Manila, Philippines
January 20, 1999

I. Introduction

1. The Government of the Philippines' economic program remains on track, notwithstanding a difficult external environment. Most notably, financial stabilization is taking hold with inflation well under control, the peso strengthening, and the external current account moving into surplus. These welcome developments reflect continued strong policy implementation under the program, which is laying the foundations for a recovery of confidence in the economy. All performance criteria for end-October have been met. Structural reforms have been implemented in line with program commitments.



2. Notwithstanding these achievements, economic activity remains weak, buffeted by adverse shocks from abroad and the weather-related decline in agriculture. While agriculture will stage a sound recovery once weather conditions normalize, the outlook for growth in other sectors remains affected by the uncertain regional and global environment. The external position remains fragile as long as access to private foreign capital--sharply curtailed since the crisis in global emerging markets in September--is not fully restored. Even so, the strengthening current account should lead to a significant improvement in the overall balance of payments and reserve position.



3. The priority for economic policy now is to support a recovery in output, while consolidating stabilization and protecting the poor from the worst effects of the crisis. In pursuit of these goals, the program is being strengthened further along the lines of the modifications introduced since mid-year: (i) a well-measured shift toward a more expansionary fiscal policy stance to stimulate domestic demand and fund anti-poverty programs, supported by additional external financing and within a clear medium-term framework for fiscal sustainability; (ii) continued focus of monetary policy on reducing inflation and preventing renewed pressure on the peso--as these objectives are being achieved, interest rates will gradually come down further; and (iii) vigorous pursuit of a broadened structural reform agenda to underpin the recovery and sustain stabilization.



4. The revised macroeconomic framework of the program is summarized below:

   Macroeconomic Framework 1998-1999

   	1998	1999
   	(in percent)
   Real GNP growth	1	1½–3½
   Real GDP growth	0–½	1–3
   Inflation (end-period), 1994 basis	...	7½
   Inflation (average), 1994 basis	...	8½–9
   Inflation (end-period), 1988 basis	11½	...
   Inflation (average), 1988 basis	9.5	...
   	(in billions of US$)
   External current account balance	0.8	0.4
   Gross official reserves (adjusted)	9.4	11.7
   	(in billions of pesos)
   Underlying consolidated public sector deficit	-98.7	-100.3

   The government remains committed to the key objective of achieving an early and strong recovery of output in 1999. Given the major uncertainties in the external environment, however, as well as in the timing of the recovery in agriculture, current program projections assume a range of possible growth outcomes (real GDP growth of 1-3 percent). As developments unfold in 1999, the program will be adjusted on the basis of a continuous re-evaluation of the macroeconomic framework.

II. Fiscal Policy

5. The fiscal program has been revised to allow for a higher deficit in 1999, to be followed by consolidation in subsequent years as the economy recovers. The revised target for the underlying consolidated public sector deficit (CPSD) is 100.3 billion, 36.6 billion higher than envisaged earlier. Consistent with this target, performance criteria have been established for the public sector financing requirement (PSFR) during the first half of the year.



6. The national government (NG) budget for 1999 recently approved by Congress remains an appropriate framework for new budgetary spending commitments in 1999, reflecting the priorities of the new government. The budget envisages total expenditures of 590.3 billion. However, the overall cash deficit of NG operations in 1999 is now projected at 68.4 billion, compared with 30.4 billion previously, consistent with the CPSD target noted in paragraph 5. Revenues are projected to reach 521.9 billion (down from 538 billion projected at the last review), reflecting the more cautious growth assumption. Moreover, the government intends to release in 1999 additional expenditures from existing appropriations, totaling 21 billion (about 0.7 percent of GNP), with the objective of providing a front-loaded stimulus to the economy.



7. The additional expenditures to be released from the 1997 and 1998 budgetary appropriations will not adversely affect fiscal consolidation efforts in subsequent years since they will focus on the clearance of overdue accounts for 1997 and 1998 in addition to the release of expenditure authorizations using the 1998 budgetary appropriations. The payment of arrears will include those on social safety net programs. The expenditures will consist of the following:



• outlays for infrastructure amounting to 15.2 billion, mostly for projects under the public works program which will include rehabilitation efforts for the recent typhoon calamities;


• outlays for basic education, health, social welfare and skills training of 3.2 billion, including funding of the Poverty Alleviation Fund; and


• outlays for agriculture of 2.9 billion, focussing on irrigation projects.



These outlays have been selected in collaboration with the World Bank in the context of protecting priority social expenditures for which the government has officially requested financial support.

8. The rise in government payables that has resulted from the efforts to compress expenditures over the past year highlights the need for improved expenditure control at the commitment level and better monitoring of payables. As a first step, a database on payables and arrears will be set up by end-January 1999 which will be updated on a monthly basis. The government then intends to establish a plan for clearing arrears according to a schedule to be agreed at the next review. In addition, the government has embarked on a long-term project to computerize the monitoring system of expenditure on a commitment basis to facilitate expenditure control as well as management of arrears. More generally, the government intends to avoid, if at all possible, the need for further ad-hoc expenditure cuts, and implement any expenditure restraint that may become necessary at the level of appropriations or commitments.



9. The government remains committed to the revenue measures agreed during the last program review as they reflect important structural improvements in the tax system and increase the scope for growth-oriented expenditures and reforms of financial sector taxation. Specifically, draft legislation on the following measures has been submitted to Congress: comprehensive rationalization of tax incentives including tightening of new granting of duty-free importation of capital goods for non-export industries; a road user charge; a tax on large unused land holdings; and a tax to discourage conversion of agricultural lands. The broadening of the excise tax on passenger motor vehicles has been implemented through administrative action. Additional measures to tighten the approval process of tax exemptions on imports of capital equipment have been put in place including rules on consigned equipment. In light of the increase in the share of nondutiable imports in total imports and in order to support BOC's preparations for the implementation of the WTO Valuation Agreement in 2000, we intend to review the administration of Customs with a view to increasing Customs' revenue.



10. As part of the ongoing efforts to strengthen the financial sector, the government intends to develop a tax reform package for the financial sector. The objective is to reduce the transaction costs in the capital market and develop a more efficient instrument for taxing banks and other financial institutions. This package will include (i) the phased introduction of tax deductibility of specific loan loss provisions; (ii) elimination of the documentary stamp tax and a phased reduction in the gross receipts tax applicable to financial transactions; and (iii) a gradual move toward harmonization of the withholding tax on interest income from residents' foreign currency deposits and interest earned on peso deposits. The documentary stamp and the gross receipts taxes will be replaced by a noncreditable tax on profits and wages for banks, lending investors, and the nonleasing business of finance companies. Our aim is to implement this tax reform package in a broadly revenue-neutral manner. Progress in implementing the policy package will be assessed at the time of the next program review.



11. The government is fully aware that the higher fiscal deficit currently envisaged should be financed in a noninflationary manner and without crowding out the private sector. On current estimates, this requires net foreign financing of the budget of approximately $1.8 billion ($2.4 billion excluding amortization). The government will re-evaluate the expenditure program (mentioned in paragraph 7) in the event that the additional foreign financing does not materialize. This will be done at the next program review, with a view to safeguarding the objectives of the program.



12. The temporary increase in the fiscal deficit during 1998-99 underscores the need for fiscal consolidation in subsequent years to ensure that public debt remains sustainable. The government's medium-term fiscal framework envisages a steady reduction of the NG deficit starting in 2000, with a view to returning the budget to a small surplus. Part of this improvement will derive from growing revenues as the economy recovers and tax administration improves, as well as the one-time nature of the additional expenditures to be released in late 1998/early 1999. In addition, the government is committed to taking the necessary fiscal measures to attain the medium-term consolidation goals.



13. The aggregated deficit of government-owned and -controlled corporations (GOCCs) is projected at 19.2 billion in 1999. To achieve this result, the National Power Corporation (NPC) will seek an adjustment in the base tariff as soon as feasible. We will also seek assistance under the Miyazawa initiative to assess options for a restructuring of NPC's debt. Furthermore, weather conditions permitting, we will sell part of the rice stock that was accumulated by the National Food Authority in 1998. If these measures do not turn out to be sufficient to limit the deficit, we stand ready to curtail lower priority capital expenditures and take other measures as necessary.




III. Monetary and Exchange Rate Policy

14. The prime objectives of monetary policy remain the control of inflation and stabilization of the peso. Achievement of these goals on an enduring basis will permit further declines of nominal interest rates and provide a basis for the resumption of sustained growth.



15. Consistent with the program's macroeconomic framework, the monetary program for 1999 is based on projected broad money growth of 15 percent (12-month basis), with base money growth of 10.2 percent. Quarterly ceilings on base money during the first half of the year have been established as performance criteria under the program, with monthly indicative limits to guide policy implementation.



16. Interest rate policy will continue to "lean against" exchange market pressures, with the Bangko Sentral ng Pilipinas (BSP) using open-market operations as the chief monetary instrument. To enhance the efficiency of financial intermediation, the BSP is committed to gradually lowering the statutory reserve requirement as soon as monetary conditions permit, subject to measures that address the emerging quasi-fiscal deficit of the BSP (paragraph 17 below).



17. The effective implementation of monetary and interest rate policy requires a sustained sound financial position for the BSP. In this context, draft legislation to amend the Central Bank Act, including restoration of BSP's tax exempt status, has been submitted to Congress. This will be accompanied by increased transfers of BSP net income to the government. The precise modalities of this reform will be finalized by the time of the fourth program review.



18. The peso will continue to float, with intervention in the foreign exchange market limited to what is necessary to meet the program targets for net international reserves (NIR) and to preserve orderly market conditions. Quarterly floors for NIR during the first half of 1999 have been established as performance criteria under the program. Outstanding nondeliverable forward contracts (NDFs) with the BSP will be unwound as they mature. We remain committed to maintaining open current and capital accounts for external transactions.




IV. Balance of Payments and Debt Management

19. The external current account will continue to improve during 1999, although the capital account will remain volatile while global financial markets remain unsettled. The current account is expected to register a surplus of about $0.4 billion in 1999. Assuming a gradual improvement in the Philippines' access to foreign capital and additional program financing (paragraph 21), an overall balance of payments surplus of $1.6 billion is in prospect.



20. The government is confident that its policies will contain the risks emanating from regional and global markets, and bring about a significant strengthening of the external position. Key elements of the ongoing strategy to reduce external vulnerability include:



• an appropriate stance of monetary policy, ready to tighten quickly if necessary (paragraph 16);


• mobilization of external financing on appropriate terms and scale (paragraph 21);


• improvement in the structure of external debt toward longer maturities, and a further buildup of international reserves;


• measures to strengthen the banking and corporate sectors with support from the World Bank (paragraphs 24-30);


• assessment of the prudential framework with a view to reduce banks' vulnerability to exchange rate volatility.


• development of the domestic capital market (with support from the AsDB and the World Bank); and


• a monitoring framework that allows timely and comprehensive assessment of balance of payments and external debt developments, especially in the shorter maturity range (paragraph 22).



21. The government intends to return to private foreign capital markets, on appropriate terms, as soon as possible. In the interim, the government has sought additional support from official sources, including the World Bank, the Asian Development Bank (AsDB), and Japan (see paragraph 35). Such support is essential to finance the balance of payments, to provide a cushion in the current volatile external environment and to finance the budget. Consistent with these plans, quarterly limits on short-, medium-, and long-term external debt have been established as performance criteria under the program.



22. Significant progress is being made in strengthening balance of payments and debt statistics under the action plan of the Inter-Departmental Committee on "Improvement of External Debt and Balance of Payments Statistics". In this connection, the BSP also intends to establish an improved system to monitor, on a monthly basis, short-term debt rollover rates and terms, distinguishing between different categories of debtors (banks and corporations) and creditors. The government remains committed to meeting the IMF's Special Data Dissemination Standard by end-1998 (the end of the transition period). There are currently three outstanding transition plans related to the dissemination of the production index, producer prices, and general government operations.




III. Structural Reforms

23. The government's structural reform agenda is at the core of its medium-term growth and development strategy. Implementation of the agenda is also key to the restoration of confidence and the programmed financial support from official donors.




Banking sector

24. Under the action plan adopted in February 1998, a number of steps have already been taken to enhance banks' ability to withstand shocks, strengthen the prudential and regulatory framework, and streamline the process of bank resolution. Capital and prudential requirements have been tightened, regulatory standards brought closer to best international practice, bank supervision practices revamped, and policies toward weak and failing banks strengthened. In implementing the new capital requirements, the BSP will refrain from regulatory forbearance and rigorously apply the newly adopted system of prompt corrective action.



25. We are continuing our efforts in this area, and a package of additional reforms has been initiated with support from the World Bank under a recently approved Banking Sector Reform Loan (BSRL), based on the strategy developed jointly with the Fund in early-1998. Key measures supported under this loan include:



• privatization of the Philippine National Bank (PNB)--the plan is to sell the remaining government-held shares to a strategic private investor by mid-2000, at the latest;


• further improvements to the framework for failure resolution--inter alia, through adoption of a system of prompt corrective action for capital deficiencies, measures to streamline the bank receivership process, and preparation of contingency plans for cases of systemic stress; and


• further measures to strengthen prudential standards and bank supervision--including introduction of tax deductibility for specific loan loss provisions (paragraph 10), higher penalties for prudential noncompliance, and tighter standards for bank licensing, disclosure, consolidated supervision, and external audits of banks. The issues of appropriate legal protection for bank supervisors, further disclosure requirements, and access of bank supervisors to vital depositor information are being kept under review.



26. To minimize the financial risk to the BSP from its role as lender of last resort, we are proposing legislation that would prevent banks from incurring uncollateralized overdrafts; in the meantime, regulations have been issued by the BSP to require thrift banks to provide collateral against all overdrafts, and additional regulations will be issued to extend this treatment to commercial banks to the extent feasible under existing laws. In addition, we intend to undertake an assessment of the payment system with a view to reduce the risks for the central bank and the banks arising from its operations.




Corporate Sector

27. Although the Philippine corporate sector has proven more resilient than in some other crisis-affected countries, the increased stress from slowing growth, high interest rates, and peso depreciation has exposed some vulnerabilities which the government intends to address without delay. Planned reforms to be implemented with assistance from the World Bank will focus on:



• improvements to the debt resolution framework administered by the Securities and Exchange Commission (SEC);


• facilitating informal debt workouts;


• eventual transfer of the SEC's quasi-judicial functions to the court system under a new bankruptcy law;


• better corporate disclosure (paragraph 30) ;


• measures to foster diversification in the corporate financing structure; and


• steps to limit the future buildup of excessive short-term debt and foreign currency exposure.




28. The revised debt resolution framework will continue to be regulated by the SEC but it will be guided by the corporate debtors and their creditors according to a clearly defined set of rules and time-bound procedures. Changes that are consistent with the existing legal framework will be adopted by mid-March 1999. For changes that are outside the existing legal framework, we will submit to Congress proposals for amendments that will be needed. While the possibility of an interim suspension of payments will continue to exist to allow development of a rehabilitation plan, rights of secured and unsecured creditors will be protected to the extent possible in line with best international practice.



29. While it is important to improve the resolution framework for distressed corporate debts by strengthening the legal and procedural environment, the government remains committed to a decentralized approach anchored in the private sector. More direct government involvement, including any public funding of an "asset management corporation,"would only be considered actively to deal with the risk of widespread corporate and bank failures with possible systemic implications, which is not the case in the Philippines.



30. A new Securities Act has been submitted to Congress, designed to establish a modern legal and regulatory framework. Inter alia, the new Act defines the structure and mandate of the SEC; rules for public offerings of securities and derivatives; disclosure and reporting requirements; the protection of shareholder interests (including minority shareholders); rules against fraud, manipulation, and insider trading; and the regulation of securities market professionals, exchanges, and self-regulating organizations.




Public sector reforms

31. Medium-term public sector reforms have become even more important given the need for fiscal consolidation after the current temporary increase in the deficit. The basic strategy remains to raise public savings through an enhanced revenue effort and with greater efficiency of expenditures, with emphasis on human capital, infrastructure, and poverty alleviation. The government intends to collaborate closely with the World Bank in developing and implementing this agenda, and has requested officially the World Bank's support in the form of a Public Sector Reform Loan (PSRL). Appraisal of the PSRL is envisaged by mid-1999, with Board approval by October, 1999.



32. Key reforms planned in this area include: (i) further improvements to the NG budget and expenditure framework; (ii) completing the reform of the civil service started several years ago; (iii) a review of the system of allocating resources and delineating responsibilities between the national and local government units (with technical assistance from the AsDB); and (iv) a comprehensive overhaul of the system of fiscal incentives to strengthen the medium-term revenue base and facilitate tax administration.



33. The government remains fully committed to the action plan to improve tax administration developed and adapted with technical assistance from the IMF. The large taxpayer division (LTD) at BIR headquarters started operations on September 1, with a sizable revenue flow remitted through the LTD during the first two months of operations (17.7 billion). In addition, the Large Taxpayer Unit of the special audit division had initiated 295 audits by October 31, in line with the structural performance criterion under the program.



34. In addition to the measures envisaged at the time of the last review, the audit function in the BIR will be strengthened by establishing an audit unit within the LTD. The number of staff assigned to the LTD will also be increased. Furthermore, cooperation between BIR, BOC and BOT will be enhanced by setting up a system for the electronic transfer of data. Finally, a study on tax arrears will be completed by January 1, 1999, as a basis for action to reduce arrears significantly in 1999.




Electric power sector

35. The government has re-submitted to Congress the Omnibus Electricity bill. The bill is expected to be approved in 1999 and will enable comprehensive restructuring and eventual privatization of the NPC as planned under the program. We have also completed all other actions required for approval of the Power Sector Adjustment Loan from the AsDB.




Trade and investment liberalization

36. Trade and investment liberalization will proceed as planned. The average nominal tariff rate will be reduced further to 9.5 percent in 1999 (from 10.7 percent in 1998) and the maximum tariff rate (which applies to some agricultural goods) will be reduced to 65 percent (from 80 percent in 1998). The system of quota allocations under the Minimum Access Volumes (MAV) is being improved with a view to making it more transparent. Draft legislation to liberalize the retail trade sector is being considered in Congress, as is a draft law to allow up to 100 percent foreign participation in banks that are in financial difficulties (to be gradually reduced to 70 percent over a period of 10 years).




National Food Authority (NFA) and grains sector

37. The planned reforms related to the NFA will proceed in 1999, with support from the AsDB. In particular, the intention is to separate the regulatory functions of the NFA from its market intervention functions, and to implement a targeted food safety net program for the poor. In addition, we intend to allow private sector imports of some types of rice during 1999. The medium-term objective remains to strengthen the grains sector with a view to eventual conversion of the quantitative restriction on rice imports into an out-quota tariff rate and gradual reduction of the tariff protection for corn.




* * * *

38. The government is confident that the policies outlined in this memorandum will achieve the objectives of its economic program. The government is prepared to take additional measures that may be required, and will consult with the Fund on the adoption of such measures. The next (fourth) review of the program is scheduled to be completed by mid-May, and will be combined with the next Article IV consultation. That review will focus, in particular, on the implementation of fiscal and monetary policies in the context of a comprehensive reassessment of the growth outlook; the external financing of the program; and progress with key structural reforms in the areas of banking, tax administration, public sector, and corporate sector. The fourth review will also establish performance criteria for the second half of 1999.