## _cr04317

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---

### Executive Summary — I. Introduction
- President Arroyo won a new six-year term with 40 percent of the votes, a three point margin over the runner-up; her coalition secured the Vice Presidential post and majorities in both houses of Congress.
- The President announced a 10-point agenda including anti-poverty initiatives and a commitment to balance the budget.
- The new mandate provides an opportunity to move boldly on fiscal and structural reforms.

### II. Recent Developments
- Financial markets:
  - Recent stability since April after pre-election volatility; markets await concrete details of reform implementation.
- Growth and labor:
  - Q1 GDP growth: 6.4 percent (y/y).
  - Expected 2004 GDP growth for the year: 4.9 percent.
  - Unemployment rate: 13.7 percent in Q2, up from 12.2 percent a year ago.
- Inflation:
  - CPI inflation: 6.0 percent in July (y/y).
  - Authorities’ 2000-based CPI: 6.6 percent in July (y/y).
  - Average inflation first seven months of 2004: 4.3 percent, compared to 3.0 percent in 2003; target range is 4–5 percent.
- External sector and reserves:
  - Exports grew by 8½ percent in the first half of 2004 (y/y); 2003 full-year export growth was 2.9 percent.
  - Remittances increased by 2.6 percent (y/y) in the first half of 2004.
  - Planned 2004 public sector external commercial borrowing: $4 billion; almost two thirds has been raised to date.
  - BSP adjusted gross reserves: $14.7 billion as of end-June, or 113 percent of short-term debt by remaining maturity.
  - BSP unwound over half of a $0.7 billion oversold nondeliverable forwards (NDF) position accumulated in Q1.
- Fiscal:
  - National Government deficit (authorities’ definition) through June on course to meet 2004 target of 4.2 percent of GDP, compared to 4.6 percent of GDP in 2003.
  - Nonfinancial public sector deficit expected to remain at about 5¾ percent of GDP in 2004 due to increasing NPC losses and shrinking cash surpluses at public pension funds.
  - Nonfinancial public sector debt projected to remain at about 100 percent of GDP.
  - Domestic treasury bill rates have trended up in line with inflation.
  - 2004 budget performance benefited from Marcos wealth recovery proceeds amounting to 0.3 percent of GDP.
  - Staff adjusted debt statistics downward by about 5 percent to net out some intra-public sector claims.

### III. Outlook and Vulnerability
- Near-term risks:
  - Large external financing requirement is the primary near-term vulnerability.
  - Upside U.S. inflation or growth surprises could trigger sharper Fed tightening and global risk aversion with adverse effects for the Philippines.
  - Potential credit rating downgrades if reforms are not implemented decisively.
  - Further increases in oil prices could weaken growth and raise inflation.
- Medium-term prospects:
  - Growth prospects depend on the pace of reform.
  - Strong implementation of reforms would reduce the deficit, create room for infrastructure spending, and remove power supply risks.
  - Weak reform implementation would keep financing requirements and vulnerabilities high; growth could trend down to about 4 percent by the end of the decade (Table 6).
  - Per capita growth under weak reform scenario could be about 2 percent by end of decade.
  - Estimated 40 percent of the population have incomes below $2 a day.

### IV. Policy Discussions

- Monetary Policy
  - Core issue: How much extra inflation to tolerate from recent supply shocks.
  - Staff view:
    - Projected average inflation likely to rise above the authorities’ 4–5 percent target range in 2005.
    - There is a case for monetary tightening given rising world interest rates and likely upward pressure on inflation from indirect tax increases and power price adjustments.
    - Recommended that BSP announce ex ante how much breach of the 2005 inflation target it would tolerate due to supply shocks and to review the 2005 inflation forecast once markets react to the reform package.
  - Authorities’ view:
    - Holding interest rates steady given considerable slack in the economy and expectation of easing food prices.
    - Prefer to invoke escape clauses ex post if the target is missed rather than publish precise quantitative estimates ex ante.
  - BSP inflation-targeting escape clauses include:
    - (a) volatility in the prices of unprocessed food;
    - (b) volatility in the prices of oil products;
    - (c) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies; and
    - (d) natural factors affecting the major part of the economy.

- Fiscal Policy
  - Presidential commitment to balance the budget; if interpreted as eliminating the National Government deficit by 2009, this implies a fiscal adjustment of 4½ percentage points of GDP compared to the 2003 outturn.
  - Staff recommendation on timing and scale:
    - Staff argued deficit reduction should be front-loaded rather than linear over 2004-09.
    - Staff recommendation: reduce the nonfinancial public sector deficit by 2½ percentage points of GDP by 2005.
    - Linear alternative cited as insufficient: about ¾ percentage point of GDP each year during 2004-09.
    - If staff’s 2½ percentage point reduction were achieved: the 2009 deficit target would be easier to attain and the ratio of nonfinancial public sector debt to GDP would be placed on a clear downward path.
  - Revenue measures under consideration and realistic near-term outcome:
    - Three revenue measures with reasonable chances of congressional passage over the next six months:
      - Increasing alcohol and tobacco excises.
      - Increasing petroleum excises.
      - Introducing a telecom franchise tax.
    - Combined expected additional revenue on a full year basis: roughly P 60 billion (1.2 percent of GDP).
    - NPC petition to ERC in June to increase average generation tariff by P 1.87 per KwH:
      - If granted in full, would generate additional public sector revenue of about P 70 billion in 2005 (1.4 percent of GDP).
      - Uncertainty over whether such a large rate increase would be approved.
    - Some additional public sector revenue would be spent on higher interest obligations and restoring capital expenditure.
    - Authorities had yet to commit to a particular 2005 target; realistic reduction in the nonfinancial public sector deficit compared to 2003 suggested to be about 1 percentage point of GDP.
  - Other revenue options and staff assessment:
    - Options being considered: scaling back tax incentives; strengthening tax compliance; repealing nonstandard VAT exemptions and zero-ratings; introducing a gross income tax (GIT) with a sharp reduction in deductions; tax amnesty proposals.
    - Staff concerns:
      - GIT is ill-advised given uncertainty of revenue impact and potential distortions.
      - Restricting deductions to costs of goods sold would discriminate against industries with low costs-of-goods-sold and would require different tax rates or bases to ensure equity, undermining simplification.
      - Strong advice to resist new tax amnesties due to harmful effects on taxpayer compliance.
    - Staff view on VAT:
      - Higher VAT rate is an attractive revenue-raising option; current rate at 10 percent.
      - International evidence suggests raising the VAT rate would significantly increase tax revenues, even with low VAT efficiency.
      - Authorities concerned about burden on honest taxpayers and prefer concentrating on strengthening VAT administration and compliance.
  - Expenditure rationalization and pensions:
    - Civil service reform: eliminate redundant positions with a voluntary early retirement scheme; establish a comprehensive personnel information system.
    - Staff recommendation: contain wage bill growth by tilting future wage increases to most understaffed/underpaid positions.
    - Proposal under consideration: tighten restrictions on congressional allocations (currently about ½ percent of GDP).
    - Public pension reform:
      - Social Security System (SSS) long-run actuarial deficit expected to deplete assets by 2015; staff welcomed attempts to extend fund life by increasing contribution rates and cutting costs.
      - Government Service Insurance System (GSIS) facing long-run financial difficulties despite recent cash surpluses; concerns about sub-optimal asset management.

- Power Sector
  - Authorities considering power sector reforms.
  - If approved, the recent petition to significantly increase average generation tariffs would substantially restore sector financial health.
  - Approval of the Transco franchise bill by Congress is critical to promote investment.
  - Reducing regulatory uncertainty is essential to attract investors and ensure success of power sector reforms.
  - Power sector problems are contributing to the nonfinancial public sector deficit through increasing NPC losses.
  - NPC specifics:
    - Preliminary estimate: without a significant tariff increase, NPC’s total deficit will amount to at least P 60 billion in 2004 (1.2 percent of GDP).
    - NPC’s P 1.87 per KwH tariff petition would translate into an almost 20 percent increase in the average price paid by end-users in the Manila area.
    - Privatization plans: authorities intended to privatize 70 percent of NPC’s generation assets by end-2005; franchise bill for Transco pending since September 2002.

- Banking Sector
  - Asset quality problems in the banking system remain an important concern.
  - Current voluntary offloading of NPAs by banks needs stronger pressure to force recognition of latent losses and, if necessary, additional capital injections.
  - Key statistics and problems:
    - Nonperforming asset ratios remain around 25 percent.
    - Provision coverage ratios remain around 30 percent.
    - Weaknesses in accounting practices—particularly valuation of foreclosed assets (ROPOAs)—and loan classification deficiencies obscure actual capital adequacy.
    - After allowance for these factors, banking system capital adequacy fell well short of regulatory requirements.
  - Recommendations:
    - Strengthen legal protection for bank supervisors via actions by the new administration and Congress.
    - Enhance BSP and PDIC legal powers, including enabling them to write down banks’ shareholder capital.
    - Implement a thorough diagnosis of capital needs of individual banks.
    - Require viable but undercapitalized banks to present rehabilitation plans; intervene if plans are insufficient.
    - Continue policy favoring mergers and consolidation.
    - As last resort, an incentive-based public recapitalization scheme with safeguards to encourage private capital injections.
    - Implement a restructuring strategy and pass the Corporate Recovery Act to support corporate restructuring.
  - Recent regulatory/supervisory steps welcomed:
    - Amendments to PDIC Charter in July enhanced bank resolution framework.
    - Regulations issued to improve credit risk management, documentary requirements, and investor protection.
    - Establishment of the Financial Sector Forum in July 2004.

### V. Staff Appraisal — Key Policy Recommendations
- Implement fiscal and structural reforms promptly to reduce vulnerabilities and bolster market confidence.
- Reassess the 2005 inflation forecast once markets respond to the fiscal package; tighten monetary policy if inflation is expected to exceed what can be justified by first-round supply shocks.
- Front-load fiscal consolidation by saving the bulk of additional revenue measures when feasible to reduce medium-term deficits.
- Ensure high-quality revenue measures:
  - Avoid tax amnesties.
  - Scrutinize the proposed GIT.
  - Consider raising the VAT rate (currently 10 percent).
- Advance power sector reforms:
  - Approve tariff adjustments and the Transco franchise bill.
  - Reduce regulatory uncertainty to attract investment.
- Strengthen banking sector supervision and enforce recognition of NPAs; require capital injections as needed and implement a restructuring plan.
- Strengthen statistics and implement recommendations made in the data ROSC.

### Conclusion — Authorities' commitment and macroeconomic context
- Authorities recognize the importance of policy discipline and sustained reform initiatives; legislative priorities and details will be announced.
- Recent macroeconomic developments:
  - Financial market conditions came under increasing pressure in the first quarter of 2004; conditions stabilized following reform measures announced on July 26.
  - GDP growth: 6.4 percent in Q1 2004 (y/y).
  - Unemployment: 13.7 percent in Q2 2004.
  - Inflation accelerated to 6.0 percent (y/y, 1994-based CPI) in June 2004 from 3.1 percent at end-2003.
  - BSP raised liquidity reserve requirements earlier in the year but held policy rates steady.
  - Exports grew by 8½ percent through June 2004 (y/y).
  - Remittances increased by 2.6 percent (y/y) in the first half of 2004.
  - Gross reserves of the BSP were $16.2 billion at end-June 2004.
- Fiscal position and public debt:
  - Through June 2004, the National Government deficit (authorities definition) was on course to meet the 2004 target of 4.2 percent of GDP, compared to 4.6 percent of GDP in 2003.
  - The nonfinancial public sector deficit is expected to remain at about 5¾ percent of GDP in 2004.
  - Nonfinancial public sector debt is projected to remain above 100 percent of GDP.
- IMF staff projections (August 2004):
  - GDP growth: 2004 projection 4.9 percent; 2005 projection 4.5 percent.
  - CPI inflation (average): 2004 projection 5.0 percent; 2005 projection 6.2 percent.

### Selected economic indicators (2000–2005) — key figures
- GDP growth (in percent change): 2000: 4.4; 2001: 1.8; 2002: 4.3; 2003: 4.7; 2004: 4.9; 2005: 4.5.
- CPI inflation (average, in percent): 2000: 4.4; 2001: 6.1; 2002: 3.0; 2003: 3.0; 2004: 5.0; 2005: 6.2.
- National government balance (in percent of GDP, IMF definition): 2000: -4.5; 2001: -4.6; 2002: -5.6; 2003: -5.0; 2004: -4.4; 2005: -3.9.
- Nonfinancial public sector balance (in percent of GDP): 2000: -4.7; 2001: -4.8; 2002: -5.7; 2003: -5.8; 2004: -5.7; 2005: -4.8.
- Revenue and grants (in percent of GDP): 2001: 23.0; 2002: 20.9; 2003: 20.9; 2004: 21.1; 2005: 22.3.
- Expenditure (in percent of GDP): 2001: 27.8; 2002: 26.5; 2003: 26.7; 2004: 26.8; 2005: 27.0.
- Broad money (M3, in percent change): 2000: 4.6; 2001: 6.8; 2002: 9.5; 2003: 3.3; 2004: 6.4.
- Credit to the private sector (net, in percent change): 2000: 8.1; 2001: -3.0; 2002: 1.2; 2003: 1.8; 2004: 4.2.
- Interest rate (91-day Treasury bill, end period, in percent): 2000: 12.9; 2001: 8.9; 2002: 5.2; 2003: 6.5; 2004: 7.4 (auction rate as of August 30, 2004).
- Trade balance (in percent of GDP): 2000: 5.0; 2001: -1.0; 2002: 0.5; 2003: -1.0; 2004: -2.2; 2005: -2.4.
- Current account balance (in percent of GDP): 2000: 8.2; 2001: 1.9; 2002: 5.7; 2003: 4.9; 2004: 2.8; 2005: 2.0.
- Gross international reserves (in billions of U.S. dollars): 2000: 15.0; 2001: 15.6; 2002: 16.2; 2003: 16.9; 2004: 16.0 (as of end-July 2004).
- Adjusted reserves (in billions of U.S. dollars): 2000: 13.4; 2001: 13.2; 2002: 14.3; 2003: 14.7; 2004: 14.4.
- Adjusted reserves (in percent of short-term liabilities): 2000: 128.1; 2001: 114.3; 2002: 123.9; 2003: 126.9.

*Source: Executive Summary (IMF staff report) — _cr04317.*

### Executive Summary ......................................................................................................

### Executive Summary

### I. Introduction
- President Arroyo won a new six-year term with 40 percent of the votes, a three point margin over the runner-up; her coalition secured the Vice Presidential post and majorities in both houses of Congress.
- The President announced a 10-point agenda including anti-poverty initiatives and a commitment to balance the budget.
- The new mandate provides an opportunity to move boldly on fiscal and structural reforms.

### II. Recent Developments
- Financial markets: Recent stability since April after pre-election volatility; markets await concrete details of reform implementation.
- Growth and labor:
  - Q1 GDP growth: 6.4 percent (y/y).
  - Expected 2004 GDP growth for the year: 4.9 percent.
  - Unemployment rate: 13.7 percent in Q2, up from 12.2 percent a year ago.
- Inflation:
  - CPI inflation: 6.0 percent in July (y/y).
  - Authorities’ 2000-based CPI: 6.6 percent in July (y/y).
  - Average inflation first seven months of 2004: 4.3 percent, compared to 3.0 percent in 2003; target range is 4–5 percent.
- External sector and reserves:
  - Exports grew by 8½ percent in the first half of 2004 (y/y); 2003 full-year export growth was 2.9 percent.
  - Remittances increased by 2.6 percent (y/y) in the first half of 2004.
  - Planned 2004 public sector external commercial borrowing: $4 billion; almost two thirds has been raised to date.
  - BSP adjusted gross reserves: $14.7 billion as of end-June, or 113 percent of short-term debt by remaining maturity.
  - BSP unwound over half of a $0.7 billion oversold nondeliverable forwards (NDF) position accumulated in Q1.
- Fiscal:
  - National Government deficit (authorities’ definition) through June on course to meet 2004 target of 4.2 percent of GDP, compared to 4.6 percent of GDP in 2003.
  - Nonfinancial public sector deficit expected to remain at about 5¾ percent of GDP in 2004 due to increasing NPC losses and shrinking cash surpluses at public pension funds.
  - Nonfinancial public sector debt projected to remain at about 100 percent of GDP.
  - Domestic treasury bill rates have trended up in line with inflation.
  - 2004 budget performance benefited from Marcos wealth recovery proceeds amounting to 0.3 percent of GDP.
  - Staff adjusted debt statistics downward by about 5 percent to net out some intra-public sector claims.

### III. Outlook and Vulnerability
- Near-term risks:
  - Large external financing requirement is the primary near-term vulnerability.
  - Upside U.S. inflation or growth surprises could trigger sharper Fed tightening and global risk aversion with adverse effects for the Philippines.
  - Potential credit rating downgrades if reforms are not implemented decisively.
  - Further increases in oil prices could weaken growth and raise inflation.
- Medium-term prospects:
  - Growth prospects depend on the pace of reform.
  - Strong implementation of reforms would reduce the deficit, create room for infrastructure spending, and remove power supply risks.
  - Weak reform implementation would keep financing requirements and vulnerabilities high; growth could trend down to about 4 percent by the end of the decade (Table 6).
  - Per capita growth under weak reform scenario could be about 2 percent by end of decade.
  - Estimated 40 percent of the population have incomes below $2 a day.

### IV. Policy Discussions

#### A. Monetary Policy
- Core issue: How much extra inflation to tolerate from recent supply shocks.
- Staff view:
  - Projected average inflation likely to rise above the authorities’ 4–5 percent target range in 2005.
  - There is a case for monetary tightening given rising world interest rates and likely upward pressure on inflation from indirect tax increases and power price adjustments.
  - Recommended that BSP announce ex ante how much breach of the 2005 inflation target it would tolerate due to supply shocks and to review the 2005 inflation forecast once markets react to the reform package.
- Authorities’ view:
  - Holding interest rates steady given considerable slack in the economy and expectation of easing food prices.
  - Prefer to invoke escape clauses ex post if the target is missed rather than publish precise quantitative estimates ex ante.
- BSP inflation-targeting escape clauses include:
  - (a) volatility in the prices of unprocessed food;
  - (b) volatility in the prices of oil products;
  - (c) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies; and
  - (d) natural factors affecting the major part of the economy.

#### B. Fiscal Policy
- Presidential commitment to balance the budget; if interpreted as eliminating the National Government deficit by 2009, this implies a fiscal adjustment of 4½ percentage points of GDP compared to the 2003 outturn.
- Staff recommendation on revenue measures:
  - Authorities are formulating a significant package of tax measures.
  - Staff argued the bulk of additional revenues should be saved to front-load medium-term deficit reduction, boost market confidence, and exploit greater potential to enact tax measures early in the new administration.
  - Authorities judged a large initial deficit reduction to be politically infeasible.
- Quality of revenue measures:
  - Concern over the proposed gross income tax (GIT) because it may introduce significant distortions and has uncertain revenue impact.
  - Staff urged resistance to proposals for new tax amnesties due to harmful effects on taxpayer compliance.
  - Staff recommended considering an increase in the VAT rate, noting the current VAT rate is low by international standards.

#### C. Power Sector
- Authorities considering power sector reforms.
- If approved, the recent petition to significantly increase average generation tariffs would substantially restore sector financial health.
- Approval of the Transco franchise bill by Congress is critical to promote investment.
- Reducing regulatory uncertainty is essential to attract investors and ensure success of power sector reforms.
- Power sector problems are contributing to the nonfinancial public sector deficit through increasing NPC losses.

#### D. Banking Sector
- Asset quality problems in the banking system remain an important concern.
- Current voluntary offloading of NPAs by banks needs stronger pressure to force recognition of latent losses and, if necessary, additional capital injections.
- Recommendations:
  - Strengthen legal protection for bank supervisors via actions by the new administration and Congress.
  - Implement a comprehensive restructuring strategy for the banking sector.

### V. Staff Appraisal — Key Policy Recommendations
- Implement fiscal and structural reforms promptly to reduce vulnerabilities and bolster market confidence.
- Reassess the 2005 inflation forecast once markets respond to the fiscal package; tighten monetary policy if inflation is expected to exceed what can be justified by first-round supply shocks.
- Front-load fiscal consolidation by saving the bulk of additional revenue measures when feasible to reduce medium-term deficits.
- Ensure high-quality revenue measures: avoid tax amnesties, scrutinize the proposed GIT, and consider raising the VAT rate.
- Advance power sector reforms: approve tariff adjustments and the Transco franchise bill; reduce regulatory uncertainty to attract investment.
- Strengthen banking sector supervision and enforce recognition of NPAs; require capital injections as needed and implement a restructuring plan.

*Source: Executive Summary (IMF staff report).*

### 14.      While the authorities had yet

### 14.      While the authorities had yet

### Fiscal adjustment: timing and scale
- Staff argued deficit reduction should be front-loaded rather than linear over 2004-09.
- Staff recommendation: reduce the nonfinancial public sector deficit by 2½ percentage points of GDP by 2005.
- Linear alternative cited as insufficient: about ¾ percentage point of GDP each year during 2004-09.
- Rationale for front-loading:
  - Markets require strong initial evidence of the authorities' ability to tackle the fiscal problem.
  - Fiscal measures are likely to be easiest in the opening period of the new administration.
- If staff’s 2½ percentage point reduction were achieved:
  - The 2009 deficit target would be easier to attain.
  - The ratio of nonfinancial public sector debt to GDP would be placed on a clear downward path.
- If fiscal adjustment flags (weak reform scenario shown in Table 6), debt would decline more slowly.

### Revenue measures under consideration and realistic near-term outcome
- Authorities considered three revenue measures with reasonable chances of congressional passage over the next six months:
  - Increasing alcohol and tobacco excises.
  - Increasing petroleum excises.
  - Introducing a telecom franchise tax.
- Combined expected additional revenue on a full year basis: roughly P 60 billion (1.2 percent of GDP).
- NPC petition to ERC in June to increase average generation tariff by P 1.87 per KwH:
  - If granted in full, would generate additional public sector revenue of about P 70 billion in 2005 (1.4 percent of GDP).
  - Uncertainty noted over whether such a large rate increase would be approved.
- Some additional public sector revenue would be spent on higher interest obligations and restoring capital expenditure.
- Authorities had yet to commit to a particular 2005 target; realistic reduction in the nonfinancial public sector deficit compared to 2003 suggested to be about 1 percentage point of GDP.

### Other revenue options and staff assessment
- Options being considered:
  - Scaling back tax incentives.
  - Strengthening tax compliance.
  - Repealing nonstandard VAT exemptions and zero-ratings.
  - Introducing a gross income tax (GIT) with a sharp reduction in deductions in exchange for a lower tax rate (possible limitation of deductions to direct costs of goods sold).
  - Tax amnesty proposals to bring evaders into the tax net.
- Staff concerns:
  - GIT is ill-advised given uncertainty of revenue impact and potential distortions.
  - Restricting deductions to costs of goods sold would discriminate against industries with low costs-of-goods-sold and would require different tax rates or bases to ensure equity, undermining simplification.
  - Under a GIT, tax officials would still have discretion; taxpayers could disguise non-deductible costs as deductible.
  - Strong advice to resist new tax amnesties due to likely harm to future compliance.
- Staff view on VAT:
  - Higher VAT rate is an attractive revenue-raising option; current rate at 10 percent.
  - International evidence suggests raising the VAT rate would significantly increase tax revenues, even with low VAT efficiency.
  - Authorities concerned about burden on honest taxpayers and prefer concentrating on strengthening VAT administration and compliance.

### Expenditure rationalization and pensions
- Authorities plan to rationalize expenditure through civil service reform:
  - Plan to eliminate redundant positions with a voluntary early retirement scheme.
  - Establishment of a comprehensive personnel information system to facilitate reform.
  - Staff recommendation: contain wage bill growth by tilting future wage increases to most understaffed/underpaid positions.
- Proposal under consideration: tighten restrictions on congressional allocations (currently about ½ percent of GDP) to better focus funds on high-priority areas.
- Public pension reform:
  - Social Security System (SSS) facing long-run actuarial deficit expected to deplete assets by 2015; staff welcomed attempts to extend fund life by increasing contribution rates and cutting costs.
  - Government Service Insurance System (GSIS) facing long-run financial difficulties despite recent cash surpluses; concerns about sub-optimal asset management with all assets invested domestically and poorly-monitored loans to employees.
  - Staff supported professionalizing asset management and expressed concerns about GSIS plans to expand policy lending.

### Power sector: tariffs, privatization, and investment
- Large unfinished agenda for power sector reform; EPIRA (2001) implementation has been difficult.
- NPC unable to cover costs due to populist influences on tariff setting and regulatory uncertainty.
- Preliminary estimate: without a significant tariff increase, NPC’s total deficit will amount to at least P 60 billion in 2004 (1.2 percent of GDP).
- NPC’s P 1.87 per KwH tariff petition:
  - Would translate into an almost 20 percent increase in the average price paid by end-users in the Manila area.
  - Authorities concerned about consumer backlash and adverse effect on industrial competitiveness and FDI.
  - Consideration of better targeting life-line tariffs and time-of-use pricing to reduce industrial impact.
  - Staff noted less revenue from electricity consumers implies more revenue government must raise elsewhere.
- Privatization plans:
  - Franchise bill for Transco pending in Congress since September 2002; speedy passage urged to signal private participation.
  - Bidding for Transco to be reopened; foreign investor interest renewed.
  - Authorities intended to privatize 70 percent of NPC’s generation assets by end-2005; some small plants already sold.
  - Staff warned reducing regulatory uncertainty is essential to attract investors and avoid supply shortages.

### Banking sector: asset quality, supervision, and restructuring
- Major concerns:
  - Banks have high nonperforming assets (NPAs) and low profitability.
  - True capital adequacy obscured by weaknesses in accounting, especially ROPOAs.
  - Loan classification deficiencies likely understate distressed assets.
- Staff analysis: after allowance for these factors, banking system capital adequacy fell well short of regulatory requirements and insufficient to buffer major shocks.
- Recapitalization of banks viewed as urgent to increase resilience and enable contribution to economic growth.
- Recent regulatory/supervisory steps welcomed:
  - Amendments to PDIC Charter in July enhanced bank resolution framework (e.g., seamless take-over of banks under receivership).
  - Regulations issued to improve credit risk management, strengthen documentary requirements and compliance, and enhance investor protection via securities custodianship and registry requirements.
  - Establishment of the Financial Sector Forum in July 2004 had potential to improve cooperation among supervisory and regulatory agencies.
- Concerns and staff recommendations:
  - Little progress in resolving NPAs under the SPV framework; hope that deals would occur before the framework expired in April 2005.
  - Staff urged BSP to pressure banks to enhance valuation and provisioning of NPAs, especially ROPOAs, and to enforce international accounting standards so losses are reflected in financial statements.
  - Advocated a two-pronged approach: strengthen legal powers of BSP and PDIC and implement a restructuring strategy.
  - Need to provide legal protection to supervisors; currently BSP and PDIC supervisors are primarily liable for contested regulatory actions.
  - Authorities seeking amendments to BSP Charter and waiver from deposit secrecy law; BSP seeks power to write down shareholder capital of noncompliant banks as part of prompt corrective action.
  - Restructuring strategy should include:
    - Thorough diagnosis of capital needs of individual banks.
    - Requiring viable but undercapitalized banks to present rehabilitation plans; intervene if plans are insufficient.
    - Continuation of policy favoring mergers and consolidation.
    - As last resort, an incentive-based public recapitalization scheme with safeguards to encourage private capital injections.

### Staff appraisal: overall assessment and policy advice
- Election victory seen as an opportunity to implement reforms to achieve higher growth, lower unemployment, and reduced poverty; staff welcomes efforts to formulate a substantive reform package and calls for early legislative endorsement.
- Vulnerabilities remain sizeable despite recent market stability; without decisive fiscal restoration, situation could quickly unravel given large external financing requirements and vulnerability to sudden shifts in emerging market sentiment.
- Potential for credit rating downgrades if reforms do not proceed briskly, limiting market access and harming the economy.
- Monetary policy:
  - May need tightening ahead due to prospect of breaching the 2005 inflation target from higher food and oil prices, prospective hikes in indirect taxes and power tariffs, and a global interest cycle turning.
  - Some slack in the economy and the peso not currently a source of inflationary pressure.
  - BSP should reassess inflation forecast after market response to the new fiscal package and tighten policy if inflation is expected to exceed that attributable solely to first-round effects of recent supply shocks.
- Fiscal policy recommendations reiterated:
  - Commitment to reducing the fiscal deficit is welcome; adjustment should be front-loaded.
  - Bulk of additional revenues from proposed tax measures and large NPC tariff increase should be saved to front-load fiscal adjustment.
  - Early large adjustment would put public debt on a clearly sustainable path and create room for private sector investment recovery.
  - Nature and quality of measures critical: staff supports increasing alcohol, tobacco, and petroleum excises and repealing nonstandard VAT exemptions and zero-ratings.
  - Staff urges raising the VAT rate (currently 10 percent) and continuing efforts to strengthen tax administration.
  - Strong caution against introducing GIT due to revenue risks and potential distortions; recommends scaling back tax incentives as a better avenue for tax reform.

*Source: _cr04317 - 14.      While the authorities had yet*

### 33.      Over the medium term, other reforms are necessary to ensure fiscal

### _cr04317 - 33.      Over the medium term, other reforms are necessary to ensure fiscal

### Fiscal sustainability and civil service / pensions
- Staff welcomes proposals to streamline the civil service, including through voluntary retirement.
- Staff underscores the critical importance of steps being taken to shore up the finances of the pension funds.
- Staff encourages the authorities to strongly resist proposals for new tax amnesties, given the potentially harmful effect on taxpayer compliance over time.

### Power sector reforms and implementation challenges
- Important reforms are being proposed in the power sector; implementation will be key.
- Stemming NPC losses is a critical challenge for the new administration that will be difficult to meet without a sizable increase in generation tariffs.
- Proposed mitigation measures and priorities:
  - Adverse effects on industry will be mitigated by time of use pricing.
  - Life-line tariffs should be carefully targeted to shield vulnerable consumers.
  - Priority to Congress passing the Transco franchise bill, pivotal in promoting much needed investment.
  - Reducing regulatory uncertainty is essential for attracting investors and for the success of power sector reforms.

### Banking and financial sector reform
- Priority should be attached to financial sector reform.
- Asset quality problems in the banking system continue to be an important concern.
- Current assessment: the system is fragile and ill-equipped to contribute to economic growth.
- Recommended measures:
  - Accompany the strategy of inducing banks to offload NPAs on a voluntary basis with greater pressure from supervisors.
  - Strengthen legal protection for BSP and PDIC supervisors (urged to the new administration and Congress).
  - Follow legal amendments with the implementation of a restructuring strategy for the banking sector.

### Strengthening statistics
- Further strengthening of statistics is necessary in the period ahead.
- Staff welcomes the authorities’ commitment to redress data shortcomings.
- Authorities are encouraged to intensify efforts to implement the recommendations made in the data ROSC.

### Box 1 — The New Administration’s Policies (Key elements)
- President Arroyo announced a 10-point plan (inaugural speech on June 30) including:
  - Create more than 6–10 million  jobs, support 3 million entrepreneurs, and develop 1–2 million hectares of land for agribusiness.
  - Ensure that everyone of school age is in school in an uncrowded classroom and in surroundings conducive to learning.
  - Balance the budget.
  - Link the entire country via a network of transport and digital infrastructure.
  - Provide power and water to all barangays (neighborhoods).
  - Decongest Metro Manila.
  - Develop the Subic-Clark corridor into the most competitive international service and logistic center in the region.
  - Computerize the electoral process.
  - Bring peace to Mindanao.
  - Reconcile the divisive issues generated by EDSA I, II, and III.
- SONA and preceding speeches highlighted:
  - Recognition that the most urgent problem was the chronic budget deficit which had led to a squeeze on infrastructure investment and programs necessary for societal peace.
  - Key fiscal priorities: expanding revenues, spending more on infrastructure and social programs, and finding budgetary savings.
  - Administration proposed 8 legislative revenue measures aimed at raising P 80 billion (1.6 percent of GDP), including:
    - (i) a gross income tax system;
    - (ii) some as yet unspecified changes to the VAT;
    - (iii) a telecom franchise tax;
    - (iv) indexation of excises on alcohol and tobacco products;
    - (v) indexation of excises on petroleum products;
    - (vi) rationalization of fiscal incentives;
    - (vii) introduction of a targeted tax amnesty; and
    - (viii) the creation of a performance driven framework for revenue agencies.
  - Government expected to raise another P 20 billion through administrative measures such as increasing efficiency and cutting costs, increasing specific charges and fees, raising duties on petroleum products, and increasing profit transfers from government corporations.
  - Near-term cheap power objective achievable by privatization of electricity assets; priority for Congress to pass Transco franchise bill to facilitate sale of the national electricity grid.
  - Government re-engineering: 80 offices under the Office of the President had been abolished and another 30 would soon be abolished; Congress urged to pass a law on government reengineering with “silver parachutes” to facilitate needed reduction in staffing levels.
  - Other priorities: spending on health, clean water and education; advance land reform and passage of the “farmland as collateral” bill.

### Box 2 — Revenue raising options (summary of assessment)
- Gross Income Tax (GIT) proposals:
  - Common previous proposals: alter business income taxes so that only direct costs of production would be deductible; overhead expenses (advertising, wages for administrative personnel) might not be deductible.
  - Claimed benefits by proponents: simplify tax system, reduce opportunities for discretion among corrupt tax officials, allow reduction in business income tax rates, increase revenue.
  - Staff concerns:
    - GIT proposals are unlikely to be simpler or reduce corruption, since there will still be many opportunities to debate deductibility of expenses.
    - GIT likely to be more distortionary with widely differential effects across sectors.
    - Attempts to address sectoral differences through differing rates and/or bases would undermine the GIT rationale (simplicity and ease of administration).
    - If the number of excluded deductions is sufficiently large, the GIT may be ruled under some countries’ tax law as a turnover tax rather than as an income tax, potentially preventing multinationals from offsetting GIT payments against home country income tax liability and negatively affecting foreign direct investment.
- Value-Added Tax (VAT) considerations:
  - Several factors argue for an increase in the VAT rate:
    - VAT has important efficiency and administrative advantages over other revenue sources.
    - VAT is moderately progressive in the Philippines due to exemptions for most agricultural goods and small traders.
    - At 10 percent, the current Philippine VAT rate is low (comparative averages cited: 14 percent in Latin America, 20 percent in Eastern Europe, 11 percent average in Asia).
    - A higher VAT rate has proven to be a reliable revenue-raiser even in countries with low initial efficiency ratios (such as the Philippines where the efficiency ratio is 0.31).
  - Opponents argue a VAT increase will put honest taxpayers at a further disadvantage given significant VAT evasion; evidence of VAT evasion exists (including low efficiency ratio), but it is not clear evasion would be greater for VAT than for other available revenue enhancers.
- Empirical table (Changes in VAT Rates and Revenue: Experience with Single Rate VATs in Asia and Latin America) — selected entries preserved exactly as presented:
  - Bolivia: Initial rate 10, Old rate 13, March 1, 1992; Year of change columns show 2.9    4.3    4.6    5.3; Elasticity and ratios listed.
  - Chile: Initial rate 16, Old rate 18, July 1, 1990; Year of change columns show 7.5    7.8    7.6    8.2; Elasticity and ratios listed.
  - Dominican Rep.: Initial rate 6, Old rate 8, June 1, 1992; Year of change columns show 1.5    2.1    2.6    2.6; Elasticity and ratios listed.
  - Ecuador (two entries): Initial rate 6→10 Early 1986; Initial rate 10→12 Between 3/99 and 9/00; Year of change columns show respective sequences.
  - El Salvador: Initial rate 10→13 Between 1/95 and 9/95; Year of change columns show 4.4    4.9    5.2    5.3.
  - Guatemala: Initial rate 7→10 January 1, 1996; Year of change columns show 2.8    3.7    3.7    3.7.
  - Japan: Initial rate 3→5 April 1, 1997; Year of change columns show 1.5    1.8    2.0    2.1.
  - Averages and source note: Average 3.85 11.7 0.37; Sources: Fund staff documents and estimates.

### Box 3 — Financial problems in the power sector (key findings and statistics)
- NPC financial deterioration:
  - NPC financial position deteriorated from being almost in balance in 1999-2000 to a loss of 1 percent of GDP in 2003, and is projected to further deteriorate to 1¼ percent of GDP in 2004.
  - NPC liabilities, including debt and capitalized Independent Power Producer (IPP) lease obligations, increased from 17 percent of GDP in 1998 to 28 percent of GDP in 2003.
  - Debt service rose to nearly 50 percent of NPC’s revenue.
- Main contributors to deterioration:
  1. Politicization of NPC tariff setting:
     - In May 2002, the NPC board capped the purchased power adjustment (PPA) at P 0.4 per KwH, resulting in a P 0.85 per KwH decline in NPC tariffs.
  2. Legacy of over-contracting of IPPs:
     - Government invited private participation in the early 1990s, incurring higher than envisaged costs from IPP power purchase contracts (due to take or pay clauses) as electricity demand growth was lower than expected.
     - Some IPP power purchase costs were not allowed to be passed on to NPC tariffs.
  3. Loss of market share:
     - Meralco shifted power purchase from NPC to its own IPPs, resulting in a drop in NPC’s sales by 14 percent in 2002.
- Burden sharing and policy implications:
  - An increase in generation tariff is essential to restore NPC viability.
  - NPC’s losses include sunk costs from over-contracting with IPPs; on efficiency grounds the entire cost should not necessarily be borne by electricity consumers.
  - EPIRA envisages that electricity consumers pay up to the market-determined competitive price, and both electricity consumers and taxpayers share costs exceeding the market price; this approach is not practical at this stage given the lack of a competitive market.
  - Authorities need to address who can afford the costs and what division of costs is politically feasible.
- Charts and notes preserved as described:
  - Financial Operation of the power sector (In percent of GDP) shown for 1998–2004 proj.: Overall deficit, Revenue, Expenditure, NPC liabilities and debt service.
  - NPC liabilities and debt service (In percent of GDP; unless otherwise indicated) shown for 1998–2003 with Debt (LHS), Capitalized IPP lease obligations (LHS), Debt service/revenue ratio (RHS).
  - Footnote: "Excludes IPP lease obligations and domestic debt amortization."

*IMF staff report content extracted from the provided chapter text.*

### Box 4. Strengthening the Philippine Banking System

### Box 4. Strengthening the Philippine Banking System

### Asset quality and profitability
- Nonperforming asset ratios remain around 25 percent.
- Provision coverage ratios remain around 30 percent.
- Weaknesses in accounting practices—particularly valuation of foreclosed assets—and concerns about loan classification practices obscure the extent of capital adequacy.
- Lackluster profitability constrains the system’s ability to strengthen its capital base through retained earnings, completing a vicious circle.

### Assessment of past remedial efforts
- Authorities’ approach has centered on tax, regulatory and other incentives through the Special Purpose Vehicle (SPV) Act, combined with the notion that asset disposal to private SPVs occurs on a purely voluntary basis.
- Banks have not been willing to recognize latent losses on their portfolios, which, at least for some banks, imply substantial recapitalization needs.
- Remedial efforts have thus far not been effective.

### Case for more forceful action
- The banking system is fragile and not well equipped to contribute to future growth momentum.
- Regulatory forbearance based on the expectation that the system will eventually grow out of its problems is likely to be counterproductive.
- Delaying action may significantly inflate the ultimate resolution costs.
- The comprehensive reforms being planned by the new administration provide a ready opportunity to take financial sector measures.

### Key components of a more forceful strategy
- Enhancements to the legal and regulatory framework to enable supervisors to exert greater pressure on banks:
  - As a matter of priority, the legal powers of the BSP and PDIC need to be enhanced, including by ensuring adequate legal protection and enabling them to write down banks’ shareholder capital.
- A thorough diagnosis of the banking system, applied to individual bank portfolios and based on international accounting standards:
  - Particular attention to valuation of loans and foreclosed assets, connected lending, and the condition of state banks.
- Implementation of a restructuring strategy:
  - Nonviable banks should be liquidated or merged with viable banks.
  - Viable but undercapitalized banks should be allowed an adjustment period to come up with additional capital or else be intervened.
  - Before any new investors are attracted, the capital of existing shareholders should be written down.
  - As a last resort, a public incentive scheme could be considered to bring in private capital.
  - In support of bank restructuring, a corporate restructuring strategy needs to be worked out, including by passing the Corporate Recovery Act.

*Source: Box 4. Strengthening the Philippine Banking System.*

### Conclusion

### Conclusion

### Authorities' commitment and reform agenda
- Authorities recognize the importance of policy discipline and sustained reform initiatives.
- Legislative priorities and details of economic plans are being developed and will soon be announced.
- The key is strong and prompt implementation of initiatives predicated on responsible macroeconomic and structural policies.
- Authorities view the current period to be a “unique opening” to advance more decisively the reform process.
- Authorities intend to employ all resources at hand to consolidate the process of sustained and balanced growth.
- The days ahead will be a crucial test of the will and strength of the administration.

### Recent macroeconomic developments
- Financial market conditions came under increasing pressure in the first quarter of 2004 as uncertainty regarding the May 10 elections clouded investor sentiment; conditions stabilized following reform measures announced on July 26.
- GDP growth: the economy grew 6.4 percent in the first quarter of 2004 (year-on-year), supported by strong growth in agriculture and a pre-election surge in consumption; manufacturing improved with a recovery in exports.
- Unemployment rose to 13.7 percent in the second quarter of 2004.
- Inflation accelerated to 6.0 percent (year on year, 1994-based CPI) in June 2004 from 3.1 percent (y/y) at end-2003, driven by higher food, fuel, and transportation prices.
- The Bangko Sentral ng Pilipinas (BSP) raised liquidity reserve requirements for banks earlier in the year but held policy rates steady.
- Exports grew by 8½ percent through June (y/y) in 2004, improving on the 2.9 percent increase recorded in 2003 (full year).
- Remittances increased by 2.6 percent (y/y) in the first half of 2004.
- Gross reserves of the BSP were $16.2 billion at end-June 2004.

### Fiscal position and public debt
- Through June 2004, the National Government deficit (authorities definition) was on course to meet the 2004 target of 4.2 percent of GDP, compared to 4.6 percent of GDP in 2003.
- The nonfinancial public sector deficit is expected to remain at about 5¾ percent of GDP in 2004 due to increasing losses at the National Power Corporation (NPC) and shrinking cash surpluses at the public pension funds.
- Nonfinancial public sector debt is projected to remain above 100 percent of GDP.
- Government domestic borrowing in 2004 to date was much the same as last year, but domestic treasury bill rates have trended up in line with the pick up in inflation.

### Financial sector and banking reform
- The banking sector remains saddled with high levels of nonperforming assets backed by relatively low reserve coverage; profitability continues to be constrained.
- Low capitalization and weak credit demand have led banks to prefer investing in government securities rather than expanding credit.
- Directors urged acceleration of banking sector reform, including:
  - Stepping up supervisory pressure on banks to improve balance sheets and adopt best accounting practices to better recognize latent loan losses.
  - Providing stronger legal protection for supervisors and mustering political support for legal amendments to the charters of the BSP and the Philippine Deposit Insurance Corporation to support comprehensive restructuring.
  - Advancing implementation of Anti-Money Laundering/Combating Financing of Terrorism measures.
- Directors welcomed recent steps to strengthen the regulatory and supervisory framework, including the financial reform package announced by the BSP in late August.

### Monetary policy stance and inflation outlook
- Directors stressed the importance of continued prudent monetary policy management under the BSP’s inflation-targeting framework.
- The inflation outlook is uncertain, particularly given potential impacts of the reform package; recent supply-side shocks and prospective increases in power tariffs and indirect taxes risk breaching the official inflation target in 2005.
- Directors welcomed the authorities’ intention to stand ready to tighten monetary policy if inflation would exceed the target by more than what can be attributed to first-round impacts of food and oil price shocks.
- Directors emphasized maintaining a high degree of transparency in communicating monetary policy; some suggested announcing acceptable deviations from the inflation target for 2005, while others cautioned that such ex ante announcements could cloud the policy message.

### Energy sector reforms
- Directors underscored the importance of steadfast implementation of power sector reforms to restore financial viability and reduce the drain on public finances.
- Arresting NPC’s losses likely requires further significant increases in power tariffs, which are already high by regional standards.
- Directors supported:
  - Implementation of time-of-use pricing to mitigate the impact of tariff increases on international competitiveness.
  - Considering better targeting of life-line tariffs to shield vulnerable consumers.
  - Strengthening the independence of the Energy Regulatory Commission in tariff decisions.
  - Accelerating privatization of power generation and transmission assets.
  - Prompt enactment of the Transco franchise bill by Congress and reduction of regulatory uncertainty to attract private investment and minimize supply shortage risks.

### Fiscal policy guidance and tax measures
- Directors agreed that putting public finances back on a sustainable path is essential and welcomed the authorities’ commitment to balancing the budget by 2009.
- Directors emphasized saving the bulk of revenue gains from tax measures to improve debt dynamics and create room for private investment recovery.
- Directors generally considered that a front-loaded reduction in the fiscal deficit would help bring public debt onto a clearly sustainable path.
- Views on tax measures:
  - Welcomed proposals to increase alcohol, tobacco, and petroleum excises and to rationalize tax incentives.
  - Supported efforts to strengthen tax administration, particularly VAT compliance.
  - Called on authorities to consider raising the VAT rate.
  - Expressed concern that the proposed introduction of gross income taxation carries revenue risks, could introduce significant distortions, and could complicate tax administration.
  - Warned that proposed new tax amnesties could hamper taxpayer compliance over time.
  - Welcomed authorities’ intention to carefully consider staff advice in formulating new tax policies.
- Directors welcomed plans to revive the Fiscal Responsibility Bill to ensure no new expenditures are approved without corresponding revenue measures.
- Directors considered rationalization of public expenditure equally important, welcoming proposals to streamline the civil service (eliminating redundant positions and voluntary early retirement) and steps to shore up pension fund finances, while noting the importance of protecting expenditure on social programs.

### Institutional, data, and Fund relations
- Directors welcomed completion and publication of the data module of the Report on the Observance of Standards and Codes and encouraged intensified efforts to implement its recommendations.
- Directors expressed support for continuing a close and constructive relationship with the Fund through post-program monitoring.

### Staff growth and inflation projection (IMF staff projections, August 2004)
- GDP growth: 2004 projection 4.9 percent; 2005 projection 4.5 percent.
- CPI inflation (average): 2004 projection 5.0 percent; 2005 projection 6.2 percent.

### Selected economic indicators (2000–2005) — key figures
- GDP growth (in percent change): 2000: 4.4; 2001: 1.8; 2002: 4.3; 2003: 4.7; 2004: 4.9; 2005: 4.5.
- CPI inflation (average, in percent): 2000: 4.4; 2001: 6.1; 2002: 3.0; 2003: 3.0; 2004: 5.0; 2005: 6.2.
- National government balance (in percent of GDP, IMF definition): 2000: -4.5; 2001: -4.6; 2002: -5.6; 2003: -5.0; 2004: -4.4; 2005: -3.9.
- Nonfinancial public sector balance (in percent of GDP): 2000: -4.7; 2001: -4.8; 2002: -5.7; 2003: -5.8; 2004: -5.7; 2005: -4.8.
- Revenue and grants (in percent of GDP): 2001: 23.0; 2002: 20.9; 2003: 20.9; 2004: 21.1; 2005: 22.3.
- Expenditure (in percent of GDP): 2001: 27.8; 2002: 26.5; 2003: 26.7; 2004: 26.8; 2005: 27.0.
- Broad money (M3, in percent change): 2000: 4.6; 2001: 6.8; 2002: 9.5; 2003: 3.3; 2004: 6.4.
- Credit to the private sector (net, in percent change): 2000: 8.1; 2001: -3.0; 2002: 1.2; 2003: 1.8; 2004: 4.2.
- Interest rate (91-day Treasury bill, end period, in percent): 2000: 12.9; 2001: 8.9; 2002: 5.2; 2003: 6.5; 2004: 7.4 (auction rate as of August 30, 2004).
- Trade balance (in percent of GDP): 2000: 5.0; 2001: -1.0; 2002: 0.5; 2003: -1.0; 2004: -2.2; 2005: -2.4.
- Current account balance (in percent of GDP): 2000: 8.2; 2001: 1.9; 2002: 5.7; 2003: 4.9; 2004: 2.8; 2005: 2.0.
- Gross international reserves (in billions of U.S. dollars): 2000: 15.0; 2001: 15.6; 2002: 16.2; 2003: 16.9; 2004: 16.0 (as of end-July 2004).
- Adjusted reserves (in billions of U.S. dollars): 2000: 13.4; 2001: 13.2; 2002: 14.3; 2003: 14.7; 2004: 14.4.
- Adjusted reserves (in percent of short-term liabilities): 2000: 128.1; 2001: 114.3; 2002: 123.9; 2003: 126.9.

*IMF Public Information Notice (PIN) No. 04/116 — IMF Concludes 2004 Post-Program Discussion with the Philippines (October 3, 2004).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2004/_cr04317.pdf_