Philippines: Moodys delivers a harsh verdict

Moody's 2-notch downgrade of Philippines sovereign rating from Ba2 to B1 is a disappointment. Not only has some important progress been made on the fiscal reform front in 2005, but there are tentative signs that offshore sentiment is also beginning to turn in the Philippines favour. We think markets will stabilise quickly following this latest setback, just as the fallout from the Abu Sayaf bombings earlier this week was well contained. As we have long argued, getting the fiscal house in order is the Philippines' key priority this year. Provided the government continues to make progress on this front, then we expect to see some palpable improvements in the debt dynamics this year. This in turn will help underpin the ongoing recovery in sentiment.

Harsh but fair?
Markets first started pricing in the possibility of a 2-notch downgrade from Moody's back in November. We agreed then the outlook for the Philippines did not look encouraging. The government's new fiscal measures faced strong opposition in Congress and any kind of consensus looked far from being reached. The risk of a slow fiscal deterioration was, at the time, very real. However, the situation has improved markedly since then, a fact reflected in S&P's decision to limit its recent downgrade to 1-notch in January.

Already this year we have seen two of the government's new tax measures passed in quick succession (the indexation of alcohol/tobacco tariffs, lateral attrition). Combined the two measures could cut up to P20bn off this year's budget deficit. Admittedly proposals to hike VAT to 12% (from 10%) are still encountering opposition in the Senate and it is difficult to say when this will be resolved. A watered down bill still looks possible, although the actual tax take is likely to fall short of the original estimates of P35bn. Even so, taking these changes into account, the fiscal outlook looks arguably better than it did three months ago. Moreover, the stronger peso, at its highest since October 2003, is also a significant fiscal positive. Taking into account recent performance then Moody's double downgrade appears a harsh decision.

Dodging Damocles' sword
In some ways, Moody's decision clears away some of the uncertainty that has been hanging over the Philippines for some time. The threat of a 2-notch downgrade may well have delayed decisions. Moving the Philippines back to a 'stable' outlook removes a degree of the uncertainty. However, this raises an interesting issue, a possible risk factor that needs close watch. The government has long pointed to the threat of a double credit downgrade as a means of pressuring Congress into pushing through fiscal reforms as quickly as possible. Now it has occurred the 'stick and carrot' approach may have lost some of its bite.

Needless to say, it remains critical that fiscal reforms continue on their current course as the measures passed so far are not sufficient in themselves to ensure meaningful fiscal consolidation. Any sign of reform inertia creeping back in again the markets will quickly withdraw their recent faith. That said, provided the Philippines maintains steady progress on fiscal reform, the impact of Moody's downgrade could blow over relatively quickly.

Mike Moran, Senior Economist