moneytalks - bdo...on urbanization and its role in raising growth/incomes/productivity, and reducing...

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March 30, 2017

Roy I. Ramos, [email protected] Roque, [email protected]

Karen Cua, [email protected]

The long view: Our high-conviction views, amidst ongoing headwinds & uncertainties

Yes, we face global/local headwinds and “known unknowns”Headwinds include: rising interest rates and bond yields, likely continued US$ strength and peso/EM currencies weakness. “Known unknowns” include: how long & how high for terminus Fed Funds rates/bond yields, US Fed QE (US$4.5tn) unwind, Trump policies & impacts, US protectionism (trade, immigration, jobs) & impacts, Brexit/upcoming Europe elections & impacts, and prospect/shape/effects/fiscal sustainability impact of tax and other reforms in Philippines.

But…But there has been enough time now to assess these headwinds and uncertainties. There are also “green shoots” suggesting synchronized economic upturn globally, helped along by central bank stimulus. Here, we share our BDO house view on 8 high-conviction themes that underpin our fundamentally positive outlook for Philippine growth/development in next several years. Also here: our answers to five key questions on interest rates, the peso, tax reform, and investing opportunities.

MoneyTalks

March 30, 2017 BDO Unibank

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Food for thought… Notable quotes… on urbanization & infra build-up

Night and day: Shenzhen in 1960s/1970s, and Shenzhen now (yes, Shenzhen, not Hong Kong)

1. Shenzhen in 1960s/1970s: ~30,000 population. 2. Shenzhen now: 10.8mn population (18mn greater metropolitan area), US$258bn GDP and US$19,500 per capita income in 2015. 3. Now also the base for Tencent, Huawei, BYD, ZTE, Shenzhen Stock Exchange, iPhone global supply chain and China’s Silicon Valley. 4. Food for thought: Rome did not get built in a day… But Shenzhen did get built in a little over three decades. Source: Wikipedia, HK Trade Development Council, Pinterest, Mashable.

On urbanization and its role in raising growth/incomes/productivity, and reducing povertyThe world is in the throes of a sweeping population shift from the countryside to the city. The global urban population is growing by 65 million annually, equivalent to adding seven new Chicagos a year. And for the first time in history, more than half of the world’s population is now living in towns and cities. Underpinning this transformation are the economies of scale that make concentrated urban centers more productive. This productivity improvement from urbanization has already delivered substantial economic growth and helped radically reduce poverty in countries such as China. The expansion of cities has the potential for further growth and poverty reduction across many emerging markets. Urbanization will be one of this century’s biggest drivers of global economic growth.

- McKinsey Global Institute, Urban World: Mapping the Economic Power of Cities, March 2011.

On building up infrastructure, the country’s stock of capital(Note: this comment focuses on China, but is as relevant for Philippines)

In short, the biggest single task for China over the past thirty-five years was to increase its capital stock: the total value of equipment, buildings, and other forms of physical capital… The primary job for any country that wants to move from poor to rich is therefore to increase its capital stock to a degree approaching rich-country levels…

It is more vital for poor countries to focus on putting in as much appropriate capital as possible than to try to maximize the marginal productivity of each individual project…Under these conditions, most new capital investments are likely to generate very large returns quite quickly, thanks to the ability of infrastructure and new technologies to dramatically boost productivity from its very low starting base. This is the advantage of “backwardness”.

- Arthur R. Kroeber, China’s Economy: What Everyone Needs to Know, 2016 Partner, Gavekal Dragonomics, senior fellow at Brookings-Tsinghua Center for Public Policy.

The authors thank Maria Lourdes Dumol, BDO Securities analyst, for her contributions to this report.The authors thank Euben Paracuelles, ASEAN macroeconomist at Nomura Securities (our joint venture partner at BDO-Nomura Securities), whose perspectives and analytics we include in this MoneyTalks piece.


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The long view: 8 high-conviction views we hold, amidst ongoing headwinds and “known unknowns”

Yes, we face ongoing headwinds and “known unknowns”, both globally and domestically1.

We do not mean to dismiss, or gloss over, these headwinds and uncertainties - these will inevitably pressure financial markets and raise volatility, globally and locally, for some time to come.

But there has been enough time now to understand and assess these headwinds and uncertainties. And we believe most of these headwinds will prove manageable for the Philippines.

There are also “green shoots” suggesting synchronized economic upturns globally, helped along by central bank stimulus and QE (quantitative easing).

In this piece, we share our bank’s house view 2 including 8 high-conviction views that underpin our continued fundamentally positive outlook for Philippine growth/development in next several years, and our answers to five key questions we get frequently asked.

1. Monetary policy normalization, starting with US; Continued rising interest rates globally, including the Philippines

Our viewContinued rising interest rates in the US, with several other DM (developed market) and EM (emerging market) countries following in due course, including the Philippines, reflecting ongoing upturn for the US and other economies.

One additional but less-flagged headwind: likely start of unwind of the US Fed’s QE program by YE2017 and gradual reduction of the Fed’s US$4.5 trillion balance sheet (impact: incremental reduction of excess liquidity in US and globally).

1 Global headwinds include: ongoing rate hikes in US, rising US and global bond yields, continued US$ strength and EM (emerging markets) currency weakness and continued EM to US funds flows.

Local headwinds include: peso weakness, rising fiscal and trade deficits, lower current account surpluses, higher inflation, and needed rate hikes.

“Known unknowns” globally include: pace/extent and terminus for US rate hikes and rising bond yields, unwind of the Federal Reserves’s QE (quantitative easing) program (US$4.5 trillion balance sheet), Trump policies & impacts, US protectionism (trade, jobs, immigration, borders) & impacts, Brexit & impacts, upcoming Europe elections & potential impacts, and geopolitical risks (e.g. North Korea, South Korea THAAD, Taiwan/one-China policy, China/US trade tensions).

“Known unknowns” locally include: shape and timeframe of tax reforms and likely impacts, impact of weakening trade, fiscal and current account balances, impact of weakening peso, and ongoing impacts of the war on drugs.

2 The bank’s “house view” on global/Philippine macro and markets-related issues are formally discussed, debated and formed by the bank’s Investment Committee. This ~16-person committee meets monthly and includes the bank’s CEO and key executives from various parts of the bank, including BDO Nomura/BDO Research, Treasury, Trust & Investments, Private Banking, BDO Capital, BDO Securities, and Corporate Planning.

Core members of the Investment Committee include: Nestor Tan (CEO & President), Dioscoro Ramos (Independent Director & Committee Chairman), Karen Cua (Head of Strategic Program Management, Corporate Planning), Dante Tinga (Head, BDO Nomura Research), Gabriel Roque (BDO Macroeconomist), Pedro Florescio (Head, Treasury Group), Martin Dalmacio (Deputy Head, Treasury Group), Jonathan Ravelas (Treasury Markets Economist), Ador Abrogena (Head, Trust & Investments), Fritz Ocampo (Chief Investment Officer, Trust & Investment), Albert Yeo (EVP, BDO Unibank), Rich Grau (Investment Strategy Head, BDO Private Bank), Paolo Magpale (Treasurer, BDO Private Bank), Ed Francisco (CEO, BDO Capital), Jerome Guevarra (CEO, BDO Securities), and Luis Reyes (Head, Corporate Planning & Investor Relations).


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Key points, basis for viewsMonetary stimulus has done its job – monetary stimulus applied by central banks across DMs starting to work, starting to see signs of synchronized upturn globally (see Exhibits 1 and 2). The Fed has essentially met its twin goals for US employment and inflation.

Exhibit 1: Inflection point for inflation rates: now starting to move upInflation swap forward rates, %

Exhibit 2: Synchronised global upturn – fleeting or rooted now?Manufacturing PMIs (Purchasing Manager Index) for US, Eurozone, China, Japan now rising

-1.0

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

2010 2011 2012 2013 2014 2015 2016 2017

UK

US

Euro

Japan

47

49

51

53

55

57

59

61

2012 2013 2014 2015 2016 2017

US Eurozone Japan China

Source: Bloomberg. Source: Bloomberg.

From one-and-done-for-the-year to a series of rate hikes in 2017 and 2018: we expect three 25bp Fed Funds rate hikes in 2017 (in June and September, in addition to the 25bp announced this month), and another 3 in 2018.

We expect a Fed Funds terminus (or peak rate) between 2.5% to 3% sometime in 1H2019 (implying a total of between 7-9 25bp rate hikes from here). This 2.5% to 3% terminus rate would be more in line with ~2% GDP growth and ~2% inflation rates we expect for the US in the next few years.

We expect the US 10-year bond yield to also continue rising, terminus between 3.5% to 4.5% (a bit below the 160bp L/T historical spread between 10-yr yields and the Fed Funds rate). Note that the 10-yr bond yield Bloomberg consensus is only at 3.08% for 2Q 2018, with implied forwards at 2.67%.

We project the BSP to raise rates as well, but with a lag at least at onset (i.e. no rate hikes until July 2017 or later), reflecting continued ample domestic liquidity (Phil banking sector L/D ratio at 72.5%) among other factors.

Legacy of successful normalization by the Fed, sans disruption. We think Fed Chairman Janet Yellen’s lasting legacy (and key focus during her term) may end up being success in returning US monetary policy to more normal “orthodox” settings3, without big macro or market disruptions.

QE unwind as part of normalization. As an aside, normalization will likely include the Fed starting to reduce its US$4.5tln balance sheet and unwind its US$4.24tln QE portfolio (of purchased treasury and other fixed income securities – see Exhibit 3).

YE2017 start for QE unwind? We think this unwind (i.e. the Fed stopping the reinvestment of repayments on its QE portfolio, as it has done to date) starts by YE2017.

QE unwind a manageable process, if not non-event. While there is some debate on this point, we believe this QE unwind can be done in a gradual non-disruptive setting, with the Fed’s QE portfolio naturally unwinding itself within 5 years via non-reinvestment of repayments on securities owned.

3 i.e. from unorthodox zero or negative interest rate policies (ZIRP, NIRP) and money printing/bonds-buying (or QE – quantitative easing) for US/Europe/Japan since the 2007 global financial crisis, back to more normal monetary policy.


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Exhibit 3: US Fed US$4.24tln QE portfolio unwind: assuming no further reinvestment of repayment proceeds, most of portfolio will mature in 5 yearsWe think this will be a manageable event, if not quite a non-event, rather than a source of market disruption.

Source: US Federal Reserve Bank.

Risks/qualifiers to our base-line view• Pace of US rate hikes will continue to be data-dependent.

• The data coming out of the US, however, has been predominantly positive of late.

• Significant market or geopolitical disruptions.

2. Low debt levels (government, corporate, consumer) for Philippines: Resilience amidst rising rates + room for stimulus

Our view, and key pointsLow debt levels, anyway you look at it. The Philippines continues to have one of the lowest levels of debt relative to GDP (91%), and relative to other countries in Asia (see Exhibit 4).

…including government, corporate and consumer debt. This applies equally to all key components: government debt, corporate debt and consumer debt (Exhibit 4). Indeed, Philippine consumer debt/GDP is the lowest in region at just 9%, versus 92% for Korea and 71% for Thailand..

Also relatively low levels of FX borrowings. FX borrowings as % of GDP for both government and corporates are also low (and declining since 2013), reflecting lessons learned by corporates during the 1980s political tumult and sharp peso depreciation, and the 1997 Asia banking crisis (Exhibits 5 and 6).

Resilience to (and limited impact of) higher rates, weaker peso. All these would clearly suggest limited impact/resilience to rising rates and also a weaker peso.

All these suggest ample scope for stimulus measures from government (i.e. the ability to stretch/lever up) including higher spending on infrastructure projects as the government plans (see Exhibit 7).

…as well as the ability of many corporates to pursue expansion projects.

…helped along by a banking system that is liquid (72.5% L/D ratio), well-capitalized (12.8% average Tier 1 CAR) and fundamentally healthy (1.4% ROA, 1.9% NPL ratio) banking sector.

Rising rates good for some sectors, reflective of better growth. Gradually rising rates should be good for some sectors, in particular banks and insurers, and reflective of better global and domestic growth.


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Exhibit 4: Room to expand: low overall, gov’t, corporate, consumer debt for Phil in absolute and relative terms Debt as % of GDP, as of 2Q16, or latest date available: Philippine total debt/GDP second lowest at 91%, consumer debt/GDP lowest in region at 9%.

74

216

112

119

106

104

46 42 53

32

68

42 28

67

62

62

88

59 79

43

92 70

71 11

9

10

232

94

121 77

104

73

166 10

4

67

50

50

40

23

-

50

100

150

200

250

300

350

400

HK JP SG UK EU US CN KR MY TH IN PH ID

General government Households Non-financial corporations

Source: BIS, CEIC, World Bank.

Exhibit 5: External debt for Philippines down since 2012External debt for Phil government and private sector, in US$ million

Exhibit 6: External debt low relative to GDP, FX reserves ample relative to importsFX reserves months of imports; external debt as % of GDP

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

80,000

90,000

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Public Private

0

2

4

6

8

10

12

14

16

18

0

10

20

30

40

50

60

70

80

90

1993

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2008

2009

2010

2011

2012

2013

2014

2015

2016

Foreign Exchange Reserves (months of imports, RHS)

External Debt (% of GDP)

Source: BSP. Source: CEIC.


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Exhibit 7: Ample fiscal space for infra ramp, higher deficit for Philippines

Low public debt to GDP provide fiscal space… …and the government ran lower than budgeted deficits (yet GDP growth remained strong)

33

38

43

48

53

58

63

68

73

78

1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015*

National government debt

Consolidated general government debt

% GDP -4.0 -3.0 -2.0 -1.0 0.0 1.0

2008

2009

2010

2011

2012

2013

2014

2015

Target

Actual

%GDP

Source: Nomura Global Economics Research.

Risks/qualifiers• Flip side: low savings pool. The flip side of the coin is an also relatively low total savings pool (or

deposits-to-GDP ratio as proxy, see Exhibit 8) for the Philippines versus most of Asia.

• Domestic liquidity is ample and not the issue here (e.g., 72.5% banking sector L/D ratio).

• Rather, this condition reflects relatively low incomes and low accumulated savings/wealth for a sizable part of the population, and a relatively under-banked population (86% of all Filipino households still do not have bank accounts, as per most recent BSP Consumer Finance Survey).

• Financial deepening. There is much scope/opportunity for financial deepening (rising credit/ GDP and deposit/GDP ratios), helped along by many factors as discussed in this piece.

Exhibit 8: Flip side of coin of low debt/GDP: low savings pool, reflecting low incomes & low accumulated wealth, but also suggesting good scope for financial deepening if strong growth and infra ramp-upBanking sector deposits as % of GDP, as at YE2014

0

50

100

150

200

250

300

350

HK JP MY KR SG TH US EU IN PH ID VN

Source: World Bank.


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3. Increased infra spending, especially directly by government: Structurally higher and more inclusive growth

Our view and key pointsWill to spend more. The government has committed to addressing the country’s long-standing inadequate infrastructure, via more aggressive spending, to 5-7% of GDP (see Exhibit 9), but with two notable differences versus prior administrations.

Government-funded spending. The first is a greater focus on direct government infra expenditures including ODA (Official Development Assistance), including from China and Japan.

Greater focus on infra projects in Rest of Philippines ex-NCR (National Capital Region) as second key difference. Of the 17 approved projects in 2016, 12 were outside NCR, accounting for almost two thirds of the total value of approved projects (see Exhibit 10).

Addresses disparities. This makes much sense to us, given the wide disparity of infrastructure, economic development and per capita incomes between NCR and the Rest of Philippines (RoP), NCR being as prosperous GDP per capita-wise as China, RoP as poor as India.

Lifting RoP incomes is arguably a better way for more inclusive growth, higher average incomes across the board, and reduced income disparity/Gini coefficients.

High incremental returns off low base. The low stock of infrastructure assets in Philippines would, just like with India, enable infra asset additions to have significant incremental productivity and multiplier effects. As an example, a first-ever bridge connecting 2 key islands will have a lot more benefits for commerce/trade/travel than a fourth bridge between the same.

Iloilo-Guimaras-Negros-Cebu bridge as example of high incremental returns from a ground-breaking project. An example of a government infra project that should have significant multiplier effects: the Iloilo-Guimaras-Negros-Cebu Link Bridge (Exhibit 11), which is approved, about to start and will link 4 islands, and which the Department of Public Works and Highways describes as “the most ambitious bridge program in the history of our nation”.

Structurally higher growth: we see scope for structurally higher sustainable GDP growth from higher infra spending combined with other reforms (e.g. cutting red tape, ease-of-doing-business, peace-and-order, addressing the drugs problem) being pursued by the government (see Exhibit 12).

Exhibit 9: Government ramp-up of infra spending Planned government infrastructure spending as % of GDP

Exhibit 10: Gov’t infra spending focuses on Rest-of-Philippines ex-NCR 12 of 17 projects approved in 2016, and 63% of budget for projects outside NCR

1.6

2.2

2.5

3.5

4.0

5.1

5.3

7.4

0.0

1.0

2.0

3.0

4.0

5.0

6.0

7.0

8.0

2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022

Target Actual Approved Infrastructure Projects in 2016 PHP bn % of Total

Outside Metro Manila 252.7 64.3

North-South Railway Project — South Line 170.7 43.4

Expansion of the Philippine Rural Development Project 20.9 5.3

Plaridel Bypass Road Project 10.5 2.7

Inclusive Partnership for Agricultural Competitiveness project 10.2 2.6

New Cebu International Port 9.2 2.3

Second phase of the Maritime Safety Capability Improvement project for Phil Coast Guard 8.0 2.0

Change in scope of New Bohol Airport Construction & Sustainable Environmnt Protect'n proj 7.8 2.0

Malitubog-Maridagao Irrigation Project, Stage 2 5.4 1.4

Increase in area of Bicol International Airport’s passenger terminal building in Albay 4.8 1.2

Modernization of Eastern Visayas Regional Medical Center in Leyte 2.4 0.6

Modernization of Gov. Celestino Gallares Memorial Hospital in Bohol 2.2 0.6

Scaling up of the Second Cordillera Highlands Agricultural Resources Management Project 0.6 0.2

Metro Manila 140.3 35.7

Ninoy Aquino International Airport (NAIA) Public-Private Partnership (PPP) project 74.6 19.0

Metro Manila Bus Rapid Transit (BRT) in EDSA 37.8 9.6

First Phase of the Metro Manila Flood Management Project 23.5 6.0

Improvement/Widening of General Luis-Kaybiga-Polo-Novaliches Road to Valenzuela City 3.0 0.8

New Nayong Pilipino at Entertainment City 1.5 0.4

Total 393.1 100.0

Source: Philippine Development Plan, 2017-2022. Source: NEDA.


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Exhibit 11: The importance of building connectivity for Philippines as an archipelagic country – high incremental returns from a first-ever bridge project that will link four islands in VisayasIloilo-Guimaras-Negros-Cebu Link BridgeNote that Philippines is one of 5 UN/UNCLOS classified archipelagic countries – Indonesia is another.

Source: Department of Public Works and Highways..

Exhibit 12: Infra ramp-up and reform efforts should raise sustainable GDP growth rates (to 6.7% base-line, 7.5% with more reforms)Infra ramp-up raises capital contribution to growth; reform efforts raises TFP (total factor productivity) contribution to growth. Simply put, total factor productivity is about working smarter/more efficiently/more effectively, about making the sum (of capital and labor inputs) greater than the parts, via reforms or wider adoption and new uses for tech and process innovations (e.g. bridges, mass transit systems, wider adoption of smartphones or broadband internet).

Source: Nomura Global Economic Research estimates, World Bank.

Risks and qualifiers (foremost being Philippines as one of 5 archipelagic countries)• Key risks: delays in starting approved projects, poor execution in implementing projects, budget

deficit implications for significant cost overruns.

• Re PPPs (public-private partnership projects): transparent and well defined framework in place with proven track record for over a decade now (e.g. power projects, Cebu Mactan International Airport). However, new projects will take time given complexities, bid situations, and changing terms of reference (e.g. from consolidated bids for the 5 approved regional airport projects4, to now individual bids for each of the 5 airports).

• A particular challenge for Philippines is its nature and UN/UNCLOS classification as an archipelagic country (together with Indonesia, Fiji, Papua New Guinea and the Bahamas) rather than a unified land mass (e.g., as China, India and Thailand are for most part) – entailing more effort and infrastructure to connect/integrate/develop the country’s key islands/economic hubs.

4 These five approved airport projects are: New Bohol Airport, Laguindanao Airport, Davao Airport, Bacolod Airport, and Iloilo Airport.


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• Connectivity (bridges, ports, airports, telecom infrastructure) is crucial for archipelagic countries to develop its outlying lower-income less-developed areas, and to promote greater incomes convergence rather than continued disparity.

• However, there should be even greater multiplier effects for the Philippines as an archipelagic country from connectivity-related infra projects. Refer again to our example of the Iloilo-Guimaras-Negros-Cebu Link Bridge, with its significant multiplier effects for Visayas.

For more on Philippines infra ramp: We also refer you to our BDO Nomura Research team’s February 14, 2017 Nomura Securities anchor report on infrastructure titled “Philippines infrastructure: Aggressive ramp in infra spending ahead“ lead-written by Dante Tinga, Jr. This report is available on the BDO Nomura Securities website for BDO Nomura clients (https://www.bdo.com.ph/bdonomura/home). Alternatively, please contact your BDO relationship manager for a copy of this report.

4. Co-opting the private sector: Robust corporate capex/expansion; “Crowding in” not “crowding out” effects

Our view and key points“Animal spirits”. We believe the government (the prior and this administration) has helped raise “animal spirits” in the private sector (business confidence has remained close to all-time highs since 2010; consumer confidence at all-time highs, see Exhibits 13 and 14).

Coopting the private sector. We believe the government has also successfully coopted the private sector to go along, co-invest, bid on projects, start new projects in anticipation of government infra projects, focus more on expansion in Rest-of-Philippines, and help accelerate the process of urbanization outside Metro Manila.

Corporate buy-in. More fundamentally, we believe many corporates (BDO included) buy into the government’s economic platforms, including its infra build-out plans and its focus on channeling more development efforts away into the outlying regions ex-NCR/Metro Manila.

Crowding in, not crowding out. All these go to the concept of “crowding in” as opposed to “crowding out” successfully achieved herewith, i.e. of rising government capex spurring the private sector to do the same (win-win) (see Exhibits 15 and 17), or actually leveraging the private sector, which in the Philippines is spending 4X more than the government on capex/investments (see Exhibit 17).

“Crowding in” needed to address the massive need for new jobs as 1.1mn people enter the work force each year. As we pointed in our Oct 11, 2016 MoneyTalks piece “Reforms + multiplier effects = double for GDP since 2002, triple for PCOMP since Oct 2006. Mean reversion, or continued gains from here?”, some of the country’s bigger challenges are:

• a net increase in the country’s working-age population5 by 1.1 million each year, or by a total of 16.4mn through 2030, versus an average of 620,000 new jobs created/year since 2010 (see Exhibit 16).

• implying a need to create a minimum of 700,000 new jobs each year and more like 1.12mn new jobs/year to accommodate all these new entrants to the labor force, and reduce the country’s still high underemployment rates and sheer number of OFWs (overseas Filipino workers, 2.5 million officially) many of whom may stay home if good jobs were available

• We believe the bulk of these 1.1mn new jobs created each year are best filled by the private not the public sector.

There are many crowding-in examples we can cite. To use one key example – the planned renovation and expansion of NAIA and/or construction of a second airport for Greater Metro Manila – we have at very least 7 corporate groups6 (apologies to any corporates we missed) publicly stating their intention to participate, if not submitting unsolicited bids/proposals, often in partnership with foreign airport operators.

5 People between the age of 15-64 years.6 Including, in alphabetical order: Ayala Corp/AC Infrastructure, DMC, Megawide, Metro Pacific Investments, San Miguel Corp,

and the SM Group.


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Risks and qualifiers• It remains to be seen how quickly much-needed PPP projects (e.g. NAIA, regional airports) get

launched and implemented,

• …given the numerous iterations and long gestation periods past projects have entailed,

• …and given the administration’s preference for using its own balance sheet/resources in tandem with ODA for government-led and funded infra projects.

Exhibit 13: High business confidence Philippine Business Confidence Index has remained close to all-time highs since 2010

Exhibit 14: Very high consumer confidence index Philippines Overall Consumer Outlook Composite Index since start of index in 2007

Source: BSP, Bloomberg. Source: BSP, Bloomberg.

Exhibit 15: “Crowding in” / coopting the private sector: Both public and private sector capex up since 2008 Total investments as % of GDP (actual plus forecasts through 2021); PCOMP aggregate capex spend through 2017 (trailing 12 mos), in PHP bn

Exhibit 16: Around 1.1mn new entrants to labor force each year, implying need for country to create from 700,000 to 1.12 mn new jobs each year for demographic edge to be a sweet, not trouble, spot

0

100

200

300

400

500

600

15

17

19

21

23

25

27

29

31

1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017F2019F2021F

Total Investments (% of GDP)

PCOMP Capital Expenditures (PHP bn, RHS)

Philippines needs to create 17.9mn new jobs by 2030 for demographic edge to be a sweet, not trouble, spot. That’s 1.1 million jobs/yr, vs. 620k/yr run-rate of late.

Working-age population, 2015 63.90UNDP projected growth in working age population by 2030 26%Projected working age population by 2030 80.30Projected increase in working-age population through 2030 16.40

x assumed ideal labor participation rate 68%

(a) Equals: implied no of new jobs needed to accommodate increase in working age

11.15

Implied no of new jobs/year 0.70

Add: underemployed working-age population (17.3% of total) 11.08Add: OFWs at present, many we assume will return home to better-paying jobs

2.45

Equals: subtotal 13.52(b) x 50% adjustment factor (i.e. half of underemployed and

OFWs reduced)6.76

Implied total no of jobs needed by 2030 to get closer to “full employment” (a+b)

17.91

Implied no of new jobs/year 1.12

Note : total investments as % of GDP refers to both public and private investments ; we estimate that public investments are ~19% of total investments from 2010-2016. PCOMP aggregate capex refers to listed companies’ capex spend.

Source: IMF, Bloomberg.

Source: BDO Research estimates, Asia Pacific Human Development Report: Shaping the Future – How changing demographics can power human development, 2016 ; Philippine Statistics Authority.


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Exhibit 17: A case of government coopting and leveraging the private sector – public and private sector investments as % of GDP for PhilippinesPrivate sector ideally spends more on capex investments than government. This is the case in Philippines, where public sector investments have risen relative to GDP but also helped boost private sector investments, 4.3X that of public sector.

18.3

18.4

15.1 17

.0 17.7

17.3 19

.2

2.2

2.1

3.1

3.0 2.

8

3.3

4.5

-

5.00

10.00

15.00

20.00

25.00

2010 2011 2012 2013 2014 2015 2016

Private Public

Source: Department of Budget Management, BDO Economics Research estimates.

5. Increasing urbanization: Broader-based growth and lifting of incomes

Our view and key pointsWe have seen urbanization and its key role in raising incomes play out elsewhere in Asia. Urbanization has been an integral part of the Asian growth story of rising incomes and growing prosperity7. We have seen this in Korea, Taiwan, more recently in Malaysia, Thailand, now in China.

Urbanization away from Metro Manila/NCR is particularly apt for the country given people’s traditional migration to Metro Manila in search of jobs, and ever-worsening Metro Manila congestion and other problems as a result. We welcome the government’s focus on infra build-out outside of Metro Manila/NCR, i.e. 93.2% of the DPWH capital budget is for Rest of Philippines (Exhibit 18).

Urbanization across the country taking root: of the 10 most populous cities in the country, 8 grew faster than the national population growth rate from 1990-2015, including 3 in Mindanao (Exhibit 19). That said, the country’s urbanization rate is still low by Asian standards (Exhibit 20), i.e. good scope for gains, given ample focus and infra build-up.

7 i.e. developing rural areas into cities, third-tier into second-tier or first-tier cities, promoting stronger local governments, developing additional concentric layers of agri-based industries, light manufacturing, services (malls, fast food and convenience store chain stores, and tertiary institutions (vocational schools, universities), along with the skills, specialization and higher incomes as more people move from agri to services/manufacturing jobs.


13

Greater urbanization in Rest-of-Philippines also particularly important given the wide (4X) gap in incomes with between NCR and R-o-P, i.e. NCR as prosperous as China, RoP as poor as India. Per capita incomes in NCR are US$7,544 – 4X higher than per capita income in RoP at US$1,887 (Exhibit 21). Thailand has a lower incomes gap (2.7X) between Greater Bangkok versus the Rest of Thailand8.

Starbucks store density index: on a lighter note, we point to the Starbucks store density index charted by BusinessWorld (Exhibit 22) as an offbeat cutting-edge proxy for urbanization esp. in RoP, i.e. young urban upwardly mobile higher-income professionals going for their daily espresso, cappuccino or macchiato latte). Note the emergence of higher-Starbucks-density cities outside NCR including Tarlac City, Baguio, Angeles City, Cebu, Bacolod City, Davao, Cagayan de Oro and General Santos City.

Exhibit 18: Greater focus on Rest of Philippines: government budgeting 93.2% of FY2017 capital outlays of P342.3bn towards Rest of Philippines ex-NCRDistribution of FY2017 government budget for capital outlays by region

CAR – P 13.1 B

Region I – P 16.6 B

Region II – P 13.4 B

Region III – P 24.1 B

NORTHERN LUZON-P67.2 B (19.6%)

Region XIII – P 23.2 B

Region X – P 38.7 B

Region IX – P 16.6 B

Region XI – P 38.1 B

Region XII – P 16.5 B

MINDANAO – P133.1 B (38.9%)

NCR – P 23.4 B (6.8%)

Region IV-A – P 23.6 B

Region IV-B – P 15.8 B

Region V – P 20.7 B

SOUTHERN LUZON-P60.1 B (17.5%)

Region VI – P 13.0 B

Region VII – P 12.4 B

VISAYAS – P58.5 (17.1%)

Region VIII – P 22.6 B

TOTAL : P 342.3 B

* Excludes Inter-Regional/Nationwide-P77.3B

Negros Island Region-P 10.6 B

NIR

Distribution of FY 2017 Budget by Region (Capital Outlays):

Amount in Billion Pesos

17 Source: Department of Public Works and Highways, September 2016

8 In fairness, Indonesia (another archipelagic country) has a higher gap in incomes than Philippines between Greater Jakarta and the Rest-of-Indonesia (4.8X), underscoring our point about challenges facing archipelago countries.


14

Exhibit 19: Urbanization taking root: 8 of the 10 most populous cities have grown faster than the overall population, including 3 from MindanaoPopulation CAGR (%) of Philippines and ten most populous cities, 1990-2015. Cities roughly sequenced by geographic location (Luzon, Visayas, Mindanao) not size.

Exhibit 20: Philippine urbanization rate still low by Asian standards, suggesting good scope gains, given ample focus and infra build-upUrbanization rate, 2015 or latest data available

2.06%

0.42%

2.60%

2.28%

2.96%

2.43%

4.52%

1.67%

2.65%

2.79%

2.70%

0% 1% 2% 3% 4% 5%

Philippines

Manila

Pasig

Quezon City

Caloocan

Valenzuela

Taguig

Cebu

Davao

Cagayan de Oro …

Zamboanga City

100.00%100%

82%75%

56% 54% 50%44%

34% 33%

90.00%

80.00%

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%Singapore United

StatesMalaysia China Indonesia ThailandPhilippinesVietnam India

Source: Philippine Statistics Aurthority. Source: World Bank.

Exhibit 21: Wide income disparity between NCR and Rest of Philippines at 4X, versus 2.7X for Thailand. (In fairness, even wider income disparity for Indonesia – another archipelagic country – at 4.8X).Incomes for capital region versus rest of country, for Philippines, Thailand, Indonesia, 2014 data

Population GDP

(local currency, mn)Per capita income

(local currency)

Per capita income: Capital region vs rest

of country

PHILIPPINES

National Capital Region 12,799 4,679,829 365,629 4.0 X

Rest of Phil ex NCR 87,081 7,962,907 91,443

Philippines 99,880 12,642,736 126,579

THAILAND

Greater Bankok 15,203 5,723,246 376,455 2.7 X

Rest of Thailand 51,552 7,186,786 139,408

Thailand 66,755 12,910,032 193,394

INDONESIA

Jakarta Special Capital Region 11,345 1,983,420 174.824 4.8 X

Rest of Indonesia 263,238 9,667,705 36.726

Indonesia 274,583 11,651,125 42.432

A tale of two countries: Metro Manila/NCR as prosperous as China, Rest of Philippines as poor as India

Source: Philippine Statistics Authority, Bloomberg, Bank of Thailand, Bank Indonesia.


15

Exhibit 22: Young urban upwardly-mobile higher-income professionals going for their Starbucks espresso, cappuccino or macchiato latte – an offbeat but cutting-edge proxy for pace of urbanization in PhilippinesStarbucks coffee store density across Philippine cities

Source: BusinessWorld

Risks and qualifiers• Large capex needs. Urbanization of outlying less-developed areas entails significant capex, both hard

and soft, on the part of both national and local governments – roads, ports, airports, utilities, schools, hospitals, cultural facilities, urban master planning/zoning, etc.

• Need for better-resourced city planning. Risks to inadequate planning or commitment of hard/soft resources: urban blight, slums, lack of peace and order.


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6. Tourism upside, especially with China: Scope for a double or triple given more focus

Our view and key pointsAt least 15 years of consecutive growth. The country has seen 15 consecutive years of growing tourism, with tourist arrivals rising by 8.5% CAGR (compound annual growth rate) from 1.70mn incoming tourists in 2001 to 5.78mn in 2016 (see Exhibit 23).

Country still still punching well below its weight. Consistent growth notwithstanding, the country still generates far less annual tourism revenues versus its Asian peers (see Exhibit 23 and 24): less than a third that of Malaysia, less than 15% that of Thailand.

The growth of tourists from East Asia and in particular China is stronger: from 109,473 in 2008 to 258,275 in 2016 for a CAGR of 11.3% (see Exhibit 25).

Tourism brings many benefits/multiplier effects: boost to many related services including food, transportation, entertainment, retail outlets; and lifting of incomes for outlying less-developed areas (see Exhibit 26).

China tourism potential upside amidst the administration’s heightened focus on China. The following China-related items are worth noting:

• Note, as per Exhibit 26, that a total of 490,000 Chinese tourists visited the Philippines in 2015. That compares to 7.9mn Chinese tourists visiting Thailand in 2015 - 16X higher.

• Note also, as per Exhibit 26, that only 4% of Chinese citizens have passports currently, versus 38% of American citizens. We think this 4% proportion can easily triple if not quintuple in the coming decade.

• Dream case. The average Chinese tourist spent US$1,790 per trip in 2015. Assuming 2mn Chinese tourists per year to the Philippines with that same spend rate, that would imply Chinese tourism receipts of US$3.58bn, or ~1% of Philippine GDP.

Exhibit 23: Fifteen consecutive years of growing tourist arrivals (8.5% CAGR) for Philippines; but total intake still lower than ASEAN peers, and slower-growingTourist arrivals (in millions, 12-month rolling sum)

Exhibit 24: Philippines and tourism: still-underappreciated hospitality, still-untapped beautyHave airport, flight, roads and bridges, will visit, in lieu of Thailand or Malaysia

0

5

10

15

20

25

30

35

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

Indonesia Malaysia ThailandVietnam Philippines Country

International tourism receipts, 2014, US$mn

United States 220,757 France 66,803 United Kingdom 62,830 China 56,913 Hong Kong 46,031 Italy 45,547 Thailand 42,063 Australia 34,117 Korea 23,008 Malaysia 22,600 Japan 20,790 India 20,756 Indonesia 11,567 Vietnam 7,330 Philippines 6,052

Source: CEIC. Source: World Bank, World Tourism Organization, Yearbook of Tourism Statistics.


17

Exhibit 25: Stronger growth (11.3% CAGR since 2011) for tourist arrivals from East Asia, including ChinaTourist arrivals from East Asia, including China (monthly arrivals)

Exhibit 26: Significant scope for tourism upside with China, in time and with more focusFood for thought: 120 million outbound China tourists in 2015, of which 7.9mn went to Thailand versus just 0.49mn to Philippines, and that was with only 4% of Chinese with passports (versus 38% of Americans with passports).

China (and Philippines): some key numbers

120 millionNo of outbound China tourists, 2015

US$215bn | US$1,790Chinese tourists total overseas spend in 2015; ave spend per China tourist

7.9mn | 0.49mnNo of Chinese tourists in 2015 going to Thailand | Philippines

4% | 38%% of Chinese with passports; % of Americans with passports

Source: Bloomberg. Source: BDO Research estimates, World Bank, World Tourism Organization, Yearbook of Tourism Statistics.

Exhibit 27: Tourism multiplier effects: employment trends for tourism-related industries, especially accommodation/food/beverage and passenger transportEmployment, in thousands

0

400

800

1200

1600

2000

2000 2002 2004 2006 2008 2010 2012 2014

Accommodation, food and beverage Passenger transportTravel agents, tour operators and guides

Recreation, entertainment and cultural svcsRetail trade on tourism-characteristic goodsMiscellaneous

Source: Department of Tourism.

Risks and qualifiers• Tourism upside, including from China, not an automatic given: many things are needed, including

winning a more consistent image of safety/security, better infrastructure, better flight connections, streamlined/easier visa arrangements, more Mandarin-speaking staff, etc.

• The weaker peso and enhanced affordability adds to the appeal of the country’s many pristine and still-untouched beaches/coastline/resorts, and colorful towns.


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7. Property markets: Still ample room for price/volume growth for most subsectors

This section includes perspectives and analytics from Abi Chiw, BDO Securities analyst seconded to Nomura Securities and covering the Philippine property sector, among others.

Our view and key pointsFirst, the real estate sector itself has been a major contributor to the economy, now comprising around 11.6% of GDP, and construction activities another 6.2% (Exhibit 28).

Demand fueled by favorable demographics, the rise of cities, and BPO expansion to date. As the country’s population growth stabilizes and average family size falls9, household formation is bound to gather steam, which will continue to drive demand for residential for years to come.

Rising property launches. Indeed, most developers under BDO Nomura coverage have disclosed higher residential property launches for 2017 citing: (1) recovering demand, (2) declining inventory, and (3) resolving permitting and contractor capacity issues (Exhibit 29).

BPOs. Commercial property demand in turn has been driven by BPO industry expansion (Exhibits 30 and 31), which may slow down from the past rapid pace, but will still continue as a key driver going forward, as per feedback from major developers.

Higher affluence and urbanization should lead to wider financial inclusion and improved access to credit, which enhance households’ ability to purchase (and upgrade) housing over the long haul.

Supply remains tight, 5.7 million low-cost housing backlog. With the exception of condominium subsector, which we believe faces a near-term supply glut10, the current supply of property infrastructure appears tight. The government estimates the low-cost housing backlog at 5.7 million units, with about 1.5 million informal settler families nationwide, as per the National Housing Authority.

Infra build-out a boon to developers. Nonetheless, public infrastructure projects, particularly those that enhance interregional connectivity and metropolitan transport systems, provide impetus for property developments outside urban centers as property values rise.

Local developers, households well-placed to accommodate rising interest rates. Listed property companies in the Philippines have comfortably low gearing levels compared to US and Japanese property indices, with the four largest developers at par with Asian counterparts.

Risks and qualifiers• A dimmer BPO industry growth outlook has direct bearing on commercial property demand, and

indirectly on residential property demand via weaker job creation and wage growth.

• Ultimately, continued growth in property volumes and prices is a function of (i) continued jobs creation, (ii) rising incomes and (iii) affordability, in case of housing. Supply/demand is but a reflection of these swing factors. Leverage (property loans/GDP and mortage loans/GDP) is low and should rise, not fall, going forward.

9 A key pattern seen in Philippines and elsewhere in Asia, just as with US in past: smaller average household size as parents have less children on average, and as children eventually get jobs/enjoy rising incomes and opt to buy their own homes rather than stay with parents in “extended family” households.

10 From our property analyst Abi Chiw: Property developers have already addressed the condominium glut via lower project launches in 2015 and 2016, as evident in Exhibit 29. Inventory levels are back to not-unhealthy levels of 1.5 years and below.


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Exhibit 28: Urbanization means building homes and buildings; and the real estate sector itself is a key and rising contributor to overall GDP% contribution to GDP

Exhibit 29: Residential property launches rising again, reflecting recovering demand, declining inventory, and resolving permitting and capacity issuesRebounding issuances in HLURB licenses to sell (no. of units)

5.7% 5.7% 5.9% 6.2%

10.9% 11.2% 11.3% 11.6%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

2013 2014 2015 2016

Construction Real estate, renting & business activities

0

50000

100000

150000

200000

250000

300000

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Lots Only House & Lots Condos

Source: HLURB (Housing & Land Use Regulatory Board). Source: BDO Research estimates, World Bank, World Tourism Organization, Yearbook of Tourism Statistics.

Exhibit 30: New supply/launches of commercial property still driven by BPO demandGLA in square meters

Location As of 2016 2017 2018 2019 2020 TOTALAlabang 483,148 55,315 59,189 64,753 38,900 701,305Fort Bonifacio 1,544,757 401,910 210,813 245,223 32,927 2,435,629C-5 Corridor 57,779 34,713 97,399 94,392 0 284,283Makati CBD 3,213,190 28,405 77,623 51,534 193,841 3,564,593Makati Fringe 221,332 25,328 61,029 0 120,754 428,443Mandaluyong 305,970 60,440 87,577 0 0 453,987Ortigas Center 1,578,063 66,414 43,344 13,675 341,815 2,043,312Pasay Bay Area 330,608 99,883 162,337 136,373 116,400 845,601Quezon City* 795,886 65,553 93,557 172,842 43,364 1,171,203Others** 353,917 50,549 75,076 92,409 64,859 636,809Total 8,884,650 888,509 967,945 871,200 952,860 12,565,165

Note: Colliers believes that office demand is still driven by Information Technology and Business Process management (IT-BPM) companies but was augmented by offshore gaming firms, particularly in Q4 2016. Close to 60% of take-up in Metro Manila came from IT-BPM companies, while 32% was from non-BPO firms and the balance from off-shore gaming companies. Colliers expects demand to grow 8% in the next 12 months with vacancies likely to remain low despite new office completions with strong pre-leasing seen across submarkets.

The 3 major drivers are: 1) influx of offshore gaming companies; 2) continued expansion of IT-BPM; and 3) tenants looking for flight-to-quality opportunities.

Source: Colliers.

Exhibit 31: Manila and, encouragingly, more VisMin cities, are now top outsourcing destinations globallyNumbers refer to global ranking, with 1 as the highest among the Top 100

Tholons' Top 100 Outsourcing DestinationsRanking 2010 2012 2014 2016Manila 4 4 2 2Cebu City 9 9 8 7Davao City 69 69 69 66Bacolod 100 – 93 85Iloilo City 98 92 95 90Dumaguete City – – – 93

Source: Tholons.


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8. Demographics: Philippines in a truly unique and potentially very sweet spot, infra ramp and jobs creation needed to unlock edge

Our view and key pointsThe country’s demographic appeals are well-known: a young population, with a median age of just 23.5 years, versus 27.0 for India, 36.2 for Thailand, 36.7 for China and 46.1 for Japan (see Exhibits 32 and 33).

However, certain demographic aspects of the country are less appreciated and truly unique.

One such unique aspect is a working-age population11 that will keep growing all the way to 2080, at ~1.7% per annum, going from 63.6mn at present to 80mn by 2030, i.e. an increase of 1.1mn new job entrants each year. Most other Asian countries’ working age population will have peaked before then – Indonesia in 2060, India in 2050. Some countries have in fact already peaked now or in past – Thailand, China and Korea all in 2015, Japan in 1995 (see Exhibits 34 and 35).

Another unique aspect is the dependency ratio12 falling all the way to 2055. Almost all other countries in Asia bottom out on their dependency ratio earlier13: Japan in 1990, China, Thailand and Korea in 2010, Vietnam in 2015, Malaysia in 2020, Indonesia in 2030.

Exhibit 32: Demographic sweet spot: median age of 23.5 years for PhilippinesHalf of all Filipinos were born after 1992, with zero or little memories of Philippines under martial law or the 1997 Asia FX/banking crisis.

Exhibit 33: Filipino millennial to the fore: half of all Filipinos under 24 yrsQualities of Filipino millenials: Relatively optimistic, no political baggage; Tech savvy (70% of internet users); community focused; considerable purchasing power (50% of all workers); values convenience and quality of life, experiences over physical goods.

Median age, 2014

PhilippinesIndiaMalaysiaIndonesiaVietnamSingaporeThailandChinaUSKoreaJapan

23.527.027.729.229.233.836.236.737.640.846.1

Source: CIA World Factbook, 2014 Source: Philippine Statistics Authority, BDO Nomura Research estimates.

11 Defined as those between 15-64 years.12 Ratio of dependents – people below the age of 15 and above the age of 64 – to total population. The inverse of the working

age population ratio.13 This has often had a significant bearing on inflection points on structural sustainable growth, i.e. if the working age population

is starting to shrink, so to will growth rates as we saw with Japan when the dependency ratio peaked in 1990 and Korea in 2010. This slowdown is bound to happen, barring sharp increases in productivity, or a surge in investments in infrastructure/hard assets as China has done in an effort to stave off further slowdown.


21

Exhibit 34: Many countries have passed their peak in working-age people; for the Philippines, the working-age population will continue growing until 2080!Projected year of peak working-age population, as % of total pop’n, and in absolute numbers

Exhibit 35: Graphing the % of population between 25-64 years over time: Philippines to experience the longest growth for this cohort, until 2080% of population between 25-64 years, from 2010 to 2100

Year of maximum share of working-

age population

Year of maximum number of

working-age population

East Asia

China 2010 2015

Japan 1990 1995

Korea 2010 2015

ASEAN

Indonesia 2030 2060

Malaysia 2020 2045

Philippines 2055 2080

Thailand 2010 2015

Vietnam 2015 2040

South Asia

India 2040 2050

Pakistan 2070 2080

Oceania

Australia 2010 2100+

New Zealand 2010 2070

40

45

50

55

60

65

2010

2015

2020

2025

2030

2035

2040

2045

2050

2055

2060

2065

2070

2075

2080

2085

2090

2095

2100

Indonesia

Malaysia

Philippines

Singapore

Thailand

China

India

Vietnam

Note: working-age population generally defined as between ages of 15 to 64 years.

Source : Asia Pacific Human Development Report, United Nations Development Program, 2016.

Source: United Nations.

Risks and qualifiers• The country’s unique demographic edge is a double-edged sword, i.e. it can cut both ways.

• The biggest challenge: creating enough new jobs each year to accommodate the ~1.1mn new entrants to the labor force each year (versus ~620,000 net new jobs creation/year in the past 5 years).

• Key benefit if jobs creation challenge is met: higher GDP growth rates, higher average per capita incomes (in tandem mathematically with the falling dependency ratio).

• Key risks if jobs creation challenge not met: more unemployed/underemployed people, more OFWs and the social/family costs and sacrifices this overseas route entails, higher income disparities/higher Gini coefficients, higher risk of backlash and growth-reducing populist policies.


22

Our take on five key questions we frequently get asked

1. Will the pace of US rate hikes increase?Short answer: Yes.

Somewhat longer answer: We go from one-and-done-per-year with the Fed, to a series of 3 rate hikes in 2017 (2 more 25bp rate hikes in June and September most likely, on top of the 25bp rate hike on March 17) and another 2-3 in 2018.

Ultimately, we believe the Fed may end up with a terminus Fed Funds rate of between 2.5% to 3%, more in line with the ~2% GDP growth rates and ~2% inflation rates seen for the US economy.

Of course, the Fed’s move will remain data dependent. But the data coming out of late has been pretty consistently positive, main issue is if it stays that way.

And while it’s early days, there are more signs of synchronized upturns globally (in US, UK, Europe, Japan, China, see Exhibit 2), partly reflecting the impacts of central bank stimulus and QE programs.

What could make us wrong, make for slower pace of rate hikes:

• Tax and deregulation reform obstacles and legislative gridlock in US

• More tepid US/global macroeconomic growth

• Significant market or geopolitical disruptions.

2. Will the peso continue to weaken?Short answer: Yes.

Longer answer: We see several factors that may exert more pressure (and greater near-term volatility in both directions) on the peso vis a vis the dollar, and cause the exchange rate to further weaken to the P51.5 level or beyond, before settling down to our longer-term forecast of P51. These include:

• Rising Philippine trade deficits (in part due to higher infrastructure-related imports, which we think the market will differentiate versus consumer spending related trade deficits)

• Falling current account surpluses, on back of trade deficits and weaker foreign portfolio investments/risk of continued drawdowns

• US$ strength in general

• EM to US funds flows in general

What could make us wrong, make for stronger peso:

• More dramatic pace to Philippine tax reform and infra ramp

• Fast/clear BSP response to US rate hikes

• Stronger than expected growth in BPO revenues and OFW remittances

• Upturn in growth for Philippines and listed companies; turn in investor sentiment.

3. Is peso back to persistent weakening, as seen from 1980 to 2005? Short answer: We cannot rule this out, but we think unlikely.

The longer answer: Older readers will remember what was essentially a straight line down for the peso from 1980 (P7: US$1) to 2005 (P56.5 peak).

Some ask if peso strength between 2005 and 2016 (which included a prolonged period of US$ weakness post US-turned-global-financial-crisis of 2007) was a temporary or finite respite, and if we return to the longer-term trend of persistent peso weakening.


23

We resist this thinking for several reasons.

First, the 1980 to 2005 period was a time of political upheaval and ongoing tumults for the country. It also encompassed the Asian currency and financial crisis of 1997.

Second, the Philippines ran a fairly structural trade AND current account deficit during most of that period. OFW remittances and BPO revenues – now a strong net offset to the country’s persistent/structural trade deficits – had yet to make much of a dent to the trade deficit then.

On the premise that persistent currency weaknesses often reflect persistent significant current account deficits as we have seen for the Philippines (see Exhibit 36), it is useful to assess where to for the country’s current account balance going forward (see Exhibit 37).

Exhibit 36: Persistent peso weakness from 1980-2005 reflected current account deficits for most of that periodStatistically significant 39% correlation between Phil current account balance as % of GDP and PHP/USD

Exhibit 37: OFW remittances and BPO revenues have more than offset the country’s persistent trade deficits since 2010Three key swing factors going forward for the country’s current account balance and for PHP/USD: (1) BPO revenues outlook; (2) OFW remittances outlook; (3) trade balance outlook. We have a measured but still positive outlook on all three swing factors.

-30

-25

-20

-15

-10

-5

0

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1996

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1999

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2002

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2008

2009

2011

2012

2014

2015

Current account balance (% of GDP) PHP/USD (% qoq, inverted scale)

Source: CEIC. Source: CEIC, Nomura Global Economics Research

In our view, there are three key swing factors for the country’s current account balance (see Exhibit 37) – and if you are more bearish than us with any or more of these swing factors, then you will almost by definition be more pessimistic over the long-term course of the peso:

• First, the trade balance – likely to remain in deficit, but with potential upside from tourism, agri exports and the pivot to China, i.e. greater trade/tourism/investment flows with China.

• Second, the outlook for OFW remittances – we believe this is, barring massive jobs protectionism across the world and a forced return of many OFWs, a stable source that will continue to grow, perhaps in the 5% range.

• Third, the outlook for BPO remittances – this generates more debate than the outlook for OFW remittances14. Our view is that existing businesses/revenues are sticky/will persist and that BPO revenues from 2018 onwards will settle down to the 5%-9% range (versus a 14% CAGR for the past 5 years), for the following reasons:

o BPO operators in the country point to resilience and continued growth, despite the aforementioned headwinds, AI impacts (artificial intelligence) included.

o Offshore call centers have, to date, not been a particular focus of the Trump administration.

14 …given the accompanying noise of the previously announced pivot to China away from the US, Trump jobs/trade protectionism, and the rise and rise (tipping point?) of AI, voice recognition and ever more ubiquitous voice bots and popular device/smartphone assistants (especially for youngsters) including Amazon’s Alexa, Apple’s Siri, Google Now and Microsoft’s Cortana.


24

o Wide all-in wage costs disparity – doing the same job in the US is ~4X costlier with 30%+ attrition rates part of that cost differential (see Exhibit 38); the weaker peso widens this gap.

o Many BPO firms are focused on the importance of upgrading to more value-added services and moving in that direction, e.g. industry verticals such as health, insurance, IT (as India has successfully done, with Infosys and Wipro, the India equivalents of an Andersen Consulting, as examples) and financial services and in-house analytics.

What could make us wrong, make for a persistently weakening peso:

• Reversion to persistent current account deficits.

• Weaker than expected BPO revenues.

• Weaker than expected OFW remittances.

• Larger than expected trade deficits going forward.

Exhibit 38: BPO all-in wage costs: Philippines less than a quarter of US costs; weaker peso widens the gap

Cheaper WagesIndia, Philippines are cheapest destinations for outsourcing

India Philippines China Mexico U.K. U.S.

$100,000

90,000

80,00070,000

60,000

50,000

40,000

30,000

20,000

10,0000

Source: Bloomberg, Everest Group.

4. Where to for Philippine tax reform, and its likely biggest effects?Short answer: Onwards but behind schedule. Net positive for growth.

Longer answer: Given its importance in financing the government’s infrastructure program, we think the first tranche of the Comprehensive Tax Reform Program (CTRP) has a fairly good chance of enactment this year, albeit behind the scheduled target of June 2017.

Since the start of the session in July 2016, HB 4774 has not been submitted for second reading, only after which the period of floor debates and amendments will start. In order to be legislated by mid-year, and assuming the lower house is able to approve a final version by May, the Senate will have to replicate in less than a month what the House accomplished in over six.

Nonetheless, we are optimistic that the CTRP will move forward this year, given that it complements the government’s ambitious investment program and is in line with the broader inclusive growth strategy. Furthermore, the President’s allies constitute ~90% of the House and ~70% of the Senate. Finally, Congressional leaders, multilateral agencies, former DOF secretaries, and the business community are supportive of the reforms.

The most important features of the first tranche of tax reform, in our view, are:

• Increasing the exemption threshold and lowering personal income tax rates

• Broadening the VAT base by limiting exemptions to raw food and necessities


25

• Hiking excise taxes on petroleum products and automobiles and indexing to inflation starting 2020

• Relaxing bank secrecy laws for tax audits and other measures to strengthen tax administration

Future tranches, according to the DOF, may include lower corporate income taxes (from 30% to 25%), higher real property taxes (via updated property valuations), and higher luxury taxes – all consistent with shifting the burden from the poor and middle class, lowering rates, and broadening the base.

If implemented, 99% of taxpayers will face a tax rate of 25% or lower, including 83% who will become totally exempt.

Higher disposable incomes will likely provide a boost to consumption, which accounts for roughly 70% of the Philippine economy.

Lower corporate taxes are also expected to make the Philippines more competitive as an FDI destination, which has room to grow (the country attracts FDI inflows equivalent to 1.4% of GDP on average, compared to 7.6% in Cambodia, and 5.4% in Vietnam). Higher FDI inflows, in turn, creates more jobs and supports GDP growth.

Manageable impact from VAT. The broadening of the VAT base and higher excise taxes on fuel and automobiles are likely to nudge consumer prices higher, but we think the impact on headline inflation should be manageable, for two reasons:

• The outlook on crude oil has softened, with US shale production effectively capping price gains from OPEC supply cuts. Note crude oil has yet to break above USD60/bbl since May 2015.

• Having held rates steady in March, the BSP still has ample headroom to raise policy rates, and hence keep inflation at bay.

Finally, the most crucial impact of tax reforms is fiscal sustainability. We take comfort in legislators’ insistence on tackling tax rate reductions simultaneous with offsetting VAT/revenue raising measures.

What could make us wrong:

• Legislative delay and reforms dilution are the biggest threats to timely/meaningful tax reforms.

• Higher-than-expected crude prices and a much weaker peso can induce faster inflation.

5. What key investing opportunities do we see?

First, we adopt a selective rather than across-the-board buy-the-index investing bias.

For fixed income investors, we would have a preference for floating rate notes and higher yielding subordinated/junior position/preference share issues of high-quality names with strong credit profiles. We prefer to wait for long bond yields to continue rising before buying fixed-rate bonds significantly.

Second, we expect continued higher volatility with financial markets, and therefore would pay more attention to timing and entry points, especially on the equities side. And rather than a “buy the index” approach, we would be selective, given fairly high valuations relative to cycle and history and the region, and given the varying range of negative/positive effects for each sector and each company to rising rates, a weaker peso, tax reform and other likely government reform moves.

Third, we are very much in the “buy on dips/major corrections” rather than in the “take profits/lighten up on strength” camp, given our fundamentally positive long view on Philippine growth prospects, both for the economy (6% to 7.5% sustainable GDP growth, depending on extent of reforms and infra build undertaken) and listed corporate sectors (9% EPS growth or better each year). Patience and discipline, in our view, will be rewarded.

Fourth, among equities, we are particularly positive, sectors-wise, on consumer-facing names (given resilient consumer spending, high consumer confidence, lift to incomes from tax reform, more inclusive growth policies and likely higher jobs creation with current government policies) and financials (given cyclical margins expansion from steeper yield curve, rising deposit spreads, and financial deepening,


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continued robust loan/deposit growth as structural drivers). We believe patience, amidst headwinds and volatility, will ultimately be rewarded as companies continue delivering revenue and earnings growth (our BDO Nomura research team projects 9% EPS CAGR for PCOMP companies in next 2-3 years).

Lastly, we continue to espouse for more currency and asset class diversification, into high quality equity names at reasonable (GARP - growth at a reasonable price) in US, Japan, Australia, Europe.

Please refer to Exhibit 39 for our BDO Nomura research team’s top Buy recommendations.

Please refer to the back cover of this report for our updated BDO House View Dashboard.

Exhibit 39: Our BDO Nomura research team’s top BUY recommendations

Stock (Rating)

Share Price (PHP) PERx EPS CAGR2017F ROE%

Comments

3/24/2017 Target Upside (%) 2017F 2018F 2015-18F %

ALI (Buy) 34.50 43.72 26.7% 20.7 18.4 14.4% 15.1% Trading at low end of PER range despite healthy EPS growth, above trend ROEs; and extensive project pipeline/land bank

CHP (Buy) 7.48 13.40 79.1% 10.1 8.9 13.1% 11.5% Current undervaluation of cement consumption growth from infrastructure development focus, notwithstanding a weak performance in 4Q16.

ICT (Buy) 87.50 92.82 6.1% 24.3 21.2 7.3% 7.8% Healthy EBITDA growth signals ramp-up of new concessions; balance sheet and cash flow at positive inflection. ROE and EPS optically depressed due to cessation of interest expense capitalization and higher depreciation & amortization levels, cashflow generation strong.

MBT (Buy) 77.45 94.45 21.9% 12.3 9.8 10.4% 9.6% Peer-leading NIMS and good VisMin coverage. Trading at 30% discount vs historical P/B.

MEG (Buy) 3.48 4.61 32.5% 9.7 8.3 9.3% 8.9% Improving earnings quality and under-appreciated land bank. Trading at 20% discount vs historical PERx. Profitability and ROEs to improve moving forward with build-up of higher-margin leasing portfolio.

MPI (Buy) 6.03 8.10 34.3% 13.7 12.6 10.5% 8.9% Profits and ROEs depressed by regulatory environment. Risks priced in but not rewards. Stock undervalued even w/o improvement in reg. environment.

PGOLD (Buy) 43.80 51.00 16.4% 18.8 16.6 13.4% 14.0% Trading below regional PER average of 21-22x 2017F earnings despite healthy EPS growth. Aggressive store rollout program (25 per annum) and healthy SSSG of +3%-4% underpin growth.

RRHI (Buy) 77.50 95.00 22.6% 19.5 17.3 12.7% 11.1% Multi-format model proxy for broad private consumption growth; net cash balance sheet and RLC link add value

SCC (Buy) 146.10 158.00 8.1% 11.7 10.0 22.5% 29.8% Regulatory risk appears overdone; cost competitive integrated power business model provides expansion opportunities

SM (Buy) 666.00 765.00 14.9% 22.8 19.8 12.1% 11.9% Dominance in key sectors. Increasing contribution of SM Retail to overall conglomerate valuations.

Source: BDO Nomura Research estimates.


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BDO MoneyTalks publications

BDO House View Dashboard: Our macro and markets outlookFebruary 24, 2017

Part 2.1: China pivot and c.US$28.5bn in agreements – infra kickstart + multiplier effects; many pointers to take away from China’s reform winsOctober 28, 2016

Part 2: Reforms + multiplier effects = double for GDP since 2002, triple for PCOMP since Oct 2006. Mean reversion, or continued gains from here?October 11, 2016

Thinking about 3-baggers, 30-baggers and beyondPart 1: The power of compounding, patience, and stock-pickingJuly 28, 2016

Nomura Securities research involving or written by BDO-Nomura Research team

Philippines infrastructure: Aggressive ramp in infra spending ahead Initiating on property, conglomerates, construction, and othersFebruary 14, 2017

ASEAN consumption: 14 stocks that could double in 5 years Initiating coverage on the Philippine consumer space and othersJanuary 20, 2017


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BDO Dashboard: our house view March 30, 2017

Metric 2015 2016 Latest 2017E 2018EDirection

2016-2018 Basis, comments, upside or downside risk

US GDP growth** 2.6 1.9 1.9 2.3 2.3 Þ Pro-growth from Trump policies + Republican Senate/House: tax reform, infra spend, regulatory roll-backs. Downside risk: trade wars, Trump/legislative gridlock.

China GDP growth** 6.9 6.7 6.7 6.5 6.4 à Gradual slowdown reflecting declining effectiveness of credit stimulus, trade headwinds. Downside risk: US trade protectionism.

Phil GDP growth* 5.9 6.8 6.6 6.3 6.5 à then Þ 2017 slowdown reflecting slower growth in exports, OFW/BPO revenues & consumer spending, offset by infra-led pick-up esp in 2H17 and 2018. Potential upside: faster infra roll-out, corporate capex. Downside risks: sharp hike in excise taxes, US clampdown on Phil BPOs (not our base case).

C (Private consumption) 6.3 6.9 6.3 6.2 6.5 à then Þ Modest slowdown from lower OFW/BPO growth, potential excise taxes

I (Gross fixed capital formation) 15.2 22.5 15.0 11.1 17.1 à then Þ 2017 normalization from surge in 2016, renewed infra-led boost in 2018

G (Government consumption) 7.8 8.2 4.2 4.2 5.8 à then Þ Upside risk: faster pace of budget disbursements, infra implementation.

X (Exports) 9.0 8.2 10.4 4.4 3.0 à Muted global trade outlook. Potential upside: China trade agreements, surge in exports to China.

M (Imports) 14.0 16.9 15.0 6.1 8.3 à then Þ Dampening effect of weaker peso, consumer spending slowdown

Phil unemployment rate* 6.3 5.4 4.7 5.0 4.8 à Bright spot reflecting corporate capex/expansion, infra rollout.

Curr acct bal, % of GDP* 2.6 1.3 1.0 0.5 0.4 à Weaker exports outlook, infra-related imports ramp-up. Upside potential: surge in China trade, continued strong growth in OFW remiitances & BPO revenues.

Fiscal bal, % of GDP* (0.9) (2.2) (2.5) (2.7) (2.8) à Higher deficit part of govt plan reflecting 10 point econ plan, increased infra spend.

USD/PHP (EOP)* (PDDONE) 47.06 49.72 50.25 51.5 51.0 à then Þ US$ strength, US rates normalization, ongoing capital flows from EM to DM, global political uncertainties, narrowing Phil current acct surplus. For historical perspective, note all-time USDPHP high was P56.5 on 3/31/04. Peso resilience/upside potential: successful/fast infra rollout, stronger actual GDP growth, faster BSP rate hikes, rising investor confidence, resumed capital net inflows.

US Fed Funds (EOP)** 0.50 0.75 1.00 1.50 2.25 Þ Still data dependent, but data coming out are positive - we expect 3 25bp rate hikes in 2017, another 3 in 2018, terminus Fed Funds rate of 2.5% to 3%

USD 3mo LIBOR (EOP)** 0.612 1.00 1.15 1.72 2.48 Þ Offshore LIBOR may rise faster than Fed Funds on crowding out effect of US corporate offshore cash repatriation (US$1.3 tln total stock) back to US.

US 10yr bond yld (EOP)** 2.27 2.45 2.41 2.89 3.20 Þ US budget deficit may rise from 2.6% to ~5% of GDP from (1) tax reform (2) infra spend. Rising bond ylds on higher inflation, govt borrowings, crowding out effect.

₱ 3mo PDST-R2 (average)~~ 2.02 1.72 2.37 3.00 Þ Current IRC mid-point and RRP rate at 3.00% could be adjusted up as BSP reacts to global EM outflows as the Fed pursues normalizing policy. Note high (>80%) correlation between USD and Phil 5 yr bond yields, i.e. upward pressure on US bond yields will feed through to 5-yr PDST R2.

₱ 5-yr PDST-R2 (average)~~ 3.51 3.64 4.51 5.00 Þ Technical resistance at 5.00% could breakout on upside due to higher UST yield trajectory, lower domestic system liquidity, and reduced capacity for local funds to warehouse GS risk.

Crude Oil (Brent) (EOP)** 37.28 56.82 50.80 51.74 51.60 Þ Demand reflation. OPEC cutbacks. However, sharper rise curbed by US fracking as key swing producer factor.

Phil CPI, % chg* 1.4 1.8 2.7 3.3 3.7 Þ Feed-through impact of weaker peso, lower unemployment, wage growth.

PCOMP (EOP)* 6,952 6,840 7,269 7,710 8,520 Þ Despite external/rate hike/other headwinds, PCOMP big stock bias makes for resilient P/E's and index upside roughly in line with PCOMP earnings progression, which we estimate at ~9% in 2017.

PCOMP forward P/E* 16.9X 15.6X 17.5X 16.6X 16.7X Þ Rising rates + higher domestic/global political uncertainties + EM to DM outflows = lower supportable P/E valuations.

Legend: Positive trend Negative trend Negative then positive trend

Negative then flat trend

Legend/source: *Source: Nomura/BDO Nomura Research. **Source: Bloomberg Consensus. ~~Source: BDO Treasury & Mkts Research.

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