The Solomon Islands’ SCF arrangements have provided a crucial policy anchor for the authorities, as they have progressed a structural reform agenda that lays the foundations for inclusive growth and poverty reduction. The first SCF commenced following spillover from the global financial crisis that combined with pressures from the decline of the logging industry. The economy rebounded in 2010/11, and while remaining relatively strong, growth has slowed in 2012. As noted in staff’s report, the mining and services sectors are expected to support future growth in the range of 4 percent, and inflation is expected to ease to around 4 percent over the medium term.

The growth outlook is largely underpinned by the development of the mining sector, with substantial international interest expressed in Solomon Islands’ mining potential. The return to full production at the Goldridge mine (following its closure in 2002 due to civil unrest) accounted for a significant share of growth in 2011, alongside a surprisingly strong (but not sustainable) logging performance. While prospects for further mining development are favorable, controversy surrounding mine development can cause delay, as has been the case for a large nickel mine on Isabel Island. Other agricultural commodities (fishing, palm oil, copra) performed well in 2011 and early 2012, contributing to a significantly reduced trade deficit in 2011. However, agricultural production can be highly price sensitive, and some weakening in prices of key commodities has been observed since the start of 2012.

The authorities have continued to demonstrate strong program ownership under the second SCF. Most of the structural benchmarks were met, and the remainder are being steadily progressed. Many of the structural benchmarks contribute to a comprehensive and far-reaching fiscal reform agenda. Work towards a new Public Finance Act (PFA) will strengthen the fiscal framework, and the authorities are conscious that deriving benefit from the new act will depend on the implementation of its legislative requirements. Improvements in revenue collection have been made, with strong focus now being applied to reducing tax exemptions, including through work on the new Customs and Excise Tax Act. A critical new mining tax regime is being developed, though progress has been delayed due to insufficient drafting capacity – a problem that has also slowed progress in other areas. Minimum levels have been set on education and health spending, in line with ensuring quality public spending. Improvements to budget processes have included the new chart of accounts and enhanced consultation, and a planned shift to multi-year budgeting.

The authorities have also developed a new debt management strategy, which has been incorporated into the Honiara Club Agreement. The new strategy, which includes an annual borrowing limit, provides for the measured and careful resumption of external borrowing by government to finance key infrastructure investment. In particular, the new debt management strategy will facilitate two projects that will be crucial to encouraging private sector investment: the Submarine Cable System Project to improve internet connectivity, and the Tina River Power Project. However, tests of the new strategy will quickly appear and in order to provide further guidance a description of how the Debt Management Strategy will apply to SOE borrowing will soon be released. Progress is being made on solvency and debt issues surrounding key state-owned utilities, although work remains to clarify the outstanding debt of troubled SOEs. As described in the DSA, the economy continues to face moderate risk of debt distress.

In addition to steady progress on structural benchmarks, most of the program performance criteria for end-June 2012 were met comfortably, with the exception of the cash balance indicative target. This target was met in June, but missed in September due to revenue expectations that proved overly optimistic, alongside higher development spending on rural constituency development funds (“constituency funds”), higher tertiary education expenditure, and one-off expenditure related to hosting of the Festival of Pacific Arts. The additional spending reflects the practical challenge of preserving fiscal buffers in the face of strong development needs. Capacity constraints have meant that the authorities have frequently struggled to execute development spending, with disbursement regularly below budget allocations. In response, the authorities have increased budget allocation to the constituency funds, which have typically had a higher disbursement rate. However, the authorities recognize the need to contain and ensure proper governance of the constituency funds, and have called on the Office of the Auditor General to audit twenty of the fifty funds.

With regard to revenue forecasts, the authorities agree that these forecasts must be appropriately conservative going forward, particularly given uncertainties in the external outlook. Over-spending on the Festival of Pacific Arts highlighted poor procurement processes, that must also be addressed. However on a more positive note, Solomon Islands’ successful hosting of the Festival generated an intangible but real confidence boost, as well as increased economic activity.

While agreeing that spending must be contained in order to preserve fiscal buffers, the authorities plan to raise public sector wages in the 2013 budget, as described in staff’s report. The increase is intended to reduce the extent of decline in the real wage that is occurring through inflation, and is considered necessary in light of the deterioration that has already taken place in the real wage over the last two decades. A review of the remuneration structure is also planned, and has the potential to streamline non-wage benefits and reduce administrative costs.

Efforts to improve fiscal management are taking place with the assistance of development partners, with coordination facilitated by the Core Economic Working Group. The CEWG is highly supportive of government’s goals to strengthen budget preparation and planning systems, and to improve the quality of budget execution and reporting, as well as the goal to improve the environment for private sector investment, as set out in government’s Economic and Financial Reform Program.

Turning to the financial sector, banks are stable, profitable, and well capitalized. Credit growth remains weak, with banks attributing this to a dearth of lending opportunities. The authorities, however, remain concerned at the high spread between deposit and lending rates in Solomon Islands, and would be appreciative of technical assistance to help them better understand this. Staff has noted several areas of legislative reform that are underway to strengthen the financial sector framework, including the new CBSI Act, the National Provident Fund Act and the Financial Institution Act. Monetary policy continues to focus on price and external stability. Following IMF technical assistance, the de facto peg to the US dollar has been replaced by a basket peg, with weights based on the largest shares of Solomon Islands external payments. The central bank continues to actively promote financial inclusion, including through the expansion of mobile phone banking, though access to financial services in Solomon Islands’ many remote regions remains limited.

In order to build on progress made under the previous SCF arrangements, the authorities have requested an ECF arrangement with an access level of 10 percent of quota. The proposed ECF fits well with government’s structural reform agenda, and is based on continued vulnerabilities inherent in the commodity-dependent economy. Engagement with the Fund has been especially important as the country transitions through the phased withdrawal of the Regional Assistance Mission for the Solomon Islands (RAMSI). The ECF would catalyze donor support, as the two SCFs have successfully done, and we note that aid flows have been an important explanatory factor behind the reserves position. In terms of other program options, we note that the 2.5 year limit on precautionary SCF usage has been reached, and the country is not yet considered ready for a PSI.