PHILIPPINES QUARTERLY UPDATE Public Disclosure …...Sailing Through Stormy Waters July 2009 ... (1) a substantial downward revision in global prospects for 2009, which will affect

PHILIPPINES QUARTERLY UPDATE

Sailing Through Stormy Waters

July 2009

The World Bank Group in the Philippines

Making Growth Work for the Poor

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Philippines Quarterly Update — July 2009

2

Overview Economic activity contracted sharply in Q1 on a QoQ seasonally adjusted basis. A YoY 0.5 percent contraction is now expected for 2009 and a modest recovery is projected for 2010. Several factors are driving our growth forecast: (1) a substantial downward revision in global prospects for 2009, which will affect the prospects for exports and remittances, (2) the large revisions to 2008 growth, which revealed that the economy was weaker than initially estimated, (3) the contraction in domestic demand in Q1 2009 despite continued positive remittance inflows, which suggests that precautionary savings is affecting private consumption, (4) a delayed impact of the fiscal stimulus, and (5) weaker than expected underlying remittance inflows.

Rising remittance flows stopped buffering private consumption in early 2009. Despite modest growth of remittances in dollar terms, private consumption contracted sharply. Precautionary savings, possibly linked to the repatriation of savings by returning OFWs and flight-to-safety considerations (as households feared that foreign banking institutions that held their savings might fail) could explain this structural break. Preliminary evidence points to the latter as a potentially widespread motive. This would indicate significantly lower underlying remittance flows. Remittances to the Philippines are projected to contract by 4 percent in US$ terms in 2009 and to grow by 2 percent next year.

The economic contraction has started to affect the labor market. While unemployment decreased unexpectedly to 7.5 percent in April, other indicators suggest that the labor market is adversely affected by the crisis. These include: (1) a sharp increase in labor force participation, which is likely due to rising participation from spouses and children to supplement lower household income and could signal a rise in returning workers from overseas, and (2) an increase in informal sector employment (i.e. the number of wage and salaried workers declined, while self-employed and unpaid family workers increased).

The Government’s strategy to accompany the Economic Resiliency Plan with enhanced revenue efforts strikes the right balance. Despite large cash fiscal deficits in the first quarter of 2009, the public sector contribution to GDP growth was modest, because much of the cash outlays went to pay for work done last year. The impact of the Plan is expected to increase during the rest of 2009 as projects and measures to enhance social protection come on stream. However, the weakening of tax revenues limits the room for policy adjustments later in 2009 and risks undermining the stimulus. High deficits combined with uncertainty related to the 2010 general elections could put upward pressure on yields and crowd out private demand, thereby partially offsetting the fiscal stimulus. Therefore, speedy approval of the policy and administrative measures that the government has proposed to contain the overall fiscal deficit would be highly desirable.


3

Recent Economic Developments1

Output and Demand

1. The economy contracted significantly in the first quarter of 2009, following a rapid deceleration in economic growth in the second half of 2008. In 2008, growth slowed to 0.7 percent in the third quarter and to 0.3 percent in the fourth quarter (QoQ, seasonally adjusted)—Figure 1. However, as the global recession intensified, the Philippine economy shrank by 2.3 percent in the first quarter of 2009 (QoQ, seasonally adjusted), the lowest in over 20 years. GNP also contracted noticeably (by 1.2 percent, QoQ seasonally adjusted). The last simultaneous quarter-on-quarter contraction in seasonally adjusted GDP dates back to the first quarter of 2001. On a year-on-year basis, the economy expanded by 0.4 percent in Q1 2009 (Figure 2).

Figure 1. The Philippines contracted in the first

quarter (QoQ Seasonally Adjusted) Figure 2. YoY GDP growth reached its lowest

level since the Asian financial crisis

GDP & GNP Grow th (seasonally adjusted)

-3.0

-2.0

-1.0

0.0

1.0

2.0

3.0

4.0

Q1

-20

06

Q3-

200

6

Q1

-20

07

Q3-

200

7

Q1

-20

08

Q3-

200

8

Q1

-20

09

%

GDPGNP

GDP Growth (YoY basis)

-15%

-10%

-5%

0%

5%

10%

15%Q

4-1

982

Q2-

198

5

Q4-

198

7

Q2-

199

0

Q4

-19

92

Q2

-19

95

Q4

-19

97

Q2-

200

0

Q4-

200

2

Q2-

200

5

Q4

-20

07

GDPDomestic DemandPrivate Consumption

Source: National Statistical Coordination Board. 2. Domestic demand, the backbone of the economy, unexpectedly shrank in Q1 2009 while exports and imports continued to plummet. In the first quarter of 2009, private consumption—accounting for over 70 percent of GDP—contracted by 3.1 percent. On a year-on-year basis, it reached a 23-year low last observed during the deep recession of 1984-85. During both the 1991 power crisis and the 1997-98 Asian financial crisis, private consumption proved far more resilient than during the current recession (Figure 2). The decline in consumption is all the more surprising as data on consumer sentiment (e.g., from SWS, BSP), although still negative, were improving and 1 The Philippines Quarterly provides an update on recent economic developments and policies, and presents findings from ongoing World Bank work on the Philippines. The update is produced by a team from the Manila office consisting of Eric Le Borgne (task team leader), Karl Kendrick Chua, and Sheryll Namingit with support from the Philippines country team. Questions can be addressed to David Llorito ([email protected]).


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remittances—an important source of household income—proved resilient in nominal dollar terms and was even stronger in real peso terms.

3. Meanwhile, public spending provided only modest support to growth in Q1 2009. Stronger year-on-year growth in government consumption in the quarter was more than offset by public construction which continued to decline for the fifth consecutive quarter since Q1 2008 (with the notable exception of a surge in Q3 2008). The contraction occurred in spite of a 58.5 percent increase in payments for capital spending compared to Q1 2008 as strong cash disbursements were made for payments of goods and services rendered prior to Q1 2009. It should be noted, however, that a large dichotomy between cash payments and actual spending has been relatively common during economic downturns (Figure 3).

Figure 3. Despite hefty disbursement, public spending contributed modestly to growth 1/ 2/

Figure 4. Agriculture and industrial production contracted while services posted zero growth

Comparative Growth Between Govt Spending and Budget Disbursements

-20

-10

0

10

20

30

40

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

Govt Spending (NIA)Budget Disbursements

GDP Growth (QoQ seasonally adjusted)

-8

-6

-4

-2

0

2

4

Q1

-20

06Q

2-2

006

Q3

-20

06Q

4-2

006

Q1-

200

7Q

2-2

007

Q3-

200

7Q

4-2

007

Q1-

200

8Q

2-2

008

Q3

-20

08Q

4-2

008

Q1

-20

09

%

AgricultureIndustryServices

Sources: National Statistical Coordination Board and Department of Budget and Management. 1/ Government spending refers to government consumption and public construction. 2/ Budget disbursements refer to primary expenditure from the Department of Budget and Management.

4. Investment shrank significantly, with investment in durable equipment posting its largest contraction since the Asian financial crisis.2 The double-digit drop in capital formation observed during the last quarter of 2008 accelerated in the first quarter of 2009 with many business expansion put on hold. Private investment was noticeably lower as the buoyant growth of private construction, which for the most part represented ongoing property developments and a few new projects, did not offset the fall in investments in durable equipment. Quite the opposite, the ownership of dwelling and real estate sub-sector in the services sector was weak, reflecting lower demand even as prices of office spaces have reportedly gone down and inventory of residential and office units has increased since the latter part of 2008.

2 On a year-on-year basis as seasonally adjusted quarter-on-quarter growth is officially available only for the following series: GDP, GNP, PCE, agriculture, industry, and services.


5

5. On the supply side, industrial and agricultural production both contracted, while the large services sector was flat (Figure 4). After being almost flat in 2008 Q4, industrial production contracted by a twenty-year record of 6.6 percent (quarter-on-quarter seasonally adjusted) as both external and domestic demand for manufactures came under intense pressure. Agriculture, a priority sector under the government’s Economic Resiliency Plan also contracted, albeit by a more moderate 1 percent due to weak harvests of corn, sugarcane and other crops. The services sector, the growth driver in the past five years and which accounts for over half of GDP and employment, has been anemic for some time (it contracted by 0.2 percent in Q1 2008 and posted small positive growth in the subsequent quarters as key subsectors were affected by double digit inflation and the global financial crisis). The sector posted zero growth in Q1 2009 as the trade subsector, the largest of the services subsectors, dived. One subsector that continues to post robust growth is the Business Process Outsourcing industry. Some segments of the industry are even benefiting from the global recession-induced intensified search for expenditure optimization. As a result, the industry grew (YoY) at 7.6 percent in the first quarter from 8.4 percent in the same period last year.

Box 1. Philippines: Downward Revisions to 2006-2008 National Income Accounts

Annual accounts were revised downward from 2006 to 2008, with large revisions for 2008 (Table B1). Revised GDP estimates reveal that the economy decelerated from the 7.1 percent record YoY growth rate of 2007 to 3.8 percent in 2008 (instead of 4.6 percent, as initially reported), showing that the global economic crisis impacted the Philippines more profoundly than first estimated. On the supply side, downward revisions in services growth (mostly in the trade subsector) from 4.9 percent to 3.3 percent were the main source of downward GDP revision. On the demand side, net exports and capital formation were significantly revised downwards but a large upward revision on the statistical discrepancy buffered these (without the large statistical discrepancy, gross domestic expenditure actually contracted by 1.9 percent in Q1 2009). The magnitude of the recent revisions was observed to be higher than the historical mean of absolute revisions.1/

Table B1. Summary of YoY GDP Growth Revisions, in percentage points 1/

Demand Side 2006 2007 2008 Supply Side 2006 2007 2008Private Consumption 0.0 0.0 0.1 Agriculture 0.0 0.0 0.0Government Consumption 0.0 -0.1 -0.1 Industry -0.1 -0.1 0.0Capital Formation 0.0 0.2 -0.5 Services 0.0 0.0 -0.8Exports 0.0 -0.1 -0.9 Trade 0.0 0.0 -0.6Imports 0.0 0.2 1.6 Finance 0.0 0.0 -0.1

Statistical discrepancy -0.1 0.1 2.2O. Dwellings & Real Estate 0.0 0.0 -0.1Private Services 0.0 0.0 -0.1

GDP -0.1 -0.1 -0.8 GDP -0.1 -0.1 -0.8 Source: National Statistical Coordination Board. 1/ Figures in GDP subsectors refer to changes in contribution to GDP growth due to revisions. A positive number means an upward revision compared to the original estimates. _______________________________ 1/ Global Source Monthly Report, June 2009


6

Employment and Poverty

6. The economic contraction has started to affect the labor market. Seemingly good news emerged from the April 2009 official labor market data, which reported a drop in the unemployment rate to 7.5 percent from 8.0 percent in the same period last year (and 7.7 percent in January 2009). Given the sharp contraction in economic activity that took place during that quarter-on-quarter period, this is all the more surprising. The fall in the unemployment rate is nonetheless consistent with the results of a World Bank-commissioned rapid response household survey3 which showed that the share of current employment to total adult population increased.4 The following factors are likely to explain the drop in the unemployment rate, all pointing to a weakening labor market:

• An increase in labor force participation (Figure 5). More than 1.3 million people joined the labor force between April 2008 and April 2009, pushing the labor force participation rate to 64.0 percent compared to 63.2 percent in the same period last year (and the 63.3 percent in the January round of the survey). The following reasons could explain this increase in the labor force during an economic contraction:

o An increase in returning overseas foreign workers (OFWs). Although comprehensive data on returning OFWs do not exist, anecdotal evidence and return migration observed in other countries point to such a potential.

o Increased participation from spouses and children, to supplement diminished household income as the main breadwinner might be affected by the sharp increased in reduced working hours and other crisis measures introduced by firms.

• A deterioration of the quality of the labor market:

o Increased employment in informal sectors. While overall under-employment declined from 19.8 to 18.9 percent (YoY) in April, visible under-employment5 as a share to total underemployment increased to 62.6 percent from 57.5 percent, mirroring the large number of people under a reduced work hour scheme (which is especially prominent among exporting firms). Thus, since end-2008, an additional 420,000 workers worked less than 40 hours a week. Preliminary

3 The rapid response assessment survey inquired about the impact of the global recession on Filipino households. The study comprised of quantitative and qualitative surveys carried out by Pulse Asia, Inc. in May 2009 with February to April 2009 as reference period. The quantitative survey consisted of 1,600 nationally representative sample of households. 300 households were sampled in each of Luzon, Visayas, Mindanao, and NCR. This was complemented by 200 samples each in the Laguna and Cavite economic zones. Results of the study are still being finalized. The share of current employment to total adult population in the survey is different with the official employment rate because the base used in the former covers the total adult population, regardless of whether the person is looking for job or not. 4 This contrasts with the results of another survey group, Social Weather Station, which conducted in Q1 2009 an employment survey and found that adult unemployment—defined differently from the government—reached a record high 34.2 percent, of which 13 percent of those unemployed voluntarily left their job and 12 percent were retrenched. 5 Visibly under-employed people are officially defined as those working less than forty hours a week.


7

findings from the World Bank’s rapid assessment also show that an estimated 35 percent of those who were working during Q1 2009 experienced a reduction in income or hours of work because of adjustments made by firms in response to the crisis.

o A decline in the share of wage and salaried workers, particularly from private establishments, while self-employment and unpaid family workers increased (Figure 6). Self-employed and unpaid family workers increased on a QoQ basis by more than 400,000, significantly more than the 19,000 decline in the number of unemployed. This indicates that the growth in employment came mostly from the informal sector. Looking at the sources of new employment, most of the jobs generated were seen in agriculture (464,000), a sector with high informality while increasing job losses are still evident in the manufacturing sector.6 This trend towards the informal sector is supported by the findings of the labor department, which showed a growing informal sector during the crisis.7

Figure 5. Labor force participation and unemployment move in tandem as the economy contracts

Figure 6. Employment of unpaid family workers is trending up.

LFPR and Unemployment Rate

62

63

64

65

Apr 0

5

Oct

05

Apr 0

6

Oct

06

Apr 0

7

Oct

07

Apr 0

8

Oct

08

Apr 0

9

5.0

6.0

7.0

8.0

9.0

Labor Force Participation RateUnemployment Rate

Employment Structure ( in percent of total employment)

30

35

40

45

50

Apr 0

6Ju

ly 0

6O

ct 0

6Ja

n 07

Apr 0

7Ju

ly 0

7O

ct 0

7Ja

n 08

Apr 0

8Ju

l 08

Oct

08

Jan

09Ap

r 09

9

10

11

12

13

Wage & Salary (lhs)Ow n Account (lhs)Unpaid Family Worker (rhs)

Source: National Statistics Office.

7. The crisis has also adversely affected the living standard of poor and unemployed. The results of the Q1 2009 Social Weather Station poll confirm that hunger is higher among the unemployed and is particularly severe among retrenched workers. Severe hunger, referring to those people reporting that they were “often” or “always” 6 Preliminary results of the World Bank’s rapid assessment also supports these findings: namely a significantly higher proportion of workers in manufacturing (76 percent) and wholesale and retail trade (64 percent) reported reductions in income or working hours against those in agriculture (less than 21 percent). 7 Bureau of Labor and Employment Statistics, Department of Labor and Employment (http://business.inquirer.net/money/breakingnews/view/20090611-209873/Half-of-33M-workforce-now-self-employed)


8

hungry in the last three months, reached a high of 16.9 percent among retrenched workers compared to 13.9 percent among families of the employed. Consumption of NFA subsidized rice, has also risen sharply (55 percent YoY) in the year through May, pointing to a potential shift by poorer Filipinos from more nutritious but expensive food to cheaper rice. The World Bank’s rapid assessment survey confirms such preferences among the poor: while an average Filipino household would cut down consumption of utilities as an immediate response to economic difficulties, poorer households respond by first cutting down their food consumption.

Balance of Payments and External Debt

8. Thanks to an improving trade balance and stable remittances, the balance of payments returned to positive territory in the first quarter of 2009 (Figure 7). The large trade deficit narrowed in recent quarters as imports and exports contracted by similar (30+) percentages (Figure 8). Import contraction was driven by the sharp drop in imports of raw materials and capital goods (which is consistent with the sharp drop in investment of durable equipments in the national accounts). At the same time, remittances growth slowed from its earlier double-digit rate but remained slightly positive . Hence, the current account improved sharply in the first quarter of 2009 (to 5.9 percent of GDP) against the first quarter of 2008 (at 3.2 percent of GDP). Direct and portfolio investment remained at low levels as investors continue to be risk averse. Notwithstanding the weak capital account, the overall balance of payments through March 2009 remained in surplus at 4.8 percent of GDP, which compares well (though it also reflects weaker investment) with the 4.2 percent of GDP seen in the same period last year, and the two consecutive quarterly deficits experienced in the second half of 2008.

9. Earlier signs of “green shoots” for the exports sector have dissipated. After a series of sharp fall since October 2008, merchandise exports and imports grew by 16 percent and 7 percent on a seasonally adjusted month-on-month basis in March as trading partners, most importantly China, increased their imports. Part of the reason for the uptick in trading partners imports stems from the implementation of their respective stimulus packages (e.g., China’s imports have picked up swiftly since March). While these presented early signs of a “bottoming out” and foundations for a recovery, these “green shoots” proved to be short-lived as far as the Philippines is concerned. In April, both exports and imports posted sharp falls (Figure 9). The earlier month’s improvements were mostly of a technical nature, reflecting restocking of inventories. The Philippines is not expected to be among the first round of countries (e.g., commodity exporters) that would benefit from a recovery in China. Indeed, with electronics exports accounting for about 60 percent of total Philippine exports, final consumer demand located mostly in the US, Europe, and Japan, will be a key driver of a sustainable recovery in exports.

10. Workers’ remittance flows have slowed down considerably but remain positive, in sharp contrast to developments observed in most recipient countries (e.g., Mexico with annual contraction of 11.3 percent through May 2009). In the first four months of 2009, remittance flows posted a moderate 2.6 percent growth in nominal dollar terms from 14.5 percent in the same period of 2008. In real peso terms, however, remittances grew by 12.2 percent compared to a contraction of 8.3 percent in the same


9

period of 2008 due to a combination of a weaker Peso and the lower inflation (Figure 10). Remittances have also provided a boost to gross international reserves, which reached USD39.6 billion as of May 2009, a 9.3 percent increase from its level in May 2008 and deposits (of universal and commercial banks), which posted annual growth of 19.1 percent in March. However, as discussed above, the real growth in peso remittances failed to induce local household consumption (See Box 2 for possible explanations).

Figure 7. Despite the crisis, the BOP managed

to be in surplus, thanks to remittances Figure 8. The trade deficit narrowed as import

values fell faster than exports’1/ Balance of Payments (in Billion US$)

-6

-4

-2

0

2

4

6

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

Q2

Q3

Q4

Q1

2006 2007 2008 2009

bln US$

Net Unclassif ied ItemsCapital and f inancial AccountCurrent AccountOverall BOP Position

Balance of Trade (in billion US$)

-80

-60

-40

-20

0

20

40

Apr-

07Ju

n-07

Aug-

07O

ct-0

7D

ec-0

7Fe

b-08

Apr-

08Ju

n-08

Aug-

08O

ct-0

8D

ec-0

8Fe

b-09

Apr-

09

percent

(2)

(1)

-

1bln US$

Exports Gr (lhs)Imports Gr (lhs)Trade Balance (rhs)

Figure 9. No greenshoots for exports1/ Figure 10. Real peso remittance stonger but did

not support consumption

Exports, YoY change (in percent)

-60

-40

-20

0

20

40

60

Apr-

06

Jul-0

6

Oct

-06

Jan-

07

Apr-

07

Jul-0

7

Oct

-07

Jan-

08

Apr-

08

Jul-0

8

Oct

-08

Jan-

09

Apr-

09

percent

Non-ElectronicsElectronicsTotal

OFW Remittance Growth (in percent)

-20

-10

0

10

20

30

Jan-

08Fe

b-08

Mar

-08

Apr-

08M

ay-0

8Ju

n-08

Jul-0

8Au

g-08

Sept

-08

Oct

-08

Nov

-08

Dec

-08

Jan-

09Fe

b-09

Mar

-09

Apr-

09

percent

Dollar Remittance (Nominal)Peso Remittance (Nominal)Peso Remittance (Real)

Sources: Bangko Sentral ng Pilipinas and National Statistics Office. 1/ Trade figures are NSO-based statistics. 11. External debt, which decreased during the quarter on account of currency movements, is well covered by reserves in the short-term. External debt decreased by USD1.4 billion between end-December 2008 and end-March 2009 to USD52.5 billion. Of the decrease, USD1.3 billion was a result of a weakening of the Japanese Yen against the US dollar. The structure of external debt remains comfortable, with only 12 percent


10

due in the short term. Gross international reserves are over three times these short-term maturities and exports, while contracting sharply, still represent twice this short-term debt.

Box 2. Philippines’ Consumption and Remittances The resiliency in domestic demand has, in the last decade, been associated with strong remittance flow. However, with the unexpected and historical weakness in consumption in the first quarter of 2009—the weakest growth rate since 1986—despite robust real peso remittance inflows, the previously observed buffer role of remittances for consumption seems to have weakened lately. The present box reviews two motives, not mutually inconsistent, that could explain this phenomenon.

• Precautionary savings motives. The view proposed by the government, the central bank and most analysts, is that precautionary savings out of remittances increased as Filipino overseas workers—more attuned to the global recession and the impact on global labor markets than households residing in the Philippines—informed their family back in the Philippines to prepare for hard times. This motive could also capture returning OFWs that bring with them their accumulated savings, but face poor prospects of rapidly finding new contracts.

• Flight-to-safety motives, as OFWs fear their host country banks might fail, they shift their assets to institutions perceived to be of lower risk, including to banks back home in the Philippines. A shift of financial assets away from large foreign banks engulfed in the midst of the global financial crisis and into Philippines banks could explain why remittance inflows were not consumed to the same historical extent. Supporting this view, aggregate deposit levels in universal and commercial banks increased by 16 percent in 2008 while deposits in foreign bank branches and subsidiaries dropped by 9 percent and foreign bank branches, which include the bigger foreign banks (e.g., HSBC, Citibank, Standard Chartered, ING), saw deposits dropping by 17.5 percent.1/ To the extent this flight-to-safety motive took place on a large scale—and the stark divergence in deposit trends between large domestic banks and foreign ones would tend to indicate it did—it would imply that underlying remittance flows to be consumed domestically are significantly weaker than the aggregate headline remittance flows indicate. This conclusion is supported by findings from a World Bank rapid response assessment of the impact of the crisis.2/

Disentangling between these two possible motives, or their relative importance, is critical to assessing economic prospects. Were the first motive to dominate, this implies that a significant amount of remittances have been saved in the country and are ready to be consumed as soon as consumer confidence returns. The second, however, could imply that a significant share of remittance inflows could turn into outflows when confidence in global banks returns and that underlying remittance flows are much weaker than currently thought. Ongoing World Bank research aims to shed light on this issue. __________________

1/ Within the Philippines banking system a similar flight-to-safety also occurred, as money moved from smaller to larger banks. For 2008, BSP data show that peso deposit liabilities of rural banks and cooperatives declined by 6.5 percent while universal and commercial banks witnessed a 14.7 percent increase in deposits.

2/ Of remittance receiving households captured by A World Bank rapid assessment conducted in May 2009 (see details below), 47 percent of respondents reported a decline in remittances received from migrant family members.


11

Policies Fiscal Policy

12. As the government implements its Economic Resiliency Plan, the deficit through May continues to expand—Figure 11. As part of the government’s ERP calling for a frontloading of spending, total expenditures continued to grow at double digits rate since March, buoyed by strong primary spending (GFS basis), which as of May stood higher by 0.8 percentage points in terms of its share to annual GDP (Table 1). However, with the tax effort falling by 0.5 percentage points and non tax revenues to annual GDP inching up by only 0.1 percentage point, total revenues continued to underperform. The cash deficit through May reached 1.6 percent of annual GDP, significantly higher than the 0.3 percent in the same period last year. Meanwhile, the consolidated non-financial public sector balance continued to post a surplus, for the third year in a row, in 2008 (of about P32.3 billion; government definition). The surplus occurred in spite of the deficits posted by both the National Government and monitored GOCCs (P68.1 billion and P27.7 billion, respectively). Box 3 points to significant fiscal risks in the Philippines. History also reveals that such risks have a higher likelihood of materializing during economic downturns. These highlight the importance of contingency planning.

13. Tax revenues continue to shrink in nominal terms (Figure 12). For the fifth month in a row, in May, collection of both the Bureau of Internal Revenue (BIR) and the Bureau of Customs (BoC) continued to contract in nominal terms (by 6.1 percent and 8.3 percent (YoY), respectively). This contraction stems from: (1) a weakening economy; (2) tax policy changes generating large revenue losses; (3) unfavorable exogenous factors or one-offs (e.g., exchange rate movements for BoC; last year’s tax amnesty collection for the BIR); and (4) weak administrative capacity. As a result, tax collection from January to May 2009 reached 5.3 percent of estimated annual GDP, against 5.8 percent in the same period of 2008 (Table 1). Moreover, despite improvements in tax enforcement efforts including through “Oplan Kandado”, and the re-listing of large taxpayers to the Large Taxpayer Service, tax compliance continues to decline.8 Recent developments highlight the need for more productive tax administrative and policy measures.

14. Robust growth in public spending observed in the first quarter continued in April and May (Table 1). As the government launched the Economic Resiliency Plan, total disbursement in the first quarter grew by 16.4 percent year-on-year buoyed by strong disbursement for infrastructure (+73.5 percent), MOOE (+41.2 percent) and allotment to LGUs (+15.7 percent). In April and May, disbursement on personal services also increased by 14.8 percent (on account of the release of the increased mid-year bonus and salaries) while frontloading of spending on infrastructure continued to register robust growth at 59.5 percent. This brought spending as a percent of annual GDP through May at 7.7 percent, 0.8 percentage point higher than the ratio in the same period last year. 8 As stated in the concluding statement of the June 2009 IMF staff visit.


12

While the impact of infrastructure spending was only modest in the first quarter, preliminary evidence from the labor force survey (which showed that construction jobs created, on a QoQ basis, reached 247, 000 in April compared to net job losses in the past two quarters) indicates an increasing impact of government spending.

Figure 11. The deficit is reaching record levels Figure 12. Tax Revenues are contracting in nominal terms while expeditures are robust

Cash deficit, in billion PhP

-60

-40

-20

0

20

40

60

Jan-

07

Aug-

07

Mar

-08

Oct

-08

May

-09

Revenues and Expenditure Growth

-30

-20

-10

010

20

30

40

Jan-

08

Mar

-08

May

-08

Jul-0

8

Sep-

08

Nov

-08

Jan-

09

Mar

-09

May

-09

%

Tax RevenueExpenditureTotal Revenue

Figure 13. The tax effort is weakening Figure 14. Estimated cash balances of the

Treasury are dwindling fast. Tax Effort (in percent)

-15

-5

5

15

25

Q1-

2006

Q2-

2006

Q3-

2006

Q4-

2006

Q1-

2007

Q2-

2007

Q3-

2007

Q4-

2007

Q1-

2008

Q2-

2008

Q3-

2008

Q4-

2008

Q1-

2009

percent

Tax EffortTax Revenue Grow th

Bureau of Treasury's Cash Balance

(130)

(30)

70

170

270

370

Jan-

08Fe

b-08

Mar

-08

Apr-

08M

ay-0

8Ju

n-08

Jul-0

8Au

g-08

Sep-

08O

ct-0

8N

ov-0

8D

ec-0

8Ja

n-09

Feb-

09M

ar-0

9Ap

r-09

May

-09

bln PhP

Cash BalanceChange in Cash

Source: Bureau of Treasury and National Statistical Coordination Board.

15. The large deficit has, so far, been financed at reasonable cost but at the expense of rising short-term financing risks. Thanks to its large foreign bond issuance in January (USD1.5 billion) and successful funding from bilateral and multilateral development partners, the government has been able to finance its external needs rapidly and at reasonable cost. However, on the domestic side, as yields demanded by the market were deemed too expensive by the Bureau of the Treasury, bond auctions have been repeatedly cancelled. As a result, the government has had to draw down significantly on its cash deposits. Such a policy, however, is not sustainable and a replenishing of the government’s cash reserve to its desired level of coverage of expenditure is expected. Since the beginning of 2009, however, the cash account balance of the Bureau of


13

Treasury is sharply down (Figure 14) as some large drawdowns were observed from February to May.

Box 3. Containing Fiscal Risks in the Philippines1/

Fiscal risks pose a great challenge to stabilizing the macro-fiscal front. Two key points emerge from an analysis of fiscal risks in the Philippines: (1) fiscal risks have been, and remain, material in the Philippines, sometimes to the point of endangering the sustainability of the public debt, and (2) fiscal risks originate from diverse sources, including unexpected movements in key macro-economic variables (especially the exchange rate and economic growth), but also the financial sector, GOCCs, PPPs, and natural disasters. The forthcoming 2009 Philippines Development Report discusses fiscal risks in greater detail.

The total fiscal risk the Philippines currently face is material and originates from diverse sources. Unexpected movements in growth, exchange rate, and inflation (notwithstanding weak tax administration) significantly affect revenue collection. In recent years, revenues have been systematically underestimated (By up to 1.1 percent of GDP in 2008). The government has mitigated the impact of lower revenue on the deficit by cutting down expenditures by about 0.7 percent of GDP. Public debts are also a large source of fiscal risk. Although debt levels are broadly sustainable, there is a significant probability that the National Government debt could exceed 80 percent of GDP over the next five years (Figure 15). High gross financing requirements, estimated at more than 18 percent of GDP this year and almost 20 percent next year adds further fiscal risk.

Contingent liabilities arising from bailouts of GOCC liabilities and buy-outs of PPP are also a huge contributor to the fiscal risk. Total liabilities of GOCCs are estimated at about 30 percent of GDP and guarantees are over 8 percent of GDP. Total buy-out price of PPP projects is estimated at 11 percent of GDP in 2005. In addition, guarantees on the deposit insurance fund and the central bank’s assistance to troubled banks are not small and can easily run up to 10 percent of GDP or more during systemic banking sector failures. Finally frequent natural disasters are directly costing the government 0.5 to 1 percent of GDP. Adding all these sources of fiscal risk gives a total annually recurring fiscal risk of about 20 percent of GDP and about 60 percent in non-recurring fiscal risks.

Decreasing fiscal risk would entail improving the institutional setup for assessing, approving, managing, and disclosing fiscal risk—this in itself would reduce a source of risk. Significant benefits are expected to arise, for example, from the following institutional improvements: (1) establishing a Debt Management Office (a goal already expressed in the government’s 2004-2010 MTPDP); and (2) establishing a dedicated Fiscal Risk unit, presumably within the Department of Finance, tasked with centralizing all information pertaining to fiscal risk (e.g., from GOCCs, PPPs). Recent reforms undertaken in Indonesia’s Ministry of Finance both for the DMO and the Fiscal Risk unit would seem especially relevant for the Philippines. In the meantime, re-institute a performance evaluation system and subject GOCCs to performance targets.

In the short-term, preparing and disclosing a fiscal risk statement, as done by several countries in the region, would be an important step towards addressing fiscal risks more systematically and comprehensively. Such a comprehensive and up-to-date statement would provide valuable information for policy decisions, especially as the economy enters a downturn. _______________ 1/ For more details, see Chapter 4 of the forthcoming 2009 Philippines Development Report.


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Table 1. Philippines: National Government Cash Accounts, 2006-2009

2006 2007Act Act Jan - May Est. Jan - May Budget WB Proj.

Revenue and grant 16.1 15.7 6.4 15.8 6.0 16.6 15.2Tax revenue 1/ 14.3 14.0 5.8 14.1 5.3 14.9 13.4Nontax revenue 2/ 1.9 1.7 0.6 1.6 0.7 1.7 1.7

Total expenditure 17.3 17.3 6.8 17.3 7.7 19.8 18.7Current Expenditures 15.7 15.1 6.0 14.1 6.4 16.0 15.5

Personal services 5.4 5.3 2.0 5.0 2.1 5.7 5.5MOOE 1.7 1.9 0.7 1.9 0.8 2.5 2.1Allotment to LGUs 2.9 2.9 1.2 2.3 1.4 2.7 2.7Subsidies 0.2 0.4 0.0 0.2 0.1 0.1 0.1Tax expenditures 0.3 0.4 0.2 0.8 0.2 0.7 0.7Interest payment 5.2 4.2 1.9 3.9 1.8 4.3 4.4

Capital Outlays 3/ 1.6 2.0 0.8 3.0 1.2 3.6 3.0Net lending 0.0 0.1 0.0 0.2 0.1 0.2 0.2

Balance (GFS definition) -1.2 -1.6 -0.4 -1.5 -1.7 -3.2 -3.5Balance (Government definition) 4/ -1.1 -0.2 -0.3 -0.9 -1.6 -2.6 -3.0

Memorandum itemPrivatization receipts 0.1 1.4 0.1 0.4 0.0 0.4 0.3Primary balance (GFS definition) 4.1 2.7 1.4 2.3 0.1 1.1 0.9National Government Debt 4/ 63.9 55.8 .. 56.7 .. .. …Nominal GDP (PHP billions) 5/ 6,031 6,647 7,423 7,423 7,622 7,622 7,622

(in percent of GDP unless stated otherwise)

2008 2009

Source: Bureau of Treasury (BTr), Department of Budget and Management (DBM) and National Statistical Coordination Board. 1/ Includes document stamp tax and tax expenditures 2/ Excludes privatization receipts (these are treated as financing items, in accordance with GFSM) 3/ Data on personal services and MOOE from the Department of Budget and Management. Due data discrepancies on several items,

capital outlay is made as residual. 4/ As defined by the Bureau of Treasury 5/ Nominal GDP for 2009 is World Bank estimate/forecast.

Monetary Policy

16. Disinflation continues at a rapid pace, driven by the decline in international fuel and commodity prices. Headline inflation has been sliding for the past nine months, dropping to a low 3.3 percent in May, the lowest since November 2007 (Figure 15). The sustained fall is largely due to the decline in fuel and commodity prices (Figure 16). Rice inflation dropped to 8.4 percent in May from its peak of 50 percent in July 2008 while fuel prices continued their deflation. Month-on-month inflation has remained stable in 2009 (Figure 17). Risks however are on the upside given rapidly rising fuel prices in recent months. Locally, pump prices were raised for the fifth time in June, pushing these prices to be 23.2 percent higher since end-January. Headline (YoY) inflation is projected to still trend downward for the remainder of 2009 as domestic consumption weakens, the output gap widens and the exchange rate posts moderate depreciation.


15

Figure 15. YoY inflation has sharply receded... Figure 16. ….as fuel and rice inflation

continue to fall Contribution to YoY Inflation Rate

(in percentage points)

0

4

8

12

16

May

-07

Jul-0

7Se

p-07

Nov

-07

Jan-

08M

ar-0

8M

ay-0

8Ju

l-08

Sep-

08N

ov-0

8Ja

n-09

Mar

-09

May

-09

FuelOthersFoodInflation

Rice and Fuel YoY Inflation Rates(in percent)

-25-15-55

15

25354555

May

-07

Jul-0

7Se

p-07

Nov

-07

Jan-

08M

ar-0

8M

ay-0

8Ju

l-08

Sep-

08N

ov-0

8Ja

n-09

Mar

-09

May

-09

Fuel Inflation(rhs)Rice Inflation(rhs)

Figure 17. MoM inflation alco dropped in May

but fuel prices seem poised to rise again. Figure 18. Policy rate were reduced as

inflation moderated MoM Inflation (in percent)

-14

-10

-6

-2

2

6

10

14

Jan-

08Fe

b-08

Mar

-08

Apr-

08M

ay-0

8Ju

n-08

Jul-0

8Au

g-08

Sep-

08O

ct-0

8N

ov-0

8D

ec-0

8Ja

n-09

Feb-

09M

ar-0

9Ap

r-09

May

-09

FuelOverall CPIRice

Policy & Interbank Rates (in percent)

0

5

10

15

20

25

30

35

40Ja

n-97

Sep-

97M

ay-9

8Ja

n-99

Sep-

99M

ay-0

0Ja

n-01

Sep-

01M

ay-0

2Ja

n-03

Sep-

03M

ay-0

4Ja

n-05

Sep-

05M

ay-0

6Ja

n-07

Sep-

07M

ay-0

8Ja

n-09

RP rateRRP RateInterbank Call Loan Rate

Source: Bangko Sentral ng Pilipinas and CEIC database.

17. With inflation falling, the central bank continues to implement expansionary monetary policies by cutting policy rate and ensuring adequate liquidity. As inflation prospects remain favorable, the central bank has been cutting rates since December (by a total of 175 basis points so that the key policy rate is now at a decade low 4.25 percent—Figure 18). Supporting its previous decisions to lower the reserve requirement by 2 percentage points and augment the peso rediscounting facilities to P60 billion to improve domestic liquidity, the BSP still stands ready to boost liquidity should adverse market developments transpire. Despite a tightening of bank lending standards, outstanding commercial loans (gross of reverse repurchase loans) remained strong through April with lending growth of 13.4 percent year on year. Lending growth, however, seems to be mostly driven by large companies and by companies belonging to conglomerates that include a banking institution.


16

Global Outturn

18. The sharp global contraction in output seen through the first quarter of 2001 seems to be stabilizing, with a few “green shoots” emerging.9 The tight links between global trade in durable, capital, and high-tech goods, and the closely entwined investment spending that supports economic activity in both high-income and developing countries, generate a vicious cycle between the financial and real sectors of the global economy. The difficulty of obtaining capital, together with uncertainty about future demand, has delayed investments and caused a collapse in demand for durable goods, resulting in a sharp contraction in the production of and global trade in manufactured goods. World industrial production declined by an unprecedented 5 percent in the fourth quarter of 2008 (or 21 percent at an annualized rate). Output continued to decline in the first quarter of 2009, reducing the level of industrial production in high-income countries by 17.3 percent in March 2009, and in developing countries by 2.3 percent relative to March 2008. The collapse in industrial production is truly global, with major producers of advanced capital goods particularly hard-hit—Japan (34 percent, year-on-year) as of March 2009, Germany (22 percent), and South Korea (12 percent). Growth in most East Asian countries also worsened considerably in the first quarter with Singapore, Hong Kong, South Korea and Thailand slipping into recession, joining Taiwan (China). With the sizeable stimulus package in China, the Chinese economy continued to grow, albeit at a slower pace of 6.1 percent.

19. Expansionary fiscal policy in many countries has proven to be less effective than programmed and room for further monetary easing has reduced. Although there are tentative signs of improvements—that is, smaller month-on-month decline—in a few sectors (e.g., U.S. retail sales, home sales, and factory sales) it is too early to say whether these improvements will be sustained. In contrast, the financial sector appears to be stabilizing although risk aversion is still high. Equity markets have picked up in recent months while interbank transactions have considerably eased in response to extensive guarantees of such transactions by central banks. However, international capital flows are still holding back and many developing countries continue to have difficulty in accessing finance at affordable rates.

20. Commodity prices, in general, have fallen significantly from their peaks in 2008 given subdued demand. However in recent months, oil prices have begun to rise sharply, increasing by about 40 percent in the last six months.

PROSPECTS 21. Output is projected to contract in 2009 despite the ongoing and projected policy actions. The large fiscal easing and sharp cut in central bank rates are helping to buffer the Philippines economy from the challenging environment both domestically and from outside. A modest recovery is expected for 2010 as both fiscal and monetary policies are expected to become slightly less expansionary than in 2009, while global and

9 For details, see the June 2009 edition of the World Bank’s Global Development Finance.


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domestic private sector demand recover from their 2009 levels. A return to high commodity prices would significantly reduce the BSP’s room to continue its monetary policy easing, including its liquidity injection to the banking system.

22. While global output is expected to shrink by 2.9 percent in 2009--the first contraction since World War II--the economic contraction is expected to slow in the remainder of 2009, followed by a sluggish return to growth beginning in early 2010 (Table 2).10 Growth in the developing world is expected to slow to 1.2 percent. Excluding China and India, GDP in other developing countries is expected to fall at a rate of 1.6 percent. International trade is likely to experience the sharpest drop (10 percent) since that time. Unemployment, already soaring in industrial countries, will follow a similar path in the export-dependent economies of East Asia, as high-income countries reel from an unprecedented asset-market bust, and global investors retreat from emerging markets. “Green shoots” have nonetheless recently emerged globally. In the region, these included a 5.9 percent increase in Japanese industrial output in May as car and electronics production pulled out of a deep slump, signs of stabilization in China (see World Bank’s June edition of the China Quarterly Update), and a 17 percent MoM (not seasonally adjusted) increase in Korean exports in June. 23. The recovery in emerging markets is, however, not expected to benefit the Philippines as much as a recovery in developed markets. First, most of the emerging market economies have more protected economies regarding manufacturing. Second, these are non-traditional markets for the Philippines and building new trade links takes time. Third, much of the resiliency in countries such as China stems from fiscal stimulus and other measures that are mostly benefiting domestic firms and non-tradables. Finally, these countries have not been a large source of OFW migration. Nevertheless, the government has been very active in developing these non-traditional markets for exports and for OFWs.

Table 2. Global Economic Prospects, 2007-2010 1/ 2007 2008 2009 ( f ) 2010 ( f )

GDP volume: World 3.8 1.9 -2.9 2.0High-income countries 2.6 0.7 -4.2 1.3Developing countries 8.1 5.9 1.2 4.4

East Asia and the Pacific 11.4 8.0 5.0 6.6China 2/ 13.0 9.0 7.2 7.7

Export volume (GNFS): World 7.5 3.7 -9.7 3.8 High-income countries 6.3 2.4 -10.7 3.6 Developing countries 10.8 7.0 -7.2 4.3

Trade Prices ($) manufacturing (MUV) 5.5 3.2 1.5 1.7Oil ($/bbl) 71.1 97.0 55.5 63.0Non-oil commodities 17.1 21.0 -30.1 -2.1

Source: World Bank, Global Development Finance, June 2009. 1/ Percentage change per annum, unless otherwise specified. 2/ Updated projection based on the China Quarterly Update (June 2009)

10 World Bank, 2009, “Global Development Finance: Charting A Global Recovery,” Washington DC, June.


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24. Commodity prices are not expected to rise significantly beyond their current levels in the next one to two years. Annual average oil prices are expected to decline in 2009 before rising by 14 percent in 2010. Prices will unlikely hit the high levels seen in 2008 given the slump in demand and large supply overhang. Prices of non-oil commodities are seen to be on the downtrend (up to 2010) as the global recession progresses.

Output and Demand

25. The drop in external demand and investments, as well as lackluster consumption growth, will drag down overall growth in 2009. Real GDP growth is now projected to fall by 0.5 percent in 2009 and grow by only 2.4 percent in 2010 (Table 3), down from an earlier growth forecast of 1.9 and 2.8 percent respectively. Our revision is also driven by the lowering by one percentage point of 2008 growth compared to initial estimates. The sources of the downward revision, investment in particular, point to an economy less resilient than originally thought and also undermines growth prospects. Nevertheless, the magnitude of the slowdown as measured by peak-to-trough in annual GDP growth is broadly in line with previous recessions (i.e., the 1991 power crisis and the 1997/1998 Asian financial crisis)—see Box 1 of the April 2009 Philippines Quarterly Update for a more detailed analysis of the peak-to-trough exercise. Despite the revised growth prospects, the Philippines is still projected to post a better than average growth performance compared to other developing countries (excluding China and India). China is projected to grow by 7.2 percent in 2009.

26. Private consumption growth is projected to remain at historically weak levels in 2009. Building on the weak Q1 performance, the lowest growth in 23 years, private consumption growth is projected to be subdued this year, at 0.8 percent. It is projected to slowly recover by early next year, with the extra boost provided by the early start of the election period. Rising global unemployment, a deteriorating labor market, a weaker impact of remittances on consumption, and consumers switching to staple food11 all point to rising household concern going forward.

27. Domestic demand will also be dampened by falling investments, especially on durable equipment and private construction. Public construction could provide a boost in the latter half of 2009 but this depends on the absorptive capacity of the government and how fast the government can begin new infrastructure projects after a slow start early this year. The government’s economic resiliency program, which includes a number of large private sector infrastructure projects, could also improve investment prospects. Moderating this chance to increase investment could be the forthcoming election period. Indeed, experience suggests that many private investments are put on hold until after the election period. Moreover, government consumption could be restrained if revenues continue to perform poorly, limiting fiscal loosening. Given 11 The 55 percent increase in rice consumption in the first five months of 2009 suggests that many poor people can no longer afford more nutritious food such as meat and vegetables and are substituting these with rice, which is much cheaper.


19

these considerations, we project the investment-to-GDP ratio to fall to 14.4 percent of GDP this year from 15.2 percent of GDP last year.

Box 4. The Philippines’ Non-Financial Corporate Sector and the Global Recession1/

The corporate sector entered the current economic downturn from an improved financial position compared to the pre-Asian financial crisis period. Prior to the current global recession, and coming from a post-Asian financial crisis strengthening, the Philippine non-financial corporate sector enjoyed a favorable operating environment, benefiting from liberalization policies previously put in place and from a booming global economy. Strong net sales coupled with costs containment, drove profitability up by 40 percent on average between 2000 and 2007; the average return on assets reached 9 percent in 2007 compared to 5 percent in 1996. While the average debt ratio has been falling since 2003, the 2007 debt ratio (total liabilities over total assets) stood higher than pre-Asian crisis levels (148 against 116 percent, respectively) as firms continued to finance asset growth primarily through debt rather than equity. Firms, however, have significantly reduced their vulnerabilities by cutting their holdings of short-term loans and foreign currency denominated loans and, with the rapidly appreciating peso in 2007, many firms pre-paid their foreign loans.

Despite the improved financial health, credit has tightened since late 2008. Through 2008, strong lending growth was observed to the agriculture, real estate, trade and utilities sectors. However, lending moderated in early 2009 with most banks tightening credit standards and concentrating on larger firms. In 2008, about $1.6 billion was raised in the corporate bonds market. Although yields to date have risen, especially on the long end, the bonds market is still very active, with record issuances to date in 2009 (e.g., San Miguel’s record P38 billion issuance). By contrast, a small IPO boom similar to the experienced before the Asian crisis was observed in 2005-2007 vanished as no IPO has yet been floated in 2009. Difficulty in obtaining external financing is also visible through (1) the reduction in short-term loans (mostly trade credits) which account for a large part of foreign financing; (2) minimal equity infusions and lack of foreign currency denominated bond issuances in 2009.

The global financial crisis and recession had a particularly sharp impact on a few specific sectors. Prior to the crisis, exporters, especially multinationals, simply maintained open accounts with their foreign counterparts, while ordinary exporters still relied on letters of credit opened by their customers. However, with the crisis, all banks had become more selective with respect to industries that are severely affected by the crisis, or whose long-term prospects are not particularly positive. Examples of the industries on which export credit availability was lessened are garments, furniture, small electronics firms, automotive parts and exporters who do not have ability to provide collateral. The sharp rise in government guarantees and credit insurance for the export sector also reflect the credit squeeze faced by the export sector. Banks have also become more discerning among types of companies, with SMEs, especially those not belonging to a conglomerate, particularly affected—though access to finance from SMEs is an issue, even in good times.

Government owned and controlled corporations are also particularly exposed. Two GOCCs have large short-term loans maturing (e.g., the NFA and NPC have short-term loans of about P35 billion and P14 billion—these are, however, mostly government guaranteed).2/

Firms in the power sector are also exposed to rollover risk. Loans to power firms are typically large syndicated loan transactions. As economic growth weakens, not only will power companies have to face a more difficult operating environment, they will also have to contend with heightened regulatory risk (e.g., political interference in tariff setting). Similar to the power sector, steel firms are also exposed to rollover risk. As of 2007, seven of the 20 steel and metal-related manufacturing companies belong to the top 100 firms with high short-term loans. The prospects for financing may be adversely affected not only by the crisis (and prospects on construction) but also by the poor historical performance of steel manufacturers.

________________________

1/ This box is based on an ongoing World Bank study of the impact of the global recession and crisis on the Philippines corporate sector (captured through its top 1,000 corporations).

2/ Based on 2007 Balance Sheets.


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28. While the corporate sector has so far remained resilient, risks to the non-financial and financial corporate sector are tilted upwards as the economic slowdown progresses. For the non-financial corporate sector, the crisis has mostly severely impacted export-oriented companies with most other non-financial firms still posting positive profitability. A sustained weakening in domestic demand would, however, put pressure on profitability. This could negatively feedback to the domestic banking sector (For more of non-financial and financial corporate sector risks, see Boxes 4 and 5, respectively).

Box 5. Risks to the Philippine Banking Sector from Global Developments1/ Alert levels on the vulnerability of the banking system to external and domestic shocks have come down over the past six months. With the recovery of domestic and external markets, tensions over interest rate risk have given way to concerns over credit risk as the economy enters a possible recession.

Banks continue to have a large exposure to interest rate risks. Although banks have moved some of their tradable debt securities to accounts that are not subject to fair value accounting, about P700 billion, representing 12 percent of total assets, continue to be exposed to interest rate risk. For a 100 basis point increase in spreads on all types of government securities, it is estimated that banks can potentially lose about 50 to 70 percent of average 2006-08 profits on their government security holdings.2/

Given high concentration of bank investments in Philippine government paper, a further deterioration in government’s fiscal position exposes Philippine banks to potentially higher mark to market losses.

Liquidity risk, on the other hand, is mitigated by banks’ cash-rich position as seen in low loan to deposit ratios. The BSP’s current easing stance injects further liquidity into the system. However, at the individual bank level, some banks may face greater risk due to (1) smaller deposit base, (2) dependence on high net-worth depositors who can easily move funds elsewhere should there be a crisis of confidence and (3) minimal counterparty lines. Moreover, the interbank market lacks depth.

While banks’ and corporates’ financial conditions were better entering the current global crisis than the period leading up to the 1997/98 crisis (e.g., high lending growth, high corporate leverage), a deterioration in credit quality can be expected. Already, banks have reported upticks in default rates related to sectors directly affected by the crisis (e.g., exports, housing for OFWs). It is estimated that based on average 2006-08 pre-provision profits, banks can afford to write off 3 percent of currently performing loans without charges to equity. The NPL ratio of the banking system has fallen to 4.5 percent of total loans (excluding interbank loans) as of end-2008 from high teens in the early 2000s.

Sectors that have seen acceleration in lending growth in recent years and are being watched closely for potential defaults include property (particularly end-user residential loans for OFWs), power and other infrastructure project financing, and consumer lending. Credit risk is moreover heightened by the increasing concentration of lending to a few large conglomerates.

Potential drags on bank earnings moving forward are likely to result from a more difficult operating environment that will see banks’ interest rate margins squeezed, loan growth decelerating and cost of lending rising. The overhang of non-performing asset can be expected to further add pressure on earnings. The more difficult operating environment will also test the appropriateness of individual bank capital in terms of covering unexpected losses and/or higher risk taking. While the financial system’s liquidity may provide opportunities for capital raising, some small banks may find it more difficult to increase capital, resulting in pressure for further consolidation of the banking system. ______________________ 1/ This box summarizes some of the findings of a longer World Bank note on the financial sector. 2/ Assuming banks are not able to minimize losses, which is likely when spreads rise rapidly within a short time span.


21

Employment and Poverty

29. As labor market prospects lag economic activity, the labor market is expected to continue to weaken throughout 2009 and remain weak for most of 2010. Similar to what we have seen in the April labor force survey, more workers are expected to move to lower quality jobs (i.e., from paid jobs to unpaid jobs and from the wage and salaried work to self-employment) in the coming quarters. The impact of the recession on the labor market can be better gleaned not from the headline unemployment rate, which might not rise significantly, but rather from the components of employment such as the number of unpaid family workers and the number of jobs in the formal manufacturing and finance sectors. With industrial output projected to be weaker and falling consumption, the number of formal sector jobs is expected to fall. With declining quality of employment and real income, poverty incidence in 2009 could deteriorate slightly from the 32.9 percent rate measured in 2006. Falling commodity prices, however, have significantly cushioned the increase in poverty. Had prices remained at their mid-2008 peak , poverty incidence could have grown by some 4 percentage points. The government can mitigate the impact of the recession on the poor by fast-tracking social service and protection spending, such as the conditional cash transfer program.

Balance of Payments and External Debt

30. The external sector is projected to gradually recover in the second half of 2009 but would remain subdued throughout much of the year. Both exports and imports are projected to post sharp contractions in 2009 with the resulting trade deficit would reach 7.9 percent of GDP. Electronics exports, however, will be structurally weakened with the closure of several multi-national companies such as Intel towards end-2009 (Intel used to be the country’s tenth largest exporter by value). Outsourcing of electronic parts production to the Philippines, which has gained some prominence in recent years, could improve the prospect for electronics exports in the medium-term. The resurgence in fuel prices and the potential for commodity and food prices to rise anew as the global economy recovers could add further pressure onto the already large trade deficit.

31. Remittances are projected to remain resilient compared to other sources of finance and income. While remittances through April have remained positive on a year-on-year dollar basis, in light of the weak global prospects for economic growth and employment, remittances in nominal dollar terms are still projected to decrease by 4 percent in 2009 and to moderately rebound the following year (by 2 percent) (Table 3). In real peso terms, remittance flows are projected to remain positive given prospects for subdued inflation and a weaker peso. This contrasts, for example, sharply with exports which are projected to decrease by 25.5 percent in 2009.

32. Large downside risks exist around the remittance baseline projection. The prospects for remittance flows to remain resilient and help buffer the economy are subject to significant downside risks. First, a quantitative one, as the aggregate inflows to date could mask much weaker underlying flows. Second, a qualitative one, as current and


22

projected inflows could have a less beneficial role for the economy than initially expected. These risks include:

• The weakening of the global labor market through end-2010, as projected by the ILO, would increasingly affect OFWs’ income and their net deployment, especially for new hires. This could also worsen the domestic unemployment rate;

• The current resiliency of remittances could be driven by returning OFWs bringing home their entire stock of savings. Although this provides a temporary boost in the short-term, it would negatively impact future remittance streams; and

• Although flight-to-safety away from large foreign banks have been at the forefront of the global financial crisis (e.g., Citibank with its large remittance operation), this is not projected to continue as the financial system stabilizes. Quite the opposite, flows could reverse to foreign banks given the flight-to-quality tendency and uncertainties surrounding the 2010 election could accelerate such portfolio shifts.

33. The combination of resilient remittance flows and broadly stable trade deficit would continue to provide the Philippines with a healthy current account surplus. With remittance net flows projected at about 9 percent of GDP, and a trade deficit projected to contract slightly compared to 2008 (to 7.5 percent of GDP), a 2.3 percent of GDP surplus in the current account is projected for 2009. Broadly similar levels of surpluses are projected in the medium term. Given still ongoing tight international credit condition, the projected surpluses—and relatively comfortable level of net international reserves—provide a desirable buffer for the domestic economy. However, prospects for a small deficit cannot be ruled out, especially if commodity prices rise beyond projected levels and remittance flows are weaker than expected.

Fiscal Policy

34. The small fiscal impact on growth observed to date and the upside risks of a rising deficit limit the rationale for further fiscal loosening. The overall deficit is projected by the World Bank to reach 3.5 percent of GDP for 2009 (GFS definition), and 3.2 percent for 2010. The higher projected deficits are based on several assumptions. First, the ongoing revenue decline will be reversed or at least stopped. Second, the government will not spend all its budgeted expenditure (estimated on a GFS basis at 19.8 percent of GDP). Reasons for under-spending range from abortive capacity constraints as highlighted in weaker-than-programmed capital spending in the first five months to deficit containment measures leading to a re-prioritization of spending. The non-financial public sector deficit is also projected to post a large deficit (which the government estimates at 3 percent of GDP for 2009) following three years of consecutive surpluses. The rising deficits of both the National Government and of GOCCs explain most of the fiscal deterioration.

35. The prospect of a larger than 3.5 percent of GDP deficit for 2009 cannot be ruled out unless corrective policy measures are adopted. The measures required have been discussed in our previous Quarterly Updates. On the revenue part, most are actively


23

supported by the government but need Congressional approval; e.g., the bills on the rationalization of excise taxes and fiscal incentives. Administrative measures include the strengthening of the large taxpayer office in the Bureau of Internal Revenue. These are needed to contain the growing the deficit within the government’s targets and improve social outcomes and the equity of taxes. Further delays would make any revenue measures ineffective in controlling the 2009 deficit since effectiveness of new laws could well begin in 2010. In addition, there is scope to consider raising excise taxes on petroleum products, which have not been adjusted since 1996, to raise revenues and to reduce negative externalities from fuel use.

36. The tax-to-GDP is expected to return to pre-VAT reform levels (13.4 percent). Election related spending and weaker tax collection in 2010 could add downward pressure on the tax-to-GDP ratio which could fall below 13 percent of GDP if measures are not enacted immediately after the elections. A rapid way to generate revenues and to improve taxpayer compliance appears to be the reinvigoration of the “Run after Tax Evaders” (RATE) Program. Past successes of the RATE point to the potency of this measure if implemented properly.

37. With sustained growth in spending especially in infrastructure, the impact of the ERP is expected to become more pronounced in the latter part of 2009. To battle the recession, the government commendably introduced an economic resiliency plan (ERP) to pump-prime the economy but its impact in the first quarter was muted as the budget approval was delayed and disbursements were used to pay spending prior to 2009. As the government however continues to frontload infrastructure and social spending, the impact of the ERP is expected to be felt more. Notwithstanding this, there are still challenges to the full implementation of the ERP. One example is the lack of shovel-ready infrastructure projects qualified for funding from the P100-billion infrastructure stimulus fund. Moreover, unless the structural decline in tax collection is tackled, as discussed above, either expenditures or the overall deficit (or both) will derail the intended ERP structure.

38. Managing these implementation dilemmas is crucial to maintaining macroeconomic stability and credit-worthiness, especially if the global recession is protracted and high financing needs continue into 2010. Given the limited fiscal space, fiscal easing would need to be temporary and nested within a credible medium-term fiscal framework. The latter can be achieved by implementing policies needed to correct the structural decline in tax collection efficiency. Moreover, low absorptive capacity of crucial agencies (e.g., education and health) hamper their ability to spend the greater allocations intended in the ERP for investment in human capital and social services. This calls for quick reforms in these sectors and, in the meantime, close monitoring to ensure that ERP spending is indeed allocated as intended. Contingent plans are also needed given the uncertainty regarding both the depth and length of the global recession.

Financing and debt dynamics

39. Given the higher than originally projected deficit, the government has begun to consider additional sources of financing. The external financing options being


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considered by the government (e.g., Samurai bond up to USD1.5 billion, and ADB’s Countercyclical Lending Facility of up to USD500 million) would significantly help finance the deficit. The government is also revisiting its desired financing mix between domestic and foreign sources, with a view toward limiting upward pressures on domestic yields, which would impact the private sector.

40. With the higher deficit and weaker peso, total debt is projected to rise markedly in 2009. After a moderate increase to 56.9 percent of GDP in 2008, the national government debt is projected to increase to 59.2 percent of GDP in 2009 and 59.0 percent of GDP in 2010 (Table 3). The non-financial public sector debt is also expected to increase this year before moderately declining the following year. The debt-to-revenue ratio is projected to increase from 351 percent in 2008 to 389 percent in 2009.

41. Looking forward, risks to the debt-to-GDP ratio are tilted upwards (Figure 15). Our World Bank macroeconomic framework suggests that NG debt is projected to rise over the next few years before eventually declining by 2013, as a ratio of GDP (Table 3). Figure 15 adds information by modeling risks—i.e., adding confidence intervals—around this central debt path projection. The confidence interval is constructed by drawing on the joint distribution of historical (Philippines) shocks to key macroeconomic variables (e.g., economic growth, the exchange rate, domestic and foreign interest rates). The fan chart suggests that while the most likely outcome is a debt path that is broadly stable or declining, based on historical shocks that have hit the Philippines, there is a 20 percent probability that the NG debt-to-GDP ratio would exceed 80 percent by 2013. The fan chart also reveals an asymmetrical risk profile. Furthermore, a traditional debt sustainability analysis reveals that the Philippines public debt is highly sensitive to economic growth and exchange rate shocks. With the projected 2009 recession and subdued growth over the medium-term, further reducing the relatively high debt-to-GDP ratio will become more challenging and requires a solid primary fiscal surplus and the containment of fiscal risks (see Box 3 on recent World Bank work on fiscal risks, including contingent liabilities).

Figure 19. Philippines: NG Debt Sustainability Analysis Using a Fan Chart Model

20%

40%

60%

80%

100%

120%

140%

2005 2006 2007 2008 2009 2010 2011 2012 2013

40-60th percentile

Source: World Bank staff based on Celasun et al. (2006), “Primary Surplus Behavior and Risks to Fiscal Sustainability in Emerging Market Countries: A "Fan-Chart" Approach,” IMF Staff Papers, Vol. 53(3), pp3-34.


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Table 3. Philippines: Macroeconomic prospects, 2006-2013

2006 2007 2008 YTD 2009 1/ 2009 2010 2011 2012 2013Growth, inflation and unemployment (percent)

Gross national product 5.4 7.5 6.2 4.4 … … … … … 4/

Gross domestic product 5.3 7.1 3.8 0.4 -0.5 2.4 4.0 4.5 5.0 4/

Inflation (period average); 2000 base year 6.2 2.8 9.3 5.7 3.2 4.5 4.0 4.0 4.0 5/

Unemployment 8.0 7.3 7.4 7.6 … … … … … 6/

Savings and investment Gross national savings 19.1 20.3 17.8 20.5 16.7 16.1 16.7 17.7 18.3 4/

Gross domestic investment 14.5 15.4 15.2 14.5 14.4 14.3 14.7 15.1 15.5 4/

Public sector National government balance 2/ -1.1 -0.2 -0.9 -1.6 -3.0 -2.8 -2.6 -2.3 -2.2 5/

Total revenue 16.2 17.1 16.2 6.0 15.5 15.0 15.1 15.2 15.4 5/

Tax revenue 14.3 14.0 14.1 5.3 13.4 13.4 13.6 13.9 14.1 5/

Total spending 17.3 17.3 17.1 7.6 18.6 17.8 17.7 17.5 17.6 5/

National government debt 63.9 55.8 56.9 55.4 59.2 59.0 57.8 56.0 52.5 4/

Money and credit 3/

M3 22.7 10.6 15.6 13.7 … … … … … 7/

Credit to the private sector 6.7 8.5 16.8 19.0 … … … … … 7/

Balance of payments Merchandise exports 15.6 6.4 -2.6 -36.4 -25.5 1.5 4.5 7.3 8.9 7/

Merchandise imports 10.9 8.7 5.0 -35.1 -20.7 3.4 4.4 5.1 6.3 7/

Remittances (expressed in US$) 19.4 13.2 13.7 2.6 -4.0 2.0 5.0 7.0 7.0 7/

Current account balance (percent of annual GDP) 4.5 4.9 2.5 5.9 2.3 1.8 2.0 2.6 2.8 4/

International reservesGross official reserves 23.0 33.8 37.6 39.6 39.0 40.7 41.6 42.9 43.3 4/

Gross official reserves (months of imports) 4.2 5.7 6.0 … 7.3 7.3 7.2 7.0 6.5 4/

External debtTotal (billions of dollars) 53.4 54.9 53.7 52.5 68.2 67.4 67.6 69.4 71.2 4/ 9/

Total (percent of annual GDP) 45.4 38.1 32.3 32.3 43.9 41.3 39.1 37.6 36.1 4/ 9/

Debt service ratio (to exports of G&S and income) 12.0 10.1 9.6 15.2 … … … … … 4/ 9/

Exchange rate (peso/dollar, period average) 51.3 46.1 44.5 47.8 …. …. …. …. …. 8/

Real effective exchange rate (WB Estimate) 101.9 110.9 119.4 112.8 …. …. …. …. …. 5/

Stock market index (period average) 2412 3443 2631 2075.0 …. …. …. …. …. 8/

(year-end percent change)

(percent change unless otherwise indicated)

(in billion US$ unless otherwise indicated)

Actual Projections

(percent)

(percent of annual GDP)

(percent of annual GDP)

Source: Government of the Philippines and World Bank . 1/ 2009 nominal GDP is based on WB estimate 2/ Based on Government's definition 3/ From Depository Corporations Survey 4/ YTD 2009 is as of March 5/ YTD 2009 is as of May 6/ For unemployment: Annual average using new definition adopted in 2005 and based on 2000 census (except for 2004 which is

based on 1995 census); YTD 2009 is as of average of January and April 7/ YTD 2009 as of April; For Trade: Exports and Imports numbers in YTD 2009 is based on NSO definition; historical and projection are BOP-based 8/ YTD 2009 is as of June 9/ Actual data on external debt is as reported by the BSP; Projection is based on World Bank definition


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Table 4. Philippines: Corporate Performance of Listed Companies, 2007-2008

2008 2007 % change 2008 2007 % change PSEi 148.8 190.9 -22.0 1,813.0 1,606.5 12.9Financials Sector 27.2 46.2 -41.1 282.4 289.7 -2.5Industrial Sector 49.4 57.3 -13.8 1,267.1 1,067.9 18.7Holding Firms Sector 37.5 62.0 -39.6 492.5 439.3 12.1Property Sector 26.7 26.7 0.0 134.4 108.8 23.5Services Sector 53.8 82.4 -34.7 463.9 432.3 7.3Mining & Oil Sector 4.3 6.9 -38.3 31.6 31.5 0.5Small and Medium Enterprises 0.0 0.0 -61.0 0.1 0.1 -6.3

Total Non-Financial 171.7 235.4 -27.1 2,389.6 2,079.9 14.9Total 198.9 281.5 -29.4 2,672.0 2,369.5 12.8

Net Income Revenues 2008 (in billion PhP, unless otherwise indicated)

Source: Philippine Stock Exchange.

Table 5. Philippines: Banking Sector Indicators, 2003-2008

2003 2004 2005 2006 2007 2008Capital adequacy Total capital accounts to total assets 13.1 12.6 12 11.7 11.7 10.6Capital adequacy ratio (consolidated basis) 1/ 17.4 18.4 17.8 17.5 15.7 15.3

Asset quality NPL ratio 2/ 16.1 14.4 10.3 7.5 5.8 4.5NPA ratio 3/ 13.2 11.8 8.8 6.9 5.8 5.1Distressed asset ratio 4/ 27 25.3 20 15.7 13.0 10.6NPL coverage ratio 5/ 51.5 58 73.8 75 81.5 86.0NPA coverage ratio 6/ 30.9 33.2 39.2 37.3 39.7 44.4

ProfitabilityReturn on assets 1.1 0.9 1.1 1.3 1.3 0.8Return on equity 8.5 7.1 8.8 10.6 10.8 6.9Cost-to-income ratio .. 65.5 64 66.5 65.2 74.2

Liquid assets to deposits 47.9 53.2 53.1 52.1 51.9 52.3Loans (gross) to deposits 80.3 73.4 72.4 69.3 70.9 69.7

Sources: Philippine authorities, and IMF staff calculations. Note: ROPA = Real and Other Property Acquired. ROPA is a measure of the stock of foreclosed properties held by a bank. 1/ as of the second quarter of 2008 2/ Nonperforming Loan (NPL) Ratio (excluding IBL). 3/ (Nonperforming loans + ROPA) over total gross assets 4/ Ratio of (NPLs + Gross ROPA + current restructed loans) to (Gross total loan portfolio + Gross ROPA 5/ Ratio of loan loss reserves to NPLs 6/ Ratio of valuation reserves (for loans and ROPA) to NPAs.

Selected recent World Bank publications on the Philippines (for an exhaustive list, please go to http://go.worldbank.org/BRHFJLLQD0)

Name Publication Date Document Type

Philippines - Transport for growth : an institutional assessment of transport infrastructure 2009/02/24 Public Expenditure Review

Climate resilient cities : a primer on reducing vulnerabilities to disasters - Makati city, Philippines

2009/01/01 Working Paper

Grand corruption in utilities 2008/12/01 Policy Research Working Paper Protecting temporary workers : migrant welfare funds from developing countries 2008/10/24 Brief

Philippines - Country procurement assessment report` 2008/10/03 Country Procurement Assessment (CPAR)

Doing business 2009 : country profile for Philippines - comparing regulation in 181 economies


A road to trust 2008/09/01 Policy Research Working Paper Managing migration : lessons from the Philippines 2008/08/11 Brief Do community-driven development projects enhance social capital? Evidence from the Philippines

2008/07/01 Policy Research Working Paper

Doing business in the Philippines 2008 : comparing regulation in 21 cities and 178 economies


Engaging local private operators in water supply and sanitation services 2008/06/01 Brief So you want to quit smoking : have you tried a mobile phone ? 2008/06/01 Policy Research Working Paper Philippines - 2008 Development Forum Clark Field, Philippines March 26-27, 2008 : summary report

2008/04/29 Board Report

Rising growth, declining investment : the puzzle of the Philippines 2008/01/01 Policy Research Working Paper Who's at the wheel when communities drive development? The case of the KALAHI CIDSS 2007/09/01 Working Paper Yield impact of irrigation management transfer : story from the Philippines 2007/08/01 Policy Research Working Paper Doing business 2008 Philippines : a project benchmarking the regulatory cost of doing business in 178 economies


Economic results of CDD programs : evidence from Burkina Faso, Indonesia and the Philippines

2007/06/01 Brief

The Philippine environmental impact statement system : framework, implementation, performance and challenges


Philippines - The indigenous peoples rights act : legal and institutional frameworks, implementation and challenges


Philippines : Agriculture public expenditure review 2007/06/01 Working Paper Philippines environment monitor 2006 2007/06/01 Working Paper Philippines - Invigorating growth, enhancing its impact 2007/05/18 Development Policy Review Philippines - client perspectives on elements of World Bank support 2007/04/24 Working Paper Philippines - Consultative group meeting : summary report 2007/03/21 Board Report Inequality and relative wealth: do they matter for trust? Evidence from poor communities 2007/03/01 Working Paper Measuring the costs and benefits of community driven development : the KALAHI-CIDSS project


Mindanao Trust Fund reconstruction and development program : annual report 2006 2007/01/01 Annual Report Unsolicited infrastructure proposals : how some countries introduce competition and transparency


Engaging local private operators in water supply and sanitation services 2006/12/01 UNDP-Water & Sanitation Program

Documents

PHILIPPINES QUARTERLY UPDATE Public Disclosure …...Sailing Through Stormy Waters July 2009 ... (1) a substantial downward revision in global prospects for 2009, which will affect