Philippines. Real Sector. Growth slowed in the first half, then picked up in the third quarter.

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1 Philippines Real Sector Figure 1: GDP Growth Rates (%) -6 q-o-q annualized, seasonally adjusted y-o-y Growth slowed in the first half, then picked up in the third quarter. Economic growth slowed to 4.5% in the first quarter and 4% in the second quarter because of weakness in the agricultural sector, sluggish exports, and a tightening of fiscal policy. A drop in tourism-related income as a result of SARS also hurt. During the third quarter, however, growth increased to 4.4%, bringing the expansion for the first three quarters to 4.3% (Figure 1). The Government forecasts growth for all of 23 at % (Table 1). Table 1: GDP Growth and Projections (%) 1 NEDA, Press Release, October 23; NEDA Web site. 2 ADB, Asian Development Outlook 23 Update, October IMF, World Economic Outlook, October World Bank, East Asia Update Regional Overview, October Consensus Economics Inc., Asia Pacific Consensus Forecasts, November Official ADB IMF World Bank Consensus Economics Figure 2: Growth of GDP Expenditure Components (y-o-y, %) -3 Private Consumption Public Consumption Gross Domestic Investment Overseas remittances continue to support consumer spending. Domestic investment supported growth in the first quarter, increasing 17.4%. However, the investment was largely attributable to inventory accumulation, and in the second quarter domestic investment grew at a slower rate of 2.7% (Figure 2). Fixed investment grew just 3.5% in the first quarter, contracting 2% in the second because of a downturn in construction. In the third quarter, however, domestic investment rose 7.7%, with a surge in investment in machinery and equipment. Consumer spending, helped by an increase in remittances from overseas Filipinos, grew 5% in the three quarters to September. Export growth remained weak and government consumption contracted as fiscal policy tightened.

2 Figure 3: Sectoral GDP Growth (y-o-y, %) -2 Agriculture Construction Manufacturing Services Agriculture recovered in the third quarter. Although second-quarter growth was slightly affected by the SARS impact on foreign tourism and related industries, services helped to drive the economy in the first three quarters, expanding 5.6%. Manufacturing posted robust growth of 5.3% in the first quarter, but weakness in electronics exports brought it down to 4.6% in the second quarter (Figure 3). The sector remained soft in the third quarter, with growth trimmed further to 4.4%. Drought, caused by the El Nino phenomenon, and typhoons in the second quarter pulled down agricultural growth to 1.6% from 3% in the first quarter. Agriculture showed a strong recovery in the third quarter, expanding 5.5%. Construction fell in the first three quarters as public construction was cut back. Fiscal and Monetary Developments The budget deficit was within target for the first 1 months. Improved revenue collection and restrained spending enabled the Government to contain the budget deficit for the first 1 months to P163.9 billion, within the target. This was a welcome reversal from last year s fiscal slippage. However, third quarter overspending made the Government miss the deficit target for that period. In October, expenditure exceeded the target by 1%. But higher-than-expected revenue kept the deficit for the month within the target. Fiscal authorities are confident they can meet the planned full-year budget deficit of P22 billion, or 4.7% of GDP. Faced with substantial financing requirements for the deficit, the central government debt (including domestic and external debt) rose to P3.2 trillion by August from P2.8 trillion at end-22. The debt burden remains substantial at 71% of GDP, although much is medium or long term. Monetary policy was tightened, eased, then tightened again. The Bangko Sentral ng Pilipinas (BSP) tightened monetary policy in March to pre-empt inflationary risks arising from market concerns over the budget deficit, the Iraq war, and a weakening of the peso. The central bank increased bank liquidity reserves and, while rates were maintained, it removed its rate tiering system. This effectively lowered the yields on placements with the BSP. Monetary policy was eased midyear when the BSP re-established the tiering system and lowered 75

3 2 1-1 Figure 4: Short-Term Interest Rate, Real Bank Credit Growth, and Inflation Rate (%) -2 Three-Month Interbank Lending Rate, End of Period Growth in Real Bank Credit to Private Sector, End of Period (y-o-y) Inflation Rate (y-o-y) policy rates 25 bps. However, the unsuccessful mutiny by a small group of military officers in late July and the court decision ordering the suspension of the BSP governor in mid-august (although he remains in office pending appeal) jolted financial markets. This prompted the BSP to tighten monetary policy by again removing the tiering system in late August. Later political developments, including corruption allegations against the President s family and attempted removal of the chief justice of the Supreme Court, kept financial markets unsettled and reduced chances of monetary easing. Inflation is benign as a result of subdued domestic demand. The patchy economy and continued accumulation of bad debts by banks have hampered lending. Real credit growth was an anemic 2.2% in the first quarter and 1% in the second, even while interest rates remain relatively low. Subdued domestic demand and weak credit growth have helped to keep prices under control. Inflation edged up from 2.9% in the first quarter to 3.1% in the third (Figure 4). It inched higher to 3.3% in November as the peso weakened and petroleum prices rose. The BSP s inflation outlook for 23 is %, below its original target of %. Balance of Payments Figure 5: Growth of Merchandise Exports and Imports, Dollar Value (y-o-y, %) -3 Exports Imports Overseas remittances buoy the current account. Electronic products make up more than 6% of the country s exports, so weakness in the global IT industry depressed total exports, which grew a meager 1% in the first 1 months. In October, though, export growth picked up to 6.2%. Imports, meanwhile, rose 4.8% in the first nine months, spurred by increases in imports of raw materials and crude oil in the run-up to the Iraq war (Figure 5). This brought the nine-month trade deficit to $1.7 billion, three times the year-earlier gap. Still, a strong flow of remittances from overseas Filipinos left a current account surplus of $1.1 billion for the first seven months. Maturing loans helped cause capital account deficit. Weak investment inflows and large net repayment of maturing loans resulted in a net outflow of $2.1 billion in the capital and financial accounts in the first seven months, compared with a year-earlier net inflow of $54 million. Many foreign companies delayed expansion plans because of the slack global economy. Thus, foreign direct investment 76

4 totaled just $139 million in the first seven months, down from $76 million a year earlier. Portfolio investment yielded an inflow of $1 billion during the same period, down from $1.3 billion a year earlier, largely because of weak corporate earnings and increased investment in foreign securities by residents. Figure 6: International Reserves and External Debt ($ billion) 98Q1 98Q3 99Q1 99Q3 Q1 Q3 1Q1 1Q3 2Q1 2Q3 3Q1 3Q Gross International Reserves Total External Debt Short-Term External Debt Jun 1997 Figure 7: Exchange Rate Index, Weekly Average (last week of Jun 1997=1, $/Peso) 22 Jan Jan 2 12 Apr Nov 23 The balance of payments shifts into deficit. The balance of payments moved into a $239 million deficit in the seven months to July, from a year-earlier surplus of $1.1 billion. Gross international reserves rose from $16.2 billion at the start of the year to $16.8 billion in November, when the Government and central bank increased foreign-currency borrowings. The amount covers 4.7 months of imports of goods and services, and is 2.8 times the level of short-term external debt based on original maturity or 1.4 times based on residual maturity. Total external debt at mid-year was $56.1 billion, with shortterm external debt comprising 11.1%, or $6.24 billion (Figure 6). The peso has weakened in volatile trading. The peso has been volatile but overall weak in 23 (Figure 7). Early in the year, market concerns over the Iraq war and the budget deficit kept the currency soft against the dollar. Monetary tightening, seasonal inflows of remittances, and the better fiscal performance helped the peso recover from late March to early June, while downgrades in sovereign debt ratings eroded the gains. The July mutiny attempt started another run on the peso and further political uncertainties and the resignation of the finance secretary kept it weak. The currency depreciated 4% by late November from the start of the year. The BSP introduced measures such as limiting the tenor of forward contracts to reduce currency speculation and imposed sanctions against banks violating BSP foreign-exchange regulations. The peso depreciation, however, did allow the country to maintain its competitiveness, with the real effective exchange rate index showing a real depreciation of 8.3% on average during the first three quarters. Financial and Corporate Restructuring The NPL ratio improved to 14.5% by September. The NPL ratio began 23 at 15%, increased slightly through the first half, then improved to 14.5% in September. The BSP plans to introduce several measures to reduce risky lending, including tightening the rules 77

5 for lending to a bank s own directors, officers, and stockholders. The banking system remains healthy in terms of capital, with its risk weighted capital adequacy ratio 16.6% at end-22, well above the 8% BIS norm. Banks return on assets increased to.8% in June from.6% a year earlier. Only one SPV is registered so far. A Special Purpose Vehicle (SPV) law was enacted in January 23 to address the accumulation of banks nonperforming assets. Relying largely on private sector initiatives, the law aims to speed up disposal of nonperforming assets without directly using public funds or creating a state-owned asset management company. Instead, tax incentives and fee abatements will encourage banks to sell bad assets and attract investors to set up SPVs. A two-year window, which began in April, allows banks to transfer assets to privately funded independent SPVs. According to the central bank, domestic banks have indicated they are likely to transfer as much as 5% of their eligible nonperforming assets into SPVs. It had approved four certificates of eligibility to transfer such assets by late in the year. But the establishment of SPVs has been slow, with the SEC approving the registration of only one since the law was passed. The SEC moves to improve corporate governance. To improve corporate governance, the Securities and Exchange Commission (SEC) issued the Code of Corporate Governance. This code requires that financial statements of listed companies and other issuers of public securities be audited by an accredited external auditor. The SEC plans to extend this requirement to companies holding secondary franchises from the SEC, including brokers, dealers, and investment houses. Prospects and Policy Issues GDP growth in 24 is forecast at 4%. The Consensus Economics survey forecasts that GDP growth will be 3.7% in 23, against the Government prediction of %. For 24, the Consensus Economics survey puts growth at 4%. The outlook for Philippine exports of electronics goods is healthy, assuming the global recovery stays on track. Consumption will continue to be aided 78

6 by strong remittances from overseas Filipinos. And agricultural production is likely to recover after the drought and typhoons of this year. However, as national and local elections are scheduled for next May, politics will take center stage during the first half of 24. Policies concerning the economy and restructuring might have to take a back seat until the new Government is in place. Also, investors may take a wait-and-see attitude until the outcome of the elections is known. Fiscal credibility and continued tax reform are required. The authorities will have to look beyond limited short-term gains and focus on needed structural adjustments for fiscal sustainability. Reaching this year s fiscal targets would be a positive step toward improved fiscal credibility. More effort is required to reform the tax system. Broadening the narrow tax base is imperative because restraining public spending to meet fiscal targets can sacrifice important public services, and may be counterproductive over the long run. A bias toward revenue generation over spending restraints should be reflected in the mediumterm fiscal program, which targets a near-balanced budget by 29. Real credit expansion is needed to spur economic growth. Credit growth must accelerate if the economy is to move to a higher growth path. With the benign inflation environment, there may be room for further easing monetary policy. The SPV law is a positive step toward providing a framework to resolve the bad-debt problem, and to encourage banks to resume lending. In addition, the monetary authorities must closely supervise the financial system to prevent excessive risk taking. 79

7 Philippines: Selected ARIC Indicators Q1 Q2 Q3 Q4 1Q1 1Q2 1Q3 1Q4 2Q1 2Q2 2Q3 2Q4 3Q1 3Q2 3Q3 Output and Prices GDP Growth (%) Private Consumption Expenditure Growth (%) Public Consumption Expenditure Growth (%) Gross Domestic Investment Growth (%) Gross Fixed Investment Growth (%) Agricultural Sector Growth (%) Manufacturing Sector Growth (%) Construction Sector Growth (%) Services Sector Growth (%) Exports of Goods and Services Growth (%) Imports of Goods and Services Growth (%) Inflation Rate (%) Unemployment Rate (%) Monetary and Fiscal Accounts Growth of Broad Money, M2 (%) Three-Month Interbank Lending Rate (%) Growth in Real Bank Credit to Private Sector (%) NPL Ratio of the Financial System NPL Ratio of the Commercial Banking System Average Stock Price Index 3,53 2,591 1,792 2,17 1,584 1,347 1,212 1,882 1,575 1,487 1,399 1,582 1,435 1,3 1,65 1,35 1,326 1,13 1,44 1,32 1,113 1,263 Central Government Fiscal Balance as % of GDP Central Government Debt as % of GDP Government Expenditure on Education (% of Total) Government Expenditure on Health (% of Total) External Account, Debt, and Exchange Rates Growth of Merchandise Exports ($ fob, %) Growth of Merchandise Imports ($ cif, %) Current Account Balance as % of GDP Net Foreign Direct Investment ($ Billion) Net Portfolio Investment ($ Billion) Gross International Reserves ($ Billion) Total External Debt as % of GDP Short-Term Debt as % of Gross International Reserves Short-Term Debt as % of Total Debt Real Effective Exchange Rate (1995=1) Average Exchange Rate (Local Currency to $) Note: All growth rates are on a year-on-year basis.... = not available. 1 End of period. 2 Trade weighted using wholesale price index for trading partners and consumer price index for the home country. Sources: Data on output and prices, M2, real bank credit to private sector, nonperforming loan ratios of the financial and commercial banking system, central government fiscal balance, central government debt, government expenditure on education and health, merchandise epxorts and imports, current account balance, net foreign direct and portfolio investments, gross international reserves, and total and short-term external debts are from national sources. Data on interbank lending rate, average stock price index, and average exchange rate are from Bloomberg LP. Real effective exchange rates are based on REMU staff calculations.