Statement by Christopher Legg, Executive Director for Samoa and Christopher Becker, Advisor to Executive Director, Jun 15, 2012

After a moderate recovery in 2010–11, the Samoan economy has shown signs of slowing down amid rising inflation. After two consecutive years of contraction, real GDP has expanded by 2 percent in 2010–11. The Central Bank of Samoa has maintained an accommodative monetary policy to support economic activity. However, continued structural reforms are required to lift Samoa’s economic growth and to ensure financial stability. Considerable progress has been made in tapping customary land for productive use.

Abstract

After a moderate recovery in 2010–11, the Samoan economy has shown signs of slowing down amid rising inflation. After two consecutive years of contraction, real GDP has expanded by 2 percent in 2010–11. The Central Bank of Samoa has maintained an accommodative monetary policy to support economic activity. However, continued structural reforms are required to lift Samoa’s economic growth and to ensure financial stability. Considerable progress has been made in tapping customary land for productive use.

The Samoan economy continues to face substantial challenges in the post-Tsunami and world financial crisis environment. Economic growth remains sluggish and the public debt that was accumulated in the aftermath of the natural disaster has now exceeded its medium-term target of 50 percent of GDP. In this context, we note the authorities’ full recognition of the policy challenges that lie ahead and their plans to address the need for fiscal consolidation. These plans were already well progressed but further benefited from Staff input during the recent Article IV mission. The Samoan authorities welcomed the Staff assessment and advice, and attach particular importance to obtaining the technical assistance highlighted in the Staff Report to facilitate implementation of key Fund recommendations. The authorities also want to express their appreciation for the frank, constructive, and collegiate approach to the discussions adopted by Staff.

1. Exchange rate and monetary policy

The Central Bank of Samoa has lowered interest rates to near zero in an attempt to stimulate the economy. However, pass-through is constrained by the commercial banks’ concern about risk following the recession, and is hindered by an underdeveloped financial market where there is a lagged and only loose link between the policy rate, bank funding costs, and lending rates. As a result, there is only a very small fillip to growth from monetary policy. Commercial banks continue to be deposit funded and set lending rates as a fixed, risk-based, markup on their administratively determined funding costs. Lending rates have therefore not fallen by anywhere near as much as the policy rate, or indeed deposit rates.

The real exchange rate has appreciated, principally as a result of two significant import price shocks that fed directly into domestic inflation. As a result, there has been a loss of international competitiveness in the tourism and agricultural sectors. The Staff exchange rate assessment indicates an overvaluation of the real effective exchange rate in the order of 10 to 25 percent.

Should economic conditions deteriorate substantially, the authorities are open to the Staff recommendation to implement a gradual devaluation but remain apprehensive about the timing and practicalities of doing so, and attach particular importance to obtaining technical assistance (as agreed with the Fund) which would be necessary to help work through the many implementation issues involved. These include the preponderance of foreign currency denominated external debt, the continued heavy reliance on imports, and the challenges posed for monetary policy by the associated recommendation that monetary policy should be tightened to head off any resulting upward pressure on inflation. (It is concerning to contemplate how much interest rates might have to rise to create a sufficient domestic output gap in order to lower domestic prices enough to offset the much more important increase in imported inflation, given the limited effectiveness of the transmission mechanism noted earlier. The use of statutory reserve deposits to influence lending rates might be an option.)

Our authorities therefore look to the Fund to follow through in facilitating the technical assistance needed to ensure its advice can be implemented. It will be particularly important to consider the composition of the devaluation among the currencies in the basket to which Samoa pegs.

For instance, it might be possible to engineer a larger devaluation against the currencies that represent the main sources of tourism and other exports, while limiting the devaluation against the currencies in which the majority of external debt is denominated.

It is well understood that addressing a potential overvaluation in the exchange rate will also be important to prevent the depletion of foreign exchange reserves, which could eventually force the central bank to devalue the exchange rate in a manner that might be more disruptive.

2. Macroeconomic conditions

The economy grew by just 2.0 percent in 2010/11 and is expected to post GDP growth of 1.5 percent in 2011/12. Lack of competitiveness as a result of the real exchange rate appreciation could well be a key reason for the more sluggish performance in recent years. More indirectly, the sharp appreciation of the Australian and, to a lesser extent, the New Zealand dollar against the US and euro area currencies are probably responsible for diverting many of the traditional tourists destined for Samoa to the United States and Europe. Furthermore, consumers have shown a general tendency to spend less and save more in developed economies like Australia.

Progress has been made on tackling the issue of land ownership. About 85 percent of land is subject to traditional/communal entitlements, which means that basic property rights are not well defined. Commercial banks are unwilling to lend against traditional land or for housing built on that land. As a result, the government continues to consult widely with land owners and financial institutions in an effort to come up with a framework whereby the lease of customary land can be accepted as collateral for commercial investment.

In line with sluggish domestic economic growth, inflation remains relatively subdued and does not threaten to destabilize the macroeconomic prospects of the country. However, given the high dependence on imports, especially of food and fuel, the inflation outlook remains subject to the possibility of adverse shocks that quickly feed into the domestic price level.

3. Fiscal policy and public sector indebtedness

The authorities recognize the need for fiscal consolidation in order to achieve a more favorable debt position that also builds the appropriate buffers to allow scope for fiscal policy to absorb potential future shocks.

Bringing the budget deficit down from around 6.5 percent of GDP this year to the recommended benchmark will require a sustained effort and a significant commitment to build public consensus. Infrastructure needs and further development will need to be carefully prioritized to ensure that fiscal policy does not place an undue burden on the fragile recovery and that, within the constraints, as many social projects are maintained as possible

Public indebtedness is expected to peak in coming years before gradually declining. The consolidation task is considerable and authorities recognize the need to remain austere for many years to achieve a more sustainable level of debt. One of the issues is that much of the donor support comes in the form of soft loans, which while assisting in the development of local infrastructure, nonetheless adds to the existing debt burden. Again, prioritization of competing donor projects will be important to ensure Samoa gets the maximum benefits without unduly constraining its ability to deploy fiscal policy when needed.

Nevertheless, since most of the debt has been incurred on concessional terms, the servicing burden is relatively benign.

There are some issues concerning the effective coordination of spending and debt management which the authorities are addressing.

4. Financial sector issues

The government has recently set up a new unit trust which has several purposes. Unit Trust of Samoa (UTOS) is open to deposits from residents and would allow Samoans access to a broader and more diversified investment portfolio than simple bank deposits. The deposits would be channeled into domestic investments and, eventually, into overseas assets. Matching Samoan savers with Samoan investors is seen as a worthwhile policy objective which also provides competition to the highly concentrated banking sector dominated by two foreign banks. The deposits taken by UTOS are currently guaranteed by the government for the initial 5 year period.

The trust is currently not subject to prudential supervision but is guided by directives from the Ministry of Finance. The authorities are still working on how this new financial institution is best integrated with the rest of the financial system and expect it to evolve over time.