Public Information Notice No. 99/29

Public Information Notice: IMF Concludes Article IV Consultation with Grenada

April 2, 1999

On March 23, 1999, the Executive Board concluded the Article IV consultation with Grenada¹.

Background

Grenada carried out important reforms during the early 1990s, which included a restructuring of the civil service, acceleration of privatization, and trade liberalization. Progress in these reforms and the pursuit of prudent macroeconomic management helped restore private sector confidence and economic performance improved. While continuing the reform effort, the government that took office in 1995 sharply reduced the personal income tax and accelerated the investment program. This helped bolster economic activity and employment, but also led to a large increase in the fiscal deficit and a rapid deterioration in the external current account.

Driven by a sharp increase in domestic demand, real GDP growth rose from about 3 percent a year in 1995–96 to nearly 5 percent a year in 1997–98. In both years, robust growth in construction and trade activities more than offset the relatively weak performance in agriculture and manufacturing. Inflation decelerated from an average of 2.5 percent a year during 1995–96 to an average of just over 1 percent a year during 1997–98, mainly reflecting the local currency’s peg to the U.S. dollar and a decline in import prices.

The public finances deteriorated markedly in 1997 and remained weak in 1998. Central government savings, which exceeded 2 percent of GDP in 1995–96, virtually disappeared in 1997–98, reflecting a combination of weak revenue performance and higher current expenditures. With capital expenditures also rising rapidly, the overall deficit of the central government increased from an average of about 2 percent of GDP in 1995–96 to an estimated 6 percent of GDP in 1997–98. Savings of the rest of the public sector improved somewhat, but with increased investment expenditures its overall balance deteriorated. The consolidated public sector deficits in 1997–98 were financed largely by divestment proceeds and bank borrowing.

Growth in broad money has accelerated over the past two years, and has been significantly faster than GDP growth, in part mirroring the large inflows of private transfers. However, bank credit increased even faster, resulting in a sharp decline in the net foreign assets of the banking system. Despite the high credit demand, interest rates remained broadly unchanged, owing to competition as well as large foreign borrowing by banks.

The current account deficit of the balance of payments widened from an unusually low 2.1 percent of GDP in 1995 to 13.2 percent in 1997 and to an estimated 17.5 percent in 1998. The deterioration reflected mainly a surge in imports. Although exports recovered on the strength of higher prices of nutmeg and mace, they continued to represent only about one-sixth of dollar imports. The deterioration in the current account has also been affected by the relatively modest growth of tourism, a major source of Grenada’s foreign exchange earnings. The current account deficit in 1998 was more than covered by large inflows of official and private capital. External public and publicly guaranteed debt was steady in dollar terms, but declined in relation to GDP during 1995–97. However, it rose very sharply in 1998 to an estimated 29 percent of GDP. The external debt service burden remains low at about 6 percent of exports of goods and nonfactor services.

Structural reforms progressed satisfactorily in 1997–98, with the government selling most of its remaining shares in two commercial banks, the radio and TV station privatized, the Post Office moved off budget and outside government control, and import tariffs reduced further under the CARICOM tariff agreement.

Executive Board Assessment

With a view to stimulating economic activity, the government that assumed office in 1995 has pursued an expansionary fiscal policy with sizable personal income tax cuts and a sharp increase in public investment. The result has been a visible acceleration in demand and output growth, but also a rapid deterioration in the public finances and a widening of the external current account deficit, which raises serious concerns about the medium-term sustainability of the output growth. The policy strategy for sustained growth should emphasize, instead, improvements in economic efficiency and competitiveness in an environment of macroeconomic stability. Such a strategy will depend critically on the expeditious and sustained pursuit of fiscal consolidation, which in turn calls for a deepening of structural reforms particularly in the tax and wage areas. The policy focus should emphasize early actions involving: (I) the reduction of tax exemptions; (ii) the overhaul of the public sector wage policy; and (iii) improved prioritization of investment projects.

Executive Directors supported the authorities’ intention to sharply curtail ad hoc tax exemptions. These widespread exemptions not only are costly and inequitable, but also distort the efficiency in resource allocation, thereby reducing Grenada’s growth potential. A fundamental problem of Grenada’s current tax system is heavy dependence on imports, with high tax rates that encourage "rent-seeking" by businesses. The authorities are considering the eventual introduction of a VAT; Directors recommended that such an initiative be implemented promptly.

Directors attached the utmost importance to the overhaul of the current public sector wage policy that is being considered by the authorities. The present system results in unsustainable wage costs and fails to provide adequate incentives to improve performance. The reform should involve (i) an overall ceiling for the wage bill; (ii) the elimination of three-year bonus awards; and (iii) the installation of an effective merit-based pay system. Such a change will also assist in government efforts to improve public services, particularly in health and education, and improve competitiveness by dampening wage demands in the private sector.

The government should review its public sector investment program to ensure consistency with its development priorities and macroeconomic policy requirements. Emphasis should be given to projects that are financed largely with concessional assistance and that promise an adequate rate of return. In this connection, Directors were concerned about the potential budgetary implications of the planned construction of a large new cruise ship harbor. They took note of the authorities’ assurances that the stadium will be financed by a bilateral donor; there remain questions, however, about the priority of this project. Also, Directors stressed the importance of ensuring that the stadium will operate without budgetary support.

Notwithstanding recent improvements, the high level of nonperforming bank assets and the rapid credit expansion in recent years warrant close vigilance over financial institutions. Strict monitoring of bank portfolios and compliance with provisioning requirements must remain a priority, and supervision of credit unions and other financial intermediaries not regulated by the Eastern Caribbean Central Bank (ECCB) needs to be strengthened. The financial position of the Grenada Development Bank (GDB) remains weak despite the Caribbean Development Bank (CDB) assisted recovery plan. Executive Directors endorsed the authorities’ intention to continue monitoring the GDB’s long-term financial viability and assessing the potential implications for the budget.

Directors considered that the current exchange rate arrangement has served Grenada well. To preserve international competitiveness, efforts are needed to control costs, particularly wages in the public sector. Also, it is important to reduce the high labor costs at the port and the elevated tariffs for electricity and telephone services.

Executive Directors welcomed Grenada’s adherence to the scheduled reductions of the maximum rate in the Caribbean Community (CARICOM)’s Common External Tariff and the intention of the authorities to effect the final reduction in January 1999. Directors supported the authorities’ intention to eliminate the 16 percent ceiling on lending rates and to recommend to the ECCB that the 4 percent interest rate floor on passbook savings be removed and the remaining foreign exchange controls be phased out in the period ahead. They also urgedmoving away from the markup margins applying to a number of commodities in favor of well-targeted subsidies to protect the poorest segments of the population.

Directors urged the authorities to redouble efforts in improving the quality and management of social expenditures. In this regard, the reorientation of resources to provide universal access to secondary school education is clearly needed. Investment in human capital is of paramount importance in helping achieve the government’s goal of establishing a service-based export economy. Directors endorsed the intention to improve the delivery and cost recovery of health services, for which the implementation of a merit-based pay system could play a substantial role.

Directors welcomed the authorities’ plan to strengthen the monitoring of offshore business activities. Since the number of these entities in Grenada is expected to continue growing rapidly in the coming years, it is urgent to provide an adequate framework for screening and supervision to protect Grenada’s international reputation, and thus maintain private sector confidence.

Grenada has improved the provision of basic statistics to the Fund. However, deficiencies remain in several areas, particularly the national accounts, labor statistics, balance of payments, and the operations of the public sector other than the central government, which hampers timely government policy decisions and effective Fund surveillance.