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O C C A S I O N A L   P A P E R     
Toward Sustainable and Rapid Growth
Recent Developments and the Agenda Ahead

M. Rodlauer, P. Loungani, V. Arora, C. Christofides, E. G. de la Piedra, P. Kongsamut, K. Kostial, V. Summers, and A. Vamvakidis

I   Overview and Background
Markus Rodlauer

1990–96: Reforms Bear Fruit
1997–99: Crisis Management
Remaining Challenges
II   Economic Growth
Piyabha Kongsamut and Athanasios Vamvakidis

Role of Policies and Institutions in Shaping Growth
Growth Performance During the Asian Crisis
Sources of Growth in the 1990s
Medium-Term Growth Outlook
III   Public Finance: Sustainable Fiscal Adjustment
Kristina Kostial and Victoria Summers

Fiscal Developments During the 1990s
Trends in National Government Revenues and Expenditures During
   the 1990s
Other Public Sector Entities
Fiscal Response to the Asian Crisis, 1997­99
Fiscal Sustainability and Medium-Term Outlook
Remaining Reform Agenda
IV   Monetary and Exchange Rate Policy
Vivek B. Arora

Early Experience: 1980–93
Years of Change: 1993–97
The Crisis and Its Aftermath: 1997–99
V   External Sector
Charalambos Christofides

Developments in the Balance of Payments and External Debt
External Competitiveness
Medium-Term Outlook and Issues
VI   Banking System Reform
Enrique G. de la Piedra

Philippine Banking System
Soundness of the Banking System
Financial Sector Reforms Prior to 1997
1998–99 Reform Program
Initial Results and Agenda for Further Reform
VII   Corporate Governance
Prakash Loungani

Shareholders' Rights
Creditor Rights and Debt Restructuring
Accounting, Disclosure, and Enforcement
Ownership and Control
VIII   Equity, Growth, and Economic Policies
Prakash Loungani

Trends in Equity
Impact of Growth and Economic Policies on Equity
II   1.   Trade Liberalization in the Philippines: Results from "Trend-Break" Tests
2.   Impact of Trade Liberalization on Growth
III   1.   Summary of the Tax System
2.   Illustrative Medium-Term Scenario
IV   1.   Analysis of Demand for Broad Money in the Philippines
V   1.   External Competitiveness: A Macroeconomic Balance Approach Applied to the Philippines
II   1.   Estimates of Potential Output for the Philippines, 2000–05
III   1.   Tax Reforms Since 1994
2.   Tax Incentives
3.   Military Expenditures: Developments in the 1990s and Outlook
4.   Electricity Sector and National Power Corporation
5.   Fiscal Stance, 1997–99
IV   1.   The Bangko Sentral ng Pilipinas
2.   Key Monetary Aggregates and Interest Rates
3.   Financial Obligations of the Bangko Sentral ng Pilipinas
V   1.   Electronics Exports--Rapid Growth
2.   Nondeliverable Forwards: Their Use in the Philippines
3.   External Data Issues
VI   1.   Structure of the Philippine Banking Sector
2.   Nonbank Financial Intermediaries
3.   Prudential Framework for the Banking System
4.   The Philippine National Bank
II   1.   Growth in the Philippines and ASEAN-3: Historical Average and Recent Performance
2.   GDP Growth by Subperiods
3.   Estimates of Total Factor Productivity Growth
4.   Structure of Output and Employment
5.   Economic Growth in the Crisis Countries
6.   Gross National Product by Expenditure and Industrial Origin at Constant 1985 Prices
7.   Gross National Product by Expenditure and Industrial Origin at Current Market Prices
8.   Gross Value Added in Manufacturing by Industry Group
9.   Production by Major Crops
10.   Investment and Saving
11.   Structural Breaks in Trade Shares, 1960–97
12.   Country Comparisons of the Determinants of Growth
III   1.   Consolidated Public Sector Balance
2.   Operations of the National Government
3.   National Government Revenues and Grants
4.   National Government Expenditures and Net Lending
5.   Operations of Social Security Institutions
6.   Local Government's Budgetary Operations
7.   Statement of Financial Operations of Major Monitored Public Corporations
8.   Functional Classification of National Government Expenditures
9.   Revenue Generation and Structure in the Asian-5
10.   Expenditure Structure in the Asian-5
11.   Changes in National Government Fiscal Balances
IV   1.   Summary of Monetary Accounts
2.   Selected Countries: Broad Money/GDP, 1998
3.   Selected Interest Rates
4.   The Bias Against Peso Intermediation
V   1.   Balance of Payments
2.   External Indicators
3.   Volume, Unit Prices, and Values of Principal Exports
4.   Composition of Imports, 1993–98
5.   Nonmerchandise Trade
6.   Direction of Trade
7.   International Reserves of the Banking System
8.   Total External Debt
9.   External Debt Service
VII   1.   Shareholders' Rights
2.   Creditors' Rights
3.   Suspension of Payments Cases Filed with Securities and Exchange Commission
4.   Rating on Accounting Standards
5.   Average Ownership of Ten Largest Nonfinancial Domestic Firms by Three Largest Shareholders
6.   Control of Publicly Traded Companies in East Asia
7.   Concentration of Family Control
8.   Means of Enhancing Control in East Asian Corporations
9.   Aspects of Corporate Relations with Banks
VIII   1.   Indicators of Poverty
2.   Decomposition of Poverty Incidence into Growth and Redistribution Components
3.   Regional Poverty Incidence and Regional Growth
Appendix Tables
II   2A1.   Results of Panel Growth Regressions
III   3A1.   Illustrative Medium-Term Fiscal Scenario
IV   4A1.   Augmented Dickey-Fuller Tests for a Unit Root, 1991–98
4A2.   Demand for Money, 1991–98
II   1.   Real GDP per Person
2.   GDP per Capita
3.   GDP Growth by Sector
4.   Exports and Imports
5.   Investment and Saving
III   1.   Public Sector Balance and National Government Balance
2.   National Government Wage Bill and Public Sector Employment
3.   National Government Expenditure in a Functional Breakdown
4.   Local Government Units
5.   Government-Owned and -Controlled Corporations
6.   Sustainability of National Government Primary Balances
7.   Public and National Government Debt
IV   1.   Money Demand
2.   Money and Credit
3.   Monetary Impact of Foreign Inflows
V   1.   Real Exchange Rate Measures
2.   Asian Exchange Rates
3.   Current Account and Real Exchange Rate
4.   Merchandise Trade Volume
5.   Goods and Services Trade Volume
6.   Asian Export Competitiveness
7.   Selected Export Components
VI   1.   Structure of the Banking System
2.   Deposit Liabilities and Loans of the Banking System
3.   Indicators of Financial Intermediation in the Philippines and Other Asian Countries
4.   Deposits in Commercial Banks' Foreign Currency Deposit Units
5.   Selected Asian Countries: Capital Adequacy Requirements
6.   Nonperforming Loans of the Banking System
VIII   1.   Poverty Incidence and Rural Share
2.   Income Inequality, 1994 and 1997
3.   Share of Education and Health Expenditures


I.  Overview and Background

Markus Rodlauer

The Philippines has received considerable attention in recent years as it "emerged" in the early 1990s from a long period of slow growth and economic imbalances, and then managed to escape the "Asian crisis" relatively unscathed. This suggests that the reforms under way since the late 1980s, and intensified in the 1990s, have paid off, and are continuing to bear fruit with the help of skillful crisis management through the recent turbulence. By the same token, the pressure of recent shocks has put the spotlight on the remaining structural weaknesses that need to be addressed for sustained rapid growth and development. The Philippines' recent experience may contain valuable lessons for emerging economies' efforts at crisis prevention and crisis management, as well as for the country's own policy choices at the threshold of the next decade. This Occasional Paper describes this experience, focusing on the elements behind the relatively strong performance in recent years as well as the remaining reform agenda.

The economic situation in the Philippines deteriorated sharply in the 1980s. Roiled by economic policy mistakes, external shocks, natural disasters, and political instability, the economy suffered two setbacks that left real per capita income at the end of the decade about 7 percent lower than at the beginning. This performance contrasted sharply with that of other countries in the region, which resulted in the latter being called "Asian tiger" economies, while the Philippines was often labeled the "sick man of Asia."

The first half of the 1980s witnessed the collapse of the regime of Ferdinand Marcos and the growth strategy pursued since the mid-1970s. Although growth averaged more than 6 percent during 1975–80, it was accompanied by a large buildup of external debt, much of it to fund an expansion of the public sector. Easy credit encouraged excessive borrowing by private firms, and protectionist industrial and trade policies caused investment to increase mainly in import-substitution and nontradable activities, undermining competitiveness. Serious governance problems, often characterized as "crony capitalism," exacerbated the vulnerabilities. A series of external shocks in the early 1980s1 exposed these weaknesses and, compounded by domestic events,2 led to a major crisis with default on external obligations, widespread failure of domestic banks and corporations, and a deep recession.

While the economy remained on a rocky path during the second half of the 1980s, this period witnessed important changes that paved the way for fundamental improvement in the 1990s. After growth bounced back during 1986–89 under a new government, the recovery faltered in 1990–91 with a string of natural disasters,3 external shocks, and renewed political instability. The setback was compounded by policy slippages, including a sharp widening of the fiscal deficit, lax monetary policy, and real currency appreciation, leading to a sharp increase in the current account deficit, a jump in inflation, and a near-balance of payments crisis in 1991. The repeat "boom-and-bust" cycle also reflected structural constraints including high import dependence and a shallow domestic capital market. At the same time, however, the change in government in 1986 ushered in a new, democratic, and open political regime that, although initially plagued by instability, set the stage for the political stability achieved in the 1990s. The government of Corazon Aquino also initiated outward-looking and market-oriented economic reforms that, although implemented only partially and not without setbacks, signaled a shift in policy direction on which the comprehensive reforms of the 1990s would build.

1990–96: Reforms Bear Fruit

The 1990s have witnessed impressive economic progress in the Philippines, reflecting sound economic policies in a more favorable external environment and greater political stability. By 1996, growth had accelerated to about 6 percent; inflation was down to 5 percent; and the external position had strengthened, with rapid export growth and rising reserves. The new government led by President Fidel Ramos (1992–98) embraced a comprehensive reform strategy aimed at further opening up the economy, reducing macroeconomic imbalances, and addressing other structural rigidities. Under this program, supported since 1994 by an Extended Fund Facility (EFF) from the IMF, the fiscal deficit was brought down sharply, privatization was accelerated, and the central bank was recapitalized under a new statute. A number of important sectors were opened to new competition (including banking, telecommunications, domestic shipping, and the oil sector), and limits on foreign participation were liberalized in various sectors. Quantitative import restrictions were removed (except for rice), and the average import tariff is now about 10 percent, one-third the level of the mid-1980s.

Notwithstanding the progress made, some barriers to sustained rapid growth proved difficult to uproot, and the Philippines' arrival as a successful emerging market economy entailed new vulnerabilities. The lingering structural problems included low domestic savings; limited progress in addressing long-standing public sector issues such as weak tax collection and civil service and local government reforms; weaknesses in the banking sector; and the continued high incidence of poverty. Many of these problems reflected the legacy of the past as unequal income distribution, past heavy regulation of the economy, and the degradation of governance under the Marcos regime created powerful interest groups resisting the reform efforts designed to level the playing field. The acceleration of growth, investment, and capital inflows experienced in the mid-1990s masked these shortcomings, but also heightened the economy's vulnerability to the eventual shift in market sentiment. The de facto pegging of the Philippine peso to the U.S. dollar in late 1995 added to the risks by encouraging rapid growth of short-term capital inflows.

Thus, on the eve of the Asian crisis, the Philippine economy was vulnerable, albeit less so than the most heavily affected neighboring countries. By mid-1997, the peso had appreciated by more than 25 percent in real effective terms since 1993 (nearly 40 percent since 1990), and the external current account deficit had widened to more than 5 percent of GNP (with a trade deficit of about 13 percent). Large external borrowing in 1996, especially by banks, had raised foreign currency debt exposures, including on short-term debt which, at about $10 billion, about equaled the level of usable gross official reserves. Private sector credit had expanded rapidly during 1995–96, including a significant rise in credit to real estate and consumption. While these developments had increased the economy's vulnerability, the Philippines was less susceptible to a sudden downturn than most other East Asian economies. In particular, the period of rapid credit expansion and debt accumulation in the Philippines was much shorter than elsewhere, resulting in lower levels of corporate leverage; major banks were well capitalized; and the structural and political reforms under way since the mid-1980s had created a more open, market-oriented, and competitive system that was able to resist the type of systemic collapse witnessed elsewhere. Both government and the private sector had significant experience with crisis management, and a flexible policy response to the unfolding crisis was facilitated by the close policy dialogue under the existing arrangement with the IMF.

1997–99: Crisis Management

From early 1997, economic conditions deteriorated as the regional downturn interacted with the country's own vulnerabilities. A decline in capital inflows and a slowdown in manufacturing output combined with sharp falls in the stock market and mounting pressures on the peso. The authorities initially responded by tightening monetary policy and by intervention to maintain the de facto peg of the peso. When this stance became unsustainable in the aftermath of the float of the Thai baht, the peso was floated on July 11, accompanied by a strengthening of fiscal, monetary, and structural policies. The new program was supported by augmentation and extension of the EFF (scheduled to expire in mid-1997), followed by a new two-year Stand-By Arrangement in early 1998.

The authorities' strategy focused initially on stabilizing the situation through relatively tight monetary and fiscal policies; as stabilization took hold, the stance shifted gradually toward supporting recovery. The program also comprised a set of key structural reforms to underpin stabilization and medium-term growth prospects. Monetary policy during this period would "lean against" pressures in the exchange market by raising interest rates, without attempting aggressively to resist market forces. Likewise, the Bangko Sentral would intervene in the exchange market to provide liquidity and restore calm during periods of extreme volatility, but refrain from large-scale intervention to defend any particular level of the rate. As the peso began to stabilize during the second half of 1998, interest rates were brought down--cautiously at first, in view of the still unsettled external environment and the relatively high rate of inflation. The monetary stance became more fully supportive of recovery in early 1999, as the turnaround in the balance of payments was firmly established and inflationary pressures abated. Fiscal policy was also adapted gradually to the slowdown in output and the associated revenue shortfall: from a precrisis target for 1998 of a fiscal surplus of 1 percent of GNP, the program was revised several times to an eventual deficit target of 3 percent of GNP. Structural reforms under the program, in addition to completing the agenda of the Ramos administration (oil deregulation, tax reform, and continued trade liberalization), focused on strengthening the banking sector and improving tax administration, both key to the stabilization and medium-term growth objectives.

Financial markets remained volatile through late 1998, reflecting both external and domestic developments. Several waves of external shocks put further pressure on the peso and equity prices. The collapse of the Korean and Indonesian economies brought the peso to a low of PHLP46 per $1 in January 1998 (a 44 percent depreciation from mid-1997). After a brief recovery in early 1998, the deterioration in Japan coupled with uncertainties over the policies of the newly elected government of Joseph Estrada4caused a new downturn over the summer that culminated in the emerging market crisis in September5 (with the stock market index falling below 1,200, compared with the high of more than 3,400 in January 1997). Since then, financial markets have strengthened continually, with equity prices up twofold; peso appreciation and a large increase in official reserves; and interest rates declining to below precrisis levels.

Economic activity began to stall in the second half of 1997, followed by a slight recession in 1998. After growing by 5.2 percent in 1997,6 real GDP dropped by 0.5 percent in 1998, weighed down by a severe drought that reduced agricultural output by over 6 percent. Industry also declined (by 1.7 percent), while services remained relatively buoyant (growing by 3–5 percent). On the demand side, growth was supported by continued strong export growth (20 percent in volume terms), which was one of the key factors distinguishing the Philippines' adjustment experience from that of its neighbors. Private investment, however, fell sharply, and unemployment rose to more than 10 percent. Reflecting the impact of peso depreciation and a drought-related increase in food prices, inflation reached 10.4 percent by year's end. In the external accounts, 1998 witnessed a dramatic turnaround in the current account, to a surplus of nearly 2 percent of GNP, on the strength of continued export growth, while imports fell sharply.

Following the upturn in financial markets, the real economy also bottomed out in early 1999. Led by a recovery in agriculture, first-quarter real GDP grew by 1.2 percent, followed by 3.6 percent growth in the second quarter, as the recovery spread to other sectors. Thus, on balance, the Philippine economy has been able to weather the regional crisis better than most of its neighbors, reflecting more favorable starting conditions as well as the pragmatic implementation of sound economic policies. That this has been achieved during a period of political transition testifies to the resilience of the Philippine economy and a broad-based consensus for sound economic policies.

Remaining Challenges

While policies pursued over the past decade have had major positive results, events over the past two years have highlighted that much remains to be done. The task is not only to restore the momentum of growth and investor confidence of the mid-1990s, but also to sustain it through policies that prevent a return to the boom-and-bust cycles of the past while ensuring the Philippines' full and competitive participation in the global marketplace. Against this background, and considering the policy agenda into the next decade, two imperatives are: to deal with the still quite pervasive legacy of the past, such as low savings, widespread poverty, accommodation of rent-seeking activities, and a weak public sector; and to manage successfully the challenges of globalization, allowing the country to fully partake of the benefits of integration while minimizing the associated risks of excessive leverage, currency overvaluation, and sudden capital flow reversals. In particular, this agenda includes:

  • maintaining prudent macroeconomic policies, with emphasis on avoiding fundamental inconsistencies that risk disruptive shifts in capital flows;

  • raising domestic savings and investment from the current unsustainably low levels;

  • further leveling the playing field through domestic and external liberalization, as well as effective programs to assist the poor and to enhance the opportunities of the disadvantaged;

  • streamlining and strengthening the public sector--a traditional "Achilles' heel" of the economy;

  • further strengthening prudential, supervisory, and debt resolution frameworks in the financial and corporate sectors (including prudential-based management of foreign currency risk);

  • accelerating rural development through agricultural modernization and by encouraging the growth of small- and medium-sized enterprises in the countryside; and

  • improving further the investment climate, including by strengthening governance and "economic security."

In a wider sense, successful implementation of this agenda will need to be embedded in a continuous strengthening of Philippine democracy and its institutions, to overcome elements of stagnation such as a weak judicial system; corruption in public administration; concentration of control over economic resources, the media, and the political process; and rapid population growth.

The sections that follow review a range of issues that have arisen as the Philippines has progressed from a major crisis case in the 1980s to a successful emerging market in the 1990s. Section II examines the evolution of output growth and the elements that have contributed to its acceleration in the 1990s, as well as the remaining structural barriers to sustained rapid growth. Section III reviews fiscal developments and the various reforms that have been implemented to put the public finances on a sounder footing, and discusses the remaining weaknesses in public sector management that have been brought to the fore by the recent economic slowdown. Section IV considers the conduct of monetary policy, describing inter alia the evolution of the central bank from an institution with limited independence, a weak balance sheet, and underdeveloped instruments of monetary control to a modern, independent, and financially sound "Bangko Sentral." Section V describes external sector developments and prospects, reviewing the structural transformation that has occurred, and is still under way, in the external accounts; the section also evaluates external competitiveness from a variety of angles, and looks at the medium-term outlook and related policy issues. Section VI reviews the development of the banking sector in the Philippines, describing how it has "emerged" as an increasingly sophisticated market in the 1990s, while outlining the reform challenges that remain. Section VII surveys corporate governance in the Philippines, highlighting the need for progress in many areas, particularly reforming the framework for debt resolution and insolvency. A final section discusses social issues, in particular, the impact on poverty of accelerating growth in the 1990s.

1Including the second oil price shock, a hike in world interest rates, recession in industrialized countries, and the Latin American debt crisis.
2These included a financial scandal in 1981 and the assassination of Ninoy Aquino in 1983.
3Including a major earthquake, drought, and a volcanic disaster.
4Presidential and legislative elections were held in May 1998, and President Joseph Estrada, his government, and a new congress took office in July.
5Following the introduction of capital controls in Malaysia and Russia's default on part of its government debt.
6On a seasonally adjusted quarter-to-quarter basis, real GDP growth decelerated sharply in the second half of 1997 (to an annual rate of 1.4 percent).