Solomon Islands: Staff Report for the 2017 Article IV Consultation
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
05 Mar 2018
eISBN:
9781484344583
Language:
English
Keywords:
ISCR; CR; center; government; debt; Solomon Islands government economic reform priority; cash balance; exchange rate; total spending; debt service; current account; Currencies; monetary policy
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2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Solomon Islands

Abstract

2017 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for Solomon Islands

Context

A small fragile state with multiple challenges

1. Solomon Islands faces numerous problems common to Pacific islands.

  • The economy has a narrow production base reliant on logging, it is geographically-dispersed, remote, with capacity constraints, vulnerability to natural disasters and climate change, has a large infrastructure gap, and is highly dependent on aid and imports (Figure 1).

  • Solomon Islands is ranked the fourth most vulnerable country to natural disasters among the Pacific islands. In any year, there is a 14 percent probability of a natural disaster affecting more than 5 percent of the population or inflicting damage/loss of more than 3 percent of GDP. In its worst natural disaster, more than half of the population was affected and damage/loss reached 14 percent of GDP. Natural disasters weigh on potential growth.

  • The economy is also vulnerable due to political fragility and fiscal slippage.

Figure 1.
Figure 1.

Solomon Islands: The Cross-Country Context

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

2. The have been episodes of political instability. In 1998 clashes between ethnic groups over control of resources led to “The Tensions” which ended following the 2003 arrival of an Australia-led international security force—the Regional Assistance Mission to Solomon Islands (RAMSI). On June 30, 2017, RAMSI withdrew, having succeeded, together with the authorities, in restoring law and order and re-establishing public institutions (Box 1). Fluid political alliances result in frequent changes in government. In November 2017, the Prime Minister was replaced following a vote of no confidence. The current coalition faces elections by early 2019.

Achievements of RAMSI 2003–17

RAMSI assisted Solomon Islands in reestablishing stability after “The Tensions” through a joint peacekeeping and nation rebuilding mission. Alongside investment in security operations, RAMSI focused on reviving the economy, building inclusive civic institutions, establishing financial infrastructure, a justice system, and restoring public health and education services.

Early successes included stabilizing government finances and normalizing debt, as well as helping the government to carry out economic reforms, including a Public Financial Management Act, debt management framework, and a Central Bank Act. The focus later shifted to capacity building, though progress is slow due to skills gaps. Land rights grievances, an underlying cause of the tensions, and corruption have yet to be fully resolved. Development partners’ support is important to sustain progress.

3. IMF-supported programs were successful in supporting the authorities’ reform agenda but reforms have stalled recently. A program in 2010 was followed by an ECF, which successfully concluded in March 2016. The programs helped build policy buffers, macroeconomic management capacity and institutions. Subsequently, with rising spending and revenues falling short of target, the fiscal position has deteriorated. Restraining fiscal spending will be difficult ahead of the elections.

4. Medium-term challenges include generating new sources of growth and achieving the Sustainable Development Goals (SDGs). Only 28 percent of indicators in the National Development Strategy (NDS) 2011–20 registered progress by 2015. The new NDS 2016–35 identifies tourism, fisheries, and agriculture as sectors for development. It sets five development goals—sustained and inclusive growth, poverty alleviation, access to social services, sustainable environmental development, and stable effective governance/public order (Appendix I). Progress on the new NDS has been slow. On the positive side, good progress has been made on Tina River Hydro project which will reduce reliance on diesel imports (Box 2). Key impediments to development include the slow pace of legislative and policy reforms, land tenure, and security and governance.

Tina River Hydropower Development Project (TRHDP)

Solomon Islands’ first large energy project aims to reduce electricity costs—among the highest in the world—and reduce reliance on diesel imports. It leads efforts to diversify electricity generation in favor of clean, renewable sources such as hydro and solar power. It has the potential to more than cut in half annual greenhouse gas emissions. The project is supported by development partners including the Green Climate Fund (GCF). The project will be completed over 2018–22.

Financing Scheme

(In millions of US dollar)

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Source: Consideration of funding proposals – Addendum VII, Green Climate Fund.

Recent Developments

Macro-conditions are favorable but fiscal buffers are depleted.

5. Economic activity is solid and inflation is contained. Real GDP growth reached 3.5 percent in 2016 with record logging production (Figure 2, Table 1). A loosening of regulations allowed expansion into designated timber reserve areas and low export-duty benchmark prices boosted activity. Cash crops, fishing revenues, and construction also supported growth. In 2017 forestry activity has fallen back but agriculture and construction remain robust. The annual inflation rate was just 1.6 percent in October 2017.

Figure 2.
Figure 2.

Solomon Islands: Macroeconomic Developments and Outlook

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Country authorities and IMF Staff estimates.
Table 1.

Solomon Islands: Selected Economic Indicators 2013–22

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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 2016 numbers refer to June.

Total spending is defined as total expenditure, excluding grant-funded expenditure

6. The current account deficit widened a little in 2016 but international reserve levels are comfortable. The 2016 current account deficit (CAD) widened to 3.9 percent of GDP as gains from a stronger trade balance—due to higher logging exports and improved terms of trade—were offset by higher dividend payments on FDI. Net international reserves stood at around US$557 million in November 2017, 9.5 months import cover, and above reserve adequacy benchmarks. Following a loss in competitiveness in recent years, the REER stabilized in 2016–17, with greater movement of the basket peg against the U.S. dollar (paragraph 26), a steadier U.S. dollar, and favorable inflation differentials.

uA01fig01

Volatility against the Australian dollar is lower…

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Central Bank of Solomon Islands; Bloomberg; and IMF, staff estimates.
uA01fig02

… the real exchange rate has stabilized.

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

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

7. Fiscal discipline has slipped and the setting is challenging. The deficit widened to 3.3 percent of GDP in 2016 as lower revenues and grants were not matched by expenditure restraint (Figure 3, Table 2).

  • Revenues: lower goods tax collection and income and profits tax more-than-offset higher-than-expected export duties and fishing license fees.

  • Expenditures excluding grants: fell by 0.3 percentage points but this was less than the decline in grants. Recurrent expenditure remained high. Constituency Development Funds (CDFs)—transfers to electoral constituencies for rural development—have doubled since 2013 and amounted to 3.3 percent of GDP.

  • Grants: were 3.4 percent of GDP down reflecting the completion of several donor-assisted projects, a delay in the disbursement of EU budget support, and lower grants in anticipation of RAMSI’s departure.

Figure 3.
Figure 3.

Solomon Islands: Fiscal Indicators

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Country authorities and IMF staff estimates.
uA01fig03

The fiscal position has deteriorated

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Country authorities and IMF staff estimates.
uA01fig04

CDF spending is high

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Country authorities and IMF staff estimates.

8. Fiscal buffers have substantially eroded. With revenues not meeting overly optimistic expectations, the Supplementary Budget now projects a large deficit for 2017. The narrow cash balance fell from 3.6 months of recurrent spending at end-2015 to 2.0 months at end-2016 and further to 1.7 months in July 2017.1 The broader cash balance also declined.2

9. This has led to government payment delays. Domestic arrears were 1.4 percent of GDP in September, and spending pressure has risen, with an unanticipated increase in tertiary scholarship spending. There have been delays in education allowance payments and government employees’ housing rent; moreover, a hiring freeze for nurses and doctors was announced in August.

10. Public debt has picked up from a low to finance infrastructure investment. Development partners pulled out of financing an undersea fiber-optic cable from Honiara to Sydney as procurement procedures required by development agencies to ensure sound investment allocation were not followed. Instead, the government issued a SI$150 million bond to the National Provident Fund (NPF) to finance this project. Loan guarantees also increased. These raised the level of public and publicly-guaranteed debt from 7.9 percent of GDP at end-2016 to 10 percent of GDP in mid-2017.

11. Monetary conditions are accommodative but the transmission mechanism is weak. Commercial banks’ structural excess reserves are high, reflecting the accumulation of exports receipts and unsterilized inflows of donor financing. Bokolo bills issuance to mop up excess liquidity is high, but the cash reserve requirement ratio (CRR) is unchanged. Interest rates are below their long-term average and at its latest meeting the Central Bank of Solomon Islands (CBSI) maintained an accommodative policy stance. High spreads of around 10 percent and a low loan to deposit ratio of 60 percent suggest that the transmission mechanism is weak.

12. Credit growth has moderated. Credit growth—which averaged 15.5 percent throughout 2013–16—has decelerated to around 10 percent (Figure 4). Following a reassessment of risk and guidance from the CBSI, commercial banks have reined in their exposure to households—housing loans had been a major contributor to credit growth in recent years, emerging as a supervisory concern. In 2017 lending has been channeled to the retail sector, alongside buoyant retail spending, boosted by higher royalty payments from logging activity.

Figure 4.
Figure 4.

Solomon Islands: Macroeconomic Developments and Outlook

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Central Bank of Solomon Isalnds and IMF staff estimates.
uA01fig05

Credit growth has moderated

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: Central Bank of Solomon Islands; IMF staff calculations.

13. Financial soundness indicators (FSIs) do not suggest immediate stability concerns but require close monitoring. While a thin financial sector means that FSIs can be volatile, in 2017 Q2 capital adequacy, earnings and profitability, and liquidity were comfortably within historical norms, though NPLs have risen each quarter since end-2016 (Text-Table 1). The CBSI inaugural Financial Stability Report highlighted the main supervisory concerns as governance (for non-banks) and government payment delays. While banks can cope with some payment delays, the position would become more fragile if they become protracted.

Text Table 1.

Solomon Islands: Core Financial Soundness Indicators, 2013–171

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

Commercuak banks only, at end-period.

14. Buffers have eroded and reforms have slowed. Of the seven outstanding ECF structural benchmarks, all but one remain outstanding (Text Table 2, Appendix II).

Text Table 2.

Solomon Islands: Policy Buffer Indicators, 2010–17

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Latest available or estimate.

Recurrent spending is defined as total recurrent expenditure, excluding donor-funded recurrent expenditure.

Total spending is defined as total expenditure, excluding donor-funded expenditure.

Red = deterioration and Green = improvement after the conclusion of the ECF.

Outlook, Risks, and Vulnerabilities

15. Near-term growth is set to be relatively buoyant. Growth is projected at 3.2 percent in 2017 and 3.0 percent in 2018 buoyed by infrastructure spending, though logging production is expected to gradually decline. The authorities are also looking to push forward the undersea cable project financed by domestic borrowing after the withdrawal of donor financing.

16. However, the medium-term outlook is uncertain. Interest in bauxite mining has increased and the Gold Ridge Mine has secured funding for rehabilitation. However, if government payment problems persist this will weigh on growth. Staff’s baseline projections assume fiscal problems remain a drag in the near term, while the resumption of mining activity is an upside risk.

  • Real GDP growth averages 2.9 percent over 2017–22 with infrastructure spending being supportive, logging production flat, and intermittent domestic arrears impinging on activity. The years 2017–22 are assumed to be disaster-free but from 2023 onwards the baseline reflects the average long-term effects of natural disasters by lowering growth, raising imports and increasing the fiscal deficit (see Debt Sustainability Analysis (DSA) document). Without disasters, in the long run, growth gradually rises to 3.5 percent underpinned by infrastructure development and mining (Appendix III) but is scaled down by 0.3pps a year in the projections, to 3.2 percent, to account for natural disasters. A stress test of a severe natural disaster shock is added to the DSA in 2018.

  • Inflation remains low in 2017 and 2018 and rises over the medium term to 4.0 percent, a little lower than its historical average.

  • The current account deficit widens to 5–6 percent of GDP over 2017–22 as infrastructure projects (including the TRHDP) have a high import content. Non-oil commodity prices remain low, but rising oil prices could potentially exert pressure on the current account.

  • Fiscal outlook. Staff’s projections envisage a deficit of 4.1 percent of GDP this year, with the broader cash balance falling to one month of total spending by the end of 2017. The deficit widens further to 5.7 percent of GDP in 2018 as infrastructure projects progress and then narrows to around 3 percent of GDP over the medium term.

uA01fig06

Real GDP Growth Trajectory

(In percent)

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Sources: IMF staff estimates.

17. Public debt rises over the medium term. The authorities tripled the annual borrowing limit to SI$900 million in the 2017 Budget, and raised the public debt-to-GDP ratio limit to 30 percent in a revised debt management strategy. The DSA indicates that the risk of debt distress is moderate, in line with the previous assessment, though it illustrates a high vulnerability to shocks. The nominal public debt-to-GDP ratio could exceed the 30 percent limit in 2028.

18. Risks are, on balance, on the downside (see Risk Assessment Matrix, Text-Table 3, Appendix IV). Mining sector potential (gold, nickel and bauxite) and lower-than-expected commodity prices could emerge as upsides, potentially adding to growth. Infrastructure investment (in energy, transport and internet connectivity) could boost growth more than currently expected. Tax reforms (Box 3) could boost revenues over the medium term and improve fiscal resilience. But on the downside fiscal pressures could increase in the run-up to the election; and natural disasters are an ever-present risk. External risks include volatile global financial conditions and weaker than expected growth in emerging market economies, including China. While the withdrawal of correspondent banking relationships has so far been limited, it is a non-negligible risk.

Text Table 3.

Solomon Islands: Summary Risk Assessment

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19. The deteriorating fiscal situation aggravates downside risks. With a fast-shrinking fiscal cushion, Solomon Islands is ill-prepared to deal with any shock—external, natural disaster, social unrest, or combination of unexpected events. Fiscal strains could intensify these risks directly—by triggering unrest through non-payment of salaries and transfers—or indirectly as mounting arrears weigh on suppliers.

20. Fiscal-financial linkages could amplify the risks. Previous delays in the government’s rental payments for civil servants’ housing led to jumps in non-performing loans (NPLs) given banks’ exposure to housing loans, and landlords’ tendency to default on mortgage payments when rental payments are delayed. Although NPL spikes reversed quickly after landlords were paid, a protracted delay would dent banks’ balance sheets. With the SI$150 million bond issue, the NPF holds 86.5 percent of the government’s outstanding domestic debt securities. This is just 5 percent of the NPF’s total assets, but it may start a trend raising financial sector exposure to the public sector. 3

uA01fig07

Macrofinancial and Fiscal Linkages

Citation: IMF Staff Country Reports 2018, 057; 10.5089/9781484344583.002.A001

Authorities’ Views

21. The authorities are more optimistic about growth prospects. The Gold Ridge mine could restart production soon and this, and other mining activities, would add to growth. Over the medium-term, the investment in the undersea cable would improve connectivity and infrastructure investment would yield returns, boosting growth and making a temporary increase in the debt burden manageable. 2016 was a peak year for logging and high volumes continued in 2017. While the logging industry would gradually decline over the medium term, the trajectory of the industry is highly uncertain.

Policy Discussion

22. Fiscal adjustment, tax reform and public financial management strengthening together with structural reforms and financial deepening would improve economic outcomes. Better fiscal management would widen policymakers’ options, increase the ability to respond to shocks and boost the efficiency of government spending. Financial deepening would help improve monetary policy effectiveness and expand financing options. Structural reforms, aimed at improving the business environment and ensuring strong compliance with regulations in key sectors, would promote sustainable development.

A. Restoring Fiscal Buffers

Staff’s Assessment

23. Remedial actions are needed to (i) stem domestic arrears and rebuild the cash balance; and (ii) place fiscal policy on a sustainably firmer footing. Staff recommends a policy action scenario:

  • Rebuilding the cash balance. Some welcome steps were taken for 2017 by revising down overly optimistic revenue projections, and asking line ministries to contain spending for the final months of the year. But more actions are needed to rebuild the cash balance to an adequate level. In the 2018 Budget staff recommend that the authorities aim for the broader cash balance of 1.3 months of spending gradually building to 2.0 months by 2020 (Table 6 sets out some possible measures).

  • A multi-year plan is needed to get back on track, beginning with 2018 Budget. Staff sees a gradual cumulative consolidation of 6.0 percent of GDP by 2020 as feasible (see policy action scenario and measures, Tables 7, 8):

    • Revenues. The tax review is welcome (Box 3) but will take time to yield results.4 For the near-term staff suggest aligning the tax reference price for logs to the world market prices from 2018 Q1 and eliminating ad-hoc tax exemptions. Efforts to improve compliance, and strengthen revenue administration should continue. Tackling tax arrears could significantly boost revenues—reducing outstanding cases by 5 percent by June 2018 and outstanding returns by 15 percent could generate up to 0.7 percent of GDP in additional revenues.

    • Expenditures. Recent efforts to curb spending were necessary but should be balanced by also restraining expenditures on tertiary scholarships, CDFs, and shipping grants. The 2018 Budget provides the opportunity to realign spending to the goals of the NDS and preserve critical social services. The use of department ceilings for annual expenditure is welcome. Discretionary recurrent expenditures—travel and allowances—can be scaled back. While the CDFs aim to provide public services to the rural population and fill gaps left by government, their use is opaque and there is little evidence available on their development impact. Reining in spending on CDFs and making them transparent is necessary to have an accurate picture of overall development spending. Spending allocations for 2018/19 should include room to eliminate domestic arrears.

    • These measures should not adversely affect growth. Fiscal multipliers are likely to be low, as the measures aim at improving the quality of spending. Moreover, tackling tax debt would improve equity, and addressing domestic arrears would instill confidence and reduce delays in capital spending (Table 7).5

    • Budget realism. More realistic revenue projections would help establish the budget as a fiscal planning tool. Overly ambitious projections create cash management problems, and result in uncertainty for capital project execution.

    • Transparency of CDFs. As a first step, the 2015 and 2016 annual reports of CDFs should be published. In the 2018 Budget, staff recommends publishing a supplement describing for each CDF: the planning process, use of funds, development achievements, and future-plans.6

Table 2a.

Solomon Islands: Summary of Fiscal Accounts

(In millions of Solomon Islands dollars)

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

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

Defined as total revenue minus recurrent expenditure, excluding grant-funded recurrent expenditure

Defined as the sum of government deposits held at the CBSI and the commercial banks minus unpaid payment orders and unpresented checks.

From 2016 onward, deposits held at the CBSI and the commercial banks have used as a proxy for the narrow cash reserve

Recurrent spending is defined as recurrent expenditure, excluding grant-funded recurrent expenditure.

Total spending is defined as total expenditure, excluding grant-funded expenditure

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

Table 2b.

Solomon Islands: Summary of Fiscal Accounts

(In percent of GDP)

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

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

Defined as total revenue minus recurrent expenditure, excluding grant-funded recurrent expenditure.

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

Table 3.

Solomon Islands: Government Operations and Balance Sheet, 2014–16 1/

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Budgetary central government.

Net acquisition of financial assets minus net incurrenc of liabilities minus net lending/net borrowing.