The Philippines: But for some harsh words, it's going well Asia Pacific Economic Outlook, Q4 2016

Rodrigo Duterte inherited a strong economy when he became the 16th president of the Philippines, and he has vowed to keep the momentum going with tax reforms and a continued focus on infrastructure development. However, his recent outburst against the president of the United States threatens to sour relations with an important ally.

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Special Topic: ASEAN Economic Community

Countries:
Malaysia
Taiwan
Vietnam

A strong economy is every elected leader’s dream as he or she inherits office. Rodrigo Duterte couldn’t have asked for more when he took over as the 16th president of the Philippines in June.1 The economy has been performing well for the past few years, much better than some of the country’s more illustrious neighbors. In fact, August brought in fresh cheer as the Philippines Statistics Authority announced that the economy expanded at one of the fastest rates in Asia in Q2. The new president has pledged to keep the momentum going by reforming the taxation regime, making it easier to do business, and continuing with his predecessor’s focus on infrastructure development. What would help the president a bit more, however, is perhaps a little more diplomacy as he tries to maneuver his way through international relations with high economic and political stakes.

A good economy to inherit

The economy grew by 7.0 percent year over year in Q2, the fastest pace since Q2 2013. Consumer spending continued to shine in Q2, growing 7.3 percent. Low inflation, upbeat sentiment, low unemployment, and strong remittances have augmented consumer spending. Remittances from overseas Filipinos, which amounts to 9.0 percent of GDP (2015), grew 4.1 percent in the first half of this year.

Private investment continues to be strong; so does government spending (figure 1). The lone worry is export growth, which slowed for the second straight quarter. Merchandise exports, in particular, have been under pressure, declining for the 16th straight month in July. Services exports, however, continue to rise, aided by the expanding business process outsourcing sector.

APAC Q4 2016

Price pressures remain benign amid easy credit conditions. In August, inflation fell to 1.8 percent from 1.9 percent in July. Inflation is likely to remain within the Bangko Sentral ng Pilipinas’ (BSP’s) 2.0–4.0 percent target corridor this year. With an able central bank chief who has presided over the global financial crisis of 2008–09 and the current bout of domestic economic growth, President Duterte can draw comfort from the strong stewardship of monetary policy.

Starting with the right agenda: Tax reforms

For those initially nervous about President Duterte’s economic agenda, the first two months in power have been reassuring. Both the president’s first State of the Nation Address and his economic team’s 10-point agenda give glimpses of a strong reform agenda, especially tax reforms.2

First, the government wants to change the income brackets for direct income taxes.3 These brackets were framed about two decades ago. A rise in the exemption limit—logical due to inflation over the years—will benefit low- and middle-income households. Any form of inflation indexing will be even better. Second, in a bid to boost tax payment the government is eager to reduce the highest rate of income tax from 32.0 percent to 25.0 percent.4 This will also help those whose nominal incomes fall in the top tax bracket, one that was decided nearly 20 years ago. These measures will also boost consumer spending in the medium term.

For those initially nervous about President Duterte’s economic agenda, the first two months in power have been reassuring. Both the president’s first State of the Nation Address and his economic team’s 10-point agenda give glimpses of a strong reform agenda, especially tax reforms.

To offset possible losses in income taxes, the government will likely raise taxes on luxury goods and non-essential items like tobacco. A hike in the excise duty on oil products is also likely. The government is seeking suggestions on whether to raise the value added tax rate and cut down exemptions, although there is yet no clarity on this.5 It has also hinted at reducing tax incentives for foreign investors, a move that may add to the discomfort of foreign companies having to comply with red tape and poor infrastructure compared to other parts of Asia.6 However, the government contends that any reduction in tax incentives will be accompanied by the easing of business conditions to offset costs for foreign investors. The government is also planning to cut down corporate tax from 30.0 percent to 25.0 percent, a move likely to aid private investments.7

Higher spending and changes in the tax regime will have an immediate impact on the fiscal deficit, which was 0.9 percent of GDP in 2015. Already, the government has said that the deficit will rise to 2.5 percent this year as it aims to ramp up spending on infrastructure and social welfare.8 However, any sharp spike in fiscal deficit beyond the revised target will invite unwanted scrutiny from rating agencies under whom the country got its first investment grade rating last year. To meet its strong spending targets on infrastructure and social welfare—26.3 percent of the people still live below the poverty line—the government will have to expand the tax base, which is woefully small, especially among the self-employed.9 Not only will that take care of funds for development, it will also ensure that the fiscal gains of the past few years will continue.

A careful choice of words, perhaps?

President Duterte, however, has a long way to go in global diplomacy. His recent outburst against the president of the United States threatens to sour relations with an important ally. The United States has close military ties with the Philippines and, in 2014, signed a 10-year military deal.10 US support will also be crucial in any talks with China over an International Court of Justice ruling that supports the Philippines’ claims against China’s in the South China Sea.11 Economically too, the Philippines has much to gain from the United States. The latter is the largest source of foreign direct investment in the Philippines—about $0.7 billion out of a total of $5.7 billion in 2015—and its role is vital in the Philippines’ efforts to join the Trans-Pacific Partnership trade bloc.12

President Duterte’s harsh words on military relations with the United States and his recent overtures to China may be an effort to draw benefits from both countries.13 But, it is a fine line that he is treading and is not likely to bring in immediate benefits. Increasing rhetoric against other countries and the United Nations will also not mitigate concerns about President Duterte’s war on drugs, which has resulted in more than 3,000 deaths over three months.14 Although the logic behind his clampdown on drugs is accepted—about 1.7 million people in the country are addicted to illegal substances—the method behind the surge in killings is unnerving many in the global community.15 Surely, any outbursts alone will not stop such concerns being expressed occasionally by leading nations.

Things could, in fact, turn worse for the Philippines if the country loses out on the economic and political goodwill it has gained over the years. President Obama, for example, cancelled his meeting with President Duterte after the latter’s outburst. And there are early signs that the economy could be impacted in the absence of better diplomacy as foreign inflows slow down and the stock market sheds some of its gains this year (figure 2).16 The Philippines needs all the global help it can get to continue the economic momentum of the past few years and to improve infrastructure and regulations. Loopholes in the latter were evident during the $81 million cyber heist at Bangladesh’s central bank, in which part of the stolen money was routed through the Philippines.17

Fig 2 APAC Q4 2016

While acting the strongman may play well for President Duterte at home, reconciling differences in geopolitics will be a far tougher task. The world, especially foreign investors, will be watching closely.