Morgan Stanley's Daniel Lian: Philippines: Political Uncertainty Stirs Fiscal & Economic Reforms

Previously Morgan Stanley economist for Southeast Asia Daniel Lian saw bullish prospects in the country, today with a brewing political storm, Mr Lian, does a turnaround to cite a ‘decisively bearish political economy’ and sees significant headwinds for the country, quoting Mr. Lian’s entire article…

Philippines: Political Uncertainty Stirs Fiscal & Economic Reforms

Daniel Lian (Singapore)

Growth Expected to Retard

Several macro economic indicators point to a slowdown in economic growth in 2005, following robust momentum of 6.1% YoY last year. Government spending remains low, in line with the fiscal consolidation strategy. Meanwhile, consumption growth hinges on household spending (80% of GDP), supported by soaring remittances from overseas Filipino workers (the second-largest source of foreign currency following export earnings). Given the weak macro fundamentals of towering prices, high unemployment (11.9%) and reduced government spending on social development projects, the shield provided by these remittances is likely merely to delay the coming economic slowdown, in our view.

Another strong indicator of slowing growth is the decline in export growth. Exports are a key driver of GDP growth (50% of GDP). A slump in the global electronics cycle and falling demand from key export destinations – also adversely affecting other export-led Asian economies – are likely to lower both export earnings and allied private consumption significantly, in our view.

No Structural Change in the Deficit

We believe the recent improvements in the budget deficit are due largely to the continued squeeze in government expenditure. As a percentage of GDP, government spending has fallen from 19.6% to 18.7% in the period 2002 to 2004 accounting for 68% of the improvement in fiscal balances, as revenue collection has expanded by a mere 0.4% of GDP. In addition, what increase there has been in tax revenue has resulted from culmination of the cyclical upturn, whereby increased income levels have generated higher tax. However, the 1Q05 GDP slowdown to 4.6% YoY vs 6.1% in 2004 marked the end of this cyclical upturn, in our view, and we expect 2005 growth to shrink to 4% YoY.

The lack of structural improvement in the country’s fiscal accounts is reflected in the low tax effort ratio. Improving GNP in 2004, due to 6.1% growth in GDP and increased remittances from overseas workers, hasn’t improved tax revenue and the tax effort ratio remains low. Any positive impact from structural reforms to the tax structure would have been reflected in a rising tax effort ratio.

Heavy Debt Burden Raises Concerns

Another serious concern as regards the deficit is its unproductive use to finance consumption rather than investment. Government borrowing reached PHP 242.5 billion in 2004 to meet its financial requirements (27.5% of total expenditure). Thus additional tax revenue is required to cut the country’s dependence on borrowing and reduce the debt stock.

Persistent budget deficits since 1998 have resulted in the accumulation of both domestic and external debt (PHP2.0 trillion and PHP1.8 trillion, respectively, in 2004). The pinch has been the sudden surge in public-sector debt service payments. Interest and principal payments on the public-sector debt stock have doubled from 32.1% of total national government expenditure in 1998 to 67.8% in 2004.

Moreover, the Philippines’ ability to repay debt is considered low, because of its moderate growth path, high inflation and low saving rate. Poor tax collection is exaggerated by tax evasion, with corporates alone evading around 45% of taxes due (see our report Pulling Up Its Fiscal Socks at Last?, April 1, 2005). This makes it tougher to reduce the foreign debt burden. Consequently, government debt as a percentage of revenue exceeds 500%, substantially more than the country’s indebted Asian counterparts.

Fiscal Constraints Hamper Development Plans

We believe declining public expenditure could cause infrastructure investment bottlenecks, jeopardizing the Philippines investment appeal. Poor infrastructure increases the cost of doing business and reduces the country’s attractiveness to investors. Hence we think an increase in productive expenditure is required.

However, limitations such as high interest payments and the need to lower the budget deficit, are keeping productive expenditure low. The country’s soaring outstanding debt has raised its interest payment liability to 29.4% in 2004 and consequently lowered the share of other expenditure. The increase in the cost of servicing public debt has sharply reduced national government expenditure, particularly on social services (social service expenditure is reported to have fallen from 35% of total national government expenditure in 2000 to 23% in 2004).

Education, health and poverty and unemployment eradication programmes are among the public disbursements that are contracting to meet the government’s conservative expenditure targets. This has led to sluggish growth in the skilled labour pool and widespread unemployment (as high as 11.9%), forcing Filipino workers to seek jobs overseas. Moreover, high levels of corruption further increase the cost of doing business in the country.

Political Economy Is Decisively Bearish

Following Ms. Arroyo’s decisive electoral victory (she won by 1 million votes) last year and the commencement of her reform programme (which centred on raising sin taxes and VAT, as well privatizating the key state energy producer), the market turned decisively bullish on the Philippines. The economy’s relative outperformance since the beginning of 2Q04 and a small rebound in investment inflows have strengthened the bulls’ resolve that this story is finally turning around.

However, we remain cautious on the structural outlook (see Upgrading Growth and Upping the Ante on Reform, September 3, 2004). We were not surprised that President Gloria Arroyo upped the ante on reform or that she chose to focus on the fiscal sector – we view this as the primary structural economic malaise of the republic and a worthy priority for the government. Nevertheless, the financially strapped government has caused a significant drag on the country’s saving rate, and in turn slowed capital formation and economic growth.

We would note that, while fiscal reform is a critical first step, the structural impediments confronting the republic stretch beyond mere government finances. In our view, Ms. Arroyo must strengthen the rural development platform and engineer a new economic strategy that places emphasis on the long-term development needs of the urban poor, resources, SMEs, and the government and corporate sectors. We believe that Thailand’s dual track strategy, for example, has a lot of relevance for the Philippines. Concomitantly, Ms. Arroyo needs to overcome the institutionalized rent-seeking complex that permeates Philippine society. We also see a danger that the country’s powerful oligarchic interests could derail the President’s efforts.

The political events of the past three weeks strengthen our belief that the country’s structural impediments stretch far beyond mere economics. The oligarchs remain extremely powerful, and the market has begun to speculate over the political future of the President. Whether or not Ms. Arroyo survives this latest challenge, the country’s economic outperformance may already be coming to an end as exports across Asia are rapidly slowing down and the recent political uncertainty may once again hamper remittances and domestic investment. In a nutshell, we think the republic continues to face significant economic and political challenges.

Bottom Line: Political Uncertainty Stirs Fiscal and Economic Reforms

The Philippines’ two strong pillars of economic growth stand on unstable fundamentals, pointing towards an economic retardation this year, in our view. The Asia-wide export slowdown is likely to cause a drop in export earnings and allied private spending. Private consumption is being supported largely by overseas Filipino workers’ income, deferring an economic slowdown.

The low tax effort ratio implies that improving tax revenue has been due not to structural factors, but to the culmination of the cyclical upturn, with increased income levels generating higher tax and curbing the deficit. We expect this to fade with the slowdown in economic growth.

Successive deficits have led to the accumulation of a large debt stock and doubled the country’s debt service payments over the last six years. Besides a moderate growth path, high inflation and a low saving rate limits the Philippines’ ability to repay debt. Additional tax revenue is required to cut the dependence on borrowing and lower debt.

Interest payments on debt have lowered the share of productive expenditure on infrastructure and social development projects. A lack of such development programmes has led to sluggish growth in the skilled labour pool and higher unemployment. Moreover, rising business costs due to the lack of infrastructure facilities and widespread corruption make the investment climate less favourable.

While fiscal reform remains the critical first step, political events unfolding over the past three weeks strengthen our belief that the structural impediments stretch far beyond mere economics. Looking ahead, we perceive political uncertainties as well as significant economic challenges for the republic.