United Kingdom-Montserrat-British Overseas Territory
2011 Article IV Consultation

The 2011 Article IV Consultation highlights that low growth is expected for Montserrat in 2011 after sharp output contractions in 2009–10. Stress in the financial sector and slower-than-expected development of major capital investment projects continue to limit prospects for growth. Directors have welcomed the development of a strategy for addressing financial vulnerabilities and the initial progress in implementing it. They have supported preemptive action to minimize costs and risks and preparation of an action plan spelling out the roles of key players.

Abstract

The 2011 Article IV Consultation highlights that low growth is expected for Montserrat in 2011 after sharp output contractions in 2009–10. Stress in the financial sector and slower-than-expected development of major capital investment projects continue to limit prospects for growth. Directors have welcomed the development of a strategy for addressing financial vulnerabilities and the initial progress in implementing it. They have supported preemptive action to minimize costs and risks and preparation of an action plan spelling out the roles of key players.

SETTING

1. Montserrat, a small island with limited natural resources, was devastated by the eruption beginning in 1995 of a long dormant volcano, which has continued to cycle through periods of activity and inactivity. The eruption took place at a time when a vibrant economy had reemerged after Hurricane Hugo destroyed 95 percent of the island’s structures in 1989. The volcano left more than half of the island uninhabitable, including the former capital, airport, port, and the best agricultural land. Although the volcano has been inactive since early 2010, certain areas are subject to evacuation during periods of high volcanic activity.

2. The island has made enormous progress in its recovery, with substantial support from the UK government, the European Union, and other donors.

Nevertheless, the eruption has had a large and lasting demographic, economic and social impact. In a number of key respects the economy has not fully adapted to living with a volcano (Box 1). Much of the government remains in temporary quarters, and the construction of a new capital city and of a permanent port is at an early stage. The government dominates the economy and accounts for over half of employment.

3. The volcano led about three quarters of the population to emigrate, redefining the island’s demographics. There remain skill shortages from significant brain drain, an aging population, and inadequate housing. Unemployment is estimated at 14 percent. The population shrank from about 14,000 persons to a low of around 3,500, and has since recovered to about 5,000. A significant portion of emigration was to the UK where Montserratians are automatically citizens, and also to North America and other Caribbean countries.

4. The economy has been losing ground, with tourism in a continued decline. First, residential tourism by part-year residents and retired expatriates has had to confront volcano-related hassles, including ash clouds and evacuations of certain areas during periods of high volcanic activity. Second, access to the island has become more difficult. The discontinuation of fast ferry service in 2005 led to a large drop in day visitors from Antigua, and the current limited ferry service has faced operational difficulties over the past year. Two air carriers provide service with small airplanes (less than ten seats) after a regional carrier flying larger planes (with 19 seats) rationalized its routes in December 2010. Cruise ship visits are sporadic.

5. The island’s only goods export is volcanic sand used for construction, and import dependence is very high. The small capacity of the port and unpredictable weather conditions further increase the cost of importing and exporting. There has been progress toward self sufficiency in some agricultural products, complicated by concentration in land ownership. The island is a net sender of remittances, despite the high level of emigration, reflecting remittances by relatively more recent immigrants. Foreign investment, largely in residential real estate, is limited.

6. Montserrat’s budget is sustained by grants from the UK, which finance around half of expenditure. The ability to mobilize revenue domestically is constrained by the dominant role of the government and donor activity which is not taxable.

7. Resources mobilized by the two commercial banks are primarily directed abroad due to limited domestic lending opportunities. Most domestic lending is for real estate and personal loans. The banking system does not finance the government.

RECENT DEVELOPMENTS AND OUTLOOK

8. UK grants buffered the impact of the global crisis on Montserrat. Although the economy grew in 2009, it contracted in 2010 due in part to a small volcanic eruption and the passage of Hurricane Earl in 2010. These events contributed to a decline in the number of stayover visitors and weak import demand. However, growth in credit to the (very small) private sector was sustained at previous levels. Inflation remained low at around 2.5 percent in 2009-10.

9. Although grants sustained expenditure in 2009, the fiscal stance in 2010 was contractionary. In that year, grants and to a lesser extent revenue fell off, notwithstanding a tax amnesty which yielded 0.6 percent of GDP, and current expenditure was curtailed. The fiscal stance and weak activity reflect in part implementation delays in key capital projects.

10. Public sector debt is low at 5 percent of GDP. The debt consists primarily of borrowing from the Caribbean Development Bank for the construction of the former port. However, the large exposures of the public sector and financial system to CLICO/BAICO (49 percent of GDP) are to some extent explicit or implicit contingent liabilities of the government.

11. Loan quality deteriorated since the onset of the global crisis, but not to the same extent as the rest of the ECCU. Loan write-offs have reduced profitability and capital ratios, but capital adequacy is well above required levels.

12. The economic outlook hinges upon progress with major public capital projects, improving access to the island, and strengthening the private sector. Staff projections assume that capital projects contribute to an initial burst of growth in near term, and that growth converges in the medium-term to 3 percent.

POLICY ISSUES

The key policy challenges are addressing financial sector vulnerabilities, increasing fiscal independence, and enhancing growth prospects.

A. Addressing Financial Vulnerabilities

13. Due in part to limited domestic investment opportunities, Montserrat’s financial and public sector institutions became heavily exposed to CLICO/BAICO.

The overall exposure is EC$ 76 million (nearly half of GDP). The only indigenous commercial bank, although exposed to CLICO/BAICO, has been provisioning for its exposures, and plans to be fully provisioned by 2012. The bank is solvent, based on available information, but has recognized the need to strengthen its capital base.

14. Nonbank financial institutions also have significant exposures. These institutions are supervised by a single regulatory unit, the Financial Services Commission (FSC), with the exception of the Building Society which is conservatively managed and does not pose risks to the financial sector.1 Nevertheless, it should be brought under the authority of the FSC.

  • The only credit union has been running a loss. In addition to its exposure to CLICO/BAICO, its NPLs have been increasing, and it has not published audited accounts since 2007.

  • The Government Savings Bank (GSB) also has significant exposure to

Estimated Exposure to CLICO and BAICO 1/

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Source: Data provided by Authorities.

As of June 2011

  • CLICO/BAICO and indigenous banks. The GSB is a statutory institution operated, supervised, and legally backed by the government that takes deposits from the public and invests both regionally and overseas.

15. The offshore banking sector has been shrinking in assets and deposits. There are six offshore banks, all subsidiaries of banks outside the Caribbean subject to home country supervision, and none with a physical presence in Montserrat. The indigenous bank also has an offshore license as it takes deposits from individuals who are not full year residents. The offshore banking sector does not appear to be a source of vulnerability to Montserrat’s financial system.

16. The authorities should continue to strengthen the regulation and supervision of the financial sector. A joint regional task force is being formed to determine the size of the liquidity and capital shortfalls in indigenous institutions, assess direct and indirect linkages, and develop resolution strategies. It will be important to move urgently and preemptively to shore up the balance sheets of those institutions with impaired assets and to obtain new capital where necessary. An action plan is needed that spells out the respective roles of the Montserratian government, the Eastern Caribbean Central Bank, and the FSC.

17. The authorities welcomed the staff’s assessment and recognized the need to shore up weak financial institutions, pointing to several initiatives in this regard.

In particular, the government is working closely with the indigenous bank to strengthen its capital base, including by converting its claims on the bank to equity. At the same time, they recognize the need for a regional approach.2 The government has retained a consultant to assess options for strengthening the credit union, relying on new legislation which has strengthened the FSC’s powers. The government is defining options to shore up the GSB’s finances and to restructure its operations.

B. Increasing Fiscal Independence

18. The guiding principles for fiscal policy have been to target an overall balance, while reducing dependence on UK grants over time. In 2011, UK current grants are expected to fall below the unusually high levels in 2009-10 and the reduction in current grants is expected to continue in 2013 and beyond. As a result, although revenue is expected to improve, expenditure will fall by 3 percentage points of GDP.

19. The immediate fiscal policy challenge is to agree on a revised quantitative framework and timetable for reforms in discussion with the UK. The roadmap agreed in 2009 with the UK to reduce dependence on current grants, from EC$ 57 million in 2009 to EC$ 44 million in 2014, was built upon assumptions for economic growth and revenue which have not been borne out.3 This in part reflects delays in the implementation of capital projects, including the construction of a new capital and port that would have stimulated economic activity. Given that the scope in the near term to increase revenue appears limited given the small size of the private sector, a new medium term framework could define new trajectories for current grants and expenditure. Transfers should be targeted toward vulnerable groups, while allowing full passthrough of changes in international prices, in accordance with a 2008 ECCB Monetary Council decision.4 In addition, the fiscal framework should also address contingent liabilities stemming from the territory’s large BAICO/CLICO exposure.

20. The medium-term trajectory for capital expenditure will be determined primarily by the pace of implementation of the major donor-financed projects. The authorities should assess with particular care any future projects with a loan financing component to ensure that they will generate a revenue stream sufficient to repay the loan.

21. Significant efforts have been made to improve tax administration. The merger of Inland Revenue and Customs has led to efficiency gains, and the merged services have increased the yield of taxes on international trade, launched an income tax amnesty program which has yielded EC$ 1 million, and increased compliance with tax legislation. The planned creation of a single Taxpayer Identification Number and the addition of an income tax module to the existing ASYCUDA World system for customs would provide a single technology platform for tax administration.

22. The staff also supports plans to simplify the tax system. The authorities intend to replace the Service Tax and the multi-rate Consumption Tax with a General Consumption Tax in a revenue neutral manner. The tax is envisioned to have a single rate of 15 percent with limited exemptions for food and other necessities. In addition, the authorities will introduce excise taxes on goods with inelastic demand to be identified. Taxation of income will become more progressive, with the introduction of a higher 40 percent tax rate for individuals with high income while reducing the tax burden for tax payers below a threshold. The staff encourages the authorities to take the opportunity to rationalize the system of fees and non-tax revenues and to remove nuisance taxes. When the new framework for the export of volcanic sands is in place, the government should consider raising the royalty on sand mining. A levy on over-flights of the volcano originating in Antigua could also be explored.

23. The government has adopted measures to improve the sustainability of the Social Security Fund. According to a 2005 actuarial review, the Fund will extend the expected date of asset depletion beyond 2034. The Legislative Council adopted a Pension Amendment which will gradually increase the retirement age of civil servants from 55 to 65, adjust the pension accrual rate from two to one percent, and cap the combination of Social Security payments and Civil Service Pension at 85 percent of salary. The next actuarial review should assess to what extent the passage of the Pension Amendment has stabilized the Social Security Fund finances and indicate if any additional measures are needed. The review will also need to account for the Fund’s CLICO/BAICO exposure, which was over one third of the Fund’s investment portfolio at end-2009. In addition, the government should settle its obligations to the Social Security Fund of EC$ 21 million per an agreement in June 2009.

24. The authorities recognized the needs to revise the medium-term framework. They observed that the scope for cutting current expenditure was limited without scaling back government services or labor shedding that would lead to additional emigration to the UK, undercutting population objectives. They recognized the desirability of rationalizing the system of fees and non-tax revenue, and will explore the scope for higher royalties from sand mining once the new framework is in place.

C. Enhancing Growth Prospects

25. Montserrat has a number of promising opportunities to enhance its growth prospects and the viability of its economy. These include constructing a new capital and port, enhancing the tourism product and access to the island, putting in place a sound framework for the export of volcanic sand, lowering energy costs, and harnessing the resources of the diaspora.

26. The keystone of this investment program, the construction of a new capital and port in Little Bay, has faced delays in implementation. A larger port would allow simultaneous docking of a cruise ship and the ferry to Antigua. A new capital would provide a focal point for public and private sector activity, which could encompass government buildings, offices and retail outlets, and a foreign financed hotel. The project is likely to be completed in 2013. The short-run priority should be to accelerate the investment program by overcoming implementation constraints and obtaining grant financing.

27.Improving access to the island and enhancing the tourism product are also priorities. The government and its development partners are exploring options to restore fast ferry service and to reestablish service by a regional airline. In addition, an investment program is underway to enrich the tourist experience by taking advantage of Montserrat’s unique characteristics. There is scope to gain more benefit from volcano-based tourism.

28. The current problematic approach for the mining of volcanic sands, the only goods export, is being replaced with a sound and sustainable strategy. The mining of sand, which flowed during the eruption through a quiet center of residential tourism, and trucking it across the island has entailed numerous negative externalities while placing the industry at a cost disadvantage. The new strategy would put in place a new dedicated jetty near the mining operations with legal and regulatory safeguards aimed at minimizing negative environmental impacts while increasing industry and government revenue. Establishing a national consensus behind the new strategy will be crucial for it to succeed in resolving a highly controversial issue.

29. Lowering energy costs including through geothermal energy would improve economic prospects. In the near term, a new diesel generation facility to be financed by the Caribbean Development Bank will improve efficiency and help reduce the state electricity company’s operating losses, which may also require tariff revisions. Prospects for geothermal energy production are good, and the authorities are seeking financing to drill an exploratory production well, which if successful could become operational in two years. Subsequently, exporting electricity to neighboring islands is a realistic possibility, and there have been early consultations with potential foreign investors. The island, which was dropped from the Caribbean fiber optic link after the eruption, is also seeking to improve communications linkages.

30. Improving the business environment will be essential to rebuilding a viable private sector. The business community noted some strengths, such as the ability to clear items through customs within the day taking advantage of the full computerization of customs using ASYCUDA World. However, some other administrative and legal procedures are cumbersome. Staff recommended establishing a one-stop shop for investors, making a more formal assessing of the business environment to provide a diagnostic and benchmark for progress. Although two of three quantitative methods used to assess the level of the exchange rate suggest large overvaluations of 39-56 percent (Box 2), these may reflect Montserrat’s grant-driven balance of payments and significant data limitations, and private sector representatives did not raise the issue.

31. The authorities have recognized the need to increase the population in order to achieve a viable scale for the economy. The population has been growing gradually in recent years, driven more by immigration from the Caribbean region rather than from returning residents. Nevertheless, there would be significant gains from better harnessing the resources of the diaspora. The staff noted the potential for an investors’ conference to shift perceptions by highlighting the numerous initiatives that are approaching fruition, and the authorities plan several events aimed at foreign investors and former residents.

32. The authorities with concurred with the staff on the range of opportunities available to enhance growth. They recognized the need to accelerate the investment program. They are hopeful the new framework for sand mining, which was developed after extensive consultation, will address widespread concerns in a mutually beneficial manner. They are exploring measures to monitor and enhance the business environment, and have already held several events directed at investors and former residents.

STAFF APPRAISAL

33. Montserrat has made considerable progress in recovering from the eruption of the volcano, which remains intermittently active. However, in many respects, the island’s economy is still out of equilibrium, as it adapts to living with the volcano while exploiting related opportunities. The economy is sustained by grants from the UK and is expected to gradually recover and reduce its dependence.

34. The authorities need to undertake a range of actions to take advantage of opportunities to promote long run growth. Access to the island is an important bottleneck that impedes economic growth generally and the growth of tourism specifically. Restoration of fast ferry service and expansion of the port would address this concern. Construction of a new capital would provide a focal point for private and public activity, and the short-run priority should be to accelerate the investment program by overcoming implementation constraints and obtaining grant financing. The authorities are putting in place a sound framework for the mining of volcanic sands, which is a promising export industry, but has also imposed several negative externalities on the island. Notwithstanding indicators of possible overvaluation, the private sector did not identify the level of the exchange rate as an issue.

35. Ensuring a reliable energy supply and minimizing its cost is essential for faster growth. The authorities should continue with the development of the diesel generating capacity and also fully explore the possibility to develop geothermal energy sources. Lower energy costs could transform the island’s economy.

36. Reducing dependence on recurrent and capital grants is a key objective of fiscal policy. After the volcanic eruption, fiscal operations have centered on maintaining an overall balance. The immediate challenge is to reach agreement with the UK on a revised fiscal framework and timetable for reforms in light of implementation delays in key projects and the current economic environment.

37. The authorities have made commendable progress in improving the tax administration. They should maintain this momentum through further progress with its reform strategy including introducing a single Taxpayer Identification Number and integrating IT systems.

38. The government has already developed a strategy for addressing financial vulnerabilities and made initial progress. Urgent and preemptive action is essential, as is an action plan spelling out the roles of the key players. Regulation and supervision of the nonbank financial sector needs to be further improved, and the building society should be brought under the purview the FSC.

Living with the Volcano

After a long period of dormancy, the volcano’s eruption in 1995 redefined the island geographically, economically and demographically. The eruption affected most of the southern part of the island, destroying the economic center of the island, including the capital city, the port, the airport, and the best agricultural land. The volcano has subsequently gone through five cycles of activity and inactivity, and it is unpredictable if and when the current period of inactivity will end. Certain zones must be evacuated during periods of high activity, which along with other hassles has led some expatriates to leave over time.

Despite progress toward recovery, in many respects the economy is still adjusting to a new equilibrium:

  • The post-eruption economy has been sustained by grants, although the eventual goal is to reduce dependence. The public sector employs the majority of the labor force, and tourism, which is largely residential, has been declining, with the number of total visitors falling from 40,000 annually prior to the volcanic eruption to about 9,400 in 2010. The island’s only goods export is volcanic sand used for construction, while the island imports 95 percent of its consumption.

  • The construction of a new port and capital in Little Bay is at an early stage, and much of the government is still in temporary quarters. The redevelopment of the existing port is expected to take several years to complete. Efforts to exploit the economic benefits of the volcano are at an early stage.

  • The mining of volcanic sand has entailed many negative externalities. The sand is mined in a valley where many expatriates have homes. Furthermore, it is trucked to the other end of the island along the main highway to the port at Little Bay, which has damaged the road and increased costs. A new framework is being implemented to address these issues.

  • The potential for volcano-based tourism is also not fully developed. Tourists can see the volcano and its impact on the former capital city, described as a modern Pompei, by air and by sea, and a museum is being developed. However, the only air tours are based in Antigua, with no benefit to Montserrat.

  • There is a high probability of an exploitable geothermal system which could be used to produce energy. The next step is to find financing to drill a production well to prove the existence of a viable resource before approaching private investors. The well would be in the exclusion zone, while the generation facility would not.

Exchange Rate Assessment

Both the customer- and the competitor-based real effective exchange rates (REERs) have been on a declining trend in the last two years.

The customer-based real effective exchange rate has been on a declining trend since 2009, when it appreciated due to increases in global food and fuel prices. It then moved in line with US dollar depreciation against major customer currencies. The competitor-based real effective exchange rate has stayed broadly constant since 2005.

The assessment of the exchange rate using CGER methodologies is constrained by significant data limitations.

The fundamentals-based equilibrium real exchange rate (ERER) approach, which looks at fundamentals that are believed to determine the equilibrium REER, indicates that the actual real effective exchange rate has been close to its long-run equilibrium.1 During 2004-10, the REER has indeed remained within a 90 percent confidence interval around the equilibrium.

The macroeconomic balance approach, points to an overvaluation of 39 percent. The CGER methodology based on a world sample of 111 countries suggests that the current account (CA) norm is minus 17.3 percent of GDP against the underlying CA of minus 23.7 percent of GDP. Closing the gap between the norm and the current account in the medium term would therefore require the specified large depreciation. The implied overvaluation reflects the island’s high dependence on imports, imports being greater than exports, inducing a very low CA balance to GDP elasticity.

The external sustainability approach2 suggests an overvaluation of 56 percent. This approach indicates that the NFA-stabilizing CA is minus 14.6 percent of GDP while the underlying CA is minus 23.7 percent of GDP, implying a large depreciation would be needed to stabilize net foreign assets.

A01bxufig01

Montserrat: External Competitiveness, 2003–2011 (July)

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Sources: Fund staff estimates.1/ An increase (decrease) indicates an appreciation (depreciation).2/ The sharp movements in the competitor-based real exchange rate in 2002-04 were largely driven by the Dominican Republic’s peso
A01bxufig02

Montserrat: Actual and Equilibrium REER, 2003–2010 1/

(Index 2005=100)

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Sources: IMF, Information Notice System; and Pineda, Cashin and Sun (2009), “Assessing Exchange Rate Competitiveness in the ECCU,” IMF Working Paper 09/78 (Washington: International Monetary Fund).1/ The dotted lines around the equilibrium exchange rate represent 90 percent confidence intervals of the prediction.
1

The estimation of the equilibrium exchange rate takes into account productivity differential in the tourism sector (using per capital tourist arrivals instead of per capital GDP), terms of trade for tourism, government consumption, and net foreign assets. For more details see: Pineda, Cashin and Sun, 2009, “Assessing Exchange Rate Competitiveness in the ECCU,” IMF Working Paper 09/78 (Washington: International Monetary Fund).

2

Unlike in the standard CGER methodology, capital account transfers including grants were included in the estimation for the ECCU region, as they represent an important source of financing.

Table 1.

Montserrat: Selected Indicators, 2006-12

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Sources: Authorities; ECCB; and Fund staff estimates and projections.

Estimates are for the year 2010, except where noted.

Table 2a.

Montserrat: Central Government Operations 2006–131

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Sources: Authorities; ECCB; and Fund staff estimates and projections.

The fiscal year coincided with the calendar year until 2009, and thereafter the fiscal year is April to March of the

Includes property transfer tax.

Includes transfers to public utilities and state enterprises.

Table 2b.

Montserrat: Central Government Operations, 2006–131

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Sources: Authorities; ECCB; and Fund staff estimates and projections.

The fiscal year coincided with the calendar year until 2009, and thereafter the fiscal year is April to March of the

Includes property transfer tax.

Includes transfers to public utilities and state enterprises.

Table 3.

Montserrat: Summary of Balance of Payments, 2006–16

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Sources: Eastern Caribbean Central Bank (ECCB); Authorities and Fund staff estimates and projections.
Table 4.

Montserrat: Monetary Survey, 2006–12

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Sources: Eastern Caribbean Central Bank; and Fund staff estimates and projections.
Table 5.

Monserrat: Vulnerability Indicators 2006–11

(In percent, unless otherwise indicated)

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Sources: Eastern Caribbean Central Bank (ECCB); and Fund staff estimates and projections.

All banks include indigenous and foreign banks.

As of June, 2011.

Table 6

Montserrat: Medium Term Macro Framework, 2006–16

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Sources: Authorities; and Fund staff estimates and projections.
Figure 1.
Figure 1.

Montserrat: Real Sector Developments

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Source: ECCB; EM-DAT; and Fund staff estimates.1/ AIA stands for Anguilla; ATG Antigua and Barbuda; DMA Dominica; GRD Grenada; KNA St. Kitts and Nevis; LCA St. Lucia; MSR Montserrat; VCT St. Vincent and the Grenadines
Figure 2.
Figure 2.

Montserrat: Fiscal Developments

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Source: ECCB; and Fund staff estimates.
Figure 3.
Figure 3.

Montserrat: Financial Soundness Indicators, 2006–11

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Source: ECCB.
Figure 4.
Figure 4.

Montserrat: External Sector Developments

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Source: ECCB; and Fund staff estimates
Figure 5.
Figure 5.

Montserrat: Monetary Developments

Citation: IMF Staff Country Reports 2012, 009; 10.5089/9781463932503.002.A001

Source: ECCB; and Fund staff calculations.
1

The FSC reports to the UK-appointed Governor of Montserrat, who also has responsibility for external relations for external affairs and security.

2

The Premier of Montserrat is now Chair of the ECCB’s Monetary Council.

3

The fiscal projections in Tables 2a-b incorporate the roadmap’s trajectory for grants with staff projections for revenue and expenditure.

4

The UK’s subsequent mid-term budget review recognized that current revenue and expenditure targets are no longer achievable and it was agreed to develop a new roadmap and reform timetable later this year.