Staff Report for the 2008 Article IV Consultation

The 2008 Article IV Consultation with Dominica discusses external competitiveness and key policy issues. The real effective exchange rate is broadly in line with macroeconomic fundamentals. Fiscal policy is appropriately focused on reducing high public debt. Plans for developing the tourist sector, including improving air access and roads to tourist attractions, are well advanced and should be financed with a view maintaining the sustainability of public debt. The authorities rightly emphasize improving the business climate, strengthening regulation and supervision of the financial sector, and improving disaster preparedness.

Abstract

The 2008 Article IV Consultation with Dominica discusses external competitiveness and key policy issues. The real effective exchange rate is broadly in line with macroeconomic fundamentals. Fiscal policy is appropriately focused on reducing high public debt. Plans for developing the tourist sector, including improving air access and roads to tourist attractions, are well advanced and should be financed with a view maintaining the sustainability of public debt. The authorities rightly emphasize improving the business climate, strengthening regulation and supervision of the financial sector, and improving disaster preparedness.

I. Introduction1

1. Dominica is extremely vulnerable to exogenous shocks, and recent economic policy has been aimed at creating buffers against such events. The economy is susceptible to a variety of natural disasters, and is ranked 12th on the list of 111 countries on the Commonwealth Secretariat/World Bank’s composite vulnerability index. The economy is also sensitive to external economic developments such as the global slowdown after September 11, 2001. The crisis in 2002 was also precipitated, however, by lax fiscal policy, as inefficiencies in the tax system magnified the revenue impact of weaker activity. In contrast, the current slowdown finds the economy with slightly more fiscal room to maneuver due to a lower debt burden and greater flexibility from structural reforms.

2. The authorities implemented bold measures under the PRGF–supported program that ended in 2006, but additional steps are necessary to increase the country’s resilience. Measures taken under the program helped stabilize the fiscal position and thereby placed debt ratios firmly on a declining path. Reform of indirect taxes has improved revenue performance. Since the expiration of the PRGF arrangement, the thrust of the authorities’ policies has been consistent with Fund advice. Further efforts are needed, however, to achieve a more comfortable debt level, and thus create room to deal with natural disasters and eventually provide scope for countercyclical policies. It is also important to continue reducing vulnerabilities in the financial system to increase resilience to external shocks, and to continue working with other stakeholders to improve the catastrophic risk insurance facility.

II. Background

3. Dominica was struck by Hurricane Dean in August 2007, causing damage estimated at almost 20 percent of GDP (Box 1). The agricultural sector, one of the major sources of foreign exchange earnings, took the brunt of the damage. Economic growth is estimated to have slowed to around 1½ percent in 2007 from a pre–hurricane forecast of 3 percent, while the loss in export earnings in 2007 is estimated at 2½ percent of GDP (Figure 1 and Table 1). Inflation reached 5½ percent in December 2007, reflecting significant increases in food prices and the pass–through of higher petroleum prices. The donor community has responded by providing disaster relief grants to help address immediate humanitarian needs, and to undertake repair and reconstruction of essential infrastructure. However, given the severity of structural damage, the reconstruction process will require considerable resources, and is likely to be limited by implementation capacity.

Dominica: Emergency Natural Disaster Assistance

Dominica was struck by Hurricane Dean in August 2007, which caused damage estimated at nearly 20 percent of GDP and loss of life. The agriculture sector was most severely affected, and damage to the housing stock and infrastructure was also considerable. The international donor community provided assistance to help in disaster relief and rehabilitation of essential infrastructure. The Executive Board approved a request for Emergency Natural Disaster Assistance (ENDA) in the amount of SDR 2.05 million on February 4, 2008.

In the letter of intent, the government committed to maintaining a primary surplus of 3 percent of GDP despite the effects of the hurricane. They proposed to limit additional spending to 2½ percent of GDP after reallocation of expenditure already in the FY 2007/08 budget. The implementation of the planned income tax reform was expected to proceed, but the schedule could be varied to protect the primary surplus target and pressures to reduce VAT rates arising from inflation concerns would be resisted. Structural reforms aimed at fostering private sector growth and poverty reduction would proceed as planned.

Dominica: Key Fiscal Indicators, FY 2007/08 In percent of GDP

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

Adjusted for FY 2006/07 outturn and implementation capacity.

Deflated by GDP projected at the time of the ENDA request.

Fiscal performance has been in line with expectations at the time of the ENDA request. The surplus projected for the end of the fiscal year is expected to be about 3 percent of GDP as increased revenue from VAT and import duties have offset the revenue forgone by lowering the excise duty on fuel for electricity generation. Expenditure increases have been limited to about 2 percent of GDP. The first phase of the income tax reform was implemented on schedule in January 2008, while VAT rates were kept unchanged.

Looking ahead, the authorities have revised the GSPS to update their reform agenda and have sought the support of the international donor community for their policies. They have retained the medium–term fiscal targets but would need to keep open the option to vary the pace of implementation of the income tax reform to protect these targets.

Figure 1.
Figure 1.

Dominica: Selected Indicators

Citation: IMF Staff Country Reports 2008, 310; 10.5089/9781451810998.002.A001

Sources: Dominica authorities; ECCB; WHD Staff Forecast Database; IMF, Information Notice System; and Fund staff estimates.1/ Includes wholesale and retail trade, hotel and restaurant, air transport, and half of local transport.2/ Aggregates are PPP weighted averages.
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.

4. Fiscal performance remained strong in FY 2007/08 despite hurricane–related increases in expenditure. Robust revenue performance in VAT and import duties, due in part to the surge in imports related to reconstruction, helped partially compensate for revenue forgone from the introduction of the income tax reform in January 2008 and the reduction in the excise tax on fuel used for electricity generation (Figure 2 and Table 2). Higher revenue has offset the increase in expenditure after Hurricane Dean. Outlays on goods and services related to rehabilitation increased following Hurricane Dean while grants financed the enlarged capital investment, enabling the achievement of a primary fiscal surplus of 3 percent of GDP. The first phase of a multiyear personal income tax reform was implemented in January 2008, which is projected to result in revenue losses of about ½ percent of GDP in 2007/08, and 1½ percent of GDP annually over the medium term (Box 2).

Figure 2.
Figure 2.

Dominica: Fiscal Developments, 2003–07 1/

(In percent of GDP, central government)

Citation: IMF Staff Country Reports 2008, 310; 10.5089/9781451810998.002.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.
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.

IM F 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).

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.

Dominica: Income Tax Reform

The authorities announced in the Budget address for FY 2007/08 a far–reaching income tax reform to reward effort, increase competitiveness, and reduce the tax burden. The income tax reform builds upon the rise in revenue that resulted from the introduction of the VAT and excise duty regime in March 2006. The three main features of the income tax reform are: an increase in the personal allowance; a reclassification of tax brackets, and a reduction in tax rates in each of the three income brackets.

The average tax rate paid by a representative taxpayer will decline substantially with the reform, providing proportionally the greatest benefit to lower income taxpayers. Taking as representative taxpayer a central government employee, his/her average tax rate will be cut by nearly one–half from 9.8 percent in the old tax schedule to 6.9 percent in FY 2007/08 to 4.8 percent over the medium term.

Dominica: Income Tax Reform

(In Eastern Caribbean dollars and percentages)

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Source: Ministry of Finance.

How will Dominica’s income tax regime compare to that in other countries in the region after the reform? On completion, at 35 percent the maximum personal income tax rate will be equal to that in Trinidad and Tobago, but still above most of the rates in other Caribbean countries. The ratio of the exempted threshold to GDP per capita will, however, rise to 1.7—above most countries in the region.

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Caribbean: Personal top income tax rates

Citation: IMF Staff Country Reports 2008, 310; 10.5089/9781451810998.002.A001

1/ Antigua and Barbuda data include the nontaxable income threshold.

Income tax cuts need to be undertaken gradually and consistent with the primary surplus of 3 percent of GDP that guides the authorities’ growth and debt sustainability strategy. The income tax reform is being introduced in stages starting in January 2008. The pace of implementation of the tax reform remains flexible to protect the primary surplus target of 3 percent of GDP. The annualized tax revenue foregone due to the income tax reform amounts to about 0.9 percent of GDP for FY 2007/08 rising to the 1.4–1.7 percent range over the medium term. The bulk of the fiscal cost comes from increasing the exempted threshold.

5. The achievement of satisfactory primary surpluses in recent years has kept the public debt on a firmly downwardpath following the 2005 debt restructuring. The public debt/GDP ratio declined to below 95 percent of GDP in 2007. The authorities have continued to make good–faith efforts to negotiate agreements with hold–out creditors. Anagreement that preserves equality of treatment for all debtors is being finalized with one of the remaining creditors, and payments continue to be made into the escrow account established under the debt restructuring agreement.

6. The current account deficit is estimated to have widened by almost 6 percent of GDP in 2007 to 23½ percent of GDP. As a result of the hurricane, exports are estimated to have declined by 1 percent of GDP, while imports have risen by 2½ percent of GDP, reflecting reconstruction activities (Figure 3 and Table 3). The deterioration in the current account was exacerbated by lower tourist receipts, as well as the rising petroleum and imported food bill.

Figure 3.
Figure 3.

Dominica: External Competiveness Indicators

Citation: IMF Staff Country Reports 2008, 310; 10.5089/9781451810998.002.A001

Sources: Dominica authorities; and IMF Information Notice System.1/ An increase (decrease) indicates an appreciation (depreciation). Index 2000=100.2/ The sharp movements in the competitor–based real exchange rate in 2002–04 were largely driven by the Dominican Republic’s peso.
Table 3.

Dominica: Balance of Payments

(In percent of GDP)

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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.

Refers to financing associated with Dominica’s debt restructuring.

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.

7. Private sector credit growth slowed in 2007 following a rapid expansion in 2006. As a disaster–related surge in remittances led to a lower demand for credit, and external grants increased the liquidity of the banking system, banks placed more assets abroad. Net foreign assets of the banking system increased by EC$50 million to over EC$300 million during 2007 (Figure 4 and Table 4). The banking system appears profitable and well–capitalized—although the ratio of capital to risk weighted assets has been declining, it is still over 16 percent compared with the ECCU minimum requirement of 8 percent (Table 5). The regulation of the nonbank financial sector is uneven despite recent efforts to improve oversight. In particular, credit unions and insurance companies compete with commercial banks for deposits and loans, but are not subject to similar supervisory standards.

Figure 4.
Figure 4.

Dominica: Financial Sector Developments

Citation: IMF Staff Country Reports 2008, 310; 10.5089/9781451810998.002.A001

Sources: ECCB; and Fund staff calculations.
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: Financial and External Vulnerability Indicators

(In percent of GDP, unless otherwise indicated)

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Sources: ECCB; and Fund staff estimates and projections.

Treasury bill rate adjusted by end–of–period inflation.

Includes errors and omissions.

Imputed reserves at the ECCB until 2001. From 2002, transactions with the IMF are included as transactions of the monetary authorities.

Debt at remaining maturity (measured as public sector external amortization due the next year).

Refers to public sector debt.

Banking System Indicators

(In percent unless otherwise stated)

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Provisioning for loan losses to total loans.

8. The Growth and Social Protection Strategy (GSPS), developed alongside the PRGF–supported program, is being revised to amplify the structural reform agenda. The emphasis is on reducing the cost of doing business, including improving the efficiency of the energy sector. Recent structural reforms have helped improve the business climate, resulting in steady improvement in the World Bank Index of Doing Business. Nevertheless, private investment is limited by infrastructure constraints, combined with inefficient contract enforcement and land registration processes. Delivery of fuel under the PetroCaribe agreement began in February with the opening of the Venezuelan–constructed oil terminal, and steps are being taken to explore Dominica’s geothermal potential.

III. POLICY DISCUSSIONS

9. Dominica is grappling with the challenges facing the entire ECCU—slower growth and a spike in inflation triggered by external shocks and a weakened global environment. Accordingly, policy discussions focused on the growth outlook, fiscal policy, and structural reforms to improve competitiveness and reduce vulnerabilities. In particular, the discussions dealt with: (i) risks to the growth outlook posed by the weakening global economy and rising commodity prices; (ii) maintaining fiscal stability; and (iii) continuing the reform momentum to enhance private sector growth and further reduce financial sector and weather–related vulnerabilities. There was broad agreement on the staff’s recommendations and the policy implications.

A. Outlook and Risks

10. The economy is expected to rebound in 2008, but is unlikely to regain pre–hurricane growth for some time. The spillover effects of the slowdown in the U.S. economy are expected to be partly offset by domestic factors.2 Growth is projected at 2½ percent in 2008, supported by reconstruction efforts and recovery in agriculture. Inflation is expected to reach 6½ percent at end–2008, and then to moderate gradually in line with WEO projections of international food and petroleum prices. The external current account deficit is projected to rise another 5 percent of GDP in 2008, as exports are projected to fall by 2 percent of GDP, reflecting the full–year impact of the hurricane and the loss of export income due to the closure of a toothpaste factory in the last quarter in 2007. Meanwhile, imports would continue to rise due to reconstruction efforts (Table 6). The large current account deficit would be financed mainly by FDI and public sector grants. Domestic consumption and investment would be supported by remittance flows and abundant liquidity in the banking system.

Table 6.

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.