The International Economic Environment and the Philippine Economy

Policy Notes

Philippine Institute for Development Studies

August 1998

The International Economic Environment and the Philippine Economy

No. 98-04

period from the 1870s to 1913, right before the first world war.

Technological developments in shipping, refrigeration and communications, the low rate of protection in much of the world, and currency convertability under the gold and silver standards gave rise to the first truly international economy in world histor y.

Some economic convergence occurred at this time as the peripheral economies grew faster than the advanced countries of the time (Sachs and Warner 1995).

T

he world economy has become increasingly open and integrated in the last two decades of the twentieth centur y, which is not the norm.

Between the 1930s and the 1950s, the world economy was essentially closed. Trade protectionism was the norm. From the 1960s on to the 1980s, the opening up of Third World economies has been slow and in many cases, “stop and go,” thereby delaying the prospects for a truly open and integrated global economy.

That said, there really is not enough economic historical precedent within this centur y with which to illuminate the risks and benefits arising from the deepening integration of the world economy today. That element of uncertainty continues to be an open challenge to today’s policymakers and analysts.

The first global open economy The only period in world economic histor y similar to the current international economic environment is the

Philippine trade surpluses were a thing of the past Philippine participation in international trade during the period circa 1880-1890 was characterized by deteriorating terms of trade. As a result, volume export growth was simply offset by the decline in export prices (in gold terms). However, the peso (that is, the silver Mexican peso then in circulation) depreciated to 50 percent vis-à-vis the gold bullion. This development stimulated the growth of Philippine exports despite the decline in export prices. Hence, trade surpluses were comPIDS Policy Notes are observations/analyses written by PIDS researchers on certain policy issues. The treatise is wholistic in approach, and like the PIDS Executive Memo, it aims to provide useful inputs for decisionmaking.

This Notes was recast and repackaged by Wilbert R. San Pedro based on PIDS Discussion Paper No. 98-25 of the same title authored

by Ponciano S. Intal, Jr. and Leilani Q. Basilio, President and Research Assistant, respectively, of the Institute. The views expressed are those of the authors and do not necessarily reflect those of PIDS or any of the study's sponsors.

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mon for the Philippines during the declining years of Spanish rule. When the Americans came, the process of integrating the Philippine economy with the world market was further accelerated (Intal 1983).

The plot thickens After the second world war, opening up the world economy was institutionalized by the United Nations through the General Agreement on Tariffs and Trade (GATT). The 1994 GATT Uruguay Round expanded multilateral trade to the once excluded sectors of agriculture, textiles and garments, among others. The Round also deepened and widened reductions in tariff and nontariff barriers. Other achievements include the continuing process of world trade liberalization, improvement of the dispute settlement system in international trading, establishment of the World Trade Organization (which has stronger powers than the GATT secretariat), and clearer rules on antidumping and counter vailing duties.

August 1998

exports of goods and ser vices by 1992 (World Bank 1996).

Time to shine The world’s growth area has shifted from Northwest Europe at the turn of the nineteenth centur y to Asia and the Pacific today. The share of APEC membereconomies (excluding Brunei) to total world trade has increased from 33.3 percent in 1970 to 45.1 percent in 1995. The share of the East Asian and APEC membereconomies to world output increased from 47.5 percent in 1980 to 53.6 percent in 1993. The rise in the share to total world trade and output is due to higher rate of growth of output, exports and imports of many of the East Asian economies during the past two decades.

Table 1. Share to Total World Trade in 1996 (In percent)

Regional economic cooperation spreads the word

Southeast Asia* East Asia

24.50

Closer to home, the ASEAN Free Trade Area (AFTA ) agreement and the Asia Pacific Economic Cooperation (APEC) Bogor declaration are two regional pacts which ushered in the era of free trade in the Asia-Pacific region.

Meanwhile, under ASEAN’s common effective preferential tariff scheme, intra-ASEAN trade for nonsensitive manufactures and agricultural product would have tariffs of zero to 5 percent by 2003 resulting in average tariff rates for the whole of ASEAN declining from 7.1 percent in 1996 to 2.7 percent in 2003 (ASEAN Secretariat).

Pacific and LA

20.21

Total Asia-Pacific*

51.20

Open, global and … multinational Today’s world economy has become truly open, global and integrated as a result of several developments not available in the late nineteenth centur y. The remarkable improvements in air transport and telecommunications has led to the global production networks of multinational corporations. The sales of foreign affiliates of multinational corporations already exceeded total world

Policy Notes

6.49

*except Brunei Basic data source: IMF International Finance Statistics

One key characteristic of these countries is their high investment rate, funded principally by high domestic savings although vigorous foreign investment flows played a critical role. Apart from high economic growth rate, the high savings rate is, to a large extent, a demographic bonus: the result of the happy happenstance of declining fertility rates and dependency ratios and of sound economic policy regimes (Mason 1997).

The World Bank projects that East Asia will remain the economic growth leader in the world, with a per annum growth rate of 7.9 percent between 1996 and 2005 (World

3

Bank 1996). It is likely that by 2005, the three largest economies in the world—the U.S., Japan, and China— are all located in Asia-Pacific.

Rubbing in some of that growth on the Philippines The Philippines will be heavily influenced by the developments in the Asia-Pacific region. In the past two decades, Philippine trade has moved toward greater integration with the rest of the region. There has also been a change in trading partners. Western Europe and Middle East countr y partners slid down in importance to Asian trading partners.

Like geese in flight The intimate link between the fortunes of the Philippines and Asia-Pacific is exemplified by the economic restructuring in East Asia in the latter part of the 1980s.

Described by Japanese analysts in terms of a flock of wild geese in flight, the ongoing regional economic restructuring reflects shifts in comparative advantage arising from two sources. One is changing relative factor prices accelerated by changes in exchange rate. The other is greater vertical and horizontal integration of production systems that are, in part, moving along the lines of endogenous product cycles in the region.

Regional comparative advantage is not static but shifting Investment flow and technology transfer are two important mechanisms for accelerating regional shifts in comparative advantage. Differing countr y factor endowments and levels of development in tandem with comparatively high economic growth contributed to the increased economic linkages and shifts in comparative advantage in the region.

As a case in point, the countries comprising ASEAN4 and China experienced a dramatic rise in the share of their manufactures for exports while exports of primary products declined substantially.

No. 98-04

"Investment flow and technology transfer are two important mechanisms for accelerating regional shifts in comparative advantage."

What it does best: The Philippines’s revealed comparative advantage The Philippines’s revealed comparative advantage in agriculture resource-intensive exports declined substantially in the late 1970s and 1980s. By that time, comparative advantage has shifted to low skilled laborintensive manufactures (primarily garments) and in human resource-intensive industries, especially electronics and electrical machinery. It is likely that the revealed comparative advantage in human resource-intensive industries has consolidated further in the 1990s.

In contrast, the countr y’s revealed comparative advantage in low skilled labor-intensive manufactures is likely to have deteriorated in the light of stiff competition faced by the local garments industr y from lower-cost exporting countries in the region.

More fundamentally, the poor per formance of the Philippine trade sector during the period reflects the effects of stagnant labor productivity in the Philippines (the rest of the region experienced a sharp rise in labor productivity) combined with the real appreciation of the peso vis-à-vis the currencies of competitor countries.

Competing in the open economy In order for the Philippines to benefit from deeper economic integration with the rest of the world, it would need a facilitative macroeconomic policy environment (i.e., higher savings rate, outward orientation and “investment friendly” measures), sustained productivity improvements and stronger institutional and human resource capacity.

Policy Notes

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Sustained growth in productivity, in turn, necessitates more efficient resource allocation, more effective infrastructure and bureaucratic support ser vices, and a higher rate of technological absorption and adaptation (Intal and Geron 1996).

Lowest savings rate in the region Between 1970 and 1997, savings rate rose sharply for most of Southeast Asia. Positive real interest rate, availability and accessibility of financial instruments, and higher returns on investment ventures all promoted domestic savings (Eggleston 1997). Higher economic growth rate and a rapid demographic transition also contributed to the sharp rise in domestic savings rates (Mason 1997).

In contrast, Philippine gross domestic savings rate (which was comparable to other Southeast Asian countries in the 1970s) dropped substantially over the 1980s and early 1990s. It is now the lowest in the region despite some slight increase in recent years. As a result, the investment rate in the countr y has also been low, meaning the countr y would have to rely heavily on foreign financing (e.g., foreign investments) which makes it vulnerable to changes in foreign investor sentiments.

Recessions and economic crises: Same old story The drop in savings rate resulted from the decline in per capita incomes during the economic crises and recessions of 1983-85 and 1991-93. Household and unincorporated business savings, which dominated national savings until the late 1980s, was hard hit by the decline in per capita incomes. It has not recovered since then and is still low. As for corporate and government savings, these have been rising in recent years.

August 1998

small savings and other taxes like the documentary stamp tax on small-denominated government securities.

A robust economy, competitive environment and an efficient pension system are major factors for raising the corporate savings rate. The government can contribute by raising the government savings rate through fiscal discipline. The East Asian experience indicates that a steady decline in the dependency ratio and fertility rates over time, in an environment of high economic growth, facilitates a rise in savings rate.

Enticing foreign capital Inspite of a low domestic savings rate, other sources can be tapped to stimulate the economy. Foreign capital inflows have been the most obvious choice to beef up local investments although direct investments are preferred to foreign loans or portfolio inflows.

The Philippines has not been a major destination of foreign direct investment. Only one-third of investment inflows in the early 1990s was accounted for by foreign direct investments (FDIs) compared with about half for other economies in the region. The bulk of investments remain as portfolio flows and external borrowing (World Bank 1997).

Table 2. Gross Domestic Savings (As percent of GDP)

1971-1980

1997

Indonesia

21.6

31.0

Korea

22.3

34.5

How to save a lot

Malaysia

30.4

43.8

To encourage high domestic savings, the macroeconomic environment needs to provide robust economic growth, positive real rates of interest, more attractive and accessible saving instruments, and a lower fertility rate. Explicit incentives to encourage small savers include the elimination of the final tax on interest incomes from

Philippines

23.4

19.2

Thailand

22.2

31.0

Policy Notes

Source: Asian Development Bank and Asian Development Outlook

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Improved economic prospects and political stability remain as ultimate encouragements for foreign investors. But more than this, the government should be more aggressive in promoting investments by investing more resources in this area. The bureaucracy would have to be more investor-friendly. Greater coordination among agencies to streamline systems and procedures will help reduce the transaction costs of setting up a business.

Government’s fiscal incentive system should focus on fewer industries in support of exports and industrial restructuring, which will help reduce the fiscal burden of current fiscal incentives.

The ties that bind: the productivity-wage rateexchange rate nexus The Philippines lagged in labor productivity growth between the late 1970s and early 1990s. The country significantly lost its international competitiveness during the 1980s and early 1990s as reflected by poor export per formance during the period. On a brighter note, labor productivity has improved in selected industries in the manufacturing sector in recent years (World Bank 1997, and Cororaton and Abdula 1997) which may have contributed to the recent improvement in the countr y’s export per formance.

ASEAN currencies have significantly appreciated in real effective terms since the early 1990s, halted only by the 1997 currency devaluations. The Philippine peso appreciated the most. It should be noted that currency appreciation or an increase in wage costs means loss of competitiveness unless productivity improvements can maintain competitive niches.

Speculation fever hits Asia In 1997, the East Asian countries experienced attacks on their currencies following the major depreciation of the Thai baht in the middle of that year. The peso lost 42 percent of its value at the end of 1997. Unlike past devaluations, the current depreciation of the peso has not been significantly inflationar y due in part to tight monetar y and fiscal policies, high protection rate in food crops in the 1990s, more realistic wage adjustments, and reduction in world oil prices.

No. 98-04

Blessing in disguise Despite the current macroeconomic problems brought about by high interest rates and the slowdown of the economy, the currency realignment—which is, in fact, a market-based adjustment—is seen to help improve the economic prospects of the Philippines in the long run. A depreciated currency increases the competitiveness of the export industr y and corrects long-standing price distortions in the economy.

Food security should be ahead on the list For most of East Asia, high economic growth coincided with increases in per capita food and agricultural output including agricultural trade surpluses. The same

"Government’s fiscal incentive system should focus on fewer industries in support of exports and industrial restructuring, which will help reduce the fiscal burden of current fiscal incentives."

cannot be said of the Philippines where per capita output in food and agriculture had declined between 1980 and 1990. The countr y has in fact suffered agricultural trade deficits by the early 1990s.

Watch out for the drawbacks Despite agricultural trade deficits, Philippine agricultural production grew fast in the early 1990s as a result of the sharp rise in agricultural protection. With high agricultural tariffs, domestic agriculture-based industries face a formidable task of competing when manufactures tariff within the ASEAN region are reduced to a range of zero to 5 percent in 2004.

High agricultural protection also implies higher food prices in the Philippines. With higher food prices come workers’ clamor for higher wages. When this is coupled with the effects of the currency appreciation and the mar-

Policy Notes

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ginal increase in productivity, this translates to eroded competitiveness for the countr y.

Agricultural productivity is the key The poor state of Philippine agriculture calls for improvements in these areas: greater investment and improved institutional framework of the agricultural research and extension system to sustain agricultural productivity, improvement in the infrastructure support system, and redesigned market inter vention policies.

"The Philippines needs to invest more in technical skills for improved labor competitiveness."

Better infrastructure support The Philippines’s infrastructure investments, at 2.5 percent of GDP, is lower than the regional average of 4.7 percent. The countr y also ranks close to the tail end of the level and quality of infrastructure list. In 1995, only 17 percent of the countr y’s total roads were paved. The World Bank estimates that the Philippines needs to invest 6.8 percent of GDP in 1995-2004 to meet infrastructure needs. Since the financial capability of government is not enough to meet these requirements, there is a need to maximize public-private partnerships. Facilitating private investment requires improved policy conducive to private participation. The two most important aspects would be greater transparency and regulator y reforms to encourage appropriate pricing of infrastructure ser vices.

Enhancing skills Between 1970 and 1994, East Asian enrolment ratio in all levels has dramatically increased. Adult literacy rates have also markedly improved. The Philippine figures are comparable in both instances. However, it has the highest dropout rate in primar y level completion.

At the tertiar y level, enrolment data disguise the prob-

Policy Notes

August 1998

lem of quality and relevance. It is also disturbing to note that 40 percent of students drop out of colleges and universities. The shorter school cycle means higher education institutions have to compensate by spending more time on bringing students up to basic levels. The curriculum is hardly geared to modern technological needs and there is little input from industr y. In the developed countries, there is a direct and continuing interaction between providers and users of higher education (World Bank 1997).

The government remains the most important provider of education particularly at the lower levels. However, education as a percent of total government expenditure has dropped from 24.4 percent in 1970 to 10.5 percent in 1994. This has an adverse effect on the quality of education. The Philippines needs to invest more in technical skills for improved labor competitiveness. While the general skills are comparable with other countries, the skill base needs reorientation and quality level needs improvement.

Developing technology The technological system in the Philippines is still in its early stages compared with those of other Asian countries. R&D expenditures are low (only 0.2 percent of GDP in 1991) while R&D effort and management are of poor quality. The science and technology sector is also ineffectively integrated with productive activity (World Bank 1997).

The private sector is central to technology development. Hence, private participation should be encouraged to ensure that technological research would have a direct linkage with industr y. The public science and technology system also needs reforms to make it more autonomous, customer-driven and proactive (World Bank 1997). Government can likewise encourage greater technology transfer from multinational companies.

Facilitating small- and medium-scale enterprises The importance of small and medium enterprises (SMEs) is recognized for their capacity to provide a strong

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base for export-oriented industrialization. SMEs in the Philippines have increased between 1983 and 1988. This is attributed primarily to trade liberalization and the recover y of the economy. More open trade facilitated the growth of SMEs through easier access to more cost competitive inputs. Freer exchange encouraged greater exports of manufactures and motivated the use of subcontracting (Medalla et al. 1996). Recognizing the role played

by SMEs, institutional support must be intensified and linkages between SMEs and large enterprises should be encouraged.

Greening the domestic economy The integration of environmental issues into the world trading system calls for a reshaping of domestic policies. Environment-related multilateral trade provisions as well as green consumer expectations are rising. This means that government needs to encourage the private sector to be more environment friendly. Externality costs of pollution and environmental damage should be incorporated in domestic market prices.

There are fears that the internalization of environmental costs will have a negative effect on the international competitiveness of local industries. Initial studies show that industries, on the average, could internalize to a large extent environmental costs and still remain competitive. In doing so, however, the overall incentive structure becomes more skewed against export industries (Intal 1997). Thus, it is best that the internalization of environmental costs is complemented with further rationalization of the tariff and nontariff trade regime.

No. 98-04

Polluters must pay It is projected that as the domestic economy grows, domestic production of pollutive industries would be on the increase. It is therefore important to improve the domestic pricing system and the institutional capability to cope with increased pressure from industrial pollution.

Concrete steps would include widespread adoption of the polluters pay principle. Revenues from pollution taxes can be invested in environment-regenerative programs and facilities. 4

Selected references Cororaton, C. and Abdula, R. “Productivity of Philippine Manufacturing.” Draft report submitted to the Philippine Institute for Development Studies, September 1997.

Eggleston, K. “The Sustainability of East Asian Growth.” ASEAN Economic Bulletin 14, No.1 (July 1997): 14-31.

Intal, P. “Three Essays on the Philippine External Sector.” Ph.D. dissertation, Yale University, 1983.

———. “Perspectives from the Philippines and ASEAN.” In Tay, S. and Esty, D. Asian Dragons and Green Trade, Times Academic Press, 1997.

——— and M.P. Geron. “Integrative Report on the Agroindustrial Restructuring and Competitiveness Program.” Report submitted to the National Economic and Development Authority, Manila, 1996.

Mason, A. “Will Population Change Sustain the “Asian Economic Miracle”?”

Asian Pacific Issues No. 33, October 1997.

Medalla, E., G. Tecson, R. Bautista, et al. Philippine Trade and Industrial Policies: Catching Up with Asia’s Tigers Vol II. Makati: Philippine Institute for Development Studies, 1996.

Sachs, J. and A. Warner. "Economic Reform and the Process of Global Integration." Brookings Papers on Economic Activity, 1995.

World Bank. Global Economic Prospects and the Developing Countries 1996.

Washington, D.C.: American Writing Corporation, 1996. ________. “Philippines Managing Global Integration, Volume 2: Background Papers.” Draft report prepared by the Poverty Reduction and Economic Management Sector Unit, East Asia and Pacific Regional Office, 19 September 1997.

Importing pollution The pattern of Philippine trade shows dramatic changes in the pollution intensity of both exports and imports. The share of nonpollutive and nonhazardous products in exports and imports have sharply increased over the years. Meanwhile, the share of highly pollutive exports decreased but the share of pollutive imports is still relatively high. This means that the Philippines is importing products, which, had they been produced locally, would have aggravated local pollution problems.

For further information, please contact The Research Information Staff Philippine Institute for Development Studies NEDA sa Makati Building, 106 Amorsolo Street Legaspi Village, Makati City Telephone Nos: 8924059 and 8935705; Fax Nos: 8939589 and 8161091 E-mail: pintal@pidsnet.pids.gov.ph, jliguton@pidsnet.pids.gov.ph

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List of PIDS Discussion Papers* for 1998 98-01

Strengthening Credit Institutions for Rural Poverty Alleviation Gilberto M. Llanto and Ma. Teresa C. Sanchez

98-02

Financial Reform and Development in the Philippines, 1980-1997: Imperatives, Performance and Challenges Ponciano S. Intal, Jr. and Gilberto M. Llanto

98-03

Macroeconomic Policy Change and Household Health Outcomes: A Simulation of the Impact of the 1988-1992 Tariff Reform Program on the Demand for Outpatient Care in the Philippines Aniceto C. Orbeta, Jr. and Michael M. Alba

August 1998

98-14

Providing a Metropolitan Perspective to Development Planning: Cagayan de Oro Ruben G. Mercado and Casimira Balandra

98-15

Metropolitan Cebu: The Challenge of Definition and Management Ruben G. Mercado

98-16

Re-owning the Metropolitan Vision: The Case of BLIST Ruben G. Mercado and Carmel P. Chammag

98-17

To Each Its Own: The Case of the Cotabato City Special Project on Health and Sanitation Virginia S. Pineda and Ma. Lourdes Lim

98-18

People Power at Work: The Case of the Surigao City Primary Health Care (PHC) Federated Women's Club Virginia S. Pineda and Jazmin Beridol

98-04

The East Asian Crisis and Philippine Sustainable Development Ponciano S. Intal, Jr. and Erlinda M. Medalla

98-19

Emergency Rescue Naga: An LGU-Managed Emergency Rescue Project Virginia S. Pineda and Rose Buan

98-05

Trade and Industrial Policy Beyond 2000: An Assessment of the Philippine Economy Erlinda M. Medalla

98-20

Puerto Princesa City's Satellite Clinics: A Curative Rural Network Virginia S. Pineda

98-06

Poverty Alleviation and Equity Promotion Celia M. Reyes and Edwin A. del Valle

98-21

Reaching Out: The Case of the Gingoog City Total Integrated Development Approach (G-TIDA) Virginia S. Pineda and Clark Clarete

98-07

Beyond 2000: An Assessment of Infrastructure Policies Ramonette B. Serafica

98-22

The Low-Cost Housing Program of Puerto Princesa City, Palawan Anicia C. Sayos and Antonio C. Fernandez

98-23

The "Lote Para sa Mahihirap" Housing Program of San Carlos City, Negros Occidental Anicia C. Sayos and Estela F. Paredes

98-24

"Kaantabay sa Kauswagan" (Partners in Development) Mass Housing Strategy: The Case of Naga City Anicia C. Sayos

98-25

The International Economic Environment and the Philippine Economy Ponciano S. Intal, Jr. and Leilanie Q. Basilio

98-26

Productivity Growth in the Philippines After the Industrial Reforms Myrna S. Austria

98-08

Beyond 2000: Assessment of the Economy and Policy Recommendations – Social Sector Dealing with Technology Policy Jose A. Magpantay

98-09

Beyond 2000: Assessment of the Economy and Policy Recommendations – Social Sector Dealing with Agrarian Reform Marideth R. Bravo and Blanquita R. Pantoja

98-10

Philippine Employment and Industrial Relations Policies: An Assessment Gonzalo M. Jurado and Ma. Teresa C. Sanchez

98-11

Fiscal Adjustment in the Context of Growth and Equity, 1986-1996 Rosario G. Manasan 98-27

98-12

Metro Iloilo: A Struggle for Acceptance and Organization Ruben G. Mercado and Raul S. Anlocotan

The Emerging Philippine Investment Environment Myrna S. Austria

98-28

Metropolitan Naga: A Continuing Challenge of Local Autonomy and Sustainability Ruben G. Mercado and Victor B. Ubaldo

Beyond 2000: Assessment of Economic Performance and an Agenda for Sustainable Growth Josef T. Yap

*Preliminary versions and subject to revisions.

98-13

Policy Notes