Public Information Notice No. 07/27

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Vanuatu

March 2, 2007

On February 26, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Vanuatu.¹

Background

Vanuatu has recently emerged from a long period of low growth and falling per capita incomes. Following two years of contraction, output growth recovered beginning in 2003, spurred by stronger performance in construction and a pickup in tourist arrivals. Growth reached 7 percent in 2005 and an estimated 5½ percent in 2006, well above the average for Pacific island countries. After peaking at 3 percent in 2003, inflation has since declined to 1½ percent in 2006. The overall external balance has benefited from rising foreign direct investment, aid, and private capital inflows, with reserves increasing to over 7 months of imports.

Budget performance has also improved. With cuts in capital spending and improved tax collection, the budget moved from a deficit of 4 percent of GDP in 2002 to a surplus of nearly 2 percent of GDP in 2005. The increase in civil servants' wages from July 2006, the first in some ten years, has led to an erosion of the budget position, with an expected deficit in 2006 of around ½ percent of GDP. However, the public debt-to-GDP ratio continued to decline to about 30 percent from nearly 45 percent in 2002.

If good macroeconomic policies continue and political stability is maintained, near-term prospects are positive. Growth should be maintained at about 4-5 percent over the next two-three years, boosted by the direct impact of aid and private capital inflows on investment and growing tourism following the launching of new flights to Vanuatu in 2006. Inflation is expected to increase modestly but remain subdued. There is, however, a risk that a loosening of fiscal policy and increased capital inflows could put upward pressure on private sector wages and prices.

Medium-term prospects will depend on the pace of structural reforms, an area where progress has been limited. On the positive side, financial sector reforms have been impressive, with the government taking steps over the last several years to substantially improve supervision of domestic banks and the offshore financial sector. At the same time, fiscal structural reforms have not advanced. The wage bill remains high, crowding out development-related spending. Numerous exemptions on the value-added tax and duties have not been streamlined. In addition, little progress has been made on reforms to address the substantial barriers to private sector development, which are key to placing Vanuatu on a higher growth path. Without stronger efforts to undertake these reforms, the positive growth projected in the near term could prove temporary, with medium-term growth reverting to its historical performance and per capita income growth remaining stagnant.

Executive Board Assessment

Executive Directors commended the authorities for maintaining sound macroeconomic policies, which have strengthened the economic recovery, as well as for progress made in financial sector supervision. Directors encouraged the authorities to take advantage of the recent favorable developments to establish the foundations for maintaining strong economic growth over the next several years. Improved relations with donors have led to a significant increase in donor support that, if used effectively, could help reduce some of the deep-seated barriers to development that Vanuatu faces.

Directors stressed that although growth is strong at present, aid flows alone cannot maintain this performance over the medium term without a more concerted effort to address structural weaknesses. Directors urged the authorities to accelerate policies to reduce Vanuatu's impediments to private sector development, including poor and expensive infrastructure and shortcomings in the legal framework. This would enhance Vanuatu's external competitiveness and promote private sector activity.

Directors considered that the recent large civil service wage increases could add to demand pressure and a pickup in inflation. While recognizing that Vanuatu's basket exchange rate peg system limits the role of monetary policy, Directors nevertheless urged the central bank to monitor the situation carefully with an eye to preventing credit growth from adding to demand pressures as well as leading to an increase in nonperforming loans. Strong bank supervision will be important in this regard.

Directors emphasized that the present economic situation provides an opportune time for the authorities to begin undertaking long overdue fiscal restructuring. They urged the authorities to focus reforms on improving the delivery and efficiency of government services, restructuring the civil service and reducing the associated wage bill, and removing numerous tax exemptions and enhancing tax administration. Directors stated that loss-making state-owned enterprises should be restructured, including through privatization.

Directors considered the transactions-weighted, basket pegged exchange rate regime as appropriate for Vanuatu's stage of development, and stressed that progress on the structural agenda will be key to improving Vanuatu's competitiveness.

Directors welcomed the considerable progress in reforming the financial sector, but noted that additional steps are needed in certain areas. In particular, they urged the authorities to place the proposed agriculture development bank under strict central bank supervision from its inception to prevent the mismanagement and loan losses experienced by the previous development bank. Directors encouraged the authorities to promote commercial bank awareness of their responsibilities under the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) legislation.

Directors underscored the need to improve the domestic capacity to compile statistics for timely monitoring and policy analysis, and encouraged the authorities to intensify their efforts in this area.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.