Ease of Doing Business

Kurap at mahirap pa rin

Poverty does not seem to be abating, neither is good governance improving much.

This inconvenient truth is the conclusion derived by the National Statistical Coordination Board (NSCB) as of its latest data releases.

Back in April, it found that the change in poverty incidence in the country during the first semester of 2012 (27.9 per cent) was not statistically significant from what it was during the same period in 2009 (28.8 per cent) and 2006 (28.6 per cent).  This rather dismal outcome of the administration’s first two years in office was downplayed by the Palace. It came after the employment report for the April-2013 quarter showed signs that jobs generation was heading south despite the economy’s stellar growth posted in the same period.

Then last week, the NSCB released a set of indicators on Philippine development. When it came to our performance under the global scorecard for good governance, the report said,

The country’s percentile rank based on the World Governance Indicators (WGI) on control of corruption, rule of law, regulatory quality, and voice and accountability had low probabilities of attaining the 2016 targets.

It went on to say that the likelihood of us achieving a better score in terms of government effectiveness under the WGI by 2016 were high. Government effectiveness is different from control of corruption, rule of law, regulatory quality and voice and accountability, though. The former is probably what you would call, “good enough” governance as opposed to “good governance” which is what the latter implies. In the “light v darkness” narrative promoted by the ruling party, “good enough” governance is simply “not good enough”.

The most telling sign that the administration has failed to address the governance issue so far is that the country’s latest ranking in the Ease of Doing Business report slipped two places (from 134th to 136th) and that there was a drop in total investments in 2012. Reducing the cost of doing business is vital to attracting investments. Many say, that in order to open the floodgates to foreign direct investments, all we need to do is change the economic provisions in the charter that limit foreign participation in the local economy.

I personally have a different view, but even if, for argument’s sake that were to happen, if the cost of doing business remained high, it would still discourage investors from investing, as per the current situation in many sectors of the economy that already have been opened up to foreign investment.

It appears when it comes to fulfilling the administration party’s mantra of kung walang kurap, walang mahirap (there will be no poverty if there is no corruption) the government is making little headway, notwithstanding its herculean efforts to impeach the Ombudsman and the Supreme Court Chief Justice and jail the lady president that appointed them. By their own standards, the government seems to be failing in achieving its vision. As a result, income inequality, or the gap between the rich and the poor seems to be widening, as borne out by another NSCB paper released last week.

The government tried to put on a brave face by saying that income among all groups has risen. Unfortunately for the poor, their incomes have risen, but not enough to keep up with the higher cost of living to lift them out of poverty. The conditional cash transfers program which was given a significant boost by this administration was not sufficient. By the NSCB’s calculations, the cost of the government’s welfare program of about Php40 billion for the full year of 2012 was only half the amount required to deal with the problem in the first semester of that year.

The economic management of the nation does not seem to be progressing very well. The Philippine Development Plan talked about promoting inclusive and sustainable growth, but what we seem to be having is none of the sort. Despite all its efforts to improve the efficiency of tax collection and expenditure, to reduce debt and increase social spending and to promote the country as a destination for investment through good governance, these results show that we are just as far away from achieving that goal as we were before.

My advice to the government is not to seek to airbrush these blemishes from its record. It should acknowledge that its efforts thus far have fallen short. The president and his team need to then chart a different way forward. In other words, they need to attend to that “vision thing“, which is what I have been arguing it should have done from the start.

Challenging Conventional Wisdom about the Philippines

We could characterise our country as being stuck in a developmental trap where the only way to make it more competitive is to improve the productivity of its labour force. The primary way to do that is through capital deepening. But without capital, productivity declines relative to other countries where investments flow. The nation’s inability to raise productivity deters future investors, and on it goes.

It’s that time of the year, the month of Janus, when people take stock of what has gone before and produce an outlook for what lies ahead. Most balanced and fair commentators in the Philippines (and there are some) often highlight the things that year in, year out don’t change. It is funny because year after year, all they seem to offer are the same old platitudes, which our leaders do take to heart, but it all seems to lead to the same old results.

Let us start with the economy. Most analyses about the economy point to our strong macro-economic fundamentals. This year is no different. The growth registered in 2012 was 6.5 per cent. It is about the same as the average for the financial years 2000-01 to 2009-10 which was 6.1 per cent based on the national statistics board. The first two years of PNoy’s presidency have tracked closely to that long-run average. Nothing new there.

Aside from respectable growth, the country has experienced a relatively mild inflation rate of 3.2 per cent in 2012. Again, over the past half dozen years, apart from the blip in 2008 when the global financial crisis was in full swing and food prices soared, the country’s annual inflation rate has fluctuated within a narrow band of 3-5.5 per cent. There is nothing new or surprising here either.

The third item is employment. The latest data shows that from October 2011 to October 2012, the country suffered a net loss of 900,000 jobs. That would seem alarming. But considering that in the previous year, employment rose by 2.5 million, a truly anomalous situation, the recent decline (or correction in my view), means that over the two years, the nation created an average of 800,000 new jobs per year. Again, there is nothing new there. Net job creation has hovered around that mark for the past decade.

In order to prove that there has been some progress made, most analysts usually point to the intangibles. A change in the national mood due to renewed efforts to address intransigent issues is usually heralded as a precursor to better times ahead. Again, this year is no different. Without a doubt, there has been progress with the enactment of several laws, the impeachment of the chief justice, the improvement of budget rules for transparency, and the reaching of an agreement that might settle the conflict in the south.

Another way to argue that there has been renewed confidence in the Philippines is by pointing to the property market, buoyed by the business process outsourcing industry, the peso, buoyed by the country’s credit rating upgrades, and the stock market, buoyed by our sound macro fundamentals.

The only problem with all this is that it has yet to translate into what really counts —growth in fixed investments. Again, there seems to be no change here. In 2012, foreign direct investments have amounted to a mere $1.5 billion. That is about 3 per cent of the total that flowed into the ASEAN-5. This is a very dismal result, as usual.

The question here is why? The reasons given usually are a lack of competitiveness, restrictive investment policy, and poor governance and institutions. I would like to tackle these one by one, and offer my own insights into why I think the conventional wisdom surrounding them are misguided, and offer my own solutions.

Competitiveness

It is a bit farcical but after the National Competitiveness Council’s efforts over the past two years to improve the country’s score in the World Bank’s Ease of Doing Business report by talking to foreign experts, understanding their methodology and working to satisfy their requirements, the result for 2013 was that the country slipped by two places down to 138th place in a league table of 185 nations. There had been a change in methodology, as there often is, which did not reflect the nation’s efforts, the NCC said, but needless to say, it is still a dismal record.

Disparities in administration across local government units as well as in- and outside of special economic zones and inefficient systems at national agencies are often cited as the causes for the abysmal performance, as is petty corruption among bureaucrats. While the Ease of Doing Business report indicates that government regulatory red tape has not improved, it would be wrong to say that the country’s overall competitiveness has not.

The Global Competitiveness Survey by the World Economic Forum takes a broader look at the issue –not just at how different a country’s rules, regulations and tax policies are from the leading economies of the world where most investments come from, but also at how well its labour force, infrastructure and innovation systems, to name a few, stack up in comparison. Here the country performed a bit better by advancing 22 places. It is now in the upper half of the league table. Whether this is enough to make investors change their minds is subject to speculation. We have to wait and see.

However, one of the main obstacles is the rising peso. It appreciated by 7 per cent last year. This makes the cost of producing things in the country for export relatively more expensive, particularly for the labour-intensive business process outsourcing industry. We could characterise our country as being stuck in a developmental trap where the only way to make it more competitive is to improve the productivity of its labour force. The primary way to do that is through capital deepening. But without capital, productivity declines relative to other countries where investments flow. The nation’s inability to raise productivity deters future investors, and on it goes.

Something has to break the cycle, and this won’t occur by simply relying on the Invisible Hand of the market, as private players suffer from the free rider problem—waiting for the first mover to take action before joining in. It will take some coordinated effort by government, and I will have more on this, shortly.

Investment Policy

Another oft-cited problem is the country’s overly restrictive policy on foreign ownership in selected industries. The 1987 Constitution is identified as the culprit. Actually, prior to adopting the present constitution, there were more industries in which foreigners could not invest or own a majority stake in. Under the present charter, foreigners are restricted from owning a major share in the mining, utilities and education sectors. They are also prohibited from owning land.

Removing these restrictions analysts say will unlock the investment potential of the country, creating jobs for millions of Filipinos, allowing them to escape poverty and the country to realise its true growth potential. The representatives of the foreign chambers, local economists and some foreign bankers claim this is what is needed. Are they right?

If we look at the size of the industries in question, mining accounts for about 0.9 per cent of our gross national income, utilities 2.7 per cent, and education is so small it does not even merit a separate line in our national accounts reporting. With respect to employment, the mining industry employs 250 thousand, utilities 153 thousand, and education 1.2 million. That is about 1.6 million out of a total work force of 37.7 million!

That means that to make a serious dent in the number of  unemployed which was at 2.7 million in October, 2012, we would have to at least double the size of these industries so that they could employ twice the number of people. I cannot really see this happening in the utilities sector or education. To double the size of those sectors would require a doubling in the demand for their services, which is close to impossible.

Mining, one might argue could double its size, but it only employs 250 thousand. Also, the problem here is in guaranteeing world-class labour and environmental regulations while ensuring that the nation derives a fair share of the profits from mining operations, since what is being dug up out of the ground belongs to the nation, and mining firms are only seeking ownership of the right to mine it on their behalf.

When it comes to the ownership of land, foreign investors do not really see that as a deterrent since they can obtain long-term leases and very favourable rates at the special economic zones in the CBDs of the nation and in the regions. Where it proves a deterrent is to small-time investors who want a piece of the property boom. Again, does the property sector look like it needs a boost? I would even argue that it needs to be slowed down because of possible overheating.

Governance, Institutions and Political Reform

The final missing ingredient that is currently the flavour of the month among our business and political elite is good governance and institutions. The improvement in this aspect is cited by the World Economic Forum as the reason why the country improved its business environment in 2012. Faith in institutions is grounded on the belief that this is why the Industrial Revolution took place in England in the 18th century and not in China, which was just as prosperous as Western Europe at the time.

To attain the foundations for rapid economic growth, the same set of of superior cultural norms, institutions and technology have to take over the ways of “traditional societies” or the “primitive mode of production” found in the the developing world today, so the theory goes. According to one author who has written a very short introduction to global economic history, however

The English constitution had many features that promoted economic growth, although they were not the ones stressed by modern economists, who emphasize restrictions on taxation and the security of property. Parliamentary supremacy actually resulted in the reverse…the English state collected about twice as much per person as the French state and spent a larger fraction of the national income.

…France suffered because property was too secure: profitable irrigation projects were not undertaken in Provence because France had no counterpart to the private acts of the British Parliament that overrode property owners opposed to the enclosure of their land or the construction of canals or turnpikes across it. What the Glorious Revolution meant in practice was that the ‘despotic power’ of the state that ‘was only available intermittently before 1688…was always available thereafter’. [emphasis mine]

Over the past decade, there has been a new school of thought emerging called the California School of Economic History which has challenged the paradigms of the New Institutional Economics school. Its general conclusion is that the Industrial Revolution took place in England because of the discovery of coal as a cheap substitute for wood as an energy source and the Americas as a source of metals and farmland. Coal led to steam power which in turn lowered transportation costs. The so-called Scientific Revolution of the 17th century had very little to do with such inventions.

What allowed England to compete with China and India which were then the leading centres of manufacturing in the world was their investment in labour-saving technology such as coal-powered steam engines to increase the efficiency of their cotton mills. A population boom in the hinterlands of China led to labour-intensive production which made the adoption of such mechanised production technology uneconomical, since capital was expensive and labour cheap.

Multifactor productivity is what led to competitiveness which led to higher wages for English workers, which led to further productivity improvements and so on. The entire 19th and 20th century was all about the de-industrialisation of Asia and the catching up to England by other Western states such as Germany and the US and later by East Asia which belatedly includes China. This was achieved through deliberate state policy which sought to channel limited capital into strategic sectors.

Failed Wisdom

The failure of conventional wisdom to explain why the nation’s competitiveness is in such a rut should force us to look elsewhere. Posing the problem in that manner is misguided to begin with. The first question we need to ask ourselves is, why do we even need foreign direct investments in the first place? The conventional answer to that question is that we need them because we don’t have the capital to finance development ourselves.

Again, I would challenge that view. From 2000-01 to 09-10, investments in the country have grown by 7.1 per cent per year on average. That is even with our low attraction rate of foreign investors. Since the the last decade, national savings has exceeded investments, meaning we are a net saving nation now. Many have said that was because private investors were wary of investing under the Arroyo regime. But the Aquino government does not seem to have convinced them to change their minds and invest their surplus capital. There is something amiss there.

More importantly, the inward flow of dollar remittances from overseas Filipinos has created a national treasure amounting to $85 billion worth of foreign reserves. That is about the size of the Czech Republic’s entire economy. It is also about 75 per cent larger than the total official reserve assets of the Reserve Bank of Australia, which was at US$49 billion in December 2012. Let me ask then, what is an economy the size of the Philippines which produces about $250 billion a year doing with reserves of that amount compared to the Australian economy which is about $ 1 trillion a year? Do we need to maintain such a high level of reserves relative to our economy?

Policy Implications

The reason why our policy makers have not realised that they are sitting on a pile of untapped wealth is because they have been used for so long to go cap in hand to the foreign community for loans. There is a saying in business that banks will only be willing to lend to you when you don’t need to borrow. The same holds true in our case. Yet our officials continue to trumpet the ease with which they are able to borrow, without realising that they don’t need to do so anymore.

The preceding discussion leads to the following policy implications

  • Continue to raise taxes in order to close the fiscal gap. Continue tax reforms such as the sin tax law that has just been signed. Expand the tax base by closing loopholes and consider other measures to raise revenue such as fiscal incentives rationalisation and a one per cent national land tax piggy backed on local property taxes. If we can reduce the gap to within 1-2 per cent of GDP, that would be fine. If we could completely close the gap, that would be even better.
  • Undertake coordinated investments in strategic sectors by leveraging sovereign wealth. Japan and South Korea did not rely on foreign direct investments to boost their economies during their periods of rapid growth because they directed their banking institutions to lend to heavy industries with their implicit sovereign guarantees. We can adopt a new approach by setting up a sovereign wealth fund, which would serve as the main vehicle for channelling our excess foreign reserves into infrastructure, minerals exploration joint ventures, agro-industry clusters and clean technology hubs. I have outlined how this could be done here and here. There are enough internal resources currently to increase our growth rate by 1-2 percentage points a year for the next four years. Once government acts as the catalyst, other players, including foreign investors will follow. This will incidentally temper the rise of the peso, which is currently hurting our export sector.
  • Continue to improve and enhance our educational system. Higher educational attainment among our populace is one of the best ways to resolve our economic and political problems. A highly literate and skilled workforce not only is what our industries need, it is also what will help shape political reform. Tinkering with our political system won’t really address the problem. An educated voter will not be satisfied with handouts from the government but will demand much more.

If we focused on these three policy areas: improving our tax revenues, coordinating investments and enhancing educational opportunities, then we will be on our way to unlocking the development trap that we find our country in. It is important for our leaders to challenge conventional wisdom regarding what is hampering our nation’s growth potential. Otherwise, we might find ourselves attempting to improve our situation using the same methods, year after year, decrying the same problems, but achieving the same dismal results.

Jammed

Does public infrastructure represent the best use of private investment?

It seems that our corporate titans have nothing better to do with their excess cash than to pour it into the growing public utilities and infrastructure sector. Whether it is San Miguel the beverage giant which went heavily into power or the Metro Pacific group a major player in telecoms which operates the NLEX-SCTEX road networks, there does not seem to be anything which competes for their attention than this sector.

About one-and-a-half trillion pesos is sitting in Special Drawing Accounts with the BSP deposited by banks which are unable or unwilling to lend them out. With a country as underdeveloped as ours, one would think that such excess savings could be put to better use. Why for instance isn’t San Miguel investing to develop coco juice exports which it has the capital and expertise to do?

Since our lost decade in the 1980s when a banking crisis followed by a political upheaval reduced our economy to tatters, manufacturing has never really recovered from the heights it once achieved by the end of the 70s and early 80s (see chart). Meanwhile, our ASEAN neighbors Indonesia, Malaysia and Thailand overtook us in moving their economies towards industry. Our gross capital formation as a percentage of GDP is the weakest in the region as a result.

Vietnam, a relative latecomer in the game has seen its manufacturing sector grow by leaps and bounds, while Singapore cannot be held up as an example for us to follow since it is a city-state with a tiny population and workforce. It can afford to de-industrialize its economy, while we can’t. While some would argue the high value services sector is nothing to sneeze at, it still cannot be relied on to provide the kind of jobs that match the skills held by our bulging population. The answer lies with manufacturing.

The Philippine Development Plan identifies infrastructure as the “binding constraint” to speedier growth. The reason it claims Philippine goods remain uncompetitive is our inability to bring them to market efficiently. Apart from that there is the implicit “tax” that comes by way of corruption which increases the cost of doing business and the unfair competition from smuggled or pirated goods that discourages domestic manufactures, the result of weak rule of law.

With its low tax collection rate and chronic fiscal deficits, partly to do with an aggressive liberalization policy pursued since the 1990s, the government was more than willing to let the private sector fill the breach in public infrastructure.

Since private business seems so gung-ho about providing public goods, it seems the identification of infrastructural bottlenecks was the correct diagnosis of the problem of underdevelopment. One wonders, however, if these firms are moving into such projects because there is no attractive alternative in other sectors, or is it because of higher returns now currently on offer from public-private partnerships?

Also, if indeed there are “bottlenecks” causing the cost of doing business and cost of living to skyrocket, then one would expect the public would be willing to absorb the fees charged by private operators under existing PPP arrangements. That is not what has been observed though (think MRT and LRT). One would then have to conclude that either the private operators have negotiated prices above the market-clearing level or that the demand for such infrastructure was not sufficient to begin with.

Investing in public goods by their very nature would often produce a private return lower than the commercial rate of return. That is why it is often financed in capital scarce countries through “concessionary loans” from foreign governments and multilateral institutions. If private operators borrow at prevailing market rates, then they cannot possibly make a profit unless the government provides a subsidy to pay for the spread between the “risk free” government borrowing rate and the commercial lending rate.

Turnaround

The sudden flash of insight Sec Mar Roxas used to interject into the president’s faltering public-private partnerships roll-out was that it would be better for the government to borrow at the risk-free rate and contract out the construction phase of some projects in effect passing on the cheap cost of capital to contractors. It could then auction off the operations and maintenance contract separately minimizing the need to subsidize fees charged to customers.

The question then is can government afford to borrow more in order to finance its infrastructure roll-out? It could if it chooses take-up the BSP’s offer to borrow against the country’s excess international reserves that accumulate each year. The state would effectively be borrowing against itself. Given the total cost for the original projects of about one hundred billion pesos, the surplus of reserves flowing into the country each year of four to five billion dollars is enough to cover these projects twice over.

If the public sector is then able to deal with the cost of providing infrastructure, how can it stimulate complementary investments needed in the private sector? If the lack of domestic capital and skilled labor are not responsible for the observed underinvestment, neither are low rates of return (low taxes and labor market flexibility are found in special economic zones), then what else could it be?

There are a number of candidates. Government failures which include corruption or weak property rights and rule of law are one option. A second possible candidate is market failure due to inabilities to coordinate investments in complementary upstream and downstream sectors or to internalize the benefits of innovation and experimentation.

The first has been identified by the National Competitiveness Council and the government as an area of concern. The decline of the Philippines ranking in the latest Ease of Doing Business survey by the World Bank reflects the country’s inability to address government failure. On the other hand, if these are the causes for underinvestment, why is it that manufacturing has suffered a decline relative to services in terms of investment and output? Shouldn’t they all be suffering the same fate?

This leads me to identify the problem of market failures as well. The systematic break that occurred in the mid-80s when the country turned away from industry policy and underwent an aggressive reduction of tariffs unilaterally ahead of WTO commitments left our manufacturing sectors at a disadvantage vis-à-vis our ASEAN neighbors. This is perhaps the reason services have oustripped manufacturing since it represents non-tradables which can only be provided domestically. Think retail, housing, commercial property and yes, utilities. Mining is a similar story. How then could the government begin to stimulate activity within the tradable industries? The following five measures would represent the most important steps.

  1. Partially rollback tariffs to within acceptable levels still within WTO commitments targeting in particular greenfields. Sustainable technology is one example of greenfields. To partly offset the modest rise of inflation that would come with this, tax cuts and (conditional cash) transfers should be directed to low income families.
  2. Finalize the list of investment priorities to signal the areas that government wants growth to occur in. Government must consult with business groups in compiling this list, but it must also exert some independence and take the lead in some areas and not simply take a market follower approach.
  3. Rationalize fiscal incentives and gradually fine-tune the selectivity of sectors for promotion. This has already been initiated by the BOI, but follow through and institutional capacity building needs to occur, which leads to the next item.
  4. Strengthen the economic bureaucracy to solve investment coordination problems across related sectors. Improve the ability of state agencies like the BOI, PEZA, DTI and other government agencies to undertake a consultative and promotional role.
  5. Create a research and innovation fund jointly run by public and private enterprise to encourage commercialization of ideas. Given the excess foreign reserves cited earlier, the state can also afford to undertake this strategy in partnership with academe and the business community.

Compared to the strong-arm tactics being employed by Argentina and Brazil which like us bought into the liberal free trade argument in the 1990s and have like us seen their manufacturing sectors stagnate (see chart), these measures would be considered rather tame.

From 1949 to 1959, the Philippines used heavy handed trade and industry policies similar to what LatAm countries pursued from the 1930s to the 1980s. This led to the fastest growth ever sustained in our history (and theirs). Unfortunately, it did not last long enough for investments to expand beyond light industries as Paul D Hutchcroft notes. The direpute to which import-substitution subsequently fell was the result of the Filipino First policy instituted in 1958 towards the end of the decade of growth, an over-reach of the “elite” nationalists. The poor administration and outright corruption that the policy bred stymied it and led to the liberal policies of the 1960s supported by the landed agricultural exporters.

Pres Marcos tried to weaken the landed aristocracy and revive our nascent industry sector in the 1970s, but the lack of checks to the predatory nature of his regime led to its collapse. The Philippines has been following the liberalization paradigm ever since. The stagnancy of our manufacturing and overall weak economic performance is hard to explain given the structural reforms undertaken from the late-80s. The Philippines since the early 2000s has become a net saving country due to overseas remittances and is rapidly accumulating foreign reserves (it has more than enough to pay off all our external debts). With some tweaking, we can unlock this capital and put it to better use.

So far from encouraging private investors to get into public utilities, the government should actually follow Sec Roxas’s advice to break-up build, operate and transfer contracts to lower their cost to the public. Finally, the government must look to revive investments in the industry sector (which includes high value agricultural and services too) through pragmatic policies. It must create as much policy space within existing WTO arrangements to maximize the benefits of industrialization. Without this its vision for a rapid, sustained and inclusive pace of development might simply come to naught.