Report No. 20066-PH Philippines Growth with Equity: The Remaining Agenda A World Bank Social and Structural Review May 3, 2000 Poverty Reduction and Economic Management Sector Unit East Asia and Pacific Regional Office u Document of the World Bank CURRENCY EQUIVALENTS (As of May 3, 2000) Currency Unit Peso $1.00 , = 41.27 pesos 1.00 peso = $ 0.024 FISCAL YEAR January 1-December 31 ABBREVIATIONS AND ACRONYMS ACEF Agricultural Competitiveness Enhancement Fund ADB Asian Development Bank AFMA Agriculture and Fisheries Modernization Act AFP-RSBS Armed Forces of the Philippines Retirement and Separation Benefits System AFTA ASEAN Free Trade Area APEC Asia-Pacific Economic Cooperation APIS Annual Poverty Indicator Survey APT Asset Privatization Trust ASEAN Association of Southeast Asian Nations B.P. Batasang Pambansa BIR Bureau of Internal Revenue BOC Bureau of Customs BOT Build-Operate-Transfer BSP Bangko Sentral ng Pilipinas BTr Bureau of Treasury CAMELS Capital Adequacy, Asset Quality, Management, Earnings, Liquidity and Sensitivity CARP Comprehensive Agrarian Reform Program CB-BOL Central Bank-Board of Liquidators CEPT Common Effective Preferential Treatment CES Career Executive Service CESO Career Executive Service Officer CMDC Capital Markets Development Council COA Commission on Audit CSC Civil Service Commission CTRP Comprehensive Tax Reform Program Vice President Jemal-ud-din Kassum, EAP Country Director Vinay Bhargava, EACPF Sector Director Homi Kharas, EASPR Task Manager Bernard Funck, EACPF CYFP Children and Youth Foundation of the Philippines DAR Department of Agrarian Reform DBM Department of Budget and Management DBP Development Bank of the Philippines DND Department of National Defense DOH Department of Health DOSRI Directors, Officers, Stockholders and Related Interests DPWH Department of Public Works and Highways DSWD Department of Social Welfare and Development EO Executive Order EPR Effective Protection Rate FDI Foreign Direct Investments GAAM Government Accounting and Auditing Manual GAAP Generally Accepted Accounting Principles GDP Gross Domestic Product GNP Gross National Product GOCC Government Owned or Controlled Corporations GOP Government of the Philippines GSIS Government Service Insurance System HIGC Home Insurance and Guarantee Corporation HPA Hanoi Plan of Action HT High Technology ICRG International Country Risk Group IFAC International Federation of Accountants IMF International Monetary Fund INTOSAI International Organization of Supreme Audit IPOs Initial Public Offering IPP Independent Power Producers IRA Internal Revenue Allotment IT Information Technology ITCs Investment Trust Companies LBP Land Bank of the Philippines LGUs Local Government Units LWUA Local Water Utilities Administration MAV Minimum Access Volume MFIs Microfinance Institutions MLT Medium and Long-Term Loans MNCs Multinational Corporations MTDP Medium-Term Development Plan MTPDP Medium-Term Philippine Development Plan NAFTA North American Free Trade Agreement NAPOCOR National Power Corporation NCC National Credit Council NDHS National Demographic and Health Survey NEA National Electrification Administration NEAT National Education Achievement Test NFA National Food Authority NG National Government NGOs Non-Government Organizations NHMFC National Home Mortgage Finance Corporation NIC Newly Industrializing Countries NPC National Power Corporation NPLs Non-Performing Loans NSCB National Statistical Coordination Board NSO National Statistics Office OCW Overseas Contract Workers ODA Official Development Assistance OECD Overseas Economic Cooperation and Development OPP Private Occupational Pension Plans Pag-IBIG Home Development Mutual Fund PAYG Pay-As-You-Go Systems PCFC People's Credit and Finance Corporation PCIC Philippine Crop Insurance Corporation PD Presidential Decree PDIC Philippine Deposit Insurance Corporation PECC Pacific Economic Cooperation Council PEZA Philippine Export Zone Authority PHIC Philippine Health Insurance Corporation PICPA Philippine Institute of Chartered Public Accountants PIDS Philippine Institute for Development Studies PMO Project Management Office PNB Philippine National Bank PPI Private Provision of Infrastructure PSE Philippine Stock Exchange QRs Quantitative Restrictions R&D Research And Development RA Republic Act RIC Presidential Retirement Income Commission SAS Service Area Scheme SEC Securities and Exchange Commission SSL Salary Standardization law SSS Social Security System ST Short-Term T-bills Treasury Bills TFP Total Factor Productivity TWG Technical Working Group UNDP United Nations Development Programme USAID U.S. Agency for International Development VAT Value Added Tax WTO World Trade Organization TABLE OF CONTENTS EXECUTIVE SUMMARY .............. ......................i Structural Transformation ................................... . ii Governance ....................................v Vulnerability \ Sustainability ................................ ..x PROLOGUE ....................................2 1. Poverty Reduction and Economic Performance ..................................6 A. Introduction ....................................6 B. Trends in Growth and Poverty Reduction ....................................6 C. Sources and Patterns of Growth ................................... 10 D. The Asia Crisis and Beyond ................................... 27 E. Lessons and Challenges for the Medium-Term ................................... 29 F. Conclusions ................................... 39 2. Challenges for the Private Sector .. ................................. 40 A. Strengthening Corporate Governance ................................... 41 B. Broadening Access to Land ................................... 54 C. Opening Up and Leveling the Playing Field ................................... 58 D. Conclusions ................................... . 65 3. Finance for Development .................................... 67 A. Introduction ................................... . 67 B. Overview of the Financial Sector .. ................................. 68 C. The Legacy of Early Financial Reforms ............... .................... 70 D. The Asia Crisis and Its Aftermath .. ................................. 72 E. Key Challenges for the Future ................................... 76 F. Conclusions ................................... 82 4. The Business of Government .............. ..................... 84 A. Introduction ................................... . 84 B. Providing Public Goods .............. ..................... 84 C. Delivering Effective Justice .............. ..11................... I D. Improving Revenue Performance ............. .. .................... 115 E. Conclusions ................................... . 119 5. Vulnerability / Sustainability .. ................................. 122 A. Introduction ................................... . 122 B. Limiting Vulnerability .................................... 122 C. Domestic Savings Mobilization .............. .. ................... 126 D. Resuming Fiscal Consolidation .............. .. ................... 130 E. Requirement for Foreign Assistance ............... .................... 133 BIBLIOGRAPHY ................................... . 136 Statistical Annex ................................... . 144 Tables 1.1: RECENT EVOLUTION OF POVERTY, 1985-97 ........................................................... 7 1.2: POVERTY REDUCTION IMPACT OF GROWTH FOR SELECTED COUNTRIES .......... ........... 7 1.3: INFLOWS OF FOREIGN SAVINGS, 1992-99 ........................................................... 8 1.4: POPULATION AND GDP PER CAPITA IN SELECTED COUNTRIES ................. .................... 9 1.5: GROWTH RATES IN SELECTED COUNTRIES ........................................................... 10 1.6: ELASTICITY OF POVERTY TO GROWTH . ........................................................... 0 1.7: EVOLUTION OF SOURCES OF GROWTH OVER TIME ..................................................... 1 1 1.8: SOURCES OF GROWTH: AN INTERNATIONAL COMPARISON .................. ..................... 12 1.9: SOURCES OF GROWTH BY SUB-PERIOD ........................................................... 12 1.10: EFFECTIVE RATE OF PROTECTION, 1990-2000 ........................................................ 13 1.11: NOMINAL PROTECTION RATES OF MAJOR AGRICULTURAL COMMODITIES .............. 15 1.12: WAGE COSTS IN MANUFACTURING ............................... ............................ 15 1.13: SOURCES OF SECTORAL GROWTH BY SUB-PERIOD ..................................... ............. 16 1.14: EAST ASIAN EXPORT SHARES IN INTERNATIONAL IMPORT MARKETS .......... ........... 17 1.15: MANUFACTURING EXPORTS OF SELECTED DEVELOPING COUNTRIES .................... .. 18 1.16: COMPOSITION OF OUTPUT IN SELECTED COUNTRIES, 1992-98 ................................ 20 1.17: EMPLOYMENT BY SECTORS, 1980-98 ........................................................... 21 1.18: COMPENSATIONS BY SECTORS, 1991-97 ........................................................... 21 1.19: EMPLOYMENT BY SECTORS IN SELECTED COUNTRIES ......................... .................... 21 1.20: EVOLUTION OF POVERTY BY SECTOR OF EMPLOYMENT, 1985-97 ........................... 22 1.21: SECTORAL PROFILE OF POVERTY, 1997 ........................................................... 22 1.22: EDUCATION ENROLLMENTS AT THE TERTIARY LEVEL, SELECTED COUNTRIES ....... 24 1.23: POVERTY AND EDUCATIONAL ATTAINMENT ........................................................... 25 1.24: DISTRIBUTION OF INCOME AND CONSUMPTION IN SELECTED COUNTRIES ............... 27 1.25: DEMOGRAPHIC SCENARIOS ............................................................30 1.26: POVERTY AND FAMILY SIZE ........................................................... 30 1.27: FEMALE EDUCATION, FERTILITY AND LABOR FORCE PARTICIPATION ..................... 31 1.28 GOVERNMENT AND DONOR SHARE IN FUNDING FOR SELECTED PROGRAMS, 1996 ........................................................... 32 1.29: GROWTH PROSPECTS ........................................................... 33 1.30: FOREIGN INVESTMENT INFLOWS TO EAST ASIA ....................................................... 36 2.1: GROWTH AND FINANCIAL PERFORMANCE OF TOP 1 000 CORPORATIONS BY CORPORATE CONTROL STRUCTURE ........................... ................................ 42 2.2: OWNERSHIP CONCENTRATION AND LEGAL FRAMEWORKS ................... ..................... 43 2.3: MARKET SHARE OF GROUPS OF COMPANIES IN SELECTED INDUSTRIES, 1991-97 ..... 46 2.4: VARIABLES AFFECTING THE ENFORCEMENT OF INVESTOR RIGHTS ............ ............... 48 2.5: MEASURES FOR PROTECTING CREDITOR RIGHTS ....................................................... 50 2.6: DURATION OF DEBT SUSPENSION PROCEDURES ......................................................... 51 2.7: SIZE AND CHARACTERISTICS OF DIFFERENT LAND REFORMS ................. ..................... 55 2.8: LAND DISTRIBUTION UNDER CARP STATUS BY LAND TYPE AND MODE OF COVERAGE, 1972-97 ........................................................... 56 2.9: IMPACT OF LAND REFORM ON BENEFICIARIES .......................................................... 57 2.1 0: EVOLUTION OF EFFECTIVE RATES OF PROTECTION ..................................... ............ 59 2.1 1: AVERAGE MFN RATES OF SELECTED ECONOMIES .................................... .............. 60 2.12: IMPACT OF TARIFF REFORMS .......................................................... 61 2.13: IMPACT OF TARIFF REFORMS .......................................................... 62 2.14: SHARE OF FOOD IN CONSUMPTION BY DECILE ......................................................... 63 3.1: FINANCIAL DEPTH AND INDEBTEDNESS IN SELECTED EAST ASIAN COUNTRIES ........ 70 3.2: NPLS AND FINANCIAL RESTRUCTURING IN SELECTED EAST ASIAN COUNTRIES ....... 73 3.3: VOLUME OF GOVERNMENT SECURITIES: 1990-97 ..................................................... 75 3.4: OVERHEAD COSTS OF BANKS: 1992-97 .......................................................... 77 3.5: NET INTEREST MARGINS OF BANKS: 1992-97 .......................................................... 77 4.1: GOVERNMENT EXPENDITURES BY FUNCTION IN SELECTED COUNTRIES .......... .......... 85 4.2: GOVERNMENT EXPENDITURES BY NATURE IN SELECTED COUNTRIES ........... ............ 86 4.3: SIZE OF THE CIVIL SERVICE IN SELECTED COUNTRIES ............................................... 86 4.4: EVOLUTION OF THE CIVIL SERVICE, 1970-97 .......................................................... 87 4.5: ACCESS TO EDUCATION, 1998 .......................................................... 88 4.6: ACCESS TO HEALTH, 1998 .......................................................... 88 4.7: SELECTED HEALTH INDICATORS BY LEVEL OF INCOME, 1998 ................................... 89 4.8: QUALITY OF INSTITUTIONS IN VARIOUS COUNTRIES .................................................. 90 4.9: SELECTED CONTINGENT EXPOSURESa .................................. ........................ 92 4.10: RULE OF LAW RATINGS FOR SELECTED EAST ASIAN COUNTRIES, 1988-98 .......... 112 4.11: CASE BACKLOG IN PHILIPPINE COURTS .......................................................... 113 4.12: MAJOR FISCAL INCENTIVE SCHEMES IN THE PHILIPPINES ...................................... 116 5.1: DOMESTIC SAVINGS RATES .......................................................... 127 5.2: INVESTMENT-SAVINGS BALANCE, 1997-2010 ......................................................... 129 5.3: PUBLIC DEBT IN SELECTED COUNTRIES .......................................................... 130 5.4: FISCAL DEVELOPMENTS UNDER VARIOUS SCENARIOS, 1997-2010 ......................... 133 5.5: EXTERNAL FINANCING REQUIREMENT, 1998-2010 ................................................. 134 Figures 1: FARM AND NON-FARM COMPONENTS OF GDP .2 2: DESEASONALIZED GDP DEVELOPMENTS, 1998-99 .2 3: GROWTH IN EMPLOYMENT .3 4: KEY RATIOS OF THE BANKING SYSTEM (percent) .3 5: UNEMPLOYMENT RATE .3 6: SELF-RATED POVERTY INCIDENCE (percent) .3 7: NATIONAL GOVERNMENT CUMULATIVE SURPLUS/DEFICIT .4 8: NATIONAL GOVERNMENT REVENUE AND EXPENDITURE .4 9: PRIME RATE AND INFLATION .4 10: NET DOMESTIC CREDIT GROWTH ..................................................4 11: CORE AND HEADLINE INFLATION ..................................................5 12: MERCHANDISE TRADE ...................................................5 1.1: GDP GROWTH RATES IN SELECTED COUNTRIES, 1960-98 ..........................................8 1.2: INCOME AND CONSUMPTION PER CAPITA ...................................................9 1.3: CAPITAL/LABOR RATIO ................................................. 11 1.4: LABOR FORCE PARTICIPATION AND UNDEREMPLOYMENT, 1971-99 ......................... 11 1.5: SECTORAL PRICE DEVELOPMENTS .................................................. 14 1.6: REAL EXCHANGE RATE INDEX ....................................................... 14 1.7: HIGH-TECHNOLOGY EXPORTS IN SELECTED COUNTRIES ........................... ................ 19 1.8: GROSS SECONDARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES ........... 23 1.9: GRoSS TERTIARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES ................ 24 1.10 DISTRIBUTION OF THE GROSS NATIONAL DISPOSABLE INCOME ................................ 26 1.11: POVERTY, DISPOSABLE INCOME, AND FAMILY CONSUMPTION ................................ 26 1.12: EVOLUTION OF INCOME BY QUINTILE ....................................................... 27 1.13: CONTRIBUTIONS TO FINAL DEMAND ........................................................ 28 1.14: CONTRIBUTIONS TO GROSS DOMESTIC PRODUCT ..................................................... 28 1.15: STRUCTURE OF OUTPUT ....................................................... 33 1.16: STRUCTURE OF EMPLOYMENT ....................................................... 33 2.1: CORPORATE LEVERAGE IN SELECTED COUNTRIES ..................................................... 49 2.2: EFFECTIVE PROTECTION RATES FOR MANUFACTURING AND AGRICULTURE ............. 60 2.3: AGRICULTURAL EXPORTS ........................................................ 63 2.4: PRICE OF RICE IN SELECTED COUNTRIES ................................. ...................... 63 3.1: RATIO OF DEPOSIT MONEY BANK ASSETS TO TOTAL FINANCIAL ASSETS ......... ........ 69 3.2: STOCK MARKETTURNOVER ....................................................... 80 4.1: EVOLUTION OF NATIONAL GOVERNMENT EXPENDITURES, 1994-99 ......................... 87 4.2: WAGE COMPRESSION RATIOS IN SELECTED COUNTRIES .......................................... 101 4.3: TRANSPARENCY INTERNATIONAL CORRUPTION PERCEPTION INDEX (CPI) ............. 108 5.1: CURRENT ACCOUNT BALANCE, 1996-2010 ........................................................ 123 5.2: FOREIGN RESERVES, 1996-2010 ....................................................... 124 5.3: EUROSPREADS, SELECTED COUNTRIES . ........................................................ 124 5.4: NATIONAL GOVERNMENT EXPENDITURE ..................................... .................. 125 5.5: STOCK EXCHANGE DEVELOPMENTS IN SELECTED COUNTRIES ............... ................. 126 5.6: FAMILY SAVINGS RATES BY LEVEL OF INCOME .......................................1 128 5.7: GROSS NATIONAL SAVINGS BY SECTORS ....................................... 128 5.8: EVOLUTION OF NATIONAL GOVERNMENT AND PUBLIC SECTOR GOVERNMENT BALANCES ....................................... 131 5.9: EVOLUTION OF NATIONAL GOVERNMENT REVENUES ....................................... 131 5.10: ODAUTILIZATIONRATEa/ ..................... 135 Boxes Box 2.1: EXAMPLES OF BEST PRACTICES IN CREDITOR PROTECTION . . 50 Box 3.1: WHY DOES FINANCE MATTER? .......................................... 68 Box 3.2: THE PHILIPPINES' 1980s CRISIs ......................................... 71 Box 3.3: PROMOTING RuRAL AND MICRO FINANCE ......................................... 79 Box 4.1: FIRST THINGS FIRST IN BUDGET REFORM .......................................... 105 Box 4.2: REPRESSION OF CORRUPTION IN HONG KONG AND IN THE PHILIPPINES .109 FOREWORD This report has been prepared by a core staff team comprising Bernard Funck (main author), Rajashree Paralkar, Joven Balbosa and based, among others, on valuable contributions by Ceasar Cororaton and Janet Cuenca (sources of growth, impact of trade liberalization), Charles Woodruff (corporate governance), Rick Messick (judiciary); MacDonald Benjamin (financial sector), Cecilia Vales (procurement), Dana Weist (tax administration), Leonora Gonzales and Angelina Ibus (civil society). The team drew upon a number of background studies, including by Arsenio Balisacan (poverty profile), Mike Alba (incidence of public expenditures), Klaus Deininger et al. (land reform), Aldo Baietti et al., Gilbert Llanto et al. (private provision of infrastructure), Ma. Joy Abrenica (telecommunications), Leonard Early and Sylvie Trosa (budget and performance management), Denis Ives, David Steedman (civil service), Subrahmanya Ramamurthy (budget execution and accounting), Kenneth Dye (audit), Vinay Bhargava et al. and Robert Beschel (anti-corruption). The team gratefully acknowledges its indebtedness to the analytical work produced by the Philippine Institute for Development Studies; under the AGILE project of USAID-particularly the studies of Rosario Manasan (trade liberalization), Ramon Clarete (food policy) and Kevin Fogarty (corporate governance); as well as to research supported by the Asian Development Bank-in particular by Cesar Saldafia (corporate governance), by the International Monetary Fund, as well as various United Nations agencies. A complete bibliography is attached at the end of the report. The team also received useful input and advice from a number of reviewers within the World Bank, including Masahiro Kawai, Homi Kharas, Sanjay Dhar, Daniela Gressani and Milan Brahmbhatt. Eduard Bos produced the demographic projections used in this report, and Rosalinda Dacumos helped with the macroeconomic simulations. The production of the report would not have been possible however without the logistical support of Araceli Tria , Myla Grace de Guzman and Lily Tsang. EXECUTIVE SUMMARY 1. The following facts command attention: (a) Poverty incidence dropped by about 15 percentage points between 1985 and 1997. When growth exceeded 5 percent prior to the Asia crisis, the pace of poverty reduction accelerated to 2 percentage points per year. (b) With the share of government corporations in the sales of the top 1000 firms shrinking from close to 20 percent in the mid-1980s to about 6 percent at present, the private sector has been the main engine of growth. (c) With export growth accelerating from an average 4 percent in the 1980s to 16 percent in 1990-98, the country doubled its share of world markets. (d) The Philippines was among the first countries directly affected by the Asia crisis to regain (and exceed) pre-crisis levels of economic activity. 2. For anyone familiar with the country's history, these are encouraging signs that a new Philippines has begun to emerge. 3. With the Asia crisis receding, the question facing the authorities is how to sustain this achievement and bring back growth to a pace healthy enough to make a serious dent into poverty. The concern is real: the recovery has been hampered by a wider fiscal deficit, slow progress in implementing structural reforms in the last two years, and governance concerns. On financial markets, widening spreads on foreign borrowing and a poor stock market performance are current areas of concern. For the man on the street, the perception is that poverty is no longer declining. 4. This report highlights how much recent achievements in terms of growth and poverty reduction owe to the progress the country has made on a broad front of policy issues, ranging from openness to trade, investment and competition, to education, and from governance and empowerment to financial regulation. 5. But it is also the case that progress has been uneven in many areas, leaving enough of a remaining agenda to support growth and poverty reduction efforts over the medium term. The report outlines this agenda, some of the key elements of which are: (a) Intensifying trade liberalization and domestic competition. (b) Strengthening standards of governance across financial, corporate and public sectors. (c) Broadening asset ownership, and the poor's access to tangible assets (e.g., land) and intangible ones (e.g., education). (d) Nurturing domestic savings, in the public sector to start with. -ii- 6. On that basis, this report envisages that GDP growth would pick up in 2000 from the 3.2 percent recorded in 1999, and again cross the 5 percent threshold, as needed to meet the Government's target for poverty reduction under the medium-term development plan for 1999-2004. STRUCTURAL TRANSFORMATION 7. Following the crisis of the 1 980s, two major factors helped revive growth: (i) the structural reforms undertaken to move from the import substitution industrialization policies of the previous decades to a more balanced development strategy; and (ii) the restoration of orderly relations with the country's creditors following the debt restructuring agreement of 1992. 8. The country's shift from inward to an outward orientation not only permitted a world-class export industry to finally emerge in the Philippines, it also succeeded in making growth more beneficial to the poor by: (a) Making growth more labor-intensive, allowing comparatively modest growth performances to translate into relatively large drops in poverty incidence. This resulted at least as much from changes in the composition of output in favor of more labor-intensive activities (particularly in non- tradable sectors) as from a change in factor intensity within sectors. Employment in construction and services thus opened a main escape route out of poverty, poverty reduction being faster and deeper for those engaged in these sectors. (b) Forcing a relative desegmentation of the labor market under the pressure of competition. The resulting convergence of wages across sectors helped spread the benefits of growth across the economy. (c) Causing a redistribution of the national income in favor of households and consumers, reflecting not only a rising share of labor in the national income but apparently also a redistribution of the previous rents to the consumer as a result of trade liberalization and de-monopolization. 9. This process, however, left a number of issues outstanding. First, what did not improve is income inequality among families. The fact that lower income groups also enjoyed unprecedented poverty reduction may have made growing inequality more socially acceptable. But, this may change in a slower growth scenario. 10. Second, a shift in the domestic terms of trade against tradables in the run-up to the Asia crisis-linked in part to the uneven progress of competition across sectors- indicates that rigidities persist which stand in the way of sustaining rapid growth. As mounting inflows of foreign savings fueled domestic demand, the related pressure applied differently across the economy, causing prices to rise in sectors less exposed to competition, and factors to shift towards those sectors. Conversely, where international competition limited price adjustments, the same demand pressures caused the current account deficit to expand, leaving the country exposed to volatile market sentiments. -iii- 11. An attempt to maintain the country's self-sufficiency in food actually exacerbated the problem for the rest of the economy. While other tradables were exposed to higher competition, the effective protection granted to key food items (mainly rice, corn, meat, and sugar) increased until 1997. The ultimate result of this policy was to drive up wages to levels considerably higher than in neighboring countries at comparable levels of development. This hindered the capacity of the tradable sector to adjust to the shift from inward to outward orientation and limited its capacity to create jobs in activities where the value added per worker was sufficiently high to make up for high wage costs, i.e. relatively high skilled jobs, such as in electronics. As a result, industry's contribution to the national output shrank through the 1 990s in contrast to neighboring countries. 12. Agriculturalperformance also remained weak, special protection notwithstanding: not only is agriculture the sector where poverty is highest (over 40 percent of the people engaged in agriculture), but it is also the sector where the pace of poverty reduction has remained the slowest. One can hardly avoid the proposition that the protection granted to the sector in the name of food self-sufficiency actually served to retard a process of structural transformation which would otherwise have benefited the poor, had it been allowed to unfold more freely. 13. To regain the higher growth rates needed for rapid poverty reduction, it will be necessary to arnplify the process of structural transfornation by which factors of production, particularly labor, shift to higher productivity activities. The word "industrialization" could be used in this context if it encompasses those services which are quickly "industrializing" as a result of the IT revolution, and in which the Philippines is already showing good potential. A key condition will be to restore a more balanced structure of incentives across sectors, including by (a) Aligning the pace of trade liberalization across tradables. While the county forges ahead with cutting down the average tariff to 5 percent by 2004, it is also essential to bring the so-called "sensitive items" into the fold, as indeed contemplated under the Hanoi Plan of Action under AFTA. The devaluation of the peso was actually instrumental in setting that process in motion: as a result of it, the implicit rate of protection dropped in the case of rice from about 80 percent to about 35 percent between 1997 and 1998. It would be important to stay on this trajectory. Indeed, the pace at which the country is able to bring down its food prices, and thereby enhance labor competitiveness, will have a crucial bearing on its capacity to expand into any internationally competitive, labor-intensive activity in any sector and to seize the opportunities which world trade expansion offers beyond the confines of electronics. Feeding a growing population will in any case require a different concept of food security than the ideal of food self-sufficiency, which underpins current policies. With cultivated areas constrained and cereal yields sluggish, there is little prospect that the sector could feed 15 to 20 million more mouths by 2010, without putting further pressure on food prices, -iv- further straining household budgets and hampering growth. Trade is a better way of achieving both the objectives of growth and food security. (b) Fostering competition in services. The case of telecommunications vividly illustrates the potential benefits from opening up service sectors to heightened competition. Early gains from the liberalization of the telecommunication industry in the early 1 990s-together with the development of an electronic industry-have positioned the country well to participate in the global information revolution (e.g., Internet-based back-office functions, e-commerce). It is now important to consolidate this advance by removing remaining policy bottlenecks in the sector, and, emulating its example, to extend the process to other service sectors, where competition remains stifled (e.g., ports, inter-island shipping). 14. Transforming economic structures is obviously not just a matter of price incentives. Sectoral interventions are also critical in the fields of (i) education and skills development; (ii) population; (iii) urbanization; and (iv) agricultural modernization. Education and Skills 15. The Philippines might not have benefited as much from the process of structural transformation described above, had it not been for its long-standing effort in favor of education. Thanks to this, enrollment in primary education has become almost universal, secondary education has reached the level of "mass education," and even at the tertiary level, enrollment compares to levels found in developed countries. This investment in human capital made it possible for labor to gradually shift towards higher productivity activities and offer sufficient skills to make up for comparatively high wage cost. 16. Quality and relevance have, perhaps inevitably, not always kept up with quantitative achievements: dropout rates are stubbornly high, mean achievement scores remain well below target, and in higher and vocational education, low quality state universities and colleges are displacing private institutions. Whereas more than half of the non-poor proceed beyond primary education, only a quarter of the poor do so. The measures proposed to improve the effectiveness and efficiency of education, and its accessibility to all, include: (i) increase the relative allocation for instruction material (as opposed to wages and buildings) and better target investments in basic education to benefit under-served areas and groups; (ii) implement a comprehensive teacher training (both pre- and in-service) and deployment program; and (iii) reverse the haphazard expansion of low quality post-basic public education, wean them from public funding, and develop accreditation systems applicable to both public and private institutions. Population 17. Curbing population growth would make the task of lifting people out of poverty that much easier. At 95 million by 2010, the population will be 9 million larger than it would have been, had women had as many children as they wished since 1990. For education, for instance, this means attending to 7 million more children and youth than would otherwise have been the case. With such numbers, the ambition of reaching the poor becomes even more daunting. Conversely, the persistence of this discrepancy between actual and desired maternity points towards the scope for more vigorous population policies, starting with a better funding ofpopulation programs. Urbanization 18. If cities are to play host to the process of structural transformation, the country will need to step up its investment in urban and inter-urban infrastructure (particularly in the completion of the country's arterial road network). The resources required to bring cities up to par and to operate the related services efficiently extend far beyond the government's own capacity. Hence the need to tap private investment. Whether these materialize-and the cost at which they do-depends in large measure on whether credible regulatory frameworks are established (see below). Agricultural Modernization 19. Considerable effort will need to go into agriculture to help the sector adjust to trade liberalization and seize the opportunities offered by the opening up and expansion of markets along the entire western Pacific Rim to diversify into internationally competitive crops (tree crops, for instance). To see the sector through the transition, there will be a need for a strategic (public and private) investment into land, facilities and infrastructure, as well as for research and extension services to develop and spread alternative farming packages to the farmers. This should be the main thrust of the implementation of the Agriculture and Fisheries Modernization Act. GOVERNANCE 20. Given the Philippines' open economy and heavy reliance on trade and capital flows, strengthening investor confidence will be vital to sustain a higher growth path. This objective in turn will be best served by undertaking a concerted effort to raise standards of governance in public institutions and the private sector. Much has been achieved since the return to democracy in 1986-ranging from devolution to banking regulation. Yet the remaining agenda is also large. Raising Standards of Government 21. The Philippines has taken important strides since the people power revolution of 1986 towards stamping out rent seeking and patronage from government. Witnessing this, international surveys report a steady improvement in perceptions of corruption and in the prevalence of the rule of law since the late 1980s. While recognizing this progress, the same surveys also confirm that much remains to be done for a culture of performance and accountability to set in. Indeed, the Philippines' ranking in terms of bureaucratic and judiciary effectiveness is low, while corruption indicators remain uncomfortably high. This report (as well as the 9-point action plan put forward by the World Bank to fight corruption) highlights the need to get some of the basics in place, including: -vi- (a) A meritocratic civil service. At present, public employment remains heavily politicized and poorly motivated. By any standard, an extraordinary number of positions at all levels of government remain filled through political appointment. As a result, less than 40 percent of the senior executive positions are currently filled by fully qualified career officers. Even within the career service, appointment and promotion is only loosely linked to merit, and performance evaluation and rewards systems have been debased. Moreover, while the salaries of the rank and file have been adjusted to market levels under the Salary Standardization process, those of senior executives lag behind, creating crippling problems of retention, morale, and perhaps even public morality. Two priorities emerge. The first one is to professionalize the service. This is one of the objectives of the revised Civil Service Code, which is before Congress. The second is to revamp the pay and grading system with a view to better motivate and retain senior career officers. This would also be the opportunity to initiate a long-term reflection on the proper scope of the civil service code. (b) Reliable financial management systems. In recent years, a number of countries have blazed new trails in using budget reform to improve public service performance. A prerequisite, however, is to create a culture that expects performance and demands accountability. The main issue at present is not so much with the way the budget is put together (which is being improved), but with the way it is spent and accounted for. Sophisticated accounting and monitoring systems do exist, but they are too unwieldy to produce much that is of use in day-to-day management. Because of these defects, fiscal and department managers are too often left groping in the dark when trying to pilot the execution of the budget, a situation unlikely to foster performance, ... or probity for that matter. Much of the burden in this respect has historically rested on the Commission on Audit. In addition to external audit, it has traditionally performed many accounting and most internal control functions. But, in line with international practices, the Commission is gradually disengaging from non-audit responsibilities, leaving a vacuum where the executive branch needs urgently to step in, with two priorities: bringing accounting in line with international standards and developing internal control. (c) A foolproofprocurement system. Although current systems espouse the principles of competition, economy, efficiency and transparency, practices are known to be riddled with fraud and inefficiencies. The heart of the problem is not the lack of rules, but rather an excess of inconsistent ones, which have proliferated over the years, as piecemeal responses to recurring leakage. Much gain could come from (i) consolidating existing rules in a harmonized procurement code; and (ii) developing standardized forms and fornats, the use of which would limit discretion, streamline the approval process, and facilitate contract monitoring and audit. -Vii- (d) An effective judiciary. There is widespread concern, domestically and internationally, that Philippine courts do a poor job of upholding the "rule of law," and thereby debilitate efforts to improve the development policy framework. Laws might, for instance, be more effective at stamping out corruption if courts were more diligent in sanctioning the culprits. On the face of it, the Philippines has a full arsenal of rules and institutions to identify and suppress the syndrome. But comparison with Hongkong indicates why this does not happen: only 1 in 10 prosecuted cases result in a sustained conviction, while the ratio is 8 to 10 in Hong Kong. Two issues first warrant attention: (i) lengthy delays in resolving civil and criminal cases (the court backlog has increased from about 300,000 to about 650,000 cases between 1992 and 1998); and (ii) unpredictable results when a decision is finally reached. Improving procedures for transparent, merit-based judicial appointments and rooting out corruption in the judiciary would help in both respects. Devolution and Empowerment 22. With the 1986 revolution, the country has also moved away from the view that the state must or can itself address all the legitimate demands from society, and learned that, in many cases, citizens are often willing to pay or contribute their time and energy to the fulfillment of social needs that they care about. In those cases, the Philippines has learned that it is often best for the state not to abdicate but to focus on providing the enabling environment in which private and local initiatives will flourish. (a) Although it has caused an uncomfortable accumulation of contingent exposures, there is no question that the option in favor of private provision of infrastructure has, on balance, served the country well and will remain irreplaceable for unlocking the growth potential of the economy. (b) Another important initiative has been to bring government services in closer contact with users and more responsive to their needs, under the devolution of the 1991 local government code. Devolution, it was also hoped, would put local government at the forefront of the fight against poverty. How much of that has been achieved is unknown. It is now time for such stocktaking to take place, based on a rigorous data investigation. (c) In the same spirit, the growing participation of non-government organizations (NGOs) in public affairs, although of a different nature and scale, has been one of the greatest successes of the decade. 23. This blooming of civil society initiatives offered a fertile ground for broader approaches to poverty alleviation to emerge. Under these approaches, the poor have come to be seen not merely as recipients/beneficiaries of government programs or policies, but as agents of their own destinies. Through the nineties, a new consensus began to form around the need to empower the poor, including by securing the rights of poor communities and individuals and their equitable access to assets. -viii- 24. Two of the most important programs to help lower income groups get access to tangible assets have been: (i) the National Shelter Program (NSP) of 1986 for housing; and (ii) the Comprehensive Agrarian Reform Program (CARP) of 1988. The former unfortunately failed. Although it has involved great expenses (pensioners' money, essentially), there is little evidence that, aside from a few remarkable exceptions (such as the Community Mortgage Program), the NSP made much of an impact on the housing conditions of the poor. There is now growing recognition that: (i) public funding on its own cannot solve housing problems; (ii) to bring in commercial-based financing, low income housing loans need to be at market rates of -interest; and (iii) ensuring affordability for the poor could best be achieved through a carefully targeted and transparently budgeted up-front subsidy program. This vision, cast by the Medium-Term Development Plan for Shelter, remains to be acted upon. 25. There is better evidence of success in the case of the agrarian reform program. Although its implementation is lagging behind schedule, fresh data presented in this report confirm the intuition that access to land ownership gave the leg up to those who benefited from the program. But what about the many more who did not? It also appears it has become harder for the landless to access land, and that this may be due to the restrictions to the operation of the land market (particularly land rental), which agrarian reform introduced. If further research confirms these preliminary findings, it might be justified to target CARP implementation more toward landless; and to identify which CARP-induced land market restrictions could be relaxed to give a better chance to non- beneficiaries to access land outside of the program. By driving down land prices, food trade liberalization would further help. In the meantime, a more effective collection of existing land taxes would increase the efficiency of land use. In addition, it would be worth piloting mechanisms to fund poor communities directly to purchase CARP land on a mutually agreeable basis to supplement existing compulsory CARP arrangements, and speed up land transfers in areas where landlord resistance is fiercest. Corporate and Financial Sector Framework 26. The newfound financial resiliency of Philippine banks and corporations in the face of the Asia crisis similarly bears testimony to the progress achieved in the area of corporate and financial sector governance. At the same time, market reactions to a recent spate of stock market scandals and murky corporate maneuvers point to the magnitude of the unfinished agenda, as well as to the urgency of tackling it to restore confidence. 27. Another telltale sign of an underlying problem is the concentration of ownership around family-based conglomerates. Not only is it high by regional standards, this concentration also rose in recent years. In the current environment, the limited scope for outside creditors or minority shareholders to discipline corporate insiders also constrains the capacity of firms to raise external finance. To this, ownership concentration and conglomerate structure offer the palliatives of stronger internal control and internal capital markets. The success of this corporate structure potentially poses two major risks to the economy, which the country has begun to address: (a) Group-based companies might abuse dominant market positions to extract monopoly rents. With the opening up of the economy to trade and -ix- investment, these positions have begun to erode. But further efforts to stimulate competition will be required to put this concern to rest. (b) Corporate groups might use their ownership of banks for connected lending purposes, undermining the stability of the banking system. After a history of banking turbulence often caused by such poor lending practices, vigorous reforms efforts since the late 1 980s have made considerable headway toward strengthening the regulation of the sector, in part by elevating the independence and authority of bank regulators. These reforms proved their worth when the Asia crisis struck. It then appeared that the comparatively better regulated (and also more fragmented) banking industry of the Philippines had been less prone to take on unduly large risk exposures. Furthermore, fresh memories of the 1980s' debt crisis served to cool the appetite for risk of many corporations and banks, while an only recent reentry into international capital markets inhibited the more adventurous from turning to those to circumvent domestic constraints. Banking regulators will not have the luxury of resting on their laurels. First, recurring abuses of connected lending limits signifies the need for continued supervisory vigilance in this respect. Furthermore, the ongoing consolidation of the banking industry will also (i) relax the constraints which connected lending ceilings had so far been placing on individual exposures; and (ii) increase the scope for oligopolistic behaviors on the part of remaining banks. To obviate the related risk, banking sector consolidation will need to go hand in hand with fresh efforts to improve bank governance; enhance contestability; further strengthen supervision; as well as to ensure prompt resolution of distress cases, should any arise. 28. If the country is to generate the external finance which its corporations need to grow, a more direct effort will be required to tackle, not only the symptoms and side- effects of corporate and capital market governance weaknesses, but also their more deep-rooted causes. Such effort should involve, inter alia, reinforcing the protection of minority shareholders and creditors vis-a-vis corporate insiders (i.e., majority shareholders and managers); straightening out the governance and regulation of markets and institutional investors; and elevating the independence and authority of regulators vis-a-vis market participants (particularly that of SEC and PSE), in a similar fashion as was done for the banking industry. An early approval of the proposed Securities Act by Congress, and of effective debt resolution procedures by the Securities and Exchange Commission would considerably improve the formal framework. 29. Little would have been accomplished however unless the rules which are on the books are more deliberately enforced (e.g., integrity of regulatory, accounting and auditing practices; compliance with disclosure requirements). For market participants, this will be the litmus test that the rules of business are indeed changing. VULNERABILITY \ SUSTAINABILITY Sources of Vulnerability 30. Resuming growth is one thing. The country just experienced how essential proper financial regulation was in sustaining it. A lack of savings also leaves the country more exposed than most to shocks and turbulences. As a nation, the Philippines has one of the lowest domestic savings rates in the region. Thus, any spur of development energy rapidly threatens its external balance. 31. The same goes for low-income groups: taken together, the lower three income deciles of the population do not save. They have therefore little cushion to fall back on in hard times, or capacity, even in good times, to access formal credit markets or makes the most basic investments. As a result, they are the ones who can least afford economic shocks, as research on the impact of the recent crisis confirms. 32. To sustain the level of growth required for rapid poverty reduction, while keeping the country out of future financial troubles, the investment-savings coverage ratio will need to rise over time. A number of factors could contribute to lifting private savings: (i) maintaining confidence in the country's banks and currency will remain central; (ii) diversifying savings instruments and broadening the coverage of contractual savings schemes; (iii) bringing down food prices through trade liberalization; (iv) accelerating the decline in the age dependency ratio (through more vigorous population policies). Sustaining faster growth may further induce a virtuous circle of higher private saving. Fiscal Consolidation 33. One needs to recognize that private saving has a high degree of inertia and that sustained changes tend to materialize only over the long term. For a more immediate impact on aggregate savings, a resumption of fiscal consolidation is needed. After the fiscal deficit widened beyond target in 1999 (to 3.6 percent of GNP), government should be steadfast in its resolve to bring the deficit down to 1.9 percent of GNP this year. 34. The main instrument of fiscal consolidation should be to reverse the recent losses of revenues (down from 18.5 of GNP in 1997 to 15.2 of GNP in 1999). Anticipating the impact of trade liberalization, the Philippines tax system underwent a fundamental overhaul under the three rounds of the Comprehensive Tax Reform Program in a bid to make taxation more buoyant, remove distortions in incentives, and reduce corruption by streamlining tax provisions, closing loopholes, and generally limiting the room for discretion. This tax reform needs to be brought to closure, including by streamlining the many tax incentives, which continue to puncture tax collection efforts. 35. Beyond this, all efforts should turn to revenue collection. To start with, the pattern of tax amnesties should be stopped, and the government should distance itself from the various efforts currently afoot in Congress in favor of a new one. Second, the Commission on Audit must be authorized to extend its oversight to the Bureau of Internal Revenue, to help root out allegedly endemic corruption in revenue collection. Third, the -xi- recently decided restructuring of the Bureau from a functional to a client-based organization needs to proceed, and underpin more forceful audit efforts. 36. The biggest threats to fiscal stability, however, often arise, not from the mainstream of budget operations but from off-balance sheet risks, such as the performance guarantees embedded in PPI contracts. Large as those might be, they do not constitute the only form of contingent exposure. There is also a well-established tradition in the Philippines for the government to use off-balance sheet mechanisms to meet social needs (e.g., local water, rural electrification, housing, deposit insurance). These arrangements also create considerable-and in some cases, much less contingent- exposures. Going forward, a more careful use of guarantees and a better monitoring- and pricing-of the risks involved will be in order (e.g., when capitalizing the Home Insurance and Guarantee Corporation). 37. Even if the Philippines succeeds in cutting back its investment/savings gap substantially over this decade, as this report anticipates, the Philippines will continue for some time to come to require official development assistance to meet its development priorities. For this assistance to be forthcoming, however, the country will need to restore its record of aid utilization, which has deteriorated sharply in recent years. -2- PROLOGUE The Philippines was among the first countries directly affected by the Asia crisis to regain (and exceed) the level of activity achieved before the crisis. The pace of the 1999 recovery may have been milder than in other crisis-affected country (3.2 percent GDP growth in 1999), but so was the previous contraction (see Figure 1). Indeed, were it not for the impact of El Nifo (which caused rice and corn production to contract by 19 percent and 13 percent in 1998, respectively), the economy would likely have avoided a recession. In fact, GDP shrank somewhat (-0.5 percent in 1998), but growth of nonfarm output remained positive (+1.1 percent in 1998). Figure 1: FARM AND NON-FARM Figure 2: DESEASONALIZED GDP COMPONENTS OF GDP DEVELOPMENTS, 1998-99 (percent year on year) (percent, annualized quarterly growth rate) 350 -5.0 _ R _ _ > | 5 9 ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~2.0 -25l01 Q2 03 Q4 Q1 Q2 03 04 ~~ -GDP ----- Farm -Nonfarm F-~GOP -~Agricuhue Industry :se~c:s Source:NSCB Source: NSCB Similarly, employment has risen by 4 percent since 1997 (see Figure 3), limiting the social impact of the crisis. Furthermore, Philippines banks have remained capitalized considerably beyond Basle-standards with an average capital adequacy ratio at 17.6 percent. The question now facing the authorities is how to bring back growth to a pace strong enough to make a serious dent into poverty. -3 - Figure 3: GROWTH IN EMPLOYMENT Figure 4: KEY RATIOS OF THE BANKING (percent year on year) SYSTEM (percent) &g=1~~ Farpo<-,nm ----oo (ft) V4Wi Source: NSO Source: BSP The concern is real. With the technical rebound of agriculture, growth did bounce back in 1999. But nonfarm activity remained sluggish (+2.4 percent in 1999). Furthermore, on a deseasonalized basis, growth has actually been decelerating (see Figure 2), and might already be too slow for unemployment to come down further (see Figure 5). In this context, the public perception is that poverty is not any longer declining (see Figure 6). Figure 5: UNEMPLOYMENT RATE Figure 6: SELF-RATED POVERTY (percentage point difference, year on year) INCIDENCE (percent) 3% 69 2% 67 1%/ 63 0% 61i. -2% 57 Jan July Jan July Jan July Jan 55 97 97 98 99 00 1994 1995 1996 1997 1998 1999 Source: NSO Source: Social Weather Station The authorities' attempts at reviving demand have met with only mixed success. Of course, growth might have been weaker, had fiscal and monetary policies not been relaxed. And fiscal expansion may have helped to maintain essential expenditure programs. But, with the fiscal deficit well beyond original targets (from an initial target of 0.6 percent for 1999, the national government deficit widened instead to 3.6 percent of GNP, (see Figure 7), with revenue losses (down from 18.5 of GNP in 1997 to 15.2 of GNP in 1999, (see Figure 8), policy credibility has suffered and the policy of fiscal stimulation has run its course before private demand could gain much momentum. Investment continued to contract and private consumption decelerated in 1999. Concerned to limit pressures on interest rates (see Figure 9), the government is now actively trying to reverse the fiscal trend (see Figure 7 and Figure 8), in the hope of bringing the deficit down to 1.8 percent of GNP this year. -4 - Figure 7: NATIONAL GOVERNMENT Figure 8: NATIONAL GOVERNMENT CUMULATIVE SURPLUS/DEFICIT REVENUE AND EXPENDITURE (billions of pesos, 12-months moving sum) (percent year on year, 3 months moving average) ~ yA t ~~~~~~~~__ * _ , __ = to -Revenue --Eq~nditureK Source: Department of Finance Source: Department of Finance Similarly, a steady relaxation of monetary policy and the ensuing fall in interest rates since the Spring of 1998 (see Figure 9) may have saved banks and corporations from more serious stress, but they have so far breathed little new life into private credit demand (Figure 10). Lower interest rates notwithstanding, the Philippines stock exchange has also had one of the least inspiring performances among major Asian stock markets since they hit bottom in late Summer 1998. Figure 9: PRIME RATE AND INFLATION Figure 10: NET DOMESTIC CREDIT (percent year on year) GROWTH (at constant exchange rate, percent year on year) ) a WI SS 41 * / \'/ rE- `77`;1 7-77 t;'n Difference (rts) CPI (llhs) -Prime Rate (Iha Total (Ihs) -Priv_Sect._(rhs): Source: BSPa NSO Source: BSP The combination of an ever widemng fiscal deficit inconsistent structural policy signals, and repeated allegations of cronyism have created a malaise strong enough to blunt the economy's response to the stimulus provided. Things do notwneed to be that way. With stronger confidence, there are many reasons to believe that the country could afford to pick up the pace of growth without major immediate financial risk. Weak domestic demand has helped bring down core inflation from 12 to 8 percent between 1998 and 1999 (the impact of the bumper crop -5 - temporarily brought headline rate further down below 3 percent in early 2000, (see Figure 11) and put the country's external accounts in a position of rare strength. Spurred by relentless growth of electronics exports, the trade account swung into surplus (about 5 percent of GDP in 1999) for the first time in 26 years (see Figure 12) and drove the current account to a record surplus. Heavy sovereign borrowing (US$4.4 billion in 1999) to meet the public sector financing requirement have helped boost reserves to historically high levels (about US$15 billion at the end of 1999); though reserve accumulation was at the same time limited by the unprecedented level of unexplained outflows. With subdued demand from other sectors of the economy, the country's external debt remained relatively stable at US$48 billion as of June 1999. Furthermore, most of it (86 percent) is for medium to long-term maturities, while short-term obligations now fall well below the level of external reserves. Figure 11: CORE AND HEADLINE Figure 12: MERCHANDISE TRADE INFLATION (percent year on year in US$ million) (percent year on year, 1994=1 00) -GPI - PI x fod & utlities Tradebalanice (rhs) -E,qports (fth) - linwots (us) Source: NSO Source: NSO With the impact of the Asia crisis receding, it is therefore time for policy-makers to train their sights again on the structural challenges of the medium term. The main priority in the view of this report is to set the country on target towards the international objective of reducing absolute poverty by half by 2015. The past decade saw the country make unprecedented progress in that direction. To be able to pick up the pace again, it is useful to reflect on the lessons learned from both recent successes and disappointments. The chapters that follow contribute to this reflection. -6 - 1. POVERTY REDUCTION AND ECONOMIC PERFORMANCE A. INTRODUCTION 1.1 The Philippines' shift since the mid-1980s from inward to outward orientation changed the nature of growth, making it more labor-intensive and more beneficial to the poor. Thanks to a long-standing effort in favor of education, larger numbers were able to contribute to the structural transformation and share in the benefits of growth. A redistribution of the national income in favor of households and a convergence of earnings across sectors further helped spread the benefits of growth. Unfortunately, the period also coincided with a series of shocks-largely exogenous to the structural transformation itself-which limited the duration of the growth years and hence, the full impact on poverty. 1.2 During the run-up to the Asia crisis, moreover, the macroeconomic foundations of growth became more fragile. With the prior appreciation of the currency, the domestic terms of trade increasingly tilted towards nontradables (e.g., real estate, services), while rising food protectionism further hindered the development of sectors more open to international competition. Booming exports notwithstanding, this powerful undertow eventually destabilized the external account, exposing the country to the reversal of market sentiment throughout the region. These developments are discussed in the second section of this chapter. 1.3 As described in the prologue, the country succeeded during 1998-99 in restoring its external financial situation at a much lower social cost than its neighbors more severely affected by the Asia flu. The issue now is how to rekindle growth and put poverty reduction back on track. The final section discusses some of the main challenges involved: (i) containing population growth while dealing with its implications; (ii) resuming faster, labor-intensive, but also better balanced growth; and (iii) managing the rapid urbanization which will necessarily accompany the needed structural transformnation3 of the economy. B. TRENDS IN GROWTH AND POVERTY REDUCTION 1.4 By all accounts, the policies pursued since the return of democracy have been good to the poor (see Table 1.1). Not only has the number of people living below the poverty line fallen steadily in relation to the population (from 41 percent to 25 percent '"The potential of the concept of structural transformation to unify the study of various aspects of development is demonstrated by the use of such terms as agricultural transformation, industrialization, demographic transition, and urbanization, each of which describes one or more dimensions of the overall transformation process.... What are the main features of the transformation that affect the ways in which economies grow and that distinguish developed and developing countries? ... * Engel's law of the declining share of food in consumption • Lewis' hypothesis of the elastic supply of labor in most developing countries... * Balassa's "stages of comparative advantage," derived from the Heckscher-Ohlin model * Kuznets' observation of systematic differences in the level and growth of productivity by sector * The demographic transition, a set of factors that produces first a rise and then a decline in population growth as per capita income rises" in Chenery, H., S. Robinson, M. Syrquin, 1986, "Industrialization and Growth," World Bank, Washington DC, page 11. -7 - between 1985 and 1997 2), but also those who have remained below have moved closer to the threshold (as the evolution of the poverty depth index indicates). Even at the margin, giving greater weight to welfare of the poorest, absolute poverty has become less acute (as the evolution of the severity index shows). Table 1.1: RECENT EVOLUTION OF POVERTY, 1985-97 (percent) INCIDENCE DEPTH SEVERITY 1985 40.9 1312 5.8 1988 34.4 10.1 4.2 1991 34.3 10.6 4.5 1994 32.1 8.7 3.4 1997 25.0 6.4 2.3 Source: Balisacan (1999) 1.5 The resumption of growth (see Table 1.2 and Figure 1.1) obviously played a key role in this accomplishment. Indeed, during the years when growth crossed the 5 percent threshold in a sustained manner for the first time since the 1 970s, the country even recorded unprecedented success, with poverty incidence dropping by more than two percentage points a year. Table 1.2: POVERTY REDUCTION IMPACT OF GROWTH FOR SELECTED COUNTRIES PERIOD PERCENTAGE POINT GROWTH OF GNP PER CAPITA REDUCTION PER YEAR 1980-94 (percent per year) Philippines 1985-94 1.0 1.7 China 1987-94 0.7 7.8 Indonesia 1984-96 0.9 6.0 EAP (excl. China) 1987-93 1.6 6.9 Source: Balisacan, Causes of Poverty: Myths, Facts and Policies (1999) 1.6 A number of studies (including Austria, 1998; and IMF, 1999) have shown how much that burst of growth owed to the opening up of the economy, both through (a) structural reforms-including trade liberalization, privatization, financial sector reforn and fiscal consolidation-which will be discussed in the course of this report; as well as (b) The country's renewed access to foreign savings on regular terms. Through the debt restructuring agreement of 1992, the country succeeded in normalizing relations with its major creditors, and regaining access to international capital markets from which it had been practically shut-off since the debt moratorium of 1982. Important legislative breakthroughs (e.g., Foreign Investment Law of 1996, "BOT" law of 1990, and PEZA 2 Unless noted otherwise, this report uses the "constant cost-of-basic needs" poverty incidence indicator developed by Professor A. Balisacan, University of the Philippines. This indicator differs from the official poverty incidence indicator developed by the National Statistical Coordination Board (NSCB) in two respects: (i) to provide a measure of absolute poverty, the poverty threshold utilized remains constant over time and space (whereas it varies in the case of the official indicator, making it akin to a measure of relative poverty); and (ii) poverty incidence is measured based on consumption levels, rather than income levels (as for the NSCB indicator), which are typically more difficult to measure accurately. It should also be noted that, consistent with international practices, the poverty incidence indicators used in this report refer to the percentage of the population living below the poverty threshold, while the practice in the Philippines is often to refer to the percentage of households living below that threshold (NSCB publishes both). -8 - law of 1995) opened up the economy to foreign investment, particularly in manufacturing and utilities. As confidence returned, resident Filipinos began to repatriate their deposits abroad while overseas ones sent back home increasingly large amounts of remittances. In total, inflows of foreign savings (see Table 1.3) swelled from US$5 billion in 1992 to US$16 billion in 1996, before falling back again below US$7 billion in the wake of the Asia crisis. Table 1.3: INFLOWS OF FOREIGN SAVINGS, 1992-99 (millions of U.S. dollars) 1992 1993 1994 1995 1996 1997 1998 1999' REMTANCESa 2537 2587 3452 4402 4875 6799 5130 6382 OFFICIALTRANSFERSbl 229 187 362 338 338 302 300 259 DnRECTINVESTMENT 675 864 1289 1361 1338 1113 1592 589 PORTFOLIO INVESTMENT 62 -52 269 248 2179 -351 80 254 MLT LOANS DISBURSEMENTS 633 2455 1313 1276 2841 4824 2740 4203 O.W. ODALOANS' 3301 2950 2392 1978 2250 2437 2196 1866 CHANGEiNTHENFAOF KBS 289 -299 674 564 4214 1188 -1330 -1540 SHORT TERM CAPITAL 660 -148 1002 -56 540 495 -1521 -2856 TOTAL 5,085 5,594 8,361 8,133 16,325 14,370 6,991 7,291 Sources: BSP SPEI, IFS, Bank estimates a/ personal income and worker's remittance transfers b/ to govemment ci from bilateral and multilateral sources gross inflows d/ first 1 1-months data from 1.7 Growth cannot be the whole story, though, for (a) growth rates remained moderate compared to those observed in neighboring countries, and considerably below those recorded by the Philippines itself in the 1960s and 1970s (Figure 1.1); Figure 1.1: GDP GROWTH RATES IN SELECTED COUNTRIES, 1960-98 1IsI 5 0 G. - ' .. 961 1964 1967 1970 1973 1976 1979 198;2-985 1988 1991 1994 197 -10 -20 Indonesia - -Malaysia - - - Philippines - - Thailand Source: Global Development Data, World Bank (b) the comparative record is even less favorable in terms of GDP per capita (see Table 1.4). Indeed, if national accounts are to be believed,3 GDP per There are reasons to believe that national accounts would underestimate the amount of real growth in the economy, particularly due to the use of an old (and unrepresentative) base year (1985, a year of recession and revolution). The bias is likely to grow over time. -9 - capita would not yet have regained the level the country enjoyed twenty years ago (see Figure 1.2). Table 1.4: POPULATION AND GDP PER CAPITA IN SELECTED COUNTRIES (average annual percentage change) 1961-70 1971-80 1981-90 1991-98a' CHINA Population 2.0 1.8 1.5 1.1 Per capita income 3 3.6 7.6 10.0 INDONESLA Population 2.2 2.3 1.8 1.7 Per capita income 1.9 5.4 4.5 5.6 MALAYSIA Population 2.9 2.4 2.8 2.5 Per capita income 3.5 5.4 3.1 5.9 PHILIPPINES Population 3.1 2.5 2.6 2.3 Per capita income 1.8 3.3 -0.8 0.8 THAILAND Population 3.0 2.7 1.7 1.2 Per capita income 5.0 4.1 6.1 5.5 BANGLADESH Population 2.6 2.6 2.4 1.6 Per capita income 1.4 -0.8 2.3 3.1 INDIA Population 2.3 2.3 2.1 1.8 Per capita income 2.2 0.8 3.7 3.8 a/ per capita GDP growth rate is for 1991-97. Source: Global Development Data, World Bank Figure 1.2: INCOME AND CONSUMPTION PER CAPITA (1985= 100) 140.0 . _ _ _ _ 130.0 120.0 110.0 10-0 0 90.0 80.0 l9b A G t 9 96 996969 9 9 -u-GDP GNP Private Cons. Source: NSCB (c) the previous time the country reached respectable rates by international standards, i.e., in the 1960s and early 1970s (see Figure 1.1 and Table 1.5), a number of authors-including Gustav Ranis4-had been struck by the lack of poverty response to it. This time around, despite more moderate growth, poverty reduction achievement stands the comparison with countries like China and Indonesia (see Table 1.2), i.e., those neighboring country whose level of income per capita (at purchasing power parity) was closest to that of the Philippines Ranis, Gustav and Frances Stewart. 1993. "Rural Non-agricultural Activities in Development: Theory and Application. Journal of DevelopmentEconomics(40): 75-101. -10 - 1.8 A rising elasticity of poverty to growth (see Table 1.6) confirms that other factors must have been at play to make growth more pro-poor. The following sections will highlight how much this owes to (a) A more labor-intensive pattern of growth. (b) A redistribution of the national income in favor of households. (c) A convergence of earnings across sectors. Table 1.5: GROWTH RATES IN SELECTED Table 1.6: ELASTICITY OF POVERTY COUNTRIES TO GROWTH (percent) (percent) 1980-85 1985-90 1990-97 1998 INCIDENCE CHINA 9.9 8.8 10.3 7.8 INDONESIA 6.2 6.5 7.6 -14.3 1960-85 -0.26 MALAYSIA 5.5 5.5 8.7 -4.8 PHILIPPINES -0.1 2.7 3.1 -0.5 THAiLAND 5.4 9.4 7.4 -9.4 KOREA 6.3 9.5 7.4 -5.8 1985-97 -1.57 EAP5aj 4.7 6.7 6.8 -7.0 al all countries in table, except China. Source: Global Development Data Source: World Bank Staff C. SOURCES AND PATTERNS OF GROWTH From Inward to Outward Orientation 1.9 The shift, which the economy operated in the last two decades, from inward to outward orientation, accounts for a large part for this improved "quality of growth."5 This shift allowed for a more efficient use of the factors available to the economy and a more labor-intensive pattern of growth. A range of studies have documented how the protectionist policies pursued from the 1 950s to the 1 970s, if they had initially spurred growth, had done so through an inefficient accumulation of capital (and at the cost of the country becoming increasingly over-indebted). This had resulted in a lower absorption of labor and an overall decline in the productivity of production factors. Table 1.7, which summarizes some of this earlier research,6 illustrates how inward oriented policies bent the use of factors out of shape, entrenching poverty. 5 see Austria, M. S. 1998. "Productivity Growth in the Philippines after the Industrial Reforms." PIDS Discussion Paper Series No. 98-26. Makati, Philippines.; Cororaton, C. B., and M.T. Duenas-Caparas. 1998. "Total Factor Productivity: Estimates for the Philippine Economy." Revised final report submitted to the TWG-Productivity Indicators and Monitoring System.; and Cororaton, C.B., and R. Abdula. 1999b. "Productivity of Philippine Manufacturing." PIDS Discussion Paper. Makati, Philippines. 6 Kawai, H. 1994. "Intemational Comparative Analysis of Economic Growth: Trade Liberalization and Productivity." The Developing Economies 32(4): 373-397; Nehru, V., and A. Dhareshwar. 1994. "New Estimates of Total Factor Productivity Growth fbr Developing and Industrialized Countries." Washington D.C.: World Bank; Bosworth, B., et al. 1995. "Accounting for Differences in Economic Growth." Economic Studies Program, Brookings Institution, Washington, D.C. show similar results. Drysdale, P., and Y. Huang. 1995. "Technological Catch-Up and Economic Growth in East Asia." Economic Record, 73(222): 201-211 using a much longer timeframe (1950-90), shows positive TFP growth, probably capturing the impact of the productivity growth during the post- war to 1960 period (also highlighted in Williamson, J. 1969. "Dimensions of Postwar Philippine Economic Progress. " Quarterly Journal of Economics 83(1): 93-109.). -11 - Table 1.7: EVOLUTION OF SOURCES OF GROWTH OVER TIME (percentage contribution to growth) WILLIAMSON SANCHEZ AUSTRIA & AUSTRIA CORORATON (1969) (1983) MARTIN (1992) (1997) (1999) FACTORS 1947-55 1955-65 1960-73 1960-87 1960-96 1981-98 LABOR 33 54 52 24 27 37 CAPITAL 9 25 24 87 76 72 LAND 3 5 n.a. n.a. n.a. n.a. TOTAL FACTOR PRODUCTIMTY 55 15 24 -11 -3 -9 TOTAL 100 100 100 100 100 100 MEMO ITEM GDP GROWTH 7.3 4.5 4.6 4.8 3.8 2.2 Source: Austria, Myrna & Martin, Will, Economics Division Working papers, Macroeconomic Instability & Growth in the Phil: A Dynamic Approach. Research School of Pacific Studies, Australian National University, 1992; Cororaton, 1999d. 1.10 The subsequent shift to outward orientation policies (see Chapter 3, for a discussion of the policies pursued) brought the economy back in line with developing economies' standards (see Table 1.8 and Table 1.9). As in other developing countries, the accumulation of capital remained the main driver of growth during the period 1980- 98, contributing two thirds to the economies' growth rate (in developed countries, growth typically derives much more heavily from total factor productivity). But the economy also mobilized more effectively its most abundant factor, i.e., labor, whose contribution to growth rose in this more outward oriented setting (see Figure 1.3 and Table 1.7). The labor force participation rose from an estimated 55 percent in the mid-i 970s to about 65 percent in recent years, while underemployment retreated (see Figure 1.4). While growth increased, it also became more labor intensive than had previously been the case-much to the benefit of the poor whose main asset became in demand. As a result, employment expanded at an annual rate of 2.8 percent between 1980 and 1998 (leading to the creation of 11 million new jobs). Figure 1.3: CAPITALILABOR RATIO Figure 1.4: LABOR FORCE PARTICIPATION (1985=100) AND UNDEREMPLOYMENT, 1971-99 (percentage of age group, and labor force, resp.) 110 6. 64.0 ~~~~~~~~~~~~~35.0 100 XX0 30.0 90~~~~~~~~~~~~~~~~~6. 1 8Ot I 54Qt .uL 4,0 X W; ' 22000 70 I Source: Cororaton, 1999, World Bank staff calculation Source: NSO; Note: Pre-1987 adjusted to reflect change in estimation methodology (recall period) -12 - Table 1.8: SOURCES OF GROWTH: AN INTERNATIONAL COMPARISON (percent contribution to growth) REGION CAPITAL LABOR TFP PHILIPPINES 72 36 -9 DEVELOPING COUNTRIES, 1960-87 65 23 14 AFRICA 73 28 0 EAST ASIA 57 16 28 EUROPE 58 14 28 LATN AMERICA 67 30 0 SoUTHASIA 67 20 14 SELECTED DEVELOPED COUNTRIES, 1960-85 FRANCE 27 -5 78 WEST GERMANY 23 -10 87 JAPAN 36 5 59 UNITED KINGDOM 27 -5 78 UNITED STATES 23 27 50 Source: Lim (1994), Table 1 1.11 This structural transformation has not been smooth, as the closer inspection below of sectoral developments during that sub-period reveals. Twice during the twenty years concerned, the economy embarked upon unsustainable courses. First, as a result of the debt crisis and political turmoil of the 1980s, the economy failed to invest as much as it should have and ran its capital stock to the ground, ...until it was unable to grow at all due, inter alia, to power shortages. The abnormally low contribution of capital to growth during the 1980-89 sub-period (see Table 1.9), followed by an abnormally high contribution during the subsequent "reconstruction" period reflects in part the subsequent catch up effect. Second, during the mid-1990s, the country caught a milder strain of the "Asian Flu." Table 1.9: SOURCES OF GROWTH BY SUB-PERIOD (percent) GROWTH CONTRIBUTION TO GROWTH Output Labor Capital TFP Labor Capital TFP 1981-89 1.6 3.0 0.5 0.4 49.6 24.1 26.4 1990-98 2.7 2.7 3.7 -0.8 28.6 101.0 -29.6 1980-98 2.1 2.9 2.1 -0.2 36.5 72.2 -8.7 Source: Cororaton (1999d) Sectoral Trends 1.12 An examination of sectoral trends allows us to better understand the nature of the transformation as it actually took place, highlighting how the shift towards more labor intensive growth resulted at least as much from changes in the composition of output in favor of more labor intensive activities (particularly in non-tradable sectors) as from a change in factor intensity within sectors. It will also help begin to identify the tensions, which mounted in the run-up to the Asia crisis. -13 - Domestic Terms of Trade 1.13 Perhaps one of the most spectacular, and to some extent, unexpected impact of the two decades of trade liberalization policies (see next Chapter) is the impact they have had on the domestic terms of trade (see Figure 1.5). After fluctuating without clear directions during the high inflation years of the 1980s, domestic terms of trade shifted against industry and in favor of services. Essentially, they gradually turned against the sectors where progress was achieved earlier towards freeing up competition. 1.14 As regards tradables, the beginning of trade liberalization dated back to the early 1980s (under the government of Prime Minister Virata). During the 1990s only, the effective rate of protection was cut by half overall (see Table 1. 10), with even faster progress in the area of manufacturing. Of course, after decades of import substitution policies, the tradable sectors most sorely needed competition. But there is also a need to balance treatment across sectors, and as this chapter will argue, it would to the detriment of the whole economy to allow agriculture and nontradable sectors to lag behind. 1.15 Progress has indeed been more recent in nontradable areas, where many of the important milestones bear recent dates-e.g., liberalization of inter-island shipping (1996), liberalization of petroleum trade (1997-98), partial liberalization of retail trade (2000); even when in areas where the formal decisions are slightly older (e.g., earlier in the 1990s in the cases of telecommunication and power), their impact on prices is only beginning to be felt. Table 1.10: EFFECTIVE RATE OF PROTECTION, 1990-2000 (Percent, weighted average) 1990 1995 1996 1998 2000 AGIUCULTURE 26.4 25.6 28.7 25.0 22.5 MANUFACTURING 31.0 23.1 28.2 19.9 14.5 OVERALL 29.4 24.8 25.5 18.7 14.4 Source: Manasan and Pineda (1998) -14 - Figure 1.5: SECTORAL PRICE DEVELOPMENTS (1985=100) 115 _ 115 11 0 - P 110 105 ~~~~~~~~~105 100 100 95 95 90 90 85 85 &Industry Manufacturing j E ~Services _ - _..Agriculture i; Source: NSCB 1.16 Furthermore, whereas the exchange rate should have been expected to depreciate in parallel with trade liberalization, and relieve some of the competitive pressures on sectors producing tradable goods, the reverse happened during the nineties (see Figure 1.6). At the heart of the matter is the upsurge of foreign capital inflows, which followed the country's re-entry into international capital markets and amplified as emerging markets heated up in the mid-1990s. This inflow of savings fuelled domestic demand pressures throughout the economy. Where competition prevented prices from rising, as in the case of tradables, these pressures led to a growing current account deficit. In contrast, in non tradable sectors where the supply is (almost by definition in an open economy) less elastic, demand pressures translated more readily into price escalation- and all the more readily that in many instances, competition was still insufficient to hold prices in check (as noted above). Non tradable sectors were thus able to turn the terms of trade in their favor. Figure 1.6: REAL EXCHANGE RATE INDEX" (1995 =100, increase = appreciation) 150 140 130. 0120- ujI 1 1 0 100 90. 80 O N st cD X 0 N c (D (0 ( OD X0 co co 0 ) 0 0) 0) 0) a) 0) 0) 0) a) 0) 0 so ax a) 1/ 1999 data is through September Source: International Financial Statistics, IMF -15 - 1.17 An attempt to nevertheless maintain the country's self sufficiency in food actually exacerbated the problem for the rest of the economy. While other tradables were exposed to higher competition, the effective protection granted to key food items (mainly rice, corn, meat, and sugar) increased until 1997 (see Table 1.11). As a result, from 1995 onward, and for the first time in history, agriculture enjoyed a higher degree of protection than manufacturing (see Chapter 2, Figure 2.2). Table 1.11: NOMINAL PROTECTION RATES OF MAJOR AGRICULTURAL COMMODITIES (percent) 1980-84 1985-89 1990-94 1995 1996 1997 1998 RICE -13 16 19 63 91 82 34 CORN 26 67 76 104 54 96 72 SUGAR 42 154 S1 91 93 66 99 COCONUTOIL -4 7 18 10 5 0 0 PORK -9 43 31 44 n.a. n.a. n.a. CHICKEN 46 39 74 84 n.a. n.a. n.a. Source: David (1999) 1.18 The ultimate result of this autarky policy was to drive up wages to levels considerably higher than in neighboring countries at comparable levels of development (as measured by GNP at purchasing power parity, see Table 1.12). This affected particularly unskilled labor, as the latter devotes a proportionately larger share of its income to food. Being less subject to competitive pressures, non-tradable sectors were also better able to pass on the related costs to their customers, which in turn further widened intersectoral price differentials. Table 1.12: WAGE COSTS IN MANUFACTURING GNP PER AVERAGE LABOR AVERAGE VALUE CAPITA MINIMUM COST PER WORKER ADDED PER WORKER AT PPP WAGE % IN MANUFACTURING IN MANUFACTURING ($ per year) ($ per year) 1998 1995-99 1980-84 1995-99 1980-84 1995-99 PHILIPPINES 3527 1472 41.7 1240 2450 5266 10781 INDONESIA 2423 241 9.9 898 1008 3807 5139 KOREA 13289 3903 29.4 3153 10743 11617 40916 MALAYSIA 7167 ... ... 2519 3429 8454 12661 THAILAND 5382 1083 20.1 2305 2705 11072 19946 CH¢NA 3192 ... ... 472 729 3061 2885 VIETNAM 1521 134 8.8 ... 711 ... .. Source: World Development Indicators, 2000 Sectoral Composition of Output 1.19 Sectoral performances have essentially mirrored those terms of trade developments. Capital poured in non-tradable sectors (see Table 1.1 3)-such as construction, services, and utilities-where profitability was rising as a result of the real appreciation. Even San Miguel, the food and beverage giant, went into real estate. Wage competitiveness being less of an issue for non-tradables, labor followed, and the composition of the national output shifted towards more labor-intensive sectors of activity, such as construction and services. -16 - 1.20 Unfortunately, the pace at which factors were mobilized into the non-tradable sector overtook that of output growth.7 Although the quality of the statistics may overstate its magnitude, there seems to be little doubt that factor productivity dropped across non-tradable sectors. Table 1.13: SOURCES OF SECTORAL GROWTH BY SUB-PERIOD (percent) Growth Rate Output Labor Capital TFP TRADABLES AGRICULTURE 1981-89 1.3 1.5 5.0 -3.0 1990-98 0.9 1.1 -2.8 2.9 1981-98 1.1 1.3 1.0 0.0 MINING 1981-89 1.7 4.6 -6.2 4.4 1990-98 -0.4 -3.7 -11.2 2.1 1981-98 0.7 0.4 -8.7 5.7 MANUFACTURING 1981-89 1.0 2.6 2.1 -1.2 1990-98 2.4 1.8 2.8 -.0.2 1981-98 1.7 2.2 2.4 -0.7 NON-TRADABLES CONSTRUCTION 1981-89 -3.8 5.1 11.9 -12.6 1990-98 3.9 6.2 4.8 -1.8 1981-98 ... 5.7 8.3 7.0 UTILITIES 1981-89 3.8 5.3 -2.4 4.3 1990-98 5.1 5.1 0.7 3.0 1981-98 4.4 5.2 -0.8 3.6 TRANSPORT & COMMUNICATION 1981-89 3.7 4.4 3.5 0.1 1990-98 3.8 6.2 12.1 -6.8 1981-98 3.8 5.3 7.7 -3.4 TRADE 1981-89 2.7 6.6 12.7 -9.3 1990-98 3.5 3.8 7.8 -3.7 1981-98 3.1 5.2 -6.4 FINANCE & DWELLINGS 1981-89 2.1 2.4 9.8 -6.5 1990-98 3.7 6.0 8.8 -4.7 1981-98 2.9 4.2 9.3 -5.6 OTHER SERVICES 1981-89 4.3 4.1 8.2 -1.3 1990-98 3.4 3.9 10.3 -2.6 1981-98 3.8 4.0 9.2 -1.9 Source: Cororaton (1999d) 1.21 There are many reasons for such productivity losses. In some cases, as in transport, this reflects merely the fact that massive investments needed to sustain growth8 were still under gestation at the close of the period. In others (e.g., housing), they might reflect a need to catch up with demographic or other fundamental trends after a period where growth would have been suppressed. It remains nonetheless telling that the only 7 Note as a caveat that (i) capital accumulation in sectors, which generate substantial externalities, such as in transport and communications, should not necessarily be expected to generate output in the same sector. ae.g., Manila light rail train, skyway and flyovers, and new air terminal, Mactan bridge, Cagayan Valley and in land - and cellular phone facilities across the country. -17 - non-tradable sector which would have registered productivity gains-utilities-is one where (as will be discussed in Chapter 2) competition heightened through the 1 990s. 1.22 Squeezed as they were between wage and competitive pressures, tradables had little option but to improve their productivity performance, or fold (see evolution of total factor productivity in those sectors, in Table 1.13). But the same pressures also constrained their expansion, as well as their capacity to generate jobs (see below). Export Take-off 1.23 A key feature of this improved productivity performance in tradable sectors is the emergence of a world-class export industry. Whereas total exports had grown at an annual average rate of 4 percent in the 1980s, they surged to a rate of about 16 percent in 1990-98. As a result, their share in GDP nearly tripled from 21 percent in 1980-85 to 57 percent in 1998. Similarly, the country doubled its share of world markets (see Table 1.14). Table 1.14: EAST ASIAN EXPORT SHARES IN INTERNATIONAL IMPORT MARKETS (percent) IMPORT WORLD INDUSTRIAL UNITED JAPAN DEVELOPING MARKET COUNTRIES STATES ASIA EXPORT SOURCE 1985 1990 1995 1999 1985 1990 1995 1998 1985 1990 1995 1998 1995 1990 1995 1998 1985 1990 1995 1998 EASTASIA 9.3 11.7 16.2 16.0 8.8 9.6 13.3 13.1 15.8 19.0 23.1 22.2 25.5 26.5 34.4 35.3 21.3 28.8 33.1 37.0 CHINA 1.6 2.5 4.5 4.6 1 1 1.7 3.7 4.0 1.2 3.2 63 7.2 5.0 5.1 10.7 12.1 5.2 7.7 9.5 10.1 NIES 5.1 6.4 76 7.3 5.2 5.5 5.9 5.5 11.6 12.2 11.0 9.3 7.6 11.0 12.3 11.3 10.2 15.2 16.1 18.2 HONGKONG, 1.2 1.4 1.1 1.1 1.1 1 0.9 0.9 2.5 1.9 1.4 1.1 0.6 0.9 0.8 1.0 3.3 4.6 2.2 2.3 CHINA KOREA 1 3 1.7 2.3 2.2 1.4 1.7 1.8 1.6 3.0 3.7 3.2 2.6 3.2 5 5.2 4.5 1 4 2.4 4.3 5.1 SINGAPORE 0 9 1.2 1.8 1. 0.6 0.9 1.2 1.2 1.2 2 2.5 2:0 1.2 1.5 2.0 1.9 3.2 3.9 4.4 5.7 TAIWAN, CHINA 1.7 2.1 2.5 2.2 1 9 1.9 2.0 1.9 4.9 4.6 3.9 3.6 2.6 3.6 4.3 3.9 2.4 4.3 5.2 5.1 SOUTHEASTASIA 2.6 2.8 40 4.1 2.6 2.4 3.6 3.6 3.1 3.6 5.9 5.7 12.9 10.4 11.4 11.9 5.9 5.9 7.5 8.7 INDONESIA 1.0 0.8 0.9 0.9 1.2 0.8 0.9 0.9 1.4 0.7 1.0 1.0 7.8 5.4 4.2 4.0 0.9 1.1 1 3 1.6 MALAYSIA 0 9 1 1.6 1.6 0.7 0.7 1.3 1.2 0.7 1.1 2.3 2.0 3.3 2.3 3.1 3.3 3.4 3.3 3.8 4 1 PHILEPPINES 0.3 0.3 0.4 0.6 0.3 0.3 0.4 0.6 0.6 0.7 1.0 1.3 1.0 0.9 1.0 1.7 8.S 0.3 0.5 0.9 THAILAND 0.4 0.7 1.1 1.0 0.3 0.6 1.0 0.9 0.4 1.1 1.5 1.4 0.8 1.8 3.0 2.9 1.0 1.2 1.8 2.1 LATINAOAERICA 5.8 4.5 4.7 5.3 62 4.7 5.1 5.7 13.6 13 14.0 16.1 47 4 3.4 3.4 2.6 1.8 1.5 1.4 Mexico 1.5 1.2 1.6 2.0 1.9 1.5 2.1 2.7 5.4 6 8.1 10.2 1.4 0.8 0.4 O.5 0.2 0.2 0.2 0.2 Note: 1998 is for first half of 1998. Source: World Bank staff 1.24 Manufacturing led this export boom. The growth rate of manufactured exports more than doubled from 11 percent in 1985-90 to 26 percent in 1995-97 (Table 1.15). The only other country in the region that came close to such performance was China with 11 percent growth. Outside the region, manufactured export growth was also impressive in Mexico (20 percent), largely due to the North American Free Trade Agreement (NAFTA), but even that growth was lower than the Philippines. -18 - Table 1.15: MANUFACTURING EXPORTS OF SELECTED DEVELOPING COUNTRIES VALUE RATES OF GROWTH (millions of U.S. dollars) (percent per annum) 1980 1985 1990 1995 1985 1990 1995 1997 -85 -90 -95 -97 1998 I sem 99 CHINA 6,049 48,043 132,784 164,209 51 23 11 -5 MALAYSIA 8,627 21,772 64,823 68,995 7 20 24 3 -7.7 12 INDONESIA 3,856 11,901 29,019 29,241 -2 25 20 0.4 -10.5 -12 THARAI 3,658 17,255 46,129 47,190 10 36 22 1 -6.9 1 PHILIPPINES 3,429 5,663 13,704 21,823 -3 11 19 26 16.9 14 MECICo 8,336 13,216 64,822 92,646 9 10 37 20 - - EAP 120,084 309,972 719,342 710,452 8 21 18 -1 - - SHARE IN EAP EXPORTS (percent) CHINA 5 15 18 23 MALAYSIA 7 7 9 10 INDONESIA 3 4 4 4 THAnAND 3 6 6 7 Philippines 3 2 2 3 Source: Lall, Albaladejo, and Aldaz (1999); CEM, 1999 1.25 How could Philippine exports have performed so well in the face of a real appreciation, while they ground to a halt for the same reason in countries like Malaysia, Indonesia, and Thailand? Mainly, because all the expansion that took place came from high-technology sectors where "raw" wage competitiveness is only one of the cost considerations which influence investors' decisions on production location, and less of a critical one than in more labor intensive activities, such as toys, garments or footwear, for instance. 1.26 Indeed, the boom in manufactured exports was on the whole a result of investments by multinational corporations (MNCs) in the electronics industry, particularly in the semi-conductor industry. Fortunately for the Philippines, this was also the fastest growing segment of world trade: high technology (HT) exports increased their share in world exports from 17 percent in 1980 to 28 percent in 1996, growing on average at 12 percent annually between 1980 and 1996. As a result, the share of HT exports in the Philippines manufactured exports almost doubled from 37 percent in 1985 to 68 percent in 1996, higher than its closest competitor in this area, Malaysia (Figure 1.7). 1.27 Where wage competitiveness is paramount, however, Philippine exports performed poorly. Growth performance for garment exports slowed down from 4.5 percent in 1991 to just 0.5 percent in 1998, while that of agricultural exports posted contractions in both periods, -3.4 percent and -14 percent, respectively. Consistent with the poor growth performance, the share of garment exports in total exports also fell from 25 percent in 1991 to just 8 percent in 1998, while that of agricultural exports dropped from 19 to 5 percent over the same period. 1.28 Reflecting both this performance and counter-performance, the Philippines emerged from the 1990s with the most high-tech export structure in the region, and also perhaps in the world. -19 - Figure 1.7: HIGH-TECHNOLOGY EXPORTS IN SELECTED COUNTRIES (percentage of manufactured exports) 70 1 60 50 401 &301 20, IL 1 10 1985 1996 | EChina uMalaysia nPhilippines 3Thailand Mindonesia I Source: Lall, Albaladejo, and Aldaz (1999); CEM, 1999 1.29 Impressive as it was, export performance was not such as to make up for the missed opportunities of the 1970s and 1980s, when the country missed out on labor- intensive industrialization. Philippines' exports therefore took off from a lower base than, say, China's, Thailand's or Malaysia's. The case is particularly striking when comparing Philippines and Thailand in the mid-1980s. The two countries enjoyed the same share in East Asia's manufacturing exports. But, in just five years, Thailand was able to double its share of East Asia manufacturing trade, and to peg it at about three times that of the Philippines. Similarly, by moving earlier, China was successful in increasing its share in regional exports from 5 percent in 1985 to 23 percent in 1997, followed by Malaysia and Thailand. In contrast, in the case of the Philippines, the recent boom only brought back the country's share to where it was in 1985 (Table 1.15). 1.30 This export performance was not enough either to reverse the process of (relative) desindustrialization, afoot since the early 1980s, and make up for the demise of those import-substituting industries failed to match increased competition, as Indonesia, for instance, managed to do. The latter country was not handicapped, however, by similar currency appreciation, nor by elevated food prices or wage costs (see Table 1.12 and Table 1.16). Whereas in most other countries of the region, industry's contribution to the national output continued to expand through the 1990s, (albeit at a slower pace, in countries which experienced rapid currency appreciation), in the Philippines, it shrank (see Table 1.16). In this, the Philippines shared the same experience as Latin America, a region which had to deal with a similar legacy of import substitution industrialization. -20 - Table 1.16: COMPOSITION OF OUTPUT IN SELECTED COUNTRIES, 1992-98 (percentage of GNP) AGRICULTURE INDUSTRY MANUFACTURING SERVICES 1980 1990 1998 1980 1990 1998 1980 1990 1998 1980 1990 1998 CHINA 30 27 18 49 42 49 41 38 37 21 31 33 INDONESIA 24 22 20 42 40 45 13 20 25 34 38 35 MALAYSIA 22 19 3 38 40 44 21 26 29 40 41 43 PHILIPPINES 25 22 17 39 35 32 26 25 22 36 43 52 THALAND 23 12 11 29 39 40 22 26 29 48 48 49 KOREA 15 9 6 40 45 43 28 31 26 45 46 51 Low AND MIDDLE INCOME COUNThIES EASTASiA 24 n.a. 15 42 n.a. 45 30 n.a. 32 33 n.a. 41 LAM AMERICA 10 n.a. 8 40 n.a. 29 28 n.a. 21 50 n.a. 64 Source: World Development Report, 1999; SIMA Sectoral Employment, Earnings and Poverty Impact 1.31 As we shall see below, this shift of resources during the 1 990s towards nontradable sectors eventually found a limit in the unsustainability of the external current account. But while it lasted, the process lifted many people out of poverty. The dynamics of poverty reduction during the 1990s are now clearer. Essentially, labor shifted from agriculture and mining to the more labor-intensive sectors of services and construction (see Table 1. 17). As productivity is respectively about twice to five times as large in the sectors where labor moved to than in agriculture, those who made the move also found better income opportunities. 1.32 Indeed, higher competition on goods markets also led to a relative desegmentation of the labor market. Observers had previously noted that the dualistic nature of that market was one of the impediments which prevented the benefits of growth to spread more widely to the population, split as it was between well-guarded high paid jobs in heavily protected, capital intensive industries and an informal sector which hardly paid a living wage.9 With liberalization however, sectoral earnings began to converge (see Table 1. 18). Stripped of their shares of the rents, which trade protection used to generate, industrial wages came down on average (as competitive jobs replaced uncompetitive ones). A sharp drop in the number of workers covered by collective bargaining agreements10 may have precipitated the phenomenon. Conversely, the draw of the services and construction sectors would have helped lift rural wages. 1.33 This wage convergence helped manufacturing employment expand somewhat despite the odds, although that expansion was limited to jobs where the value added per worker was sufficiently high to make up for high wage costs, i.e. jobs requiring a certain amount of skills (see Table 1.12). In contrast, starting from 1996 onward, agriculture started to shed large amounts of labor (see Table 1.17 and 1.19), notwithstanding the special protection extended to it. 9 See Lall, D. 1979. "Wages and Employment in the Philippines." World Bank, Washington, D.C. 10 From 230,000 in 1990 to 68,000 in 1998, despite union membership having risen from 3 to 3.7 million over the same period. -21 - Table 1.17: EMPLOYMENT BY SECTORS, 1980-98 (percentage of total employment) 1980 1985 1990 1995 1996 1997 1998 AGiucuLTuRE 51.65 49.31 44.53 43.41 42.83 40.82 39.17 MING 0.67 0.65 0.63 0.42 0.42 0.47 0.43 MANUFACTURING 10.91 9.67 10.55 10.19 9.92 9.86 9.73 CONSTRUCTION 3.54 3.54 4.38 5.07 5.53 5.91 5.75 UTLITmEs 0.34 0.38 0.38 0.44 0.43 0.48 0.51 TRANSPORT AND COMMNCATION 4.33 4.50 4.85 5.75 6.00 6.29 6.62 TRADE 10.30 13.02 14.56 14.67 14.76 14.93 15.45 FINANCE & DWELLINGS 1.92 1.85 1.87 2.08 2.26 2.48 2.41 OTHER SERVICES 16.35 17.07 18.24 17.95 17.85 18.77 19.92 TOTAL 100.00 100.00 100.00 100.00 100.00 100.00 100.00 Source: Esguerra, et at. (1999); 1999 Philippine Statistical Yearbook for 1998 figures Table 1.18: COMPENSATIONS BY SECTORS, 1991-97 1991 1992 1993 1994 1995 1996 1997 AGRICULTURE: average daily wage ratel" 38.11 39.87 41.62 42.46 44.91 INDEX OF COMPENSATION MANUFACTURING 103 102 95 87 81 74 71 CONSTRUCTION 120 116 119 123 114 TRANSPORT& COMMUNICATION 184 197 193 202 216 211 223 TRADE 90 91 95 95 103 95 96 COMMuNrrY, SOCIAL SERVICES 142 143 144 143 221 252 257 1/ pesos per day, 1988 base year Source: Esguerra, et al. (1999) Table 1.19: EMPLOYMENT BY SECTORS IN SELECTED COUNTRIES (percentage of economically active population) AGRICULTURE INDUSTRY SERVICES 1980 1990 1998* 1980 1990 1998* 1980 1990 1998* PHILIPPINES 51.7 44.5 39.2 15.5 15.9 16A 32.9 39.5 44A THAILAND 71.0 64.0 50.3 10.0 14.0 19.7 19.0 22.0 30.0 INDONESIA 59.0 57.0 41.2 12.0 14.0 19.0 29.0 29.0 39.8 MALAYSIA 41.0 27.0 17.3 19.0 23.0 19.0 40.0 50.0 63.7 KOREA 37.0 18.0 13.6 27.0 35.0 33.2 36.0 47.0 53.2 * latest year available Source: World Development Indicators, World Bank, 1997; Esguerra, et.al (1999) 1.34 Through the 1990s, employment in construction and services thus opened a main escape route out of poverty. Conversely, poverty emerged not so much as a rural issue, but as agriculture issue (Table 1.20 and Table 1.21). Special protection notwithstanding, agriculture remained the sector where poverty is highest (over 40 percent of the people engaged in agriculture are poor, see Table 1.20) and the sector which contributes the most to overall poverty (about two thirds of it, see Table 1.21). It is also the sector where the pace of reduction has remained slowest: between 1985 and 1997, it was twice as slow as in services. Even in rural areas, non-farm employment stands a better chance than farm jobs to lift people out of poverty, confirming -22 - (a) earlier findings' I that location per se is not a particularly significant determinant of poverty;12 and (b) early insights of economic theory13 that food protection benefits more the landlord than the tiller... the vast majority of which is landless (on this subject, see last two sections of Chapter 2). 1.35 One can hardly avoid a suspicion that the protection granted to the sector in the name of food self-sufficiency actually served to retard a process of structural transformation which would otherwise have benefited the poor, had it been allowed to unfold more freely. Indeed, the next chapter presents the results of simulations indicating how the poor in general would have benefited from more even trade liberalization. Table 1.20: EVOLUTION OF POVERTY BY SECTOR OF EMPLOYMENT, 1985-97 1985 1988 1991 1994 1997 1985-97 (percentage of population) (percentage change) AGRICULTURE 57.7 51.2 51.9 49.9 42.3 -17.38 INDUSTRY 32.0 23.8 25.0 22.4 16.8 -29.41 SERVICES 21.8 17.6 16.8 15.1 10.6 -39.77 OTHERS* 21.6 19.5 16.8 17.2 12.1 -37.95 TOTAL 40.9 34.4 34.3 32.1 25.0 -27.33 *Others include unemployed and activities not elsewhere classified. Memo item: Rural Population only AGRICULTURE 60.0 53.3 55.2 52.5 44.8 -15.95 NoN-AGRicuLTuRE 38.7 31.8 35.7 32.2 23.6 -25.79 TOTAL (RURAL) 53.1 45.7 48.6 45.4 36.9 -19.26 Source: Balisacan (1999) Table 1.21: SECTORAL PROFILE OF POVERTY, 1997 (percent) EMPLOYMENT SECTOR OF CONTRIBUTION TO TOTAL HOUSEHOLD HEAD POVERTY INCIDENCE POVERTY"/ AGRICULTURE 42.3 67.8 MINING 30.0 0.7 MANUFACTURING 13.5 3.8 UTILITY 9.5 0.3 CONSTRUCTION 23.1 7.1 TRADE 13.5 4.7 TRANSPORT 13.7 4.4 FINANCE 3.0 0.2 SERVICES 9.9 4.9 a! Figures do not add up to 100 because households whose heads were unemployed were excluded. Source: Balisacan (1999) " Balisacan, A. M. 1999. Causes of Poverty: Myths, Facts and Policies. School of Economics, University of the Philippines, Quezon City, Philippines. 12 This refers to the direct impact of location on poverty outcome. Location may however have an indirect influence through its impact on other determinants of poverty, such as access and quality of health and education. Note that the figures in Table 1.15 actually understate the contribution of non-farm employment. This is because of the demarcation between rural and urban changes over time. As soon as a rural barangay acquires a minimum of basic infrastructures and services, it is re-classified as urban, leaving the related jobs out of the calculation. '3 Dating back to David Ricardo. -23 - Skills and Education 1.36 With this structural transformation, the country thus began to realize the benefits of its long-standing effort in favor of education, an effort which the big push in favor of secondary education since the Aquino administration most recently epitomizes.14 This investment into human capital put the country ahead of its neighbors in terms of secondary and, even tertiary enrollment (see Figure 1.8 and Figure 1.9) and made it possible for labor gradually to shift towards higher productivity activities, as we saw above. Even better, as far as the development of information technology (IT) industries is concerned, at the tertiary level, a higher proportion of population is enrolled in the technical subjects than in either China, Malaysia or Thailand (Table 1.22). As a result, more technical and engineering skills are available in the Philippines than even in countries like Malaysia, where firms often face an acute shortage of skilled workers, and have to rely on expatriate workers (including from the Philippines). Figure 1.8: GROSS SECONDARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES (percentage of age group) 120 600 60 1970 1975 1980 1985 1990 1995 Source: UNESCO, 1997 Although it has been argued that this policy would have merely resulted in crowding out pnvate initiative, recent research (Jimenez, 1999) shows that this "crowding out" effect, while it exists, would actually have been limited: an increase in public school enrollment of, say, 10 pupils would increase additional enrollment of 7 pupils by public and private schools together -24 - Figure 1.9: GROSS TERTIARY ENROLLMENT RATIOS IN SELECTED ASIAN COUNTRIES (percentage of age group) 60 50 40 w~~~~~~~~~~~~~~~~~~~Maysaa Mlncdonesia 30 OTaiaand 20 1970 1975 1980 1985 1990 1995 Source: UNESCO, 1997 1.37 That investment in education also gave the Philippines an edge in attracting HT activities, when the country opened up more widely to foreign investment in the early 1990s. The facilities offered by the Bureau of Investment (BOI) and the Philippine Export Zone Authority (PEZA)15 undoubtedly lured many MNCs to the country. But what decided them more often than not to stay and disregard its lack of infrastructure and relatively high wages was the ample supply of relatively skilled and English-speaking workers who could quickly adapt to the HT production methods. Table 1.22: EDUCATION ENROLLMENTS AT THE TERTIARY LEVEL, SELECTED COUNTRIES TOTAL ENROLLMENT mN TECHNICAL SUBJECTS AT THE TERTIARY LEVEL Number % of population CHINA 1,238,100 0.101 INDONESIA 447,000 0.226 PHILIPPINES 373,900 0.551 MALAYSIA 26,100 0.130 THALAND 108,300 0.186 a/ data is for latest year available Source: UNESCO, 1997; World Development Indicators, 1999 1.38 Education therefore provided a key underpinning to the poverty reduction process described above. As Table 1.23 shows, the higher the education attainment, the better able the poor were to join in the structural transformation process. Much remains to be done, of course, to make the ideal of equal education opportunity for all a reality (as we shall see in Chapter 4) .16 But recent achievements should be give reason to forge ahead. 15As will be noted in Chapter 4, these schemes introduced substantial fiscal incentives, which resulted in a loss in revenue as well as considerable complication of tax administration. 16 See Asian Development Bank and The World Bank. 1999. "Philippine Education for the 21I' Century: The 1998 Philippines Education Sector Study." Manila, Philippines. -25 - Table 1.23: POVERTY AND EDUCATIONAL ATTAINMENT (percent) POVERTY POVERTY CONTRIBUTION TO TOTAL SHARE POVERTY Incidence Depth Severity Incidence Depth Severity NO EDUCATION 3.8 46.2 13.8 5.5 7.0 8.1 9.0 ELEM. UNDERGRADUATE 22.8 41.6 11.4 4.4 37.8 40.8 42.9 ELEMENTARY GRADUATE 24.5 31.4 7.8 2.8 30.8 29.9 29.2 HS UNDERGRADUATE 11.5 24.4 5.7 1.9 11.2 10.3 9.5 HiGHSCHOOLGRADUATE 18.6 13.5 2.9 0.9 10.0 8.5 7.5 COLLEGEUNDERGRADUATE 10.5 6.3 1.2 0.3 2.6 1.9 1.5 DEGREE HOLDER 8.2 1.7 0.3 0.1 0.6 0.4 0.3 NOTREPORTED 0.2 3.1 0.0 0.0 0.0 0.0 0.0 ToTAL 100.0 25.0 6.4 2.3 100.0 100.0 100.0 Source: Balisacan (1999) based on the 1997 Family Income and Expenditures Survey. Distribution of Income and Consumption 1.39 The shift from inward to outward orientation, also appear to have led to a major redistribution of the national income in favor of families. (see Figure 1. 10).' 7 Although the data in the area is spotty, this redistribution would have reflected (i). a rising labor share of the national income (as growth became more labor intensive, as seen above) and (ii) a redistribution of the previous monopolist/protectionist rents to society at large.18 This element of rent redistribution, in particular, may have helped the purchasing power of families (as captured by the Family Income and Expenditure Survey) as it expand faster during the period under review than a cursory look at the national accounts would lead to believe (see Figure 1.1 1). 1.40 Furthermore, an inflow of overseas remittances served to maintain the expansion of private consumption consistently above that of GDP (see Figure 1.2 above). 17 The data utilized here is different than the one generated by the national accounts, which lump together "household" and unincorporated enterprises." This category provides an imperfect approximation of developments affecting household stricto sensu. First, it covers a broad, but gray area of economic activities having little to do with the economic definition of a "household," ranging from small subsistence farms to sophisticated business enterprises (carried out at the individual, family levels or under the guise of non-corporate partnerships) and to underground economic activities. Second, being often calculated by residual, the related accounts reflect measurement errors affecting the calculation of other items. The analysis above relies instead on the information generated by the Family Income and Expenditure Survey (FIES), and substitutes in the national accounts under the appellation "family income, consumption and savings." The "enterprise" category is calculated by residual so as to encompass both incorporated and unincorporated enterprises. The reader should be aware however of methodological differences between FIES and national account data, and treat the figures presented for "families" and "enterprises" merely as broad order of magnitude. Is This rent redistribution may help explain why family income (FIES definition) would have expanded faster during the period under review than that of "household and unincorporated enterprises). A gradual "incorporation" of business activities, accompanying the emergence of the underground economy would provide a further explanation. -26 - Figure 1.10 DISTRIBUTION OF THE GROSS NATIONAL DISPOSABLE INCOME (percentage of total) 100.0 90.0 80.0 70.0 60.0 50.0 40.0 30.0 20.0 10.0 0.0 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 |L Families * Enterprises * General Govemment Source: NSCB, NSO, World Bank staff calculations Figure 1.11: POVERTY, DISPOSABLE INCOME, AND FAMILY CONSUMPTION (average percent change per year) 8.0 4.0 0.0. 1988 1991 1904 -2.0 -4.0----- j-Dip. kcome-NA Disp. k,come-FES . .Consumpton-FES Source: NSCB, NSO, World Bank Staff calculation 1.41 What did not improve however is the distribution of income among families (see Figure 1.12). Until recent years, gains in purchasing power appear to have been evenly shared across families, leaving the distribution of income unchanged. But for reasons, which are yet poorly understood, the benefits from the acceleration of growth in 1994-97 appear to have accrued disproportionately to the higher categories of income. The fact that, in the overall growth, the lowest income categories also experienced unprecedented poverty reduction may have first made this growing inequality more socially acceptable-as it has been in Malaysia, the country which the Philippines came to par with in terms of high income inequality (see Table 1.24).19 But a slower growth scenario may make distribution issues much more sensitive. '9 Such levels of inequality are high by intemational standards, although they are exceeded in Latin America and in the former apartheid countries (Zimbabwe, South Africa). -27 - Figure 1.12: EVOLUTION OF INCOME BY QUINTILE (average percent change per year) 10.0 0s.-- 6.0 4.0 2.0 0.0 20 i <' -4 ; d;: 10 J:tSt t ; z>X0: i -2.0 t -4.0 _ Household Disp. Income (NA) _ Family Average * Lowest Quinbile Top Quintile Source: NSCB, NSO, World Bank staffcalculation Table 1.24: DISTRIBUTION OF INCOME AND CONSUMPTION IN SELECTED COUNTRIES (percentage of total, unless otherwise indicated) INCOME DISTRIBUTION DISTRIBUTION LOWEST HIGHEST LOWEST HIGHEST GINI DECILE DECILE DECILE DECILE PHILIPPINES INCOME 48.9 1.7 39.3 4.4 55.5 CONSUMPTION 46.2 2.3 36.6 5.4 52.3 INDONESIA INCOME 36.5 3.6 30.3 8.0 44.9 KOREA CONSUvPTION 31.6 2.9 24.3 7.5 39.3 MALAYSIA INCOME 48.5 1.8 37.9 4.5 53.8 THAILAND CONSUMPTION 41.4 2.8 32.4. 6.4 48.4 Source: World Development Indicators, 2000 D. THE ASIA CRISIS AND BEYOND 1.42 This growth and poverty reduction pattern-relying heavily as it did on a shift of resources towards nontradables and on foreign rather than domestic savings-was not tenable for ever, however;.real appreciation led to unsustainably high macroeconomic imbalances. Whereas demand pressures mounted on the tradable sector, factors moved in the opposite direction-towards the non-tradable sectors where they piled up (see decline in total factor productivity in non-tradable sectors, in Table 1.13) in anticipation of profits which ffirther real appreciation would generate. Investment motives therefore became increasingly precarious and vulnerable to a shift in the underlying macroeconomic parameters. Witness for instance how the forays of an appliance manufacturer such as the Eyco group entry into real estate turned sour shortly after the onset of the crisis, bringing down the entire group. 1.43 The outstanding export performance initially provided a respite (and shielded the Philippines from the brunt of the crisis). Whereas total exports had grown at an annual -28 - average rate of 4 percent in the 1980s, they surged to a rate of about 16 percent in 1990- 98. As a result, their share in GDP nearly tripled from 21 percent in 1980-85 to 57 percent in 1998. 1.44 But export boom notwithstanding, the impulse provided by the external sector ultimately turned negative (see Figure 1.13 and Figure 1.14), as the pace of import growth overtook that of exports. The resulting external imbalances were for a while masked by a surge of overseas remittances (see Table 1.3). By 1997, however, the current account had begun to widen to uncomfortably large levels, exposing the country to the manic-depressive sentiments of international markets. Figure 1.13: CONTRIBUTIONS TO FINAL Figure 1.14: CONTRIBUTIONS TO DEMAND, GROSS DOMESTIC PRODUCT 1991-98 (percent) 1991-98 (percent) a/O%] 10% 18%- 5% 6% 0%- 2%~~~~~~~~~~~~~~~~-0 -2%- -4%- 15% 1991 1992 1993 1994 1995 1996 1997 1998 1999 1991 1992 1993 1994 1995 1996 1997 1998 1999 3E4xts _Donrsic Denia -Fe1alDermnd | _Domestic Demand =Net Eapods -GDP| Source: NSCB, staffcalculation Source: NSCB, staffcalculation 1.45 Luckily for the country, this incipient bout of Asia flu did not become virulent. The later collapse of Gotesco-Orient Bank group after breakneck expansion into real estate and shopping malls financed by connected lending shows that the seeds had been sown, but before the crisis itself stopped the infection from spreading. The main reason is that, thanks in part to comparatively better banking regulation, in part to the country's track record of booms and busts, corporate and banking balance sheets did not generally become as overextended as they did in neighboring countries. Chapters 2 and 3 will return to these points. 1.46 Imbalances remained essentially macroeconomic in nature, and liable therefore to be treated through conventional macroeconomic instruments. A sharp rise in interest rates, against a background of soaring exports, knocked the wind off domestic demand and shifted the current account sharply into surplus. The social impact of the crisis was therefore also more modest than in other affected countries: although the Asia crisis /El Ninlo episode may have caused poverty incidence to slide back by about 9 percent, two third of that impact may be attributable to the weather phenomenon rather than to financial developments (see Datt and Hoogeveen, 2000). 1.47 As was seen in the prologue, the country succeeded during 1998-99 in restoring its external financial situation at a much lower social cost than its neighbors more severely affected by the Asian crisis. -29 - 1.48 The problem now is that the subsequent efforts to revive growth through fiscal and monetary stimulation have been less effective. This is in part because the private sector remains uncertain as to which course the economy is taking next. While the uncertainty persists, poverty reduction is at a standstill. The final section of this chapter will highlight some of the challenges involved in reviving broad-based growth. E. LESSONS AND CHALLENGES FOR THE MEDIUM-TERM 1.49 If the record of the nineties is any guide, it ought to be possible to reduce poverty incidence from 25 percent of the population on most recent count to 15 percent by the end of this decade. Achieving this would cut down the absolute number of poor by over 4 million, despite current demographics. This would set the country on target towards the international objective of reducing absolute poverty by half by 2015. Meeting this challenge, as will now be argued, will require (a) containing population growth and dealing with its implications. (b) resuming faster, labor-intensive, but also better balanced growth. (c) managing the rapid urbanization, which the needed structural transformation of the economy will necessarily involve. Coming to Grips with Demographics 1.50 Current rates of demographic expansion hinder the realization of poverty reduction ambitions. Although the country's rate of population growth remains on a secular deceleration path, population would still, on present trend, rise from about 75 million in 1998 to about 95 million in 2010. Although it has come down over the years, the Philippines still has a high fertility rate (3.6) by Asian standards (see Table 1.27). As a result, population growth in the Philippines remains one of the highest in the region. 1.51 Recent National Demographic and Health Survey (NDHS, 1998) data help explain why fertility remains so high: on average, each Filipino woman has one more child than she would desire (Herrin, 1999). Put differently, of the births in the last five years, 27 percent were to mothers who wanted children later and another 18 percent were to mothers who did not wish to have another child at all. Why should it be this way? Essentially because 20 percent of married men want more children than their wives (as the latter perceive it), while 20 percent of married women who do not want to become pregnant are not practicing contraception. 1.52 The consequences of this discrepancy on population trends can hardly be overstated. The population is, in year 2000, five million larger than it would have been, had women had as many children as they wished during the past decade (see Table 1.25). By 2010, it will be 9 million larger because of it. -30 - Table 1.25: DEMOGRAPHIC SCENARIOS (thousands) BASELINE PROJECTIONS AGE GROUP 1995 2000 2010 5-19 25,001 26,711 30,334 20 - 64 33,242 38,573 50,615 65 + 2,428 2,848 4,116 TOTAL POPULAnON 70,267 78,602 95,553 SCENARIO 1 (desired fertility rates from 1990 onward) AGE GROUP 1995 2000 2010 5- 19 25,003 24,262 22,968 20 - 64 33,244 38,571 50,614 65 + 2,417 2,836 4,092 TOTAL POPULATiON 67,789 73,308 86,544 SCENARIO 2 (desired fertility rate from 2000 onward) AGE GROUP 1995 2000 2010 5-19 25,001 26,711 28,215 20 - 64 33,242 38,573 50,615 65 + 2,428 2,848 4,116 TOTAL POPULATION 70,267 78,602 91,921 Source: World Bank staff estimates 1.53 These demographic factors frustrated poverty reduction efforts in many different ways. First, at the family level: although perhaps on the high side,20 available estimates indicate that poverty incidence increases with family size (see Table 1.26). Further research is needed to elucidate the dynamics at play. One of the factors might be that repeated pregnancies2' lower the participation of women in the labor force, leading to losses of income opportunities and lower living standards for the family as a whole. This may help explain why female labor force participation rate is relatively low compared to other countries in the region, given how relatively well-educated women are (Table 1.27)-even slightly better than Philippine males. Table 1.26: POVERTY AND FAMILY SIZE (percent) POPULATIONPOVERTY CONTRIBUTION TO TOTAL POPULATION POVERTY SHIARE Incidence Depth Severity Incidence Depth Severity FAMILYSIZE 1-2 10.4 8.5 1.8 0.6 3.5 2.8 2.5 3-4 32.4 15.8 3.3 1.0 20.4 16.9 14.4 5-6 32.2 28.0 6.9 2.4 36.0 35.0 34.0 7-8 16.9 39.4 11.4 4.5 26.6 30.0 32.7 9 & ABOVE 8.2 41.3 11.8 4.6 13.6 15.2 16.5 NATIONAL 100.0 25.0 6.4 2.3 100.0 100.0 100.0 Source: Balisacan (1999) based on the 1997 Family Income and Expenditures Survey 20 As they ignore economies of scale in consumption. 21 Awareness and usage of contraceptive methods does not appear to be influenced by the level of income Alba, Michael M. 1999. "Exploring the APIS Data on the Accessibility of Public Services." -31 - Table 1.27: FEMALE EDUCATION, FERTILITY AND LABOR FORCE PARTICIPATION (percent, unless otherwise indicated) PRIMARY TERTIARY LABOR FORCE ENROLLMENT" ENROLLMENTa" FERTILITY PARTICIPATION (% net) (% net) 1995 CHINA 101.9 3.9 1.9 72.9 INDONESlA 94.7 8.0 2.7 49.1 KOREA 92.6 46.0 1.6 47.9 PHILIPPINES 98.0 40.7 3.6 47.3 THAILAND _ 22.3 1.9 65.2 a/ latest year available Source: UNFPA, 1999; World Development Indicators, 1999 1.54 What is clearer however is the sheer magnitude of the challenge to deliver the basic public goods needed to lift people out of poverty under such demographics. Due only to the prevailing discrepancy between desired and actual maternity, there are currently over 2.5 million-and there will be 7 million by 2010-more children and youth of age to go to school than there would otherwise have been! Translate that into teachers, classrooms, desks, chairs, and textbooks and the burden of demands comes in full view. 1.55 Growing population will also pose new challenges. First, feeding it will require a different concept of food security. The ideal food self-sufficiency may have looked plausible in the 1 970s when population was half its current level. Already during the last 20 years, rice use has been growing at a faster pace (3.4 percent) than rice output (2.4 percent),22 leading to higher imports and price pressures. With cultivated areas constrained and cereal yields sluggish, there is little perspective that the sector could feed 15 to 20 million more mouths by 2010. Supply restrictions (including imports) are more likely to end up putting upward pressure on food prices, further straining household budgets (particularly for low-income family for whom food counts most) and dragging down overall economic growth. 1.56 Slowly also, the population will begin to age over the next decade, as the demographic transition unfolds. With this aging will come new challenges. For one, the nature of disease burden will change. The 10 million more people over the age of forty by the year 2010 than in 1995 (on present trends) are likely to put heavier demand on the hospital sector, as well as on the embryonic health insurance system. Second, with two million more people beyond retirement age, old-age poverty and how to prevent it will become a much more vivid issue than it has been so far. These trends will amplify the coming pressures on social programs, already noted in the case of education. 1.57 It is not too late to do something to curtail population pressure. The inherent inertia of population dynamics, notwithstanding, the population simulation shows (see Table 1.25, Scenario 2) that the 2010 population could still be curbed by 3.5 million if fertility rates were brought down to desired levels starting from this year onward. 22 Of which 1.6 percent reflects higher yields and 0.8 percent due to increase in area harvested. -32 - 1.59 Although there has been Table 1.28: GOVERNMENT AND DONOR SHARE IN some recent progress in the use of FUNDING FOR SELECTED PROGRAMS, 1996 contraceptives, family planing (percent) efforts have largely been neglected. SELECTED PROGRAMS GOP DONOR The reluctance on part of the SHARE SHARE government has forced the country POPULATION COMMISSION 63 37 to rely disproportionately on funding REPRODUCTIVE HEALTH 4 96 from foreign donors (Table 1.28), limiting effectiveness and increasing STD/HIV/AIDS 18 82 vulnerability to foreign cutbacks. NUTRITION SERVICES- 61 39 MOTHERS Source: UNFPA, 1999 Resuming Faster, Labor-Intensive Growth 1.60 Such rapid population trends put an even greater onus on policymakers to bring back growth to pre-crisis rates. Achieving such growth rates will require amplifying the ongoing process of structural transformation by which factors of production particularly labor, shift to higher productivity activities. The word "industrialization" could be used in this context if it encompasses those services which are quickly "industrializing" as a result of the IT revolution, and in which the Philippines has good potential to expand. Figures 1. 1 5 and 1.16 illustrate how the process could unfold (see also Chapter 2). 1.61 For growth to return to and sustain a 5 percent trend rate during the remainder of the decade (i.e., not counting a cyclical El Nifio impact), the baseline scenario envisages that industry should expand to produce 37 percent of the country's value added (the position it had at the beginning of the 1980s) and absorb 20 percent of the labor force. In parallel, agricultural employment would further shrink from about 40 percent now to 34 percent at the end of the decade. 1.62 The resulting growth performance, although not stellar, would constitute a clear improvement on anything the country has known for the last quarter of a century. It would allow average income per capita to grow by a cumulative 27 percent during the decade. Most of the gains would be recorded in industry and services, and, as these sectors expand, those gains would extend to a growing share of the population (see Table 1.29). This process will remain the main escape hatch out of poverty. A reduction in rural underemployment may also boost rural living standards. Still, there are few scenarios under which agricultural earnings could catch up with national averages, short of a more drastic restructuring and downsizing of the sector than envisaged under this scenario. -33 - Table 1.29: GROWTH PROSPECTS (percent, annual growth rate) 1998 1999 2000-04 2005-10 GDP -0.5 3.2 4.6 4.5 o.w. AGRICULTURE -6.6 6.6 2.6 1.5 INDUSTRY -1.9 0.5 5.8 7.2 SERVICES 3.5 3.9 4.6 3.2 EMPLOYMENT 0.7 1.3 3.2 2.8 o.w. AGRICULTURE -3.4 6.3 1.5 1.3 INDUSTRY -1.0 -1.1 4.2 6.3 SERVICES 5.3 3.5 4.0 2.5 INCOME PER CAPITA 1/ -2.6 0.8 2.4 2.5 PRIVATE CONSUMPTION PER CAPITAL -0.1 -0.5 2.7 2.3 1/ GDP per capita at constant prices Source: National Statistical Coordination Board, Department of Labor, World Bank Estimates Figure 1.15: STRUCTURE OF OUTPUT 1999 2010 Agriculture Agnculture 18% 11% Serce Serce 51 % n Industry _ ndustry ._ 37% _t 31% Source: National Statistics Office, staff estimates Figure 1.16: STRUCTURE OF EMPLOYMENT 1999 2010 Agdculture ~~~~~~~~~~~~Agriculture Serce 40% Serce 34i 45% 46%0o Industry Industry 15% 20% Source: National Statistics Office, staff estimates 1.63 In practice, the pace at which this structural transformation will take place will depend particularly on the following policies: (a) Preventing renewed currency overvaluation. Whatever else happens to capital inflows, the country's heavy reliance on overseas remittances will continue to exert upward pressure on the real exchange rate. Hence the -34 - need to redouble efforts at reducing structural factors of inflation-such as supply bottlenecks (e.g., on food supply) and impediments to competition (e.g., in services)-in order to limit the negative side-effects from these beneficial inflows. (b) Broadening trade liberalization. The pace at which the country is able to bring down its food prices, and thereby enhance labor competitiveness, will have a crucial bearing on its capacity to expand into any internationally competitive, labor-intensive activity, be it in agriculture, industry or services, and to seize the opportunities which world trade expansion offers beyond the confines of electronics. The devaluation of the peso was actually instrumental in setting that process in motion: as a result of it, the implicit rate of protection dropped in the case of rice from about 80 percent to about 34 percent between 1997 and 1998 (see Table 1. 11). It would be important to stay on this trajectory. Chapter 2 will outline the remaining trade policy agenda, as well as the difficult transition problems involved. (c) Fostering competition in services. Factor productivity will also need to grow within each of the sectors. The discussion above shows how productivity was beginning to improve in tradable sectors under the pressure of competition. The source of the economy-wide counter- performance lies primarily in the non-tradable sectors. If the experience of tradables were any guide, the situation would call for subjecting non- tradables also to a healthy dose of competition (see Chapter 4). Retail trade (recently passed into law), public works, telecommunications, power, ports, shipping should be some of the first targets. (d) Strengthening the corporate framework and capital markets. Weak protection of minority shareholders and creditors, by limiting firms' access to outside finance (both equity and credit) has held back growth and contributed to a concentration of ownership within closely held, family- based conglomerates. As will be discussed in the next two chapters, an early approval of the proposed Securities Act by Congress, and of effective debt resolution procedures by the Securities and Exchange Commission would considerably improve the formal framework. Overtime, there may be grounds to transfer the quasi-judicial functions of SEC to specialized courts. Little would have been accomplished however unless and until the rules which are on the books are more deliberately enforced (e.g., authority and independence of the Security and Exchange Commission, integrity of regulation, accounting and auditing practices; compliance with disclosure requirements; diligence of judicial procedures). (e) Reinforcing governance. A growing body of international evidence documents the importance of good governance for economic growth and poverty reduction. As will be seen in Chapter 4, international surveys report for instance a steady improvement in perceptions of corruption and in the prevalence of the rule of law since the late 1 980s; they also indicate -35 - how much remains to be done in order to bring the core machinery of government up to standards. (f) Mobilizing domestic savings. A lack of savings helps to explain why the country as a whole and poorer individuals in particular are so highly exposed to shocks and turbulences (as will be seen in Chapter 5). Both international and national research point toward a virtuous circle between accelerating growth and rising savings rate. The policies outlined above to sustain the level of growth required for rapid poverty reduction should therefore also help improve the country's investment-savings coverage ratio. More direct interventions to bolster confidence in banks and currency, broaden financial markets and instruments, particularly through contractual savings instruments (see Chapter 3), alleviate the burden of food expenditure on lower income budgets (see (a) above and Chapter 2), and resume fiscal consolidation efforts (see Chapter 4) will also be in order. (g) Maintaining the country's attractiveness as a production location. The country still has scope to attract considerably more foreign direct investment. For all its recent successes in the area, the country remains a smaller player in this field (see Table 1.30). With trade liberalization within AFTA, foreign direct investment will become less and less motivated by access to market considerations, and more by production and marketing environment factors (e.g., infrastructure, factor markets). The Philippines will need to redouble its efforts in the area if it wants to benefit from the ensuing industrial consolidation across the region, as well as to position itself for the incipient relocation of service activities from developed to developing countries (see Chapter 2). Improving urban and inter-urban infrastructure is the top priority, as discussed below. -36 - Table 1.30: FOREIGN INVESTMENT INFLOWS TO EAST ASIA 1980 1985 1990 1993 1994 1995 1996 1997 1998 FDI INFLOWS-BILL. US DOLLARS CHINA -- 1.7 3.5 27.5 33.8 35.8 40.2 44.2 45.5 INDONESIA 0.2 0.3 1.1 2.0 2.1 4.3 6.2 4.7 -0.3 KOREA, REP. 0.0 0.2 0.8 0.6 0.8 1.8 2.3 2.8 5.1 MALAYSIA 0.9 0.7 2.3 5.0 4.3 4.2 5.1 5.1 3.7 PHILIPPINES -0.1 0.0 0.5 1.2 1.6 1.5 1.5 1.2 1.7 SINGAPORE 1.2 1.0 5.6 4.7 8.6 7.2 7.9 9.7 7.2 THAIL.ND 0.2 0.2 2.4 1.8 1.4 2.1 2.3 3.7 7.0 TOTAL 7 -- 4.1 16.2 42.8 52.6 56.9 65.5 71.5 69.9 Cisis 5 1.2 1.4 7.2 10.6 10.2 13.8 17.5 17.6 17.2 WORLD 46.3 55.7 203.1 219.4 253.5 328.9 358.9 464.3 643.9 FDI INFLOWS-PERCENT OF GDP CHINA -- 0.5 1.0 6.4 6.2 5.1 4.9 4.9 4.7 INDONESIA 0.2 0.4 1.0 1.3 1.2 2.2 2.7 2.2 -0.4 KOREA, REP. 0.0 0.2 0.3 0.2 0.2 0.4 0.5 0.6 1.7 MALAYSIA 3.8 2.2 5.5 7.8 6.0 4.7 5.1 5.2 5.2 PHILIPPINES -0.3 0.0 1.2 2.3 2.5 2.0 1.8 1.5 2.6 SINGAPORE 10.5 5.9 14.9 8.0 11.8 8.7 8.0 9.0 8.4 THAiLAND 0.6 0.4 2.9 1.4 0.9 1.2 1.3 2.4 2.4 ToTAL7* -- 1.4 3.8 3.9 4.1 3.5 3.5 3.7 3.5 CRisis 5* 0.9 0.7 2.2 2.6 2.2 2.1 2.3 2.4 2.3 * Simple Averages Source: UNCTAD (1999), World Bank data. Stimulating Agricultural Modernization 1.64 Considerable research and effort will need to go into agriculture to help the sector adjust to trade liberalization and seize the opportunities offered by the opening up and expansion of markets along the entire western Pacific Rim to diversify into internationally competitive crops (tree crops, for instance). To see the sector through the transition, there will be a need for a package of strategic interventions to expand and prioritize strategic public and private investments in the countryside (with innovative cost sharing arrangements), promote improved natural resource management, consistent with increasing smallholder productivity and diversification, and rationalize institutional arrangements and roles (in support of devolution and convergence), as well as for research and extension services to develop and spread alternative farming packages to the farmers. This should be the main thrust of the implementation of the Agriculture and Fisheries Modernization Act. Improving the Efficiency and Effectiveness of Education. 1.65 As we noted above, under current demographic trends, the country will have about 4 million more children and youth of school age by 2010 than it has now. Whether or not this growing pool of talents is able to drive the country's modernization, will depend on how much the country is able to achieve in improving the relevance of education, and its accessibility to all. 1.66 Four major studies23 have recently highlighted how quality and relevance had, perhaps inevitably not kept up with quantitative achievements. The school system is 23 Asian Development Bank and The World Bank. 1999. "Philippine Education for the 215 Century: The 1998 Philippines Education Sector Study." Manila, Philippines; National Committee on Education for All. 1999. "Philippines: Education for All: -37 - succeeding in its most basic mission: the functional literacy rate has risen from 73 percent in 1989 to 84 percent in 1994. But other indicators of effectiveness and efficiency leave considerable room for improvement, as the following figures indicate (a) Whatever official objectives are stating, the cohort survival rate and dropout rates are stubbornly high (63 percent and 8.8 percent in 1996 and 1997). (b) The availability of school inputs has dropped (to a point where [] pupils now need to share one textbook). (c) The improvement in mean achievement scores, despite a steady improvement from 42 percent to 51 percent between 1993 and 1997 in elementary education, and from 39 percent to 49 percent in secondary education between 1995 and 1998, remain way below target. (d) In higher and vocational education, a proliferation of low cuality state universities and colleges is displacing private institutions,2 with the result that on average less than half the training graduates pass post training skills examination tests. (e) Accessibility also remains an issue for the poor (as will be documented in Chapter 4). 1.67 It is not possible, in the context of this report, to do full justice to the wealth of ideas, suggestions, and recommendations that these two studies have brought for forward. Let us highlight a few, while inviting the reader to peruse the studies themselves for a more detailed prescription: (a) Targeting future investments in primary and secondary education benefit underserved areas and groups. (b) Develop and monitor school performance standards. (c) Step up and rationalize the procurement of textbooks and other instructional materials so that it becomes financially feasible for all pupils to have textbooks. (d) Use hardship and performance allowances, in preference to across the board pay raises to elicit performance from the teachers and incite them to serve in difficult areas. (e) Deconcentrate the management of the school system to school principals and local education boards. Philippine Assessment Report. " Unicef, October 1; Human Development Network and UNDP. Philippine Human Development Report 2000; and "Philippine Agrenda for Educational Reform: the PCER Report" Presidential Commission for Educational Report, Manila 2000. 24 Four out of the five tertiary, vocational and technical training places are provided by the private sector. -38 - (f) Implement a comprehensive teacher-training program, both pre- and in- service. One particular objective should be to raise the proportion of tertiary level teachers meeting minimum qualification standards from 30 to 70 percent. (g) Reverse the haphazard expansion of low quality post-basic public education, wean them from public funding and develop accreditation systems applicable to both public and private institutions. (h) Use the savings to augment current scholarship programs so as to cover within three years, a minimum of 10 percent of the students. Making Urbanization Work 1.68 Rapid urbanization should be the spatial translation of the transformations in the country's economic structure anticipated above. Whether the latter transformation actually occurs will depend on whether cities are able to play host to the process. If they do, perhaps 15 million more would live in cities by 2010 than today. This is equivalent to adding a new metropolis the size of Metro Manila! Of particular importance will be the growth of secondary towns, if the structural transformation process is to spread beyond the confines of the Manila-Cavite-Southern Tagalog, Cebu-Mactan, and a few other areas where a modicum of infrastructure exists to support industrial activities. 1.69 The consequences of this urbanization can be enormous. On the bright side, urbanization would help ease the pressure on natural resources, although with rural population reaching a plateau of above its current level (at around 43 million), pressure on watersheds, forests, marine, coastal and upland environments would remain heavy. 1.70 But in urban areas, congestion costs (rising crime rates, squatter problems, sanitation, transport problems, infrastructure needs, etc.) may worsen, if not addressed more vigorously than they currently are. Otherwise, urban congestion may reach critical proportions. Unless supported by an expansion of the road system, a rapid rise in car ownership from the current 1 car per 5 families to 1 per 3 families would more than double the number of cars in Metro Manila and potentially choke the metropolis. The same may happen with solid waste. Out of the total 16,400 tons of waste generated by the current urban population, only an estimated 2,600 tons are properly disposed in controlled dumpsites, endangering public health as well as increasing cities' vulnerability to flooding (as garbage piles block waterways). Projections for the next 15 years indicate that an additional 12 million poor people in cities will generate 4,000 more tons of daily waste to collect and dispose of. 1.71 The government has long realized that the investments required to bring cities up to par and to operate the related services efficiently extend far beyond its own capacity. Hence the need to tap private resources. Chapter 2 will stress that the extent to which they will materialize and the cost at which they do depends in large measure on whether credible regulatory frameworks are established, by which all, including the government, are made to abide. Nagging doubts on this score (caused by such things as capricious meddling by the executive or the judiciary with legitimate adjustments in tariffs, a laxibiased enforcement of regulatory requirements, or preferential handling of the related franchises) would seriously undermine urban development prospects. -39 - 1.72 With the decentralization of 1991, the country has equipped itself with a framework with which to deal with urbanization. Local governments will have to rise to the challenge if local governments are to live up to the hope that this reform would be a major source of poverty reduction. At this stage, Chapter 2 will argue, the jury is still out on their performances. F. CONCLUSIONS 1.73 The irony of the situation, which developed during the 1 990s, is that, amidst the momentous transformation which made the country aspire-legitimately-to "NIC" status, the contribution of its industry to output actually dropped. It is now time to act in line with this aspiration. Painful as it may have been, the Asia crisis brought some benefits in terms of realignment of incentives between tradable and non tradable sectors, and reduction in the implicit protection provided to key food items (rice, in particular). But private demand has not yet picked up due in part to uncertainties as to which course the country will be taking next. 1.74 Perhaps, the most decisive contribution that the government could make at this stage to reinvigorating private initiative is to act upon stated intentions to further equity, fiscal consolidation, and structural reform and to dispel perceptions that the country's governance framework might be regressing. The discussions above brought out a number of important priorities, including that of: (a) accelerating the pace of agricultural trade liberalization with the view to aligning agricultural protection with that of manufacturing; (b) helping the agricultural sector modernize in response to (a); (c) stimulating competition in the service sector; (d) investing in urban and inter-urban infrastructure particularly in the completion of the country's arterial road network; (e) reinforcing efforts in favor of education (particularly with a view toward providing more equitable access to quality education); and, (f) shedding current inhibitions towards active population policies. 1.75 Acting on those priorities would put the country more strongly on target toward international poverty reduction targets, as well as its own. -40 - 2. CHALLENGES FOR THE PRIVATE SECTOR 2.1 Much of the growth and employment needed to lift people out of poverty will continue to be generated by the private sector. The Philippines took that strategic option in the late 1 980s. The ensuing deregulation, demonopolization, broadening of private ownership and opening up of the economy has served the country well, as Chapter 1 made clear, and will continue to do so if the country stays on course. The Asia crisis, however, highlighted the risks of private sector-led financial crisis. 2.2 How much growth versus instability, the private sector will actually deliver over the medium tern will depend on both constitutive factors of "corporate governance," as well as environmental factors, linked for instance to the competitive framework in which private agents operate. The latter also influences the way in which the benefits of growth are shared across society. How well benefits are shared depends also in part on the distribution of the underlying assets. Hence, the importance of ongoing efforts to expand access to private ownership, particularly through land reform. 2.3 This chapter seeks to identify ways to maximize the upside (broad-based growth), while minimizing the downside (instability). The first section notes that, although the Philippines escaped the worst of the crisis, the country's corporate sector exhibits many of the same vulnerabilities as in some of its neighbors, and some of the same symptoms: limited recourse to equity finance, concentration of ownership, and ownership of banks by corporations. This section puts forward a few suggestions on how to move towards a system of corporate governance based on international best practices. 2.4 Although massive transfers of land during the last decade have already expanded private ownership of productive assets, simply continuing with existing arrangements may not be the best way to achieve the program's objectives, and most probably not within the established timeframe. Novel ideas could be entertained to reinforce the impact of the program and expedite its implementation, as discussed in the second section. 2.5 Although trade barriers have fallen in the last ten years, serious distortions remain, particularly in the food sector, which cripple the country's poverty reduction ambitions. Although it has already begun to benefit from earlier liberalization, more is required to enable the country to take full advantage of the upcoming delocalization of service activities. In both areas, the Philippines should take advantage of ongoing concerted regional efforts to position itself to make full use of its resources and talents to reap the rewards of globalization, as well as of its recent advances in the information technology (IT) sector. The final section addresses this set of issues. -41 - A. STRENGTHENING CORPORATE GOVERNANCE The Role of Corporate Governance 2.6 The Asia crisis has highlighted how important a country's corporate governance framework was for stability. In the strictest sense, the objective of corporate governance is to solve an agency problem by compelling corporate insiders to behave in a way which is consistent with the interests of outside investors, including minority shareholders and creditors.25 When outside investors can impose good governance on corporate managers, external financing is more readily available from a wide variety of sources (both equity and credit) at competitive costs. 2.7 But when outside investors cannot impose good governance, risks arise that insiders (managers and controlling shareholders) might attempt to: (i) expropriate the returns rightfully due to minority shareholders; or, (ii) frustrate efforts by creditors to recover their investment following involuntary or willful default by a borrower. Sources of financing are likely to be fewer and the cost of financing is likely to be higher to compensate for the additional risks associated with weak governance (unless directed credits are available from government owned financial institutions).26 Also, when the agency problem cannot be otherwise resolved, ownership and control of corporations tends to be concentrated in the hands of insider shareholders that are also active in the management of their corporations.27 The result is to constrain the growth of corporations or to skew their financing structure towards the source of funding which is most readily available. Many neighboring countries experienced the latter problem (witness the high leverage of Korea's chaebols and other Asian corporations, and the role this played in the outbreak of the Asia crisis. As will be seen below, the Philippines is more affected by the former. Structure of the Corporate Sector 2.8 The Philippines' corporate sector is highly concentrated. According to a 1997 survey, 757 of the 1,000 largest corporations (ranked by sales) were Philippine-owned and 216 of these-belonged to only 39 corporate groups (see Table 2. 1).28 The total sales of these 216 group-owned companies accounted for 51 percent of the total sales of the largest Philippine-owned corporations. The same study also found that in 1997, among publicly listed non-financial companies, one dominant shareholder controlled on average 41 percent of the equity, while the top 5 shareholders have majority control of 3 out of every four listed company. The figure actually underestimated the phenomenon as less than 10 percent of the 1,000 largest corporations are listed on the Philippine Stock Exchange. Furthermore, those that are listed seldom make available to the public more 25 Shleifer, Andrei and Robert W. Vishny. 1996. A Survey of Corporate Governance. NBER Working Paper 5554, p. 2. 26 La Porta Raphael, Florencio Lopez-de-Silanes, Andrei Shleifer and Robert W. Vishny. 1999. Investor Protection: Origins, Consequences, Reform. Financial Sector Discussion Paper No. 1. Washington, D.C.: World Bank, pp. 1-3. Ibid., pp. 11-13. 2S Saldaiia, Cesar G. 1999. Philippine Corporate Governance Environment and Policy and their impact on Corporate Performance and Finance. Manila- Asian Development Bank. -42 - than the minimum number of shares prescribed by listing requirements (10 to 20 percent of total shares outstanding).29 Table 2.1: GROWTH AND FINANCIAL PERFORMANCE OF TOP 1000 CORPORATIONS BY CORPORATE CONTROL STRUCTURE GROWTH RATE 1988 1996 1997 (1988-97) A. GROUP MEMBER SECTOR SHAREOFSALES(PERCENT) 27.6 37.1 34.0 FINANcLg. RATiOS (PERCENT) Leverage 57 42 51 49 Return on Equity 21.9 15.0 8.8 15.8 Return on Assets 9.5 8.6 4.3 8.0 Net Profit Margin 10.7 18.5 11.5 12.3 No. OF NON-FINANCiAL COMPANIES 110 211 216 159 B. INDEPENDENT SUBSECTOR SHARE OF SALES (PERCENT) 54.7 55.4 60.0 FINANCIAL RATIOS (PERCENT) Leverage 72 61 68 61 Return on Equity 19.9 15.4 3.3 15.8 Return on Assets 5.6 6.1 1.0 6.1 Net Profit Margin 3.9 6.1 1.0 5.0 No. OF NON-FINANCiAL COMPANIES 759 664 666 715 C. GOVERNMENT-OWNED SUBSECTOR PERCENTOFCORPORATESECTORSALES 17.7 7.5 6.0 FiNANCL4L RAnOS (PERCENT) Leverage 73 58 67 65 Return on Equity 5.9 5.4 2.3 5.7 Return on Assets 1.6 2.3 0.8 2.1 Net Profit Margin 5.8 15.4 6.2 10.1 No. OF NON-FINANCLAL COMPANIES 30 23 14 24 Source: Saldafia, C. G. 1999. 2.9 Such high level of ownership concentration at thefirm level found in the Philippines is not necessarily uncommon. In a study of ownership concentration in 45 countries,30 La Porta et al. found that, on average, the three largest shareholders own 46 percent of the shares of the largest corporations in the countries surveyed. The number is higher for the Philippines (57 percent of the shares), which is equal to Brazil, and less than the levels of concentration found in Sri Lanka, Colombia, Egypt, Indonesia, Italy, Mexico, Turkey, Austria and Greece. For other East Asian countries, excluding the Philippines, Taiwan (China) and Indonesia, ownership concentration is also quite high with the three largest shareholders owning, on average, 47.5 percent of the largest corporations.31 2.10 Among Asian countries, however, only Indonesia exceeds the Philippines' degree of ownership concentration across.firms (see Table 2.2). 29 Ibid. 'o Ibid. '" La Porta R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny. 1999. "Investor Protection: Origins, Consequences, Reform." Financial Sector Discussion Paper No. 1. Washington, D.C.: World Bank. conclude: "dispersed ownership of large corporations is simply a myth. Even in the United States, the average for the 10 most valuable companies is 20 percent. The only countries where the three largest shareholders own, on average, less than 30 percent of the largest 10 corporations are Australia, United Kingdom, the United States, Sweden, Japan, Taiwan and Korea." Ibid. pp. 1145-1146. -43 - Table 2.2: OWNERSHIP CONCENTRATION AND LEGAL FRAMEWORKS CONCENTRATION OF OWNERSHIP CONTROL EFFICIENCY OF AMONG TOP 15 JUDICIAL SYSTEM RULE OF LAW CORRUPTION FAMILIES (PERCENT) INDEX INDEX INDEX JAPAN 2.8 10.00 8.98 8.52 TAIWAN 20.1 6.75 8.52 6.85 MALAYSIA 28.3 9.00 6.78 7.38 SINGAPORE 29.9 10.00 8.57 8.22 HONGKONG 34.4 10.00 8.22 8.52 KOREA 38.4 6.00 5.35 5.30 THAILAND 53.5 3.25 6.25 5.18 PHILIPPINES 55.1 4.75 2.73 2.92 INDoNESIA 61.7 2.50 3.98 2.15 Note: All three indexes rank from l(worst) to 10(best). Countries are ranked by degree of ownership concentration. The efficiency of judicial system index assesses the efficiency and integrity of the legal environment as it affects businesses, particularly foreign firms. Source: Claessens, Djankov, and Lang (1999); La Porta et al. (1998 and 1999). Sources of Ownership Concentration 2.11 The structure of the corporate sector, as it exists today, was shaped by two sets of converging forces: (a) history: the roots of today's concentration can often be traced back to the concentration of land ownership during the colonial period, whose wealth served as a basis for large land holding families to found the country's first industrial and commercial corporations. In the post independence period economic development policies promoting import substitution industries created a new group of family-owned industrial companies as family-owned trading companies shifted to manufacturing in order to take advantage of government incentives, including protection from imports and subsidized credit. (b) the existing corporate governance framework. As in other parts of Asia,32 however, a weak protection of shareholder rights has exacerbated this legacy of ownership concentration (see Table 2.2 and Table 2.4). To quote La Porta et al., "there are at least two reasons why ownership in such countries should be concentrated. First, large or even dominant shareholders that monitor the managers might need to own more capital, ceteris paribus, to exercise their control rights and thus avoid being expropriated by the managers. Second, when they are poorly protected, small investors might be willing to buy corporate shares only at such low prices that make it unattractive for corporations to issue new shares to the public. Such low demand for corporate shares by minority investors 32 In many advanced market economies, outside shareholders are protected from insider self-dealing by an array of legislation, including company laws, securities laws, accounting laws and auditing laws. These laws and regulations are vigorously enforced by regulators and public prosecutors and penalties are severe enough to act as deterrents. In enforcing these laws and regulations, an honest and efficient judiciary and/or regulatory agency plays an essential role. There are also other private means of enforcing shareholder rights. Outside shareholders can also launch civil actions against directors and auditors who have failed to perform their duties with due care and diligence. Also, the market for corporate control can be a powerful force which compels insiders in widely held corporations to work on behalf of its outside shareholders or risk losing their jobs when shareholders vote in favor of a merger or takeover by another corporation. -44 - would indirectly stimulate ownership concentration."33 Thus, "with poor investor protection, ownership concentration becomes a substitute for legal protection."34 2.12 Reflecting the impact of these converging forces, 39 family-owned corporate groups owned 216 of the 1,000 largest corporations, representing about one third of the sales of those large corporations.35 These conglomerates exhibit many characteristics similar to the Korean chaebols and Japanese zaibatsus: they are family owned; have diversified sectoral interests; include a bank among their component firms (or ITCs, in the case of chaebols); very few are publicly traded on the stock exchange; according to some researchers, they receive preferential treatment from government and some of their directors are politically influential.36 2.13 The influence and strength of conglomerates has even increased in recent years, as that of government corporations diminished with privatization. The number of top 1,000 firms they control has doubled since 1988, and the latter's market share had expanded by a third (see Table 2. 1). They also appear to have weathered the crisis better than "independent firms." On the one hand, being able to rely on internal financial markets to raise equity (including through cross-ownership arrangements), members of conglomerates were also less leveraged than their "independent" counterparts. This, and a diversification of activities, helped them maintain better return on equity when the crisis hit (see Table 2. 1). 2.14 The concentration of ownership around family-based conglomerates is nevertheless giving rise to three main concerns: (a) Market power: As Table 2.1 indicates, group members operate, on average, with higher profit margins. Do these arise from monopolistic behaviors, from the nature of the activities they undertake, or from superior efficiency? Table 2.3 does show that in a number of sectors (such as food, tobacco, and beverage, coconut oil, glass, paper, inter-island shipping, pipelines), group-based companies command dominant market positions, which they may be tempted to abuse. Fortunately, that position is being eroded. With trade liberalization and the opening up of the economy to foreign investment, new firms have emerged which to challenge the former champions of inward orientation have replaced those favoring protectionism and an inward orientation. In particular, foreign and multi-national corporations have come in to upset the status quo by establishing with new green-field operations (e.g., petroleum product distribution) or by buying out the holdings of 33 La Porta R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny. 1998. "Investor Law and Finance." The Journal of Political Economy 6 (106). December 1998. 3 Ibid. (denoting p. 1145 again). 3S Saldafia, C. G. 1999. "Philippine Corporate Governance Environment and Policy and their Impact on Corporate Performance and Finance." Manila: Asian Development Bank. 36 Tan, Edita A. 1993. "Interlocking Directorates Commercial Banks, Other Financial Institutions and Non-financial Corporations." Philippine Review of Economics and Business, Volume XXX, 1993. p. 6. -45 - Philippine investors in sectors which badly needed restructuring, such as cement. (b) Corporate ownership of banks: High ownership concentration and the ownership linkages between corporations and banks had also led to a significant concentration in lending with the top 100 corporate borrowers in the Philippines accounting for 30 percent of the outstanding loans of the banking system.37 As long as banks are so intimately linked to conglomerates, there will a fear that some of that lending be done on the strength of corporate links, rather than on the merit of the activities being financed. (c) Constraints to growth. The main concern, however, is that however efficient conglomerates might be, their success constitutes essentially a second-best solution to the agency problem (outlined at the outset of this discussion) in the presence of a weak corporate governance system. By limiting the scope for external corporate control, these weaknesses also limit the capacity of (raise the cost to) firms to raise external finance and expand in areas where they can compete. Conversely, practices such as cross-holdings of equity,3" interlocking directorates of banks and corporations and pyramid holding structures, quite common in the Philippines, are effective barriers to hostile takeovers and help prevent productive assets from coming into the hands of those best positioned to managed them most efficiently.39 Legal Protection of Shareholders 2.15 The main problem is not so much that the design of the corporate governance framework would be intellectually flawed. Although (as will be seen below) this framework should still be strengthened, a recent study of shareholder protection in 49 countries40 gave the Philippines, (which is grouped with 21 French-origin civil law countries) a score of three out of a possible seven points, which is at the high end of its group which had an average score of only 2.33. In East Asia, the Philippines scored higher than Indonesia, Thailand and South Korea, the same as Taiwan, but lower than Hong Kong, Malaysia, Singapore and Japan. 317 Lim, C. H., and C. Woodruff. 1998. "Managing Corporate Distress in the Philippines: Some Policy Recommendations." International Monetary Fund Working Paper (Draft). Washington, D.C. September 1998. 3S Cross-holdings occur when firms within a family controlled group hold shares in each other, often as a defense against hostile takeovers. 39 Leechor, C. 1999. "Reviving the Market for Corporate Control." Viewpoint Note No. 191. Washington, D.C.: World Bank. p. 1. 4° Ibid. p.1131. -46 - Table 2.3: MARKET SHARE OF GROUPS OF COMPANIES IN SELECTED INDUSTRIES, 1991-97 (percent) SUBSECTOR AND INDUSTRY % SHARE OF GROUPS % POINT % SHARE OF LEADING % POINT DIFFERENCE COMPANY DIFFERENCE 1991 1997 1991-97 1991' 1997 1991-97 FOOD & OTHER FOOD PRODUCTS SUBSECTOR Alcoholic Beverages, Malt Liquor 94.1 89.5 -4.6 587 70.2 11.5 Chocolate, other Food Products 556 69.1 13.5 45.3 64.4 19.1 Meat & Vegetable Oil 57 1 56.4 -0.7 50 7 19.6 -31.1 Flour Milling & Animal Feeds 52.4 35.1 -17.3 52.4 19.6 -32.8 Milk&DawryProducts 38.0 518 13.8 32.1 198 -12.3 Coconut Oil 33.4 31.3 -2.1 25.5 34.3 S.8 Sub-Total (above industries) 722 64.5 -7.7 51.9 55.2 3.3 Sub-Total far the Subsector 67.3 63.0 -4.3 48.1 51.9 3.8 ELECTRICITY, GAS AND WATER SUBSECTOR Gen. & distribution of electicity 44.8 38.7 -6.1 43 2 38.4 -4.8 Sub-Total for the Subsector 44.8 38.7 -6.1 43.2 38.4 -4.8 TRANS, STORAGE AND COMM. SUlBSECTOR Telecommunication 85 0 80.3 -4.7 76.0 64.5 -11.5 Inter-island water transport 14.5 29.7 15.2 11.2 29.7 18.5 Pipelines 59.0 96.5 37.5 59.0 96.3 37.3 Sub-Total (above industries) 62.1 76.9 14.8 88.9 38.2 -50.7 Sub-Total for the Subsector 61.7 71.6 9.9 84.3 35.5 -48.8 WHOLESALE AND RETAIL SUBSECTOR Retail Selling in Supermarkets 668 45.7 -21.1 31.1 21 5 -9.6 Passenger Motor Vehicle Retailing 47.0 45.6 -1.4 27.1 24.4 -2.7 Constraction Materials 31.2 51.9 20.7 27.9 35.3 7.4 Medicinal, Pharmaceuaical Prod. 55.3 13.5 -41.8 26.0 13.5 -12.5 Sub-Total (above industries) 57.6 41.5 -16.1 28.8 31.3 2.5 Sub-Total for the Subsector 37.6 26.8 -10.8 14.8 18.7 3.9 FINANCIAL INTERMEDIATION SUBSECTOR Fin. Holding & Investment Co. 52.7 65.4 12.7 27 3 24 9 -2.4 FinancingCompanies 6.6 15.2 8.6 2.7 23.2 20.5 Sub-Total (above industries) 18.2 61.7 43.5 88 42.8 34.0 Sub-Total for the Subseetor 37.8 40.2 2.4 1.2 6.7 5.5 REAL ESTATE AND BUSINESS SECTOR Real Estate 60.4 41.3 -19.1 20.4 14.3 -6.1 Real Esate Renting 52.0 81.0 29.0 45.7 54.4 8.7 Architectural Engr Services 36 6 12.1 -24.5 36.6 12.1 -24.5 Sub-Total (above industries) 58.2 40.2 -I8.0 25.2 16.7 -S.5 Sub-Total for the Subsector 56.9 45.4 -11.5 20.3 16.8 -3.5 MOTOR VEHICLES SUBSECTOR Motor Vehicles 29.4 47.9 18.5 294 250 -4.4 Motorcycles 24.4 31.2 6.8 24.4 31.2 6.8 Parts and Accessories 8 5 20.9 12.4 8.5 11.3 2.8 Shipbuilding 78 1 38.5 -39.6 78.1 38.5 -39.6 Sub-Total (above industries) 27 4 40.1 12.7 27.4 40.4 13.0 Sub-Total for the Subsector 28.0 39.0 11.0 25.6 39.8 14.2 CONSTRUCTION SUBSECTOR General Engineering 48.6 37.7 -10.9 20.8 17.8 -3.0 Sub-Total for the Subsector 48.6 35.1 -13.5 20.8 17.8 -3.0 CONSTRUCTION MATERLALS SUBSECTOR Cement 53.7 56.9 3.2 14.7 36 3 21.6 Glass Products 87.2 8 1 -79.1 87.2 57.3 -29.9 Ceramic & Other Concrete PFd 15.7 13.8 -1.9 15.7 28.6 12.9 Sub-Total (above industries) 52.9 58.5 5.6 28.3 41.8 13.5 Sub-Total for the Subsector 24.5 31.6 7.1 12.3 21.2 8.9 HOTELS AND RESTAURANTS SUBSECTOR Rest.,Cafes,&FastFoodCenters 41.6 51.4 9.8 41.6 51.4 9.8 Sub-Total for the Subsector 28.8 11.3 -17.5 25.0 24.1 -0.9 MINING AND QUARRYING SUBSECTOR Gold Mining 83.2 97.7 14.5 53.5 64.6 11.1 Sub-Total for the Subsector 70.8 76.6 5.8 21.8 44.6 22.8 TEXTILE, WOOD & PAPER PRODUCTS SUBSECTOR Paper Products 9.7 15.8 6.1 7.3 64.6 57.3 Sub-Total for the Subsector 11.5 15.0 3.5 4.8 10.7 5.9 OTHER COM., SOCIAL AND PERSONAL SERV. SUBSECTOR Radio and TV Bcoadeasting 49.6 57.8 8.2 49.6 57.8 8.2 Sub-Total for the Subsector 49.6 23.9 -25.7 49.6 23.9 -25.7 ELECTRICAL MATERIALS SUBSECTOR Insulated Wires & Cables 54.0 40.4 -13.6 54.0 40.4 -13.6 Electrical Trmsformers 98.8 78.9 -19.9 988 41.9 -56.9 Sub-Total (above industries) 30 0 11.9 -88.1 30.0 9.7 -20.3 Sub-Total for the Subsector 5.3 3.4 -1.9 4.2 3.3 -0.9 AGRICULTURE, HUNTING AND FORESTRY SUBSECTOR Hog Faming 645 52.1 -12.4 64.5 33.3 -31.2 Sub-Total for the Subrector 38.0 52.1 14.1 14.8 52.1 37.3 PETROCHEMICALS SUBSECTOR Organic Chemicals 6 2 32 4 26.2 6.2 23.5 17.3 Sub-Total for the Subsector 16.2 9.1 -7.1 0.8 0.7 -0.1 METAL PRODUCTS SUBSECTOR Forge, Packaging Oth Fab Metal 4.3 169 12.6 4.3 11.2 6.9 Sob-Total for the Subsector 2.6 6.0 3.4 2.6 0.1 -2.6 Aggregate Group for Subsectors A to Q 54.5 39.5 -15.0 39 6 32.0 -7.6 AGGREGATE GROUP OF COS. FOR ALL SUBSECTORS AND INDUSTRtES 41.1 31.9 -9.2 21.9 20.5 -1.4 a 37 groups in 1991 b/ 29 groups C/ 1988 figures in place of 1991 Sources ofbasic data: SEC-Business World Annual Survey of Top 1000 Corporations (1991); PSE databank and Amnual Reports ofCompanies; Saldana (1999) -47 - 2.16 Similarly, according to another study, "the country already has reasonable corporate laws, although they are not perfect, particularly with respect to potential self dealing. The Corporation Code includes many familiar minority-protection measures such as cumulative voting, appraisal rights, inspection rights and audit requirements, as well as standard fiduciary duties binding directors. The Code, in addition, grants the Securities and Exchange Commission (SEC) rule making power for code implementation in general and protection against insider abuses in particular. These Code provisions are further supported by basically sound accounting and audit rules and securities-law disclosure requirements."4" The study also found that "the legal framework for remedial recourse is also largely in place, providing both for public remedies (although fines available at present are tiny) and for civil damages liability (sometimes multiplied), stockholder derivative suits, class actions and recovery of attorney fees."42 2.17 In practice, however, two factors undermine the effectiveness of the legal framework. For one, "the presence of large shareholders in most Philippine companies precludes the effectiveness of U.S.-style legal provisions that are designed to prevent expropriation of resources of minority shareholders and creditors. Specifically the Corporation Code does not adequately deal with conflicts of interest by large shareholders on minority shareholders."43 Existing legislation should therefore be strengthened by: (i) requiring independent directors especially in listed corporations; (ii) protecting the staff of regulatory agencies from legal harassment; (iii) prohibiting of interest on the part of members of the stock exchange vis-a-vis listed firms; and, (iv) restricting the application of pre-emptive rights by majority owners in order to allow minority stockholders to dispose of their shares at the best available price. The proposed new securities law should go some way in that direction. 2.18 "In principle, a strong system of legal enforcement could substitute for weak rules since active and well functioning courts can step in and rescue investors abuses by management."44 This is where the main weakness of the Philippines lies. Table 2.2 shows the overall performance of the Philippines in terms of enforcement is the worst of all of the countries included in the survey. Its average score for the 6 variables is 4.49 out of a possible 10, compared to the average score of 7.19 for all countries surveyed and 7.41 for the other East Asian countries. The Philippines ranks at or very near the bottom in almost every category. While the country reviews its legal framework to adjust it to the realities of high ownership concentration and weak judiciary protection, considerable early gains could thus be obtained "simply" by enforcing more diligently what provisions are already in place. 1' Fogarty, Kevin S. 1999. "Corporate Govemance in the Philippines: An Assessment of Needed Reform Efforts." USAID. p. 2. 42 lbid.(denoting p. 2. again). 43 Saldaiia, C. G. 1999. "Philippine Corporate Governance Environment and Policy and their Impact on Corporate Performance and Finance." Manila: Asian Development Bank. u" La Porta R., F. Lopez-de-Silanes, A. Shleifer and R. W. Vishny. 1999. "Investor Protection: Origins, Consequences, Reform." Financial Sector Discussion Paper No. 1. Washington, D.C.: World Bank. p. 1140. -48 - Table 2.4: VARIABLES AFFECTING THE ENFORCEMENT OF INVESTOR RIGHTS45 AVERAGE AVERAGE SCORE (OUT SCORE FOR 8 VARIABLE OF 10 POINTS) SCORE OTHER EAST RANKING OF FOR 49 FOR THE ASIAN PHILIPPINES COUNTRIES PHILIPPINES COUNTRIES OUT OF 49 1. EFFICIENCY OF JUDICIAL SYSTEM 7.67 4.75 7.19 48 2. RULE OF LAW 6.85 2.73 7.08 46 3. ABSENCE OF CORRUpToN 6.90 2.92 6.52 48 4. Low RISK OF EXPROPRIATION/NATIONALIZATION 8.05 5.22 8.40 49 5. Low RISK OF CONTRACT REPUDIATION 7.58 4.80 8.45 48 6. ACCOUNTING STANDARDS 6.09 6.5 6.84 20 (Out of 43) AVERAGE SCORE 7.19 4.49 7.41 Source: LaPortaet.al. (1998) Accounting and Disclosure 2.19 The only category where the country ranks better is on accounting standards. But enforcement is again the issue. While statutory accounting guidelines in the Philippines are sound, the accounting profession is well established, and companies listed on the stock exchange are subject to disclosure requirements, there is little capacity to enforce accounting guidelines and disclosure requirements. "In practice, auditors choose from a wide range of disclosure style and reporting standards, for example local GAAP, International Accounting Standards or U.S. GAAP. Penalties for poor conduct of audits by independent auditors and the mechanism for imposing them are weak. In spite of the many well-known cases of poor quality of audited financial statements that caused losses for investors, SEC and PICPA (Philippine Institute of Chartered Public Accountants) have not publicly sanctioned any auditor in the past."46 Furthermore, many companies prepare different financial statements for different end users.47 Similarly, whatever the quality of disclosure requirements might be, the sanctions for non compliance are so puny that some companies prefer to pay the related fines as a matter of course rather than disclose their financial condition. Impact on Corporate Finance 2.20 Flaws of the same nature in corporate governance ultimately brought down many Asian corporations. Limited in their recourse to equity finance, they went on a borrowing spree to finance their expansion. As long as growth was going, high gearing ratios generated even better profit rates to their shareholders. Such ratios, unfortunately, exposed them dangerously to the eventual downturn. 45 Ibid. p. 1143. `6 Saldaiia, C. G. 1999. "Philippine Corporate Governance Environment and Policy and their Impact on Corporate Performance and Finance." Manila: Asian Development Bank. 4 The statements provided to the Bureau of Internal Revenue, the Securities and Exchange Commission (SEC) and outside shareholders may be quite different from those shown to insiders including the controlling shareholder, or those accompanying an application for a bank loan. -49 - Figure 2.1: CORPORATE LEVERAGE IN SELECTED COUNTRIES (1997 debt equity ratio) Taiwan Philippines Singapore Malaysia Indonesia Thailand Japan Koreal t -1 1 3 5 7 Source: World Bank staff 2.21 Why did Philippine corporations not meet the same fate? As it happened, they generally entered the Asia crisis with some of the lowest corporate leverage in Asia (see Figure 2.1). There are essentially six reasons for that: (a) A history of boom-and-bust made one-way bets on growth less plausible. (b) Philippine banks were better regulated (the central bank even tightened restrictions in real estate lending and foreign exchange exposures and raised capitalization requirement during the run-up to the crisis, (see Chapter 3). (c) The Philippines' banking sector is also more fragmented than elsewhere (see Chapter 3), which limits the capacity of any single bank to marshal resource: to any one corporation (even within the same group). (d) Borrowing abroad only recently became a feasible alternative, only after the debt restructuring agreement of 1992 ushered the country back into international capital markets. Even then, Philippines corporations had less time than their peers to develop a brand name and a track record with international investors. (e) Lower domestic savings. (f) Creditors' rights are not better enforced than those of minority shareholders. This is the next topic. Protection of Creditors 2.22 In an international survey of creditor protection frameworks, the Philippines comes out at the bottom: it obtains a score of zero, while the 21 French-origin civil law countries, as a group, have an average score of 1.58 (see Table 2.5). In East Asia, the Philippines scores lower than all other countries included in the survey. In contrast, Hong Kong, Malaysia and Singapore, and even Indonesia, for instance, score a full 4.0 (maximum). -50 - Table 2.5: MEASURES FOR PROTECTING CREDITOR RIGHTS AVAILABILITY NUMBER OF NUMBER OF MEASURE FOR CREDITOR PROTECTION IN THE WITH WITHOUT PHILIPPINES MEASURE MEASURE I. SECURED CREDITORS PROTECTED FROM AuToMATIc STAYS OF FORECLOSURE. No 27 24 2. SECURED CREDITORS PAID FIRST No 42 9 3. CREDITOR CONSENT REQUIRED FOR REORGANIZATION OF DISTRESSED COMANIES. No 30 21 4. CREDITORS EMPOWERED TO CHANGE MANAGEMENT OF COMPANIES UNDER REORGANIZATION. No 25 26 5. AVAILABILITY OF AT LEAST 3 OF THE 4 PROTECTIVE MEASURES No 21 30 Source: Saldana (1999) 2.23 In contrast to the evolution of best practices internationally, the Philippines' legal framework has evolved in a way that has weakened creditor protection. Absent is the threat of civil action by creditors against independent auditors or company directors who are negligent in carrying out their duties. There is no duty of care compelling corporate directors to: (i) protect the interests of creditors when a corporation defaults on its obligations; or (ii) require the company to cease trading when it becomes apparent that the company is insolvent. BoX 2.1: EXAMPLES OF BEST PRACTICES IN CREDITOR PROTECTION Many idvanced market economies also offier aeditors a wide nge of instruments and numerous teseas for imposig corporate governance. When insiders fil to honor the terms of thei agreements with sured ceditors4 *eyfac foreclosure actions and:possibly liquidation. Most jurisdictions recognize secured creditors as mvestors whe laiii. are senior to those of shareholders. Wben a corporation is irn default to its creditors, best pracice requires that Ae: directrs of the corpoation exercise their duty of care on. behalf of te creditors rather than the shareholders,- Ads in nay- uyrisdictions, diretors ae personally liable for additional creditor losses which are likely to occur when a:. corporation continues to trade after it has become insolvent. When creditors suffer losses because auditors fail to out their work in accordance with normal auditing standards, the latter may be liable though civi acti;ons fXt ssch liosses as well as for punitive damages. Even unsecured creditors can quickly obtain court judgements compelting corporate insiders to pay the debts in question. Again, such outcomes depend on judicial systemns thaare hoest aind effiient.-; - ...-- Most modem bankruptcy laws provide for rehabilitation as well as the liquidation of distressed corporations: To enalle implementation of a corporate rehabilitation program. it may be necessary for courts to intervene and.prevent one r more secured creditors from exercising their contractual rights to seize and sell the assets of the debtor corporation in orderto recover their claims. However. when this happens best practice calls for the courts toensur fwt sen oTs can be compensated for any losses resulting from a stay of foreclosure. Bankrutcy eases are oftn handled by specializedcourts that have the capacity to deal with complex business and financial issues. 2.24 Furthermore, creditors can be deprived of their right to foreclose and when stays are imposed on creditors which are not accompanied by specific measures to protect their security interests. The decree (PD 902-A)49 which transferred responsibility for dealing with distressed companies from the courts to the SEC has a strong bias towards the goal 48 Ibid. p. 1137. 49 A 1909 law (Act 1956) dealing with cases of corporate insolvency does require that two-thirds of the creditors representing at least three-fifths of the claims must approve: (i) any agreement allowing a suspension of debt service payments by a distressed but still solvent corporation; or (ii) any plan for distributing the proceeds from the liquidation of an insolvent corporation. However, the law did not empower the court to stay foreclosure actions by secured creditors. Therefore, following a rash of corporate failures starting in 1979, Act 1956 was replaced in 1981 by Presidential Decree 902-A. -51 - of preserving the business of a distressed company and hence the investment of shareholders. Under that decree, a distressed company can petition the SEC for permission to suspend payments to its creditors, or if it has more than a temporary liquidity problem, it can petition for rehabilitation. In either case, any foreclosure action by secured creditors can be stayed for extended periods of time. Absent are the principle that corporate insolvency extinguishes the rights and claims of shareholders. In fact, under PD 902-A, the SEC can: (i) allow an insolvent company to continue to trade even if this means further losses for creditors; and, (ii) impose a suspension of payments without the consent of a majority of creditors-without any provision for protecting secured creditors from losses which might occur due to the erosion in the value of their collateral over the period that a stay of foreclosure is in effect. 2.25 Furthermore, debt reduction procedures can be exceedingly long and fruitless. Fogarty reviewed 86 cases filed from the beginning of 1995 through September 1999 (see Table 2.6). During that period, it took, on average, well over one year for the SEC to reach a decision ...if a decision was ever reached. For over one-third of the cases there has been no decision, even though these cases have been with the SEC for an average of 580 days. Among the 106 filings since 1982, there have only been two reported cases of companies being successfully rehabilitated.50 Table 2.6: DURATION OF DEBT SUSPENSION PROCEDURES DECISION NUMBER OF CASES NUMBER OF DAYSa' CASE DISMISSED OR DENIED 35 419 PETITION VOLUNTARILY WITHDRAWN 11 181 REPAYMENT/REHABiLITATiON PLAN APPROVED 1 0 517 NONE (DECISION PENDING) 30 580 a/ average time for a decision in decided cases and average time pending for undecided cases. Source: Fogarty, Kevin S. (1999) 2.26 The situation can become self-defeating. As it may take six to eight years or even longer if the debtor decides to fight the action all the way to the Supreme Court, most creditors are secured.51 This, in turn, blunts the interest of creditors for the going concern value of the corporation.52 Thus, in the event of default, when seniority of claims becomes an important consideration, creditors have an incentive to rush to realize their securities at any cost. In reaction, PD 902-A turns the normal order of seniority upside down by subordinating the claims of all creditors secured or unsecured, to the goal of preserving the interests of the shareholders. Predated checks have therefore developed as ;° To make matters worse, realizing that assets can be difficult, property foreclosed under mortgages cannot be seized by a creditor but must be sold at public auctions with the proceeds of the sale going to the creditor. However, before an auction can be held, the debtor is given up to one year to settle the claim. When a sale takes place and there is a shortfall, the creditor may try to recover it by filing a complaint with the court. While movable property foreclosed under a pledge must also be offered for sale at auction, in the event it remains unsold after two auctions, it may be seized by the creditor in exchange for an acquittance for the entire claim. If a pledged object is sold for less than the creditor's claim, the creditor has no right to file a complaint to recover the shortfall. Given the delays associated with TROs and the restrictions on foreclosures, debts are often settled "dacion pago" where the debtor settles his debt by simply handing over title to real property to the creditor. 5' Regala, T. D. 1999. "Report on the Philippines." Manila: Asian Development Bank. p. 15. 52 "As a rule, creditors in the Philippines do not lend money without a security. Hence it is not unusual if almost all the creditors of a given corporation are secured. If we require these creditors to meet and vote they, almost without fail, will reject the moratorium proposed by the corporation for the simple reason that a postponement of their recovery will greatly increase their risk of losing their money." See Concepcion, L. 1999. "Corporate Rehabilitation: The Philippine Experience." Presentation to seminar on Corporate Rehabilitation by Associate Commissioner of Securities and Exchange Commission. Mimeo. Manila, Philippines. p. 10. -52 - an alternative form of security, as they are protected by criminal rather than civil law. Unfortunately, related cases are now clogging criminal courts (see Chapter 4). 2.27 To cap it all, the process lacks transparency and is highly susceptible to influence peddling. In applying debt resolution procedures, the SEC has wide discretionary powers, but lacks clear rules and time bound procedures. As a result, debtors use the threat of petitioning the SEC as a means of forcing creditors to accept generous terms for debt restructuring while avoiding necessary real restructuring and changes in management. This further undermines the possibility for creditors to impose good governance on their borrowers. 2.28 The SEC has begun to address these problems. In December, 1999, it adopted "Rules of Procedure on Corporate Recovery." The first merit of these rules is to fill a damaging vacuum. They leave in place however a system which is essentially regulator- led. For example, while the rules provide that a rehabilitation plan cannot be approved if rejected by either the secured or unsecured creditors, there is no provision for voting by creditors the hearings on the plan. Also while the rules allow the SEC to override the rejection of a plan by creditors, they provide no guidance as to the circumstances under which a decision by creditors could be considered manifestly unreasonable. While interim receivers are subject to conflict of interest rules, professional conduct rules, minimum qualification requirements and strict reporting requirements, as well as scrutiny and oversight by the SEC, the same cannot be said of members of management committees. The three-man committees, which can be appointed to monitor the management of the debtor company, will include one representative of the secured creditors, one representative of the unsecured creditors and one representative of the debtor. Thus two members have a conflict of interest with the debtor and the third has a conflict of interest with the creditors. Finally, the rules still do not require adequate protection of the interests of secured creditors. Experience with these new rules is likely to show the benefit of evolving further towards a creditors-led process and a more protection of secured creditors. Reforming Corporate Governance 2.29 By hindering firms' access to outside finance be it equity or credit, these factors have held back corporate start-up and expansion, and growth more generally. 2.30 The international experience is then, barring crisis situations, changes in corporate governance do take time. Not only because the resulting reordering of wealth may meet resistance, but also because, as Black notes,53 a culture of compliance among accountants, lawyers and company managers is a precondition for effective investor protection. Such a culture takes time to develop, as it requires a myriad of converging actions. The discussions above highlighted the importance of a few of them, including: (a) Reforming debt resolution procedures. Further improve the recent guidelines for suspension of payments (refer to World Bank. 1999. Philippines: The Challenge of Economic Recovery-Country Economic Memorandum. Washington, D.C.). 5 Black, Bemard S. 1999. The Legal and Institutional Preconditions for Strong Stock Markets: The Non-triviality of Securities Law." Stanford School of Law, Stanford, California. p. 26. -53 - For the long term, the government envisages that a high level task force would be established under the Capital Markets Development Council to examine alternative approaches for dealing with distressed or insolvent corporations, including the possibility to remove responsibility for suspension of payments from the SEC. (b) Strengthening the legal and administrative framework for corporate governance. A high level task force, under the Capital Markets Development Council, should be established to review and evaluate: (i) all of the existing studies concerning the performance of the current legal and institutional framework for corporate governance in the Philippines; (ii) alternative approaches and institutional arrangements for dealing with corporate governance which have been adopted in other countries, including but not necessarily limited to, Canada, the United Kingdom, Australia, Singapore, Malaysia and Hong Kong; and (iii) new and innovative measures to address the excesses and market failures of the last few years which might be more readily applicable to the Philippines. (c) Guaranteeing the independence and integrity of the Security and Exchange Commission (including by routing out any semblance of conflict of interest among its officers). (d) Disentangling banks and corporations. Ongoing efforts to strengthen bank regulations (e.g., measures to strengthen disclosure of lending to connected parties and place limits on such lending as well as limits on the lending to a single corporate group and to increase banks' statutory minimum capital, forcing some family owned groups to divest their banks) will undoubtedly help. In the longer term, however, the Philippines might be well served by simply prohibiting non-financial corporations from owning banks (as in the case, for instance, in the USA). (e) Mandating public sector institutional investors to act as "vigilant outsiders " and to uphold minority shareholder rights. At the moment, minority shareholders lack a champion, while public pension funds too often get enmeshed in inside corporate maneuvers. Pensioners, and the public at large, would be better served if these funds limited themselves to passive investments, but performed their "passive" duties with utmost diligence. (f) Broadeningfinancial disclosure requirements, and charge punitive fines for non-compliance. (g) Challenging PICPA to more forcefully uphold professional and ethic standards within its membership. -54 - (h) Educating directors.54 This will be the primary mission of the newly created Institute of Corporate Directors. 5 (i) Strengthening the legal framework. Passage of the proposed Securities Act (which has been languishing in Congress since 1995) will be a major step forward. Next, a task force should be established under the Capital Markets Development Council (the Council) to review the Company Code, Philippine Stock Exchange (PSE) rules and other laws and regulations affecting corporate governance, including possible changes to the existing legal and institutional framework for corporate governance. The Task Force might draw inspiration from international best practices in corporate governance,56 including regarding the rights of minority shareholders, disclosure of actions by the board and large shareholders, external control on large shareholders, reporting standards, range of assets eligible as security, and corporate disclosure. 2.31 Changes in the operating environment will also make a difference. The judicial reforms discussed in Chapter 4 are obviously key. But opening up sectors of the domestic markets to domestic and foreign competition (as discussed below), where the businesses of the family owned groups are concentrated, will also help disentangle pyramid holding and conglomerate structures by forcing the owners of a group to focus on core activities and divest non-core businesses. B. BROADENING AcCESS TO LAND 2.32 Concerns about ownership concentration go beyond, and actually predate the discussion about corporate structure. As noted above, they find their historical roots in the concentration of land ownership in colonial times, and the subsequent efforts, spanning over an entire century, to broaden access to land.57 The process, however, only came into its own in the last quarter of a century. First steps were taken under Presidential Decree (PD) 27 from 1972. The process subsequently expanded vastly under Republic Act (RA) 6657 from 1988, also known as the Comprehensive Agrarian Reform Program (CARP). The latter program resolved to solve once and for all a problem, which had been festering for too long by organizing the transfer of the full ownership of eight 5 Fogarty, Kevin S. 1999. "Corporate Govemance in the Philippines: An Assessment of Needed Reform Efforts." USAID, notes: "It would be an achievement simply to make board members aware that there is a duty of due care (which should at least imply attending meetings now and again) and one of loyalty to the corporation as a whole rather than to any particular shareholder or individual." 55 A project of the Center for Corporate Governance of the Foundation for Community-Building in the Asia-Pacific, Inc, it held its inaugural meeting in September 1999. 56 Including (i) altemative approaches and institutional arrangements for dealing with corporate governance which have been adopted in other countries, including but not necessarily limited to, Canada, the United Kingdom, Australia, Singapore, Malaysia and Hong Kong; and (ii) new and innovative measures to address the excesses and market failures of the last few years which might be more readily applicable to the Philippines. 57 The first systematic attempt at land redistribution, undertaken by the US colonial govemment in 1903, involved the purchase of about 166,000 has from the Catholic Church. It was followed by the 1933 Rice Share Tenancy Act which limited share rent to 50 percent and imposed a ceiling of 10 percent per annum on credit extended by the landlord and two major pieces of Agrarian Reform legislation under the Magsaysay administration, namely the 1954 Agricultural Tenancy Act and the 1955 Land Reform Act. The former aimed to improve the situation of tenants by limiting share rent to 30 percent, firther reducing the interest ceiling to 8-1- percent, and improving the enforcement of existing legislation. The latter was to provide for expropriation of large estates, but in practice remained rather ineffective. -55 - million hectares (has.) of land over a 1 0-year period.58 Table 2.7 provides a comparative indication of the orders of magnitude involved. Table 2.7: SIZE AND CHARACTERISTICS OF DIFFERENT LAND REFORMS COUNTRY AREA BENEFICIARY AREA PER TIME HOUSEHOLDS PERIOD TOTAL AREA % OF NUMBER % OF RURAL HOUSEHOLD (1000 HAS) ARABLE (IOOOS) HOUSEHOLDS (HAS.) LAND ASiA JAPAN 2,000 33.3% 4,300 60.9% 0.47 1946-49 SOUTHKOREA 577 27.3% 1,646 45.5% 0.35 1948-58 TAiwAN 235 26.9% 383 62.5% 0.61 1949-53 PHILIPPNES PRE-CARP 1,092 10.8% 1,511 24.2% 0.72 1940-85 UNDER 4,300 N.A. N.A. N.A. N.A. 1988-97 CARP AFRICA EGYPT 390 15.4% 438 10.0% 0.89 1952-78 KENYA 403 1.6% 34 1.6% 11.85 1961-70 ZMMBABWE 2,371 11.9% 40 3.1% 59.28 1980-87 CENTRAL AMERICA EL SALVADOR 401 27.9% 95 16.8% 4.22 1932-89 MEXICO 13,375 13.5% 3,044 67.5% 4.39 1915-76 NICARAGUA 3,186 47.1% 172 56.7%/a 18.52 1978-87 SOuTH AMERICA BOLIViA 9,792 32.3% 237 47.5% 41.32 1953-70 BRASIL 13,100 11.3% 266 5.4% 49.32 1964-94 CHILE 9,517 60.1% 58 12.7% 164.09 1973 PERU 8,599 28.1% 375 30.8% 22.93 1969-79 Source: Deininger et al. 2000 2.33 More than ten years after the promulgation of CARP, one must recognize that, despite the magnitude of accomplishments, progress lags behind target. As illustrated in Table 2.7, the Department of Agrarian Reform (DAR) has, during the 1972-97 period, covered only about 2.5 million hectares, or less than 60 percent of the targeted area. Even under the optimistic assumption that the pace of land redistribution achieved between 1972 and 1997-i.e., the redistribution of about 100,000 has. per year-can be maintained, it would take 17 years to accomplish the stated target. 2.34 Furthermore, although few disagree with the need for land reform in principle, the extent and modalities under which such reform is supposed to take place are becoming 5s PD 27 consisted of two key provisions, the applicability of which is limited to rice and corn lands. First, it called for a land ownership ceiling of 7 has and the mandatory sale of all land that is owned in excess of this limit to tenants. Second, it outlawed share tenancy and mandated the conversion of tenants on landholdings below 7 has to leaseholders with a rent ceiling of 25 percent of crop revenue after appropriate deductions for inputs. The 1988 CARP expanded the scope of land reform in two respects. First, land reform is no longer limited to rice and corn land but is expected to cover the whole country, with implementation expected to occur in three main phases over the subsequent 10 years. Second, with everybody owning less than 3 has of land eligible, the range of potential beneficiaries was considerably expanded to include, at least in principle, the landless. Finally, full land ownership was granted to all the beneficiaries who benefited from the earlier land reform under PD 27. Implementation of the land reform legislation under CARP was expected to proceed in three distinct steps over a total period of 10 years. A first phase aimed to complete coverage of tenanted rice and corn lands, transfer ownership to these areas, and include in addition lands that were voluntarily offered, alienable public lands, and holdings with a size above 50 hectares. This phase was expected to last 4 years. A second phase, to cover agricultural holdings between 24 and 50 hectares, was expected to be implemented during the subsequent 3 years. Finally, a third phase with an expected duration of 3-4 years would aim to encompass all lands between 5 and 24 has. In addition, to allow recovery of the fixed investments made, an initial exemption of 10 years was granted to agri-business operations and plantations. Little detail was given concerning how to proceed following the expiration of this exemption in the hope that, once the remainder of land reform has been dealt with, appropriate mechanisms could be found. -56 - increasingly controversial. First, questions have been raised as to whether the approach may not be too centralized to allow active participation by beneficiary communities, proper accountability, and adequate provision of complementary services that are necessary to realize the full productive potential of land reform projects. There is also a concern that-by reducing access to land through rental and share-cropping--current land reform legislation may actually reduce access to land for the poor. Finally, a lack of a sustainable source of financing makes the program dependent on political lobbying and congressional appropriations that are not always guided by the needs of the poorest. Table 2.8: LAND DiSTRIBUTION UNDER CARP STATUS BY LAND TYPE AND MODE OF COVERAGE, 1972-97 (hectares) LAND TYPE TARGET ACCOMPLISHMENT % ACCOMPLISHED BALANCE DEPARTMENT OF AGRARIAN REFORM TENANTED RICE/CORN 579,520 500,643 86.39 78,877 VOLUNTARY OFFER-TO-SELL 396,684 265,744 66.99 130,940 VOLUNTARYLANDTRANSFER 284,742 276,307 97.04 8,435 GOVT. FINANCING INSTITUTION-OWNED 229,796 148,900 64.80 80,896 COMPULSORY ACQuSITION: >50HAS. 456,588 74,687 16.36 381,901 COMPULSORYACQUISITION: >24-50 HAS. 312,355 6,251 2.00 306,104 COMPULSORYACQuSITION: >5-24 HAS. 736,420 20,483 2.78 715,937 KILUSANG KABUHAYAN AT KAUNLARAN LANDS 657,843 606,347 92.17 51,496 SETrLEMENTS 662,727 662,727 100.00 0 TOTALDAR 4,316,675 2,562,089 59.35 1,754,586 DEPARTMENT OF ENVIRONMENT AND NATURAL RESOURCES PUBLIC ALiNABLE & D SposABLE LANDs 2,502,000 927,734 37.08 1,574,266 INTEGRATED SOCIAL FORESTRY AREAS 1,269,411 832,651 65.59 436,760 TOTALDENR 3,771,411 1,760,385 46.68 2,011,026 TOTAL CARP 8,088,086 4,322,474 53.44 3,765,612 Source: Garilao (1997) 2.35 Unfortunately, until recently, a lack of systematic monitoring and evaluation of program implementation has prevented the program to be refined and improved based on experience gained, to ensure that it achieved its development objectives. Data are finally now coming out to permit such an assessment.'9 2.36 Preliminary research results60 reinforce the view that land reformn has had a significant impact on improving the beneficiaries' well being (see Table 2.8). Despite having been selected from the poorer segments of society, per capita consumption of beneficiaries from the 1972 land reformn in 1998 (the only time when information on this was collected) was 45 percent higher than that of non-beneficiaries. Econometric estimates using a number of different indicators confirm this notion: children of land reform beneficiaries have accumulated human capital faster than those from non- beneficiaries. Rates of physical asset accumulation by land reform beneficiaries were significantly higher than those by non-beneficiaries, both in the period immediately '9 This refers to a unique data-set covering five villages in Central Luzon and Iloilo that represent the rice and corn environments which were the main focus of the 1972 land reforms. One of the villages in each province (Maragol in Central Luzon and Pandon in Iloilo) represents favorable agroclimatic environments with irrigated rice production. Two further villages in less favorable environments combine reliance on rain-fed production with supplemental irrigation during the dry season. The fifth village (Signe) is located in mountainous and marginal environment. "O Deininger, K., F. Lara Jr., M. Maertens, and A. Quisumbing. 2000. "Agrarian Reform in the Philippines: Past Impact and Future Challenges." Mimeo. Washington, D.C: World Bank. -57 - following land reform as well as during 1988-98. While rice yields obtained by beneficiaries in 1985 (the first time when information is available) were not different from those of non-beneficiaries, the data suggest that, in the longer term, land reform beneficiaries were able to improve their productivity more than non-beneficiaries- enabling them to harvest 1,400 kg. per has. more in 1998. All of these suggest that land reform had a positive impact on beneficiaries' livelihood. Table 2.9: IMPACT OF LAND REFORM ON BENEFICIARIES (Beneficiaries compared to reference group) INDICATOR ADDMONAL SCHOOLING (YEARS) 0.60 - 0.83 ADDriTONAL iNCoME (US$) 73-92 ADDITIONAL ASSET ACCUMULAnON (US$) 996- 1526 INCREASE IN RICE YIELDS 85-98 (KG/HA) 565-638 ADDmONAL PROFITS 85-98 (US$) 80-102 Source: Deininger et.al.(2000) 2.37 However, while, by their very nature, both sets of land reform have favored people who were already cultivating at least some land, the first phase was better targeted towards the poor than the second one. In addition to focusing on larger households (with more available family labor) who were less educated and had lower non-land asset endowments, the first phase of land reform provided land access to a large number of previously landless. The lack of any obvious targeting during the second phase suggests that either access to land through regular land markets has become more restricted than it was earlier, or that as it became more difficult to find "CARP-able" areas, DAR officials may have been less able to target land to the most deserving beneficiaries. 2.38 Furthermore, the restrictions on land rental needed to implement CARP may actually have restricted the capacity of the poorest to access land in such a way that welfare losses from malfunctioning land markets would outweigh the gains from land reform to those who benefited. Research results indeed suggest that the functioning of land markets may have worsened considerably between 1985 and 1998 and that CARP related land reform legislation and the associated attenuation of land ownership rights decreased land owners' ability and willingness to rent out land to the landless, thereby reducing access to land for the vast majority of poor who did not benefit from the land reform program; In part as a result, the probability of a landless person accessing land may have decreased by more than 60 percent between these two dates. 2.39 The implications in terms of welfare are important. To start with, the number of landless farmers exceeds by far the number of CARP beneficiaries. Data from 1998 Annual Poverty Indicator Survey indicate that, of the households who have at least one member working in agriculture, 68 percent do not have access to land other than their residence, while only about 3 percent received land through CARP. Furthermore, the welfare losses to the landless might be quite high. Comparing consumption levels between landless with and without land in 1998 indicates that the income lost due to inability to access land may be significant-up to 30 percent of total household income. 2.40 If these preliminary findings are confirmed by further research, (a) A shift in CARP implementation toward better targeting the landless would be warranted. -58 - (b) A systematic effort should be undertaken to identify and relax those land market restrictions, which are not strictly essential to (a). This would create opportunities for the poor to access land through a rental arrangement of their choice and at the same time greatly increase agricultural productivity, by bringing areas under cultivation which are currently fallow and not rented out due to fear of land loss. 2.41 In the meantime, (a) effective collection of existing land taxes (which are currently poorly enforced due to landlord resistance) might provide a more powerful incentive to increase the efficiency of land use than any threat of bureaucratic intervention and/or expropriation. This might involve a prohibition of further land tax amnesty by local governments and a mandatory update of land assessed values (for tax purposes). Since the one-time cost of such exercise is likely to exceed the capacity of many LGUs, financial assistance may need to be secured from the national government or from donors. (b) directlyfunding poor communities to purchase CARP land on a mutually agreeable basis could usefully supplement the existing compulsory CARP arrangements. Such program could help speed up land reform implementation, particularly in areas where landlord resistance is likely to be fierce. Even better, such program might also provide an effective mechanism to target land reform toward the landless, and to enhance the its poverty impact. Implementing an approach of this nature in the context of the pilots for "community-managed land reform," which the Philippine Government is currently planning, would provide the learning experience needed before proceeding on a broader scale. (c) progress towards agricultural trade liberalization (see next section) would help reduce the price of land in general, make land more easily accessible to all, and also ease the financial burden of land acquisition under CARP. C. OPENING UP AND LEVELING THE PLAYING FIELD Trade Liberalization in the 1990s 2.42 The environment itself in which private firms and farms operate has changed drarnatically over the last decade under the combined influence of trade liberalization and heightened domestic competition. As noted in Chapter 1, tariff reform and import liberalization were used in tandem over the last two decades to shift the economy from an inward to an outward orientation. Following a first wave of trade policy reform starting in the early 1980s, a second one began in the mid 1990s61 with tariff walls falling in the manufacturing sector, quantitative restrictions in the agricultural sector being replaced by 61 The first wave of Tariff Reform was implemented in 1981 to 1985 (Manasan & Pineda, 1999). As a result of this initiative, the average Effective Protection Rates (EPR) declined and the bias against primary agriculture and exportables was reduced. The second wave came in the mid 90s, with Executive Order No. 264 (July 22, 1995), adopting the policy of a unitary tariff of 5% by 2004, for industrial and non-sensitive agricultural products. -59 - tariffs,62 and reduction in the level and dispersion of tariffs. The end objective of the recent generation of reform is to bring tariffs to five Xpercent across all sectors by the year 2004, except for sensitive agricultural commodities. 2.43 The tariff reform initiatives of the Philippine government have been pursued mainly on a unilateral basis. President Joseph Estrada himself expressed his support for such approach most clearly when he said: "...The greatest benefits of liberalization are enjoyed by those economies that undertake it, whether others follow suit or not. Without acceptance of this notion, APEC would have bogged down. Its members would have been preoccupied with minimizing the beneficialfall-outs of unilateral liberalization to 'free riders " instead of maximizing the benefits for themselves, regardless ofsuch fall-outs. ,64 2.44 Commitments to the World Trade Organization (WTO) also provided some push to the reforms, in particular, with regard to tariffication of agricultural commodities formerly protected by quantitative restrictions. 2.45 As a result of the reforns, there has been a substantial reduction in the effective protection rate65 (EPR) across sectors (see Chapter 1, Table 1.10 and Table 2.9). Notably also, while neighboring countries slowed down their pace of tariff reduction in response to the Asia crisis, the Philippines kept up its own (see Table 2.1 l-in keeping with the principles enunciated by President Estrada hereabove. Table 2.10: EVOLUTION OF EFFECTIVE RATES OF PROTECTION (1990 to 2000) BEFORE WITH UNDER 1998 EOs TARIFFICATION TARIFFICATION 1990 1995 1996 1998 2000 No. OFTARIFFLINES 6,193 5,538 5,721 5,627 5,566 EFFECTIVE RATE OF PROTECTION WEIGHTED AVERAGE (PERCENT) 29.4 24.8 25.5 18.7 14.4 STANDARD DEVIATION 22.1 23.0 26.1 20.8 18.0 COEFFICIENT OF VARIATION 75.0 92.0 102.0 111.0 125.0 Source: Manasan & Pineda, (1999) 62 Quantitative Restrictions (QRs) of so-called sensitive agricultural commodities was replaced by high tariff in March 1996, by virtue of RA No. 8178. 63 Such as, rice, corn, sugar, selected vegetables (i.e., garlic, onion), poultry, livestock, and meat products (see Department of Agriculture. 1998. "Rules and Regulations for the Implementation of the Agricultural MAV." MAV Management Committee. Quezon City, Philippines.). 64 Speech delivered by Pres. Joseph Estrada during the 13' General Assembly of the Pacific Economic Cooperation Council (PECC) in Manila October 21, 1999. 65 EPR or Effective Protection Rate measures the extent to which the protection system increases an industry's domestic value added above its free trade value. The higher the EPR, the more protected is a given commodity (see Manasan & Pineda 1999 for a detailed discussion). -60 - Table 2.11: AVERAGE MFN RATES OF SELECTED ECONOMIES (percent) COUNTRY 1993 1996 1997 1998 1999 INDONESIA 17.00 13.14 11.76 11.76 13.5 MALAYSIA 12.80 9.00 7.8 9.3 9.45 PHILIPPINES 23.50 15.55 13.43 10.69 9.98 THAIAND 37.80 17.00 18.36 N.A. 16.97 Source: APEC Individual Action Plan 2.46 Disaggregating the sectors would reveal, however, that the pace of tariff reduction was much faster in manufacturing compared to the agriculture subsector (see Figure 2.2). The enactment of high tariffs in place of the QRs for sensitive items actually pulled up the average tariff in the agricultural sector (Manasan and Pineda, 1999 and David, 1999). 2.47 The high tariff walls for sensitive commodities in agriculture slowed the momentum of reform in the agricultural sector.66 As a result, a switchover in effective protection structure occurred. Agriculture, which used to be less protected, has overtaken the manufacturing sector in degrees of effective protection (see Figure 2.2). Figure 2.2: EFFECTIVE PROTECTION RATES FOR MANUFACTURING AND AGRICULTURE (percent) 40 35 1 / 30~ I254 15 10 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 l Agr -Manf l Note: 1995 to 1996 are transition years from EO 313 to EO 486, when QRs where converted to tariffs for sensitive agricultural commodities. Source: Manasan & Pineda (1999) Economic impact of trade reforns 2.48 An analysis on the impact of tariff reforms carried out for the period 1995 to 2000 was made by Cororaton and Cuenca (1999).67 Their results indicated that trade reforms had benefited the economy. Household income rose faster as a result while employment improved. In addition, they also observed that the lower income group benefited more from the trade reform than the upper income group (see Table 2. 1 0). 66 The Minimum Access Volume (MAV) scheme was put in place to ensure a specific level of market access in the event that a country "over-tarrifies." Under EO 313, the government imposed lower duty (i.e., in-quota rate) for imports falling within the MAV and higher duty (i.e., out-quota rate) for imports in excess of the MAV. However, while it served as a compromise between protectionist and liberal camps, it also presented some opportunities for rent seeking activities among market players who are able to comer MAV allocations (see David, 1999). 67 The analysis was done with the use of a 50-sector computable general equilibrium model of the Philippine economy using 1994 economic data (see Cororaton and Cuenca, 1999 for more details). -61 - 2.49 One should however point out that there are some sectors, which are negatively affected in the reform, process. Cororaton and Cuenca (1999) showed clearly the loss of jobs in the agriculture sector during the transition.68 Their simulations also found that a more aggressive tariff reduction, particularly as concerns "sensitive" items would have been even more beneficial to the economy (see Table 2.11). 2.50 These gains did not come without pain, though. According to the simulations presented below, trade liberalization would have eliminated close to 200,000 jobs to create 500,000 new ones. Interestingly enough, it does not seem that the pain would have been much higher, had agricultural tariff reform been pursued much more aggressively. It appears that even agricultural employment would have fared better, as the cost of rural labor would have been reduced as a result (see Table 2.1 0 and 2.11). This is not entirely surprising if one considers that a full two third of the households who have at least one member engaged in agriculture are actually landless. Table 2.12: IMPACT OF TARIFF REFORMS (Baseline Scenario: Tariff reduction based on present tariff schedules) CUMULATIVE CHANGE 1995 TO 2000 (W/O 1996) CHANGE IN GROSS INCOME OF HOUSEHOLDS (PERCENT) HHI (lowest income group) 4.9 HH2 2.6 HH3 2.7 HH4 2.7 HH5 3.1 CHANGE IN LABOR INCOME OF HOUSEHOLDS HHI 4.1 HH2 3.9 HH3 3.7 HH4 3.6 HH5 2.8 CHANGE IN EMPLOYMENT (THOUSANDS) Agriculture (including fishery & forestry) -30.1 Industry (including construction & utilities) 156.0 Service (EXCLUDING GOVERNMENT SERVICE) 146.0 TOTAL (EXCLUDING GOVERNMENT SERVICE) 271.9 Note: 1996 data was excluded due to the technical change from QRs to tariff for sensitive agriculture commodities Source: Cororaton and Cuenca (1999) 6a Tan, E. 1999. "Measuring Poverty in Education." In A. M. Balisacan, ed., Causes of Poverty: Myths, Facts and Policies. and Medalla, E. 1998. "Trade and Industrial Policy Beyond 2000: An Assessment of the Philippine Economy." PIDS Discussion Paper Series No. 98-05. Makati, Philippines. May 1998, share these findings. -62 - Table 2.13: IMPACT OF TARIFF REFORMS (Aggressive Scenario: target 5 percent tariff across all sectors in year 2000) CUMULATIVE CHANGE 1995 TO 2000 (WIO 1996) CHANGE IN GROSS INCOME OF HOUSEHOLDS (PERCENT) HHI (lowest income group) 5.3 HH2 2.7 HH3 2.8 HH4 2.9 HH5 3.3 CHANGE IN LABOR INCOME OF HOUSEHOLDS HHI 4.4 HH2 4.2 HH3 4.1 HH4 3.9 HH5 3.1 CHANGE IN EwLOYMENT (THOUSANDS) Agriculture (including fishery & forestry) -17.1 Industry (including construction & utilities) 218.4 Service (EXCLUDING GOVERNMENT SERVICE) 160.5 TOTAL (EXCLUDING GOVERNMENT SERVICE) 362.8 Source: Cororaton and Cuenca (1999) Remaining Distortions in the Agriculture Sector 2.51 Thus far, the Philippine government has achieved much in leveling the economic playing field and promoting competition. But, remaining distortions in the agriculture sector must be addressed to achieve greater benefit from trade liberalization. There are four major reasons for moving forward with tariff reforms in agriculture. (a) First, current tariffs stifle the development of downstream activities. Protecting sugar means high input prices for the food and beverage industry, such as, processed fruits, chocolate and sugars confectioneries, carbonated drinks and juices. Similarly, protecting corn results in high feed prices for the hog and poultry industry, areas where the country has great exports potential (David, 1999). (b) Second, current protection diverts agricultural production away from exports (as happened during most of the 1990s, see Figure 2.3). Conversely, Figure 2.3 also shows how exports can react, as they did in 1998, to a reduction in the implicit protection provided to "sensitive items" since the depreciation of the peso (see Chapter 1, Table 1 .11). Pursuing tariff reform in agriculture makes the country better positioned, for instance, to capture the benefits provided by a rapidly liberalizing China market.69 (c) Third, Philippine rice prices are higher compared to some Asian countries (see Figure 2.4). This situation erodes the competitiveness of labor vis-a- vis other Asian countries.70 69 With China's entry into the WTO, we should expect a wider potential for Philippine exports to reach the 1.2 billion Chinese market. 70 see World Bank. 1997. "Philippines: Managing Global Integration." Washington, D.C. -63 - (d) And finally, this imposition falls disproportionately on the poor, who devote a larger portion of their income to food expenditure (see Table 2.12), and weighs down the wage competitiveness of unskilled labor. As the poor are, in general, net buyers of food, they should also generally benefit from the reduction in food price which trade liberalization would bring about. Figure 2.3: AGRICULTURAL EXPORTS Figure 2.4: PRICE OF RICE IN SELECTED (percentage of agricultural value added) COUNTRIES (US$ per metric ton) 13 * 500, 12, 400 11 3004 2004 10 100 91 0 gi, | g; 8 i 88 89 9091 9293 94 95 969798 019 s19 Source: Statistical Yearbook, NSCB Note: No data available for 1999 Malaysia and 1994 Vietnam rice prices Source: World Bank Table 2.14: SHARE OF FOOD IN CONSUMPTION BY DECILE (percentage of total consumption expenditures) PER CAPITA EXPENDITURE DECILE FIRST (POOREST) 68.0 SECOND 64.6 THiRD 62.3 FouRTH 59.8 FIFTH 58.2 SIXTH 55.6 SEVENTH 52.3 EIGHTH 48.4 NNTH 43.5 TENTH (RIcfEsT) 28.6 Source: Balisacan (1999); Family Income and Expenditure Survey (1997) 2.52 There will clearly be winners and losers as the economy moves towards a more liberal environment. Lowering import barriers for rice, corn, and sugar, for example, could be a wrenching process. Farmers who have grown accustomed to planting only rice and corn may find it hard to compete as imported rice/corn come in cheaper and in greater quantity. Indeed, some studies have pointed out that further tariff reduction for sensitive agricultural commodities may cause an initial dip in production before sustainable growth could be realized (Cororaton,1999; Tan,1997; Medalla, 1998). However, this is not to say that obstacles in the transition are enough reason for reforms to stall. On the contrary, policies to smoothen the transition and provide safety nets to vulnerable sectors should be carried out as soon as possible, without disrupting the momentum of tariff reforms. The resources in support of the smooth transition would come from the Agricultural Competitiveness Enhancement Fund (ACEF) under R.A. No. 8178; and the Agriculture and Fisheries Modernization Act (R.A. 8435). Both laws are -64 - envisioned to provide more resources towards agricultural modernization and cushion the negative impact of tariff reforms. Role of AFTA and the next wave of trade reform 2.53 The next wave of tariff reform is likely to take place in a regional context. Two recent developments within the ASEAN Free Trade Area (AFTA) merit closer attention in this respect: (a) the acceleration of the target year to achieve free trade within ASEAN, moving it five years earlier than planned, from 2015 to 2010; (b) the expansion of commodities to be covered under the Common Effective 71 Preferential Treatment (CEPT) to include all sensitive items including 72 rice as envisioned under the Hanoi Plan of Action (HPA). As an example of the resolve of ASEAN member countries to lower tariffs, Thailand has already declared lowering tariffs (to 20 percent) on rice and open cross-border trading.73 2.54 Drawing inspiration and support from the AFTA initiatives, the Philippines may find it to its advantage to pursue further trade liberalization74. McKibbin and Stoeckel (1999) find, for instance, that further unilateral trade reform initiatives in the Philippines will be beneficial for the economy. Real investment is expected to rise, while consumption would get a boost as consumers anticipate the gains of the removal of protection, and real GDP would be over 3 percent above baseline by 2010 given a more efficient resource allocation. Services, Next Frontier in Globalization 2.55 Technological innovation, especially in telecommunications and information processing, is expanding significantly the scope for service tradability. The quality of the existing telecommunications infrastructure is at the heart of the information revolution. A recent OECD study lists three criteria for developing countries to capture new markets for such long-distance services. Such services need to: (i) be information-intensive, and by implication, relatively labor-intensive; (ii) require limited direct contact with customers; and (iii) not involve manipulation of physical objects.75 ' New commitments under the Common Effective Preferential Treatment (CEPT) cover highly sensitive agricultural commodities, like rice for the Philippines. 7Z The HPA is the first in a series of plans of action building up to the realization of the goals of the ASEAN Vision 2020, adopted during the Second ASEAN Informal Summit, in Kuala Lumpur on 15 December 1997. The HPA has a six-year time frame covering the period 1999 to 2004. 7 Philippine tariff on rice at present is 50 percent. Import allocation is however dictated by NFA (National Food Authority), the sole rice importer. " The tariff reduction program of the country gets added support from the individual action plan committed by the country to the APEC. This bolsters the country's resolve to follow the tariff reduction schedule it set for itself towards the target unitary rate of 5 percent in 2004. 7 See Wallace, P. 1999. "The Philippines as A Regional Center for Shared Services." Speech at CFO Magazine/Citibank Conference, October 28, 1999. and Overseas Economic Cooperation and Development (OECD). 1999. "Global Trade Analysis Programme (GTAP)." August 1999. -65 - 2.56 With early gains from the liberalization of the telecommunication industry in the early 1 990s,76 and a labor force known for its English language proficiency, the Philippines is poised to capture the opportunities presented by the global information revolution (see Abrenica, 1998; Abrenica and Warren, 1999). Industry watchers already took note of the Philippines' fast becoming an attractive spot for back-office functions and a strategic e-commerce hub for multinational corporations in the region (Jardine Collier, 1999; Wallace, 1999).77 Success in this regard should be seen as an enticement for other sectors of the economy to follow suit in the path of deregulation and heightened competition, such as port services, inter-island shipping, aviation, and retail trade. 2.57 Much of these early success in attracting service industries can be attributed to the improvement of telecommunication after the liberalization of the sector in the 1990s. But, as the impact of the early generation of reforms in the telecommunication industry ran its course, it is now time to re-assess the gains and find solutions to policy bottlenecks that constrain the industry. Abrenica (1998) cited three main concerns: (i) failure by telecommunication carriers to meet roll-out obligations under the Service Area Scheme (SAS); (ii) continued fending-off of competition by the dominant carriers; and (iii) inefficiencies in pricing policies, i.e., cross subsidies which encourage under-usage of long distance network while encouraging excessive usage of local network. The first two concerns point toward the need for a more resolute enforcement of regulations. As to the latter, it is one which the emerging competition in long distance services may bring to a head. 2.58 Opening up the telecommunications industry, and the consequent increase in market activity, will create new and complex regulatory problems. The key therefore is to provide regulators with up to date and accurate information to function more effectively. A proactive regulator is needed during this time where rapid changes in the industry will accelerate the infrastructure needed in information technology and help the country capture the opportunities presented by the information revolution. D. CONCLUSIONS 2.59 For reasons linked to the legacy of the past and the prevailing framework on corporate governance and land tenure, the ownership of both corporations and land is exceedingly concentrated. The insecurity of "outsiders"-be they minority shareholders, unconnected creditors, sharecroppers or landless farmers-has retarded development. Recently however, land reform and the opening up of the economy to foreign and domestic competition have begun to change the former status quo. Similarly, trade liberalization has removed rent opportunities. Progress, although rapid, remains uneven. 76 A breakthrough was reached in the early 1990s with the promulgation of the Universal Telephone Service Policy which served as the basis for the Service Area Scheme (SAS). With the entry of more players, an investment surge ensued during the period 1994 to 1997, which greatly benefited consumers. As a result, telephone penetration jumped from less than I percent at the beginning of the decade to about 9.5 percent in 1998. There was also a marked improvement in the industry's productivity, as incumbent carriers streamlined operations to meet competition (Abrenica 1998). 77 Collier Jardine Bulletin. 1999. "The Philippines: A Growing Regional Service Center." listed a number of multinational companies that have utilized the Philippines for their backroom operations in the region, as follows: Citibank's Corporate Technology Support, AOL's intemet service center, Bechtel's engineering blueprints and design, Caltex' corporate back office, Barnes & Noble intemet service center, SPI Technologies data processing center, among others. -66 - 2.60 Addressing remaining constraints would make the private sector better able to become the engine of faster, more sustainable and widely shared growth. The chapter highlighted the importance of: (a) Strengthening the protection of minority shareholders and creditors. This would put corporate finance on a sounder footing and ease access for all, particularly those smaller, independent firms not connected by business interests, to financial resources. First priorities are to: (i) adopt the proposed revised securities act as well as even-handed, and prompt procedures for disposing of suspension of payment filings; (ii) enhance the independence and integrity of the SEC and PSE and (iii) begin to enforce more forcefully existing provisions for disclosure and accounting. It would also help if public pension funds turned themselves into passive investors and champions of minority shareholder rights. A reflection should finally be initiated on evolving debt resolution proceedings towards international best practices, expanding the range of available securities, and eventually also on disentangling banks from corporations. (b) Supplementing the land reform program with measures to facilitate the access of the landless to land, including by relaxing restrictions inhibiting land markets, enforcing land taxes, and using land tax proceeds to fund land acquisition by poor communities on a mutually agreed basis. (c) Bringing the pace of agricultural trade liberalization in line with the one ongoing for manufactures and reinforcing competition in the services sectors. The latter is essential if the Philippines wishes to strengthen its hand as potentially one of the primary beneficiaries of the upcoming wave of Internet-based globalization of service activities. -67 - 3. FINANCE FOR DEVELOPMENT A. INTRODUCTION 3.1 The Philippine banking system weathered the regional crisis relatively well, avoiding major failures or a systemic crisis. This is explained in part by relatively strong pre-crisis capital positions and portfolio quality among Philippine banks compared to several neighbori-ng countries: lower corporate leverage at the onset of the crisis, less overheated real estate markets, and strong export growth and remittance flows. Nevertheless, the banking system has been weakened by the downturn. 3.2 The authorities have responded by initiating a significant reform program in 1998 to strengthen prudential regulation, improve the incentive framework and enhance strategies for prompt corrective actions and failure resolution. This program represents a new phase in a long process of stabilization, restructuring and strengthening of the banking system that began more than a decade ago. Notwithstanding the major progress made to date and the resilience displayed by the banking system, further reforms and progress (in areas such as consolidation of banks, increasing efficiency and technology, improving governance and transparency, strengthening prudential regulation and supervision, and rationalizing financial sector taxation) will be needed to realize the vision of a modern, robust and internationally competitive banking system. 3.3 An important dimension of the recent crisis was the over-reliance on foreign savings as opposed to domestic ones, and excessive dependence by enterprises on short- term bank debt as opposed to long-term debt and equity finance. This suggests that structural reforms to support the development of robust and transparent capital markets and promote long-term domestic savings may be warranted. Over the medium term, such reforms would reduce pressures on the banking system, lengthen the maturity of debts, provide more equity-based financing for enterprises and reduce incentives for speculative investment in real estate. More developed capital markets, including efficient housing finance and well-functioning contractual savings institutions, could also contribute importantly to fiscal sustainability and labor market flexibility. Taken together, these reforms would play a critical role in spurring economic growth and reducing poverty (see Box 3.1). 3.4 This chapter first provides a brief overview of the financial system and highlights key historical trends that help to explain the current status of the sector. Proceeding from there, the chapter characterizes the origins and impact of the crisis and assesses the measures taken to address it. On this basis, it charts out key challenges for the future development of the financial system. -68 - Box 3.1: WHY DOEs FINANCE MATTER? Financial markets play an essential role in the etficient functioning of the real sector. In particular. they facilitate pooling of savings and more efficient allocation of these savings to potential investments, as banks and other financial players acquire specialized skills and information in evaluating the risks and retumns of alternative investments, and reduce the costs of intermediation. When operating effectively, financial markets ensure that resources arc directed to their most productive use, thereby maximizing opportunities for economic growth. The savings. credit and insurance instruments that allow households and companies to trade across time and across states of nature also make it possible for them to cope better with risks, by pooling and sharing them with others. Access to savings and credit enabies households to smoothen consumption patterns over time, increasing their welfare. There is also an important nexus between risk management and resource allocation, as risk-averse entrepreneurs will choose unduly low-risk/low-return investmnents if they are unable to borrow or insure sufficiently against contingencies. The depth and efficiency of financial markets have a major impact on the poor. This impact occurs through both direct and indirect channels. In particular. liberalized, but well supervised, financial markets encourage greater competition and the expansion of formal financial services directly to smaller enterprises and poorer households (e.g., through working capital. mortgage loans, credit cards and small denomination savings instruments). Although a large share of Philippine households operates beyond the formal financial frontier. developing deep and efficient financial markets also results in major indirect welfare gains for the poor (and in times of crisis, reduced welfare losses) through economic growth, employment. and reduced economic volatility. Since financial crises are closely correlated with macroeconomic crises, and since these particularly affect the poor through wage declines and unemployment increases. the indirect impact on the poor of refonns that promote sound and efficient banks and non-bank financial markets should not be underestimated. al See Levine (1994) who reviewed linkages between financiaI depth and economic gowth, and Hausmann and 3avin (1996>. on linkages between macroeconomic volatility, financial depth and economic growth, B. OVERVIEW OF THE FINANCIAL SECTOR 3.5 Even more than in the rest of the region (see Figure 3.1), Philippine banks have traditionally taken the lion's share in mobilizing the country's savings. Their total assets represented 101 percent of GDP, and 82 percent of the total assets of the financial system at the end of 1999. In contrast, those of the second largest segment of the financial system, the contractual savings sector (public and private pension funds, pre-need plans and life insurance companies) amounted to only about 20 percent of GDP. 3.6 As was noted in Chapter 2, large, domestically-owned corporate groups control most major banks in the system, and, like the corporate sector, the banking system is relatively highly concentrated: the largest six banks control close to 60 percent of banking system assets. The other 40 percent of assets, however, are highly fragmented across the remaining 47 universal and commercial banks, 117 thrift banks, and about 830 rural banks.78 Foreign commercial banks account for around 10 percent of banking system assets. Off-balance sheet activities, including trusts and contingent accounts of banks, amount to over 40 percent of banking system assets, with trusts engaging in significant quasi-banking activities. 3.7 As a result of banks' dominance of financial intermediation, most corporate finance is obtained through the banking system. Since most household financial savings are placed with banks for fairly short maturity accounts and instruments, bank lending is 7 The banking system is largely private, with public holdings limited to two development banks, one Islamic investment bank, and a 30 percent share in the Philippine National Bank (PNB) which is being divested. -69 - also generally fairly short-term. Borrowers are therefore relatively exposed (and sensitive) to interest rate risks 3.8 For longer maturities, savings are channeled primarily into contractual savings vehicles (direct investment in equities and debt instruments by the general public remains fairly limited). Public pension funds79 and mobilized over 60 percent of contractual savings as of December 1998. Life insurers account for the next largest share,80 followed by private occupational pension plans (OPPs) offered through a large number of Philippine corporations and pre-need plans offered through around 70 pre-need companies. In a bid to generate the longer term lending resources needed to finance social overhead investment (e.g., housing, local utilities), successive governments have created a range of public non-banking institutions, such as NHMFC, LWIA, Pag-IBIG or NEA, backed by either contractual savings schemes and/or by foreign assistance. Unfortunately, the financial record of these institutions has been poor (see Chapter 4). Figure 3.1: RATIO OF DEPOSIT MONEY BANK ASSETS TO TOTAL FINANCIAL ASSETS (percent) *i1988 .1997 80%l 60% 50% 40% 20% 10% 0% ... .. Philippines Korea Malaysia Thailand Source: Financial Sector Database, World Bank 3.9 Capital markets cater primarily to Government's domestic borrowing requirements. At this point in the financial sector's development, they are still a secondary source of finance for private Philippine corporations (see Table 3.1)," in part reflecting the difficulty of raising finance from inadequately protected investors (see Chapter 2). 79 Comprising the Social Security System (SSS), the Govemment Service Insurance System (GSIS), the Home Development Mutual Fund (Pag-IBIG), and the Armed Forces of the Philippines Retirement and Separation Benefits System (AFP-RSBS). 80 The private insurance industry comprises 27 life insurance companies, 97 non-life insurance companies, 4 reinsurers and one composite insurer. Life insurance accounted for 56 percent of the total net premiums written while non-life insurance amounted to 41 percent and reinsurance to 3 percent. Public insurers include the Home Insurance and Guaranty Corporation, Philippine Crop Insurance Corporation, Philippine Deposit Insurance Corporation and Philippine Health Insurance Corporation. " Domestic capital markets comprise markets for equities, government securities and other domestic debt. Equities are traded on the Philippine Stock Exchange (PSE), which has around 180 member firms and 220 listed companies. On the debt side, Govemment securities are the backbone of the Philippine debt market. While Government owned or controlled corporations (GOCCs) also issue both domestic and extemal bonds, the private domestic bond market is limited, although trade in commercial paper was fairly active prior to the crisis. Mutual funds are a fairly recent innovation and their total asset value is relatively small. There are only a few local govemment units (LGUs) issuing municipal bonds, due to high transaction costs and market perceptions of risk. -70 - Table 3.1: FINANCIAL DEPTH AND INDEBTEDNESS IN SELECTED EAST ASIAN COUNTRIES (percentage of gross domestic product) INDONESIA KOREA MALAYSIA THAILAND PHILIPPINES DOMESTIC CREDIT PROVIDED BY THE 58 84 162 160 64 BANKING SECTOR STOCKMARKETCAPITALIZATION 22 38 150 23 54 BONDISSUESOUTSTANDiNG 5 6 12 9 14 PUBLIC DEBT 26 9 17 14 31 Source: World Development Report, 1999; World Development Indicators, 1999; Bank Staff; latest data available C. THE LEGACY OF EARLY FINANCIAL REFORMS 3.10 The Philippine financial system confronted the Asia crisis better equipped than many of its neighbors. First, it benefited from the fruits of the decade-long financial restructuring, which had followed the debacle of the Marcos regime (see Box 3.2). During 1985-95, the Government embarked upon a major program of financial sector restructuring that resulted in the following key reforms: (a) Restructuring of the central bank, with bad assets assigned to a Central Bank Board of Liquidators and establishment of a new central bank (Bangko Sentral ng Pilipinas) in 1993, with powers to pursue independent monetary and exchange rate policy and to regulate the banking system. (b) Recapitalization of the Philippine Deposit Insurance Corporation (PDIC) and vesting it with the authority to act as the receiver for all banks under liquidation. (c) Restructuring the balance sheets of the Development Bank of the Philippines (DBP) and the Philippine National Bank (PNB), which together had accounted for around 50 percent of banking system assets, by transferring their non-performing assets to an Asset Privatization Trust. Government also revised their charters in the late 1980s to rationalize access to special privileges and funds, and started a gradual process of privatization of PNB and conversion of DBP into a wholesale lender. (d) Increasing minimum capital requirements for banks on four separate occasions during 1986-94, while lifting a moratorium on new banks after 1989, permitting the entry of 10 foreign banks in 1994, and relaxing branching restrictions. (e) Gradual reduction in selective credit control programs, and related simplification of central bank discounts to a unified rate for all preferential lending programs.82 82 Although the Agri-Agra requirement that 25 percent of bank lending be to agriculture, agrarian reform or qualifying exemptions remains in effect. -71 - (f) Deregulation of the foreign exchange market, opening of the capital account and encouragement of foreign currency deposit units, particularly as a vehicle for capturing remittances from overseas Filipinos. (g) Strengthening of prudential regulations, including requiring a minimum 10 percent tier 1 capital adequacy ratio, improving the application of generally accepted accounting principles to Philippine banks, tightening of regulations and disclosures governing asset classification and loan loss provisioning, and a limited relaxation of banking secrecy related to connected lending. (h) Upgrading banking supervision by enhancing skills, and introducing a CAMELS83 rating system for banks. :Heay texternal borroing Xand inefficent allocation ;of thesereouresduring the 970s, Ecoupledwith high; global: iterstrates andpoitialinstblt Win th0eealy198s fconEtribted tthePhlippines bing unable to Vservice theC prnipal balne of its extenl debt0 by1983. Follow;iOngg th 10983 fdebt mortorifum doesticF Xliquidity decreavseddby smej sevenpercentae points of GN:P Xand bak :credi toff te kprvt Vsector decine by: Snearly20 percent in: three years. WMit the political turmoil aSnd; macrcnmic dinstabiltyofthe id-lat t980s and with 'ncreased 0financial0 libeaization in a weaklyt reguated 0environmet, private; Xbak w#ere epeiencing tsevere tliqii&ty and solvenc polems In. aditio, te inanin olrg pubic Adefiitsprimarly thruh domstic borowng rel cting the scarity of extena fncing 0 fo prvate soures following te debt crisis), fresultedin shrpincreasesit domestic00 $debt and; real; interet r ates, and fur:thrstress on gthe :financial s ystem.0 Yars Xof pol1itically tinfluem ed credit 00alloctions also erodidte cai0tal ' Philippin Natinl 0Bank PNB Z the Developent Ba ik of the Phiippne (01W), bot of wE0hic hto berstrwuctued.Fially the fnacawl poiton of theCgenta ank itself deeroatdto th pint' reqiting ajr resrutuin,asitws focedto ?,sue tthefrign crenyIi hties of; a ma ober of Vpublic and private eterrises. Thefi anc Isitution wvas so egradedthat, during the 1981.l087;period pat ipatcd aL massiv rehai li