Vanuatu
2009 Article IV Consultation: Staff Report; Public Information Notice on the Executive Board Discussion; and Statement by the Alternate Executive Director for Vanuatu

The staff report for Vanuatu’s 2009 Article IV Consultation discusses economic developments and policies. Vanuatu is well placed to take countercyclical measures should growth slow more than expected. Although close monitoring of banks is necessary given the rapid growth in the private sector credit last year, the wide differential in policy rates between Vanuatu and its major trading partners suggest that there is some scope for monetary easing if things deteriorate more than expected.

Abstract

The staff report for Vanuatu’s 2009 Article IV Consultation discusses economic developments and policies. Vanuatu is well placed to take countercyclical measures should growth slow more than expected. Although close monitoring of banks is necessary given the rapid growth in the private sector credit last year, the wide differential in policy rates between Vanuatu and its major trading partners suggest that there is some scope for monetary easing if things deteriorate more than expected.

I. Introduction

1. After a period of relative political instability, the political situation has stabilized. With no party commanding a majority, a coalition government, headed by Edward Natapai, took office on September 22. After defeating several opposition-led no-confidence votes, the political situation has stabilized and the government is moving ahead on policymaking. The 2009 budget was also finally passed in March. With support from donors, a number of initiatives, including improving transparency of government operations, are underway.

2. The 2009 Article IV consultation focused on the spillovers from the global slowdown in Vanuatu and measures to reduce its adverse impact on the economy. In particular, while Vanuatu’s close links with Australia and New Zealand (through tourism and foreign direct investment (FDI)) have been the major sources of growth so far, they have heightened Vanuatu’s vulnerability to the projected downturn in these two countries. In addition, growth could be affected further if concerns about the global slowdown were to drive domestic banks to cut back lending. On the positive side, the decline in food and fuel prices should help reduce inflationary pressures, providing room to ease monetary policy.

II. Recent Economic Development and Outlook

A. Economic Backdrop

3. Vanuatu has so far been largely sheltered from the impact of the global financial turmoil. Coming out of a decade of stagnant growth, Vanuatu has grown at an average rate of 6 percent in 2003–08, outperforming most of the other Pacific Island countries (PICs), while maintaining a relatively low inflation rate and an improving fiscal balance (Box 1).

uA01fig01

Contribution to GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Vanuatu authorities.
  • A booming tourist sector helped to keep economic activity buoyant. Growth remained strong in 2008 at 6½ percent, driven primarily by the service sector (which accounts for about two-thirds of GDP) and aid inflows, including increased disbursements from the Millennium Challenge Account (MCA). The agricultural sector also pitched in last year on the back of higher commodity prices.

Vanuatu’s Recent Success

After several years of low growth, economic growth in Vanuatu has picked up since 2003. A booming tourism sector combined with FDI, particularly in real estate by Australians, has helped Vanuatu achieve these high growth rates. Inflation has remained low compared to other PICs, and the introduction of VAT, combined with improved tax compliance and strengthened expenditure controls, has resulted in improvements in the fiscal position. Some factors for Vanuatu’s success are:

  • Progresses in transportation and communication sector: Vanuatu has a natural advantage over other PICs in terms of proximity to Australia and New Zealand, encouraging low-cost carriers to offer flights to Vanuatu, including Pacific Blue, which initiated an international flight operation in 2004. Following this, the government relaxed restrictions and allowed foreign carriers to compete with the local airlines. Port Vila is now connected with Australia, New Zealand, and Fiji by several airlines. In addition, the government ended the monopoly in the telecommunication sector in 2006 by allowing a second telecommunication license. More recently, Digicel has been allowed to offer cellular phone services in Vanuatu.

  • Fiscal resource management: Introduction of VAT and commitment to capacity building in the tax office have contributed to an increase in government revenues. The government has also improved transparency in fiscal management through more frequent reporting. The regulatory framework for the state-owned utility company has been strengthened. Privatization of Air Vanuatu is also under consideration and should help reduce inefficiencies in the state-owned enterprise sector.

  • Sound monetary and financial policy: With the help of technical assistance from the Pacific Financial Assistance Center (PFTAC) and other donors, the Reserve Bank of Vanuatu (RBV) has increased capacity and transparency of monetary operations. The exchange rate arrangement has helped to contain inflationary pressures. The banking sector follows international prudential standards. Vanuatu’s AML/CFT framework has been assessed against the Financial Action Task Force (FATF) 40+9 Recommendations in 2007 by the Asia-Pacific Group on Money Laundering. Progress has been made in many areas over the past few years and further improvements are underway.

  • Political stability: While the government changed hands frequently in 1995–2003, political stability under the former coalition government, which managed to stay in office for four years, boosted confidence in the economy and enabled the government to pursue structural and fiscal reforms.

Continued reform efforts are essential for further growth. Notwithstanding the recent impressive performance, if reform efforts stall and political instability reappears, Vanuatu could fall back to lower growth rates.

  • Inflation accelerated to 5.8 percent in 2008 from 4.1 percent in 2007. The increase was driven largely by the pass-through of higher international food and fuel prices, with the depreciation in the Australian dollar since August and rapid private sector credit growth also being contributory factors.1 More recently, food and fuel prices have started to decline, and with core inflation remaining relatively stable, the second round effects appear to be limited and manageable.

uA01fig02

Inflation Components

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: Vanuatu authorities; and IMF staff calculations.
  • The current account deficit widened but was largely financed by aid flows. The current account deteriorated in 2008 as rising exports, driven primarily by the recovery in copra and coconut oil exports and tourist revenues, were more than offset by increased imports of food and fuel, and machinery and transport equipment (the latter due to infrastructure projects under the MCA). An uptick in aid inflows, mainly disbursements from the MCA, helped finance the large import bill. On the other hand, FDI slowed considerably in 2008 as Australia and New Zealand, the largest sources of FDI, came under increasing strain from the financial crisis. Foreign exchange reserves remain comfortable at about 5½ months of projected imports of goods.

  • Overall, fiscal performance continued to improve. The overall fiscal surplus increased to 2.2 percent of GDP in 2008, following a small surplus in 2007. Improved VAT and trade taxes, reflecting an improvement in tax compliance, more than offset the additional (election-related) spending on goods and services. Development expenditure also picked up as the long-awaited donor financing from the MCA began to feed into capital projects.2

  • Credit growth accelerated in 2008. Bank lending increased significantly last year, in part reflecting the entry of a fourth foreign-owned commercial bank. Most bank loans went to the construction and consumer finance sectors. However, tighter liquidity conditions in the domestic money market combined with stricter lending standards have resulted in a slow down in credit growth since the fourth quarter of 2008.

  • There has been some progress on structural reforms. A new Utilities Act aimed at strengthening the regulatory framework was passed in 2007. The Personal Property Securities Act, which broadens the range of assets that can be used as collateral and strengthens the rights of secured creditors, was passed in 2008. In addition, the telecommunications sector has been opened up to foreign competition.

B. Outlook and Risks

4. The global slowdown is likely to affect Vanuatu more than some of the other PICs, given its heavy dependence on tourism.

  • Growth is projected to moderate to 3 percent in 2009. Indications (based on banking sector data) are that real estate activity, which has attracted capital inflows from Australia and New Zealand, has begun to slow. While tourist arrivals remain strong (airlines and hotel operators suggested confirmed bookings through May remain strong; frequency of cruise ships has also increased this year so far), spending by tourists has declined (Box 2). However, MCA disbursements, which picked up last year after several delays, are expected to remain strong and combined with other aid inflows should help alleviate some of the negative impact on growth. In addition, the recent easing in monetary policy and a more accommodative fiscal stance for the 2009 budget would help cushion the impact on growth. Inflation will likely fall, reflecting lower international food and fuel prices. The current account deficit is expected to narrow and foreign exchange reserves to improve, reflecting lower imports due to the decline in commodity prices.

  • Risks to the outlook are tilted to the downside. Should the global slowdown be more protracted than expected, including in Australia and New Zealand, this would further exacerbate the negative impact on tourism and FDI. Furthermore, with three of the four commercial banks being subsidiaries of foreign banks, banks could come under increasing pressure from their parent companies to tighten lending standards and add to the slowdown in growth.

5. The authorities agreed that growth will moderate in 2009, but only modestly. The authorities project growth in 2009 at 4½ percent, somewhat higher than staff’s projections. While there was no fundamental difference in views, the authorities believe that the impact from the global slowdown is likely to be smaller given the dominance of subsistence farming and continued strong tourist arrivals based on Vanuatu’s geographic advantage. Also, Australians concerned about future income are likely to curb their travel budgets and instead of far away vacations may come to Vanuatu. That said, the authorities concurred with the staff’s views that overall the risks to the economic outlook are tilted to the downside given developments in the global economy.

Tourism Sector in Vanuatu

Tourism plays a greater role in Vanuatu’s economy compared to other PICs. Helped by the open sky policy adopted by the government in 2004, visitor arrivals have grown at an annualized rate of about 13 percent since then. Travel receipts cover most of the gap arising from trade in goods and have been the largest source of foreign exchange revenue. Tourism-related sectors (wholesale and retail trade, hotels and restaurants, and transport and communication) play an increasingly important role in the domestic economy. These three sectors account for over two-thirds of GDP, and about 70 percent of the increase in real GDP in the three most recent years.

uA01bx02fig01

Travel Receipt and Trade Deficit

(In millions of vatu)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Vanuatu authorities.

While tourist arrivals have held up well so far, there are some risks going forward. Visitor arrivals by air continued to show strong growth in the first two months of this year, boosted by the addition of a direct flight from Melbourne in January. The frequency of cruise ships also increased in the first two months. However, slowing growth in Australia and New Zealand could have an adverse impact as three-fourths of tourists come from these two countries. During the IT crisis, downturns in these countries, together with cyclone-related disasters pushed down travel receipt by 18 percent in 2001. There is also anecdotal evidence that tourist spending per day is declining. On the positive side, lower fuel prices may provide some relief through reduced flight costs.

III. Policy Discussions

Against this backdrop, policy discussions focused on how Vanuatu could mitigate the effects of the global slowdown, especially if tourism were to nosedive. In this context, staff recommended that while fiscal policy should be primarily used to counter the effects of a downturn, the relatively high policy rate in Vanuatu provides scope to use monetary policy (though constrained by the exchange rate system) by lowering the policy rate to those prevailing in trading partner countries, notably Australia and New Zealand. However, it will be critical to ensure that any policy easing is supportive of growth without creating inflationary pressures. In addition, the mission stressed that continued structural reforms remain critical to place the economy on a higher trajectory of long-term sustainable growth.

A. Macroeconomic Policies

Fiscal Policy

Background

6. Fiscal performance has improved substantially.

  • The budget surplus for 2008 is estimated at 2.3 percent of GDP. Reflecting improved tax compliance (partly due to additional staffing in the tax office) and continued strong growth, total revenues, especially from VAT and trade taxes, were up by 16 percent from 2007. Expenditures were higher than in the budget, although the strong revenue performance resulted in a sizable fiscal surplus. Furthermore, expenditure remains skewed toward nonproductive spending, with all revenue collections going toward meeting recurrent expenditure. The wage bill continued to constitute about half of recurrent expenditure, and allocations for emergency spending were, in part, used to finance election-related spending.

uA01fig03

Budget Developments

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.
  • The 2009 budget is expected to be broadly balanced. In light of the projected slowdown in economic activity, the mission’s revenue projections are somewhat lower than in the authorities’ budget (which envisages fiscal surplus of about 1 percent of GDP). Keeping recurrent expenditure similar to the authorities’ projections, staff projects the fiscal balance to be broadly balanced.

7. Fiscal consolidation has helped to reduce debt. The authorities’ successful efforts at fiscal consolidation combined with no new borrowing for several years led to a decline in the debt-to-GDP ratio to about 14 percent in 2007 from over 40 percent in 2002. The debt ratio inched up in 2008 reflecting disbursements under a newly contracted bilateral loan to finance the “E-government project” which will computerize fiscal operations across the different ministries and enhance expenditure tracking and transparency. That said, the debt ratio remains low, gradually declining over the medium term and debt burden indicators remain below the indicative thresholds (see Appendix I on debt analysis).

uA01fig04

Domestic and External Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.

8. Several structural problems continue to hinder effective fiscal management.

  • Large public wage bill. Vanuatu’s wage bill (in percent of total expenditure) is the highest among PICs, while the share of public employment in total employment is broadly the same as in other PICs. Furthermore, this ratio has increased from 10½ percent of GDP in 2005 to an estimated 12 percent of GDP in 2008.

uA01fig05

Pacific Islands: Expenditure on Wages, 2007

(In percent of total expenditure)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Country authorities; and IMF staff estimates.1/ 2006 data for Micronesia.
  • Inefficient public enterprises. In total, there are 24 public enterprises in Vanuatu, the majority of which continue to receive financial assistance from time to time. While some of them (e.g., Air Vanuatu) have played a critical role in supporting Vanuatu’s key industry, tourism, privatization (under consideration for Air Vanuatu) and/or better management could help to reduce the burden on the budget.

  • Narrow tax base. Vanuatu has a relatively low tax revenue/GDP ratio among PICs. This reflects the existence of large tax exemptions (especially on interisland shipping and tourism), estimated at average of 3½ percent of GDP.

Staff views

9. The mission welcomed the recent fiscal performance and the more accommodative fiscal stance under the 2009 budget. The authorities are on firmer ground to use counter-cyclical fiscal policy given the fiscal consolidation achieved so far. The overall accommodative fiscal stance in the 2009 budget (although there are no explicit stimulative measures) appears appropriate, especially given some signs of a forthcoming slowdown. The fiscal balance is expected to remain in surplus over the medium term as economic activity and tax revenues recover. That said, the authorities should avoid an expansion in areas where retrenching spending is difficult (e.g., a general increase in the public wage bill) so as not to jeopardize medium-term fiscal sustainability.

10. In the event of a sharper-than-expected downturn, a fiscal stimulus could be provided through better prioritization of fiscal spending and additional donor support. Measures could be designed to counter the effect of the global slowdown on Vanuatu, including the following:

  • Allowing the automatic stabilizers to work. While the scope for automatic stabilizers is limited by Vanuatu’s dependence on VAT, the budget could accommodate a decline in other taxes, notably customs and property taxes.

  • Expanding the social safety net (with assistance from donors), including conditional cash transfers targeted to those who lose their jobs as businesses cut back spending. The 2006 Household Income and Expenditure Survey suggests that urban areas are more susceptible to the global slowdown with more than 30 percent of the urban population being wage earners, while the majority of the rural population appears to be engaged in subsistence agriculture.

  • Expediting implementation of pending projects in road construction, including in the outer islands.

  • Bringing forward new projects (principally financed by additional donor funding).

11. From a longer-term perspective, the mission emphasized that the authorities should focus on fiscal “structural” reforms as below:

  • Reorienting expenditure. More than half of the recurrent budget is spent on the wage bill, crowding out expenditure in areas that could help improve the productive capacity of the economy. Most development expenditure is currently financed by aid inflows. While aid inflows are expected to remain strong over the next few years, the government could increase development spending in priority areas through restructuring expenditures. These measures include:

    • streamlining the wage bill by eliminating vacant positions, and avoiding ad-hoc increases in wages;

    • enhancing monitoring and accountability of public enterprises to improve efficiency, and restructuring those that continue to make losses and require government subsidies; and

    • improving the budget framework to establish transparency and accountability, including through the passage and implementation of the Public Expenditure Financial Management (PEFM) Act.

  • Widening the tax base. The staff stressed streamlining the large tax exemptions, especially in the tourism sector and rationalizing exemptions in interisland shipping. In addition, tax administration could be further rationalized by better integrating the VAT and customs duty collection.

12. External debt should be maintained at a low level, especially given donors willingness to provide aid. The mission underscored that the authorities should improve their capacity to implement aid-related programs and work more closely with donors to align donor assistance with their own development objectives. This would allow more effective use of donor assistance while eliminating the need to borrow.

The authorities’ views

13. The authorities agreed with the thrust of staff’s assessments.

  • 2009 budget. The authorities agreed that the revenue target may be challenging to achieve, but they believed that this could be achieved through enhanced efficiency of the tax system, including the introduction of a Large Tax Payer Unit this year.

  • Policy response to a larger-than-expected slowdown. The authorities welcomed the mission’s focus on this issue and indicated initiation of contingent plans, including possibly asking donors to expedite their projects and taking steps to streamline bureaucracy within the government to expedite projects in the pipeline.

  • Structural issues. While the authorities stressed that Vanuatu’s dispersed landscape requires a larger civil service especially in education, they agreed that there is scope to streamline expenditures. In this respect, the authorities have started to reduce vacant positions in the public sector. They strongly agreed on the need to monitor public enterprises and recognized that more transparent fiscal management is necessary. With this in mind, the PEFM bill, which will enhance budget monitoring and transparency, has been submitted to parliament.

  • External debt. The authorities stressed that the newly contracted loan was a one-off event and would help provide cheap financing for improving the efficiency and transparency of budget spending. They have no further plans to borrow and remain strongly committed to reducing their debt levels.

Monetary Policy

Background

14. Following a monetary tightening in September, the RBV reversed course in December as the liquidity condition in the interbank market tightened. In addition to the lagged impact of rising food and fuel prices, strong growth in domestic credit was fueling inflationary pressures. In an effort to prevent these pressures from becoming entrenched, the RBV raised its discount rate by 25 basis points in September. However, the monetary stance was eased in December—the discount rate was lowered by 25 bps to 6 percent, and the Liquid Asset Requirement (LAR) and the Statutory Reserve Deposit (SRD) requirement were reduced respectively to 7 percent and 5 percent (from 8 percent and 10 percent)—following a liquidity shortage in the banking sector, caused in large part because lending had accelerated while deposit growth remained modest.

uA01fig06

Credit and Deposit Growth

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Vanuatu authorities.
Staff views

15. With lending and inflation decelerating recently, and assuming credit growth continues to moderate, there is some scope to ease the monetary stance if the global slowdown has a significant adverse impact on the economy.

  • While inflation is starting to come down, it is still too early to assess the impact of last year’s credit expansion (very strong until the third quarter and slowing thereafter) on bank balance sheets. In particular, with most loans concentrated in the construction and consumer finance sectors, a slowdown in growth could have potentially significant negative consequences for bank balance sheets. Staff underscored the need to monitor bank balance sheets closely and ensure that they were complying with all prudential regulations.

  • That said, the policy rate in Vanuatu still remains significantly above those in Australia and New Zealand (countries with relatively large weights in the currency basket), providing the central bank room to reduce rates, if growth begins to slow more than expected. Alternatively, the SRD could be lowered as this has a more direct impact by releasing additional liquidity in the banking sector than a change in the policy rate. However, any easing in monetary policy, before it is undertaken, should ensure that RBV’s goal of achieving low inflation and ensuring a sound banking system are not jeopardized.

uA01fig07

Policy Rates

(In percent, end of period)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: CEIC Data Company Ltd; and Reserve Bank of Vanuatu.
The authorities’ views

16. The authorities concurred with the mission’s assessment and agreed that their policy stance going forward should be guided by developments on both the domestic front as well as spillovers from the global slowdown. The authorities agreed with the need to closely monitor bank balance sheets for signs of portfolio deterioration. If inflation fails to decline to the 3–4 percent range and the economy proves resilient to the global downturn, they may tighten the SRD/LAR requirements. On the other hand, if growth slows substantially a more accommodative stance may be warranted. In this context, apart from standing ready to provide liquidity in the case of emergency, they are also exploring other financial assets, besides the RBV notes, that can be used as collateral for liquidity provision.

Exchange Rate and Competitiveness

Background

17. Staff analysis suggests that Vanuatu’s REER is broadly in line with economic fundamentals. With the fluctuations in major currencies broadly offsetting each other, the vatu has been largely stable in real effective terms since early 2000s (Box 3). Although the trade deficit has risen recently, exports of both goods and services were strong and helped to finance the large import bill due to higher international prices of food and fuel. Foreign exchange reserves remain strong.

Staff views

18. The current exchange rate policy remains appropriate. Given the small size of the economy and limited administrative capacity to conduct monetary policy, the relative stability of the nominal effective exchange rate has provided an important anchor for inflation expectations. Structural bottlenecks and international commodity prices, rather than external price competitiveness, better explain the modest widening in the current account deficit last year. That said, the current account deficit, mainly reflecting FDI and donor-financed imports, is expected to remain large over the medium term.

Authorities’ views

19. The authorities continue to believe that their current basket regime remains appropriate. They shared the mission’s views that eliminating structural bottlenecks holds the key to increasing competitiveness.

Financial Sector

Background

20. Despite rapid credit growth, the banking system remains sound. Banks are well capitalized with the capital adequacy ratio above 30 percent while nonperforming loans (NPLs) have been declining rapidly. (partly reflecting the recent rapid growth in total loans). Profitability remains high although the tight financing conditions toward the end of the year led to a decline in lending margins.

uA01fig08

Banking Soundness Indicators

(In percent)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Vanuatu authorities.1/ Average of 2008:Q1–Q3.

An Exchange Rate Assessment for Vanuatu

  • Vanuatu’s currency has been stable in nominal effective terms. While the bilateral nominal exchange rate against the U.S. dollar and the Australian dollar was volatile, the impact has been largely offsetting. This has helped to keep the NEER stable, despite rapid currency movements during the recent period of financial market volatility.

  • The real effective value of the vatu has remained broadly in line with economic fundamentals. With inflation in Vanuatu under control, and moving broadly in line with those of major trading partners, the vatu has also been stable in real effective terms. A quantitative exchange rate assessment based on the fiscal position and the terms of trade confirms that the vatu remains in line with economic fundamentals.1

  • External price competitiveness is not an issue. Receipts from tourism have been increasing and commodity exports have also increased while the REER continued to remain unchanged. This suggests that structural factors (e.g., liberalization of the aviation sector) and commodity prices (especially last year) drive these two rather than exchange rate considerations. That said, if commodity prices weaken and wages continue to increase, they could affect competitiveness in the future.

uA01bx03fig01

Exchange Rate

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: IFS, INS, BIS, and IMF staff calculation.1/ Trade weight is based on data (2005–07) from the authorities.
uA01bx03fig02

Real Effective Exchange Rate and Equilibrium Rate

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: IFS, INS, BIS, and IMF staff calculation.1/ Trade weight is based on data (2005–07) from the authorities.
uA01bx03fig03

Number of Tourist Arrivals

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: Vanuatu authorities.
1 Data constraints preclude implementing the macroeconomic and external sustainability approaches.

20. The VADB was established last year, with an initial capital of vatu 200 million from the budget (total capitalization to reach vatu 500 million by 2011) with the aim of providing loans to farmers. The VNPF has also started to engage in providing loans to its members with their savings in the provident fund as the collateral.

Staff views

21. Financial sector supervision should be enhanced given the recent rapid growth of credit and the global financial environment. In this context, the authorities should be vigilant of the additional risks commercial banks face from a possible slowdown, especially given their exposure to personal and construction-related loans. Both the VADB and VNPF should be brought under RBV supervision. While financial sector supervisory standards are in line with international practice and financial sector supervision has been strengthened significantly, lack of sufficiently trained staff still constrains the effectiveness of monitoring. In addition, the recent decision to move insurance supervision from the Financial Service Commission to RBV should be carefully planned and enough resources should be devoted to ensure adequate supervision. The mission also underscored the importance of making the Financial Intelligence Unit fully operational so that it can enforce AML/CFT provisions.

The authorities’ views

22. The authorities agreed with the importance of enhanced supervision given the current environment. In particular, they underscored that they have been closely watching the recent increase in personal-consumption loans and have alerted banks. The authorities are planning to bring VADB under central bank supervision to ensure sound management. On AML/CFT, the authorities reiterated their commitment to fully implement the regulations and indicated that they were seeking additional technical assistance for training staff.

B. Policies to Support Sustainable Growth

Background

23. There have been some improvements in the business climate, but much remains to be done. Recent steps taken by the government are encouraging (as described in the background section), but several challenges remain:

  • Infrastructure bottlenecks. Poor infrastructure, including lack of a good road network, lack of interisland shipping, lack of storage facilities at wharfs, congestion at ports, all raise the cost of doing business.

  • Labor market cost. A new Employment Act (passed by parliament, but not yet implemented), would raise the severance pay scale fourfold. This could raise labor costs significantly and has raised widespread concerns across the business community. 3

Staff views

24. Staff underscored the importance of continued structural reforms to help reduce business costs. Improving infrastructure to lower trade-related costs at ports would help Vanuatu raise its growth potential. At the same time, striking a better balance between workers rights and employer constraints with regard to the Employment Act will help to improve worker pay and safeguard employment while ensuring that Vanuatu remains attractive for businesses.

Authorities’ views

25. The authorities pointed to a number of steps being taken to address structural bottlenecks:

  • Discussions are underway with a donor to upgrade the wharf facilities. The Efate Ring Road (financed by MCA) is underway and due to be completed by early 2011. They are also seeking donor assistance to extend roads further and develop interisland shipping.

  • Plans for privatizing Air Vanuatu are underway and the government is trying to identify other enterprises that could be privatized.

  • The Employment Act is being reviewed and the government plans to consult all stakeholders in order to reach a consensus before implementing the act.

IV. Staff Appraisal

26. Vanuatu has recently shown remarkable growth, but is not immune to the current global slowdown. Driven by strong growth in tourism and construction sectors, real GDP has been growing at an average of 6 percent in the last five years. Although the impact from the global slowdown is yet to be felt, construction-related FDI and spending by tourists appear to show some signs of a slow down. At this conjuncture, growth in 2009 is expected to be at 3 percent, with risks tilted to the downside.

27. Vanuatu is well positioned to respond with counter-cyclical fiscal measures, should growth slow more than expected. The 2009 budget aims for a more modest surplus than last year and in this sense is more accommodative. However, given the strong fiscal position and low public debt, the authorities have room to use temporary fiscal stimulus measures (e.g., targeted conditional cash transfers) to cushion the impact on the economy. In addition, expediting pipeline infrastructure projects will also help.

28. A cautious easing of the monetary stance may be warranted if the slow down turns out to be more serious than anticipated. Domestic price pressures have been coming down, although with a lag compared to most other regions. Provided inflation continues to decline and bank balance sheets remain strong, the monetary stance could be further relaxed to support growth.

29. Further improvements in bank supervision are advisable. In particular, closer monitoring of bank balance sheets, including RBV supervision of VADB, will help early detection of any signs of deterioration in loan quality and help the authorities to take timely action to ensure a continued sound banking system.

30. The current exchange rate regime remains appropriate. The exchange rate appears to be broadly in line with economic fundamentals. With a sound reserve position supported by tourism and capital inflows, there appears to be little sign of exchange rate misalignment.

31. Further structural reforms are necessary to sustain a high growth path. The significant progress to date has already yielded tangible results. Looking forward, the priority areas are improving road and port infrastructure, improving management and efficiency at public enterprises, and ensuring a flexible labor market.

32. Improving capacity to compile statistics is necessary. The authorities identified several areas for technical assistance, especially to improve national accounts and balance of payments data. Fund staff, including through PFTAC, will continue to provide assistance in these areas.

33. It is recommended that the next Article IV consultation with Vanuatu takes place on a 24-month cycle.

Figure 1.
Figure 1.

Vanuatu: Regional Comparators

(Averages, 2006–08)

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

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

Vanuatu: Selected Economic Indicators, 2004–08

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

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

Vanuatu: External Sector Developments, 2002–08

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

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

Vanuatu: Monetary and Financial Indicators, 2004–08

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: Vanuatu authorities; and IMF staff estimates.
Table 1.

Vanuatu: Selected Economic and Financial Indicators, 2004–09

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

2007–08 figures are based on the authorities’ budget estimates, with adjustments by staff.

Includes Millennium Challenge Account (MCA) project grant since 2006.

Weighted average rate of interest for total bank deposits and loans. 2008 data are as of September.

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

Medium- and long-term public debt only.

In percent of exports of goods and nonfactor services.

Table 2.

Vanuatu: Central Government Fiscal Operations, 2004–09

(In percent of GDP, unless otherwise indicated)

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

Net of tax rebate for import duties paid by UNELCO.

Cash grants only. MCA is not included in 2009 in the authorities’ budget, as it will be directly disbursed to contractors.

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

A newly contracted loan of VT 3.3 billion is equally allocated to three years 2008–10.

Table 3.

Vanuatu: Balance of Payments, 2004–09

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

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

The pick up in 2008 reflects a jump in MCA disbursements.

In 2005, includes debt forgiveness.

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

Table 4.

Vanuatu: Monetary Survey, 2002–08

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

Reserve Bank of Vanuatu and small treasury foreign exchange operations.

Table 5.

Vanuatu: Medium-Term Baseline Scenario, 2004–13

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

Including official transfers.

Medium- and long-term public debt only.

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

Table 6.

Vanuatu: Social Indicators 1/

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Sources: World Bank, World Development Indicators (2008); and Millennium Development Goals.

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

Table 7.

Vanuatu: Vulnerability Indicators, 2004–09

(In percent of GDP, unless otherwise indicated)

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

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

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

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

Medium- and long-term public debt only.

Appendix I. Vanuatu: Public and External Debt Sustainability1,2

This appendix summarizes the debt sustainability analysis (DSA) for Vanuatu using the framework for low-income countries. Vanuatu’s public debt has been declining on average, reflecting strong growth performance, successful fiscal consolidation, and large aid inflows which eschewed the need for borrowing. As a result, most debt burden indicators under the baseline scenario are below their indicative thresholds. This analysis suggests that Vanuatu’s public debt dynamics are sustainable and the country faces a low level of debt distress.

I. Introduction and Baseline

Reflecting strong growth and fiscal surpluses over the last few years, Vanuatu’s total public sector debt stock is estimated to have declined to 18½ percent of GDP in 2008 from 28 percent of GDP in 2005. The ratio of external debt to GDP fell from over 30 percent in 2000 to 13¾ percent in 2007, inching up a little to 15¾ percent in 2008, due to a new bilateral loan. This DSA presents the projected path of Vanuatu’s external and public sector debt burden indicators, and draws some conclusions on the forward-looking sustainability of debt.

Vanuatu’s DSA builds on the baseline scenario assumptions presented in Box I.l. It assumes real GDP growth rate of about 4½ percent on average over the medium term, inflation of about 3 percent, and modest fiscal surplus. The baseline assumes no additional external borrowing other than the new bilateral loan contracted in 2008.3 The authorities are strongly committed to fiscal consolidation and do not anticipate the need to borrow given donor flows.

II. External Debt Sustainability

External debt stood at 15¾ percent of GDP in FY2008, down from over 20 percent in FY2005 (Table I.la, Figure I.1). The government took on a new loan in 2008 to expedite improvements in IT-related infrastructure. Under the baseline scenario, the NPV of external debt is projected at 10½ percent of GDP in 2008 (below the indicative threshold based on the CPIA rating which assumes Vanuatu to be a weak reformer).4 This ratio is expected to fall to 9¼ percent by FY2013 and further in the medium term. The NPV of debt-to-exports and revenue ratios increase somewhat in 2009–10, but declining thereafter. All the ratios (including PPG debt service in percent of exports and revenue) remain well below their respective indicative thresholds as shown.

The alternative scenarios and bound tests indicate that external debt sustainability is sensitive to an exchange rate shock (Table I.lb, Figure I.1) If growth is assumed to be at its historical average, the NPV of debt-to-GDP ratio falls, reflecting the strong performance of the last five years. Among the various stress tests, bound test 6 (30 percent nominal depreciation of the exchange rate) results in the largest increase in the NPV of debt-to-GDP ratio, which jumps to 18 percent in 2009–10, then declines gradually. None of the stress tests cause any breaches in the thresholds.

III. Public Debt Sustainability

Vanuatu’s public debt has declined from over 40 percent of GDP in 2002 to 18½ percent of GDP in 2008, reflecting the authorities’ commitment to fiscal consolidation (Table I.2a). The NPV of debt-to-GDP is expected to decline from 14½ percent at end-2008, to 10¾ percent in 2013, and further to around 1 percent by end-2028.

Public debt is sensitive to exchange rate changes, given the dominance of external debt in total public debt. Compared to 2008, a one-time 30 percent real depreciation of the exchange rate would raise the NPV of public debt-to-GDP by 6 percent age points in 2009, mirroring the impact on external debt, and fall gradually thereafter. A sizable growth shock in 2009–10 (economy is assumed to contract by 11½ percent in two years compared to the baseline) will likely have a lasting effect over the medium term. The baseline scenario is more favorable than the historical one, reflecting the success of government’s fiscal consolidation efforts and commitment to continue this in the future. The other factors have a modest impact on the NPV of debt-to-GDP.

IV. Staff Assessment

Assuming Vanuatu continues to make steady progress in reducing its public debt burden, as it has done in the past few years, public debt sustainability should be manageable. While several indicators show that the economy’s debt is low, debt remains somewhat vulnerable to a major shock in the exchange rate. Also, changes in GDP growth in particular affect the debt dynamics. Given that both growth and balance of payments are driven by tourism, the external environment, especially the current global environment does pose a challenge. Therefore, the authorities must remain committed to bringing down the external debt further to reduce vulnerabilities. Going forward, improved coordination with donors to align their plans with authorities’ development objectives can help to mobilize/use aid inflows more effectively.

Assumptions for the Medium-Term Baseline Scenario

Real GDP growth is projected to average 4½ percent over the medium term as further structural reforms, including improvements in infrastructure, boost productivity. After moderating in 2009–10, tourism is expected to grow at a somewhat more moderate pace than in the last few years.

Inflation is projected at around 3 percent over the projection period. With a transaction-based exchange regime providing an effective inflation anchor, inflation has been on average 2½ percent in the recent five years.

The overall fiscal balance is projected to register an average surplus of ¼ percent of GDP over the medium term given the recent strong fiscal performances supported by authorities’ commitment to a sound fiscal policy. This envisages a modest fiscal expansion (in the current expenditure) in the near term, but assumes that the authorities limit expenditures as a share of GDP after 2012.

The current account deficit is expected to decline in 2009–10 as import prices are expected to fall (around 5 percent of GDP) while economic activity will slow with some lags from the global economy, but is expected to widen to about 6½ percent by 2014, due mainly to a substantial pick up in tourism-related imports financed by FDI inflows. The real effective exchange rate is assumed constant.

Aid inflows are assumed to remain stable. FDI related to tourism and real estate is expected to increase significantly. With these developments, reserve cover is projected to remain around six months of projected imports by 2014.

Figure I.1.
Figure I.1.

Vanuatu: Indicators of Public and Publicly Guaranteed External Debt under Alternative Scenarios, 2008–28 1/

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Source: IMF staff projections and simulations.1/ The most extreme stress test is the test that yields the highest ratio in 2018. In figure b. it corresponds to a nondebt flows shock; in c. to a nondebt flows shock; in d. to a nondebt flows shock; in e. to a nondebt flows shock and in picture figure f. to a nondebt flows shock.
Figure I.2.
Figure I.2.

Vanuatu: Indicators for Public Debt under Alternative Scenarios, 2008–28 1/

Citation: IMF Staff Country Reports 2009, 166; 10.5089/9781451840599.002.A001

Sources: Country authorities; and IMF staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2018.Revenues are defined inclusive of grants.
Table I.1a.

Vanuatu: External Debt Sustainability Framework, Baseline Scenario, 2005–28 1/

(In percent of GDP, unless otherwise indicated)

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Source: IMF staff simulations.

Due to data constraints, it includes only public external debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Derived as [r - g - r(1+g)]/(1+g+r+gr) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and r = growth rate of GDP deflator in U.S. dollar terms.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).