Evolution in progress: A slow and steady transition toward value-added production

Like many of its neighbours, the Philippines’ economy has been evolving towards a more value-added economic model, following in the path of Japan, South Korea and Taiwan. Unfortunately, a number of factors have so far limited the pace of this transition and the country still lags behind many of its regional peers, despite the benefits of increasing regional and global trade. While fellow ASEAN members Malaysia, Thailand and Vietnam have managed to boost the contribution of exports to GDP to 81%, 68% and 61%, respectively, as of 2009 the Philippines (32%) has lagged behind, placing closer to Indonesia (24%), according to data compiled by the UN and the ASEAN Secretariat.

POISED FOR A REBOUND: The country appears poised for a rebound after a difficult 2009, however; investments in the manufacturing sector increased dramatically in 2010 and 2011, while exports and domestic retail sales have mirrored this sharp uptick, though 2011 did see total exports fall by 6.9%. In December 2011 the IMF forecast overall economic growth of around 4.2% for the Philippines in 2012, down from an earlier 4.9%, on the back of wider concerns regarding the slowdown in advanced economies.

The administration of President Benigno Aquino III has targeted between 5% and 6% growth for 2012 via public spending. While speaking in Washington, DC at the end of January 2012, Anoop Singh, the director of the IMF’s Asia and Pacific department, said, in regard to the Philippines, “Growth should pick up and this is partly a result of the higher public construction.”

BY THE NUMBERS: The gross national income (GNI) of the manufacturing sector was approximately P1.27trn ($28.83bn) in 2010, up 11.16% over the P1.14trn ($25.88bn) recorded in 2009, according to data from the Bangko Sentral ng Pilipinas (BSP), the country’s central bank. The combined industrial sector, which included the categories of mining and quarrying, construction, manufacturing, and utilities like electricity, gas and water, contributed P1.86trn ($42.22bn) of the country’s total GNI of P7.56trn ($171.61bn) for 2010.

These increases can be partially attributed to the strengthening economy, as well as increased foreign direct investment (FDI) over the past few years, which grew to P256.1bn ($5.81bn) in 2011, the highest level since 1996. According to preliminary data from the National Statistics Office, FDI for the manufacturing sector increased to $51.57bn in 2010, up 51.55% over the $24.58bn that was registered the previous year. This is roughly double the 25.61% average growth rate for total FDI over the same period. During 2003-09, the manufacturing sector accounted for approximately one-third of all FDI – more than any other segment.

Yet despite the increase in value of the sector, its contribution to the economy continues its slow but steady decline as the industry is squeezed by high energy prices, increased regional competition and investor uncertainty. As a percentage of GNI, the manufacturing sector has declined from 19.57% in 2003 to 15.87% as of June 2011. There are signs of stabilisation, however; after six years of annual drops, culminating in a low of 16.28% in 2009, the manufacturing sector’s contribution to GNI levelled off in 2010 at 16.72%.

Exports from the Philippines in 2010 were led by electronics products, which accounted for some 60.4% of total exports – worth $31.08bn, or 79%, according to data from the BSP. Apparel and clothing accessories ranked second with a share of 3.3%, worth $1.70bn; followed by coconut oil, with 2.5% ($1.27bn); woodcrafts and furniture, 2.3% ($1.18bn); automotive wiring, approximately 2.2% ($1.11bn); cathodes ($804.87m); other products manufactured from materials imported on a consignment basis ($776.83m); metal components ($775.01m); and petroleum products ($371.16m).

CHEMICAL REACTION: One sector poised for growth after years of limited development, due in large part to a lack of raw materials, is petrochemicals. New investments should breathe life into the sector, which exported $1.58bn in 2010, up 61.5% from $978m in 2009.

One of the most substantial ongoing projects in the country is the construction of a new $700m naphtha cracker in Batangas. Scheduled to begin production sometime in 2014, the new cracker plant is being developed by JG Summit Holdings and has a projected capacity of approximately 320,000 tonnes of ethylene, 190,000 tonnes of propylene and 270,000 tonnes of pyrolysis gasoline, in addition to other by-products including methane, pyrolysis fuel oil and acid gases.

The Philippines’ largest oil refiner, Petron Corporation, is also embarking upon a P74.78bn ($1.69bn) plant conversion at its Bataan refinery to boost output. As well as upgrading technology to produce Euro 4-compliant clean fuels and improve efficiency, the retooling will allow for increased production of other by-products including propylene, which is used in the manufacture of plastics. Upon completion, the overhaul is expected to increase propylene production by 200%.

In 2010 Petron’s petrochemicals sales included propylene, benzene, toluene and mixed xylene, totalling around 1.7m barrels. With new domestic sources of the olefins ethylene and propylene, the country’s chemical industry should be well positioned for a dramatic expansion in the coming years.

UNQUENCHABLE THIRST: The beverage industry has also been experiencing a degree of volatility in recent years. Since its level of 88.1 in 2001, the industry’s total volume production index reached its peak at 111.2 in 2008, before declining to 84.8 by 2010. The drinks market is heavily segmented, according to the president of Pepsi Philippines, Partho Chakrabarti, with health and wellness drinks targeting the top end of the market and carbonated soft drinks focused on the middle ground. While the lower end of the drinks market is currently underserved, substantial growth potential exists, as the average Filipino consumes between 160 and 170 servings of carbonated soft drinks annually. The primary competitors in the carbonated beverage market are Coca-Cola, Pepsi and RC Cola.

Beer consumption is also widespread in the Philippines, with the highest rates in the metro areas of Luzon Island. But despite its prevalence among alcoholic beverages, per capita consumption has remained relatively low, which has kept production fairly static over the past decade. The local market is dominated by San Miguel Brewery, which has a market share of approximately 90%. The company has extensive marketing and distribution throughout the country and retains strong brand loyalty, particularly for San Miguel Pale Pilsen, Red Horse and San Mig Light products.

In 2010 San Miguel Brewery produced 221m cases of beer worldwide, with revenues increasing 32% over the previous year to P68bn ($1.54bn). Domestic operations are served through five breweries located in San Fernando, Polo, Bacolod, Mandaue and Davao and distributed through approximately 471,000 retail outlets.

AUTOMOTIVE: As in other sectors, trade liberalisation has slowly been eating away at the domestic automobile market, resulting in a 50:50 split between locally produced vehicles and imported completely built-up (CBU) vehicles. In 2011 the market share of locally produced vehicles declined to 41%, as manufacturers experienced a temporary slowdown due to production parts shortages. The natural disasters that occurred in Japan and Thailand, which are major sources of automotive production inputs, caused supply chain disruptions that heavily affected the automobile industry.

In 2011, approximately 67,742 of the country’s total vehicle sales were assembled from knocked-down parts and components, compared to 97,451 imported CBUs, according to consolidated sales data from the Chamber of Automotive Manufacturers of the Philippines (CAMPI), Truck Manufacturers Association and Association of Vehicle Importers and Distributors. The main source of CBUs is Thailand, which is responsible for some 51% of the total vehicle imports, followed by Korea, with 25% of total imports.

After achieving the highest recorded sales of 170,267 units in 2010, sales closed at 165,193 units in 2011, registering a 3% decline. As a whole, the Philippines’ automobile industry performed better in 2011, notwithstanding the supply chain disruptions that resulted from the natural disasters in Japan and Thailand. Despite the decline, the 2011 sales performance is still the second highest recorded over the past decade and a half.

The effects of the Thailand crisis may still be felt in the first quarter of 2012, but the industry is optimistic that supply will stabilise by the second quarter of the year. A further increase in sales is expected in 2012, as the government predicts strong economic growth for the year, which will be fuelled by improved government spending and the implementation of public-private partnership projects in 2012.

GROWTH ENGINE: Despite the high percentage of CBUs on the market and the production slowdown of 2011, a recent research paper published by the Centre for Research and Communication of the University of Asia and the Pacific indicates that automotives could become one of the manufacturing sector’s key growth engines in the future. According to the report, the country’s 14 automotive manufacturers could more than double the current annual production capacity of around 300,000 units by 2015. This dramatic increase in production could then be exported to other ASEAN member nations, which have favourable tariff agreements for the automotive industry. Thus far, the ASEAN trade agreements have significantly altered the manufacturing landscape of the sector, as tariffs have been slashed or eliminated outright, according to CAMPI’s president, Rommel Gutierrez.

Additional agreements with Japan and the Asian Free Trade Agreement (AFTA) could slash import duties on vehicles to zero. In the longer term, the ASEAN-South Korea and ASEAN-China agreements are scheduled to come into force in 2016 and 2018, respectively.

OFFERING INCENTIVES: To facilitate growth, Gutierrez told OBG that the government is currently working with the auto industry to develop both fiscal and non-fiscal incentives to help protect the sector while still operating within the parameters laid out in the various trade agreements to which the country is a signatory. As of late-2011, two separate laws were pending approval in the Philippine House of Representatives. One of these would establish a comprehensive framework for the industry, while the other would promote fiscal incentives for domestic manufacturers.

One thrust of the House bill is to make the regulatory environment more stable by creating a long-term road map to replace the existing executive order, which can be more easily rescinded. The fiscal bill proposes incentives for domestic auto manufacturers including income-tax breaks, duty-free status (when not applicable to existing trade agreements), value-added tax exemptions and reductions in excise tax. These areas are currently regulated through a series of laws and executive orders, including the automobile export and motor vehicle development programmes. These measures are in addition to the new comprehensive motor vehicle development programme, which was introduced in April 2010 with the intention of increasing support for domestic automotive manufacturing.

With the natural disasters of 2011 exposing the auto industry’s supply chain vulnerabilities, the Philippines’ domestic automotive parts sector could receive a timely boost in the coming months, as manufacturers look for ways to ensure supplies going forward. According to the Philippine Automotive Competitiveness Council, which is composed of parts manufacturers from Ford, Honda, Isuzu, Mitsubishi and Toyota, member parts makers exported $3.1bn worth of products in 2010, up 20% from the previous year. Fabricated by 256 different parts and components manufacturers, these products consist primarily of wiring harnesses, transmissions, instrument clusters, aluminium wheels, tyres, ABS modules as well as semiconductor assemblies, including batteries, forgings, stampings and cast products.

ELECTRONICS: Since rising to prominence in the late 1970s, electronics has been a mainstay of the manufacturing sector and has attracted high-profile global producers including Intel, National Semiconductor, Texas Instruments, Acer, Epson, Lexmark, as well as the home-grown operation, Integrated Microelectronics. Although the industry has fallen off recently due to increased regional competition, supply disruptions from Japan caused by the natural disaster in March 2011 and softening global demand, electronics is still a significant contributor to the economy.

Exports declined from a 2007 high of $31.09bn to $28.5bn the following year and $22.18bn in 2009, before rebounding to approximately $31.08bn in 2010. Despite losing substantial ground in the first half of 2011, with y-o-y exports down by over 20% owing to dampened demand in Western markets and supply chain disruptions due to the disasters in Japan, the electronics products segment maintained its position as the country’s top export category, accounting for 51.1% of all exports. For the full year the Semiconductor and Electronics Industries in the Philippines, the industry’s representative body, predicted an 18% drop in exports as compared to the levels that were reached in 2010.

SOLAR CELLS: One bright spot in the electronics industry going forward is the growth of photovoltaic solar manufacturing. One of the forerunners in this fledgling industry is the First Philippine Electric Corporation (First Philec), a fully owned subsidiary of First Philippine Holdings Corporation, which also controls several power distribution and generation companies.

First Philec is currently engaged in two silicon wafer-slicing joint ventures with two international solar companies. Wafers form the core of high-efficiency solar cells in photovoltaic solar panels. First Philec Solar Corporation’s production capacity stands at around 240m wafers, while First Philec Nexolon Corporation’s capacity is around 100m wafers. Combined, both facilities are capable of supporting 1.1 GW of solar generation.

Despite the industry’s early success, challenging times are expected in the short-term photovoltaic market, according to Arthur de Guia, the president of First Philec. In terms of demand, the solar photovoltaic market is still largely dependent on incentive schemes, such as feed-in tariffs and green certificates, due to its comparatively high installation costs. As recession and debt crises continue to grip the US and Europe, demand has slowed in two of the largest solar markets, relative to earlier years in the solar electricity industry.

The rise of China’s solar panel manufacturing industry, which produces a variety of products along the length of the value chain, has contributed to the significant rise currently being witnessed in overall supply levels, as well as the falling margins being felt by local producers. The resulting glut that accumulated in the first half of 2011 is now estimated to be as high as 10 GW and could last through 2013.

Due to these economies of scale, the price of key inputs such as polycrystalline silicon, which is used to make the wafers, has dropped from around $400 per kg to just $30 per kg in only two years. While this price drop has indeed helped in lowering the cost of photovoltaics for the consumer — moving it closer to grid parity — the overcapacity in all parts of the value chain has also served to trim the margins for producers. Thus, as demand for solar power generation continued to increase throughout 2011, revenues for solar manufacturers conversely decreased, making the segment much less lucrative than it had been in the previous years.

Future demand predictions are further complicated by the fact that large solar markets in Europe such as Italy, which recently overtook Germany as the largest solar power producer in Europe, could reduce or even cut incentive programmes, as such industry leaders continue to deal with the ramifications of the sovereign debt crisis and thus seek cheaper energy sources to improve their energy security and viability. Over the longer term, other markets are projecting sustained growth, including the US, due to its strengthened green energy policies under President Barack Obama’s administration, and China, which is seeking to bolster its renewable manufacturing base with domestic demand.

BROADER CHALLENGES: Despite generous fiscal incentives and a large, well-regarded labour force, the Philippines still lags behind other regional competitors in terms of attracting investment and boosting its exports. While some of this lag has historically been linked to investor hesitancy, whether due to vague government policies or the perception of governmental corruption, more tangible factors, such as basic infrastructure, have also had an impact.

According to a Gallup survey conducted by the American Chamber of Commerce from 2003-10, corruption was consistently rated the highest area of dissatisfaction, with an annual average of 83% of respondents singling it out. The second-highest area of dissatisfaction was government and political system stability, with an average of 60%, followed by infrastructure, with 58%.

In terms of infrastructure, high electricity prices are one of the most common grievances voiced by investors. As of 2010 the Philippines ranked behind only Singapore in terms of industrial electricity tariffs, according to a study conducted by International Energy Consultants for the Philippine government. Local industrial power prices were $0.13 per KWh, compared with $0.05 for Indonesia and Vietnam, $0.06 for South Korea and Malaysia, $0.07 for Thailand, $0.11 for Japan and $0.14 for Singapore. The IMF’s Singh underlined these concerns over infrastructure in his comments in late January 2012. “To raise potential growth in the Philippines, it needs more investments, especially in public infrastructure,” he told the press.

OUTLOOK: Hampered by higher power prices and fierce regional competition to attract international investment, the Philippines industrial sector is in a state of flux. Labour and infrastructure costs, combined with increasingly liberal trade agreements, are hastening the transition towards higher-margin and less energy- and labour-intensive operations. While traditional manufacturing segments such as electronics will continue to play a crucial role in the coming years, the prognosis points firmly towards more value-added products.