Kiribati: Staff Report for the 2015 Article IV Consultation
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
29 Jul 2015
eISBN:
9781513526805
Language:
English
Keywords:
ISCR; CR; expenditure growth path; development expenditure; debt-to-GDP; real GDP; reserve fund; current account; RERF balance; fishing revenue; exchange rate; Climate change; Public enterprises; Infrastructure
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KEY ISSUES Context. Donor-financed large infrastructure projects, increased public spending, and a pick-up in credit to households have boosted real GDP growth to close to 4 percent in 2014 and to about 3 percent in 2015. Inflation remains low, underpinned by lower food and commodity prices. Steps are being taken to reduce the many hurdles to private growth that Kiribati faces, among which are high transportation and communication costs and an increasing impact of climate change. Fiscal policy. The fiscal outlook has improved, but further efforts are needed to ensure sustainability. The recurrent balance was in large surplus in 2014 and is expected to remain positive in 2015, reflecting high revenue from license fees, and notwithstanding a large increase in expenditures. But under the historic pace of spending the sovereign wealth fund (Revenue Equalization Reserve Fund—RERF) would be depleted in about 20 years. Ensuring sustainability requires containing nominal expenditure growth to around 1½ per annum over the next five years (after accommodating climate-change-related costs), with transparent and symmetric transfers and withdrawals from the RERF around this path. Structural reforms. There is a consensus among donors that significant progress has been achieved. The State-Owned Enterprise (SOE) Reform Act is being implemented in a satisfactory way, as illustrated by the recent successful privatization of the telecommunication company. Key outstanding issues include further reforming the energy and copra sectors and improving the investment climate.

Abstract

KEY ISSUES Context. Donor-financed large infrastructure projects, increased public spending, and a pick-up in credit to households have boosted real GDP growth to close to 4 percent in 2014 and to about 3 percent in 2015. Inflation remains low, underpinned by lower food and commodity prices. Steps are being taken to reduce the many hurdles to private growth that Kiribati faces, among which are high transportation and communication costs and an increasing impact of climate change. Fiscal policy. The fiscal outlook has improved, but further efforts are needed to ensure sustainability. The recurrent balance was in large surplus in 2014 and is expected to remain positive in 2015, reflecting high revenue from license fees, and notwithstanding a large increase in expenditures. But under the historic pace of spending the sovereign wealth fund (Revenue Equalization Reserve Fund—RERF) would be depleted in about 20 years. Ensuring sustainability requires containing nominal expenditure growth to around 1½ per annum over the next five years (after accommodating climate-change-related costs), with transparent and symmetric transfers and withdrawals from the RERF around this path. Structural reforms. There is a consensus among donors that significant progress has been achieved. The State-Owned Enterprise (SOE) Reform Act is being implemented in a satisfactory way, as illustrated by the recent successful privatization of the telecommunication company. Key outstanding issues include further reforming the energy and copra sectors and improving the investment climate.

Background

1. Kiribati is one of the most remote and geographically dispersed small states in the world. Its territory comprises 33 islands spread over 3.5 million square kilometers of ocean and a population of about 100,000. High transportation and communication costs, together with weak infrastructure and poor investment climate, are key obstacles to development. Extreme poverty is low, at around 5 percent, but 22 percent of the population lives below the basic needs poverty line. Climate change presents significant challenges given the low elevation of the land and rising sea levels.

2. Kiribati’s economy is supported by revenues from the sovereign wealth fund, fishing license fees and donors’ aids. The sovereign wealth fund (RERF) was established in 1956 to save proceeds from mining phosphate deposits before they were exhausted in 1979 and for fiscal stabilization. Its balance declined from 565 percent of GDP in 2006 to 365 percent last year due to higher than sustainable drawdowns (to finance deficits stemming largely from weak tax compliance and increasing subsidies to SOEs) but also because of capital losses during the Global Financial Crisis. Fishing license fees have been volatile, but their management has improved due to a regional agreement to charge higher fees and limit the total number of fishing days and the number of vessels (‘Nauru Agreement’). The country relies on foreign aid to finance its large development needs.

3. The key policy challenge is to continue to manage these resources wisely, while overcoming obstacles to private sector growth To this end, the authorities have embarked on an ambitious macroeconomic reform program supported by the IMF (through provision of technical assistance) and other development partners. 1 The Economic Reform Plan intends to restore fiscal sustainability through improvements in revenue performance and containing public expenditure, while safeguarding vital public services and infrastructure investments. Significant progress has been made following the previous Fund advice, including in the area of debt management (costly overdraft debt has been cleared and non-concessional borrowing eliminated), tax reforms (implementation of the VAT last year), asset management of the RERF, and SOE performance. But more progress is needed in fiscal reforms to fully secure sustainability and improve resilience to shocks, and in structural reforms to support private sector growth.

Recent Developments And Outlook

4. Recent economic performance has been strong. With the strengthening of the vessel day scheme, fishing license fees have been on the rise in the last three years, reaching a record-high 68 percent of GDP in 2014 (compared to the past average of about 20 percent). Donor-financed infrastructure projects (mainly in the road, port, and aviation sectors) have also reached unprecedented levels (45 percent of GDP in 2014). This, together with a pick-up in credit to households, boosted GDP growth, which was around 4 percent in 2014. Growth is projected at about 3 percent in 2015, driven by stepped-up infrastructure projects feeding through into activity in the retail sector, as well as reconstruction activity after the extreme weather damages earlier in the year. Inflation remains subdued, underpinned by lower food and commodity prices.

A01ufig1

Growth

(In percent, year-on-year)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: Kiribati Authorities; and IMF staff calculations.
A01ufig2

Current Account Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Source: Kiribati Authorities; and IMF staff estimates.

5. The current account turned positive in 2014 on account of the high fishing license fees, but is expected to revert to a deficit in 2015. High imports related to donors’ projects—largely matched by external grants—are projected to offset gains from lower oil prices, estimated at around 5 percent of GDP in 2015. Remittances have decreased in recent years, but they should pick-up as employment overseas increases back to past levels after the implementation of additional employment schemes. Reflecting developments in the Australian dollar, the exchange rate has depreciated in real effective terms to below the historical average, but the effect on the current account is expected to be limited as trade dynamics are dominated by structural factors (Box 1).

6. Fishing license fees should remain high in 2015. On the one hand, fishing license fees revenues have been very strong during the first four months of 2015, exceeding their level during the first four months of 2014. On the other hand, the Phoenix Island Protected Area (PIPA) has been temporarily closed to protect the stock of fish, and the significant drop in tuna price since the beginning of the year should have a negative impact on revenues going forward. On balance, staff anticipates that fishing revenues should remain high in 2015, although below the 2014 peak.

7. Against this backdrop, the recurrent fiscal balance is expected to be positive in 2015 for the third consecutive year. The recurrent balance turned positive in 2013, further strengthened in 2014, and should remain in surplus in 2015. The improvement was mainly driven by record high fishing license fees. Recurrent expenditures increased by nearly 13 percent in 2014 and a further 5 percent in 2015 (per supplementary budget), but wages and salaries have remained under control. The increase in expenditures in 2014 reflected bringing on budget the previously non-transparent support to the state-owned power company (equivalent to around 3½ percent of GDP) and a one-off transfer to clear the debt of one large SOE (worth around 4 percent of GDP), both following previous staff recommendations. The increase in 2015 expenditures was largely the result of weather damage-related costs. Notwithstanding the rollout of the VAT in April 2014, tax revenues have yet to pick up, reflecting challenges in tax compliance and collection.

A01ufig3

Revenue and Expenditure

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: Kiribati Authorities; and IMF staff estimates.
A01ufig4

Fiscal Balance and Financing

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: Kiribati Authorities; and IMF staff estimates.

External Competitiveness and Exchange Rate Assessment

The real effective exchange rate (REER) depreciated over last two years and is now below its historical average. This mainly reflects the weakening of the Australian dollar, which circulates as legal tender in Kiribati. Nevertheless, competitiveness continues to be hampered by high transportation costs, lack of scale and remoteness as discussed in this report. This makes structural reforms to improve the business climate and growth opportunities critically important for competitiveness. Precise CGER-like estimates of exchange rate alignment are neither feasible – given data limitations – nor meaningful for Kiribati: the REER plays a limited role in current account developments, which are mostly driven by exogenous factors (fishing license fees and donor flows on the one hand, and global commodity prices on the other hand).

A01ufig5

Real Effective Exchange Rate

(Index, 2010 = 100)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: IMF, Information Notice System, APDCORE; and IMF staff calculations.

The use of the Australian dollar as the official currency remains appropriate2. Kiribati needs a strong nominal anchor and does not have institutional capacity to conduct its own monetary policy. The choice of the Australian dollar is dictated by strong trade and financial linkages (investment of a large share of RERF assets in Australian markets).

8. The medium-term outlook is more uncertain and will be mostly driven by the realized level of future fishing license fees. The fishing license fees are expected to stay higher than their historical level but fall from their 2014 peak. These revenues remain highly volatile and subject to downside risks. Furthermore, donors’ activity is projected to diminish with the completion of large infrastructure projects. This will reduce growth in the medium term and, if the discipline is not maintained, could again expose fiscal pressures. Furthermore, the extent of the recent damages caused by Cyclone Pam and high tidal waves underscore the risks and the economic and social costs related to climate change. Finally, returns on RERF and other financial assets could also be affected by global risks. A protracted period of slower global growth and low inflation could compress both equity returns and bond yields for several years (RAM Annex).

Restoring Sustainability and Improving Resilience to Shocks

The key policy challenge is to manage the intergenerational benefits of Kiribati’s large sovereign wealth fund against a background of uncertainty about future fishing license fees and spending pressures to address important infrastructure and social needs and prepare for the adverse consequences of climate change. Spending growth should be reduced from historic levels, public investments largely grant-financed, and structural fiscal reforms accelerated.

9. The medium-term fiscal outlook appears more favorable in the context of higher expectations for fishing license fees, but downside risks are significant. The baseline for the main fiscal revenue—fishing license fees—has been revised upwards. The large increase in this source of revenue in the past years can be attributed to the recent changes adopted under the Parties to the Nauru Agreement (PNA): effective in 2012, the PNA introduced a US$5,000 minimum fee for fishing per vessel day, subsequently increased to US$6,000 in 2014 and to US$8,000 in 2015. If member countries manage to enforce the agreement, this could lead to a lasting increase in revenues. Staff considers such enforcement as the baseline scenario, and annual fishing license fees are accordingly projected to be around 40 percent of GDP on average over 2015–20, up from an average of about 24 percent of GDP over the past decades, but below outturns averaging more than 50 percent of GDP in 2013–14. Because these revenues are inherently uncertain (fishing stock and prices are volatile, including the risk of overfishing), lower fishing license fees represent a plausible and high impact downside risk. Staff accordingly discussed fiscal policy approaches that would be sustainable in the event that license fees revert to the past historical average (Box 3).3

10. In addition, spending pressures are increasing. First, additional infrastructure and other spending will be needed to mitigate the effects of climate change, such as drought, loss of potable ground water, and rising sea levels. Climate change related costs are highly uncertain but are assumed to be at around 3½ percent of GDP per annum (Box 2). Second, room needs to be made within the budget envelope to accommodate future maintenance costs of the newly constructed infrastructure, which are expected to be only partly covered by user charges. Taken together, these pressures could require additional budgetary expenditures amounting to around 4 percent of GDP per annum (largely for capital maintenance and recurrent climate-change-related costs), and the continuation of high donors’ support for capital spending.

The Key Challenge of Adapting to Climate Change

Climate change poses a major threat to Kiribati and could lead to significant fiscal pressures.

The rise in the sea levels has both a structural and a cyclical component. The structural component is related to climate change and while still moderate, it is on track to become much more significant as Kiribati’s average height above sea level is only around 2 meters and climate model simulations estimate that sea level could increase by 24 cm by 2050 and 61 cm by 2100 compared to the 1985–2005 average.1 This trend is compounded by the medium term cyclical impact of predominance of El Niño, putting upward pressure on sea levels and causing larger and more frequent high tide levels (the current cycle could continue for another 10–20 years).

The main impact of climate change will be through rising sea levels, but also warmer average temperatures and more frequent and severe storms. This would lead to permanent erosion of the shoreline and loss of land, frequent inundation, lower biodiversity, lower agricultural production, and water resource and food security issues. Waves and unprecedented flooding already caused severe and costly destruction earlier this year. Higher temperatures and wider flooded areas could increase the spread of vector borne diseases such as dengue fever.

While the fiscal costs are uncertain, they are likely to be substantial. Coastal protection costs alone are estimated be in the region of 1 percent of GDP per annum.2 These estimates can be seen as a floor: they exclude any transition costs, as well as the potential cost of inefficiencies in adaptation responses. Additional expenditures will be needed to adapt to climate variability, such as repairing damages arising from more frequent extreme weather events, or those associated with adjustments in response to the salinization of agricultural land. The annual adaptation costs could be in the range of ½ to 1½ percent of GDP (medium emissions scenario) and as high as 2½ percent of GDP in the worst case scenario.3

Overall, climate change related costs could reach 3½ percent per year, and possibly more in worst case scenarios. Given Kiribati’s fiscal constraints, this would require more donor funding towards these needs, including from the new Green Climate Fund.

1 High emission scenario. See “Climate Variability, Extremes and Change in the Western Tropical Pacific: New Science and Updated Country Reports 2014.”2 Nicholls and Tol, 2006, “Impacts and Responses to Sea-Level Rise: A Global Analysis of the SRSS Scenarios over the Twenty-first Century,” Philosophical Transactions of the Royal Society, Vol. 363, pp. 1073–1095.3 “The Economics of Climate Change in the Pacific,” Asian Development Bank, 2013 and “Enhancing Macroeconomic Resilience to Natural Disasters and Climate Change in the Small States of the Pacific,” Ezequiel Cabezon, Leni Hunter, Patrizia Tumbarello, Kazuaki Washimi and Yiqun Wu.

11. Against this backdrop, continued fiscal prudence is required to preserve fiscal sustainability and maintain resilience to shocks. Given that the (RERF) is the main mechanism to save wealth for future generations and a buffer against shocks, staff policy advice focused on strengthening its role as an anchor for fiscal sustainability:

  • Preserving wealth. Returns on RERF investments are an important source of income for Kiribati. For intergenerational equity, they should be distributed proportionally to the growing population, ensuring constant real per capita budget drawdowns over time. From this perspective, the sustainable level of drawdown is estimated at about 3–4 percent of GDP (the wide range reflects uncertainty surrounding projected investment returns and population growth). Given the downside risks to fishing license fees, staff recommended that expenditure plans be framed around a more conservative fiscal stance, aiming at a RERF drawdown averaging about ½ percent of GDP over 2016-2020. This would help accumulate savings when fish license fees remain strong, while limiting the RERF drawdown in the event that they would disappoint.

  • Expenditure rule. The RERF drawdown of ½ percent of GDP annually would be consistent with recurrent expenditure growth of 1.5 percent per annum over the next 5 years, assuming fishing licenses fees remain robust. This would result in a gradual reduction in real per capita spending, but leave sufficient room to cover pressing expenditure needs (see below). If license fees remain strong, real per capita RERF balances would rise, implicitly saving for future generations part of the fishing revenues and providing a buffer against higher climate-change-related costs. With greater confidence about the durability of fishing license fees, the sustainable rate of spending could be revisited, perhaps leading to faster spending growth beyond the 5-years horizon. With lower fishing revenues—closer to the historical average—RERF per capita balances would initially fall, but later stabilize, guaranteeing that the proposed expenditure path is sustainable, although with smaller buffers (Box 3). This approach to fiscal sustainability would also require that capital spending be primarily grant-financed.

  • Stabilization. For the RERF to perform its dual role, the policy of budget transfers and withdrawals should be more transparent, systematic and symmetric around the proposed expenditure path. Staff recommended saving a substantial part of the revenues in the RERF when license fees are above average to allow for a sustainable drawdown when they fall below the average. Given more volatile weather patterns, staff also recommended maintaining a larger cash buffer—equivalent to around two months of budget expenditures (around AUD20 million)—in light of volatility of revenue and in case of emergency needs. A part of the cash balance from the 2014 budget surplus could be used for this purpose, with the rest transferred to the RERF. To date, only AUD 10 million out of the record 2014 fiscal surplus of around AUD 50 million was transferred to the RERF.4

Managing Volatility of Fishing License Fees and Ensuring Fiscal Sustainability

The RERF has been managed well relative to peers, but recent developments have jeopardized its sustainability. The RERF was capitalized with revenues from phosphates until reserves were exhausted in 1979 and, in the early decades, with fiscal surpluses. But the sharp increase in current expenditures—from an average of 48 percent of GDP in 1991–2000 to 58 percent in 2010–14—resulted in large deficits financed by drawdowns from the RERF, which stopped only when fishing revenue increased in 2013 (even though regular spending has largely been contained since 2011, regularizing SOE subsidies and clearing overdrafts kept the deficit high). The global financial crisis also caused significant capital losses. As a consequence, the current per capita value of the RERF is down to around AUD 5,400 (in 2006 dollars) from around AUD 9,300 in 2000.

A01ufig6

Cross-Country Comparison: Sovereign Wealth Fund Values

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: Authorities data and IMF staff calculations

Staff simulations indicate than targeting an annual expenditure growth of 1½ percent in the medium term would restore sustainability. Staff analyzes two scenarios for revenues from fishing license fees: (i) a baseline where they stay high (AUD 100 Million on average over 2015–35); (ii) a decrease to an average of AUD 63 million, consistent with the historical average of around 24 percent of GDP since 1991:

  • The historical pace of spending (‘historical path’—nominal expenditure growth of 5.5 percent per annum) would be unsustainable, leading to a depletion of the RERF in about 20 years, even in the higher fishing revenue scenario.

  • Expenditure growth of 1½ percent per year would ensure sustainability in both scenarios. Under the lower revenue scenario, it would stabilize the RERF around AUD 4,000 in real per capita terms by 2035. In the higher revenue scenario, this path would increase RERF real per capita balances to around AUD 6,000, effectively saving part of the fishing revenue windfall, and therefore further improving intergenerational equity. This would allow for higher sustainable transfers to the budget, helping stabilize real per capita expenditures in the long term.

A01ufig7

Real Per-capita RERF Balance - Simulations

(In Australian dollars, 2006 prices)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Source: IMF Staff estimates.

Fishing revenues are likely to remain volatile, and long-term policy commitments should be guided by indicators that are not affected by such volatility. While the proposed expenditure path is a viable anchor, complementary indicators could include the recurrent non-fish balance (i.e. the current fiscal balance excluding fishing revenues). The proposed expenditure path would be consistent with maintaining the recurrent non-fish deficit at below 35 percent of GDP.

12. Improved management of the RERF is critical for the success of the adjustment. The disappointing financial performance of the RERF in the past several years highlighted that investment policy and strategic asset allocation were not aligned with the long term objectives and nature of the fund. With ongoing assistance from the World Bank, the Cabinet of Ministers recently approved reforms that are in the process of being implemented. The current phase is focusing on the appointment of new asset manager(s), which is advancing well. In the context of reforming the fund investment mandate, staff also discussed the idea of better articulating the saving and stabilization roles of the RERF and making these objectives explicit in formulating the optimal investment strategy of the fund.

13. The recommended fiscal path has sufficient room to accommodate new spending needs, but it will require the continuation of efforts on several fronts. The 2015 budget includes one-off expenditures—mainly for weather-related damages—equivalent to around 4 percent of GDP. Staff projections assume that costs of a similar magnitude (covering both climate-change-related spending and the maintenance of new capital assets) will become permanent. There is sufficient room for this in the overall budget envelope provided that other recurrent spending remains contained. This requires the continuation of the current wage policy (allowing for a ‘wage drift’ from the automatic promotion process, but no additional wage increases) and maintaining subsidies to SOEs at the current nominal level (by exploiting efficiency gains from the restructuring of the energy sector and the copra sector, for which Technical Assistance is underway). To avoid expenditure surprises and enhance fiscal discipline budget, contingencies for unexpected expenditures should be provided within the envelope consistent with the recommended path. The authorities’ prudent debt management and policy of avoiding non-concessional debt financing of the recurrent budget should also continue. Given moderate growth prospects, the scope for external borrowing—even from IFIs at concessional terms—remains limited (DSA Annex).

14. Improving tax compliance and collection is also an essential element of the strategy. After staying broadly stable at around 19 percent of GDP in the two decades leading to 2007, tax revenues started declining in 2008 and had dropped to about 14 percent of GDP in 2014. The VAT was introduced in 2014 as a key element of the fiscal reforms. The implementation of the tax has been successful, as revenues are in line with expectations. This, together with efforts to improve compliance and strengthen SOE efficiency, would allow for the tax ratio to gradually increase to 17 percent in the next five years. However, recent policy proposals—such as widening the already broad list of exemptions to essential services—would undermine tax collection. It would also increase tax administration and compliance costs for businesses. To guard against this risk, further exemptions should be avoided, and consideration should be given to phasing out existing exemptions and replacing them with targeted support for low income households and direct transfer payments. If exemptions are to be maintained, the list should be short and narrowly defined.

Authorities’ Views

15. The authorities remain committed to secure a sustainable fiscal position. They acknowledged that given the volatility of fishing license fees, they cannot count on fees staying at their 2014 level for an extended period. Reflecting these concerns, spending in 2014 and 2015 budgets had remained contained, notwithstanding increases that were due to more transparent budgeting, one-off spending, and natural disasters. They have the intention to maintain spending discipline in the future, and are considering additional transfers to the RERF, as well as maintaining a larger cash buffer and investing part of the surplus in alternative safe financial assets given the transition in RERF asset management. They also pointed out the trade-off between the need to strengthen the RERF and the immediate infrastructure and social needs of Kiribati, and in this context they welcomed staff advice to allocate additional resources to climate-change-related and maintenance expenditures. Regarding tax policy, the authorities were concerned about the negative public perception of the impact of VAT on prices, which led to the proposal to exempt essential services from the tax, but the authorities remain committed not to undermine the tax.

Promoting Growth and Reducing Poverty

Increasing growth opportunities will require alleviating key barriers to private sector growth, pursuing the implementation of SOE reforms, and enhancing access to finance for viable business projects, while maintaining adequate financial risk management.

A. Removing Barriers to Private Sector Growth

16. Important progress is being made in creating conditions for private sector growth, but more needs to be done. In addition to progress in improving the physical infrastructure through donor-funded projects, the authorities have successfully privatized the telecommunication company. Improvement in telecommunication can lower transaction costs and foster private sector activity in a number of areas. Most importantly, it could promote the development of mobile banking, where Kiribati is currently lagging behind other small states in the Pacific. It could also facilitate the delivery of government services and the payment of taxes, fees and bills via electronic and mobile devices. In this context, consideration could be given to initiatives that may further support investment in these areas utilizing donors’ funding. The government is also making efforts to promote competition in the airline industry. Enhancing competition could make Kiribati more accessible by reducing transportation costs, and promote tourism. Going forward, improving business climate, in particular through further streamlining business registration processes and facilitating private usage of government-owned land, is critical to fostering private sector growth (see Box 4).

17. Supporting policies should continue to focus on building human capital and better utilizing marine resources. The recent expansion of the Marine Training Center will help raise teaching standards for fishermen to internationally-recognized levels. This is an important achievement given improved employment prospects abroad and also in the context of government efforts to develop the domestic fishing industry. In this context, the expansion of joint projects with Kiribati Fishing Limited—if well-managed—may boost employment, exports and domestic activity. Developing other domestic resources—such as agriculture production—should also be encouraged particularly if government support is limited and if it facilitates a gradual reduction in copra subsidies. As donor-funded infrastructure projects are completed, shifting the focus to maintenance of infrastructure could also promote private sector growth and employment by outsourcing this activity to microenterprise units.

Growth and Investment Climate1

High costs related to geographic isolation and small size are formidable barriers to growth. The remoteness, dispersion, and small population lead to a lack of scale and high transportation costs, constraining private sector development, Accordingly, the private sector in Kiribati remains small and is concentrated in fisheries, retail trade, copra, and tourism. While the Chamber of Commerce estimates that there are some 2,000 businesses, only 2 employ over 200 people. The public sector dominates the economy: recurrent budget expenditures are close to 60 percent of GDP and SOE revenues are about 40 percent of GDP. Overall, the public sector represents nearly 80 percent of jobs in the formal sector. Only 20 percent of the labor force is employed in the formal sector, and the unemployment rate exceeds 30 percent.

A01ufig8

Cross-Country Comparison: Ease of Doing Business Ranking

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: World Bank, Doing Business Reports 2016 and 2015.

While overcoming physical constraints is difficult, a more enabling business environment would support private sector growth. Insufficient infrastructure—including in communication systems—weak business climate, and limited financial intermediation are key obstacles to be removed. Kiribati’s investment climate ranks 134th out of 189 economies globally and 8th out of 11 within the Pacific region in the World Bank’s 2015 Doing Business Report. Its ranking has fallen each year since 2010, although primarily as a result of lack of improvements rather than worsening in the country’s regulatory regime.2 Starting a business, for example, takes 31 days, against the regional average of 26 days and the regional best practice of 9 days. Land sales are prohibited except between Kiribati citizens and are only allowed after the consent of the Land Court, which applies strict eligibility criteria. It takes on average 153 days to register a property and almost a year to settle a contract dispute. Getting credit is costly and a large proportion of the population remains outside the formal banking system. Businesses are also subject to price controls that cover a wide range of goods and are subject to irregular revisions issued by the Minister of Commerce.

A01ufig9

Doing Business, 2015

(Ranking, scale 1 -189 with lower number means more conducive regulatory environment)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: World Bank, Doing Business Reports 2016; and IMF staff calculations
1 Prepared by Mizuho Kida, World Bank.2 The absence of changes in absolute scores in most of the ten dimensions studied in the Report and small changes in the distance to frontier (DTF) scores over time support this assessment.

Authorities’ views

18. The authorities broadly agreed with priorities identified by staff to foster private sector growth. They reiterated that continued development of the fishing sector is key to improve growth and employment. They are also committed to reducing communication and transportation costs, not only internationally but also between Tarawa and outer islands, but pointed to difficulties in developing viable alternatives for international air transport links.

B. Implementing SOE Reforms

19. Significant progress has been made in SOE reforms. Reforming SOEs is important not only for a better allocation of scarce public resources (through reducing subsidies and guarantees to underperforming enterprises), but their divestment would also open opportunities for private sector growth. Recent progress includes the adoption of the SOE Act in 2013, the closure of underperforming SOEs, and the measures taken to commercialize and improve the operational efficiency of other SOEs (Box 5).

Improving the Efficiency of State-Owned Enterprises1

The SOE Act approved in 2013 was an important milestone, stipulating the requirement for every SOE to operate as a successful and sustainable business. The key areas of focus are the following:

  • Improved financial reporting and governance. All SOEs (currently 18) should submit Statement of Intents no later than 2 months before the beginning of the financial year. This allows SOEs to think strategically, improve their business plans and better manage their cash flows. The number of civil servants on SOE Boards has also been reduced.

  • Greater transparency of subsidies, in particular through introducing on-budget subsidies covering community service obligations.

  • Restructuring. Because the public sector had expanded excessively into several commercial activities that could be undertaken by the private sector, it was decided to assess for each SOE whether it should be kept as a fully public entity (and possibly restructured), privatized, or moved towards a public-private partnership model. Decision criteria included the SOE primary role (commercial, regulatory, administrative), its supply of community service obligations, and its viability.

  • Monitoring. The Act also established the SOE Monitoring Unit within the Ministry of Finance and Economic Development to monitor the performance of all SOEs.

Significant steps have already been taken, with the assistance of the Asian Development Bank and the World Bank. Several SOEs were successfully privatized (government hotel, government retailer, and Telecommunications Company) and a few others should be transformed into public-private partnership concessions (shipping and shipyard), although the majority will remain under government control. The government is also merging the two SOEs in the coconut sector to improve efficiency. Overall, profitability of most SOEs has been improving. Future technical assistance will assist in seeking solutions to improve performance of the electricity company.

1 Prepared by Malie Lototele, AsDB

20. Staff also encouraged the authorities to speed up the restructuring of the energy sector. Notwithstanding recent improvements and plans for further increasing the efficiency of the electricity and oil importer/distributor companies, the financial situation of the former remains a drain on public sector resources and also undermines the performance of the latter through payment arrears. Going forward, rationalizing the structure of both fuel and electricity prices (cushioning the impact of higher tariffs through targeted transfers for the poor) would be an important step towards increasing the transparency of public sector operations and improving the provision of essential services. The current level of oil prices provides an opportunity to implement these changes without delay.

Authorities’ Views

21. The authorities remain fully committed to the SOE reform agenda. On the energy sector, they noted the need to see more efficiency gains in the electricity company and to wait for upcoming technical assistance before considering additional measures.

C. Fostering Financial Deepening

22. The recent credit expansion has been driven by personal loans, largely from public financial institutions (PFIs). The financial system is composed of one commercial bank (a joint-venture between ANZ and the Government of Kiribati), the Development Bank of Kiribati (DBK), the Kiribati Provident Fund (KPF—the national pension plan), an insurance company, and a few credit unions. The recent increase in personal loans was mainly triggered by increased lending from PFIs: KPF small loans scheme (SLS) and personal loans from DBK. The rise in personal loans have boosted short term consumption and retail activity, but the boom may be short-lived given still limited growth prospects, and increasing risks to the financial sector.

Kiribati: Outstanding Banking Loans, 2012–14

article image

KPF’s small loan scheme: data is estimated.

Source: Kiribati authorities and IMF staff calculations.

23. Financial system development is an essential element of the growth strategy, but PFIs should not expand into commercial ventures. The increase in the DBK personal loan portfolio is not consistent with its development bank mandate, and staff recommended against its further commercialization by expanding into deposit taking, in particular given the poor track record of loan collection (NPLs in the DBK remain high at around 20 percent in 2014) and without supervisory and regulatory frameworks in the country. In the same vein, the KPF should not allocate a larger share of its investment portfolio to commercial real estate, as this creates high risks for participants in the system.5 Liquidity in the commercial bank (ANZ) has been ample after the repayment of public sector overdrafts, which creates room for lending to the private sector. Facilitating private sector access to credit would therefore be best achieved by removing structural impediments: improving financial education, land access procedures, dispute resolution mechanism, recovery processes and financial reporting.

A01ufig10

Commercial Banks Outstanding Deposits and Loans

(In percent of GDP)

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: IMF Financial Acess Survey and staff calculations.

Authorities’ Views

24. The authorities agreed that some of these plans were risky and noted that Cabinet approval was required for any substantial change in the activities of public financial institutions.

D. Improving Social Outcomes

25. Extreme (food) poverty is low in Kiribati (around 5 percent), but basic needs poverty is relatively widespread. The share of population with income below the cost of acquiring enough food for adequate nutrition and other essentials such as clothing and shelter is around 22 percent, with over 24 percent in the main urban center of South Tarawa. About half of all households do not have access to toilet facilities and access to safe drinking water is available to about 65 percent of households.

26. Kiribati also faces challenges in improving health and education outcomes. Rising population density, particularly in South Tarawa, increases risks of communicable diseases. Non-communicable diseases (diabetes in particular) also represent a significant challenge. On education, about 57 percent of the population reached the secondary level, but only about 3 percent the tertiary level.6 At the same time, education and health already represent the two largest items in the budget. Kiribati is also among the top Pacific Island countries in terms of health expenditures as a percent of GDP and ranks twentieth in the world.7

27. Given fiscal constraints, Kiribati will need continued support from donors and IFIs. Future donor-supported projects should focus on improving the provision of basic services such as water, electricity, housing, education, and health. The relatively high share of health and education expenditures as a percent of GDP and as a share of the budget is partly a result of high fixed costs due to the lack of scale, but also suggests that there is room for efficiency gains, particularly in personnel management (Figure 3).

Figure 1.
Figure 1.

Kiribati: The Setting in a Cross-Country Context

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: IMF LIC data and staff estimates.
Figure 2.
Figure 2.

Kiribati: Macroeconomic Prospects

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: Kiribati authorities and IMF staff estimates.
Figure 3.
Figure 3.

Kiribati: Health, Education Expenditure, and Selected Human Development Indicators

Citation: IMF Staff Country Reports 2015, 207; 10.5089/9781513526805.002.A001

Sources: World Bank, WDI; board paper “Macroeconomic Developments and Selected Issues in Small Developing States” and IMF staff estimates.

Pacific Islands: Health Expenditure in 2013

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Source: World Bank, World Development Indicators.

Authorities’ Views

28. Education and health will continue to be the highest priorities going forward. While acknowledging possible efficiency gains, the authorities emphasized challenges remaining in the health and education sectors, in particular insufficient resources to maintain capital assets and inadequate supplies in hospitals. Several infrastructure projects are being implemented to improve water access and sanitation.

A01ufig11
* Density computed as inhabitants per square kilometers. The variable was rescaled by taking log of the density multiplied by 1,000. Efficiency measured as secondary enrollment rate divided by public education expenditure-to-GDP ratio. Efficiency measured as life expectancy divided by public health expenditure-to-GDP ratio, 1990–2012. (Red dots: Kiribati)Source: Board Paper “Macroeconomic Developments and Selected Issues in Small Developing States” (FO/DIS/15/40).

Staff Appraisal

29. Economic performance has been strong, buoyed by large donor-financed infrastructure projects. Staff projects real GDP growth will remain above 3 percent in 2015, while inflation should stay low.

30. The fiscal position has improved markedly, but further efforts are needed to ensure sustainability. We commend the authorities for achieving substantial fiscal surpluses in recent years, although the improvement was mainly driven by record-high fishing license fees which can be volatile. Recent increases in recurrent expenditures are partly explained by a more transparent support to SOEs. Nevertheless, the historical pace of increase in spending is unsustainable over the long term.

31. Nominal expenditure growth should be limited to 1½ per year over the next years. In order to enhance fiscal discipline, budget contingencies should be built in for unexpected expenditures consistent with this expenditure path. Public sector wages and SOEs’ subsidies should be contained to create room for pro-growth and climate change-related expenditures. Expenditure growth path may be increased over time when the fiscal position has strengthened and become more sustainable, depending on the fishing license fees outturn.

32. The introduction of the VAT has overall been successful and revenues are in line with expectations. Consideration should be given to phase out existing exemptions and replace them with targeted support of low income households. If exemptions are to be maintained, the list should be short and narrowly defined.

33. Strengthening the RERF should remain a key policy goal. Important progress has been made in reforming RERF financial management. Transfers and withdrawals should be more transparent and symmetric around the proposed expenditure path: subject to maintaining a cash buffer equivalent to around two months of budget expenditures, a substantial part of the current above-average surpluses should be saved to allow for sustainable drawdowns when they fall below the average. Accordingly, the major part of the 2014 surplus should be transferred to the RERF.

34. Progress has been made in creating conditions for private sector growth. Going forward, further lowering telecommunication and transportation costs, streamlining business registration processes, and facilitating the private usage of land will be critical to improve the investment climate and lift growth prospects.

35. There has also been progress on implementing the reform of SOEs to improve their efficiency and contain the drain on public finances. Going forward, the authorities are encouraged to further reduce the copra subsidy and speed up the restructuring of the energy sector through further increasing the efficiency of the two energy companies and rationalizing the structure of both fuel and electricity prices.

36. Given fiscal constraints, Kiribati will need continued support from donors and IFIs. Future donor-supported projects should focus on climate change mitigation measures, and improving the provision of basic services such as water, electricity, housing, education, and health.

37. It is recommended that the next Article IV consultation takes place on the standard 12-month cycle.

Table 1.

Kiribati: Selected Economic Indicators, 2009–17

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Sources: Data provided by the Kiribati authorities; and Fund staff estimates and projections.

Current balance excludes grants and development expenditure.

Balances assume A$25 Million from the 2014 surplus are transferred to the RERF

The Australian dollar circulates as legal tender.

Index, 2005=100.

Table 2.

Kiribati: Summary of Central Government Operations, 2009–20 1/

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Sources: Data provided by the Kiribati authorities; and staff estimates and projections.

Expenditure path based on staff recommended “active policies” scenario

Includes subsidies to copra production.

Development expenditure equals grants plus loans for development projects.

Current balance excludes grants and development expenditure (see footnote 2 above)

Overall balance in the table is different from official budget because loans are classified as financing.

Table 3.

Kiribati: Medium-Term Projections, 2009–20

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Sources: Data provided by the Kiribati authorities; and Fund staff estimates and projections.
Table 4.

Kiribati: Outstanding Banking Loans, 2007–14

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KPF’s small loan scheme: data is estimated.

Source: Kiribati authorities and IMF staff calculations.
Table 5.

Kiribati: Balance of Payments, 2009–20

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Sources: Data provided by the Kiribati authorities; and Fund staff estimates and projections.

Includes fishing license fees, which would be shown as current transfers under conventional international guidelines.

Including errors and omisions for projections.

Excludes valuation changes.

Comprises the Consolidated Fund, Development Fund, and STABEX Fund.