Public Information Notice No. 03/16

Public Information Notice: IMF Concludes 2002 Article IV Consultation with Barbados

February 21, 2003

On February 7, 2003 the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Barbados.¹

Background

Fiscal policies implemented during 1993-2000, as well as structural reforms that further shifted Barbados' productive base from agriculture into tourism and offshore services, helped promote strong growth of service exports in the context of its fixed exchange peg since 1975 of BD$2 to US$1. Real GDP growth averaged 3 percent annually and inflation 2 percent, as the unemployment rate declined from 24½ percent to 9¼ percent.

Eight consecutive years of growth ended in 2001 as real GDP contracted by 2¾ percent, owing mainly to the adverse impact on tourism of the global economic slowdown and the September 11 terrorist attack, as well as continuing declines in agriculture and manufacturing output (Table 1). To lessen the impact of the September 11 attack, the authorities implemented a national emergency program in the fourth quarter of 2001, comprised mainly of fiscal stimulus measures that included: shifting spending to promote the tourism, manufacturing, and agricultural sectors; reintroducing import licenses for selected agricultural products to protect domestic production; and accelerating implementation of public investment projects.

The 12-month increase in consumer prices, which averaged less than ¼ percent over 1998-99, rose to 2½ percent in 2001, reflecting in part an increase in tariff rates on agricultural and manufactured imports implemented in November 2001. The real effective exchange rate depreciated by 9 percent in the 12 months to end-October 2002, largely reflecting depreciation of the U.S. dollar against the euro. The unemployment rate rose to 10¼ percent by end-March 2002.

Due to public sector wage increases in the face of the sharp recession, the fiscal stimulus and emergency measures implemented by government to reduce its depth, and deterioration in the finances of public enterprises, including significant losses in the public hotel enterprise, the overall deficit of the nonfinancial public sector widened substantially from ¾ percent of GDP in FY2000/01 to 3¾ percent of GDP in FY2001/02 (fiscal year is April-March). The central government deficit rose sharply from 2 percent of GDP in FY2000/01 to 4¼ percent of GDP in FY2001/02.

Broad money grew by 5½ percent in 2001, reflecting capital inflows and an increase in international reserves. The central bank continued to ease credit conditions,² but credit to the private sector stagnated. Broad money is projected to rise 5½ percent in 2002, with private credit sluggish and the level of official international reserves remaining unchanged. Nonperforming loans increased to 5 percent of total loans in 2001, with about half fully provisioned. The offshore sector contracted in 2001 owing mainly to Barbados' inclusion in the OECD's list of noncooperative tax havens, recovered somewhat in 2002 after its removal from the list early in the year, and slipped again as tax haven issues reemerged in bilateral tax treaty negotiations.

The external current account deficit declined from 5½ percent of GDP in 2000 to 3¾ percent of GDP in 2001. This outcome stemmed from a contraction in imports in the wake of the decline in tourism and national income that was only partly offset by increased government spending. Net capital inflows more than covered the external current account deficit in 2001 as the government issued US$150 million in 20-year bonds in the international capital market at an annual interest rate of 7¼ percent, 230 basis points above the 30-year U.S. treasury bond rate. As a result, the outstanding stock of public external debt rose from 21¼ percent of GDP at end-2000 to 27½ percent of GDP at end-2001. At end-2001 the central bank's net international reserves exceeded US$700 million—equivalent to over 6 months of projected imports of goods and nonfactor services in 2002.

Executive Board Assessment

Directors observed that Barbados' economic performance has weakened since 2001, reflecting adverse external events and continuing declines in agricultural and manufacturing output. Expansionary fiscal policies, including large public sector wage increases and deterioration in the finances of public enterprises have led to rising fiscal deficits and public debt. Directors stressed that restoration of sustained economic growth will depend on the implementation of strong fiscal measures and perseverance with structural reforms.

Directors therefore welcomed the progress made by the Barbadian authorities in implementing a medium-term program of fiscal tightening and structural reform since October 2002. They considered the authorities' fiscal consolidation efforts to be a critical step toward reducing the public debt ratio relative to GDP and preserving the fixed exchange rate, while providing the savings needed for critical public investment and a return to steady economic growth and lower unemployment. They welcomed the authorities' plans to reduce discretionary spending, cut government employment through attrition, and undertake other measures to move the public sector budget toward overall balance. They also commended the authorities for the farsighted changes made to the public pension system to ensure actuarial balance.

Nevertheless, Directors cautioned that stronger fiscal measures than those envisaged may be needed to achieve the medium-term objectives. They emphasized, in particular, the need for wage restraint in the public sector—especially in view of the lead role the public sector plays in wage-setting in Barbados; fuel price reform to permit full passthrough of international oil price movements to domestic fuel prices; and reductions in government spending on tourism projects that can be undertaken by the private sector. Directors agreed that new commercial external borrowing should be aimed solely at lowering costs and lengthening maturity.

Directors supported the authorities' plans for comprehensive tax reform over the medium term to lower direct and import tax rates and increase the budget's reliance on the value-added tax and other domestic indirect taxes. They commended the authorities for eliminating tariff protection for some agricultural and manufactured products and import licenses for agricultural products. However, the increase in some tariff rates was considered a continuation of selective protection policies, that is not consistent with the objective of making industries more efficient.

Directors shared the authorities' concerns about the unsustainable operating deficits of some public enterprises. They encouraged privatization to engender efficiency gains and to generate revenue to reduce the public debt, suggesting that the authorities involve the private sector in the provision of services outside the government's core areas.

While acknowledging that the fixed exchange rate has served Barbados well, Directors noted that Barbados' external competitiveness has declined in recent years due to appreciation of the U.S. dollar, wage increases in excess of productivity increases, and foreign trade distortions. They therefore welcomed the agreement reached in May 2002 among labor, business, and government on prices and incomes as reflecting a common understanding of the need to link wage increases to productivity gains, inflation, and personal income tax cuts. However, it was stressed that the tradeoff between wage increases and tax cuts will need to be strictly enforced, since tax cuts in the absence of sufficient wage restraint will continue to impart fiscal stimulus.

Directors commended the authorities for successful participation in the Financial Sector Assessment Program (FSAP). They agreed that the adoption of a more flexible and market-oriented monetary policy framework would lead to more effective liquidity management. They considered the planned elimination of the maximum lending rate by March 2003 and the elimination of the tax on bank assets to be important steps toward financial sector liberalization, and urged further deregulation of interest rates along with complementary capital market liberalization in a regional context. It was also recommended that the Financial Institutions Act be amended to strengthen central bank independence.

Directors noted that the banking system is resilient and fundamentally sound. Nevertheless, they stressed that close surveillance over the banking system should remain a priority. They also emphasized the importance of strengthening the supervision of non-banks and improving the regulatory framework for offshore financial institutions. Directors commended the authorities for their efforts to develop an effective regime for combating money laundering and the financing of terrorism.

Directors encouraged the authorities to continue to use the General Dissemination Data System (GDDS) framework to improve statistical reporting, especially regarding the finances of public enterprises, the consolidated public sector account, the operations of offshore banks, and the external debt.