Kingdom of the Netherlands - Netherlands Antilles -- 2005 Article IV Consultation, Preliminary Conclusions of the IMF Mission
December 12, 2005
1. The Netherlands Antilles is at a crossroad. Curaçao and St. Maarten will adopt status aparte, while Bonaire, St. Eustatius and Saba will be integrating more closely with the Netherlands. Greater self-determination provides an opportunity to address social and economic problems in a more island specific context. It comes with the responsibility to give the future countries a clear direction, and implement a set of coherent policies that deliver higher growth on a sustained basis, which is key to reducing unemployment and alleviating poverty. A stable macroeconomic framework is essential, and structural reforms are also needed to better exploit the potential for higher growth and the opportunities offered by globalization. In the context of the ongoing Round-Table discussions on the future relations within the Kingdom, the Netherlands has offered support. Conditional on future fiscal discipline, the Netherlands has committed itself to find a solution of the debt problem, which the Antillean authorities see as the major obstacle to their economic development. The Netherlands Antilles' central and island governments on their side have pledged to adopt responsible fiscal policies, including binding budget rules, supported by improved transparency and strengthened fiscal management. We call on all parties to display flexibility, discipline and speed in the negotiations, as economic problems need urgent resolution.
2. The Antillean economy has barely grown in this decade and income per head has declined. GDP growth is projected to accelerate to about 1½ percent in 2006, led by domestic demand, while the negative contribution of net exports becomes smaller. Private investment is expected to pick up, helped by the extension of two airports and several hotel projects that will boost construction activity. Private consumption should benefit from the reduction in income taxes. Consumer price inflation should slow to below 3 percent, as the impact of oil prices peters out. The economic outlook is, however, subject to considerable risks, with uncertainties linked to break up of the federation, sizeable fiscal problems, and tensions between major trade partners on the downside, and the chances of bringing forward large investment projects on the upside.
3. The pace of growth has been uneven among the islands. Following its strong recovery from the post-September 11 decline in tourism, St. Maarten is expected to stay on a healthy growth path, and is significantly expanding its hotel capacity. Curaçao's growth has been anemic, though recent developments in tourism, and the prospect of major investments, including in the refinery, are encouraging. The agreement with the Netherlands on the taxation of dividends is good news for Curaçao's offshore business and is expected to slow its trend decline. However, high unemployment persists, especially among the young, while poverty and crime rates have risen.
4. After three years of deterioration, public finances in 2005 show signs of improvement. However, the reduction in the overall budget deficit is entirely due to a one-off windfall (dividend tax revenues from the Netherlands) while the underlying fiscal situation has not improved. The general government debt ratio will reach 86 percent of GDP. The 2006 budgets of the central and Curaçao governments fall short of what is necessary to make a dent into public debt, although they foresee a small underlying adjustment in the order of ½ of a percent of GDP. However, it is unclear how these savings will be achieved, as no specific measures have been announced to date. In addition, revenue losses from the income tax cut are not fully reflected. The mission urges the authorities to execute the 2006 budget rigorously and use all available margins to achieve a primary surplus of at least ½ of percent of GDP. In 2007, to start building a buffer against shocks, the aim should be to achieve a primary surplus of at least one percent of GDP, which is feasible by further improving tax collection, exercising strict expenditure discipline, including on personnel, and implementing reforms in health care and pension systems without delay.
5. Reforms in health care and pension systems are needed to help reaching a sustainable position of public finances in the medium term, and support employment and economic growth. The state has provided comprehensive benefits to its citizens that are outstanding within the region, including free universal education, a high standard of health care, social assistance and a general pension. But the rapidly rising cost of the health care system absorbs an ever larger share of budgetary resources, raises the price of labor and crowds out spending on education and investment. Identified savings opportunities should be exploited swiftly, including through more competitive pricing and imports of pharmaceuticals from neighboring markets, better management of hospitals and removal of barriers to entry into the medical services markets. A gradual increase in the retirement age is also necessary to safeguard the actuarial balance of pension systems in view of the increase in life expectancy.
6. Earlier plans for a comprehensive tax reform that aimed at a reduction of high marginal income tax rates with offsetting base-broadening measures and a shift toward higher indirect taxes have been partially executed. While personal income tax rates were reduced by up to 6 ½ percentage points (at the top) in 2005, and another 6 percentage points cut is planned for 2006, the other reform elements were shelved. The reduction in marginal tax rates is likely to have a positive impact on economic activity, but the annual revenue loss from the income tax cut is substantial and ill-afforded given the current budget situation. Therefore the authorities would be well-advised to introduce offsetting measures or consider postponing the second phase of the tax cut. The planned replacement of the current sales tax by a VAT has been appropriately put on hold as, with incomplete preparations, revenues would be placed at risk. In addition, the benefits of eliminating the cascading features of the sales tax have to be weighed against the administrative cost of a much more complex tax, taking into account the small size and administrative capacity of the Antillean economy.
7. The island government of Curaçao has created an energy fund to mitigate the detrimental impact of high oil prices on the economy. The authorities are concerned that a further rise in utility prices would hurt vulnerable households and drive business from the island. The mission understands these concerns, but advises against the subsidization of energy prices, which distorts price signals and reduces incentives to raise energy efficiency. It will be important to terminate the energy fund as planned in 2006, as it risk otherwise becoming a permanent drag on public finances. The subsidy should be gradually phased out by end-2006, and substantial part of its financial resources should be saved.
8. We support the joint efforts of the Netherlands Antilles and the Netherlands authorities to establish a sound financial starting position for the future countries of Curaçao and St. Maarten, as well as for the smaller islands, and to lay the foundations for well-managed macroeconomic policies. While agreement has been reached on a number of important principles, opinions differ with respect to the appropriate design of fiscal rules. With respect to balanced budget rules, two crucial issues have emerged: borrowing limits and enforcement.
9. On borrowing limits, the islands have expressed concerns that restrictions on their borrowing capacity could hamper economic development, if applied to capital spending. While a "golden rule", which allows borrowing for capital spending, has economic merits (i.e., tax smoothing), political economy arguments may play against it. In any case, to avoid unlimited debt accumulation, a golden rule would have to be supplemented by a debt ceiling, the prudent level of which is difficult to determine without prior establishment of a track record of sound fiscal policies. Alternative options to finance capital spending, such as the establishment of a public investment fund, could usefully be explored.
10. The second issue is that of enforcement and compliance. There are in principle two approaches to ensure durable compliance with the commitment to fiscal discipline: one is based on institutions, the other on economic incentives. In case of a solution to the debt problem that involves a complete debt takeover by the Netherlands (an irreversible step), compliance can be achieved by setting up appropriate institutions, such as a constitutional budget law and an independent institution with enforcement powers. Alternatively, if the solution to the debt problem was to alleviate its financing burden, it could in principle be closely tied to fiscal performance, as to achieve compliance through economic incentives. A give-and-take strategy could also include a mechanism for gradually retiring the debt, conditional on a the establishment of a track record of prudent fiscal behavior. Obviously, there are a variety of possible intermediate solutions.
11. A well-designed budget rule should ideally be supported by a broad political consensus and become enshrined in constitutional law. Although such a law is no substitute for a firm political commitment to fiscal discipline, it can be particularly useful to overcome governance problems, a frequent source of fiscal indiscipline. The law should cover all fiscal and quasi-fiscal operations of the public sector, and define a simple, transparent fiscal indicator against which budget outcomes can be measured. Escape clauses should only apply in very exceptional circumstances, such as natural disasters, to minimize the risk of weakening the binding character of rules. As a shelter against economic shocks, an appropriate annual primary surplus target should be set to build up a contingency fund, ideally held in foreign exchange reserves. We recommend a primary surplus of 1 percent of GDP in excess of that needed to stabilize any remaining debt ratio (which could be zero) until the size of the fund has reached a target level that is sufficient to cover island-specific uninsured risk.
12. Good practices in transparency and accountability can help improve fiscal performance. The authorities should adopt and swiftly implement their plans to strengthen financial management and accountability, clarify procedures to formulate and execute budgets, and reinforce independent budgetary audits. To better allocate scarce budgetary resources and help avoiding wasteful spending, more resources should be devoted to developing a medium-term fiscal framework. This would also make policy priorities more transparent and subject them to the scrutiny of voters.
13. A political decision to integrate tax collection services at the island level has been taken, and awaits its implementation. The necessary preparatory work at the administrative level appears to be sufficiently well advanced so that the integration could be carried out at short notice. Wasteful overlap can be avoided and the very limited staff resources be redeployed to priority areas, resulting in higher tax collection. Timely adoption by parliament of the draft law to decentralize the tax inspection service would be welcome and consideration should be given to consolidating both tax administrations into an integrated revenue service, which could be transferred to the island governments in preparation of their new status.
14. The long-standing peg to the U.S. dollar has served the economy well. It has delivered low inflation and imposed some discipline on economic policies. Its credibility has kept interest rate differentials with the U.S. narrow, even though expansionary fiscal policies have frequently run counter to the requirements of a fixed exchange rate regime. Within the foreseen new constitutional arrangements, a monetary union with an independent central bank for all five islands, which could build on the experienced staff and reputation of the BNA, would be a resource-efficient way to manage the peg. Financial sector supervision could also usefully be located in the central bank. In this context, we welcome efforts to establish an even closer cooperation with the supervisors within the Kingdom of the Netherlands.
15. Structural reforms need to be revived in order to raise productivity and potential growth and to reduce poverty on a lasting basis. Improved industrial relations provide a climate conducive to reform, with labor unions and employer organizations prepared to work together with the government (colaborativo) to improve economic performance. Raising labor productivity is key to creating jobs and raising the standard of living for Antillean citizens. The free movement of labor to the Netherlands has resulted in wages that are detached from the current level of productivity. Consequently unemployment is high, while vacancies cannot be filled, due to a mismatch in the labor market. As the lack of economies of scale imposes limits on diversification, the use of development funds should be better targeted. Markets should be deregulated to set free entrepreneurial spirits in search of niches, and the costs of doing business reduced to improve the economy's attractiveness for investment in productivity-enhancing technologies and increased tourism capacity. Local and foreign investment is more likely to be forthcoming following appropriate structural reforms, and its effect on growth can be very significant. Policy action in the following areas is necessary:
• Labor markets. Dismissal rules should retain safeguards against discrimination and other forms of abuse, but need to be adapted to allow a more flexible use of labor, in particular in jobs with seasonal variation in demand, such as tourism. Similarly, working-time and opening hours regulations need to be relaxed to better accommodate variations in demand. Child care facilities need to be provided, and their quality improved. The poorly functioning school system, which has led to many drop-outs, needs urgent attention. Work permit procedures should be simplified to fill low-paying jobs in the service sector and contain illegal immigration.
• Product markets. The management of public enterprises needs to be strengthened, and utilities should become more efficient to achieve lower electricity and water prices on a durable basis without burdening the budget. Privatization is the best option for most public enterprises, including UTS, Curoil, the dry dock and Isla. Curaçao's oil refinery has become a valuable asset, but needs significant investments to meet environmental standards and improve product quality, which are however unlikely to be forthcoming unless potential investors have a stake in the company. Privatization should be pursued with emphasis on raising budget revenues while realizing the potential for lower-cost electricity production. In addition, privatization is instrumental in creating─on a small scale─an equity market that provides investment alternatives for local investors. An independent regulatory agency should be established to safeguard the public interest against monopoly power, and to reassure international investors. The complementarities of better airlift services are well known, but we advise against state participation in a new national air carrier. The authorities should implement swiftly all OECD recommendations to improve the investment climate (Caribbean Rim Investment Initiative).
• Trade. The elimination of the import surcharge and the maintenance of a trade environment free of non-tariff barriers are commendable, will enhance consumer welfare, and provide incentives to improve efficiency. The authorities' proactive approach toward WTO accession is welcome. However, there is a need to further lower external tariffs, which according to World Bank estimates are significantly above the corresponding level in neighboring CARICOM countries.
16. The financial system continues to be sound, resilient to most potential adverse shocks, and well supervised. Banks' returns have improved as the demand for credit increased, despite low economic growth. Even though the amount of non-performing loans has fallen, prudent bank behavior has resulted in increased provisioning. Insurance firms and pension funds, like banks, benefited from relatively higher security prices, and the increase in interest rates eased the challenge posed by a low-yield environment on insurance companies. Any solution to the debt problem will need to take into account its impact on capital markets. In this context, financial supervisors and policymakers will have to monitor closely markets and investors' portfolio management. In addition, it is important that fiscal arrears to pension funds do not adversely affect the risk profile of institutional investors' portfolios.
17. The authorities' responsiveness to the recommendations made in last year's Assessment of the Supervision and Regulation of the Financial Sector is commendable. Actions have already been taken on several recommendations. These include the new provisions for the disclosure of consolidated financial highlights of domestic financial institutions; advances toward harmonizing various legislations to diminish the disparity between onshore and international supervision requirements, including those pertaining to administrative fines and MOUs for the exchange of information; enhanced transparency of the boundaries of responsibility between onsite and offsite supervision of insurance companies; the end of the process of registration and dispensation requests of company service providers, the completion by the end of this year of the obligation to file reports at the BNA, and the start of on-site examinations planned for the second quarter of 2006; improvements in the guidelines for the detection and deterrence of AML/CFT including the screening of applicants for employment.
18. The Netherlands Antilles agreed with the United Nations Development Program (UNDP) and the World Bank (WB) to undertake a poverty reduction program. In addition to structural measures, the program proposes a number of short-term actions, including education and training, neighborhood and infrastructure improvement, social development (e.g., single and teenage parenthood, youth and elderly care, and care for drug addicts), health care as well as measures to alleviate labor market mismatches. Several areas of poverty alleviation have been identified and consensus has been reached on the causes of long-term unemployment. The authorities are encouraged to move to implement the recommendations of the UNDP and WB program. Following up on the program conclusion that the principal cause of unemployment (and the poverty and social exclusion that ensue), is not the absence of jobs, the authorities should remove incentives to drop out of the labor force, generalize mean-tested social benefits and improve their targeting, enforce controls and penalties to increase the supply of work effort, and separate social welfare from transitory unemployment assistance.
19. Despite progress in a number of areas further improvement in national accounts, wage and employment data, the coverage and presentation of public finance data, and of balance of payments statistics are needed.
20. The mission would like to thank the authorities for their hospitality and cooperation. We wish that the new countries of Curaco and St. Maarten, and the islands of Bonaire, Saba and St. Eustatius will meet with success. To that end it is important to start the new status on a good footing, with a commitment to sound fiscal policies and structural reforms.