This staff report discusses Seychelles 2013 Article IV Consultation, Seventh Review Under the Extended Arrangement and Request for Modification of Performance Criterion. The repayment of domestic debt, a preference for foreign financing, and shallow domestic financial markets have resulted in significant structural rupee liquidity in the banking system. Tourism has been the main driver of growth, but there is a tension with the number of tourists the islands can absorb. Despite the challenging global environment, tourist arrivals have grown strongly, with diversification toward nontraditional markets more than offsetting stalling European arrivals. The Seychellois rupee is broadly in line with medium-term fundamentals, and tourism remains competitive among peers.
Our Seychellois authorities’ unwavering commitment to the economic reform agenda has yielded impressive results. Past reform efforts continue to bear fruit and have helped position the economy towards a strong and sustainable growth path. Seychelles, however, remains highly vulnerable to external shocks, due to its reliance on tourism and imports, which are inherent features of its economy. To ensure that macroeconomic stability is maintained, the government is determined to build adequate buffers to mitigate downside risks, address structural impediments to growth and to maintain prudent macroeconomic policies in accordance with program targets.
Economic Development and Outlook
Despite challenging economic conditions last year, the Seychellois economy remained resilient, achieving real GDP growth of 2.9 percent in 2012. A tightening in monetary policy to cope with high inflation, coupled with a slowdown in tourism from traditional European markets led to a moderation in growth.
There are promising signs that economic activity has picked up in the first few months of 2013, underpinned by a fall in inflation and a strong recovery in tourism. Seychelles has managed to successfully diversify and expand into new tourist markets. The tropical cyclone which hit Seychelles in January is expected to have a small adverse effect on GDP, with reconstruction activity offsetting some of the impact. While the budget is expected to incur some of the recovery cost, we believe the objective of achieving a primary surplus of 5 percent of GDP can still be met this year.
Prospects for Seychelles over the near and medium term are favorable, as the economy has responded well to the economic reform program. The Seychellois economy is expected to gain momentum over the next two years as inflationary pressure abates and benefits of recent reforms begin to materialize. Real GDP growth is forecast to grow around 3.3 percent in 2013 and 3.9 percent in 2014. Investment is expected to peak over this period, and unemployment and inflation are expected to remain low.
The current account deficit is expected to narrow as FDI moderates from the strong flows experienced in recent years and international reserves are forecast to remain above the risk-weighted reserve metric over the medium term, but slightly below three months of import coverage. The Central Bank of Seychelles (CBS) will remain attune to favorable conditions for reserve accumulation, to meet the government’s objective of rebuilding buffers.
The authorities’ strong commitment to achieving fiscal surplus is an important source of stability for the economy. The good fiscal performance has also added credibility to the task of bringing public debt down to 50 percent of GDP by 2018, which remains well on track. The government’s objective is to run primary surplus of around 5 percent of GDP per year over the medium term.
Our government is maintaining tight control over spending, including through the establishment of the Public Enterprise Monitoring Commission (PEMC). The PEMC will assist in strengthening the oversight of parastatals and will lead to greater compliance with reporting requirements. Our authorities share staff’s assessment that improving the financial performance of parastatals will be important for fiscal sustainability.
Efforts to strengthen public financial management are being complemented by broader public sector reforms. Most notably, the preparation of the financial instructions and accounting manuals related to the Public Financial Management Act and the compilation of data under the new Chart of Accounts. The central government’s decision to adopt program-based budgeting will strengthen PFM practices, and this initiative will be developed with technical assistance support from donors.
Inflation remained elevated in 2012, but has been on a downward trend over the past 8 months as a result of central bank intervention, rupee appreciation, and a moderation in food and commodity prices. The introduction of the VAT in January 2013 led to a temporary pick-up in inflation, which was offset by an appreciation of the rupee, which is currently at its highest level in more than three years.
Seychelles has been susceptible to bouts of liquidity overhang, with excess liquidity emerging again as a key challenge for the central bank at the start of 2013. To absorb the excess liquidity, our government is considering the possibility of issuing longer term instruments. While the adoption of reserve money target as a nominal anchor for monetary policy has played a useful stabilizing role in the period following the floating of the exchange rate in 2008, its effectiveness as a guide for inflation expectations is currently being reviewed.
The CBS recognizes the limitations with the current framework for monetary policy and that a more flexible regime is needed to achieve the central bank objective of domestic price stability. Strengthening the monetary framework and improving the monetary transmission mechanism will give the CBS more control over liquidity management and more flexibility in implementing monetary policy. Our authorities appreciate the technical assistance provided by MCM in February to strengthen the monetary policy framework and to begin work on establishing an alternative operational target. The central bank concurs with staff’s recommendation that establishing a reference interest rate is an important first step. Authorities also took strong note of staff’s advice that regular public communication of economic conditions and monetary policy decisions is crucial to establishing central bank credibility, transparency, and to anchor inflation expectations.
Steps are also being taken to improve the functioning of the credit market and the banking sector. The CBS is monitoring credit and price developments closely, and continues to make good use of technical assistance from the IMF. Open and frank dialogue between the Ministry of Finance and the CBS on financial reform is continuing regularly. At the same time, our authorities will continue to work with commercial banks to strengthen the financial sector and to create a competitive business environment to foster growth in small and medium enterprises. The recent establishment of the stock exchange should also support the development of the private sector.
The Seychellois economy has achieved impressive results from extensive reforms pursued over the past few years, but the structural reform process is not yet complete. Maintaining the momentum on reform is important to the Seychellois Government and will help consolidate the recovery from the 2008 crisis. Ensuring continuity and discipline in policy making are key ingredients for the longer term success of the economy.
The government has been proactive in progressing key reforms while cognizant of the constraints faced by small, open and remote economies. As highlighted in the staff report, the unique features of microstates can make it difficult to develop significant depth and competition in the financial sector. Nonetheless, Seychelles scored well in the 2013 Doing Business indicators and investor confidence in Seychelles remains strong, as evident by the ongoing strong inflow of FDI.
The authorities’ structural reform agenda is focused on: strengthening PFM, improving the financial discipline of the public sector and public enterprises, transitioning towards a more flexible monetary policy framework, and completing the implementation of utility tariffs rebalancing over seven years. Lifting institutional capacity and strengthening policy implementation capabilities will enhance the timely delivery of these reforms.
Reforming the labor market to reduce skill mismatch and to lower structural unemployment will also need to be addressed. As a middle-income microstate with full employment, an ongoing inflow of foreign workers will be needed to sustain economic growth. The integration of foreign workers into the labor force will be balanced against the need to develop the skills base of the Seychellois work force.
The Seychellois economy is in the midst of a period of extensive reform that has broad implications for the wider population. Comprehensive reforms are being pursued along many fronts, and authorities are aware that the social safety net for the most vulnerable must be protected to compensate for the social impact of reforms. Our authorities recognize that adjustments to the welfare system are required to keep pace with the broader changes in the economy. To this end, means testing will be increasingly used to determine eligibility for social welfare.
Extended Arrangement under EFF
Program performance throughout the life of the EFF has been exemplary. Our Seychellois authorities comfortably met all end-December quantitative performance criteria and structural benchmarks. As staff notes, authorities have a proven record of implementing past staff advice and a strong performance record under the EFF. The overperformance in the end-December 2012 Net International Reserves (NIR) target has prompted our authorities to request for modification of the end-June 2013 performance criterion, and the end-September and end-December 2013 indicative targets for NIR.
As noted in previous Buff statements on the review of the EFF, a key factor in the success of the program has been the high level of ownership by the authorities. Adherence to the targets set under the program has helped support macroeconomic stability and instilled discipline on policy formation, which coupled with intensive technical assistance, ensured that ‘best practices’ were being developed and implemented. With the program due to expire at the end of the year, the Seychellois authorities are keen to maintain their strong collaboration with the Fund and look forward to discussions on possible successor arrangements over the course of the year.
Finally, our Seychellois authorities would like to express their gratitude to Management, the TA mission teams, the IMF mission chief and her team for their continued hard work and dedication in helping to shape Seychelles’ economic reform agenda.