Manila's main stock market index slumped as much as 4.2% and the peso fell nearly half a per cent against the dollar on Monday in reaction to a Supreme Court ruling late on Friday that froze an expanded sales tax seen as crucial to cutting the budget deficit and attracting investors.
"It's hard to catch a falling knife," said Astro del Castillo, managing director at First Grade Holdings in Manila. "The supposed medicine that will cure our fiscal illness was somehow withdrawn."
The opposition, which wants Arroyo to quit over the allegations, has challenged the constitutionality of part of the tax package, but there is speculation the president may have leaned on the court to help defuse anger over rising prices.
All of the Supreme Court justices appointed by Arroyo voted to freeze the broader tax, which had come into effect for just 18 hours on Friday.
The new law would have raised prices by applying sales tax to previously exempt items such as power and fuel.
The government denied having any influence on the ruling and said it would file a motion on Monday to have the freeze lifted.
But analysts said a final ruling could take months from the start of hearings on 26 July and that the damage had been done.
"Resignation would prevent the person from dragging the whole Philippines down, and we feel it has reached that point"
De La Salle University president
Foreign investors, ratings agencies and economists had cited the expanded value-added tax as the main cause for optimism that the government could get its $3.3 billion budget deficit under control and reduce its heavy dependency on debt.
Traders said the peso was saved from a heavier fall on Monday by sustained central bank dollar-buying around 56.10.
Philippine dollar bonds held steady on Monday after they had fallen on Friday in the wake of the freeze on the tax package.
But Citigroup said it had cut its weighting on Philippine bonds to "neutral" from "overweight" due to the court ruling and the allegations against Arroyo.
"We think these two uncertainties are enough to justify recommending that investors take a more cautious view in the near term and wait to see how legal and political developments pan out," the bank said in a report.
The country's leading newspaper reported on Monday that Arroyo was losing some support from the middle class and the Roman Catholic Church - two of the key constituencies behind her rise from vice-president amid mass protests in 2001.
Arroyo may be losing support
from the Roman Catholic Church
The Philippine Daily Inquirer said administrators of De La Salle University, an upscale Catholic college with 100,000 students nationwide, had joined calls for Arroyo to quit.
"Resignation would prevent the person from dragging the whole Philippines down, and we feel it has reached that point," university president Armin Luistro was quoted as saying.
The paper said two lawyers' groups and faculty members of the prestigious University of the Philippines' law school had also joined calls for Arroyo to step down.
Analysts doubt the opposition, which also accuses Arroyo's family of graft, can muster the support needed for a successful impeachment attempt in Congress. Street protests against Arroyo have so far been relatively small.
But Arroyo's apology last week for a "lapse of judgment" in talking to an election official during vote-counting in 2004 and the exile of her scandal-prone husband have failed to defuse a crisis that threatens to paralyse her reform agenda.
"In many respects, Mrs Arroyo has become a premature lame duck president"
Pacific Strategies & Assessments
Media reported her husband, Jose Miguel, had returned to the Philippines from a brief stay in Hong Kong but would soon leave for the United States.
"In many respects, Mrs Arroyo has become a premature lame duck president," risk consultants Pacific Strategies & Assessments said in a report.