Report No. 11853-PH Philippines Private Sector Assessment (PSA) (In Three Volumes) Volume II: Main Report July 12, 1994 Industry and Energy Operations Division. Count;v Department East Asia and Pacific Regional Office Private Sector Strategies Division, Corporate Planning Department International Finance Corporation FOR OFFICIAL USE ONLY Dlocument of the Wor!d Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization CURRENCY EQUIVALENTS July II, 1994 - Pesos 26.9 Average 1993 - Pesos 27.1 Average 1992 - Pesos 25.5 Average 1991 - Pcsus 27.5 Average 1990 - Pesos 24.3 Average 1989 - Pesos 21.7 ABBREVIATIONS AND ACRONYMS ADB - A,sian Development Bank APT - Asset Privatization Trust ASEAN - Association of Southeast Asian Nations BER - Basic Economic Report BOI - Board of Investments BGO - Build-Operate-Own BOT - Build-Operate-Transfer BSP - Bangko Sentral ig Pilipinas BTO - Build-Transfer-Operate CAB - Civil Aeronautics Board CB-BOL - Central Bank-Board of Liquidators CBP - Central Bank of the Philippines CCPAP - Coordinating Committee for Philippine Assistance Program CEM - Country Economic Memorandum CIB - Credit Information Bureau CISO - Conference of International Shipowners and Operators CMA - Central Monetary Act CMTS - Cellular Mobile Telephone Service COA - Commission on Audit COP - Comnmittee on Privatization CPCN - Certificate of Public Convenience and Necessity CPSD - Consolidated Public Sector Deficit DBP - Development Bank of the Philippines DENR - Department of Environment and Natural Resources DGES - Directorate General of Electricity Supply (Malaysia) DO - Department Order DOE - Department of Energy DOTC - Department of Transportation and Communications DPWH - Department of Public Works and Highways DST - Documentary Stamp Tax DSWO - Department of Social Welfare and Developnment DLI - Department of Trade and Industry ECO - Expanded Cofinancing Operation }IlS - Environmental Impact Statement T () - Executive Order I PR - Effective Protection Rate l i-i - Export Processing Zone > i I/A - Export Processing Zone Authority I:RB - Energy Regulatory Board l:RL - Economic Recovery Loan FOR OFFICIAL USE ONLY ABBREV'IATIONS AND ACRONYMS (cont.) ESAP - Enrg-v Sector Action Plan ESW - Economic and Sector Work FCDU - Furaign Currency Deposit Unit FDI - Forcign Direct Investment FIA - Foreign Investment Act FIAS - Foreign Inves.nient Advisory Services F1'AA - Financial and Technical Assistance Agreement FSAL - Financial Sector Adjustrnent Loan GATT - General Agreement on Tariffs and Trade GDP - Gross Domestic Product GFI - Government Financial Institution GFS'ME - Guarantee Fund for Small and Medium Scale Enterprises GMCC - Goxernmenc Monitorh.g and Coordinating Committee GMDSS - CGl(>',al aIaritime Distress and Safety System GNP - C(ross National Product GOCC - G(C;o.errrnent-Owned and -Controlled Corporation GRT - Gr - Receipts Tax GSIS - kemrnient Service Insurance System GT - Ci, Tr n IBRD - i:: Litional Bank for Reconstruction and Development IFC - 1:n - :ia-nal Finance Corporation lIvF M - munal Monetary Fund IPO IV al Pubhic Offering IPP ! Pcwaer Producer (Power Sector) IPP I 'nt Priorities Plan ISIC na1 Stardard Identification Code JEXIJM r: \ Im r-liport Bank of Japan KDC h D n lopment Center KLSE - _Kj aLa lumpur Stock Exchange LBP 1 Bnd Bank of the Philippines LGU - L -al Government Unit LIFRB Tfransportation Franchising and Regulatory Board MARINA - V v .2ine Industry Authority MERALCO V' 'Electric Company MICT ': i International Container Terminial MIGA -i: aral Investment Guarantee Agency MKSE - Stock Exchange MMTC N lanila Transit Corporation MSE - Stock Exchange MI'C - ' 'rban Center MWSS hu',Iitan Waterworks and Sewerage Systems MVD'DP - Vehicle Development Program MWN ,.5L att NCSo !. Census and Statistics Office N EA ' nal Electrification Administration NEB ,a;!1 Electricity Board (Malaysia) NED "Iia Economic Development Authority NF F Aal Foo, d Authority NIG i wrnal Government I Ttus Idof .=^;ic !t billion (P billion) touai sector assets (%) Agriculture 1 1.5 15.5 Mining 12 50.7 96.4 Manufacturing: Food processing 17 53.6 87.4 Beverages 3 45.4 98.1 Textiles 1 1.6 45.7 Apparel, leather, footwear 0 0 0 Wood products, fumiture 1 1.4 28.6 Paper products 1 1.2 46.2 Industrial chemicals 3 4.2 30.2 Other chemicals 5 10.3 50.5 Petroleum refining 5 88.3 99.7 Rubber goods 6 12.2 77.7 Plastic, pottery, china 0 0 0 Glass products 1 3.6 55.4 Cement 6 12.1 69.9 Iran & steel 4 32.2 84.5 Nonferrous 0 0.0 0 Fabricated Metal 2 4.8 80 Machinery 3 3.3 76.7 Electrical Machinery 10 15,2 64.6 Transport Equipment 0 6.3 0 Electricity, gas, water 4 262.1 99.1 Construction 3 4.9 41.5 Wholesale, retail 4 29.6 24.2 Transport, communication 15 127.7 94.4 Conununity & other services 6 8.8 51.2 Source: SEC, 2000 Top Corporations in the Philippines, 1991 Edition. 1.26 Small and Medium Scale Enterprises (SMEs). Due to various constraints, medium-scale enterprises have never grown in number or expanded to any significant degree. This is largely due to the fact that once firms reach a certain size, compliance with business taxes and minimum-wage laws is more likely to be enforced. At the same time, they do not enjoy enough economic power to circumvent these costs (as do the large establishments) that cut into profits. The sector includes 115,000 establishments (and 60,000 microfirms not registered in official statistics), employs more than three- fifths of the manufacturing workforce, and generates more than one-fifth of manufacturing value added and of manufacturing fixed assets. Micro and small-scale firms account for about 98 percent of all establishments, but employ only 41 percent of the workforce and create about 14 percent of value added. By contrast, large-scale establishlnen.. (employing more than 200 workers) account for three- - 10- quarters of value added and half of employment in manufacturing, although theN represent only 1 percent of all firms (Table 1.3). 1.27 Of the limited number, most are concentrated around Metro Manila. I ortN percent of the country's industrial firms are located in Metro Manila area and about 23 percent in the nearby central Luzon and southern Tagalog regions.'0 All other regions, including such urbanized growth areas as Cebu, Davao, and Iloilo, accounted for about 40 percent of all SMEs. Larger firms are more concentrated in the Metro Manila area: Over 60 percent of firms with more than 50 employees are in this region. This occurred mainly due to the city's attractiveness as a center of power and therefore essential in terms of lobbying policy makers. Such concentration explains why the rest of the country remained underdeveloped and underscores the need to speed up the Government's plans for decentralization through encouraging the further development of Local Government Units (LGUs). Table 1.3: Employment and Value Added of Manufacturing Establishments (By firm size. 1988) Percentage Percentage V alue Percentage Number of Number of of Total of manuf added of employees firns total employees employment Thou Pesos) manuf. _alue added 0-10 67,147 88.0 234,428 21 8 1.- 3.0 10-99 7,639 10.0 202.910 18 9 51!) 11.4 100-199 680 0.9 97,670 9 1 141.>48 10.9 200 or tnore 822 1.1 542.309 50.2 ' 1'( 74.7 TOTAL 76,288 100.0 1.077,317 100 (1 l3f',M39 8;) 100 0 Source: Census of Establishments, 1988, National Census and Statistics Office (NCSO). Manila 1.28 Large firms provide a significant source of manufacturing jobs in the Philippines. But SMEs take the lead in leather and footwear (80 percent); nonmetal mineral industries. excluding cement (75 percent); metallic and nonelectrical machinery (68 percent), paper. printing. and publishing (63 percent); and chemicals, rubber, and plastics (54 percent). About 57 percent of microenterprise employees were in wholesale and retail trade; 18 percent in manufacturing; 21 percent in personal and financial services; and the rest, about 4 percent, in construction, mining, and transport. Food and beverage retailing represented about one-third of cottage employment. 11 1.29 Government policies have attempted to encourage subcontracting. Promotional policies have included financing programs, such as the Tulong Sa Tao Subcontracting Financing Program, the National Subcontractors' Exchange (SUBCONEX), a registry and placement service for subcontractors. There have also been mandatory local content requirements for cars. motorcycles. trucks. and electronic consumer goods. 0 1983 Census of Establishments. "1 1983 Census. i.30 Subcontracting is usually more important in labor-intensive components or subassembly sectors, such as garments, wood furniture, transport equipment, scientific instruments, electronics, and nonferrous metals. According to 1983 and 1988 census data, subcontracting in the Philippines is most important for small supplier firms, declining as a share of output as establishment size increases. However, medium-size establishmnents subcontract out a larger share of their work in terms of total cost of production than either snaller or larger firms. The sectors that relied most on subcontracting included garments (19 percent of total costs), printing (7 percent), wood funiture (7.8 percent), nonmetal mineral products (6 percent), wood products (5 percent), fabricated metal products (4 percent), and electronics (4 percent). 1.31 Despite the direct and indirect encouragement given to subcontracting in the Philippines over the past 20 years, it still remains limited to a few subsectors. And although it increased between 1983 and 1988, subcontracting accounts for only a small share of the value of manufacturing output - 2.5 percent in 1988. In Japan, by contrast, purchases of subcontracted supplies account for about 70 percent of total manufacturing costs in the automobile sector. 1.32 Agribusiness makes up a key component of private sector activity in the Philippine economy. Broadly defined to include all production, marketing and processing activities linked to food and fiber conmmodities, agribusiness accounted for about 49 percent of GDP in 1993, made up of primary agricultural value added of 23 percent, agro-industry value added of 13 percent and agribusiness services value added of 13 percent. 1.33 The private sector also includes the small, nonplantation farners who produce food staples, coconuts, and other agricultural products. In the 1950s and early 1960s, absentee landlords and land tenancy were major constraints to agricultural diversification and efficient land use, but during the periods of rapid economic growth in the 1970s, these farmers prospered. During the early part of the 1980s, however, when price controls tended to favor the urban consumer, increased production did not translate into increases in farmers' incomes, so their ability and incentives to undertake investments declined. 1.34 The sector also comprises a small number of very large conglomerates coexisting with a large number of small farmers and processors. Total business activities (agricultural and non- agricultural) of the top 50 agribusiness groups accounted for 11 percent of Philippine's GDP in 1989, but it is within the agribusiness sector itself that concentration is most evident. Government policies which date back to the 1960s have enabled six conglomerates to control a large part of the agribusiness sector. In 1990, these six groups controlled about 80 percent of the commercial poultry market, 93 percent of the dairy market, 60 percent of the animal feed market, 100 percent of coconut oil processing, 90 percent of banana exporting, and 100 percent of tobacco processing. Expansion and diversification of business activity over the past two decades (at times on the basis of favorable franchise, licensing or financing arrangements with Government) have seen some of these groups extend their interests beyond the agribusiness sector. I2 1.35 Since 1989, small farmers have been adversely affected by natural disasters, such as droughts, earthquakes, and t:le eruption of Mt. Pinatubo, in addition to the usual seasonal typhoons and floods. Growth remained stagnant owing to limited scope for production increases in grains and poor market prospects for traditional crops like coconuts and soya. Furtherrnore, the incomplete 12 As an exa.mp!. in 1992, a tobacco-brewing-banking conglomerate associated with Fortune Tobacco financed 40 percent of the US$369 million paid by the PR Holdings consortium for controlling shares in Philippine Airlines. - 12 - implementation of agrarian reform has created uncertainty and deterred private investment, and so has not had the desired effect of increasing agricultural output. 1.36 The main reason for relatively slow growth in the agro-business (particularl) processing) sector during the second half of the 1980s has been the limited flow of new investments into the sector. This in turn has resulted mostly from the same series of constraints which have had a negative impact on other aspects of sectoral development (a) the Government's indecisive and slow implementation of the agrarian reform program; (b) poor transport, conmmunications and power infrastructure; (c) high real domestic interest rates and lack of sufficient long-term credit. (d) periodic overvaluation of the domestic currency; (e) trade and investment policies which continue to be biased against agriculture and agro- processing; (f) inadequate market information systems, and (g) law and order problems. Somewhat more specific impediments to effective development of modern agro-processing include irregular (quantity and quality) supply of raw materials, excessive cost of packaging materials (due to high protection on these materials), and high minimum wages compared to successful agro-business centers. 1.37 While agro-industry's share of industrial activity has been declining, it still remains an important part of the Philippine economy. In 1993, agro-industry accounted for 52 percent of manufacturing value added, down from a high of 58 percent in 1986. Food processing dominates agro- industry. Beverage manufacturing, tobacco and wood processing industries are the other main components of agro-industry. Nevertheless, food processing has grown slowly in the Philippines because of limited diversification of its raw material base beyond rice. corn, coconuts, and sugar. Unlike some other countries in the region, the Philippines has largely failed to attract significant investment in processing of non-traditional agricultural crops for domestic consumption as well as for exports. 1.38 The manufacturing sector has not performed strongly during the past decade. Total productivity in manufacturing fell. The share of workers in manufacturing has remained at around 11 percent since 1970 -- comipared to one-fourth to one-third of the total labor force in most other ASEAN countries - while manufacturing's contribution to GDP has similarly remained unchanged at around 25 percent. A recovery in manufacturing output in the second half of the 1980s was accompanied by an improvement in measured productivity. but much of the increase in output was due to increased utilization of existing capacity and not associated with any sustained increase in business fixed investment. The growth of output from manufacturing firms fell to only 0.7 percent in 1993. 1.39 An important indicator of the state of private ownership in the manufacturing sector is the low share of manufacturing workers employed in factories. The 1988 census revealed some 2.2 million employees in manufacturing establishments in the Philippines, but almost two-thirds of these (1.4 million) were employed in the household/unorganized labor se.tor (i.e.. outside of factories). Census data indicate a gradual shift toward factory employment ove; the past three decades, but the current structure of employment is still very much concentrated in smaller and unorganized establishments. The productivity of labor within the smaller establishments is believed to be lower than in the organized factory units, which not only, sustains inefficiencies in the manufacturing sector, but also explains the high share of output comiiing from a relatively small number of large establishments. 1.40 As external financing became difficult, domestic debt was substituted for foreign debt in the last part oth 1980s. Since 1988. as external debt declined as a share of GDP. domestic debt's share rose (Tahhe 1 4). While part of this increase was attributable to the continued budgetary deficits, persistent large losses of the CBP were also a major factor accounting for the accumulation of domestic debt. Over the rneriod 1990-92, the GOP issued a large amount of Treasury securities to finance CBP's - 13 - losses and to assist the CBP in conducting open market operations. Also, the maturity of domestic public debt shortened. In 1983, about one-half of Government securities were in the form of long-term bonds but, by 1992, 95 percent of Government securities were in short-term Treasury bills, mainly 91- day instrunents. This change in maturity reflected concerns over domestic inflation, the continued financing needs of the National Govermnent, and the lack of depth of the domestic financial market. Part of the high real interest rate reflects the risk premium, which should decline over time as the ratio of debt to GDP falls. The burden of domestic debt also grew over time. In 1992, interest expense accounted for six percent of GDP and 31 percent of Government expenditures. The impact of interest rate volatility on the Government budget is very substantial. Therefore, the domestic debt situation in the Philippines requires the GOP's serious attention for a coherent debt management strategy. Table 1.4: Total Debt of the Public Sector, Selected Yeas, 1983-93 (As % of GDP) 1983 1985 1987 1990 1992 1993 Total debt outstanding 62.5 79.2 90.5 75.6 85.9 97.0 Domestic debt 12.5 17.0 22.2 23.0 37.9 49.0 External debt b/ 50.0 62.2 68.3 52.6 48.0 48.0 o/w: NG 20.5 29.3 43.4 46.5 52.5 63.1 Domestic debt 9.2 10.4 20.7 22.3 32.5 43.8 External debt c/ 11.3 18.9 22.7 24.2 20.1 19.2 Central Bank 12.0 23.5 19.6 12.6 15.3 15.7 Domestic Debt 0.0 4.2 0.1 0.2 5.0 5.0 External Debt 12.0 19.3 19.5 12.5 10.3 10.7 Other d/ 30.0 26.5 27.5 16.5 18.1 18.2 a/ As of mid-September. Data includes P 220 billion of Treasury securities issued to the Central Bank. b/ Data for 1992 and 1993 are estimates. c/ IMF. d/ Residual. 1.41 The financial strength of manufacturing firms has, however, irnproved in recent years following depressed earnings during the early to mid-1980s. As shown in Table 1.5, the most significant improvement in the financial condition of the top 1,000 corporations since 1986 has been in the increase in return on equity despite a significant reduction in leverage. These data indicate that, while balance sheet restructuring has improved the overall capability of Philippine corporations to undertake further investment, depressed domestic market activity until last year coupled with a plethora of disincentives to invest in fixed plant and equipment has been a barrier to resumed investment growth (see Chapter II). 1.42 One significant area of adjustment which occurred within the manufacturing sector over the past two decades has been in the composition of exports. In the early 1970s, about 70 percent of - 14 - Philippine mnanufactured exports came from the food sector but, commencing in the mid-1970s, the Philippines, like many other developing countries, began to shift more into "nontraditional" exports, mostly garments and electrical goods (mainly semiconductor assembly), with low domestic value added. By the mid-1980s, semniconductors accounted for 26 percent and garrnents 15 percent of Philippine manufactured exports. Now, about three product categories account for a significant share of total exports. Nevertheless, the extent of export diversification achieved by Philippine manufactures has been far less than that of successful exporters like Indonesia, Malaysia and Thailand. This is attributable to low investment and the problems of achieving appreciable cost efficiency. The collapse of Philippine footwear exports during the 1980s (at a time when Indonesia, China, and Thailand were increasing their footwear market share) illustrates the extent of this problem. Table 1.5: Financial Performance of the Manufacturing Sector, 1979-92 Net profit Retum on Return on margin assets equity Turnover Leverage Year (in %) (in %) (in %) (ratio) (ratio) 1979 3.00 3.15 9.97 1.05 2.17 1980 1.51 1.60 5.61 1.06 2.51 1981 1.12 1.22 3.87 1.09 2.17 1982 n. a. -0.12 -0.39 n.a. 2.16 1983 n.a. 0.63 2.16 n.a. 2.43 1984 1.26 1.56 6.14 1.24 2.94 1985 0.47 0.59 2.35 1.26 2.98 1986 2.70 3.09 9.84 1.15 2.18 1987 4.07 4.03 13.76 0.99 2.41 1988 5.13 5.73 17.20 1.12 2.00 1989 4.95 5.57 16.03 1.13 1.88 1990 4.44 5.11 14.45 1.15 1.83 1991 4,7 6.0 15.6 1.3 1.0 1992 5.9 6.9 14.5 1.2 1.2 Notes: Net profit margin is after-tax income as percent of gross revenues, Return on assets is after-tax income as percent of total assets. Retum on equity is after-tax income as percent of net worth. Tumover is ratio of net sales to total assets. Leverage is ratio of total liabilities to net worth. Sources: Business Day. 1000 ToD Corporations, 1981, 1982; Philippines SEC, ToD 1000 CorporationS, 1985, 1986, 1990; Mahal Kong Philippines Foundation, Inc. Philiopines' Best 1000 Corporations, 1989; World Bank reports. 1.43 Other factors have also limited Philippine exports. First, manufactured exports did not develop backward linkages and have resulted in a high import content of exports. Second, manufacturing is poorly diversified. The continuing overreliance on two products, garments and electronics, makes exports vulnerable to changes in the international markets. Garments are subject to international quotas and electronics are affected by rapidly evolving technology. Also, Philippine export markets are poorly diversified and this might limit future growth. The country's intraregional trade has been the lowest in Southeast Asia, and 75 percent of its exports go to only three industrial markets: the United States (37 percent), Japan (20 percent), and the European Community (17 - 15 - percent). Most Southeast Asian countries have increased their intraregional trade. For instance, 42 percent of Singapore's exports went to Southeast Asian countries excluding Japan, compared with 7.5 percent for the Philippines in 1991. 1.44 "Nontraditional" Exporters. Of the 330 exporters among the top 1,000 companies, 90 percent are controlled by either conglomerates or multinationals. Another group of domestic companies export both labor-intensive ready-to-wear garments and capital-intensive goods. The owners of some of these firms tend to be ethnic Filipinos, and the managers are relatively young, many with degrees from foreign universities. Some are Chinese-Filipinos. There are also many small handicraft exporters, with an annual export volume of about US$100 million. The financing for non-traditional exporters comes from banks and other formal sources, as well as from savings and extended family relationships. Since these firms have to survive in highly competitive, fast-changing international markets, their main impediments to growth - besides the periodic overvaluation of the currency and the overall anti-export bias of the trade and investment regime - are operational problems such as industrial bottlenecks (in particular power blackouts during 1991-93), the still high cost of finance and a slow-moving government bureaucracy. 1.45 Similar to the situation in Indonesia, there are few inter-firm linkages within the industrial sector in the Philippines, and the linkages that exist between exporting firms and the rest of the economy remain limited. Firms that were established within Export Processing Zones (EPZs) or under bonded warehouse arrangements have tended to focus on export markets exclusively and, as a result, few mixed sales businesses have developed. In 1988, of the top 200 exporters (who provided over two- thirds of export sales), virtually all were 100 percent for export." Since the trade policy framework simultaneously affords protection against imports and, at the same time, provides export incentives such as duty exemptions, it resulted in a dualism within industry whereby a number of export-oriented firms coexist with less efficient domestic-oriented firms. The quality and cost of components and services provided by the domestic-oriented firms are in many cases not up to international standards and, for this reason, exporters make relatively few purchases from domestic firms. As a result, the expansion that has taken place amona exporting firms over the past decade has not had a significant impact on the business opportunities for other firmns. 1.46 While the range of goods being produced in the Philippines gradually expanded during the 1960s (such that textiles, paper, cement, metal products and chemicals joined the traditional industries of wood processing, food and beverages), there has been little change in the overall structure of manufacturing since then (Table 1.6). Even with the reform efforts started in the 1980s, there is little evidence of creation of significant new lines of business - unusual for a country located within the dynamic growth region of Southeast Asia. For example, an attempt to introduce upstream petrochemical capabilities into the Philippines was abandoned in 1991 due to legal entanglements. The circumstances surrounding this legal challenge have been cited by some business groups as one factor contributing to the overall caution of foreign business investors. Although the entry of new firms started accelerating toward the end of 1993, the static structure of industrial output until recently indicates that the incentives structure and enabling environment within the Philippines has not been as conducive to the growth of new enterprises or lines of business as took place in other successful Southeast Asian countries. This is the result of several factors, including macroeconomic problems, continuing anti-export biasZ the trade and investment regime, crowding out of private investment by large public sector horrowigs and, more recently, severe infrastructure limitations. '3 In addition. ot tle top 50 exporters, 20 were majority foreign-owned. - 16 - 1.47 The Philippine private sector is burdened with cost disadvantages (due to infrastructure inadequacies, high cost of power, labor costs) which make it difficult for them to switch easily from domestic sales to export narkets. Development of new export capabilities will depend on timely removal of the anti-export bias of the trade and investment regime. As discussed in Chapter II, a more concerted export-oriented effort on trade and competition policies to lower the costs of doing business in the Philippines will be needed to stimulate investment-led growth by private business, and current Government plans are in this direction. Table 1.6: Distribution of Value-Added Across Manufacturing Subsectors, 1967-93 (share in %) ISIC codes Manufacturing subsector Average Average Average Average 1967-70 t975-80 1985-91 1992-93 311/12 Food manufactures 46.44 43.91 41.50 37.0 313 Beverage manufactures 2.01 2.29 4.22 3.9 314 Tobacco manufactures 2.37 3.16 3.01 2.8 321 Textile manufactures 5.27 5.19 3.89 3.2 322/4 Wearing apparel and footwear 3.92 4.02 4.89 6.2 323 Leather and leather products 0.17 0.12 0.08 0.08 331 Wood and cork products 4.46 3.71 2.12 1.9 332 Furniture and fixtures 1.93 1.49 1.27 1.2 341 Paper and paper products 0.87 1.09 1.12 1.03 342 Printing and publishing 1.18 1.35 1.37 1.6 351/2 Chemicals and chemical products 3.65 7.04 6.44 6.26 353/4 Petroleum and coal products 11.44 10.86 13.83 17.78 355 Rubber products 1.75 1.81 1.45 1.38 356/61-3/69 Non-metallic mineral products 3.07 2.79 2.29 2.74 371/2 Pasic metal products 1.15 1.55 2.95 2.24 381 Fabricated metal products 2.72 2.24 2.19 2.42 382 Machinery except electrical 1.53 1.25 1.04 1.24 383 Electrical machinery 1.70 1.77 3.66 4.49 384 Transport equipment 3.21 3.24 0.83 1.22 385/6/980 Miscellaneous manufactures 1.17 1.11 1.84 1.86 All Manufacturing 100.00 100.00 100.00 100.oo Notes: Derived from constant price value added. Sources: National Income Accounts, NSCB. 1.48 One important area in which growth has taken place in recent years has been in the equity market as more firms have sought to expand through public listings. The number of listed firms has increased from 130 in 1986 to 186 by mid-1994, and this increase has been accompanied by phenomenal growth in market capitalization from US$2 billion to US$39 billion. The stock market grew by 130 percent in US dollar terms, becoming the best performing stock exchange in 1993. In 1993, initial public offerings (IPOs) of 13 companies reached P 13.7 billion. For the first quarter of 1994, there are already 21 applicants for IPOs filed with the SEC. While the size of the Philippine equity market is still small when compared to the overall domestic economy, as well as to other emerging markets (see section on the capital markets), further growth potential is large. In 1993, the stock market grew by 154 percent, and large family-owned enterprises have started to go public. Commercial and industrial firms now account for more than 90 percent of the total market capitalization compared to 10 percent six years ago. Recent developments in the nurnber c. new listings and total capital raised are shown in Table 1.7. Table 1.7: New Equity Listing and Total Capital Raised, 1989-93 (USS milons) 1989 1990 1991 1992 1993 Number of new listings 7 9 9 9 13 Total capital raised 103 351 447 408 493 (US$ millions) Source: Manila Stock Exchange. 1.49 Compared with those of its neighbors and countries of a similar size, the Philippine market is small. Also, like many other equity markets in the developing world, the Philippine market is very narrowly based: daily trading value is approximately US$13.5 million, but 85 percent of business by value is accounted for by transactions in only five stocks. 1.50 Most firms are privately owned and want to keep tight corporate control. They are therefore reluctant to provide the information required for registering securities or disclosing material financial information. As a result, they tend to shy away from equity financing. In addition, the beneficial tax treatment of debt and the high real domestic interest rates on goverrament securities have meant that equity offerings are mostly unattractive to investors. With high real domestic interest rates, Philippine firms have generally found it too costly to meet the investor expectations of high returns. 1.51 As a result, the equity market is underdeveloped in terms of both supply and demand (see Chapter II). On the supply side, only a small number of high-grade securities are offered by a small group of listed companies. On the demand side, only a narrow base of investors is actively involved in the stock market. Their limited demand for stocks leads to depressed prices, which in turn limits the incentive for issuers to make public offerings. Although there was a large inflowv of foreign funds into domestic equities in 1993. the size of the market is still small compared to other emerging markets (para. 1.48). Moreover, small individual investors have a limited opportunity to participate in primary offerings of popular shares because stock exchange member firms distribute shares among themselves and to preferred clients. 1.52 Recent growth in the volume of funds raised in the Philippine equity market has maue it a more important source of investment financing than previously. Nevertheless, the amounts raised are not large, neither in relation to alternative sources of company finance nor relative to the overall size of private sector investment."4 One reason is that privatization initiatives, which have been used in other countries to stimulate equity market growth, have for the most part bypassed the stock exchanges in the Philippines. The Government will time further privatization of PNB to avoid adversely affecting its share price. The main exception to this was the listing of l 1.8 billion of shares in Philippine National '' In 1991, tta <:apttal raised on the equities market was equivalent to 6.8 percent of total investment expenditure by the private sector - 18 - Bank (PNB) in 1989. This underscores the need to expedite the introduction of capital market reformns as discussed in Chapter II of the report. C. lhe Effect d Gof w E i ad Public Debt on Private Busin 1.53 The public sector's direct involvement in the economy increased significantly between 1972 and 1986, with the number of government-owned or controlled corporations (GOCCs) increasing from 75 in 1970 to 301 in 1986. The new GOCCs included corporations nationalized in the early years of martial law, those established by government agencies or subsidiaries created by existing GOCCs, others confiscated from political opponents of the president (sequestered assets), troubled corporations foreclosed by Government financial institutions and those created to advance the political or personal objectives of public officials. 1.54 These GOCCs were engaged in a various activities. More than a third were in finance, housing, and services, and most of the gross value added was in utilities and finance. Their contribution to the overall public sector deficit grew from eight percent in 1975 to 22.5 percent in 1984. Without this burden, the public sector would have had a surplus during this period.'5 1.55 Also during this period, state-owned banks acquired holdings in a large number of corporations through default. The Development Bank of the Philippines (DBP) and the Philippine National Bank (PNB) becarne saddled with nonperforming assets, particularly from 1981 to 1983, due mainly to investments by unethical businessmen and the banks' own faulty credit decisions, often dictated by politics. For example, investments that featured overpriced assets were common and created bloated liabilities and a subsequent loss of equity for these banks. The credit compression exposed financial weaknesses in undercapitalized firms. To prevent large sca'e failures, the Government set up a rehabilitation fund to help financially troubled companies, but this did not prevent many defaults and only increased the DBP's and PNB's nonperforming assets further. By 1986, there were an estimated 399 nonperforming assets on the books of state-owned banks, with an estimated book value of P 132 billion. This figure excludes smaller companies, those with book values of less than P 10 million, whose recoverable value has been estimated at P 24 billion. Thus, the DBP and PNB were in serious technical default whca the new administration took power in 1986. 1.56 Virtually all of the provision of infrastructure services (with the main exception of PLDT - telecommunications - and MERALCO - electricity distribution - both of which are private) in the Philippines has in recent decades been publicly owned and operated. Because of this, and the fiscal crisis that accompanied the economic problemns of the 1980s, there has been a significant reduction in public spending on infrastructure. The public investment program, which peaked at nearly 11 percent of GDP in 1981 (five percent for infrastructure, the rest for capital transfers to other government corporations), had by 1993 fallen to six percent of GDP (with infrastructure accounting for just over half of the total). During 1988-92, public infrastructure spending has averaged at less than two percent of GDP, far below the Indonesian performance of around five percent. In 1993, even including PL.DT's and MERALCO's total capital outlays, Philippine infrastructure expenditures were about three percent of GDP. In recent years, the Government has announced a number of infrastructure spending targets, but a number of problems, including revenue shortfalls, have prevented it from implementing even two-thirds of the planned programs. The Government depends on foreign borrowing (ODA) for Is Manasan and Buenaventura (1985). - 19 the majority (77 percent in 1992) of its infrastructure investment programn, but the record of implementation has been poor. 1.57 The expansion of the Government sector in the 1970s led to growth in external borrowings. Over the past decade, these public borrowings have been from official aid agencies. The stock of long-term external debt stood at USS8.8 billion in 1980, of which some 72 percent was public or publicly guaranteed. Over the following decade, public long-term external debt grew rapidly, reaching US$29.1 billion by 1993, with official (multilateral and bilateral) agencies being the principal debt suppliers. Private external debt, on the other hand, declined rapidly after the onset of the external debt crisis in 1983. By 1993, private long-term external debt had declined to US$1 1. billion, or just 3.6 percent of total long-term external Philippine debt. 1.58 The accumulation of public external debt during the 1980s was more rapid than growth in the overall economy and has been one of the major contributing factors to the continuing adverse perception of Philippine country risk. In 1982, just prior to the onset of the external debt crisis, the long-term debt-to-GDP ratio stood at 33 percent, but this ratio climbed rapidly to reach 74 percent in 1987 before declining. By end-1993, the long-term debt-to-GDP ratio was 62 percent, still well above the pre-debt crisis level. The external debt service burden followed a similar pattern, partly because of a iarge-shift toward variable interest rate debt (although interest rates have fallen since the early 1980s) and an increasing volume of official debt obtained on concessional terms. The ratio of long-term debt service to exports increased from 26 percent in 1983 to 30 percent in 1987, but then contracted to 20 percent at the end of 1993. The reduction in debt service burden has improved international perceptions of Philippine country risk. 1.59 The management of the Philippines' external debt remains a critical factor in mobilizing finance for efficient private sector development. Reducing the debt-to-GDP ratio will be important to securing an enhanced perception of Philippine creditworthiness, which ultimately means reduced internal debt borrowing costs for private investors as well as better access to external equity and securities markets. Controlling the growth of public and publicly-guaranteed debt will remain a priority issue if private external borrowing is not to be further crowded out (see Chapter II). 1.60 The public sector has also been a major participant in domestic capital markets. The issuance of domestic government securities accelerated in the second half of the 1980s as budget deficits persisted and domestic debt substituted for external debt. Government securities outstanding at the end of 1985 were equivalent to US$4.1 billion, but by 1993 these had expanded to US$25.2 billion, with the private sector and semi-government entities accounting for most of this growth. The holding of Government securities by private firms and individuals has been at the expense of investment in productive capital and other financial and nonfinancial assets. 1.61 Deposit money banks (a major source of finance to the domestic economy) also shifted a significant share of their domestic credit toward the public sector during the past decade. In the early 1980s, the deposit money banks allocated 80 to 85 percent of their credits to private sector borrowers, but with the onset of the external debt crisis this share declined (to a low of 68 percent in 1986) and has remained at around 70 to 73 percent in recent years. By March 1994, these banks provided credit to the public stctor of about US$3.4 billion equivalent in domestic currency. For the whole banking sector, the increased portfolio allocationL toward government paper has followed a .imilar pattem. Between 1987 and March 1994, the banking sector's holdings of securities (mainly goverrunent) rose from US$1.9 billion to US$4.9 billion. - 20 - 1.62 Part of the Government's extensive borrowing requirements resulted from financing losses incurred by public enterprises. Most stemmed from uneconomic investments and imprudent levels of financial leverage. In 1986, at the end of the Marcos administration, there were some 301 GOCCs, the transfers to which accounted for one-fourth of consolidated public expenditures. The transfers were made to companies such as Manila Electric Company (MERALCO) and Philippine Airlines (PAL) which had been confiscated by the Marcos administration for political reasons and buy-outs (such as that of ESSO) for nationalization objectives. In addition, there were the "nonperforming assets" of Government financial institutions (GFIs) which had previously made "behest loans"" to favored private business groups. Fourteen of the larger public corporations have been singled out for closer monitoring by the Government Monitoring and Coordinating Committee (GMCC), and later by the Department of Finance as part of monitoring the reduction in the consolidated public sector deficit." The overall performance of these companies has shown little improvement since the mid-1980s (see Table 1.8), and because their overall impact on the fiscal balance is still a concern, all are currently being assessed for privatization by the Government. The overall deficit of the 14 monitored nonfinancial corporations is projected to decline to 0.8 percent of GNP during 1994 from 1.7 percent in 1993. All of this reduction, however, is attributable to sales of companies by the APT and the privatization of PETRON. The deficit of other public enterprises, in particular NPC. is expected to remain unchanged. As a result, the aggregate deficit would rise in 1995 to 1.2 percent of GNP, and then stabilize at this level. To achieve even these targets. the Government plans to undertake a substantial restructuring of NPC (see Chapter II). "Table I.8: Financial Situation and Financing Requirements of Monitored Government CorporationLs, 1988-93 (Million Pesos) 1988 1989 1990 1991 1992 1993 Overall surplus (+) deficit (-) a/ 1,300 -7,541 -21,327 -10,767 -12,956 -30,144 Government subsidies 1,644 4,546 2.190 3,369 2,296 4,537 Government equity -2.943 2,078 3,274 2,101 610 5,640 Government lending 4,063 2,174 2,181 4,564 1,330 1,549 Domestic bank credits -1,224 2,236 7,456 -3,668 3,730 1,986 Other domestic financing 34 -6,094 -47 4,240 -1,726 -5,427 a/ Net of subsidies. Source: GOCCs. 16 Loans giveln tm Marcos' "cronies" with political motives. 1 7 Thlest: T i. h11\pkrt Processing Zone Authority. (ii) Local Water Utilities Administration. (iii) Light Rail Transit Audiolrn , Meiro Manila Transit Corporation, (v) Metropolitan Waterworks and Sewerage Systems (MWSS), (vi) Nat. l1l I; i,ipment Corporation (a holding company), (vii) National Electrification Administration (NEA), (viii) Nationa! Fr-d Authority (NFA), (ix) National Housing Administration, (x) National Irrigation Administration (NIA), (xi} Natwnid Power Corporation (NPC), (xii) Philippine National Oil Company (PNOC), (xiii) Philippine National Railway,. and (xiv) Philippine Port Authority. - 21 - 1.63 Privatization was undertaken in 1986 for economic and political reasons. The rmain economic objective was to reduce the financial burden imposed by GOCCs and nonperforming assets on the public sector finances, and partly to raise the efficiency of the domestic economv. The political objective was to reverse the politically motivated nationalization of particular indust ies in the 1970s. Initial efforts at privatization started prior to 1986, when DBP was forced to dispose of its nonperforming assets. At about the same time, in view of increasing financial difficulties, the Government began to divest itself of some of the GOCCs. 1.64 The previous administration stated its policy on privatization in Proclamation 50 in 1986. The Proclamation outlined the Goverrunent's intention to dispose of GOCCs and nonperforming asse.s to reduce the size of the Governmnent corporate sector (as well as to remove the poor legacy of the p;evious administration), financially rehabilitate PNB and DBP, reduce the consolidated public sector deficit, increase government revenues through rehabilitation of GOCCs and nonperforming assets, and fund the Comprehensive Agrarian Reform Program (CARP) from the expected sale proceeds of privatization of GOCCs. 1.65 The Proclamation also defined the institutional framework for privatization. It led to the creation of the Committee on Privatization (COP) tasked to oversee the Philippine privatization program, setting objectives and policies concerning the divestment of public assets, and the Asset Privatization Trust (APT) as the main implementing body. 1.66 The Prcclamation was later amended by RA 7181, which extended the life of the COP and APT from December 8, 1991 to August 31, 1992, and added certain provisions on the conduct of privatization. The new law mandated that there shall be no dislocation of labor outside boundaries established by existing laws or collective bargaining agreements; assets shall not revert back to previous owners who were found, through appropriate legal procedures, to have mismanaged or diverted resources from the assets. resulting in loss and/or in bankruptcy; at least 10 percent of the assets, in corporate form, shall first be offered to small domestic investors; and a loss recovery provision shall be a condition of sale for any assets below the transfer price. The law also subjected the sale of strategic industries to presidential approval and spelled out the role of the National Economic Development Authority (NEDA) in determining what constitutes a strategic industry. 1.67 Republic Act No. 7661 further extended the life of the COP and APT until June 30, 1995. The same law confirmed the same conditions in the privatization of non-performing assets in R.A. 7181. The initial privatization program focused mostly on the reduction of nonperforming assets and less on the sale of GOCCs. As of December 1993, the APT and the other disposition entities had sold or liquidated 327 out of 419 transferred assets (nonperforming assets transferred to the APT for disposition) and 81 out of 130 GOCCs targeted for disposition. Total revenues amounted to P 77.8 billion, of which P 38.1 billion came from transferred assets, more than originally estimated. 1.68 COP and APT reports on unsold GOCCs and transferred assets define the future direction of privatization. There are still 92 nonperforming assets, and 49 GOCCs that remain to be privatized. The other 179 GOCCs have been slated for retention, abolition and consolidation. In December 1992, President Ramos signed Executive Order 37 which seeks to take the privatization effort further by speeding up the sale of the remaining GOCCs that have been scheduled for disposition and ordering a review of whethL! ilA.re is a need to retain the remaining 81 GOCCs. In 1993, President Ramos identified seven awi: w nal GOCCs for privatization. A discussion of the remaining GOCCs can help to illustrate some oi the issues that will have to be addressed. - 22 - 1.69 The remaining GOCCs have a book value of P 28.3 billion. Four GOCCs that carry substantial foreign debt account for the largest portion. (Table 1.9 shows companies that are targeted to be privatized in the near term.) Two of these, the Philippine Associated Smelting and Refining Corporation (PASAR) and the Philippine Phosphate Fertilizer Corporation (PHILPHOS), were part of the Government's attempt to pursue industrialization by investing in proiects beyond the means or below the average cost of capital used by the private sector. The Semirara Coa; Corporation was created in this way as part of the country's energy development program. Semirara was intended to produce low- grade coal from the country's largest known reserves for the National Power Corporation's Calaca power plant, but the coal turned out to be unsuitable. Another GOCC, the Metro Manila Transit Corporation, was created by the Metro Manila Commission to ease public transportation shortages in metropolitan Manila. Sales of these four GOCCs have been hampered by large foreign debt, and Semirara is barely operating because existing coal users require coal of a higher grade than it produces. Its excessive leverage reduces the financial viability of the mine. 1.70 Legal impediments, primarily injunctions against the sale of assets initiated by former owners, have prevented the sale of four other GOCCs. with a book value of P 5.9 billion, and of about 20 transferred assets. Although Proclamation 50 specifies that "no court of administrative agency shall issue any restraining order or injunction against the Trust in connection with the acquisition, sale. or disposition of assets transferred to it .., privatization undertaken by "disposition entities" does not have the same protection. Table 1.9: Companiies to be Privatized in the Near Term 1. National Steel Corporation 2. Calinog-Lambunao Sugar Mill 3. Cellophil Resources 4. Manila Gas 5. Nonoc Mining and Industrial Corp. 6. North Davao Mining Corp. 7. Land Oil Resources Source: APT. 1.71 Much progress has been made in disposing of GOCCs and transferred assets, but more needs to be done for privatization to achieve its full potential. Table . 10 shows the status of remaining GOCCs targeted for privatization as of 1993. - 23 - Table I.10: Status of Remaining GOCCs Targeted for Privatizadon Nwnber Book value of assets Percentage Status of GOCCs (Millions of Pesos) of total With substantial foreign debt 4 12,559.6 44.4 With legal impediments 4 5,907.0 20.9 For dissolution 6 4,783.3 16.4 For marketing action 22 2,791.7 9.8 Ongoing valuation/private study I 1 1,725.4 6.1 Awaiting Commission on Audit 4 530.9 1.9 (COA) clearance 1Total 51 28,298.0 100.0 Source: COP, APT. 1.72 The implementing guidelines to E.O. 37 contain a broad definition of "privatization", encompassing initiatives other than sale to the private sector: "Privatization shall refer to the transfer of government corporations, activities or assets of Government to total, majority or minority private ownership or to private control. It includes sale of shares and physical assets, leasing of assets, management, maintenance and other service contracts or build-operate-transfer (BOT) schemes and other similar arrangements under Republic Act No. 6957." 1.73 This definition of privatization offers considerable flexibility to the agencies responsible for the shares and assets of individual GOCCs. During 1993, the implementing guidelines require that privatization action plans for the 48 GOCCs already identified for privatization by the President be presented to the Committee on Privatization (COP) for approval. Included in this group of companies are the Manila Hotel, PASAR and parts of PNOC. In December 1993, 40 percent of the total shares of PETRON were bought by the Aramco Corporation of Saudi Arabia through a bidding process. Depending on the financial attractiveness of the assets that are brought forward, the divestiture strategy should target increased use of public offerings to develop capital markets and disburse public ownership of the companies being privatized. The IPO of PETRON, covering 20 percent of the firm's shares, planned for July 1994 is a step in the right direction. Another form of encouraging wide dispersion in ownership of public assets for disposition is that approved by the COP for the Metro Manila Transit Corp. (MMTC), which is planned to have a negotiated sale with private organization/cooperative majority owned by former MMTC workers. 1.74 The implement-ng guidelines also required that the remaining 81 public enterprises and assets be assessed for retention or privatization and, upon approval by the President, a privatization action plan be dra'. n up for each corporation by the appointed disposition authority. In May 1993, the National Development Company took this process one step further with advertisements notifying privatization opportunities for the National Steel Corporation, PASAR, PHILPHOS, NDC-Guthrie - 24 - Plantations, Refractories Corporation of the Philippines, SEMIRARA Coal Corporation, and National Shipping Corporation. 1.75 From 1987 to March 31, 1994, the Philippine Government's privatization program generated P 98 billion cumulative revenues as follows: * P 41 billion from the sale of transferred assets (TAs); * P 42 billion from the privatization of GOCCs; and * P 15 billion the sale of other assets. This includes the sale of the following big-ticket GOCCs: Table 1.11: Key Privatizations in 1994 Proceeds from Sale Degree of Buyer (P Billions) Privatization (% of total ownership) l Petron Corporation 14.8 40 Saudi Arabian Oil Co. Philippine Airlines, Inc. 10.7 67 PR Holdings, Inc. Philippine National Bank 4.6 43 Various Interbank 2.2 100 DBP Consortium Philseco 2.1 87 Philyards Holdings, Inc. Narina Properties 1.8 100 Tan Yu Group of Cos. Phil. Plaza Holdings, Inc. 1.5 100 Allied Kajima Union Bank of the Philippines 1.3 87 Aboitz, Insular, etc. Source: COP. 1.76 Some of the most significant privatization transactions during January to March 1994 were the sale of the following (a) 38.7 million government-owned shares in Meralco to SSS and GSIS for P 13.6 billion; (b) 72 percent government-owned shares in PICOP, the only tirnber and paper product company in the Philippines, to Valderrama Consortium for P 2.4 billion; (c) 87 percent of the sales of stock of Philseco to Philyards Holdings, Inc. for iP 2.1 billion; and (d) 19.4 billion Government-owned shares in Oriental Petroleum Minerals Corporation for P 1.5 billion to an international investor. 1.77 Future privatization activities include the additional 20 percent IPO of the shares of stocks on Petron Corporation and the sale of Government-owned shares in National Steel Corporation. 1.78 During 1994-96, the Government expects to receive about l 78 billion (4.5 percent of GNP) in privatization receipts. The Government plans to reduce domestic debt with part of the expected revenues. 1.79 Fht Government corporations which are to be retained under public control will nevertheless be required to identify specific assets or activities which may be more efficiently handled by the private sector, and to carry out asset sales, leasing, management, service or other arrangements (including BOTs) which will enable private sector efficiency gains to be effectively utilized. These privatization initiatives are potentially important to the development of the Philippines private sector. - 25 - H. REMANING CONSTRA1INTS TO PRIVATE SECTOR DEVELOPMENT A. An Overview 2. 1 A number of the constraints to private sector development that were identified in Chapter I have been addressed as part of Government reform initiatives in recent years. Chapter 11 reviews these initiatives and highlights the remaining obstacles to efficient private sector development and the unfinished reform agenda. The progress achieved in improving the business climate has vastly improvcd in the last two years: Success in external debt management and macroeconomic stabilitv have enabled the Philippines to move toward voluntary external financing; however, there is still an unfinished agenda of reforms One of the report's main findings is that the private sector needs to be reformed at the sarne time that public sector management is strengthened (especially the regulatory agencies). to improve efficiency. Until recently, the main obstacles were largely a heavy external debt, macroeconomic disequilibria, a restrictive foreign exchange regime, and complete isolation from international capital markets. Changes in these areas will help promote more efficient and more dynamic business investment in the coming years, but completing the unfinished agenda of reform initiatives is key The focus of private sector development for the future should promote greater openness; this should be followed with institutional reforms designed to consolidate the changes, to improve efficiency, and to establish an adequate framework for sustained vrowth in efficient privatc 3ector investment and production. 2.2 An enterprise survey was conducted on small- and medium-scale firms in August: September 1992. The survey covered more than 100 firmns in textiles, food processing. software, and wooden furniture in metropolitan Manila. Cebu, and Mtindanao. Entrepreneurs pointed to macroeconomic and infrastructure constraints as the most handicapping (Figure 11 1 ). They singled out high real domestic interest rates and the uncertainty of the macroeconomic environment (especially the periodic overvaluation of the exchange rate), despite ongoing policy reforms, as well as policy uncertainty and discretional use of regulations. In infrastructure, the major impediments were electric power, transport. and telecommunications, problems that reflect years of neglect, policy distortions, and strategic conduct by monopolies and oligopolies (as in telecommunications and transport, respectively). The tax burden, legal regulations, and compliance costs were not identified as major obstacles, indicating that many firms are able to ciruumvent formal rules and practices. Also, security issues were not cited as a key concem because respondents were selected from among enterprises owned by Philippine nationals. Mission findings indicate that security is an important concern to some foreign investors. Firms located in Cebu ranked all constraints much more severely than did firms in Manila or Davao, perhaps because the firms in Cebu are more export-oriented than the respondents in other regions. 2.3 Respondents were concerned that policies were frequently changed and did not provide a sense of stability. Also. although they ranked regulations as less important constraints, they simultaneously complained of bureaucratic red tape. This seeming contradiction could be explained by the fact that firms have found ways to evade the burdens of regulations by participating in informal systems of rules and practices. If this is indeed the case, then the low constraint scores for regulation indicate that the level of constraint imposed by the regulatory regime is mitigated by the ability of some firms to circumvent the formal system. Evidence from other developing countries suggests that, once . .... . . . . Is Thc jeer , !i cxamnple Because of the long and tedious approval process and the paperwork involved. many ot e.: .i:. Aorked Aithout a license, although chey were willing to pay the appropriate license fees and various required dues. But when the registration process was simplified. many of them registered and paid the approl-ate rI;' tees. This could indicate that front-line gomerrnmenic agencies do not seem to be client-oriented, but raliet ulnrO l- eticd to saitst audit procedures. - 26 - EF r.ul1: Summary Constraints to Operatos and Growth (Average for AJI rifis) Tax regulations .... . Labor regulations . Import regulations.ML Admin. of Import regulations . . Cost of licensing .... . ........______________ Number of licenses .. Trade/union restictons CQettig producdon llcenses Export regulations Investment regulations Price contols: Inputs _______________ Price controls: cutputs 2 3 Ranking z Small Mecium _,Large M Allfrms NOW Raati ma.d ht b_tn Od frvrn tre hill t 4 raNte m fIt t?e inred of OWOuu aoma. - 27 - macroeconomic and policy instability issues are addressed, impediments related to bureaucratic red tape are likely to figure more prominently. As the discussion below also emphasizes, the regulatory burdens are not costless and the reform of arrangements which govern business-to-business and business-to- government transactions will be a priority in coming years. Given the recent fall in domestic inflation and interest rates, and some nominal devaluation that has taken place recently, infrastructure constraints are now likely to emerge as binding constraints to private sector development in the short-term. 2.4 One of the major concerns of local and foreign business groups seeking to expand output and improve efficiency was the acute power shortages that adversely affected activities in most of the country, but especially in Luzon and Mindanao. According to a study prepared by Baring Securities Inc. in early 1993, the power crisis was a major constraint to increased utilization of existing plant capacity, in addition to blocking implementation of new investment plans. Also, a survey undertaken by Business International Philippines Inc., 40 multinational companies pointed to infrastructure deficiency as a key factor in reducing the Philippines' attractiveness as a business destination. Business groups also cite many other issues they regard as problematic. Distortions in financial markets (linked in part to macroeconomic problems) make it difficult to mobilize funds for private investment on a large-scale; administrative weaknesses and regulatory controls are delaying private sector project start-ups; well-defined competition policy is virtually non-existent (although the Governrent is taking steps to remedy this problem), particularly where franchising arrangements are operating; the scope and depth of the capital markets are still shallow, despite the recent phenomenal growth; and privatization initiatives have thus far been modest. These types of problems reflect unresolved issues surrounding the public-private interface. Their continued presence suggests that even if problems of a more cyclical nature are addressed, a strong and sustained private sector investment response would be unleashed after the reform effort has been fully consolidated. In part, this will require a change in the regulatory and institutional framework that will need to redefine some of the traditional relationships that have existed between business and Government. B. Mac nomic Stability and the Busineus Environmet 2.5 The macroeconomic situation in the Philippines in 1994 shows substantial improvements in stability: single digit inflation, some capital repatriation, an increase in foreign portfolio investment, a market-determined exchange rate, the restructuring of commercial external debt, and improved access to international capital markets indicate the positive results that has been achieved in the overall business environment. Nevertheless, among domestic and foreign business groups, the Philippine economy is still thought to have a potential for macroeconomic instability, partly due to historical record, but more fundamentally due to weaknesses in public finances which continue to be a major threat to the business environment. Overcoming the fragility within the macroeconomic balances has been an essential requirement to strengthen recovery of business confidence and can be expected to spur private investment over the next few years, esp^cially now that the authorities plan to introduce a stabilization program with IMF assistance (see paras. 2.20 and 2.25). 2.6 Weaknesses in public finances - evidenced by continuing public sector deficits and the mode of financing these deficits - continue to threaten a sustainable macroeconomic environment, and their o, igins go back more than a decade. After a period in the 1970s of expenditure-led growth financed by external debt accumulation, the domestic economy decelerated (in the early 1980s). A series of domestic crises coupled with external shocks led to the worst economic contraction in the post-war years, with GDP plunging by 7.3 percent in 1984 and again in 1985. Per capita income fell even faster, at close to 10 percent for both years. Domestic inflation accelerated to 50 percent in 1984 before slowing to 23 percent in 1985 In the second half of 1983, the authorities initiated a stabilization prograrn to reduce - 28 - domestic inflation and discourage capital flight. During 1986-88, moderate economic growth took place in response to implementation of economic reforms. 2.7 A series of shocks then hit the economy. In December 1989, an attempted military coup led to a crisis in confidence at home and abroad, and to a period of looser fiscal and monetary management. In July 1990, an earthquake severely damaged infrastructure in central Luzon. This was followed by the Gulf crisis, which sharply raised the cost of oil imports. In November 1990, a typhoon triggered flash floods, killing more than 4,000 people in the Visayas. In June 1991, the eruption of Mount Pinatubo devastated a large area and created a medium-term threat of mud flows. In 1992, American military forces withdrew from the Philippines and their accompanying expenditures ended. 2.8 Macroeconomic management was unable to react effectively to these shocks throughout this period. The most difficult choice appeared to involve adjusting the exchange rate, which would have been useful to restrain import growth. However, this also would have increased public expenditures, especially after the natural disasters (and reveals the problems with regard to policy trade-offs). During the first half of the year, while the current account of the balance of payments continued to deteriorate, the exchange rate was held stable and fiscal policy continued to be expansionary. 2.9 Public borrowing at high nominal and real rates of interest was used to mop up excess liquidity. Domestic inflation fell, as desired, but so did gross domestic investment, which exacerbated the recession. Throughout this period, fiscal decisions became increasingly don inated by debt management concerns, resulting in reduced investment and O&M expenditures and an increasing reliance on short-term fiscal initiatives. It has only been in the past few years that authorities have acted to reverse the growing consolidated public sector deficit and pave the way for more stable public finances. 2.10 Macroeconomic policy has imposed severe constraints on the private sector in the recent past. Financing large p 'olic sector requirements to deal with internal and external disequilibria have resulted in high real domestic interest rates, a periodic overvaluation in the exchange rate, volatile domestic inflation, and insufficient infrastructure services. High and volatile domestic interest rates and an overvalued exchange rate have discouraged long-term investment and led to the misallocation of resources to nontradable sectors. 2.11 However, even in the 1980s, macroeconomic stability never deteriorated to the degree witnessed in other highly-indebted middle income countries (especially in Latin America). In the last three decades, domestic inflation has generally remained at single digit rates, with the GDP deflator exceeding 20 percent in only two years (1974 and 1985). Consolidated public sector deficits and current account deficits in the balance of payments have rarely exceeded 5 percent of GDP. The 1980s was a decade in which repeated stabilization efforts coupled with tight aggregate demand management, aimed at containing domestic inflation and emerging balance of payments deficits in the wake of the debt crisis. 2.12 The Impact of the Public Finance and Foreign Debt Constraints on the Private Sector. Since 1989, basic prices in the economy, interest rates, domestic inflation, and the exchange rate have been driven by the stabilization efforts of the Government. Rising domestic debt has led to higher real domestic interest rates, which have crowded out private investment. High real domestic interest rates resulting from high levels of debt have also made fiscal adjustment more difficult - by raising interest expenditures, by depressing domestic growth and thus eroding the tax base, and by increasing pressures on spending, in particular on subsidies. The result has been monetary policy subordinated to the cash management needs of the National Treasury. - 29 - 2.13 The Central Bank has favored a strong peso in the past, and with large foreign liabilities on its balance sheet, it took measures to defend the peso and support its overvaluation in the 1980s. Its attempts to achieve a real devaluation of the exchange rate, however, have been less frequent and far less successful than attempts to support the exchange rate. The recent financial restructuring of the Central Bank was completed in December 1993, but took effect as of July 3, 1993 (see paras. 2.226 and 2.227). The new law stipulated the creation of a new Central Bank called "Bangko Sentral ng Pilipinas" (BSP). As part of the restructuring, the National Government (NG) will pay interest to fund the cash needs of the CB-BOL, which will be liquidating the previous external debts over the next 25 years. The financial restructuring involved shifting most external liabilities and non-performing assets to the CB-BOL9 and which were replaced by P 220 billion in Government securities bearing interest at market rates. This operation provided the BSP with a strong balance sheet, including capital of P 20 billion, which is to planned to be raised to P 70 billion in 1995 through a further issue of Government securities. As a result, BSP will be profitable even at much lower levels of reserve requirements (RRs). Moreover, the large portfolio of Treasury bills will enable it to conduct open market operations without financial assistance from the NG. These obligations will increase the Government's interest payments to more than 7.5 percent of GNP. The restructuring resulted in a net positive asset and income position, and it should eliminate incentives for the Central Bank to defend the domestic currency at unrealistic levels. 2.14 Structural Reforms. The reform steps already taken by the GOP to bring about improved macroeconomic stability, and the strategy being developed, have been documented in Bank studies prepared in late 1992 and early 1993.20 Interest rates were deregulated in the early 1980s, two major public banks were rehabilitated in the mid-1980s, and the Central Bank was restructured in 1993 (as mentioned above). Together, these actions made interest rates more market-determined. Regarding the exchange rate, deregulation of foreign exchange is now virtually complete, and the exchange rate is market-determined. Although the Central Bank has continually intervened to prop up the value of the domestic currency in the past, this should be less of a problem in the future (see para. 2.13 above). The 1992 Brady deal has strengthened creditworthiness and reduced pressures on the budget. The budget is now supportive of more public infrastructure investment despite institutional problems, although full and timely execution of the budgeted expenditures, especially capital expenditures, depends on revenue performance and strengthened public institutions. Thus, some of the key macroeconomic constraints on the private sector have been addressed. 2.15 However, even though the current macroeconomic situation is no longer a major constraint on private investment, the long history of macroeconomic volatility has fostered a cautious attitude and uncertainty among investors, both domestic and foreign. This caution can only be overcome through time and a consistent track record of prudent fiscal and monetary management - needed to create credibility in government policies. 2.16 Continuing Issues. A number of macro policy decisions taken in recent years have been unhelpful to business growth. Cutbacks in public investment and reduced operations and maintenance on public works have helped the authorities to contain its deficit in the short-term, but at a high cost in terms of reduced quality and quantity of services to the private sector. Similarly, the reliance on distortionary taxes to supplement government revenues has also added to the cost of doing business in the Philippines. The temporary nine percent import levy introduced in 1991 increased the cost of inputs to industry. This exacerbated already-low levels of private investment activity as has the Gross Receipt 19 The pres ious Central Bank will continue to exist as the Central Bank Board of Liquidators (CB-BOL). 20 See The Philippines: An Onenine for Sustained Growth, World Bank, April 1993. - 30 - Tax (GRT) on funancial intermediaries (coupled with high reserve requirements), which has raised the costs of mobilizing funds for private production, investment, and exports. 2.17 The impact of monetary policy on exchange rates in 1992 also adversely affected returns to producers in the industrial and agricultural sectors. While domestic interest rates generally eased throughout 1992 (with the 91-day Treasury bill rate falling from 21.5 percent at end-1991 to 14.8 percent at end-1992), the peso appreciated about 12 percent, impairing the competitiveness of tradables. Large capital inflows (partly in response to high domestic interest rates as compared to intemational rates) have been the principal factor behind the real peso appreciation. The continued decline in nominal interest rates in 1993, paralleling reduced domestic inflation, has since resulted in a nominal devaluation of the peso, somewhat improv...g prospects for exporters. However, with an open capital account and a convertible exchange rate, there is a risk of large swings in private capital flows with the attendant impact on appreciating the exchange rate and hence harming export growth. 2.18 From the viewpoint of promoting stronger private investment growth, it is evident that the broad thrust of macro policy should aim at avoiding actions which either impair business competitiveness through distortionary taxes or overvalued exchange rates, or which crowd out private investors through high real domestic interest rates or a large volume of government borrowings. The main requirement is for fiscal policy to shoulder more of the burden of controlling aggregate demand so as to reduce the adverse business impact of tight monetary policy on the exchange rate and on private investment. In short, the focus should be on reducing continued reductions in the consolidated public sector deficit without at the same time impairing business competitiveness. The reduction in the consolidated public sector deficit should be achieved in a sustained and credible way and not through short-term palliative measures. 2.19 To be sustainable, a reduction in the consolidated public sector deficit will need to be achieved by permanently increasing non-distortionary tax revenues and decreasing low priority expenditures. Temporary levies, revenues from the privatization program, and excessive reduction of operation and maintenance spending can all reduce the public sector deficit in the short-term, but cannot yield a lasting improvement in fiscal balances. Although excessive reduction in growth-oriented expenditures - public infrastructure and social services - might be sustained, the resulting reduction in growth will reduce the tax base in the long run and thus undermine fiscal adjustment. Unless the public finance constraint is perrnanently overcome and the burden of both external and domestic public debt reduced to more sustainable leve;s, the economic recovery will remain weak and will continue to be vulnerable to exogenous developments, reducing the country's capacity to successfully confront external shocks in the future. 2.20 Strategies for achieving these outcomes form the basis of ongoing discussions between GOP, the Bank, and IMF. To further reduce the consolidated public sector deficit and achieve a better balance between fiscal and monetary policies, with the thrust of adjustment falling more on fiscal policy, this report recommends continued efforts to increase resource mobilization by strengthening the administration and greater reliance on value-added and income taxes instead of by trade and excise taxes and phasing out tax exemptions. The largest scope for improved revenues comes from more effective implementation of existing taxes; weaknesses in collection have resulted in individual and corporate income taxes yielding only about one-half of their measured potential.2" Public corporations have also been a drain on the 21 Said ditterentd,. businesses are likely to be better off if they pay their tax obligations rather than bear the cost of being crowded out. At the same time, businesses should reasonably expect the Government to cut back on wasteful expenditure and to promote efficiency in public provision of services. - 31 - budget because of recurring financial losses and a failure to pay taxes in full and on a timely basis. Options for reducing these losses include greater efficiency, improved management, and binding budget constraints, 2.21 A number of new measures are under consideration by the Congress and the Administration, the most important of which are listed in Table 11.1. The minimum three percent import tariff put in place in April 1994 is to be extended to BOI exemptions by narrowing the sectors covered, reducing the length of tax holidays, and by not renewing exemptions nor granting them for plant expansions. More comprehensive tax reforn is also in the works. A new Task Force on Tax and Tariff Reform has been at work since February 1994 to suggest improvements to the tax system and the tariff code. By mid- 1994, it is expected to provide recommendations on a modified income tax for corporations and an asset- based minimum corporate tax (similar to one in operation in Mexico), aimed at increasing corporate tax collections above their current level of two percent of GNP, as well as any further revisions to the VAT. By February 1995, the group is to prepare suggestions on individual income tax revisions, tax incentive restructuring, excise tax simplification, and import tariff changes. 2.22 The Government took action to raise new revenues in the last two years. In 1993, VAT withholding was extended to government contractors and suppliers. In 1994, the Congress broadened the tax base for VAT to cover most previously exempted areas, including telecommunications; road freight and other transportation; lease and sale of real property; restaurants; hotels and motels; and books, newspapers, and broadcasting. Also in 1994, a minimum three percent customs charge was applied by administrative action to all zero-rated goods and certain currently exempt items, to be extended over time to goods imported under projects registered with BOI. 2.23 In addition, the Government is taking action to improve tax collection through a number of measures, including the establishment of separate treatment for large taxpayers and strengthening of penalties for non-payment of VAT. The Bureau of Internal Revenue will begin monitoring the tax returns of large taxpayers; the 1000 largest taxpayers in Metro Manila have been notified and issued Taxpayer Identification Numbers. 2.24 On the expenditure side, the options for reform should focus on public employment and on high priority public investment, since close to two-thirds of National Government expenditures represent wage and interest payment obligations. The Government needs to exercise caution in incurring new debt obligations, including contingent liabilities. In effect, the Government will need to resist borrowing commitments in activities which can be financed and undertaken by the private sector. Given that public sector employment has grown at an annual average of 5.6 percent in recent years, this report recommends continued efforts to streamline public spending, with a focus on privatization and a restructuring of public employment. The Governrnent plans to reduce the number of departments to avoid duplication and the size of the civil service. Also, the Government plans to devolve additional functions and personnel to the LGUs to ensure that their responsibilities are raised to the level of funds being made available to them. While discretionary current expenditure is restrained, interest payments should decline as domestic debt is reduced and domestic interest rates fall in line with reduced domestic inflation and a fall in risk premiums (para. 1.40), creating room for increasing capital expenditure prudently. This should allow the Government to provide the infrastructure necessary to support economic growth. Increasing private sector delivery of public services represents a viable means of achieving the same public purpose with fewer public resources. - 32 - Table II.1: Revenue Fnhancement Measures (billons of Peos) &bu to lam. Te Ce..ed _ Stu os Emnm d Rvenaue , , . , s9g~~~~~~~~~~~~~~~~~~~l3 W%9 Exewcile Brach Comperindon On going 00 0.0 Investigation and prosecnon of tax evasion and smugling cae On going Tap pnivae sector in disposing goods by BOC/BIR On going Liberalize importation of luxury vehicles On goitg 0.1 0.3 Energy conservaDon and environmental levy EO 115 2.0 0.0 Re-registmtion of imported vehicles deficiency taxes On going 0.1 0.5 Capital gains tax from privatzaoion Pending in Congress 2.2 Excise tax on bottied water Pending 0 0 0.0 Moratorium on new tax exemptioos and review of current exemptions Pending 0.0 0.0 Legislative Branch Consolidation of trust and special funds with the General Fund On going . Strucmtural reforms in VAT RA 7716 0.0 3.0 Administrative reforms in VAT 2 1 0.0 Excise tax on alcohol Pending in Congress 0.0 0.0 Excise mx on cigarettes On going 0.0 2.3 Land conversion tax Pending 0.0 0.1 Measnrs to lcreae Non-Tax Reu Sts Estimated Revenue impact _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ 199" 1994 Executive Branch Adjust fees and chu.rges On going 1.7 1.4 Accelerate privatizatJon and extend life of APT/COP RA 7661 0.0 23.9 5 ~~~~~~~Other Rteubmai Measures_ ______ S.atus Eesmaed Revenue __________________________________________________________ ________ _______ t 1993 1994 Executive Branch 8% minimum tariff EO 172 0.0 1.2 Administative measures Being implemented 0.7 Increase in registration fees of motor vehicles Effective on same 0.5 date as increase in PMVT Legislative 2% affluent consumpoon tax Under discussion 0.5 Increase in PMhVT Under discussion 0.1 - 33 - 2.25 Stabilization Program. With IMF support, the Government will start implementation of a stabilization program. The program aims at reducing the share of the consolidated public sector deficit (CPSD) and domestic debt to GNP. The CPSD is to be lowered from 2.6 percent of GNP currently to 0.6 percent in 1996, which should enable the domestic debt/GNP ratio to decline to 41 percent. To achieve these objectives, a significant improvement in the savings/investment balance will be necessary, together with an increase in the efficiency of investment. Under the program, the ratio of national savings to GNP would increase by about six percentage points to 24 percent of GNP by 1996, virtually all of which would come from planned public sector fiscal adjustment. The program would continue to reduce domestic inflation, limit the current account deficit of the balance of payments to prudently financeable levels, and rebuild gross international reserves. 2.26 While the large foreign public debt has made new external borrowings difficult for private firms in the past because it had a negative impact on country risk rating, with the completion of the comprehensive commercial bank debt restructuring in December 1992. the Government decided to seek an investment rating from international credit rating agencies. In July 1993, both Moody's and Standard and Poor's gave the Philippines ratings (Ba3 and BB-. respectively), putting the country on a par with Latin American countries, but lower than neighboring Southeast Asian countries. Since then, external borrowing has exceeded US$1 billion (Table 11.2). One of the reasons for the increased use of external financing by the private sector is the relatively lower interest rates available in international capital markets. Table II.2: Philippines - Debt Issuance in International Capital Markets, 1993-March 1994 Date Issuer Amount Type Maturity Spread Sovereign (IUS$ mil) (years) at Issue Guarantee Feb. 93 Republic of the Philippines 150.0 Eurobond 3 320 Yes Jun. 93 Development Bank of the Philippines 175.0 Eurobond 5 310 No Aug. 93 Philippine Airlines 100.0 Eurobond 3 375 No Oct. 93 Philippine National Oil Company 90.0 Eurobond 5 265 No Nov. 93 Philippine National Power Corp. 200.0 Eurobond 7 225 Yes Nov. 93 Philippine National Bank 150.0 Eurobond 3 220 No Dec. 93 Subic Power 105.0 Eurobond 15 385 No Dec. 93 J.G. Summit 260.0 Convertible 10 No Mar. 94 Philippine National Bank 54.0 Eurobond 3 No Mar. 94 Filinvest 100.0 Convertible 10 No Source: Salomon Brothers and Government of the Philippines, C. Incentive and Investment Regme Constraints 2.27 The emphasis of Philippine industrial policy since the 1950s on high trade protection (to encourage import substitution) and, since the 1970s, on provision of fiscal incentives (to counteract the effects of trade protection and other distortions) had created, by the beginning of the 1980s, a business sector that was high Cost and pursued rent-seeking activities. However, especially in the last five years, the trade and investment regimes have become much more liberal and outward-oriented. Foreign exchange regulations have been lifted. Philippine import tariffs and non-tariff restrictions have steadily fallen. Regulationis on foreign investment have been relaxed. The policy of promoting specific industrial - 34 - sectors has largely been abandoned. The main area of future reform is the successful coinpletion of the reform in trade and in the foreign investment regime as discussed in this report, 2.28 Liberalization of foreign exchange transactions in the Philippines took place in August 1992 following partial liberalization in December 1991.- The business rcsponse to the liberalization initiatives has been positive, both in terms of portfolio capital inflows and reduced transactions costs for exporters. In the past, proceeds from exports and remittances from overseas workers had to be surrendered to authorized agent banks who were entitled to hold the funds for 30 days before conversion into domestic currency. Repatriation abroad was allowed only for certain forms of foreign investment income such as interest and dividend payments. The controls discouraged both trade and investment. Exporters can now hold up to 100 percent of their export earnings in foreign exchange, thereby saving on conversion margins for inputs purchased from abroad. Repatriation of funds by registered foreign investments can also now be made without prior Central Bank approval (before it used to take three to six months). Short-term loans under the dollar-based FCDU credit facility no", have a ceiling equal to 100 percent of exporters' L/Cs or expected foreign exchange receipts. The transaction volume in foreign exchange markets has increased significantly since 1991. Exporting firms cite these changes as providing a substantial benefit in facilitating business expansion. Foreign financiers also view forex liberalization as a positive factor in their assessment of country risk. The latest liberalization in this area was the lifting on June 17, 1994. bv the Monetary Board of existing restrictions on repayment and repatriationl of foreign investments financed v.v tiansactions using the debt-to-equity scheme. 2.29 The gradual lowering ot' imiport tariff protection will continue through 1995 according to the schedule set out in Executive Order 470 (introduced in July 1991). By the final phase. the P'hilippines will have a nine-hand tariff structure, with items concentrated at 3. 10. 2() and 50 percent tariffs Capital equipment. initially at an average rate of 3() percent. will face a 20 percenit rate if produced domlesticaliv and a 10 percent rate if not Items to remain covered by 50 percent tariffs inclide rice, vegetable oils, sugar, fruits. alcohol. toFbacco and leather goods -- industries wielding political clout. 2.30 Althouglh there was a bias against exportables in general. ancd agricultural and manufactured exports in particular. there was only marginal growth in the ratio of effective protection rates (T PRs) for agriculture to manufacturing between 1985 and 1992. from 0.28 in 1985, to 0.32 in 1990. to 0.34 in 1992 (Table 11.3). (Anniex I contains tables on the trade regime.) 2.31 In general. however, variances between effective protection rates (EPRs) for exportables and importables have been vern wide, between -6.9 percent for exportables and 102.2 percent for importables in 1985, and between -4 I percent and 74.1 percent in 1992. Thus, some categories of importables carry far higher protection than the average, indicating a bias against exportables and in favor of importables. Delays encountered in tihe payment of rebates under the export duty drawback scheme reduce benefits to exports and fail to lesen the anti-export bias of the trade regime. Restrictions on potential export industries and the protection provided to inputs and intermediate products increase the bias. For example, the substantial EPRM on imported paper, rubber. leather, and plastic, which could be inputs to food 22 Only mrni it tt nc (m foreign exchange transactions have been retained: dividends tromn investments in norn-priority sectors un.I 0.- . I- inequity conversion program cannot he repatriated for four y ears fa testriction that the Government plan. t, , 'ii. multiple exchange rates operate for oil imports becauqe of the forward exchange cover ariallort t-. tho te OPSF (which will be eliminated as part of the overall deregulation of the oil sector): and foreien ex( hatize to) service debts may be purchased from the banking system onlv for loans approved hv the RSP (to assht or - tai! authorities in monitoring roreign borrowing). Also. outward investment hy residents of over US$1 million recrr i lHSP approval. - 35 - exports, penalize downstream industries by increasing costs.23 The protection levels embodied in EQO. 470 are not expected to achieve sector neutrality or to reduce penalties for exports - imposed by the import tariff regime - by the end of the current trade reform program. Several items that will continue to be taxed at 50 percent are necessary inputs to downstream industries. 2.32 In the Philippines, highly protected capital-intensive upstream industries, such as textiles and paper, have usually obtained high import tariff protection, while downstream industries, such as garments and printing (dominated by smaller firms), have received lower protection. To the extent that inefficient upstream industries dominated by large firms survive behind protectionist policies, they reduce the international competitiveness of downstream SMEs. Table 11.3: Average Effective Protection Rates, 1985, 1990, and 1992 (percent) Sector 1985 1990 1992 /a All sectors 49.0 41.8 35.7 Exportables -6.9 -4.1 -4.1 Importables 102.2 75.1 74.1 Agriculture 20.7 18.2 18.1 Exportables -6.6 -0.7 -0.7 Importables 82.2 57.1 59.7 Manufacturing 73.3 57.5 53.4 Exportables -4.4 -1.3 -1.3 Importables 107.3 79.2 77.5 Agricultural EPR 0.28 0.32 0.34 Manufacturing EPR /a - Projected, based on E.O. 470. Source: USAID (1991), Erlinda Medalla (1992). 2.33 Although there was a rapid decline in the proportion of restricted items to total items, and of their value to total import value between 1985 and 1988, the value of restricted imports did not decline in relation to toti imports between 1988 and 1991. Several of the items that remain restricted are essential to support domestic competition and to encourage export growth. These include second-hand trucks and buses, motor vehicle parts, accessories, passenger cars and jeeps, pesticides, fertilizers, and refined petroleum products. In fact, these items accounted for six percentage points of the 13 percent share in 1991. Although the Government agreed to phase out the remaining QRs in 10 years as part of the Uruguay Round:. this report recommends that the remaining QRs on imports be phased out by the end of 1996. 23 IrnporuiVlie- ( as inputs to garments and related industries), however, benefitted from EPRs of 262.3 percent in 1985 adL S7 percent in 1992. - 36 - 2.34 It is easier for larger firms to obtain licenses and quotas. Licenses are usually allocated to applicants based on criteria related to scale or previous performance, such as capacity, past imports, and value of assets. These criteria have created a bias in favor of large firms and have discouraged the entry of new firms. SMEs without access to imported raw materials or capital goods are forced to procure them from domestic producers, who generally offer lower quality, or from importers, often at a higher markup than their larger competitors pay for direct imports. An example of a policy that gives a clear advantage to larger enterprises is the restriction on the import of used light conimercial vehicles for the transport of merchandise. Conversely, imports of larger commercial vehicles, more likely to be purchased by larger firms, are not restricted. 2.35 Regarding QR elimination, the Government reduced the number of restricted items from 3,000 items in 1980 to 183 items at end-1993. Coverage has been reduced to around five percent in 1993. However, the number of items under QRs increased during 1993 due to the imposition during that year of restrictions on 57 commodity categories, mostly related to grain and livestock products. While only a small number of import items today are subject to administrative restriction, the resulting price distortions impose efficiency costs on some important areas of the domestic economy'. Remaining import restrictions kept domestic agricultural prices hiigh. especiall) for corn. for which the domestic price was more than 50 percent above world levels. thereby hindering the expansion of poultry and other processing industries. 2.36 T'he Government stated its intentiotn to use administrative orders to lift QRs on processed meats and rescind the administrative component of the QR on coal products. A speedy ratification of the Uruguay Round Agreement of the GAT'F and aggressive action to eliminate import restrictions on the broad range of agricultural products negotiated for t:vriffication under the GATT (including all agricultural items except rice) would uniderscore thie Government's commitment on trade liberalization. By end-1996. virtually all QRs will have been eliminated, apart from those needed for reasons of security, health, or safety. The only exceptions will he the QRs on rice and petroleum products, which will be lifted in early 1997; and those under the Motor Vehicle l)evelopment Program (MVDP). which will he phased out by end- 1998. 2.37 While E.O. 470 is a step in the right direction. it is clearly n(ot sufficient to alter the anti- export bias of the trade regime and hence assist the Philippines in catching up withi some other countries that have gone much farther in reducing trade barriers and integrating their economies with world markets. Although the Philippines' current tariff rates are not radically different from some of the other East Asian countries such as Korea. Malaysia, and Thailand. the overall bias of the trade regime is not pro-export. As a result, the "export push" which characterizes those countries is not evident in the Philippines.24 In some last Asian economies - Hong Kong, Malaysia and Singapore - outward orientation reflected neutral trade policies. since those countries largely or entirely eliminated trade barriers. However. sevOral other economies - notably Korea and China (Taiwan) - selectively supported exports withlout dramatically cutting import barriers (see "Foundations of East Asian Success", by Peter A. Petri. 1993) Given the f'iscal conistraints and the decision to join GATT, the latter alternative is not fcoisible t'or the Philippinies. Hence, drastic reduction in import tariffs would remove the anti-export bias of the trade regime. Some of the countries in Latin America that have been most successful in expanding exports in recent years are Colombia, Chile. Argentina. Cost Rica, and Bolivia. These countries ha e all achieved high rates of export growth. following implementation of trade reforms. The import tariff i.,iwc in most of these countries is 5-20 percent. (The exceptions are the top rates in Bolivia and \ ir a 10 percenit and 22 percent, respectively - and Chile's uniform tariff of II 24 East Am>an Nlnaje. World Bank. 1993. - 37 - percent for all imports.) All have virtually eliminated import licensing and other non-tariff barriers. Based on the success of these examples, most other countries in Latin America and the Caribbean have introduced or are in the process of introducing similar trade regimes. Improving customs administration should generate fiscal revenues which would be needed to offset the expected decline in revenues as a result of reduced import tariff rates. It may also be noted that the cost of distortions (i.e, high import tariffs) is lost output and employment, which the country can no longer afford. This report recommends accelerating trade liberalization and reducing import tariff rates to a range of 5 to 20 percent, with few rates in between, and striving for revenue neutrality in trade reform by phasing out import tariff exemptions, and strengthening customs.' It also recommends phasing out all QRs, except for health considetations, and maintaining the market-determined exchange rate while minimizing Central Bank intervention in foreign exchange markets, except to smooth out high volatility in the exchange rate in line with current policy. This report also recommends introducing net operating loss carry-over and accelerated deprecation over time once public finances stabilize, tax holidays are phased out, and reliance of the tax system shifts from international and excise taxes to VAT and income taxes.26 2.38 The Philippines has made important progress in liberalizing the foreign investment regime. As further administrative efficiencies are gained, the process of business registration should not be an issue for most investors. Rules governing foreign direct investment were substantially liberalized with the Foreign Investments Act of 1991. (Annex 2 provides a summrary of repealed provisions of the Omnibus Investment Code.) Under the new regime, foreigners can invest up to 100 percent of the capital in an enterprise that is not covered by the negative list simply upon registration with the SEC. If they wish to benefit from the fiscal incentives provided under Book I of E.O. 226, they must apply to the Board of Investments (BOI) for approval. Foreigners can own up to 100 percent equity in any enterprise that exports at least 60 percent of its output (rather than the 70 percent cutoff rate under E.O. 226) or in any domestically-oriented enterprise that is not in those sectors included in the negative list. No divestment cf foreign majority control is required. (Annex 3 lists investment areas closed to 40 percent foreign equi;y participation; Annex 4 shows table of nationalized activities and their requirements; and Annex 5 describes citizenship requirements for foreign investment in different activities.) Previously, foreign investors had been required to transfer control to Philippine nationals within 30 years of registration. Corporations with less than 40 percent foreign equity can obtain SEC registration within about nine days; for companies with 41 to 100 percent foreign equity, the processing time is about 24 days. (Annex 6 describes rights provided to foreign investors under the existing laws.) 2.39 The Act does not apply to the banking industry, but in May 1994, a law was passed liberalizing the entry and scope of operations of foreign banks. RA 7721, signed into law in May 1994, allows for entry of up to 10 additional foreign banks and further scope of operation for foreign banks already in the country. The new entrants, six allowed within the next five years and another four upon approval of the President. will be limited to six branches and will require minimum capital of US$7.5 million. No limits were set on setting up subsidiaries in the country or buying into existing domestic banks as long as 70 percent of the assets of the banking sector remain controlled by domestic banks with majority Philippine ownership. Under the new law, a foreign bank may choose one of the following modes of entry (I) by acquiring, purchasing, or owning up to 60 percent of the voting stock of an existing bank; (2) by investing in up to 60 percent of the voting stock of a new banking subsidiary 25 NEDA propo' i in 1994. an acceleration in the reform described in "Guidelines for the Overall Tariff Review" which sets out tr .d,! iheralization targets. The proposal, which is under discussion, is to reduce tariffs gradually to two rates: three pe.; 1 JnJ 10 percent after the last yeir of E0470. By the year 2000, a uniform tariff of five percent is being targeted. The President has yet to approve the guidelines. 26 The Government has already taken steps to shift reliance of the tax system to the VAT (see para. 2.22). - 38 - incorporated under the laws of the Philippines; or (3) by establishing branches with full banking authority. Regarding the last mode of entry, on ten new foreign banks will be given a license within five years of the effectiveness of the law, but each one of them may have up to six branches. The four existing foreign branches may also open up to six additional branches each. The law stipulates that only those among the top 150 foreign banks in the world or the top five banks in their country of origin as of the date of application will be allowed entry (para. 2.223). According to the BSP, 15 foreign banks have already indicated their intemest in applying for a bank license, most of which prefer to enter as a branch. The passage of this law should help promote competition within the financial sector generally and improve the level of funds mobilization for private investors (see section on finance). 2.40 Other actions have been taken to improve the environment for foreign investors. Full and imrnediate repatriation of dividends, profits, and capital from foreign investment was put into place as part of foreign exchange liberalization in 1992. Streamlining of procedures for obtaining work permits and visas for foreigners also occurred in 1992. In 1993. the maximum length of land leases were extended from 25 to 75 years, giving foreign investors greater securitv of tenure. 2.41 Greater perception of political stability and internal security will likely encourage potential new foreign investors. Most foreign investors decide to undertake investments in a particular countr) based on an overall assessment of risks and opportunities. In this respect, the timely implenmenitation of reforms suggested in this report should lead to higher foreign investment flows to the country, since the expected benefits should alter the balance between risks and opportunities in the Philippines' favor. Equally important is the need to address the issue of legal restrictions prohibiting foreigners from investing in certaiii industries and from owning land. Some sectors, such as retail trade, are completely closed to FDI. Furthermore, tht dilapidated infrastructure in the Philippines also has constrained foreign investment, while economic stagnation in the past several years has deterred increased FIDI flows. 2.42 The first Negative List consists of Lists A. B and C. List A includes areas in which foreign ownership is limited by mandate of the Constitution and specific nationalization laws. List B contains investment areas where foreign ownership is limited tor purposes of public health and safety and to protect small and medium-sized domestic market enterprises, List C includes investnment areas in which existing enterprises are assumed to meet domestic demand. Under the law, inclusion in List C requires a petition by a Philippine national engaged in the area before public hearings may be held. Among the restricted areas in List A are mass media, licensed professions, cooperatives, utilization of natural resources, public utilities. List B includes manufacture of weapons and explosives, dangerous drugs, small and medium scale domestic market enterprises, and small and medium scale export enterprises which utilize raw materials f'rom depleting natural resources. In contrast to the Transitory Negative List, List C in the first Negative List is empty because no petitions for inclusion in said list had been received as of the August 31, 1993 - the deadline set by the implementing Rules and Regulations of the FIA. With the empty List C. new areas will be effectively opened to foreign investments upon the expiry of the trarsitory Negative List on October 24, 1994. Legislation amending the Foreign Investments Act to eliminate Negative List C has already been submitted to Congress. The Government also plans to eliminate the restrictions under Negative List B, limiting the entry of medium-size firms and the ban on foreign retail firms in L.ist A These areas include, among others, travel agencies, tourist lodging services (pension houses and tourist inns), convention and conference organizers, life and non-life insurance business including professional reinsurance services and insurance brokerage. 2.43 '11 (Iwptv List C is considered welcome for the following reasons: (a) "Adequate capacity" is not a sound basis for excluding foreign investments in a particular sectx i A foreign firm would enter if it has something better to offer, and can compete with - 39 - the incumbent firms by offering quality products at lower prices which would respond to the consumers, and domestic producers as well. (b) Restricting entry into an industry on the basis of "adequate capacity" meanwhile, encouragers existing firms with high-cost production techniques to continue operating at the expense of consumers. 2.44 Foreign ownership restrictions on mining finns remnain a major constraint to mobilizing needed equity investments in this sector (in contrast to Indonesia where foreign investments in mining have been critical to the development of the sector). As a result, the sector has been contracting due to lack of new investment. With the assistance of foreign mining firms, a Financial and Technical Assistance Agreement (FTAA) policy has been drawn up but as yet no specific projects have been authorized by the Government. Under the proposed FTAA, a wholly foreign-owned firm may engage in mining ventures, as a contractor, but must divest 60 percent of its holdings to local investors within 10 years from the recovery of its pre-operating and property expenses. Foreign firms must therefore judge the risk of an adequate return from divestiture against the revenue sharing arrangements under which the Government takes 60 percent of net revenue and the company receives 40 percent.'7 In the shipping industry also, restrictions on foreign ownership are preventing the growth of adequate shipping to meet inter-island commerce needs. Industry estimates indicate that passenger and cargo vessels will need to double (to around 600) in the coming decade, but mobilizing the capital for this expansion will be more difficult if the majority of equity has to remain local. 2.45 On June 2, 1994, the House of Representatives approved on the third and final reading a bill that proposes five major amendments to the FIA, including the (1) reduction in the minimum equity requirement for foreign-owned domestic and export enterprises which use depleting natural resources from US$500,000 to US$150,000; (2) deletion of the three-year requirement before a domestic market enterprise can change its status to export enterprise; (3) repeal of the entire provision on strategic industries in order to include these in the BOI-IPP (Section 10 of the FIA); (4) deletion of all provisions pertaining to Negative List C (Sections 8-c, 9 and 15 of the FIA). These changes will make the country more attiractive to foreign investors. On the other hand, the Senate version which is yet to be discussed by the chamber proposes to modify only the two following major provisions of the FIA (1) repeal of a provision on "strategic industries"; and (2) removal of the three-year requirement before a domestic market enterprise shifts to an export enterprise. 2.46 The Lower House filed a bill in 1993 seeking to liberalize retail trade business. The three major features of the bill include: (a) the retail trade business will be exempted from the FIA; (b) the three levels of capitalization will be a 100 percent foreign ownership for ventures with capitalization of at least US$100 million, a inaximum of 51 percent equity participation for ventures with at least US$10 million worth of investment, and a maximum of 49 percent foreign equity participation for capitalization of less than US$10 million, and (c) enterprises partially or wholly owned by foreigners, involving the establishment of a chain of retail stores, are required to have capital of at least US$10 million for every store or branch established in the country. 2.47 The challenge to the Philippines in attracting manufacturing investment from abroad has become tougher with the emergence of southern China and the expected take-off of Viet Nam as the most 27 Because 1. I kA is designed to circumvent constitutional limitations on foreign ownership (at least in the initial phases of a vcritirt, ' It also carries the risk of a legal challenge. Foreign mining groups are believed to remain cautious about the legal h.i' it this initiative. - 40 - dynamic growth area in Southeast Asia. Foreign investors in Asia (many of whom are ethnic Chinese) see China as an increasingly preferred investment site, and the recent decision by Taiwan (China) to officially allow Taiwanese (China) firms into China indicates that countries such as the Philippines will have to compete much harder .n the future to attract foreign direct investment.2" Addres; ing infrastructure and capital mobilization issues on a timely basis will remain a priority, as will the need for much greater professionalism on the part of Government officials who deal with business people directly. One issue of importance in coming years will be the need for a coordinated effort from the Export Processing Zone Authority (EPZA) and the Subic Bay Authority in attracting foreign investment. 2.48 As discussed earlier, foreign investors typically are influenced by overall macroeconomic and political stability - areas in which the Philippines has been making good progress recently. Red tape and bureaucracy are still perceived as impeding speedy implementation of projects, particularly at the level of line agencies. However, there are also legal and regulatory impediments which will need to be modified through legal changes. The most important legal constraint is the 40 percent maximum ownership allowed for foreigners in some key sectors. The other restrictions are as follows * Foreign Investment in Land. It is recommended that the nationality requirements be relaxed to allow noncitizens to lease land in industrial estates or export processing zones, as proposed in a legislation presented to the Congress four years ago. It is also suggested that noncitizens be permitted to lease public lands. o Minimum Capitalization. The minimum capitalization requirements (domestic market enterprises not involved in advanced technology or export companies utilizing raw materials from depleting natural resources must have a minimum paid-in equity of US$500,000 if they are more than 40 percent owned by foreign nationals) should be deleted or reduced substantially to attract smaller foreign investment which can grow over time. * Existing Production. Because List C enumerates areas in which foreign investment need not be encouraged, it discourages competition and a healthy private investment environment. It is recommended that List C be deleted from the Negative List. - Import and Wholesale Activities. The language in List C restricts the "import and wholesale activities not integrated with production or manufacture of goods" to Philippine nationals. Thus, foreign enterprises proposing to engage in import and wholesale activities in the Philippines, through a branch, partnership, or majority-owned subsidiary. must manufacture the products to be distributed. Prospective foreign investors who have expressed a desire to engage in such activities without owning a manufacturing facility have been prevented from doing so. It is recommended that restrictions on import and wholesale activities be removed from the Negative List. * Joint Venture. Once a foreign investor enters into a joint venture with a Philippine national. the Philippine partner has a right of veto with regard to any competing activity by the foreign investor in the domestic market. Anti-competitive restraints of this kind entered 28 Wiiiic tt . percent of people in the Philippines are pure Chinese. Chinese-ovwned companies account for two- thirds ut .hL r.ies ot the 67 biggest corporations (The Economist, July 18, 1992). Philippine businesses have yet to exploti tih. eav Chinese business network to the same extent as other Southeast Asian countries such as Indonesia. Thailand, at d Mlalaysia. - 41 - into by a competitor and a potential new entrant are illegal in most market economies. It is proposed that this restriction be deleted from the implementing rules of the FIA. * Nationality Restrictions. Nationality laws are too restrictive for certain classes of business. These include retail trade, construction, shipping, airlines, mining, travel, media, advertising, utilities, and insurance. Foreign investments can be increased if these restrictions and limitations are relaxed to permit foreign investors to own up to 100 percent equity. 2.49 To attract higher levels of FDI, this report recommends the following legal changes: (a) Phasing out the 40 percent limitation on foreign ownership. (b) Reducing the minimum capitalization requirements for FDI. (c) Allowing foreign ownership in sectors - presently closed to 100 percent foreign ownership - such as retail trade. (d) Eliminating the negative list. 2.50 The investment response since the introduction of the [or n Investment Act has been generally modest. While the Act itself' was an important step to make the ' lippines more internationally competitive in attracting [Il. the realization of these flows has awaited the resolution of other more binding constraints to investment activity (notably political uncertainty before the May 1992 elections, power supply shortages, capital mnobilization difficulties and macroeconomic stability) as well as the factors listed above. Many FDI inflows are accompanied by some type of foreign loans as part of a project financing package, and the reluctance of foreign commercial banks to take on additional Philippine exposure in recent years has been a contributing factor to the muted FDI response. It is for this reason that the recent Brady-type restructuring of foreign commercial bank debt to the public sector and the consequent improved credit rating secured by the Philippines are major positive steps toward regaining the confidence of foreign banks, institutional lenders, and equity investors - an essential step for the resuniption of strong [1)1 growth in the next few years. FEscal Incentives 2.51 Fiscal incentives affect relative factor use because of their effects on relative factor prices. Fiscal incentives also intiluenice the flow of resources across different economic activities by changing re!ative profitability rhic B3oard of Investments (BOI)-administered incentives created biases in market orientation and in interseLioral and geographical distribution of registered activities, thereby adversely affecting resource allocation, (Annex 7 describes BOI incentives.) 2.52 'I'lTe 1301. which was established in 1968, is charged with responsibility for preparing the annual Investment Priorities Plan (IPP), processing applications for registration of enterprises under the IPP and approving incentives, and periodically monitoring compliance by enterprises. (Annex 8 describes thle Investment Pr6intie Plan.) Since the incentives are given selectively, they serve as an entry barrier. In preparingt thc !1' thle B01 was guided by tthe concept of "measured capacity". that is, incentives are not given t ;ippia,tt' it thie BOI decides that the existing capacity can meet domestic demand. Potential entrants arc li,>l riithited t'rom entering the market, but they will no longer enjoy the fiscal incentives. This is infctCli I,t t, !w onlv entity with a viable investment program in telecommunications assets other than PLDT hi,v, hc'mn the Government, which in turn lacks a viable operation and maintenance capability. - 60 - 2.113 With some important exceptions, the structure of the sector has remained essentially unchanged over the past three decades. Nevertheless, there have been some important developments. For example, in 1989, the National Telecommunications Commission (NTC) authorized a second and third competitive international voice gateway, with the goal of creating an incentive for local network investment by affiliates of these new gateway owners. Also, cellular telephone technology has developed new opportunities for competition in the sector. Further, in April 1993, on a technicality, the Government nominated six of the 11 members of the PLDT Board of Directors. Although previous interventions into business sector operations have not generally been successful in the Philippines, the case of recent Government actions in PLDT mean that the company started to focus on increasing neglected investments and improving its efficiency. The lesson is that if the Government is deternined to improve the services of a monopolist, it can do so within the existing legal framework and without passing a new law, Firm Goverrunent determination and consistent actions are key to creating and maintaining corporate accountability. 2.114 Legislative franchises are generally required to operate public utilities, including telecommunications. In addition, carriers must also be authorized by NTC to install and operate telecommunications systems. NTC decisions can be challenged in the courts. In practice, this legal and regulatory framework has obstructed new entry into the sector in the past, mainly by enabling PLDT to challenge entry based on franchising issues. The company has engaged in lengthy legal battles and has succeeded in blocking new entry into the sector. 2.115 The public sector's inability to regulate the sector adequately and induce a favorable supply response through the creation of contestable markets is part of the reason for the sectoz's poor performance. Annex 13 describes the Government's role in the telecommunications sector. Despite its intentions, the Governrnent's regulations, especially around the issues of underinvestment and the sector's structure, have not been effective: The Department of Transportation and Communications (DOTC) and NTC have not enforced the requirement for interconnecting telecommunications networks. Thus, NTC's performance in regulating the sector and its major carriers needs to be dramatically improved in several key areas, including (a) carrier obligations to provide service; (b) network interconnection, (c) revenue settlement; (d) tariff review; (e) rate of return monitoring; and (f) carrier transaction monitoring with linked companies. Regulatory reform can only be made effective by improving governance, eliminating the need for legislative franchises, and revising the laws to make the regulatory agencies self-financing. 2.116 The Government has to become more effective at managing the sector's development. For years, it has lacked a policy framework to manage it in an orderly fashion with a plan against which PLDT's performance, as well as others, could be assessed, In 1988-90, the Governrment convened the National Telecommunications Policy Committee, which discussed at length the key issues that underlay sector policy; and, in 1991, it adopted the National Telephone Development Plan. (See Table 11.5 for physical targets in the plan.) 2.117 Tariffs, Both the distortions in the current tariff structure and the high international rates tilt incentives against investing in local network facilities. The tariff structure and cross-subsidization between domestic and international tariffs need to be carefully reviewed and reforms introduced to make cross-subsidies unnecessary over time; this would reduce tariffs for international calls and improve incentives for investment in domestic lines, which could be achieved through raising charges for domestic calls without jeopardi7ing the development of rural telephone infrastructure. - 61 - Table 11.5: Telecommunications - Summary of Physical Targets 1992 Target Target Year Status Status 1. Main station density per 100 inhabitants 1.4 3.8 1998 6.2 2004 10.0 2010 2. Percentage of municipalities with local exchange 20.6% 50% 2000 service 75% 2004 100% 2010 3. Telephone quality of service Monthly trouble rate 18% 10% 1998 5% 2004 Trouble response within two days 89% 90% 1998 98% 2004 Service application response within four weeks 65% 94% 1998 98% 2004 Other standards N/A To be set by NTC 4a. Percentage of municipalities and cities with access 2.5% 31% 1998 to pubic switched data network (a) 46% 2004 52% 2010 4b. Percentage of municipalities and cities with access 12% 41% 1998 to non-switched digital data circuit 51% 2004 57% 2010 5. Establishment of nationwide maritime 100% 1999 communications in accordance with Global Maritime Distress and Safety System (GMDSS) 6. Percentages of Barangays with public calling office 22% 26% 1998 (PCO) service 38% 2004 51% 2010 7. Cellular mobile telephone service (CMTS) (b) Metro Manila & Cebu Available Digital CMTS 1993 Percentage of municipalities and cities with CMTS 100% of MUCs 2010 service 70% of KDCs (a) Locations for data services correspond to Major Urban Centers (MUCs) and Key Development Centers (KDCs). (b) PCO services tn the barangays could use a mobile technology overlay with fixed subscribers. Source: Nationial 1ecph1ne Development Plan, 1991-2010, Department of Transportation and Communications. - 62 - Recent Dula Meaes 2.118 Reforn of the telecommunications sector was initiated in 1987 with the issuance of DOTC Department Circular No. 87-188. This circular contains a broad package of policy statements However, it was only in the last two years that the Governmnent accelerated the reform process. It issued several policy measures to deregulate the sector in order to improve its efficiency and to bring about a robust supply response through encouraging healthy competition in the sector. 2.119 While the Philippines Long Distance Company (PLDT) remains as the dominant carrier, there are now new entrants in response to the Government's policy to encourage and broaden competition in the industry (see Table 11.6 for cu-rent telecommunications services and carriers). Prior to the new policy, competition to PLDT consisted essentially of two gateway operators associated with MCI and Cable & Wireless, and small local telephone companies. A cellular phone company. EXTELCOM, subsequently entered the market. However, it was primarily in the last year and a half that developments have responded and several tzlecommunications companies are now poised to operate gateways, cellular lines and fixed land lines. Among the developments which enhanced competition in the industrv are the following: (a) The interconnection of the facilities of all public communications carriers has been made mandatory by Executive Order No. 59 issued on Februarv 24, 1993. (b) Entry into the supply of customer premises equipment has been deregulated. Consumers are not obligated to buy their equipment from the supplier of telephone 'ervices. (c) The issuance of E.O. No. 109 in July 1993 to introduce universal access to basic telecoryimunications services by requiring international gateway operators and providers of services to provide local exchange carrier service in unserved or underserved areas. (d) The formulation and issuance in November 1992 of Government Policy on Cellular Mobile Telephone Service (CMTS) contained in DOTC Department Circular No. 92-269. (e) The development and issuance in June 1993 of a Policy on Domestic Satellite Communications contained in DOTC Department Circular No. 93-273. (f) Pursuant to Executive Order 108 issued on July 12, 1993, the NTC divided the country into 11 major areas to be serviced by various telecommrunications companies. The plan requires companies granted gateway and cellular telephone licenses to put up a certain number of fixed lines in the particular region assigned to them. There has likewise been an increasing number of foreign telecoimmunication companies engaged in various activities in the Philippines " 34 As of end of I Q93, among the telecommunications companies reported to have activities in the Philippines (I) Alcatel, supply of equipment for microwave switching exchange and lines; (2) Cable & Wireless, 40 percent ownership in Eastern Philippine Telecoms, Inc., 40 percent ownership in Oceanic Wireless Network. Inc., and 27 percent ownership of Dri,ii;l l, n Philippines, Inc (3) Ericsson, supply and installation of cable network and installation of cable netw& , ( , '-S cellular system; (4) NEC, supply of ESS lines and microwave transmission equipment: (5) Siemens, turokF. . .1 and part installation of eichanges, gateway switches. joint venture for the manufacture of telephone terminals and components; (6) Telstra, joint venture for satellite and microwave sets, voice and vide network: (7) Sprint, ex' 111I I \1.morandum of Understanding with Smart Communications, Inc. under which Sprint agreed to provide iuppori th c international requirements of Smart should the latter secure an international gateway license from the NTC: arni 1. Singapore Telecom, joint venture with the Ayala Group. - 63 - labte JI: Telecommunications Services and Carries in the Phlllppne Telephone Services Local Exchange Long Distance * PLDT National Intemational * Other PAPTELCO members * PLDT * PLDT * Government * Other carriers 0 PhilCom * ETPI Record Carrier Services Domestic I Intemational * PT&T 0 ETPI * RCPI * Capwire * TELOF * Globe Telecom * PhilCom Other Services CMTS Trunked Repeater VSAT Paging Services * Extelcom * . LBNI * LBNI * Easy Call * PIL FEL 0 Romasanta * CRS * Pocketball * S. Lustre 0 ICC * Digipage * Omninet * PLDT * Satellite Paging, * ICC 0 Capwire Inc. * A. Zaragoza I __ Source: National Telecommunications Development Plan, 1991-2010, Department of Transportation and Communications. 2.120 The National Telecommunications Commission (NTC) issued implementing guidelines for each of the above-noted measures. NTC also introduced several initiatives to liberalize the sector. Furthermore, several bills were filed in both the Senate and the House of Representatives seeking to enhance competition and strengthen NTC. Competition Policies and Sub-sector Market Strucure 2.121 Satellite Services. In 1989, the NTC granted provisional authorities to five companies to provide either VSAT services or carrier type services despite strong opposition from the incumbents. The DOTC Circular No. 93-273 spelled out the liberalization policy on domestic satellite communications In particular, Section 3 of the circular states that "Authorizations for the provision of satellite c6mrnunication services will not be limited to those satellite services provided currently possessing provisirnal authorities or certificates of public convenience and necessity (CPCN). Any qualified applicant may apply for a CPCN/PA to install, operate and maintain any satellite related services." - 64 - 2.122 Recently, the private sector formally agreed with the Government to launch a Philippine satellite. It is a privately owned project with the Government acting as a facilitator. Accordingly, "The consortium or corporation will have the exclusive right to provide space segments to Philippine users for their operations within the footprint of the subject satellite for ten (10) years from date of actual operation ....." Unlike in Thailand, in which such privilege was given to a single firm, the Philippine project will be carried out by a consortium of 17 firms. Participation in this consortium is open to duly enfranchised telecommunications carriers. Moreover, the consortium will provide satellite space segments in the Philippine satellite to all interested parties on a non-discriminatory way. Further, DOTC is now in the process of defining satellite policy with the intention of opening up this market for more competition. It is envisioned that interested parties will have direct access to international satellite services, thereby ending the monopoly of PHILCOMSAT. 2.123 Cellular Mobile Telephone Services. T'he issuance of DOTC Circular No. 92-269 in 1992, NTC liberalized this sub-sector to expose the two incumbents to greater competition. Since then, seven CMTS operators applied to provide CMTS services, and NTC approved three of them, thus bringing the number of service providers to five. 2.124 Radio Paging Services. NTC took action to open up this sector, previously dominated by a monopoly. To date. there are five radio paging service operators. 2.125 Telephone Services. PLDT used to be the only operator of an international switching center in the Philippines. Recently. however, the NTC liberalized this sector and approved the applications of four firms to operate their own gateways, thereby bringing the number of players in this sub-sector to five. The national long-distance service is still largely dominated by PlDOT which owns and operates an extensive nationwide backbone transmission network. The Government is currently encouraging the development of an alternative backbone. The dominance of PLDT in this sub-sector has been lessened with the issuance of EO 59, niandating interconnections of all public telecommunications mentioned earlier. There are small municipal telephone operators. With the liberalization policy pursued by the Government, Congress approved several medium-size national telephone operators in the last two years. Bell Telecommunications Philippines, Inc., which has foreign partners, is the latest recipient of a franchise to operate on a nationwide basis. 2.126 Clearly. these changes will break the monopoly power of PLDT through increased competition. It may take some time to see the results of the current liberalization in the telecommunications sector because investments have yet to be made and, if they are made. they may need a long lead time. In somiie sectors, as in the case of the CMTS and international gateways, tangible results have already resulted. It is expected that the sector structure will consolidate over time, and the suggested regulatory framlework and cornpetition policies when put in place would ensure healthy comnpetition while allowing the expected consolidation in the sector. 2.127 Additional steps will also be needed to improve the performance of the sector. T'hese should involve: * Jmproi in, tile tariff structure. Rebalance the tariff structure as described in para. 2. 05. * /or-,' ' uZ' tlie regulation of telecommunicatiois operations and making NTC an autonomous 'r ,, o( countable agency with an adequate budget and ability to recruit, train, and retain l:'fic3 professional staff. Regulatory strengthening would encourage new investment in r1,. rcrr. - 65 - Trno Sector 2.128 In transport, infrastructural limitations are also very apparent. The limited availability and high cost of services impose serious competitive disadvantages on private businesses, and limit the growth of a dynamic export sector. 2.129 The Philippine transport system is composed of over 700 km of railways, over 160,000 kIn of roads, about 85 public ports, some 90 municipal ports, over 200 private ports, and six international and more than 80 other public airports. The system is basically bimodal: Road transport and inter-island shipping together account for almost all the national freight and over 95 percent of passenger movements. Domestic air transport is very limited and almost entirely passenger traffic, while railway traffic, both passenger and freight, is negligible. 2.130 Highways. Many of the existing roads suffer from a lack of maintenance and only about one-third of the national roads was considered to be in good condition, according to a recent Department of Public Works and Highways (DPWH) survey. It is estimated that over two-fifths of the provincial roads and over half the barangay roads are in such poor condition that they cannot be maintained and have to be rehabilitated or abandoned. 2. 131 The quality of the main network is significantly inferior to several Southeast Asian countries: In 1992, the latest year for whicth comparable data is available, a very low share of main roads in the Philippines were paved (29 percent in the Philippines compared with 60-70 percent in other Southeast Asian countries). 2.132 The primary problem in the highway sector is the neglect of maintenance. The replacement value of the entire Philippine road network is estimated to be US$8 billion. Due to the enormous backlog of reconstruction and maintenance, the cost of rehabilitating the existing network is estimated at US$11.3 billion, which implies that almost half the value of the road network has been lost.35 This puts the current value of the road network at only US$6.0 billion, or about 12 percent of GNP, as compared with 15 percent of GNP in other Southeast Asian and Pacific countries. The seriousness of the road maintenance problem promises significant benefits from maintenance. 2.133 The sharp decline in road expenditures in real terms during the 1980s, especially for maintenance, contributed to the poor condition of road infrastructure. National Government (NG) expenditure for both road construction and maintenance in constant 1985 prices is estimated to have dropped from P 6.3 billion in 1981 to P 4.5 billion in 1990. Maintenance expenditure for the main arterial network (national roads) is estimated to have decreased from around P 25,400 per km in 1985 prices in 1981 to about P 16.000 per km in 1990. Thus, during the next few years, the Government should emphasize public expenditure for basic road maintenance rather than for new road construction, according to the road management system model proposed in the World Bank's Highway Management Project. The Government should also increase private contracting for road maintenance, which will complement needed teductions in Department of Public Works and Highways (DPWH) staff, and free remaining staff to concentrate on planning improved management. 35 The has is fi . 1w ornputation of the replacement value of the entire road network is the inventory at end-December 1993 based on assumed average unit cost for existing concrete. asphalt, and gravel roads, and for rehabilitation works. - 66 - 2.134 Underfunding compounds the maintenance problem as available financial resources are used to carry out the most urgent repairs. Regular and preventive maintenance on relatively good roads is deferred until they too deteriorate to the point they become urgent or need major rehabilitation. The relative share of road construction in GDP fell from I percent in 1981 to 0.5 percent in 1990 and the share of maintenance from 0.4 percent to 0.2 percent. 2.135 While overall resources were constrained during the last decade, even the funds available funds may not have been effectively utilized due to poor management practices. In particular. the quality of the construction has often been poor and supervision has not always been adequate. 2.136 The transport industry is predominantly privately owned and most of the trucking and bus companies are small. Companies with less than five vehicles and owner-operators with only one vehicle are estimated to comprise around 75 percent of the trucking industry and large companies with more than 50 trucks about one percent. On paper, the road transportation sector seems highly regulated. and governed by laws, regulations and practices dating back to the 1930s: For example. official authorization or franchise from the LTFRB is needed to provide freight and passenger services. In practice. however. the regulations have not been fully enforced and the industry has been de facto deregulated with costs to shippers reflecting market conditions. Nevertheless, potential restrictions to entry. CGovernment- detertnined tariffs, and uneven enforcement of the regulations have constrained the development of the road transport industry. The Government has recently taken steps to address some of these regulatory issues. 2.137 By far the most important urban center is Metro Manila. It accounts for 40 percent of total vehicle registrations and the main urban congestion problems. Adding to congestion is pool ohysical traffic management (location of stops, bus lanes. enforcement of parking regulations, and traftic light phasing). The extent to which there might be scope for using the franchising system to direct more transport to less heavily trafficked roads is not clear, but this could obviouslv reduce cnngestion 2.138 The main cause of congestion is probably the private automobile. which typically has an occupancy of not more than 10 percent of a jeepney and occupies about the same road space. In 1993, 5,000 new cars a month were being added to the Luzon road system. Reducing private car use, and substituting either buses or jeepneys, could probably reduce congestion - but this has proved very difficult in most industrial and developing countries. In this context, it is also suggested that authorities consider allowing the duty-free import of buses, vans, and trucks. It is unclear whether there has been any significant progress in recent years in addressing Manila's urban transport problems. The Philippines Traffic Control Center (TCC) has estimated that congestion costs amount to P 16 billion a year. 2.139 If the TCC congestion cost estimate is accurate, and the population of greater Manila continues to grow at the present high rate, actions to improve traffic flows in the city will probably become the most urgent in the whole transport system. The TCC data should be reviewed and a comprehensive urban transport study carried out. This study should evaluate the economic feasibility of extending the LTR system and of restricting automobile access to central Manila, based on the Singaporean experience - 67 - Table II.7: Priority BOT Projects Project Cost (Millions of USS) Road Projects M. Manila Skyway 635.6 North Expressway, Subic/Clark 290.5 Manila-Cavite Expressway 79.1 S. Luzon Expressway Expansion 69.7 1,074.9 Transport Projects Light Rail Transit No. 4 678.4 Light Rail Transit No. 5 279.8 Mainline North Rehabilitation 76.8 NAIA Cargo Terminal 84.8 Manila Grains Terminal 95.5 1,215.3 Power Projects Small Hydro Program 425.4 Mindanao Geothermal 323.1 748.4 Water Supply Projects Bulacan Central Water Supply 37.1 Cavite Water Supply 164.0 201 .1 Tourism Projects Panglao Island Tourismin Estate 42 7 Samal Island Tourisin Estate 44.7 87.4 Industrial Estate Projects PHIVIDEC Expansiorn 6.6 Batangas City Agro-Industrial Center 83.5 Bacnotan Agro-Industrial Center 50.4 Pavia Agro-Industrial Center 30.2 Davao City Agro-Industrial Center 24.2 Zamboango Agro- industrial Center 12.2 207.1 TOTAL 3,534.2 Source; Coordinating Council on the Philippines Assistance Program. 2.140 To respond( to the infrastructure inadequacies by involving the private sector, the Government defined a plan as "the Philippine Lnfrastructure Privatization Program" (PIPP). The PIPP, which is predicated on the need to respond to short-term needs, is a multt-sectoral integrated infrastructure prli%atiation program based on the law RA 6257 as amended by RA 7718. The Coordinati;ip ( w',Milttree tor Philippine Assistance Programs (CCPAP) is the coordinating agency. Given the continutiny ind cx pected fiscal constraints on public spending, the PIPP would encourage the private sector to participate in infrastructure development under a variety of privatization schemes covering a wide range ofti c., 1rs and activities. - 68 - 2.141 The Governmnent also created a BOT program for non-power infrastructure services based on the experience in the power sector as well as from careful analyses of the lessons learned in BOT projects in other countries. The Government has developed a preliminary estimate of US$13.5 billion over the next five-year period to establish the infrastructure required from transition to higher economic growth. (Table 11.7 shows some of the BOT projects.) 2.142 Maritime. The maritime transport sector, particularly inter-island shipping, has not played as important a role as expected in the economic integration of the country. It consists of both infrastructure (ports) and operations (shipping). With close to 96 national ports, another 497 municipal ports and 375 privately-owned ports, the Philippines is not faced with a shortage of harbors. Rather, the main problem in public ports is inefficiency and high costs, reflecting administrative practices and regulation by PPA, MARINA, as well as the Bureau of Customs. Restrictive practices, the lack of facilities such as forklifts and cranes, inadequate storage and the mixing of passenger and cargo operations in most domestic ports, hinder the efficient loading and unloading of vessels. PPA's practice of negotiating arnual contracts for stevedoring (on-board cargo hauling) and arrastre (land handling) operations with a single operator leads to monopolistic behavior and high prices. 2.143 The PPA has taken several measures to improve the efficiency of port operations. First, it upgraded the facilities in the Port of Manila, Cebu and other major ports with financial assistance from bilateral and multilateral financial institutions. Second. PPA established "one stop shops" (Port Integrated Clearing Offices) in its ports to facilitate the processing of paper work. Third, it awarded the operation and management of the Manila International Container Terminal (MICT) through competitive bidding to a private operator. Fourth. it is formulating standards on cargo handling productivity and efficiency. It is also moving toward modernization of equipment in ports, training of workers, and improvement of procedures in cargo handling operations. Regarding cargo handling, it is now PPA's policy that after the existing contracts expire. awarding cargo handling will be done through public bidding with contract terms ranging from 5 to 10 years depending on the classification of a port, i.e., major, sub-port, etc. Longer contract periods (up to 15 years) will be granted depending on the operator's commitment to acquire modern equipment. among others. Despite these improvements. PPA's role as both regulator and operator of ports is considered to be a key constraint to the development of effective port operations over the long-term. At present, it collects various fees from private ports for which it does not provide services.36 Thus, this relieves PPA of the pressure to strive for more operational and cost efficiency in its ports. A further problem is the extensive cross-subsidization between ports.3 This distorts the incentive structure between PPA ports, reduces pressures for cost control in loss making ports, prevents a rationalization of the ports structure and of shipping operations, and may influence investment decisions adversely. 2.144 MARINA is responsible for developing shipping, shipbuilding and repair facilities, setting policies and regulations governing passenger fares, freight rates and route franchises, and coordinating maritime training. Dormestic shipping is provided by the private sector operating within the regulatory framework established bv MARINA. Scheduled liners account for about half the domestic freight and almost all of the passenger service. The remaining cargo is carried by unscheduled contract carriers 36 The practo c *t I'PA to get a share ot income tromo arrastreistevedoring from private ports has been discontinued. Instead. an .nmd,ji regulatory fixed fee of between P 10.000 to P 20.000 will he collected from private port owners depetin(liT . t t ,.t criteria for approval by the PPA Board of Directors. 37 Cross-subsidization between ports exists because of the nature of PPA's franchise. PPA granted a franchise hy the National (W einment to perform public service on a self-sustaining basis. - 69 - (trarnpers) and by own-account vessels. As with the trucking and passenger transport, shipping was highly regulated. 2.145 The inter-island shipping industry consists of liner operators, trampers. tankers. barges (long-distance and lighterage), and industrial or specialized operators. The domestic shipping fleet consists of over 740 vessels of more than 50 gross tons (GT) (100 passenger cargo ships, 200 ferries, 400 cargo ships and 40 tankers) and a large number of smaller vessels and barges. The liner-shipping industry provides virtually all inter-island shipping passenger services, and it accommodates most non- bulk cargoes. Inter-island shipping is dominated by the Conference of Inter-island Shipowners and Operators (CISO), which comprises 17 members owning about 80-85 percent of the country's shipping tonnage and carries about the same percentage of inter-island cargo and passenger traffic. 2.146 Government regulations combined with the oligopolistic structure of the liner operators are thought to have resulted in price and service distortions, protecting the least efficient operators and allowing the more efficient ones to earn a rent. While liner operators have offered discounts below regulatory rates, CISO has now established an effective control mechanism which ensures that the prescribed rates and fares and other conditions of carriage are adhered to. There is also a cabotage law which prohibits foreign shipping companies from competing for national traffic. The Govermnent has now taken steps to address some of the regulatory issues in the transport sector and has recently started to deregulate inter-island shipping. The expected impact from these reforms should be lower prices and better service quality - a sine qua non for improved export performance. 2.147 Aware of the major bottlenecks and inefficiencies in the transport sector, the Government has adopted several measures to improve performance. Deregulation has proceeded to encourage entry and competition on major routes and to liberalize price setting. In particular, in March 1992, the Government issued a Departmental Order (DO) which significantly reduced the barriers to entry/exit in the transport industry by eliminating several cumbersome administrative practices enacted by the Public Service Act of 1936. The Government also allowed for market-determined fares, with the exception of mandatory rates imposed on routes monopolized by a single operator. However, there is a need to reinforce competition in shipping. But, lacking competition rules (and their strict enforcement), price deregulation may actually lead to monopolistic pricing practices in markets where entry is relative costly and/or can be restricted to a small number of participants. The possibility of cartelization and price fixing in liner shipping is strong because of the substantial sunk cost at stake. 2. i48 Aviation. Domestic aviation is also an important part of transport infrastructure. Most of the countries in the regioni have good airport facilities. Typically, domestic airlines service inland cities while international carriers service frequently scheduled routes to major cities around the world. The Philippines has more than 80 operational airports, of which half are used by scheduled air carriers, while Manila and Cebu are the two major international cargo centers. 2.149 In 1986. the Government revoked the one-airline policy, paving the way for the entry of other carriers, particularly in domestic operations. Philippines Airlines (PAL) opposed this policy on grounds that new entrants would limit their operations to lucrative routes, putting PAL at a disadvantage because it woulJ have to continue servicing unprofitable routes. PAL eventually abided by the Government's decision and a new airline started competing with PAL in minor routes only. It operates at a higher cost tlhan) i'AL because it uses smaller aircraft, and PAL dominates the domestic airline industry and 0 cr1c L on all major routes. 2.150 '[lie industry's inefficiency is well known. Service is poor: Flights are canceled without proper notificationi ot passengers, flight delays are common, and there are long lines during peak season. - 70 - Airlines continue to operate unprofitable routes for social reasons, passing the additional cost to passengers through higher fares in other routes. Enhanced competition in the sector should help improve service quality in the future. Congress is presently considering the request of All Asia Airlines for a franchise to establish and operate transport services. Most recently. Congress approved a similar franchise for the Aboitiz Air Transport Corp. and Cebu Air. 2.151 It is suggested that the Government study options to determine if further deregulation of airline route franchising would encourage efficiency through greater competition. Investment in airports needs to be increased, including greater opportunities for private investment. In addition. private sector investment in specialty air freight handling equipment, such as cold storage, should be promoted. E. Reglatory ad Legal Constraints 2.152 The current regulatory framework for business in the Philippines is mostly pro-incumbent. given the nature of entry barriers, which has sustained rent-seeking behavior. This behavior is reinforced by the lack of sufficiently clear rules of the game, of enforcement of rules, and of a credible referee. In addition, high transaction costs have deterred the creation of new and viable private firms and have made it difficult for small and medium-size firms to grow to a larger scale. Further. domestic industry is characterized by high concentration. This situation is one of the main causes of the weak supply response to the economic reforms that have been undertaken to date. Although the structure of the economy will likely change as trade is further liberalized, regulatory reform with a view to increasing competition is key to increasing the efficiency of the domestic economy in the next few years. 2.153 Part of the problem is that the regulatory agencies typically lack autonomy from the executive branch, lack the budgetary and other resources necessary to carry out their tasks, and are in a weak political positioni in relation to the firms they regulate. With these problems, the regulator) agencies can hardly take the necessary steps to resolve market imperfections and control monopolies while sustaining incentives for productive private investment. At the same time, regulatory processes have allowed dominant incumbent firms to curb or limit competition, while failing to create enough confidence in the system to encourage these dominant firms to expand investment. 2.154 In the enterprise survey (see paras. 2.2 and 2.3), all regulatory issues received average constraint scores, a finding seemingly at odds with entrepreneurs' complaints about bureaucratic "red tape". This finding may indicate a phenomenon observed in other developing countries, where firms have found ways to evade the burdens of regulation and the bureaucracy by participating in informal systems of rules and practices. If this were indeed the case, then the survey scores would indicate that the perceived level of constraint imposed by the regulatory regime is mitigated by the ability of the incumbent firms to circumvent the formal system. This outcome could also indicate that regulatory constraints are more onerous to new entrants than to incumbents. 38 Most ime umlnrlt firms are small by international comparisons, but conduct of some incumbent firms are believed to have been aimed at curhing competition which limits entry of other firms and paradoxically keeps them small (see Box 11.31. - 71 - (i) Rpglatory System for r cture 2.155 The Philippines has recently given the private sector a significant role in developing and operating public utilities. In the power generation sector, in addition to the publicly owned and operated National Power Corporation (NPC), there are private generators which supply power to distributors that are privately owned companies or cooperatives. Telecommunications is virtually private, there is limited public ownership and most Government systems have recently been privatized. The dominant carrier, Philippine Long Distance Telephone Company (PLDT), is controlled by private interests and has share listings on domestic and foreign stock exchanges. New entrants to the sector are all private. 2.156 The regulatory process has created incentives for the dominant firms in infrastructural sectors to deter the entry of new firms in order to limit competition and earn high profits. At the same time, it has not built enough confidence in the system to encourage large-scale investment by the dominant firms to expand services sufficiently. (Annex 14 discusses the regulation of utilities; Annex 15 reviews regulations and competition in infrastructure; and Annex 16 analyzes regulations and competition in natural monopolies in infrastructure.) 2. 157 At present, there is substantial scope for liberalizing the rules of entry for private operators in these industries: For example, in infrastructure, the requirements for obtaining a franchise are unnecessarily complex. 2.158 Securing a franchise for operating a public utility is a two-step process. In the first step, Congress or a local legislature must enact an authorizing law, generally tailored to the individual operator, which details the nature of the franchise and the restrictions on transfer and changes of ownership: For example. the franchise holder must be a Philippine citizen, or a domestic corporation or association with at least 60 percent of its capital owned by Philippine citizens. The franchise is never exclusive, has a maximum term of 50 years, and Congress retains the power to amend, alter or repeal it at any time. In the second step, the industry regulatory authority must give its approval, determnining if the applicant is financially capable of establishing and operating the service, and if it will promote the public interest. Although the law does not define the criteria for a legislative franchise, those applied by the regulatory authority are generally comprehensive. Thus, there is not likely to be any public benefit in maintaining the two-step process. Instead, Congress could delegate the licensing functions to the regulatory agencies. as it has already done for public land transportation and radio and television broadcasting. 2.159 Once a franchise has been granted, the regulatory agency has the power to set performance standards, determine rates, and define geegraphic areas of operation. In the telecommunications sector, the regulator can direct an operator to interconnect its network with that of another operator. PLDT, however, as the dominant operator in the market for toll telephone services, has vigorously argued that its competitors do not have the legislative franchise to operate a telecommunications system. The scope for those actions would be eliminated if the practice of issuing specific legislative franchises were ended. 2.160 The regulatory agencies' ability to function is hampered by weakness and inefficiency, characteristics fostered by the political structure: The agencies are quasi-judicial bodies whose decisions can be appealed to the Supreme Court. Also, agency heads are appointed by the President, subject to approval by the Conigress. which also controls their budgets. They can be dismissed by the President at any time. (Annrex I- discusses possible causes of regulatory failure in the Philippines.) The weaknesses are clearly reIleCL!i in the regulatory system's main characteristics: - 72 - * Lack of sufficient insulation from political processes. * Limited effectiveness. The Philippine regulatory agencies are often poorly endowed with the equipment, skills, and other resources needed to perform their mandated tasks. Their budgets are limited, salaries are low, and recruitment is not subject to strict criteria. * Weakness vis-a-vis those regulated. The regulatory agencies for infrastructural sectors are appendages of the relevant departments, although the recently-created DOE is separate from NPC. The agency heads rank low in the Government hierarchy and have little access to the top echelons. In contrast, the firms they regulate are owned or controlled by groups that have significant resources and political clout. * Nonspecificity of regulations. The regulatory agencies typically have quite general mandates that leave them a great deal of discretion. The Government has not provided detailed instructions about the content of regulatory rules in order to achieve sectoral goals. For example, there is no fixed rule for setting utility prices. * Entry restriction bias. Public utility regulators do not fully control entry. They can exert control by issuing or canceling operating permits for franchised companies. but franchises are nonexclusive and must be obtained from the Congress or, for local projects, from local governments. This system, because it requires entrants to pass two major hurdles, tends to restrict entry. 2.161 A reform agenda to address the underinvestment in infrastructure should have four main objectives. It should increase the autonomy of regulatory agencies, allow them to issue more specific rules, create conditions for contestable markets, and regulate against anticompetitive practices. Regulatory agencies should be strengthened by improving their technical and human resources and their bureaucratic standing. But, full public sector commitment will be needed to achieve the four main objectives. Also, more equipment and increased training for regulators will bear little fruit as long as decisions are not based on economic fundamentals. 2.162 Two factors are likely to hamper the suggested reforms. First, the weakness of the judiciary could adversely affect implementation: Without effective enforcement, regulatory rules will be useless. Nevertheless, progress can be made in this direction by focusing on simple and transparent rules that are easy to enforce. Second, the reforms are likely to meet with opposition from vested interests. But the present condition of the Philippine public utilities should give sufficient reason for pushing for expeditious reform. (il) Competiton Poficies 2.163 Government policy has played a prominent role in the structure and perfornance of the domestic economy. While policy has addressed social, economic, and political concerns, it has also fostered the development of industries characterized by high levels of concentration, and poor productivity and growth, in both domestic and international markets.39 Mostly through interlocking directorates, large incumbent enterprises are often in a position to raise prices through collusion, exclude potential competitors. and 'Tigage in rent-seeking through intervention in the political and regulatory processes. Because the ecopnmoL. interests of special interest groups have been accommodated, if not facilitated, by 39 Medalla 0(190 Paw;. and Medalla (1990). 7he World Bank Basic Economic Report (1993). - 73 - successive administrations,' the pursuit of private gain has not produced the public benefits that usually accrue in a market economy through the efficient allocation of resources. Public policy failure has perpetuated existing and introduced new market failures. Lack of an effective competition policy has heightened barriers to entry and has limited competition, which in turn has had an adverse effect on the efficiency of the private sector. The persistent high levels of industry concentration and the lack of a level playing field between large and small firms, coupled with the "missing middle" (the absence of mediwn-size firms), indicate that substantial successful entry of new medium size enterprises have been blocked until recently. High concentration ratios when coupled with anti-competitive conduct have led to reduced efficiency and inward-orientation of much of the domestic industry (see para. 1. 18). (See Annex 18 for a discussion of the current practice of competition policies.) 2.164 Many firms are inefficient, high-cost producers,4' reflecting the effects of tariff and non- tariff barriers. These barriers insulate domestic firms from foreign competition and the international market, and sustain high concentrations and oligcpolistic market behavior, enabling domestic firms to price up to the tariff (even higher in the case of non-tariff barriers) without facing import competition; this, in turn, dampens incentives for firms to be cost-efficient, leading to misallocation of resources in the domestic economy. 2.165 The prevalence of concentrated market structures and tariff protection is a result of rent- seeking behavior by special interest groups and economic stakeholders, many of whom are linked by extensive interlocking corporate directorates,42 as in the financial sector (studies of the banking system reveal interlocking ownership).43 For example, one of the largest unibanks has links with three other large commercial banks, and a controlling interest in four smaller thrift and savings banks. In addition, this ownership extends to 40 companies in other sectors. Such concentration of ownership seems to have contributed to the slow growth of the banking sector, and restricted finance available to small and medium-size enterprises (SMEs). Because of their socioeconomic and political importance in a concentrated economy, the special interests are well positioned to influence public policy, and have often been able to block competition.' Under their influence, successive governments have created barriers to entry and limited competition through licensing and regulations, ownership controls, granting of special access to resources, and various trade protection measures (see Box 11.3 on how lack of competition adversely affects performance). 2.166 There is considerable evidence that large Philippine enterprises engage in anti-competitive conduct. A 1989 survey of SMEs found that 30 percent of respondents in food processing were subjected to exclusionary tactics by incumbent suppliers; in garments and metal-working, the numbers were 34 percent and 25 percent, respectively.45 However, exclusion is not directed solely to SMEs; large conglomerates also use the tactic to reduce competition from each other. During the Marcos regime, the 40 SGV-USAID, (1992), "Barriers to Entry," especially Volume 1. 41 SGV-USAID. orp) ci- 4.2 Tan, "Interlocking I)irectorates: Commercial Banks, Other Financial Institutions and Non-Financial Corporations,' 1989. '4 SGV- Y\S' s cIi. t. and citations, and Tan (1991). 45 See " Phe Philippines: An Opening for Sustained Growth," p. 187. . 74 - Romualdez and Lopez groups competed for control of (statutory) MERALCO's monopoly on electric power distribution, and the Jacinto and Elizaldes groups competed for the right to set up a cold-rolling steel milU. Thcse disputes were settled through the political process rather than through commercial competition in the marketplace. In addition, large enterprises have persistently and often with success opposed efforts to promote trade, financial, and market liberalization, and their ability 'to intervene in political and regulatory processes has been cited to account for the reluctance of foreign investors to invest in the Philippines.4' Bo :. SI rDw B r_iasu, Dflmt Emino A Tale of Two Compmi 1 . I!PuWic polcies slgnificanf ayfct corporte perftrmnce. The relative comnmrcial success of the Far Eastern Textile Ltd. (FtL) Compay of Taiwan (Cbina over tie Filipinas Synthetic Fiber Corporation (FILSYN) of the Philippines illustrates this pobt vividy. Boh compwles produce synthetic fibers, weu estabied in 198 and had about the same level of initial capacity, 4,700 metric t W a year. Sidlar levels of tariff protection wete provided to each 2. Today, FILSYN's capacity is rated at 37,000 MT. An additional capacity of 4,500 MT is being added under an ongoing modemization project. FISYN is the soh domestic producer and its capacity even after modemization falls short of meeting dometc demand. Excess demand is met through impotts-higher priced, because FILSYN continues to receive tariff protection. 3. In starg connst. FEL's capacity is currently 400,000 MT, ten times that of FILSYN's. Taiwan (China) removed import tariffs on synthedc fiber several years ago. There ar nunerous domestk producers of synthetic fibers and they compete with Japanese nanufhcrurers. 4. In 1989. FETL acquired 40 percent of FILSYN and entered into a management/consultancyagreement. The equity infbsion enabled FILSYN to reduce its leverage. In addition, through FSTL. it is able to procure rajor raw material inputs at lower prices. 5. AIthough FETl and FILSYN had common starting points, they performed differentfy in part because of different government policies: While both imposed tariffs on the import of synthetic fibers, Taiwan (China) iUposed no further entry controls. In the Philippines, the Board of Investments (801) deternined (with advice from incumbent finrs) that additional capacity was needed and-preferred the expansion of the existing firm, Tbis led to the development of a highly concentrated ythediC fiber industy with no competition. 6. It the Philippines, Govermment policy was designed to promote import substitution, while in Taiwan (China), because of dte imied domestic market, the main objective was to promote exports. The inward' vs, 'ousward' policies also had different effect in related sectors. In the Pbilippines. the high cost of donmestically sourced syntbetic fibers and textiles irnpeded the development of a Large export-orientedgunent industry; in Taiwan (China), the syntheti fiber industry became Linked to the tsxtle ad garment industries because of the success and stimlus provided by export markets. 7. In Taiwan (China), tariffs on synthetic fibers have been reduced to zero whereas they continue to be maintained at a high lIvel in the Phippines. The domestic 'monopoly' producer in tbe laer thus has no domestic or external competitive stimulus. 8. The case of FETL vs. FILSYN reminds us of the advice of Michael Pote,r in his book, The Comoeritive Advantage of :Nadons.ft99(n 'Few romes of government are more imponat to the upgTding of an economy thda ensuring vigorous domestic rivalry. Rivaltry a hom is not only unuely iomtw sterin innovadon, but beefits national Industry. In fact, creatng a dmant domestc competitor rry resuts in internasioo compeitive advantage. Firms that do not have to compete at home aely succeed abroad. Economies of scale are best gained througb selling globally .notthrough dominating the home mnarket." (page 662). 2.167 The Philippines has no mechanism for effectively monitoring anti-competitive conduct, but some rerarkable examples of such conduct stand out. In the cement market, the PCIA had regulated entry and marketing arrangements. But in 1987, it delegated its authority over marketing arrangements to a supplier, PHILCEMCOR, which supervised monthly meetings among cement suppliers on pricing 46 See the description of the political backlash against E.O. 470 in BDrrirs to Entry Study, p. 109; see also 'The Philippines An Opening for Sustained Growth,' pp. 233-234, 245-254. - 75 - and establishing exclusive territories."7 Even after the PCIA was disbanded in 1987, these monthly meetings, a form of overt collusion, continued. In a similar case, two competing transit operators agreed to allocate bus routes. This agreement was successfully challenged in a private lawsuit. The Supreme Court ultimately ruled to vacate the agreement between the transit companies but did not otherwise impose penalties. In most industrial and in many developing nations, horizontal price-fixing cases such as these would expose the participating executives to criminal prosecution and their companies to heavy fines. 2.168 Although present Philippine competition law is ibased on U.S. law, a good deal of the practices in the Philippines would not be tolerated in the United States or many other countries. Competition law has been weakly enforced: There is a dearth of private litigation, and only two antitrust cases have been appealed as far as the Supreme Court. Administrative enforcement has been equally weak. Although both the Central Bank and the BOI are authorized to promote competition, their regulatory programs havc often served to promote suppliers' interests at the expense of competition and to the detriment of buyers. As a result, there is a public perception that anti-competitive behavior is tolerated.4" 2.169 Reflecting the impact of entry barriers, the recent trend in market concentration in the Philippines is significant. Between 1983-88, a number of markets became even more concentrated: By 1988, petroleum refining, sewing machines, cells and batteries, transport equipment, motor vehicle parts, motorcycles and bicycles, fruit and vegetable canning, tobacco products, synthetic and treated fabrics, furniture and fixtures, clay products, foundries, steel making, non-ferrous smelting, and photographic and optical equipment had three-firm concentration ratios of nearly 109 percent. Concentration also increased in transport equipment, non-ferrous smelting, grain milling, general hardware, fouadries, synthetic resins and plastics, furniture, mattresses, synthetic and coated fabrics, and food manufacturing. processed milk, dairy products (except miilk), canning and preserving of fruits and vegetables, vegetable and animal oils and fats, cigarettes, matches. synthetic resins. plastic materials, and manmade fibers, glass and glass products, coffee roasting and processing, fertilizers, pesticides, refrigerators, primary cells and batteries. motorcycles and bicycles, non-ferrous sme'ting and refining, and adhesives and glues. Ownership of firms is also highly concentrated and only one percent of companies are listed in the SEC.49 2.170 All in all, 66 Standard Industry Trade Classification (SITC) lines had concentration ratios of at least 70 percent in 1988. up from 63 in 1983. This suggests that market concentration in the manufacturing sector remains unabated. 2.171 Entry barriers are largely the result of Government policies, programs, statutes, and regulations. For example. in the transport industry, until recently, the capacity-regulating rule for inter- island shipping required very long and highly centralized procedures to acquire a public utility franchise for land transport. In telecommunications, the Governmnent namned the dominant firm as the sole international gateway for telephone services, and allowed it to expand services and acquire existing telephone systems until recently. In power, the ownership of power generation was legally separated 47 Agreements amonrig competing suppliers to establish exclusive marketing territories prevent competitinn and thereby allow each suppliet to charge a monopoly price over its assigned territory. Suppliers sometimes allege that such agreements tidcim, tteiglt costs (which can be substantial for cement). Unfortunately. the agreements remove any competatne im ctin tor suppliers to offer low (cement or freight) prices to buyers. 4t See Sen,lit hil N 45. pr 7. 49 These maikcits l hibited increases of more than 20 percent in the three-firm concentration ratio. - 76 - from the ownership of power distribution, and a Government-owned corporation was designated the sole generator of electric power until recently. Private companies and cooperatives are allowed to distribute this power, provided they obtain a franchise to operate a public utility. 2.172 Entry barriers have been created consciously or unconsciously by Government policies and regulations; however, the reasons for erecting them may differ among industries. For instance, the Government's perception of a natural monopoly is one reason. The development of infant industries is another (Box 11.4). Structural entry barriers, on the other hand (for example, economies of scale and cost advantages), are formidable barriers that an incumbent can exploit to discourage new entrants. (Annex 19 shows products covered by various regulations, and Annex 20 provides an overview of some of the manufacturing sectors in which entry barriers are encountered and of actions taken by the last two administrations to lessen them). Other policy-induced barriers to entry include promotion of import substitution and restriction of foreign investment. 2.173 A license is an authorization to engage in or operate a business or commercial activity. For a public utility, however, the license is called a franchise. This is a legal instrument that confers upon existing corporations or entities the right and privilege to use public property for their private business. Under the Commonwealth Act No. 146, also known as the Public Service Act, only the Public Service Commission (PSC) can issue the franchises to utility operators. The Public Service Act was passed not only to protect the public against unreasonable charges and poor or inefficient service, but also to prevent "ruinous competition". Since these objectives are contradictory, the Act has, for the most part, limited competition at the expense of the public interest. 2.174 Currently. the functions of the PSC are carried out by several government agencies: for sea transportationi, by the Maritime Industry Authority (MARINA); for land transportation, by the Land Transportation Franchising and Regulatory Board (LTFRB), for air transportatior by the Civil Aeronautics Board (CAB), and for telecommunications, by the National Telecommunications Commission (NTC). These agencies are all attached to the Department of Transportation and Communications (DOTC). In the franchise, the agency specifies, among other things, the routes to be served and the services to be provided by the operator. They are also authorized to determine rates and fares. This authority allows these agencies to play a key role in determining the structure of an industry. 2.175 In the Philippines, competition has often been viewed as "ruinous" and therefore undesirable. However. it is only ruinous to the inefficient supplier, and in fact is an effective means of allocating resources and therefore beneficial to society. 2.176 In addition to competition, another important factor in determining efficiency is corporate control. That is, mergers that result in changing the ownership from less efficient to more efficient firms would be welcome. However, mergers that increase market power and reduce competition should be avoided. However, mergers of neither sort arc occurring, partly because the Philippines lacks a well- functioning securities market (see the section on the capital markets): Each year between 1987 and 1991, there were fewer than 20 mergers and acquisitions among the more than 220,000 registered corporations. Reform of Compeion Policies 2.177 Competition reforms can be a powerful tool for encouraging economic development. They invelve creati'ig domestic institutions to impede or counteract private or regulatory actions that restrain cornpetition. Competition reform, by inhibiting private restraints of trade and encouraging the design of efficient regulations, would increase the efficiency and flexibility of domestic ma. kets and enhance the - 77 - Box 1.4: Barrien to Entry and the Mobility of Resources Barriers to entry are broadly defined as factors that enable existing firms to earn excessive profits without the threat of new entrants. These factors usually fall into three categories: economic, strategic, and institutional/regulatory. The interaction between these factors is also important as this can further heighten barriers to entry. Economic barriers generally include absolute cost advantages and product differentiation. Absolute cost advantages are a "firm-specific characteristic" and can arise because incumbent firms are more experienced in the manufacture of a given product. This experience may take time to acquire or may not be easily replaced by entrants. First-mover advantages, which arise from being the first firm to enter an industry and establish buyer acceptance for its products, would also be a source of absolute cost advantage. One factor that promotes buyer acceptance and repeat purchasing is product differentiation (creation of real or perceived differences between competing products, such as in product d .. i, image, and quality in the mind of purchasers). Product differentiation can be an industry- or a firm-sn'..ific characteristic, or both. Strategic barriers arise from incumbent firms' behavior aimed at raising the costs of entrants. Examples include predatory piicing, foreclosing sources of inputs or distribution channels, maintaining excess capacity, and product differentiation, such as through large advertising outlays. Firms may also employ strategies using institutional arrangements (such as the legal system) and the regulatory process as barriers to new competition. In the Philippines, it has been alleged that two of the largest and most profitable firms, the Philippine Long Distance relephone Co. (PLDT) and San Miguel Breweries (SMC) have used litigation to delay and increase the costs of entry by new firms. Institutional and regulatory barriers include tari ff and non-tariff barriers to trade, foreign ownership restrictions, quotas, patents, trademarks, and licensing policies. Like many countries, the Philippines has a plethora of these types of barriers. Some are erected to meet social, political, and economic objecLives, but most are questionable. The overall "height' of barriers to entry has generally been defined in terms of the magnitude of prices over competitive costs, the magnitude of cost differences between incumbent firms and entrants, or the magnitude of excess profits. Because of the lack of information on individual firms' costs, and differences in accounting conventions, the overall height of barriers to entry is best measured by the length of time it takes firms to start supplying the market. Thus, regulatory approvals, lags, administrative procedures, and solving the economic and technical problems that a firm may face become high!y relevant in this measurement. The longer the time it takes to begin supplying the market, the higher are the barriers to entry. And the longer the incumbent firms will enjoy the latitude to charge high prices without facing competitive pressures. effectiveness of other structural reforms. It can also reinforce trade and other structural reforms. In addition, it can be effective where trade reform is not. Such reforms would also complement the trade liberalization suggested, especially where the latter would not be effective (as in non-tradable sectors such as transport, utilities, retailing and distribution). 2.178 A great deal can be accomplished in the short-term by reducing entry barriers in regulatory and licensing matters, by focusing on the procedural rules. For example, if an applicant for a license to conduct business must wait to enter while appeals are made, a substantial barrier to entry is created. However, if all applications for a license or permit were automatically granted in a short period, this barrier would be eased. Further, even if the agency denied a license, the applicant could nevertheless continue its business during the appeal process. - 78 - 2.179 Competition policies, like trade liberalization, would serve the goals of efficiency, competitiveness, and economic development, but do so by directly affecting commercial conduct and constraining corporate transactions that lead to inefficiency. By influencing conduct, competition policies expand and reinforce the effects sought by trade liberalization and other structural reforms. By influencing corporate transactions, they preserve the effects sought by other structural reforms. Similarly, competition advocacy reinforces structural reforms by providing an institutional check on government actions that would weaken domestic competition and undermine the effects sought by trade liberalization and other structural reforms. 2.180 Competition reform has been a significant trend worldwide since 1980 and has accelerated since 1988. Many small or emerging market economies have recently adopted new competition laws, including Colombia, the Czech and Slovak Republics, Hungary, Italy, Jamaica, Korea, New Zealand, Poland, the Russian Republic, and Venezuela. In addition, Argf 'i, Taiwan (China), Turkey, and Zimbabwe are now considering or enacting such laws. In Australi a!,.. New Zealand, recent competition reforms were designed to strengthen Common Market initiatives, but in the emerging market economnies, they have been used mainly to support domestic industrial restructuring and reinforce domestic market- oriented reforms (in trade, capital markets and other areas). 2.181 The Philippines' competition statutes - modeled after the U.S. Sherman and Clayton Acts - are not enforced because they rely primarily on criminal sanctions and because of a lack of merger control, vague statutory language, and the absence of a central enforcement agency. Two bills presented to the 1992 Congress would strengthen enforcement: The Senate proposal is especially welcome because it would establish a strong, independent, specialized enforcement agency. The need for such an agency, with exclusive authority to enforce the competition law, derives from the weaknesses of the judiciary. which, in the Philippines. as in most nations, ultimately enforces conmmercial law. The judiciary is plagued by delays, particularly in the lower federal courts, which make it difficult to establish a conmnercial code of conduct (see section on the legal framework). Strong administrative enforcement could offset many of these weaknesses, provided it is structured to ensure that decisions are made objectively and without undue influence or prejudice. Annex 21 discusses specific aspects and factors that must be included in the recent proposals for refon.iing competition policies. 2.182 The Philippines does not presently practice competition advocacy.50 In light of the restrictive regulations, however, it would be useful for authorities to develop an institutional mechanism to counter them. Thus, this report recommends the competition agency be empowered to intervene in the regulatory process and provide expert comment on the competitive effects of regulations. 2.183 Even if the Government enforces competition policy, this would not, in itself, bring about tangible results. Instead, the function of the policy is to maintain a demonopolization program over time. The highest level of Government must fully support the policy and the agency charged with carrying out the reforms should protect and continue the progress that would be made. In particular, the agency should be given the right to overturn anticompetitive decisions and rules of other public sector agencies. Annex 22 provides a list of recommendations to implement the reforms. 2.184 In order to encourage the creation and subsequent maintenance of contestable markets, this report recommnends that the Philippines adopt an adequate competition law and establish an administrative agency to enforce the law. To be effective, the proposed law should treat violations as part of civil law, 50 CoMpetitIOn advocacy implies a formal public expert commentary on government policies with respect to their effect on competition. - 79 - increase civil penalties, and prohibit market dominance. The agency should be responsible for competition advocacy and empowered to review competition policy and activities of other public agencies. In addition, this report also recommends that private rights of appeal he ensured. 2.185 For the reforms to be lasting and successful, all private sector firms must be persuaded that the efficiency gains for the economy will produce benefits that outweigh the costs of introducing these reforms. In some ways, the oligopolies themselves may be helpful to reform, since they stat . to gain considerably from the increase in commercial activity and econiomic growth that would result from microeconomic reforms. For a political coalition to succeed, it may need to persuade these powerful economic interests that they will benefit.5" 2.186 Competition reform would have various effects on the commercial environment. In the short run, merger control and the review of privatization would immediately constrain mergers and privatization in highly concentrated markets. Similarly, legal constraints on inter-corporate relations (cross-ownership and interlocking directorates) would reduce aggregate concentration. 2.187 Also, deregulation could lead to tangible results given the fact that the Philippines still maintains many regulations that are highly restrictive and distortionarv. Further, there are many areas in which the competition agency could provide public studies and recommend regulatory reforms. 2.188 The long run effects could be substantial. particularly for the structure of markets and industries: Competition policies would create an environment that encourages specialization and subcontracting and reduces the advantages of affiliation and conglomeration. This environment would give large Philippine conglomerates an incentive to invest. 2.189 The need to increase efficiency needs to he balanced, however, with the need to control monopolization and market dominance by a few players. It is thus reconmnended that, given the already high concentration ratios in Philippine manufacturing, the proposed competition policy needs to use flexible standards for merger control and to balance the two key objectives of increasing efficiency and controlling market dominance. 2.190 To slow the increase in market concentration, the competition agency should require pre- merger notification and engage in merger control. This would enable the agency to prevent mergers that weaken competition in specific markets. Similarly, the agency should review the proposed privatization of state-owned enterprises and be authorized to block those that reduce competition. Such a policy would help ensure that privatization does not increase the already high level of concentration and market control. (iii) Corporate Insolvency 2.191 The closing of corporations or partnerships in ihe event of insolvency is an unavoidable part of a well-functioning market economy. Thus, insolvency laws should allow failing enterprises to be reorganized on behalf of both debtors and creditors, and should provide a speedy and efficient means of liquidating them and disposing of their assets. In this respect, the laws supporting institutional arrangements in the Philippines are unsatisfactory and need to be modernized. 5I The conglomerates are probably caught in a prisoner's dilemma. Each one benefits directly from protectionist action, but sufters fron the protectionism fostered by other interests. Though all would benefit from general reform, no one wants its own sector reformed. - 80 - 2.192 Jurisdiction over insolvency matters is now divided between the SEC and the regular courts. The SEC is solely responsible for the reorganization of corporations and partnerships unable to meet their current obligations but are solvent, if the balance sheet value of their assets exceeds their liabilities at book values. The regular courts have jurisdiction over the liquidation of insolvent debtors. But in some circumstances, the SEC may appoint a receiver or management commnittee for an insolvent corporation, resulting in an overlap of authority. In addition, SEC officials are required to deal with complex legal and economic issues without clear legal guidelines, and often without the necessary professional training and experience. 2.193 The reorganization option for a debtor in financial difficulty but not yet insolvent, which is modeled on Chapter 11 of the U.S. Bankruptcy Code, should be revised to include certain elements that application of Chapter 11 in the United States has shown to be necessary. In particular, the courts should be able to appoint a trustee to supervise the reorganization, and, if appropriate, dismiss the management and make new appointments. The debtor should be responsible for preparing the reorganization plan, under strict time limits. The role of the courts should be to give final approval to the plan after it has been approved by the creditors. A more rigorous and explicit regime of this kind will ensure that the reorganization option provides a proper balance between the interests of the debtors and those of the creditors, and will increase the confidence of lenders and suppliers who provide credit to private businesses. 2.194 The Philippine law on bankruptcy, in both its substantive and procedural aspects, must be modernized and made consistent and comprehensive if it is to be an efficient judicial mechanism for debt recovery and the liquidation of insolvent business. A system that promotes the first objective also promotes the second; however, the present Insolvency Law, enacted early this century, does not contain the provisions found in modern bankruptcy statutes, and is therefore not well equipped to address current situations. 2.195 The Philippine bankruptcy law does not provide detailed guidelines, standards, or objectives for reorganization and liquidation. An attempt was made to modernize the laws through provisions in Presidential Decree No. 902-A, which authorized the SEC to appoint a rehabilitation receiver or a management committee to determine whether a bankrupt business should be continued in the best interests of the creditors and other affected parties. This appointment may be made even when a business is technically insolvent, and against the wishes of the creditors. However, the decree did not sufficiently define the standards and limitations for the exercise of such powers, leaving the SEC with broad discretion. A new bankruptcy law should specify precisely when rehabilitation oI reorganization can be undertaken, which procedures must be observed, the objectives and parameters of the rehabilitation process, the rights of creditors, and the powers of the rehabilitation receiver or management committee. 2.196 Reform of the Philippine bankruptcy law also calls for an unequivocal policy that should be given precedence in bankruptcy cases: At present, the legal framework does not unambiguously favor debtors or creditors. Instead, the law should specify how the interests of debtors and creditors will be balanced in cases of insolvencies. Although a finding of insolvency usually results in the liquidation of the debtor, the rehabilitation of the debtor seems to be the paramount consideration when a rehabilitation receiver or a management committee is appointed under the Presidential Decree No. 902-A. 2.197 The bankruptcy law should be modernized along with institutional changes. To ensure efficient implemenitation of the revised law, special courts should be created that have exclusive jurisdiction over all cases involving bankruptcy, insolvency, suspension of payments, rehabilitation, reorganization. and illiquidity. This has several advantages. First, it will facilitate the disposition of cases, and reduce the time and expense involved. Second, judges can be appointed who have the - 81 - necessary technical expertise. Third, it will prevent debtors from using the SEC procedures to delay recovery by creditors. With a system of special bankruptcy courts, one person will evaluate a business' financial problems and decide whether to rehabilitate or liquidate. 2.198 Regarding the financial sector, inability to intervene quickly and effectively with failing institutions, even when problems are diagnosed in a timely inanner, perpetuated the weakness and inadequate capitalization of the domestic banking system in the past. In most cases, the Central Bank took remedial actions such as recapitalization, and negotiated with bank owners on corrective measures, but often the finances of the institution further worsened during these negotiations, ultimately resulting in failure. Moreover, because the Central Bank did not have the legal power to issue cease and desist orders until the passage of the Central Monetary Act (CMA) last year, some insolvent banks continued to operate, while others were closed; this led to lawsuits from bank owners and directors over inconsistent rules. These lawsuits further challenged the Central Bank's authority to intervene. Many examiners were sued in the aftermath of the bank closures in the 1980s and were personally at risk because the Central Bank did not - by law - financially protect examiners if they were sued by the banks. Under the new Central Bank Act, the Monetary Board may indermnify its members and other officials of the BSP against all costs and expenses reasonably incurred in connection with any civil or criminal action unless courts judge actions of the officials liable for negligence or misconduct. 2.199 One of the most serious challenges to the authority of the banking system's administrators was a Supreme Court case involving the Monetary Board's closure of a savings bank on the grounds of insolvency. In Banco Filipino Savings & Mortgage Bank v. Court of Appeals, December 11. 1991, the Supreme Court overturned the action of the Monetary Board stating that the bank was not insolvent at the time of closure, since valuation reserves should not have been deducted from the assets of the bank. Under the new CMA mentioned above, the supervisory powers of the Central Bank were strengthened. As a result, it is expected that the BSP will address insolvency issues expeditiously in the future. (iv) Legal Framework 2.200 The Philippine judicial system is widely perceived as failing to meet the needs of the private sector. Although the system is generally adequate for a market economy on paper.,2 its ability to render justice and enforce contracts is seriously constrained by the inabiiity of the courts to cons istently provide (a) relief against abuses by Government officials or improper administrative actioils; (b) prompt determination of the rights of parties to comnmercial transactions; and (c) reliable and rapid disposal of civil litigation. A well-functioning legal system is essential to resolve disputes quickly and inexpensively, to enforce contracts properly and rapidly, and to ensure fair, transparent, and competitive markets. Although existing firms, especially large ones, find ways to circumvent the existing legal barriers and use them in order to deter new firms from entering, a well-thought-out judicial reform could be an important component of a program to promote efficient private sector development. 2.201 The Constitution provides maximum periods for disposing of cases.53 Once the parties to a dispute have filed their pleadings, a trial court is required to make a decision within three months, and the Supreme Court within 24 months. In practice, however, these time limits are frequently exceeded; the failings of lawyers. judges, and court personnel have made delay endemic. One reason is the failure to dispose of outstanding cases when a judge retires, resigns, dies, or is transferred or promoted, even 52 As discussed ahmt. laws fbr promoting competition and regulating monopolies need to be improved. 53 Anicle Vill. Section 15. - 82 - though delays impose significant costs on the parties to civil litigation. Not only are court proceedings expensive, but delays can affect other business transactions in which financial issues are at stake. Long delays can also be ruinous to the party bearing the financial risk of the disputed contract, and highly advantageous to the party relieved from the obligation to make payment during the trial period. Such delays can dissuade a party with a meritorious claim from pursuing that claim and instead force an unsatisfactory compromise. 2.202 Respondents in the enterprise survey discussed earlier (see paras. 2.2 and 2.3) indicated a high level of dissatisfaction with the legal system. Most strikingly, all respondents said they would not attempt to resolve a legal dispute entirely within the formal system, even though most had previously attempted to do so (Table 11.8). The data on the time required to resolve disputes in court as opposed to outside clearly indicate a major source of discontent for the private sector. On average, court cases took more than a year, with some firms still awaiting a decision after a year and a half. In contrast, settlements were reached out of court in less than four months. Asked to explain their preference for resolving future disputes out of court, most firns said that court settlements were too costly, time- consuming, or both. Three firms felt that involvement in formal legal actions would hann their business reputation. 2.203 The ratio of practicing private lawyers to the general population is relatively high and, in the major urban centers, there are significant numbers of law firms to serve the needs of the private sector. In rural areas, however, private lawyers are in short supply. In Palawan, for example, the number of trial courts exceeds the number of practicing lawyers. Most major law firms include partners who obtained academic qualifications or work experience outside the Philippines, frequently in the United States. Law firms are well equipped with computers, libraries, and other facilities, and are fully capable of hJlping their clients minimize business risks. 2.204 Although the problem of judicial misconduct exists in all systems, the public and members of the legal profession believe that corruption is widespread in Philippine courts. Between January 1991 and June 1992, out of a total of 1,936 judicial positions, eight judges were dismissed for misconduct, two were suspended, 19 were fired, eight were censured, and eight were reprimanded. In the mid-1980s, El Ponente, the official newsletter of the Ateneo Law School, conducted a survey among judges and lawyers. The respondents said that they believed that dishonest judges outnumbered honest ones and that incompetent judges outnumbered competent judges. Similar results have appeared in other Philippine public opinion surveys. When public confidence is weakened or lost, it contributes to a spiral of declining standards among litigants and their lawyers who seek other ways to win cases in what they feel is a capricious environment.54 54 On August 27. 1992, the Philippine Supreme Court issued a decision in the case of 'Philippine Long Distance Telephone Co. v. National 1elecommunications Commission et al.' (G.R. No. 94374) which revoked the grant to Eastern Telecommunications Philippines, Inc. (Eastern) - a license to operate an international gateway facility in the Philippines. The Supreme Court ruled that Eastern's franchise did not authorize it to engage in telephone services, but merely in record and data services. Eastern was considered as one of PLDT's strongest competitors in the telecommunications industry. But the Supreme Court decision weakened Eastern's bid to challenge PLDT in the market for overseas traffic. On JanuarN 28. 1993, two local newspapers reported the findings of a language expert that the decision on the Eastern case may have been prepared for one of the justices by a lawyer working for PLDT. Claiming innocence, the justice resigned trnm the Supreme Court a few days after the newspaper articles came out. This controversy sparked a discussion on the existence of graft and corruption in the judiciary. The Office of the President expressed concern and indicated that initiative in investigating the matter shnotId be taken by the Supreme Court. - 83 - Table 11.8: Firms' Experience with the Legal System In court Before decision Before going to trial How firms have 64 9 36 resolved disputes (percent) l How firns would 0 7 93 resolve next dispute (percent) l Months required to 13 18 4 resolve previous disputes Note: Data in the first two rows refer to disputes occurring in the first two-year period prior to the survey. Source: World Bank, Enterprise Survey. 2.205 The perception that the courts are corrupt continues to erode public confidence in the system. The Government should ask the Supreme Court to review its procedures for handling complaints against judges and court personnel, in order to investigate and dispose of complaints rapidly, fairly, and transparently. 2.206 The Government should articulate its commitment to reforming the judicial system. A strategy could include establishing a standing judicial commission of judges from each level of the system together with the Secretary of Justice or an alternate. The commission would be responsible for judicial training and improving court facilities and resources. 2.207 The Integrated Bar of the Philippines should require its members to comply with the Canons of Professional Ethics. In particular, lawyers should be encouraged to seek reviews of the interlocutory orders of trial courts only when they are satisfied that there is an arguable case for relief. It is suggested that the Integrated Bar actively pursue complaints of professional misconduct by lawyers and judges. 2.208 Complaints of judicial misconduct by lower court judges should be promptly dealt with by a division of the Supreme Court, and the Court should encourage judges against whom complaints have been filed to step down until matters are resolved. When a complaint is upheld, the details of the charge, the name of the judge, and the penalty should be publicized. - 84 - 2.209 Although arbitration is now used in relatively few disputes," the practice is growing to include comiipulsory arbitration provisions in important commnercial contracts.,' however, there are two problems with this alternative. The first is the shortage of qualified arhitrators. The second is the inability of arbitrators to enforce their awards if one of the parties does not accept the outcome. The successful party can apply to the courts to enforce it within one month after it is mad,:, but the ease with which the opposing party can delay enforcement by tiling motions for relief or taking other procedural steps weakens the benefit of arbitration. 2.210 The use of arbitration for commercial cases complemenms the other mechanisms for resolving disputes. However, there will always be a significant number of commercial cases that must be dealt with in the courts because the parties do not agree to arbitration. Judges must therefore develop the skills to deal with complex commercial cases. 2.211 Given the courts' heavy workload, it is suggested that the tieeds of the business community would be most effectively a ldressed through specialized commercial courts. These courts would have exclisive jurisdiction to deal with commnercial matters and would be located in urban centers, where the majority of commilercial disputes arise. Initially, pilot courts could be set up in Manila with three to five judges who would handle only commercial law matters. The advantage ot this arrangement. which is widely used in many coutiries, is that it develops a high level of skill amorng the judges. who would then be able to use flexible procedures to encourage mediation and conciliation or, where that fails, to try cases expeditiously. Another advantage of removing commercial cases fromz the trial courts is that it frees up thiose courts so that they canl deal more effectively wvith criminal and other minor civil cases. It is suggesteti thiat the pilot cotimimiercial courts be given expanded powers to provide rapid and flexible justice. If the cOuTts prove successtul in reducing delays and improving judicial pertormance, consideration could be given 1ll estahli*1hin1p wLiniercill courts in other major urban centers. F. Financial Sector Constraints Introduction 2.2 12 rhe Philippiteis f'iriancial sector, and in particular the capital markets, have played a limited role in tiniancinig the investment requirements of the private sector. The size of the financial system as a share of GDP is small in comparison to the other ASEAN countries. Macroeconomic distortions, particularly the losses of the Central Bank of the Philippines (CBP) until recently, have contributed to the disintermediation of the domestic financial system. Also, the equity market has remained small when compared to other countries in the region despite a sizeable growth in market capitalization in 1993 and the early part of 1994 (see Chapter 1). There is a need to strengthen bank supervision, including oversight of public financial institutions. There is also a need to improve the efficiency of the domestic financial system both in terms of mobilizing additional savings and allocating financial resources. 55 ior (i(v t' 1mt ,n irasiructure contracts, the Department of Public Works and Highways insists on a standard arbitration ff Theei ha\t heen instances in whicha majorcommercialdisputebetweentwo Philippine corporationshavebeen referred to arbitratioi im Hong Kong. Although the costs of sending lawyers and witnesses to Hong Kong are considerable, the benefit can he a fast and reliable resolution. - 85 - 2.213 Financial market development in the Philippines has lagged behind that of other ASEAN countries, and Philippine banks are smaller in both asset size and capital base than their ASEAN counterparts.57 In a 1992 ranking of 200 Asian banks by the size of capital,5" the three largest Philippine commercial banks - all Government-controlled institutions - ranked 52, 80 and 81. By asset size, they ranked 93, 161 and 164. The top three privately-owned commercial banks ranked 110, 111 and 112 in capital stiength, and 136, 150 and 163 in asset size. The 18 Philippine commercial banks that rank among the top 200 Asian banks control only 0.9 percent of total Asian bank assets, as compared with 3.9 percent for Thailand, 3.3 percent for Indonesia, and 2.2 percent for Malaysia. 2.214 The level of domestic savings in the Philippines has been among the lowest in Asia relative to the level of economic activity. Savings averaged less than one-fifth of GDP as compared to more than 30 percent in other ASEAN countries. This reflects low levels of financial intermediation: by 1993, the ratio of M3 to GNP had still not recovered to the pre-crisis levels, while the share of bank credit to the private sector in GNP amounted to less than one-third the rate in neighboring countries (see Table 11.9). Also, domestic credit to the private sector has fallen in the last decade; this trend needs to be reversed and equity mobilized if private investment is to expand on a sustained basis. To accomplish these goals, incentives must be improved for channeling market-sourced funds (both domestic and foreign) into productive private investment, particularly since infrastructure projects have been earmarked for private investors and the Government is promoting privatization (see Chapter I). Table 11.9: Philippines - Gross Domestic Savings, 1991-93 (as a % of GDP) 1991 1992 1993 Avg. 1971-80 Avg. 1981-90 Indonesia 35 37 38 22 32 Malaysia 31 36 38 29 33 Singapore 46 47 48 30 43 Thailand 35 35 37 22 27 Philippines 16 15 15 27 22 Source: ADB. Investment Finance 2.215 Long-term credit for private sector investment projects fell in the past decade, primarily because the uncertain economic and political climate slowed down private investment. At the same time, banks shortened loan maturities in response to the volatility of domestic interest rates. As a result, investments in development and expansion projects, requiring long-term financing, were not undertaken. The short-term loans have been based largely on collateral and not on cash flows, and this has restricted funds for small and medium size businesses. 57 There are 91f6 operating financial institutions in the financial system as follows: commercial banks (32), private development hanks (37), savings and loan associations (52), savings and mortgage banks (8), and rural banks (787). 58 The Banker, "Top 200 Asian Banks," October 1992. - 86 - 2.216 In the past. thie private sector's long-term financing needs were met by the public development banks; but this source was greatly reduced when both the Philippine National Bank (PNB) and the Development Bank o! dit Philippines (DBP) became insolvent in 1986. Long-tern loans as a share of total banking sector lenidinig fell from 12 percent to 10 percent between 1980 and 1990. reflecting a further reduction of already limited long-term funds. Within the domestic banking system, the main source of long-term lending is currently rollovers of short-term credits, but most long-term funds have been available only through the World Bank, the Asian Development Bank, and Japan under the ASEAN Japan Development Facility and through the OECF and the Export-Import Bank of Japan. To finance private investment on a sustainahle basis, long-term domestic funds need to be generated. Recently, macroeconomic stability and liberaiizationi of foreign exchange markets have increased access to foreign exchange financing. The Go' ernmient successfully sold a US$150 million Eurobond issue in early 1993. It is also highly likely that ahout lt) of the largest and financially strong firms (both public and private) could sell securities in limited anmaUnts in international capital markets: In 1993, PLDT, PAL. PNB, PNOC and NPC borrowed fr-ni these m'iarkets. Although foreign exchange financing from abroad is still limited due to the perceived i. .' isk. international lending should increase if political and economic conditions remain favorahbc Role of Government BaYl.s .2 17 The roik p1 o Julih hanks has not encouraged the development of the domestic bankitig sector in the Philippu.:, Iaroni the early 1970s until 1985, the two largest Government-owned banks, PNB and DBIP. aczotJlowj d tin about lhalf the domestic financial system's total assets. Until 1986. PNB held lialf of all conini 1 1 _. .n ih assets. and its large government deposits resulted in a lower cost structure than that of oithtr iltl, P'NB became insolvent in 1986 with large noni-performinlg assets - tht- result of mismarnagenient and loatns tor nonviable projects made at the request of the Miarcos administration - which r %crc *rintied nmostly on political grounds. 2.218 In 1986. PNI 3 .v rcstruI;tured under the Economic Recoverv ILoan (ERL) and 5( percent of its assets were transferred to the: \sset Privatization Trust iAPT)C" The Loan also included an institutional strengtheninlg programn that entailed reducing staff, consolidating hranches, and improving the budgeting and planning processes. This program has worked satisfactorily. In 1989, PNB was partially privatized and 30 percenit of its shares were offered to the public. The Government plans an eventual 100 percent divestiture, which this report supports. 2.219 Like PNB. DBP also became insolvent in 1986 and underwent a major financial restructuring. DBP's insolvency resulted from its financing of Marcos' political "cronies" as well as its assuming non-performning loans for failed public and corporate projects between 1982-86.i' To provide term-finance, DBP was tasked to become a predominantly wholesale bank, providing long-term funds sourced from multilateral and bilateral agencies to domestic financial institutions for on-lending to the private sector. To sustain DBP's wholesale operations, the absorptive capacity of its active conduits has to be expanded. Currently. most of the conimercial bank conduits, which are the more active participants under the various wholesale lending programs, have reached their credit ceilings, which are based on DBP's single borrower's limit (SBL). If DBP will pursue its wholesale role, there is a need to address the above constraint. Until the domestic capital market is fully developed and is capable of providing 59 Econrnti Recovery Loan (No. 2787-PH). 60 Ttiie'., hr sets ., e 'c!tN . huo,,-;r nm1 <: -eo f'< ; t + 't r,'',W- - 87 - adequate financing to the private sector, DBP will need to continue to play a pivotal role in addressing the funding gap in the financial system. 2.220 The Land Bank was created as a conduit for Government funds for agrarian reform, and to make loans for agricultural development projects. LBP has incurred losses in its agrarian credits because of the high cost of lending (high cost of funds, excessive administrative costs, and loan losses) compared to the interest rate charged to small agri-borrowers. Through its commercial banking operations, LBP generates income which offsets the agrarian sector lending losses. Under the FSAL (the Financial Sector Adjustment Loan), LBP was given the role of the apex bank for agricultural credit (this function was transferred from the CBP). LBP will remain publicly-owned and will serve as both a development bank for agriculture and a commnercial bank. 2.221 Rural banks comprise 86 percent of the banks in the country, but their total loan portfolios and deposits are only four percent (P 15 billion of P 370 billion) and three percent (P 13 billion out of P 508 billion), respectively, of the domestic banking system. In Regions I (Ilocos) and IV (Southern Tagalog) alone, there are 104 and 153 rural banks, respectively, with average resources of only P 27 million each. If these banks combine their resources, they will likely raise their efficiency in the delivery of credit. particularly to the countryside, where there is poor access to formal lending channels. This has been done in the past as in the case of 18 rural banks in Central Visayas which merged to form the First Consolidated Rural Bank of Bohol. Competition in the Banking Sector 2.222 New banks may be established with the BSP's approval. According to the BSP guidelines, qualifications for a banking license include, but are not limited to, compliance with all laws and requirements for capitalization and administration: integrity and responsibility of the organizers and administrators; and their ability tc ensure the institution's safety. Despite this open entry policy, bank entry seems restricted. Because of the financial sector's past problems, the BSP prefers banks with a large capital base. However, the limit on the foreign equity investment in domestic banks limits their capital base. Foreign banks, except the four already operating when the sector was closed to new foreign entrants, were de facto precluded from opening new domestic branches. These barriers have contributed to an oligopolistic structure and concentration in the financial system. 2.223 In April 1994, a reform bill (Republic Act 772i) was passed to allow entry of foreign banks (see Table 11. 10 for a comparison of various bills presented to the legislature). The number of branches that may be established by foreign banks is limited to six, with the possibility of increasing this number to ten upon recommendation of the Monetary Board, subject to the approval of the President as the national interest may require. Also, branch banking is allowed only during the five years following the effectivity of the loan (see para. 2.39). In approving entry applications of foreign banks, the Monetary Board will take into account the following criteria (1) geographic representation of foreign banks; (2) strategic trade and investment relationship between the Philippines and the country of origin of the applicant; (3) the applicant's reputation; (4) reciprocity rights; and (5) the willingness of the applicant to share advanced technology. In order to prevent the dominance of foreign banks in the banking sector, the Monetary Board has been mandated to ensure that at least 70 percent of the resources or assets of the entire Philippine banking system are held at all times by domestic banks which are majority-owned by Filipinos. Although current liberalization is expected to lead to modernization of the sector, further liberalization in the future is desirable. (Table 11. 10 shows a comparison of various bank reform bills presented to Congress.) - 88 - 2.224 It is expected that the enactment of RA 7721 would attract the entry of reputable foreign banks which, with large capital base and established track record should contribute to a stronger and more efficient domestic banking system and stimulate further trade flows and foreign investment. In particular, the entry of foreign banks is expected to improve financial intermediation as commercial banks compete with each other for market share through improved quality and broader scope of services, lower interest rates and loans and introduction of technological innovations should further enhance productivity, risk management and competence in the bankirig systemi. Table 11.10: Comparison of Bank Refonn Bills HB 8226 SB 1606 RA 7721 MODE OF ENTRY l wholly or majority-owned domestic subsidiary up to 60% of locally incorporated subsidiary up to 60% ot locally incorporated acquire up to 70% of existing domestic bank acquire up to 60% of existing domestic bank. subsidiary acquire up to 60% of existing domestic bank. wholly-owned branch. wholly-own:d branch. wholly-owned branch. NUMBER OF BANKS OF ALLOWED Branch mode no limitation. maximum of 6 foreign hanks + 2 upon maximum of 6 toreign banks - 4 upon .ippros il h\ the Pre.vient approval by the President (in addition to 4 existing foreign banks). no limitation, Subsidiary /acquired bank no limitation no limitation. NUMBER OF BANK BRANCHES Branch mode maximum of 6 branches. maximum of 6 branches maximum of 6 branches (for existing toreign banks. present number of hranches +6). full branching capability, subsidiary/acquired bank full branching full branching capability. capability. LOCATION OF BRANCHES Branch mode no restriction. bank to decide location of first 3 branches. bank to decide location of first 3 branches. Monetary Board may decide location of new 3 Monetgry Ronrd will designate location of branches. next 3 branches. subsidiary/acquire bank. no restriction. no restriction. - 89 - CAPITALIZATION Oranch Mode PAC of P 125 million for first 3 branches plus PAC of P300 million "or first 3 branches plus PAC of P210 million for tirst 3 bianches P25 million for each additional branch up to P50 million for each additional brarch up to plus P35 million for each additional 6 6. branch up to 6 some requirements as local bank commercial Subsidiary/acquired bank some requirements some requirements as local bank- bank P750 million universal bank P1.5 as local bank-commercial bank P750 million commercial bank-P750 million universal billion. universal bank - P11.5 billion. bank - P 1.5 billion. NET DUE TO HEAD OFFICE capital = PAC + NDTHO. capital = PAC + NDTHO. capital = PAC + NDTHO. maximum permitted ratio of 5:1 but amounts PAC-NDTHO ratio to be set by Monetary PAC-NDTHO ratio to be set hy Monetary and ratio may be modified by Monetary Board. Board. Board. RESTRICTION ON CAPITALIZATION PACNDTHO to be remitted to thc LOuntrv PAC and 15% of NDTHO rousi he and converted to pesos. re nitted to the country and oenerted to p:,s,s (except where amounts are invested in productive enterprises or utili7ed hy Philippine companies for export activities). LINITATION ON ENTRY PERIOD Branch mode none 5 years. 5 years subsidiary/acquired bank. none. none. RESTRICTIONS Monetary Board to give preference to publicly Monetary Board may adopt measure.; to: Monetary Board may adopt measures to: held foreign hanks considering indicators of dispersed ownership, such as levels of single * ensure that at all times 60% of assets * ensure that or all 60% of assets of ownership, number of shareholders. of the banking system is held by the banking system is held by domestic banks. Filipino barks. * prevent a dominant market position * prevent dominant market position by one bank or groups with related by one bank or groups with interests. related interests. * secure listing of shares and ensure * secure public listing of that at least 10% of shares for public subsidiaries and foreign acquired listing be reserved and sold to bank's banks. employees. - 90 - CRITErIA FOR APPROVAL BY MONETARY BOARD consider geographic representation and sane, geographic representation and strategic strategic trade and invesutent relationships trade and investment relationship between between the Philippines and the bark's home the Philippines and bank's home country. courtmy. reciprocity. same. reciprocity rights are enjoyed by Philippine banks in foreign bank's horie country. global reputation for financial innovation an;d same. global reputation for financial innovations stability. and stability. technology transfer. willingness to share technology. For subsidiary or branch preference for publicly held banks subsidiary no foreign bank may qualify to set up or acquire equity in a domestic bank. subsidiary or acquire equity in existing bank * only those among top 150 banks unless it is widely-owned and publicly listed in in the world or top 5 banks in country of origin (except if it is amongst the country origin, top 3 banks in its home country). * must be wiuely owned and publicly-listed in home country except where applicant is state- owned bank. Crowding Out 2.225 Credit to the Philippines' public sector crowded out credit to the private sector during the past decade. In 1983, the share of domestic credit channeled to the private sector equaled 33 percent of GDP; by mid-1994, it had fallen to 27.3 percent. In 1991, the claim of the public sector on domestic financial resources (bank credit to public sector plus the public borrowing through the sale of T-bills) rose to 33 percent of GDP." To expand credit to the private sector, there is aiso a need to increase the capitalization requirement, to ensure the safety and soundness of the banking system, and to enable banks with branch networks to service a wide client base. 2.226 The insolvency of the Central Bank created a major macroeconomic distortion and resulted in disintermediation of the financial market in the past. Its financial problems have constrained the growth of the banking sector through its imposition of high reserve requirements (RRs) of 24 percent until recently. Those losses averaged about 2.5 percent of GNP during 1986-92. These also stemmed from high debt levels, in particular, the large foreign liabilities assumed during the debt crisis of the early 1980s and improper currency forward and swap transactions (see para. 2.13). These deficits made the Central Bank dependent on the NG to issue Treasury bills to control liquidity, and also necessitate high reserve requirements - 25 percent by 1992 - that aggravated already-high bank intermediation costs. Moreover, the losses tended to grow over time because of depreciation and interest payments on debt issued to fund previous deficits. The growing mismnatch between the Central Bank's foreign exchange assets and4 liabilities led to large deficits that were not dealt with for some time by the Central Bank and 61 1990 Annual Report, "Statistical Bul'etin," Central Bank of the Philippines. - 91 - the Goverrnent. Substantial losses were also incurred in recent years in connection with open market operations (OMOs). 2.227 After a long delay, the Central Monetary Authority Act was passed in June 1993 and became law one month later. The plan consisted of the following features (a) issuance at market rates of Peso 220 billion in Goverrunent securities to the CBP. Of this amount, Peso 50 billion will have a maturity of no less than 25 years;lb) placement of a core deposit of Peso 50 billion at market rates by the Government with the BSP to match the maturity of long-term Government securities. The core deposit will have a maturity of no less than 10 years; (c) BSP will contribute 75 percent of its net income after reserves to the Government as a dividend. Any net income over one percent of average total assets will also be declared as an extra dividend for the Government; and (d) the Government services all C3P loans to itself at market interest rates. With the implementation of the above plan, the Philippines now has a financially strengthened Central Bank. This plan satisfies the key objectives of the restructuring, which are to (a) make the Central Bank financially solvent with a positive net worth; (b) facilitate effective monetary policy operations, including appropriate open market operations without resorting to the use of monetary instruments that distort financial intermediation; (c) reduce the financial intermediation cost over time; and (d) have a financial structure that would ensure that BSP will not hzve to depend on the GOP for budgetary support. 2.228 Government lending programs have been largely ineffective in the past. tying up credit that could have been used to fund efficient private sector initiatives. Most of these programs have been phased out. However, a new program - Magna Carta for Small Enterprises - was introduced in 1992 This program requires all lending institutions lend a predetermined share of their total loan portfolio to small businesses. The requirement demandJ five percent the first year, and 10 percent the second through fifth years of the programn. However, it is virtually impossible for commercial banks to achieve these targets in the short time frame provided under the program. Therefore, they prefer to buy the promissory notes issued by Small Business Guarantee and Finance Corporation, which carry more attractive returr.s than other investment alternatives allowed under the law. However, at only two-thirds of the yield of the T-bills, this represents an additional cost to commercial banks.62 Given the unequivocal past failure of such programs, this report recommends that such programs - those lent at subsidized rates - be phased out. 62 The Go%ernmti- - c2ognized under the medium-term development plan that mandatory credit allocation increases intermediani .:I The current BSP rediscounting facility channeled to export credits of commercial hanks provides additional incentt'es to exporters, but not as a direct credit allocation. Rediscounting of eligible papers of indirect exporters ha%c 7t ctrntly been allowed for cottage/small and medium industries (producers/manufacturers) with supply arrangenient v itni direct exporters. - 92 - Tabk 11.11: Revenue Collected from Taxes on the Financial Sector, 1993 Share of Central Type of Tax Nfillions of Pesos Government Revenues (S) Tax on dealers in securities and lending investors 3,360 /a 1.5 /a Gross receipts tax on banks and nonbank financial 3,980 1.54 intermediaries Tax on insurance premiums 876 0.03 Documentary stamp tax on financial instrumtnuts 5,733 lb 2.22 Transaction tax on sale of shares of stocks 456 ic 0.02 /a 1991 figures. /b Other documentary stamp taxes are included. /c A tax rate of 0.25 percent on both listed and unlisted shares of stocks. Source: Department of Finance. 2.229 Taxation of Financial Instruments. Heavy and distortionary taxation of the financial sector retarded its development as it raised the intermediation cost (Table II. 11 shows revenue collections). The gross receipts tax (GRT) and documentary stamp tax (DST) on financial transactions account for the largest tax revenues collecLed. A comparison of real lending rates across selected Southeast Asian countries shows that the Philippines had the highest real domestic lending rates during 1986-91, followed by the Republic of Korea, Taiwan (China) and Thailand. In 1992, the spread between lending and deposit rates in the Philippines was about nine percentage points and this raised the cost of capital even further. Although in iine with the recent deceleration in domestic inflation, nominal rates have been falling, but bank spreads have not yet come down appreciably. High real interest rates have led in the past to reduced private investment. The Government plans to replace the GRT and DST on financial transactions with the newly expanded value-added tax (VAT) law. However, the VAT will be levied, assessed, and collected on services rendered by banks, non-bank financial intermediaries, finance companies, and other financial intermediaries perforrning quasi-banking functions two years after the effectivity of the Act. Since VAT is deductible as an input tax credit by borrowers, the distortion caused by the GRT will thus be removed. Furthermore, the Government plans to review the DST and capital gains tax as part of the ongoing work of the Task Force on Tax and Tariff Reforms (see para. 2 21). 2.230 The Philippines has the highest RRs of all ASEAN countries: RRs in Malaysia, they are 4.25 percent, Singapore 6 percent, Thailand 7 percent, and Korea 8 percent. High RRs (currently at 22 percent) reduce the financial resources that can be channeled to the private sector and increase intermediation costs.`3 Until recentiy, commercial banks were required to have higher reserves than 63 The reserve requirement against deposit and deposit substitute liabilities of commercial banks was reduced from 25 percent a, .), end- 1992 to 22 percent effective July 30, 1993. In lieu of the scheduled further reduction in reserve ratio and effec 1x e end- 1993, banks were allowed to invest two percent of their reserveable deposit and deposit substitute liabilities in Governrent securities purchased from the BSP in order to increase banks' earnings on reserves and reduce intermedhation cost. As monetary conditions may allow, BSP intends to make similar adjustments in the reserve requirement. to enable further reductions in lendina rates without jeopardizing the price stability objective of the BSP. - 93 - thrifts and rural banks in order to offseL the cost advantages they enjoyed; however, because the smaller institutions consistently lent at higher rates, the RR was subsequently equalized for all domestic financial intermediaries. RRs are estimated to contribute more than 50 percent to intermediation costs. with commercial banks receiving a below-market interest rate of only four percent on these reserves. The restructuring of the BSP will gradually reduce the need to tax the financiai system through high RRs, and the Goveniment has announced a program to gradually lower them. However, under the BS? restructuring program, the RRs are progranuned to be reduced only to 12 percent - still a high rate when compared to tiiose in other Southeast Asian countries. 2.231 Since RRs in the Philippines are so large, and the rate of return paid on them is so small, the RRs are effectively an implicit tax on the banking and the real sectors. The GRT and the implicit tax have received considerable attention in discussions of the tar. burden on bank inter.e.diation. Removing the GRT over time would reduce the effective tax rate. Securities Markets 2.232 Private sector development will require stronger regulations, supporting institutions, improved disclosure, and lo.,er tax burdens. The vision for the future is one of rapid development of the corporate bond and equities markets, and a more efficient Government securities market. 2.233 A long-term corporate bond market does not yet exist, but a limited short-term debt (commercial paper) market has started to grow in the last few years. Outstanding commercial paper with maturities of less than one year amounts to some P 7.3 billion, while paper with maturities between one and five years totals l 12.8 billion. Current spreads on successful offerings are 1.5-1.6 percentage points over the Government's 91-day T-bill rate. There is negligible secondary trading of commercial paper. Undoubtedly, uncertainty regarding the future course of domestic inflation is partly responsible for limiting the amount of negotiable private sector debt, given the lack of variable interest rate instruments. 2.234 The presence of the DST may have b..en a key factor in retarding the development of domestic bond markets. Any negotiable private sector debt instrument is subject to the DST. Because the DST rate is 1/2 of I percent on the face value of the instrument, the cost of a debt issue is 1/2 of 1 percent higher than the cost of a bank loan; thus, the domestic bond market has not developed. The DST also acts as an impediment to the development of a secondary market in corporate bonds. To raise revenues, the Government passed a law to increase the DST in December 1994, which took effect in mid- January 1994. This report recomnnends early phasing-out of the increase, eventually eliminating the DST and replacing the loss in revenues with increases in non-distortionary taxes. 2.235 In the short-term, the need to protect the public revenue base may preclude attempts to reduce the heavy taxes and equalize effective rates on financial instruments. However, some reforms could keep revenues from being reduced, especially if they were introduced in one package. In particular, the following changes merit the Government's consideration. * Removing the DST on negotiable debt (this would lessen tlhe reliance on short-term financing. and since there is currently little negotiable debt, this chinge would have virtually no effect on public revenues). * Remo1 ing the GRT, which would reduce the effective tax rate on intermediation (this would result mn a revenue loss, estimated at P 3.7 billion in 1991. However. removing the GRT o(n die financial intermediation cost would have a marginal impact compared with reducing the RRs or increasing remuneratior. on RRs). -94 - 2.236 The revenue loss resulting from these changes were estimated to have been around ia 4.3 billion in 1991. This loss could be offset with the following statutory revisions: * Taxing capital gains on all equity, whether listed or not, and on individual real property at a uniform rate. There is no justification for differential treatment of capital gains of any kind; thus, it is suggested that the final withholding tax on Fales of listed e4uity (1/4 of I percent) and on unlisted equity (10 percent for gains under P 100,000 and 20 percent for gains in excess of this amount) be replaced by a single tax on capital gains. It might be argued that this differential tax treatment is necessary for equity market development; however, while it is true it should provide a significant incentive for firms to list in the domestic exchange, it does not seemn to have had this effect. (It may well be that the owners of closely held corporations do not want to reveal company-related business information to the tax authorities. This could be overcome if tax compliance was improved.) * Increasing the final withholding rate on Treasury obligations and deposit accounts. This would significantly lessen arbitrage opportunities, and the adverse impact on intermediation of such an in^rease would be mitigated to some extent by the removal of the GRT. 2.237 Providing more uniform treatment of capita! gains requires equalizing the rate chosen for them and the higher final withholding rate for deposits and Treasury obligations. Further, this new rate needs to be determined in such a way that the resulting revenue gains should offset the revenue losses discussed earlier. Liited Access to Finance for SMEs 2.238 SMEs suffer from limited access to credit, partly due to the higher transaction costs and the generally greater risk associated with lending to them; as such, they have been discriminated against by the banking sector. Further, microenterprises have always had difficulty obtaining financing: Commercial and thrift banks have argued that the relatively small loans cottage industries would need, along with the perceived risks and the firms' lack of acceptable collateral, make them unacceptable. In addition, they often do not have real estate deeds (other than for homes), which are usually already mortgaged, nor established premises, reputations and track records. Thus, they rely primarily on moneylenders. who charge extremely high interest rates, ranging from three percent to 17 percent or more a month. Consequently, they limit their operations to what can be financed with their own savings and hence they are effectively deterred from expanding and seeking out new business opportunities. Past efforts to address the problem of credit access by SMEs have led to the fraginentation of credit programs and failed to attain their objectives. The number of lending programs has risen recently. There are currently 39 credit programs for agriculture, 13 for the absolute poor, 21 for the salaried and self- employed and 38 for the SMEs. A number of these credit programs are directly managed by non- financial Government agencies, such as the DTI and Department of Social Welfare and Development (DSWD). Monitoring these programs has proven to be difficult in the past. The President created in October 1993 a National Credit Council (NCC) which is mandated to rationalize the use and delivery of the various credit programns. The Council prepared an initial draft implementing guidelines designed to define the role, ii!d! resporisibilities of the key players such as the implementing Government agencies, the particlptv. :, nial institutions, borrowers. donor agencies, and policies on guarantees and collaterals ' . mnnended that efforts be made to identify sources of funding to be channelled to viable small enternrises that use a market-based approach. - 95 - Govermt ad Domestic Securite Markets 2.239 The shift in financing from external to domestic sources has led to a growing market for Government securities. As of December 31, 1993, these amounted to P 682 billion, or 45 percent of GDP. In fact, the public sector has increasingly financed its consolidated deficit through the domestic money market at a rising cost. Treasury bills accounted for 75.2 percent of all outstanding Government securities at the end of 1992. 2.240 A trend toward shorter maturities began to emerge at the same time: About three-fourths of the Goverrnent securities had maturities of one year or less, and most paper carries a 91-day maturity. Shortened maturities and the inability of the public sector to manage its cash flows adequately have added to the volatility of domestic interest rates in the recent past. 2.241 Since 1986, the Government has issued Treasury securities using an auction system. Only accredited dealers can compete directly in the auctions, although they may represent their customers when they submit tendeis In advanced markets such as those in the United States, investors other than dealers may directly submit bids along with bank deposits or with a letter of credit for U.S. Treasury securities. However, in the Philippines, only the approved dealers are allowed to submit competitive bids, and the minimum bid is fixed at P 1.0 million. The market's efficiency could be improved substantially if the number of participants were increased and the minimum amount required for non-competitive bids was reduced from P 1.0 million to P 200,000. Lowering the amount required would increase the pool of potential buyers of Treasury bills and should likewise put downward pressure on domestic interest rates, which in turn would have a beneficial effect on export growth as lower real domestic interest rates could reduce overvaluation of the currency. Moreover, all non-competitive bids of P 200,000 would be awarded. The recent decision by the auction coimmittee to include both Social Security System (SSS) and Gc 'ernment Service Insurance System (GSIS) as participants in the primary market of Government securities is a step in the right direction. However. participation in the market should also be extended to other potential participants such as private insurance companies and mutual funds in order to widen further the participants in this market. A larger number of qualified participants should increase competition and improve the marketing of these securities. 2.242 The decision of the auction commnittee on June 14, 1994 tc issue a two-year fixed rate Treasury notes starting in July 1994 is a move in the right direction. The Monetary Board is expected to endorse the decision and send to the President for approval. The Bureau of Internal Revenue (BIR) will decide whether the bonds will be discounted up front or pay semi-annual coupon. 2.243 The secondary market for the securities is an over-the-counter one run by accredited Government securities dealers. Secondary market trading in government securities has become more active in recent years (the volume of Treasury bills sold grew to P 600 billion in 1992), but has not reached its potential because of (a) the lack of market makers; (b) the 0.5 percent DST on each transaction, which increases the cost and discourages trading; (c) the capital gains tax; (d) the absence of timely information on Government securities: and (e) the lack of an efficient clearing and settlement system. Capital gains in fixed-income securities are also subject to a regular corporate tax rate of 35 percent, compared with a 0.25 percent tax for capital gains in equities. -96 - 2.244 The Philippine domestic securities markets have large potential for development and, with the institutional and regulatory reforms now contemplated, they could fulfill that potential. The obstacles have been discussed for several years, but for the first time iW three decades, there are now signs of firm Government commnitmnent to reform. 2.245 In addition to the necessary institutional and regulatory changes that are needed to create a successful warket, macroeconomic stability is essential. Then, once the macroeconomic, regulatory and policy constraints to the capital markets are adequately addressed, they should be able to mobilize much needed financing for private sector ventures; also, they should grow to be important instruments for risk management by investors. On the demand side, this will mean that contractual savings institutions and commercial banks will be able to manage their portfolios more efficiently. On the supply side, it will allow both the Government and private firms to improve the management of their balance sheets. And in the process, the markets will provide an avenue for increased capital accumulation for productive purposes and an another investment avenue to provide competition and encourage efficiency in the financial sector. (Annex 23 provides an overview of the status of capital markets in the Philippines.) 2.246 The legal and regulatory framework has not helped develop capital markets, nor has a policy been pursued to create capital markets as part of the privatization of public corporations. In addition, the concentrated and oligopolistic structure of protected domestic industries has reduced the need for private corporations to seek financing for efficiency-enhancing investments. And, because of the risks associated with domestic securities, pension funds and insurance companies have invested heavily in high- yielding T-bills - issued to finance the large consolidated public sector deficits - and have limited their equity investments to a few high-grade securities. This has further constrained the domestic capital market. As the Government T-bill market has grown disproportionately, the corporate bond market has remained virtually nonexistent. Commercial paper issues have grown in recent years but remain relatively small. The taxation of financial instruments has also contributed to distorting the capital markets (paras. 2.234-2.237). The extent to which these markets are underdeveloped can be seen by comparing the depth and trading activity with that in neighboring countries (Table 11. 12). Table 11.12: Market Capitalization -___________ Market Capitalization (US$ billion) Growth Rate (%) 1983 1988 1993 IQ 94 83-88 88-93 83-93(x) Hong Kong 19_ 5 74.3 385.3 301.3 280 419 18.7 Singapore 15.5 24.2 135.6 119.8 56 459 7.7 Malaysia 22.7 23.3 220.3 174.8 2 845 8.7 Ihailand 1.5 8.8 127.6 102.1 492 1349 84.8 Indonesia 0.1 0.2 33.0 31.5 151 n.m. 325.3 Philippines 1 4 4.3 40.3 35.0 208 842 28.0 Korea 4.4 94.2 139.4 143.9 2049 48 30.8 Taiwan 7.6 120.0 195 1 170.2 1479 63 24.7 TOTAL 72.8 349.4 -8 380 265 16.5 n.m. not meaningful figure. Source: IFC. Saloolton Brothers. 97 - 2.247 A more important factor that has constrained the growth of the equity market is the preference of family-run companies to maintain close control of business operations and to limit their disclosures of financial performance (the latter being partly for tax reasons). These factors also operate among fainily-controlled companies in other parts of Southeast Asia, with the result that many companies still rely on retained earnings and borrowings as sources of investment funding; this limits the pace of new capital formation to earnings growth and additional borrowing capacity. In addition, firms are generally reluctant to bring forward public offerings unless there is a reasonable chance of capital gain, which in turn requires buoyant ex ante interest from potential investors. 2.248 Restrictions on foreign participation have constrained a key source of capital. The Foreign Investment Act of June 1991 eased these restrictions; however, share classifications continue to restrict foreign portfolio investment. Because most companies classify their common shares into class A (only Filipino nationals can purchase) and class B (both Filipinos and foreigners can buy) shares (the ratio of one to the other is 60:40), and because Philippine nationals prefer to purchase class B shares, the scope for foreign investors is further limited. 2.249 Although foreign portfolio investment is growing slowly, it still accounted for half of total new share purchases and half the trading activity; also, foreign participation in the domestic capital markets is increasing. It is recommended that authorities consider phasing out the A and B classifications to encourage foreign portfolio investment in the medium-term. 2.250 Demand for securities would also be greatly enhanced by the increased participation of institutiopral investors, especiallv the contractual savings institutions. Institutions such as the Social Security System, Government Service Insurance System (GSIS). and insurance companies have been able to mobilize large amounts of long-term resources that could be invested in the capital market. 2.251 On the supply side, there are many opportunities for increasing the market for securities through privatization, macroeconomic reforms, ending the crowding out of the private sector in the financial markets, and addressing tax evasion issues. Also, additional structural adjustment reforms to open up the economy would create incentives for companies to go public, which, in tum, would enable them to grow and compete in foreign markets. Privatization of public enterprises could greatly increase the supply of new issues and thereby help develop the capital markets and attract foreign capital. Reduced domestic interest rates should be one of the key components of any prograrn to encourage the development of a domestic corporate bond market. 2.252 Another way to increase the supply of securities is to make it easier for companies to carry out private placements. At present, only large, established companies with proven track records can access the Philippine capital markets through a public securities offering. Small and young companies can privately place their securities, but the SEC's rules on private placements and limited offerings are not helpful: There are no safe harbor rules that qualify an offering as limited or private. Thus, relaxing and clarifying the rules on private placements could create a market for privately placed securities and give small companies access to funds. Some of these companies, over time, should grow and become qualified to offer their shares to be publicly traded on the stock exchanges. Therefore, it is suggested that the SEC promulgate safe harbor rules on the private placement of securities, define what constitutes a private placement. and eliminate the requirement for a special exemption from the payment of fees. - 98 - Lel and Regulary Framework 2.253 The Revised Securities Act (RSA) of 1982 and Presidential Decree 902A of 1976 are the basic legal foundations of the securities markets. They regulate the distribution of securities, the operation of markets, and the activities of intermediaries in the markets, and they specify the powers and responsibilities of the Philippine Securities and Exchange Commission (SEC). The RSA is based on the U.S. Securities and Exchange Act of 1936. It is basically sound, but market developments have rnade reforms necessary. The principal limitations of the Act are as follows: * The SEC has inadequate power over entry and exit of intermnediaries in the industry, the rules of self-regulating organizations (such as the stock exchange), and the securities market activities of banks and quasi-banks; * The SEC's jurisdiction is overly broad and causes it to spread its resources too thinly; * The SEC can determine the offer price of securities and other matters that should be left to the market* * Market manipulation and insider trading are not sufficiently well defined, making successful prosecution difficult. 2.254 Other laws relevant to securities markets (such as the Corporation Code, Investment House Act, Financing Company Act, Omnibus Investment Code, and Foreign Investment Act) are also basically sound but require amending to bring them into line with modern practices. Most Important, the Corporation Code should better protect the interests of minority shareholders and define the powers of company managers, the Investment House Act should allow underwriting by stockbrokers. The SEC is currently finalizing a draft of a proposed bill to reform the Investment Company Act. It has also initiated work to amend the RSA, the Corporation Code, and the Investment House Act. 2.255 The SEC's own rules urgently need to be consolidated and updated. The last consolidation was in 1986, and it is now very difficult for even the SEC staff to easily determine which rules apply to a particular situation and what precedents exist to help interpret the rules. 2.256 The SEC has not been able to perform its mandate effectively, and its strategic goal is not clear. While the scope of its activities has expanded considerably since 1976, budget constraints and the inadequacy of its organizational structure have not allowed it to adequately regulate the capital markets or enforce regulations. On the other hand, it has issued rules and regulations, in an ad hoc fashion, that have not yet been codified, creating uncertainty for market participants. 2.257 There is considerable overlap among the SEC's departments and divisions, and much duplication of legal and statistical research activity. Interdepartmental coordination seems to be ineffective, and most work is done manually, without a computer. The procedures for monitoring the activities of registrants and securities' issuers are cumbersome and inefficient. Because of outdated data storage and retrieval systems, the SEC's ability to compile and publish timely information on securities, for the benefit of both investors and issuers, has been greatly constrained. 2.258 1,. SE C lacks the necessary resources and staff to effectively carry out its mandate. The 100 or so tII:4i staff cannot handle the increasing volume of registration and monitoring functions, which novi 'v :rutinizing more than 30,000 financial statements a year and making more than 3,600 -99 - field inspections. Moreover, commissioners seem to be overwhelmed by daily administrative and operational matters, a problem aggravated by budget constraints, which make it difficult to train, attract and retain qualified staff. It is reconimended that the SEC: * Divest its non-regulatory functions and limit its activities to capital market regulation; * Reorganize to allow more personnel to regulate the capital markets, and to strengthen enforcement; * Recruit more economists and financiel sector experts as well as lawyers with corporate experience; * Increase self-financing revenues; * Emphasize self-regulation for the stock exchange.' 2.259 The Commission should direct its activities away from voluminous, routine record keeping toward ciosely-focused market monitoring and targeted enforcement through adniinistrative and legal action. To achieve tangible bereficial results from this reorientation, the management systenis, staff skills, and computer support systems will all have to be upgraded. Such a program is planned by the Asian Development Bank (ADB) under a technical assistance program which started in late 1993, as well a USAID-financed program. 2.260 Although the SEC is the principal regulatory aut-ority in the securities markets, several other agencies also have a role. To eliminate duplication, it is suggested that the current system be replaced with one based on regulation by function, with clear cooperative mechanisms between regulatory agencies. Most notably, the SEC should be given clear jurisdiction over the public offering and trading of securities issued by banks, quasi-banks and public utilities. The present division of responsibilities among the SEC, the Ministry of Finance and the Central Bank in this area is anachronistic. Similarly, administration of the Financing Company Act should be made the responsibility of the Central Bank, not the SEC, as the institutions it covers are primarily involved in the provision of credit.65 Prundetial Regulations 2.261 A major weakness of the securities system in the Philippines is the lack of sound prudential regulations. Three principal aspects are described in the paragraphs that follow. 2.262 Adequate Capital. Current regulations require that a broker/dealer have paid-up capital of P 10 million.' As a matter of priority, the SEC should instead establish rules that they maintain a minimum adjusted net capital as a share of their assets, in line with other securities' markets. 64 The SEC as one of the conditions in the license issued to the Philippine Stock Exchange that "it shall set up the corresponding ss stems and mechanisms necessary for a self-regulatory body." 65 Under thc (l Act. the BSP is supposed to transfer its regulatory powers over finance companies without quasi- bankinLe tun!. r.t the SEC within a period of 5 years. The BSP will supervise only those with deposit-taking functions. 66 The paid-up Lapital requirement has been recently increased from P 3 million. -100- 2.263 Prudential Supervision. The system should require record-keeping by stockbrokers in a standard form prescribed by the SEC, frequent reporting of financial positions, immediate reporting of failure to comply with the capital requirements and a programn of on-site compliance audits by the SEC. !..54 Investor Protection Fund. The Securities Investor Protection Fund (SIPF) needs to be restructured to fulfill its mandate as the second line of defense against loss to clients from the financial failure of an intermediary. At present, the rules and procedures of the Fund are unclear, its management is not sufficiently professional, and its pool of funds is inadequate. For examnple, there is no clarity conceming whether the Fund can pay out only after the liquidation of a broker or whether it can compensate a client for loss from fraud or other illegal activity. Theie has been only one payout. And finally, the total amount available in the Fund is currently P 13 million with a limit on any one payout of a maximurn of P 40,000.67 Both these amounts are inadequate for the size of the domestic market. 2.265 The quality and quantity of information disclosed about public companies are inadequate, which hinder further healthy development of capital markets. Although the accounting profession in the Philippines is developed and a body of accountiih. rules and auditing practices has been adopted by the professional bodies, the quality of financial informnation disclosed about public companies is very poor in practice, and the lack of joint ventures with foreign partners as well as of direct foreign borrowing contribute to this problem. Comparisons between companies and between periods for the same company are very difficult to carry out. The accounting profession needs to update its rules and practices to conform with international standards, and to supervise its members in order to improve the uniformity and standards of financial disclosure. 2.266 At the time of an initial public offering of securities, a prospectus must be registered by the SEC and the offer to the public approved. The disclosure requirements are reasonably complete. although a comparison of domestic and international offer documents highlights some areas of concern. Most of the deficiencies are addressed in proposed disclosure requirements contained in a draft listing manual prepared by the two stock exchanges in 1989. These should be implemented as soon as possible by the SEC and the exchanges; the SEC's reluctance to approve the changes before completing the merger of the two exchanges unnecessarily delayed the changes. The audited financial statements included in a prospectus should cover a period ending no longer than six months prior to registration of the prospectus (the current regulations allow for a year). A risk statement should be required specifying the risk factors an investor should take into account when assessing the offer. Profit forecasts should not be required in a prospectus and, when they are included, a clear statement of the basis for calculating the forecast should be given (at present they are mandatory for all prospectuses and little or no justification for their magnitude is given). 2.267 The Revised Securities Act requires public companies to produce and distribute an annual report with audited financial statements. The listing rules of the exchanges require companies to lodge with them copies of annual and semi-annual reports. These requirements are generally acceptable but are weakened by the relatively poor quality of the financial reporting and the propensity of companies to include overly optimistic assessments of past and future profitability with insufficient justification. The SEC and the exchanges should monitor the quality of the reports more closely to ensure that they are in line with the spirit of the regulations. More fundamentally, continued effort must be made to improve 67 The maximum payout was recently revised from P 10,000. - 101 - the professionalism of the accounting and auditing professions and the clarity and completeness of the standards and practices used in preparing financial reports. 2.268 In line with international practice, two forns of continuous disclosure are mandated: that of information about the company and that of the holdings of substantial shareholders in the company. Reform is suggested in both areas. Disclosure to the rnarket of material information about the company is hampered by an unclear definition in the SEC and stock exchange rules of what must be disclosed and by out-of-date procedures that have been unable to prevent many inequities from arising in recent years. The rules should be modified to better specify the parameters of the information to be disclosed, and the procedures should be changed to require simultaneous disclosure to both exchanges in a way that allows release of the information to the general public on a fair and equal basis. The requirement to disclose substantial shareholdings has been widely avoided. To facilitate disclosure, the disclosure threshold should be reduced from the current 10 percent (a very significant holding in the Philippines) to, say, five percent, and disclosure should be enforced on a continuous basis. Rules on Proxy Soltaons and Tender Offers 2.269 Another weakness in the regulatory system is the lack of clear guidelines for conducting proxy solicitations and tender offers. The RSA provides that the SEC shall prescribe the rules necessary or appropriate to protect investors with regard to the solicitation of proxies or authorizations. The RSA also requires that the SEC provide rules on the information that must be stated in connection with tender offers or invitations or requests for tender offers, and empowers the SEC to promulgate rules on the tender offer process. Only limited rules have been promulgated, leaving participants irn a proxy contest or a tender offer without sufficient guidelines. It is, therefore, suggested that more comprehensive rules be promulgated. Stock Exchns 2.270 Until recently, the Phdiippines had two stock exchanges - the Manila Stock E- change (MSE), founded in 1927, and the Makati Stock Exchange (MKSE), which began operat' ig in 1963. The lack of computer linkage between the two had created a number of problems. Apart from making operations (trading automatioi, central depository, and so on) more costly, it also resulted in policy differences and variations in enforcement. It further led to different pricing of the same securities, creating opportunity for arlitrage, and hence divided the limited demand and supply. Moreover, since the operations of the two exchanges had not been harmonized, corporations had to deal with dual fees and reporting requirements. 2.271 The President, through the SEC, revoked the licenses of the Makati Stock Exchange (MKSE) and the Manila Stock Exchange (MSE), and allowed the operation of a unified stock exchange, the Philippine Stock Exchange (PSE) in March 1994. The new exchange is now operating. Although there are still two trading floors, both are already electronically linked and on.e price list for each listed share is posted by the PSE. To send a clear signal to investors that the PSE is determined to guard the integrity of the stock market, it appointed an outsider as president of the new exchange. Upon the commencement of its operations, the PSE began loading stock issues into its own computer system. Finally, on March 25, 1994, all 289 listed issues had been phased into the order routing system. On the PSE's first month of operation, the PSE Board approved the general and trading rules of the PSE. 2.272 To facilitate the turnover of management functions, record and documents from the MSE and MKSE to the PSE, SEC formed ad hoc committee in March 1994. SEC plans to set up a - 102 - computerized link with the PSE by 1995 in order to monitor the daily trading activities of the PSE and to take immediate action on any unusual or unexplained stock movements. 2.273 PSE: piins to set up an automated central clearing system to more effectively transfer records of ownership of traded stock and give investors easy access to information on listed issues. To broaden the ownership base on listed companies, PSE also plans to set up trading terminals in strategic public areas throughout the Philippines. Inter_ of the Capial Markes 2.274 Although the Philippines has adequate legislation to protect against insider trading, the SEC has not been effective in enforcing the laws, enabling trading abuses to erode investor confidence. Under Section 30 of the RSA, the SEC is responsible for enforcing insider trading rules. Section 30 identifies insiders and precludes them from making unfair use of material information. This provision has been enhanced by a number of SEC rules, and other modifications may be made to Section 30 to penalize insiders who do not purchase or sell a security but merely pass on insider information. 2.275 The RSA also contains anti-fraud provisions that are broad enough to prohibit and penalize any manipulative practice or fraudulent transaction, but the SEC has not used these provisions to prosecute or even make iules regarding manipulators of the stock markets. 'n addition to its anti-fraud provisions, the RSA also grants certain express rights of action to persons who suffer damages arising from fraudulent acts, but these provisions, too, are not being enforced. The SEC. in close cooperation with the exchanges, should begin to combat fraud and insider trading by strictly enforcing the provisions of the RSA. 2.276 The stock exchange must demonstrate its commitment and capacity to effectively regulate its members. Establishing an effective self-regulatory capacity in the exchanges is vital. Unless confidence in the functioning of the market is substantially enhanced, it is unrealistic to expect a major inflow of foreign institutional portfolio investment in securities. This may impede financial sector development and limit the availability of long-term investment funds for private industry. 2.277 Given the need to build up the necessary skills and commitments to make self-regulation a success, the main trnphasis should remain on ensuring that the SEC fulfills its regulatory functions effectively. The capacity of the SEC to undertake its work should be built up quickly. But, the self- regulatory role of the recently merged exchange should be developed at the same time so it can ultimately play its part in a modern securities market. 2.278 The exchanges' listing requirements contribute to a narrow investor base. The main requirements include (a) a minimum authorized capital of P 100 million, with a subscribed capital stock of P 25 million and paid-up capital of P 12.5 million: (b) distribution of 25 percent of the authorized capital through brokers in equal shares; (c) a minimum of 300 shaveholders; and (d) the submission of necessary documentation. The requirement for 300 shareholders, in particular, limits broader investor participation by allowing the issuer to distribute shares among employees, relatives and friends. This tends to make shares less availablc to small investors, especially in the case of blue chip securities such as PLDT or the San Miguel Corporation. 2.279 Stockbrokers. There are 76 active brokers on the Makati Stock Exchange and 59 on the Manila Stock Exchange, but nearly half of the business by value is transacted by only 15 brokers, Securities intermediaries in the Philippines consist of a large group of individual and small incorporated - 103 - brokers with relatively limited capital and a small group of large incorporated brokers who have access to large amounts of capital and are increasingly professional and innovative in their operations. The larger brokers find it to their advantage to support many of the modernization proposals for the Philippine market and can usually adapt their operations to a changing environment without great difficulty. The smaller brokers are at a disadvantage, however, and often oppose needed reforms. Their opposition has often been instrumental in holding up essential reforms, for example, the introduction of a comprehensive prudential regulation system. 2.280 Risk Assessment. The Philippines has a publicly owned credit rating agency. Its fees are inadequate to enable it to recruit, train and retain good-quality staff. Unsatisfied with the services of this agency, the Bankers Association of the Philippines set up its own credit investigation agency in 1991, called the BAP Credit Bureau Inc. Banks exchange infoi-mation about borrowers, unpaid checks, canceled credit cards and other rele, ant credit information. The BAP is planning to extend its services to non-member banks. It is suggested that the institutional capabilities of the existing agencies be strengthened, given that a credible system for rating bonds is a necessary element for a fully functioning e:apital market. Condusions 2.281 The financial sector of the Philippines has not performed as well as its ASEAN neighbors in recent years, The growth of the financial sector has been constrained by economic and political crises in the past decade, directed credit programs. distortionary taxes, large losses of the CBP, and the crowding out of the private sector in financial markets. The financial sector's small size. high real domestic interest rates, intermediation costs, lack of long-term financing, and the oligopolistic structure of the sector, coupled with restricted bank entry, have constrained access to credit. particularly for small and young companies. The GOP should therefore take corrective measures to address these problems to increase long-term domestic resources and credit for private sector investment. To reduce the crowding out of the private sector, the GOP should intensify its efforts to improve its macroeconomic performance, especially on the fiscal side. Until this is accomplished, many of the restrictions, including those on local and foreign jank entry, could be phased out to enhance competition and improve access to finance by the private sector. 2.282 Poor macroeconomic performance, an uncertain political climate, and the lack of market integrity have retarded the development of the Philippines capital market in relation to its neighbors and comparably sized countries. The securities markets have not contributed to financial sector development and economic growth in the way they have in Thailand or Mala~,ia, for example. There is a need to make concerted efforts to implement the much needed reforms in the structure of the securities market, the regulatory framework. prudential regulations, disclosure requirements, and professionalization of the stock exchanges. The reform programs contemplated under the ADB's proposed program loan for capital market development should promote the equity market. 2.283 If properi implemented, these measures, combined with political and macroeconomic stability, should accelerate development of securities markets and increase the pool of domestic resources for private sector operations and investments, facilitate privatization, and provide financing for infrastructure projects - 104- m. STRATEGY A. World Bank Stategy The Goverment Prora 3.1 Since economic growth is ultimately linked to the success of the private sector, the Government will need to intensify its efforts to carry out economic reforms that will help it develop efficiently. Until now, the Government has introduced some adjustments, but their full potential has yet to be realized: At present, the private sector still has lower investment rates, is less productive and exhibits less export push than in Korea, Malaysia and Thailand (as discussed in Chapter I). Thus, reforms will need to be more comprehensive, introduced as a package, well sequenced, and implemented quickly (see the attachment to the Executive Summary for an outline of the recommended reforms). 3.2 Successive Governments since 1986 have introduced a series of reforms to make the domestic economy more efficient. As a result, major economic distortions have been addressed. These reforms focused on the following: (a) Macroeconor.;c stability - In the context of major external shocks, dorr-stic political problems, and a high external debt, authorities intensified efforts to raise revenues - including the recent passage of the law to expand the scope and coverage of the VAT - limit public expenditures, and implement a restrictive monetary policy, and recently reaching an agreement with the IMF on a three-year Extended Program to successfully complete stabilization; (b) Trade policy - Various reforms reduced the non-tariff barriers on imports and lowered the level and dispersion of import tariffs. The maximum import tariff rate was decreased from 100 percent in the early 1980s to 50 percent. Together with liberalizing the exchange rate, authorities have started to make the incentive regime more favorable for private production and investment, (c) Liberalization of foreign investment - The Foreign Investment Act, introduced in 1991, relaxed restrictions on foreign investment and opened a number of sectors to FDI. Government actions in 1994 further lessened constraints to FDI; (d) Privatization - A large number of Government-owned and operated enterprises were privatized. The private sector was allowed to generate electricity through BOT and BOO schemes. and the Congress passed a law to institutionalize the role of the private sector in the power sector; (e) The financial sector - Interest rates were liberalized, two major public banks were recapitalized, directed and subsidized credits were greatly reduced, the Central Bank was restructured and recapitalized .,id foreign bank entry was allowed; (t) Copnetition policies - The Government began to ease entry into a number of sectors, inlLliuding telecommunications and inter-island shipping, - 105 - (g) Agriculture liberalization- Agricultural monopolies were dismantled, especially in sugar and coconut trading; (h) Transport regulations - Those pertaining to entry by the domestic private sector were liberalized. 3.3 At the end of 1993, the macroeconomic situation was substantially improved (see para. 2.6). Nevertheless, local and foreign business groups will still need to be assured that macroeconomic conditions will be stable, due to the continued weakness in public finances and the structure of external accounts, despite economic policy reforms. Thus, continued efforts at macroeconomic stabilization are essential to restore business confidence and encourage private investment. 3.4 The politicai situation today is much more stable than at any time in the recent past. Threats of coups have almost become non-existent; also, the President has built strong political support among the leadership of both the Senate and the House. The improved coordination in policy making between the executive and legislative branches was demonstrated when Congress granted the President emergency powers to deal with the energy crisis, the passage of the laws on foreign bank entry, the BOT and VAT laws mentioned in para. 3.2 above. The Government also appears committed to encouraging competition in markets dominated by monopolies and has required the PLDT to improve its performance and raise its investments and opened the sector to greater competition. These are positive steps, but the change in power relationships is still evolving. Moreover, continued - albeit declining - security/kidnapping problems remain an area of major concern to investors, especially foreigners. 3.5 The next stage of the reform effort must focus on four key areas (a) creating and maintaining an enabling environment in which the private sector can develop; (b) establishing contestable markets and reforming the judiciary; (c) eliminating the anti-export bias of the trade regime and moving the incentives regime toward neutrality between exports and import substitution; and (d) addressing the crowding out of the private sector in the domestic financial markets to enable it to expand and develop. If these reforms are carried out on a timely basis, the Philippines will have an internationally competitive economy, able to attract high ievels of foreign investment and, ultimately, achieve sustained economic growth. 3.6 Success in achieving efficient private sector development will depend on good governance - strong leadership, a sense of urgency and a commitment to implement the policies. In addition, remaining entry barriers must be eliminated and trade liberalized further, as these actions will also stimulate the development of small and medium enterprises. However, because of past policy reversals (in part due to external shocks and internal domestic problems), the Government will need to establish a track record that can instill investor confidence. The Philippines must attract foreign direct investment to a much greater extent than most of its neighbors, given its low domestic savings. With these goals realized, the industrial and infrastructure sectors are expected to be the main engines of growth in the next few years, in line with the medium-term development plan. 3.7 To create an enabling environment for the private sector, the Government must continue to promote macroeconomic stability and improve and expand the country's dilapidated infrastructure (much is old, but some has simply not been adequately maintained). In fact, if recommended reforms are not fully implemented. the payoff from the overall adjustments will be greatly reduced. Also, the reforms will need to include measures to vastly improve the country's administrative capacity for effective implementation and enforcement. - 106 - 3.8 Strengthening regulatory agencies along the lines described in Chapter 11 is the kley element of regulatory reform, especially for infrastructure. Moreover, competition reform, by inhibiting private restraints of trade, should increase the efficiency and flexibility of domestic markets and enhance the effectiveness of other structural reforms. 3.9 In promoting good governance, authorities will need to continue decentralizing various governmnent functions. Until now, they have devolved some responsibilities to the local government level and started transferring some budgetary resources. However, decentralization, if not well managed, can strain local government capacity and could lead to fiscal imbalances, with the National Government (NG) ultimately covering part of the costs. Thus, the NG must adjust the pace and provide technical assistance for cffective implementation. (Annex 24 discusses the possible impact of decentralization on private sector development). 3.10 As part of the decentralization efforts of the past two administrations, governors (in Bulacan, Cavite, Cebu, and Negros Occidental) have been able to stimulate local economic growth; and, at present, the Government is converting Subic Bay facilities into an export processing zone with Bank-financial support. If the concept is expanded and the area is turned into a free port, the same model could be applied to a limited number of other ports and this, in turn, could expand trade and provide jobs. 3.11 Incentives, w hich should be introduced over time, will involve acceleration in trade reform, a phase-out of QRs. a review of the minimLim wage, accelerated depreciation, non-operating loss carry- over, and an expedited payment of tax rebates in the export drawback s) stem. 3.12 Future refornms must also address the crowding out of the private sector in financial markets: To achieve this, tax revenues must be increased. In fact, when compared to its neighbors, Philippine taxes are considerably less as a percentage of GDP. Thus, the Govermnent has relied on foreign borrowing to finance its major investments and public external debt was USS29 billion, or 61 percent of GDP in 1993. Moreover, some of the projects for which the Government has borrowed have been inefficienit ot niever used, such as the Bataan Nuclear Power Plan (see para. 2.83). 3. 13 In addressiing the four broad areas of reforrn, both the public and private sectors will have to adopt new roles and the traditional relationships between business and Government will need to be redefined. One advantage for the Philippines is that, unlike other countries, it has a small public sector which accounts for less than one-fifth of GDP. Nevertheless, it will have to shrink even more, although this is but one of several issues. Also, the Government will need to continue to address fiscal disequilibria by raising non-distortionary revenues and reducing low-priority expenditures, while it increases infrastructure investments. But, perhaps more importantly, it will have to (a) strengthen its regulatory functions so as to establish and maintain contestable markets and hold the private sector accountable to improve efficiency; (b) assume the role of a neutral arbitrator by creating a level playing field between differenit private sector firms, foreign and domestic firms and the public and private sector; and (c) continue to minimize its interventions that, in the past, led to macroeconomic and sectoral distortions. Policies anid programs to support this process must seek to attract high levels of direct foreign investment into larec infrastructure and export-oriented projects, high-priority labor-intensive sectors, and joint ventures with Philippine nationals. 3.14 1 t lii part, thie private sector will need to adopt new approaches. In general, it will be called up-n i inure risks, invest more in infrastructure and industry than until now, produce more for expor :i nd 'duce new technology - and in this way, compete more effectively in international markets. - 107 - 3.15 Obviously, private sector dievelopment is not an end in itself; rather, it is needed to stimulate the economy and sustain growth in incomes and employment. Therefore, policies that promote greater competition and contestable markets in the domestic economy will support the overall goals. 3.16 Given that the four areas of reform are tightly interrelated, the next stage must be introduced as a package. For example, even if financing becomes available to ease the crowding out, increased private investment will materialize only if the remaining barriers to entry and efficient production are removed. Similarly, benefits from competition policies cannot be fully realized unless the judicial system is reformed. In the same way, trade liberalization cannot be accelerated and crowding out cannot be ended unless macroeconomic stability is fully restored. Further, contestable domestic markets cannot be created until trade is further liberalized. 3.17 Reform efforts are difficult given expected opposition from vested interests and will likely take time to bear fruit; nevertheless. they have to be intensified and carried out more rapidly. The adjustments will need to be carefully sequenced. 3.18 Although the Government is addressing some elements of this agenda, progress in other areas has been uneven. In trade reform and privatization, it is widely believed that the pace of reform has been slow: For example, continued monopoly privileges for business groups can undermine the credibility of the reform agenda (there are signs now that a new competition law could pass the legislature). In addition, judicial legal reform is long overdue. With regard to foreign direct investment, a positive step was the relaxation of restrictions in 1991 and continued reforms since then, but many still remain. Further, the prudential regulations governing the financial sector need to be strongly enforced as currently envisaged under the recently enacted Central Monetary Act. Because these issues persist, investors are waiting to see whether reforms are implemented before committing significant funds. 3.19 Implementing the needed reforms to ensure greater competition and to develop the institutional and support framework is likely to involve significant political costs, but the gains for the economy as a whole will likely far outweigh them. 3.20 The Bank's overall assessment is that there is now a window of opportunity for the country to achieve sustained economic growth. Authorities have moved to put some reforms into place, begun to open up the economy, and deregulate markets; if they move decisively to sustain these improvements and deepen the structural reforms recommended in this report, the key elements will be in place for strong economic growth. Past Bank Assistance and Status of the Portfolio 3.21 The most critical part of the World Bank's assistance program has been its macroeconomic analysis, which developed a common position with the Internationai Monetary Fund k>MF) and informed Consultative Group members about the state of the domestic economy and the prospects for growth and balanced development. Also, World Bank reports have helped orchestrate the dialogue and mobilized substantial external aid flows. At present, the Bank is engaged in a number of economic and sector stud-.s that will help define and analyze development issues and formulate lending strategy in key sectors. Reports on managing natural resources and the environment, and on the energy, financial, and education sectors were completed during 1990-93. The last Country Economic Memorandum (CEM) focused on resource mobilization and expenditure allocation, and the recently completed Basic Economic Report (BER) examiiied key issues in the government, corporate, and household sectors. Other economic - 108 - and sector work completed since 1990 has included studies on capital markets, family planning, irrigated agriculture, and fiscal decentralization. The Bank is currently undertaking a study on infrastructure, the power sector and health care, along with a CEM update. World Bank Strateg 3.22 The Philippines faces challenges in meeting the three major requirements for growth - improved incentives, institutions, and investments. The World Bank can assist in investment lending to expand infrastructure capacity and strengthen the implementing institutions and institutional framework. Already, it has helped the Government finance projects in urban health and nutrition, power transmission and rehabilitation, geothermal projects (Leyte-Cebu and Leyte-Luzon), Subic Bay, tax computerization, and irrigation, as well as in external debt and Central Bank restructuring. For FY95, the Bank plans to appraise the following projects: women's health and safe motherhood, electricity system efficiency, Manila sewerage and water resources development. Further, the Bank may consider helning Government efforts in promoting decentralization, creating trade, building institutions and improving the budgetary systems and customs administration. It would also be useful to explore options to work individually with local governments on relevant private sector development issues. 3.23 In power, the Bank plans to be involved in financing generation and transmission as well as ensuring proper implementation of policies conducive to the uninterrupted growth of the sector. In telecommunications, the Bank's further involvement will depend on the financing needed to increase telephone coverage, including areas not well covered (such as rural parts of the country). However, the Bank's involvement for the sector hinges on the following (1) solutions should be private; (2) competition in the sector should be enhanced and entry barriers removed; and (3) supply should be expanded and efficiency in investments should be oaught. In industry, it is anticipated that the Bank will selectively intervene in the areas of pollution and SME development through appropriate lending instruments. Regarding the institutional framework for private sector development, an area in which further progress is essential to ensure efficient economic growth, the Bank should also play a key role, including inter alia providing a large dose of technical assistance over a number of years. In privatization, the Bank may selectively intervene to ensure orderly implementation of further actions while ensuring an appropriate regulatory framework. 3.24 In transport, the Bank's strategy is to build on the progress made under the Highway Management Project, formulate a road network management program and increase expenditure for road maintenance. The Bank is preparing a Maritime Sector project to improve service levels, correct price distortions and increase competition on inter-island shipping and improve efficiency at ports. 3.25 In agriculture, production and marketing are mainly private sector activities. Thus, lending would largely concentrate on necessary public infrastructure, improved delivery of credit to small scale farmers and rural enterprises, and upgraded support services including research and extension. It would also promote the participation of beneficiaries through user groups and NGO collaboration. The policy dialogue will continue to press for continued and consistent liberalization of trade for agricultural products; this will involve reducing protection and subsidies. Equally important, uncertainties associated with agrarian reform will need to be eliminated in order to increase investment in agriculture. To enhance international competitiveness in agriculture, the Bank is preparing a project on rural infrastructure. Also. it is supporting national irrigation investment programs that emphasize low-cost communal and run-of-the-river systems, while transferring management responsibilities and O&M costs to user groups. - 109 - 3.26 In education and training, although the Bank has lent significant amounts, a change in approach is now warranted; it should move away from physical construction towards improved quality and greater economies. Also, programs should provide instruction in mathematics, science and technology tc improve the technical skills of the labor force. 3.27 Although the Philippines has adequate foreign exchange reserves, the cyclical economic growth pattern, which characterized past decades, does not yet seem to have been eradicated; and, if balance-of-payments problers emerge, the Bank should also be ready to provide BOP assistance. 3.28 The Economic and Sector Work (ESW) Program. A strong ESW program is needed to deepen the World Bank's understanding of the factors that constrain private sector development and to support the Bank's sector lending operations. For FY95, studies will be conducted on public expenditures, cooperatives and privatization in agriculture and NGOs. The emphasis will be on cross- sectoral and sector issues such as institutional, legal and regulatory reforms, competition policies, and the overall framework for the private provision of public services. Regarding the former, the ESW will continue to focus on macroeconomic issues and incentives and pay increasing attention to other critical issues, such as competition policies. 3.29 Bank Interface with the Private Sector. Although Bank lending will still be geared to the public sector, the objective of its financing activities will be to ease the constraints on private sector development as identified in this report. The Bank will build upon the IFC's established and newly emerging interaction with both the local private sector and prospective foreign investor companies. In addition, the experience of the past few years has shown that the World Bank, the IFC and the Multilateral Investment Guarantee Agency (MIGA) need to work jointly to help the private sector meet some of the financing gaps. The Congress ratified the MIGA convention in November 1993. making the country eligible for MIGA services to investors; exploratory discussions are expected soon. 3.30 The recently completed Brady deal restructured the country's external debt and greatly improved creditworthiness. As a result, the Philippine public sector was able to re-enter international capital markets, as did domestic companies as well. Evidence of improved creditworthiness includes: the GOP's successful US$150 million Eurobond issue at 320 basis points above US Treasuries, which was subscribed in full in February 1993; sizeable private financing packages, including a power project of US$900 million (of which US$250 million is from private sources); PLDT's US$300 million equity offering in 1992; and portfolio investment in 1992 of US$375 million. The most recent price of Philippine debt paper on the secondary market was US80C on the dollar, up from US50c cents two years ago. However, access to foreign markets still seems restricted except for a few of the large companies: It is likely that only about 10 of the largest and most profitable public and private Philippine companies could raise funds from international capital markets. Moreover, the public sector's further access to international capital markets will probably be restricted to limited security offerings. Although access to international capital markets is limited, it is still better than it has been in the recent past; thus, neither public nor private entities should rush imprudently into internaiional capital markets, since this could endanger the country's improved piospects. As a result, Bank instruments to support private sector investments will still be required over the next few years. According to Bank policy, such lending will require Government guarantees. 3.31 The Bank's Board of Directors issued guidelines in April 1992 stating that the institution should finance a pri% ate company only if (a) the commercial market cannot provide the required funds; (b) the IFC does not plan to provide the funds; and (c) the policy environment for the sector or operation in question is suitable. In the past, financing for private sector development was channeled through -110 - Government-owned financial institutions (GFIs), with the resources designated for investment financing by a specific company under suitable onlending arrangements. In the future, the Board's criteria will apply to each project at appraisal; thus, in justifying specific projects, evolving market prospects will need to be closely monitored. Where it is established that the market cannot provide the needed funds, the Bank will consider assisting the project. The Bank's strategy should be to provide funds in key sectors that may face capital market imperfections. For large, creditworthy private sector borrowers, ECOs could be used. In each case, the market imperfection should be clearly identified as a precondition for the operation. 3.32 To deal more effectively with private sector development issues, the Bank needs to establish institutional contacts with different private groups. In some countries, this interface is now formally promoted. In the Philippines, the Bank should explore ways to fostei this relationship, both through direct contacts as well as through various private sector organizations. This should enable the Bank to better gauge the issues the private sector confronts. B. EFC Stratg 3.33 The principal message in this report is that the prospect for a resumed private sector investment and growth is good provided that: * A comprehensive program of infrastructure development (covering power. transport, and telecommunications) is implemented. * Priority is given to market-based strategies that encourage higher domestic savings, increase equities and securities participation from abroad, and reduce the crowding out of private investment by the public sector. 3.34 The difficulties that private investors (including IFC) have encountered in completing projects in recent years have been mostly due to problems in the above-mentioned areas.68 Although many large-scale private projects have been able to proceed (including the Hopewell Power project, Shell refinery expansion and several hotel projects), all have involved complex and extended financial negotiations that have been made more difficult by the country's debt burden and limitations on foreign borrowing. The investment opportunities that are opening up to private investors have yet to be matched with an improved environment for market-based mobilization of funds; and, from IFC's perspective, this issue remains central to any strategy for private sector development. In addition, infrastructure constraints continue to depress productive investment across a range of sectors. Notwithstanding the improvements that have taken place in the trade regime, foreign investment policy, and foreign exchange access, there will be few incentives to undertake new private investment until more power, better roads, more cost-effective shipping, and expanded telecommunications services are made available. In these areas as well, IFC has a strong interest in seeing regulatory and administrative improvements that will remove bottlenecks to the private delivery of public services. 3.35 IFC's ability to support the reform process will continue to evolve in response to the constraints and opportunities which are reshaping the business climate for private sector investors. The 68 While .nru iamnt. such as legal vagaries (which led to the abandonment of the Luzon Petrochemical project) and foreign ownership restrictions (which have prevented a satisfactory restructuring of NONOC) have also been important. - 111l - most immediate constraint to business development has been the shortage of power generating capacity, but as this constraint is now easing, a pickup in investor interest is anticipated. A related development influencing IFC strategy are ongoing policy reforms which are opening up new areas of activity to private investors both in infrastructure and through privatization. These new reforms are helping to redefine the respective roles of IFC and the Bank and as new initiatives are announced during the course of 1994, IFC will determine the appropriate levels of investment and advisory inputs on a case by case basis. Another major factor shaping IFC's strategy in the Philippines is the prospect of greater funds mobilization by private investors on domestic and international markets. It is anticipated that the Philippines will continue to improve its external financing status during 1994 which in turn will make mobilization by private firms of equity, securitized loans and commercial bank loans from abroad easier to secure. The extent of private sector funds mobilization from abroad (which will influence the volume of IFC-related activity) will depend on government limiting its external borrowing requirements. On domestic markets also, the prospect for increased mobilization of long-term investment capital will depend on limiting the growth of governmnent borrowing and reducing the amount of crowding out that has taken place in recent years. Domestic equity remains a critical constraint for many large-scale projects. and IFC will continue to play an active equity mobilization role. 3.36 In addition to direct investment activity, IFC is also providing fee-based advisory services, covering privatization, restructuring, and BOT projects. Projects under preparation. as >.ell as future prospects, include major involvement in private energy schemes, and the industrial sectors. IFC is also working on advisory assignments in the mining sector. IFC will remain active in supporting activities which contribute to increased competitiveness of the industrial sector and create new employment opportunities. 3.37 In the financial sector, IFC is supporting a local currency loan guarantee scheme and has equity participation in two Venture Capital Funds. The latter is supporting the growth of capital markets in the Philippines which suffer from a shortage of long-term financing. With it, IFC will help develop the Philippines' nascent venture finance industry and mobilize scarce equity capital for small industrial enterprises that lack access to capital. In addition, IFC is considering participating in the restructuring of commercial banks and is assessing the requirements for creating new investment vehicles (mutual funds, investment companies) for mobilizing equity and loan funds through domestic markets to support large-scale investment activity. 3.38 The past three years have set the scene for a rapid and sustained takeoff of private investment in infrastructure in the Philippines. Although IFC has been a MERALCO investor since 1966, and made its first investment in PLDT in 1969, these operations did not kindle the same broadly based investor interest in Philippines as did IFC's support for the Hopewell Navotas power project in 1989. This project demonstrated the willingness of investors to construct and operate a large fixed investment under a limited-term operating agreement, and the willingness of lenders to provide project financing for such investments on a limited recourse basis. IFC's more recent support for the much larger Hopewell Pagbilao power project, and for the "fast track" power projects commissioned to overcome the short-term power cri;is in the Philippines, reinforced the view that private investors can provide timely, and lo\& cost solutiolns for infrastructure needs and that financing for private projects can be arranged. Investors are now active in power, telecommunications, and transportation sectors, although the backlog of needed investments in these key sectors is still large. 3.39 New ijnl stment opportunities for private companies are just now emerging, and the Government's eagerness to embrace a Private sector approach to management and operation of infrastructure operations has been instrumental in fostering a sound basis for the new activities. The roles - 112 - for the IFC and the IBRD in the Philippines are evolving to reflect the new roles that Government and private investors are shaping for themselves in infrastructure sectors. 3.40 IFC, for its part, is seeking to assist on several fronts. First, in line with its broad mandate to assist in the development of the private sector, IFC will be looking for opportunities to use new financing requirements for private infrastructure projects to develop borrowing instruments that will '-elp widen and deepen Philippine capital markets. One of the major benefits from the infrastructure privatization, from IFC's point of view, is in the general development of capital markets, as a means of mobiiizing private savings, independently of the more traditional route for the sector of government- guaranteed financing. 3.41 Second, IFC has the expertise to advise on the process of private participation in infrastructure, particularly with a view to ensuring the appropriate allocation of risk between public and private parties. IFC is accumulating a substantial body of knowledge on a broad front on how private participation in infrastructure can be managed, and has an array of models for contractual and regulatory arrangements that fit a number of circumstances. In particular, IFC is in a position to ensure that any continuing government participation in project operations or management (say through so-called golden shares, or board membership) does not pose unnecessary risk for investors or lenders. 3.42 Last, IFC stands ready to consider requests trom sponsors to assist in structuring investment projects, and to participate in their financing, particularly for projects that have potential to act, as the Hopewell deal, as catalysts for expanded private sector operation and management of infrastructure sectors. The willingness of the Philippine Government to embrace private sector participation in the delivery of infrastructure services owes a lot to the experience gained through earlier IFC-assisted projects and continuing support from IFC will help to consolidate this progress. IFC does not, however, see its principal financial support for Philippine infrastructure through its own investments but through its role in mobilizing resources through the market. As well as support for the domestic capital market. IFC will expand financing available for Philippine infrastructure through loan syndications, through introducing new lenders, including structures that will have a powerful demonstration effect for international lenders. The extent to which these objectives can be achieved depends, however, on initiatives to improve the climate for private sector funds mobilization and in particular on a reduction in the extent of crowding out due to public borrowing as discussed in this report. 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AAll 26 Soangos X SOUTHERN MINDANAO 27 Morinduqw 67, Surio diu Su' 2i l8indoroOnianloi r' DarooOionbl Moa 2 y M,ndoro Occden-tol 1 ~g e 0eCTNIA 22 omb.or Col .o8 Daoo del NS 3 ~ ~ ~ ~ ~ ~ ~ Ler C r;T DUANTL V i e ;wa., Sou onsaeat Uwnante. Pill SICOL CENTRAL INDANAO , I :32 CamrnneG N. I' Lnc dd Nor o sai 400 33 ICarnrne Sur Lance delS Nom onltia,, IIo --o 3 X Crrin Sur ; ~Lranrz edl Sur manl r wo 34 Corftandwna ! No Cotab.tul ,35Aib z.Fouindonno 1 8 Sonogon S,lnr, Kudaorat 7on M OoO .-~~~~~~~~~~~~~~~~~~~~I on thi ma do not dnoPO imply, ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ ~ lel theor part o sTatu bof nyi torrior V15 AS, d anymnto on d oomny to imi?w on tn-hport of sc boundori-.as. TorIb. or~~~~~~~~~~~~~ ~ ~~~~~~~~~~ -AlI;la.1- ooI b PAMIDANA CHINA ~ V HO Cmp F~ n N p. of,Teu MACAO 1111o-- emRo -',r,^ 51*5 1WWt,it0t: .qla M.,.. No SUtn oCLU buars. deOro WALAYSIA~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~Iig. Ne A I N oAeIA _ ^xer~~~~~~~~~~~~~10 12, 1 2i _ . . w.n j...A I9b