## Executive Summary (content unit: _cr05372)

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---

### I. Introduction and Background
- President Arroyo elected to a six-year term in May 2004, enabling focus on long-standing fiscal and structural problems.
- Key actions and progress in first year of new administration:
  - EVAT legislation passed by Congress in May 2005 (broadening the VAT base from July; authority to increase the VAT rate from 10 to 12 percent from January 1, 2006).
  - NPC average generation tariffs raised by more than one half.
  - SPV framework to facilitate sale of nonperforming assets began to gain traction.
- Political interruptions to reforms:
  - Allegations of wrongdoing against the President surfaced in June 2005; impeachment complaints filed.
  - Supreme Court issued a temporary restraining order in July halting implementation of the EVAT law.
  - Resignations on July 8 of eight cabinet members, including the Finance Secretary and the Budget and Management Secretary.
- Authorities’ response:
  - New economic team appointed; argued for full implementation of EVAT and proposed alternative fiscal measures if EVAT is declared unconstitutional.
  - BSP intervened temporarily in the foreign exchange market and raised reserve requirements on banks.

### II. Recent Economic Developments — growth, inflation, external sector, fiscal
- Growth:
  - GDP grew by 4½ percent y/y in the first quarter of 2005, down from 5½ percent in the fourth quarter of 2004.
  - Growth slowdown reflects El Niño effects on agriculture and weak manufacturing; services remained buoyant (tourism, BPO).
- Inflation and monetary measures:
  - Headline inflation: 7.1 percent in July (y/y), 7.6 percent in June, and 8.5 percent in each of the three previous months.
  - BSP raised policy rates by 25 basis points in April and lifted reserve requirements by 2 percentage points in July.
- External sector and reserves:
  - Balance of payments surplus of $2 billion in the first half of 2005.
  - Overseas worker remittances rose by more than one-fifth (y/y) in the first half of 2005.
  - Net portfolio inflows: $1.9 billion in first half of 2005 vs. $0.1 billion in same period in 2004; portfolio inflows slowed after June events.
  - Exports grew by only 3 percent through June (y/y).
  - Reserves (net of pledged assets): $17.2 billion at end-July; $15.2 billion at end-2004.
- Fiscal performance:
  - National Government budget through June on course to achieve 2005 deficit target of 3½ percent of GDP (authorities’ definition).
  - NFPS deficit projected to be reduced to 4 percent of GDP in 2005, compared to 5¼ percent of GDP in 2004.
  - Improvement in tax collections coincided with campaign against tax evasion; preliminary data indicate improvement may have been interrupted in July.
  - 91-day treasury bill rate declined by about 210 basis points in 2005 to date.

### III. Outlook, principal risks, and staff scenarios
- Principal risks:
  - Protracted political uncertainty could stall reforms, weigh on investment, and undermine market confidence.
  - High public debt and external financing needs increase vulnerability to adverse market sentiment and global interest rate movements.
- "Reforms stall" (staff projection):
  - GDP growth is unlikely to exceed 4¾-5 percent in 2005 and 2006.
  - Exchange rate likely to remain weak; inflation expected to exceed BSP target range of 5–6 percent in 2005 and to be 4–5 percent in 2006.
  - NFPS deficit would remain about 4 percent of GDP.
  - Public sector debt-to-GDP ratio: 98 percent of GDP at end-2004; projected to decline only very gradually with projected ratio in 2010 at 88 percent under this scenario.
  - National Government planned external issuance: yet to raise $850 million out of $3.1 billion planned for the year.
- "Reforms proceed" (staff projection):
  - Full implementation of EVAT or alternative measures with similar yield would permit NFPS deficit to be reduced to about 2¾ percent of GDP in 2006.
  - Consolidation would encourage higher investment and growth, potentially reinforced by declining interest rates.
  - If reform momentum continues, public sector debt-to-GDP ratio projected to fall below 70 percent by 2010.
- Staff note on sensitivity:
  - Debt dynamics under the "reforms stall" scenario can be reversed by a small (but permanent) shock to underlying macro variables.

### IV. EVAT design, fiscal impact, and contingency measures
- EVAT summary:
  - Broadens VAT base to include electricity, petroleum products, and selected professional services effective July 1, 2005.
  - President given authority to increase VAT rate from 10 to 12 percent after January 1, 2006.
  - EVAT increases corporate tax rate from 32 to 35 percent until 2009; introduces limits on investment and input VAT credits; reduces excises on petroleum products.
- Staff estimate of EVAT fiscal yield and impact:
  - Staff estimate: EVAT package yields annual revenue of 1½ percent of GDP; would permit NFPS deficit to be reduced to 2¾ percent of GDP in 2006.
- Annualized revenue yield from VAT bill (Fund staff estimates):
  - Widening the base: 30.4 (Billions of pesos); 0.4 (Yield % of GDP, full year basis)
  - Raising the rate from 10 to 12 percent: 30.0; 0.5
  - Raising the CIT rate: 15.4; 0.3
  - Reducing excises on petroleum products: -13.6; -0.2
  - Changing refund procedures: 15.8; 0.3
  - Net impact: 78.0; 1.4
- Legal and administrative concerns:
  - Staggering VAT investment credits over five years likely to increase the cost of capital.
  - Limit on VAT input credit risks increasing effective taxation of businesses with low value added margin and could lead to tax cascading.
  - Limit on VAT input credit was among provisions challenged before the Supreme Court.
- Contingency measures under consideration (authorities’ estimated annual revenue gains in parentheses):
  - Increasing import tariffs across the board by 1 percent (0.2 percent of GDP).
  - Rationalizing fiscal incentives (0.1 percent of GDP).
  - Introducing Simplified Net Income Taxation (SNIT) of the self-employed (0.3 percent of GDP).
- Staff view: revenue impact of rationalizing fiscal incentives and SNIT considered uncertain; staff underscore importance of persevering with EVAT.
- Other tax measures:
  - Increase in alcohol, cigarette and tobacco excises passed December 2004 expected to yield 0.2 percent of GDP annually; generated little in 2005 to date due to advance stockpiling.
  - Lateral attrition bill passed January 2005 to incentivise revenue collectors likely to affect revenue gradually.
- Note on tariffs: Philippine bound tariff average under the WTO agreement is 25.6 percent, while the actual average tariff is 7.4 percent.

### V. Fiscal consolidation in public enterprises and power sector
- NPC financial improvements and measures:
  - ERC finalized approval of P 0.98 per kWh increase in average generation tariffs (provisionally granted September 2004) and allowed NPC to increase generation tariffs by another P 0.46 per kWh to recover past losses.
  - These awards imply more than a 50 percent increase in NPC’s average generation tariffs, and about a 20 percent increase in retail tariffs in the Manila area.
  - Government absorbed P 200 billion of NPC debt at the beginning of 2005, reducing NPC’s interest costs.
  - Measures expected to reduce NPC’s deficit from 1½ percent of GDP in 2004 to ½ percent of GDP in 2005 and 2006.
  - Recommendation: adjust generation tariffs in a timely manner to reflect changes in fuel and other costs.
- Privatization and market reforms:
  - Bidding strategy for Transco changed to open competitive bidding; concession bidding schedule postponed until late this year.
  - Authorities likely to fall well short of target of privatizing 70 percent of generation assets (Gencos) by end-2005; less than 15 percent sold thus far.
  - ERC approved time-of-use pricing for NPC; full implementation expected to improve production efficiency.
  - Cross subsidies for residential consumers in Manila scheduled to be eliminated by October 2005.
  - Authorities committed to launching a wholesale electricity spot market in early 2006 and retail competition in mid-2006.

### VI. Civil service and pension reform
- Civil service reform:
  - Implementing rules and regulations (IRRs) issued in May.
  - Authorities’ initial estimate: 27,000 positions may be eliminated with total severance payments of about P 8 billion (0.15 percent of GDP); affected employees may opt for redeployment within civil service.
  - IRRs exclude years of service beyond age 59 from severance payment calculation.
  - Authorities working with World Bank on detailed cost estimates.
- Pension reform:
  - Actuarial review of the Social Security System (SSS) under way; expected to show continuing depletion of reserves and need to adjust pension benefits and contributions for long-term solvency.
  - SSS and Government Service Insurance System (GSIS) focusing on improving collections and strengthening and diversifying investment portfolios.

### VII. Monetary policy, inflation, and BSP actions
- Inflation drivers and outlook:
  - Inflation remains above target; continued high inflation partly reflects supply shocks, including rice prices affected by El Niño.
  - Staff judged inflation excluding supply shocks on the CPI to be still considerably above target.
  - Staff projected inflation to remain high due to increases in transportation fares and rising oil prices; risk of lifting long term inflation expectations.
  - Staff forecasts (in Staff Report): inflation to be 8.2 percent in 2005 and 7.5 percent in 2006, versus BSP target ranges of 5–6 percent in 2005 and 4–5 percent in 2006.
- Policy recommendations and BSP actions:
  - Staff recommended tightening monetary policy and higher policy interest rates to keep inflationary expectations in check.
  - BSP position at mission time: saw no clear reason to tighten further; considered prior communication effective that one-off supply shocks were primary cause.
  - Subsequent action: BSP raised reserve requirements on July 7:
    - Regular reserve requirements raised from 9 to 10 percent.
    - Liquidity reserve requirements raised from 10 to 11 percent.
  - BSP later raised reverse repo rate (key policy rate) to 7 percent for overnight placements (reported in supplement).

### VIII. Financial sector reform, NPLs, SPV framework, and IFRS
- Banking sector developments:
  - NPL ratios have declined owing to transactions under the SPV Act and expected further decline reflecting last-minute sales before SPV framework expiry in April.
  - Sales of about P 50 billion completed and another P 54 billion waiting for certificates of eligibility; together would cut almost a fifth of the stock of nonperforming assets in the banking system.
  - Even if pipeline transactions materialize, about P 400 billion of nonperforming assets would remain in the banking system.
  - Authorities prioritizing draft bill to extend SPV framework for another two years; approved at committee level in the House of Representatives.
- IFRS adoption and implications:
  - Authorities intend to adopt IFRS; banks have up to end-December 2005 to comply.
  - IFRS valuation requirements expected to enhance transparency and discipline consistent with Basle II.
  - New standards could significantly impact banks’ reported earnings and capital; some institutions may need time and an understanding with BSP on recapitalization plans.
- BSP Charter amendments and other legislation:
  - Proposed BSP Charter amendments would strengthen legal protection for supervisors, clarify receivership and asset disposal conditions, and enhance prompt corrective action and bank resolution frameworks.
  - Authorities working on legislation to set up a credit information system and personal equity retirement accounts.
- Trust funds and pre-need industry:
  - New BSP guidelines require liquid assets of Common Trust Funds (CTFs) be transferred to Unit Investment Trust Funds (UITFs) and placed in highly liquid and tradable instruments; implementation could give rise to losses where trusts are valued unrealistically high.
  - Preliminary review showed major players’ holdings in CTFs well-provisioned, but sector-wide provisioning unclear; losses should be borne by investors rather than banks where possible.
  - Pre-need industry (supervised by SEC) has encountered financial difficulties; President prioritized passage of a Pre-need Code.

### IX. Statistics, AML/CFT, and data revisions
- AML/CFT:
  - Philippines removed from list of Non-Cooperative Countries and Territories in February 2005.
  - FATF observes Philippines has continued to implement anti-money laundering measures to remedy previously identified deficiencies.
- Statistical improvements and revisions:
  - Progress consolidating nonfinancial public sector debt data.
  - BSP made major revisions to BOP data in April 2005 to correct long-standing recording deficiencies; revisions leave overall BOP position essentially unchanged but revise up measured imports.
  - NSO made broadly similar trade data revisions in August; lack of coordination between revisions does not permit reconciliation at this stage.
  - Authorities indicated further changes to BOP data may be forthcoming.

### X. Staff recommendations and key policy messages
- Fiscal policy:
  - Implement the VAT reform as soon as events permit to allow the public sector deficit to be reduced below 3 percent of GDP.
  - If the Supreme Court rules part of EVAT unconstitutional, explore legislative remedies or swiftly introduce alternative fiscal reform measures.
- Power sector:
  - Accelerate power sector privatization; maintain timely tariff adjustments to reflect fuel and other cost changes.
- Monetary policy:
  - Tighten monetary policy to prevent inflationary expectations from rising; consider higher policy interest rates.
- Financial sector:
  - Prioritize passage of amendments to the central bank charter to strengthen legal protection for bank supervisors.
  - Extend SPV framework and manage IFRS transition with appropriate supervisory arrangements.

### XI. Selected quantitative tables, indicators, and fiscal/budgetary implications
- Staff projections and key statistics (preserved as reported):
  - Nominal GDP (2004): P4,826 billion ($92.2 billion)
  - Population (2003, est.): 81.8 million
  - GNP per capita (2003, est.): $1,035
  - IMF quota: SDR 879.9 million
  - Real GDP (2002–2006, staff projections where shown): 4.4, 4.5, 6.0, 4.7, 4.8
  - CPI (annual average): 3.0, 3.5, 6.0, 8.2, 7.5
  - CPI (end year): 2.5, 3.9, 8.6, 8.1, 6.0
  - Gross investment (percent of GDP): 17.5, 16.7, 17.1, 17.2, 17.2
  - National saving (percent of GDP): 23.2, 18.4, 19.8, 19.2, 19.1
  - National government balance (authorities definition, percent of GDP): -5.3, -4.7, -3.9, -3.6, -3.6
  - Nonfinancial public sector balance (percent of GDP): -5.7, -5.6, -5.1, -4.0, -4.0
  - Revenue and grants (percent of GDP): 20.9, 21.0, 20.5, 21.8, 21.8
  - Expenditure (percent of GDP): 26.6, 26.6, 25.6, 25.8, 25.8
  - Nonfinancial public sector debt: 93.7, 101.3, 96.1, 92.4, 90.0
  - Interest rate (91-day Treasury bill, end of period, in percent): 5.9, 6.5, 8.4, 6.4
  - Export value (percent change): 10.0, 2.8, 9.6, 4.0, 8.9
  - Import value (percent change): 6.2, 20.1, 10.6, 5.2, 9.2
  - Current account (percent of GDP): 5.7, 1.8, 2.7, 2.0, 1.9
  - Monitored external debt (percent of GDP): 77.7, 79.3, 71.5, 66.2, 63.3
  - Reserves, adjusted (US$ billions): 14.3, 14.7, 15.2, 15.0, 15.6
  - Exchange rate (period averages) Pesos per U.S. dollar: 51.6, 54.2, 56.3, 56.3
- Impact of interest rates on NG budget (Fund staff estimates):
  - First year, PHLP bln.: New external borrowing -0.7; 90-day T-bill -4.2; New bond borrowing -3.3; Total -8.3
  - First year, percent of GDP: New external borrowing -0.01; 90-day T-bill -0.07; New bond borrowing -0.05; Total -0.14
  - After five years, PHLP bln.: New external borrowing -7.7; 90-day T-bill -9.4; New bond borrowing -23.5; Total -40.6
  - After five years, percent of GDP: New external borrowing -0.09; 90-day T-bill -0.11; New bond borrowing -0.27; Total -0.46
  - Footnote: 1/ Assumes a 100 b.p. permanent decline in average interest rates.
- Box 1: Risk premium and budgetary implications:
  - Philippines bonds returned 8.2 percent in 2005 to date; EMBI Global returned 5.2 percent.
  - Estimated potential spread reduction since mid-March: 90-130 bps lower than at the beginning of the year.
  - Rule-of-thumb: 100 bps permanent reduction in average interest rates → annual gain of 0.5 percent of GDP per annum (medium term).

*Executive Summary — IMF staff report (content unit: _cr05372 - Executive Summary).*

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

### Executive Summary

### I. Introduction and Background
- President Arroyo’s election to a six-year term in May 2004 opened the way for long-standing fiscal and structural problems to be addressed.
- Important progress during the first year of the new administration:
  - EVAT legislation passed by Congress in May 2005 (broadening the VAT base from July; authority to increase the VAT rate from 10 to 12 percent from January 1, 2006).
  - NPC average generation tariffs raised by more than one half.
  - SPV framework to facilitate sale of nonperforming assets began to gain traction.
- Political interruptions to reforms:
  - Allegations of wrongdoing against the President surfaced in June 2005; impeachment complaints filed.
  - Supreme Court issued a temporary restraining order in July halting implementation of the EVAT law.
  - Resignations on July 8 of eight cabinet members, including the Finance Secretary and the Budget and Management Secretary.
- Authorities’ response:
  - New economic team appointed; argued for full implementation of EVAT and proposed alternative fiscal measures if EVAT is declared unconstitutional.
  - BSP temporarily intervened in the foreign exchange market and raised reserve requirements on banks.

### II. Recent Economic Developments
- Growth:
  - GDP grew by 4½ percent y/y in the first quarter of 2005, down from 5½ percent in the fourth quarter of 2004.
  - Growth slowdown reflects El Niño effects on agriculture and weak manufacturing; services remained buoyant (tourism, BPO).
- Inflation:
  - Headline inflation: 7.1 percent in July (y/y), 7.6 percent in June, and 8.5 percent in each of the three previous months.
  - BSP raised policy rates by 25 basis points in April and lifted reserve requirements by 2 percentage points in July.
- External sector and reserves:
  - Balance of payments surplus of $2 billion in the first half of 2005.
  - Overseas worker remittances rose by more than one-fifth (y/y) in the first half of 2005.
  - Net portfolio inflows: $1.9 billion in first half of 2005 vs. $0.1 billion in same period in 2004; portfolio inflows slowed after June events.
  - Exports grew by only 3 percent through June (y/y).
  - Reserves (net of pledged assets): $17.2 billion at end-July; $15.2 billion at end-2004.
- Fiscal performance:
  - National Government budget through June on course to achieve 2005 deficit target of 3½ percent of GDP (authorities’ definition).
  - NFPS deficit projected to be reduced to 4 percent of GDP in 2005, compared to 5¼ percent of GDP in 2004.
  - Improvement in tax collections coincided with campaign against tax evasion; preliminary data indicate improvement may have been interrupted in July.
  - 91-day treasury bill rate declined by about 210 basis points in 2005 to date.

### III. Outlook and Risks
- Principal risks:
  - Protracted political uncertainty could stall reforms, weigh on investment, and undermine market confidence.
  - High public debt and external financing needs increase vulnerability to adverse market sentiment and global interest rate movements.
- “Reforms stall” scenario (staff projection):
  - GDP growth is unlikely to exceed 4¾-5 percent in 2005 and 2006.
  - Exchange rate likely to remain weak; inflation expected to exceed BSP target range of 5–6 percent in 2005 and to be 4–5 percent in 2006.
  - NFPS deficit would remain about 4 percent of GDP.
  - Public sector debt-to-GDP ratio: 98 percent of GDP at end-2004; projected to decline only very gradually with projected ratio in 2010 at 88 percent under this scenario.
  - National Government planned external issuance: yet to raise $850 million out of $3.1 billion planned for the year.
- “Reforms proceed” scenario (staff projection):
  - Full implementation of EVAT or alternative measures with similar yield would permit NFPS deficit to be reduced to about 2¾ percent of GDP in 2006.
  - Such consolidation would encourage higher investment and growth, potentially reinforced by declining interest rates.
  - If reform momentum continues, public sector debt-to-GDP ratio projected to fall below 70 percent by 2010.
- Staff note on sensitivity:
  - Debt dynamics under the “reforms stall” scenario can be reversed by a small (but permanent) shock to underlying macro variables.

### IV. Report on the Discussions — Fiscal Policy (selected points)
- Discussions (held prior to suspension of EVAT) focused on:
  - Economic implications of VAT reform.
  - Medium-term fiscal strategy.
  - Fiscal risks from public enterprises.
  - Civil service and pension reforms.
- EVAT package design and estimated fiscal impact:
  - EVAT broadened the VAT base to include electricity, petroleum products, and selected professional services effective July 1, 2005.
  - President given authority to increase the VAT rate from 10 to 12 percent after January 1, 2006.
  - EVAT increases corporate tax rate from 32 to 35 percent until 2009; introduces limits on investment and input VAT credits; reduces excises on petroleum products.
  - Staff estimate: EVAT package yields annual revenue of 1½ percent of GDP; would permit NFPS deficit to be reduced to 2¾ percent of GDP in 2006.
- Annualized revenue yield from VAT bill (Fund staff estimates):
  - Widening the base: 30.4 (Billions of pesos); 0.4 (Yield % of GDP, full year basis)
  - Raising the rate from 10 to 12 percent: 30.0; 0.5
  - Raising the CIT rate: 15.4; 0.3
  - Reducing excises on petroleum products: -13.6; -0.2
  - Changing refund procedures: 15.8; 0.3
  - Net impact: 78.0; 1.4

### Staff Recommendations and Key Policy Messages
- Fiscal policy:
  - The authorities should make every effort to implement the VAT reform as soon as events permit. This would allow the public sector deficit to be reduced below 3 percent of GDP.
  - If the Supreme Court rules that part of the EVAT law is unconstitutional, legislative steps to remedy this should be explored; if infeasible, alternative fiscal reform measures should be swiftly introduced.
- Power sector:
  - Recent power tariff increases have much improved the financial health of the state-owned power utility, but power sector privatization has lagged and needs to be accelerated.
- Monetary policy:
  - Monetary policy should be tightened; inflation is set to remain above target, and although primarily supply-shock driven, there is a risk that inflation expectations may rise.
- Financial sector:
  - Recent progress with banking sector reform notwithstanding, priority needs to be given to the passage of amendments to the central bank charter necessary to strengthen legal protection for bank supervisors.

*Executive Summary — IMF staff report (content unit: _cr05372 - Executive Summary).*

### 14.      While welcoming the VAT reform, the mission cautioned that some of the

### _cr05372 - 14.      While welcoming the VAT reform, the mission cautioned that some of the

### VAT reform, legal challenge, and contingency measures
- Mission cautioned that some EVAT provisions might complicate tax administration and discourage investment.
- Specific concerns:
  - Staggering of the VAT investment credits over five years would likely increase the cost of capital.
  - The limit on the VAT input credit risked increasing the effective taxation of businesses with a low value added margin and would lead to tax cascading.
- Authorities agreed with assessment of the input cap and were considering amelioration; limiting the VAT input credit was one of the provisions of the EVAT law challenged before the Supreme Court.
- With the EVAT law suspended, authorities developed a contingency plan to replace lost revenue and stated first priority would be to amend legislation if the Supreme Court declared aspects unconstitutional.
- Alternative tax policy measures under consideration (authorities’ estimated annual revenue gains in parentheses):
  - Increasing import tariffs across the board by 1 percent (0.2 percent of GDP).
  - Rationalizing fiscal incentives (0.1 percent of GDP).
  - Introducing Simplified Net Income Taxation (SNIT) of the self-employed (0.3 percent of GDP).
- Staff view:
  - Revenue impact of rationalizing fiscal incentives and SNIT considered uncertain, underscoring importance of persevering with the EVAT.
- Other tax measures passed:
  - Increase in alcohol, cigarette and tobacco excises passed December 2004 expected to yield 0.2 percent of GDP annually; generated little in 2005 to date due to advance stockpiling.
  - Lateral attrition bill passed January 2005 to incentivise revenue collectors likely to affect revenue gradually.
- Note on tariffs: Philippine bound tariff average under the WTO agreement is 25.6 percent, while the actual average tariff is 7.4 percent.
- Other EVAT provisions challenged included granting the President authority to increase the VAT rate and allowing pass through of VAT on petroleum products and electricity to consumers.
- Authorities verifying that proposed increase in import tariffs would be compatible with Philippine commitments under the WTO and ASEAN agreements.

### Medium-term fiscal measures and revenue potential
- Even assuming fiscal program back on track by 2006, additional measures likely needed over the medium term.
- Authorities expected improvements from further tax compliance and lower interest expenditure.
- Staff suggested additional measures especially if corporate income tax rate reduced from 2009 (as under EVAT) and share of EVAT revenue allocated to new spending increased over time.
- At mission time, authorities planned to use 30 percent of the revenue gain from the EVAT law in 2006 to finance priority spending such as infrastructure investment; share would be increased gradually subsequently.
- Staff identified significant additional revenue potential from rationalization of fiscal incentives if applied to cooperatives; authorities noted political difficulty in taxing cooperatives.
- Other potential revenue sources identified by staff included increasing alcohol, tobacco, and fuel excises and indexing them to inflation.
- Revenue projections under the “reforms proceed” scenario (Table 6) assume additional revenues from such measures during 2006-2010.

### Fiscal consolidation in public enterprises
- NPC financial situation improved:
  - ERC finalized approval of P 0.98 per kWh increase in average generation tariffs (provisionally granted September 2004) and allowed NPC to increase generation tariffs by another P 0.46 per kWh to recover past losses.
  - These awards imply more than a 50 percent increase in NPC’s average generation tariffs, and about a 20 percent increase in retail tariffs in the Manila area.
  - Government absorbed P 200 billion of NPC debt at the beginning of 2005, reducing NPC’s interest costs.
  - Measures expected to reduce NPC’s deficit from 1½ percent of GDP in 2004 to ½ percent of GDP in 2005 and 2006.
  - Recommendation: adjust generation tariffs in a timely manner to reflect changes in fuel and other costs.
- Privatization progress slow:
  - Bidding strategy for Transco changed to open competitive bidding; concession bidding schedule postponed until late this year.
  - Authorities likely to fall well short of target of privatizing 70 percent of generation assets (Gencos) by end-2005; less than 15 percent sold thus far.
  - Slow progress attributed to delays in finalizing Transitional Supply Contracts between NPC and distribution utilities.
- Other power sector reforms and challenges:
  - ERC approved time-of-use pricing for NPC; full implementation expected to improve production efficiency.
  - Cross subsidies for residential consumers in Manila scheduled to be eliminated by October 2005.
  - Authorities committed to launching a wholesale electricity spot market in early 2006 and retail competition in mid-2006, with remaining issues to resolve for smooth introduction.

### Civil service and pension reform
- Civil service reform momentum:
  - Implementing rules and regulations (IRRs) issued in May.
  - Authorities’ initial estimate: 27,000 positions may be eliminated with total severance payments of about P 8 billion (0.15 percent of GDP); affected employees may opt for redeployment within civil service.
  - IRRs exclude years of service beyond age 59 from severance payment calculation to address concerns over generosity for those close to retirement.
  - Authorities working with World Bank on detailed cost estimates of reform.
- Pension reform:
  - Authorities conducting actuarial review of the Social Security System (SSS); review expected to show continuing depletion of reserves and need to adjust pension benefits and contributions for long-term solvency.
  - Meanwhile, SSS and Government Service Insurance System (GSIS) focusing on improving collections and strengthening and diversifying investment portfolios.

### Monetary policy and inflation
- Inflation context:
  - Inflation remains above target; continued high inflation partly reflects additional supply shocks, including rice prices affected by El Niño and other factors.
  - Staff noted rising prices of clothes, rentals and services indicating inflation spread to other sectors.
  - Staff judged inflation excluding supply shocks on the CPI to be still considerably above target.
  - BSP viewed increases as largely first-round effects of supply shocks and expected inflation target to accommodate them.
- Staff view and recommendation:
  - Staff concerned about persistent inflationary pressures and favored early tightening of monetary policy.
  - Projected inflation to remain high due to increases in transportation fares and rising oil prices; risk of lifting long term inflation expectations.
  - Higher policy interest rates recommended to keep inflationary expectations in check.
- BSP position at mission time:
  - Authorities saw no clear reason to tighten policy; considered prior communication effective that one-off supply shocks primary cause.
  - Aggregated demand remained weak; narrowing interest rate differentials had not led to portfolio shifts to dollar assets.
  - Rate increase in April framed as attempt to act on expectations; BSP saw no compelling evidence to further tighten.
- Subsequent action:
  - BSP raised reserve requirements on July 7 in response to exchange rate pressures from late June political turmoil:
    - Regular reserve requirements raised from 9 to 10 percent.
    - Liquidity reserve requirements raised from 10 to 11 percent.
  - Authorities view reserve requirement changes as effective in mopping up liquidity that otherwise might spill into foreign exchange market.

### Financial sector policy and banking sector progress
- Banking sector developments:
  - NPL ratios have declined owing to transactions under the SPV Act and expected further decline reflecting last-minute sales before SPV framework expiry in April.
  - Sales of about P 50 billion completed and another P 54 billion waiting for certificates of eligibility; together would cut almost a fifth of the stock of nonperforming assets in the banking system.
  - Banks will amortize implied losses over time; ability depends on future profits.
  - Progress in rehabilitating intervened banks, including completion of initial bidding for Philippine National Bank (PNB).
  - Planned purchases of stakes in small banks by bigger banks expected to contribute to consolidation.
- Distressed assets and SPV extension:
  - Even if pipeline transactions materialize, about P 400 billion of nonperforming assets would remain in the banking system.
  - Authorities giving high priority to draft bill to extend SPV framework for another two years; approved at committee level in the House of Representatives.
  - Prospective implementation of IFRS and BSP decision to phase in higher risk-weighting on NPLs considered to have encouraged deals under SPV framework.
- IFRS implementation:
  - Authorities intend to adopt IFRS; banks have up to end-December 2005 to comply.
  - IFRS valuation requirements (loan loss reserves, deferred tax assets, valuation of foreclosed real estate) expected to enhance transparency and discipline consistent with Basle II.
  - New standards could significantly impact banks’ reported earnings and capital; some institutions may need time and an understanding with BSP on recapitalization plans.
- BSP Charter amendments:
  - Proposed amendments seen as fundamental to strengthen the banking system by providing supervisors adequate legal protection and enhancing prompt corrective action and bank resolution frameworks.
  - Senate Banking Committee version holds supervisors to standard of diligence no higher than that required of all public servants, improving on current “extraordinary diligence” standard.
  - Amendments would clarify conditions of receivership and asset disposal.
  - Authorities also working on legislation to set up a credit information system and personal equity retirement accounts, among other bills.
- Trust funds and pre-need industry:
  - New BSP guidelines require liquid assets of Common Trust Funds (CTFs) be transferred to Unit Investment Trust Funds (UITFs) and placed in highly liquid and tradable instruments; effective implementation could give rise to losses where trusts are valued unrealistically high.
  - Preliminary review showed major players’ holdings in CTFs well-provisioned, but sector-wide provisioning unclear; any losses should be borne by investors rather than banks where possible.
  - Pre-need industry (supervised by SEC) has encountered financial difficulties; industry small but a source of risk for banks with linkages to pre-need companies.
  - President gave high priority to passage of a Pre-need Code in State of the Nation Address at end-July.

### Other issues: AML/CFT and statistics
- AML/CFT:
  - Philippines removed from list of Non-Cooperative Countries and Territories in February 2005.
  - FATF observes Philippines has continued to implement anti-money laundering measures to remedy previously identified deficiencies.
- Statistical improvements:
  - Progress consolidating nonfinancial public sector debt data.
  - BSP made major revisions to BOP data in April 2005 to correct long-standing recording deficiencies, in line with IMF Statistics TA mission; revisions leave overall BOP position essentially unchanged but revise up measured imports to integrate electronic recording and improved methodology.
  - NSO made broadly similar trade data revisions in August; lack of coordination between revisions does not permit reconciliation at this stage.
  - Authorities indicated further changes to BOP data may be forthcoming.

*Source: IMF staff report excerpt (_cr05372).*

### 35.      President Arroyo’s election to a six-year term in May 2004 opened the way for a

### _cr05372 - 35.      President Arroyo’s election to a six-year term in May 2004 opened the way for a

### Political and macroeconomic context
- President Arroyo’s election to a six-year term in May 2004 opened the way for a revival of the economy.
- Significant progress with much-needed economic reforms was made in the first year of the new administration.
- Prominent milestones: approval of power tariff hikes that will substantially stem NPC’s losses and the passage of the EVAT law.
- Fiscal consolidation aided by resolute control over expenditures and a crack-down on tax evaders that showed initial success in raising collections.
- GDP grew strongly, boosted by buoyant remittances and service sector activity; foreign investors began to show a new-found interest in the Philippines.
- Recent political developments threaten the progress made; unresolved political issues risk markets revising downward the Philippines’ economic prospects.
- Recommendation: front-loaded implementation of reforms in key policy areas (fiscal, power, and banking sectors) is critical.

### Outlook and external risks
- Staff projection: GDP growth of about 4¾ percent is expected in 2005-06.
- Major external risks:
  - Soaring oil prices, which may soften demand for Philippine exports.
  - Adverse developments in international capital markets; a correction in long-term global interest rates could have severe consequences.

### EVAT and near-term fiscal consolidation
- EVAT reform represents the best option to reduce the fiscal deficit.
- Some parts of the EVAT law (e.g., limits on input and investment credits) may complicate tax administration and discourage investment.
- If the VAT rate is increased to 12 percent, the package implies a substantial and durable revenue yield, which should allow the NFPS deficit to be reduced to about 2¾ percent of GDP in 2006.
- Delaying EVAT implementation would necessitate alternative revenue-raising measures to prevent negative market reactions.

### Medium-term fiscal strategy
- Even implementing EVAT as originally planned will leave the authorities short of their balanced-budget goal.
- Factors that will help reduce the gap:
  - Lower government borrowing reducing interest payments over the medium term.
  - Yield from better tax compliance, particularly if the campaign against tax evaders is sustained.
- These factors are unlikely to be sufficient; authorities should plan measures additional to EVAT for 2007 and beyond, such as a sweeping rationalization of tax incentives.

### Public enterprises and GOCCs
- NPC’s losses have been substantially reduced by recent tariff increases.
- To maintain improvement, NPC must file petitions for future tariff adjustments in a timely manner.
- Steps needed to limit NFA losses; priority to improve targeting of the rice subsidy that the NFA provides.
- Authorities’ plans for developing medium-term deficit targets for GOCCs are essential to support fiscal consolidation.

### Civil service and pension reform
- Actuarial review of the SSS is likely to show a need for parametric changes to pension benefits and contributions.
- Ensuring solvency of the pension system aided by current efforts by SSS and GSIS to improve collections and strengthen balance sheets.
- Civil service reform progressed with issuance of IRRs in May.
- Budgetary costs more manageable given limits set on severance packages for civil servants close to retirement.

### Power sector reform
- Timetable announced for privatization has slipped.
- New open bidding strategy for the Transco concession is more transparent, but further delays risk discouraging buyers.
- To accelerate Gencos privatization, early finalization of Transition Supply Contracts (TSCs) between NPC and major distribution utilities is key.
- TSCs should be carefully designed to ensure sufficient revenue predictability for potential investors.
- Considerable preparation needed before launch of a spot market and retail competition next year for market-based mechanism to achieve intended efficiency gains.

### Inflation and monetary policy
- Continued above-target inflation risks increasing inflation expectations.
- Base effects from last year’s supply shocks are beginning to drop out, but inflation will remain high in the near term due to increases in transportation fares and the current surge in oil prices.
- If the VAT reform is implemented as planned, there will be an additional impact on prices of as much as 1¾ percent.
- Staff forecasts inflation to be 8.2 percent in 2005 and 7.5 percent in 2006, well above the inflation targets of 5–6 and 4–5 percent, respectively.
- Staff view: monetary policy should be tightened.
  - Evidence suggests price pressures have become more generalized.
  - Increases in fuel and transportation prices may cause future wage demands to pick up.
  - Interest rate differentials are narrowing while the Philippine political risk premium may have risen, risking exchange rate weakening and additional inflationary pressure.
  - Higher policy rates are needed to forestall an increase in inflationary expectations and help preserve the credibility of the BSP's inflation targets.

### Banking and financial sector developments
- Encouraging developments: planned implementation of IFRS by end-2005 and phasing-in of higher risk weights on NPLs appear to have encouraged banks to sell NPAs under the SPV framework.
- Decline in NPA ratios exaggerates improvement in bank balance sheets because losses on asset sales will be amortized over time.
- Progress with privatizing PNB and prospective acquisitions of banks pave the way for banking consolidation.
- Legislative changes required to further banking sector reform:
  - Passage of amendments to the BSP Charter necessary to strengthen legal protection for bank supervisors.
  - Staff welcomes proposal to hold supervisors to a standard of diligence no higher than that required of all public servants.
  - Amendments are a precondition for durable strengthening of the banking system.
  - Staff support the bill proposing a two-year extension to the SPV framework.
- Continued vigilance required:
  - New BSP guidelines requiring trust funds to place resources in highly liquid and tradable instruments will cause losses where current assets are valued at above-market levels; BSP intends losses to be borne by investors rather than banks when possible.
  - Authorities need to address weakness in the pre-need sector due to inter-linkages with certain banks.
  - Staff welcome recent FATF judgment that the Philippines is continuing to implement anti-money laundering measures to remedy previously-identified deficiencies.

### Statistics and data improvements
- Commendable progress in consolidating the non-financial public sector debt data.
- Attempts to revise Balance of Payments data are welcome, but better coordination among agencies is needed.

### The Philippines: Impact of Interest Rates on the NG Budget (Fund staff estimates)
- First year, PHLP bln.: New external borrowing -0.7; 90-day T-bill -4.2; New bond borrowing -3.3; Total -8.3
- First year, percent of GDP: New external borrowing -0.01; 90-day T-bill -0.07; New bond borrowing -0.05; Total -0.14
- After five years, PHLP bln.: New external borrowing -7.7; 90-day T-bill -9.4; New bond borrowing -23.5; Total -40.6
- After five years, percent of GDP: New external borrowing -0.09; 90-day T-bill -0.11; New bond borrowing -0.27; Total -0.46
- Footnote: 1/ Assumes a 100 b.p. permanent decline in average interest rates.

*Source: Fund staff estimates.*

### Box 1: The Philippines’ Risk Premium and its Budgetary Implications

### Box 1: The Philippines’ Risk Premium and its Budgetary Implications

### Market performance in 2005
- Philippines bonds have returned 8.2 percent in 2005 to date (compared with 5.2 percent for the overall index).
- Performance was uneven across the year:
  - Early 2005 (first few months): investors optimistic about passage of the EVAT legislation; Philippines significantly outperformed the EMBI Global index.
  - From mid-March: Philippine spreads widened in line with deterioration in external credit market conditions; the actual passage of EVAT in May had little impact on spreads.
  - From end-May to date: Philippines significantly underperformed the broad emerging market rally due to political turmoil in June and the suspension of the EVAT law in July.

### Spread comparisons (benchmarks and observed changes)
- The box compares Philippines performance relative to three benchmarks:
  1. EMBI Global index.
  2. An index of equally weighted countries with BB and split BB-single B ratings ("Equal weight").
  3. A peer index weighted to capture relative liquidity and market capitalization within the EMBI Global ("Mkt weighted").
- Reported changes in spreads (bps) as presented in the source:
  - Jan to Mid-March: Philippines EMIBIG Peers ("Equal weight") Peers ("Mkt weighted") — presented as the sequence "-50 -22427"
  - Mid-March to End-May: "281758"
  - June to Date: "-25 -100 -48 -44"
- Interpretation provided in the box:
  - "These measures show that Philippines spreads could be 90-130 bps lower than at the beginning of the year, if the country had kept pace with the market or its peers since mid-March (the 50 bps tightening to mid-March, plus the net tightening since mid-March in the benchmark index of choice)."
- Footnote: "The spread tightening in the EMBIG since June may be overstated due to the re-weighting of Argentina, but this does not hold for the two “peer” indices, neither of which includes Argentina."

### Translation of potential spread gains into budgetary effects
- Rule-of-thumb linking spreads to government budget:
  - "The annual gain from a 100 bps permanent reduction in average interest rates for the National Government budget would be 0.5 percent of GDP per annum over the medium term."
- Dynamics of savings:
  - "The savings in the first year are small, but would grow over time as a result of dynamic factors, such as the gradual transmission of lower interest rates on new borrowing to average interest rates on government debt, and the reduction in required borrowing in the outer years as a result of interest savings in the earlier years."

### Key quantitative statements and assumptions (as presented)
- Philippines bond return in 2005 to date: 8.2 percent.
- EMBI Global index return in 2005 to date: 5.2 percent.
- Estimated potential spread reduction relative to benchmarks since mid-March: 90-130 bps lower than at the beginning of the year.
- Budgetary translation: 100 bps permanent reduction in average interest rates → annual gain of 0.5 percent of GDP per annum (medium term).

### Caveats and broader impacts noted
- The box explicitly notes it "does not address the broader impact on the economy of lower interest rates, which would also be positive."
- Political events (political turmoil in June; suspension of EVAT in July) materially affected recent outperformance and underperformance episodes.
- The measured EMBIG tightening since June may be distorted by index re-weighting (Argentina); peer indices not affected.
- Benefits to the budget are dynamic and accrue gradually as lower new-borrowing costs transmit to the average debt interest rate and reduce future borrowing needs.

*Source: Box 1, "The Philippines’ Risk Premium and its Budgetary Implications" (excerpt). *

### 1.      This supplement updates the information in the Staff Report issued on

### _cr05372 - 1.      This supplement updates the information in the Staff Report issued on

### I. RECENT DEVELOPMENTS
- Political developments
  - Impeachment charges against President Arroyo were dismissed by the House of Representatives on September 6.
  - On September 1, the Supreme Court declared the expanded value-added tax (EVAT) law to be constitutional, but retained the temporary restraining order in place for 15 days to allow for any appeals.
  - Moves in Congress to cancel, or at least postpone, the provision in the EVAT law for the elimination of the VAT exemptions on petroleum and power products in response to sharp increases in petroleum and power prices.
- Economic performance and markets
  - GDP growth: 4.8 percent (y/y) in the second quarter.
  - Headline inflation: 7.2 percent (y/y) in August, up from 7.1 percent in July.
  - Export growth: jumped to 11½ percent in July (y/y), implying growth of 4½ percent in the first seven months of 2005 (y/y).
  - Government external commercial borrowing: successfully raised $1 billion in early September, completing the program for the year.
  - Foreign reserves, adjusted for pledged assets: rose to $17.5 billion at end-August, $2.3 billion above the end-2004 level.
  - National government deficit through August: provisionally estimated at P 80 billion, less than half of the annual target of P 180 billion (3½ percent of GDP) and below the P 111 billion recorded in the first eight months of 2004.
  - Expenditure contraction: primarily due to continued compression of capital spending.
  - BSP policy actions: reserve requirements raised by 2 percentage points in mid-July to mop up liquidity accumulating in the reverse repo facility; reverse repo rate (BSP's key policy rate) is currently 7 percent for overnight placements.

### II. REPORT ON THE DISCUSSIONS
- Fiscal policy and EVAT
  - Authorities remain committed to fiscal consolidation and intended to implement the EVAT as soon as the Supreme Court order was lifted; they were hopeful implementation would be possible within the next few weeks.
  - Authorities confident that the 2005 budget target was attainable even without any EVAT revenue this year.
  - The sharp reduction in the deficit targeted for 2006 rests squarely on full implementation of the EVAT.
  - Medium-term objective: balance the budget and aim to achieve this goal ahead of schedule by 2008.
  - Authorities expect improved tax administration to play a crucial role after EVAT implementation; staff argued additional measures would be needed, such as a sweeping rationalization of tax incentives.
- 2006 budget and macro assumptions
  - 2006 National Government budget sets a deficit target of 2.1 percent of GDP.
  - Budget macro assumptions (nominal GDP growth, interest rates, exchange rate) broadly in line with staff projections in the Staff Report under the "reforms proceed" scenario.
  - Budget assumes full implementation of the EVAT law, including the rate increase from January 2006.
  - Budget allows for some increases in infrastructure spending, maintenance and operations, and wages.
  - Implied NFPS deficit in 2006: about 2¾ percent of GDP, aligning with staff-recommended upfront fiscal adjustment.
- Risks to fiscal outlook
  - Extension of VAT to power and petroleum products faces mounting opposition in Congress, with amendments under consideration to re-introduce exemptions on electricity and fuel.
  - Increasing the VAT rate next January is expected to face resistance.
  - Authorities stated that achieving fiscal targets was the major priority; in the event of revenue shortfalls they would adjust expenditure and seek alternative revenue, acknowledging short-run limitations.
  - Possible deterioration in GOCC finances is a risk; authorities monitoring individual enterprises to ensure contribution to deficit reduction.
- Mitigating measures to increase public support for EVAT
  - Considered measures: elimination of excises on kerosene (already provided), reduction in excises on gasoline (already provided), reducing oil import duties from 5 percent to 3 percent or possibly to zero, increasing subsidy through electricity life-line tariffs.
  - Public relations campaign launched to explain benefits of the EVAT to the public.
  - Staff endorsed mitigating measures that preserve the integrity of the EVAT law and emphasized measures should be well-targeted with limited cost in terms of foregone revenue.
  - Staff estimate: widening the VAT base to include fuel and power yields annual revenue of P 27 billion (0.5 percent of GDP); planned reduction in petroleum excises reduces revenue by P 14 billion; cutting the oil duty rate from 5 to 3 percent would cost a further P 7 billion; reducing the oil duty rate to zero would imply a net negative for the budget.
- Oil price effects and energy conservation
  - Authorities planning to revise down growth projections due to sharp oil price rises; staff projections in Staff Report of GDP growth of 4¾ percent in 2005 and 2006 already incorporate recent oil price rises.
  - Current energy savings campaign: rationing of fuel for government cars and agencies required to cut energy consumption by at least 10 percent; extension to private sector under consideration on a voluntary basis.
- Monetary policy discussion
  - BSP core inflation: 6.6 percent (y/y) in August, down from 6.8 percent in July and 7.1 percent in June.
  - Staff concerns: continued above-target inflation feeding into higher inflationary expectations; narrowed interest differentials given latest Fed tightening; risks from keeping interest rates too low illustrated by regional developments.
  - Authorities view: July increase in reserve requirements represented tightening not fully reflected in staff assessment; downplayed contagion risks from Indonesia due to lack of comparable fuel subsidies in the Philippines.
  - Authorities ready to raise policy rates if necessary to prevent inflation from escalating.

### III. STAFF APPRAISAL
- Endorsements and recommendations
  - Staff welcome authorities’ reaffirmation of commitment to reform, particularly amid high oil prices.
  - EVAT law is key to achieving the sharp reduction in the public sector deficit targeted for 2006 and should be fully implemented as soon as the Supreme Court lifts the restraining order.
  - Staff support authorities’ preference for mitigating measures that preserve the integrity of the EVAT law rather than amending EVAT legislation to defer removal of VAT exemptions on energy.
  - Mitigating measures should be well-targeted and affordable in terms of foregone revenue.
  - Staff welcome authorities’ intention to continue allowing full pass through of high oil prices into domestic fuel prices to avoid subsidies and help prevent reversal of fiscal consolidation.

### Key statistics and projections (preserved as reported)
- Nominal GDP (2004): P4,826 billion ($92.2 billion)
- Population (2003, est.): 81.8 million
- GNP per capita (2003, est.): $1,035
- IMF quota: SDR 879.9 million
- Selected time-series (2002–2006, staff projections where shown)
  - Real GDP: 4.4, 4.5, 6.0, 4.7, 4.8
  - CPI (annual average): 3.0, 3.5, 6.0, 8.2, 7.5
  - CPI (end year): 2.5, 3.9, 8.6, 8.1, 6.0
  - Gross investment (percent of GDP): 17.5, 16.7, 17.1, 17.2, 17.2
  - National saving (percent of GDP): 23.2, 18.4, 19.8, 19.2, 19.1
  - National government balance (authorities definition, percent of GDP): -5.3, -4.7, -3.9, -3.6, -3.6
  - Nonfinancial public sector balance (percent of GDP): -5.7, -5.6, -5.1, -4.0, -4.0
  - Revenue and grants (percent of GDP): 20.9, 21.0, 20.5, 21.8, 21.8
  - Expenditure (percent of GDP): 26.6, 26.6, 25.6, 25.8, 25.8
  - Nonfinancial public sector debt: 93.7, 101.3, 96.1, 92.4, 90.0
  - Interest rate (91-day Treasury bill, end of period, in percent): 5.9, 6.5, 8.4, 6.4
  - Export value (percent change): 10.0, 2.8, 9.6, 4.0, 8.9
  - Import value (percent change): 6.2, 20.1, 10.6, 5.2, 9.2
  - Current account (percent of GDP): 5.7, 1.8, 2.7, 2.0, 1.9
  - Capital and Financial account (US$ billions, excluding errors and omissions): 1.2, -2.2, -2.1, -1.9, -1.2
  - Foreign direct investment (net, US$ billions): 1.7, 0.2, 0.1, 0.2, 0.4
  - Overall balance (US$ billions): 0.7, -1.7, 0.6, -0.1, 0.6
  - Monitored external debt (percent of GDP): 77.7, 79.3, 71.5, 66.2, 63.3
  - Debt-service ratio (percent of exports): 19.9, 20.6, 19.7, 18.4, 19.2
  - Reserves, adjusted (US$ billions): 14.3, 14.7, 15.2, 15.0, 15.6
  - Reserves / Short-term liabilities, adjusted: 123.9, 122.9, 121.2, 109.8, 110.5
  - Exchange rate (period averages) Pesos per U.S. dollar: 51.6, 54.2, 56.3, 56.3
  - Nominal effective exchange rate (Jan 2, 2003 =100): 107.4, 95.1, 83.8, 87.3
  - Real effective exchange rate (Jan 2, 2003 =100): 92.5, 95.6, 91.5
- Additional reported figures
  - Inflation through August averaged 8.1 percent.
  - 91-day treasury bill rate declined about 200 basis points in 2005 to date.
  - Balance of payments: surplus of $2 billion in the first half of the year; overseas worker remittances rose by more than one-fifth (y/y); net portfolio inflows jumped to $1.9 billion, compared with $0.1 billion in the same period in the previous year.

*International Monetary Fund: Post-Program Monitoring discussions and accompanying staff supplement (as presented in the supplied content).*

### 2004. Events since June have led to a marked slowing in portfolio inflows. Exports grew by

### _cr05372 - 2004. Events since June have led to a marked slowing in portfolio inflows. Exports grew by

### Economic performance and recent developments
- Exports grew by only 4½ percent through July as a result of soft market conditions for Asian electronics and the lagged effects of relatively low investment in production capacity in recent years.
- Despite higher oil prices, imports remained virtually flat.
- Reserves (net of pledged assets) were US$17.5 billion at end-August, well above the end-2004 level of $15.2 billion.
- Recent growth has been largely consumption-driven.
- For the first seven months of this year, the budget deficit was less than half the P180 billion (around US$3.2 billion) forecast for the year, on the back of better revenue collection and prudent spending.

### Risks to the near-term outlook
- Primary risk: prevailing state of uncertainty proving protracted and sidelining economic reforms.
  - If reforms stall, investment is likely to remain subdued, and GDP growth of 4¾ percent is projected for 2005 and 2006.
- Soaring oil prices pose a threat, particularly if they soften demand for Philippine exports.
- Adverse developments in international capital markets and changes in market sentiment, increases in global interest rates, and oil prices could materially weaken the outlook.
- Concern that persistence of above-target inflation for a prolonged period could lead to an upward and permanent revision of inflationary expectations, especially when considering higher oil prices, a weaker exchange rate, and planned VAT increases.

### Executive Board and Directors’ assessment and recommendations
- Commendation for significant progress with economic reforms in the first year of the new administration and improved market stability as recent political uncertainties receded.
- Emphasis on pressing ahead with implementation of the comprehensive reform package in fiscal, power, and banking sectors to:
  - reduce vulnerabilities,
  - achieve public debt sustainability over the medium term,
  - improve the investment and business climate for higher and sustainable growth.
- Directors emphasized that an accelerated pace of reforms would send a strong signal to markets and boost investor confidence.
- Directors underscored the crucial importance of meaningful fiscal consolidation and debt reduction for enhancing stability and growth prospects.
- Considered the expanded Value Added Tax (EVAT) reform, including the envisaged VAT rate increase, as the best option to reduce the fiscal deficit; expressed concern at EVAT implementation delays due to a Supreme Court appeal and urged consideration of alternative revenue-raising measures if EVAT cannot be implemented in full.
- Urged authorities to resist pressures to exempt energy products from the VAT increase, but supported well-targeted and affordable mitigating measures to preserve EVAT integrity given hardship to the poor.
- Noted that even with full EVAT implementation a gap remains to balance the budget by 2010; encouraged planning additional measures such as sweeping rationalization of tax incentives and expenditure reforms (including rationalizing and improving targeting of rice subsidies).
- Welcomed authorities’ intention to allow full pass through of high oil prices in domestic fuel prices to avoid subsidies and prevent reversal of fiscal consolidation.
- Viewed significant increases in generation tariffs awarded to the National Power Corporation as important to fiscal consolidation; encouraged timely future tariff adjustments and development of medium-term deficit targets for Government-Owned and Controlled Corporations.
- Highlighted civil service and pension reforms as critical for sustainable fiscal consolidation; welcomed reform efforts and actuarial review of the social security system.
- Stressed that power sector privatization is essential to restore sector financial viability and facilitate needed investments; expressed concern about delays in bidding for transmission assets and urged finalization of agreements holding up privatization of generation assets within a sound regulatory framework.
- Considered a case still exists for tightening monetary policy to guide inflation expectations down, despite recent reserve requirement increases; welcomed authorities’ readiness to monitor developments closely.
- Welcomed progress in banking sector reform (decline in nonperforming loan ratios) and use and planned extension of the special purpose vehicle (SPV) framework; encouraged close monitoring of trust and pre-need sectors.
- Expressed concern that amendments to the central bank’s charter critical to strengthening bank supervision are still pending in Congress; stressed need for early approval.
- Looked forward to adoption of International Financial Reporting Standards by end-2005 to improve banking sector transparency.
- Welcomed continued progress in strengthening anti-money laundering/combating the financing of terrorism regime and in strengthening financial and balance of payments statistics.

### Fiscal policy, tax reform, and social mitigation
- Since 2004, three new tax measures enacted: higher excise taxes on tobacco and liquor; a rewards and penalties system to enhance performance in revenue collection agencies; and restructuring of the VAT system.
- EVAT signed into law in May to broaden the VAT base and provide for a rate adjustment in 2006; implementation stayed by the Supreme Court in July but early September ruling was favorable and law expected to take effect late this month or early October.
- Social protection measures in the EVAT law include:
  - reduction to zero of excise taxes on diesel, kerosene and bunker fuel oil,
  - zero-rating of VAT on electricity from non-oil power plants,
  - removal of the franchise tax on power distribution utilities,
  - reduction of import tariffs on petroleum products when EVAT is implemented.
- Authorities plan to use part of 2006 and beyond revenue gains to fund spending on critical social needs and infrastructure while keeping overall expenditures under close watch.
- Next fiscal reforms include acceleration of privatization and rationalization of fiscal incentives; proceeds from state-owned asset sales to be used for deficit reduction (example: sale of stake at Philippine National Bank).

### Monetary policy and exchange rate stance
- Monetary policy focused on quelling inflationary pressures; a rate hike in April and increases in reserve requirements in July aimed at cementing inflation expectations.
- Central bank committed to price stability, communicates policy considerations, and monitors inflation drivers—including spiraling oil price effects, indicators of slack, demand pressures, domestic liquidity, and other variables.
- Central bank stands ready to respond to threats to price stability as warranted; not ruling out further policy action in the short run.
- Maintains a flexible exchange rate policy while building comfortable international reserves; peso broadly stable.
- Authorities aware of exposure due to high foreign debt and large external financing requirements and emphasize prudent debt management and accelerated reforms to reduce reliance on external debt.

### Structural reforms: power, banking, and financial market development
- Power sector:
  - Recent hikes in power rates have reduced NPC’s shortfall, helping limit public sector deficit.
  - Lifeline or discounted rates continue for poor households to mitigate social impact.
  - Government plans to sell 70 percent of NPC’s power generating assets by the first quarter of 2006; to date six power plants sold, amounting to 11 percent.
  - Bidding for transmission company concession expected by the first quarter of 2006, if not earlier.
  - Authorities pursuing reduction of systems losses, efficiency improvements, energy conservation, expansion of rural electrification.
- Banking sector:
  - Non-performing loan (NPL) ratio down to single digit at 9.2 percent (as of end-June 2005), the lowest in seven years.
  - Nearly a fifth of the stock of non-performing assets has been reduced through sales to SPVs and improved collections/loan settlements.
  - Progress in rehabilitation of intervened banks, including sale of PNB, and in bank consolidation.
  - Plans to adopt International Financial Reporting Standards by end-2005 and to phase in higher risk-weighting on NPLs prior to Basel II implementation in 2007.
  - High priority on BSP charter amendments to strengthen regulation and supervision, enhance legal protection for supervisors, and ensure prompt resolution of problem banks.
- Financial market development:
  - Steps to develop domestic capital market infrastructure include launch of the Fixed Income Exchange System in March and implementation of third party custodian system.
  - Support for establishment of more domestic credit rating agencies and an enhanced credit information system (Credit Information System Act).
  - Advocacy for passage of key legislation: Corporate Recovery Act, Revised Investment Company Act, Personal Equity Retirement Account Act, Pre-Need Industry Code.

### Policy implementation, governance, and social protection
- Authorities emphasize short-term difficult adjustments and sacrifices to realize lasting dividends of sustainable and balanced growth; intensified public information campaigns to explain costs of inaction or delay.
- Measures to improve public governance include e-procurement, streamlining bureaucracy and procurement law, more transparent and accountable procedures, lifestyle checks, and suspension or removal of erring public officials.
- Social safety nets exist but must be well targeted given tight fiscal constraints; authorities plan well-targeted social transfers and mitigation measures incorporated into EVAT law.

### Key statistics and projections (as presented)
- GDP growth: 2002 4.4 2003 4.5 2004 6.0 2005 (IMF Staff Proj.) 4.7
- CPI inflation (average): 2002 3.0 2003 3.5 2004 6.0 2005 8.2
- National government balance (authorities definition, percent of GDP): 2002 -5.3 2003 -4.7 2004 -3.9 2005 -3.6
- National government balance (IMF definition, percent of GDP): 2002 -5.6 2003 -5.0 2004 -4.2 2005 -3.9
- Nonfinancial public sector balance (percent of GDP): 2002 -5.7 2003 -5.6 2004 -5.1 2005 -4.0
  - Revenue and grants (percent of GDP): 2002 20.9 2003 21.0 2004 20.5 2005 21.8
  - Expenditure (percent of GDP): 2002 26.6 2003 26.6 2004 25.6 2005 25.8
- Broad money (M3, percent change): 2002 9.5 2003 3.3 2004 9.2 2005 13.2 (note 5/)
- Interest rate (91-day Treasury bill, end period, percent): 2002 5.9 2003 6.5 2004 8.4 2005 6.4 (note 6/)
- Credit to the private sector (net, percent change): 2002 1.2 2003 1.8 2004 4.7 2005 2.8 (note 5/)
- Trade balance (billions of U.S. dollars): 2002 0.4 2003 -5.5 2004 -6.4 2005 -7.2
- Current account balance (billions of U.S. dollars): 2002 4.4 2003 1.4 2004 2.3 2005 2.0
- Gross international reserves (in billions of U.S. dollars): 2002 16.2 2003 16.9 2004 16.2 2005 17.9 (note 6/)
- Adjusted reserves, in billions of U.S. dollars (note 7/): 2002 14.3 2003 14.7 2004 15.2 2005 17.5 (note 6/)
- Adjusted reserves, in percent of short-term liabilities (note 8/): 2002 123.9 2003 122.9 2004 121.2

*Source: IMF staff report and Executive Board assessment as summarized in the provided content.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2005/_cr05372.pdf_