Abstract
This 2002 Article IV Consultation highlights that despite frequent shocks and an uncertain policy environment in Vanuatu, macroeconomic stability has been maintained. Real GDP growth was 2½ percent in 2000 owing to an agriculture-led recovery. However, the economy contracted by 2 percent in 2001, owing to the effects of several major cyclones and a global downturn in agriculture and tourism. Inflation remained subdued, increasing from 2½ percent in 2000 to 3¾ percent in 2001. The current account surplus declined from 2 percent of GDP in 2000 to ¾ percent in 2001.
Key Points
Vanuatu faces many challenges, given its small size, high cost structure and cyclone-prone environment. It has faced a significant decline in the prices for its major export crops. Frequent changes in government have also been an impediment to advancing a comprehensive reform agenda.
Notwithstanding these challenges and uncertainties, macroeconomic stability has been maintained - a testament to generally sound macroeconomic policies.
The fiscal position is tight and the authorities have taken steps to control expenditures and boost revenue, particularly through improvements to VAT and customs administration. Capacity limitations hamper the introduction of more comprehensive reforms, including in the area of debt management.
There have been improvements in budget monitoring and steps have been taken to control the growth in the government wage bill.
A cautious approach has been taken with respect to the 2003 budget, which is generally in line with the staff recommendations. The 2003 budget which the government is to table in Parliament targets a recurrent deficit of 0.1 percent of GDP and an overall surplus of 0.4 percent of GDP.
The authorities are conscious of the need to maintain healthy reserve levels and have requested technical assistance to examine some of the recommendations with respect to exchange rate and reserve management raised by the staff.
There have been significant developments in strengthening the regulation and supervision of the offshore financial sector and the anti-money laundering regime.
A challenging environment
Vanuatu faces many challenges. Some of these are associated with its size and geography. With a population of around 197,000, like other small states it faces the problem of diseconomies of scale that result in a high cost of doing business. Adding to its cost structure is the fact that it consists of a dispersed group of islands which is a considerable distance from major population centers. There are also the pressures that come from a rapidly growing population. Then there is the weather. Vanuatu experiences an average of 2.6 cyclones each year, with only one year in seven or eight being cyclone-free. There is also the risk of volcanic eruptions and earthquakes. As noted in the selected issues paper, the Commonwealth Secretariat has ranked Vanuatu as the most vulnerable country to natural disasters among 111 developing countries.
In recent years Vanuatu has experienced a degree of political uncertainty which has presented another challenge to pursuing reform. Over the past decade there have been ten changes of government, with three changes since 1999. Added to these uncertainties, the economy has had to contend with the effects of the weaker external environment and a significant decline in the prices of some of its major exports, particularly copra, cocoa and kava. Since 1997, the prices of copra, cocoa and kava have all fallen by more than 50 percent, although there was some improvement in cocoa prices in the first half of 2002.
The tourism sector is particularly important to Vanuatu and was adversely affected by the terrorist attacks on the United States in September 2001. More recently, there has been increased competition from Fiji which has seen a recovery in its tourist sector with greater political stability. The Vanuatu authorities have recently launched a new tourism marketing campaign.
Despite these many challenges, the authorities have maintained macroeconomic stability. Inflation is under control, external debts are manageable, and the fiscal situation has improved. In addition, the authorities have continued to make progress in addressing structural weaknesses in the economy under the Comprehensive Reform Program and are committed to making further progress in order strengthen medium-term growth.
As noted, relatively frequent changes of government have not facilitated the implementation of reforms. The current government is a coalition and has a substantial majority in Parliament. This holds out the prospect for greater political stability, although all governing coalition arrangements pose particular challenges.
In terms of the future direction of policy, the government recognizes the importance of maintaining macroeconomic stability as well as the need to advance structural reform in order to enhance the competitiveness of the economy. Specifically, the Prime Minister is emphasizing ‘Five Millennium Priorities’, which are: achieving the goals of good governance; supporting and improving private sector led growth; improving the participation of all people in the economic, social and political development of Vanuatu; improving the standard of living for all ni-Vanuatu; reducing inequalities; and distributing equally all benefits of the services and resources of the government.
Fiscal policy
The authorities are aware of the need to address the fiscal situation and have taken a cautious approach in formulating the 2003 budget. The 2003 budget, which is ready to be tabled in Parliament, targeted a recurrent deficit of 0.1 percent of GDP and an overall surplus of 0.4 percent of GDP.
More broadly, there have been improvements in budget preparation and reporting. Since 1999 the government has published an annual fiscal strategy report. The cash position is very tight and expenditure has been kept under close control through the use of monthly warrants. The introduction of the Financial Management Information System has improved budget monitoring and should allow the use of quarterly expenditure warrants by next year, thus making budget implementation more flexible. The authorities have taken note of the staff’s recommendation for greater reliance on treasury bill auctions to meet government financing needs, although the authorities believe this needs to be addressed in the context of strengthening overall debt management.
Some important steps have been made towards strengthening revenue performance. VAT and customs administration have been improved with the introduction of automated systems which strengthen tax audit and compliance procedures. The Lands Department is in the process of improving the collection of land leases, which would have a positive impact on the 2003 fiscal position. Excises on tobacco and alcohol products are included in the 2003 budget and become effective as of January 2003. The authorities are also considering increasing duties on select imports, and are investigating ways of further improving customs and VAT compliance.
On the expenditure side, the authorities recognize the importance of reducing the wage bill to divert resources to health and education, rural infrastructure and development of the outer islands. In this regard, new arrangements have been introduced whereby additional recruitment by any agency must obtain approval from the Finance Ministry.
Copra is the main source of income in the outer islands, where a significant proportion of the population lives. Given the limited means available to provide support to the outer islands, the authorities have been using copra subsidies. The subsidies are aimed at reducing income disparities between rural and urban communities and to help support producers, given the volatility in international copra prices. Nevertheless, to ensure the subsidies achieve their intended objective and given the tightness of the fiscal position and the need to avoid market distortions, the authorities are looking to ensure that this support is well targeted. The Vanuatu Commodities Marketing Board is readjusting its marketing arrangements to reduce costs. Due to the tight fiscal situation, direct financial assistance by the government to the Vanuatu Commodity Marketing Board has been minimal.
Exchange rate regime
While reserves have declined since the late 1990s, the decline has been gradual. This year uncertainty about the elections has affected reserve levels.
The authorities are mindful of the need to maintain healthy reserve levels. In this vein, they have requested technical assistance to examine further staff’s suggestions to improve reserves management. While the authorities are willing to consider deepening the interbank market through widening the Reserve Bank of Vanuatu’s trading band, they have reservations about disclosing details of the basket. Based on previous experience, they are concerned that disclosure might encourage destabilizing speculation on exchange rate movements.
Financial sector issues
A key focus of the authorities’ reform efforts has been on financial sector issues. Notwithstanding limited capacity, they have tackled vigorously identified weaknesses in the anti-money laundering regime and the regulation and supervision of the offshore financial sector (OFC). They have made good progress since the last consultation, including:
approval of the Financial Transactions Report Act in September 2000, which sets out procedures for customer identification, record keeping and suspicious transaction reporting;
establishing a Financial Intelligence Unit;
issuing a ‘know-your-customer’ regulation for domestic banks; and
conducting on-site examination of domestic banks’ AML procedures.
The Offshore Financial Centre Module II Assessment conducted by MAE earlier this year made recommendations to strengthen the regulation and supervision of domestic banks and also the OFC. The authorities support MAE’s recommendation and have acted rapidly to address weaknesses identified in both the domestic sector and the OFC.
While the domestic banking sector is generally sound, the Assessment did identify some areas for improvement. To address these issues, customer due diligence guidelines were approved in July. The Financial Institutions Act is being amended to improve oversight of banks’ anti-money laundering systems and controls and introduce a more rigorous ‘fit and proper’ regime.
The weaknesses in the regulation and supervision of the OFC were more significant, but the authorities have moved to address the weaknesses as quickly as possible, with valuable technical assistance from the Fund. The Parliament recently passed the International Banking Act, which will strengthen the oversight of offshore banks. Under the Act, supervision of the OFC will be brought under the authority of the Reserve Bank of Vanuatu with effect from January 1, 2003. Parliament has also recently passed several bills related to combating terrorist financing.
Progress has been made on state-owned enterprise reform since the last Article IV consultation with the sale or liquidation of 10 enterprises. Further progress is expected to be made following the completion of the review of the divestment strategy at the end of this year.
In closing, we would like to thank staff for the well written report. The authorities value this opportunity to consult with the Fund on the broad economic and policy outlook, and also appreciate greatly the technical assistance being provided by the Fund and through PFTAC. This technical assistance has certainly had many benefits, particularly in terms of strengthening the financial sector and improving statistical methods and reporting.