Public Information Notice No. 03/87

Public Information Notice: IMF Concludes 2003 Article IV Consultation with The Bahamas

July 23, 2003

On July 2, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with The Bahamas.¹

Background

The Bahamas, a small open economy that is highly dependent on tourism, has a long track record of prudent macroeconomic management and financial stability. In the second half of the 1990s, large foreign investment flows raised growth to 4-5 percent. Policies focused on fiscal consolidation (the deficit was virtually eliminated) and the strengthening of financial regulation and supervision to address risks of money laundering and fraud in the offshore financial sector.

Growth turned negative in 2001 and remained subdued in 2002 and early 2003 under the impact of the global economic slowdown and lingering terrorism-related security concerns. With the downturn, the central government deficit widened markedly, to 3.4 percent of GDP in FY 2001/02. The new government (elected in May 2002) aimed at a gradual reduction of the deficit while supporting the recovery through selective tax exemptions. However, the deficit is estimated to have remained at 3.4 percent of GDP, with public debt rising to 36 percent of GDP at end 2002.

The tightening of monetary policy (through the imposition of a bank-by-bank credit freeze) halted the decline in reserves. Available indicators suggest that, so far, the banking system has weathered the slowdown well. The government is still in the process of shaping its structural policy agenda, and progress in this area has been limited.

Economic activity is expected to pick up gradually in 2003 and 2004 with the resumption of strong capital inflows, but the fiscal deficit would narrow only modestly, to 2.8 percent of GDP, contributing to further debt accumulation. For 2003-2004, the government debt-to-GDP ratio would still be below 40 percent. However, the debt path is vulnerable to significant downside risks related, in the near term, to slower U.S. growth and continuing security concerns and, over the medium term, to a gradual erosion in external competitiveness because of relatively high labor and utilities costs.

Executive Board Assessment

Directors commended The Bahamas' long track record of prudent macroeconomic management that led to an extended period of relative prosperity. Inflation is low, the public debt is moderate, the banking system is sound, and the country's credit rating is good. However, Directors noted that since 2001 economic growth has slowed, and the fiscal position has weakened, under the impact of the global economic slowdown and the lingering security concerns. While the economy is expected to strengthen gradually in 2003 and 2004, it remains vulnerable to developments in the United States and to growing competition from other tourist destinations and offshore financial centers.

Directors cautioned that the scope for policy maneuver has narrowed because of the weakening of the fiscal position. They recommended that economic policy focus on raising international reserves, regaining room for fiscal maneuver, and diversifying the economic base to maintain confidence and reduce economic vulnerabilities. They emphasized the importance of structural reforms to improve competitiveness over the medium term.

Directors stressed the need to consolidate the fiscal position in order to reduce the debt-to-GDP ratio and ensure fiscal sustainability, although there was support for allowing the full play of automatic stabilizers in view of the sluggish economic growth. In this regard, they supported the steps taken to contain the wage bill and recommended additional spending restraint, particularly with respect to transfers to inefficient public enterprises. Directors also encouraged action to reverse the recent decline in the tax ratio. They called for tax reform to broaden the tax base and eliminate distortions in the tax system. Improvements in revenue administration should be given high priority.

Directors considered that the fixed exchange rate peg to the U.S. dollar has served The Bahamas well, and welcomed the strong commitment of the authorities to the peg. However, noting the real effective appreciation of the currency over the last two years, they stressed that maintenance of the peg would require sound fiscal, wage, and structural policies to protect external competitiveness.

Directors recommended a gradual move toward a more flexible and market-oriented framework for liquidity and credit management. In the short term, credit restraint will be necessary until the fiscal and international reserve positions have strengthened. For the medium term, Directors thought that a prudent, gradual relaxation of foreign exchange controls could help deepen the domestic credit market and foster competition in the banking sector. These changes would need to be accompanied by adequate prudential regulations, higher foreign reserves, flexible liquidity management, and a stronger fiscal position.

Directors advised prudent use of external financing, given the need to reduce the debt-to-GDP ratio. A formal public debt management framework integrating government and government-guaranteed obligations, including those of public corporations, would help guide decisions on the appropriate balance between domestic and external debt.

Directors commended the continuing efforts to improve financial supervision and regulation, including the introduction of legislation to bring the regimes for combating money laundering and terrorism financing into compliance with relevant international standards. They recommended continued development of the framework for cooperation with regulatory agencies in other countries.

Directors emphasized that further progress with structural reform would help lower costs and preserve external competitiveness. They welcomed efforts to garner political support for reform, and encouraged vigorous implementation. They emphasized labor market reform to reduce labor costs, including the linking of wage increases to productivity increases. They commended the progress toward privatization of the telecommunications company, but noted that there is scope for increased private sector participation and efficiency in the utilities and infrastructure sectors. Directors also stressed the need to reduce trade restrictions, including the very high tariff rates, and to simplify the complex tariff structure. They encouraged greater regional integration and closer links to the World Trade Organization.

Directors welcomed The Bahamas' participation in the General Data Dissemination System and encouraged action to remove the significant gaps and inconsistencies that currently exist in the economic data. They supported the authorities' request for technical assistance to address these issues.