Vanuatu
2006 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
05 Mar 2007
eISBN:
9781451840575
ISBN:
9781451840575
Language:
English
Keywords:
ISCR; CR; government; government finance; supervision; Vanuatu; Vanuatu authorities; authorities of Vanuatu; growth performance; efficiency of government service delivery; Public sector wages; Pacific Islands
Download PDF (415 KB)

This 2006 Article IV Consultation highlights that following two years of contraction, output growth in Vanuatu recovered beginning in 2003, spurred by stronger performance in construction and a pickup in tourist arrivals. Growth reached 7 percent in 2005 and an estimated 5½ percent in 2006, well above the average for Pacific island countries. The overall external balance has benefited from rising foreign direct investment, aid, and private capital inflows, with reserves increasing to more than 7 months of imports. If good macroeconomic policies continue and political stability is maintained, near-term prospects are positive.

Abstract

This 2006 Article IV Consultation highlights that following two years of contraction, output growth in Vanuatu recovered beginning in 2003, spurred by stronger performance in construction and a pickup in tourist arrivals. Growth reached 7 percent in 2005 and an estimated 5½ percent in 2006, well above the average for Pacific island countries. The overall external balance has benefited from rising foreign direct investment, aid, and private capital inflows, with reserves increasing to more than 7 months of imports. If good macroeconomic policies continue and political stability is maintained, near-term prospects are positive.

I. Economic Developments and Outlook

A. Background

1. Vanuatu has recently emerged from a long period of low growth and falling per capita incomes. The historically poor growth performance reflects a number of deep-seated structural problems. A weak environment for private activity and rapid population growth have added to the difficulties that come from a narrow output and export base, with per capita incomes falling since 1999. Infrastructure spending is low compared to most Pacific island and Caribbean countries, and inter-island travel and communications are a particular problem. The weak education system has resulted in shortages of skilled workers, matched only by Papua New Guinea and the Solomon Islands. Vanuatu experiences almost no emigration and few remittances, in marked contrast to Samoa and Tonga. Vanuatu is also particularly vulnerable to natural disasters. Human development indicators are among the lowest of the Pacific island countries, with about 80 percent of the labor force employed in subsistence farming in rural areas.

uA01fig01

Real GDP Per Capita, 1997–2006

(1997=100)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; IMF, WEO database; and IMF staff estimates.

Gross Domestic Product (GDP) Per Capita and Human Development Index (HDI) in Vanuatu and Comparator Countries

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Sources: UN, Human Development Report (2006); and IMF, WEO database.

Rank out of 177 countries.

Antigua and Barbuda, Dominica, Grenada, St. Kitts and Nevis, St. Lucia, and St. Vincent and the Grenadines.

2. Persistent political uncertainties have added to macroeconomic instability and retarded structural reform. Vanuatu’s fragmented political party structure has led to a series of fragile coalition governments which survived for only short periods as political unions were created and dissolved with frequency. Although not subject to the unrest seen in some of the neighboring Pacific island countries, the political instability distracts from needed action on reforms, and the private sector regularly lists this instability among its major concerns inhibiting investment. The current coalition government led by Prime Minister Lini has been in place since December 2004 when the previous government was dissolved in a no confidence vote. Most of the major structural reform initiatives proposed by the staff, in particular civil service reform and measures to improve the private sector environment, could continue to prove politically difficult in the run-up to the next general election, due in July 2008.

3. Since the formation of the present government, donor pledges have increased sharply. Reflecting sound macroeconomic management and improved relations with traditional bilateral aid donors in the last two years, Vanuatu now faces the possibility of receiving significantly higher aid flows over the near and medium term. In addition, Vanuatu has become the first Pacific island country to receive funds from the U.S. Millennium Challenge Account, which could amount to as much as US$66 million in grant aid (17 percent of 2006 GDP) over the next five years to support infrastructure projects (discussed below).

uA01fig02

Official Development Assistance to Vanuatu

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: AusAID; Millennium Challenge Corporation; NZAID; OECD; and IMF staff estimates.

4. In these circumstances, the country has the opportunity to place itself on a higher growth path. Vanuatu fulfills many of the theoretical conditions for higher growth, in particular a wealth of natural resources, and growth opportunities in agriculture, fisheries, and tourism. The society is more homogeneous than in Papua New Guinea, Solomon Islands, and Fiji. There is currently less urban poverty and its associated problems than in many other island countries. Donor aid, if used effectively, could help reduce some of the barriers to development that Vanuatu faces.

B. Economic Developments

5. Macroeconomic conditions have improved over the last several years. Following two years of contraction, output growth recovered beginning in 2003, spurred by stronger performance in construction and a pickup in tourist arrivals following an expansion of airline capacity to Vanuatu (Table 1). Growth reached 7 percent in 2005 and an estimated 5½ percent in 2006, well above the average for Pacific island countries.1 After peaking at 3 percent in 2003, inflation has since declined to 1½ percent in 2006 (Figures 1-4).

Table 1.

Vanuatu: Selected Economic and Financial Indicators, 2002–07

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Sources: Vanuatu authorities; and Fund staff estimates and projections.

Includes Millennium Challenge Account (MCA) project grant which was launched in 2006.

Assumes 20-25 percent civil service wage increase beginning July 2006.

Weighted average rate of interest for total bank deposits and loans. 2006 data are as of September.

Imports values are on c.i.f. basis.

Medium- and long-term public debt only.

In percent of exports of goods and nonfactor services.

Figure 1.
Figure 1.

Vanuatu: Regional Comparators

(Averages, 2004–06)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and Fund staff estimates.
Figure 2.
Figure 2.

Vanuatu: Selected Economic Indicators, 2002–06

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities, and Fund staff estimates.1/ Measured with respect to a weighted average lending rate on bank loans and the four-quarter average inflation rate.
Figure 3.
Figure 3.

Vanuatu: External Sector Developments, 2000–06

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities, and Fund staff estimates.1/ Agricultural exports include beef, cocoa, coconut oil, copra, kava, and timber.
Figure 4.
Figure 4.

Vanuatu: Monetary and Financial Indicators, 2002–06

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities, and Fund staff estimates.

6. Budget performance has also improved. With cuts in capital spending and improved tax collection—led by higher VAT collection, increased revenue from property taxes, and larger payments by hotels and retail operations—the budget moved from a deficit of 4 percent of GDP in 2002 to a surplus of nearly 2 percent of GDP in 2005 (Table 2). The 20–25 percent increase in civil servants’ wages from July 2006, the first increase in some ten years, has led to an erosion of the budget position, with an expected deficit in 2006 of around ½ percent of GDP. However, the public debt-to-GDP ratio continued to decline to about 30 percent, from nearly 45 percent in 2002.

Table 2.

Vanuatu: Central Government Fiscal Operations, 2002-07

(In percent of GDP, unless otherwise indicated)

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Sources: Vanuatu authorities; and Fund staff estimates and projections.

Net of tax rebate for import duties paid by UNELCO.

Includes Millennium Challenge Account (MCA) project grant which was launched in 2006.

Annual increases in wages and salaries generally reflect trends in public sector employment. Wages and salaries were increased by an additional 20 to 25 percent in July 2006.

China provided VT 486 million of debt relief in 2005.

uA01fig03

Budget Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

7. The overall external balance has strengthened. The current account deficit remains in the range of 8–10 percent of GDP, but has been more than offset by FDI, aid, and private capital inflows (Table 3). Reserves have increased to over 7 months of import cover, well above the official target of 4 months. The real exchange rate has appreciated slightly relative to 2002.

Table 3.

Vanuatu: Balance of Payments, 2002–07

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Vanuatu authorities; and Fund staff estimates and projections.

Imports values are on c.i.f. basis.

uA01fig04

Components of 2006 Balance of Payments

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

8. However, progress on structural reforms has been limited. On the positive side, financial sector reforms have been impressive, with the government taking steps over the last several years to substantially improve supervision of domestic banks and the offshore financial sector. At the same time, fiscal structural reforms have not advanced. The wage bill in 2006 reached over half of total expenditures (at around 12½ percent of GDP, high by regional standards), despite the government’s own reform agenda to allow for more development-oriented public spending. The increase in civil service wages will boost these figures further beginning in 2007, underscoring the need for reforms. Numerous exemptions on VAT and duties have not been streamlined. In addition, little progress has been made on reforms to improve the private sector environment (discussed below), which are key to placing Vanuatu on a higher sustainable growth path.

uA01fig05

Public Expenditures

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

9. The proposed agriculture development bank raises concerns. In June 2006 a law was passed allowing for a new development bank, although it has not yet been established. Previously, a similar bank dominated by politically-motivated lending and mismanagement resulted in bankruptcy in 1998 and a corresponding increase in public debt.

C. Outlook and Risks

10. If good macroeconomic policies continue and political stability is maintained, near-term prospects are positive. Baseline projections show growth being maintained at about 4-5 percent over the next two-three years, boosted by the direct impact of aid and private capital inflows on investment and growing tourism following the launching of new flights to Vanuatu in 2006. Inflation is expected to increase modestly but remain subdued. There is, however, a risk that a loosening of fiscal policy and increased capital inflows could put upward pressure on private sector wages and prices.

11. However, without structural reforms to improve the private sector environment, aid flows may be, as in the past, insufficient to deliver sustained growth over the medium term. Although Vanuatu has been among the highest donor recipients of the Pacific island nations, aid has been relatively ineffective thus far in improving its growth performance. Barriers to private sector development remain substantial, and key structural and financial sector reforms are needed to render aid more effective. Without much stronger efforts to undertake these reforms, the positive growth projected in the near term could prove temporary. In this case, growth over the medium term is unlikely to exceed Vanuatu’s historical performance of 2-2½ percent, with per capita income growth remaining stagnant.

II. Policies to Improve Growth Prospects

The discussions focused on the policies required to promote sustainable economic growth over the medium term. The authorities and staff team agreed on the importance of maintaining macroeconomic stability, and the need to avoid inflationary pressures that might begin to emerge as the result of the recent civil service wage increase. The staff team emphasized the need to accelerate structural reforms, focusing on improving the framework for fiscal policy formation, improving the efficiency and effectiveness of spending in health and education, facilitating the redirection of spending toward development-related priorities, and strengthening the private sector environment. Staff and authorities agreed on the importance of subjecting the newly proposed agriculture development bank to strict central bank supervision.

Donor Aid Flows Per Capita

(U.S. dollars)

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Sources: Vanuatu authorities; OECD; IMF, IFS database; and IMF staff estimates.

A. Maintaining the Favorable Macroeconomic Environment

Monetary and Exchange Rate Issues

12. The monetary conditions have eased somewhat in the last two years, with little sign of inflation. Capital inflows from FDI, donor aid, and private nonresidents have resulted in an increase in reserves and domestic liquidity. Correspondingly, domestic credit has increased, reflecting lending related to property purchases, construction, and investment in the tourist sector. At the same time, there are few signs of inflationary pressures, suggesting growing money demand with the deepening of the financial sector.

13. The staff team regards the transactions-weighted, basket pegged exchange rate regime as appropriate for Vanuatu’s stage of development, given the country’s small open economy with a narrow export base, its generally sound fiscal policy stance, and its limited institutional capacity to conduct monetary policy. Although it comes at the price of less monetary policy independence, and prevents the nominal exchange rate from playing a role in absorbing external shocks, the regime has served as an anchor to help keep inflation subdued. The current account deficit mainly corresponds to higher imports related to FDI and donor inflows, which are likely to continue over the medium term (Annex I, Table 4). With a stronger reserve position and good prospects for exports of many goods and tourism, there appears to be little sign of exchange rate misalignment at present. As such, staff regards resolving structural problems as the key to improving Vanuatu’s competitiveness. The team reiterated the desirability of disclosing the weights of currencies in the basket and outlining the policy with regard to implementing changes in the weights.

Table 4.

Vanuatu: Balance of Payments, 2006–11

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Vanuatu authorities; and Fund staff estimates and projections.

Imports values are on c.i.f. basis.

14. The staff team and authorities agreed that the prospect of continued capital inflows, particularly if accompanied by a loosening in fiscal policy, could pose a challenge to near-term macroeconomic management. Increased donor inflows and a weakening of the budget position could add to domestic demand, increase imports, and put upward pressure on Vanuatu’s real exchange rate. At the same time, other capital inflows, which may already be contributing to the reported increase in urban property prices, could remain substantial. Given Vanuatu’s basket pegged exchange rate regime, monetary conditions are determined by balance of payments developments, and the role of monetary policy in offsetting these pressures remains limited. The authorities considered sterilization as an option, but argued it would be a costly and potentially counterproductive policy beyond the short run. With the budget parameters largely set in the short run, the staff and authorities saw the risk that demand growth could outpace supply capacity over the next several years, with few policy tools available to prevent a possible overheating of the economy. The staff urged that these developments be closely monitored in the future, particularly with the aim of protecting the external position and, if necessary, preventing an excessive increase in credit growth. The Reserve Bank of Vanuatu agreed with this assessment, emphasizing the role for strong bank supervision in the current environment. The authorities were confident that recent steps to improve supervision (discussed in Section C) and the prevalence of foreign-owned banks would help to limit any buildup of nonperforming loans.

Fiscal Issues

15. The staff team emphasized that the current economic situation provided an opportune platform to restructure the government budget and improve fiscal policy formulation. Improving the efficiency of government service delivery and reorienting the structure of expenditures toward development is a key priority. As part of this effort, the staff strongly supported the establishment of a medium-term expenditure framework. The authorities agreed that public service delivery could be improved, but emphasized that Vanuatu’s large geographic spread necessitated a larger civil service than in many other Pacific island countries. The staff stated that the public sector wage bill reaching 14 percent of GDP in 2007, with levels of public employment similar to that in other countries, suggests that public sector wages are among the highest in the region. The authorities maintained that the recent wage increase was justified given the differential between civil service and private sector wages, while at the same time agreeing with staff that large ad hoc increases in wages are potentially damaging to macroeconomic management and recognizing the need to develop a more rational mechanism for civil service wage increases going forward.

uA01fig06

Public Sector Wages

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

Regional Comparison of Wage and Salary Expenditures1

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Sources: Authorities of Vanuatu, PNG, Samoa, Solomon Islands, and Fiji; and IMF staff estimates.

The latest data for wages with corresponding employment data are 2003 figures.

16. If these issues are not addressed, much of the improvement in the overall budget position to date is likely to unwind going forward. Expenditure heavily directed toward the wage bill crowds out much needed development-related spending and could reduce Vanuatu’s competitiveness by limiting the supply of labor available to the private sector, putting pressure on wages in growing export-oriented sectors including tourism. Added to this is the risk that some of the outstanding registered legal claims on land disputes against the government will materialize.

17. Staff reiterated the considerable scope for improving the structure of revenues and widening the tax base. Tax rates are high, variable, and with numerous exemptions. In addition to needed further improvements in tax administration, the staff encouraged a streamlining of the VAT and duty collections, which could increase budget revenue considerably. The authorities are beginning to recognize this more explicitly; the 2007 budget includes for the first time, an estimate of revenue lost to tax and duty exemptions. According to this estimate, the lost revenue in 2006 was over 3½ percent of GDP.

18. The structure of the 2007 budget only partially addresses these concerns. The authorities are projecting a balanced budget in 2007, although staff estimate that higher-than-budgeted expenditure needs could produce a deficit of ½ percent of GDP.

  • Tax revenue is expected to increase by 2 percent of GDP. While the budget includes some commendable, albeit limited, measures to improve tax collection and limit VAT and duty exemptions, increased revenue mainly reflects the strong economic outlook and an expected increase in tax receipts associated with higher consumer spending following the civil service wage increase.

  • Some import duties have been adjusted to increase revenue slightly, with the result that import duty spreads may increase, in contrast to the goal of streamlining the structure of import duties (duty rates range from 0 to 55 percent). Prior to the 2007 budget, the number of duty rates has been sharply reduced. However, the 2007 budget increases import duties on some items and reduces them on others, with the possible result that duty spreads will increase.

  • Current expenditures are to increase by 2½ percent of GDP. This is almost entirely accounted for by the wage increase, with the public sector wage bill expected to approach nearly two-thirds of current expenditures.

  • Maintenance spending will rise in line with the increase in donor-related capital spending, particularly that associated with the MCA (Box 1).

  • Capital expenditures related to development needs are budgeted to rise by nearly 4 percent of GDP, although this increase is more than financed by donor grants, raising the question of sustainability of development spending if grants were to decline.

The U.S. Millennium Challenge Account Program in Vanuatu

Vanuatu is the first Pacific island country to receive funding from the Millennium Challenge Account (MCA). The MCA was established in 2002 by the United States government for provision of foreign aid to countries meeting a set of established criteria (www.mcc.gov/about/index.php). In 2006, Vanuatu reached an agreement with the MCA for a grant of nearly $66 million over a five-year period (2006-10), with the objectives of benefiting poor, rural agricultural areas and spurring tourist-related goods and services by reducing transportation costs and improving access to transportation services. Eleven projects over eight islands have already been identified for funding in consultation with the Vanuatu government. The MCA’s long-run program goals include increasing average income per capita by $200, providing market and social service access to rural inhabitants, and expanding tourism by 15 percent.

Vanuatu’s MCA program is focused on a specific set of projects required to be completed within five years. Some 83 percent of total funds will be allocated towards engineering and construction, 9 percent to institutional strengthening for sustainability and maintenance, 6 percent for program administration and audits, and 2 percent for monitoring and evaluation. The program’s projects include roads, bridges, and other infrastructure. Engineering and construction for all eleven projects will be tendered to a single external contractor as a design-build contract. After a competitive bidding process, the contract is expected to be finalized in early 2007 with the bulk of the construction occurring from end-2007 through 2009.

uA01fig07

MCA Disbursement Schedule

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Source: Millennium Challenge Corporation, http://www.mcc.gov/countries/vanuatu/Vanuatu_Compact_Summary.pdf

The MCA is projected to have a significant impact on the local economy. Most contracted employees will be living in Vanuatu, boosting local housing and consumer markets. Depending on the external contractor, the projects’ local content of labor, goods and services could be as much as 20 percent. The program also requires the government to budget annually funds for maintenance of program-related roads. Similarly, the government will be required to develop and implement wharf user fees for wharf maintenance.

19. State-owned enterprise (SOE) reform is a key priority. Many of Vanuatu’s SOEs are heavily subsidized, depleting budget resources and distorting price-setting mechanisms that would encourage private sector development. Most SOEs operate without adequate oversight or accountability. The staff underscored the need to take quick action to restructure the national airline, Air Vanuatu, and the Vanuatu Commodities Marketing Board, two of the largest recipients of budget subsidies. The authorities recognize these problems, although they emphasized that SOE restructuring is particularly difficult in the current political environment. They nevertheless agreed that at a minimum attention should be given to establishing plans to restructure Air Vanuatu as soon as feasible. The staff strongly supported the government’s initiative to establish a framework, with the objective of improving accountability and performance, to require all government business enterprises to provide regular financial reports to the Ministry of Finance.

20. Overall, the authorities agreed that the medium-term fiscal strategy should focus on maintaining Vanuatu’s debt sustainability. While the projected deterioration in the budget balance is unlikely to produce a sharply rising debt-to-GDP ratio (Appendix I), the budget is currently overly reliant on donor grants. A strong fiscal position would reduce this reliance and create a cushion against lower revenue if growth slows or if unforeseen expenditure needs arise, such as in the event of a natural disaster.2 The staff estimate that a fiscal deficit of less than 1½ percent of GDP would be sufficient to stabilize the debt-to-GDP ratio at its current level under the baseline scenario.

uA01fig08

Total Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

B. Promoting Private Sector Growth and Improving Competitiveness

21. A key factor inhibiting Vanuatu’s growth performance has been considerable barriers to private sector development, including poor and expensive infrastructure and shortcomings in the legal framework, particularly for land use. These barriers have limited Vanuatu’s external competitiveness and prevented sustained private sector-led growth (Box 2). The structural policies needed to reduce these barriers are well mapped out. The staff agrees with the list of policy measures that are needed and incorporated in the government’s development plan focusing on improving the physical and legal infrastructure and strengthening the regulation of utility monopolies. While addressing these barriers is a difficult and ongoing challenge, important steps can be taken now to lay the basis for future policy actions. In this regard the staff strongly supported the authorities initiative to establish a secured transactions system for the use of moveable assets as collateral, and to put in place a utilities regulatory authority to exercise oversight over monopolies in telecommunications, energy, and other utilities.

Reasons for Vanuatu’s Historically Poor Growth Performance

Until recently, Vanuatu has witnessed low growth and falling per capita income. In the past decade, real GDP growth averaged only 2 percent, while relatively rapid population growth led to a decline in per capita terms. Vanuatu’s GDP per capita of $1,557 in 2004 was below many of its neighbors and one-fourth of the Caribbean average.

Vanuatu’s economy continues to be plagued by barriers to private sector development. Key impediments include:

  • Political instability. Policy uncertainty arising from a series of short-lived coalition governments has stifled key economic reforms and deterred foreign investment.

  • High costs of doing business. According to the World Bank, Vanuatu’s ease of doing business index ranked 58th out of 175 in 2006, below Fiji, Samoa and Tonga. Compared to its neighbors, Vanuatu ranks particularly low in the ease of obtaining credit, registering property, and trading.

  • Poor and expensive infrastructure. The cost of electricity, telecommunication, and transportation remains high by regional standards, while sanitation and water supply are inadequate.

  • Insecure transactions framework. The legal framework for securing transactions is incomplete, in particular with regard to the use of collateral and debt collection.

  • Weak property and land rights. Land-sharing arrangements enshrined in the Constitution make it difficult to use land as security for loans and for productive investment purposes, and often give rise to land ownership disputes.

Structural Indicators

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Sources: Vanuatu authorities; Energy Information Administration; International Telecommunication Union, World Telecommunication Development Report (2006); and World Bank, World Development Indicators (2006).

Moving forward, there is a need to push ahead with policies to improve the climate for private investment. Measures should focus on reducing the high costs of doing business; upgrading and maintaining infrastructure; strengthening the regulation of utility monopolies; improving the legal framework to allow for a wider range of securitization and more efficient debt collection; reforming the land tenure system to ensure transparent, fair and enforced property rights; and restructuring loss-making SOEs including through privatization.

22. With Vanuatu’s relatively open trade regime, reducing these barriers could contribute directly to the country’s external competitiveness. Beginning in 2004 the country expanded its regional trade links, participating in the Pacific Island Countries Trade Agreement, and the Pacific Agreement on Closer Economic Relations, and it intends to participate in the prospective Economic Partnership Agreement with the EU. Prior to the 2007 budget, Vanuatu had sharply reduced the number of tariff rates, although the average rate is still high by regional standards. The authorities have taken some steps to liberalize exports of copra, cocoa, and kava by reducing the role of the Vanuatu Commodities Marketing Board, although these steps can be easily reversed, creating uncertainty which continues to hinder agricultural development. In addition, the structural weaknesses discussed above prevent Vanuatu from being more competitive relative to other Pacific island nations.

C. Strengthening the Financial Sector

23. Staff commended the authorities on the substantial strengthening of financial sector supervision, emphasizing that additional steps are needed in certain areas.

  • Domestic bank supervision has been brought to international standards. Vanuatu’s banking supervision is now largely compliant with all of the Basel Core Principles. Nevertheless, staff training is required both for further development and to address the current lack of supervisory skills. The banking system, comprising two Australian-owned commercial banks and one domestically-owned bank, is generally sound and profitable, although problems related to a few large loans have led to a recent increase in the nonperforming loan ratio. Some loans were resolved last year through collateral sales, and the remaining loans are adequately provisioned for.

  • The supervision of the offshore financial center has seen a dramatic improvement since the last assessment in 2002, a result of the authorities’ desire to improve Vanuatu’s reputation as a financial center. With the elimination of licenses for shell banks (those lacking a physical presence in Vanuatu), the number of offshore banks fell from some 100 in the early 1990s to 7 by end-2006.

  • Improving supervision of insurance companies remains a key priority. While a regulatory framework for insurance oversight is now in place, a lack of skilled staff remains a shortcoming. Staff encouraged a timely transfer of insurance supervision to the Reserve Bank of Vanuatu.

  • AML/CFT legislation has been put in place, but awareness of legislative obligations needs to be increased. The staff urged the authorities to take steps to bring the Financial Intelligence Unit to full operational capacity, and in this regard, reexamine the current institutional setting for the unit with the aim of increasing its effectiveness.

24. Staff and the authorities agreed that the establishment of the state-owned Vanuatu Agriculture Development Bank (VADB), if not carried out carefully, could pose risks to the financial system and public sector debt. According to the legislation, the VADB is intended to facilitate economic development with special regard to agriculture, forestry, fisheries, livestock, manufacturing, and tourism. The bank may issue bonds and borrow money, but is not allowed to take deposits. Under the current law, the bank would not be subject to central bank supervision, but would be required to provide information to the Ministry of Finance. The authorities agreed that the Ministry of Finance lacks the capacity to supervise such a bank, and recognized that Vanuatu’s previous experience with a development bank did not end well. Given this, the authorities agreed that the VADB should be required, from its inception, to operate under central bank supervision. The authorities also expressed awareness that preventing political interference in lending decisions would require a board which included independent members skilled in commercial banking operations.

III. Staff Appraisal

25. Vanuatu is now in a position to capitalize on recent favorable developments to maintain strong economic growth over the next several years. Output growth has rebounded, private capital inflows have increased, and near term growth prospects are good. Macroeconomic conditions are sound, and improved relations with donors have led to a significant increase in donor pledges. This aid, if used effectively, could help reduce some of the barriers to development Vanuatu faces.

26. Although growth is strong at present, aid flows alone cannot maintain this performance over the medium term without a more concerted effort to address structural weaknesses. Vanuatu’s economy continues to be plagued by barriers to private sector development, including poor and expensive infrastructure and shortcomings in the legal framework, particularly for land use. Policies to reduce these barriers would enhance Vanuatu’s external competitiveness and lead to sustained private sector-led growth.

27. In the near term, there is a risk that recent civil service wage increases could add to already strong demand and lead to a more pronounced pickup in inflation. Given Vanuatu’s basket exchange rate peg system, the role of monetary policy in offsetting these and other pressures is limited. The central bank should nevertheless monitor the situation carefully with an eye to preventing credit growth from adding to demand pressures as well as leading to an increase in nonperforming loans. Strong bank supervision will be important in this regard.

28. The present economic situation provides an opportune time to begin undertaking long overdue fiscal restructuring. Reforms should focus on improving the delivery and efficiency of government services, reducing the size of the wage bill, and removing numerous tax exemptions. Loss-making state-owned enterprises should be restructured, including through privatization.

29. The transactions-weighted, basket pegged exchange rate regime is appropriate for Vanuatu’s stage of development. With a stronger reserve position and good prospects for exports of many goods and tourism, there appears to be little sign of exchange rate misalignment at present. As such, staff regards resolving structural problems as the key to improving Vanuatu’s competitiveness.

30. Recent financial sector reforms are commendable, but additional efforts are needed to ensure this sector remains sound. In particular, the proposed agriculture development bank should be placed under strict central bank supervision from its inception to prevent the mismanagement and loan losses experienced by the previous development bank.

31. Improving domestic capacity to compile statistics is necessary to strengthen monitoring and policy analysis. Fund staff, including through PFTAC, will continue to assist in this area.

32. It is recommended that the next Article IV consultation take place on the 24-month cycle. The authorities welcomed a proposed interim staff visit during 2007.

Table 5.

Vanuatu: Vulnerability Indicators, 2002–07

(In percent of GDP, unless otherwise indicated)

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Sources: Vanuatu authorities; and Fund staff estimates and projections.

Change in percent of end-of-period broad money.

Through end-September 2006.

Imports values are on c.i.f. basis.

Foreign currency exposure is defined to be foreign currency liabilities as a percentage of foreign currency assets.

Through end-August 2006.

Medium- and long-term public debt only.

Table 6.

Vanuatu: Social Indicators 1/

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Sources: World Bank, World Development Indicators (2006) and Millennium Development Goals.

Figures represent latest single year of data over the years 2000-06.

Appendix I. Vanuatu—Medium-Term Outlook

This appendix describes the result of medium-term simulations under a baseline scenario and a scenario assuming an acceleration of structural reforms to improve the private sector environment and the structure of the public sector budget. The results indicate that under either scenario, Vanuatu’s public debt appears sustainable, assuming no weakening of fiscal policy going forward. The results also show that Vanuatu’s growth rate, external position, and public debt profile are substantially better under the reform scenario.

Baseline scenario

Policy assumptions. After rising initially, medium-term real GDP growth is assumed to fall to historic levels of about 2½ percent, reflecting poor and expensive infrastructure, as well as shortcomings in the legal framework, particularly for land use. Revenues rise in line with GDP, while expenditures increase in line with increasing needs for spending on maintenance and development-related investment, resulting in a worsening over time in the budget deficit.

Outcomes. Under this assumption, flows from the traditional bilateral donors and the MCA grant will raise GDP in the short term. In the medium term, as the MCA grant money fades, growth will decline to its historical trend. The current account deficit is sustainable as it is driven by imports that are related to donor flows, rising initially and declining in the medium term. Public debt declines gradually from 30 percent of GDP to 24 percent of GDP over a ten year period.

Comprehensive reform scenario

Policy assumptions. In this scenario, structural reforms are implemented expeditiously, with policies to reduce barriers to private sector development enhancing Vanuatu’s external competitiveness and leading to higher sustained private sector-led growth than in the past. As a result, real annual GDP growth is assumed to be maintained at 4 percent over the medium term. With the widening of the tax base, revenues rise faster than GDP, while improvements in the efficiency of public sector services allow the budget to accommodate increasing needs for spending on maintenance and development-related investment with lower overall expenditures than in the baseline scenario. As a result, the budget remains at near balance over the medium term.

Outcomes. Structural reforms in combination with Vanuatu’s relatively open trade regime improve external competitiveness resulting in a strong export-driven economy, particularly for tourism. Relative to the baseline scenario, export growth increases by 4 percent. The resulting improvement in the current account leaves Vanuatu in a stronger reserve position, with reserves increasing by 2 months of import cover (relative to baseline scenario). Public debt declines more rapidly, from 30 percent of GDP to 18 percent of GDP.

uA01fig09

Real GDP Per Capita

(U.S. dollars)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.
uA01fig10

Total Government Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2007, 092; 10.5089/9781451840575.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

Baseline Scenario

article image
Sources: Vanuatu authorities; and IMF staff estimates.

Reform Scenario

article image
Sources: Vanuatu authorities; and IMF staff estimates.
1

Vanuatu’s national accounts estimates have undergone frequent revisions, making it difficult to draw any firm conclusions about the growth rate solely based on national accounts data. The latest revisions, following external technical assistance, are particularly large, and produce GDP growth rates for 2004-05 that are unusually high relative to Vanuatu’s historical growth experience. At the same time, the staff regard the direction of the revisions as broadly correct—all other indicators support a recent rebound in the economy.

2

Vanuatu is now eligible for graduation from LDC status, which while welcome, could have an impact on future aid and trade preferences over the medium term. The possible loss of preferential trade status and reduced aid after graduation reinforce the need to increase competitiveness and reduce reliance on donor grants.

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Cover IMF Staff Country Reports
Vanuatu: 2006 Article IV Consultation: Staff Report; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Volume/Issue:
Volume 2007: Issue 092
Publisher:
International Monetary Fund
ISBN:
9781451840575
ISSN:
1934-7685
Pages:
47
DOI:
https://doi.org/10.5089/9781451840575.002