The Bahamas: Staff Report for the 2015 Article IV Consultation

Context. Economic activity strengthened somewhat in 2014 while the external current account deficit worsened primarily as a result of Baha Mar construction-related imports. The authorities continue to make substantial progress on fiscal consolidation with successful VAT implementation in January 2015 setting the stage for continued improvements in the fiscal position. Lower oil prices helped keep inflation anchored in 2014. Still, notwithstanding the capital flow management (CFM) regime, international reserves remain low. Key policy advice: Despite the U.S. recovery and the imminent opening of the Baha Mar resort, the growth outlook remains well below pre-global crisis levels, and strong and timely measures should be implemented to strengthen competitiveness and raise potential growth. In addition, rebuilding fiscal and external buffers will be essential for sustaining macroeconomic stability: • Reigniting strong and inclusive medium-term growth. Structural reforms are needed to address longstanding competiveness issues including labor market impediments to growth. Energy sector reforms could substantially lower energy costs, boost productivity and facilitate economic diversification in the medium term. A diversification strategy should explore the potential for increasing value added in the tourism sector, including through deepening linkages with agriculture. • Rebuilding fiscal and external buffers. Notwithstanding the CFM regime, the fixed exchange rate peg constrains monetary policy, leaving fiscal policy as the main instrument for macroeconomic stabilization. Steadfast implementation of the VAT and expenditure rationalization in the context of a medium-term budgetary framework, together with public enterprise reforms, would help rebuild fiscal buffers and support international reserves. • Preserving financial sector stability. The pre-crisis credit boom has left the banking system with an overhang of non-performing loans, which will likely continue to generate headwinds for the economy. Despite this, the banking system remains very well capitalized and liquid. Measures should be put in place to resolve the debt overhang while further strengthening the regulatory and supervisory framework.

Abstract

Context. Economic activity strengthened somewhat in 2014 while the external current account deficit worsened primarily as a result of Baha Mar construction-related imports. The authorities continue to make substantial progress on fiscal consolidation with successful VAT implementation in January 2015 setting the stage for continued improvements in the fiscal position. Lower oil prices helped keep inflation anchored in 2014. Still, notwithstanding the capital flow management (CFM) regime, international reserves remain low. Key policy advice: Despite the U.S. recovery and the imminent opening of the Baha Mar resort, the growth outlook remains well below pre-global crisis levels, and strong and timely measures should be implemented to strengthen competitiveness and raise potential growth. In addition, rebuilding fiscal and external buffers will be essential for sustaining macroeconomic stability: • Reigniting strong and inclusive medium-term growth. Structural reforms are needed to address longstanding competiveness issues including labor market impediments to growth. Energy sector reforms could substantially lower energy costs, boost productivity and facilitate economic diversification in the medium term. A diversification strategy should explore the potential for increasing value added in the tourism sector, including through deepening linkages with agriculture. • Rebuilding fiscal and external buffers. Notwithstanding the CFM regime, the fixed exchange rate peg constrains monetary policy, leaving fiscal policy as the main instrument for macroeconomic stabilization. Steadfast implementation of the VAT and expenditure rationalization in the context of a medium-term budgetary framework, together with public enterprise reforms, would help rebuild fiscal buffers and support international reserves. • Preserving financial sector stability. The pre-crisis credit boom has left the banking system with an overhang of non-performing loans, which will likely continue to generate headwinds for the economy. Despite this, the banking system remains very well capitalized and liquid. Measures should be put in place to resolve the debt overhang while further strengthening the regulatory and supervisory framework.

Recent Developments, Outlook and Risks

A. Recent Economic Developments

1. Economic activity is slowly recovering. Real GDP expanded by an estimated 1 percent in 20141 on the back of increased tourist arrivals, but growth remains well below pre-global crisis levels (the level of real GDP also remains below its pre-crisis peak). Supported, in part, by rising U.S. economic activity, air arrivals grew by almost 5 percent in 2014 and applied room rates improved by 7 percent. Domestic demand has been weighed down by the weak macroeconomic outlook, high household indebtedness, and high unemployment which stood at 15.7 percent in November 2014. Inflation rose to 2.2 percent in January 2015 (1.2 percent in December 2014), as the imposition of the value added tax (VAT) offset the effects of declining oil prices.

A01ufig1

Growth and Unemployment

(in percent)

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Source: The Bahamian authorities; and Fund staff estimates.

2. The fiscal deficit in FY 2013/14 (July to June) is estimated to have narrowed to 3.3 percent of GDP (from 5.4 percent). Revenue was lower-than-budgeted, but a substantial reduction in current spending, including on wages and salaries, and on goods and services resulted in an overall fiscal deficit below budget target. The debt-GDP-ratio is estimated to have reached 61 percent in FY2013/14 from 56 percent in FY2012/13. Key public enterprises including Bahamasair, Bahamas Electricity Corporation (BEC) and the Water and Sewerage Corporation (WSC) continue to be a drag on government finances. In September 2014, Moody’s downgraded The Bahamas’ rating one notch to Baa2 citing deterioration of the government’s balance sheet and subdued economic growth.

3. The external current account continues to record sizable deficits. Reflecting the large import components of the Baha Mar resort project, the external current account deficit surged to 22 percent of GDP in 2014. The investment/GDP ratio remains in excess of 25 percent of GDP, and an improved fiscal position has raised the rate of public saving, albeit overwhelmed by an implied reduction in the private saving rate (Figure 4). Foreign financial inflows, including government borrowing, are estimated, however, to have helped cushion reserve losses.

Figure 1.
Figure 1.

The Bahamas: Recent Developments

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Sources: The Bahamian authorities; WEO; and Fund staff estimates and projections.
Figure 2.
Figure 2.

The Bahamas: Fiscal Developments and Outlook 1/

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Sources: The Bahamian authorities; and Fund staff estimates and projections.1/ Central government fiscal year ending June 30.
Figure 3.
Figure 3.

The Bahamas: Exchange Rate Assessment

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Sources: IMF, Information Notice System; and Fund staff calculations.1/ The equilibrium value is computed using the equilibrium real exchange rate approach as in Vitek (2010).2/ The current account (CA) norm is computed using the estimated parameters from the panel regression in Vitek (2010), and staff medium-term projections for the conditioning variables. In particular, the CA norm depends positively on the country’s oil trade balance, the level of net foreign assets, relative fiscal balance, and negatively with respect to relative income growth.
Figure 4.
Figure 4.

The Bahamas: External, Saving, and Investment Developments

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Source: The Bahamian authorities, and IMF staff estimates and projections.

4. Traditional external competiveness indicators do not unambiguously indicate real effective exchange rate (REER) misalignment. A simple average of the three methodologies used suggests an improvement in competitiveness, albeit under 10 percent, would be needed to close the external current account balance. On the other hand, The Bahamas’ share of Caribbean tourism arrivals has been stable recently with upside prospects from the opening of Baha Mar and other FDI-financed investments (Figure 3, Annex 2).2 Nonetheless, the mixed picture suggests that enhancing competitiveness including through structural reforms remains a priority.

A01ufig2

Share of Caribbean Tourist Arrivals

(in percent)

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Source: IMF staff estimates.

5. External reserves remain low. Reserves totaled US$839 million at end-March 2015, equivalent to 2.3 months of next year’s projected imports of goods and services. However, this reflects, in part, a net purchase of US$175 million from the government following an external bond placement early last year (Box 1).

6. The domestic banking system’s deleveraging process continues but the sector remains well capitalized and liquid. Net domestic assets declined by 2.6 percent through December 2014 with private sector credit falling back to its 2009 level. Nonperforming loans remain elevated, with 16 percent of total loans overdue by 90 or more days in March 2015. In October 2014, the government established a special purpose company to take over non-performing commercial loans (US$100 million, 1.1 percent of GDP) of a weak state-owned bank. The banking system’s end–2014 capital adequacy, in excess of 33 percent of risk-weighted assets, remains well above the central bank’s 17 percent target. With subdued lending prospects, banks also continue to be liquid (with the liquid/total asset ratio at 23 percent at end–2014).

A01ufig3

Private Sector Credit, NPLs, and Interest Rates

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

Sources: Central Bank of Bahamas; and Statistics Office.

B. Macroeconomic Outlook and Risks

7. Growth is expected to strengthen over 2015–16 with the improvement in U.S. activity and the opening of Baha Mar, but significant structural impediments remain. Staff estimates potential GDP growth at about 1½ percent over the medium term, insufficient to generate a significant reduction in the high unemployment rate. Structural impediments, including in the labor market and the energy sector, imply that significantly higher growth than currently projected will be required to absorb new entrants to the labor force and reduce the unemployment rate to single digits over the medium term. However, the full opening of Baha Mar and two smaller projects would increase hotel room inventory by about 20 percent, and together with the strengthening U.S. economy could represent a major boost to exports and the near-term growth outlook. Nonetheless, staff growth projections are tempered by the significant risk that Baha Mar would cannibalize arrivals to other Bahamian destinations unless existing structural challenges are addressed. The improvement in activity from lower oil prices is broadly offset by VAT introduction and ongoing private sector deleveraging. U.S. dollar appreciation is expected to have only a marginal impact on activity, given the peg and dominance of the U.S. as a trading partner. Beyond 2016, growth tapers off as U.S. growth decelerates over the medium term, and the base effects from the opening of Baha Mar fade. Inflation is expected to remain low over the medium term, but VAT implementation early this year would add an estimated 2½ percentage points to the CPI. Over the medium term, the external current account deficit returns to single digits as construction-related outflows are anticipated to be replaced by a rise in travel services receipt.

A01ufig4

Real GDP Growth Under Alternative Scenarios, 2013-18

(average, percent)

Citation: IMF Staff Country Reports 2015, 203; 10.5089/9781513502649.002.A001

8. Risks continue to be tilted to the downside although with considerable uncertainty (see Table 8). Spillover risks to The Bahamas stem mainly from the U.S. economy, mostly through the trade and financial channels, but oil price shocks are also important (Annex 3). While the offshore financial system remains substantial, the 2012 FSAP concluded that the domestic financial sector’s susceptibility to offshore spillovers is limited (Annex 4). Nonetheless, the eventual normalization of U.S. monetary policy could further strengthen the dollar, worsening the external competitiveness of The Bahamas vis-à-vis non-U.S. dollar pegged competitors. This, together with adverse shocks to the U.S economy, weaker than projected activity in the global economy, and a disappointing Baha Mar performance would dampen economic recovery, make fiscal consolidation challenging, and weigh on the current account and foreign reserves. However, the net effects of these adverse risks on the external balance are uncertain, as the winding down of Baha Mar construction and lower oil prices are expected to reduce imports going forward. VAT implementation setbacks, and a weak fiscal consolidation generally, could undermine the authorities’ policy credibility, and heighten risks to long-term debt sustainability and the country’s credit rating. The persistently elevated non-performing loan (NPL) ratio poses a tail–risk threat to financial sector stability. Meanwhile, the recent rapprochement in U.S./Cuban relations poses an as yet un-quantified risk to the economic model of many tourism-based Caribbean economies.

Table 1.

The Bahamas: Selected Social and Economic Indicators

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Sources: Central Bank of The Bahamas; Department of Statistics; Ministry of Finance; UNDP Human Development Report; CIA World Factbook; and Fund staff projections.

The data refer to fiscal years ending on June 30.

The data refer to calendar years.

Table 2.

The Bahamas: Operations of the Central Government 1/

(In millions of Bahamian dollars)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Fiscal year ends June 30.

Table 3.

The Bahamas: Operations of the Central Government 1/

(in percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Fiscal year ends June 30.

Table 4.

The Bahamas: Outstanding Stock of Public Debt

(in percent of GDP) 1/

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Source: Central Bank of The Bahamas.

Calendar year basis.

Excludes central government debt holdings by public corporations.

Table 5.

The Bahamas: Balance of Payments

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Sources: Central Bank, Department of Statistics; and Fund staff estimates.

Includes SDR allocation in September 2009.

Includes errors and omissions.

Table 6.

The Bahamas: Summary Accounts of the Central Bank and the Financial System

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Sources: Central Bank of The Bahamas; and Fund staff estimates and projections.
Table 7.

The Bahamas: Indicators of External and Financial Vulnerability

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Sources: Central Bank of The Bahamas; and Fund staff estimates and projections.

Includes errors and omissions.

Table 8.

The Bahamas: Risk Assessment Matrix1

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The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood of risks listed is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability of 30 percent or more). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities.

Policy Discussions

While growth momentum is improving amid U.S. recovery, it remains weak. With relatively low international reserves, policy discussions focused on rebuilding fiscal and external buffers and raising productivity and competitiveness to reignite growth. Specifically, staff’s recommendations centered on policies to (i) reignite strong and inclusive medium term growth; (ii) restore fiscal and debt sustainability; (iii) rebuild external buffers; and (iv) preserve financial sector stability.

A. Reigniting Strong and Inclusive Medium-Term Growth

9. Staff noted that The Bahamas faces several challenges in boosting its growth potential. First, the country must attract sufficient tourist demand to fill the large impending increase in supply. Second, labor market rigidities constrain the potential supply of labor in the medium term. Persistently high unemployment rates suggest the presence of wage rigidities while business surveys cite a lack of skilled labor as an important constraint to growth. Third, there are significant impediments to the growth of small and medium enterprises (SMEs). Fourth, there are more general constraints to investment. The 2015 World Bank Doing Business Indicators ranks The Bahamas 97th out of 189 countries. Moreover, The Bahamas had a Distance to (best practice) Frontier score of 61.37 out of a maximum of 100, indicating much room for improvement. The Bahamas has particularly low rankings in getting credit, protecting investors, and registering property.

10. Persistently high unemployment underscores the need for policies to promote more inclusive growth (Box 2). The Bahamas enjoys a relatively high per capita income (third highest in the Western Hemisphere behind the U.S. and Canada), which has helped to maintain high living standards. However, since the onset of the global financial crisis, the unemployment rate has remained in double digits mostly due to depressed domestic demand and exports and may have contributed to the recent rise in crime rates. There is evidence of significant structural unemployment, which suggests the existence of impediments to job creation and proper functioning of the labor market. Evidence points to skills mismatches, which partly reflects deficiencies in the education system and migration of skilled labor. At the same time, according to the private sector, efforts to hire foreign labor to fill skill shortages are occasionally hampered by difficulties in securing work permits. Moreover, the job content of growth appears relatively low and is compounded by low productivity and high real wages.

11. Inclusive growth policies would also reduce inequality and gender imbalances (Box 2). Income inequality appears relatively high as indicated by the Gini coefficient estimated at 46 percent in 2011. Although the 2014 World Economic Forum’s global gender gap report ranks The Bahamas high in attaining gender balance (35th out of 142 countries), males appear to be lagging in educational attainment, and much more in securing technical and professional jobs. Females, on the other hand, seem to be lagging in political empowerment as indicated by the proportion of women in parliament and cabinet.

12. Staff concurred with the authorities on the need to finalize and implement the National Development Plan (NDP). The NDP would assess the country’s macroeconomic performance, institutions, and governance and propose strategies to accelerate economic, institutional, and social development over the medium term and long run. The NDP should review The Bahamas’ economic diversification strategy with a view to exploring scope for increasing value added, including in the tourism sector through deepening linkages with agriculture. In view of the employment and labor market challenges, staff recommended enhancing active labor market policies to foster job creation and deliver more inclusive growth. In the short term, the focus should be on building upon existing vocational and on-the-job training programs, and job placement services, while seeking to attract skilled Bahamians in the Diaspora and easing restrictions on intra-Caribbean labor mobility. In the long term, improving educational outcomes, better alignment of educational curricula with skills demand, aligning wages to productivity, and enhancing the efficiency of labor market regulations and institutions would be essential to increasing productivity and competitiveness. In addition, greater investment in infrastructure and human capital would be necessary to ensure that growth is broad-based and that the benefits are spread more widely.

13. Affordable and dependable electricity supply is critical to maintaining The Bahamas’ image as a high-end tourist destination (Annex 5). Improving the efficiency of the electricity company could substantially lower energy costs, boost productivity, and facilitate economic diversification over the medium term. There appears to be significant scope for boosting energy efficiency through more efficient generation, appropriate pricing (balancing cost reduction and investment needs), expanding the use of alternative energy sources, and improved monitoring (including the collection of arrears).

14. Advancing far reaching reforms at the state-owned enterprises (SOEs) is key to reigniting growth. The pace of reforms in loss-making public entities, including the BEC, Bahamasair, and WSC, appears to be lagging and could hamper efforts towards alleviating infrastructure bottlenecks and enhancing medium term growth. Staff urged speedy reform of these entities, focusing on lowering operating costs, rationalizing tariffs, increasing capital investment, enhancing the regulatory framework and generally raising the quality and reliability of service. In particular, staff urged the authorities to press ahead with plans to place the electricity company on a commercially-sound basis and to liberalize the regulatory framework.

Authorities Views:

  • The authorities fully agreed with staff on the need to promote higher and more inclusive growth, observing in particular that there was an urgent need to reduce the very high youth unemployment rates, thus also helping to stem rising crime rates. They noted that growth has not been strong enough to absorb new entrants to the labor force, but are optimistic that Baha Mar opening and other new projects could potentially lower unemployment. They acknowledged that income inequality is high, but it is partly due to highly paid expatriates, especially in the financial sector.

  • They regarded the NDP as critical to their efforts to strengthen and diversify the Bahamian economy and have set up the Bahamas Investment Promotion Agency (BIPA) within the Office of the Prime Minister to spearhead efforts to finalize the NDP. The BIPA would be tasked with monitoring all priority projects in a centralized fashion, ensuring timely implementation. Currently, work on the NDP is focusing on diagnostic studies along several dimensions, including educational policy, the business environment, and policies pertaining to the Family Islands. The authorities also indicated that energy sector policies would be integrated with the NDP to ensure consistency. They are building an agriculture school that would train students in commercial farming, among other activities, which would help reduce food imports.

  • On energy sector reforms, and in addition to those already announced (Annex V), the authorities indicated that they would be outsourcing the management of the Bahamas Electricity Corporation to a private sector company with a mandate to run the BEC on a fully commercial basis. This would imply rationalization of tariffs and employment policies, and laying the basis for increased investment and the modernization of generation plants. In addition, they were considering options to set up an independent regulator for the electricity sector. Transformation of the BEC should lower energy prices, and enhance the competitiveness of the tourism sector.

B. Rebuilding Fiscal and External Buffers

15. The lack of fiscal space and modest external buffers constrain the use of demand-side policies to stimulate growth. Notwithstanding capital controls, the exchange rate peg constrains monetary policy. Furthermore, the scope for fiscal stimulus to support the recovery is limited by low international reserves and the need to reverse the debt trajectory.

16. The introduction of the new VAT reaffirmed the authorities’ commitment to medium-term fiscal consolidation. Staff commended the authorities for the introduction of a broad-based VAT on January 1, 2015 with a standard rate of 7.5 percent and very few exemptions. This represents a significant step towards boosting policy credibility, and bolstering market confidence. The implementation of the VAT appears to have been relatively smooth despite some transitional issues that are being resolved. Early indications of its performance are encouraging, and the authorities seem on course to achieving their initial revenue targets. Following the VAT implementation, the authorities should advance other revenue reform measures on which progress had lagged, including modernization of customs and property tax administration, and establishment of a central revenue agency.

Medium-Term Fiscal Framework 1/

(in percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

Fiscal year ends June 30th.

Defined as revenue and grants minus total expenditure (excluding interest payments).

17. Over the medium term, the government proposes to continue its fiscal consolidation efforts. The fiscal position is projected to improve steadily in the medium term as envisaged during the 2013 Article IV consultation, with the fiscal deficit expected to narrow to about 2 percent of GDP in FY2015/16 reaching 0.3 percent in 2019/20. The primary balance is projected to move into a surplus in 2015/16. In addition to enhancing revenue, the government proposes to rein in current spending while keeping capital spending around 3 percent of GDP.

18. The central government debt to GDP ratio will remain elevated, but decline slowly over the medium term as the fiscal position strengthens. Under the baseline scenario of the debt sustainability analysis, central government debt is projected to peak at 63 percent of GDP in FY2014/15, declining marginally thereafter to 62 percent in FY2019/20. Gross financing requirements will decline from 5.7 percent of GDP in FY2014/15 to about 2.0 percent of GDP in FY2019/20. External financing requirement is highlighted as a significant risk to the debt profile, which could be mitigated by the projected strengthening of the external current account in the medium term. The main risks to debt sustainability remain slower than expected growth and weak fiscal efforts (Annex 1).

19. Staff agreed that the pace of consolidation planned by the authorities was broadly appropriate, notably in view of the relatively weak growth outlook. Staff urged the authorities to intensify efforts with regard to the implementation of other tax reforms. Steadfast implementation of the planned fiscal consolidation is key to placing debt levels on a declining path. On the expenditure side, staff welcomed ongoing efforts to tighten spending control, and plans to reform public procurement and payroll management. Currently, the fiscal consolidation plan envisages a small saving on expenditures reform. Accelerated rationalization of current expenditure in the context of a medium–term budgetary framework is therefore warranted to help preserve the hard-won benefits of the VAT and help to restore fiscal and debt sustainability. Staff also urged the authorities to press ahead with plans to introduce fiscal responsibility legislation.

20. SOE reforms would facilitate fiscal consolidation. Staff noted that key state-owned entities continue to record sizable financial losses as a result of their public service mandates, operational inefficiencies and inadequate enabling regulatory framework. In particular, operating costs are notably high, mainly reflecting aged facilities and generous employment policies, while productivity is low. Moreover, SOE tariffs have not kept pace with the cost of service delivery, necessitating continued budget support. For example, government support to both Bahamasair and WSC is expected to reach US$60 million (0.7 percent of GDP) in FY2014/15. Aggregate SOE debt was 16 percent of GDP in FY2013/14. Reforms of these entities are thus critical to stemming the drag on public finances.

21. The large band of uncertainty on the growth outlook calls for continued fiscal vigilance. Staff recommended the identification of contingency measures for meeting fiscal targets, including offsetting measures, should downside risks materialize. Such measures should aim to protect growth enhancing capital spending given the large infrastructure requirements. In addition, with growth remaining tepid, staff underscored that fiscal consolidation is not only needed to achieve fiscal and debt sustainability, but also critical to rebuilding external buffers in the near term, and to sustaining the peg. Over the longer term, measures would need to be taken in the area of pensions and health insurance to put these on a fiscally sustainable footing, notably in view of population aging.

Authorities Views:

  • The authorities broadly agreed with staff’s assessment of the fiscal position, and reiterated th