## cr1873

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---

### FISCAL ANCHORS: OPTIONS/TRADEOFFS — Background and recent fiscal outcomes
- Program period: June 2010 to March 2016 — program cash balance kept above target floor.
- Staff recommendation: maintain broader cash balance at a minimum of two months of total spending; anchor fiscal plans to a non-commodity primary deficit target of 2.5 percent of GDP.
- Cash balance trajectory:
  - End-2015 program cash balance: SI$694 million (equivalent to 3.6 months of recurrent spending).
  - End-2016 program cash balance: SI$412 million (2.0 months of recurrent spending).
  - End-2016 broader cash balance: SI$552 million (1.9 months of total spending).
  - As of July 2017 program cash balance: SI$363 million (1.7 months of recurrent spending).
- 2016 revenue and expenditure drivers:
  - Higher export duties from logging and higher-than-expected fishing license yields.
  - Lower goods tax collection due to lower fuel prices and widespread exemptions, including income tax exemptions for members of parliament.
  - Recurrent expenditure slightly higher than the 2016 budget, driven by increased compensation of employees.
- Debt outlook:
  - On current policies, public debt-to-GDP ratio projected to rise above the government’s target of 30 percent by 2028; primary drivers are high disbursement schedule and continued expansionary policy.

### Current fiscal framework (features and limits)
- Key components and limits:
  - Program commitment: broader cash balance should cover at least 2 months of total spending. <At end-2016, 1.9 months>
  - Public Financial Management Act (PFMA) 2013: restricts government borrowing to finance recurrent expenditures; allows new borrowing for high priority infrastructure and development, except for short-term borrowing in exceptional circumstances.
    - 2017 budget planned short-term borrowing up to SI$100 million (about 1.0 percent of GDP).
    - 2017 budget provides SI$85 million (1.8 percent of total expenditure) recurrent and development contingency warrants.
    - PFMA requires use of contingent warrants to be tabled in the next sitting of National Parliament and disclosed within 30 days after it is tabled.
  - Debt Management Strategy (DMS) limits: public debt-to-GDP ratio 30% and debt service to domestically-sourced revenue ratio 10%.
    - 2016 actuals: public debt 7.9% of GDP; debt service to domestically-sourced revenue 2.7%.
    - Annual borrowing limit in 2017 budget: SI$900 million (about 8.8 percent of GDP), comprising SI$600 million for Tina hydropower project and SI$300 million for other purposes, including undersea cable.
    - Worst-case scenario in DMS: 30 percent depreciation in the Solomon Islands dollar against all foreign currencies.
  - Medium Term Fiscal Strategy (MTFS): five-year fiscal direction, developed in 2008 and updated annually; not published since 2014.
- Operational limits for Treasury bills: SI$40 million (operational limit) and SI$100 million (policy limit).
- Observed weaknesses:
  - Current balance recorded a surplus of 6.8 percent of GDP in 2016, higher than government target of zero percent — PFMA not binding.
  - Development spending has expanded substantially and exceeds the surplus on the current balance.
  - Debt ratio constraints not binding when debt is well below the 30 percent ceiling.

### Need for a new fiscal anchor: objectives and rationale
- Near-term priority: tackle public financial management problems and rebuild the cash buffer to cope with day-to-day management.
- Roles for a fiscal anchor:
  - Provide short- and medium-term guidance for fiscal policy and annual budget discipline when debt is well below the ceiling.
  - Manage extremely high revenue volatility from logging and fishing license fees.
  - Address recurrent spending rigidity due to high costs of public service delivery across remote islands.
  - Create policy space to scale up infrastructure investment and spending on health and education to support higher and inclusive growth.
  - Build fiscal buffers to enhance resilience to shocks, enabling immediate liquidity for disaster relief and recovery.
- Structural features:
  - Development expenditure accounts for 13.6 percent of GDP (noted as much lower than the average 32 percent of low-income countries).
  - Revenue volatility and recurrent expenditure rigidity promote procyclicality of fiscal policy; fiscal anchors can enable saving windfall revenues in good times.

### International experience: types of fiscal rules and tradeoffs
- Four broad rule types:
  - Budget Balance Rules (BBRs): targets can be overall balance, structural/cyclically adjusted balance, or balance “over the cycle”; includes Golden Rule (net of capital expenditure).
  - Debt Rules (DRs): set explicit public debt limits/targets.
  - Expenditure Rules (ERs): limits on total, primary, or current spending in absolute terms, growth rates, or percent of GDP.
  - Revenue Rules (RRs): ceilings or floors on revenues.
- Pros/cons summary:
  - BBRs: clear operational targets and help safeguard debt sustainability; require output gap estimation and are hard to communicate when structural adjustments used.
  - DRs: easy to communicate; ineffective when debt is well below ceiling (Solomon Islands at 7.9 percent vs. 30 percent).
  - ERs: easy to communicate and monitor; no direct link to debt sustainability without revenue control.
  - RRs: can improve tax policy/administration; challenging to set due to business cycle effects.
- Commodity-exporter considerations:
  - Rules must address volatility of commodity prices and depletion of natural resources.
  - Approaches: revenue split rules, price smoothing rules, expenditure rules.
  - Intergenerational approaches: Permanent Income Hypothesis (PIH) and Bird-in-hand.

### Practical implications and contingency provisions
- Fiscal anchors should balance debt sustainability with infrastructure and development needs and allow flexibility for disaster response through contingency mechanisms and pre-funded funds once buffers rebuilt.
- 2017 budget contingency warrants: SI$85 million (1.8 percent of total expenditure); international experience suggests contingency provision typically around 2 percent of total expenditure for immediate liquidity support.
- Recommendation: include contingency warrants in the budget; if disasters do not occur, save allocation in a contingency fund for natural disasters.

*Prepared by Hidetaka Nishizawa (APD). Source: IMF staff note (January 4, 2018) on Fiscal Anchors: Options/Tradeoffs for Solomon Islands.*

---

### Fiscal-anchor choices, objectives, and trade-offs; conditions for effective rules
- Fiscal-anchor options and trade-offs:
  - Overall or primary balance — Objective: Control accumulation of debt or assets. Trade-off: “In case revenue are volatile, expenditures may be volatile (Pro-cyclicality)”.
  - “Modified” balance — Objective: Control volatility of expenditures. Trade-off: “Little control of accumulation of debt/assets (endogenous)”.
  - Limit on growth of spending — Objective: Smooth expenditures and reduce economic volatility; allows accumulating savings. Trade-off: “Limit the flexibility to respond to shocks”.
  - Debt target — Objective: Maintains sustainability and allows maintaining buffers. Trade-off: “Implies that fiscal policy may be pro-cyclical (you need to keep deficit under control)”.
  - Assets (net of debt) — Objective: Build buffers against shocks or save for future generations. Trade-off: “May impose spending cuts and limits on investment”.
- Conditions for effective fiscal rules (IMF, 2014):
  - (i) Relevant objective.
  - (ii) Simplicity and transparency.
  - (iii) Resilience to shocks — include an escape clause and rules for buy-back post-shock.
  - (iv) Enforceability — automatic correction mechanisms (e.g., “debt brake”).
- PFM prerequisites:
  - Reliable data and minimum technical forecasting capacity.
  - Comprehensive budget reporting systems producing in-year and end-year reports timely.

### Institutional support and monitoring
- Typical supporting arrangements: statutory norms, political commitments, fiscal responsibility laws, independent fiscal councils.
- Solomon Islands: Public Accounts Committee (PAC) role and capacity:
  - PAC composition: “consists of eight Members of Parliaments and is headed by the former Deputy Prime Minister, with eight secretariats and one technical advisor from UNDP.”
  - PAC powers: can summon public officers, accounting officers, and technical staff; can consider draft estimates for the Annual Appropriation Bill.
  - Recommendation: use current PAC assets rather than creating another independent fiscal agency.

### Numerical fiscal-rule proposals for Solomon Islands
- BBRs, overall fiscal deficit: “1.5 percent of GDP”
  - Assumption: government rebuilds broader cash balance during 2017-2022 and implements consolidation measures to maintain fiscal deficit around 1.5 percent of GDP.
- BBRs, non-commodity primary deficit: “4 percent of GDP”
  - Note: “The 1.5 percent fiscal deficit would correspond to the 4.6 percent non-commodity primary deficit on average... The target is weaker than previous recommendation of 2.5 percent of GDP but would still be consistent with maintaining debt sustainability.”
- ERs, constraint on recurrent expenditure, excluding grant-funded recurrent expenditure: “25.0 percent of GDP”
  - Operational note: public wage bills account for around 39 percent of recurrent expenditure and need review.
- Rationale and outcomes of 1.5 percent overall fiscal deficit:
  - Ensures fiscal sustainability, meets infrastructure demands, maintains fiscal buffer to cope with procyclicality, unforeseen spending, contingent liabilities, and large shocks.
  - Complying with target would keep public debt-to-GDP ratio and its present value below government’s target thresholds of “30 percent” and “38 percent” respectively under the DSA for low-income countries.
  - “It would also maintain cash balance above two months of total spending over the projection period (2017–37).”

### Stress tests used and results
- Five stress tests:
  1. Growth shock: “real GDP growth is at historical average minus one standard deviations in 2018–19”.
  2. Primary balance shock: “Primary balance is at historical average minus one standard deviations in 2018–19”.
  3. Combination of 1) and 2) using one half standard deviation shocks.
  4. One-time depreciation shock: “one-time 30 percent real depreciation in 2018”.
  5. Non-debt flows shock: “10 percent of GDP increase in other debt-creating flows in 2018”.
- Result: “The results show that the most extreme shock is 1) Growth shock and that debt trajectories for other shocks do not exceed the threshold during the projection period (2017–37).”

### Fiscal-adjustment numbers (2017–2022–37, in percent of GDP relative to baseline)
- Revenue (2017–2022–37):
  - Revenue: 0.3 0.85 0.85 0.85 0.85 0.85
  - Tax Revenue: 0.3 0.85 0.85 0.85 0.85 0.85
  - Income and profits: 0.05 0.10 0.10 0.10 0.10 0.10
  - Reducing stock of tax arrears: 0.20 0.70 0.70 0.70 0.70 0.70
  - International trade and transactions: 0.05 0.05 0.05 0.05 0.05 0.05
- Expenditure (2017–2022–37):
  - Expenditure: -0.40 -0.90 -0.90 -0.90 -0.90 -0.90
  - Recurrent spending: -0.10 -0.35 -0.35 -0.35 -0.35 -0.35
    - Compensation of employees: -0.05 -0.10 -0.10 -0.10 -0.10 -0.10
    - Other recurrent spending: -0.05 -0.25 -0.25 -0.25 -0.25 -0.25
  - Development spending: -0.30 -0.55 -0.55 -0.55 -0.55 -0.55
    - CDFs: -0.10 -0.20 -0.20 -0.20 -0.20 -0.20
    - Other development spending: -0.20 -0.35 -0.35 -0.35 -0.35 -0.35
- Total Savings (2017–2022–37): 0.7 1.8 1.8 1.8 1.8 1.8
- Source: “Staff estimates.”

### Policy recommendations (fiscal framework and PFM)
- Introduce an additional fiscal anchor: long-term target to ensure fiscal and debt sustainability.
  - Recommendation: overall fiscal deficit at “1.5 percent of GDP”.
- Include an escape clause and operational shock provisions:
  - Include escape clause for natural disasters; include a “debt brake” requiring fiscal adjustment in case of ex-post deviations.
  - PAC can play monitoring role.
- Contingency warrants and contingency fund:
  - “Contingency warrants for unforeseen expenditures, including from natural disasters, should be included in the budget in line with international best practices.”
  - If a disaster does not occur, save allocation in a contingency fund once fiscal buffers rebuilt.
- Medium-Term Fiscal Strategy (MTFS):
  - Update annually and publish the five-year MTFS; include specific fiscal measures to achieve targets and manage fiscal risks, including natural-disaster risk.
- Strengthen public financial management (PFM):
  - IMF technical assistance for cash flow forecasting and budget revenue forecasting.
  - Produce and publish Mid-Year Budget Review and Final Budget Outcome on schedule.
  - Include donor-funded development expenditure in budget aggregates with enhanced grant-data quality.
  - Ministry of Finance and Treasury to strengthen capacity to compile GFS currently conducted by the central bank.
- Develop domestic debt market over time:
  - Treasury bills limits: operational limit “SI$40 million or about 0.4 percent of GDP” and policy limit “SI$100 million or about 1 percent of GDP”.
  - Over time develop a larger treasury bill market to support fiscal policy and financial deepening.

### Context: infrastructure gap and natural-disaster vulnerability
- Infrastructure access and costs:
  - Less than half of the population has access to electricity; only “15 percent” of rural inhabitants have access to electricity.
  - “59 percent of households in the country have to travel long distances to access water.”
  - Mobile phone ownership: “over a third of the population”; internet access: “3 percent” of the population.
- Natural-disaster frequency and impact:
  - IMF staff estimates (based on EM-DAT): Solomon Islands is hit, on average, by a natural disaster inflicting damage and losses equivalent to more than “3 percent of GDP” or affecting more than “5 percent of the population” once every “6–7 years.”
  - Worst episodes: devastation amounted to “14 percent of GDP” and affected more than half of the population.
  - The 2014 flood inflicted damage and losses equivalent to “5 percent of GDP” and partly contributed to the closure of the country’s only gold mine.
- Planned infrastructure scaling-up:
  - Under the 2017 Budget, two planned large infrastructure projects (Tina River hydropower plant and submarine cable Honiara–Sydney) slated for implementation between 2017 and 2022 are “equivalent to around a quarter of the GDP.”

*Source: cr1873 - 17.      Fiscal anchors should be designed and tailored to specific country objectives*

---

### A tailored application of the Debt-Investment-Growth (DIG) model — context and purpose
- Solomon Islands is a pilot case under the IMF’s Infrastructure Policy Support Initiative (IPSI).
- DIG model objective: evaluate macroeconomic and financial implications of alternative investment programs and financing strategies, and inform public investment management.
- Model focus: investment-growth linkages, public external and domestic debt accumulation, and fiscal policies to ensure debt sustainability.
- Model structure: dynamic general equilibrium framework of a small open economy with traded and non-traded goods sectors.
- Prior application findings:
  - Well executed high-yielding public investment can stimulate growth and be self-financing long run.
  - Poor execution, delayed fiscal reactions, or persistent negative shocks can yield unsustainable debt dynamics.

*Source: cr1873 - 4.      A tailored application of the Debt-Investment-Growth (DIG) model helps illustrate the*

---

### Modeling natural-disaster vulnerability: extended DIG framework, simulations, and findings
- Model extensions and channels:
  - Government investment in standard infrastructure and adaptation capital; government saving in an external contingency fund for reconstruction.
  - Adaptation capital features: reduces damages from natural disasters; depreciates at a lower rate than conventional public capital; can raise marginal product of private capital and crowd in private investment.
  - Natural disaster channels: (i) permanent damages to public infrastructure; (ii) permanent damages to private capital; (iii) temporary losses of productivity; (iv) increased inefficiencies in public investment during reconstruction.
  - Evidence: Vanuatu (cyclone Pam) shows adaptation infrastructure can complement conventional infrastructure and support debt sustainability with development partner aid and grants.

- Simulation set-up common assumptions:
  - Scaling-up of infrastructure spending for a five-year period; natural disaster hit after scaling-up.
  - Natural disaster shock: average damage equivalent to 20 percent of GDP, with effects lasting three years.
  - Government aims to fully rebuild damaged infrastructure in about 6 to 8 years.
  - Financing options: (i) domestic borrowing; (ii) external concessional loans; (iii) grants; (iv) higher taxes; (v) prioritizing capital spending over recurrent spending.
  - Grant financing assumed to increase by an additional 2 percentage points during the scaling-up period compared to steady state.
  - To fund new investment, government splits burden equally between higher taxation and lower recurrent spending.

- Simulation scenarios:
  - Simulation 1: Conventional vs. adaptation infrastructure; scaling-up = public spending sustained at 4 percent of GDP above steady-state levels for five years.
  - Simulation 2: Adaptation infrastructure with and without meaningful PFM reform (PFM reform raises returns and investment efficiency).
  - Simulation 3: Financing choice — full external concessional financing; full domestic borrowing; equal split between the two. Grants same across scenarios.

- Key simulation results:
  - Simulation 1 (Conventional vs. adaptation):
    - Fiscal deficit: identical during scaling-up; post-disaster adaptation infrastructure results in lower repair costs and lower long-run average maintenance/repair fiscal burden.
    - Public debt: adaptation infrastructure associated with lower public debt in the long term.
    - Private investment: conventional infrastructure gives a higher near-term boost; adaptation infrastructure yields larger medium- and long-term private investment via confidence effects.
    - Growth: adaptation infrastructure contains disaster-related drop in real GDP growth and supports higher medium- and long-term growth.
  - Simulation 2 (PFM reform):
    - Growth: higher-quality public investment raises capital efficiency and productivity, with full gains in medium and long run.
    - Recurrent expenditure and fiscal deficit: modest reduction in recurrent expenditure and lower long-term fiscal deficit due to lower maintenance costs.
    - Public debt: unchanged short term; lower long term.
  - Simulation 3 (Financing choice):
    - Domestic borrowing crowds out private-sector activity, especially in short and medium term.
    - Crowding-out leads to lower real GDP growth in medium and long term.
    - Domestic financing costs in Solomon Islands are among the highest in Pacific island countries; higher domestic debt service channels fiscal resources away from productive uses.
    - Fiscal position outcomes broadly similar across financing options despite growth differences.

### Policy implications and recommendations from simulations
- Prioritize disaster-resilient (adaptation) infrastructure despite higher upfront fiscal burden and longer implementation time to:
  - Cushion economy from worst disaster effects.
  - Limit contraction in economic activity.
  - Foster private investment via confidence effects.
  - Improve long-term fiscal position and lower indebtedness.
- Pursue timely PFM reforms to raise public investment quality and efficiency; PFM reforms amplify benefits of adaptation infrastructure.
  - Continue progress: passing of the PFM Act, draft Procurement Rules and Regulations; strengthen public investment management.
  - Improve transparency and accountability of Constituency Development Funds (CDF): publish 2012 CDF audit report, conduct regular audits, increase awareness of selection criteria and decision processes.
  - Leverage forthcoming Pacific Region Infrastructure Facility (PRIF) report for improvements.
- Seek external concessional financing where possible:
  - External concessional financing mitigates high domestic financing costs and crowding-out.
  - Benefits: supports debt sustainability, enforces discipline in investment spending, enables skill and knowledge transfer, and supports capacity building.
- Long-term objective: develop domestic markets and financial deepening to mobilize domestic savings for long-term growth.

### Base case calibration — key parameters and assumptions (percentages)
- Country-specific parameters (Table 1):
  - User fees for infrastructure services (percent of recurrent costs): 5.0
  - Public infrastructure investment to GDP ratio: 8.0
  - Public adaptation infrastructure investment to GDP ratio: 0.0
  - Consumption tax rate (VAT): 10.0
  - Public domestic debt to GDP ratio: 0.5
  - Public concessional debt to GDP ratio: 8.5
  - Public external commercial debt to GDP ratio: 0.0
  - Grants to GDP ratio: 10.0
  - Other revenue to GDP ratio: 4.0
  - Government savings to GDP ratio: 0.0
  - Remittances to GDP ratio: 0.3
  - Private external debt to GDP ratio: 10.3
  - Real interest rate on public domestic debt: 3.0
  - Trend per capita growth rate: 3.0
  - Imports to GDP ratio: 52.3
  - Value added in non-tradable Sector: 43.1
- Key assumptions (Table 2):
  - Initial return on standard infrastructure investment: 15.0
  - Initial return on adaptation infrastructure investment: 40.0
  - Efficiency of public infrastructure investment: 30.0
  - Steady state efficiency of public infrastructure investment: 30.0
  - Share of public debt adj. between commercial external and domestic (=100 when only domestic debt is used): 5.0
  - Capital's share in value added in the tradable-sector: 40.0
  - Capital's share in value added in the non-tradable sector: 55.0
  - Depreciation rate in tradable and non-tradable sector: 5.0
  - Depreciation rate of public capital (standard infrastructure): 15.0
  - Depreciation rate of public capital (adaptation infrastructure): 3.0
- Rationale highlights:
  - Initial return on standard infrastructure chosen as 15 percent versus World Bank median returns of 17 percent–31 percent.
  - Initial return on adaptation infrastructure set at 40 percent given literature (adaptation can avert up to 65 percent projected losses).
  - Public infrastructure investment efficiency base case 30.0; increased to 80.0 under PFM reform.
  - Share of public debt adj. between commercial external and domestic set at 5.0 due to low domestic borrowing capability.
  - Capital shares (tradable 40.0; non-tradable 55.0) based on GTAP guidance.

*Source: IMF staff, “Building Resilience to Natural Disasters: An Application to Small Developing States” (Ricardo Marto, Chris Papageorgiou, Vladimir Klyuev, forthcoming) and IMF staff note (January 4, 2018) on Fiscal Anchors: Options/Tradeoffs for Solomon Islands.*

### References _______________________________________________________________________________ 12

### FISCAL ANCHORS: OPTIONS/TRADEOFFS

### A. Background and recent fiscal outcomes
- Program period: June 2010 to March 2016 — program cash balance kept above target floor.
- Staff recommended maintaining broader cash balance at a minimum of two months of total spending.
- Staff also advised anchoring fiscal plans to a non-commodity primary deficit target of 2.5 percent of GDP.
- Cash balance deterioration:
  - End-2015 program cash balance: SI$694 million (equivalent to 3.6 months of recurrent spending).
  - End-2016 program cash balance: SI$412 million (2.0 months of recurrent spending).
  - End-2016 broader cash balance: SI$552 million (1.9 months of total spending).
  - As of July 2017 program cash balance: SI$363 million (1.7 months of recurrent spending).
- Revenue and expenditure drivers in 2016:
  - Higher export duties from logging and higher-than-expected fishing license yields.
  - Lower goods tax collection due to lower fuel prices and widespread exemptions, including income tax exemptions for members of parliament.
  - Recurrent expenditure slightly higher than the 2016 budget, driven by increased compensation of employees.
- Debt outlook:
  - On current policies, public debt-to-GDP ratio projected to rise above the government’s target of 30 percent by 2028; primary drivers are high disbursement schedule and continued expansionary policy.

### B. Solomon Islands: Current fiscal framework (features and limits)
- Key components:
  - Program commitment: broader cash balance should cover at least 2 months of total spending. <At end-2016, 1.9 months>
  - Public Financial Management Act (PFMA) 2013: restricts government borrowing to finance recurrent expenditures; allows new borrowing for high priority infrastructure and development, except for short-term borrowing in exceptional circumstances (major economic shock or natural disaster).
    - 2017 budget planned short-term borrowing up to SI$100 million (about 1.0 percent of GDP).
    - 2017 budget provides SI$85 million (1.8 percent of total expenditure) recurrent and development contingency warrants.
    - PFMA requires use of contingent warrants to be tabled in the next sitting of National Parliament and disclosed within 30 days after it is tabled.
  - Debt Management Strategy (DMS):
    - Limits: public debt-to-GDP ratio 30% and debt service to domestically-sourced revenue ratio 10%.
    - 2016 actuals: public debt 7.9% of GDP; debt service to domestically-sourced revenue 2.7%.
    - Annual borrowing limit in 2017 budget: SI$900 million (about 8.8 percent of GDP), comprising SI$600 million for Tina hydropower project and SI$300 million for other purposes, including undersea cable.
    - Worst-case scenario used in DMS: 30 percent depreciation in the Solomon Islands dollar against all foreign currencies.
  - Medium Term Fiscal Strategy (MTFS): five-year fiscal direction, developed in 2008 and updated annually; not published since 2014.
- Operational limits for Treasury bills: SI$40 million (operational limit) and SI$100 million (policy limit).
- Observed weaknesses:
  - Current balance (revenue excluding grants minus recurrent expenditures excluding grant-funded recurrent expenditure) recorded a surplus of 6.8 percent of GDP in 2016, higher than government target of zero percent — PFMA not binding.
  - Development spending has expanded substantially; development expenditure exceeds the surplus on the current balance.
  - Debt ratio constraints not binding when debt is well below the 30 percent ceiling.

### C. Need for a new fiscal anchor: objectives and rationale
- Primary near-term priority: tackle public financial management problems and rebuild the cash buffer to cope with day-to-day management.
- Roles for a fiscal anchor:
  - Provide short- and medium-term guidance for fiscal policy and annual budget discipline, especially when debt is well below the ceiling.
  - Help manage extremely high revenue volatility from logging and fishing license fees.
  - Address recurrent spending rigidity due to high costs of public service delivery across remote islands.
  - Create policy space to scale up infrastructure investment and spending on health and education to support higher and inclusive growth.
  - Build fiscal buffers to enhance resilience to shocks, including national disasters and climate change, enabling immediate liquidity for disaster relief and recovery.
- Structural country features:
  - Development expenditure accounts for 13.6 percent of GDP (noted as much lower than the average 32 percent of low-income countries).
  - Revenue volatility and recurrent expenditure rigidity promote procyclicality of fiscal policy; fiscal anchors can enable saving windfall revenues in good times.

### D. International experience: types of fiscal rules and tradeoffs
- Four types of fiscal rules (IMF, 2009; Schaechter and others, 2012):
  - Budget Balance Rules (BBRs):
    - Targets: overall balance, structural or cyclically adjusted balance, balance “over the cycle”.
    - Pros: clear operational targets, help safeguard debt sustainability.
    - Cons: adjustments require output gap estimation; structural and cyclically adjusted balances are difficult to communicate and monitor; balance-over-cycle may postpone corrective actions.
    - Golden Rule (GR): overall balance net of capital expenditures to safeguard public investment — less linked to debt sustainability.
  - Debt Rules (DRs):
    - Set explicit limit or target for public debt in percent of GDP.
    - Pros: direct link to debt target, easy to communicate and monitor.
    - Cons: when debt is well below ceiling (e.g., Solomon Islands at 7.9 percent vs. 30 percent ceiling), DRs do not provide sufficient guidance for fiscal policy.
  - Expenditure Rules (ERs):
    - Limits on total, primary, or current spending in absolute terms, growth rates, or percent of GDP.
    - Pros: relatively easy to communicate and monitor; operational tool to trigger consolidation when accompanied by BBRs or DRs.
    - Cons: no direct link to debt sustainability as revenue side not contained.
  - Revenue Rules (RRs):
    - Ceilings or floors on revenues.
    - Pros: can improve tax policy and administration.
    - Cons: challenging to set due to business cycle effects; not directly connected to debt sustainability.
- For commodity exporters, rules must account for:
  - (i) Volatility of commodity prices.
  - (ii) Depletion of natural resources.
  - Approaches to cope with price volatility and macro stability:
    - Revenue split rules: set aside a predetermined percentage of revenues.
    - Price smoothing rules: save difference between actual resource revenues and those consistent with a commodity reference price.
    - Expenditure rules: limit spending growth during price booms.
  - Approaches to ensure intergenerational equity and sustainability:
    - Permanent Income Hypothesis (PIH) approach: non-resource primary deficit constant and equal to the return on total wealth.
    - Bird-in-hand approach: tighter than PIH; spend only interest income generated from accumulated financial assets.

### E. Practical implications and policy tradeoffs highlighted
- Fiscal anchors should be chosen to:
  - Balance safeguarding debt sustainability with addressing severe infrastructure gap and development needs.
  - Allow flexibility for disaster response through contingency mechanisms and pre-funded contingency or disaster funds once fiscal buffers are rebuilt.
- Contingency provisions:
  - 2017 budget contingency warrants: SI$85 million (1.8 percent of total expenditure) for recurrent and development contingencies — consistent with selected country experiences suggesting contingency provision typically around 2 percent of total expenditure for immediate liquidity support.
  - Recommendation: include contingency warrants in the budget in line with international best practice; if disasters do not occur, save allocation in a contingency fund for natural disasters.

*Prepared by Hidetaka Nishizawa (APD). Source: IMF staff note (January 4, 2018) on Fiscal Anchors: Options/Tradeoffs for Solomon Islands.*

### 17.      Fiscal anchors should be designed and tailored to specific country objectives

### 17.      Fiscal anchors should be designed and tailored to specific country objectives

### Fiscal-anchor choices, objectives, and trade-offs
- Overall or primary balance
  - Objective: Control the accumulation of debt or assets.
  - Trade-off: “In case revenue are volatile, expenditures may be volatile (Pro-cyclicality)”.
- “Modified” balance
  - Objective: Control volatility of expenditures.
  - Trade-off: “Little control of accumulation of debt/assets (endogenous)”.
- Limit on the growth of spending
  - Objective: Smooth expenditures and so reduces economic volatility; allows accumulating savings.
  - Trade-off: “Limit the flexibility to respond to shocks”.
- Debt target
  - Objective: Maintains sustainability and allows maintaining buffers.
  - Trade-off: “Implies that fiscal policy may be pro-cyclical (you need to keep deficit under control)”.
- Assets (net of debt)
  - Objective: Allows building buffers against shocks, or save for future generations.
  - Trade-off: “May impose spending cuts and limits on investment”.

### Conditions for effective fiscal rules
- Four conditions for effective fiscal rules (IMF, 2014):
  - (i) Relevant objective — most common objective is to preserve debt sustainability; rules should be well designed to address country-specific issues.
  - (ii) Simplicity and transparency — complicated rules with multiple numerical targets, broad exemptions, and limited coverage are hard to monitor and easily circumvented.
  - (iii) Resilience in the face of shocks — rules should be flexible enough to respond to adverse shocks (including natural disasters); an escape clause that allows temporary breach of rules as part of the response to shocks is recommended. “Ideally, fiscal rules should include specific provisions for how fiscal targets would be adjusted in the event of shocks and how policies would be bought back in line with fiscal rules in the post-shock periods.”
  - (iv) Enforceability — fiscal rules with automatic correction mechanisms can enhance enforceability; a “debt brake” requires fiscal adjustment in case of ex post deviations from the rule.
- Effective implementation requires strong public financial management (PFM) systems (IMF, 2009):
  - Reliable data and a minimum technical forecasting capacity to ensure sufficient accuracy in budgetary aggregates.
  - Comprehensive budget reporting systems to produce and publish in-year and end-year reports in a timely manner to allow internal and external monitoring.

### Institutional support and monitoring
- Typical arrangements supporting fiscal rules: BBRs, DRs, ERs established through statutory norms, political commitments, coalition agreements.
- Fiscal responsibility laws expand procedural and transparency requirements, particularly in emerging market economies.
- Independent fiscal councils can assess and monitor implementation in some countries.
- Solomon Islands: the Public Accounts Committee (PAC) under the National Parliament examines public accounts and can monitor implementation of fiscal rules.
  - PAC composition and capacity: “consists of eight Members of Parliaments and is headed by the former Deputy Prime Minister, with eight secretariats and one technical advisor from UNDP.”
  - PAC powers: can summon public officers, accounting officers, and technical staff to produce background information and explanations; can consider draft estimates for the Annual Appropriation Bill.
  - Given limited resources, the report suggests using current PAC assets rather than creating another independent fiscal agency.

### Possible application of fiscal anchors for the Solomon Islands — numerical proposals
- Numerical fiscal-rule proposals suggested by staff:
  - BBRs, overall fiscal deficit: “1.5 percent of GDP”
    - “We assume that the government takes interim steps to rebuild the broader cash balance during 2017-2022 … and continues to implement fiscal consolidation measures … to maintain fiscal deficit of around 1.5 percent of GDP (see Table 4).”
  - BBRs, non-commodity primary deficit: “4 percent of GDP”
    - Note: “The 1.5 percent fiscal deficit would correspond to the 4.6 percent non-commodity primary deficit on average, but it is probably best to err on the side of conservatism … The target is weaker than previous recommendation of 2.5 percent of GDP but would still be consistent with maintaining debt sustainability.”
  - ERs, constraint on recurrent expenditure, excluding grant-funded recurrent expenditure: “25.0 percent of GDP”
    - Operational note: authorities need to review public wage bills, which “account for around 39 percent of recurrent expenditure.”
- Rationale and outcomes of 1.5 percent overall fiscal deficit:
  - Ensures fiscal sustainability, meets high infrastructure demands, and maintains fiscal buffer to cope with procyclicality, unforeseen spending, potential contingent liabilities, and large shocks (e.g., natural disaster).
  - Complying with target would keep public debt-to-GDP ratio and its present value below government’s target thresholds of “30 percent” and “38 percent” respectively under the DSA for low-income countries.
  - “It would also maintain cash balance above two months of total spending over the projection period (2017–37).”
- Stress tests (five tests used in the framework):
  - 1) Growth shock: “real GDP growth is at historical average minus one standard deviations in 2018–19”.
  - 2) Primary balance shock: “Primary balance is at historical average minus one standard deviations in 2018–19”.
  - 3) Combination of 1) and 2) using one half standard deviation shocks.
  - 4) One-time depreciation shock: “one-time 30 percent real depreciation in 2018”.
  - 5) Non-debt flows shock: “10 percent of GDP increase in other debt-creating flows in 2018”.
  - Result: “The results show that the most extreme shock is 1) Growth shock and that debt trajectories for other shocks do not exceed the threshold during the projection period (2017–37).”

### Fiscal-adjustment numbers (Table 4 excerpts: Fiscal Adjustments to Fiscal Balance 2017-37, in percent of GDP relative to the baseline)
- Revenue (by component, 2017–2022-37):
  - Revenue: 0.3 0.85 0.85 0.85 0.85 0.85
  - Tax Revenue: 0.3 0.85 0.85 0.85 0.85 0.85
  - Income and profits: 0.05 0.10 0.10 0.10 0.10 0.10
  - Reducing stock of tax arrears: 0.20 0.70 0.70 0.70 0.70 0.70
  - International trade and transactions: 0.05 0.05 0.05 0.05 0.05 0.05
- Expenditure (by component, 2017–2022-37):
  - Expenditure: -0.40 -0.90 -0.90 -0.90 -0.90 -0.90
  - Recurrent spending: -0.10 -0.35 -0.35 -0.35 -0.35 -0.35
    - Compensation of employees: -0.05 -0.10 -0.10 -0.10 -0.10 -0.10
    - Other recurrent spending: -0.05 -0.25 -0.25 -0.25 -0.25 -0.25
  - Development spending: -0.30 -0.55 -0.55 -0.55 -0.55 -0.55
    - CDFs: -0.10 -0.20 -0.20 -0.20 -0.20 -0.20
    - Other development spending: -0.20 -0.35 -0.35 -0.35 -0.35 -0.35
- Total Savings (2017–2022-37): 0.7 1.8 1.8 1.8 1.8 1.8
- Source: “Staff estimates.”

### Policy recommendations
- Introduce an additional fiscal anchor: a long-term target to ensure fiscal and debt sustainability.
  - Recommendation: overall fiscal deficit at “1.5 percent of GDP” to balance debt sustainability and infrastructure needs; benefit of simplicity and comprehensiveness.
  - A stronger fiscal framework would help avoid fiscal procyclicality by saving windfall revenue in good times and vice versa.
- Include an escape clause and operational shock provisions
  - Given vulnerability to natural disasters, include an escape clause to allow temporary breach of fiscal rules as part of the response to shocks, with specific provisions for how targets would be adjusted and how policies would be brought back afterwards.
  - Include a “debt brake” requiring fiscal adjustment in case of ex-post fiscal policy slippages.
  - PAC can play an important monitoring role.
- Contingency warrants and contingency fund
  - “Contingency warrants for unforeseen expenditures, including from natural disasters, should be included in the budget in line with international best practices.”
  - If a disaster does not occur, the allocation could be saved in a contingency fund for natural disasters; the fund would be set up once fiscal buffers have been rebuilt.
- Medium-Term Fiscal Strategy (MTFS)
  - Update annually and publish the five-year MTFS.
  - The MTFS should include specific fiscal measures to achieve fiscal targets and identify, disclose, and manage fiscal risks, including natural-disaster risk.
  - Continue to outline economic and fiscal strategies to promote long-term economic growth.
- Strengthen public financial management (PFM)
  - IMF technical assistance to support better cash flow forecasting and improved budget revenue forecasting.
  - Authorities should produce and publish the Mid-Year Budget Review and the Final Budget Outcome in the predetermined time frame.
  - Donor-funded development expenditure needs to be included in budget aggregates with enhanced grant-data quality.
  - Ministry of Finance and Treasury should strengthen capacity to compile GFS now conducted by the central bank.
- Develop domestic debt market over the longer term
  - Current limits on treasury bills: operational limit “SI$40 million or about 0.4 percent of GDP” and policy limit “SI$100 million or about 1 percent of GDP” for outstanding stock of Treasury bills.
  - These limits are “very limited” reflecting previous defaults; over time, developing a larger treasury bill market would help support fiscal policy and financial deepening.

### Context: infrastructure gap and natural-disaster vulnerability (selected findings)
- Infrastructure access and costs
  - Less than half of the population has access to electricity; only “15 percent” of rural inhabitants have access to electricity.
  - “59 percent of households in the country have to travel long distances to access water.”
  - Mobile phone ownership: “over a third of the population”; internet access: “3 percent” of the population.
- Natural-disaster frequency and impact
  - IMF staff estimates (based on EM-DAT): Solomon Islands is hit, on average, by a natural disaster inflicting damage and losses equivalent to more than “3 percent of GDP” or affecting more than “5 percent of the population” once every “6–7 years.”
  - Worst episodes: devastation amounted to “14 percent of GDP” and affected more than half of the population.
  - The 2014 flood inflicted damage and losses equivalent to “5 percent of GDP” and partly contributed to the closure of the country’s only gold mine.
- Planned infrastructure scaling-up
  - Under the 2017 Budget, two planned large infrastructure projects (Tina River hydropower plant and submarine cable Honiara–Sydney) slated for implementation between 2017 and 2022 are “equivalent to around a quarter of the GDP,” marking a significant scaling up of capital spending.

*Source: cr1873 - 17.      Fiscal anchors should be designed and tailored to specific country objectives*

### 4.      A tailored application of the Debt-Investment-Growth (DIG) model helps illustrate the

### 4.      A tailored application of the Debt-Investment-Growth (DIG) model helps illustrate the outcomes of different profiles of public investment and inform policy discussions.

### Context and objectives
- Solomon Islands has been identified as a pilot case under the IMF’s Infrastructure Policy Support Initiative (IPSI).
- The DIG Model is part of a suite of tools available under the IPSI package that could be tapped to help countries evaluate macroeconomic and financial implications of alternative investment programs and financing strategies, as well as bolster institutional capacity in managing public investment.
- In applying the DIG model to Solomon Islands, the aim is to take into account the country’s characteristics, including capacity constraints, high vulnerability to natural disasters, and limited access to financing.
- The model provides a framework for thinking through the macroeconomic effects of public investment scaling up, while recognizing that simulation findings are driven, to some degree, by the assumptions made under different scenarios.

### The Debt-Investment-Growth (DIG) model — purpose and structure
- The DIG model was developed to study the macroeconomic impact of public investments in low-income countries.
- The model focuses on evaluating:
  - investment-growth linkages,
  - public external and domestic debt accumulation,
  - fiscal policies to ensure debt sustainability.
- Model structure: a dynamic general equilibrium framework of a small open economy featuring both traded and non-traded goods sectors.

### Key findings from prior applications
- In the original application of the model to a typical Sub-Saharan African country, the results suggested that well executed high-yielding public investment could meaningfully stimulate growth and be self-financing in the long run.
- Conversely, Buffie et al suggested that poor execution, delayed fiscal policy reactions, or persistent negative exogenous shocks can result in unsustainable debt dynamics.

*Source: cr1873 - 4.      A tailored application of the Debt-Investment-Growth (DIG) model helps illustrate the*

### 6.      To study the macroeconomic challenges portrayed by the high vulnerability to natural

### 6.      To study the macroeconomic challenges portrayed by the high vulnerability to natural disasters, we applied the model developed by Marto, Papageorgiou, and Klyuev (forthcoming).

### Model framework and channels
- The model extends the DIG framework by allowing government investment in:
  - standard infrastructure (e.g. roads), and
  - adaptation capital (e.g. seawalls),
  - and by allowing government saving in an external contingency fund for reconstruction.
- Distinct features of adaptation capital:
  - reduces damages from natural disasters,
  - depreciates at a lower rate than conventional public capital,
  - can raise the marginal product of private capital and crowd in private investment.
- Natural disaster channels in the model:
  - (i) permanent damages to public infrastructure;
  - (ii) permanent damages to private capital (tradable and non-tradable sectors can be disparately affected);
  - (iii) temporary losses of productivity;
  - (iv) increased inefficiencies in public investment during reconstruction.
- Application evidence (Vanuatu, cyclone Pam): investing in adaptation infrastructure can complement conventional infrastructure, raise private capital productivity, and support debt sustainability with aid from development partners and grants.

### Simulations: set-up
- General assumptions across simulations:
  - Scaling-up of infrastructure spending for a five-year period.
  - A natural disaster is assumed to hit after the five-year scaling-up period.
  - Natural disaster shock: average damage equivalent to 20 percent of GDP, with effects lasting three years.
  - Government aims to fully rebuild damaged infrastructure in about 6 to 8 years.
  - Financing options considered: (i) domestic borrowing; (ii) external concessional loans; (iii) grants; (iv) higher taxes; (v) prioritizing capital spending over recurrent spending.
  - Grant financing assumed to increase by an additional 2 percentage points during the scaling-up period compared to steady state.
  - To fund new investment, government splits burden equally between higher taxation and lower recurrent spending.
- Simulation 1: Conventional vs. adaptation infrastructure
  - Scaling-up: public spending sustained at 4 percent of GDP above steady-state levels for five years.
  - Under adaptation infrastructure, calibration reflects lower public capital depreciation relative to conventional infrastructure but higher cost and longer implementation time.
- Simulation 2: PFM reform vs. no PFM reform
  - Same scaling-up and adaptation infrastructure assumption as Simulation 1.
  - Two scenarios: baseline adaptation infrastructure; adaptation infrastructure with meaningful PFM reform.
  - PFM reform assumed to raise returns on public investment and increase public investment efficiency.
- Simulation 3: Domestic borrowing vs. external concessional financing
  - Financing scenarios: (i) full reliance on external concessional financing; (ii) full reliance on domestic borrowing; (iii) equal split between the two.
  - Grants same as in other simulations; taxation and spending policies unchanged.

### Simulation results — key findings
- Simulation 1: Conventional vs. adaptation infrastructure
  - Fiscal deficit:
    - Fiscal burden during the scaling-up period identical by assumption.
    - Post-disaster, adaptation infrastructure results in lower repair costs and a lower fiscal deficit.
    - Although adaptation infrastructure has higher per-unit maintenance/repair costs, its resilience implies less frequent repairs and a lower long-run average maintenance/repair fiscal burden versus conventional infrastructure.
  - Public debt:
    - Post-disaster higher fiscal spending leads to higher public borrowing under conventional infrastructure than adaptation infrastructure.
    - In relative terms, adaptation infrastructure is associated with lower public debt in the long term.
  - Private investment:
    - Near term: conventional infrastructure gives a higher boost to private investment (due to faster operationalization).
    - Medium and long term: adaptation infrastructure yields a bigger boost to private investment via confidence effects and insulation from disaster shocks.
  - Growth:
    - Adaptation infrastructure contains the natural disaster-related drop in real GDP growth relative to steady state and supports higher medium- and long-term growth via confidence effects.
- Simulation 2: PFM reform amplifies benefits of adaptation infrastructure
  - Growth:
    - Higher-quality public investment increases capital efficiency, lifting economic productivity gradually, with full gains realized in medium and long run.
  - Recurrent expenditure and fiscal deficit:
    - Modest reduction in public recurrent expenditure and lower fiscal deficit in the long term due to lower maintenance costs from slower depreciation of higher-quality capital.
  - Public debt:
    - Unchanged in short term; lower in long term, consistent with lower recurrent spending and stronger growth under PFM reform.
- Simulation 3: Financing choice matters — external concessional vs. domestic borrowing
  - Private investment and consumption:
    - Heavy reliance on domestic borrowing to finance public investment crowds out private-sector activity, especially in short and medium term.
  - Growth and fiscal deficit:
    - Domestic borrowing crowding-out leads to lower real GDP growth in medium term and more markedly in the long term.
    - Domestic financing costs in Solomon Islands are among the highest in Pacific island countries; higher domestic debt service channels fiscal resources away from productive uses, weighing on long-term growth.
    - Fiscal position outcomes are broadly similar across financing options despite growth differences.

### Policy implications and recommendations
- Prioritize disaster-resilient infrastructure:
  - Reprioritizing public spending towards developing disaster-resilient infrastructure can yield long-term dividends despite higher upfront fiscal burden and longer implementation time.
  - Benefits: cushions economy from worst disaster effects, limits contraction in economic activity, fosters private investment via confidence effects, improves long-term fiscal position and lowers indebtedness.
  - National budget should rationalize recurrent spending to create space for more capital spending and optimize spending composition.
- Pursue timely PFM reforms:
  - Strengthening public investment management raises quality and efficiency of public investment and amplifies infrastructure gains.
  - PFM reforms take time and should be pursued without delay.
  - Build on progress under the Extended Credit Facility arrangement: passing of the PFM Act and draft Procurement Rules and Regulations; continue to strengthen public investment management.
  - Improve transparency and accountability of development spending channeled through Constituency Development Funds (CDF): publish the 2012 CDF audit report, conduct regular audits, and increase awareness of selection criteria and decision-making processes.
  - Leverage forthcoming Pacific Region Infrastructure Facility (PRIF) report to identify areas to improve transparency and quality of public investment.
- Seek external concessional financing where possible:
  - Given high domestic financing costs and crowding-out effects, Solomon Islands should seek external concessional financing from development partners to finance large infrastructure projects.
  - Benefits: supports debt sustainability, enforces greater discipline in investment spending, enables skill and knowledge transfer from creditors, and supports capacity building for complex disaster-resilient projects.
  - Over the longer term, develop domestic markets and financial deepening to mobilize domestic savings for long-term growth.

### Base case calibration — key country-specific parameters and assumptions
- Table 1: Country-specific parameters (In percentage)
  - User fees for infrastructure services (percent of recurrent costs): 5.0
  - Public infrastructure investment to GDP ratio: 8.0
  - Public adaptation infrastructure investment to GDP ratio: 0.0
  - Consumption tax rate (VAT): 10.0
  - Public domestic debt to GDP ratio: 0.5
  - Public concessional debt to GDP ratio: 8.5
  - Public external commercial debt to GDP ratio: 0.0
  - Grants to GDP ratio: 10.0
  - Other revenue to GDP ratio: 4.0
  - Government savings to GDP ratio: 0.0
  - Remittances to GDP ratio: 0.3
  - Private external debt to GDP ratio: 10.3
  - Real interest rate on public domestic debt: 3.0
  - Trend per capita growth rate: 3.0
  - Imports to GDP ratio: 52.3
  - Value added in non-tradable Sector: 43.1
- Table 2: Key assumptions (Definition / Value)
  - Initial return on standard infrastructure investment: 15.0
  - Initial return on adaptation infrastructure investment: 40.0
  - Efficiency of public infrastructure investment: 30.0
  - Steady state efficiency of public infrastructure investment: 30.0
  - Share of public debt adj. between commercial external and domestic (=100 when only domestic debt is used): 5.0
  - Capital's share in value added in the tradable-sector: 40.0
  - Capital's share in value added in the non-tradable sector: 55.0
  - Depreciation rate in tradable and non-tradable sector: 5.0
  - Depreciation rate of public capital (standard infrastructure): 15.0
  - Depreciation rate of public capital (adaptation infrastructure): 3.0
- Rationale notes:
  - Initial return on standard infrastructure: chosen as 15 percent to represent a low-return scenario relative to World Bank median returns of 17 percent–31 percent.
  - Initial return on adaptation infrastructure: 40 percent chosen based on literature (e.g., adaptation can avert up to 65 percent projected losses; 40 percent used given Solomon Islands’ development level).
  - Public infrastructure investment efficiency: base case set at 30.0; increased to 80.0 under PFM reform scenario in simulations.
  - Share of public debt adj. between commercial external and domestic set at 5.0 due to low capability to borrow domestically.
  - Capital shares: tradable 40.0 and non-tradable 55.0 based on GTAP-derived guidance.
  - Depreciation choices follow Buffie et al. (2012).

*Source: IMF staff, “Building Resilience to Natural Disasters: An Application to Small Developing States” (Ricardo Marto, Chris Papageorgiou, Vladimir Klyuev, forthcoming) and associated simulation results for Solomon Islands.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr1873.pdf_