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Kingdom of the Netherlands-Aruba: Concluding Statement of the 2010 Article IV Consultation Mission
September 8, 2010
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
The Aruban economy is slowly emerging from a severe recession. Tourism is picking up, and Aruba’s oil refinery is scheduled to reopen by the end of this year. Monetary policy should remain accommodative in the short-term, but be prepared to react rapidly once demand for private sector credit recovers. A “social dialogue” between the government, employers, and trade unions has resulted in an agreement on key measures that will enhance the financial soundness of Aruba’s main pension and health care schemes. However, there remains a large underlying fiscal shortfall that needs to be addressed within the context of a medium-term consolidation plan.
A Gradual Economic Recovery
1. Aruba is a small, open economy with a history of policies geared towards macroeconomic stability. The long-standing peg to the U.S. dollar has supported a positive investment climate. Annual credit ceilings set by the central bank kept credit growth at sustainable levels consistent with the peg. A generally prudent fiscal policy—the central government deficit averaged 1.7 percent of GDP in the past 10 years—contained public debt and earned Aruba an investment grade rating.
2. Since 2008, external shocks have left the economy in a difficult spot. Tourism declined in the wake of the global downturn and Aruba’s oil refinery, which contributed about 5 percent to employment, temporarily closed in July 2009 due to slim margins for refined petroleum products and a dispute over tax payments. As a result, real GDP contracted by 7½ percent in 2009, and the unemployment rate has increased to more than 11 percent.
3. A gradual, uneven recovery is under way. Real GDP (excluding refining) is projected to stagnate this year, owing to still weak private consumption and investment. In 2011, overall GDP growth is projected to surge temporarily to 7 percent. This reflects a general recovery in private demand, the realization of investment projects in hotel construction and infrastructure, and the re-opening of the refinery, as refining spreads have recovered and the tax dispute has been settled.
4. At the same time, achieving the growth rates from pre-crisis years will be challenging going forward. Aruba’s medium-term growth outlook depends heavily on U.S. consumption, given that two-thirds of tourists come from the United States. However, U.S. consumption growth is projected to remain significantly below pre-crisis levels. Moreover, the potential for a further quantitative expansion of tourism is limited. As a consequence, the government is pursuing a growth strategy that puts emphasis on upgrading existing tourism facilities, improving Aruba’s infrastructure, and moving to more energy-efficient modes of production. IMF staff estimates long-term potential annual real growth at about 1½ percent.
5. Aruba's external competitiveness appears solid and reserves coverage is broadly adequate, thus underpinning the peg with the U.S. dollar. The real effective exchange rate measured in terms of core prices (i.e., excluding temporary fluctuations in food and energy prices) has depreciated slightly in recent years, and Aruba’s market share in Caribbean tourism 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 appear contained due to limited short-term and/or portfolio funding.
The Fiscal Outlook
6. Aruba faces serious fiscal challenges. Recent tax cuts—including a halving of the business turnover tax to help stimulate the economy—and spending pressures that have built over several years have contributed to a large underlying fiscal deficit. Moreover, Aruba’s health care and pension schemes have long been structurally underfunded, constituting a large current and future liability to the budget. To address these challenges, the government has initiated a “social dialogue” with the business community and labor unions.
7. The social dialogue has already yielded important results that, once approved by parliament, will enhance the soundness of Aruba’s pension and health care schemes. Premium hikes to the universal health care system (AZV) and the general pay-as-you-go pension scheme (AOV) will reduce and/or delay the need for government transfers going forward. The long-term financial position of APFA—the defined-benefit pension scheme for civil servants—will improve significantly as a result of entitlement reforms. These include computing pension claims on the basis of average career wages instead of final wages, an increase in the retirement age from 55 to 60 years, and the calculation of APFA pensions net of AOV pension claims.
8. Notwithstanding these steps, a large fiscal gap remains that needs to be closed to safeguard sustainability of the public finances. 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. In the absence of 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. Such an increase would imply a significantly higher interest burden. As regards financing, excess liquidity in Aruba’s financial system supports demand for government paper at this juncture. Once private sector demand for credit recovers, however, the government would compete with the private sector for funds. Rising public debt could make it also more difficult for the government to attract external funding.
9. Well aware of these pressures, the government has proclaimed that it intends to reduce the deficit by about 1½ percentage points of GDP per year in 2012-14. However, the policy changes needed to achieve this adjustment have yet to be specified. The announced deficit path would imply a deficit of somewhat below 2 percent of GDP by 2014. Public debt as a share of GDP would be around 52 percent of GDP by end-2015.
Options for Fiscal Adjustment
10. IMF staff recommends targeting a deficit of below 1 percent of GDP over the medium-term, corresponding to a primary surplus of 2¼ percent of GDP. A deficit of this size would put public debt as a share of GDP on a gradually falling path even under cautious assumptions about future growth. It would also leave room for maneuver in case Aruba again faces external shocks, as in 2001/02 and in 2009. Such a target implies a fiscal effort of about 5½ percent of GDP beyond the initiatives recently announced in the context of the social dialogue.
11. Fiscal adjustment involves two key choices: the speed of adjustment and the composition of measures. Given that Aruba’s public debt is not yet at excessive levels, there is no need to achieve the entire adjustment in one step. Instead, IMF staff recommends stretching the implementation of the required fiscal consolidation over a period of two to three years, thus aiming for a long-term sustainable fiscal position by 2013. As for composition, adjustment can be achieved through both expenditure and revenue reforms. The government has expressed a preference to accomplish the adjustment in part through expenditure cuts and the promotion of growth-enhancing investments.
12. Achieving the entire adjustment without recourse to revenue side reforms seems exceedingly difficult, however. Aruba’s public spending is tilted heavily towards wages, a category in which major savings are difficult to realize in a short period. Room for adjustment exists mainly for AZV, with a savings potential of about 2 percent of GDP if premia were increased or costs be lowered to an extent that would eliminate the need for a government transfer. The government may also be able to realize savings in spending on goods and services, which amounts to around 5 percent of GDP, compared to 4 percent in 2007. Nevertheless, these figures still do not add to the total required adjustment efforts.
13. Some adjustment will therefore likely have to come from revenues, where international comparison suggests that Aruba has room for maneuver. On unchanged policies, Aruba’s tax revenues are projected at about 18 percent of GDP going forward. This compares to a regional average of about 25 percent of GDP across 15 other Caribbean countries. Moreover, only about half of Aruba’s tax revenues result from indirect taxes, compared to a regional average of almost two-thirds.
14. IMF staff suggests considering a tax reform that balances fiscal constraints with social priorities. The reform should be oriented toward the longer-term needs of the economy, thus avoiding short-term fiscal activism.The following principles could usefully guide reform efforts: (i) the tax system should raise sufficient revenue, (ii) it should be growth-friendly, fair and transparent, and (iii) it should trigger high taxpayer compliance with low administrative costs. A comprehensive reform may also help achieve other objectives, such as lowering currently high income tax rates, eliminating nuisance taxes, and protecting real income levels of the poor. In this context, the installation of a three-partite commission to study reform options in the context of the social dialogue is a positive step.
15. A key component of a reformed tax system could be a value-added tax (VAT) designed to fit Aruba’s specific needs. A VAT would avoid the distortionary cascading effects of the business turnover tax. To limit administrative costs for both the government and the private sector, the VAT could exempt small businesses. International experience suggests that a VAT introduction would require careful preparation of at least 1½-2 years. IMF staff encourages the authorities to seek technical expertise oriented on international best practices, for example by joining the Caribbean Technical Assistance Center (CARTAC).
16. Some steps will likely be needed in the interim to limit the increase in public debt. One possible option is increasing excise taxes, which have seen little adjustment since the 1980s, with the exception of a modest increase that has been agreed on in the context of the social dialogue. As a result, excise receipts have fallen to less than 2½ percent of GDP from more than 4 percent in the early 1990s.
Enhancing the Effectiveness of Monetary Policy
17. Until end-2009, monetary policy was conducted mainly by setting a ceiling on banks’ annual increase in private sector lending. This ceiling was complemented by regulation requiring banks to maintain a non-negative net foreign asset position below 10 percent of their liabilities.
18. The experience with the credit ceiling has been mixed. On the one hand, the ceiling helped maintain the peg with the U.S. dollar, prevented unsustainable credit booms, and contained underlying inflation, thus safeguarding external competitiveness. On the other hand, it discouraged banks from competing for market share, thus helping sustain large interest rate spreads and fee revenues in Aruba’s banking system. Moreover, in the downturn when lending volumes contracted, the ceiling provided no instrument to the central bank to spur credit.
19. As a result, the central bank made several adjustments to its policy toolkit recently. The credit ceiling was eliminated in January 2010 and replaced by an unremunerated reserves requirement as key monetary policy instrument. This overhaul is welcome and should allow for a more efficient conduct of monetary policy going forward. However, the transition to the new monetary arrangement and the associated risks need to be managed carefully. At this juncture, the reserves requirement is set rightly well below a level that would restrict banks.
20. As long as credit conditions remain depressed, IMF staff recommends signaling monetary easing and encouraging banks to compete for lending. The central bank should continue to leave excess liquidity in the banking system and emphasize in its communication that it no longer targets credit growth. To foster competition between banks, the central bank may also wish to consider temporary waivers to some prudential rules that would facilitate the opening of banking subsidiaries in Aruba, provided the subsidiaries are owned by reputable, international parent banks subject to comprehensive, consolidated supervision by their home supervisors.
21. Monetary tightening will become necessary once demand for credit rebounds. In doing so, monetary policy should continue to be guided first and foremost by the objective of protecting the central bank’s foreign reserves position, with a view to safeguarding the currency peg. Should pressures on the foreign reserves position emerge, the central bank needs to be prepared to use the reserves requirement rapidly and to the full extent needed. Possible concerns that a large increase in mandatory reserves may be overly costly for banks could be addressed by modest remuneration within the financial means of the central bank. By contrast, a rapid introduction of certificates of deposits may be problematic, given the absence of a liquid interbank market and the potential for negative repercussions on the central bank’s financial position.
Safeguarding Financial Stability
22. In spite of the downturn, Aruba’s banking system has remained profitable and preserved capital buffers that are ample in international comparison, supported by conservative capital and liquidity requirements. Nonperforming loans have increased significantly in the wake of the recession, in particular in commercial real estate and unsecured corporate lending, but are almost fully provisioned. Elsewhere in the financial system, the coverage ratios of some private defined-benefit pension funds have fallen below 100 percent as a result of losses on the funds’ investment portfolio, but good progress in restoring financial soundness has been made in the context of recovery plans.
23. The central bank’s new monetary policy framework will likely increase the challenges to prudential regulation and supervision. The absence of a credit ceiling may well result in more aggressive lending, which, in turn, could trigger a deterioration in banks’ lending standards. Supervisors will need to monitor market developments closely as well as the strategies and actions of individual institutions. Enhancing the forward-looking character of the central bank’s stress tests could help in this endeavor.
24. Aruba’s off-shore financial sector is small but carries a potential for reputational risk. Off-shore banks sector should be permitted only to the extent that the central bank can monitor their activities and enforce prudential rules. In this regard, requesting a material physical presence of licensed off-shore banks in Aruba is crucial.
Other Issues
25. While the macroeconomic information compiled and published by the Aruban authorities is generally sufficient for surveillance, some areas require improvement. Most importantly, medium-term macroeconomic projections would allow for a more comprehensive framework to analyze fiscal and monetary policies. As regards historical data, discrepancies between national accounts, balance of payments data, and external debt statistics should be eliminated. Moreover, data on the maturity of private sector external debt would facilitate the computation of reserve adequacy ratios.
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