Public Information Notice No. 04/116

Public Information Notice: IMF Concludes 2004 Post-Program Discussion with the Philippines

October 3, 2004

On August 27, 2004, the Executive Board of the International Monetary Fund (IMF) concluded Post-Program Monitoring discussions on the Philippines based on information available through that date.¹

Background

Financial markets conditions came under increasing pressure in the first quarter of 2004 as uncertainty regarding the May 10 elections clouded investor sentiment. Conditions have since stabilized as markets look to implementation of reform measures announced in President Arroyo's state of the nation address on July 26.

The economy grew a robust 6.4 percent in the first quarter of 2004 over the same period last year. Strong growth in agriculture and a pre-election surge in consumption supported the first quarter GDP outturn. Conditions also improved in the manufacturing sector on the back of a recovery in exports. However, despite the good growth performance, unemployment rose to 13.7 percent in the second quarter. Meanwhile, inflation has accelerated and reached 6.0 percent (year on year,1994-based CPI) in June from 3.1 percent (y/y) at end-2003. Higher food, fuel, and transportation prices have contributed to the pick-up in inflation. With a view to draining excess peso liquidity the Bangko Sentral ng Pilipinas (BSP) raised liquidity reserve requirements for banks earlier in the year but has held policy rates steady.

External developments have been positive. Exports grew by 8½ percent through June (y/y), a significant improvement on the 2.9 percent increase recorded in 2003 (full year), and to date have offset a higher oil import bill. Remittances have increased only modestly, by 2.6 percent (y/y) in the first half of 2004, partly due to developments in the Middle East where a significant number of Filipino overseas workers are employed. Reflecting in part public sector borrowing, gross reserves of the BSP were $16.2 billion at end-June 2004.

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

The banking sector continues to remain saddled with high levels of nonperforming assets, which are backed by relatively low reserve coverage, and profitability continues to be constrained. With low capitalization and weak credit demand, banks have preferred to invest in government securities instead of expanding credit.

The economic outlook for the Philippines depends importantly on the pace of implementation of the authorities' reform program. The staff expects GDP growth to moderate to 4.9 percent for 2004 as a whole while average inflation will likely be close to the upper end of the authorities target range of 4-5 percent.

Executive Board Assessment

Executive Directors agreed with the thrust of the staff appraisal. They welcomed the robust growth performance of the Philippine economy, and commended the authorities for their success in maintaining economic stability during the preelection period. Directors noted, however, that over the last few years the pace of reforms has been slow. As a result, the large external financing requirements and high public indebtedness leave the Philippine economy vulnerable to a sudden deterioration in investor sentiment and/or a sharp increase in global interest rates, with potentially adverse implications for access to capital markets and for the stability of the public finances and the economy.

Directors underscored that the favorable growth performance, combined with the recent renewal of the government's political mandate, present the administration with a unique opening to break from the past by addressing long-standing economic weaknesses and boldly pursuing a vigorous and far-reaching agenda of economic reforms. Seizing this opportunity will be crucial for addressing the Philippine economy's vulnerabilities to external shocks while helping to underpin investor confidence and improve debt dynamics. This will lay the basis for stronger and more sustained economic growth and job creation, and contribute to significant poverty reduction over the medium term. Directors accordingly welcomed the authorities' commitment to formulate a substantive package of fiscal and structural reforms, particularly in the energy and banking sectors, and encouraged them to develop, present, and implement specific action plans in these areas at an early stage. They endorsed the authorities' clear articulation of the need for reforms, which hopefully will help to build the legislative support and social consensus critical for successful implementation of the reform package.

Directors agreed that putting public finances back on a sustainable path is an essential element of the reform package, and welcomed the authorities' commitment to balancing the budget by 2009. They emphasized that the high and rising level of public debt underscores the importance of saving the bulk of the revenue gains from the tax measures under consideration. Directors also generally considered that a front-loaded reduction in the fiscal deficit will help to bring public debt on a clearly sustainable path, and create room for a much-needed recovery in private investment. They expressed concern that were the bulk of the additional revenue from the new tax measures to be spent, the 2009 target would be harder to achieve.

Directors emphasized that the nature and quality of the fiscal measures will also be critical. They welcomed the current proposals to increase alcohol, tobacco, and petroleum excises and to rationalize tax incentives. Directors also supported the authorities' ongoing efforts to strengthen tax administration, particularly Value Added Tax (VAT) compliance. They called on the authorities to consider raising the VAT rate, which is low by international standards. Directors welcomed the authorities' intention to revive the Fiscal Responsibility Bill, which aims to ensure that no new expenditures are approved without the corresponding revenue measures. While recognizing the authorities' intentions to simplify the tax system, Directors generally concurred that the proposed introduction of gross income taxation carries revenue risks, could introduce significant distortions in the tax system, and could in fact complicate tax administration and continue to provide undue room for discretion by revenue officials. In addition, the proposed new tax amnesties could hamper taxpayer compliance over time. In view of these concerns, Directors welcomed the authorities' intention to carefully consider the staff's advice in formulating their new tax policies.

Directors considered the rationalization of public expenditure as equally important in placing public finances on a sustainable footing over the medium term. They welcomed the current proposals to streamline the civil service, including through eliminating redundant positions and voluntary early retirement, as well as the concrete steps being taken to shore up the finances of the pension funds. Directors also noted the importance of ensuring that expenditure on social programs is protected.

Directors stressed the importance of continued prudent monetary policy management in underpinning a stable macroeconomic environment conducive to the implementation of reforms. They commended the BSP for its conduct of monetary policy in recent years under its inflation-targeting framework. The inflation outlook appears uncertain at this juncture, particularly as regards to the potential impact of the reform package. Directors noted that the recent acceleration in inflation stemming from adverse supply-side shocks, along with prospective increases in power tariffs and indirect taxes, risks breaching the official inflation target in 2005. They accordingly welcomed the authorities' intention to stand ready to tighten monetary policy if it appears that inflation would exceed the target by more than what can be attributed to the first-round impact of the food and oil price shocks. More generally, Directors stressed the importance of the BSP maintaining a high degree of transparency in communicating its monetary policy stance. Some Directors suggested that one way to further strengthen transparency could be to announce the extent to which the central bank would allow the inflation rate to exceed the envisaged target for 2005 before taking corrective measures. However, other Directors cautioned that ex ante announcements of acceptable deviations from the target could cloud the policy message for markets and the public.

Directors underscored the importance of the steps under consideration to further reform the power sector, and urged their steadfast implementation in order to restore the sector's financial viability and reduce its drain on public finances. They recognized that arresting the NPC's losses will be a difficult goal to meet without further significant increases in power tariffs, which are already high by regional standards. In this regard, Directors supported the authorities' intention to implement time-of-use pricing to mitigate the impact of the envisaged tariff increases on international competitiveness as well as to consider better targeting of life-line tariffs in order to shield vulnerable consumers. Directors indicated that these measures will need to be complemented by efforts to support the independence of the Energy Regulatory Commission in making decisions regarding tariff rates. They also stressed the need to accelerate the privatization of power generation and transmission assets. In particular, the prompt enactment of the Transco franchise bill by Congress and reduction of regulatory uncertainty will be pivotal for attracting private investment in the power sector and minimizing risks of supply shortages over the medium term.

Directors underscored the need to accelerate banking sector reform. They expressed concerns about the quality of the assets in the banking system, which has left the system with low capitalization and not fully able to support economic growth. While welcoming the recent steps taken to strengthen the regulatory and supervisory framework, including the financial reform package that was announced by the BSP in late August, Directors observed that the current strategy of inducing banks to voluntarily off-load nonperforming assets needs to be supported by stepping up the supervisory pressure on them to improve their balance sheets and to adopt best accounting practices so that latent loan losses are better recognized. Provision of stronger legal protection for supervisors will be critical for enhancing their ability to exert supervisory pressure. Directors urged the authorities to muster the political support needed for legal amendments to the charters of the BSP and the Philippine Deposit Insurance Corporation that would support the authorities' implementation of a comprehensive restructuring strategy for the banking system. The authorities were also encouraged to advance their implementation of Anti-Money Laundering/Combating Financing of Terrorism measures.

Directors welcomed the completion and publication of the data module of the Report on the Observance of Standards and Codes and encouraged the authorities to intensify efforts to implement the recommendations made in it.

Directors expressed support for the authorities' intention to continue a close and constructive relationship with the Fund through post-program monitoring.