Investment and Savings

In view of the low investment expenditure prior to independence, and the high incremental capital-output ratio that typically existed because of the structure of the island economies, increased investment appeared to be the essential driving force in the development process. Most countries have substantially raised the rate of public investment. Attention has focused on transport, including roads, harbors, and shipping services, and airport and airline facilities; domestic and external telecommunications; public utilities, especially electricity, water, and sewerage; and education and health, notably the provision of schools and hospitals. Public enterprises have been created to undertake many of these industrial and commercial functions.

In addition to promoting social development, the buildup of infrastructure has been intended to facilitate private investment. To this end, most countries have maintained a favorable regulatory environment. Price controls have been seldom used; few barriers have existed to the establishment of business firms; and exchange and trade systems have usually been liberal and nondiscriminatory, with a general absence of controls on current payments. Nevertheless, private investment has remained sluggish in most countries, particularly in the agricultural sector, where a lack of clear access to land has been an inhibiting factor. Infrastructure remained rudimentary, transport costs high, and markets fragmented. The departure of expatriates has exacerbated shortages of skilled labor. Although a high degree of automaticity has usually permitted inward and outward capital movements, little foreign direct investment has been attracted since independence, except for mining enterprises in Papua New Guinea and plantations in Solomon Islands.

Public and private savings have financed a small part of investment throughout the region. Public resource mobilization has been constrained by the lack of activities on which domestic taxes could be imposed and by the high expectations of the population with respect to government services. Apart from the tradition of low rates of interest on bank deposits and the limited range of alternative financial savings instruments, private savings have been discouraged by social impediments to the acquisition of individual wealth. In view of the constraints on voluntary savings, most countries have introduced national provident funds to which wage and salary earners in both the public and private sectors have been required to contribute.

Concessionary assistance has financed the bulk of the public investment programs. Aid per capita from bilateral and multilateral sources has been generous relative to other parts of the world. In addition to important political and strategic considerations, donors have recognized that capital-output ratios are unusually high in this region and the effective minimum size of infrastructural projects is large in relation to the small population. The lack of skills and experience with the planning process, rather than the shortage of capital, has been the main constraint on the pace of initiating, appraising, and executing projects. To strengthen absorptive capacity, short-term expedients in aid programs have included the provision of foreign experts, simplified administrative procedures, greater local cost recovery, and allowances for maintenance. To correct the fundamental problems over the longer term, aid programs emphasize human resource development, institution building, and improvement of the statistical base. The success of programs has been enhanced when aid agencies have responded to the priorities of recipients, made medium-term commitments, and maintained close coordination with each other.

Agriculture

Agriculture has remained the mainstay of the seven Pacific island economies in this study. Both the subsistence and plantation sectors have potential to increase productivity by diversifying into nontraditional crops and exploitation of additional land, but gains in output have been limited. An increased supply response has usually characterized periods of favorable prices, although after the relatively buoyant conditions of the second half of the 1970s, lower export prices reduced incentives for expansion during most of the 1980s. Aging trees and disease have also adversely affected production in the tree crop sectors. While large-scale investment in new facilities might not have been appropriate, given long-term world market price projections, greater replanting and maintenance could have raised yields considerably. Attempts have been made in several countries to diversify production into such areas as tropical fruits and vegetables. Progress has often been difficult because of the lack of adequate transport and marketing facilities.

Communal land ownership has been a major impediment to agricultural investment and growth. Traditional practice and legislation have usually severely restricted the transfer and leasing of land. Frequent disputes have developed over boundaries and ownership, especially in cases where land appropriated by foreigners was returned to communal owners after independence. Where official bodies have had the authority to settle land tenure disputes, adjudication procedures have been complex and extremely slow. In view of the widespread social repercussions, few governments have been willing to contemplate radical changes in land reform.

Shortages of trained managers have limited the growth of commercial agriculture in the postindependence era. In Papua New Guinea and Vanuatu, production in the plantation sector has stagnated or declined with the departure of expatriate managers. In Western Samoa, management difficulties on public sector estates have inhibited agricultural revitalization. These difficulties have been compounded by the strong preference in rural areas for subsistence activities rather than wage employment on plantations. Solomon Islands consolidated the gains in production and diversification it achieved in the 1970s through the establishment of joint ventures between the Government and foreign private investors, but it has undertaken few additional projects.

Publicly owned commodity boards have been established to purchase and market the main export crops and, in most cases, to operate intervention schemes to counter the impact of fluctuations in world market prices on producer prices. A formula, based on a moving average of actual prices received for the past several years, has normally been applied to set procurement prices in relation to medium-term trends. In some countries, pressures from growers impeded the retention of funds to build up reserves when world prices were high in the late 1970s and 1983–84. The degree of downward adjustment to domestic prices was also inadequate when world prices declined in 1980–82 and 1985–86, thereby eroding reserves and ultimately necessitating budgetary support. However, these operations have led to greater stability in export earnings which, in turn, has helped to increase production incentives, particularly for copra. Fiji has been successful in helping to stabilize incomes in the sugar sector through the negotiation of long-term sales contracts at fixed prices with the European Community.

Nonagricultural Primary Production

Most countries have acted to exploit fish resources more comprehensively. In the subsistence sector, greater government assistance has been provided for boat-building, fishing gear, harbor facilities, marketing arrangements, and bank credit. Since the advent of 200-mile exclusive economic zones, several countries have established fishing fleets, mainly for tuna, with public funds or foreign investment. External aid projects and joint ventures have been undertaken to supply capital and technical expertise, enhance the knowledge of available fish resources, and provide onshore infrastructure. Processing canneries have been established in Fiji, Papua New Guinea, Solomon Islands, and Vanuatu. In recent years, the strong competitive position of fishing fleets from outside the South Pacific region has left prospects for expansion uncertain. In these circumstances, Kiribati and other nations have negotiated licensing arrangements to permit foreign-owned vessels to operate in their waters.

The mining sector has had a major impact on economic growth in the postindependence era only in Papua New Guinea, where two of the world’s largest copper-gold mines are in operation. While the employment possibilities of these projects have been limited and their local purchases of materials and equipment small, they have made an important contribution to the country’s budget and balance of payments. Kiribati, on the other hand, experienced the exhaustion of phosphate deposits in 1979, the same year that it achieved independence.

Industry and Services

The industrial sector is small in all seven countries. Although Fiji has a larger manufacturing sector than the other countries, its role as a regional center has evolved slowly. Opportunities for export-oriented production have been enhanced by the provision, since 1981, of duty-free access to the Australian and New Zealand markets under a South Pacific regional trade agreement. There has been scope for import substitution because of the relatively high degree of effective protection resulting from reliance on tariffs as a major source of government revenue. Fiscal incentives, including income tax holidays and duty drawbacks on imported materials, have been offered to motivate investors. Nevertheless, the structural features identified at independence, such as high transport costs, infrequent shipping, lack of marketing skills, and rigidities in labor markets, have continued to impede growth.

The public sector remains the main source of employment creation in all of these countries, reflecting increased current and capital spending by both the central government and the public enterprises, although relatively high wages have tended to limit employment growth. To ease budgetary pressures, several countries implemented policies in the early 1980s to leave existing vacancies unfilled, to freeze recruitment, and to impose retirement. However, the creation of positions commonly proved easier than the elimination of posts, and cutbacks in public sector employment were usually temporary. Fiji has developed a diversified private services sector that includes a large tourist industry and trade and financial services. Vanuatu has created jobs in tourism and its offshore financial center. However, throughout the region, the growth in demand for formal employment has outpaced the available opportunities. In Tonga and Western Samoa, pressures have been partially eased by emigration.

Wages Policy

Centralized wage-setting arrangements, especially de facto indexation for consumer price changes, have been prevalent. The use of such arrangements has limited the potential for real wage flexibility. Additional factors influencing wage determination have included the presence of strong labor unions, the dominant role of the public sector in establishing wage rates throughout the economy, and expectations of living standards on the scale of that enjoyed by expatriates. Such features of the labor market have been deeply entrenched in Fiji and Papua New Guinea and have also existed in Solomon Islands, Vanuatu, and Western Samoa. Strong demand for government services during the 1970s enabled trade unions in these countries to negotiate public sector wages that were high in relation to productivity and subsequently to secure regular increases in real wages. In some cases, the government has favored such a policy to attract and retain in the public sector those with managerial and technical skills who might otherwise have sought employment opportunities abroad. This level of wages has spread to the private sector, inhibiting the business investment needed to create job opportunities and promoting the adoption of labor-saving techniques, while at the same time enhancing the attractiveness of wage labor in village societies.

Downward real wage rigidity has been of particular concern when external adjustment has been required in response to a long-term deterioration in the terms of trade. Pressures for more flexible wage policies have also arisen because of the reservoir of underutilized labor in the rural economy. The need to strengthen competitiveness intensified following the weakening of the regional external payments position during the 1979–82 period of increased oil prices and world recession. In most of the seven countries, the initial response was slow and competitiveness was weakened, but greater wage flexibility was gradually introduced during 1983-87. Papua New Guinea introduced elements of flexibility into centralized wage determination beginning in 1983, when it gave only partial indexation for consumer price changes. Fiji discontinued the link between wages and prices when it implemented a 15-month wage freeze in late 1984. In 1986, it introduced wage fixation procedures that took into account changes in productivity and the terms of trade as well as price adjustments. Vanuatu and Western Samoa implemented more restrained wage policies in the public sector in 1983-87 as part of programs to secure external adjustment.

Foreign Trade

The importance of merchandise exports has varied considerably among the island countries. Fiji has had a long-established and profitable export sector, which continued to be based on sugar after independence. By diversifying into cocoa, palm oil, fishing, and timber over the past two decades, Solomon Islands boosted exports to more than 50 percent of GDP during the 1970s. Papua New Guinea, through the exploitation of copper and gold, raised exports to 40 percent of GDP by the mid-1980s. Export growth was weak in the other four countries whose production base was dominated by coconut products, and their export sectors have accounted for only 10–15 percent of GDP in this decade. In Kiribati, exports declined sharply after the exhaustion of phosphate reserves in 1979. In Tonga and Western Samoa, production of bananas declined and output of other traditional crops was stagnant over the past two decades. In Vanuatu, exports were adversely affected by the departure of expatriate plantation managers after independence. In these cases, poor export performance restricted the growth of real GDP.

Imports have ranged between 40 and 70 percent of GDP in the island economies, apart from Fiji, which has had a smaller degree of import dependence. Typically, food and beverages have represented about one fourth of the total, and finished consumer goods an additional 10–15 percent, reflecting consumption standards that have been well above the poverty level. Despite the heavy dependence on imported energy, petroleum products have normally been equivalent to less than 15 percent of total imports. Most energy has been used for transport, commercial, and household purposes, in view of the small industrial demand. Materials and capital equipment, financed largely out of aid flows, have accounted for up to one half of total imports. This share increased substantially after independence as a result of higher investment in economic and social infrastructure.

Exports and imports have been of about the same magnitude for Papua New Guinea and Solomon Islands and the trade deficit of Fiji has been limited to about 10 percent of GDP. Trade deficits have ranged between 30 and 60 percent of GDP for Kiribati, Tonga, Vanuatu, and Western Samoa, and, in each of these cases, the proportion of exports to imports has declined considerably since independence. The viability of this situation has been preserved by the strong growth of receipts of services and transfers, including private remittances and concessional assistance.

Services and Transfers

Fiji has recorded net surpluses on its services account as a result of tourist receipts, as has Kiribati because of interest on its foreign asset portfolio and fees under fishing agreements with foreign countries. Interest earnings on official reserves have been an important item for several countries. Following natural disasters, in addition to higher aid flows, compensation has normally been received from foreign insurance companies. This made an important temporary contribution to the easing of balance of payments pressures in Fiji, following cyclones in 1983 and 1985, and in Solomon Islands after the cyclone of 1986. Papua New Guinea recorded a net deficit on its services account because of management and investment income payments by the mining sector, and Solomon Islands did so reflecting dividend payments. For all countries, freight and insurance have been major payment items in the services account, representing about one fourth of the import bill.

With regard to private transfers, Tonga and Western Samoa have received workers’ remittances equivalent to about one third of GDP, well in excess of merchandise exports. Large numbers of citizens residing in Australia, New Zealand, and the United States have sent funds to relatives at home. The strength of family ties has encouraged the transmittal of a high proportion of earnings, even after long periods of absence abroad. While some funds have been sent as savings to facilitate the eventual return of emigrants to their own countries, the overwhelming proportion of remittances has financed imports of consumer goods by relatives at home. Although several recipient countries tightened their immigration laws during the 1980s, remittances have grown rapidly because additional emigrants have been able to join family members abroad and the earning capacity of those established abroad has continued to grow. Kiribati has received considerable receipts from private transfers through the employment of its citizens on foreign-owned ships.

Official transfer receipts have been large throughout the region, since most external concessional assistance has been provided in grant form. Fiji has been an exception, because, in view of its higher per capita income, aid flows have been smaller and much of the assistance provided in the form of low-interest loans. During the 1980s, receipts were equivalent to nearly 10 percent of GDP in Papua New Guinea; 15-20 percent in Solomon Islands, Tonga, Vanuatu, and Western Samoa; and 60 percent in Kiribati. Although cash budgetary support was gradually withdrawn after independence by the former colonial powers, these donors have been willing to provide additional funds for development projects. While the region has not been completely immune to the effects of budgetary constraints in the industrial world, most bilateral aid programs have expanded considerably during the 1980s. In addition to a willingness to help development, there have been regional and security considerations in the cases of Australia, Japan, New Zealand, and the United States; and assistance for former dependencies provided by France and the United Kingdom.

Capital Flows and External Debt

By comparison with official transfers, capital account transactions have been relatively small in most island countries. Multilateral financial institutions, especially the World Bank and the Asian Development Bank, have provided a limited amount of concessional loan finance. Several countries undertook extensive borrowing during 1980–82, when external conditions deteriorated sharply. Except for Papua New Guinea, which since the early 1970s has experienced a regular flow of private foreign capital into the mining sector, and Western Samoa, which during the late 1970s greatly expanded its public investment program, external commercial borrowing has not been undertaken on a continuing basis. The authorities have recognized that their ability to finance commercial loans is highly limited.

The ratio of outstanding debt to GDP in 1987 was 70–75 percent for Papua New Guinea, Solomon Islands, and Western Samoa, and 40 percent for Fiji. External debt service for Solomon Islands was about 7 percent of exports of goods, services, and private transfers in recent years. For the other three countries, external debt service was within 15–20 percent of receipts of goods, services, and private transfers. External borrowing has almost always been avoided by Kiribati, Tonga, and Vanuatu, except on highly concessional terms. For these three countries, external debt service was about 2 percent of current receipts in 1987. The island countries have not encountered problems in meeting their debt-service obligations, except for Western Samoa during 1980–82. In view of their vulnerability to external factors, most of these countries have maintained gross reserves equivalent to about 4–5 months of imports.

Exchange Rate Policy

At independence, the three island countries that possessed their own currencies pegged them at par to the currency of a metropolitan power. In this manner, the Fiji dollar was linked to the pound sterling; the Tongan pa’anga to the Australian dollar; and the Western Samoa tala to the New Zealand dollar. Other countries adopted similar arrangements when they issued their own currencies. Papua New Guinea and Solomon Islands fixed their currencies (the kina and the dollar, respectively) to the Australian dollar, and Vanuatu linked the vatu to the French franc. In view of the fluctuations in the value of the main currencies and a desire to secure greater stability in the overall value of their exchange rates, most island countries subsequently moved to a system of determining their exchange rate daily in relation to a weighted basket of currencies, usually those of their four or five main trading partners. All Pacific island member countries have established this system, except for Kiribati, which has not issued its own currency, and Tonga, which has continued to peg the pa’anga to the Australian dollar. Vanuatu pegged the vatu to the SDR between 1981 and early 1988 and then switched to a basket of currencies.

During the 1970s, little use was made of flexible exchange rate policy to strengthen competitiveness. In Fiji and Papua New Guinea, depreciation was considered to be of limited usefulness in view of the close link between wages and prices. In several countries, exchange rate appreciation was considered an appropriate means to counter inflationary pressures. Western Samoa was virtually alone in pursuing an active exchange rate policy, but the impact of several depreciations was quickly eroded by expansionary domestic demand policies. During the 1980s, most countries introduced greater exchange rate flexibility as part of their external adjustment policies in response to less favorable world economic conditions and to help develop the traded goods sector. Fiji and Vanuatu made several large discrete changes against their baskets, while Solomon Islands and Western Samoa made small, frequent adjustments against their baskets. Except for Papua New Guinea and Tonga, the currencies of the other island economies depreciated considerably in real effective terms between 1984 and 1987.

Budgetary Receipts

Budgetary receipts among the island countries have ranged from about 25 percent of GDP in Fiji to 85 percent of GDP in Kiribati. Tax revenue has averaged at least 17-20 percent of GDP. Higher ratios have been recorded in Solomon Islands, where the presence of large profitable foreign-owned companies in the plantation sector has helped to raise the ratio to 22 percent, and in Western Samoa, where revenue-raising measures implemented in recent years as part of external adjustment policies have raised the ratio to 30 percent. Nontax revenue in the island countries has averaged about 5 percent of GDP, except in Kiribati where interest earnings on foreign assets and fees under fishing agreements with foreign countries have increased the ratio to 33 percent. External grants have ranged from a negligible amount in Fiji to 35 percent of GDP in Kiribati, primarily reflecting differences in income levels. For Papua New Guinea and Vanuatu, which were unusually dependent on grant assistance during the colonial period, external aid has declined in relation to GDP since independence but, for most other countries, aid has risen substantially.

Import duties have been the largest single source of tax revenue in all of the island countries, except in Fiji and Papua New Guinea where they have represented about one third of taxes. Taxes on imports have been attractive because of the ease of collection, at relatively few points of entry into the country, and the need only for simple accounts, audits, and other procedures in order to secure compliance. Selective high taxes have been imposed to discourage consumption of luxury goods and to protect domestic producers against foreign competition. Generally, tariffs have been preferred to quotas and licensing as a means of limiting imports. Duty drawback schemes have often existed for materials used in export production, with exemptions granted on machinery and equipment in order to promote private investment.

Export levies have been modest, except in Solomon Islands where they have accounted for 13 percent of tax revenue as a result of duties on the exported output of commercial plantations. In the past, export taxes were used more commonly as a convenient means of obtaining revenue from the crops of small-scale farmers who were otherwise difficult to reach by income and land taxes. Over the years, rates have been reduced or taxes abolished in order to encourage agricultural production and exports. In circumstances of temporarily high world prices, several of the Pacific island countries have preferred to allow agricultural marketing boards to build up reserves rather than to levy additional export duties. Taxation of nontraditional exports has generally been avoided.

The main source of income tax has normally been wages and salaries of public employees, which could be easily deducted at the source by the government. Receipts from private businesses have usually been limited because of their small share in national income and the availability of incentives to reduce tax liability and encourage investment in manufacturing, hotels, and tourist activities. Public enterprises have usually been treated in the same manner as private companies but limited profitability has restricted the revenue yield from this source. Income tax has accounted for 50 percent of tax receipts in Fiji and Papua New Guinea, partly because of the importance of private corporations in these countries but primarily because of progressive personal tax rates. Income tax has not been imposed in Vanuatu.

Budgetary Expenditure

Budgetary expenditure has ranged from about 30 percent of GDP in Fiji to 85 percent of GDP in Kiribati. In most countries, current expenditure has varied between 22 and 30 percent of GDP, except for Kiribati where, although substantial cuts were made in real terms after the end of phosphate mining, the ratio has remained above 50 percent of GDP. Budgetary capital expenditure has ranged from 20 to 35 percent of GDP in those countries where investment by the public enterprises has been incorporated in the budget presentation. In Fiji, Papua New Guinea, and Solomon Islands, where this is not the case, development spending has been considerably smaller.

Efforts have been made to redirect current expenditure to areas that reflected more closely the priorities of the postindependence era. Increased attention has been given to health facilities, particularly since the age structure of the population is changing, including growing percentages of young and elderly people; and education, where intensified development efforts and the replacement of expatriate staff have demonstrated the shortage of trained workers. The traditional functions of defense and law and order have not imposed an unduly heavy burden on the budget. Most countries retained the structure of expenditure inherited from the colonial period for these purposes. With regard to administration, several countries have determined that the number of civil servants inherited from the preindependence era was beyond their resources and needs.

Wage and salary payments have comprised a large share of total expenditure. In most cases, real wages increased after independence, except in Kiribati, where repeated cuts in real wages were imposed to constrain expenditure to levels consistent with the more limited resources of the postphosphate era. In the context of economic adjustment programs, greater public sector wage flexibility has been introduced in Papua New Guinea and Western Samoa from 1983 and in Fiji from 1984.

Purchases of goods and services have represented about one fourth of total current expenditure in the island economies. When it was necessary to reduce fiscal deficits, this type of expenditure often bore a large share of the adjustment because of the difficulties of reducing spending in other areas. This has been of particular concern with respect to ensuring adequate funds for maintenance of the growing capital stock. Interest payments have been a small element of total spending, because domestic borrowing has been limited in most countries and foreign funds have been provided in grant form or on highly concessional terms.

The development of social welfare and fiscal transfers has been accorded low priority, partly because of the income-sharing ethic of the extended family system. Food subsidies for consumers have not been needed, because there is limited urbanization and large subsistence food production, even among wage earners, in most countries. Subsidies to public enterprises have often been a more substantial item. While the profitability of many enterprises has been modest, the need for budgetary support to cover operating expenses has been reduced by flexible pricing policies and investment capital provided out of aid funds on highly concessionary terms. When export prices were weak and the reserves of agricultural marketing boards needed replenishment, funds have usually been provided by the on-lending of compensatory grants received from the European Community.

Budgetary Framework and Implementation

Most countries have well-developed procedures for the formulation of annual budgetary estimates of central government revenue and current expenditure. Revenue projections, including the yield of new measures, have generally been predictable on the basis of expected domestic activity and international trade. Current expenditure estimates have been formulated from the submissions by the relevant ministries, on the basis of assumptions about overall economic trends given by the ministry of finance and interdepartmental discussion of these estimates. Although most countries have emphasized the desirability of a current budget surplus to meet a portion of development spending, increases in government revenue have been absorbed by an expansion of current spending.

The development budget, financed largely if not entirely by external aid, has normally been prepared as a separate exercise. The ministry of finance has often played a lesser role in this process, with greater influence accorded to the planning authorities. To maximize the adherence to multiyear national plans, overoptimistic assumptions have sometimes been made about the availability of funds and implementation capacity, with the result that an excessive number of projects have been included in the budget. Increased attention is being given to the integration of current and capital budgets to help achieve more reliable estimates of total expenditure; closer coordination between investment spending and future allocations for maintenance; and emphasis on the need to generate additional current savings.

In the short run, budgetary policy has been relatively inflexible. The narrow range of productive activity has made it difficult to devise new taxes. Countries have not always been able to contain current expenditure within approved limits. Efforts are being made to improve the administrative process by developing allocation systems under which the release of funds is controlled with sufficient regularity; adequate supervision is exercised over the cost and quality of goods and services acquired; accounting systems record government transactions in a framework appropriate for the analysis of their implications; and reporting systems provide data for the prompt periodic appraisal of the actual implementation of fiscal policy. When supplementary budgets have been introduced during the fiscal year, simple procedures to curb expenditure, such as across-the-board cuts in all programs or quarterly cash limits have tended to be favored. In these circumstances, resources have not always been used efficiently.

During the 1970s, growth in expenditure in relation to GDP did not create budgetary deficits in most of the countries, and fiscal policies did not add notably to external pressures. The major exception was Western Samoa where slow revenue growth, frequent wage and salary increases, higher transfers to public enterprises, and the financing of development spending in advance of aid receipts were major contributors to balance of payments pressures. In the early 1980s, continued strong growth in expenditure in most of the countries, despite declines in national income, resulted in larger budgetary deficits that exacerbated the external problems associated with the deterioration in world economic conditions. Subsequently, these countries generally pursued less expansionary fiscal policies for several years in order to achieve the required degree of adjustment.

These experiences have underlined the desirability of framing expenditure policy in a medium-term context. In periods of buoyant world demand and rising government revenues, vigilance has been needed to ensure the application of stringent criteria to new spending projects because excessive expenditure growth would prove difficult to trim back later, especially if it came in the form of an expanded wage bill. To strengthen revenue performance, several island countries have requested Fund technical assistance with tax reform. Measures may be examined to broaden the tax base, including the possibility of general sales taxes and hotel and other tourist taxes; moderate the disincentive effects of high marginal rates; promote private savings and improve resource allocation; strengthen collection and administration; and rationalize the tariff structure. In many cases, continued strong reliance on import duties has appeared inevitable. While these taxes do not differ fundamentally from the taxation of incomes, in view of the openness of these economies, difficulties could arise when imports have to be compressed.

Public Enterprises

Overall, public enterprises have added to budgetary pressures rather than contributed to resource mobilization. While some enterprises have earned considerable profits over a long period, including the corporations engaged in sugar production and distribution in Fiji and plantations in Solomon Islands, no country has been immune from these pressures. In the industrial and commercial fields, high wage costs, overstaffing, and management problems have been common. Additional difficulties in the fishing industry have arisen from weak foreign demand and external competition. In the transport sector, the largest losses have been incurred by the national airlines, especially where efforts were made to develop networks on highly competitive or sparsely traveled regional routes, and on interisland shipping services. Road transport has typically been provided by the private sector. In energy and housing, problems have been associated primarily with insufficiently flexible pricing policies.

During the 1980s, in the face of increased balance of payments pressures, several countries attempted to limit the creation of new enterprises and stem the losses of existing ones. To secure greater management efficiency in cost control and investment decisions, several countries instigated more detailed discussion within the government during annual budgetary preparations. Since few countries have had facilities for the systematic collection of annual data on enterprise performance, monitoring units have been created to strengthen the assessment of financial performance. A shortage of capital among potential buyers has hampered efforts to privatize selected enterprises.

Banking Structure

Central banks were established with Fund technical assistance in most of the island countries. In Papua New Guinea and Vanuatu, full-fledged central banks were established shortly after independence. In Fiji and Solomon Islands, central monetary authorities operating under the direction of their ministries of finance were first created as an intermediate step; these institutions were granted virtually all central banking functions and were transformed into central banks after several years. In Western Samoa, prior to the establishment of the Central Bank, a monetary board operated between 1974 and 1983 that was staffed by officials of the Ministry of Finance. In Kiribati, the Government decided that the present arrangement, whereby monetary authority functions were shared between the Ministry of Finance and a commercial bank, was adequate at this stage of economic development.

In most countries, there have been a relatively small number of commercial banks, usually branches of Australian, New Zealand, and other foreign-owned banking groups. The government has often been a minority shareholder in one or more of these banks. Given the banks’ international connections and conservative attitude toward domestic private sector lending, the financial soundness of the banking system has usually not been in question. In these circumstances, the supervision of bank activities by the monetary authorities has been relatively underdeveloped. Reflecting the limited degree of competition, banking operations have generally been profitable. A concern in most of the island countries has been the disinclination of the banks to pursue domestic lending opportunities.

Evolution of Monetary Instruments

Prior to independence, domestic currencies had been issued for many years in Fiji, Tonga, and Western Samoa. The ministry of finance, a monetary board, or the local commercial bank undertook the automatic conversion of foreign notes and coins into domestic currency, which was normally issued at par with that of the metropolitan power. These arrangements did not permit control over credit creation; the maintenance of a rigid link between the volume of currency in circulation and balance of payments developments safeguarded the external position and the value of the domestic currency. Near independence, the authorities introduced domestic currencies in Papua New Guinea, Solomon Islands, and Vanuatu. A dual currency period of about one year was normally allowed, after which the foreign currency ceased to be legal tender. In view of the absence of exchange controls, few difficulties were experienced in securing local acceptance of these arrangements. Kiribati has retained the Australian dollar as its domestic currency for reasons of convenience and the costs associated with the introduction of its own currency.

The central monetary authorities of most countries took over the management of foreign exchange reserves shortly after their establishment, except in Vanuatu where the function was retained by a local commercial bank for several years. The substitution of domestic currency for foreign assets created the potential for large credit creation. To prevent balance of payments problems that could arise from a highly liquid banking system, the monetary authorities usually imposed reserve requirements to neutralize a substantial part of these funds. However, reflecting the absence of demand from the public sector for bank credit and the perceived lack of lending opportunities in the private sector, most of the assets of the commercial banks have been invested abroad.

The most commonly used instrument to influence bank liquidity has been variable reserve requirements in the form of a stipulated minimum liquid assets ratio for bank holdings of cash, deposits at the central bank, and government securities in relation to deposit liabilities. A minimum cash ratio has also sometimes been imposed. The main problem with this type of instrument has stemmed from the wide fluctuations in bank liquidity, which required frequent adjustments in the reserve ratio to maintain control over bank lending capacity. Some authorities have relied on direct credit ceilings applied to each bank to limit credit growth. The Western Samoan authorities followed this approach during 1983-86, but to avoid undue rigidity in credit allocation, that system was then replaced with a more flexible arrangement that tied the growth in lending of each bank to the growth of deposits, thereby promoting greater competition among banks for deposits.

The principal private sector credit operations of the commercial banks have consisted of short-term business financing, especially of foreign trade. Longer-term loans for the purchase of capital equipment and other investment goods in agriculture, tourism, and industry have been made, but borrowers have usually been able to obtain cheaper loans from the development finance institutions. In most countries, central banks can provide facilities for the rediscounting of trade bills and for short-term advances to commercial banks, but these have not been used as a major instrument of monetary policy. To promote domestic lending and the efficient allocation of resources, sparing use has been made of selective credit controls that favor priority areas.

The monetary authorities in most countries have not relied on intervention through open market operations in securities. Although it is recognized that the flexible and fast acting nature of these instruments could have been helpful in a monetary environment subjected to large swings in bank liquidity associated with external events, financial markets are not sufficiently broad and deep to permit their effective use. Where treasury bills and other short-term securities have been issued, notably in Fiji and Papua New Guinea, the initial purchasers normally held these until maturity; secondary and interbank markets generally have not developed. Secondary markets in longer-term government and public enterprise instruments remain undeveloped.

Conduct of Monetary Policy

Monetary targeting has been considered to be of limited usefulness in the island economies. Liquidity growth has been difficult to gauge accurately because of unpredictable export earnings and other large external shocks. Attempts to influence monetary growth were pursued most actively in Papua New Guinea during the 1970s, including the sterilization of a substantial part of the accumulated reserves of the agricultural stabilization funds during periods of high export demand. However, officials have seen little need to influence monetary growth that has arisen from other foreign transactions. At least in the short run, changes in demand have influenced imports more than domestic price movements, thereby weakening the link between monetary growth and inflation. While increased foreign exchange receipts have initially been reflected in higher external reserves and a surge in monetary growth, these trends have subsequently been reversed, as domestic demand strengthened and imports rose. If a weakening of the external position had been predicted, steps might have been implemented to tighten monetary policy in advance of the prospective loss of international reserves, but turning points in the balance of payments were usually difficult to determine.

The main aim of most of the monetary authorities has been to establish money and credit conditions that are consistent with the achievement of external objectives. In this regard, the determination of the appropriate rate of growth of domestic credit, irrespective of the possible existence of monetary targets, has been important. Occasionally, the public sector borrowing requirement, over which the monetary authorities have had little control, has dominated credit growth. In Western Samoa, an expansionary fiscal policy contributed to rapid monetary and credit growth and a deteriorating balance of payments during the late 1970s. In most of the other countries, where fiscal policy was less expansionary, monetary policy has been broadly successful in keeping the growth of domestic credit within acceptable limits, as evidenced by generally moderate price movements and the maintenance of liberal trade and payments systems.

The deterioration in external economic conditions in the early 1980s demonstrated the usefulness of influencing bank liquidity to moderate import demand and protect the balance of payments. During this period, private traders in several countries expanded their use of bank credit to finance imports. In Western Samoa, the authorities applied moral suasion to curtail credit expansion, but the absence of other instruments limited their ability to restrain lending. Credit growth was also rapid in Solomon Islands, partly because reserve requirements had not been imposed earlier on commercial banks. In other countries, including Fiji, where reserve requirements could be raised quickly, monetary policy was more effective in curbing private sector credit. In 1983–87, as part of adjustment policies, the authorities of most of the countries closely monitored developments in bank liquidity.

Interest Rates

Bank deposit and lending rates in the Pacific region have traditionally been determined administratively, and interest rate policy has not been actively employed as a tool of economic management. Nominal bank rates have generally been kept low and stable. Higher deposit rates have not been thought likely to influence savings since income sharing in traditional societies made it difficult for individuals to save. Deposit rates have also not been seen as a major factor in encouraging remittances from residents living abroad. Transfers have been prompted by the obligation to support the income and consumption levels of family members at home. With regard to lending rates, interest rates have not been thought to influence the allocation of resources, particularly since a large part of total investment has been undertaken by the public sector with financing obtained through external concessional assistance.

In 1980–82, most interest rates became negative in real terms, as nominal rates were not adjusted for higher rates of price increase. During 1983–87, most island countries introduced greater flexibility in interest rate policies to establish positive real rates for longer-term deposits and virtually all loans. In this period, increased weight was given to the possibility that higher deposit rates would encourage savings by the growing urban household sectors and the private business communities. Several countries raised ceilings on loan rates to encourage banks to more actively seek domestic lending opportunities. In other cases, higher rates were aimed at discouraging borrowers in order to reduce domestic demand and balance of payments pressures or investment in areas of relatively low profitability. The only country that did not move toward more market-oriented rates was Tonga, where legislation, in effect for 50 years, stipulated a 10 percent ceiling on lending rates and where deposit rates were kept commensurately low.

Market-determined rates were applied to virtually all transactions in Vanuatu after independence, because the authorities felt that the imposition of controls was inconsistent with the country’s role as an offshore financial center. In Kiribati, the introduction of internationally competitive rates on large-scale time deposits in 1984 resulted in the transfer to that country of considerable funds that had previously been held abroad. Other countries that adopted higher nominal rates as part of external adjustment programs in the 1980s were sometimes reluctant to align rates fully with the markedly higher rates prevailing in regional centers, especially Australia and New Zealand.

Other Financial Institutions

Each of the island countries has established a development bank to provide longer-term finance for private sector investment, mainly in agriculture and industry. While the government has usually provided most or all of the equity, the loanable funds have generally been made available on concessional terms by multilateral financial institutions, notably the World Bank and the Asian Development Bank, by bilateral aid donors, and by the European Community. In several countries, the new institutions replaced agricultural and industrial loan boards that had been financed out of the government budget. Such budget allocations were on a smaller scale and subject to abrupt changes. The development banks have improved the availability of credit for small businesses, where high risk and administrative costs deterred commercial bank lending. However, the shortages of staff and lack of experience in processing loan applications have affected the quality of their loan portfolios in several countries. Loans have been made at below market rates, reflecting the low average cost of funds. This has increased the likelihood of the allocation of resources to unprofitable activities and has contributed to the growth of loan arrears.

All of the countries, except Tonga, have established national provident funds for wage earners in the public and private sectors. Rates for employers and employees together have ranged from 6 to 14 percent of the wage and salary bill, usually payable in equal proportions by the two groups. Given the social constraints on voluntary savings, compulsory and contractual schemes have been a useful means of raising private savings. Most funds have earned substantial surpluses, which proved to be an important source of financing for the public sector, especially in Fiji, Papua New Guinea, and Solomon Islands. With a lack of demand at home, the assets of the Kiribati institution have been almost entirely invested abroad.