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.
