ASIAN DEVELOPMENT BANK RRP: PHI 31655 REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE BOARD OF DIRECTORS ON A PROPOSED LOAN AND TECHNICAL ASSISTANCE GRANT TO THE REPUBLIC OF THE PHILIPPINES FOR THE NONBANK FINANCIAL GOVERNANCE PROGRAM October 2001 CURRENCY EQUIVALENTS (as of 10 October 2001) Currency Unit – Peso (P) P1.00 = $0.02 $1.00 = P51.90 ABBREVIATIONS ADAPS – automated debt auction processing system ADB – Asian Development Bank ASEAN – Association of Southeast Asian Nations BOA – Board of Accountancy BSP – Bangko Sentral ng Pilipinas CMDP – Capital Market Development Program CPA – certified public accountant DOF – Department of Finance DST – documentary stamp tax DVP – delivery-versus-payment FSAP – Financial Sector Assessment Program GDP – gross domestic product GNP – gross national product GSED – Government securities eligible dealers IAS – international accounting standards IMF – International Monetary Fund IOSCO – International Organization of Securities Commissions IPO – initial public offering IRR – implementing rules and regulations LIBOR – London interbank offered rate MIS – management information system NBFI – nonbank financial institution NFG – nonbank financial governance NPL – nonperforming loan PCDI – Philippine Central Depository, Inc. PDIC – Philippine Deposit Insurance Corporation PICPA – Philippine Institute of Certified Public Accountants PNB – Philippine National Bank PRC – Professional Regulation Commission PSE – Philippine Stock Exchange QB – quasi bank RTGS – real time gross settlement SCCP – Securities Clearing Corporation of the Philippines SDR – special drawing rights SEC – Securities and Exchange Commission SRC – Securities Regulation Code SRO – self-regulatory organization TA – technical assistance USAID – United States Agency for International Development NOTE In this report, "$" refers to US dollars. CONTENTS Page LOAN AND PROGRAM SUMMARY ii I. THE PROPOSAL 1 II. INTRODUCTION 1 III. THE MACROECONOMIC CONTEXT 3 A. Government Development Objectives, Strategy, and Plans 3 B. Recent Economic Performance and Prospects 4 IV. THE SECTOR 7 A. Background and Recent Perfromance 7 B. Constraints and Issues 13 C. External Assistance to the Sector and Aid Agency Coordination 19 D. ADB’s Operations and Strategy in the Sector 20 V. THE PROGRAM 21 A. Rationale 21 B. Objective and Scope 22 C. Policy Framework and Actions 22 D. Social and Environmental Issues 28 VI. THE PROPOSED LOAN 29 A. Amount of Loan and Source of Funds 29 B. Interest, Maturity, and Utilization Period 30 C. Implementation Arrangements 30 D. Procurement and Disbursement 30 E. Counterpart Funds 30 F. Monitoring and Tranching 30 VII. THE TECHNICAL ASSISTANCE 31 VIII. PROGRAM BENEFITS AND RISKS 31 A. Benefits 31 B. Risks 32 IX. ASSURANCES 34 X. RECOMMENDATION 34 APPENDIXES 35 LOAN AND PROGRAM SUMMARY Borrower The Republic of the Philippines The Proposal Support to the Government for its Nonbank Financial Governance (NFG) Program through a program loan of $75 million, and technical assistance (TA) of $1 million for Strengthening Regulatory and Market Governance. The Program Rationale The Asian crisis highlighted the risks associated with vulnerable financial structures in a financially integrated world. The buildup of vulnerabilities stemmed from excessive reliance on bank financing, weak corporate and financial regulation, including poor compliance with accounting and auditing standards, and inadequate disclosure of financial information. These developments are inevitable if enforcement and governance at the regulator level are weak. Despite the fact that the Philippines withstood the Asian financial crisis relatively well, its financial and corporate structures continue to make it vulnerable to external shocks. This vulnerability stems from the uneven application of good governance standards and lack of risk diversification in the financial market. Indeed, the Philippines exhibits a very high dependence on bank financing and has not been able to develop sufficient levels of financial intermediation through its nonbank sector. To lay the foundation for a strong and robust financial sector, the Government needs to launch broad-based financial and corporate governance reforms, including (i) strengthening the governance and enforcement capacity of the regulators, Securities and Exchange Commission (SEC) and Bangko Sentral ng Pilipinas (BSP); (ii) modernizing the securities market; (iii) introducing more transparency in market transactions; and (iv) encouraging enforcement of rules and regulations. These reforms are critical to meet the challenges of growing volatility from a weak stock exchange, competitive pressures from technological innovation, as well as globalization and integration of financial markets. Objective and The Program will support the process of capital formation Scope through improved corporate governance in the nonbank financial services sector. The key components of Phase I are (i) enhancing and strengthening the governance of SEC by (a) allowing SEC greater administrative, operational, and financial autonomy; and (b) enhancing monitoring and enforcement capacity; (ii) modernizing the governance and regulatory iii structure of the Philippine Stock Exchange (PSE) by (a) developing arrangements for PSE to strengthen its governance during the transition period, (b) restructuring and demutualizing PSE; (c) enhancing self-regulatory organization (SRO) reporting, and (d) developing arrangements for effective regulation of PSE; (iii) strengthening market oversight, compliance, and enforcement by (a) developing market governance, (b) strengthening prudential regulation of nonbank financial institutions, (c) preventing misconduct and market abuse, and (d) improving financial management and governance by strengthening financial disclosure monitoring; and (iv) facilitating diversification and innovation in corporate financing by (a) developing a policy, regulatory, and taxation framework for the corporate bond market; and (b) enhancing institutional investors’ participation to augment market liquidity. Phase II will consist of policy actions based on the Agenda for Phase II Dialogue. These actions, when agreed between the Government and ADB, may form the basis of future ADB assistance to the Government in the nonbank financial sector. The Agenda for Phase II Dialogue includes the following Core Topics (i) implementing demutualization of PSE; (ii) strengthening market regulation; (iii) strengthening market governance and compliance; and (iv) facilitating diversification and innovation in corporate financing. Classification Economic growth Environmental Category C Assessment The ADB Loan Loan Amount A loan of $75 million from the Asian Development Bank’s and Terms (ADB’s) ordinary capital resources will be provided under ADB’s LIBOR-based lending facility. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB’s LIBOR-based lending facility, a commitment charge of 0.75 percent per annum, a front-end fee of 1.0 percent; and conversion options that may be exercised in accordance with the terms of the draft Loan Agreement, the Loan iv Regulations, and ADB’s Conversion Guidelines; and other terms and conditions set forth in the draft Loan Agreement. The loan closing date is 31 December 2002. Program Period The Phase I of the Program is three years (1998-2001). The loan and Tranching will be released in one tranche, which will be made available upon loan effectiveness. Executing The Department of Finance (DOF) will be the Executing Agency Agency for the NFG Program and SEC will be the Implementing Agency. SEC will set up a coordinating committee headed by the Chairperson of SEC and comprising representatives from Bangko Sentral ng Pilipinas, Bureau of Treasury, DOF, National Economic and Development Authority, PSE, SEC, and the Capital Market Development Council that consists of members from business and industry associations. ADB will also be a member of this committee to oversee progress on Phase II of the reform program. Procurement The loan proceeds will be used to finance the foreign exchange costs of items produced and procured in ADB member countries (other than items specified in the list of ineligible items and imports financed by other bilateral and multilateral sources). The Government will certify that the volume of eligible imports exceeds the amount of ADB’s projected disbursements under the loans for the given period. ADB reserves the right to audit the use of the loan proceeds and verify the accuracy of the Government’s certification. Counterpart The Government will utilize local currency counterpart funds Funds generated by the loan to meet program expenditures and associated costs of reform and to help maintain current levels of social expenditures. The structural adjustment costs for Phase I stem from restructuring SEC, administrative reforms linked to computerization of SRO, monitoring systems in SEC and PSE, and demutualization costs already borne by SEC and PSE. Technical Assistance The advisory TA of $1 million will strengthen market governance by developing (i) an effective SRO framework to address the potential conflicts of interest in PSE’s newly demutualized ownership structure; (ii) SEC capacity to investigate and enforce market rules; (iii) an efficient management information system and staff training in the use of these systems; and (iv) accounting and auditing skills and standards. The TA will be financed from the Asian Currency Crisis