3QIR 26 October

analysis of the BSP ... the inflation target may sometimes occur because of factors beyond the ... 6 The Advisory Committee is supported by a Technica...

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FOREWORD

T

he primary objective of monetary policy is to promote a low and stable rate of inflation conducive to a balanced and sustainable economic growth. The adoption in January 2002 of the inflation targeting framework for monetary policy was aimed at helping to fulfill this objective. One of the key features of inflation targeting is greater transparency, which means greater disclosure and communication by the BSP of its policy actions and decisions. This Inflation Report is published by the BSP as part of its transparency mechanisms under inflation targeting. The objectives of this Inflation Report are: (i) to identify the risks to price stability and discuss their implications for monetary policy; and (ii) to document the rigorous economic analysis behind the conduct of monetary policy and convey to the public the overall thinking behind the BSP’s decisions on monetary policy. The broad aim is to make monetary policy easier for the public to follow and understand and enable them to better monitor the BSP’s commitment to the inflation target, thereby helping both in anchoring inflation expectations and encouraging informed debate on monetary policy issues. The government’s targets for annual headline inflation under the inflation targeting framework have been set at 4.5 percent and 4.0 percent for 2010 and 2011, both with a tolerance interval of ± 1.0 percentage point. The inflation target range for 2010 therefore is 3.5-5.5 percent and for 2011, 3.0-5.0 percent. For the medium term, the BSP shifted to a fixed inflation target of 4.0 ± 1.0 percent for 2012-2014. The report is published on a quarterly basis, presenting a survey of the various factors affecting inflation. These include recent price and cost developments, prospects for aggregate demand and output, labor market conditions, monetary and financial market conditions, fiscal developments, and the international environment. A section is devoted to a discussion of monetary policy developments in the last quarter, as well as a comprehensive analysis of the BSP’s view of the inflation outlook for the policy horizon. This is followed by a discussion of the implications of the assessment of inflation and economic conditions on the monetary policy settings of the BSP. This issue also features a box article on the shift of the BSP to a fixed medium-term inflation target to promote a long-term view on inflation and help better anchor inflation expectations. The Monetary 14 October 2010.

Board

approved

this

Inflation

Report

at

its

meeting

AMANDO M. TETANGCO, JR. Governor 29 October 2010

on

List of Acronyms, Abbreviations, and Symbols AFF AP AL BAS BES BIR BIS BOC BPO BTr CAMPI CAR CBD CCRs CES CDS CI CPI DBCC DOF EIA EMBI ERC EU FAO GDP GNP GRAM ICERA IEA IMF IPP KBs LFS LPG LTFRB MB MEM Meralco MISSI MTP NCCP NDA NEDA NFA NFIA NG NPC NPLs NSO OPEC PBR PCE

Agriculture, Fishery, and Forestry Asia Pacific Auto Loans Bureau of Agricultural Statistics Business Expectations Survey Bureau of Internal Revenue Bank for International Settlements Bureau of Customs Business Process Outsourcing Bureau of the Treasury Chamber of Automotive Manufacturers of the Philippines, Inc. Capital Adequacy Ratio Central Business District Credit Card Receivables Consumer Expectations Survey Credit Default Swaps Confidence Index Consumer Price Index Development Budget Coordination Committee Department of Finance Energy Information Administration Emerging Market Bond Index Energy Regulatory Commission European Union Food and Agriculture Organization Gross Domestic Product Gross National Product Generation Rate Adjustment Mechanism Incremental Currency Exchange Rate Adjustment International Energy Agency International Monetary Fund Independent Power Producer Commercial Banks Labor Force Survey Liquefied Petroleum Gas Land Transportation Franchising and Regulatory Board Monetary Board Multi-Equation Model Manila Electric Company Monthly Integrated Survey of Selected Industries Major Trading Partner National Council for Commuter Protection Net Domestic Assets National Economic and Development Authority Net Foreign Assets, National Food Authority Net Factor Income from Abroad National Government National Power Corporation Non-performing Loans National Statistics Office Organization of the Petroleum Exporting Countries Performance-based Rate Personal Consumption Expenditure ii

PMI PSEi RB REER ROP RP RRELs RRP SEM SMS SDA TCS U/KBs WEO WESM

Purchasing Managers’ Index Philippine Stock Exchange Composite Index Rural Banks Real Effective Exchange Rate Republic of the Philippines Repurchase Residential and Real Estate Loans Reverse Repurchase Single-Equation Model Short Message Service Special Deposit Account Transportation, Communications, and Storage Universal/Commercial Banks World Economic Outlook Wholesale Electricity Spot Market

iii

THE MONETARY POLICY OF THE BANGKO SENTRAL NG PILIPINAS The BSP Mandate The BSP’s main responsibility is to formulate and implement policy in the areas of money, banking and credit, with the primary objective of maintaining stable prices conducive to a balanced and sustainable economic growth in the Philippines. The BSP also aims to promote and preserve monetary stability and the convertibility of the national currency. Monetary Policy Instruments The BSP uses various instruments to effect the desired monetary policy stance to achieve the inflation target. These include (a) raising/reducing the BSP's policy interest rates; (b) increasing/decreasing the reserve requirement; (c) encouraging/discouraging deposits in the special deposit account (SDA) facility by banks and trust entities of BSP-supervised financial institutions; (d) increasing/decreasing its rediscount rate on loans extended to banking institutions on a short-term basis against eligible collaterals of banks’ borrowers; and (e) outright sales/purchases of the BSP’s holdings of government securities. The BSP’s primary monetary policy instruments are its overnight reverse repurchase (RRP) or its borrowing rate and overnight repurchase (RP) or its lending rate. Policy Target The BSP uses the headline inflation rate derived from the Consumer Price Index (CPI) which is compiled and released to the public by the National Statistics Office (NSO) as its target for monetary policy. The policy target is set by the Development Budget Coordination Committee (DBCC)5 in consultation with the BSP. For 2010, the headline inflation target has been set at 4.5 percent ± 1.0 percentage point, while for 2011, the inflation target has been set at 4.0 percent ± 1.0 percentage point. On 15 July 2010, the BSP announced its shift to a fixed inflation target for the medium term of 4.0 percent ± 1.0 percentage point for 2012-2014. BSP’s Explanation Clauses These refer to the predefined set of acceptable circumstances under which an inflationtargeting central bank may fail to achieve its inflation target. These clauses recognize the fact that there are limits to the effectiveness of monetary policy and that deviations from the inflation target may sometimes occur because of factors beyond the control of the central bank. Under the inflation targeting framework of the BSP, these exemptions include inflation pressures arising from: (a) volatility in the prices of agricultural products; (b) natural calamities or events that affect a major part of the economy; (c) volatility in the prices of oil products; and (d) significant government policy changes that directly affect prices such as changes in the tax structure, incentives, and subsidies. 5

The DBCC, created under Executive Order (E.O.) No. 232 dated 14 May 1970, is an inter-agency committee tasked primarily to formulate the National Government's fiscal program. It is composed of the Department of Budget and Management (DBM), National Economic and Development Authority (NEDA), and the Department of Finance (DOF). The BSP sits as a resource agency.

iv

The Monetary Board The powers and functions of the BSP, such as the conduct of monetary policy and the supervision over the banking system, are exercised by its Monetary Board, which has seven members appointed by the President of the Philippines. Beginning in July 2006, the Monetary Board meets every six weeks to review and decide on the stance of monetary policy. Prior to July 2006, monetary policy meetings by the Monetary Board were held every four weeks. Chairman

Amando M. Tetangco, Jr.

Members

Cesar V. Purisima Juanita D. Amatong Nelly F. Villafuerte Alfredo C. Antonio Ignacio R. Bunye Peter B. Favila

The Advisory Committee The Advisory Committee was established as an integral part of the institutional setting for inflation targeting. It is tasked to deliberate, discuss and make recommendations on monetary policy to the Monetary Board. The Committee meets every six weeks (beginning July 2006) but may also meet in between the regular meetings, whenever it is deemed necessary. Prior to July 2006, the Committee met every four weeks. Chairman

Amando M. Tetangco, Jr. Governor

Members6

Diwa C. Guinigundo Deputy Governor Monetary Stability Sector Nestor A. Espenilla, Jr. Deputy Governor Supervision and Examination Sector Ma. Cyd N. Tuaño-Amador Assistant Governor Monetary Policy Sub-Sector Ma. Ramona GDT Santiago Assistant Governor Treasury Department

6

The Advisory Committee is supported by a Technical Secretariat composed of officers and staff from the Department of Economic Research, Center for Monetary and Financial Policy, and the Treasury Department.

v

2010 SCHEDULE OF MONETARY POLICY MEETINGS, INFLATION REPORT PRESS CONFERENCE AND PUBLICATION OF MB HIGHLIGHTS

Period

2 0 1 0

Jan

Advisory Committee (AC) Meeting

Monetary Board (MB) Meeting

25 (Mon)

28 (Thu)

Feb

MB Highlights Publication 14

(Thu)

25 (Thu)

Mar

8 (Mon) 8

11 (Thu)

Apr

19 (Mon)

22 (Thu)

May

31 (Mon)

Jun

Inflation Report (IR) Press Conference

12 (Fri) 7

8 (Thu) 20 (Thu)

7 (Fri) 9

30 (Fri)

3 (Thu)

Jul

12 (Mon)

15 (Thu)

1 (Thu)

Aug

23 (Mon)

26 (Thu)

12 (Thu)

Sep

23 (Thu)

Oct

4 (Mon)

7 (Thu)

29 (Fri)

Nov

15 (Mon)

18 (Thu)

4 (Thu)

Dec

28 (Tue) 10

30 (Thu)

16 (Thu)

7

Inflation Report press conference scheduled on the last Friday of January (29 January 2010) will be moved two weeks later (12 February 2010) due to a scheduled AC meeting on 25 January 2010 and MB meeting on 28 January 2010. 8 There is a scheduled BIS bi-monthly Governors’ meeting on 7-8 March 2010. 9 Inflation Report press conference scheduled on the last Friday of April (30 April 2010) will be moved one week later (7 May 2010) due to a scheduled AC meeting on 19 April 2010 and MB meeting on 22 April 2010. 10 AC meeting scheduled on 27 December 2009 (Monday) will be moved to 28 December 2010 (Tuesday). As per Proclamation No. 1841 dated 21 July 2009, 30 December 2010 (Rizal Day), which falls on a Thursday, will be moved to 27 December 2010 (Monday nearest 30 December 2010 - Republic Act No. 9492 dated 24 July 2007).

vi

CONTENTS Overview

1

I.

3

Inflation and Real Sector Developments Prices

3

Aggregate Demand and Supply

9

Aggregate Demand

10

Other Demand Indicators

11

Aggregate Supply

17

Labor Market Conditions II.

18

Monetary and Financial Market Conditions

19

Domestic Liquidity and Credit Conditions

19

Interest Rates

23

Financial Market Conditions

24

Banking System

28

Exchange Rate

31

III.

Fiscal Developments

33

IV.

External Developments

34

V.

Monetary Policy Developments

38

Box Article: Medium-term Inflation Target for the Philippines

40

Inflation Outlook

44

VI.

VII.

Private Sector Economists’ Inflation Forecasts

44

BSP Inflation Forecasts

46

Risks to the Inflation Outlook

51

Implications for the Monetary Policy Stance

55

vii

OVERVIEW11

Inflation decelerates further in Q3 2010. Headline inflation dropped further to 3.8 percent in Q3 2010 compared to 4.2 percent in Q2 2010 as a result of lower non-food inflation. The decline in non-food inflation could be traced mainly to the rollbacks in the prices of petroleum products, which brought down inflation for fuel and transportation and communication services during the quarter. Meanwhile, core inflation increased slightly to 4.0 percent from 3.9 percent in the previous quarter. The rise in core inflation was due mainly to higher light inflation as electricity prices went up due to higher cost of power from the Wholesale Electricity Spot Market (WESM). Available indicators point to a solid pick-up in domestic demand. Real GDP grew strongly in the first half of 2010, buoyed by the solid expansion in private demand and capital formation, as well as the continued recovery in exports. Economic activity was supported in part by electionrelated spending and post-disaster rehabilitation efforts following the spate of typhoons that occurred in the second half of 2009. Other demand indicators likewise reflected the economy’s strengthening internal momentum. Capacity utilization in the manufacturing sector remained high while merchandise trade activity continued to grow robustly. Business confidence and consumer sentiment continued to improve while labor demand showed signs of picking up as employment levels continued to increase, with the unemployment rate dropping significantly to 6.9 percent in July 2010. Global economic activity strengthens in the first half of 2010 but the pace of recovery is expected to moderate in the near term. Output growth in most advanced economies continued to be held down by weak consumer confidence, tepid employment conditions, and impaired household balance sheets. Meanwhile, recovery in emerging economies proceeded at a stronger pace on the back of resilient domestic demand and increased investment spending. The rebound in global trade also benefited the manufacturing sector of advanced Asia, helping propel growth in the rest of the region. Going forward, global growth prospects will be determined by the internal rebalancing of demand from public to private sources and stronger progress toward the resolution of global imbalances involving countries running significant external surpluses as well as in countries running large external deficits. The recovery in developed economies will remain fragile until improving business sentiment is translated to firmer employment prospects. Risks to the growth forecasts are mainly on the downside but the possibility of a sharp global downturn due to the sluggish recovery in advanced economies appears slim. Meanwhile, inflation is expected to be generally subdued as substantial slack in the global economy remains and employment conditions continue to be soft. Domestic financial market conditions improve further on the back of positive economic developments on the local front and easing concerns about the sovereign debt problem in some parts of Europe. Positive domestic economic developments, including the continued strong growth performance, manageable inflation outlook, rising export receipts and investment inflows along with improved fiscal position in August, boosted market sentiment. Renewed appetite for emerging market assets encouraged by international yield differentials favoring emerging markets in the region likewise underpinned steady capital inflows to the country. These were translated into bullish trading in the local bourse, generally narrower Philippine bond debt spreads, and the appreciation trend of the peso. Meanwhile, the robust bank lending growth continues to suggest that ample funds are available to support the growth requirements of the economy despite the slower growth of domestic liquidity.

11

The analyses in this report are based on information as of 30 September 2010.

1

The favorable inflation dynamics over the policy horizon have provided the BSP with the flexibility to keep policy interest rates steady during the quarter. The favorable outlook for inflation has allowed the BSP to keep policy rates steady since July 2009. The Monetary Board (MB) noted that inflation projections continued to indicate a manageable inflation environment, with inflation averaging within the target ranges for 2010-2012. The forecasts were also supported by well-contained inflation expectations while the various measures of core inflation point to a broadly stable trend for consumer prices. Meanwhile, the BSP has announced the shift to a fixed medium-term inflation target from a variable annual inflation target on 15 July 2010. The adoption of a fixed medium-term target is expected to help promote a long-term view on inflation, increase the predictability of monetary policy and better anchor inflation expectations. For 2012-2014, the inflation target range was set at 4.0 percent ± 1.0 percentage point. The baseline inflation scenario, going forward, remains favorable, consistently tracking a within-target inflation path. Latest baseline projections indicate that headline inflation will likely fall within the 4.5 percent ± 1.0 percentage point target range for 2010 and the 4.0 percent ± 1.0 percentage point target range for 2011-2012. Compared with the projections in the previous report, the latest forecasts follow a slightly lower trajectory, due mainly to lower actual inflation outturns and the continued strength of the peso during the quarter. Well-contained inflation expectations over the policy horizon also support the within-target inflation outlook. Recent surveys of private economists showed that inflation expectations have been steadily declining, reflecting in part the general downtrend of headline inflation as well as prospects of slower global economic growth in the near term and its potential impact on international commodity prices. The economy, therefore, continues to be at a point where the goal of safeguarding inflation is compatible with that of helping support economic activity, as inflation remains low even as demand has strengthened. While output growth appears to be gaining momentum, inflation pressures have remained subdued due to a number of reasons. Capital formation will help to increase the economy’s productive capacity, therefore tempering the build-up of demand-induced price pressures. At the same time, favorable labor market conditions are likely to moderate pressures for wage increases. World economic conditions also point to a tepid global recovery, keeping a lid on imported price pressures. Nonetheless, the BSP will remain attentive to inflationary pressures going forward to ensure that monetary policy settings continue to be appropriate. Potential sources of upward pressures on future inflation include a possible rebound in oil prices given the continuing strong demand in emerging economies, the impact of adverse weather conditions on agriculture, petitions for electricity rate adjustments, and a stronger-than-expected domestic economic recovery that could induce demand-side price pressures. Meanwhile, the inflation path may be dampened by a slow recovery scenario for global growth and a sustained strengthening of the peso which could temper the impact of imported inflation. [On 7 October 2010, the Monetary Board decided to maintain the RRP and RP rates at 4.0 and 6.0 percent, respectively. The Monetary Board also maintained the current interest rates on term RRPs, RPs and SDAs. The current reserve requirement ratio was also kept unchanged.]

2

I. INFLATION AND REAL SECTOR DEVELOPMENTS Prices The year-on-year headline inflation of 3.8 percent in Q3 2010 was lower than the quarter-ago rate of 4.2 percent but was higher than the 0.3 percent rate registered in the comparable period a year ago.

Inflation decelerates further.

Headline Inflation Quarterly average in percent (2000=100)

13 11 9

Q3 2010 3.8

7 5 3

Meanwhile, core inflation increased marginally to 4.0 percent from 3.9 percent (revised) in the previous quarter. The increase in core inflation was influenced mainly by the uptick in light inflation due to higher power rates, and was not indicative of broad-based price pressures.

1 -1 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Headline and Core Inflation

Headline inflation declines on account of lower non-food inflation. Headline and Core Inflation Quarterly average in percent (2000=100)

14 12

Q3 2010 10

Headline inflation dropped further to 3.8 percent in Q3 2010 compared to 4.2 percent in Q2 2010 as a result of lower non-food inflation. The decline in non-food inflation, in turn, could be traced mainly to the rollbacks in the prices of petroleum products which brought down inflation for fuel and transportation and communication services during the quarter relative to Q2 2010.

Headline 3.8

8 6 4 Core 4.0

2 0

Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 2002

2003

2004

2005

Headline Inflation

2006

2007

2008

2009

2010

Core Inflation

Official core inflation rises due mainly to higher electricity prices.

Core inflation, which excludes some food and energy items to measure generalized price pressures, inched up anew during the quarter. The official NSO core inflation measure was higher at 4.0 percent in Q3 2010 compared to 3.9 percent (revised) in the previous quarter due mainly to higher light inflation. Electricity prices went up with higher cost of power from the WESM. Likewise, Q3 2010 core inflation was higher compared to the core inflation measure of 3.0 percent in the same quarter a year ago. Meanwhile, all the three alternative measures of core inflation estimated by the BSP reflected a downtrend in Q3 2010 relative to the levels registered in the previous quarter. The trimmed

3

Alternative Core Inflation Measures Quarterly averages of year-on-year change Quarter

Official Core Inflation

2008 Q1 Q2 Q3 Q4 2009 Q1 Q2 Q3 Q4 2010 Q1 Q2 Q3

Trimmed Mean 1/

Weighted Median 2/

Net of Volatile Items 3/ *

6.2 4.1 6.2 6.9 7.7 4.1 6.3 4.4 3.0r 2.8r

7.6 5.1 7.7 9.5 7.9 3.6 5.8 3.9 1.8 3.0

7.2 4.5 7.4 8.9 8.1 3.6 5.6 3.9 2.2r 2.9

7.7 5.1 8.0 9.6 8.1 2.9 5.2 2.6 1.1 2.6

3.8 3.5 3.9r 4.0

3.2 3.4 3.2 2.8

3.0 3.2 2.9 2.4

5.2 5.0r 5.5 4.8

1/ The trimmed mean represents the average inflation rate of the (weighted) middle 70 percent in a lowest-to-highest ranking of year-on-year inflation rates for all CPI components. 2/ The weighted median represents the middle inflation rate (corresponding to a cumulative CPI weight of 50 percent) in a lowest-to-highest ranking of year-on-year inflation rates. 3/ The net of volatile items method excludes the following items: educational services, fruits and vegetables, personal services, rentals, recreational services, rice, and corn. r/ Revised. * The series has been recomputed using a new methodology that is aligned with NSO’s method of computing the official core inflation, which re-weights remaining items to comprise 100 percent of the core basket after excluding non-core items. The previous methodology retained the weights of volatile items in the CPI basket while keeping their indices constant at 100.0 from month to month.

Source: NSO, BSP estimates

Contribution to Quarterly Inflation in percent Item

Core Inflation Non-core Items Rice Corn Fruits and Vegetables Gas, LPG Kerosene Oil, Gasoline and Diesel Headline Inflation

Weight in Headline CPI

81.6 18.4 9.4 0.9

Percentage Contribution to Year-on-Year Headline Inflation Q3 Q3 Q2 2010 2010 2009 3.32 3.33 1.39 0.48 0.87 -1.05 0.08 0.03 -0.36 0.00 -0.04 -0.04

5.3

0.12

0.13

0.09

1.3 0.3

0.12 0.02

0.37 0.05r

-0.19

1.3

0.14

0.33

-0.48

100.00

3.8

4.20

0.33

Source of Basic Data: NSO, BSP

-0.07

mean, weighted median, and net of volatile items measures dropped to 2.8 percent, 2.4 percent, and 4.8 percent from 3.2 percent, 2.9 percent, and 5.5 percent, respectively. Core inflation contributed 3.3 percentage points to headline inflation in Q3 2010, the same as in Q2 2010 but higher than the 1.4 percentagepoint contribution a year ago. Non-core Consumer Price Index (CPI) items contributed 0.5 percentage point to headline inflation during the period, lower than the previous quarter’s 0.9 percentage-point contribution but higher than the -1.1 percentage-point contribution in the same quarter a year ago. The proportion of CPI components showing inflation rates above a given threshold provides an indication as to whether pressures on consumer prices are becoming generalized over time. The number of items with inflation rates greater than the threshold of 5.5 percent (the upper end of the inflation target for 2010) decreased to 16 in Q3 2010 from 20 in the previous quarter. These items accounted for a lower proportion of the CPI basket at 13.6 percent compared to 15.5 percent in the previous quarter. Dividing the CPI basket into food and non-food components showed fewer number of items above the threshold for both groups. There were 9 food items with inflation rates above the threshold from 11 in the previous quarter, while 7 non-food commodities posted inflation rates higher than the threshold in Q3 2010 from 9 in the previous quarter.

4

Food Inflation

Higher sugar and rice prices push up food inflation. Inflation Rates for Selected Food Items Quarterly averages in percent (2000=100)

2010

Commodity

Food, Beverage and Tobacco Food Cereal & Cereal Products o/w Rice Corn Dairy Products Eggs Fish Fruits & Vegetables Meat Misc. Food Beverages Tobacco

Q3

Q2

3.3 3.4 1.4 0.8 0.1 1.5 2.9 2.4 2.3 4.3 7.1 1.7 2.7

3.1 3.2 0.7 0.3 -4.7 1.6 2.4 3.5 2.4 5.1 5.9 1.7 2.9

2009 Q3

Q2

1.9 1.8 -2.1 -3.8 -5.0 5.0 6.4 6.5 1.7 2.6 2.7 3.2 3.5

5.6 5.7 7.4 7.1 6.7 7.1 7.4 5.4 5.8 4.2 4.0 4.3 3.8

Source of Basic Data: NSO, BSP

Food, beverage, and tobacco inflation inched up in Q3 2010 to 3.3 percent from 3.1 percent in the previous quarter and 1.9 percent a year ago, with higher prices of agricultural commodities. In particular, sugar prices went up in Q3 2010 due to tightness in domestic supply after El Niño affected the harvest and delayed the milling season this crop year. The prices of major cereal grains also rose in Q3 2010 relative to Q3 2009, reflecting the impact of adverse weather conditions to production. The farmgate price of palay went up to P15.28 per kilo in September 2010 from P14.15 per kilo in September 2009. Similarly, the retail prices of ordinary rice and special rice increased in Q3 2009 to P30.81 per kilo and P34.41 per kilo, respectively, in Q3 2010 from P30.33 per kilo and P33.83 per kilo. The retail price of yellow corn averaged P18.92 per kilo in September 2010, also higher than its year-ago level of P18.63. Meanwhile, the prices of palay and milled rice declined generally compared to their end-Q2 2010 levels, reflecting the onset of the main harvest season in September. Corn prices also registered lower prices on a quarter-on-quarter basis. Non-food inflation

Rollbacks in the prices of petroleum products lead the decline in non-food inflation. Inflation Rates for Selected NonFood Items Quarterly averages in percent (2000=100) 2010

Commodity Non-Food Items Clothing Housing & Repairs Fuel, Light & Water Fuel Light Water Services Transpo & Comm. Miscellaneous

2009

Q3

Q2

Q3

Q2

4.3 2.0 1.6 13.8 7.6 20.9 7.5 3.5 3.4 1.3

5.4 2.0 1.7 16.9 20.5 16.4 9.5 5.1 6.9 1.4

-1.2 2.2 2.2 -4.5 -12.8 -1.5 12.4 -3.9 -10.6 2.3

0.7 2.6 3.0 -4.2 -12.2 -1.4 10.3 0.2 -4.4 2.9

Non-food inflation at 4.3 percent was lower relative to the 5.4 percent posted a quarter ago but was higher relative to the -1.2 percent registered a year ago. In particular, inflation for fuel and transportation and communication services accounted for the reduction in non-food inflation in Q3 2010. From 20.5 percent and 6.9 percent in Q2 2010, fuel and transportation and communication services inflation declined to 7.6 percent and 3.4 percent, respectively, during the quarter, reflecting the lower prices of petroleum products.

Source of Basic Data: NSO, BSP

5

Energy Prices

Average oil price falls on concerns over the sustainabilty of the recovery in developed economies.

The international price of Dubai crude oil dropped by 5.4 percent quarter-on-quarter to US$73.90 per barrel in Q3 2010 from an average of US$78.12 per barrel in Q2 2010, influenced by the significantly lower average price in July. Meanwhile, the international oil price was higher by 8.8 percent on a year-on-year basis. The price of oil decreased during the quarter as weak economic reports in the world’s three biggest oil-consuming countries (US, China, and Japan) reinforced concerns that global economic growth may be weakening. In particular, higher initial jobless claims in the US during the first two weeks of August and the third week in September, coupled with the lower-thanexpected increase in private payrolls and the decline in overall employment in the US, fanned concerns that the world’s biggest energy consumer is struggling to recover. Forecasts for oil demand by global energy authorities were broadly unchanged from earlier assessments, with growth expected to come from countries outside of the Organization of Economic Cooperation and Development (OECD). Based on the September 2010 Oil Market Report of the Organization of the Petroleum Exporting Countries (OPEC), the economic recovery in most developed countries is moderating and encountering turbulence. The phase-out of stimulus measures in some OECD countries as government fiscal positions worsen is likely to soften economic activity in the second half of 2010, leading to weaker oil demand compared to the first half. The Energy Information Administration (EIA),12 the OPEC, 13 and the International Energy Agency (IEA) 14 forecast 2010 global oil demand to grow by 1.6 million barrels per day (mbd), 1.0 mbd, and 1.9 mbd, respectively. Demand growth is expected to come mainly from China, India, the Middle East, and Latin America.

Local pump prices decline generally.

12 13 14

During Q3 2010, the domestic prices of unleaded gasoline, kerosene, diesel, and LPG declined by P2.50 per liter, P2.00 per liter, P1.75 per liter, and P0.31 per liter, respectively, relative to endQ2 2010 levels. During the review quarter, the prices of unleaded gasoline, kerosene, and diesel were reduced seven times but raised five

EIA, Short-Term Energy Outlook for September 2010, www.eia.doe.gov OPEC Oil Market Report for September 2010, www.opec.org IEA, Oil Market Report, www.iea.org

6

times, while the price of LPG was reduced twice and increased twice. Compared to end-Q3 2009, pump prices of petroleum products were all higher at end-Q3 2010. In particular, the prices of unleaded gasoline, kerosene, diesel, and LPG increased by P3.01 per liter, P1.59 per liter, P3.38 per liter, and P2.63 per liter, respectively.

World oil prices are expected to track a higher path. Spot and Estimated Future Prices of Dubai Crude Oil* Price in US dollars per barrel 150 130

Meanwhile, the government has removed the tariff on imported crude oil and petroleum products effective 5 July 2010, regardless of source. Executive Order (EO) No. 890, which was issued by President Arroyo on 10 June 2010, set a uniform zero tariff on imported crude oil and refined petroleum products.

110 30 Sep 10

90 70

30 Jun 10

50 30 10 2000

2001

2002

2003

2004

2005

2006

2007

*Futures price derived using Brent crude futures data.

2008

2009

2010

2011

2012

The estimated future prices of Dubai crude oil, based on movements in Brent crude oil futures, suggest a continuously increasing and higher path for 2010 and 2011 compared to the forecasts at end-Q2 2010. This could be attributed to expectations of continued growth, albeit at a moderated pace, in US and China, the two largest energy-consuming economies in the world. Transportation In the transport sector,15 petitions for minimum taxi fare and jeepney fare hikes remained pending with the Land Transportation and Franchising Regulatory Board (LTFRB). The petition filed by the Philippine National Taxi Operators Association (PNTOA) on 26 January 2010 requested an increase in the flag-down rate and charge for succeeding meters and waiting time by P10.00 and P1.50, respectively. The petition for an additional charge of P70, particularly for taxis with radio, was also still pending with the LTFRB. The additional amount will be charged on top of the flag-down rate and is aimed at compensating taxi drivers for their waiting time and the risk of losing customers (those who decided not to wait for the taxis they requested). Meanwhile, the petition by the Alliance of Concerned Transport Operators (ACTO) for a 50-centavo provisional fare increase was already filed for resolution.

15

Land transportation expense accounts for 3.5 percent of the total CPI basket.

7

Water

Water rates are slightly lower due to the strengthening of the peso.

Water rates were lower in the third quarter due to the appreciation of the peso. The Metropolitan Waterworks and Sewerage System-Regulatory Office (MWSS-RO) approved the reduction in water rates for Q3 2010 through foreign currency differential adjustments (FCDA). For Q3 2010, the FCDA component was zero for Manila Water while Maynilad passed on a refund of P0.09/m 3. On a quarter-on-quarter basis, water rates of Manila Water and Maynilad decreased by 1.2 percent and 0.7 percent, respectively. However, on a year-on-year basis, the rates of Manila Water and Maynilad were higher by 8.1 percent and 7.2 percent, respectively. Telecommunications

The NTC continues to pursue the reduction in interconnection charges on SMS and voice calls.

The National Telecommunications Commission (NTC) will continue to pursue the reduction in interconnection charges from P0.35 to P0.15 on short message service (SMS) and from P4.00 per minute to P1.50 per minute on voice calls. If the access charges will be reduced, the SMS retail rate may go down by about P0.40 to P0.60 per text from the current P1.00. Power

Power rates decline generally due to lower generation costs.

Contrary to expectations of lower power rates due to the onset of the rainy season, higher cost of purchases from the WESM led to a hike in electricity rates in the early part of the quarter. In August, generation charges registered the second highest level for the year.16 Meanwhile, the lower cost of supply from the National Power Corporation (NPC) tempered the high cost of WESM purchases. Towards the end of the quarter, however, electricity rates moderated as Meralco passed on lower generation costs to consumers. Generation costs declined due to the decline in both prices at the WESM and cost of supply from independent power producers (IPPs) as power plants operated more efficiently. However, there remain potential sources of upside pressures on electricity rates stemming from pending petitions with the ERC. These include: (1) Meralco’s petition to increase its retail electricity charges in 2011-2015; (2) Power Sector Assets and Liabilities Management’s

16

Generation charge reached the peak level of P6.77/kwh in April.

8

(PSALM) petition to recover NPC’s stranded contract cost and debts; (3) NPC’s petition to recover actual and incremental fuel, IPP and foreign exchange rate fluctuation costs under the 13th-17th generation rate adjustment mechanism (GRAM) and the 12th-16th incremental currency exchange rate adjustment (ICERA); and (4) the National Grid Corporation’s petition to recover the costs of repair on damages caused by the tropical storms in 2009 and the bombings in Lanao del Norte.

Aggregate Demand and Supply Economic growth accelerates.

The domestic economy continued to post strong growth in Q2 2010, reflecting solid growth in private demand and capital formation, as well as continued recovery in industrial production. Real GDP grew by 7.9 percent, significantly higher than the year-ago growth rate of 1.2 percent and the highest quarterly GDP expansion posted since Q2 2007. This brought GDP growth in the first semester to 7.9 percent.

GDP and GNP Growth Rates Annual Growth in Real Terms (%) 10 9 8 7 6 5 4 3 2 1 0 2002

2003

2004

2005

GDP

2006

2007

GNP

2008

2009

2010

On the production side, the contraction in agricultural output due to the El Niño phenomenon was offset by the growth in industry and services. On the expenditure side, growth was driven mainly by increased consumption, investments in construction and durable equipment, and the continued strong recovery in external trade. Meanwhile, net factor income from abroad (NFIA) rose by 7.7 percent on the back of the continued growth in overseas Filipino remittances. This resulted in the 7.9 percent expansion in the Q2 2010 real GNP compared to the 4.4 percent growth recorded in the same quarter 2009. Seasonally-adjusted estimates show that GDP expanded by 1.3 percent in Q2 2010 from 3.8 percent in Q1 2010. The slowdown was due mainly to the continuing decline in agricultural production.

9

Aggregate Demand

Domestic Demand Annual Growth in Real Terms

Expenditures by major economic sectors

30 25 20 15 10 5 z

0 -5 -10 -15 -20 -25 2002

2003

2004

Private Consumption

2005

2006

2007

Govt. Spending

2008

2009

2010

Fixed Investment

Government consumption increased by 5.6 percent with continued spending for on-going projects, increased provision for pro-poor programs, and the additional disbursements for the 2010 national elections.

Economic Performance Growth rate (in percent)

2009 Q2

Q1

Q2

By expenditure item Personal consumption Government consumption Capital formation Fixed capital formation Exports

5.5 11.9 -5.9 -0.3 -18.0

5.4 20.0 21.9 16.0 22.4

4.9 5.6 11.0 25.5 27.4

Imports

-2.1

22.4

23.9

Sector

Source: NSCB

On the expenditure side, personal consumption expenditure (PCE) remained the major driver of growth during Q2 2010. The upsurge in OF remittances supported consumer spending, with PCE growing firmly by 4.9 percent year-on-year, albeit slower than the 5.5 percent and 5.4 percent posted in Q2 2009 and Q1 2010, respectively.

2010

Capital formation sustained its double-digit growth in Q2 2010, expanding by 11.0 percent from a 5.9 percent contraction in the same period a year ago. The third consecutive quarter of capital formation growth came from increased investments in durable equipment. Fixed capital formation was also supported by the accelerated growth rate of construction at 22.5 percent. Investments in construction rose on account of public construction, which maintained its doubledigit growth due to the carry-over disbursement for Ondoy rehabilitation and reconstruction activities and the settlement of on-going and completed projects. Likewise, growth in private construction was higher as confidence in the property market returned. With the global economy emerging from recession, the country’s external trade performance continued to recover as both exports and imports posted year-on-year growth rates of more than 20 percent in Q2 2010 for the second consecutive quarter.

10

Other Demand Indicators Other demand indicators point to firmer growth prospects in the near term. Capacity utilization in the manufacturing sector remained high while merchandise trade activity continued to grow robustly. Business and consumer sentiment were on an uptrend while labor demand showed signs of picking up. The property sector, meanwhile, remained generally stable despite ongoing market correction. Property Prices

Land values are lower due to on-going market correction.

The latest report from Colliers International indicated that, on a quarter-on-quarter basis, implied land values17 continued to decline in Q2 2010. On a year-on-year basis, implied land values for the Makati Central Business District (CBD) and Ortigas Center also showed a decline of 7.9 percent and 7.0 percent, respectively, in the second quarter of 2010. Implied land values in the Makati CBD and Ortigas Center were lower at P265,365/sq.m. and P120,000/sq.m., respectively, due to the continuing correction in the commercial property market. According to Colliers, while commercial values in general have bottomed out, land values in the Makati CBD are expected to remain stable towards the end of the year. Land values are presently at about 61-63 percent of their 1997 levels in nominal terms, but only about 30-32 percent of their 1997 levels in real terms. Vacancy Rates

Makati CBD office vacancy rates decline marginally…

The monthly office vacancy rate in the Makati CBD of 6.9 percent was lower in Q2 2010 compared to the quarter-ago level but higher than its year-ago level. According to Colliers, although the overall office vacancy rate in the Makati CBD declined marginally in Q2 2010, vacancy rates increased significantly in both the Premium and Grade A segments due to decentralization pressures as office buildings outside the Makati CBD experienced strong demand from the outsourcing and offshoring industry.

17

In the absence of reported closed transactions, implied land values based on trends are used by Colliers International to monitor prices.

11

… while residential vacancy rates are expected to rise further with the expected completion of more residential condominiums in the near term.

Meanwhile, the residential vacancy rate at 7.8 percent during the quarter was higher compared to the Q1 2010 level but lower than the year-ago level. There is an anticipated trend of rising vacancies in most locations in Metro Manila, particularly for studio and onebedroom units aimed at young professionals and start-up families as new residential condominium units are scheduled to be completed in the near term. In contrast, there remains a shortage of expatriate-quality twobedroom and three-bedroom units. Rental Values

Office rental values increase slightly…

Monthly office rents in the Makati CBD reached P614/sq.m. in Q2 2010, marginally higher by 0.7 percent than the level in the previous quarter.18 Rents in the Makati CBD were slightly higher in Q2 2010 with only a modest uptick in the Grade B market. Meanwhile, with the expanding demand for office space outside the Makati CBD, the incentives given by landlords to tenants last year have been steadily reduced and rental rates are expected to increase by 5-10 percent by the end of 2010. Office rental values in Q2 2010 fell below the 1997 levels for premium grade offices. In real terms, office rental values were about 38.4 percent of the comparable levels in 1997.

… while residential rental values are broadly unchanged.

Monthly rents for 3-bedroom condominium units in the Makati CBD remained at P539/sq.m. from the previous quarter despite movements in the secondary market. Colliers noted that the three-bedroom segment of the market in Makati, Rockwell, and Bonifacio remains strong and will probably withstand supply pressures in the coming years because most new residential condominiums do not offer big units to satisfy expatriate demand. Residential rental values were above their 1997 levels in nominal terms but were only about 56.9 percent of their 1997 levels in real terms.

18

This was computed as the average of the rental values for the Premium, Grade A and Grade B segments. Premium refers to office space with capital values of P75,000/sq.m. and above; Grade A, between P65,000 and P75,000/sq.m.; and Grade B, P65,000/sq.m. and below.

12

Vehicle Sales

Sales of passenger cars and commercial vehicles sustain double-digit growth. Quarterly Sales of Passenger Cars Year-on-year change in percent 50.0

Q3 2010 41.2 pct

40.0

30.0

20.0

10.0

0.0

-10.0 Q1

Q2

Q3

Q4

Q1

Q2

2008

Q3

Q4

Q1

2009

Q2

Q3

2010

Passenger car sales continued to grow by 41.2 percent year-on-year in the first two months of Q3 2010 (July–August), higher than the growth in the previous quarter (first two months) of 34.5 percent. Meanwhile, passenger car sales declined by 7.2 percent in the same period last year. According to the Chamber of Automotive Manufacturers of the Philippines, Inc., sales increased as more units became available to serve higher demand levels. Demand was influenced by the introduction of new models and attractive marketing campaigns. On a quarter-onquarter basis, passenger car sales grew at a slower rate of 11.9 percent compared to the 16.5 percent growth posted in the first two months of Q2 2010 (April – May).

Quarterly Sales of Commercial Vehicles Year-on-year change in percent

Year-on-year sales of commercial vehicles expanded by 35.0 percent in the first two months of Q3 2010, sustaining the doubledigit growth in the past three quarters as demand remained high. Likewise, quarter-onquarter sales of commercial vehicles grew by 3.5 percent from 15.5 percent in the first two months of Q2 2010.

50.0 40.0 30.0

Q3 2010 35.0 pct

20.0 10.0 0.0 -10.0 -20.0 Q1

Q2

Q3

Q4

Q1

2008

Q2

Q3

Q4

Q1

2009

Q2

Q3

2010

Quarterly Sales of Trucks and Buses Year-on-year change in percent 40.0

Q3 2010 12.3 pct

30.0 20.0 10.0 0.0 -10.0

Meanwhile, sales of trucks and buses during the review period (July – August) grew by 12.3 percent year-on-year, a turnaround from the 27.8 percent contraction in the comparable period in the previous quarter. This was also higher than the 5.2 percent growth in same period in 2009. Sales rose as supply caught up with demand. Likewise, quarter-on-quarter sales of trucks and buses almost doubled, growing by 88.7 percent in Q3 from 39.2 percent in the previous quarter.

-20.0 -30.0 -40.0 -50.0 Q1

Q2

Q3 2008

Q4

Q1

Q2

Q3 2009

Q4

Q1

Q2

Q3

2010

13

Energy Sales

Energy sales growth moderates. Quarterly Meralco Power Sales Year-on-year change in percent 20.0 15.0 10.0 5.0 0.0 -5.0 -10.0 Q1

Q2

Q3

Q4

Q1

2008

Q2

Q3

Q4

Q1

2009

Q2

Q3

2010

Spare capacity in the economy continues to narrow. Monthly Average Capacity Utilization for Manufacturing In percent 84.0

Jul 2010 83.1 pct

83.0 82.0 81.0 80.0 79.0 78.0 77.0 76.0 75.0

2007

2008

2009

2010

Manufacturing activity expands further.

year-on-year change in percent

2008 Volume of Production

2009

Capacity Utilization The latest survey of capacity utilization, which captures the intensity with which companies use their employees and capital, showed a sustained high level of manufacturing activity. This indicates that the margin of spare capacity in the economy remained narrow with improved demand. Based on the rates presented in the NSO’s Monthly Integrated Survey of Selected Industries (MISSI), average capacity utilization in manufacturing at 83.1 percent in July 2010 sustained the historical peak seen in June and May and surpassed for the ninth consecutive month the historic peak seen in 2008 before the crisis.

Volume and Value of Production Based on MISSI data, indicators for volume and value of production also reflected robust expansion as these showed, for the eighth and seventh consecutive month, respectively, double-digit year-on-year growth in July 2010 after reverting to positive growth in November 2009. Furniture and fixtures, transport equipment, leather products, machinery, both electrical and non-electrical, and miscellaneous manufactures were among the major sectors that reported production increases.

Volume and Value Indices of Manufacturing Production 40 35 30 25 20 15 10 5 0 -5 -10 -15 -20 -25 -30 2007

Power sales of the Manila Electric Company (Meralco) grew by 5.5 percent year-on-year in the first two months of Q3 2010 (July–August), lower than the 12.9 percent expansion in the first two months of Q2 2010 but higher than the 4.5 percent growth posted in the same period in 2009. According to Meralco, the slowdown in the growth of energy consumption can be traced to the easing of demand for cooling appliances with the onset of the rainy season. Meanwhile, power consumption declined by 1.1 percent quarter-on-quarter in the first two months of Q3 2010; the higher consumption of electricity in the first two months of Q2 2010 was due mainly to election-related activities and the usual higher demand for cooling appliances during summer.

2010 Value of Production

14

Business Expectations Survey

Business confidence continues to climb due to solid macroeconomic performance. Business Expectations Survey Index Business Outlook Index Current Quarter Next Quarter

2009 Q3

Q1

2010 Q2

Q3

18.4

39.1

43.9

45.0

33.7

52.6

46.3

59.2

Source: BSP

Business optimism rose further in Q3 2010 to approximate pre-crisis peaks. The overall confidence index (CI) rose to 45.0 percent from 43.9 percent in the previous quarter. Notably, business confidence in the NCR was more upbeat compared to areas outside the NCR. Meanwhile, the next quarter outlook at 59.2 percent set a new all-time high and was a pronounced turnaround from the decline seen in the previous quarter. The improvement in the overall outlook is consistent with the solid macroeconomic environment as evidenced by the narrowing of the country’s credit spreads, rising equity market index, appreciating peso, and moderating inflation. Businesses also attributed their optimistic outlook to the following factors: steady growth of OF remittances, smooth transition of power and favorable expectations on the new government, better performance of exports, sustained investment inflows, and government spending on infrastructure, services, and environmental protection that could spur business activity. Consumer Expectations Survey

Consumer confidence hits all-time high on expectations of more favorable economic conditions.

Consumer Expectations Survey Index

2009

2010

Q3

Q1

Q2

Q3

Current Quarter

-31.9

-27.6

-28.7

-14.0

Next 3 months

-3.7

-4.8

-1.8

15.3

Next 12 months

-0.9

5.1

10.0

33.4

Source: BSP

Following a minor drop in Q2 2010, the nationwide consumer confidence index in Q3 2010 jumped to an all-time high at -14.0 percent. Respondents cited good governance under the new administration as the main factor for their brighter outlook for the quarter. For the next three months, the consumer confidence index reverted to a positive number after 11 consecutive quarters of recording negative indices. Consumers expect that more favorable macroeconomic conditions would generate better employment and business opportunities that would, in turn, improve their financial standing. Meanwhile, the CI for the next twelve months, which hit an all-time high as of the last survey at 10.0 percent, set a new record at 33.4 percent.19 Improving consumer confidence was likewise observed in India, Indonesia, Singapore, China, and Vietnam. The sovereign debt crisis in some European countries during Q3 failed to dampen the high consumer confidence level among Asian nations in the same period.

19

The overall consumer confidence index is determined by the outcome of three measures, namely, outlook on macroeconomic condition, family financial situation, and family income.

15

External Demand Exports Exports of Goods (BOP data) Growth rate (in percent)

Commodity Group

2009

2010

Q2

Q1

Q2

Coconut products

-57.8

135.6

116.1

Sugar and Products

-14.5

-3.8

-54.5

-5.5

-18.9

-29.9

Other Agro-based products

-25.9

23.6

38.1

Forest products

-12.4

0.0

-10.0

Mineral products

-49.4

12.0

21.8

Petroleum products

-59.4

192.3

-60.0

Manufactures

-25.5

45.6

36.0

Fruits and Vegetables

Special transactions

-43.6

3.6

3.2

Total Exports, as per NSO Foreign Trade Statistics

-28.9

42.9

33.3

Conceptual and coverage adjustments

-2.8

-18.9

9.6

-29.4

43.5

34.3

Total Exports, BPM5

Source: BSP

Imports

Imports of Goods (BOP data) Growth rate (in percent)

Commodity Group

2009

2010

Q2

Q1

Q2

Capital Goods

-27.2

42.7

26.7

Raw Materials & Intermediate Goods

-27.9

19.6

25.3

Mineral Fuels & Lubricants

-44.4

55.0

34.9

Consumer Goods

-13.1

64.7

15.1

Special Transactions

-23.0

82.0

57.1

-29.5

34.6

26.1

Conceptual and coverage adjustments

-71.0

-47.9

0.0

Total Imports, BPM5

-29.9

34.0

26.0

Total

Imports1/

Exports of goods20 sustained double-digit growth at 34.3 percent year-on-year in Q2 2010 from 43.5 percent in the previous quarter. Exports contracted by 29.4 percent in the same period a year ago. The bulk of the expansion can be traced to shipments of manufactures which increased by 36.0 percent and contributed 32.0 percentage points to export growth. Exports of electronic products topped the list as strong demand for a wide range of electronic products boosted shipments of semiconductors. The average book-to-bill ratio was 1.15 in Q2 2010 as bookings exceeded billings for the fourth consecutive quarter. Machinery and transport equipment came in second, driven by sales of motor cars and vehicles to major Asian markets as well as strong demand for wiring harness by the US and Japan. Deliveries of coconuts, which sustained triple-digit growth in Q2 2010, also contributed to the expansion of exports. Export earnings from coconut products grew by 116.1 percent.

On a quarterly basis, imports of goods grew by 26.0 percent year-on-year in Q2 2010 from 34.0 percent in the previous quarter. Imports contracted by 29.9 percent in the same period a year ago. All major commodities sustained double-digit growth during the review quarter. Import billings for raw materials and intermediate goods rose by 25.3 percent and contributed 13.3 percentage points to the growth of imports, driven by materials and accessories for the manufacture of electronic equipment. Mineral fuels, lubricants, and related materials, grew by 34.9 percent with the higher importation of petroleum crude. Inward shipments of capital goods also expanded by 26.7 percent.

1/ Include valuation adjustments to NSO data Source: BSP

20

Based on BPM5 concept [i.e., excluding from the NSO foreign trade figures those goods that did not involve change in ownership such as goods exported for exhibit purposes and equipment previously imported for use in manufacturing and eventually re-exported to mother companies abroad (temporary exports)].

16

Aggregate Supply

Industry continues strong rebound. Agriculture, Industry and Services Sectors Annual Growth in Real Terms 20.0

15.0

10.0

5.0

0.0

-5.0

-10.0 2002

2003

2004

2005

Agriculture

2006

2007

Industry

2008

2009

2010

Services

Economic Performance

On the production side, industrial expansion was the main driver of economic growth in Q2 2010 (contributing 5.2 percentage points to GDP growth). The growth in industry was fueled by the 36.3 percent growth of the mining and quarrying sub-sector and the 22.6 percent growth of the construction sub-sector. Driving the surge in mining was the strong rebound in global demand for nickel.21 Meanwhile, reflecting the rebound in exports in the first half of 2010 and the increase in production capacity, export-based industries (e.g., electrical machinery, transport equipment, petroleum and chemical products) continued to recover, supporting the double-digit growth of the manufacturing sector for two consecutive quarters.

Growth rate (in percent) Sector By industrial origin Agriculture, Fishery & Forestry Agriculture and Fishery Forestry Industry Mining and quarrying Manufacturing Construction Electricity, gas and water Services Transport., Comm., & Storage Trade Finance O. Dwellings & real estate Private services Government services Source: NSCB

2009

2010

Q2

Q1

Q2

0.2 0.3 -14.4 -0.6 22.1 -7.4 22.2 -4.9 2.7 1.0 0.2 5.8 -2.5 5.9 10.7

-2.7 -2.8 14.1 15.9 7.4 20.4 4.3 8.2 7.1 -1.1 12.6 6.5 4.9 8.5 6.5

-3.0 -2.8 -37.8 15.8 36.3 12.4 22.6 8.4 6.4 4.2 7.8 2.2 9.4 6.7 7.6

The services sector likewise contributed 3.2 percentage points to GDP growth. Services, which accounted for 49.5 percent of total GDP, grew by 6.4 percent year-on-year in Q2 2010, a slowdown compared to the quarter-ago growth of 7.1 percent but higher than the yearago growth rate of 2.7 percent. The expansion in the services sector was supported by trade, private and government services, and other dwellings and real estate. Meanwhile, AFF was affected adversely by the El Niño weather condition. AFF, which accounted for 14.9 percent of GDP, contracted by 3.0 percent in Q2 2010. Palay and corn production fell by 8.9 percent and 37.1 percent, respectively. Similarly, sugarcane and coconut declined by 60.4 percent and 0.4 percent, respectively, in Q2 2010. The decline in sugarcane production was due to the reduction in area harvested and ratooning22 while the decline in coconut production was attributed to the El Niño phenomenon. The contraction in these four sub-sectors offset the higher growth posted by the livestock and poultry subsectors. Seasonally-adjusted estimates show that GDP expanded by 1.3 percent in Q2 2010 from 3.8 percent in Q1 2010. The slowdown was due to the continuing decline of AFF and the lower growth of the industry and services sectors.

21

The rise in the demand for nickel was due mainly to an increase in demand for stainless steel. Stainless steel production is the largest end-use for nickel. 22 Ratooning is a method which leaves the lower parts of the plant along with the root uncut at the time of harvesting. The main benefit of ratooning is that the crop matures earlier in the season. Ratooning is known to give a steady yield for three years under most conditions.

17

Labor Market Conditions Unemployment rate declines. Unemployment and Underemployment Rates in percent 9.0

30.0

July 2010 17.9

8.5

25.0

8.0

20.0

7.5

15.0

7.0

10.0

July 2010 6.9

6.5

6.0

5.0

0.0 2006

2007

2008

Unemployment rate, SA (LHS)

2009

2010

Underemployment Rate (RHS)

Based on the results of the July 2010 Labor Force Survey (LFS), unemployment declined significantly to 6.9 percent from 8.0 percent and 7.6 percent a quarter and a year ago, respectively, due to the slight improvement in the employment level and slower labor force growth. The proportion of underemployed to total employed persons was also lower at 17.9 percent compared to 19.8 percent in July 2009 but was slightly higher compared to 17.8 percent in April 2010. The number of employed persons in July 2010 was recorded at 36.3 million, higher by 777,000 compared to the level registered in the same period a year ago. The services sector employed 51.2 percent of the total employed persons, while the agriculture and industry sectors accounted for 33.9 percent and 14.9 percent, respectively. Employment grew by 2.2 percent year-on-year in July 2010, faster than the labor force growth of 1.5 percent during the period. Employment increased during the quarter as employment in the agriculture sector recovered from the impact of El Niño. In terms of major occupation groups, the yearon-year increase in the employment level was due to the higher number of farmers, forestry workers, and fishermen, clerks, and professionals. However, the increase in employment in Q3 2010 was pulled down by the 1.6 percent decline in the number of employed persons in the services sector as well as the 1.5 percent reduction in the number of laborers and unskilled workers.

18

II. MONETARY AND FINANCIAL M ARKET CONDITIONS Domestic Liquidity and Credit Conditions

Liquidity growth slows down slightly…

… but bank lending growth continues to accelerate.

Despite some slowdown in the growth of domestic liquidity, liquidity conditions remained appropriate and consistent with the solid pickup in domestic demand as evidenced by the steady uptrend in credits extended to the private sector. Domestic liquidity or M3 continued to be underpinned by improved financial market conditions and robust foreign exchange inflows from overseas remittances, exports receipts, and outsourcing revenues. M3 growth decreased to 8.6 percent year-onyear in August 2010 compared to 10.3 percent in June. The slower expansion of domestic liquidity during the quarter can be traced mainly to the deceleration in the growth of net foreign assets (NFA) at 12.1 percent from 22.7 percent in June as the growth in the BSP’s NFA position declined. This was due in part to the moderation in the growth of the BSP’s foreign investments. Meanwhile, net domestic assets (NDA) grew by 4.4 percent in August after contracting marginally in the previous quarter given the stronger expansion in private sector borrowing. Credits extended to the private sector rose by 10.9 percent, in line with the continued uptrend in bank lending activities. Meanwhile, the growth in credits to the public sector slowed down to 6.9 percent in August, owing to the slower expansion in credits extended to the National Government (NG) at 2.6 percent. The sustained growth of bank lending is consistent with the strong pick-up in domestic demand and the rebound in global trade. As of August, bank lending growth, net of banks’ reverse repurchase (RRP) placements with the BSP, accelerated to 12.5 percent from 9.6 percent in June. The faster growth of bank lending was traced to loans for production activities (led by manufacturing; real estate, renting and business services; and agriculture, hunting and forestry) as well as consumer loans (credit card, auto loans and others).

19

Meanwhile, overall credit standards remain generally unchanged in Q3 2010.

The results of the Q3 2010 Senior Bank Loan Officers’ Survey,23 showed that most banks had generally unchanged credit standards for the sixth consecutive quarter starting Q2 2009, based on the proportion of banks indicating whether they tightened, loosened, or maintained credit standards.24 However, using the diffusion index approach,25 the survey results indicated an increase in net tightening in credit standards for loans extended to enterprises but no net tightening for loans to households in Q3 2010 relative to Q2 2010.26 Lending to Enterprises Classified according to firm size, the net tightening of general credit standards increased for top corporations but declined for large middle-market enterprises. Meanwhile, banks ceased tightening credit standards for small and medium-sized as well as for micro enterprises. The responses of banks indicated overall net tightening in terms of loan margins, collateral requirements, loan covenants, and loan maturities. However, the results also showed a net increase in credit lines for all firm sizes, except for micro enterprises, for which respondents reported unchanged credit lines from the previous quarter. Looking at the external and bank-specific factors affecting banks’ credit standards, in spite of the reported strong growth of the domestic economy in the first semester and the robust activity in the stock market, banks’ outlook on the economy and certain industries (notably real estate, renting, and business services) has become less certain, probably due to indications of tepid demand recovery for the global economy. This development, in addition to banks’ reduced tolerance for risk, contributed to the increase in net tightening of overall credit standards for enterprises.

23

Survey questions were sent to 35 commercial banks, with 25 banks responding, for a response rate of 71 percent. Commercial banks’ loans accounted for around 85 percent of the banking system’s total outstanding loans. 24 Prior to the Q1 2010 survey, the BSP looked only at the mode of responses in interpreting the results of the survey, i.e., the number of banks that tightened, loosened, or maintained credit standards. Since Q1 2010, the BSP started analyzing the results of the survey by looking at the percentage difference (“diffusion index”) between banks reporting that credit standards have been tightened and those reporting that they have been eased. 25 A positive diffusion index indicates that more banks tightened credit standards compared to those that eased (“net tightening”), whereas a negative diffusion index indicates that more banks eased credit standards compared to those that tightened (“net easing”). 26 The analysis in the survey is based on comparisons with the immediately preceding quarter.

20

Lending to Households Banks had basically unchanged credit standards for the sixth consecutive quarter for loans extended to households. Comparing the number of respondents declaring tighter credit standards to those that indicated the opposite, there was no net tightening of credit standards overall and across all types of household loans,27 except for personal/salary loans (which reflected a lower net tightening). Increased competition from other banks as well as nonbank lenders was cited as contributing to the zero net tightening of overall credit standards to households. For specific credit standards, a bigger proportion of respondents reported a narrowing of loan margins overall and across all types of household loans. Respondents also reported unchanged credit lines for most types of loans. Collateral requirements (except for housing loans) remained the same in Q3 relative to the previous quarter for all types of loans. Collateral requirements and loan covenants for housing loans were stricter, which is consistent with survey responses indicating that the outlook for real estate, renting, and business activities contributed to the tightening of credit standards to enterprises. Loan demand The survey results also pointed to a stronger overall increase in net demand28 for loans from enterprises compared to the previous quarter. Demand increased across all firm sizes, except for micro enterprises. Among the key reasons cited by respondent banks for the net increase in demand for loans by enterprises were firms’ upbeat outlook for the domestic economy going forward, lower interest rates, improved terms of financing by banks, and lack of other sources of financing. For household loans, banks reported a stronger increase in net demand for housing and auto loans. The higher demand for auto loans is consistent with the double-digit growth of total vehicle sales in the first two months of 27

Loans extended to households include: (1) housing loans; (2) credit card loans; (3) auto loans; and (4) personal/salary loans. 28 “Net demand” refers to the percentage difference between banks reporting an increase in loan demand and banks reporting a decrease. Net demand will therefore be positive if more banks reported an increase in loan demand compared to those stating the opposite, whereas it will be negative if more banks reported a decrease in loan demand compared to those reporting an increase.

21

Q3 2010. Meanwhile, net demand for credit card loans and personal/salary loans was unchanged. The net increase in demand for loans is consistent with the stronger growth in bank lending during the first two months of the quarter.

22

Yield Curve

Interest Rates Yields in the secondary market decline at the longer end of the curve.

Secondary market yields reflected market participants’ expectations on the future path of policy rates as well as their sentiment on the fiscal developments in the country. Yields were markedly lower at the long end of the curve (4-10 year tenors) as of end-September 2010 relative to the end-June 2010 levels, supported by ample liquidity and market preference for longer-term maturities.

Yield of Government Securities in the Secondary Market In percent 12 11

Yield in percent

10 9 8 7 6 5 4 3 2 3Mo

6Mo

1Yr

2Yr

3 Yr

4Yr

5Yr

7Yr

10Yr

20Yr

25Yr

Maturity end-June 2010

end-Sep 2010

Interest Rate Differentials

end-Sep 2009

Interest rate differentials widen.

The average positive differentials between domestic and US interest rates, net of tax, widened in Q3 2010 relative to the level in the previous quarter due to the combined effect of the rise in the RP 91-day T-bill rate and the decline in both the US 90-day LIBOR and 90day T-bill rate.

INTEREST RATE DIFFERENTIALS quarterly averages; in basis points 600 500 400 300 200 100 0 -100 Q1

Q2

Q3

Q4

Q1

Q2

2008

Q3 2009

Q4

Q1

Q2 2010

RP 91-day T-bill vs. US 90-day LI BOR (before tax)

RP 91-day T-bill vs. US 90-day T-bill (bef ore tax)

RP 91-day T-bill vs. US 90-day LI BOR (after tax)

RP 91-day T-bill vs. US 90-day T-bill (af ter tax)

Q3

BSP RRP RATE AND US FEDERAL FUNDS TARGET RATE in percent 7 6 5 4 3 2 1 0 -1 Q1

Q2

Q3

Q4

Q1

Q2

2008

Q3

Q4

Q1

2009 BSP RRP Rat e

Q2

Q3

2010

US Federal Funds Target Rate

Real lending rate declines. PHILIPPINES' REAL LENDING RATE in percent 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 -1.0 -2.0 -3.0 -4.0 Q1

Q2

Q3 2008

Q4

Q1

Q2

Q3 2009

Q4

Q1

Q2 2010

Q3

Meanwhile, the positive differential between the BSP's policy interest rate (overnight borrowing or RRP rate) and the US federal funds target rate was unchanged at 375 basis points in Q3 2010, reflecting the steady monetary policy stance of both the BSP and the US Fed during the review quarter. Adjusted for the risk premium—which is measured as the differential between the 10-year Republic of the Philippines (ROP) note and the 10-year US Treasury note—the average spread between the BSP’s policy rate and the US federal funds target rate, however, rose to 211 basis points from 180 basis points in Q2 2010. This development may be traced to the decrease in the risk premium, by the same magnitude, given the bigger decline in the yield of the 10year ROP note during the review period. The decline in the inflation rate and nominal bank lending rates in September 2010 resulted in the slight decrease in the real lending rate—measured as the difference between the average bank lending rate and inflation—at 4.3 percent in September 2010 from 4.5 percent (revised) in June 2010. The real lending rate of the Philippines in September 2010 ranked second highest (since May 2010) in a sample of 10 Asian countries, while Indonesia recorded the highest real lending rate at 6.8 percent during the quarter.

23

Financial Market Conditions Domestic improve.

financial

market

conditions

Domestic financial market conditions improved further on the back of positive economic developments on the local front and easing concerns about the sovereign debt problem in some parts of Europe. Positive domestic economic developments, including the continued strong growth performance, manageable inflation outlook, rising export receipts and investment inflows along with improved fiscal position in August boosted market sentiment. Renewed appetite for emerging market assets encouraged by international yield differentials favoring emerging markets in the region likewise underpinned steady capital inflows to the country. These were translated into bullish trading in the local bourse, generally narrower Philippine bond debt spreads, and the appreciation trend of the peso. Meanwhile, the robust bank lending growth continues to suggest that ample funds are available to support the growth requirements of the economy despite the slower growth of domestic liquidity. Stock Market

The Philippine stock market index reaches a new record high since October 2007. Daily Stock Performance January 2008 - September 2010 4,500 4,300 4,100 3,900 3,700 3,500 3,300 3,100 2,900 2,700 2,500 2,300 2,100 1,900 1,700 1,500

PSEi, index points

During the third quarter of 2010, Philippine equities rallied on the back of strong economic fundamentals and easing concerns about the sovereign debt crisis in some parts of Europe. The 30-stock composite index (PSEi) advanced to its highest level since October 2007, posting a new record high of 4,124.0 index points on 28 September 2010. Overall, the PSEi averaged 3,697.8 index points during the period, higher by 11.7 percent and 30.8 percent compared to the previous quarter’s and previous year’s average, respectively. The rally was steady during the period in review despite concerns over the 23 August hostage drama in Rizal Park and amid indications that the pace of global recovery was slowing down. o In July, the index was buoyed by benign inflation, the continued increase in merchandise exports, and President Aquino’s pronouncement to clean up the government and promote investments during his first State of the Nation Address.

24

o In August, reports of higher local and foreign corporate earnings for the first half of 2010 and a robust second quarter GDP growth of 7.9 percent, combined with the listing of a P10 billion stock rights shares by the BPI as well as abating euro zone concerns, helped the market breach the 3,500-level. o In September, the market breached the 4,000 mark, boosted by strong domestic economic fundamentals, including improvements in the labor market, the successful completion of the country’s first ever peso-denominated global bond issue that raised US$1 billion, reports of the P1.3 billion fiscal surplus posted in August, and strong corporate returns on equity; and robust gains in major bourses abroad following reports that the US manufacturing sector grew faster than expected.

P/E ratio jumps on expectations of higher future earnings.

The index surged to 4,100.1 index points at the close of the quarter, around 34.3 percent higher year-to-date, with market capitalization reaching P7.4 trillion from P6.0 trillion at the close of 2009. The price-earnings (P/E) ratio also jumped to 14.7 in September, the highest in 2010, indicating expectations of higher future earnings growth for listed firms.

Government Securities

Oversubscription of T-bill Auctions In billion pesos

A very liquid market and positive outlook on domestic prices boosted investors’ interest for government debt papers in the third quarter of 2010. Most market players continued to prefer longer-term debt instruments given a benign inflation path. The amount of oversubscription during the third quarter of 2010 increased to P75.7 billion from P67.6 billion in the second quarter of 2010.

140 120 100 80 60 40 20 0

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

However, the optimism that prevailed during the third quarter was tempered by concerns on the NG’s higher budget deficit.

25

Sovereign bonds and CDS spreads

Debt spreads narrow as concerns over the impact of the sovereign debt crisis in EU countries ease. JP Morgan EMBI+ Sovereign Bond Spreads (In basis points) 900 EMBI+ Philippines

700

EMBI+ Global 500

300

Ju l-0 Se 8 p0 No 8 v0 Ja 8 n09 Ma r-0 Ma 9 y09 Ju l-0 Se 9 p0 No 9 v0 Ja 9 n10 Ma r-1 Ma 0 y10 Ju l-1 Se 0 p10

100

Philippine Senior 5-year CDS Spreads (In basis points) 1,400 1,200 1,000

Philippines

Indonesia

Thailand

Malaysia

After widening in the second quarter over concerns on the sovereign debt crisis in Europe and election jitters at the local front, sovereign debt spreads started to narrow beginning July and continued to tighten towards September. Spreads shrank to their lowest during the end of Q3 2010 after investors took reassurance from the Committee on European Banking Supervisors (CEBS) report that almost all of the European banks have passed the “stress test” in their ability to deal with the debt crisis. Market sentiment was likewise bolstered by reports that the Basel Committee will scale back some of its proposals to beef up capital, relieving worries about the need to raise more capital from the market.29 The record-low rates in the US and Europe and the higher yields in emerging market (EM) papers increased carry-trade transactions, driving demand for EM debt, including ROP bonds. The announcement of the US Fed to extend its quantitative easing and the Bank of Japan’s (BOJ) similar move to relax its monetary policy drove further investors’ hunt for yields, resulting in the narrowing of spreads of EM debt.30

800 600 400 200

Ja nMa 08 r Ma -08 y0 Ju 8 l-0 Se 8 pNo 08 vJa 08 nMa 09 r Ma -09 y0 Ju 9 lSe 09 pNo 09 vJa 09 nMa 10 r Ma -10 y1 Ju 0 lSe 10 p10

0

In the domestic debt market, strong export receipts, benign inflation environment, and the higher-than-expected second quarter GDP growth likewise supported the tightening of spreads. Reports on the country’s fiscal surplus in August and the robust investment inflows and remittances, which kept the country’s balance of payments in surplus, also buoyed market sentiment. Bucking the general trend, however, were occasional reports of decelerating economic data from the US, signaling that the recovery in the world’s biggest economy has slowed down.31 There were also renewed worries

29

The report was taken positively by the market despite some skepticism that the tests were not tough enough, with only seven small regional lenders out of 91 banks failing the reviews. 30 On 10 August, the US Federal Reserve decided to keep its securities holdings constant by reinvesting principal repayments of maturing mortgage backed securities in long-term US Treasury bonds, extending its quantitative easing program beyond March 2010. On 30 August, the Bank of Japan took a similar step to shore up its fragile economic recovery through further monetary easing. In particular, the BOJ increased its fixed-rate bank funding scheme by JPY10 trillion to JPY 30 trillion. The BOJ also lengthened the term of loans provided to six months from three months. At a policy review on 21 September, the Fed expressed concern about the sluggish pace of economic growth and low inflation and it was ready to do more to support the world’s largest economy. Source: Roubini Global Economics, August 2010. 31 The decline in the US new orders of durable goods in June, drop in consumer sentiment to its lowest in almost a year, slowdown in the growth of factory sector, decline in wholesale prices for a third straight months, and weak employment and job claims figures added to evidence that the US economic recovery is losing steam.

26

about the weakness of the stress test conducted earlier on European banks, which translated to a temporary widening of debt spreads in September. Also during the month, some investors turned cautious in holding ROPs as they perceived the rise in bond prices as a signal for profit-taking. The surge of fresh supply of bonds in the global market also added to the partial swelling of debt spreads as some investors unloaded some of their holdings of ROP for new issues. Nonetheless, average and end-of-period debt spreads narrowed in Q3 2010 compared to the previous quarter. The EMBI+Philippine spread stood at 180 bps at end-September, last seen during the pre-Lehman episode and significantly lower relative to the 261 bps recorded at end-June. Likewise, the EMBI+Global spread also traded lower at 277 bps from 337 bps during the same reference period. Against neighboring economies, the Philippine CDS traded at 139 bps, tighter than Indonesia’s 142 bps but wider than Malaysia’s 80 bps and Thailand’s 102 bps at the end of Q3. These debt spread levels were lower compared to the levels posted in the previous quarter and the same period a year ago.

27

Banking System Key performance indicators show sustained resilience of the banking system.

The Philippine banking system remained resilient during the review quarter. The continued fine-tuning of regulatory and supervisory mechanisms to match international norms helped to further strengthen the banking system. Key performance indicators showed solid asset growth, improving credit quality, easing non-performing loan (NPL) ratio, and robust capitalization above international norms. Savings Mobilization Savings and time deposits remained the banks’ main sources of funds. Banks’ total deposits 32 as of end-August 2010 amounted to P3.4 trillion, 8.2 percent higher than the year-ago level of P3.2 trillion. The growth in deposits reflected sustained depositor confidence in the banking system. Savings deposits registered a 10.7 percent growth and continued to account for nearly half of the funding base. Demand deposits expanded by 14.1 percent year-onyear. Meanwhile, time deposits posted a moderate contraction of 0.1 percent. Institutional Developments The total resources of the banking system rose by 6.5 percent to P6.4 trillion as of end-July 2010 from the year-ago level of P6.0 trillion. The increase could be traced to the growth in currency and deposits, indicative of the public’s continued trust in the banking sector. U/KBs accounted for the bulk (almost 90 percent) of the total resources of the banking system. The number of banking institutions (head offices) fell further to 773 as of end-June 2010 from the previous quarter- and year-ago levels of 779 and 804, respectively, reflective of the continued consolidation of banks as well as the exit of weaker players in the banking system. By banking classification, banks (head offices) consisted of 38 universal and commercial banks (U/KBs), 74 thrift banks (TBs), and 661 rural banks (RBs). Meanwhile, the operating network (including branches) of the banking system increased to 8,685 from 8,663 in Q1 2010 and 7,898 during the same period last year, reflecting mainly the increase in commercial and rural banks’ branches/agencies.

32

Total peso-denominated deposits.

28

Banking system’s asset quality continues to improve.

The asset quality of the Philippine banking system continued to improve as the NPL ratio eased further to 4.1 percent as of end-July 2010 from 4.3 percent a year ago but higher than the 4.0 percent level in Q1 2010. The continued adoption of prudent lending standards helped banks minimize the incidence of problem debts. The lower NPL ratio was likewise attributed to the 7.1 percent expansion in the industry’s total loan portfolio (TLP), which offset the 1.8 percent rise in NPLs. In particular, TLP expanded to P2,966.2 billion in end-July 2010 from P2,769.8 billion a year earlier, while the NPL level rose to P120.3 billion from the previous year’s level of P118.1 billion. Meanwhile, the NPL ratio of U/KBs was lower at 3.4 percent as of end-July 2010 compared to 3.5 percent in the same period in 2009, but was higher than the 3.3 percent level as of endMarch and end-June 2010. The Philippine banking system’s NPL ratio of 4.1 percent was comparatively lower than Thailand’s 4.5 percent but higher than Indonesia’s 3.0 percent, Malaysia’s 2.1 percent, and Korea’s 1.2 percent.33 The lower NPL ratios of Malaysia and South Korea could be traced to the creation of publicly-owned asset management companies (AMCs), which purchased the bulk of their NPLs, a practice which was not resorted to in the Philippines.

Banks remain adequately capitalized, exceeding prescribed levels set by the BSP and the BIS.

The loan exposure of banks remained adequately covered as the banking system’s NPL coverage ratio improved to 94.3 percent as of end-July 2010. The ratio was indicative of banks’ continued compliance with the loan-loss provisioning requirements of the BSP to ensure adequate buffers against unexpected losses. Meanwhile, the banking system remained adequately capitalized as of end-December 2009 with the average capital adequacy ratio (CAR) remaining strong at 14.8 percent on a solo basis and 15.8 percent on a consolidated basis. The ratios were unchanged from the previous quarter as the slight improvement in the banking system’s CARs was due to the almost matching growth rate of qualifying capital and risk-weighted assets (RWA). The industry’s CAR continued to exceed both the statutory level set by the BSP at 10.0 percent and the Bank of International Settlements (BIS) standard at 8.0 percent.

33

Sources: Various central bank websites and IMF Global Financial Stability Report, Indonesia (Commercial banks,

29

The Philippine banking system’s CAR continued to be slightly higher than those of Malaysia (15.1 percent) and Korea (14.6 percent), but lower than Thailand’s (17.4 percent). Indonesia posted the highest CAR in the region at 18.1 percent.34 Meanwhile, banks’ special deposit account (SDA) placements went up year-on-year by P294.6 billion to P911.4 billion as of endSeptember 2010 from the P616.8 billion posted during the same period last year. Moreover, the total volume of banks’ placements with the BSP under the RRP window amounted to P245.1 billion, an increase of P29.3 billion compared to a year earlier.

June 2010); Malaysia (Banking system, August 2010); Thailand (Commercial banks, June 2010); and Korea (Banking system, December 2009). 34 Sources: Various central bank websites, Malaysia (Banking System, August 2010); Korea (Commercial banks, December 2009); Thailand (Average Full Branch, June 2010) and Indonesia (Commercial banks, June 2010).

30

Exchange Rate

The peso appreciates further on sustained foreign exchange inflows and capital reflows due to improved risk appetite for emerging market assets.

Daily Peso-US Dollar Rate P/US$ 60

55

50

45

The peso averaged P45.27/US$1 in Q3 2010, appreciating by 0.5 percent from the P45.51/US$1 average in the previous quarter.35 On a year-on-year basis, the peso appreciated by 6.4 percent from the P48.15/US$1 average in Q3 2009. The peso’s strength, especially during the latter part of the review quarter, was due mainly to the improved risk appetite for EM assets which has led to a revival of capital inflows in Asia. The sustained inflow of OF remittances, along with the strong export sector performance, likewise supported the peso.36 The market’s positive reaction to President Aquino’s first state of the nation address which further boosted optimism on the Philippine economy, also buoyed up the peso.

40

35

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

Changes in Selected Dollar Rates Appr./Depr. (-) Year-to-date 29 Jun*

30 Sep**

Philippine peso

-0.4

5.3

Thai baht (onshore)

3.1

9.8

Chinese yuan

0.5

2.1

Malaysian ringgit

5.7

11.1

South Korean won

-4.3

2.1

Singaporean dollar

0.8

6.8

New Taiwan dollar

-0.4

2.5

Indonesian rupiah

4.0

5.4

Japanese yen

5.0

11.1

Indian Rupee

0.0

4.4

However, during the early part of the review quarter, the peso was weighed down by concerns over China’s weaker-than-expected economic performance. Apprehension over the country’s deteriorating fiscal position after the NG failed to meet its tax revenue and budget deficit targets also exerted downward pressures on the peso.37 Likewise, market concerns following news about troubled Irish banks and the decline in the US consumer confidence tempered the peso’s appreciation.38 On a year-to-date basis, the peso appreciated against the US dollar by 5.3 percent on 30 September 2010 as it closed at P43.88/US$1, moving in tandem with other Asian currencies.39

Source: Bloomberg, Reuters and PDEX *As of 4:00 p.m., 29 June 2010 **As of 4:00 p.m., 30 September 2010

35

Dollar rates or the reciprocal of the peso-dollar rates were used to compute for the percentage change. Figures were based on real time transactions. 36 Based on BSP Data, in the first seven months of 2010 OF remittances posted a 7.1 percent increase relative to the same period a year ago. Meanwhile, according to NSO Philippines’ July exports increased by 35.9 percent from its year ago level. 37 According to the Bureau of Treasury (BTr), the NG’s January to June fiscal deficit reached P196.7 billion, P51.0 billion higher than its programmed ceiling of P142.5 billion 38 Source: the BSP Treasury Department USD/PHP Update (as of 12 noon, 20 September 2010) 39 Based on the last done deal in the afternoon.

31

Meanwhile, volatility, as measured by the coefficient of variation of the daily average exchange rates increased slightly to 1.93 percent in Q3 2010 compared with 1.89 percent in Q2 2010 as the peso traded around a wider range of P43.88/US$1 - P46.65/US$1. On a real, trade-weighted basis, the peso maintained its external price competitiveness in Q3 2010 relative to the previous quarter against the baskets of currencies of major trading partners (MTPs) as the real effective exchange rate (REER) index of the peso decreased minimally by 0.02 percent. 40 During the same period, the peso gained external price competitiveness against the narrow basket of competitor countries but lost external price competitiveness against the broad basket of competitor countries. The REER index against the competitor countries in the narrow series declined by 0.7 percent as the nominal depreciation more than offset the widening inflation differential for this basket of currencies. Meanwhile the REER index against the broad basket of competitor countries increased by 0.6 percent as the widening inflation differential more than offset the nominal depreciation of the peso against this basket of currencies.41 On a year-on-year basis, the peso gained external price competitiveness against the basket of competitor currencies in the broad and narrow series in Q3 2010 as the REER index of the peso decreased by 4.7 percent and 1.1 percent, respectively. Meanwhile, the peso lost external price competitiveness against the MTPs during the same period as the REER index of the peso against this basket of currencies increased by 11.9 percent.

40

The basket of the major trading partners is composed of the currencies of US, Japan, the euro area and the United Kingdom. The broad basket of competitor countries comprises the currencies of Singapore, South Korea, Taiwan, Malaysia, Thailand, Indonesia and Hong Kong while the narrow basket is composed of the currencies of Indonesia, Malaysia and Thailand only. 41 The REER index represents the Nominal Effective Exchange Rate (NEER) index of the peso, adjusted for inflation rate differentials with the countries whose currencies comprise the NEER index basket. A decrease in the REER index indicates some gain in the external price competitiveness of the peso, while a significant increase indicates the opposite. The NEER index, meanwhile, represents the weighted average exchange rate of the peso vis-à-vis a basket of foreign currencies.

32

III. FISCAL DEVELOPMENTS The January-August 2010 fiscal deficit is higher compared to its year-ago level.

National Government Fiscal Performance January- August 2010 In billion pesos January-August Surplus/(Deficit) Revenues Expenditures

Growth (%)

2009

2010

-210.0 739.1

-228.1 802.8

8.6 8.6

949.1

1,030.9

8.6

*Totals may not add up due to rounding Source: BTR

The fiscal deficit in January-August 2010 reached P228.1 billion, 8.6 percent higher than the P210.0 billion deficit incurred in the same period in 2009. This also represented about 96.1 percent of the P237.4 billion programmed deficit for the first three quarters of 2010. Revenue collections increased by 8.6 percent to P802.8 billion in the first eight months of 2010 compared to the P739.1 billion in the same period last year and accounted for 84.6 percent of the programmed level of P949.2 billion for the first three quarters. The BIR and the BOC contributed P546.4 billion and P170.7 billion, respectively, to total revenues. The BIR and BOC collections went up by 9.1 percent and 16.0 percent, respectively, compared to the levels in the same period last year. On the other hand, collections by the BTr decreased by 12.9 percent to P40.2 billion from P46.2 billion in the comparable period last year. Meanwhile, revenues from other offices increased by 1.1 percent to P45.5 billion. Expenditures for January-August 2010 amounted to P1,030.9 billion, 8.6 percent higher than the disbursements in the comparable period in 2009. The total expenditures for the first eight months is equivalent to 86.9 percent of the P1.19 trillion programmed for the first three quarters of 2010. Excluding interest payments, total disbursements rose by 9.7 percent to P818.2 billion. Interest payments also went up by 4.6 percent to reach P212.7 billion.

33

IV. EXTERNAL DEVELOPMENTS Global economic activity strengthens in the first half of 2010 but the pace of recovery is expected to moderate in the near term.

The global economic recovery strengthened during the first half of 2010 but the depth of the upturn continued to be uneven. Growth in advanced economies reached only around 3.25 percent as weak consumer confidence, sluggish incomes and reduced household wealth continued to hold consumption down.42 The recovery in these economies is seen to remain fragile going forward until improving business sentiment is translated to firmer employment prospects. In contrast, emerging market economies expanded by about 7.5 percent during the same period on resilient domestic demand and increased investment spending.43 The rebound in global trade also benefited the manufacturing sector of advanced Asia, helping propel growth in the rest of the region. Going forward, the global economic recovery is expected to proceed at a moderate pace. Risks to the growth forecasts are mainly on the downside due to ongoing uncertainties in the global financial markets and as policy stimulus programs are being withdrawn. Meanwhile, inflation is expected to be generally subdued as substantial slack in the global economy remains and employment conditions continue to be soft.

US economic recovery softens on wider trade gap and weaker inventory build-up.

The US economic recovery softened in the Q2 2010 as the country’s quarter-on-quarter real GDP growth rate was revised downward to 1.6 percent (annualized) from the advance estimate of 2.4 percent.44 Meanwhile, real GDP grew by 3.7 percent in the previous quarter. The weaker output growth estimate reflected a wider trade gap on account of strong import growth and slower inventory build-up. Personal consumption expenditures and fixed investment spending, however, strengthened further, supporting continued optimism on the US economic recovery. Available leading indicators suggest that the recovery will continue, although at a slightly weaker pace. US industrial production grew by 1.0 percent in July relative to the previous month, exceeding the median forecast by Bloomberg News. Retail sales likewise grew by

42

October 2010 IMF W EO ibid 44 US Bureau of Economic Analysis, available at www.bea.gov 43

34

0.4 percent month-on-month in July, following two consecutive months of contraction, due to strong automobile and petroleum sales. The Purchasing Managers’ Index (PMI) also climbed in August owing to gains in production, employment and new orders. Consumer confidence posted modest gains in August due to the improved short-term economic outlook, but declined in September as consumers remained generally pessimistic, exacerbated by persistent uncertainties about future job prospects and business conditions. Stiff headwinds also remain in the US labor market. The unemployment rate continued to be high at 9.5 percent in August while total non-farm payroll employment declined further by 54,000. As regards price developments, headline inflation inched up slightly to 1.2 percent in July from 1.1 percent in June on account of higher energy and food prices.

Euro area expansion strengthens, but growth patterns within the region remain uneven.

The pace of economic recovery in the euro area quickened considerably in the second quarter as real GDP expanded by 1.0 percent quarter-on-quarter compared to the 0.3 percent growth in the first quarter. Stronger private consumption, gross capital formation, and export growth boosted economic activity. Growth patterns remained uneven, with Germany and the Netherlands leading the recovery and debt-ridden countries Greece, Spain, and Portugal lagging behind. Survey-based indicators, meanwhile, suggest economic recovery will further take root in the months ahead. The European Commission’s Economic Sentiment Indicator (ESI) improved for the second consecutive month in August to 101.8, up by 0.7 from the July index. Consumer confidence rose significantly on widely-felt optimism about the general economic situation and further easing of unemployment fears. The Business Climate Indicator (BCI) remained broadly unchanged in August after surging significantly in the previous month. Managers in the industry sector were upbeat about their export orders while production and employment expectations remained unchanged. Meanwhile, the euro zone composite PMI was down slightly in August to 56.2 from 56.7 in the previous month as the manufacturing PMI eased to its weakest since May, while the growth of services sector business activity accelerated to a three-month high. Meanwhile, the seasonally-adjusted unemployment rate remained at 10.0 percent

35

for the fifth straight month in July. The highest unemployment rate was recorded for Spain at 20.3 percent while the lowest was recorded for Austria at 3.8 percent.

Economic recovery slows down in Japan as private demand continues to be tepid.

The economic recovery in Japan did not moderate as much as previously expected. The real GDP growth in the second quarter was revised upward to 0.4 percent (quarter-onquarter) from the preliminary estimate of 0.1 percent. However, the revised estimate still represents a sharp slowdown from the first quarter output growth of 1.2 percent, providing further evidence that the global economic recovery is beginning to lose steam. Private consumption continued to be sluggish, reflecting the unwinding of fiscal stimulus. Inventories and public investment also weighed down on output growth. Meanwhile, net exports boosted economic activity as it contributed 0.3 percentage point to the real GDP growth. Output growth, like in most advanced economies, is expected to moderate further. Investment activity will be supported by robust exports in the near term. Meanwhile, household spending is expected to remain subdued as employment conditions continue to be tepid and stimulus measures are unwound.

Emerging Asia continues to lead global economic growth.

Emerging Asia remains the engine of growth. Private consumption and fixed investment drove GDP growth in the first half of the year in most economies, while strong net exports were relatively more important in some. Asia is projected to grow by about 7.8 percent in 2010 and 6.7 percent in 2011.45 Risks to the nearterm growth are tilted to the downside, due mainly to uncertainties in the external environment. However, a more durable-thanexpected recovery in private demand could provide the needed cushion. Asia’s mediumterm economic prospects, meanwhile, will be ultimately determined by how successful it will be in rebalancing the drivers of growth from external demand to more domestic sources of growth. China’s economic growth remained strong in Q2 at 10.3 percent, with private domestic demand becoming more self-sustained. This implies that Chinese authorities may now have more room to withdraw fiscal stimulus gradually.

45

October 2010 IMF W EO

36

Headline inflation in China rose anew in August at 3.5 percent from 3.3 percent in the previous month. Nationwide property and land prices have picked up strongly in recent months, in an environment of still ample liquidity, loose credit conditions, and negative real interest rates on deposits. Meanwhile, the administrative measures implemented at endApril to curb speculative demand in the housing market have started to produce results. Nevertheless, it may be too early to assess the impact of these measures on property prices and residential investments.

37

V. MONETARY POLICY DEVELOPMENTS The Monetary Board decides to maintain policy rates throughout the quarter. BSP Policy Interest Rates In percent 11 10 9 8 7 6 5 4 3 2004

2005

2006 Overnight RRP Rate

2007

2008

2009

2010

Overnight RP Rate

During the 15 July and 26 August 2010 policy meetings, the MB decided to maintain policy rates at 4.0 percent for the overnight borrowing or RRP facility and 6.0 percent for the overnight lending or repurchase (RP) facility. The interest rates on term RRPs, RPs, and SDAs were also left unchanged. The continued favorable outlook for inflation has allowed the BSP to keep policy rates steady since July 2009. The MB noted that the latest inflation projections continued to indicate a manageable inflation environment, with inflation averaging within the target ranges of 4.5 ± 1.0 percent for 2010 and 4.0 ± 1.0 percent for 2011 and 2012. The forecasts were also supported by well-contained inflation expectations while various measures of core inflation point to a broadly stable trend for consumer prices.

The manageable inflation environment has allowed the BSP to keep rates steady, but risks around the central projection would require attention going forward.

Nonetheless, the MB noted accompanying risks to the central projection which would require attention going forward. These risks relate mainly to a possibly stronger-thanexpected recovery of the domestic economy in spite of the fragile global macroeconomic environment. The country’s growth momentum continues to strengthen and demand-pull price pressures could emerge over the medium term unless there is an expansion of the economy’s productive capacity. Supply-side risks include a potential rebound in international commodity prices as the global economic recovery steams ahead and as structural constraints to global oil production persist. Other risks include the potential adverse impact of the La Niña episode on domestic agricultural production and petitions for electricity rate adjustments.

At the same time, the Monetary Board takes note of factors that could limit price pressures in the near term.

The MB also took note of factors which could limit the pace of price increases in the near term. These include the observed strengthening of capital formation which could have contributed to the higher-than-expected real GDP growth of 7.9 percent for second quarter 2010 and the revised first quarter 2010 real GDP growth of 7.8 percent. This could increase the economy’s productive capacity, thus moderating price pressures going forward. Meanwhile, a sustained strengthening of the peso-dollar exchange rate, due to the surge in capital inflows to emerging Asian economies

38

like the Philippines on account of the firmer growth prospects in the region, could help temper imported inflation.

The BSP’s efforts to promote price stability remain consistent with the maintenance of supportive conditions for domestic economic growth amid lingering uncertainties.

On the whole, the MB was of the opinion that the favorable inflation dynamics over the policy horizon provided the flexibility to keep policy interest rates steady during the quarter. The BSP’s efforts to promote low and stable inflation are consistent with the maintenance of supportive conditions for domestic economic growth amid lingering uncertainties surrounding global growth prospects. Potential inflationary pressures over the policy horizon are not expected to create permanent and appreciable shifts in the long-run inflation path. The threat of possible second-round effects appears limited while inflation expectations remain well anchored. The Monetary Board also announced the shift to a fixed medium-term inflation target from a variable annual inflation target. For 2012-2014, the inflation target range was set at 4.0 percent ± 1.0 percentage point (see box article).

39

Medium-Term Inflation Target for the Philippines

I. Introduction The key defining element of an inflation targeting (IT) framework is the inflation target itself. The careful design of the inflation target is integral to realize the associated benefits of IT and to help build the credibility of the monetary policy regime. Heenan, Peter and Roger (2006) point out that a well-designed inflation target could help anchor expectations, serve as yardstick for central bank accountability and reflect the central bank’s objectives. One of the critical aspects in the design of the inflation target is the target horizon. The target horizon refers to the period of time over which the central bank promises to achieve its inflation target.46 There is no existing standard on the choice of the target horizon. In fact, it has varied considerably among inflation targeters. Some IT central banks have opted for a fixed target for a specified period of time (i.e., constant annual target over a multi-year period) while others have subscribed to an average target over the medium term. There are also IT central banks that set annual inflation targets that change from year to year. This note presents the overall thinking behind the decision to adopt a fixed medium-term inflation target for the Philippines in place of the variable annual targets. II. A Review of Different Target Horizons There is no acknowledged international best practice on the choice of a target horizon. In general, relatively new IT central banks and those from emerging economies choose to specify short-term inflation targets (i.e., annual targets) in line with a desired disinflation path. The more advanced IT central banks typically set targets for a relatively longer horizon. That is, some central banks set their target as a fixed annual target for a multi-year period or as an average target over the medium term. Some central banks adopt a fixed inflation target. In these cases, central banks set a constant target for a number of years with some keeping a target effective for an indefinite period of time. However, these targets are not exactly permanent targets. Rather, they are subject to periodic reviews by their respective central banks. In fact, in some cases, the targets are reviewed annually. Nonetheless, these targets are perceived to be fixed due to the infrequent adjustments in the target. Other central banks pursue an average inflation target over a multi-year period. A central bank operating under average inflation targeting does not have a target for a particular year but aims to bring inflation towards an average rate over the medium term. The concept of average inflation targeting is continuing to gain popularity in the literature. The Reserve Bank of Australia (RBA) and Reserve Bank of New Zealand (RBNZ) are often cited as examples of central banks that pursue average IT because of the way their targets are specified. However, it should be noted that average IT as implemented by RBA and RBNZ appears to be less stringent than the definition provided in the literature (see Nessen (2002) and Warburton and Lees (2005)). Strictly speaking, average IT requires that periods of higher-than-target inflation 46

This definition was adopted from Heenan, et al. (2006). The said authors identified three important time horizons for IT central banks. Apart from the target horizon, Heenan, et al. (2006) note that the forecast horizon and the policy horizon are relevant time frames for central banks. The forecast horizon refers to the period of time for which the central bank generates forecasts while the policy horizon refers to the time required to bring back inflation to target.

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must be followed by periods of lower-than-target inflation in order to meet the medium-term inflation target.47 In this case, bygones are no longer bygones as the central bank must compensate for the past deviation of inflation from the target. However, Debelle (2009) explains that under the Australian IT framework, the average over the cycle refers more to the distribution of CPI outcomes rather than the strict averaging of inflation. The RBA implements medium-term inflation targeting by ensuring that the bulk of the distribution of year-ended inflation outcomes lies between 2 and 3 percent. The same could be said of the RBNZ which implements its medium-term IT framework by ensuring that inflation outturns fall into its target range in the latter half of the 3-year target horizon.48 The table below provides an overview of the advantages and disadvantages associated with each target horizon. Advantages and Disadvantages of Different Target Horizons Variable Annual Target Advantages Disadvantages  Allows monetary authorities to incorporate  Frequent changes in inflation targets could more recent information in target-setting undermine the integrity of the inflation targets,  Provides room for authorities to adjust particularly if the public perceives that the subsequent targets following a shock, in line adjustments are undertaken to ensure that the with the desired adjustment pace central bank actually hits the target  Places greater emphasis on target itself and  Annual revisions could hinder the minimizes possibility to pursue other goals consolidation of inflation expectations at a such as short-run output stabilization particular level for a sustained period of time  Could be associated with greater volatility in interest rates and the real economy given need to drive inflation to target over a shorter period of time





  

Fixed Multi-Year Target Advantages Disadvantages Helps stabilize inflation expectations at a  Reduces the flexibility of monetary policy desired range for a longer period of time as it which could be costly if a series of major increases the predictability of monetary supply-side shocks hit the economy policy  Presents a challenge to forecasting given low Reduces long-term uncertainty in monetary informational value of forecasts generated policy beyond the 2-3 year horizon Average Multi-Year Target Advantages Disadvantages Affords flexibility to a central bank as it  Average IT provides room to pursue shortrecognizes that inflation is difficult to control term output goals but such could hurt in relatively short periods of time credibility of IT framework Could provide scope to pursue short-term  Averaging inflation could weaken policy output stabilization accountability as it lengthens the measured May result into less aggressive monetary lag between policy decisions and inflation policy response as impact of a shock on outcomes (Heenan, et al. (2006)) inflation could be assigned lesser weight

47 48

W arburton and Lees (2005) Bollard (2002)

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III. Considerations for the Adoption of a Fixed Medium-Term Target for the Philippines After a careful review, the Development Budget Coordination Committee (DBCC) approved the shift to a fixed medium-term inflation target on 9 July 2010 under DBCC Resolution No. 2010-3. The adoption of a fixed medium-term target is expected to help promote a long-term view on inflation, increase the predictability of monetary policy and better anchor inflation expectations. In turn, this should facilitate and promote better-informed decisions relating to consumption and investment, as it helps reduce uncertainty. It is acknowledged that there are associated challenges with the shift to a fixed medium-term inflation target, such as the need for more calibrated responses to supply shocks and more rigorous inflation forecasting capability. It could be noted, however, that the BSP has already predefined, since the adoption of IT in 2002, a set of acceptable of circumstances under which the BSP may not achieve its target. These acceptable circumstances pertain mainly to supply-side related shocks that fall largely outside the domain of monetary policy. These include: (a) volatility in the prices of agricultural products; (b) natural calamities or events that affect a major part of the economy; (c) volatility in the prices of oil products; and (d) significant government policy changes that directly affect prices such as the changes in the tax structure, incentives and subsidies. With regard to the concern on generating forecasts extending to the medium-term, the BSP continuously refines, improves and expands its forecasting capability. As to the choice between a fixed multi-year target or an average multi-year target, the fixed annual target is preferred over an average target as it could better help anchor inflation expectations and is easier for the general public to understand. Furthermore, as argued in the literature, averaging of inflation could also weaken policy accountability as it may lengthen the lag between policy decisions and inflation outcomes. Another crucial aspect relating to the shift to a fixed medium-term inflation target is the determination of the appropriate target range. Essentially, authorities need to identify a target that is optimal for the economy, a quantitative representation of the medium-term goal of price stability. The assessment of the DBCC showed that a target of 4.0 percent with a ± 1.0 percentage point tolerance interval for the period 2012-2014 is appropriate for the Philippines. The said target range is consistent with latest inflation forecasts, the private sector’s inflation expectations, and the growth prospects of the economy. Furthermore, authorities also note that most central banks with medium-term inflation targets set their targets within a 1-3 percent range. However, it is not necessary for the Philippine target to be exactly aligned with their targets since the inflation target should incorporate country-specific factors. An inflation target of 1-3 percent for the Philippines may be too restrictive since this may entail large interest rate adjustments to effect a significant reduction in the current inflation. Going forward, the fixed medium-term inflation target will be periodically reviewed to determine its continued suitability to macroeconomic conditions. This is consistent with the general practice of other central banks adopting a fixed annual target. The periodic review is also part of the process for determining the appropriate target for the subsequent period.

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References: Bollard, A., 2002. The Evolution of Monetary Policy in New Zealand. A speech to the Rotary Club of Wellington, 25 November. Debelle, G., 2009, The Australian Experience with Inflation Targeting, Banco Central do Brazil XI, Annual Meeting on Inflation Targeting, Rio de Janeiro, 15 May. Heenan, G., Peter, M., and S. Roger, 2006, “Implementing Inflation Targeting: Institutional Arrangements, Target Design and Communication,” IMF Working Paper 06/278 (Washington: International Monetary Fund). Nessen, M., 2002, “Targeting Inflation over the Short, Medium and Long Term,” Journal of Macroeconomics 24, pp.313-329. Rezessy, A., 2006, “Considerations for Setting the Medium Term Inflation Target,” MNB Bulletin, (Budapest: Magyar Nemzeti Bank). Stevens, G., 2003, “Inflation Targeting: A Decade of Australian Experience,” Address to the South Australian Center for Economic Studies, Adelaide, 10 April. Warburton, S. and K. Lees, 2005, “A happy “halfway house”? Medium Term Inflation Targeting in New Zealand,” RBNZ Discussion Paper 2005/03 (Wellington: Reserve Bank of New Zealand). Websites of Selected Central Banks

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VI. INFLATION OUTLOOK Private Sector Economists’ Inflation Forecasts Mean inflation forecasts for 2010-2012 in the Based on the results of the BSP’s survey for BSP’s survey of private economists decline September 2010, inflation is expected to be during the quarter. within the target ranges for both 2010 and 2011. The mean inflation forecasts for 2010 MEAN INFLATION FORECASTS BY PRIVATE ECONOMISTS/ANALYSTS and 2011 were lower at 4.0 percent and 4.1 percent from 4.5 percent and 4.8 percent, 5.4 respectively, in the previous quarter.49 For 5.3 5.2 2012, the average inflation forecast was also 5.0 lower at 4.5 percent from 5.3 percent. 4.9 4.9 In percent

4.8

4.8

4.8

4.8

4.8 4.7 4.7

4.6

4.8

4.7

4.6

4.6

4.4

4.5

4.5

4.4

4.2 4.1 4.0

4.0 Q4 2008

Q1 2009

Q2 2009

Q3 2009

2010

Q4 2009

Q1 2010

2011

Q2 2010

Q3 2010

2012

Private Sector Forecasts for Inflation Annual Percent Change Q4 Asia ING ATR Deutsche Bank HSBC IDEA Metrobank PEP RCBC

2010 Full year

2011 Full year

Q1

2012 Full year

3.2 4.50 4.20 2.60 3.80 2.8-3.2

3.9 4.30 4.20 4.20 3.70 4.20 3.90 3.8-3.9

3.9 4.50 4.40 2.30 3.20 2.7-3.2

4.3 4.90 4.40 4.50 2.40 3.90 3.5-4.5

4.7 5.50 2.70 4.5-5.5

3.5 3.6 4.5 2.6 6

4.1 4.0 4.3 3.7 8

3.6 3.5 4.5 2.3 6

4.3 4.1 4.9 2.4 7

4.9 4.5 5.5 2.7 4

4.5±1.0

4.0±1.0

Median Forecast Mean Forecast High Low Number of observations Memo Item: Government Target

Analysts noted that the fragile global economic recovery as well as the firm peso will temper inflationary pressures. Meanwhile, some analysts noted that the onset of La Niña could lead to higher prices of agricultural products. Based on the probability distribution provided by six respondents, average inflation is viewed to have a 54.3 percent chance to lie within 3.1-4.0 percent in 2010, well within the 4.5 percent ± 1.0 percentage point target range for the year. The Asia Pacific consensus forecasts (for July, August, and September) for Philippine inflation also showed within-target inflation expectations for 2010 and 2011.

Probability Distribution For Analysts' Inflation Forecasts* 2010-2012 70.0

60.0

54.3

50.0

41.7 40.0

32.5 30.0

20.0

10.0

0.0

<1

1.0-2.0 2.1-3.0 3.1-4.0 4.1-5.0 5.1-6.0 6.1-7.0 7.1-8.0 8.1-9.0 9.1-10.0 10.1-11 11.1-12

2010

2011

>12

2012

*Probability distributions were averages of those provided by 6 respondents. (Source: BSP Survey)

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For Q4 2010 and Q1 2011, inflation is expected at 3.6 percent and 3.5 percent, respectively.

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Results of the BES for Q3 2010 show a smaller number of respondents anticipating inflation to increase in the survey quarter.

Relative to the previous survey, a smaller number of respondents expects inflation to move up in the survey quarter (from a diffusion index of 20.9 percent to 9.5 percent) as well as in the next quarter (from 18.6 percent to 12.3 percent).

Results of the CES for Q3 2010 show that consumers expect a lower inflation rate over the next 12 months.

A lower inflation rate is expected by consumers over the next 12 months relative to the previous survey: from 9.1 percent to 5.7 percent. Respondents expect all the 14 items included in the survey to have lower inflation, with the following items registering the most significant decrease: rice (from 9.3 percent to 4.7 percent); meat (from 7.8 percent to 4.2 percent); fish and seafood (from 11.5 percent to 6.1 percent); fruits and vegetables (from 14.3 percent to 7.2 percent); and water (from 8.7 percent to 5.0 percent).

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BSP Inflation Forecasts Baseline forecasts indicate inflation for 2010-2012.

within-target

The latest baseline forecasts suggest that inflation is likely to remain within the target ranges of 4.5 percent ± 1.0 percentage point for 2010 and 4.0 percent ± 1.0 percentage point for 2011. Initial forecasts for 2012 indicate that inflation could settle at the lowend of the medium-term inflation target range of 4.0 percent ± 1.0 percentage point. On balance, inflation is expected to remain manageable over the policy horizon in the absence of adverse shocks. The upside risks to the future inflation path include the potential rebound in commodity prices given the continuing strong demand in emerging economies, stronger-than-expected domestic economic recovery that could induce demandbased price pressures, impact of adverse weather conditions on agriculture, and petitions for electricity rate adjustments. Meanwhile, the risks to the inflation outlook may be dampened by the slow recovery for global growth and a sustained strengthening of the peso which will temper the impact of imported inflation. The key source of uncertainty in the inflation outlook remains to be the strength and pace of the global economic activity and its impact on commodity demand.

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Demand Conditions Available data continue to point to strengthening domestic demand conditions. Output in the first semester of the year has expanded at a faster-than-expected pace, underpinned by solid private demand, recovery in industrial production, and remarkable increase in fixed capital formation. Likewise, other demand indicators suggest a pick-up in domestic economic activity. For instance, the unemployment rate declined, capacity utilization in the manufacturing sector hovered at historic peaks while energy sales continued to increase. In addition, business confidence has continued to improve as indicated by the results of the latest BES survey conducted by the BSP which showed the overall confidence index for the current quarter approaching the pre-crisis peaks and that for the next quarter reaching an all-time high. Similarly, a separate consumer survey by the BSP indicated an improvement in consumer sentiment with the consumer confidence index reaching an all-time high for the current quarter, the next 3 months and the next twelve months. Given these favorable developments, the full-year 2010 GDP growth is now expected to settle at a rate which could be even higher than the DBCC assumption of 5.0 - 6.0 percent range. Supply Conditions

Outlook for global cereal production remains favorable.

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Despite the shortfall in Russia’s wheat production, the Food and Agriculture Organization (FAO) does not foresee a spike in food prices similar to that in 2007-2008. The FAO estimated world cereal production in 2010 to decline by just one percent compared to a year ago and would still be the third highest harvest on record. With relatively large cereal inventories, the FAO noted that supply should remain adequate with the world stocks to use ratio dropping by only one percent.50

FAO, Crop Prospects and Food Situation, No. 3, September 2010, available at http://www.fao.org

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Meanwhile, AFF output fell by 2.9 percent in the first semester of 2010, owing mainly to the adverse impact of the El Niño weather phenomenon. The crops subsector contracted by 6.7 percent with rice and corn production declining by double-digit rates. Nevertheless, the July 2010 forecasts of the Bureau of Agricultural Statistics (BAS) indicate a rebound in palay production and a smaller decline in corn output in the second semester. Palay harvest is expected to increase by 8.2 percent in the second semester following a 10.2 percent drop in the first semester. Meanwhile, corn output could decline by 0.4 percent in the second semester after a 25.0 percent contraction in the first six months of the year.51

In the absence of adverse shocks, the rise in global oil prices is likely to remain modest.

In the global oil sector, the IMF is of the view that increases in oil prices are likely to be modest over the near term. While increasing oil demand from emerging economies could put upward pressures on oil prices, this could be tempered by subdued oil consumption from advanced economies. The IMF added that current upstream investment projects could help accommodate strong demand from emerging and developing economies without the need for substantial draws on OPEC spare capacity. However, there are risks to medium-term prospects for oil prices. On the supply side, the IMF noted that obstacles to new and replacement investment projects as well as geopolitical tensions are risk factors that could have lasting impact on oil prices. In particular, the sluggish development of new fields and maintenance of existing fields due to long timeto-build lags could have a longer-term impact on oil prices. On the demand side, the strength and pace of the global economic recovery remains a key source of uncertainty.52

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BAS, Rice and Corn Situation Outlook, Vol.24, No.3, July 2010, available at http://www.bas.gov.ph IMF, World Economic Outlook, October 2010, available online at http://www.imf.org

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Output gap estimate widens.

The balance of demand and supply conditions, as captured by the output gap (or the difference between actual and potential output) provides an indication of potential inflationary pressures in the near term. Inflation tends to rise (fall) when demand for goods and services exert pressure on the economy’s ability to produce goods and services, i.e., when the output gap is positive (negative). Based on the latest GDP data, preliminary estimates yielded an output gap of 3.8 percent in Q2 2010, up from 3.3 percent (revised) in the previous quarter. The slightly bigger output gap suggests a modest uptick in demand-side inflationary pressures. The moderate expansion in the output gap was due to strong growth in actual output. While potential output also expanded, the moderation of this growth was traced to weaker full-time equivalent employment which pulled down the growth in potential output. The Philippines appears to be in a “sweet spot” with high output growth and low inflation. In part, this could be attributed to improved productivity owing to past reforms. The high output growth may also be reflecting the base effect from low economic growth in the previous year. To a certain extent, the strong first semester economic performance may be viewed as part of the normalization process after last year’s slowdown.

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Key assumptions used to generate the BSP’s inflation forecasts The BSP's baseline inflation forecasts generated from the BSP’s single equation model (SEM) and the multi-equation model (MEM) are based on the following assumptions: (a) National Government fiscal deficits for 2010 – 2012 which are consistent with emerging estimates of the Development Budget Coordination Committee (DBCC); (b) BSP’s overnight RRP rate at 4.0 percent from October 2010 to December 2012; (c) 91-day T-bill rate which is consistent with the DBCC-approved macroeconomic assumptions; (d) Dubai crude oil price assumption which is consistent with the futures prices of oil in the international market; (e) Annual increase in nominal wage of 5.8-6.2 percent in 2010 – 2012; (f) Real GDP growth rates which are endogenously-determined in the BSP’s MEM; and (g) Foreign exchange rates which are endogenously-determined in the BSP’s MEM through the purchasing power parity and interest rate parity relationships.

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Risks to the Inflation Outlook The latest fan chart suggests inflation will ease over the next four quarters and increase slightly towards the second semester of 2011.

The risks to the inflation outlook may be presented graphically through a fan chart. The fan chart depicts the probability of different inflation outcomes based on the central projection (corresponding to the baseline forecast of the BSP) and the risks surrounding the inflation outlook. The central projection of the latest fan chart suggests inflation would slightly slow down until the second quarter of 2011 and increase gradually towards the end of the year. Based on data as of the first week of October 2010, annual average inflation would fall within the 4.5 percent ± 1.0 percentage point target range for 2010 and the 4.0 percent ± 1.0 percentage point target range for 2011. Relative to the previous report, the baseline forecasts for 2010 and into the first half of 2011 have declined due to the lower inflation turnouts in the third quarter of 2010 and the dampening impact on inflation of the strengthening peso. Meanwhile, the central baseline forecasts for the second half of 2011 have increased compared to the previous report, reflecting mainly the bulk of the estimated impact of potential increases in toll fees, transport fares and electricity charges. Initial forecasts for 2012 also show that inflation could settle within the medium-term target range of 4.0 percent ± 1.0 percentage point. The latest fan chart also shows that there are uncertainties further out as depicted by the widening bands of the chart over time.

Downside risks to the inflation outlook include uncertainty over the strength and pace of the global economic recovery and sustained peso appreciation.

The possibility of slower global economic growth and its potential impact on international commodity demand presents a downside risk to future inflation. While global economic growth in the first semester of 2010 has been stronger than anticipated initially, the IMF is of the view that the recovery process remains fragile as the downside risks to economic activity have intensified. The IMF noted vulnerabilities related to the financial markets, weaknesses in the real estate sector, deleveraging by households, eventual slowdown in inventory accumulation and diminishing fiscal stimulus as factors that could limit growth in the near term.

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Against this backdrop, the IMF anticipates global economic growth to ease in the second half of 2010 and into the first half of 2011 before reaccelerating. As the prospects for commodity prices remain tied to the pace and strength of global economic activity, a slower recovery could temper commodity prices. Similarly, the sustained appreciation of the peso also represents a downside risk to the inflation outlook. The steady inflow of OF remittances, rebound in exports and improving appetite for the Asian region’s assets could help support the strengthening of the peso. In turn, a stronger peso helps reduce the cost of imported goods and services.

The fan chart shows the probability of various outcomes for inflation over the forecast horizon. The darkest band depicts the central projection, which corresponds to the BSP’s baseline inflation forecast. It covers 25 percent of the probability distribution. Each successive pair of bands is drawn to cover a further 25 percent of probability, until 75 percent of the probability distribution is covered. The bands widen (i.e., “fan out”) as the time frame is extended, indicating increasing uncertainty about outcomes. The band in wire mesh depicts the inflation profile as of Q2 2010.

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Potential risks to inflation include a strongerthan-expected improvement in domestic economy; buoyant commodity demand from emerging economies; petitions for cost recovery which could increase electricity rates in the near term; and the impact of the La Niña phenomenon on agricultural production.

While commodity prices are expected to remain stable in the near term, the balance of risks for commodity prices remains tilted to the upside. The presence of sizable capacity and inventory buffers for both oil and non-oil sectors could provide a counterbalance to demand-induced price effects. Nevertheless, the possibility of sharper-than-expected commodity price increases could not yet be fully ruled out should global economic prospects bounce back more strongly than anticipated. Moreover, the strong recovery of private demand in Asia and in other emerging economies could offset the sluggish demand from advanced economies and hence, exert upward pressures on global commodity prices. This is particularly important given the increasing role of emerging and developing economies in global commodity demand. In its October 2010 WEO, the IMF also pointed out that broader economic and financial market developments could drive commodity prices. In particular, expectations about global economic prospects appear to be a key determinant as inventory demand, including that for commodities, is essentially forward-looking. Thus, the IMF noted that unexpected changes in the pace of global economic activity and renewed volatility and stress in financial markets are key risk factors for commodity prices. Furthermore, the IMF cited major supply disruptions due to geopolitical tensions and adverse weather conditions as main potential causes of a commodity price spike. Hence, the likelihood of an increase in global prices of oil and non-oil commodities continues to pose an upside risk to the inflation outlook. Domestically, the growth momentum appears to be strong. As discussed in the previous subsection on demand conditions, most indicators point to a strengthening domestic economy. If sustained, robust domestic economic growth—on the back of renewed reform momentum and improving consumer and business confidence, among other factors—could support faster growth in consumer prices.

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Furthermore, there are also cost-side related risks to the inflation outlook. These include the potential impact of La Niña on agricultural production and petitions to increase utility charges. Moreover, an increase in rice prices should the government decide to reduce its subsidy to NFA as part of its fiscal consolidation strategy could also pose a risk to inflation.

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VII. IMPLICATIONS FOR THE MONETARY POLICY STANCE The baseline inflation scenario remains favorable, consistently tracking a within-target inflation path.

Latest baseline projections indicate that headline inflation will likely fall within the 4.5 percent ± 1.0 percentage point target range for 2010 and the 4.0 percent ± 1.0 percentage point target range for 2011-2012. Compared with the projections in the previous report, the latest forecasts follow a slightly lower trajectory, due mainly to lower actual inflation outturns and the continued strength of the peso during the quarter. Well-contained inflation expectations over the policy horizon also support the within-target inflation outlook. Recent surveys of private economists showed that inflation expectations have been steadily declining, reflecting in part the general downtrend of headline inflation as well as prospects of slower global economic growth in the near term and its potential impact on international commodity prices.

Meanwhile, there are indications that domestic activity is expanding at a solid pace.

Incoming demand data in the third quarter have been robust and uniformly strong. Firmness in domestic demand indicators alongside record-high consumer and business confidence and accelerating credit growth could continue to underpin sustained domestic economic growth going forward. Labor demand has also shown initial signs of picking up. Based on the July Labor Force Survey, unemployment rate went down to 6.9 percent from 7.6 percent in the same period last year.

Nevertheless, the economy continues to be at a point where the goal of safeguarding inflation is compatible with that of helping support economic activity, as inflation remains low even as demand has strengthened.

The BSP, however, will remain attentive to inflationary pressures going forward to ensure that monetary policy settings continue to be appropriate.

While output growth appears to be gaining momentum, inflation pressures have remained subdued due to a number of reasons. Capital formation will help to increase the economy’s productive capacity, therefore tempering the build-up of demand-induced price pressures. At the same time, favorable labor market conditions are likely to moderate pressures for wage increases. World economic conditions also point to a tepid global recovery, keeping a lid on imported price pressures. Potential sources of pressures on future inflation include a possible rebound in oil prices given the continuing strong demand in emerging economies, the impact of adverse weather conditions on agriculture, petitions for electricity rate adjustments, and a strongerthan-expected domestic economic recovery that could induce demand-side price pressures. Meanwhile, the inflation path could

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be dampened by a slow recovery scenario for global growth and a sustained strengthening of the peso which will temper the impact of imported inflation. Thus, while the inflation outlook appears benign, challenges also lie ahead given the potential risks around the central projection. These necessitate careful monitoring over the months ahead to assess how these risks would evolve. [On 7 October 2010, the Monetary Board decided to maintain the RRP and RP rates at 4.0 and 6.0 percent, respectively. The Monetary Board also maintained the current interest rates on term RRPs, RPs and SDAs. The current reserve requirement ratio was also kept unchanged.]

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The BSP Inflation Report is published every quarter by the Bangko Sentral ng Pilipinas. The report is available as a complete document in pdf format, together with other general information about inflation targeting and the monetary policy of the BSP, on the BSP’s website: www.bsp.gov.ph/monetary/inflation.asp If you wish to receive an electronic copy of the latest BSP Inflation Report, please send an e-mail to [email protected] The BSP also welcomes feedback from readers on the contents of the Inflation Report as well as suggestions on how to improve the presentation. Please send comments and suggestions to the following addresses: By post:

BSP Inflation Report c/o Department of Economic Research Bangko Sentral ng Pilipinas A. Mabini Street, Malate, Manila Philippines 1004

By e-mail:

[email protected]