Dollar ROPs: blessing and curse

Introspective
Business World

In contrast to the 1990s, an important feature of the government's borrowing strategy since the turn of the millennium is its increasing reliance on international capital markets to fund budget shortfalls. From about $6 billion, representing less than a third of government's foreign debt stock in 1999, these borrowings have grown to $21 billion today or almost 60% of government's outstanding foreign debt. About 90% of these are dollar-denominated, widely referred to as ROPs.

In a world where financial markets have become highly integrated, these outstanding obligations are an important channel through which (a) markets exact real-time discipline on government and (b) external financial turbulence is transmitted to local markets. The latter has become a key concern today, especially as it is a way through which fiscal problems and/or external financial turmoil can lead to local financial sector instability.

It is estimated that of the $21-billion outstanding government foreign-denominated securities, $5.5 billion is held by local banks while another $2 to $5 billion is held by trust units. On the one hand, this is reassuring to the extent that local bondholders can be expected to be more comfortable with Philippine government risk, reducing repayment/ rollover risk as a result (in the event, they may even by willing to be paid in pesos).

On the other hand, most of the ROPs held by banks are classified as "held for trading" (HFT) or "available for sale" (AFS) securities. Under international accounting standards, their book values are required to be marked to market, i.e., reflect gains or losses in market prices.

With collapsing market values worldwide, it is estimated that the value of ROPs held by banks declined by an average of 11% so far this year. Coupled with an estimated 4% decline in the value of peso instruments, which represent a much bigger portion of bank portfolios, banks had been looking at about P55 billion of potential losses. Were it not for the quick intervention of the BSP, that would have meant a loss equivalent to about 10% of bank capital, around one year's net income. Last October, the BSP allowed a one-time transfer of financial assets from HFT or AFS to "held to maturity" (HTM) or "unquoted debt securities classified as loans" (UDSCL), which are booked at values on a specified date. Most banks are expected to move assets to the latter accounts, which partly explains the BSP's current focus on ensuring adequate financial system liquidity.

While the BSP's present action may be justified, considering the source of market volatility and the trend worldwide of shielding financial systems from the global crisis, it will be harder to justify a similar intervention if it is government itself, through fiscal irresponsibility, causing a run on ROPs. Already, government has abandoned its 2009 deficit target, supposedly to provide fiscal stimulus at a time of slowing growth.

By itself, this should not be worrisome. What would be worrisome is if government raised spending without a corresponding increase in its tax effort, or worse slacken on its tax drive. The IMF has warned that the tax effort next year "may fall close to levels seen before the reform of the VAT." This means a decline from over 14% of GDP at present to less than 13%, which would see a significant rise in the budget deficit to over 2% of GDP. Considering slower expected growth and further forecasted peso depreciation, this would mean rising debt ratio anew. Government's debt ratio remains about 10 percentage points above those of peer sovereigns.

While government has to be responsive to the needs of the poor in this difficult time, it has also to ensure that the fiscal situation does not deteriorate so that it does not add even more risks to an already nervous market (and, if needed, so that it will have the fiscal space to support the financial system). These twin objectives can be achieved by increasing the tax effort and improving the composition of government expenditures. The former requires not only improved tax administration but also passage of tax bills in Congress (including proposals to index excise taxes to inflation, to rationalize fiscal incentives and possibly a new special tax on oil to capture a part of the sharp decline in world crude price) to offset some of the programmed/legislated declines in taxes (e.g., corporate income tax, exemption from income tax of minimum wage earners). The latter requires better targeting of subsidies to the poor and enhancing efficiencies in capital spending (i.e., less tax exemptions, NFA spending and fertilizers and instead more efficient support like conditional cash transfers). Likewise, off-budget guarantees for infrastructure projects should be incurred prudently and not be seen as sowing the seeds of future fiscal problems which will make markets equally nervous.

There is an additional benefit to continuing fiscal reform. Given donors' interest in this area, continuing reform may unlock multilateral financing at low relative cost to government, helping to cover funding shortfalls at a time when capital markets have become less dependable. This will also increase the BSP's reserve ammunition, helping to assuage markets and keep the country away from an IMF program.

Not Quite an Island of Calm; But We’ll Stay Afloat

Remarks of Romeo Bernardo before the FINEX Symposium, “Weathering the Storm” October 23, 2008, Dusit Hotel, Makati

Senator Mar Roxas, Pres. Ed Francisco, Fellow Finex Directors and Members, Mr. Kwan.

Tierra Incognita

We are all so painfully aware of what is going and was more than fully covered by the two previous speakers, but not quite sure where we are headed and for how long.

I stumbled upon a picturesque analogy for our situation, taking off from the often repeated cliché – that the other shoe has yet to fall.  But, it was observed, we are talking about Imelda’s closet.

So it is perhaps important to adopt a properly humble position.  Most prognosticators need to tread carefully these days—we all have crystal balls.

 Before all of these happened a couple of years ago—it was fashionable to talk about decoupling.  I think what we are seeing now though is that the world is much more integrated, primarily through, finance—and also to a high degree—trade, and labor, than many were perhaps wistfully thinking.  Having said that, I still come away with the conclusion that Asia will fare better than many regions—thanks to headroom for internally generated demand by China, a more robust banking sector that has been tested and rehabilitated by the Asian crisis—and that the Philippines even if not “an island of calm”, surely better placed than many, and better placed than it has ever been (just think of the 80’s debt crisis) to weather this storm.

It is widely appreciated that governments, multilateral institutions, financial players, indeed, all of us are still in the midst of a raging financial storm of unprecedented intensity and breadth

Put in simplest terms, the U.S. (and to some extent European countries)  lived beyond their means for a long period of time, issuing magically prime now suddenly junk  securities underwritten  by highly leveraged institutions and blessed by flawed credit rating institutions while the regulators were asleep at wheel, and we are now trying to untangle the mess  in a situation of global institutions exposed to these toxic assets, insufficient information on state of health of counterparties,  resulting liquidity strangulation,  deleveraging of investment banks and other institutions that used to provide liquidity.
This has implications and adjustments on financial markets not only in the affected countries, but due to interconnectedness of markets, even countries that have very little to do with it like ours.  There are also adjustments at the country level that imply significant slow down in spending—read recession—that cannot but ripple down to others who were at the margins of this phenomenon.

Let me start by showing some slides on what it has done to various financial markets-

- PSE down deep but still above where we were during the Asian Crisis Focus on Financial Stocks
- RoP’s spreads, domestic interest rates (though the latter more driven by inflation—now no longer a concern, and reverse is true.). Risk aversion and sourcing liquidity where they can find it.
- Fx rates depreciating (tracking recently really strengthening dollar. Peso depreciated by 4 percent vs. 8 percent average depreciation for fed index of  26 currencies)

At the same time, in contrast to many banks and financial institutions, our banks have been relatively unscathed.

Why?

- Little exposure to toxic assets, no more than 2 percent of total resources
- Invested instead in Philippine government paper, in a context of an improving fiscal and external debt story.
- Asian crisis has been trigger to strengthen the banks---
- Lower NPL’s - from over 17% in 2001 to less than 5% this year
- Non-performing-assets-to-gross-assets ratio went down from over 15% in 2002 to less than 6% this year.
- Better capital adequacy ratios (now at 15% way over the 10% requirement)

At the same time, improving macro story:

- Improving fiscal accounts since 2004. Debt-to-GDP which went down to 57% from 78% in 2004 provides fiscal headroom to assist in strengthening the financial system.
- BOP, driven by OFW, BPO, etc
- Healthy reserves GIR [$36.7 billion], including FCDU’s [$26 billion]

      -     Professional, tried and experienced monetary and financial managers in the persons of Gov. Tetangco, Sec. Teves and their teams who have had to deal with earlier crises dating back to the debt crisis of the 80’s.

These help cushion us somewhat from some of the risks, even though our markets suffered nonetheless, perhaps it would seem to some “unjustly” but we are paying the price of having a shallow and illiquid market.   Likewise, I would like to stress that stock market/financial markets are not the economy.

Looking at the economy, we still see some growth, ending the year at 4.5% and perhaps as good as 4 % next year, driven by some resilience in OFW remittances, as well as BPO, and consumer spending that may perhaps be even better this year, thanks to a more depreciated peso, that allows remittances to go a longer way, as well as sharply lower food and fuel prices.

We see both continuing, albeit slower growth in remittance, and lower oil and food imports as also cushioning the current account position and thus protecting us from what would have been in earlier times (e.g. when we were more dependent on exports) a looming pressure on  balance of  payments.

Resilience of OFW

OFW remittances have been growing over the years, and indeed even though some would date “US sub-prime problem” to about a year ago, still managed to run at 17% year to date.

- Graph showing how much vs. other flows, percent of GDP
Remittance year-to-date growth as of August stands at 17%
- Graph showing where from
- Growth in deployment recently (suggests some supply side response). Deployment year-to-date growth as of August stands at 26%.

Analysis by type

- U.S. around 35% of total per BSP.  My guess is that less than a fifth of this are pro-cyclical to both U.S. and Philippine conditions [really in the nature of sending savings to buy homes]. This will be lost, both with the diminished wealth of Phil-Ams and with the limited upside in appreciation for Philippine real estate investments.  However, for the 30% that come from current income, much will continue. Even assuming unemployment doubles from the current 6 %  to 10%, (the highest level of unemployment in  75 years where data is available),  and assuming Phil-Ams no differently employed than other Americans, implies a decline of 4% of 30%, i.e. 1.2% in remittance from this source.

- Other sources in the meantime should continue to grow.  Countries in the Gulf, particularly heavyweight Saudi Arabia pitched their budget on $50 per barrel, and will continue their public expenditure programs, building new cities costing billions of dollars, and increased refinery capacity (which takes four years to build), many of which are already in train.  There are reportedly over 4 million Filipinos just in the Middle East alone, not fully captured by POEA statistics. Indications of supply response from schools and also from construction firms that essentially become training/suppliers not just for their own but for other companies.  EEI case in point with 10,000 Filipinos working globally, mostly in M.E.

- Health workers, caregivers, domestics—mostly driven by demographics—aging population, and increased labor force participation of women in richer countries. Not likely to be affected much by cyclical factors.

- We believe that these factors are enough to offset the slowdown in remittance in U.S. so that essentially we will see no contraction in OFW remittance, even if it will be in a flat to a single digit level.

At the same time, indications are that BPO earnings [estimated to be around 2.5% of GDP or approximately $3.5 billion] while slowing down initially as business activity ( including from financial institutions doing outsource work here)  lets up, over time will resume long term growth as firms respond to  lower profits due to slowdown by striving to bring down costs. Only scratched surface on BPO processing, supposed to be $ 450 billion in opportunities out there.

On the capital accounts side, maturing foreign currency debt of the public and private sectors for next year only at $ 6 billion, around half and half, and even with the tightness in international credit markets can be accommodated by GIR of $36.7 billion and FCDU deposits of $26.2 billion.

Lower Oil and Food Prices Bring Relief to Consumers,

With the clouds of recession in the horizon, cost of fuel is expected to stay at around $ 70, a far cry from the around $ 100 average price we paid over most of this year, which translates to about $2.5 billion in savings on an annual basis.    Conversely, this will both bring savings for consumers and help us register possibly still a surplus despite assumptions on flat exports, BPO, tourism and even assuming a flat OFW remittance earnings, all told.

The lower prices of oil and food will also help keep consumption spending going, as we see a reversal in what we saw at the beginning of this year, plus a more depreciated currency than past two years, and will drive what we expect to continuing modest growth of 4%.

Prices, Interest Rates, Monetary Policy

Inflation is projected to hit an average of 9.8% and 6.5% this year and in 2009, respectively, taking into account these developments and the spent up effect of the peak in rice and oil prices.

Despite the lower inflation expected for next year due to these developments, we think there will be pressure on domestic interest rates driven by:

- Global risk re-pricing, as evidenced in higher spreads of RoPs (Show graph). Today I have just heard that this has spiked to higher than in excess of 600 bps for 5 year instruments.  Also driven by rush liquidation of foreign holders who are pressed for liquidity, we saw this with high level of hot money outflows last month.

RoP’s give absolute yield higher than local rates (8.9% vs. 8.4% the other day) and coupled with no withholding tax on it, will create pressure on local rates.

Tightness in dollar liquidity and freezing/long que for bond financing may mean the government and private firms would need to rely on even more domestic borrowing than the earlier planned 75 percent of the deficit.  May also mean maturing foreign currency public and private debt will be funded in domestic market putting pressure on local interest rates and the currency.

There are expectations of the BSP easing up on policy rates or reserve requirements, with the shift in balance of concerns away from inflation towards promoting growth. However, with the higher risk premium demanded by savers globally, this may simply encourage speculation against the peso.  (It helps that some of the hedge fund players are no longer around.)

Fiscal Policy

We are heartened that economic managers plus one (i.e. our friend Gov. Joey Salceda) are no longer talking about a fiscal stimulus package but rather a “re-alignment” of the budget at a time when markets are nervous, spreads are rising.

I think many now recognize that growing more slowly next year to say between 3.5 to 4 percent is not the worst thing that can happen in a situation where markets are prone to irrational, sometimes, panic behavior.

We are confident that government will not throw away the gains from fiscal consolidation that has been achieved over the years, including the most helpful VAT law, and will broadly stay within its fiscal targets even if not exactly the balanced budget in 2010 earlier aimed for.  There seems to be resolve, despite what may seem like “public relations” for pro-poor spending to keep to a conservative and cautious position.  Clearly there will be pressure on the revenue collection side, arising from lower growth, some programmed/ legislated declines in taxes – eg. corporate income tax, exemption from income tax of minimum wage earners, underachievement of privatization revenues in an environment where market players are attaching a high premium to being liquid.  But if the revenues don’t come in, I think there will be corresponding control in spending to keep it manageable, as has been done in the past.  Does not promote development, but government can do worse by shooting itself in the foot.

As we move closer to 2010, or even possible earlier initiatives to mount later this year or early next year, a chacha musical show on the road, there may be relaxation in the quality of spending towards hard to audit agricultural commodities that are distributed via local governments, but I have some confidence that this will not come at the expense of macro-stability, only lower priority spending like infrastructure and maybe education and health. (This is supposed to be a joke ;^)

In this respect, we can also support Sen. Mar’s endorsement of government’s intended conditional cash transfer program, including his proposal to double it, provided it is kept away from political agenda.  It would also be a good opportunity, to find the resources to support this without busting the deficit targets, to re-align spending for programs that have not proven effective, and indeed may have been source for leakages and efficiency drags on the economy, like NFA subsidies and land reform.

(Today’s papers report a proposed $2 billion fund.  Some of us can only hope it goes the same way as the reported $10 billion fund.)

Government response.

There have been yesterday, which continues this morning, disturbances in emerging markets, including further widening in the ROP spreads, problems and near defaults in  Pakistan, Argentina, and perhaps elsewhere that have made the concern over the health of the Philippine financial system paramount at this time.

So far, government response, especially from the BSP has been properly calibrated – by and large appreciating that over-reaction or poorly thought out responses can actually erode market confidence in a situation where confidence is at the bedrock of financial stability. This is clearly job one.

Part of the calibrated response we are seeing include:

- Easing pressures on liquidity for both peso and dollar markets, including providing special facility to liquefy ROP’s, which is over 30 percent of the banking system portfolio, and under particular stress from risk aversion;

- Potential revisions on a temporary basis of mark to market guidelines to alleviate pressure on banks’ books that drive their demand for dollars in order to fully cover dollar deposits when ROP’s are under such global stresses;

More can be done to strengthen the arsenal of our monetary and fiscal authorities to respond to global market turbulence:

- Increase the capital of the BSP to make good on what was in the BSP law passed more than a decade ago.  There has been mention of tranching this on a multi-year basis in order not to create a large visible headline budget impact, and doing “securitization” financing for this.  I think this is undue complication—and that a simple up front appropriation and release is the way to go.  The recorded increase in the budget will be well read by keen eyed market analysts, not as expenditure – the way some of the fiscal stimulus packages we read about, whether off or on budget – but as something that strengthens the system.  Besides, I gather that BSP has already earned half of that P40 billion this year and will be “dividended” up to government, i.e. offsets against this “expenditure item”.

- Similarly PDIC capitalization need to be strengthened.  Can support Sen. Roxas suggestions for an increase in deposit guarantees.  While some modest – and I emphasize “modest”-- upward adjustments in amount guaranteed on a time bound basis may be useful.  I think we need to be careful that this does not lead to a situation where we may be rewarding banks that take imprudent risks (or worse those that may have built a business model based on exploiting moral hazard opportunities).

In this respect, it is a necessary corollary to discussion to increasing deposit guarantees that our lawmakers strengthen the supervisory powers of both the BSP and the PDIC.

In particular –
- Strengthen legal protection of bank examiners, including:  revising the concept of “extra-ordinary due diligence”, unique to Philippine regulatory regime that have been used by erring owners as a sword over the heads of supervisors doing their jobs;
- Enabling power to write down value of shares of bank owners.

Other things that can be done, this time by the fiscal authorities, could be to issue more warrants (that allow conversion of dollar ROP’s in pesos) that relieve pressure on banks to unload them to meet capital requirements.

What not to do: would be to embark on interventions that are not poorly thought through, and can actually spook the markets because: a) no money, b) no execution capability, or c) no trust/credibility.

Risk Factors

A reading such as this would not be complete without an enumeration of risk factors.  I will not belabor them as I consider the chances of them happening as remote and are largely manageable.

These are:

- A much deeper and longer recession globally than the base case that we used for our forecast, i.e. from October IMF, i.e. a recession and a gradual recovery towards the end of 2009.

- An event triggered widespread pressure on the financial system and against the peso driven either by a domestic event or contagion from similarly situated countries.  This, against a backdrop of neighbors that have provided blanket guarantees on all bank deposits, “beggar thy neighbor” policies.  (though again, highly unlikely in given health of the system and tools available to savvy authorities);

- A perfect storm – combination of stress in the economy with heightened political strife driven by very unpopular political initiatives to amend constitutional term limits.  (Though I disagree with political analysts who say efforts will be pursued by the leadership by all means and at all costs.)

In sum, despite the turbulence we read every time we open our newspapers for the past months now, we are clearly better placed – thanks to fiscal consolidation, health of the banking system and healthy reserves, and financial authorities that are alert and with enough ammunition, for us all to weather the storm than perhaps at any other time in recent memory.  Not an island of calm, but we will certainly stay afloat.

Thank you and good day.

Capital market

FINEX
Business World

With-out much fanfare, a very important bill has been passed in the bicameral conference before Congress adjourned last month - the Personal Equity Retirement Account (PERA).

The bill provides tax incentives for long-term savings that will help fund long-term investments. In the works for several years now, it is puzzling that the President has not signed the bill into law yet. It would have made a perfect pasalubong to our kababayans when she visited the US. The law-in-waiting provides a maximum PERA annual contribution to the tax-free savings account of P100,000, and in the case of Overseas Filipino Workers, double this amount.

Institutions active in the Capital Market Development Council jointly chaired by the secretary of finance and a private sector representative (former Finex President Dave Balangue) are hoping for the passage of another important bill for development of financial markets - the Credit Information System Act (CISA). This bill is critical to financial market development because it will facilitate and lessen the cost of lending. With the mandatory submission of standard credit information on a timely manner, credit evaluation will be much easier.

As observed in a recent IFC paper, credit bureaus are essential elements of the financial infrastructure that facilitates access to finance. In particular, improved credit information helps increase the likelihood of small businesses being able to access credit. As much as 49% of small entrepreneurs reported high financial constraints in countries without credit bureaus, vs. only 27 percent for those that have them.

The bill has passed third reading in both chambers. But players in the financial market have raised important concerns over revisions in the features of the bill. In particular, the House version provides for a Credit Information Corporation to be 60% owned by government. This subjects it to restrictions on budgetary appropriations, bidding, and salary standardization law - a sharp departure from the public-private partnership that was the anchor for the original bill, and that has been found to work in other contexts.

Of even more serious concern is the regulatory framework. The original bills provided for the BSP to be the regulator, given that it supervises the majority of credit providers and has an overarching responsibility and enforcement power over credit matters. Instead, the bills now look only to the SEC to be the sole regulator. To be fair, it is an institution that is quite competent as well, but it has more general responsibilities in overseeing corporations.

As the IFC study noted, the role of the supervisor is crucial.

"It is the supervisor's role, as a trusted, reputable third party, to play the role of setting an enabling environment for credit reporting to flourish. By establishing the right regulatory environment, increasing cross-sector participation and hence the number of lenders contributing information and the quality of information they provide, many other variables - sector competition, increased sophistication of lenders, quality and pricing of bureau services, usage penetration and overall development and efficiency of infrastructure - will follow an outward expansion through market forces. "

The twin problems of (a) having a start-up institution which has the usual limitations covering government corporations and (b) leaving out the BSP from the regulatory framework are expected to impair the development and effectiveness of the institution in pursuing its mandate from day one of its corporate life. We are hopeful that the sponsors of the CISA bill in both houses can address these concerns in the bicameral committee and hammer out, on the back of the passage of PERA, a double win for financial and capital market development.

Power struggles

ANALYSIS
Business World

Since its passage in 2001, the Electric Power Industry Reform Act (EPIRA), the law setting out the restructuring of the power sector, has gone through a slow start and progressed in what seems like fits and spurts.

The year 2007 turned out to be one of the good years. Government, through the Power Sector Assets and Liabilities Management Corporation (PSALM), was able to dispose of some of the large generating assets, most notably two coal-fired power plants, Masinloc and Calaca, each with a rated capacity of 600MW. It also managed to off-load via a concession agreement the Transmission Company, whose franchise from Congress is expected to pass this year. This is something that it had failed thrice to do.

By the end of 2007, having privatized over 40% of generating assets, government finally came within sight of its 70% asset sale goal.

Nevertheless, after PSALM opened up other generating assets for sale in the early part of 2008, a sense of uncertainty settled anew over the industry. In a biting article that pieces together developments in the past months, the Wall Street Journal comes to a view that government is backtracking on its commitment to privatize the electricity industry. However, a less pessimistic, though still worrisome picture emerges from discussions with local players knowledgeable about the industry.

Distorted price signals

From what we gathered, the latest deadlock is more likely linked to recent developments in electricity pricing that highlight weaknesses in the spot market and the regulatory environment, which can be expected to lead to a withdrawal of investor interest. In the last two months, spot prices at the Wholesale Electricity Spot Market (WESM), the country's power trading platform, dropped sharply to their lowest levels since the start of operations (Chart 1), reportedly falling below the variable operating cost of an efficient coal-fired power plant. From all indications, the price drop was likely the result of the market's thinness, which makes prices susceptible to swings in the bids of a small group of players, mostly still government, operating under a weak or non-existent incentive framework at this time.

Also last June, the Energy Regulatory Commission (ERC) decided that the National Power Corporation (NPC) should reduce electricity tariffs by 71 centavos per kilowatt-hour (kWh) in Luzon, the country's largest power grid. This appeared to have been a surprise to NPC. The decision was in response to NPC applications for (a) a reported 37-centavo increase in its basic generation charge and (b) a 40-centavo decrease in pass-through costs related to fuel, purchased power and currency adjustments from an earlier period (2006), or a net reduction of 3.62 centavos/kWh. The ERC decision was based only on the second request, applying in addition "carrying costs" to account for the delay in implementation. It has yet to act on the application to increase generation cost.

While it would be tempting to read more into the twin price cuts, we think, based on discussions with industry experts, that these are in fact independent developments rather than politically driven populist moves. The WESM, created in June 2006, continues to suffer birth pains, related largely to the market dominance of government trading teams, that have affected its efficiency in price discovery.

The ERC, order on the other hand, appears to be a delayed and ill-timed ruling for past adjustments. Apparently, electricity tariffs, which were supposed to adjust with exchange rate movements, failed to do so when the peso was appreciating in the 2006-07 period. Given the time lag and in light of current high fuel costs, there had been informal agreements with the regulator to stretch out the refund of overcharges over a longer- than-prescribed time period so as to maintain electricity tariffs near the industry's "long-run avoidable cost," or the generation cost of the most efficient new entrant, approximated at P4.30/kWh. However, ERC decided in the end to play by the rules, applying the prescribed six-month recovery period, thus ordering a much larger rate reduction. This had the effect of distorting price signals, considering that markets have moved on since 2006, which reduces incentives for conservation. NPC is reportedly now challenging the reduced rates.

Risk to public finances

From the viewpoint of NPC finances, the larger-than-sought for rate reduction may not be deleterious, considering past over- recoveries, if NPC were operating in a more mature regulatory environment. Under the rules, input costs may be recovered through a rate adjustment mechanism implemented on a quarterly basis. Given the unpredictability of regulatory decisions, however, a tariff increase in a time of economic hardship may not be guaranteed. Hence, it would be more prudent to consider a lump-sum payment for refunding accumulated overcharges, rather than tinker with the tariffs.

There remains, however, the question of NPC's basic generation rate, which reflects the operating cost of its mix of power plants and is where profits are embedded. The gap between the current rate, i.e., P3.89/kWh, and the P4.30/kWh long-run avoidable cost, already significant, is growing.

By one estimate, recent cost increases brought about by high fuel prices have pushed the number up to as much as P4.45/kWh. If fuel costs stay at current levels or worse, continue to rise, ERC would have to act on NPC's rate increase application. Not doing so would risk the public sector's fiscal health as has happened prior to late 2004.

An important consideration too is that not only are private players looking at WESM rates, the prices of transition supply contracts attached to some of the generating assets sold are linked to NPC rates and are thus exposed to rising raw material costs. These transition supply contracts were meant to increase the value of the assets by assuring winning bidders of a ready market for power generated.

Already, local banks, which currently have large exposures to the power industry, are worried about the impact of low WESM prices on their borrowers' profitability. Insiders noted that the two newest entrants into the power market, AES (which bought the Masinloc plant) and Suez (Calaca plant), sell 30% and 25%, respectively, of their excess capacities through the WESM.

Meanwhile, the problems of the Manila Electric Company (Meralco), which accounts for about 60% of electricity sales in the Philippines, are a separate issue altogether. As of March 2008, government, through five of its agencies, owns about one-third of Meralco.

Risk to privatization

Another concern is that recent developments may derail government's privatization program.

Receipts from the sale of generating assets have been a major source of income for the public sector. Last year, PSALM earned over P20 billion from privatization-related activities.

On the side of the private sector, those who have already bought into the sector are concerned that open access, ushering in full competition where electricity buyers of a certain size can freely shop for suppliers, may not happen soon enough. Government is aiming to complete 70% of its privatization program by end-2008, a prerequisite for open access. In light of recent developments, industry players have grown doubtful that this will be achieved.

This would be a pity as fast-tracking privatization, which would bring in the critical mass of players and hopefully impose more discipline in the regulatory structure, appears to be the only way to ensure that all the elements envisioned for privatization to work can come into play.

Overall, the risk of the prevailing uncertainty in the power sector is that more delays in the privatization program can potentially damage economic growth should the needed investments in power generation capacities fail to materialize. Not only is there a risk of returning to the rotating blackouts experienced in the early 1990s, but the fiscal cost of bailing out the economy from these blackouts may set economic growth back anew over the medium term.

Fiscally challenged

THE FINANCIAL EXECUTIVE
Business World

The Philippines has become the world's poster child for fiscal consolidation, and appropriately so in many ways. Within just a few years, the country has been able to slash budget deficits, cut public debt, and reduce external vulnerability without the domestic economy having to undergo a painful recession. The degree of fiscal correction (4% of GDP in just three years) is truly exceptional for a country not yet in a fiscal or financial crisis.

Hoping to live up to its newly minted reputation, the current administration is aiming for a zero budget deficit this year, a first in over a decade. This last feat would supposedly seal investor confidence in the domestic economy and eventually bring down the risk premium attached to the country's debt.

But as most analysts agree, this year may not be the most opportune time for balancing the budget with an expected global slump and rising inflation combining to slow growth.

Not only will the spending side be affected as government feels the pressure to provide subsidies (e.g., on food and fuel) especially to the poorest segments of society, but revenues may also be placed at risk as the clamor for lower taxes intensifies.

As if on cue, the President recently remarked that a balanced budget may not be achieved this year and that creditors would understand such failure in light of emerging economic conditions and for as long as the country demonstrates a strong capacity to raise revenues. Some have mourned this pronouncement as the end of the era of fiscal consolidation. Some, however, have cheered this on as they believe that an economic slowdown, especially in a developing economy, is no time for severe fiscal restraint anyway.

However, finance officials I have talked to insist that the government remains devoted to the original fiscal program. Even as they gave no assurance that a zero deficit goal will be met, they have crowed that government has so far been able to meet its fiscal targets.

With lesser reliance on privatization sales this year, the country's tax collection agencies are expected to do the heavy lifting. In the first quarter, the Bureau of Internal Revenue (BIR) surpassed its target while the Bureau of Customs (BoC) was very close to meeting its goal. In April, the country reported a P25.8-billion budget surplus, with BIR and BOC revenues growing by about 20% and 26%, respectively.

If finance officials seem to be less concerned than expected by the effects of macroeconomic shocks this year, one only has to look at their estimated budget sensitivities to see why. According to Department of Finance (DoF) calculations, the most-feared developments today - soaring import prices, heightened inflation, and higher domestic interest costs - actually serve to improve the budget balance (e.g., through higher customs duties and larger tax revenues).

While finance officials admit these are merely first-round effects which should hold true for as long as economic activity remains robust, they say the unfavorable longer-run impact (e.g., slower growth and hence lower corporate income taxes) can be expected to emerge only after two quarters, giving them a slight buffer this year this year. The fly in the ointment appears to be the continued depreciation of the peso, and even then it is argued that net effects (rise in dollar debt payments less the increase in import taxes) will likely be negligible.

With regard to the country's long-term fiscal and economic health, it would seem that it is not so much the temporary deterioration of macro environment that we should be worried out, as the response of the government to the economic shocks as it impacts on the quality of public spending.

To date, the country is estimated to spend over P50 billion (about 1% of GDP) in food subsidies for rice price support. There is also loud clamor for a stronger buffer to the escalating costs of fuel and hence power. While it is a commendable gesture to shield the poor from increasingly harsher economic conditions, it is best that economic managers keep leakages to a minimum and prevent a distortion of incentives that may hurt productivity and adversely affect the poor in the longer run.

From a long-term perspective, a better use finances would be better quality spending with an eye to future development such as improved infrastructure, investment in health and education, and other outlays that can boost domestic efficiency. Going down this road, government's temporary fiscal policy adjustment can more widely be understood and may even be appreciated.

Do numbers paint correct picture?

THE FINANCIAL EXECUTIVE
Business World

The economy's phenomenal 7.3% growth last year not only exceeded expectations but also defied historical trends. It was, after all, the first time that economic performance broke past the 7% mark in over 30 years. But it was not the first time that mainstays in policy and academic circles have doubted the numbers. A growing number of experts are now finding it difficult to believe in recent growth trends.

One indicator that growth may have been overstated in the past several years is allegedly the way the national income accounts (NIA) and a national survey of households (the Family Income and Expenditures Survey or FIES) now paint totally different pictures of the economy.

As former Economic Planning Secretary Felipe Medalla repeatedly points out, whereas GNP and GDP statistics depict rapid growth in the new millennium, family income and spending as measured by the FIES, which is conducted every three years, grew at a slow pace during those years.

While personal consumption spending (PCE) under NIA expanded by 5.4% annually in 2003-2006, for example, family spending rose by only 1.7% on an annualized rate during the period. This had not been the case prior to 1997 when family spending typically outstripped PCE.

A similar break in the pattern is seen with regard to incomes. Family income grew by only 0.9% in 2003-2006 even as GDP grew by about 5.6%.

Another indicator is the fact that the poverty level has not declined - it even worsened lately from 24.4% in 2003 to 26.% in 2006. This occurred even as measures of inequality hardly changed and even slightly improved.

Some have attempted to explain the divergence in the pictures depicted by the two sets of data as due to differences in methods and definitions.

Presidential adviser Joey Salceda believes this divergence indicates that profits had instead gone to business and government rather than to households.

Joseph Yap of the Philippine Institute for Development Studies (PIDS) similarly attributes the apparent disconnect between the NIA and the FIES in terms of coverage and a presumably lower share of wages versus corporate profits. The FIES, he said, does not collect income and expenditures data from private corporations and government entities.

The PCE component under the NIA, in particular, includes spending by non-profit institutions serving households such as nongovernment organizations, religious groups, and political parties whereas the FIES data captures only the behavior of households. This is known to many poverty experts who have tried to reconcile national accounts and household survey trends in order to assess whether growth has been able to trickle down to the poor.

The question in this case becomes, which data set is correct?

Household surveys and national income accounts are known to have their own estimation weaknesses, with each having its own set of supporters. Some tend to doubt the latter more these days, however, because of inconsistencies with a few other data sets where, for instance, national accounts data were not found to correlate as well as the household surveys with income tax revenues.

To a certain extent, questionably high growth rates in recent years may be explained by the fact that the agency in charge of national accounts (the National Statistical Coordination Board or NSCB) has been slowly changing its methodology. The NSCB itself cautions against linking and comparing certain data points.

For example, it began to include high-growth industries such as BPOs (including call centers) and to correct for the supposed undercoverage of IT-related businesses beginning 2004, which may partly explain a jump in growth that year. The NSCB also started to alter how it measures manufacturing output which may help account for some of the emerging discrepancies found there.

To a large degree, inconsistencies point to a need to improve the gathering and processing of national income data to make it more reflective of what goes on in the real economy. Some of the weaknesses of the NIA noted by the IMF in country reports include the following: (1) inadequate capture of deaths and births of establishments in censuses; (2) use of an outdated benchmark year and fixed input-output ratios; and (3) inadequate statistical techniques in estimating GDP at constant prices. The first weakness mentioned may be particularly relevant in the present case, where sampling biases may have played a role.

Though the country's growth numbers are being debated, there does seem to be some consensus that the economy has indeed expanded in recent years. Two former economic planning secretaries (Cielito Habito and Mr. Medalla) agree on a useful rule of thumb in correcting for overstatement to make the figures more or less comparable to past growth (i.e. prior to 2004) - simply trim away one or two percentage points. This means last year's growth was likely in the 5.3-6.3% range - more in line with the historical average, yet still quite high.

Romeo L. Bernardo is president of Lazaro Bernardo Tiu and Associates (LBT), a boutique financial advisory firm based in Manila, and serves as GlobalSource advisor in the Philippines (http://www.globalsourcepartners.com).