Widening trade deficits are usually seen as a policy problem, and understanding the pattern and sources of the deficit is important to help us formulate the correct policy advice. From a macro perspective, deficits are explained partly by economic growth and changes in relative prices measured by real effective exchange rates. Microeconomic factors also play a role, particularly the declining competitiveness of our industries and failure to upgrade and move up the global value chain.
From the 1980s till the 1990s, we embarked on a unilateral trade liberalization policy that reduced tariffs and removed quantitative import restrictions. Towards the mid-1990s, we committed to reduce tariffs through the ASEAN trade schemes. From an import substitution strategy, the thinking then was by removing trade distortions and allowing markets to work through more competition from imports, domestic industries would become more competitive. This was expected to lead to the growth of industries and the shift towards an export-oriented strategy.
However, the structural transformation promised by opening up the economy has remained elusive. As our experience in the last 40 years has shown, the more open the economy is, the higher the trade deficits. The country’s deficits are high even in relation to those countries we signed free trade agreements (FTAs) with.
Two simple measures are often used in analyzing trade deficits: trade deficit/GDP ratio, which measures trade imbalance, and trade/GDP ratio, which measures trade integration. The trade deficit is the difference between exports and imports, while trade is the sum of exports and imports.
Figure 1 shows that in a span of four decades, perennial trade deficits were experienced except in 1999 and 2000. Our trade to GDP ratio rose from 43% in 1980 to 93% in 2004, but started to fall thereafter with some improvement in the more recent years. A positive correlation between the deficit to GDP ratio and the trade to GDP ratio is evident, which implies that as trade integration rises (falls), deficits also increase (decline). For instance, the deficit to GDP ratio increased substantially from -4 percent in 2015 to -14.7% in 2018. Trade openness was also rising from 43.8% in 2015 to 54.7% in 2018.
Table 1 presents our average trade deficit ratios by trading partner. We have trade deficits with FTA partners like ASEAN, Korea, China, and Japan and surpluses with countries such as the US and from the European Union where FTAs have not yet been concluded although both provide tariff preferences to our exports. Our average deficit with ASEAN increased from -0.86% during the 1980s to -6.8% during 2010-2018. In 2018, our deficits reached -US$17.8B.
Deficits were present in a wide range of products; the largest were in transport equipment and petroleum. Trade surpluses were few with the most significant found only in special transactions and electrical machinery.
Within ASEAN, Indonesia has been the largest source of deficits amounting to US$5.9B in 2018. Our deficit/GDP ratios with China deteriorated from a small surplus in 2000-2009 to a deficit in 2010-2018. With South Korea, the country’s deficits remained, although a decline in the ratios is observed.
In the case of Japan, trade deficits were sustained from the 1980s till the early 2000s, although these were closed in the recent period. Recently, deficits are again starting to surface from -US$928M in 2017 to -US$1.94B in 2018.
The Philippines has always been in a trade surplus position with the US, although this has been declining substantially from 1.9% of GDP in the 1990s to 0.42% in 2010-2018.
In the last four decades, clothing has been the biggest source of surplus with the US registering an average share of 1.46% of GDP in the 1990s to 1.71% in the early 2000s, but this declined substantially to only 0.35% in the current period. The same declining trend is observed for the other products where we have a surplus with the US.
With the EU, the Philippines has been running trade surpluses from an average of 0.41% of GDP in the 1980s to 3.14% in the early 2000s, but which was not sustained as the average dropped dramatically to only 0.35% in the current period.
Most of the products where we have huge deficits consist of intermediate goods like petroleum, iron and steel, chemicals, and plastic as well as final products such as transport equipment, paper, coffee, dairy, meat, and cereals and cereal preparations. In the same period, trade surpluses were observed mostly in electrical machinery and apparatus, wood and cork manufactures, clothing, fruits and vegetables, fixed vegetable oils and fats, and metalliferous ores.
Philippine manufacturing has been largely dominated by food processing followed by electronics. While manufacturing growth has been quite remarkable from 2010 to 2018 averaging at 7.3%, its average contribution to GDP has remained stagnant at 22.8%. The reasons are:
First, the main orientation has been largely on the domestic market. This is shown by the declining trade/GDP ratio from 2004 to 2015, indicating a less open and more inward-oriented economy as resources went to non-tradable sectors like construction and real estate.
Second, manufacturing has been largely characterized by broken supply and value chains with many of the necessary materials, supplies and intermediate parts missing in the domestic market. With a highly fragmented domestic production system, manufacturers have to depend on imports.
Third, the peso appreciation has made imports much cheaper, thus weakening industry competitiveness.
Fourth, the absence of a strategic industry development program in the past has made it difficult to attract complex and high value exports.
Export expansion requires upgrading our global value chain (GVC) activities. Our current participation in the electronics GVC is mostly limited in the back-end, low value stages of assembly, process, and test. This makes us vulnerable to any shock that raises the cost of manufacturing leading to the transfer of operations to relatively low-cost countries.
In the auto GVC, our role is limited to manual transmission assembly, with parts imported from Japan and exported to regional auto hubs, Thailand and Indonesia. We import the completely-knocked-down packs for Vios from Thailand and Innova and Avanza from Indonesia.
To increase our exports, we need to upgrade our GVC position by diversifying into strategic parts and components manufacturing. We have to produce these at costs much lower than Thailand or Indonesia and attain scale economies in auto production to be assigned as a regional export hub. The Comprehensive Auto Resurgence Strategy Program aims to jump-start the development of the auto industry. Vehicle demand is expected to reach one million by 2027. Without domestic manufacturing, this would be served by imports from Thailand and Indonesia.
An industrial policy is crucial to upgrade our GVC participation, address missing markets and establish a more integrated production system that will reduce our overdependence on imports. Without increasing our exports, the current pattern of rising deficits as we increase our integration with other economies will persist. A carefully crafted industry support scheme that is time-bound, targeted, transparent, and performance-based is necessary given the need to attract investments that will bring in new technologies such as artificial intelligence, robotics, Internet of Things, 3D printing, etc. and will incentivize firms to upgrade and move up the value chain, reskill and upskill their workforce, invest more in R&D, and promote start-up development.
Rafaelita M. Aldaba is a Senior Fellow at Action for Economic Reforms and is Undersecretary for Competitiveness and Innovation, Department of Trade and Industry.
