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A Philippine Sovereign Wealth Fund

The Philippines is suffering from a rare form of “Dutch disease”, the negative consequences of a rapid rise in income normally associated with the export of natural reserves. In our case, the income comes from our export of labour. Overseas remittances rising every year swell our foreign currency reserves. The peso appreciates as a result. This diminishes the global competitiveness of our manufacturing sector with adverse implications for domestic employment.

Meanwhile government keeps borrowing from international markets to finance its chronic budget deficits. This contributes to the upward pressure on the domestic currency as more dollars flow in to purchase government securities. To keep its borrowing down and make credit rating agencies happy, government constrains its spending. It wants to rely on public-private partnerships (PPP) to provide infrastructure which are both time-consuming to arrange and limited in scope.

As it postpones development spending credit rating upgrades keep coming. Each time this happens, fund managers around the world increase the flow of “hot money” into the stock market, thus contributing to more upward pressure on the peso. Property developers also cash in as the value of residential and commercial assets appreciates with the rising peso, which creates even more demand for new development.

The families that receive remittances on the other hand suffer as the purchasing power of the dollar declines. And due to their dependence on these transfers, the income that families receive goes mostly to household expenditures. Very little is invested in productive activity. And when it is, the investment normally goes into retail or transport enterprises, which earn very marginal returns.

For the rest of the population, finding a job is a struggle. Life is hard as there are not enough opportunities that come by due to a dearth of fixed private capital expenditures on plant and equipment let alone research and development. Most of the inflows go to short-term investments, i.e. the stock market, or to fund property purchases, which results in very little job generation outside the construction industry which demands casual employment due to the seasonality of its activity.

This in a nutshell is the problem that confounds the Philippines.

Foreign remittances for the twelve months to January 2012 hit $20 billion according to the World Bank. Remittances for the first ten months of 2012 have already equaled that amount according to central bank figures (with the Asian Bankers Association estimating the real amount to be in the order of $27 billion). This was close to 90 per cent of the Bureau of Internal Revenue”s total tax collections for 2011, and would have been enough to finance that year’s budget deficit four times over. As of November 2012, the country’s gross international reserves (GIR) stood at $84 billion exceeding the BSP’s full year estimate of $78 billion.

This was enough to cover our imports for a full year or to settle all short-term debt obligations 12 times based on original maturity and 6.8 times based on residual maturity (that is short-term loans based on original maturity plus principal payments on medium- and long-term loans of both private and public sectors falling due in the next 12 months).

In fact back in June 2012 when the GIR stood at $76.1 billion, the country’s external debts belonging to both the public and private sectors stood at $62.5 billion. That means the BSP had enough to settle all external obligations and still have roughly $14 billion left over.

The two charts below show what has happened over the past decade. The first one shows that after a rocky first half, the country has been producing consistent balance of payments (BoP) surpluses averaging about 3.8 per cent of GDP from 2005-2011. That is the inward flow of foreign currency exceeded the outward flow by the said ratio. A quick rule of thumb is that 1 per cent of GDP is roughly $2.5 billion or Php100 billion.

So on average, the annual surplus has been about Php380 billion during the past six years. The average BoP surplus is therefore more than enough to accommodate government’s annual revenue shortfall averaging 1.11 per cent a year. The second chart shows the effect these surpluses have had on our GIR. From 2001 to 2011, it has grown on average by 16.7 per cent. Up until 2005, you can see that the line is pretty flat. Afterwards it rises steeply. This means that a tipping point in the flow of overseas remittances occurred back then which placed our BoP structurally in surplus territory from that point on.

Surpluses and deficits, in per cent of GDP

No wonder bond markets have had such confidence in the Philippines. As the saying in business goes, banks will only offer you credit when you don’t need it. The question is do we just keep accumulating these reserves knowing the problems they create for our economy? Or do we actually put the excess funds to good use by investing in the country’s development?

As the title of the piece suggests, we could set up a sovereign wealth fund (SWF) with our excess reserves. The $14 billion mentioned above, which by the end of the year will probably be $15 billion would be the seed money. That is enough to double our infrastructure spending which is currently 1.5 per cent of GDP to 3 per cent, much closer to the recommended 5 per cent, over the next four years. With that added spending, the government could easily meet its aspirational stretch target of growing the economy by 7-8 per cent a year.

Every year, depending on how well our balance of payments performs, we could just keep adding to the SWF. Assuming that the government’s new revenue measures and fiscal consolidation will mean an annual deficit of about 1 per cent of GDP and that the annual BoP surplus remains at 3 per cent of GDP, there would be enough to fund government’s deficit and set aside another 1 per cent to augment the SWF, with the remaining 1 per cent going to GIR.

But we are getting ahead of ourselves. Let us first define what is a SWF? According to the Sovereign Wealth Fund Institute, it is

a state-owned investment fund or entity that is commonly established from balance of payments surpluses, official foreign currency operations, the proceeds of privatisations, governmental transfer payments, fiscal surpluses, and/or receipts from resource exports.

The Institute cites some “interesting facts” about SWFs, namely that some of them “invest indirectly in domestic industries” and that “they tend to prefer returns over liquidity, thus they have a higher risk tolerance than traditional foreign exchange reserves. Most often SWFs receive their initial capital through “commodity exports, either taxed or owned by the government” or through “transfers of assets from official foreign exchange reserves”.

There are about US$5.1 trillion invested in SWFs globally. About three of every five dollars come from oil and gas exports, the remainder from other sources. The size of funds varies from as little as US$300 million for Indonesia to as large as US$664 billion for Norway. Of the 64 SWFs that currently exist, 39 were established since 2000.

Some have argued that the Bangko Sentral is restricted by its charter, RA 7653, the Central Bank Act, from investing in instruments other than Triple-A rated bonds of foreign governments. At the time this law was passed, the problem facing the country was chronic balance of payments deficits. More transfers out rather than in were being made.

The BSP is tasked under the law with maintaining international monetary stability in the country. Part of this according to Article II, Section 64 of the law is “to preserve the international value of the peso and to maintain its convertibility into other freely convertible currencies”.

To maintain such stability, Section 65 says that “the Bangko Sentral shall maintain international reserves adequate to meet any foreseeable net demands on the Bangko Sentral for foreign currencies”. It would have to judge for itself the adequacy of these reserves based on “prospective receipts and payments of foreign exchange by the Philippines”.

Finally, Section 66 lays out the composition of such reserves which it says “may include but shall not be limited to” gold and other assets that took the form of “documents and instruments customarily employed for the international transfer of funds; demand and time deposits in central banks, treasuries and commercial banks abroad; foreign government securities; and foreign notes and coins”.

So why did the central bank governor offer in September of 2011 to purchase Philippine treasury using its dollar reserves given that these notes are not Triple-A rated? Well, he had probably realised as I had back in November 2010 that the Bank already had an adequate supply of reserves to meet international obligations.

Given that the law says nothing about what to do if the Bank were to have more than a sufficient level of reserves we can say that the Bank is sailing in unchartered waters. If the law does not specify what it should do in such a situation, then it should be left to the discretion of its board to decide on how best to deal with it.

Currently, the return on short-term US treasury notes is between 0 and 0.25 per cent, negative in real terms, meaning that the Bank is paying the US government to borrow from its reserves. And the Fed has said that it plans to keep interest rates as low as they are for the foreseeable future until the US unemployment rate goes under 6.5 per cent (it is currently at 7.7 per cent). If the BSP lent its excess reserves to the Philippine government, it would gain a better return and preserve the value of its assets.

Now that we have cleared the financial viability and legality issues, what would be the purpose of a Philippine SWF? The nature and purpose of SWFs are varied, but in the Philippines it might be to do the following (as adapted from the SWF Institute):

  • Protect and stabilise the budget and economy from excess volatility in revenues/exports
  • Diversify our industry sector to make growth more inclusive and robust
  • Earn greater returns than on foreign exchange reserves
  • Assist monetary authorities dissipate unwanted liquidity
  • Increase savings for future generations, or
  • Fund social and economic development.

Given the need to boost productivity and improve competitiveness, addressing the infrastructure backlog would be the most obvious answer. The public-private partnership projects would be a good initial source of demand for funding as these projects are designed to earn a market rate of return for the investor. Another possibility would be for the SWF to enter into joint-ventures with mining firms for the joint-exploration and production of oil and other commodities. This would ensure that we received a larger share of the benefits from such operations.

A third possibility would be to fund innovation through government procurement, business incubators, industry clusters, and competitions aimed at the commercialisation of ideas. Government could serve as a catalyst in the germination of new activity around key areas of specialisation that the country has already exhibited proficiencies in. The expansion of our semiconductor and electronics industry into higher value adding activities could be one priority. The growth of agribusinesses into higher yield crops and again value adding processes could be another. A fourth priority could be the generation of clean technology and renewable energy.

Finally, beyond just the economic, financial, legal and commercial viability, there is the political viability of doing this. Creating a Philippine SWF would be politically astute as it would be seen as the Aquino administration’s unique contribution to the development of the country. The vice president has also expressed his support for the concept of using foreign reserves for development. This means that the measure would have the support of both leaders and their coalition partners in both houses of Congress.

Beyond that, the consensus formed by our leaders would mark the first time a remittance dependent nation’s government deliberately leveraged the income derived from its work force overseas to channel resources into highly productive activity back home. It would be a shift in the development paradigm of such countries and provide a model for them to follow. Just as conditional cash transfers were forged through a consensus among Mexico’s and Brazil’s leaders as a way to alleviate poverty, the Philippine consensus would provide a path for low income households out of poverty and into the middle class by providing jobs to people of low skills through the fruits of their countrymen’s sacrifice overseas.

If we don’t recognise the opportunity that lies before us in this regard, then when our overseas workers return home, all their hard work may come to nothing as their children will then have to go abroad because there would be no jobs left for them here. With the Aquino government’s good governance credentials, it should be able to shape the probity and prudential measures needed to ensure that the SWF is properly managed and its funds transparently and judiciously utilised for public benefit. This would prove that good governance is indeed good economics and that the righteous path can create in the Philippines opportunities not just for some but for all.

Budget 2013: The Bottomline

If the State of the Nation Address of the president is meant to rally the country behind him, the budget statement is meant to inspire confidence in markets both financial and political.

As far as this year’s budget statement goes, does it draw confidence from its intended audience? Who are the winners and losers? This being an election year (the midterm elections are scheduled for May 2013), are there any red flags or curious things to watch out for?

Let us first examine the figures.

Beginning with the bit aimed at financial markets, the government with its fiscal program for 2013 seeks to spend just over two trillion pesos, a jump of about 160 billion or 9.9% from 1.84 trillion in 2012. This level of expenditure will be financed by revenues that are expected to rise from 1.6 trillion in 2012 to 1.8 trillion in 2013, a growth of 14%, and borrowing or deficit spending that is set to go down from 280 billion to 240 billion in the same period, a decline of about 14%.

Expressed as a share of GDP (the value of all goods produced within the country), expenditures will rise from 16% of GDP in 2011 to 16.9% in 2013. Revenues are also set to rise from 14% of GDP to 14.9%. The deficit is set to go down from 2.6% of GDP in 2011 to 2% in 2013.

Relative to the budget position of rich countries, the fiscal program in the Philippines is sure to inspire confidence in bond markets as the deficit-to-GDP ratio will be less than half that in the OECD whose deficit-to-GDP ratios averaged 6.3% in 2011 and are projected to be 4.2% in 2013.

Given that the government’s total debt-to-GDP ratio went down to just under 51% in the first quarter of 2012, it is likely that it might go down further to below 50%, which would be crucial in gaining the coveted investment grade rating from credit agencies. Compared to the rich countries of the OECD whose debt-to-GDP ratios averaged 97% in 2010, the Philippine public sector looks a lot more solvent indeed.

So now let us turn to political markets and see how next year’s budget seems to fare. It is worth comparing budgeted levels in 2013 to that of previous election cycles. Back in 2010, expenditure levels were exactly at the same level compared to what they are proposed to be in 2013—that is, they were 16.9% of GDP. The same goes for 2007, the last time mid-term elections were held.

Incidentally in that year, the budget was practically balanced. Had the global financial crisis not followed, the government might have been achieving surpluses afterwards. It was the stimulus spending of subsequent years combined with weaker revenues that caused the government to incur deficits which have carried over until today. In 2004, a presidential election year, the expenditure to GDP level was at its highest over the past decade at 17.5%.

So is next year’s budget an election budget? Is it geared to win or buy votes for the administration? On the face of it, it would seem that the spending rate is at par with other election years. The 2004, 2007 and 2010 election spending by the Arroyo government earned the ire of the then opposition for what they said were blatant attempts to divert money into the ruling party’s campaign kitty. So could the same thing happening again?

First let us have a look at where the money is meant to go. The profiles of the 2012 and 2013 budgets are shown below. We can clearly see from this that from year to year, the structure hardly changes although next year’s budget goes up by 240 billion pesos. The shares of spending for defence (14%), debt (17%), and general expenses (17%) are down by one percentage point each from their 2012 ratios. Meanwhile the share received by social services goes up by 1% point to 35% and that of economic services (transport and public works) by 2% points to 26%.

The ‘doughnut’ chart shows how the additional spending is split across portfolios. Social services receive the biggest increase with an additional 85 billion pesos allocated on top of its budget this year of 613 billion pesos. Economic services receive the next biggest share of about 72 billion on top of the 439 billion from 2012. General services get 26 billion more on top of its current 320 billion, while defence gets an additional 3 billion above its current 87 billion. Net lending (currently at 23 billion) and debt repayments (at 333 billion) each go up by 4 billion and 1 billion respectively.

In terms of which departments get the largest growth in their budgets, the Department of Education sees the biggest growth of 54 billion pesos. Public Works follows with 27 billion. Third comes the Department of Interior and Local Government with 21 billion followed by National Defence with 14 billion. The Department of Agriculture comes in fifth with an additional 13 billion followed by the Health with 11 billion. Rounding out the final four are Finance with 9.6 billion, Social Welfare with 7.4 billion, Environment with 6.2 billion and Transport with 2.4 billion.

The president announced in his SONA that his administration would seek to clear the backlog of classrooms to provide sufficient facilities to public school pupils. This was in line with the K-12 reform which increased the years of secondary school by two while providing universal kindergarten classes at the primary level. It appears that his budget delivers on that.

He also announced the completion of repairs for all paved roads nationally. The procurement of guns for police and of modern equipment for the armed forces also featured in the SONA. The same goes for the improvement of irrigation for agriculture and health coverage of the government insurance system. The Pantawid Pamilya continues to be ramped up which is evident in the figures, and the same can be said of community based forest protection. Finally, the task of getting NAIA-1 refitted and NAIA-3 operational was raised.

So in terms of this budget being meant to win votes at the next election, if the president intends to show that his administration’s ticket deserves the support of the electorate on the basis of his government’s delivery of promises, this budget might be seen as a way to address that.

Other notable things about this coming year’s proposed budget include: an increase of the capital outlays for the compensation of land owners under the Comprehensive Agrarian Reform Program with Reforms by 100% from 2.5 billion pesos in 2012 to 5 billion in 2013; a similar increase of subsidies to government owned and controlled corporations by about 114% from 20 to 42 billion pesos; and a ten billion peso fund to provide performance based bonuses to civil servants.

The increased CARPeR funding is in line with the government’s target of completing land distribution by 2014 when the program ends. The increased subsidies to GOCCs and bonuses to government executives is a curious thing given how the president earlier decried the massive waste incurred by these firms which led to a ballooning of subsidy paid to them and the bonuses executives paid themselves as their firms suffered losses. I could be proven wrong, but it appears that the same could be occurring here.

It would be interesting to see just where these subsidies are going and how successful the bonus scheme is in its first year. Allowing government agencies to take a hit financially could be a way of avoiding the political fallout if fees and other charges were otherwise increased to cover the cost of service delivery adequately. In this sense, one might characterize this increased support to GOCCs as pandering to the electorate.

The question then becomes what the government intends to do after the elections. Will it seek to claw back some of these losses by increasing fees and charges to what they ought to be? In that sense, shouldn’t the administration be up front with the public instead rather than try to deceive them? The budget statement is silent on these matters despite the glaring deterioration that seems apparent among GOCCs.

At the end of the day however budgets do very little to give incumbent governments a boost, at least a lasting one. Previous budgets under the Arroyo presidency prove this point. Despite the massive infrastructure program and social insurance expansion undertaken from 2007 to 2010, very little improvement in its standing with the public occurred.

The fact of the matter is expanding the budget is fine for as long as the economy keeps growing briskly. Both financial and political markets will accept that the government has to do its part in maintaining the country’s growth trajectory. For as long as revenues are able to keep up with the expanded services, that is.

And this will be the biggest challenge moving forward. In the past, government revenues have not kept pace with growth in the economy. This was due to a range of factors, from technical smuggling of petroleum products, to the non-indexation of sin taxes, to the erosion of the revenue base by granting tax exemptions to targeted voter and interest groups.

This is where the administration could break with tradition: if it makes signing up to new tax measures a condition for its support to allied parties in Congress. That way it becomes less a marriage of convenience and one of principled politics. Candidates under the ruling coalition or alliance should be asked to commit, to sign an agreement to that effect.

Although the budget for 2013 won’t depend on new revenue measures like the mining tax, sin tax indexation and rationalization of fiscal incentives, future budgets and the fulfilment of the president’s agenda towards the latter half of his term will. It is incumbent upon the president to now forge a fiscal compact that guarantees his social contract with the Filipino people. How successful he is in doing this in an election year will prove just how skillful a leader he is.

Is the Philippines a Late Bloomer?

“Whenever we find a late bloomer, we can’t but wonder how many others like him or her we have thwarted because we prematurely judged their talents. But we also have to accept that there’s nothing we can do about it. How can we ever know which of the failures will end up blooming?”
Malcolm Gladwell

In the Philippines, children trooped to school this week as yet another academic year began. It seemed like any other year, with the rising cost of private education and the shortage of classrooms and teachers plaguing the public system giving concern to parents.

There was one significant difference though: the country became one of the last in the region to adopt a K-12 (kindergarten to Year 12) structure. The additional two years to secondary education and one year of kindergarten meant that the educational system in the country has finally caught up with the rest of the world.

It is hoped that with this reform, the country would be able to lift the academic test scores of its pupils which have been lagging behind that of neighbouring states. Previously it was hypothesised, educators tried to cram in too much content within the span of ten years. It is hoped that allowing more time to learn the new national curriculum would produce better results.

But apart from giving students the tools to succeed in life, there is a number of policy areas in which the Philippines has lagged behind but could now be catching up. Reproductive health and family planning is an example of where the country has remained staunchly intransigent even when there has been a near universal consensus arrived at around the world on this issue. The long-delayed reproductive health bill that has languished in Congress for over a decade may finally pass.

In the area of peace and order and social justice, the country has one of the longest running communist insurgencies in the world. Its land reform program whose implementation has taken decades longer than expected, may finally be completed with the resolution of the Hacienda Luisita case.

After a chequered history, the revised sin tax legislation may finally pass, giving government finances a boost and allowing credit rating agencies to give a positive outlook for the country, which in turn lowers the cost of borrowing for the government. Having been a net debtor nation to the rest of the world, the nation’s ability to shore up international reserves through balance of payments surpluses now make it a net creditor.

After being the consistent laggard of Southeast Asia when it comes to attracting foreign direct investments, an investment pipeline involving infrastructure projects may soon reverse its fortunes. With growth slowing in the BRIC economies, the US and the EU, a first quarter growth of 6.4% year-on-year making the average for the past two years 5.6% make the country a stand-out along with Indonesia and Turkey (see video below for an explanation).

With employment growing and inflation easing, some are beginning to wonder if the Philippines is finally getting its act together. Two thousand and twelve could be a “breakout” year for the country.

Bullet-proofing the economy

Ominous clouds are hovering over the horizon, and yet the government seems unprepared.

What would happen if the US receives a credit downgrade? This scenario is appearing more likely as reported today. This same week, as Ireland joined Greece and Portugal in receiving “junk status” for its bonds, there was talk of Spain and Italy joining them. These are the so-called PIIGS economies (Portugal, Ireland, Italy, Greece and Spain) that are miring the EU and the IMF with costly bailouts.

In the US, US Fed Chair Ben Bernanke signaled that he stood ready to assist their ailing economy with a third round of stimulus via quantitative easing (translation: the central bank buying US treasury notes) but then quickly quashed speculation of it definitely happening. Meanwhile, the political leadership in Washington could still not arrive at an agreement to lift the US debt ceiling with Republican tea partyers unwilling to cut a deal with Pres Obama before the August 2 deadline.

What all this means is that global economic recovery from the financial crises of 2008 is in jeopardy. A second crisis could hit our shores soon. Some ominous signs of this are already apparent with our exports experiencing an annual decline in May. The last one was registered in October of 2009, when the first wave hit our shores.

The threats

There are two simultaneous shocks that will occur once the US credit rating is downgraded. One, the dollar will devalue, potentially leading to more portfolio investments into the country causing the peso to appreciate. This will have an adverse effect on our already dwindling exports sector. Two, the excess liquidity flowing from these funds would put upward pressure on inflation which in turn would make interest rate hikes more likely. This will impact on borrowing costs.

So in the coming months, weak demand for our products and services from advanced economies coupled with an unfavorable exchange rate will create an enormous drag on our economy. Combined with higher domestic interest rates which would dampen consumer spending and private capital expenditure, and you could end up with quite a powerful cocktail of doom and gloom.

Compounding these problems are the woes suffered by our overseas labor force in the Middle East with the policy of Saudization to impose quotas on hiring of foreign nationals as well as the overall disturbance of deployment to the region as a result of political instability, and the second half of 2011 could turn out to be pretty tough one for labor exporting countries like the Philippines.

Growth predicated on PPPs

Multilateral institutions and national economic planners have already pegged expectations for growth at 5%, but that is predicated on the government being able to wheel out its PPP projects and ramp up government spending in the second half. So far though, the roll-out has been anything but brisk, with several delays hampering the timetable. Even scheduled projects involving overseas development assistance had to be cancelled for alleged overpricing and poor technical specifications. This led Ricardo Saludo in an op-ed piece for the Manila Times to write

The government recently issued more assurances that the much-awaited partnership program guidelines are under way. But investors are getting tired of yet more pledges to roll out the program and give adequate protection to joint ventures. Until one deal actually gets done and well, PPP may only encourage the perennial wait-and-see attitude toward the Philippines.

The budget department has signaled it plans to extend social safety nets to more indigent families through the conditional cash transfers program by re-channeling unspent public works expenditures from the first half. Meanwhile, PNoy began distributing benefits relating to social reforms (land, health, and social safety nets) in an apparent move towards a permanent campaign mode.

Political circus

Congressional investigations into alleged corrupt practices involving former president Gloria Arroyo and officials of the Philippine Charity and Sweepstakes Office heat up. The pornography of corruption involving hundreds of millions of public money being siphoned off to unlawful purposes and to questionable tranfers to religious persons and their charities has once again made for captivating viewing.

As the trial of the Ampatuans over their alleged masterminding of a massacre of political rivals and their escorts in Maguindanao, a new round of poll fraud and corruption allegations involving the former first gentleman surfaced courtesy of Zaldy Ampatuan son of the accused principal conspirator, Andal, Sr as part of an offer to turn state witness. Once again, as dark economic clouds gather, the Philippines is engaged in the theatrics of political scandals, investigations and trials.

Second SONA

All eyes and ears will be turned to the president’s second State of the Nation Address to Congress on July 25 to see what set of priorities he lays down for the sophomore year of his term. Will he continue to focus on the alleged waste and corruption that took place under his predecessor? Or will he lay down a plan for bullet-proofing the economy against the increasingly menacing global environment?

In the final analysis, it will be nearly impossible to ignore the controversies involving the past administration, as it brings out the contrast between the old and the new. A year after he unveiled PPPs as his government’s centerpiece program for growth, not a single project has been awarded. Markets and observers anxiously await PNoy to pivot towards his economic blueprint for the future, before the impression that the present is just a continuation of the past settles in.