Scenarios

THE FINANCIAL EXECUTIVE
Business World

I was recently part of a three-man international team tasked by a major donor group to look at the Philippine situation and identify areas where it can direct its assistance. We thought it would be useful to do some scenario analysis of where the country may be five years from now and what are the things that may bring them about.

Scenario 1: Muddling through

Over the past two decades and especially since the Asian crisis, the Philippines' growth pattern can best be described as "muddling through" - not quite able to mount the critical mass of action needed to attract investments and put the country to a higher growth path; not quite performing poorly enough to trigger a crisis, given the reliability of workers remittances and competent fiscal managers who make sure through budget management that the continuing poor revenue performance does not cause a complete loss of creditor confidence, and a fiscal meltdown. This unimpressive and low-quality historic growth record, coupled with the lack of a population management policy, has consigned a third of the people to below the poverty threshold and perhaps their children and grandchildren too, especially if government, due to its budget constraint, continues to falter in providing them the needed education and health care, and the economy the needed physical and institutional infrastructure with which to bring them and the economy out of the poverty cycle.

Without reforms on the fiscal front as well as in the regulatory framework and institutional capability to be able to attract more investments and generate more jobs to keep Filipinos gainfully employed within the country, the Philippines can be expected to continue to just muddle through.

Scenario 2: Crisis.

Worse than muddling through is the risk of an Argentina-like debt crisis founded on government's inability to deal with unsustainable fiscal deficits and growing pubic external debt. The large amount of public debt in foreign currency that needs to be refinanced annually ($4 billion) makes the country vulnerable to event risk, i.e. political or economic event that makes financial markets unwilling to refinance such amounts when due. Political instability feeds this process and vice versa, as seen in many country experiences in the past - including the Philippines in 1983 to 1986. The political situation will have its own dynamics that are completely unpredictable, which may include chaos and installation of a new leader. The impact of such a crisis on the economy could be devastating. During the Philippines' crisis in the mid-'80s, domestic output contracted by 7%-8% for two consecutive years, inflation reached almost 50% in 1984, and the local currency fell from about P8.50/$ to P20.40/$ over a four-year period.

Although this scenario is not very likely under "normal" states of the world, it is an event-triggered nightmare (and there is no telling what external or domestic shock could trigger it), and thus, a very real risk, as can be concluded from an ADB study likening government debt management to a Ponzi game (i.e., incurring new debts to pay for old ones).

Scenario 3: Opportunity

What we labeled a "high" case scenario would see the country achieving the ambitious targets set forth in the Medium Term Philippine Development Plan 2004-2010, that is, by the end of the plan period, a sustainable growth rate of 7.5%, balanced fiscal budget, poverty incidence cut by a third from 30% to 20%. Developments over the past three months have already improved the chances for this outcome: the death of actor-turned political Fernando Poe, Jr. and an effective (if somewhat tragic) end to the presidential electoral challenge; and action taken by the executive that seems to suggest heightened political will to pursue bold action:

Adjustments in power tariffs;
Pushing for new tax measures (indexation of sin taxes which were passed and the increase in the VAT which is in deliberation at the Senate after being passed in the House of Representatives),
Lobbying by the administration that led to the Supreme Court decision favoring the opening up of the mining industry to foreign investors despite opposition from "cause-oriented" groups,
Measures that led to the Paris-based FATF to take the Philippines out of the watch list for money laundering, and
Appointment of highly regarded professionals in key cabinet positions (Departments of Finance, Trade and Industry, Energy and the Bangko Sentral ng Pilipinas) and reportedly providing them with a freer hand than their predecessors.
Early results in terms of positive business confidence, economic growth and job creation will enhance political will, public support, and investor interest and can lead to a virtuous cycle.

Nowhere is this more obvious than in the case of the VAT bill (increasing the rate by 2% and removing most of the exemptions) where we are at the tipping point that will define our long-term direction. This is a crucial piece of legislation that dramatically frontloads government's fiscal efforts in a credible and sustainable way. In the form submitted by the executive, it can yield P52 billion to P75 billion (1% to 1.5% of GDP) per DoF estimates. Given the 1.5% primary surplus (equivalent of private firms' EBITDA) achieved last year, this measure alone could raise the primary surplus to or past the 2.5% of GDP mark computed by the UP economists as the level needed to stabilize the debt to GDP ratio.

Nothing else can yield such an impressive and early result - estimated revenue from sin tax only P15 billion - and no other window exists for such a major fiscal fix given elections coming up in two years. Many investors (both foreign and local) in recent weeks have placed a bet that this bill will pass - thus explaining buoyant activity and pumping up stock market, exchange rate, and credit markets. If the VAT craters, they will surely dump their bets, maybe for the last time.

The country is at a defining moment. Where the VAT goes, the country goes.

A perfect storm

MANILA, PHILIPPINES

Commentary

At the rate the President's fiscal measures are being taken up in Congress, analysts are becoming more and more worried that we're headed for a crisis -- one in the truest sense of the word.

Already, rating agencies have warned of another credit downgrade if nothing is done to improve the government's fiscal position.

Worrisomely, the way things look, only three bills are likely to pass before the end of the year -- Attrition Law (yawn), Tax Amnesty (good grief) and a diluted alcohol and tobacco tax, which will raise the impressive amount of PhP3 billion to PhP6 billion, much less than the DoF-estimated PhP14-billion potential revenues.

A one-notch credit downgrade is expected to raise the government's financing cost by about 25 basis points, which translates into additional interest expense of PhP400 million on a $3-billion refinancing requirement for 2005 of the national government and Napocor alone (i.e., not counting additional costs of new deficit financing and borrowings of the private sector). The increased spreads moreover will likely be accompanied by higher base interest rates given expectations of further monetary tightening particularly in the US (interest rate on three-month dollar commercial paper projected to increase from 1% in 2003 to 5% by 2006).

It is unfortunate that after belatedly and reactively recognizing that the country is facing a crisis and pushing spreads on Philippine bonds up by almost 100 bps, the President and Congress have yet to do something that the market respects as addressing the fiscal problem.

Indeed, the only thing worse than denial of a serious situation is to recognize it but then be completely incapable of doing anything about it.

And time is running out.

Even as another corruption scandal, this time involving the military, grips the nation and sows unrest among junior officers, world oil prices are rising at a dizzying pace not seen since the 1980s oil price shock. While oil prices today, in inflation-adjusted terms, are still about 40% lower than prices then and economies worldwide have since become less dependent on oil, for a country like the Philippines that's dependent on imported oil, higher oil prices translate directly into larger foreign exchange outflows.

This is worrisome as one of the country's strengths to date (and one aspect that distinguishes it from Argentina) is its current account surplus, recorded at over $3 billion last year. Even under more favorable oil price assumptions (around $33/bbl for Dubai crude oil), the surplus is already expected to fall to about $1.5 billion this year and around $650 million next year. What more if prices were to stay where they are today (almost $38/bbl as of Oct. 22)?

Obviously, the Bangko Sentral ng Pilipinas is worried. It has been urging the government to borrow a bigger percentage of its financing requirements externally. A $650 million current account surplus is clearly not enough to cover the $3-billion estimated refinancing requirement. If oil prices persist at current levels and if the government remains unwilling or unable to tap external financing sources, the impact will be declining foreign exchange reserves and reduced cushion against event risk.

What's more, given the country's increased exposure to the capital markets and markets' wont to telescope future events to the present, a fiscal-cum-financial crisis may even come sooner than expected. Who knows what event or series of events will trigger a rush to the exit? Non-passage of revenue measures and perception of the government's inability to resolve its self-declared fiscal crisis? A ratings downgrade? Global interest rates rising faster than expected? A bigger oil price shock? A confidence run on one of the bigger banks given still high nonperforming assets in some banks and their generally large holdings of government securities? Another coup?

Dark clouds loom. Government can still forestall a crisis but it must act NOW.

Passing a watered-down version of the "sin" tax bill does not help convince markets of the government's resolve. Congress must do more.

In the meantime, the Executive can on its own, signal intent to address the fiscal problem through a number of measures, e.g., withholding some percentage of the internal revenue allotment to local government units, imposing a minimal and temporary import surcharge while Congress is in recess (clearly second-best but may be resorted to under present circumstances), raising motor vehicle registration fees, permitting the SSS to raise its contribution rate, permitting increases in user fees (e.g., toll fees, rail fares) to reflect costs, among others.

One of the key lessons from the Asian financial crisis as well as from Argentina's multiple crisis is that countries with strong economic fundamentals when crises hit are better able to weather negative shocks.
No one can prevent storms from coming. But one can certainly reinforce the shutters to withstand the winds and protect the house from costly damage.

The author was Finance undersecretary during the Ramos administration.