This paper discusses Tuvalu’s economic condition, internal happenings, external linkages, and climate. The country has reported slow economic growth after the global crisis. The export and economic expansions have been minimal with many of its goods imported. The main source of income for the country continue to be remittances from its citizens working abroad and donor assistance. The government has laid out a rigid agenda for improving fiscal strength, literacy rate, power, health, and reducing nonpriority expenditure. The authorities believe that these challenges have given a fighting spirit to the country.

Abstract

This paper discusses Tuvalu’s economic condition, internal happenings, external linkages, and climate. The country has reported slow economic growth after the global crisis. The export and economic expansions have been minimal with many of its goods imported. The main source of income for the country continue to be remittances from its citizens working abroad and donor assistance. The government has laid out a rigid agenda for improving fiscal strength, literacy rate, power, health, and reducing nonpriority expenditure. The authorities believe that these challenges have given a fighting spirit to the country.

Background

1. This is the first Joint IMF/World Bank DSA for Tuvalu. Tuvalu joined the Bank and Fund in 2010; an Article IV consultation concluded in February 2011 did not incorporate a DSA due to data limitations. The analysis below is based on the most updated data available to Bank and Fund staff as of June 2012. Underlying macroeconomic data and debt data were updated during the 2012 Article IV mission to Funafuti, based on discussions with the authorities, donors and the Pacific Financial Technical Assistance Center (PFTAC).

2. A preliminary assessment tied to the 2010 IMF Article IV consultation concluded that Tuvalu was at high risk of debt distress. External debt and debt service ratios breached many indicative thresholds under the baseline scenarios. Stress tests confirmed that Tuvalu's debt burden was highly vulnerable to deteriorating macroeconomic conditions or a weaker financing outlook. Overall, the DSA concluded that greater access to grants would be essential for Tuvalu to meet its development needs. Since 2010, the fiscal situation has improved somewhat as tax compliance has improved and spending has begun to be reined in, though the still-strong Australian dollar has widened trade imbalances.

3. Tuvalu’s small economy is highly dependent on external flows and vulnerable to shocks. The smallest member of the Bank and Fund, Tuvalu’s GDP in 2011 was only US$36 million. Almost all goods, and even many services, are imported; the country’s main sources of foreign currency are donor assistance and earnings from Tuvaluans working abroad as seafarers; and the government budget is generally in deficit even in good times. The economy shrank after the global financial crisis and returned to growth only in 2011, while the strong Australian dollar has boosted imports.

4. There are large external holdings of public assets, though these are not freely usable by the government. The Tuvalu Trust Fund (TTF) was capitalized by donors in 1988 and by end-March 2012 had grown to 345 percent of GDP (A$122.9 million) through reinvestment of its own earnings and contributions by the government during surplus periods. The TTF is not fully sovereign: it can only be drawn down either with approval of its Board (where donors are represented) or when its market value exceeds a “maintained value” linked to Australian CPI. When it exceeds this value, additional funds are deposited into the Consolidated Investment Fund (CIF), which the authorities may freely draw upon. As of mid-2012, the TTF remains around 3.6 percent below its maintained value, and the CIF holds A$6.1 million, including a A$4.0 million injection from Australia in 2012.

5. With official borrowing halted since 2008, the main issue is Tuvalu’s outstanding debt and new borrowings from unofficial sources. Bilateral donors provide only grant assistance. Tuvalu’s public and publicly guaranteed (PPG) debt stock has declined in the past two years, and amounted to A$17.3 million (50 percent of GDP) at end-2011. External PPG debt was A$14.9 million (36.7 percent of GDP in PV terms) at end-2011. The Asian Development Bank (accounting for 42 percent of the stock in PV terms) provided concessional loans until 2008; subsequent disbursements have been on a grant basis, as – on a provisional basis – was an initial World Bank disbursement in 2012. However, loans contracted at market rates by joint ventures -(JVs) signed in 2008 and 2010 with companies from Korea and Taiwan Province of China (TPOC) constitute a possible substantial contingent liability, and guarantees of domestic borrowing by both public and private enterprises have been made at market rates2. These loans account for half the debt stock in NPV terms, with the remainder owed to the European Investment Bank3.

Macroeconomic Framework

6. Growth is expected to be close to historical averages. Throughout the scenario, growth is estimated to average 1.2 percent, slightly below the average of the past ten years. Depressed seafarer employment, at levels that are likely to remain significantly below pre-crisis levels, is expected to have a negative impact on growth. With little scope for import substitution or export diversification, the trade balance will remain close to historic norms.

7. The fiscal outlook is based on a continuation of current trends. Taxes will stabilize at slightly above current levels, based on continued levels of compliance but with higher tax rates. License revenue will be boosted in 2012 in line with the new .tv domain and fishing license agreements as well as the depressed U.S. dollar, but will stabilize at this level thereafter. Recurrent grants are expected to average 14 percent of GDP over the medium and long term. Under the assumption that other assistance will be provided in the form of grants and no new joint ventures will be signed, the only new stream of borrowing assumed in the DSA is term IDA borrowing of A$1¾ million annually. Annual financing needs will thus be covered by concessional financing and use of half the available CIF balance, with the rest of the CIF, along the lines of previous practice, being reinvested.

8. The limited financing envelope forces a consolidation, but expenditure will eventually expand again. With CIF financing limited and no scope for domestic borrowing, expenditure is projected to fall by 13 percent of GDP to around 80 percent of GDP in the next few years, with capital expenditure bearing some of the burden. This will bring the deficit to around A$3½ million (around 10 percent of GDP). But as the TTF recovers fully and disbursements into the CIF rise, additional financing will eventually permit the government to raise spending4. For this reason, beginning around 2016, expenditure will rise modestly, to around 85 percent of GDP.

9. The current account deficit is expected to improve somewhat. Tuvalu has only eleven years of balance of payments data, three years of which have been affected by the global financial crisis. During this time the country’s external assets have grown strongly. Income from these assets should continue to rise, while employment from seasonal schemes replaces some seafarer income. Imports are expected to normalize in 2012, post one-off construction projects, and return to their historical average in the medium term. The current account is projected to settle at around a 4 percent surplus, slightly above its eleven-year average of 2 percent. Reserves rise gradually over time.

10. Risks to the baseline are largely on the downside. A slowdown in global growth, particularly if accompanied by a sudden financing stop that damages global trade, would severely affect Tuvalu. On the fiscal side, weak revenue performance, from poor tax compliance or from a decline in fishing or telecommunications licensing proceeds, is a serious risk to the baseline outlook. Finally, continued low demand for seafarers or an inability to place workers in seasonal employment schemes would depress earnings from abroad, weakening the current account.

Macroeconomic Assumptions for the DSF

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External and Public Debt Sustainability Analysis

A. External Debt

11. External debt breaches stock thresholds under the baseline scenario. The ratios of the present value (PV) of debt to GDP and of debt to exports both begin at high levels due to recently contracted JV debt. Levels than fall as new concessional lending comes online and older ADB debt is paid off. As grace periods for concessional loans come to a close, both ratios rise (Figure 1). The export ratio remains above thresholds throughout the simulation period, while the GDP ratio rises above only as repayments come into view. The debt service to exports ratio similarly falls from its current high level to a more sustainable level, but then rises back toward unsustainable levels as loan repayments come online.

Figure 1.
Figure 1.

Tuvalu: Indicators of Public and Publicly Guaranteed External Debt under Baseline and Alternative Scenarios, 2012-2032 1/

Citation: IMF Staff Country Reports 2012, 259; 10.5089/9781475505795.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2022. In figure b. it corresponds to a Terms shock; in c. to a Terms shock; in d. to a Terms shock; in e. to a Terms shock and in figure f. to a One-time depreciation shock.

12. Stress tests show the debt burden is particularly sensitive to growth and exchange rate assumptions. The PV of public sector external debt closes the simulation at 36 percent of GDP, but a one-time 30 percent nominal depreciation raises this ratio to 51 percent. Under the historical scenario, in which the current account deficit does not recover in the medium term and financing needs remain large, all stock ratios rise throughout the simulation period, with the PV of public external debt reaching 108 percent of GDP around 2027.

B. Public Debt

13. Public debt ratios are relatively stable under the baseline. As concessional lending comes online, the ratios of debt PV to GDP and to revenue both remain close to current levels even as grace periods come to a close (Figure 2). The ratio of debt service to revenue mostly falls for the first half of the simulation period, but then rises gradually in the second half as more payments come due. Historical scenarios for public debt are generally more benign than the baseline.

Figure 2.
Figure 2.

Tuvalu: Indicators of Public Debt under Baseline and Alternative Scenarios, 2012-2032 1/

Citation: IMF Staff Country Reports 2012, 259; 10.5089/9781475505795.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2022.2/ Revenues are defined inclusive of grants.

14. These ratios are also fragile to shifts in underlying assumptions. GDP growth below baseline assumptions would raise the public debt burden well above sustainable levels: under the baseline the PV of public debt in 2032 reaches only 38 percent of GDP, but scenario with permanently lower GDP growth pushes this ratio to 113 percent. Similar dynamics are observed for the ratio of PV of debt to revenue, By contrast, given that all long-run debt is on IDA terms, debt service indicators are not as strongly affected under these scenarios.

Implementation of the Policy Reform Matrix

15. The authorities have presented to donors a Policy Reform Matrix (PRM) which aims, inter alia, at strengthening macroeconomic management. The PRM is intended to be a reform roadmap as well as a streamlined list of potential triggers for budget support disbursements by donors. Its main targets in the areas of macroeconomic management are better tax compliance, reorientation of expenditure toward priority areas in health and education, and improving the business environment to strengthen growth. IMF staff estimates that full implementation would raise growth and investment in Tuvalu modestly, while allowing for some expansion of spending as the fiscal envelope is widened by better tax collection and additional donor support. Overall, the deficit is contained below 15 percent of GDP, and the current account surplus stabilizes at around 6 percent of GDP. Significantly, neither under the baseline nor under the alternative scenario is there any borrowing beyond new IDA disbursements, as there are no additional prospective lenders.

16. Debt dynamics under the reform scenario are somewhat more benign. Faster GDP growth would bring the ratio of the PV of external public debt to GDP below sustainability thresholds and keep it on a gradual downward trend; the relationship with exports is similar (Figure 3). Debt service ratios display similar dynamics to the baseline, but levels are lower. Public debt, which remained almost stable under the baseline, displays a gradual downward trend under the reform scenario.

Figure 3.
Figure 3.

Tuvalu: Indicators of Debt under Reform Scenario and Alternative Scenarios, 2012-2032 1/

Citation: IMF Staff Country Reports 2012, 259; 10.5089/9781475505795.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in 2022. In figure b. it corresponds to a Terms shock; in c. to a Terms shock; in d. to a Terms shock; in e. to a Terms shock and in figure f. to a Terms shock2/ Revenues are defined inclusive of grants.

Conclusions

17. Tuvalu’s weak capacity to service debt means renewed loan disbursements are unlikely to lead to a sustainable outcome. Even when the only new disbursements are those provided by the development partners on IDA terms, indicators of public and publicly guaranteed external debt stocks remain well above indicative thresholds, indicating high levels of debt distress. Tuvalu’s revenue base (including licensing income) is relatively high, but its small export base and GDP mean that even small disbursements result in a long-term reduction in sustainability. While stock indicators do not rise strongly under the baseline scenario, Tuvalu’s current fiscal situation is unsustainable, and maintaining its current level of debt service is unlikely to improve it even as it is able later in the simulation period to take advantage of its external asset holdings.

18. Implementation of the PRM would bring debt sustainability somewhat closer. While debt ratios remain fragile even under the PRM scenario, a stronger fiscal position and modestly faster GDP growth would make the current debt position more sustainable, and improve debt dynamics.

19. Moreover, the most damaging risks – a slowdown in GDP and a nominal depreciation– are not low-probability events. GDP growth in Tuvalu is highly volatile and may not return to historical levels without a significant effort to improve macroeconomic management, the business climate and human capital. Donor assistance can help growth and resilience, by building policymaking capacity and by supporting infrastructure investment. But a slowdown of the magnitude presented in this scenario, while not a baseline event, cannot be ruled out. Similarly, the current strength of the Australian dollar cannot be guaranteed: a return of the Australian dollar to levels seen only eight years ago would cause a dangerous increase in Tuvalu’s debt ratios.

Table 1.:

External Debt Sustainability Framework, Baseline Scenario, 2009-2032 1/

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r - g - ρ(1+g)]/(1+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, and ρ = growth rate of GDP deflator in U.S. dollar terms.

Includes changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes (the hight voltility of the AUD)

Assumes that PV of private sector debt is equivalent to its face value.

Current-year interest payments divided by previous period debt stock.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability. Median used for current account.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Table 2.

Tuvalu: Public Sector Debt Sustainability Framework, Baseline Scenario, 2009-2032

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Public sector includes central government (excludes public enterprises)and public enterprise loan guarantees by the government. Gross debt is used.

Residuals reflect the CIF drawdown and official grants received

Revenues excluding grants.

Debt service is defined as the sum of interest and amortization of medium and long-term debt.

Historical averages and standard deviations are generally derived over the past 10 years, subject to data availability.

Table 3.

Tuvalu: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2012-2032

(In percent)

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, growth of GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Assumes that the interest rate on new borrowing is by 2 percentage points higher than in the baseline., while grace and maturity periods are the same as in the baseline.

Exports values are assumed to remain permanently at the lower level, but the current account as a share of GDP is assumed to return to its baseline level after the shock (implicitly assuming an offsetting adjustment in import levels).

Includes official and private transfers and FDI.

Depreciation is defined as percentage decline in dollar/local currency rate, such that it never exceeds 100 percent.

Applies to all stress scenarios except for A2 (less favorable financing) in which the terms on all new financing are as specified in footnote 2.

Table 4.

Tuvalu: Sensitivity Analysis for Key Indicators of Public Debt 2012-2032

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Sources: Country authorities; and staff estimates and projections.

Assumes that real GDP growth is at baseline minus one standard deviation divided by the square root of the length of the projection period.

Revenues are defined inclusive of grants.

1

This DSA has been produced in consultation with the Asian Development Bank (ADB). It is based on the common standard LIC DSA framework. Under the Country Policy and Institutional Assessment (CPIA) Tuvalu has been provisionally rated a weak performer, and the DSA uses the indicative threshold indicators on the external public debt for countries in this category: 30 percent for the ratio of the present value (PV) of debt to GDP; 100 percent for the ratio of PV of debt to exports; 200 percent for the ratio of PV of debt to revenue; 15 percent for the ratio of debt service to exports; and 18 percent for the ratio of debt service to revenue.

2

An effectively defunct and wholly government-owned public enterprise called the National Fishing Corporation of Tuvalu (NAFICOT), is party to both JVs. NAFICOT owns 50 percent of the TPOC venture and 40 percent of the Korean one, and pays dividends to the government. Loans taken out by both JVs are on market terms. Tuvalu’s share of the debts amounts to 28 percent of GDP.

3

The EIB loan is a credit line to the Development Bank of Tuvalu, which is fully owned by the government. Overdrafts at the National Bank of Tuvalu, which the government uses for cash management but also for short-term financing, are not included in the debt stock.

4

The scenario assumes TTF nominal returns of 7 percent, slightly below historical levels and in line with the authorities’ targeted asset returns.

Tuvalu: Staff Report for the 2012 Article IV Consultation
Author: International Monetary Fund
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    Tuvalu: Indicators of Public and Publicly Guaranteed External Debt under Baseline and Alternative Scenarios, 2012-2032 1/

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    Tuvalu: Indicators of Public Debt under Baseline and Alternative Scenarios, 2012-2032 1/

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    Tuvalu: Indicators of Debt under Reform Scenario and Alternative Scenarios, 2012-2032 1/