Dominica
2007 Article IV Consultation-Staff Report; Staff Supplement; and Public Information Notice on the Executive Board Discussion
Author: International Monetary Fund
Publication Date:
20 Sep 2007
eISBN:
9781451810967
ISBN:
9781451810967
Language:
English
Keywords:
ISCR; CR; debt; Dominica; authority; reform strategy; government; exchange rate; indirect tax; reform effort; fiscal policy; reform agenda; Real effective exchange rates
Download PDF (496.2 KB)

This 2007 Article IV Consultation highlights that Dominica has fully recovered from the 2001–02 economic and financial crisis. Output growth has rebounded, reaching 4 percent in 2006, and it is expected to remain above trend in 2007. The rebound is driven by a pickup in tourism, recovery in banana production, and buoyant construction and offshore school activity. Inflation has remained subdued, reflecting stabilizing oil prices, and is projected to remain low. The external current account deficit narrowed sharply in 2006, and is likely to remain large at about 20 percent of GDP in 2007.

Abstract

This 2007 Article IV Consultation highlights that Dominica has fully recovered from the 2001–02 economic and financial crisis. Output growth has rebounded, reaching 4 percent in 2006, and it is expected to remain above trend in 2007. The rebound is driven by a pickup in tourism, recovery in banana production, and buoyant construction and offshore school activity. Inflation has remained subdued, reflecting stabilizing oil prices, and is projected to remain low. The external current account deficit narrowed sharply in 2006, and is likely to remain large at about 20 percent of GDP in 2007.

I. introduction

1. Dominica has fully recovered from the 2001-02 crisis. Expansionary fiscal policy in the 1990s led to an acute economic crisis. In response, the authorities adopted a bold reform strategy in late 2002, supported by the Fund. Performance under the program was exemplary. The fiscal primary surplus in 2005/06 was some 10 percentage points of GDP higher than in 2000/01, and public debt declined by 30 percentage points of GDP (Figure 1). As a result, economic activity rebounded markedly, inflation remained subdued and international reserves rose considerably.

Figure 1.
Figure 1.

Dominica: Economic Developments in Perspective

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: Dominica authorities; and Fund staff calculations.

2. Dominica is now in a strong position to address remaining challenges. Key remaining challenges are: (i) reducing further the public debt ratio, which is still high at about 100 percent of GDP and renders the economy vulnerable to external shocks, in particular natural disasters and abrupt declines in aid; (ii) ensuring that the financial sector is well regulated and supervised; and (iii) diversifying the economy further away from the waning banana sector and find new growth drivers.

3. Political support for structural reforms remains unabated. The current government, in power since early 2000, increased its majority in the 2005 elections with a reform platform. The government has successfully implemented often unpopular yet critical reforms, such as nominal wage cuts and imposition of stabilization levies. Following the end of the PRGF-supported program last December, the authorities publicly launched the Growth and Social Protection Strategy (GSPS), a home-grown reform strategy that had been formulated in close consultation with donors. The authorities are currently conducting wide-ranging public consultations regarding the possibility of a successor Fund program to support the GSPS.

4. Dominica has generally been receptive to the Fund’s policy advice. The authorities have demonstrated strong program ownership both in fiscal consolidation and structural reforms. Some structural reforms have been slow, mainly reflecting limited implementation capacity. Technical assistance from the Fund has been active, mostly through CARTAC, particularly in tax policy and administration, public finance management, and social security reform.

II. recent economic developments

5. Dominica’s economic performance has strengthened remarkably. The economy grew by an estimated 4 percent last year, the strongest in nearly two decades, driven by a pickup in tourism and buoyant construction (Figure 2, first panel). A recovery in banana production as well as a boost in offshore school activity also played a role. Annual inflation was limited to 1.6 percent in 2006, reflecting stabilizing oil prices and the currency peg regime, despite an uptick in service prices related to the VAT introduction and increasing shipping costs (Figure 2 second panel).

Figure 2.
Figure 2.

Dominica: Selected Economic Indicators

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: Dominica authorities; ECCB; and Fund staff calculations.1/ Tourism includes transport and hotels and restaurants.2/ Excluding volatile fuel, electricity, and transportation prices.

6. The fiscal target for 2006/07 is likely to be met by a wide margin. Fiscal performance has been very strong, supported by tax buoyancy, in particular from the newly-introduced VAT and excise (Box 1), and sustained wage freeze effective since 2001/02 (Figure 3). Noninterest expenditures run somewhat higher than last year, mainly due to more project-related expenses and larger transfers to public sector entities. Based on preliminary information, the primary surplus before grants is projected at about 6 percent of GDP for 2006/07, even after a 3 percent increase in base salaries introduced later in the fiscal year.

Figure 3.
Figure 3.

Dominica: Fiscal Developments, 2002-06 1/

(In percent of GDP, central government)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: ECCB and Fund staff estimates.1/ Figures shown for a given calendar year relate to the fiscal year (July-June) beginning on July 1 of that year.

Dominica: Recent Fiscal Performance

(In percent of GDP)

article image

Adjusted for grants and grants-related spending.

Including net lending, nongrant-financed investment and statistical discrepancy.

7. Grant flows have more than doubled the pre-crisis level. Dominica received grants of almost 13 percent of GDP for the first nine months of this fiscal year, compared with a budget projection of 8½ percent and the average pre-crisis level of 4½ percent. The surge is mainly due to one-off disbursements from the European Union (EU) and new donors, including Venezuela and Trinidad and Tobago. A large proportion of the grants has been saved in bank accounts, reflecting limited implementation capacity and the authorities’ commitment to sound spending.

8. Credit to the private sector increased apace, underpinned by deposit growth and fiscal consolidation. Bank credit to the private sector rose by 11 percent in 2006, the highest in 15 years (Figure 2, third panel). Private sector deposits have continued to increase in part due to strong inflows from expatriates in Europe. The increase in public savings has also contributed to funding the credit expansion (Figure 2, fourth panel). The ample liquidity as well as competition among lenders led to a 70 basis points decline in average lending rates to 9.2 percent during 2006. Bank lending remains concentrated in consumer loans, particularly mortgages (Figure 2, fifth panel).

9. Banking prudential indicators have continued to improve. The banks are well capitalized, profitable and liquid with declining nonperforming loans (NPL). The NPL decline mainly reflects stricter enforcement of prudential guidelines by the Eastern Caribbean Central Bank (ECCB) and write-offs of large bad loans. Strong macroeconomic performance has also helped improve credit quality. Nevertheless, the average NPL ratio remains high by international standards and exceeds the ECCB prudential target of 5 percent (Figure 2, last panel). In addition, provisioning levels are low in part due to the recent write-offs, while banks face tough competition in a saturated loan and deposit market, in particular from credit unions and insurance companies.

10. Supervision of the nonbank financial sector remains weak. Credit unions, whose deposits amount to about 30 percent of bank deposits, remain under-regulated despite their systemic importance. A near-insolvent Agricultural and Industrial Development Bank (AID), which mostly on-lends concessionary loans, remains to be rehabilitated. The weak supervision largely reflects resource constraints as well as delays in enacting key regulatory legislation. After much delay, a draft law providing regulatory and supervisory power to the Financial Service Unit has recently been submitted to parliament.

11. The external current account deficit narrowed sharply in 2006. The improvement mostly reflects stronger tourism receipts. The deficit is likely to remain large at around 20 percent of GDP this year, but continues to be covered almost fully by large capital grants and foreign direct investment.

12. Discussions on debt restructuring continue with nonparticipating creditors. Since the offer of restructuring terms in June 2004, 78.5 percent of eligible debt has been restructured. The authorities have maintained good-faith efforts in pursuing agreements with the nonparticipating creditors, including a recent visit by the Prime Minister to Kuwait. The negotiations with one major private creditor, the most recent of which took place in January 2007, have been particularly challenging, given a complex derivative overlaid by the creditor to finance the bond purchase.1

13. Further progress has been made in structural reforms since the end of the PRGF arrangement. The contribution rate for the Dominica Social Security was raised by 1 percentage point in March and set to be raised further in coming years as part of a comprehensive reform (see below). The authorities have recently started to merge the port and airport authorities and to breakup the National Development Corporation into a tourism board and an investment promotion agency with a view to improve their efficiency.

III. macroeconomic outlook and risks

14. Dominica’s near-term economic outlook is positive. The growth momentum is expected to slow somewhat in the near term, in part due to the closure of a major factory, but its underlying trend will remain above the historical average. Public investment will remain buoyant, funded by large aid receipts, while consumption is likely to remain robust, in part supported by the increases in public sector wages. The momentum in the tourism sector will likely be sustained, underpinned by a major diaspora event and recent promotional efforts. Ongoing efforts to improve marketing and quality controls will help boost agriculture and fishery production although their full effects will take time to materialize. Inflation is projected to remain low.

15. The medium-term economic prospects hinge on the continued implementation of the authorities’ reform agenda. The authorities’ reform strategy, as embodied in the GSPS, envisages above-trend output growth of 3 percent per annum and gradual reductions in unemployment and poverty, underpinned by structural reforms and prudent fiscal policy. Public investment is expected to play an important role in achieving the policy objectives by providing social and physical infrastructure critical for private-sector led growth. The strategy relies heavily on external grants to avoid an increase in public debt. The maintenance of the primary surplus at 3 percent of GDP, as envisaged in the GSPS, will bring about a gradual reduction in the debt-to-GDP ratio and enable Dominica to meet the ECCB target for the debt ratio (60 percent by 2020).

16. Vulnerabilities remain high, notwithstanding progress made in recent years. Public finances have been greatly strengthened through sustained fiscal consolidation, debt restructuring and, more recently, social security reform. The debt dynamics nonetheless remain vulnerable to external shocks, in part due to the bunching of debt service payments in 2009-11 as well as the high public debt. Staff projections show that, should the government react to a decline in grants to their pre-crisis level by scaling up commercial borrowing, public debt would quickly become unsustainable. In addition, natural disasters remain a main source of vulnerabilities, although somewhat mitigated by Dominica’s recent participation into the Caribbean Catastrophe Insurance Facility of the World Bank.

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Dominica: Debt Sustainability Analysis

(Sensitivity to Aid flows)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Source: Fund staff calculations based on data from Dominican authorities.1/ Assumes that grants decline to the pre-crisis historical average in 2009.

IV. report on policy discussions

17. Against this background, policy discussions centered on the medium-term challenges of sustaining growth and reducing poverty.

A. Ensuring Fiscal Sustainability

18. The mission welcomed the authorities’ medium-term fiscal framework as a sound and coherent strategy and laid out key fiscal challenges going forward. Notwithstanding the remarkable fiscal consolidation, fiscal flexibility remains limited in Dominica due to the high debt and large investment needs under the GSPS. In addition, the recent surge in aid poses policy challenges, especially since the levels and volatility of past aid point to unsustainability of the surge (Box 2). In this regard, the mission welcomed the authorities’ fiscal framework that envisages a primary surplus of 3 percent of GDP (excluding grants and grant-related spending) and recommended saving the aid in excess of budgeted amounts. The mission stressed that the prudent fiscal policy will not only bring about a gradual decline in the debt ratio but also provide for smooth budget execution in the event of aid shortfalls. Key policy challenges are to continue to keep current expenditures under control, maintain revenue strength, and improve the management of aid and aid-related investment.

19. The authorities agreed with the thrust of the mission’s recommendations, particularly on the need to meet the primary surplus target and manage aid prudently. They reaffirmed their commitment to the primary surplus target, and indicated that, if necessary, saving would be sought from nonwage current spending. They also stressed that the scaled-up aid would not be used to increase the overall budget envelope unless sustainability is assured. They noted however that there is scope for tax reductions, given strong revenue performance in recent years and successful reform of indirect taxes. They also noted that some measures for a major taxpayer are being considered to compensate its loss of tax privileges at the time of VAT introduction. After five years of nominal wage freeze, there is a consensus about compensating public employees adequately in consideration of strong economic activity and the need to improve and retain the quality of public services.

20. The mission cautioned that tax cuts need to be modest and wage increases be consistent with the fiscal framework. The mission noted that fiscal flexibility is constrained for the next year even without tax reductions. Tax revenues are likely to fall relative to GDP as the VAT refund process normalizes and the effect of the factory closure filters through the economy.2 At the same time, current expenditures will likely remain elevated due to large project-related expenses, while the aid outlook is uncertain. The primary surplus will hence likely decline next year under the existing policies although its target will be met by a narrow margin. The mission hence emphasized the importance of not undermining underlying revenue strength while recognizing the scope for modest reductions in income taxes, in particular for low-income brackets. It also urged the authorities to keep the deviation in the wage bill to a minimum,3 and welcomed the authorities’ commitment to adopt compensatory expenditure measures, if needed to ensure meeting the primary surplus target.

21. The mission further advised the authorities to explore alternatives to the current tax incentive regime. The income tax yields are very low due to a myriad of tax incentives in place. The mission, while acknowledging intense pressure from regional tax competition, stressed the need to improve the current incentive regime, which is centered on tax holidays and exemptions that are very difficult to administer and not tied to the level of investment or employment. The authorities concurred with the mission that consideration should be given to alternative, more efficient forms of tax concessions such as investment credit and accelerated depreciation, or expenditure commitment in lieu of tax concessions. They also reaffirmed their commitment to continue to publish all government decisions on tax concessions and, to the extent possible, their cost estimates to ensure transparency.

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Source: Fund staff calculations, based on 2003 data.

22. There was agreement that maintaining the integrity of the VAT is critical for a successful implementation of the GSPS. The VAT has performed well in terms of the revenue yield and compliance, accounting for one third of tax revenues. Given the substantial resource needs for social spending, quality public services, and crucial infrastructure investment, it would be critical not to undermine the integrity of the VAT and to continue to improve revenue administration. Legitimate concerns about small business and low-income earners would be better addressed by improving refund arrangements, raising the VAT threshold, or increasing income tax allowances, as highlighted by a recent FAD/CARTAC mission. In this regard, the mission welcomed the authorities’ reaffirmation to undertake a comprehensive review of the VAT by September 2007.

23. The mission urged the authorities to strengthen public finance management, in particular of aid and aid-related spending. Public investment represents about 40 percent of total investment in Dominica, with two thirds of it financed by aid. However, public investment in Dominica, while sizable, is far less productive than in countries in other regions.4 In this regard, consideration could be given to establish an aid-coordination unit within the Ministry of Finance that integrates aid administration, including aid negotiations as well as planning and monitoring of aid-financed expenditure. Further progress will also be needed in multiyear budgeting, procurement and auditing as well as donor coordination, as highlighted by a recent EU-sponsored study. The enactment of the Financial Administration Act, as committed by the authorities, would help in this regard. The authorities agreed on the need to improve aid management but noted that donors could also play an important role by improving predictability of aid and streamlining disbursement procedures.

24. The mission welcomed the progress made in social security reform. The social security system had become unsustainable due to adverse demographics and inadequate reserves.5 The authorities responded by adopting a comprehensive pension reform in mid-2006, the implementation of which began early this year. The reform includes gradual increases in the contribution rates and retirement ages as well as changes in the accrual rules and benefit formula, broadly in line with FAD’s recommendations. In addition, the government has paid off its contribution arrears, amounting to 5 percent of GDP in 2003. These changes, together with improved administration, have increased the number of contributors significantly. Changes are also being considered to increase the fund’s overseas investments by up to 5 percent of its portfolio.

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Accounts of the Dominica Social Security

(In Millions of EC Dollars)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: Fund Staff estimates; and Dominica Social Security reports.

25. The mission urged further progress in debt restructuring. It would be important that the authorities continue their good-faith efforts toward collaborative debt agreements that maintain inter-creditor equity, including making payments into the escrow account and regular attempts to discuss with the remaining holdout creditors. The authorities indicated that they are considering closing the three-year long negotiations if not much progress is in sight. The mission stressed the importance of continuing to uphold the good-faith efforts.

B. Strengthening Resilience of the Financial Sector

26. The mission expressed concern whether supervision keeps pace with ongoing financial sector expansion. The recent credit expansion is a positive sign of increasing domestic activity and a welcome reflection of increased confidence instilled by fiscal consolidation. Nonetheless, its rapid pace suggests the importance of being watchful about credit quality, especially given the possibility of weakening lending standards under intense competition. The low levels of loan loss provisions are also of concern. To this end, the mission suggested that the authorities encourage the ECCB to strengthen supervision—in particular intensify on-site inspection—in order to safeguard financial sector stability. It also noted that extensive financial linkages in the region and increases in cross-border transactions require closer coordination among supervisory bodies in the region and, ultimately, the establishment of a regional framework for consolidated supervision.

uA01fig05

Markets Shares of Regional Banks in CARICOM

(In percent of bank assets, 2004)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: Country authorities; and Fund staff estimates.

27. The weak oversight of the nonbank financial institutions is a matter of concern. Given the systemic importance of the nonbank financial institutions, in particular credit unions, a proper regulatory and supervisory framework needs to be put in place as a matter of priority. Further progress is needed in rehabilitating the AID Bank and improving its supervision. In this context, the mission welcomed the progress made in enacting the Financial Services Unit Act and urged that the unit rapidly become fully operational with adequate resources and supporting legislation—in particular the amendment of the Cooperative Societies Act and new insurance legislation. The mission also noted that a regional approach to regulation and supervision would be useful given the extensive regional financial linkages as well as resource constraints.

28. The authorities agreed that further progress is needed in improving financial sector supervision. The authorities indicated that they are keenly aware of potential systemic risks from credit unions, and put a priority to ensuring that the Financial Services Unit is fully functioning. The lack of resources and expertise remains the biggest challenge and, in this regard, the authorities are considering outsourcing part of supervisory functions to other regulatory bodies in the region. There are also challenges in establishing a regulatory framework for credit unions due to the need to harmonize it with the position of the Caribbean Confederation of Credit Unions.

C. Fostering Growth and Reducing Poverty

29. Dominica, a small island economy, faces unique challenges in sustaining growth. Structural factors—such as high transportation costs and the lack of economies of scale—continue to pose challenges to the economy, as exemplified by a recent decision of a multinational company to close one of its factories in Dominica. The economy is also more vulnerable to external shocks than larger countries. The outlook for the banana sector will likely remain challenging due to the erosion of trade preferences although the Fair Trade niche that relies on organic branding could bring some support to the sector. In addition, tourism, while promising, will remain sensitive to external factors. In this regard, the authorities agreed with the mission that efforts for diversification to nonbanana crops need to be pursued further, with a focus on improving productivity including through better marketing and quality control.

30. The staff noted that, while some sources of vulnerability are unavoidable, sound macroeconomic policies and structural reforms would offer Dominica the best prospect for sustainable growth. There was broad agreement between the mission and the authorities that reforms are necessary in public entities, the judiciary, utilities and customs. The mission also discussed deficiencies in statistics, in particular the national accounts, that hinder analysis of economic developments and formulation of policy. The authorities reaffirmed their commitment to structural reforms while noting that the effects of prior structural reforms need to be assessed.

  • Public sector entities need to be streamlined along core mandates. Many national development agencies—notably, the Dominican Export Import Agency (DEXIA), the AID Bank, and the National Development Corporation (NDC)—have not fully fulfilled their mandates and lack efficiency and adequate oversight. While the recent start of the NDC restructuring is a positive move in this regard, further progress is needed in restructuring other entities, in particular DEXIA, which remains in a large loss and is widely seen as competing with private sector activities.

  • Contract enforcement and foreclosure arrangements. According to the World Bank, Dominica is among the weakest in the world in dispute settlement and foreclosure arrangements, hindering business transactions and raising borrowing costs. The authorities are considering taking steps to establish additional magistrate courts, streamline foreclosure arrangements, and facilitate summary proceedings.

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Costs of Doing Business

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Source: World Bank. The numbers refer to world rankings among some 175 countries.

  • Utilities reform. Notwithstanding the abundant nonhydrocarbon energy sources, electricity tariffs are among the highest in the region due in part to an outdated regulatory system. The recently approved electricity supply act is an important step forward, but a properly functioning utilities commission is needed without delay.

  • Customs reform. Customs administration needs to modernize its operations, introduce manifest control, rationalize the appeals process and improve its efficiency, especially regarding processing time, as recommended by a recent FAD/CARTAC mission.

31. Dominica’s external competitiveness remains broadly appropriate. The CPI-based real effective exchange rate has declined since 2001, reaching at end-2006 its lowest level in nearly 20 years. This reflects relative price stability in Dominica, associated with the fiscal consolidation, and the depreciation of the EC dollar against the currencies of trading partners (Box 3). Other indicators of competitiveness, in particular tourism costs and recent developments in the tourism sector, as well as a comprehensive study of the EC dollar6 also point to the same conclusion.7 The weakening of the real exchange rate could help boost Dominica’s competitiveness in key export markets, particularly in Europe and neighboring French territories, and thereby narrow the current account deficit.

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Dominica: Real Effective Exchange Rate

(Index 2000=100)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Source: IMF, Information Notice System.

32. The authorities’ poverty reduction strategy is coherent and properly balanced. The strategy, as laid out in the GSPS, recognizes critical roles played by sustained economic growth and fiscal soundness in reducing poverty and emphasizes the importance of targeted social programs. An integral part of the strategy is to prioritize interventions with immediate and direct impact on the most vulnerable groups. In this regard, the mission welcomed the commitment of the authorities to undertake poverty assessment this year, which will help design efficient and well-targeted social safety nets. It also noted that the ongoing reform of the Dominica Social Security, which accounts for about half of total social spending, should help provide secure resources for social spending over the long term.

V. Staff Appraisal

33. The authorities’ reform efforts following the 2001/02 crisis have been bearing fruit. Fiscal consolidation has helped re-establish macroeconomic stability and thereby contributed to strong output growth. These efforts, together with debt restructuring, have moved the debt trajectory towards a sustainable path. The continuation of sound fiscal policy is critical to attaining debt sustainability and ensuring external stability. In addition, the authorities have made substantial progress in structural reforms, in particular in indirect tax and social security reforms.

34. The economy is poised to maintain above-trend growth, sustained by sound economic policy and continued structural reform. Despite a near-term softening arising from the closure of a major factory, the economy’s underlying growth is expected to remain above the historical average in coming years, with successful implementation of the authorities’ reform strategy. The steady growth with low inflation will help achieve the authorities’ social objectives, namely poverty reduction and job creation.

35. The authorities are to be commended for their commitment to address remaining policy challenges. Their medium-term reform strategy appropriately envisages the maintenance of a fiscal policy geared at achieving a primary surplus target of 3 percent of GDP and thereby bringing about a gradual reduction in the debt ratio. It also lays out a structural reform program focused on the need to foster private sector-led growth.

36. The recent surge in budgetary aid is a welcome development but presents policy challenges as well. The recent aid flows were extraordinarily large and unlikely to be sustained in coming years. Given the uncertain aid prospects, large investment needs and high debt, the authorities are right in smoothing spending over time and in using some of the savings to substitute expensive borrowing and reduce debt. They have recognized the need to improve budget management, in particular as regards capital expenditure, in order to use aid efficiently, transparently and consistently with macroeconomic objectives. The Fund, together with donors, will continue to provide technical assistance in this area through CARTAC.

37. Tax cuts, while justifiable, need to be modest and accompanied by revamping the tax incentive system without undermining the integrity of the VAT. The successful indirect tax reform provides modest scope for tax reductions, without jeopardizing the primary surplus target. Some tax incentives are unavoidable to attract investment and create jobs, especially given intense tax competition in the region. However, the current system, centered on tax holidays and exemptions, needs to be replaced with more efficient schemes such as accelerated depreciation and investment credit. Legitimate concerns about low-income earners and small businesses would be better addressed by targeted measures such as increases in allowances and VAT thresholds.

38. Greater progress is needed in financial sector supervision. While recent improvements in banking prudential indicators are welcome, the rapid credit expansion and low provisioning, together with strong competition from loosely-regulated nonbank financial institutions, warrant enhanced supervision over the entire financial sector. Given extensive regional financial linkages and the lack of supervisory expertise, the authorities are right in considering outsourcing part of supervisory functions to a regional pool as a short-term solution. A long-term solution could be sought from the creation of a regional regulatory body in the context of ongoing regional integration initiatives.

39. Dominica’s external competitiveness remains broadly appropriate. The real effective exchange rate is the lowest in nearly 20 years, supported by fiscal consolidation and the EC dollar depreciation against the currencies of trading partners. This, together with other indicators such as tourism cost indices and recent developments in the tourism sector, suggests that the real exchange rate level is broadly competitive and the exchange regime, if supported by sound fiscal policy, continues to serve Dominica well.

40. Continued progress in structural reforms is critical for private-sector led growth. While some structural factors such as high transportation costs and the lack of economies of scale will continue to pose a challenge to the economy, the government could play an important role through structural reforms, including reforms of public entities, utilities, the judiciary and customs. This will help reduce costs of doing business and facilitate diversification away from the waning banana sector. Improvement of the management of public investment programs would also go a long way towards enhancing productivity of the private sector.

41. While data provision for surveillance purposes is adequate, weaknesses remain in the coverage, timeliness and dissemination. Comprehensive, reliable, and timely data are essential for policy analysis, effective policy-making and informed public debate. Ongoing economic transformation from agriculture to services makes it all the more important to improve the statistics. Priority would need to be given to compilation of national account statistics, in particular tourism, agriculture and labor statistics, and dissemination of intra-year fiscal statistics.

42. It is proposed that the next Article IV consultation with Dominica take place on the standard 12-month cycle.

Dominica: Reform of Indirect Taxes

The move to the new indirect tax regime has been largely successful. Dominica introduced a new VAT and excise duty regime in March 2006 to replace the sales, consumption, hotel occupancy and entertainment tax. Excise taxes covered motor vehicles, alcoholic beverages, petroleum and tobacco products. Preliminary evidence suggests that the new regime boosted indirect revenues. VAT collection in the first half of 2006/07 was much higher (10.4 percent of GDP) than budgeted (8.5 percent of GDP) although the buoyancy is likely to decline somewhat in the future with the normalization of VAT refund arrangements. The VAT yield during the same period was somewhat lower than the historical yield of the replaced taxes due to weak non-oil imports in 2006.

Dominica: VAT and Excises Reform

(As a percentage of GDP for the first half of a fiscal year) 1/

article image

First half of fiscal year covers July-December.

Excludes petroleum excise.

However, challenges remain. While the VAT efficiency, measured as the VAT share in GDP divided by the standard rate, remain high relative to other small islands, the filing rate is steadily declining. There is also room for improving VAT audit and refund management. Also, experience so far indicates that the registration threshold may be too low, making the tax costly to administer.

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VAT Efficiency*

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

* VAT efficiency is defined as the ratio of VAT revenues to GDP for 2002 divided by the standard rate.

Dominica: Managing an Aid Surge

As noted in a recent Occasional Paper,8 a surge in aid flows, while positive in principle, presents challenges as well. Scaled-up aid flows can cause upward pressure on the real exchange rate of the recipient countries if not handled by proper macroeconomic policies. Debt sustainability could be jeopardized if the aid is volatile and come in the form of debt. Aid flows can also strain the administrative capacity of recipient governments, fragment and impair budgetary procedures, and encourage rent-seeking behavior.

Dominica’s policy response to a recent aid surge helped boost private sector activity. Budgetary aid inflows rose by about 4 percent of GDP over the 2002-05 period, but as the authorities efforts led to an even larger improvement in the budget balance, the government saved more than the aid surge, reflecting the authorities’ primary concern about restoring fiscal and debt sustainability. In contrast, the external current account showed little improvement during the same period as the private sector increased its absorption, almost fully offsetting the rise in public savings without raising inflation or appreciating the currency.

This pattern of response to an aid surge is uncommon among PRGF-eligible countries. Ethiopia and Ghana neither absorbed nor spent in response to an aid surge, which led to an accumulation of international reserves without raising demand pressure. Mozambique, Tanzania, and Uganda spent the incremental aid without fully absorbing it. This helped build up international reserves, yet at the risk of real exchange rate appreciation.

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Experience with Aid in Selected Countries

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Source: Fund staff calculations.1/ The comparison periods are 1994-01 versus 2002-05 for Dominica, 1998-99 versus 2000-04 for Tanzania, and 1999-00 versus 2001-03 for others.2/ Fiscal aid inflows are budgetary grants, concessional loans, and debt relief to the government. External aid flows are fiscal aid inflows and external grants to the private sector including trade preferences for banana. Net flows deduct debt services and arrears clearance from gross inflows.3/ The external absorption ratio measures the extent to which the non-aid current account widens in response to an increase in external aid inflows. Similarly, the fiscal spending ratio measures the extent of widening in the non-aid fiscal deficit relative to an increase in fiscal aid flows.

External Competitiveness

Dominica’s export sector has been in transition since the early 1990s. The high-cost banana sector has been shrinking amid global trends of trade liberalization. Diversification to nonbanana production will likely continue as banana preferences are further eroded, although specialization in the Fair Trade niche could bring some support to the sector. Tourism is likely to maintain its expansion, supported by recent promotional efforts and new investment. In addition, the opening of a new off-shore medical school is also expected to be supportive. The future of manufacturing is more uncertain, due to structural impediments including a small domestic market and high transportation costs. The sector has potential, however, to keep a niche in regional markets for some products, given deepening trade integration in the Caribbean.

Notwithstanding the sector’s diverging performances, Dominica’s external competitiveness remains broadly appropriate. The tourism sector has so far been able to compensate for anemic growth in the rest of the export sector. The tourism sector has also performed well compared to other destinations in the region: (i) stay-over arrivals increased at an average annual rate of 3.7 percent during 2000-06, compared to 2.2 percent for the broader Caribbean region (World Tourism Organization); and (ii) tourism competitiveness indicators of World Travel and Tourism Council rank Dominica well compared to other Caribbean destinations. The EC dollar is broadly competitive, as in real effective terms it is nearly at a 20-year low. Its real effective rate has declined by some 14 percent since end-2000, reflecting relative domestic price stability and its depreciation against the currencies of appropriately weighted trading partners.1/ Although Dominica’s current account deficit remains high, it improved substantially in 2006 and continues to be financed mainly by capital grants and FDI.

Dominica’s fiscal consolidation has played a role in maintaining external competitiveness. Dominica’s real effective exchange rate has depreciated more than those in most of the other ECCU countries, largely reflecting fiscal consolidation in Dominica.

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Dominica: Main exports

(Millions of U.S. dollars)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Source: Dominica authorities.
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Dominica: Effective Exchange Rates

(Index 2000=100)

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: IMF, Information Notice System; and Fund staff calculations.
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Fiscal Consolidation and Real Effective Exchange Rate (REER) Decline, 2003–06

Citation: IMF Staff Country Reports 2007, 322; 10.5089/9781451810967.002.A001

Sources: Dominica authorities; and Fund staff calculations.
1 The weights used in these calculations are based on 1999-2001 data, and differ from those used in previous consultation reports in that they reflect, inter alia, Jamaica’s increased importance as a trading partner. This change has had little impact on the real effective exchange rate, but has reduced the extent of nominal depreciation. The weights have been further adjusted to capture an ongoing structural change, and so differ from those published in IFS.
Table 1.

Dominica: Selected Economic and Social Indicators

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Sources: Dominica authorities; ECCB; and Fund staff estimates and projections.

IMF Country Report No. 07/1, Seventh PRGF Review (November 2006).

Percentage changes relative to the stock of M2 at the beginning of the period.

Including errors and omissions.

Figures shown for a given calendar year relate to the fiscal year (July-June) beginning on July 1 of that year.

Does not include grants that were received but not spent, in line with IMF Country Report No. 05/384.

For 2005, it includes the reallocation of part of an external bond (around 4 percent of GDP) from external to domestic.

In percent of exports of goods and nonfactor services. Data are on prerestructuring terms up to 2005, and on postrestructuring terms for creditors participating in the debt restructuring and on prerestructuring terms for nonparticipating creditors

Transactions with the IMF are included as transactions of the monetary authorities.

Table 2.

Dominica: Summary Accounts of the Central Government 1/

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Fiscal years beginning July 1.

IMF Country Report No. 07/1, Seventh Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Assurances Review (November 2006).

Does not include grants that were received but not spent, in line with IMF Country Report No. 05/384.

2005/06 includes a reclassification of EC$2.3 million (0.3 percent of GDP) to other expenditure, reflecting a transfer of teachers from the government payroll to that of the State College.

Difference between identified financing and overall above-the-line balance.

Computed using overall deficit measured from below-the-line. Reported grants exclude resources received but not spent.

Historical data are subject to reconciliation with authorities.

Table 3.

Dominica: Balance of Payments

(In millions of U.S. dollars)

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Sources: Dominica authorities; ECCB; and Fund staff estimates and projections.

IMF Country Report No. 07/1, Seventh Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Financing Assurances Review (November 2006).

Projections based on WEO’s baseline oil prices projections of February 2007.

Data are on prerestructuring terms up to 2005, and on postrestructuring terms for creditors participating in the debt restructuring and on prerestructuring terms for nonparticipating creditors.

As a percent of exports of goods and services. For 2005 it includes the reallocation of part of an external bond (around 4 percent of GDP) from external to domestic.

Table 4.

Dominica: Summary Accounts of the Banking System

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Sources: ECCB; and Fund staff estimates and projections.

Program figures as shown in the Seventh Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Financing Assurances Review (November 2006). Transactions with the IMF are included as transacations with the monetary authorities.

Includes interbank float.

Including deposits denominated in U.S. dollars.

Percentage changes relative to broad money at the beginning of the period

Commercial banks; end-of-period rates for local currency, percent per annum.

Table 5.

Dominica: Medium-Term Macroeconomic Framework

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Sources: Dominica authorities; ECCB; and Fund staff estimates and projections.

Program figures as shown in the Seventh Review Under the Three-Year Arrangement Under the Poverty Reduction and Growth Facility and Financing Assurances Review (November 2006).

Calculated using the external current account including net external capital transfers.

Calculated on a fiscal year basis, with the figure shown relating to the fiscal year beginning in July.

Does not include grants that were received but not spent, in line with IMF Country Report No. 05/384.

For 2005, it includes the reallocation of part of an external bond (around 4 percent of GDP) from external to domestic.