## _cr14253

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### Context and structural constraints
- Population and geography:
  - Population of some 11,000 people on 26 square kilometers; more than 3,000 kilometers from nearest major external market (New Zealand).
- Structural constraints:
  - Remoteness, lack of scale economies, weak institutional capacity, climate change and rising sea levels.
- Main external inflows:
  - Fishing revenues, foreign aid, and remittances.
  - Fishing revenues and foreign aid are highly volatile and uncertain.
  - Remittances fell to 10 percent of GDP (from nearly 20 percent pre-crisis).
- Policy setting:
  - Australian dollar is legal currency; fiscal policy is the main macro policy tool.
  - Economy dominated by inefficient public enterprises.
  - Banking sector lending capacity constrained by severe asset quality problems.

### Recent developments and key statistics
- Growth and inflation:
  - Real GDP growth volatile, averaging only 1 percent in the past decade.
  - Inflation rose to 3 percent by end-2013.
- External sector and revenues:
  - Fishing exports and fishing license fees have more than doubled in just a few years; each accounting for about half of GDP now.
  - Foreign aid (budget support and off-budget project financing) hovered at around half of GDP.
- Fiscal position and buffers:
  - Fiscal surplus for the second consecutive year in 2013.
  - Fiscal surplus reached 26.3 percent of GDP.
  - Extrabudgetary spending supported by project financing from development partners have been around 25 percent of GDP.
  - Consolidated Investment Fund (CIF) built up to more than $A 15 million (38 percent of GDP).
  - Tuvalu Trust Fund (TTF) market value recovered to more than $A 140 million (3.5 times of GDP).
- Public and external debt (end-2013):
  - Public debt: 41 percent of GDP (US$ 14.6 million).
  - External debt: US$ 12.5 million (35 percent of GDP).
  - Domestic debt: US$ 2.1 million (6 percent of GDP).
  - Debt projected to rise sharply to 56.9 percent in 2014 due to a new loan agreement taken on by a fishing joint venture (loan could be government-guaranteed).
- Banking and public enterprise sector health:
  - State-owned dual-bank system unsupervised; about half of loan portfolio is nonperforming.
  - DBT net capital fell from $A 2.5 million (7.2 percent of GDP) to $A 0.7 million (1.7 percent of GDP) in the past three years.
  - DBT accounts for about 10 percent of banking sector assets and experienced a sharp drop in deposits in 2013.
  - Non-bank public enterprises accumulated losses of more than 3 percent of GDP in the past few years; total capital below 0.5 percent of GDP.
- Exchange rate and competitiveness:
  - No sign of significant exchange rate misalignment; real effective exchange rate depreciated about 8 percent since its recent peak in early 2013 and returned to its 10-year average due to a weakening Australian dollar.
  - Competitiveness remains weak due to remoteness, high transportation cost, isolation, and lack of scale.
- Political calendar:
  - General elections expected to be held by March 2015.

### Outlook and risks
- Growth outlook:
  - Several infrastructure projects financed by grants from development partners (amounting to more than 40 percent of GDP) expected to come on stream in next three years; may boost growth to 2.5 percent in that period.
  - Long-run growth impeded by weak capacity and competitiveness; long-run growth projected to moderate to about 2 percent.
- Macroeconomic and financial risks:
  - Near-term: impaired DBT balance sheet could further weaken lending, drag on private-sector growth, threaten macro-financial stability, and undermine business confidence.
  - Medium- to long-term: maintaining fiscal sustainability is the primary challenge; DSA suggests a high risk of debt distress under the baseline.
  - Fishing revenues are highly uncertain and face downside risks (overfishing, climate change).
  - Contingent liabilities associated with state-owned banks and public enterprises are substantial.
- External account and reserves:
  - CIF and liquid foreign assets held by the National Bank of Tuvalu define reserves.
  - Reserves increased to around nine months of imports after CIF buildup in 2012–2013.
  - With depletion of CIF, foreign exchange reserves projected to decline from 9 months of imports to 5 months over the medium term.
  - Risks to fishing license fees and remittances from slower growth in advanced/emerging economies or a slowdown in China.
  - U.S. tapering could cause Australian dollar depreciation (improving competitiveness) but disorderly tapering may increase volatility in asset markets where TTF is invested.

### Fiscal policy, public financial management, and recommendations
Findings:
- 2014 budget targets a surplus but finances a more than 20 percent expansion of spending (largely one-off increases), including a 25 percent rise in civil servant salary and potential costly revival of the Tuvalu Cooperative Society (TCS).
- On-budget foreign grants expected to return to historical average levels; budget projected to move into a deficit from 2015 onwards and fully deplete fiscal buffers over the medium term unless the spending increase is unwound.
- Tariff rate cuts under PICTA may shrink tax revenue; deferred to 2017 for least developed countries including Tuvalu.
- Bringing insolvent non-bank public enterprises to positive capital would cost at least 4 percent of GDP.
- Government guarantees for public enterprise debt (including external loans of fishing joint ventures) constitute contingent liabilities.

Recommendations / Policy actions:
- Immediate consolidation and expenditure control:
  - Scale government expenditure down from the 2014 budget level at 93 percent of GDP to about 80 percent of GDP in the next three years.
  - Proposal: largely freeze spending to bring its share in GDP to 84 percent within three years, and cut back a few rapidly growing expenditures.
  - Put expenditures on goods and services and grants and subsidies under tight scrutiny using the newly introduced procurement mechanism and the PRM framework.
  - Explore more cost-effective policies to supply necessities to outer islands rather than reviving TCS (reviving TCS could cost 10 percent of GDP to clear arrears; TCS currently holds arrears of $A 2.5 million).
  - Improve cost effectiveness of social programs such as the scholarship program and Tuvalu Medical Treatment Scheme (TMTS).
  - Refrain from providing guarantees for public enterprise borrowing.
- Revenue-side and administration:
  - Strengthen tax administration, including legal actions on non-compliance.
  - Conduct a tax policy review.
  - Recognize narrow economic base limits scope for further increases in tax revenue.
- Medium-term fiscal framework and funds management:
  - Implement a medium-term fiscal framework to ensure sustainability, address procyclicality, and build buffers.
  - Anchor transfers among the budget, the CIF, and the TTF by a structural balance target:
    - Target a structural balance by adjusting fishing license fees to reflect their moving average.
    - Staff estimates a structural surplus of 0.5-1 percent of GDP is needed to maintain fiscal buffers and bring down the risk of debt distress from high to moderate.
    - Transform the CIF into a fiscal stabilization fund with a clear rule of accumulation and withdrawal.
    - Position the TTF as a rainy day fund, with returns on investment saved in a reserve account for use in the event of severe adverse shocks.

### Banking sector vulnerabilities and recommended reforms
Key metrics and vulnerabilities:
- NBT’s reported metrics (to be verified under prudential standards):
  - Return on assets of around 3 percent.
  - Capital equivalent to 24 percent of total assets.
- DBT deterioration:
  - DBT net capital fell to $A 0.7 million (1.7 percent of GDP).
  - Government-guaranteed borrowing of the DBT equals 1.4 percent of GDP.
- Risks:
  - DBT problems could imply spillover risks across the banking system and large government liabilities.

Recommended actions:
- Urgent establishment of a framework of banking supervision and resolution.
- Implement a banking supervisory and regulatory framework; establish a Bank Commission and employ supervisors with cost control.
- Assess financial condition and fiscal implications (e.g., cost of possible recapitalization) on the basis of prudential standards.
- Set up a banking resolution framework.
- Seek development partners’ support and technical assistance (mission suggested contacting PFTAC for technical assistance).

### Public enterprises: status, risks, and reform priorities
Findings:
- Audited accounts for 2012 show most public enterprises reported financial losses; losses exceed 3 percent of GDP in recent years.
- PERMU established by the 2010 Public Enterprise Act is effectively not in operation (Director and supporting positions vacant).
- CSOs determine government compensation by negotiation rather than clear costing.

Specific case — Tuvalu Electricity Corporation (TEC):
- Fuel grants by development partners to be phased out by end-2014.
- A recent review suggests tariff adjustments may be inevitable.
- It is estimated electricity tariff rates need to rise by around 50% for TEC to be profitable.

Reform recommendations:
- Develop a reform plan to enhance commercial orientation and financial soundness.
- Clearly define and cost social responsibilities of public enterprises.
- Strengthen accounting and auditing practices.
- For TEC: review electricity tariff rates periodically and allow adjustment to reflect operational cost and fuel price movements; direct government social policies to protect the most affected poor.
- Fully staff and operationalize PERMU.

### Debt sustainability analysis (DSA) — baseline, sensitivity, and alternative scenario
Baseline macro and projections:
- Real GDP growth: projected to average 2.2 percent per annum over the medium term and 2 percent over the long run (2014 DSA).
- Inflation: projected to reach about 3 percent in the near term and gradually moderate to below 2 percent in the long run.
- Exports of goods and services: projected at 60 percent of GDP over the medium and long run.
- Imports: peak at 168 percent of GDP in the medium term and moderate to 115 percent of GDP over the long run.
- Current account deficit widens to 37 percent of GDP over the medium term, then narrows to 4.4 percent of GDP by the end of the projection period.
- Fishing license fees projected conservatively at around A$14 million in 2014-2019 and to gradually decline to A$11 million over the long run.
- Foreign grants to the budget expected to decline from 51 percent of GDP in 2014 to 13 percent of GDP by 2034.
- Expenditures projected to decline from 100 percent of GDP in 2014 to 62 percent in 2034.

DSA key findings:
- Under the baseline, external debt trajectory declines from 52 percent of GDP to just above 20 percent over the medium term, then rises and breaches the indicative threshold by 2029 as CIF is depleted.
- PV of public debt to GDP: 58 percent in 2014; declines below 38 percent over the medium term, then rises to 40 percent of GDP by 2034.
- PV of debt-to-revenue ratio: rises from 50 percent in 2014 to 69 percent in 2034.
- Overall DSA conclusion: high risk of debt distress (same conclusion as 2012 DSA).
- Sensitivity:
  - One-time 30 percent nominal depreciation in 2015 would cause the debt-to-GDP ratio to stay above the indicative threshold for most of the projection period and push PV of debt-to-GDP ratio to peak at 73 percent in 2015.
  - Standard shock to growth causes PV of debt-to-revenue ratio to rise from 50 percent in 2014 to 194 percent in 2034.

Alternative scenario (structural-balance/fiscal anchoring):
- Structural-balance approach: target a structural surplus estimated by a seven-year moving average of fishing license fees; excess saved in CIF, drawn down when receipts fall short.
- Under alternative scenario targeting a structural surplus of 0.5-1 percent of GDP:
  - CIF buffers would be maintained at a comfortable level.
  - PV of external debt-to-GDP would fall from 53 percent in 2014 to around 10 percent by 2034.
  - Risk of debt distress is reduced to a moderate level.

### Public financial management (PFM) progress and remaining gaps
Progress:
- Central procurement unit established and regulations adopted.
- Authorities published a budget manual outlining the budget process and policies.
- Strengthened monitoring of outer island budget operations.
- Monthly reports of budget execution started.

Remaining gaps and recommendations:
- Anchor the budget process by a sustainable medium-term fiscal framework that incorporates development objectives.
- Streamline management of fishing license fees to reconcile treasury receipts and Fisheries Department sales.
- Introduce a commitment control system.
- Over the medium term, establish a wage-setting mechanism linking public sector wages to productivity gains.

### Risk Assessment Matrix (selected risks and recommendations)
- Surges in global financial market volatility:
  - Likelihood: H. High.
  - Impact: Elevated volatility affects TTF market value; recommendation: make TTF a rainy day fund, save most if not all investment returns, and smooth TTF transfers.
- Protracted slower growth in advanced and emerging economies:
  - Likelihood: H. Medium.
  - Impact: Remittances fall; recommendation: develop human capital and foster domestic business climate.
- Growth slowdown in China:
  - Likelihood: M. Medium.
  - Impact and recommendation: similar to above.
- Climate change:
  - Likelihood: M-H. High.
  - Impact: Extreme weather could cause fluctuation in fishing revenues and large economic loss; recommendation: strengthen fiscal buffers and build adaptive capacity with development partners.
- Weak fiscal policy and lower foreign aid:
  - Likelihood: M-H. High.
  - Impact: Fiscal buffers could be fully depleted; recommendation: establish transparent fiscal framework, conduct fiscal consolidation, and engage development partners.
- Poor governance of public enterprises and banks:
  - Likelihood: H. High.
  - Recommendation: adopt public enterprise reforms to enhance transparency and accountability.
- Elevated banking risks/Insolvency of DBT:
  - Likelihood: H. High.
  - Impact: Large NPLs impede lending and pose substantial contingent liabilities; recommendation: establish regulatory framework for banks, assess fiscal cost of restructuring, and develop a bank resolution framework.

### Other institutional and capacity issues
- Exchange system and Article XIV/VIII:
  - At joining the Fund in 2010, Tuvalu availed itself of transitory provisions of Article XIV, Section 2.
  - Exchange control regulations are restrictive on paper but liberal in practice for current international transactions; staff recommended updating regulations to align with practice so Tuvalu can accept obligations of Article VIII, Sections 2, 3, and 4; authorities have no current plans to do so.
- AML/CFT:
  - Strengthening AML/CFT framework based on 2006 law with technical assistance; Tuvalu became an observer to the Asia/Pacific Group on Money Laundering (APG) in 2014.
- Statistics and capacity building:
  - Progress in budget execution reporting and balance of payments statistics.
  - Statistical office understaffed; weaknesses in national accounts impede analysis; urgent need to increase resources and technical assistance, including from PFTAC.

### Staff appraisal — priority actions (condensed)
- Unwind the 2014 budget expansion and implement fiscal consolidation.
- Introduce a medium-term fiscal framework targeting a structural surplus of 0.5-1 percent of GDP to manage revenue volatility and preserve CIF buffers.
- Urgent action on banking risks: contingency plan for possible DBT failure, full banking system review, and establish regulatory and resolution frameworks.
- Strengthen public enterprise reforms: fully staff PERMU, define and cost CSOs, align tariffs (notably electricity) with costs.
- Rationalize social spending: institutionalize referral committee, scrutinize TMTS, explore alternative health financing, and target scholarship numbers.
- Improve data and statistics: increase resources for national accounts and statistical work.
- Continue PRM III focusing on fiscal sustainability, PFM, banking and public enterprise weaknesses, and private sector development.

*Source: IMF staff report excerpt — "1. External Sector and Exchange Rate Assessment" and accompanying sections (Tuvalu).*

### 1. External Sector and Exchange Rate Assessment _______________________________________________ 13

### 1. External Sector and Exchange Rate Assessment

### Context
- Tuvalu: population of some 11,000 people on 26 square kilometers; more than 3,000 kilometers from nearest major external market (New Zealand).
- Key structural constraints: remoteness, lack of scale economies, weak institutional capacity, climate change and rising sea levels (Appendix III).
- Income and economic structure:
  - Per capita income among the highest in the group of small Pacific island countries.
  - Main external inflows: fishing revenues, foreign aid, and remittances.
  - Fishing revenues and foreign aid are highly volatile and uncertain (Appendix IV).
  - Remittances have not recovered to pre-global financial crisis levels, reflecting limited human capacity and weak competitiveness (Appendix V).
- Policy space and vulnerabilities:
  - Australian dollar is legal currency; fiscal policy is the main macro policy tool.
  - Economy dominated by inefficient public enterprises.
  - Banking sector lending capacity constrained by severe asset quality problems.
  - Emphasis on developing sound fiscal framework, addressing bank and public enterprise weaknesses, and fostering private-sector–friendly business environment.

### Recent developments and key statistics
- Growth and inflation:
  - Real GDP growth volatile, averaging only 1 percent in the past decade.
  - Inflation rose to 3 percent by end-2013 (pickup in nonfood inflation; influenced by a weakening Australian dollar).
- External sector and revenues:
  - Introduction of the Vessel Day Scheme and fishing joint ventures: fishing exports and fishing license fees have more than doubled in just a few years, with each accounting for about half of GDP now.
  - Foreign aid (budget support and off-budget project financing) hovered at around half of GDP.
  - Remittances fell to 10 percent of GDP (from nearly 20 percent pre-crisis).
- Fiscal position:
  - Fiscal surplus for the second consecutive year in 2013.
  - Fiscal surplus reached 26.3 percent of GDP.1
  - Extrabudgetary spending supported by project financing from development partners have been around 25 percent of GDP.2
  - Consolidated Investment Fund (CIF) built up to more than $A 15 million (38 percent of GDP).
  - Tuvalu Trust Fund (TTF) market value recovered to more than $A 140 million (3.5 times of GDP).
  - Public debt at end-2013: 41 percent of GDP; external debt (including public enterprise debt on commercial terms) 35 percent of GDP.
  - Debt projected to rise sharply to 56.9 percent in 2014 due to a new loan agreement taken on by a fishing joint venture (loan could be government-guaranteed).
- Banking and public enterprise sector health:
  - State-owned dual-bank system is unsupervised; about half of loan portfolio is nonperforming.
  - Development Bank of Tuvalu (DBT) net capital fell from $A 2.5 million (7.2 percent of GDP) to $A 0.7 million (1.7 percent of GDP) in the past three years.
  - DBT accounts for about 10 percent of banking sector assets and experienced a sharp drop in deposits in 2013.
  - Non-bank public enterprises accumulated losses of more than 3 percent of GDP in the past few years; total capital below 0.5 percent of GDP (Appendix VI).
- Exchange rate and competitiveness:
  - No sign of significant exchange rate misalignment; real effective exchange rate depreciated over the past year and returned to its 10-year average due to a weakening Australian dollar.
  - Competitiveness remains weak due to remoteness, high transportation cost, isolation, and lack of scale.
- Elections:
  - General elections expected to be held by March 2015.

1/ Fishing license fees reached a record high in 2013 because of improved negotiating power under the Vessel Day Scheme and increased revenues under the bilateral treaty with the U.S. government. Tax revenue outperformed the budget target due to improved compliance, favorable performance of a fishing joint venture, and a VAT rate increase. Current spending was generally restrained; on-budget capital spending was small.  
2/ Extrabudgetary spending supported by project financing from development partners have been around 25 percent of GDP.

### Outlook and risks
- Growth outlook:
  - Several infrastructure projects financed by grants from development partners (amounting to more than 40 percent of GDP) expected to come on stream in next three years; may boost growth to 2.5 percent in that period.
  - Long-run growth impeded by weak capacity and competitiveness.
- Macroeconomic and financial risks:
  - Near-term: impaired DBT balance sheet could further weaken lending, drag on private-sector growth, threaten macro-financial stability, and undermine business confidence.
  - Medium- to long-term: maintaining fiscal sustainability is the primary challenge; debt sustainability analysis suggests a high risk of debt distress under the baseline.
  - Fishing revenues are highly uncertain and face downside risks (overfishing, climate change).
  - Contingent liabilities associated with state-owned banks and public enterprises are substantial.
- External account and reserves:
  - Large inflows of foreign grants likely to be offset by rising imports due to increased budget spending and public investment.
  - With depletion of CIF, foreign exchange reserves projected to decline from 9 months of imports to 5 months over the medium term.
  - Risks to fishing license fees and remittances from slower growth in advanced/emerging economies or a slowdown in China.
  - U.S. tapering: could cause Australian dollar depreciation (improving Tuvalu competitiveness) but disorderly tapering may increase volatility in asset markets where TTF is invested, generating fluctuations in TTF market value and likely transfers to Tuvalu’s budget.

### Authorities’ views
- Authorities generally agreed with staff’s views on the economic outlook.
- Authorities attribute weak growth to lack of large projects and expect growth to pick up as several large projects are implemented.
- Authorities anticipate balance of payments pressure given uncertainty in fishing-related receipts.

### Policy discussions — overarching agenda
- Key policy agenda items:
  - Develop a medium-term fiscal framework that anchors sustainable fiscal policy.
  - Address banking sector risks by establishing a regulatory framework.
  - Enhance efficiency of public enterprises.
  - Foster inclusive growth and competitiveness through structural reforms.

### Fiscal policy and public financial management (findings and recommendations)
Findings:
- 2014 budget: targets a surplus but finances a more than 20 percent expansion of spending (largely one-off increases), including a 25 percent rise in civil servant salary and potential costly revival of the Tuvalu Cooperative Society (TCS).
- On-budget foreign grants expected to return to historical average levels; budget projected to move into a deficit from 2015 onwards and fully deplete fiscal buffers over the medium term unless the spending increase is unwound.
- Medium-term fiscal risks:
  - Tariff rate cuts under PICTA may shrink tax revenue (tariff rates for trade among Pacific island countries cut to zero by 2015; deferred to 2017 for least developed countries including Tuvalu).
  - Potential decline in fishing revenue.
  - Liabilities from banks and public enterprises: bringing insolvent non-bank public enterprises to positive capital would cost at least 4 percent of GDP; cost of addressing banking vulnerabilities requires assessment under a regulatory framework.
  - Government guarantees for public enterprise debt (including external loans of fishing joint ventures) constitute contingent liabilities.

Recommendations / Policy actions:
- Immediate consolidation and expenditure control:
  - Scale government expenditure down from the 2014 budget level at 93 percent of GDP to about 80 percent of GDP in the next three years.
  - Proposal: largely freeze spending to bring its share in GDP to 84 percent within three years, and cut back a few rapidly growing expenditures.
  - Put expenditures on goods and services and grants and subsidies (budgeted to grow by double digits) under tight scrutiny using the newly introduced procurement mechanism and the PRM framework.
  - Explore more cost-effective policies to supply necessities to outer islands rather than reviving TCS (reviving TCS could cost 10 percent of GDP to clear arrears and regain market share; TCS currently holds arrears of $A 2.5 million against external suppliers and domestic banks).
  - Improve cost effectiveness of social programs such as the scholarship program and Tuvalu Medical Treatment Scheme (TMTS).
  - Refrain from providing guarantees for public enterprise borrowing given already high risk of debt distress.
- Revenue-side and administration:
  - Strengthen tax administration, including legal actions on non-compliance.
  - Conduct a tax policy review given uneven cost-benefit among different taxes.
  - Acknowledge narrow economic base limits scope for further increases in tax revenue.
- Medium-term fiscal framework and funds management:
  - Implement a medium-term fiscal framework to ensure sustainability, address procyclicality, and build buffers.
  - Anchor transfers among the budget, the CIF, and the TTF by a structural balance target:
    - Target a structural balance to reduce expenditure fluctuation from revenue volatility; staff suggests a simple approach to estimate structural revenue by adjusting fishing license fees to reflect their moving average.
    - Staff estimates that, with CIF already at a comfortable level, a structural surplus of 0.5-1 percent of GDP is needed to maintain fiscal buffers and bring down the risk of debt distress from high to moderate over the medium and long run.
    - Transform the CIF into a fiscal stabilization fund with a clear rule of accumulation and withdrawal: save temporary windfalls from fishing revenues in the CIF and draw it down when there is a revenue shortfall.
    - Position the TTF as a rainy day fund, with returns on investment saved in a reserve account for use in the event of severe adverse shocks.

*Source: IMF staff report excerpt — "1. External Sector and Exchange Rate Assessment" (Tuvalu).*

### 18.      Marked progress has been made in strengthening public financial management.

### _cr14253 - 18.      Marked progress has been made in strengthening public financial management.

### Public financial management: progress and remaining gaps
- Notable achievements:
  - A central procurement unit has been established, and associated regulations adopted.
  - Authorities published a budget manual outlining the budget process and policies.
  - Strengthened monitoring of outer island budget operations.
  - Monthly reports of budget execution have been started, enhancing transparency and facilitating budget control.
- Remaining scope for strengthening:
  - The budget process needs to be anchored by a sustainable medium-term fiscal framework that incorporates development objectives.
  - Management of fishing license fees should be streamlined to reconcile treasury receipts and the sale of licenses by the Fisheries Department.
  - Introducing a commitment control system would further improve budget management.
  - Over the medium term, a wage-setting mechanism is necessary to ensure public sector wage increases are in line with productivity gains in the economy.

### Scenarios and projection note
- Baseline and alternative scenarios referenced; alternative scenario assumption:
  - The alternative scenario assumes a structural surplus of 0.5-1 percent of GDP over the long run.

### Authorities’ views on fiscal risks and PFM
- Shared staff’s views on fiscal sustainability risks, including concern about:
  - Lack of transparency in the TMTS and potential overspending; intend to contain its cost by establishing a comprehensive database and closely following patients’ treatment schedules.
  - Careful estimation of the cost of reviving the TCS and consideration of alternative options as needed.
- On debt sustainability:
  - Authorities generally concur with staff assessment.
  - They indicate contingent liabilities from fishing joint ventures are not a key concern as joint ventures have a favorable outlook and the probability for the government to assume their debt obligation is small.
- Agreement with staff proposal on introducing a medium-term fiscal framework:
  - Share concern about revenue volatility.
  - Support suggestion to have fiscal policy anchored by a structural balance and to make the TTF a rainy day fund, with its investment returns saved in a reserve account for large adverse shocks.
- Commitment to enhance PFM:
  - Developing an IT system to better reconcile fishing license fees between the Treasury and Fisheries Department.
  - Aim to further improve public financial management when implementing the third phase of PRM.

### Financial stability: banking sector vulnerabilities and priorities
- Key vulnerabilities and metrics:
  - NBT’s reported financial metrics (to be verified under a prudent regulatory framework):
    - Return on assets of around 3 percent.
    - Capital equivalent to 24 percent of total assets.
  - DBT’s rapid deterioration points to a looming solvency issue.
  - Government-guaranteed borrowing of the DBT equals 1.4 percent of GDP.
- Risks and implications:
  - DBT problems could imply spillover risks across the banking system and large government liabilities.
  - Fresh capital injection into the banking system may be required; introducing private capital could be challenging given underdeveloped private sector and past unsuccessful privatizations.
- Recommended actions:
  - Urgent establishment of a framework of banking supervision and resolution.
  - Implement a banking supervisory and regulatory framework; establish a Bank Commission and employ supervisors as soon as feasible with due regard to controlling administrative costs.
  - Assess financial condition and implications (e.g., cost of possible recapitalization) urgently on the basis of prudential standards.
  - Set up a banking resolution framework.
  - Seek development partners’ support and technical assistance (mission suggested contacting PFTAC for technical assistance).

### Authorities’ views on banking sector
- Authorities are cognizant of the need to strengthen the banking sector.
- They are considering establishing the Bank Commission as stipulated by law.
- They agree with the need to strengthen the banking sector, with more focus on expanding banking services.

### Public enterprise reform: status, risks, and reform needs
- Progress noted:
  - Improved financial reporting and enforcement of the Public Enterprise Act.
  - Progress in merging and privatization efforts.
  - Enhanced monitoring and auditing of public enterprises and removal of civil servants from Board positions.
- Persistent problems:
  - Public enterprises remain broadly inefficient and far from operating on a commercial basis.
  - Most are making losses despite receiving large government subsidies.
  - Tuvalu Electricity Corporation (TEC) is particularly worrisome:
    - Fuel grants by development partners are to be phased out by end-2014, increasing fiscal burdens and exposure to fluctuating oil prices.
    - A recent third-party review suggests tariff adjustments may be inevitable to make the TEC financially viable.
- Reform recommendations:
  - Develop a reform plan to enhance commercial orientation and financial soundness.
  - Clearly define and cost social responsibilities of public enterprises.
  - Strengthen accounting and auditing practices to improve transparency and accountability.
  - For TEC: review electricity tariff rates periodically and allow adjustment to reflect operational cost and fuel price movements; direct government social policies to protect the most affected poor.
- Authorities’ commitment:
  - Committed to advancing public enterprise reform with assistance from development partners.
  - Working with the Asian Development Bank on privatization and merging; seeking additional technical assistance for Telecommunication Corporation review.

### Promoting inclusive growth and PRM
- Reform momentum and priorities:
  - Continue reforms to promote macroeconomic stability and growth.
  - Completion of PRM I and II is commendable; initiation of PRM III is important.
  - PRM III should focus on strengthening the fiscal framework and addressing structural weaknesses, notably in banking and public enterprise sectors.
- Structural priorities to promote inclusion and competitiveness:
  - Rebalance resources toward basic and vocational education.
  - Improve gender equality in accessing training opportunities.
  - Enhance infrastructure.
  - Foster domestic job market and explore employment abroad, including seasonal worker schemes in the Pacific region.
- Authorities’ view:
  - Committed to continued reforms and working with development partners on PRM III design; PRM III may be launched in a few months and will focus on fiscal sustainability, public financial management, and structural issues to foster private sector development.

### Other issues
- Exchange system and Article XIV/VIII:
  - At joining the Fund in 2010, Tuvalu availed itself of the transitory provisions of Article XIV, Section 2.
  - Exchange control regulations are restrictive on paper, but in practice payments and transfers for current international transactions are administered liberally.
  - Staff recommended updating regulations to align with current practice so Tuvalu can accept the obligations of Article VIII, Sections 2, 3, and 4; authorities have no current plans to do so.
- AML/CFT:
  - Tuvalu is strengthening its anti-money laundering framework based on the 2006 AML/CFT law with technical assistance.
  - Tuvalu became an observer to the Asia/Pacific Group on Money Laundering (APG) in 2014.
- Statistics and capacity building:
  - Progress in budget execution reporting and balance of payments statistics.
  - Statistical office is understaffed; weaknesses in national accounts statistics impede economic analysis.
  - Urgent need to increase resources for statistical work and strengthen training and technical assistance, including from PFTAC.

### Staff appraisal: summary of assessments and recommendations
- Positive assessments:
  - Significant strides in reform implementation, including tax administration (especially compliance of public enterprises) and public financial management.
  - Strengthened monitoring and auditing of public enterprises.
- Key recommendations and priorities:
  - Build on favorable budget outcomes of the last two years to further enhance fiscal sustainability.
  - Fiscal consolidation is crucial, particularly unwinding the 2014 budget expansion.
  - Introduce a medium-term fiscal framework targeting a structural surplus to manage revenue volatility.
  - Create more savings in the TTF to build resilience against adverse shocks.
  - Rationalize social spending:
    - Institutionalize the referral committee and closely scrutinize medical expenses under the TMTS.
    - Explore alternative health plans with burden sharing by individuals (e.g., negotiating health insurance purchasable using citizens’ savings at the Tuvalu National Provident Fund).
    - For scholarships, target the total number of students studying abroad instead of new students to improve predictability and budget management.
  - Urgent action on banking risks:
    - Develop a contingency plan for possible DBT failure, including a resolution framework and estimate of associated fiscal costs.
    - Contain DBT losses; conduct a complete review of the banking system and establish a regulatory framework as soon as feasible.
  - Public enterprises:
    - PERMU should be well staffed and prioritize defining social responsibilities and enhancing transparency via strengthened accounting and auditing.
  - Macroeconomic policy and structural reform:
    - Restrain government spending and wage increases to reduce inflationary pressure and real exchange rate appreciation.
    - Over the longer horizon, improve education and vocational training (e.g., upgrade Tuvalu Maritime Training Institute and allow access by women) to improve employment and competitiveness.
    - Next PRM phase should aim at containing fiscal risks, addressing banking and public enterprise weaknesses, and enhancing the business environment.
  - Data improvements:
    - Additional resources needed for national accounts and other statistical work to support surveillance and policymaking.
  - Consultation cycle:
    - Staff recommends the next Article IV consultation take place on a 24-month cycle.

*Source: IMF staff report content as provided.*

### Box 1. Tuvalu: External Sector and Exchange Rate Assessment

### Box 1. Tuvalu: External Sector and Exchange Rate Assessment

### Real effective exchange rate (REER) and exchange rate alignment
- The REER has returned to its historical level.
- The REER has depreciated by about 8 percent since its recent peak in early 2013.
- The real depreciation was mainly driven by the weakening of the Australia dollar, the legal currency in Tuvalu.
- Historically, Tuvalu’s REER has moved closely with that of Australia, but has been less appreciated since the global crisis.
- There is no sign of significant exchange rate misalignment.
- Policy risk: Loose policies could increase the risk of overvaluation over the medium term.
- Inflation context:
  - Benefiting from lower global food and commodity prices, increased trade diversification, and retail competition, inflation in Tuvalu has been below trading partners’ inflation.
  - The expected sizable increase in public sector wages would boost domestic demand, widen the trade deficit, and exert upward pressure on inflation and real exchange rate appreciation.

### Reserves, CIF, and medium-term outlook
- Current reserve assessment:
  - Reserves appear sufficient by traditional cover metrics.
  - Reserves are defined as the sum of CIF and liquid foreign assets held by the National Bank of Tuvalu.
- Short-term reserve developments:
  - The significant increase in the CIF as a result of fiscal surplus in 2012 and 2013 is estimated to push reserves up to around nine months of imports.
- Medium-term projection and risks:
  - The fiscal balance is expected to move into a widening deficit on the back of stagnated fishing license fees and loose control on expenditure.
  - This will cause the CIF to be fully depleted by 2020 and a rise of imports.
  - As a consequence, import cover will decline to five months.
  - Although the reserve cover appears sufficient by traditional cover, an estimate based on risk metrics suggests it should be kept at above seven months of imports.

### Competitiveness, structural constraints, and policy priorities
- Tuvalu’s competitiveness remains weak due to:
  - Remoteness causing high transportation costs and isolation.
  - Lack of scale increasing transaction costs.
  - Insufficient human capital impeding Tuvaluans from exploring overseas job opportunities.
  - Declining remittances pointing to structural weaknesses.
- Policy and reform priorities for the long run:
  - Improving the business climate.
  - Taking an innovative approach to exploring growth opportunities.
  - Strengthening education and training.

*Prepared by Sung Eun Jung. Reserves are defined as the sum of CIF and liquid foreign assets held by the National Bank of Tuvalu.*

### Appendix I. Tuvalu: Risk Assessment Matrix 1/

### Appendix I. Tuvalu: Risk Assessment Matrix 1/

### Surges in global financial market volatility
- Likelihood: H. High.
- Potential Impact: Elevated market volatilities will feed through to the market value of TTF that is primarily invested in Australia, making TTF’s transfers to the budget more uncertain.
- Recommendation:
  - Make TTF a rainy day fund, save most if not all investment returns, and smooth TTF transfers to the budget by targeting a longer-horizon benchmark.

### Protracted period of slower growth in advanced and emerging economies
- Likelihood: H. Medium.
- Potential Impact: Slower growth and reduced demand in the Pacific region would cause remittances by seafarers and seasonal workers to fall. But meanwhile, a weakening Australian dollar would help improve Tuvalu’s competitiveness.
- Recommendation:
  - Develop human capital to improve competitiveness
  - Foster domestic business climate to improve employment
  - Take an innovative approach to explore foreign employment opportunities

### Growth slowdown in China
- Likelihood: M. Medium.
- Potential Impact: Slower growth and reduced demand in the Pacific region would cause remittances by seafarers and seasonal workers to fall. But meanwhile, a weakening Australian dollar would help improve Tuvalu’s competitiveness.
- Recommendation:
  - Develop human capital to improve competitiveness
  - Foster domestic business climate to improve employment
  - Take an innovative approach to explore foreign employment opportunities

### Climate change
- Likelihood: M-H. High.
- Potential Impact: The occurrence of extreme weather conditions could cause fluctuation in fishing revenues and large economic loss, while tuna stock tends to relocate and decline on variability of the ocean’s conditions over the long run.
- Recommendation:
  - Strengthen fiscal buffers (see above)
  - Build adaptive capacity to increase resilience, with assistance by development partners

### Weak fiscal policy and lower foreign aid
- Likelihood: M-H. High.
- Potential Impact: Fiscal buffers could be fully depleted, making the economy highly vulnerable to adverse shocks.
- Recommendation:
  - Establish a transparent fiscal framework that addresses pro-cyclicality and saves for rainy days
  - Conduct fiscal consolidation and build fiscal buffers
  - Closely engage with development partners to mobilize foreign aid.

### Poor governance of public enterprises and banks
- Likelihood: H. High.
- Potential Impact: The weaknesses in public enterprises and banks pose challenges to growth and stability.
- Recommendation:
  - Adopt public enterprise reforms to enhance transparency and accountability

### Elevated banking risks/Insolvency of DBT
- Likelihood: H. High.
- Potential Impact: Large NPLs impede lending, and pose substantial contingent liabilities to the budget. A possible insolvency of the DBT could cause spillover risks to the banking system and large fiscal cost.
- Recommendation:
  - Establish a regulatory framework for banks
  - Assess fiscal cost of bank restructuring based on prudential standards
  - Develop a bank resolution framework

*The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly.*

### Appendix VI. Tuvalu—Public Enterprises in Tuvalu

### Appendix VI. Tuvalu—Public Enterprises in Tuvalu

### Financial performance
- The audited accounts for 2012 show that most public enterprises reported financial losses and revealed significant vulnerabilities in their financial position.
- Losses made by these enterprises—at more than 3 percent of GDP in the past few years—entail substantial potential liabilities of the government.
- The 2013 audited accounts are not available yet.

### Impediments and structural vulnerabilities
- Impediments to public enterprise operations remain the same as those identified in the 2012 Article IV staff report:
  - persistent inefficiencies in management practices;
  - weak tariff structures;
  - arrears on payments by the government; and
  - limited scope to gain from economies of scale.
- Government compensation for public enterprises’ social services (for instance the provision of electricity and banking services to the outer islands) is allocated through Community Service Obligations (CSOs), but:
  - CSO amounts are determined on the basis of negotiations between the recipients and the government rather than a clear defining and costing of social responsibilities assumed by public enterprises.

### Reform efforts, governance, and institutional arrangements
- The 2010 Public Enterprise Act (PEA) established an ambitious reform plan and created the Public Enterprise Reform Monitoring Unit (PERMU) to monitor enterprises’ compliance with the legislation.
- Progress has been slow in most areas:
  - Progress was made in removing civil servants from Board positions.
  - PERMU is effectively not in operation as the Director and supporting positions are presently vacant.
  - Other areas of reform have seen limited progress.

### Specific risks and near-term pressures
- Recent wage increases for civil servants induced public enterprises to raise salaries for their employees by a similar margin, adding to operational costs.
- Tuvalu Electricity Corporation (TEC) faces substantial challenges as fuel grants from Japan are to be phased out by end-2014:
  - the corporation would make more losses and be more susceptible to global oil price movements.
  - It is estimated that tariff rates at the electricity company need to rise by around 50% for it to be profitable.

### Key statistics by public enterprise (as presented)
- National Bank of Tuvalu (NBT) — 2012 — Assets (Percent of GDP): 80 4 — Solvency (Profit/Liabilities in Percent): [no separate value shown]
- Development Bank of Tuvalu (DBT) — 2012 — Assets (Percent of GDP): 6 — Solvency (Profit/Liabilities in Percent): -55
- Tuvalu Telecommunications Corporations (TTC) — 2012 — Assets (Percent of GDP): 6 — Solvency (Profit/Liabilities in Percent): -9
- Vaiaku Lagi Hotel (VHL) — 2012 — Assets (Percent of GDP): 0 — Solvency (Profit/Liabilities in Percent): -28
- Tuvalu Electricity Corporation (TEC) — 2012 — Assets (Percent of GDP): 15 — Solvency (Profit/Liabilities in Percent): 8
- Tuvalu Maritime Training Institue (TMTI) — 2011 — Assets (Percent of GDP): 17 — Solvency (Profit/Liabilities in Percent): -2
- Tuvalu Philatelic Bureau — 2010 — Assets (Percent of GDP): 0 — Solvency (Profit/Liabilities in Percent): -35
- National Fishhing Company of Tuvalu (NAFICOT) — N.A. — Assets (Percent of GDP): N.A. — Solvency (Profit/Liabilities in Percent): N.A.

### Policy implications and priorities
- Sustained and strengthened reform implementation under the PEA is needed, including:
  - fully staffing and operationalizing PERMU to monitor compliance with the legislation;
  - clarifying and costing CSOs to ensure transparent and targeted compensation for social-service provision by public enterprises;
  - addressing weak tariff structures (notably the electricity tariff) to reduce enterprise losses and limit fiscal contingent liabilities.
- Containing wage-driven cost pressures in public enterprises and aligning tariffs and subsidies with fiscal capacity will be important to limit further deterioration in enterprise financial positions and associated government liabilities.

*Prepared by Inderjit Sian; content as presented in Appendix VI. Tuvalu—Public Enterprises in Tuvalu (IMF staff report material).*

### 1. Being one of the smallest and most isolated countries in the world, Tuvalu faces

### _cr14253 - 1. Being one of the smallest and most isolated countries in the world, Tuvalu faces

### Key challenges and context
- Population and geography: population of some 11,000 people living on 26 square kilometers; more than 3,000 kilometers away from its nearest major external market.
- Structural constraints: weak competitiveness and capacity, remoteness causing high transportation cost and isolation, and lack of scale increasing transaction cost.
- Development strategy: authorities have developed a broad reform agenda to enhance governance and social development, facilitate private sector growth, and safeguard macroeconomic stability.

### Recent fiscal outcomes and public assets
- Fiscal outturns:
  - Fiscal surplus in 2013: 26.3 percent of GDP (second consecutive year of substantial surplus).
  - 2014 budget: targets a more than 20 percent expansion of spending financed by a large temporary increase of foreign grants and transfers.
  - Risk: the substantial fiscal expansion would result eventually in a depletion of fiscal buffers and accumulation of foreign debt.
- Government-controlled buffers:
  - Consolidated Investment Fund (CIF): built up to more than $A 15 million (38 percent of GDP).
  - Tuvalu Trust Fund (TTF): grown from $A130 million in 2012 to more than $A 140 million in 2013 (356 percent of GDP); TTF is not fully sovereign, owned by Tuvalu, Australia, and New Zealand, and cannot be drawn down freely—excess market value over a “maintained value” indexed to Australian CPI can be transferred to the CIF by the TTF Board.
  - Analytical note: DSA analyzes gross public debt because of the limited conditional access to the TTF.

### Public and external debt stock (end-2013)
- Total public and publicly guaranteed (PPG) debt: US$ 14.6 million, equivalent to 41 percent of GDP.
  - External debt: US$ 12.5 million (35 percent of GDP).
  - Domestic debt (owed to domestic banks): US$ 2.1 million (6 percent of GDP).
- Creditor breakdown (outstanding amounts):
  - Central Government Debt — ADB: 6.2 (17.4); Concessional: Yes
  - Development Bank Debt — EIB: 1.4 (3.8); Concessional: No
  - Fishing Joint Venture Debt — Commercial bank: 5.0 (14.1); Concessional: No
  - Domestic debt: 2.1 (5.8); Concessional: No
- Notes on contingent liabilities:
  - Loans contracted at nonconcessional terms by two fishing joint ventures (NAFICOT joint ventures) account for a significant share of public debt and are largely government-guaranteed; a new loan agreement under discussion implies a large addition of public debt most likely in 2014 or 2015.

### Baseline macroeconomic framework and projections
- Baseline fiscal stance: accommodative and procyclical fiscal policy; without timely spending cuts from the 2014 budget level, fiscal balance shifts into deficit from 2015, financed first by CIF drawdowns and later by concessional borrowing once CIF is depleted in 2021.
- Macroeconomic assumptions (comparison of 2012 DSA and 2014 DSA averages):
  - Real GDP growth: 2012 DSA 1.2 ; 2014 DSA 2.2
  - Inflation (GDP deflator): 2012 DSA 1.9 ; 2014 DSA 2.1
  - Current account balance/ GDP: 2012 DSA 0.5 ; 2014 DSA -11.9
  - Revenue excluding grants/ GDP: 2012 DSA 58.5 ; 2014 DSA 60.0
  - Grants/GDP: 2012 DSA 13.7 ; 2014 DSA 24.4
  - Expenditure/GDP: 2012 DSA 81.0 ; 2014 DSA 87.0
  - Fiscal Balance/GDP: 2012 DSA -8.8 ; 2014 DSA -2.2
- Other projections and changes vs. previous DSA:
  - Growth projected to average 2.2 percent per annum over the medium term and 2 percent over the long run (previous DSA constant of 1.2 percent).
  - Inflation projected to reach about 3 percent in the near term and gradually moderate to below 2 percent in the long run (similar to previous DSA).
  - Exports of goods and services projected at 60 percent of GDP over the medium and long run (previous DSA: just above 10 percent, revision reflects large exports by fishing joint ventures).
  - Imports peak at 168 percent of GDP in the medium term and moderate to 115 percent of GDP over the long run (previous DSA: peak 151 percent, long run 112 percent).
  - Current account deficit widens to 37 percent of GDP over the medium term, then narrows to 4.4 percent of GDP by the end of the projection period.
  - Revenue slightly higher over the medium term reflecting buoyant fishing license fees but expected to fall to 45 percent of GDP towards end of projection period (previous DSA: 56 percent).
  - Grants decline to 13 percent of GDP by 2034 (previous DSA: 17 percent).
  - Expenditures projected to decline from 100 percent of GDP in 2014 to 62 percent in 2034 (previous DSA projected broadly stable above 80 percent).
  - Discount rate increased from 3 percent in the last DSA to 5 percent reflecting the most recent DSA guidelines.

### Debt sustainability assessment (key findings)
- External debt:
  - Under the baseline, external debt trajectory declines from 52 percent of GDP to just above 20 percent over the medium term (reflecting amortization and no new borrowing), but increased borrowing in outer years and full depletion of CIF by 2021 cause the debt trajectory to rise again and breach the indicative threshold by 2029.
  - Negative contribution of residuals to the debt trajectory is largely driven by withdrawing from external assets under the CIF.
- Sensitivity to shocks:
  - One-time 30 percent nominal depreciation in 2015 would cause the debt-to-GDP ratio to stay above the indicative threshold for most of the projection period.
  - Standard shock to exports results in breach of the debt-to-export threshold over the next few years.
  - Debt service-to-exports threshold would be breached for four years over the medium term under stress.
- Public debt:
  - PV of public debt to GDP: 58 percent in 2014; declines gradually below benchmark of 38 percent over the medium term, then rises again as new borrowing occurs after CIF depletion, reaching 40 percent of GDP by 2034.
  - PV of debt-to-revenue ratio: rises from 50 percent in 2014 to 69 percent in 2034.
  - PV of debt service-to-revenue ratio: falls from 8 percent to 3 percent.
  - Sensitivity: one-time 30 percent depreciation pushes PV of debt-to-GDP ratio to peak at 73 percent in 2015; standard shock to growth causes PV of debt-to-revenue ratio to rise from 50 percent in 2014 to 194 percent in 2034.
- Overall risk assessment:
  - The DSA concludes a high risk of debt distress (same conclusion as 2012 DSA).
  - Significant portion of public debt contracted on nonconcessional terms, compounding weak debt servicing capacity.
  - Stress tests indicate susceptibility to shocks (30 percent nominal depreciation, slower real GDP growth, lower export growth).

### Alternative scenario (fiscal anchoring) and policy implications
- Structural-balance approach:
  - Targeting a structural balance estimated on a moving average of fishing license fees over seven years: fishing license fees in excess of the structural level would be saved in the CIF; CIF can be drawn down if fishing license fees fall short of structural level.
  - Under the alternative scenario, fiscal policy targets a structural surplus of 0.5-1 percent of GDP over the medium to long run.
- Effects of anchoring fiscal policy:
  - CIF buffers would be maintained at a comfortable level.
  - Debt indicators improve significantly: PV of external debt-to-GDP would fall from 53 percent in 2014 to around 10 percent by 2034.
  - Conclusion: the risk of debt distress is reduced to a moderate level under the alternative scenario.

### Authorities’ views and caveats
- Authorities broadly concurred with the DSA assessment, with observations:
  - Authorities are more optimistic about near-term fishing revenues and expect revenues to be higher than staff projections in the next few years.
  - They indicated the fishing joint venture has a favorable outlook and the probability for the government to assume the company’s debt obligation is small.
- Analytical caveats:
  - Baseline excludes potential large liabilities from weaknesses in banks and public enterprises due to lack of reliable data; the fiscal cost of addressing banking fragilities and public enterprise weaknesses needs assessment under prudent regulation/resolution and comprehensive public enterprise reform.

### Conclusions
- High risk of debt distress persists: PV of debt-to-GDP ratio remains above indicative threshold over the long run.
- Debt dynamics are highly sensitive to shocks (exchange rate, growth, exports); stress tests show potential breaches of debt thresholds.
- Implementing and maintaining a modest structural fiscal surplus (0.5-1 percent of GDP) materially reduces debt risks and preserves CIF buffers.

*International Monetary Fund — Tuvalu Debt Sustainability Analysis (excerpt).*

### Box 1. Macroeconomic Assumptions Under Baseline Scenario

### Box 1. Macroeconomic Assumptions Under Baseline Scenario

### Growth and inflation
- Growth is expected to be boosted to about 2.5 percent in the next few years thanks to the implementation of a few large infrastructure projects financed by grants from development partners. 1/  
- Over the long term, the growth will moderate to about 2 percent as these projects are completed.  
- The share of the public sector in the economy would gradually decline, while the private sector would play a more important role over time on the back of great potential in the fisheries sector, which is consistent with the Te Kakeega II development strategy.  
- Inflation is projected to rise to about 3 percent in 2014 as a result of increased government spending and civil servant wages as well as a weakening Australian dollar. Inflation would moderate gradually to just below 2 percent in the outer years.

### Balance of payments
- Current account deficit will peak over the medium term at 37 percent of GDP mainly because of a spike in imports, and gradually narrow to about 4 percent of GDP over the long run.  
- Fishing exports are expected to double in value over the next 20 years reflecting improved capacity to tap into marine resources by both public and private enterprises.  
- Driven by large infrastructure projects and the purchase of fishing ships, imports would rise substantially in the next few years, and grow moderately thereafter. The trade balance will move into a deficit over the medium term, and return to a moderate surplus in 2018 and onwards.  
- FDI inflows would be minimal and mostly include reinvestment of fishing joint venture earnings. No significant FDI inflows associated with privatization are assumed.

### Fiscal policy and financing
- Fishing license fees are projected conservatively at around A$14 million in 2014-2019 and to gradually decline to A$11 million over the long run reflecting the adverse impact of overfishing and climate change.  
- Foreign grants to the budget are expected to decline gradually from 51 percent of GDP in 2014 to 13 percent of GDP by 2034. It is assumed that the government’s implementation of reforms induces continued support from development partners.  
- Expenditures would be compressed gradually from nearly 100 percent of GDP in 2014 to 62 percent of GDP by 2034, reflecting weakening fishing license fees and foreign grants and a reduced share of the public sector in the economy.  
- The overall fiscal deficit will hover around 5-7 percent of GDP over the medium term, and decline gradually to just above 4 percent of GDP by 2034. Financing of fiscal deficits would be mostly from external borrowing, while domestic banks are not capable of providing sustainable financing over the long term due to severe asset quality problems.

### Key debt and financing assumptions (selected numerical assumptions and projections)
- Current account deficit peak: 37 percent of GDP (medium term); long run: about 4 percent of GDP.  
- Fishing license fees: A$14 million in 2014-2019; decline to A$11 million over long run.  
- Foreign grants to budget: 51 percent of GDP in 2014; decline to 13 percent of GDP by 2034.  
- Expenditures: nearly 100 percent of GDP in 2014; 62 percent of GDP by 2034.  
- Overall fiscal deficit: around 5-7 percent of GDP over the medium term; just above 4 percent of GDP by 2034.  
- FDI inflows: minimal (mostly reinvestment of fishing joint venture earnings).  
- Financing source: mostly external borrowing.

### Stress tests and alternative scenarios (summary from figures and tables)
- Multiple stress tests and alternative scenarios were run for the period 2014–2034, including Alternative (policy adjustment) shocks, historical-scenario shocks, one-time 30 percent nominal depreciation, and less favorable financing on new public sector loans.  
- The baseline and scenario tables present indicators including PV of debt-to-GDP ratio, PV of debt-to-exports ratio, PV of debt-to-revenue ratio, debt service-to-exports ratio, debt service-to-revenue ratio, and grant element assumptions on residual financing.  
- Memorandum and sensitivity results include detailed year-by-year projections and bound tests; specific scenario values are reported in the source tables.

### Policy recommendations and assessments (Executive Board and staff emphasis)
- Urgent actions recommended to strengthen the fiscal position: unwind the 2014 budget expansion by cutting expenditures, keep public sector wages aligned with productivity growth, and rationalize social spending.  
- Adopt a medium-term fiscal framework that targets a structural budget surplus and builds up savings to boost resilience.  
- Further reform of public enterprises: enhance transparency and accountability, better identify social responsibilities, and exercise stricter control of public guarantees.  
- Address banking sector fragilities: resolve nonperforming loans, develop contingency plans, establish a sound regulatory framework, and undertake a comprehensive review of bank balance sheets. Support for a Banking Commission was welcomed.  
- Continue reforms to enhance competitiveness, strengthen education, and build institutional capacity for public sector functions, including compilation of economic statistics. Continued engagement with development partners is key to mitigate climate change effects.

### Other notable points from accompanying text and tables
- Growth boosted near term to about 2.5 percent; long-term growth about 2 percent.  
- Inflation: about 3 percent in 2014; just below 2 percent in outer years.  
- Staff note: expenditures for large infrastructure projects would be extrabudgetary. 1/  
- Fiscal performance and buffers: fiscal surplus in 2013 around 26 percent of GDP (AUS$ 10.5 million); Consolidated Investment Fund increased to AUS$ 19.9 million (around 48 percent of GDP as of March 2014).  
- Wages increased by 25 percent in 2014 (about AUS$ 720/year for 900 government employees).  
- CIF provides a fiscal buffer; authors consider combining TTF operation with a medium-term fiscal framework to build buffers and ensure fiscal sustainability.

*Source: Box 1. Macroeconomic Assumptions Under Baseline Scenario, _cr14253 - Box 1. Macroeconomic Assumptions Under Baseline Scenario (IMF staff).*

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