Developing the Philippine capital market

SPECIAL FEATURE
Business World


Economic development and capital market development go hand in hand. As economies develop, the importance of a well-functioning capital market becomes paramount to ensuring that savings are channeled to their most efficient uses.

In turn, this ensures that risks associated with leveraging, as is the case with a financial system dominated by banks, sourcing foreign capital, and attendant foreign exchange risk due to mismatch with revenues, are kept at a minimum.

The extent of development of the Philippine capital market reflects the country's stage of economic development. The stock market, which has been around for more than 70 years, remains shallow and illiquid, with tax avoidance - lower capital gains versus income tax - or regulatory impositions the major for companies' decisions to list. The bond market is dominated by government securities, most of which are held to maturity.

Because of the importance of developing the domestic capital market to complement the functions of the banking system, domestic capital market development has been part of the government's reform agenda for decades. While there have been small steps forward every now and then (e.g., the recent removal of documentary stamp tax on secondary trades), by and large, the Philippine capital market remains underdeveloped.

Why is this so?

A fundamental reason is macroeconomic instability: The country's historical boom-bust economic growth pattern is a major deterrent to capital market development. The key concern at this time is government's fiscal problem, which makes it difficult for investors to take a long-term perspective given its potential destabilizing impact on growth and inflation. The government's large budget deficit is also a drag on the economy's savings rate, already low vis-a-vis other Asian countries. And without savings, there is no demand for capital market instruments. Thus, addressing government's fiscal problem, mainly through revenue measures, remains a top priority.

Some of the other issues at this time include the following:

Strengthening financial system

Strengthening the financial system, especially the banking system, and reorienting this to capital market development, is the first among these key issues. This requires resolving banks' bad asset problem given that banks are the 900-pound gorilla of the financial system, as banks account for over 80% of assets of financial system. Banks probably own a large part of the remaining non-bank sector - investment banks, insurance, stock brokerage, trust funds - outside of the government pension funds and dominate the government securities market.

Consolidation of banks through mergers will both strengthen the banking system and spur capital market development as an important pillar for financial reform. This can be done through stricter enforcement of trust regulations, among others, including revamping common trust funds (CTFs) into unit investment trust funds (UITFs), which are subject to higher levels of transparency and compliance to international accounting standards - e.g. mark to market - as well as making such more marketable to the investing public.

Together with mutual funds, such investment vehicles need to be encouraged as a way for small savers to have a wider range of savings medium. Other approaches for catering to small savers such as retail Treasury bills or the selling of stocks to small investors sound good but is actually bad economics - high transaction costs eventually result in buyers of such instruments being illiquid and ignored.

Pooled funds, on the other hand, provide small slavers convenience in participating in a more diversified and therefore less risky fund, access to the services of professional fund managers, and assurance and ease in liquefying investments.

Putting in place an enabling tax and regulatory framework that encourages such savings and investment vehicles is critical.

A study for harmonization of tax laws and regulatory regime for like products is being pursued by the private-public Capital Market Development Council. The Bangko Sentral ng Pilipinas (BSP) and the private sector members of the council are also pushing for the enactment of enabling legislation that will provide incentive to save for retirement, the so-called Personal Equity and Retirement Account or PERA bill. Apart from encouraging supplementary savings for retirement, this can be an important focus point for harmonized regulation.

Improving pension institutions

Strengthening the financial health of the government pension funds, particularly the Social Security System (SSS), which have the potential for mobilizing large amounts of long-term savings and directing them toward capital market development, is also of key concern.

Next to banks, the pension institutions, mostly government-managed and -guaranteed, are the largest players in the financial market.

Unfortunately, the SSS in the next couple of years will likely become a net taker instead of provider of funds. Unless its actuarial deficiency is corrected by increasing member contributions to match the level of benefits, SSS's financial weakness will aggravate the scarcity of long-term funds and potentially, feed into the problem of fiscal imbalance, exploding public debt, and crowding out of private corporate fund users.

Some thinking needs to be done to revamp basic architecture of pension system since government cannot afford the large accumulated pension liabilities - estimated by a team of consultants to be unsustainable - and will find it politically difficult to secure public acceptance of an increase in contribution rate to close the large gap between contributions and benefits. As noted earlier, over short-term legislation for favorable tax treatment of voluntary personal savings retirement vehicles will help in this regard.

An ambitious medium-term approach would be to institute a nationally defined contribution savings scheme, privately managed and fully portable, to complement a scaled-down, government-run and -guaranteed defined benefit pension system. This will help provide financial institutions and the market with long-term source of savings, estimated at some P32 billion annually based on needed adjustment of SSS's contribution rate from 9.4% to 17% that will in turn help provide long-term funding to corporations.

Solving the pre-need industry's problems

There is also a need to sort out the problem of large pre-need companies experiencing difficulties. The rapid growth of the pre-need sector demonstrated people's ability and willingness to save for the long-term given a good savings product and a delivery system that's culturally attuned to the Filipino community.

The challenge is how not to throw the baby out with the bath water. Government may need to find at least cost way of helping (e.g. special purpose asset vehicle (SPAV)-type fiscal incentives government-organized write downs), if deemed necessary to preserve gains in fostering long-term savings in this form. Down the road, introducing a rating system for pre-need companies may be essential to protect less financially savvy buyers.

Appointing a good regulator

There is likewise a need for a good regulator who does not merely check compliance with a given set of rules and regulations but is also able to attract technically competent downstream sector regulators who have both the confidence of the players and the self-confidence in the correctness of their official acts.

Immunity from suit for regulators, exemption from salary standardization, and ability to retain resources for institutional development may need to be secured. Greater coordination among regulators is being pursued through the newly organized financial regulators forum and should result in avoiding sectors "falling between the cracks," eliminating regulatory arbitrage - the pre-need lesson - and rewards that are not driven by inherent value.

Continuing reforms

Continuing reforms started in improving corporate governance and new legislation to improve functioning of corporate recovery process is also a must. Moreover, there is a need to develop financial infrastructures and conventions to enable efficient securities transaction, and institutions that support capital market development, like credit bureaus, secondary mortgage institutions (which the recently passed Securitization Law will make feasible), title insurance companies, and well-functioning systems of good corporate governance, and corporate recovery.

This is a full plate - more reason why we should start doing the right things soonest.