Philippines Philippines at a Glance: 2005-06

Country Report

Philippines Philippines at a glance: 2005-06

OVERVIEW On July 1st the Supreme Court decided to suspend the implementation of an act raising value-added tax (VAT) and corporate income tax, pending a ruling on its constitutionality. This threatens to throw off course the government’s fiscal deficit reduction programme. The VAT act, coupled with higher inflation and increased power and transport tariffs, has deepened the unpopularity of the government led by the president, Gloria Macapagal Arroyo. Plans to move from the current presidential system to a parliamentary-style republic will come to the forefront of politics later in the year. Despite political problems, GDP growth will remain reasonably healthy at 5.1% this year and 4.8% in 2006, supported by continued strong inflows of workers’ remittances.

Key changes from last month Political outlook • A demonstration on June 24th in the capital, Manila, by several thousand people calling for Ms Macapagal Arroyo’s resignation highlighted the increase in political pressure on the government, amid fresh accusations of electoral fraud in the May 2004 presidential election and corruption allegations that have touched the presidential family. However, the small numbers taking part in such demonstrations so far indicate that the president is likely to survive in power. Political instability will, however, need to be countered by careful cultivation of the government’s supporters within the upper ranks of the armed forces. Economic policy outlook • The achievement of a 12.4% year-on-year reduction in the budget deficit in January-May, even before the hoped-for extension of VAT, points to a significant improvement in the public finances in 2005-06. The Economist Intelligence Unit continues to forecast a budget deficit of around 3.1% of GDP this year; a fall to 1.8% in 2006 is likely on the assumption that further revenue-raising measures will come into force in January next year. Economic forecast • A modest improvement in export and import data in April points to a moderate increase in external trade over the forecast period. In view of data released so far, we now expect a narrowing of the merchandise trade deficit this year, followed by a slight widening of the deficit in 2006. July 2005

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Contents

Philippines

3 Summary

4 Political structure

5 Economic structure 5 Annual indicators 6 Quarterly indicators

7 Outlook for 2005-06 7 Political outlook 8 Economic policy outlook 10 Economic forecast

13 The political scene

18 Economic policy

22 The domestic economy 22 Economic trends 27 Sectoral trends

29 Foreign trade and payments

List of tables

10 International assumptions summary 10 Gross domestic product by expenditure 12 Forecast summary 21 Budget 23 Gross domestic product and gross national product 24 Gross domestic product by origin 24 Expenditure on gross domestic product 25 Consumer prices, 2005 28 Manufacturing production, 2005 29 Foreign trade 30 Leading exports, Jan-Apr 31 Imports by major categories, Jan-Mar

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List of figures

13 Gross domestic product 13 Consumer price inflation 21 Government budget outturn 23 Gross national product 27 Exchange rate 31 External trade

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Philippines July 2005 Summary

Outlook for 2005-06 The Philippines seems to be entering a less stable period politically, despite the fact that the president, Gloria Macapagal Arroyo, is only one year into her six- year term. Allegations of fraud in the May 2004 presidential election have resurfaced, and the forthcoming increase in indirect taxation will add to pressures created by the increase in power and transport tariffs. Ms Macapagal Arroyo currently looks unlikely to be driven from power, but will need to cultivate the armed forces carefully. GDP growth will be lower this year and next, in line with global trends. However, the continued strong pace of the increase in remittances from overseas Filipino workers will support growth.

The political scene Coup rumours have begun to circulate once again, following a call by a retired general, Fortunato Abat, for a “revolutionary transition government”. Unrest in the armed forces has been accompanied by accusations of corruption in the president’s own family. Congressional hearings are also taking place into a controversy surrounding what is claimed to be a tape recording of a telephone conservation between Ms Macapagal Arroyo and an election official discussing the vote count following last year’s presidential election. Peace talks with the Moro Islamic Liberation Front remain on track.

Economic policy On May 24th a bill extending value-added tax (VAT) was signed into law by Ms Macapagal Arroyo. However, the implementation of the bill has since been suspended by the Supreme Court. Further revenue-raising legislation could be pushed aside later this year by the beginning of debate on constitutional reform. High liquidity in the local banking sector has held down Treasury bill rates.

The domestic economy Economic growth slowed in the first quarter of 2005 owing to a poor agricultural performance. Inflation has remained high, boosted by energy prices. The peso has lost nearly all of the gains that it recorded earlier this year, owing to political jitters. Investment approvals by the Board of Investments have fallen sharply so far this year. Banks’ asset portfolios have improved.

Foreign trade and payments Poor sales of electronic goods in the first four months of this year have dragged down exports overall. However, the balance of payments is likely to have been in surplus in the first half of this year. China is emerging as a more significant economic partner.

Editors: David Webb (editor); Robert Ward (consulting editor) Editorial closing date: July 1st 2005 All queries: Tel: (44.20) 7830 1007 E-mail: [email protected] Next report: Full schedule on www.eiu.com/schedule

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Political structure

Official name Republic of the Philippines

Form of state Under the 1987 constitution, the government is based on a separation of powers between the executive presidency, a bicameral legislature and an independent judiciary

The executive The president is chief executive, head of state and commander-in-chief; serves no more than one six-year term; and may approve bills passed by Congress or exercise a veto, which can be overridden only by a two-thirds majority of Congress. Cabinet appointments are subject to approval by the Congressional Commission on Appointments

Legislature The Congress of the Philippines consists of the Senate (24 members) and the House of Representatives (212 directly elected members and 24 members selected by party list). Senators are elected for six-year terms and representatives for three-year terms

Legal system Based on US common law; the 1987 constitution contains a Bill of Rights, and provides for a judiciary with the Supreme Court at its apex

National elections May 10th 2004 (for the presidency, the House of Representatives and one-half of the Senate); the next elections are due in May 2007 (for the House of Representatives and one-half of the Senate)

National government Gloria Macapagal Arroyo, who became president on January 20th 2001, replacing Joseph Estrada in the middle of his term, won re-election in her own right on May 10th 2004 for a six-year term

Main political organisations The pro-administration coalition, including Lakas ng Edsa (Lakas, the National Union of Christian Democrats), Kabalikat ng Malayang Pilipino (Kampi, Ally of the Free Filipino) and the Nationalist People’s Coalition (NPC); Laban ng Demokratikong Pilipino (Laban); Puwersa ng Masa (PnM); the Communist Party of the Philippines (CPP); Moro National Liberation Front (MNLF); Moro Islamic Liberation Front (MILF)

President & foreign affairs secretary Gloria Macapagal Arroyo Vice-president Noli de Castro Key ministers Agrarian reform Rene Villa Agriculture Arthur Yap Budget & management Emilia Boncodin Defence Avelino Cruz Economic planning Romulo Neri Education Florencio Abad Energy Raphael Lotilla Finance Cesar Purisima Foreign affairs Albert Romulo Health Manuel Dayrit Interior & local government Angelo Reyes Justice Raul Gonzalez Labour & employment Patricia Santo Tomas Public works & highways Hermogenes Ebdane Tour ism Jose Ace Durano Trade & industry Juan Santos Transport & communications Leandro Mendoza Executive secretary Eduardo Ermita

Central bank governor Rafael Buenaventura

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Economic structure

Annual indicators 2000a 2001a 2002a 2003a 2004a GDP at market prices (P bn) 3,354.7 3,631.5 3,959.6 4,210.5 4,739.1 GDP (US$ bn) 75.9 71.2 76.7 77.7 84.6 Real GDP growth (%) 6.0 1.8 4.3 3.6 6.1 Consumer price inflation (av; %)b 4.3 6.1 3.1 2.9 6.0 Population (m) 79.7 81.4c 83.0c 84.6c 86.2c Exports of goods fob (US$ m) 37,295 31,243 34,377 35,342 38,728 Imports of goods fob (US$ m) -33,481 -31,986 -33,970 -40,797 -45,109 Current-account balance (US$ m) 6,258 1,323 4,383 1,396 2,080 Foreign-exchange reserves excl gold (US$ m) 13,090 13,476 13,329 13,655 13,116 Total external debt (US$ bn) 60.8 58.5 60.0 62.7 65.9c Debt-service ratio, paid (%) 12.8 19.6 19.7 20.6 15.7c Exchange rate (av) P:US$ 44.19 50.99 51.60 54.20 56.04 a Actual. b Break in series end-2002; old basket used to extend series back before 2003. c Economist Intelligence Unit estimates.

Origins of gross domestic product 2004 % of total Components of gross domestic product 2004 % of total Agriculture, forestry & fishing 13.7 Private consumption 70.6 Industry 32.4 Government consumption 10.4 Manufacturing 23.5 Fixed investment 16.8 Services 53.9 Change in inventories 0.6 Exports of goods & services 51.5 Imports of goods & services -50.9

Principal exports 2004 US$ m Principal imports 2004 US$ m Electronic products 26,644 Semi-processed raw materials 13,712 Semiconductors 18,645 Parts for manufacture of electrical equipment 6,205 Garments 2,171 Chemicals 3,182 Petroleum products 380 Telecommunications equipment & electrical machinery 8,741 Coconut oil 578 Crude petroleum 2,520

Main destinations of exports 2004 % of total Main origins of imports 2004 % of total Japan 20.1 Japan 19.8 US 17.9 US 13.7 Netherlands 9.1 China 7.7 Hong Kong 7.9 Singapore 7.4 China 6.7 Taiwan 7.0 Singapore 6.6 South Korea 5.6

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Quarterly indicators 2003 2004 2005 2 Qtr 3 Qtr 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Government finance (P m) Revenue 168,516 150,983 169,861 152,601 190,671 173,062 183,365 172,625 Expenditure 188,270 212,348 223,934 204,937 217,755 226,791 231,627 231,708 Balance -19,754 -61,365 -54,073 -52,336 -27,084 -53,729 -48,262 -59,083 Output GDP at constant 1985 prices (P m) 264,844 259,770 296,096 265,155 281,674 276,040 312,038 277,317 GDP at constant 1985 prices (% change, year on year) 5.0 3.5 2.8 6.4 6.4 6.3 5.4 4.6 Manufacturing index (1994=100) 112.7 112.7 108.2 104.8 111.8 114.1 116.5 106.6 Manufacturing index (% change, year on year) 0.9 1.5 -5.1 -4.1 -0.8 1.2 7.6 1.7 Employment and prices Employment ('000) 30,418 30,451 31,553 31,547 31,520 31,623 31,733 31,634 Employment (% change, year on year) 0.8 1.2 4.2 4.7 3.6 3.9 0.6 0.3 Unemployment rate (% of the labour force) 12.2 12.6 10.1 11.0 13.7 11.7 10.9 11.3 Consumer prices (2000=100) 113.3 114.5 115.1 116.8 118.8 122.4 124.5 126.6 Consumer prices (% change, year on year) 2.9 2.9 3.0 4.1 4.8 6.8 8.1 8.4 Wholesale prices (1998=100) 131.9 133.4 135.3 139.1 143.0 146.3 149.0 153.3 Wholesale prices (% change, year on year) 5.2 5.1 6.1 5.6 8.8 9.7 10.1 10.2 Financial indicators Exchange rate P:US$ (av) 52.90 54.58 55.26 55.97 55.91 56.00 56.28 55.01 Exchange rate P:US$ (end-period) 53.71 54.94 55.57 56.36 56.18 56.34 56.27 54.79 Deposit rate (av; %) 6.2 5.1 5.3 5.5 5.9 6.6 6.6 5.9 Lending rate (av; %) 10.1 9.4 9.6 9.6 9.9 10.4 10.4 10.1 M1 (end-period; P bn) 454.3 453.9 519.8 507.9 509.5 498.4 567.7 n/a M1 (% change, year on year) 10.2 8.6 8.6 11.6 12.1 9.8 9.2 n/a M2 (end-period; P bn) 2,337 2,366 2,447 2,478 2,483 2,497 2,689 n/a M2 (% change, year on year) 8.2 7.4 3.6 6.0 6.2 5.5 9.9 n/a PSE composite index (end-period; 1985=100) 1,222.8 1,297.4 1,442.4 1,424.3 1,579.4 1,761.6 1,822.8 1,954.7 PSE composite index (% change, year on year) 5.7 14.9 41.6 37.0 29.2 35.8 26.4 37.2 Foreign trade (US$ m) Exports fob 8,614 9,367 9,601 9,193 9,541 10,158 10,706 9,520 Imports fob -9,446 -9,385 -9,504 -9,752 -10,187 -10,293 -10,070 -9,397 Trade balance -832 -18 97 -559 -646 -135 637 123 Balance of payments (US$ m) Merchandise trade balance fob-fob -730 -65 121 -528 -582 -23 n/a n/a Services balance -391 -208 -207 -173 -261 -267 n/a n/a Income balance 1,540 1,191 1,417 1,279 1,483 1,553 n/a n/a Net transfer payments 136 150 166 144 134 147 n/a n/a Current-account balance 555 1,068 1,497 722 774 1,410 n/a n/a Reserves excl gold (end-period) 13,012 13,107 13,655 13,217 13,207 12,739 13,116 13,826

Sources: Bangko Sentral ng Pilipinas, Selected Economic Indicators; IMF, International Financial Statistics; National Statistical Co-ordination Board, Economic Indicators.

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Outlook for 2005-06

Political outlook

Domestic politics The rising unpopularity of the president, Gloria Macapagal Arroyo, is threatening the survival of her administration. Although the Economist Intelligence Unit believes that the administration will survive in office, given the small size so far of demonstrations calling on the government to resign, unrest within the armed forces and opposition from within the influential Roman Catholic church have weakened its support base within the establish- ment. It is significant that the president’s authority has begun to weaken so early in her administration, as traditionally Philippine presidents, who are permitted to serve for one term only, are at the height of their authority earlier on in their six-year presidential terms. Should the president survive in office, she is nevertheless likely to weakened by the current political crisis, which threatens to reverse some of the legislative progress made so far this year. The passage in mid-May of a bill providing for an increase in value-added tax (VAT) was a major victory for the administration, coming after weeks spent cajoling Congress into co-operating with the government’s fiscal deficit reduction programme. However, the implementation of the law, which is vital to government plans to avoid a descent into financial crisis, was suspended on July 1st by the Supreme Court in order to consider opposition claims that the measure is unconstitutional. The court will hold a hearing on the VAT act on July 26th. The fact that the temporary restraining order was passed by a 13:2 vote in the Supreme Court, with the chief justice and ally of the president, Hilario Davide, being one of the two dissenting votes, indicates that the government faces an uphill task in getting its policy programme back on track. The revenue-raising legislation, coupled with the increase in inflation and higher power and transport tariffs, has compounded the dissatisfaction with the current government of the many Filipinos who believe that Ms Macapagal Arroyo did not win the May 2004 presidential election fairly. The president has been forced to admit, following the production of a tape recording, a “lapse in judgment” when she contacted a senior election commissioner during the vote count that followed the 2004 presidential election (which she won by a small margin). However, no wrongdoing has been proven. There have been calls for Ms Macapagal Arroyo to be impeached, but allies of the president command a majority in the House of Representatives (the lower house of Congress), which would currently allow the president to survive any such process. The government’s image has also been tarnished by allegations of corruption against the president’s family and members of the government. The president’s husband, Mike Arroyo, has gone into temporary exile in order to help calm the political temperature, and the former agriculture secretary, Arthur Yap, recently resigned in order to fight tax-evasion charges. The long-drawn-out task of cajoling Congress into co-operating with the president’s policy agenda and the Supreme Court’s foray into fiscal policy-

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making both expose the weaknesses of the Philippine constitution. However, the president’s declining authority gives no grounds for optimism regarding plans to move to a parliamentary and federal system of government, which would enable future administrations to push their policy agendas through the legislature more easily. Rumours of coup plots have increased, and dissatisfaction not only among ordinary Filipinos but also within the ranks of the armed forces will need to be managed carefully. A failure to do so could in the worst case cause Ms Macapagal Arroyo’s position to be threatened. Later in the forecast period, party-political jostling may start again as parties begin to prepare for the mid-2007 congressional election. Talks with the main rebel group fighting for Muslim autonomy on the southern island of Mindanao, the Moro Islamic Liberation Front (MILF), took place in Malaysia in April. The MILF said recently that the political crisis had not derailed the peace process, as it would negotiate with whoever was in power. A full peace conference may be convened later this year. However, there are many insurgent groups, and the MILF itself is believed to include factions less favourable to the peace process, so that a full resolution of the various security problems confronting the government is unlikely to be achieved soon.

International relations Islamist terrorism in the Philippines has underlined the country’s front-line role in the wider global “war on terror”. Relations with the US wobbled after the Philippines pulled its small contingent of troops out of Iraq in July 2004, but the US will continue to offer training and financial assistance to the Armed Forces of the Philippines. The Philippines is to receive US$120m in military, trade and development assistance from the US this year. The recent visit of China’s president, Hu Jintao, to the Philippines produced a raft of investment and co-operation agreements. The two countries continue to dispute ownership of the Spratly Islands in the South China Sea, but they have agreed to conduct joint seismic exploration in the contested area.

Economic policy outlook

Policy trends The central challenge facing the government is to tackle the large fiscal deficit, which is partly funded by overseas borrowing. A number of revenue-raising laws have been passed, but the implementation of the largest and most significant of these has been delayed by the Supreme Court. Despite the improvement in the deficit and the rapid rate of GDP growth achieved in 2004, national government debt rose to 78.7% of GDP last year from 78% in 2003, well above the 59% of GDP recorded as recently as 1999. Moreover, the true rate of public-sector indebtedness is much higher than these figures indicate: when debts run up by the state-owned National Power Corporation (Napocor) and other contingent liabilities are included, the public debt total is equivalent to around 130% of GDP. Power tariff increases implemented recently should produce a sharp fall in Napocor’s deficit in 2005, with a consequent large narrowing of the consolidated public-sector deficit, which came in at 5% of GDP in 2004. The government is hoping to make further progress later in 2005 on the sale of Napocor’s assets, including the transmission infrastructure hived off into the National Transmission Corporation (Transco).

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Fiscal policy The 2004 Philippine budget deficit came in well below the official target for the year of P197.8bn (US$3.5bn), at P186.1bn; this was equivalent to around 3.9% of GDP, and constituted an improvement compared with the deficit of P199.9bn (4.7% of GDP) recorded in 2003. Further progress on the budget deficit will be made in 2005. The April budget surplus of P3.3bn was the first monthly surplus since April 2001, and was an encouraging turnaround compared with the year- earlier deficit of P7.8bn. Although a deficit of P7.6bn was recorded in May 2005, the cumulative deficit of P67.8bn in the first five months of the year represented a 12.4% reduction compared with the year-earlier period. The suspension of a law eliminating a number of VAT exemptions from July 1st has cast a shadow over the outlook for the public finances. If the suspension becomes permanent, hopes of achieving a large fall in the deficit this year would be dashed, although the government’s fiscal performance so far this year indicates that a reduction in the fiscal deficit, albeit a much smaller one, would be achieved in any case. The provision of the threatened VAT law permitting the president to vary the rate of VAT from 10% to 12% if the previous year’s deficit exceeds 1.5% of GDP or if VAT collections in that year exceed 2.8% of GDP, and that raising the rate of corporate income tax from 32% to 35%, were, until the Supreme Court’s recent intervention, due to come into force in January 2006. The government estimated that P100bn in additional revenue would be raised in 2006 as a result of the VAT legislation alone. Our forecast, which is based on the assumption that the VAT law will be implemented, is for a reduction in the budget deficit as a proportion of GDP to 3.1% in 2005 and 1.8% in 2006. The outturn would be much less impressive were the law not to come into effect.

Monetary policy Consistently high inflation figures and the prospect of continuing strong global oil prices led the Bangko Sentral ng Pilipinas (BSP, the central bank) on April 7th to increase by 25 basis points its overnight borrowing and lending rates, which now stand at 7% and 9.25% respectively. By contrast, the US federal funds rate has risen by 225 basis points over the past year and is expected to rise further over the forecast period. Policy interest rates are likely to rise modestly over the forecast period, reflecting increases in US interest rates as well as the need to support the peso and check inflationary pressure, but liquidity in the local banking sector (owing to lacklustre lending activity) should enable the BSP to limit the increase.

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Economic forecast

International assumptions International assumptions summary (% unless otherwise indicated) 2003 2004 2005 2006 Real GDP growth World 3.9 5.1 4.2 4.0 OECD 2.0 3.3 2.3 2.3 EU25 1.2 2.3 1.7 2.0 Exchange rates ¥:US$ 115.9 108.1 107.4 103.0 US$:€ 1.132 1.244 1.222 1.260 SDR:US$ 0.714 0.675 0.679 0.666 Financial indicators € 3-month interbank rate 2.33 2.13 2.05 2.00 US$ 3-month Libor 1.21 1.62 3.46 4.77 Commodity prices Oil (Brent; US$/b) 28.8 38.5 50.5 46.5 Gold (US$/troy oz) 363.3 409.5 425.6 402.5 Food, feedstuffs & beverages (% change in US$ terms) 6.6 9.2 -6.5 -1.5 Industrial raw materials (% change in US$ terms) 13.0 21.0 4.2 -6.2 Note. Regional GDP growth rates weighted using purchasing power parity exchange rates. Global GDP growth in purchasing power parity terms will decelerate from the 5.1% rate posted in 2004 to 4.2% this year and 4% in 2006, reflecting developments in the US and Japan. US growth will fall to 3.2% in 2005 and 2.8% in 2006, from 4.4% in 2004, and Japanese GDP is likely to expand by 1.3% in 2005 and 1% in 2006, after growing by 2.6% in 2004. World trade growth reached 10.8% in 2004, but will slow to an average of 6.9% a year in 2005-06. We expect crude oil prices (dated Brent Blend) to rise from an average of US$38.5/barrel in 2004 to US$50.5/b in 2005, and to fall back only slightly, to US$46.5/b, in 2006.

Economic growth Gross domestic product by expenditure (P bn at constant 1985 prices; % change year on year in brackets unless otherwise indicated) 2003a 2004a 2005b 2006b Private consumption 853.6 903.1 944.2 984.0 (5.3) (5.8) (4.5) (4.2) Public consumption 74.4 74.4 73.7 74.8 (2.5) (0.0) (-1.0) (1.5) Gross fixed investment 218.1 227.3 236.4 248.3 (3.1) (4.2) (4.0) (5.0) Final domestic demand 1,146.2 1,204.9 1,254.3 1,307.1 (4.7) (5.1) (4.1) (4.2) Stockbuilding -2.9 8.5 -3.0 5.0 (-0.2)c (1.1)c (-1.0)c (0.7)c Total domestic demand 1,143.3 1,213.4 1,251.3 1,312.1 (4.5) (6.1) (3.1) (4.9)

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Gross domestic product by expenditure (P bn at constant 1985 prices; % change year on year in brackets unless otherwise indicated) 2003a 2004a 2005b 2006b Exports of goods & services 464.1 529.6 562.8 600.7 (4.1) (14.1) (6.3) (6.7) Imports of goods & services -584.4 -619.1 -649.7 -692.7 (9.8) (5.9) (4.9) (6.6) Foreign balance -120.4 -89.5 -86.8 -92.1 (-3.3)c (2.9)c (0.2)c (-0.4)c GDP 1,070.0 1,134.9 1,193.3 1,250.3 (3.6) (6.1) (5.1) (4.8) a Actual. b Economist Intelligence Unit forecasts. c Contribution to real GDP growth. Full-year data for 2004 show a 6.1% increase in real GDP, the fastest rate of expansion for 15 years. Year-on-year GDP growth in the first quarter of 2005 was 4.6%; the rate of growth was reduced by continuing problems in the agricultural sector, reflecting typhoon damage in late 2004 and the impact of the El Niño weather phenomenon. Philippine GDP growth is likely to moderate to 5.1% in 2005 and 4.8% in 2006, in line with trends in the OECD economies and China. However, OECD demand for Philippine medical staff and other migrant workers will remain firm. Consequently, remittances from overseas Filipino workers will continue to grow rapidly, helping private consumption growth to remain firm at 4.5% in 2005 and 4.2% in 2006, and thus playing a key role in propping up overall GDP growth. An improved agricultural performance is also likely in the latter half of this year and into 2006. Customs-based trade data for the first quarter of 2005 were disappointing, but data for April showed a modest pick-up in external trade. We continue to expect gross fixed investment growth to remain relatively stable at an average of around 4.5% a year in 2005-06. In December 2004 the Supreme Court handed down a ruling permitting foreign investment in the Philippine mining sector. As a result, Chinese and Australian companies are expected to launch significant investments in the mining sector over the forecast period: if all the projects under discussion were to come to fruition, they would eventually bring in investment of more than US$3bn. A number of infrastructure projects under way this year will also support growth.

Inflation The year-on-year rate of consumer price inflation was stable at 8.5% in the first five months of 2005. This was well in excess of the 4.5-5.5% range targeted by the BSP, and the planned extension of VAT would add to inflationary pressure. Inflation has been boosted not just by the rise in global oil prices and faster food price inflation, but also by the higher power tariffs that have been implemented to reduce Napocor’s losses. We forecast an increase in consumer price inflation to 8.2% this year, from 6% in 2004. We expect inflation to ease back only moderately to 7.2% in 2006, when a fall in oil prices will be offset by the imposition of a higher rate of VAT.

Exchange rates The Philippine peso was trading at P56.275:US$1 on July 5th 2005, having lost all of the gains made earlier this year as a result of a rise in political tensions. The peso is likely to recover later in the year as markets register further progress on the government’s fiscal deficit reduction programme. However, exchange-rate

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volatility is likely to continue as the peso remains hostage to political instability and coup rumours. Our revised forecast for the peso assumes that the currency will manage by the end of the year to recover recently lost gains, leading to an average exchange rate of P54.5:US$1 in 2005, with a further strengthening to P53.5:US$1 in 2006, when the US dollar is forecast to weaken further and the Philippine government is expected to achieve a significant reduction in the fiscal deficit.

External sector Following year-on-year falls in the value of exports and imports in February and March, data for April showed an 8.8% increase in exports and a 6.5% rise in imports. The Philippine trade performance in 2005-06 will be less impressive than it was last year, reflecting a slowdown in world trade growth from the rapid rate recorded in 2004. Data for the year so far point to a narrowing of the merchandise trade deficit (in balance-of-payments terms) this year, followed by a slight widening in 2006. The deficit will be more than offset by the substantial surplus on the current transfers account generated by inflows of remittances from Filipinos working overseas. The overall result will be a increase in the current-account surplus to US$3.5bn (3.7% of GDP) in 2005; the surplus will fall back slightly in 2006 to US$3.2bn (3% of GDP).

Forecast summary (% unless otherwise indicated) 2003a 2004a 2005b 2006b Real GDP growth 3.6 6.1 5.1 4.8 Gross agricultural production growth -1.8 5.1 3.8 3.6 Unemployment rate (av) 11.4 11.8 12.2 12.0 Consumer price inflation (av) 2.9 6.0 8.2 7.2 91-day Treasury-bill rate 5.9 7.3 6.2 6.4 Government balance (% of GDP) -4.7 -3.9 -3.1 -1.8 Exports of goods fob (US$ bn) 35.3 38.7 41.1 43.4 Imports of goods fob (US$ bn) 40.8 45.1 47.1 50.0 Current-account balance (US$ bn) 1.4 2.1 3.5 3.2 Current-account balance (% of GDP) 1.8 2.5 3.7 3.0 External debt (year-end; US$ bn) 62.7 65.9c 67.0 68.8 Exchange rate P:US$ (av) 54.20 56.04 54.50 53.50 Exchange rate P:¥100 (av) 46.77 51.83 50.74 51.94 Exchange rate P:€ (year-end) 70.09 76.17 63.75 71.09 Exchange rate P:SDR (year-end) 82.57 87.38 78.06 82.67 a Actual. b Economist Intelligence Unit forecasts. c Economist Intelligence Unit estimates.

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Gross domestic product Consumer price inflation (% change, year on year) (av; %)

Philippines Asia excl Japan Philippines Asia excl Japan 7.0 9.0

6.0 8.0 7.0 5.0 6.0 4.0 5.0 3.0 4.0 2.0 3.0 1.0 2.0

0.0 1.0 01 02 03 04 05 06 01 02 03 04 05 06 2000 2000

The political scene

The administration fears for its In May 2005 the administration of the Philippine president, Gloria Macapagal military backing Arroyo, secured a major political victory when, after months of debate, Congress finally approved a bill expanding value-added tax (VAT), the most important measure on her tax-raising agenda. This victory has since been jeopardised by a Supreme Court decision on July 1st to stay the implementation of the act while the court considers its constitutionality. The fate of the VAT act has thus become enmeshed in the most serious political crisis faced by the government since the period immediately after the presidential election in May 2004, when the election results were challenged by the opposition. Coup rumours have begun to circulate, fresh charges of corruption have been made against the president’s family, and accusations that the presidential election was manipulated have risen to the surface once again. Trouble had been brewing during May. In April, Fortunato Abat, an 80-year-old retired general and former defence secretary, called for a “revolutionary transition government” and proposed a solidarity march to the presidential Malacañang Palace in late June. Although his demand for a transition government was rejected by opposition groups, the fact that he played an important role in the ouster of the previous president, Joseph Estrada, in 2001 and that he is close to the highly influential former president, Fidel Ramos, will have caused alarm in the administration. Mr Ramos, who has been a core supporter of Ms Macapagal Arroyo, immediately distanced himself from General Abat’s stance. The government has been considering whether to charge General Abat with sedition. In the meantime it has kept him under surveillance, along with other retired generals. In the following weeks controversy built up over two projects pursued by the military high command!a multi-million-peso pavement renovation at Camp Aguinaldo (the major military base in the capital, Manila) and the construction of a military beach resort on the holiday island of Boracay. In the Philippines all such projects are understood to involve substantial “kickbacks”, and corruption in the military high command has for some time been a live and

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destabilising issue. It was one of the core complaints of the nearly 300 junior officers and enlisted men who participated in the Oakwood mutiny in July 2003, which was intended to spark mass civilian protest and the subsequent overthrow of Ms Macapagal Arroyo’s government. On that occasion the government’s response to the mutineers’ demands!the removal of the former chief of staff, Angelo Reyes, from the post of defence secretary!was essentially cosmetic, because the president could not afford to alienate the military high command. Its support remained critical when the presidential election failed to give Ms Macapagal Arroyo a clear democratic mandate. The margin of victory over the popular opposition candidate, Fernando Poe, was relatively narrow, at around 1m votes, and the opposition immediately (and inevitably, given the conduct of elections in the Philippines) claimed electoral fraud. Significantly, General Reyes returned to the cabinet after the 2004 election, taking on the highly influential interior and local government department portfolio. Meanwhile, the military corruption issue has been kept alive by court hearings into allegations against General Carlos Garcia, the former comptroller of the armed forces, and a stream of accusations against other high-ranking officers! including two former chiefs of staff. The difficulty is that, although the administration is not about to push hard for court judgments against former members of the high command, neither does it want to feed resentment lower down the ranks by appearing to soft-pedal on the issue. In a reversion to the pattern seen under a former president, Corazon Aquino, who faced numerous military coup attempts, those charged with involvement in the Oakwood mutiny are being held to account on lesser charges. In May 184 enlisted personnel were found guilty on charges of disrespect to the president and superior officers and conduct prejudicial to military discipline. The military court trying them dropped mutiny charges, and recommended demotion and one year’s imprisonment!with the latter deemed to have been served during the 22 months that the accused had already spent in detention. They were therefore immediately released. A similar plea bargain is being sought by 67 of the 104 officers facing mutiny charges, and a similar outcome is expected. It is unclear at present how those remaining, including the six who led the mutiny, will be dealt with.

The president’s close relatives Against this background of simmering discontent within the military, the are accused of corruption administration was hit at the beginning of June by what had the appearance of a concerted attack by the opposition. For some weeks rumours had circulated that the president’s husband, Miguel Arroyo, and her son, a congressman, Juan Miguel Arroyo, had been receiving payoffs from the operators of jueteng, an illegal numbers game. Significantly, this was one of the major charges that was brought against Ms Macapagal Arroyo’s predecessor, Joseph Estrada, in 2000, precipitating his fall. The president has ordered the Department of Justice to investigate the allegations. The matter was then brought before two Senate committees (those on public order and gaming). Archbishop Oscar Cruz, the former head of the Catholic Bishops’ Conference in the Philippines and a long-standing campaigner against corruption, offered to present eight witnesses testifying to kickbacks from jueteng and protection of the activity, implicating Juan Miguel Arroyo and two

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other congressmen, senior members of the Philippine National Police (PNP, the national constabulary), governors and mayors. One of the witnesses claimed that the younger Mr Arroyo had received P600,000 (US$11,000). His charges were dismissed as hearsay by administration spokesmen, and the National Bureau of Investigation (NBI) produced witnesses to discredit his statement.

Charges of electoral fraud are In early June, just days before Senate hearings on jueteng-related corruption revived were due to start, the administration was informed of the existence of a tape- recording of a telephone conversation in which, allegedly, the president was discussing the vote count with a high-ranking official of the Commission on Elections (Comelec). This was a far more serious allegation than the jueteng payoff charges against the president’s relatives!the public is relatively inured to evidence of corruption in high places!since it went to the root of Ms Macapagal Arroyo’s legitimacy as president. The government claimed that the tape!evidently secured through phone-tapping!had been doctored. But given the political storm that its publication would unleash, the administration rounded up its military backing. The chief of staff, Efren Abu, publicly pledged his support for the government against groups that he claimed were seeking to destabilise the country. Another set of pledges was required on June 8th, when a witness came forward at the Senate hearings testifying to the involvement of Juan Miguel Arroyo and the president’s brother-in-law, a congressman, Ignacio Arroyo. This time the line-up of support for the president was extended to the director- general of the PNP, Arturo Lomibao (who was among those accused of sanctioning jueteng) and the chiefs of the three military services. General Lomibao claimed that the various controversies and scandals were a prelude to a larger scheme to overthrow Ms Macapagal Arroyo’s administration. The army chief said that “certain groups” involved in “destabilisation” were trying to recruit among the military. In this febrile atmosphere, the military in the Manila area were put on red alert on June 9th. On the following day Samuel Ong, a former deputy director of the NBI, came forward to attest to the authenticity of the tape, of which he claimed to have the master copy, obtained from the armed forces’ intelligence service, and said that he had evidence that Mr Poe, who died in December 2004, had won the presidential election. Mr Ong took refuge in a seminary in Manila, and then fled to an unidentified hideaway when the government charged him with inciting sedition on June 15th, following allegations that he had called for the ousting of Ms Macapagal Arroyo. On the same day the House of Representatives (the lower house of Congress) began hearings on the authenticity of the tape. Senate committees resumed hearings on the jueteng payoff charges on June 24th.

The president is unpopular, The crisis has underlined the president’s increasing dependence on the military. but there is no clear alternative Her popularity ratings have been sliding since the high point reached just after the election last year. From May 14th to May 23rd, when the jueteng allegations were the focus of attention, the Social Weather Stations polling agency recorded its lowest satisfaction rating for any president since it began its surveys in 1986. The president received a rating of minus 33%!calculated by subtracting from

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the 26% of those surveyed who supported her the 59% who opposed her. Other factors have also recently eroded popular support for an administration that is perceived by many Filipinos to be heedless of the plight of the poor. These include an increase in consumer price inflation well in excess of the recent modest rise in the minimum wage, and the scheduled increases in value-added tax coverage and rates. The opposition is currently handicapped by the absence of an agreed and recognised figurehead (although Mr Estrada would be willing to assume the mantle of the deceased Mr Poe), and there does not seem to be a mass popular movement ready to go on to the streets to demand Ms Macapagal Arroyo’s impeachment or resignation. However, this situation will not necessarily hold.

Nervousness persists about a Recent events bear out the dire picture of political life portrayed in assessments possible violent challenge by international institutions. The World Bank recently published a study on the quality of governance in 209 countries, which gave the Philippines a low score and one that deteriorated in the period covered (1996-2004). The six areas covered were: respect for political, human and civil rights; political instability and violence; government effectiveness (the competence of the bureaucracy and the quality of public-sector delivery); the quality of regulation; the rule of law; and control of corruption (defined as the exercise of public power for private gain). In each of these categories, the Philippines’ score fell between 1996 and 2004. The country scored worst, on a scale of -2.5 to 2.5, for political instability and violence, at -1.01 in 2004, compared with -0.12 eight years earlier. Its next worst score was for corruption, with a score of -0.85, compared with -0.40 previously. There was an even more marked deterioration in the score for the rule of law, which fell from -0.11 to -0.62. Meanwhile, the US-based Committee to Protect Journalists rates the Philippines as the most dangerous country in the world for journalists. Since the beginning of this year there have been nine recorded murder attempts against journalists, five of them fatal. This compares with the 13 deaths in 2003-04 recorded by the group. The killing of journalists (for which no-one has yet been convicted) is frequently attributed to influential local people, whether civilians or members of the military, whose alleged crimes have been exposed or are threatened with exposure in the media. A report in April by the International Federation of Journalists pointed to “the tolerance of a culture of violence involving senior government officials”. One of this year’s assassinations was that of Marlene Esperat, a journalist who had accused the former agriculture secretary, Arthur Yap, and two under-secretaries in his department of corruption. Meanwhile, the killing of left-wing and human-rights activists is popularly attributed to the security forces. As of March, 14 members or supporters of Bayan Muna, a left- wing party represented in Congress, had been assassinated in 2005, with many of the deaths occurring in the Eastern Visayas, where in May a prominent radical pastor was also murdered. The thinking behind official violence against civilians was exemplified in a briefing, revealed in April, by the armed forces intelligence service, which listed the Catholic Bishops’ Conference and the National Union of Journalists of the Philippines as being among the “enemies of the state”. Left-wing activists are routinely branded as members of the New People’s Army, the communist guerrilla movement active in the Philippines.

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Progress towards peace in A long-delayed round of peace talks was held in Malaysia on April 18th-20th Mindanao remains vulnerable between representatives of the government and the Moro Islamic Liberation Front (MILF, the mainstream Muslim autonomy movement in Mindanao). Described as exploratory and technical in nature, the talks were intended to prepare the ground for a formal peace conference later this year. Some progress was apparently made, with consensus reached on the geographical area covered by “ancestral domain”, that is, the Muslim ancestral homeland in Mindanao. However, the issue of how this area should be governed was not settled, and it was agreed that a further round of technical talks would be required. The environment for negotiations was greatly improved when the MILF announced in early June that it would help to hunt down 53 Islamic militants identified by the government, following its own verification of the list. MILF units will either operate on their own to arrest those named, or will team up with government forces. This is a significant step forward in implementing the co-operation between the two sides in tracking down criminal elements that was agreed in the August 2001 ceasefire. However, major uncertainties remain. The MILF needs to sell the deal to its own constituency. To this end, it held a three-day general convention at the end of May, the Bangsamoro People’s General Assembly, which US and Japanese representatives and members of the Organisation of the Islamic Conference (OIC), among others, were invited to attend. The MILF leadership received the endorsement that it sought, when 45 Muslim provincial and city leaders affirmed its mandate to negotiate a peace settlement. It is vital that the MILF retain the backing of the local Muslim population, which has suffered decades of fighting, a large-scale military presence and well-attested human rights abuses by the security forces, against the competing claims of more radical Islamist groups, such as the Abu Sayyaf kidnapping outfit or Jemaah Islamiah (JI), a regional terrorist group that is believed to be linked to the al-Qaida international terrorist network. The MILF leadership also needs to get a better deal from the government than the one that the other mainstream Muslim autonomy movement, the Moro National Liberation Front (MNLF), secured in 1996. That agreement provided for the setting up of the Autonomous Region of Muslim Mindanao, covering the four provinces that voted for inclusion in it. But nine years of peace have not brought the economic development that the local Muslim community hoped for, and the region remains the poorest in the country. Leaders of the MILF have indicated that they will not accept a 1996- style autonomy deal. The government, for its part, will not concede independence!the traditional goal of the Muslim rebel movements. A work- able formula could, however, be devised within a federal structure, once this has been introduced through a revision of the constitution. The Philippine Congress will begin discussions on constitutional reform in August, but speedy progress is highly unlikely. It is also vital to the peace process that the MILF is not branded a “foreign terrorist organisation” by the US on the grounds that it is harbouring Abu Sayyaf and JI members. Comments in April by the chargé d’affaires at the US embassy, Joseph Mussomeli, to the effect that individuals and factions within the MILF had links with local and foreign militant groups, and that an “Afghanistan-style” situation could develop in Mindanao, were immediately

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rebuffed as “hyperbole” by the Philippines government. A formal note was presented, declaring Mr Mussomeli’s statement “grossly inaccurate, unfair and prejudicial” to the efforts of the government to bring peace to Mindanao. The issue flared up again a month later, when the outgoing US ambassador, Francis Ricciardone, said that leaders of the MILF had been placed under surveillance for possible inclusion in the US list of terrorists, and that the city of Cotabato in Mindanao was becoming a “doorway” for terrorist activities. There is in fact no disagreement between the US and the Philippine government on the presence of al-Qaida-linked militants in Mindanao and the need to secure a firmly based, enduring peace settlement. But the Philippine government is more sensitive to the political fallout that would result from labelling as terrorists the leadership of a mass-based Muslim autonomy movement.

Economic policy

The VAT bill is threatened On May 24th 2005 the Philippine president, Gloria Macapagal Arroyo, signed into law the Expanded Value-Added Tax (VAT) bill. The law provides for the removal of 11 VAT exemptions from July 1st, and for an increase in the rate of VAT from 10% to 12% and a rise in the corporate income tax rate from 32% to 35% from the beginning of 2006. However, the act has since been threatened by a Supreme Court decision on July 1st to stay its implementation pending a ruling on its constitutionality. The measure was expected by the Department of Finance to raise tax revenue by P27bn-31bn (US$490m-564m) this year and by P97bn-105bn in 2006. Implementation of the act would thus meet the target specified in the package of revenue-raising measures that the then newly elected president proposed to Congress (the legislature) in July 2004. Hailed as a fiscal and political milestone, the enactment of the measure was quickly followed by an upgrade in the outlook accorded to the country’s foreign- and local-currency ratings by a UK credit-rating agency, Fitch. A failure to re-implement the act would considerably dampen the outlook for the public finances once more. The act as it stands differs significantly from the original proposal, which was for a simple 2-percentage-point increase in the rate of VAT. In the course of discussions in Congress, proposals emerged from the finance department for the removal of seven of the 27 VAT exemptions. The House of Representatives (the lower house) proved amenable, applying the 2-point increase, removing five exemptions and imposing graduated VAT rates on power and petroleum products, both of which had previously been accorded zero-rate VAT status. The Senate (the upper house), however, refused to accept the blanket increase, arguing instead for the removal of a larger number of exemptions and an increase in the corporate income tax rate to 35% for a period of three years. The bicameral committee seeking to reconcile the two versions of the bill met in April and May, with most senators refusing to be identified with a tax increase that would hit the whole population, and which would jeopardise their hopes of re-election in 2007 or even election to the presidency in 2010. (By tradition, presidential candidates are mainly drawn from the membership of the Senate.) The deadlock was finally broken when the committee agreed to authorise the president to vary the rate of VAT to 12% from the beginning of 2006 under

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either of two conditions. As one of these is that the budget deficit should exceed 1.5% of GDP, this requirement will be easily satisfied. The other condition is that VAT collections in the preceding year should account for at least 2.8% of VAT, a provision designed to force the administration to do its part by improving collection rates. The final version of the measure is thus close to the proposal of the Senate, with a slight softening on corporation tax, as the corporate income tax rate is to be reduced to 30% from January 2009. In a recognition of the unpopularity of a VAT amendment that will raise energy prices (by removing the VAT exemption from electricity, petroleum products and natural gas), the measure has removed the excise tax on petroleum products and natural gas and has ended the franchise tax on power utilities. After the VAT bill was enacted, the Department of Energy recommended that the import duty on petroleum products, which was raised to 5% at the beginning of this year, should revert to 3%.

ThePublic-sector budget-balancing debt keepsschedule on Assuming that the VAT act is brought back into force and that the president is could be shortenedrising willing to bear the political cost of decreeing an increase in the VAT rate in January, the new law represents a major step forwards in the government’s tax- enhancement agenda and should speed up the pace of the reduction in the government’s fiscal deficit. The government has said that the additional revenue raised in 2005 should bring the budget deficit down to P151bn (US$2.8bn) this year, well below the target of P180bn. The expansion in VAT rates and coverage and the higher corporation tax are forecast by the government to yield a total of up to P105bn in 2006, P123bn in 2007, P141bn in 2008, P164bn in 2009 and P190bn in 2010. Not all of the extra revenue will be used to reduce the budget deficit, but the bulk is intended for this purpose, on a sliding scale. In 2005 all the additional proceeds will be retained, while in 2006, 70% will be used for deficit reduction, with the rest going to fund additional spending. The proportion of additional revenue put towards deficit reduction will then fall by 5 percentage points each year, reaching 50% in 2010. This would allow the budget to be balanced by 2008, two years ahead of schedule. However, given the government’s poor record in VAT collection, which has recently run at around 70% of revenue owing, the actual take from the VAT increase could be well below the figures cited. Government figures appear to assume a collection rate still well short of 100%, although better than 70%. The government seems to be pinning high hopes on the removal of exemptions in improving the audit trail, and hence compliance, and also on changes in the requirements for recording VAT liability. The country’s creditors will be watching closely how effectively the government utilises its enhanced taxation capacity, as well as how the additional revenue is used.

Constitutional debate may The prospects for progress on the remaining items of the revenue-raising push aside other tax proposals agenda set out by the president in July last year are uncertain. The pressure has eased now that the VAT bill has been enacted, since it could provide all the additional P80bn a year that the administration said in 2004 was essential to stave off a fiscal crisis a few years down the line. The four measures in the president’s original fiscal reform package still to be passed by Congress are: the reimposition of the franchise tax on telecommunications companies; a switch

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from a net to a gross income taxation system; a tax amnesty; and the rationalisation of fiscal incentives to investment. One other proposal!to increase the excise tax on petroleum products!has been superseded by the ending of zero-rated VAT under the recently passed law. The telecoms franchise tax proposal is likely to be replaced by one for a tax on text messages, but discussion of this is still at an early stage, and Congress has yet to consider the gross income tax proposal. The lower house has approved the terms of a tax amnesty and the rationalisation of fiscal incentives. The amnesty measure has been opposed in the Senate (and by the IMF in discussions with the government) and seems now to be in abeyance, but the rationalisation of investment incentives has been identified by Cesar Purisima, the minister of finance, as the priority measure for enactment. However, there is a danger that the rest of the tax enhancement programme, and any new initiatives in this area, will fall victim to the planned revision of the constitution. The president declared in early June that she would bring proposals before the 2005/06 session of Congress (which formally opens in late July) for an election to be held in 2006 for a constitutional convention, which would consider a switch to a parliamentary system of government and a federal state. The government will also be seeking to loosen or eliminate the constitution’s restrictions on foreign participation in the Philippine economy. Ms Macapagal Arroyo’s statement ended the moratorium on debating the issue of constitutional change that was agreed late last year in order to create space for the tax agenda. At that time the two houses of Congress had reached a de facto consensus on the desirability of taking the constitutional convention route rather than transforming Congress into a single-chamber constituent assembly to revise the constitution. The two houses will now return to this issue with some gusto. Revision of the constitution along the lines favoured by the administration is highly contentious: a parliamentary system would remove the single-term limit on the presidency (which could entrench the incumbent), and any weakening of the constitution’s economic restrictions would reduce the protection afforded to domestic interests.

The 2005 budget has been kept The budget deficit was held well below target in the first quarter of this year, at on schedule so far P63.5bn compared with the scheduled P77.8bn. This mainly reflected higher than expected revenue receipts (P9.3bn above the forecast level, at P172.6bn) as a marginal shortfall at the two tax agencies, the Bureau of Internal Revenue (BOI) and the Bureau of Customs (BOC), was more than offset by extra proceeds at the Bureau of Treasury. Tight control of spending, which was P4bn below schedule, also made a contribution. The budget remained under control in April, when the seasonal surge in income tax payments reduced the deficit for the first four months of the year to P60.1bn. The budget surplus of P3.3bn recorded in April was the first monthly budget surplus since April 2001. In May a budget deficit of P7.6bn was recorded, bringing the five-month total to P67.8bn. This represents a 12.4% fall compared with the budget deficit of P77.4bn recorded in the year-earlier period. Revenue collection will receive a boost if the Supreme Court agrees to lift its temporary restraining order on the implementation of the VAT act.

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Budget (P bn) 2005 % change, 2004 Jan-Mar year on yeara Revenue 698.3 172.6 13.1 Bureau of Internal Revenue 469.6 110.9 10.2 Expenditure 884.4 236.1 12.7 Balance -186.1 -63.5 – a January-March 2005 compared with year-earlier period.

Source: Department of Budget and Management.

Government budget outturn (P bn)

Revenue Expenditure Balance 100 80 60 40 20 0 -20 -40 -60 -80 -100 Jun JulAug Sep Oct Nov Dec Jan FebMar Apr May Jun Jul Aug Sep Oct Nov Dec Jan FebMar Apr May 2003 04 05 Source: National Statistics Office.

The four-day week is Throughout April and May this year government employees other than those abandoned working in agencies considered to provide essential services (namely the security forces, revenue agencies, hospitals, schools and universities) were put on a four-day week in order to reduce the government’s energy consumption. The cut, facilitated by lengthening the working day, was expected by the government to produce savings of P144m (US$2.6m) on its oil and utility expenses over the two-month period. An extension of the programme was being considered for June. However, in late May the initiative was abandoned, as work productivity was found to have gone down.

Liquidity growth holds down In the first quarter of 2005 the pace of growth in domestic liquidity continued domestic interest rates the acceleration seen in the final months of 2004. M3, the broadest measure of money supply, rose by 9.2% year on year at the end of 2004, by 11.5% in at end- January, by 12% at end-February and by 12.1% at end-March. This acceleration was explained by the increase in the foreign-exchange holdings of the banking sector, as inflows of remittances and portfolio investment surged during a period of peso appreciation. Domestic credit growth meanwhile faltered. Contrary to the trend in nearly every month of 2004, the year-on-year rise in public-sector credit slackened from 16.7% at end-December to 6.7% at end-March. Growth in private-sector credit picked up modestly in January and February, from 3.6% at end-2004, but was down to 2.2% by March. The sluggishness in credit demand has been a factor allowing the Bangko Sentral ng Pilipinas (BSP, the central bank) to limit further interest-rate increases.

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The increase in the central bank’s interest rates on April 7th!when the official overnight borrowing and lending rates were raised by 25 basis points to 7% and 9.25% respectively!had been widely expected, given the rise in US interest rates and the pick-up in local consumer price inflation. Its impact on benchmark short-term interest rates, such as short-term Treasury bill rates, was therefore limited. At the first auction after the increase, the yield on the 91-day T-bill rose by only 9 basis points, to 6.69%. The rate then fell at each subsequent weekly auction, reaching 5.69% on June 6th. Nervousness about the political situation then prompted a marginal rise to 5.78% a week later and 5.88% on June 20th. This softening of Philippine T-bill yields in the second quarter occurred while year-on-year consumer price inflation was a sustained 8.5%!a high rate by the standards of recent years. In addition, for most of the period the bill to increase the rate and scope of value-added tax (VAT), which held out the prospect of a faster reduction in the government’s borrowing requirement, was stalled in Congress. These pressures, which might have been expected to push up interest rates, were more than offset by the impact of considerable excess liquidity at the commercial banks.

The government decides not to For some years one of the items on the government’s asset disposal list has sell a stake in Malampaya been a 4.9% tranche!part of the 10% equity held by the Philippine National Oil Company-Exploration Corporation (PNOC-EC)!in the US$4.5bn Malampaya natural gas project. Its sale to a South Korean consortium including LG Group was approved by the government in late March this year. However, the transfer had to wait until PNOC-EC’s partners!ChevronTexaco (US) and Shell Philippines Exploration (the local unit of the Netherlands-based Royal Dutch/Shell)!had decided whether to exercise their options to make matching offers. Both indicated in April that they would do so. However, government expectations of the return from the sale have been pushed up by the rise in world oil prices. It consequently decided to hold on to the asset, in the hope of receiving a higher price at a later date. At the time of the South Korean bid, observers valued the equity at US$200m.

The domestic economy

Economic trends

Economic growth slows The pace of year-on-year GDP growth slackened to 4.6% in the first three months of 2005. This was the third successive quarter of deceleration, the lowest year-on-year rate of increase since the final quarter of 2003, and below the bottom end of the government’s target range for GDP growth of 5.3-6.3% in 2005 as a whole. GNP growth also slackened in January-March!and by a similar margin!as the pace of the year-on-year increase in net factor income (dominated by inflows from the overseas Filipino community) eased.

Gross domestic product and gross national product (% change, year on year; constant 1985 prices) 2004 2005 1 Qtr 2 Qtr 3 Qtr 4 Qtr Year 1 Qtr GDP 6.4 6.4 6.3 5.4 6.1 4.6 Net factor income 7.0 18.7 -1.0 8.7 8.5 6.7 GNP 6.4 7.3 5.7 5.6 6.2 4.7

Source: National Statistical Co-ordination Board, National Accounts of the Philippines.

Gross national product (real growth rates; % change, year on year) 35 GDP 30 Net factor income from abroad 25 Gross national product 20 15 10 5 0 -5 -10 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 2003 04 05 Sources: Economist Intelligence Unit; National Statistics Office.

The slowdown in economic growth in the first three months of the year partly reflected the poor performance of the agricultural sector for the second quarter in succession. This owed something to the continuing impact of the unusually severe typhoons in eastern Luzon, one of the largest islands in the country, in November and early December 2004, but was mainly the consequence of the dry conditions associated with the El Niño weather phenomenon, which hit both rice and maize production. It was the performance of these two staples that boosted agricultural output in 2004, contributing to unusually rapid growth in GDP. The stagnation in the first quarter of this year!agricultural and fisheries output rose by 0.2% year on year, whereas that of forestry, a minor sector, was down by 40.7%!likewise constrained overall growth, and agricultural performance is expected to have depressed growth in the second quarter too. The overall slowdown in January-March also owed much to the slackening in industrial growth after the unusually strong performance recorded in the final quarter of 2004. The latter was the result of a surge in manufacturing, reflecting high export demand for Philippine electronic goods and an acceleration in construction. While the recovery in construction slowed marginally in the first quarter, manufacturing expansion eased back to the modest pace of the first nine months of 2004 as growth in electronics exports flagged.

Gross domestic product by origin (% real change, year on year; constant 1985 prices) 2003 2004 2005 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Agriculture, fisheries & forestry -3.8 8.6 3.7 7.8 1.4 -0.1 Industry 2.7 4.7 5.3 3.6 7.2 4.2 Manufacturing 3.2 3.9 4.8 4.2 7.4 4.2 Construction -2.1 1.7 10.6 7.0 9.2 7.9 Services 6.2 6.6 8.1 7.8 5.9 6.9 Trade 6.2 7.1 6.7 7.8 5.8 6.1 GDP 2.8 6.4 6.4 6.3 5.4 4.6

Source: National Statistical Co-ordination Board, National Accounts of the Philippines.

Domestic demand growth The year-on-year growth in domestic demand, which had risen in the two weakens preceding quarters, eased sharply in the first three months of this year. This partly reflected slightly slower growth in private consumption spending, in response to the higher inflation that set in during the final quarter of 2004 and the impact on farm incomes of the sluggishness in agriculture. But, at 5% year on year, growth in private consumption once again exceeded the increase in overall GDP and was responsible for the bulk of year-on-year economic growth. Capital formation, however, which had contributed 3.1 percentage points to GDP growth in the final quarter of 2004, contracted by 4.1% year on year in January-March, depressing the rate of GDP growth by 1 percentage point. The deterioration was largely the result of the 7.5% year-on-year fall in spending on durable equipment and a lower build-up in inventories, probably owing to the rise in fuel costs. The slackening in the pace of domestic demand growth was exceeded by the fall in the growth of external demand for goods and services. Export growth fell to only 3.1% after four successive quarters of double-digit growth, with the volume of merchandise exports rising by only 3.2% year on year. However, the fall in import volumes, which reflected the slowdown in investment and less buoyant demand for electronics inputs, meant that the deficit on net trade narrowed in the first quarter of this year, contributing 3.7 percentage points to overall GDP growth.

Expenditure on gross domestic product (% change, year on year; constant 1985 prices) 2003 2004 2005 4 Qtr 1 Qtr 2 Qtr 3 Qtr 4 Qtr 1 Qtr Private consumption 5.5 5.7 6.3 5.5 5.7 5.0 Government consumption 5.2 4.1 -1.2 -7.2 5.6 -0.9 Capital formation incl stocks -9.8 7.7 3.6 10.4 16.5 -4.1 Fixed capital investment -0.5 5.0 4.0 3.6 4.3 -2.4 Domestic demand 2.3 6.1 5.3 5.4 7.6 2.6 Exports of goods & services 9.8 11.6 16.1 17.1 11.2 3.1 Imports of goods & services 9.7 4.5 6.8 6.6 5.8 -4.0 GDP (incl statistical discrepancy) 2.8 6.4 6.4 6.3 5.4 4.6

Source: National Statistical Co-ordination Board, National Accounts of the Philippines.

is co Energy prices keep inflation Year-on-year consumer price inflation continued at the high rate seen in the above target first quarter of this year in both April and May, to average 8.5% over the first five months of the year. This is well above the official inflation forecast for 2005, which the Bangko Sentral ng Pilipinas (BSP, the central bank) has now raised on four occasions this year, from 5-6% at the beginning of the year to 7.9% in mid-June. The recent rise in oil prices has been the root cause of the doubling of the inflation rate over the past 12 months. This prompted increases in public transport fares (in mid-2004) and in electricity tariffs (in June and September last year). The upward pressure continued throughout the first five months of this year, with the average price of Dubai crude oil (the benchmark used for government economic planning) reaching US$47.2/barrel in April!up by 49% compared with the year-earlier figure. A further ratcheting up in inflation was expected after the National Power Corporation (Napocor, the state-owned power utility) was granted permission in April to increase its rates by an average of 10.2%. In addition, an increase in public transport fares, including a 36% rise in the minimum fare on jeepneys (small buses) in the capital, was approved in early May. Because of this increase the government froze proposed fare rises for commuter rail services in the capital, Manila, increasing its subsidies to the Light Rail Transit Authority (a government corporation) and the cover provided to Metro Rail Transport (a build-operate- transfer, or BOT, project, whose losses are covered by a government guarantee). The rise in public transport fares was delayed following protests from passenger groups, but was finally implemented on June 21st.

Consumer prices, 2005 (base year 2000; % change, year on year) Jan Feb Mar Apr May Food, beverages & tobacco 7.4 7.6 7.2 7.0 6.9 Fuel, light & water 20.1 18.7 18.3 19.7 20.1 Consumer prices 8.4 8.5 8.5 8.5 8.5

Source: National Statistics Office.

The pace of consumer price inflation could ease in the second half of this year. The appreciation of the peso against the US dollar in the first months of 2005 acted as a modest counterweight to higher oil prices, and the expectation is that the currency, which has more recently fallen in value in response to political concerns, will regain ground at the same time as oil prices soften slightly. Already in May the Dubai oil price was falling, averaging US$45.39/b in the month (a fall of 4% compared with April), which prompted a slight reduction in local petroleum products prices in June. However, two uncertainties remain: wages rises and the impact on inflation of the ending of some value-added tax (VAT) exemptions under legislation approved in May. The two major union confederations, the Trade Union Congress of the Philippines (TUCP) and the more radical Kilusang Mayo Uno (May 1st Movement), petitioned for increases in the minimum daily wage in May. The former sought an increase of P78 (US$1.40) in the Metropolitan Manila minimum wage of P300, while the latter demanded P125. These rises were far ahead of the BSP’s earlier assumption of a 6% (P18 per day) increase this year and its recent estimate of a 10% rise, and

there was no likelihood that the unions’ demands would be met by the regional wage boards that set the minimum wage. As of mid-June the National Capital Region Wages and Productivity Board had agreed to an increase of P25 (a rise of 8.3%), whereas other regions had permitted increases in the cost-of-living allowance (a measure that excludes overtime and bonuses) in the range of P11-P20. None of these increases matches the current rate of consumer price inflation, but they will push up production costs in those sectors where the minimum wage applies. Meanwhile, the impact of the changes to VAT!which were not factored into the BSP’s inflation forecast for 2005 until the most recent estimate!will be minimal this year, arising from the impact on energy prices of the lifting of exemptions. The Department of Trade and Industry forecasts the consequent increase in consumer prices at “below 1%”. It is not clear whether this estimate took into account all the reductions in taxes and levies, but the forecast by the National Economic and Development Authority (NEDA, the government’s planning agency) was for a surge in inflation to 9.7% in August, after which the rate is forecast to ease back down. This would produce full-year inflation well above the BSP’s latest estimate; the Economist Intelligence Unit forecasts average inflation of 8.2% in 2005. The slackening in the final months of 2005 may prove temporary, since the increase to a 12% rate of VAT from January 2006 is forecast by the government to produce a rise of 1.6-1.8 percentage points in the rate of inflation.

The peso falls back in response The peso maintained its trend of modest appreciation against the US dollar into to political jitters the second quarter of this year, averaging P54.49:US$1 in April and P54.34:US$1 in May compared with P55.01:US$1 in the first quarter. However, the currency fell back to trade at P55.62 on June 22nd. Opposing pressures on the peso have been in evidence this year. The currency was lifted in early April by the increase in central bank interest rates, while the government’s success in holding the fiscal deficit to target in the first quarter and the prospect of a speeding up in deficit reduction after congressional approval of the VAT bill were positive forces in May. The surge in portfolio investment inflows in the first five months of the year and the sustained rise in remittances from overseas workers also gave strong support to the currency. By end-May net portfolio inflows had reached US$1.8bn, compared with US$99m in the first five months of 2004. Portfolio investment was stimulated earlier in the year by the appreciation of the peso and a number of stock offerings by major Philippine companies (namely the water distribution company, Manila Water, and the local retail and commercial services company, SM Investments). On the negative side, export revenue was recording year-on-year declines in February-March, and further increases in the large stock of public-sector debt have generated concerns about the stability of the peso. Finally, political turmoil in June dented confidence in the currency, which has now lost most of the gains that it made early in 2005.

Exchange rate, 2005 (P:US$; published daily rates; inverted scale) 53.8 54.0 54.2 54.4 54.6 54.8 55.0 55.2 55.4 55.6 55.8 56.0 1 Apr 8 Apr 15 Apr 22 Apr 29 Apr 6 May 13 May 20 May 27 May 3 Jun 10 Jun 17 Jun 24 Jun Source: Bangko Sentral ng Pilipinas.

Investment approvals Foreign direct investment registered by the central bank over the first three plummet months of 2005 was down year on year by almost three-quarters, at US$94m. Investment approvals by the Board of Investments (BOI) fell by 21.4% in January-May 2005, to P90.7bn. However, the government said that year-on-year comparisons were being skewed by a large investment in 2004, when P96.6bn was invested by a Nauru-based company in a power plant The government prefers to highlight an increase to 77 in the number of new projects approved, from 63 in January-May 2004. (The government’s target for investment approvals by the BOA and the Philippine Economic Zone Authority is a combined P230bn this year.)

Sectoral trends

Agriculture gets off to a The impact of the El Niño weather pattern, which produces dry conditions, was weak start already evident in the final quarter of 2004, when year-on-year agricultural growth in national-accounts terms slumped to only 1.4% from an average of 6.7% in the preceding three quarters. The weakness persisted through the first three months of this year, when real output in agriculture and fisheries rose by only 0.1% compared with the same period of 2004. This was almost wholly owing to a decline in the output of rice, which fell by 1.5% year on year, and maize, which was down by 18.4%. The much worse results for maize reflected the more severe dry conditions in Mindanao, which is a significant producing area. In April a state of calamity was declared in two provinces in Mindanao!North and South Cotabato. The consequent 3.6% year-on-year fall in national crop production was largely offset by continuing strength in fisheries output (which was up by 5.9%) and increases of 2.4% and 7.5% respectively in livestock and poultry output. The expectation is that crop results will have continued to be weak through the second quarter but will improve in the second half of the year, when the relatively mild El Niño ceases to have an impact (other than a lagged one in the case of coconut production).

The manufacturing sector After a pick-up in the final quarter of 2004, manufacturing performance lost loses momentum momentum in the first three months of this year. The volume of output, as measured in the monthly survey by the National Statistics Office (NSO) of 500- 550 enterprises in 20 sectors, was up by an average of only 1.7% year on year in the quarter, compared with 7.6% in October-December 2004. Performance again varied widely between the leading sectors, with food manufacturing (by far the largest) continuing to contract. Electrical machinery moved from strong growth to decline (reflecting external demand trends), whereas footwear and clothing did rather better than expected. Another export-oriented sector!transport equipment!posted strong growth, well above the rates recorded in 2004.

Manufacturing production, 2005a (% change, year on year; volume) Jan Feb Mar Food -5.4 0.2 -4.1 Electrical machinery 11.0 3.0 -8.9 Footwear & clothing 15.2 19.2 1.0 Transport equipment -5.4 43.1 63.0 All sectors 0.7 1.6 2.7 a Measured by monthly surveys of 500-550 enterprises; subject to continual revision. Source: National Statistics Office.

Banks’ portfolios improve The quality of commercial banks’ asset portfolios has continued to improve, modestly albeit at a slow pace. At end-March the non-performing loan ratio was down to 11.3% from 12.7% at the end of 2004, and banks’ property holdings as a percentage of total assets were down to 5.1% from 5.6% at end-2004. However, this still leaves a deadweight of non-performing assets that undermine banks’ profitability, underlining the need for an extension of the Special Purpose Vehicle Act that provided incentives for the transfer of these liabilities!the act expired in April this year. The central bank estimates that the two-year extension approved by the House of Representatives (the lower house) would generate P100bn (US$1.8bn) in disposals. This is nearly double the P52bn transferred during the original two-year duration of the act, and therefore assumes a much more vigorous take-up by the commercial banks (with a greater readiness to accept steep discounts). The BSP expects most of this to be in the form of foreclosed real estate. Sales at this level would bring the ratio of non-performing assets to total assets down to single digits, but the ratio would remain above the level seen before the 1997-98 regional financial crisis.

Water utility rehabilitation is At the beginning of June a regional court approved a financial rescue plan for imminent Maynilad, the water utility serving the western half of Metropolitan Manila. This comes more than a year after Maynilad and its creditors came together to hammer out a deal to save the utility from liquidation. The plan provides for a seven-year extension of Maynilad’s P10bn debt to foreign and commercial banks and the conversion of its P8bn debt (from unpaid concession fees) to the state-run Metropolitan Waterworks & Sewerage System (MWSS) into 84% equity. The residual 16% equity will be controlled by Ondeo Philippines, the French minority partner in the utility. Ondeo will write off 13% of equity and

Benpres, the local majority 59% shareholder, will write off all of its P3.06bn equity as well as P621m (US$11m) in advances. The financial restructuring will pave the way for MWSS to sell off its equity. A number of investors have already expressed interest in taking over the utility; they include Manila Water, which holds the franchise for the eastern half of Metropolitan Manila. Their interest in taking over what was a loss-making operation stems from the expectation that the government regulator will allow an increase in water rates and that MWSS will have secured US$30m from the World Bank for investment in the utility. This will tackle two major causes of Maynilad’s failure: delays in introducing water rate increases and inadequate investment, which meant that the utility lost two-thirds of its output through leaks and theft.

Foreign trade and payments

External trade disappoints as The Philippines’ overall foreign trade (customs basis) contracted in the first electronics sales slow quarter of this year, when export receipts rose by only 3.6% year on year to US$9.5bn, while import spending fell by 3.6% to US$9.4bn. Reflecting these divergent trends, the merchandise trade balance registered a modest surplus of US$122m in the quarter, compared with a deficit of US$559m in the year-earlier period. The external sector is thus exhibiting a much weaker performance than in 2004, when according to customs data exports rose by 9.3% and imports grew by 7.5%. Export revenue did, however, begin to grow faster in April, rising by 8.8% year on year and bringing the year-to-date increase to 4.4%!around one-half of the official forecast for export growth this year. Imports also picked up, growing by 6.5% year on year in April.

Foreign trade (US$ m unless otherwise indicated; % change year on year in brackets) 2004 2005 Jul-Sep Oct-Dec Jan Feb Mar Apr Exports 10,158 10,706 3,282 2,982 3,256 3,229 (8.4) (11.5) (15.4) (-0.6) (-2.8) (8.8) Imports 10,293 10,070 3,112 2,850 3,435 3,680 (9.7) (6.0) (-2.1) (-4.8) (-4.0) (6.5) Balance -135 637 170 132 -179 -451

Source: National Statistics Office.

Trends in sales of electronic goods continue to determine the overall pace of export growth. Thus the 12.8% year-on-year rise in electronics exports in January pushed total export growth to 15.4%, and year-on-year declines of 0.9% in February and 3.7% in March were reflected in the fall in total exports in those months, while the 6.3% increase in electronics sales in April underpinned that month’s 8.8% growth in overall revenue. Within the electronics category, semiconductor exports improved on the growth recorded in 2004, with the year-on-year rate of increase picking up to 13.3% in January-April, from full-year growth of 9.6% in 2004. However, exports of the second most important component, electronic data-processing equipment, were down by 19.2% year on year in the first four months of this year, holding down the total increase in

electronics earnings in January-April to 3.3%. Electronics sales are likely to have remained generally weak throughout the second quarter of 2005, owing to high inventory levels. Overseas sales of garments were flat in year-on-year terms in January-April at US$659.1m, with the surge recorded in January being offset by declines in each succeeding month. This fall is in line with predictions of the impact on clothing exports of the removal of global quotas on textile trade from January 1st 2005, which has exposed the Philippine industry to competition in its major markets from suppliers in China. The only strong performance among leading exports in the first four months was by ignition wiring sets, sales of which were up by 28.2% year on year to US$235m, and copper cathodes, exports of which rose by 31.9% to US$139m. Agricultural exports were mixed, but earnings from coconut oil were up by 15.2% to US$200m in January-April. The overall export picture is one of slow growth, with little prospect of a sustained marked recovery in the short term. The latest forecast by the Bangko Sentral ng Pilipinas (BSP, the central bank) of 8% export growth this year!down from its earlier figure of 10%!still looks optimistic.

Leading exports, Jan-Apr (US$ m unless otherwise indicated) % change, 2004 2005 year on year Electronic products 8,118 8,385 3.3 Semiconductors 5,444 6,168 13.3 Garments 659 659 0.0 Total incl others 12,162 12,749 4.8

Source: National Statistics Office.

Imports decline in The year-on-year decline in imports that began in December 2004 deepened in January-April subsequent months, reaching a trough of 4.8% in February 2005. At a period of higher oil prices, which pushed up spending on fuel imports by 26.2% in the first quarter, this decline reflected lower demand for electronic components as external demand for Philippine products weakened. Spending on capital goods continued to decline, with imports down on a year-on-year basis in every month since November 2004. Spending on consumer goods remained above year-earlier levels, but the rate of growth eased back sharply in January-March from the 24.5% year-on-year rise recorded in the final quarter of 2004. Imports rose by 6.5% year on year in April, but the cumulative total for January-April was nevertheless down by around 1% year on year. A full breakdown of April imports is not yet available.

Imports by major categories, Jan-Mar (US$ m unless otherwise indicated) % change 2004 2005 year on year Capital goods 3,874 3,468 -10.0 Raw materials & intermediate goods 3,778 3,593 -4.9 Mineral fuels & lubricants 1,038 1,310 26.2 Consumer goods 663 801 20.8 Total incl others 9,752 9,398 -3.7 Electronic products 4,542 4,003 -11.9

Source: National Statistics Office.

External trade (US-dollar value; % change, year on year) 20 18 Exports 16 Imports 14 12 10 8 6 4 2 0 -2 -4 -6 May Jun Jul Aug Sep Oct Nov Dec Jan Feb Mar Apr 2004 05 Source: National Statistics Office.

The balance of payments is in Comprehensive payments data are not yet available for the early part of this surplus year, but the overall balance for the year so far was in surplus to the tune of US$887m at the end of April. This reflected, on the current account, a likely modest surplus on merchandise trade and strong inflows of workers’ remittances, which rose by 17.2% year on year in January-April to total US$3.1bn. The capital account will also have been supported in the first half of the year by both the government’s global bond issues of US$1.5bn in January and US$750m in May and a surge in net inward portfolio investment to US$1.82bn by end-May, according to BSP figures. The higher than expected inflows of remittances and portfolio investment have prompted the BSP to revise up its forecast for the balance of payments this year, from a surplus of US$505m to one of US$852m. The government’s decision to return to the international capital markets in May came earlier than expected, as it sought to take advantage of good budget results and congressional approval of a bill extending value-added tax (VAT). The government therefore took the chance to reopen 10- and 25-year bonds, securing US$750m. The response was strong, with the offer being eight times oversubscribed. This issue brought government global bond sales so far in 2005 to US$2.3bn. International reserves have consequently been rising in recent months, reaching US$17.2bn (including gold) at end-May, up from US$16.1bn at the end of 2004 and sufficient to cover more than five months of imports at the January-March rate.

China moves up the league A significant development in recent years has been the growth in trade with table of economic partners China, which was in fifth place as an export market for Philippine goods in 2004 (at 6.7% of foreign sales) and third as source of imports (at 7.7%). China’s share of Philippine exports rose further in the first four months of this year, when the 77.3% rise in Philippine sales to China, to US$1.1bn, brought its ranking up to a close fourth behind the Netherlands, with a share of 8.9%. China’s greater importance as a trade partner reflects the sustained growth of its economy in recent years. Along with the stimulus from the increase in bilateral trade, Chinese companies are also set to invest in the Philippine mining sector. In April the state visit by China’s president, Hu Jintao, saw the formal signing of 14 loan and investment agreements. These included a US$950m contract with two Chinese state-owned enterprises, Jinchuan Nonferrous Metals and the Shanghai Baosteel group, for the rehabilitation of the Nonoc nickel and cobalt mines in Surigao del Norte, and a US$500m loan for the second phase of the Northrail project, which will extend the railway north of Manila to the Subic Freeport Zone. The Philippines also signed a memorandum of understanding for participation in China’s “early-harvest” programme of tariff concessions. This forms part of the 2002 agreement between China and the Association of South-East Asian Nations (ASEAN), under which a free-trade area is to be established by 2010 between China and the six original members of ASEAN, including the Philippines; free trade between China and less-developed members of ASEAN is scheduled for 2015. In preparation for free trade, the early-harvest programme provides for cuts in tariffs on agricultural products to 0-5%, with the exact coverage to be negotiated with individual ASEAN countries. The Philippines was the only country not to have signed up to the programme by the end of 2003, owing to the fact that the two sides had not agreed on product coverage. The impasse has apparently now been overcome, and tariffs are to be eliminated on around 200 farm commodities from the beginning of 2006. Vegetables have been excluded, to alleviate Philippine concerns. One month earlier the Philippines and China signed a groundbreaking deal for joint petroleum research with Vietnam in a 143,000 sq km area of the South China Sea, including the disputed Spratly Islands area. State oil firms from the three countries will carry out seismic research over a three-year period; no drilling activity is envisaged.