Kingdom of the Netherlands-Aruba: Concluding Statement of the 2010 Article IV Consultation Mission
IMF News, September 8, 2010
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- Published: September 8, 2010
A gradual economic recovery
- Aruba is a small, open economy with a long-standing peg to the U.S. dollar and annual credit ceilings set by the central bank.
- Recent shocks and outcomes:
- Tourism declined following the global downturn.
- Aruba’s oil refinery temporarily closed in July 2009; refinery contributed about 5 percent to employment.
- Real GDP contracted by 7½ percent in 2009.
- Unemployment increased to more than 11 percent.
- Near-term projections and drivers:
- Real GDP (excluding refining) is projected to stagnate this year due to weak private consumption and investment.
- In 2011, overall GDP growth is projected to surge temporarily to 7 percent reflecting private demand recovery, hotel and infrastructure investment, and the re-opening of the refinery.
- IMF staff estimates long-term potential annual real growth at about 1½ percent.
- External position and reserves:
- The real effective exchange rate (core prices) has depreciated slightly; Aruba’s Caribbean tourism market share has held up well.
- At end-2009, the central bank’s gross reserves covered about 5½ months of imports and 100 percent of short term debt by residual maturity.
- Aruba’s total external debt is elevated at more than 90 percent of GDP, but risks are viewed as contained due to limited short-term and/or portfolio funding.
The fiscal outlook
- Structural fiscal pressures and recent measures:
- Recent tax cuts, including a halving of the business turnover tax, and spending pressures have contributed to a large underlying fiscal deficit.
- Health care and pension schemes are structurally underfunded and constitute a large current and future liability.
- A “social dialogue” with business and labor has produced measures to enhance pension and health scheme soundness (pending parliamentary approval).
- Reforms from the social dialogue (expected effects):
- Premium hikes to the universal health care system (AZV) and the general pay-as-you-go pension scheme (AOV) to reduce/delay government transfers.
- APFA entitlement reforms: compute pension claims on average career wages instead of final wages; increase retirement age from 55 to 60 years; calculate APFA pensions net of AOV claims — improving APFA’s long-term financial position.
- Fiscal projections and risks:
- IMF staff projects an overall fiscal deficit of about 4 percent of GDP this year, with revenues boosted by a one-off tax settlement payment from the refinery.
- In 2011, the deficit is projected to increase to nearly 7 percent of GDP.
- Without corrective measures, the deficit would hover between 6 and 6½ percent of GDP in subsequent years, bringing public debt to about 65 percent of GDP by 2015, from 41 percent of GDP in 2008.
- Rising public debt would imply a significantly higher interest burden and could complicate attracting external funding once private credit demand recovers.
- Government intentions:
- The government intends to reduce the deficit by about 1½ percentage points of GDP per year in 2012-14, implying a deficit somewhat below 2 percent of GDP by 2014 and public debt around 52 percent of GDP by end-2015. Specific policy measures to achieve this have yet to be specified.
Options for fiscal adjustment and tax reform
- IMF staff recommendation:
- Target a deficit of below 1 percent of GDP over the medium-term, corresponding to a primary surplus of 2¼ percent of GDP.
- This implies a fiscal effort of about 5½ percent of GDP beyond initiatives announced in the social dialogue.
- Speed and composition:
- Stretch implementation of required consolidation over two to three years aiming for long-term sustainable fiscal position by 2013.
- Adjustment can be achieved through expenditure and revenue reforms; government prefers some expenditure cuts and promotion of growth-enhancing investments.
- Limits on expenditure-side savings:
- Public spending is tilted heavily towards wages, limiting rapid savings.
- AZV offers savings potential of about 2 percent of GDP if premia were increased or costs lowered to eliminate government transfers.
- Spending on goods and services amounts to around 5 percent of GDP (compared to 4 percent in 2007), offering some room but not enough alone.
- Revenue-side considerations:
- On unchanged policies, Aruba’s tax revenues are projected at about 18 percent of GDP going forward.
- Regional comparison: regional average about 25 percent of GDP across 15 other Caribbean countries.
- Only about half of Aruba’s tax revenues result from indirect taxes, compared to a regional average of almost two-thirds.
- Tax reform principles and steps:
- Reform should: (i) raise sufficient revenue, (ii) be growth-friendly, fair and transparent, and (iii) trigger high taxpayer compliance with low administrative costs.
- Objectives could include lowering currently high income tax rates, eliminating nuisance taxes, and protecting real income levels of the poor.
- Installation of a three-partite commission to study reform options in the context of the social dialogue is a positive step.
- Value-added tax (VAT) option:
- A VAT could avoid the distortionary cascading effects of the business turnover tax.
- To limit administrative costs, VAT could exempt small businesses.
- VAT introduction would require careful preparation of at least 1½-2 years.
- IMF staff encourages seeking technical expertise oriented on international best practices, e.g., by joining CARTAC.
- Interim revenue options:
- Increasing excise taxes is a possible interim option; excise receipts have fallen to less than 2½ percent of GDP from more than 4 percent in the early 1990s (with only a modest increase agreed in the social dialogue).
Enhancing the effectiveness of monetary policy
- Historical framework:
- Until end-2009, monetary policy relied on annual ceilings on banks’ private sector lending increases, complemented by a regulation requiring banks to maintain a non-negative net foreign asset position below 10 percent of their liabilities.
- Assessment of the credit ceiling:
- Pros: supported the peg, prevented unsustainable credit booms, contained underlying inflation.
- Cons: discouraged bank competition, sustained large interest rate spreads and fee revenues, and provided no tool to spur credit during downturns.
- Recent policy toolkit changes:
- Credit ceiling eliminated in January 2010 and replaced by an unremunerated reserves requirement as the key monetary policy instrument.
- The reserves requirement is currently set well below a level that would restrict banks.
- Short-term guidance:
- While credit conditions remain depressed, IMF staff recommends signaling monetary easing and encouraging banks to compete for lending.
- Central bank should continue to leave excess liquidity in the banking system and emphasize it no longer targets credit growth.
- To foster competition, consider temporary waivers to some prudential rules to facilitate opening banking subsidiaries in Aruba, provided reputable international parents and comprehensive consolidated supervision exist.
- Exit strategy and reserve protection:
- Monetary tightening will be necessary once credit demand rebounds; monetary policy should prioritize protecting foreign reserves to safeguard the peg.
- If pressures on reserves emerge, the central bank should be prepared to use the reserves requirement rapidly and fully.
- Concerns about large increases in mandatory reserves could be addressed by modest remuneration within the central bank’s means.
- Rapid introduction of certificates of deposit may be problematic given absence of a liquid interbank market and potential negative repercussions on the central bank’s financial position.
Safeguarding financial stability
- Banking sector condition:
- Despite the downturn, Aruba’s banking system has remained profitable with capital buffers ample in international comparison, supported by conservative capital and liquidity requirements.
- Nonperforming loans have increased significantly, particularly in commercial real estate and unsecured corporate lending, but are almost fully provisioned.
- Other financial sector concerns:
- Coverage ratios of some private defined-benefit pension funds have fallen below 100 percent due to investment losses; recovery plans show good progress.
- Supervisory implications of the new monetary framework:
- Removal of the credit ceiling may lead to more aggressive lending and potential deterioration of lending standards.
- Supervisors need close monitoring of market developments and individual institution strategies.
- Enhancing the forward-looking character of central bank stress tests is recommended.
- Offshore sector:
- Aruba’s offshore financial sector is small but carries reputational risk.
- Offshore banks should be permitted only if the central bank can monitor activities and enforce prudential rules.
- Requesting a material physical presence of licensed offshore banks in Aruba is crucial.
Data, transparency, and other issues
- Macroeconomic information:
- Compiled and published macroeconomic information is generally sufficient for surveillance but some improvements are needed.
- Medium-term macroeconomic projections would provide a more comprehensive framework for fiscal and monetary analysis.
- Data consistency and gaps:
- Discrepancies between national accounts, balance of payments data, and external debt statistics should be eliminated.
- Data on the maturity of private sector external debt would facilitate computation of reserve adequacy ratios.
Kingdom of the Netherlands-Aruba: Concluding Statement of the 2010 Article IV Consultation Mission, Oranjestad, September 8, 2010.