Philippines - Managing global integration (Vol. 1 of 2) : Main Report

Report No. 17024-PH Philippines Managing Global Integration (In Two Volurmes) Voliume l: Main Report November 17, 1997 Povertv Reduction an(] Economic Managenment Sector Unit East Asia and Pac ific Regional Office Document of,the World Bank  CURRENCY EQUIVALENTS (As of November 17, 1997) Currency Unit = Peso $1.00 = 34.05 pesos 1.00 peso - $0.029 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System Vice President Jean-Michel Severino, EAP Country Director Vinay K. Bhargava, EACPF Sector Manager (Acting) Pieter Bottelier, EASPR Staff Member Sanjay Dhar, Principal Economist, EASPR  CONTENTS Acronyms and Abbreviations .................................................... iii Acknowledgments .....................................................v Executive Summary .................................................... vii Introduction .................................................... xv 1. ECONOMIC DEVELOPMENTS AND ISSUES: AN OVERVIEW ........................1 Financial Market Instability in 1997 ....................................................7 2. POLICY IMPLICATIONS AND PRIORITIES .................................................... 10 Macroeconomic and Financial Policies .................................................... 10 Structural Reform and Competitiveness .................................................... 17 Issues in Manufactured Export Development .................................................... 20 3. THE ECONOMIC OUTLOOK .................................................... 26 Alternative Scenarios .................................................... 27 Official Development Assistance (ODA) Requirements ....................................... 27 Statistical Annex ................................................... 29 TABLES Table 1: Selected Economic Indicators, 1992-97 .....................................................2 BOXES Box 1: Lessons from the Thai Crisis ................................................... 7 FIGURES Figure 1: Balance of Payments Trends ....................................................4 Figure 2: Financial Market Trends .....................................................6   Acronyms and Abbreviations iii ACRONYMS AND ABBREVIATIONS BAP - Bankers' Association of the Philippines BCDA - Bases Conversion Development Authority BOI - Board of Investments BSP - Bangko Sentral Ng Pilipinas CARP - Comprehensive Agricultural Reform Program CPU - Central Processing Unit CTRP - Comprehensive Tax Reform Package DENR - Department of Environment and Natural Resources DOLE - Department of Labor and Employment DOST - Department of Science and Technology DRAM - Dynamic Random Access Memory EDC - Export Development Council EPZA - Export Processing Zone Authority FCDU - Foreign Currency Deposit Unit FDI - Foreign Direct Investment FIAS - Foreign Investment Advisory Service GDP - Gross Domestic Product GNP - Gross National Product GOCC - Government-Owned and Controlled Corporations GOP - Government of Philippines GTAP - Global Trade Analysis Project IC - Integrated Circuits IDC - Industry Development Council IRR - Implementing Rules and Regulations LGU - Local Government Unit MFA - Multifiber Agreement MFN - Most-Favored Nation MNC - Multinational Corporation NCR - National Capital Region NG - National Government NIE - Newly Industrialized Economy NPC - National Power Corporation NTB - Nontariff Barriers OBM - Own Brand Manufacture ODA - Official Development Assistance OEM - Original Equipment Manufacture PEDP - Philippine Export Development Plan  iv Acronyms and Abbreviations PEZA - Philippine Economic Zone Authority PHILEA - Philippine Industrial Estates Association QR - Quantitative Restriction RCA - Real Comparative Advantage R&D - Research and Development RDC - Regional Development Council SFB - Standard Factory Building SITC - Standard International Trade Classification SME - Small and Medium Enterprise STAND - Science and Technology Agenda for National Development TESDA - Technical Education and Skills Development Authority ULC - Unit Labor Cost LJNCTAD - United Nations Conference on Trade and Development WTO - World Trade Organization  Acknowledgments v ACKNOWLEDGMENTS This report was produced by a team led by Sanjay Dhar and included Francisco Ferreira, Kumiko Imai, Fred Kilby, Sanjaya Lall (consultant), Yuzuru Ozeki, Kishore Rao (consultant), T.G. Srinivasan and Vivek Suri. Hedwig Abbey and Meredith Dearborn assisted in document processing. We gratefully acknowledge the cooperation and support of government officials and private sector representatives for the preparation of this report.   Executive Summary vii PHILIPPINES: MANAGING GLOBAL INTEGRATION EXECUTIVE SUMMARY INTRODUCTION An integral element of the Philippines' economic turnaround in the mid-1990s has been a parallel rise in trade and capital flows in proportion to the domestic economy. Faster integration into the global economy is the result of falling transport and communications costs worldwide, increasing diversification of investment funds, as well as the substantial liberalization of trade and capital flows enacted by the Philippines. More rapid integration has brought with it greater opportunities and rewards through increased trade and investment, which have been instrumental in fostering greater competition within the domestic economy and contributing to a foreign direct investment (FDI)-led export boom within the electronics sector. At the same time, the volume and volatility of private capital flows have increased at a much faster pace than trade. Such flows have, hence, played an increasingly important role in real exchange rate determination and motivated the financial market turbulence in 1997. The heightened rewards and risks from global integration, therefore, place a rising premium on the quality of economic policy. In an open economy such as the Philippines, the challenge to policymakers is to incorporate realistic assessments of both opportunities and risks from global integration, and to align policies to take maximum advantage of the opportunities while adequately managing the risks. FINANCIAL MARKET INSTABILITY: CAUSES AND CONSEQUENCES Although the trigger for the shift in investor sentiment in early 1997 was Thailand's intensifying crisis, the resulting financial market turbulence should not be attributed to irrational market sentiment alone. The appreciating real exchange rate, rising trade deficit, rapid growth of private credit facilitated in large part through intermediation in foreign currency, associated buildup in real estate prices in Metro Manila, and the long-term consequences for the banking system of these trends were legitimate concerns prior to the exchange rate adjustment on July 11, 1997. (See, for example, World Bank 1996.) The 29 percent depreciation of the peso since July 10, the sharp increase in the level and volatility of interest rates, and the 40 percent decline in equity prices thus far in 1997 pose potentially severe problems for corporations, particularly if the period of financial market volatility is protracted. The risks in the current situation are aggravated by the prospect of greater fiscal, corporate and banking stress, slower economic growth  viii Executive Summary and higher inflation, and the adverse impact of these on investor confidence and external capital availability. Conflicting policy requirements have also complicated the adjustment to the shift in market sentiment in 1997: tight monetary policies are called for to adjust to the diminished demand for domestic assets, to limit the extent of exchange rate depreciation and increase in inflation, and to maintain the confidence of international creditors, exporters and overseas workers; yet, concerns about corporate and financial health in light of the sharply higher interest rates witnessed are also legitimate, particularly since private investment and consumption can be expected to react adversely in the new environment. Fortunately, the adjustment to the new market reality has been relatively rapid in the Philippines, and the financial policies enacted since the decision to allow a more market determined exchange rate have on balance been appropriate-even though the tradeoffs involved have inevitably caused policy tensions to arise. Notwithstanding these concerns and conflicts, in a number of aspects the Philippines' recent performance and attributes can be differentiated from the other countries in Southeast Asia affected by the regional currency crisis. For example: T The period of significant foreign borrowing by the private sector and rapid credit growth was shorter in the Philippines relative to its neighbors. As a result, the ratio of private credit/GNP is more modest, large corporations appear less leveraged, and vacancy rates for vulnerable segments of the real estate market appear lower. * Export growth since 1995 has been the highest among market economies in the region-and including the 23 percent growth through September 1997 ranks as among the best export performances globally in recent years. * Over the past decade, the Philippines has made significant progress in the areas of structural reform and deregulation, and has developed transparent approaches to the design of economic policy-progress that is increasingly valued by the investor community. * There is a recognition among policymakers that global integration is a reality that has to be managed rather than reversed. Policy statements as well as actions since the crisis have reflected this understanding. POLICY IMPLICATIONS The critical factor over the next year will be to rebuild investor confidence. While more difficult in the current environment, confidence can be bolstered through the perception that macroeconomic policies will remain sound, financial institutions and the regulatory environment will continue to be strengthened, firther repercussions from financial market instability will be decisively handled, structural reforms will be pursued  Executive Summary ix in a timely manner and recent progress on improving governance will continue. To strengthen policy stability and predictability, developing close coordination between the key government agencies responsible for economic policy and maintaining cooperation between the executive and legislative branches through the pre- and post-election periods will both be important. Short-Term Macroeconomic Policy Continued vigilance over monetary and fiscal policies will clearly be vital in the short term. To strengthen the basis for conducting monetary policy, gathering precise information on the profile of foreign debt service requirements of the private sector in the short term will be helpful to gauge pressure on the exchange rate from this source. Similarly, identifying corporations that are particularly vulnerable to high interest rates and their primary creditors could provide the authorities with advance information of impending problems in the corporate and banking sectors. Since July 11, the authorities have relied on frequent adjustments of liquidity reserve requirements to influence liquidity conditions in the market. Yet the effectiveness of monetary policy would be enhanced if greater reliance could also be placed on open- market operations. Use of the latter is, however, constrained by the ruling (effective as of 1997) that banks are subject to taxation on repurchase agreements with the central bank of greater than five days' maturity; this ruling therefore needs to be reconsidered in light of the current financial market volatility. The prospective passage of the comprehensive tax reform bill should be beneficial to investor confidence if it is seen to significantly enhance revenue in the context of broadening the tax base and improving efficiency. Hence strong implementation of the program will be needed to attain the Administration's original revenue objectives from the recent legislation. On the expenditure side, if further public expenditure cuts are needed, it would be preferable to cancel or delay projects and programs that are ranked low in terms of economic priority, rather than administer across-the-board cuts to the entire public investment program. Poverty alleviation and social safety net programs that are effective in attaining their objectives should be protected from cutbacks. Hence, the government may wish to consider temporarily raising the share of official development assistance (ODA) financing of public investment, if needed to protect its high-priority objectives. At the same time, greater caution and selectivity is warranted in granting fiscal incentives to promote private investment (whether through the tax system or guarantees) in view of the need to reduce the private sector-generated current account deficit and the risk of exacerbating overcapacity in a slowing economy. The Supreme Court's decision on November 5, 1997 rendering the oil deregulation bill unconstitutional needs to be addressed as soon as possible (through new legislation if necessary, as is the government's intention) to minimize damage to investor  x Executive Summary confidence, to reestablish the deregulation objectives of increased competition and investment, and to protect the government's fiscal targets. Structural Reforms Addressing those aspects of the structural reform agenda that will place the Philippines in a favorable position to take advantage of the post-turbulence regional environment will be particularly important. To the extent that the structural reform agenda can be accelerated, this would add to investor confidence, which in turn could help to ease the difficult tradeoffs the economy will have to endure in the short term. Fiscal Policy. Lower economic growth and corporate profits and higher interest costs are likely to pressure the fiscal accounts through 1998. Yet fiscal policy is currently constrained by its relative inflexibility, forcing too high a proportion of the burden of adjustment to be borne by cuts in maintenance and investment. If the increase over the past three years in government personnel costs is to be reversed, streamlining public agency roles in the context of the existing civil service reform agenda remains of high priority. Recent progress on tax reform should be complemented with sustained attention to strengthen tax administration, and incentives for revenue generation by local governments need to be strengthened. The government's intention to review the policy framework governing public enterprises is timely; in this regard, the program to restructure the National Power Corporation (NPC) and privatize its remaining generation capacity needs to be considered with renewed vigor in view of the added pressure to its financial position from exchange rate depreciation. The Banking System. The Thai crisis indicates that strengthening the regulatory and supervisory infrastructure for the financial system is a sound investment that can generate substantial payoffs in terms of forgone costs. In particular, allowing financial institutions that are insolvent (and likely to remain so under stable macroeconomic conditions) to continue to operate can undermine both macroeconomic stability and the incentive framework for healthy financial institutions; the cost of delaying action against such institutions generally increases significantly over time. The short-term priority therefore is to strengthen coordination among the bank supervisory agencies to ensure that the capacity of regulators to implement and enforce failure resolution policies is adequate and can be implemented through prompt, confidence-maintaining action to respond to sudden difficulties as they arise. The more resilient the banking system to volatility in financial markets, the less constrained and more effective macroeconomic policies can be in guiding a return to stability. Hence, improving the incentive and ability of supervisors, the market and owners to monitor and support prudent banking will remain vital. Significant progress has recently been made in increasing capital adequacy requirements, loan loss provisions and liquidity requirements on foreign currency deposits, and further measures are envisaged  Executive Summary xi under the General Banking Act submitted to Congress. While the pace at which further reform now progresses needs to be calibrated to the evolving financial market situation, the following areas are stressed: * Strengthen the credibility of supervisors against excessive risk taking, including insulating supervisors from legal challenges by those who they regulate. . Improve transparency by raising minimum disclosure standards. Stronger representation of outside shareholders on bank boards-particularly those that are closely held-would also enhance transparency. * Incorporate a risk-weighting scheme into the definition of capital adequacy inclusive of accounting for off-balance sheet activities. Savings Mobilization. The recent volatility of external capital flows highlights the need to develop domestic capital markets in order to finance a larger proportion of investment through domestic saving. In addition to increasing public saving, encouraging the development of domestic bond markets will be important. Several factors will be needed for this effort: establishing independent credit rating agencies (or contracting the services of foreign agencies); creating a level playing field in terms of taxation between debt and equity finance; liberalizing investment constraints on the long-term investment resources of the social security agencies; encouraging private institutions to play a greater role in housing finance; and developing instruments such as mortgage-backed securities, more active secondary markets and, more generally, longer-term floating rate debt instruments to provide comfort against macroeconomic volatility. International Competitiveness. The Philippines appears well placed to take advantage of integrating global markets given its high-quality English-speaking workers and its relatively deregulated economy that reflects a decade of structural reform. Competitiveness would be further enhanced if the recent real exchange rate depreciation can be substantially sustained in a stabilized macroeconomic environment and complemented by efforts to increase labor productivity. The relative stagnation of traditional industries such as garments, footwear and food processing in recent years appears unwarranted when viewed against the Philippines' large pool of surplus labor, rapidly growing labor force relative to major competitors, and a broad base of literacy and trainability. Part of the reason may be the high level of minimum wages in relation to per capita income levels, exacerbated by the nearly 40 percent appreciation in the real exchange rate between 1990 and mid-1997. (In this regard, it is important that prospective wage adjustments do not unduly undermine the beneficial impact of the recent depreciation on competitiveness.) Part is also the shift in sourcing patterns in its largest market, the United States, which is switching to Latin American suppliers with privileged access in terms of quotas and tariffs. Upgrading of  xii Executive Summary quality and efficiency has also been limited to the larger companies; smaller suppliers will face increasing difficulties in meeting world market standards, and may be adversely affected when the implicit protection given by the Multifiber Agreement comes to an end in 2004. The premature "graduation" from such industries is undesirable for enhancing competitiveness. In technology-intensive industries, Philippine exports have performed very well recently, particularly given the slowdown of electronics exports in neighboring countries. However, these exports are highly concentrated in one product-semiconductors-and in the lowest levels of technology with little local value added. Over the longer term, this structure may face an erosion of competitiveness from low-wage entrants, which also offer high levels of skill and a stronger local supply base. Raising labor productivity-where growth has lagged that of neighboring market economies-may be the most important element of improving competitiveness; the key policies in this regard relate to education, maximizing the benefits from FDI, and improving technological support to industry, particularly small- and medium-size enterprises (SMEs). In education, quality, relevance, access and completion rates need to be raised, and the length of schooling brought into line with international norms. The variation in the quality of higher education institutions needs to be reduced, improvements in teaching standards and equipment are needed for the high-level technical and management skills that competitiveness requires, and specific skills needed by traditional industries (e.g., garments) as well as new ones (e.g., electronics) have to be better met. There needs to be greater private sector participation in the design and implementation of training programs. The enterprise sector itself, especially SMEs, has to be induced to invest more in upgrading employee skills. The environment for FDI has considerably improved, but the benefits of FDI have yet to reach full potential. FDI into the manufacturing sector is narrowly concentrated into activities that generate exports at relatively low levels of local integration and technological complexity. Adhering to the government's program of trade liberalization presents the surest means of encouraging greater integration of FDI-led activity. In addition, the FDI promotion system needs to shift toward regional best practice, with incentives geared toward a performance-based system and away from the existing "front- loaded" system where tax holidays are provided at the beginning of the investment cycle. There is also a need to consolidate the promotion and incentive systems, by establishing clear responsibility for FDI promotion for the country as a whole, hence removing duplication and rent-seeking possibilities. (Measures to this effect are currently under consideration.) In particular, incentives emanating from the Board of Investments and the Philippine Economic Zone Authority need to be consolidated; the advantages of locating within economic zones would nevertheless be significant, stemming from the duty-free  Executive Summary xiii environment, streamlined procedures, and access to an integrated package of infrastructure and facilities. The technology support system in the Philippines has all the necessary ingredients in place, but needs to be better organized and made more relevant to industrial needs. There is a particular need to improve quality levels and linkages with SMEs, to upgrade their competitiveness directly and improve their capability to act as suppliers and subcontractors to large exporters. The following measures are also expected to be important for enhancing competitiveness: * Reversing the recent increase in agricultural protection by accelerating the schedule for lowering agricultural tariffs to bring down import protection to at least its pre- 1996 level. The motivation for this policy is twofold: to lower the prices of basic food commodities-which are significantly higher than in neighboring countries, and may be an important factor in wage determination; and to enhance the competitiveness of the food processing industry, where current performance appears well below potential, in part due to higher input costs. It should be noted that reducing import protection needs to be complemented by supporting efforts to enhance agricultural competitiveness and productivity, World Bank (1997). * One objective of a successful restructuring/privatization of NPC (discussed above) should be to provide more competitive electricity costs for industry, which have been among the highest in East Asia. Responding to a Soft Landing of the Currency Crisis The shift in investor sentiment during 1997 has meant that policy attention has had to adjust from moderating the consequences of overexuberant markets to the opposite concern. It is, however, possible that the Philippines may again need to address concerns about excessive short-term portfolio inflows and foreign borrowing in the not-too-distant future, particularly if regional markets were to stabilize more rapidly than anticipated. Under these circumstances, the most important policy responses would be to deepen the program to strengthen incentives for prudent banking, while retaining a considerable degree of exchange rate flexibility in macroeconomic management-so that private agents can adequately evaluate and protect against the risks associated with foreign borrowing. In addition, the experiences of other countries with influencing the nature and maturity of capital inflows would need to be studied with respect to their applicability to the Philippines.   Introduction xv INTRODUCTION This report analyzes the prospects for and consequences of continued global integration of the Philippine economy and examines the policy implications. Volume 1 summarizes recent economic developments and the nature of the financial instability experienced in 1997, and then focuses on three topics that will require ongoing policy attention in the context of continued integration: financial policies and risk management; enhancing international competitiveness; and strategic and institutional issues in manufactured export development. Volume 1 concludes with a discussion of economic prospects and attendant requirements for official development assistance. Volume 1 draws on three background chapters contained in Volume 2. Chapter 1 of Volume 2 places the key elements of the Philippines' global integration in perspective, comparing their evolution with that of other developing and East Asian countries. It then assesses the Philippines' competitiveness as a host for foreign direct investment (FDI), examining comparative infrastructure and labor costs across East Asia. The chapter concludes with a more indepth labor market assessment, focusing in particular on productivity, compensation and unit labor costs, and their impact on the competitiveness of tradable sectors. Chapter 2 examines the underlying competitiveness of Philippine export industries and the sustainability of their growth. The chapter compares the characteristics of Philippine exports with those of the more industrialized ASEAN economies, China, Korea and Taiwan (China), and describes the Philippines' competitive "positioning" in world markets. It then deals with the position and prospects in world markets of three product groups: textiles and garments, electronics, and software, and subsequently analyzes the main supply-side determinants of competitiveness-inward FDI, special economic zones, domestic industrial policies, skills, and technological activity and support. It concludes by reviewing the institutional and policy measures needed to improve and diversify export activities. An important aspect of Philippine export competitiveness relates to the role of special economic zones (ecozones), which have expanded rapidly in recent years, and have had a growing impact on the economy in terms of exports, investment and employment. Chapter 3 reviews changes in the concept and development practices of ecozones and identifies international best practice. It then evaluates the performance and competitiveness of Philippine zones in relation to other countries, assesses areas for improvement in the policy and institutional framework, and finally evaluates the strategic role of ecozones over the next decade from the perspective of falling trade barriers.  xvi Introduction Finally, using the World Bank's Global Trade Analysis Project (GTAP) model and a set of assumptions about the world economy, two annexes in Volume 2 discuss: (a) a feasible scenario for the long-term evolution of the Philippine economy (through 2020); and (b) prospects for the Philippines' two leading exports-semiconductors and garments.  Section 1. Economic Developments and Issues: An Overview I PHILIPPINES: MANAGING GLOBAL INTEGRATION VOLUME 1: THE MAIN REPORT 1. Section 1 of this volume summarizes recent economic developments and the nature of the financial instability experienced in 1997. Section 2 then focuses on three topics that will require ongoing policy attention in the context of continued global economic integration: macroeconomic and financial policies, enhancing competitiveness by pursuing further structural reform, and strategic and institutional issues in manufactured export development. The volume concludes with a discussion of economic prospects and attendant requirements for official development assistance. 1. ECONOMIC DEVELOPMENTS AND ISSUES: AN OVERVIEW 2. Over the past four years, the Philippine economy has benefited from a decade of structural adjustment that has focused economic policies on trade liberalization and increased domestic competition, privatization, and greater private management and investment in infrastructure. Favorable investor reaction to these changes has induced significant increases in private investment and capital inflows contributing to higher growth. In 1996 economic growth accelerated to 6.9 percent (GNP) and 5.7 percent (GDP), year-end inflation fell, investment and saving rates rose driven primarily by the private sector, export growth-though reduced reflecting slower external demand for electronics exports-was the highest among market economies in East Asia. While fiscal restraint was maintained, with the 1996 consolidated public sector account in approximate balance, the trade deficit continued to rise to 13 percent of GNP. Private capital inflows rose to nearly 10 percent of GNP and worker remittances amounted to another 12 percent of GNP in 1996, contributing to the continued strengthening of the Philippine peso in real terms and an acceleration in credit growth. Table 1 provides a summary of the key economic parameters; further details are provided in the statistical annex. 3. The economic turnaround of the mid-1990s has contributed to improving social welfare although the incidence of poverty remains a major development issue, particularly in rural areas. About 3.5 million jobs were generated during 1993-96, reducing the unemployment rate to 8.6 percent in 1996 from over 10 percent in 1991-92. Home ownership among lower-income families has sharply increased. Functional literacy has risen to 88 percent from 75 percent in 1989. Life expectancy increased from 62.5 in 1992 to 69.5 in 1997. Over the same period, the infant mortality rate declined from 53.6 to 45.8 per 1,000 live births. The officially measured poverty rate declined from 40  2 Section 1. Economic Developments and Issues: An Overview TABLE 1: SELECTED ECONOMIC INDICATORS, 1992-97 1992 1993 1994 1995 1996 1997L (percentage change) Growth and Inflation Real GNP 1.6 2.1 5.3 5.5 6.9 5.9 (Jan-Jun) Real GDP 0.3 2.1 4.4 4.8 5.7 5.3 (Jan-Jun) CPI (period average) 8.9 7.6 9.0 8.1 8.4 4.8 (Jan-Oct) CPI (end period) 8.2 8.4 7.1 10.9 5.2 5.7 (Oct) Unemployment Rate (percent) 9.8 9.3 9.5 9.5 8.6 (in percent of GNP) Saving and Investment National Saving 19.4 18.1 17.6 16.1 19.1 Private 17.8 13.7 14.5 12.9 14.6 Public 1.6 4.4 3.1 3.3 4.5 Gross Investment 21.0 23.6 23.5 21.6 23.9 Private 16.2 17.9 18.7 17.0 19.4 Public 4.8 5.7 4.8 4.6 4.5 Public Sector National Govemment Tax Revenue 15.2 15.3 15.6 15.8 16.1 16.6 (T) Investment 3.4 2.5 1.9 2.7 2.5 2.6 (T) Balance /b -1.2 -1.5 0.9 0.6 0.3 0.5 )T) Monitored Corporations Balance -0.8 -1.7 -0.5 -0.1 -0.5 -0.4 (T) Consolidated Public Sector Balance -1.9 -1.7 -0.4 -0.1 0.3 0.3 (T) PublicDebt 118.6 127.4 109.4 110.8 95.0 National Govemment Debt 71.2 84.6 70.9 66.7 58.3 (end-year percentage change) Money and Credit Broad Money 11.0 24.6 26.5 25.3 15.8 23.7 (Aug) Credit to Private Sector 24.6 38.0 27.9 43.5 51.0 32.0 (Aug) Commercial Bank Loans 24.0 32.2 25.4 35.8 51.9 39.1 (Sep) (end-year percentage change, $ value) Balance of Payments Merchandise Exports 11.1 15.8 18.5 29.4 17.7 23.0 (Jan-Sep) Merchandise Imports 20.5 21.2 21.2 23.7 20.8 12.6 (Jan-Aug) (in percent of GNP) Trade Deficit 8.7 11.2 11.9 11.7 13.0 12.1 (Jan-Jun) Current Account Deficit 1.6 5.5 4.5 4.3 4.5 4.5 (Jan-Jun) Intemational Reserves Gross Official Reserves ($ billion) L/ 5.3 5.9 7.1 7.8 11.7 10.4 (Aug) (in months of imports) 3.3 3.1 3.1 2.6 3.1 2.6 Extemal Debt Total ($ billion) 30.9 34.3 37.1 37.8 41.9 InpercentofGNP 57.4 62.0 56.4 49.6 48.1 Debt Service Ratio (percent) 17.0 17.1 17.4 15.8 12.5 11.1 (Jan-Jun) Exchange Rate (Pesos/$; period average) 25.5 27.1 26.4 25.7 26.2 35.3 (Oct 31) Real Effective Exchange Rate (1990=100) 110.9 110.4 117.3 120.3 ' 129.8 137.7 (Jan-Jul) La Latest period. lb Excluding central bank restructuring. L/ Including gold. ad Increase indicates appreciation. T. Official target Source: Govemment of the Philippines, Intemational Monetary Fund, World Bank staff estimates.  Section 1. Economic Developments and Issues: An Overview 3 percent in 1991 to 36 percent in 1994; the trend of other welfare indicators since 1994 suggests a further subsequent decline in poverty.' 4. The Domestic Economy. Exports and investment were the driving factors underlying the increasing growth rates during 1994-96. Output and export of electronics was particularly rapid-electronics exports now account for over half of merchandise exports, and have grown by 34 percent over the past three years. Indeed, boosted by substantial foreign direct investment (FDI) in industrial estates and economic zones primarily outside Metro Manila, the Philippines has emerged as a major center for chip assembly and testing. A further impetus for the higher growth rates witnessed through 1996 has come from construction and utilities, where some 25 private power plants have contributed to a major expansion of electricity provision. The financial services industry has also expanded rapidly, aided by the entry of 10 new foreign banks since 1995 with reduced restrictions on their operations. 5. By contrast, expansion within the manufacturing sector as a whole has been more subdued, with growth peaking in 1995 at 6.8 percent but slowing to 5.5 percent in 1996 and to 3.9 percent in the first half of 1997. Slower manufacturing growth in 1996 reflected low or negative growth among a number of traditional industries such as textiles, footwear, furniture and rubber, in which investment slowed and competitive pressures from lower wage economies appear to have increased. Finally, while agricultural production recovered sharply in 1996 following the previous year's drought, viewed from a longer-term perspective, agricultural performance has been weak, with growth averaging less than 2 percent in the 1990s. 6. In the first half of 1997, real GNP growth slowed to 5.9 percent, down from 7.5 percent during the same period in 1996. Real GDP growth in the first semester reached 5.3 percent, with the reduced differential between GDP and GNP growth reflecting decelerating factor income growth. Industrial production grew by 5.4 percent driven by 16 percent growth within construction. The services sector and agriculture grew by 6.3 and 3 percent, respectively. 7. Inflation was on a downward trend through mid-1997, averaging less than 5 percent in the first half of the year, aided by lower food prices and a stable nominal exchange rate against the dollar. Even prior to the shift toward greater exchange rate flexibility on July 11, 1997, inflation was forecast to increase slightly in the second half of the year, reflecting a projected pickup in food prices. The extent of increase in prices Government measures of poverty use a higher income cutoff level than in many other countries. For example, using a standardized definition of poverty across countries-households with per capita incomes below $1 a day in 1985 prices, at purchasing power parity (PPP) exchange rates-Ahuja et al. (1997) estimated poverty in the Philippines to have declined from 32.4 percent in 1985 to 25.5 percent in 1995.  4 Section 1. Economic Developments and Issues: An Overview will now also depend on the FIGURE 1: BALANCE OF PAYMENTS TRENDS degree of exchange rate External Balances depreciation and the speed 13 with which domestic prices subsequently adjust. The 6.5 government's original 0~ inflation targets for 1997- O of 6.5 percent (year-average) a ,- - . Current Account and 7.1 percent (year-end)- . - - -------------- were reinstated following -6.5 ~~~~~~~Trade Balance the exchange rate adjustment, after an initial -13- I II adjustmnt, after an initial 1990 1991 1992 1993 1994 1995 1996 1997 downward revision of these QI targets. Merchandise Trade 8. External Sector. On the external front, the trade 35000 deficit widened in 1996, but 30000 | the continued buoyancy of = 25000 .2 20000 remittances from overseas - workers-which grew to 10000- over $10 billion-held the 5000 current account deficit o-_ _ _ _ relatively stable at 4.5 1990 1991 1992 1993 1994 1995 1996 percent of GNP (Figure 1).2 Exports Imports - Electronics Exports In the first half of 1997, the trade deficit declined as export growth rose to 22 Foreign Investment Flows percent, more than double 8000 8000 the pace of import growth. 7000 7000 The current account deficit 5000 00 c 5000 -~~~~~~~~~~~~50 in the first half of 1997 was 6 4000 -4000 e 4000= hence reduced to 4.5 percent E 3000 Q" 3000 30 of GNP from 6.6 percent for 2000 2000 the samne period in 1996, 1000 --1000 notwithstanding a decelera- 0 14 o tion in the growth of 1990 1991 1992 1993 1994 1995 1996 remittances. The overall Portfolio-in Portfolio-out - DFI-net balance of payments 2 Difficulties in distinguishing remittances from peso conversions of foreign currency deposit units (FCDUs), and the latter from export receipts however add a measure of uncertainty to the current account figures.  Section 1. Economic Developments and Issues: An Overview 5 position through June, however, deteriorated sharply from a $2.4 billion surplus in 1996 to a $209 million deficit in 1997 primarily reflecting a reversal of portfolio flows (Annex Table 3). 9. Philippine export growth since 1995 has considerably outperformed that of neighboring market economies (starting however from a lower base), with electronics exports leading this expansion. Electronics exports grew by 35 percent in 1996, notwithstanding the regional slowdown within the sector. The export performance of manufacturing other than electronics has been less dynamic, however, with growth averaging 11 percent during 1994-96. This factor, the relatively high import content of electronics exports, and the heavy demand for transport and telecommunications imports have combined to widen the trade deficit in recent years. The share of consumer goods imports has risen in recent years but still comprised only 10 percent in 1996. Appreciation of the real effective exchange rate by about 38 percent between 1990 and mid-1997 also contributed to the widening trade deficit. 10. Foreign investment declined by about one third in 1996 as net inflows of FDI and portfolio investment both fell. While net portfolio flows turned slightly negative, both inflows and outflows of gross portfolio flows nearly doubled to over $8 billion each. As a result of rising portfolio flows-which have been primarily directed into and out of equities-foreign capital accounted for at least 60 percent of the turnover in the local stock market through mid-1997 and was a major factor in the fall in equity prices in 1997. Portfolio flows turned increasingly negative in early 1997 (Annex Table 3), as investor sentiment began to shift. 11. Notwithstanding the moderation of private investment net flows, the capital account surplus more than doubled to nearly $9 billion in 1996, permitting a significant accumulation of central bank (BSP) reserves, and reflecting large increases in both short- term and long-term borrowing which continued through the first quarter of 1997. Such borrowing appears to have been motivated by the lower cost of foreign currency loans and the expectation of a stable nominal exchange rate, and was facilitated by the Philippines improving creditworthiness (Figure 2). The largest item of increase within the capital account was a $4.2 billion rise in foreign borrowing and equity inflows of commercial banks. The foreign exchange liabilities of commercial banks have grown by significantly more than implied by this figure, once the increase in commercial banks liabilities from holding FCDUs are also included-as of June 1997, deposit liabilities from FCDUs amounted to $16.9 billion and FCDU loans and discounts totaled $12.2 billion. 12. Credit Expansion. This growth in banks' foreign exchange liabilities fueled a significant credit expansion that peaked in 1996: commercial bank loan growth averaged  6 Section 1. Economic Developments and Issues: An Overview 31 percent in 1993-95 and accelerated to 52 percent in 1996,3 before declining to 34 percent through July 1997. The acceleration of credit growth in 1996 occurred notwithstanding substantial sterilization of capital inflows by the BSP. It is worth noting that this rapid credit expansion started from a low base-even now, at 50 percent, the share of private credit to GNP in the Philippines is significantly lower than in neighboring market economies. Nevertheless, the pace of credit expansion has raised concerns about the ability of banks to maintain credit quality, particularly within segments of the commercial and luxury real estate markets where prices rose at an unsustainable pace through 1996 but have since stagnated or declined. FIGURE 2: FINANCIAL MARKET TRENDS Foreign Liabilities of Commercial Banks Stock Market Index (at end of period) 25 Mar 97 30 20 28 3000- 2400 10 24 , X ~ 0~~~~~~~~~~~~~~~20 5 -- '''''''..........22 2100 _ n - N | l l - 20 t800 I I I I I I I I I I' I - 1990 1991 1992 1993 1994 1995 1995 O) OL 0 0~~~~~~~~~ ------ Foreign UaLilaies of CBs ind. FCDUs (left) - Exchange Rate (right) 0 u. BSP Overnight Rate and Exchange Rate Money and Credit Growth 35T -36 60T 25 1 ""' ' - 32 , Private Sector = 20 j_ > ; e - 40 Credit 5-'''20 '''''''' -26 e 20 X / <\0 15 ~~~~~~~~~~~~~~~~" 30 28 M4 10 0 ::IIII.III 24 10 N ; s ) o N t t 4 I : I I II I I 1990 1991 1992 1993 1994 1995 1996 1997 BSP overmight rate ------ Exchange rate Q1 3 The acceleration of credit growth in 1996 also reflects the startup operations of 10 new foreign banks and the reclassification of the Philippine National Bank (PNB) as a commercial bank.  Section 1. Economic Developments and Issues: An Overview 7 FINANCIAL MARKET INSTABILITY IN 1997 13. In early 1997, financial markets began to exhibit increased anxiety over the Philippines' rising trade deficit, the pace of credit expansion, and the impact of a possible correction in property prices on banks and real estate developers. Thailand's intensifying economic and financial difficulties added to foreign investor concern toward the Philippines and other market economies in Southeast Asia. The impact of such concern was first felt in the stock market, which reached a record high in early February but declined by 40 percent (in peso terms) between January and mid-November, with bank and property stocks initially leading the decline. Since April, the flight from equities began to spill over into the foreign exchange market, and the BSP shifted from net purchaser to net seller of foreign exchange. After accumulating substantial reserves in past years to prevent nominal appreciation of the peso against the dollar, the BSP spent about $2.5 billion between April and July 10 defending the peso, with the bulk of this occurring after Thailand's shift to a managed float exchange rate system on July 2, after which the Philippine peso came under sustained pressure. The volume of turnover in both the equities and foreign exchange markets also increased significantly in the first half of 1997, with average daily turnover in the latter market exceeding $200 million and peaking at over $1 billion after the baht float. 14. The BSP's overnight borrowing rate was increasingly used to defend the currency-for example on July 2, the BSP's key overnight borrowing rate (the reverse repurchase rate) was raised from 15 to 24 percent, and further to 32 percent by July 10. On July 10, faced with sustained speculative attacks and declining reserves-gross reserves had declined to $9.7 billion-the BSP announced it would allow greater exchange rate flexibility by no longer intervening as actively in the foreign exchange market. The following day, the peso depreciated by 11.5 percent before trading was halted. The peso strengthened somewhat through most of July, permitting progressive reductions in the overnight interest rate, but came under renewed pressure subsequently and had depreciated by 29 percent between July 10 and mid-November. Increased pressures on other currencies and stock markets in the region contributed to the general malaise in investor sentiment. 15. An agreement with the International Monetary Fund (IMF) was approved on July 18 to extend the existing Extended Financing Facility to end-1997; coupled with an augmentation of this Arrangement, $1.05 billion was made available from the IMF, of which some $700 million was subsequently disbursed. Loans from the Japan EXIM Bank and private banks were also utilized to replenish central bank reserves. 16. In the context of the IMF program, the authorities decided to retain most of the principal economic targets for 1997 notwithstanding the increased financial instability. Hence, real GNP growth was targeted to remain at 7 to 8 percent and inflation to average 6 to 7 percent. (The growth target was subsequently adjusted to 5.5 to 6 percent). The target of a small national government (NG) surplus was retained, despite weaker-than-  8 Section 1. Economic Developments and Issues: An Overview expected revenue performance in the first half of 1997. A series of measures to reduce both current and capital spending have been implemented; on the revenue side, efforts to overcome delays in the tax payments system are being intensified, a number of fees and charges are being reviewed, and access to duty free stores has been reduced. And, indeed, through September 1997 the NG surplus reached about 5 billion pesos, exceeding the government's program for this period. The fiscal program for 1998, which again targets a small public sector surplus, assuming passage of an appropriate Comprehensive Tax Reform Package in 1997, or, if the revenue-enhancing features of the latter fall short, enactment of compensatory fiscal measures. Monetary policy is aimed at realizing the government's inflation and reserve targets, thereby containing pressures in the foreign exchange market and implying a tight program of base money expansion. 17. In the aftermath of the exchange rate shift, pressure against the peso did not subside, however, prompting several measures to tighten domestic liquidity, strengthen prudential requirements, and discourage further speculation: interest-bearing (liquidity) reserve requirements were raised progressively-to a high of 8 percent before subsequently being lowered,4 over-the-counter foreign exchange availability from banks was reduced from $100,000 to $25,000; previous limits on banks' foreign exchange positions were tightened as a proportion of unimpaired capital-the permissible oversold position was reduced from 10 percent to the smaller of 5 percent or $10 million (the overbought position had earlier been lowered from 20 to 10 percent)-and monitoring of banks' forward foreign exchange positions was tightened; and access to the BSP's overnight lending window was closed between mid-August and early October. And for two weeks between late July and mid-August, six major foreign banks were requested not to participate in the spot foreign exchange market, and required instead to buy foreign exchange through forward contracts of up to 90 days. The volume of trading in the official foreign exchange market diminished significantly following the regime shift on July 11, and a parallel foreign exchange market also emerged (though with only a small premium of 1 to 2 percent over the official rate). By September, turnover volume had returned to earlier levels. 18. With the peso falling to new lows in early October, BSP intervention increased, and on October 7 the Bankers' Association of the Philippines (BAP) introduced a volatility band for the peso, which consists of a series of intermediate circuit breakers and limits overall daily volatility to 4 percent, after which trading is suspended for the day. 19. Tightened liquidity and higher short-term interest rates in response to continued selling pressure on the peso soon spilled over into longer-term maturities, raising interest 4 Liquidity reserve requirements were raised from 2 to 3 percent on July 31; to 5 percent on August 15; and 8 percent on August 29. They were subsequently lowered in stages to 5 percent by October 15 and are scheduled to be reduced to 4 percent on November 15. In addition, the statuary (noninterest- bearing) reserve requirement of 13 percent has been maintained throughout this period.  Section 1. Economic Developments and Issues: An Overview 9 costs on government and corporate paper as well as commercial bank lending rates. During September-October, the benchmark 91-day Treasury bill rate averaged 15 to 16 percent and peaked in early October at 20 percent, compared to a low of under 10 percent in April. Prime lending rates at banks peaked at 30 to 35 percent and have averaged between 25 and 30 percent more recently. Interbank rates have been particularly susceptible to credit conditions, with average rates peaking in early October at over 100 percent, although for a short period and followed by swift reduction. Box 1: LESSONS FROM THE THAI CRISIS The unfolding Thai economic and financial crisis provides ample insight for emerging market economies including the Philippines. Over the past decade, Thailand recorded among the highest economic growth, investment and saving rates in the world, maintained inflation at close to OECD levels, consistently ran fiscal surpluses prior to 1997, and witnessed a prolonged export boom prior to 1996. Large current account deficits in the 1990s were readily financed by bank borrowing, permitting substantial reserve accumulation through 1996, when gross reserves amounted to more than 6 months of imports. The practically fixed exchange rate against the dollar, coupled with higher domestic borrowing costs provided a powerful incentive for borrowing abroad to finance domestic investment. Thailand's strong creditworthiness ratings rendered foreign banks eager to supply such credit, although in recent years the nature of external financing had begun to shift-toward short-term loans and away from FDI. The easy availability of foreign credit fueled a credit boom, which in turn was increasingly channeled into consumption and the real estate sector, generating a boom in construction as well as property prices. When market sentiment began to shift in 1996 and the first half of 1997, the Thai authorities initially resisted allowing the currency to depreciate, primarily out of concern over the impact on the financial system's heavy exposure to foreign exchange liabilities. Defending the exchange rate following the shift in sentiment required substantial use of reserves, a prolonged period of increased interest rates, and capital controls. Nevertheless, the authorities ultimately were forced to shift to a managed float exchange regime on July 2, 1997. In the meantime, the extended period of high interest rates and slowing economic activity had further weakened the financial system and adversely affected international creditworthiness, exacerbating the costs of the economic adjustment that followed the shift in exchange rate regime. With the benefit of hindsight, the costs to the economy and financial system would have been less significant had Thailand permitted greater flexibility in the exchange rate with less delay, once it was clear that investor sentiment had fundamentally shifted. Another lesson from the Thai crisis is that prudent fiscal policy does not suffice to ensure stability; the size -of the current account deficit and the nature of its financing matter, even if these are entirely driven by private agents. And indeed private agents generally respond to economic signals-including the perception of official policy favoring a stable exchange rate. Finally, lapses in supervision of the financial system can be extremely costly to the economy; as a corollary, efforts to upgrade the regulatory and supervisory infrastructure for the financial system can be a sound investment that can generate substantial payoffs in terms of forgone costs.  10 Section 2. Policy Implications and Priorities 2. POLICY IMPLICATIONS AND PRIORITIES 20. Developments in recent years and months have illustrated well the benefits as well as risks of rapid global integration. The Philippine export sector has boomed aided by increased FDI, contributing to higher growth and employment, improving foreign debt servicing capacity, and upgrading the average technological content of exports. At the same time, the increased availability of private capital contributed to a credit and property boom through 1996. The sudden shift in foreign investor sentiment, exacerbated by the intensifying Thai crisis, has demonstrated the risks inherent in the increased volume and volatility of capital flows and their impact on macroeconomic variables and the banking system. 21. The following sections discuss appropriate policy responses to rapid global integration in the areas of: (a) macroeconomic and financial policies; (b) structural reform to enhance competitiveness; and (c) strategic and institutional issues in the development of manufactured exports, including the evolving role of special economic zones. MACROECONOMIC AND FINANCIAL POLICIES 22. The Philippine authorities' rapid response to shifting investor sentiment by adjusting exchange rate policy and tightening fiscal and monetary policies in the context of an IMF program is to be welcomed. Moreover, during the year prior to the shift in exchange rate stance, a series of measures to address concerns about banks' vulnerability to real estate exposure, credit expansion, and foreign exchange risk were taken. A survey of banks' exposure to real estate was commissioned in 1996 that indicated a relatively modest exposure of 11 percent of the loan portfolio for the banking system as a whole- lower than in neighboring countries,5 notwithstanding particularly rapid expansion of credit within the category that includes real estate.6 Nonetheless, in April 1997, the BSP adopted two measures to tighten regulations on real estate lending by banks: it lowered the ceiling on an individual bank's exposure to real estate from 30 to 20 percent of loan portfolio, giving banks one year to comply; and it lowered the permissible ceiling on the loan-to-value ratio for real estate lending from 70 to 60 percent of the market value of the property. Increases in minimum capital requirements for banks became effective as of January 1997. And in June 1997, banks were required to maintain a 30 percent foreign exchange liquidity requirement effective as of December 1997 (subsequently reduced to 5 Data as of March 1997 indicated an exposure of 11.6 percent; and 12.6 percent including banks' trust units. These figures may be underestimated to the extent that loans to manufacturing companies for property-related activities are excluded. 6 Available data classify real estate exposure together with credit to financial institutions and business services (Annex Table 11). Commercial bank credit within this category expanded by 97 percent in 1996, but slowed to 70 percent through September 1997.  Section 2. Policy Implications and Priorities 11 15 percent for an interim period) on their FCDU holdings, in order to improve the maturity profile of banks' foreign currency asset structure. 23. In light of recent market turbulence, the criteria for classifying nonperforming loans have been tightened, and a special 2 percent loan loss provision (staggered over three years) has been applied to all banks. These measures, coupled with tighter monetary policy and the maintenance of a flexible exchange rate, should have a major dampening impact on credit growth. Financial Market Instability: Consequences and Implications 24. In assessing the consequences of recent instability, it is useful to distinguish between the short and medium term. Over the medium term, there are likely to be a number of beneficial effects. Greater exchange rate flexibility is expected to strengthen the effectiveness of monetary policy. It should also curb the use of foreign borrowing and speculative portfolio flows that were induced by large interest rate differentials and the implicit assumption of a stable nominal exchange rate. Banks and corporations will also have greater incentive to adequately hedge their exposed foreign exchange positions if they continue to expect exchange rate flexibility (thereby promoting the development of more sophisticated hedging instruments). These factors indicate that a greater proportion of future foreign capital inflows can be expected to be driven by longer-term investment and foreign exchange-generating objectives rather than speculative activity-though initially this is expected to result in a reduced level of net capital inflow and hence the need to reduce the current account deficit. 25. Sustaining a significant real exchange rate depreciation from recent nominal exchange rate movements-which implies the need to avoid a major wage-price spiral- would provide a boost to traditional exports, redirect investment toward tradable goods, and help to contain external deficits. Pressure on government to slow or reverse the pace of trade liberalization should also be easier to resist. 26. There will nevertheless be significant costs in the short term. As discussed in Section 3, growth in the year beginning in the third quarter of 1997 is expected to be reduced; ancd the period before which growth resumes at robust levels could be protracted- vith regional linkages adding to the uncertainties. Public finances are likely to be adve sely affected on balance as reduced revenue from slower growth and lower public and k -ivate corporate profits and higher debt service costs can be expected to dominate over increased import tariff revenue resulting from depreciation. Higher import costs will cut profit margins and force some increase in domestic prices. The pass- through of higher overnight interest rates into longer-term rates will tend to delay investment plans and pressure asset prices, particularly for that portion of the real estate market where prices had previously been rising rapidly. Finally, corporations will be adversely affected by tighter credit conditions and will incur additional debt servicing  12 Section 2. Policy Implications and Priorities costs (in both foreign currency and pesos), while spreads for external borrowing can be expected to rise. 27. These costs are exacerbated by factors that add to the risks faced in the current environment and complicate the implications for policy. The risks are heightened by the heavy reliance on private capital flows (para. 2) and the scope for currency substitution facilitated by the FCDU system. Meanwhile, the demand for foreign currency would rise if the corporate sector expects further depreciation and hence attempts to prepay its external debt servicing obligations or to more adequately hedge against its foreign liabilities. These factors indicate the need for a rapid resumption of investor confidence. 28. Yet gaining such confidence is hampered by external factors. The flow of bad news from elsewhere in the region has had a negative influence, and could continue at unpredictable intervals. And the upcoming elections in May 1998, which even under normal circumstances would have added an element of uncertainty for investors, could now become a more serious cause of delay of private investment plans. Short-Term Macroeconomic Policy 29. Short-term macroeconomic management will continue to involve difficult tradeoffs. In particular, a tight monetary stance is called for as long as demand for domestic assets remains weak and selling pressure on the peso remains significant. Yet the authorities cannot ignore the impact of tighter credit conditions and higher interest rates on the real economy and corporate balance sheets. Over the medium term, an interest rate structure that causes intensifying corporate distress is not viable, particularly when the costs to the banking system are factored in. But at the same time, relaxing the monetary policy stance before speculative pressure on the peso has eased would not be helpful to generate confidence and would prolong the adjustment period. 30. Thus far, the authorities appear to have struck the appropriate balance in the difficult new environment, and indeed relative to other impacted countries have coped favorably. Nevertheless, there may be opportunities for improving policy effectiveness. For example, the frequent adjustment of liquidity reserve requirements in recent months as a tool for controlling liquidity, while perhaps effective in its primary objective, impacts banks unevenly depending on their liquidity positions. Yet the alternative of greater use of BSP open market operations to influence liquidity is constrained by the recent ruling (effective from 1997) that taxes bank repurchase agreements of longer than five days maturity. To improve the effectiveness and reduce the cost of open market operations, taxation of repurchase agreements therefore needs to be reconsidered. 31. To strengthen the basis for conducting monetary policy, more precise information on the profile of foreign debt service requirements of the private sector in the short term would be helpful to gauge pressure on the exchange rate from this source. Similarly, identifying corporations that are particularly vulnerable to high interest rates and their  Section 2. Policy Implications and Priorities 13 primary creditors could provide the authorities with advance information of impending problems in the corporate/banking sectors. 32. As market conditions settle, the trend of deposits and credit extended through FCDUs-which until recently had been rising as shares of domestic intermediation-will need to be evaluated in light of recent policy adjustments relating to liquidity requirements and the exchange rate, and the possibility of a withholding tax on resident FCDU deposit holders as contained in the prospective tax reform bill. In conducting such an evaluation, it should be noted that the share of FCDUs in total monetary liabilities (M4) is relatively high in the Philippines, at about 30 percent as of end-1996 with an increase likely post-depreciation, and regulations on the use of such accounts by both residents and nonresidents remain relatively liberal. Particularly if FCDU intermediation is still rising in relative terms-i.e., as a proportion of M4 or total credit, additional measures to level the playing field between foreign currency and peso intermediation would need to be considered, although the current period is unlikely to be the optimal time to introduce such measures. 33. In view of risks and regional dimensions of the financial market turbulence discussed, monetary policy is unlikely on its own to generate a full return of investor confidence. In particular, with the loss of exchange rate stability as a source of credibility, the perception that structural reforms continue to be pursued can be helpful to bolster credibility. Experience during past episodes of instability indicates that countries that resist short-term palliatives and focus on the fundamentals of sound macroeconomic policy and structural reform experience less output loss over the medium-term. To the extent that the structural reform agenda can be accelerated, this would add to investor confidence and may therefore ease the difficult short-term tradeoffs that the economy will have to endure. The following paragraphs stress measures that would be supportive to the conduct of monetary policy in the short term; the focus of the remainder of Section 2 is on the structural reform agenda, including issues in fiscal policy, banking, enhancing competitiveness, and strengthening the framework for manufactured export development. 34. Timely passage of the comprehensive tax reform package (CTRP) would serve to enhance confidence if it is clearly evident to be revenue-enhancing. By cbntrast, if the final bill that emerges indicates negative or insignificant revenue impact, investor reaction to its passage could be indifferent. In the short run, further expenditure cuts may be required to adhere to the government's fiscal program. If further cuts in investment are required, projects of low economic priority should be canceled or delayed rather than administering across-the-board expenditure cuts. And programs that are effective for poverty alleviation need to be protected. 35. The movement of the exchange rate has naturally generated pressures to adjust wages. Yet substantial wage adjustment at this stage would: undermine the beneficial impact of depreciation on competitiveness-which has been adversely impacted by the  14 Section 2. Policy Implications and Priorities nearly 40 percent real exchange rate appreciation in the 1990s prior to July 1997; exacerbate the distress already being faced by corporations from recent movements of interest and exchange rates; and increase investor concerns about the likelihood of initiating a serious wage-price spiral with negative inflationary consequences. These concerns need to be communicated during the wage bargaining process. 36. Finally, it should be noted that pressures for special treatment from the adverse impact of exchange rate depreciation can be expected from various categories of importers. These pressures need to be resisted since they can adversely impact the fiscal or quasi-fiscal position, can lead to price distortions, and are inequitable-since all importers cannot by definition be given such preferential access. Fiscal Policy 37. Restrained fiscal policy has been one of the cornerstones of the recent economic recovery as the consolidated public sector financial position has steadily improved since 1992 and was in approximate balance in 1995-96-helping to reduce the Philippines' still high public debt burden, lengthen the maturity structure of government debt, and reduce public sector interest costs. In view of the pressures on fiscal policy arising from slower growth and corporate profits, the government's intention to proceed with a program to further strengthen public finances and raise public saving is well conceived, and the adjustment of expenditures to the lower-than-programmed revenue performance through mid-1997 is appropriate. 38. Yet there is no room for complacency. Particularly in the coming political year, it will be essential to demonstrate that the authorities are able to promptly calibrate fiscal policy adjustments to changing circumstances. But the ability to adjust fiscal expenditure remains constrained by its relative inflexibility-in 1996, over two thirds of National Government (NG) expenditures were still accounted for by personnel, interest payments, and local government unit (LGU) allotrnents-and has been hindered by the rising share of NG personnel expenditures, which have risen by nearly 1.5 percent of GNP since 1993. The latter reflects adjustments to civil service salaries that have been applied progressively but have not yet addressed the problem of noncompetitive salaries for senior executives. Hence, when public expenditure needs to be adjusted, as currently, the burden of adjustment tends to fall unduly on maintenance and investment. 39. At 4.5 percent of GNP, however, public investment in 1996 had already fallen to its lowest level in the 1990s, and it is also low in comparison to neighboring countries. There are a number of mitigating factors in the Philippines, including the relatively high share of private investment in health and education and the relatively advanced policy framework for private investment in infrastructure. But the backlog of public investment is large within infrastructure, as is the need to strengthen the social safety net.  Section 2. Policy Implications and Priorities 15 40. Regarding revenues, import tariffs are expected to generate declining revenue in real terms, reflecting the tariff reduction program envisioned through 2004. This also implies that the share of NG revenue allotted to LGUs-which are linked to internal revenue-is likely to increase. Revenue from privatization peaked in 1994-95 and has diminished significantly since then. And the scope for raising corporate tax rates will become more limited, as the importance of maintaining parity with competitor countries increases with global integration. Finally while tax revenue has increased steadily in real terms, and at 16 percent of GNP in 1996, compared favorably with neighboring countries, public saving in the Philippines of 4.5 percent remains low relative to these same countries. 41. Several adjustments will therefore be needed over the medium term in order to maintain a tight fiscal stance, improve the flexibility of government expenditures, and raise public saving in a sustainable manner. On the latter, passage of the administration's original proposals for tax reform represents the most appropriate vehicle for raising revenue without unduly raising tax rates-through broadening the tax base, ensuring that corporations pay a minimum level of tax, while at the same time strengthening incentives for investment. Parallel efforts to improve tax administration, reduce tax evasion, and strengthen the incentives for revenue collection at the local government level will also be needed. 42. On the expenditure side, to allow for increases in public investment while maintaining an appropriate fiscal stance, the recent increase in civil service personnel costs will need to be arrested and ultimately reversed. Moreover, the evolving public sector role from provider of services to facilitator and regulator of private activity requires adjusting compensation at the senior and executive levels to enable selected public agencies to attract and retain high-caliber staff. Hence, a complementary streamlining of public agency roles will be needed to reverse the recent increase in government personnel costs. 43. Finally, as discussed in the section on structural reform and competitiveness below, the urgency for restructuring and privatization of the National Power Corporation (NPC) has increased, with the fiscal costs of delaying such reform likely to grow in light of the recent exchange rate depreciation. Strengthening the Banking System 44. Recent developments highlight the need to ensure that the banking system can adequately cope with the increased volume and volatility of capital flows it is required to intermediate, and the resulting volatility in interest and exchange rates that this implies. The more resilient the banking system to such volatility, the less constrained and more effective can macroeconomic policy be in guiding a return to stability. The frequency and cost of bank solvency problems across both developing and developed countries over the past decade makes the rationale for strengthening clear. For an open economy such as the  16 Section 2. Policy Implications and Priorities Philippines, the presumption has to be that regulations governing bank behavior need to be more stringent than in OECD economies since the volume of foreign capital flows is relatively large in relation to domestic capital markets,7 the volatility of financial variables tends to be more substantial, and the opportunities for diversification may be more limited. 45. The quality of bank supervision and the legal framework in the Philippines compare favorably with many developing countries, including within the region, and commercial bank profits have risen rapidly in recent years, including through the third quarter of 1997. Efforts to strengthen supervisory and regulatory skills to cope with emerging risk areas (for example, in the area of derivatives) have also intensified. 46. These efforts need to be supported and strengthened, particularly through supervision of commercial banks on a consolidated basis given the rapid growth in off- balance sheet activity, and increased attention to the quality of bank management and risk management systems that are in place within banks. Moreover, the credibility of supervision will have to be reinforced by enhancing supervisors' ability to examine banks as and when needed and to take appropriate actions against excessive risk taking. Hence, the legal position of the BSP to close banks needs to be strengthened, and supervisors need to be insulated from legal challenges by those who they regulate. Such actions would reduce moral hazard and generate the appropriate incentives among bank managers and owners. 47. Another priority is to improve transparency so that the market is better able to discipline those banks taking excessive risk. Clearly this already occurs in the Philippines, as evidenced by the sharper-than-average downturn in bank stock prices during 1997. Yet it is important for market participants to have access to as much accurate information as feasible that would allow for more discriminatory assessments across banks. Minimum disclosure standards should therefore include ample information on income, expense and loss recognition practices, asset quality, and concentration. Extending disclosure of pertinent information on brokerage firms would also enhance transparency. 48. Coupled with efforts to strengthen supervision and market discipline, the ownership structure of banks, particularly those that are closely held, could be broadened by requiring more capital to be raised by the market. The government could also promote stronger representation of outside shareholders on bank boards, including for small and medium-size banks. 7 Deepening the domestic capital markets is clearly an important objective. But even in the medium term, foreign capital flows are likely to comprise a large share of the total.  Section 2. Policy Implications and Priorities 17 49. The recent increase in minimum capital adequacy requirements to 10 percent (for both total and tier 1 capital) places the Philippines at the high end relative to other East Asian countries (although the requirement is 12 percent in Singapore). This should now be complemented by reinforcing efforts to incorporate a risk-weighting scheme into the definition of capital adequacy, inclusive of accounting for off-balance sheet risks, as called for under a bill to amend the General Banking Act submitted to Congress. 50. In summary, improving the incentive and ability of supervisors, the market and owners to monitor and support prudent banking will require an ongoing investment that should be of high priority to the government. Similar efforts have been taken or are under way in a number of OECD and developing countries. STRUCTURAL REFORM AND COMPETITIVENESS 51. Notwithstanding the recent regional instability, the trend of increasing FDI globally is expected to continue in the medium term. Declining transport and communication costs and falling trade barriers are leading to increasing specialization and expanding trade, encouraging multinational corporations (MNCs) to organize their production on a global basis through international production and subcontracting relationships. East Asia has been at the cutting edge of this change. MNCs have invested heavily in the region, relocating component manufacturing and assembly operations to take advantage of lower labor costs, strong work ethics, and liberal trade regimes. 52. Countries that display strong macroeconomic management and stability, credible trade and investment liberalization, high-quality infrastructure, improved governance and greater private sector participation will stand to benefit from the globalization trend of FDI. Structural reforms over the past decade in the Philippines have already improved economic efficiency, rendering the Philippines among the more deregulated economies in the region and making it an increasingly attractive location for FDI. Over the past year, deregulation of prices and entry into the downstream oil sector, and transfer to private management of Metro Manila's water supply system have enhanced the competitive environment and prospects for investment in these two important sectors.8 Furthermore, a major factor attracting FDI into the Philippines is the presence of a large pool of high- quality English-speaking workers-business surveys consistently rank the Philippines high in terms of the quality and availability of both its unskilled labor and its managers and technicians. 8 Recent Supreme Court rulings freezing oil prices for a month and then rendering the oil deregulation bill unconstitutional need to be addressed as soon as possible (as is the government's intention) to minimize damage to investor confidence, to reestablish the deregulation objectives of increased competition and investment, and to protect the government's fiscal targets.  18 Section 2. Policy Implications and Priorities 53. The Philippines has moved rapidly on tariff reforms in recent years and has announced its intention to move to a uniform tariff rate of 5 percent by 2004 for nonagricultural commodities.9 Further compression of the tariff structure will provide additional impetus to improvements in economy-wide efficiency and greater encouragement for domestic producers to move into export markets, as well as develop subcontracting arrangements with exporters who are operating on a duty-free basis in the economic zones. The government's trade reform goals involve deeper tariff reductions than required by its international commitments under WTO or APEC. This means that the ultimate pace and depth of tariff reductions will reflect the resolution with which it implements its own policy plans. Reform Priorities 54. Against this background of encouraging progress, it is important to maintain the momentum of structural reform, to strengthen competitiveness but also to signal to investors that regional instability will not derail the reform process. To the extent that planned reforms can be accelerated, the credibility of such signaling will be enhanced. Three areas that still constrain international competitiveness and are briefly noted here relate to agricultural trade protection, the labor market and education policy implications, and electricity prices."0 55. Agricultural Protection. Import protection provided to most agricultural commodities has increased since 1996-in the context of shifting from quantitative restrictions to tariffs for agricultural commodities, protection for most affected products increased, with tariffs of 100 percent prevailing for many key commodities. As a consequence, input costs for the food processing industries, which have substantial potential for expansion in the Philippines, have risen. Relatively high food prices also constrain the attainment of more competitive wages for unskilled labor referred to below. Finally, as tariff reductions for the nonagricultural sector proceed at a faster pace, relative distortions in the tariff structure could rise in the interim. 56. Agricultural tariffs are scheduled to be reduced to the 40 to 60 percent range by the year 2000 and to a range of 20 to 40 percent by 2004. But the targeted protection rate by 2000 still represents an increase over implicit or explicit protection provided most commodities prior to 1996, and the credibility associated with these reductions is less than for the nonagricultural sector. Accelerating the pace of tariff reduction to at least reach pre-1996 protection levels sooner would therefore represent an important first step. 9 Official data indicate that the average nominal tariff rate (MFN) was reduced to 15.5 percent in 1996, and is expected to be reduced to 13.4 percent in 1997 and to 9 percent by 2000. Note, these figures can vary depending on the weights used. 10 Recent World Bank reports discuss these in more detail.  Section 2. Policy Implications and Priorities 19 Subsequent tariff reductions should be complemented by the appropriate design and implementation of transitional social assistance to poor farmers/laborers adversely affected by lower protection. 57. Labor Market and Education Policy. Regarding the labor market, wages and salaries in the Philippines are high in relation to per capita income: for example, remuneration levels are close to those prevailing in Thailand, where per capita income is more than double the level of the Philippines, and are significantly above those in Indonesia, which has a similar per capita income."' Since overall compensation in real peso terms has been relatively stagnant in the 1990s, the nearly 40 percent real exchange rate appreciation between 1990 and mid-1997 must bear much of the responsibility for the increased remuneration, measured in foreign currency terms. This in tum may have contributed to the relative stagnation of traditional manufacturing industries such as garments and footwear in recent years, a trend that appears premature when viewed against the Philippines' large pool of surplus labor and rapidly growing labor force relative to major competitors. Moreover, while unit labor costs have declined in recent years, this is primarily the result of the declining compensation, since labor productivity has been relatively stagnant in the 1990s, particularly in comparison with neighboring economies.12 58. The recent exchange rate depreciation, if largely sustained in real terms, should benefit employment generation in manufacturing industries. Yet over the longer term, enhancing labor productivity at a faster pace will remain vital. Perhaps the most important policy area in this regard is to improve the quality of basic education in order to maintain and hopefully enhance the relatively strong reputation that the Philippines already enjoys regarding labor quality. One priority in this area should be to lower the age for access to public education from seven to six. This should have the effect of ratcheting up quality through the school system. If resources are constrained, shifting funds from the plethora of publicly supported nontechnical colleges across the country would represent a better use of public funds. Some specific suggestions on skills and technology enhancement are provided in the discussion below on manufactured export development. 59. Electricity Prices. High electricity costs in the Philippines-which have been the highest in East Asia after Japan-reflect several factors: the relatively expensive supply of privately generated power negotiated in the midst of the power crisis of the early 1990s; the weak financial position of the National Power Corporation (NPC), whose liabilities are large and almost entirely in foreign currency; relatively high leakages within the distribution system; the country's unique geography of some 7,000 islands; and geographic cross-subsidization particularly from Luzon to the more remote islands. 11 Using 1996 data on remuneration and per capita incomes. 12 The data for more recent years, however, indicate an improving productivity trend.  20 Section 2. Policy Implications and Priorities 60. In recognition of these constraints and deficiencies, a significant adjustment program to restructure NPC and privatize the bulk of its power generation capacity has been initiated. But the enabling legislation for this program (the Omnibus Bill) has languished in Congress and needs to be enacted. The government has rightly resisted relieving NPC of its financial burden until a major restructuring can be completed. However, in the context of implementing a satisfactory program for restructuring and privatization that addresses existing incentive problems, the government may wish to transfer a portion of NPC's financial burden to the tax payer in the interest of enhancing competitiveness. Similarly, if particular geographic areas need to be subsidized for social reasons, this too should be financed from general tax revenue rather than taxing other electricity users. ISSUES IN MANUFACTURED EXPORT DEVELOPMENT 61. The Philippines' export performance has improved greatly in the 1990s. World market shares for all exports rose from 0.25 to 0.38 percent during 1990-95, and for manufactures from 0.14 to 0.39 percent. Electronics exports grew at 37 percent a year during 1991-96, and now account for 60 percent of manufactured exports. Machinery and transport equipment also grew rapidly (24.5 percent), becoming the third largest manufactured export. Garments, the largest traditional consumer export, grew at only 5.8 percent, and fell in 1996; other consumer exports also rose slowly. There were thus significant changes in the export structure: "industrial manufactures," largely nontraditional and complex items raised their share by 22 percentage points of the total. 62. A comparison of export patterns shows that the Philippines has a relatively advanced structure in terms of the technological complexity of its products. However, the absolute values involved are small; its high-tech exports are around 15 percent of Korea and Taiwan (China), 20 percent of Malaysia and 42 percent of Thailand. This reflects the large gap that opened up during the period of relative export stagnation; it also suggests that such exports may be able to grow rapidly. This is supported by the analysis of its market "positioning," which shows that many manufactured exports are expanding their world market shares in dynamic products in world trade. The engine of its export growth are the world's leading MNCs in electronics, most of whom are planning substantial increases in production capacity in the Philippines. 63. However, there is need for caution. Stagnation in simpler exports is undesirable and premature, since the Philippines remains a labor-surplus economy with more rapid labor force growth than most neighbors. These exports retain considerable potential for export growth; they are particularly important for the small and medium enterprise (SME) sector; and they offer strong externalities and "cluster" benefits. Their export slowdown, in concert with weakening growth in traditional industries at home, may indicate an undue weakening of the competitive base. The high level of product concentration on (and within) electronics is inherently risky; their export growth has been due primarily to  Section 2. Policy Implications and Priorities 21 low-end assembly activity, which can be a secure base for long-term growth only if local value-added and technological levels are raised. The export-oriented sector has relatively shallow roots in the domestic economy, and its long-term growth requires a strengthening of these roots. This conclusion merits greater attention in view of the recent sharp slowdown of export growth in neighboring countries-in particular, Thailand and Malaysia-and the less-than-full understanding of the causes and suddenness of these slowdowns. 64. In garments, the Philippines has done poorly for some time in relation to many Asian exporters. The reasons do not lie only in cheaper labor elsewhere, since even countries with higher wages have displayed faster growth. However, the Philippines' edge does not lie in cheap labor; it cannot compete with South Asia, China or Vietnam in low-quality, standardized products. It can compete in products where skills, technology, specialization, design, marketing and flexibility are important competitive factors. But investments and FDI in the industry have fallen behind those in other industries. Worker productivity and delivery times by Philippine exporters are variable and design capabilities are growing but remain weak. Philippine garments fetch lower unit prices than those of major competitors including lower-wage economies such as China, India, and Indonesia. The Philippine industry suffers from a lack of integration with the upstream local textile industry, which suffers several weaknesses and may handicap garment competitiveness. 65. In electronics, exports are dominated by semiconductors (77 percent of the total in 1995). The Philippines maintained high export growth in 1996, when neighboring countries suffered large declines, because of different product compositions (CPUs suffered less than DRAM chips), the coming onstream of new facilities and the existence of supply contracts of over one year. The main competitive edge lies in relatively low- cost, skilled and English-speaking work force, with good infrastructure for exports. The weaknesses of the industry arise from the high concentration on semiconductors, the low technological level of local manufacturing activity, and low local value added. The high level of concentration can be an advantage as long as semiconductors are growing in demand and new manufacturing technologies continue to be transferred, but not otherwise. The continued transfer of process technologies depends on growing local capabilities, and progress has been slow compared to Malaysia and the newly industrialized economies (NIEs). 66. Much electronics activity remains at the lowest assembly and testing level; more demanding technological functions or downstream products are not being shifted sufficiently to the Philippines. Semiconductor technologies are subject to rapid change, and without a flexible and advanced base to cope with new products and processes, competitiveness remains uncertain: there remains the risk that new technologies will be exploited in competing locations with more advanced production, design and supply capabilities. Low local value-added levels (20 percent in semiconductors), much below  22 Section 2. Policy Implications and Priorities average levels in Malaysia (45 percent) and Taiwan, China (75 percent), and its stagnation over the past two decades, suggest that local supplier capabilities are not improving despite growing demand from assemblers, and that specific measures are required to help firms, in particular SMEs, to raise their skills and technology levels. 67. The main supply-side determinants of competitiveness are FDI, domestic industrial policies, skills, technology and the institutional framework for export strategy. The driving force behind recent export growth has been FDI. While the environment for FDI has improved greatly, the economy is still underperforming relative to its potential. Inflows into the manufacturing sector are narrowly concentrated in activities that generate exports at relatively low levels of local integration and technological complexity. The FDI promotion system lags behind regional best practice. Incentives are not sufficiently geared to performance; there is a proliferation of incentives and agencies offering them, leading to duplication. There is a need to rationalize and consolidate the promotion and incentive systems, establish clear responsibility for FDI promotion for the country as a whole, and remove duplication and possibilities of rent-seeking. The main promotion agency, the Board of Investments (BOI), needs to be improved: it does not devote sufficient resources to promotion, its strategy tends to be unfocused, and lacks the capabilities needed for targeted FDI attraction. 68. The Department of Trade and Industry has recently launched several measures addressing these weaknesses. Their effective implementation will depend on the government's ability to support promising export activities flexibly without distorting resource allocation, which in turn requires a strengthening of evaluation, monitoring and follow-up capabilities coupled with mechanisms to ensure effective governance. 69. The industrial structure remains highly concentrated and segmented, not the most conducive for competitive new activities and enterprises. While policies are being reformed, there still seem to be gaps in the competition regime and in its enforcement. Industry associations lag behind many regional counterparts in supporting members to enhance competitiveness. SMEs face particular hurdles in accessing finance, information, technology and skills. The SME support system is inadequate, and holds back their growth as direct and indirect exporters. One reason for low local-content levels is the low levels of efficiency; the NIE experience suggests that strong, well-staffed and proactive government and cooperative measures are needed to overcome this."3 70. In skills, literate and plentiful manpower is the Philippines' most valuable resource. However, substantial improvements are needed to the education and training system. In schooling, quality, relevance, access and completion rates need to be raised, and the length of schooling brought into line with international norms. The variation in 13 But further analysis on institutional capacity in the Philippines is needed before concluding what lessons from NIE experience are relevant.  Section 2. Policy Implications and Priorities 23 the quality of higher education institutions has to be reduced; a broad improvement of teaching standards and equipment is needed for the high level technical and management skills that competitiveness requires. The technical training system needs greater funding and must orient its curricula to employer needs; the specific skills needed by traditional industries (garments) as well as new ones (electronics) have to be better met. Employee training by firms is undertaken mainly by large firms, but smaller firms invest little in upgrading skills of workers. There are no studies of how much training is being provided and by whom; without this, appropriate policies cannot be mounted. 71. The technology support system has the necessary elements but lacks implementation and coherence. There is no systematic analysis of the technological needs of the country and how to achieve them. The private sector does little technology development, and there is little policy effort to stimulate technological activity in industry. There is a need for a "technology foresight" exercise involving industry, technology institutions and academia in evaluating technological needs. The technology infrastructure does not provide effective support to industry. Its salary structures and management are not conducive to actively seeking out and helping enterprises with technical problems and upgrading. There is too much attention to routine testing and laboratory services (which could be in the private sector) and not enough on "public goods" like basic or (subsidized) contract research, information collection and dissemination, and extension services to SMEs. The large number of institutions need to be rationalized, better structured and funded. A thorough analysis of the functions, structure and management of the Department of Science and Technology (DOST) seems to be needed, with measures to link it more tightly to industry. There is a need for consultancy and productivity-raising measures for industry, using benchmarking techniques and drawing upon the experience of economies like Taiwan that cater to large numbers of export-oriented SMEs. 72. The institutional framework for export development seems well-designed, but its effectiveness needs analysis. The Export Development Council (EDC) is weak in collecting information on competitive export performance and in SWOT14 analysis of major export products. There is currently little comparative assessment of the current or emerging competitiveness of Philippine exporters in technological, quality, design or cost terms. The analytical framework for carrying out competitiveness studies can be strengthened. It is not clear how effective the EDC has been in identifying and, more importantly, remedying constraints facing exporters, or how its sanction powers against poor performers are used. In theory, the private sector and various govermnent departments participate in its policy analysis and implementation, but their actual role and commitment should be evaluated. The EDC could play a vital role in promoting competitiveness-if properly equipped with the skills, resources and authority needed to 14 Strengths, weaknesses, opportunities and threats.  24 Section 2. Policy Implications and Priorities develop, coordinate and implement strategies across the agencies and departments involved. Since the institution is in its formative stages, it is recommended that its structure and effectiveness be thoroughly evaluated and the necessary steps taken to strengthen its capabilities. Special Economic Zones and Export Competitiveness 73. The evidence in Volume 2, Chapter 3 suggests that special economic zones (ecozones) have been of vital and growing importance to the Philippines' recent export surge: by 1996, they accounted for nearly one third of merchandise exports. The integrated package of policies, streamlined procedures, physical infrastructure and facilities offered by the ecozones have acted as a magnet for attracting FDI. In terms of performance, the Philippine ecozones also compare favorably with most other developing countries, including within East Asia. 74. Volume 2, Chapter 3 provides an in-depth assessment of the Philippine ecozone program in relation to other countries and discusses a number of specific issues and recommendations relating to improving the competitiveness of ecozones in terms of institutional and administrative arrangements, facilities and services, and the policy framework. The summary discussion here is limited to two issues: the rationale for ecozones in a world of diminishing trade barriers; and an assessment of the current incentive regime associated with ecozones. 75. Rationale. The first issue is whether ecozones should be regarded as transitional arrangements in the face of trade policy distortions and should be phased out as trade liberalization proceeds. While ecozones can become inadequate substitutes for (and impediments to) full trade policy reform, the evidence in the Philippines indicates that their growth has coincided with progress on trade reform. Moreover, their rationale extends beyond compensating for antiexport bias. If properly designed and efficiently managed, they can concentrate in one discrete area the infrastructure required for exports, the administration of tariff and other regimes, and the provision of training and various support services. Thus, ecozones can not only compensate for distorted trade regimes, but also reap economies of scale, scope and agglomeration in the production, support and administrative activities related to exporting (as well as serving regional development objectives). The prevalence of free zones in industrialized countries with open economies also suggests that the role of ecozones will continue to be important even with the advent of modern production concepts and approaches. 76. The dominance of the private sector in providing on-site (and increasingly off- site) infrastructure and managerial services for the more recent ecozones reduces the costs to government of their development-though it is important that social and environmental costs are adequately incorporated into the decision framework.  Section 2. Policy Implications and Priorities 25 77. The development of more sophisticated ecozones, catering to specific types of industries and offering specialized services and facilities, is a natural outcome of the growth in the number of zones and increasing competition among private development groups. There is little that the government needs to do to facilitate this process. On the other hand, there may be a rationale for government support for certain types of zones- such as science and technology parks, business incubators-in which case a program to facilitate their development would have to be initiated by the Philippine Economic Zone Authority (PEZA). 78. Incentive Regime. The package of benefits, privileges and incentives offered by the PEZA regime is easily among the most generous available anywhere. But there are several opportunities for rationalization. First, duplication of incentives among PEZA, BOI and freeport regimes offers a multitude of rent-seeking opportunities. A priority therefore is to eliminate the separate set of PEZA and BOI investment incentives in favor of a universal set of measures equally available to firms engaged in promoted activities within and outside ecozones implemented through the tax code. This will eliminate existing distortions which unnecessarily favor locations within ecozones over others. 79. A second priority is to shift from less effective "front-loaded" incentives such as income tax holidays, to various "performance-based" measures available through the tax code. Income tax holidays that are provided at the beginning of the investment cycle are less effective than performance-based measures, which reward firms that actually meet performance targets or make qualifying expenditures. Use of these measures in the tax code will eliminate the need for an up-front screening/evaluation process. It will also obviate the need for the ponderous IPP list that is used to define and restrict access to the BOI incentives. Finally, permitting duty-free imports of all project-related items goes beyond international norms and is difficult to implement. Such privileges should therefore be limited to import of production-related capital equipment, spares and inputs. 80. As described in Volume 2, Chapter 3, the competitiveness of ecozones could be improved through addressing a number of deficiencies including: lack of clarity regarding the ecozone concept itself, particularly as it applies to nonmanufacturing activities; unclear policies governing sales to the local market; cumbersome approval procedures for new ecozone projects and ecozone expansions. Moreover, local purchases and subcontracting by ecozone enterprises could be initiated through easing of regulations governing subcontracting between ecozone and nonzone enterprises, and shelter plan concepts should be promoted to nonzone enterprises. The implementing rules and regulations (IRR) of the PEZA law should be streamlined. The existing IRR have many cumbersome rules and requirements that can be eliminated. An example is the time- consuming procedures required to obtain the necessary permits for a new ecozone project, and expansions of existing zones.  26 Section 3. The Economic Outlook 3. THE ECONOMIC OUTLOOK 81. Assessing the Philippines' economic prospects is complicated by the uncertain outlook for private capital flows in the region and their repercussions for domestic financial markets. Several related factors will be important in determining economic prospects: the depth and duration of the current decline in net private capital inflows; the speed with which domestic financial markets stabilize; the ability to avoid a major wage- price spiral in response to the exchange rate adjustment; and the ability to increase the domestic saving rate in the medium term. 82. In 1996, net private capital inflows had risen to nearly 10 percent of GNP, which is well above the level reached in past years either in the Philippines or for East Asian countries in aggregate (Figure 1.1, Volume 2).'5 Given the extent of financial turbulence in the region during 1997, it would be prudent to provision for a substantial decline in private inflows at least through 1998. Although FDI inflows may be sustained at the level of recent years, i.e., of about $1.5 billion (gross inflow), net portfolio flows are estimated to have turned substantially negative in 1997 and may remain negative in 1998. And foreign borrowing by commercial banks can be expected to decline sharply from its level of over $4 billion in 1996. Even beyond 1998, it appears unlikely that private inflows in the order of 10 percent of GNP would be sustainable. 83. The Philippines responded relatively rapidly to the shift in investor sentiment during 1997. But an essential ingredient of that response was a tightening of monetary policy and an increase in interest rates, which together with a tightening of credit conditions is expected to slow economic growth in the second half of 1997. The full-year growth figure for 1997 is therefore projected to slow to about 5 percent; slower growth of net factor income would tend to reduce the differential between GDP and GNP growth relative to recent years. Output growth in 1998 is expected to slow further as the full ramifications of the current financial market instability are felt. The intensity of the slowdown will depend on the duration of the period during which high interest rates are required, the extent of distress experienced by the corporate and banking sectors as a result, and the fiscal consequences of such distress. Disruptions caused by El Nino may also slow agricultural growth significantly in 1998. 84. The past four years have provided ample evidence of the Philippines' ability to compete in international markets-for example, export growth since 1995 has been the strongest among market economies in the region. A depreciation of the real exchange rate relative to 1996 in response to the prospect of lower capital inflows is likely, and would 15 Figure 1.1 refers to long-term private flows.  Section 3. The Economic Outlook 27 further enhance competitiveness, particularly if it occurs in the context of relatively stable (single-digit) inflation as targeted. 85. If real export growth during 1998-2000 can be maintained at close to its pace during 1995-97 and domestic savings can continue to rise (by about 2 percentage points through 2000), a recovery of output growth to 5 to 6 percent during 1999-2000 is feasible, notwithstanding the lower private capital inflows anticipated relative to the 1994-96 period. Under this scenario, the current account deficit would average 3 percent of GNP during 1998-2000 relative to 4.3 percent during 1994-96, with private capital inflows dropping by a similar proportion relative to 1994-96. ALTERNATIVE SCENARIOS 86. If the current financial market instability is prolonged, there may be a need for substantial restructuring within the corporate and banking sectors with significant fiscal repercussions. Under these circumstances, private capital flows may be deterred over an extended period, in which case the slower growth that is anticipated for 1998 could become more extended. 87. Another factor that should be borne in mind is the almost ideal conditions that have existed in international markets in the mid-1990s, with strong growth in trade volumes among OECD countries and historically low interest rates particularly in Japan, the Philippines' most important source of official capital. Although major changes in the international environment are not anticipated through 2000 (and have not been assumed in the above scenario), the possibility of slower growth in trade and/or higher interest rates among the major OECD countries adds another element of risk to the medium-term outlook. 88. Alternatively, the Philippines may be able to distinguish itself within the region, particularly if export growth accelerates from its recent performance, inflation falls within its official target in 1997 and remains relatively subdued thereafter, and interest rates return quickly to their preturbulence levels. Under these circumstances, the anticipated cutback in external capital might be smaller than assumed and would permit higher than projected economic growth. OFFICIAL DEVELOPMENT ASSISTANCE (ODA) REQUIREMENTS 89. Under the above base-case economic and external financing scenario, the bulk of the adjustment to lower private capital inflows occurs through a reduction in the current account deficit (and slower reserve accumulation). The current account adjustment in turn will likely require adjustment in both public and private spending plans; in the case of the former, prior intentions to increase public investment-from 4.5 percent of GNP in 1996 to 5.3 percent by 1998-may have to be compromised. Hence, it is assumed that public investment through 1998 remains at about 4.5 percent of GNP, rising gradually thereafter.  28 Section 3. The Economic Outlook The proportion of ODA financing of public investment can however be expected to rise somewhat from 35 percent in 1996, reflecting the overall tightening of government outlays. 90. These assumptions translate into projected disbursement requirements from ODA of about $1.7 billion for 1998. Based on the projected pipeline from existing commitments and standard assumptions relating to disbursement ratios, new ODA commitments of some $2.5 billion, or somewhat less than in recent years, are projected to be required.'6 A larger proportion of these funds is expected to be required to support the government's initiative of increasing public investment in Mindanao. 91. The above figures do not incorporate further use of balance of payments support from official sources beyond the IMF and Japan EXIM Bank resources committed in 1997. The need for additional such financing, including the options of adjustment or program loans from multilateral institutions, would depend on the pace at which private capital inflows recover from their fall in 1997. 16 The lower commitment figure also reflects an assumption of real exchange rate depreciation.  Statistical Annex 29 STATISTICAL ANNEX Table 1: National Accounts, 1987-96 (as percentage of GNP) Table 2: National Accounts, 1987-96 (growth rates) Table 3: Balance of Payments, 1992-97 Table 4: Exports and Imports by Major Commodity Group, 1987-96 Table 5: External Debt, 1991-97 Table 6: Monetary Survey, 1992-97 Table 7: Exchange Rates, Inflation and Selected Interest Rates, 1991-97 Table 8: Consolidated Public Sector Financial Position, 1992-97 Table 9: Outstanding Public Sector Debt, 1992-96 Table 10: National Government Cash Operations, 1991-96 Table 11: Loans Outstanding of Commercial Banks, 1990-97  TABLE 1: NATIONAL ACCOUNTS, 1987-96 (as percentage of GNP) 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 GDPatmarketprices 101.8 100.9 101.5 100.5 99.5 98.3 98.3 97.5 97.3 96.2 NetIndirectTaxes 8.9 7.2 2.3 8.2 9.1 9.7 10.0 10.4 10.6 10.0 Indirecttaxes 9.2 7.5 9.1 9.4 9.8 10.1 10.4 10.8 11.0 10.3 Subsidies 0.3 0.3 6.8 1.2 0.7 0.3 0.4 0.4 0.4 0.3 GDP at factor cost 92.9 93.7 99.2 92.3 90.4 88.6 88.3 87.1 86.7 86.2 Agriculture 24.4 23.2 23.0 22.0 20.9 21.5 21.2 21.4 21.0 20.6 Industry 35.0 35.5 35.4 34.7 33.8 32.3 32.1 31.7 31.2 30.5 Mining and quarrying 2.1 1.9 1.7 1.6 1.4 1.2 1.1 1.0 0.9 0.8 Manufacturing 25.3 25.9 25.2 25.0 25.2 23.8 23.3 22.7 22.4 21.7 Services 42.3 42.3 43.0 43.9 44.8 44.6 44.9 44.3 45.1 45.1 Imports of GNFS 26.7 27.2 30.7 33.5 32.4 33.5 39.1 39.1 43.0 49.8 Exports of GNFS 27.1 28.6 28.5 27.7 29.4 28.6 30.8 33.0 35.4 40.4 Total Consumption 80.4 79.7 80.9 81.8 82.9 83.6 84.8 83.0 83.2 81.2 Public 8.5 9.1 9.7 10.2 9.9 9.5 9.9 10.5 11.1 11.3 Private 71.9 70.6 71.2 71.6 73.0 74.1 74.8 72.5 72.1 69.9 Statistical discrepancy 3.1 0.9 0.9 0.3 -0.6 -1.5 -1.7 -2.8 0.1 1.2 Gross domestic investment 17.8 18.8 21.9 24.3 20.1 21.0 23.6 23.5 21.6 23.3 GDFI 16.8 18.0 21.1 23.2 19.9 20.6 23.4 23.0 21.6 22.3 Nonfinancial Public Sector 2.9 2.9 3.6 4.2 4.1 4.8 4.9 4.8 4.5 National Government 1.9 1.9 2.3 2.7 3.0 3.4 2.5 2.4 2.6 Public Enterprises 0.9 1.0 1.3 1.5 1.1 1.5 2.4 2.4 1.9 Private Sector 13.9 15.1 17.5 19.0 15.8 15.7 19.0 18.2 17.2 Changes in stocks 1.0 0.9 0.8 1.0 0.2 0.4 0.2 0.4 0.0 1.0 Net factor income -1.8 -0.9 -1.5 -0.5 0.5 1.7 1.7 2.5 2.7 3.8 GNP (million pesos) 670,826 792,012 912,027 1,071,433 1,254,562 1,374,838 1,500,287 1,736,382 1,958,932 2,282,958 Source: NSCB.  TABLE 2: NATIONAL ACCOUNTS, 1987-96 (Growth rates) 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 GDP at market prices 4.3 6.8 6.2 3.0 -0.6 0.3 2.1 4.4 4.8 5.7 NetlndirectTaxes 25.0 -17.1 12.8 3.0 10.1 6.0 4.9 6.5 9.1 GDP at factor cost 2.4 9.5 5.6 3.0 -1.6 -0.2 1.8 4.2 4.3 Agriculture 3.2 3.2 3.0 0.5 1.4 0.4 2.1 2.6 0.9 3.0 Industry 4.0 8.7 7.4 2.6 -2.7 -0.5 1.6 5.8 7.0 6.3 Mining and quarrying -8.8 4.2 -2.7 -2.6 -2.9 6.7 0.7 -7.0 -0.8 -1.5 Manufacturing 5.6 9.5 5.8 2.7 -0.4 -1.7 0.7 5.0 6.8 5.6 Services 5.2 7.2 7.0 4.9 0.2 1.0 2.5 4.2 5.0 6.5 ImportsofGNFS 28.6 19.6 15.2 10.0 -1.1 8.7 11.5 14.5 16.0 21.1 Exports of GNFS 6.8 14.5 8.9 1.9 6.3 4.3 6.2 19.8 12.0 20.3 Total consumption 4.1 6.5 5.2 5.5 1.8 2.9 3.3 3.9 3.8 4.8 Public 4.9 9.1 7.0 6.8 -2.1 -0.9 6.2 6.1 5.4 5.2 Private 4.0 6.2 5.0 5.4 2.3 3.3 3.0 3.7 3.8 4.6 Gross domestic investment 19.7 14.7 20.5 15.8 -17.3 7.8 7.9 8.7 3.0 15.6 GDFI 6.9 16.4 21.6 15.0 -14.2 6.4 8.7 7.5 4.7 12.0 Nonfinancial Pub. Sector 3.4 9.9 28.2 23.2 -3.1 21.5 -1.9 5.3 4.8 National Government 2.5 8.7 22.9 24.4 10.1 15.4 -27.6 5.0 16.6 Public Enterprises 5.3 12.3 38.7 21.1 -26.8 38.0 56.0 5.6 -7.4 Private 7.6 17.7 20.3 13.3 -16.7 2.5 16.3 4.0 6.5 Gross national product 4.6 7.7 5.6 4.0 0.5 1.6 2.1 5.3 5.0 6.9 Source: NSCB.  32 Statistical Annex TABLE 3: BALANCE OF PAYMENTS, 1991-97 La (in $ million) January-June 1992 1993 1994 1995 1996 1996 1997 Trade balance -4,695 -6,222 -7,850 -8,944 -11,342 -6,046 -5,584 (% of GNP) (8.7) (11.2) (11.9) (11.7) (13.0) (14.7) (12.1) Exports (FOB) 9,824 11,375 13,483 17,447 20,543 9,582 11,700 Imports (FOB) 14,519 17,597 21,333 26,391 31,885 15,628 17,284 Services (net) 3,020 2,507 3,964 4,765 6,839 3,012 3,199 Receipts 7,443 7,497 10,550 14,374 19,006 8,221 11,100 o/w Remittances/Private transfers 3,485 3,956 5,824 8,696 10,169 5,060 6,151 Payments 4,423 4,990 6,586 9,609 12,167 5,209 7,901 o/w Interest 1,703 1,513 1,579 2,179 2,167 1,055 1,261 Transfers (net) 817 699 936 882 689 326 315 Current Account Balance -858 -3,016 -2,950 -3,297 -3,814 -2,708 -2,070 (% of GNP) (1.6) (5.5) (4.5) (4.3) (4.5) (6.6) (4.5) Foreign investment (net) 737 812 1,558 1,609 1,168 1,014 -1,493 Direct Investment 675 864 1,289 1,361 1,338 726 738 Portfolio Investment 62 -52 269 248 -170 288 -2,231 MLT borrowing (net) 666 2,105 1,313 1,276 2,690 1,140 1,696 Inflows 7,436 4,853 4,369 3,927 6,329 2,709 2,892 Outflows 6,770 2,748 3,056 2,651 3,639 1,569 1,196 Short-term Capital (net) 660 -148 1,002 -56 540 214 241 Change in Commercial Banks' NFA 459 -547 465 1,309 4,211 2,949 2,800 (- indicates increase) Errors and Omissions -360 84 160 -291 -683 -198 -1,261 Others lb 188 544 254 81 -5 5 -122 Changes in net reserves L -1,492 166 -1,802 -631 -4,107 -2,416 209 (- indicates increase) La 1997 data cover the January to June period Lb Includes monetization of gold, revaluation adjustments and $469 million purchase of collateral in 1992. k Includes net credit of IMF. Source: BSP.  TABLE 4: EXPORTS AND IMPORTS BY MAJOR COMMODITY GROUP, 1987-96 (in $ million) 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 Exports Coconut Products 561 582 541 503 447 643 532 639 989 730 SugarandProducts 71 74 113 133 136 110 129 77 74 139 Fruits and Vegetables 150 306 317 326 393 371 439 429 458 486 Other Agro-Based Products 585 480 454 431 503 432 476 530 575 506 Forest Products 243 261 197 95 73 57 45 26 38 42 Mineral Products 224 764 829 723 581 633 686 780 893 772 Petroleum Products 88 162 95 155 175 150 136 132 171 273 Manufactures 3,642 4,338 5,192 5,706 6,432 7,293 8,720 10,615 13,868 17,106 Elect. & Elect. Equipments 1,119 1,476 1,751 1,964 2,293 2,753 3,551 4,984 7,413 9,990 Garments 1,098 1,317 1,575 1,776 1,861 2,140 2,272 2,375 2,570 2,423 Others 156 107 83 114 100 135 212 255 381 489 Total Exports 5,720 7,074 7,821 8,186 8,840 9,824 11,375 13,483 17,447 20,543 Imports Capital Goods 1,210 1,637 2,424 3,122 2,952 4,023 5,610 6,868 8,029 10,472 Raw Materials & Intermediate Goods 3,426 4,415 5,388 5,808 5,851 6,769 7,855 9,606 12,174 14,058 Unprocessed Raw Materials 303 672 807 862 841 947 961 1,278 1,562 1,720 Semiprocessed Raw Materials 3,123 3,743 4,581 4,946 5,010 5,812 6,874 8,328 10,612 12,338 Manufactures 957 1,238 1,787 1,794 1,714 2,139 2,590 2,893 3,572 3,948 Embroideries 334 377 437 426 514 502 468 411 472 349 Materials for Elect. Equipt. 767 910 885 1,106 1,208 1,401 1,808 2,711 3,772 5,130 Mineral Fuels and Lubricants 1,249 1,096 1,397 1,842 1,784 2,050 2,016 2,040 2,461 3,008 Consumer Goods 547 597 899 1,061 990 1,241 1,687 2,109 2,784 3,331 Durable 179 218 365 392 478 620 842 1,124 1,459 1,653 r4 Nondurable 368 379 492 669 512 624 745 985 1,325 1,678 Others 305 414 311 373 474 436 529 710 943 1,016 Total Imports 6,737 8,159 10,419 12,206 12,051 14,519 17,697 21,333 26,391 31,885 Source: BSP.  34 Statistical Annex TABLE 5: EXTERNAL DEBT, 1991-97 (in $ million) June 1991 1992 1993 1994 1995 1996 1997 By Type of Debt 29,956 30,934 34,282 37,079 37,778 41,875 44,809 Medium and Long-Term La 25,129 25,678 29,247 31,882 32,449 34,668 36,261 Short-Term 4,827 5,256 5,035 5,197 5,279 7,207 8,548 Trade 4,589 4,937 3,495 3,401 2,674 4,096 4,513 Nontrade 238 319 1,540 1,796 2,605 3,111 4,035 By Borrower 29,956 30,934 34,282 37,079 37,778 41,875 44,809 Banking System LB 7,465 4,214 2,403 3,027 4,187 8,632 10,892 Central Bank 5,325 2,303 - - - - - Bangko Sentral - - 1,288 855 1,212 1,415 1,817 Commercial Banks 2,140 1,911 1,115 2,172 2,975 7,217 9,075 Public and Private 22,491 26,720 31,879 34,052 33,591 33,244 33,916 Public 18,453 21,745 26,583 27,193 26,340 24,132 23,060 Private 4,038 4,975 5,296 6,859 7,251 9,112 10,856 By Creditor 29,956 30,934 34,282 37,079 37,778 41,875 44,809 Commercial Banks 10,451 9,083 5,682 4,688 5,106 7,415 8,090 Other Financial Institutions 556 324 303 841 1,239 958 1,378 Suppliers' Credits 2,802 2,963 3,185 3,549 2,587 2,588 2,531 Multilateral 6,499 7,168 7,949 8,216 8,028 8,634 8,304 O/w IBRD 3,130 3,473 3,936 3,985 4,095 4,676 4,408 ADB 1,889 2,113 2,300 2,558 2,643 3,117 3,159 IMF 1,165 1,183 1,312 1,139 814 405 278 Bilateral 9,572 11,328 13,369 15,033 14,393 13,439 13,645 Export Agencies 3,659 3,351 3,997 4,487 3,939 4,677 4,520 Others 5,913 7,977 9,372 10,546 10,454 8,762 9,125 Others 76 68 3,794 4,752 6,425 8,841 10,861 Memo Items: Debt service Lg 2,828 2,942 3,229 4,188 5,032 4,961 2,502 Debtservice/Exports 19.6 17.0 17.1 17.4 15.8 12.5 11.1 Total external debt / GNP (O/O) 65.6 57.4 62.0 56.4 49.6 48.1 Total extemal debt / Exports (%) 207.1 179.2 181.7 154.3 118.7 105.9. La Includes cumulative foreign exchange revaluation of US$-denominated multicurrency loans from the World Bank and Asian Development Bank of $433 and $384 million, respectively, for end-1996. /b Effective July 3, 1993, accounts of old CB were split between Bangko Sentral ng Pilipinas and Central Bank - Board of Liquidators. /c For 1991-94, debt service burden represents principal and interest payments after rescheduling. Source: BSP.  Statistical Annex 35 TABLE 6: MONETARY SURVEY, 1992-97 August 1992 1993 1994 1995 1996 1997 (in billions of pesos) Total Liquidity 401.1 499.4 630.8 786.4 913.9 992.7 Broad Money 385.4 480.3 607.6 761.4 881.4 959.9 Other Liabilities 15.7 19.1 23.2 25.0 32.5 32.8 Net Foreign Assets 76.5 104.6 123.6 117.9 70.2 -11.9 o/w Central Bank 45.5 56.8 91.8 118.4 232.7 202.7 Deposit Money Banks 30.9 47.9 31.8 -0.5 -162.4 -214.6 Net Domestic Assets 324.6 394.8 507.1 668.5 843.7 1,034.5 Net Domestic Credit 277.1 682.1 821.5 1,084.0 1,507.8 1,712.3 Public Sector -18.6 274.1 299.8 335.3 377.2 400.5 Private Sector 295.7 408.0 521.7 748.7 1,130.5 1,311.8 FCDs, residents -94.5 -136.2 -158.8 -206.7 -317.6 -366.4 Other Items (net) 142.0 -151.1 -155.6 -208.8 -346.5 -311.4 (percentage change; end of period) Broad Money 11.0 24.6 26.5 25.3 15.8 23.7 Net Domestic Assets 3.0 146.2 20.4 32.0 39.1 28.1 Private Sector Credit 24.6 38.0 27.9 43.5 51.0 32.0 (in percent of GNP) Broad Money 28.0 32.0 35.0 38.9 38.6 Net Foreign Assets 5.6 7.0 7.1 6.0 3.1 Net Domestic Assets 23.6 26.3 29.2 34.1 37.0 Private Sector Credit 21.5 27.2 30.0 38.2 49.5 Sources: BSP, IMF.  TABLE 7: EXCHANGE RATES, INFLATION AND SELECTED INTEREST RATES, 1991-97 1991 1992 1993 1994 1995 1996 1997 Mar Jun Sep Exchange Rates: Period Average (Pesos/$) 27.5 25.5 27.1 26.4 25.7 26.2 26.3 26.4 32.6 End of Period (Pesos/$) 26.7 25.1 27.7 24.4 26.2 26.3 26.4 26.4 34.3 Real Effective (1990=100) 99.8 110.9 110.4 117.3 120.3 129.8 139.6 138.6 Inflation: CPI (1990=100) 118.7 129.3 139.1 151.7 164.0 177.8 184.1 186.6 189.3 Yearchange(%) 18.7 8.9 7.6 9.1 8.1 8.4 4.8 4.8 5.3 Interest Rates: (end of period) Manila Reference Rates: MRR60 19.2 13.8 14.8 9.8 11.4 11.8 10.1 10.2 15.8 MRR90 17.2 14.1 15.0 8.8 10.3 11.0 8.9 9.6 11.9 MRR180 17.1 11.9 14.1 9.1 10.4 10.2 8.1 8.4 12.2 All Maturities 18.7 13.7 14.7 9.6 11.1 11.6 9.9 9.9 15.5 Bank Lending Rate 23.0 18.2 16.4 13.4 14.6 14.8 13.7 13.3 18.7 p/ Time Deposits: Short-Tern(< I yr) 18.9 12.9 14.1 8.3 11.4 10.5 9.2 8.2 12.8 Long-tenn(> I yr) 18.0 13.0 13.0 10.8 9.6 11.1 8.6 9.3 13.2 91-day Treasury Bill Rate 21.1 14.5 15.9 10.7 12.0 11.5 10.1 10.5 15.0 ReserseRP(term)Rate 15.5 N.T. N.T. 14.0 13.4 11.1 9.9 10.3 14.7 InterbankCallLoanRate 14.9 23.2 24.1 12.0 14.1 11.2 9.9 15.1 13.6 p/ Preliminary. Source: BSP, IMF.  Statistical Annex 37 TABLE 8: CONSOLIDATED PUBLIC SECTOR FINANCIAL POSITION, 1992-97 Program 1992 1993 1994 1995 1996 1997 (in billion pesos) National Government -16.0 -21.9 16.3 11.1 6.3 13.0 Monitored GOCCs -10.7 -25.6 -8.7 -1.3 -11.2 -9.3 Central Bank Restructuring 0.0 -15.1 -24.3 -20.0 -13.8 -11.9 Oil Price Stabilization Fund (OPSF) Lg 4.4 -7.9 2.6 -9.2 4.8 -0.8 Adjustment to GOCCs Lb 2.5 11.9 7.6 2.8 1.5 1.4 Other Adjustments L/ -0.6 2.8 0.0 0.0 0.0 0.0 Public Sector Borrowing Requirement (PSBR) -20.4 -55.8 -6.5 -16.6 -12.4 -7.7 SSS/GSIS 8.6 11.7 -12.0 0.0 8.5 5.9 Bangko Sentral ng Pilipinas -21.8 -1.0 5.2 3.6 -2.3 2.1 Govemment Financial Institutions 3.8 6.1 3.1 5.0 8.4 3.3 Local Government Units 0.8 5.9 5.0 1.9 5.7 2.8 Time Adj. of Interest Payments to BSP 3.5 7.0 -2.3 3.0 -0.7 0.0 Other Adjustments -0.4 0.3 0.1 0.6 0.0 0.1 Consolidated Public Sector (CPS) -25.9 -25.8 -7.4 -2.6 7.3 6.5 (in percent of GNP) National Government -1.2 -1.5 0.9 0.6 0.3 0.5 Monitored GOCCs -0.8 -1.7 -0.5 -0.1 -0.5 -0.4 Central Bank Restructuring 0.0 -1.0 -1.4 -1.0 -0.6 -0.5 Oil Price Stabilization Fund (OPSF) La 0.3 -0.5 0.1 -0.5 0.2 0.0 Adjustment to GOCCs Lb 0.2 0.8 0.4 0.1 0.1 0.1 Other Adjustments L/ 0.0 0.2 0.0 0.0 0.0 0.0 Public Sector Borrowing Requirement (PSBR) -1.5 -3.7 -0.4 -0.8 -0.5 -0.3 SSS/GSIS 0.6 0.8 -0.7 0.0 0.4 0.2 Bangko Sentral ng Pilipinas -1.6 -0.1 0.3 0.2 -0.1 0.1 Government Financial Institutions 0.3 0.4 0.2 0.3 0.4 0.1 Local Government Units 0.1 0.4 0.3 0.1 0.2 0.1 Time Adj. of Interest Payments to BSP 0.3 0.5 -0.1 0.2 0.0 0.0 Other Adjustments 0.0 0.0 0.0 0.0 0.0 0.0 Consolidated Public Sector (CPS) -1.9 -1.7 -0.4 -0.1 0.3 0.3 La Includes OPSF balance, transfers between NG and OPSF, and adjustments for PNOC share of OPSF balance. Lb Includes NG transfers to monitored corporations, NPC transfers to NG, NG transfers to PNOC and PNB transfers to NG. lZ Includes adjustments for net lending for debt buyback, reconciliation of cash accounts with bank data and other adjustments. Sources: DOF, IMF.  38 Statistical Annex TABLE 9: OUTSTANDING PUBLIC SECTOR DEBT, 1992-96 (year-end, in billions of pesos) 1992 1993 1994 1995 1996 Total Public Sector Ia 1,630.0 1,910.7 1,900.5 2,170.9 2,167.8 Domestic 1,082.7 1,158.6 1,170.1 1,426.8 1,467.0 External 547.3 752.1 730.4 744.1 700.8 (US$ billion) 21.6 27.2 29.9 28.4 26.7 Total Public Sector /b 1,062.0 1,407.2 1,347.5 1,528.4 1,504.0 Domestic 587.6 764.8 743.7 922.8 946.6 External 474.4 642.4 603.8 605.6 557.4 (US$ billion) 18.7 23.2 24.7 23.1 21.2 National Government Ic 979.4 1,268.8 1,232.2 1,307.1 1,331.8 National Government /d 873.8 1,165.0 1,118.6 1,185.3 1,145.7 Domestic Ic 502.9 682.6 671.0 722.8 718.3 External /d 476.5 586.2 561.2 584.3 583.5 (US$ billion) 18.8 21.2 23.0 22.3 22.2 14 Monitored GOCCs Le 188.2 242.2 228.9 343.1 358.3 Domestic 89.7 87.0 77.9 205.9 204.6 External 98.5 155.2 151.0 137.2 153.7 (US$ billion) 3.9 5.6 6.2 5.2 5.8 Central Bank/CB-BOL If 409.8 59.6 81.1 82.6 77.1 Domestic 351.5 14.9 40.4 42.1 37.0 External 58.3 44.7 40.7 40.5 40.1 (US$ billion) 2.3 1.6 1.7 1.5 1.5 Bangko Sentral /g 209.3 240.9 253.8 330.3 Domestic 173.6 183.9 185.8 262.6 External 35.7 57.0 68.0 67.7 (US$ billion) 1.3 2.3 2.6 2.6 Government Financial Institutions 158.2 234.6 231.1 306.1 256.4 Domestic 143.6 205.3 202.2 276.1 220.8 External 14.6 29.3 28.9 30.0 35.6 (US$ billion) 0.6 1.1 1.2 1.1 1.4 Memo Items: Public Sector Debt Stock/GNP/a 118.6 127.4 109.4 110.8 95.0 Domestic 78.8 77.2 67.4 72.8 64.3 External 39.8 50.1 42.1 38.0 30.7 Public Sector Debt Stock/GNP lb 77.2 93.8 77.6 78.0 65.9 Domestic 42.7 51.0 42.8 47.1 41.5 External 34.5 42.8 34.8 30.9 24.4 National Government Debt Stock/GNP L/ 71.2 84.6 70.9 66.7 58.3 National Government Debt Stock/GNP /d 63.6 77.7 64.4 60.5 50.2 Domestic Ic 36.6 45.5 38.6 36.9 31.5 External 34.7 39.1 32.3 29.8 25.6 La Includes National Government, 14 Monitored GOCCs, CB/CB-BOL/BSP and GFIs. L2 Same as La except for CB/CB-BOL/BSP and GFIs. /c Includes direct, assumed and contingent liabilities. Ld Excludes direct, assumed and contingent liabilities. La Includes direct, guaranteed and assumed liabilities. Lf Includes net lending from NG, borrowings relent/guaranteed by National Government. Lg Liabilities less currency issue and intergovermment accounts. Source: DOF.  Statistical Annex 39 TABLE 10: NATIONAL GOVERNMENT CASH OPERATIONS, 1991-96 (in million pesos) 1991 1992 1993 1994 1995 1996 Total Revenue 220,787 242,714 260,405 336,160 361,220 410,449 Tax Revenue 182,275 208,706 230,170 271,304 310,517 367,894 Bureau of Intemal Revenue 116,256 133,904 145,927 187,445 210,105 260,774 Bureau of Customs 64,391 72,871 81,971 81,610 97,691 104,566 Other Offices 1,628 1,931 2,272 2,249 2,721 2,554 Non-Tax Revenue 38,512 34,008 30,235 64,856 50,703 42,555 Total Expenditure 247,136 258,680 282,295 319,874 350,146 404,193 Current Expenditure 196,525 214,939 226,618 267,813 277,265 318,462 Personnel Services 72,399 74,337 78,696 92,678 109,074 135,406 Maintenance and Operations 36,199 33,673 34,565 46,837 46,950 48,702 Subsidies 4,270 3,531 5,147 7,021 3,580 5,862 Allotment to LGUs 6,708 16,114 27,773 37,753 41,394 45,275 Interest Payments 74,922 79,571 76,491 79,123 72,658 76,522 Tax Expenditures 1,989 7,713 3,946 4,401 3,609 6,695 Capital Expenditure and Net Lending 50,611 43,741 55,677 52,061 72,881 75,731 Capital Expenditure 40,681 50,186 44,773 43,068 64,461 69,628 Infrastructure and Other Capital Outlays 37,607 46,125 37,830 33,606 52,673 57,547 Transfers to LGUs 3,074 4,061 6,943 9,462 11,788 12,081 Equity and Net Lending 7,667 -6,949 9,402 8,993 8,420 3,176 CARP Land Acquisition and Credit 2,263 504 1,502 0 0 2,927 OPSF 10,000 Overall Surplus/Deficit -26,349 -15,966 -21,890 16,286 11,074 6,256 Financing 26,349 15,965 21,891 -16,286 -11,074 -6,256 Net Domestic Financing 19,469 1,575 8,979 -4,709 2,272 -348 Net Foreign Financing 6,880 14,390 12,912 -11,577 -13,346 -5,908 Memo Items: (in % GNP) Total Revenue 17.6 17.7 17.4 19.4 18.4 18.0 Tax Revenue 14.5 15.2 15.3 15.6 15.9 16.1 Current Expenditure 15.7 15.6 15.1 15.4 14.2 13.9 Capital Expenditure and Net Lending 4.0 3.2 3.7 3.0 3.7 3.3 Overall Surplus/Deficit -2.1 -1.2 -1.5 0.9 0.6 0.3 Source: DOF.  40 Statistical Annex TABLE 1 1: LOANS OUTSTANDING OF COMMERCIAL BANKS, 1990-97 Sep Ip 1990 1991 1992 1993 1994 1995 1996 1997 ECONOMIC ACTIVITY Growth rates (% on year earlier) Agriculture, fisheries, & forestry 30.6 10.1 19.1 8.1 19.6 6.4 30.9 Mining and quarrying -10.5 23.2 56.9 -48.1 55.9 9.4 91.1 Manufacturing -3.0 25.6 26.9 32.5 33.9 42.5 17.6 Electricity, gas & water 10.6 15.4 159.5 25.7 24.7 90.6 56.8 Construction 8.7 18.5 65.3 32.3 37.4 74.2 26.8 Wholesale & retail trade 27.7 19.9 27.8 39.8 37.3 38.1 35.9 Transportation, storage & communication 0.5 21.9 52.8 53.8 72.0 53.3 74.0 Fin. inst., real estate & business services 19.2 36.1 10.1 37.4 24.8 97.2 69.7 Community, Social & Personal services 3.4 25.4 92.1 -10.4 61.8 57.6 33.2 TOTAL 9.9 24.0 32.2 25.4 35.8 51.9 39.1 Share of Total Loans (%) Agriculture, fisheries, & forestry 11.2 13.3 11.8 10.6 9.2 8.1 5.7 5.5 Mining and quarrying 2.6 2.1 2.1 2.5 1.0 1.2 0.9 1.3 Manufacturing 38.5 34.0 34.4 33.0 34.9 34.4 32.3 29.0 Electricity, gas & water 1.3 1.3 1.2 2.4 2.4 2.2 2.8 3.1 Construction 2.7 2.6 2.5 3.1 3.3 3.4 3.9 3.6 Wholesale & retail trade 14.5 16.8 16.3 15.7 17.5 17.7 16.1 15.3 Transportation, storage & communication 3.8 3.4 3.4 3.9 4.8 6.1 6.1 7.5 Fin. inst., real estate & business services 16.9 18.3 20.1 16.7 18.3 16.8 21.8 25.2 Community, Social & Personal services 8.6 8.1 8.2 11.9 8.5 10.2 10.5 9.5 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 /p = Provisional. Source: BSP.