Public Information Notice No. 09/126

Public Information Notice: IMF Executive Board Concludes 2009 Article IV Consultation with the Solomon Islands

November 4, 2009

On October 16, 2009, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Solomon Islands.¹

Background

Economic conditions in the Solomon Islands have weakened in 2009, given the effects of the global recession and a logging sector decline. Real GDP growth is projected at 0.4 percent this year, compared to 6.9 percent in 2008. On the positive side, inflation pressures have eased substantially, mainly owing to lower fuel and food prices. An expected drop in timber exports has been more than offset by the lower cost of commodity imports, leading to a projected narrowing in the external current account deficit to 11 percent of GDP in 2009, from around 19 percent in 2008.

In light of the slowdown, the fiscal position will likely weaken in 2009, with possible financing constraints. The overall fiscal balance is expected to slip into a deficit of around 0.4 percent of GDP this year, as compared to a surplus of 1.5 percent of GDP in the previous year. Affecting this are lower timber-related tax receipts and weak spending controls, despite measures taken by the government to conserve cash. As a result, its cash position is expected to remain under strain in 2009 and possibly the next few years, absent further fiscal adjustment and new external assistance.

At the same time, liquidity conditions have tightened, with external inflows and deposit growth slowing significantly. Private sector credit is projected to rise by only 6 percent this year, compared to 26½ percent in 2008. The exchange rate vis-à-vis the U.S. dollar has been allowed to weaken modestly since mid-2008, but in real effective terms it has increased substantially, possibly adding to external pressures.

In the near to medium term, growth is expected to remain below the levels observed in recent years. Although recovery of the global economy and new foreign direct investment, especially in mining and telecommunication sectors, could provide a lift to the economy in 2010, declining logging and ancillary activity will likely act as a drag to income and employment, fiscal revenue, and export receipts over the medium term. In the event, both the fiscal position and current account could come under more strain, with the possibility of large and unsustainable macroeconomic imbalances.

In order to place the economy on a more stable path and lay down the conditions for higher sustained growth, policy measures should be adopted to strengthen the fiscal position, reduce external vulnerabilities, and improve the overall investment climate. On the fiscal front, more efforts are needed to broaden the revenue base and contain recurrent spending, especially in view of the current cash and borrowing constraints, which may persist for some time. In this light, the 2010 budget should be geared toward a modest surplus.

Regarding monetary policy, the current accommodative stance appears appropriate. However, greater exchange rate flexibility may be needed, in view of tight liquidity conditions and to protect foreign reserves. Over the longer term, additional monetary control will need to come through development of new policy instruments and a strengthening of the liquidity management framework.

The banking system appears well positioned against the current slowdown, but given rapid credit expansion in earlier years and signs of rising liquidity and credit risks, tight enforcement by the Central Bank of Solomon Islands of new prudential rules will be important to ensuring sound financial performance and proper risk management control by banks.

Creating conditions for higher growth in nonlogging sectors is essential to improving the fiscal and external position, providing new employment opportunities, and reducing vulnerability to shocks. In addition to maintaining a stable macroeconomic environment, further structural reforms aimed at lowering operating costs and ensuring better access to land are also needed.

Executive Board Assessment

Executive Directors noted that the Solomon Islands faces a more challenging environment than in the recent past. The impact of the global recession and lower logging output could dampen short-term growth prospects, undermine the fiscal position, and increase external vulnerability given projected reserve losses. Against this background, Directors encouraged the authorities to continue to gear macroeconomic policies toward maintaining stability, while pressing ahead with essential structural reforms aimed at strengthening public administration, improving the business climate, and diversifying the production base.

Directors advised the authorities to address the increasingly unsustainable fiscal situation, given possible permanent losses in logging-related revenues, relatively large expenditure outlays, and government financing constraints. They highlighted the need to tighten fiscal policy to conserve cash and avoid external pressures in the near-term through greater spending discipline, especially in nonessential recurrent areas and the government wage bill, which could also avoid squeezing out domestically financed development spending. Directors welcomed the authorities’ intention to adopt an internationally accepted tax regime for the emerging mining sector, with the help of Fund technical assistance.

Directors agreed that medium-term fiscal sustainability hinges on steady implementation of structural fiscal reforms aimed at strengthening revenue administration and reducing tax and customs exemptions, as well as improving cash management, budget integration, and accounting and auditing functions. They underlined the importance of additional external budget support to safeguard essential social spending and help secure more lasting fiscal adjustment. In view of the continued moderate risk of debt distress, Directors commended the efforts to implement a sound debt management strategy.

Directors noted that the current accommodative monetary stance is broadly appropriate, given the moderation of inflation. They encouraged the authorities to improve the liquidity management framework to strengthen the central bank’s effectiveness, including through the development of short-term debt instruments and new standing facilities, which would also help to promote interbank activity. Directors welcomed the authorities’ intention to use the recent SDR allocation to boost reserves, given external pressures.

Directors noted the staff’s assessment that the exchange rate appears to be substantially overvalued, which could undermine medium-term external sustainability. In this context, Directors generally considered that greater exchange rate flexibility could help improve overall competitiveness and facilitate external adjustment, while noting that this should be accompanied by efforts to improve transportation infrastructure, reduce operating and borrowing costs, and streamline business regulations.

Directors welcomed the timely steps taken to strengthen banking supervision, while highlighting that credit and liquidity risks necessitate close monitoring. They encouraged banks to bring risk management controls in line with parent bank operations. Closer monitoring of the National Provident Fund would also be useful, given the recent impact of adverse global conditions on operating income.