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Draft Report for the Philippines Development Forum 2008

Accelerating Inclusive Growthand Deepening Fiscal Stability

THE WORLD BANK

March 2008

This document is a draft and the findings, interpretations, and conclusions expressed herein are those of the author (s) and do not necessarily reflect the views of the Executive Directors of the International Bank for Reconstruction and Development / The World Bank or the governments they represent.

Draft for discussion purposes only



ABBREVIATIONS

ASA Air Services Agreements ATO Air Transportation Office BIR Bureau of Internal Revenue BNPP Bataan Nuclear Power Plant BROT Rehabilitate, Operate, and Transfer BSP Bangko Sentral ng Pilipinas CAB Civil Aeronautics Board COA Commission on Audit CoE Conflict-of-interest DBCC Development Budget Committee DBM Department of Budget & Management DOE Department of Energy DOF Department of Finance DOJ Department of Justice EO Executive Order GDP Gross Domestic Product GFIs Government Financial Institutions GOCCs Government Owned and Controlled Corporations GOP Government of Philippines GPRA Government Procurement Reform Act IPSAS International Public Sector Accounting Standards LGUs’ Local Government Units M&E Monitoring and Evaluation MNCs Multinational companies NEDA National Economic & Development Authority PAP Programs/Activities/Projects PPA Philippines Ports Authority RDC Revenue Data Centers RDO Revenue District Office SPF Purpose Funds SSS Social Security System TFP Total Factor Productivity VAT Value-Added Tax WGI Wide Governance Indicators


Acknowledgements

This report was prepared by a team comprising of Vera Songwe and Milan Brahmbhatt (Task Team Leaders), Swati Ghosh, Karl Chua, Carole Figueroa Heron, Fabrizio Bresciani, Felizardo K. Virtucio, Jehan Arulpragasam and Rashiel Besana Velarde. The team received valuable comments from peer reviewers Mona Haddad and Itzhak Goldberg. The team is also grateful for inputs from Yasuhiko Matsuda, Lynnette De la Cruz Perez, Kim Jacinto-Sy Henares, Gaurav Datt, Antonio Ollero and Jeanette Jimenez. The team would like to thank Cecile Vales, Abigail Sanglay, Mukami Karuiki, Ben Eijbergen, and Maryse Gautier for their comments. Assistance from Gloria Elmore, Necitas Garcia, Cesar Banzon and the Business Center Team in type-setting and printing the draft report is gratefully acknowledged. The report was produced under the general guidance and supervision of Swati Ghosh, Lead Economist, Philippines; Vikram Nehru, Chief Economist and Sector Director, Poverty Reduction and Economic Management Unit, East Asia and Pacific Region; and Bert Hofman, Country Director, Philippines. The team wishes to specially acknowledge the comments of Government counterparts in finalizing the draft report.


Accelerating Inclusive Growth and Deepening Fiscal Stability Draft Report for the Philippines Development Forum 2008

Table of Contents

Page Nos.

1. EXECUTIVE SUMMARY.......................................................................................................1 2. RECENT ECONOMIC DEVELOPMENTS ..........................................................................9 Real Sector ..........................................................................................................................9 Inflation and Monetary Conditions ...................................................................................10 Balance of Payments Developments .................................................................................11 Fiscal Developments .........................................................................................................14 Poverty ..............................................................................................................................14 3. HOW SUSTAINABLE IS THE PHILIPPINES GROWTH ACCELERATION?............21 Vulnerabilities in an Uncertain Global Environment ........................................................21 The Philippines Growth Acceleration in Longer Term Perspective..................................27 The Philippines Growth Acceleration in the International Context ..................................30 Longer-term Competitiveness: some Concerns................................................................31 4. ENSURING PROGRESS ON STRUCTURAL REFORMS ...............................................35 Importance of Fiscal Discipline and Macro Stability........................................................36 Governance: Enhancing Credibility, Predictability and Transparency ............................40 Investing in Infrastructure .................................................................................................50 5. PROMOTING INNOVATION ..............................................................................................57 Openness to External Knowledge .....................................................................................58 Diffusion of Technology ...................................................................................................59 Research and Development in the Philippines ..................................................................60 Patenting in the Philippines...............................................................................................61 Absorptive capacity and the National Innovation System.................................................64 6. FOSTERING INCLUSIVE GROWTH ................................................................................67 Poverty Trends ..................................................................................................................67 Investing in Human Capital of the Poor ............................................................................72 The Role of Agriculture and Rural Development in Poverty Reduction and Inclusive Growth...............................................................................................................................78 APPENDIX ...................................................................................................................................85 REFERENCES .............................................................................................................................97


BOXES 6.1: Frequently-used Quantitative Measures of Poverty ...............................................................71 CHART SETS 1: Real Sector Developments ........................................................................................................16 2: Monetary and Financial Sector Developments..........................................................................17 3: External Sector Developments ..................................................................................................18 4: Fiscal Sector Developments......................................................................................................19 FIGURES 2.1: Public and Private Contributions to Growth ............................................................................9 2.2: Industry Contribution to Growth..............................................................................................9 2.3: Monetary Conditions..............................................................................................................11 2.4: M3 and Nominal GDP Growth ..............................................................................................11 2.5: Government Dollar Bond Spread over US Treasuries ...........................................................11 2.6: Composite Stock Price Index .................................................................................................11 2.7: Cumulative Monthly Export Growth .....................................................................................13 2.8: Philippines Export Markets 2007 vs. 2006.............................................................................13 2.9: Oil Imports and Oil Price .......................................................................................................13 2.10: Real Exchange Rate Movements...........................................................................................13 2.11: Number of Poor and Poverty Incidence ................................................................................15 2.12: Regional Poverty Incidence 2006.........................................................................................15 3.1: Geographical Distribution of OFW Workers .........................................................................25 3.2: Construction Investment.........................................................................................................28 3.3: Durable Equipment Investment..............................................................................................28 3.4: Shares of World Exports ........................................................................................................32 3.5: Philippines’ Share of Country Imports...................................................................................33 3.6: Philippines: Share in World Product Exports.........................................................................33 3.7: Philippines Real Exchange Rate and Share in World Exports 1990-2006.............................33 3.8: Development of Export Varieties in East Asia ......................................................................34 4.1a: Firm Perceptions of Severe Constraints 2004 ......................................................................36 4.1b: Most Problematic Factors for doing Business 2007.............................................................36 4.1: Contribution to Improvement in Overall Fiscal Balance........................................................37 4.2: Revenue Performance: Structural and Cyclical Elements.....................................................38 4.3: 76 % Optimistic that GPRA can reduce Corruption ..............................................................46 4.4: 2006 Assessment of the Philippines Procurement System.....................................................47 4.5: Ratings – Cross-border Logistics ...........................................................................................52 5.1: Exports and Imports ...............................................................................................................58 5.2: Stock and Flow of Inward FDI...............................................................................................58 5.3: Diffusion of Older Technologies............................................................................................59 5.4: Diffusion of Newer Technologies ..........................................................................................59 5.5: R&D Intensity and Per Capita GDP.......................................................................................60 5.6: Philippines – Patents Granted at USPTO ...............................................................................61 5.7: Technology Concentration 2002-04.......................................................................................63 6.1: Poverty Incidence of East Asian Economies, 1990-2000 ......................................................69 6.2: Gini Ratios, 1990s vs 2000s ...................................................................................................69

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TABLES 3.1: Destination of Philippines’ Exports .......................................................................................22 3.2: Estimated Impact of Key Factors on Philippines’ Exports.....................................................23 3.3: Adequacy of Reserve Levels under different Criteria ............................................................27 3.4: Philippines: Economic Growth by Expenditure and Industrial Sector..................................27 3.5: Philippines: Growth Accounting ...........................................................................................29 3.6: The Philippines Acceleration in International Context ..........................................................31 4.1: Philippines: Trends in Governance ........................................................................................41 4.2: Summary and Lessons for Philippine Corruption Cases .........................................................45 4.3: Infrastructure Indicators .........................................................................................................50 4.4: Selected Road Indicators ........................................................................................................51 5.1: Patenting in an International Context .....................................................................................62 5.2: National Innovation Systems and Business Environment – Selected Variables ....................65 6.1: Poverty Incidence in Rural and Urban Areas, 1985-2006......................................................68 6.2: Philippines MDG Rate of Progress at the Sub-national Levels..............................................77 6.3: Average Annual Net Returns derived from Rice ...................................................................80 6.4: Average Annual Net Welfare Impact of Rice Self-sufficiency Policy...................................80 6.5: Department of Agriculture Budget Share of MFOs ...............................................................81 6.6: Rising Share of NFA’s Deficit in GOCC’s Total Deficit.......................................................81

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EXECUTIVE SUMMARY Recent growth in the Philippines has been impressive. It has been the highest in three

decades and has gained momentum over the last three years. To achieve the Philippines’ goal of joining the ranks of advanced nations, this level of growth needs to be sustained for at least a generation. Moreover, for growth to make a serious dent in poverty levels, it needs to become more inclusive. Both pose a major challenge to the authorities, more so because the favorable international environment of the last four years is weakening. With the economy nearing full capacity, sustaining high growth must increasingly come from higher investment, greater productivity increases, lower transactions costs and better technology. A stronger emphasis on policy reforms will therefore be critical in ensuring that rapid growth can both be sustained and more inclusive.

Exceptional economic performance in 2007 (Chapter 2)

GDP expanded by 7.3 percent in 2007, the highest in decades. As in recent years, more than 60 percent of growth was from private consumption, supported by growing migrant workers’ remittances. Fiscal reforms in 2004–06 and hefty privatization receipts helped the government increase spending, with the public sector contributing an estimated 20 percent to real GDP growth. The national government deficit dropped to 0.1 percent of GDP in 2007. But private investment growth remained weak, especially on durable equipment, as it has been since the 1997-98 financial crisis. Real imports contracted by over 5 percent. And real export growth slowed to around 3 percent, partly reflecting slower demand growth in the United States and Japan. On the supply side, growth continued to rely heavily on services, which accounted for nearly 60 percent of GDP growth. Monetary conditions were generally benign in 2007. Averaging 2.8 percent during the year, inflation fell below the government’s target of 4–5 percent. The banking system as a whole was affected only mildly by the global crisis, given its small holdings of subprime mortgage linked securities.

External balances remained robust, due mainly to rising remittances from migrant workers and large capital inflows. Reserve accumulation accelerated, with reserve levels rising by almost 50 percent to $34 billion—more than enough to cover short term liabilities. Electronics exports slowed markedly, reflecting depressed semiconductor prices linked to excess supply. In real trade-weighted terms, the peso has gained sharply against the currencies of trading partners and competing countries since 2004, although the recent rise only partly makes up for the steep decline in the real value of the peso from 1997 through 2004.

Recently released government data shows that poverty has increased over the past few years. Notwithstanding this high growth, the latest official poverty estimates show that between 2003 and 2006, when GDP growth averaged 5.4 percent, poverty incidence increased from 30.0 percent to 32.9 percent, almost as high as it was in 2000. Indeed, in 2006, the number of poor people rose to record highs: out of the 84 million Filipinos, 27.6 million lived below the poverty threshold of P15,057. Changes in poverty have also varied geographically. Although the national poverty rate increased between 2003 and 2006, poverty declined in four of the nation’s 17 administrative regions. Poverty declined in the Zamboanga Peninsula and in Caraga, both in

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Mindanao. Poverty incidence also declined in Northern Mindanao and Western Visayas. In contrast, poverty in the remaining 13 regions increased in 2006.

The key development challenge remains to sustain a fast pace of growth and ensure that it is more inclusive. This will require deepening reforms in key areas including:

• Continuing to make progress on fiscal consolidation on a sustainable basis. The government must raise more revenues in order to finance the spending on infrastructure needed to sustain growth and the social programs to make it more inclusive.

• Continuing and expanding efforts to make government more effective by improving institutional effectiveness, expenditure management and procurement processes and eliminating corruption.

• Focusing on the quality, not just quantity, of infrastructure—which is key to sharing growth across regions and sectors.

• Boosting capacity for innovation and knowledge absorption—to reap the full benefits of linking the country to global production chains.

• Investing in human capital of the poor by improving service delivery and the poverty focus of service delivery.

• Enhancing agricultural productivity and rural development to accelerate poverty reduction.

How sustainable is the recent growth acceleration? (Chapter 3)

External conditions for the Philippine economy are becoming more adverse in 2008. Growth in the developed countries had already slowed in 2007 and is expected to further slow quite sharply in 2008. Philippine export growth had already fallen in 2007 and will likely slow further in 2008 while international investors are becoming more risk averse following the sub-prime crisis. Preliminary analyses suggest that an increase in 100 basis points in the Philippines Emerging Market Bond Index (EMBI) spread—a measure of investor risk aversion—tend to reduce net portfolio flows by 0.3 percent. The growth of inbound remittances is also likely to slow. But 2007 was also a year in which the Philippines accumulated substantial reserves, which, at more than $30 billion, is considerably more than the $16.2 billion needed to cover three months of imports or $12 billion of short term external debt. This level of reserves should help the country cope with the cyclical downturn and potential shocks.

There are also concerns for the long term sustainability of growth. Although there is some evidence that Total Factor Productivity (TFP) growth picked up in the 2000s, a significant part of the recent growth acceleration was facilitated by the uptake of spare capacity. Now that spare capacity is mostly exhausted, continuation of faster growth will require faster growth in the capital stock—that is, much higher investment—and faster productivity growth. Signs of declining Philippine export market shares and competitiveness this decade are a concern. Indeed, international experience suggests that growth accelerations often fizzle out unless they are supported by continued policy reforms.

Addressing these challenges will require government to deepen structural reforms and foster an environment conducive to greater innovation that is the engine for longer term growth.

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Progress on structural reforms (Chapter 4)

Progress on structural reform has been mixed. Efforts need to focus on consolidating the recent improvements in the fiscal position, grappling with problems of governance and corruption and promoting more infrastructure of higher quality.

Consolidating fiscal progress (4.1)

The government surpassed its budget deficit target in 2007, recording a deficit of only 0.1 percent of GDP. The improvement occurred despite higher spending and a lower tax effort, mainly due to hefty privatization revenues. The tax effort, estimated at 14 percent of GDP in 2007, was well below the 15.2 percent target and lower than in 2006, raising concerns about the government’s ability to reach the programmed 16.6 percent of taxes to GDP by 2010. Much of the improvement in the fiscal balance in recent years has also come from cuts in capital spending, with adverse effects on already insufficient infrastructure. Macroeconomic stability is widely recognized as a critical prerequisite for long term growth. Putting the fiscal improvement of recent years onto a more sustainable and permanent footing is fundamental for ensuring macroeconomic stability and therefore remains a high priority.

Improving the government’s fiscal position over the long term requires strengthening tax administration. This will require, as a first step, a more effective tax registry. By conservative estimates, the registry omits 20–28 percent of individuals, and some 12 percent of corporations remain unregistered. Pursuing taxpayers who have stopped filing tax returns, more than 100,000 in Manila alone, should also be a high priority. Better audit selection and revamping the “Run after Tax Evaders” (RATE) program can also raise collections in the short to medium term. Higher inflation-indexed excise taxes can also make a significant contribution to strengthening revenue. Revenue from fuel, cigarette, and alcohol taxes has declined by about 1.5 percent of GDP since the late 1990s, largely because most are not indexed. Finally, rationalization of tax incentives is important. A bill supported by the Department of Finance would keep the same effective tax rates but cut tax redundancies—incentives for activities that would have taken place anyway.

Improving governance (4.2)

Improving governance is critical to sustaining high long term growth and achieving faster poverty reduction in the Philippines. Weak governance hurts economic performance in multiple ways. Political instability, corruption and special interest influence over policies make for a highly uncertain business climate, weak appropriability of returns to capital and low investment. Weak public financial management contributes to poor fiscal outcomes and a lack of resources for much needed infrastructure and social services.

Most governance indicators in the Philippines have fallen over the last decade and now lie below the average for other middle income East Asian economies, despite a strong civil society presence, an open media, and highly capable individuals working in public administration. Nevertheless, in spite of daunting governance challenges, reform efforts continue to yield small but noticeable advances, and civil society efforts continue to keep the issue at the forefront of public awareness. Sustained reform efforts in key areas such as budget management, public procurement, civil service modernization and oversight and enforcement can yield appreciable improvements in the business climate and in public service delivery.

The Philippines’ budget process is characterized by fragmentation between priority setting and funding, between the recurrent budget and the investment budget, and between the central agencies and the line agencies. The legislature too has played a role in increasing

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fragmentation. To make budget execution more effective and to improve overall accountability in public resource use, the government could consider strengthening existing good practices and implementing key reforms, including continuing to build on the good coordination between the main agencies, Department of Finance, Department of Budget Management and the Bureau of Treasury (DOF, DBM, BTr), strengthening the treasury function by using a treasury single account, further developing the government financial management information system and eliminating the proliferating and poorly controlled special purpose funds.

Many of the Philippines’ most notorious corruption cases over the last four decades have involved failures in procurement. The Government Procurement Reform Act, enacted in January 2003, began to change things. Now there is only one omnibus procurement law, with uniform applicability to national and local government units and civil society is involved in the bidding process, thus strengthening the checks and balances. The legislative and regulatory framework receives high marks and is used by several donors for procurement in the Philippines. However, actual procurement operations still regularly fail to meet expectations. By one estimate, an average of 20–30 percent of every contract is lost to corruption or inefficiency—about PHP 30 billion a year. Implementation can be strengthened though:

• Expanding civil society and private sector involvement in monitoring procurement. This would increase transparency and reduce the risk of abuse.

• Reviewing rules and regulations for foreign-funded procurement and unsolicited bids. The scope for abuse will be reduced through further harmonization of those rules as per the Paris Declaration, and ensuring that those rules follow the same basic principles of transparency and competition on which the Philippines Law is based.

• Enforcing procurement practices including thought severe penalties to deter possible wrongdoers. The law asks for blacklisting of firms and firms can also be disbarred and criminal charges be brought against them. However, these provisions are rarely used.

• Improving training and career development to foster a professional procurement cadre.

Proposals for an omnibus civil service rationalization program and for improvements in the civil service job classification system and pay scales have become stalled. The lack of clear policy guidelines on the direction, scope, and pace of civil service reform is weakening the capacity of the government to perform its functions. It is also potentially responsible for the rise in corruption, as civil service salaries in the Philippines, especially for high level staff, are significantly lower than their private sector counterparts. There is an urgent need for the government and the legislature to provide leadership and guidance.

Strengthening governance measures requires stronger oversight and enforcement across all branches of the State. Long legislative delays mean that the budget is frequently not passed until well into the fiscal year, with earmarking and patronage delaying project cycles, undermining resource allocation and hurting transparency and performance. Without credible enforcement, corruption will continue to be encouraged. While other governance reforms often take time, it is possible to build credibility for reform with a few quick and forceful actions such as pursuing large perpetrators. The Millennium Challenge Corporation (MCC) will step up support to the Philippines for this activity if it is selected as a MCC eligible country. The government should also build on recent promising initiatives for oversight and enforcement. These include the agreement to establish a covenant among the anticorruption agencies to strengthen the enforcement of punitive, penal, administrative, and civil sanctions prescribed for violators of procurement rules. Doing so will require coordinated actions across offices and ministries. Far-reaching judicial reform, under way for quite some time, must increase judges’ accountability, through the use of transparent case management monitoring systems. The

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publication of statements by judges is also important in understanding how judges administer their duties. For the judiciary to perform effectively, courts need straightforward procedures and adequate funding, and judges need adequate incentives.

Improving the quality of infrastructure (4.3)

Recent assessments identify weak infrastructure as among the most import constraints to doing business in the Philippines. The Global Competitiveness Index ranks the Philippines at only 71 out of 131 countries, rating the country particularly poorly on a majority of the infrastructure indicators. The quality of transport infrastructure (which includes roads, railways, ports, airports and logistics) is a particularly serious concern, with consequences for trade-related transaction costs and overall competitiveness. Recent assessments indicate that transport infrastructure is poorly maintained and badly managed, with years of underinvestment, especially in maintenance.

Substantial additional expenditures are required to bring the quality of transport infrastructure up to an acceptable standard. This applies particularly to maintaining road and rail assets, and to improving the capacity and quality of seaports and airports—all the more important in view of the Philippines’ rapid population growth and urbanization. Between 1980 and 2000 the total population grew at 2.3 percent per year, and the urban population grew even faster at 4.5 percent per year. Congestion in Metro Manila alone cost an estimated P100 billion a year in 1996 prices, or 4.6 percent GDP.

Funding shortages are not the only reason for low quality, deteriorating infrastructure. Resources are heavily skewed to cities, widening the disparity between urban and rural areas. Funding is allocated suboptimally, with 25 to 65 percent devoted to activities that are labor intensive but with somewhat transitory impacts—such as the road beautification program—and with funds distributed equally to districts regardless of need. Some progress is being made—the maintenance regime is improving, and internal business processes in the Department of Public Works and Highways are becoming stronger. However, further action is still needed in several areas. Local governments’ share in national taxes is insufficient to fund devolved functions. Allocation and budget preparation fragment expenditures over many small projects, typically at the barangay level and to the particular neglect of inter-municipal facilities.

The government has made higher infrastructure spending a priority—the 2008 budget has an additional P14.3 billion for infrastructure. But these expenditures must offer the best value for money. This means better planning and embedding infrastructure financing, including private sector participation, in agency policy and planning frameworks. Planning also must also involve local governments more fully. One approach will be to reform the Local Government credit market to remove bottlenecks to private participation in local government lending.

More private sector participation is needed but so is a new approach, to avoid the at-best mixed results of past Public Private Participation (PPP). Infrastructure ministries need more capacity to better allocate budget resources and to assess and oversee public-private partnerships, Project management, including quality assurance, has to be tightened. Improving the usefulness of the Constructors’ Performance Evaluation System would raise the quality of the project life cycle. A system for the official acceptance of completed projects is needed, and road maintenance by contract should be extended. Some other key requirements for successful public-private partnership are contractable service quality; well prepared, bankable projects; competition or incentive-based regulation; and adequate and commercial risk transfer from the government to the private sector.

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Promoting innovation (Chapter 5).

The Philippines’ engagement in the world economy—and access to global knowledge—increased dramatically in the 1990s, but has slowed recently. Exports increased from 20–30 percent of GDP in the 1980s to 55 percent by 2000. Imports surged on the back of the electronics industry. The stock of inward Foreign Direct Investment (FDI) increased from around 4 percent of GDP in the early 1980s to 17 percent by 2000. But based on the same indicators, the Philippines’ integration into the global economy has slowed or even reversed since 2000 as shares of trade and FDI inflows to GDP have declined compared with the late 1990s. In addition, the predominant role of FDI and multinational companies in the expansion of Philippines trade during the 1990s raises a question about the extent to which these developments have remained an ‘enclave’ and the extent to which they have succeeded in generating ‘spillovers’ and transfers of new technologies and knowledge to the wider economy. The volume of international patenting in the Philippines accelerated during the 2000s, reaching a record 35 patent in 2006, although still less than in economies such as Thailand or China on an absolute or per capita basis. Virtually all these patents were assigned to multinational companies (MNCs).

The absorptive capacity of the domestic economy for assimilating new knowledge is critical to whether MNC investments generate spillovers. By this measure, the Philippines has work to do. UNESCO reports that Philippines R&D in 2002/03 was only 0.15 percent of PPP GDP, below the average for its per capita income—and down from 0.25 percent in the early 1990s. This is important because domestic R&D not only generates new knowledge but also enhances firms’ ability to assimilate and exploit existing knowledge from abroad. The costs are potentially high: estimates find a 78 percent social rate of return for every percentage point increase in R&D intensity. Fixed investment—a key to embodying new technology in the country’s capital stock—is also lower in the Philippines than in regional competitors. Low financial depth limits the ability of firms to finance risky or long term innovation projects while low domestic technical and research capacity creates further obstacles.

Policy recommendations to strengthen innovation need to be viewed in a broad perspective:

• Given the importance of R&D and overall fixed investment for the country’s ability to absorb new knowledge, improvements in the overall investment climate due to macroeconomic stability, better governance and more infrastructure, will pay dividends for innovation.

• Strengthening of technical education and other forms of human capital development will help buttress a fundamental underpinning for both domestic innovation activity and for the learning capacity of the economy.

• Direct public support for innovation through funding for public sector and university research or fiscal incentives can play a positive role in innovation, but these would need to overcome the governance problems affecting public expenditure as a whole in the Philippines. Current public support for R&D suffers from inadequate volume, fragmentation across agencies, lack of coordination and few links with potential private sector users.

Fostering more inclusive growth (Chapter 6)

Despite high economic growth, poverty incidence increased from 30 percent to 32.9 percent between 2003 and 2006—eroding previous gains. Of a population of 84 million in 2006, 27.6 million Filipinos fell below the poverty line—more than ever before. Poverty reduction is slower in the Philippines than in Indonesia, Thailand, Vietnam, and China. One of the reasons why growth has historically not translated into greater poverty reduction is due to the

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high rate of inequality in the Philippines—across income brackets, regions, and sectors. Income inequality has fallen slightly but remains higher than many other countries in the region. Further analysis is required of the recently released 2006 household survey data to understand the causes of the increase in poverty and how the poor can better benefit from growth. However, there are several apparent factors that likely drove the increase in poverty between 2003 and 2006. First, the increase in the poverty headcount in 2006 has been partly caused by a fall in real income of households. Second, indications are that the quality of growth has not favored poverty reduction. While growth averaged 5.4 percent between the conduct of the FIES in 2003 and 2006, GDP by factor shares of institutions shows that growth accrued largely to the corporate sector which grew by 27.7 percent on average over the three years (in nominal terms). In contrast, the household sector grew by only 3.6 percent on average over these years. The sharp growth in the corporate sector relative to the household sector could partly explain an increase in poverty. A third is the country’s fiscal crisis, which cut real per capita social spending from P1,440 in 2003 to P1,317 in 2006.

In addition to slow progress in reducing income poverty, there has been mixed progress in addressing the non-income dimensions of poverty, particularly as they relate to human development outcomes. Improving these outcomes requires increasing spending on the social sectors, improving service delivery and improving the poverty focus of service delivery. In addition, greater attention must be paid to social protection measures to protect poorer households from the high degree of vulnerability to shocks.

Improving service delivery will require greater funding but also using budgets more efficiently by:

• Spending more on recurrent expenditures to address quality constraints. In the education sector, for example, a large share of spending for many years has been on personal services. While the last three years saw a significant increase in the allocation for recurrent and capital outlay expenditures to address supply shortages, there is a need to allocate more resources for recurrent expenditures for direct interventions on teaching-learning improvements and to upgrade the quality of basic education.

• Focusing on lagging outcomes. In the social sectors, more effort should go into allocating resources to address lagging outcomes. In education, for example, key short-comings are high drop out and completion rates and poor transition between primary and secondary education.

Improving the poverty focus of service delivery through better targeting is critical. Reaching the poor on the one hand requires geographic targeting of supply side interventions in areas where the poor live. It also calls for targeted demand side interventions, including insurance, that can increase the ability of poor households to access health and education services.

Most of the country’s poor are found in agriculture and in rural areas. Thus, developing these sectors should be a focus for reducing poverty. A three-pronged approach is needed:

• Fostering a better paying, more productive, and more sustainable agriculture. This will mean improving budget allocation, making agricultural production more sustainable, raising the yields of traditional agriculture, and expanding the share of high value agriculture—which will also require revisiting trade policy.

• Promoting off farm employment and urban migration. Landless households have been left out of land redistribution. For these households, migration to low productivity non-farm jobs, many of them in urban areas, has become the best alternative to low paid agricultural jobs. Combined with the limited development of a system of secondary cities, this trend is leading

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to the progressive urbanization of poverty. A broad view of agrarian reform is required, with land redistribution being only one component.

• Improving assistance to subsistence farmers and populations in lagging regions. Social spending, very low by international standards, is insufficient to address the basic needs of the poor, especially in stagnant regions. In the long run, investment in infrastructure and development of local economic opportunities will be the main path out of poverty for the lagging regions. In the short run, however, the focus should be on safety nets and programs targeting poverty, particularly for indigenous populations. The government is undertaking several important community-based rural poverty programs. To the extent that these address infrastructure constraints at community levels, such programs can be important interventions. However, the framework for community-based rural poverty reduction programs also needs to be strengthened. The challenge is to ensure that the government’s investments in rural poverty reduction programs are coordinated, consistent, properly sequenced and responsive to the national and local development context.

With the Government’s increased emphasis on poverty reduction, the need for deeper analysis of the causes of poverty and inequality in the Philippines has become more urgent.

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2. RECENT ECONOMIC DEVELOPMENTS

2.1 Real sector

The Philippine economy performed exceptionally well in 2007. Having picked up gradually since 2002, GDP growth reached 7.3 percent in 2007, the highest growth in three decades. Aggregate demand growth was largely driven by consumer spending, with public sector expenditures on current and capital outlays providing an extra boost. In line with the pattern in recent years, over 60 percent of growth in 2007 can be traced to private consumption, supported in part by growing migrant workers remittances (the appreciation of the peso notwithstanding). Fiscal reforms in 2004-06, as well as hefty privatization receipts during the year permitted government to increase expenditures, with the public sector estimated to have contributed over 20 percent to real GDP growth (Figure 2.1).

Private investment growth remained weak, however, especially on durable equipment, as it has been since the 1997-98 regional financial crisis. Real export growth also slowed to only around 3 percent, in part reflecting slower demand growth in the US and Japanese markets. But the fact that exports slowed more sharply than most other East Asian economies also raises concerns about competitiveness. Real imports contracted by more than 5 percent in 2007, an unexpected development given the strength of domestic demand and the appreciation of the exchange rate, which made a substantial arithmetical contribution to GDP growth.

Figure 2.1: Public and Private Expenditure Contributions to Growth in Aggregate

Demand

Figure 2.2: Industry Contributions to Growth

-20%

0%

20%

40%

60%

80%

100%

120%

2003 2004 2005 2006 2007

Private

Public

*Government consumption plus public construction. Source of basic data: NSCB

percent

-1%0%1%2%3%4%5%6%7%8%

2003 2004 2005 2006 2007

Government ServicesPrivate ServicesO. Dwellings & R. EstateFinance TradeTransport., Comm., Stor.Elect,Gas and WaterConstructionM anufacturingM ining & QuarryingAgricultureGDP

Source of basic data: NSCB

percent

On the production side, growth continued to rely heavily on services, which accounted for nearly three-fifths of GDP growth. Expansion in all service sub-sectors, notably retail trade, communications, finance, and private services (which includes the fast-growing business process outsourcing industry) combined to bring overall services growth to an impressive 8.7 percent in 2007, up from 6.7 percent in 2006 (Figure 2.2). Agricultural and industrial growth also

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accelerated, but at a slower pace than overall economic growth. More rapid industrial growth largely reflected faster growth in public investment financed construction, while manufacturing growth, weighed down by slowing export demand, continued to decelerate for a fourth straight year.

2.2 Inflation and monetary conditions

Monetary conditions were generally benign in 2007. The benchmark 91-day Treasury bill rate dipped below 3 percent in the first quarter and stayed below 4 percent through the rest of the year (Figure 2.3). The peso strengthened by nearly 20 percent over the year, helping inflation to fall below the government’s target range of 4 percent-5 percent. Inflation averaged 2.8 percent during the year, its lowest since the 1980s. (See Chart Set 2 at the end of this chapter). Supply-side risks, notably rising food and fuel prices in international markets, were held in check by the firm peso, which was supported by heavy foreign exchange inflows (in both current and capital accounts).

Despite benign monetary conditions, the central bank on the whole kept a tight leash on the money supply through the third quarter, relaxing its stance only in the fourth quarter, following US Fed easing. The authorities used various tools to achieve multiple objectives, including direct dollar purchases to beef up reserves and temper the peso’s rise, entering into currency derivatives to sterilize foreign exchange purchases, introducing “liquidity management measures”1 to mop up excess liquidity, and until July, adopting a tiering scheme for policy rates that effectively lowered them 2, a measure intended to encourage more bank lending. The policy moves allowed the Bangko Sentral ng Pilipinas to build up its foreign exchange holdings and moderate the rapid increase in monetary aggregates—with the growth of M3 slowing from over 26 percent in the early part of the year to 10 percent by end-2007 (Figure 2.4). There was some pick-up in loan activity, with domestic credit to the private sector rising even after adjusting for inflation. (Real lending grew by over 5 percent after contracting from 2002-05 and remaining flat in 2006). Lending growth has been more rapid in particular segments, e.g., automobile loans, credit card receivables. On the other hand, the year saw the BSP incurring net losses of over $60 billion in the first 11 months of the year, due in large part to foreign exchange losses.

The domestic financial system exhibited resilience in the face of international market turbulence. Rocked in mid-year by global asset repricing following the crisis in the US sub-prime market, Philippine sovereign bond yields rose sharply in the end-July/early August period while stock prices, led by bank shares, dived (Figures 2.5-2.6). Both markets recovered soon afterwards, but worries re-surfaced in the fourth quarter on increasing risk of a US recession. With the exception of a handful of banks, the banking system as a whole was only mildly affected given their small holdings of sub-prime-linked securities (0.2 percent of total assets according to the BSP). There was more, albeit still quite small, collateral damage resulting from falling sovereign bond prices. Banks’ limited exposure may be traced to a combination of factors: (a) heretofore steady supply of high-yielding government securities with a risk profile that local banks are comfortable with; (b) local banks who are focused on cleaning up balance sheets and are avoiding new instruments that are still seen as “exotic” in the domestic market; and 1The measures (a) encouraged GOCCs to deposit funds with the BSP; (b) allowed trust entities to deposit funds with the BSP; and (c) allowed SDA placements of banks to be considered as alternative compliance with the liquidity floor requirements for government deposits. The policy move succeeded, over the ensuing months, in siphoning over P400 billion from the monetary system. The BSP has had to resort to the SDA rather than issuing marketable instruments given limitations in its charter, amendments to which have been proposed. 2Through a tiered policy rate scheme that paid successively lower rates on higher bank placements with the BSP. The scheme, introduced in November 2006, was lifted in July 2007.

10


(c) regulatory improvements introduced by the BSP over the years, including better risk management systems under the Basle II framework and adoption of International Accounting Standards that have helped in risk assessment and pricing. During the year, commercial banks succeeded in further reducing nonperforming assets to 4.5 percent of gross assets as of end 2007 and bringing the system’s capital adequacy ratio to almost 20 percent as of March 2008, well above the 10 percent minimum regulatory capital.

Figure 2.3: Monetary Conditions Figure 2.4: M3 and Nominal GDP Growth

Percent

0%1%2%3%4%5%6%7%8%

Jan-0

7

Mar-07

May-07

Jul-0

7

Sep-07

Nov-07

0

10

20

30

40

50

60

91-Day T-bill rate, lhs

Policy rate, lhsP/$ rate, rhs

Source of data: www.bsp.gov.ph

0%

5%

10%

15%

20%

25%

30%

Dec-06

Feb-07

Apr-07

Jun-0

7

Aug-07

Oct-07

Dec-07

M 3 growth

Nominal GDPgrowth

Source of basic data: BSP and NSCB

Percent

Figure 2.5: Government Dollar Bond Spread over US Treasuries

Figure 2.6: Composite Stock Price Index

Basis points

0

50

100

150

200

250

300

Jun-07

Jul-07

Aug-07Sep-07

Oct-07

Nov-07

Dec-07

Jan-08

*ROP2016. Source of data: ADB Bonds Online

Subprime crisis

Composite Price Index

2,800

3,000

3,200

3,400

3,600

3,800

Jan-0

7Mar-

07May

-07Aug

-07

Oct-07

Dec-07

Feb-08

Source of basic data: Philippine Stock Exchange

2.3 Balance of payments developments

The overall external balance remained robust in 2007 due mainly to rising remittances from migrant workers (which made up for the larger deficit in the trade account), and large capital inflows. Both led to a more rapid rate of reserve accumulation, with international reserves rising by almost 50 percent in 2007 to $34 billion. At this level, international reserves provide over three times the cover for short-term external debt maturing in the next 12 months.

Consistent with the experience of other Asian countries, Philippine exports of electronics products slowed markedly (Figure 2.7), reflecting depressed semiconductor prices due to excess

11


supply conditions. Overall export performance was driven by electronics exports, which comprise roughly 65-70 percent of total exports. Demand weakened not only in the U.S. but also in Japan and Europe (Figure 2.8).3 Exports to Asian markets continued to expand, especially to China (including Hong Kong), where exports grew from an 18 percent share of the total in 2006 to 23 percent in the first three quarters of 2007. Import growth meanwhile outpaced export growth slightly (6.8 percent versus 6.1 percent in 2007), with the share of oil imports rising in the course of the year as international crude oil prices increased anew (Figure 2.9). Imports, though, like investment, continued to decline as a share of GDP.

The issue of export competitiveness has re-entered policy debates in light of the peso’s strength. In contrast to the mid-1990s debate when peso appreciation was driven by short-term capital inflows, the peso’s current strength is based on remittance-driven current account surpluses which imply that the peso is fundamentally-supported and its strength can be sustained to the extent that structural factors continue to drive overseas employment. In real, trade-weighted terms, the peso has been gaining sharply against the currencies of trading partners and competing countries starting in 20044 (Figure 2.10) albeit the gain against the currencies of the three most direct competitors—Malaysia, Thailand and Indonesia—has been less (about 13 percent on a cumulative basis since 2004 vs. a 27 percent appreciation against trading partners). Viewed from a longer perspective (since 2001), the loss in competitiveness is much less (and for the three direct competitors, the peso remains weaker).5 It is nonetheless true that if sustained, the peso appreciation may shift resources away from the tradable sector and can be expected to add to the difficulty of revitalizing manufacturing, which is needed for sustaining growth and creating more jobs.6

So far, the impact of various policy responses to the appreciating currency has been muted by the size of the inflows. In addition to direct intervention intended more to manage volatility rather than reverse trends, monetary authorities have turned to pre-paying dollar debts (US$805 million worth of bonds were prepaid in 2007) as well as further liberalizing foreign exchange rules, including of outward investments of residents. The national government has also gradually shifted away from foreign borrowings to finance the budget deficit. Programmed domestic financing for 2008 increased from 64 percent to 70 percent.

3See IMF Regional Economic Outlook: Asia and Pacific, October 2007. 4The BSP identifies major trading partners to include the U.S., Japan, EMU and U.K, and competing countries to include Singapore, South Korea, Taiwan, Hong Kong, Malaysia, Thailand and Indonesia. 5IMF staff estimates suggest that the peso’s appreciation corrects for past misalignments. IMF, “Philippine Country Report 07/62,” February 2007. 6On the other hand, competitiveness issues go beyond the exchange rate (e.g., higher unit labor and power costs) which require deeper policy reforms at the micro-level.

12


Figure 2.7: Cumulative Monthly Export Growth

Figure 2.8: Philippines Export Markets 2007 vs. 2006

Percent

0%

5%

10%

15%

20%

25%

Jan-0

7

Mar-07

May-07

Jul-0

7

Sep-07

Nov-07

Total

Electronics

*Est imates. Source of basic data: www.bsp.gov.ph (Jan-Sep), www.census.gov.ph (Oct-Dec)

Percent

0%

10%

20%

30% USA

Europe

Japan

China, inclHongkong

East & SEA

Others

2006

J-S07

Source of basic data: www.bsp.gov.ph

Figure 2.10: Real Exchange Rate MovementsFigure 2.9: Oil Imports and Oil price

-15%

-10%

-5%

0%

5%

10%

15%

2001 2002 2003 2004 2005 2006 2007

Nominal $/P, lhsREERI a, rhsREERI b, rhsREERI c, rhs

REERIa against major trading partners, REERIb against broad basket of competing countries, REERIc against narrow basket of competing countries. Source:

Percent

0%2%4%6%8%

10%12%

Jan-0

7Mar-

07May

-07

Jul-0

7Sep

-07Nov

-07

0

20

40

60

80

100

Share of petroleum imports, lhs

Dubai oil price (US$/bbl), rhs

Cumulat ive import growth, lhs

Source of basic data: www.bsp.gov.ph (Jan-Sep imports), www.census.gov.ph (Oct-Nov imports), www.eia.gov.ph (oil price)

USD

Capital flows strengthened through July, reversed sharply in August, immediately following the US sub-prime crisis and the reduced risk appetite for emerging market assets, and then recovered tentatively in September.7 Short-term portfolio investments, which resumed beginning in 2005, following progress in government’s fiscal consolidation efforts, have primarily been in the form of portfolio equity and have fuelled stock price run-ups (increase of over 20 percent in 2007). Gross portfolio inflows ranged from US$3.5 to US$4 billion in the last three years, roughly twice the level of gross direct investment inflows (which increased by over 20 percent in the first three quarters of 20078). The fickleness of these flows may nevertheless be seen in the large withdrawals out of equity securities in the months following the US credit market turmoil. Meanwhile, net loan availments by government (official loans), banks and private corporations led to a slight increase in the country’s external debt stock to US$54 billion as of

7Data on BSP-registered portfolio investments show reduced inflows in the last quarter of the year. 8On a net basis, foreign direct investments was negative in the first nine months of the year, a reversal of past performance due mainly to the loan-financed share acquisition of Mirant Corporation (contra entry in “Other Investments” account).

13


September 2007 from US$53 billion at end 2006. The external debt stock has nevertheless continued to decline as a share of GDP with debt service ratios improving as well.

2.4 Fiscal developments

The government more than met its budget deficit target in 2007, recording a 0.1 percent of GDP deficit, below the 0.9 percent of GDP target for the year. The much smaller deficit was achieved despite increased expenditures, mainly as a result of hefty revenues from privatization (over P90 billion, the bulk of which was received from energy-related sales in the last quarter). Total revenues expanded 16 percent, outpacing the 9.5 percent expenditure increase. Non-interest expenditures rose by 20 percent during the period, which reflects higher capital outlays, while interest payments declined 14 percent following lower interest rates and improved exchange rates. The positive primary balance (reaching almost 4 percent of GDP) helped trim the national government’s debt stock which, given robust economic growth and peso appreciation, continued on its downward trajectory (59 percent of GDP as of September 2007 down from 64 percent of GDP in 2006).

Government commitment to the overall deficit targets is commendable but requires parallel efforts to sustain gains in the tax effort in order to support medium-term development spending. Efforts to shore up tax revenues faltered as the tax effort, estimated at 14 percent of GDP in 2007, dipped slightly below the level achieved in 2006 and well below the 15.2 percent target for the year. The shortfall in 2007 has raised concerns about the government’s ability to bring the tax effort to the programmed 16.6 percent by 2010, especially in view of structural erosion caused by non-indexation of excise taxes to inflation and the reduction in the corporate income tax from 35 percent to 30 percent by 2009 as provided by law. In the meantime, raising efficiencies in the two main collection agencies, the Bureau of Internal Revenue and the Bureau of Customs, remains the most immediate challenge, especially considering the difficulty of pushing for additional tax measures at this time. Additionally, reported tax leakages due to petroleum-related smuggling activities need to be plugged. The economic return to oil smuggling increased following the VAT’s application to the sector.

The improved national government budget position, coupled with the combined surplus of the 14 monitored public corporations, other financial institutions and local government units, increased the consolidated public sector financial surplus to the equivalent of 1 percent of GDP in the first three quarters of 2007 (from a balanced position in 2006). Between end-2006 and June 2007, the non-financial public sector debt fell by seven percentage points to 67 percent of GDP.

2.5 Poverty

Recently released data shows that poverty increased in 2006 relative to 2003, despite the higher growth in recent years. Moreover, income inequality, as measured by the Gini coefficient, is little changed from 0.46 in 2003 to 0.45 in 2006, and is high relative to Asian neighbors (and more in line with Latin American countries). In fact, in the Philippines, growth is translating into lesser poverty reduction than in other countries in the region, and this slow pace of poverty reduction (and high income inequality) in the face of accelerating economic growth remains the key development challenge9 Based on available survey data, poverty incidence is estimated to have risen from 30 percent of the population in 2003 to 33 percent in 2006, with the number of poor rising by over 5.4 million between the two periods (Figure 2.12). Wide regional disparity is also observed (Figure 2.12). Geographically, the National Capital Region and the two adjacent regions (CALABARZON and Central Luzon) which account for more than half of GDP, 9Arsenio Balisacan estimates a 1.3 response of Philippine poverty to growth compared with Ravallion’s (2001) estimate of 2.5 (average) for 47 other developing countries.

14


receive a disproportionately large share of infrastructure spending, have per capita incomes above the national average, and have consistently recorded the lowest poverty headcount. On the other hand, the poorest regions (ARMM and Caraga) have per capita incomes of only 50-60 percent of the national average and receive a very small share of total investments. These regions also have the highest incidence of poverty.

Poverty in the Philippines is largely found in rural areas and is linked to low-income agricultural-based livelihoods. It is estimated that as of 2006, three quarters of the poor reside in rural areas10. These estimates also show that rural poverty increased from 12.1 percent in 2003 to 14.4 percent in 2006 and that poverty among agricultural households is about three times higher than poverty in other sectors.

However, with urbanization the share of urban poverty is also rising. Between 2003 and 2006, the share of the poor population living in urban areas increased from 22.7 percent to 25.2 percent.

Figure 2.11: Number of Poor and Poverty Incidence

Figure 2.12: Regional Poverty Incidence 2006

010203040506070

Percent

Source of basic data: National Stat ist ical Coordinat ion Board

2122

23242526

2728

2000 2003 200628

29

30

31

32

33

34

Magnitude (lhs) Incidence (rhs)

Millions Percent

Source of basic data: Nat ional Stat ist ical Coordinat ion Board

10 Balisacan (2008)

15


Chart Set 1: Real Sector Developments

… driven on the demand side by consumption Economic growth has been accelerating… Gross domestic product (real growth)

0%1%2%3%4%5%6%7%8%

2001 2002 2003 2004 2005 2006 2007

Source of basic data: National Statistical Coordination Board (NSCB), BSP SPEI

Contribution to real GDP growth

-10%

-5%

0%

5%

10%

15%

2001 2002 2003 2004 2005 2006 2007

C G I X-M GDP

Source of basic data: NSCB

… and services on the supply side. (which is supported by growing remittances)…

Migrant workers' remittances

0%

2%

4%

6%

8%

10%

12%

14%

2001 2002 2003 2004 2005 2006 2007-5%

0%

5%

10%

15%

20%

25%

30%

Share of GDP*, lhs

Growth in dollar remittances, rhs

*NIA definition, current prices. Source of basic data: BSP and NSCB

Sectoral contribution to GDP growth

-2%-1%0%1%2%3%4%5%6%7%8%

2001 2002 2003 2004 2005 2006 2007

Agriculture Industry Services

Source of basic data: NSCB And unemployment remains high But investments have been declining, with a slight

uptick in 2007 due to public construction Labor indicators

0200400600

800100012001400

2004 2005 2006 20070%

2%

4%

6%

8%

10%

New entrants, lhs Jobs created, lhs Unemployment rate,

Source of basic dat a: www.census.gov.ph

'000Fixed capital formation, % of GDP

0%

5%

10%

15%

20%

25%

2001 2002 2003 2004 2005 2006 2007

Public constructionPrivate investments*

* Fixed capital formation less public construction. Source of basic data:

16


Chart Set 2: Monetary and Financial Sector Developments

… despite steep oil price hikes, lately countered by an appreciating peso

Inflation has stayed at single-digit levels…

Saudi Arab crude oil ($/bbl) and P/$ rate

0

10

20

30

40

50

60

70

2000 2001 2002 2003 2004 2005 2006 J-Jul 070

10

20

30

40

50

60

$/bbl, lhsP/$, rhs

Source of data: w w w .bsp.gov.ph

CPI inflation and its components

0%

1%

2%

3%

4%

5%

6%

7%

8%

2001 2002 2003 2004 2005 2006 2007

Miscellaneous

Services

Fuel, light, w ater

Housing

Clothing

Food, bev, tob

Overall inf lation

Source o f basic data: www.bsp.gov.ph

… but lending is only starting to recover… Interest rates have been declining since 2005…

Domestic interest rates

0%

2%

4%

6%

8%

10%

12%

2001 2002 2003 2004 2005 2006 2007

91-Day T-bill rate

Policy rate

Source of basic data: w w w .bsp.gov.ph

Domestic credit growth

-10%-8%-6%-4%-2%0%2%4%6%8%

2002 2003 2004 2005 2006 2007

Nominal

Real

Source of basic data: w w w .bsp.gov.ph

… following healthier bank balance sheets. And the stock market performance has improved Stock market performance

0

500

1000

15002000

2500

3000

3500

4000

2001 2002 2003 2004 2005 2006 20070

200

400

600800

1000

1200

1400

1600

Value turnover (Pbil), rhs

PSEi, lhs

Source of data: Philippine Stock Exchange

Commercial banking system: selected indicators

0%

10%

20%

30%

40%

2001 2002 2003 2004 2005 2006 2007*

NPA ratio

Capital adequacy ratio

2007 data as of November for NPA ratio and 1Q07 for CAR. Source: w w w .bsp.gov.ph

17


Chart Set 3: External Sector Developments

Robust external accounts due to both current account and capital account surpluses…

… income and transfer inflows have offset trade deficits. Balance of payments position (US$ Bil)

Current account components (US$ Bil)

-15

-10

-5

0

5

10

15

2001 2002 2003 2004 2005 2006 J-Sep07

Goods trade Services trade Income & transfers


(3)(2)(1)012345678

2001 2002 2003 2004 2005 2006 J-Sep07

Capital & financial account

Current account


and capital flows have also been increasing… … contributing to more rapid reserve accumulation Financial flows (US$ Bil)

-8

-6

-4

-2

0

2

4

6

2001 2002 2003 2004 2005 2006 J-Sep07

Other investments

Portfolio investments

Direct investments


Gross international reserves

0

5

10

15

20

25

30

35

40

2001 2002 2003 2004 2005 2006 20070.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

GIR (US$ Bil), lhs

Short-term debt cover*, rhs

*Residual maturity. Source: w w w .bsp.gov.ph

External debt stock has remained steady, with greater reliance on capital market financing…

… and debt service ratios have improved

0

10

20

30

40

50

60

70

2001 2002 2003 2004 2005 2006 J-S070%

5%10%

15%20%

25%

30%35%

40%

Private, lhsPublic, lhsShare of bond/noteholders, rhs


External debt profile

US$Bil

Debt service burden ratios

0%2%4%6%8%

10%12%14%16%18%

2001 2002 2003 2004 2005 2006 J-S07

DSB to current account receipts

DSB to GDP


18


Chart Set 4: Fiscal Sector Developments

… although has had less success with further increasing the tax effort.

National government is on track to achieve balanced budget by 2008… Public sector financial position, % of GDP

-6%-5%-4%-3%-2%-1%0%1%2%

2001 2002 2003 2004 2005 2006 2007

National government

Consolidated public sector*

*CPSD for J-Sep07. Source of basic data: Bureau of the Treasury, NSCB

Tax revenues, % of GDP

0%2%4%6%8%

10%12%14%16%

2001 2002 2003 2004 2005 2006 2007

2007 target

Tax effort

Source of basic data: Bureau of the Treasury, NSCB ..has created room for increasing expenditures The government’s privatization program and fiscal

consolidation National government expenditures, % of GDP

0%2%4%6%8%

10%12%14%16%

2001 2002 2003 2004 2005 2006 2007

Interest paymentsNon-interest expenditures

Source of basic data: Bureau of the Treasury, NSCB

Privatization receipts, PBil

0102030405060708090

100

1987

1989

1991

1993

1995

1997

1999

2001

2003

2005

J-Nov

07

Source of basic data: Bureau of the Treasury

… and peso appreciation and economic growth, government’s debt ratio has been declining.

Helped by rising primary surpluses… National governmnet primary surplus, % of GDP

-1%

0%

1%

2%

3%

4%

5%

2001 2002 2003 2004 2005 2006 2007

Source of basic data: Bureau of the Treasury, NSCB

0102030405060708090

2001 2002 2003 2004 2005 2006 2007

Domestic Foreign

N at io nal go vernment o utstanding debt , % o f GD P

Source: Bureau of Treasury, NSCB

19


3. HOW SUSTAINABLE IS THE PHILIPPINES GROWTH ACCELERATION?

The decade of the 2000s has seen a distinct increase in the pace of economic growth in the Philippines. Real GDP growth averaged 5.1 percent in 2000-07, compared to only 2.8 percent in 1990-99, with per capita growth picking up from merely 0.5 percent in the earlier period to 3.2 percent more recently. Will this growth acceleration be sustained over a long period, providing the basis for significant reductions in poverty and improvements in living standards? Or might it turn out to be merely temporary, as have many growth accelerations in other countries?

This section examines three questions. First, what is the likely impact of a cyclical global slowdown in 2008 on the Philippines? The recent growth acceleration in the Philippines occurred during a period of strong, sustained world growth since 2002. In 2008, however, world economic growth has started slowing sharply as a result of the sub-prime crisis in the US, accompanied by much increased volatility in global financial markets and in international capital flows.

Second, what are the sources of the Philippines growth acceleration in a growth accounting framework: the contributions from growth in unskilled labor, human capital, physical capital and total factor productivity (TFP)? Understanding the sources can help shed light on the longer term sustainability of this growth. From this perspective, while there does appear to have been a significant improvement in the underlying rate of TFP growth, a substantial part of the growth acceleration appears to have been cyclical in nature, resulting from the uptake of spare capacity created after the 1997-98 regional financial crises and the 2001 global recession. With the economy now at or above full capacity, maintaining the recent higher growth path will require a faster pace of TFP growth combined with faster physical and human capital accumulation.

Third, what lessons can the Philippines draw from international cross-country experience of growth accelerations? In particular, what does international experience teach us about the durability of such accelerations and the conditions under which they can be sustained?

The growth accounting analysis and the comparison with cross country experience raise some concerns about the sustainability of the recent growth acceleration. We end this chapter with a closer look at the slackening export competitiveness which echoes these concerns. The findings of this chapter set the stage for Chapters 4 and 5. Chapter 4 considers the key areas of reform that need to be deepened in order to improve the overall investment climate and sustain the pace of growth. Chapter 5 then looks at how well the Philippines is doing on innovation—the principle driver of TFP growth and hence long term growth. While many of the elements conducive to innovation and R&D investments are the same that encourage investment more generally—and hence are those that are discussed in Chapter 4—there are also some specific elements that are important for innovation, including the appropriate design of any direct public support for innovation.

3.1 Vulnerabilities in an uncertain global environment

At present there is much uncertainty about the global economic environment. Growth in the OECD countries already slowed to 2.5 percent in 2007 (from 2.8 percent in 2006) and is forecast to slow further to 1.8 percent in 2008. The US is now projected to grow at around 1.6

21


percent in 2008, although given rapidly unfolding developments in the financial markets, these projections may get further revised downwards during the course of the next few months. Under the baseline scenario, world trade growth is projected to slow from 7.5 percent in 2007 to 6.0 percent in 2008, while private capital flows to low and middle income countries are expected to decline by around 8 percent to US$906 billion.

However, a much more adverse scenario could just as easily unfold, in which the US would slide into a recession and the OECD countries as a group would suffer a severe slowdown. Should unexpected and large new losses occur in the financial markets—concentrated among commercial and investment banks or among major investors—credit conditions globally would also tighten further. The negative spillovers on emerging markets could be exacerbated by higher risk aversion on the part of investors—with spreads on emerging market debt rising further and private capital flows declining significantly.

In this section we discuss the potential sensitivity of Philippines’ exports, remittances and private capital flows in the more uncertain global environment. We end the section with an assessment of the adequacy of Philippines international reserve levels in the light of different benchmarks that are commonly used.

Exports

The composition of the Philippines’ exports has changed significantly since the early 1990s and is now heavily skewed towards machinery and transport equipment, particularly high-tech exports11. Machinery and transport equipment, which accounted for less than 20 percent of total exports in 1990, now makes up over 70 percent. A significant part of these exports is in parts and components (indeed parts and components account for 40 percent of total manufacturing exports).

The high-tech industry has its own sector dynamics: in 2001 for example, global growth in the high tech sector fell much more than other sectors and in fact led the recession, following an investment boom in that sector. However in general the demand for high tech products is relatively elastic. Exports of high-tech goods therefore tend to be quite sensitive to global growth conditions.

Table 3.1: Destination of Philippines’ Exports (% of total)

Total exports Manufacturing SITC 7 1990-95 2000-2005 1990-95 2000-2005 1990-95 2000-2005

US 36.3 21.4 38.9 22.4 36.7 16.9 Japan 16.1 15.5 12.2 15.4 16.3 15.9 EU 16.8 16.2 18.2 16.8 15.4 17.4 China 1.3 4.9 0.6 4.6 0.1 5.1 Other SEA 9.8 16.1 9.5 14.8 12.3 17.4 East Asia 9.2 15.6 8.9 15.9 11.4 17.4 Other Asia 0.6 0.3 0.6 0.3 0.2 0.2 ROW 9.9 10.0 11.1 9.8 7.6 9.8 Source: Asian Development Outlook 2007 Update. Note the SITC 7 category covers machinery and transport equipment.

A factor that may at first glance, appear to mitigate some of the effects of any sharp slowdown in the US and other OECD countries is the broadening geographical destination of

11 Machinery and transport equipment are classified in the United Nations Commodity Statistics Database (Rev 3) as SITC 7. Here we refer to high tech products as products in the two digit SITC classifications 75, 76, and 77.

22


Philippines’ exports to other East Asian economies (Table 3.1). However, while East Asia itself—and notably China—is providing a market for other East Asian exporters, much of the Philippines’ changing pattern of trade reflects its participation in the international and regional production networks associated with multinational companies (MNCs). With technological advances in production, firms have been dividing up the production process into finer and finer components to take advantage of specialization, while innovations in transport and communications have improved the speed and efficiency of coordinating geographically dispersed production processes. As a result, many countries are involved in the assembly process at different stages, leading to product parts and components crossing borders repeatedly before they are incorporated into the final product. But, since the final products are still destined primarily for the US and European Union, the slowdown in growth in the US and other OECD countries is likely to have a sizable impact on Philippines’ exports.

12Drawing on a recent study , Table 3.2 shows the estimates of the impact on Philippines’ exports (total, manufactured and high tech) of changes in its trading partner countries’ demand and in its real exchange rate. Based on these estimates, a 1 percentage point appreciation in the real exchange rate can be expected to lead to a decline in overall exports of 0.22 percentage points and a decline in manufacturing and high-tech exports of about 0.35 percentage points.13 A slowdown in partner country demand of 1 percentage point would lead to a decline in Philippines exports ranging from 0.24 percentage points for manufactured exports to 0.26 percentage points for high tech exports. Overall, these estimates would suggest an impact of around 0.25 percentage points on Philippines exports from a 1 percentage point slowdown in partner country demand. Thus, with a projected slowdown in world trade growth to 6 percent, export growth in the Philippines is likely to slow to 1.5 percent in real terms. A conservative estimate would be to assume zero growth in exports in real terms in 2008 (and a nominal growth of 5 percent).

Table 3.2: Estimated Impact of Key Determinants of Philippines’ Exports Impact of a one

percentage point change:

Total exports Manufacturing exports SITC 7 (percentage point) (percentage point) (percentage point)

Increase in world demand

0.25 0.24 0.26

Appreciation of real exchange rate

-0.22 -0.35 -0.36

Source: Asian Development Outlook 2007 Update. Note the SITC 7 category covers machinery and transport equipment.

Private capital flows

As mentioned above, the Philippines has seen an increase in capital inflows in recent years, albeit starting from a relatively small base. Much of this has been in the form of portfolio equity flows, which grew by an average of 60 percent during 2005-07 to reach an estimated

12 Asian Development Outlook 2007 Update. 13 Some authors argue that the impact of the real exchange rate on exports is likely to be more muted with the growing importance of parts and components in total exports, because intermediate products, by definition, involve a high component of imported components and parts and a depreciation of the currency—while lowering the foreign currency price of exports—also increases the home currency price of imports. However, others have argued that the increasing importance of product fragmentation and of trade in parts and components induces stronger substitution responses as the presence of production facilities in different countries allows firms to respond more nimbly to international price changes by shifting activities across borders. Ultimately the impact of the real exchange rate on exports is an empirical issue. It is interesting to note that this study finds that the long elasticity with respect to the real exchange rate of the Philippines is one of the lowest in the region.

23


US$4.0 billion in 2007. Total net portfolio flows amounted to an estimated US$4.4 billion in 2007, so the debt component has been very small. Net FDI flows have also picked up since 2005—reaching US$2.7 billion in 2007.

How sensitive are these flows likely to be to the global downturn? Studies of determinants of portfolio flows to emerging markets generally find that while factors such as the growth performance and prospects and the overall institutional environment in the recipient countries are important, global interest rates play a key role. In particular, a decline in global interest rates is a “push” factor, encouraging investors to look for higher returns in emerging markets. Under the current base case scenario, short-term policy interest rates are actually expected to decline in the OECD countries in response to the slowdown in economic activity. However, given that the industrial country slowdown has originated from problems in the financial markets and has already resulted in increased investor risk aversion14, global interest rate elasticities are not likely to provide much guidance as to how capital flows to emerging markets may be affected. Any “push” from lower industrial country interest rates may be counteracted by increased risk aversion. A more relevant question therefore is how sensitive are portfolio flows to the Philippines to an increase in risk aversion? Some preliminary analysis which looks at the impact of an increase in the Philippines EMBI spread as an indication of investor risk aversion suggests that an increase in 100 basis points in the spread could lead to a decline of around 0.3 percent in net portfolio equity flows.

Most empirical analyses on determinants of FDI find that, although FDI flows are affected by global cyclical conditions—particularly long-term interest rates (as these affect the opportunity cost of investing in emerging markets)--the most important variables are structural in nature: the host country’s macroeconomic performance, the investment environment, infrastructure and resources, and the quality of institutions. Thus, to the extent that the Philippines can continue to make progress in structural reforms, FDI flows to the Philippines are likely to be less affected by the cyclical downturn. Clearly though, in the event of a severe global recession, FDI flows to emerging markets are also likely to falter.

Remittances

During the past few years recorded remittances to the Philippines have grown strongly, rising from US$6.0 billion in the early 2000s to US$14.4 billion in 2007. The strong growth in remittances over the past few years has reflected not only an increasing number of overseas workers in the context of a strong global economy (particularly in the Middle East where high oil prices have boosted demand) but also the rise in the share of skilled workers over time. In 1993 professional and technical workers accounted for 25 percent of overseas workers, while production workers accounted to just over 36 percent. By 2004 professional and technical workers accounted for 33 percent of overseas workers, while the share of production workers had fallen to 22 percent.15

Although the geographical distribution of overseas Filipino workers—particularly temporary workers—is relatively well diversified, the US still accounts for 33 percent of total Filipino overseas workers, and 68 percent of permanent overseas workers (Figure.3.1).

14 The Philippines the EMBI spreads increased from the low of 137 basis points in June 2007 to 192 basis points in January 2008. 15 Excludes immigrants or legal permanent residents abroad whose stay do not depend on work contracts.

24


Figure 3.1: Geographical Distribution of OFW Workers (2006)

There has been considerable debate in the literature on remittances as to whether host country macroeconomic developments matter or whether remittance levels are determined primarily by home country considerations. A recent empirical study looking at remittance flows from the US as a host country to the rest of the world (including the Philippines), finds that host country (US) macroeconomic factors are very important in driving remittances—more important

actually than home country factors.16

0.0 0.5 1.0 1.5 2.0 2.5 3.0

Asia

Middle East

Europe

US

Others

Seabasedpermanent temporary

Millions

Total: 1.2 million

Total: 1.8 million

Total: 0.8 million

Total: 2.7 million

Total: 1.3 million

Total: 0.2 million

In particular, the study finds that higher income and lower interest rates in the US encourages more remittances, while an increase in inflation or unemployment in the US reduces remittances. This would suggest that, since significant share of overseas Filipino workers reside in the US, the projected slowdown in the US could be expected to be accompanied by a slowdown in the growth of remittances to the

Philippines in the coming year.

Over the medium term though, structural factors that encourage out-migration point to a high likelihood of sustained remittance inflows to the Philippines, albeit at a slowing pace. Factors such as greater labor mobility in a globalized world, aging populations in host countries that offer wages several times higher than local levels, and increased proportion of skilled workers in areas that may be less prone to cyclical swings, are expected to continue to create demand for Filipino workers and support remittance flows. In the longer run, the prospects for sustaining remittances will depend critically on the country’s ability to continue to supply high quality workers.

Overall sensitivity of Philippines’ economy to industrial country developments

As a means of gauging the overall sensitivity of the Philippines economy to industrial country developments, a Vector Autoregressive (VAR) model was estimated, which in addition to trade channels, includes financial channels and third-country effects. The results of this model suggest that a one percentage point shock to industrial country GDP leads to an approximately 0.4 percentage point change in Philippines’ GDP, measured cumulatively over the first-four quarters.17.

Given the baseline projections for the global economy, the government’s current macro economic policy stance would seem to be appropriate. Clearly, in the event of a significant

16 “Macroeconomic determinants of workers’ remittances”. Vargas-Silva et al (2006). Journal of International Trade and Economic Development. 17 The model considers, in a Vector Autoregressive (VAR) framework, the evolution and interdependencies of GDP, inflation, short-term interest rate, and the real exchange rate for the Philippines and for the industrial countries and China. The price of oil is also included as an endogenous variable.

25


deterioration in the global environment, the appropriate policy stance and mix may need to be revisited. An important point to bear in mind is that the scope for a significant fiscal stimulus may be circumscribed by the need to ensure that the market confidence that the Philippines has gained through the strengthening of its fiscal position over the past few years, is not eroded. Indeed, should market confidence falter, interest rates could increase sizably, crowding out some of the short-run impact of a fiscal stimulus. Nonetheless, should developments in the global economy worsen very significantly and a fiscal stimulus package is deemed necessary, it would be important that it be guided by the following general principles:

• The package should be timely: not enacted prematurely, delayed too long or consist of tax cuts or spending decreases that would take too long to be implemented or to boost output,

• The package should be targeted to the households that are most vulnerable in the downturn. Since these households are also the most likely to stimulate the economy by spending the increases quickly, this would make sense from a macroeconomic stabilization perspective too.

• The fiscal stimulus should be temporary. Taxes should be cut or spending increased in order to stimulate in the short run. However, these policy changes should not increase in the budget deficit in the long run. Doing so could actually reduce the extent of the short run stimulus by raising interest rates as mentioned above.

Reserves as a buffer for shocks

Since 2005, the authorities have taken advantage of the higher remittance inflows and stronger FDI and portfolio flows to build reserves, even as they have prepaid debt and allowed an appreciation of the exchange rate. Reserve accumulation was particularly strong in 2007, rising to US$34 billion. Table 3.3 shows some common indicators that are used to scale the level of reserves by the main components of the current and capital accounts.

The reserve import coverage—perhaps a less relevant indicator for countries with open capital accounts—attempts to capture an economy’s vulnerability to shocks in the current account. The commonly used benchmark is 3 months of imports. Under this rule, given the Philippines’ imports in 2007, the country would need US$16.2 billion—and as Table 3.3 indicates—the Philippines had US$14 billion of reserves in excess of this. The ratio of reserves to short term debt attempts to measure the rollover risk. An often used threshold is the Greenspan-Guidotti rule which recommends 100 percent reserve coverage to short term debt. Under this measure, given Philippines’ short term debt, US$12.3 billion would be required, and again as of end 2007, reserves were US$17.9 billion in excess of this amount. Finally the Jeanne-Rancierre Model explicitly takes into account the probability of sudden stops in capital flows, based on factors such as the extent of financial integration of a country, public and external indebtedness and the extent of previous real exchange rate appreciation. Based on this criterion, the Philippines held US$16 billion of reserves in excess at the end of 2007. Overall, therefore the past year has seen a substantial improvement in reserve cover.

26


Table 3.3: Adequacy of Reserve Levels under different Criteria Required/suggested reserve levels under

different “optimal” reserve rules Excess reserves (actual minus suggested

reserve levels) (US$ billions) (US$ billions)

Months of

imports Greenspan-

Guidotti Rule

Jeanne-Ranciere Model

Months of imports

Greenspan-Guidotti Rule

Jeanne-Ranciere Model

1/

2/ 3/

2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 2006 2007 Philippines 14.9 16.2 10.0 12.3 12.8 14.1 5.1 14.0 10.0 17.9 7.2 16.1

1/ Three months of imports of goods and services (period-ahead). 2/100% of short term debt (debt due within one year). Short term debt data are from the BIS (defined on a residual-maturity basis). 3/10.1 percent of GDP (period ahead). Based on calibration of the parameter ρ in R(t)= ρ *Y(t+1) for the benchmark of 34 countries in Jeanne-Ranciere (2006).

3.2 The Philippines Growth Acceleration in Longer Term Perspective

The above discussion suggests that, barring any severe disruptions in the global economy, the Philippines should be relatively well placed to weather the global cyclical downturn. This section examines the Philippines recent growth acceleration in a longer term context. As Table 3.4 shows, growth in 2000-07 has averaged 2.4 percentage points higher than in 1990-99. It has been the longest period of sustained growth in average per capita GDP since the 1970s.

Table 3.4: Philippines: Economic Growth by Expenditure and Industrial Sector Growth Contribution to

- Annual Average % Change Change in Growth 1970-79 1980-89 1990-99 2000-07 2006 2007 2000-07 * 2007 Real GDP 5.8 1.9 2.8 5.1 5.4 7.3 2.4 1.9 (Per-capita GDP) 2.0 -0.5 0.5 3.2 3.5 5.4 .. ..

Expenditure Pers. Consump. 4.5 2.9 3.7 4.8 5.5 6.0 1.0 0.5 Govt. Consump. 7.2 1.0 3.5 2.2 6.1 10.0 -0.1 0.3 Fixed Investment 8.6 0.3 3.4 1.9 1.4 9.5 -0.3 1.3 Construction 9.9 -1.4 3.9 1.3 5.5 18.0 -0.3 0.9 Durable Equip. 7.8 1.7 2.9 2.5 -1.8 2.7 -0.1 0.4 Exports 8.1 6.8 5.9 6.9 11.2 3.1 0.9 -3.7 Imports 5.9 5.0 6.8 3.5 1.9 -5.4 1.2 3.8

Industrial Sector Agriculture ** 3.6 1.5 1.4 4.0 3.8 5.1 0.5 0.2 Industry 8.0 0.6 2.4 4.3 4.5 6.6 0.6 0.7 Manufacturing 6.5 1.0 2.3 4.4 4.6 3.3 0.5 -0.3 Construction 13.3 -3.0 2.5 1.8 7.3 19.5 -0.1 0.5 Services 5.2 3.5 3.7 6.2 6.7 8.7 1.3 1.0 *Contribution to change in average growth between 1990-99 and 2000-07. **Includes forestry and fishing.

Investment and import weakness

However, looking at contributions to overall demand growth by different expenditure categories, there are at least two aspects that give concern for the long term sustainability of growth. First there is the long standing weakness of fixed investment, which grew only 1.9 percent on average in 2000-07. Fixed investment is running at only 14 percent of GDP, lower even than during the deep recession in the first half of the 1980s, and substantially lower than in most of the other larger East Asian economies. Linked to this weak investment has been weakness in import growth, which averaged only 3.5 percent in 2007, down from 6.8 percent in

27


181990-99, due in particular to lower capital goods imports . Remarkably, weaker import growth made the largest single arithmetical contribution to the growth acceleration in 2000-07 compared to 1990-99. Neither of these trends seems consistent with sustained fast growth in the longer term. As we note in the discussion of innovation in the Philippines in Chapter 5, imports of capital equipment are a major source of new technology and innovation in developing countries, and these, in turn, are key drivers of long term growth. Investment both adds to the capital stock needed for production, and, by embodying new technologies and knowledge in the production process, contributes to total factor productivity growth.

One positive recent indicator is the strong upswing in construction investment in 2007. As Figure 3.2 indicates, much of the upswing results from stronger public construction spending, in particular on infrastructure, one of the benefits of the recent improvements in the government’s fiscal position. Private construction spending, although picking up modestly, remains near historic lows as a share of GDP. More perplexing still is the continued weakness in durable equipment investment, which reached a new low at 5.5 percent of GDP in 2007 despite the improved macroeconomic environment (resulting from the impressive degree of fiscal adjustment), exhaustion of spare capacity left over from the Asian crisis (capacity utilization in manufacturing is around 80 percent), and healthier corporate and bank balance sheets. Business sentiment likewise turned rosier during the year19.

Figure 3.2: Construction Investment Figure 3.3: Durable Equipment Investment (% of GDP) (% of Sector value Added)

0

5

10

15

20

25

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

Per

cent

of S

ecto

r Val

ue A

dded

Industry Services Total0

2

4

6

8

10

12

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

Perc

ent o

f GD

P

PublicPrivate

Source: World Bank data and staff estimates. Source: World Bank data and staff estimates

One hypothesis advanced to reconcile lower investment rates with higher growth is the economy’s greater reliance on services, which are expected to be less capital intensive. As Figure 3.3 shows, the ratio of durable equipment investment to value added in the services sector is indeed generally lower than in industry. However the rise of services output does little to explain the decline in overall durable equipment investment between 2000 and 2007. Around 80 percent of that decline is explained by the fall of investment within the industrial sector. Investment within the services sector is also lower as a share of output than it was during the economic

18 Analysts have looked at the possibility that slow import growth is a statistical artifact due to worsening data collection and rising smuggling. We do not pursue this topic here. However initial econometric estimates suggest that investment is by far the strongest determinant of Philippines imports, and that weak investment can explain much of the slowdown in import growth. 19For example, results of the quarterly BSP Business Expectations Survey show much higher confidence indices in 2007 compared with 2006—the index rose from 31.5 to 45.1.

28


upturn of the mid 1990s. Looking forward, there remains a question about whether growth in services can be sustained at recent rates without stronger investment within the sector. Or perhaps a more relevant question is whether the services sector can achieve the even faster growth needed to generate more jobs without a significant increase in investment. In 2007 the economy was able to reduce the unemployment rate to 6.3 percent partly because more of the working-age population opted not to join the labor pool20.

We conclude that continued weak investment and imports in the present growth recovery are likely to reflect a variety of deeper institutional and policy weaknesses affecting the investment climate. Studies of the investment climate in the Philippines point to concerns about macroeconomic stability, and uncertainties related to governance and inadequate infrastructure, among others.21 These issues are taken up in more detail in Chapter 4.

A growth accounting perspective

A simple growth accounting exercise can provide further insight into the Philippines growth acceleration during the 2000s, decomposing growth into contributions from accumulation of factors of production or from improved total factor productivity (TFP). This exercise builds on the estimates for 1960-2000 developed by Bosworth and Collins (2003), updated for the period 2001-07 by World Bank staff. Table 3.5 shows that growth in output per worker fell sharply to -0.9 percent a year in the recessionary decade of the 1980s and was near zero in the 1990s. Growth in TFP was negative on average in these two decades.

From a simple or unadjusted growth accounting perspective, the growth acceleration of the 2000s has been largely the result of a pickup in TFP growth. Growth in output per worker picked up to an estimated 2.3 percent per year in 2000-07.22 Given the weakness in fixed investment noted above, growth in physical capital stock made virtually no contribution to growth. TFP growth, meanwhile, jumped to an estimated 1.9 percent per year, stronger even than in the faster-growth decades of the 1960s and 1970s.

TFP growth estimates are residuals that can combine many types of economic effects—technological progress, for example, or greater efficiency due to better allocation of factors of production within sectors, movement of factors between sectors, improvements in the quality of factors of production or changes in the utilization rate of factors of production. Here we focus on the last point. The

Table 3.5: Philippines: Growth Accounting Growth in Contribution to Growth of: Output per Physical Human TFP TFP Cycl.

Worker Capital Capital Adjusted* 1961-06 1.1 0.8 0.4 -0.1 -0.1 1961-79 2.4 1.2 0.4 0.7 0.5 1980-89 -0.9 0.8 0.4 -2.0 -2.2 1990-99 0.1 0.4 0.4 -0.7 0.1 2000-07 2.3 0.1 0.3 1.9 1.1 Source: Bosworth and Collins (2003) through 2000. World Bank staff estimates after 2000. * Cyclically adjusted.

20 The labor force participation rate declined slightly from 64.2 in 2006 to 64.0 in 2007. There is some evidence from surveys that suggest that an increasing number of households are reducing their participation since they receive remittances. In addition, there is growing evidence that some adults are dropping out of the labor force to go back to school. 21 See for instance the World Economic Forum’s Global Competitiveness Report, the World Bank-ADB 2005 Investment Climate Assessment and ADB (2007). 22 Growth in output per worker is generally lower than growth in output per capita because the labor force in the Philippines is growing significantly more rapidly than population, the result of higher fertility rates in the past affecting the size of the age cohorts entering the labor force today.

29


rate of capacity utilization is estimated to have fallen significantly when economic growth fell as a result of the 1997-98 financial crises in the region and the 2001 global high tech recession. Conversely, as aggregate demand growth recovered from 2002 onwards, a significant fraction of increases in output are likely to have been met by increases in capacity utilization23.

Our initial estimate of 1.9 percent per year TFP growth in 2000-06 is therefore likely an over-estimate of this TFP growth because of rising capacity utilization. The last column of Table 3.5 suggests that the underlying rate of TFP growth (after adjustment for changes in capacity utilization) did indeed increase, but more modestly, to around 1.1 percent per year in 2000-07.24 This is a welcome development and could be taken as evidence that the Philippines economy in the 2000s has indeed been benefiting from the economic reforms undertaken over the last 15-20 years. On the other hand these estimates also raise a warning flag. With the economy now generally estimated to be operating at or above full capacity, the growth bonus from rising capacity utilization—worth around 0.8 percentage points per year according to these calculations—is likely to disappear. Trend rates of growth could decline unless improvement in policies and institutions help foster faster rates of physical and human capital accumulation as well as faster TFP growth.

Cororaton (2003) provides an econometric investigation of factors affecting TFP in the Philippines25. He finds that measures of global integration such as the ratio of trade to GDP and the ratio of FDI to GDP have a significant positive impact on TFP, presumably reflecting the efficiency gains and the access to new technology and knowledge made possible by such integration. The share of manufacturing in GDP was also found to have a positive impact, indicating, according to Cororaton, the potential for greater spillover effects from new technology in this sector than in agriculture or services. Finally, the share of R&D has a significant positive impact. It is a concern that, as noted, the shares of exports and imports to GDP have fallen in the 2000s. The ratio of FDI to GDP fell to 1.6 percent of GDP in 2000-06 as compared to 2.5 percent in 1990-99 (although there was a mild upturn in 2006). And, as we note, in the later discussion of innovation in the Philippines, R&D spending is very low by international standards.

3.3 The Philippines growth acceleration in an international context

A look at cross-country experience with growth accelerations can provide a useful perspective on the Philippines’ recent performance. For example, how does the Philippines’ acceleration compare in robustness to international experience? Is it similar to international experience in its composition and features? What can international experience teach about the sustainability of growth accelerations?

To make this evaluation we compare the Philippine experience to the results of a study on “Growth Accelerations” by Hausmann, Pritchett and Rodrik (henceforth HPR).26 HPR define a growth acceleration as one where (i) growth in per capita GDP over an 8 year period reaches at least an average 3.5 percent per year; (ii) growth is at least 2 percentage points higher than in the

23 The capacity utilization rate, estimated to have been 78 percent in 2000, declined to 75 percent in 2002 and then rose again to 80 percent in 2006. 24 The cyclically adjusted estimate of TFP growth is derived after calculation of the underlying trend level of the output-capital ratio using the Hodrick-Prescott filter. The IMF in its recent 2008 Selected Issues Paper computes the output gap using more sophisticated methods, including a structural VAR, a state space model and a Cobb-Douglas production function. All three approaches tell a broadly similar story, with actual output levels generally estimated to be at or above potential GDP (a positive output gap) in the last 1-2 years. IMF. (2008). Philippines. Selected Issues. Estimating the Output Gap: Implications for Monetary Policy. 25 Caesar B. Cororaton. (2003). Research and Development and Technology in the Philippines. Philippines Institute for Development Studies. Perspective Paper Series No. 10 26 Ricardo Hausmann, Lant Pritchett and Dani Rodrik. (2005). “Growth Accelerations.” Journal of Economic Growth, vol. 10(4), pages 303-329, December.

30


previous 8 years; and (iii) per capita output at the end of the period exceeds the peak output level before the growth acceleration. HPR find that such growth acceleration episodes are relatively common, with some 83 from the 1950s through the 1990s, with an average acceleration of some 4.7 percentage points per year.

By comparison the Philippines growth acceleration has been modest. In fact it does not qualify as a growth acceleration by the (admittedly arbitrary) filter used by HPR, since per capita GDP growth in the 2000-2007 period averaged 3.2 percent and the acceleration over the previous period was only 1.5 percentage points (Table 3.6).27

Table 3.6: The Philippines Acceleration in International Context Philippines Cross-country 2000-2007 filter or average*

Average per capita GDP growth 3.2 >= 3.5 Growth acceleration 1.5 >= 2.0 Export/GDP ratio (% change) -20.3 14.6 Import/GDP ratio (% change) -18.6 14.3 Investment/GDP ratio (% change) -25.4 14.9 In the column for cross-country experience the first two rows show the filter used by Hausmann, Pritchett and Rodrik (2005). The final 3 rows show cross-country averages in their sample for percent changes in export/GDP ratios etc.

The Philippines growth acceleration is also rather anomalous in terms of its composition. Hausmann, Pritchett and Rodrik find that growth accelerations are correlated with significant increases in the ratios of investment, imports and exports to GDP. A variety of plausible reasons could be offered to explain this pattern, for example that improvement in business profitability and the overall investment climate leads to an investment boom, which stimulates rising imports of new capital equipment, while improved competitiveness supports stronger export growth. As noted though, in the Philippines all these key ratios have fallen during the recent growth acceleration (Table 3.6).28 This deviation from the international pattern also points to the need to put the Philippines’ recovery on a more sustainable footing going forward.

Finally, the work by HPR offers some insights on the sustainability of growth accelerations. HPR find that a little under half the number of growth accelerations fail to sustain themselves; in these cases growth in the post-acceleration period falls back to less than 2 percent above the pre-acceleration trend. They find two determinants that have a statistically significant positive impact on the probability that acceleration will be sustained. The first is a political change in the direction of democracy. The second is economic reform. The latter finding has an obvious important implication for the Philippines: continued efforts at economic reform will help ensure the sustainability of the recovery.

3.4 Long term competitiveness: some concerns

The trends discussed above shed some concerns about the longer-term sustainability of growth. These concerns are echoed in recent export performance.

27 One could of course “include” the Philippines by relaxing the HPR criteria for growth accelerations. But the underlying point would remain that the growth acceleration in the Philippines has been relatively modest compared to international experience.. 28 Changes in trade and investment to GDP ratios are measured using nominal values. Using the real or constant price series, investment and import to GDP ratios in the Philippines continue to show marked declines in 2000-07, although the real export ratio shows an increase.

31


The Philippines’ export performance over the last 15-20 years is in many ways a striking success story. The industrial structure of exports has been transformed as trade and FDI barriers were sharply reduced from the late 1980s onwards. As noted above, high tech exports climbed from less than 20 percent of the total in 1990 to over 70 percent by 2000, driven largely by foreign MNC investment in the country and the geographical direction of exports has also become more diverse.

But recent years have also seen the emergence of some more problematic trends. The share of the Philippines in world exports grew from 0.24 percent in 1990 to 0.63 percent by 1999, but fell quite sharply during the 2000s to 0.39 percent by 2006. Philippines is not, of course,

alone in this respect. The rise of China has heightened competitive pressures and led to declines in world trade shares for many countries, balancing the rapid gains in China’s market share. However, as Figure 3.4 shows, the 37 percent fall in the Philippines’ share in 2000-06 was larger than for other countries in Emerging East Asia, whose combined world export market share fell by less than 10 percent. Among these other East Asian economies, Korea, Singapore and Thailand even managed to maintain or modestly increase their shares, despite the competitive pressure from China. (World Bank (2007) provides a more systematic econometric study of the impact of competition from China on other countries’ exports to third markets, controlling for other factors, and finds that the Philippines is among the countries significantly affected.).

Figure 3.4: Growth Rate in World Export Shares

Percent Change in Share 2000-06

-40 -20 0 20 40 60

United States

Japan

China+HK

Other Emerging EAP

Indonesia

Korea, Rep.

Malaysia

Philippines

Singapore

Taiwan, China

Thailand

Source: World Bank data and staff estimates.

As noted previously, like most East Asian economies, Philippines’ exports have also benefited from rapid growth in China’s own markets. Indeed, the Philippines was able to increase its share of China’s imports (inclusive of Hong Kong imports) from 0.59 percent in 2000 to 0.74 percent in 2006. But, as Figure 3.5 shows, this was combined with significant declines in the Philippines’ share of imports of other major markets, for example the US market or the imports of other non-China emerging East Asian markets. Looking at export performance in terms of products, declines in world market shares have occurred in many of the Philippines’ major export categories, including high tech exports, apparel and edible oils and fats (Figure 3.6).

32


Figure 3.5: Philippines’ Share of Country Imports

Figure 3.6: Philippines: Share in World Product Exports

(% of total) Percent Change in Share – 2000-06

-60 -40 -20 0 20 40

United States

Japan

China+HK

Other Emerging EAP

Indonesia

Korea, Rep.

Malaysia

Singapore

Taiwan, China

ThailandSource: World Bank data and staff estimates.

0.0

1.0

2.0

3.0

4.0

1990 1995 2000 2006

Total exportsHigh Tech (SITC 75-77)ApparelOils & Fats (SITC 42-43)

Source: UN Comtrade.

Is the decline in Philippines’ global market share in the 2000s primarily the result of the appreciation in its exchange rate? Figure 3.7 provides some prima facie evidence against this

hypothesis. Much of the rise in Philippines’ global market share during the 1990s occurred when the real effective exchange rate of the peso was appreciating strongly, from 1990 through 1996-97. Conversely, much of the sharp decline in the Philippines’ share of world exports during the 2000s occurred even though accompanied by a sharp depreciation of the peso in real effective terms. It is true that there has been a significant appreciation of the peso from 2005 onwards and this is likely to be contributing to pressure on exporters’ profit margins more recently. But the pattern in Figure 3.7 suggests that it is unlikely to be the major factor explaining changes in the competitiveness of Philippines’ exports in this decade.

Figure 3.7: Philippines Real Exchange Rate and Share in World Exports 1990-2006

A different perspective on competitiveness is provided by the capacity of countries to develop new export varieties.

The Philippines export structure is much more concentrated than that of other larger East Asian economies; its export concentration ratio is 2-4 times higher than other middle income economies in South East Asia. Figure 3.8, based on Feenstra and Kee (2006), shows the change in export variety in six East Asian countries compared to a sample of 44 countries. The figure shows that China has become among the leaders in the development of new products.

0.20

0.25

0.30

0.35

0.40

0.45

0.50

0.55

0.60

0.65

199019

9119

9219

9319

9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

06

50

60

70

80

90

100

110

120

130

140

Share in World Exports (%) - Left Scale

Real Effective Exchange Rate Index

Source: IMF, World Bank data.

33


Figure 3.8: Development of Export Varieties in East Asia

-60

-40

-20

0

20

40

60

80

100

China

Indonesia

Malaysia

Philippines

Thailand

Taiwan

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

Percentage difference in country versus sample mean

Note: Percentage difference in country versus sample mean (sample includes 44 countries from 1980-2000). Source: Feenstra and Kee, 2006.

The Philippines, however, has been less successful at developing new export product varieties than other leading East Asian economies, performing at only about the average for the 44 countries in the sample. Feenstra and Kee (2006) observe that there is a strong positive correlation between export product variety and total factor productivity. Lederman and Maloney (2006) find that, conversely, export concentration has a strongly negative effect on growth. It seems plausible that productivity and export variety are likely to have positive, mutually reinforcing effects on each other. High productivity—a high level of technological knowledge, for example—should help development of new export varieties. Development of new export varieties, on the other hand, could also have positive learning effects that boost productivity more generally.

The emerging difficulties with export performance in the 2000s point to the need for a stronger focus on underlying determinants of the investment climate that are curbing the incentive for firms to undertake new investment, including investment in new export capacity and new export varieties.

34


4. PROGRESS ON STRUCTURAL REFORMS This chapter turns to look at areas of policy reform that could help the Philippines sustain

its recent higher pace of economic growth. Chapter 3 noted several factors that could undermine the sustainability of the growth acceleration of the 2000s. The global economic environment in 2008 is more adverse than in recent past years, with slowing developed country growth, surging oil prices and rising risk aversion. Supply side constraints are likely to bite as excess capacity is used up and activity levels exceed potential output, especially if private investment remains weak. Sliding export market shares are suggestive of weak underlying productivity trends. Finally, international experience suggests that, while growth accelerations such as that in the Philippines are not uncommon, it is also not uncommon for them to fizzle out after some time. But more hopefully, experience also suggests that economic reforms increase the probability of growth accelerations being sustained.

Which economic reforms though? This chapter does not undertake a separate growth diagnostic study but instead relies on the common conclusions of two previous studies, the 2005 World Bank-Asian Development Bank Investment Climate Assessment and the Asian Development Bank 2007 “Philippines: Critical Development Constraints” study. These studies agree in identifying at least three inter-related issues as critical in shaping the overall investment climate and important areas to address if growth in the Philippines is to be sustained: macroeconomic instability arising from chronic fiscal deficits; weak governance and high levels of corruption (particularly what is referred to as grand corruption or political corruption); and poor infrastructure. These studies note that, among various ill-effects, macroeconomic instability and weak governance have had a particularly harmful effect on investment by creating high levels of uncertainty about economic prospects, government policies and the ‘rules of the game’ facing businesses, putting at risk the appropriability of private returns to capital. Returns to investment are also eroded by poor access to infrastructure, an important complementary input in production.

Based on the findings of these studies, this chapter focuses on the specific reforms in these three areas that can help underpin sustained high growth in the longer term. Of the three, the government has certainly made the greatest progress in recent years on strengthening the fiscal position, thereby reducing the most potent source of macroeconomic instability. This improvement appears to be reflected in firms’ perceptions about the major problems constraining their functioning. Although the two sets of survey results in Figure 4.1 are not strictly comparable (different samples, survey questions etc.), it is interesting that in 2004 firms listed macroeconomic instability as among their primary concerns, while in 2007 concerns about inflation were near the bottom of the list. That however does not mean that fiscal issues do not remain close to the center of the reform agenda.29 The first section of this chapter focuses more closely on recent fiscal developments. Given that a significant part of the improvement in the fiscal position since 2003 has been the result of sharp cuts in public capital spending (with

29 Firm level surveys need to be interpreted with care as a source of information about economy-wide constraints to growth. Rodrik (2007) notes that the sample of firms will inevitably be biased towards firms that have best adapted to the constraints in the economy. For example, firms that successfully evade taxes are unlikely to complain about the ill-effects of corruption in the revenue agency. (Dani Rodrik: “The (mis)use of ICASs”. http://rodrik.typepad.com/dani_rodriks_weblog/2007/12/the-misuse-of-i.html ).

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http://rodrik.typepad.com/dani_rodriks_weblog/2007/12/the-misuse-of-i.html


adverse effects on infrastructure), one-off privatization revenues and cyclical factors, what measures are needed to make the fiscal improvement more permanent or sustainable? The chapter argues that measures to strengthen tax administration, increases in and indexation of excise taxes and rationalization of fiscal incentives can play an important role.

Figure 4.1a: Firm Perceptions of Severe Constraints 2004

Figure 4.1b: Most Problematic Factors for doing Business 2007

(% firms finding issue a major constraint) (% of responses)

0 5 10 15 20 25

CorruptionInadequate infrastructure

Political instabilityInefficient bureaucracy

Government instability / coupsTax rates

Tax regulationsAccess to financing

Restrictive labor regulationsCrime and theftPoor work ethic

InflationInadequately educated workforce

Foreign currency regulations

Percent of Responses0 10 20 30 40

Macroeconomic Instability

Corruption

Electricity

Tax rates

Regulatory Policy uncertainty

Crime, theft, disorder

Tax administration

Labor regulations

Anti-competitive practices

Cost of financing

Customs and trade regulations

Transportation

Percent of firms finding issue a major constraint

Source: World Economic Forum & Makati Business Club Source: WB-ADB Investment Climate Survey 2004.

The scale and complexity of governance problems and corruption in the Philippines appears daunting. It is one of few East Asian countries where the World Bank’s Worldwide Governance Indicators have become substantially worse since 1998, and where, despite more than 20 years of democracy, political stability is rated only slightly higher than the bottom 10th percentile worldwide. Political instability, corruption and special interest influence over policies make for a highly uncertain business climate, while weak public financial management and misuse of fiscal resources create a structural tendency towards poor fiscal outcomes—a prime source of macroeconomic instability and lack of resources for critical infrastructure and public services. Nevertheless, as the second section of the chapter notes, reform efforts have yielded small but noticeable advances while, perhaps most important, civil society efforts have kept problems of governance and corruption high in public awareness. The chapter focuses on some areas where specific governance reforms could yield concrete benefits in terms of better control of public resources and more certain rules of the game, in particular in budget management, public procurement and anti-corruption enforcement.

4.1 Importance of fiscal discipline and macro stability

The importance of fiscal discipline—prudent fiscal balances and sustainable public debt—as a pre-requisite for macroeconomic stability and for longer-term growth is well recognized. Sizable fiscal imbalances are a source of aggregate demand pressure that can lead to inflation and balance of payment problems, which in turn can limit the scope to use fiscal policy to stabilize output. Monetary policy is also more effective if it does not have to compensate for loose fiscal policy. Large fiscal deficits and high debt or adverse debt dynamics tend to put upward pressures on borrowing costs which can crowd out private investment—jeopardizing growth. Moreover, once fiscal imbalances become large, fiscal adjustment calls for quick-acting

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revenue and spending measures. Often public investment bears the brunt of the adjustment which can have adverse consequences for infrastructure development and growth.

Over the past few years, the Philippines has made very significant progress in reducing the overall fiscal deficit and the stock of public debt. The national government fiscal deficit has declined progressively from 4.6 percent of GDP in 2003 to 2.7 percent in 2005 and 0.1 percent in 2007. Indeed, as mentioned above, the 2007 budget deficit outturn has been significantly lower than targeted. The stock of debt has also declined sizably: that of the national government from 77 percent of GDP in 2003 to 59 percent in 2007, and that of the consolidated non-financial public sector from a peak of about 100 percent of GDP in 2003 to about 68 percent in 2007.

The larger part of the improvement in the overall fiscal balance during 2003-06 was achieved through a reduction in expenditures. A sizable portion of this reduction in expenditures, in turn, was on account of reductions in capital outlays (Figure 4.1). A decline in capital outlays contributed to almost 8 percent of the improvement in the overall balance during the period. In fact, capital outlays as a percentage of GDP which were already low in at 2.7 percent in 2004 (compared to the late early 2000s) fell further in 2005 and 2006. Since 2006 however a reduction in interest payments has made a significant contribution to the improvement in the overall balance on the expenditure side. At the same time, the trend in declining capital outlays was reversed in 2007. But capital expenditures as a percentage of GDP in 2007 were only back where they were in 2004.

Figure 4.1. Contribution to Improvement in Overall Fiscal Balance

-100

-50

0

50

100

tax revenues

other non-taxrevenues

privatization

lowerinterestpayments

lower capital outlays

lower otherexpenditures

Contribution of revenues to improvement in overall balance = 39.9%

2003-2006

perc

ent

Contribution of lowerexpenditures to improvement in overall balance = 60.1%

-100

-50

0

50

100

150

tax revenues

privatization

other non-taxrevenues

lowerinterestpayments

higher capital outlays

Contribution of revenues to improvement in overall balance = 87.9%

2006-2007

higher other expenditures

Contribution of lowerexpenditures to improvement in overall balance = 12.1%

perc

ent

Source: World Bank data and staff estimates. Source: Source: World Bank data and staff estimates.

Revenues, which were already much lower in 2003 compared to the late 1990s and early 2000s, remained relatively flat around 15 percent of GDP until 2006. In 2006, revenues increased by 1.2 percent of GDP, reflecting higher tax revenues following important tax reforms—the extension the VAT base to include energy products and the increase in the VAT rate from 10 percent to 12 percent. This helped raised the contribution of revenues to the improvement in the overall balance during 2003-06 to almost 40 percent. However in 2007 the momentum of tax revenue increases flagged again, both at the Bureau of Internal Revenue and the Bureau of Customs. Thus while overall revenues improved by as much as 1 percent of GDP in 2007 over 2006 and the contribution of revenues to the improvement in the overall fiscal balance rose to

37


almost 88 percent during 2006-07, these gains were due to the increase in non-tax revenues from the privatization of the National Transmission Corporation (amounting to 1.4 percent of GDP). Tax revenues at 14.0 percent of GDP, actually declined relative to the 14.3 percent of GDP in 2006.

The recent increase in capital outlays is welcome given the compression in capital spending, particularly on infrastructure over the past few years. As discussed below, the paucity of infrastructure investment and the quality of infrastructure is seen as a serious factor affecting the investment climate30. To meet the government’s capital spending goals of about 4.5 percent of GDP (from the current 2.0 percent of GDP), without jeopardizing the fiscal balance, it is estimated that revenues will need to rise to just under 18 percent of GDP.

This raises an important question of how much revenue performance has improved on a structural basis—that is, abstracting from both privatization (which cannot and should not be relied upon as a source of revenue over the medium term), as well as from the effects of the economic cycle31. Figure 4.2 shows the cyclically-adjusted (or the structural component) revenues. As can be seen, having improved significantly in 2006 following the tax reforms mentioned earlier, the cyclically-adjusted or structural component of revenues deteriorated again in 2007 to 15.2 percent of GDP. The cyclical component of revenues—associated with the robust growth—amounted to almost 0.5 percent of GDP. With the slowdown expected in economic growth for 2008 and 2009, the cyclical component of revenues can also be expected to decline.

Figure 4.2. Revenue Performance: Structural and Cyclical Elements

2003 2004 2005 2006 200713.0

14.0

15.0

16.0

17.0Structural component of revenues

2003-2007

perc

ent o

f GD

P

13.5

14.5

15.5

16.5

17.5

13.0

14.0

15.0

16.0

17.0

18.0

perc

ent o

f GD

P

structural component

cyclicalcomponent

privatization

Decomposition of revenues in 2007

Source: World Bank data and staff estimates. Source: World Bank data and staff estimates.

30 Recent work that looks at infrastructure in the Philippines include a cross country study by the World Bank and Turku School of Economics (2007) which ranked the Philippines 86th among 150 countries in terms of adequacy of infrastructure; the 2006 Global Competitiveness Index of the World Economic Forum where the Philippines is ranked 88th out of 125 countries in terms of overall infrastructure quality, and the 2007 World Competitiveness Yearbook (IMD 2007) where the Philippines is ranked 51st out of 61 countries in terms of adequacy of infrastructure. 31 The cyclically-adjusted or structural component of revenues is calculated as the revenues that would prevail if the economy was operating at full employment: Rs= R – R (Yp α/Y) Rs where is structural component of revenues, R is actual revenue, YP is potential output and α is the elasticity of revenue with respect to output.

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Clearly meeting the capital outlay targets will require sustained improvements in revenue performance and of tax revenues in particular. There are several measures that can be taken to reverse the slump in tax revenues.

Strengthen tax administration

There appears to be ample scope for improving tax administration across the tax categories. First, registration is incomplete. The BIR database captures 7.9 million individuals; a conservative estimate, comparing membership of the Social Security System and the Labor Force Survey, would suggest that this is 20-28 percent lower than potential number32. Moreover, in 2006 less than 50 percent of the registered taxpayers filed income tax returns.

Under-registration also extends to corporations, although the problem is less severe. A recent data matching exercise by the BIR using third party information revealed that 12 percent of corporations registered with the SEC are not registered with BIR. In terms of VAT registration, a albeit more dated comparison of active registrants in the BIR database with the Annual Survey of Philippine Business Establishments shows that the BIR database covers only one third of the establishments. While the number of VAT registrants depends on several factors such as turnover thresholds, exemptions, size of firms and so on, a cross country comparison shows that the Philippines has the lowest VAT registration as a share of the labor force.

It is estimated that the BIR stands to collect up to 35 percent more taxes than it currently does if it can address the sources of leakage in the income and value added tax systems.

A key problem is that BIR’s current registry database is unreliable. It includes businesses that have long ceased to exist and multiple registrations by some taxpayers (either mistakenly or fraudulently). Importantly, data related to taxpayer registrations that are held by the revenue district offices (RDOs) or revenue data centers (RDCs) may not have been systematically included in the central database. At the same time, many individuals and businesses are not captured in the system at all. The BIR recently identified about 130,000 inactive taxpayers, i.e., they have not filed returns or have not paid taxes for three consecutive years. In addition, as of January 2008 the BIR identified over 16,500 registrations backlogged (employees and businesses) that need to be registered or updated.

Reform measures should therefore focus on a) cleaning up the existing registry including reconciling registrants within the BIR registers (National Office, RDO, RDC), physically verifying inactive taxpayers and completing the backlog cases; b) identifying non-registered taxpayers, by finalizing the legal and administrative frameworks in which BIR can seek data from other agencies, Local Government Units, developing and implementing data exchange facilities and matching tools to identify non-registered taxpayers; and c) enforcing compliance and in particular actively reviving the Run after Tax Evader’s program. There should also be better training of personnel, a standardizing and updating of registration policies and procedures and allocation of resources to clean up and maintain the registry. Registration status should also be used as a key performance indicator. In addition to improving taxpayer registration, arrears collection and audits also need to be strengthened.

32 The SSS had 27 million members in 2006 and the Labor Force Survey estimates 28.9 million employed individuals receiving pay in 2006. Even if two thirds of individuals in SSS and LFS are excluded on the assumption that they fall under the tax threshold, there would still be 20-28 percent more taxpayers than are currently registered with the BIR.

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Increase excise tax rates and index them.

Revenue from excise taxes—fuel, cigarettes and alcohol has declined by about 1.5 percent of GDP since the late 1990s, largely because most excise taxes are not indexed to inflation. In the case of tobacco taxes for example, the Philippines has a multi-tier price system, where the rates have been adjusted only once since 1997, making the tax rates and excise burden among the lowest in the world. Should the government shift to a uniform and higher specific excise tax rate that is automatically linked to inflation, it is estimated that an additional 1.3 percent of GDP in revenues could be generated.

Rationalize tax incentives.

Tax incentives substantially reduce effective tax rates on corporate income, International Monetary Fund (IMF) staff estimates suggest that the rationalization bill supported by the DOF—phasing out tax holidays and instead offering a reduced corporate income tax rate or a 5 percent tax on gross receipts—would broadly retain the current effect tax rates while enabling the government to tap into tax redundancies—that is the provision of tax incentives for activities that would have taken place already

4.2 Governance: enhancing credibility, predictability and transparency

The ability of the state to provide key public goods and well functioning institutions is an important determinant of growth and poverty reduction. Governance is the manner in which the state exercises its authority over the institutions which provide public goods and services. Studies increasingly document the positive relationship between good governance and sustained economic growth. Through its impacts on economic growth and on resource allocation, good governance is also central to the goal of poverty reduction. Weak governance in the Philippines hurts economic performance in multiple ways. Political instability, corruption and special interest influence over policies make for a highly uncertain business climate, weak appropriability of returns to capital and low investment. Weak public financial management and misuse of fiscal resources and chronic underperformance in revenue administration contribute to a tendency towards poor fiscal outcomes—a prime source of macroeconomic instability—as well as a lack of resources for critical infrastructure and public services. For the Philippines to sustain high levels of economic growth and increase the pace of poverty reduction, it will need to strengthen governance and the quality of its public institutions.

4.2.1 Benchmarking governance and corruption

The issue of governance in the Philippines presents an interesting paradox. In spite of a strong civil society presence, an open media, and highly capable individuals working in public administration, most governance indicators in the Philippines have fallen substantially over the last decade and are also lower than the average for middle income East Asian economies (Table 4.1).

As measured by the International Country Risk Guide (ICRG) Indicators ‘Government stability,’ has dropped over the last decade compared with regional peers. Transparency International's ‘Corruption Perception Index’ (CPI) also suggests that corruption in the Philippines has worsened significantly more than other countries. With the exception of Indonesia, the Philippines is the only other country where the CPI has not improved over the last 10 years. The Global Integrity Report measure ‘Public Access to Information’, on this indicator, the Philippines also performs poorly compared with Thailand but is better than Indonesia and

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33Vietnam. On ‘Bureaucratic quality ,’ however, as measured by ICRG the Philippines performs better than China, Indonesia, Vietnam and Thailand and is on par with South Korea and Malaysia. Similarly, the state’s ability to manage its budget balance as a share of GDP has consistently improved over the last five years compared with its peers34. However efforts to increase revenues remain slow. This largely good performance indicates some measure of improving government effectiveness which the Philippines can build on going forward.

Table 4.1: Philippines Trends in Governance Country Indicator 1998 2004 2007

Bureaucratic Quality 3.0 3.0 3.0 Government Stability 11.0 9.5 5.0 Philippines Budget Balance (% GDP) 0.4 -4.5 -1.7 Corruption Perceptions Index (CPI) 3.3 2.6 2.5 Bureaucratic Quality 2.0 2.0 2.0 Government Stability 9.0 7.5 7.5 Indonesia Budget Balance (% GDP) -2.0 -2.3 -1.7 Corruption Perceptions Index (CPI) 2.0 2.0 2.3 Bureaucratic Quality 3.0 3.0 3.0 Government Stability 9.0 10.5 9.0 Malaysia Budget Balance (% GDP) 0.0 -5.0 -3.2 Corruption Perceptions Index (CPI) 5.3 2.8 5.1 Bureaucratic Quality 3.0 3.0 3.0 Government Stability 10.0 8.5 6.5 South Korea Budget Balance (% GDP) 0.0 1.5 0.4 Corruption Perceptions Index (CPI) 4.2 4.5 5.1 Bureaucratic Quality 2.0 2.0 2.0 Government Stability 11.0 9.5 6.5 Thailand Budget Balance (% GDP) -3.0 0.4 -1.9 Corruption Perceptions Index (CPI) 3.0 3.6 3.3 Bureaucratic Quality 2.0 2.0 2.0 Government Stability 9.0 10.5 10.5 Vietnam Budget Balance (% GDP) -5.0 -2.4 -2.0 Corruption Perceptions Index (CPI) 2.5 2.6 2.6

Sources: International Country Risk Guide, Transparency International

Recent progress

Corruption is perhaps the most visibly recognizable characteristic of weak governance. The control of corruption, however, is not an independent activity. It requires a multifaceted approach, with progress on a variety of fronts. It requires that citizens have voice, that there be stability in governing institutions, and that the government is accountable and transparent. It requires stronger checks and balances, audit trails and more “corruption-resistant” administrative procedures, systems and institutions. It requires rule of law and credible deterrents to encourage compliance. To make progress on this dauntingly wide agenda the government could build on some areas of strength. These include government effectiveness and voice. The government could

33 This is measured as the ability of the State to maintain a consistent level of bureaucratic service despite political pressures and changes in leadership and policy. 34 The Philippines has demonstrated strong ability to deal with macro issues but has yet to do so at the service delivery level.

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build on past success such as the enactment of the procurement law, the passage of the E-VAT Law, and the adoption of a disciplined budget to further improve government effectiveness. In parallel the promoting of civil society monitoring of government activities can be further increased. Equally important is for the government to make its key decisions more transparent, especially the budget.

Among recent advances, the government has improved the budget formulation process using the Paper on Budget Strategy, and the forward estimates. It has piloted the use of a results monitoring with the use of Major Final Outputs and the Operational Performance Indicators Framework (OPIF), and has at the sector level introduced flash reporting cards to inform senior management. The coordination of oversight agencies is being improved through the Development Budget Coordination Committee (DBCC), the Investment Coordinating Committee (ICC), and the NEDA Board. Other fora such as the Philippines Development Forum extend this coordination to the legislature, civil society and development partners. On service delivery, the government continues to grapple with the issue of civil service and judicial reform (see below). The existence of an independent Ombudsman, a Presidential Anti-Graft Commission, and a series of rules and regulations that aim to increase the transparency and accountability of civil servants (such as the mandatory declaration of assets and liabilities by all high level public officials) have all helped create a strong platform from which the Philippines’ governance and anti-corruption program could be strengthened. The Philippines has recently been selected by the Millennium Challenge Corporation (MCC) as “Compact Eligible”. The decision is based on “a rigorous assessment of independent indicators that measure the country’s performance in good governance, investments in its people, and adoption of policies that encourage economic freedom”

In the rest of this section we focus on four areas where further progress can contribute to better governance: budget processes, public procurement, civil service reform and overall accountability and oversight institutions.

4.2.2 Improvements in budget practices

There are several key weaknesses in the Philippines’ budget process, improvements to which could help strengthen governance and control corruption.

Budget allocation

Resource allocation decisions in well functioning systems are underpinned by clear policy directives from the head of government and made as the comprehensive budget is discussed. A feature of the Philippines’ budget process is the high level of fragmentation between priority setting and funding, between the recurrent budget and the investment budget, between central and line agencies, and between central and regional offices within an agency. A further element of fragmentation is added by the role of the legislature in shaping the budget at an excessively detailed level (see below).

DBM has been investing in improving its technical capacity to update forward estimates and prepare a PBS annually. Still most of the department’s budget submissions are not yet based on an explicit, comprehensive sector strategy, which weakens both the line departments’ ownership of the MTEF process and its policy basis at the sectoral level.

Despite these efforts and improvements, the integrity and the credibility of the budget is undermined by the frequently delayed approval of the General Appropriations Act (GAA) by Congress, the use of congressional insertions not driven primarily by policy considerations, and by the use of executive discretion to reallocate funds or create new initiatives during the year.

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Budget execution

Budget allocation imperfections are aggravated by difficulties in budget execution. There is continuous policy making throughout the budget cycle, which contributes to the lack of predictability in policy and funding and also creates room for the introduction of new special interest programs not subject to proper vetting.

To increase the effectiveness of budget execution and improve overall accountability in the use of public resources, the government could consider strengthening existing good practice through improved monitoring of sector performance during the budget year and implementing a number of reforms that are under consideration such as the passage of the fiscal responsibility bill. The coordination among the three main agencies (DOF, DBM, and Treasury) involved in monitoring and forecasting cash flows is reasonably good, but this has to translate into better predictability in cash availability to spending agencies.

Reforms under consideration include further development of the government financial management information system and streamlining of the allotment and cash releases. The current system of managing releases of allotments and cash with individual release authority slips often creates uncertainty about availability of funds for the most critical parts of agency budgets, such as capital outlays and maintenance expenditures. To improve reliability of budget execution data, improve cash management and provide greater transparency most countries have strengthened the treasury function through a treasury single account and introduced a modern financial information management system.

Special purpose funds

A proliferation of poorly controlled Special Purpose Funds (SPFs) severely compromises the extent to which the budget is realistic and is implemented as intended:

• There is no clear legal basis for the creation of some SPFs, or for their inclusion in the general budget. Some are created by legislation, others by executive order. Initially the SPFs were meant to highlight some key expenditure priority items for the Congress, control some expenditure items in the budget and allow for contingencies. Over the years this clarity has been eroded. The fluid way with which some of these funds are created weakens the ability of the state to have a simple unified and transparent budget.

• SPFs are not broken down by Programs/Activities/Projects (PAPs), making them difficult to trace and account for. They offer tempting opportunities to officials to use their discretion in misusing these resources.

• Extensive reallocations of the approved budget between line agencies and SPFs during the year add to the difficulty of matching budget allocations with budget execution.

• SPFs aggravate the problem of deviations from the budget. Deviations between expenditure outcomes and approved spending in SPFs occasionally reach over 20 percent variance.

The elimination of SPFs will improve the credibility of the budget, improve transparency in budgeting and ensure that there is stability and predictability in the policymaking process. Revisiting the use of SPFs in the Philippines would have a considerable impact on the perception of transparency in budgeting.

Budget transparency

A cross-cutting theme that leaves much room for improvement is transparency of the budget. A variety of fiscal and financial reports are available on the web sites, including COA

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audit reports, statements of income and expenses by Local Government Units and budget documents (for example, the executive budget proposal and the National Expenditure Program, including such accompanying documents as the Budget and Estimates of Sources of Financing). At the moment, though, these budget documents are voluminous collections of detailed fiscal and budgetary data with limited analytical content. Their format and detailed content makes them less accessible in practice to a majority of citizens, or even CSOs, intent on learning how the Government is spending public money. The Government might also consider publishing a version of the PBS as a guide to explaining the policy intent and priorities underpinning the government’s budget proposal. Over time, simplifying the GAA format could be considered. Reporting on budget execution could incorporate assessments of results (outputs and outcomes) based on the OPIF.

A particular weakness in the Government’s public fiscal reporting practices is the absence of any meaningful in-year and year-end reporting on budget execution. With COA’s adoption of accrual accounting the annual audit reports do not reflect the structure of the budget. Thus neither year-end annual audit reports nor agency annual financial statements reflect how resources from the GAA were spent. This weakness in ex post reporting can easily be corrected The Government already possesses the relevant information. It simply has to make it public through a system of regular reporting. COA could also consider adding reports on budget accounts execution in its audit reports. Furthermore, COA could audit each agency’s budgetary including its non-financial performance (outputs), in addition to its financial statements as is done currently.

4.2.3 Procurement in the Philippines

Public procurement is big business in the Philippines as elsewhere. In 2007 procurement spending accounted for over 16 percent of government expenditure and about 2.8 percent of GDP. It is also the government activity most vulnerable to corruption and where the effectiveness of the state is among the most critical.

Many Filipinos believe that a significant portion of grand corruption and political corruption occurs during procurement, either during the sale of public assets or simply the process of awarding contracts. Grand corruption involves the theft of large sums by top politicians or officials. Political corruption (also called clientelism or state capture) is defined as the misuse of state power by officials to shape the rules of the game for their own benefit and the benefit of those who pay them. These processes are facilitated by the combination of weak budget allocation processes, intricate and non-transparent budget execution and the predominance of patron-client relationships in politics and the bureaucracy. It is not surprising that many of the most notorious corruption cases in the Philippines over the last four decades have involved the inappropriate use of power by public officials and the private sector alike. They thwart the system by taking advantage of loopholes in the procurement system. Unsolicited bid proposals for major infrastructure projects for example frequently lead to above market pricing and accusations of irregularity. Putting in place remedies to address this situation is high on the government’s agenda.

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Table 4.2: Summary and Lessons for Philippine Corruption Cases

Corruption Case

Summary Impact/Lessons

Bataan Nuclear Power Plant (BNPP) project

Nuclear power contract awarded by the President over recommendations of advisers. The power plant was completed but never produced a single watt of energy.

• Fiscal losses (debt repaid only in 2007). • Failure to improve infrastructure. • Lack of rule of law and ‘even playing

field’ in procurement. Kamag-anak Inc. Philippine Chamber of Commerce estimated that

P50 billion, annually, was lost to government corruption and inefficacy during post-Marcos privatizations.

• Uneven ‘playing field’ in vendor selection. • Undermined reform /government

credibility • Lack of transparency and accountability

PEA/AMARI Land Deal

P2.3 million in known bribes and kick-backs • Absence of rule of law and accountability • Uneven ‘playing field’ in vendor selection Purchase of reclaimed islands by the Public

Estates Authority and subsequent resale to the AMARI Corporation at only a fraction of their value.

• Undermined reform/ government credibility

• Fiscal losses. BW scandal • Highlighted private sector corrupt

practices A gaming firm with close ties to the top was awarded a public franchise to run an online gaming service. • Loss of credibility in government

• Created political instability • No sanctions.

IMPSA Case Questionable choice of procurement method in award of contract and questions about the thwarting of institutional processes in place. Rehabilitate, Operate, and Transfer (BROT) contract offered to vendor.

• Lack of transparency and accountability in policy and awarding of contracts

• Loss of credibility in government • Fiscal loss.

NBN/ZTE Deal Procurement of a National Broadband Network under government to government procurement policy rules. Two competing unsolicited proposals. ICC process unable to appropriately vet project quality o r financial merits . Questionable project pricing and policy relevance.

• Transparency and accountability in policy and awarding of contracts

• Continuous policy making during budget execution

• Fiscal cost/wasteful use of resources • Uneven playing field • Undermined government credibility

NAIA • Lack of transparency in bid award procedures Two competing unsolicited bid proposals.

Award of contract challenged. Supreme Court nullified the original contract. Operators charged with corruption.

• Uneven playing field • Undermined government credibility • Criminal charges filed by Ombudsman

against government officials and private sector.

Recent progress

The Republic Act No. 9184, otherwise known as “The Government Procurement Reform Act” (‘GPRA’), was enacted in January 2003 with Implementing Rules and Regulations issued in September 2003. The new law institutionalized a number of reforms including:

• Simplification of the procurement process by replacing the pre-qualification with an objective eligibility check;

• Setting the Approved Budget for the Contract to address the problems of delays, collusion, discretionary criteria, and lack of competition;

• Creation of an electronic procurement system;

• Use of the objective non-discretionary criteria in the award of contracts; and

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• Other measures aimed and simplifying of rules and procedures.

Before the passage of RA 9184 the civil service relied on a patch-work of laws and regulations to guide procurement, with much resulting confusion. Now there is only one omnibus procurement law with uniform applicability to national and local government units alike. Involvement of civil society organizations in the bidding process to report any irregularities helps to strengthen checks-and-balance. A large majority of the public are optimistic that the GPRA can help reduce corruption (Figure 4.3).

Another recent development that could yield significant results is the formation of the Procurement Transparency Group (PTG) in September 2007 under the GPPB. The PTG is comprised of five oversight agencies (DBM, NEDA, DOJ, DILG, PACG) and five CSOs including Transparency Accountability Network, Makati Business Club, and the Bishop’s Businessmen Conference of the Philippines. The PTG is tasked with strategically deploying CSO observers to monitor the procurement of major government projects and calling the attention of agency heads to potential non compliance with the law and recommending measures to the GPPB to enhance transparency and streamline procurement procedures.

Figure 4.3: 76% Optimistic that GPRA can reduce corruption

Implementation weaknesses

Despite much political effort, implementation of the procurement law has not progressed as fast as expected. While the legislative and regulatory framework receives high marks, actual procurement operations still fail to meet expectations (Figure 4.4). This failure allows the situation of costly and sometimes worsening corruption in procurement to persist. By one estimate, an average of 20-30 percent of every contract is lost to corruption or inefficiency, or about P30 billion annually35. According to the Global Competitiveness Report 2006-2007, the Philippines ranks 112 out of 125 in the list of countries where irregular payments are required for public contracts.

35 Philippines Country Procurement Assessment Review, 2007, forthcoming, World Bank.

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Figure 4.4: 2006 Assessment of the Philippines Procurement System

Source: Country Procurement Assessment Report forthcoming World Bank (2007)

There are several directions in which implementation of the new procurement law can be strengthened:

• Deepen civil society and private sector involvement in vigilant monitoring of procurement operations. This will require that more data are made available to the public early in the process. The government is considering plans to develop and implement a Strategic Communication Plan for procurement reform to improve public awareness. Over the next year it will also operationalize a monitoring and records management system for procurement and contract management, including implementation of PhilGEPS phases 2 to 5. To be effective, civil society organization participating in budget formulation, execution and monitoring activities also need to be trained. Ideally they should have similar levels of expertise on the subject.

• Review and formulate implementing rules and regulations for foreign funded procurement activities or IRR-B and unsolicited proposals, including harmonization of blacklisting guidelines with Multilateral Development Banks. Major procurement requires competitive bidding, but under existing law government-to-government contracts are exempt. The government is reconsidering this provision in the law in an effort to ensure greater transparency in intergovernment procurement.

• Strengthen enforcement. Individuals and companies who are known to have defrauded the government can be “perpetually disqualified” from securing government contracts. Stricter due diligence should be required of procurement officers to ensure that bids are made by legitimate companies that have the right to tender public services. Coordination needs to be improved between the several anti-corruption bodies responsible for enforcing of the law and penalizing violators.

• Improve training to develop a professional procurement cadre. Professional procurement training is mandated by law but in practice it is inconsistent and unstructured. What little training occurs is not supported by follow-up monitoring and evaluation (M&E) to determine the efficacy of the training and the understanding of the trainees. While there are clear conflict-of-interest (CoE) policies, these also need better enforcement.

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4.2.4 Executive Order 366 and the path to a modern civil service

Developing a high quality, modern and motivated civil service that delivers quality services is critical for good governance and anti-corruption. Recent efforts in this direction have however been hampered by factors such as political control of civil service appointments, patronage, excessive interference by the legislature, low compensation levels, lack of meritocracy and poor training.

Executive Order (EO) 366 in 2003 launched an omnibus civil service rationalization program motivated at the time mainly by the objective of reducing the fiscal deficit and reallocating expenditures to improve service delivery. The GOP proposed a bill to rationalize the civil service job classification system, set up a performance based compensation system and adjust the civil service pay scale to the relevant private-sector comparator. The bill, known as the Salary Standardization Law III, is still pending in Congress. The combination of EO 366 and the Compensation Reform Act or SSL III bill has unfortunately led to a considerable amount of inertia within the civil service. Even though fiscal pressures have waned, all agencies have a hiring freeze until they have their rationalization plan approved by DBM. After more than four years since the issuance of the EO366, the rationalization program has moved at a snail’s pace, despite some movement in a few agencies 36, preventing a number of agencies from adjusting their staffing levels and composition in response to emerging priorities and shifting modes of service delivery. This is particularly damaging for departments such as the Department of Social Welfare and Development whose mandate is increasing and other agencies such as DPWH and the BIR. At the same time, the rationalization without civil service pay reform runs the risk that the agencies loose more experienced and competent staff. The lack of clear policy guidelines on the direction, scope and pace of civil service reform is contributing to weakening the capacity of the government to perform its functions. There is an urgent need for the government and the legislature to provide clear guidance. Experience suggests that civil service reform is successful when undertaken as part of a comprehensive modernization process and it is most successful when carried out on an agency by agency basis, underpinned by clear agency strategies and policy directions.

In the long run professionalization and de-politicization of the civil service could eliminate some of the causes of corruption, although such reforms are still unlikely to have a dent in curbing politicians’ incentives to go after public money for private or political gains. If civil servants are paid insufficient salaries, salaries untied to performance, performance unlinked with unit function and unit function unaligned with institutional mission, corruption will remain an “acceptable” alternative source of income. There is increasing evidence in the literature that levels of corruption in public agencies are inversely related to some core good practice institutional variables such as meritocracy in hiring, promotion and firing; absence of arbitrary discretion in decision making; and transparency in budget management (Hellman, Jones and Kaufman, 2000).

4.2.5 Accountability and oversight institutions

Oversight is essential to ensuring good governance. But in the Philippines, how to ensure that central agencies are held accountable remains unclear. While DBM makes an effort to demand accountability from individual government agencies as a basis for budget approvals and

36 To date 30 plans have been approved out of 82 submitted. Some 2,132 positions have been abolished, of which 1,879 were funded and filled. About P402 million has been reallocated for capital outlays and maintenance as a result of these changes.

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budget releases, the monitoring responsibility of oversight agencies over national budget operations remains unclear. Progress needs to be made in several directions.

Legislative oversight

In theory the legislature’s ‘power of the purse’ provides a critical accountability mechanism to ensure that the people’s money is not stolen or squandered. In practice the legislature in the Philippines has increasingly been perceived as a major impediment to transparency and adequate public scrutiny. Frequently the budget is not passed until well into the fiscal year. The Philippines lacks a strong system of political parties that offer contrasting policy alternatives to the voters and that can exercise firm discipline over party representatives. Legislators and other party members owe their primary allegiance to patronage networks or clans. The absence of disciplined, program-based political parties creates the need for the legislators to negotiate individual deals as part of the budget enactment. These negotiations continue until all the particularistic claims of Congressmen and Senators for their own allocations or individual development funds have been addressed in some fashion. The consequences of this practice on transparency and performance are severe as project cycles are delayed and resource allocation processes are undermined.

One possible way of addressing this issue is by passing legislation that ensures that the budget is law before the start of the year. This could be included in the Fiscal Responsibility Bill under discussion in Parliament and by the executive. Increasingly Congress is also working with civil society organizations to monitor budget implementation and ensure that key social spending is protected. Recently Congress passed a resolution allowing civil society participation in the budget legislation process. This is an important advance in the struggle for increased transparency. These practices should be encouraged and scaled up.

Commission on audit

The Commission on Audit (COA) is the highest external auditor of the individual agencies of government and the entire financial system. However the focus and format of these reports are determined by COA and are not necessarily aligned with the structure of the national budget. There is a need to develop strategies and mechanisms to involve the COA in harmonizing its financial reports with those of the other central agencies. These include the reviewing of earlier practices on inter-institutional cooperation and developing new, innovative strategies involving civil society and the legislature.

A more serious deficiency is the general lack of financial accountability, as evidenced in numerous COA audit reports that find a variety of irregularities. A vast majority of agencies receive qualified or adverse opinions, which suggest that an adequate internal control arrangement is either absent or not operating properly in these agencies. In 2005, for example, COA gave either adverse or qualified opinions to virtually all of the 28 national government agencies sampled for this review (including 10 adverse opinions). Among the common weaknesses cited in various COA audit reports (2006) of national government agencies include laxity in enforcing liquidation of fund transfers and slow implementation of priority programs. The lack of adequate follow up on COA’s audit findings severely undermines the role of COA in ensuring that services are delivered efficiently.

Anti-corruption institutions and the judiciary

It is telling to note that in the list of grand /political corruption cases in Table 4.2 above, no senior government official or private-sector perpetrator has been convicted. While proving a corruption charge is technically difficult and may take time even in a successful case, there is a

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perception of impunity in the Philippines, in spite of the recent conviction of the former president on a plunder charge. Without credible enforcement, corruption will continue to be encouraged. While other governance reforms can often take time, government can move quickly to address issues of corruption. To increase the perception of risk for acts of corruption, the government should go after large perpetrators ( “catching the big fish”). In 2006 when tax revenues were at an all time high, the government adopted the strategy of filing tax evasion cases against prominent tax evaders. The Run After Tax Evaders’s (RATE) drive led to an unprecedented increase in personal and corporate income taxes in less than four months. The main reason why the program was effective was its credibility and the high cost of evasion imposed on the alleged errant tax payers. The RATE program has since slowed dramatically, in the last two quarters of 2007 no new rate cases were filed. More importantly the commissioner issued Revenue Memorandum Order # 38 which further limits the ability of the RATE investigative unit in the BIR to file cases. The order shifts the technical responsibility of preparing RATE cases from the well equipped and adequately trained staff unit to the regional directors who have neither the expertise not the incentive to build good RATE cases. Overall there appears to be no branch of government capable of enforcing the RATE.

Among recent positive developments, the government has agreed to establish a covenant among the anti-corruption agencies to strengthen the enforcement of the punitive, penal, administrative and civil sanctions prescribed by the law on violators of procurement rules. This means coordinated actions by GPPB, DBM, Ombudsman, PAGC, COA, NBI, DOJ and others. The recent strengthening of the Ombudsman’s office and the development of the National Anti-corruption plan are also positive developments. The Philippines also has appropriate legislative powers to enforce anti-corruption measures within and outside the civil service, such as the Anti-Graft and Corrupt Practice Act which is notable because it provides for the sanctioning of not only corrupt officials but also of those private citizens who influence government decisions. Implementation of the act has however been lackluster however.

The role of the Department of Justice is critical in the success of any anti-corruption or good governance program. To avoid corruption within the justice sector the government might establish an independent investigator, prosecutors and arbitrators office. All other legal staff would also have to be held to the highest standards. Similarly, for the judiciary to be perceived as an independent body it will have to earn the public trust by demonstrating its ability to be impartial. The Supreme Court has been spearheading a far reaching judicial reform for a while now. The success of these reforms will depend on increasing the accountability of the judges; and as with the rest of the civil service, providing them with incentives to perform effectively, simplifying procedures, and providing adequate funding. Ultimately, the most important element affecting judicial accountability in the Philippines is transparency.

4.3 Investing in infrastructure

Recent investment climate assessments or growth diagnostic studies for the Philippines have identified infrastructure development as among the most important constraints to doing business. The Global Competitiveness Report rankings, based on business surveys, also underscore the importance of infrastructure in the Philippines. The overall Global Competitiveness Index ranks the Philippines as 71 out of 131 countries in 2007-08, much lower than the ranking of Thailand, Indonesia, Singapore, India and China. Within the overall composite index, the Philippines does particularly poorly on the majority of the infrastructure and transport indicators (Table 4.3).

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The quality of transport infrastructure in the Philippines is an especially serious concern, one which is exacerbated by weak logistics, with serious consequences for trade-related transaction costs and overall competitiveness. (The transport sector is defined to include roads, railways, ports, airports and logistics, the latter including the activities that impact trade, such as customs, trade-related infrastructure, inland transit, information efficiency and port efficiency). Recent assessments of the Philippines transport infrastructure show their quality to be poor and costs high, mainly because infrastructure is poorly maintained and badly managed, with years

of underinvestment, especially in maintenance.

Table 4.3: Infrastructure Indicators Quality of Infrastructure

Indicators Ranking

(out of 131) Quality of Overall Infrastructure 101 Quality of Roads 91 Quality of Railroad Infrastructure

90

Quality of Port Infrastructure 102 Quality of Air Transport Infrastructure

82

Available Seat Kilometers 30 Quality of Electricity Supply 80 Telephone Lines 104 Source: World Economic Forum. Global competitiveness Report 20071-2008 (http: //wreform.org

Trade-related transaction costs - the monetary and time costs incurred in moving freight from the farm, point of production, or procurement to the final destination - are a crucial determinant of a country’s productivity and competitiveness. These costs depend on the quantity and quality of transport infrastructure and on the quality of logistics. The essential logistics of export-oriented industries include inland or inter-island transport, inter modal exchange of cargo and trade facilitation activities like customs clearance.

Despite the natural advantage of its geographical location and ports, the Philippines export performance remains modest (discussed in Chapter 3). Gains from trade have mainly accrued to areas in and around Metro Manila and where the multinational electronic companies are located (Bulacan and Pampanga to the north and Laguna, Batangas and Cavite to the South). These areas are better served with transport links and logistics services provided by 3rd party logistics suppliers. The benefit from trade to the other regions especially Mindanao is more limited - despite these regions having comparative cost advantage in non-traditional agricultural goods. Improvements in transport infrastructure and logistics are therefore critical for the Philippines to realize its full trade potential. This section will therefore focus on the state of Philippine’s transport infrastructure and logistics and will suggest some options for reform.

Review of main transport modes

The Philippines actually fares quite well in terms of road density (Table 4.4) due to a fairly extensive road network, covering 200,934 kms. Road density by population is higher than in Vietnam, Indonesia and Thailand and by land area is one of the highest in the region. However, when measured in terms of road surface (the extent of the total road network that is paved) the Philippines fares worse. More than half of roads are in poor or bad condition requiring rehabilitation. The poor road surface and

Table 4.4: Selected Road Indicators

Density Km per 1,000 people

Density Km per 1,000 sq Km

Paved Roads as % of Total Indicator

Indonesia 1.7 203.3 NA Thailand 0.9 112.4 99% Philippines 2.3 669.8 21% Malaysia 2.9 200.3 Vietnam 1.2 286.6 25% Infrastructure PER: 2007, World Bank forthcoming

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condition translates into higher vehicle operating costs per kilometer. On average these have doubled since 1999, while the consumer price index has increased by only 20 percent.

With regard to international ports and shipping, about 99 percent of Philippine freight (66 percent in value terms) was transported by sea in 2006. About 54 percent of cargo was domestic. Most cargo is non-containerized (bulk or loosely packed), implying a competitive disadvantage because of the lack of ports that provide efficient bulk cargo handling and storage. Containerized cargoes face delays and high costs because of inefficient domestic container handling and shipping services. Larger international line long haul vessels do not stop at Philippines ports. Instead main line operators use carrier feeders to transport containers to and from their regional hubs. While this adds somewhat to the cost and time for international transport, it is not as serious problem as the high cost of internal and inter island transport.

In air transport, as in roads, the Philippines does reasonably well on quantity, with over 85 airports. However lack of personnel and upgraded technology undermine the quality of airport infrastructure. Domestic services have been liberalized and strong competition exists on most routes. The government has also been liberalizing international bilateral air services agreements (ASA) to facilitate tourism and some liberalization has also occurred through “open skies. However, the United States’ Federal Aviation Administration recently rated the Philippines an unsafe port of origin, downgrading the country's rating in its international air safety assessment, due to failure to provide safety oversight of air carriers in accordance with international standards.37

On trade facilitation the Philippines does relatively well, being rated higher than Indonesia, Thailand and Malaysia (Figure 4.5). An important indicator of effective trade facilitation procedures is the goods time release. For the Philippines on average it takes 119 hours to clear a cargo. More than 60 percent of the clearance time is due to steps before lodgment of the declaration, which is more than twice the time Customs take to release the goods once the declaration is lodged. It is clear that Customs is not the only agency responsible for the long release times. Efforts to improve clearance times should involve these other agencies, though Customs can play an important catalytic role. In addition, poor road quality results in intercity freight rates that are 50 percent higher than in Thailand or Vietnam. The poor road surface translates into higher vehicle operating costs per kilometer.

Figure 4.5: Ratings – Cross-border Logistics g g

0 20 40 60 80 100 120 140

Thailand

Malaysia

China

Vietnam

India

Indonesia

Philippines

Trading Across BordersRanking(out of 178countries)

Overall Ranking (out of178 countries)

37 US FAA finds RP unsafe port of origin downgrades rating. INQUIRER net Philippines, January 14, 2008. Daily Inquirer.

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Need for increased public expenditure on transport infrastructure

The government has rightly made increasing infrastructure expenditure a priority. Urban population grew by 4.5 percent a year between 1980 and 2000, faster than total population growth of 2.3 percent a year. Congestion in Metro Manila alone was estimated to cost around P100 billion a year in 1996 prices, or 4.6 percent GDP. 38 Substantial additional expenditures are thus required to bring the quality of transport infrastructure up to an acceptable standard. This applies particularly to maintaining road and rail assets, improving the capacity and quality of seaports and airports and making trade facilitation improvements. In the 2008 budget an additional P14.3 billion is identified for infrastructure. DPWH will account for 70 percent of that, almost a third for additional preventive maintenance of major roads. Of the remaining additional funding, DOTC was assigned P2.8 billion for three ongoing principal airports.

However, for new spending to be effective, better budget processes are needed to ensure that spending focused on areas that offer the best value for money. The government has already taken important initiatives in this direction, but much remains to be done. The annual budgetary process must be harmonized with multiyear planning. The practice of allocating resources by default to fund the chronic deficits of some government owned and controlled companies (GOCCs) warrants review. Better analysis is required of all investment projects, whether funded by the government, by international financial institutions and donors, or by the private sector. The contingent costs of public-private partnerships need more careful analysis and criteria should to be developed to assess public contributions to such schemes.

Improved planning and policy framework

Increased public spending on transport infrastructure will be effective only if accompanied by efforts to reduce major policy distortions, as well as a better framework for infrastructure planning, policy development, implementation and coordination.

Line agencies need to develop stronger policy and planning capacities combined with better coordination between line agencies and oversight agencies. Best practice in middle and higher income countries is that line agencies and departments are responsible for multi-year infrastructure planning, In the Philippines, however, policy and planning tasks are often assumed by oversight agencies. With stronger planning capacity, line agencies can develop multi-year infrastructure plans consistent with macroeconomic and budget conditions and constraints set by oversight agencies such as NEDA (a multi-year infrastructure planner at the macroeconomic and project level) and DBM (which intervenes at the project level in its role as the national budget manager). Line agencies should engage in infrastructure policymaking at three levels to facilitate reform: long term strategy—say 10–20 years, in line with the national development plan; mid-term programs—say 3–5 years, in line with a priority investment plan and multi-year budgeting; and short term action—a 1 year (rolling) action plan, in line with the annual budget.

Despite the obvious need for coordination between the two line agencies and the oversight authorities, there is no overall master plan to provide an integrating framework for infrastructure. There is no updated nationwide intermodal transport plan that would harmonize and rationalize road (DPWH), rail, sea and air (DOTC) investments and operations. Existing plans are useful in identifying priority projects on roads, rail, and airports, but except for three routes, the intermodal linkages in transport planning and operations are still weak. In addition, many project feasibility studies and engineering designs are old and need to be reviewed and updated for use in current programming.

38 World Bank, Infrastructure Sector Department East Asia and Pacific Region, “Philippines: Meeting Infrastructure Challenges,” 2005.

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Among specific sectoral considerations:

• Urban transport could benefit from a new metropolitan planning agency with the authority and the skills to develop a comprehensive urban transport strategy.

• For roads, a stronger framework for better asset maintenance is crucial.

• Interurban and freight transport can benefit from more competition, requiring separation of planning and regulatory roles from operations. Several public operating agencies and government owned and controlled companies need reform

• For the ports, the issue of extensive cross-subsidies needs to be addressed. The major source of PPA’s income is revenue from terminals in Manila, particularly international container terminals, while domestic ports under PPA’s jurisdiction do not generate adequate income to cover operations and maintenance because of very low port tariffs. PPA’s revenues from Manila ports therefore subsidize domestic ports. These cross-subsidies, as well as the requirement for PPA to turn over 50 percent of its net profit to the government, leave it with very limited ability to support needed port development investments.

• In the air transport sector consideration should be given to a new civil aviation authority to assume the functions of the Air Transportation Office (ATO) and the Civil Aeronautics Board (CAB)—and to oversee safety regulations. Private sector participation in civil aviation development can also be increased.

Local government aspects

Improvements in transport and trade logistics infrastructure also need more local government involvement. This has been challenging for a number of reasons. First, there is a widespread perception that LGUs’ share in national taxes is insufficient to fund devolved functions. Second, current arrangements favor the more urbanized LGUs in infrastructure investments. Variations in net resource transfer across levels of local government are substantial. The concentration of resources in cities also means that infrastructure investments are heavily skewed in their favor, widening the disparity between urban and rural areas. Third, expenditures are fragmented over many small projects, typically at the barangay level and to the particular neglect of intermunicipal facilities. Fourth, LGU allocations are poorly related to national strategies and priorities.

Reforming the LGU credit market to remove bottlenecks to private participation is desirable. A deeper credit market would enable LGUs to undertake more lumpy investments. Three measures are key: transforming MDFO as an entity for pooling LGU loans and bonds and securitizing them, better implementing a policy for LGUs to graduate from GFIs to private sources, and repealing the rules that give GFIs a monopoly over LGU Internal Revenue Allotment accounts

In the medium term, the tax autonomy of local governments should be increased giving them greater taxing power and allowing them to piggyback on some national taxes. These changes would enhance the accountability of local officials to communities and encourage LGUs to raise more revenues to finance infrastructure investments. In addition, efforts to ensure that LGUs receive the share of taxes set out in the LGU code should be pursued.

The use of performance-based incentives is gaining momentum. Performance would be measured by improved LGU revenue, service delivery, and planning/budgeting links. Preliminary work would involve better monitoring of the outcomes of central government transfers and

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benchmarking LGUs based on key indicators. Also needed is rationalizing LGU grant policy by unbundling grants from loans in the administration of on-lent official development assistance.

Strengthening the focus on maintenance

Funding shortages are a primary reason for the deteriorating road network—but not the only one. The funds, when they exist, are often allocated sub-optimally, with over 25 to 65 percent of maintenance funds devoted to inefficient job-oriented roadside activities, and with funds distributed equally to districts regardless of need. In addition, the implementation of works appears very inefficient. At the heart of the problem is the politicized allocation of project resources. These points to serious weaknesses in how road maintenance is organized. Cost increases are still a major concern for all road works. Excessive variation orders are a common source of spending overruns, and the number of quality defects per project remains high. In addition, the productivity of the road administration is low. DPWH employs one employee for every 1.3 kilometers of national roads, compared with one for every 10 kilometers of roads in Indonesia. On current forecasts, the annual maintenance deficit is unlikely to change much in the next few years. Moreover the allocation of these inadequate resources to tasks remains questionable, with too little for preventive maintenance.

The maintenance regime is improving. The internal business processes in DPWH are becoming stronger. Much of the progress has been in developing technical and financial information systems. But action has also been taken to limit variation orders, and the competitive procurement of maintenance services is proving to be a success.

But further action is still needed in several areas. Project management, including quality assurance, has to be tightened. A quality assurance system for engineering designs and estimates should be established. Construction supervision should increasingly be outsourced. Improving the usefulness of the Constructors’ Performance Evaluation System would raise the quality of the project life cycle. A system for the official acceptance of completed projects is needed, and road maintenance by contract should be extended. Perhaps most important, the institutional basis for reform is not secure. Action is still necessary for road users to exercise more influence on charges and expenditures.

Public private partnerships

To meet the financing needs required to improve quality, increase quantity, ensure good maintenance, reduce costs and ensure broad coverage, additional public resources will have to be complemented by private resources. In the mid-1990s the Philippines enjoyed a rich supply of mostly unsolicited proposals for private infrastructure finance. These initiatives, often poorly coordinated, met with mixed results. Many unsolicited proposals needed better public analysis and scrutiny. Recent experience suggests that the bonanza days of private sector eagerness to invest in public transport infrastructure are over. Many PPP deals have failed. LRTA’s Line 1 South Extension is an example of public-private projects that have led to delay, long project cycles,39 deferred service delivery and significant budgetary problems, leaving the government holding the liability for poorly designed projects.

So, a new approach is required. Only better processes and stronger institutions will attract private funding. Some key requirements for success in PPP arrangements can be identified:

• Contractable service quality. This requires that the government clearly specify the quality of services it wants and translate that into measurable indicators incorporated in a contract that link payments to delivery.

39 Project cycle refers to the period of time required to identify, tender, award, and monitor a PPP contract.

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• Well prepared, bankable projects. Government needs to ensure that projects have strong justifications, including government priorities and economic rationales; that sound feasibility studies are undertaken on a whole-of-life basis; that bidding is well documented, managed, and transparent; and that the financial, commercial, legal, and technical advice is incorporated.

• Competition or incentive-based regulation. Open bidding for contracts should be the norm. This will help promote competition, save public resources and to ensure formal commitment to the contract terms. Regulation also limits monopoly profits and protects consumers.

• Adequate and commercial risk transfer from the government to the private sector. This measure is crucial to getting the full benefit from an inflow of private capital and a change in management. Note that sustainable PPP projects are not about maximum risk transfer; rather, they are long-term contractual relationships between the public and private sectors based on allocating risks to the party best able to manage them.

• Agency competence must be improved. The project development capability of the implementing agencies needs to be strengthened to give them greater responsibility for and ownership of projects. Solicited BOT projects should become the norm rather than the exception. The oversight role of the NEDA-ICC should be retained to confirm project quality, ensure transparency and accountability, and provide fair, rational, and predictable review and approval. The Philippines should consider guiding the implementation of PPP through a dedicated unit that transfers knowledge and best practice to government users. Such a unit would be most effective in an oversight agency, such as DOF.

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5. PROMOTING INNOVATION In this chapter we analyze innovation in the Philippines. That is, the generation,

diffusion, absorption and application of new technologies, knowledge or ideas that are now widely regarded as among the crucial drivers of long term economic growth and development.40 While the policy reforms discussed in Chapter 4, that are important for shaping the overall investment climate, are also key to fostering innovation, there are also elements that are more specifically related to innovation, such as the direct public support for innovation, which also need to be looked at carefully.

The activities associated with innovation cover a wide ground. In developed countries they include large scale, long term Research and Development (R&D), typically undertaken by large multinational firms, resulting in discoveries that add to the frontiers of global knowledge and that can be patented. Most innovation by firms in developing countries does not entail advances in the frontier of global knowledge, but, instead, ‘catching up’ to the global frontier, through adoption and adaptation of existing knowledge drawn mostly from abroad. It is widely understood that growing engagement in the international economy through channels such as international trade and foreign direct investment (FDI) is an essential precondition for adoption of knowledge from abroad. We therefore begin this chapter by briefly reviewing Philippines engagement through these channels.

Access to global knowledge does not however necessarily translate into widespread adoption and dissemination of new technologies and knowledge within the country. That will depend on the absorptive capacity of the country. In the second part of this chapter we look at some direct measures of how extensively selected technologies have diffused in the Philippines. We next turn to R&D in the Philippines. The primary importance of R&D in developing countries is in adapting global knowledge to make it useful for local conditions. From this perspective local R&D is an important element in the absorptive capacity of the country. From R&D we turn to briefly review the small but growing volume of international patenting by Philippines-based inventors. In principle these patents represent additions to the frontier of global knowledge. Looking at detailed patent assignment data, we observe that patenting in the Philippines is undertaken entirely by the local affiliates of multinational companies. In principle such activities by MNCs in the Philippines creates a valuable cadre of researchers whose expertise could, over time, and given enough absorptive capacity, become more widely diffused in the wider economy. The last section looks at aspects of the relatively weak absorptive capacity in the Philippines, some of which originate in broader investment climate weaknesses, others in specific policy approaches to innovation.

40 Innovation can be broadly defined as the introduction of new or improved goods, services, production processes and marketing methods, as well as better modes of business organization in general. The basic requirement is that the innovation be new to the firm that adopts it, even though it may not be new in the world at large.

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5.1 Openness to external knowledge

The Philippines’ engagement in the world economy—and potential access to global knowledge—increased dramatically in the 1990s. Primarily as a result of investments by multinationals in the electronics industry, the Philippines’ exports (on a national income account basis) increased from around 20-30 percent of GDP in the 1980s to 55 percent by 2000. Imports also surged, drawn by capital equipment and components for the electronics industry (Figure 5.1). The stock of inward FDI increased from around 4 percent on GDP in the early 1980s to 17 percent by 2000 (Figure 5.2).

Figure 5.1: Exports and Imports Figure 5.2: Stock and Flow of Inward FDI (% GDP) (as % GDP)

0

2

4

6

8

10

12

14

16

18

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

2006

0

1

1

2

2

3

3

4Stock of Inward FDI - left hand sideFDI Inflow - right hand side

20

40

60

80

1980

1982

1984

1986

1988

1990

1992

1994

1996

1998

2000

2002

2004

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Per

cent

of G

DP

Exports - PhilippinesImports - PhilippinesExports - Thailand

Source: World Bank data and staff estimates. Source: UNCTAD World Investment Report 2007.

These developments have in principle improved the scope for innovation in the Philippines in a number of ways. Imports of advanced capital goods are one of the main ways in which developing countries gain access to advanced technologies. While the econometric evidence is mixed, a rich body of case study literature argues that East Asian firms have derived significant technological benefits from exports under longer term Original Equipment Manufacturing (OEM) contracts, as part of the global production networks of foreign multinationals. East Asian economies have varied more widely in their openness to FDI than they have in their engagement in trade. Evidence for technology transfers through ‘vertical’ relationships between local firms and MNC affiliates is more convincing than for other channels that have been suggested.41

There are some qualifications to these generally positive developments. First, the 2000s have seen a slowdown or even some reversal in the pace at which the Philippines has been integrating into the global economy. As Chapter 3 noted, the Philippines export structure has been unusually concentrated and has also been losing market share in world trade in recent years. Figure 5.1 shows that these difficulties have translated into a declining share of exports in GDP as well. The share of imports to GDP has also declined, in part because of weak export demand for imported components, and also because weak domestic investment has slowed demand for

41 Evidence for the impact of these global channels for access to knowledge and productivity is reviewed in Brahmbhatt and Hu (2007).

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imported capital goods, a prime source of new technology in developing countries. By comparison, Thailand’s share of exports to GDP continued to rise in this decade. The stock of FDI to GDP has also leveled off in the Philippines. Again, by contrast, the stock of FDI to GDP in Thailand (not shown) has been rising. Second, the predominant role of FDI and multinational companies in the expansion of Philippines trade raises the question as to what extent these developments have remained an ‘enclave’ and to what extent they have succeeded in generating ‘spillovers’ and transfers of new technologies and knowledge to the wider economy.

5.2 Diffusion of technology in the Philippines – some direct measures

Measuring innovation and technology diffusion is inherently difficult. This section draws on recent World Bank research that directly measures access to a range of existing technologies.42 Some of these are ‘old’ technologies that have been available for more than a century and which are present in virtually all countries, although the extent of their penetration varies widely. Figure 5.3 shows an index combining the penetration of four older technologies: electricity consumption per capita, agricultural machinery (tractors per 100 hectares), outgoing international phone traffic and international air carrier departures. Overall penetration of these technologies in the Philippines is the second lowest among the larger economies in East Asia, slightly ahead of Indonesia, but only about half the penetration levels in Thailand and well below half of the average penetration rate for all lower middle income countries. To take a specific example, electricity consumption of 597 Kwh per capita in 2004 was only 30-40 percent of that in China or Thailand. Outcomes are somewhat better for some newer technologies like cell phone use, where the Philippines is on a par with Thailand and significantly higher than in China or Indonesia. Internet use, however, remains among the lowest in the region (Figure 5.4).

Figure 5.3: Diffusion of Older Technologies Figure 5.4: Diffusion of Newer Technologies (Index – 2000) (per 1000; 2004)

0 200 400 600 800 1000

China

Indonesia

Malaysia

Philippines

Thailand

Korea, Rep.

Singapore

Lower middle

Upper middle

High income

Internet per 1000

Mobile phone per 1000

0.000 0.040 0.080 0.120

China

Indonesia

Malaysia

Philippines

Thailand

Korea

Singapore

Lower Middle

Upper Middle

High Income

* See text for definition.

Source: World Bank. World development Indicators.

Source: World Bank. Global Economic Prospects 2008

42 World Bank Global Economic Prospects and the Developing Countries, 2008.

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5.3 Research and development in the Philippines

Most research and development spending occurs in the developed world, and as Figure 5.5 shows, R&D intensity (the ratio of R&D to GDP) not only increases with per capita GDP but does so at an accelerating pace. Nevertheless, even low income and lower middle income countries carry out some R&D. Figure 5.5 shows that R&D intensity in Asian economies such as China, India, Korea and Taiwan (China) has generally run at levels much higher than those suggested by their per capita income levels alone. On the other hand R&D intensity in the Philippines, Indonesia and Thailand has systematically undershot the estimated average relationship. The UNESCO Statistics on Research and Development report that Philippines R&D in 2002-03 was only 0.15 percent of Purchasing Power Parity (PPP) GDP, substantially lower than an estimated average of around 0.4 percent of GDP for all countries at around that income level. Recent R&D intensity is also lower than estimates of around 0.25 percent of GDP for the early 1990s. Around 60-70 percent of R&D in the Philippines is undertaken by business enterprises, with 15-20 percent by public sector institutes and the rest from higher education institutions. This distribution is roughly similar to that found in a number of other East Asian economies such as China, Korea, Malaysia and Singapore. In this sense the low level of overall R&D in the Philippines is not the particular result of under-spending in any one sector: spending is relatively low across the board, by businesses, the public sector and higher education institutions.

Figure 5.5: R&D Intensity and Per Capita GDP

(Mid 1970s – Mid 2000s)

Is low R&D spending a significant worry for a lower middle income country like the Philippines? Arguably it is. As Cohen and Levinthal (1989) point out, R&D itself has two faces: innovation and learning. Domestic R&D not only generates new knowledge but it also enhances the firm’s ability to assimilate and exploit existing knowledge, including—the aspect most important for firms in developing countries—assimilating knowledge from abroad. For example, developing country firms are more likely to benefit from FDI spillovers if they conduct some R&D themselves, a point we return to below. They are more likely to be selected as suppliers to sophisticated global production networks if they already possess significant in-house design, engineering and other technical capabilities.

0

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

6 7 8 9 10 11GDP per capita (log)

R&

D (

% o

f GD

P

China

Japan

Korea

India

Singapore

USA

T hailand

Philippines

Source: UNESCO, World Bank.

43

Lederman and Maloney (2003) estimate the impact of R&D intensity on total factor productivity growth for a sample of both developed and developing economies. They find that a one percentage point increase in R&D intensity is associated with a 0.78 percent rise in TFP growth—in effect a 78 percent social rate of return on R&D investment.44 Compared to the prevailing cost of capital, these returns imply that actual levels of R&D are only a fraction of

43 As suggested by the review of the case study literature in Brahmbhatt and Hu (2007). 44 The term social here indicates that the returns measured include not only private returns to the firm making the R&D investment, but also the benefits for others generated by R&D spillovers or externalities.

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socially optimal levels. However, although potential returns to R&D in developing countries are high, R&D in these economies is held back by macroeconomic instability, underdeveloped financial systems, weak intellectual property rights, and low quality public research institutions. We return to these points in the discussion of absorptive capacity below.

5.4 Patenting in the Philippines

Innovations protected by a patent in principle represent original contributions to the frontier of global knowledge.45 In this section we look at some dimensions of Philippines patenting: its level and trends, patenting performance in an international context, the types of private or public sector bodies that are innovating, the technologies in which Philippines is patenting, the quality of Philippines patenting and the sources of knowledge on which Philippines’ inventors are drawing.

The volume of patenting by Philippines’ inventors has accelerated during the 2000s, reaching a record 35 patents in 2006 (Figure 5.6). As Table 5.1 shows, the average number of Philippines patents increased from 5 per year in 1990-96 to 21 per year in 2000-06. However the table also suggests that, on a relative basis, the Philippines’ is patenting somewhat less than other lower middle income countries in East

Asia such as Thailand or China, whether measured in terms of the number of patents or patents per capita. As the table shows, the middle income South East Asian economies themselves patent at far lower levels than technological leaders such as Korea, Taiwan (China) and Singapore.

Figure 5.6: Philippines – Patents Granted at USPTO pp

0

10

20

30

40

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93*

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

Pre 1993: annual average over period 1963-1992

Source: US Patent and Trademark Office

Dominant role of MNCs in Philippines patenting

Virtually all patents granted to Philippines’ inventors are assigned to multinational companies, indicating that the research and invention activities are undertaken by staff working for the Philippines’ affiliates of those companies. In 2004, the last year for which we have detailed information on assignees and inventors from the USPTO, some 84 percent of patents granted to Philippines based inventors were assigned to US companies. Another 14 percent were assigned to non-US multinationals from Canada, France, Hong Kong, Netherlands and Taiwan (China).

The predominance of multinationals in patenting activity in the Philippines points to a sometimes unrecognized benefit of foreign direct investment, that is, the creation on the soil of the host country of superior research facilities and the development of a cadre of local researchers working for MNCs with high levels of expertise and exposure to global knowledge networks. Even though the knowledge that is patented is proprietary to the multinational company, positive spillovers to the wider local economy could occur through a variety of mechanisms. These could include turnover of R&D workers employed by foreign firms who go on to work for domestic

45 We use patenting at the US patent office.

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firms or who set up their own firms. Or it might occur through demonstration effects, where activities by foreign firms suggest new ideas to local firms.

Table 5.1. Patenting in an International Context *

Number of Patents Patents per 100000 People 1990-96 2000-06 1990-96 2000-06 % Change* East Asia (9) 2763 12810 0.17 0.73 15.4 NIEs 2680 12173 3.76 15.68 15.4 Hong Kong 202 633 3.39 9.26 10.6 Korea 853 4450 1.93 9.31 17.0 Singapore 48 394 1.44 9.36 20.5 Taiwan, China 1577 6697 7.56 29.73 14.7 S.E. Asia 32 155 0.01 0.04 15.4 Indonesia 5 16 0.00 0.01 10.3 Malaysia 14 79 0.07 0.32 16.2 Philippines 5 21 0.01 0.03 12.3 Thailand 8 40 0.01 0.06 16.9 China 50 482 0.00 0.04 24.2 World 110298 181011 2.10 3.04 3.7 Developed (21) 106584 165695 13.09 19.10 3.8 Japan 22881 35668 18.36 27.98 4.3 USA 61293 95766 23.60 32.93 3.4 Developing Latin America (11) 181 352 0.05 0.08 5.3 Emerging Europe (9) 232 343 0.08 0.11 3.8 Source: U.S. Patents and Trademark Office. * Annual averages.

As regards the overall question of spillovers from FDI (i.e. not just restricted to spillovers from R&D), recent research finds only mixed support for so-called horizontal spillovers in developing countries (i.e. those from a MNC to domestic firms in the same industry), but rather more for the vertical technology transfers (i.e., typically, deliberate transfers of training and other knowledge from the MNC to its local suppliers)46. There is some evidence, though, that spillovers are more likely when the foreign firm undertakes R&D in the host country. Todo and Miyamoto (2006) found that, found that domestic Indonesian firms receive positive spillover benefits from foreign firms that undertake local R&D, but not from those that do not47.

In general, however, there is considerable evidence that the critical factor determining the extent of positive spillovers from MNCs is the absorptive capacity of the domestic economy for assimilating new knowledge. If a Filipino R&D worker leaves his or her job with an MNC, would it be hard to find an equivalent job with a domestic firm that has an ambitious R&D program, perhaps because domestic firms are spending little on new investment and R&D? Would it be hard for that worker to establish a new firm of his or her own, perhaps because of financing difficulties, bureaucratic obstacles and uncertainties, entry barriers and anti-competitive practices of established dominant local firms and difficulty in finding the right quality of technical staff?

46 See Brahmbhatt and Hu (2007) for a review of this evidence. 47 Todo and Miayamoto (2006).

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We return to this question later, after completing this survey of some other features of Philippines patenting.

Technological concentration in Philippines patenting

Two thirds of Philippines patents in 2002-04 were in the Electrical and Electronics class, with around 15 percent in an undifferentiated “Other” class, 7.5 percent in “Mechanical” and 5-6 percent each in Chemicals and Drugs and Medical. (In absolute terms the last two classes

represent just one patent per year). The predominance of electrical and electronics patenting is expected to some extent, given that all patenting is done by MNCs, the bulk of whose investment in the country is in the high tech sector. However, while a number of other East Asian economies have a strong patenting focus on electrical and electronics, none is so narrowly focused in this area as the Philippines. The countries nearest in profile were Singapore, Taiwan (China) and Malaysia, each with 40-50 percent of patents in the electrical and electronics class in 2002-04, and Korea with just under 40 percent. Figure 5.7 shows a more comprehensive measure of concentration, the adjusted Herfindahl

index, which confirms the much more narrowly focused pattern of patenting in the Philippines.

Figure 5.7: Technology Concentration 2002-04 (Adjusted Herfindahl Index)

0

0.1

0.2

0.3

0.4

USA

Thaila

ndJa

pan

Malays

iaKore

a

Taiwan,

China

Singap

ore

Philipp

ines

Source: USPTO

48

Quality of patenting in the Philippines

A particularly useful feature of patents is that they contain citations to the previous patents and scientific literature which define the “prior art” to which the patent is making an original contribution. Trajtenberg et al (1997) suggest measuring the quality of patents with indexes of patent “generality” and “originality” based on patent citations. A patent is said to have greater generality and impact if it is cited more often by a wider range of technology classes. A patent is said to be more basic or original if it cites a wide range of patent technology classes. US patents generally have higher generality and originality indexes across all technology fields and can serve as a convenient benchmark. Hu (2008) finds that Philippines patents in the electrical and electronics class in 2000-04 achieved basicness and generality ratings 70-80 percent as high as US ratings, on a par with patenting in Taiwan (China), though still somewhat below quality ratings in Japan and Korea, which were around 80-90 percent of US ratings. The relatively high quality ratings for Philippines electrical and electronic patents can no doubt be linked to the predominance of multinational companies in Philippines patenting.

48 The adjusted Herfindahl index ranges from zero, when all classes have an equal share, to 1, when a single category has the entire market.

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5.5 Absorptive capacity and the national innovation system

The preceding discussion has noted that the Philippines substantially increased its integration into the global economy during the 1990s. Despite some troubling declines in the 2000s, the ratios of trade and FDI to GDP remain significantly higher than in the pre-reform period. The increase in the Philippines global integration in the 1990s was primarily driven by multinational companies, whose investments in the electronics sector drove the rapid rise in the Philippines’ exports and also in the capital goods and components imports needed to supply the high tech sector. MNCs are likely to be the source of most of the R&D undertaken in the country and are certainly the source of all of the international patenting undertaken.

As in most developing countries, the principal source of innovation in the Philippines will be absorption and adaptation of ideas from abroad, including through the channels of trade and FDI. But a growing body of evidence suggests that the actual extent of innovation will depend on the absorptive capacity of the country and the quality of its national innovation system broadly understood.

Take the question of positive spillovers from FDI. There is much more evidence for spillovers in developed than in developing economies, most likely because firms in developed countries are more technologically capable of absorbing spillovers from foreign firms. Glass and Saggi (2002) find that the smaller the technology gap between local and foreign firms, the better the quality of technology transferred and the greater the potential for spillovers. Numbers of studies have emphasized the need to improve educational capacity in the host economy as a means of strengthening absorptive capacity to incorporate positive spillovers, for example, Borensztein et al. (1998) and Lipsey (2000). Emphasizing the role of domestic R&D, Kinoshita (2001) finds that in the Czech Republic it is only domestic firms that undertake their own R&D that enjoy horizontal FDI spillovers. Further, distinguishing between ‘the two faces of R&D’ analyzed by Cohen and Levinthal (1989), Kinoshita finds that domestic Czech firms undertaking R&D benefit not only from innovations produced by that R&D, but also by being better able to learn and absorb knowledge from the outside. This learning effect is several times larger than the own-innovation effect.

The exceptionally low level of R&D in the Philippines has already been noted. More generally, fixed investment itself can be viewed as an important element of absorptive capacity, as the way in which in which new technologies become physically embodied in the firm’s capital. And since R&D and other innovative activities are a form of capital investment, it is not surprising that they are affected by many of the same factors as overall business investment. Research at the World Bank by Lederman and Maloney (2003)—one of only a few studies to look at R&D in developing countries—finds that, in common with other types of investment, R&D intensity declines with higher real interest rates and greater macroeconomic volatility. It increases with greater financial depth and stronger intellectual property rights, as well as with subjective measures of the quality of research institutions such as universities and public research centers, and the quality of collaboration between these institutions and the private sector.

Table 5.2 summarizes some key aspects of the Philippines absorptive capacity and national innovation system in a cross-country comparison. The first two columns recap observations about the exceptionally low level of fixed investment and R&D in the Philippines. From this perspective, the critical weaknesses in the Philippines investment climate discussed earlier in the report – concerns about macroeconomic volatility, policy uncertainty and poor governance, and weak infrastructure – are also weaknesses in its absorptive capacity and innovation system. The “Doing Business” perceptions index suggests that the overall ease of doing business in the Philippines is among the lowest in East Asia, with particularly significant

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difficulties in starting and closing a business and investor protection. Linked to investor protection, the Global Competitiveness Report perceptions index also gives a relatively low rating for intellectual property rights (IPRs).

Table 5.2. National Innovation Systems and Business Environment – Selected Variables R&D Inves-

tment Credit Market Depth 2004/6

(2)

Quality of Scientific Research

Institutions (5)

University- Industry Research

Collaboration (5)

(% PPP GDP)

Early/mid 2000s (1)

Ease of Doing

Business 2006 (3)

(% GDP) 2004/6

Researchers per million

Quality of IPRs

(5) 2003/4 (4) 1.20 24.3 53 92.4 East Asia

(9) 1604 4.5 4.1 4.3 2.10 23.7 19 115.7 NIEs (4) 3165 5.2 4.7 5.1 0.27 21.2 76 68.9 SE Asia 279 4.1 3.6 3.8 0.05 21.6 135 25.8 Indonesia 207 3.9 3.4 3.2 0.63 19.7 25 126.5 Malaysia 509 5.0 4.7 5.1

Philippines 0.14 15.4 126 31.5 111 3.3 2.7 2.8

0.25 28.0 18 92 Thailand 287 4.0 3.6 4.1 1.34 40.9 93 116.1 China 663 3.8 3.9 3.2

2.30 20.0 .. 156.7 3616 5.1 4.4 5.5 OECD 3.18 22.9 11 174.1 Japan 5287 5.6 4.6 5.3 2.68 18.7 3 195.2 USA 4484 6.4 5.7 6.4

(1) Source: UNESCO Science and Technology Statistics. (2) Credit to Private Sector as % of GDP. (3) World Bank. Doing Business 2007. 1=most business friendly regulations. (4) UNESCO S&T. Stats. (5) Source: Global Competitiveness Report 2005. Index ranging from 1 (weakest) to 7 (strongest). (All regional data are simple averages).

A well developed financial sector and capital market help meet the widely different financing needs of more or less risky short term and long term innovation projects undertaken by firms. Aryaggari et al (2006), for example, find the availability of finance from sources external to the firm to have a strong association with broader measures of firm innovation in developing countries, and is but one among a range of studies finding similar results for financial system quality and innovation. Table 5.2 shows that Philippines has a relatively low ratio of credit to the private sector, a broad measure of financial system depth49.

Education and other forms of human capital development provide a fundamental underpinning for both domestic innovation activity and for the learning capacity of the economy. The Philippines scores quite well on some measures in this area, for example the measures calculated by Barro and Lee (2000) on the average years of schooling of the population, or the proportion of the population with post-secondary education. It does less well on measures of education quality, for example, the TIMSS scores for math and science. Most striking though, despite the high number of tertiary education graduates, is the extremely small number of researchers in the country—a mere 8866 in 2003 as reported by UNESCO, or only 111 per million population (Table 5.2).

Finally we turn briefly to direct public support for innovation, for example through funding for public sector and university research or fiscal incentives for innovation. The theoretical rationale for direct public interventions of this type is that they might help offset market failures associated with knowledge, for example, non-excludability, which make it difficult for private firms to appropriate all the returns from their R&D investments, leading to less than optimal private innovation activities. There is a good deal of evidence for the positive effect of R&D funded or performed by universities and the public sector on both overall

49 See also “East Asian Finance: The Road to Robust Markets”. S Ghosh. World Bank.

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50productivity and on business R&D. For developing countries, Lederman and Maloney (2003) find that the perceived quality of research institutions such as universities and public research institutes has a significant positive impact on overall R&D intensity in both developed and developing countries, as does the perceived quality of the interaction between these institutions and the private sector. Table 5.2 though, shows that the Philippines does relatively poorly on the perceived quality of research institutions and the quality of business-research institution interactions. Cororaton (2003) touches on many of the policy and institutional problems affecting public support for innovation including:

• Inadequate overall funding, due, ultimately, to the fiscal difficulties of the government;

• Resources channeled through many agencies with little coordination, few common goals or priorities and lack of any critical mass;

• Poor planning and budgeting and lack of prioritization within agencies (e.g., with most sectors becoming ‘priority sectors’);

• Misallocation of resources; e.g., very high proportions of expenditure spent on salaries and very little on capital outlays or maintenance; or diffusion of spending over many fragmented and short term projects with little monitoring of outcomes;

• Lack of links with the private sector or potential final users of research;

• Complexity and burdensomeness of procedures that work against the uptake of available fiscal incentives for innovation and commercialization of new technologies.

50 See Brahmbhatt and Hu (2007) for a brief survey.

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6. FOSTERING INCLUSIVE GROWTH

6.1 Poverty trends

Recently released government data shows that poverty in the Philippines increased in 2006 relative to 2003, despite higher economic growth in recent years. Since 2000, the Philippines has been growing at an average of 5 percent—higher than its historical average—and in 2007, growth accelerated to its highest level in 30 years at 7.3 percent, making it the best performing economy among Southeast Asian middle income countries. Notwithstanding higher growth, the latest official poverty estimates show that between 2003 and 2006, when GDP growth averaged 5.4 percent, poverty incidence increased from 30.0 percent to 32.9 percent. This level of poverty incidence is almost as high as it was in 2000 (33 percent). Indeed, the magnitude of poor population rose to its highest in 2006: of a population of 84 million in 2006, 27.6 million Filipinos fell below the national poverty threshold of P15,057. Poverty incidence based on alternative measures of the poverty line (see Box 6.1) also show increases in the poverty rate between 2003 and 2006, consistent with the official statistics.51

Beneath the national average, regional poverty estimates vary significantly. Although the national poverty rate increased between 2003 and 2006, poverty declined in four of the country’s 17 administrative regions. Poverty did decline in three regions in Mindanao: Zamboanga from 49.2 percent to 45.3 percent, Caraga’s from 54.0 percent to 52.6 percent, and Northern Mindanao from 44.0 percent to 43.1 percent. Poverty in Western Visayas also declined from 39.2 percent to 38.6 percent, albeit mildly. In contrast, poverty headcounts in the other 13 regions increased in 2006. In particular, poverty in conflict-affected Autonomous Region of Muslim Mindanao (ARMM) swelled by almost 10 percentage points (52.8 percent to 61.8 percent). Further work is required to understand the differential performance of regions in reducing poverty during this period.

Poverty remains largely a rural phenomenon in the Philippines. It has been estimated that three-quarters of the poor reside in rural areas52 (Table 6.1). These estimates also show that rural poverty increased from 12.1 percent in 2003 to 14.4 percent in 2006 and that poverty among agricultural households is about three times higher than poverty in other sectors. Indeed, according to these estimates, poverty incidence among households in the agricultural sector also increased from 45.9 percent to 48.7 percent between 2003 and 2006. Given the incidence and magnitude of rural poverty, reducing poverty in rural areas will be key to reducing poverty in the Philippines.

However, with the rapid growth of urbanization, the share of urban poverty has also risen. Between 2003 and 2006, it is estimated that the share of the poor population living in urban

51 Using a consumption based approach, Balisacan (2008) computes a poverty line that accounts for differences in provincial cost of living and estimates that poverty of the population increased from 26 percent to 28.1 percent between 2003 and 2006, while the $1-a-day poverty headcount increased from 12.9 percent to 13.4 percent (See Box 6.1). Surveys from the Social Weather Stations on self-rated poverty and hunger, meanwhile, indicate mixed results. Self-rated hunger doubled in 2006 to 19 percent from 9.4 percent in 2003 while self-rated poverty declined from 59.5 percent to 54.3 percent between 2003 and 2006, but remains nearly twice the official poverty estimate. 52 Balisacan (2008).

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53areas increased from 22.7 percent to 25.2 percent . With rural-urban migration and rapid population growth, this trend can be expected to continue over time, as in other emerging middle income countries. Hence generating employment and ensuring the delivery of services to these poor populations—such as health, education, water, sanitation and housing, which is already an issue, will become more of a challenge. Improvements in urban service delivery will require further focused Government attention.

Table 6.1: Poverty Incidence in Rural and Urban Areas, 1985-2006

1985 1988 1991 1994 1997 2000 2003 2006

Philippines 40.9 34.4 34.3 32.1 25.0 27.5 26.0 28.1

Urban 21.7 16.0 20.1 18.6 11.9 13.2 12.1 14.4

Rural 53.1 45.7 48.6 45.4 36.9 41.3 39.5 41.5

Contribution to total poverty

Urban 20.5 17.7 29.3 28.8 22.6 23.5 22.7 25.2

Rural 79.5 82.3 70.7 71.2 77.4 76.5 77.3 74.8

Source: Balisacan, 2008.

Economic growth has translated into less poverty reduction in the Philippines than in other countries in the region. While the Philippines has been successful in bringing down poverty incidence from nearly half its population in the 1990s to about a third in recent years, the pace of poverty reduction in the Philippines has been slower than its Asian neighbors, particularly Indonesia, Thailand, Vietnam, and China (Fig. 6.1). Balisacan (2007)54 estimates the growth elasticity of poverty in the Philippines at 1.3. While this figure reflects a more than one-to-one reduction in poverty due to growth, it is significantly lower than elasticities for other developing countries. Cline (2004)55, for instance, estimates growth elasticities of 2.9 for China, 3.0 for Indonesia, and 3.5 for Thailand using four decades of data. Based on a sample of 47 developing countries in the 1980s and 1990s, Ravallion (2001)56 estimates an average growth elasticity of poverty at 2.5.

There are also large disparities in the performance of growth in reducing poverty across geographic regions. The National Capital Region and its adjacent regions (CALABARZON and Central Luzon) account for more than half of GDP, receive a disproportionately large share of infrastructure spending, and have per capita incomes above the national average. Not surprisingly, the region also has the lowest poverty headcount (not necessarily in magnitude given its large population). On the other hand, the poorest regions (ARMM and Caraga) have per capita incomes of only 50-60 percent of the national average and receive a very small share of total investments. These regions also have the highest incidence of poverty.

53 Balisacan (2008). 54 Balisacan, A. (2007) “Local Growth and Poverty Reduction,” in A. Balisacan and H. Hill (eds.), The Dynamics of Regional Development – The Philippines in East Asia. 55 Cline, W.R. (2004). “Technical Correction” in Trade Policy and Global Poverty, Institute of International Economics, Washington DC. 56 Ravallion, M. (2001). Growth, Inequality, and Poverty: Looking Beyond Averages. World Development, 29: 1803-15.

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Figure 6.1: Poverty Incidence of East Asian Economies, 1990-2000

Note: Figures pertain to proportion of population with income per capita below US$ 1 a day (in PPP).

Sources of data: World Bank and ESCAP.

One of the reasons why growth has historically not translated into greater poverty reduction is due to the high rate of inequality in the Philippines. Indeed reported income inequality in the Philippines remains higher, (with the Gini Coefficient for 2006 computed at 45.8 percent), relative to other countries in the region (Fig 6.2). While further analysis is required of the recently released 2006 household survey data, one question to be assessed is how well the survey instrument captures actual income and expenditures of respondents, in particular those of the richest percentiles.57

Figure 6.2: Gini Ratios, 1990s vs 2000s

Thailand, 42.0

Bangladesh, 33.428.3

Philippines, 45.6

48.7

46.2

Vietnam, 34.435.7

20.0

30.0

40.0

50.0

60.0

1990s 2000s

%

Bangladesh Philippines Thailand Vietnam

Source: WDI Online

Understanding the causes of the increase in poverty and how the poor can better benefit from growth are critical questions for the Philippines. In order for the Philippines to rapidly reduce poverty, growth must not only be sustained, but it must be more inclusive. The World 57 Survey specialists believe that while incomes and expenditures are often understated in household surveys, richer households often understate their incomes and expenditures disproportionately more than poorer households. Non-sampling bias also occurs when richer households turn away interviewers or do not complete the survey. As an example, according to the FIES, the top percentile of households earns an average income of P1,471,730 in 2006. Assuming that both parents work, the computed monthly income of one parent is only about P56,605 and is equivalent to the income of a mid-level manager in the private sector. This appears to be a serious understatement, especially in light of the significant growth in corporate earnings.

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Bank, along with other partners, is embarking on a study to further analyze the nature and causes of recent poverty and to assess how growth could result in greater reductions in poverty. While more careful analysis is required, there are several apparent factors that drove the increase in poverty between 2003 and 2006.

First, the increase in the poverty headcount in 2006 has been partly caused by a fall in real income of households. While nominal income rose by 17.5 percent between 2003 and 2006, cumulative inflation in the period was higher at 21.1 percent.58 In particular, cumulative food inflation of 19.3 percent was more than double the cumulative food inflation of 9.5 percent in 2000-2003. These translated into falling average real income for all deciles. Average real family income declined by 3.7 percent between 2003 and 2006, while average family expenditures declined by 2.4 percent. Efforts aimed at increasing incomes and opportunities for the poor, while maintaining a stable macroeconomic environment, will be key to poverty reduction.

Second, indications are that the quality of growth has not favored poverty reduction. While growth averaged 5.4 percent between the conduct of the FIES in 2003 and 2006, GDP by factor shares of institutions shows that growth accrued largely to the corporate sector which grew by 27.7 percent on average over the three years (in nominal terms). In contrast, the household sector grew by only 3.6 percent on average over these years.59 Consequently, the share of the corporate sector to GDP increased from 43 percent to 55 percent, while households’ share to total GDP fell from 47 percent to 37 percent.60

The sharp growth in the corporate sector relative to the household sector could partly explain an increase in poverty. The corporate sector, it is argued by some economists, used its profits largely to shore up its accounts and fix balance sheets in the early 2000s following the Asian financial crisis. The poor investment climate and the growing macroeconomic instability at that time did not entice the corporate sector to invest their profits. As a result, unemployment remained high and wages were kept low. However to the extent that it is likely that not all these earnings were retained, it would presumably have resulted in some real increases in income of households in the higher deciles of the income distribution, resulting in greater inequality61. This would imply an increase in poverty, which is not inconsistent with the story of the growth in corporate incomes.

58 A number of factors explain the higher inflation between 2003 and 2006. In 2004, oil prices began to escalate, adding pressure to the prices of basic commodities. The increase in general prices, however, was mitigated by the rapid appreciation of the peso beginning late 2005. Two super typhoons struck the country in 2006 and consequently affected food supply resulting in higher food prices. The increase in the VAT rate from 10 percent to 12 percent, although often cited as a cause of inflation, is estimated to have had a minimal impact on the poor given that most of their expenditure items (i.e. unprocessed food and transportation means) are exempt from VAT. This is also evident from a comparison of headline inflation with a recalibrated inflation of the poor (taking into account the bottom three decile’s consumption basket) which shows the poor’s inflation to be lower than headline inflation in 2006. 59 GDP by factor share of institutions are only available in current prices. Moreover a change in methodology in 2004 means that 2003 data is not comparable to 2004-06 data. Nevertheless the significant difference in corporate growth vis-à-vis household growth over the three years cannot be discounted. 60 There is some debate over the accuracy of data generated by both the national income accounts and the household data. Several research institutions and think tanks have advanced some explanations although there is still no consensus. The government has begun to address this question, and other related issues pertaining to the Philippine statistical system, by commissioning a high level committee composed of respected and independent academics to look into the matter. The committee is scheduled to deliver its overall assessment in May 2008. 61 As discussed earlier, this raises questions as to whether the household survey data accurately captures incomes particularly of the higher income deciles.

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Box 6.1: Frequently-used Quantitative Measures of Poverty In the Philippines, two methods to compute the national poverty line are often reported in media: (i) the official method used by the National Statistical Coordination Board; and (ii) the “consistent basic needs” approach used by research institutions. In addition, as for other countries, the $1 and $2 a day poverty lines are computed by the World Bank for the purposes of international comparison. All three methods use as input the Family Income and Expenditure Survey (FIES), which is conducted every three years since 1985. The official national poverty line is based on household income data. The food threshold is based on regional menus determined by the Food Nutrition and Research Institute (FNRI) that gives 100 percent adequacy for protein and energy (2,000 kcal per person per day) and 80 percent adequacy for other nutrients. The regional menus are derived from FNRI food consumption survey and are subject to change as new data becomes available. Provincial food prices are then applied to the regional menus to arrive at provincial food thresholds. The non-food threshold is measured indirectly using ratios and is based on the expenditure pattern of families within the 10-percentile band around the food threshold. In 2006, the official national poverty line (average per capita poverty threshold) is P15,057 and 32.9 percent of the population falls below this threshold. The alternative “consistent basic needs” (CBN) approach is based on household consumption data. This approach is more in line with international best practice for a number of reasons (see for example, Ravallion (1994)). Under this method, poverty lines and family expenditures are adjusted for provincial cost of living differences to make them comparable over space and time. The food threshold is derived from the food expenditure pattern of the bottom 30 percent of the national population using information from the 1997 FIES that will meet the minimum 2,000 kcal energy requirement. The food basket is fixed over time and is valued at provincial prices to arrive at provincial food thresholds. Similarly, provincial non-food thresholds are derived directly from the expenditure pattern of the bottom 30 percent of the national population using 1997 FIES. The non-food basket is fixed over time and valued at provincial prices. The poverty thresholds for the succeeding years are adjusted for inflation. In 2006, average per capita poverty threshold using this approach is P17,559 and 28.1 percent of the population falls below this threshold. When estimating poverty worldwide or comparing poverty across countries, the same reference poverty line has to be used and expressed in a common unit across countries. This is not possible with the use of national poverty lines. Therefore, for the purpose of global aggregation and cross-country comparison, reference lines are set at $1 and $2 consumption levels per person per day in 1993 Purchasing Power Parity (PPP) terms. The $1 a day is typically cited in comparing poverty in low income countries. The $2 a day poverty line, which is more typically used to compare poverty in middle-income countries, is also used. The $1 consumption basket and prices were collected in 1993 by the International Comparison Project. The $1 or $2 a day poverty line is often misunderstood and thus wrongly reported in the media. This is especially true if reports do not mention PPP and 1993 prices. PPP refers to the equalization of a currency’s purchasing power on a common basket of goods, while 1993 prices refer to the basket’s cost in 1993 prices. Therefore, $1 PPP in 2006 is not the prevailing exchange rate of about P51 but P12.96 (using the revised 2000-based PPP). In 2006, the $1 a day line is equivalent to P9,575 and the $2 a day line is twice the $1 a day line or P19,150. These poverty thresholds result in poverty headcounts of 13.4 percent for $1 a day and 46.9 percent for $2 a day.

Poverty Thresholds and Headcount 2006 Method Threshold Headcount Approach

$1 a day P9,575 13.4 ConsumptionCBN P17,559 28.1 ConsumptionOfficial P15,057 32.9 Income$2 a day P19,150 46.9 Consumption

Sources: Balisacan (2001), NSCB, and World Bank.

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6.2 Investing in human capital of the poor

In addition to slow progress in reducing income poverty, there has been mixed progress in addressing the non-income dimensions of poverty in the Philippines, particularly as they relate to human development outcomes. The Philippines is doing poorly in meeting key social MDG targets. In education, net enrolment in grade school declined from 99.1 percent in 1990 to 84.4 percent in 2005. Only 70 percent of students that enter grade 1 make it to grade 6 (Department of Education Basic education System, 2006) and almost 2 in 5 children aged 6-11 are not in school (Department of Education, BEIS 2006). In health, important progress has been made in reducing infant mortality (24 deaths per thousand live births), but immunization rates are not close to universal and malnutrition remains a major issue, with only 68 percent of children under 5 years old attaining normal WHO weight-for-age standards (WHO, 2006). Meanwhile maternal mortality rates remain high at 162 per hundred thousand live births in 2006. The 2003 NDHS revealed that only 66 percent of women received any post-natal care and that of women who received prenatal care, few obtained complete recommended care. Meanwhile tuberculosis persists to be a main cause of deaths and non-communicable causes of death, particularly hypertension and diabetes, have steadily increased.

Overarching issues

Low overall spending on the social sectors during the period of fiscal compression early this decade is one reason for lagging outcomes. In aggregate, total spending on social services at the national level, at 4.9 percent of GDP including education, health, social welfare, housing, other services and transfers to local governments, is significantly less than the regional average and among those countries with similar per capita income (CPBD, 2007; ADB, 2006). This has been compounded by fiscal compression, which contributed to a fall in real per capita spending on social services by as much as 28 percent between 1997 and 2006 (Manasan, 2007).

Service delivery has also been difficult by the ongoing challenges to adapting systems to decentralized service delivery. Service delivery, including in health and social welfare services, continues to be complicated in the Philippines by the fact that systems have not completely been adapted to the decentralization that took place in 1993. With the passage of the Local Government Code (LGC) in 1991, the delivery of most services was devolved to the local government units. For example, DOH’s and DSWD’s functions were henceforth to be focused on leadership primarily through policy formulation, standard setting, program development, technical assistance, and resource augmentation. Yet these Departments recognize that they have not fully adjusted following decentralization, and each has undertaken to implement sectoral reform agendas that will help them do so.

Focusing programs on building the human capital of the poor has also been compromised by the lack of a legitimate and functional system to target poor households. The effectiveness of social protection services in the Philippines is severely compromised by the lack of an accurate and legitimate system to target poor households. A variety of programs have been designed to reach poor households in the past, but they have relied on faulty targeting systems which have often been manipulated for political intent. Currently, different targeting schemes are being used for different programs. Assessments of these schemes show high leakage rates to the non-poor and under-coverage of the poor. For example, it is estimated that the leakage rate to the non-poor of the Food-for-School Program implemented by DepEd was 62 percent in 2006/2007 (Reyes, 2002; Manasan and Cuenca, 2007).

In addition, there has been little attention to social protection measures to protect poorer households from the high degree of vulnerability they face. Poorer households are vulnerable to

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shocks that perpetuate poverty. Over annual periods between 1997 and 1999, panel data showed that some half of poor families were not poor in the previous year (Reyes, 2002). Likewise, a more recent study by NAPC and NSCB estimated that 45 percent of all Filipinos are vulnerable to shocks that will throw them into poverty. Shocks that commonly throw Filipino households into poverty are those related to health (e.g. loss or illness of a family member, especially the household head), employment, natural disasters, civil unrest, and food prices (World Bank, 2001). In the absence of appropriate safety net programs, household coping mechanisms following a shock tend to erode human capital and would perpetuate poverty among these households. Filipino households tend to respond to income shocks by increasing working hours, changing eating patterns, receiving transfers from relatives/friends, or withdrawing children from school (World Bank, 2001). Unemployment and underemployment (triggered by economic crisis) coincided with significant declines in high school enrollment rates (Esguerra et al., 2002), and increased the likelihood of child labor (Esguerra, 2002). These coping behaviors following income shocks tend to erode the human capital accumulation of households, especially among kids, which would further diminish the prospects of households pulling themselves out of poverty. Meanwhile, interventions in the area of social protection are fragmented across government institutions. Moreover, national government spending on social protection services is estimated by one study as constituting only 0.2 percent of GDP in 2005 (Manasan, 2006).

Some key areas for improving service delivery

Despite recent increases in spending in the social sectors, overall investment in developing the human capital of Filipinos through investment in health, education, and social protection is low and should be increased. In the last couple of years, with the easing of fiscal constraints, the Government should be commended for increasing spending in the social sectors. In particular, between 2004 and 2008, the real budget of the Department of Education increased by 6 percent and that of the Department of Health by 18 percent (CPBD, 2007). Nevertheless, the total spending in these sectors as shares of GDP – 2.5 percent in education and 0.3 percent in health – are considerably lower than in other countries. While averages are not available for developing country income groups, many of these countries spend between 4 to 6 percent of GDP on education and 3 percent of GDP on health (WB, HNP Stats). Moving forward, there is still a need for increased resource allocation to the social sectors.

More funding to the social sectors alone, however, will not be enough; there is important scope for improving how budgets in these sectors can be used more efficiently.

• Invest in recurrent expenditures to address quality constraints. In the education sector, for example, a large share of spending for many years has been on personal services. While the last three years saw a significant increase in the allocation for recurrent and capital outlay expenditures to address supply shortages, there is now a need to allocate more resources for recurrent expenditures for direct interventions on teaching-learning improvements and to upgrade the quality of basic education. Addressing inefficiencies in resource management will be key. These include, for example, implementation of the Department of Education’s synchronized planning-budgeting system, financial management reform action plan and procurement plan. In the health sector, performance-based budgeting is being introduced for both the public health and hospital components of the Department of Health’s budget.

• Focus on lagging outcomes. In the social sectors, more effort should go into allocating resources to address lagging outcomes. In education, for example, key short-comings are high drop-out and completion rates, and poor transition rates between primary and secondary education. For example, the drop out rates for elementary and secondary school increased from 6.98 percent to 7.33 percent and from 7.99 percent to 12.51

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percent respectively between the 2004 and 2005 school years. Success here depends on both supply side and demand side interventions (see below). In health, there is a need to invest in the care of expectant mothers and their newborns. Global evidence points to the importance of investing in health facilities and professionals who can attend to mothers during delivery. In 2005, only 63.7 percent of births were attended by skilled health professionals. Success in this area depends critically on the ability of central government to work with local government to focus jointly on this priority (see below).

Further improving efforts to enhance partnerships and clarify roles in decentralized service delivery could increase the responsiveness of these services to local clients. Education continues to be centralized in its service delivery, as it is not a devolved sector. Nevertheless, significant improvements can be made to the responsiveness of schools to local communities. In recent years the Department of Education is moving toward a system of school-based management (SBM) as a way to empower schools, their communities, and other stakeholders to take more responsibility for improving the learning of their students. This effort should be reinforced, which requires a move away from prescription from the center.

In contrast, the health sector and social welfare sector have been devolved with the enactment of the Local Government Code of 1991. In health, the provision of primary care sits with municipalities while the responsibility of 1st nd and 2 level hospital care sits with provinces. In social welfare, DSWD’s functions were henceforth to be focused on leadership primarily through policy formulation, standard setting, program development, technical assistance, and resource augmentation. Yet the central agencies are still adapting to their revised role under devolution, while local governments are struggling with the provision of service delivery. Ongoing reforms in these sectors will have to focus directly on how central governments can better work with local governments to support service delivery that continues to be weak. For example, in the health sector, DOH is allocating increased budget for maternal health, but actual delivery of these primary services at the local level will require increased investment by LGUs in emergency obstetric care (EmOC) facilities and professionals, as well as an important role for the private sector. Innovations being introduced to enhance partnerships between central and local governments, such as performance-based grants for LGUs under the health reform program, show promise.

Some key areas for improving the poverty focus of service delivery

In addition to the fact that the poor would benefit from addressing the systemic service delivery failures above, there is also a pressing need to target human capital interventions to poorest households. Often it is poor areas that are least served by health and educational services. And poor households often are least able to avail of health and education services. Educational gaps between poor and non-poor areas and between poor and non-poor families persist, in terms of children’s access to schools of good quality and other inputs, as well as in terms of outcomes (World Bank Philippines Education Policy Notes, 2004). Across all regions, it is disproportionately the youth from poor families who do not go to school and who drop out of school the earliest (Lam, 2005, World Bank Philippines Education Policy Notes, 2004, APIS 2002). Many studies indicate that the high cost of education is among the most important barriers to school enrollment and completion among children from poor families in the elementary and secondary levels (Kattan and Burnett, 2004; World Bank Philippines Education Policy Notes, 2004). Moreover, the infant mortality rate among the poorest quintile of the population is more than twice that of the richest quintile, and more than thrice for under-five mortality rate (2003 NDHS; Gwatkin, et.al).

Reaching the poor on the one hand requires geographic targeting of supply-side interventions in areas where the poor live. Human development outcomes vary significantly

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across geographical areas (Table 6.2). This is reflected by wide geographical disparities in the availability of good schools. Visits to schools in poor areas reveal basic supply shortages. In poor, overcrowded urban areas, pupil-teacher ratios are as high as 1:80 in many NCR schools, (DepED BEIS 2006)) and school shifts are too short (three to four class shifts in highly urbanized areas such as in NCR, Cebu and Region IVA). In poor rural areas, many students sit in classrooms without the rudiments of instruction, including a teacher who has mastered the curriculum. DepEd’s latest BIES data on teacher distribution across schools and regions shows the difficulty of attracting good teachers to schools that serve poor, backward areas and schools that have few resources. Meanwhile, the National Demographic and Health Survey showed that while more than 85 percent of births in NCR and Central Luzon were attended by a skilled health professional, less than 30 percent of births were similarly attended in the ARMM and MIMAROPA regions. There is a need for investing further in service delivery in lagging or poorer regions.

Reaching the poor also calls for targeted demand side interventions, including insurance, that can increase the ability of poor households to access health and education services. Addressing supply side shortcomings alone will not help the poor. To the extent that the poor find it hard to afford schooling and health care, targeted interventions to increase the resources of the poor to access health and education will be key. One of the implications of targeted demand side interventions for the poor is the need for an administrative targeting system that is credible, transparent, and as accurate as possible. There are several such demand side transfer programs in the Philippines—including the Food-for-School program and the important PhilHealth Indigent program aimed at subsidizing health insurance enrollment for the poor. The operationalization and efficacy of each of these programs is compromised by the lack of an administrative national household targeting system. Indeed, improved targeting of the poor will be critical to the efficacy of using public funds for poverty reduction and should be of highest priority.

A program such as the proposed Ahon Pamilyang Pilipino conditional cash transfer program is a “convergent” program that, properly designed and implemented, can address a number of the issues above. The conditional cash transfer (CCT) currently being designed by government is a commendable effort with several attractive dimensions. Such programs have been proven successful in the numerous countries that have adopted them globally.

• Targeted to the poorest. Successful CCT programs require a robust administrative household targeting system that is based on objective measures and not subject to political manipulation, either at the central or local level. Current efforts to adopt the international best practice approach of a proxy means test (PMT) based targeting system could put into place a targeting system for poor households that will not only benefit the CCT program, but also benefit other poverty focused programs such as the PhilHealth Indigent program.

• Demand side income support as social protection to stimulate increased access to services among the poorest. The CCT program aims to supplement the incomes of poor households by some 10 percent based on regular support on condition that health and education “co-responsibilities” are met. This supplemental income provides a safety net for the poorest that will be useful in helping them mitigate shocks such as sickness, unemployment, food price increases, etc. These funds are aimed specifically to help households ensure that they access critical health and educational services.

• Supply side pressure to improve service delivery to the poor. By stimulating demand by the poor for these services, global experience shows that municipalities are pressured to take measures to improve supply to meet increased demand. In a decentralized context

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such as the Philippines, this provides added impetus to LGUs to invest in the supply side of health and education.

• Health and education “co-responsibilities” have been proven to improve lagging human capital outcomes among the poor. Based on rigorous impact evaluations, global experience has also shown that the requirements or “co-responsibilities” to be met by households to continue receiving support through CCT programs significantly improve targeted human development outcomes. For example, by conditioning cash transfers to the poor on the continued enrollment of their children in school, vaccination of their children, and delivery care by skilled health professionals, a CCT program in the Philippines shows promise for addressing these lagging outcome indicators in health and education.


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Table 6.2: Philippines MDG Rate of Progress at the Sub-national Levels

Source: NEDA-UNDP, Philippines Midterm Progress Report on the Millennium Development Goals 2007


6. 3 The role of agriculture and rural development in poverty reduction and inclusive growth

As noted above, in the Philippines, almost three quarters of the poor live in rural areas. Three elements are seen as critical in enhancing the opportunities of the poor and providing the main pathways out of rural poverty. These are: a) fostering a more remunerative, productive and sustainable agricultural sector; b) promoting off farm employment and urban migration; and c) improving assistance to subsistence farmers and populations in lagging regions (World Bank 2007, 2008).

Fostering a more remunerative, productive and sustainable agricultural sector

Achieving a more productive agricultural sector will in turn require addressing three areas (World Bank 2008a, and 2008b):

i) Expanding the share of high value agriculture and improving the yields of traditional agriculture. Total factor productivity (TFP) growth in Philippine agriculture is low by regional standards. During 1961-98, TFP grew at an average of 10 percent, compared to 32 percent in Thailand and 44 percent in Indonesia. Such low performance reflects the failure to achieve a significant shift in the sector’s output mix towards high value crops. To date, changes in the structure of agricultural production have been due to sustained growth in the livestock and fisheries sectors rather than a shift in the crop mix.

Diversification of the crop mix is hampered by the policy and tariff structure. The structure of agricultural production continues to be centered on the rice sub-sector, which represented 28 percent of value added from crop production during 2001-05 due to the Government’s thrust of rice self-sufficiency. Importable crops such as rice, corn and sugarcane remain highly protected and distort the market.

Evidence suggests that during 2000-04, exportable crops received a negative rate of support of 3 percent, while protection of import competing corps was around 43 percent (David and Balisacan 2007). Rice trade policy, by keeping the price of rice artificially high, acts as a regressive policy (World Bank 2007; IRRI 2007), as higher prices for rice impact negatively on the urban poor. The policy of rice self sufficiency has in fact undermined food security by making rice less affordable to the Filipinos and has caused the Philippines on average a net welfare loss of more than $1 billion a year or 1.6 percent of GDP during 2000-05 (Table 6.4), mainly borne by the poorest Filipinos. A growth promoting agricultural support policy will permit increased production of fruits and vegetables and ultimately a more labor intensive crop mix (see IRRI, 2007).

The recent enactment of the Biofuel Act is likely to lead to increased protection of sugarcane and further hamper the readjustment towards more competitive crops. The key crop in the production of ethanol is sugarcane, which has traditionally enjoyed a high degree of protection. As a key ingredient in foods and food processing, the high rate of protection on sugar has contributed to the country’s relatively high food prices. The expected increase in demand for sugar for ethanol production, abetted by the incentives provided by the Biofuel Act which, among others, mandates a minimum amount of bio-fuel use, can be expected to further pull sugar prices up, and consequently food prices. In addition the bio-fuel policy will most likely put pressure on extending cultivation on marginal lands and converting forests to agricultural uses, thereby worsening the impact of agriculture on natural resources. Finally, it is also expected that this policy will increase both the value of sugarcane farms and the difficulty in completing the Comprehensive Agrarian Reform Program in these areas.

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Overall staple crop yields and rice yields in particular, remain low. Factors contributing to these low yields include, among others, soil degradation, sub-optimal use of fertilizers, and to some extent, financial constraints affecting the small farm sector.62 Policies to address these issues are critical to improving productivity in the sector.

Assistance to the agricultural sector needs to include a revitalized Agricultural Knowledge and Information System. So far, low investment in R&D and the poor performance of the extension services have been major constraints to long-term growth (Sebastian et al 2006). Public expenditure on agricultural R&D represented 0.36 percent of total agricultural value added (which is low by international standards), and 5 percent of DA’s total appropriations during 2000-05. In the case of rice, R&D expenditure amounted to less than 0.10 percent of agricultural value added. Similarly, public extension services have failed to deliver knowledge and technologies to the majority of small farmers. Extension services are under-funded, fragmented and un-coordinated within the national extensions system.

Alternative institutional models of agricultural extension are required where R&D and extension are fully integrated and mutually responsive, allowing for improved coordination between main stakeholders and for more demand driven processes. Also more efficient competition is needed between the private and public systems of extension—competition that ensures that the public goods elements of extension do not become under-supplied and that small farmers are not kept at the margin. Finally, the government should scale up the Farmer Field School (FFS) model which favors investment in farmers’ education as a means of diffusing technology in the small farm sector.

ii) Improving the quality of public expenditure in agriculture for greater fiscal space and anti poverty measures. The efficiency gains from reforming the National Government’s (NG) expenditure in agriculture are substantial. A review of agricultural public expenditure (World Bank 2007), using 1998-2005 public expenditure data, noted that 46 percent of the investment budget of the Department of Agriculture is allocated to Irrigation Development Services. This mainly covers large scale irrigation systems which exclusively support rice production that generates lower farm income than other crops. Production Support Services, which receives 14 percent of agricultural public investment, largely involves the provision of production inputs such as seeds and fertilizers, which are more effectively and efficiently supplied by the private sector.

Overall, over 60 percent of the total agricultural budget supports rice production, even though rice accounts for only 16 percent of total agricultural value added (World Bank 2007). As shown in World Bank (2007), the annual net incomes derived from rice production represent only a fraction of the poverty line (Table 6.3).

Thus fiscal as well as policy biases for rice have prevented the Philippines from diversifying crop production. Indeed, the Philippines’ agriculture sector has been locked in a cereal dominant mold for decades. The policy focus on less profitable, traditional, agricultural commodities and the possible “crowding out” of the private sector by the government in the provision of production inputs may also partly account for the disturbing trend of increasing public sector share in total agricultural investments. The share of the public sector in agricultural investments has grown from only 5.6 percent of total agricultural gross value added in 1998 to 26.4 percent in 2005. Thus, the government’s rice self-sufficiency policy will also have to be re-examined if the fiscal space for pro-poor agricultural development is to be significantly expanded.

The provision of public goods, which should be the main function of the Department of Agriculture, has been consistently under-funded as a result of this allocation pattern. The

62 For instance, IRRI (2007) argues quite convincingly that access to credit is of secondary importance in explaining the sub-optimal use of fertilizer by rice farmers.

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proposed 2008 DA budget allocation shows an even greater imbalance (e.g. greater share of production support, lower share of regulatory services, R&D, market development) (Table 6.5). Another potential concern is the proposal to reduce the DA’s 10 MFOs into three: MFO 1 (Support Services), MFO 2 (Regulation) and MFO 3 (Plan and Policies). This will not, however, result in the reduction and fine tuning of the DA’s MFOs, but rather in the mere merging and the continued retainment of all existing functions. This may make it more difficult to manage and monitor the Department’s budget and expenditures.

Table 6.3: Average Annual Net Returns Derived from Rice (2000-2004)*

Rice 2000 2001 2002 2003 2004 (P)

Per hectare all palay 4,447 3,978 5,619 6,755 7,582 irrigated 4,701 3,988 6,754 8,930 9,250 non irrigated 4,395 4,422 2,947 3,711 4,620 Per farm Annual net income from rice (irrigated)

8,462 7,176 12,157 15,102 16,650

Per capita poverty threshold 13,823.0 14,667.4 15,123.0 15,545.1 16,670.5 Household poverty threshold ** 16,115.0 73,336.8 75,614.8 77,725.6 83,352.7 Rice farm income as a proportion of household poverty threshold

12.0 9.6 16.1 19.4 20.0 Source: NEDA, NSO. *Based on CPI (2000=100)

Table 6.4: Average Annual Net Welfare Impact of Rice Self-sufficiency Policy 2000-2005 (billions of P)

2000 2001 2002 2003 2004 2005 Average

Change in producer welfare 31.1 20 23.9 12.7 0.2 1.7 16.8

Change in consumer welfare -100.1 -79.7 -84.7 -66.9 -38.9 -61.1 -72.8

Change in budget surplus: -12.3 -7.4 -12.1 -15.1 -12.1 -11.38 -12

Revenue from import tariffs 0 0 0 0 3.9 12 2.7

NFA’s stabilization subsidy 0 -1.1 -0.9 -0.9 -0.7 -1.2 -0.8

NFA’s tax subsidy 0 0 0 0 -3.9 -12 -2.7

NFA’s deficit -1.9 -2.3 -8.1 -3.7 -1.8 -10 -5.3

NFA’s total costs* -6 -2.2 -5.3 -8.6 -10.9 -19.3 -8.7

Budget spending (AFMA)** 6.3 6.1 6.8 6.5 5.1 4.1 6.1

Total net welfare change -81.3 -68.0 -72.9 -69.3 -50.8 -70.7 -68.2 Total costs as % of GDP 2.4 1.9 1.8 1.6 1.0 1.3 1.6

2.59 2.4 2.43 2.26 2.34 2.37 2.4 Palay contribution as % of GDP

Note:* Total costs of NFA are adjusted for change in inventories. Source: Author, based on DOF (2007), DA (2006a) and NSCB (2006).

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Table 6.5: Department of Agriculture Budget Share of MFOs 2008 Major Final Output 2006 2007 (Proposed)

Irrigation 33.4 41.6 36.5 Other Infra & Post-harvest Devt. 15.1 9.2 17.6 Credit Facilitation 1.0 1.1 0.7 Market Development 6.4 6.9 6.2 Extension, Education, & Training 5.8 5.9 5.8 Production Support 14.1 13.2 19.0 Regulatory 3.4 4.0 3.8 Policy & Planning 7.0 8.5 6.3 Information Support Services 2.7 3.2 0.9 Research and Development Services 5.8 6.4 3.2 GASS 5.3 Total 100.0 100.0 100.0

GASS was treated as a separate budget item in the 2006 budget but was distributed by MFO in the 2007 and 2008 budgets.

The National Food Authority’s (NFA) borrowings have also increased substantially in recent years to cover the surging deficit which has resulted from the importation, distribution and buffer stocking of rice, and from the associated administrative costs. In 2006, the NFA’s deficit surged to P16.4 billion form the already high P10 billion in 2005 (Table 6.6). Its share of the total deficit of government-owned and controlled corporations (GOCCs) ballooned from 8 percent in 2000 to 43 percent in 2005.

Table 6.6: Rising Share of NFA’s Deficit in GOCC’s Total Deficit 2000-06 P millions (unless otherwise stated)

2000 2001 2002 2003 2004 2005 2006 NFA’s deficit 1,897 2,274 8,086 3,689 1,836 9,978 16,430 Total deficit of GOCC 22,581 32,832 25,937 39,649 85,412 22,987 n/a Share of NFA in total deficit (%)

8 7 31 9 2 43 n/a

Improvements in the NFA’s operational efficiency are unlikely to produce significant and sustainable cost reductions in the medium to longer term (World Bank 2007). What is needed is policy level reforms (especially trade reforms) such as: i) complete replacement of quantitative restrictions on rice with tariffs; ii) subsequent reduction of rice import tariffs, iii) separation of the NFA’s regulatory and trade functions; iv) use of public rice stocks mainly for disaster mitigation and safety net programs; and v) further incentives for private sector participation in rice importation. Without these reforms, even the recent P8 billion sale of 10 year bonds by the NFA will only provide temporary financial relief.

iii) Improving the sustainability of agricultural production systems. Land degradation in the Philippines is becoming a major constraint to increasing agricultural productivity. Almost half of the country’s land suffers from moderate to severe erosion. Population pressure contributes to increased cultivation of steeply sloping land. Salinization and water logging are problems in some irrigated areas, and saline water intrusion affects coastal areas. In addition, deforestation has assumed alarming proportions as a result of conversion to agricultural uses (both subsistence and commercial agriculture) and as a result of expansion of urban areas. The rate of deforestation during 1990-2005 was about 2.2 percent per year, which is very high compared to international levels. This high conversion rate also reflects weak tenure arrangements and property rights

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system and a skewed distribution of land and natural resources rights (World Bank 2003). On the positive side, Sloping Agricultural Land Technologies to conserve soils are increasingly being adopted.

Promoting off farm employment and urban migration

As in other East Asian countries, the industrialization of rural areas and job creation in non-farm activities has been substantial. The development of non-farm activities in rural areas has resulted from two distinct activities. First, increasing business costs associated with urban congestions have led to more labor intensive industrial processes (the footloose capital) transferring to rural areas in search of cheaper labor and lower overall production costs. This pattern of development is therefore associated with proximity to major urban centers such as Manila, Cebu and Davao. This, in turn, presents a serious problem as it encourages migration of the rural poor instead of daily or short-term commuting to access local non-farm activities in secondary cities.

Second, in areas of high agricultural potential, the Green Revolution has led to an increase in real wages and a demand for local services which has boosted the growth of non-farm activities. However, while the benefits of the Green Revolution have reached tenant farmers through the redistribution of high quality agricultural lands, especially rice lands, there is substantial evidence that landless households have been left out of the process. For these households, migration to low productivity non-farm jobs, many of them in urban areas, has become the best alternative to lowly paid agricultural jobs. The limited development of a system of secondary cities is leading to a progressive urbanization of poverty.

The impact of the 1998 Comprehensive Agrarian Reform Program (CARP), whose extension is being currently debated, is still not entirely clear. This is in great part because the CARP includes both land distribution as well as delivery of support services to agrarian reform beneficiaries. Recent evaluations of the program (APPC, 2007; Balisacan and Fuwa, 2004) find that the program has had a positive impact on growth but its poverty alleviation effects through changes in income distribution in rural areas has been rather small. The program has primarily targeted tenants on large farms to the detriment of agricultural laborers, who are among the poorest in rural areas. CARP may very well have had a marginal impact on poverty.

Access to land may not be an effective pathway out of poverty in the future. It is estimated that future redistribution of land will allow creation of farms of on average 1.7 hectares. Given the competitive pressures faced by the small farm sector and the relatively low level of total factor productivity achieved, it is unlikely that access to such small parcels of land will in fact achieve a large reduction in the incidence of poverty. A broader view of agrarian reform is therefore required, by which redistribution of land is seen as one component of a multi-activity strategy of household income growth. In addition, CARP must not undermine the functioning of land markets as they are the most effective way to redistribute agricultural land from less to more efficient producers and at the same time open the agricultural ladder to landless households (Deininger 2003).

There are a number of actions the government could take to support rural-urban migration. These include i) the promotion of rural industrialization and job generation through local agro-based clusters where agricultural producers and agro-industries in a specialized activity interact to better compete; ii) improvements in transport links between rural, periurban and urban communities; iii) development of active labor market programs which include job-matching programs for migrants; and on-the-job trainings by enterprises; iv) provision of employment options to the most vulnerable rural youth, linking them to jobs in semi-urban areas or at the local

82


level with associated training programs; and v) promotion of conditional cash transfer programs to assist the vulnerable as discussed above.

Improving assistance to subsistence farmers and populations in lagging areas

As mentioned earlier, social expenditures have been very low by international standards and have been insufficient to address the basic needs of the poor, especially in the more stagnant regions of the country. While migration has responded to income differentials, as one would expect, inter-regional differences in real incomes and poverty have proven long term in nature (Balisacan and Hill 2007; Esguerra and Manning 2007). In the long run, investment in infrastructure and the development of local economic opportunities will continue to represent the main pathway out of poverty for the lagging regions. In the short run however, the focus should be on safety nets and poverty targeting programs. This is particularly important with respect to indigenous populations (IPs), the majority of whom live below the poverty line. In this regard, the operationalization of the Indigenous Peoples Rights Act (IPRA) of 1997 requires financial, logistical and human resources to be made available to the IPs.

The Government is undertaking several important community-based rural poverty reduction programs. To the extent that these address infrastructure constraints at community level, especially if also generating labor-intensive public works, such programs can be important interventions to address poverty in poor and lagging areas. However, the framework for community-based rural poverty reduction programs also needs to be strengthened. Previous interventions have not been undertaken within a broader systematic operational framework for poverty reduction. The challenge for the Government is to ensure that its investments in rural poverty reduction programs are coordinated, consistent, properly sequenced and responsive to the national and local development policy context.

The recent and apparently continuing trend of hefty food price increases further underscores the urgency of reviewing the country’s rice policy in order to promote food security (in both supply and affordability) especially among the poor and vulnerable. Figure 6.3 shows that the price of both Thai rice63 64 (35 percent brokens) and wholesale well-milled Philippine rice strongly increased during the period February 2006-January 2008; from US$262 per mt to US$362 per mt for the former (an increase of almost 39 percent) and from US$397 per mt to US$577 per mt for the latter (an increase of 45 percent). Domestic rice prices appear to be shadowing the movement of international rice prices, so that their differential has not narrowed. In fact, Thai prices generally increased more slowly than the price of well-milled Philippine rice, except for the last four months of the period. Thai rice price increased by a monthly average rate of 1.4 percent compared to 1.6 percent for well-milled Philippine rice. The price difference between Philippine and Thai rice prices, have, consequently, widened from US$135 per mt (a differential of 52 percent) to US$215 per mt (a differential of almost 60 percent) in January 2008.

63 Source: World Bank Global Economic Monitor (GEM) 64 Source: Bureau of Agricultural Statistics (BAS)

83


Figure 6.3: Price of Rice in the Philippines and Thailand, 2006-2008

200

300

400

500

600

Jan 2006 May 2006 Sept 2006 Jan 2007 May 2007 Sept 2007 Jan 2008

$ pe

r met

ric to

n

Well-milled rice Philippines

Thai market rice plus freight cost

Sources: Global Economic Monitor, World Bank; Bureau of Agricultural Statistics

It appears that tariffs account for much more of the price difference between Thai and Philippine rice than do freight costs. Without tariffs and just factoring in freight costs, Thai rice price at the domestic market will still, on average, be cheaper—by about US$ 140 per mt or by one third of the wholesale price of well-milled Philippine rice. On the other hand, with freight costs and tariffs, Thai rice costs nearly the same as well-milled Philippine rice. This highlights the need to start reducing rice import tariffs now and to prepare for—and not further postpone—the NFA reforms and the full liberalization of rice trade by 2012.

Reducing rice tariffs would promote the welfare of the majority of Filipinos, since three quarters of rural households and all urban households in the country are net rice consumers and thus are vulnerable and adversely affected by high rice prices. It would benefit the poor more since food costs account for a larger share of their expenditures—rice constitutes 17 percent of the total consumption and 27 percent of the total food expenditures among the poorest 30 percent of families. Rice farmers constitute only about one quarter of total rural households, 40 percent of whom accounts for two thirds of the marketable surplus of rice. The urban poor and the majority of the rural poor would be better served if domestic prices of rice were lower (through trade liberalization) than through the NFA’s safety net programs which reportedly significantly fall short in coverage and suffer form major leakages. The fiscal savings from this policy reform can be used to finance an adaptation or transition program for rice farmers to improve their competitiveness or assist them in moving to other crops.

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APPENDIX

Page No. Table 1 Summary Indicators .............................................................................................86 Table 2 Selected Economic Indicators ..............................................................................87 Table 3 National Accounts ................................................................................................88 Table 4 Inflation Rates ......................................................................................................89 Table 5 Monetary Survey ..................................................................................................90 Table 6 National Government Operations.........................................................................91 Table 7 Consolidated Public Sector Debt..........................................................................92 Table 8 Consolidated Public Sector Fiscal Position..........................................................93 Table 9 Balance of Payments ............................................................................................94 Table 10 Labor and Employment Indicators .......................................................................95 Table 11 Social Indicators ...................................................................................................96

85


2003 2004 2005 2006 2007

National income (growth rates)Gross national product 5.9 6.9 5.3 6.1 7.8Gross domestic product 4.9 6.4 4.9 5.4 7.3

Prices Consumer prices (period average)/1 3.5 6.0 7.6 6.2 2.8 Exchange rate (period average) 54.2 56.0 55.1 51.3 46.1

Savings and investment (percent of GDP) Gross national savings/2 17.2 18.6 16.6 19.3 19.9e Gross domestic investment 16.8 16.7 14.6 14.3 14.7 Resource gap 0.4 1.9 2.0 5.0 5.2e Public sector (percent of GDP) Consolidated public sector balance -5.1 -4.8 -1.9 0.1 0.8 National government balance -4.6 -3.8 -2.7 -1.1 -0.1 Revenue 14.8 14.5 15.0 16.2 17.1 Expenditure 19.5 18.3 17.7 17.3 17.2

Monetary and financial sector Broad money (growth rate) 3.3 9.2 9.0 22.3 10.4 Private sector credit (growth rate) 1.8 4.6 -1.5 6.0 8.4 91-day treasury bill rate 6.0 7.3 6.3 5.4 3.4 PSE composite index (year end) 1,442 1,622 2,067 2,983 3,622

External sector (billions dollars)Current account balance 0.3 1.6 2.0 5.9 7.5e

Percent of GDP 0.4 1.9 2.0 5.0 5.2eMerchandise exports 35.3 38.8 40.3 46.5 49.4e

Growth rate 2.7 9.8 3.8 15.6 6.1eMerchandise imports 41.2 44.5 48.0 53.3 57e

Growth rate 3.1 8.0 8.0 11.0 6.8e

External debt /2Total external debt (billions of dollars) 57.4 54.8 54.2 53.4 54.4

Percent of GDP 72.1 63.1 54.9 45.4 ..Debt service ratio (G&S and receipts) 16.9 13.8 13.5 11.7 9.6

Social sectorPopulation (millions) 81.2 82.9 84.6 86.3 87.9Poverty incidence (PPP $1 a day) 13.1 13.7 12.9 13.4 11.9Per capita GNI, atlas method 1,080 1,200 1,290 1,420 ..

Source: Government of the Philippines, World Bank* as of Sept. 2007e/ Estimate1/ Base year: 20002/ Reported by BSP

Table 1. Summary Indicators

86


2003 2004 2005 2006 2007

Growth, inflation and unemployment (percent)Gross national product 5.9 6.9 5.3 6.1 7.8Gross domestic product 4.9 6.4 4.9 5.4 7.3Inflation (period average); 2000 base year 3.5 6.0 7.6 6.2 2.8Inflation (end period); 2000 base year 3.9 8.6 6.6 4.3 3.9Unemployment /1 7.1 7.1 7.7 7.9 7.3

Savings and investment (percent of GDP)Gross national savings 17.2 18.6 16.6 19.3 19.9eGross domestic investment 16.8 16.7 14.6 14.3 14.7

Public sector (percent of GDP)National government balance -4.6 -3.8 -2.7 -1.1 -0.1 Total revenue 14.8 14.5 15.0 16.2 17.1 Tax revenue 12.8 12.4 13.0 14.3 14.0 Total spending 19.5 18.3 17.7 17.3 17.2Consolidated public sector balance -5.1 -4.8 -1.9 0.1 0.8 **Nonfinancial public sector debt 100.8 95.2 86.0 73.9 66.8 *National government debt 77.7 78.2 71.5 63.8 59.9 *

Money and credit (year-end percent change)M3 3.3 9.2 9.0 22.3 10.4Credit to the private sector 1.8 4.6 -1.5 6.0 8.4

Balance of payments Merchandise exports (percent change) 2.7 9.8 3.8 15.6 6.1eMerchandise imports (percent change) 3.1 8.0 8.0 11.0 6.8eCurrent account balance (percent of GDP) 0.4 1.9 2.0 5.0 5.2e

International reservesGross official reserves (billions of dollars) 17.1 16.2 18.5 23.0 33.8Change in reserves (billions of dollars) 0.7 -0.9 2.3 4.5 10.8Gross official reserves (months of imports) 4.2 3.6 3.8 4.3 5.9

External debtTotal (billions of dollars) /2 57.4 54.8 54.2 53.4 54.4 **Total (percent of GDP) /2 72.1 63.1 54.9 45.4 46.5 **Debt service ratio (G&S and income) /2 16.9 13.8 13.5 11.7 9.6 ***

Exchange rate (peso/dollar, period average) 54.2 56.0 55.1 51.3 46.1Real effective exchange rate (2000 = 100) 89.1 86.2 92.3 102.5 112.3Source: GOP, World Bank, IMFMemorandum items2007 population: 87.9 million* as of June 2007** as of Sept. 2007*** as of Nov. 2007e/ Estimate1/ Annual average; using new definition base on 1995 census except 2007 which is based on 2000 census2/ Reported by BSP

Table 2. Selected Economic Indicators

87


2003 2004 2005 2006 2007(Growth rates)Gross national product 5.9 6.9 5.3 6.1 7.8Gross domestic product 4.9 6.4 4.9 5.4 7.3

By industrial originAgriculture, fishery and forestry 3.8 5.2 2.0 3.8 5.1

Agriculture and fishery 3.7 5.0 2.0 3.9 5.0Forestry 24.3 53.2 4.3 -4.1 12.2

Industry 4.0 5.2 3.8 4.5 6.6Mining and quarrying 16.8 2.6 9.3 -6.1 25.0Manufacturing 4.2 5.8 5.3 4.6 3.3Construction -0.8 3.4 -5.9 7.3 19.5Utilities 3.2 4.2 2.5 6.4 7.2

Service 6.1 7.7 6.8 6.7 8.7Transport, storage, communication 8.6 11.2 7.3 6.3 8.2Trade 5.7 6.8 5.6 6.1 9.8Finance 5.9 9.9 13.6 11.4 12.3Real estate 4.0 5.3 5.3 5.7 6.0Private services 8.1 10.6 7.5 6.9 8.8Government services 2.9 0.5 3.0 4.7 3.3

By expenditure classPersonal consumption 5.3 5.9 4.8 5.5 6.0Government consumption 2.6 1.4 1.6 6.1 10.0Capital formation 3.0 7.2 -8.8 2.7 9.3

Fixed capital 3.8 1.3 -6.6 1.4 9.5Construction -1.2 -0.8 -7.3 5.5 18.0Durable equipment 9.2 3.2 -7.1 -1.8 2.7Breeding stock & orchard development -0.5 0.9 1.1 -0.4 4.6

Changes in stocks 141.7 -444.1 -58.1 69.2 2.3Exports 4.9 15.0 4.8 11.2 3.1Imports 10.8 5.8 2.4 1.9 -5.4Statistical discrepancies 131.2 -53.0 69.9 -93.6 -1530.5

Memorandum itemsGIR (billions of dollars) 17.1 16.2 18.5 23.0 33.8Exchange rate (period average) 54.2 56.0 55.1 51.3 46.1Tax effort (percent of GDP) 12.8 12.4 13.0 14.3 14.0Deficit (percent of GDP) -4.6 -3.8 -2.7 -1.1 -0.1Non-performing loans ratio 14.1 12.7 8.2 6.0 4.5Nominal GDP (billions of pesos) 4316 4872 5438 6033 6651

Sources: National Statistical Coordination Board, Central Bank of the Philippines, Bureau of Treasury

Table 3. National Accounts

88


2003 2004 2005 2006 2007(Percent per annum, average)

All items 3.5 6.0 7.6 6.2 2.8Food, beverages and tobacco 2.2 6.2 6.5 5.5 3.3Clothing 3.4 2.7 3.5 3.0 2.3Housing and repairs 4.3 3.7 4.6 3.9 1.5Fuel, light and water 6.3 7.3 18.1 12.9 3.2Services 5.7 9.3 11.8 8.9 2.8Others 1.9 2.1 3.2 3.0 1.6

Source: National Statistics Office

Table 4. Inflation Rates

89


2003 2004 2005 2006 2007(Billions of pesos)Total liquidity 2,474 2,711 2,887 3,397 3,589

Broad money (M3) 1,725 1,884 2,053 2,511 2,773Narrow money 510 556 605 753 862

FCDU deposits 676 766 762 818 691Other liabilities 73 62 72 68 125

Net domestic assets 1,801 1,985 1,925 2,011 1,932Net domestic credit 2,313 2,533 2,428 2,593 2,714

Public sector 807 956 875 947 930Private sector 1,507 1,577 1,553 1,646 1,784

Net other items -513 -548 -503 -582 -782

Net foreign assets 673 727 961 1,386 1,657Central bank 637 690 846 1,075 1,365Deposit money banks 37 37 115 311 292

(Growth rates)Total liquidity 5.3 9.6 6.5 17.7 5.7

Broad money (M3) 3.3 9.2 9.0 22.3 10.4Narrow money 8.6 9.0 8.7 24.5 14.5

FCDU deposits 7.6 13.2 -0.5 7.3 -15.6Other liabilities 38.6 -14.8 15.8 -5.6 84.5

Net domestic assets 0.1 10.2 -3.0 4.5 -3.9Net domestic credit 4.8 9.5 -4.1 6.8 4.7

Public sector 11.0 18.5 -8.5 8.2 -1.8Private sector 1.8 4.6 -1.5 6.0 8.4

Net other items 25.7 7.0 -8.3 15.7 34.3

Net foreign assets 22.1 7.9 32.2 44.2 19.6Central bank 16.3 8.4 22.6 27.1 27.0Deposit money banks 942.5 0.2 214.5 170.4 -6.1

(Percent of GDP)Total liquidity 57.3 55.7 53.1 56.3 54.0

Broad money (M3) 40.0 38.7 37.8 41.6 41.7Narrow money 11.8 11.4 11.1 12.5 13.0

FCDU deposits 15.7 15.7 14.0 13.6 10.4Other liabilities 1.7 1.3 1.3 1.1 1.9

Net domestic assets 41.7 40.7 35.4 33.3 29.0Net domestic credit 53.6 52.0 44.6 43.0 40.8

Public sector 18.7 19.6 16.1 15.7 14.0Private sector 34.9 32.4 28.6 27.3 26.8

Net other items -11.9 -11.3 -9.2 -9.6 -11.8

Net foreign assets 15.6 14.9 17.7 23.0 24.9Central bank 14.8 14.2 15.6 17.8 20.5Deposit money banks 0.8 0.8 2.1 5.2 4.4

Source: Bangko Sentral ng Pilipinas

Table 5. Monetary Survey

90


91


2003 2004 2005 2006 2007(Percent of GDP)Total revenue 14.8 14.5 15.0 16.2 17.1

Tax revenue 12.8 12.4 13.0 14.3 14.0Bureau of Internal Revenue 9.9 9.7 10.0 10.8 10.7

Net income & profits 5.7 5.7 5.9 6.2 ..Excise tax 1.3 1.2 1.1 1.0 ..Sales taxes & licenses 2.3 2.2 2.2 3.0 ..Other domestic taxes 0.6 0.5 0.6 0.6 ..Travel tax 0.0 0.0 0.0 0.0 ..

Bureau of Customs 2.7 2.6 2.8 3.3 3.2Other offices 0.1 0.2 0.2 0.1 0.1

Nontax revenue 2.0 2.1 2.0 2.0 3.0Bureau of Treasury 1.3 1.3 1.3 1.2 1.0Fees & charges 0.4 0.4 0.3 0.3 0.3Privatization 0.0 0.0 0.0 0.1 1.4CARP 0.0 0.0 0.0 0.0 0.0Others 0.3 0.2 0.2 0.2 0.3Marcos wealth 0.0 0.2 0.1 0.1 0.0

Grants 0.0 0.0 0.0 0.0 0.0 Total expenditure 19.5 18.3 17.7 17.3 17.2

Interest payment 5.2 5.4 5.5 5.1 4.0Total primary expenditure 14.2 13.0 12.2 12.2 13.2

Allotment to LGUs 3.4 3.0 3.0 2.9 2.9Tax expenditures 0.3 0.1 0.2 0.3 0.0Subsidy 0.3 0.3 0.2 0.2 0.4Equity 0.1 0.0 0.0 0.1 0.1Net lending 0.1 0.1 0.0 0.0 0.1Others 10.0 9.5 8.7 8.7 9.7

Personnel services 6.4 5.8 5.4 5.4 5.3MOOE 1.8 1.7 1.6 1.7 1.9

Total capital outlay/1 2.6 2.7 2.4 2.3 2.9

Balance -4.6 -3.8 -2.7 -1.1 -0Primary balance 0.6 1.5 2.8 4.1 3.9

Financing 6.6 5.0 4.3 1.8 1.5Net domestic 3.3 3.3 2.6 -0.2 0.6Net foreign 3.3 1.7 1.7 2.0 0.8

Source: Bureau of Treasury, Department of Budget and Management, World Bank estimates1/ Includes capital allotments to local government units

Table 6. National Government Operations

.1

92


2003 2004 2005 2006 2007H1(Percent of GDP)Consolidated public sector debt 117.6 108.7 93.1 81.9 77.2

Domestic 35.5 35.1 32.1 31.7 31.6Foreign 82.1 73.7 61.0 50.2 45.6

Financial public sector debt 33.9 27.3 19.3 22.0 24.6Domestic 20.1 16.4 11.2 17.0 20.2Foreign 13.8 11.0 8.1 5.0 4.4

Consolidated non-financial public sector debt 100.8 95.2 86.0 73.9 66.8Domestic 32.4 32.5 33.6 28.7 25.5Foreign 68.3 62.7 52.4 45.2 41.3

GOCC debt 38.4 31.9 28.9 24.0 21.0Domestic 6.5 6.4 8.5 6.9 6.0Foreign 32.0 25.5 20.5 17.1 15.0

Consolidated general government debt 71.7 69.2 61.8 53.6 49.3Domestic 32.0 31.1 29.4 25.4 23.0Foreign 39.6 38.1 32.3 28.2 26.3

National government debt 77.7 78.2 71.5 63.8 59.9Domestic 39.5 41.1 39.8 35.7 33.6Foreign 38.3 37.2 31.7 28.1 26.3

Source: Department of Finance

Table 7. Consolidated Public Sector Debt

93


2003 2004 2005 2006 2007 Q1-3

(Percent of GDP)Consolidated public sector balance -5.1 -4.8 -1.9 0.1 0.8Public sector borrowing requirements 6.4 5.9 3.5 1.3 -0.1

National government -4.6 -3.8 -2.8 -1.1 -0.6CB restructuring -0.4 -0.4 -0.3 -0.2 -0.1Monitored GOCCs -1.5 -1.9 -0.5 0.0 0.6OPSF 0.0 0.0 0.0 0.0 0.0Adjustment of net lending and equity to GOCCs 0.1 0.2 0.0 0.0 0.2Other adjustments 0.0 0.0 0.0 0.0 0.0

Other public sector 1.2 1.0 1.6 1.4 0.7SSS/GSIS 0.4 0.5 0.9 0.9 0.6BSP 0.2 0.1 0.1 0.0 -0.5GFIs 0.1 0.1 0.1 0.1 0.1LGUs 0.5 0.3 0.4 0.4 0.4Timing adjustment of interest payments to BSP 0.0 0.1 0.1 0.0 0.0Other adjustments 0.1 -0.1 0.0 -0.1 0.0

Source: Department of Finance

Table 8. Consolidated Public Sector Fiscal Position

94


2003 2004 2005 20062007

Q1-3(Billions of US dollars)Current account balance 0.3 1.6 2.0 5.9 4.2

Trade Balance -5.9 -5.7 -7.8 -6.8 -5.5Exports 35.3 38.8 40.3 46.5 36.6

o/w manufacturing 32.0 35.5 36.9 41.2 32.0o/w electronics 25.0 27.9 28.5 31.1 24.0

Imports 41.2 44.5 48.0 53.3 42.1o/w oil and petroleum products 3.8 4.7 6.3 8.0 6.7o/w electronics parts 15.9 17.4 18.2 20.8 16.2o/w capital 8.8 8.7 8.9 9.2 6.6

Services -2.0 -1.8 -1.3 0.3 0.1Receipts 3.4 4.0 4.5 6.5 5.4Payments 5.4 5.8 5.9 6.1 5.3

Income -0.3 -0.1 -0.3 -0.8 -0.7Receipts 3.3 3.7 3.9 4.4 4.0Payments 3.6 3.8 4.2 5.2 4.7

o/w interest payments 1.3 1.3 1.5 1.6 1.4

Transfers 8.4 9.2 11.4 13.2 10.3Receipts 8.6 9.4 11.7 13.5 10.8Payments 0.2 0.3 0.3 0.3 0.5

Workers' remittances 7.6 8.6 10.7 12.5 9.9

Capital and financial account 0.7 -1.6 2.2 -1.5 3.2

Capital account 0.1 0.0 0.0 0.1 0.0

Financial account 0.7 -1.6 2.2 -1.6 3.1Direct Investment 0.2 0.1 1.7 2.0 -1.2Portfolio Investment 0.6 -1.7 3.5 2.4 2.8Other investment -0.1 0.0 -3.0 -5.9 1.6

Net unclassified items -0.9 -0.3 -1.8 -0.7 -0.7

Balance of payment 0.1 -0.3 2.4 3.8 6.7

Source: Bangko Sentral ng Pilipinas

Table 9. Balance of Payments

95


2003 2004 2005 2006 2007(In thousands)Population 81,172 82,868 84,566 86,264 87,892

Growth rate 2.1 2.0 2.0 1.9

Working age population 51,793 53,144 54,388 55,626 56,569 Growth rate 2.6 2.3 2.3 1.7

Labor force /2 33,387 34,039 34,993 35,787 36,218 Growth rate 2.0 2.8 2.3 1.2Labor force participation rate 64.5 64.1 64.3 64.3 64.0

Employed 31,002 31,634 32,313 32,963 33,560 Employment rate 92.9 92.9 92.3 92.1 92.7Employment growth 2.0 2.1 2.0 1.8

Wage and salaried 15,354 16,472 16,316 16,789 ..Growth rate 7.3 -0.9 2.9 ..Percent of employed 49.5 52.1 50.5 50.9 ..

Own account 11,517 11,614 12,104 12,134 ..Growth rate 0.8 4.2 0.2 ..Percent of employed 37.1 36.7 37.5 36.8 ..

Unpaid family workers 3,765 3,527 3,893 4,040 ..Growth rate -6.3 10.4 3.8 ..Percent of employed 12.1 11.2 12.0 12.3 ..

Underemployed 5,652 5,483 6,785 7,470 6,756 Underemployment rate 18.2 17.3 21.0 22.7 20.1Underemployed growth -3.0 23.8 10.1 -9.6

Unemployed /2 2,385 2,404 2,680 2,825 2,653 Unemployment rate 7.1 7.1 7.7 7.9 7.3Unemployed growth 0.8 11.5 5.4 -6.1

Source: National Statistical Coordination Board, National Statistics Office

1/ Figures are average of quarterly surveys; estimates are based on the 1995 census except for 2007 which is based on the 2000 census2/ New unemployment definition was adopted in 2003 and include all persons who are 15 years old and over as of their last birthday and are reported as (1) without work; and (2) currently available for work; and (3) seeking work or not seeking work due to valid reasons.

Table 10. Labor and Employment Indicators /1

96


1970-75 1980-85 1990-95 2000-07POPULATION Total population, mid-year (millions) 42.0 54.2 68.4 87.9Growth rate (% annual average for period) 2.8 2.4 2.2 1.9Urban population (% of population) 35.6 43.1 54.0 63.4Total fertility rate (births per woman) 5.2 4.5 3.8 3

POVERTY(% of population)National headcount index .. 49.0 40.6 32.9 Urban headcount index .. .. .. .. Rural headcount index .. .. .. ..

INCOMEGNI per capita (US$) 380 530 1,040 1,420Food price index (2000=100) .. 46 80 131

INCOME/CONSUMPTION DISTRIBUTIONGini index .. .. 42.9 44.5Lowest quintile (% of income or consumption) .. .. 6.0 5.4Highest quintile (% of income or consumption) .. .. 49.5 50.6

SOCIAL INDICATORSPublic expenditure Health (% of GDP) .. .. .. 1.4 Social security and welfare (% of GDP) .. .. 0.6 0.9

Net primary school enrollment rate Total 97 96 96.5 93.7 Male 94 97 96.9 92.9 Female 99 96 96.0 94.6

Access to an improved water source(% of population) Total .. .. 87.0 85.0 Urban .. .. 92.0 87.0 Rural .. .. 81.0 82.0

Immunization rate(% of children ages 12-23 months) Measles .. 49 72.0 80.0 DPT .. 59 70.0 79.0Child malnutrition (% under 5 years) 50 33 29.6 28

Life expectancy at birth Total 59 63 67.7 71.0 Male 58 61 65.7 68.9 Female 61 66 69.9 73.2

Mortality Infant (per 1,000 live births) 60 55 35.0 25.0 Under 5 (per 1,000 live births) 90 81 49.0 33.0 Male (per 1,000 population) 376 323 .. 249 Female (per 1,000 population) 314 259 .. 142 Maternal (modeled, per 100,000 live births) .. .. .. 200

Source: World Development Indicators database World Bank

Note: 0 or 0.0 means zero or less than half the unit shown. Net enrollment rate: break in series between 1997 and 1998 due to change from ISCED76 to ISCED97. Immunization: refers to children ages 12-23 months who received vaccinations before one year of age.

Table 11. Social Indicators

Latest single year

.2

97


REFERENCES

Asian Development Bank (2006) Key Indicators 2006.

Balisacan, A. (January 2008) “Poverty Reduction: What We Know and Don’t” in the University

of the Philippines Centennial Lecture Series.

______. (2007) “Local Growth and Poverty Reduction,” in A. Balisacan and H. Hill (eds.). The

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