Public Information Notice No. 04/56

Public Information Notice: IMF Concludes 2004 Article IV Consultation with Barbados

May 14, 2004

On May 5, 2004, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Barbados.¹

Background

The mainstays of the economy are tourism and financial services. The population is about 275,000, per capita income is about US$9,500, and the unemployment rate is slightly less than 11 percent. The United Nations Development Program's Human Development Index ranked Barbados 27th among 175 countries in 2003.

Barbados' economy did well in the 1990s, supported by prudent policies and a favorable external environment. During 1993-2000, per capita real GDP growth averaged 2.5 percent per year, annual inflation was 2 percent or less, and unemployment declined sharply. The structure of the economy shifted from agriculture to tourism and financial services. This performance was achieved in the context of small fiscal deficits (less than 2 percent of GDP), a conservative monetary policy (which resulted in a substantial accumulation of external reserves), and a range of market-oriented reforms.

The economy shifted into a recession in 2001, reflecting the global slowdown, and the impact of the September 11 events on the tourism sector. Real GDP dropped by a cumulative 4 percent in 2001-02. To mitigate the recession, the government launched a national emergency program of public investment projects aimed at promoting economic activity and upgrading the tourism and economic infrastructure. These and other measures contributed to an increase in the central government deficit, from 2.3 percent of GDP in FY 2000/01 (April-March) to 9.5 percent of GDP in FY 2002/03, including extra-budgetary spending of about 4 percent of GDP. As a result, the central government debt-to-GDP ratio rose from 63 percent in March 2001 to 76 percent in March 2003.

Over the past year, the economy recovered partially from the 2001-02 recession, as real GDP grew by an estimated 2 percent in 2003, led by a recovery in the tourism sector. Inflation remained low at 1.5 percent, reflecting the currency peg. The external current account deficit widened in 2003, as merchandise exports declined and imports recovered from their low recession levels. The central government deficit narrowed to 6.5 percent of GDP in FY 2003/04, including extra-budgetary spending of close to 4 percent of GDP. Tax revenue increased by 1¼ percent of GDP, on account of higher receipts from the value-added tax, and capital expenditure declined by a similar amount. More than half of the government deficit was financed through privatization proceeds resulting in a marginal decline in the government debt ratio, to 75 percent. Notwithstanding widening of the current account deficit, the net international reserves stood at US$751 million (six months of imports of goods and services) at the end of the year.

Broad money growth decelerated in 2003, although it was still faster than GDP growth, and banks became increasingly liquid. In an effort to unwind the excessive buildup of liquidity, the central bank reduced the government securities ratio to 16 percent in November 2002; in December 2002, the central bank reduced the minimum administered interest rate on time and savings deposits, from 3 percent to 2.5 percent, and discontinued setting maximum indicative lending rates for banks on selected loans. While the banking system remains generally sound, the ratio of nonperforming loans to total loans has increased to about 9 percent, and profitability indicators have weakened somewhat.

Over the past year, important progress was made in the area of structural reforms, as steps were taken to enhance the budget process, strengthen the national pension system, promote transparency in the public sector, improve financial intermediation, and enhance the supply responsiveness of the economy.

Executive Board Assessment

Executive Directors observed that Barbados' economy has started to recover from the 2001-02 recession, led by the strong performance of the tourism sector and supported by the countercyclical fiscal stance adopted in the downturn. However, this fiscal stance gave rise to a substantial increase in the government debt, which must now be reversed. Directors were encouraged by the improvement in the public finances in fiscal year 2003/04 and stressed that, over the medium term, debt sustainability would critically depend on the government's success in further reducing its deficit and deepening reforms to boost growth. They welcomed the strengthening of the international reserve position over the last three years, which reflects Barbados' continued access to foreign financing and strong private capital inflows.

Directors stated that, notwithstanding the improvement in fiscal year 2003/04, the current level of the government's deficit implied continued high government debt ratios and has contributed to large, albeit declining, external current account deficits. They cautioned that these factors could pose a risk to the fixed exchange rate anchor, the central pillar of Barbados' policy framework, especially in the event of a turnaround in private capital flows. A number of Directors therefore recommended that the fiscal deficit be reduced to ensure adequate reserve cover and a declining debt ratio, and that gradual fiscal tightening be combined with growth-enhancing structural reforms. In this regard, Directors also attached importance to anchoring the pace of fiscal adjustment on Barbados' longstanding framework of social consensus. At the same time, other Directors, noting the size of the fiscal imbalance and the high debt level, urged the authorities to build domestic consensus for a more rapid fiscal adjustment.

Directors agreed with the government's focus on expenditure control and welcomed the commitment to wage restraint and the projected reduction in extra-budgetary spending, mainly transfers to public enterprises, which remains high and has diminished the transparency of fiscal operations in recent years. But they also saw a need to intensify the revenue effort, both to facilitate deficit reduction and to protect social spending. Directors encouraged the authorities to consider, in particular, measures to reduce exemptions from the VAT, as well as increases in the rates of the VAT and excises. They commended the authorities' proposals to harmonize the domestic and offshore tax regimes and supported the proposed reduction of income tax rates. Directors recommended that privatization proceeds, which have been used to finance extra-budgetary spending, should in the future be allocated mainly to the retirement of government debt. They urged the authorities to review the tariffs of major public enterprises, concurrently with a reduction in government transfers to these entities.

Directors encouraged the authorities to move to more market-based mechanisms of monetary control, to enhance control of credit expansion and reduce distortions in financial intermediation. Accordingly, they welcomed the initial steps by the central bank to prepare the technical infrastructure for open market operations, and recommended phasing out, in due course, the administered minimum interest rate on savings and time deposits. Regarding broader financial sector reforms, Directors welcomed the actions taken to implement most of the 2002 Financial Sector Assessment Program recommendations, including improvement in the supervisory and regulatory frameworks for the banking and insurance sectors. They encouraged rapid implementation of the remaining recommendations, including increasing the independence of the central bank, and the strengthening of efforts with regard to Anti-Money Laundering/Combating the Financing of Terrorism issues. Directors supported the authorities' sequenced approach to capital account liberalization, in line with the ongoing strengthening of the financial sector and the development of indirect instruments of monetary control.

Directors shared the authorities' view on the continued appropriateness of the fixed exchange rate regime for Barbados, although it was also suggested that the authorities keep the current regime under review. They noted that the long-standing peg to the U.S. dollar, supported by prudent fiscal and monetary policies, has acted as a strong anchor of price stability and investor confidence. Directors emphasized, however, that the long-term viability of the regime required that the public debt dynamics be returned to a sustainable position, under robust economic policies and reforms to boost growth and competitiveness.

Directors noted that the decline of agriculture and manufacturing in recent years highlights the need to broaden the productive base. In this regard, they welcomed the authorities' recent structural reform achievements, which include the reform of the National Insurance Scheme; establishment of a regulatory framework for private pension schemes; corporatization of the Port Authority; privatization of the Barbados National Bank; and the move toward greater competition in the telecommunications sector. Looking ahead, Directors supported the authorities' focus on reforms relating to the budget, tax policy, government pensions, and enhancing the supply responsiveness of the economy. Directors commended the authorities for their continued commitment to further trade liberalization in the context of the CARICOM, the WTO, and the envisaged FTAA, and recent initiatives to enhance labor market flexibility.

Directors noted that, while the statistical information provided by Barbados is broadly adequate for surveillance purposes, there remains scope for substantial improvement, particularly with regard to the operations of the public enterprises and the capital account of the balance of payments.