Great barrier rift: Tariffs and reform are the hot topics of debate

In actively considering a liberalisation programme, the Philippines is hoping to better align itself with the more open of its regional peers and better integrate itself with the global economy. Reform is a top priority. At the same time, it needs to move carefully. While the country’s various impediments to trade and investment have held it back in some ways, it is becoming increasingly evident that they may have in fact helped it in the past, especially during times of severe instability (such as was experienced in 2008). Studies suggest that some of the remaining barriers may have acted as buffers, and it can be argued that some protection should remain. Whether to totally open markets or to engage in a sort of low-level managed trade is a debate raging throughout the world, especially in East Asia, and this issue is very much a part of the conversation in the Philippines.

BARRIERS: The Philippines has long been criticised for its restrictions on market access. The US Trade Representative’s (USTR) National Trade Estimate has for a number of years reported that the country puts up many barriers to trade and investment, both tariff and non-tariff in nature. The Canadian Trade Commissioner Service, the World Trade Organisation (WTO), the World Bank, the Heritage Foundation and others have made similar observations. As recently as 2010, sugar was dutied at 65% and rice 50%, while sausages, animal feeds and carrots attract rates of between 30% and 45%. Other products similarly taxed upon import are potatoes and distilled spirits. According the USTR, the rates are unusually high for vehicles, with passenger cars dutied at 30%.

More worrying than the level is the trend, which suggests that the commitment to low tariffs is not as firm as it could be. For a number of years, the Philippines worked hard and successfully to lower rates, with the average weighted tariff applied falling from 22.4% in 1989 to a low of 2.6% in 2003, according to the World Bank. However, it seems the country has been unable to hold the line on reforms, and rates have begun to creep up. World Bank figures indicate that the average tariff applied rose to 5.7% by 2008.

TARIFFS & MORE: Figures from the WTO demonstrate much the same and show that the backsliding is out of line with the region. The organisation found that the average applied tariff rate in the country in 2010 was 5.8%, up from 4.3% in 2004. While the Philippines’ rates were not the highest in East Asia (South Korea and Indonesia had tariffs slightly higher, both at 6.6% in 2010), it seems it is the only country among the ASEAN-5 to record an increase in the rate. This came at a time of widespread and in some cases impressive liberalisation. India, for example, dropped its average applied rate from 27.7% in 2004 to 10.1% in 2010. The WTO noted in a 2012 report that the average applied tariff rate was at the time 19.3 percentage points below the simple average bound rate. This gives the country considerable room to raise rates if necessary.

RISING RATES: In another study, conducted by the Philippine Tariff Commission, rates were bottoming out in 2002 and then slowly rose, with tariffs for manufactured goods up from 6.03% in 2002 to 7.01% by 2005. The Heritage Foundation found the same trend. In the Trade Freedom category of the foundation’s 2005 Index of Economic Freedom, the Philippines had a score of 79.4 and a rank of 31. With a score of 80 or above, it would have been deemed “Free” – under 80, it is considered “Mostly Free”. Its score rose to 79.8 the next year, but its rank dropped to 37, reflecting relative improvements in the world as a whole. Since then, all the metrics have been falling. The country now has a score of 75.5 in the Trade Freedom category and a rank of 95.

A wide range of non-tariff barriers are said to be used to limit imports. According to the World Economic Forum’s “Global Enabling Trade Report 2012”, the Philippines fared poorly in terms of restrictions of this sort. In the non-tariff barrier category, it was ranked 58 out of 132 with a score of 75.3 (100 being the worst) – Thailand was 26th. In the Burden of Customs Procedures category, it was ranked 118th. In the Irregular payments in exports and imports category, it was 123rd. Overall, the country was ranked 72nd in the report (below Indonesia, Thailand, Malaysia, Singapore and Vietnam).

Complaints include burdensome import procedures, problems at the border and technical requirements and standards. The USTR cites a number of specific non-tariff barriers. It mentions the National Food Authority’s monopoly on the importation of grains and the Maximum Drug Retail Price Act of 2009, which is said to put foreign drug makers at a disadvantage in selling in the domestic market. It also notes the tendency for the courts to venture outside their traditional roles and try to make policy, which the USTR argues makes the playing field less than level. Other non-tariff barriers include a ban on the importation of used cars and the need for import licences for pork and poultry.

In its 2012 report, the WTO noted that the import licencing system was too complicated, with different fees for different products. In addition, the organisation, while recognising a number of advances made over time (especially with regard to tariffs), identified a long list of potential trade barriers, including stringent sanitary and phytosanitary regulations, lack of a competition law, and price supports and other incentives for agriculture.

RESTRICTIONS ON FOREIGN INVESTMENT: What makes trade most difficult perhaps is the Foreign Investment Negative List (FINL) and the constitutional restrictions forbidding foreign ownership of land and certain specified activities. The former is a wide-ranging catalogue of sectors and businesses from which non-Filipinos are barred or in which they are restricted. According to the Joint Foreign Chambers of the Philippines, the list is a hodgepodge of legacy laws and practices on which new restrictions are regularly piled. The chamber argues that the FINL is very much in need of a thorough review and comprehensive reform. The latest additions came with Executive Order No. 98, published in 2012 and known as the Ninth FINL. Under the order, real estate brokerage, lending, respiratory therapy and psychology are now covered. While new restrictions are added every two years to the list, since 1991 only two liberalisations have been undertaken: foreign investment in large retail establishments (and only in some cases) and casinos in special economic zones.

Under Article XII of the 1987 constitution, foreigners are prohibited from owning land outright – the cap is 40% on equity in land. This is seen by a number of foreign trade missions and chambers as a severe impediment to trade and investment. The USTR points out that the lack of ownership rights discourages foreign investment and prevents foreign entities from using land as collateral for loans.

INTELLECTUAL PROPERTY: Concern has also been expressed, especially by the US, about protection of intellectual property rights (IPR). The USTR must identify countries that fail to protect intellectual property and classify them according to the level of perceived infractions. The Philippines is not on the Priority Watch List – which includes Thailand and Indonesia – but is on the Special 301 Watch List, mostly for lack of enforcement. Since 1988 IPR has been a central element of US trade negotiations.

The argument is that allowing counterfeit goods thus ruins the market for producers of legitimate goods. In some markets, local patents are registered that are intentionally close to existing international patents to prevent the importation of the original foreign-made products. The Philippines has improved its intellectual property code and the workings of the courts dealing with patent cases, especially with the Supreme Court’s 2011 Rules of Procedure for Intellectual Property Rights Cases. Yet the USTR found a lack of implementing regulations and worrying gaps in the legislation, particularly with respect to the patentability of some chemicals.

TRADE DEFICITS: Despite all its efforts to keep its markets protected, the country’s trade situation has not historically been good. It has recorded a trade deficit for most of the past 50 years and has not had an annual trade surplus since 1998. As a ratio to GDP, the trade deficit has been as high as 10% (1997), though it was last recorded at 3.2% in 2012. The country’s biggest import sector was raw materials, representing 38% of the total in January-September 2013. In that category, chemicals, iron and steel, and material for the manufacturing of electronic equipment were the biggest imports in dollar terms. The number two category was capital goods, at 27%, led by telecoms and power generating equipment, followed by fuel oil and mineral fuels, at 22%.

Particularly worrying has been the persistent trade deficit with ASEAN. While the Philippines has been able to reduce its rice purchases from Thailand and Vietnam, it still purchases large quantities of oil and finished goods from its regional partners without selling enough components and raw materials to balance them. For the past five years the Philippines has recorded a steady deficit with the region, according to the National Statistics Office. In 2012 it was in the red with all countries in ASEAN except Laos, Cambodia and Singapore. For the year, the country experienced a $4.4bn regional trade deficit – more than $1bn with Thailand, almost $2bn with Indonesia and almost $1.5bn with Malaysia.

CHINESE TAKEAWAY: Like many others, the Philippines is also beginning to buy more from China than it sells to it. In 2012 its trade deficit with China was $511m. Trade between the two has been growing rapidly, and for several years the balance has been good. Each side at one time or another claimed the surplus, with China in the plus column two out of the five years to 2012 and the Philippines three out of the five. The Philippines in fact reported its first trade surplus with China in January 2000.

Top exports from the Philippines to China are hard drives and semiconductors, with resources only in third place. The main export from China to the Philippines was telecoms-related products, number two was liquefied petroleum gas and light petroleum oils was third. It was not a case of China buying resources and dumping manufactured goods. The concern is that as China seeks to rebalance its trade with ASEAN that the flows could become less favourable and less fair, with China pushing its manufactured goods and seeking to control resources.

FDI: Foreign direct investment (FDI), meanwhile, is weak. According to Dan Steinbock, research director at the ICA Institute, FDI as a percentage of GDP was in line with regional competitors Thailand and Indonesia in the 1990s, but the Philippines now lags behind, attracting half the foreign investment as a percentage of GDP compared with Indonesia, and a quarter of Thailand’s. In 2012 the Philippines reported only $2.8bn of FDI (against Vietnam’s $8.3bn, Thailand’s $8.6bn and Indonesia’s $19.9bn).

Steinbock notes that while FDI did increase in the Philippines, the country missed out on the global explosion in cross-border investment and, as a result, has high levels of unemployment and poverty. He blames the poor business environment, saying that red tape, poor governance, weak infrastructure and a rigid labour market keep international businesses away. In the World Bank’s Ease of Doing Business 2014 rankings, the Philippines was 108th, behind Thailand (18), Malaysia (6) and China (96).

According to Priscilla Tacujan of Corr Analytics, it is significant that some of the policies against foreign ownership and activity are built into the constitution. That reduces flexibility and makes even the smallest changes a matter of intense national debate – it is impossible to just tweak the system. Tacujan said that the constitutional limitations on non-Filipinos are broad, deep and material. Foreign investment enterprises must have local management, non-Filipinos are restricted in terms of the exploitation of natural resources, media is monopolised by locals, foreigners are barred from professions and education is closed. These restrictions not only make foreign investment difficult, but they stand in the way of major improvements that could be made within the economy but are not, for lack of international-level skills and technologies. Tacujan told the Philippine Star that this ultimately results in a less-than-ideal economic structure and business environment: “The economic provisions of the Constitution will continue to enable an inefficient rent-seeking, monopolistic economy that benefits only a few entrenched interests rather than those who need new jobs from broad economic growth.”

TURNAROUND: Efforts to improve the situation are being encouraged by many interested parties. The Philippine Chamber of Commerce and Industry has asked that the government address cost of doing business issues, such as expensive and unreliable electricity, while others have called for constitutional revisions. Economic leaders have noted that while the Philippines has an investment-grade rating, it is having more trouble attracting FDI than lesser-rated economies, such as Vietnam and Indonesia. It appears that the lobbying is starting to work. In the Ease of Doing Business survey, for example, the Philippines jumped from 133rd in 2013 to 108th in 2014, demonstrating that it is making progress.

While it is too early to make a judgment and identify a trend, FDI does seem to be increasing. In the first half of 2013, the total was up by 10.9% – the second-fastest growth rate in ASEAN behind Malaysia. Singapore and Thailand both recorded a drop in FDI in the first half of 2013. In the third quarter of 2013, the country’s 13 investment promotion agencies reported an 87% rise in investment approvals to P33bn ($795m). In January-September 2013, total approvals were up by 115% to P127bn ($3.06bn). Most of the commitments (33.9%) were to manufacturing. The agencies include the Board of Investments (BOI); Clark Development Corporation; the Philippine Economic Zone Authority (PEZA); Subic Bay Metropolitan Authority (SBMA); the Authority of the Freeport Area of Bataan (AFAB), BOI-Autonomous Region of Muslim Mindanao; Cagayan Economic Zone Authority and Aurora Pacific Economic Zone and Freeport Authority. Of these, the PEZA zones received the most foreign investment commitments, at P28.3bn ($682m), and the total was up by 181%. “The main strategy of most economic zones is to attract a higher industrial presence to fully maximise available land. Subic has a modern container terminal and strategic location to reach the Asian market, so it is fertile ground for export industries,” Roberto V Garcia, chairman and administrator at SBMA, told OBG.

In 2012 foreign investors poured a net $3.9bn into the country, and in 2013 up to mid-October $2.8bn was invested, compared with $2.7bn over the same period a year earlier. Foreign portfolio investment totalled $18.5bn in 2012, the most in a decade, according to the Bangko Sentral ng Pilipinas.

Yet investments of this type are not always preferred. The money can leave the market as fast as it enters it, and does not indicate the same sort of commitment as FDI. In the past, especially in the late 1990s, a rush for the exits by portfolio investors caused considerable damage to economies in Asia.

BUBBLE TROUBLE: In recent years, money coming in has been the real problem, especially when it is directed to the wrong type of instruments. Since the advent of cheap money in the US, funds have been gravitating toward Asia to get relatively high yields and gain from rising currencies. Concern has been expressed about this flow, which can cause inflation and economic bubbles, increase dependence on short-term funding, reduce competitiveness and crowd out more-productive investments. When it leaves, it can cause collapse.

The situation became critical in the spring of 2013, and capital controls were discussed to keep hot money from damaging the domestic economy. Ultimately, no restrictions were put in place. The process that had caused such concern started to reverse as rates began to rise in the US on hopes of economic recovery and as money began to leave the country. In March, May, June and August, net portfolio outflows were recorded and the peso weakened from under 41 to the dollar to over 44. The Philippine Stock Exchange index also started to fall.

It is important to recognise that the Philippines is fairly unique with respect to the structure of its trade balance and current account. It has a large and persistent trade deficit, but it also has a consistent long-term surplus in services – this has been growing in recent years – and strong remittances. Though the positives do not exactly match the negatives and make up for the goods imports, business process outsourcing (BPO) goes a long way to balancing the ledger. In recent years, this sector has managed to pull the number close to zero again. BPO should still have room to grow, and Standard Chartered expects more remittances to flow in from the Asian region. REFORM?: Despite all the talk of reform, some observers wonder whether liberalisation is necessary and whether it would be helpful. According to a working paper by the IMF, the relatively closed markets of the Philippines may have helped it weather recent global economic storms. The bank notes that the more open of the countries in the region faced financial and trade shocks, and were generally more dependent on increasing exports to get their economies going again.

The Philippines did not have as much to lose and could count on the engine of domestic demand to keep GDP from collapsing. Also, countries with less financial depth in terms of private credit and stock market capitalisation as a percentage of GDP, such as the Philippines, generally fared better and were more cushioned from the financial shocks that reverberated around the globe.

Further liberalisation is written into the future of the Philippines. The country is bound by the terms and schedule of the ASEAN Free Trade Area and it has a number of free trade agreements signed and in negotiation. Headline reform cannot be stopped. Yet, as many nations are discovering, free trade is becoming another name for managed trade; tariff rates are lowered and agreements are signed, but non-tariff barriers are set up, certain key sectors are exempt and subsidies are offered so that the flow of goods can be controlled and balances maintained.

“The primary goal of the ASEAN Free Trade Area will be to make economies more efficient and competitive through the elimination of tariff and non-tariff barriers and attract more foreign direct investment into the region,” Ponciano C Manalo Jr, undersecretary for trade and investment promotions and governor of the Board of Investments, told OBG. “The chance to do business in an integrated market of close to half a billion people will generate opportunities for the efficient companies and risks for those who are not able to compete.”

Free flows of capital have also been brought into doubt as nations try to work out ways to limit the damage caused by hot money. In this environment, the current state of liberalisation in the Philippines might be just about right, and indeed the country may find itself looking for new ways to limit the damage that might be caused by fully open markets.

INDUSTRIAL PARKS: A drive to increase the number of industrial parks is gathering pace as the country seeks to attract FDI. PEZA is spearheading efforts to expand the network of industrial and information technology (IT) free zones and boost the presence of major multinationals. “The Philippine economic zones have seen substantial growth because China has become more costly. In its southern provinces minimum wages have grown by at least 20% per year over the last five years. As a result, many firms are looking to transfer their operations,” Deogracias Custodio, chairman and administrator at AFAB, told OBG.

In May 2013, economist Bernardo Villegas said that the manufacturing and services sectors were set to drive growth. “Manufacturing will compete with services in fuelling a GDP growth rate of 7-9% in the next 20 years,” the Business Mirror reported Villegas as saying. He also called on the government to take full advantage of economic growth by making changes to the rules governing foreign ownership of businesses and building new free trade zones. The network of free zones has grown from 16 when the PEZA was set up in 1995 to 277 as of the end of 2012. IT centres, which include BPO facilities, accounted for 139 of this total, followed by manufacturing with 69. Multinationals that set up in these areas benefit from a number of financial incentives, including up to six years of tax exemptions.

First Philippine Industrial Park (FPIP) has played a key part in spearheading industrial growth since it was set up in 1996. Located in Santo Tomas and Tanauan City in Batangas, the zone houses businesses operating across a broad range of industrial and manufacturing activities, including electronics and semiconductors, solar cells and aircraft components. Businesses at the Batangas site created 40,000 jobs in 2012, and FPIP expects a further 10,000 posts to be generated in the zone by 2014.

FPIP, which is owned by the Lopez Group (70%) and Sumitomo (30%), is looking to develop new industrial parks in Subic, Clark and other key areas in Southern Luzon on the back of increased demand from potential investors. Elpidio Ibañez, who is on FPIP’s board of directors, told the Philippine Daily Inquirer that increased demand, particularly from Japanese companies, was spurring the expansion plans. “As the Philippines becomes a favoured foreign investment destination, we will continue with the acquisition of additional industrial land, the development of recurring revenue businesses and the creation of new ancillary services,” he said. The venture’s expansion record to date, together with demand for industrial space and the Philippines’ incentives, bodes well for FPIP. The park saw a spate of activity in 2012, with companies such as Canon and Brother establishing facilities at the Batangas location. Other multinationals that recently set up at FPIP include electronic component producer Murata and aircraft interior fabricator BE Aerospace.

Clark is also looking to improve its infrastructure to meet growing demand. “In Clark, the efforts to improve physical infrastructure are focused on two points: improvement in the movement of goods and people, and the reliability of utilities,” Arthur P Tugade, the president and CEO of Clark Development Corporation, told OBG.

OUTLOOK: As an economy, the Philippines is one of the bright spots of Asia, if not the world. Its growth is holding up at a good pace as others struggle to maintain even anaemic expansion. The problem is the disparity between this performance and the lack of productive investment and balanced trade. It is unclear how the conundrum will be addressed. While free trade and open markets remain the dominant theme globally, the mood is shifting. The Philippines may well hold the line and hold off on further reforms. It is also possible that key liberalisation will take place. The country is, overall, positive on reforms, despite strong resistance from some sectors, and with the Trans-Pacific Partnership on the horizon, long overdue and difficult steps may be taken (see analysis).