After experiencing a debt crisis in 2008-09, the very small archipelago state of Seychelles has pursued ambitious and wide-ranging reforms aimed at stabilizing the economy and reorienting fiscal and monetary policies to lift and entrench growth. The authorities have made significant progress in building a resilient and more diversified economy under successive programs supported by the Extended Fund Facility. Macroeconomic stability has been restored, growth has returned, inflation has moderated, the exchange rate has stabilized, public debt has declined sharply, and net international reserves have been steadily accumulated. These outcomes have been underpinned by the floating of the exchange rate, and tighter monetary and fiscal policies. However, the authorities are keenly aware that continued efforts are needed. As a very small, highly open economy that is heavily reliant on tourism and imports, Seychelles remains particularly vulnerable to external shocks. The authorities continue to focus on strengthening macroeconomic stability by further reducing public debt from high levels, accumulating additional international reserves, and pursuing deep structural reforms to promote inclusive growth.

The authorities remain firmly committed to the program and request the completion of the second review. The authorities successfully met all but one of their quantitative program targets for end-December 2014. Importantly, public debt remains on track to fall below 50 percent of GDP by 2018, which has been a target firmly embedded in the authorities’ reform program since 2008. The targets for the fiscal primary surplus and higher net international reserves were surpassed comfortably last year, while the reserve money ceiling was exceeded by a very small margin, which was later corrected. The authorities request a waiver for this minor and temporary breach. The authorities have made considerable progress on the structural benchmarks, which remain broadly on track albeit with some delays.

Recent Economic Developments and Outlook

With stronger fundamentals now in place, the Seychellois economy proved better equipped to deal with external challenges in 2014. Real GDP grew by 3.3 percent in 2014, while the decline in oil prices contributed to stable inflation outcomes. External pressures heightened through 2014, with weaknesses in key exports. The economy adjusted successfully, benefitting from the reforms of recent years. The exchange rate depreciated by 16 percent in the three months to October 2014 before stabilizing and appreciating by around 6 percent since the start of this year. The balance of payments pressures abated towards the end of 2014 as a result of tightened monetary policy, the decline in oil prices and in response to the exchange rate depreciation. The current account deficit of 21 percent of GDP was lower than projected at the time of the first review, largely due to lower oil prices. It continues to be financed by strong FDI inflows. For 2014, the primary fiscal surplus exceeded program targets, as indirect tax collections reflected strong import growth and domestic demand. Income tax and business tax collections fell modestly below initial targets. Non-tax revenues were lower than targeted, as a result of lower dividends from SOEs. Primary current expenditures were in line with program targets, while capital expenditure modestly exceeded the target. While expenditure on wages and salaries increased following the pay increase to civil servants granted at the beginning of 2014, such expenditure remains relatively low compared to other small island states and the authorities have maintained appropriate wage restraint more recently.

The outlook for 2015 is positive, though substantial risks remain. In 2015, the authorities expect real GDP growth to accelerate modestly to 3.5 percent. Inflation is likely to be around 5 percent, with the effect of the depreciation of the exchange rate being partially offset by the decline in oil prices. The current account deficit is expected to contract to 15 percent of GDP in 2015, again largely reflecting the falling cost of petroleum imports. The US dollar value of tourism earnings has declined modestly, reflecting the pricing of most hotel tariffs in the weakening euro. Given the considerable reliance on tourism from Europe, Seychelles remains vulnerable to the faltering recovery in Europe.

Fiscal and Structural Policies

Seychelles is continuing to make good progress in restoring fiscal discipline, reducing debt, and strengthening public financial management. The 2015 budget aims to achieve a primary surplus of SR 720 million, equivalent to 3.8 percent of projected GDP. Prudent debt policy aims to reduce public debt to 63.7 percent of GDP in 2015, and is on track to achieve the target of 50 percent of GDP by 2018. Considerable progress has been made in implementing public financial management reforms, including the adoption of a Medium-Term Fiscal Framework that has anchored Seychelles’ fiscal strategy and the medium-term national development strategy. However, the authorities are conscious that more remains to be done. A new PFM action plan for 2015-18 is geared towards improvement in capital project cash and asset management as well as a further enhanced medium-term budget framework.

The introduction of a VAT and flat-rate personal income tax has yielded sound revenue collections and the authorities are now focused on improving business tax collections. Tax collections are relatively high compared with other countries in the region as well as other small island states. Reforms implemented between 2008 and 2012 improved the efficiency of the tax system by broadening the base and reducing rates, while maintaining the overall tax burden. The authorities continue to modernize tax administration and are now focusing on improving business tax compliance, including by undertaking risk-based audits of 60 large businesses, and improving the revenue administration’s capacity to analyze transfer pricing arrangements. They are also focusing on simplifying payment procedures and improving the collection of arrears.

The authorities are focused on ensuring the quality of spending and that ongoing investments in health, education and social programs support growth prospects and social outcomes. Seychelles has achieved sound outcomes for its citizens in education, health, poverty eradication, and the environment. Underpinning these outcomes has been a policy of free access to healthcare and education. The authorities are taking steps to improve the training of functional skills, as a means to address the skills shortage and mismatches.

The authorities are continuing to strengthen the accountability, monitoring and control of SOEs to improve the efficiency of SOEs and reduce fiscal risks. As a microstate of many small islands, the lack of competition and need for scale in some sectors of the economy call for a larger role for government. Accordingly, SOEs exist in Seychelles to deliver a range of essential services in electricity, water, roads, seaports, fuel supply, transport and aviation. The authorities are mindful of the need for accountability, monitoring and control so that SOEs do not present undue risks to public finances. In particular, the authorities are placing more emphasis on applying best practices to SOEs through management and governance audits so as to further enhance transparency and efficiency in the delivery of public services. The operational performance of the state-owned petroleum (SEYPEC) and utilities (PUC) companies improved in 2014. However, Air Seychelles recorded large operational losses, which were offset by contributions previously committed by the government of Seychelles and by the airline’s other private shareholder. Air Seychelles has announced the introduction of a direct route to Paris from 1 July 2015, codeshared with Air France, aimed at boosting arrival numbers from this key market. The government of Seychelles has worked with Air Seychelles to establish a clear plan to return the airline to profitability, including milestones by which progress will be assessed.

The authorities also recognize that the private sector is the engine of growth and are committed to ensuring that the operation of SOEs does not obstruct the participation of private sector in competitive markets. The authorities agree on the need for SOEs to focus on core mandates in order to minimize risks to the public finances and to allow for the development of the private sector. Furthermore, recognizing the need for a vibrant and competitive private sector, the authorities will continue to promote competition in key sectors such as fisheries and port services. The authorities are pursuing a PPP model for the participation of private investors in the expansion of the port of Victoria, and are working to appropriately balance the share of risks and incentives for the private involvement. More generally, the authorities are working with the African Development Bank and other partners to develop a PPP policy, which would ensure transparency and accountability in the risks to the public balance sheet.

Seychelles is on track with its strategy of reducing public debt to sustainable levels. The strong fiscal performance and forecast of GDP growth in the medium term mean that public debt is expected to fall below 50 percent of GDP in 2018. The authorities aim to place borrowings on favorable terms and gradually extend maturities of the debt portfolio. With debt service set to rise sharply in the near term as grace periods come to an end, one of the key debt management goals is to smooth out the debt service profile and shift borrowings on to local currency wherever possible. It is with these objectives in mind that the authorities have agreed on a debt reorganization to smooth and reduce debt service obligations while providing a stream of resources to support marine conservation. Under this agreement, Paris Club creditors and South Africa will receive the immediate repayment of a share of claims, at a moderate discount. The government of Seychelles benefits from an extended period over which it will make repayments, which are partially converted into domestic currency. A portion of the repayments will be set aside for marine conservation activities through a global environmental NGO.

Seychelles continues to deepen its integration with the global economy. Seychelles joined the WTO in April 2015, an important step given the economy is reliant on open access to trade in goods and services. The authorities also ratified the Convention on Mutual Administrative Assistance in Tax Matters, bringing Seychelles into line with existing international standards on the exchange of tax information. Seychelles has also joined the group of early adopters of the new global standard to automatically exchange tax information. Seychelles is strongly committed to transparency through the adoption of internationally accepted best practices in statistics, and has recently graduated from the GDDS to subscribe to the SDDS. As an EITI Candidate country, Seychelles will publish its first EITI Report by February 2016.

Monetary Policy and the Financial Sector

The Central Bank of Seychelles (CBS) intends to maintain a tight monetary policy stance as long as necessary to guard against possible inflationary pressures and support external balance. Recent data suggest some emerging inflationary risks and the aim is to moderate the recent strong growth in private sector credit to more sustainable levels. While the small size of the foreign exchange market led to some backlogs in the last 12 months, these delays were short-lived and the CBS remains committed to a floating exchange rate regime to ensure adjustments reflect economic fundamentals.

In order to build further resilience to external shocks, reserves accumulation remains an important objective of the authorities. In line with program objectives, the authorities are targeting a modest increase in net reserves. During 2015, CBS plans to make opportunistic purchases of international reserves that do not influence the exchange rate. The CBS remains committed to improve its reserves management capacity with the help of the World Bank.

The CBS continues to move towards a more forward-looking monetary policy framework. An interest rate corridor is providing guidance to the market and allowing commercial banks to improve liquidity management while also improving the transmission of monetary policy. The CBS and the Ministry of Finance have agreed that the Ministry will continue to issue T-Bills and T-Bonds for monetary policy purposes. The CBS learnt from the experience in late 2014 that led to the temporary breach of the reserve money ceiling and is receiving technical assistance from the IMF to further strengthen its liquidity management.

The authorities continue to bring financial regulation into line with evolving international standards. The CBS continues to upgrade banking regulations to cater for implementation of Basel II and III standards. Moreover, a new resolution framework for banks will be developed to ensure that it is in line with new developments, both domestically and internationally. Given emerging risks from the offshore sector, the authorities are bringing the AML regulatory framework in line with international standards.

The CBS is also working to draw on recent experience to strengthen the frameworks for offshore banking supervision and bank resolution. In November 2014, the CBS took over management control of the Bank of Muscat International Offshore (BMIO), which had lost its foreign correspondent banking relationship as a result of worldwide de-risking associated with the increased focus on AML/CFT obligations. By December 2014, the CBS had re-established a correspondent banking relationship for BMIO. However, given tighter international risk management requirements, the CBS decided to reorganize BMIO and retained full management control over BMIO during this process. Despite its operational difficulties, BMIO remained financially sound throughout and as an offshore bank with funds primarily invested in liquid securities, there were no significant impacts on the economy.

The authorities agree on the need for a strong macro-prudential policy framework to continue to safeguard the financial sector. In this regard the CBS is establishing a Financial Stability Committee that will be responsible for taking action to address systemic financial system risks. The recent strong private credit growth is expected to moderate to more sustainable levels following the policy tightening of the CBS. While there are no indications of weakening lending standards and the recent growth comes after a period where the supply of credit appeared to be overly restrained, the authorities are closely monitoring these trends.

The CBS is continuing to develop the financial infrastructure, in particular the payments and credit information systems, and improving access to credit for SMEs and households. Work on a modern payment system is being accelerated. In 2013, Seychelles implemented a system for the electronic transfer of funds across all banks. In 2015, a further phase in this project will extend this online platform from banks to the general public. The CBS is also focused on enhancing consumer protection and financial literacy.

Conclusion

The authorities are very appreciative of the continued close engagement with the IMF, which has supported the considerable progress they have made in restoring inclusive growth and resilience to the economy. They wish to thank the Article IV team, led by Mr. Marshall Mills, for the constructive discussions, analysis and advice. In addition, the IMF’s technical assistance continues to be highly valuable to the authorities as they make progress on their reform agenda.