Kiribati: Staff Report for the 2016 Article IV Consultation
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
09 Sep 2016
eISBN:
9781475535860
Language:
English
Keywords:
ISCR; CR; government; Kiribati; real GDP; dollar; development partner; GDP; cash reserves; investment strategy; real value; climate change resiliency; SOE portfolio; Climate change; Budget planning and preparation; Infrastructure; Return on investment; Global; competitiveness hinge
Download PDF (623.5 KB)

Kiribati is a small and fragile state vulnerable to climate change. Record high fishing revenue in recent years has boosted growth, improved the current account, and strengthened the balance of the sovereign wealth fund, the primary vehicle for intergenerational saving. However, fishing revenue has declined in the early months of 2016 and is projected to remain at more modest levels over the medium term. Building fiscal buffers to enhance resilience and continued support from development partners are essential to mitigate downside risks to growth.

Abstract

Kiribati is a small and fragile state vulnerable to climate change. Record high fishing revenue in recent years has boosted growth, improved the current account, and strengthened the balance of the sovereign wealth fund, the primary vehicle for intergenerational saving. However, fishing revenue has declined in the early months of 2016 and is projected to remain at more modest levels over the medium term. Building fiscal buffers to enhance resilience and continued support from development partners are essential to mitigate downside risks to growth.

Context

1. Kiribati is a small and fragile state. The country faces development challenges due to its geographical disadvantage and vulnerability to climate change. With a population of roughly 120,000 sharing a territory of 33 remote islands spread over 3.5 million square kilometers of ocean, lack of scale and high transportation cost limit production opportunities. Growth averaged around 1.8 percent in 1998-2014, compared to the average growth of 2.1 percent in other small island states in the Pacific. With the lowest income per capita in the region, about a fifth of the population lives below the basic needs poverty line and access to clean water and sanitation remains restricted for many. Long-run prospects are further clouded by sea level rise—low elevation of the atolls (1.8 meters on average) make them particularly vulnerable to coastal erosion and groundwater contamination.

2. Extreme remoteness and large dispersion underpin the high cost of public service delivery in Kiribati. The public sector dominates the economy (text chart), while private sector activity—mostly fishery, subsistence agriculture and retail trade—remains limited. Weaknesses in infrastructure (text chart), business climate and financial intermediation pose further development obstacles. Limited job opportunities in the private sector, coupled with the fast growing labor force, has led to a high youth unemployment rate at around 50 percent.1

uA01fig01

Government Spending and Connectivity

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: IMF Working Paper 15/124.
uA01fig02

Infrastructure Indicators, 2015 1/

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

1/ Or latest data availableSources: World Bank, WDI; U.S. Energy Information Agency; National Statistics Office of Solomon Islands; and IMF staff estimates.

3. Fishing license fees and development partner assistance contribute the bulk of Kiribati’s income. The Revenue Equalization Reserve Fund (RERF), Kiribati’s sovereign wealth fund, serves as the primary vehicle for intergenerational saving. Revenue from fishing license fees are historically volatile, but regional cooperation through the introduction of the Vessel Day Scheme (VDS) 2 and favorable weather conditions have significantly improved its performance in recent years (text chart). As the fishing license fees are collected in the U.S. dollar, the strengthening of the dollar vis-a-vis the Australian dollar (A$), Kiribati’s legal tender, also contributed to higher fees. The strong revenue in 2015, nearly 100 percent of GDP (A$220 million), halted a prolonged period of relying on drawdowns from the RERF to finance the budget deficit (text chart). Nonetheless, following lower receipts in early-2016, the authorities forecast the license revenue to halve to around A$100 million in 2016, in line with the historical average of the last seven years, leading to a decline in real gross national income (GNI) of about 20 percent following several years of strong growth. Donor grants amounted to nearly 50 percent of GDP in 2015, the highest in the Pacific region (Figure 1).

Figure 1.
Figure 1.

Kiribati: The Cross Country Setting

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

uA01fig03

Fishing volumes and values

(In thousands of metric tonnes)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Sources: Kiribati Authorities, World Bank, and Forum Fisheries Agency
uA01fig04

RERF Withdrawals and Fishing License Fees

(In millions of AUS$)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: Kiribati Authorities.

Recent Developments, Outlook and Risks

4. Growth remained strong at 3½ percent in 2015, thanks to the record high fishing revenue. Donor-financed infrastructure investment and reconstruction in the aftermath of cyclone Pam further supported growth. Inflation remained contained at around 0.5 percent owing to low food and commodity prices, in line with the global trends.

5. High fishing revenue contributed to a recurrent fiscal balance of almost 50 percent of GDP in 2015, more than offsetting the increase in government recurrent spending of 13 percent. Public debt increased from less than 10 percent of GDP in 2014 to 23 percent of GDP at the end of 2015 owing to the commencement of the Bonriki International Airport repair and upgrade project, financed by development partner concessional loans.

6. The current account surplus reached 40 percent of GDP in 2015, with fishing revenue more than offsetting elevated imports related to donor financed projects. Seamen’s remittances also recovered somewhat after years of decline with the slowdown in global trade (text chart). Reflecting developments in the Australian dollar, the exchange rate has depreciated in real effective terms to below the historical average. Nonetheless, competitiveness remains hindered by structural factors (Box 1).

uA01fig05

Seamen’s Remittances

(In millions of USD)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: South Pacific Marine Services, Kiribati.

7. A new government took office in March 2016 following the general and presidential elections. Mr. Taneti Maamau, a former finance secretary and candidate of the Tobwann Kiribati Party, became the country’s fifth president since its independence in 1979. The new government pledged to pursue a more even distribution of sovereign wealth between the current and future generations, implying an increase in current spending and less savings into the RERF. The 2016 budget passed in May envisaged an increase in recurrent spending by 9 percent, mostly due to increased subsidies and grants including a doubling of the copra subsidy program3.

8. Growth is projected to moderate to around 3 percent in 2016 as several large infrastructure projects come to completion and fishing revenue is projected to decline sharply. Inflation is expected to remain low at around 1.5 percent in 2016, while picking up to around 2.5 percent over the medium term, in line with trading partner inflation and international food and fuel price dynamics (the bulk of Kiribati’s consumer price basket comprises imported items). With the expected fall in fishing license fees, the current account is expected to reverse to a deficit of 7 percent of GDP in 2016 and to converge to a near balanced position over the medium term.

9. Risks to the outlook are on the downside (Annex I). Changing climate cycle could increase uncertainty for fishing revenue over the medium term, as the VDS has not been tested in a low revenue environment for Kiribati since its implementation. Global financial market turmoil can feed into the domestic economy through the exposure to foreign assets of the RERF and the Kiribati Provident Fund (KPF), the country’s two main savings vehicles. Given Kiribati’s high reliance on imported goods, commodity price shocks and volatility in the Australian dollar could swing imports in ways hard to accommodate. Without a central bank, fiscal policy is the only macroeconomic policy lever and buffer against such shocks.

Authorities’ views

10. The authorities broadly shared staff’s assessment of Kiribati’s economic outlook. They pointed out that fishing revenue could be highly volatile with risks on both sides. They felt that it was appropriate to aim for a modest increase in public spending on subsidies, education, and health for long run economic and social returns. They also noted that the recent increase in copra subsidies was important to support more inclusive growth, including by providing income opportunities in the outer islands, and could help reduce health care costs due to overcrowding on Tarawa. They acknowledged Kiribati’s vulnerability to natural disasters and climate change related shocks and were mindful of the need to maintain buffers against such shocks.

Kiribati: External Competitiveness and Exchange Rate Assessment

Kiribati’s real effective exchange rate (REER) continued to depreciate for much of 2015 and remains below its historical average after stabilizing since the beginning of the year. The REER has closely tracked changes in the Australian dollar circulating as the legal tender. Nonetheless, the real exchange rate has limited effect on Kiribati’s current account developments. With a small and narrow export base (copra, fish and seaweed), receipts are dominated by fishing license fees, donor flows and RERF investment returns, all largely driven by exogenous factors. Kiribati is also heavily reliant on imported goods, and consequently sensitive to swings in global commodity prices. An assessment based on EBA-lite methodologies would therefore not be meaningful nor feasible due to data limitations.

uA01fig06

Real Effective Exchange Rate

(Index, 2010 = 100)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

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

Beyond the exogenous factors, Kiribati’s competitiveness hinges on continued efforts to boost private sector development and addressing long-standing structural impediments. Lack of scale, high transportation costs and infrastructure deficits remain key structural challenges. Kiribati also continues to lag Pacific island countries on average under several of the World Bank’s Ease of Doing Business rankings. Securing grant instead of loan financing for development investment remains critical for containing risks to external sustainability.

The use of Australian dollar as the legal tender remains appropriate. It provides a strong nominal anchor given close trade and financial linkages with Australia (high share of RERF assets are invested in Australian markets) and limited capacity to run an independent monetary institution. Kiribati has accepted the obligations under Article VIII of the IMF’s Articles of Agreement and maintains an exchange system free of restrictions on payments and transfers for current international transactions.

Enhancing Sustainability and Resilience

11. Prudent management of public resources remains the key policy priority. The authorities have made remarkable progress in strengthening the fiscal position. Reforms to improve the RERF governance have also been important steps towards better aligning its investment strategy with the fund’s long-term objectives. Nonetheless, the conditions underlying the strong fishing activity have started to wane. To support the government’s long run development agenda, budget decisions need to be taken in the context of a medium term fiscal framework with prudent assessment of spending goals, revenue projections and wealth management targets. Given the expected decline in fishing revenue and Kiribati’s susceptibility to climate change related shocks, this framework should embed adequate fiscal buffers which would likely imply saving much of the fishing revenue windfall. Further strengthening the RERF would also support the fund’s capacity to provide sustainable future income for intergenerational equity.

A. Strengthening the Fiscal Framework

12. Accommodating Kiribati’s considerable public spending needs in a fiscally sustainable way requires embedding policies in a medium-term fiscal framework. While the government’s balance sheet is currently strong owing to large RERF assets and relatively low public debt, available fiscal space is limited by the projected decline in fishing revenue and Kiribati’s continued high risk of debt distress. To support implementation of the authorities’ development plan in a fiscally sustainable way, this fiscal framework should include: (i) committing to a balanced structural budget over the medium term; (ii) strengthening the RERF as an anchor for long run fiscal sustainability by formulating a rule-based withdrawal mechanism; and (iii) maintaining an appropriately-sized cash reserve buffer to cope with revenue volatility and external shocks.

  • Committing to a balanced structural budget over the medium term. Steps are needed to ensure fiscal sustainability in the face of a projected moderation of annual fishing license fees to the A$100 million range over the medium term.4 On current policies, staff’s baseline projections envisage a widening of the recurrent deficit to around 10 percent of GDP over the medium term, resulting in a gradual depletion of the RERF (Box 2). A more sustainable outturn would be achieved by targeting a structurally balanced budget over the medium term, based on assumed fishing license fees of A$100 million (text table below). This would require fiscal adjustment of around 4½ percentage points of GDP in 2017 rising to 8½ percentage points by 2021 compared to the baseline scenario. The adjustment could comprise efforts to boost revenue collection (e.g., by phasing out VAT exemptions to restore tax revenue collection to the 2015 level) and steps to limit recurrent spending growth to under 1.5 percent per year. Staff advise to cap nominal spending on copra subsidies at the 2016 level and refrain from any increase in subsidies and grants beyond the 2016 budget commitment. Wage increases should also be set within the current wage policy framework which allows for a “wage drift” from the automatic promotion process without additional increases in salaries. The recommended structural budgeting approach would insulate spending from potential volatility in fishing license fees. In the event of a temporary surge in fees, the resulting fiscal surplus should be saved in the RERF, while any shortfall in fees relative to the A$100 million baseline could be met by transfers to the budget from the reserve buffer. As additional information is accumulated on license fee trends, the A$100 million baseline can be gradually adjusted, while preserving a structural balance to ensure fiscal sustainability.

  • Formulating a target-level for the RERF and a rule-based withdrawal mechanism. After strengthening the RERF, the structural balance target discussed above could be adjusted over the longer term to allow moderate annual financing from the RERF. This process should be rule-based and transparent, to simplify budget planning and to ensure that the RERF is maintained as an endowment fund that can provide the population with a permanent and stable stream of income. The sustainable level of the RERF drawdown depends on the government’s wealth management target (see Box 2 for a scenario analysis of the RERF). If the goal is to preserve the real value of the fund after reaching a certain level, the withdrawal rate should be limited to around 1-2 percent of the overall balance, assuming an average return rate on the fund of 3-5 percent5 and a long run inflation rate of 2.5 percent. The withdrawal could also be indexed to nominal GDP based on the projected long run average growth rate and the targeted return rate of the fund—under this approach the withdraw would be a more stable source of public financing, but it could also make the RERF balance more volatile depending on the return of the fund. In either case the drawdown from the RERF could be gradually adjusted if needed to preserve the real value of the fund in the event of shortfalls in investment returns. Maintaining the real value of the fund over the long run would also be consistent with the authorities’ policy to ensure a more equitable distribution of the income from the RERF between generations while protecting the capital growth of the fund.

  • Limiting the complementary cash reserve buffer to three months of recurrent expenditure. The sizeable cash reserves from the 2014-15 fishing license revenue in excess of this amount should be transferred to the RERF as soon as possible. On the basis of the 2016 level of current expenditure, this would leave a cash reserves buffer of roughly A$40 million (40 percent of the projected fishing revenue) against future temporary revenue shortfalls and external shocks. The policy of drawdowns from the cash buffer should be transparent and also ensure its replenishment when revenue exceeds expectations. Any fiscal surplus after replenishing the cash reserve buffer should be transferred to the RERF to expand its principal base.

Medium-term Fiscal Projections

(%of GDP)

article image

The 2016 current expenditure includes a one-off payoff to the Ministry of Health of A$2.2 million.

Source: staff calculations.

13. The VAT introduced in 2014 was a key element in fiscal reforms to reverse a decline in the non-fishing revenue since 2008. Implementation of the VAT has been broadly successful in diversifying the revenue base, but there remains scope for further improvement. The revenue outcomes in 2014–15 were in line with expectations and the new tax also had positive spillover effects on other revenue collection through improved record keeping and tax compliance. However, the VAT implementation was partially hampered by reintroduced SOE exemptions in late 2015, which was estimated to have reduced VAT collection by around 15 percent in 2016. As such, staff urge the authorities to phase out the SOE exemptions to ensure the credibility of the tax system and maintain a level playing field for public and private entities. Further training of tax office staff, greater utilization of improved IT systems and increased emphasis on tax payer assistance would also improve the overall performance of revenue collection.

14. Kiribati remains at high risk of debt distress despite of the RERF assets. As the RERF serves as a vehicle for intergenerational saving, it is not viewed as buffer against debt distress risk. In this regard, containing the risk of debt distress will require ensuring fiscal sustainability and securing grants to finance the country’s large development needs. Government borrowing through concessional loans should be closely monitored to safeguard long run debt sustainability.

Kiribati: Fishing Revenue and the Impact on the RERF

The RERF forms the primary savings vehicle for the Kiribati people. It was initially capitalized with revenue from phosphate mining royalties until deposits were exhausted in 1979 and continued to grow through its investment returns and modest drawdowns. However, acceleration in drawdowns to finance a sharp increase in current expenditure since the turn of the millennium and periods of negative investment returns in early 2000s and during the global financial crisis significantly eroded the fund’s capital base until recently.

Future growth of the fund will depend heavily on fishing revenue. Staff’s simulations indicate that in the baseline scenario, due to the projected decline in fishing revenue to around A$100 million dollars leading to a widening deficit that needs to be financed by RERF drawdowns, the RERF nominal balance will decline gradually to below A$800 million dollars by 2030. If a balanced structural budget can be achieved over the medium term, the RERF balance will reach A$1 billion by 2021 thanks to the accumulation of investment returns. If the authorities set the target to preserve the real value of the fund at the A$1 billion level, this would allow a 1.5 percent annual withdrawal equivalent to 5.5 percent of GDP in 2021. On the other hand, if fishing revenue declines to A$60 million (average level since 2001), the current pace of spending would be unsustainable, leading to a depletion of the RERF in about 15 years.

uA01fig07

RERF Balances in Different Scenarios

(A$, million)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: Staff projections

Preservation of the RERF’s real value would still imply some erosion in its value in per capita terms. Tolerance to this cost would ultimately depend on the authorities’ policy preferences for intergenerational income distribution and would need to be weighed against investment needs for economic and social development. At the current low-yield environment, a real per capita target would limit any drawdowns from the RERF given the projected long-run annual rate of population growth of 1.5–2 percent.

15. Any new investment expenditure plans should also be carefully framed within a stronger PFM framework. Given limited resources, priorities of public investment should be placed on functions that yield high economic and social returns, namely, infrastructure investment, regulatory framework and business facilitation services. Scaling up of infrastructure spending through the budget should be assessed on a case-by-case basis. Consideration should also be given to enhancing the monitoring and reporting of fishing revenue and further improving the monitoring and auditing of SOE and joint-venture liabilities.

Authorities’ Views

16. The authorities welcomed staff’s analysis on the medium term fiscal position and noted that the government had implicitly targeted a balanced budget historically. While the new government was still formulating its medium term fiscal framework, they saw drawings from the RERF as a last resort and then only for development, rather than recurrent, purposes. They welcomed staff’s recommendation for a rule-based withdrawal mechanism for the RERF and would consider it in the context of the government’s fiscal and development strategy. The authorities also expressed their intent to transfer the current cash reserves in excess of three months of recurrent spending to the RERF, a process that had been temporarily delayed given a change in wealth managers, in line with staff recommendations.

B. Enhancing Resilience to Climate Change

17. Climate change and natural disasters are macro critical for Kiribati. Kiribati’s land area consists almost entirely of low elevation coral atolls and with limited fresh water supply, making it vulnerable to sea level rise. Although the probability of natural disaster occurrences in Kiribati is less than 10 percent, half the regional average of around 20 percent, the cost tends to be large relative to the size of the economy: the 2015 Budget included one-off expenditures—mainly for Cyclone Pam related damages—equivalent to around 4 percent of GDP. Staff’s analysis of potential growth suggests that growth is likely to be 0.1 percent lower than the historical average of 1.8 percent over the long run due to climate change (Box 3).

18. Staff support the authorities’ efforts to improve Kiribati’s climate change resiliency, including through more explicit recognition of adaption costs. The authorities’ adaption approach is embedded in the Kiribati Joint Implementation Plan for Climate Change and Disaster Risk Management 2014–23 (KJIP) that seeks to integrate climate change and disaster risk sensitivities and impacts across sectors, identify measures to reduce vulnerabilities and coordinate priorities for action. The 2016-19 Kiribati Development Plan (KDP) also identifies climate change as one of the key priority areas, in line with the United Nations 2030 Agenda for Sustainable Development. In support of this approach, staff recommend that the budget include an explicit provision for climate change adaption costs and that outturns be monitored. The allocation would cover coastal protection, damage repairing, and soil desalinization, and should amount to around 2 percent of GDP annually over the medium term. Tracking of spending on climate change adaptation would help ensure adequate provision of resources, and would help in seeking donor funding for climate change projects. Additional room within the budget envelope is also needed to accommodate maintenance costs of the newly constructed infrastructure (about 0.5 percent of GDP). The cash reserve buffer as outlined above can enhance Kiribati’s ex-ante readiness to respond to natural disasters, backstopped by the RERF as a last-resort measure.

Authorities’ Views

19. The authorities were open to identifying climate change adaption cost in the budget, noting that current adaption projects, largely financed by development partners, were probably already at or above 2 percent of GDP. They also agreed that budget plans need to consider the infrastructure maintenance cost. They noted the challenges of catalyzing external climate change financing sources, including capacity constraints to meeting the access requirements.

Kiribati: The Growth Impact of Climate Change

Given Kiribati’s susceptibility to climate change and natural disasters, staff’s analysis of the baseline should explicitly reflect their long run impact. To the extent that the historical average growth already captures the average impact of periodical natural disasters1, the key question is how to quantify the growth impact of climate change. AsDB (2013)2 estimated that climate change is likely to have significant impact on agriculture, fisheries, tourism, environment protection and health, costing the Pacific 0.5–2.5 percent of GDP by 2050.2 Applying these sectoral impact on the level of GDP to Kiribati’s long run growth path, staff estimate that the average growth rate is likely to be 0.1 percent lower than the historical average of 1.8 percent, with the adverse impact of climate change on agriculture, fishing and tourism industries offsetting stronger growth in the service sector.

uA01fig08

Climate Change Impact: GDP Growth by Sector

(Year-over-year percent change)

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: IMF staff estimates.

While the largest component of GDP is the government sector, agriculture and fishing has the second largest share of economic activity. Due to higher incidences of climate related disasters, the output from the primary sector is declining and its share in total GDP has declined from one third in the 1990s to around 25 percent. An alarming issue is seawater intrusion from storm surges and high tides. This increases the saline content in soil (also a source of potable water for the people of Kiribati). The mining and quarrying industry is also affected by this. As arable and resource rich land depletes by rising sea waters, other sources of income generating activites are sought putting more strain on other sectors of the economy. Performance of other industries that are related to agriculture and fishing, and tourism, such as real estate, and wholesale and retail trade can be negatively affected. However, stronger aggregate demand places upward pressure on output thereby negating some, if not all of the unwanted spillovers.

1 Cabezon et al (IMF WP/12/125) showed that during 1980-2014, trend growth was 0.7 percentage point lower than it would have been without natural disasters in the Pacific region.2 The Economics of Climate Change in the Pacific, AsDB 2013.

Promoting Private Sector Development

20. Achieving more sustained and inclusive growth in Kiribati depends on creating conditions for private sector growth and expanding employment opportunities. Building on the success of recent reforms, the newly launched Kiribati Development Plan (2016–19) identifies key medium-term priority areas staging a pathway toward achieving the Sustainable Development Goals (Table 5). The focus of the new Plan remains on investing in human capital, expanding connectivity infrastructure, building climate change resilience and strengthening public sector reforms.

Table 1.

Kiribati: Selected Economic Indicators, 2012–18

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

Current balance excludes grants and development expenditure.

The Australian dollar circulates as legal tender.

Index, 2005=100.

Table 2.

Kiribati: Summary of Central Government Operations, 2014–21

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

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.

Projections assume the custodial account maintains cash reserves buffer of three months of current expenditure.

Table 3.

Kiribati: Medium-Term Projections, 2014–21

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

Kiribati: Balance of Payments, 2014–21

article image
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.

Table 5.

Kiribati: Key Priority Area and SDGs

article image
Source: Kiribati Development Plan 2016-19

A. Maintaining the Momentum of SOE Reforms

21. SOE reforms are important for creating space and a level playing field for private commercial operation and employment. The authorities have made commendable progress in SOE reforms through the adoption of the SOE Act in 2013, closure of underperforming SOEs, and measures to commercialize and improve operational efficiency (Box 4). Nonetheless, the costs of basic utilities—electricity, water and sanitation—remains high by regional standards, and improving the delivery of public utilities services is a key priority.

Kiribati: Progress in SOE Reforms and Future Priorities1

The SOEs serve a vital role in the Kiribati economy. Kiribati has sixteen active SOEs involved in a range of commercial activities including utilities, transport, communication and finance. In 2014 the SOEs represented 18 percent of the total capital stock of the country and contributed 12 percent to GDP. Kiribati’s SOE portfolio also achieved an average return on equity (ROE) of 3.8 percent and return on assets (ROA) of 2.9 percent for 2010–14, making the country a top performer in the region over that period.

The authorities have made substantial progress in improving SOE performance and reducing large and ad hoc subsidies. Most notable reforms include the reduction in operational SOEs from twenty-five to currently sixteen by 2016, the merger of the two SOEs in the copra sector, and the privatization of the telecom company. The government also plans to further reduce the number of SOEs to twelve over the next five years.

Considerations should be given to improve the compliance of the Community Service Obligations (CSO) policy. The lack of adequate compensation for CSOs has led to a flat trend in portfolio profitability in SOEs. While the SOE Act requires CSOs to be properly documented, and a price agreed with the government, it does not stipulate that the price allow SOEs to fully recover costs, including the cost of capital. Seven SOEs lodged CSO claims totaling $7 million for the 2014 financial year. Despite government allocating $4.5 million in the 2014 budget to fund CSOs, by October 2015 only $0.9 million had been paid. Inadequate funding and low utilization have hindered the government’s efforts to improve SOE performance and service delivery. In this regard, regular learning events and briefings for government officials and senior civil servants will ensure that there is ongoing political and bureaucratic support for the CSO policy.

1 Prepared by Lai Tora, AsDB.

22. Maintaining the momentum of SOE reforms is also important to contain the risk of contingent spillovers to the budget. The lack of funding for community service obligations (CSOs)—non-commercial services “purchased” by the government from the SOEs—remains a major issue undermining SOE performances. Although the budget recognized the subsidy to SOEs of A$5 million, it can fall short to cover the full cost of the CSOs based on previous years’ experience. The financing gap for SOEs to breakeven may widen even further due to rising commodity prices. Against this background, the authorities should consider strengthening the commercial mandate of the SOEs and consolidating SOE ownership responsibility under a single minister for both the operational goals of SOEs and their financial management. Continued divestment and outsourcing of SOE activities to the private sector will also help improve efficiency and strengthen public finances.

Authorities’ Views

23. The authorities reiterated their commitment to continuing SOE reforms with an aim to further reducing the number of SOEs while improving SOE performance and financial returns. They noted that the recent merger of the two SOEs in the copra sector would generate savings, partly offsetting the increased spending on copra subsidy.

B. Enhancing Infrastructure and Human Capital

24. Continued investment in business climate and infrastructure remain the key pillars for private sector growth and employment. Despite the substantial progress in improving physical infrastructure and connectivity, transportation needs still remain considerable while additional room for infrastructure spending within the budget envelope is needed. Promoting air transportation and shipping services could facilitate development of tourism as well as support recent private sector efforts to develop fishing and agricultural industries, while thorough feasibility analyses are needed to assess the economic benefits against the cost. Efforts to improve physical infrastructure should also go hand in hand with improving business climate, in particular through further streamlining of business licensing process by improving land registration.

25. Human resource development is one the key priorities of the government’s structural reform agenda. The authorities have launched a new strategic plan for the education sector, developed in collaboration with Kiribati’s development partners, focusing on improving the quality of teaching, refining the curriculum and improving related infrastructure. Staff welcome the authorities’ focus on improving the quality of education and training. Given the growth potential in the fishing industry, building human capital especially through vocational and technical training would help Kiribati better utilize its marine resources. Further development in other domestic sectors including tourism and routine infrastructure maintenance would also offer employment possibilities. Finally, international labor mobility presents a substantial opportunity for overcoming geographical constraints to employment. Improving workforce skills and strengthening institutional framework could help increase Kiribati’s participation in the overseas seasonal work schemes.

Authorities’ Views

26. The authorities vigorously agreed on the importance of further improving infrastructure and the business climate for private sector development. They placed high priority on promoting air transportation and shipping services and agreed that the costs and benefits of any investment in this area would need to be carefully assessed. Here they noted the importance of development partner support to get multiple viewpoints and to make informed decisions. They emphasized challenges remaining in land registration given the customary land ownership system. They also saw ongoing efforts to improve educational outcomes as a key stepping stone for promoting private sector growth, including through intensive community involvement to ensure that graduating students are better suited to workforce demands.

C. Fostering Sustainable Financial Deepening

27. Private sector credit has continued to expand, supported by public financial institutions. The Kiribati financial sector essentially consists of one commercial bank (a joint venture between the ANZ and the Government of Kiribati) and two public financial institutions (the Development Bank of Kiribati, DBK, and the Kiribati Provident Fund, KPF).6 The commercial bank primarily serves the public sector and larger private sector customers, with the public institutions financing most personal and small business loans. The credit expansion exposes these institutions to relatively high and correlated credit risks given borrowers’ susceptibility to common shocks and weak supervisory and regulatory frameworks. The recent regional withdrawal of correspondent banking relations has so far had limited impact on financial services in Kiribati, notwithstanding anecdotal evidence of increased compliance costs.

Outstanding Loans by Public Financial Institutions (PFIs)

article image

In gross terms before provisions.

Consists mostly of housing and student loans.

KPF’s small loans scheme.

Source: Development Bank of Kiribati and Kiribati Provident Fund; IMF staff calculations.

28. Enhancing financing deepening is an essential element to promote growth and employment. Unsecured household lending by the commercial bank is constrained by problems with obtaining collateral and recovery in case of default. In this regard, facilitating private sector access to credit would be best achieved by removing structural impediments and improving financial education, land access procedures, dispute resolution mechanism and loan recovery processes. The potential growth benefits are particularly large given the low level of financial deepening in Kiribati (text chart). The public financial institutions have a critical role in supporting access to financial services, but ensuring their long-term sustainability calls for strengthened risk monitoring and more decisive efforts to address longstanding weaknesses in their balance sheets.

uA01fig09

Financial Development Effect on Growth

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: IMF Staff estimates, based on the methodology in SDN 15/08 and Cihak and others (2012).

29. A more comprehensive approach is needed to address the KPF’s persistent funding deficit. Broadly positive investment performance over recent years has failed to close the KPF’s sizeable funding deficit that opened as result of negative returns incurred in 2008 (Box 5). To shore up the KPF’s long-term sustainability, staff encourage consideration of a more rules-based crediting policy linking the interest rates on member balances more closely to the fund’s investment returns.

Kiribati: Addressing the Financing Deficit of the Kiribati Provident Fund

The Kiribati Provident Fund (KPF) is a national compulsory saving scheme set up in 1977 and is de facto served as a savings fund for its participating members. Participation in the KPF is mandatory for all citizens employed in the public or private sector and the plan is funded by equal contributions from the employee as well as the employer. Citizens employed outside Kiribati, the unemployed, or the self-employed can participate on voluntary basis. KPF is the second-largest sovereign fund of Kiribati after the RERF, with most of the assets managed and invested overseas by external fund managers.

The persistence of the deficit reflects KPF’s high crediting rates that are inconsistent with sustainable rate of return on its investments. The KPF operates similarly to a cash-balance pension plan, where members are in effect owners of a balance that is carried forward year to year and accrues interest at rate determined annually by the KPF Board (crediting rate). Notwithstanding the fund’s persistent deficit, recent years’ crediting rates have been set substantially above the minimum rate of 4 percent, with the latest rate for 2015 set at 7.5 percent. In nominal terms interest on KPF members’ accounts amounted to AUD 9.5 million in 2015, substantially above the AUD 3 million increase in total investment assets, contributing to the widening deficit in 2015 to nearly A$18 million, roughly 15 percent of KPF’s total investments.

KPF’s investment returns are unlikely to remain consistently high to match the recent level crediting rates. While more buoyant investment returns over 2012–14 reduced the deficit somewhat, the current low interest rate environment and market volatility lowers average returns over the longer term. The average annual increase in the fund’s investment assets over past ten years was only 3 percent (roughly 5 percent over the past five years, excluding the nearly 20 percent loss incurred in 2008). Moreover, return expectations going forward may be further dampened by the current uncertain global investment environment. In this light, setting the crediting rate to its minimum 4 percent level would only gradually reduce the deficit.

uA01fig10

KPF Balance and Investment Performance 2005-2015

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Source: Kiribati Provident Fund, IMF staff calculations.

Introduction of a rules-based crediting policy could therefore be considered to secure the KPF’s long-term sustainability. As the KPF operates on a cash-balance basis, additional member contributions would be ineffective in reducing the deficit, since they simply increase the fund’s liabilities by the same amount. The deficit could in principle be eliminated by recapitalization by the government, but the fund’s financial position would remain vulnerable to further shocks in absence of additional measures to address the underlying drivers of its asset-liability imbalance. Crediting rates should therefore be explicitly linked to the fund’s investment returns to secure its long-term sustainability. To reduce annual volatility, the rates could be guided by multi-year average investment returns, e.g. over a 3-year period. In view of past volatility in returns, this may require lowering the minimum floor below its current 4 percent level, as well as symmetrically introducing a maximum cap that allows the fund to be replenished in years of high returns.

Concerning KPF’s overseas investments, consideration should be given to switching to a fully passive and potentially more conservative asset allocation. Vast majority (nearly 90 percent) of KPF’s investments are in diversified overseas portfolio and under external management. In light of the recent performance of the fund, a more conservative investment strategy may be more appropriate for KPF’s institutional investor role, where determination of risk-tolerance should put more emphasis on the need to protect the value of its assets, particularly in current absence of financial buffers to absorb losses. A fully passive mandate for both managers could also help reduce management fees.

Under such a policy the crediting rates could be guided by multi-year average returns to reduce year-to-year volatility. The minimum floor for the crediting rate could be accompanied by a maximum cap to allow for the fund’s replenishment in years of higher returns. Staff also recommend reviewing the KPF’s investment strategy to ensure its consistency with the KPF’s institutional role and closely monitoring the recent growth in the KPF’s exposure to the domestic economy, particularly through the small loans scheme offered to its members against their accrued balances.

30. While DBK’s recent performance has been positive, slow progress in addressing legacy doubtful loans raise concerns over asset quality. Further efforts are needed to address the persistently high share of doubtful loans in DBK’s loan portfolio, standing at roughly 23 percent of total loan stock (A$2.6 million) at the end of 2015. Staff also recommend reviewing that these loans’ current provisioning practice adequately reflects their expected rate of recovery. Further commercialization of DBK into deposit taking should accordingly be carefully weighed against its current risk monitoring capacity, including its ability to meet potentially correlated depositor demands in periods of stress, and limited reserves. Commercialization would also warrant development of the regulatory and supervisory frameworks and an assessment how it fits with the bank’s developmental objectives, including ensuring continued affordable access to financial services.

Authorities’ Views

31. The authorities saw the need to address the issues of the public financial institutions including the DBK’s financial situation and the sustainability gap of the KPF. They also pointed out that most household borrowings were backed by their provident fund savings and therefore did not constitute a systemic risk to financial stability. They stressed the importance of further enhancing financial deepening especially for the outer islanders.

Staff Appraisal

32. Kiribati’s recent economic performance has been strong. Record high fishing revenue has boosted growth, improved the fiscal position and strengthened the current account. Growth is projected to moderate somewhat to around 3 percent this year, while inflation is projected to remain subdued owing to low food and commodity prices. Risks to the economic outlook are largely related to external factors and on the downside.

33. Prudent management of public resources remains the key policy priority, especially against the projected decline in fishing revenue. Budget decisions need to be taken in the context of a medium term fiscal framework that could entail achieving a balanced structural budget in the medium term, strengthening the RERF as an anchor for long run fiscal sustainability, and maintaining a cash reserve buffer to deal with revenue volatility and external shocks. After strengthening RERF balances, the authorities should consider formulating a rule-based mechanism for RERF withdrawal with the aim to preserving the RERF as an endowment fund that can provide the population with a permanent and stable stream of income, with the government’s spending plans aligned to this mechanism.

34. Budget provision needs to explicitly recognize climate change adaption costs. Additional room within the budget envelope is also needed to accommodate infrastructure maintenance. Given the fiscal constraint and the high risks of debt distress, Kiribati needs continued support from development partners.

35. Maintaining the momentum of SOE reforms is important to support private sector growth. The authorities should consider further strengthening the commercial mandate of the SOEs and consolidating SOE ownership responsibility under a single minister responsible for both the operational goals of SOEs and their financial management. Continued divestment and outsourcing of SOE activities to the private sector will help improve efficiency and strengthen public finances.

36. Further improvement in infrastructure, business climate and human capital remains critical for private sector development and employment. This includes promoting air transportation and shipping services, streamlining business licensing process and improving land registration. Building human capital especially through vocational and technical training would help Kiribati harness its marine resources. Further development in other domestic sectors including tourism and routine infrastructure maintenance would also offer employment possibilities.

37. Financial deepening needs to be implemented in a more sustainable way. Long-term sustainability of the operations of public financial institutions calls for strengthened risk monitoring and addressing deficiencies in financial supervision. Plans to expand the DBK activities into deposit taking should be carefully assessed against its track record in recovering nonperforming loans and its capacity to assume the increased liability risk, while the crediting rates for KPF member balances should be more closely guided by its investment returns to address the financing deficit.

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

Figure 2.
Figure 2.

Kiribati: Recent Developments

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Figure 3.
Figure 3.

Kiribati: Labor Market Indicators

Citation: IMF Staff Country Reports 2016, 292; 10.5089/9781475535860.002.A001

Annex I. Risk Assessment Matrix 1/

article image

The Risk Assessment Matrix (RAM) shows events that could materially alter the baseline path (the scenario most likely to materialize in the view of IMF staff). The relative likelihood is the staff’s subjective assessment of the risks surrounding the baseline (“low” is meant to indicate a probability below 10 percent, “medium” a probability between 10 and 30 percent, and “high” a probability between 30 and 50 percent). The RAM reflects staff views on the source of risks and overall level of concern as of the time of discussions with the authorities. Non-mutually exclusive risks may interact and materialize jointly. “Short term” and “medium term” are meant to indicate that the risk could materialize within 1 year and 3 years, respectively.

Annex II. Main Recommendations of the 2015 Article IV Consultation

article image
1

According to the 2010 census.

2

The VDS, established under the eight-country Parties to the Nauru Agreement (PNA) in 2012, limits the number of days that fishing vessels are licensed to fish in PNA waters and sets the minimum fee for the VDS days ($8,000 for 2015–16). The majority of Kiribati’s fishing license fees are subject to the scheme, but it also has separate bilateral and multilateral agreements with other countries, including the European Union and the United States. The latter two agreements formed roughly 10 percent of Kiribati’s total revenue from fishing agreements in 2014.

3

Copra subsidies serve mainly as a livelihood subsidy to support inhabitants of outer islands. Previous Article IV consultations have concluded that, without job creation on the outer islands, alternative social transfer schemes are unlikely to reduce the cost in a significant way.

4

This projection is consistent with projected 2016 receipts and with the expected reversal of recently favorable climatic conditions. While the impact of the different factors contributing to strong fishing license revenue performance cannot be clearly delineated, the recent strong El Niño effect is believed to have attracted tuna to Kiribati’s warmer waters, contributing to higher catch volumes and greater demand for Vessel Days. Since the peak at end-2015, the sea surface temperatures in Kiribati waters have started to rapidly cool. Forecasts of the El Niño Southern Oscillation cycle are highly uncertain due to historical irregularity, but the opposite phases of El Niño (implying warmer than normal surface water temperatures for Kiribati) and La Niña (cooler waters) occur on average every two to seven years. Prolonged peak episodes may last for years.

5

The projected RERF return rate reflects the more conservative investment strategy of the fund after its restructuring. Information was from the World Bank Treasury who has been providing technical assistance to the RERF reform.

6

Others include the Kiribati Insurance Corporation and a few credit unions that remain very small in size and whose operations are largely limited to their membership.

Same Series

Other IMF Content

Other Publishers

Cover IMF Staff Country Reports
Kiribati: 2016 Article IV Consultation-Press Release;Staff Report; and Statement by the Executive Director for Kiribati
Author: International Monetary Fund. Asia and Pacific Dept
Volume/Issue:
Volume 2016: Issue 292
Publisher:
International Monetary Fund
ISBN:
9781475535860
ISSN:
1934-7685
Pages:
59
DOI:
https://doi.org/10.5089/9781475535860.002