Market reforms in the Philippines should see exports and investment increase

After years of lagging behind its South-east Asian peers, the Philippines is seeing a long-awaited awakening of foreign direct investment (FDI). Although FDI volumes are still smaller than what countries in its peer group attract, the Philippines has been catching up at an impressive pace. Although many of the challenges that impeded investment in the past have yet to be overcome, the faster economic growth of recent years and stronger efforts to attract investment have improved perceptions of the country’s prospects.

Human capital, young demographics and consumerist culture are the country’s key strengths in both investment and trade. Growth has been led by investment in the business process outsourcing (BPO) sector, but recently investment in manufacturing has begun to pick up after a long period of stagnation. Large numbers of Filipinos who leave for higher-paying work abroad still contribute to the local economy by sending money home to their families worth more than 10% of GDP, which supports a healthy consumer market and a current account surplus.

LAGGING LEGACY: The Philippines’ comparatively low FDI performance is a legacy of growth rates that were well behind regional peers, especially before the 1990s. It also reflects traditionally high obstacles to investment, including a corrupt and slow-moving bureaucracy and a somewhat more protectionist legal climate. Foreign investment is restricted in many business areas, and the country’s constitution bans foreigners from owning land or from holding more than 40% of a company that owns land. The Philippines has also struggled to compete as an export-oriented manufacturer due to its paucity of domestic energy resources and chronic underinvestment in infrastructure.

The discrepancy is most visible in the accumulated stock of inward FDI, which is a long way behind other large South-east Asian countries. The Philippines’ $32.5bn stock of FDI at the end of 2013 was equal to 12% of GDP or $333 per capita, according to UN Conference on Trade and Development and IMF data. By comparison, Indonesia had $230bn of FDI stocks, equal to 26% of GDP or $929 per capita. Vietnam’s $82bn of FDI stocks equalled 48% of GDP or $911 per capita; Thailand’s $185bn of FDI stocks represented 48% of GDP or $2718 per capita; and Malaysia’s $145bn of FDI stocks were equal to 46% of GDP or $4831 per capita.

CATCHING UP: In terms of FDI inflows, the country is still at the back of the pack but has caught up rapidly. Annual FDI rose from $1.1bn in 2010 to $3.9bn in 2013 and $4.9bn in the first nine months of 2014, according to balance of payments (BOP) data from the central bank, Bangko Sentral ng Pilipinas (BSP). That $4.9bn inflow was equal to 2.4% of the period’s GDP and an annual pace of $66 per capita, and was on par with FDI’s contribution in Indonesia in 2013. At $18.4bn Indonesia’s investment stock was 2.1% of GDP or $74 per capita. Other peers are still well ahead: Vietnam’s $8.9bn of 2013 FDI was equal to 5.2% of GDP or $99 per capita; Thailand’s $12.9bn represented 3.3% of GDP or $190 per capita; and Malaysia’s $12.3bn was equal to 3.9% of GDP or $411 per capita in the same year.

SWEET SPOT: The turnaround has been gathering pace since 2010 as economic growth has accelerated and economic policies have generally improved. The results have turned investors’ attention to the country’s positives, and it has become widely recognised the Philippines is in a sweet spot for rapid catch-up growth.

Demographics are very favourable, with 2% annual population growth and a bulge in the young-adult bracket. A relatively healthy banking system, relatively low indebtedness and growing banking penetration give the country plenty of room for credit expansion. Greater orientation towards the US economy in the Philippines than in other Asian countries is increasingly seen as an advantage, especially as the dollar has strengthened. The Philippines has also seen more investment interest from Japan as large-scale quantitative easing has encouraged foreign investment and relations with China have worsened. “Japan historically and to date is the biggest foreign investor in the Philippines. They’ve had some supply chain issues in Thailand and their share of political risk in China, and that happens to be working in our favour,” Edwin Coseteng, president of First Philippine Industrial Park, told OBG.

English-language skills are the best in Asia, especially for interacting with Americans, and the education system is relatively strong and rapidly improving. The large inflows of funds from overseas workers and é migrés, and the recipients’ propensity to consume them, make the Philippines a particularly attractive market for producers of consumer goods compared to other countries of similar size and wealth.

However, the flip side of the country’s high rate of consumption is that investment as a share of GDP is comparatively small. “Our biggest problem is the overall rate of domestic investment is low, at around 19% of GDP. The regional average is about 35% of GDP,” Bernardo Villegas, an economist who chairs the Centre for Research and Communication at the University of Asia and the Pacific, told OBG.

RATINGS UPGRADE: The improved perceptions are reflected most prominently in upgrades by the major credit ratings agencies of the Philippines’ sovereign rating to investment grade in 2013. That was followed by upgrades in 2014 to BBB by Standard & Poor’s and Baa2 by Moody’s, both one notch above the agencies’ minimum investment grade ratings. The Philippines has also improved its ratings in international surveys of business conditions. The World Economic Forum noted in its 2014-15 “Global Competitiveness Report” that the Philippines’ climb to a ranking of 52nd out of 144 countries in 2014 from 85th out of 139 in 2010 was the biggest improvement of any country during that period. It was driven largely by improved ratings of institutions, especially for lower perceptions of corruption. The Philippines scored especially well for its macroeconomic environment (5.8 points out of the 7-point maximum) and health care and education (5.4), while infrastructure (3.5) and innovation (3.5) were regarded as the weakest points. The overall ranking was still well behind peers Malaysia (20th), Thailand (31st) and Indonesia (34th), which have traditionally ranked high in the survey, but was ahead of Vietnam (68th).

Likewise, the Philippines was also the most improved country in the Heritage Foundation’s economic freedom rankings between 2011 and 2015, moving up from 115th in 2011 to 76th in 2015. And the Philippines has also advanced rapidly in the World Bank’s 2014-15 “Doing Business” rankings, to 95th out of 189 countries in the report (published in late 2014) from 144th out of 183 countries in 2010.

The “Doing Business” survey, which judges conditions for local small businesses, gave the Philippines strong rankings for ease of getting power hooked up (16th), resolving insolvency (50th) and foreign trade (65th), but gave low scores for protecting minority shareholders (154th) and starting a business (161st).

A National Competitiveness Council, established in 2006, is tasked specifically with advising the government on how to improve the country’s score in the “Doing Business” rankings and other such surveys.

NEGATIVE LIST: The Philippines’ system of restrictions on foreign investment has developed over decades and is continuing to evolve. The core restrictions are written in the constitution, which bars any foreign ownership of mass media and limits foreign ownership of land, public utilities and educational institutions to 40%. The constitution also requires that any natural resource extraction business with foreign ownership of more than 40% have a “financial and technical assistance agreement” with the government, but that requirement has been interpreted liberally.

There are further restrictions adopted in various laws. Roughly every two years the government publishes a foreign investment negative list, which summarises the constitutional and legislative restrictions and adds a handful of others. However, there is an evolving tradition of interpretation, which can be more important than the written legislation.

Besides mass media, foreigners are banned from most licensed professions, as well as from private security, small retail businesses and small-scale mining. Foreign ownership of advertising businesses is capped at 30%, and foreigners are limited to 40% ownership in education, rice and corn processing, retail trade, government contractors, deep sea fishing, most small businesses, and arms and explosives.

PARTNERSHIPS: Infrastructure projects can be no more than 40% foreign owned unless they are buildoperate-transfer (BOT) contracts, also called publicprivate partnerships (PPP), a method of financing favoured by the government. “What we really need to develop is our infrastructure. That’s what I think we should focus on for the rest of this administration,” Ponciano C Manalo, Jr, undersecretary at the Department of Trade and Industry and a governor at the Board of Investments (BOI), told OBG. “Foreign ownership isn’t an issue with BOT financing, but we were a little slow off the starting block with PPPs. This government would rather err on the side of transparency.”

Foreigners can own up to 49% of lending companies and 60% of finance companies and investment banks. Many foreign banks entered the market in the 1990s2000s but most have left, reduced operations or stayed very small. After a reform implemented in December 2014, publicly listed or state-owned foreign banks are allowed to acquire full ownership of commercial banks, and any foreign bank can establish a new fully owned bank branch, which are limited to six sub-branches. Other foreign investors are restricted to 40% of commercial banks and 60% of certain types of small banks.

A P17.92bn ($403.2m) deal signed in December 2014, but under way since before the reform, was seen as a sign of a new wave of foreign investment in the banking sector. Cathay Financial Holding, the parent of Taiwan’s Cathay United Bank, agreed to pay P18bn ($405m) for a 20% stake in Rizal Commercial Banking Corporation, the seventh-largest Philippines bank. Joey Cuyegkeng, chief economist at ING Bank in Manila, told OBG, “The interest is there. A lot of Asian financial institutions are looking at Philippines banks.”

INCENTIVISING: The Philippines offers considerable incentives to attract foreign investors and has relied on these extensively to draw in both BPO and manufacturing investors. The availability of such enticements has become so widespread that virtually every major foreign investment receives incentives. The system is complicated, with seven different investment promotion agencies offering a variety of tax exemptions and other benefits, such as greater leeway to hire foreigners. The most active of those has been the Philippine Economic Zone Authority (PEZA), which was originally intended to attract export-oriented investment to high-priority areas and then created hundreds of socalled “ecozones” all over the country.

PEZA has been especially active drawing in BPO firms, sometimes even creating a zone specifically for a particular investor. Since 2012 PEZA has stopped issuing most privileges to new locations within Manila in an effort to push investment out into less developed regions. PEZA locators are required to export at least 70% of their output to receive incentives.

First Philippine Industrial Park operates a popular industrial park in Batangas, south of Manila, which is designated by PEZA as an ecozone. The company would like to see PEZA’s mandate changed to encourage investment that initially targets the local market. “In the first stage of development businesses naturally want to sell the domestic market. It’s harder to make exports work if access to the local market is restricted,” Coseteng told OBG. “The idea is to structure the incentives to create jobs, and not just move them from a higher cost base to a lower cost base.”

The next-biggest investment agency is the BOI, which offers incentives to invest in priority business sectors. These include BPO, manufacturing, exports of any kind, infrastructure, agriculture and fisheries, green initiatives, research and development, tree plantation, printing, waste management, disaster prevention or mitigation, and creative businesses. Generally, BOI incentives are less generous than those offered by PEZA. The BOI also has a branch covering five regions of Mindanao that offers somewhat better incentives.

MONETISING THE MILITARY: There are two agencies that promote investment in projects converting former military bases. The Clark Development Corporation (CDC) is tasked with developing a 44-sq-km area called the Clark Freeport Zone, including the 24-sq-km Clark International Airport, although that is managed separately, and 20 km of land to the west of the airport. The area was formerly Clark Air Base, a US military facility, until 1991 and is located about 100 km north-west of Manila near the city of Angeles.

The CDC is a subsidiary of the Bases Conversion and Development Authority (BCDA), which is in turn a unit of the armed forces and helps fund its budget. BCDA is best known for the very successful Bonifacio Global City and Newport City developments in Metro Manila, which were previously parts of Fort Bonifacio and Villamor Air Base, respectively.

Near the Clark Freeport Zone the BCDA is taking on a more ambitious, longer-term project to create what it hopes will be the largest industrial and BPO centre outside Metro Manila. Within a 315-sq-km area of undeveloped land called the Clark Special Economic Zone, the BCDA is planning to build an entirely new city, Clark Green City. A first phase of the project is currently being tendered (see analysis).

The Clark project is linked to another conversion at another former US military facility, the Subic Bay Naval Base, 70 km south-west of Clark. The Subic Bay conversion is intended as a port and industrial zone, and is connected to Clark by a four-lane expressway built by the BCDA in 2005-08. The CDC and Subic Bay Metropolitan Authority offer investment incentives comparable to PEZA. There are two more locale-based investment promotion agencies, the Authority of the Freeport Area of Bataan and the Cagayan Economic Zone Authority, which manage another two port and industrial zone projects. Bataan is on the north side of the entrance to Manila Bay, and Cagayan is on the northern coast of Mindanao.

GLOBAL PULLBACK: While FDI has boomed, portfolio and other financial investment has slowed sharply amid a global pullback from emerging markets that began with the so-called taper tantrum in the spring of 2013, when the US signalled it would phase out quantitative easing and the dollar began to strengthen. The Philippines’ relatively strong financial position, high growth rates and ties to the US economy have shielded it from the stormy weather and helped it avoid the more traumatic reversals of financial flows that many other emerging markets have undergone. Nonetheless, flows did slow sharply or reverse.

Portfolio investment had been quickest to respond to the improving business climate as investors poured money into emerging market funds and fund managers overweighted the Philippines. Portfolio inflows averaged $4.5bn a year in 2010-12, according to BOP data. They dropped to $363m in 2013 and $292m in the first nine months of 2014 as fund managers’ continuing preference for the country was overwhelmed by large outflows from the emerging market asset class. Other financial investment – mainly loans, interbank credit, non-residents’ deposits and trade credit – averaged $3.5bn a year in 2010-12 and dropped to $395m in 2013 and a $2.1bn outflow in the first nine months of 2014, according to BOP data.

The nature of the outflow was unclear, as it was marked as repayment of short-term interbank credit by banks and appears as such in the BSP’s gross foreign debt data, but does not figure in a separate BSP report on bank balance sheets.

DOMESTIC INVESTMENT: Despite the lack of net financial inflows other than FDI, domestic groups are able to raise funds and invest in major projects. Domestic groups have, for example, been piling into power generation investments as the grid was facing an anticipated short-term shortfall. “In three to five years we’ll be awash with power plants. Even groups that haven’t traditionally been investors in the sector, such as San Miguel, are going big into power plants,” Villegas said.

First Philippine Industrial Park is affiliated with First Philec, a leading power sector investor. The park’s president told OBG the investment lag currently being seen was mainly due to the lengthy process of organising and getting approvals for investment in coal power. “We still need base load and coal is the cheapest, but lead times for coal plants are longer,” Coseteng said.

EXPORTS & IMPORTS: Even as investment in the export-oriented BPO sector has been a key growth driver, the share of trade in GDP has been in decline in recent years as industries catering to the domestic market have grown more quickly overall. Although BPO has thrived and the electronics sector has recently enjoyed a revival, overall export growth over the past several years has been weak. Imports, meanwhile, have increased at a pace closer to that of rising incomes, leading to a widening trade deficit.

Although the country reports sizeable current account surpluses, the true state of the Philippines’ international balances are subject to considerable uncertainty due to incomplete trade data. Evasion of Customs duties leads to substantial undercounting of imports, while transfer pricing leads to undercounting of exports. Other countries’ data on their trade with the Philippines and the BSP’s gradually dwindling foreign exchange reserves since early 2013 suggest that the trade deficit is wider and the current account surplus much smaller than reported. The Philippines Statistics Authority (PSA) cited $62.4bn worth of imports in 2013 and a modest average nominal growth rate of 2% a year since 2007. Other countries reported $102.1bn of exports to the Philippines in 2013 and a much stronger 7.8% nominal growth rate since 2007, according to the UN Comtrade database. The dollar value of Philippines GDP grew at an average 10.6% rate during the period.

The Philippines’ and other countries’ trade data agree that merchandise exports have been weak, but differ on the details. PSA data show $56.7bn worth of exports in 2013 and a 2% average nominal growth rate since 2007. Comtrade data shows $74.8bn of exports in 2013 and a 0.8% average rate of contraction since 2007. The largest export destination is China, with 24.3% of goods exports, or 35.6% including Hong Kong and Taiwan, according to Comtrade data. The US and Japan took 12.9% and 12.4%, respectively, while ASEAN countries accounted for 14.7% led by Singapore with 6.8%. Europe took 11.3% of goods exports led by Germany with 4.2%.

Exports have struggled with high energy and logistics costs exacerbated by the strong peso. Real appreciation against the dollar averaged 4.1% a year in 2007 to 2013. Real appreciation against the dollar slowed to about 1% in 2014, but the BSP’s policy of holding the peso in a range of 43 to 45 to the dollar led to substantial appreciation relative to other currencies that devalued against the dollar in 2014, including those of most of ASEAN, Japan, Taiwan, Europe and Australia.

Exports were improving in 2014, thanks largely to a pickup in global demand for electronics, which is by far the largest export industry (see analysis). PSA data showed exports up 9.9% in the first three quarters of 2014 versus the same period of 2013, with electronics exports up 7.4%. Electrical and electronic goods accounted for 50.3% of exports in 2013 according to Comtrade data, while other machinery accounted for 17.4%, metal and mineral products for 11.7% and agriculture-related products for 9.1%.

Import growth is mainly of consumer goods, automobiles, construction materials and fuels. As with exports, China is the largest source of imports, accounting for 19.5% in 2013, according to Comtrade, or 35.8% including Hong Kong and Taiwan, which largely reexport mainland goods. About 20% of imports came from ASEAN, led by Singapore with 6.6% and Thailand with 4.9%. Japan, the US and Korea were also major sources of imports, accounting for 9.5%, 8.7% and 8.6%, respectively. About 8% of imports came from Europe.

BALANCING ACT: When calculating the merchandise trade balance, the BSP makes large adjustments to the PSA trade data to conform with other financial flows in the overall BOP. The BOP data shows a substantial merchandise trade deficit of $17.7bn or 6.5% of GDP in 2013, compared to $14bn or 9.4% of GDP in 2007.

Comtrade data, however, shows a much larger merchandise trade deficit of $27.3bn or 10% of GDP in 2013, and there is good reason to believe that figure could be more accurate. The BSP’s BOP data have two major discrepancies that are probably explained by undercounted imports. First, the data show a $5.1bn inflow into foreign reserves in 2013, although the BSP’s separate count of its stock of foreign reserves shows they shrank by $600m. The BOP data also include $3.2bn of “unclassified items”. If both those discrepancies were added to the imports line, it would reduce the reported 2013 current account surplus from $10.4bn or 3.8% of GDP to $1.5bn or 0.6% of GDP.

STRONG IN SERVICES: In services trade, the growth of the BPO sector has sustained a substantial positive balance, which came to $6.4bn in 2013, according to the BSP. Counted as “other business services” and “computer services” in BOP data, the BPO sector’s contribution to exports grew from $6.6bn in 2007 to $15.2bn in 2013 – an average growth rate of 15% a year. Exports of service categories associated with BPO were up a further 11.3% year-on-year in the first nine months of 2014. The rapidly growing BPO sector is in turn the main driver of the construction industry and its demand for imported building materials. About 80% of BPO service exports go to the US, according to an industry estimate. Services exports came to $22.6bn in 2013, with travel and transport services the other major contributor at $6.6bn. Services imports have also grown quickly, from $7.5bn in 2007 to $16.2bn in 2013, driven by booming outbound travel. Combining Comtrade data on merchandise trade with BSP data on services trade, total exports in 2013 came to $97.4bn or 35.8% of GDP, while total imports were $118.3bn or 43.5% of GDP and the trade deficit was $20.9bn or 7.7% of GDP.

INVESTMENT INCOME: In addition to the trade deficit, the Philippines runs a substantial investment income deficit. Income earned on outward investment came to $1.3bn in 2013 and $1.1bn in the first nine months of 2014, while income paid on inward investment stood at $7.5bn in 2013 and $6.2bn in the first nine months of 2014. However, the trade and investment income deficits are funded by huge inward remittances from Filipino overseas workers and émigrés. Remittances came to $28.6bn in 2013 or 10.5% of GDP, up from $17.7bn in 2007. Also, a substantial portion of outward investment income is re-invested. That has allowed the Philippines to avoid the risky practice of relying on inward investment flows to fund imports. Indeed, since 2013 outward investment has exceeded inward investment as the country’s major business groups have acquired foreign businesses and moved some of their cash offshore. Outward investment totalled $6.5bn in 2013 and $8.5bn in the first nine months of 2014, while inward investment came to $4.2bn in 2013 and $2.9bn in the first nine months of 2014, according to BOP data. Outward FDI came to $3.8bn in 2013 and $3.9bn in the first nine months of 2014.

The ability to fund imports from current income has been crucial to avoiding a heavier pullback of global financial capital. Still, the BSP has dipped into its foreign currency reserves to stabilise the peso, with reserves dropping from a January 2013 peak of $85.3bn to $80.2bn at the end of January 2015. Pressure on the peso was expected to lighten somewhat in 2015 thanks to a steep drop in oil prices and a slowdown of inflation. Net imports of oil and its products came to $11.1bn or 4.1% of GDP in 2013, according to Comtrade data. That suggests the 40-50% drop in oil prices in late 2014 will save the Philippines around 2% of GDP.

TRADE: The Philippines has a relatively open trade regime, but with substantial room for improvement. The trade-weighted average of applied tariffs was 4.2% in 2012, compared to 4.3% in Malaysia, 4.7% in Indonesia, 5.4% in Vietnam and 6.2% in Thailand, according to World Bank data. Tariffs are highest for raw materials and finished goods and lowest for intermediate goods, according to a 2012 World Trade Organisation report.

The extent of undercounting of imports, however, shows that tariffs on many goods are high enough to incentivise evasion, which would skew trade-weighting. For example, foreign firms that were motivated by high tariffs on assembled automobile imports to build assembly plants in the Philippines have long complained that large numbers of automobiles are imported through secondary ports without being counted or tariffs being paid. The Philippines is most restrictive on trade in rice, which is subject to import quotas to protect a subsidised domestic industry. Plantation logs are subject to a 20% export tax and exports of natural forest logs are banned in an effort to slow deforestation.

ASEAN: As one of the original members of ASEAN, the Philippines has had tariff-free trade with Singapore, Malaysia, Thailand, Indonesia and Brunei since 2010, and it is due to initiate tariff-free trade with Vietnam, Myanmar, Laos and Cambodia at the end of 2015, when the bloc will formally inaugurate the ASEAN Economic Community. However, to obtain tariff-free entry, importers must obtain certificates of origin confirming that at least 40% of the value of the products were produced within ASEAN, which is often not done.

ASEAN is expected to focus next on reducing barriers to trade in services, and attention is already being given to restrictions on cross-border banking. The 2014 reform liberalising foreign access to the Philippines banking market was done largely in preparation for a 2020 target date when ASEAN countries have agreed that banks chartered anywhere in the region will be able to operate throughout the bloc. So far ASEAN banks have made little headway in the Philippine market – of the two Singapore banks that entered in the 1990s, one sold out completely and the other nearly completely, leaving Malaysia’s Maybank as the only ASEAN bank with more than one branch location.

The Philippines is also part of ASEAN’s free trade agreements with Japan, Australia and New Zealand, which are relatively strong, and with China, Korea and India, which are weaker. In 2012 ASEAN and those six countries launched negotiations on a common, deeper free trade area called the Regional Comprehensive Economic Partnership. The country has also expressed interest in joining the Trans-Pacific Partnership, a rival potential group involving the US, Japan and a dozen other countries on both sides of the Pacific.

OUTLOOK: FDI is likely to continue to grow as low oil prices benefit consumers of the Philippines’ electronics and BPO services exports. The gradual market reform policies of President Benigno Aquino III are widely expected to be continued after his second and final term ends in 2016, although there is no clarity as to who would succeed him. The biggest visible risk to the Philippines is that slowing Chinese growth could decelerate more rapidly and drag down other Asian economies and financial markets, but the drop in prices in late 2014 for oil and other commodities that China imports should give some relief. In the longer run, the Philippines’ success will depend on whether it tackles the tough issues of institutional reforms and infrastructure investment. The latter has been a disappointment in recent years, as plans have been announced for infrastructure projects that foreign banks have shown clear interest in helping to fund, but few tenders have been issued. The recent pace of progress is encouraging and also putting pressure on the government to take the next steps.