Chapter

IV. Low-Income Countries and Pacific Islands

Author(s):
International Monetary Fund. Asia and Pacific Dept
Published Date:
October 2010
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A. Introduction

Asian low-income and Pacific Island economies experienced a strong rebound during the first half of 2010. Growth was helped by macroeconomic stimulus and by strong global demand for commodities and garments. Looking ahead, however, many of these economies face important challenges, some of which are discussed in this chapter. A key priority for many low-income countries is fiscal consolidation, which, as discussed in Section B, will help to create space for much needed development spending and also reduce debt sustainability concerns that have increased in a few cases owing to high government deficits. To raise their growth potential and reduce vulnerabilities, several economies are undertaking important reforms. Sections C and D focus on the outlook and challenges in Sri Lanka and Mongolia, respectively. Meanwhile, several Pacific Island countries will need fiscal reforms to cope with an expected reduction of overseas assistance during the next decade, and Section E discusses the cases of the Marshall Islands, Micronesia, and Palau.

B. Postcrisis Fiscal Adjustment in Asian Low-Income Countries

Fiscal positions in Asian low-income countries (LICs) deteriorated significantly during the global crisis, largely reflecting surges in expenditure.1 Although governments in Asian LICs (apart from Vietnam) in general did not spend much on temporary stimulus measures, they did support the economy by increasing wages, improving safety nets, and accelerating development projects that were planned prior to the crisis. Widening fiscal deficits in these countries have raised debt sustainability concerns and pointed to the need for fiscal consolidation.

However, Asian LICs’ fiscal challenges go beyond consolidation, as these countries also face large financing needs for development spending. To create fiscal space for development spending without damaging fiscal sustainability, Asian LICs need to enhance revenue mobilization and to improve expenditure efficiency. Revenue mobilization is of higher priority across Asian LICs that are stuck in a ‘low-revenue, low-expenditure” equilibrium. Improving efficiency is essential for those that have less scope for enhancing revenues, and for commodity exporters that face volatile revenues and are more likely to suffer from procyclical fiscal policies.

On average, Asian LICs’ fiscal deficit as a share of GDP widened by more than 5 percentage points in 2009 relative to precrisis levels, close to Newly Industrialized Economies (NIEs) but more than in the ASEAN-4 (Figure 4.1). The only exception was Bangladesh, whose fiscal deficit narrowed in 2009 due to capacity constraints in implementing the budgeted expenditures.

The higher deficit among Asian LICs resulted mainly from higher expenditure. With robust growth during the crisis and relatively narrow tax bases (few taxes are related to volatile asset prices), Asian LICs on average did not suffer as large a collapse in revenue-to-GDP ratios as industrial and emerging Asia (Figure 4.2). On the other hand, expenditures (in percent of GDP) increased more significantly in Asian LICs than in other regional economies. A large part of the surge in expenditure was for planned projects that coincided with (but were unrelated to) the crisis (e.g., preparation for the Southeast Asian Games in Lao PDR; starting of liquefied natural gas projects in Papua New Guinea; and acceleration of postwar reconstruction spending in Sri Lanka). Although some of the one-off increases in expenditure would be reversed relatively easily, a large part of the increase in fiscal deficits is structural.

Figure 4.1Asia: Changes in Fiscal Balance Relative to Precrisis Level

(In percent of GDP)

Source: IMF staff estimates.

1 Changes in fiscal balances from pre-crisis levels are calculated as the difference from 2005-2007 average.

Figure 4.2Asian LICs: Expenditure versus Revenue

(Average over 2005-08, in percent of GDP)

Source: IMF staff estimates.

Fiscal deteriorations in Asian LICs have increased debt sustainability concerns in these countries. Most of the Asian LICs ended up with higher public debt ratios by end-2009 than envisaged before the crisis (Figure 4.3). Although external debt sustainability is not yet a problem in these countries, their external debt trajectories could enter an unsustainable path in the absence of decisive fiscal consolidation. Costly domestic financing, the need to rebuild government deposits, vulnerabilities in the financial sectors, external and exchange rate risks, and large contingent liabilities all point to the need for fiscal consolidation to maintain public debt sustainability. Based on staff estimates, apart from Bangladesh, Asian LICs need to narrow their fiscal deficits by about 3—5 percent of GDP from 2009 to 2015 to preserve debt sustainability. Bangladesh, though not facing the challenge of fiscal consolidation, needs to enhance both revenue and capital expenditures.

Figure 4.3Asian LICs: Public Debt1

(In percent of GDP)

Sources: National authorities; and IMF, Debt Sustainability Analysis, and staff projections.

1 Projections for 2009 refer to those made before the global financial crisis.

In the meantime, more development spending is needed in Asian LICs to improve both physical and human capital and reduce the gap with emerging Asia (World Economic Forum, 2009). What should Asian LICs do to meet both the financing needs for development and their fiscal consolidation targets?

  • Enhancing revenue. Many Asian LICs, especially those with low revenue-to-GDP ratios, have begun another round of tax reforms mainly by introducing or reforming value-added taxes (VAT) and strengthening tax administration (Bangladesh, Cambodia, Nepal, Lao PDR, Sri Lanka, and Vietnam) (Table 4.1). In past tax reforms, some countries have been more successful than others. One successful example is Vietnam, which has increased its tax yield from an average of about 20 percent of GDP during 2001-04 to an average of 24 percent of GDP during 2005—08. Since 2005, Vietnam has reformed its tax policies by improving the design of the corporate income tax, the VAT, and the personal income tax. In the meantime, tax administration has been strengthened by introducing a new law, reorganizing the General Department of Taxation based on tax administration function, replacing the traditional system of administrative assessment with a self-assessment system, and upgrading both information technology systems and staff training. Another example is Nepal, where domestic revenue increased by about 4 percent of GDP from 2005/06 to 2008/09, largely driven by reforms in customs administration and the Inland Revenue Department (IRD). The authorities have developed a comprehensive reform strategy for the customs department, and have embarked on a range of measures to curb tax evasion, broaden the tax base, and improve the audit function of the Large Taxpayers Office, as well as of the IRD in general.

  • Strengthening fiscal discipline and improving expenditure efficiency. Fiscal discipline can be strengthened by adopting a medium-term fiscal framework or a fiscal rule. These fiscal institutions are particularly important for commodity exporters, which tend to face volatile and uncertain revenues and are more likely to suffer from procyclical fiscal policies. For example, in Mongolia, pressures appear to be building to increase spending, on account of surging mineral revenues, although the recent passage of a fiscal responsibility law that includes numerical rules will help contain these pressures and promote fiscal discipline. Expenditure efficiency gains can be achieved by containing real growth in primary current expenditure (e.g., wage bills), reprioritizing projects (e.g., by exiting from low quality projects or collaborating with the private sector), and tightening poorly targeted subsidy schemes. Finally, expenditure policies could be underpinned by public financial management (PFM) reforms. Several Asian LICs have started to undertake PFM reforms. Vietnam, for example, is expected to approve a new State Budget Law to align fiscal reporting and accounting with international standards, institute medium-term planning, introduce performance budgeting, and reduce overlap of budgetary responsibilities between various levels of government. Cambodia also launched PFM reforms, and has made substantial progress over the last five years in moving toward a medium-term expenditure framework and improving cash management. It has now entered the second stage of PFM reforms, focusing on strengthening budget integration, improving fiscal monitoring and reporting, and reinforcing controls over payroll and procurement.

Table 4.1.Asian LICs: Planned and Ongoing Fiscal Reforms
BangladeshCambodiaLao PDRNepalSri LankaVietnam
RevenueSide
VAT introduction or reformXXXX
Income tax reformXX
Excises reformX
Investment tax reformX
Trade tax reformX
Tax administration reformXXXXX
ExpenditureSide
Review wage bills/allowancesX
Reprioritize development projectsXX
Reduce/eliminate subsidiesXX
Reduce recurrent expenditureX
PublicFinancialManagementXXXXX
Source: National authorities.

C. Sri Lanka: At a Crossroads

The three-decade war distorted economic policy, hindered development, and reduced Sri Lanka’s growth potential. Carrying out a national, integrated investment strategy proved very difficult with the country in a persistent state of conflict—infrastructure suffered, and political uncertainty and security concerns held back private domestic and foreign investment. In an effort to offset these concerns, the government relied on sweeping tax concessions to attract investment, resulting in an erosion of the tax base and chronically high budget deficits financed in large part by external borrowing. The tax system became increasingly ad hoc and distorted, with a narrowing portion of economic activity taxed at high rates. Public debt grew to unsustainable levels as security and interest expenditures increased, with the resulting debt dynamics raising the risk of ultimate debt distress.

As a result, the country was left with few policy options to manage the unfolding global crisis. In the face of a sudden reversal in capital flows at the end of 2008 and heavy intervention by the central bank to maintain the de facto peg, foreign exchange reserves fell to dangerously low levels by March of 2009 (Figure 4.4). Inflation was successfully brought under control through tight monetary policy, but as expected this resulted in a slowdown of output growth and a surge in banks’ nonperforming loans, compounded by a decline in exports as global demand weakened in 2009 (Figure 4.5). Budget revenues remained weak and the deficit high.

Figure 4.4Sri Lanka: Gross Official Reserves

(In percent of GDP)

Source: Central Bank of Sri Lanka.

Figure 4.5Sri Lanka: Inflation and GDP Growth

(Year-on-year, In percent)

Sources: CEIC Data Company Ltd.; and IMF staff calculations.

Short-term vulnerabilities eased significantly following the end of the war in May and the approval of the IMF program in July 2009. A sharp increase in foreign investor enthusiasm led to large and persistent capital inflows. Remittances also increased, and exports began to rebound. The central bank responded by aggressively purchasing foreign exchange to prevent an appreciation of the rupee, boosting reserves to historically high levels.

With the end of the war and the crisis averted, future growth prospects have improved markedly. But the country is now at a crossroads, and significant near- and medium-term macroeconomic challenges need to be addressed if Sri Lanka is to take full advantage of the current favorable environment. First, fundamental tax reform is needed to simplify the existing system, broaden the tax base, spread the tax burden more equitably, and support economic growth, all while boosting the revenue-to-GDP ratio. The resulting fiscal space would allow increased public capital spending on reconstruction and infrastructure as well as social spending. But higher growth potential requires investment significantly higher than historical levels, and it is clear that these investment needs cannot be met through the government budget alone. Private-sector investment needs to play a critical role. To foster this investment, policies will need to be geared toward preserving macroeconomic stability, ensuring external competitiveness, facilitating capital market development, and improving the investment climate. These challenges are intertwined and cross-cutting, but each is focused on the ultimate goal of restoring and boosting further Sri Lanka’s growth potential over the medium term.

D. Mongolia: A Remarkable Turnaround

The global financial crisis pushed the Mongolian economy to the verge of economic collapse early last year, with international reserves plummeting and the government running low on cash to finance the budget. Now, the economy is set to grow by 8 percent this year, international reserves have reached an all time high, and fiscal policy has been put on sound footing (Figure 4.6). What explains this remarkable turnaround?

Figure 4.6Mongolia: Real GDP

(Year-on-yearpercent change)

Source: IMF staff calculations.

The first and foremost factor behind the turnaround is the authorities’ strong policy implementation in the wake of the crisis. Their IMF-supported program aimed to stabilize markets and put the economy on a strong, sustainable, and equitable growth path. Their strategy centered on the following:

  • Flexible exchange rate. In early 2009 the authorities implemented a flexible exchange rate regime with central bank intervention limited to a transparent twice-weekly auction. This regime was buttressed by an upfront 400 basis-point hike in the policy interest rate, which calmed markets and helped stabilize capital flows.

  • Healthier publicfinances. A large fiscal adjustment in 2009 was achieved mainly through a reprioritization of spending. The fiscal adjustment continued in 2010 and, aided by the rebound in copper prices and the economic recovery, the budget deficit is expected to fall to 2 percent of GDP.

  • Furthermore, parliament passed a comprehensive fiscal responsibility law that builds the foundation for lasting fiscal discipline and will help prevent a reemergence of boom-bust policies.

  • Protecting the poor. Spending on the poor was protected during the fiscal adjustment, and social transfers actually increased during the program period. In addition, the authorities plan to soon introduce a targeted poverty benefit that will significantly strengthen the social safety net.

  • Bolstering the banking system. Confidence in the system is being restored, and risks have been contained even as two important banks were put into receivership. A revised banking law was adopted that will strengthen the regulatory framework. A second piece of legislation to recapitalize banks has been submitted to parliament and banking supervision has been strengthened, including through the issuance of improved supervision regulations.

The IMF-supported program has provided confidence, financing, and breathing space for the authorities to adjust policies more gradually. It has also catalyzed significant financial contributions from the World Bank, the Asian Development Bank, the Japan International Cooperation Agency, and many other bilateral donors.

The success of the Mongolia program illustrates how the IMF has refocused its lending. The program’s conditions were restricted to those areas necessary to return the country’s economy to strong growth. The program also adjusted flexibly as economic circumstances evolved. For example, when growth in 2009 turned out to be weaker than expected, the fiscal deficit targets were loosened to support the economic recovery.

Strong demand from China and a rebound in copper prices, a key export for Mongolia, also contributed to Mongolia’s rapid reversal of fortunes. Coal production has expanded rapidly this year, and coal exports are up 170 percent, while copper exports are up 80 percent driven largely by the recovery in global copper prices (Figure 4.7).

Figure 4.7.Mongolia: Mineral Exports

(In millions of U.S. dollars)

Source: IMF staff calculations.

The outlook for Mongolia’s economy is extremely favorable. The signing of a landmark investment agreement in late 2009 to develop the Oyu Tolgoi mine—referred to by some as the biggest undeveloped copper-gold project in the world—has been a cornerstone for the development of Mongolia’s substantial mineral resources. The development of other major projects, such as the massive Tavan Tolgoi coal deposits in southern Mongolia, is also under way. The economy is growing strongly and this ongoing development of the mineral sector points to a bright future.

The authorities’ policy reforms have laid a solid foundation for managing the pending boom in the mineral sector and ensuring that Mongolia’s substantial mineral wealth leads to a period of sustained economic growth that spreads prosperity to all Mongolians.

E. Fiscal Challenges for Compact Countries—Marshall Islands, Micronesia, and Palau

Many Pacific Island countries (PICs) face significant fiscal adjustment and reform challenges in the coming years. The need for these adjustments and reforms arises from many sources, including trade liberalization and declining overseas assistance. The latter is a concern especially for Marshall Islands, Micronesia, and Palau, as an important source of foreign aid that has greatly supported economic development in these economies in the past, the U.S. Compact grants, is expected to dry up within 15 years. This section focuses on these countries, and discusses the expenditure and revenue measures that are needed to ensure their long-term fiscal sustainability.

The Compact of Free Association (the “Compact”) is a treaty between the United States and each of three Pacific Island countries— Marshall Islands, Micronesia, and Palau. The Compact entered into force in FY1986 in both Marshall Islands and Micronesia and in FY1994 in Palau.2 Under the Compact, the United States controls defense and security matters in these countries. In exchange, the United States has committed to provide grants (Compact grants) through the end of the second Compact period, which is FY2023 for both Marshall Islands and Micronesia, and FY2024 for Palau.3 Compact grants come in the form of budget support and federal services (e.g., postal).

These three economies depend heavily on Compact grants. In recent years, the shares of (current and capital) grants in overall revenue have been in the range of 50—65 percent, and Compact grants constitute an important fraction of total grants (Figure 4.8). In Palau, the share of Compact grants is relatively low as Palau has been quite successful in obtaining non-Compact (capital) grants, partly thanks to its favorable development prospects (e.g., tourism).

The dependence on grants translates into large underlying fiscal imbalances. Although these countries’ overall fiscal deficits are about zero, current deficits excluding grants are between 15 percent and 35 percent of GDP, reflecting large current expenditure and a small domestic revenue base (relative to other Pacific Island countries) (Figure 4.9). High current spending is driven by large civil service wage bills and subsidies for utilities, fuel, and public enterprises (Figure 4.10). Tax bases (excluding nontax revenue such as fees) are narrow due in part to exemptions and inefficient tax administrations, and there is a need to replace distortionary gross revenue taxes with more efficient profit or other taxes (Figure 4.11).

Figure 4.8.Compact Countries: Share of Grants in Overall Revenue, FY20081

(In percent)

Source: National authorities.

1 Fiscal year ending on September 30.

Figure 4.9.Compact Countries: Fiscal Balance, FY20081

(In percent of GDP)

1 Fiscal year ending on September 30.

Figure 4.10.Pacific Island Economies: Public Wage Expenditure, 20071

(In percent of GDP)

Source: IMF, Palau Article-IV Staff Report, 2010.

1 FY2007 for Palau, Marshall Islands, Micronesia, and Tonga.

Figure 4.11.Pacific Island Economies: Tax Revenue, 20071

(In percent of GDP)

Source: IMF, Palau Article-IV Staff Report, 2010.

1 FY2007 for Palau, Marshall Islands, Micronesia, and Tonga.

The performance of the Compact Trust Funds has also fallen short of expectations. Under the Compact, the United States set up a trust fund (Compact Trust Fund) in each of the Compact countries and has financially contributed to those funds. The purpose of the funds is to provide a steady stream of income once Compact grants expire. So far, the performance of the funds has generally failed to meet expectations, particularly in recent years due to the global financial crisis. For example, by FY2009, the Compact Trust Fund in Palau had accumulated US$140 million (70 percent of GDP), compared to US$260 million expected by this date at the outset (FY1995) (Figure 4.12). This is mainly due to lower-than-expected returns—12½ percent was initially anticipated but the fund returned only 7½% percent per year (although 7½% percent is not low by international standards).

Figure 4.12.Compact Trust Fund Balance1

(In percent of GDP)

Source: National authorities.2010.

1 Fiscal year ending on September 30.

Given their current fiscal positions, significant fiscal adjustment is needed in these countries to ensure fiscal sustainability, assuming that Compact grants will end at the end of the current Compact period (FY2023 or FY2024). The required size of adjustment estimated by IMF staff varies across the three countries, reflecting country-specific circumstances (and differences in the estimation methods). However, the common message is that the needed improvement in the fiscal balance is substantial—in the range of 5—8 percentage points of GDP over the next five years.

In all of the Compact countries, fiscal adjustment requires a combination of expenditure and revenue measures. Among the three countries, Marshall Islands has already started taking concrete expenditure measures to achieve the necessary consolidation. Micronesia and Palau acknowledge the need for fiscal adjustment. Looking forward, a priority for these two countries is to start implementing comprehensive reforms.

Marshall Islands

  • Expenditure measures. The FY2010 budget envisages elimination of vacant positions and significant spending cuts in goods and services. That said, Marshall Islands would still need to take further expenditure measures to meet its targeted savings.

    • Civil service rationalization. The public sector wage bill has doubled over the past decade, and now is one of the highest among the Pacific Island economies. Building on the elimination of vacant posts, a combination of civil service pay cuts and reductions in employment would need to be implemented.

    • Limitingfinancial support to state-owned enterprises (SOE). Public support to SOEs has reached 3-4 percent of GDP annually during the past several years. Subsidies to SOEs could be reduced, including through improving efficiency and raising tariffs (e.g. electricity).

  • Revenue measures. The authorities already have a plan to implement comprehensive revenue reform, which could involve broadening the personal income tax base; strengthening tax administration by unifying the social security and tax offices; and shifting from the distortionary gross revenue tax to the VAT.

Micronesia

  • Expenditure measures. Despite the recent successful payroll reductions, current expenditure is still high at about 60 percent of GDP—well above the Pacific Islands average (35 percent of GDP). There remains significant scope for a further reduction in public employment and subsidies to state governments and SOEs.

  • Revenue measures. Given the relatively small personal income tax base, greater information sharing between the national and state governments on self-employed contractors could help boost revenue. Over the medium term, passing the planned tax reform package (currently facing political opposition), which mainly consists of the VAT and the net profits tax, is critical.

Palau

  • Expenditure measures. While wage cuts in FY2009 are an important step forward, a further reduction may be required in light of relatively high wage expenditure. Curtailing subsidies to SOEs (e.g., water and sewage services) would also be a key to achieve the recommended adjustment.

  • Revenue measures. As recognized by the authorities, eliminating import duty exemptions and shifting to cost, insurance and freight (CIF) evaluation could generate substantial revenue. Replacing the gross revenue tax with a less distortionary corporate income tax (as tax administration capacity develops) could also be considered.

  • Strengthening budget processes. To complement the expenditure and revenue measures, continued efforts to fix weaknesses in the budget process and improve cash control are critical. In this respect, creation of a cash management committee, which ensures a transparent allocation of cash resources, would be helpful.

Note: The main authors of this chapter are Ran Bi and Svitlana Maslova (section B), Brian Aitken (section C), Steven Barnett, Julia Bersch, and Yasuhisa Ojima (section D), and Kiichi Tokuoka (section E).

The low-income countries (LICs) comprise Bangladesh, Cambodia, Lao PDR., Mongolia, Nepal, Papua New Guinea, Sri Lanka, and Vietnam.

Fiscal year ending on September 30.

The first Compact period ended in FY2003 in both Marshall Islands and Micronesia and in FY2009 in Palau.

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