Page No. Policy and the Productive Sectors ..................................1.. Earlier Problems and Policy Reforms ......... ........................ 3 An Enabling Environment for the Private Sector. 4 Power. 6 Telecommunications 6 Transportation . The Regulatory and Legal Framework and Competition Policies. 8 Judicial Svstem ............................................ 9 Foreign Investment 9 Privatization .10 The Incentive Structure .10 Access to Finance .12 Strategy .14 Past World Bank Assistance and Status of the Portfolio .15 World Bank Strategy .15 The Economic and Sector Work Program .16 IFC Strategy .. . . .. . ............................ ...... ... . ... 17 Conclusion .19 Attachment 1: A Summary of Actions Introduced by the Government .20 Attachment Il: nt wti.shed Agenda of Issues, Objectives and Reforms .27 Iofficial dutzs. Its contents may not otherwise be disclosed without World Bank authorization. Thi douet_sarsrce itiuinadmyb sdb eiinsol ntepromneo hi  EXEUIVE SUMARY"l 1. As a result of Government initiatives (particularly over the past two years), the framewtrk for private sector development in the Philippines has undergone a dramatic transformation. Stability in the macroeconomic and political environment and a successfu: reentry to the international capital markets have been accompanied by the creation of new areas of investment opportunity through privatization and private infrastructure. More recent initiatives have created opportunities for foreign investors in mining and banking, which will streegthen the Philippines' linkages with the international economy. As at mid- 1994, many other initiatives are in the legislative pipeline and their eventual implementation will further enhance efficient private sector development. 2. The response of the private sector to the Government's deregulation and liberalization initiatives had been slowed until this year by the acute power crisis. On the strength of the success of the Government's "fast-track" power program, the conditions have substantially improved for a resumption in business investment. With the first i.gns of investment recovery starting to emerge, the Government's strategy for private sector development is shifting from recovery to sustainability. The strategy is being developed across a broad range of initiatives is a continuation of the reform program of the recent past. The main elements of this strategy involve macroeconomic stability (with an emphasis on continuing fiscal reforms), improved trade competitiveness (including tariff reform,', competition policies, continuation of privatization and private infrastructure initiatives, and further development of the domestic financial markets and capital markets. 3. This report reviews the strategy for private sector development being pursued in the Philippines from the viewpoint of both documenting the reforms that have been undertaken to date and the reform priorities which lie ahead. On the basis of discussions held with the Philippine Government on June 14-15 1994, there is a substantial deal of concurrence between the priorities identified in this report and those already being pursued by the Government. Attached to this Executive Summary are Attaci.ment I which documents the policy reforms undertaken to date, and Attachment II which outlines the unfinished reform agenda. Nlcy and the Productive Sectors 4. Until recently, the problems that have dampened economic growth in the Philippines have ranged from a series of exogenous shocks and high foreign debt to power outages, recurrent political crises, and lack of depth and poor sequencing of policy reforms. Although previous governments have introduced a series of reforms to address major economic distortions and to make the domestic economy more efficient, they have had difficulty maintaining a stable macroeconomic environment and responding in a timely, w-ll-orchestrated fashion to unanticipated developments, whether internal or external. In the past two years, however, that environment has been improved and the Philippines has taken the first substantive and important steps to reintegrate the country's economy with the trade and investment flows in Asia and the rest of the world. V This report was dislussed with the Philippine Government on June 14-15, 1994, and significant input was also obtained from a roundtable with key private sector representatives on June 14, 1994.  2- 5. Unlike the case itl many developing countries, the size of the public sector is not the problem in the Philippines where the private sector accounts for over four-fifths of the domestic economy. This ratio reflects a change in the economy since the 1970s and early 1980s, when public investment and an import-substituting industrial sector financed by external and behest loanrs were the primary engines of economic growth. 6. Despite thir expansion of the private sector and the recent policy reforms, productivity has lagged and private investment has stagnated over the past decade. In 1993, gross domestic investment was only 24.3 percent of GDP in the Philippines, compared with 34.4 percent in the Republic of Korea, 43.5 percent in Thailand and 33.5 percent in Malaysia. While economic growth slowed in the Philippines in 1990 and turned negative in 1991, Thailand grew by more than 7 percent and Indonesia by close to 10 percent in each of those years. The efficiency of private investment was also much lower in the Philippines than in neighboring countries. The country's export base was limited, with three sectors accounting for a significant share of total exports - and most of them as highly import-intensive as the rest of the economy. Private manufacturing employment has not risen above 12 percent of total employment in the last decade. 7. Concentration is high in much of tne industrial and services sectors: ownership is concentrated among a small number of family-held conglomerates and multinational companies that produce about half of value-added in manufacturing. Medium-sized firms are rare. Few firms hlave been able to break through the entry barriers imposed by monopolistic and oligopolistic practices, and a plethora of entry barriers have limited imports and domestic competition and have dampened incentives for cost-efficient operations. Geographic concentration is also high, with 40 percent of all manufacturing in Metro Manila and most of the rest concentrated in only a few major cities. The Government has recognized the need to correct these biases against healthy competition and has started the complex process of reducing entry barriers and simplifying the administration, as seen in the recent liberalization in the telecommunications industry. 8. Interventionist public policies and the close relationships that developed between the public and private sectors have also contributed to the poor performance of the domestic economy in the past. Established elements within the business sector have given as much attention to their relationship with the Government and the public sector as they have to their markets as a source of growth. These relationships probably explain much of the private sector's inward orientation and rent-seeking behavior, as well as the lack of an export push. Protectionist and interventionist policies in the public sector, inconsistent enforcement of regulations, and such preferential actions as the granting of utility frai..hises or the allocation of loans through public financial institutions have fostered rent-seeking behavior and a lack of accountability. (The origin of these problems has been documented in a series of World Bank economic reports.3') Only recently have reforms been initiated to improve the institutional framework, and to foster business-government relationships that are transparent, more at arms-length, and aimed at levelling the playing field. 9. To complement the considerable progress in recent policy reforms, the authorities plan other important initiatives to bring about a more solid foundation for economic growth. Fiscal problems and 2' Behest 1 ans were those lent by Public Financial Institutions (PFls) to Marcos' 'cronies'. it The nnmsm recent Bank Economic Report is the Philippines: An Opening for Sustained Growth, The World Bank, April 1993.  -3 - the country's urgent development needs mean that the public sector canmot shoulder the full burden of developing more infrastructure and public utilities. Consequently, much of the development will be through private sector Build-Operate-Transfer (BOT) and Build-Operate -Own (BOO) projects or similar arrangements. The role of the public sector is being redefined to encompass only the functions governments can and should perform, leaving other activities to the private sector. Though the public sector is already small, the Government believes that it will need to shrink even more and its efficiency raised. Actions are also being planned to make the public sector fiscally sound through increasing non- distortionaty revenues and cutting non-priority spending. However, in several areas, the public sector needs to strengthen its regulatory capabilities while assuming the role of a neutral arbitrator and leveling the playing field. 10. The private sector, for its part, will neea to shift from its too often protectionist stance to a new perspective, a focus on encouraging greater openness, helped by institutional reforms in order to improve its efficiency. Thet sector will be called on to take more risks and to be more internationally competitive. To compete more effectively in international markets, it will have to invest more in new technology, and to concentrate more on exports and the quality needed to achieve them and leveling the playing field. Earlier Problems and Policy Reforms 11. In the past, macroeconomic policies imposed on the private sector many severe constraints that are only beginning to be eased through recent policy reforms. Large public sector financing requirements created high and volatile real domestic interest rates that raised the cost of capital and made fiscal adjustment politically difficult. Past policies resulted in a chronic overvaluation, and appreciation recently of the exchange rate which discouraged investments in export-oriented activities, and led to a shift in resources to nontradable sectors such as construction. High and volatile domestic interest rates and volatility in the nominal and real exchange rate, as well as its periodic overvaluation, raised the risk premiums for private business, driving up capital costs and discouraging investment bv increasing the hurdle rates for new investments. Inadequate infrastructure services also severely impeded the growth of the private sector. 12. By creating high real interest rates for government debt paper, to which all other domestic interest rates are related, the public sector's large debt burden contributed to the volatility of domestic interest rates and the crowding out of the private sector in domestic financial markets. This raised the cost of finance for the private sector. Increased private capital inflows in response to the higher domestic interest rates as compared to international interest rates, led to an appreciation of the real exchange rate, hence resulting in reduced export growth. In addition, the Central Bank by assuming large external debt obligations and the consequent large liability exposure to foreign exchange increased its vulnerability to exchange rate movements and reduced the effectiveness of domestic monetary management in the recent past. Investors in the Philippines faced the unwelcome prospect that their future external transactions could be disrupted by restrictions imposed on trade or capital flows, as had occurred previously. These conditions fed private sector uncertainties and reinforced concerns about the sustainability of Government actions. 13. The Philippines also faced numerous exogenous shocks during the last decade, which further depressed econc)iri n growth. Rising oil prices during the Gulf Crisis in 1990-91 was a serious blow to the country's balance of payments. A string of severe natural disasters - a prolonged drought, a  4 - devastating earthquake in July 1990, t:ue eruption of Mount Pinatubo in June 1991, and a damaging typhoon in the south in November 1993 - hit the country hard as well. 14. The authorities have introduced a series of policy measures over the past few years to improve the macroeconomic situation. These actions included new taxes and spending cuts; liberalization of import restrictioMs; relaxation of foreign investment restraints; privatization; liberalization of the exchange rate and interest rates; restructuring and recapitalization of the Central Bank; dismantling of agricultural monopolies in sugar and encouraging competition, including in telecommunications (see Attachment I fo,- reform actions introduced by the successive administrations in the last several years). 15. A Brady deal restructuring of the country's external debt in 1992 improved its creditworthiness. Reflecting the improvement in the overall economic outlook, the reduced external debt burcen and political stability, the country was granted a new credit rating (Ba3/B3- rating from Moody's and Standard & Poor's, respectively) in 1993. This has improved the country's access to international capital markets. The Government launched a successful US$150 million Eurobond issue at 320 basis points above US Treasuries, which was sv bscribed in full in February 1993. Private domestic companies with good credit ratings also gained access to the international capital markets. Total international bond issuance (both by the public and private sector) since February 1993 rose over US$1.4 billion. 16. Over the last two years, the macroeconomic situation has continued to improve substantially. Domestic inflation had been brought down to a single digit level, some capital had been repatriated back into the country, private investment increased and foreign direct investment totalled US$1.1 billion and portfolio investment equalled US$2.2 billion in 1993. Despite reforms, continued weaknesses in public finances and the structure of external accounts underscore the need for further Governmuent actions at macroeconomic stabilization - a sine qua non for fully restoring business confidence that is needed for a sustained increase in private investment. 17. The political situation has improved considerably as well, and is stronger today than at any time in the recent past. Threats of coups d'etat have become essentially non-existent, and the President has built up strong political support among the leadership of both houses of Congress. This improved coordination in policy making between the executive and legislative branches was demonstrated in the last two years when Congress granted the President emergency powers to deal with the energy crisis by allowing him to bypass red tape in the ordering and construction of power plants; the power short-term crisis was resolved with blackouts having been eliminated by the end of 1993. Congress also cooperated with the Executive in passing measures replacing the oil import levy which was lifted in January 1994, approved a more expanded coverage of the value-added tax (VAT) system, and passed a bill to permit entry of new foreign banks in early 1994. These are important positive steps in a continuing Government agenda aimed at completing stabilization and structural adjustment. An Enabling Environment for the Private Sector 18. To get a notion of what entrepreneurs see as the greatest constraints to private sector development, an enterprise survey was carried out in the context of this Private Sector Assessment (PSA). Entrepreneurs pointed to macroeconomic and infrastructure constraints as the most handicapping. Despite ongoing policy reforms, they singled out the uncertainty in the macroeconomic environment and high real domestic interest rates and especially the appreciation of the exchange rate, as well as the discretional use of regulations, as major concerns. In infrastructure, according to the survey, major impediments were electric power, transport, and telecommunications, problems that reflect years of neglect and policy  -5- distortions. Also raised as concerns were the restraining of entry of other players by monopolies as in telecommunications which have since been addressed and oligopolies ;: in transport. The tax burden, legal impediments, and compliance costs were not identified as major obstacles, indicating perhaps that many firms are able to circumvent formal rules and practices. Security concerns were also rarely mentioned as a key issue, probably because respondents were selected from among enterprises owned by Philippine nationals for whom this has not been so much of a problem. 19. Since the survey, the macroeconomic situation has continued to improve as mentioned earlier, and some of the infrastructural problems (particularly in power and telecomnunications) have been addressed through an aggressive program of private investment. Measures were taken to bring competition to the telecommunications sector which had long been dominated by one firm. Power blackouts were alleviated in the short-term through purchase of diesel.power standby generators (but in the longer term, base load plants must be put in place as planned). Other infrastructure problems (transport, roaos, inter-island shipping) will remain, however, still reflecting years of underinvestment and entry barriers. 20. For many, the Philippine business environment is still perceived to entail high risks and costs, and continued macroeconomic stability and the provision of adequate infrastructure investments will fundamentally alter that perception. The persistent currency overvaluation of the past could be less of a concein (particularly to exporters) as the Governrment moves to make the exchange rate more competitive by reducing the consolidated public sector deficit and establishing a better balance between fiscal and monetary policies, with the thrust of further macroeconomic adjustm.nt falling more on fiscal policy so that domestic interest rates would decline. Strengthened tax collecti( n and streamlined public spending through reforming the tax structure, privatization, and restructuring of public employment are critical elements in reduced domestic interest rates and consequently making the real exchange rate more competitive. 21. Reduced financial resources in previous years have led to infrastructure inadequacies and poor maintenance of existing infrastructure facilities, a situation exacerbated by successive fiscal crises which have resulted in cuts in infrastructure investment. In many cases, official foreign loan funds were available for these projects, but the public sector had difficulty utilizing them as planned because counterpart funds were not available. Fiscal problems also contributed to a neglect of operations and a drop in maintenance expenditures, so that existing infrastructure deteriorated: a number of public sector power stations were running at a fraction of capacity, and roads and bridges were difficult to traverse. 22. The chronic unmet demand and poor services in telecommunications, dilapidated transport infrastructure, high cost of power, and inefficient port and shipping facilities increase the costs of doing business in the Philippines. Private firms now pay a great deal to obtain reliable services. 23. Fiscal shortages and crises are not the only cause of the infrastructure crisis. The poor economic performance and weak finances of many public enterprises have seriously limited their capacity to maintain and invest in infrastructure systems over the past decade. They were also hampered by unclear and often conflicting commercial and social objectives, low capitalization, and limited accountability for performance. Price controls, inadequate tariff structures, and difficulties in collecting payments impeded internal revenue generation and many Government-owned or operated firms had to rely increasinglv on transfers from the National Government to sustain their activities. Consequently, many infrastructur; t-nterprises failed to expand in order to meet the needs of a growing population or to improve the quality of services.  -6 - 24. Inefficiencies resulting from concentrated structures in the utilities sector, long dominated by public enterprises and private monopolies, also play a part. Barriers to entry, as posed by monopolistic and oligopolistic structures, characterized by anti-competitive conduct - especially in lucrative market segments, discourage new firms from providing more and better quality of services. The practice of combining commercial and regulatory functioas into a single organization (for example, the Philippine Ports Authority) also stifled competition in the provision of infrastructure-related services. Such practices prevented realization of the benefits of competition in contestable markets, such as improved quality and efficiency. Special initiatives such as build-operate-transfer (BOT) and build- operate-own (BOO) schemes werc able to address short-term supply prc blems, but more fundamental restructuring is needed for long-run improvements, particularly on the regulatory framework governing the supply of infrastructure services. Increased public allocation to infrastructure and improved efficiency of resource use are also important. 25. Power. The new administration is committed to a fundamental reform of the energy sector. Recent amendments to the BOT law now institutionalize the role of the private sector - which helped bring about this very positive outcome - in power generation. The January 1993 energy sector plan emphasizes clear rules and mechanisms for monitoring the behavior cf key players in the sector. The plan sets out remedial measures in many areas - particularly in sector coordination, the regulatory framework, private sector paiticipation, power and oil pricing, environmental management, energy conservation, operational efficiency, and project implementation. Some key recommendations have already been implemented, including the establishment of the Department of Energy (DOE). As part of the oagoing dialogue on further implementation issues, the Bank is engaged in a sector study to achieve consensus with the Governrment on a long-term structural framework for the power sector. 26. The main physical targets for energy sector development include a doubiing of generating capacity in the Luzon grid to 8,000 megawatts by the year 2000 to meet projected demand, with most of the planned incremental powe'r privately financed and operated. Conventional base-load supply projects (coal, geothermal, and hydro) require three to six years to bring them on-line so as to provide relief in the short-term, the Government embarked on a "fast-track" expansion program to produce several gas turbine and diesel-engine driven systems. The Electric Power Crisis Act of 1993 granted the President special powers to facilitate tariff increases if and when needed and to speed up project approvals. 27. Studies are underway to identify measures to address key weaknesses of the National Power Corporation (NPC). Over the next few years, NPC plans to continue to provide for increases in generation capacity through BOT and BOO arrangements with the private sector. At the same time, plans are underway to corporatize NPC along commercial lines, with a possible split into three entities being contemplated as one option, which will need careful review to ensure that all the entities are financially viable. In the medium term, once the NPC has gained experience as a cornmercially-oriented utility, this report suggests privatizing NFC but this will first require changes in the legal statutes and regulations under which the company operates. 28. Telecommunications. The Government recently introduced drastic reform measures to bring competition to a sector long dominated by one firm, the Philippine Long Distance Telephone Company (PLDT). as well as to boost the efficiency of PLDT in order to deal with extremely poor coverage and servi-ce in the telecommunications industry. Several additional measures were undertaken. The first step) .. as to establish clear sectoral policies and a sectoral development plan. Other major telephone carriers were encouraged to develop and increase supply of telecommunications facilities. The  - 7 - Govemrnent divided the country into 11 areas, and assigned different service operators in each area. It required PLDT to allow other telecommunications companies to interconnect into its system. Other telecommunication modes - cellular mobile telephones, telex, facsimile, etc., - were also opened up to new -"rriers. The Government is also taking steps to improve the regulation of telecommunications operations. This report recommends that the National Telecommunications Commission (NTC) be made an autonomous and accountable agency, with an adequate budget and the ability to recruit, train, and retain qualified professional staff. 29. Transportation. In the past, government regulations, which in the past also perpetuated the oligopolistic structure of the industry, resulted in price and service distortions that protected inefficient transport operators and allowed the more efficient ones :o earn rents in internationai shipping. To ease some of the major bottlenecks in the transport sector, the Government encouraged entry and competition on major shipping routes through deregulation and liberalized price setting. In March 1992, the Government removed controls on all but the lowest class fares and eliminated cumbersome administrative practices that had severely impeded entry and exit. Conference of International Shipowners and Operators (CISO) esiablished a pro-competitive control mechanism for ensuring that prescribed rates and fares and other conditions of carriage are adhered to. The Government also started to deregulate other aspects of inter-island shipping. 30. The Government plans to focus more on rehabilitating and maintaining roads and other infrastructure already in place, and open other secors - particularly power and telecomnmunications - to the private sector under a competitivc environrment. The Government firmly believes that the pri-ate sector has a crucial role to play in addressing the managerial and financing problems that have contributed to infrastructure degradation. But encouraging the domestic private sector to invest in infrastructure will require improved governance, greater transparency in the relations between the public and the private sectors, reform of incentives, macroeconomic stability, and greater openness. To this end, there is a nieed to: - * Encourage efficiency as well as ownership and management that are fully accountable and autonomous. * Establish competitive industry structures to attract new firms to supply infrastructure needs. * Foster an effective and transparent regulatory framework. * Maintain a stable macroeconomic, legal, and political environment to generate confidence in the economy and the reforms. In addition, privatization schemes such as build-operate-own and build-operate-transfer are introducing substantial private sector participation and new sources of financinp for infrastructure investment - at least in power and telecommunications as the infrastructure investment gap is so large that the public sector cannot fund all the needs. 4 An anah cNi rtf key constraints to infrastructure development and proposed solutions are provided in 'The Phihippines. Infrastru.tuc ). sessment Study", 1993.  The Regulry and Legal Framework and Competition Policies 31. The present regulatory framework has not encouraged the growth of private business. In fact, by favoring incumbent firms, it acts as a significant barrier to the entry of new firms. Most regulatory agencies are weak, lacking political clout, adequate budgets and clear-cut procedures. The system of utility franchising (firms are required to obtain permits to operate utility services from Congress) encourages inefficient business practices and creates opportunities for abuse. The lack of sufficiently clear rules, proper enforcement, and a credible referee has encouraged rent-seeking and discouraged new entry. High transaction costs have made it difficult for new firms to enter markets and for small and medium-size firms to grow. One option to explore to lower entry barriers would be to empower the executive branch to issue franchises for public utilities, with clear and specific guidelines defining eligibility so that there is little individual discretion required. The regulatory agencies need to be strengthened by insulating them from political interference, making them autonomous and self- financing, and granting them adequate regulatory powers. 32. The Philippines lacks adequate competition policies. Government believes that its policies should help to create contestable rnarkets as a way of increasing the efficiency of the domestic economy and encouraging economic development. Ongoing and planned economic policy reforms in the incentives regime and financial sector in this regard should mean that the private sector will operate in a far more dynamic setting in the future. However, there is still a need to put in place reforms to introduce adequate competition policies along the lines of the reform bi!l presented to the Congress. Toward this end, this report supports introducing an adequate competition law and an administrative agency to enforce it. The new agency would ensure contestable markets are maintain;.d and that monopolistic practices are not undertaken as well as practice competitive advocacy.'i' It would also provide expert -ommnent on the competitive effects of regulations. The proposed framework would also treat violations of the proposed law as violations of civil law, increase civil penalties under the law, and ensure private rights of appeal. Legal constraints on inter-corporate relations (cross-ownership and interlocking directorates) would reduce the chance for even greater industrial and market concentration. Given the institutional weakness in the Philippines, these reforms will likely take time and might require a strong dose of extern I technical assistance. 33. Competition policy enforcement is not, however, the proper mechanism for bringing about major regulatory changes. Proceeding on a case by case basis, no agency is likely to have the resources or political power to undertake widespread public and private sector reforms. Rather, the highest level of Governrnent needs to be tasked to undertake demonopolization of the economy. Then the competition agency would be empowered to protect and continue the progress that his been made. In particular, the competition agency should have the authority to overturn anti-competitive decisions and rules of other public agencies. 34. A public awareness campaign would be needed to persuade private sector firms that the efficiency gains for the economy will produce benefits that outweigh the costs. Without that understanding, reforms are unlikely to be lasting. Once persuaded of the benefits of the reform, the powerful oligopolies might even aid the process. These powerful economic interests stand to gain considerably from the increase in commercial activity and economic growth that would result, but they 5' Comp<t. - aJvocacy implies a formal public expert commentary on Government policies with respect to their effect on cornneti-(nm  -9- need to be made aware of that fact.