Risk of Global Crunch (WSJ ARTICLE: For Philippine Economy, Harsh Remedies Pay Off)

By JAMES HOOKWAY

MANILA, Philippines — The perpetual sick man of Asia is making an unexpected recovery.

Once among Asia’s most prosperous nations, the
Philippines had languished economically for decades while neighboring
countries, big and small, raced ahead. But for the past two years –
almost lost amid the international excitement about the growth of
China, India and Vietnam — the Philippines has been rebounding.

This year, the nation’s economy is expected to post
its fastest growth rate since the early 1990s, despite the economic
shadow cast by the global credit squeeze sparked by problems in the
U.S. mortgage market. The Philippine economy grew at a 7.5% annual rate
in the second quarter. The stock market has soared over the past two
years, although it has faltered recently. Foreign investors are coming
back, attracted by the Philippines’ young population — the average age
of its 89 million people is 22 — and the widespread use of English, a
legacy of its past as an American colony. The call-center business is
thriving, some of it poached from India.

Not long ago, Fort Bonifacio, a sprawling old military
base in the heart of Manila, was an emblem of economic malaise — a
stalled redevelopment taken over by cyclists, skateboarders and kite
enthusiasts. Now, office towers, embassy buildings and shopping malls
are going up there. Nike Inc., Starbucks Corp. and Nokia Corp. have
opened stores, and the Manila stock exchange will be joining them soon.

“The Philippines could be the next India in terms of
its ability to surprise,” says Adrian Mowat, a stock strategist at J.P.
Morgan Securities Ltd. in Hong Kong.

Gloria Macapagal Arroyo, the country’s 60-year-old
president, gets much of the credit for the turnaround. Two years ago,
with thousands of street protestors threatening to oust her and the
country drifting toward a financial crisis, she pushed a higher sales
tax through Congress and signed it into law over the objections of her
advisers. The move raised the tax to 12% from 10% and expanded it to a
range of new products and services, including gasoline.

That politically risky step showed investors the
nation was serious about putting its house in order after years of
half-hearted attempts to cut its budget deficit, crack down on
corruption, and do something about its decaying ports and power grid. A
J.P. Morgan report in May predicted that the Philippines could have a
balanced budget by next year and a budget surplus by 2009.

“I knew the risks, but I decided that if we had to
bite the bullet, then that’s what we would do,” said Ms. Arroyo in a
recent interview.

The nation’s economic comeback shows the kinds of
remedies that struggling developing nations must consider to compete in
the global economy. Following China’s rise as a manufacturing power,
the nations of Southeast Asia — once one of the world’s most popular
manufacturing hubs — have been trying to make themselves more
attractive to foreign investors and markets.

“The whole region is going through the same process,
and it’s all in response to China,” says Luz Lorenzo, an economist who
covers the region for ATR-Kim Eng Securities Inc. in Manila. “How do
these countries survive China?”

Many problems remain in the Philippines. One of the
richest countries in Asia before World War II, the Philippines saw its
economy deteriorate during decades of misrule, punctuated by military
coups and economic mismanagement. Ms. Arroyo herself has survived two
attempts by military officers to grab power. The country has called in
U.S. military advisers to help tackle a persistent Islamist insurgency,
and it continues to be criticized widely for human-rights abuses and
corruption.

The recent economic progress could be undermined by
problems that have long plagued the economy. The country has a legacy
of crony capitalism that has left former business associates of late
President Ferdinand Marcos in powerful positions in the business
sector. Political analysts say Ms. Arroyo must avoid spending the
growing tax receipts on unnecessary projects that benefit her own
political supporters. And questions remain about the government’s
ability to collect corporate taxes.

Moreover, the Philippine economy is heavily dependent
on exports, which account for around 40% of gross domestic product. A
significant economic slowdown in the U.S. could harm that sector. But
economists contend that domestic investment and demand has become a
more important driver of the economy — and could help buffer it from
global economic problems. “The growth story here is changing from one
which is export driven to one which is domestic led,” says Ms. Lorenzo
of ATR-Kim Eng.

High-rise buildings in the financial district of Manila loom over a landscape of smaller houses.
Ms. Arroyo’s current six-year term expires in 2010.
It’s unclear whether the next president will continue her economic
policies, or will resort to past practices. Prior governments have
limited the business opportunities available to foreign companies,
allowing local tycoons to build lucrative monopolies.

Ms. Arroyo’s father, Diosdado Macapagal, was president
of the Philippines in the early 1960s. After studying economics at
Georgetown University, she returned home to teach at the University of
the Philippines, then entered politics.

She was elected vice president in 1998. She quickly
set about distancing herself from her unpopular boss, President Joseph
Estrada, a former action-movie star who became embroiled in a series of
corruption scandals. In 2000, she openly began plotting his removal. In
January 2001, after the armed forces joined hundreds of thousands of
demonstrators in the streets of Manila to force him from office, she
was sworn in as his successor.

Ms. Arroyo, whose short fuse has led her to slam
cellphones on tables and publicly berate her deputies for making
mistakes, has proved to be a tough political infighter. She’s stood up
to two failed military-coup attempts by rallying her allies in the
armed forces and the powerful Roman Catholic Church, of which she is a
devout member. When the business dealings of her husband began drawing
political heat in 2005, she exiled him to the U.S. for several months
until the fuss subsided.

Her priority after winning the 2004 presidential
election was to put the nation’s chronically ailing finances in order.
A key problem: anemic tax revenues due to endemic corruption among tax
officials and loopholes in the tax code. In 2003, tax revenues were
14.8% of GDP. That’s a lower rate than in poverty-ridden countries such
as Indonesia and India, and far below rates in developed countries such
as the U.S., where government revenue totaled 25% of GDP in 2006.

A combination of weak state revenues and high foreign
debt — 70% of the government’s budget went to paying interest in 2005
– was spooking investors. They worried that too much of the
government’s budget went to service debt, and not enough to fix roads,
schools and the power supply. Japan’s Toshiba Corp. shut down its
Philippine laptop factory in 2004 and moved the operation to China.

GROWTH STORY

? The Situation: After languishing for years, the Philippine economy is showing signs of renewal.

? The Background: President Arroyo pushed through higher taxes, which helped persuade foreign investors she was serious about economic reform.

? What’s Next: Like other Southeast Asian nations, the Philippines is worried about a potential economic slowdown in the U.S.

“Our country was going through a credibility gap with
the institutional and financial community globally,” says Jaime Augusto
Zobel de Ayala, chief executive officer of Ayala Corp., one of the
companies redeveloping Fort Bonifacio. The Philippines, he says,
“needed to send a signal.”

Ms. Arroyo warned in 2005 that if the Philippines
didn’t act decisively to improve its tax-collection rate, it risked
becoming the next Argentina, where economic problems led to a currency
collapse. She and her advisers began looking for ways to raise new
money.

She increased tobacco and alcohol taxes, but that
wasn’t enough. She and her economic team began working to push another
unpopular measure through Congress in 2005: an expanded sales tax.

Demonstrators took to the streets to contest her tax
plans. One of her advisers, former stock analyst Joey Salceda,
suggested that she limit the new sales tax to soften the political
backlash. Gasoline prices, he said, should be excluded because they
were already spiking. She ignored the advice.

“I was determined not to sacrifice long-term gains for
political expediency, even though we had to do it at the worst possible
time,” Ms. Arroyo says.

At first, the sales tax hike appeared to make things
worse. Her opponents challenged the legality of the legislation, and
the Supreme Court suspended the tax law the day it was to take effect
in July 2005. Stock prices slumped at the Philippines Stock Exchange,
and ratings agencies Moody’s and Standard & Poor’s lowered their
already dim outlooks on the nation’s ability to pay its debt. Ms.
Arroyo’s popularity took a pounding.

Eventually, the Supreme Court dismissed the objections
and the tax hike took effect in early 2006. That greatly reassured
business leaders and foreign investors, who were worried about the
burden of the government’s $54 billion in foreign debt.

“The single turning point that changed people’s minds
about the Philippines was that she was able to pull off the expanded
tax, and at such a difficult time,” says Fernando Zobel de Ayala,
brother of Ayala’s CEO and head of its Ayala Land unit.

President Gloria Macapagal Arroyo visits the Philippine Stock Exchange.
The tax take in 2006 was 22% higher than in 2005,
lifting government revenue to 16.3% of GDP. To further reduce the
deficit, Ms. Arroyo started privatizing the nation’s debt-burdened
power industry in 2005. In addition, she encouraged foreign investment
in the mining sector — which antimining activists and the Catholic
Church had blocked for years.

Since then, institutional investors have been
returning to the country’s bond and stock markets. Since the new tax
took effect in January 2006, the Philippines Stock Exchange Index has
climbed 58%, outstripping most Asian markets over the same period. Net
stock investment by foreign investors hit a record $870.8 million in
June, according to the Philippine Stock Exchange, up from just $12.9
million in January 2004. The Philippine peso has risen 13.6% against
the U.S. dollar since the tax took effect, partly due to the inflows of
foreign money. The peso is the second best performing currency in Asia
this year, after the Indian rupee.

Rather than borrowing overseas, local companies are
once again turning to the stock market to raise funds. There were
numerous initial public offerings on the Philippines Stock Exchange in
2005 and 2006, following years in which offerings were rare. Eight 2006
offerings were aimed specifically at foreign investors, raising $1.56
billion. So far this year, five IPOs have hit the market.

With business confidence on the mend, inflation and interest rates have declined.

Local and foreign businesses have begun investing
again, and multinational companies are adding plants and shipyards. In
May, Texas Instruments pledged $1 billion to build a new chip testing
and assembly plant at the old U.S. Air Force base at Clark Field, 62
miles north of Manila, to complement a plant it already has here.

Kevin Ritchie, Texas Instrument’s senior vice
president for technology and manufacturing, said at the time that the
country’s skilled work force encouraged the company to raise its
investment. Philippine officials said the company was also looking for
reliable power and water, which are more available now that power
privatization is under way.

One of the world’s largest shipping companies,
Beijing-based China Ocean Shipping Co., is studying whether to build a
multibillion- dollar cargo hub near Manila, company officials say. South
Korean shipbuilder Hanjin Heavy Industries & Construction Co. is
investing $1.7 billion in a new shipyard at a former U.S. Navy base at
Subic Bay. It was attracted by the skilled, English-speaking work force
and low costs, a company official says.

Filipino expatriates — more than 10 million work
abroad — have taken notice. They are now sending home $14 billion a
year, double what they sent five years ago, government figures
indicate. Economists see this as a relatively secure source of revenue.
While 35% of these expatriates work in the U.S., there are also large
pockets in Europe, the Middle East and East Asia. That geographical
diversity could provide some insulation against a downturn in the U.S.

The remittances aren’t just going to support families,
but into the stock market and property investments. Ayala Land, one of
the country’s biggest real-estate companies, says that in 2006, 37% of
revenue came from Filipinos overseas buying land and condominiums, up
from 26% the year before and just 16% in 2004. The company’s chief
financial officer, Jaime Ysmael, told shareholders on Tuesday that if
economic problems in the U.S. deepen, Ayala Land can still count on
Filipinos working in Europe and the Middle East.

Norma Ravanzo, a 58-year-old retired nurse from
Houston, is one such investor. An American citizen for more than 30
years, Ms. Ravanzo is planning to return to her homeland with her
husband, who was also born in the Philippines. Encouraged by the
economic progress and improving living conditions, Ms. Ravanzo bought
property in Cebu City, Manila’s financial district, and a retirement
home in Subic Bay. “It’s like living in a first-world community at
third-world prices,” she says.

Write to James Hookway at james.hookway@ awsj.com