Solomon Islands: 2018 Article IV Consultation—Press Release; Staff Report; and Statement by the Executive Director for the Solomon Islands

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Solomon Islands

Abstract

2018 Article IV Consultation-Press Release; Staff Report; and Statement by the Executive Director for the Solomon Islands

Context

1. Solomon Islands has made significant gains since the Tensions, in restoring law and order, re-establishing public institutions, and improving human development indicators. Macroeconomic and financial stability have been established over the past fourteen years and important structural reforms implemented, including a Public Financial Management Act, a new debt management framework, and a Central Bank Act. IMF-supported programs from 2010–16 were successful in supporting efforts to build policy buffers, macroeconomic management capacity and institutions. However, following the end of the programs, the fiscal position deteriorated sharply, and, although debt is low, fiscal cashflow problems have emerged (Appendix I).

2. The country faces large economic development and governance challenges. The economy has a narrow base concentrated on an over-exploited logging sector, is located far from international markets, has a geographically dispersed population, is highly vulnerable to natural disasters and climate change, is facing a large infrastructure gap and capacity constraints and the political situation remains fluid (Figure 1). These challenges weigh on long-term growth. With the logging industry facing depletion, new sources of growth are needed to meet the Sustainable Development Goals (Appendix II).

Figure 1.
Figure 1.

Solomon Islands: The Cross-Country Context

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

3. Governance challenges are significant. They stem from management of the logging and the newly-emerging mining sectors, a lack of transparency in government spending, including in Constituency Development Funds (CDFs), and weak public financial management. Problems are long-standing and exacerbated by the lack of local services provision and strained capacity. This results in fiscal slippages undermining stability. Growth is impeded by these governance issues, a slow pace of legislative reforms, and land tenure issues. The new government is aiming to tackle the challenges including through an anti-corruption strategy (paragraph 45), and a focus on sustainable forestry and mining policy. But mitigating governance risks will require sustained effort with greater transparency and effective policy implementation.

4. The economy is vulnerable due to fiscal slippage, political fragility and natural disasters.

  • The erosion of fiscal buffers leaves the authorities with little room to respond to exogenous shocks.

  • Solomon Islands is ranked the fourth most vulnerable country to natural disasters among the Pacific islands. In any year, there is a 13.5 percent probability of the occurrence of a severe natural disaster.1

  • There have been episodes of political instability. Fluid political alliances result in frequent changes in government. In November 2017, the Prime Minister was replaced following a vote of no confidence. The new government coalition faces elections in early 2019.

Recent Developments

Recent Developments Have Been Encouraging But The Fiscal Position Has Deteriorated.

5. Economic activity has held up well and inflation is contained. Real growth held up at 3.5 percent in 2017, as logging continued to outperform expectations, coupled with higher cash crop yields, fishing revenues, and construction activity (Figure 2, Table 1). Headline inflation stood at 2.4 percent in June 2018.

Figure 2.
Figure 2.

Solomon Islands: Macroeconomic Developments and Outlook

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

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

Solomon Islands: Selected Economic Indicators 2014–23

article image
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

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

6. The current account deficit remained at around 4.2 percent of GDP in 2017. Imports outpaced exports reflecting increased infrastructure development, higher import costs and a small nominal effective exchange rate (NEER) depreciation during 2017, weakening the trade balance. The exchange rate moved closely tandem with the US dollar with greater volatility against the Australian dollar. The reserves position remains comfortable, at 8.8 months of import cover in June 2018.

uA01fig01

Solomon Islands: Bilateral Nominal Exchange Rates

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

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

Solomon Islands: Effective Exchange Rate and Basket Peg

(index Sept-2012=100)

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

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

7. The fiscal position deteriorated further. The deficit reached 3.8 percent of GDP in 2017 as revenues fell short of expectations, and spending on tertiary scholarships, shipping grants and CDFs remained high. The strained fiscal position led to domestic expenditure arrears (1.3 percent of GDP in 2017). The government’s broad cash balance declined to 1.5 months of total spending, below the two-month target2 Though public debt remains low, it increased to 9.4 percent of GDP in 2017 following the issuance of domestic bonds to the National Provident Fund (NPF) for infrastructure development (Figure 3, Table 2).

Figure 3.
Figure 3.

Solomon Islands: Fiscal indicators

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

Sources: Country authorities and IMF staff estimates.
Table 2a.

Solomon Islands: Summary of Fiscal Accounts

(in millions of Solomon Islands Dollars)

article image
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.

Broader cash balance=Narrow cash balance+ SIG Deposit Account; 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)

article image
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.

uA01fig03

Fiscal Balance

(In percent of GDP)

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

Sources: Country authorities and IMF staff estimates.

8. Monetary conditions are accommodative. Excess liquidity remains high but credit growth slowed to 5 percent year on year by May 2018—as banks pulled back personal sector lending against a backdrop of rising NPLs. Spreads are high at 10 percent and highlight the need for greater competition among banks.

9. Financial sector vulnerabilities increased at end 2017. Net non-performing loans (NPLs) almost doubled in 2017 to 11.5 percent of capital and reserves, as asset quality declined following a period of rapid credit growth and delays in government payments to contractors and service providers disrupted debt service payments. In 2018 Q1 NPLs moved back down and banks curtailed credit.

Text Table 1.

Solomon Islands: Core Financial Soundness Indicators, 2013–17

article image
Sources: Central Bank of Solomon Islands.

10. Withdrawal of correspondent banking from a domestic bank poses a potential financial stability risk. While foreign banks have retained correspondent banking relationships (CBR), environmental and governance concerns surrounding the logging industry have led to difficulties for a domestic bank providing financial services to the industry in finding a replacement CBR. A temporary solution is in place until the end of the year and good progress is being made on a permanent solution to establish a new link (once strengthened screening and transaction monitoring is in place), lessening the immediate vulnerability. However, a recurrence of this problem would pose a downside risk.

Outlook, Risks, and Vulnerabilities

An Uncertain Outlook

11. Growth is expected to hold up in 2018 and moderate in 2019. Donor-supported infrastructure spending is moving ahead following the government’s greater engagement with development partners. This together with accelerated logging activity, will underpin growth at around 3.4 percent in 2018. Growth is expected to moderate to 2.9 percent in 2019, due to continuing fiscal problems and a tapering of logging activity. The current account deficit is likely to widen to 6.4 percent of GDP and 8.3 percent of GDP respectively with higher imports for infrastructure (financed by aid and concessional borrowing). Inflation is projected at 3.2 percent in 2018 as higher global commodity prices feed through to the CPI, and then to ease below 3 percent in 2019 and thereafter.

12. The medium-term outlook is challenging. On the positive side, large infrastructure projects are going ahead. The Tina hydropower project is expected to come on stream by 2022. The Gold Ridge Mine could restart activity in 2020 (an upside risk to staff’s forecast). The undersea internet cable should boost activity over the longer run. But on the negative side, fiscal challenges may prove hard to manage, logging activity is likely to decline, and the timing of the mining sector expansion is unclear. Staff projects growth at 2.9 percent on average over 2018–23. Inflation is expected to remain moderate at 3.2 over the medium term.

13. The current account deficit is projected to widen to 7.5 percent of GDP on average over 2018–23 as upcoming infrastructure projects (including the TRHDP) have a high import content. Non-oil commodity prices remain low, but higher oil prices and transport costs would add to pressure on the current account.

14. If the fiscal situation is not addressed, cash reserves would be exhausted in 2021. The government aimed for a balanced budget (excluding external financing) for 2018 to maintain the level of cash balance as of December 2017. However, the reemergence of domestic arrears in the early months of 2018 and other spending pressures, led to a supplementary budget of 2 percent of GDP. Nonetheless, the budget includes a sharp cut in government-funded development expenditures that appears unattainable. Spending on CDFs has been cut only a little for 2018, while development expenditures for most ministries have been cut sharply, leading to some shortages. IMF staff expect the deficit to remain high at 3.6 percent of GDP in 2018 with the cash balance falling to one month of total spending and new domestic arrears of 0.7 percent o cash balance would decline to zero in 2021.

uA01fig04

Development Expenditure Cut, 2018 budget

(In percent change from the authorities’ 2017 revised budget estimate)

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

Source: Solomon Islands Authorities.

15. Public debt is expected to rise over the medium term. The nominal public debt-to-GDP ratio was raised by 5 percentage points to 35 percent of GDP to promote infrastructure development. The Debt Sustainability Analysis (DSA) indicates that the risk of external debt distress remains moderate, in line with the previous assessment, though it illustrates a high vulnerability to shocks. A one-off natural disaster shock, in line with Solomon Islands experience, would significantly add to debt, leading to a breach of the threshold for public debt (see the debt sustainability analysis, tailored shock for natural disasters, Chart, Appendix IV).

uA01fig05

PV of Debt-to-GDP Ratio

(In percent)

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A001

Source: Solomon Islands Authorities.

16. Three downside risks cast a shadow over the outlook:

  • Elections in early 2019 are likely to slow policy reform, lengthening the legislative backlog, and delaying the resolution of fiscal problems.

  • The impact of a possible large natural disaster on the economy would be intensified as fiscal buffers are almost depleted.

  • Re-emerging difficulties securing correspondent banking links. Although a solution is in sight for the recent issue, it underscores the concern about dealing with institutions linked to the logging industry. Renewed difficulties would have a major adverse impact on logging exports and the fiscal position—a deterioration compared to the baseline (Appendix V).

17. The weak fiscal position increases the vulnerability of the economy to shocks. Fiscal problems could generate an adverse financial sector feedback loop. Continued delays in government payments would drive NPLs up.

Text Table 2.

Solomon Islands: Summary Risk Assessment

article image

Authorities’ Views

18. The authorities agreed with staff’s assessment of the medium-term growth outlook. They expect logging activity to decline as policies to improve the sustainability of the sector will result in a significant cut in production and new sources of growth are needed over the medium term. In the near term, they expect donor-supported infrastructure projects, such as the undersea cable project and Tina river hydropower project, as well as a reopening of the Gold Ridge mine, and bauxite mining, to provide an offsetting boost to economic growth. Fish catch is also expected to grow.

19. The authorities are cognizant of the risks to the economy and the need to strengthen the fiscal position to reduce vulnerabilities. Actions are being taken to contain the fiscal deficit. The authorities are focused on ways to improve the sustainability of the forestry industry. More broadly, the authorities are keen to establish policies to promote development of a healthy mining sector and to promote growth in other sectors, including agriculture and tourism.

Policy Discussion: Priorities for Stability

20. Fiscal adjustment, tax reform and public financial management strengthening, together with new sources of growth, would promote sustainable development. Staff emphasized that structural reforms, infrastructure investment, and improved governance would support the business environment and generate growth. It is critical that the governance problems which inflicted the logging sector do not spread to the mining sector. Retaining correspondent banking relationships is essential to preserve foreign exchange inflows and fiscal revenues.

A. Managing the Fiscal Position

Staff’s Assessment

21. Fiscal problems have become acute and remedial action is needed. Staff recommends policy action to rebuild the cash balance to around 2 months of total spending by 2021 while clearing arrears. A multi-year plan would help get back on track with a cumulative consolidation of 7.3 percent of GDP by 2021 (Table 6).

  • A thorough stocktaking of arrears would clarify the true position. Claims for 2017 have been paid and contractual commitments for 2018 identified, but it is not clear that all arrears have been eliminated.

  • The 2019 Budget should aim for a cash balance of 1.2 months of total spending.

    • Revenues. Strengthening revenue administration and compliance should continue. The authorities’ efforts to reduce tax arrears are yielding good results and will help generate a one-off revenue increase. Steps to streamline and adjust the tax reference prices for logs to bring them into line with world prices should be implemented to reduce the scope for transfer pricing. Similar efforts are needed for bauxite.

    • Spending. The 2019 budget offers an opportunity to streamline spending in areas which have increased rapidly in recent years (e.g. CDFs, tertiary scholarships and shipping grants), clear arrears, and better align spending priorities with the National Development Plan. Staff urged the authorities to lower CDF spending, and partially restore critical line-ministry development spending. Expenditure on the 2023 Pacific Games needs to be limited in a prudent manner. While the 2019 budget strategy encouragingly proposes a reallocation of development spending, it also includes a sizeable increase in payroll.

    • The revenue and expenditure measures should only moderately affect growth. Fiscal multipliers are likely to be low as the measures aim improving the quality of spending; tackling tax debts and improving efficiency.3

Table 3.

Solomon Islands: Balance of Payments, 2014–231

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

Incorporates the authorities’ revision of historical data, including a new formula for f.o.b/c.i.f conversion, new estimates of reinvested earnings and donor grants, and reclassification of current and capital transfers.

FDI numbers have been revised down as a result of changes to ensure the correct treatment of net losses under reinvested earnings, in line with

Includes actual and prospective disbursements under the IMF-supported arrangement.

Table 4.

Solomon Islands: Summary Accounts of the Banking System, 2014–231

article image
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.