Public Information Notice No. 05/142

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with the Solomon Islands

October 13, 2005

On September 28, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Solomon Islands.¹

Background

The recovery, which began after the arrival of Regional Assistance Mission to the Solomon Islands (RAMSI) in mid-2003, has continued. With the restoration of law and order and extensive donor assistance, in the last two years the economy registered positive per capita growth, lower inflation, improved public finances, and a stronger external position. International reserves have been rebuilt to comfortable levels.

After several years of underperformance, the Solomon Islands' growth in the past three years has been about 2½ percentage points above the Pacific Island Countries' average.

Boosted by logging, real GDP growth was 5½ percent in 2004 for the second year running. In 2005, although nonlogging growth should accelerate due to the pickup in investment and significant fiscal stimulus, absent a net contribution from logging, growth is projected to moderate to 4½ percent. Inflation rose to 7.8 percent in 2004 due to increased nontradable demand by expatriates and rising fuel prices, and is projected to be broadly unchanged this year, due to the continued pass-through of persistently high oil prices and the pickup in economic activity.

The central government recorded a large surplus of 8¼ percent of GDP in 2004 due to higher budget support grants, improved tax collection, eliminating militia payments, tighter expenditure controls, and limited spending capacity. Despite further revenue gains, a small deficit (½ percent of GDP) is projected in 2005, as capacity and the wage bill rise and budget support falls. About half of the deterioration between 2004 and 2005 is due to exceptional factors, primarily Australia's withdrawal of budget support, one-off revenue from a tax amnesty and payment of back taxes in 2004, and one-off civil servants bonus this year.

The external position improved markedly in 2004. The current account recorded a surplus of 12½ percent of GDP, owing to a strong recovery of both timber and other primary commodity exports, low imports, and an almost doubling of current transfers. Net international reserves (NIR) rose to US$76 million, equivalent to 5½ months of 2005 projected imports. In 2005, the current account is projected to post a large deficit, mainly due to the high import content of investment projects, but also to a rising oil import bill and recovery from a low import base. Despite the wide current account deficit projected for 2005, with development grants expected to be strong and FDI to rise considerably, NIR are projected to decline only marginally.

Soaring net foreign assets at the central bank led to a 74 percent rise in reserve money in 2004. However, a large buildup of banks' excess reserves prevented strong money growth from translating into high inflation. Banks' caution limited real private credit growth to 2.5 percent and resulted in banks accumulating excess reserves equivalent to 39 percent of deposits. Real private credit growth rose to 21 percent year-on-year in May 2005, as banks' excess reserves dropped to 32 percent of deposits.

In the fiscal area, tax administration has improved, and the government has started work on a medium-term fiscal framework. In the structural area, work has started on a wide range of reforms, but progress, especially on the legislative front, has been slow, mainly because attaining reform buy-in has required extensive consultations.

Executive Board Assessment

Executive Directors welcomed the continued recovery of the Solomon Islands' economy and the maintenance of macroeconomic stability. Inflation is expected to remain in single digits; strong commodity exports and substantial aid flows have strengthened the external position; and reserve coverage is comfortable. Directors commended the authorities for these improvements, but noted that the country still faces difficult challenges that will require sustained policy efforts in the coming years. Logging is expected to decline from its current unsustainable level over the medium term and unless growth in other sectors picks up, living standards will likely fall. Against this background, Directors urged the authorities to set macroeconomic policies with a longer-term horizon, embrace fiscal reform to make room for social and infrastructure-related spending without jeopardizing fiscal sustainability, and step up the pace of structural reform to promote private sector development.

Directors commended the authorities for the marked improvement in the fiscal position in 2004 and welcomed the increased focus of spending on priority sectors in the 2005 Budget. At the same time, spending plans should take into account the country's still limited absorptive capacity, and the authorities were advised to save any revenue overperformance and underspending to keep this year's deficit below budget. Going forward, Directors stressed the need for continued fiscal consolidation, given limited financing sources and the need to reduce the high level of public debt. In this connection, they emphasized the importance of implementing a medium-term fiscal framework, and urged the authorities to adopt a combined-source budget that would include all aid flows.

Directors agreed that further rationalization and tighter controls over expenditure, in particular the wage bill, are needed in order to help reorient spending toward primary education and health, infrastructure, and maintenance. Progress over the medium term will require a broad based reform of the civil service. Directors welcomed the authorities' proposed tax reform to bolster domestic revenue in the face of declining import and logging duties and encouraged continued efforts to strengthen tax administration. They also urged the authorities to reduce the scope of tax exemptions. Directors considered that fiscal decentralization should be preceded by a strengthening of the public finances and of administrative capacity and should not be allowed to weaken fiscal discipline. Given that the Solomon Islands debt situation will remain fragile even if sound policies are implemented, Directors welcomed the authorities' plans to normalize relations with creditors, and, in this context, emphasized the importance of tackling arrears.

Directors considered that the policy of stabilizing the exchange rate in the face of strong foreign inflows, which has been in place since early 2003, remains appropriate at the current juncture. Looking ahead, they agreed that it will be important to avoid intervention in the face of possible downward pressures on the exchange rate, and a few Directors also suggested keeping under review the possibility of allowing some appreciation if warranted. Directors noted that continued strong foreign inflows, a drawdown of government deposits, and the acceleration in private credit growth could pose challenges for the conduct of monetary policy. They called on the central bank to continue to develop further its instruments of monetary policy, and to stand ready to rein in credit growth in the face of inflationary pressures.

Directors noted that the banking system of the Solomon Islands is generally sound, although the pick up in credit growth will require strong risk management practices by banks. Directors expressed concern about the continued poor profitability of the National Provident Fund (NPF) and the associated fiscal risks. In this context, they welcomed the authorities' efforts to introduce greater transparency in the NPF's operations and their initiative to improve its governance, including through the planned legislation. Directors also recommended that the troubled Development Bank of the Solomon Islands be liquidated. They welcomed the amended anti-money laundering (AML) Act and the steps being taken to combat money laundering and the financing of terrorism.

Directors underscored that a strengthened commitment to wide-ranging structural reforms will be key to creating an enabling business environment for private sector development, and mitigate the impact of declining logging activity on growth over the medium term. In this context, the passage of the foreign investment bill and significant efforts to streamline regulation and licensing procedures will send a positive signal to investors and donors. It will also be important to deepen state-owned enterprise reform and strengthen the regulatory environment for utilities in order to improve service delivery and reduce fiscal risks. Directors also highlighted the critical importance of better governance and stronger institutions, including an efficient civil service, to enhance confidence, promote a level playing field for private sector activity, and ensure the effective management of aid flows.

Directors noted that several shortcomings of the statistical database continue to hamper surveillance. While welcoming the remedial efforts that are currently under way, they urged the authorities to step up efforts to improve the reliability, coverage, and timeliness of data, which will enable the authorities to strengthen economic analysis and policymaking.