## cr17161

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### Climate change context and recent trends
- 14 of the 15 warmest years on record have occurred since year 2000.
- Ongoing global coral bleaching since mid-2014, exacerbated by a subsequent 2015-16 strong El Niño, described as the longest, most widespread, and most damaging on record (NOAA, 2017).
- A 2016 survey documented average bleaching levels of 80 per cent, with up to 95 per cent for some sites surveyed.
- Coastal areas in Seychelles are eroded every year by about 50 cm (Pouponneau 2015).
- Sea levels in Seychelles are rising by a 2.3 mm every year.
- On a global scale, sea levels have already risen by roughly 9 inches since 1880.
- Sea levels are projected to increase by another 12 to 35 inches by 2100 (United Nations IPCC assessment report 2014).

### Impacts on ecosystems, coasts, and livelihoods
- Coral bleaching and ocean acidification cause:
  - reduction of fisheries output;
  - impairment of coral reefs’ defensive capacity against land erosion and rising sea levels;
  - intensification of storm-event magnitude and stronger tides leading to severe coastal erosion that threatens tourism.
- Fisheries and food security:
  - Per capita fish consumption is approximately 57 kg per annum.
  - Fisheries products account for up to 50% of total protein consumed.
  - Seychelles’ artisanal fishery lands about 4,000 tons of fish per year.
  - The Mahé Plateau covers around 41,000 km2 and is fished up to approximately 50m deep by 140 whalers and schooners and at least 400 outboard vessels.
- Vulnerability:
  - Seychelles is highly vulnerable to climate change: rising sea levels, changing rainfall patterns, increasingly intense and frequent tropical cyclones, and massive coral bleaching compound economic and social risks.
  - Vulnerability is exacerbated by the economy’s high dependence on its coastal zone for urban development and the main economic pillars: tourism and fisheries.

### Historical natural disasters and costs
- During 1997-2016, Seychelles experienced seven natural disasters that affected around 26,000 people or 30 % of the population and led to a combined economic damage of over 4.6 percent of GDP.
- Table of selected disasters (EM-DAT / source figures preserved):
  - 1997: Flood; 1,237 people affected; 0.3 (or 0.5 percent of GDP in later table) estimated economic damage.
  - 2002: Tropical cyclone; 6,800 people affected; - estimated reported economic damage.
  - 2004: Tsunami; 4,830 people affected; 3.6 percent of GDP estimated reported economic damage.
  - 2006: Epidemic; 5,461 people affected; - estimated reported economic damage.
  - 2013: Tropical cyclone; 3,000 people affected; 0.7 percent of GDP estimated reported economic damage.
  - 2014: Flood; 4,435 people affected; - estimated reported economic damage.
  - 2016: Epidemic; 253 people affected; - estimated reported economic damage.
- Relative comparisons and averages:
  - The average economic cost of natural disasters in Seychelles is roughly 1 percent of GDP, almost twice as much as the average damage cost of SSA peers.
  - During 1990-2014, storms and epidemics accounted for 15,610 people or 16.6 percent of the population affected by natural disasters in Seychelles.
  - Floods accounted for 22 percent of the population affected by natural disasters in Seychelles, roughly twice the proportion affected in SSA peers.
- Example of large-impact event: a tsunami in 2004 affected 4,630 people and caused an estimated damage of 3.6 percent of GDP.
- Observation: While droughts accounted for most of the population affected due to natural disasters in SSA small states, Seychelles has recently experienced climate-induced and prolonged dry seasons causing concern.

### Authorities’ plans, estimated costs, and financing needs
- Authorities announced long-term action plans in September 2015 and committed to a multilateral agreement under the UNFCCC coming into effect in 2020.
- Authorities estimate total cost of priority mitigation and adaptation actions at US$604 million (US$309 million for mitigation and US$295 million for adaptation): 43 percent of the estimated 2016 GDP.
- Out of the climate mitigation and adaptation projects costing US$604 million, projects amounting to about US$25 million are listed in the authorities’ Public Sector Investment Plan (PSIP).
- Government measures already taken:
  - Set-up of a focused unit aimed at overcoming hurdles to access climate funding.
  - Buildup of innovative financing resulting from engagement with the World Bank, recently on the blue bond.
- Recommended financing instruments:
  - Create larger fiscal buffers for climate change adaptation and mitigation drawing on budgetary flexibility and independent monetary policy.
  - Introduce a specific carbon tax to enable reduction in other distortionary taxes and strengthen revenue mobilization.
  - Explore innovative financial instruments, including weather derivatives, debt swaps, and carbon markets.
  - Apply cost-effectiveness tests on an ongoing basis for climate-related projects.

### Fiscal framework, public debt projections, and climate investment scenarios
- EFF baseline scenario assumptions:
  - Authorities committed to a primary surplus of 3 percent of GDP from 2017 onwards.
  - GDP growth would stay around the estimated potential rate (3‒3½ percent) after 2018.
  - CPI inflation would stay at 3 percent.
  - Under these assumptions, public debt to GDP ratio would fall below 50 percent by 2020 and to 16½ percent by 2036.
- EFF baseline with climate-change investments (modifications):
  - Mitigation and adaptation investments executed evenly over 20 years starting in 2018.
  - Financing assumption: one-third external project grants; one-third concessional external project loans; remainder by domestic sources.
  - GDP growth assumed to notch up starting in 2025 and reach 4½ percent by 2036 due to improved infrastructure and resilience.
  - Mitigation and adaptation investments would reduce the primary surplus by ¼‒1¼ percent of GDP each year during the projection period compared with the EFF baseline scenario.
- Debt-path outcomes with climate-change investments:
  - Public debt still projected to decline each year but falls below 50 percent by 2022 (two years later than EFF baseline).
  - Public debt to GDP ratio at end of projection period estimated around 26 percent.
  - If all climate-change investments financed domestically, debt to GDP ratio projected around 36½ percent in 2036.
  - Emphasis: importance of concessional external financing.

### Disaster shock scenarios and fiscal risks
- Catastrophic disaster (tail risk) scenario: 30 percent of GDP damage in 2017
  - Scenario assumptions:
    - Real GDP reduced by 30 percent in 2017 compared with baseline.
    - Real GDP growth same as baseline during 2018‒19, then accelerates to around 8½ percent during 2020‒22, returning to the EFF baseline with climate investments after 2023.
    - Seychelles rupee depreciates by 30 percent in 2017 against major currencies, gradually recovering to baseline by end-2022.
    - CPI inflation accelerates to over 15 percent by end-2017, then gradually declines to baseline by 2020.
    - Reconstruction investments total 15 percent of GDP implemented over five years starting 2018 (3 percent of GDP per year).
    - Reconstruction financing: one-third external project grants; one-third concessional external project loans; remainder domestic sources.
    - Climate mitigation and adaptation investments implemented as in the climate-change investment scenario.
  - Debt-path outcome:
    - Public debt to GDP ratio spikes to 115 percent in 2017 from slightly over 70 percent in 2016.
    - Public debt gradually declines to around 90 percent over next several years supported by growth, revenue recovery, and external grants and concessional lending.
    - Public debt projected to rise again in mid-2020s as principal repayments to concessional borrowing resume and interest burdens increase, possibly reaching 120 percent by 2036.
  - Note: About 9 percent of disasters in small states involve damage of more than 30 percent of GDP.
- Moderate disaster scenario: 10 percent of GDP damage in 2017
  - Scenario assumptions:
    - GDP reduced by 10 percent in 2017 in real terms versus baseline.
    - Real GDP growth same as baseline during 2018‒19, accelerates to around 6 percent during 2020‒22, then returns to EFF baseline with climate investments after 2023.
    - Seychelles rupee depreciates by 15 percent in 2017, gradually recovering to baseline by end-2022.
    - CPI inflation accelerates to over 10 percent by end-2017, then gradually declines to baseline by 2020.
    - Reconstruction investments total 5 percent of GDP implemented over five years starting 2018 (1 percent of GDP per year), financed similarly to catastrophic scenario.
  - Debt-path outcome:
    - Public debt to GDP ratio spikes to around 85 percent in 2017 from slightly over 70 percent in 2016.
    - Gradual decline over several years to slightly below 50 percent supported by growth and external financing.
    - Decline stops thereafter as principal repayments to concessional borrowing resume; public debt to GDP ratio could reach 51 percent by 2036.

### Policy recommendations on climate and disaster finance
- Enhance ex-ante resilience and ex-post adaptive capacity: a single severe natural disaster could jeopardize fiscal sustainability.
- Create fiscal space for climate mitigation and adaptation:
  - Climate change related spending estimated to cost almost 1 percent of GDP each year over the next 15‒20 years.
  - Revenue-side measures suggested:
    - (i) introduce a carbon tax gradually in line with the recent FAD recommendation;
    - (ii) introduce the sugar tax that is under consideration;
    - (iii) align the business tax of the tourism and fishing sectors with the other sectors.
  - Expenditure-side measures suggested:
    - (i) contain growth in wage bill and goods and services to a level significantly lower than the trend recent years;
    - (ii) SOE sector reform to save current transfers to SOEs over the medium term;
    - (iii) better targeting of the social welfare program;
    - (iv) full implementation of Program Performance Based Budgeting (PPBB) and effective use of Public Private Partnership (PPP) to improve public investment efficiency.
- Incorporate disaster risks in public finance management:
  - Explicitly integrate climate-related natural disaster risks into the medium-term fiscal framework and debt sustainability analysis to identify adequate fiscal buffers for self-insurance.
  - Seek capacity building support from the IMF and other IFIs.
- Explore disaster risk transfer mechanisms and insurance instruments (see disaster risk-management items below).

### Disaster risk-management framework and contingency planning
- Framework elements (summarized):
  - Identify risks and vulnerabilities: assess vulnerabilities and probabilities; adopt fast evidence-based decision processes.
  - Invest in risk reduction: integrate risks into medium-term investment programs.
  - Have a clear contingency plan: explicitly integrate risks into fiscal framework and budget planning; agree in advance coordinated post-disaster plans.
  - Arrange contingency financing via risk retention (self-insurance) and risk transfer (insurance).
- Financing implications by probability/return period (Disaster Financing Risk Layering Matrix):
  - 5 percent or up to 20 years: Ex ante Financing — Up to 3 percent of GDP
  - 3.33 percent or 20 to 30 years: Ex ante Financing — Up to 5 percent of GDP
  - 1 percent or 30 to 100 years: Ex ante Financing — Above 5 percent of GDP
  - 0.5 percent or 100 to 200 years: Ex ante Financing — Above 5 percent of GDP
  - Below 0.5 percent or above 200 years: Ex ante Financing — Above 5 percent of GDP
- Typical financing instruments:
  - Grants & humanitarian aid; Catastrophe bonds; Global partnerships; Budgetary reserves; Emergency budget allocations; Contingent loans; Emergency loans; Insurance & Reinsurance.
- Seychelles’ current mix and observations:
  - Ex post Own financing: most recent disasters largely financed by emergency budget allocations and emergency loans.
  - Ex-ante Own-financing: very little dedicated natural disaster contingency or reserve funds; a general contingency line exists in the budget.
  - Contingent loans: Seychelles subscribes to a World Bank CAT DDO and pays a commitment fee; CAT DDO currently only available for middle income countries; Seychelles is the only small state that has negotiated one.
  - Indemnity Insurance: scope limited; property damage of about 0.3 percent of GDP caused by cyclone Fantala in 2016 was covered by indemnity insurance held by a state-owned enterprise.
  - Parametric Insurance: gaining traction with World Bank assistance; costs less and disburses faster (examples: CCRIF, PCRFI, ARC).
  - Other Financial Instruments: no small state has yet issued a catastrophe bond; World Bank issued one to finance CCRIF; Seychelles’ small size limits access.

### Monetary policy and financial sector implications of disasters
- Destruction of productive capacity creates supply shocks; shortages of food and necessities can push up inflation for extended periods.
- Inflows of monetary disaster relief, remittances and insurance payments increase demand while reconstruction needs can raise wages and raw material costs, leading to inflation spikes—especially food price inflation.
- Policy guidance:
  - Accommodate first-round effects of a supply shock and offset second-round effects.
  - Conventional monetary policy can address small to moderate disasters.
  - For large disasters causing significant dislocation in small states, less orthodox measures may be required, including temporary price controls and direct efforts to contain exchange rate depreciation.
- Financial sector operational priorities:
  - Ensure banks and the national payments system are operational with minimal delay through robust central bank business continuity plans.
  - Include extreme natural disaster scenarios in bank stress testing.
  - Strengthen financial access through mobile banking and microfinance.

### Tourism, blue economy, and labor markets
- Tourism sector:
  - Average tourism sector monthly earnings are Rs. 15,650 versus a national average of Rs. 9,544.
  - Total recorded employment in tourism was about 9,000 in 2015.
  - New and renewed temporary expatriate worker permits (Gainful Occupation Permits, GOPs) issued for tourism were 3,081 in 2015, rising to 4,028 in 2016.
  - Tourism contributes directly about one third of total taxes and tourism-related sectors account for 32 percent of GDP.
- Blue economy opportunities and constraints:
  - Potential expansion of ancillary services in fisheries and tourism; sustainable seafood production could reduce food import demand (Seychelles imports about US$70m worth of food annually, constituting 9% of total goods imports, figures exclude tuna imports for re-export).
  - Environmental sustainability requires appropriate regulations and enforcement; production likely needs orientation to small, high value products for local tourism or niche international markets.
  - A larger blue economy can support public revenues and benefit the poorest depending on allocation and quality of public spending.
- Fisheries and food security vulnerabilities:
  - Continued sustainability of the demersal fishery is critical to food security; poorer households would be hardest hit if local supply deteriorated and prices rose.
  - Food items constitute just under 16 percent of the Consumer Price Index.
  - A dated (2011) survey found that about one fifth of households did not have the ability to buy sufficient meat and fish.

### Fiscal consolidation, revenue options, and expenditure priorities
- Fiscal stance and targets:
  - Authorities committed to reducing public debt to GDP ratio below 50 percent by 2020, requiring a primary surplus of 3 percent of GDP each year from 2017 onwards.
  - After one-off measures in the 2017 budget expire, if no additional measures are taken in 2018 the authorities will face a fiscal gap of about 1½ percent of GDP from 2018 onward compared with the primary surplus targeted at 3 percent of GDP.
- Business tax and incentives:
  - Tourism-related companies subject to a business tax rate of 15 percent versus 30‒33 percent applied to other companies.
  - The Tourism Investment Acts provides concessions including accelerated and additional depreciation; 200 percent bonus deduction on marketing and promotion expenses up to 5 percent of turnover; extra deduction for training expenses and salaries paid for one year to qualified graduates.
  - The 2016 FAD TA mission estimated the revenue loss of these preferences and the lower business tax rate of the 24 sample companies at 0.6 of GDP.
  - Business taxes to GDP ratio hovered 4¼‒5½ percent since it peaked at 7.1 percent in 2011.
  - Tourism-related companies’ share in total business tax collections hovered around 7¾‒10¼ percent during 2011‒15, compared with their share of 25‒34 percent in personal income tax and VAT.
- Revenue measures discussed (estimated revenue impact, in percent of GDP):
  - Increase fuel excises in line with FAD TA recommendations: 0.50
  - Increase yacht fees: 0.05
  - Increase passenger air duty from $10 to $150: 0.10
  - Impose 10 percent tax on sugary drinks and confectionary: 0.10
  - Total: 0.75
- Expenditure composition:
  - Capital spending’s share in total spending is 12¾ percent in Seychelles.
  - Seychelles spends 10½ percent of GDP on compensation (wage bill); wage bill to GDP ratio envisaged to reach 11 percent of GDP in the 2017 budget from around 9½ percent in 2015.
  - Recommendation: scope to streamline salary costs in the public sector and improve public investment management (PEFA, PIMA, EAT references in source).

### Social protection, education, and health efficiency
- Social protection:
  - Seychelles spends about 4½ percent of GDP on social protection.
  - The current system supports households that are not needy while many households in need do not get assistance; scope for savings by better targeting (World Bank Social Protection Policy Note, June 2016).
- Education efficiency:
  - Data envelopment analysis (DEA) indicates Seychelles does not compare favorably with many Caribbean countries in converting spending into enrollment; salary costs accounted for over 90 percent of education costs (World Bank Public Expenditure Review, 2014).
- Health efficiency:
  - Seychelles is top performer in SSA in health outcomes; health-adjusted life expectancy used as output shows some SADC countries and many Caribbean countries score better than Seychelles on efficiency.
  - Introducing a sugar tax under consideration could boost revenue while improving health.

### External stability, competitiveness, and reserves
- Sector concentration and risks:
  - Tourism-related sectors account for 32 percent of GDP and tourism earnings account for 30 percent of total exports of goods and services.
- Real exchange rate assessments (selected EBA-lite numbers as reported):
  - CA-Actual: -0.19
  - CA-Fitted: 0.03
  - CA-Norm: 0.00
  - Residual (CA model): -0.21
  - CA-Gap: -0.19
  - Policy gap: 0.03
  - Elasticity: -0.85
  - Real Exchange Rate Gap (CA Model): 0.22
  - Cyclical Contributions: -0.01
  - Cyclically adjusted CA: -0.18
  - Cyclically adjusted CA Norm: 0.01
  - IREER ln(REER)-Actual: 4.76
  - IREER ln(REER)-Fitted: 4.94
  - IREER ln(REER)-Norm: 4.89
  - Residual (IREER model): -0.17
  - REER-Gap: -0.13
  - Policy gap (IREER model): 0.04
- Other indicators:
  - Seychelles fell from 80th to 93rd in the World Bank’s Doing Business overall indicator over the past three years.
  - Reserve adequacy: after a decline in 2016 from above 4 months of imports, reserves will stay stable around 3½ months; projected reserves around 170 percent of the ARA-EM metric.
  - Rationale: higher reserves justified by increasing vulnerability of Seychelles’ tourism economy to natural disasters and climate change.

### Monetary transmission, banking liquidity, and policy reforms
- Main conclusion on transmission:
  - Monetary transmission in Seychelles is generally weak.
  - Impact of the money and interest rate channels are statistically insignificant.
  - Only partial evidence exists for a credit channel and an exchange rate channel.
- Structural VAR results (summary):
  - For GDP: shocks to the exchange rate and interest rate account respectively for 5.3 percent and 3.5 percent of the variation in GDP.
  - For CPI: shocks to credit and exchange rate account respectively for 4.9 percent and 2.6 percent of the variation in CPI.
  - Impulse responses: neither output nor price react to a one standard deviation shock of reserve money and T-bill rate.
- Identified inefficiencies:
  - Structural excess liquidity in the banking system largely built up by accumulation of net foreign assets (NFA).
  - Limited interest rate corridor that does not allow clear signaling of monetary stance.
  - Underdeveloped money markets and interbank market; interbank rates are quoted rather than transacted rates.
  - Unstable money multiplier and declining velocity (notably between 2013 and 2015).
- Banking system liquidity episodes:
  - 2009: NFA increased significantly, forcing the CBS to mop-up excess liquidity.
  - Fall of 2013: massive excess liquidity from opportunistic CBS purchases of foreign exchange; CBS unable to mop-up without undermining capital position, driving short-term interest rates down.
  - 2014: government issuance of medium-term rupee-denominated bonds and weekly T-bills considerably reduced excess liquidity.
- Reforms under consideration:
  - Transition from a reserve money based framework to an interest rate based framework.
  - Reintroduction of an interest rate corridor; introduction of a monetary policy rate scheduled to be approved by June 2017 and implemented by July 2017 (as per source).
  - Modernize liquidity management instruments, clarify master repurchase agreement (scheduled mid-2018 in source), and leverage government securities for monetary purposes.
  - Improve liquidity forecasting, coordination between CBS and Ministry of Finance, and market communication.

### Institutional and capacity priorities
- Strengthen public investment management and implementation capacity to reduce under-execution of capital budget.
- Prepare a fiscal risk statement as part of the 2018 budget and quantify fiscal risks from natural disaster and climate change.
- Use IMF TA tools: PIMA, PIMA diagnostic, PEFA, EAT for public investment and expenditure efficiency.
- Invest in better understanding of cyclone patterns, ocean and air currents, and climate–economy interplay.
- Shore up reefs as natural storm barriers, install early storm-warning and information-dissemination systems, and build evacuation shelters and sea walls.

*Prepared by Mounir Bari (AFR); Tetsuya Konuki (AFR); Wendell Samuel (AFR); Sources: National Center for Environmental Information; NOAA; Commonwealth Scientific and Industrial Research Organization (CSIRO); EMDAT database; IMF staff calculations; United Nations IPCC assessment report 2014; IMF staff analysis and projections as presented in the source document (cr17161).*

### 1. Global Surface Temperature, Deviation From 20

### 1. Global Surface Temperature, Deviation From 20th-Century

### A. Climate change context and recent trends
- 14 of the 15 warmest years on record have occurred since year 2000.
- Ongoing global coral bleaching since mid-2014, exacerbated by a subsequent 2015-16 strong El Niño, is described as the longest, most widespread, and most damaging on record (NOAA, 2017).
- A 2016 survey documented average bleaching levels of 80 per cent, with up to 95 per cent for some sites surveyed.

### B. Impacts on Seychelles’ ecosystems and coasts
- Coral bleaching and ocean acidification are causing widespread loss of live coral cover and deleterious impacts on economic and social development through:
  - reduction of fisheries output;
  - impairment of coral reefs’ defensive capacity against land erosion and rising sea levels;
  - intensification of storm-event magnitude and stronger tides leading to severe coastal erosion that threatens tourism.
- Coastal areas in Seychelles are eroded every year by about 50 cm (Pouponneau 2015).
- Sea levels in Seychelles are rising by a 2.3 mm every year.

### C. Sea level change: historical and projected figures
- On a global scale, sea levels have already risen by roughly 9 inches since 1880 (Figure 3).
- Sea levels are projected to increase by another 12 to 35 inches by 2100 (United Nations IPCC assessment report 2014).
- Figure 3 caption: Cumulative sea level change (inches) with data sources including tide gauges (trend based on tide gauges) and satellite measurements; interquartile range shown.

### D. Natural disasters: incidence, human and economic costs
- During 1997-2016, Seychelles experienced seven natural disasters that affected around 26,000 people or 30 % of the population and led to a combined economic damage of over 4.6 percent of GDP (Table 1).
- Table 1: Seychelles: Natural Disasters (years, disaster, number of people affected, estimated reported economic damage (in percent of GDP)):
  - 1997: Flood; 1,237; 0.3
  - 2002: Tropical cyclone; 6,800; -
  - 2004: Tsunami; 4,830; 3.6
  - 2006: Epidemic; 5,461; -
  - 2013: Tropical cyclone; 3,000; 0.7
  - 2014: Flood; 4,435; -
  - 2016: Epidemic; 253; -
- Relative comparisons and averages:
  - The average economic cost of natural disasters in Seychelles is roughly 1 percent of GDP, almost twice as much as the average damage cost of SSA peers.
  - During 1990-2014, storms and epidemics accounted for 15,610 people or 16.6 percent of the population affected by natural disasters in Seychelles.
  - Floods accounted for 22 percent of the population affected by natural disasters in Seychelles, roughly twice the proportion affected in SSA peers.
- Example of large-impact event: a tsunami in 2004 affected 4,630 people and caused an estimated damage of 3.6 percent of GDP.
- Observation: While droughts accounted for most of the population affected due to natural disasters in SSA small states, Seychelles has recently experienced climate-induced and prolonged dry seasons causing concern.

### E. Policy response: adaptation and mitigation priorities
- High-level guidance:
  - Articulate a proactive sector-specific strategy to build resilience of the blue economy, prioritizing climate-sensitive sectors given scarce resources.
- Fisheries and marine ecosystems:
  - Better management of fisheries and marine ecosystems and increased coverage of marine protected areas to mitigate climate impacts.
- Tourism:
  - Sustainable tourism development to foster habitat restoration, geo-spatial planning, and maintenance of green areas and beach vegetation.
  - Involvement of local communities in tourism development and diversification to build resilience and ensure inclusive growth.
- Built environment and planning:
  - Improve and mainstream geo-spatial planning across all sectors.
  - Improve building codes and ensure rigorous enforcement.
  - Undertake a nation-wide drainage study to minimize flood damage and preserve coastlines.
- Adaptation measures and sectoral priorities (areas of long-term adaptation):
  - Water security: seek a fully integrated approach to water management addressing ecosystem health, waste management, water treatment and supply, sewage, and agriculture.
  - Energy security: emphasize renewable energy where possible; encourage efficient fuel-based land transport and more use of electric vehicles charged with renewable energy technology.
  - Food security: introduce new and innovative technologies across food production, supply and value chains and reinforce skilled human resources.
- Capacity building and preparedness:
  - Invest in better understanding of cyclone patterns, ocean and air currents, and climate–economy interplay.
  - Shore up reefs as natural storm barriers, install early storm-warning and information-dissemination systems, and build evacuation shelters and sea walls.

### F. Financing options for adaptation and mitigation
- Government measures already taken:
  - Set-up of a focused unit aimed at overcoming hurdles to access climate funding.
  - Buildup of innovative financing resulting from engagement with the World Bank, recently on the blue bond.
- Recommended instruments and fiscal measures:
  - Create larger fiscal buffers for climate change adaptation and mitigation drawing on budgetary flexibility and independent monetary policy.
  - Introduce a specific carbon tax to enable reduction in other distortionary taxes and strengthen revenue mobilization.
  - Explore innovative financial instruments, including weather derivatives, debt swaps, and carbon markets, to centralize and mainstream climate financing needs.
  - Apply cost-effectiveness tests on an ongoing basis for climate-related projects.

### G. Conclusions and policy implications
- Vulnerability and risks:
  - Seychelles is highly vulnerable to climate change: rising sea levels, changing rainfall patterns, increasingly intense and frequent tropical cyclones, and massive coral bleaching compound economic and social risks.
  - Vulnerability is exacerbated by the economy’s high dependence on its coastal zone for urban development and the main economic pillars: tourism and fisheries.
- Natural disaster trends:
  - The increased frequency and severity of natural disasters in Seychelles is worrisome; while frequency is lower compared to SSA small states’ average, damage cost is relatively high in Seychelles.
- Recommended policy mix:
  - Combine adaptation and mitigation strategies aligned with Seychelles’ NDC and the government’s technical and financial capacity.
  - Where adaptation and mitigation measures are inadequate, exploit insurance policies and innovative financial instruments further.
- Fiscal planning:
  - The authorities are encouraged to articulate long-term fiscal plans to accommodate mitigation and adaptation investments and to seek to reduce vulnerability to catastrophe.

*Prepared by Mounir Bari (AFR); Sources: National Center for Environmental Information; NOAA; Commonwealth Scientific and Industrial Research Organization (CSIRO); EMDAT database; IMF staff calculations; United Nations IPCC assessment report 2014.*

### 1. While catastrophic natural disasters have so far spared Seychelles, the country would

### cr17161 - 1. While catastrophic natural disasters have so far spared Seychelles, the country would

### Vulnerability and recent disaster history
- Seychelles has been hit once by a major natural disaster entailing economic damage over 2 percent of GDP—the average annual cost of natural disasters for small states.
- Based on history, Seychelles ranks 26th among 33 small states worldwide as to the vulnerability to natural disasters and climate change.
- As a small archipelagic country, long-run rising sea level could pose a serious threat; a catastrophic weather event may occur at any time albeit with low probability.
- Table of major natural disasters (EM-DAT):
  - 1997 Flood: 1,237 people affected; Estimated economic damage 0.5 percent of GDP.
  - 2004 Tsunami: 4,830 people affected; Estimated economic damage 3.6 percent of GDP.
  - 2013 Tropical storm: 3,000 people affected; Estimated economic damage 0.7 percent of GDP.

### Authorities’ plans and estimated costs
- Authorities announced long-term action plans in September 2015 and committed to a multilateral agreement under the UNFCCC coming into effect in 2020.
- Authorities estimate total cost of priority mitigation and adaptation actions at US$604 million (US$309 million for mitigation and US$295 million for adaptation): 43 percent of the estimated 2016 GDP.
- Out of the climate mitigation and adaptation projects costing US$604 million, projects amounting to about US$25 million are listed in the authorities’ Public Sector Investment Plan (PSIP).

### Impact of climate-change investments on long-term public debt dynamics
- EFF baseline scenario assumptions:
  - Authorities committed to a primary surplus of 3 percent of GDP from 2017 onwards.
  - GDP growth would stay around the estimated potential rate (3‒3½ percent) after 2018.
  - CPI inflation would stay at 3 percent.
  - Under these assumptions, public debt to GDP ratio would fall below 50 percent by 2020 and to 16½ percent by 2036.
- EFF baseline with climate-change investments (modifications):
  - Mitigation and adaptation investments executed evenly over 20 years starting in 2018.
  - Financing assumption: one-third external project grants; one-third concessional external project loans; remainder by domestic sources.
  - GDP growth assumed to notch up starting in 2025 and reach 4½ percent by 2036 due to improved infrastructure and resilience.
  - Mitigation and adaptation investments would reduce the primary surplus by ¼‒1¼ percent of GDP each year during the projection period compared with the EFF baseline scenario.
- Debt-path outcomes with climate-change investments:
  - Public debt still projected to decline each year but falls below 50 percent by 2022 (two years later than EFF baseline).
  - Public debt to GDP ratio at end of projection period estimated around 26 percent.
  - If all climate-change investments financed domestically, debt to GDP ratio projected around 36½ percent in 2036.
  - This underscores importance of concessional external financing.

### Catastrophic disaster (tail risk) scenario: 30 percent of GDP damage in 2017
- Scenario assumptions:
  - Real GDP reduced by 30 percent in 2017 compared with baseline.
  - Real GDP growth same as baseline during 2018‒19, then accelerates to around 8½ percent during 2020‒22, returning to the EFF baseline with climate investments after 2023.
  - Seychelles rupee depreciates by 30 percent in 2017 against major currencies, gradually recovering to baseline by end-2022.
  - CPI inflation accelerates to over 15 percent by end-2017, then gradually declines to baseline by 2020.
  - Reconstruction investments total 15 percent of GDP implemented over five years starting 2018 (3 percent of GDP per year).
  - Reconstruction financing: one-third external project grants; one-third concessional external project loans; remainder domestic sources.
  - Climate mitigation and adaptation investments implemented as in the climate-change investment scenario.
- Debt-path outcome:
  - Public debt to GDP ratio spikes to 115 percent in 2017 from slightly over 70 percent in 2016.
  - Public debt gradually declines to around 90 percent over next several years supported by growth, revenue recovery, and external grants and concessional lending.
  - Public debt projected to rise again in mid-2020s as principal repayments to concessional borrowing resume and interest burdens increase, possibly reaching 120 percent by 2036.
- Note: About 9 percent of disasters in small states involve damage of more than 30 percent of GDP.

### Moderate disaster scenario: 10 percent of GDP damage in 2017
- Scenario assumptions (scaled from catastrophic scenario):
  - GDP reduced by 10 percent in 2017 in real terms versus baseline.
  - Real GDP growth same as baseline during 2018‒19, accelerates to around 6 percent during 2020‒22, then returns to EFF baseline with climate investments after 2023.
  - Seychelles rupee depreciates by 15 percent in 2017, gradually recovering to baseline by end-2022.
  - CPI inflation accelerates to over 10 percent by end-2017, then gradually declines to baseline by 2020.
  - Reconstruction investments total 5 percent of GDP implemented over five years starting 2018 (1 percent of GDP per year), financed similarly to catastrophic scenario.
- Debt-path outcome:
  - Public debt to GDP ratio spikes to around 85 percent in 2017 from slightly over 70 percent in 2016.
  - Gradual decline over several years to slightly below 50 percent supported by growth and external financing.
  - Decline stops thereafter as principal repayments to concessional borrowing resume; public debt to GDP ratio could reach 51 percent by 2036.

### Key policy implications and recommendations
- Enhance ex-ante resilience and ex-post adaptive capacity: a single severe natural disaster could jeopardize fiscal sustainability despite low probability.
- Create fiscal space for climate mitigation and adaptation over the medium term:
  - Climate change related spending estimated to cost almost 1 percent of GDP each year over the next 15‒20 years.
  - Revenue-side measures suggested:
    - (i) introduce a carbon tax gradually in line with the recent FAD recommendation;
    - (ii) introduce the sugar tax that is under consideration;
    - (iii) align the business tax of the tourism and fishing sectors with the other sectors.
  - Expenditure-side measures suggested:
    - (i) contain growth in wage bill and goods and services to a level significantly lower than the trend recent years;
    - (ii) SOE sector reform to save current transfers to SOEs over the medium term;
    - (iii) better targeting of the social welfare program;
    - (iv) full implementation of Program Performance Based Budgeting (PPBB) and effective use of Public Private Partnership (PPP) to improve public investment efficiency.
- Incorporate disaster risks in public finance management:
  - Explicitly integrate climate-related natural disaster risks into the medium-term fiscal framework and debt sustainability analysis.
  - This integration would help identify adequate fiscal buffers for self-insurance.
  - Capacity building support from the IMF and other IFIs could be important.
- Explore disaster risk transfer mechanisms (discussed in the subsequent chapter).

### Disaster risk-management framework and current actions
- Seychelles has many elements of a disaster risk-management framework but could benefit from systematic evaluation of climate/disaster risks, inclusion in the national fiscal risk statement, and strengthened ex-ante disaster risk financing.
- Elements of a global disaster risk framework (summarized from World Bank, UN, and Dercon and Clarke) include:
  - Identify risks and vulnerabilities: assess vulnerabilities and probabilities; adopt fast evidence-based decision processes.
  - Invest in risk reduction: integrate risks into medium-term investment programs.
  - Have a clear contingency plan: explicitly integrate risks into fiscal framework and budget planning; agree in advance coordinated post-disaster plans.
  - Arrange contingency financing:
    - Risk retention (self-insurance): build extra fiscal reserves, financial sector capital buffers, and foreign reserves.
    - Risk transfer: use insurance to shift risks to capital markets.
- Current country actions:
  - Recognition and inclusion of climate change and natural disaster risks in the country’s statement of fiscal risks is emerging practice.
  - Seychelles plans to prepare a fiscal risk statement as part of the 2018 budget; initial steps to quantify fiscal risks from natural disaster and climate change would be useful.
  - In their NDC, authorities identified priority climate mitigation and adaptation expenditure amounting to about 40 percent of GDP, including:
    - Diversifying electricity generation to achieve 15 percent renewable energy by 2030.
    - Shifting land transport to renewable energy.
    - Adaptation investments for critical infrastructure including the port, coastal management and tourism.
  - Strengthening public investment management is a priority: implementation capacity needs reinforcement given under-execution of the capital budget in recent years; the IMF Public Investment Management Assessment (PIMA) tool could provide a comprehensive diagnostic.

*Prepared by Tetsuya Konuki (AFR); prepared by Wendell Samuel (AFR) — IMF staff analysis and projections as presented in the source document.*

### 7. Risk assessment should inform comprehensive contingency plans for natural disasters.

### 7. Risk assessment should inform comprehensive contingency plans for natural disasters.

### Role of risk assessment in contingency planning
- Country risk profiles and hazard maps should be an integral part of the design of contingency plans.
- Contingency plans should be developed with incentives for households and business to adopt risk reduction behaviors.
- To avoid delays from "agreeing intervention priorities" and "lack of clarity in leadership and coordination roles," contingency plans should:
  - carefully assign roles;
  - spell out essential procedures; and
  - identify the critical resources needed for a given response.
- Seychelles has set up a Division of Disaster Risk Management that oversees contingency planning and has collaborated with the World Bank (under the CAT DDO) to expand coverage of plans.

### Budget flexibility and fiscal frameworks
- Medium-term budgets with contingencies for natural disasters are regarded as best-practice at the macroeconomic level.
- At the micro level, the budget law should permit rapid reallocation of expenditure to meet pressing needs.
- Two Caribbean small states, in IMF-supported programs, have adopted fiscal responsibility laws that allow them to create fiscal space and accommodate natural disasters through escape clauses.
- Example: The parliaments of Grenada and Jamaica have passed fiscal responsibility laws that allow them to increase expenditure if the country is hit by a hurricane of a predefined severity.

### Arrange contingency financing (risk-layering framework)
- The World Bank proposes a risk-layering framework based on frequency and severity of disasters relative to cost-effectiveness of risk transfer.
- Financing implications by probability/return period (Disaster Financing Risk Layering Matrix as presented):
  - 5 percent or up to 20 years: Ex ante Financing — Up to 3 percent of GDP
  - 3.33 percent or 20 to 30 years: Ex ante Financing — Up to 5 percent of GDP
  - 1 percent or 30 to 100 years: Ex ante Financing — Above 5 percent of GDP
  - 0.5 percent or 100 to 200 years: Ex ante Financing — Above 5 percent of GDP
  - Below 0.5 percent or above 200 years: Ex ante Financing — Above 5 percent of GDP
- Typical financing instruments (examples listed in source):
  - Grants & humanitarian aid
  - Catastrophe bonds
  - Global partnerships
  - Budgetary reserves
  - Emergency budget allocations
  - Contingent loans
  - Emergency loans
  - Insurance & Reinsurance

### Self-insurance considerations
- Post-disaster increases in public expenditure combined with stagnant or falling revenues frequently result in the need to contract public debt.
- Reduced debt service capacity can limit ability to borrow or cause defaults (example: Grenada in 2008).
- Small states should seek lower debt levels to create fiscal space for post-disaster scale-up in public expenditure.
- Disbursements from creditors lag post-disaster spending needs because application-to-disbursement processes occur after the event.

### Risk transfer instruments and practices
- Contingent loans and grants (e.g., World Bank Catastrophe deferred drawdown options, CAT DDO) can be fast-disbursing because the loan is pre-approved and ready to disburse ahead of time.
  - The CAT DDO is currently only available for middle income countries; Seychelles is the only small state that has negotiated one.
- Pre-financing humanitarian grants is recommended to avoid delays and dislocation following a disaster.
- Small states should be willing to pay more than the expected loss to transfer some risks through insurance and other financial instruments.
- International community assistance (technical and possibly financial) can help small states operationalize risk-transfer mechanisms.
- Seychelles’ current mix and options (preliminary findings and country-specific observations):
  - Ex post Own financing: Seychelles’ most recent disasters were largely financed by ex post own financing (emergency budget allocations and emergency loans).
  - Ex-ante Own-financing: Seychelles provides very little budgetary resources in advance in the form of dedicated natural disaster contingency or reserve funds; Seychelles has a general contingency line in the budget usable in the event of a natural disaster.
  - Contingent loans: Seychelles subscribes to a World Bank CAT DDO and pays a commitment fee for the right to draw down pre-arranged financing if struck by a cyclone.
  - Indemnity Insurance: Seychelles has traditional indemnity insurance but its scope is limited; example—property damage amounting to about 0.3 percent of GDP caused by cyclone Fantala in 2016 was covered by indemnity insurance held by a state-owned enterprise.
  - Parametric Insurance: With World Bank assistance, parametric insurance is gaining traction in small-state risk-pooling arrangements (e.g., CCRIF, PCRFI, ARC); parametric insurance costs less and disburses faster because payouts are triggered by objective parameters.
  - Other Financial Instruments: No small state has yet issued a catastrophe bond; the World Bank issued one to finance CCRIF. Seychelles’ small size limits access to such instruments.

### Monetary policy and financial sector issues
- Destruction of productive capacity creates supply shocks; shortages of food and necessities can push up inflation for extended periods.
- Inflows of monetary disaster relief, remittances and insurance payments increase demand while reconstruction needs can raise wages and raw material costs, leading to inflation spikes—especially food price inflation.
- Policy guidance:
  - Accommodate first-round effects of a supply shock and offset second-round effects.
  - Conventional monetary policy can address small to moderate disasters.
  - For large disasters causing significant dislocation in small states, less orthodox measures may be required, including temporary price controls and direct efforts to contain exchange rate depreciation.
- Post-disaster operational priorities for the financial system:
  - Ensure banks and the national payments system are operational with minimal delay through robust central bank business continuity plans.
  - Include extreme natural disaster scenarios in bank stress testing to ensure post-disaster viability.
  - Over the medium term, strengthen financial access through mobile banking and microfinance to better serve vulnerable populations.

_Italic: IMF staff report excerpt — "7. Risk assessment should inform comprehensive contingency plans for natural disasters." (cr17161)_

### 10. More important direct employment effects can occur through the tourism industry,

### 10. More important direct employment effects can occur through the tourism industry

### Tourism employment, earnings, and labor supply
- Average tourism sector monthly earnings are Rs. 15,650 versus a national average of Rs. 9,544.
- The tourism sector has been fast-growing with strong derived labor demand, but:
  - The sector average masks significant earnings dispersion, including a wide gap between male and female wages.
  - Many jobs are less desirable because of heavy manual workloads and difficult hours.
- A predominant share of increased labor demand in tourism has been met by importing foreign workers:
  - Total recorded employment in tourism was about 9,000 in 2015.
  - New and renewed temporary expatriate worker permits (Gainful Occupation Permits, GOPs) issued for tourism were 3,081 in 2015, rising to 4,028 in 2016.

### Opportunities and constraints for small businesses in the blue economy
- Potential to expand small business opportunities to provide ancillary services in fisheries and tourism.
- Concerns about market structure limiting competition despite government MSME support (e.g., credit guarantees):
  - Market share and vertical integration of main operators are high, likely limiting opportunities for small-scale providers.
  - Limited pool of local start-up knowledge, capital, and skills has led to limited innovation and a largely undifferentiated offering of accommodation, transport, retail and excursion options.
- The existing industry model succeeded in tourist sector development over two decades, but fresh analysis is needed to:
  - Identify measures to reduce barriers to entry.
  - Stimulate competition and innovation in light of fast global change and new competitors.

### Fisheries, food security, and the domestic blue economy
- Fish consumption and production:
  - Per capita fish consumption is approximately 57 kg per annum.
  - Fisheries products account for up to 50% of total protein consumed.
  - Seychelles’ artisanal fishery lands about 4,000 tons of fish per year.
- Mahé Plateau fisheries:
  - The Mahé Plateau covers around 41,000 km2 and is fished up to approximately 50m deep.
  - The plateau is fished by 140 whalers and schooners and at least 400 outboard vessels, as well as sport and recreational boats.
  - These vessels go to sea for a day to a week and use hook and line, and traps.
- Sustainability and household vulnerability:
  - Continued sustainability of the demersal fishery is critical to food security; poorer households would be hardest hit if local supply deteriorated and prices rose.
  - Food items constitute just under 16 percent of the Consumer Price Index.
  - A dated (2011) survey found that about one fifth of households did not have the ability to buy sufficient meat and fish.

### External balances, diversification, and environmental constraints
- Import substitution and exports:
  - Seychelles imports about US$70m worth of food annually, constituting 9% of total goods imports (figures exclude tuna imports for re-export).
  - Further sustainable seafood production could reduce food import demand.
  - Increased export-oriented maritime products (e.g., crab, sea cucumber, seaweed, shrimp, sponge-based biotech products), including mariculture, could raise and diversify foreign currency earnings currently concentrated on tourism and tuna sales.
- Environmental sustainability:
  - Ensuring environmental sustainability will be critical, requiring appropriate regulations and enforcement.
  - Given Seychelles’ delicate ecology, production would likely need to be oriented to small, high value products supplied into the local tourism industry or to niche international markets.
- Fiscal benefits:
  - A larger blue economy can support public revenues and, depending on allocation and quality of public spending, benefit the poorest.

### Fiscal and distributional context
- Government fiscal averages and sectoral contribution:
  - Government revenues and absorption of total expenditures averaged 34% and 37% of GDP over 2011-2016, respectively.
  - The tourism sector contributes directly about one third of total taxes.
- As the blue economy develops and contributes more taxation revenues, fiscal incidence will change and may need assessment and adjustment to ensure shared prosperity.

### Policy priorities for making blue economy growth inclusive
- Strengthen the evidence base:
  - Improve satellite accounts for tourism (visitor spending figures currently unreliable) and fisheries (value chains for non-tuna fisheries lack systematic data collection; little statistical capture of charter sport and recreational fisheries).
  - Use such data to apply analytical techniques (e.g., adjusted net savings) to determine sustainability with respect to preserving natural capital.
  - Invest in more regular, standardized household surveys (including fishing-dependent households) and enterprise surveys to assess inclusiveness.
- Planning, regulation, and enforcement:
  - Further develop and streamline planning and regulatory requirements and enforcement.
  - Coordinate blue economy development strategy with sectoral and national policy planning frameworks (Ministry of Environment, Energy and Climate Change; Ministry of Finance, Trade and Economic Planning).
  - Regularity, clarity and consistency are needed to support private sector investment and ensure fair, transparent access to benefits.
- Skills, small business support, and fiscal calibration:
  - Ensure local labor force participants can obtain skills to access new, higher-earning opportunities in the sector.
  - Address general small business development challenges (such as the high cost of credit).
  - In the public sector, calibrate fiscal incidence to an evolving revenue base while strengthening quality of public services.

### Fiscal consolidation, revenue options, and expenditure priorities (context from broader chapter)
- Medium-term fiscal target and 2018 need:
  - Authorities committed to reducing public debt to GDP ratio below 50 percent by 2020, requiring a primary surplus of 3 percent of GDP each year from 2017 onwards.
  - After one-off measures in the 2017 budget expire, if no additional measures are taken in 2018 the authorities will face a fiscal gap of about 1½ percent of GDP from 2018 onward compared with the primary surplus targeted at 3 percent of GDP.
- Business tax structure and incentives:
  - Tourism-related companies are subject to a business tax rate of 15 percent, against 30‒33 percent applied to other companies.
  - The Tourism Investment Acts provides concessions including: (i) accelerated and additional depreciation for investments; (ii) 200 percent bonus deduction on marketing and promotion expenses up to 5 percent of turnover; and (iii) extra deduction for training expenses and salaries paid for one year to qualified graduates.
  - The 2016 FAD TA mission estimated the revenue loss of these preferences and the lower business tax rate of the 24 sample companies at 0.6 of GDP.
  - Business taxes to GDP ratio hovered 4¼‒5½ percent since it peaked at 7.1 percent in 2011.
  - Tourism-related companies’ share in total business tax collections hovered around 7¾‒10¼ percent during 2011‒15, compared with their share of 25‒34 percent in personal income tax and VAT.
- Revenue measures discussed (estimated revenue impact, in percent of GDP):
  - Increase fuel excises in line with FAD TA recommendations: 0.50
  - Increase yacht fees: 0.05
  - Increase passenger air duty from $10 to $150: 0.10
  - Impose 10 percent tax on sugary drinks and confectionary: 0.10
  - Total: 0.75
- Expenditure composition and wage bill:
  - Capital spending’s share in total spending is 12¾ percent in Seychelles, while this share slightly exceeds 20 percent on average among Caribbean countries and SADC members.
  - Seychelles spends 10½ percent of GDP on compensation (wage bill), higher than most peer countries.
  - Wage bill to GDP ratio is envisaged to reach 11 percent of GDP in the 2017 budget from around 9½ percent in 2015.
  - There could be scope to streamline salary costs in the public sector, for instance by more efficient use of personnel or greater use of technology.

*Source: IMF staff chapter text (cr17161).*

### 9.      The government could create savings by better targeting the social welfare spending.

### 9.      The government could create savings by better targeting the social welfare spending.

### Social protection targeting and savings
- Seychelles spends about 4½ percent of GDP on social protection.
- The current social protection system supports households that are not needy, while most households in need do not get assistance.
- Eligibility criteria create inequities through a complex system of exclusions, deductions, and cost sharing arrangements.
- There would be room to create savings over the medium term by implementing recommendations proposed in the Social Protection Policy Note by the World Bank (June 2016), including review and adjustment of means test and benefit level of home care program and social welfare assistance.
- Reference: See the Social Protection Policy Note (World Bank, 2016).

### Education spending efficiency
- Method: Data envelopment analysis (DEA) approach used to measure relative efficiency of translating public spending (inputs) into measurable outcomes (outputs).
- Inputs: primary and secondary education spending; Outputs: net enrollment ratio.
- Interpretation: distance to the efficiency frontier equals the output increase achievable with the same inputs or the reduction of inputs achievable while leaving output unchanged.
- Finding: Seychelles does not compare favorably with many Caribbean countries with similar per-capita income level and geographic characteristics.
- The World Bank’s Public Expenditure Review in 2014 found salary costs accounted for over 90 percent of all education costs, leaving little for other vital spending such as learning materials.
- Policy implication: The government could find a way to restrain personnel costs across the public sector.

### Health spending efficiency and fiscal savings opportunities
- Finding: Seychelles is the top performer in the SSA in terms of health outcomes; health indicators compared favorably with some OECD countries (World Bank Public Expenditure Review, 2014).
- Efficiency analysis: health-adjusted life expectancy used as output and health spending as input; some SADC countries and many Caribbean countries score better than Seychelles (closer to the frontier).
- Opportunity: Both the country’s already impressive health outcomes and the fiscal balance could be further improved.
- Specific policy proposal: introducing sugar tax, which is under consideration by the government, could boost revenue while helping improve population health.

### Public investment, infrastructure quality, and efficiency
- Despite a smaller share of capital spending in total government spending, quality of public infrastructure in Seychelles compares favorably with peers (airports, ports, roads).
- Seychelles ranks favorably in terms of stock (quantity) of physical infrastructure, given smaller share of total expenditure to capital spending.
- PEFA assessment completed in late 2016 indicates authorities could further improve efficiency and quality of public investments.
- Weaknesses identified: project selection, costing, and monitoring.
- Institutions in place: Development Committees, Public Sector Investment Plan, and Public Investment Manual (PIM) adopted.
- Recommendation: Capacity enhancement in project selection, costing, monitoring, and efficient use of PPPs would help create space for priority investments in electricity, sewage, and water projects, as well as climate change and adaptation investments in the medium term.
- Source for expenditure assessment: IMF FAD Expenditure Assessment Tool (EAT).

### External stability and competitiveness — overview
- Seychelles’ exchange rate appears broadly in line with fundamentals, but authorities need to arrest recent appreciation in the REER before it poses a risk to external stability.
- Sector concentration: tourism-related sectors account for 32 percent of GDP and tourism earnings account for 30 percent of total exports of goods and services.
- Comparator thresholds for special cases: 15 percent of GDP and 25 percent of total exports.
- Implication: Traditional model coefficients may not reflect concentrated external income; quantitative estimates should be complemented with qualitative comparisons to structurally similar small island tourism-based economies.

### Real exchange rate assessment (EBA-lite results)
- CA model suggests a real exchange rate gap of +22.1 percent (implying sizable overvaluation of the rupee) with a large residual of -21.3 percent.
- IREER model estimates a real exchange rate gap of -13 percent (i.e. undervaluation of the rupee) with a residual of -17 percent.
- Discrepancies explained by country-specific circumstances and limitations of the approach for small, tourism-based countries.
- Selected EBA-lite numbers (as reported):
  - CA-Actual: -0.19
  - CA-Fitted: 0.03
  - CA-Norm: 0.00
  - Residual (CA model): -0.21
  - CA-Gap: -0.19
  - Policy gap: 0.03
  - Elasticity: -0.85
  - Real Exchange Rate Gap (CA Model): 0.22
  - Cyclical Contributions: -0.01
  - Cyclically adjusted CA: -0.18
  - Cyclically adjusted CA Norm: 0.01
  - IREER ln(REER)-Actual: 4.76
  - IREER ln(REER)-Fitted: 4.94
  - IREER ln(REER)-Norm: 4.89
  - Residual (IREER model): -0.17
  - REER-Gap: -0.13
  - Policy gap (IREER model): 0.04
- Sources: Fund staff estimates.

### Other competitiveness indicators
- Tourism performance:
  - Since 2009, Seychelles experienced stronger growth in tourist arrivals relative to comparator group average and increased share in the group total.
  - International tourism receipts have not grown as fast; slower growth related to depreciation of the euro relative to the US dollar (bulk of receipts denominated in euro).
  - Foreign direct investment (inward) pattern similar to other countries except a large one-off investment in 2012.
  - Since 2014, authorities have imposed a moratorium on new large hotel investments.
- REER dynamics:
  - The REER has been appreciating since end 2014, following a sharp depreciation.
  - Pace slowed starting in [March 2016], reflecting negative domestic inflation.
  - Current level of the REER is around 13 percent higher than the average during the first 5 years under the program.
  - Continued appreciation of the REER could pose risks given an already large external current account deficit.
- Other indicators:
  - Current account position compared to comparator group has been weaker in recent years.
  - Pace of accumulation of international reserves has been faster than comparator group except for last year when significant depletion occurred with commencement of amortization of a restructured bond.
  - Terms of trade indicator shows deterioration over the past two years, indicating slight loss of competitiveness relative to peers.
- Business environment:
  - Seychelles fell from 80th to 93rd in the World Bank’s Doing Business overall indicator over the past three years.
  - Areas of concern: starting a business, dealing with construction permits, access to electricity and finance, and enforcing contracts (all ranked in mid-100s among 190).
  - Areas of improvement: paying taxes (32) and trading across borders (84).

### Reserve adequacy
- After a decline in 2016 from above 4 months of imports, reserves will stay stable around 3½ months.
- Based on the Assessment of Reserve Adequacy for Emerging Market (ARA-EM), this level appears to be adequate, with projected reserves staying at around 170 percent of the ARA-EM metric.
- Rationale for higher reserves: justified by increasing vulnerability of Seychelles’ tourism economy to natural disasters and climate change.

### Monetary transmission effectiveness
- Empirical assessment: structural VAR model finds monetary transmission mechanisms are generally weak; results may reflect inefficiencies of the current monetary framework.
- Context:
  - Central Bank of Seychelles (CBS) adopted a reserve money targeting framework since November 2008 IMF-supported program to support liberalization and a floating exchange rate regime.
  - Seychelles is among very few small states classified as flexible in exchange rate regime both de jure and de facto.
- Channels examined: money, interest rate, exchange rate, and credit channels.
  - Money channel: changes in reserve money transmitted to broad money via money multiplier.
  - Interest rate channel: increases in money supply reduce interest rates, stimulating investment and output.
  - Exchange rate channel: uncovered interest rate parity affects exchange rates, net exports, and aggregate demand.
  - Credit channel: asymmetric information raises external finance premia, affecting supply of credit; includes bank-lending and balance-sheet channels.
- Constraint: unstable money multiplier and velocity can make the relationships between reserve money, money supply, and output unpredictable.
- Note: two additional channels (asset price and expectation channels) exist but are not discussed due to data availability.

*Source: IMF staff report text (cr17161).*

### 6. To assess the efficiency of monetary transmission mechanisms, we follow the widely

### 6. To assess the efficiency of monetary transmission mechanisms, we follow the widely

### Methodology
- Structural VAR methodology used to identify purely exogenous shocks to monetary policy and trace dynamics of variables after shocks.
- Structural VAR (formal): A X_t = β_0 + β_n X_{t-n} + λ Y_t + u_t
  - X_t is a vector of endogenous time series variables.
  - Y_t is a vector of contemporaneous exogenous variables.
  - u_t are independent structural shocks.
- Reduced-form VAR obtained by multiplying structural model by A^{-1}: X_t = G_0 + G_1 X_{t-n} + e_t, where e_t = A^{-1} . u_t.
- Identification of structural shocks achieved via Choleski decomposition on matrix A.
- Variable ordering for Choleski: real GDP (y), price level (p), reserve money (m), policy rate (r), credit to the private sector (c), nominal effective exchange rate (e).
  - Implications of ordering:
    - Shocks to real GDP and price level result in contemporaneous responses of reserve money.
    - Reserve money is assumed to be the main monetary policy instrument; shocks to reserve money considered monetary policy shocks.
    - Policy rates are assumed to be used as instruments to signal changes in monetary policy stance.
    - Commercial banks react with a delay to the policy rate.
    - Exchange rates are determined by market forces.

### Endogenous and Exogenous Variables
- Endogenous variables: real GDP (y), price level (p), reserve money (m), policy rate (r), credit to the private sector (c), nominal effective exchange rate (e).
- Exogenous variables: global oil price index, global food price index, the US federal funds rate, US industrial production (assumed proxies for global demand).
- Variables are in log levels, except for interest rates.

### Data and Specification
- Frequency and transformations:
  - Monthly measures used for real GDP, CPI, reserve money, credit to the private sector, interest rates, nominal effective exchange rates.
  - Quarterly real GDP interpolated to monthly using a cubic spline, then seasonally adjusted with X13 ARIMA.
  - T-bill rate used as policy rate proxy due to absence of official policy rate in Seychelles.
- Data sources:
  - Quarterly GDP: National Bureau of Statistics of Seychelles.
  - CPI, reserve money, credit to the private sector, NEER: IMF IFS database.
  - Global oil and food indices, US federal funds rate, US industrial production: IMF GAS database.
- Stationarity and residual diagnostics:
  - All variables tested with Phillips-Perron test: all non-stationary in levels but first differences are stationary.
  - Residuals tested for serial correlation; lags excluded where serial correlation found.
- Lag selection and system stability:
  - Lag length criteria and Likelihood ratio test selected a lag of 3.
  - Stability assessed via inverse roots of characteristic AR polynomial: all roots lie inside the unit circle, resulting in the VAR being stationary.
  - Note: Had a root equal to one, cointegration would require a VECM rather than an unrestricted VAR.

### Results — Variance Decomposition and Impulse Responses
- Variance decomposition summary:
  - Contribution of monetary shocks to the variability of GDP and inflation is very small.
  - For GDP: shocks to the exchange rate and interest rate account respectively for 5.3 percent and 3.5 percent of the variation in GDP.
  - For CPI: shocks to credit and exchange rate account respectively for 4.9 percent and 2.6 percent of the variation in CPI.
- Impulse response findings:
  - Money and interest rate channels appear to be weak.
    - Neither output nor price react to a one standard deviation shock of reserve money and T-bill rate.
  - Credit and exchange rate channels only weakly present.
    - A one standard deviation positive shock to credit has some brief impact on CPI.
    - Reserve money and interest rate were not found to have an impact on credit.
    - A one standard deviation positive shock to the exchange rate results in a weak increase in GDP.
    - NEER was not found to be responsive to either reserve money nor interest rate.

### Additional Diagnostics: Velocity and Money Multiplier
- Trends indicate both velocity and money multiplier have not been stable over time, which may indicate some ineffectiveness in monetary transmission.
  - Velocity tended to decline over time, especially between 2013 and 2015.
  - Fluctuations in velocity were mainly driven by volatility in broad money rather than GDP.
  - Money multiplier: broadly stable from 2011 to 2013, increased slightly from 2013 to 2014, then declined in months during 2015.
- Implication: Unstable money multiplier (affecting transmission from reserve money to money supply) or unstable velocity (affecting link from money supply to output) would make those relationships unpredictable.

### Conclusion and Policy Recommendations
- Main conclusion:
  - Monetary transmission in Seychelles is generally weak.
  - Impact of the money and interest rate channels are statistically insignificant.
  - Only partial evidence exists for a credit channel and an exchange rate channel.
- Identified inefficiencies in the current monetary framework that likely limit transmission:
  - Structural excess liquidity in the banking system, which could significantly affect monetary transmission through the money channel.
  - Limited interest rate corridor that does not allow clear signaling of the monetary stance and guidance to market short-term interest rates, likely hampering the interest rate channel.
  - Underdeveloped money markets including interbank markets, which would probably limit effectiveness of the credit channel.
- Ongoing and planned reforms:
  - CBS transitioning from a reserve money based framework to an interest rate based framework to strengthen the interest rate impact and improve transmission.
  - Reintroduction of an interest rate corridor to allow better signaling and transmission of the monetary stance.
  - Introduction of a monetary policy rate scheduled to be approved by June 2017 and implemented by July 2017, expected to help reduce short-term interest rate volatility and provide guidance to short-term interest rates.

*IMF staff estimates and Seychelles authorities (content unit: cr17161).*

### 4. Seychelles’ banking system is prone to structural excess liquidity, largely built-up by

### 4. Seychelles’ banking system is prone to structural excess liquidity, largely built-up by

### Structural excess liquidity: sources and episodes
- Excess liquidity in the banking system is largely built up by the accumulation of net foreign assets (NFA).
- Notable episodes:
  - 2009: NFA increased significantly, forcing the CBS to mop-up excess liquidity.
  - Fall of 2013: a massive excess liquidity resulting from opportunistic CBS purchases of foreign exchange; the CBS was unable to mop-up excess liquidity without undermining its capital position, consequently driving short-term interest rates down.
  - 2014: the government issued medium-term rupee-denominated bonds as well as weekly T-bills, which considerably reduced excess liquidity.
- Policy implication: Because excessive liquidity represents a risk to macro stability, the government should continue to provide all the T-bills needed to achieve the country’s monetary policy goals, even if that means a higher debt burden. Macro stability is a public good and as such, should be a priority.

### Interest rate signaling and the auction process
- After a brief introduction in 2014, authorities are considering the reintroduction of an interest rate corridor.
- Current issues undermining market signaling:
  - The CBS regularly influences auction outcomes by eliminating bids it views as out of line or to avoid interest rate volatility.
  - This practice has confused market participants about what rate to bid and what rate would be accepted.
  - Lack of understanding of the CBS’s auction directions by market participants has contributed to weak signaling of the preferred monetary policy stance.

### Weaknesses in money and interbank markets
- Structural excess liquidity may have contributed to an underdeveloped money and interbank market.
- Characteristics of the current interbank market:
  - Interbank rates are quoted rather than transacted rates.
  - Pricing is mainly the result of bilateral negotiations, longstanding relationships, or credit lines between counterparties.
  - T-bill rates and standing facilities’ rates play a marginal role in interbank pricing.
- Market infrastructure gaps:
  - Lack of a trading platform.
  - Cumbersome procedures for ownership transfer.
  - Still-pending legislation for master repurchase agreements.
- Consequence: absence of a secondary market and limited development of interbank and secondary markets, which can render even short-term financial instruments illiquid and incentivize banks’ liquidity hoarding.

### Reforms under consideration — Improving liquidity forecasting
- The CBS is receiving TA to strengthen analysis of the banking system’s liquidity position and the size of its precautionary liquidity buffer.
- Measures under consideration:
  - Training additional staff for continued liquidity forecasting.
  - Conducting forecasts on foreign exchange auctions for reserve management purposes for the medium-term.
  - Better monitoring of the currency composition of required reserves.
- Coordination requirement: these measures would reduce liquidity risk but call for more coordination within the CBS and between the CBS, the Ministry of Finance and the Treasury.

### Reforms under consideration — Modernizing liquidity management operations and instruments
- Constraints: issuance of T-bills and government bonds is constrained by the government’s debt reduction strategy.
- Options:
  - Identify alternative instruments that would not compromise the CBS’ capital position to manage liquidity.
  - Clarify and accelerate resolution of legal issues related to repurchase operations and the introduction of a master repurchase agreement so that, over the medium term, repurchase operations can substitute for CAAs and DAAs as primary open market instruments.
  - Leverage current government securities on the CBS balance sheet for monetary purposes.
- Footnote: master repurchase agreement currently scheduled for mid-2018.

### Reforms under consideration — Reinforcing the interest rate corridor and monetary framework
- A functioning interest rate corridor would:
  - Support development of the interbank market.
  - Give incentive for banks to more actively manage liquidity.
- Proposed framework:
  - Introduce a new monetary framework focused on an implicit monetary policy rate (MPR) that would fluctuate within a corridor formed by the SCF and SDF rates.
  - The reintroduction of the interest rate corridor, currently scheduled to be approved by June 2017 and implemented by July 2017, would help reduce short-term interest rate volatility and provide guidance for short-term interest rates.
  - The implicit MPR and hence the interest rate corridor should be set consistently with the RM target and adjusted up or down to achieve the medium-term inflation target.

### Expected market development effects
- As the interest rate corridor strengthens, the money market and interbank market should further develop, reducing the need to issue more monetary debt.
- A better liquidity management and a functional interest rate corridor should support development of the interbank market and secondary markets, eliminating incentives for banks’ liquidity hoarding.
- Improved communication with market participants will support well-functioning financial markets and promote effective monetary policy implementation.

### Ongoing discussions and design considerations
- Based on recent TA missions and discussions with the authorities, issues under consideration include:
  - (i) how much focus needs to be put on interest rates;
  - (ii) the width of the corridor;
  - (iii) whether the corridor should be symmetric or asymmetric;
  - (iv) access to standing facilities;
  - (v) auction frequency and maturities;
  - (vi) the implementation date of the new framework; and
  - (vii) the sequencing of communication events.

*Source: IMF staff report excerpt.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2017/cr17161.pdf_