Information about Asia and the Pacific Asia y el Pacífico
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Philippines: Selected Issues

Author(s):
International Monetary Fund
Published Date:
March 2007
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II. Can a shift to services set the Philippines on a stronger growth path?1

A. Introduction and Background

1. Over the past year, the Philippines has seen a marked change in sentiment regarding its macroeconomic prospects. As business sentiment has improved, and sovereign spreads have fallen, expectations are high that the economy could shift to higher growth, with stronger fiscal and external balances, an a declining debt trajectory. This transformation in expectations is all the more striking given that manufacturing output and investment; have been steadily declining as a share of GDP since the 1990s. While fiscal reforms have largely driven the recent macroeconomic ebullience, this chapter examines the role that the services sector can play in advancing the economy to a stronger long-term growth path.

2. Growth performance in recent years has been led by the service sector. Especially since the Asian crisis, the services sector’s contribution has been key for both GDP and employment growth. The share of services in the economy has grown over the past decade to reach over 50 percent of GDP, while agriculture and industry have declined in relative importance. The decline in industry’s share of GDP has been marked, falling by some 7 percentage points since 1980. Available data suggest that the growth in the services sector has been mainly for the domestic economy, and that the contribution of services to exports has been limited thus far.2 Meanwhile, the investment-to-GDP ratio has fallen to about 15 percent over the past few years.

Sectoral performance
Real GDP growthEmpolymentExports 1/
1991-19971998-20051991-19971998-20051991-19971998-2005
(Growth rate, y/y, in percent)
Agriculture2.042.871.710.714.361.38
Industry3.362.834.450.9219.897.31
Services3.355.174.293.5521.57−2.70
(Contribution to growth, in percent)
Agriculture0.450.560.780.220.480.01
Industry1.170.950.700.1413.195.71
Service1.522.371.711.644.72−1.27
Total3.143.893.192.0118.394.45

Data for 1991-1999 uses service and income data based on the old BoP methodology, but excludes investment income, personal income, and peso conversions of FCDs. Differences between the two methodologies in classification of certain income and services likely cause services contribution in 1991-1997 to be overstated.

Data for 1991-1999 uses service and income data based on the old BoP methodology, but excludes investment income, personal income, and peso conversions of FCDs. Differences between the two methodologies in classification of certain income and services likely cause services contribution in 1991-1997 to be overstated.

GDP share by industry and investment

(in percent of total GDP, nominal)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

3. Recent trends distinguish the Philippines from of its neighbors. Average GDP growth is higher in the post-Asian crisis period in the Philippines, while the majority of Philippines’ regional peers have experience substantially lower growth in the post-Asian crisis period Compared with the pre-crisis period. Nevertheless, those countries have seen a gradual recovery in their investment ratios, even if they are also still considerably below pre-crisis Levels. 3 Futhermore, Sectoral growth in those countries has been more balanced, and services do not appear to have played a significant part in the region’s resurgent growth, with the exception of Hong kong SAR and Singapore.

Real GDP Growth and Services share
Real GDP growthService Sector Share
(in percent, average)(in percent, nominal)
1991-19971998-20051991-19971998-2005
China11.538.9533.8738.77
Hong kong SAR5.333.7678.1784.10
Indonesia6.882.0240.6539.23
India5.765.8742.5548.78
Korea7.254.2242.5560.63
Malaysia9.243.7745.0041.82
Philippines3.143.8946.3052.78
Singapore8.643.7662.4963.48
Thailand6.812.9849.9147.96

Gross Fixed Captial Formation

(in percent of GDP)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

B. A Closer Look at Service Sector-led Growth

4. Trade and transport, storage, and communications services have been growth drivers, while private and financial services have started to add new momentum. Trade and transport, storage, and communications services have been supported by resilient retail consumption associated with steadily increasing remittance inflows over the last five years, while transport services have recently gained momentum due to the expansion in tourism. Reflecting the upsurge in BPO activity (see Box), private services have started to record higher growth since 2003. Financial services and real estate services have also picked up in the last two years, as both of these services have now been marketed to Overseas Filipino Workers (OFWs), who are beginning to save and invest more as they earn higher incomes.4

Service sector growth

(in percent Y/Y)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Contribution to service sector growth

(in percent Y/Y)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

5. Several factors could explain the Philippines’ strength in the service sector. These include: (i) large and growing remittance inflows; (ii) sufficient supply of skilled-labor, and (iii) competitive wages in certain service sectors.

  • Large and growing remittance inflows. Recorded remittances have grown rapidly, particularly since 2002, reaching 11 percent of GDP in 2005 compared to 7 percent of GDP in 2002. This is not only because the number of workers deployed abroad has grown, and remittances are being better captured in the data, but also because the technical skill levels and wages being earned in a strong global economy are higher.5 The steadily rising remittance inflows have also kept consumption growing at a healthy pace, relative to regional peers, supporting domestic demand. Some other emerging market countries that benefit from large remittances inflows—notably India and Mexico—have also recently experienced rapid growth in remittances, accompanied by an expansion in services in their domestic economies.

Worker’s Remittances and Service Growth

(Quarterly, in U.S. dollar, y/y, 3mma)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Private Consumption growth

(In percent, q/q)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

  • Sufficient supply of skilled-labor. The unemployment rate in the Philippines remains high, averaging over 10 percent during 2000-2006, as the economy has not created a sufficient number of jobs for a growing population. Population has grown on average by 2 percent per year, while employment growth has not kept pace. Due to a lack of attractive job opportunities, a number of skilled-workers and new graduates have migrated to industrialized countries, such as the U.S. and Canada. However, the rate of migration can be stemmed if more jobs become available in the high value-added service sector.6

Unemployment

(Quarterly, n.s.a.)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

  • Competitive wage levels. In addition to language skills, cost savings are the most significant determinant of location for BPO centers. Salary levels for skilled workers such as workers for the BPO industry in the Philippines are recognized as competitive relative to other countries in the region, and slightly higher than those in China and India. Together with cultural and social affinities with customer countries such as the U.S., competitive wages have played a key role in attracting BPOs to the Philippines. Moreover, industry observers believe wage pressures going forward might be higher in countries such as India and Vietnam which have begun to hit supply bottlenecks with regard to the available labor pool.

6. Looking ahead, the services sector in the Philippines holds significant promise, but there may be challenges in climbing up the value-added ladder. The Philippines has established a strong presence in voice-based BPO sectors such as call centers, and there are also signs of growth potential in other offshore services, such as medical transcription and animation. However, the Philippines faces greater challenges in higher value-added sectors, such as engineering design, research outsourcing, and other Knowledge Process Outsourcing (KPO) services. This is in part because operators sometimes find it difficult to retain the relatively few skilled workers in these areas, who are frequently enticed by higher pay to other offshore destinations, where a stronger critical mass of such skills exists.

Service Competitiveness indicator
PhilippinesChinaVietnamPakistanIndiaIndonesiaThailand
Global service location index, total score 1/5.786.145.006.875.475.72
Of which: Financial structure3.583.213.553.473.513.27
People and skill availability1.161.760.692.141.060.94
Business environment1.051.170.761.260.891.15
Ranking among total 40 countries42261136
ITO/BPO Success factors indicator 2/ 3/3.753.503.252.75
Offshore attractiveness index, ITO4/2.843.404.25
Ranking among total 14 countries1131
Offshore attractiveness index, BPO4/3.853.314.14
Ranking among total 14 countires291

Source: A.T. Kearney, 2005. The weighted distribution for the three categories is 40:30:30. The financial structure is rated on a score of 0 to 4, and the categories for people and skills availability, and business environment are on a scale of 0 to 3.

Source: Lehman Brothers. The indicators are scored with consideration of educational infrastructure, labor cost, entrepreneurialism, supportive policies, political stability, and linguistic skills.

ITO: information technology outsourcing, BPO: business service outsourcing.

Source: neo IT. The index is scored with consideration of financial benefit, service maturity, people, infrastructure, and catalyst.

Source: A.T. Kearney, 2005. The weighted distribution for the three categories is 40:30:30. The financial structure is rated on a score of 0 to 4, and the categories for people and skills availability, and business environment are on a scale of 0 to 3.

Source: Lehman Brothers. The indicators are scored with consideration of educational infrastructure, labor cost, entrepreneurialism, supportive policies, political stability, and linguistic skills.

ITO: information technology outsourcing, BPO: business service outsourcing.

Source: neo IT. The index is scored with consideration of financial benefit, service maturity, people, infrastructure, and catalyst.

7. The emergence of off-shoring services in the Philippines could have a significant multiplier effect. From a macroeconomic standpoint, comparisons with India are the most tempting, because India’s shift to a much stronger growth path has coincided with it establishing its presence in the BPO and KPO industries.7 In India’s case, the indirect impact of the growth of these services may have been much stronger than the direct contribution—the creation of wealth in urban centers related to these services also generated a large multiplier effect, as it created demand for other domestic services, drawing in labor from the more rural areas, who in turn remitted part of their earnings to rural areas, generating further demand for services (particularly financial) 8. While it is too early to make definitive predictions, if the growth of the Philippines’ off-shoring industry were to mirror India’s in the mid-1990s, such indirect effects could take root as well. However, in explaining the strong growth generated by the service sector in India, there are two other factors that appear to have played a role: (i) the direct effects have been enhanced by a return of many high skilled workers in the Indian diaspora abroad; and (ii) the indirect effects were enhanced by a banking sector that was willing and able to expand lending to the Small and Medium Enterprise (SME) sector of the economy. Neither of these factors is as yet strongly evident in the case of the Philippines.

C. Has the Sectoral Shift toward Services Lowered the Investment Ratio?

8. The investment ratio may have been affected by on-going sectoral shifts. It is, plausible that the service sector is not capital-intensive, and as economies shift from industry and manufacturing to services, output overall becomes less capital intensive, and the, investment ratio might decline. Cross-country plots suggest some support for a relation between the investment ratio and sectoral composition of GDP—a higher share of industry might raise the investment ratio, and a higher share of services might lower the investment ratio (with these two statements synonymous if the agricultural sector is small).

Share of industry and investment

(2000-05, in percent of GDP)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Share of Services and investment

(2000-05 average, in percent of GDP)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

9. Cross-country panel regressions were run to test more formally for a relationship between sectoral shares and investment. The basic specification uses three explanatory variables for the change in the investment ratio: (i) changes in the real interest rate; (ii) lagged growth of GDP as a proxy of expected growth; and (iii) changes in the sectoral share in GDP of each sector.9 A separate dummy variable was also included to test if the pre-Asian crisis period had a significant effect on the investment ratios of all the countries in the sample, as might be expected given the investment boom that preceded the crisis. The main independent variable of interest is the sectoral share of industry, or services. Thus, the equation tested is:

where I is the investment ratio in percent of GDP, Y is real GDP, r is the real interest rate, H is each sector’s share in GDP with i= D (industry), or S (services). For each sector, a separate regression was run. The model is estimated with annual data for 1985-2005, with the sample economies j, including China, Hong Kong SAR, India, Indonesia, Korea, Malaysia, Philippines, Singapore, and Thailand. Fixed effect terms are suppressed.

Estimation Result
(i)(ii)(iii)(iv)(v)(vi)
α11.03(5.44)***1.04(5.65)***1.02(2.36)***1.05(2.46)***0.21(0.77)0.21(0.76)
α20.01(4.76)***0.01(4.08)***0.01(4.45)***0.01(3.98)***0.01(5.01)***0.01(4.25)***
α3−0.08(−0.46)−0.01(−0.57)−0.09(−0.58)−0.11(−0.68)−0.02(−0.11)−0.03(−0.23)
α4, s−0.02(0.06)−0.01(0.03)
α4, D0.76(4.31)***0.77(4.16)***
Dummy0.01(0.77)0.01(0.70)0.02(0.92)
Adj. R20.170.170.160.160.220.22
DW stat.1.791.771.781.761.721.70
Note: Absolute values of asymptotic t-statistics in parentheses;

significant at the 1 percent level.

Note: Absolute values of asymptotic t-statistics in parentheses;

significant at the 1 percent level.

10. The regression results suggest that the share of industry has a significant and positive relationship with the investment ratio. The estimated coefficient on the industry share is statistically significant, and positive, while there appears to be no significant relationship between changes in the investment ratio and the services sector share. The coefficient on lagged growth bears the expected sign and is statistically significant, but the real interest rate is not statistically significant, though the coefficient bears the expected sign. A clear indication of the excessively high investment ratio relative to expected growth is not observed for the pre-Asian crisis period, possibly because expected growth was also high during the period.10 There is support for the notion that the declining share of industry partly explains the decline in the investment ratio. However, there is no strong support in the data for the notion that a rise in the services sector share actually lowers the investment ratio. This could be because the services sector may not indeed be less capital-intensive as hypothesized, but could also be because the services predominant across the economies in the dataset are themselves likely to have large variations in capital intensities.

D. Is there a Relationship between Remittances and Investment?

11. Rising remittances appear thus far to have a weak association with investment. In a cross-section of remittance receiving countries, there appears to be little relationship between remittances and investment, as country specific factors could determine whether a rise in external inflows leads to greater consumption, including housing-related spending on the one hand, or greater investment in fixed capital on the other. 11 In the Philippines, the investment ratio has steadily declined since the Asian crisis, thus it is clear that the increase in remittances has not increased investment thus far. It is difficult to tell whether investment is falling predominantly because of issues with the supply of credit, or whether the demand for credit that is also low.12 The fact that banks are still repairing their balance sheets, and are risk averse in the current environment might suggest that financial intermediation is the primary issue. Yet, if this were the case, one might have expected that a rise of more than 3 percentage points of GDP in remittances since 2002 might have had a more pronounced effect on investment, which has, however, continued to decline as a share of GDP. 13

Remittances and investment

(In percent of GDP, 2000-05 average)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Gross fixed capital formation

(in percent, y/y)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Bank Deposits and Remitances

(In percent of GDP)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

Private building construction

(In millions of Peso)

Citation: 2007, 131; 10.5089/9781451831405.002.A002

12. However, the lack of response of investment could also be a transitory phenomenon. Over time, a rise in remittances can cause an endogenous change in, consumption-investment decisions. The shifting skill and regional patterns could also have potentially powerful implications for the saving patterns of the dependents in the Philippines who are the end users of these funds. In 1991, nearly 60 percent of families in the Philippines who considered their main income source as coming from abroad came from the bottom two quartiles of the income distribution. By 2003, this share had dropped to just under 18 percent, implying that the share of families in the top two brackets counting income abroad as their main source of income rose from 40 percent to 82 percent.14 The most likely interpretation of this fact is that the skill set of remitters has shifted exogenously, and there are both “pull” and “push” factors taking higher skilled workers abroad. Given that some 80 percent of families that receive income from abroad as their main source are now middle and high- income families, it is much more likely now than in 1991 that the uses for this income go beyond consumption and subsistence, and are put toward saving and investment. This suggests that the lack of a relationship between investment and remittances could indeed be transitory, and that going forward, one may see a pick up in investment in physical capital.

E. Policy Implications and Conclusions

13. Whether it is through growing remittances, or through growth in off-shoring services, the Philippines is increasingly “exporting” its labor to sustain growth, while domestic investment has declined. Put differently, to sustain slightly higher growth rates over the post-Asian crisis period during which investment has declined, the Philippines has relied on a combination of: (1) a scale effect—sending higher numbers of workers abroad; and (2) a quality effect—exploiting higher returns to human capital abroad, and more recently through the growth of off-shoring, capturing a share of those higher returns domestically.15 From the standpoint of long-term sustainability, there are natural limits to the scale effect. Therefore, to move to a decisively stronger growth path, the Philippines needs to prioritize the following areas:

  • First, improvements in infrastructure are necessary to support the emerging service sector. For the BPO industry, these include not only continuous upgrading of the technological hardware that has made the Philippines competitive thus far, but also access, in terms of roads and transportation to cities that are new emerging centers for these industries beyond Metro Manila.

  • A renewed emphasis on the provision of stronger education, including across engineering and scientific disciplines, are essential if higher value-added overseas jobs, or high value offshore servicing industries are to make the Philippines their home.

  • The need for education is further underscored, if the Philippines is to turn its relatively high population growth into a demographic advantage in an “aging” world. Otherwise, sustaining a growing population on income sources that emanate directly or indirectly from abroad with a stagnant set of labor skills could prove untenable.

  • Finally, as the demographics of the end-users of income from service sector jobs (domestically and abroad) change, besides education, there is also a need for greater savings out of these incomes, and more productive investments being made using these savings.16 Absent this, the strong indirect effects from the growth of services which have been seen in other countries may not be realized.

Box:Emergence of the Business Process Outsourcing (BPO) Industry

The Philippines has recently established a strong presence in the Business process outsourcing (BPO) industry. Although the growth contribution has remained small thus far (contributing 0.2 percent to real GDP growth in 2005), employment and revenues from BPO have significantly increased in recent years. Among the various type of operations, voice contact centers have witnessed a significant expansion, while other services such as software, animation, and medical transcription have gradually started to emerge. Currently, about 90 percent of BPO firms in the Philippines are foreign-owned, mainly for in-house operations.

The Philippines is an attractive outsourcing destination. According to some business attractiveness surveys, the country is highly ranked as an outsourcing location, compared with other key destinations. Low labor costs, high linguistic and cultural compatibility with the US, and the quality of telecommunication infrastructure are widely recognized factors that work in the Philippines’ favor, especially for voice-related operations. However, the lack of a sufficiently deep Information Technology (IT)-skilled labor pool has prevented the country from ranking similarly in IT, and IT-enabled services.

This recent emergence of the BPO industry has had positive spilled-overs. With increasing demand for office space, the real estate market has been tightening, especially in Metro-Manila, reducing the office vacancy rate to 6.0 percent in 2006 from over 15.0 percent in 2002. This has also started to create new construction demand, together with demand for residential buildings for BPO employees, and construction and sub-sectors, such as mining and quarrying, and electricity, gas, and water, have started to gain.

Growth in the BPO industry is expected to accelerate. Total revenue is expected to grow by on average 38 percent per year, to over US$12 billion by 2010, while employment is also expected to increase by almost 50 percent per year. Should such expectations be borne out, the BPO industry should be a key growth driver in the Philippines.

BPO Industry overview

(As of 2005)

RevenueEmpolyment
(in bin of U.S.$)(in thousand)
Contact center1.79112.00
Back office0.1822.50
Medical transcription0.075.50
Legal transcription0.010.45
Other data transcription0.040.03
Animation0.074.50
Software development0.2012.00
Engineering design0.052.80
Distal content0.010.50
Total2.42163.25
Source: Business processing Association, philippines (BPA/P).
Source: Business processing Association, philippines (BPA/P).
Comparsion with other BPO Destination

(Millions of U.S. dollar, as of 2004)

BPOIT Service
ExportsRanking 1/ExportsRanking 1/
Canada5,50058,2002
India5,200112,2001
Philippines800233011
China30097003
Mexico20061009
Poland7031104
Malaysia4081208
Czech Republic407606
Russia25145507
Hungary25105010
Romania25113012
Source: neo IT, Mapping Offshore Markets Update 2005

The ranking is based on a country’s aggregated ratings on five factors: these factors include financial benefit, service maturity, people, infrastructure, and catalyst.

Source: neo IT, Mapping Offshore Markets Update 2005

The ranking is based on a country’s aggregated ratings on five factors: these factors include financial benefit, service maturity, people, infrastructure, and catalyst.

BPO forecast

Source: Business Processing Association, Philippines (BPA/P).

References

Prepared by Ayako Fujita and Srikant Seshadri.

With the recent emergence of the Business Process Outsourcing (BPO) industry, this may have already changed. However, the growth in the exports of services is not, as yet, evident in the balance of payments data. The authorities are currently taking steps to strengthen data gathering in this area.

In Malaysia, 2006 data suggest that investment has recovered.

In the case of financial services, part of the rise is also due to services emanating from the disposal of NPLs in the banking system, so part of this rise may be temporary.

There is now greater regional diversification of worker placements, with increasing numbers of workers being placed in the Middle East, and Central and Eastern Europe, whereas in the past workers were mainly concentrated in the U.S., Western Europe, and closer to home, in Hong Kong SAR and Singapore.

A recent survey indicates that the annual number of graduates in engineering, science, and business has grown by 23.7 percent since 1994-95, while the total jobs in the economy across all sectors have grown by less than 20 percent.

According to industry consortium estimates, the service sector related to Information and Communications Technology (ICT) in India has grown rapidly, currently employing 1.3 million people (4.5 times the employment in 1990), while revenues have trebled to 4.5 percent of GDP in 2005-06 from 1.5 percent of GDP in 1997-98. By comparison, the Philippines industry consortium estimates that the BPO sector’s employment has grown nearly five-fold since 2000 to 112,000 employees in 2005, while revenues have grown from a negligible share to 1.5 percent of GDP over the same period.

There are many studies on the impact of service sector growth on the Indian economy, and potential development lessons it offers, from academic, multilateral, and private financial institutions. Among them: Singh (2006), Malik (2006a, and 2006b) and Gordon and Gupta (2004).

The inclusion of lagged-growth of GDP assumes adaptive expectations, where past growth is seen as a basis for current investment decisions. Other more sophisticated specifications are certainly possible, and a more robust econometric specification would be an interesting refinement for future research. The coefficient for lagged-growth is expected to be positive, and the interest rate coefficient is expected to be negative. For sectoral shares, a positive coefficient is expected for the industry sector and a negative for the service sector.

Since a simple adaptive expectations model is employed using lagged-growth as a proxy of expected growth, the high investment during the period is largely explained by the high growth expectations and associated expected return on investment prior to the crisis. A more sophisticated specification might reveal stronger statistical significance of the dummy variable.

Hausmann et al (2005) offers some possible explanations for this. Countries where economic returns to investment are low, or the private appropriability of those returns may be low (due to high taxes or corruption, for example) may tend to see a rise in remittances go towards increased consumption, housing, and/or capital flight. Whereas, countries where the primary problem is due to poor financial intermediation, causing access to capital to be limited (even though there may be plenty of productive uses for it), and the cost of finance to be prohibitive, are likely to see increased investment from a rise in external inflows.

See Chapter III of this Selected Issues Papers.

Remittances may be substituting for consumer lending which has not taken off as in other countries, yet consumption has maintained its steady growth.

Based on the Family Incomes and Expenditures Surveys conducted by the National Statistics Office. The bottom two brackets are defined as those having incomes under 50,000, and 100,000 pesos respectively. The third quartile has income between 100,000 and 250,000 pesos, and the top bracket has income over 250,000 pesos.

To the extent that the returns to human capital are higher where the stock of physical capital is higher, as elucidated, among others, by Lucas (1988), the Philippines may also be successfully leveraging off the world’s physical capital stock to sustain growth.

The BSP, together with the Overseas Workers Welfare Administration (OWWA), is conducting an education campaign to encourage OFWs to save and invest greater shares of their remittances domestically.

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