Welcome Remarks, 10th FVR_RPDEV Lecture

By Romeo L. Bernardo (for RFO Center for Public Finance and Regional Cooperation)

Good afternoon distinguished speakers and guests. Welcome to the 10th RPDEV Lecture Series.

I have been asked by my former boss and still friend, Bobby de Ocampo to deliver the  welcome remarks on his behalf as a member of the Board of Advisers of the RFO Center, as he had to travel on urgent business.

Let me start by quoting something he said over a decade ago when he received the highly esteemed recognition of Euromoney Finance Minister of the Year in 1996, explaining the hard tasks of a Finance Secretary--- “ A Finance Secretary has many difficult and important decisions he has to make—the most critical by far being --- which president to serve.”

He has decided most wisely—( Pause for applause.. “palakpak naman diyan” ! ;^)

The nation is at that threshold when we need to decide whom to choose to lead us.  But even before then we need to ensure first of all that we do have credible and orderly elections in 2010 that will allow us to renew our faith in democracy and to chose our leaders.

At this time of unprecedented global financial and economic challenge and domestic divisiveness and failures in governance, perhaps at no time in our history do we need visionary and effective leadership as do we do today.  Such kind of leadership was defined in a paper documenting the  Political Economy of Reform during the Ramos Administration ( Growth Commission, World Bank, 2008) as one, like PFVR’s, able  “to set the vision, rally the people to bring results in ways that are possible to accomplish at the time given and openings available and working through  weak institutions and contending with  strong vested interests.

This is the third time RPDEV and the RFO Center are working together to ensure that our common advocacy of an informed public sector is realized. Past Lectures have tackled issues concerning our development post 1997 Asian financial crisis and global financial situation relative to the current crisis. .

 Today we have brought together 6 people whom you perceive as potential leaders of our country.  We will listen to what they have to say on socio-economic development and prospects for peace.  Our speakers have consistently been mentioned as possible “presidentiables” in the forthcoming 2010 elections.  

(We look forward to listening to and interacting with them, even though some may believe that it is useless to try to hold people to anything they say when they are madly in love, drunk or running for office. )

Now with all seriousness, allow me to formally welcome all of you to the 10th FVR-RPDEV Lecture.


I turn you over to our Moderator, Atty Mike Toledo, Country President of  Webershandwick Worldwide, our co-sponsor-- to begin the Presentation Proper.

Slow drag

Business World
Introspective

We do not foresee a recession in the Philippines in the technical sense, but the economy will in all likelihood grow at a snail's pace. Though the sharp slowdown of economic activity in the first quarter has set the pace for the entire year, we don't expect conditions rapidly deteriorating from that point forward. Remittances have so far managed to hold steady, which means any decline, if it happens, will be minimal, while export and import numbers have been observed to slowly even out, improving the balance.

The effects of higher fiscal spending may soon start to become perceptible especially as elections near, while expectations of a global recovery should help revitalize consumers somewhat later in the year.

But an upturn in the world economy, especially a weak one, may not mean much for the Philippines. Ironically, while low export vulnerability has kept the country sheltered from the global downturn, this same feature prevents it from riding any global revival to the hilt. With major trade partners on a slow road to recovery and nothing much on the domestic front to spark domestic activity, we see the Philippine economy still performing below trend even in the subsequent year.

Growth numbers for 1Q09 were worse than expected, at 0.4% year on year or below consensus expectations of about 2%. The results have prompted multilateral agencies to slash further their gloomy forecasts. The IMF now predicts a GDP decline of about 1% from earlier expectations of flat growth, while the World Bank expects a 0.5% dip in output (from 1.9%). The consensus estimate of private analysts has likewise fallen to a mere 1.2%.

The pessimism comes from the sudden weakness in consumer spending (up by just 0.8% year on year), which had been a stable engine of growth for nearly two decades. We are wary of the reported statistics for several reasons: (1) remittances during the period slowed but did not decline while the peso correspondingly depreciated; (2) purchasing power had actually risen due to softer prices of oil and commodities; (3) minimum wage tax exemptions should have worked to increase personal incomes; and (4) employment numbers did not deteriorate radically based on government statistics.

The sharp slowdown in consumer spending, initially measured with the help of production data, is likely traced in part to what appeared to be a plunge in tobacco consumption as manufacturers front-loaded sales to marketing arms to escape a scheduled increase in excise taxes this year. Moreover, value-added taxes rose 14% annually in 1Q09 (10% in the first four months), indicating that the domestic economy may not have been as anemic as the national income accounts estimates suggest. Hence, we will not be surprised to see some correction upward in future periods.

Going forward, we continue to see growth of 0.5%-1% with downside risks. Remittances may slow further and possibly still decline (by as much as 3% in our latest estimate) as world unemployment trails the global recession. Capital formation will likely still suffer as firms cut down inventory and defer large-scale investment under an uncertain business environment. The spread of swine flu - the Philippines already has the highest count in Southeast Asia and the seventh highest in the world - may be another dampener to economic activity, particularly for tourism-related sectors and businesses dependent on people coming out and converging such as in malls, hotels, and restaurants.

However, exports may have already bottomed and we can realistically expect external trade to even out further and the decline in manufacturing to slow. Services exports, especially of the business process outsourcing (BPO) sector, will remain strong according to industry insiders we have talked to, likely growing at double-digit rates. Government spending delayed by the late signing of the national budget and allegedly held back for reasons of political strategy may begin to reflect in the national accounts beginning 2Q09. We also hope to see some clarity in the political scene after the President's state-of-the-nation address later this month (July 27, 2009). This should serve as the strongest signal for unleashing election-related spending which can help push up domestic demand.

The latest consumer expectations survey by the central bank was still downbeat, but with possible "green shoots" in the world economy those holding out for bad days may eventually start loosening purse strings. It is interesting to note that business expectations had started to turn around in the last survey, particularly in construction and services and we can expect a sense of normalcy returning to the business sector. Real estate companies, for instance, have noticed a marked improvement in sales beginning 2Q09 even in the high-end property sector.

While fiscal and monetary policies remain supportive, we will probably not see more aggressive measures to prop up growth. The most recent widening of the fiscal deficit target (from P199.2 billion to P250 billion) basically involved a P56.6-billion reduction in expected revenues and a P5.8-billion cutback in planned spending. Finance officials seem deeply concerned these days about the impact of large deficits on fiscal sustainability as opposed to intensifying the fiscal stimulus to spur growth.

Monetary policy could remain expansionary for the meantime though supply side risks to inflation may eventually constrain monetary authorities, especially with world oil prices rising along with some recovery in global demand. There is also an acknowledged limit to what monetary policy can achieve in spurring bank lending given current appetites for investment and consumption combined with banks' precautionary tightening of loan standards.

The Bangko Sentral ng Pilipinas notes how policy cuts have only partially translated to a decline in lending rates - only about 40% of the 175 bps decline in the overnight RRP rate since December has translated to a fall in bank lending rates.

We may not see unemployment rising above 8% on average this year as anticipated by many analysts, as the latest numbers even improved on quarter-ago and year-ago figures (7.5% recorded last April compared with 7.7% last January and 8% a year ago). While this can be interpreted as another sign that a recession may not be afoot, the picture is mixed. Employment numbers rose for unpaid family workers and the self-employed who do not employ other workers, while jobs for wage and salary workers in private establishments hardly grew. The former classes of workers are negatively correlated with GDP growth while the latter are positively correlated with growth.

Meanwhile, even if global economic recovery is expected by the end of the year, the Philippines may not capitalize much from this. Low export exposure has shielded the country from the global downturn, but also prevents it from maximizing the benefits of a revival. Coupled with likely weak recovery in advanced economies, we see only 3.0%-3.5% growth next year, which is still below trend.

The risks to our forecasts include the following: * Prolonged global downturn. Things are starting to look up though as global projections have lately improved. The IMF in its latest World Economic Update now sees forces pulling the world economy down decreasing in intensity, but also says the forthcoming recovery will likely be weak. * Larger-than-expected remittance drop. The likely shock to our forecast now seems to be on the upside, with remittances still up by 2.6% in the first four months of the year and deployment reportedly growing. Forecasts of economists from the World Bank and the IMF range between -4% to -7%, which is similar to the average for private analysts. Their poor prognosis for remittance inflows partly underpins their expectations of a Philippine recession (between -0.5% and -1% GDP decline). * Oil market volatility. This remains a serious risk that could derail recovery in the local economy. A continued uptick in oil prices may be the inevitable consequence however as forward-looking oil markets detect a global recovery. Crude oil prices (Dubai fateh) have risen over 70% since the start of the year, when prices bottomed. * Fiscal slippage. This can be a serious concern for the country given both structural and cyclical drags to revenue collection. This is one area that needs to be constantly monitored especially given its impact on financial markets. * Political turmoil. There continue to be rumblings about the push for a charter change (cha-cha) initiative by administration allies, possibility of failure of elections, and of the President possibly running for a congressional seat in her home province with the end goal of becoming prime minister. This is happening in an environment of isolated bombings in the South and pyrotechnic bombings in Metro Manila by unidentified parties with unclear objectives, thus raising the much-feared scenario of martial law and emergency rule.

Excerpt from Global Source quarterly report on the Philippines - "Snail's Pace" by Mr. Romeo Bernardo and Ms. Margarita Gonzales. Mr. Bernardo is a board member of The Institute for Development and Econometric Analysis, Inc.

Turning back clock on fiscal reform

Business World

Reforms undertaken in recent years in the fiscal, monetary and financial sphere contributed importantly to the resiliency of the Philippine financial sector, keeping it relatively insulated from the global financial tsunami. In the fiscal area, the reform pillars were the adjustments in the VAT system and in power tariffs. These were instrumental in reversing the deficit in the consolidated public sector from 5.5% of GDP in 2002 to a surplus of 0.5% by 2007 and in bringing down the non financial public sector debt from over 100% of GDP in 2003 to only 61% by 2007.

These in turn helped to enhance confidence and stability of financial markets that contributed to reduced risk premium, greater willingness to hold Philippine credit, and lower interest rates.

Improved fiscal headroom has placed the Philippine government in a position to consider using some spending to cushion the economy from the synchronized recession happening externally. The operational word, as a World Bank friend observed, considering the still high debt ratio relative to peers and vulnerability to financial market sentiment is "controlled fiscal stimulus."

I would consider "control" to mean not just avoiding overspending, but also spending as planned. This is a matter that the BSP brass, concerned over the burden on monetary policy, has recently commented on, remarking at the disappointing first-quarter growth outcomes that could have been cushioned by government spending planned under the widely heralded economic resiliency plan.

Most importantly, control means having an eye on long-term fiscal sustainability despite a short- term spike in the deficit needed to prevent a recession. Even the monopoly printer of the world's money realizes this. Fed Chair Ben Bernanke, in a testimony to Congress, said: "Unless we demonstrate a strong commitment to fiscal sustainability in the longer run, we will have neither financial stability nor healthy economic growth."

While a fall in revenues as a result of lower growth is something financial markets understand, indeed is part of what economists call "automatic fiscal stabilizers," there have been structural erosion and administrative lapses gnawing away at fiscal sustainability that needs to be addressed. These include: the inflation eroding the value of non-indexed sin taxes, the exemption of minimum wage earners from income taxes, lower corporate income tax, new exemptions legislated for tourism, etc. Likewise, continuing slippages in tax administration, notably VAT and tariffs on imports particularly oil, is a cause of concern, the latter especially so with the approach of June 2010. The under-declaration of imports of about 2% of GDP due to "election-related lenience" (the terms used by the IMF in its report, "Philippines: 2007 Article IV Consultation- Staff Report") could have cost P20 billion in lost collections in 2007. In addition, the tax effort (tax-to-GDP ratio), has already fallen to 14.1% last year from 14.3% in 2006, which are low versus the best level achieved during the Ramos period of 17% in 1997, when the Philippine credit rating was at least two notches higher than it is now. The tax effort even fell further to 11.5% of GDP in the first quarter (not considering seasonality).

In light of this, the public needs to support the vigorous efforts of the Department of Finance (DoF) to push forward with its agenda for long-term fiscal sustainability, especially in an environment where there are pressures to turn back the fiscal reform clock.

The architecture that underpinned much of the reforms over the years is a buoyant system that casts a wide net and is neutral across sectors. It was considered that an expanded VAT, covering heretofore earlier exempted sectors like professional services, power, and fuel while exempting purchases of the poor (like agricultural products in their raw state), best achieved this objective. This VAT pillar is supposed to sit side by side with: a) a flat low rate and non-distorting tariff system, b) an income tax system that is equitable and simple and depends on withholding mechanisms where feasible and c) a robust excise tax system on goods whose social costs are not reflected in their commercial cost, i.e., liquor, tobacco, and oil.

How do some of the initiatives stack up against this model? One initiative gaining ground is to revert to a system of taxation of distribution utilities in power to a franchise tax instead of a VAT. This is the second attempt to dilute the structural reform under RA 9337 (RVAT). When the legislative franchise was approved for Transco, the law reverted the taxation to franchise tax in lieu of all taxes. Apart from making government lose an estimated P7.1 billion in VAT and income taxes annually, this new bill will create holes in the self-policing nature of a widely cast VAT net where one person's tax payment is another one's tax credit. Finally, electric power is an item of consumption that is elastic with income (the DoF says that 93% of power is consumed by the high- and middle-income groups). If the intent is to help the poor, it is better to do it by way of expenditures for education and health as well as the newly adopted conditional cash transfer program.

Also actively under discussion are DoF initiatives to prevent further erosion of the value of collection from "sin taxes"- alcohol and tobacco - and to increase the take from these. The Philippines has one of the lowest levels in Asia of taxation of these two products as well as of oil. Consumption of all three products is imbued with what economists call "negative externalities," i.e., the broader public carries the costs for the consumption of the good in the form of pollution, public health care costs, driving accidents, crime, etc. not reflected in the price of the good. Thus, there are special taxes on such goods/activities (on top of what is already collected in the form of VAT and income taxes) to discourage consumption and to provide government resources needed to address their ill effects. Given the influence of the industry players that will be affected by this renewed initiative of the DoF to yet again align our collection from these to international standards, it will sadly likely fail to pass again for the nth time of trying in decades. That is, unless the political leadership is prepared to spend political capital for it. (Something that is perhaps being saved for more ambitious objectives than fiscal sustainability at this time).

Finally, there is the tax on text - a fiscal measure that surfaces every now and then as a quick fix, even when it does not fit the architecture. The proposals in its various forms have technical flaws and they have legal flaws, all of which have been ventilated in Congress' halls. In my view, though, the basic flaw is philosophical, i.e., why are texting and other products/services of telecommunication companies being treated like sin products in approaching it for taxation? Why is it being singled out for imposition of a special levy or burden? Does it give rise to costs to the public which the individual consumer is not bearing?

This is the opposite of the reality. Improving communication among people is something that creates "positive externalities." It creates welfare-enhancing benefits to larger society, including allowing OFWs to strengthen bonds with their family and the national community. It is key to the development of new businesses that help keep joblessness at bay and the economy afloat - from the BPOs that contribute 4% of GDP to the hundreds of thousands of sellers of text load. It improves efficiency in communications for production activities from the largest conglomerates to the smallest micro-entrepreneur or farmer trying to find out the price of produce in the market.

In its present reincarnation the tax on text comes in the form of a 20% tax on gross SMS receipts (the current Senate version) and a more complicated version (via House resolution) where the NTC implements a P0.05 per text tax in the form of a kind of fee. Considering that the current cost of texting via promos is only P0.10 to P0.30 per text, such a tax is no different from excise tax ranging from 20 % to as high as 50% - on a product that is not a sin, but is indeed a blessing.

(Disclosure: The author is a director of Globe Telecom, and more importantly is an inveterate texter.)

Let's get fiscal, a second look

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.

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.

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).

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.