i

FOREWORD

he primary objective of monetary policy is to promote a low and stable rate of inflation conducive to balanced and sustainable economic growth. The adoption in January 2002 of the inflation targeting framework for monetary policy was aimed at helping 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 convey to the public the overall thinking and analysis behind the BSP’s decisions on monetary policy, so that monetary policy is easier to follow and understand, and (ii) to enable the public to better monitor the BSP’s commitment to the inflation target, thus helping anchor inflation expectations. The government’s targets for annual headline inflation under the inflation targeting framework have been set at 5-6 percent for 2005 and 4-5 percent for 2006.

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, monetary and financial market conditions, labor market conditions, fiscal developments, and the international environment. A section is devoted to the BSP’s view of the inflation outlook during 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 of the Inflation Report also features a two box articles. The first box article provides an assessment of the trend and outlook for oil prices. Meanwhile the second box article discusses the differences between the monetary data generated by the new Depository Corporations Survey (DCS) and the Monetary Survey (MS).

The Monetary Board approved this Inflation Report at its meeting on 28 April 2005.

RAFAEL B. BUENAVENTURA

Governor

April 2005

T

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 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 Instrument

The BSP uses the overnight repurchase rate (RP) and reverse repurchase rate (RRP) as the key policy rates to set the monetary policy stance. Policy Targets

The BSP uses the CPI or headline inflation rate (compiled and released to the public by the National Statistics Office) as its target for monetary policy. The policy target is expressed in the form of a range for a given year and is set by the government in coordination with the BSP. For 2005-2006, the government’s targets for annual headline inflation have been set at 5-6 percent and 4-5 percent, respectively. BSP’s Exemption Clauses These refer to the predefined set of acceptable circumstances under which an inflation-targeting central bank may fail to achieve its inflation target. Such exemptions 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 price 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; (d) significant government policy changes that directly affect prices such as changes in the tax structure, incentives and subsidies.

iv

The Monetary Board The powers and functions of the Bangko Sentral, 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. The Monetary Board meets every four weeks to review and decide on the stance of monetary policy.

Chairman Rafael B. Buenaventura

Members Cesar V. Purisima*

Juan Quintos, Jr.

Antonino L. Alindogan, Jr.

Melito S. Salazar, Jr.

Vicente B. Valdepeñas, Jr.

Raul A. Boncan

* Replaced Monetary Board Member (MBM) Juanita D. Amatong upon her retirement from the Department of Finance. Secretary Cesar V. Purisima was appointed MBM on 21 February 2005.

v

The Advisory Committee The Advisory Committee was established as 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 regularly every four weeks but may also meet in between the regular meetings, whenever it is deemed necessary.

Chairman Rafael B. Buenaventura Governor

Members Amando M. Tetangco, Jr.

Deputy Governor Monetary Stability Sector

Alberto V. Reyes Deputy Governor Supervision and Examination Sector

Diwa C. Guinigundo

Assistant Governor Monetary Policy Sub-Sector

Ma. Ramona GDT Santiago

Acting Managing Director Treasury Department

Technical Staff

(Head) Editha S. Alido Director Department of Economic Research

vii

Mtg. No. Advisory Committee 1/ Monetary Board 2/ Publication of Monetary Board

Highlights 3/

1 11 January, Tuesday a/ 13 January, Thursday 24 February, Thursday

2 7 February, Monday 10 February, Thursday 23 March, Wednesday b/

3 7 March, Monday 10 March, Thursday 21 April, Thursday 4 4 April, Monday 7 April, Thursday 19 May, Thursday 5 2 May, Monday 5 May, Thursday 16 June, Thursday 6 30 May, Monday 2 June, Thursday 14 July, Thursday 7 27 June, Monday 30 June, Thursday 11 August, Thursday 8 25 July, Monday 28 July, Thursday 8 September, Thursday 9 22 August, Monday 25 August, Thursday 6 October, Thursday

10 19 September, Monday 22 September, Thursday 3 November, Thursday 11 17 October, Monday 20 October, Thursday 1 December, Thursday 12 14 November, Monday 17 November, Thursday 29 December, Thursday 13 12 December, Monday 15 December, Thursday 27 January 2006, Thursday

1 9 January, Monday 12 January, Thursday 23 February, Thursday 2 6 February, Monday 9 February, Thursday 23 March, Thursday 3 6 March, Monday 9 March, Thursday 20 April, Thursday 4 3 April, Monday 6 April, Thursday 18 May, Thursday 5 TBA c/

4 May, Thursday 15 June, Thursday 6 29 May, Monday 1 June, Thursday 13 July, Thursday 7 26 June, Monday 29 June, Thursday 10 August, Thursday 8 24 July, Monday 27 July, Thursday 7 September, Thursday 9 21 August, Monday 24 August, Thursday 5 October, Thursday

10 18 September, Monday 21 September, Thursday 2 November, Thursday 11 16 October, Monday 19 October, Thursday 29 November, Wednesday d/

12 13 November, Monday 16 November, Thursday 28 December, Thursday 13 11 December, Monday 14 December, Thursday 25 January 2007, Thursday

Notes: 1/ Held every four weeks

b/ The minutes of the meeting will be published a day earlier since 24 March 2005 (the sixth week after the 10 February meeting)

c/ TBA- To be announced since 1 May 2006 (the fourth week after the 3 April AC meeting) is a legal holiday.

is a legal holiday. d/ The minutes of the meeting will be published a day earlier since 24 March 2005 (the sixth week after the 19 October

meeting

3/ Six weeks after the Monetary Board meeting on monetary policy

SCHEDULE OF THE MEETINGS ON MONETARY POLICY AND PUBLICATION OF HIGHLIGHTS FOR 2005-2006

2/ Monetary Board meetings on monetary policy are held on the Thursday after the latest Advisory Committee meeting

2005

2006

a/ The Advisory Committee meeting was moved a day later to give way for the BSP's Planning Conference.

is a legal holiday.

ix

CONTENTS

Overview 1

I. Recent Developments in Inflation and Economic Conditions

3

Price and Cost Developments 3

Box: Trends and Outlook for Oil Prices 9

Aggregate Demand and Supply 15

Employment Conditions and Wages 23

Fiscal Developments 24

Financial Market Conditions 25 II. Recent Monetary Conditions 27

Interest Rates 27

Exchange Rate 30

Monetary Aggregates 32

Box: Expanding the Monetary Survey 33

Banking System 35

III. External Developments 40

IV. Monetary Policy Developments 45

V. Inflation Outlook 48

Inflation Forecasts 48

Risks to the Inflation Outlook 50

Private Sector Economists’ Inflation Forecasts 52

VI. Implications for the Monetary Policy Stance 53

VII. Concluding Remarks 56

First Quarter 2005

1

OVERVIEW

? Inflation continued to rise in the first quarter of 2005. Inflationary pressures in the first quarter continued to be dominated by the impact of supply-side factors, particularly rising global oil prices. Non-food inflation continued to rise, led by utility charges, while food inflation slowed down relative to the fourth quarter but was still higher than the average inflation posted in the same quarter a year ago. Similarly, core inflation remained on an uptrend indicating that price pressures have started to feed into other commodities other than the volatile food and energy components of the CPI.

? Demand continued to expand, but soft spots remain. Christmas holiday

demand and inflows of OFW remittances fueled strong consumer spending in the fourth quarter, accompanied by robust spending on imported goods and inflows from non-factor services. However, growth in fixed capital formation slowed from the previous quarter as public construction spending fell and growth in durable equipment investments tapered off, leaving room only for inventory accumulation. Other available indicators of demand in the first quarter also continued to display mixed trends, suggesting some tentativeness in the overall strength of demand. In addition, employment conditions remained soft, with the jobless rate remaining at double-digit, and capacity utilization remained fairly below its maximum.

? Ample liquidity pulls down market interest rates and boosts financial market

activity. Ample liquidity in the banking system and improved market sentiment pulled down Treasury bill yields (and consequently bank lending rates) as Treasury bill auctions continued to attract excess bids from banks. Liquidity also found its way into local equities trading, which also benefited from upbeat market sentiment. Growth in commercial bank lending continued to improve during the quarter, but overall liquidity growth continued to be driven mainly by banks’ investments in government securities.

? The peso staged a rebound in the first quarter of 2005. The local currency

strengthened from sustained dollar inflows from OFW remittances and portfolio investments owing to a generally positive outlook for the domestic economy, which was tied to sustained economic growth and improved fiscal performance. The peso also benefited from the regional trend towards currency appreciation amid the prevailing weakness of the dollar.

? Global economic expansion remained broadly on track in the fourth quarter of

2004, supported by sustained gains in investment spending and gradual improvements in labor market conditions. Industrial production and export gains, however, appeared to have slowed down in most economies, reflecting both a return to more sustainable pace of expansion and the contractionary impact of higher oil prices. The global economy is expected to demonstrate a moderate, yet continued solid growth performance in the year ahead. However, the presence of global imbalances, such as the large fiscal and current account deficits of the US, alongside continued volatility in world oil prices and weakening of the US dollar present downside risks to the outlook.

First Quarter 2005

2

? Against this backdrop, monetary settings were left unchanged during the

quarter. The Monetary Board kept the BSP’s policy interest rates steady during all of its meetings for the quarter, citing baseline forecasts indicating a deceleration toward the target by 2006 and the continued predominant role of supply-side factors in the inflation outlook. Equally important, assessment of various demand conditions continued to indicate resource slack in the economy, given by the moderate levels of capacity utilization alongside modest employment and lending growth. The observed expansion in aggregate demand has been driven largely by consumption and only partly by net exports and investment spending.

? The path for inflation going forward continues to suggest a deceleration.

Cost-side pressures, the driving factor for the inflation outlook, are expected to moderate over the policy horizon as the impact of supply shocks play themselves out. At the same time, overall output conditions continue to suggest slack in the economy. Recovery in money demand has taken place, but credit activity remains generally subdued.

? The main policy concern for the near term is the impact of continued supply-

side pressures on wage- and price-setting behavior. The prospect of sustained cost-side pressures are likely to fuel the risk of second-order effects in the form of nominal wage increases and other adjustments. This also implies a greater risk that the public will come to expect future inflation to continue to spiral away from the Government’s target.

? The overall stance of monetary policy will be oriented towards responding to

inflationary risks and delivering price stability over the policy horizon. The BSP will focus on assessing the evolving path for future inflation and demand conditions as well as the public’s inflation expectations and whether they continue to be well-anchored in the face of sustained commodity price increases. Policy action will be considered given strong evidence of demand-side effects arising from supply shocks, particularly in terms of adjustments in nominal wage rates in excess of losses in purchasing power. Particular attention will also be paid to shifts in public inflation expectations.

? At the same time, prospective actions toward monetary tightening will be

taken primarily to guide inflation expectations. Significant monetary tightening does not appear justified at present given the prevailing inflation outlook and the continuing presence of slack in the economy. Although these conditions may change, any monetary policy action at this stage should be geared more toward steering inflation expectations in the right direction rather than dampening demand-side impulses.

First Quarter 2005

3

I. RECENT DEVELOPMENTS IN INFLATION AND ECONOMIC CONDITIONS

Price and Cost Developments

Inflation continues to rise; full-year target likely to be exceeded.

Inflation continued to rise in the first quarter of 2005. Inflationary pressures continued to be dominated by supply factors given the specter of rising global oil prices. This was tempered partly by slower inflation for food. Going forward, inflation is expected to exceed the Government target of 5.0-6.0 percent for 2005. Nevertheless, the BSP’s baseline inflation forecasts indicate that inflation could begin to decelerate in the coming months and to average within the target range of 4.0-5.0 percent in 2006, in the absence of further adverse shocks. However, there continue to be potential risks to the outlook for inflation such as the sustained uptrend in world oil prices, consequent adjustments in transport fares and utility charges as well as possible calls for wage increases.

0

2

4

6

8

10

12

14

16

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Headline Inflation Year-on-year change in percent (2000=100)

May

First Quarter 2005

4

Headline and Core Inflation

Headline inflation increases further in the first quarter despite observed moderation in food prices.

Average headline inflation rose to 8.5 percent in the first quarter from 8.1 percent in the previous quarter and 4.1 percent a year ago. Food inflation slowed down relative to the fourth quarter of 2004 but was still higher than the average inflation posted in the same quarter a year ago. By contrast, average non-food inflation during the review quarter was higher by one-percentage point compared to the previous quarter’s average and was more than double the average inflation in the first quarter of 2004. Of the 8.5 percent average inflation for the first quarter of 2005, 3.6 percentage points were attributed to food, 1.3 percentage points to fuel, light and water and 2.2 percentage points to services (of which 1.6 percentage points were accounted for by transportation and communication). This underpinned the BSP’s argument that consumer price pressures are linked primarily to supply-side factors.

-2 0 2 4 6 8

10 12 14 16

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Headline Inflation Food Inflation Non-food Inflation

Headline, Food and Non-food Inflation Year-on-year change in percent (2000=100)

First Quarter 2005

5

Core inflation continues to trend higher in the first quarter.

Trimmed Weighted Net of Mean 1/ Median 2/ Volatile

Items 3/2003 3.2 3.2 2.1

Q1 2.8 3.2 1.8Q2 3.3 3.4 1.9Q3 3.2 3.1 2.2Q4 3.5 3.2 2.2

2004 5.6 4.6 5.2Q1 3.7 3.9 2.7Q2 4.0 3.4 3.5Q3 5.7 4.3 5.4Q4 6.7 5.2 6.5

2005 6.9 5.3 6.6Q1 6.9 5.3 6.6

Notes:

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.

Sources of Basic Data: NSO, BSP-DER

BSP's Alternative Measures ofCore Inflation

Similarly, core inflation continued to rise.1 The National Statistics Office (NSO) reported that the core inflation rate (defined as CPI inflation after excluding selected food- and energy-related components) averaged 8.0 percent in the first quarter, up from 7.4 percent in the previous quarter and 4.2 percent in the same quarter a year ago. Alternative measures of core inflation computed by the BSP also show a continued upward trend in the first quarter. Averages for the trimmed mean, weighted median and “net of volatile items” measures of core inflation for the first quarter were higher compared to the previous quarter and the same quarter a year earlier. The continued increases in core inflation, particularly for the trimmed mean and weighted median, indicate that the majority of the items in the CPI basket—after excluding those showing extreme price changes—are experiencing higher inflation rates. This suggests that price pressures have started to feed into other commodities other than the volatile food and energy components of the CPI.

1 The NSO began releasing official core inflation data in February 2004 alongside headline inflation. A primer on core inflation is available in electronic format on the BSP website at http://www.bsp. gov.ph/downloads

0

2

4

6

8

10

12

14

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Headline Inflation Core Inflation

Headline and Core Inflation Year-on-year change in percent (2000=100)

First Quarter 2005

6

Food inflation eases as holiday demand tapers off and supply levels restored.

2005Q1 Q2 Q3 Q4 Q1

All Food Items 4.3 5.4 7.2 7.9 7.4 Food 4.4 5.6 7.5 8.2 7.6 Cereal & Cereal 2.2 3.3 4.8 5.7 6.3 Rice 1.3 2.0 3.2 3.8 4.7 Corn 5.4 10.1 14 13.1 11.3 Dairy Products 5.2 7.4 9.0 10.4 12.2 Eggs 4.6 3.5 6.2 7.0 4.1 Fish 5.1 7.7 9.4 9.6 9.0 Fruits & Vegetables 4.2 2.5 7.7 9.6 8.8 Meat 9.8 13.7 14.5 14.0 8.9 Misc. Food 2.7 3.0 4.3 5.2 6.1 Beverages 3.1 3.7 4.7 4.9 5.6 Tobacco 1.9 1.7 1.5 1.8 4.2

Average Quarterly Inflation of Selected Food Items2000=100Commodity 2004

Food Prices Food inflation decelerated to 7.6 percent in the first quarter from 8.2 percent in the previous quarter but was still higher relative to a year ago. The slowdown from the previous quarter was due to lower inflation for corn, eggs, fish, fruits and vegetables and meat. Meat inflation, in particular, eased to 8.9 percent from 14.0 percent previously as demand for poultry and livestock eased after the holiday season. Lower meat demand also reduced local feedstuff demand and helped ease prices for corn. Corn inflation declined to 11.3 percent from 13.1 percent in the fourth quarter. Similarly, lower inflation rates were noted for fish, fruits and vegetables as supply recovered from the effects of the previous quarter’s typhoons. This was also aided by the various initiatives undertaken by the government to mitigate the negative impact of the El Niño weather phenomenon on farm output. By contrast, rice inflation rose to 4.7 percent from 3.8 percent a quarter earlier. Local supply was affected by delays in planting and re-planting in typhoon-affected areas due to damaged irrigation systems which needed repair. Higher import prices also partly pushed local rice prices. Inflation rates for canned fish and meat, likewise, increased during the quarter as producers passed on the higher cost of tin packaging to consumers. Beverage and tobacco inflation, meanwhile, rose to 5.6 percent and 4.2 percent, respectively, following the imposition of higher excise taxes on alcoholic beverages and tobacco products in January.

First Quarter 2005

7

Non-food inflation picks up, led mainly by oil and energy-related items.

2005Q1 Q2 Q3 Q4 Q1

Non-Food Items 3.9 4.1 6.7 8.3 9.3 Clothing 3.2 2.3 2.3 3.1 3.6 Housing & Repairs 4.4 3.6 3.3 3.5 4.5 Fuel, Light and Water 3.2 3.6 7.6 15.0 19.0 Fuel 4.5 7.7 17.5 24.4 18.6 Light 3.0 1.8 3.0 12.2 18.7 Water 1.0 1.3 2.3 2.7 21.5 Services 4.7 6.1 12.3 13.7 13.6 Transpo.& Comm. 2.9 6.2 19.2 22.0 21.5 Miscellaneous 2.0 1.8 2.0 2.7 3.1

Average Quarterly Inflation of Selected Non-Food Items2000=100Commodity 2004

Moving forward, the outlook for agricultural production for the rest of the year remains generally favorable as the El Nino phenomenon comes to an end by mid-year and government programs to enhance farm productivity and mitigate the impact of the dry spell buoy up domestic production.2 Non-Food Prices Non-food inflation likewise continued to rise in the first quarter compared to both the preceding quarter and a year ago. Compared to the previous quarter, higher inflation rates were noted for most non-food CPI items except for services. This was driven primarily by the renewed surge in world oil prices and the resulting series of upward adjustments in domestic pump prices in February and March. Fuel, light and water (FLW) registered the highest inflation at 19.0 percent on account of higher inflation for water and electric utilities. By contrast, fuel inflation eased to 18.6 percent from 24.4 percent in the fourth quarter due to falling prices for cooking gas. Services continued to post double-digit inflation at 13.6 percent, albeit slightly lower compared to previous quarter’s 13.7 percent. Except for transportation and communication, medical and other services, all items under services posted higher inflation rates during the period in review. Meanwhile, inflation for the rest of the non-food items such as clothing, housing and repairs, and miscellaneous items likewise edged up during the quarter.

2 Normal conditions are expected by the end of the first semester. The potential for neutral weather conditions through the April-June period carries a probability of 65 percent while the chance for a La Niña condition is virtually nil. Among the major interventions implemented by the government to mitigate the impact of El Niño are cloud seeding, construction of shallow tube wells and pumps for irrigation, intensive information campaign on the impact of the El Niño and the rehabilitation of major sources of water for irrigation.

First Quarter 2005

8

World oil prices track an uptrend in the first quarter.

Energy Prices International oil prices surged anew in the first quarter, with the average price per barrel of Dubai crude oil rising by 16 percent from the previous quarter (to US$41.21) and by 40 percent from a year earlier. The uptrend was traced to a host of factors, including seasonally stronger demand for heating oil, higher fuel consumption due to the robust global economic expansion, and supply concerns due to security threats to major refineries in the Middle East. Market expectations of a post-winter season cut in oil production by the Organization of Petroleum Exporting Countries (OPEC) to prevent prices from falling also put further pressure on prices. Going forward, global oil prices are likely to remain high in the near term for a number of reasons. Firstly, there are doubts over the ability of the world’s oil producers to immediately increase output capacity in order to meet rising energy demand of the growing economies, particularly the US, China and India. Demand is likely to be pushed up in the coming months by continued global economic expansion along with the plans of major oil importers to increase their inventories. This will further trim down the existing margin of spare production capacity among the world’s oil exporters. At the same time, continuing security threats to oil fields and pipelines in the Middle East are likely to fuel anxiety and bid up prices in the international oil market.3 The presence of geopolitical risks such as threats of terrorism also increase the risk of disruptions in global oil supply.

3 International Energy Agency, Oil Market Report, 10 February 2005, http://www.iea.org

0 5

10 15 20 25 30 35 40 45

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Dubai Crude Oil Quarterly average spot price in US dollars per barrel

First Quarter 2005

9

Box 1: Trends and Outlook for Oil Prices Oil prices have been the predominant influence on inflation in the past year, and are more than likely to remain so over the near term. The outlook for inflation over the next year or so thus depends crucially on what will happen to oil prices, particularly in the foreign market. It is therefore, worthwhile to take a look at the prospects for prices in the global oil market. Crude oil prices are expected to be higher in 2005 compared to the previous year (Table 1). For example, the latest forecast of the Energy Information Administration (EIA) of the US Department of Energy indicates that the average oil price for 2005 could be higher by about 40 percent compared to the average price in 2004. In the list of oil price forecasts presented in Table 1, there is a general agreement among analysts that the average price of WTI (light and sweet) crude, the reference price for the US, should remain well above US$40 per barrel for 2005, with the possibility of staying above US$50 per barrel. Meanwhile, the average price of Brent crude, the reference price for Europe, is also predicted to be around US$40 per barrel.i Overall, the IMF sees that the mean price of the WTI, Brent crude and Dubai crude, the reference price for Asia, oil prices could average US$46.50 per barrel. Even the OPEC’s target price band of US$22-28 per barrel was temporarily suspended in January 2005 considering that the actual OPEC reference price have remained outside the target for over a year already, and pending further study on the change in world oil market structures.ii

Table 1 Forecasts of Oil Prices for 2005 Analyst Oil Price Projection Year-on-Year

Change (per barrel)

Level (per barrel)

Type of Crude Oil

Forecast Horizon

Date Released

EIA (US DOE)

+US$14.3 * (40.1%)

US$54.74 US$54.83

WTI

2005- 2006

7 April 2005, Short-Term Energy Outlook

IMF

+US$9.25 * (24.8%)

US$46.50

Average of Brent, Dubai and WTI

2005

April 2005, World Economic Outlook

ADB

+US$2.7 * (7.0%)

US$41.00 US$39.00

Brent

2005 2006

April 2005, Asian Development Outlook

EIU

+US$2.7 (average increase for the next 3 years)

US$38

Brent

2005

January 2005, The World in Figures 2005

Morgan Stanley

+US$ 3.9 (10.3 %) * +US$2.7 (6.5 %) *

US$42.10 US$44.10

Brent WTI

2005

21 February 2005, Oil Price Alert: Marking to Market

OPEC

Target: US$22-US$28 (temporarily suspended)

OPEC basket

30 January 2005, Press Release No. 2/2005

*derived from projected oil price levels Source: various websites, BSP-DER

The same pressures and risks that were generally present in 2004—which saw crude oil prices rise year-on-year by 25.5 percent—have persisted this year.iii On the demand side, increased economic activity in many countries, led by the US and China, continues to fuel the consumption of oil. Although economic growth is likely to moderate in the world’s major economies, global oil consumption is expected to continue to rise—albeit less sharply—from record levels. At the same time, higher demand for oil is being matched by the tightening of excess capacity among oil producing countries. As a result, the crude oil inventory among major oil consumer countries relatively declined over the past year compared to the previous years’ levels.iv

First Quarter 2005

10

Meanwhile, geopolitical factors—such as security risks arising from terrorist attacks on oil fields and pipelines in the Middle East—continue to pose threats of supply disruptions among major oil producers. This leads to speculation among market participants on the stability of world oil supply and thereby raising the risk premium on oil prices. In addition, the build up of stocks by net oil-importers, such as China and India, is likely to induce greater demand for oil in the coming months. On the other hand, the pressures on global oil prices may be partly mitigated by the expansion of production capacities in Saudi Arabia, the second largest producing country in the world. This could continue depending on the swift expansion of production capacities in other oil exporting countries. In addition, the end of the winter season in the second quarter should help reduce demand for heating fuel in the coming months. However, the beginning of the summer driving season (in the US and other parts of the Northern Hemisphere) could put pressures on oil prices during the third quarter. After the third quarter, oil prices could rise again as the regular build-up of crude oil stocks starts in preparation for the next winter season. In addition, there are indications that hedge funds could continue increasing their participation in the oil futures market given the profitability of buying crude oil one month or several months forward and selling them in the spot market. Reports on future trading indicated that the net long positions (in effect, bets on higher prices) held by non-commercial investors have been the increasing over the past several months.v Data from the financial markets also contain useful information on the prospective path of oil prices. Using the futures contract prices, the price of Dubai crude oil is likely to average US$43.98 per barrel.v i

Chart 1

Sources of Basic Data: Department of Energy, BSP-DER, Bloomberg

i Brent crude oil is the reference price in Europe. It is naturally cheaper than the WTI crude because of greater sulfur content,

making it heavier and less sweet. ii OPEC Press Release, 134th Meeting of the OPEC, 30 January 2005, available at www.opec.org iii Dubai crude oil prices averaged $33.63/bbl in 2004 from $26.79/bbl in 2003. iv IEA, 10 February 2005 Oil Market Report, available at www.iea.org v The Economist, “Oil Prices, The Bears Appear,” 16 April 2005; and Commodity and Futures Trading Commission (CFTC),

“Commitment of Traders Reports,” 12 April 2005, available at http://www.cftc.gov. vi The futures prices are estimated Dubai crude prices based on the movements of Brent futures prices. References: Asian Development Bank (ADB), “Asian Development Outlook 2005,” April 2005, http://www.adb.org

Energy Information Administration (EIA), US Department of Energy, “Short-Term Energy Outlook,” 7 April 2005, http://www.eia.doe.gov

EIA, US Department of Energy, “Annual Energy Outlook 2005 (With Projections to 2025), February 2005, http://www.eia.doe.gov

Economist Intelligence Unit (EIU), “The World in Figures –Industries”, (in The World in 2005), http://www.eiu.org

Dubai Crude Oil Price Path, (based on futures prices)

Dec-04 34.20

Mar-05 45.84

25

30

35

40

45

50

Jul 2004

Oct Jan 2005

Apr Jul Oct Jan 2006

Apr Jul Oct Jan 2007

Apr Jul Oct

US$/barrel

13-Apr-05 Contracts

30-Dec-05 Contracts

First Quarter 2005

11

International Energy Agency, “Oil Market Report,” 10 February 2005, http://www.iea.org

International Monetary Fund (IMF), “World Economic Outlook 2005–Globalization and External Imbalances,” April 2005

Berner, R. and Chaney, E. at Morgan Stanley Global Economic Forum: “Oil Price Alert: Marking to Market,” 21 February 2005, http://www.morganstanley.com

Organization of the Petroleum Exporting Countries (OPEC), “Monthly Oil Market Report,” March 2005, http://www.opec.org

OPEC, “Oil Outlook to 2025,” September 2004, http://www.opec.org

OPEC, Press Release No. 2/2005, 30 January 2005, http://www.opec.org

Lev, Benjamin ed., 1983, “Energy Models and Studies”, in Studies in Management and Science and Systems Volume 9, North-Holland Publishing Company, New York

First Quarter 2005

12

Local oil companies raise pump prices to reflect rising world oil prices.

Industry Average: Retail/Pump Price of Petroleum Products

(In peso per liter)Premium Unleaded Regular AVTurbo Kerosene Diesel Oil Fuel Oil LPGGasoline Gasoline Gasoline

Year MonthDay/s2003 Dec 21.63 21.03 20.04 21.45 16.96 16.73 13.39 13.042004 Mar 20, 22-Mar-04 23.63 23.03 22.04 21.94 18.16 17.83 13.69 13.132004 Dec 8 to 10-Dec-04 28.83 28.23 27.24 26.65 24.01 23.41 15.33 17.472004 Dec 21 to 23-Dec-04 28.53 27.93 26.94 26.65 23.91 23.28 15.33 16.912005 Jan 1 to 7-Jan-05 27.53 26.93 25.94 26.65 23.91 23.28 14.83 16.36

Feb 6 to 7-Feb-05 27.93 27.33 26.34 26.95 24.21 23.58 15.13 16.58Feb 26 to 27-Feb-05 28.53 27.93 26.94 27.44 24.69 24.06 15.43 16.58Mar 6 to 7-Mar-05 29.03 28.43 27.44 27.94 25.19 24.56 15.78 16.58Mar 13 to 16-Mar-05 29.53 28.93 27.94 28.43 25.69 25.06 16.28 16.58Mar 18 to 19-Mar-05 30.03 29.43 28.44 28.93 26.19 25.56 16.53 16.58Mar 26 to 27-Mar-05 30.53 29.93 28.94 28.93 26.69 26.06 16.73 16.58

Last Change 26 Mar 05 - 27 Mar 05 0.5 0.5 0.5 0.0 0.5 0.5 0.2 0.0Change from Previous Periods (End-of-Month and End-of-Quarter )End-Mar 05 - End-Dec 04 2.0 2.0 2.0 2.28 2.78 2.78 1.40 -0.33End-Mar 05 - End-Feb 05 2.0 2.0 2.0 1.49 2.00 2.00 1.30 0.00 (in percent) 7.0 7.2 7.4 5.4 8.1 8.3 8.4 0.0Cumulative Change End-Dec 04 - End-Dec 03 6.9 6.9 6.9 5.2 6.95 6.55 1.94 3.87End-Mar 05 - End-Mar 04 6.90 6.90 6.90 6.99 8.53 8.23 3.04 3.45End-Mar 05 - End-Dec 04 2.00 2.00 2.00 2.28 2.78 2.78 1.40 -0.33 (In percent) 7.0 7.2 7.4 8.6 11.6 11.9 9.1 -2.0

Source of Basic Data: Department of Energy

Domestic oil prices typically follow the movements of foreign prices after a lag of about a month or so. Thus, easing international oil prices in the fourth quarter led to price rollbacks in domestic pump prices in the early part of January 2005. However, a subsequent uptrend in the same month led to a new series of domestic increases in February and March. Domestic oil companies have to raised their pump prices in order to recoup their under-recoveries from higher crude prices. Compared to their December levels, the March 27 prices of domestic oil products per liter were higher by the following amounts: P1.40 for fuel oil, P2.00 for gasoline products, and P2.78 for diesel and kerosene and P2.28 aviation turbo. By contrast, the price of liquefied petroleum gas (LPG) per liter fell by 33 centavos over the same period. Relative to their year-ago levels, price increases per liter of the same oil products ranged from P3.04 (for fuel oil) to P8.53 (kerosene). Domestic inventories fell slightly during the first quarter and may have partly cushioned the impact of sharp adjustments in imported crude oil prices. The industry’s oil inventory level declined to an equivalent of 62 days of supply as of 21 March 2005 from 67 days by end-December 2004. This includes an equivalent of 38 days of finished products, which is more than twice the Government’s required minimum inventory level of 7 to 15 days. In addition, the inventory of crude in stock and crude in transit is equivalent to 17 days and 7 days, respectively.

6 6

11 11

16 16

21 21

26 26

31 31

36 36

1998 1998

1999 1999

2000 2000

2001 2001

2002 2002

2003 2003

2004 2004

2005 2005

Premium Gasoline Premium Gasoline

Diesel Oil Diesel Oil

Local Retail Prices of Selected Oil Products Local Retail Prices of Selected Oil Products

Price in Pesos per liter Price in Pesos per liter

First Quarter 2005

13

There are petitions for transport fare hikes.

The minimum public mass transport fares for jeepneys and buses have been unchanged since the last Government-approved increase on 9 June 2004. However, various transport groups have recently filed petitions seeking for transport fare hikes before the Land Transportation Franchising and Regulatory Board (LTRRB), which oversees public land transport fares, in response to the domestic oil price increases in February and March. Petitions for fare hikes amounting to a P2.50 increase for the first 4 kilometers in the minimum jeepney fare of P5.50 and P3.00 increase in the minimum bus fare of P6.00 for the first 5 kilometers are currently being studied by the LTFRB.

End-user power rates are adjusted in the Meralco grid.

Utility Charges The Manila Electric Company (Meralco), the largest power distributor in the Philippines, was allowed to raise its charges to its customers during the first quarter. Beginning 1 February 2005, Meralco rates increased by P0.093 per kwh upon the approval of the Energy Regulatory Commission (ERC). The increase, however, was smaller than the amount originally applied for by Meralco. Revenues from the rate increase will be used to cover expenses incurred for the period June to October 2004 which are recoverable under the Deferred Accounting Adjustment (DAA) scheme of the ERC.4 The additional cost shall be charged to consumers until 31 January 2007.5

4 With the adoption of the automatic adjustment mechanism for generation charges in November 2004, ERC ordered distribution utilities to submit their final GRAM filing to recoup prior under-recoveries under GRAM, which have not yet been recovered. Said recoveries are reflected as deferred accounting adjustment. This also includes carrying cost, which accounts for the delay in the recovery of the shouldered cost. 5 ERC, ERC Case number 2004-466, available online at http://www.erc.gov.ph, 25 January 2005

First Quarter 2005

14

However, Meralco subsequently announced a reduction of its generation rate by P0.375 per kwh in March 2005, citing the improved dispatch of power from independent power producers (IPPs), which translated into lower power costs. It could be noted that under the automatic adjustment mechanism approved by the ERC in October 2004, Meralco is allowed to make generation charge adjustments on a monthly basis, depending on the cost of generation supplied by the National Power Corporation (NPC) and IPPs in the previous month.

Meanwhile, the ERC has yet to issue its final ruling on the provisional authority it issued to the National Power Corporation (NPC) to raise generation charges. The ERC earlier granted the NPC a provisional authority to raise its charges by P0.9798 per kwh effective 26 September 2004 subject to the results of a review and public hearings. The ERC has a year from the date of the issuance of the provisional authority to release its final ruling. The NPC has originally applied for a rate adjustment of around P1.87 per kwh. In the near term, adjustments in electricity rates are likely to depend on movements in international oil prices, with increases in world oil likely to result in higher power rates. In addition, the proposed imposition of the value added tax (VAT) on the power generation activities of IPPs will also likely push up the cost of power.

First Quarter 2005

15

Aggregate Demand and Supply

Philippine economy sustains growth and performs better- than-expected in 2004.

Economic PerformanceGrowth Rate (in percent)Sector

FY Q4 Q3 FY Q4GDP 6.1 5.4 6.3 4.7 5.0NFIA 4.9 7.0 5.8 17.9 2.8GNP 6.1 5.5 6.1 5.6 4.8Source: National Statistical Coordination Board (NSCB)

2004 2003

Economic expansion remained strong based on available data for the fourth quarter. Gross Domestic Product (GDP) expanded by 5.4 percent in real terms, up from 4.0 percent in the same period a year ago. However, this was lower than the 6.3 percent rise in the third quarter. The slowdown was mainly due to the weak performance of agriculture, which was adversely affected by the series of typhoons late last year. Faster growth in net factor income from abroad (NFIA), driven by overseas remittances, was not enough to stem the deceleration in growth of Gross National Product (GNP). Nevertheless, full-year figures show that the GDP grew by 6.1 percent in 2004, marking the strongest performance of the economy since 1996. GNP expanded by a similar 6.1 percent for the year. The economy’s performance thus exceeded the Government’s targets of 4.9-5.8 percent for GDP and 5.2-6.0 percent for GNP.

-4

-2

0

2

4

6

8

10

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 GDP GNP

GDP and GNP Growth Rates Annual Growth in Real

Terms

First Quarter 2005

16

Private consumption remains the main driver of growth.

Economic PerformanceGrowth Rate (in percent)By expenditure item

FY Q4 Q3 FY Q4Personal consumption 5.8 5.8 5.6 5.3 5.5Government consumption -0.8 2.8 -5.9 0.5 2.9Capital formation 12.7 15.9 16.2 0.1 -13.3 Fixed capital formationExports 14.0 14.1 16.5 4.4 9.8Less: Imports 6.3 8.3 6.1 10.2 9.4

2004 2003

2.9 1.2

Source: NSCB

5.1 1.6 4.6

Merchandise Imports

Category Percentage Share Jan-05 Jan-05 Dec-04

Capital Goods 35.8 -7.4 -7.7Raw Materials 41.2 3.4 -8.1Mineral Fuel & Lubricants 13.2 9.0 29.7Consumer Goods 7.5 2.2 34.3Special Transactions 2.4 -45.0 11.2Total 100 -2.1 -0.9

Year-on-year growth rate

Source: NSO

Aggregate Demand Expenditures by major economic sector Seasonally strong Christmas holiday demand and inflows of OFW remittances propelled consumer spending to a higher growth rate of 5.8 percent in the fourth quarter of 2004 compared to the preceding quarter. Robust spending on imported goods and inflows from non-factor services likewise contributed to demand expansion. By contrast, growth in fixed capital formation slowed from the previous quarter as public construction investments declined and growth in durable equipment investments tapered off, leaving room only for inventory accumulation. Meanwhile, government consumption recovered from a decline in the previous two quarters, expanding by 2.8 percent. For the year, the growth in private consumption accelerated to 5.8 percent on the back of election-related spending in the first semester, improved farm income, higher OFW remittances, and sustained increase in the use of mobile phone services. Fixed capital formation grew faster at 5.1 percent due to the recovery in construction investments, helped by stable real interest rates during the year. By contrast, government consumption declined slightly, reflecting efforts of the National Government to rein in the budget deficit. Limited recent trade data suggest a slowdown in import demand. Merchandise imports recorded by the NSO fell at a faster rate of 2.7 percent in seasonally-adjusted terms in January compared to 0.4 percent in December last year. Imports were also lower on a year-on-year basis during the month.

-25 -20 -15 -10

-5 0 5

10

15 20 25 30

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Govt. Spending Private Consumption Fixed Investment

Domestic Demand Annual Growth in Real

Terms

First Quarter 2005

17

Other demand indicators show mixed trends, indicating some tentativeness in the strength of domestic demand.

Other Demand Indicators Selected indicators of demand exhibited positive trends such as solid revenue growth of the country’s major corporations, recovery in export growth, and improving business optimism. There was also a slight improvement in consumer expectations. However, the sizeable unemployment rate and spare capacity in manufacturing indicate some slack in resource use. Moreover, car and energy sales declined. ? Average capacity utilization in

manufacturing declined slightly to 79.8 percent in January 2005. This, however, was higher than the utilization rate a year ago. More than half of the manufacturing firms in the sample (54.6 percent) were operating at 70-89 percent capacity in January, while 14.2 percent reported full or near-full capacity operation (90-100 percent), and the remaining third (31.2 percent) reported capacity utilization of below 70 percent.

? The year-on-year growth in the value of production index (VAPI) for manufacturing dipped slightly to 15.7 percent in January 2005. On a month-on-month basis, VAPI declined for the third straight month (2.9 percent in January). Meanwhile, the year-on-year growth in volume of production index (VOPI) for manufacturing slowed to 5.5 percent in January, while its month-on-month decline inched up to 3.1 percent from 0.9 percent in December last year.

50 55 60 65 70 75 80 85 90 95

100

2000 2001 2002 2003 2004 2005

Average Capacity Utilization for Manufacturing In percent

-20

-10

0

10

20

30

1999 2000 2001 2002 2003 2004

Volume of Production Value of Production

Growth in Volume and Value Indices of Manufacturing Production In percent

First Quarter 2005

18

Company 2004* 2003Ayala Corp. Revenues 43.7 37.3 17.1 Net Income 7.1 3.1 130.4Globe Telecom Revenues 55.6 49.5 12.4 Net Income 11.3 10.3 8.8Jollibee Foods Revenues 26.3 21.6 21.3 Net Income 1.6 1.3 25PLDT Revenues 126.2 112.0 12.7 Net Income 28 2.1 1233.3San Miguel Revenues 174.7 148.6 17.6 Net Income 8.1 7.4 9.6SM Prime Revenues 10.2 8.8 16.0 Net Income 4.6 4.2 10.5

Sources: Company websites, Securities and Exchange Commission, Bloomberg

Financial Performance of Selected CompaniesIn billion pesos

*Unaudited

Growth Rate (%)

? The country’s major corporations posted financial performances in 2004. Robust domestic and international sales volume of beer boosted San Miguel Corporation’s revenues, while heightened expansion drove sales of fastfood leader Jollibee Foods Corporation. Ayala Corporation also reported strong revenue growth, owing to the solid performance of its key operating subsidiaries and affiliates including Globe Telecom. Globe and its competitor Philippine Long Distance Telephone (PLDT) posted revenue growth of over 10 percent as the subscriber base for their wireless business continued to expand.

? The Chamber of Automotive Manufacturers of the Philippines, Inc. (CAMPI) reported a larger annual decline in passenger car sales of 7.1 percent in February 2005. This also marked a downturn from the previous year’s 64.4 percent expansion. Month-on-month, car sales declined at a slower pace of 0.1 percent in February compared to 13.2 percent in January. Seasonally-adjusted car sales data showed a marginal increase of 0.6 percent in February from a drop of 12.0 percent in the previous month. Meanwhile, sales of trucks and buses in February were 42.4 percent lower than a year ago and were unchanged from January.

Meralco's Energy Sales

Feb-05 Jan-05Residential 31.5 -8.8 2.3 -3.0Commercial 36.7 0.1 9.5 0.0Industrial 31.2 1.5 11.4 0.5Others 0.6 0.0 3.5 0.0Total 100.0 -2.5 7.2 -2.5

Sector

Year-on-Year Growth (%)

Percentage Share to Total

Sales

Percent Contribution to Growth

? Energy sales by Meralco declined by 2.5 percent year-on-year in February 2005, a reversal from month-ago and year-ago levels. Month-on-month, energy sales recovered from January’s 11.5 percent decline to grow by 7.0 percent in February. Seasonally-adjusted energy sales increased marginally by 0.8 percent in February from a 1.3 percent decline in the previous month.

First Quarter 2005

19

? The first quarter 2005 Business Expectations Survey (BES) showed business optimism maintaining a relatively steady and positive outlook in the current quarter and improving significantly in the second quarter of the year. Respondents attributed the improving optimism to higher market demand both here and abroad, stronger peso, political and fiscal reforms, higher tourist arrivals, and improvement or expansion in their business operations.

? Results of the Consumer Expectations Survey (CES) conducted by the BSP on 27 January to 2 February 2005 suggested some improvements in consumer outlook in the first two quarters of 2005. The overall CE diffusion index, however, remained negative although it improved to -44.2 percent in the first quarter of 2005 from -49.1 percent in the fourth quarter of 2004. All components of the consumer expectations index such as family financial situation, level of family income, and economic condition of the country reflected improved prospects. The second quarter 2005 DI also improved to -16.8 percent from -20.5 percent in the previous survey, as more households see better economic conditions for the country. Respondents expect an improvement in employment conditions and a slowdown in interest rate increases and peso depreciation in the next 12 months. Their expected inflation rate for the next 12 months is higher in the latest survey than in the previous one.

4Q '04 1Q '05(Previous) (Current)

Current Quarter 18.6 17.6Next Quarter 21.3 34.2

Business Expectations Survey

Business Outlook Index

First Quarter 2005

20

Strong foreign demand for local products boosts growth of the economy.

External Demand Strong export performance was also a major source of the robust growth in GDP last year. The solid expansion of the global economy in 2004, driven by business spending in the US, recovery in Japan, and rapid growth of fixed investments in China provided a welcome atmosphere for export activity to flourish. As a result, total exports grew by 14.0 percent, more than three times the growth rate in 2003, with both merchandise and non-factor services exports posting double-digit growth. During the fourth quarter alone, total exports grew by 14.1 percent from 9.8 percent in the same period a year ago. Meanwhile, based on the latest trade data from the NSO, merchandise exports fell slightly by 0.6 percent year-on-year in February 2005. This was attributed to the 0.9 percent decline in exports of electronic products, which accounted for two-thirds of total export sales. On a month-on-month basis, merchandise exports fell by 9.1 percent in February. Similarly, seasonally-adjusted exports contracted by 8.3 percent.

Aggregate Supply

Major production sectors post higher full year growth in 2004.

On the production side, economic growth in the fourth quarter of 2004 was buoyed by the performance of the industry and services sectors, which together accounted for 5.1 percentage points of the 5.4 percent growth in GDP. Meanwhile, the agriculture, fishery and forestry sector grew at a slower pace of 1.2 percent during the fourth quarter due mainly to the series of typhoons which hit the country late last year.

-30

-20

-10

0

10

20

30

2000 2001 2002 2003 2004 2005 Export Growth Rate 3-Month Moving Ave.

Growth in Merchandise Exports Year-on- year change in percent

First Quarter 2005

21

Economic PerformanceGrowth Rate (in percent)By industrial origin

FY Q4 Q3 FY Q4Agriculture, Fishery & Forestry 4.9 1.2 7.9 3.8 5.3Industry 5.3 6.3 4.5 3.8 3.2Services 7.3 6.7 7.1 5.8 6.1Source: NSCB

2004 2003

The combined agriculture, fishery and forestry output increased at a faster pace of 4.9 percent in 2004. Major drivers of growth in agricultural production were palay and corn, which expanded by 7.4 percent and 17.3 percent, respectively. This strong performance was attributed to early planting, use of high-yielding varieties, sufficient water supply, use of improved seeds, controlled pests and diseases, and generally favorable weather conditions during the year. Poultry output increased by 4.2 percent in 2004 with the robust outturn in chicken production. On the other hand, livestock production declined slightly due to the high cost of feedstuffs such as corn. For the full year 2004, the services sector recorded the largest contribution to the 6.1 growth of the economy, followed by industry and agriculture. Foremost was transportation, communication and storage which was driven by aggressive expansion of telecommunication companies and influx of business process outsourcing investments. All the other subsectors except government services posted higher growth rates in 2004. In particular, trade services benefited from the opening of new malls and the proliferation of wholesale clubs and convenience stores, while ownership of dwellings and real estate gained from higher residential property sales and lease income from call centers. Industry growth likewise accelerated in 2004, buoyed by the strong performance of manufacturing and construction. Manufacturing output was boosted by production in food, electrical machinery (which includes semiconductors and electronics), chemicals, and beverage. Meanwhile, construction recovered from the previous year’s decline with the upturn in sales of residential, commercial and office spaces, and the completion of several public infrastructure projects.

-15.0

-10.0

-5.0

0.0

5.0

10.0

15.0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 Agriculture Industry Service

Agriculture, Industry and Service Sectors Annual Growth Rates in percent

First Quarter 2005

22

The Philippines is expected to post sustained growth.

The Philippine economy is expected to post sustained growth. It is expected to grow by 5.3-6.3 percent in 2005, slightly tapering off relative to the 2004 performance. Growth in agriculture may settle within the 4.2-5.2 percent government forecast, with an anticipated decline in palay and corn production in the first quarter as harvest area for these crops may fall in anticipation of the El Niño. Mitigating these adverse effects requires continued government support for intervention measures against El Niño, and generally, for programs aimed at improving the availability of, access to agricultural inputs, and increasing productivity. The services sector is expected to grow by 5.7-6.6 percent in 2005, led by transportation, communication and storage. The expansion of the call center industry will help boost services output. Meanwhile, growth in the industry sector could range from 5.0-6.0 percent. The expected slowdown in the global economy this year may put downward pressure on growth in manufacturing. This, however, may be tempered by the expansion in the mining and quarrying sector, which will benefit from the Supreme Court’s decision to uphold the constitutionality of the 1995 Mining Act. Industry, as well as agriculture and services, should also gain from major infrastructure projects slated this year, including the Northrail Phase I, Section I project, Subic-Clark-Tarlac Expressway Project, Subic Bay International Port, and SLEX-STAR.

First Quarter 2005

23

On the demand side, consumption growth may ease in 2005 due to higher consumer prices arising from the uptick in oil prices. Nonetheless, consumption will be buoyed by OFW remittances and new jobs in IT-enabled industries. Capital formation will be supported by public investments and private sector participation in the aforesaid infrastructure projects. Stronger investor confidence, which is contingent on the credible and effective implementation of the fiscal consolidation program, can further boost investments.

Employment Conditions and Wages

Labor market conditions continue to be soft in the first quarter. No formal petitions for adjustments in minimum wages have been filed yet.

Employment conditions in the first quarter of 2005 remained soft, marked by double-digit unemployment and the absence of calls for wage increase. The January 2005 Labor Force Survey (LFS) published by the NSO indicated that the unemployment rate increased to 11.3 percent in January 2005 compared to 11.0 percent for the same period last year, and 10.9 percent in October 2004. This came as the 0.6 percent increase in the labor force population to 35.7 million from 35.4 million in January 2004 was accompanied by a decrease in the labor force participation rate by 1.2 percentage points, from 67.3 percent to 66.1 percent. Nevertheless, the total number of employed persons managed to grow by 0.28 percent. Employment in the agriculture sector comprising 35.9 percent of total employment, grew by 1.7 percent due largely to the increase in the jobs in the agriculture, hunting and forestry subsector.

4

6

8

10

12

14

16

1997 1998 1999 2000 2001 2002 2003 2004 2005

Unemployment Rate Annual Change in percent

First Quarter 2005

24

Selected Labor Market StatisticsLevels, in millions

% %Jan-05 Jan-04 Change Oct '04 Change

Labor force 35.7 35.4 0.6 35.6 0.1 participation rate (%) 66.1 67.3 66.5Employment 31.6 31.5 0.3 31.7 -0.3 Rate (%) 88.7 89.0 89.1Unemployment 4.0 3.9 3.3 3.9 3.7 Rate (%) 11.3 11.0 10.9Underemployment 5.1 5.5 -7.7 5.4 -4.8 Rate (%) 16.1 17.5 16.9

Total Employment 31.6 31.5 0.3 31.7 -0.3 Agriculture 11.4 11.2 1.7 11.8 -3.6 of w/c Agri, Hunting, Forestry 9.9 9.8 1.8 Industry 5.0 5.1 -1.4 4.9 2.0 of w/c Manufacturing 3.0 3.1 -3.5 Services 15.3 15.3 -0.2 15.1 1.5 of w/c Other community, 0.8 0.9 -13.2

social, etc.

The services sector, which comprised the biggest share to total employment of 48.4 percent shed 24, 000 jobs (or 0.2 percent) in January 2005, mainly form other community, social and personal service activities. Similarly, jobs in industry, which represents 15.7 percent of total employment declined by 1.4 percent due mainly to the 109,000 jobs lost in manufacturing. Wage adjustments were called for and settled completely in 2004. In 8 of the 13 regions, including the NCR, these included an increase in the emergency cost of living allowance (ECOLA). While there are no pending petitions for wage adjustments filed before the Regional Tripartite Wage and Productivity Boards (RTWPBs) during the first quarter, the impact of rising oil prices and possible increases in transport fares could fuel demand for wage adjustments. Moreover, the regional wage boards can also issue wage orders (WOs) without formal petitions. Of the 133 WOs issued since 1990, only 50 or 38 percent were preceded by formal petitions for wage adjustments.

Fiscal Developments

First Quarter NG deficit is lower-than-target.

National Government Fiscal PerformanceFirst Quarter 2005(In billion pesos)

Growth 1st Qtr. % of 1st 2005 2004 (%) Program Qtr. Prog.

Surplus/(Deficit) -63.5 -56.8 11.6 -77.8 81.6Revenues 172.6 152.6 13.1 163.3 105.7Expenditures 236.1 209.5 12.7 241.1 97.9Source : BTr/Bloomberg News

January-March

The National Government’s (NG) budget deficit in March 2005 reached P23.4 billion bringing the actual deficit for the first quarter to P40.1 billion, about 81.6 percent of the P77.8 billion first quarter fiscal program. The over performance in the first quarter and the administrative measures against tax evasion and higher taxes on sin products are expected to contain the full-year deficit within the target.

First Quarter 2005

25

The NG’s deficit in March was around 5.1 percent higher than P22.3 billion deficit in the same month last year. Spending in March 2005 grew by 7.5 percent to P82.9 billion while revenues rose by 8.4 percent to P59.4 billion. The increase in expenditures was attributed mainly to higher interest expenses. The cumulative deficit for the first quarter of the year reached P63.5 billion, 11.6 percent higher than the budget gap registered during the comparable period last year but equivalent to only 81.6 percent of the first quarter deficit target. The rise in the deficit could be attributed to the moderate increase in NG’s spending as a result of the additional expenses incurred resulting from the assumption by the NG of around P200 billion WPC debt.

Financial Market Conditions

Ample liquidity fuels demand for both local stocks and government securities.

Financial market conditions improved further in the first quarter of the year, fueled by the presence of ample liquidity in the market. The upbeat market sentiment provided a boost to local equities trading. Meanwhile, T-bill auctions also continued to attract high bids over the offered amount, as banks prefer to invest their funds into risk-free government securities.

First Quarter 2005

26

Upbeat market sentiment buoys stock trading.

Stock Market Share prices advanced during the quarter with the Philippine composite index (PHISIX) breaching the 2,000–level during the period. The PHISIX averaged 1,917.3 index points by end-January, inching higher to 2,042.7 index points for February, and 2,078.8 index points in March. Despite a credit rating downgrade early in the year, investors appeared enthusiastic with the prospects of the local stocks, prompted by foreign investments as the Supreme Court repealed the Philippine Mining Act. Favorable economic data on output and the fiscal deficit also encouraged participation in local equities during the first three months of the year. The Initial Public Offerings (IPOs) of SM Investments and Manila Water Company in March further enhanced the gains in the equities market during the reference quarter as the new offerings attracted foreign investors.

The market is expected to remain resilient in the coming months, with fresh confidence boosted by the progress made in the passing of amendments to the VAT, a major step towards fiscal reform. However, gains in the PHISIX could be limited by rising world oil prices, possible delays in the passage of key legislative measures as well as expectations of rising foreign interest rates.

500

1,000

1,500

2,000

2,500

2000 2001 2002 2003 2004 2005

PSE Composite Index (Phisix)

First Quarter 2005

27

BTr auctions for GS continue to be oversubscribed.

Government Securities Demand for T-bills remained healthy as auctions by the Bureau of the Treasury continued to attract large volume of bids in the first quarter of 2005. Total oversubscriptions for the quarter amounted to around P81.5 billion, significantly higher than the P27.4 billion in the previous quarter. This resulted as the seven regular T-bill auctions in the first quarter drew a total of P171.5 billion tenders as against the P90 billion total offering. Total rejections for the period reached close to P97 billion. This was around P63.5 billion more than the P33.5 billion rejection in the fourth quarter of 2004.

II. RECENT MONETARY CONDITIONS

Interest Rates

Market interest rates ease in the first quarter.

Domestic interest rates were generally lower during the first quarter. The weighted average benchmark 91-day T-bill rate eased to 7.0 percent in the first quarter of 2005 from 7.8 percent in the previous quarter. The decline in T-bill yields could be traced to the presence of ample liquidity in the system on the back of a strong peso as foreign money poured into the local equities and debt markets. Market sentiment also improved following the Financial Action Task Force’s (FATF) decision to remove the Philippines from its list of non-cooperative countries and territories (NCCTs) in the global fight against money laundering. Interest rates charged on bank loans followed the same downward trend during the quarter. From a range of 10.5-12.6 percent in December 2004, average bank lending rates declined to 9.4-11.5 percent in March 2005.

2 4 6 8

10 12 14 16 18 20

2000 2001 2002 2003 2004 2005

91-day T-bill rate Overnight RRP Rate Bank Lending Rate

91-day T-bill, BSP RRP rate and KBs Lending Rate In percent

0

50

100

150

200

250

1997 1998 1999 2000 2001 2002 2003 2004 2005

Oversubscription of Primary T-bill Auction in billion pesos

First Quarter 2005

28

Yield curve for government securities in secondary market shifts downward.

2

4

6

8

10

12

14

16

3Mo 6Mo 1Yr 2Yr 3 Yr 4Yr 5Yr 7Yr 10Yr 20Yr 25Yr

Maturity

Yie

ld in

per

cen

t

30 Sep 2004 29 Dec 200431 Mar 2005

Yield of Government Securities in Secondary Market in percent

Yield Curve Reflecting the downtrend in market rates in the primary market, the yield curve for government securities in the secondary market as of 31 March 2005 shows a downward shift relative to those for end of the preceding two quarters. This primarily suggests the presence of ample liquidity in the banking system, which accounts for the bulk of the private sector’s holdings of government securities.

RP-US spreads narrow but remain sizeable.

Interest Rate Differentials Domestic interest rate differentials with those of the US were generally narrower compared to the previous quarter. Differentials between the RP 91-day T-bill rate (net of RP withholding tax) and the 90-day LIBOR and 90-day US T-bill declined from 373.2 basis points and 378.2 basis points, in December 2004 respectively, to 227.2 basis points and 245.2 basis points in March 2005. Interest rate differentials declined as a result of the uptrend in foreign interest rates —following the upward adjustment in the US federal funds target rate in the first quarter—but remained sizeable. The differential between the BSP’s policy interest rate (overnight borrowing or RRP rate) and the US federal funds target rate settled at 400 basis points as the US Federal Open Market Committee (FOMC) decided to raise the federal funds target rate by 25 basis points each on 2 February and 22 March 2005 to reach 2.75 percent. Meanwhile, the Monetary Board of the BSP opted to keep policy rates unchanged during the review quarter. 0

2 4 6 8

10 12 14 16

BSP RRP rate US Fed funds rate

BSP RRP Rate and US Fed Funds Rate In percent

2001 2002 2003 2004 2005

First Quarter 2005

29

Adjusted for the risk premium—as measured by the differential between the 10-year ROP note and the 10-year US Treasury note—the differential between the BSP’s policy rate and the US federal funds target rate widened in the fourth quarter. The risk-adjusted differential widened to 89 basis points as of 31 March 2005 from 56 basis points registered on 28 December 2004, a result mainly of the upward adjustment in the US federal funds target rate in March 2005, which in turn influenced an increase in the 10-year US Treasury Note.

RP’s real lending rate is now lowest in a sample of Asian economies.

Real Lending Rate The real lending rate—measured as the difference between the low-end of the range of banks’ lending rate and inflation—in the Philippines edged lower, declining from 2.4 percent in January to 1.1 percent in February and further to 0.9 percent in March to average 1.3 percent for the first quarter. This was due mainly to the lower banks’ lending rates during the quarter. The average level was 1.04 basis points lower than the previous quarter’s average of 2.4 percent. The Philippines’ average real lending rate in March at 0.9 percent ranked the lowest in a sample of 10 Asian countries with real lending rates ranging from 0.9-6.9 percent during the same period.

Meanwhile, the spread between the Philippine lending rate and the benchmark 91-day T-bill rate widened to 282 basis points in March 2005, compared to 273 basis points in December 2004, due mainly to the larger decline in the 91-day T-bill rate. Among the 10 Asian countries surveyed, the Philippines ranked the third lowest in terms of the spread between lending rates and benchmark interest rates.

0.93 1.85

2.31 3.00

3.60 4.20

6.23 6.90

5.29 5.30

0 2 4 6 8 10 Philippines

Japan South Korea

Thailand Malaysia

Hong Kong Taiwan

Singapore India

Indonesia

Average Real Lending Rates: Selected Asian Countries in percent

1.55 2.19

2.82 3.19

3.52 3.59

4.50 4.89

5.36 6.78

0 1 2 3 4 5 6 7 8 Japan

South Korea Philippines

Malaysia Singapore

Hong Kong Thailand

Taiwan India

Indonesia

Spread of Lending Rates over Benchmark Rates in percent

First Quarter 2005

30

Exchange Rate

The peso gains momentum against the US dollar.

The peso staged a rebound in the first quarter of 2005, appreciating by 2.91 percent at end-March 2005 to average P54.75/US$1 over the end-December 2004 level.6 The peso drew its strength from the sustained dollar inflows from OFW remittances and portfolio investments. The generally positive outlook on the domestic economy, which was attributed to sustained economic growth momentum as well as the lower-than-programmed fiscal deficit, also influenced the peso’s recovery. Boosting the positive market sentiment is the decision by Paris-based Financial Action Task Force (FATF) to remove the Philippines from its list of non-cooperative countries in the fight against money laundering. Moreover, the peso also benefited from the regional trend towards currency appreciation amid the prevailing weakness of the dollar. During the period, the local currency proved to be resilient despite uncertainties brought about by the bombing incidents in February as well as the sovereign credit rating downgrades by Standard and Poor’s Ratings Services7 and Moody’s Investors Service.8

Currencies Appr/Depr(-) from 31 December 2004

Philippine peso 2.44South Korean won 1.95New Taiwan dollar 0.88Thailand baht -0.54Singaporean dollar -1.07Indonesian rupiah -1.98Japanese yen -3.96

CHANGES IN SELECTED DOLLAR RATES

Relative to end-December 2004, the peso appreciated by 2.4 percent. This was the largest gain for the said period in a sample of Asian currencies.

6 Dollar rates or reciprocal of the peso-dollar rates were used to compute for the monthly percent changes. 7 On 17 January 2005, Standard and Poor’s Ratings Services lowered the country’s long-term foreign and local currency credit ratings to BB- from BB and to BB+ from BBB-, respectively. Similarly, the Philippines’ short-term local currency rating was also downgraded to B from A-3, while the country’s short-term foreign currency sovereign credit rating of B was affirmed. 8 On 16 February 2005, Moody’s Investors Service downgraded the country’s foreign and local currency credit ratings by two notches to B1 from Ba2.

30

35

40

45

50

55

60

2000 2001 2002 2003 2004 2005

P /US$

Daily Peso-US Dollar Rate

First Quarter 2005

31

However, the movement of the peso was more volatile during the period relative to the previous quarter with its continued appreciation. The standard deviation of the daily exchange rates rose to P0.33/US$1 at end-March 2005 from P0.10 at end-December 2004.

Competitiveness weakens on a real, trade weighted basis following the nominal appreciation of the peso.

The nominal appreciation of the peso translated to a real appreciation, indicating some decline in the peso’s external price competitiveness. In particular, the peso’s REER index relative to the currencies of its major trading partners (MTPs) increased by 5.15 percent in March 2005 from the December 2004 level. The same period also saw the rise in the peso’s REER index by 2.78 percent and 3.15 percent against its competitor countries in the broad and narrow series, respectively. This development was due to the combined effects of the nominal appreciation of the peso and the widening of the price differentials of the peso against the three baskets of currencies.

The peso is likely to sustain its strength on account of sustained dollar inflows.

Over the near term, the peso is likely to remain relatively strong, mainly on account of sustained remittances by OFWs as well as the recent surge in foreign investments. Positive market sentiment, boosted by the continued strength in the country’s economic fundamentals will also provide further support to the peso.

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

2.0

2000 2001 2002 2003 2004 2005

Volatility of the PesoMonthly Standard Deviation

First Quarter 2005

32

Monetary Aggregates

Demand for money strengthens. The strength of the demand for money observed in the last quarter of the previous year continued in the first two months of 2005. The growth in domestic liquidity or M3 accelerated to 12.2 percent in February from 11.5 percent in January 2005.9 The increase in depository corporations’ (DC) investments in government security was the main contributing factor to the overall increase in net domestic credits and in domestic liquidity as a whole. Meanwhile, improvement in net foreign assets was traced largely to the marked decrease in the BSP foreign exchange liabilities and some gains in the DC’s foreign assets associated with continued foreign exchange inflows. On a month-on-month basis, M3 using the DCS concept increased only slightly by 0.1 percent. Meanwhile, the year-on-year growth in other monetary aggregates such as the reserve money decelerated from an average of 8.3 percent for the first quarter of 2005 from 10.7 percent in the fourth quarter of 2004.10

9 M3 refers to the stock of broad money based on data on the Depository Corporations Survey (DCS). The DCS, which replaces the Monetary Survey (MS) as the basis for measuring domestic liquidity, features an expanded list of surveyed institutions that includes the BSP, commercial banks, thrift banks, rural banks, non-stock savings and loan associations and non-banks with quasi-banking functions. 10 Reserve money (RM) is a narrower definition of money supply defined as the sum of currency issue net of cash in vaults of the BTr and banks’ reserve balances with the BSP.

First Quarter 2005

33

Box 2: Expanding the Monetary Survey

As an important tool in the conduct of monetary policy, the BSP compiles data on monetary aggregates as well as loans and discounts using data obtained from individual financial institutions. Prior to March 2004, such data was aggregated into a consolidated balance sheet or statement of account known as the Monetary Survey (MS). The Monetary Survey (MS) consists of data from the BSP and commercial banks on the following: (1) monetary aggregates or broad money liabilities, which include currency, demand deposits and other money liabilities; (2) net claims on the public sector, which includes loans to or bonds purchased from the government; (3) net domestic credits (or lending) to the private sector, and (4) net foreign assets, which are essentially claims on foreign residents. In March 2004, as part of the BSP’s continuing efforts to improve its statistical database, the Monetary Board approved the expansion of the institutional coverage of the MS to include not only commercial banks and rural banks authorized to accept demand deposits, but also thrift banks, rural banks not authorized to accept demand deposits, and non-banks with quasi-banking functions (NBQBs). The expanded MS is referred officially as the Depository Corporations Survey (DCS), in accordance with the new terminology of the 2000 Monetary and Financial Statistics Manual. The expansion of the MS coverage marks the initial phase in the BSP’s program to further align its monetary and financial statistics with international standards. The Bangko Sentral ng Pilipinas ran a parallel series of both the DCS and MS in 2004. This was aimed at facilitating the transition from the MS to DCS in 2005. The expanded DCS series includes almost thrice the number of institutions surveyed in the MS and provides a more comprehensive view of movement of M3. In January 2005, the BSP began its transition to the DCS as its measure of M3 or domestic liquidity.

No. of Institutions CoveredMS DCS

Commercial Banks 42 42Rural Banks 221 755Thrift Banks 89Non-stock Savings and Loans Associations 10Non-banks w/ Quasi Banking functions 10

Total 263 906

Chart 1 shows that the level of M3 based on the DCS and MS tracked a similar trend in 2004. This indicates that the DCS mirrors the movements of MS and the switch to the DCS is more than warranted.

Chart 1

1 5 0 0

1 6 0 0

1 7 0 0

1 8 0 0

1 9 0 0

2 0 0 0

2 1 0 0

2 2 0 0

2 3 0 0

January March May July September November J a n u a r y

D C S M S

2004 2005

Domestic Liquidity (M3)Levels, in billion pesos

First Quarter 2005

34

The difference between the DCS and MS measures of M3 shows a steady increase over the course of 2004. However, the overall trend suggests that the addition of the rural and thrift banks, along with the non-stock savings and loan associations and non-banks with quasi-banking functions did not significantly alter the overall trend of M3. Chart 2 shows a gradual increase in the difference between M3 under the DCS and the MS for 2004, which may indicate the increased significance of the institutions previously not covered by the MS.

Chart 2

190

195

200

205

210

215

220

January February March April May June July August September October November December

Difference between DCS and MS for 2004Levels, in billion pesos

The BSP is currently undertaking the construction of the DCS data for years prior to 2004. The BSP no longer publishes the MS and has shifted completely to using and recording the DCS in its stead.

First Quarter 2005

35

Banking System

The banking system is generally stable.

The Philippine banking system remained stable and resilient during the period buoyed by positive macroeconomic and corporate developments. Key banking indicators for the period under review showed general improvements. The banking system’s total resources stood at P4,253.4 billion as of January 2005, slightly higher by 2.1 percent than the P4,165.9 billion posted in December 2004 and a much higher increase of 12.6 percent compared to the year-ago level of P3,777.6 billion. The modest growth in the system’s resources may be traced to the rise in the due from central bank’s account and the continued expansion in investments and loans and discounts.

Deposit liabilities continue to increase.

Savings Mobilization The deposit liabilities of the banking system continued to advance, registering a 5.3 percent increase as of end-December 2004 from the previous quarter. Commercial banks, which account for almost 90 percent of total deposits, led the expansion in deposit base registering an increase of 6.0 percent. Total deposit liabilities was dominated by savings deposits with a 55.7 percent share, slightly lower than the 55.2 percent registered during the previous quarter.

First Quarter 2005

36

Growth in bank lending improves.

Lending Operations KBs loans outstanding grew by 5.8 percent year-on-year to P1.525 trillion as of end-February 2005, an increase from the 2.6 percent year-on-year and 1.9 percent quarter-on-quarter growth posted in December 2004. Compared to the previous month, however, total KB loans continued the decline observed in the previous month, posting a minimal 0.1 percent drop in February. Compared to end-December 2004 level, growth in KBs lending was driven mainly by loans to the construction sector, which recorded a 15.4 percent increase, followed by the 9.0 percent growth to financial institutions, real estate and business services sector. In contrast, loans to other sectors recorded sharp declines particularly in electricity, gas and water (9.9 percent), agriculture, fishery and forestry (8.4 percent), and wholesale and retail trade (7.8 percent) sectors.

Banks’ resources continue to grow.

Institutional Developments The banking system’s total resources stood at P4,253.4 billion as of January 2005, slightly higher by 2.1 percent than the P4,165.9 billion posted in December 2004 and a much higher increase of 12.6 percent compared to the year-ago level of P3,777.6 billion. The modest growth in the system’s resources may be traced to the rise in the due from central bank’s account and the continued expansion in investments and loans and discounts.

-10 -8 -6 -4 -2 0 2 4 6 8

10

1999 2000 2001 2002 2003 2004 2005

Total Loans Outstanding of Commercial Banks Annual Growth in Percent

First Quarter 2005

37

Number of bank branches increases. Reflecting the BSP’s continued efforts to further strengthen the banking system by encouraging consolidation and by closing weak banks, the number of banking institutions declined from 896 to 893 as of end-December 2004. The total number of banking institutions comprised of 42 commercial banks, 87 thrift banks and 764 rural banks. However, the operating network of the banking system increased to 7,612 as of end-December 2004 from 7,593 at end-September 2004 reflecting the increase in commercial and thrift banks’ branches.

Asset quality shows improvement as NPL ratio declines.

Banks’ asset quality improved steadily as the non-performing loans (NPL) ratio declined to 12.9 percent as of end-December 2004 compared to the end-September 2004 level of 14.0 percent. The decrease in the ratio during the period was mainly due to the decrease in both total loan portfolio and NPLs by 0.2 percent and 7.7 percent, respectively. Compared to those of other countries in the region, the Philippines’ NPL ratio was close to Thailand’s 10.9 percent but higher than Malaysia’s 7.6 percent, Korea’s 2.1 percent and Indonesia’s 5.8 percent.11 The lower NPL ratio in other Asian countries may be traced to the publicly-owned asset management companies’ (AMC) purchases of the bulk of their NPLs. Despite the improvements, the country’s NPL ratio remains relatively high even as authorities continue to encourage banks to clean their balance sheets of non-performing assets through private special purpose vehicles (SPVs).

11 Source: ARIC Financial Indicators, ADB website. Financial system’s NPL, Thailand (January 2005), Malaysia (January 2005); Korea (September 2004); and Indonesia (December 2004).

10 11 12 13 14 15 16 17 18 19 20

2000 2001 2002 2003 2004

Non-Performing Loans of Commercial Banks Percentage of Total Commercial Bank Loans

First Quarter 2005

38

As of 31 March 2005, 171 Certificates of Eligibility (COEs) have been issued to 31 financial institutions (30 banks and 1 non-bank) under the Special Purpose Vehicle (SPV) Act of 2002. In addition, 2 COEs were issued for the sale of the NPLs of National Steel Corporation by a consortium of creditors represented by Philippine National Bank in the amount of P11.05 billion. The amount of NPAs transferred under the said law totaled P49.776 billion involving various transactions. Several banks have pending applications for COEs for the bulk sale of NPAs to SPVs and dacion of a syndicated loan involving a total amount of P39.104 billion and P1.175 billion, respectively. Likewise, the COEs that have been issued so far involved the sale of ROPOAs of banks to individuals.

Loan exposure remains adequately covered.

Notwithstanding the decline in banks’ NPL, banks’ loan exposure remained adequately covered as the banking system’s NPL coverage ratio12 remained steady at 57.7 percent as of December 2004, reflecting banks’ diligent compliance with the loan-loss provisioning requirements of the BSP as a cushion against possible losses.

12 Computed as the ratio of loan loss reserves to the NPL level, based on the new framework provided for by BSP Circular No. 351.

First Quarter 2005

39

Using the new risk-based framework, the KB’s capital adequacy ratio (CAR)—a measure of net worth-to-risk assets, increased to 18.4 percent as of June 2004 from 18.3 percent during the last quarter. The increase in CAR indicated market participants’ continued commitment to their respective capital build-up programs and reflects the banking system's improved ability to cover risky assets. The industry’s CAR exceeded the statutory level set by the BSP at 10.0 percent and the Bank for International Settlements’ (BIS) standard of 8.0 percent.13 The high CAR reflects the banking system's improved ability to cover risky assets. The Philippines’ CAR was relatively high compared to that of Malaysia (13.9 percent), Thailand (12.6 percent) and Korea (10.9 percent).14 Indonesia with 19.4 percent as of December 2004, posted the highest CAR in the region.

Banks continue to park funds with the BSP.

-60

-30

0

30

60

90

120

150

180

2000 2001 2002 2003 2004 2005

Banks' Placements with the BSP in billion pesos

Reverse Repurchase Agreements (RRPs)

Special Deposit Accounts (SDAs)

The total volume of banks’ placements with the BSP under the reverse repurchase (RRP) window aggregated P102.8 billion as of end-February 2005, higher by P55.6 billion from end-December 2004 level, as the BSP’s key policy interest rates were kept unchanged at 6.75 percent for the overnight borrowing or RRP rate and 9.0 percent for the overnight lending or repurchase (RP) rate. Banks’ excess funds continued to be placed with the BSP under the RRP facility as the growth in bank lending remained relatively modest.

13 BSP Circular No. 280, dated 29 March 2001, approved the guidelines for the adoption of the risk-based capital adequacy ratio along the criteria prescribed by the Bank for International Settlements (BIS). 14 Source: ARIC Financial Indicators, ADB website. Commercial banks CAR: Malaysia (January 2005); Thailand (December 2004); and Korea (September 2004).

First Quarter 2005

40

III. EXTERNAL DEVELOPMENTS

Current pace of global economic expansion is expected to proceed. However, global imbalances pose risks to the outlook.

Global economic expansion remained broadly on track based on data for the fourth quarter of 2004, supported by sustained gains in investment spending and gradual improvements in labor market conditions. Industrial production and export gains, however, appeared to have slowed down in most economies, reflecting both a return to more sustainable pace of expansion and the contractionary impact of higher oil prices. The December 2004 tsunami, meanwhile, had a modest impact on the global GDP since its adverse effects were offset largely by reconstruction activities. On the price front, inflation and inflation pressures remained modest even as oil prices surged anew to highs in March. The global economy is expected to demonstrate a moderate, yet continued solid growth performance in the year ahead, underpinned by favorable financial market conditions, improving corporate profitability and sustained growth in China. However, the presence of global imbalances, such as the large fiscal and current account deficits of the US, alongside continued volatility in world oil prices and weakening of the US dollar present downside risks to the outlook.

Strong domestic demand and robust exports serve as backbone to Asia’s emerging economies.

? Economic momentum in emerging Asia15 remained strong in 2004 due mainly to rapid increases in exports and continued strength in domestic demand. Real GDP growth picked up to 7.8 percent from 7.4 percent in the previous year even as economic activity moderated slightly in the second half of 2004.16 However, headline inflation increased to 4.0 percent from 2.4 percent in 2003 on account of pronounced increases in fuel and food prices.17 In China, real GDP growth accelerated to 9.5 percent year-on-year in the fourth quarter of 2004 despite various government tightening measures.

15 The term emerging Asia refers to developing Asia, the newly-industrialized Asian economies, and Mongolia 16 International Monetary Fund, World Economic Outlook (WEO), April 2005 17 Ibid

First Quarter 2005

41

Consequently, headline inflation rose to 4.9 percent in the fourth quarter from 4.4 percent in the previous two quarters. GDP growth in India, meanwhile, slowed down to 7.0 percent in the first two quarters (April to September) of the fiscal year 2004 following an annual growth of 8.5 percent in the fiscal year 2003.18 Inflation rose sharply to 4.0 percent in the last quarter of the year from an average of 2.2 percent in the three-months July to September 2004. The region is expected to demonstrate a moderate—but still robust—growth performance in the year ahead. However, adjustments with regards to the excess capacity in the IT sector will continue to weigh down domestic and external demand in the region.

US economy shows vigor in 2004 but large twin deficits cloud prospects for sustained growth.

? The brisk pick-up in consumer spending and private domestic investments boosted the overall performance of the US economy in 2004. Real GDP rose at an annual pace of 4.4 percent—the fastest recorded since 2000—from 3.0 percent in the previous year. Inflation and inflation expectations appear to be well anchored despite the rise of price pressures stemming from oil price developments. The average annual inflation rate eased to 3.0 percent in the first quarter of the year from an average of 3.3 percent in the last quarter of 2004. Going forward, the mounting budget and current account deficits continue to cloud prospects for sustained economic growth as foreign investors could eventually slow their accumulation of dollar-denominated assets to finance the deficit. At the same time, private consumption growth is expected to moderate as fiscal and monetary stimuli are gradually withdrawn and households begin to rebuild their savings.

18 Asian Development Bank, India Economic Bulletin, January 2005

First Quarter 2005

42

Growth in the euro area loses steam. ? Economic recovery in the euro area lost some steam in the second half of 2004 on account of subdued domestic demand and weak export growth against the background of sustained gains in investment spending. Quarter-on-quarter real GDP growth of the Euro-zone and EU 25 was estimated at 0.2 percent and 0.3 percent in the first quarter, respectively, unchanged from the previous quarter’s growth rate. The Euro-zone and EU25 year-on-year HICP inflation both eased to 2.1 percent in February 2005 from 2.3 percent in the previous quarter. Over the medium term, the European Central Bank (ECB) noted the lack of evidence pointing to the build-up of inflationary pressures as wage growth remained limited given moderate economic growth and weak labor markets.19 However, continued volatility in world oil prices and the further strengthening of the euro present risks to the ongoing economic recovery as the first dampens consumer spending and the second restraints labor market recovery.20

19 European Central Bank, Introductory statement to the ECB Press Conference on 3 February 2005 by ECB President Jean-Claude Trichet, available online at http://www.ecb.int 20 SG Economic Research, Global Economic Outlook First Quarter 2005

First Quarter 2005

43

UK economy grows close to trend. ? United Kingdom’s real GDP grew close to trend at 0.7 percent in the fourth quarter of 2004 following the 0.6 percent expansion posted in the previous quarter, boosted by the robust output performance of the services sector and the modest recovery of manufacturing. Household spending, meanwhile, expanded at a slightly weaker pace during the quarter, coupled with the observed slowdown in housing market activity. Inflation remains well below the government’s target even as the average annual CPI inflation rose to 1.7 percent in the first quarter from 1.4 percent in the previous quarter. The Bank of England (BOE) noted that the overall risks to UK growth and inflation are somewhat to the downside given the moderate growth outlook for the world economy, measured slowdown in domestic spending and housing prices, and absence of significant upward pressure on wages.21

The Japanese economy is on a gradual recovery path.

? The Japanese economy remained on a gradual recovery trend despite ongoing adjustments stemming from the slowdown in the global IT market. The fourth quarter real GDP growth of Japan was revised upwards by the Japan Cabinet Office to 0.1 percent, reversing the initially released output contraction of 0.1 percent, from the 0.3 percent drop in the previous quarter.22 Deflationary pressures, meanwhile, surfaced anew as the annual CPI inflation for January declined to -0.3 percent in February 2005 from 0.5 percent in the fourth quarter of 2004. Going forward, healthy corporate profits alongside strengthening consumer and business sentiments should support a renewed expansion—albeit at a more modest pace—in Japan. Future developments in IT-related demand and the continued volatility of world crude oil prices, however, present downside risks to the prospect of recovery.23

21 Bank of England, Inflation Report, February 2005, available online at http://www.bankofengland.co.uk 22 Methodological changes in the construction of the Japanese national income accounts also played a role in the reported contraction of the economy. 23 Bank of Japan, “Monthly Report of Recent Economic and Financial Developments,” 17 February 2005, available online at http://www.boj.or.jp/en

First Quarter 2005

44

The US continues with its tightening stance at a “measured” pace.

Prompted by the brisk pace of output expansion in the US alongside rising price pressures emanating from oil price developments, the US Federal Open Market Committee (FOMC) decided to raise its target for the federal funds rate by 25 basis points to 2.75 percent in its 22 March 2005 meeting. This marked the seventh time that the US FOMC has increased its policy rate since June 2004 for a cumulative rise of 175 basis points. Nevertheless, the Committee believed that “policy accommodation can be removed at a pace that is likely to be measured” with underlying inflation still expected to be well-contained.24

Other major central banks keep policy settings unchanged during the latest policy meeting.

Meanwhile, the BOE’s Monetary Policy Committee voted to maintain the key repo rate at 4.75 during its 9-10 March 2005 meeting. Available data point to continuing uncertainty about the momentum in consumption growth alongside the lack of evidence indicating that inflationary pressures in the supply chain are passed on to wages and thus, consumer prices. The most recent increase in policy rate of 0.25 percentage point to 4.75 percent was made on 5 August 2004.25 By contrast, monetary authorities in the Euro area and Japan kept their monetary policy settings unchanged during their last policy meetings to provide continued support to the ongoing recovery process. On 3 March 2005, the Governing Council of the ECB decided to maintain the minimum bid rate on the main refinancing operations and the interest rates on the marginal lending facility and the deposit facility steady at 2.0 percent, 3.0 percent, and 1.0 percent, respectively.26 Similarly, the nine-member Policy Board of the Bank of Japan voted to keep the target balance of current accounts held at the Bank at its current level of “around 30 to 35 trillion yen” during its 15-16 March 2005 monetary policy meeting.

24 Federal Reserve, FOMC Statement dated 22 March 2005, available online at http://www.federalreserve.gov/ boarddocs/ press/ monetary/2005 25 Bank of England, Minutes of the Monetary Policy Committee Meeting dated 9-10 March 2004, available online at http://www.bankofengland.co.uk /mpc/mpc0502.pdf 26 European Central Bank, Introductory statement to the ECB Press Conference on 3 March 2005 by ECB Pres ident Jean-Claude Trichet, available online at http://www.ecb.int

First Quarter 2005

45

IV. MONETARY POLICY DEVELOPMENTS

BSP keeps key policy rates unchanged in the first quarter.

During the quarter in review, the Monetary Board of the BSP met three times and voted unanimously each time to maintain the BSP’s key policy rates at current levels. The overnight reverse repurchase rate (RRP) or borrowing rate was left unchanged at 6.75 percent while the overnight repurchase rate (RP) or lending rate was maintained at 9.0 percent. Policy interest rates were last changed on 2 July 2003.27

Baseline forecasts indicate a decelerating path for inflation.

The Monetary Board’s decision to keep policy rates unchanged was based on the assessment that the outlook for inflation remains consistent with the maintenance of present monetary settings. The members of the Monetary Board noted that while inflation is fairly high, future inflation nevertheless showed a possible deceleration to around 5.0 percent by the fourth quarter of 2005. Staff’s baseline projections presented during the Monetary Board meetings showed that the 2005 inflation target of 5.0-6.0 percent is still likely to be exceeded but average inflation should revert back to the 4.0-5.0 percent target range by 2006, in the absence of further negative shocks.

27 Please refer to the Chronology of Monetary Policy Decisions for a listing of the dates of the monetary policy meetings of the Monetary Board and their corresponding decisions on the BSP’s policy stance.

4

6

8

10

12

14

16

18

1999 2000 2001 2002 2003 2004 2005

BSP Policy Interest Rates In percent

Overnight Repurchase (RP) Rate

Overnight Reverse Repurchase (RRP) Rate

First Quarter 2005

46

Supply-side factors continue to dominate the risks to inflation while demand-side influences on prices are still limited.

The Monetary Board emphasized that expected price pressures continue to be linked primarily to supply-side factors, notably price fluctuations in the world oil market and weather-induced pressures on agricultural food prices. Equally important, assessment of various demand conditions continued to indicate resource slack in the economy, given by the moderate levels of capacity utilization alongside modest employment and lending growth. The observed expansion in aggregate demand has been driven largely by consumption and only partly by net exports and investment spending.

The Monetary Board also recognized that the outlook for prices is not without risks. While changes in tax measures, such as the proposed increase in the VAT, along with fluctuations in food and oil prices are considered part of the BSP's exemption clauses under the inflation targeting, price pressures resulting from these factors are often used as grounds for petitions for wage and transport fare adjustments. Possible exchange market pressures arising from narrowing interest rate differentials and other sources could also pose a threat to inflation and inflation expectations. However, the prospect of a weak US dollar should continue to provide countervailing influence on import prices.

First Quarter 2005

47

The main policy concern of monetary authorities for the near term is the impact of continued supply-side pressures on wage- and price-setting behavior

Thus, the main policy concern for the near term is the impact of continued supply-side pressures on wage- and price-setting behavior. The members of the Monetary Board were of the view that policy action may be considered when a high proportion of the information on hand points to demand-side effects arising from supply shocks. Such information would include but should not be limited to the following circumstances: (1) inflation is expected to breach the target even after accounting for the impact of supply-side shocks; (2) adjustments in minimum wage rate in excess of what is necessary to compensate workers for the loss of purchasing power. Minimum wage increases that are significantly higher than these assumed values may require a monetary response. Current price pressures could lead to public calls for some form of relief.

The monetary authorities maintained that direct non-monetary policy measures, that would, among other things, facilitate the timely importation, distribution and delivery of certain commodities, remain the most sensible tool against the likely supply-side pressures on prices over the near term. Accordingly, the Monetary Board continued to articulate its support for the use of non-monetary measures by strengthening representation and coordination with various government agencies.

The BSP continues to articulate its support for the use of non-monetary measures to address inflationary pressures.

Going forward, monetary authorities will continue to assess the appropriate response to the risks to the inflation outlook, paying particular attention to adjustments in nominal wages and transport fares. The Monetary Board has reiterated in its various press releases its readiness to use its policy instruments to help quell price pressures if the need arises. They stressed that should such prospective policy actions become necessary, these should be geared more toward managing expectations rather than dampening demand-side impulses.

First Quarter 2005

48

V. INFLATION OUTLOOK

Inflation Forecasts

Inflation is likely to exceed target in 2005 but should revert to target by 2006. In the near term, supply-side factors would continue to influence price dynamics.

Inflation is expected to remain above the target level for 2005, although the outlook is for a deceleration in the inflation path as the impact of supply shocks play themselves out. The 2005 inflation target of 5.0-6.0 percent is still likely to be exceeded as the full impact of supply-side pressures sets in. However, average inflation for 2006 is expected to revert to within the target range of 4.0-5.0 percent in the absence of further adverse shocks. Supply- or cost-side factors are expected to remain the central influence on the path of inflation. Such factors include the impact of weather conditions on food supply (notably a weak El Niño phenomenon in the first quarter of 2005) and uncertainty in the trend of world oil prices. Meanwhile, some recovery has taken place on the demand side. Consumption continues to grow strongly, fixed capital formation has accelerated, and other demand indicators have improved, as noted previously. The first quarter 2005 Business Expectations Survey (BES) showed business optimism maintaining a relatively steady and positive outlook in the current quarter and improving significantly in the second quarter of the year. Moreover, as had also been noted above, there are some indications that the base for inflation has broadened. Although these factors signal recovery in demand, in sum, however, overall output conditions still indicate slack in the economy. Labor market conditions have remained soft, capacity utilization below maximum, and although some recovery in money demand has taken place, credit activity remains generally subdued.

First Quarter 2005

49

Using the 2000-based CPI series, the BSP forecasts that average headline inflation will continue to surpass the 5-6 percent target for 2005. The BSP’s forecasts are based on the following assumptions: a. Real GDP growth is consistent with the

National Government’s (NG) targets of 5.3-6.3 percent for 2005 and and 6.5-7.5 percent for 2006;

b. NG deficit levels will amount to P180.0

billion in 2005, and P161.8 billion in 2006.

c. The overnight RRP rate was assumed

constant at 7.00 percent from April 2005 to December 2006;

d. The 91-day Treasury bill rates

assumed an increasing trend with an average of 8.0 percent for 2005 and 7.5 percent for 2006; and

e. International crude oil prices consistent

with the latest DER projections (as of 28 March 2005, based on futures prices) of US$45.22 for 2005, and US$46.07 for 2006.

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Risks to the Inflation Outlook

Latest fan chart exhibits an upward skew.

The fan chart depicts the BSP’s current assessment of inflation over the policy horizon, including judgments on the major risks to the outlook. To highlight the various outcomes for inflation over the forecast horizon, the width of the current fan chart has been widened to 25 percent probability from 10 percent probability as in the previous quarter. With the wider band of the current fan chart, it can be seen that the current inflation profile exhibits an upward skew, i.e. the bands above the central projection (the darkest band) are wider than those below it. The upward skew of the current fan chart depicts a host of supply-side risks to the inflation outlook that include price fluctuations in the world oil market; petitions for adjustments in transport fares and wages; possible increase in electricity rates; and movements in the peso-dollar exchange rate.

Inflation Profile as of Previous Quarter Latest Inflation Profile

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Year-on-Year Inflation

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

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Risks to the inflation outlook remain.

Price fluctuations in the world oil market. International prices of Dubai crude oil have recently climbed to new highs, and there are good reasons to expect that prices will remain high for the foreseeable future. Such outlook has been traced by market analysts to the continued rising energy demand by growing economies against the limited capacity of oil producers to meet increasing global oil requirements. In addition, there are indications that hedge funds could continue increasing their participation in the oil futures market given the perceived profitability from tight supply conditions and the rapid increase in oil consumption. Possible increase in electricity charges. Continued increase in world oil prices implies renewed cost-push pressures on electricity prices over the policy horizon. This is on top of ongoing petitions for adjustments of NPC rates which could be passed on to end-users of electricity in the near term. Petitions for adjustment in transport fares and wages Given the outlook on oil prices, the likelihood for continued pressures for adjustment in transport fares and wages increases. In addition, declining real wages increase the likelihood of petitions from the labor sector for nominal wage adjustments, which would constitute a second-round effect of the oil price shock. Similarly, current petitions for transport fare adjustments may also be taken as second-round effects of the oil price shock. Movements in the peso-dollar exchange rate. While the peso staged a rebound during the first quarter of 2005, exchange market pressure remains a risk to the inflation environment, particularly given the potential shifts in market sentiment due to uncertainties in the passage of remaining tax measures. Moreover, the narrowing differential between local and US interest rates which is poised to continue as the US pursues its tightening stance could also lead to some exchange rate pressures.

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Additional risks from the passage of legislative revenue measures. In addition to the abovementioned risks considered in the construction of the fan chart, the passage into law of new legislative revenue measures such as the imposition of excise taxes on alcohol, cigarettes and tobacco and the proposed increase in the VAT could also exert upward consumer pressures on prices. Nevertheless, with regard to the proposed increase in the VAT, legislators recognize the needs of low-income consumers and intend to exempt basic commodities and socially-sensitive products from VAT. It should also be noted that impact of said revenue measures on inflation could be classified as part of the BSP’s exemption clauses.

Private Sector Economists’ Inflation Forecasts

Private forecasters raise inflation forecasts following the continued upswing in world oil prices. Private Forecasts for GDP and Inflation2005-2006

2006 2006Point

ForecastRange

ForecastPoint

ForecastRange

ForecastATR Kim Eng Securities 5.0 6.3 6.8 5.2Banco de Oro 5.5 7.5-8.0BPI 5.0-5.5 7.5-8.0Citibank 4.3 4.5 8.0 7.3Credit Lyonnais SA 3.8 3.6 8.8 10.4Deustche Bank 5.0 5.5 9.0 8.0DBS 4.5 7.0Metrobank 5.6 5.3-5.9 6.9 6.7-7.1 -Multinational Investment 6.0-6.5 8.0-8.5Nomura Securities 5.0 4.6 6.7 5.2UBS Warburg 5.0 6.0 7.5 6.0University of Asia & the Pacific 4.9 5.4 7.3Wallace Business Forum 5.0 5.4 6.0 4.7

Median Forecast 5.0 5.4 7.6 6.7Mean Forecast 5.0 5.2 7.5 6.7High 6.3 6.3 9.0 10.4Low 3.8 3.6 6.7 5.2Memo Item:Government Assumption/Target 5.3-6.3 5.0-6.0 4.0-5.0

2005GDP Inflation (2000=100)

2005

The BSP’s survey of inflation and GDP growth forecasts of private economists and analysts show that the private sector expects inflation to remain high and GDP growth to be lower than government assumption in 2005. The mean forecast on inflation reached 7.5 percent for 2005, higher than the 6.3 percent mean forecast in the previous quarterly survey. Analysts attribute the upward adjustments in inflation forecasts for the year to the unimpeded rise in world oil prices. Expectations of further hikes in US federal funds target rate in the coming months as well as the rise in food prices owing to the El Niño weather disturbance across Southeast Asia may add some pressures on price trends for the year. In 2006, inflation is expected to ease slightly as forecasts show an average of 6.7 percent inflation for the year.

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In the real sector, private analysts’ forecasts on real GDP growth averaged 5.0 percent for 2005, lower than the Government’s growth target of 5.3-6.3 percent for the year. The moderate growth was attributed to the slower agricultural output due to the El Niño phenomenon; reduced economic activity resulting from higher energy and transport prices; and investors’ concerns over the uncertainty over the enactment and implementation of the government revenue measures.

VI. Implications for the Monetary Policy Stance

The outlook for prices continues to suggest a decelerating path for inflation. Nevertheless, the prospect of sustained cost-side pressures may fuel the risk of second-order effects on wage- and price- setting.

Despite the uptrend in current inflation, the outlook for prices continues to suggest a decelerating path for inflation. Both ongoing and expected price pressures over the two-year policy horizon also continue to be linked primarily to supply-side influences, notably rising global oil prices and weather-induced pressures on domestic food prices. On the other hand, there continues to be no strong evidence of demand-side inflationary pressures. Labor market conditions have remained soft, with real wages falling over the past year, while capacity utilization has remained below maximum and credit activity generally subdued. Imported inflation has also been subdued by the continued nominal appreciation of the peso. Nevertheless, the prospect of sustained cost-side pressures over the next several quarters may fuel the risk of second-order effects on wage- and price setting. For example, the factors associated with the rise in world oil prices in the past year—namely strong demand, declining spare production capacity and geopolitical risks—remain intact and continue to underpin expectations that the average price of imported crude oil will remain high for the foreseeable future.

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Continued cost-side pressures may also fuel the risk that inflation expectations will spiral away from the target.

The task of monetary policy is to act preemptively against spillover effects from supply shocks and keep inflation expectations under control.

Petitions for additional cost-of-living nominal wage adjustments (also driven in part by declining real wages) are likely to ensue, along with requests for increases in transport fares. Such adjustments, if granted, would constitute a second-round effect of the oil price shock, and would require monetary adjustment. The prospect of renewed cost-push pressures also implies a greater risk that the public will come to expect future inflation to continue to spiral away from the Government’s target. There is some evidence that cost-side influences may already be feeding into the public’s inflation expectations. For example, mean inflation forecasts (for both 2005 and 2006) of private analysts polled by the BSP have been on the rise in recent quarters. Results of the first quarter CES by the BSP show that households anticipate a higher inflation rate percent over the next 12 months, with price increases seen to come from electricity bills, transportation, water bills, fish and seafood, fruits and vegetables, meat and rice. The spreads between long-term and short-term interest rates in the secondary market have also been widening, suggesting higher inflation expectations. The key task of monetary policy, therefore, is, firstly, to look for evidence of spillover demand-side effects and, secondly, to act preemptively against signs that inflation expectations are becoming disanchored from the inflation target. Particular attention is being focused on the labor market. The round of cost-of-living adjustments in minimum wage rates around the country during the second half 2004 has continued into 2005, the latest being for ARMM (in January) and Southern Mindanao (in February). No formal wage petitions were made before the regional wage boards in the first quarter, but adjustments in the near future cannot be ruled out.

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Non-monetary measures against supply-side risks will also continue to be pursued

The overall stance of monetary policy will be oriented towards responding to inflationary risks and delivering price stability over the policy horizon. The BSP will focus on assessing the evolving path for future inflation and demand conditions as well as the public’s inflation expectations and whether they continue to be well-anchored in the face of sustained commodity price increases. At the same time, any prospective action toward monetary tightening will be taken primarily to guide inflation expectations. Significant monetary tightening does not appear justified at present given the prevailing inflation outlook and the continuing presence of slack in the economy. Although these conditions may change, any monetary policy action at this stage should be geared more toward steering inflation expectations in the right direction rather than dampening demand-side impulses. Equally important, given the importance of supply-side developments in the inflation outlook, direct non-monetary action against supply-side risks will remain a key policy strategy, and all potential avenues for non-monetary intervention in the supply and delivery of affected commodities will continue to be explored and pursued accordingly.

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VII. CONCLUDING REMARKS

A central bank often conducts monetary policy under a fair amount of uncertainty about the true state of economic activity. The BSP’s decision to keep policy rates steady in recent months was guided by forecasts and past experience.

Conducting monetary policy in an emerging economy setting is seldom a straightforward matter. The central bank not only has to respond to the many shocks that assail the domestic economy but also it has to do so under a fair amount of uncertainty about the true state of economic activity, based on various evidence that could be oftentimes conflicting or unclear. Such a situation tends to elicit varied opinions on the appropriate policy response, and in many cases decisions involve a judgment call on the part of the central bank based on its best assessment of the evolving conditions and outlook. In the case of the BSP, the decision to accommodate recent supply shocks by keeping policy interest rates unchanged between July 2003 and the first quarter of 2005 has been based on the assessment, guided by forecasts and experience, that inflation was likely to decelerate over the policy horizon after a brief surge. Equally important, unlike other Asian economies, the Philippines does not have evidence of a declining output gap, given the continuing moderate levels of capacity utilization and employment growth. Moreover, the expansion in aggregate demand does not appear to be as yet broad-based, being driven primarily by consumption and only partly by net exports and investment spending. The choice to keep policy interest rates steady in recent months was also deemed a beneficial tactic, since it provided implicit support to credit (and therefore investment) activity by preventing large upticks in market interest rates.

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To be sure, there are arguments to support a policy rate increase to help guide inflation expectations, but the evidence has not given the BSP a compelling reason to do so. On the other hand, the stronger prospects for continued high oil prices poses a clear risk to inflation expectations. Going forward, the BSP will continue to assess the appropriate response to the risks

To be sure, there are arguments to support a policy rate increase in order to help anchor and guide inflation expectations down. However, the evidence of the past year has not given the BSP a compelling reason to do so. Moreover, monetary authorities could still guide the public’s inflation expectations down without resorting to monetary tightening by (1) disclosing its decelerating outlook for inflation; (2) pointing out the muted evidence of second-round effects from supply shocks; and (3) carefully explaining the basis for all policy decisions. This was in fact the approach taken in all communications with the public concerning the stance of monetary policy. On the other hand, the stronger prospects for continued high oil prices pose a clear risk to inflation expectations, a risk that may necessitate monetary action in the near future. Changes in inflation expectations have an impact on overall price- and wage-setting behavior in the economy. A measured increase in policy interest rates can help prevent rising inflationary expectations from becoming widespread and entrenched and prevent ongoing supply shocks from generating further second-round effects. It will also underline the BSP’s commitment to fighting inflation. Thus, in the months ahead, the BSP will continue to assess the appropriate response to the risks to the inflation outlook, paying particular attention to adjustments in nominal wages, transport fares, and public inflation expectations. The overall stance of monetary policy will be oriented towards responding to inflationary risks and delivering price stability over the policy horizon.

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Chronology of Monetary Policy Decisions 2000 24 January 2000 The Monetary Board–the policymaking body of the BSP–adopted in principle the shift to inflation targeting as the BSP's framework for conducting monetary policy. 2001 26 December 2001 The BSP announced formally the adoption of inflation targeting as framework for monetary policy beginning January 2002. The BSP also announced the Government’s annual average inflation targets of 5.0-6.0 percent for 2002 and 4.5-5.5 percent for 2003. 2002 17 January 2002 The Monetary Board decided to reduce the overnight reverse repurchase (RRP) and repurchase (RP) rates by 25 basis points each to 7.5 percent and 9.75 percent, respectively. Consequently, the Monetary Board also adopted a change in the tiering structure for banks’ overnight RRP placements with the BSP as follows: 7.5 percent for the first P5 billion, 4.5 percent for the next P5 billion and 1.5 percent for placements in excess of P10 billion. The Monetary Board also approved a two-percentage point reduction to 7.0 percent of the liquidity reserve requirements on deposits and deposit

substitute liabilities, common trust funds and other trust and fiduciary liabilities of commercial banks and non-banks with quasi-banking functions. These monetary policy measures took effect on 18 January 2003. Moreover, it could be noted that this decision marks the first action of the Monetary Board under the inflation-targeting framework. 14 February 2002 The Monetary Board opted to lower the BSP’s policy rates further by 25 basis points each, bringing the overnight RRP rate to 7.25 percent and the overnight RP rate to 9.5 percent effective 15 February 2002. The Monetary Board also approved an adjustment in tiering scheme for banks’ overnight RRP placements with the BSP as follows: 7.25 percent for placements of up to P5 billion, 4.25 percent for the next P5 billion and 1.25 percent for placements in excess of P10 billion. The tiering scheme also covered special deposit accounts (SDAs) and would be applied on a consolidated basis. 14 March 2002 The Monetary Board decided to reduce BSP’s key policy rates by another 25 basis points. The overnight RRP rate was lowered to 7.0 percent while the overnight RP rate was reduced to 9.25 percent effective 15 March 2002.

Correspondingly, the interest rates on overnight RRP and SDA placements with the BSP under the tiering scheme were adjusted as follows: 7.0 percent for placements of up to P5 billion, 4.0 percent for the next P5 billion and 1.0

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percent for placements in excess of P10 billion. 11 April, 8 May, 6 June, 4 July, 1 August, 29 August, 26 September, 23 October, 21 November, 19 December 2002 During the monetary policy meetings held for the period April-December 2002, the Monetary Board decided to keep the overnight RRP and RP rates steady at 7.0 percent and 9.25 percent, respectively. 2003 16 January 2003 The Monetary Board voted to keep the BSP’s policy rates unchanged at 7.0 percent for the overnight RRP rate and 9.25 percent for the overnight RP rate. 7 February 2003 The BSP announced the Government’s official target for the average annual inflation for 2004 at 4-5 percent. 12 February, 13 March 2003 The Monetary Board kept the BSP’s policy rates unchanged at 7.0 percent for the overnight RRP rate and 9.25 percent for the overnight RP rate. 19 March 2003 (Special Monetary Board Meeting) The Monetary Board decided to lift the three-tiered scheme on banks’ placements with the BSP. Thus, overnight placements under the RRP window would be accepted at a flat rate of 7.0 percent effective 20 March 2003. The Monetary Board also raised the liquidity reserve requirement against peso demand, savings, time deposit and

deposit liabilities of universal banks and commercial banks by one-percentage point to 8.0 percent effective 21 March 2003. 10 April, 8 May 2003 The Monetary Board maintained the overnight RRP and RP rates steady at 7.0 percent and 9.25 percent, respectively. 5 June 2003 The Monetary Board decided to leave the overnight RRP and RP rates unchanged at 7.0 percent and 9.25 percent, respectively. The Monetary Board also decided to restore the tiering scheme on banks’ placements with the BSP under the RRP and SDA windows effective 5 June 2003. In particular, overnight RRP placements would be subject to the following interest rates: 7.0 percent for the first P5 billion, 4.0 percent for additional amounts in excess of P5 billion but below P10 billion and 1.0 percent for amounts in excess of P10 billion. 2 July 2003 The Monetary Board voted to reduce the BSP’s key policy interest rates by 25 basis points each to 6.75 percent for the overnight RRP rate and 9.0 percent for the overnight RP rate effective 2 July 2003. The interest rates on banks’ placements under the tiered system were also adjusted as follows: 6.75 percent for the first P5 billion, 3.75 percent for amounts in excess of P5 billion up to P10 billion and 0.75 percent in excess of P10 billion.

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31 July 2003 The Monetary Board left unchanged the overnight RRP and RP rates at 6.75 percent and 9.0 percent, respectively. 28 August 2003 The Monetary Board opted to keep the BSP’s policy rates unchanged at 6.75 percent for the overnight RRP rate and 9.0 percent for the overnight RP rate. The Monetary Board also decided to lift the tiering scheme for banks’ placements with the BSP. Thus, effective 28 August 2003, overnight RRP transactions with the BSP were accepted at a flat rate of 6.75 percent. 2 October, 23 October, 20 November, 18 December 2003 The Monetary Board voted unanimously to leave the BSP’s policy rates unchanged at 6.75 percent for the overnight RRP rate and 9.0 percent for the overnight RP rate. 2004 15 January 2004 The Monetary decided to keep monetary policy settings unchanged. The overnight RRP and RP rate were maintained at 6.75 percent and 9.0 percent, respectively. 5 February 2004 (Special Monetary Board Meeting) The Monetary Board decided to increase the liquidity reserve requirement for universal banks and commercial banks by two percentage points to 10 percent effective 6 February 2004.

12 February, 11 March, 15 April, 6May, 3 June, 1 July, 29 July, 26 August, 23 September, 21 October, 18 November, 16 December 2004. The Monetary Board opted to maintain the key rates steady at 6.75 percent and 9.0 percent for the overnight RRP rate and overnight RP rate, respectively. 2005 13 January, 10 February, 10 March 2005 The Monetary Board decided to maintain the BSP’s key overnight RRP and RP rates unchanged at 6.75 percent and 9.0 percent, respectively.