Recent Economic Developments

This paper describes economic developments in Vanuatu during the 1990s. In 1993, real GDP growth rebounded to 4½ percent. Agricultural output recovered from the effects of the 1992 cyclones, and construction activities picked up on account of cyclone rehabilitation and a new stadium. Reflecting increased import demand associated with these activities, as well as substantially lower export prices and weak tourism receipts, the external current account registered a deficit equivalent to 6 percent of GDP. Inflation slowed to less than 2 percent in line with the trend in import prices.


This paper describes economic developments in Vanuatu during the 1990s. In 1993, real GDP growth rebounded to 4½ percent. Agricultural output recovered from the effects of the 1992 cyclones, and construction activities picked up on account of cyclone rehabilitation and a new stadium. Reflecting increased import demand associated with these activities, as well as substantially lower export prices and weak tourism receipts, the external current account registered a deficit equivalent to 6 percent of GDP. Inflation slowed to less than 2 percent in line with the trend in import prices.

I. Recent Economic Developments 1/

In 1993, real GDP growth rebounded to 4 1/2 percent. Agricultural output recovered from the effects of the 1992 cyclones, and construction activities picked up on account of cyclone rehabilitation and a new stadium. Reflecting increased import demand associated with these activities, as well as substantially lower export prices and weak tourism receipts, the external current account registered a deficit equivalent to 6 percent of GDP. Inflation slowed to less than 2 percent in line with the trend in import prices. On the fiscal side, a current expenditure overrun and a small shortfall in nontax revenue collection resulted in a slippage from a balanced budgetary target, and the overall deficit remained at 2 1/2 percent of GDP. A drawdown of government deposits to finance this deficit and smaller private outflows (reflecting a return in confidence following the elections in 1991) accommodated a resurgence in broad money growth–even though private sector credit stagnated. The strengthening of the capital account more than offset the deterioration in the current account, allowing a small gain in gross international reserves.

In 1994, GDP growth is estimated to have slowed to 2 percent. A severe drought adversely affected agricultural output, and a prolonged civil service strike reduced domestic demand and eroded private sector confidence; however, their effects were partly offset by sharply rising international copra prices that permitted the maintenance of high procurement prices and rural incomes. Budgetary savings generated by the strike, the elimination of subsidies to copra producers, and higher-than-budgeted customs revenue collection led to a small fiscal surplus despite substantial supplementary budgetary appropriations. The external current account deficit narrowed to 5 percent of GDP, reflecting the improved fiscal position and higher export earnings, and gross official reserves continued to increase. The fixed exchange rate helped contain inflation close to that of Vanuatu’s trading partners, at about 3 1/2 percent.

1. Aggregate supply and demand 2/

The Vanuatu economy, like other island economies in the South Pacific, is dependent predominantly on agriculture and a relatively large services sector--in particular, tourism and banking. Agriculture accounts for 20 percent of output, 80 percent of ni-Vanuatu (indigenous) employment, and most of the commodity export receipts, while tourism contributes close to 45 percent of total foreign exchange earnings. 3/ The Vanuatu economy, however, has been frequently set back by its vulnerability to extreme weather and other external shocks. In addition, isolation from the major markets and the small size of the domestic market have hampered economic development.

Real economic growth rate in 1993 is estimated at 4 1/2 percent, led by a strong recovery in agriculture from the impact of the previous year’s cyclones (Appendix Tables 1 and 2). Agricultural production grew by 7 1/2 percent, reflecting increased production of copra, beef, and nontraditional exports, including squash pumpkin and kava (Appendix Table 3). Industrial production--accounting for some 15 percent of GDP 1/--increased by 3 1/2 percent, led by cyclone rehabilitation activities and the construction of a new stadium for the South Pacific Mini Games held late in the year (Appendix Tables 4-6). 2/ The services sector, which comprises two thirds of GDP, also benefited from the Mini Games and expanded by 3 3/4 percent with relatively strong growth in tourism and banking subsectors (Appendix Table 7).

On the demand side, expenditures by the central government had, in the past, accounted for more than one half of GDP, with much of the public investment financed by foreign grants and concessional loans. 3/ As major donors began to reduce assistance to Vanuatu, public investment declined steadily in the early 1990s with a matching decline in imports of capital goods. Nonetheless, it would appear that the demand by the government sector continued to be significant. In 1993, however, private activities also contributed strongly to domestic demand.

Preliminary data indicate that GDP growth in 1994 slowed to about 2 percent, reflecting a decline in agricultural production and the negative impact of the prolonged civil servants’ strike on demand. In particular, the production of cocoa and coffee was adversely affected by a severe drought early in the year. Tourism stagnated in the first half of 1994 but increased in the second half in line with the economic recovery of the region.

2. Employment, wages, and prices

a. Employment and wages

The economically active population is estimated at 75,000 or 50 percent of ni-Vanuatu population, with the majority engaged in subsistence agriculture. In the formal sector, the total number of paid employees registered with the Vanuatu National Provident Fund (VNPF) in 1993 was about 28,000 (Appendix Table 8). The Government is the largest employer; within the private sector, subsectors with large employment include retail trade, manufacturing, hotels and restaurants, banking and financial institutions, and telecommunications. Localization of employment is an important policy, and work permits for expatriates can be issued only if a ni-Vanuatu with required skills cannot be found. There are four major labor unions that form the new Vanuatu National Committee of Unions (VNCU), with total membership of about 4,500. 4/

Although private sector wages are freely determined, the labor market appears to be characterized by considerable rigidity. Employment of unskilled labor appears to have been discouraged by the high level of statutory minimum wages and employment legislation restricting the dismissal of workers once confirmed, while high-paying urban jobs encouraged migration from the rural areas; consequently, open unemployment is estimated to have risen. This suggests that the current minimum urban wage exceeds the market-clearing level. 1/ Based on available but incomplete data, the average nominal wage of ni-Vanuatu employees has remained broadly unchanged since 1989, and any increase in employment since 1992 has been at the level close to the minimum wage. In 1993, about 50 percent of ni-Vanuatu employees earned the minimum wage or only slightly more (Chart 1). The Minimum Wage Board’s proposal to increase the minimum wage by a further 50 percent for urban workers and 40 percent for rural workers, to become effective in early 1995, is currently under consideration. As for civil servants’ wages, settlements at end-1993 provided for a 15 percent cumulative pay raise in three tranches covering 1994-95. 2/

Source: Data provided by the Vanuatu authorities; and staff estimates.1/ Including self-employment.

b. Prices

Retail prices are largely market-determined and depend heavily on import prices, which represent some 60 percent of the consumer price index (CPI); other factors influencing price developments are adjustments of import tariffs, utility charges, and other policies affecting costs. During 1990-92, the CPI averaged some 5 percent, broadly reflecting a stable nominal effective exchange rate, slowing inflation of Vanuatu’s trading partner countries, and adjustments in utility costs in 1991-92 (Appendix Table 9). However, in 1993, inflation slowed to less than 2 percent in line with the fall in petroleum prices and a modest increase in other import costs. In 1994, the CPI is estimated to have increased by about 3 1/2 percent, close to inflation rates in Vanuatu’s trading partners.

3. Fiscal developments

a. Overview 3/

After a reduction of the budget deficit to 2.5 percent of GDP in 1992, the fiscal deficit remained broadly unchanged in 1993, reflecting higher-than-anticipated current expenditures and weak revenue collections (Chart 2 and Appendix Table 10). As in previous years, the 1994 budget targeted a balanced recurrent budget with import duties as the main source of government revenue. Preliminary indications show a sizable recurrent surplus for the year, owing to net savings on the public sector wage bill and higher-than-budgeted customs duty receipts. As a result, the overall fiscal deficit for 1994 is estimated to have declined to less than 1 percent of GDP.

Sources: Data provided by the Vanuatu authorities; and staff estimates.1/ After central government transfers.

b. Developments in 1993

Despite a balanced recurrent budget target, the fiscal deficit widened in 1993 to 1.1 percent of GDP, according to the authorities’ definition of current expenditure, or equivalent to 2.6 percent of GDP, according to the Fund definition. The worsening fiscal position was largely attributed to higher-than-budgeted increases in wages and salaries and purchases of goods and services, of 4.6 percent and 2.1 percent, respectively (Appendix Table 11). 1/ The increase in current expenditure was more than sufficient to offset the fall in total development expenditure resulting from the repayment of VT 300 million of Air Vanuatu debt and a decline in transfers to the Development Fund of 14.7 percent (Appendix Table 12). 2/ The fiscal deterioration was further compounded by a shortfall in revenue collections of about VT 71 million (Appendix Table 13). Although tax revenue receipts were broadly in line with the original budget target, nontax revenues fell short by VT 66 million, owing to the failure of the Urban Lands Department to implement revised rents in Port Vila and Luganville and to raise significant revenue from the one-time sale of deportees’ properties. The resulting budget deficit was financed through foreign borrowing and a drawdown of deposits with the Reserve Bank.

c. Budget for 1994

The 1994 budget reaffirmed the authorities’ policy of a balanced recurrent budget. Although the tax base was broadened with the introduction of a 4 percent gross turnover tax on some sectors in place of a flat business license fee, import duties continued to constitute the main source of fiscal revenues, accounting for 50 percent of total revenue and over 60 percent of tax revenue. The 1994 budget targeted an increase in import duties of 15.7 percent from the previous year, in line with the expected rise in imports and continued tightening of import duty exemptions. Nontax revenues, however, were budgeted to decline to 5 percent of GDP, partly reflecting the decline in interest receipts from Air Vanuatu and the Development Bank of Vanuatu. On the expenditure side, a 5 percent general wage increase was to be granted effective January 1, 1994, bringing the share of the wage bill to approximately 60 percent of current expenditure. 3/ The wage increase was to be accommodated by departmental efficiency savings and a concurrent reduction in the size of the civil service by 200 positions (about 10 percent of the civil service excluding teachers, doctors, nurses, the police force, and the Vanuatu Military Force). In accordance with Government priority given to the provision of education and health services, the 1994 budget allocated additional resources, amounting to VT 159 million, to satisfy those concerns.

Preliminary estimates by the authorities indicate a VT 200-250 million recurrent budget surplus for 1994, in spite of two supplementary appropriations totalling VT 400 million. 1/ The expected favorable outcome stems from two main factors: (i) net savings on the wage bill of around VT 200-300 million as a direct result of the civil service strike that began in November 1993 and ended only in August 1994; 2/ and (ii) buoyant customs duty collections, projected to exceed the budgeted level by nearly VT 200 million.

d. Vanuatu Commodities Marketing Board

The Vanuatu Commodities Marketing Board’s (VCMB) operating deficit increased significantly in 1993 to VT 304 million, as large copra trading losses were incurred when world copra prices fell sharply, but domestic copra procurement prices were maintained (Appendix Table 14). By September 1993, VCMB arrears to local producers reached VT 40 million. The operating losses were financed in part by a loan from the Government of VT 120 million, repayable on demand and interest free, and through overdraft facilities with the Reserve Bank. 3/ In addition, STABEX receipts, which had been frozen since 1988 pending reforms of the VCMB, were released in December 1993 in the amount of VT 100 million. 4/

In 1994, however, the financial situation of the VCMB improved markedly with an operating surplus of VT 6 million. The positive outcome was due to a number of factors, including a major streamlining of operations that resulted in a substantial reduction of costs, increased diversification of markets to more profitable Asian destinations, negotiations to lower domestic and international freight charges, 5/ and an increase in world copra prices beginning the second quarter of 1994. In particular, the rise in world copra prices during the second half of the year more than offset the losses incurred during the first quarter. Domestic procurement prices per metric ton for copra, VT 25,000 for the hot-air dried and VT 20,000 for the smoked varieties, had not been adjusted since mid-1992.

4. Monetary developments 1/

a. Developments in money and credit

Reserve money grew sharply during 1993 and the first three quarters of 1994, with about two thirds of the growth originating from the foreign sector and the remainder from increased net credit to the Government and public enterprises (Appendix Table 15). Such rapid growth was accompanied by less-than-proportionate expansion in bank credit and domestic liquidity, and commercial bank’s excess balances increased overall (Chart 3 and Appendix Tables 16-17). Commercial bank deposits at the Reserve Bank at end-September 1994 were more than double the level at end-1992 and were close to 24 percent of banks’ vatu deposit liabilities, compared with the reserve requirement of 10 percent. 2/ 3/

Sources: Data provided by the Vanuatu authorities; and staff estimates.1/ Ratio of total liquidity to reserve money.2/ Ratio of vatu liquidity to reserve money.

In 1993, total liquidity grew by 10 percent, reflecting mainly a resurgence in foreign currency deposits matched by an increase in net foreign assets of the banking system. As in the past, banks maintained a broadly balanced foreign exchange position (Appendix Table 18). Domestic credit expansion was mostly in the form of a drawdown of government deposits, consistent with the worsening of the fiscal position, whereas private sector credit stagnated after a significant increase in the previous year, mirroring the end of cyclone-related construction. These developments were partially reversed in the first three quarters of 1994, when foreign currency deposits contracted, resulting in a 3 percent fall in total liquidity even though vatu liquidity continued to expand. The decline in foreign currency deposits can be attributed to the lag with which domestic interest rates adjust to rising international rates, the civil servants’ strike that eroded private sector confidence, and capital outflows by investors in search of opportunities abroad. Notwithstanding a relative fall in the share of foreign currency deposits in recent years, such deposits still accounted for 65 percent of total bank deposits or over 60 percent of total liquidity at end-September 1994. Reflecting an improved fiscal position, net credit to the Government was broadly unchanged in the first three quarters of 1994. Private sector credit rebounded, reflecting buoyant housing and land purchases facilitated in part by the ongoing reforms in the land tenure system. Commercial bank credit for personal loans, which included housing and land purchases, and credit for construction activities increased substantially (Chart 4 and Appendix Table 19). Lending to the agricultural and manufacturing sectors picked up as well, but it still accounted for a small proportion of total commercial bank loans. Credit approved by the Development Bank of Vanuatu also expanded significantly, as the Bank made extensive use of an umbrella loan from the Asian Development Bank (Appendix Table 20).


(In percent of total credit)

Source: Data provided by the Vanuatu authorities.1/ Including housing and land purchases.2/ Productive sector comprises agriculture and fisheries, mining and manufacturing, construction, transportation, and tourism.

b. Interest rates 1/

Domestic interest rates changed little in 1993 and in the first half of 1994. The interbank rate remained at 6 percent, reflecting inactivity in the interbank market despite a shortage of liquidity in the government-owned bank and excess balances in the foreign-owned banks. While deposit rates in Australia and the United States rose, domestic rates on both foreign currency and vatu deposits remained largely stable. The average deposit rate, however, increased slightly reflecting a shift of deposits to longer maturities earning higher interest rates. Similarly, the fluctuation in the average lending rate reflected shifts in the pattern of lending, as there had been no changes in the lending charges. During 1993-94, the average lending rate remained within the range of 13 1/2 and 14 1/2 percent, and the margin above the Australian prime lending rate widened from 3 1/4 percentage points at end-1992 to 5 percentage points at end-June 1994. The spread between average deposit and lending rates remained high, ranging between 7 1/2 and 9 1/2 percent.

c. Offshore Finance Center

The Offshore Finance Center, established in 1971, comprises banks, insurance companies, trust companies, shipping companies, and accounting and law firms. “Exempt” companies registered with the Center are prohibited from domestic activities (except those necessary to support their offshore activities); although they are required to file financial reports annually, they are guaranteed confidentiality concerning their business activities. They pay annual registration and other fees but are exempted from business turnover taxes. The International Companies Act, effective May 1993, was designed to enhance Vanuatu’s attractiveness as an offshore center. The Act expedites the procedure for the incorporation of new international companies, 2/ lowers the start-up fees, removes stamp duty requirements, and streamlines the annual renewal registration process. Furthermore, international companies are not required to report financial accounts, although they are required to remain solvent. Following the introduction of this Act, about 400 “exempt” companies switched to “international company” status. At end-June 1994, the respective numbers of “exempt” and “international” companies totaled approximately 600 and 400. 3/ As a further step to streamline the administrative procedure related to the Offshore Center, as well as to initiate the process for its supervision, the Financial Services Commission Act (December 1993) established the FSC as a statutory body responsible for registering and overseeing the activities of offshore financial institutions. Unlike the Registrar’s Office, the agency within the Ministry of Finance which the FSC replaced, the FSC is envisaged to have financial and political autonomy. However, with the exception of international companies, company licenses continue to be granted by the Minister of Finance, following the FSC’s recommendations.

Vanuatu is a member of the Offshore Group of Banking Supervisors. 1/ Its continued membership status, to be reviewed in late 1995, will depend on Vanuatu’s progress toward applying the Basle Committee on Banking Supervision’s recommended minimum standards on banking supervision, including in particular the implementation of the 1990 Report of the Financial Action Task Force on countering money laundering. 2/ Consistent with the report, a rule was introduced in Vanuatu in 1994 requiring domestic banks to seek positive identification of customers and sources for their deposits; however, the requirement has not yet been applied to offshore banks. Legislation is still pending that will grant the newly formed FSC the necessary supervisory powers, which will entail the authorization of new offshore banks, the ongoing supervision of existing banks, and the exchange of information with other supervisory authorities.

5. External sector developments

Vanuatu’s trade deficit has been substantial, with merchandise exports and imports accounting for some 10 percent and 45 percent of GDP, respectively. Nonetheless, a large surplus on the services and transfers accounts had permitted the current account to be in surplus. In 1993, however, the current account turned into a deficit (6 percent of GDP) for the first time in six years, reflecting increased import demand, a sharp decline in international copra prices, and weakening tourism receipts (Appendix Table 21). The overall balance maintained a surplus, with the current account deficit offset by long-term public borrowing (mostly concessional) and foreign direct investment (mostly reinvested earnings), allowing a small gain in gross international reserves. 3/

a. Exports, imports, and direction of trade

After a substantial increase in 1992, domestic exports in 1993 declined by some 2 percent in U.S. dollar terms reflecting, in large part, a sharp drop in the international price of copra (Appendix Table 22). The poor performance of copra exports was partly offset by rapid growth in exports of beef and timber. In 1994, domestic exports are estimated to have expanded by 11 percent, benefiting from a rapid rebound in copra prices even though cocoa exports declined because of the drought. Following a significant contraction in 1991 in line with the completion of major development projects, imports of capital goods and construction materials picked up once again in 1993 in association with cyclone rehabilitation activities and the construction of a new stadium (Appendix Table 23). In 1994, with the continued growth in construction activities, imports are estimated to have increased by 7 percent.

Vanuatu had traditionally exported a large share of its commodities to the European Union (EU), facilitated by long-term arrangements for the sale of copra. Diversification of agricultural production and export markets has reduced this share, from 56 percent in 1990 to 32 percent in 1993 (Appendix Table 24). Japan has been the primary destination for exports of beef and squash, followed by Australia and New Caledonia; and an increasing portion of copra has been destined for Bangladesh. Merchandise imports are mainly from the Pacific region, with Australia accounting for some 40 percent, followed by France, New Zealand, and Japan. 1/

b. Invisibles

Vanuatu’s foreign exchange receipts are dominated by services--tourism and interest income--and official transfers, together accounting for 85 percent of the total. In 1993, net services receipts declined further, reflecting falling tourism receipts and interest income of the Reserve Bank of Vanuatu, higher payments for freight and insurance in line with increased imports, and higher investment income payments to foreign-owned enterprises (Appendix Table 25). Net official transfers, including capital in cash, in kind, and technical assistance, increased by 5 percent (Appendix Table 26).

c. Capital account and international reserves

In 1993, the long-term capital account surplus rose by 6 percent, reflecting higher foreign direct investment (Appendix Table 27). As a result, the basic balance remained positive, offsetting the deterioration in the current account. Although public debt in terms of GDP increased during 1990-93, its concessional terms have helped maintain the debt-service ratio at a low level, 1.9 percent in 1993 (Appendix Table 28). 2/ The major sources of finance included the Asian Development Bank, the International Development Association, and bilateral institutions. Gross international reserves increased slightly and were maintained at eight months of imports at end-1993.

II. Tax Structure and Policy

1. Overview of tax structure

There is virtually no direct taxation in Vanuatu in that no personal income tax, corporate tax, or capital gains tax are imposed (Annex I). Government revenue is derived primarily through indirect taxation, with customs duties accounting for over 60 percent of tax revenue and close to 50 percent of total revenue (Appendix Table 13). The remaining fiscal revenues are raised through business license fees, company registration fees, work permit fees, rental taxes, stamp duties, airport and wharfage taxes, a 10 percent sales tax on all hotel and restaurant charges, and other nontax revenues including fines and fees. From 1989 to 1993, total tax revenue averaged 19 percent of GDP. 1/ The tax exempt status, as applied to offshore companies in Vanuatu, encouraged the establishment of the Offshore Finance Center in 1971 and has enhanced its continued development. 2/

Although Vanuatu’s fiscal position does not yet pose a threat to macroeconomic stability, its current tax system is unsustainable over the medium term because it is too narrowly based and inefficient. Vanuatu has a high population growth rate and is undergoing rapid urbanization, particularly around Port Vila and Luganville. Its increasing social and infrastructure demands have placed a heavy burden on public finances. Like many other Pacific islands, Vanuatu relies on foreign aid to finance development expenditures. However, as the flow of foreign assistance steadily declines, the need to raise additional revenues domestically becomes more urgent. Recognizing the importance of implementing fiscal reforms to broaden the tax base and lower the level of tariff protection, the Government commissioned a consultant to conduct a fundamental review of the tax system and identify possible revenue-raising measures without impinging on the continuing development of the Offshore Finance Center.

2. Development of tax policy and structure

The tax regime in Vanuatu has undergone little change since independence in 1980 (Chart 5). Many basic features of the tax system during the colonial era were retained. Tax receipts from international trade continue to dominate total fiscal revenue, although their contribution has gradually declined since 1988. The share of taxes on goods and services to total revenue remains broadly unchanged. However, business license fees, the largest component of goods and services taxes, have fluctuated considerably. Following a high of 11.8 percent of total revenue in 1987, business license fees dropped sharply in 1988 but slowly increased to 11.4 percent of total revenue in 1993, reflecting recent government policy to broaden the tax base by replacing flat fees with a turnover tax. In particular, effective January 1993, fees levied on professional services were replaced by a 4 percent tax on gross turnover. 3/ Other taxes have also risen gradually over the years, owing to increased airport and wharfage taxes. Nontax revenues remain an important source of fiscal revenues, contributing 22 percent of total revenue on average over the past 13 years.



(In percent of total revenue)

Sources: Data provided by the Vanuatu authorities, Reserve Bank of Vanuatu, Quarterly Economic Review; and staff estimates.

3. Taxes on international trade

a. Import duties and exemptions

Import duties are the main source of government revenue. Between 1989 and 1993, import duties fluctuated at about 60-70 percent of tax revenue, with ad valorem duty rates ranging from zero percent to over 100 percent on a cost, insurance, and freight (c.i.f) basis. In addition to being highly differentiated, the tariff structure is regressive with relatively higher rates imposed on basic necessities, such as food items, compared with rates on luxury goods, and on goods for which the Government has sought to encourage import substitution or discourage consumption. A 5 percent service tax is also charged, based on the value of imports c.i.f. inclusive of the duty. About one third of the tax base is exempt from duty, and the average effective tariff rate 1/ was estimated at 30 percent in 1992. This average, however, hides considerable sectoral variation. For example, the average effective rate for food is estimated at 41 percent; tobacco at 230 percent; selected household items at 23 percent; and aircraft, ships, and boats at 3 percent. Furthermore, given extensive exemptions, the average tariff burden on the remaining taxable imports 2/ was higher, estimated at 43 percent. 3/

Despite the Government’s efforts to tighten import exemptions beginning August 1993, the level of exemptions continued to be high and the average effective rate on total imports remained low, at 26 percent and 29 percent in 1993 and 1994, respectively. 4/ The small impact of these efforts reflects the continued exempt status awarded to Union Electrique du Vanuatu Limited (UNELCO) on its fuel and fuel-related imports; Telekom Vanuatu Limited; foreign aid agencies on their imported inputs for development projects; and export-oriented industries. It is estimated that revenue forgone from exemptions amounted to about VT 900 million in 1993, and between VT 600-700 million in 1994.

b. Export duties

Export duties are mainly ad valorem (f.o.b. export price), and in recent years have accounted for only about 2-3 percent of total tax revenue. 5/ Duties range from zero percent (coffee) to 15 percent (unworked shells). Of the major exports, a 4 percent duty is imposed on copra, a 2 percent duty on frozen meat, a 3 percent duty on squash pumpkins, and rates of 8-15 percent on timber exports. Copra and timber products accounted for the largest share of export duty revenues in 1993, representing 23 percent and 26 percent, respectively. In 1994, however, the share of export duties on copra is estimated to have increased to 25 percent, reflecting the rise in copra prices, while that on timber products fell to 8 percent as a result of a policy to restrict timber exports.

4. Tax reforms: recommendations of the Warren Report 1/

The purpose of the Warren Report (September 1994) was to formulate an equitable and efficient tax strategy and to propose reforms to the existing tax system in Vanuatu. The report, however, was subject to an important constraint: Vanuatu’s tax haven status, as applied to offshore companies, should not be challenged. The major recommendations of the study included: (i) a 3 percent training levy (payroll tax) to fund educational training programs; 2/ (ii) a 3 percent wages and salaries tax earmarked for education, health, and infrastructure development; (iii) a local business income tax of 3 percent on a cash flow basis, imposed on both incorporated and unincorporated businesses, in conjunction with a lowering of the threshold level of business turnover required to lodge audited returns to VT 5 million; 3/ (iv) the eventual replacement of the turnover-based component of business license fees by a 5 percent business sales tax, to be levied on a uniform base at a flat rate and not to be increased above 10 percent; (v) the simplification of the import duty schedule, with a view to eventually reducing the rates (see below); (vi) an indexation of excise duty rates for inflation and harmonization of the differential rates on close substitutes; and (vii) the elimination of all export taxes and their replacement with either low-rate withholding taxes or special environmental levies for exports of natural resources such as timber. The tax reform options were divided into three stages of implementation: those capable of immediate introduction (Phase 1), those to be implemented in the short to medium term (Phase 2), and those to be targeted in the longer term (Phase 3).

On import duties, the report recommended that the current tariff schedule be made simpler and more transparent in the short to medium term (Phases 1 and 2). In particular, in light of the high level of exemptions granted, the report advised that the Government assess the level and nature of current exemptions, and identify and quantify the magnitude of the tax concessions in annual budget documents. This would serve to highlight the fiscal cost of the tax exemptions (Phase 1). Over the medium term (Phase 2), the report proposed that the current tariff structure be simplified to a seven-rate schedule, and that the current 5 percent service tax imposed on goods subject to ad valorem duties be temporarily retained. The proposed schedule would be in line with a policy to encourage import substitution and local industry development. In addition, by imposing relatively higher rates on some luxury items, the regressivity of the duty structure would be partly addressed. Over the longer term (Phase 3), the report viewed it important that the dependence of Vanuatu on import duties as the main source of revenue be reduced, in view of the move toward a free trade zone within the Pacific region. Toward this end, it recommended the eventual abolition of the current two-tier tariff schedule, comprising the duty rate and the service tax rate, to a single-tier system. Combining the duty rate and the service tax would enhance the transparency of the tax and lay a sound basis for further reductions in the basic rate of duty.

In scaling down the importance of import duties as a major source of revenue, additional revenue-raising measures need to be in place. Toward this objective, the report recommended, as mentioned above, the introduction of a wages and salaries tax, and a local business income tax in conjunction with a business sales tax over the medium term (Phase 2). In the long term, a broader-based personal income tax, company income tax, and a value-added tax were suggested (Phase 3).

The findings of the Warren Report are under consideration by the Council of Ministers, who are to make the final decision on the adoption of each recommendation. Notwithstanding, a 4 percent turnover tax on wholesalers and retailers, in place of an annual flat business license fee of VT 50,000, has been incorporated in the 1995 budget.

III. Structure of Interest Rates and Profitability of Commercial Banks

1. Overview

The sizable spread between commercial banks’ deposit and lending rates (ranging between 7 1/2 and 10 percent in recent years) has been an ongoing concern to the Vanuatu authorities. Despite large unremunerated banks’ excess balances with the Reserve Bank of Vanuatu and falling international interest rates since 1990, bank lending rates have not declined (Chart 6). Although capital movements are unrestricted, rates offered on foreign currency deposits have at times lagged behind international rates, and rates offered on vatu deposits have fluctuated counter to movements in the international markets. The authorities feel that such a large spread may have reflected the banking sector’s oligopolistic structure. 1/



Source: Data provided by the Vanuatu authorities.1/ Weighted average rate of interest for bank loans.2/ Weighted average rate of interest on total vatu deposits.3/ Australian dollar deposit rate quoted in Vanuatu (one-month maturity).

However, an examination of the structure of interest rates and banks’ profitability, elaborated below, would seem to indicate that banks do not make excessive profits. Neither is there evidence of overt collusion among banks. Nevertheless, the lack of strong competition, owing to the small number of banks and a very narrow credit market, may have allowed banks to operate less efficiently. Notwithstanding the absence of capital control, the minimum size imposed on foreign currency accounts effectively constrains the free flow of capital, permitting banks to set vatu interest rates with little regard to international trends. These elements in turn have contributed to the high interest rate spread, constrained credit growth, and impeded productive investment. Other structural barriers--including geographic factors and the land tenure system--have also limited the private sector’s access to bank credit.

2. Structure of interest rates

a. Deposit rates

Although close to two thirds of bank deposits are in foreign currencies, most of them are placed abroad and banks maintain a broadly balanced foreign position; a minimum amount of US$5,000 is required to maintain foreign currency accounts. As for vatu deposits, commercial banks offer demand deposits, savings deposits (both can be withdrawn upon demand), and time deposits (Table 1).

Table 1.

Vanuatu: Distribution of Vatu Deposits and Interest Rates, 1990-94

(In percent)

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Sources: Reserve Bank of Vanuatu; and staff calculations.

The majority of demand deposits does not earn interest.

Average of quarterly figures, which are in turn computed as total interest paid during each quarter divided by total deposits at end-quarter.

Including noninterest-bearing demand deposits. Because of fluctuations of both deposit volumes and interest rates within each period, the relationship between the average rate of total deposits and their components is not evident.

Banks offered higher interest rates for larger deposits or deposits with longer maturities (Table 2). Besides interest rate differentials, commercial banks have not sought to mobilize longer-term deposits and there are no savings instruments for maturities longer than one year. However, the differentials appear insufficient to attract long-term deposits. At end-June 1994, only 39 percent of the total was in the form of time deposits, of which less than 11 percent was for six-months or longer maturities (Table 3). Including demand and savings deposits, less than 4 percent of total vatu deposits were of maturities of six months or longer.

Table 2.

Vanuatu: Vatu Deposit Rates and Australian Dollar Rates Locally Quoted, 1990-94

(In percent)

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Source: Reserve Bank of Vanuatu.
Table 3.

Vanuatu: Distribution of Vatu Time Deposits by Maturity, 1990-94

(In percent)

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Source: Reserve Bank of Vanuatu.

Between 1990 and late 1993, locally quoted foreign currency deposit rates declined sharply in line with corresponding rates in Australia, with discounts that may reflect the absence of direct taxation in Vanuatu. However, since late 1993, locally quoted rates have not adjusted in response to rising rates abroad, leading to a contraction of foreign currency deposits. In contrast, vatu deposit rates, which had been substantially below international rates in 1990-91, have risen slightly since, stabilizing at levels close to the three-month deposit rate in Australia. In fact, the average vatu deposit rate has approximately maintained a fixed margin below the average lending rate while remaining positive in real terms. Beginning in 1992, vatu deposit rates have exceeded locally quoted rates on Australian dollars, possibly generating a substitution of vatu for foreign currency deposits and leading to a fall of the latter’s share in total deposits (Table 4). To the extent that a more-than-proportionate share of such a switch went into 6-12 month time deposits, a distinct shift during 1992 in the term structure toward larger maturities was observed. Such a shift, in turn, resulted in an increase in the weighted-average rate on vatu deposits even during the period of falling rates for each maturity. A narrowing of rates offered to deposits of different maturities in 1993-94, however, has dampened these effects.

Table 4.

Vanuatu: Distribution of Vatu and Foreign Currency Deposits by Residents, 1990-94

(In percent)

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Sources: Reserve Bank of Vanuatu; and staff estimates.

b. Lending rates

The Reserve Bank guidelines on lending rates issued in the mid-1980s are not enforced and, in principle, commercial bank lending rates are market determined. 1/ However, the weighted-average rate for bank loans has been relatively stable, fluctuating between 13 1/2 and 14 1/2 percent during 1990-94 notwithstanding substantial fluctuations in international rates, suggesting that banks may have voluntarily followed the guidelines in order to avoid public criticism (Table 5). 2/ At the same time, banks may have maintained profitability by keeping a certain margin between lending and deposit rates, and this practice may explain both the gap between vatu deposit rates and the high international rates prior to 1992 as well as the little response of vatu deposit rates to foreign rates since then.

Table 5.

Vanuatu: Lending Rates, 1990-94

(In percent)

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Source: Reserve Bank of Vanuatu.

Average of quarterly figures, which are in turn computed as total interest received during each quarter divided by total loans outstanding at end-quarter.

In addition to explicit charges on loans, borrowers face miscellaneous fees and are required to back up their borrowing with full security. While this practice is not unique to Vanuatu, the land tenure system--until very recently--did not permit borrowers to use land as collateral for bank loans. Given the limited range of other available assets, banks have required up to 100 percent of countervailing deposits as collateral. This, in effect, precluded a large number of potential borrowers and added considerably to the cost of funds to actual borrowers. As mentioned earlier, a reform in the land tenure system, allowing the use of land as collateral, has eased access to bank credit. Furthermore, the government-owned bank has lowered the required countervailing deposits to as low as 50 percent of the loan amount, resulting in a substantial increase in its lending. Nevertheless, access to financing has remained a serious problem. Available information suggests that the scope of informal markets is limited, and that their lending charges and 100 percent countervailing deposit requirement are similar to those of banks.

As of end-September 1994, close to one fifth of bank lending to residents was denominated in foreign currencies, largely to expatriates for personal loans (Appendix Table 19). Trade credit in foreign currencies was limited. While, in principle, commercial banks charge expatriates and ni-Vanuatu customers the same interest rate and require the same collateral, it would appear mat the condition on credit guarantees implies higher overall charges on ni-Vanuatu borrowers.

c. Spread between deposit and lending rates

The spread between vatu deposit rates and rates on lending to residents has fluctuated between 8 1/4 and 10 percentage points since 1990. Although the spread seems high by international standards, it is in line with the level in neighboring countries (Table 6). Given similarly undeveloped transportation and communication infrastructures, as well as comparable geographic conditions and land tenure systems, business undertakings in these economies involve a high degree of risk. Relatively small loan sizes and preferences for short-term deposits, as well as unfamiliarity with accounting practice on the part of most ni-Vanuatu borrowers, result in high administrative expenses on the part of commercial banks. While unremunerated reserve requirements add to banks’ costs, the 10 percent ratio in Vanuatu is low compared with many other countries; however, the unusually large excess balances of banks raise these costs further.

Table 6.

Pacific Islands’ Interest Rates, 1990-93 1/

(In percentage points)

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Sources: IMF, International Financial Statistics; and the Reserve Bank of Vanuatu.

Data for Vanuatu, Fiji, and Papua New Guinea are averages; those for the remainder are some representative rates.

3. Profitability of commercial banks

It would seem that, although the interest rate spread has been high, the profitability of commercial banks in Vanuatu has not been excessive. Based on the 1992-94 data of one of the largest banks, its interest margin (defined as the ratio of the difference between total interest received and total interest paid to total assets) was moderate compared with similar ratios for developing countries for which data are available (Table 7). The discrepancy between this margin and the average interest spread for the period (about 9 percent) can be accounted for by the substantial amount of noninterest-earning assets, nonperforming loans, and the smaller spread between banks’ foreign currency assets and liabilities with nonresidents.

Table 7.

Vanuatu: Profitability of Banks Compared with Selected Countries

(In percent)

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Based on information on one of the largest banks in Vanuatu.

Comparator countries were Egypt (1986-90), Portugal (1985-89), Greece (1985-89), Morocco (1988-90), and Thailand (1986-88). Source: D. Vittas and C. Neal, Competition and Efficiency in Hungarian Banking, (World bank, 1992).

The noninterest margin (the ratio of noninterest income to total assets) of the Vanuatu bank was comparatively high and reflects fees and other incomes from its large share of foreign exchange transactions. The ratio of operating costs to total assets, typically small in low-inflation developing countries, was also high for the Vanuatu bank considering that operating costs related to foreign currency assets and liabilities must have been minimal. Such high costs reflect various factors enumerated above that added to the bank’s administrative expenses, and possibly a relatively larger proportion of expatriate personnel than in the comparator countries. The ratio of provisioning for loan losses to total assets was comparatively low, suggesting that banks in Vanuatu may not have provisioned adequately against potential loan losses, in particular, given the perceived high risks of investment in the country.

The overall return on assets (the ratio of net income to total assets) of the Vanuatu bank, at 1.2 percentage points, exceeded the average of omparators. This ratio reflects a relatively high noninterest margin and low level of provisioning, offset by higher operating costs and a slightly lower-than-average interest margin. The bank’s return on equity (the ratio of net income to total shareholder funds), at 12 percent, was modest compared with that of other countries; actual returns may have been lower to the extent that loan loss provisioning was insufficient.

Although banks in Vanuatu may not earn exorbitant profits, the small number of banks and their high degree of concentration 1/ indicate that banks as a group face little competition or pressure to maximize their efficiency. Furthermore, most ni-Vanuatu do not, in practice, have access to the international markets, allowing banks much leeway in setting vatu interest rates and other conditions to make up for inefficient operations. Although the market in Vanuatu is open to new financial institutions, 2/ the size of the economy is unlikely to attract many more banks. Thus, in the near future, improved efficiency would need to originate within the current oligopolistic structure, including a strengthening of banks’ domestic portfolios and the promotion of longer-term savings instruments.

IV. Export Performance and Prospects

Exports of agricultural crops--primarily copra--and tourism receipts together account for about one half of Vanuatu’s foreign exchange earnings (Chart 7). Since 1989, Vanuatu’s terms of trade has deteriorated overall (reflecting falling international prices of these crops) and the growth of tourism receipts slowed (owing to inadequate infrastructure and the country’s high cost structure). Consequently, the current account (excluding private and official transfers) has gradually deteriorated. Against this background, the Government has placed emphasis on the diversification of agricultural commodities and the promotion of tourism, while taking measures to safeguard the country’s cultural heritage and ecology. In 1994, the Government commenced the preparation of a Tourism Master Plan, which focuses on tourism as the major source of foreign exchange earnings.



Source: Data provided by the Vanuatu authorities.1/ Commodity exports and services receipts, excluding investment income, and other receipts not identified elsewhere.

1. Agricultural exports

Against the decline in international copra prices, the diversification of agricultural exports has developed in two directions: (i) a shift to better-quality copra and nontraditional markets for the product, and (ii) cultivation of other crops. However, efforts to cultivate alternative crops have proven to be difficult, given that tree crops are vulnerable to cyclones and other extreme weather conditions, and cash crops require close care and marketing expertise not yet fully developed in Vanuatu.

a. Traditional crops

Although export earnings from copra declined from about half of total commodity export earnings in the late 1980s to about 35 percent in the early 1990s, copra remains the most important export and provides ni-Vanuatu with their main source of cash income. The volume of copra exports declined from 47,000 metric tons--the peak recorded in 1984--to 28,000 metric tons in 1993, in line with a sharp fall in its world price during the same period. However, value added in copra production increased, attributable to the rising share of the higher-quality sun-dried variety (as opposed to the hot-air variety), which, by 1993, accounted for more than 80 percent of total production. Furthermore, higher copra export earnings were realized through a shift from the traditional EU market to Asia, which significantly reduced transportation costs. Further improvements in productivity and export earnings are expected to derive from more systematic replanting and additional savings in marketing and transportation costs. The production of cocoa and coffee, the other traditional export crops, has been volatile owing to natural disasters and diseases. Their expansion has also been deterred by falling prices since the late 1980s, and prospects for their exports in the next few years are unfavorable.

b. Prospects for diversification

Beef production began to expand rapidly in the 1980s, following the purchase of the Luganville abattoir by a Japanese company, and is now the second largest export commodity. About 30 percent of beef production is exported, mainly to Japan and New Caledonia. Although efforts are under way to diversify its markets to other Asian destinations, exports have been constrained by the absence of accredited disease-free status and abattoir standards; to address this constraint, technical assistance is being provided by the EU. Exports of cowhide have also expanded in line with beef production.

Kava, indigenous to certain Pacific islands, has traditionally been used as a relaxant. Its export recently took off, both in the form of fresh roots for relaxant (to Australia and New Caledonia) and in powder form for pharmaceutical purposes (to European countries). The latter use of this product is still exploratory and under research, but its potential for export growth could be strong.

Squash production increased sharply in 1993-94, targeting the Japanese market during off-season. However, prospects for its export growth were hampered in 1994 by strong regional competition, causing a sharp decline in its price.

Largely for environmental reasons, the authorities decided to ban exports of uncut logs in mid-1994. At the same time, and within the framework of the Forest Utilization Project, they intend to promote the export of higher value-added timber, sawn timber, and wood products. A new large-scale logging venture, based on a more selective cutting operation and a reforestation program, is under way, which is expected to result in increasing exports of processed wood, including plywood, destined largely for Asian markets.

2. Tourism

a. Background

After expanding substantially in the late 1980s, tourism slowed in the 1990s, owing to limited infrastructure--mainly airport facilities and hotel accommodations. Although there is regular international air service to Vanuatu by four carriers serving the region, the two main airports at Port Vila and Luganville are currently too small to accommodate wide-bodied aircrafts for long-haul flights, prohibiting in effect the potentially large Asian markets. The country is also served by cruise ships, but their contribution to the economy is limited by the minimal length of stay. The bulk of tourists arrive by air from within the region, mostly from Australia and New Zealand. Modern accommodations are limited to 11 hotels, totaling some 500 rooms; only four hotels (all in Port Vila) meet international standards for quality hotels, making up some 70 percent of the rooms. Capacity utilization of hotel rooms increased significantly in the late 1980s but remained at about 60 percent on average since, with the capacity fully used during the peak season.

b. Tourism Master Plan 1/

The main objectives of the Tourism Master Plan include the expansion of tourism infrastructure; the promotion of greater ni-Vanuatu participation in the sector; and the diversification of tourist markets. The Plan considers the upgrading of the two airports, Santo/Pekoa Airport and Efate/Bauerfield Airport, key to the expansion of tourism in Vanuatu. Once direct air links to major Asian cities are established, foreign investment in hotel facilities and other infrastructure is anticipated to follow. The project is expected to eventually serve the Government’s objectives to decentralize economic development to Santo and the adjoining islands and to increase ni-Vanuatu employment. Investment in the project is scheduled to commence in 1995 and be completed in 1997, with the total cost estimated at US$18-24 million.

3. Policy issues

a. Land tenure system

The development of commercial agriculture, the manufacturing sector, and the tourism industry, however, faces a constraint common to the Pacific region. Despite abundant land supply, the land tenure system whereby virtually all land is customary-owned has effectively made land unavailable and adversely affected foreign investment, particularly in tourism development. In order to address this issue, the Parliament recently adopted legislation allowing the Government to purchase land for commercial development projects. The land may also now be leased by foreigners for up to 75 years, and the Government will assist in land negotiations. Further legislation to permit freehold titles is being prepared. This is expected to help prevent land conflicts that hamper investment and to ease ni-Vanuatu’s access to bank financing requiring collateral.

b. External competitiveness

Within the framework of a fixed exchange-rate regime, 1/ the exchange rate of the vatu fluctuated widely in 1990-91 but has since remained relatively stable in effective terms. Nominal and real effective rates have moved closely together (Chart 8), suggesting that the real effective rate is influenced more by movements in the basket of currencies than inflation differentials between Vanuatu and its partner countries. The small appreciation of the vatu in 1993-94 against the U.S. dollar was largely offset by the depreciation against the Japanese yen and the Australian dollar, and these variations appear to have had little impact on the export sectors. In the case of commodity exports, copra producer prices and natural conditions are considered more important factors affecting the supply; in the case of tourism, recovery of the regional economies appears to have compensated for rising costs. However, hotel and food costs facing tourists overall rank high by international standards and are considerably more than in some other countries in the region, such as Fiji. Any large-scale expansion of the tourism sector in Vanuatu would likely be contingent on the availability of efficient service at moderate prices. Given already high wages overall, concurrent measures to maintain nominal wages and upgrade labor productivity would help preserve Vanuatu’s external competitiveness.


(1988 = 100)

Sources: Data provided by the Vanuatu authorities, IMF, Information Notice System; and IMP, International Financial Statistics.


Table 1.

Vanuatu: Gross Domestic Product by Type of Economic Activity in Constant 1983 Prices, 1989-93

(In millions of vatu)

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Sources: Statistics Office; and staff estimates.
Table 2.

Vanuatu: Gross Domestic Product by Expenditure Components in Constant 1983 Prices, 1988-90 1/

(In millions of vatu)

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Sources: Statistics Office; and staff estimates.

Efforts are under way to compile national accounts for later years.

Table 3.

Vanuatu: Agricultural Production, 1989-93

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Sources: Statistics Office; Vanuatu Commodities Marketing Board; and Department of Agriculture and Horticulture.

Copra purchased by the Vanuatu Commodities Marketing Board for export and/or processing. Estimates of domestic consumption of coconuts by villagers are not available, but may be as high as 20,000 metric tons of copra equivalent.

Totals by category and by center do not yield precisely the same figure in some periods.

Total volume slaughtered in Port Vila and Luganville abattoirs.

Cocoa purchased by the VCMB for export. Domestic consumption is negligible.

Metric tons of green beans processed and dried.

Metric tons of exports on a dried weight volume basis. Kava exported for pharmaceutical purposes is dried, whereas kava for the beverage market is sold fresh (green).

Port Vila abattoir only.

Production from Melektree Dairy.

Production of Toa Enterprises and Chicken City on Efate.

Includes transportation allowance.

Table 4.

Vanuatu: Manufacturing Industries, 1989-93

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Sources: Data provided by the Department of Industry; and staff estimates.
Table 5.

Vanuatu: Imports of Petroleum Products, 1989-93

(In thousands of barrels of oil equivalent) 1/

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Sources: Statistics Office; Energy Unit; Ministry of Energy; and staff estimates.

The conversion factor is one kiloliter = 6.29 barrels of oil for gasoline, distillate, kerosene, and aviation gas; in the case of LPG, the conversion factor is one ton LPG/butane = 10.9 barrels of oil equivalent.

Excludes jet fuel for re-export.

Based on sales data.

Table 6.

Vanuatu: Electricity Production by Union Electrique du Vanuatu in Port Vila and Luganville, 1989-93 1/

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Sources: Ministry of Lands, Energy, and Rural Water Supply, Energy Planning Unit, based on extracts from the annual returns of Union Electrique du Vanuatu (UNELCO).

Data prior to 1992 exclude Luganville.

Table 7.

Vanuatu: Tourism Statistics, 1989-93

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Sources: Statistics Office; and National Tourism Office.
Table 8.

Vanuatu: Operations of National Provident Fund, 1989-94 1/

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Source: Vanuatu National Provident Fund, Annual Report, various issues.

The VNPF was established in 1986 and its coverage of the Vanuatu labor market is now universal.

Includes private sector investments and loans, but excludes investments in real estate assets.

Assuming that the average contribution is equal to 6 percent of labor income.

Table 9.

Vanuatu: Consumer Price Index, 1989-93 1/

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Sources: Data provided by the Statistics Office; and staff estimates.

The weights are derived from the 1985 Household and Expenditure Survey. Expatriates account for 38.87 percent of the index, ni-Vanuatu for 61.13 percent. Port Vila accounts for 84.97 percent of the index, Luganville for 15.03 percent.

Totals differ from the weighted average of changes in the components.

Table 10.

Vanuatu: Central Government Fiscal Operations, 1989-94

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Sources: Data provided by the Vanuatu authorities; and staff estimates.

Includes grants in cash and in kind, and cyclone reconstruction funds amounting to VT 21 million in 1989. The 1989 figure also includes a VT 538 million grant from the Australian Government for the purchase of an aircraft paid directly to the seller.

Includes nonbank financing, change in balance of Special Funds not included above the line; and errors and omissions.

The authorities’ definition of recurrent revenue is the same as that of the staff. Recurrent expenditure excludes subsidies to the VCMB and technical assistance (which is wholly grantfinanced) and includes principal debt repayments, bond redemption provisions, and transfers to the Development Fund.

Year to September.

Table 11.

Vanuatu: Central Government Current Expenditure, 1989-94

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Sources: Data provided by the Vanuatu authorities; and staff estimates.

Including service charges on loans.

The total current expenditure figures presented in Table 10 are found by adding technical assistance.

Excluding VCMB subsidies.

Excluding principal repayments of loans and bond redemptions, and transfers to the Development Fund.