Philippines - the challenge of economic recovery

Report No. 18895-PH Philippines The Challenge of Economic Recovery February 26, 1999 Povertv Recduction and Economic NManagemenit Sector Unit East Asia ancl Pacific Regional Office Document of the World Bank  CURRENCY EQUIVALENTS (As of February 26, 1999) Currency Unit = Peso $1.00 = 39.12 pesos 1.00 peso = $0.026 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS AMC - Asset Management Corporation BIR - Bureau of Internal Revenue BOI - Bureau of Investments BOT - Build-Operate-Transfer BTr - Bureau of the Treasury BSP - Bangko Sentral Ng Pilipinas CIBI - Credit Information Bureau Inc. CPSD - Consolidated Public Sector Deficit DBM - Department of Budget and Management DENR - Department of Environment and Natural Resources DOF - Department of Finance DOTC - Department of Transport and Communication DPWH - Department of Public Works and Highways DST - Documentary Stamp Tax EDC - Export Development Council ERB - Energy Regulatory Board FCDU - Foreign Currency Deposit Unit FDI - Foreign Direct Investment GASTPE - Government Assistance to Students and Teachers in Private Education GOCC - Government-owned or Controlled Corporation GOP - Government of Philippines GRT - Gross Receipt Tax GSIS - Government Service Insurance System Vice President Jean-Michel Severino, EAP Country Director Vinay K. Bhargava, EACPF Manager (Acting) Kyle Peters, EASPR Task Manager Sanjay Dhar, EASPR  HIGC - Home Insurance and Guaranty Corporation HUDCC - Housing and Urban Development Coordinating Council IASC - International Accounting Standards Committee ICZM - Integrated Coastal Zone Management IRA - Internal Revenue Allotment LGU - Local Government Unit MDF - Municipal Development Fund NHMFC - National Home Mortgage Finance Corporation NEA - National Electrification Administration NEDA - National Economic Development Authority NG - National Governnent NPC - National Power Company NPL - Nonperforming Loan OECF - Overseas Economic Cooperation Fund OPP - Occupational Pension Plan PAYG - Pay-As-You-Go PAL - Philippine Airlines PAS - Philippine Accounting Standards PCFC - People's Credit and Finance Corporation PEZA - Philippine Economic Zone Authority PDIC - Philippines Deposit Insurance Corporation PNB - Philippine National Bank PNR - Philippine National Railways PSE - Philippine Stock Exchange SEC - Securities and Exchange Commission SME - Small and Medium Enterprise SRO - Self-Regulated Organization STAND - Science and Technology Agenda for National Development SSS - Social Security System TSP - Total Suspended Particles UHLP - Unified Home Lending Program USGAAP - U.S. Generally Accepted Accounting Principles WTO - World Trade Organization  Table of Contents Page No. EXECUTIVE SUMMARY .v..........................v INTRODUCTION ........................... xv I. THE CHALLENGE OF ECONOMIC RECOVERY .1. A. Recent Developments: On the Edge of the Regional Crisis .1 B. Why Did the Philippines Escape the Worst of the Regional Crisis?. 8 C. Policy Challenges and Opportunities .10 D. Economic Prospects and Financing Requirements . 18 II. STRENGTHENING THE CORPORATE SECTOR .21 A. Introduction .21 B. Structure of the Corporate Sector ..21 C. Impediments to Corporate Recovery and Growth .26 D. Corporate Sector Reform Agenda. 3 1 III. FOSTERING FINANCIAL SOUNDNESS AND GROWTH. 35 A. Introduction. 35 B. Implementing Reforms in the Banking System. 36 C. Deepening Capital Markets .40 D. Developing Long-Term Domestic Savings .42 E. Reforming Housing Finance ....................... 44 F. Ensuring Access to Rural, Micro and Small Enterprise Finance. 46 IV. EXPORT PERFORMANCE AND COMPETITIVENESS. 48 A. Introduction. 48 B. Recent Export Performance.48 C. Structural Competitiveness .52 D. Implications .64 V. ECONOMIC SLOWDOWN AND THE POOR .67 A. Progress till 1997: Declining Poverty but Urban Biased .67 B. The Economic Crisis: Little Impact So Far .70 C. A Strategy for Social Protection .71  VI. ENVIRONMENTAL CHALLENGES AND STRATEGY ...................... 75 A. Introduction ........................................... 75 B. Sources of Environmental Degradation .................................... .. 76 C. Impact of the Crisis on the Environmient .................................... 80 D. Challenges: Improving Governance and Coordination ..................... 80 STATISTICAL ANNEX .84 REFERIENCES.97 REFERENCES .............................................................................. 9 TABLES 1.1 Selected Economic Indicators, 1993-98 ......................................... . 2 1.2 Sectoral Breakdown of Growth ........................................... ... 3 1.3 National Government Financing Requirement .................... ............... 14 1.4 Expenditure Shares within National Government Budget .......... ........... 15 1.5 External Financing Requirements and Sources, 1999-2000 ......... ......... 20 2.1 Corporate Sector Profitability and Level of Indebtedness in 1997 ....... ..... 23 4.1 Annual Growth Rates of Merchandise Exports................. 49 4.2 Philippines Manufactured Export Performance 1991-1998 ............... ..... 50 4.3 Evolution of World Manufactured Exports by Technological Categories (1980-96) ............. 52 4.4 Technological Structure of Manufactured Exports, 1996 .......... ............ 53 4.5 Philippine Electronics Exports . ............................................... 54 4.6 List of Leading 50 Philippines Exporters in 1996 .............. ................ 55 4.7 Comparative Exports of Semiconductors ......................................... 56 4.8 Educational Enrollments ..................... .......................... 58 4.9 R&D Employment and Expenditures ............................................. 59 4.10 Exports as Percentage of Imports in Philippine Electronics Industry .......... 64 5.1 Indicators of Poverty Incidence ............................................... 67 5.2 Number of Poor People ................... ............................ 68 5.3 Poverty in East Asia, Summary Statistics: 1975-95 ............................. 68 5.4 Persistent Poverty in Certain Rural Regions ................................... 69 5.5 Indicators of Income Inequality ................................... 70 FIGURES 1.1 Domestic Demand and Domestic Credit ....................... ............ 3 1.2 Changes in the Unemployment Rate . ................................... 4 1.3 Interest Rates and Inflation ................................... 5 1.4 Balance of Payments ................................... 6 1.5 Financial Market Indicators ................................... 7 1.6 Regional Financial Markets ................................... 8 4.1 Value of major Categories of Philippines Manufactured Exports ....... ...... 51 4.2 Hourly Labor Costs in the Apparel Industry ........................... .......... 61  BOXES 2.1 Survey of Philippine Industry and the Asian Financial Crisis: Preliminary Results .............................................. 25 2.2 Policy Framework for Suspension of Payments ................. ................ 3 1 2.3 Proposals for Corporate Sector Reform . 33  ACKNOWLEDGEMENTS This report was produced by a team led by Sanjay Dhar, and included Bernard Funck and Joven Balbosa (macroeconomy and public sector), Charles Woodruff and Mary Hallward-Driemeier (corporate sector), McDonald Benjamin and Patrick Honohan (financial sector), Sanjaya Lall (consultant, export performance and competitiveness), Gurushri Swamy (poverty), Glen Morgan, Patchamuthu Illangovan and Giovanna Dore (environment). David Bisbee provided research assistance. Hedwig Abbey and Gloria Elmore assisted with document processing. The report was discussed with the Philippine authorities in February 1999. We gratefully acknowledge the cooperation of government officials.  EXECUTIVE SUMMARY A. IMPACT OF THE REGIONAL CRISIS The Philippine economy has withstood the regional crisis better than most market economies in East Asia as the banking and corporate sectors have resisted the type of systemic collapse witnessed elsewhere, export growth has remained remarkably robust, and the social repercussions of the financial crisis have perhaps been less severe to date. The more resilient response to the crisis in the Philippines reflects the shorter period of rapid credit expansion and debt accumulation by the private sector, stronger capitalization of major banks and lower levels of corporate leverage, greater private sector experience with previous crises, and a favorable macroeconomic policy response to the crisis. Moreover, following 18 months of enormous volatility, financial markets have strengthened since September 1998 as equity prices have risen by some 85 percent from their six year low in mid-September, the peso has strengthened, and real interest rates have declined towards pre-crisis levels. Nevertheless, the momentum of growth and optimism that had built through early 1997 has been dealt a severe blow. With investor confidence shaken through much of the region and prospects for economic recovery uncertain, the policy environment in the early years of the new administration has undoubtedly become more challenging. Economic activity stalled in 1998-real GDP contracted by an estimated 0.5 percent, weighed down by a severe drought which reduced agricultural production by nearly 7 percent, unemployment and inflation both approached 10 percent, private investment fell sharply, and banks' non-performing loans (NPLs) rose from 4 to 11 percent of their loan portfolio between mid-1997 and end-1998, after reaching 12.5 percent in October 1998. Reflecting higher levels of financial stress, investors remain cautious towards initiating new projects and bankers remain reluctant to extend credit to new or small borrowers-bank credit to the private sector was flat in nominal terms in 1998 (versus over 50 percent growth in 1996). While the current account shifted to a small surplus in 1998 from a 5 percent of GNP deficit in 1997, the consolidated public sector deficit (CPSD) is estimated to have widened to over 3 percent of GNP. And the scope for stimulating the economy through fiscal policy remains constrained by a heavy public debt (over 90 percent of GNP in 1997), a large refinancing burden for peso denominated debt, and an uncertain external environment for private capital- notwithstanding a successful return to the global bond market by the Philippine Govermnent in early January 1999 after a hiatus since the Russian default. Macroeconomic Policy Stance The policy responses to the crisis have been basically sound, particularly when taking into account the low level of foreign exchange reserves and the need to balance the damaging effects of sharp depreciation and high interest rates on the banking, corporate  vi and public sectors. Periodic bouts of speculative attack on the peso have been blunted through a mix of short-term interest rate adjustments, tightening of liquidity, relatively mild intervention (subsequent to the initial Thai crisis), use of moral suasion with market leaders and collaborative initiatives with the Bankers Association of the Philippines, but without resort to capital controls. National Government (NG) expenditures were cut sharply from initial appropriations as tax revenue fell, but once the extent of economic weakening became apparent, selective adjustments to better protect social expenditures were enacted. In an effort to provide a modest fiscal stimulus in 1999, both current and capital expenditures in the NG budget are targeted to rise gradually relative to 1998, and increased reliance on external financing to finance the NG deficit is proposed in order to reduce pressure on domestic interest rates. Current projections assume that the CPSD in 1999 would remain at about 3.2 percent of GNP, about the level estimated in 1998, although it is recognized that a weaker than anticipated recovery may warrant a larger public deficit. The use of a larger fiscal stimulus on a sustained basis is, however, constrained by longstanding concerns regarding fiscal sustainability and the possibility that financial distress may yet claim more significant fiscal resources. To mitigate investor concerns arising from higher public deficits, an important immediate task is to improve tax administration and enforcement, so that future deficit reduction can be accomplished more effectively as recovery takes hold, and the current reliance on higher deficits can credibly be regarded as temporary. Economic Outlook Notwithstanding the milder initial impact of the crisis, the outlook for recovery is clouded by the uncertain prospects for private capital flows and high levels of corporate and banking stress, which could continue to restrain investment, credit demand and credit access. While the economy in 1999 may receive a boost from higher-than-trend agricultural growth from its depressed level of 1998, export growth was slowing in late 1998. Declining industrial production and imports in late 1998 appear to indicate that the economy may not have bottomed out. Yet without an early resumption of industrial growth, it will be difficult to record even a modest recovery of 2 percent in 1999. In the medium term, the pace of recovery will be heavily influenced by two factors: the extent to which financial stress has been alleviated, thereby improving the environment for corporate investment and bank lending; ancd the nature of private capital flows. In view of the uncertain outlook for private capital flows (and the undesirability of depending excessively upon them), it would be prudent to assume continued volatility and a considerably smaller net inflow than witnessed during 1993-97 (when current account deficits averaged nearly 5 percent of GNP). These factors point to a relatively modest recovery in the medium term, with growth averaging about 41/2 percent during 2000-03 and current account deficits remaining below 2 percent of GNP throughout this period. While the rate of growth is not expected to return quickly to pre-crisis levels, the crisis does provide an impetus to accelerate structural reforns that would improve both the quality and sustainability of the growth that is achieved.  vii B. PROTECTING THE POOR FROM GREATER HARDSHIP Parallel to the economic turnaround through 1997, the Philippines achieved a significant reduction in poverty incidence as the proportion of households living in poverty fell from 40 percent in 1991 to 32 percent in 1997 according to official estimates, and other social indicators improved commensurately.' However, the reduction in rural poverty incidence was less significant-the number of rural poor actually increased by 2.4 million between 1991 and 1997-and income inequality is estimated to have increased sharply during 1994-97, and rural-urban income differentials have also widened. Data to fully delineate the impact of the financial crisis and the drought in 1998 are not yet available, although a rise in unemployment in the second half of 1998 appears primarily attributable to the financial crisis, as the decline in construction and manufacturing began to reduce labor demand. Government actions to cushion the impact of the crises have included: partially protecting social expenditures in the context of a declining budgetary envelope; influencing employers and workers to promote wage restraint thereby moderating increases in unemployment and inflation; and using massive rice imports to stabilize domestic prices. Contingent measures in response to the possibility of intensifying hardships among the poor and near-poor if the crisis lingers or deepens include: expansion of labor intensive employment programs which attract only the poor by setting wages below the market rate; and protection of existing government expenditures on health and education targeted towards the poor. On the latter: the textbook appropriation in the 1999 budget needs to be increased; the school construction program restored; and decrease in coverage for public health (malaria, shistomaisis and tuberculosis control) and immunization programs reversed. Financing for these programs could come from, inter alia, vetoing new funding for state universities, freezing new hiring of school teachers until redeployment possibilities are exhausted, and canceling the re-nationalization of two hospitals and upgrading of five others. In addition, preventing sharp increases in food prices on items such as rice and corn on which the poor spend higher proportions of their income remains essential. It may become necessary not only to import and distribute more rice than normal, but also to target the rice to the poor, including those who have newly become poor. Geographical targeting, income-based targeting of food coupons, as well as targeting by subsidizing the lower qualities of rice, are all options to be considered. A well targeted food distribution system could replace the current costly and poorly targeted system, and would facilitate the eventual replacement of the quantitative restriction on rice with a tariff. l Governnent measures of poverty use a higher income cutoff level than in many other countries, which may inflate Philippine poverty estimates somewhat in international comparisons.  viii Finally, since local governments are primarily responsible for administering social safety net programs, enhanced ability by the National Government to monitor and influence the effectiveness of such programs is needed on an urgent basis. C. AN AGENDA FOR SUSTAINABLE ECONOMIC RECOVERY The following sections outline the elements of a medium-term reform agenda. The priorities within this agenda are (i) to effectively tackle the problem of stress in the corporate and banking sectors, without which it is difficult to envisage a robust recovery; and (ii) to improve governance within public institutions. Progress on both these fronts is needed to strengthen investor confidence on a sustained basis, which in turn is a vital component of recovery given the Philippines' open economy and heavy reliance on trade and capital flows. Governance and the Reform Agenda A common element that pervades the reform agenda is the need for a strategy on improving governance. This report identifies several areas where improved governance in public institutions is critically needed. Examples include: even-handed implementation of tax laws; strengthening the framework for delbt resolution and governance in the public agencies charged with this task; enhancing financial and corporate transparency through more rigorous enforcement of existing regulations; improving the effectiveness of government programs to protect the poor; enabling more stringent enforcement and compliance with environmental regulations. More broadly, it is worth stressing the importance attached by investors to items such as improved law and order, adequate infrastructure, integrity in the process of awarding public contracts, and predictability in the incentive regime and judicial processes. A strong and reliable legal framework for investment and debt resolution will be of utmost importance in the medium term. Finally, the urgency of improving public governance has increased with the onset of the crisis, as investors and the public are likely to demand greater accountability for the use of public resources. President Estrada's administration has recognized the importance of good governance by listing as among its top priorities the goal of tackling graft and corruption. The credibility of this objective can be enhanced by taking corrective actions to address problems already identified, building a broader strategic agenda for strengthening public institutions, and developing benchmarks for monitoring of progress. Implementing reforms to strengthen the civil service will be an. essential element of this agenda. Reforming the Public Sector A stronger public sector in the Philippines is needed to fulfill a number of objectives, including: to place public finances on a sustainable debt path without sacrificing essential government activities and investment; to improve regulatory oversight and contingent liability management capacity, particularly as these involve private management of infrastructure; and to enhance administrative efficiency and integrity. While the problems may be deep-rooted, the crisis should provide an impetus  ix to tackle them with greater urgency. It is essential for the credibility of any fiscal stimulation that it be accompanied by measures to enable the budget to be brought back towards balance once the need for fiscal expansion has passed. Priorities in this respect include: (i) implementing the objectives of the "Streamlining the Bureaucracy" bill submitted to the previous Congress, which have bcgome more urgent as the personnel bill has consumed a progressively larger share of NG expenditure; (ii) strengthening national expenditure management in the pursuit of greater allocative and operational efficiency, particularly through the introduction of a medium-term expenditure framework that tightens the linkage between planning, programming and budgeting; (iii) improving revenue performance by strengthening tax administration on a sustained basis, streamlining tax incentives and privileges and reforming taxation of financial instruments; (iv) reassessing the scope of decentralization in view of the actual performance of local governments (which requires improved monitoring capacity), and revising the Internal Revenue Allotment (IRA) formula which governs transfers to local governments with an objective to improve its equity, incentives for local revenue mobilization, and fiscal sustainability; (v) enhancing transparency and accountability at all levels of government; and (vi) institutionalizing mechanisms to monitor the poverty impact of government programs. The search for efficiency gains also needs to be pursued at the sectoral level. Most important from a fiscal perspective is the successful restructuring and privatization of the National Power Corporation, whose foreign debt and contingent liabilities constitute a substantial fiscal burden. But opportunities for enhancing efficiency also exist in the roads, rail, ports, water and food sectors where there is scope for greater private participation and reforming existing public management and financing approaches. Corporate and Banking Reform Priorities A strong private-led economic recovery is unlikely to occur in an environment of high or rising financial stress, since firms' appetite towards new investment would remain diminished and banks would remain reluctant to expand lending beyond their core clients. As a corollary, expediting the resolution of financial stress remains a prerequisite for sustainable recovery. In the Philippine context, a fiscal stimulus may be able to limit the severity of the current downturn, but it cannot substitute for a well-functioning bank and corporate restructuring framework that facilitates vigorous private investment-since investors recognize that a heavy public debt burden limits the scope for fiscal stimulus on a sustained basis. Corporate Restructuring and Governance. Philippine corporations have withstood the regional crisis better than in neighboring countries, but both the number of distressed corporations and the severity of stress experienced has nonetheless increased sharply. Debt restructuring is usually enacted on an informal basis but this can fail for a variety of reasons, upon which time the distressed corporation may petition the Securities and Exchange Commission (SEC-which, in 1976, replaced the court system as the  x formal venue for resolving distressed corporate debt-for protection from its creditors. However, the manner in which cases are handled appears prejudicial against creditor (particularly secured creditor) interests and seldom leads to rehabilitation. Debt resolution is generally protracted, prompting both debtors and creditors to opt for alternative informal resolution mechanisms. And SEC's capacity to handle its increasing workload has been strained by the crisis as the backlog of cases has grown. The system for addressing corporate insolvency therefore needs a major overhaul. In the short term, given the heavy backlog of existing cases, there may be no alternative but to augment SEC's capacity. The authorities are considering adoption of a policy statement, which would guide the creation of a new set of rules and procedures for debt resolution which, inter alia, would enhance the role of creditors. The above framework could be made more credible by forming a high-level debt resolution committee (DRC) consisting of the SEC, members of the judiciary, experienced business leaders and international insolvency practitioners with the objective of developing a more predictable and efficient debt resolution framework, including rules on priority of claims and voting procedures applicable to different classes of claim holders. To enforce the new system of priority claims, the terms of the 1976 Presidential Decree transferring corporate insolvency jurisdiction to the SEC may need to be amended. Whatever the mechanism for strengthening the SEC, a revamped SEC cannot be allowed to become an obstacle to the transfer of corporate insolvency jurisdiction back to the courts. Any strengthening of the SEC should therefore be conducted in the context of a time-bound transition to a court administered system, and will need to be buttressed by increased focus on improving the SEC's technical capability and internal governance. The Philippines is one of very few courntries that relies on an administrative body to manage insolvency cases, and recent events have indicated the practical drawbacks encountered in such a system, implying that the adoption of a modern bankruptcy law (the existing bankruptcy law dates back to 1909) and the training of judges to implement the new law is of the utmost priority. Since building effective capacity of the courts is a substantial task which will take time, one means of expediting the shift to a court administrated system would be to create a special bankruptcy court with a small number of full-time judges. Disclosure standards within corporations also need to be strengthened and better enforced-as indeed proposed under the new SEC law submitted to Congress; the concentrated ownership structure and cross-holdings between banks and corporations makes improved disclosure especially important. Enabling creditors to determine the true condition of firmns through greater transparency would improve credit access in the medium term, particularly for smaller firms, and could reduce capital flow volatility. Access to credit by small and medium enterprises (SMEs), problematic even during periods of strong credit growth, appears to have deteriorated during the crisis (although preliminary findings from a sample of 200 firmis in late 1998 indicates that weakened demand for credit may have contributed more to the slowdown than tighter credit standards by banks). Improving the legal framework for secured creditors and  xi rectifying current abuses of their rights in SEC administered payments suspension cases offer an opportunity for enhancing SME credit access. Prudential Framework for Banking. Philippine banks have weathered the crisis better than in many neighboring countries, but the level and trend in NPLs confirms that the system remains under stress. The ability of the banking system to contribute strongly to the economic recovery will depend on careful attention to a strengthening of the prudential framework and the incentive environment. The authorities have initiated a significant banking reform program that includes: higher minimum capital and stricter provisioning requirements; stricter disclosure requirements; tighter restrictions on bank licensing; intensified supervision and monitoring; explicit rules establishing a graduated response to capital shortfalls; enhanced legal authority for the central bank (BSP) to close insolvent institutions and the Philippine Deposit Insurance Corporation (PDIC) to resolve closed banks more promptly; stronger enforcement of existing rules backed by tougher penalties for noncompliance; incentives for foreign investment in troubled banks; and measures to reduce intermediation costs and regulatory arbitrage. In addition, the Government has decided to strengthen the Philippines National Bank (PNB)-the second largest bank in the country which among the major banks has suffered disproportionately from the crisis-and sell its controlling interest to a strategic private investor, and has enlisted specialized advisors to facilitate this process. Recent and prospective increases in minimum capital and provisioning requirements, coupled with rising financial stress, has prompted a number of bank mergers, and further consolidation appears likely to continue. This is desirable given the large number of banks in the system and the strain this poses for effective supervision. There is nonetheless no room for complacency as banking stress may not have peaked, the financial market recovery remains susceptible to external shocks, the capacity to resolve banking failures promptly is likely to be severely tested, and full implementation of the reform program will require persistence and political will. Congressional approval of the legislative agenda proposed to facilitate banking reforms is essential for the long- term soundness of the banking system. Strengthening the prudential and incentive framework for banking towards international best practice should therefore remain among the top policy priorities in the Philippines and will require ongoing attention. Because of its wider social implications, banking must be seen as a privilege, rather than a right. A reasoned decision by the prudential regulators to withdraw this privilege in the public interest must be adequately protected by the judicial system. Mobilizing Long-term Savings An important dimension of the recent crisis lies in the over-reliance on foreign as opposed to domestic financing, and excessive dependence by corporations on short-term bank loans as opposed to longer-term debt and equity finance. The prospect of reduced  xii access to foreign savings adds to the urgency of financing a larger proportion of investment domestically. Structural reforms to support the development of capital markets and promote long-tern domestic savings therefore appear warranted. Over the medium term, such reforrns would reduce pressures on the banking system, lengthen the maturity of debts, provide more equity-based financing for enterprises and reduce incentives for speculative investment in real estate. To promote undistorted capital market development, the Government is preparing reforms to streamline taxation of securities transactions, reduce tax arbitrage loopholes, and introduce a more level playing field across instruments and institutions. Institutional reform priorities to complement such tax policy include: increased information disclosure by issuers of debt and equity instruments; sound implementation of self-regulated organization (SRO) status for the Philippine Stock Exchange; increased competition in underwriting of securities; gradual lengthening of the benchmark yield curve; and establishing independent credit rating agencies. Well-functioning contractual savings institutions and more efficient housing finance can contribute importantly to capital market development, as well as fiscal sustainability and labor market flexibility. Both major public pension plans are gradually drifting towards pay-as-you-go systems, while private occupational plans are also characterized by unfunded or under-funded pension liabilities. Hence a rationalization of pension plans, strengthening prudential regulation and supervision of contractual savings institutions, and improved enforcement of existing contribution requirements is needed. Improving investment strategies within the public pension systems to assure sound, liquid investments that earn market rates of return can improve actuarial viability and also boost development of the domestic capital market. The costs and contingent liabilities associated with government support for the housing sector are significant. The Government is developing a program of reforms that aims to: provide a better framework for mortgage loan origination, underwriting, servicing, enforcement and securitization; increase transparency and efficiency in housing subsidies; resolve non-performing assets; improve asset-liability management and institutional strengthening; and strengthen policy formulation capacity. The ultimate goal is to achieve a higher proportion and volume of privately funded low- to middle- income housing loans, reduced delinquencies on mortgage lending, greater liquidity in housing markets, and improved access to shelter for Filipino families. Sustaining Export Performance and Competitiveness In a reversal of recent economic history, Philippine export growth has outpaced that of its neighbors since 1995; and in 1998, Philippine exports grew by 17 percent while all its neighbors recorded negative growth. The favorable relative performance reflects several factors: (i) a manufactured export structure that is heavily weighted towards high technology activities-84 percent of export value growth in 1991-97 came from electronics; (ii) the main electronic export, semiconductors, is the fastest growing product in world trade. The semiconductors made in the Philippines (microprocessors and  xiii custom made chips) have not suffered the recent price falls of more standardized products like the DRAM chips made by Korea; (iii) multinationals dominate export activity, and foreign direct investment (FDI) in electronics has grown strongly, including in 1998, facilitated by the growing importance of the special economic zones (ecozones). These trends suggest a strong base for future export growth, but there are grounds for caution. The high dependence on one activity to drive national exports is risky, however dynamic that activity. Any slackening of FDI or a technological shift that affects costs or productivity in the Philippines could be disastrous; the very fact that the activity is so dynamic and globalized increases the risk, with skill and technical requirements changing constantly. Moreover, other Philippine exports have performed poorly. Consumer goods exports declined between 1996 and 1998 reflecting weaknesses in most major consumer commodities-garments, footwear, toys and leather goods. The recent performance of garment exports in non-quota markets, which face the most intense competition from lower-wage countries, has been particularly weak. The most important resource-based export, processed foods, shows weak and cyclical growth performance. It is not possible to give an unequivocal response to the question of whether the boom in semiconductor exports is temporary or sustainable. It is not obvious why there has been a shift in multinational sourcing to the Philippines away from traditional centers like Malaysia. If based on genuine competitive advantages like the Philippines' less expensive and plentiful technical labor, the shift is sustainable-provided the human capital base upgrades in line with technological needs. If not, the sourcing simply reflects the timing of new investments, and the boom may fade as new plants reach full capacity. The rapidly changing world market implies that government policies are best directed towards strengthening fundamentals such as improving the quality of basic education and raising the school cycle towards international norms. The relevance of training facilities geared towards the high-tech technical and management skills needed by employers also needs upgrading. Adhering to the established path of trade reform in nonagricultural goods would add to efficiencies in integrating trade, from which the Philippines is likely to benefit. Faster reductions in agricultural protection, which remains high, would reduce the price of basic food commodities and improve the competitiveness of food processing. An assessment of the major barriers to competition and entry-both formal and informal-also appears warranted. It is imperative for the Philippines to strengthen its competitiveness in labor- intensive export activities other than electronics. Not only is it necessary to diversify the export base to reduce the risk inherent in high product concentration, it is inappropriate for labor-intensive exports to lose their competitiveness. The garment industry, for example, is falling behind relative to both higher and lower wage competitors, and needs to upgrade its product range and quality. Strategies aimed at redressing skill, technology and marketing weaknesses in a range of manufacturing activities are warranted. Local technological effort is low particularly in the private sector, which will constrain competitiveness as wages rise and more complex activities are undertaken. R&D is needed to use new technologies effectively, to move up the value chain from assembly  xiv into design and manufacturing, and to promote the growth and competitiveness of local suppliers. There are institutional weaknesses in the major support institutions and insufficient efforts to benchmark and raise enterprise level productivity. The Government is aware of these needs and deficiencies, and has mounted a comprehensive response-but much of this remains to be implemented. Safeguarding the Environment The Philippines faces two broad categories of environmental challenges. The first is to reduce the negative public health, ecological and aesthetic effects associated with industrial and domestic air and water pollution. The second is to reverse the rate of natural resource degradation associated with unsustainable exploitation and conversion of forest land and other biologically sensitive areas for agricultural, industrial, infrastructure and settlement purposes. While the economic crisis may temporarily ease urban pollution levels, reduced resources within firms for investment in environmental protection and compliance with existing regulations, and reduced budgets for public agencies to develop, monitor and enforce environmental priorities represent potentially serious consequences of the crisis. A prolonged economic downturn would exacerbate degradation in the countryside through increased natural resource extraction as alternative means of livelihood diminish. The primary environmental challenge facing the nation is to translate laudable policy intent into tangible achievements on the ground. This will require a multi-faceted approach involving the evolution and refinement of the legislative and regulatory framework; use of market based mechanisms to encourage private sector investment in environmental protection; greater reliance on communities in the formulation and implementation of local level environmental initiatives; and the establishment of a more effective system of environmental governance, compliance and enforcement. While the Department of Environment and Natural Resources (DENR) should continue to take the lead in framing policies and overseeing compliance, local governments need to be made more responsible for implementation. Sectoral governnent agencies also need to become more accountable for environmental protection in their respective sectors. This applies particularly to energy and transport, while explicit programLs to address the public health impact of environmental degradation are also needed.  xv INTRODUCTION The objectives of this report are two-fold: to provide an assessment of the economic, financial and social impact of the regional crisis on the Philippines; and to assist the Government in developing a strategic agenda to promote a sustainable economic recovery in the medium term. The first chapter assesses the economic impact of the regional crisis, distinguishes special features in the Philippines that limited the severity of the crisis relative to neighboring economies, discusses the policy priorities for recovery and sustained growth, and develops a medium-term economic scenario with attendant financing requirements. The following two chapters address reform issues within the corporate and financial sectors, both of which are central to the resolution of the crisis. Chapter 2 provides an overview of the conditions facing the corporate sector and the nature of adjustments in firm behavior in response to the crisis. It then assesses the framework for debt restructuring and rehabilitation of distressed companies, outlining the priorities for improvement. The chapter also addresses the requirements for improving corporate governance and transparency, arguing that these would have beneficial impacts on credit access particularly for small and medium enterprises. The following chapter on the financial sector begins by reviewing the nature of stress in the banking system and the content of the reform program initiated. It emphasizes the importance of implementation particularly in buttressing the prudential framework and developing a credible environment for failure resolution. The remainder of Chapter 3 provides an overview of the inter-related issues of capital market development and reforms in the contractual savings system and in housing finance, and concludes by assessing the issues of credit access for rural and micro enterprises. Chapter 4 examines the factors underlying the Philippines' extraordinary recent export performance and the sustainability of this performance. After examining the positive and negative aspects of structural competitiveness, it concludes by reviewing the institutional and policy measures needed to improve export performance, particularly among labor intensive consumer goods, which have not participated in the electronics export boom, and indeed have weakened relative to the Philippines' major competitors. The final two chapters address issues of social and environmental protection. Chapter 5 reviews trends in poverty and inequality prior to the crisis, assesses the impact of the crisis on the poor thus far, and outlines social protection priorities to deal with the possibility of greater hardship to come. Chapter 6 discusses the major urban and rural sources of environmental degradation, assesses the impact of the crisis on the environment, and examines implications and policy priorities in light of current institutional weaknesses.  1. THE CHALLENGE OF ECONOMIC RECOVERY A. RECENT DEVELOPMENTS: ON THE EDGE OF THE REGIONAL CRISIS 1.1 Following several years of increasing growth with GNP growth peaking in 1996 at about 7 percent, the Philippine economy stagnated in 1998, inflation and unemployment rose towards double digits, private investment fell sharply, the public sector deficit grew to over 3 percent of GNP, and the current account shifted into surplus from a deficit of 5 percent of GNP in 1997 reflecting both strong export growth and sharp import contraction. Table 1.1 provides a summary of key economic indicators; details are provided in the Statistical Annex. 1.2 Although Philippine financial markets experienced unprecedented volatility over the past two years, a stabilizing trend was evident since mid-September 1998 as equity prices recovered strongly from their six-year lows, the peso strengthened -and interest rates edged lower. Banking and corporate stress however continued to increase as indicated by the banking system's rising non-performing loan ratio through most of 1998. The stagnation in 1998 reflected the general malaise in the investment environment which has made private investors more cautious towards committing new resources and banks more reluctant to extend credit, particularly to new clients and small borrowers. The Domestic Economy 1.3 Government estimates for 1998 indicate a contraction of real GDP by 0.5 percent, although real GNP growth remained marginally positive at 0.1 percent on the strength of continued growth in net factor income. From the supply side (Table 1.2), agriculture and construction proved to be the weakest links-the former reflecting the impact of the worst drought in 30 years. Overall industrial production fell by 1.7 percent as its largest component, manufacturing, also recorded a decline of about one percent. The decline in seasonally adjusted quarter-over-quarter growth rates of industrial output in the second half of 1998 appears to indicate that this critical sector of the economy may not have bottomed out by end 1998. By contrast, the service sectors and utilities continued to display positive growth albeit slower than in 1997. Notwithstanding the sharply weakening economy, its performance does need to be evaluated in proper regional perspective, i.e. in the context of the much larger declines in 1998 economic activity ranging from 5-7 percent in Malaysia, Thailand and Korea, and 14 percent in Indonesia.  -2 - Table 1.1: Selected ]Economic Indicators, 1993-98 Nominal GNP (1998e) $68.2 bn Population (1998): 75.1 million GNP per capita (1998e): $908 1993 1994 1995 1996 1997 1998 (percentage change) Growth and Inflation Real GNP 2.1 5.3 5.5 6.9 5.3 0.1 (e) Real GDP 2.1 4.4 4.8 5.7 5.2 -0.5 (e) Inflation (CPI, period average)/a 7.6 9.0 8.1 8.4 6.0 9.7 Inflation (CPI, end period) 8.4 7.1 10.9 5.2 7.3 10.4 Unemployment Rate (percent) 9.3 9.5 9.5 8.6 8.7 10.1 (in percent of GNP) Saving and Investment National Saving 18.1 17.6 17.3 18.8 20.3 23.3 (e) Private 13.7 14.5 14.2 14.9 18.3 21.9 (e) Public 4.4 3.1 3.1 3.8 2.0 1.4 (e) Gross Investment 23.6 23.5 21.6 23.3 25.2 22.2 (e) Private 17.9 18.7 17.0 18.9 21.8 17.6 (e) Public 5.7 4.8 4.6 4.4 3.4 4.6 (e) Public Sector National Government Total Revenue 17.4 19.4 18.4 18.0 18.6 16.6 Tax Revenue 15.3 15.6 15.8 16.1 16.1 14.9 Total Expenditure 18.8 18.4 17.9 17.7 18.6 18.4 Balance/b -1.5 0.9 0.6 0.3 0.1 -1.8 Consolidated Public Sector Balance -2.2 -2.3 -1.4 -0.6 -1.4 -3.2 (e) Public Debt 127.4 109.4 109.7 96.3 91.5 National Government Debt 71.6 62.3 59.4 51.1 53.4 65.0 (end-year percentage change) Money and Credit M3 24.6 26.5 25.3 15.8 20.9 7.2 (Nov) Credit to Private Sector 37.6 28.2 43.5 51.0 28.7 0.8 (Nov) Commercial Bank Loans 32.2 25.4 35.8 51.9 26.5 -0.5 (Nov) (end-yearpercentage change; $ value) Balance of Payments Merchandise Exports 15.8 18.5 29.4 17.7 22.8 16.9 Merchandise Imports 21.2 21.2 23.7 20.8 14.0 -18.2 (Jan-Nov) (in percent of GNP) Trade Balance -11.2 -11.9 -11.7 -13.0 -12.9 -1.7 (Jan-Sept) Current Account Balance -5.5 -4.5 -4.3 -4.5 -5.0 +1.0 (Jan-Sept) International Reserves Gross Official Reserves 5.9 7.1 7.8 11.7 8.8 10.8 ($ billion) /c (in months of imports) 3.2 3.1 2.6 3.2 2.0 2.9 External Debt /d Total ($ billion) 35.5 38.7 39.4 41.9 45.4 46.4 (Sept) In percent of GNP 64.2 58.9 51.7 48.1 52.2 66.9 (e) Debt Service Ratio (percent) /f 23.5 20.2 15.8 12.2 11.5 11.1 (Jan-Oct) Exchange Rate (Pesos/$; period average) 27.1 26.4 25.7 26.2 29.5 40.9 Real Effective Exchange Rate 110.4 117.3 120.3 129.8 128.7 104A (Jan-Sept.) (1990=100) /g a. CPI is 1994-based for 1997-98, all other years are e. Estimate. 1988-based. f After rescheduling, as a percentage of current account b. Excluding central bank restructuring. receipts. c. Including gold. g. Period average. Increase indicates appreciation d. External debt reported by BSP. Source: GOP; IMF, WB staff estimates  - 3 - Table 1.2 Sectoral Breakdown of Growth (Percent Year on Year, at Constant 1985 Prices) Annual Quarterly 1998 1997 1998 QJ Q2 Q3 Q4 GNP 5.3 0.1 2.0 -0.3 0.0 -1.2 GDP 5.2 -0.5 1.6 -0.8 -0.7 -1.9 Agri, Fishery, Forestry 2.9 -6.6 -3.8 -11.5 -3.1 -7.8 Industry 6.1 -1.7 1.6 -0.2 -3.4 -4.4 Manufacturing 4.2 -1.1 2.0 -0.9 -1.5 -3.4 Construction 16.2 -8.1 -5.0 -1.8 -15.6 -10.0 Utilities 4.8 4.4 7.2 6.1 3.2 1.5 Services 5.5 3.5 4.5 3.6 2.7 3.3 Transp,Stor,Telecom 8.2 6.4 8.1 6.5 5.5 5.8 Trade 3.9 2.4 4.1 2.1 1.3 2.4 Finance 13.0 4.5 6.6 5.7 3.4 2.5 Real Estate 3.8 1.6 2.3 2.1 1.3 0.8 Source: GOP; 1998 Q4 figures are estimated. 1.4 On the demand side, personal Figure 1.1 Domestic Demand and Credit consumption expenditure rose by 3.5 percent, with households tending to Growth in Domestic Demand protect expenditure on basic (percent year on year, at constant 1985 prices) necessities while foregoing spending 20 - on durable and luxury goods. But this was countered by a 17 percent fall in 0 investment as corporations ran down their inventories and cut back on their 3 _ L purchase of durable equipment. The .30 Q 7 22 03 04 02 030 investment decline correlates closely 1 907 C9 nu po Go98 ver Q3 Q4 * , ,,E,B, Polval eW C-nsuption _ G - -rn et C_naumpti_ to the rapid deceleration of credit -T.t.1 expansion (Figure 1.1); bank credit Growth in Domestic Demand (percentyear on growth to the private sector was year) and Net Domestic Credit approximately zero in 1998, down (at constant exchange rate, percent year on year) from a peak of over 50 percent in 1996. The sharp decline in investment 452 8 4T/6~ ~ ~ ~ ~~~~6 and imports in late 1998 suggests 35% continued weakness in economic 304 activity in early 1999. 25h 61 2% 20% Ul/O~~~~~~0 -2