Economics Markets Strategy - the DBS Vickers Securities Equities ...

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Economics: Philippines Economics – Markets – Strategy With its inflation target shattered, the central bank will lift interest rates by a further 75bps, taking the repo rate to 7.25% by end-08 Slower growth in the US will weigh on remittances; peso weakness helps only to a degree Business spending will rise by a decent 7% this year, but largely on public spending As will interest rate hikes Still, our inflation forecasts are well above the BSP’s inflation targets for this year and the next. This year the central bank’s inflation target is at 3-5%, and next year inflation is targeted at 2.5-4.5%. In view of this, we expect the central bank to continue the tightening cycle it embarked on earlier this month. The overnight reverse repo (borrowing) and repo (lending) rates were lifted 25bps to 5.25% and 7.25% respectively, and we expect a further 75bps of tightening before the year is up, to be delivered in three moderate steps of 25bp each. These interest rate hikes should help to contain risks of a wage-price spiral by dampening activity. Under pressure from the unions to mitigate the impact of higher food and fuel prices on workers, the government in mid-May mandated a nation-wide increase in private-sector minimum wages, to be rolled out in the different regions over the next few months. Some areas (like metro Manila) will see moderate hikes of around 5%, but increments in some provinces will come to around 10%. Some of these wage increments will also come on top of previous wage orders still currently being implemented. As part of a longer-standing plan, public sector workers are also set to receive a 10% pay rise on July 1. Admittedly, even after lifting rates by a further 75bps, monetary policy can still be described as “loose”; after adjusting interest rates for inflation, they are negative. In other words, the value of money sitting in a consumer’s bank deposit actually decays, and there is greater incentive for him to take it out to spend or invest. But free spending would occur only if consumers had no concerns over economic and labour market prospects. Clearly this will not be the Chart 5: Remittances and real US GDP growth case in the coming quarters. We continue to expect the US % YoY % YoY, 3mma to fall short of longer-term 4.5 30 potential growth both this year Remittances 4.0 and the next, having pencilled (RHS) US GDP 25 3.5 in growth of 2.0% and 2.6% respectively; potential growth 3.0 20 is widely thought to be between 2.5 2.75-3.25%. Given that the US 15 2.0 accounts for 53% of the Philippines’ remitted earnings 1.5 10 and 17% of the export market, 1.0 this will have a negative bearing 5 on domestic wage and spending 0.5 patterns (Chart 5). Further 0.0 0 weakness in the peso this year Mar-02 Mar-04 Mar-06 Mar-08 will help soften the blow on both remitted earnings and exports – we expect USD/PHP to end the year at 47.00 – but not sufficiently. Investment to remain robust on public spending Investment spending was the only component in the first quarter GDP figures that did not disappoint us, and while we believe last year’s 11.8% surge in capital outlays will not be replicated, investment this year should still rise a decent 7.0%. However, this is likely to ride on public, rather than private outlays. As input costs like oil and commodities continue to rise and it becomes increasingly difficult to pass on higher costs to consumers, private firms will feel greater margin pressure. In such an environment, business spending plans will naturally be deferred. Indeed, private-sector investment indicators so far this year have been very weak. According to the BSP’s second-quarter Business Expectations 128

Economics – Markets – Strategy Economics: Philippines Survey, only a net 12.6% of firms were optimistic over conditions in the current quarter, a 17.3pt plunge from the 1Q08 reading and the lowest in three years. For the quarter ahead – or 3Q08 - only a net 16.6% were optimistic, a 24.4pt drop from the previous reading (Chart 6). The unwillingness of the private sector to spend will contrast sharply against ongoing public spending on infrastructure. Plans to balance the budget this year have been pushed aside (possibly till as late as 2010, judging by official comments), and this year’s PHP 1.23trn budget now looks set to be upped to PHP 1.255trn. This is a sum that includes a PHP 18.6bn windfall from the 12% VAT on petroleum products. Details of the new budget have not yet been released, but under the previous spending plan, some PHP 113bn – or 9.2% of the budget – was to have been spent on infrastructure items such roads, bridges, airports and sea ports. The private sector will hold back spending, but the government is planning fiscal stimulus Chart 6: Business expectations plunge Business Outlook index 60 50 40 Chart 7: Balanced budget goal out the window % of GDP 1 0 -1 30 -2 20 10 0 Current qtr Next qtr -3 -4 Govt forecast -10 Latest: 1Q08 -5 -20 Dec-04 Dec-05 Dec-06 Dec-07 -6 1997 1999 2001 2003 2005 2007 According to Finance Secretary Teves, the increased spending will take the budget deficit to at most PHP 75bn, or 1% of GDP (Chart 7). This implies revenues of at least PHP 1.18trn will be needed. Based on our growth assumptions, this should be achievable, with some room for expenditure to even slightly exceed current plans. External outlook still rough As with consumption, the country’s external trade performance this past quarter has been disappointing, and we now look for net exports to subtract a hefty 1.6%-pts from the overall growth headline. Real exports in the first quarter contracted 11.1% YoY, the first decline in six years. Imports, reflecting export trends and weaker domestic demand, also declined, by 6.6%. As is evident from Chart 8, the drop in exports occurred on a combination of weak external demand particularly Chart 8: Exports feeling the pain on all fronts % YoY, 3mma Ratio 25 USD terms 1.3 20 PHP terms 1.2 15 10 1.1 5 0 -5 -10 -15 -20 US Semicon BB ratio (RHS) Latest: Exports Mar08, BB ratio Apr08 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 1.0 0.9 0.8 0.7 0.6 Net exports will subtract 1.6%-pts from growth this year 129

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