Page 1 PROJECT INFORMATION DOCUMENT (PID) PROJECT APPRAISAL STAGE Project No. 37940 Project Name Philippines First Development Policy Loan Region East Asia and Pacific Sector Poverty Reduction and Economic Management Unit Project ID 100706 Borrower (s) Government of The Philippines Implementing agency Department of Finance Environment Category [ ] A [ ] B [ X ] C [ ] FI [ ] TBD (to be determined) Date PID Prepared October 26, 2006 Date of Appraisal Authorization October 31, 2006. Date of Board Approval December 19, 2006 1. Country and Sector Background Fiscal adjustment in recent years has benefited the Philippine economy and financial markets. Economic growth since 2004 has been robust even in the face of higher oil prices —and well above its historical trend of 3.8 percent over the previous 25 years. In 2004, GDP growth reached 6.2 percent, its highest level in 15 years. Growth slowed to 5 percent in 2005 reflecting an agricultural slowdown and terms-of- trade deterioration (due to higher oil prices and weakness in electronics export prices), but picked up to 5.6 percent in the first half of 2006, amidst a recovery of agriculture and exports. Strong growth of remittance flows has boosted consumption and also appears to have reduced the volatility of consumption, while functioning as the most important social safety net in the country. Some 8½ million Filipino workers, about a quarter of the domestic labor force, work abroad. Rapid growth of remittances and transfers from overseas workers, amounting to about 14 percent of GDP in 2005, has converted large trade deficits into modest current account surpluses, and raised average GNP growth to above 6 percent since 2004. Higher growth in recent years has been primarily driven by the service sector including back office activities such as business process outsourcing, although since 2005, manufacturing growth has also risen at a pace of nearly 6 percent. Higher imported energy prices and the major adjustment in power generation tariffs in late 2004, raised inflation to 8½ percent in 2004. Since then inflation has been on a gradually declining path, with the 12- month CPI declining to 5.7 percent as of September 2006. In August 2004 a series of tax measures were proposed by the President to address the worsening fiscal environment. These included: an increase in the excise tax on cigarettes, tobacco, and alcohol; a comprehensive tax reform package which included broadening VAT coverage by the removal of exemptions for petroleum products, power, and medical and legal services, authority for the president to increase the VAT rate from 10 percent to 12 percent upon satisfaction of certain criteria, an increase in the corporate income tax from 32 percent to 35 percent (reverting to 30 percent in 2009); and lateral attrition for revenue agencies (to improve incentives for tax administrators). In parallel, power generation tariffs were raised by over 60 percent in late 2004/early 2005, and import duties on oil products were raised from 3 to 5 percent (subsequently reversed to mitigate the impact of the VAT reform on fuel prices). In addition, the Department of Finance (DOF) intensified programs to identify and prosecute tax evaders and smugglers and a revenue integrity protection service that charged corrupt collectors in the revenue agencies was promulgated. A 30 percent average increase in excise taxes was enacted in December 2004, and, after considerable debate, the crucial VAT reform was enacted in two steps (November 2005 for the removal of exemptions and February 2006 for the increase in rates). Throughout this period, and subsequently, tight controls on government spending continued to be maintained. Page 2 The consolidated public sector deficit (CPSD) was reduced by 2.8 percent of GDP in 2005. Tax revenue increased by 24 percent through September 2006, setting the stage for a more significant improvement in tax effort in 2006. Non-financial public sector debt declined from 101 percent of GDP in 2003 to 87 percent in 2005. Bond spreads have fallen significantly in the past two years, reflecting both the liquidity in emerging market spreads and improving Philippine spreads vis- à-vis the EMBI. For example, in early 2005, the spread paid on a long-term bond issue was 505 basis points, versus 333 basis points on a $2.2 billion issue in January 2006, and 246/262 basis points for a $750 million issue in July 2006 (maturing in 2016 and 2031). FDI and portfolio flows grew rapidly in 2005 and early 2006 but these flows remain small in relation to the economy. 1 Domestic investment has been on a declining path, falling to about 15 percent of GDP. Private investment has yet to respond to the higher growth rates of recent years, and has not been helped by the political instability and uncertainties of recent years. Private sector credit as a share of GDP fell by some 40 percent between 2000 and 2005. Public investment, estimated at only 2.3 percent of GDP in 2004-05, has been limited by fiscal constraints, and deficiencies in infrastructure appear to be a drawback to increased private investment. Continued robust economic growth is expected to raise capacity utilization and private investment demand. The pace of formal employment has increased in parallel to the stronger economic activity in the most recent period, but overall employment growth is heavily influenced by developments in the less formal parts of the labor force, in particular, agriculture. Key sector issues . The Philippines needs to continue its fiscal consolidation program to reduce its public debt/ GDP ratio while increasing non-interest spending in priority sectors. This will require increases in the tax effort as is intended by the government. The government has made some commendable and impressive efforts in fiscal consolidation: it has reduced public sector deficits and debt, and proposes to address governance and sustainability issues through a reform agenda which the Bank agrees with and intends to assist. Sustained tax administration and governance improvements are needed to ensure that recent policy reforms translate into sustained deficit and debt reduction as well as larger and more effectively implemented public resources for infrastructure and social programs. 2. Project Objectives The DPL supports the Government’s significant achievements in reducing public sector deficits and debt through tax reform and power tariff adjustments, and seeks to bolster this performance by: strengthening tax administration; improving budget execution and fiduciary performance; and strengthening the finances of the power sector. In addition, it lays the groundwork for deeper reforms in the areas of fiscal consolidation, governance and the fiduciary environment, the investment climate and social policy. 3. Rationale for Bank Involvement The Bank Group CAS for 2006-08, discussed at the Board in May 2005, seeks to help the government improve public institutions and services and thus help the country achieve higher and sustained growth coupled with greater social inclusion. Within this objective, the Bank aims to support recognized and replicable successes in delivering public services. It also identifies two important levers for pursuing these goals: fiscal consolidation and improved governance. The CAS identified weak fiscal performance 1 FDI inflow is estimated to have reached $1.1 billion through July 2006, 60% over the previous year. BSP expects FDI to reach $1.9 billion in 2006 (1.6% of GDP). Page 3 as the single most important short-term obstacle to more rapid development in the Philippines. It therefore lays out criteria for development policy lending squarely focused on the extent of fiscal adjustment. Based on these criteria, the Philippines is now eligible for development policy lending. 4. Description The DPL supports the Government Reform Agenda for macro-economic and fiscal stability, governance, public expenditure management, investment climate and infrastructure, and social inclusion. (i) Macroeconomic and Fiscal Stability Fiscal Consolidation. A central objective of the Reform Agenda is to reduce the public debt burden to 65 percent of GDP by 2009. Reaching this objective would represent a major turnaround from the early years of this decade when public debt was rising rapidly, exceeding GDP by 2003, and generating intensifying concern about fiscal sustainability. Tax Effort. The DPL will support the deepening of the tax policy reforms implemented in 2005 and 2006 as well as the Government effort to improve tax administration, all critical to the success of the fiscal and macroeconomic reform agenda. Strengthening GOCC financial viability. Even as the national government deficit is being reduced, pressure of higher deficits originating from the GOCCs remains an area of vulnerability. Hence in the context of fiscal consolidation, the DPLs will support the strengthening the financial performance of GOCCs, in particular the Power Sector Assets and Liabilities Management Corporation (PSALM). (ii) Governance and Anti-corruption The DPL will support a more robust set of institutional mechanisms to enhance government accountability to the public for its fiscal management and service delivery. This includes aligning policy priorities and funding, improving the predictability of budget, strengthening transparency and monitoring in budget execution and procurement, and strengthening of performance management for improved civil service delivery. Good governance reform with an emphasis on more predictable and transparent management of public resources is intended to have on the quality and effectiveness of public spending , as well as on improving government performance overall. The DPL will support Government initiatives to control corruption, such as life- style checks, strengthening the Ombudsman’s Office, prosecuting tax evaders and smugglers, and strengthening anti-corruption in the Bureau of Internal Revenue and the Bureau of Customs. (iii) Investment Climate and Infrastructure The Government’s strategy for strengthening infrastructure rests on two pillars: (i) increasing public investment in infrastructure financed from the proceeds of improved tax policy and administration, i.e., within the proscribed fiscal envelope; and (ii) encouraging greater private investment by streamlining procedures, rationalizing investment incentives, strengthening the framework for public-private partnerships, and strengthening the banking system and the capital market. Page 4 (iv) Social Inclusion The focus of social sectors reforms supported by the DPL in 2006 –2007 will be on continued improvement in the management of public expenditure, public procurement and transparency. These are seen as important foundations for ensuring that the planned increase in expenditure in the social sectors is focused on results, and that the impact of existing expenditure is increased. Accordingly, the governance component of the DPL includes actions and triggers for the Departments of Education and Health, including preparing the ground for increased availability of resources as a result of fiscal consolidation. Future DPLs are envisaged to encompass more specific sectoral dimensions of the Government’s program for improving the quality of and access to essential social services, and for developing a social protection framework to enhance and complement the impact of economic growth on poverty reduction. 5. Project Financing Amount: US$250 million (Single Tranche) Terms: IBRD – Repayable in ___, including five-year grace, at the standard interest rate for LIBOR-based [TBD]-spread loans in US Dollars. Commitment Fee: 0.75% per annum on undisbursed balances 6. Project Implementation Borrower and Loan Amount . The borrower is the Republic of Philippines and this operation is a single- tranche loan of US$ 250 million that would be made available upon loan effectiveness, as all policy actions supported by the loan would have been completed prior to Board presentation. Disbursement Arrangements and Use of Funds . The loan disbursement will follow the standard Bank procedures for Development Policy Lending as provided in OP/BP 8.6. The loan amount will be disbursed into a Dedicated Bank Account (DA) in US Dollars at the central bank, Bangko Sentral ng Pilipinas (BSP) that forms part of the Philippines’ official foreign exchange reserves. This amount will then be converted to Philippine Pesos and the equivalent amount in Pesos will immediately be transferred in a single tranche to the National Treasury Account of the Borrower that is used to finance budget expenditures, as the loan is intended to be used to support the general government budget. Disbursements of the loan will not be linked to any specific purchases and no procurement requirements have to be satisfied, except that the Borrower is required to comply with the standard negative list of excluded items that may not be financed with Bank loan proceeds. Prior to disbursement, the Borrower would provide to the Bank a copy of written instructions issued to the Bangko Sentral ng Pilipinas for conversion of the foreign exchange amount of the loan into local currency and that an equivalent amount be credited to an account of the Government available to finance budgeted expenditures. 7. Sustainability The design of this DPL program takes into account the nature of the reform program and government capacity to implement it. To secure recent fiscal gains and bolster credibility of the government program, the prior actions for DPL1 and the triggers for proceeding with DPL2 are framed primarily in terms of fiscal policy and administration. To the extent a wider reform agenda is supported through the DPL series, its rationale is to reinforce the core fiscal objective: by making public expenditures, particularly for social service delivery more effective; and by enhancing the climate for investment and growth, which in turn would help to sustain the recovery in tax effort. 8. Lessons Learned from Past Operations in the Country/Sector Page 5 Key lessons from past operations include: · The importance of consensus building. Bank staff and development partners have been involved in a lengthy process of consensus building on the reform program with key government officials. Concerned officials have taken the lead in an iterative process of proposing reforms, taking into account comments from different departments (oversight and line agencies) and external partners, and then re-developing internal consensus. This process has allowed for stronger ownership of the reforms within the affected government departments than was typical for previous Bank adjustment lending. · Focus on actions that can be implemented by the executive branch. All activities proposed depend on the Executive Branch and not on any third parties, thus improving the prospects for implementation. · Preference for single tranche operations. The new loans have been designed as acknowledgement of past government successes, and more importantly, as incentives for sustained good performance. 9. Safeguard Policies (including public consultation) Safeguard Policies Triggered by the Project Yes No Environmental Assessment ( OP / BP / GP 4.01) [] [X] Natural Habitats ( OP / BP 4.04) [ ] [X] Pest Management ( OP 4.09 ) [ ] [X] Cultural Property ( OPN 11.03 , being revised as OP 4.11) [ ] [X] Involuntary Resettlement ( OP / BP 4.12) [ ] [X] Indigenous Peoples ( OD 4.20 , being revised as OP 4.10) [ ] [X] Forests ( OP / BP 4.36) [ ] [X] Safety of Dams ( OP / BP 4.37) [ ] [X] Projects in Disputed Areas ( OP / BP / GP 7.60) * [ ] [X] Projects on International Waterways ( OP / BP / GP 7.50) [ ] [X] 10. Contact Points: Ms. Vera Songwe, Senior Economist Philippines Country Office World Bank Office Manila 23/F The Taipan Place, F. Ortigas Jr. Road, Ortigas Center, Pasig City Phone : (632) 637-5855 11. For more information, contact: The Infoshop The World Bank,1818 H Street Washington D.C. 20433 Telephone: (202) 458-5454 ; Fax: (202) 522-1500 * By supporting the proposed project, the Bank does not intend to prejudice the final determination of the parties' claims on the disputed areas. Page 6 Note: This is information on an evolving project. Certain components may not be necessarily included in the final project. Processed by the InfoShop week ending _______.