Cablegate: Upbeat Economic News but Underlying Problems

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OO RUEHCHI RUEHDT RUEHHM
DE RUEHML #5050/01 3550333
ZNR UUUUU ZZH
O 210333Z DEC 06
FM AMEMBASSY MANILA
TO RUEHC/SECSTATE WASHDC IMMEDIATE 4344
RUEATRS/DEPT OF TREASURY WASHINGTON DC IMMEDIATE
INFO RUCPDOC/USDOC WASHDC IMMEDIATE
RUEHZS/ASSOCIATION OF SOUTHEAST ASIAN NATIONS IMMEDIATE
RHHMUNA/CDR USPACOM HONOLULU HI//FPA// IMMEDIATE

UNCLAS SECTION 01 OF 03 MANILA 005050

SIPDIS

SIPDIS

STATE FOR EAP/MTS, EAP/EP, EB/IFD
STATE ALSO PASS EXIM, OPIC, AND USTR
STATE ALSO PASS USAID FOR AA/ANE, AA/EGAT, DAA/ANE
TREASURY FOR OASIA
USDOC FOR 4430/ITA/MAC/ASIA & PAC/KOREA & SE ASIA/ASEAN

E.O. 12958: N/A
TAGS: ECON EFIN EINV PGOV RP
SUBJECT: UPBEAT ECONOMIC NEWS BUT UNDERLYING PROBLEMS

REFS: A) Manila 4878
B) Manila 4687

1. Summary: The Philippines is ending 2006 with good economic
news. Growth is exceeding expectations, inflation and domestic
interest rates are declining, the peso is strong, the stock market
is soaring, international reserves are at an all-time high, and the
balance of payments shows a hefty surplus. Unfortunately, the
long-term prognosis is not nearly as positive. The privatization of
the power sector, legislatively mandated years ago, is far behind
schedule. Infrastructure is crumbling and government investment in
education has not been sufficient to give all children classrooms,
let alone materials and qualified teachers. Necessary
constitutional changes to liberalize the investment regime are not
being discussed as part of the on-going debate over constitutional
reform. And corruption continues to drain away many of the
resources the GRP does devote to resolving these serious problems.
End Summary.

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Growth Rate Good; Inflation Easing
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2. This year's economic results are impressive. Growth projections
for 2006 are now 5.5%, spurred by a recovery in exports and
resilience in agriculture despite inconsistent rainfall in some
areas and a spate of damaging typhoons. The economy is anchored by
the 15% increase in remittances from Overseas Filipino Workers'
(OFW) this year and a booming business process outsourcing (BPO)
sector. The International Monetary Fund and the World Bank recently
upgraded their GDP growth forecast for 2007 from earlier projections
of between 5.5% and 5.6% to between 5.7% and 5.8%. Stable food
prices, a stronger local currency, moderating oil prices, and
responsible monetary policy brought consumer price inflation down to
4.7% in November 2006, the lowest rate since mid-2004.

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Highs for Stock Market and Forex Rate
-------------------------------------

3. The foreign exchange rate has risen steadily to a six-year high
of 49.31 pesos to the dollar in December while the Philippine stock
market index hit a nine-year high recently. Domestic Treasury bill
rates, the benchmark for interest rates on loans, are at a four-year
low. Another indication of optimism is that the premium the
government must offer to borrow money -- the interest rate
differential between comparable U.S. and Philippine government
foreign bonds in the secondary market -- has been narrowing since
2003. In fact, the risk premium on bonds maturing between 2008 and
2025 has tightened significantly from more than 500 basis points at
the end of 2002 to between 50 and 220 basis points at the end of
November 2006.

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Fiscal Deficit Falls Fourth Straight Year
-----------------------------------------

4. The government's budget deficit will shrink for the fourth
consecutive year after peaking above 5% of GDP in 2002. The deficit
is likely to end 2006 at barely 100 billion pesos, below 2% of GDP,
following greater revenue generation from new tax measures. The
amended value added tax (VAT) law will generate about $1.5 billion
in additional revenue for the year. The tax-to-GDP ratio will
increase to more than 14.5% this year from just 12.3% in 2004, about
halfway to the government's goal and former high-water mark of 17%.

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BOP Surplus Boosts International Reserves
-----------------------------------------

5. The Philippines is poised to end 2006 with the highest balance
of payments surplus in seven years -- about $3 billion. Although
the total value of imports rose from the high price of oil, the
country benefited from strong merchandise exports (up 16.4% as of
October) and OFW remittances (up 16.6% as of October). Up by 12%
thus far, the number of overseas workers has topped the 1 million
mark. Higher tourism receipts and increased foreign direct
investment also helped boost the balance of payments. As a result
of the hefty surplus, the central bank's gross international
reserves hit a record $23 billion, equivalent to 4.5 months of
imports and double the country's short-term foreign debt.

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Public Sector Debt Ratios Improving
-----------------------------------

6. The government's success in reducing the fiscal deficit and the
improved financial performance of state-owned companies has slowed
the expansion of public sector debt. As a result, the ratio of
public sector debt to GDP declined from nearly 118% in 2003 to below
90% this year. The government used its strong international
reserves to retire about $1.8 billion in foreign debt in 2006 to
eliminate future interest payments on those loans and to reduce
potential risks from the two-thirds share of foreign debt in the
public sector's loan portfolio. Taking advantage of the improved
appetite for longer debt maturities, the government also swapped
about $3 billion in domestic and foreign debt for longer-term loans.

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Non-Performing Loans Declining
------------------------------

7. Commercial banking system non-performing loan and non-performing
asset ratios continue to decline after reverting to single-digits in
mid-2005. According to the central bank, the ratio of
non-performing loans to total loans has tapered off to just 7.2%
from a high of almost 19% in 2001. The ratio of non-performing
assets (which includes loans and foreclosed properties) to total
resources has declined to 7.5% after hitting a high of over 14% in
2001. Over the next two years, the central bank expects these
ratios to fall closer to the 3% to 4% range they were in before the
Asian economic crisis of 1997.

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Better Outlook and IMF Exit
---------------------------

8. Moody's Investors Service improved its rating outlook on the
Philippines from "negative" to "stable" in early November because of
the country's fiscal progress. Moody's action followed similar
moves by four other major credit rating agencies (Standard & Poors,
Fitch, Japan Credit Rating Agency, and Rating & Investment
Information, Inc.) during the first half of 2006. According to BSP
officials, the Philippine Government expects to exit from four
decades of direct IMF oversight when the current post-program
monitoring arrangement ends in April 2007.

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But Long-Term Challenges Remain
-------------------------------

9. Despite the recent good news, the country's long-term economic
prognosis is shaky. For example, poverty remains a serious problem
with almost 40% of the population (about 33.4 million Filipinos)
living on less than $2 per day. Polls indicate that a larger
percentage of Filipinos are having trouble making ends meet than in
the past and a larger percentage are experiencing hunger. In
addition, the country is not attracting sufficient amounts of
foreign direct investment. The Philippines will receive less than
$2 billion in foreign direct investment (FDI) in 2006. Although a
significant increase from previous years, it is still small compared
to total FDI flows to the region or compared to any reasonable
assessment of potential.

10. By concentrating its efforts in the following four areas, the
Philippine government could demonstrate its will and ability to
overcome institutional hurdles and pave the way for reduced poverty
and expanded FDI:

-- Stalled Privatization: The delay in selling government power
plants threatens public sector finances and undermines the long-term
supply of affordable and reliable electricity. Even after the
recent sale of two hydropower plants, the GRP has off-loaded less
than 5% of its power generating assets - well below the 70% required
by law. Many of these plants are old, inefficient and heavily
subsidized, keeping electricity prices among the highest in Asia.
By privatizing these assets, the government could save money,
attract investment in new and more efficient power plants, and
encourage an open, competitive market.

-- Crumbling Infrastructure: Government austerity to control the
budget deficit has constricted the funding needed to improve
infrastructure. Corruption keeps those funds which are appropriated
from making the difference they should. In a 2006 World Bank study,
the Philippines ranked last among 61 countries in physical
infrastructure and near the bottom in educational facilities,

MANILA 00005050 003 OF 003

science and technology, and health. President Arroyo has reiterated
at recent public events her intention to boost spending on roads,
ports, and airports and increase budgetary resources for schools and
clinics, in part to raise the country's low competitiveness ratings
(ref a).

-- Corruption: Corruption is a major deterrent to raising
government revenue, delivering vital social services such as health
and education, improving infrastructure, and attracting foreign
investment. The Philippines ranked 121st among 163 countries in
Transparency International's 2006 Corruption Perceptions Index.
According to a recent academic study, the country loses $8 billion a
year in hidden international transactions. Although the
government's previous anti-corruption drives have not improved
perceptions, efforts have been reinvigorated with the U.S.
Millennium Challenge Account's Threshold Program which focuses on
transparency in revenue generation and combating corruption.

-- Liberalizing Restrictions on FDI: The 1987 Constitution places
limits on the ability of foreigners to own land and to participate
in various sectors of the Philippine economy. Although there is
widespread understanding in Philippine policy circles of the severe
damage this does to the country's competitiveness as a destination
for investment, revision to these provisions is not being discussed
as part of ongoing wrangling over possible constitutional reform.

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Comment
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11. To sustain the current economic momentum, the government must
maintain high quality spending and resist loosening its purse
strings during the 2007 mid-term election campaign and the
controversial initiatives to change the constitution. Over the
long-term, the government must stick with its reform efforts so the
Philippines can catch up with its regional neighbors in spurring
investment, stimulating growth, creating jobs, and alleviating
poverty.

KENNEY

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