Statement by Christopher Legg, Executive Director for Tuvalu and Christopher Becker, Advisor to Executive Director August 3, 2012

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.

Tuvalu became the 187th member of the Fund in 2010 and this is the second Article IV consultation between Staff and the authorities since that time. The authorities found the frank, constructive discussions and the commitment of the mission team very helpful, and look forward to enduring engagements with the Fund and other International Financial Institutions.

The main challenges facing Tuvalu concern the development needs of the country while ensuring the sustainability of both its natural and donor-provided resources. Fund surveillance and technical assistance play a key role in maximizing the benefits from limited endowments, and also help to catalyze contribution to the country’s development goals by other International Financial Institutions (World Bank, Asian Development Bank) and the broader donor community.

With a population of only around 11,000 people and annual Gross National Income of just US$50 million, this small atoll group of islands is particularly vulnerable due to its geographic isolation, lack of fertile land, susceptibility to the impacts of climate change, and inability to reap economies of scale in the provision of public goods and services.

1. Macroeconomic conditions

The global financial crisis spilled over into Tuvalu as slower economic activity and trade in goods translated into less demand for Tuvaluan seafarers. The associated slowdown in remittances and economic activity resulted in a worsening fiscal position which is now being addressed by the austerity actions of the incumbent authorities. Financial contagion manifested itself through the adverse impact on the principal and income from the sovereign wealth fund and is forcing the authorities to forego much needed investment in human capital and social projects. Exchange rate appreciation has allowed inflation to remain low and steady but has also eroded the local currency value of US dollar denominated receipts from the sale of fishing rights and remittances. There is little capacity for Tuvalu to build policy buffers to absorb future economic shocks given the extremity of its economic situation on a number of measures. As a result, in the foreseeable future the country is likely to remain almost completely reliant on support from the international community and its major donors for funds to respond to either real (including environmental), or financial shocks.

2. Monetary and exchange rate policy

Tuvalu uses the Australian dollar as legal tender and has no central bank. As a result, it has no independent monetary policy flexibility, no exchange rate flexibility separate from the Australian dollar, and domestic interest rates are set based on social and development objectives by the only two banks that operate in Tuvalu. Both of these banks are government-owned. Scope to absorb external shocks or decouple from developments in Australia are therefore limited on the monetary side.

For example, while the boom in commodity prices has seen Australia’s terms of trade rise to 140 year highs and led to significant exchange rate appreciation, the net benefit for the Tuvaluan economy, with no mineral resources, is clearly questionable. While imports have become significantly cheaper (and there is no export sector to speak of), the local currency value of US dollar-denominated remittances from seafarers and proceeds from fishing licenses is also commensurately lower. The recent strength in the exchange rate has helped keep inflation low but this positive influence could reverse quickly if the outlook for commodity prices were to deteriorate substantially. Furthermore, the fall in the price of imports has translated into a widening of the current account deficit and the associated depletion of foreign currency assets.

However, while noting these disadvantages, the use of the Australian dollar remains the most appropriate exchange rate arrangement. The issue of extremely small scale (in all aspects) makes the establishment of a modern banking system, financial markets, a central bank, let alone an independent currency, prohibitively expensive and therefore implausible. Given that Australia is one of the largest countries in the region, its leading role as a donor, and the lack of viable alternatives, dollarization is the least-cost option for Tuvalu.

3. Fiscal policy

Macroeconomic management and the absorption of shocks therefore largely rely on fiscal policy.

In 1988, donors capitalized an investment fund from which the income in excess of a stable real principal is used to supplement donor assistance to fund persistent budget deficits. Following a number of years of below-average returns and larger than usual deficits, these resources (over and above the principal) are almost exhausted. An important policy therefore involves broadening the tax base and improving compliance in order to finance spending on social projects. The progress made to consolidate in the most recent budget has been difficult and unpopular but clearly highlights the authorities’ commitment to setting the fiscal stance on a more sustainable footing. Budget support from Australia has also helped to alleviate the pressure.

The high risk of debt distress is a particular concern considering the multifaceted vulnerabilities confronted by the country. Grants are the only viable form of financing projects at the current juncture, as even joint ventures with foreign private sector firms in fishing could quickly become unsustainable if financed at commercial loan rates.

4. Structural policies

The government has an explicitly formulated development strategy to address governance, social development, education, human resources, macroeconomic growth and stability, natural resources and infrastructure. This plan is a useful tool for coordinating the prioritization of projects and engaging effectively with donors. An example of difficult choices that have to be made is the recent elimination of government-funded scholarships. Short-term budget pressures have led to the elimination of such subsidies but this comes at the obvious longer-term cost to the development of human capital.

The government’s involvement in the economy is extensive and the private sector remains small, accounting for only around ¼ of economic activity. Reform of public enterprises is therefore recognized by the authorities as an area where efficiency gains would be beneficial. Sound governance and professional, independent management of enterprises such as the electricity provider could limit the amount of leakage from the public balance sheet and thus reduce the need for cuts in important spending on social projects. Nonetheless, in a country this small almost all major service providers fulfill key social functions and are therefore part of the policy mechanisms through which the government is able to manage economic outcomes. The prospects for full commercialization of these enterprises are therefore limited.

An important policy to assist with the absorption of adverse shocks has been to diversify the sources of income for Tuvaluans working abroad. Aside from the natural endowment of resources that can be extracted from the country’s extensive maritime zone, income from Tuvaluan seafarers on international vessels has been the other major ‘industry’ and source of income. The local currency value of this US dollar-denominated income has been negatively impacted by the appreciation of the exchange rate and the slowdown in international shipping. Efforts to create new and more diverse work opportunities abroad are therefore important. Increasingly workers are branching out to take up seasonal harvesting work opportunities in New Zealand, and more recently Australia. This diversification has helped to offset part of the decline in remittances from seafarers and is expected to expand further in the future.

5. Other issues

Capacity problems are a major issue in almost all aspects of the economy in a microstate such as Tuvalu. For example, there is a need to improve the quality of statistics to better inform the policy making process. The authorities have ambitions to expand the statistics department by 30 percent (or one more person) to deliver better quality data but the funds and skills are lacking. Currently, a single person compiles both the National Accounts and the Balance of Payments, while the other two people in the department compile the remaining statistics and deal with administration. PFTAC and the large donor countries have been important in assisting capacity building, but there is scope for further development.

The government is facing major constraints in terms of the economies of scale in the provision of public goods and services across such a small population and commensurately limited tax base. While the most basic health services are provided domestically, most of the more complicated procedures are carried out in Fiji. Containing the costs of these services to the government has been addressed through several measures. The system by which patients are referred to hospitals abroad has become more closely scrutinized, patient accommodation while abroad has been reconsidered, the entitlement for relatives to accompany patients is now more restrictive, and patients bear part of the costs that are incurred.

These changes not only make a positive contribution to the sustainability of the budget, but they also highlight the complications of interpreting income per capita in an extremely small state such as Tuvalu. The country generates sufficient income from the sale of fishing licenses, remittances, and the donor provided wealth fund to rank relatively highly in terms of annual income per capita (US$4,760) because the total income numerator is shared across a very small population denominator. Nonetheless, it finds itself in a situation where total income is so small that it proves prohibitively expensive for the government to provide adequate health services domestically. If a substantial part of that higher income per capita therefore has to be allocated toward expensive medical services in another country, the remaining disposable per capita amount available for consumption and saving is significantly lower. The return airfare from Funafuti to Suva alone is almost ¼ of the average Tuvaluan’s annual income. In this simple illustration it is easy to recognize that assessment of welfare based on income per capita alone can be misleading. This is especially the case in countries where vulnerabilities are relatively pronounced.