Global and Regional Spillovers to Pacific Island Countries
  • 1 https://isni.org/isni/0000000404811396, International Monetary Fund

Contributor Notes

Regional integration of Pacific Island countries (PICs) with Australia, New Zealand, and emerging Asia has increased over the last two decades. PICs have become more exposed to the region’s business cycles, and spillovers from regional economies are more important for PICs than from advanced economies outside the region. While strong linkages with Asia would help in the event of a global downturn, PICs remain particularly vulnerable to global commodity price shocks. In this paper, we use a Vector Error Correction Model (VECM) for each PIC to gauge the impact of global and regional growth spillovers. The analysis reveals that the impact on PICs’ growth from an adverse oil shock would be substantial, and in some cases even larger than from a negative global demand shock. We also assess the spillovers to the financial sector from the deterioration of the global outlook. PICs should continue to rebuild policy buffers and implement growth-oriented structural reforms to ensure sustained and inclusive growth.

Abstract

Regional integration of Pacific Island countries (PICs) with Australia, New Zealand, and emerging Asia has increased over the last two decades. PICs have become more exposed to the region’s business cycles, and spillovers from regional economies are more important for PICs than from advanced economies outside the region. While strong linkages with Asia would help in the event of a global downturn, PICs remain particularly vulnerable to global commodity price shocks. In this paper, we use a Vector Error Correction Model (VECM) for each PIC to gauge the impact of global and regional growth spillovers. The analysis reveals that the impact on PICs’ growth from an adverse oil shock would be substantial, and in some cases even larger than from a negative global demand shock. We also assess the spillovers to the financial sector from the deterioration of the global outlook. PICs should continue to rebuild policy buffers and implement growth-oriented structural reforms to ensure sustained and inclusive growth.

I. Introduction

Growth in the Pacific island countries (PICs) has been weak over the last decade. The crisis in 2008–09 compounded the problem by reducing growth further, especially among the commodity importers. While recovery is still under way, headwinds remain in light of global economic uncertainty. Should downside risks to the global outlook materialize, adverse spillovers would occur mainly through regional partners. Linkages with Australia, New Zealand, and emerging Asia would help offset the downturn, thanks to their strong fundamentals. But PICs remain particularly vulnerable to commodity price shocks. To enhance their resilience to shocks, PICs should continue to rebuild policy buffers and implement growth-oriented structural reforms to ensure sustainable and inclusive growth.

II. PICS Before and After the Global Crisis

Most PICs seem to be stuck on a low-growth path (Figures 1 and 2). In the 10 years preceding the 2008–09 global financial crisis, PICs’ growth averaged just 2 percent a year—a much lower rate than the Asian low-income countries (6 percent), the Eastern Caribbean Currency Union countries (4 percent) and small states (4½ percent), which are similar comparators. Volatility remains high, but it has declined over the last decade (Figure 3) Finally, relative growth performance among PICs has changed over time (Figure 4) in favor of commodity exporters which have benefited from global price trends since 2004, suggesting a different resilience to shocks in the future.

Figure 1
Figure 1

PICs: Real GDP Growth

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: IMF, WEO database; and staff calculations.Note: ECCU includes Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent.
Figure 2:
Figure 2:

PICs: Real GDP Growth

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: IMF, WEO database; and staff calculations.
Figure 3.
Figure 3.

Standard Deviation of Real GDP Growth

(In percent))

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: IMF, WEO database; and staff calculations.
Figure 4.
Figure 4.

PICs: Relative Growth Performance

(Real GDP growth relative to regional median, in percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: IMF staff calculations.

PICs were hit by the 2008–09 global crisis and have since been recovering only slowly—although at different paces (Figure 5). The flood in Fiji and the earthquake and tsunami in Samoa further reduced growth. Excluding the net commodity exporters (Papua New Guinea and Solomon Islands), average real GDP fell by 1.2 percent in 2009, and growth rebounded to just over ½ percent in 2010 and to about 2 percent on average in 2011. In Papua New Guinea and Solomon Islands, in contrast, real GDP grew by 7–7½ percent in 2010 and 9 percent in 2011. This rapid growth was led by the construction of a liquefied natural gas (LNG) project in Papua New Guinea—amounting to 200 percent of GDP—and strong mining and logging activity in the Solomon Islands.

Figure 5.
Figure 5.

PICs: Real GDP Growth

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities; and IMF staff calculations.

PICs’ recovery is also proceeding more slowly than those in Asian low-income countries (LICs) and emerging economies, although growth has recently been reverting to pre-crisis levels. The slower recovery reflects PICs’ relatively small export base, which precludes a large increase in external demand associated with global recovery. Helped in part by the resilience of Australia during the crisis, PICs have, however, recovered more strongly than some comparators in other regions, such as in the Eastern Caribbean Currency Union (ECCU), which rely more heavily on demand and the business cycle in the United States. In particular, the strength of the Australian and New Zealand dollars continued to support the PIC tourist sector over the last two years (Figure 6).

Figure 6.
Figure 6.

PICs: Tourists Arrivals

(2005=100)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.

A closer look suggests that PIC net commodity importers are also recovering more slowly than in previous recessions. Over the past four decades, PIC importers have experienced five episodes of economic contraction—1975, 1980, 1987, 1997, and 2009. Only two of these coincided with global recessions (1975 and 2009). The 2009 contraction was milder than the previous PIC downturns, yet the recovery has been much weaker (Figure 7). The picture differs, however, for net commodity exporters (Figure 8). The contraction was still milder than in previous episodes, but the recovery has been much faster.

Figure 7.
Figure 7.

PICs Commodity Importers: Real GDP Growth around Downturns1

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.1 Historical is average of four downturns.
Figure 8.
Figure 8.

PICs Commodity Exporters: Real GDP Growth around Downturns1

(2005=100)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.1 Historical is average of four downturns.

What explains the current slow recovery of PIC commodity importers relative to past episodes and to Asian LICs? We conducted a VAR analysis following Berg and others (2010) to identify the shocks that have a larger and more persistent impact on PICs’ growth and find that terms-of-trade shocks result in a far greater output loss than do shocks to external demand (Figures 9 and 10). This may explain the milder recession in PICs in 2009 as well as the slower recovery, relative to previous episodes. In contrast, external-demand shocks have a larger impact on output in Asian LICs, which may help explain the greater impact of the global recession on those economies.

Figure 9.
Figure 9.

PICs: Response to Change in Loss Output to External Demand

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.
Figure 10.
Figure 10.

PICs: Response to Change in Loss Output to Terms of Trade

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.

Terms-of-trade shocks have a larger impact than external-demand shocks in PICs for several reasons. Given their narrow export and production base and geographical remoteness, most PICs have structural trade deficits. Except for Papua New Guinea and Solomon Islands, PICs are commodity importers and therefore vulnerable to swings in commodity prices. Given the increase in commodity prices and greater commodity price volatility in recent years, terms-of-trade shocks have translated into larger output shocks. Higher import prices have also raised the cost of production and reduced real household income.

III. Channels of Spillover: A Qualitative Analysis

If a global downside scenario materializes, the channels of contagion would also vary across PICs.

  • Tourism, remittances, and foreign direct investment (FDI). Fiji, Palau, Samoa, and Vanuatu would be hurt through a fall in tourism, which accounts for between 20 percent and 50 percent of GDP (Figure 11), with spillovers to the broader economy through reduced tourism-related FDI. Remittances would be one of the main channels of contagion in Samoa, Tonga, and Tuvalu, and to a lesser extent in Fiji, Kiribati, Marshall Islands, and Micronesia. Indeed, tourist arrivals and remittances declined during the 2008–09 crisis (Figure 12 panel chart).

  • Terms of trade. Worsening terms of trade would hurt the trade position in Papua New Guinea and Solomon Islands. However, the negative impact could be mitigated by rises in the price of gold—a metal that both economies increasingly export—if it is perceived as a safe haven. Among the commodity importers, the decline in food and fuel prices could provide some relief to household budgets, mitigating the negative impact on growth.

  • Financial channels. A fall in stock prices in the advanced economies would also affect PICs with large trust funds whose assets are invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu). A large decline in the value of these trust funds, as occurred during 2008–09, could worsen fiscal sustainability over the medium and long term in Kiribati, Marshall Islands, Micronesia, and Palau.

  • Aid. Aid flows (averaging 20 percent of GDP, Figure 13) are expected to hold up well, in line with the experience during previous crisis. The planned increase in the official development assistance (ODA) of Australia and New Zealand over the next few years would continue to support growth in the Pacific island economies.

Figure 11.
Figure 11.

PICs: Tourism and Remittances

(In percent of GDP, 2010)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities; and IMF staff calculations.
Figure 12.
Figure 12.

Pacific Island Countries—Channels of Spillover: Stylized Facts

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Figure 13.
Figure 13.

PICs: Grants

(In percent of GDP, 2011)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities and IMF staff calculations.

IV. Assessing Growth Spillovers

A. Stylized Facts

Understanding growth spillovers from the region is key to assessing how external shocks from the global economy would affect PICs. Stylized facts suggest that direct exposure to Europe is limited. The impact of a global slowdown on PICs would occur through spillovers from regional economies and to a lesser extent from the United States.

Linkages with Australia and New Zealand are strong and well established. This owes to PICs’ strong exposure to these economies through trade, tourism, remittances, FDI, aid, and financial channels. Trade with Australia and New Zealand accounts, on average, for one-third of PICs’ trade, while remittances from Australia and New Zealand account for about 60 percent of total remittances in Fiji and Samoa (Figure 14). Tourist arrivals from Australia and New Zealand represent 60–70 percent of total arrivals in Fiji, Vanuatu, and Samoa (Figure 15). The PICs’ financial sector is dominated by Australian banks (as discussed later in session III). Australia is by far the largest provider of aid. Among OECD countries is also the largest foreign investor (Figures 16 and 17).

Figure 14.
Figure 14.

PICs: Remittances by Country of Origin

(In percent of total remittances)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities; and IMF staff calculations.
Figure 15.
Figure 15.

PICs: Tourists by Country of Residence

(In percent of total arrivals)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities; and IMF staff calculations.
Figure 16.
Figure 16.

PICs: FDI by OECD countries

(In percent of total FDI, 2005-2010 average)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: OECD.1 Excludes Norway and Denmark.
Figure 17:
Figure 17:

Official Development Aid

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

The United States has a large impact on some PICs. These include in particular the islands that have signed the Compact Agreement with the United States (Marshall Islands, Micronesia and Palau). The aid from the United States represents over 65 percent of total aid in Palau and 90 percent of total aid in the Marshall Islands and Micronesia. Remittances from the United States account for 50 percent of total remittances in Tonga.

Linkages between PICs and emerging Asia have grown over the last decade. Direction of trade data points to a large increase in China’s share of PICs’ trade (Figure 18). Trade with China has increased 7 times on average for PICs since early 2000s, with China becoming the first trading partner for Solomon Islands. External financing from China has become substantial for Tonga (Figure 19). Similarly, FDI patterns have become more diverse, with the share of inward FDI from China and other East Asian trading partners, notably Korea, growing at the expense of traditional investors (Japan). (Figure 20)

Figure 18.
Figure 18.
Figure 18.
Figure 18.

Pacific Island Countries: Direction of Trade

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country authorities and IMF staff calculations.
Figure 19.
Figure 19.

Tonga: Loan Disbursements from China

(In percent of GDP)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: Country authorities.
Figure 20.
Figure 20.

PICs: FDI by Country of Origin1

(In percent of total FDI)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: OECD and UNCTAD.1 Includes Australia, China, Korea, Japan, France, Germany, Italy, Luxemburg, Netherlands, New Zealand, Sweden, United Kingdom, and United States.

B. Econometric Analysis

Can the growth impulse from still-fast-growing neighbors spill over to PICs in the form of tailwinds to the recovery process or buffers during a downward scenario? A simple correlation analysis between real GDP growth rates of Australia, New Zealand, and emerging Asia suggests an increasing co-movement between PICs’ business cycle and its regional neighbors over the last two decades, with the correlation increasing over the last 10 years (Figure 21). The econometric analysis investigates further the relevance of these potential growth spillovers from the global and regional economies.

Figure 21.
Figure 21.

Pacific Island Countries: Correlation of GDP Growth with Neighbors

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

(1) Baseline scenario

We use a Vector Error Correction Model (VECM) for each PIC to gauge the impact of global and regional growth spillovers on individual PICs. We use annual data from the late 1970s through 2011.4 The analysis examines both short- and long-term dynamics using historical data. We use a cointegration technique to identify the long-run relationship between GDP in PICs and GDP of the main trading partners, using variables expressed in levels.5 We use that long-run relationship to build a structural model that captures both long-run and short-run dynamics which is then employed for scenario analysis. Focusing on individual PICs—rather than treating them as a homogenous group—allows us to shed light on spillovers specific to each PIC. The econometric results are summarized below with technical details in the Appendix.

Our main findings can be summarized as follows:

  • Using a sub-sample analysis, the PICs appear to be more integrated with regional economies (Australia, New Zealand, and emerging Asia) than they were twenty years ago. This suggests an increase in growth spillovers from the region.

  • Australia is by far the main source of direct and indirect spillovers, both in the short and long term, with the exception of the Compact countries (Marshall Islands, Micronesia, and Palau). Australia sometimes has an indirect impact on the PICs through New Zealand. Direct spillovers from New Zealand are also highly relevant for several PICs.

  • Over the last decade, shocks from emerging Asia have had a greater impact than in the past on PICs’ business cycle (i.e., the short term). This suggests that the role of emerging Asia in explaining output in the PICs has increased while that of more traditional partners, such as Japan, has declined.

  • In the short run, the elasticity of output with respect to regional partners is at times higher than one, suggesting a larger scope for policies to stabilize the business cycle.

  • In the short term, the main channel of spillovers is commodity prices, consistent with the analysis presented in the previous section. The adverse oil shock scenario shows a larger and more negative impact on growth than the global demand shock scenario confirming that PICs are very vulnerable to commodity price shocks.

(2) Downside scenarios

We simulate the impact on PICs’ growth of two external downside scenarios. These scenarios are consistent with two global scenarios developed using the IMF Global Economy Model (GEM) and presented in the April 2012 World Economic Outlook (WEO).6 Using the econometric models discussed above, we estimate the spillovers to individual PICs from global and regional economies.

The first downside global scenario from the WEO assumes that financial turmoil in the euro area intensifies. This scenario implies that global growth will fall short of WEO baseline projections by about 1½ percentage points in 2012 and 2013, with euro area growth rate declining by 2.5 percentage points in 2012 and a further decline of 1.1 percentage points in 2013. The direct spillovers from stress in the euro area to the PICs will be limited. The slowdown in global growth would spill over to the PICs within the same year through its regional partners and the United States.7 For the commodity importers, the decline in GDP growth is estimated, on average, at a little over ½ percentage point each year, compared with the baseline. For the PIC commodity exporters, the impact on growth would be much larger, declining by almost 1 percentage point in each year of the shock. The milder impact on commodity importers depends on the fact that oil prices would decline under this scenario as a result of lower global growth. (Figure 22a-b, 23, 24, 25).

Figure 22a.
Figure 22a.

PICs: Change in Growth in a Downward Growth Scenario from Financial Turmoil in the Euro Area

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.
Figure 22b.
Figure 22b.

PICs: Change in Growth in the Oil-Price-Shock Scenario

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff calculations.
Figure 23.
Figure 23.

PICs: Real GDP Growth Under Different Scenarios

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff estimates.
Figure 24.
Figure 24.

PICs: Real GDP Growth for Commodity Importers

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff estimates.
Figure 25.
Figure 25.

PICs: Real GDP Growth for Commodity Exporters

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Source: IMF staff estimates.

The impact on PICs’ growth from an adverse oil shock scenario—the second scenario—would be substantial. This second scenario assumes a negative oil-price shock triggered by geopolitical uncertainty in the Middle East that would raise the real oil price by 50 percent, relative to the baseline, for at least two years. Global output growth would thus be lower than the WEO projection by about ½ percentage point in 2012 and a little more than 1 percentage point in 20138. Simulations using the VECM model suggest that negative spillovers spurred by higher oil prices will reduce all PICs growth rates in both years, except for the commodity-exporter Papua New Guinea whose terms of trade would improve. 9 The decline would average about 1½ percentage points of GDP for commodity importers—where the baseline trend growth is already low, at about 2 percent. On average, this impact on PICs’ growth would be larger than in the previous scenario (where the financial turmoil in the euro area intensifies). In part, the PICs’ greater sensitivity to global oil and commodity prices reflects the large weight of fuel and food in the consumer price index basket and the relatively larger share of imported items in consumption and investment, owing to their smaller domestic manufacturing base. It also reflects the fact that PICs would have to cope with higher oil prices amid slower growth among their trading partners.

V. Assessing Spillovers to the Financial Sector10

A. Stylized Facts

The financial sector in the PICs is also closely integrated with regional economies. It consists mainly of foreign-owned banks—primarily Australian—and large provident and/or trust funds. A Papua New Guinea (PNG) domestic bank—Bank of the South Pacific—has branches in Fiji and in the Solomon Islands. Foreign-owned banks are equally split between branches or subsidiaries (Table 1). These banks have been profitable and proved resilient to the global financial crisis. Reflecting their asset allocation mix and large exposure to global financial markets, the provident and trust funds did not cope as well with the crisis.

Table 1:

Commercial Banks in Pacific Island Countries 1/

article image

Subsidiaries highlighted in blue.

Insured under the Federal Deposit Insurance Corporation (FDIC) scheme.

The size of the banking sector varies across PICs. Not surprisingly, total bank assets (in U.S. dollar terms) are greatest in the largest economies, although not as a percent of GDP. Relative to GDP, the size of the banking system is broadly in line with Asian low-income countries. Reflecting the small size of their economies, the banking sector consists generally of a small number of commercial banks, or just one bank, as in Kiribati and Tuvalu. (Figure 26 and 27)

Figure 26.
Figure 26.

Total Assets

(In billions USD; 2010)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Figure 27.
Figure 27.

Total Assets

(In percent of GDP; 2010)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Note: the National Bank of Tuvalu performs some monetary functions, including the holding of government accounts and foreign assets.

The banks are well capitalized, with high total capital and Tier 1 capital adequacy ratios. This provides a buffer against financial shocks (Figures 28 and 29). Reflecting the vulnerability of PICs to shocks, in many cases the authorities have opted for a capital requirement ratio in excess of the Basel II minimum requirements. Furthermore, several banks exceed the required minimum ratio, which varies widely across the islands.

Figure 28.
Figure 28.

Total Capital Ratio

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Figure 29.
Figure 29.

Tier-1 Capital Ratio

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

As banks rely largely on domestic deposits for funding, the funding structure provides an additional buffer against turmoil in international financial markets. The lower ratios in Papua New Guinea and Solomon Islands reflect the large excess liquidity these countries have faced since the global financial crisis. Given the large bank capitalization, high loan to deposit ratios do not necessarily imply reliance on wholesale funding. These ratios have been largely stable in recent years, with the exception of Tonga and Solomon Islands, where banks have improved their funding profiles since 2008 by increasing their reliance on deposits. (Figures 30 and 31)

Figure 30.
Figure 30.

Loan to deposit ratio

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country Authorities; and IMF staff estimates.
Figure 31.
Figure 31.

Loan to deposit ratio

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country Authorities; and IMF staff estimates.

The quality of loans in PICs appears to be relatively good, with some variation reflecting country-specific circumstances, including collateral laws.11 The ratio of loan-loss provisioning to total loans—a proxy for loan quality—suggests a deterioration of this ratio in 2009 followed by an improvement across almost all PICs. (Figure 32)

Figure 32.
Figure 32.

PICs: Provision Expense to Gross Loans

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: Country Authorities; and IMF staff estimates.

Provident and Trust Funds

A more direct effect of a global economic slowdown will occur through the impact on the PICs’ provident and trust funds. These funds are large both relative to GDP (Table 3) and to the size of the domestic banking system. In some cases, the objective of the funds is to provide retirement benefits, while in others it is to finance budget deficits. The experience during the global crisis highlights the vulnerability of these funds, as demonstrated by the negative returns on investment exceeding 20 percent for the compact trust funds of Micronesia and Marshall Islands (Table 4).

Table 2.

Pacific Island Countries: Selected Sovereign Funds

article image
Sources: Annual Reports and authors’ estimates.
Table 3.

Pacific Island Countries: Rates of Return on Sovereign Fund Assets

(In percent)

article image
CSPP = Civil Service Pension Plan, FSM = Federated States of Micronesia, RMI = Republic of the Marshall Islands.Sources: Annual Reports.
Table 4.

Interest and Non-interest Income in Pacific Island Countries and Selected Regional Comparators

article image
Sources: Central Bank data; IMF, Financial Soundness Indicators database; and staff estimates.

The domestic versus foreign investment split of asset portfolios differs considerably across PICs (Figure 33). For example, all of the assets of Timor-Leste are invested overseas compared with just 5 percent in the case of Fiji. The different split has different implications for the vulnerability of the funds to external shocks.

Figure 33.
Figure 33.
Figure 33.

Pacific Island Countries: Trust and Provident Fund Investments

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

B. Spillovers from a Downside Scenario

While banks in PICs seem somewhat sheltered from shocks through their ownership and funding structures, the financial system remains subject to potential spillovers from a worsening global economy. Financial stress could occur through a fall in stock prices that could affect PICs with large provident and trust funds whose assets are invested off-shore (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu). Lower GDP growth attributable to a fall in remittances and tourism receipts would weaken the quality of loans and reduce banks’ profitability, which in turn would affect banks’ liquidity. Non-interest income, owing largely to foreign exchange activities, plays a key role in determining bank profitability in the region and is higher than in other regional comparators (Table 4).12 Thus, a slowdown in tourism and remittances will put downward pressure on profits. Banks may attempt to make up for this lost revenue through higher interest rates, which could further stifle credit growth.

A prolonged slowdown in credit growth would hinder private-sector development and lower prospects for inclusive growth. Both demand and supply factors are likely to lead to lower credit growth: tighter credit standards, as occurred after the global financial crisis, will likely follow heightened global uncertainty and turmoil in global financial markets; and lower economic growth coupled with potentially higher interest rates will reduce demand for credit. During 2008–09, credit growth fell across all PICs, with commodity exporters experiencing the largest decline, although from a high base. Since then, credit growth has remained anemic, with some mild signs of pick up in commodity exporters, but it has not yet recovered in commodity importers.13 (Figures 34 and 35)

Figure 34.
Figure 34.

Credit to Private Sector

(In percent of GDP)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Figure 35.
Figure 35.

Credit to Private Sector

(In percent, year-on-year change)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

The deleveraging of European banks could trigger a funding shock to Australian banks given their relatively high reliance on wholesale funding, but this risk is limited. Australian banks have been highly resilient to the global crisis, mainly because of sound regulation and supervision. The government’s Guarantee Scheme for Large Deposits and Wholesale Funding for banks, introduced in late 2008 also helped maintain access to funding, as did the swap arrangement between the Reserve Bank of Australia and the U.S. Federal Reserve. Indeed, a recent IMF study (Jauregui and Schule, 2012) suggests that Australia is better placed to cope with shocks from the deterioration of the global outlook than any other country because of its large policy space and flexible exchange rate.

Our analysis suggests that the ratio of provisions to loans would increase by nearly 1 percent in the event of a downside scenario (Figure 36). To estimate the impact of negative spillovers on PIC banks from a global slowdown, we use the growth results generated by the previous VECM analysis for the PICs and previous IMF analysis (Jauregui and Schule) to gauge the impact of the deterioration of the global outlook on Australia.14 We then estimate the impact of the slowdown on banks’ provisioning. Indeed, simple econometric analysis suggests that the ratio of provisions to loans in PICs is linked to both the Australian and domestic business cycle, with all coefficients significant and with the expected sign.

Figure 36.
Figure 36.

PICs: Impact of a Downward Scenario on the Financial Sector: Ratio of Provisions to Loans

(In percent)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

VI. What Role for Policies? Rebuilding Policy Buffers and Implementing Structural Reforms

The policy response to a downward economic scenario would vary across PICs depending on their policy space. Fiscal space is limited in PICs with high public debt, which narrows the scope for countercyclical policies in Marshall Islands, Fiji, Tuvalu and Tonga (Figure 37). In some countries with large trust funds, fiscal rules that prevent additional draw-downs to finance budget deficits in the face of a crisis could lead to procyclical policies. Papua New Guinea and Vanuatu still have some fiscal space. And several islands have accumulated comfortable levels of foreign exchange reserves (Fiji, Papua New Guinea, Tonga, and Vanuatu), which could provide a temporary cushion. Greater exchange rate flexibility would be warranted in economies with relatively weak monetary transmission mechanisms. This is also the case in Papua New Guinea, where the exchange rate channel of monetary policy continues to be effective, but excess liquidity is currently weakening interest rates and credit channels. In Vanuatu, lower-than-anticipated inflation could allow a pause in monetary tightening.

Figure 37.
Figure 37.

PICs: Public Debt, 2010

(In percent of GDP)

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

To strengthen their resilience to shocks, PICs will need to step up the rebuilding of policy buffers (Figure 38). Most PICs have made progress on this front after the crisis, especially with regard to reserves. However, more than half of the PICs emerged from the 2008–09 crisis with somewhat less comfortable fiscal buffers (higher debt and larger fiscal deficits) than before the crisis. Implementing growth-oriented structural reforms would help boost investor confidence and ensure sustainable and inclusive growth. Focusing on the quality of spending, for example, on education and infrastructure, could be key in lifting long-term growth potential. While rebuilding policy buffers, additional assistance from donors would also provide countercyclical support in several islands.

Figure 38.
Figure 38.

Pacific Islands: Rebuilding Policy Buffers

Citation: IMF Working Papers 2012, 154; 10.5089/9781475504491.001.A001

Sources: IMF, WEO database; staff estimates.
Global and Regional Spillovers to Pacific Island Countries
Author: Mr. Yiqun Wu, Ms. Patrizia Tumbarello, and Niamh Sheridan