The Maldives economy has shown remarkable dynamism over the past two decades that has brought living standards to middle income levels. The economy has shown resilience following the 2004 tsunami and slowdown in global growth, but remains highly dependent on tourist receipts. To maintain robust growth, the authorities have identified critical infrastructure upgrades that will entail a spike in foreign financing but are expected to propel the country’s growth potential. The authorities appreciate the constructive dialogue with staff on the potential implications of up-scaling infrastructure investment and, to some extent, agree with the assessment and recommendations.

Large external imbalances that were identified a decade ago—a current account deficit exceeding 35 percent of GDP—have significantly diminished reflecting the dynamic growth in tourism as well as the overhaul of external sector statistics with Fund Technical Assistance (TA). Tourism activity has outperformed its peers in recent years, except in 2015 when the rapid market expansion from China, Russia, and Ukraine slowed. As a small island economy, Maldives will continue to depend on imports, but strong tourism growth and foreign direct investment averaging over 10 percent of GDP have helped sustain reserves, limit pressure on the exchange rate peg, and contain external debt.

Like other small states, especially ones with a widely dispersed population, government expenditures in the Maldives are much higher than in countries at comparable income levels. Current expenditure reached 35 percent of GDP in recent years, following sharp increases in the wage bill, subsidies, and health care costs. Following the modernization of the tax authority and tax system since 2011, Maldives outperforms its neighbors in terms of tax collection and the efficiency or productivity of its taxes, as highlighted by staff.

The authorities’ 2016 budget targets a narrowing of the fiscal deficit by 1¾ percent to 6.7 percent of GDP after accounting for a 240 percent increase in capital expenditure to nearly 20 percent of GDP in 2016 to be financed by higher tax and non tax revenues as well as grants. The sharp increase is meant to signal the intention to upscale infrastructure spending, but the pace of implementation will depend on the availability of revenue or financing on favorable terms. The authorities aim to delay some projects if tax collection disappoints or if the expected non tax revenue from resort leases or grants does not materialize. Setting aside the near term spike in spending on megaprojects, the authorities believe they will be able to contain the growth in the fiscal deficit to GDP in future years by containing the growth in the wage bill and in health costs, and by significantly boosting GDP growth. The authorities will continue to consider additional fiscal measures, including a bridge toll or a higher airport departure tax, broadening the base of the business profits tax; and expenditure savings through better targeting of subsidies, improved oversight of SOE finances, and potential for greater use of renewable energy.

Spending on the three megaprojects that aim to raise the economy’s overall growth is estimated to amount to 30 percent of GDP over the next three years. The first of these projects is the expansion of the airport which is currently running at close to full capacity and whose upgrade is essential to sustain strong growth in tourism. The second project aims to support population resettlement to a large island near the capital and an airport that would reduce the cost of service delivery to the outer islands, help adapt to climate change, and improve job opportunities. The third project aims to relocate and expand port facilities to ease bottlenecks and improve resilience to climate change. These three high-priority projects will be mostly foreign-financed, at reasonable market cost, and subject to detailed feasibility studies. The initial viability assessments anticipate a sizeable growth impact and ample room for Maldives’ tourist industry to grow.

The authorities understand staff’s debt sustainability concerns but believe staff’s assessment—that the investment upscale-up will only add ½ percent to GDP growth—does not adequately capture growth prospects. First, the authorities expect continued market expansion for tourism and expect the economy to benefit from the gradual recovery of growth in Europe and expansion of Asian markets, aided by the opening of many new hotels now under construction, and the extension of airport capacities. The low price elasticity of demand in the Maldives could allow strong tourism growth despite dollar appreciation, with a positive impact on construction, communications, and fishing. They question the rationale for the staff’s downgrading of growth in the next few years compared to the previous DSA and anticipate growth to return to 6 percent levels. Second, staff’s assumption that public investment efficiency would be in line with the average of less developed countries seems too conservative, especially when Maldives’ tax system operates more efficiently than its peers (as highlighted in Appendix II and the SIP). Fund TA is supporting the further strengthening of public financial management, including of the capital budget to ensure maximum investment benefits. The authorities will be receiving IMF TA in June to conduct a public investment management assessment and to provide advice on prioritizing future investment projects within a well-defined budget envelope. Third, while the authorities understand that the DSA is based on current announced policies, Maldives has a strong track record of implementing staff recommendations, particularly in terms of tax reforms. Although a fully fleshed-out medium-term budget framework is not yet in place with time-bound measures and explicit contingency plans, they informed staff that they would consider broadening the tax base and that expenditures will be deferred if revenues disappoint or the fiscal position worsens.

In this regard, and since other island economies plan to upscale infrastructure investment to boost growth, the authorities have asked that the Fund review the DSA framework to take account of the special circumstances for small states that are necessarily reliant on large borrowing to harness the economic gains from the investment scale-up. The authorities believe that the growth dynamics should be better reflected in the DSA; they also believe that the assessment that Maldives’ debt distress has not only deteriorated but it currently faces high risk of external debt distress is a byproduct of the overly conservative growth projection and is unduly alarming.

The authorities are committed to the stabilized exchange rate regime within the currency band and agree with staff that continued improvement in the fiscal position is the best way to support it. The exchange rate has stabilized since the 2011 devaluation; the capital account is very open; and the economy highly dollarized. Like other countries pegged to the dollar, the real exchange rate has appreciated by 30 percent since 2011. There is an active parallel market, which is structural in nature due to the size of dollar-denominated tourist transactions, with a relatively stable premium. The operation of the exchange system will remain under review, taking into account market developments. Regarding the Article VIII issues, the authorities believe the deviations from the official rate would remain until the fiscal deficit narrows and official reserves strengthen.

The MMA eased monetary policy by significantly reducing the marginal reserve requirement in 2015 which helped reduce borrowing cost, boost private credit, and lengthen maturities on sovereign bonds. Despite this easing, the overall expansion in monetary aggregates remained contained in 2015, reflecting lower net foreign assets and sluggish growth of private sector credit in the first half of the year. Credit picked up in the second half of the year after a long spell of stagnation. Enhancing financial inclusion is a national priority and the authorities would welcome Fund support, including providing information on successful experiences elsewhere. They are moving toward mobile banking services through the use of Dhoni Banking Units to reach the outer islands. An announced sovereign guarantee scheme for private sector loans in tourism aims to rejuvenate investment in some projects that were stalled during the global financial crisis. In designing the scheme, the authorities plan to limit its size and its contingent cost. More generally, the MMA continues to reinforce its supervisory capacity and activities, within a risk-based approach.

The authorities’ national development plan for climate adaptation was shared with staff. It highlights the challenges and policies considered important to mitigate the impact of climate change. The authorities agree that there is scope for a more strategic approach that would set in context current infrastructure plans and include more systematic climate adaptation planning, including reporting on the budgetary impact. The authorities agree with staff’s suggestion to quantify and present the climate adaptation policies in each budget. It is hoped that adding such detail would help access possible financing. They would welcome specific examples of how this has been done by others. They also see merit in a more coordinated planning of the different investment projects and monitoring of their implementation.

The development of special economic zones could help diversify economic activity in labor intensive sectors. The authorities take note of staff’s concerns regarding excessive tax incentives and the potential for tax erosion or tax evasion, which could be mitigated by adequate reporting procedures. Safeguards will be considered when viable projects are under consideration.

The Maldives authorities welcome the opportunity to have an open and candid exchange of views with staff on their current challenges and policies. They appreciate the Fund’s valuable TA and look forward to a continued fruitful engagement with the Fund. They also welcome the Fund’s increased focus on issues of relevance to small states under the leadership of DMD Zhu.