The Philippines: Business Forecast Report Q4 2007

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Published by Business Monitor International Ltd

The Philippines BUSINESS FORECAST Q4 2007 REPORT

Published by Business Monitor International Ltd

Includes 5-year forecasts to end-2011

ISSN 1745-0659 Analyst: Matt Mirecki Editor: Sophie Gick Key Sector Analysts: Gunita Thethy, Alan Marshall Sub-Editors: Anna Phillips Subscriptions Manager: Gemma Whitaker Marketing Manager: Leila Scott Production: Jaspal Mandla/Lisa Church/Jonathan Robson Publishers: Richard Londesborough/Jonathan Feroze Copy Deadline: August 13 2007

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975 4.4

11.4

GDP per capita (US$)

Real GDP growth (%)

Unemployment rate (% avg)

59.29

77.3

172.3

External debt (US$bn)

– as % of GDP

– as % of exports

174.3

77.4

61.58

3.9

13.1

0.16

41.19

35.34

0.4

0.29

55.57

54.18

9.5

5.2

6.0

3.5

-4.6

-199.87

11.4

4.9

993

79.61

80.17

2003

158.6

70.8

61.54

3.5

12.9

0.14

44.48

38.79

1.9

1.63

56.27

56.04

10.1

6.2

7.3

6.0

-3.8

-187.06

11.8

6.4

1,065

86.91

81.62

2004

152.2

62.0

61.30

3.8

15.1

0.18

48.04

40.26

2.4

2.35

52.98

55.03

10.2

6.0

6.4

7.6

-2.7

-146.78

8.7

4.9

1,190

98.85

83.05

2005

133.5

52.3

61.63

4.2

18.6

0.28

53.11

46.16

4.3

5.02

49.25

51.12

10.2

6.1

6.9

6.3

-1.0

-62.22

7.9

5.4

1,396

117.89

84.48

2006e

117.7

42.6

60.25

4.8

22.8

0.44

57.56

51.20

4.9

6.97

46.00

47.63

9.8

5.8

6.5

2.8

-1.0

-68.36

7.5

6.0

1,646

141.39

85.88

2007f

99.0

36.2

56.38

4.6

24.8

0.44

64.06

56.97

4.3

6.72

45.00

45.50

9.4

5.3

6.0

4.3

-0.9

-64.68

7.5

5.7

1,782

155.54

87.28

2008f

85.1

32.3

53.55

4.6

27.1

0.45

70.86

62.91

3.8

6.22

43.00

44.00

9.3

5.2

5.9

4.6

-0.8

-61.78

7.5

5.5

1,868

165.60

88.67

2009f

72.9

29.0

50.89

4.5

29.5

0.47

78.02

69.85

3.6

6.41

42.50

42.75

9.4

5.3

6.0

4.6

-0.6

-54.63

7.5

5.4

1,950

175.58

90.05

2010f

62.0

25.8

47.98

4.5

31.9

0.49

86.02

77.43

3.5

6.42

40.00

41.25

9.4

5.4

6.1

4.5

-0.4

-42.39

7.5

5.3

2,034

185.93

91.42

2011f

e/f = BMI estimate/forecast. * excludes gold, ** Number of months imports covered by FX reserves + gold, † For years up to 1998, 1985=100, after 1998, 1994=100; Sources: NSO, NSCB, Bangko Sentral, IMF, BMI. The Oxford Economic Forecasting model is used when generating forecasts.

5.0

Import cover (months)**

0.17

Trade balance (fob – fob, US$bn)

13.9

39.93

Goods imports (fob, US$bn)

Foreign reserves (US$bn avg)*

34.40

-0.4

– as % of GDP

Goods exports (fob, US$bn)

-0.28

Current account (US$bn)

8.9

Lending Rate (% avg)

53.10

4.6

Deposit Rate (% avg)

PHP/US$ (eop)

5.4

91-day T-bill (% avg)

51.60

3.0

Annual inflation (% avg)

PHP/US$ (avg)

-5.3

– as % of GDP

-210.74

76.74

Nominal GDP (US$bn)

Fiscal balance (PHPbn)

78.71

Population (mn)

2002

PHILIPPINES: MACROECONOMIC DATA AND FORECASTS

Philippines Q4 2007

Business Monitor International Ltd

Philippines Q4 2007

Contents Executive Summary............................................................................................................................ 5

Chapter 1: Political Outlook................................................................................................ 6 SWOT Analysis.......................................................................................................................................................6 BMI Political Risk Ratings...................................................................................................................................7

Domestic Politics................................................................................................................................ 8 Fight Against Terrorism Takes Centre Stage President Gloria Macapagal Arroyo has signalled her intent to increase efforts to reduce terrorism in the Philippines following this year’s annual State of the Nation address, specifically mentioning the extrajudicial killings of political activists and journalists that have occurred during her leadership.

Foreign Policy .................................................................................................................................... 9 China Ties Offer Major Opportunities The Philippines is one of the ASEAN countries China intends to strengthen relations with in order to secure access to natural resources and new markets, as well as to extend its political influence, and the Philippines will be only too glad for this to happen.

Table: Cabinet & Other Key Posts..................................................................................................................... 11

Chapter 2: Economic Outlook........................................................................................... 12 SWOT Analysis.................................................................................................................................................... 12 BMI Economic Risk Ratings............................................................................................................................. 13

Introduction.......................................................................................................................................14 Economic Activity.............................................................................................................................15 Growth To Moderate Despite Impressive Q107 Numbers Following Q107’s 17-year high growth rate of 6.9% y-o-y, the Philippine government remains optimistic about hitting its full-year target of 6.1-6.7%.

Table: Economic Activity................................................................................................................................... 16

Fiscal Policy ..................................................................................................................................... 17 Poor Revenue Collection Continues To Weigh On Economy Government officials are talking positively about the outlook for revenue collections in H207, after the country’s first half fiscal deficit came in more than 30% over target. However, we remain sceptical that the PHP63bn budget deficit target will be met.

Table: Fiscal Policy.............................................................................................................................................17

Monetary Policy................................................................................................................................19 Effects Of Surprise Move Prove Short Lived At its latest monetary policy meeting on July 12, the Bangko Sentral ng Pilipinas surprised markets when it slashed its key policy interest rates by 150bps and 175bps, as well as announcing that it is to abolish its tiering scheme on overnight money. Nonetheless, the bank still insists it is maintaining its neutral stance towards monetary policy.

Table: Monetary Policy...................................................................................................................................... 19

Balance of Payments ......................................................................................................................20 Balance Of Payments Surplus To Diminish In H207 The Philippines’ balance of payments surplus rose to an 18-month high in July, thanks mainly to strong capital inflows, but several signs are already beginning to show that the surplus my be set to decline in H207, as capital inflows begin to moderate, and a slowdown in the US economy continues to weigh upon Philippine exports.

Table: Balance Of Payments............................................................................................................................. 22

Chapter 3: Special Report................................................................................................. 23 Global Inflation..................................................................................................................................23

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Philippines Q4 2007

Chapter 4: Business Environment.................................................................................... 33 SWOT Analysis.................................................................................................................................................... 33 BMI Business Environment Risk Ratings........................................................................................................ 34

Legal Issues .....................................................................................................................................35 Labour Force ....................................................................................................................................36 Table: Demographic Indicators (2005).............................................................................................................37 Table: Employment Indicators...........................................................................................................................37

Foreign Investment Policy ..............................................................................................................38 Table: Asia, Annual FDI Inflows........................................................................................................................ 39 Table: Philippines, Annual FDI Inflows............................................................................................................. 39

Foreign Trade Regime .....................................................................................................................40 Tax Regime . .....................................................................................................................................42 Table: Top Export Destinations, US$mn........................................................................................................... 42

Chapter 5: Key Sectors...................................................................................................... 43 Power.................................................................................................................................................43 Primary Energy Demand Our projections suggest that, by 2011, the Philippines will be dependent on oil for 49% of primary energy demand, with the share of coal put at a forecast 27%.

Table: Power – Historic Data & Forecasts....................................................................................................... 46

Telecoms............................................................................................................................................48 Market Overview Table: Telecoms Sector – Historical Data & Forecasts.................................................................................. 49

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Executive Summary

Global Factors To Weigh Following Q107’s 17-year high growth rate of 6.9% year-on-year (y-o-y), the Philippine government remains optimistic about hitting its full-year target of 6.1-6.7%, and has even talked of potentially revising it up. However, with exports expected to moderate in H207, as well as capital inflows anticipated to slow, we remain more cautious towards the Philippines’ growth prospects, forecasting economic growth of 6.0% in 2007, although due to the solid macroeconomic picture in the Philippines, we have recently revised this up from 5.5%. Beyond that, we are now forecasting growth to average 5.6% over our five-year forecast period, as it gradually slows from 6.0% this year, to 5.3% in 2011, as the fiscal stimulus provided by the government diminishes.

President Gloria Macapagal Arroyo has signalled her intent to increase efforts to reduce terrorism in the Philippines following this year’s annual State of the Nation address, specifically mentioning the extrajudicial killings of political activists and journalists that have occurred during her leadership. More progress is expected to be made in suppressing terrorism following the recent passing of the Philippines’ new anti-terror law, and much hope is being pinned upon renewed talks with Islamic separatists to achieve a similar end. Arroyo also singled out investing in the country’s infrastructure as a key priority, and has announced that PHP1.7trn (US$38bn) will be committed to various projects during her tenure as president.

In July, Bangko Sentral Ng Pilipinas surprised the markets by changing its key policy interest rates for the first time since October 2005, when it slashed rates by 150 basis points (bps) and 175bps, as well as announcing that it is to abolish its tiering scheme on overnight money. Nonetheless, the bank is still maintaining its neutral monetary policy stance. The key concern, however, comes in the form of weak revenue collections, which continue to weigh upon the economy. Although government officials are talking positively about the outlook for revenue collections in H207, after the country’s first half fiscal deficit came in more than 30% over target, we remain sceptical that the PHP63bn budget deficit target will be met.

The Philippines is becoming an increasingly popular place to do business, as the country’s macroeconomic fundamentals continue to improve and new initiatives to entice foreign companies to the country continue to bear fruit. Nonetheless, net FDI inflows fell 23% y-o-y in the first five months of 2007, as uncertainty surrounding May’s congressional elections deterred investors. However, following the smooth passing and favourable outcome of these elections, investors should now be drawn back to the Philippines. A substantial increase in government spending to improve the country’s infrastructure should further attract FDI going forward, although the Philippines will remain susceptible to capital flight if investor sentiment sours.

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chapter 1

Political Outlook

SWOT Analysis Strengths The Philippines is Asia’s oldest and liveliest democracy. The constitution, framed in 1987 following the ousting of dictator Ferdinand Marcos in the first ‘people power’ uprising, guarantees ‘life, liberty and property’ in a US-style bill of rights.

Weaknesses The executive typically faces long delays getting its bills through a legislature filled by the Philippines’ old landed families and new ‘showbiz’ celebrities and business tycoons.

The military is not above politics. Disaffected junior officers have staged a series of mutinies in recent years while the top brass played decisive roles in the ‘people power’ uprisings of 1986 and 2001.

Opportunities Moving towards a parliamentary-style constitution, a process referred to locally as charter change or ‘cha-cha’, could reduce the influence of powerful personalities in local politics.

Threats Stalled peace talks with the Moro Islamic Liberation Front and the communist New People’s Army could collapse leading to an escalation in armed conflict.

Kidnappings and bombings by smaller groups, like the Abu Sayyaf, are to be expected during our forecast period.

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political outlook

BMI Political Risk Ratings Philippine President Gloria Macapagal Arroyo made her seventh annual State of the Nation address on July 23, taking the opportunity to champion the economic progress the Philippines has made under her stewardship, and to set out her agenda for her remaining three years in office. Arroyo was quick to condemn the killings of political activists and journalists that have tarnished her administration’s record saying ‘it’s never right to fight terror with terror’, although some will view this comment as somewhat hypocritical following the passing of the Philippines’ new anti-terror law on July 15, which has been criticised for infringing upon civil liberties.

Singapore Hong Kong Vietnam Malaysia China Australia New Zealand North Korea South Korea Taiwan Laos Japan Myanmar Cambodia Sri Lanka Philippines India Indonesia Bangladesh Pakistan Thailand Regional Average: 75.4

Rank

Trend

97.3 86.7 86.7 86.3 83.3 82.0 80.0 79.8 79.4 77.5 77.1 76.0 73.3 72.3 70.8 69.2 64.4 61.0 60.6 60.0 59.8

1 10 10 14 23 25 32 37 38 45 47 53 63 70 79 82 100 106 107 110 112

= = = = = = = = = = = = = = = = = = = =

Emerging Market Average: 68.6

Japan South Korea Australia New Zealand Taiwan Singapore Malaysia India Sri Lanka Hong Kong China Philippines Thailand North Korea Pakistan Vietnam Cambodia Indonesia Bangladesh Laos Myanmar Regional Average: 64.1

Short-Term Composite

Long-Term Political

Rank

Trend

92.5 89.2 85.0 85.0 76.4 75.5 74.2 70.0 63.1 62.2 60.4 57.0 55.8 55.1 54.4 53.8 52.9 50.6 50.4 46.5 36.8

5 8 16 16 39 40 44 50 67 71 77 90 95 96 98 101 103 108 110 118 128

= = = = = = = = = = = = = = = = = = = = =

Emerging Market Average: 61.3

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Global Market Average: 70.2

Global Market Average: 65.0

XXXXXXXXXXX Philippines Q4QX 2007 2007

Domestic Politics BMI View President Gloria Macapagal Arroyo has signalled her intent to increase efforts to reduce terrorism in the Philippines following this year’s annual State of the Nation address, specifically mentioning the extrajudicial killings of political activists and journalists that have occurred during her leadership. More progress is expected to be made in suppressing terrorism following the recent passing of the Philippines’ new anti-ter-

Fight Against Terrorism Takes Centre Stage Philippine President Gloria Macapagal Arroyo made her seventh annual State of the Nation address on July 23, taking the opportunity to champion the economic progress the Philippines has made under her stewardship, and to set out her agenda for her remaining three years in office. Arroyo intends to devote further attention to improving infrastructure and to reducing poverty in the Philippines, as she paves the way for the South East Asian nation to ‘become a developed country in 20 years’. Beyond her economic mandate, which will see PHP1.7trn (US$38bn) committed to infrastructure projects, and record funding allocated for improving education, and ensuring the availability of cheap medicines and affordable housing, Arroyo took time to specify a number of political goals.

ror law, and much hope is being pinned upon renewed talks with Islamic seperatists to achieve a similar end.

At the forefront of these was dealing with the extrajudicial killings of political activists and journalists that have tarnished her administration’s record and attracted widespread criticism both domestically and abroad; since Arroyo came to power in 2001, it has been reported that over 800 of her political opponents have been killed or gone missing. In her speech, Arroyo called on Congress to pass laws that would ‘reserve the harshest penalties for the rogue elements in the uniformed services’, acknowledging for the first time the blame placed on the military for the spate of illegal killings. She added that ‘it’s never right to fight terror with terror’.

However, some will view this comment as somewhat hypocritical following the passing of the Philippines’ new anti-terror law on July 15. The new law establishes a permanent government body to co-ordinate anti-terror efforts, enhance surveillance capabilities (including the ability to track mobile phone communications), increase the government’s ability to monitor terrorist financing, and most significantly, it gives law enforcement agencies the power to detain terrorists pre-emptively. However, despite the fact that many believe that an initiative to boost efforts in the fight against terrorism in the Philippines has been long overdue, the new law has come under criticism from some domestic quarters for infringing upon civil liberties.

Another key initiative aimed at suppressing terrorism in the Philippines, is the ongoing negotiations with the country’s largest Islamic separatist group, the Moro Islamic Liberation Front (MILF). Talks between the government and the MILF will resume on August 22, following a resurgence of violence between troops and members of various separatist groups in the south of the country, and will focus once more upon an autonomy package.

Negotiations had stalled since September 2006 over the size and wealth of the proposed Muslim region in the south, and were further delayed by May’s local and congressional elections; the two sides were due to meet in Kuala Lumpur for informal talks on May 1-2, but the government cancelled them in view of the upcoming polls. Now, however, following the government’s recent offer of the right to self determination, there is a renewed sense of optimism that a long-awaited agreement can be successfully reached.

Initially, Manila had offered to expand the six provinces of the Autonomous Region in Muslim Mindanao (ARMM), created as part of peace negotiations with the MILF in 1996, to include more than 600 Muslim-dominated villages in Christian provinces on the southern

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political outlook

island of Mindanao. However, the MILF countered with a demand for an additional 1,000 villages on top of the government’s offer, covering Muslim areas as far away as Davao and Zamboanga provinces. This resulted in protests from a number of local officials in the south opposed to the MILF proposal, and instigated demands for a referendum asking people whether they agree to be part of the proposed expanded ARMM. This putative referendum could well prove to be a sticking point in negotiations, as the MILF opposes any referendum tied to peace deal, describing the process as the government’s ‘unilateral’ decision. For this reason, among others, many remain sceptical over the prospect of a final deal being reached any time soon, in spite of the confidence the MILF is expressing over proceedings.

The nearly 40-year old conflict between the government and the MILF has been responsible for the deaths of over 120,000 people, and has displaced up to 2mn people from their homes, and as such, there is a distinct feeling that there are too many complexities for it to be easily resolved. Nonetheless, both parties will be keen to push forward proceedings in order to bring the conflict to an end, and this fosters some hope of a reasonably swift resolution. The ongoing dispute has served to severely stunt economic growth in the resource-rich southern region. Consequently, if significant progress can be made towards bringing greater stability to the area, a significant upturn in the region’s economic contribution could be on the cards.

Mindanao is a region that is generally considered to be one of the richest areas of South East Asia in terms of untapped natural resources. However, in stark contrast to this potential, Mindanao is perhaps one of the most impoverished districts in the region. Billions of dollars in foreign investment could flow into agro-industries, fisheries and mining in Mindanao, if lasting peace can be achieved. Thus, successful peace negotiations will be high on the government’s list of priorities in their continuing efforts to achieve economic expansion, which will allow them to push forward as a regional economic power.

Foreign Policy China Ties Offer Major Opportunities Asia’s annual security summit took place in Manila in August, where a host of global issues, such as Darfur and global warming, as well as region-specific topics, including North Korea and the growing concern over bird flu, were discussed. However, one of the major talking points was the absence of US Secretary of State Condoleezza Rice, who missed the summit for the second time in three years as she instead met with top officials in the Middle East. Rice’s absence, according to some, has sent a bad signal to Association of South East Asian Nations (ASEAN) members concerning the US’s commitment to the region, especially in light of US President George W. Bush’s decision to miss an upcoming forum in Singapore this September. This has paved the way for China’s new foreign minister, Yang Jiechi, to press forward Beijing’s credentials in a region that is emerging from a long-standing wariness of the world’s most populous nation.

BMI View The Philippines is one of the ASEAN countries China intends to strengthen relations with in order to secure access to natural resources and new markets, as well as to extend its political influence, and the Philippines will be only too glad for this to happen. China has become the Philippines’ most important export market, and equally relies heavily upon China for many of its imports. As such, improving ties between the Philippines and China will serve the best interests of both nations. This year’s Asian annual security summit, in the absence of the US, will

South East Asia is becoming increasingly important to China as a trade partner, as well as a transit area for most of the imported resources, such as oil, that are fuelling the counBusiness Monitor International Ltd

afford China a great opportunity to forge closer ties with its regional counterparts.

XXXXXXXXXXX Philippines Q4QX 2007 2007

try’s rapid economic expansion. In return, China is becoming increasingly important to South East Asia, especially the Philippines. Latest quarterly data from the IMF showed that in Q406, Philippine exports to China (including Hong Kong and Macao) were valued at US$6.008bn, taking the total value of Philippine shipments to China for the year to US$19.165bn. This means that in 2006, China (plus Hong Kong and Macao) accounted for over 45% of all Philippine shipments to Asia, by far its biggest export market, and over 30% of its total exports worldwide.

However, the same relationship is far from a two-way street. While China overtook the US as the Philippines’ biggest single export market, the Philippines is not even China’s largest source of imports in the region, trailing behind Japan, Korea, Singapore, Malaysia and Thailand. In addition, while the Philippines relies upon China for around 15% of its total imports, the South East Asian nation purchases less than 1% of China’s exports.

Greater China Dominant Philippines – Export Destinations

Germany 4.0%

Others 14.4%

US 15.9% Japan 13.2%

South Korea 4.6%

Taiwan 4.7% Malaysia 5.3% Singapore 6.3%

Netherlands 7.9%

Source: National Statistics Office

China 11.2%

Hong Kong 12.5%

Furthermore, foreign direct investment (FDI) from China into the Philippines remains low.

In 2006, the Philippines received only US$2.27mn worth of net FDI from mainland China, and saw a negative net outflow of US$3.40mn to Hong Kong. This lags far behind the US, which over the past five years has poured US$1.03bn into the Philippines, and Japan, which over the same period of time invested US$937.50mn. In comparison, mainland China and Hong Kong have invested only US$269.47mn, with the bulk of that figure invested by Hong Kong in 2005, when FDI reached US$258.05mn.

Nonetheless, Philippine exports to China and Hong Kong are currently experiencing rapid growth. In May, Philippine shipments to Hong Kong grew 60.0% y-o-y, while exports to the mainland expanded 33.4%. With Chinese economic growth expected to top 11.0% this year, we anticipate this trend will continue. In addition, the Philippines’ burgeoning relationship with China will help insulate its export sector from a global economic slowdown. With such a high concentration of exports placed in electronic goods, the Philippines’ export industry is highly vulnerable to a global downturn, but China’s relentless economic growth story will help ensure demand for Philippine exports will remain well supported, even if the US, another of the Philippines’ key economic allies, experiences an economic slowdown.

However, closer ties with China does come with its downsides. An influx of Chinese immigrants into the Philippines is currently causing tensions between the new arrivals and the Philippines’ ethnic Chinese. According to the Financial Times, there are between 80,000-100,000 illegal or overstaying Chinese nationals in the Philippines, adding around 10% to the country’s approximated 1mn ethnic Chinese population.

Newcomers are drawn by a combination of weak law enforcement and the opportunity to tap into the lucrative market supplied by a burgeoning Filipino middle class. Record remittances being sent home by Filipinos working overseas have enhanced domestic incomes and consequently boosted consumer spending, meaning that the lure for many Chinese, who have greatly benefited from Manila’s move in 2005 to liberalise entry procedures for Chinese tourists and investors, is proving too great. This is, however, stirring up resentment in longer-established local Chinese communities, which regard the recent immigrants as unfair competitors in business, and worry that they will forge a bad reputation for Chinese in the Philippines via their ‘brash and pushy’ attitudes.

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political outlook

Nevertheless, the overall net effect of improved ties between the Philippines and China will be positive. We expect China to continue to exert its influence in the Philippines as it becomes an ever increasing provider of economic aid and support to the Southeast Asian country in order to gain access to natural resources and new markets. China has already been the benefactor on several occasions in the Philippines, most recently, at April’s Boao Forum for Asia, when Manila and Beijing signed a US$319mn loan agreement meant to finance the Philippines’ national broadband initiative, and we anticipate many more of these kinds of accords going forward.

Table: CABINET & OTHER KEY POSTS (AS OF August 2007) President Vice President Executive Secretary Chief of Staff Secretary of Agrarian Reform (acting) Secretary of Agriculture Secretary of the Budget & Management Secretary of Education, Culture, & Sports

Gloria Macapagal Arroyo Manuel Noli DE CASTRO, Jr. Eduardo ERMITA Joey SALCEDA Nasser PANGANDAMAN Arthur YAP Rolando ANDAYA Jesli LAPUS

Secretary of Energy

Angelo REYES

Secretary of Environment & Natural Resources

Jose ATIENZA

Secretary of Finance Secretary of Foreign Affairs Secretary of Health Secretary of Interior & Local Govt.

Secretary of Justice Secretary of Labor & Employment Secretary of National Defence Secretary of Public Works & Highways Secretary of Science & Technology Secretary of Social Welfare & Development Secretary of Socio-Economic Planning Secretary of Tourism Secretary of Trade & Industry Secretary of Transportation & Communications National Security Adviser Director of Presidential Management Governor, Central Bank

Margarito Gary TEVES Alberto ROMULO Francisco DUQUE III Ronaldo PUNO Raul GONZALEZ Arturo BRION Gilberto TEODORO Hermogenes EBDANE Estrella ALABASTRO Esperanza CABRAL Romulo NERI Joseph DURANO Peter FAVILA Leandro MENDOZA Norberto GONZALES Cegre REMONDE Amando TETANGCO, Jr.

Source: CIA

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chapter 2

Economic Outlook

SWOT Analysis Strengths Home remittances from the 8mn workers living overseas are a key source of national income and provide much-needed support to the country’s balance of payments.

Weaknesses Repeated budget deficits have led to a sharp rise in public debt, which still exceeds 60% of GDP. The cash-strapped government spends around one third of its revenues making interest payments on its outstanding borrowings.

Unemployment remains as high as 8%. The jobless rate will remain high so long as economic growth falls short of the level needed to create jobs for a fast-expanding labour force.

Opportunities The government could ease pressure on its fiscal accounts by broadening the tax base and eliminating graft at the Bureau of Internal Revenue.

Outsourcing could provide the Philippines, with its cheap English-speaking workforce, with a valuable source of foreign exchange.

Threats A Latin American-style default will remain a threat so long as the government relies on foreign borrowing to finance its budget shortfalls. Half of the government’s debt is held in foreign currencies.

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ECONOMIC outlook

BMI Economic Risk Ratings Revenue collections are expected to be ‘back on track’ in the second half of 2007 according to President Gloria Macapagal Arroyo, following a torrid first six months of the year in which targets were persistently missed. A statement from Finance Secretary Margarito Teves has said revenue collections have made an ‘auspicious start’ in H2, and that regional tax offices were on track in their collection targets for Q307. However, having missed its first quarter deficit target of PHP45.8bn, the Philippines recorded a deficit of PHP1.7bn (US$37bn) in May alone, and in our view the government will be unable to achieve its PHP63bn deficit target by year end.

Short-Term Economic

Rank*

Trend

89.2 86.9 86.7 85.2 81.3 80.8 80.4 77.9 77.0 77.0 73.1 69.6 68.8 67.0 62.1 51.3 47.3 34.8

6 7 8 10 19 22 23 26 29 29 42 57 60 66 80 106 114 127

= = = = = = = = = = = = = = = = = =

South Korea China Singapore Hong Kong Philippines India Malaysia Taiwan Japan New Zealand Indonesia Vietnam Thailand Australia Cambodia Pakistan Bangladesh Sri Lanka Regional Average: 72.0

Emerging Market Average: 62.8

Global Market Average: 64.4

* Not Ranked: Laos, Myanmar, North Korea

Long-Term Economic

Rank*

Trend

77.4 77.2 75.1 74.9 74.8 73.3 73.0 71.0 70.3 70.0 69.2 63.9 62.9 61.3 59.1 53.5 52.1 42.0

7 8 12 13 14 19 20 27 31 32 34 56 57 61 66 84 91 110

= = = = = = = = = + = = = = = = =

Australia South Korea China Singapore Taiwan Hong Kong Malaysia New Zealand Japan Thailand India Indonesia Philippines Pakistan Vietnam Cambodia Bangladesh Sri Lanka Regional Average: 66.7

Emerging Market Average: 58.7

Global Market Average: 60.6

* Not Ranked: Laos, Myanmar, North Korea

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13

Philippines Q4 2007

Introduction

Growth To Remain Stable Real GDP (% chg)

Economic Activity – Set To Slow

7 6 5 4 3 2 1

2011f

2010f

2009f

2007f

2008f

2005

2006e

2004

2003

2002

0

e/f = BMI estimate forecast; Source: National Statistical Co-ordination Board

Revenues Are Key

Total Monthly Government Revenue & Expenditure (PHPmn) 110 Expenditures

100

Revenues

90 80 70 60 50

The Philippines enjoyed its fastest growth rate in 17 years in Q107, as healthy domestic consumption, sustained export growth and increased government spending combined to boost growth to 6.9% y-o-y. Government officials have now said that the full-year growth target of 6.1-6.7% is well within reach, and could even be revised up. In light of the recent data, we have revised up our growth forecast for 2007 to 6.0%, although we still retain a slightly more conservative outlook than the Philippine government, as we anticipate exports and remittance inflows to drop slightly from their current highs in H207.

Fiscal Policy – Revenues Still A Weakness Government officials are talking positively about the outlook for revenue collections in H207, after the country’s H107 fiscal deficit came in more than 30% over target. However, we remain sceptical that the PHP63bn budget deficit target will be met. Furthermore, tax revenue targets have been cut, while non-tax revenue targets have been raised in order to meet this year’s goal, signalling concerns over the Philippines’ long-term fiscal stability.

40 30 20 10 May-07

Jan-07

Mar-07

Nov-06

Sep-06

Jul-06

May-06

Jan-06

Mar-06

Nov-05

Sep-05

Jul-05

Mar-05

May-05

Jan-05

Nov-04

Jul-04

Sep-04

Jan-04

Mar-04

May-04

0

Monetary Policy – Remaining Neutral At its latest monetary policy meeting on July12, Bangko Sentral ng Pilipinas (BSP) surprised markets when it slashed its key policy interest rates by 150bps and 175bps, as well as announcing that it is to abolish its tiering scheme on overnight money. Having issued a statement affirming its neutral stance towards monetary policy only eight days previously, the BSP confounded markets by bringing its overnight borrowing rate (or reverse repurchase rate) from 7.50% to 6.00% and its overnight lending rate (repurchase rate) from 9.75% to 8.00%, effective July 13. This was the first time since October 2005 overnight rates had been altered.

Source: Department Of Finance

Low & Steady

Consumer Price Index (% chg y-o-y) 10 9 8 7 6 5 4 3

Balance Of Payments – Surplus To Diminish

2 1

May-07

Jan-07

Sep-06

Jan-06

May-06

May-05

Sep-05

Jan-05

Sep-04

May-04

Jan-04

Sep-03

Jan-03

May-03

0

Source: Bangko Sentral ng Pilipinas

Exports Vulnerable

The Philippines’ balance of payments surplus rose to an 18-month high in July, thanks to strong remittance inflows from overseas Filipino workers and robust foreign direct investment and portfolio inflows. However, while the central bank’s outlook on the country’s balance of payments ‘continues to be positive’, we remain far more conservative on the Philippines’ external position, as capital inflows begin to moderate, and a slowdown in the US economy continues to weigh upon Philippine exports.

Merchandise Trade (US$mn) 5,500 5,000

Balance

Exports

Imports

4,500 4,000 3,500 3,000 2,500 2,000 1,500 1,000 500 0 -500

Jan-04 Mar-04 May-04 Jul-04 Sep-04 Nov-04 Jan-05 Mar-05 May-05 Jul-05 Sep-05 Nov-05 Jan-06 Mar-06 May-06 Jul-06 Sep-06 Nov-06 Jan-07 Mar-07 May-07

-1,000

Source: National Statistics Office

14

Exchange Rate – Short-Term Weakness Expected Having risen to a near seven-year high of PHP44.50/US$ on July 20, the peso has come under some pressure of late, amid global risk aversion in the face of ongoing credit market concerns. Having broken through key support at PHP46.20/US$, we see further short-term weakness for the unit, although we still maintain our long-term bullish stance towards the currency. We have set a long-term target of PHP40.00/US$ for the peso, which we expect to see reached by the end of our five-year forecast period, as healthy macroeconomic fundamentals remain supportive.

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ECONOMIC outlook

Economic Activity Growth To Moderate Despite Impressive Q107 Numbers The Philippines enjoyed its fastest growth rate in 17 years in the first quarter of 2007, as healthy domestic consumption, sustained export growth and increased government spending combined to boost growth to 6.9% y-o-y. Government officials have now said that the full-year target of 6.1-6.7% growth is well within reach, and could even be revised up after the Philippines recorded the third-best first quarter performance of all Asian countries, trailing only Vietnam (7.7%) and China (11.1%).

BMI View Following Q107’s 17-year high growth rate of 6.9% y-o-y, the Philippine government remains optimistic about hitting its full-year target of 6.1-6.7%. However, with exports expected to moderate in H207, as well as capital inflows anticipated to slow, we remain more cautious towards the Philippines’ growth prospects, fore-

Growth Momentum Intact Real GDP Growth (% y-o-y)

8 7 6 5 4 3 2 1

Q1-07

Q3-06

Q1-06

Q3-05

Q1-05

Q3-04

Q1-04

Q3-03

Q1-03

0

Q3-02

Record remittance inflows have provided a major boon to the Philippine economy, as the US$3.50bn sent home by overseas workers in the first quarter helped to fuel consumer spending. Domestic consumption accounts for around 70% of GDP, and money sent back to the Philippines from citizens working abroad provides a major source of disposable income for domestic based Filipinos. Remittances totalled US$12.8bn last year, and are projected to top US$14bn this year as migrant workers from the Philippines become evermore successful in finding higher paid work and an increasing proportion of inflows are sent home through official channels. However, there is now a worry that remittance inflows may have peaked following June’s deadline for school tuition fees, and that they may start to slow going forward. Indeed, remittance inflows have already started to show signs of slowing, with latest official data showing that remittances rose just 1% y-o-y in June, the slowest growth rate since April 2006. With the US being one of the major sources of remittance inflows to the Philippines, a major risk to remittances is a downturn in the US economy.

This would exacerbate a slowing of remittances, which would consequently have a serious negative impact upon domestic consumption, and consequently on growth.

casting economic growth of 6.0% in 2007.

Q1-02

In light of the recent data, we have revised up our growth forecast for 2007 to 6.0%, although we still retain a slightly more conservative outlook than the Philippine government, as we anticipate exports and remittance inflows to drop slightly from their current highs in H207.

Beyond this year, we have also upped our growth forecasts, although we still expect growth to slow going forward as the government’s fiscal stimulus lessens as it strives to achieve a balanced budget. We are now forecasting growth to average 5.6% over our five-year forecast period, as it gradually slows from 6.0% this year, to 5.3% in 2011.

Source: National Statistical Co-ordination Board

Strong first quarter remittance inflows were accompanied by a 13.1% y-o-y increase in government consumption, as President Gloria Macapagal Arroyo makes good on her promise to increase infrastructure spending following years of cutting back on expenditure in efforts to reduce the government’s fiscal deficit. Arroyo has earmarked PHP142bn for the construction of roads, rail links, bridges and irrigation projects along with other developments through the government’s Comprehensive Integrated Infrastructure Programme, and this in turn served to boost construction in Q107 with the sector expanding 8.6% y-o-y. Furthermore, at her seventh annual State of the Nation address on July 23, Arroyo pledged a further PHP1.7trn (US$38bn) to infrastructure projects over the remainder of her tenure as president, which will help achieve more sustained economic expansion over a longer-term period.

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Philippines Q4 2007

Another success story for the government has been the 11.0% expansion of the country’s mining and quarrying sector in Q107. This has long been an area in which the authorities have focused their attention, and so the first quarter’s performance will provide Arroyo with renewed confidence in further expanding the underdeveloped sector. However, agriculture grew at a rather modest 4.2% y-o-y in Q107, and this figure moderated further in Q207, to 3.6%, as it still recovers from last year’s super typhoons. Currently, the sector is hurting from a dry spell, and consequently, full-year growth is now unlikely to hit the government’s 4.5-5.0% target. Nonetheless, it is likely that a strong service sector performance and higher government spending will offset the negative impact on overall growth of a slower-than expected farm output in 2007.

However, we expect Philippine exports to continue to moderate throughout H207 after growing just 1.6% y-o-y in June, the lowest growth rate for any month so far in 2007; this will have a negative effect upon overall growth. With the US facing a slowdown in domestic consumption and consequently in headline economic growth, demand for Philippine exports is likely to moderate somewhat going forward. While exports will be insulated to a certain degree due to the emergence of China as major export destination, the US still accounts for approximately 15% of all Philippine shipments; consequently, the Philippines will remain exposed to the US’s economic performance, which will thus provide a downside risk to Philippine growth. The current trend in import growth supports our forecast that Philippine exports will continue to slow in H207. Philippine imports fell 3.4% y-o-y in May, sharper than the previous month’s 1.7% decline, signalling a weaker trade performance going forward as global demand for electronic goods continues to slow. More than two-fifths of Philippine imports are raw materials purchased by exporters and other manufacturers to be used in the manufacturing of goods for export, and so consequently, the slowdown in import growth could now indicate slower future export growth.

Nonetheless, growth prospects for the Philippines still remain healthy going forward. With government expenditure to continue apace and capital inflows still expected to remain robust, the government’s target of 6.1-6.7% growth this year is still well in sight. Some government quarters have also been talking up the possibility of growth reaching the so far elusive 7.0% mark, although BMI believes that this would be very ambitious. While remittances and government spending will remain strong throughout the year, it is important to note that the prospect of them tailing off from their recent impressive performances is very real. Furthermore, persistent high oil prices could also be a drag on growth going forward. Thus, while we are confident enough on the prospects of the Philippine economy

Table: ECONOMIC ACTIVITY

2002

2003

2004

2005

2006

2007f

2008f

2009f

2010f

2011f

Nominal GDP, PHPbn [3]

3,963.9

43,16.4

4,871.6

5,437.9

6,032.6

6,630.1

7,297.3

8,022.9

8,794.8

9,613.1

Nominal GDP, US$bn [4]

76.74

79.61

86.91

98.85

117.89

141.39

155.54

165.60

175.58

185.93

4.4

4.9

6.4

4.9

5.4

6.0

5.7

5.5

5.4

5.3

Real GDP growth, % change y-o-y [1,3] GDP per capita, US$ [4] Population, mn [5] Unemployment, % of labour force, eop [2,5]

975

993

1065

1190

1396

1646

1782

1868

1950

2034

78.70

80.17

81.62

83.05

84.48

85.88

87.28

88.67

90.05

91.42

11.4

11.4

11.8

8.7

7.9

7.5

7.5

7.5

7.5

7.5

Notes: f BMI forecasts. 1 The Oxford Economic Forecasting model is used when generating forecasts.; 2 Annual average; Sources: 3 National Statistical Coordition Board. 4 BMI calculation; 5 National Statistics Office.

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ECONOMIC outlook

to revise up our year-end growth forecast to 6.0%, we are staying a little more cautious of government estimates in view of the potential risks to growth that lie ahead.

Fiscal Policy Poor Revenue Collection Continues To Weigh On Economy Weak tax collections continue to be problematic in the Philippines, after the government missed its first half fiscal deficit target of PHP31.3bn by around PHP6.4bn. Finance Secretary Margarito Teves was recently quoted as saying that revenue collections have had an ‘auspicious start’ in H207, after the disappointing first half performance, but we remain unconvinced that the government will be able to achieve its full-year deficit target of PHP63bn (or 0.9% of GDP), especially in view of the fact that it has recently cut its tax revenue target for 2007 by 3%.

BMI View Government officials are talking positively about the outlook for revenue collections in H207, after the country’s first half fiscal deficit came in more than 30% over target. However, we remain sceptical that the PHP63bn budget deficit target will be met. Furthermore, tax-revenue targets have been cut, while non-tax revenue targets have been raised in order to meet this year’s long-term fiscal stability.

Gradual Decline

Fiscal Balance (% of GDP) 0

-1

-2

-3

-4

-5

2011f

2010f

2009f

2008f

2007f

2005

2006e

2004

-6

2003

However, the impending implementation of the lateral attrition law, which will introduce a system of rewards and penalties for tax officials, should improve tax collection efficiency, and consequently help revenue agencies such as the BIR to enhance their performance.

Under the law, internal revenue and customs personnel can be rewarded with cash incentives and promotion to higher posts if they meet or exceed collection targets, while on the other hand, those whose revenue collections fall short of their targets can be sanctioned with demotion or even removal from office. Nonetheless, the fact that two and a half years after the bill was passed into law, the Philippines is still waiting for it to come into force, does little to instil confidence that it will have a dramatic impact on revenue collections in H207.

target, signalling concerns over the Philippines’

2002

Once again, the Bureau of Internal Revenue (BIR) will come under scrutiny after only managing to collect PHP334.7bn in H107, PHP38.6bn under target. Jose Mario Bunag was recently replaced as BIR Commissioner after the bureau’s persistent failure to meet its targets put this year’s budget deficit goal in doubt. However, his replacement, Lilian Hefti, has made an underwhelming start to her reign as head of the BIR, and has consequently done little to ease fears that the PHP63bn deficit target will be met.

Source: Department Of Finance

The government recently cut its target for tax revenues this year in response to the poor performance from revenue agencies such as BIR and the Bureau of Customs (BoC). BIR, the country’s main tax agency, has had its target reduced from PHP765.8bn (US$16.58bn) to PHP741.3bn (US$16.05bn), while the BoC’s target has been moderated from PHP228.2bn (US$4.94bn) to PHP223.1bn (US$4.83bn) as the entire tax revenue target was reduced Table: FISCAL POLICY

2002

2003

2004

2005

Fiscal revenue, PHPbn [1]

566.0

626.6

699.8

Fiscal expenditure, PHPbn [1]

778.7

826.5

886.8

Budget balance, PHPbn [1]

-210.7

-199.9

-5.3

-4.6

Budget balance, % of GDP [1]

2006

2007f

2008f

2009f

2010f

2011f

795.7

978.8

1,056.7

1,141.9

1,224.4

1,299.6

1,380.5

942.2

1,041.0

1,125.0

1206.6

1,286.2

1,354.3

1,422.9

-187.1

-146.8

-62.2

-68.4

-64.7

-61.8

-54.6

-42.4

-3.8

-2.7

-1.0

-1.0

-0.9

-0.8

-0.6

-0.4

Notes: f BMI forecasts. 1 Fiscal balance includes a residual; Source: Bureau of the Treasury

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17

Philippines Q4 2007

from the original PHP1.003trn (US$21.72bn) to PHP973.6bn (US$21.09bn). However, it has maintained its original deficit goal after the Development Budget Co-ordination Committee, who approved the lower tax-revenue target, raised non-tax revenues by 26% to PHP145.2bn (US$3.14bn). The government is planning to raise around PHP100bn through the sale of state assets in 2007, through the sale of a 24% stake in San Miguel Corp and the sale of a 60% share in geothermal firm PNOC-EDC, but this will only be a short-term solution. Unless more is done to improve revenue collections, long-term fiscal stability will be severely at risk. The Philippines recently missed out on an upgrade of its sovereign debt rating from Standard & Poor’s after the ratings agency decided that revenue shortfalls, and in particular tax collections, would not allow it to advance the country’s score. This merely emphasises the need for the Philippines to focus upon improving revenue collections.

Teves has said that in the ‘worst case’ scenario, the revenue shortfall may reach PHP60bn this year, although Economic Planning Secretary Romulo Neri puts the figure closer to PHP100bn, and Fitch Ratings on July 24 raised its 2007 Philippine fiscal deficit forecast to PHP125bn from PHP100bn previously. While this would not necessarily mean that the year-end budget deficit goal will be missed, as privatisation receipts can fill the gap, it will raise concerns going forward. The government has increased expenditure this year in order to improve the country’s infrastructure, but we are not anticipating this fiscal stimulus to remain in place in 2008 as the administration strives to balance its budget. Essentially, government spending will remain constrained until tax collections are noticeably enhanced, and this will have negative implications on economic growth. More must be done to rectify the problem, or the Philippines will face the prospect of investor sentiment, which has been particularly buoyant over the past two years, turning sour.

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ECONOMIC outlook

Monetary Policy Effects Of Surprise Move Prove Short Lived

BMI View

At its latest monetary policy meeting on July 12, the Bangko Sentral ng Pilipinas (BSP) surprised markets when it slashed its key policy interest rates by 150bps and 175bps, as well as announcing that it is to abolish its tiering scheme on overnight money. Having issued a statement affirming its neutral stance towards monetary policy only eight days previously, the BSP confounded markets by bringing its overnight borrowing rate (or reverse repurchase rate) from 7.50% to 6.00% and its overnight lending rate (repurchase rate) from 9.75% to 8.00%, effective July 13. This was the first time since October 2005 overnight rates had been altered.

At its latest monetary policy meeting on July 12, the Bangko Sentral ng Pilipinas surprised markets when it slashed its key policy interest rates by 150bps and 175bps, as well as announcing that it is to abolish its tiering scheme on overnight money. Nonetheless, the bank still insists it is maintaining its neutral stance towards monetary policy.

The BSP has insisted that the surprise moves help to maintain its monetary policy stance, which it describes as ‘neutral relative to future inflation and output’. Inflation has been hovering around all-time lows this year, with price growth in June falling to 2.3% y-o-y, and this has prompted the central bank to recently revise down its year-end forecasts. The bank is now expecting inflation to average between 2.4-3.1% in 2007, having previously anticipated average price growth in the 4.0-5.0% range.

Surprise Move Interest Rates, %

Furthermore, domestic liquidity growth has eased of late, dropping to 19.4% y-o-y in June from 20.5% in May, as the additional liquidity management measures implemented in early May this year began to take effect. Consequently, as we had previously highlighted, there was room for rate cuts, but nevertheless the twin moves do seem to be very aggressive, especially in light of the previous comments from the BSP that implied there would be no change to monetary policy in July.

16

Repo rate

Reverse repo rate

14 12 10 8 6 4 2

Jan-01 Apr-01 Jul-01 Oct-01 Jan-02 Apr-02 Jul-02 Oct-02 Jan-03 Apr-03 Jul-03 Oct-03 Jan-04 Apr-04 Jul-04 Oct-04 Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07

0

While the benchmark reverse repurchase rate was dramatically cut, there is some suggestion that the overall effect of the central bank’s twin moves was a tightening one. By removing the tiering scheme, the bank has effectively merged the different rates offered under the system (7.5%, 5.5% and 3.5%) into one rate of 6.0% (the reverse repo rate). The net effect on monetary conditions is difficult to gauge, as with different sums of money deposited at different rates, it is not just a question of simply adding up the hikes and cuts (which would incidentally amount to a hike). However, according to rough calculations from Merrill Lynch, the effective overnight borrowing rate under the tiering scheme was

Source: Bangko Sentral ng Pilipinas

between 5.0-5.5%, meaning that the BSP’s 150bps cut would in fact have a mild tightening effect. Nonetheless, there still remains no overall market consensus on the issue, and

Table: MONETARY POLICY

2002

2003

2004

2005

2006

2007f

2008f

2009f

2010f

2011f

Lending rate, %, eop [1,3]

8.90

9.48

10.07

10.15

10.22

9.80

9.44

9.30

9.40

9.45

Real Lending Rate, %, eop [1,4]

5.72

5.80

3.86

2.32

3.72

6.81

4.90

4.53

4.58

4.69

Consumer prices, % y-o-y, eop [2,5]

3.0

3.0

8.4

6.6

4.3

3.8

4.4

4.6

4.6

4.0

Consumer prices, % y-o-y, ave [2,5]

3.0

3.5

6.0

7.6

6.3

2.8

4.3

4.6

4.6

4.5

Exchange rate PHP/US$, eop [3]

53.10

55.57

56.27

52.98

49.25

46.00

45.00

43.00

42.50

40.00

Exchange rate PHP/US$, ave [3]

51.60

54.18

56.04

55.03

51.11

47.63

45.50

44.00

42.75

41.25

Notes: f BMI forecasts. 1 Annual average; 2 2000=100; Sources: 3 IMF. 4 BMI calculation; 5 National Statistics Office.

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Philippines Q4 2007

as such, it is likely that the BSP will now adopt a wait-and-see approach before altering monetary policy again as it assesses the effect of its latest move.

The policy moves proved to be both equity positive and beneficial to domestic bonds, with the benchmark Philippine Stock Exchange index (PSEi) gaining 2.42% in the two days following the policy announcement to climb to an all-time high of 3,786.02, and the yield on the benchmark five-year government bond shedding 60bps during the same period.

However, these gains proved to be short lived as global risk appetite weakened in the face of mounting fears over the strength of the US economy, as investors switched out of riskier emerging market assets and into the more secure G7 instruments.

A key implication of the BSP’s decision will be the negative fallout concerning the institution’s credibility. On June 29, the bank published comments stating that it was pleased with the success of its tiering scheme in slowing money supply growth and improving bank lending.

However, less than two weeks later, the BSP decided to withdraw the scheme. Equally, on July 4, comments from the bank hinted strongly that interest rates would remain on hold, as it reiterated its neutral stance towards monetary policy. Now, the bank is still trying to convince investors that it is neutral, despite aggressively loosening monetary policy.

From here, it is consequently difficult to gauge how sincere the bank is in its intentions.

Furthermore, the magnitude of the cuts will provide investors with little confidence in the bank’s ability to dictate effective monetary policy. A 25bps cut would have been a surprise to the markets, but 150bps was totally unexpected. This could consequently promote investor caution towards the Philippines, and will in any case, do little to enhance the reputation of the central bank’s comments.

Balance of Payments BMI View The Philippines’ balance of payments surplus rose to an 18-month high in July, thanks mainly to strong capital inflows, but several signs are already beginning to show that the surplus my be set to decline in H207, as capital inflows begin to moderate, and a slowdown in the US economy continues to weigh upon Philippine exports.

Balance Of Payments Surplus To Diminish In H207 The Philippines’ balance of payments surplus rose to an 18-month high in July, thanks to strong remittance inflows from overseas Filipino workers (OFWs) and robust foreign direct investment and portfolio inflows. However, while the central bank’s outlook on the country’s balance of payments ‘continues to be positive’, according to Bangko Sentral ng Pilipinas (BSP) Governor Amando Tetangco, we remain far more conservative on the Philippines’ external position, as capital inflows begin to moderate, and a slowdown in the US economy continues to weigh upon Philippine exports.

The Philippines’ balance of payments surplus reached US$1.34bn in July, taking the total for the first seven months of 2007 to US$4.54bn. This is far in excess of the government’s US$2.9bn full-year estimate, and Tetangco said that it may have been even larger without early debt repayments by the government and the BSP; the government repaid its outstanding Brady bonds worth about US$126mn in May, while the BSP had repaid debt totalling US$850mn as of April. As such, the central bank has said that it may raise its 2007 estimates for the country’s balance of payments surplus, although we feel that this would be a rather hasty decision, as we expect the country’s surplus to decline during the second half of 2007.

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ECONOMIC outlook

This will be mainly due to global factors. Our view that the US housing market will correct further over a lengthy time period, will mean significant downside risks to US consumption and headline economic growth, especially given the negative personal savings rate in the US. This will consequently have a negative impact upon Philippine exports, as the US accounts for approximately 15% of all Philippine shipments. Exports will be insulated to a certain degree due to the emergence of China as major export destination, but while China’s incredible growth story looks set to continue apace, at least over the medium term, it is by no means completely shielded from US. Consequently, we expect Philippine exports to continue to moderate throughout H207 after growing just 1.6% y-o-y in June, the lowest growth rate for any month so far in 2007.

Another factor leading us to this conclusion is the trend in import growth witnessed in the Philippines of late. Philippine imports fell 3.4% y-o-y in May, sharper than the previous month’s 1.7% decline, signalling a weaker trade performance going forward as global demand for electronic goods continues to slow. More than two-fifths of Philippine imports are raw materials purchased by exporters and other manufacturers to be used in the manufacturing of goods for export, and so consequently, the slowdown in import growth could now indicate slower future export growth; if export growth were to slow more markedly than import growth, this would subsequently put pressure on the country’s current account.

Remittances To Slow

Monthly Remittances, US$mn 1,400

1,200

1,000

800

600

400

200

Jan-07

Mar-07

May-07

Jul-06

Nov-06

Sep-06

Jan-06

Mar-06

May-06

Jul-05

Nov-05

Sep-05

Jan-05

Mar-05

May-05

Jul-04

Nov-04

Sep-04

Jan-04

Mar-04

0

May-04

Strong remittance inflows from OFWs kept the Philippines’ current account in a healthy surplus in Q107, despite the country’s trade balance recording a deficit of US$1.299bn.

Remittances totalled US$3.5bn in Q107, up 17.5% y-o-y, and latest figures from the central bank have shown that this figure had risen to US$7.0bn for the first half of 2007 after June was the 14th straight month that remittances came in above US$1bn. This helped the Philippines record a current account surplus of US$1.823bn in Q107, 5.4% of the country’s GDP, an increase of 58.1% y-o-y. However, there is now a worry that remittance inflows may have peaked following June’s deadline for school tuition fees, and that they may start to slow going forward. Indeed, remittance inflows have already started to show signs of easing; latest official data have revealed that remittances from OFWs rose just 1% y-o-y in June, the slowest growth rate since 2006. While we expect remittances to remain robust throughout H207, we do expect them to continue to moderate. A pronounced downturn would have a serious negative impact upon domestic consumption, and consequently on growth. With the US being one of the major sources of remittance inflows to the Philippines, a slowdown in the US economy would not only impact upon Philippine exports, but also on the size of remittance inflows.

Source: Bangko Sentral Ng Pilipinas

The Philippines’ capital and financial account also posted a surplus in Q107, although at US$154mn, this was considerably smaller that the country’s current account surplus.

However, going forward we see several downside risks to the Philippines’ ability to record a current and financial account surplus. Net portfolio inflows in July hit a record US$1.1bn as investors poured money into secondary share offers and public offerings, bringing total inflows for the first seven months of 2007 to US$3.6bn, a 38.46% y-o-y increase on the US$2.6bn recorded in the corresponding period in 2006. This also boosted the benchmark Philippines Stock Exchange index (PSEi) to an all-time high of 3,820.55 on July 13, but the current global credit crunch, created by sub-prime mortgage market concerns in the US, has seen Asian stocks sell-off sharply in August.

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Philippines Q4 2007

The PSEi has been one of the hardest hit by the global turmoil, losing more than 17% during the global sell-off, after investors sold out of riskier emerging markets assets in favour of more secure instruments. While we remain medium-term bullish on Philippine equities, we expect to see further volatility in the short term, with the potential for further downside movement in the PSEi if risk aversion is prolonged by continuing US fears. This would see the financial account slip into deficit, thus endangering the Philippines’ external position, especially if the country’s current account were to do the same.

Alongside this, foreign direct investment (FDI) inflows have also shown signs of slowing.

Net FDI fell sharply in April, dropping 77% y-o-y, as investors remained cautious ahead of May’s congressional elections. A smooth running and favourable outcome of these elections should have had a positive effect on FDI, but May proved to be as disappointing as the previous month after net FDI was recorded at only US$151mn, a fall of 60% y-o-y. This took total net FDI for the first five months of 2007 to US$905mn, down nearly 23% from the same period in 2006. As the government extends its efforts to improve infrastructure, we would expect to see an upturn in FDI going forward. President Gloria Macapagal Arroyo has pledged PHP1.7trn (US$38bn) to infrastructure projects over the remainder of her term as president, in order to pave the way for the South East Asian nation to ‘become a developed country in 20 years’. While we hold some reservations as to the likelihood of this target being met, considering the current fiscal pressures facing the Philippines, improvements to infrastructure will most certainly remain high upon Arroyo’s list of priorities, and this should provide a much needed boost to FDI inflows.

Table: BALANCE OF PAYMENTS

2002

2003

2004

2005

2006

2007f

2008f

2009f

2010f

2011f

Exports, US$bn [1,5]

34.40

35.34

38.79

40.26

46.16

51.20

56.97

62.91

69.85

77.43

Imports, US$bn [1,5]

39.93

41.19

44.48

48.04

53.11

57.56

64.06

70.86

78.02

86.02

Trade balance, US$bn [2,5]

-5.53

-5.85

-5.68

-7.77

-6.96

-6.36

-7.09

-7.96

-8.17

-8.59

Current account, US$bn [5]

-0.28

0.29

1.63

2.35

5.02

6.97

6.72

6.22

6.41

6.42

Current account, % of GDP [6]

-0.36

0.36

1.87

2.38

4.26

4.93

4.32

3.75

3.65

3.45

Forex reserves (- gold), US$bn [3,7]

13.87

13.11

12.94

15.09

18.61

22.83

24.75

27.07

29.49

31.86

Import cover, months g&s [6] OPEC basket, US$/bbl, ave [4,8]

5.0

3.9

3.5

3.8

4.2

4.8

4.6

4.6

4.5

4.5

24.36

28.09

35.70

50.64

61.50

53.80

48.10

46.10

45.10

na

Notes: f BMI forecasts. 1 Goods f.o.b.; 2 Goods f.o.b. minus f.o.b.; 3 Foreign reserves minus gold; 4 Global assumptions correct when forecasts generated.; Sources: 5 Bangko Sentral. 6 BMI calculation; 7 IMF; 8 OPEC.

22

Business Monitor International Ltd

chapter 3

Special Report

Global Inflation Becoming A Concern Once More Over the past few years, the curse of high inflation has been kept at bay in most corners of the globe. Since 2000, Central and Eastern Europe, Latin America, and Africa have seen impressive disinflationary trends, while developed states have, by and large, enjoyed very easy monetary policy that has provided a liquidity injection into the global financial system without significant inflationary consequences. But in 2007, price pressures have returned to the fore, with global growth, elevated energy, commodity prices and ‘agflation’ taking their toll on producers and, ultimately, consumers.

Disinflationary Picture To Date Consumer Price Inflation, % chg y-o-y

30 Asia ex-Japan Africa Developed States CEE Latin America Middle East

25 20 15 10 5 0

Business Monitor International Ltd

2007f

2006

2005

2004

2003

2002

Source of Pressure

Goldman Sachs Agriculture & Industrial Metals Indices 600 Agriculture Industrial Metals

500 400 300 200 100

Apr-07

Oct-06

Apr-06

Oct-05

Apr-05

Oct-04

Apr-04

Oct-03

Apr-03

Oct-02

Apr-02

Oct-01

Apr-01

Oct-00

Apr-00

Oct-99

0

Source: BMI

Rising Price Pressures Across Developed States

Producer Prices Easing,

US Core Consumer, Producer & Personal Consumption Price Indices 3.5 3.0 2.5 2.0 1.5 1.0 Core PPI Core CPI Core PCE

0.5

May-07

Feb-07

Nov-06

Aug-06

May-06

Nov-05

Feb-06

Aug-05

May-05

Feb-05

Nov-04

0.0 May-04

Across the board, developed state central banks are having to respond to persistent price pressures by putting the squeeze on consumers with higher rates. We no longer expect the US Federal Reserve to begin an easing cycle this year; with the funds rate having been on hold at 5.25% since July 2006, the prospect of monetary easing remains as distant now as it did back then. We may even see further rate hikes in 2008, but our year-end forecasts for both 2007 and 2008 are for stable rates of 5.25%. The European Central Bank (ECB) continues to tighten policy in response to the unexpectedly robust upturn in the eurozone, and has now upped rates five times in a year to 4.0%. The Bank of Japan continues to contend with the opposite problem, of deflation, but is likely to raise its overnight call rate again in August, to end the year at 0.75%. The Bank of England raised rates in July

2001

Source: BMI

Aug-04

A quick review of financial market and macroeconomic analysis at the end of 2006 highlights the extent of the inflationary surprise this year. At that time, the prevailing consensus was that there was little prospect of major energy price hikes to boost inflationary pressures, that US economic growth would slow to such an extent that price pressures would be alleviated, and that higher G3 interest rates would drain liquidity from the global financial system. Six months down the line, and it is clear to us at BMI that not only do global inflationary pressures remain present, but also that there is more upside than downside to come on interest rates this year and well into next year (see our article ‘Beware Inflation’, published on our online service on May 16 2007). Oil prices have failed to moderate in line with expectations, despite a more favourable supply backdrop, prompting us to raise our forecast for the average price of a barrel of Brent crude oil from US$58 to US$66. US economic growth is rebounding following a dip in first quarter productivity levels, and is likely to register a full-year outturn of 2.3% y-o-y, a still-healthy pace although down from 3.3% in 2006. Food prices have been rising, with the Goldman Sachs Agricultural Price index hitting a record high of 262.09 in June, up 25.5% y-o-y. Industrial metals prices are also contributing, with the Goldman Sachs Industrial Metals index also hitting a record high in June, up 21% y-o-y.

2000

-5

Source: BMI

23

Philippines Q4 2007

A True Reflection of Cost of Living?

US – Headline & Core CPI, & Core PCE, % chg y-o-y

5 4.5 4 3.5 3 2.5

for the fifth time in 11 months to 5.75%. With headline consumer price inflation (CPI) having breached the all-important 3.0% level in March before dipping back to 2.8% and 2.5% in April and May respectively, the bank has been prompted to act aggressively, and could raise rates another 50 basis point (bps) before the end of the year. The Bank of New Zealand raised its benchmark interest rate to 8.0% in June on robust economic activity driving price rises.

2 1.5

Headline CPI Core CPI Core PCE

1 0.5

Feb-07

May-07

Aug-06

Nov-06

Feb-06

May-06

Aug-05

Nov-05

Feb-05

May-05

Aug-04

May-04

Nov-04

0

Source: US Bureau of Labour Statistics

Under Control?

US – Fed Funds Rate (%) & CPI (% chg y-o-y) 6 Fed funds rate, % US CPI, % chg y-o-y

5

4

3

2

1

Jan-07

May-07

Sep-06

Jan-06

May-06

May-05

Sep-05

Jan-05

Sep-04

Jan-04

May-04

Sep-03

Sep-02

Jan-03

May-03

0

Source: US Federal Reserve, Bureau of Labour Statistics

Energy Not The Culprit This Time

US Headline PPI & West Texas Intermediate Oil Price 80

WTI price, % chg y-o-y, (1mth lag) US Headline PPI, % chg y-o-y, RHS

70 60 50

10 8

Fed Watching The US Federal Reserve continues to face a tough policy climate, with stubborn inflation having failed to respond fully to the 425bps of rate hikes since mid-2004. US headline CPI, which dipped to 1.3% last October, from 4.3% in June 2006, has been on the rise this year, pressured higher by energy and commodities prices. The latest reading for May has the index rising by 2.3% y-o-y. Core CPI and, in particular, core personal consumption expenditure (PCE) inflation, the US Federal Reserve’s preferred indicator of the cost of living, have been trending lower, but the PCE measure only fell within the Fed’s perceived 1-2% comfort range in May for the first time since March last year. Nonetheless, as the chart (top left) shows, core PCE inflation consistently undershoots core CPI inflation, and, as such, has been criticised as an underestimate of the true movement of consumer costs, particularly when headline inflation is significantly higher. For example, the difference spread between headline CPI and core PCE only dipped below one full percentage point once between May 2004 and August 2006. This is a matter of considerable importance and, accordingly, controversy, because wage negotiations, social security benefits, pensions, and inflation-linked bonds are all dependent upon measures of CPI, so any underestimation of cost of living increases imply that recipients of such payouts would not be fully compensated. The same chart also suggests that headline CPI does lead core CPI/PCE higher, as energy and food price inflation filters through to the core of the economy through second round effects.

6

40 30

4

20 2

10 0

0

-10

May-07

Feb-07

Nov-06

Aug-06

May-06

Feb-06

Nov-05

Aug-05

May-05

Feb-05

Nov-04

Aug-04

-2

May-04

-20

Source: Bureau of Labour Statistics, BMI

The Energy Impact Our outlook for oil prices is for them to remain elevated over the rest of the year and into next year. It is not the absolute level of oil prices that has the inflationary impact on headline producer prices, but whether they are rising or falling. As the chart to the left (‘Energy Not The Culprit This Time’) illustrates, headline PPI is heavily influenced by the move in oil prices – with the annual change in both moving in tandem, albeit by different magnitudes.

We have seen a divergence in the two measures since January, with PPI picking up again despite oil price growth turning negative. But on a month-on-month basis, a simple linear regression shows that the variation in oil prices explains about 87% of PPI fluctuations.

Stripping Out Price Volatility US Headline PPI & CPI, % chg y-o-y

8 US Headline PPI US Headline CPI

7 6 5 4 3 2 1 0 -1

Source: Bureau of Labour Statistics

24

May-07

Feb-07

Nov-06

Aug-06

May-06

Feb-06

Nov-05

Aug-05

May-05

Feb-05

Nov-04

Aug-04

May-04

-2

Fed Chair Ben Bernanke has recently argued that inflation expectations are more anchored now than they have been in the past, and are less sensitive to energy prices, which makes for more stable inflation levels. This is true to a certain extent, but in large part the relatively muted impact of the higher energy prices of the last few years has been a consequence of the strength and resilience of the US economy, and the competitive environment that has cushioned the consumer from bearing the full brunt of higher production costs. As the chart of headline CPI and PPI in the US shows (‘Stripping Out Price Volatility’), consumer price inflation certainly does not experience the same more extreme fluctuations Business Monitor International Ltd

SPECIAL REPORT

The Energy/FX Impact

Price Of Brent Crude In Local Currency Terms, % chg y-o-y 15 10 5 0 -5 -10 -15 -20

Fukui that rates could rise even in conditions of continued deflation, if the BoJ expects prices to start heading higher, we reaffirm the view that we have held for some time that the overnight call rate will be raised by 25bps in H207 – and possibly as soon as August – once the dust has settled following the upper house elections in July.

Brazil

Colombia

Phillipines

Latvia

Poland

US

China

Qatar

Venezuela

South Africa

Japan

Japan – Import Price Index & JPY/US$

20

4

18

3

16

2

14

1

12

0

10

-1

8

-2

6

-3

4

-4

Import price index (% chg y-o-y)

2

-5

JPY/US$, % chg y-o-y (RHS) Apr-07

May-07

Mar-07

Jan-07

Feb-07

Dec-06

Nov-06

Oct-06

Sep-06

-6 Jul-06

0 Aug-06

At the other extreme, the weakness of the Japanese yen is pushing import prices higher, with oil prices up 8.7% y-o-y in local currency terms in May, despite CPI still struggling to remain in positive territory. According to Bank of Japan (BoJ) data, its import price index increased by 12.5% y-o-y, while the Domestic Corporate Goods Price Index (CGPI), the Japanese index of producer prices, rose by 2.2% y-o-y in May, and consumer prices were unchanged on the year. The yen is weak against the US dollar at around JPY121/US$, and the dollar itself is weak against most other global currencies – the dollar index has hit a 2½-year low of 81.15. The weakness of the currency is aiding Japanese export competitiveness and allowing exporters to raise their prices in order to offset the exchange rate effect of cheaper exports – in May export prices were up by 7.9% y-o-y. This dual effect has driven an expanding trade surplus, which stood at JPY2.134trn in May, up 50.3% y-o-y.

In light of these price pressures, and previous statements by the BoJ’s Governor Toshihiko

Weak Yen Producing Inflationary Pressures

Jun-06

The weakness of the US dollar is a major explanatory factor behind the inflationary pressures still evident in the US economy. The impact of high oil and other commodity prices has been mitigated for most countries, particularly most emerging markets, because of the long-term currency appreciation against the dollar which means that in local currency terms oil prices remain well below their highs. The chart ‘The Energy/FX Impact’ shows the inflationary impact of the change in the price of a barrel of West Texas Intermediate oil in local currency terms in May 2007. The strengthening of the Brazilian real, Colombian peso and Philippine peso over the past year has translated into a disinflationary impact in these countries because of the greater purchasing power of the local currency, even as oil prices are up by 1% in US$ terms.

Source: BMI

Apr-06

The Currency Effect

Argentina

-25

May-06

of producer prices, which are heavily influenced by energy costs. It is not in a producer’s interest to pass the full extent of their rising costs on to the consumer. This is a function of a competitive market and price inelasticity of demand, whereby producers cannot raise their prices without seeing a drop-off in sales and a loss of market share. When prices of raw materials fall, however, producers take the opportunity to recoup some of their losses instead of cutting prices by the same magnitude. That said, clearly a proportion of cost rises do get passed on to the consumer, usually with a lagged effect, and the recent spike in PPI in the US (which has risen from -1.24% last October to 4.1% in May) suggests that headline CPI will remain under a degree of upside pressure in the coming months.

Source: ESRI, BMI

Heading Into Positive Territory Japan – CPI, % chg y-o-y

1.0 0.8 0.6 0.4

Business Monitor International Ltd

0.0 -0.2 -0.4 -0.6 -0.8

May-07

Jan-07

Sep-06

May-06

Jan-06

Sep-05

May-05

Jan-05

Sep-04

Jan-04

May-04

Sep-03

-1.0

Jan-03

Inflation in most emerging markets has been brought well under control in the past few years – with a few notable exceptions of course – thanks to very credible macroeconomic policy since the start of the millennium. Greater transparency and communication on the part of central banks – which are setting explicit inflation targets and publishing minutes of their monetary policy meetings more now than ever before – is helping to quell the inflation expectations that had hitherto translated into ever higher prices. Both demand-pull

0.2

May-03

Emerging Market Trends: A Survey

Source: BMI

25

Philippines Q4 2007

and supply-push inflation have been kept under control by foresighted monetary policy manoeuvres, which have given rise to greater certainty in price expectations, fostering an environment of price stability. Now, however, global economic momentum, elevated commodity prices and rising food prices are feeding through to the consumer, and central banks are facing a more challenging policy environment. How they deal with it will be formative in terms of their reputation and the structural characteristics of developing and transitioning economies.

Latin America

Benign Trends

Latin American States – CPI, % chg y-o-y 12 Brazil Chile Mexico Peru Ecuador

10 8 6 4 2 0

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Jan-04

-2

Source: National Statistic Institutes and Central Banks, BMI

Latin America is one region where latent inflationary pressures have prompted some unanticipated rate moves that have caught markets off guard. The region can be loosely divided into those countries for which inflation remains a challenge, and those that have apparently successfully battled price pressures into submission with a strong monetary stance. The latter category includes Brazil, Chile, Mexico, Peru and, by virtue of the dollarisation of the economy, Ecuador. In Brazil, the hyperinflationary episodes of the 1990s have been well and truly banished by the Banco Central do Brasil, which has cemented its credibility by engineering a smooth disinflationary trajectory over the past few years, to bring the annual inflation rate to well below the official 4.5% target. Of course, this has been facilitated by extremely high nominal interest rates, but the bank’s steady hand and cautious approach has effected a structural shift in perceptions and expectations. This will is not only allow a normalisation of rates in the present cycle, but should also mean that future tightening cycles will not need to be as protracted or as severe as the last. The central bank of Mexico, Banxico, has also conducted a very prudent monetary policy, to bring inflation down to below the upper limit of its 2-4% target range. It has struggled a little with its own inflationary surprise this year, in the form of higher corn prices, but, as Banxico insisted, in line with our view, this was a supply-side phenomenon that is now easing of its own accord on a correction in global corn prices. To shore up its own credibility and expectations, the bank made a pre-emptive strike in April, by raising its policy rate to 7.25%. Further disinflation over the coming months should bring the year end CPI rate to 3.6% and allow rates to remain on hold, although milk prices could pose a threat to this outlook.

The pre-emptive approach has been replicated in Peru and Chile. In Chile, the central bank raised rates by 25bps in mid-July to 5.25%, as inflation has started to edge up in recent months from a low of 2.1% in October and November to 3.2% in June. Although only a touch over the central bank’s 3% target, the development of inflation in a climate of very robust economic growth is enough to justify the bank’s move. The Peru move, when the central bank unexpectedly raised the benchmark rate to 4.75% in early July, was more surprising and less warranted, in our assessment; Peru’s inflation rate has not breached 3% since January 2005, the June reading of 1.5% was comfortably within the bank’s 1-3% target range, and the sol is strong so imported inflation poses little concern. Nonetheless, the recent trajectory of CPI, with a move from 0.25% in March to 1.5% in June, amidst robust domestic demand and a thriving economy, will have spooked the bank a little, and its early action should ensure that year-end CPI will remain within its target range, at around 2.6%. Ecuador, meanwhile, is within the ranks of our better Latin performers, not so much by virtue of prudent macroeconomic policy – we retain our long-held concerns about politically driven and irresponsible inflationary fiscal policy – but as a consequence

26

Business Monitor International Ltd

SPECIAL REPORT

of lacklustre economic activity and the persistent benefits of dollarisation. On introduction, this successfully brought inflation down from 108% in September 2000 to single digits by late 2002. Since January 2006 it has only breached the 4% level once, in March 2006, and now remains muted, with a latest reading of 2.2%. With its monetary policy directed by the US Fed, credibility is not an issue. But the weakness of the dollar may hurt on the import price front, and rising food prices will certainly be felt by the consumer.

On the higher inflation front, there are five Latin states of note: Venezuela, Argentina, Colombia, Uruguay, and Costa Rica. Regular readers of BMI’s analysis will be familiar with our frequent rants about the foolhardy macroeconomic policy of the administration of President Hugo Chàvez of Venezuela. We will not go into them at length here, but in summary: the frivolous spending of the country’s oil receipts has exerted a heavy degree of inflationary pressure on the economy; the bolivar is significantly overvalued, as shown by the difference between the parallel exchange rate of VEB4,115/US$ and the official one of VEB2144.6/US$; state-controlled prices and access to US dollars has provoked a major mismatch between supply and demand, exacerbating shortages and sending prices soaring. Inflation has been trending steadily higher since its (high) nadir of 10.4% in May 2006, and came in at 19.4% in June. There is little macroeconomic reason to expect it to ease below our 17.3% forecast for year-end; risks are very much to the upside.

Price Pressures More Of A Problem Latin American States – CPI, % chg y-o-y

Argentina Colombia Costa Rica Uruguay Venezuela

25

20

15

10

5

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

0

Jan-04

Although not in Venezuela’s league on the macro unorthodoxy front, the Argentine government has given observers and interested parties cause for concern on the inflation front through apparent data manipulation. Argentine official CPI figures are now routinely mistrusted, following personnel and methodology shifts in the state statistics agency, INDEC. Distortions in the economy as a result of price caps on goods make a true assessment of price pressures more difficult, but we estimate that the latest official reading of 8.8% in June masks inflation that in reality is probably closer to 15%. Although the likely election of Senator Cristina Fernandez de Kirchner in October may provide an opportunity for the introduction of more prudent macroeconomic measures, the credibility of INDEC will need some serious resuscitation and will take some time to effect, with negative ramifications for inflation in the meantime.

30

Source: National Statistic Institutes and Central Banks, BMI

Neighbouring Uruguay is also facing higher-trending prices. At 8.05% in June (the third consecutive reading over 8%), consumer price inflation is now reflecting the higher producer prices throughout the course of last year, driven by energy costs. Cuts in VAT and business-to-business taxes should provide some relief to consumers’ pockets, however, but we expect the central bank to take more direct action to combat price pressures before the end of the year, to bring inflation down to 6-7%.

Colombia falls into the higher inflation grouping, but our general assessment of both policy implementation and the outlook for rates and inflation is pretty upbeat. Like elsewhere in the region, agflation has been driving higher prices, which saw CPI hit 6.2% in April before easing to 6.0% in June. The central bank has been on top of the move though, having raised rates by a cumulative 300bps since mid-2006; it may yet see fit to hike one more time to take the benchmark rate to 9.25%, but its vigilance should ensure that expectations remain firmly in check.

Business Monitor International Ltd

27

Philippines Q4 2007

Middle East and Africa

Inflation Troubles Gulf

Middle East States – CPI, % chg y-o-y 6 5 4 3 2 1 0 -1 Israel Kuwait Saudi Arabia

-2 -3

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Jan-04

-4

Source: National Statistic Institutes and Central Banks, BMI

A More Volatile Inflation Picture African States – CPI, % chg y-o-y

35 South Africa Egypt Kenya Nigeria

30 25 20 15 10 5

Apr-07

Jan-07

Oct-06

Jul-06

Apr-06

Jan-06

Oct-05

Jul-05

Apr-05

Jan-05

Oct-04

Jul-04

Apr-04

Jan-04

0

Source: National Statistic Institutes and Central Banks, BMI

28

In the Middle East, Israel is alone in not facing any sort of inflation threat, despite the 200bps of monetary easing seen since last October, and in fact has experienced deflation in year-on-year terms every month since February. The easing cycle is over for now, and the next move may well be up, but not in the near term, at least. Elsewhere, however, inflation is very much an issue. The Gulf Co-operation Council (GCC) countries are suffering the adverse consequences of their currency pegs to a weaker US dollar (particularly given that imports from Asia and Europe are rising), as well as very high levels of liquidity thanks to record oil receipts and the more extravagant fiscal policies that these receipts are giving rise to. No monthly figures are available, but in Q107 Qatar had the highest official inflation rate of the GCC countries, at 14.8%, up from 11.3% in Q406. The central bank attributes inflationary pressures to supply bottlenecks and argues that they are a transitory phenomenon, but we think that large fiscal injections on the back of higher oil prices have certainly contributed. Kuwait, meanwhile, has responded to its own inflationary pressures by revaluing its currency and moving away from a fixed peg against the dollar, to a peg against a basket of currencies (albeit still heavily dominated by the dollar). This move will give the authorities a degree more flexibility in the conduct of monetary policy than the fixed peg afforded, and will offset, at least in part, the effects of imported inflation from Asia and Europe. The move is prudent, and there is a possibility that other GCC states, facing their own price pressures, could follow suit. In the United Arab Emirates, for example, a combination of imported inflation and real estate pressures could prompt the authorities to rethink the peg, although they have hitherto been firmly committed to it. The bank has been slow to respond to the Kuwaiti revaluation, and far from unequivocal in its statements on maintaining the peg. And a move at this stage would make sense. Back in April, the central bank demonstrated its inability to tackle price pressures by cutting the one week and one month CD rate by 5bps one day, only to raise them by the same amount the following day. We have been very sceptical about plans for a currency union, and Kuwait’s move certainly throws the 2010 target into serious doubt, if not the whole project.

In Africa, Zimbabwe is a modern-day cautionary example of the perils of running a command economy. The country is isolated in its current hyperinflationary spiral, which is making any meaningful analysis of price pressures impossible. Although the government has stopped publishing official figures, leaked data suggest that May inflation stood at 4,530% y-o-y.

A diktat from President Robert Mugabe in June that ordered all businesses to halve prices provoked a widespread rush in the shops, and shortages of basic foodstuffs and necessities have been the inevitable consequence as retailers cannot recoup wholesale costs at official retail prices. Further legislative attacks on the private sector are to be expected, and the expropriation of foreign businesses, which will be transferred into local hands, is on the agenda. The macroeconomic lessons for the rest of the world are less pertinent, perhaps, than the human tragedy of a previously dynamic economy having been run into the ground because of ideological myopia, but it is the macroeconomic implications with which we are concerned here. The crisis is escalating and we do not believe that the government now has the resources to be able to restore confidence and arrest the economy’s decline. Elections in 2008 may bring about change, despite the government’s best efforts to engineer a favourable electoral climate, but in the meantime, the disassembling of the economy and higher inflation is set to continue.

Business Monitor International Ltd

SPECIAL REPORT

South Africa is likely to suffer some spill-over effects from Zimbabwe, particularly in the form of economic migration. In the meantime, it is battling its own inflation issues – although of course not on the same scale. Headline CPI has risen from 4.0% in January 2005 to 6.9% in May, producer price inflation is at an all-time high, and domestic credit growth in particular has been a prime concern for the central bank. Core inflation in May was 4.6%, still outside of the central bank’s comfort zone. South African Reserve Bank (SARB) Governor Tito Mboweni has acknowledged that the authorities have been surprised by the resilience of domestic spending in the wake of 250bps of rate hikes which have brought the benchmark rate to 9.5%. Another 50bps of tightening is therefore likely in August, and perhaps another move much later in the year. We expect headline inflation to rise over the 7.0% threshold, and there are significant upside risks that could see the SARB taking more dramatic steps, particularly if market-implied expectations continue to head higher. A key risk is from wage negotiations, which are ongoing; headline numbers have been giving rise to demands from domestic unions for better wage settlements, which have been expressed through strikes and protests. So far, a 28-day strike by the Congress of South African Trade Unions, which involved 700,000 public sector workers, saw the government agree to a 7.5% settlement, far short of the 12% demanded. Whether the final settlements will prove inflationary in themselves, clearly the disruptive impact of such strikes, which are a direct consequence of inflation, is a real weight on the economy and highlights the societal and economic costs of inflation.

Emerging Europe

Business Monitor International Ltd

9 Croatia Czech Republic Poland Slovakia Slovenia

8 7 6 5 4 3 2 1

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Jan-04

0

Source: National Statistic Institutes and Central Banks, BMI

Baltics Facing Tough Times Baltic States – CPI, % chg y-o-y

10 8 6 4

Latvia Lithuania Estonia

2 0

Apr-07

Jan-07

Oct-06

Jul-06

Apr-06

Jan-06

Oct-05

Jul-05

Apr-05

Jan-05

Oct-04

Jul-04

-2 Apr-04

Slovenia has experienced higher inflation since joining the EU in May 2004, and the adoption of the euro at the beginning of this year has apparently had a more inflationary impact than was initially expected, with the headline CPI rate ticking up to 3.9% in June, compared with 2.4% in January 2006. The government has increased its year-end forecast from 2.5% to 3.2%. With economic activity remaining very robust, prices are certainly set to remain under pressure. If this feeds through to expectations, we could see higher wage settlements putting pressure on labour unit costs and creating a more structural inflationary picture. The Baltic states are also facing inflationary pressures, but are suffering from a difficult economic mix, with significant trade and current account deficits raising calls for a devaluation of the currency peg that could potentially send their already high

Sub 3%, Just

European States – CPI, % chg y-o-y

Jan-04

EU membership, or the promise thereof, has had an overall disinflationary impact on most central and eastern European states. In particular, the Maastricht convergence criteria, which involve keeping inflation to within 1.5 percentage points (pp) of the three top-performing members of the EU, restraining fiscal policy and pegging the local currency to the euro, have been beneficial to EU-aspiring economies in the CEE. As a policy anchor, these criteria work by constraining fiscal and monetary policy to keep a lid on prices and, ultimately, secure price stability upon adoption of the euro as the national currency.

However, the nature of the criteria, which are evaluated on a one-off basis, are somewhat artificial. Moreover, with so many heterogeneous economies dependent upon one single monetary authority whose actions are largely influenced by the performance of the largest economies under its remit, policy rate moves are not finely attuned to local economic exigencies. We expect the European Central Bank to raise rates twice more before the end of the year, to 4.50%, which should serve to address some of the inflationary pressures that the CEE states, like other regions, are experiencing this year.

Source: National Statistic Institutes and Central Banks, BMI

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Other European States Facing Higher Inflation Environment European States – CPI, % chg y-o-y

18

Bulgaria Romania Russia Turkey Hungary

16 14 12 10 8 6 4 2

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Jan-04

0

Source: National Statistic Institutes and Central Banks, BMI

inflation profiles soaring. All three states, Lithuania, Latvia, and Estonia, are facing the prospect of a hard landing after several years of strong growth, (averaging 9.1%, 7.2% and 8.5% in Estonia, Lithuania and Latvia, respectively, from 2000-2006), with the national central banks acknowledging that abrupt adjustments are possible. Latvia in particular has seen very high inflation in recent months, with a March CPI outturn of 9.0%. Higher wage costs are generating second-round price effects, while credit growth, at a whopping 59% in Q107, could create vulnerabilities going forwards, particularly as rates rise and mortgage borrowers start to feel the pinch. Given that a sizeable proportion of credit in all three Baltic states is euro-denominated, any devaluation in the future would be extremely painful for borrowers.

Elsewhere in Europe, inflation remains a concern in Russia. While on a long-term trajectory Russian price growth is coming down, the disinflationary trend of the past two years has been reversed since the beginning of the year. We have recently raised our end-year forecast to 8.2% y-o-y. The central bank has been unwilling to allow the rouble to appreciate, in spite of massive foreign capital inflows, which has exacerbated the price pressures attending the current robust economic growth, increased fiscal expenditures due to the upcoming elections and spiralling money supply growth. Turkey also remains an inflation-watch country, though once again, on a long-term trajectory prices are coming down, having fallen to 8.6% y-o-y in June. We expect them to fall further, to 7.5% y-o-y by end-year, and the outright victory in July’s legislative election for the moderate Justice and Development Party (AKP) will ensure policy continuity and further reform. With Turkey’s financial markets remaining on an even keel, therefore, and ongoing prudence of macroeconomic policy, as well as sustained lira strength, we are not too concerned on the inflation front.

Asia In Asia, several economies appear to have inflation comfortably under control. As the chart below shows, Hong Kong, Malaysia, South Korea, Singapore, Taiwan and Thailand are all seeing sub-4% price rises, with stable or disinflationary trajectories over the past couple of years, although Singapore and South Korea have seen a recent uptick in prices. South Korea launched a pre-emptive strike against price pressures in July amid strong economic activity, with a rate hike of 25bps to bring the policy rate to 4.75%, and we expect this to be the start of a tightening cycle that will bring rates to 5.5% by the end of 2008. Overall, though, these countries have little to fear from inflation for the time being.

Prices Under Control

Asian States – CPI, % chg y-o-y 10

Hong Kong Singapore Taiwan

8

Malaysia South Korea Thailand

6 4 2 0 -2

Apr-07

Jan-07

Oct-06

Jul-06

Apr-06

Jan-06

Oct-05

Jul-05

Apr-05

Jan-05

Oct-04

Jul-04

Apr-04

Jan-04

-4

Source: National Statistic Institutes and Central Banks, BMI

On the other hand, China, India, Indonesia and Vietnam are seeing price rises that are likely to prompt official action. The Philippines, which is in our high-inflation category by virtue of its relatively high recent inflation history, has actually seen the CPI rate fall significantly over the course of 2006, and is only now starting to experience an uptick in prices. Nonetheless, a surprise 150bps cut in the Bangko Sentral ng Pilipinas’s overnight borrowing rate in July initially appeared to be somewhat imprudent. But as the bank simultaneously abolished its tiering scheme by which different borrowers were charged different rates of interest (of 7.5%, 5.5% and 3.5%), to replace it by a flat 6% rate, the overall impact of the bank’s policy should, in effect, be one of monetary tightening.

China’s efforts to tighten macroeconomic policy to effect a cooling have so far come to nothing, with the government having again revised the 2006 full-year growth outturn to

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SPECIAL REPORT

11.1%, the fastest rate in 12 years, and Q107 growth is set to be at least 10.8%. With the stock market still at very elevated levels, and CPI hitting a 27-month high of 3.4% in May, due primarily to a pick-up in food prices as well as abundant domestic liquidity, the central bank is keen to use all policy mechanisms at its disposal to fight further price rises.

Negative real deposit rates have been fuelling demand for alternative investment options, in the form of equities, which has contributed to the stock market’s stratospheric gains. In response to this, the government has secured parliamentary approval to cut the 20% tax on interest earned on bank deposits, which should encourage savers to shift some of their wealth into savings accounts. We also expect the Chinese central bank to raise rates by a further 27bps at least once this year, to bring the one-year lending rate to 7.11% with significant upside risks, in a tightening cycle that has so far seen the rate increased six times from 5.31% in October 2004. But so far, to little avail. Inflation, which hit 2.8% in 2006, spiked up to 4.4% in June, which is likely to cause considerable consternation in Beijing about the prospect of rising public discontent, particularly on higher food prices.

Not Benign Yet

Asian States – CPI, % chg y-o-y 20 China Indonesia India Vietnam Philippines

18 16 14 12 10 8 6 4 2

Apr-07

Jan-07

Jul-06

Oct-06

Apr-06

Jan-06

Jul-05

Oct-05

Apr-05

Jan-05

Jul-04

Oct-04

Apr-04

Inflation has also emerged as an issue of real concern for the Vietnamese government. It has been kept under control, under 8.0% since March 2006, but the government is aiming to bring it down towards 6% in the short to medium term, with further disinflation on the agenda over the longer term. But, having hit a three-year low of 6.45% y-o-y in January, CPI has since bounced back up to 7.8% in June, largely on the back of rising prices for food and housing material. With high foreign direct investment and a crawling peg exchange-rate policy, Vietnam faces similar problems of liquidity growth as China, which has inflated the stock market as well as prices.

Jan-04

0

Source: National Statistic Institutes and Central Banks, BMI

Economic And Business Implications Clearly, then, price pressures remain a real issue right across the globe, and we think that a broad-based tightening of liquidity is necessary, which will involve a normalisation of rates from their current, still accommodative levels – so further upside for developed state rates yet, and strong vigilance on the part of emerging market authorities will be crucial.

We have maintained for some time, for example, that US Treasury yields can move higher in the medium term. Over the coming couple of years, the higher cost of borrowing will see investment decisions scaled down or put on hold, while dearer consumer credit should restrain domestic consumption and credit growth. At the margin, over-exposed individuals and businesses might struggle with rising debt burdens. In the aggregate, such decisions will have a constraining effect on macroeconomic activity, hurting demand for goods and services and taking the edge off global growth, which we expect to dip to 4.4% by 2009, from 4.9% this year. Tighter monetary conditions should mean less money chasing yield, which could remove an element of speculation from global markets and presage a moderation of commodity and equity markets. With yields on funding currencies such as the yen and the Swiss franc set to rise, and their differential with key emerging market highyielders likely to decline, a little wind may be removed from the sails of the global carry trade. All these influences would be the result of a perfectly healthy correction, implying a soft landing for the global economy.

We are assuming that central banks will, on the whole, succeed in jumping ahead of the curve to curtail inflation without too painful an adjustment. With so many economies still performing at above-trend levels, several countries remain at risk of overheating, running Business Monitor International Ltd

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up against capacity constraints and supply bottlenecks and feeding demand-pull inflation.

State subsidies, price controls and other market distorting measures might gloss over problems in the short to medium term, but ultimately a failure to tackle the root causes of rising prices at this stage could store up greater problems further down the line.

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chapter 4

Business Environment

SWOT Analysis Strengths A cheap but educated English-speaking workforce is the Philippines’ greatest business strength. A number of Western firms have shifted their operations, particularly call centres, to the Philippines where workers are paid a fraction of the wages they would expect to earn in North America or Europe.

The Philippines is a member of the ASEAN Free Trade Area (AFTA) under which the association’s 10 member states are committed to reducing tariff and non-tariff trade barriers.

Weaknesses Political and security concerns are often cited as reasons not to do business in the Philippines.

Much-needed economic reforms remain stalled in Congress while rebel insurgencies continue in many parts of the country.

Ageing infrastructure, particularly the power sector, is a key concern for would-be foreign investors.

Efforts to attract greater private funding through build-operate-transfer schemes have met with only limited success.

Opportunities The move towards outsourcing by North America and Western Europe provides the Philippines with an opportunity to attract greater foreign investment.

The local call-centre industry is booming.

Threats China’s rising economic influence presents opportunities to Philippine firms but also threatens to starve the country of much-needed foreign investment.

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BMI Business Environment Risk Ratings DPC DATA, a leading vendor of securities data and provider of offshore management services, has launched a state-of-the-art facility in metropolitan Manila. Julius B. Gorospe, a prominent business advisor and entrepreneur in the Philippines, was quick to point out the reasons behind the company’s decision to expand to its new location, and to create the subsidiary in the first place, saying ‘the great advantage of the Philippine workforce is its compatibility with Western culture, and expertise in standard American business practices’, reiterating sentiments often touted by other foreign investors.

Business Environment

Rank

Trend

82.8 81.3 79.8 78.4 75.4 69.5 68.4 64.4 56.1 51.6 47.3 44.6 43.5 40.6 40.6 37.4 37.4 33.8 31.8 24.7 19.9

1 3 4 5 8 15 18 27 40 54 68 74 80 91 91 96 96 110 114 129 132

= = = = = = = = = = = = = = = = = = = =

Singapore Hong Kong New Zealand Australia Japan Taiwan South Korea Malaysia Thailand China Philippines Vietnam Sri Lanka India Indonesia Cambodia Laos Bangladesh Pakistan North Korea Myanmar Regional Average: 52.8

Emerging Market Average: 44.8

Global Market Average: 48.5

Risk Interaction Diagram BMI’s Risk Interaction Diagrams give a more informative picture than the composite rating of the information conveyed jointly by the political and economic ratings. One problem with the composite, which is an unweighted geometric mean Philippines Taiwan South Korea 100 Malaysia India of the short-term political and 90 Singapore short-term economic ratings, 80 Indonesia China is that a misleading picture can 70 Thailand Hong Kong be presented if the two compo60 Sri Lanka Vietnam nents are widely different. In 50 Pakistan Cambodia the Risk Interaction Diagram, 40 the short-term political rating 30 Bangladesh is plotted along the horizontal 20 axis, the short-term economic 10 rating along the vertical axis.

0 0 10 20 30 40 50 60 70 80 90 100 The averages for all countries Short-term political rating rated by BMI are indicated by Axes cross at emerging markets average horizontal and vertical broken lines. Countries in the top right quadrant, therefore, have above-average ratings. The more ‘equally balanced’ countries appear along the diagonal of the quadrant.

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business environment

Legal Issues Legal Framework The legal system is a blend of Roman civil law, US common law, Islamic law and indigenous law. The Supreme Court of the Philippines is the highest judicial court and the court of last resort. Below this are Courts of Appeal, Regional Trial Courts at municipal and metropolitan levels, plus Shari’a, District and Circuit Courts.

Islamic law is highly influential in parts of the country. A Code of Muslim Personal Laws has been developed and special shari’a courts created.

The legal system is often characterised as being weak and inefficient, creating log jams in processing cases and producing inconsistent decisions. It is now in the process of being reformed, though much work remains to be done.

Independence Of The Judiciary The constitution guarantees an independent judiciary. However, the system has been plagued by concerns over the courts’ tendency to go beyond legal interpretation into areas of policy making. Allegations of bribery are also rife. The situation is reportedly improving.

Effectiveness Of The System Byzantine court rules allowing much room for delays and appeals, together with the tendency of the Supreme Court to take on more cases than it is equipped to deal with mean the legal system can work very slowly. Businesses have complained that the courts have issued temporary restraining orders (TROs) too freely in some cases.

Investment disputes can take years to settle. Competition law is sketchy. Bankruptcy law is being reformed.

Those involved in commercial disputes say judges are often inadequately trained to deal with business-related cases.

Reforms are now under way may improve this situation. International organisations have been supporting reform efforts in areas including improving judicial capacity and integrity, legal education, bar reform and anti-corruption measures.

Moves such as 2004 legislation clarifying foreign investment legislation for the mining sector are helping to boost confidence in the system.

Property Rights The 1987 constitution bars foreigners from owning land in the Philippines. The Investors’ Lease Act of 1994 allows foreign companies to lease land for 50 years, renewable once for another 25 years. Deeds of ownership are difficult to establish and ill-regulated. The legal framework is ambiguous, making the establishment of clear ownership difficult.

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Philippines Q4 2007

Property disputes can take much time to resolve within the court system. While there is consideration of permitting foreign ownership, land legislation needs to be tightened up before this would be a practical proposition.

Intellectual Property Rights Protection of intellectual property rights (IPRs) is seen as weak. Counterfeit DVDs, CDs, branded designer clothing, handbags, cigarettes and other goods are widely available.

The Optical Media Act regulates the manufacture and trade of optical media. An Optical Media Board was established in 2005. Enforcement has since been stepped up, but prosecutions policy against IPR infringers is still seen as lacking.

Corruption/Red Tape Corruption within the government and business community are holding back investment, in spite of efforts to stem the tide.

The Philippines has yet to sign the OECD Convention on Combating Bribery. The country signed the UN Convention Against Corruption in 2003, but it has not been ratified yet.

Measures to combat corruption and other anti-competitive business practices include the Philippine Revised Penal Code, Anti-Graft and Corrupt Practices Act, and Code of Ethical Conduct for Public Officials.

Labour Force Size The labour force amounts to 36.7mn out of a total population of around 90mn. Around half the workforce is employed in the service sector, just over a third works in agriculture, with the remainder in industry. Unemployment, at above 10%, remains high.

Structure The shift towards export-oriented manufacturing and processing has boosted the proportion of the workforce working in this area.

Labour is in abundant supply and is generally productive, especially within foreign-owned companies. Workers are regarded as highly trainable. Many speak good English. Skilled professionals are fairly easy to find.

The wage bill is relatively cheap by international standards in both skilled and non-skilled sectors.

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Regulation Labour laws are reasonable and do not generally bring complaints from investors. The Labour Code of the Philippines of 1976 and its subsequent revisions houses all labourrelated legislation.

Grounds for termination of employment include neglect of duties, fraud and installation of labour-saving devices, redundancy or retrenchment to prevent losses or cessation of operations, among others.

Employers must give the Department of Labour and Employment one month’s notice of the termination of employee services. All new workers serve probation usually not exceeding six months.

Minimum wages are determined regionally by Wage and Productivity Boards in each of the government’s 14 administrative regions. Recently, these boards have adjusted the minimum wage rate around once a year.

TABLE: DEMOGRAPHIC INDICATORS (2005) 2000

2005

2010f

2030f

41.21

39.12

36.39

32.19

Dependent population, total

31,579

33,017

33,357

37,919

Active population, % of total

58.79

60.87

63.61

67.81

45,048

51,373

58,304

79,879

3.81

4.06

4.36

8.37

2,919

3,429

3,992

9,863

Dependent population, % of total

Active population, total Pensionable population, % of total Pensionable population, total Source: World Bank

TABLE: EMPLOYMENT INDICATORS Economically active pop, ‘000 % change y-o-y % of total population Employment, ‘000

1999

2000

2001

2002

2003

2004

32,000

30,908

33,353

33,673

35,120

35,629

2.31

-3.41

7.91

0.96

4.3

1.45

43.07

40.79

43.18

42.78

43.81

43.65

27,762

27,775

30,085

30,251

31,553

31,741

-1.77

0.05

8.32

0.55

4.3

0.6

male

17,131

17,258

18,334

18,440

19,498

19,836

female

% change y-o-y

10,631

10,516

11,751

11,811

12,055

11,905

female, % of total

38.29

37.86

39.06

39.04

38.21

37.51

Total emp, % of labour force

86.76

89.86

90.2

89.84

89.84

89.09

male

1,835

1,978

1,912

2,076

2,183

2,312

female

1,096

1,156

1,356

1,346

1,384

1,576

9.6

10.1

9.8

10.2

10.2

10.9

Unemployment rate Source: ILO

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Industrial Unrest/Strikes The constitution gives workers the right to form and join trade unions. Management-labour relations are generally good, including those with all but the most politically motivated trade unions.

There are more than 25,000 unions in the Philippines, but they are generally not militant.

Strikes numbered just under 30 in 2005, half the number registered in 2000. Plant closures in the past in industries vulnerable to falling trade barriers have made unions more prepared to accept productivity-based job packages.

Foreign companies are generally considered to provide the best-paid jobs with the best conditions, so their employees tend to have good attendance records.

The Labour Code recognises a number of unfair practices, such as discrimination against women and bargaining stalemates, as grounds for strikes. Suppression of labour rights is a criminal offence.

Foreign Investment Policy Overview Although attracting investment is a stated government priority, reforms have slowed in recent years. In 2005, foreign investment gathered momentum, more than doubling from a nadir of just US$319m in 2003, but still short of flows exceeding US$1bn seen in the late 1990s.

Businesses complain that corruption remains a serious issue, while legislative reform is badly needed and intellectual property rights are in urgent need of improved protection.

Political uncertainties surrounding presidential elections in May 2004 did little to improve the investment climate and hampered implementation of investment legislation. The presidency of Gloria Macapagal Arroyo has remained turbulent since, as financial scandal surrounds her government. She declared emergency rule in early 2006 in a bid to quell political unrest and may do well to last out her full term until 2010.

Tardiness in market liberalisation and the country’s privatisation programme has also contributed to a loss of momentum in FDI. The continued growth of China as a manufacturing centre has siphoned off investment from other Asian countries, including the Philippines.

FDI Regime The Foreign Investment Act of 1991, amended 1996, sets the framework for foreign investment in the Philippines. This permits full ownership of businesses in sectors not subject to legal restrictions. All investors have to register with the authorities. In the case

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of corporations or partnerships, the relevant body is the Securities and Exchange Commission (SEC).

A number of incentives are available in selected sectors. The basis for these is established in the Omnibus Investment Code of 1987. The Board of Investment deals with many of these. In particular, incentives are extensive in the energy sector, where private sector reform plans are extensive. The Electric Power Industry Reform Act of 2001 provides the framework for privatisation of state electricity generation and transmission assets. However foreign investors in the sector have been cautious in recent years given the uncertain political climate and regulatory concerns.

Despite the uncertain investment climate, some recent moves have boosted potential for foreign involvement. For example, a December 2004 Supreme Court ruling permitted 100%-foreign ownership of mining firms working on large-scale projects. This move should boost investment in copper and gold mining, if an adequate regulatory framework is put in place.

TABLE: ASIA, Annual FDI Inflows 2004

2005

US$bn

Per capita

US$bn

Per capita

Australia

42.39

2,126.90

-34.55

-1,713.60

China

60.63

46.4

72.41

55.0

Hong Kong

34.03

4,861.70

35.9

5,128.20

India

5.47

5.1

6.6

6.0

Indonesia

1.9

8.6

5.26

23.6

Malaysia

4.62

185.8

3.97

156.5

Pakistan

1.12

7.5

2.18

14.3

Philippines

0.69

8.4

1.13

13.6

Singapore

14.82

3,470.80

20.08

4,638.00

South Korea

7.73

162.2

7.2

150.5

Sri Lanka

0.23

11.9

0.27

13.8

Taiwan

1.9

83.8

1.63

71.3

Thailand

1.41

22.2

3.69

57.4

Vietnam

1.61

19.4

2.02

24.0

Source: UNCTAD, BMI.

TABLE: PHILIPPINES, Annual FDI Inflows 2000

2001

2002

2003

2004

2005

2.24

0.2

1.54

0.49

0.69

1.13

– % change y-o-y

-

-91.3

690.8

-68.2

40.1

64.5

– FDI as % of GDP

3

0.3

2

0.6

0.8

1.1

29.6

2.5

19.6

6.1

8.4

13.6

Inward FDI, US$bn

– FDI per capita (US$) Source: UNCTAD, BMI.

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Philippines Q4 2007

Foreign investment is restricted partially or entirely in a number of sectors, among which are engineering, medicine, accountancy, environmental planning, small retail trade firms, most of the mass media, small-scale mining, private security, management and use of marine resources.

There are generally no restrictions on the full transfer of funds linked to foreign investments.

Free Trade Zones The Special Economic Zone Act, passed in 1995, allows preferential tax treatment for firms in special economic zones, sometimes know also as ecozones. These may contain export processing zones, free trade zones and some types of industrial estates.

There are four government-owned export-processing zones, managed by the Philippine Economic Zone Authority (PEZA). There are around 130 privately owned and operated zones, incentives for which are administered by PEZA. There are no nationality restrictions on those registering an enterprise in an export-processing zone.

Leading Sources And Sectors Japan, the US, the Netherlands, Switzerland, the UK and China are among the main sources of foreign investment.

Leading sectors include manufacturing, the energy sector and financial services.

Foreign Trade Regime Overview As a member of the Association of South East Asian Nations (ASEAN), the Philippines is working towards complying with the trade bloc’s harmonised tariff targets. However there still remains much to be done before this is achieved, as the government remains reluctant to open up a number of sensitive areas of the economy to unfettered foreign competition.

Free trade agreements with the US and EU (via ASEAN) remain under negotiation.

Trade Agreements The Philippines has been a member of the WTO since its inception in January 1995.

It is a member of the ASEAN trade bloc, which is committed to trade tariff reduction and the creation of a single market economic community by 2020. Other members are Brunei, Cambodia, Indonesia, Laos, Malaysia, Myanmar, Singapore, Thailand and Vietnam. The Philippines is also a member of the Asia-Pacific Economic Co-operation organisation, which aims to foster growth in the region.

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Nearly 40 bilateral trade agreements have been signed. A bilateral agreement with the US is currently under negotiation. The EU and ASEAN are discussing an FTA.

Tariffs/Non-Tariff Barriers The Philippines is committed to lowering tariffs on trade within the ASEAN bloc to a maximum of 5% and has set several targets for trade with other countries. However, a perception that domestic industry requires continued protection has contributed to a slow down in the process.

For most favoured nation partners, the following targets for maximum tariff rates were set: raw materials 3% and finished products 10% by January 2003, with a uniform rate of 5% for all other non-agricultural goods by January 2004. However, these targets have not generally been met and have in some cases been reversed.

•

The simple average applied tariff fell to around 7.03% in 2005 from 7.06% in 2004.

•

Imports competing directly with domestically produced goods generally face higher tariffs.

•

The ASEAN Tariff Harmonised Nomenclature covers some 11,000 tariff lines, of which some 60% carry a rate of 0-5%; around 25% of them are in the 6-10% tariff rate range and some 13% of them carry 11-15% tariff rates.

•

Average tariffs on most agricultural products fell to around 6.2% in 2004.

•

Legislation signed in late 2004 raised excise tax on alcohol and tobacco products from 2005.

•

Various incentives are available for sectors deemed a priority by the government, including some vehicle exports.

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Tax Regime Overview The government has been considering a proposal to increase VAT to 12% from 10%. Tax incentives may ease the burden on corporations in some sectors.

•

Corporate tax: Rate is 32%. A branch profits tax of 15% may also be levied.

•

Domestically registered firms are taxed in global income. Foreign corporations are taxed on Philippines-sources income only. Of these, ‘resident’ foreign corporations – foreign corporations carrying out trade or business in the Philippines – are taxed on net income in the Philippines, while ‘non-resident’ foreign corporations are usually subject to withholding tax.

•

Individual tax: Levied progressively up to 32%. Resident individuals are taxed on global income. Non-residents are taxed on Philippines-sourced income only.

•

Indirect tax: VAT chargeable on most transactions at 10%. Registration obligatory for firms with turnover over PHP750,000. Voluntary registration is possible.

•

Businesses not VAT-registered must pay a 3% tax on gross quarterly sales. Exemptions include books and newspapers, various foodstuffs, agricultural inputs, property leasing, insurance, medical and educational services, and entertainment services.

Exports are zero-rated.

•

Capital gains: Usually taxed as income. Gains from share deals and gains of individuals from property sales are handled separately. Gains from the sale of property located in the Philippines are liable to a 6% withholding tax. Individuals are exempt on tax on the sale of a main residence, so long as the proceeds are used to buy another main residence. A stock transaction tax of 0.5% is levied on the sale price of shares listed on a Philippine stock exchange. Net gains on the sale of unlisted shares are liable for a 5% withholding tax on the first PHP100,000 and 10% on amounts above that.

TABLE: TOP EXPORT DESTINATIONS, US$MN 2000

2001

2002

2003

2004

2005

11,406

8,994

8,690

7,275

7,209

8,461

Japan

5,606

5,054

5,293

5,768

7,983

7,150

Hong Kong

1,907

1,580

2,359

3,094

3,146

4,273

Netherlands

2,982

2,976

3,055

2,922

3,583

2,730

Malaysia

1,377

1,112

1,647

2,463

2,070

2,224

38,059

32,140

35,185

36,225

69,670

39,879

61.2

61.3

59.8

59.4

34.4

62.3

United States

Total exports Top 5, % of total Source: IMF

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chapter 5

Key Sectors

Power Primary Energy Demand The Philippines has a high coal import-dependency and also relies upon imported oil, as its domestic production is insufficient to meet national needs. Only in natural gas does the country boast self-sufficiency, with a net export potential provided by significant reserves.

There is no nuclear power generation, but the country is one of the world’s biggest producers and users of geothermal energy. It also boasts substantial hydro-electric capacity.

According to BMI estimates for 2006, oil last year accounted for 54% of primary energy demand (PED), with coal taking a 24% share of the energy market. Gas was in 2006 approximately 10.0% of the energy market, with renewables (largely geothermal) and hydro-electric power accounting for around 7% apiece.

BMI View Our projections suggest that, by 2011, the Philippines will be dependent on oil for 49% of primary energy demand, with the share of coal put at a forecast 27%. Gas, at this point, should have claimed a 12% market share, while renewables and hydro-power are set to slip below 7.0%.

The Philippines has recoverable coal reserves of 366mn tonnes. In 2006, the country consumed an estimated 10.1mn tonnes, up 55% since 2000, while producing only 3.3mn tonnes. The country relies on imports for much of its coal consumption, primarily from Indonesia, China, and Australia. Proven gas reserves are put at 125bn cubic metres (bcm), almost all of which are located in the Malampaya field. The country had no significant natural gas production until 2001. During 2006, gas production and consumption in the Philippines stood at an estimated 3.1bcm, of which 96% is used for power generation purposes. The Malampaya gas-to-power project was developed at a cost of US$4.5bn to provide fuel for a 2.7 gigawatt (GW) power station complex.

There is a focus on greater gas, geothermal and hydro use in the energy mix, although oil will continue to dominate during the forecast period to 2011. Our projections suggest that, by 2011, the Philippines will be dependent on oil for 49% of PED, with the share of coal put at a forecast 27%. Gas, at this point, should have claimed a 12% market share, while renewables and hydro-power are set to slip below 7.0%.

Power Generation The country’s share of Asia Pacific regional electricity generation in 2006 is estimated at 0.9%. By the end of the forecast period, we expect the country to account for 0.8% of regional power generation, and to remain a net exporter of electricity to neighbouring states. Electricity generation in the Philippines is largely based on oil, coal, gas, hydro and geothermal. Oil provides an estimated 24% and coal 25% of generated electricity.

The share of gas has been gradually rising, and was last year estimated at just over 25%.

Hydro accounts for an estimated 15% of generation, with renewables also claiming some 15% of the power pie.

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In 2006, the Philippines had estimated installed electricity generating capacity of almost 16GW, around two-thirds of which came from conventional thermal sources. In 2006, the Philippines generated an estimated 58.4twh and consumed 50.2twh of electricity. Since 2000 electricity generation has risen by a third and consumption by more than a quarter.

The Philippines’ thermal generation in 2006 is estimated at 39.1twh, or 0.8% of the regional total (66.7% of domestic power generation). By 2011, the country is expected to account for 0.6% of Asia/Pacific thermal generation.

Conventional thermal sources of electricity generation have grown in importance, especially as the Philippine government promotes the increased use of gas-fired power plant. As oil prices have risen over the last two years, the country has looked to promote the development of domestic energy sources to displace oil imports. The largest power project to come on stream in recent years is associated with the Malampaya Gas-to-Power scheme, which began commercial operations in late 2001.

Malampaya gas is pumped ashore to supply three combined cycle power plants totalling 2.7GW: the 1GW Santa Rita plant, the 500 megawatt (MW) San Lorenzo facility, and the 1.2GW Ilijan power station. The Ilijan power plant is owned by state generator Napocor and operated by the Korea Electric Power Corporation (Kepco), while the other two facilities are owned and operated by the First Gas Power Corporation.

There are various other conventional thermal power plants under construction or consideration in the Philippines, although most companies are concerned with the restructuring and sell-off of Napocor’s existing power plants rather than the construction of additional capacity. One large project that is planned is the GNPower Energy Park, currently being developed by GNPower. GNPower led the construction of the Philippines’ first large-scale IPP project with its 470MW coal-fired facility in Quezon. The Energy Park project is being developed in the Bataan province, and envisions the eventual establishment of 1.9GW of new generating capacity, including a 600MW coal-fired power station, 1.2GW gas-fired plant, and a 100MW wind farm.

The Philippines is the second-largest producer of geothermal energy in the world behind the US, with more than 1.9GW of installed geothermal capacity. The government had originally set a goal of increasing this figure to 3.1GW within a decade, which would have made the Philippines the largest geothermal energy producer. However, the most recent national energy plan suggests an increase to nearer 2GW by the end of the current decade. Most geothermal power projects were developed by a division of state-controlled Philippines National Oil Corporation (PNOC), while two of the country’s largest projects were originally developed by Philippine Geothermal (today known as Chevron Geothermal Philippines Holdings).

Hydro-electric sources made up approximately 3GW of the Philippines’ installed electricity generation capacity, or 20%. The country has not seen a significant expansion in hydroelectric capacity during the last two decades, although some new projects are currently being developed, particularly small-scale hydro-electric facilities.

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Napocor’s assets designated for privatisation were organised into two state holding companies: the National Transmission Corporation (TransCo), which took on much of the company’s transmission assets, and the Power Sector Assets and Liabilities Management Corporation (PSALM), which assumed control of Napocor’s power plants. Under EPIRA measures, the government was also required to sell off its equity stake in the Manila Electric Company (Meralco), the country’s largest electricity distribution company that serves the island of Luzon and the metropolitan Manila area.

The government set an initial goal of selling TransCo assets by mid-2005, but this process has been delayed, as previous bidding rounds failed to yield an acceptable proposal.

PSALM began selling off Napocor’s power generation assets in 2004, although the effort has also proceeded more slowly than the government had hoped. PSALM originally set a target of privatising 70% of its generation assets by the end of 2005. However, a progress report dated April 2006 noted that PSALM had only sold off 14% of its power stations.

Philippines Power Outlook Electricity consumption per capita forecast to increase significantly over the forecast period.

The country’s power consumption is expected to increase from an estimated 50.2twh last year to 60.3twh by the end of 2011, providing export potential slipping from an estimated 8twh in 2006 to 7twh in 2011, assuming 2.9% annual growth in generating capacity.

Under the reference case of the government’s most recent energy plan, Luzon’s power requirements are seen to grow by an annual average rate of 4% to 7.9GW in 2010 and 9.4GW in 2014. For the Visayas grid there is a forecast average annual growth of 6%, while Mindano is also expected to deliver an annual growth rate of 6%. The BMI assumption for average annual demand growth between 2006-2011 is 3.9% for the whole of the Philippines power market.

Generation Conventional thermal sources are expected to remain the dominant fuel for electricity generation in the coming years, with many power projects under construction or planned that will use coal or gas. The government is looking to convert oil-fired plant to gas, while expanding the country’s geothermal capacity. Between 2005-2011, the government’s most recent forecast suggests a rise in generating capacity from 15.6GW in 2005 to 16.7GW, with coal having 26% of overall installed capacity by the end of the period, while gas has 17%, oil has 18%, geothermal claims a 12% market share and hydro-power has 19%.

BMI’s projections suggest just 2.9% average annual growth in overall power generation between 2006-2011. Philippines power generation in 2006 is estimated at 58.4twh, having grown an assumed 2.5% over the 2005 level. BMI is forecasting an increase to 67.7twh by 2011. Thermal power generation is forecast to increase from last year’s estimated 39.1twh to 41.3twh (+5.5%).

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Philippines Q4 2007

Gas-fired Overall natural gas demand is forecast to rise from an estimated 3.1bcm last year to 4.5bcm by 2011, and the proportion used in power generation looks set to remain above 90%. We are forecasting gas use in power generation climbing from an estimated 2.98bcm last year to 24.05bcm, with gas-fired power generation climbing from 14.7twh to 21.4twh – representing 31.6% of total generation by the end of the forecast period.

Oil-Fired Oil will remain a relatively significant part of the Philippines power generation mix, although its market share is likely to fall appreciably during the forecast period, as several new gas facilities are being built. Over the longer term, conversion of older oil plant to gas should mean that oil takes a smaller slice of the power pie. It currently accounts for around 24.2% of total generation, falling to a maximum of 17.1% by 2011, thanks to greater gas and geothermal expansion. We believe there will be no more than 11.6twh of oil-fired power generation by the end of the forecast period.

Coal-Fired Coal-fired power accounted for around 25.3% of the country’s total generation last year, according to BMI estimates. We expect the fuel’s market share to be up to an estimated 28.4% by 2011, firing an estimated 19.2twh at the end of the forecast period. Philippines coal consumption is forecast to increase from 6.7mn toe to 9.5mn by 2011. This equates to a rise in demand from 10.1mn to 14.3mn tonnes of hard coal.

Nuclear Energy Bataan nuclear power plant is a facility completed but never fuelled on the Bataan Peninsula, 100km north of Manila. The fuel was delivered and stored onsite, but never loaded, owing to safety considerations. As of 2006 it was the Philippines’ only attempt at building a nuclear power plant. The plant was ordered in the early 1970s by Philippine president Ferdinand Marcos, in response to the 1973 oil crisis. A Westinghouse light water reactor, it was designed Table: Philippines Power – Historic Data & Forecasts Electricity consumption, twh – growth, % y-o-y Electricity imports/(exports), twh (BMI estimates) – Electricity consumption per capita, mwh – Regional electricity consumption per capita, mwh

2004

2005

2006e

2007f

2008f

2009f

2010f

2011f

46.3

48.1

50.2

52.3

54.4

56.3

58.3

60.3

4.0

4.0

4.3

4.2

4.0

3.6

3.5

3.4

(10)

(9)

(8)

(9)

(9)

(9)

(9)

(7)

0.6

0.6

0.6

0.6

0.6

0.6

0.6

0.7

6.0

6.2

6.4

6.6

6.9

7.2

7.5

7.8

– Regional GDP per capita, US$

6,294

7,137

8,056

9,359

10,258

11,187

12,273

13,344

– Electricity cost per capita, US$

28

33

40

36

35

33

34

35

Primary energy consumption per capita, toe

0.3

0.3

0.3

0.3

0.4

0.4

0.4

0.4

Regional energy consumption per capita, toe

1.05

1.09

1.16

1.24

1.33

1.42

1.52

1.64

Thermal power generation, twh

30.8

38.2

39.1

40.5

41.5

41.4

41.6

41.3

e/f = BMI estimate/forecast, Sources: BP Statistical Review of World Energy June 2006, BMI research

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to produce 621MW of electricity. Construction began in 1976 and was completed in 1984 at a cost of US$600mn, although there have been suggestions that corruption drove the ultimate cost above US$2bn. In April 1986, the administration of Corazon Aquino refused to operate the plant, citing a lack of safety. A study was conducted and it showed the plant had more than 4,000 defects. Post-Aquino governments have looked at several proposals to convert the plant into an oil-, coal- or gas-fired power station, but all have been deemed less economically attractive in the long term than the construction of a new fossil-fuel facility.

Hydro-electric The current national energy plan calls for an increase in overall hydro-power capacity from 3.2GW to almost 4GW by 2014 through the development of all viable small and mini-hydropower plants. BMI is predicting 9.8twh of hydro-power generation by 2011, accounting for a potential 14.5% of total generation.

Renewable Energy Under the Renewable Energy Policy Framework (REPF) of 2003, renewable energy-based capacity was due to increase from its 2002 level of 4.45GW (including hydro) to 9.15GW by 2013. In its bid to become the leading producer of geothermal energy, the Philippines has targeted the installation of an additional 1.2GW by 2013, from 2005 capacity of 1.93GW. The government has forecast that geothermal production will increase at an average annual growth rate of 2.6%.

An initial assessment has placed the country’s total wind potential at 76GW. In June 2004, the Philippine Wind Investment Kit was launched, offering 16 sites for wind power development. Out of these offers, Pre-Commercial Contracts (PCCs) were awarded to five sites during the Wind Power Summit in December 2004. In March 2005, the remaining 11 wind sites were re-offered. Out of these, PCCs have been awarded to one site and another site was targeted under a bilateral agreement between the country and Spain. A milestone in wind energy development was the inauguration of the 25MW Northwind Bangui Bay Wind Power Project in the Ilocos Region in June 2005.

Our forecasts suggest that non-hydro renewables will account for 6.3% of primary energy demand and 15.5% of electricity generation by 2011.

Power Costs According to BMI estimates, the cost of power generation in the Philippines amounted to US$3.94bn in 2006. We are forecasting generating costs of US$3.45-3.64bn between 2007-2011, assuming lower oil, gas and coal prices and a rising proportion of cheaper geothermal and hydro-power in the power mix. Gas is set to become the largest component part of power generation costs. Philippines’ power prices are among the highest in Asia, with the government hoping that privatisation and competition will lead them lower over the medium term. However, the increased use of gas in the generation mix is likely to keep generating costs high and will limit the scope for distributor prices to fall. In the meantime, residential and industrial power prices are expected to track underlying generating costs.

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Transmission As of end-2004, the transmission and sub-transmission assets of TransCo covered a total length of 21,319km, with 10,494km in Luzon, 5,072km in Visayas and 5,753km in Mindanao. The combined substation rated capacities totalled 24,309 megavolt amperes (MVA). Ongoing projects in Luzon consist of substation expansion to accommodate higher demand and prevent transformer overloading, plus sub-transmission additions to provide reliable power delivery to electric co-operatives. All these projects involve the construction of 815km of transmission lines and installation of 850MVA of substation capacity. In the Visayas region, the construction of 562km of transmission lines, 1,160 of substation capacity and around 357 MVAR of capacitor devices for voltage support are planned. The ongoing projects in Mindanao cover the construction of 479km of lines and 1,100MVA of substation capacity.

Telecoms Market Overview Competitively priced tariffs and text bundling have been the major drivers for the surge in the number of new Filipino mobile subscribers during the first three months of 2007, up by 5.6%. Smart Communications and Globe Telecom represented the bulk of this growth, with 2.363mn net additions. Both operators have spent considerably in an effort to introduce loyalty programmes and reduce churn rates. Smart reported a prepaid churn of 2.7% against 3.4% a year earlier, while Globe Telecom’s prepaid churn also fell by 1.09 percentage points to 3.92%. However, this did not translate into a stronger average revenue per user (ARPU), particularly in terms of prepaid, which dominated the market’s overall subscriber base.

There is a positive aspect to this development emerging, however, namely that with a strong prepaid base contributing to strained revenues, operators are increasingly being active in the postpaid and next-generation sectors. Mobile operators have shown a greater inclination to spend on developing their 3G capabilities, seen as helping to drive profits forward. Certainly Digitel, the owner of Sun Cellular, which has been struggling against Smart Communications and Globe Telecom, appears to be doing more on this front. The operator is to invest 80% of its US$200mn capital expenditure budget for 2007 on mobile networks, to include the provision of 3G services by early 2008. Digitel is set to deploy an additional 800 cell sites capable of supporting 3G services. This will also support its subscriber base, with the aim of doubling its currently estimated 3mn customer base by the end of the year.

According to the Philippine Board of Investments, new investments spent on next generation networks (NGN) this year could top 2006’s figure. New investments last year totalled PHP190bn, up by 16% y-o-y, driven by the telecoms and power sectors. New network infrastructures, especially 3G mobile services were the main cause behind the increase in telecoms industry expenditure. Indeed, we could see a substantial rise in telecoms-related spending, with Eastern Telecommunications (ETPI), a locally based corporate services provider, announcing intentions of upgrading its infrastructure to incorporate an NGN

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platform at a cost of PHP600mn (US$12.96mn). The company aims to become the first in the country to offer a pure NGN platform.

Extending its NGN platform to include the broadband sector, ETPI CEO Eric O Rector said: ‘business will soon revolve around all things internet.’ Here, incumbent PLDT and Globe Telecom have witnessed substantial increases to their broadband subscriber bases of 134% y-o-y and 167% y-o-y, respectively. While we have maintained our existing broadband forecasts, strong growth is expected to continue over subsequent years, partially due to positive domestic developments. BMI expects 2007 to see a revival in government investment following Congress’ approval of a PHP1.13trn budget, in particular lifting expenditure on infrastructure. Already a shortlist of 10 infrastructure projects has been prepared as part of a wider programme to invest PHP1.7trn in the water, power, telecoms and transport sectors by 2010.

Mobile We estimate that by March 2007 there were 45.4mn mobile subscribers, given that there were no data provided by Sun Cellular. This represented a penetration of 52.9%, and remains in line with our earlier estimate that by year end 2007, some 57.5% of the population will be mobile subscribers.

Part of this confidence stems from a strong start to the year, with q-o-q growth of 5.6% as of Q107. While slightly above average quarterly growth of 3.7% for 2007, this is because the first and last three months of the year are traditionally peak seasons.

Globe has shown a particularly promising start to the year. While the operator attributed its growth, claiming 52.1% of the Q107 net additions market, to the lower churn rates across its mobile services, this came at some cost to the operator – marketing expenses rose 24% y-o-y on account of higher advertising costs and increased loyalty programmes. This was much the same for Smart, the operator also acknowledging that it had spent more on advertising and promotional costs. It is an indication of the growing competitiveness of the Table: Telecoms Sector – Historical Data & Forecasts 2004

2005

2006e

2007f

2008f

2009f

2010f

2011f

3,350

3,367

3,400

3,425

3,510

3,575

3,625

3,650

4.1

4.1

4.0

4.0

4.0

4.0

4.0

4.0

32,935

34,779

43,000

49,400

57,300

62,500

66,520

69,180

No. of Mobile Phone Subscribers/100 Inhabitants

40.3

41.9

51.1

57.5

65.6

70.5

73.6

75.7

No. of Mobile Phone Subscribers/100 Fixed-Line Subs

983

996

1,835

1,895

0

0

600

1,400

2,500

4,180

6,250

8,500

na

na

1.5

3.0

4.6

6.9

9.4

12.3

4,400

5,000

8,100

11,000

16,300

19,200

22,320

25,100

5.4

6.0

9.6

12.8

18.7

21.6

24.8

27.4

No. of Broadband Internet Subscribers (‘000)

60

150

630

950

1,500

2,250

2,950

3,500

No. of Broadband Internet Subscribers/100 Inhabitants

0.1

0.2

0.7

1.1

1.7

2.5

3.3

3.8

No. of Main Telephone Lines in Service (‘000) No. of Main Telephone Lines/100 Inhabitants No. of Mobile Phone Subscribers (‘000)

No. of 3G Phone Subscribers (‘000) 3G Market As % Of Entire Mobile Market No. of Internet Users (‘000) No. of Internet Users/100 Inhabitants

na = not available; Source: ITU, NTC, Operator Results

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sector, despite just three operators sharing the market, judged on price, service products and quality. With so many campaigns on offer, it is little wonder that Filipinos are able to be more selective, lending to the cycle of repeated lower price offerings, a concern for the market if this continues as it has the potential to spiral into a price war. Further, with such heavy prepaid subscriber bases, the ability for operators to recoup on investments is made harder thanks to lower ARPUs providing smaller returns. While all this is expected to contribute to solid growth over the foreseeable future, greater competition in the mobile landscape would almost certainly provide the catalyst in prompting greater increases in service take-up.

There are signs of greater non-voice service usage – Smart reported 53% of revenues from data, while Globe reported 46% – helping to raise total revenues. Although much of this can be attributed to the popularity of text messaging, Smart maintains that 92% of its data revenues derive from this type of service much to the detriment of revenues from value added services, which include mobile banking. This means that mobile users may not be ready to accept new forms of data usage that could be supplied over 3G networks. This is despite strong 3G capex budgeting. PLDT, Smart’s parent company, has promised to invest the majority of its PHP20bn capex on broadband and NGN developments to raise 3G services, while Globe has outlined a 3G investment package of US$190mn for 2007.

As previously stated, BMI retains its opinion that affordability remains a key issue with regards to the extent of 3G take-up, with handset models remaining too expensive for the average consumer. Nokia and Sony Ericsson handsets are priced at over US$200, and 2.5G and 2.75G services have until now lacked any clear commercial success.

We have not yet changed our 3G forecasts. There is still not enough evidence to downscale, and in any case our projection of about 12% of all Philippine mobile customers having access to a 3G network by the end of 2011 is relatively conservative.

Fixed-Line Once again, there is no reason to change our forecasts. The trend remains the same – minimal growth in the wireline sector. Broadband substitution is key to this decline, as is the fall in ILD inbound calls, for so long a mainstay of the Philippine fixed-line industry.

However, the growing popularity of wireless messaging services, VoIP and high-speed data services are putting pay to ILD services, with PLDT recording a fall in its ILD revenues during 2006.

There is little prospect of further investment in the fixed-line telephony industry, with PLDT keen instead on injecting funds towards its NGN, consumer broadband business and 3G services. With local exchange services now contributing just 35% of PLDT’s revenue and ILD services accounting for about a fifth of income, the operator’s strategy of focusing on its NGN and data services is correct. Meanwhile, the country’s alternative fixed-line operators continue to put little pressure on PLDT. Consequently, our projections suggest growth over the next five years at just 6.6%, taking the number of installed lines in service to just 3.65mn by the end of 2011 and penetration remaining around the 4% level.

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Aside from other emerging technologies, a key problem with the fixed-line sector remains the country’s infrastructure and the difficulties in extending a network across the country.

Indeed, in 2005, there were just 6.5mn fixed lines available, representing a possible penetration rate of just 7.8%.

Internet Recent International Telecommunications Union figures suggest that the Philippine internet user base was lower than we had originally thought, and because of the high number of multiple users of single accounts, we now put the 2005 figure at about 5mn. Indeed, given the low fixed-line penetration rate, any significant increases in the internet user base are likely to be driven by wireless internet and cyber-cafe usage.

We have maintained our broadband forecasts based on PLDT’s ongoing success in increasing its number of customers to approximately 265,000 by the end of 2006. Globe Telecom’s wireline data revenues (and those of other alternative operators) also suggest firm growth, so we have kept our forecast at over 600,000 subscribers by the end of 2006, passing the 1mn mark during H108 and the 3mn figure at the beginning of 2011.

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