Risk drivers and outlook

The Philippines is firmly rated in 3/7 for the MLT political risk. Its continued strong GDP growth trajectory and effective macroeconomic policies have indeed allowed the risks to be more contained and fundamentals to strengthen over the years. A diversifying economy, sound public finances, a small deficit on the current account and low external debt contribute to that. Therefore, these factors should allow the country to face the slowly deteriorating global context – from US protectionism spill-over to tighter monetary conditions – with relative confidence in spite of external pressures translating into capital outflows and peso depreciation. Besides, recurrent instability risks on the political and security side raise political risk levels.

The short-term political risk is classified in category 2/7 thanks to comfortable liquidity. The commercial risk is rated at a ‘normal’ level due to strong business cycle and good financial conditions which offset a rather difficult business and legal framework. Also, further depreciating pressures on the peso might cloud the outlook.

Facts & figures

Pros

  • Prudent and effective macroeconomic policies
  • Good fundamentals, strong growth
  • Ample workers’ remittances
  • Young and skilled workforce

Cons

  • Vulnerable to global trade war and US protectionism
  • Infrastructure gaps
  • High poverty
  • High terrorism risks in Muslim south

Head of State and government

  • Rodrigo Duterte

Population

  • 104.9 million

GDP (in 2017)

  • USD 313.4 bn

Income per capita

  • USD 3,660

Income group

  • lower middle income

Country risk assessment

Highlights

A stronger presidential rule is overshadowing political stability

In two years in office, populist President Duterte has marked the country with his imprint. Not only by his frank talking, but also by his strong majority in Congress and his sky-high popularity boosted by a continued strong economic momentum and the drug war which would have cost more than 10,000 lives until now. At the same time, he is using his mandate to strengthen his power. The most vocal critics of his policies, either top political opponents or the head of Supreme Court, have been arrested or ousted by a less independent judiciary, thereby highlighting a weakening rule of law. This trend is also witnessed by the prolonged state of emergency on Mindanao island that was imposed last year in the aftermath of the long fight against IS fighters in Marawi.

Besides, the president proposed a constitutional reform towards increased federalism benefiting regions’ autonomy in fiscal and judicial matters among other things. The draft constitutional reform foresees strengthened executive powers for the president and eligibility to two 4-year mandates instead of today’s single 6-year mandate. Legislative elections of May 2019 would be postponed until 2022, allowing Mr Duterte to stay in power with his strong majority until the 2022 general elections. A clause would have been included to prevent him from running for a second mandate. The reform promises to be controversial and potentially unpopular as shown by his predecessors’ failed attempts. After the Congress’ approval, the new Constitution would be submitted to referendum.

Political violence risks are a chronic concern whereas ties with China have warmed

The moderate political violence risk (in category 4/7) is dominated by domestic tensions. Internally, particularly in Mindanao, the country is faced with a chronic but growing terrorist threat from militant groups (e.g. Abu Sayyaf) due to ‘returnees’ and particularly to plans of IS-affiliated local Islamist rebel movements to set up a regional caliphate in the south of the country. On the positive side, the Congress has recently passed the law that would create the Bangsamoro Autonomous Region in the south of Philippines (where Mr Duterte formerly served as the mayor of Davao city). Though some legal hurdles ahead remain, the law implementation could help improve peace prospects for the mainly Muslim population by demobilising local armed groups (particularly the Moro Islamic Liberation Front). Externally, despite a favourable international arbitration court ruling on sovereignty in disputed islands in the South China Sea, Mr Duterte has pragmatically opted for warmer ties with Beijing. In return, the country has been benefiting from significant investments and trade from China. However, under popular and political pressure, his line might harden in front of China’s growing militarisation and more ships sailing in the disputed areas, especially around the Scarborough Shoal. Hence, risks of clashes and re-emerging tensions might rise.

Impressively strong growth cycle

Everything is fine for the Philippine economy which remains a top performer in South-East Asia. The 6.7% real GDP growth posted last year is expected to be replicated this year. The upbeat cycle is forecast to continue in the MLT at an average 6.9% rate until 2023.

Multiple drivers explain it, from a robust private consumption to a supportive global demand which has allowed a record 2017 year for electronics exports, overwhelmingly the top export goods with 2/3 of the total. The services sector is also enjoying the positive momentum with a solid business process outsourcing sector and soaring tourism receipts (+36% y-o-y in 2017). The strong growth cycle is also boosted by accelerating (public) investments in infrastructures which started in 2017 and whose over twenty projects are running full steam. By targeting the development of transports (railways, roads, metro, etc.), the 5-year USD 170bn ‘Build, Build, Build’ (BBB) programme aims to reduce the infrastructure gap and improve the business environment in the MLT. China is involved in many projects as a dominant investment partner.  

The outlook for all those growth drivers – except for non-electronic exports which have been on a negative trend so far this year – is positive in the next 12 months.

US protectionism, tighter global monetary conditions and inflation are downside risks

Still, real GDP growth could moderate in 2019 due to unfavourable external developments and domestic monetary tightening. US protectionism and an intensifying trade war with China are downside risks to the Philippine economy. It could be impacted by heavier import costs and weaker external demand. The impact could be both direct via the US, its first export market (15% of goods), and indirect via China which re-exports around 17% of Philippine merchandise exports. The electronic and electrical machinery sectors are the most exposed to a US-China trade war. The services sector raises even higher concerns as many US companies are actively outsourcing business services in the country whereas a more restrictive US immigration and labour policy could potentially affect one third of the country’s massive remittances (close to 22% of current account receipts) that come from US-based Filipino workers.

As for interest rates, their increase is an answer to inflation pressures which are fuelled by higher oil and food prices, taxes and also an economy navigating around potential. In June, the inflation rate went above 5%, i.e. a 6-year high.

Despite strong export and FDI data, the current account and balance of payments have turned into a small deficit since 2016. This is due to much expanded BBB investment-related imports of capital goods and capital outflows in a context of the US Fed’s normalisation policy that has triggered a flow of capital retreat from emerging markets and strengthened the US dollar (USD). The Philippine peso has been one of the main victims among the Asian currencies (-7% against the USD during the first half of 2018) and could remain under stress given the expected additional widening of the current account deficit.

The flexible exchange rate is nevertheless welcome to absorb external shocks. The expected further interest rate hikes and the country’s sound fundamentals might also help mitigate the peso’s depreciation and the magnitude of capital outflows. Moreover, the large FDI inflows will continue to benefit from the BBB programme and are expected to go up in the coming years on the back of a slowly improving business environment. It thus means that shaken investor confidence will not go away despite portfolio capital outflows.

Fiscal buffers and a low financial risk will cushion future shocks

Fiscal expansion could offset the monetary tightening impact and keep growth at high levels. To finance fast-rising infrastructure spending, the government has launched a tax reform – including higher taxes but also cuts on personal income tax – that is expected to raise public revenues to a still comparatively low 20% of GDP by 2020. The government can afford heightened public spending thanks to available fiscal space resulting from one of the most remarkable policy developments made during the past decade. The fiscal position has been fluctuating around balance since 2011 and is expected to be in small deficit in the MLT. Also, between 2004 and 2017, the general government debt has been halved to a manageable 37.8% of GDP and is even likely to continue slowly on a downward path.

It illustrates how continuity and caution in running an economic policy that preserves macroeconomic stability and fiscal discipline, have characterised successive governments – the policy break occurred as from 2004 under Mrs Arroyo’s term and was confirmed by Benigno Aquino III – and have contributed to healthier fundamentals and the prolonged economic success story (6.4% GDP growth on average in 2010-2017).

It also applies to external debt which is low – under 25% of GDP and 65% of current account receipts in 2017 – after a constant decline since 2004. A stronger USD and higher interest rates will nevertheless harm the most indebted companies which have a high share of debt denominated in USD.

Foreign exchange reserves are robust even though they have roughly stabilised over the past years while imports have accelerated notably related to investment projects. The import cover has thus shrunk from 9 months in 2015 to 6.3 months last April. The size of the foreign exchange reserves remains nevertheless ample to cover the low short-term debt and modest debt service.

All in all, in spite of rising external risks, the Philippine economy appears to be well armed with strong buffers to cope with future external shocks, which contributes to a moderate 3/7 rating for the MLT political risk.

Analyst: Raphaël Cecchi – r.cecchi@credendo.com