Further market reforms would boost the Philippines' trade and investment levels

The Philippines’ trade and investment sectors are at a crossroads. The new president and Congress elected in May 2016 elections face crucial decisions related to the country’s bid to join the Trans-Pacific Partnership (TPP), the “deep” free trade bloc being created by the US, Japan and other Pacific Rim countries. If the new Philippines leadership moves decisively to join the bloc, the accession process could potentially be a catalyst for a historic liberalisation.

Growth Drivers

Impressive growth has been achieved since 2010 in service exports and inward foreign direct investment (FDI) under the outgoing president, Benigno Aquino III. Faster economic growth, slower inflation, improved fiscal governance and greater efforts by the government to attract foreign 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. “The Philippines continues to grow economically and in population size to become a very critical market for ASEAN,” Sulfico Tagud Jr, president and CEO of the ferry company 2Go Group, told OBG. “The proximity to China, Japan, Taiwan and Korea and the opening of new shipping routes situate the country as one of the gateways to the transpacific.”

Business process outsourcing (BPO) is the fastest-growing export and has achieved a scale at which it drives growth in other sectors, especially construction and retail. Manufacturing exports have been showing signs of strength after a long period of stagnation, and recently have held up despite weak global trade. Large remittances from Filipinos working abroad support high import volumes relative to GDP and a current-account surplus.

But the Philippines is still behind regional peers in terms of inward FDI per capita, and there are still more legal restrictions on foreign investment in the Philippines than in most peer countries. A decision to aggressively pursue TPP membership would commit the government to a liberalisation of trade and investment policy that could see the most important of those restrictions lifted (see analysis).

Catching Up On FDI

The country’s FDI inflows have been gaining momentum but are coming from a long way behind regional peers. A gap opened up during the 1980s, when peers such as Thailand and Malaysia began to attract large-scale foreign investment while the Philippines struggled through a thorny political transition. Gradual improvement of the economy and investment conditions in the 1990s and 2000s were not enough to prevent the Philippines from falling further behind in terms of attracting FDI. Since foreign investors tend to follow each other, and they tend to re-invest earnings in the countries where they earn them, FDI flows have a natural inertia that makes it difficult to come from behind.

Foreign investment in the Philippines has also been held back by a sometimes corrupt and slow-moving bureaucracy and by legal restrictions on foreign investment. Most crucially, the constitution bans foreigners from owning land or from owning more than 40% of a company that owns land. Investment in export-oriented manufacturing has been held back by a paucity of domestic energy sources and by chronic underinvestment in infrastructure. The tradition among Filipinos of working abroad and sending money home also has the downside of keeping labour costs relatively high compared to other countries with comparable levels of development.

Regional Comparison

The lag is largest in terms of the accumulated stock of inward FDI. The Philippines’ $57.1bn of FDI at the end of 2014 was equal to 20% of GDP, or $574 per capita, according to Banko Sentral ng Pilipinas (BSP) FDI data and Philippine Statistical Authority (PSA) GDP and population data.

By comparison, Indonesia had $253bn in FDI stock, equal to 28.5% of GDP, or $1004 per capita, according to UN Conference on Trade and Development ( UNCTAD) FDI data and IMF GDP and population data. Thailand’s $199.3bn of FDI stock was equal to 53.3% of GDP, or $2903 per capita, and Malaysia’s $133.8bn of FDI stock was equal to 40.9% of GDP or $4371 per capita. UNCTAD adjusts most South-east Asian countries’ reported FDI data to account for reporting gaps, but UNCTAD and BSP data have matched since 2013.

In terms of annual FDI inflows, the Philippines is still at the back of the pack but has caught up rapidly. Annual inward FDI rose from $1.9bn in 2010 to $6.2bn in 2014 and $4.5bn in the first nine months of 2015, according to BSP data. The 2014 inflow was equal to 2.2% of GDP and an annual pace of $62 per capita.

By comparison, Indonesia drew $22.6bn of FDI in 2014, according to UNCTAD, which is equal to 2.5% of GDP or $90 per capita. Vietnam, meanwhile, attracted $9.2bn of FDI in 2014, equal to 4.9% of GDP or $102 per capita. Thailand drew $12.6bn of FDI in 2014, equal to 3.1% of GDP or $183 per capita, and Malaysia $10.8bn, equal to 3.2% of GDP or $353 per capita.

Ratings

The improved perceptions of the Philippines’ prospects are reflected most prominently in its sovereign credit ratings. Major international agencies have upgraded the Philippines from two or three rungs below investment grade in 2010 to the minimum investment grade (Fitch, with a positive outlook) or a notch above (Standard & Poor’s and Moody’s, with stable outlooks) as of February 2016.

The Philippines has also dramatically improved its ratings in international surveys of business conditions. The World Economic Forum noted in its 2014 “Global Competitiveness Report” that the Philippines’ climb to a ranking 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 reduced perceptions of corruption. The Philippines moved up to 47th out of 140 ranked countries in the group’s 2015 report.

The Philippines scored especially well for its macroeconomic environment (5.7 points out of 7 maximum) and health care and primary education (5.5), while infrastructure (3.4) and innovation (3.5) were regarded as the weakest points. The overall ranking was still behind peers Malaysia (18th), Thailand (32nd) and Indonesia (37th), which have traditionally ranked high in the survey, but was ahead of Vietnam (56th).

The Philippines has also moved up rapidly in the World Bank’s Doing Business rankings, to 95th out of 189 countries in the 2015 report (published in late 2014) from 144th out of 183 countries in 2010. The Philippines dropped to 103rd in the World Bank’s 2016 report as other countries improved faster. The Doing Business survey, which judges conditions for local small businesses, rated the Philippines highest for ease of getting power hooked up (19th) and resolving insolvency (53rd), but gave low scores for protecting minority shareholders (155th) and starting a business (165th). A National Competitiveness Council, set up in 2006, is tasked with advising the government on how to improve the country’s score in the Doing Business rankings and other surveys.

Investment Incentives

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 incentives has become so widespread that every major foreign investment receives incentives.

Seven investment promotion agencies offer 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 ran with its mandate to create hundreds of so-called “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 into less developed regions. Companies located in PEZA need to export at least 70% of their output to receive incentives.

The Board of Investments (BOI) offers incentives to invest in priority business sectors. These include BPO, manufacturing, any kind of exports, infrastructure, agriculture and fisheries, “green” projects, research and development, tree plantation, printing, waste management, disaster prevention or mitigation, and creative business. BOI incentives are less generous than PEZA’s. The BOI also has a branch covering the provinces in the Autonomous Region in Muslim Mindanao that offers relatively better incentives.

Conversion Projects

Two other investment promotion agencies facilitate the conversion of former military bases into investment zones. 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 until 1991 the Clark Air Base, a US military facility, and is located approximately 100 km north-west of Manila near the city of Angeles. “Given the limited availability of remaining land for lease in Clark and strong appetite from Taiwanese, Japanese and Chinese locators seeking large spaces, the thrust of the freeport is to prioritise employment and investment requirements of proponents,” Evangeline Tejada, vice-president for business development at CDC, told OBG. “Additionally, a 10,000 ha Clark Green City project carried out by the Bases Conversion and Development Authority (BCDA), will open further opportunities for large locators to continue their influx into the area.”

The CDC is a subsidiary of the BCDA, a unit of the Armed Forces. The 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 an ambitious, longer-haul project to create what it hopes will be the largest industrial and BPO centre outside Metro Manila. Within a bordering 315-sq-km area of undeveloped land called the Clark Special Economic Zone, the BCDA is planning to build Clark Green City, an entirely new city. A first 288-ha phase of the project was awarded to local developer Filinvest Land in January 2016. The Clark project is linked to another conversion at the former Subic Bay Naval Base, a former US military facility 70 km southwest 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 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.

Resilient To Global Slowdown

As economic growth has held up despite a slowdown in global trade, the Philippines is increasingly seen as relatively well positioned for the changing environment. With its focus on labour exports, through BPO and sending workers abroad, the Philippines is less affected than its peers by soft demand for manufactured goods. Most exports go directly or indirectly to advanced economies, especially to the US, where demand for imports has bucked the global trend and strengthened. The Philippines’ reliance on imports of energy, industrial commodities and construction materials, which was a powerful headwind when commodity prices were high, has become more affordable.

Demographics are very favourable, with around 2% annual population growth and a bulge in the young-adult bracket. English-language skills are the best of any large Asian country, especially for interacting with Americans, and the education system is relatively strong and rapidly improving. The substantial inflows of funds from overseas workers and the recipients’ propensity to consume them, make the Philippines a more attractive market for producers of consumer goods than other countries of similar size and wealth.

Money Matters

A relatively healthy banking sector, low debt levels and low but fast-growing retail banking penetration leave ample room to expand credit. Thanks to the positive current account and US orientation, there are few worries about repayment of dollar debts, and the recent retrenchment of global capital has been mild compared to peers.

As of mid-February 2016, the Philippine peso had devalued by 16% against the US dollar since April 1, 2013. About half of that occurred during the 2013 “taper tantrum” when US signalling of pending monetary tightening kicked off changes in the global financial climate. Another leg of devaluation has occurred since the second quarter of 2015, as weakness in China accelerated the global retreat from emerging markets. That compares to a 22% devaluation against the dollar over the same period in Thailand, to 37% in Malaysia and to 39% in Indonesia.

While Thailand’s and Malaysia’s FDI inflows in 2014 each shrank by just over 10% compared to 2013, according to UNCTAD, the Philippines’ 2014 FDI inflows were up 66%. Likewise, the $4.5bn of FDI inflows into the Philippines in the first nine months of 2015 was a relatively strong result during a weak period for global FDI, although down from $4.8bn in the same period of 2014.

Foreign Capital

However, international portfolio and “other” financial investment have recently been pulled out amid the global retreat from emerging markets. These types of investment are much fleeter of foot: they tend to enter fastest when expectations are beginning to improve, and they are prone to flee when local or global conditions are unsettled. Other international investment consists mostly of bank loans and interbank credit. Such flows came in well ahead of the recent increase in FDI, peaking in 2010-12 when combined portfolio and other investment inflows averaged $8bn a year, according to BSP data. In 2013 those inflows shrank to $593m. In 2014 they reversed to a $69m outflow, and in the first nine months of 2015 the outflow accelerated to $3.3bn.

Those so-called “hot money” outflows, and the BSP’s reluctance to spend foreign-exchange reserves to counter them, were the main reasons for recent peso weakness. Gross international reserves were little changed in 2014-15, ranging between $78.7bn and $81.1bn, and ended January 2016 at $80bn. By contrast, the BSP actively defended the peso in 2013 and early 2014, when reserves slid from a peak of $85.3bn in January 2013. Until then, reserves had risen rapidly from less than $15bn at the start of 2005.

Labour Exports Remain Strong

The Philippines’ long history of labour exports continues to be the central pillar supporting the country’s current account surplus. BPO is the fastest-growing major sector of the economy: two services exports categories, “other business services” and “computer services,” grew by a combined 12.1% in the first nine months of 2015 versus the same period of the previous year, to $14.3bn. The same two categories expanded from $5.1bn in 2005 to $17.9bn in 2014, an average growth rate of 14.9% a year.

Although faster-growing, BPO has yet to catch up in scale to remittances from foreign workers, international seafarers and Filipino communities abroad (see Economy chapter). Cash remittances and wage payments from abroad came to $24.3bn in 2014, according to BSP data, equal to 8.6% of GDP and 11.8% of household consumption. After adding on personal “care packages” and other transfers, total personal transfers and wage payments from abroad came to $28.4bn in 2014, equal to 10% of GDP.

Prior to 2009 remittances grew at a pace similar to the BPO sector. However, since then growth of remittances has slowed as more Filipinos have been able to satisfy their ambitions at home and as global growth has slowed. Total incoming personal transfers increased by 3.8% in the first nine months of 2015, which was a little better than half their 6.8% average annual growth pace in 2009-14. Travel service exports – the most direct form of tourism income – are also important, bringing in $5bn in 2014 and $4bn in the first nine months of 2015. The latter figure was up by 9.3% compared with same period of the previous year.

Merchandise Exports

While service exports have thrived, merchandise exports have struggled and stagnated. Exports of goods in 2015 totalled $58.6bn, down from $62.1bn in 2014 and up only 16% since 2007, according to the PSA. Other countries’ reports of their imports, compiled by UN Comtrade, indicate that the Philippines’ exports are actually significantly greater, at $80.7bn in 2014. However, the UN Comtrade data also show goods exports hardly growing since 2007, when they stood at $78.5bn.

High energy and logistics costs have been the main obstacles to export industries. Real appreciation against the dollar averaged 4.1% a year in 2007 to 2013, and devaluation since then has been largely in response to weakening global demand and less than many other countries’ devaluations against the dollar.

Despite the soft overall numbers, sentiment has improved in the main export industry of electronics and electrical goods, which has recently performed relatively well after years of seeing output slide as investment went to neighbouring countries. PSA data showed electronic and electrical goods exports up 7.9% in 2015 to $28.9bn, or almost half of goods exports, thanks to strong demand from advanced economies and mainly Japanese foreign investment. Much of the export weakness in 2015 owed to a poor year for agriculture as a major El Niño weather pattern brought heat and drought.

Import Surge Abates

The recent currency weakness and drop in commodity prices have both helped to slow rapid growth in imports, which had been outpacing exports and threatening the traditional current account surplus. The problem was not much visible in the Philippines’ imports data, which showed merchandise imports growth from $54.9bn in 2010 to $65.4bn in 2014. However, the BSP’s balance of payments reports gave a different picture, showing a large merchandise trade deficit of 5.7% of GDP.

Meanwhile, UN Comtrade’s collection of other countries’ reports of their exports to the Philippines showed them surging at an 8.2% average annual growth pace, from $76.4bn in 2010 to $104.9bn in 2014. Comparing that latter number to the UN Comtrade export figure implies a trade-in-goods deficit of $24.2bn in 2014, or 8.5% of GDP. According to UN Comtrade, the import growth has been strongest in consumer electronics, automobiles, base metals and other materials used in construction, and those are also the categories with the biggest discrepancies between PSA and UN Comtrade data.

Booming outbound tourism added further pressure on the current account, reflected in a more than doubling of imports of travel services from $5.6bn in 2011 to $11.8bn in 2014. The services trade surplus, which traditionally balanced out merchandise trade deficits, halved from $7bn in 2013 to $3.5bn in 2014.

Although BSP data showed healthy current account surpluses of $11.4bn, or 4.2% of GDP, in 2013 and $10.9bn, or 3.8% of GDP, in 2014, other indicators such as large “net unclassified items” in the balance of payments and a sudden stop in growth of central bank foreign-exchange reserves from 2013 signalled that outflows and inflows were close to even.

The situation continued to be tricky to read in 2015. Official data showed the current account surplus weakening to $5.6bn, or 2.7% of period GDP, in the first nine months of 2015. But that shrinkage appeared to reflect improved reporting more than a deteriorating balance. An improvement in “net unclassified items”, and stable central bank reserves despite hot money outflows, indicated that pressure on the current account had been relieved somewhat by the drop in commodity prices and the weaker peso.

Outlook

In the near term, low oil prices will support consumers of the Philippines’ electronics and BPO services exports, but global capital will remain cautious towards emerging markets and Asia as investors wait to see how events in China play out. However, the Philippines has relatively little direct exposure to China, as most of its exports to China feed into supply chains that lead ultimately to the US and other advanced economies. The gradual market reform policies of President Benigno Aquino III are widely expected to be continued, but there is likely to be some slowdown during the transition.

In the long term, the recent ramping up of infrastructure investment is an important and welcome development that will bring returns. Much will depend on the new president and Congress, but the broad awareness of the benefits of joining the TPP and the growing willingness of both political and business elites to support the lifting of constitutional restrictions on foreign investment bode well for the future of foreign investment and trade in the Philippines.