Kingdom of the Netherlands
Netherlands Antilles: 2008 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the Kingdom of the Netherlands: Netherlands Antilles

The 2008 Article IV Consultation analyzes the promise of fiscal discipline and debt relief that has boosted investor confidence and growth in the Kingdom of the Netherlands—Netherlands Antilles. Although exports moderated temporarily, tourism was a bright spot owing to improvements in competitiveness as a result of infrastructure investments, and cost controls from immigration. Executive Directors encouraged the authorities to take the opportunity provided by the large debt relief from the Netherlands government under the dissolution agreement to set the budget and the economy on a more sustainable footing.

Abstract

The 2008 Article IV Consultation analyzes the promise of fiscal discipline and debt relief that has boosted investor confidence and growth in the Kingdom of the Netherlands—Netherlands Antilles. Although exports moderated temporarily, tourism was a bright spot owing to improvements in competitiveness as a result of infrastructure investments, and cost controls from immigration. Executive Directors encouraged the authorities to take the opportunity provided by the large debt relief from the Netherlands government under the dissolution agreement to set the budget and the economy on a more sustainable footing.

I. Recent Economic Developments

1. The promise of large-scale debt relief and fiscal responsibility under the dissolution agreement for the Netherlands Antilles has boosted investor confidence and ended a long period of stagnation (Box 1, Table 1, Figure 1). Economic growth accelerated sharply in 2007 to 3.8 percent, driven by investments in infrastructure, housing1 and tourism sectors, and increased private consumption, supported by income tax cuts and higher employment. The expansion was partly supported by credit growth, reflecting monetary easing in the United States. Preliminary indications are that the growth momentum is continuing in 2008.

Table 1.

Netherlands Antilles: Selected Economic and Financial Indicators, 2003–07

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

National account deflators are not available. CPI index is used instead.

Contribution to GDP growth.

Net international reserves of the central bank, end of period.

Figure 1.
Figure 1.

Netherlands Antilles: Recent Economic Developments

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Sources: National authorities and Fund staff estimates.

2. Inflation, historically low, jumped in 2008 due to an elimination of implicit oil subsidies. Earlier in 2008, parliament approved a full pass-through of energy price increases to consumers, which it had delayed since 2006, forcing the budget to absorb the costs as lower dividends. As a result, inflation, which usually broadly tracks U.S. inflation due to the anchor of the exchange rate peg to the dollar, rose, reaching 4.2 percent in Curaçao in May 2008. Food price increases have had less impact, given a low weight in the CPI basket.

3. The current account deficit increased sharply in 2007 in line with the surge in FDI flows related to large hotel projects. Exports moderated temporarily due to fire-related damages in the free-trade zone. However, tourism was a bright spot; notwithstanding the U.S. slowdown,2 competitiveness was boosted by prior investments in infrastructure, the euro appreciation, strong growth in the Netherlands, and downward pressures on costs from immigration. Imports surged in tandem with high oil prices and domestic demand, as could be expected given high import elasticities typical for small open economies with limited domestic agricultural and manufacturing production. The large current account deficit—16 percent of GDP in 2007—was more than financed by FDI, increased Dutch aid, and private sector trade credits. As a result, reserve coverage improved, fully covering short-term liabilities.

4. The government retrenched its finances through 2007, mainly through controls on spending. Notwithstanding income tax cuts in 2006, revenues held steady due to improvements in collections, including reductions in tax backlogs, and more recently, the introduction of modern techniques (container scanning) to prevent evasion of import and sales taxes. Spending cuts focused on curtailing current primary spending through reductions in the wage bill and spending on goods and services, though, in 2007, some arrears to APNA (the civil service pension fund) were incurred. However, total spending has remained high because of interest payments. Public debt remains close to 80 percent of GDP ahead of debt relief. All in all, the current budget balance has been held at 2½ percent of GDP during 2005-07.

Constitutional Changes and a New Fiscal Framework: The Key Elements

According to the December 2005 agreement to dissolve the Netherlands Antilles federation, Curaçao and St. Maarten will gain status aparte (as did Aruba in 1986), while the BES islands will become part of the Netherlands. While some specific details remain to be finalized, key elements of the dissolution agreement are:

  • Debt cancellation of about 80 percent of total public debt as of December 31, 2005 by the Netherlands. Details of the coverage, schedule, and modality of debt relief remain to be finalized, and the actual operations have been delayed. Debt relief will be conditional on the establishment of a fiscal framework, applicable to the local government of each island, and including:

    • The introduction of medium-term budgeting;

    • The establishment of a fiscal supervisor (chaired by a Dutch appointee) to supervise borrowing decisions, ensure that the fiscal rule (see below) is fully implemented, and advise responsible ministers.

    • A balanced current budget rule, with borrowing restricted to within-year cash management needs. Deviations will be allowed only in case of a disaster, with disaster relief subject to the approval of the fiscal supervisor.

    • Borrowing caps for capital expenditure, limiting annual interest payments to five percent of the average total revenue of the preceding three years, with loans for investments to be approved by the fiscal supervisor only if budget implementation is in line with the fiscal rule.

  • A common central bank for Curaçao and St. Maarten responsible for monetary policy and financial sector supervision for both islands.

  • A socio-economic initiative (SEI) to tackle social and economic problems.

The implementation of the dissolution agreement has already started, although the technical changes in the islands’ status (the “constitutional changes”) have now been postponed until January 2010. The BES islands have already introduced the fiscal framework, which Curaçao and St. Maarten are scheduled to begin implementing as from 2009. They have also agreed in principle to remain in a currency union, with the central bank in charge of monetary and exchange rate policies and financial sector supervision in both islands. The BNA’s charter is being modified accordingly, with agreement on the Board’s composition still pending.

5. The Bank of the Netherlands Antilles (BNA) tightened monetary policy, restraining credit growth. To offset the reduction in its benchmark pledging rate following cuts in the target U.S. federal funds rate, and to mop up excess liquidity, the BNA raised reserve requirements—its main policy instrument, besides CD auctions—from 12¼ to 13¼ percent in several steps since 2005. Credit to the private sector has grown steadily (12 percent year-on-year in May 2008), reflecting increased investor confidence and lower lending rates associated with intensified competition. Meanwhile, with inflows strong, the BNA has exceeded its target for reserve coverage (three months of imports).

6. The financial sector seems broadly healthy and compares favorably with the region (Table 2, Figure 2). Financial soundness indicators show adequate capitalization and profitability. Nonperforming loans remain moderate by Caribbean standards, notwithstanding some increase recently. Banking sector assets remain concentrated in the top two banks, reflecting limited competition on the funding side due to capital controls on institutional investors (pension funds and insurance companies), and market segmentation. However, increasing competition from smaller banks has compressed lending spreads modestly. Following a loss of market share earlier in the decade, assets of the international financial sector3 have since begun to recover (Table 3). Neither the domestic nor the international financial sectors have been affected by the global financial turbulence. Supervision and AML/CFT efforts have been strengthened (Informational Annex I, including implementation of Fund policy recommendations).

Table 2.

Netherlands Antilles: Indicators of External and Financial Vulnerability, 2003–07:

(In percent of GDP, unless otherwise indicated)

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

Refers to exports and imports including goods and nonfactor services.

Adjusted-total-assets is defined as total assets minus the asset categories that are subject to a zero risk-weighted factor.

Figure 2.
Figure 2.

Netherlands Antilles and Selected Caribbean Countries: Financial Sector Indicators

(2007, or latest available observation)

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Sources: Bank van de Nederlandse Antillen; International Financial Statistics; and Fund staff estimates.:ANT—Netherlands Antilles; ANB—Antigua & Barbuda; BAH—The Bahamas; BAR-Barbados; BEL—Belize; DOM—Dominica; GRE—Grenada; GUY—Guyana; JAM—Jamaica; SKN—St. Kitts & Nevis; SLU-St. Lucia; SUR-Suriname; SVG—St. Vincent & the Grenadines; TNT—Trinidad & Tobago.
Table 3.

Netherlands Antilles: Structure of the Financial Sector, 2003–07:

(In percent of GDP, unless otherwise indicated)

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Source: Bank van de Nederlandse Antillen.

II. Prospects, Opportunities and Challenges

7. Discussions focused on the opportunities and challenges presented by the dissolution agreement:

  • Although many reforms are planned (Informational Annex I), unresolved details in some areas are complicating decision-making. For instance, the terms of debt relief payments remain unclear, with important implications for fiscal policy, liquidity management, and financial sector balance sheets. Decisions regarding post-dissolution public sector institutional arrangements (including mechanisms to transfer central government tasks to local governments) are also pending.

  • An ongoing challenge for policymakers will be how to use the limited tools at their disposal to support growth, while containing vulnerabilities. The exchange rate peg constrains monetary policy and the forthcoming rule will all but eliminate the fiscal policy tool. The freedom of Antilleans to migrate to the Netherlands poses an additional constraint by contributing to downward inflexibility in wages in key sectors (especially high-skilled labor); high wages and large structural unemployment impede cost competitiveness. Finally, the small size of the economy limits the scope to diversify economic activities and improve cost competitiveness through large-scale immigration.

8. Against this background, discussions focused on the macroeconomic outlook with emphasis on policies to deal with three main areas of vulnerability:

  • Accommodating the strains on public finances from ageing related costs;

  • Managing the impact of debt relief on financial sector balance sheets; and,

  • Maintaining the viability of the peg through measures to improve competitiveness and foster investor confidence.

A. Macroeconomic Outlook and External Sustainability

9. On current trends, growth is likely to remain strong in 2008 and above historical norms over the medium term provided investor confidence can be sustained (Table 4). Growth is estimated at about 3 percent in 2008, broadly in line with the expectations of the Ministry of Finance; the BNA was more cautious. Growth is expected to be shored up by imported monetary easing, and ongoing investments in infrastructure, housing and tourism. Private consumption growth is likely to be more subdued than in 2007, as the impact of higher employment and planned minimum wage increases is partly offset by the decline in purchasing power due to the uptick in inflation. Staff estimates are cautiously optimistic for the medium term (2½ percent by 2011), predicated on the expectation that export markets will recover; recent infrastructure investments will have increased potential output; and the introduction of a fiscal rule and debt forgiveness will foster crowding-in of the private sector.

Table 4.

Netherlands Antilles: Medium-Term Macroeconomic Framework, 2003–11

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

National account deflators are not available. CPI index is used instead.

Contribution to GDP growth.

Assumes debt relief in 2009 of about 80 percent of total debt at end-2005 (specific details still under negotiation). It is assumed that the full amount of debt relief will be immediately available to the budget, but that the actual debt relief will be disbursed by the Dutch (if the preconditions relating to the fiscal framework are met) in accordance with the maturity schedule of the government bonds.

Net international reserves of the central bank, end of period.

10. Following a sharp uptick in 2008, inflation is expected to broadly track that of the U.S. Staff and the authorities project inflation to reach 5 percent by end-2008, reflecting energy and utility price increases. Thereafter, inflation should again converge to U.S. levels; pending regulatory changes should eliminate significant future delays in passing international oil price developments through to domestic prices. The containment of average wages through low-wage immigration and the high import elasticity of demand will also limit inflationary pressures.

11. The 2008 current budget deficit is expected to decline, despite the delay in debt relief. This improvement can be attributed to higher revenues from stronger-than-budgeted economic growth, larger dividends from enterprises (reflecting the large adjustment in oil and utility prices), and the full-year effect of the improvements in tax collection introduced in late 2007. Current primary spending—on a downward track since 2004—has been restrained to the 2007 level, despite modest increases in outlays related to the constitutional changes and payment-in-full of APNA premiums. Thus, the current budget deficit is on track to remain below the 2007 level, despite the delay in debt relief (adding an additional 3½ percent of GDP to expenditures). A steep increase in aid-financed investment cofinancing (decided when debt relief was expected to occur in 2008) will, however, widen the overall deficit sharply, to some 3¾ percent of GDP.

Netherlands Antilles: Fiscal Adjustment:

(In percent of GDP)

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Sources: National authorities and Fund staff estimates.

12. External current account developments are likely to remain manageable (Table 5). Following the completion of big-ticket tourism-related projects, the current account deficit is likely to narrow, but remain significant, over the medium term assuming that investment needs continue to be financed by foreign savings in the form of grants and FDI. While the “headline” current account deficit will remain significant, the deficit net of grant aid and FDI—a better measure of vulnerability—will be much smaller. In the absence of such financing, the current account deficit would automatically adjust—import demand generated by these inflows would not materialize. Reserve coverage is expected to remain sufficient at 3½ months of imports. External debt, already moderate, is expected to fall further after debt relief. Its projected evolution, consistent with the benign current account outlook, is robust to shocks (Figure 3).

Table 5.

Netherlands Antilles: Balance of Payments, 2003–11:

(In percent of GDP, unless otherwise indicated)

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

Assumes debt relief in 2009 of about 80 percent of total debt at end-2005 (specific details still under negotiation). It is assumed that the full amount of debt relief will be immediately available to the budget, but that the actual debt relief will be disbursed by the Dutch (if the preconditions relating to the fiscal framework are met) in accordance with the maturity schedule of the government bonds.

Mainly taxes on the international financial and business sector.

Including commercial banks; excluding gold revaluation.

Figure 3.
Figure 3.

Netherlands Antilles: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Sources: Bank van de Nederlandse Antillen; and Fund staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2009.

13. Provided reforms are implemented, the improvement in various competitiveness indicators should continue (Figure 4). Low inflation, as well as a sharp depreciation vis-à-vis the euro by virtue of the dollar peg, has implied a significant depreciation of the CPI-based real effective exchange rate (REER). The estimated equilibrium REER has fallen since the beginning of the decade owing to reductions in government consumption and the terms of trade. The actual REER appears to be broadly in line with fundamentals (3 percentage points from its estimated equilibrium rate in the past four years). If planned reforms are implemented, then the recent gains in market share for goods exports, and tourism market shares relative to Caribbean competitors, should also hold up.

Figure 4.
Figure 4.

Netherlands Antilles: Competitiveness Indicators, 1990–2008

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Sources: Bank van de Nederlandse Antillen; and Fund staff estimates.1/ For transportation and tourism receipts, market share relative to Eastern Caribbean partners; for stayover arrivals, relative to The Bahamas and Barbados.2/ See Cashin and Pineda (forthcoming Working Paper). Equilibrium REER estimated using panel data for 11 eastern Caribbean economies, with the REER a function of the following fundamentals: productivity differentials, terms of trade, government consumption and net foreign assets.

14. In this environment, the long-standing peg to the U.S. dollar remains viable. The economy’s small size and its strong economic and commercial ties with the U.S., argue for maintaining the peg. The authorities view the peg as a durable and effective nominal anchor, instrumental in keeping inflation and inflationary expectations low, and fostering trade and investment by allowing long-term investment planning. Maintenance of a nominal peg is also consistent with policies in similarly situated competitor countries in the region (Figure 5). Staff concurred and also supported St. Maarten’s decision to continue its currency union with Curaçao, since a separate central bank (under consideration at one point) would entail high costs relative to the seigniorage and monetary policy benefits. In this context, staff urged that changes to the BNA’s charter not undermine its political independence.

Figure 5.
Figure 5.

Cross-Country Competitiveness and Vulnerability Indicators, 1995–2008

(In percent of GDP, unless otherwise indicated)

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Source: National authorities and IMF, IFS.: Netherlands Antilles=ANT, Antigua and Barbuda=ANB, Bahamas= BAH, Barbados=BAR, Dominica=DOM, Grenada=GRE, St. Kitts and Nevis=SKN, St. Lucia =SLU, St. Vincent and the Grenadines=SVG.

B. Fiscal Sustainability

15. The balanced budget rule and fiscal supervision will start in 2009; implementation will be key. Given the benign macroeconomic outlook, the authorities and staff agreed that the establishment of the proposed fiscal rule as from 2009—and the implied fiscal consolidation—would be appropriate. The annual deficit-cum-debt limits are designed to constrain fiscal policy and ensure that the benefits of debt forgiveness are not undercut by new public borrowing (a recurrent problem in the past). Staff cautioned that the successful implementation of the fiscal rule would be key. This time, the rule may be more successful in imposing fiscal discipline, given the merger of different layers of government (hitherto a key source of friction) in the new structure and a reduced expectation of future bailouts. The authorities saw the participation of the Dutch government in the supervisory body and the ability of the supervisor to escalate concerns to the Kingdom of Netherlands as being the most important deterrents. Staff also stressed the critical importance of ensuring proper accountability and insulating the supervisory body from political pressure.

16. Going forward, fiscal policy will need to balance the twin objectives of preserving competitiveness and remaining sustainable within the constraints of the fiscal rule. Competitiveness considerations argued for lower tax, wage, and social contribution rates relative to competitors to attract business; yet, wages, pensions, and safety nets needed to remain competitive with the Netherlands to attract and retain skilled labor. At the same time, public finances would need to make room for commitments arising from the entitlement policies. Public debt will be sustainable post-debt relief (Figure 6).

Figure 6.
Figure 6.

Netherlands Antilles: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2008, 315; 10.5089/9781451801064.002.A001

Sources: Sources: Bank van de Nederlandse Antillen; and Fund staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator). The depreciation shock scenario is equivalent to the baseline if debt relief results in zero foreign-currency public debt.

17. Preliminary balanced budget plans for 2009-11 assume revenue neutral tax policy changes. The authorities intend to broaden the tax base through a revenue-neutral rebalancing of the tax burden with lower direct tax rates4 and higher indirect tax rates; to convert the turnover tax into a “VAT” by eliminating cascading; and, to continue improving collections by upgrading databases, simplifying procedures and rationalizing tax rates.5 They also intend to improve public enterprise finances by introducing automatic adjustment of tariffs and better oversight of balance sheets.

18. On spending, additional measures would be required to balance the current budget. If interest savings from debt relief—some 3½ percent of GDP per year—could be fully saved, this would be more than sufficient to bring the current budget deficit of 2008 into balance from 2009 onwards. However, absent reform, additional spending pressures will arise from three sources starting 2009. First, the government’s pension premium payments to APNA are set to increase due to inflation indexation. Second, there will be a need—within the constraints of the fiscal rule—for effectively targeted social transfers to vulnerable sections of society to mitigate the impact of food and fuel price increases and indirect taxes. Finally, without entitlement reforms, the SVB (Social Insurance Bank) is set to face rising deficits every year due to increasing healthcare costs and pension payments to an ageing population. These must be met through budget transfers of some ½ percent of GDP per year during 2009–11. Together, these new spending pressures would absorb the debt relief-induced interest savings, and, furthermore, require current budget surpluses of some ½ percent of GDP to be set aside every year as transfers to SVB (Table 6).

Table 6.

Netherlands Antilles: Operations of the General Government, 2003–11:

(In percent of GDP)

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Sources: Data provided by the authorities; and IMF staff projections.

Assumes constant elasticity with respect to GDP over the projection period and no change in tax policy. Future changes in tax policy would be revenue neutral but would change the composition of revenue.

Net of ERNA transfers between different levels of government.

2008 estimate includes wage increases, payment of backlogs to police, and no build-up of arreas in pension premium payments. 2009–11 projections assume increase in APNA pension premiums and lower civil service wage bill.

2008 estimate includes expenses related to the constitutional changes. 2009–11 includes transfers for healthcare services.

Assumes debt relief in 2009 of about 80 percent of total debt at end-2005 (specific details still under negotiation). Also assumes that the full amount of debt relief will be immediately available to the budget, but that the actual debt relief will be disbursed by the Dutch (if the preconditions relating to the fiscal framework are met) in accordance with the maturity schedule of the government bonds.

Projected operational deficits at the health care fund related to increasing cost of health care may affect the fiscal balance.

Projected operational deficits at the AOV funds related to aging population may affect the fiscal balance.

19. Discussions focused on expenditure-saving measures. The authorities’ current plans (still preliminary) entail sharp real cuts in all categories of current primary spending, mostly through rationalization and greater oversight of subsidies. Given past cuts in civil service size and pay, the authorities considered further civil service downsizing would be difficult, especially since work processes had not been streamlined. Staff was sympathetic to these concerns, but noted that—given additional spending pressures in the absence of reform—there may be no alternative but to seeking further savings from rationalizing the civil service and processes in the new political structure, and limiting wage increases to productivity growth.

20. The reform of entitlements, already started, should now be completed. Staff welcomed recent actions to control healthcare costs, and reform APNA, by making inflation indexation conditional on the asset-liability coverage ratio, and changing the pension base to the average salary. However, staff also urged that the remaining reforms under consideration, namely raising the retirement age to 65 and, for SVB, eliminating the regressive income ceiling for social contributions, be completed. The authorities considered raising the retirement age an important, but politically difficult task. Staff noted that these reforms taken together would not only bring pension parameters in line with those in the Netherlands (the main competitor in the labor market), but could potentially create room for a future reduction in contribution rates and pension premiums, thereby improving competitiveness and fostering buy-in. Staff also stressed that improving the pension funds’ ability to earn higher returns on their assets—without undue risk—by gradually easing investment restrictions would be important to easing their financial burden.

Pension Systems in the Kingdom of the Netherlands 1/

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Source: National authorities.

Includes all mandatory parts of the pension system, both public and private. Excludes voluntary pensions.

The number of contribution years for early retirment is 30 and 35 years for APNA under the old and the new arrangement respectively.

C. Financial Sector Development and Stability

21. The authorities are taking steps to manage the liquidity impact of debt relief. Debt relief is likely to take the form of government security buybacks funded by the Netherlands, which could flood the economy with liquidity beyond its capacity to absorb, at a time when the fiscal rule limits opportunities to invest in new government securities. In the first instance, this would provide liquidity to the main holders of existing government securities, namely, the local institutional investors, which face restrictions on the amounts they can invest abroad (the “60:40” rule).6 These restrictions—which force institutional investors to earn lower returns on domestic investments compared with alternatives abroad—have been a source of concern for some time; matters are now more pressing given the lack of new government securities and the need for higher payouts to an ageing population. The BNA has responded to these concerns by exploring ways to develop alternative investment opportunities (e.g. the corporate bond market), and has also reduced the “60:40” penalty to make it less costly to invest abroad. Nevertheless, it is reluctant to ease the capital controls in case this would lead to capital outflows.

22. Staff proposed a three-pronged approach to addressing this problem, which the BNA has since publicly adopted. First, an effort—already underway—to reach agreement with the Dutch government on a sufficiently gradual schedule of debt relief payments to avoid excess liquidity. Second, some tightening of monetary policy instruments by the BNA may be appropriate, although all acknowledged the limited scope for further tightening, since reserve requirements are already quite high and conventional sterilization on a large scale would be cost-prohibitive, hurting the BNA’s balance sheet, and therefore the budget.7 Third, the “60:40” investment rule for institutional investors should be gradually phased out. The discussion focused mainly on the rationale and pace of phasing out capital controls.

23. A gradual easing of capital controls to accommodate the liquidity impact of debt relief would help protect financial sector balance sheets, without undermining the exchange rate peg. Staff urged the BNA to avoid removing the controls in one go (e.g. by reducing the penalty to zero) as it could generate macroeconomic imbalances in an economy used to captive funding sources. On the other hand, forcing institutional investors with large holdings of government securities to invest large amounts of liquidity locally would drive down domestic interest rates and endanger their balance sheets (with eventual fiscal consequences), given the scarcity of alternate domestic assets. Developing alternative domestic assets for investment would take time, and may not be of the size and risk-return profile suitable for institutional investors. Staff also cautioned that while banks could invest their additional liquidity abroad, they may instead seek higher rates of return by on-lending these funds domestically. This could translate into pressure on bank balance sheets as banks undertake more risky lending, and further increase asset prices. Unduly rapid domestic credit expansion could—in the extreme—fuel an import boom, thereby realizing the BNA’s fears about capital outflows.

24. The phased removal of capital controls would have the additional benefit of fostering financial sector competition. Banks would be forced to compete on the funding side and further improve operational efficiency and diversify income sources. The improvement in competition could be further facilitated by greater financial integration with Caribbean countries (supported by strong supervision), and the consolidation of smaller banks—as is underway—to level the playing field.

25. Institutions and supervisors are likely to face a more difficult environment in the period ahead. Financial institutions’ profit margins are likely to come under pressure from the disappearance of risk-free investment opportunities, and—as a side-effect of debt relief—lower income from high-yielding government securities. Banks may face incentives for greater risk-taking to maintain profitability, requiring the BNA to be especially vigilant against a deterioration in lending standards. The BNA considered these risks to be more acute in the smaller banks, on the grounds that the large banks were subject to more rigorous risk management by their parent banks. The decision to vest supervisory powers in the BNA post-dissolution was welcome, since it has the necessary expertise.

D. Structural Reforms and Competitiveness

26. With fiscal and monetary policy locked in, structural reforms take on added importance as the chief instrument for boosting competitiveness and preserving investor confidence. The broad range of reforms proposed in the draft tripartite protocol agreed between labor, government and businesses to improve productivity, and the social economic initiative, indicate strong support for seizing this “once-in-a-lifetime opportunity” to undertake necessary reforms.

27. The planned reforms are welcome, but implementation would be key. Discussions focused on two areas in particular—taxation and labor market reform—as follows:

  • On tax reforms, competitiveness considerations should also be taken into account when setting tax rates. Direct tax rates are high by regional standards, with the tax burden borne disproportionately by the largest firms and workers, deterring foreign investors and skilled labor. Thus, in setting direct tax rates, and streamlining procedures, the authorities would also need to take into account the impact on the competitiveness of businesses. In addition, representatives of the international financial sector stressed the importance of double taxation agreements for their competitiveness.

  • The draft tripartite protocol was encouraging, but implementation of the proposals as a package was required. The draft strategy emphasizes “flexicurity,” and puts the onus on all parties to contribute collectively to improving productivity. Thus, it proposes easing dismissal and work permit regulations, while emphasizing training and measures to encourage labor force participation. Staff was encouraged by the business communities’ willingness to accommodate labor costs increases (e.g. the planned minimum wage hike), provided these could be ameliorated by flexibility in other areas.

Cross-Country Comparison of Tax Rates

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Source: KPMG; Daten Info Service Eibl GmbH at http://www.icldirectory.com/

The standard rate of turnover tax is 5 percent in Curacao and Bonaire and 3 percent in St. Maarten.