Business World
Fiscal results for the first quarter look a bit disturbing, with the budget deficit more than doubling in size from a year ago and already about three-fifths of the new full-year target of P199 billion (2.5% of GDP, from 0.5% originally before being raised to 1.2% then 2.2% previously). Part of this traces to a significant acceleration of public spending under the fiscal stimulus plan (e.g., infrastructure and operational outlays up by over 60% even under a reenacted budget), but part can also be attributed to a sudden decline in revenues.
Arguably, collection agencies will continue to meet difficulties in improving their performance with the economic cycle currently not working in their favor - e.g., slower nominal income growth and a plunge in imports bringing down taxes and duties. In addition, tax relief measures repackaged as components of the state's economic resiliency plan with an attached cost of P40 billion further weigh down revenue collection this year.
Notably, a couple of weeks ago, the Bureau of Customs asked the economic managers to further lower its target for the year of P277.2 billion, which was already adjusted from P317 billion previously set. First-quarter data show that the agency fell short of its program in the first three months by 16% or by 8.2 billion. On the other hand, the Bureau of Internal Revenue, whose revenue goal was lowered to P850.6 billion from P968.3 billion originally, also failed to meet its revised target of P165.3 billion in the same period by 6.4%. Authorities, likewise, cut BIR's VATcollections target this year to P196 billion from P205 billion last year.
Taking these developments into account, it will not be surprising to see the fiscal deficit as percentage of GDP reaching the neighborhood of 3% in 2009, plus some risk of it expanding. Because of structural erosion of revenues caused by changes in the tax system, it is also likely that the tax effort ratio will decline to 13.6% or possibly, even 13.3%.
There is wide acceptance of the need for a fiscal stimulus to sustain growth, however, as even credit raters and multilateral lending institutions acknowledge the merits of such a measure. The guessing game in the market now is whether or not the 3% mark will be breached because of looser spending. Risks that indeed it will just gained steam after Secretary Recto disclosed that the possibility of incurring a fiscal deficit of about P250 billion, or approximately equivalent to the marked number, is not at all remote.
High-level fiscal managers I recently conversed with say they will certainly not want the deficit to exceed 3% of GDP, which is presumably the dreaded scenario. However, there seem to be no strong assurances that spending will be reined in to pull together even a rapidly widening fiscal gap (i.e., if revenues drastically underperform). With the May 2010 elections nearing, it would be hard to imagine such fiscal tightening down the line.
This slippery slope underscores the urgency of passing more fiscal reforms as slippage would appear to place the country on an unsustainable path. The country's debt ratio had already climbed from 55.8% to 56.3% of GDP last year (though still far below the 78.2% peak half a decade ago) and may risk rising again this year on account of lower nominal growth, likely weaker primary surpluses, and a still depreciating domestic currency. Congress is considering bills on the rationalization of fiscal incentives, simplification of net income taxes, and adjustment of excise taxes (including on oil), but nearing elections may be seriously dimming the odds of their passage into law this year.
Concerns already aired by some groups about possible lack of transparency and wastage of these injections should also be noted, especially in light of the upcoming 2010 polls. As I have always argued, the best use of a fiscal stimulus in the Philippines is actually for long-term growth through the construction of much-need infrastructure (but should be "shovel- ready" to meet the near-term goal of job generation) and well-targeted spending to alleviate the plight of the poorest families while offering them incentives to improve their human capital (e.g., through conditional cash transfers).
In contrast, we need to be careful with fiscal spending with much leakage, e.g., estimated NFA deficit which last year accounted for P72 billion (1% of GDP), or of projects that have not been sufficiently studied in terms of technical aspects, economic returns and fiscal risks being assumed, especially for new large BOT projects being recently surfaced that are unlikely to be started until way after this crisis has blown over.
Quite apart from the actual drain and wastage in resources, we need to be mindful of the signaling effect on markets, including international markets for RoPs, that are still jittery. While there is some degree of market tolerance for widened deficits with the let's-get-fiscal mantra, there is also heightened concern over specific country conditions both in the external accounts and fiscal area, as we see a growing list of countries needing to go to the IMF for emergency relief since late last year (e.g., Iceland, Poland, Hungary, Georgia, Turkey, Serbia, Ukraine, Romania, Pakistan, Sri Lanka, Mexico, El Salvador, Zambia, and Kenya).
While the Philippines spreads have tightened from the highs we saw in October together with most emerging markets, holders of Philippine paper will be watching for reversal in gains in the fiscal front that can be evident from a decline in tax effort and increasing public sector debt to GDP, that is almost certain to happen this year - we all hope, within limited bounds. Sharp deterioration in these will not only affect the government's space for social and infra spending via higher debt service, but more immediately, translates to a damper on investment climate. This is especially true for the crucial banking sector, where sharp increases in the sovereign interest rates will put at risk via their holdings of government securities (on average 25% of assets), their income outlook and possibly even capital adequacy, and thus their continued ability to sustain healthy lending. "Controlled fiscal easing" (with emphasis on "controlled") as a WB friend puts it, is necessary to contain fiscal risk, especially with the prospect of slower remittance inflows in the coming months and the onset of election season later this year.
Romeo L. Bernardo is a board member of the Institute for Development and Econometric Analysis (IDEA), Inc.
Monday, April 27, 2009
Monday, March 9, 2009
Externalities and economic reform
Business World
Introspective
Sometime after the midterm test, students of microeconomics are introduced to a topic called externalities, an inelegant term that simply refers to spillover effects of a particular action. First impressions of externalities are typically negative - how self-interested decisions of farmers to put as many cows as possible on public pasture grounds result in the tragedy of the overgrazed commons, overgrazing being the negative externality.
Much less prominent but equally important is the concept of positive externality, where actions can generate unintended benefits for third parties.
While externality is associated with market failure that requires government intervention to correct - taxes for negative externalities and subsidies for positive externalities - government action itself can generate positive or negative externalities, something that governments need to consciously be mindful of when making decisions to act.
The significance of positive externalities stuck with us in the course of doing work for the World Bank Growth Commission that tried to study the political economy of reform during the Ramos period (a copy of the working paper may be downloaded from http://www.growthcommission.org/storage/cgdev/documents/gcwp039web.pdf). We picked three successful reform cases - water privatization, telecommunications de-monopolization, and oil deregulation - that we thought best illustrated the process of reform, the elements that made reform succeed, and the resulting increase in sectoral competition and improvement in service delivery.
However, more than the sectoral efficiencies or macroeconomic stability gained, what we thought notable were the positive externalities generated by achieving a critical mass of reforms (starting with the resolution of the power crisis) within a short period of time. This helped to win public confidence, attract investor attention, and catalyze responses of a broader nature that expanded the economy's growth potential.
For instance, when Singaporean leader Lee Kuan Yew chided the Philippines in 1992 as a country where 98% of the residents are waiting for a telephone and the other two percent are waiting for a dial tone, nobody at the time realized that reforming the sector would spawn a new growth sector - business process outsourcing - for the country more than a decade later.
Similarly, the considerable positive externalities of the reform of the water sector in Manila dawned on me during a lecture of World Bank Vice President for research Danny Leipziger. His question to the audience was, "What is the single thing that explains best the quality of health in children, including infant mortality?" Answers from the audience included expenditures in public health, the number of doctors, education of mothers and their incomes, all of which were wrong. The simple answer was availability of drinking water.
Unfortunately, political instability, including what analysts consider a crisis in leadership, since the Ramos Administration has not allowed the extension of the reform to other sectors, e.g., rural water, air transport, the cement industry, agricultural commodities, ports and shipping. Pressures of the political environment have not only seen minimal follow-through in reforms but have led to government decisions that carried negative externalities in terms of their impact on long-term business investments.
An example is the non-adjustment of power rates during the Estrada administration through the Arroyo administration's first term. While this was corrected after the 2004 elections, we are now seeing something similar in the water sector with the non-implementation of agreed tariff adjustments based on the last rate rebasing exercise, a mechanism that has worked well in the past. Such actions not only expose government to the costs of potential contract disputes, but send very harmful signals that do not help reverse the decline in governance indicators since the Asian crisis.
Our case studies revealed how much leadership matters in influencing the timing of reform by clearly articulating the problems, pointing to the solutions, and rallying the people to push for change. Likewise, a maturing civil society that has a wider appreciation of the externalities generated by particular government actions seems to be more engaged now in supporting reform moves. As seen in the 2005 EVAT reform, though businesses and taxpayers realized that they would end up paying higher taxes, there was an appreciation that the reform being pushed by government would reap wide benefits to the economy and the country.
Romeo L. Bernardo is a board member of the Institute for Development and Econometric Analysis (IDEA), Inc.
Introspective
Sometime after the midterm test, students of microeconomics are introduced to a topic called externalities, an inelegant term that simply refers to spillover effects of a particular action. First impressions of externalities are typically negative - how self-interested decisions of farmers to put as many cows as possible on public pasture grounds result in the tragedy of the overgrazed commons, overgrazing being the negative externality.
Much less prominent but equally important is the concept of positive externality, where actions can generate unintended benefits for third parties.
While externality is associated with market failure that requires government intervention to correct - taxes for negative externalities and subsidies for positive externalities - government action itself can generate positive or negative externalities, something that governments need to consciously be mindful of when making decisions to act.
The significance of positive externalities stuck with us in the course of doing work for the World Bank Growth Commission that tried to study the political economy of reform during the Ramos period (a copy of the working paper may be downloaded from http://www.growthcommission.org/storage/cgdev/documents/gcwp039web.pdf). We picked three successful reform cases - water privatization, telecommunications de-monopolization, and oil deregulation - that we thought best illustrated the process of reform, the elements that made reform succeed, and the resulting increase in sectoral competition and improvement in service delivery.
However, more than the sectoral efficiencies or macroeconomic stability gained, what we thought notable were the positive externalities generated by achieving a critical mass of reforms (starting with the resolution of the power crisis) within a short period of time. This helped to win public confidence, attract investor attention, and catalyze responses of a broader nature that expanded the economy's growth potential.
For instance, when Singaporean leader Lee Kuan Yew chided the Philippines in 1992 as a country where 98% of the residents are waiting for a telephone and the other two percent are waiting for a dial tone, nobody at the time realized that reforming the sector would spawn a new growth sector - business process outsourcing - for the country more than a decade later.
Similarly, the considerable positive externalities of the reform of the water sector in Manila dawned on me during a lecture of World Bank Vice President for research Danny Leipziger. His question to the audience was, "What is the single thing that explains best the quality of health in children, including infant mortality?" Answers from the audience included expenditures in public health, the number of doctors, education of mothers and their incomes, all of which were wrong. The simple answer was availability of drinking water.
Unfortunately, political instability, including what analysts consider a crisis in leadership, since the Ramos Administration has not allowed the extension of the reform to other sectors, e.g., rural water, air transport, the cement industry, agricultural commodities, ports and shipping. Pressures of the political environment have not only seen minimal follow-through in reforms but have led to government decisions that carried negative externalities in terms of their impact on long-term business investments.
An example is the non-adjustment of power rates during the Estrada administration through the Arroyo administration's first term. While this was corrected after the 2004 elections, we are now seeing something similar in the water sector with the non-implementation of agreed tariff adjustments based on the last rate rebasing exercise, a mechanism that has worked well in the past. Such actions not only expose government to the costs of potential contract disputes, but send very harmful signals that do not help reverse the decline in governance indicators since the Asian crisis.
Our case studies revealed how much leadership matters in influencing the timing of reform by clearly articulating the problems, pointing to the solutions, and rallying the people to push for change. Likewise, a maturing civil society that has a wider appreciation of the externalities generated by particular government actions seems to be more engaged now in supporting reform moves. As seen in the 2005 EVAT reform, though businesses and taxpayers realized that they would end up paying higher taxes, there was an appreciation that the reform being pushed by government would reap wide benefits to the economy and the country.
Romeo L. Bernardo is a board member of the Institute for Development and Econometric Analysis (IDEA), Inc.
Monday, January 26, 2009
Let's get fiscal (Philippine style)
Business World
Introspective
With the synchronized recession everywhere, the call of the day even from such pillars of fiscal conservatism as the IMF is "fiscal stimulus." Such policy is seen as a way to counter a slowdown in global demand - which may affect exports, investments, and for countries like ours, workers' remittances - given the limitations of monetary policy in an environment of depressed consumer confidence, constrained financial markets and low interest rates (a potential "liquidity trap").
What is sometimes overlooked is the difference in country situations. As the IMF said, "While a fiscal response across many countries may be needed, not all countries have sufficient fiscal space to implement it since expansionary fiscal actions may threaten the sustainability of fiscal finances. In particular, many low income and emerging market countries, but also some advanced countries, face additional constraints such as volatile capital flows, high public and foreign indebtedness, and large risk premia."
What is appropriate for the US or China may not be appropriate for a country like the Philippines. The US, though at center of the storm, is still owner of the printing press for the world's reserve currency and has the capacity and responsibility for helping pull the world out of a potentially deep depression. The same goes for most countries in the euro zone. China has abundant international reserves as do Japan and many other East Asian countries.
Not so the Philippines. The country has only limited fiscal and debt headroom and still relies heavily on domestic and international capital markets, which continue to be bugged by risk aversion.
Debt-to-GDP ratio, while having been brought down from 78% in 2004 to only 57% last year (as of the third quarter), is still high relative to similarly rated peers and still higher than the lows achieved ten years ago. While recent borrowing by the Bureau of the Treasury had been inspired, it was still six percentage points over US Treasuries, revealing skittishness of investors for Philippine securities.
Government economic managers have been careful to characterize the fiscal stimulus package as manageable, and rightly so, as the markets have not shown adverse reaction so far. As well analyzed by Dr. Philip Medalla, the government can afford a public deficit of 2% to 3% of GDP (P150 billion to P200 billion) and keep its debt ratio on a declining trend - if it has a buoyant tax system (tax effort not declining), if it makes better use of taxpayers' money, and if macro stability and fiscal credibility can be maintained and off-budget deficits reduced.
Philip emphasizes that fiscal stresses over the past three decades have not come from the national government deficit but from surprises from contingent liabilities.
As government talks about a fiscal stimulus - or what they have labeled as the Economic Resiliency Package - to protect growth, it behooves us to remember how fiscal surprises in the past have raised the cost of credit to high levels.
What are the contingent, off-budget risks that the country's authorities should be mindful of and monitor closely (as indeed they do)?
One major category consists of borrowings of government firms guaranteed by the government. The NFA's debts come to mind, the agency being the biggest borrower lately. There are also potential risks in the National Development Corp. (NDC) and other GFIs providing seed money for a P100-billion fiscal stimulus package championed by some groups in the private sector (the Philippine Chamber of Commerce and Industry, in particular).
Other possible sources of contingent risks include the guarantees provided to failing banks, perhaps including a syndicate of rural banks whose business model seems patterned after the Madoff scheme, and the opaque accounting of some GFIs and government corporations.
While the numbers being discussed for the stimulus package are not alarming relative to GDP (around 3%, maybe up to 4%), this will need to be appreciated in view of likely declines in tax collection and tax effort. The dip in performance will trace not only to slower economic activity and lower corporate profits, but will be partly structural in nature - i.e., due to a lowering of the corporate income tax rate from 35 to 30%, exemptions granted to minimum wage earners, and continuing non-indexation of sin taxes.
With elections nearing, Congress cannot be expected to act with much resolve on taxing matters. So, one can imagine a fiscal slow burn becoming incendiary if markets get nervous for any variety of reasons - financial contagion and capital reversal or even political turmoil occasioned by an unwelcome Latin dance.
So by all means, let's get fiscal. But let's do it in a way that is controlled and transparent. The conditional cash transfer program (e.g., grants to the poor provided their children stay in school) delivers an excellent fiscal stimulus because it is not only effective (translates immediately to consumption and GDP increase) but also has the ability to alleviate poverty. Noteworthy is the public confidence in the leadership of the Department of Social Welfare and Development (DSWD) and the sponsorship and technical support of the World Bank, which already has many success stories under its belt (notably, Indonesia and Brazil). By contrast, we should beware of rushing spending on ill-prepared projects that will unlikely result in any activity, and will probably just be wasteful (think fertilizers in 2007 and the North Rail-ZTE project).
Introspective
With the synchronized recession everywhere, the call of the day even from such pillars of fiscal conservatism as the IMF is "fiscal stimulus." Such policy is seen as a way to counter a slowdown in global demand - which may affect exports, investments, and for countries like ours, workers' remittances - given the limitations of monetary policy in an environment of depressed consumer confidence, constrained financial markets and low interest rates (a potential "liquidity trap").
What is sometimes overlooked is the difference in country situations. As the IMF said, "While a fiscal response across many countries may be needed, not all countries have sufficient fiscal space to implement it since expansionary fiscal actions may threaten the sustainability of fiscal finances. In particular, many low income and emerging market countries, but also some advanced countries, face additional constraints such as volatile capital flows, high public and foreign indebtedness, and large risk premia."
What is appropriate for the US or China may not be appropriate for a country like the Philippines. The US, though at center of the storm, is still owner of the printing press for the world's reserve currency and has the capacity and responsibility for helping pull the world out of a potentially deep depression. The same goes for most countries in the euro zone. China has abundant international reserves as do Japan and many other East Asian countries.
Not so the Philippines. The country has only limited fiscal and debt headroom and still relies heavily on domestic and international capital markets, which continue to be bugged by risk aversion.
Debt-to-GDP ratio, while having been brought down from 78% in 2004 to only 57% last year (as of the third quarter), is still high relative to similarly rated peers and still higher than the lows achieved ten years ago. While recent borrowing by the Bureau of the Treasury had been inspired, it was still six percentage points over US Treasuries, revealing skittishness of investors for Philippine securities.
Government economic managers have been careful to characterize the fiscal stimulus package as manageable, and rightly so, as the markets have not shown adverse reaction so far. As well analyzed by Dr. Philip Medalla, the government can afford a public deficit of 2% to 3% of GDP (P150 billion to P200 billion) and keep its debt ratio on a declining trend - if it has a buoyant tax system (tax effort not declining), if it makes better use of taxpayers' money, and if macro stability and fiscal credibility can be maintained and off-budget deficits reduced.
Philip emphasizes that fiscal stresses over the past three decades have not come from the national government deficit but from surprises from contingent liabilities.
As government talks about a fiscal stimulus - or what they have labeled as the Economic Resiliency Package - to protect growth, it behooves us to remember how fiscal surprises in the past have raised the cost of credit to high levels.
What are the contingent, off-budget risks that the country's authorities should be mindful of and monitor closely (as indeed they do)?
One major category consists of borrowings of government firms guaranteed by the government. The NFA's debts come to mind, the agency being the biggest borrower lately. There are also potential risks in the National Development Corp. (NDC) and other GFIs providing seed money for a P100-billion fiscal stimulus package championed by some groups in the private sector (the Philippine Chamber of Commerce and Industry, in particular).
Other possible sources of contingent risks include the guarantees provided to failing banks, perhaps including a syndicate of rural banks whose business model seems patterned after the Madoff scheme, and the opaque accounting of some GFIs and government corporations.
While the numbers being discussed for the stimulus package are not alarming relative to GDP (around 3%, maybe up to 4%), this will need to be appreciated in view of likely declines in tax collection and tax effort. The dip in performance will trace not only to slower economic activity and lower corporate profits, but will be partly structural in nature - i.e., due to a lowering of the corporate income tax rate from 35 to 30%, exemptions granted to minimum wage earners, and continuing non-indexation of sin taxes.
With elections nearing, Congress cannot be expected to act with much resolve on taxing matters. So, one can imagine a fiscal slow burn becoming incendiary if markets get nervous for any variety of reasons - financial contagion and capital reversal or even political turmoil occasioned by an unwelcome Latin dance.
So by all means, let's get fiscal. But let's do it in a way that is controlled and transparent. The conditional cash transfer program (e.g., grants to the poor provided their children stay in school) delivers an excellent fiscal stimulus because it is not only effective (translates immediately to consumption and GDP increase) but also has the ability to alleviate poverty. Noteworthy is the public confidence in the leadership of the Department of Social Welfare and Development (DSWD) and the sponsorship and technical support of the World Bank, which already has many success stories under its belt (notably, Indonesia and Brazil). By contrast, we should beware of rushing spending on ill-prepared projects that will unlikely result in any activity, and will probably just be wasteful (think fertilizers in 2007 and the North Rail-ZTE project).
Monday, December 8, 2008
Dollar ROPs: blessing and curse
Introspective
Business World
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.
Thursday, October 23, 2008
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 IncognitaWe 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.
Tuesday, July 22, 2008
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.
Thursday, July 17, 2008
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.
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.
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