Solomon Islands: Staff Report for 2016 Article IV Consultation and the Fifth and Sixth Reviews Under the Extended Credit Facility Arrangement
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
23 Mar 2016
eISBN:
9781498371865
ISBN:
9781498371865
Language:
English
Keywords:
ISCR; CR; debt; government; ECF arrangement; deficit; cash reserves; capital spending; development agenda; government priority; procurement process; Budget planning and preparation; Natural disasters; Currencies; Pacific Islands; Asia and Pacific; Medium-Term Development Plan
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Solomon Islands is a small island state, a low-income country that is severely affected by external shocks, including commodity price declines, natural disasters, and climate change.

Abstract

Solomon Islands is a small island state, a low-income country that is severely affected by external shocks, including commodity price declines, natural disasters, and climate change.

The Setting and Outlook

1. Solomon Islands is a small island state and a low-income country that faces severe development challenges as well as great opportunities. Some challenges are common to other small Pacific island nations in fragile situations: vulnerability to external shocks, including terms of trade, natural disasters and climate change; poor infrastructure; high dependency on aid; a history of social unrest; and weak capacity. The population is geographically dispersed—with 80 percent living in rural areas. The economy has traditionally been supported by logging activity as well as agriculture. But with the forestry sector expected to decline over the medium and long term, new sources of growth and a more diversified economy are needed to keep living standards from falling. Tourism has enormous potential as well as its combined synergies with agriculture. Moving up the value chain in the fishery sector also has great potential. All this will require better infrastructure, improved public financial management (PFM), and a better business climate to attract much-needed FDI to finance development needs. External financing and technical assistance from development partners will continue to be important in meeting these challenges and tapping these opportunities.

The ECF-supported program has helped enhance resilience and strengthen institutions

2. Solomon Islands has achieved remarkable gains in macroeconomic and financial stability with the help of structural reforms since the ECF arrangement started in December 2012 (see Box 1). Policy buffers have been rebuilt and are currently among the highest in the Pacific and among other small states. Leveraging on the achievements of two previous back-to-back IMF programs supported by Standby Credit Facility arrangements since 2010, the ECF arrangement has been instrumental in strengthening macroeconomic management capacity and institutions. Important reforms have been implemented: Public Financial Management (PFM) reforms (with a new Public Financial Management Act and the introduction of a multi-year budget framework; a new debt management framework to strengthen debt management capacity and sustainability); and financial sector reforms such as the new Central Bank of Solomon Islands Act to enhance Central Bank’s independence (MEFP, Table 1). These reforms have helped strengthen macroeconomic management. Despite the low access, the ECF-supported program has been instrumental in catalyzing donors support. The pace of reforms has slowed over the last year but progress has continued. Under the ruling coalition led by Prime Minister Sogavare, the policy focus has shifted to rural development and more recently, to anti-corruption. Given delays associated with the completion of the structural agenda for the fifth review and sixth reviews, the authorities have requested an extension of the ECF-supported program through end-March 2016 and that the fifth and sixth reviews be combined.

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Policy buffers have been rebuilt

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: IMF staff calculations.1/ Estimates.

Growth remains solid despite natural disasters…

3. The economy is estimated to have grown by 3¼ percent in 2015, led by logging activity, tuna processing, construction, and retail services. The country continues to be subject to natural disasters and climate and weather-related events: the impact of Cyclone Raquel and El Niño caused a reduction in agricultural output. Inflation has remained contained at 2.9 percent (year-on-year) in December, shifting from deflation early in the year. Inflationary pressures were driven by higher food prices owing to the depreciation of the Solomon Island dollar vis-à-vis the U.S. dollar and the effects of El Niño-related drought on the domestic food supply. After a strong recovery in the first half of 2015, donor support and FDI both weakened in the second half. Net international reserves remained flat at US$506 million at end-December 2015 relative to 2014 (US$496 million) equivalent to 9.8 months of imports (Table 1).

Table 1.

Solomon Islands: Selected Economic Indicators, 2012–17

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

Includes disbursements under the IMF-supported programs.

Includes SDR allocations made by the IMF to Solomon Islands in 2009 and actual and prospective disbursements under the IMF-supported

The 2015 numbers refer to November.

4. Near-term prospects remain favorable. In 2016, growth is expected to stay solid, at 3 percent. Activity will be driven by investment in construction, communications, and manufacturing—owing to a new brewery and tobacco factory, and higher yields from increased tuna processing capacity. Because of the current economic slowdown in China, lower demand for logging exports is expected in the near term. The ongoing El Niño event—forecast to continue at least until the first half of 2016—will reduce fish catch as well as agricultural production. Inflation is expected to stabilize around 1.5-3 percent in the near term. Continued low fuel prices are also likely to support consumption and lower production costs. The current account deficit will widen slightly to 4.5 percent of GDP in 2016, but the external position should remain strong, with net international reserves projected at 9.6 months of imports.

5. New sources of growth are needed in the medium term. With the continued fall in logging production, growth will need to be supported by increased productivity across a wide range of sectors, including agriculture, tuna processing, and tourism. Boosting the economy’s competitiveness by investing in infrastructure is also key to strengthening medium-term growth. The planned decline in aid from Regional Assistance Mission to Solomon Islands (RAMSI) which will be totally wound down by 2017, could pose additional medium-term challenges. Given the weaker prospects for mining activity and more frequent natural disasters, staff has lowered the countries’ potential growth from 4 to 3 percent. The current account deficit is expected to widen somewhat to support imports related to large infrastructure projects.

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El Niño has already affected crop production…

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: IMF staff estimates.1/ September for Tonga.
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…and could further impact GDP growth in 2016

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: IMF staff calculations. Based on methodology in IMF WP/12/154, WP/ 15/89, and WP/15/125; and an event analysis.

…but headwinds are strong

6. Risks to the outlook are tilted to the downside. Weaker growth in emerging Asia—especially China—could worsen Solomon Islands’ growth prospects,1 including through lower-than-expected demand for log exports. The outlook for nickel mining continues to be clouded by protracted litigation; and the nascent bauxite sector is not expected to contribute to near-term growth despite the recent resolution of licensing disputes. El Niño will likely weigh on agriculture and fisheries. Long-standing plans for large infrastructure projects—the Tina River Hydropower Plant and submarine cable projects2—could have stronger-than-expected positive spillovers, although their implementation could be delayed again.

Authorities’ Views

7. The authorities’ economic outlook is broadly consistent with that of the staff. They also see risks tilted to the downside and mainly external. Weakening growth in emerging Asia is a source of concern.

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ECF Arrangement: Recent Performance

Summary of Program Performance Indicators

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Note: Key quantitative performance criteria from MEFP, Table 2.

Reserves reported at program exchange rates.

8. Program performance has been broadly satisfactory. All end-December 2014 PCs, end-March 2015 ITs, end-June 2015 PCs, and end-September 2015 ITs have been met by considerable margins. The exception is the Indicative Target (IT) on government-funded recurrent spending on health and education, which was narrowly missed at each test date due to a tighter procurement process by development partners. The forthcoming regulations under the Public Financial Management Act should help enhance government’s procurement process. Net international reserves remain at comfortable levels. The cash balance for December 2015, although outside the monitoring of the program, stood at SI$694 million (3.2 months of recurrent spending). The government has also maintained cash reserves of the consolidated accounts at SI$140 million (0.7 month of recurrent spending) (Table 1 and MEFP Table 2).

9. Structural reforms have continued in the context of the ECF arrangement and the program’s objectives have been achieved. As indicated in the MEFP, the authorities remain firmly committed to completing the reforms even after the ECF-supported program expires. The pace of the legislative process is proceeding steady, as the authorities’ commitment to tabling several bills at the next sitting of Parliament, even though continued capacity constraints in the Attorney General’s Chambers and the complexity of these legislations have slowed down the process.

  • Implementation of benchmarks related to the new customs and excise bill (end-September 2015 benchmarks) is proceeding and the bill was approved by the cabinet in February, together with the Policy Paper on the Credit Union legislation (end September 2015 benchmark) which will be integrated into a draft bill (end September 2015 benchmark) already prepared with the TA support by the Asian Development Bank and will be vetted by the Attorney General once approved by cabinet. The recent approval by the cabinet signals the strong momentum for these bills to proceed to the next stage of the enactment process. Similarly, a policy paper for cabinet submission is being prepared for the National Provident Fund (NPF) bill.

  • On education policies, progress in implementing the two benchmarks has been made. The rebalancing of spending away from tertiary education has been met in 2015.3 Policies on the award and continuation of tertiary scholarships have been tightened to achieve better targeting and contain costs. The government has identified problems with the quality and quantity of the teaching cadre that will require greater investment in tertiary teacher preparation programs to meet projected supply needs at the elementary/secondary level.

  • Regarding the benchmark on implementing regulations of the Constituency Development Funds (CDF) Act, the authorities, in consultation with PFTAC, have proposed an alternative commitment to increase transparency and accountability in the use constituency funds: namely the implementation of procurement regulations under the Public Financial Management Act, which apply to all government procurements. Thereby the regulations of the CDF Act have been superseded by the enactment of the Public Financial Management Act. Steps have been already taken to improve the accountability and transparency of these funds through more disciplined procurement processes and the application of the PFM Financial Instructions. In staff’s assessment, this alternative commitment addresses issues of accountability and transparency, which was the intent of the original benchmark, and is an adequate substitute.

  • The benchmark on the publication of the results of the audit reports on the use of spending of CDFs is close to being met. The audit reports have been completed by the Auditor General and will be submitted to Parliament at the next sitting before they are released to the public.

Solomon Islands—Synergies Between the Structural Agenda under the ECF Arrangement and Macro-Financial Stability

The structural reforms under the ECF arrangement have helped enhance macroeconomic and financial stability. Even where reforms are still in progress, the preparatory groundwork is continuing to support their implementation in due course.

  • The new Central Bank of Solomon Islands (CBSI) Act, by providing more independence to the Central Bank has helped maintain a sound fiscal position (December 2012 benchmark) and has strengthened the effectiveness of monetary policy.

  • The benchmarks related to debt management strategy, including SOE borrowing policy, on-lending policy and guarantee policy have contributed to increase fiscal space.

  • PFM reforms (the New Public Financial Management Act, budget strategy document, mid-year budget review and final budget outcome report, and multi-year fiscal framework) have helped strengthening fiscal institutions.

Reforms that are still in progress are also important for financial and macro stability:

  • In anticipation of the new financial institutions Act—developing financial instruction was a June 2014 benchmark—the CBSI has already laid the groundwork and issued or endorsed several Prudential Guidelines in these areas. For example, in 2015 CBSI issued two Prudential Guidelines to banks on more disclosure on bank fees and charges levied on customers and a complaints management framework and procedures for banks for dealing with complaints from customers. The issue of consumer protection is also very important in the CBSI leading role on financial inclusion, which has been also covered by a benchmark under the ECF-supported program (March 2013 benchmark).

  • In February 2016, in anticipation of the new FIA, the CBSI Board endorsed a Fitness and Propriety Regulation for applicants who apply for a license to establish a financial institution in Solomon Islands as part of the licensing and governance requirements. This regulation will be submitted to the Minister of Finance for further endorsement and gazetting.

  • In anticipation of the new Credit Union Act, the CBSI Board has endorsed a new Prudential Guideline on Credit Union Investments as part of good corporate governance. This guideline came into force on 1 March 2016.

The CBSI Board also endorsed a new Prudential Guideline on Investments for the National Provident Fund (NPF) that will come into force after further consultations with NPF.

Beyond the ECF-supported Program

10. When the arrangement expires, staff plans to continue the close engagement built over the last few years. This will include the provision of policy advice on a 12-month Article IV consultation cycle on macroeconomic policies and structural reforms that are macro critical in close coordination with other development partners. In line with Fund’s new commitments under the Financing for Development agenda to increase its focus on fragile states, we aim to step up IMF TA and trainings over the medium term. Given the focus of the government on rural development the Fund could support these objectives by offering policy advice and TA in key areas of Fund’s work (macroeconomic stabilization, strengthening fiscal framework, resilience to natural disasters, revenue mobilization, and financial inclusion). This would be done in close cooperation with development partners whose primary focus is in rural development such as the World Bank Group and the EU.

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Rural Development in Solomon Islands: Possible Areas for IMF Engagement

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: IMF staff compilation.

Policies to Support the SDGs—Investing in Resilience and Fostering Financial Inclusion

11. Achieving the Sustainable Development Goals (SDGs) is at the top of the government’s development agenda. In the forthcoming National Development Strategy (NDS) covering 2016–35, the authorities have identified five specific development objectives and aligned them to corresponding Sustainable Development Goals (SDGs).

12. To achieve the SDGs and align them in a coherent policy framework, the authorities have developed a five-year rolling plan—the medium–term development-plan (MTDP) 2016-20. Approved by Parliament in December, the MTDP is designed to translate the government’s long-term development objectives into operational priorities and specific programs and projects, and also align them with annual budget plans for line ministries. The MTDP has been submitted to the Board by the authorities as the economic development document (EDD) and meets the Fund’s requirements under the new policy for poverty reduction strategies. The plan lays out specific reforms in the main economic sectors and proposes important advances in land policies, governance, and anti-corruption. It identifies priority spending areas and strategies to enhance spending effectiveness, including by further strengthening public finance management to reach better resource allocation decisions. It sets out policies to manage the impact of climate change and natural disasters that can jeopardize development outcomes, including through greater emphasis on disaster risk preparedness and mitigation.

Solomon Islands: SDGs Identified in the 2016–35 National Development Strategy (NDS)

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Staff compilation.

13. In building stronger institutions and achieving the related SDG, an anti-corruption bill is being prepared, with drafting to be completed in the first quarter of 2016. This bill is one of the government’s top priorities and aims to put the bill before parliament by mid-2016 (MEFP, paragraph 8). The Anticorruption Bill is being accompanied by the Whistle Blower Bill and a revamped Ombudsman Bill. Measures to strengthen the anti-corruption framework will help enhance transparency in the use of public resources, could improve business climate, and boost investor confidence.

14. A review of the former NDS covering 2011-20 prepared by the Ministry of Planning in February 2015 found that only 28 percent of the indicators reflected any progress towards meeting the 2020 targets. Real GDP growth per capita fell short of expectation after the end of the commodity super cycle. Progress has been achieved in water and electricity supply, and communication, but not in transportation. Solomon Islands did not make any progress in the human development index (HDI) in recent years. The labor participation rates by youth and gender have not improved. And despite progress in electrification, electricity consumption per capita is one of the lowest among all small states.

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Pacific Islands Countries: Human Development Index Ranking

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Note: Higher ranking implies a lower achievement in human development. No ranking in 2008 for Kiribati and MicronesiaSource: UNDP.
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Infrastructure Quality: Electricity Generation Per Capita

(Percentile ranks)

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

The MTDP has a strong emphasis on poverty reduction and allocates resources totaling SI$183 million (2 percent of GDP) to this end. The plan includes investments in water supply and sanitation, a constituency renewable rural electrification program, and a national food security enhancement program. Overall, SI$730 million (or 8 percent of GDP) has been earmarked for health, education, and human resource development under the MTDP.

15. Enhancing policymaking in four key areas would help Solomon Islands attain its development goals. It will also help lock in the progress to date in strengthening macroeconomic performance and institutions under the IMF-supported programs. In line with the NDS objective and corresponding SDGs, the Article IV Consultation thus focused on the following policies:

  • Enhancing resilience to natural disasters and climate change;

  • Preserving fiscal space while investing in resilient infrastructure;

  • Enhancing monetary and exchange rate policy tools for stability and growth; and

  • Promoting financial deepening and inclusion to foster inclusive growth

A. Policy Framework to Enhance Resilience to Natural Disasters and Climate Change

16. Climate change and natural disasters are macrocritical in Solomon Islands. The combination of its location (along the ring of fire of the Pacific Rim) and its small size heightens its vulnerability to earthquakes, cyclones, tsunamis, and floods. The damage and losses related to flash floods in 2014 were estimated at 9 percent of GDP.

17. IMF staff analysis suggests that natural disasters in the Pacific have a negative impact on both short-term and potential growth.4 A natural disaster with damages and losses equivalent to 1 percent of GDP causes a drop in GDP averaging 0.3 percentage point in the year of the disaster. Given the large impact of the natural disasters, potential growth in Solomon Islands is estimated to be lower by 0.3 percentage point per year.

18. In the context of the Medium-Term Development Plan, the authorities have designed several programs on both climate change mitigation and adaptation. The Ministry of Agriculture contributes to both these goals by shielding farmers from the impact of natural disasters and climate change; enhancing soil conservation and management; improving land fertility or using crops that are climate-change-proof; and enforcing the regulatory framework. The government is currently setting up a contingency fund for natural disasters.

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Solomon Islands is highly vulnerable to natural disasters and climate change according to different metrics

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Staff’s Views

19. Enhancing resilience to natural disasters and climate change entails a multi-pillar strategy at the national, regional, and multilateral levels. It also requires enhancing Solomon Islands’ risk-management capacity. The key pillars of disaster risk management, before the event, include:

  • undertaking a risk assessment; at the national level, building ex-ante resilience entails identifying risks and explicitly integrating them into the fiscal frameworks and budget planning. This should be achieved by incorporating the projected fiscal costs of climate change and natural disasters into annual budgets within a medium-term framework;

  • providing self-insurance by building policy and financial buffers to enhance resilience to shocks. Although the current level of macroeconomic buffers is adequate, in recent budgets 0.1-0.25 percent of GDP were put aside for natural disasters purposes only. In addition to accumulating reserves and maintaining fiscal space (keeping debt low), buffers could be accumulated also in the National Transport Fund, a donor-financed infrastructure fund fully integrated in the budget;

  • reducing risks by enhancing preparedness, including by investing in “smart” infrastructure that can better cope with climate change and natural hazards and by enhancing debt-management capacity;

  • transferring risk, either through catastrophic sovereign insurance or other newly created sub-regional schemes (i.e., “Emergency and Stabilization Fund for Melanesian Countries”).

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Multi-Pillar Framework: Strengthening Ex-Ante and Ex-Post Resilience

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: Cabezon, Hunter, Tumbarello, Washimi, Wu (2015), Enhancing Macroeconomic Resilience to Natural Disasters and Climate Change in the Small States of the Pacific, IMF Working Paper 15/125. Green shows where the IMF plays a role.

20. Ex-post disaster risk management includes strategies to manage the impact of a disaster and facilitate a rapid recovery. At the national level, the main actions include emergency response and reconstruction efforts. A sound reconstruction program should consist of measures to reduce such risks through resettlement away from the coastline, where feasible, and infrastructure investment. Reconstruction can serve to accelerate broader growth-enhancing structural reforms. Donor financing will remain important in enhancing the ability to cope as these countries are too small, and the costs too high, to be fully internalized by building buffers.

Authorities’ Views

21. The authorities agreed with the multi-pillar approach proposed by staff. The government is currently setting up a contingency fund for natural disasters. It seeks to reduce risks by enhancing preparedness, including by investing in resilient infrastructure and by enhancing debt-management capacity.

22. Regional solutions to transfer risks are also being considered. Solomon Islands decided to withdraw from the third and final pilot of the Pacific Catastrophe Risk Insurance for the Pacific islands, a joint initiative led by the World Bank Group with financial support from Japan, because it did not qualify for payout during the 2014 floods as disbursements are linked to specific physical parameters (e.g. the wind speed triggering a cyclone) that were not triggered despite the massive floods. The authorities are considering whether to participate in the newly proposed Melanesian Emergency and Stabilization Fund (around US$500 million), covering not only natural disasters as well as also other macroeconomic shocks with balance-of-payment impact, and is meant to provide immediate liquidity ahead of support from the international financial institutions.

B. Preserving Fiscal Space and Investing in Resilient Infrastructure by Improving the Quality of Public Spending

23. In 2015, actual fiscal policy was much less expansionary relative to the original budget. The fiscal deficit is estimated at just 0.3 percent of GDP relative to the 5.7 percent budgeted. The smaller deficit was due to two factors: first, more buoyant revenues (equivalent to 2.8 percent of GDP) owing to higher fishing license fees and international taxes as the forestry sector surprised on the upside (with this increase more than compensated by the drop in goods and services taxes as a result of lower value of fuel imports); and second, lower government-funded development spending of 2 percent of GDP and donor-funded development spending of 0.6 percent of GDP relative to the original budget. Despite a higher payroll (1 percent of GDP), the other recurrent spending funded by the government (which includes allowances, and payment to state-owned-enterprises for community services, and scholarships) fell by almost the same amount, also the result of limiting tertiary scholarships. The increase in payroll reflects a cost of living adjustment of 4 percent to all public servants, teachers and police from July 1, 2015 as well as the use of overtime and allowance by line ministries.

24. The fiscal deficit was financed by a small drawdown in the cash balance (SI$21 million) and SI$2 million in external loans. The decline in cash balance between 2015 and 2014 was much larger than implied by the deficit, because it also reflected the repayment by the government of SI$100 million of domestic debt in mid-December, mainly to the central bank, commercial banks, and NPF, and additional scheduled amortization (totaling SI$147 million or 1.6 percent of GDP).

Summary of Fiscal Accounts, 2014-15

(In percent of GDP)

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Sources: Country authorities and staff estimates.

Includes both recurrent and development spending.

Includes unpresented checks and statistical discrepancy.

Drawdown of the Cash Balance in 2015

(In millions of Solomon Islands dollars)

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The small fiscal deficit in 2015 has been financed by using SI$21 million of cash balance and SI$2 million of extenal loans.

Sources: Country authorities and staff estimates.

25. The small deficit in 2015 relative to 2014 was driven by higher non-tax revenue (1.3 percent of GDP). On the expenditure side, after a slow start due to delays in passing the budget until April, the pace of both recurrent spending and development spending picked up in the second half of the year. Implementation of government-funded development spending—a substantial part of which is constituency development funds (CDFs)—was far higher (4 percent of GDP) than in 2014 in line with the larger share of this spending in the 2015 budget.

26. In terms of spending composition, the 2015 budget and outturn include a higher share of capital spending. In 2014 capital spending amounted to 5.2 percent of GDP, while in 2015, it reached 7.8 percent, of which 35 percent was in constituency funds.

27. Fiscal risks have increased going forward. The 2016 budget approved in December envisages a deficit of 5.7 percent of GDP, about the same as the 2015 budget. As in the past, if fully implemented, the budget implies a sharp decline in cash reserve (to SI$197 million). However, revenue projections are very conservative, with a drop of 3.3 percentage points of GDP (excluding grants) relative to the 2015 outturn, and upside surprises may occur, especially in nontax revenues. Based on more realistic revenue projections as well as assuming an 85 percent implementation rate of government-funded recurrent spending and a 90 percent implementation rate of government-funded development spending (in line with recent experience), the actual deficit will likely be closer to 1.5 percent of GDP, with the cash balance at SI$544 million at the end of 2016.

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Solomon Islands: Capital Spending

(In millions of SI$)

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Country authorities and staff estimates.1/ 2015 includes only government-funded capital spending.
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Solomon Islands: Government-Funded Recurrent Spending

(In millions of SI$)

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Country authorities and staff estimates.
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Solomon Islands: Government-Funded Development Spending

(In millions of SI$)

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Country authorities and staff estimates.

Staff’s Views

28. Given large development needs (including infrastructure, health, and education), fiscal space should be used for infrastructure investment and to build resilience over the medium term, given the country’s vulnerabilities and the uncertain outlook. A balance should be struck between building buffers and spending. Maintaining fiscal buffers is essential to enhancing resilience to shocks—including to natural disasters. While the increase in spending for capital investment to upgrade infrastructure and improve health and education outcomes is welcomed, the pace and scale of spending needs to be made consistent over the medium term with the country’s absorptive capacity, the revenue envelope, and the availability of financing. It should also reflect realistic plans for revenue mobilization. The rate of drawdown in the cash balance implied by the 2016 budget should be contained as well as the pace of spending. Improving the quality of public spending and using the cash balance wisely are paramount in view of the uncertain growth prospects and vulnerability to natural disasters and other external shocks.

29. Given the increase in fiscal risks with regard to the implementation of the 2016 budget, staff’s specific recommendations included:

  • urging the authorities to preserve cash reserves as a buffer against natural disasters and other shocks and to keep total reserves (including the consolidated cash balance) at no less than two months of total spending to anchor fiscal plans in the near term. This will imply keeping the total cash balance at a minimum of SI$595 million at end 2016. Going forward, greater attention must be paid to cash management particularly to cash flow forecasting. More accurate cash flow forecasting would also improve the analytical value of the mid-year budget review which currently evaluates inflows and spending relative to a standard assumption of equal monthly proportions, despite historical data that shows seasonality for some receipts and spending;

  • re-iterating the importance of using the budget as a tool to anchor fiscal planning and emphasizing the need for fiscal consolidation beginning 2017. Staff stressed that unrealistic budget projections are counterproductive—and jeopardize the external financing so critical for supporting the country’s economic development plans;

  • stressing the importance and urgency of improving budget presentation and reporting on budget execution by continuing PFM reforms. The latter will be key to assess the quality of public spending. For example, while the 2015 budget appropriately allocated more spending to capital projects, given the large infrastructure needs; however, the budget outturn does not report to the public the implementation of capital spending. A clearer identification of capital spending, which is now reported under both recurrent and development spending, will also better highlight government priorities;

  • urging continued efforts to improve the quality of public spending including strengthening the accountability of constituency funds. While this expenditure item meant to provide public service delivery to a broad spectrum of the population, it is important to ensure that the rate of return on this spending is higher than the opportunity costs of building buffers by enhancing its quality and accountability. The mission provided suggestions for a simple supplement to the development budget that would describe for each constituency fund the planning processes, development achievements, and future plans for CDF use. Providing this information in publicly available documents is important as these funds are viewed by the government as one of the major tools to support rural development;

  • welcoming the authorities’ intention to scale up infrastructure investment to support higher and inclusive growth, given the large infrastructure gap. The National Transport Fund is an important vehicle for investing in infrastructure, with the authorities’ plans on the driving seat.

  • stressing the need to strengthen revenue mobilization (including non-tax revenue), including by leveraging technical assistance where possible. This will be key to financing infrastructure spending and preserving debt sustainability. Exemption will also need to be streamlined as the revenue base will narrow with the depletion of the forests for logging.

  • advising the authorities to anchor fiscal plans over the medium-long term to a non-commodity primary deficit target of 2.5 percent of GDP. This will help manage revenue volatility including from natural disasters and promote fiscal sustainability. Realistic spending plans should also be pursued by sequencing development projects within a medium-term fiscal framework to carefully align resources with spending capacity; and

  • highlighting the importance of incorporating risks associated with natural disasters and climate change into the macro framework and DSA to enhance risk assessment ex ante, in line with the government’s priorities.

30. The mission strongly welcomed the authorities’ intention to establish quarterly internal fiscal targets when the ECF-supported program expires. These targets will help preserve fiscal buffers and better calibrate spending plans (see paragraph 33 below and paragraph 11 of the MEFP).

31. Fiscal space has been rebuilt and Solomon Islands has one of the lowest debt levels among peers and non-peers—at 10.4 percent of GDP. Yet, the DSA suggests that Solomon Islands continues to face a moderate risk of debt distress, consistent with the 2013 assessment in light of its vulnerability to external shocks and need to scale up infrastructure spending to finance development. Although there is no breach of debt sustainability thresholds under the baseline, under some alternative scenarios, thresholds are breached, notably the thresholds for the present value of government debt relative to exports and GDP. The authorities should be cautious in resuming concessional financing. Total public debt rises above the threshold in the extreme permanent low growth scenario. The analysis highlights Solomon Islands’ ongoing vulnerability to external risks and heavy reliance on imports and aid. Staff included in the baseline 0.2 percent of GDP as recurrent spending and 0.3 percent as development spending as mitigation costs to natural disasters and tailored an extreme-weather-event scenario. On the upside, the country’s debt management framework and capacity are strong, thanks to a series of PFM reforms as indicated in the MEFP (paragraph 13).

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The large fiscal spaces should be used to invest in infrastructure and human development

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Authorities’ Views

32. The authorities remain committed to maintaining fiscal discipline and a strong cash reserve after the IMF-supported program expires (MEFP paragraph 11). They intend to target the broad definition of cash balance (cash balance plus the reserves in the government consolidated deposit account equivalent to SI140 million) at no less than two months total spending. In addition as the ECF arrangement expires, the authorities are planning to put in place internal quarterly fiscal targets, similar to the one set in the past with the IMF, to lock in gains in terms of fiscal management achieved over the last few years.

33. The authorities are strongly committed to further strengthening PFM measures. Actions include: the implementation of the PFM Roadmap, including finalizing the draft Procurement Rules and Regulations as well as other implementing instructions for the 2013 PFM Act. The authorities are considering requesting assistance from PFTAC to improve cash flow forecasting and management.

34. The authorities concur with the importance of strengthening the fiscal framework. They are open minded on the use over the medium term of the non-commodity balance as a fiscal anchor to help manage volatility of revenues and ensure a smooth path of infrastructure spending to support rural development. They asked the mission team to continue to work together with their staff over the next few months to further discuss the choice of a fiscal anchor also in the context of building resilience to natural disasters.

C. Enhancing Monetary and Exchange Rate Policy Tools for Macroeconomic Stability and Growth

35. Monetary policy has been very accommodative in an effort to support growth—as shown by a number of indicators—high levels of bank liquidity and the very low interest rates on Bokolo bills. Credit growth reached 19 percent in November (y/y) driven by loans to households, including consumption and mortgages; and lending for investment in manufacturing and communication; and logging sector. Nonetheless, relative to GDP, credit remains at about 20 percent, much lower than in other Pacific islands and small states. Credit growth has partly fed into higher imports. Staff’s econometric analysis suggests a strong positive and statistically significant relationship between domestic credit and imports, after controlling for food and fuel prices.

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Monetary policy remains accommodative given high excess reserves

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: Central Bank of Solomon Islands.

36. The monetary transmission mechanism remains weak amid high excess liquidity. The CBSI currently uses its own debt instruments—Bokolo bills—as a tool to manage banking sector liquidity but issuance has been sufficient to absorb only a portion of the excess liquidity in the system. Bokolo bill auctions were conducted on a fortnightly basis and the amount floated was kept at SI$355 million per auction throughout the year. While there was evidently an appetite for increased Bokolo bills from the commercial banks, particularly following the takeover of Westpac by Bank South Pacific (BSP), it was decided that any excess liquidity that the banks held should be directed to private sector lending. Efforts to promote interbank lending and the establishment of a repo facility were also explored. As for Treasury bills, which are also administered by the CBSI on behalf of the government, the cap on the outstanding stock remained at SI$40 million throughout 2015.

37. The basket peg regime has worked more effectively since the removal of the operational 1 percent band around the exchange rate against the US dollar in September 2014, and the widening of the bid offer spread. The basket peg has allowed the SI dollar to weaken against the US dollar by 10 percent since then along with other currencies in the region. The Solomon Islands dollar appreciated by 12 percent against the Australian dollar over the same period, reflecting the strengthening of the US dollar against most currencies. In real effective terms, the exchange rate has been stable since the removal of the band (Box 3). Communication to the public on exchange rate policy has been strengthened by publishing the basket rate on the CBSI website. This has helped promote stability of the trade weighted index, despite some volatility.

A01ufig15

Since September 2014, the SI dollar has depreciated vis-à-vis the US$ and appreciated vis-à-vis the Australian $

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Central Bank of Solomon Islands; Bloomberg; and IMF, staff estimates.
A01ufig16

The basket peg regime has worked well since the removal of the operational band but some volatility remains

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Central Bank of Solomon Islands; Bloomberg; and IMF, staff estimates.

Staff Views

38. Excess liquidity has not fed into higher inflation, but credit growth has picked up strongly over the past two years and the authorities should begin mopping up excess liquidity. Staff’s econometric analysis suggests that credit growth of 10 percent could increase inflation by 0.6 percentage point within a year. The CBSI could use the CRR (cash reserve requirement) ratio to manage bank liquidity, and treat the level of excess liquidity more explicitly as a quantitative target. While increasing the CRR alone will not be sufficient to mop up excess liquidity completely, in combination with reforming the NPF (see paragraph 51), it could help the CBSI gain traction in liquidity management.

39. While the basket regime is working well, it can be made more flexible through a periodic review and adjustment of the appropriateness of level of the peg to ensure it remains supportive of competitiveness and economic growth. An assessment of external balance suggests that the exchange rate may already be somewhat overvalued (Box 3). While more closely tracking the exchange rate basket has slowed down the erosion of competitiveness from the appreciation of the US dollar, it has not addressed the overvaluation of the exchange rate that was carried over from the previous regime (i.e., when the currency was closely pegged to the dollar). It will also not prevent future real appreciation, caused by underlying inflation differentials. To avoid this and correct for the overvaluation, the CBSI should periodically review the level of the exchange rate and adjust its level if necessary. With China being the most important export market, the authorities should consider including the renminbi in the basket.

Authorities’ Views

40. On monetary policy, with regard to using the CRR ratio as a tool to manage liquidity, the CBSI expressed concern that not all banks are in a position to shoulder the additional burden of a higher CRR. Technical assistance on how to conduct liquidity swaps is being provided by the Reserve Bank of Australia.

41. On exchange rate policy, the CSBI noted that the effective implementation of the basket peg has allowed some flexibility to absorb external shocks, thus reducing the burden on monetary policy. The authorities noted that the rise in inflation was driven by the depreciation of the Solomon Islands dollar. They did not rule out devaluation in the future and indicated that they would monitor competitiveness indicators to identify situations where the strength of the exchange rate might be acting as a drag on growth. They also plan to keep the composition of the basket under review and consider later this year whether to include the renminbi in the basket.

D. Toward Greater Financial Development, Stability, and Inclusion

42. Despite progress, the domestic financial sector remains underdeveloped, and the reach of financial service providers has been limited. According to a comprehensive index of financial development constructed by staff—applying a methodology pioneered by Čihák and others (2012)—that combines indicators of financial depth, access, and efficiency for financial institutions and markets, Solomon Islands has lagged small states peers in financial development (but not other low-income-countries).

A01ufig17

According to staff’s newly constructed index, Solomon Islands lags most peers in financial development…

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: IMF staff estimates, based on the methodology in SDN/15/08 (Table A1), and Čihák and others (2012).
A01ufig18

…including in accessing the banking system

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: Finstats Database.

The limited size of commercial bank deposits relative to GDP also places Solomon Islands among the most underbanked countries of small states. Other measures of financial inclusion also point to limited access to financial services (Figure 2).

Figure 1.
Figure 1.

Solomon Islands: The Cross-Country Context

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Sources: Country authorities; and IMF staff estimates.
Figure 2.
Figure 2.

Solomon Islands: Financial Access and Inclusion

Citation: IMF Staff Country Reports 2016, 090; 10.5089/9781498371865.002.A001

Source: Finstats Database; IMF staff estimates.

43. The financial sector has a simple structure but is beset with inefficiencies. These reflect the small domestic market, inadequate infrastructure, the difficulty of securing collateral due to communal land ownership, and generally high transaction costs. Interest rate spreads have long been the highest among small states in the Pacific. The financial sector consists of two major foreign commercial banks, one domestic bank, a non-bank financial institution), and a saving and retirement fund—NPF, a systemically important financial institution with a large share of its assets held as deposits in the banking system.5 The impact of de-risking on costs of sending remittances has started to emerge with a few small money transfer operators having ceased operations. However, the impact of these closures is not as large as in other Pacific Islands.

44. The CBSI has been proactive in promoting financial inclusion. In 2014, together with commercial banks, the CBSI introduced mobile banking services to deepen financial access in geographically dispersed and remote areas, making Solomon Islands a leader in mobile banking services among Pacific small states, with mobile banking well positioned to leapfrog conventional banking in providing financial services. The government’s national financial inclusion target for 2015 of opening 70,000 new bank accounts was met ahead of time, as was the subsequently revised target of 160,000. In February 2016, the National Financial Taskforce, chaired by the Governor of the CBSI, endorsed Solomon Islands’ National Financial Inclusion Strategy (NFIS) for 2016–20. The strategy will introduce new financial inclusion targets for the upcoming years and promote higher usage of financial services.

45. While credit has grown by double digits since 2013 (Table 4), the financial sector indicators remain sound. The thinness of the domestic financial sector has resulted in occasional volatility in indicators of bank asset quality. The non-performing loans (NPL) ratio, however, moderated to 4.1 percent at the end of 2015, below its 5½ percent long-term average, after temporarily spiking in the second quarter. The domestic financial sector has undergone significant consolidation. In October 2015, the CBSI approved the plans of the Australian bank, Westpac, to sell its Solomon Islands operations to the PNG Bank South Pacific (BSP). As a result, the total number of banks is reduced from four to three. The increase in BSP’s market share has significantly increased market concentration in the banking sector as measured by the Herfindahl-Hirschman Index (HHI), from an average of 30 percent to 40 percent, with 100 percent being a monopoly.6

Table 2.

Solomon Islands: Medium-Term Baseline Scenario, 2012–20 1/

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Sources: Data provided by Solomon Islands authorities; and IMF staff estimates and projections.

Includes disbursements under the IMF-supported programs.

Includes SDR allocations made by the IMF to Solomon Islands in 2009 and actual and prospective disbursements under the IMF-supported programs.

Defined as nonlogging and nonmineral revenue (excludes grants) minus government-funded recurrent and development spending excluding interest payments.

Table 3

Solomon Islands: Summary of Fiscal Accounts, 2013–17

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Sources: Data provided by the Solomon Islands authorities; and IMF staff estimates and projections.

Includes spending financed by recurrent grants.

Includes changes in the stock of unpaid payment orders and unpresented checks (+ = reduction) and the statistical discrepancy.

Defined as the sum of government deposits in the cash balance accounts minus unpaid payment orders and unpresented checks.

Total spending is defined as total recurent spending and government-funded development spending in line with the consolidated budget presentation.

Defined as nonmineral nonlogging revenue (excludes grants) minus government-funded spending excluding interest payments.

Table 4.

Solomon Islands: Summary Accounts of the Banking System, 2013–16 1/

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Sources: Data provided by the Central Bank of Solomon Islands; and IMF staff estimates and projections.

Based on actual and projected exchange rates.

Includes claims of the CBSI on other (nonbank) financial corporations.

Weighted average of different maturities, period average.