## Facts about the Cook Islands

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### Background and demographics
- Mission (March 2019) requested by New Zealand authorities comprised Geoffrey Bannister (APD), Ryota Nakatani (FAD) and Iris Claus (PFTAC) to evaluate policy options for transitioning to high-income status, financial sector stability and regulatory framework, and debt sustainability.
- The Cook Islands is a self-governing territory in free association with New Zealand but is not an IMF member.
- Following recent strong economic performance, the Cook Islands will graduate from Official Development Assistance (ODA) in 2020.
- The OECD provided the Cook Islands until the end of 2018 to develop GNI data for the last three years to determine eligibility for graduation to high-income status; rebased GDP was revised up by 10 percent.
- National Statistics Office improvements: rebasing of GDP, initial balance of payments estimates, improved government financial statistics (GFS) accounting. Remaining challenges: trade, inflation, labor market and employment statistics.

Key factual details:
- Free Association with New Zealand; New Zealand responsible for defense and foreign affairs.
- 15 small islands; population 17,459 (December 1, 2016, Census 2016); EEZ of 1,800,000 square kilometers.
- Population declined by 2 percent since 2011.
- Cook Islanders are New Zealand citizens with rights to live and work in New Zealand and Australia.
- Around 72 percent of the population resides on Rarotonga.
- New Zealand dollar is legal tender; monetary union with New Zealand provides monetary and external financial stability.

### Economic context — recent developments
- Economy highly dependent on tourism (main source countries: New Zealand and Australia; recent diversification to Europe and North America).
- Diversification efforts: international financial services industry (especially international trusts) and fishing license revenues.
- Recent strong contributors to growth: construction and government administration.
- Preparations for potential subsea mineral industry for long-term income.
- Historical growth: averaged -0.7 percent in 2008-13; recovered from 2014 with higher tourist inflows.
- Real GDP expected to have expanded by about 9 percent in FY17/18 (June to June).
- Government-calculated underlying potential growth rate: about 2½ percent.
- Recorded consumer price inflation declined from close to 2 percent year-on-year in 2015 to 0.2 percent in June 2019.
- Anecdotal evidence of rapid rental increases; potential under-capture of rental component in CPI.
- Evidence of binding capacity constraints in labor markets (tourism and construction) despite guest worker inflows.
- Implied wages (based on Cook Islands Superannuation Fund contributions) suggest wages rose on average about 8 percent per year from 2015 to 2018.
- Government projects tourism industry reached maximum capacity in the high season of 2018 (June) and will continue to reach maximum capacity in high seasons through 2019/2020.
- Official external current account: deficit close to 5 percent of GDP in 2013 moved to a surplus of 2 percent of GDP in 2017, supported by tourism income, fishing licensing fees and overseas development assistance offsetting a growing trade deficit.
- Some observers suggest imports may be significantly underestimated, which could imply a rising current account deficit.

### Outlook and risks
- Near- to medium-term outlook: slowing growth and higher inflation as economy operates above potential.
- Government growth projections:
  - Growth to fall to 5½ percent in 2019.
  - Growth to average around 2½ percent through 2023, based on continued tourism growth, private investment in tourism accommodation, and public infrastructure investment (mainly financed by grants).
- Inflation expected to rise gradually due to higher imported inflation and growing capacity constraints.
- As lodging costs increase and competitiveness reduces, arrivals expected to move closer to sustainable levels; global slowdown will moderate tourist arrival growth.
- Downside domestic risks: binding capacity constraints could lead to higher inflation and sharper slowing in tourism growth; constraints could limit public investment growth and accommodation capacity expansion.
- External risks: significant China slowdown, weaker growth in advanced economies, tighter global financial conditions, retreat from cross-border integration; strong exposure to New Zealand economy.
- Natural disaster risk: high exposure due to location in South Pacific cyclone belt, remoteness and low-lying outer islands; concentration of buildings and infrastructure near coast on Rarotonga and tourism concentration reinforce exposure.

### Macroeconomic and financial policy priorities
- Policy priority: balance reducing overheating risks and sustaining capacity growth.
- No autonomous monetary policy; managing overheating requires active fiscal policy and a fiscal framework addressing natural disaster and other economic shocks.
- Ensuring medium- to long-term growth requires investment in infrastructure and human capital and structural reforms to improve efficiency and productivity.
- Government initiatives: medium-term fiscal framework (MTFS), movement toward immigration reform, investment in undersea cable and large water and sanitation projects.
- Needed: strengthen disaster resilience, improve execution of public investment projects, monitor banking system risks, and improve business climate to attract FDI.

### Fiscal policy: recent outcomes and FY20 budget
- Fiscal balance moved from a deficit of 8 percent of GDP in FY15 to consistent surpluses in FY16-FY19.
- Excluding grants, net operating balance (revenue minus current expense) moved from a deficit of 5½ percent of GDP in FY15 to a surplus of 4½ percent of GDP in FY19.
- Ratio of gross public debt to GDP fell by six percentage points to 19 percent of GDP at end FY19.
- Net public debt fell to around 15 percent of GDP.
- FY20 projections:
  - Net operating balance excluding grants projected to remain in surplus but decline to 1½ percent of GDP.
  - Overall fiscal balance expected to move into a deficit of 1½ percent of GDP reflecting a large ramp-up of capital investment to 12.7 percent of GDP, of which about two-thirds will be financed through grants.
  - Increase partly reflects carry-over of capital projects not completed in FY18; priorities include infrastructure to improve transportation, alleviate water and drainage bottlenecks, and disaster resilience for outer islands.

### Medium-Term Fiscal Strategy (MTFS) and Fiscal Responsibility Ratios (FRRs)
- MTFS underpins the Cook Islands Fiscal Framework 2019-2023; aims to smooth government expenditure over the economic cycle while maintaining fiscal sustainability.
- MTFS anchor: target on net debt with fiscal responsibility ratios for fiscal balance, expenditure growth and cash reserves.
- MTFS includes strategy to increase revenue without increasing tax burden through better administration and enforcement.

Fiscal Responsibility Ratios (as specified in the MTFS):
- Net debt target: net public debt should not exceed a soft cap of 30 percent of GDP and cannot exceed a hard cap of 35 percent of GDP.
- Fiscal balance rule: the fiscal balance cannot fall below a deficit of 1.9 percent of GDP.
- Expenditure rule: budgeted expenditure cannot grow by more than 4 percent year-on-year in nominal terms.
- Cash reserves rule: the equivalent of 3 months of operating expenditure must be held in cash at any one time.
- Exit clause: government may breach these rules in the event of a natural disaster and declaration of a state of emergency, or a severe economic shock that leads to an expected contraction in GDP of 2 percent or more.

Additional MTFS provisions:
- Stabilization Account: accumulate excess cash balances (above four months of operating expenditure) in periods of strong economic growth (nominal growth of 4 percent and above) for additional debt repayments and to cover operational and capital expenditure during economic contraction (defined as real economic growth lower than 1 percent per year).
- Sovereign Wealth Fund: to capture future revenues from seabed minerals harvesting as intergenerational savings.
- Loan Repayment Fund: net debt definition excludes balances held in this fund; balances in 2018 amounted to about 4 percent of GDP and are expected to decline to 2½ percent of GDP by 2023.
- Under the baseline MTFS scenario aiming to bring the overall surplus to 1 percent of GDP in FY23:
  - Cash reserves in the current and stabilization accounts would rise from 17 percent of GDP in 2017 to 19 percent of GDP in 2023.
  - Loan Stabilization Account expected to hold 2½ percent of GDP in 2023.
- The 2019/20 budget sets aside NZ$56.7 million to put into the stabilization account.

### Recommendations (mission)
- Complement the MTFS with a well-designed strategy for resilience to natural disasters:
  - Current arrangements include a Disaster Emergency Trust Fund with a balance of NZ$ 1.7 million, insurance coverage from the Pacific Catastrophe Risk Assessment and Financing Initiative, and a Disaster Recovery Mechanism loan from the ADB.
  - Review current disaster financing arrangements; bolster structural resilience of buildings and infrastructure, contingency planning, and mechanisms for speedy post-disaster response.
- In the context of graduation from ODA, undertake better planning for areas where assistance declines:
  - Assistance peaked in 2017/18 with donor funds for large capital projects.
  - Authorities estimate the impact on growth will be approximately 0.4 percent of GDP.

### Public financial management (PFM) and revenue regime review
- Revenue regime review expected with PFTAC in second half of 2019 to improve economic and administrative efficiency; aim to develop a Cook Islands Revenue Strategy.
- Ongoing PFM reform work (following PEFA assessment in 2015) focuses on:
  - reforms to enhance credibility and transparency of the budget;
  - development of a single platform Financial Management Information System (FMIS), expected to have been implemented in June 2019;
  - increasing information and planning requirements for procurement of capital investments;
  - accounting, recording, reporting and budget execution; and
  - external audits.
- Recommendations:
  - Reconsider tax amnesty as it creates incentives for tax avoidance and complicates tax administration.
  - External auditing of government financial accounts needs to be more timely; most recent completed audits are for the 2014 fiscal year.
  - Raise capacity in planning and execution of capital spending (particularly procurement) to better manage infrastructure plans; under-execution of capital budget and high operating costs are recurring themes.
  - Improve capacity in public administration; targeted training and salary adjustments (2019/20 Budget) to attract returning skilled Cook Islanders.

### Public debt — background and current structure
- Historical context:
  - External debt reached 140 percent of GDP during the 1990s debt crisis.
  - Debt-to-GDP ratio had been brought down to around 15 percent of GDP in 2007.
  - Gross debt ratio estimated at 19 percent of GDP in FY19; net of assets in Loan Repayment Account fell to 15.3 percent of GDP.
- As of 30 June 2020:
  - Overall public sector gross debt = NZ$110.8 million.
  - 49 percent was direct crown debt (owed by the central government).
  - 51 percent were loans held on behalf of state-owned enterprises (SOEs).
  - Creditor composition: ADB holds 74 percent, Export/Import Bank of China holds 24 percent, remaining 2 percent is commercial borrowing.
  - Currency composition: part of ADB lending is in SDRs (20 percent of total debt); remaining debt denominated in New Zealand dollars (39 percent), RMB (24 percent) and US dollars (17 percent).
  - Maturity and cost: most debt is medium- and long-term, average maturity a little over 12 years, average effective interest rate is around 3 percent.

### Debt sustainability — baseline projections and scenarios
- Baseline assumptions and projections:
  - Real growth expected to average around 4 percent and inflation to remain below 2 percent during the projection period.
  - Fiscal policy projected to go from a primary deficit of 1 percent of GDP in 2020 to a surplus of 1.4 percent in 2023.
  - Scenario assumes disbursement of the Undersea Broadband Cable loan (NZ$ 20 million) in 2020 and new debt flows of about NZ$ 5 million every year thereafter.
  - Under these assumptions, the debt ratio is projected to decline to 16 percent of GDP, driven mostly by primary surpluses and real GDP growth.
  - A fan chart presents a band of possible baseline outcomes from a low of 11 percent to a high of 24 percent (over the projection horizon).

Alternative scenarios and vulnerabilities:
- Constant primary balance scenario: if primary balance kept at 2019 level throughout projection, debt ratio falls to 10.5 percent of GDP.
- Historical scenario: with growth, inflation and primary balance at ten year historical averages, gross debt would rise to 17 percent of GDP in 2023.
- Natural disaster scenario:
  - Assumes growth falls by two percentage points below the baseline in 2020-21 and one percentage point thereafter, and the primary balance goes to a deficit of between 2 and 4 percent during the projection period.
  - Gross debt would rise to 35 percent of GDP by 2023.
  - Under a baseline projection for assets in the Loan Repayment Fund of 2.5 percent of GDP, net debt would be 33 percent of GDP (above the soft limit but below the hard limit of MTFS).
- Policy implication: soft limit of 30 percent of GDP for net debt is considered appropriately conservative given natural disaster risk, narrow base and small size of the economy.

Selected quantitative entries (from projections and tables):
- Nominal gross public debt (sample table entries): 20.3, 22.0, 20.1, 19.3, 18.6, 20.3, 18.1, 16.0, 15.4.
- Real GDP growth (percent) sample entries: 1.0, 4.9, 9.5, 8.9, 6.3, 3.8, 3.8, 3.9, 4.0.
- Inflation (GDP deflator, percent) sample entries: 2.7, -2.1, -0.2, 3.8, 1.7, 1.6, 1.2, 1.1, 1.0.
- Effective interest rate (percent) sample entries: 6.1, 3.2, 3.9, 4.0, 3.3, 3.2, 3.4, 3.6, 3.8.
- Change in gross public sector debt cumulative entries include: 0.3, 1.1, -1.9, -0.8, -0.7, 1.7, -2.2, -2.1, -0.7, -4.8.
- Primary (noninterest) revenue and grants cumulative figure: 209.3.
- Primary (noninterest) expenditure cumulative figure: 201.8.
- Identified debt-creating flows sample entries: primary deficit entries -0.7, -1.9, -9.4, -4.4, -2.0, 0.9, 0.1, -0.7, -1.4, -7.5.

### Financial sector structure and supervision
- Financial system composition: about thirty financial entities, including domestic and international banks, a superannuation fund, insurers, captive insurers, trustee companies, and money changing and remittance businesses.
- Commercial banks: ANZ Banking Group Limited (ANZ), Bank of South Pacific (BSP) Limited, Bank of the Cook Islands (BCI) Limited (government-owned). Additional domestic bank: Capital Security Bank (CSB).
- BCI operates on all islands, channels government subsidies, child benefit and pension payments, and is responsible for payment of government salaries; high financial inclusion.
- International financial services industry established in the 1980s; eight registered trustee companies provide international services. Registrations of international entities have been declining (sample table entries for international companies and trusts shown for years ended June 2014–2018).
- Cook Islands National Superannuation Fund (CINSF) is compulsory: members and employers each contribute 5 percent of employees’ salaries; funds invested and managed in New Zealand and overseas.
- Financial Supervisory Commission (FSC) is independent, licenses and regulates all financial institutions, supervises regulated entities and services, and operates registries for international entities.
- FSC finances: renewal fees contribute between 76 and 80 percent to FSC’s annual revenue; crown appropriations only in fiscal years 2014 and 2015. With risk of contraction in international financial services industry, alternative stable funding for FSC needed.

FSC supervisory framework and actions:
- Risk-based supervision model elements: regulation (legislation, prudential standards), risk identification and assessment (off-site and on-site supervision), risk rating model, supervisory action planning.
- Two banks have been put on enhanced supervision in recent years due to AML/CFT, credit risk and related party lending issues.
- FSC has MOUs with RBNZ, APRA and BPNG; close working relationship with RBNZ. Recommendations include MOUs with parents of foreign-owned branches and expansion to include contingency planning and crisis management.

### Banking sector performance, indicators and risks
- Credit and lending: despite rapid economic expansion, credit is falling in absolute terms; private sector deleveraging and banks addressing legacy high non-performing loans and low profitability.
- Non-performing loans fell from 7½ percent of lending in 2015 to 4 percent in 2018.
- Some credit growth in finance and business and personal services, but stagnation or decline in wholesale and retail trade, hotels and motels, and transportation.
- Population fell from around 18.7 thousand in 2014/15 to 17 thousand in 2017/18.
- Structural constraints on credit growth: housing mortgage rates about 300 to 400 basis points higher than New Zealand due to scale and land tenure arrangements; cost of recovery relatively higher; infrastructure shortcomings (lack of automated clearance system, poor internet connectivity).
- Introduction of a local credit bureau and a collateral registry expected to help; integration with New Zealand credit bureaus suggested.

Selected Financial Soundness Indicators (2014–2018):
- Regulatory capital to risk-weighted assets: 19.18, 16.61, 19.52, 18.56, 17.30.
- Regulatory tier 1 capital to risk-weighted assets: 15.01, 13.85, 15.93, 15.08, 14.72.
- Nonperforming loans net of provisions to capital: 29.02, 30.71, 18.53, 17.49, 14.55.
- Nonperforming loans to total gross loans: 6.79, 7.46, 5.81, 5.27, 4.04.
- Return on equity: 18.50, 13.17, 14.19, 18.47, 15.16.
- Liquid assets (core) to total assets: 44.10, 46.78, 39.71, 46.70, 50.79.
- Liquid assets (core), in NZ$ thousand: 285,700; 402,686; 341,504; 423,784; 493,106.
- Short-term liabilities, in NZ$ thousand: 310,876; 481,911; 519,192; 677,869; 514,683.
- Return on assets: 1.63, 0.97, 1.03, 1.15, 0.95.
- Nonperforming loans net of provisions, in NZ$ thousand: 13,908; 15,431; 9,690; 9,497; 7,254.
- Interest margin to gross income: 62.35, 63.99, 64.05, 70.83, 61.12.
- Noninterest expenses to gross income: 66.64, 59.24, 66.87, 72.30, 75.44.

Systemic assessment and risks:
- Aggregate capital adequacy ratio around 17 percent (above regulatory floor of 10 percent).
- Banking system is highly liquid.
- Aggregate loan-to-deposit ratio fell from 100 percent in 2014 to 50 percent in 2018.
- ROE of 15 percent and ROA around 1 percent: profitability adequate relative to advanced country levels but low compared to other Pacific island countries.
- Supervisory and crisis-management recommendations:
  - Require recovery plans for systemically important banks (FSC considers BCI systemically important).
  - Formalize roles, responsibilities and decision-making processes for crisis management and resolution powers.
  - Banking crisis management should seek to:
    - Maintain key financial transactions;
    - Minimize economic dislocation;
    - Promote market discipline and maintain market integrity;
    - Minimize the fiscal costs of failures.
- Inherent risks to monitor: concentration risk (credit in tourism-related industries as high as 60 percent), large exposure of BCI to government balance movements, natural disaster exposure and liquidity contingency needs.

### EU listing, taxation of international companies and IMF-observed impact
- In 2015 the Council of the European Union developed a list of non-cooperative jurisdictions for taxation; Cook Islands evaluated against tax transparency, fair taxation, and OECD BEPS project.
- One issue: international companies were exempt from all taxes in the Cook Islands.
- In December 2018, the Cook Islands Government agreed to amend legislation to tax profits of international companies and join the Inclusive Framework of the OECD’s BEPS project.
- Projected impact of taxing international companies:
  - Estimated one-off decline in GDP of between 2.1 and 2.6 percent if international financial services industry disappears.
  - Decline in tax revenue estimated at about NZ$3.5 to NZ$4.1 million a year (about 3 percent of total VAT, income and withholding taxes collected in 2018).
- FSC revenue exposure: renewal fees contribute between 76 and 80 percent to annual revenue; alternative funding source needed if industry contracts.

### Structural policies for transitioning to high income — constraints and recommendations
Constraints:
- Small scale, remoteness, dispersion of population in outer islands, shortage of skilled and unskilled labor.
- Infrastructure deficits: telecommunications, water, sanitation, transportation, energy.
- Labor shortages; short-term solution includes increased immigration; opportunity from new Immigration Bill.
- Land tenure system limits collateralized lending and large scale land developments.
- Uncertainty in investment environment: restrictive FDI framework, discretionary approvals, narrow licensing.

Structural policy recommendations:
- Better management of infrastructure investment and public spending:
  - Address shortages of skilled personnel for planning, preparation, and project management.
  - Consider private sector participation or public private partnerships.
  - Consider requesting a public investment management assessment (PIMA) or similar from donors or PFTAC.
- Address land tenure and land use issues to facilitate collateralized lending and efficient land use.
- Continue upgrading tourist facilities and services to attract higher income tourists and preserve niche resort status:
  - New air transportation routes, accreditation and control of private accommodations, upgrading existing facilities, include transport and accommodations and other tourist services in outer islands.
- Enhance communication and transportation links:
  - Maintain subsidies for air routes;
  - Improve communications with the undersea cable to facilitate private sector activity, mobile banking and trade flows;
  - Provide regular transportation routes to outer islands to develop tourism and trade.
- Reform the Foreign Direct Investment regime:
  - Adopt transparent non-discriminatory rules to attract feasible projects and capital;
  - Reform the investment code to open up traditionally closed areas to foreign investment to help diversification.

_Italic: Source — IMF mission report material on the Cook Islands (March 2019) contained in the referenced PDF chapter._

### 1. Facts about the Cook Islands  ________________________________________________3

### Facts about the Cook Islands

### Background
- A mission requested by the New Zealand authorities evaluated policy options for transitioning to high-income status, financial sector stability and regulatory framework, and debt sustainability. The mission took place in March 2019 and comprised Geoffrey Bannister (APD), Ryota Nakatani (FAD) and Iris Claus (PFTAC).
- The Cook Islands is a self-governing territory in free association with New Zealand but is not an IMF member.
- Following recent strong economic performance, the Cook Islands will graduate from Official Development Assistance (ODA) in 2020.
- The OECD provided the Cook Islands until the end of 2018 to develop gross national income (GNI) data for the last three years to determine eligibility for graduation to high-income status.
- The authorities, with donors (including PFTAC), developed income and balance of payments statistics and rebased GDP (revised up by 10 percent), showing Cook Islands GNI per capita comfortably above the threshold for the last three years.
- National Statistics Office improvements: rebasing of GDP, initial balance of payments estimates, and improved government financial statistics (GFS) accounting. Remaining challenges include trade, inflation, labor market and employment statistics.

Key factual details (Box 1):
- The Cook Islands is a country in “Free Association” with New Zealand; New Zealand maintains responsibility for defense and foreign affairs.
- The Cook Islands consists of 15 small islands, with a population of 17,459 (December 1, 2016, Census 2016) within an Exclusive Economic Zone (EEZ) of 1,800,000 square kilometers of ocean.
- The population has declined by 2 percent since 2011 (the previous population census).
- Cook Islanders are citizens of New Zealand, with rights to live and work in New Zealand and Australia.
- Around 72 percent of the population resides on Rarotonga.
- The New Zealand dollar is legal tender in the Cook Islands; monetary union with New Zealand has provided monetary and external financial stability.

### Economic context — Recent developments
- The economy is highly dependent on tourism; main source countries include New Zealand and Australia, with recent diversification to Europe and North America.
- Diversification efforts: international financial services industry (especially international trusts) and fishing license revenues.
- Strong contributors to recent growth: construction and government administration.
- Preparations exist for potential subsea mineral industry development for long-term income.
- Historical growth: growth averaged -0.7 percent in 2008-13, recovering from 2014 with higher tourist inflows.
- Real GDP expected to have expanded by about 9 percent in FY17/18 (June to June); recorded inflation remained relatively stable and low.
- Government-calculated underlying potential growth rate: about 2½ percent.
- Recorded consumer price inflation declined from close to 2 percent year-on-year in 2015 to 0.2 percent in June 2019.
- Anecdotal evidence suggests rapid rental increases; potential under-capture of rental component in CPI.
- Evidence of binding capacity constraints in labor markets (tourism and construction) despite guest workers influx.
- Implied wages (based on Cook Islands Superannuation Fund contributions) suggest wages rose on average about 8 percent per year from 2015 to 2018.
- Government projects tourism industry reached maximum capacity in the high season of 2018 (June) and will continue to reach maximum capacity in high seasons through 2019/2020.
- Official external current account: deficit close to 5 percent of GDP in 2013 moved to a surplus of 2 percent of GDP in 2017, supported by tourism income, fishing licensing fees and overseas development assistance offsetting a growing trade deficit.
- Some observers suggest imports may be significantly underestimated, which could imply a rising current account deficit.

### Outlook and Risks
- Near- to medium-term outlook: slowing growth and higher inflation as economy operates above potential.
- Government growth projections:
  - Growth to fall to 5½ percent in 2019.
  - Growth to average around 2½ percent through 2023, based on continued tourism growth, private investment in tourism accommodation, and public infrastructure investment (mainly financed by grants).
- Inflation expected to rise gradually due to higher imported inflation and growing capacity constraints.
- As lodging costs increase and competitiveness reduces, arrivals expected to move closer to sustainable levels; global slowdown will moderate tourist arrival growth.
- Downside domestic risks: binding capacity constraints could lead to higher inflation and sharper slowing in tourism growth; constraints could limit public investment growth and accommodation capacity expansion.
- External risks: significant China slowdown, weaker growth in advanced economies, tighter global financial conditions, retreat from cross-border integration; strong exposure to New Zealand economy.
- Natural disaster risk: high exposure due to geographic location in South Pacific cyclone belt, remoteness and low-lying outer islands; concentration of buildings and infrastructure near coast on Rarotonga and tourism concentration reinforce exposure.

### Macroeconomic and Financial Policies
- Policy priority: balance reducing overheating risks and sustaining capacity growth.
- No autonomous monetary policy; managing overheating requires active fiscal policy and a fiscal framework addressing natural disaster and other economic shocks.
- Ensuring medium- to long-term growth requires investment in infrastructure and human capital and structural reforms to improve efficiency and productivity.
- Government initiatives: medium-term fiscal framework, movement toward immigration reform, investment in undersea cable and large water and sanitation projects.
- Needed: strengthen disaster resilience, improve execution of public investment projects, monitor banking system risks, and improve business climate to attract FDI.

### Fiscal policy: recent outcomes and FY20 budget
- Fiscal balance moved from a deficit of 8 percent of GDP in FY15 to consistent surpluses in FY16-FY19.
- Excluding grants, net operating balance (revenue minus current expense) moved from a deficit of 5½ percent of GDP in FY15 to a surplus of 4½ percent of GDP in FY19.
- Ratio of gross public debt to GDP fell by six percentage points to 19 percent of GDP at end FY19.
- Net public debt fell to around 15 percent of GDP.
- FY20 projections:
  - Net operating balance excluding grants projected to remain in surplus but decline to 1½ percent of GDP.
  - Overall fiscal balance expected to move into a deficit of 1½ percent of GDP reflecting a large ramp-up of capital investment to 12.7 percent of GDP, of which about two-thirds will be financed through grants.
  - Increase partly reflects carry-over of capital projects not completed in FY18; priorities include infrastructure to improve transportation, alleviate water and drainage bottlenecks, and disaster resilience for outer islands.

### Medium-Term Fiscal Strategy (MTFS) and Fiscal Responsibility Ratios (FRRs)
- MTFS forms the basis for the Cook Islands Fiscal Framework 2019-2023; aims to smooth government expenditure over the economic cycle while maintaining fiscal sustainability.
- MTFS anchor: target on net debt with fiscal responsibility ratios for fiscal balance, expenditure growth and cash reserves.
- MTFS includes strategy to increase revenue without increasing tax burden through better administration and enforcement.

Fiscal Responsibility Ratios (as specified in the MTFS):
- Net debt target: net public debt should not exceed a soft cap of 30 percent of GDP and cannot exceed a hard cap of 35 percent of GDP.
- Fiscal balance rule: the fiscal balance cannot fall below a deficit of 1.9 percent of GDP.
- Expenditure rule: budgeted expenditure cannot grow by more than 4 percent year-on-year in nominal terms.
- Cash reserves rule: the equivalent of 3 months of operating expenditure must be held in cash at any one time.
- Exit clause: government may breach these rules in the event of a natural disaster and declaration of a state of emergency, or a severe economic shock that leads to an expected contraction in GDP of 2 percent or more.

Additional MTFS provisions:
- Stabilization Account: accumulate excess cash balances (above four months of operating expenditure) in periods of strong economic growth (nominal growth of 4 percent and above) for additional debt repayments and to cover operational and capital expenditure during economic contraction (defined as real economic growth lower than 1 percent per year).
- Sovereign Wealth Fund: to capture future revenues from seabed minerals harvesting as intergenerational savings.
- Loan Repayment Fund: net debt definition excludes balances held in this fund; balances in 2018 amounted to about 4 percent of GDP and are expected to decline to 2½ percent of GDP by 2023.
- Under the baseline MTFS scenario aiming to bring the overall surplus to 1 percent of GDP in FY23:
  - Cash reserves in the current and stabilization accounts would rise from 17 percent of GDP in 2017 to 19 percent of GDP in 2023.
  - Loan Stabilization Account expected to hold 2½ percent of GDP in 2023.
- The 2019/20 budget sets aside NZ$56.7 million to put into the stabilization account.

### Recommendations (from the mission)
- Complement the MTFS with a well-designed strategy for resilience to natural disasters:
  - Current arrangements include a Disaster Emergency Trust Fund with a balance of NZ$ 1.7 million, insurance coverage from the Pacific Catastrophe Risk Assessment and Financing Initiative, and a Disaster Recovery Mechanism loan from the ADB.
  - Government has identified need to review current disaster financing arrangements.
  - In line with IMF guidance, consider bolstering structural resilience of buildings and infrastructure, contingency planning, and mechanisms for speedy post-disaster response.
- In the context of graduation from ODA, undertake better planning for areas where assistance declines:
  - Assistance peaked in 2017/18 with donor funds for large capital projects.
  - While graduation from ODA is anticipated in 2020, engagements with donors suggest only a small impact on aid flows.
  - Authorities estimate the impact on growth will be approximately 0.4 percent of GDP.

*Source: IMF mission report material on the Cook Islands (March 2019) contained in the referenced PDF chapter.*

### 19.      The authorities plan to review the revenue regime and continue to work on

### 19.      The authorities plan to review the revenue regime and continue to work on

### Public financial management (PFM) and revenue regime review
- A review of the revenue regime is expected with the help of PFTAC in the second half of 2019, with a focus on improving economic and administrative efficiency.
- The aim of the review will be the eventual development of a Cook Islands Revenue Strategy.
- Ongoing PFM reform work (following a PEFA assessment in 2015 and a road map developed with PFTAC) focuses on:
  - reforms to enhance the credibility and transparency of the budget;
  - development of a single platform Financial Management Information System (FMIS), which is expected to have been implemented in June 2019;
  - increasing information and planning requirements for procurement of capital investments;
  - accounting, recording, reporting and budget execution; and
  - external audits.

Recommendations (from the text):
- The tax amnesty should be reconsidered, as it creates incentives for tax avoidance and makes tax administration more costly and complicated.
- The external auditing of government financial accounts needs to be more timely, and is an urgent priority. The most recent audits that have been completed are for the 2014 fiscal year. This is partly an issue of capacity, as trained auditors are scarce and hard to attract to the Cook Islands, and there are also particular challenges in helping the external islands to submit accounts.
- The government should consider raising capacity in planning and execution of capital spending (particularly procurement) to better manage infrastructure plans going forward. Under-execution of the capital budget and high operating costs are a recurring theme. This is partly a reflection of optimistic budgeting, but also a lack of capacity in the planning and implementation of capital expenditures. The MTFS presents a four year outlook for the budget which should help with more realistic budgeting and execution. Realistic medium-term forecasts will improve the credibility of the government’s budget as a signal of its fiscal program and help smooth expenditure management.
- An additional overall theme is the need to improve capacity in public administration. Although Cook Islands has a per-capita income level commensurate with higher income countries, and public administration capacity at a level above most of its peers, because of its remoteness, small size and shortage of skilled labor, capacity in public administration continues to be constrained.
- The 2019/20 Budget priority to raise government salaries to reflect increases in the cost of living and the need to attract returning highly skilled Cook Islanders from overseas is welcome. Initiating a program of targeted training aided by international financial institutions and exchanges with advanced country partners could also be beneficial.
- The taxation regime was last reviewed in 2012.

### Public debt — background and current structure
- Historical context:
  - External debt reached 140 percent of GDP during the 1990s debt crisis.
  - Debt-to-GDP ratio had been brought down to around 15 percent of GDP in 2007.
  - The gross debt ratio is estimated to have risen to 19 percent of GDP in FY19, and net of assets in the Loan Repayment Account fell to 15.3 percent of GDP.
- As of 30 June 2020:
  - Overall public sector gross debt = NZ$110.8 million.
  - 49 percent was direct crown debt (owed by the central government).
  - 51 percent were loans held on behalf of state-owned enterprises (SOEs).
  - Creditor composition: ADB holds 74 percent, Export/Import Bank of China holds 24 percent, remaining 2 percent is commercial borrowing.
  - Currency composition: part of ADB lending is in SDRs (20 percent of total debt); remaining debt denominated in New Zealand dollars (39 percent), RMB (24 percent) and US dollars (17 percent).
  - Maturity and cost: most debt is medium- and long-term, average maturity a little over 12 years, average effective interest rate is around 3 percent.

### Debt sustainability — baseline projections and fan chart
- Baseline assumptions and projections:
  - Real growth is expected to average around 4 percent and inflation to remain below 2 percent during the projection period.
  - Fiscal policy projected to go from a primary deficit of 1 percent of GDP in 2020 to a surplus of 1.4 percent in 2023.
  - Scenario assumes disbursement of the Undersea Broadband Cable loan (NZ$ 20 million) in 2020 and new debt flows of about NZ$ 5 million every year thereafter.
  - Under these assumptions, the debt ratio is projected to decline to 16 percent of GDP, driven mostly by primary surpluses and real GDP growth.
  - A fan chart presents a band of possible baseline outcomes from a low of 11 percent to a high of 24 percent (over the projection horizon).

### Alternative debt scenarios and vulnerabilities
- Constant primary balance scenario:
  - If the primary balance is kept at the 2019 level throughout the projection period, the debt ratio falls to 10.5 percent of GDP.
- Historical scenario:
  - With growth, inflation and the primary balance at their ten year historical averages, gross debt would rise to 17 percent of GDP in 2023.
- Natural disaster scenario:
  - Assumes growth falls by two percentage points below the baseline in 2020-21 and one percentage point thereafter, and the primary balance goes to a deficit of between 2 and 4 percent during the projection period.
  - Gross debt would rise to 35 percent of GDP by 2023.
  - Under a baseline projection for assets in the Loan Repayment Fund of 2.5 percent of GDP, the net debt would be 33 percent of GDP, above the soft limit but below the hard limit of the medium-term fiscal strategy.
- Policy implication:
  - The soft limit of 30 percent of GDP for net debt is considered appropriately conservative given the risk of shocks from natural disasters, the narrow base and small size of the economy.

### Public Debt Sustainability Analysis — selected quantitative details from Box 3 and tables
- Selected historical and projection figures (as presented):
  - Nominal gross public debt (table entries): e.g., 20.3 (2016), 22.0 (2017), 20.1 (2018), 19.3 (2019), 18.6 (2020), 20.3 (2021), 18.1 (2022), 16.0 (2023), 15.4 (2016? table context).
  - Real GDP growth (in percent) sample entries: 1.0, 4.9, 9.5, 8.9, 6.3, 3.8, 3.8, 3.9, 4.0 (various years as tabulated).
  - Inflation (GDP deflator, in percent) sample entries: 2.7, -2.1, -0.2, 3.8, 1.7, 1.6, 1.2, 1.1, 1.0 (various years as tabulated).
  - Effective interest rate (in percent) sample entries: 6.1, 3.2, 3.9, 4.0, 3.3, 3.2, 3.4, 3.6, 3.8 (various years as tabulated).
  - Change in gross public sector debt cumulative entries include figures such as 0.3, 1.1, -1.9, -0.8, -0.7, 1.7, -2.2, -2.1, -0.7, -4.8.
  - Primary (noninterest) revenue and grants cumulative figure: 209.3 (sum across years shown).
  - Primary (noninterest) expenditure cumulative figure: 201.8 (sum across years shown).
  - Identified debt-creating flows and components with numeric entries as tabulated (e.g., primary deficit entries -0.7, -1.9, -9.4, -4.4, -2.0, 0.9, 0.1, -0.7, -1.4, -7.5).
- Note: detailed tabular entries and graphs in Box 3 provide the projection decompositions, historical scenarios, and alternative scenario assumptions as presented.

### Financial sector policies and system overview
- Financial system composition:
  - About thirty financial entities, including domestic and international banks, a superannuation fund, insurers, captive insurers, trustee companies, and money changing and remittance businesses.
  - Three commercial banks: ANZ Banking Group Limited (ANZ) and Bank of South Pacific (BSP) Limited (foreign-owned branches), and Bank of the Cook Islands (BCI) Limited (government-owned).
  - An additional domestic bank, Capital Security Bank (CSB), is an onshore commercial bank specializing in trust and wealth management for international clients.
- BCI activities and financial inclusion:
  - BCI operates on all islands, channels government subsidies, child benefit and pension payments, and is responsible for the payment of government salaries.
  - As a result, the number of Cook Islanders with access to a bank account is very high.
- International financial services industry:
  - Offshore international financial services industry established in the 1980s; provides corporate, trust, and financial planning services.
  - International entities are generally prohibited from offering services in the Cook Islands; most international entities were established for general asset holding purposes (FSDA survey).
  - International financial services are provided by eight registered trustee companies.
  - Registrations of international entities have been declining (table entries for years ended June 2014–2018: International companies 1,090 1,090 1,095 987 931; International trusts 2,620 2,505 2,373 2,275 2,182; Limited liability companies 383 408 402 365 358; Foundations 5 18 28 5 25 1? — note table formatting in source).
- Superannuation:
  - Cook Islands National Superannuation Fund (CINSF) is compulsory.
  - Members and employers each contribute 5 percent of employees’ salaries; funds invested and managed in New Zealand and overseas.
- Regulation:
  - Financial Supervisory Commission (FSC) is independent, licenses and regulates all financial institutions, supervises regulated entities and services, and operates registries for international entities.

### Banking sector performance and challenges
- Credit and lending trends:
  - Despite rapid economic expansion, credit is falling in absolute terms; private sector deleveraging and banks addressing legacy high non-performing loans and low profitability.
  - Non-performing loans fell from 7½ percent of lending in 2015 to 4 percent in 2018.
  - Some credit growth in finance and business and personal services, but stagnation or decline in wholesale and retail trade, hotels and motels, and transportation.
  - Population fell from around 18.7 thousand in 2014/15 to 17 thousand in 2017/18.
- Structural constraints on credit growth:
  - Housing mortgage rates about 300 to 400 basis points higher than New Zealand, influenced by scale and land tenure arrangements that make land difficult to use as collateral.
  - Cost of recovery relatively higher, reflected in higher NPLs historically.
  - Infrastructure shortcomings: lack of automated clearance system and poor internet connectivity increases cost and restricts speed and quality of financial services.
  - Introduction of a local credit bureau and a collateral registry expected to help, but integration with New Zealand credit bureaus suggested by market participants.
- Financial soundness indicators (FSIs) — selected figures (2014–2018):
  - Regulatory capital to risk-weighted assets: 19.18, 16.61, 19.52, 18.56, 17.30.
  - Regulatory tier 1 capital to risk-weighted assets: 15.01, 13.85, 15.93, 15.08, 14.72.
  - Nonperforming loans net of provisions to capital: 29.02, 30.71, 18.53, 17.49, 14.55.
  - Nonperforming loans to total gross loans: 6.79, 7.46, 5.81, 5.27, 4.04.
  - Return on equity: 18.50, 13.17, 14.19, 18.47, 15.16.
  - Liquid assets (core) to total assets: 44.10, 46.78, 39.71, 46.70, 50.79.
  - Liquid assets (core), in NZ$ thousand: 285,700; 402,686; 341,504; 423,784; 493,106.
  - Short-term liabilities, in NZ$ thousand: 310,876; 481,911; 519,192; 677,869; 514,683.
  - Return on assets: 1.63, 0.97, 1.03, 1.15, 0.95.
  - Nonperforming loans net of provisions, in NZ$ thousand: 13,908; 15,431; 9,690; 9,497; 7,254.
  - Interest margin to gross income: 62.35, 63.99, 64.05, 70.83, 61.12.
  - Noninterest expenses to gross income: 66.64, 59.24, 66.87, 72.30, 75.44.
- Systemic assessment:
  - Aggregate capital adequacy ratio around 17 percent, above the regulatory floor of 10 percent.
  - Banking system is highly liquid.
  - Aggregate loan-to-deposit ratio fell from 100 percent in 2014 to 50 percent in 2018.
  - ROE of 15 percent and ROA around 1 percent: profitability adequate relative to advanced country levels but low compared to other Pacific island countries.

_Italic: Source — https://www.imf.org/-/media/files/publications/cr/2020/english/1cokea2020001.pdf_

### 31.      In 2015 the Council of the European Union (EU) developed a list of non-

### 1cokea2020001 - 31.      In 2015 the Council of the European Union (EU) developed a list of non-

### EU evaluation, tax policy change, and international financial services
- In 2015 the Council of the European Union (EU) developed a list of non-cooperative jurisdictions for taxation.
- The Cook Islands were evaluated by the EU against tax transparency, fair taxation, and the Organization for Economic Cooperation and Development’s (OECD) Base Erosion and Profit Shifting (BEPS) project.
- One issue raised by the EU is that international companies are exempt from all taxes in the Cook Islands.
- In December 2018, the Cook Islands Government agreed to amend legislation to tax the profits of international companies and join the Inclusive Framework of the OECD’s BEPS project.

### Projected economic and fiscal impact of taxing international companies
- Taxing international companies in the Cook Islands will likely lead to the contraction of the international financial services industry with an effect on growth and tax revenues.
- Using tax and Cook Islands Statistics Office’s data, it is estimated that the disappearance of the international financial services industry would lead to a one-off decline in GDP of between 2.1 and 2.6 percent and a decline in tax revenue of about NZ$3.5 to NZ$4.1 million a year, (about 3 percent of total value added tax (VAT), income and withholding taxes collected in 2018).

### Financial Supervisory Commission (FSC) finances and exposure
- The FSC generates most of its regular revenue from licensing, registration, renewal, and other fees paid by international financial service providers, and recently received crown appropriations only in fiscal years 2014 and 2015.
- Renewal fees contribute between 76 and 80 percent to the FSC’s annual revenue.
- With the risk that the international financial services industry may contract, an alternative stable source of funding for the FSC would need to be developed.

### FSC supervisory framework and recent supervisory actions
- The FSC is charged to maintain the soundness of the financial system. Its supervisory framework includes key elements of a risk-based supervision model:
  - Regulation: Legislation, prudential standards (“statements in the Cook Islands”), licensing framework;
  - Risk identification and assessment: Complete off-site and on-site supervision framework;
  - Risk rating: A risk rating model to derive an overall risk rating from assessment of inherent risk, risk management and controls, and capital support;
  - Supervisory action planning: A tool to record and prioritize key supervisory actions in response to identified key risks.
- Two banks have been put on enhanced supervision over the past few years due to AML/CFT, credit risk and related party lending issues.

### Cooperation and memorandums of understanding
- The FSC has a close working relationship with Reserve Bank of New Zealand (RBNZ), and has memorandums of understanding with the RBNZ, the Australian Prudential Regulation Authority (APRA) and the Bank of Papua New Guinea (BPNG).
- Recommendations include putting MOUs in place with the parents of foreign owned branches and expanding MOUs to include contingency planning and crisis management.

### Supervisory and crisis-management recommendations
- Some inherent risks remain in the banking system that need to be carefully monitored. The supervisory authorities are aware of these risks and are monitoring them closely. The risks include:
  - Concentration risk in small markets, including the large concentration of credit in the tourism related industries, which is as high as 60 percent (hotels/motels and personal services).
  - Large exposure of the government owned bank (BCI) to movements in government balances.
  - Natural disasters; two international banks could count on head offices to provide liquidity in case of natural disasters, but it might be advisable for BCI to have higher reserves on hand for this kind of event. Its major shareholder appropriately intends to build up cash liquidity reserves.
- Bank recovery and resolution: systemically important banks should be required to prepare recovery plans; the FSC considers BCI to be systemically important. Roles, responsibilities and decision-making processes for dealing with a crisis and the exercise of resolution powers should be agreed among stakeholders and formalized.
- Banking crisis management should seek to achieve four key objectives:
  - Maintain key financial transactions;
  - Minimize economic dislocation;
  - Promote market discipline and maintain market integrity;
  - Minimize the fiscal costs of failures.

### Structural policies for transitioning to high income
- The Cook Islands faces constraints typical of small island states: small scale, remoteness, dispersion of the population in outer islands, and a shortage of skilled and unskilled labor; assets include a stable government, relatively high capacity in public administration, a close association and special relationship with New Zealand, and natural resources for tourism and fishing.
- Given its small scale and remoteness, it is unlikely that Cook Islands will be able to integrate into global manufacturing value chains as a way to transition to a higher income economy. The likely path forward is through the provision of services.
- Tourism is the mainstay of the economy; priorities include preserving and enhancing tourism through branding and upgrading of service while preserving niche resort status and avoiding large international tourist developments.
- The international financial services industry is unlikely to supply income growth going forward; its special advantage has dissipated and the Cook Islands has decided to remove tax advantages for the industry to preserve its relationship with the European Union.
- The Cook Islands needs to diversify its economy and invest in productivity enhancing economic activity. Important constraints identified:
  - Infrastructure needs: deficits in telecommunications, water, sanitation, transportation, and energy. The government is addressing these, including with new legislation, regulations and an active program of public investments.
  - Labor: shortages of both skilled labor and unskilled labor; short-term solution includes allowing or encouraging increased immigration. A new Immigration Bill presents an opportunity to set parameters to manage inflows of new workers.
  - Land use: the land tenure system presents challenges to collateralized lending and large scale land developments.
  - Uncertainty of the Investment Environment: the framework for regulating foreign direct investment seems restrictive, picks and chooses preferred industries, allows significant discretion in approving projects, and often allows only very narrow sets of activities to be licensed.

### Structural policy recommendations
- Better management of infrastructure investment and public spending:
  - Address constraints to infrastructure investments, including shortages of skilled personnel for planning, preparation, and project management.
  - Consider bringing in private sector companies or public private partnerships.
  - Consider requesting a public investment management assessment (PIMA) or a similar process from donors or from PFTAC.
- Address land tenure and land use issues:
  - Clarify land ownership and rights to land use to facilitate collateralized lending and more efficient use of scarce land on the main island.
- Continue upgrading tourist facilities and services to attract higher income tourists and improve the tourist experience:
  - New air transportation routes, accreditation and control of private accommodations, upgrading existing facilities, and including transport and accommodations and other tourist services in the outer islands.
- Enhance communication and transportation links within the Cook Islands and with the rest of the world:
  - Maintain subsidies for air routes (already subsidized from Australia and the U.S.);
  - Improve communications with the undersea cable to facilitate private sector activity, mobile banking and trade flows;
  - Provide regular transportation routes to the outer islands to develop tourism and trade opportunities.
- Reform the Foreign Direct Investment regime:
  - Adopt transparent non-discriminatory rules to attract feasible projects and capital;
  - Reform the investment code to open up traditionally closed areas of the economy to foreign investment to help diversification.

*IMF staff report content.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2020/english/1cokea2020001.pdf_