Mission Concluding Statement 

Kiribati-- 2011 Article IV Consultation Concluding Statement of the IMF Mission

February 22, 2011

This statement contains our preliminary views and policy recommendations following discussions with the Kiribati authorities, development partners and the private sector. The discussions focused on policies to ensure fiscal sustainability and support private sector growth.

1. Kiribati is at a crossroads. Large public investment projects in key infrastructures financed by foreign assistance underpin its favorable medium-term growth prospects. Yet gains will prove transitory if a broader agenda of fiscal and structural reforms remains unfinished. Further fiscal and structural reforms are necessary to bolster the economy’s resilience and ensure sustainable growth. The increasing costs of climate change and still large development needs bring challenges to which policy will need to respond.

The Outlook and Risks

2. After two years of contraction, the recovery seems on a solid footing. The economy recovered in the second half of 2010 and is estimated to have grown by 1 percent for the year. The public sector was the main driver, but private sector activity appears to have picked up as well, especially in retail. Going forward, growth momentum is expected to strengthen. Key public projects—the rehabilitation of Tarawa’s road, airport and port—financed with external assistance should support growth in the 2–3 percent range over the medium term. However, a durable shift to higher growth hinges on deeper and broader structural reforms. Despite the rise in world food prices in 2010, inflation has fallen from 2008 highs to zero in 2010 thanks to the appreciation of the Australian dollar and slow pass-through from international to domestic prices. However, inflation is projected to tick up in 2011, especially on food and transportation, as domestic prices adjust to the international trends, but should ease again over the medium term.

3. Risks to the medium-term outlook are balanced, but long-term challenges remain. On the upside, domestic public works in the pipeline may have larger-than-expected impact on output, despite their large import content. On the downside, if the global recovery stalls Kiribati’s remittances would be hit, while a surge in world food prices could raise inflation pressures even further. Over the long run, vulnerabilities to climate change could take a toll on economic activity undermining its long-run prospects.

Fiscal Policy

4. Fiscal policy has supported the economy during the economic downturn. Copra subsidies and civil servant wages have increased and helped mitigate the impact of the output contraction on households.

5. However, fiscal risks in Kiribati have grown over the years and will likely increase further given the increasing costs of climate change. Vulnerabilities have been exacerbated by the crisis, as the Revenue Equalization Reserve Fund (RERF) assets—the primary source of deficit financing—dropped significantly. The uncertainty about aid flows and the impact of climate change will probably add to pressures on Kiribati’s fiscal position.

6. Fiscal sustainability requires preserving the value of the RERF, as a buffer against external shocks. In this respect, we welcome the authorities’ commitment to fiscal prudence and to preserve the value of the RERF. Over the medium term, fiscal consolidation will be necessary. Once key public investments in the pipeline aimed at increasing long-term productivity have occurred, we recommend stabilizing the level of the RERF in per capita terms. This would require limiting budget deficits at about 6 percent of GDP. While this fiscal anchor could only be indicative, it would link fiscal decisions to an intergenerationally more equitable drawdown of sovereign wealth.

7. As the recovery proceeds, we also recommend saving stronger-than-anticipated revenue. Revenue windfalls (compared to the budget) should be saved during upswings and used only during downturns to support the economy. Preserving higher-than-budgeted revenues would help create fiscal space by safeguarding the RERF against external shocks and support a smooth path of expenditure.

8. Savings can also be achieved by rationalizing expenditure and tax structures. The restructuring of loss-making SOEs should continue. We welcome the introduction of a withholding tax at source back in 2009. Custom administration—which reportedly has worsened in the last few years—should be shored up to improve compliance and exemptions reduced. The introduction of a VAT tax should also be considered.

9. We welcome the introduction of an auction scheme on fishing licenses. This would provide scope for increasing fishing license revenues over the medium term, as preliminary data already show. Other measures to increase license fees include adopting cooperative sub-regional measures to strengthen bargaining power of license-issuing countries. The authorities’ recent initiatives to encourage investment in domestic processing are also welcome, and the private sector should be expected to play a lead role. Participation in the Pacific Islands Forum Fisheries Agency and negotiation of a comprehensive Economic Partnership Agreement with the European Union may strengthen control over marine resources and create new opportunities for increasing revenue. 

10. We commend the authorities’ for adopting a multi-year budget framework. Casting budget decisions in a multi-year perspective would help design realistic fiscal plans. It would also provide more fiscal discipline that could help ensure long-term financial sustainability. Given the uncertainty surrounding revenue and aid flows, a conservative approach in projecting revenue should continue. We encourage the authorities to continue strengthening the framework with the assistance of the Asia Development bank (AsDB) and the IMF. Downside scenarios should also be fleshed out, with revenue shortfalls as a result of a temporary shock, and the prospective costs of climate change mitigation explicitly considered. Overall, lower fiscal deficits and a stronger sovereign balance sheet are necessary to reconstitute room for fiscal maneuver, as well as scope to meet the long-term spending pressures arising from climate change.

Climate Change

11. Kiribati is extremely vulnerable to climate change and the fiscal costs are likely to be substantial. Kiribati has taken a leadership role in advocating for vulnerable small states within international fora. A key short-term priority for donors and the authorities is to ensure that Kiribati is able to both access and effectively utilize adaptation funding committed by donors through well-coordinated and prioritized investments.

Structural Reforms

12. With a durable shift to high growth path hinging on a vibrant private sector, the implementation of the structural reform agenda should accelerate. The government’s Development Plan (KDP), spanning 2008–11, correctly recognized the need to rotate the sources of growth toward the private sector in areas such as tourism and marine resources—and indentified key weaknesses of the current system. While we understand that the pace of reforms needs to be calibrated to political realities, we strongly advise the authorities to step up the implementation of the reform agenda and take measures to improve the business climate. Reforming the state–owned enterprises (SOEs) is key to create space for private sector development and reduce the drain on the budget. We welcome the authorities’ decision to privatize an SOE by April 2011 and the plan to privatize five additional SOEs in the near term. Reforms aimed at streamlining the process of starting a business, expanding access to credit and improving access to land by strengthening administrative systems for transferring property rights are also urgent. The authorities’ interest to liberalize telecommunication with the assistance of the World Bank is a welcome step in the right direction. It clearly signals the government’s commitment to modernize Kiribati’s development model. However, more remains to be done to address long-standing structural impediments to private investment.

13. Strengthening public financial management (PFM) is crucial. PFM in Kiribati is weak, and characterized by poor data quality and expenditure commitment controls, outdated legislation and regulations, limited available information about fiscal risks arising from poorly performing SOEs, and poor links between capital investments and recurrent budgets. All these weaknesses weight on business activity. The PFM Reform Plan, which sets out the government’s reform priorities based on the findings of the 2010 Public Expenditure and Financial Accountability provides a good platform for policy dialogue and more focused technical assistance.

Financial Sector

14. Financial sector competition is limited. As a result, access to credit is difficult and costly. This represents a major impediment to private sector development and more competition in the banking sector is necessary to spur private activity. The authorities’ ongoing efforts to partly commercialize the Development Bank of Kiribati (DBK) by bringing a strategic investor are welcomed. This would introduce long-needed competition and help build up human capital capacity. In particular, strengthening managerial skills would enable the DBK to compete on a commercial basis and bring operational procedures in line with international best practice. That said, the share of non-performing loans held by the DBK is a concern and further expansion of the DBK’s activity should be postponed until a regulatory and supervisory framework is in place. Technical assistance from development partners would be key in this area. We also encourage the authorities to accelerate SOE reform to reduce DBK’s NPL portfolio and to implement land reform to ease access to credit and improve collateral recovery. We noted the authorities’ request of technical assistance in carrying out an actuarial study to assess long-term sustainability of KPF and to review the current investment strategy.

External Competitiveness and Exchange Rate Assessment

15. The Australian dollar is a strong nominal anchor for the Kiribati economy and its use as the official currency remains appropriate given Kiribati’s close linkages with Australia. From a medium-term perspective, our assessment is that is that the exchange rate is mildly overvalued. Pursuing structural reforms is crucial to regain competitiveness following the strong real appreciation.

16. The increase in public investment related imports is expected to widen the current account deficit over the next few years from 7 percent of GDP in 2010 to 13 percent of GDP in 2016. However, deficits of this magnitude should be sustainable as they are driven by key investment in infrastructure and financed by capital transfers.

17. We commend the authorities for their prudent external borrowing decisions. External debt is Kiribati is low, unlike many other pacific islands. A joint IMF-World Bank debt sustainability analysis (DSA), prepared in consultation with the AsDB, shows that continuing securing grants financing and containing fiscal deficits would be key to ensure external stability and debt sustainability going forward. In this regard, we strongly welcome the World Bank’s decision to offer grant financing on the upcoming investment projects based on the joint DSA.

The IMF team has enjoyed the candid and interesting exchange of views and appreciated the authorities’ warm hospitality and thorough preparations for this mission.