Kiribati
2011 Article IV Consultation-Staff Report, Informational Annexes, Debt Sustainability Analysis, Public Information Notice on the Executive Board Discussion, and Statement by the Executive Director for Kiribati

The staff report highlights that the economy of Kiribati showed resilience from the global crisis owing to infrastructure projects financed by foreign assistance. Executive Directors stressed the importance of preserving real per capita value of the Revenue Equalization Reserve Fund to ensure fiscal sustainability and intergenerational fairness. They appreciated the multiyear budget framework, which helped in designing realistic fiscal plans. Directors noted the joint IMF-World Bank debt sustainability analysis and encouraged authorities to secure grant financing to support the country’s development needs.

Abstract

The staff report highlights that the economy of Kiribati showed resilience from the global crisis owing to infrastructure projects financed by foreign assistance. Executive Directors stressed the importance of preserving real per capita value of the Revenue Equalization Reserve Fund to ensure fiscal sustainability and intergenerational fairness. They appreciated the multiyear budget framework, which helped in designing realistic fiscal plans. Directors noted the joint IMF-World Bank debt sustainability analysis and encouraged authorities to secure grant financing to support the country’s development needs.

INTRODUCTION

1. Kiribati is a small Pacific island economy reliant on foreign aid and vulnerable to external shocks, particularly climate change. The export and production bases are narrow and limited to copra, seaweed and fishing. The country relies heavily on foreign aid to finance its structural trade deficit. Tourism accounts for less than 2 percent of GDP due to Kiribati’s remoteness and poor infrastructure. Given its high import dependence, the economy is vulnerable to swings in commodity prices. The public sector dominates the economy, but private sector activity has picked up lately. Fishing license fees and remittances provide key sources of income as does Kiribati’s wealth fund (derived from phosphate deposits that were exhausted in 1979). The increasing costs of climate change and still large development needs also raise important policy challenges.

2. Against this background, the 2011 Article IV discussions tackled both shortterm and longer-term questions. Discussions focused on policies to support sustainable growth and priorities for structural reforms. In the near term, the main challenge is to manage the investment boom that is underway without creating inflationary pressures. In the medium-term, economic prospects are contingent on the implementation of a critical mass of structural reforms. Lifting productivity growth and living standards depend on the scope and speed of the government’s own economic transformation program. The global crisis has led to a rethinking of Kiribati’s development strategy, with the private sector playing a more vibrant role. The emerging view is that the country is now at a crossroads.

3. Political background. The current government was elected in 2007. Parliamentary elections are scheduled for August 2011. The presidential election is to be held in October 2011.

RECENT ECONOMIC DEVELOPMENTS AND OUTLOOK

A. From Crisis to Recovery

4. The impact of the global crisis was stronger than anticipated at the time of the 2009 Article IV consultation. Kiribati has been affected by a fall in remittances and large declines in the value of its wealth and pension funds—the Revenue Equalization Reserve Fund (RERF) and the Kiribati Provident Fund. The spike in food and fuel prices in 2008 has already taken a toll on economic activity. Vulnerabilities to climate change, including coastline erosion, have also worsened, with recurring disruptions at two transportation lifelines (the main road in Tarawa and its airport). As a result, full achievement of the MDGs goals by 2015 is likely now out of reach (Table 1 and Box 1).

Table 1.

Kiribati: Millennium Development Goals

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Source: World Development Indicators database.

5. After two years of contraction, the economy recovered in the second half of 2010. It is estimated to have grown by 1¾ percent for the year (Table 2). Despite a weather-related drop in copra production, private sector activity appears to have picked up, especially in retail. Tourist arrivals rebounded by 20 percent compared to 2009, although from a very low base.

Table 2.

Kiribati: Selected Economic Indicators, 2007-12

Nominal GDP (2010): US$146.7 million

GDP per capita (2010): US$1,420

Nominal GNI (2010): US$209.6 million

Population (2010): 103,280

Main export products: fish and copra

Quota: SDR 5.6 million

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

The Australian dollar circulates as legal tender.

Index, 2005=100.

6. Inflation pressures dissipated in 2010. Despite the rise in world food and fuel prices, inflation has plunged from 2008 crisis-highs into negative territory, reflecting the strong appreciation of the Australian dollar—which is used as the domestic currency—and a decline in the world price of rice (Box 2).

7. Credit growth in the overall economy declined in 2009 as economic activity stalled, but started to pick up in the second half of 2010 as the recovery gained traction.

Poverty Trends in Kiribati 1

The spike in food and fuel prices in 2008 and the global crisis have undermined past gains in poverty reduction. The UNDP and the authorities estimated that an additional 10 percent of population is likely to have fallen below the poverty line as a result, with the incidence of poverty increasing from 22 percent to 26 percent. Poverty is highly concentrated in urban areas (South Tarawa) and less in the outer islands where there is greater access to land and marine resources. However, the outer islands face higher transportation costs.

As a result, progress against the achievements of the MDGs has been set back. Five out of eight goals seem out of reach. Increased vulnerabilities to climate change have also slowed the achievement of poverty reduction goals. This reflects the need to divert resources from development expenditure toward building of seawalls.

The government’s plan and development partners’ assistance are expected to alleviate poverty going forward. The authorities’ strategy toward poverty reduction is embedded in the Kiribati Development Plan (2008–11)—the government’s overarching plan to “enhance economic growth and poverty reduction for sustainable development”. The main pillars include supporting private sector development as a key engine of growth, especially in eco- tourism and in the domestic processing fishing industry, as well as creating employment opportunities both domestically and abroad.

Kiribati: Incidence of Poverty, 1/

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Sources: Kiribati National Statistics Office (NSO) and UNDP Pacific Center, 2009.

Defined as proportion of population below the (basic need) poverty line.

Kiribati National Statistics Office Estimates, and UNDP.

Kiribati: Millennium Development Goals (MDGs) Progress

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Sources: 2010 MDG Tracking Report, Pacific Islands Forum Secretariat, and 2011 World Bank CAS.

In March 2010, the government formulated a national framework for climate change and climate change adaptation and migration. Progress has been achieved so far in creating temporary employment opportunities abroad thanks to the engagement of development partners (in particular Australia and New Zealand).

1/ Prepared by Tobias Haque (World Bank).
Figure 1.
Figure 1.

Kiribati—The Setting in a Cross-Country Context

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: APDLISC database, WB WDI, WEO, Kiribati authorities and Fund staff estimates.
Figure 2.
Figure 2.

Kiribati: From Crisis to Recovery

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: APDLISC database, WB WDI, WEO, Kiribati authorities and Fund staff estimates.

B. Outlook and Risks

Staff’s Views

8. Growth momentum in the near term is expected to strengthen. Under current policies, key public projects—the rehabilitation of Tarawa’s road, airport and port—financed with external assistance should support growth in the 3 percent range over the next few years, restoring prospects that had been undermined by the infrastructure failures. Growth would revert to 1½–2 percent in the medium to long term assuming that the impact of climate change will continue to negatively impact economic activity.

Summary of the Medium-term Baseline Macroframework

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Source: IMF staff estimates.

9. Risks to the near and medium-term outlook are balanced, but long-term challenges remain. On the upside, domestic public works in the pipeline may have larger-than-expected impact on output, despite their large import content. On the downside, if the global recovery stalls, Kiribati’s remittances would be hit, while a surge in world food and oil prices could raise inflation pressures even further (Box 2) undermining past gains in poverty reduction. Higher than expected pressures from the upcoming investment boom could also arise. Over the long run, vulnerabilities to climate change could take a toll on economic activity undermining its long-run prospects.

10. However, the outlook for the medium term depends on the scope and speed of the government’s own reform agenda. With stepped-up reforms at a realistic pace, GDP growth could reach 3 percent over the medium and long term.

Summary of the Medium-term Reform Macroframework

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Source: IMF staff estimates.

Authorities’ Views

11. The authorities agreed with staff’s assessment of the economic outlook and risks. On the downside, they emphasized the potential spillovers from a potential further escalation of the food and fuel prices, with a negative impact especially on urban poverty. On the upside, improved prospects for employment driven by the investment boom could further spur domestic demand.

Kiribati: The Impact of High Fuel and Food Prices

Kiribati is vulnerable to a surge in commodity prices. Food and fuel imports represent 30 percent of GDP. Their share in total imports increased from less than 40 percent to about 60 percent over the last decade as commodity prices trended up.

The pass-through of food—especially rice— and energy prices to domestic inflation is high. Rice accounts for 20 percent of the CPI food basket. An increase in international fuel prices historically has resulted in an equal increase in domestic prices, with a three-month lag.

However, there are some mitigating factors compared to 2008. Rice prices have fallen in 2010 and they are still well below the 2008 peak and the Australian dollar has appreciated significantly helping mitigate imported inflation pressures.

Yet, a further increase in commodity prices may eventually pass through to domestic inflation, worsening both the fiscal and external positions. This could occur through higher imports and public spending, especially in light of the large investment projects in the pipeline, and possibly through higher food and fuel subsidies, although they account for a very small part of GDP (1 percent). Under an adverse scenario with oil price increasing by 40 percent in 2011, the fiscal balance is expected to deteriorate by 2½ percentage points of GDP in 2011 compared to the baseline, and the current account balance by 3 percentage points of GDP, provided that the Australian dollar does not appreciate further.

A01ufig02

Food and Fuel Share of Imports

(in percent)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: WEO, Kiribati authorities, and IMF staff calculations.
A01ufig03

Pass-Through of Fuel Prices

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: WEO, Kiribati authorities, and IMF staff calculations.
A01ufig04

Pass-Through of International Food Prices to Domestic Food Inflation

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

* A positive value implies an appreciation of the Australian dollar.Sources: WEO, Kiribati authorities, and IMF staff calculations.

Adverse Oil-shock Scenario: Comparison with the Baseline1/

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Assumes an increase in oil price of 40 percent in 2011 compared to the baseline.

Source: IMF staff estimates.
Figure 3.
Figure 3.

Kiribati: The Medium-term Outlook

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: APDLISC database, Kiribati authorities and Fund staff estimates.

POLICIES TO ENSURE SUSTAINABLE GROWTH

A. Fiscal Policy

Background

12. The scope for countercyclical policy in Kiribati is limited. The revenue base is large but very volatile. Fishing license fees account for about half of government revenues (Box 3). The country depends on foreign aid to finance its large development needs. More extreme weather patterns related to global climate change are also putting strains on the budget. The only fiscal cushion against negative shocks has been provided by Kiribati’s wealth fund (RERF), which in recent years has been severely depleted.

A01ufig05
Sources: Country authorities and IMF staff estimates.

13. Fiscal policy has supported the economy during the economic downturn. Copra subsidies and civil servant wages have increased and have helped mitigate the impact of the output contraction on households. The fiscal deficit bottomed out at 20 percent of GDP in 2008 (Table 3), but narrowed substantially the following year as a result of expenditure compression and improved tax collection, with the introduction of a withholding tax at the source in March 2009.

Table 3.

Kiribati: Summary of Central Government Operations, 2007-12

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

Includes subsidies to copra production.

Development expenditure equals grants plus loans for development projects.

Overall balance in the table is different from official budget because loans are classified as financing.

14. However, the RERF suffered substantial losses. The RERF assets declined from A$637 million (420 percent of GDP) in 2007 to A$571 million (350 percent of GDP) in 2009. This drop reflected exposure to failed Icelandic banks (A$40 million, or 25 percent of GDP), as well as continued drawdowns to finance budgetary shortfalls.

15. In 2010 the fiscal position strengthened and budget planning improved. The estimated fiscal deficit is 8 percent of GDP, down from 12½ percent in 2009. The narrowing deficit reflects a large increase in fishing licenses fees, as a result of an auction scheme introduced in September 2010 as well as temporary factors—such as fines collected from foreign fishing vessels. The 2010 budget introduced a three-year budget framework in line with previous IMF policy recommendations (Appendix 1), with the assistance of the AsDB.

16. The 2011 budget marks a return to fiscal expansion. The fiscal balance is expected to deteriorate to 14 percent of GDP in 2011 on the back of a large increase in development expenditure in infrastructure financed by a combination of external assistance and RERF draw-downs.

17. Over the medium term, fiscal deficits will remain in the double digits (Table 4). The current government’s fiscal strategy is to target the RERF drawdown at A$15 million per year during 2011–13. Given the expected external loans to finance infrastructure spending, this strategy would imply a deficit of 10–14 percent of GDP. In 2014, revenues are expected to drop by 2 percent of GDP with lower tariffs following the implementation of Pacific Islands Countries Trade Agreement (PICTA).

Table 4.

Kiribati: Medium-Term Projections, 2009-16

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

Staff’s Views

18. The fiscal stance for the next two years is appropriate, but fiscal adjustment will be required in the out years. The deterioration of the fiscal balance in the near term is warranted by key development expenditures that will spur productivity growth. However, going forward, the focus will need to shift to fiscal consolidation. In the last ten years, budget deficits (averaging 12 percent of GDP) have been financed by drawing down the RERF. If this trend continues, the RERF real per capita balance would reach one-third of its 2000 value by 2030 (DSA baseline scenario).

19. Should food and fuel prices escalate, the authorities should refrain from increasing universal subsidies and public wages. However, as income inequality is very low in Kiribati, it may be difficult to design a targeted subsidy program. Instead the mission supported the authorities’ plan to take full advantage of the regional seasonal employment scheme offered by Australia and New Zealand to increase employment and income generating opportunities in the short term. Grant support from donors would also help limit the harm to real incomes and poverty. An increase in civil servant wages would not be an appropriate countercyclical policy because it is unlikely to be reversed when the economy recovers, as the increase introduced in early 2010 demonstrates.

20. Over the medium term, to help anchor fiscal plans, the mission suggested stabilizing the real value of the RERF in per capita terms, once key public investments in the pipeline have occurred.1 This would require limiting budget deficits to 5–6 percent of GDP over the long term (DSA reform scenario).2 Fiscal sustainability requires preserving the value of the RERF as a buffer against external shocks. While this fiscal anchor would only be indicative, it could provide an internal consistency check to link fiscal decisions to a more intergenerationally equitable drawdown of sovereign wealth.

A01ufig06

Baseline Scenario: Fiscal Stance

(In percent of GDP, 1/)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: IMF and WB staff estimates.1/ Unless otherwise indicated.
A01ufig07

Reform Scenario: Fiscal Stance

(In percent of GDP, 1/)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: IMF and WB staff estimates.1/ Unless otherwise indicated.

21. Staff commended the authorities for adopting a multi-year budget framework as it would provide more fiscal discipline. Realistic fiscal plans would be more easily designed and fiscal sustainability safeguarded. Given the uncertainty surrounding revenue and aid flows, revenue projections should be conservative assumptions. Downside scenarios should also be fleshed out, with revenue shortfalls, as a result of a temporary shock, and the prospective costs of climate change mitigation, explicitly considered. Overall, lower fiscal deficits (and a stronger sovereign balance sheet) are needed to reconstitute room for countercyclical fiscal maneuver, as well as scope to meet the long-term spending pressures arising from a rising sea level.

22. As the recovery proceeds, stronger than anticipated revenues should be saved. To help moderate pro-cyclical fiscal policies driven by volatile revenues, windfalls should be saved during upswings and used only during downturns to support the economy. This will help create fiscal space by safeguarding the RERF against external shocks and support a smooth path of expenditure.

23. Savings can also be achieved by rationalizing expenditure and tax structures.

Poorly targeted and distortionary subsidies to copra producers and other state-owned-enterprises (SOEs), amounting to some 5 percent of GDP, should be phased out. The restructuring of loss-making SOEs should also proceed apace. Customs administration— which reportedly has worsened in the last few years—should be shored up and exemptions reduced. The introduction of a VAT tax should also be considered.

24. Staff welcomed the introduction of an auction scheme on fishing licenses. This would provide scope for increasing fishing license revenues over the medium term.

25. The authorities should reconsider RERF investment strategies in line with the recent MCM TA recommendations. The report suggested reviewing current strategic asset allocation to reflect more closely the currency composition of Kiribati’s imports. The report also recommended strengthening the governance of the RERF by increasing in-house expertise over the medium term through training or secondment at other wealth fund institutions, hiring a long-term consultant to improve the investment framework, closer monitoring investment risks and returns, and publishing annual reports to increase transparency.

26. Kiribati is at high risk of debt distress. Fiscal risks have been exacerbated by the crisis as RERF assets—the primary source of deficit financing—dropped significantly. The uncertainty about aid flows and the impact of climate change will add to pressures on Kiribati’s fiscal position over the long term. The joint IMF-WB debt sustainability analysis shows that despite low external public debt— currently estimated at about 10 percent of GDP—the debt outlook is projected to worsen in the years ahead as Kiribati undertakes infrastructure investment (partly financed through borrowing from development partners) and the fiscal costs of climate change. Improving debt dynamics will require prudent borrowing, continued grant financing, fiscal consolidation, and a step up in structural reforms.

Authorities’ Views

27. The authorities reiterated their strong commitment to preserve the value of the RERF. They saw merit in staff’s advice to save stronger-than-anticipated revenues in the upswing, as well as in maintaining the real per capita balance of the RERF constant once the large public investments have occurred. They noted that their nominal drawdown rule, while imperfect, is simple to communicate and is the first step toward a fiscal anchor. Should the increase in commodity prices be persistent they may consider increasing the import levy and then using the proceeds to reimburse the freight costs for goods transported to the outer islands, where transportation costs are higher. While they agreed that the increase in civil servant wages effective in January 2010 was not a countercyclical policy measure given its permanent nature, they noted that the previous increase dated back to 2006 and thus was overdue.

28. On technical assistance, they requested assistance from PFTAC on the macro-framework and tax administration. They also expressed concerns about the volatility in fishing revenues as they are collected in U.S. dollars and are currently looking at options for hedging exchange rate risk through financial derivatives and for denominating fishing license fees using a basket of currencies. Officials would welcome technical assistance from development partners. They highly appreciated the TA on the RERF provided by MCM.

Kiribati: Prospects for Fishing License Revenues

Fishing license fees are a key source of income for Kiribati. Over the last ten years they represented on average 45 percent of government revenues. They are the highest (in terms of GDP) among regional peers reflecting the largest marine resource endowment across the Pacific.

Kiribati has still untapped potential to exploit its fishing resources and reduce the volatility of fishing revenues and some steps have been recently taken.

  • In September 2010, the authorities introduced an auction scheme for fishing rights, replacing bilateral access agreements—in line with previous IMF recommendations. Bilateral agreements specified a fixed fee per vessel and were renegotiated on a yearly basis, regardless of the value of fish catches. Thanks to the introduction of the auction scheme, as well as some other temporary factors (paragraph 15) in 2010 fishing license fees surged by almost 40 percent (year-on- year) to 52 percent of GDP.

  • The authorities are seeking options to reduce the volatility of license fees due to exchange rate movements of the U.S. dollar through financial derivatives or by denominating fishing license fees using a basket of currencies. They are currently evaluating pros and cons of moving away from the current U.S. dollar denomination as it provides a natural hedge against U.S. dollar-denominated imports.

  • Recent initiatives to encourage investment in domestic marine processing would increase proceeds from fishing resources. The recent agreement among the government of Kiribati and Chinese and Fijian fishing companies to set up a joint venture for marine processing could provide a significant boost to the economy. The FDI involved is expected to reach A$50 million.

A01ufig08

Kiribati: Fishing License Fees

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: Kiribati authorities and IMF staff estimates.
A01ufig09

Pacific Island Countries: Fishing License Fees, 2010

(In percent of GDP)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: Country authorities and IMF staff estimates.
A01ufig10

Kiribati: Fishing License Fees By Country of Origin

(In million of Australian dollars)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: Kiribati authorities and IMF staff estimates.

Further improvements can be expected. Participation in the Pacific Islands Forum Fisheries Agency and negotiation of a comprehensive Economic Partnership Agreement with the European Union may strengthen control over marine resources and create new opportunities for increasing revenue. Adopting cooperative sub-regional measures may strengthen bargaining power of license-issuing countries.

B. Structural Reforms—Supporting Private Sector Growth

Background

29. Weak private sector development is an impediment to sustainable growth.

Participation of the private sector in the economy is tenuous although it has increased over the last few years. According to the 2011 WB Doing Business Report, procedures for starting and closing a business, and dealing with construction permits are more cumbersome than in other Pacific islands. Also, access to credit is limited and costly, while poor infrastructure continues to hold back long-term growth. The government’s Development Plan (KDP), spanning 2008–11, correctly recognized the need to rotate the sources of growth toward the private sector in areas such as tourism and marine resources—including the development of niche tourism in Kiritimati (Christmas) Island—and identified key weaknesses of the current system. The outstanding issue remains the slow pace of implementation in key areas:

  • • Land reform. Limited land availability and weak enforcement of land property rights are problematic. Two thirds of the land is owned by the government and the remaining third by families rather than individuals, making property rights unclear. Most transactions are contested, and court settlement procedures are very long. Lease procedures are lengthy and perceived as arbitrary with the Minister of Land responsible for final approval.

  • • SOEs reform. Despite little progress in recent years, momentum in the SOE reforms seems finally to have gained traction. An SOE will be privatized by May 2011 and five additional SOEs have been identified for reform. The KDP calls for cutting back government guarantees on SOEs’ borrowing. The contingent liabilities from SOEs amounted to about 20 percent of GDP in 2010.

A01ufig11

Business Climate Indicators

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Source: World Bank Doing Business (2011 Doing Business Report).1/Higher rank indicates more costly.
A01ufig12

Telecommunication Cost and Charges

(In U.S. dollars, 2010)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Source: AsDB estimates.

Staff’s Views

30. With a shift to a higher growth path hinging on a vibrant private sector, the implementation of the structural reform agenda should be accelerated. Private sector development is crucial to improve growth prospects, especially in tourism and fish processing.3 While there was agreement that the pace of reforms needs to be calibrated to political realities, staff advised the authorities to bring the current structural reform momentum forward and take measures to improve the business climate. A critical mass of reform is needed to continue attract foreign assistance and increase opportunities for foreign investment. Reforms aimed at streamlining starting up businesses, and obtaining construction permits, and expanding access to credit are key. A new land law that improves access to land by strengthening administrative systems for transferring property rights and improves the legal framework for land usage and ownership is also urgent. The authorities’ interest to liberalize telecommunication with the assistance of the World Bank is a welcome step.

31. Staff supported the SOE reform underway with the assistance of the AsDB. Reforming the SOEs would create space for private sector development and reduce the drain on the budget. As advocated by the Fund in past consultations, it is important to limit SOEs to areas where the private sector operations are not viable such as in public utilities (water, electricity, and fuel distribution to the outer islands).

32. Strengthening public financial management (PFM) is crucial. PFM in Kiribati is weak, and characterized by poor data quality and expenditure controls, outdated legislation and regulations, limited information about fiscal risks from nonperforming SOEs, and poor links between capital investments and recurrent budgets. These weaknesses weight on business activity. The PFM Reform Plan, which sets out the government’s reform priorities based on the findings of the 2010 Public Expenditure and Financial Accountability, provides a good platform for policy dialogue and more focused technical assistance.

Authorities’ View

33. The authorities shared the view that a meaningful uplift in trend growth requires structural reforms on a broad front. The authorities have reiterated in the 2011 budget speech their commitment to SOE reform. While they pointed out that the pace of reforms may slow down in the second half of the year ahead of elections, the need for the private sector to support the economy has gained consensus among policymakers and the public. They are considering a law to ease constraints to the use of land as collateral. To streamline the red tape for business they are planning on instituting a “one-stop shop” to ease procedures for opening a business. They also stressed that a review of the investment regulatory framework should take place with the assistance of development partners to increase interest of foreign investors. In their view, one of main impediments to private sector development is the difficulty in accessing credit. However, they agreed that this in turn reflects the absence of clear property rights.

C. Safeguarding Financial Sector Stability

Background

34. Kiribati’s financial sector is undercut by structural impediments and a lack of competition. It consists of two banks, one insurance company, and a pension fund. ANZ Bank (Kiribati) Limited is the only commercial bank.4 Restrictions on land ownership by foreign entities tilt the bulk of its lending toward public enterprises. ANZ Bank NPLs are less than 1 percent of total loans. The Development Bank of Kiribati (DBK), wholly government-owned, has a larger share of loans to the private sector but its loan book is marred by high NPLs and secured lending remains underdeveloped. Insurance coverage is provided by another government financial institution, the Kiribati Insurance Corporation. Finally, the Kiribati Provident Fund (KPF) manages the assets of the pension system, about 60 percent of GDP in 2010 (Box 4). Overall, access to credit by the private sector remains restricted and expensive. The interest rate spread is slightly above the Pacific Islands average. The private sector has regularly complained about high charges and fees, including on remittances.

A01ufig13

Interest Rate Spreads of Commercial Banks

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: Country authorities, IFS and IMF staff estimates.

35. The authorities have tried to bolster competition and intermediation. Entry into the insurance industry was liberalized at end-2008, although the incumbent insurer remains unchallenged to date. The KPF introduced a lending scheme in July 2010, which allows short-term borrowing (i.e., one year) for any purpose of up to 14 percent of a member’s balance in the pension fund, using his pension entitlements as collateral5. In 2010, loans under this scheme totaled A$3 million (about 3½ percent of the fund’s portfolio). There are also plans afoot to strengthen the commercial orientation of the DBK through a foreign partnership.

Staff’s Views

36. More competition in the banking sector would help to spur private sector’s development. The authorities’ ongoing efforts are appropriately focused but other steps could be considered. These include: (i) expanding micro-credit with the development of village banks as done in other Pacific islands; (ii) containing NPLs at the DBK by tightening lending standards and improving risk management; and (iii) introducing a long-overdue land law to ease access to credit and improve collateral recovery. Bank regulation and supervision need to be strengthened before an expansion of the DBK’s lending activity is considered. Staff also stressed the need to enact and implement the draft law on anti-money laundering and combating the financing of terrorism (AML/CFT).

37. The new lending scheme of the pension fund could prove problematic. Although collateralization limits credit risks to the KPF, contingent liabilities to the government could build up if members exhaust their pension wealth ahead of retirement. Thus the size of the scheme should not be increased. If this were the case, asset allocation may be adversely affected by the need to ensure greater liquidity of the assets, if draw-downs under the scheme increase. If members were to use the loans for consumption or improper investments, they might compromise their future pension income. Hence, the government and/or KPF should invest in financial education. Technical assistance, including from the IMF, could help the authorities improve the design of the lending program.

Authorities’ Views

38. The officials broadly shared staff’s views on the challenges facing the financial sector and requested IMF technical assistance in this area. They agreed that greater competition would improve the private sector’s access to credit and reduce credit costs. Fund technical assistance on financial supervision and regulation would strengthen the underpinning of the reforms underway, including the restructuring of the Development Bank.

39. The authorities noted that the new KPF lending scheme is an initial step to improve households’ access to credit. Since lending is a relatively small fraction of the accumulated individual assets and collateralized, the solvency of the pension fund or its exposure to credit risk are not at issue. Nonetheless, the authorities requested IMF technical assistance in reviewing the asset allocation strategy of the KPF as well as an assessment of its long-term viability.

Financial Sector Developments: The Provident Fund and Kiribati Development Bank

Kiribati Provident Fund (KPF) is Kiribati’s government-managed pension fund.

  • The 2008 crisis hit the KPF hard. Assets values dropped by 20 percent, but rebounded in 2009-10, reaching pre-crisis value. Its assets totaled A$100 million (60 percent of GDP) at end-2010. Employers and employees each contribute 7½ percent of the employee’s salary. At the retirement age (50 years), participants receive a lump-sum payment. However, at the age of 45, members have the option of withdrawing 50 percent of their accrued balance while continuing working until age 50, or 100 percent of their balance if they retire at 45 for medical reasons. With a minimum yearly rate of return guaranteed at 4 percent, the fund is a defined-contribution scheme with an element of defined benefits.

  • The KPF has built a buffer fund to accumulate “surpluses” when rate of return on assets exceed rate of return accrued to members (decided by the KPF board). Through the years, this buffer has, however, been depleted in the wake of losses during the crisis resulting in a gap between assets and projected liabilities. Additionally, earlier losses related to lending operations to the DBK (amounting to A$1½ million) to allow households to borrow funds for education fees at terms below market rates in 2007 have further deteriorated its financial position.

  • Recognizing these risks, the KPF management has committed to a more active asset allocation strategy, increasing asset diversification in mid-2010 and hiring an additional portfolio manager.1

A01ufig14

Kiribati Provident Fund: Rate of Returns

(In percent)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: KPF and Fund Staff estimates.

The Development Bank of Kiribati (DBK) is a government-owned banking institution.

  • About 40 percent of loans are for business purposes. The interest rate charged is close to market rates. Loans of all types are collateralized (by land or pension contributions for borrowers older than 45 years). Loans are funded by a revolving government fund.

  • Although NPLs declined since 2008, they were still high at 24 percent of total loans in 2010.

  • DBK lending activity has started to pick up in the second half of 2010 as the economy recovered. In spite of the 60 percent provisions for NPLs, poor prospects for loan recovery due to issues with land titling and poor risk management undermine the soundness of the bank.

DBK: Financial Soundness Indicators

(in percent)

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September 2010.

Sources: DBK and Fund Staff estimates.
1 In mid-2010, the KPF asset allocation strategy changed from a 60-40 split between risky assets and fixed income assets to a more diversified asset class allocation.

ADDRESSING EXTERNAL COMPETITIVENESS AND SAFEGUARDING EXTERNAL STABILITY

40. The Australian dollar circulates as legal tender. Kiribati has accepted the obligations of Article VIII, Sections 2, 3, and 4 and maintains an exchange system free of restrictions on payments and transfers for current international transactions.

41. The real effective exchange rate has appreciated by 20 percent since 2008, driven by the strong Australian dollar and appears to be overvalued compared to its long-run level. However, the current account balance has improved over the last few years, reflecting strong income from fishing license fees. Looking ahead, the current account deficit is expected to deteriorate in the near term as Kiribati undertakes large public investment, and to narrow again by the end of the projection period to 24 percent of GDP (from 29 percent in 2011) in line with an improvement in the fiscal position (Tables 5 and 6). In the short term, large deficits are likely manageable as they are driven by key investment in infrastructure and financed by capital transfers.

A01ufig15

Kiribati: Real Effective Exchange Rate

(Index, 2005 = 100)

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Source: INS and IMF staff calculation.

Staff’s Views

42. The use of the Australian dollar as the official currency remains appropriate given Kiribati’s close linkages with Australia and has provided a strong nominal anchor.

43. While it is desirable to maintain the Australian dollar as nominal anchor, pursuing structural reforms is crucial to regaining competitiveness following the strong real appreciation. As noted (paragraph 29), competitiveness based on institutional indicators suggests that the business environment needs to be significantly improved.

44. Continuing to secure grant financing, instead of loans, and containing fiscal deficits are key to ensure external stability. From a macro balance perspective, the sustainability of the current account in the medium-term is totally driven by fiscal policy.

A01ufig16

Kiribati: Drivers of the Current Account Balance

Citation: IMF Staff Country Reports 2011, 113; 10.5089/9781455287635.002.A001

Sources: Kiribati authorities and IMF staff calculation.

Authorities’ Views

45. The authorities agreed that there is no scope to have an independent monetary policy. They also stressed that the fluctuation of the Australian dollar makes the economy vulnerable to exchange rate risks, given the RERF assets are mostly held in Australian dollars, while imports are not, resulting in a currency mismatch. They noted that the large current account deficit reflects to a large extent the surge in commodity prices, not only a loss in competitiveness and a large structural component—low public saving driven by large developments spending.

STAFF APPRAISAL

46. Kiribati is at a crossroads. The economy has recovered from the crisis with strong forward momentum. Large public investment in key infrastructures financed by foreign assistance underpins its favorable medium-term growth prospects. Yet gains will prove transitory if a broader agenda of fiscal and structural reforms remains unfinished. Further reforms are necessary to bolster the economy’s resilience and to ensure sustainable growth. The increasing costs of climate change and still large development needs raise important policy challenges.

47. Preserving the real per capita value of the RERF is key to ensure fiscal sustainability and intergenerational fairness. Once key public projects in the pipeline are underway, the focus should shift to fiscal consolidation. Lower fiscal deficits and a stronger sovereign balance sheet are necessary to rebuild fiscal space and help cope with long-term spending pressures arising from climate change.

48. The authorities have taken steps to bolster the public finances by introducing a multi-year budget framework. Casting budget decisions in a multi-year perspective will help design realistic fiscal plans. Positive windfall revenues compared to the budget should be saved during upswings and used only during downturns to support the economy. Continuing strengthening the medium-term fiscal framework is important to facilitate public planning and help guard against pro-cyclical policies.

49. The implementation of the structural reform agenda should be accelerated. Reforming the SOEs is key to creating space for private sector development and reducing the drain on the budget.

50. Competition in the banking sector is crucial to boost private activity. The authorities’ plans to revitalize the DBK in the medium term are welcome. In the meantime any further expansion of the DBK’s activity should be postponed until a regulatory and supervisory framework is in place. Expanding micro-credit schemes would also help ease credit constraints.

51. The use of the Australian dollar remains appropriate. To preserve external stability, continuing to secure grant financing would be key to supporting the country’s large development need, as indicated in the joint IMF-World Bank debt sustainability analysis.

52. The quality of macroeconomic data should continue to improve. The authorities should press ahead with PFTAC recommendations on the compilation and dissemination of economic data.

53. It is recommended that the next Article IV consultation take place on a 24-month cycle. This recommendation is in accordance with the Decision on Article IV Consultation Cycles (Decision No. 14747-(10/96) (9/28/2010), http://www.imf.org/external/pp/longres.aspx ?id=4515.

Table 5.

Kiribati: Balance of Payments, 2007-16

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

Includes fishing license fees, which would be shown as current transfers under conventional international guidelines.

Excludes valuation changes.

Comprises the Consolidated Fund, Development Fund, and STABEX Fund.

An increase in the debt service in 2007 reflects maturity of certain external borrowing including from Japan.