## _cr0762

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---

### Executive Summary — Recent economic developments
- Growth and inflation
  - Growth averaged 5.4 percent (y/y) in the first three quarters of 2006, up from 4.8 percent in the same period in 2005.
  - Staff revised the growth forecast for 2006 from 5.0 to 5.5 percent.
  - Headline inflation fell to 4.3 percent (y/y) in December, implying average inflation of 6.2 percent in 2006.
  - The inflation target is 4-5 percent for 2006 and 2007.
  - Staff estimate underlying (core) inflation to be running between 3-4 percent.
  - Nearly 50 percent of the population live on less than $2 a day.

- Drivers of growth and external flows
  - Private consumption and exports were principal growth drivers; remittances are up 17 percent (y/y) through October.
  - Recovery in both electronics and non-electronics exports supported growth.
  - Cumulative net FDI inflows were $1.6 billion as of September, up by two thirds compared to the same period in 2005.
  - Net portfolio inflows from July through November were $1.3 billion, five times the level in the same period in 2005.
  - The peso appreciated by 7½ percent against the U.S. dollar during 2006.

- Fiscal developments
  - Revenues grew by over 20 percent in January-October (y/y) following full implementation of the VAT reform.
  - The national government deficit is expected to have shrunk further in 2006 and to be significantly below the target of 2 percent of GDP.
  - The 2007 budget programs a further reduction in the national government deficit to 0.9 percent of GDP and a large increase in priority infrastructure and social spending.

- Reserves, debt management, and liquidity
  - The Bangko Sentral ng Pilipinas continued to build reserves while using off-balance sheet currency swaps with local banks to reduce the impact on reserve money.
  - In 2006, the BSP prepaid $1.4 billion of its external obligations, including term and gold backed loans and outstanding obligations to the Fund.
  - The national government retired around $800 million of its external debt, including Brady Bonds.
  - M3 growth peaked at 16.2 percent (y/y) in August 2005, and reached 18.5 percent in November 2006.

### Policy response and assessment — exchange rate, fiscal, and monetary
- Exchange rate and reserve policy
  - Authorities: continued exchange rate flexibility, accumulating reserves, scaling back external borrowing, and pre-paying external debt.
  - Staff view: policy mix appropriate given relatively low reserve cover, volatility of capital flows, and indicators that the exchange rate is not out of line with fundamentals.
  - Recommended: maintain exchange rate flexibility, continue reserve accumulation, prioritize pre-payment of expensive external debt, monitor reserve adequacy and capital flow volatility.

- Fiscal policy and reform
  - VAT reform and tax administration improvements boosted tax revenues and facilitated fiscal consolidation.
  - Staff welcome commitment to continued fiscal consolidation; balancing the budget over the medium term while raising priority spending will require further revenue effort.
  - Authorities regard accelerating implementation of tax administration reforms as crucial.
  - Staff emphasize need for new tax measures, such as rationalization of tax incentives, and careful monitoring of other parts of the public sector.

- Monetary policy and tiering
  - BSP reintroduced tiering in early November: progressively lower interest rates on bank liquidity placed at the BSP:
    - the policy rate on the reverse repo window (currently 7½ percent) on balances up to P 5 billion;
    - the policy rate minus 200 basis points on balances above P 5 billion and below P 10 billion;
    - the policy rate minus 400 basis points on balances above P 10 billion.
  - Staff note tiering complicates assessment of the monetary policy stance; effective easing implied is large and could endanger the inflation forecast.
  - Authorities view tiering as temporary; staff encourage removal of tiering should the inflation outlook change.

### Outlook and risks
- Debt dynamics and vulnerabilities
  - Staff expect nonfinancial public sector (NFPS) debt to have fallen below 80 percent of GDP by end-2006, compared to 100 percent at end-2003.
  - External debt is expected to have declined by a similar order of magnitude.
  - Rollover and exchange rate risk remain high; vulnerability to a sudden reversal in global risk appetite remains.

- Risk scenarios and policy implications
  - Local markets could be hard hit by renewed global risk aversion, particularly if coinciding with signs of fiscal slippage ahead of the May 2007 elections.
  - Sustaining reform momentum is essential to maintain investor confidence and generate growth spillovers needed for poverty reduction.

### Staff conclusions and recommendations (Executive Summary)
- Maintain exchange rate flexibility, continue reserve accumulation, and prioritize pre-payment of expensive external debt while monitoring reserve adequacy and capital flow volatility.
- Sustain fiscal consolidation and raise revenues through accelerated tax administration reforms and new tax measures, including rationalization of tax incentives.
- Monitor the tiering scheme closely; remove tiering if inflationary pressures re-emerge or if the inflation outlook worsens.
- Strengthen financial sector supervision by securing legal protection for supervisors through BSP Charter amendments and continue efforts to reduce distressed assets.
- Use the power sector supply contract and related reforms to accelerate privatization of power sector assets and improve sector performance.

### Medium-term outlook and reform scenarios
- Baseline scenario (Currently Identified Measures Scenario, Table 5) assumptions and outcomes:
  - National government meets its 2007 deficit target of 1 percent of GDP by spending less than budgeted amounts.
  - Staff assume slower-than-expected revenue growth and little chance of new tax measures ahead of the elections.
  - If no additional revenue measures over the medium term, the NFPS deficit would settle at 2 percent of GDP.
  - Public investment would increase only modestly.
  - Growth is expected to rise to 5.8 percent in 2007 and remain at that level over the medium term.

- Additional Reforms Scenario (Table 6) outcomes:
  - An additional revenue effort would allow authorities to meet the 2007 deficit target without compressing expenditure.
  - The NFPS deficit could be eliminated over the medium term while substantially increasing infrastructure investment.
  - Combined with improvements in the business climate, higher investment and brighter growth would follow.

- Under both scenarios:
  - Public debt would decline significantly, but would still remain sizable by 2011.

### Fiscal reforms, revenue requirements, and tax policy
- Recent achievements and 2007 challenge:
  - VAT reform fully implemented; tax revenues expected to rise by 1.3 percent of GDP in 2006.
  - Meeting the 2007 budget twin objectives requires national government revenue to grow by 15 percent, above projected nominal GDP growth of 10 percent.
  - Passing new tax measures before the May 2007 elections will be difficult; cutting expenditure would undermine infrastructure and social spending.
  - Staff suggested a slightly less ambitious 2007 deficit target might be appropriate; authorities rejected relaxation.

- Medium-term fiscal needs and policy options:
  - Additional tax effort of about 2½ percent of GDP needed over the medium term to balance the budget and augment priority spending.
  - Staff proposed reducing tax incentives and raising and indexing excises to inflation.
  - Early announcement of tax measures for the 2008 budget recommended to signal commitment to fiscal consolidation.
  - Authorities favor establishing a credible tax collection record to secure Congressional support for new measures.

### Tax administration reform and other public sector reforms
- Tax administration progress:
  - Developing an anti-tax evasion program and cleaning the taxpayer register at the Bureau of Internal Revenue (BIR).
  - Early approval of the World Bank tax administration loan expected to provide framework for donor support.
  - Staff urged BIR to accelerate cleaning the taxpayer register, auditing tax arrears, and drafting industry-based audit manuals; authorities agreed.

- Other reforms:
  - Civil service reform: most government agencies expected to submit rationalization plans by year-end.
  - Social Security System (SSS) reforms: increase in contribution rate, better policing of delinquent contributors, information campaign; projected exhaustion of SSS resources extended until 2031 while allowing benefits to be increased by 10 percent.
  - Initial steps to better monitor public enterprises; comprehensive review of the National Food Authority underway.
  - Performance reviews ongoing for 20 other government agencies.

### Monetary policy and tiering — details and guidance
- Re-introduction of tiering:
  - Initial staff calculations pointed to a 200 basis point cut in effective terms, although part was subsequently unwound (Chart 14).
  - Private sector estimates of effective easing have ranged between 50 and 300 basis points.
  - Reintroduction led to a rise in bond market volatility.

- Staff guidance:
  - Rapid removal of tiering warranted if the inflation outlook becomes less favorable, in the event of a rise in global risk aversion, or renewed hikes in international oil prices.
  - Authorities view tiering as temporary and are monitoring inflationary pressures.

### Banking sector: NPAs, capital, supervision, and recommendations
- Findings on NPAs and capital
  - Disposal of NPAs expected to accelerate with higher risk weighting under Basel II and extension of the SPV law through April 2008.
  - Where acceleration does not occur, staff suggested further tightening of regulatory requirements on NPAs.
  - Progress made in disposal of NPLs, but stock of ROPOAs remains large and concentrated; ROPOAs likely overvalued, implying some banks effectively undercapitalized.
  - Recent consolidation and capital-raising welcomed; BSP should maintain pressure on banks to raise capital.
  - Banks strengthening balance sheets likely contributed to slow loan growth; staff estimate cyclical factors could account for about a third of explained variation in bank lending.

- Legislative and supervisory framework
  - BSP Charter amendments agreed by authorities to fortify supervision by providing legal protection for supervisors; amendments remained stuck in Congress with poor near-term prospects.
  - Authorities positive about early adoption of the Credit Information Systems Act.

- Policy recommendations
  - Consider further tightening of regulatory requirements on NPAs if disposal does not accelerate.
  - Any regulatory relief provided to banks should be tied closely to the new PCA framework.
  - BSP should maintain pressure on banks to raise capital.
  - Continue to press for passage of BSP Charter amendments to make the strengthened regulatory framework fully effective.
  - Adoption of the Credit Information Systems Act should help improve credit risk management.

### Capital market development and power sector
- Capital markets
  - Action plan to further develop capital markets finalized.
  - Initiatives to improve trust industry operations and public debt management using debt swaps to develop benchmark issues.
  - Legislative initiatives pending in Congress expected to facilitate capital market development (credit information bureaus, retirement saving vehicles).

- Power sector
  - NPC operations registered a slight surplus through September, helped by a stronger peso, higher sales, and lower fuel costs.
  - Recent long-term supply contract between Meralco and NPC should remove uncertainty and drive privatization forward.
  - Steps to bid out Transco with three pre-qualified bidders for 25-year concession.
  - Medium-term challenges: substantial need for new capacity from 2009 onward; large NPC debt payments scheduled for 2009-11, averaging US$1.5 billion per year.
  - Recommendation: accelerate power sector privatization and use Meralco–NPC contract to shift assets into private hands; timely Transco sale could improve privatization prospects and strengthen the investment climate.

### Box 2 — Banking Sector Reforms (selected initiatives and standards)
- SPV framework and NPAs
  - SPV law (introduced 2002) provides regulatory and tax advantages for disposing NPAs.
  - Sales of P 100 billion of NPAs (one fifth of the stock) have been concluded.
  - Framework extended in March 2006 for another two years.

- Prudential and supervisory measures
  - DOSRI lending regulations expanded in March 2004 to include subsidiaries and affiliates; exposure limits and stiffer penalties introduced.
  - Consolidated supervisory framework phased in.
  - New PCA framework adopted February 2006 to intervene before significant capital decline and introduce sanctions for noncompliance.
  - BSP phasing in Basel II and risk-based supervision.
  - February 2005: additional 25 percent assigned to risk weighting on NPLs (bringing it to 125 percent).
  - On July 1, 2007: standardized approach for credit and operational risks required; NPAs risk weightings increased to 150 percent; capital charge equivalent to 15 percent of operating revenue for operational risk; 100 percent weighting on Philippines external sovereign bonds (ROPs) to be phased in over three years.

- Financial transparency
  - From end-2005, bank financial statements to follow International Financial Reporting Standards (IFRS).
  - Banks allowed to defer recognition of losses from NPA sales under SPV framework, but audited financial statements subject to a qualified opinion.
  - New rules issued to clarify internal and external audit roles (November 2005 and February 2005).

### Growth, inflation, public finances, external sector — key statistics and projections
- GDP growth:
  - 2002: 4.4
  - 2003: 4.9
  - 2004: 6.2
  - 2005: 5.0
  - 2006 (Staff proj.): 5.5
  - 2007 (proj.): 5.8

- Inflation (CPI, average):
  - 2002: 3.0 percent
  - 2003: 3.5 percent
  - 2004: 6.0 percent
  - 2005: 7.6 percent
  - 2006 (Staff proj.): 6.2 percent
  - 2007 (proj.): 4.0 percent

- National government balance (authorities' definition) as percent of GDP:
  - 2002: -5.3
  - 2003: -4.6
  - 2004: -3.8
  - 2005: -2.7
  - 2006 (Staff proj.): -1.5
  - 2007 (proj.): -1.0

- Nonfinancial public sector balance:
  - 2002: -5.7
  - 2003: -5.6
  - 2004: -5.0
  - 2005: -2.1
  - 2006 (Staff proj.): -0.9
  - 2007 (proj.): -0.7

- Revenue and grants (percent of GDP):
  - 2002: 20.9
  - 2003: 20.9
  - 2004: 20.5
  - 2005: 22.1
  - 2006 (Staff proj.): 23.2
  - 2007 (proj.): 23.2

- Expenditure (percent of GDP):
  - 2002: 26.6
  - 2003: 26.4
  - 2004: 25.5
  - 2005: 24.2
  - 2006 (Staff proj.): 24.1
  - 2007 (proj.): 23.9

- Current account balance (percent of GDP):
  - 2002: -0.4
  - 2003: 0.4
  - 2004: 1.9
  - 2005: 2.0
  - 2006 (Staff proj.): 2.9
  - 2007 (proj.): 2.1

- Gross international reserves (billions of U.S. dollars):
  - 2002: 16.4
  - 2003: 17.1
  - 2004: 16.2
  - 2005: 18.5
  - 2006 (Actual): 23.0

- Adjusted reserves as percent of short-term liabilities:
  - 2002: 126.1
  - 2003: 124.2
  - 2004: 125.8
  - 2005: 120.1
  - 2006: 166.8

- Reserve adequacy (authorities’ assessment):
  - International reserves approximately $23 billion at year-end 2006, exceeding the $21 billion target.
  - Reserve level can finance 4.4 months of imports of goods and services.
  - Reserve level equivalent to 4.0 times the country’s short-term external debt based on original maturity and 2.3 times based on residual maturity.

- Monetary and banking indicators:
  - Broad money (M3) percent change:
    - 2002: 9.5
    - 2003: 3.3
    - 2004: 9.2
    - 2005: 9.0
    - 2006 (as of September 2006): 14.3
  - 91-day Treasury bill secondary market end-period rates (percent):
    - 2002: 5.9
    - 2003: 6.5
    - 2004: 8.4
    - 2005: 6.4
    - 2006 (Actual): 5.1

### Effects of the tax reform and social impacts
- Distributional effects and mitigation
  - Staff analysis based on the 2003 Family Income and Expenditure Survey suggests the reform had a modest effect on household budgets, with lower income households bearing a smaller share of the tax burden relative to income.
  - Measures undertaken by the authorities have been successful in cushioning the impact of the tax increase on the lower income strata.

- Tax administration measures and expenditure reduction
  - Steps: cleaning the tax register, comprehensive computerization at the BIR, development of an anti-tax evasion program.
  - Civil service reform and rationalization plans aimed at reining in costs and increasing public service efficiency.
  - Government Electronic Procurement System (G-EPS) and intensified campaign against graft and corruption.

### Concluding policy priorities and surveillance
- Core priorities:
  - Sustain reform momentum to maintain confidence and guard against volatility.
  - Continue emphasis on exchange rate flexibility while conducting intervention to build reserves.
  - Shift toward domestic rather than external financing and seek opportunities for prepayment of external debt.
  - Accelerate tax administration reform and consider new tax measures, including rationalization of tax incentives.
  - Fortify bank balance sheets through supervisory strengthening, BSP Charter amendments, and continued NPA resolution efforts.
  - Accelerate power sector privatization and set monitorable performance targets for GOCCs.

- Surveillance and program status
  - Data provision for surveillance adequate overall though some deficiencies remain; authorities are addressing shortcomings, particularly in balance of payments data.
  - Exit from PPM appropriate given reform progress; staff recommend the next Article IV Consultation be held on the standard 12-month cycle.

*Source: Executive Summary (IMF Article IV Consultation, 2006) — _cr0762 - Executive Summary_*

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

### Executive Summary

### Recent Economic Developments
- Growth and inflation
  - Growth averaged 5.4 percent (y/y) in the first three quarters of 2006, up from 4.8 percent in the same period in 2005.
  - Staff revised the growth forecast for 2006 from 5.0 to 5.5 percent.
  - Headline inflation fell to 4.3 percent (y/y) in December, implying average inflation of 6.2 percent in 2006.
  - The inflation target is 4-5 percent for 2006 and 2007.
  - Staff estimate underlying (core) inflation to be running between 3-4 percent.
  - Nearly 50 percent of the population live on less than $2 a day.

- Drivers of growth and external flows
  - Private consumption and exports were principal growth drivers; remittances are up 17 percent (y/y) through October.
  - Recovery in both electronics and non-electronics exports supported growth.
  - Cumulative net FDI inflows were $1.6 billion as of September, up by two thirds compared to the same period in 2005.
  - Net portfolio inflows from July through November were $1.3 billion, five times the level in the same period in 2005.
  - The peso appreciated by 7½ percent against the U.S. dollar during 2006.

- Fiscal developments
  - Revenues grew by over 20 percent in January-October (y/y) following full implementation of the VAT reform.
  - The national government deficit is expected to have shrunk further in 2006 and to be significantly below the target of 2 percent of GDP.
  - The 2007 budget programs a further reduction in the national government deficit to 0.9 percent of GDP and a large increase in priority infrastructure and social spending.

- Reserves, debt management, and liquidity
  - The Bangko Sentral ng Pilipinas continued to build reserves while using off-balance sheet currency swaps with local banks to reduce the impact on reserve money.
  - In 2006, the BSP prepaid $1.4 billion of its external obligations, including term and gold backed loans and outstanding obligations to the Fund.
  - The national government retired around $800 million of its external debt, including Brady Bonds.
  - M3 growth peaked at 16.2 percent (y/y) in August 2005, and reached 18.5 percent in November 2006.

### Policy Response and Assessment
- Exchange rate and reserve policy
  - The authorities have responded to strong balance of payments inflows through continued exchange rate flexibility, accumulating reserves, scaling back external borrowing, and pre-paying external debt.
  - Staff consider this policy mix appropriate given relatively low reserve cover, the volatility of capital flows, and indicators that the exchange rate is not out of line with fundamentals.

- Fiscal policy and reform
  - Fiscal reforms, notably the VAT reform and tax administration improvements, boosted tax revenues and facilitated fiscal consolidation.
  - Staff welcome the authorities’ commitment to continued fiscal consolidation.
  - Balancing the budget over the medium term while raising priority spending will require further revenue effort.
  - Authorities regard accelerating implementation of tax administration reforms as crucial.
  - Staff emphasize that new tax measures, such as a rationalization of tax incentives, will also be needed.
  - Careful monitoring of other parts of the public sector should support the fiscal consolidation effort.

- Monetary policy and tiering
  - The BSP reintroduced tiering in early November, under which bank liquidity placed at the BSP receives progressively lower interest rates:
    - the policy rate on the reverse repo window (currently 7½ percent) on balances up to P 5 billion;
    - the policy rate minus 200 basis points on balances above P 5 billion and below P 10 billion;
    - and the policy rate minus 400 basis points on balances above P 10 billion.
  - Staff note that tiering complicates assessment of the monetary policy stance and that the effective easing implied is large and could endanger the inflation forecast.
  - Authorities view tiering as a temporary measure consistent with inflation continuing to trend down; staff encourage removal of tiering should this outlook change.

- Financial sector and structural reforms
  - Progress is being made in strengthening bank balance sheets, but the level of distressed assets remains high.
  - Approval of changes to the BSP Charter remains essential to equip supervisors with adequate legal protection.
  - In the power sector, the recent agreement on a long-term supply contract with the largest distributor represents an important opportunity to accelerate the shift of power sector assets into private hands.

### Outlook and Risks
- Debt dynamics and vulnerabilities
  - Staff expect nonfinancial public sector (NFPS) debt to have fallen below 80 percent of GDP by end-2006, compared to 100 percent at end-2003.
  - External debt is expected to have declined by a similar order of magnitude.
  - Despite improvements, rollover and exchange rate risk remain high and the Philippines remains vulnerable to a sudden reversal in global risk appetite.

- Risk scenarios and policy implications
  - Local markets could be hard hit by a renewed rise in global risk aversion, particularly if it coincides with signs of fiscal slippage in the run-up to the May 2007 elections.
  - Sustaining the reform momentum is essential to maintain investor confidence and to generate growth spillovers needed for poverty reduction.

### Staff Conclusions and Recommendations
- Maintain exchange rate flexibility, continue reserve accumulation, and prioritize pre-payment of expensive external debt while monitoring reserve adequacy and capital flow volatility.
- Sustain fiscal consolidation and raise revenues through accelerated tax administration reforms and new tax measures, including rationalization of tax incentives.
- Monitor the tiering scheme closely; remove tiering if inflationary pressures re-emerge or if the inflation outlook worsens.
- Strengthen financial sector supervision by securing legal protection for supervisors through BSP Charter amendments and continue efforts to reduce distressed assets.
- Use the power sector supply contract and related reforms to accelerate privatization of power sector assets and improve sector performance.

*Source: Executive Summary (IMF Article IV Consultation, 2006) — _cr0762 - Executive Summary_*

### 9.      A loss of reform momentum would have negative economic implications over the

### _cr0762 - 9.      A loss of reform momentum would have negative economic implications over the

### Medium-term outlook and reform scenarios
- Baseline scenario (Currently Identified Measures Scenario, Table 5) assumptions and outcomes:
  - National government meets its 2007 deficit target of 1 percent of GDP by spending less than budgeted amounts.
  - Staff assume slower-than-expected revenue growth and little chance of new tax measures ahead of the elections.
  - If no additional revenue measures over the medium term, the NFPS deficit would settle at 2 percent of GDP.
  - Public investment would increase only modestly.
  - Growth is expected to rise to 5.8 percent in 2007 and remain at that level over the medium term.
- Additional Reforms Scenario (Table 6) outcomes:
  - An additional revenue effort would allow authorities to meet the 2007 deficit target without compressing expenditure.
  - The NFPS deficit could be eliminated over the medium term while substantially increasing infrastructure investment.
  - Combined with improvements in the business climate, this scenario would be conducive to higher investment and brighter growth.
- Under both scenarios:
  - Public debt would decline significantly, but would still remain sizable by 2011 (Appendix I).

### Policy challenges discussed
- Main policy challenges identified:
  - Dealing with continued strong foreign exchange inflows.
  - Ensuring that fiscal reforms continue and are sustainable.
  - Strengthening structural and financial sector foundations for higher medium-term growth.

### Dealing with continued strong foreign exchange inflows
- Exchange rate and reserve dynamics:
  - By appreciation against the U.S. dollar metric, upward pressure on the Peso has been relatively modest (Chart 12).
  - Factoring in reserve accumulation, including off-balance sheet currency swaps, upward pressure has been much higher (Chart 13).
  - Overall appreciation pressure on the Peso comparable to that experienced by the Thai Baht, the strongest performer in the region against the U.S. dollar in 2006.
- Authorities' policy response considered appropriate by staff:
  - Allow exchange rate flexibility while further building reserves.
  - Some reserve accumulation is justifiable because:
    - The exchange rate is not obviously undervalued (Box 1).
    - Reserves are still low compared to other emerging markets.
    - Capital inflows could easily reverse.
  - Shift towards domestic rather than external financing of the budget (Text Table 3).
  - Plan to seek additional opportunities for prepayment of external debt.
  - Reintroduction of tiering represents an effective easing of monetary policy and initially helped take pressure off the exchange rate.
- Public sector external borrowings (Text Table 3, in millions of U.S. dollars):
  - Commercial: 2003 3,859; 2004 4,739; 2005 4,106; 2006 3,772; 2007 1,900.
  - National Government 2/: 2003 3,014; 2004 4,185; 2005 3,337; 2006 2,850; 2007 1,300.
  - Other Public Sector: 2003 845; 2004 554; 2005 769; 2006 922; 2007 600.
  - Official: 2003 1,449; 2004 1,172; 2005 1,186; 2006 1,157; 2007 1,466.
  - Total: 2003 5,308; 2004 5,911; 2005 5,291; 2006 4,929; 2007 3,366.

### Monetary policy and tiering
- Re-introduction of tiering:
  - Represents an easing of monetary policy; initial staff calculations pointed to a 200 basis point cut in effective terms, although part was subsequently unwound (Chart 14).
  - Private sector estimates of effective easing have ranged between 50 and 300 basis points.
  - The reintroduction led to a rise in bond market volatility (Chart 15).
- Staff guidance:
  - Rapid removal of tiering would be warranted if the inflation outlook becomes less favorable, in the event of a rise in global risk aversion, or renewed hikes in international oil prices.
  - Authorities view tiering as a temporary measure and are monitoring inflationary pressures.

### Fiscal reforms, revenue requirements, and tax policy
- Recent fiscal reform achievements:
  - VAT reform fully implemented; tax revenues expected to rise by 1.3 percent of GDP in 2006.
  - Removal of a provision limiting input credit to 70 percent of output VAT for certain businesses—welcomed by staff.
- 2007 budget and revenue challenge:
  - Meeting the 2007 budget’s twin objectives (further consolidation and higher priority spending) requires national government revenue to grow by 15 percent, above projected nominal GDP growth of 10 percent.
  - Passing new tax measures before the May 2007 elections will be difficult.
  - Cutting expenditure to meet the deficit target would undermine infrastructure and social spending.
  - Staff suggested a slightly less ambitious 2007 deficit target might be appropriate to maintain overall downward direction, but authorities rejected relaxation for political optics reasons and to incentivize collection efficiency.
- Medium-term fiscal needs:
  - An additional tax effort of about 2½ percent of GDP is needed over the medium term to balance the budget and augment priority spending.
  - Staff proposed reducing tax incentives and raising and indexing excises to inflation as potential revenue raisers.
  - Early announcement of tax measures for the 2008 budget recommended to signal commitment to continued fiscal consolidation.
  - Authorities argued Congressional support for new measures contingent on fully collecting VAT reform revenues and favored focusing on establishing a credible tax collection record.

### Tax administration reform and other public sector reforms
- Tax administration progress and priorities:
  - Initial steps: developing an anti-tax evasion program and cleaning the taxpayer register at the Bureau of Internal Revenue (BIR).
  - Early approval of the World Bank tax administration loan expected to provide a framework for donor financial and technical support.
  - While awaiting donor mobilization, staff urged the BIR to accelerate cleaning the taxpayer register, auditing tax arrears, and drafting industry-based audit manuals; authorities agreed.
- Other reforms on track:
  - Civil service reform proceeding; most government agencies expected to submit rationalization plans by year-end.
  - Social Security System (SSS) reforms:
    - Increase in contribution rate.
    - Better policing of delinquent contributors.
    - Information campaign to attract new members.
    - Result: projected exhaustion of SSS resources extended until 2031, while allowing benefits to be increased by 10 percent (first hike since 2003).
  - Initial steps to better monitor public enterprises; comprehensive review of the National Food Authority underway to set monitorable performance targets.
  - Performance reviews ongoing for 20 other government agencies to improve operational efficiency.

### Strengthening structural and financial sector foundations for higher medium-term growth
- Factors pointing to higher investment growth:
  - (i) Remittances increasingly channeled into real estate investment.
  - (ii) Profits in the non-financial corporate sector have increased sharply.
  - (iii) Financial sector has reduced its non-performing assets.
  - (iv) Finances of NPC have improved.
- Remittances:
  - Surge driven by global trends, a rise in the number of overseas workers, and a shift to higher skill jobs.
  - Remittance growth accelerated in recent years (Chart 16).
  - Market analysts estimate remittances used for home purchases in the last 12 months at about $3 billion.
  - Shift of remittances from consumption to investment is promising and may promote broader recovery in investment.
- Non-financial corporate sector and FDI:
  - Profitability in the non-financial corporate sector exceeded that in the rest of the region in 2005, with evidence of further acceleration in 2006 (Chart 17).
  - Surge in the stock market should reduce the cost of capital (Chart 18).
  - Staff expect investment in the mining sector to pick up sharply in 2007 despite legal and local government obstacles.
  - Authorities indicated FDI in mining could be in excess of $850 million in 2007, nearly quadruple the 2006 level.
  - Governance improvements in the Medium Term Philippine Development Plan (MTPDP) are targeted to support investor confidence; some signs of improvement after a decade of deterioration (Chart 19).
- Financial sector and distressed assets:
  - Solving the distressed assets problem is necessary for the banking system to support investment revival.
  - Since the 2001 FSAP, regulatory and supervisory frameworks have been strengthened, but progress in resolving NPAs has been relatively slow due to:
    - Fiscal constraints limiting use of public money.
    - Bank supervisors hindered by lack of legal protection.
  - The level of NPAs in the banking system has remained high and bank capital has grown only slowly (Chart 20), leaving the system vulnerable.
  - Regional evidence links slower NPL resolution with lower investment growth (Chart 21).
  - Banks strengthening balance sheets likely contributed to slow loan growth as weaker banks became less inclined to lend (Chart 22); staff estimate cyclical factors could have accounted for about a third of explained variation in bank lending in recent years.
  - Lending to households grew rapidly from a small base, supported by residential real estate, automobile, and credit card financing.
  - Resolution progress:
    - SPV framework (2003–2005) spurred progress, but the stock of NPAs remains large.
    - Important banks still burdened by large stocks of NPLs and ROPOAs; ROPOAs likely overvalued, implying some banks effectively undercapitalized.
    - Implementation of IFRS and gradual phasing in of Basel II increased capitalization needs, inducing weaker banks to raise capital or merge.
    - New Prompt Corrective Action (PCA) framework provides time-bound mechanisms to deal with problem banks and appears to strengthen enforcement.

*Source: IMF staff report content provided in the supplied PDF excerpt.*

### 28.      Additional efforts are needed to fortify bank balance sheets. The authorities

### _cr0762 - 28.      Additional efforts are needed to fortify bank balance sheets. The authorities

### Banking sector: NPAs, capital, and supervision
- Findings:
  - The authorities expected the disposal of NPAs to accelerate with the prospect of higher risk weighting under Basel II and the recent extension of the SPV law through April 2008.
  - Where acceleration in NPA disposal does not occur, staff suggested a further tightening of regulatory requirements on NPAs should be considered.
  - The authorities intended to provide regulatory relief strictly within the parameters of the new PCA framework.
  - There was agreement with staff that close monitoring of the implementation of the agreed MOUs would ensure the reform momentum did not stall.
  - Current positive market sentiment and the improved performance of the economy were viewed as permitting banks to raise a substantial amount of new capital.
  - Progress has been made in the disposal of NPLs, but the stock of ROPOAs remains large and concentrated.
  - Recent consolidation in the banking sector and efforts by banks to raise new capital are welcome; the BSP should maintain pressure on banks to raise capital.
- Policy recommendations:
  - Consider further tightening of regulatory requirements on NPAs if disposal does not accelerate.
  - Any regulatory relief provided to banks should be tied closely to the new PCA framework.
  - The BSP should maintain pressure on banks to raise capital.
- Related operational points:
  - Adoption of the Credit Information Systems Act currently tabled in Congress should help banks improve credit risk management.
  - Notes on ROPOAs: although values may rise with general real estate price increases, time erodes their value due to depreciation, neglect, squatters, unresolved titling, and other legal issues that may be costly when disposing of these assets.

### Legislative and supervisory framework
- Findings:
  - Amendments to the BSP Charter were agreed by the authorities to significantly fortify bank supervision by providing legal protection for bank supervisors, allowing them to increase pressure on banks to raise capital, and facilitating prompt closure of problem banks.
  - These BSP Charter amendments remained stuck in Congress and, with elections approaching, the near-term prospects for passage were poor.
  - The authorities were more positive about early adoption of the Credit Information Systems Act, which would foster greater transparency and improve credit access.
- Policy recommendations:
  - Continue to press for passage of BSP Charter amendments so the strengthened regulatory framework can become fully effective.

### Capital market development
- Findings:
  - An action plan to further develop capital markets has been finalized.
  - Several initiatives are ongoing to improve the operations of the trust industry following a sell-off in May-June 2006.
  - Authorities have used debt swaps to develop strong benchmark issues along the sovereign yield curve.
  - Various legislative initiatives pending in Congress are expected to facilitate capital market development, including the Personal Equity and Retirement Account bill, the Pre-Need Code, and amendments to the Investment Company Act.
- Policy recommendations:
  - Continue public debt management and legislative initiatives (credit information bureaus, retirement saving vehicles) to promote domestic capital market development.

### Power sector: NPC performance, privatization, and financing needs
- Findings:
  - NPC operations registered a slight surplus through September, helped by a stronger peso, higher sales, and lower fuel costs.
  - Despite initial low prices in the Wholesale Electricity Supply Market (WESM), privatization progress has been slow.
  - A recent long-term supply contract agreement between Meralco and NPC should remove uncertainty and drive privatization forward.
  - Steps are being taken to bid out Transco, with three pre-qualified bidders contending for the 25-year concession.
  - Medium-term challenges: substantial need for new capacity expected from 2009 onward; large NPC debt payments scheduled for 2009-11, averaging US$1.5 billion per year.
- Policy recommendations:
  - Accelerate power sector privatization and seize the opportunity presented by the Meralco–NPC long-term supply contract to shift power sector assets into private hands.
  - A timely outcome to the Transco sale could help improve privatization prospects more generally.
- Operational note:
  - Authorities expect successful privatization would strengthen the investment climate and help with debt repayments.

### Macroeconomic and fiscal context (Staff Appraisal highlights relevant to financial reforms)
- Findings:
  - Significant fiscal reforms have lifted financial markets and economic performance: sovereign spreads have fallen, the peso has rallied, the stock market has boomed, reserves have risen to new highs, and rating agencies have revised outlooks from negative to stable.
  - Growth has remained robust and inflation has declined.
  - Vulnerabilities remain high: public debt is highly sensitive to rollover and exchange rate risk; external commercial borrowing requirements are still large.
  - The exchange rate appreciation: Peso rose 10.3 percent versus the U.S. dollar in the year through September, and strengthened 14.8 percent in real effective terms (from Box 1).
  - The national government deficit is expected to have fallen by a further 1.2 percentage points of GDP in 2006, with a similar decline expected for the NFPS deficit.
- Policy recommendations:
  - Sustain reform momentum to reduce vulnerabilities and maintain positive growth spillovers for poverty reduction.
  - Continue emphasis on exchange rate flexibility while conducting some intervention to build reserves.
  - Shift toward domestic rather than external financing and seek opportunities for prepayment of external debt.
  - Careful monitoring to ensure monetary policy has not become too easy given recent tiering; authorities should remove tiering if the inflation outlook changes.
  - Accelerate implementation of tax administration reforms and consider new tax measures, such as rationalization of tax incentives.
  - Put performance targets in place for important GOCCs and sustain the turnaround in NPC’s finances.
- Surveillance and program status:
  - Data provision for surveillance is adequate overall though some deficiencies remain; authorities are addressing shortcomings, particularly in balance of payments data.
  - The exit from PPM is appropriate given reform progress; staff look forward to regular Article IV surveillance.
  - Recommendation: next Article IV Consultation with the Philippines be held on the standard 12-month cycle.

*Source: _cr0762 - 28.      Additional efforts are needed to fortify bank balance sheets. The authorities*

### Box 2. Banking Sector Reforms

### Box 2. Banking Sector Reforms

### Initiatives to deal with NPAs
- The Special Purpose Vehicle (SPV) law, introduced in 2002, provides regulatory and tax advantages to banks disposing of their NPAs.
- Sales of P 100 billion of NPAs (one fifth of the stock) have been concluded.
- The framework (that expired in April 2005) was extended in March 2006 for another two years.

### Regulatory and supervisory framework
- Prudential regulations governing lending to related interests (DOSRI) were expanded in March 2004 to include subsidiaries and affiliates.
- Exposure limits have also been introduced, as well as stiffer penalties for noncompliance.
- In parallel, a consolidated supervisory framework has been phased in.
- A new PCA framework was adopted in February 2006, allowing banking supervisors to intervene before a significant decline in capital occurs and introducing specific sanctions if banks do not comply with their capital restoration plan.
- The BSP is gradually phasing in Basel II and adopting risk-based supervision for the country’s commercial banks.
- In February 2005, an additional 25 percent was assigned to the risk weighting on NPLs (bringing it to 125 percent).
- On July 1, 2007, banks will be required to implement the standardized approach for credit and operational risks.
  - In particular, risk weightings for NPAs will be increased to 150 percent.
  - A capital charge equivalent to 15 percent of operating revenue will be introduced to cover operational risk.
  - A 100 percent weighting on Philippines external sovereign bonds (ROPs) will be phased in over three years.

### Financial transparency
- From end-2005, the financial statements of banks have to be prepared in line with the International Financial Reporting Standards, which imply more rigorous valuation requirements.
- Although banks will be allowed to defer recognition of losses from their NPA sales under the SPV framework, their audited financial statements will be subject to a qualified opinion.
- A new set of rules and standards have been issued to clarify the role of internal and external audit functions (in November 2005 and February 2005, respectively).

*Source: _cr0762 - Box 2. Banking Sector Reforms*

### 5.0 percent previously projected. Private consumption has continued to be the main

### _cr0762 - 5.0 percent previously projected. Private consumption has continued to be the main

### Growth and inflation
- GDP growth:
  - 2002: 4.4
  - 2003: 4.9
  - 2004: 6.2
  - 2005: 5.0
  - 2006 (Staff proj.): 5.5
  - 2007 (proj.): 5.8
- Inflation (CPI, average):
  - 2002: 3.0 percent
  - 2003: 3.5 percent
  - 2004: 6.0 percent
  - 2005: 7.6 percent
  - 2006 (Staff proj.): 6.2 percent
  - 2007 (proj.): 4.0 percent
- Headline inflation in December 2006 fell within the Bangko Sentral ng Pilipinas (BSP) inflation target of 4-5 percent for 2006; December 2006 headline inflation recorded at 4.3 percent.
- Private consumption remained the main driver of growth, underpinned by rapid growth in remittances.
- Staff expectation: on current policies, growth is expected to increase to 5.8 percent in 2007; could be higher over the medium term with additional reforms.

### Public finances and fiscal consolidation
- National government balance (authorities' definition) as percent of GDP:
  - 2002: -5.3
  - 2003: -4.6
  - 2004: -3.8
  - 2005: -2.7
  - 2006 (Staff proj.): -1.5
  - 2007 (proj.): -1.0
- National government balance (IMF definition):
  - 2002: -5.6
  - 2003: -4.9
  - 2004: -4.2
  - 2005: -3.0
  - 2006 (Staff proj.): -1.9
  - 2007 (proj.): -1.3
- Nonfinancial public sector balance:
  - 2002: -5.7
  - 2003: -5.6
  - 2004: -5.0
  - 2005: -2.1
  - 2006 (Staff proj.): -0.9
  - 2007 (proj.): -0.7
- Revenue and grants (percent of GDP):
  - 2002: 20.9
  - 2003: 20.9
  - 2004: 20.5
  - 2005: 22.1
  - 2006 (Staff proj.): 23.2
  - 2007 (proj.): 23.2
- Expenditure (percent of GDP):
  - 2002: 26.6
  - 2003: 26.4
  - 2004: 25.5
  - 2005: 24.2
  - 2006 (Staff proj.): 24.1
  - 2007 (proj.): 23.9
- Drivers of improved fiscal position in 2006:
  - Faster-than-expected adjustment due to Congress failing to pass the 2006 Budget; 2005 Budget re-enacted, constraining spending.
  - VAT reform and improved tax administration increased revenue.
  - Savings from National Power Corporation and improved social security institutions’ performance.
  - Prepayment of external debt, including to the IMF.

### External sector, capital flows, and reserves
- Trade balance (percent of GDP):
  - 2002: -7.2
  - 2003: -7.3
  - 2004: -6.6
  - 2005: -7.9
  - 2006 (Staff proj.): -7.7
  - 2007 (proj.): -7.6
- Current account balance (percent of GDP):
  - 2002: -0.4
  - 2003: 0.4
  - 2004: 1.9
  - 2005: 2.0
  - 2006 (Staff proj.): 2.9
  - 2007 (proj.): 2.1
- Gross international reserves in billions of U.S. dollars:
  - 2002: 16.4
  - 2003: 17.1
  - 2004: 16.2
  - 2005: 18.5
  - 2006 (Actual): 23.0
- Adjusted reserves in billions of U.S. dollars:
  - 2002: 14.5
  - 2003: 14.9
  - 2004: 15.2
  - 2005: 18.0
  - 2006 (Actual): 23.0
- Adjusted reserves as percent of short-term liabilities:
  - 2002: 126.1
  - 2003: 124.2
  - 2004: 125.8
  - 2005: 120.1
  - 2006: 166.8
- Reserve adequacy (authorities’ assessment):
  - International reserves at approximately $23 billion at year-end 2006, exceeding the $21 billion target.
  - Reserve level can finance 4.4 months of imports of goods and services.
  - Reserve level equivalent to 4.0 times the country’s short-term external debt based on original maturity and 2.3 times based on residual maturity.
- Capital flows:
  - Robust remittances continued to grow strongly.
  - Pick-up in foreign direct investment and a pronounced acceleration in net portfolio inflows in the second half of 2006.
  - Peso appreciated against the U.S. dollar (8.3 percent appreciation, average closing rate P49.03/$1 for 2006).

### Monetary policy and banking sector
- Broad money (M3) percent change:
  - 2002: 9.5
  - 2003: 3.3
  - 2004: 9.2
  - 2005: 9.0
  - 2006 (as of September 2006): 14.3
- 91-day Treasury bill secondary market end-period rates (percent):
  - 2002: 5.9
  - 2003: 6.5
  - 2004: 8.4
  - 2005: 6.4
  - 2006 (Actual): 5.1
- Credit to private sector (net) percent change:
  - 2003: 1.2
  - 2004: 1.8
  - 2005: 4.6
  - 2006: -1.5 (as of September 2006)
  - 2007: -2.2 (as of September 2006)
- Tiering scheme:
  - Reintroduced in early November 2006 on banks’ placements with the BSP to encourage banks to lend excess funds rather than place them with the BSP.
  - Some Directors cautioned tiering corresponded to a significant effective easing and created uncertainties about the monetary policy stance; those Directors encouraged removal of tiering should inflation outlook deteriorate. Some Directors saw tiering as appropriate to address low bank lending.
- Banking sector vulnerabilities and policy responses:
  - Progress in disposing of non-performing assets (NPAs), but stock of repossessed real estate assets remains large.
  - Directors urged tightening regulatory requirements on NPAs if disposals do not accelerate.
  - Directors welcomed bank consolidation and capital-raising but encouraged BSP to maintain pressure on banks to raise new capital, ensuring regulatory relief fits the new framework.
  - Directors urged passage of long-delayed changes to the BSP Charter to strengthen legal protection for supervisors and increase leverage over problem banks.

### Structural reforms, policy challenges, and risks
- Key challenge: sustain reform momentum to maintain market confidence and insure against market volatility.
- Structural priorities identified:
  - Put public debt on a more sustainable downward path.
  - Boost investor confidence and investment through fiscal, power, banking, and governance reforms.
  - Accelerate privatization in the power sector following agreement on a long-term supply contract between the National Power Corporation and the largest power distributor.
  - Strengthen tax administration and consider new tax measures, including rationalization of tax incentives.
  - Legislative initiatives to support domestic capital markets, including bills to create credit information bureaus and promote retirement saving vehicles.
- Main downside risks to the outlook:
  - Renewed surge in oil prices.
  - Slowdown in the global economy.
  - Sudden reversal in global risk appetite (global risk aversion).
- Authorities’ external-debt management:
  - Used greater availability of foreign exchange to prepay external debt, including to the IMF, and shifted towards reduced reliance on external borrowing.
- Executive Directors’ views:
  - Commended substantial strengthening of macroeconomic performance in 2006; welcomed early repayment of IMF obligations and exit from Post-Program Monitoring (PPM) at end-2006.
  - Urged continued reforms to sustain confidence and address remaining vulnerabilities, including sensitivity of public debt to rollover and exchange rate risks.
  - Considered current policy mix on exchange rate broadly appropriate; urged continued exchange rate flexibility and supported shift to domestic financing and prepayment of external debt.

*International Monetary Fund — Philippines: Article IV Consultation staff report and Executive Board assessment (content provided in source PDF).*

### 2005.  Measures undertaken by the authorities have been successful in cushioning the impact

### _cr0762 - 2005.  Measures undertaken by the authorities have been successful in cushioning the impact

### Effects of the tax reform
- Staff analysis based on the 2003 Family Income and Expenditure Survey suggests that the reform had a modest effect on household budgets, with the lower income households bearing a smaller share of the tax burden relative to income.
- Measures undertaken by the authorities have been successful in cushioning the impact of the tax increase on the lower income strata of the population, as indicated by staff findings discussed in the selected issues paper.

### Tax administration measures
- A more efficient tax administration is crucial to increased revenue.
- Steps taken by the authorities include:
  - cleaning the tax register;
  - instituting a comprehensive computerization program at the Bureau of Internal Revenue (BIR); and
  - developing an anti-tax evasion program.
- The authorities sought the assistance of the World Bank in the form of a tax administration loan aimed at providing a framework for financial and technical support from other donors.

### Expenditure reduction and civil service reform
- Attaining fiscal consolidation entails expenditure reduction, a major component of which relates to civil service reform.
- With most government agencies expected to submit their rationalization plans by year-end, the streamlining of the bureaucracy is aimed at:
  - reining in costs;
  - increasing public service efficiency through the abolition of overlapping functions and closure of offices that have outlived their purposes.
- Reforms in other public sector entities are proceeding vigorously to further enhance balance sheets.
- An important aspect of the reform includes comprehensive reviews of the operations of government agencies, a first step towards setting monitorable performance targets with the objective of improving efficiency of their operations.
- The Department of Finance (DOF) has intensified its campaign against graft and corruption and exerted efforts to improve procurement efficiency through the Government Electronic Procurement System (G-EPS).

### Fiscal targets, 2007 measures, and political context
- Moving forward, staff emphasized the need for new tax measures in 2007 to keep within fiscal targets for the year and in order not to undermine the authorities’ commitment to a balanced budget by 2008.
- Staff inquired on the possibility of the authorities’ adopting a less ambitious 2007 deficit target, but one which continued to show the downward deficit-to-GDP trend.
- The authorities argued strongly to maintain their target because:
  - they did not want any misinterpretation that a relaxation in the target deficit is an attempt to increase election spending;
  - they felt a lower deficit target may lead to a slackening of efforts by those in charge of collection operations;
  - a less ambitious target will not help the authorities in seeking approval for new tax measures from Congress.

### Furthering the structural reform agenda and privatization
- Staff pointed to the need to further improve the business environment; this is recognized by the authorities and improved governance is a priority area in the Medium-Term Philippine Development Plan (MTPDP).
- The Government has sustained efforts to privatize assets, mainly those in the power sector led by the National Power Corporation and the National Transmission Corporation.
- The successful privatization of three hydropower plants (472MW) in 2006 indicates strong investor confidence in the country’s energy sector, and boosts the privatization prospects further.

### Financial sector challenges and BSP strategy
- The BSP’s medium-term plan emphasizes financial system stability and aims to:
  - develop a stronger, more efficient and less vulnerable banking system that can effectively meet the requirements of the country’s medium-term economic development program;
  - foster the development of the broader financial system through a more accelerated development of the domestic capital market.
- The BSP employed a four-point strategy including:
  - acceleration of the adoption of risk-based supervision technology;
  - promotion of corporate governance reform and strengthening of market discipline through better financial transparency, more specifically through the adoption of the International Financial Reporting Standards (IFRS);
  - advancement of capital market initiatives; and
  - further improvement in the regulatory framework and its implementation, through alignment with Basel and other international standards.
- Legislative and regulatory initiatives:
  - The BSP has worked closely with Congress to ensure passage of legislation that addressed the high level of nonperforming assets in the financial system.
  - It is continuing to push for amendments to the Central Bank Act to strengthen its supervisory and regulatory powers, including by providing legal protection for bank supervisors and facilitating closure of problem banks.
  - The BSP’s Monetary Board approved a liability insurance scheme for its officers and bank examiners which offers financial safeguard to BSP officials faced with lawsuits for any act committed in relation to the performance of their duties.

### Concluding remarks and Fund relations
- The authorities are strongly aware of the importance of maintaining consistency and discipline in macroeconomic policy and pursuing additional reform measures, and of the need to initiate these additional reforms promptly.
- Developments particularly in the first half of the year when the elections are scheduled to take place, will be a crucial test of the administration’s will to continue moving ahead.
- The Philippines’ early repayment of its outstanding financial obligations to the Fund has triggered the country’s exit from its post-program monitoring, four months earlier than the scheduled termination.
- While this ends the country’s financial dependence on Fund resources, the authorities intend to maintain a close working relationship with the Fund, particularly through the regular productive exchange of views during Article IV consultations, and Fund support to enhance technical capabilities and data systems.

*Source: _cr0762 - 2005.  Measures undertaken by the authorities have been successful in cushioning the impact*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2007/_cr0762.pdf_