INTRODUCTION

Our Solomon Islands authorities would like to express their sincere gratitude to staff for the useful discussions during their recent visit to Honiara. They value the discussions with staff on issues ranging from strategies to minimizing the effects of the global shocks on Solomon Islands’ economy to reforms needed to placing Solomon Islands on a sustainable footing going forward. The authorities also express their sincere gratitude to development partners, the Pacific Financial Technical Assistance Center (PFTAC), the World Bank, and the Fund, for advice and assistance received over the years.

Solomon Islands is an import-dependent nation comprising of eight provinces scattering over a vast ocean. Strong growth performance in recent years was a result of stable policy implementation and return in confidence. However, the slowing of demand for external products, remittances and investment flows, has hit the economy and fiscal position. The authorities have tighten monetary conditions and taken a number of measures in the face of a deteriorating fiscal position. Further support of the donor community is needed to help preserve the social safety net in the face of these shocks.

The authorities wish to continue to strengthen the engagement with the Fund in the face of short-term challenges, and value the continued technical assistance to strengthen policy frameworks. Strengthened monitoring and the maintenance of a strong dialogue with donor parties on the macroeconomic framework would help the authorities address the immediate challenges. To this end, they welcome the recent assurances from the Fund regarding its willingness to remain engaged in a dialogue with donors and assist the authorities over the next 12 months.

ECONOMIC OVERVIEW

The Solomon Islands’ economy grew by 6.9 percent in 2008. The main drivers are the agriculture and forestry sectors, with each sector contributing 17 percent and 16 percent to Solomon Islands GDP, respectively. For 2009, the authorities project a growth of 1.1 percent, somewhat higher than the staff’s estimate of 0.4 percent. The difference lies in the assumptions used. The authorities and the staff both share the view that a slowdown in logging and ancillary activities will act as drag on growth. Nonetheless, the authorities consider that an uptick in agriculture, tourism, and FDI-financed construction activities will lift growth in 2009 and 2010.

After reaching a peak of 23.5 percent in September 2008, the headline inflation decelerated to 3 percent year-on-year in July 2009. Lower inflation reflects the easing of international food and fuel prices and the central bank’s tight monetary policy stance. External reserves have strengthened in recent months, increasing from less than 3 months worth of imports to 4.8 months worth of import cover in September. The improvement reflects donor inflows, a recovery in log exports, and the recent SDR allocation.

POLICY ISSUES

• Fiscal Policy

Fiscal performance was broadly on track in the first half of 2008, revenue collections exceeded targets and expenditure growth slowed as intended. However, with the onset of the global economic crisis, confidence has all but evaporated. Revenues have fallen sharply, and recurrent spending has been higher than budgeted. The effect of the pass-through of the international food and fuel price shocks was immediate. The costs of utilities (due to the increase in energy costs) and of providing and sustaining government services shot up significantly. The authorities considered the environment after the shocks hit to be abnormal and responded to the situation by increasing budget allocations to utilities and provincial government grants. Without such allocations, government services would have been disrupted and potentially destabilizing. They consider their decision to provide higher budget allocations to be appropriate at the time and viewed the increased cost of providing and sustaining government services – owing to the increase in inflation – to be the main driver of the recurrent spending overrun in 2008 and in the first half of 2009. Meanwhile, the authorities passed a supplementary budget of around SI$70 million to offset the effect of inflation on the costs of providing government services, address the needs of those hit by a tsunami last year, and advance structural reform in the telecommunications sector.

The authorities agree that fiscal pressures have emerged and that there is a need to create fiscal space to sustain fiscal operations and over time make a greater contribution to development spending. Mindful of the emerging pressures, the authorities took a series of measures to stabilize the fiscal situation. These include spending re-prioritization, freezing of public service hiring, and imposition of a 25 percent reservation on recurrent “other charges” or on non-payroll charges excluding pensions and gratuities, and debt servicing. In addition to these measures, the authorities also: (i) placed a cap on discretionary revenue exemptions at 50 percent; (ii) increased excise on beer and tobacco; (iii) broadened excise on spirits to include wine, spirits and premix; (iv) increased duty on motor vehicles; (v) increased vehicle licensing fees; and (vi) directed all government ministries to collect all outstanding dues to the government. Meanwhile, the authorities note staff’s advice of scaling back non-essential recurrent spending and parliamentary entitlements. On the latter, the authorities have sought a judicial review of the appropriateness of increasing the parliamentary entitlements.

The authorities note staff’s recommendation to raise “the taxable price of logs” and to increase the determined price of logs by “an average of US$25 per cubic meter” to lift revenue “by 1 percent of GDP a year.” The authorities understand the rationale behind this recommendation. However, experience with implementing similar policies in the past produced unwanted outcomes. Logging companies have colluded to protect their interests in the past by cutting back production, laying off workers, and holding back exports, resulting in huge revenue and foreign exchange losses. A similar reaction at this point of economic weakness and low foreign exchange reserves could prove to be counter-productive. Meanwhile, the authorities are encouraging investors to move to downstream processing and Kolombaraga Forest Products Limited has become a sustainable forestry role model.

Staff has singled out the impact of minimum wage increases as one of the factors responsible for driving recurrent costs up. The first review of the legal minimum wage rate for 12 years was completed in 2007 and came into force on May 1, 2008. However, the impact on government finances is minimal because the wage rate of the majority of civil servants is already higher than the revised minimum wage rate. The cost of living adjustments award and the hiring of labor to fill up unfunded positions – based on public service establishments rather than on budget allocations – are the two main factors contributing to the increase in public service remuneration.

The authorities welcome the staff’s recommendation to adopt an internationally-accepted tax regime for the emerging mining project. They agree that designing a good tax regime will be important to ensuring sound resource management but will lack the necessary resources and expertise in this area. As such, Solomon Islands would welcome Fund assistance in this area.

The authorities agree with the staff on the need to expedite fiscal structural reforms to enhance medium-term fiscal sustainability. Under quite difficult circumstances, the authorities are aiming to record a surplus budget in 2010. In line with this, they are committed to strengthening further the revenue and expenditure measures that they have already put in place. They are also committed to implementing further measures to enhance stability over the medium term, where appropriate. The road ahead will be difficult and, in that context, the authorities agree with staff that external budget support is critical to preserving the social safety net.

• Monetary Policy and Exchange Rate

The authorities welcome the discussion on scope for monetary easing and note the staff recommendation for a more accommodative monetary stance. The authorities agree that inflation pressures have eased but caution that a careful assessment of the impact of the global shocks on the domestic economy is required before changes to the current monetary policy stance can be considered. Solomon Islands does not produce a national CPI with monetary policy decisions largely being based on price information in Honiara. So the actual inflation rate for the country as a whole could still be higher than the one quoted in the report.

The authorities are aware of the need to enhance the monetary policy operational framework. In this regard, they are considering measures to improve the efficiency of the indirect policy instruments for liquidity management purposes and look forward to working closely with the Fund in this area.

There is broad agreement between the staff and the authorities on the need for greater exchange rate flexibility as the basis for providing an effective anchor and that, because the exchange rate alone cannot bear the full brunt of the adjustment, this will require addressing structural bottlenecks to improve the economy’s competitiveness over the medium term. Notwithstanding, the authorities are not entirely comfortable with the staff’s advice to widen the daily trading band as the basis to shore up reserves and address the external imbalances. The authorities’ past experience, however, has been that this does little to address the imbalances and simply results in additional profits to commercial banks. Against this background, and considering the desire to prevent further inflationary pressures, the authorities will continue to maintain its current exchange rate policy of pegging the value of the Solomon Islands dollar to a trade-weighted basket of currencies with the US dollar being the intervention currency.

• Financial Sector

The domestic banking system has been largely unaffected by the global financial crisis and is well-positioned to deal with the slowdown in domestic activity. The banks are profitable and continue to meet prudential requirements for capital adequacy, asset quality, and liquidity during the year. As staff mention, credit growth has slowed in 2008 owing to the general slowdown in economic activities, lack of viable investment proposals, and tight lending standards. In addition to the slowing credit growth, asset quality has also deteriorated – albeit moderately. Non-performing loans increased from 2.7 percent of total loans and advances at the end of the fourth quarter of 2008 to 4.2 percent of total loans and advances at the end of the second quarter of 2009 – while liquidity conditions have tightened.

In response to tightening liquidity condition, the CBSI provided a short-term standing facility that commercial banks can access. The commercial banks also raised deposit rates. Two out of the three commercial banks that operate in Solomon Islands are branches of well-established Australian banks. They are subject to strict banking standards from their parent banks. Viewed from this angle, the authorities are confident that, despite some evidence of emerging pressures, the domestic banks will continue to comply with the prudential requirements this year and the next.

Moving forward, the authorities wish to assure Directors that they are committed to maintaining a stable financial system. The recent upgrading of the prudential standards, along with the strengthening of the regulation and supervisory framework, are a testament to that commitment.

• Structural policies

The authorities have made significant progress in some areas of structural policy, in particular, they have streamlined business formation and regulations, established regular audits of SOE accounts, and reformed telecommunications and transport sectors to allow new entrants. These actions have begun to show results. Following the government’s decision to open up the telecommunications sector, a service provider has expressed its interest to enter the market in the second quarter of 2010.

However, the authorities agree that further structural reforms will be needed to lift Solomon Islands’ medium- to long-term growth prospects. In this regard, they are committed to working closely with their main donors to implement their medium-term development strategy. In particular, the authorities are aware that management of public enterprises, in general, needs to be improved, given the drain on budget resources.

Finally, in relation to land reform, the authorities are aware of the need to move forward. The authorities have acknowledged the concerns of the business community, in particular, on difficulties to securing land titles for investment. However, the authorities recognize that sustainable land reform needs to take place with broad public ownership. In the Solomon Islands, this requires significant time and effort, given the complex land ownership structure and the resistance to land sales.