Statement by Christopher Y. Legg, Alternate Executive Director for Solomon Islands and Mario G. Di Maio, Advisor to the Executive Director

The effects of the global recession and decline in logging have undermined macroeconomic stability in the Solomon Islands. The government’s program offers a basis for resuming strong growth in a low inflation environment, helping to advance poverty alleviation efforts and achieve other development objectives. The current monetary policy stance is broadly appropriate, with monetary targets sufficiently accommodative to support economic recovery. Sound steps toward strong financial sector policy have been taken. The program, while not without risk, is well focused and sufficiently ambitious.

Abstract

The effects of the global recession and decline in logging have undermined macroeconomic stability in the Solomon Islands. The government’s program offers a basis for resuming strong growth in a low inflation environment, helping to advance poverty alleviation efforts and achieve other development objectives. The current monetary policy stance is broadly appropriate, with monetary targets sufficiently accommodative to support economic recovery. Sound steps toward strong financial sector policy have been taken. The program, while not without risk, is well focused and sufficiently ambitious.

To safeguard macroeconomic stability in the face of external shocks my Solomon Islands authorities have developed a program of economic adjustment. They request IMF support for their adjustment program, in the form of an 18-month Standby Credit Facility for SDR 12.48 million (120 per cent of quota). International agencies and bilateral donors are also providing assistance in support of the adjustment goals. This program represents a committed effort to sustain hard won gains in macroeconomic policy following political and economic instability at the start of this decade, and helps lay the foundations for a recovery in private sector activity.

Background

The rebound in growth in the middle of the decade was the result of a return to stability after an extended period of political, social and economic disruption. With strong support from development partners, economic policy returned to focusing on bringing inflation under control, reining in the budget deficit, restructuring public debt, and addressing structural challenges to improve the climate for private sector growth. However, the challenges remain large - real economic output only returned to 1999 levels in 2007 and development and infrastructure needs remain substantial.

Output fell by 2.2 percent in 2009 as external developments reduced export demand and prices for Solomon Islands main export commodities – logs, fish and agriculture. The situation was exacerbated by a long anticipated structural decline in log volumes and lower prices. In 2008, logging revenue comprised 60 percent of export income, and it is also a substantial source of government revenue and local cash income for rural communities. The external accounts came under pressure during mid-2009 with reserves declining below 3 months before picking up towards the end of 2009 to just over four months of import cover.

The authorities’ policy space to address these external shocks was severely limited. Fiscal policy was constrained by restrictions on public borrowing, as a condition of debt restructuring. Spending was reduced by 10 percent from the 2009 budget and additional public sector hiring was suspended. Excise taxes were raised during mid-2009 to deal with anticipated revenue shortfalls. Capacity constraints limited implementation of spending plans, and together with challenges in public financial management, resulted in a fiscal surplus of more than 2.2 percent of GDP in 2009. Despite this relatively robust end-of-year position, cash constraints during the year necessitated tight control of day-to-day spending commitments and an increase in payment delays to domestic suppliers. Although monetary policy was eased, the uncertain economic and external environment meant that these changes had a limited impact on demand.

Program objectives and design

Despite better prospects for world growth in 2010, the authorities face immediate challenges in the form of a still fragile recovery, continued external vulnerabilities, and a challenging fiscal outlook that requires a concerted policy response. Their response is supported by the Fund and development partners. To safeguard external stability the central objectives of the program are: (i) to put government finances back on track by addressing immediate cash pressures through spending restraint and buttressing revenue, while using external support to build a larger cash buffer to manage cash flows and provide a buffer for future shocks; (ii) contain inflation risks by improving the effectiveness of monetary policy operations; and (iii) avert potential future financial sector risks. The program incorporates the core elements that the Board considered central to macroeconomic stability during the 2009 Article IV.

The fiscal program targets an overall balance of 2.4 percent of GDP, with substantial budget support from the European Union helping support the build-up of cash balances to 2 months of recurrent spending. The fiscal program envisages immediate adjustment to bring spending plans back into line with revenue in 2010 and to continue the disciplined approach to the public wage bill. Social spending increases in health and education are being preserved, while the fiscal surplus provides for continued repayment of debt obligations. On the revenue side, the program’s aims are supported through changes to strengthen customs collection – including increasing the effective rate of customs duty. The program will also resolve the long-standing issue of adequate taxation of logging exports by introducing a process that depoliticizes adjustment to the valuation of logs used in calculating the tax due. The authorities consider that, given the low effective customs duty rate, there are significant gains likely from recently introduced administrative measures to improve enforcement. They have been appropriately cautious in building the anticipated revenue gains from these measures into the fiscal program.

The authorities also recognize that in addition to immediate spending and tax changes, more-fundamental reform is needed. To avoid a repeat of mistakes in the logging sector, the authorities are committed to developing a robust tax regime on natural resources for pending gold and nickel projects. Further, the development of a fiscal responsibility law would provide for a more medium-term orientation to tax and spending, which will be supported by a public expenditure review undertaken in conjunction with the World Bank to improve the effectiveness of public spending.

Sound monetary and exchange rate policy has been a hallmark of Solomon Islands macroeconomic management. With the outlook for inflation subdued, the authorities do not face immediate pressure to tighten, though they remain ready to tighten policy earlier if it proves necessary to control inflation and safeguard international reserves. Foreign reserves recovered somewhat towards the end of 2009, partly due to several one-off factors. With fiscal restraint and additional support from development partners the program provides a comfortable cushion of external reserves. To be well-positioned to manage the large liquidity overhang, the Central Bank of the Solomon Islands (CBSI) will introduce an overnight facility and prepare for the issuance of short-term bank bills to manage the money supply.

Recognizing the risks associated with the strong private sector credit growth in the period leading up to the recent slowdown, the authorities began to tighten up financial regulation and supervision. As a backstop, and to buttress assurances of support from external parent banks, the authorities will issue regulations strengthening the role of the CBSI as a lender of last resort. Banks are strongly capitalized and have large and robust external shareholders. However, there are potential risks in the medium-term around the National Provident Fund (NPF), which is the largest financial institution in the Solomon Islands, stemming from uncertainty about its objectives and a lack of adequate supervision. Addressing these risks and ensuring soundness of the NPF requires institutional changes to clarify the CBSI’s responsibility for regulation and clarify that the main objective of the Fund – providing sustainable retirement savings – is not subordinated to other government goals.

Medium-term prospects and risks

The medium-term economic prospects for the Solomon Islands are reasonably good. The maintenance of macroeconomic stability and further progress on structural reform will support increased investment, including in natural resources where several large projects will make a substantial contribution to output. The authorities’ acknowledge that further progress on the agenda of structural reform is needed to strengthen medium-term growth prospects. They intend to build on the steps taken to commercialize operations in state-owned enterprises; improve competitiveness, including the deregulation of telecommunications; and reduce the cost of doing business through revision of the legal framework.

We recognize that the program is not without risks and the design of the program seeks to mitigate those. First, the political situation beyond the election due at the beginning of August 2010 and the likely makeup and policy program of the new government is not yet clear. However, the current government is committed to the program, as indicated by the implementation of significant spending, and tax actions in the lead-up to the elections. And while the execution of the 2009 budget was not ideal, the authorities took difficult decisions that ensured a broadly balanced budget. The second key risk relates to the capacity constraints in implementing the program. There is critical support being provided in the form of technical assistance from Fund, particularly on the strengthening of monetary and prudential management, development of resource revenue regime, and support to the public spending review. Our view is that these risks are manageable but they cannot be eliminated and are not unusual compared with other programs the Fund has supported. There remains a strong commitment across the political spectrum to social and economic stability to underpin the continued rebuilding of the Solomon Islands. Further, the Program is consistent with the economic and public financial management objectives of the Core Economic Working Group which brings together political leaders and development partners to discuss economic strategy.

My authorities would like to extend their appreciation to Fund management and other development partners for their support of the Solomon Islands policy response to these challenging economic circumstances. They appreciate the dedicated and professional approach from the Fund staff and look forward to maintaining a strong relationship during the period of the program and beyond.

Solomon Islands: Request for an Arrangement Under the Standby Credit Facility: Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Solomon Islands
Author: International Monetary Fund