IMF Survey: High Food, Fuel Prices a Threat Where Protection Limited

IMF News, October 21, 2008

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Publication: IMF Survey by Patrizia Tumbarello, IMF Asia and Pacific Department, October 21, 2008.
Core observation: Inflation has been rising in the Pacific Islands driven by strong increases in commodity prices (food and fuel), with limited social protection systems increasing vulnerability.
Commodity price trend: Although commodity prices have declined from recent peaks, food and fuel prices remain above historical levels and continue to be a concern.

Headline inflation:
- Headline inflation in the islands has picked up since end-2007 beyond most central banks' comfort zone.
Fuel pass-through:
- As of September 2008, the pass-through of international gasoline prices to domestic retail prices has been complete for Fiji, Palau, Papua New Guinea, Samoa, the Solomon Islands, and Timor-Leste.
- Local fuel prices have increased steadily since December 2007.
Food price transmission:
- Food price inflation has increased substantially.
- The large share of food in consumer price index baskets has magnified the impact.
- The food basket in many countries includes unprocessed or low value-added products, causing relatively high pass-through of imported food price increases due to low elasticity of demand.
Household impact:
- Food-related expenditure is a large share of household spending.
- The food share in total household spending is on average 50 percent for these islands—about twice as much as in the emerging markets.
Second-round and core inflation:
- Core inflation has started to trend up.
- Second-round effects are emerging in Papua New Guinea, the Solomon Islands, Timor-Leste, and Tonga, indicating inflation becoming more entrenched.
- Higher input costs (animal feed, fertilizer, energy) have created upstream pressures; wage pressures are mounting notably in Papua New Guinea and the Solomon Islands.

Domestic demand signals:
- Credit growth remains high and excess liquidity pervasive in Papua New Guinea and the Solomon Islands.
- Fiscal policies appear to have turned expansionary in the Solomon Islands, Timor-Leste, and Vanuatu.
Exchange rate and monetary policy constraints:
- Most islands are either dollarized or have a pegged exchange rate regime, reducing the exchange rate’s role in curbing imported inflation.
- The weakening of the Australian and New Zealand dollars has generated terms of trade losses for countries pegged to these currencies.
- In Papua New Guinea (more flexible exchange rate), the central bank increased the policy rate three times since June, but the real interest rate remains negative.

Trade and energy dependence:
- Most islands rely heavily on imports—mostly food and fuel—while export bases remain narrow; external balances are vulnerable to commodity price spikes.
- Pacific island countries rely almost exclusively on oil-based fuel for energy, limiting substitution options.
Country-specific impacts:
- Net food and oil importers (Fiji, Kiribati, Samoa, Tonga) have been hit hardest and face wider current account deficits.
- The Marshall Islands received an emergency foreign loan to support the domestic energy company; the government also contributed to payment for fuel shipments, which are secured through end-October.
- Commodity producers (Papua New Guinea, Timor-Leste) benefited from a positive terms of trade shock that strengthened external and fiscal positions but remain vulnerable to volatility.
Revenue linkages:
- In Papua New Guinea and Timor-Leste, the oil sector is largely foreign owned with limited local inputs; linkages to the domestic economy are mainly via income tax and other budget revenues or the petroleum fund.

Price and tax measures:
- Import duties and sales tax on rice were eliminated in the Solomon Islands.
- Import duties on fuel products were recently reduced in Fiji.
- In Timor-Leste, a reduction in sales taxes and import duties was introduced; the government ensured availability of agricultural inputs (seeds, fertilizer, diesel) to farmers.
- In the Marshall Islands, electricity tariffs were raised and tighter controls introduced on government use of electricity and fuel; import duties exemptions were granted on basic staples including rice and flour.
- Some price controls used in Fiji, including delaying scheduled electricity tariff increases.
Monetary policy actions:
- Papua New Guinea central bank increased the policy rate three times since June (real interest rate remains negative).

Near-term:
- The recent decline in commodity prices from record highs in mid-July may provide some respite to inflation.
- Inflation is likely to decline only gradually as high transportation costs continue to feed through with a lag.
Medium-term:
- Commodity exporters have an opportunity to increase medium-term growth prospects; benefits from high oil prices depend critically on how revenue windfalls are utilized.

Targeting protection:
- Authorities should balance protecting the poor from price increases (especially food) with supporting demand to enhance growth.
- Ideally, targeted transfer programs as part of an integrated social safety net could reach the poor efficiently.
- In the absence of effective safety nets, a package could build on existing programs such as school feeding programs, cash transfers to the most vulnerable populations, reduced education and health fees, and public transport subsidies.
- Ad hoc general increases in public sector wages would not be well targeted.
Demand and supply measures:
- A more effective approach includes targeted demand and supply responses, combined with donor support.
- Continue allowing full pass-through of higher food and fuel prices to domestic prices while allowing time to adjust.
- Long-term measures in agriculture, rural transport, and other support services can increase domestic supply and reduce price pressure.
External and fiscal measures:
- Donor support—preferably grants—would help limit harm to real incomes.
- A more flexible exchange rate regime would help cushion inflationary pressures in commodity exporting countries.
- In fully dollarized or pegged regimes, fiscal restraint is needed to facilitate external adjustment and to offset any increase in fuel and food subsidies.

IMF Survey by Patrizia Tumbarello, IMF Asia and Pacific Department, October 21, 2008.