Asia's largest sovereign issuer of offshore bonds may post its second successive record budget deficit this year, and the key factor that will determine how markets react to the election result will be whether the winning candidate tackles the fiscal situation with sufficient urgency and resolve.

Most analysts say markets should not be too ruffled in the meantime if candidates pledge not to raise taxes or impose new revenue measures. Such promises are highly unlikely to be kept.

“Any candidate who … promises no new taxes is going to eat his words,” said an economist at a large local bank. “It's going to happen, otherwise we could lose the confidence of investors.”

The four leading presidential candidates in the May polls have all promised measures to boost the tax to GDP ratio, estimated at a five-year low of 12.8 percent last year, but most of them have given scant details on how they will do it.

Of the four, frontrunner Benigno Simeon Aquino III and former President Joseph “Erap” Estrada, ranked third in opinion polls, are the only ones who have declared they would not impose new taxes or raise tax rates and would instead focus on plugging tax leakages that have kept state revenues low.

But Aquino softened his stance in February when he told reporters he would consider raising taxes if the budget gap was not quickly cut by a crackdown on tax evasion.

Aquino was aiming to soothe market worries that he did not grasp the urgency of raising state revenues. Analysts and traders say they largely ignored his first statement on taxes in January because they did not expect him to stick to it if he won power.

But if the next president does try to avoid new taxes, this will be punished with a sell-off of Philippine assets by markets worried about the precarious fiscal position.

Intensive care
“The government is like a patient in an intensive care unit and it needs to raise taxes as the prescribed medicine to recover fast,” Jonathan Ravelas, chief market strategist at Banco de Oro Unibank, told reporters.

Traders say offshore investors would sell out wholesale from the Philippines if there was any sign the next president will introduce drastic changes to economic policy that quickly show positive results via higher state revenues.

“Remember, especially the offshore investors, they don't care what happens to the country. They only want to make sure that they get paid,” said a treasury official at a foreign bank. “The moment you inject some scepticism on the ability of this country to pay, they will dump you while they can.”

The Philippines' five year credit default swap spreads are trading at 162 basis points compared to a weighted average of 120 for the Thomson Reuters Emerging Asia Index. Spreads have come down from a peak of 217.5 basis points this year after the official campaign period kicked off on February 9, but traders say they will quickly widen again if the likely election winner does not set out a clear economic plan.

Yields on Philippine sovereign bonds due in 2020 are hovering at three-month lows, suggesting that investors do not expect a fiscal blowout in the near term after the country completed its planned 2010 foreign debt issues of $2.5bn pesos ($54.79m) just two months into the year.

But ratings agencies may downgrade the country's sovereign credit from the current two notches below investment grade if Manila doesn't raise revenue collection soon.

The government is likely to incur more foreign and local debt to fund its budget deficit, thus reversing gains made since its 2005 tax reform programme.

But there is minimal risk for now of a Greece-style panic that that Manila would default on its debts. It has reduced its debt-to-GDP ratio to around 57 percent from a peak of 78 percent in 2004.

More tax reforms
All the top candidates also espouse stamping out a deeply entrenched culture of corruption at revenue agencies to improve tax collection, but analysts say such a lofty ambition would take years to implement and major results are unlikely to be seen in the first six months of the new administration.

Finance Secretary Margarito Teves said the low revenue base would make it difficult for the new government to fund higher spending on badly needed infrastructure upgrades and better social services, suggesting more tax reforms might be necessary, especially after the government passed several new laws, with others still pending, seeking to give tax exemptions.

Teves partly blames lost revenues of 49 billion pesos from tax exemptions imposed last year for the record 2009 budget deficit of 298.5 billion pesos, or 3.9 percent of GDP. Manila was hoping to limit its shortfall last year to 250 billion pesos.

Some analysts expect Manila's budget gap to exceed 300 billion pesos this year, another record high.

Economists say the next government could raise revenues by tweaking excise taxes on alcohol and tobacco. VAT of 12 percent could also be raised to 15 percent, a proposal administration candidate Gilberto Teodoro wants to adopt in exchange for lowering individual income and corporate taxes.

Former Philippine economic ministers have said there is room for substantial cuts in the funding allocation for pet projects of legislators, more widely known as pork barrel, and in the spending subsidies given to local government units.

The Philippines avoided a possible financial crisis in 2005 when President Gloria Macapagal Arroyo raised the VAT rate to 12 percent from 10 percent and expanded its coverage to include electricity and petrol sales.

That helped cut the budget deficit to 68 billion pesos, or 0.9 percent of GDP, in 2008 from a 2002 peak of nearly 211 billion pesos, or 5.3 percent of GDP. But the shortfall ballooned again last year when corporate incomes dropped due to the global economic crisis and as Manila spent more on infrastructure upgrades and social services to pump prime the economy.