Solomon Islands: Staff Report for the 2018 Article IV Consultation—Debt Sustainability Analysis1
Author: International Monetary Fund. Asia and Pacific Dept
Publication Date:
08 Nov 2018
eISBN:
9781484383797
Language:
English
Keywords:
ISCR; CR; debt; government; spending; shipping grant; debt sustainability; sustainability analysis; dynamics equation; PPG debt indicator; debt threshold; Natural disasters; Debt sustainability analysis
Download PDF (801.1 KB)

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

Public Debt Coverage

1. The coverage of public sector debt used in this report is central government debt, central government-guaranteed debt, and central bank debt, which is borrowed on behalf of the government.2 As of end-2017, no central government-guaranteed debt had been recorded; but prospectively, guarantees are anticipated in government’s borrowing plan for 2018. The outstanding debts to the IMF stood at US$6.7 million (0.5 percent of GDP).

Coverage of Public Sector Debt

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Background on Debt

2. Public debt has increased to 9.4 percent of GDP in 2017 from a historic low level of 7.9 percent in 2016. The pick-up in debt is due mainly to the SI$150 million issuance of a domestic development bond in 2017 and disbursements from multilateral creditors. The government successfully reduced debt from 50.3 percent of GDP in 2006 under the 2005 Honiara Club Agreement, which restructured around 10 percent of the stock of external public debt, and a moratorium was placed on debt servicing and new external borrowing. A new debt management framework was introduced in 2012 and revised in 2016 with new guidelines on direct borrowing, on-lending, and guarantees put in place. The debt management strategy sets a limit for the public debt-to-GDP ratio at 35 percent in nominal terms, with debt service to domestically-sourced revenue ratio set at 10 percent.

3. Public and Publicly Guaranteed (PPG) external debt stood at US$100 million (7.6 percent of GDP) as of end-2017. The International Development Association (IDA) and the Asian Development Bank (ADB) account for 29 percent and 36 percent of total public debt respectively. There were no explicit contingent liabilities—public debt guaranteed by the government—in 2017, but the government will provide a guarantee for the ADB’s forthcoming US$15.4 million loan to fund the new University of the South Pacific campus in Solomon Islands. Private sector external debt amounted to 0.8 percent of GDP in 2017.

4. Public domestic debt stood at SI$193 million (1.9 percent of GDP) at end-2017.3 The government issued a SI$150 million domestic development bond in March 2017, purchased by the Solomon Islands National Provident Fund (SINPF). Implicit contingent liabilities—mainly non-guaranteed borrowing by state-owned enterprises (SOEs)—were SI$121 million (1.2 percent of GDP) at end-2017.

5. Both domestic and external borrowing are expected to grow in the medium term. The government has set its annual borrowing limit at SI$462 million in the 2018 budget to finance key infrastructure projects, including the Tina River hydropower development project (TRHDP), which is supported by many development partners, including the Green Climate Fund, IDA, ADB, Australia and Korea. The government plans to borrow SI$30 million during 2018 from the SOEs to resolve domestic arrears.

Stock of public debt (external and domestic at end-2019

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Source: Solomon Islands authorities and IMF staff estimates.

Background on Macro Forecasts

6. The assumptions in the baseline scenario are consistent with the macroeconomic framework presented in the staff report. Similar to the last DSA, the baseline scenario incorporates the effects of natural disasters and climate change over the longer-term, with an overall view lying slightly to the downside vis-à-vis the 2017 report. The years 2018–23 are assumed to be disaster free to simplify the policy discussion of the near-term outlook. However, from 2024 onwards, the baseline incorporates the average long-term effects of natural disasters and climate change by lowering GDP growth by 0.3 percentage points (pps) annually, raising the current account deficit by 0.5 pps and increasing the fiscal deficit by 0.2 pps vis-à-vis disaster-free projections to reflect the country’s historical experience. These are consistent with the findings of staff’s research on the impact of natural disasters.4 The discount rate used to calculate the net present value of external debt remains at 5 percent. The main assumptions are:

  • Real GDP growth is projected at 2.9 percent on average during 2018–28. The projection takes into account three factors: (i) on the upside, higher capital spending on key infrastructure projects, including TRHDP and the undersea cable project, pushes growth up; on the downside, there are: (ii) continued fiscal problems that would negatively affect private sector activity; and (iii) a decline in logging activity, which might be offset over the medium term by an expected rise in mining activity.

  • Inflation (measured by GDP deflator in USD terms) is projected to average 4.2 percent during 2018–28, higher than last year’s projection due mainly to a recovery in oil prices.

  • Non-interest current account deficit is projected to rise to 7.2 percent of GDP on average over 2018–28, reflecting the high import content for key infrastructure projects and lower exports due to a long-term decline in logging activities. The reopening of the gold mine in Guadalcanal and the resumption of exports is now expected to be delayed until 2023.

  • FDI inflows are expected to increase on average to about 3.1 percent of GDP over 2018–28, slightly lower than last year’s projection due to worsening business sentiment caused by the government’s cash-flow problems.

  • Logging output is expected to be slightly lower in the next couple of years and then to start declining on average by 1.1 percent a year from 2023.

  • Mining production is expected to start over the longer term. Gold production is assumed to resume in 2023 and is assumed to peak from 2024 to 2027 and then to decrease gradually. Other mining activity (nickel and bauxite) is expected to come fully onstream in the long run, this is implicitly assumed to add a small impetus to long-term growth rates.

  • External borrowing and grants: New disbursements for projects in the pipeline, including TRHDP, are expected to take place in the next five years (2018–22). From 2023 onwards, the level of new annual external borrowing is expected to be around 3 percent of GDP. Grant and lending flows from multilateral development partners are expected to increase over the medium term due to the scale-up of IDA and ADB financing, and are partly offset by lower financing from other development partners. Grants and the grant element of new borrowing are expected to decline over the medium term.

  • Fiscal outlook: The ten-year forward-looking average of the primary deficit is expected to remain high at 3.5 percent of GDP, reflecting the recent worsening of the fiscal position that has resulted in a buildup in domestic arrears. By 2021, when the cash balance is positive, the deficit will be financed by cash reserves. Once depleted, the government is expected to seek domestic borrowing from SOEs. The accumulation of new domestic arrears is included in public debt during the projection period.

Solomon Islands: Baseline Macroeconomic Assumptions

(In percent of GDP, unless otherwise states)

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7. The new realism tools suggest that our projections are reasonable (Figure 4). The three-year adjustment in the primary balance is expected to be zero, suggesting there is no fiscal adjustment between 2017 and 2020 (3.7 percent of GDP). The assumption on real growth in 2018 and 2019 is slightly lower than possible growth paths which are calculated based on one-year fiscal adjustment. Two charts on public and private investment rates and contribution to real GDP growth are not available due to a lack of data.

Figure 1.
Figure 1.

Solomon Islands: Indicators of Public and Publicly Guaranteed External Debt under Alternative Scenarios, 2018–28 1/

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in or before 2028. Stress tests with one-off breaches are also presented (if any), while these one-off breaches are deemed away for mechanical signals. When a stress test with a one-off breach happens to be the most exterme shock even after disregarding the one-off breach, only that stress test (with a one-off breach) would be presented.2/ The magnitude of shocks used for the commodity price shock stress test are based on the commodity prices outlook prepared by the IMF research department.
Figure 2.
Figure 2.

Solomon Islands: Indicators of Public Debt Under Alternative Scenarios, 2018–28 1/

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A003

Sources: Country authorities; and staff estimates and projections.1/ The most extreme stress test is the test that yields the highest ratio in or before 2028. The stress test with a one-off breach is also presented (if any), while the one-off breach is deemed away for mechanical signals. When a stress test with a one-off breach happens to be the most exterme shock even after disregarding the one-off breach, only that stress test (with a one-off breach) would be presented.
Figure 3.
Figure 3.

Solomon Islands: Drivers of Debt Dynamics – Baseline Scenario External debt

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A003

1/ Difference between anticipated and actual contributions on debt ratios.2/ Distribution across LICs for which LIC DSAs were produced.3/ Given the relatively low private external debt for average low-income countries, a ppt change in PPG external debt should be largely explained by the drivers of the external debt dynamics equation.
Figure 4.
Figure 4.

Solomon Islands: Realism Tools

Citation: IMF Staff Country Reports 2018, 309; 10.5089/9781484383797.002.A003

Country Classfication

8. As discussed in footnote 1, the country’s debt-carrying capacity applied in the 2018 DSA is weak. The Solomon Islands’ first Composite Indicator (CI) index, which has been calculated based on the April 2018 WEO, is 2.72, indicating that the county’s debt-carrying capacity would be medium in the revised LIC-DSF framework. But a change in the classification needs await second appraisal, as two consecutive signals are required to confirm a shift in debt carrying capacity. Hence, this DSA is based on the weak category ratings.

Calculation of the CI Index

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9. The relevant indicative thresholds for the weak category are: 30 percent for the PV of debt-to-GDP ratio,140 percent for the PV of debt-to-exports ratio, 10 percent for the debt service-to-exports ratio, and 14 percent for the debt service-to-revenue ratio. These thresholds are applicable to public and publicly guaranteed (PPG) external debt. The benchmark for the PV of total public debt under weak debt carrying capacity is 35 percent. Should debt-carrying capacity change to medium, the thresholds and benchmark would increase.

PPG External Debt Thresholds and Total Public Debt Benchmarks

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Determination of Scenario Stress Test

10. Given the severity and frequency of natural disasters in the Solomon Islands, a tailored stress test for a natural disaster shock was conducted. Solomon Islands, which is defined as a small developing natural disaster-prone state in the IMF board paper on small states, is automatically subject to the LIC-DSF standard natural disaster shock.5 Default parameters for this test were altered, based on EM-DAT, the international disaster database, to reflect the country’s largest damage from natural disasters (over 1980–2016) at 14 percent of GDP. Thus, the DSA assumes a one-off shock of 14 pp of GDP to the debt-GDP ratio in 2019 and a reduction of real GDP growth and exports by 2.5 and 7.0 pps respectively. 6

11. A stress test for the combined contingent liability shock adjusts the default setting for SOE debt. To reflect the current level of implicit contingent liabilities (1.2 percent of GDP), we adjust the magnitude of the shock of SOE debts from the default value of 2 percent, which is the median SOE external liability identified by a Fund staff survey conducted in 2016. We use the default value of 5 percent for financial markets.

Combined Contingent Liability Shock

Combined Contingent Liability Shock

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The default shock of 2% of GDP will be triggered for countries, whose government-guaranteed debt is not fully captured under the country’s public debt definition (1.). If it is already included in the government debt (1.) and risks associated with SoE’s debt not guaranteed by the government is assessed to be negligible, a country team may reduce this to 0%.

Debt Sustainability

A. External Debt Sustainability Analysis

12. Under the baseline scenario, all external PPG debt indicators remain below the policy relevant thresholds for the next ten years (Figure 1). The PV of debt-to GDP ratio is expected to increase gradually from 5.3 percent in 2017 to 15.4 percent in 2028 due mainly to new disbursements for key infrastructure projects, including the TRHDP. As Figure 3 shows, the main driver of debt dynamics during the projection period is the current account deficit. Even under the 20-year forecast horizon, which was used in the previous framework, there would be no breach for all debt indicators in the baseline scenario, although debt ratios continue to rise.

13. The standardized stress test shows that an export shock has the largest negative impact on the debt trajectory, causing a breach of the threshold for the PV of debt-to-GDP ratio. This suggests the need to expand the export base, as logging exports are expected to decline over the longer run. Other shocks, including to real GDP growth, the primary balance, and a one-time 30 percent depreciation, do not lead to a breach of the debt threshold (Table 3).

Table 1.

Solomon Islands: External Debt Sustainability Framework, Baseline Scenario, 2015–38

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Includes both public and private sector external debt.

Derived as [r – g – ρ(1+g) + ɛα (1+r)]/(1+g+ρ+gρ) times previous period debt ratio, with r = nominal interest rate; g = real GDP growth rate, ρ = growth rate of GDP deflator in U.S. dollar terms, ɛ=nominal appreciation of the local currency, and α = share of local currency-denominated external debt in total external debt.

Includes exceptional financing (i.e., changes in arrears and debt relief); changes in gross foreign assets; and valuation adjustments. For projections also includes contribution from price and exchange rate changes.

Current-year interest payments divided by previous period debt stock.

Defined as grants, concessional loans, and debt relief.

Grant-equivalent financing includes grants provided directly to the government and through new borrowing (difference between the face value and the PV of new debt).

Assumes that PV of private sector debt is equivalent to its face value.

Historical averages are generally derived over the past 10 years, subject to data availability, whereas projections averages are over the first year of projection and the next 10 years.

Table 2.

Solomon Islands: Public Sector Debt Sustainability Framework, Baseline Scenario, 2015–38

(In percent of GDP, unless otherwise indicated)

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Sources: Country authorities; and staff estimates and projections.

Coverage of debt: The central government, central bank, government-guaranteed debt. Definition of external debt is Residency-based.

The underlying PV of external debt-to-GDP ratio under the public DSA differs from the external DSA with the size of differences depending on exchange rates projections.

Debt service is defined as the sum of interest and amortization of medium and long-term, and short-term debt.

Gross financing need is defined as the primary deficit plus debt service plus the stock of short-term debt at the end of the last period and other debt creating/reducing flows.

Defined as a primary deficit minus a change in the public debt-to-GDP ratio ((-): a primary surplus), which would stabilizes the debt ratio only in the year in question.

Historical averages are generally derived over the past 10 years, subject to data availability, whereas projections averages are over the first year of projection and the next 10 years.

Table 3.

Solomon Islands: Sensitivity Analysis for Key Indicators of Public and Publicly Guaranteed External Debt, 2018–28

(In percent)

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, GDP deflator (in U.S. dollar terms), non-interest current account in percent of GDP, and non-debt creating flows.

Includes official and private transfers and FDI.

14. The tailored natural disaster shock causes the debt trajectory for each indicator to move upward in the aftermath of the shock. Though the DSA assumes a one-off shock that takes place in 2019, there is a possibility that multiple severe natural disasters could occur within a ten-year timeframe. Staff’s work shows that there is a probability of around 13.5 percent of a disaster each year of a magnitude of more than 7.1 percent of damage-to-GDP ratio or 7.5 percent of the population affected-to-total population ratio. This probability translates into one shock every seven years. Multiple natural disasters would carry a larger cumulative effect on debt sustainability through damaging long-term growth and increasing borrowing for reconstruction needs.

B. Public Sector Debt Sustainability Analysis

15. Under the baseline scenario, the PV of public debt-to-GDP ratio does not breach the 35 percent benchmark (Figure 2). However, the nominal public debt-to-GDP ratio would rise from 9.4 percent and breaches the authorities’ threshold of 35 percent in nominal terms in 2028 (Table 2). As Figure 3 indicates, the breach is primarily driven by a primary deficit caused by continued expansionary fiscal policy.

16. The standardized sensitivity analysis shows that the largest shock that leads to the highest debt/GDP figures in 2028 is that to real GDP growth (Figure 2, Table 4). The PV of debt-to-GDP ratio would reach 56 percent of GDP in 2028. The vulnerability to a shock to real GDP growth highlights the need for stronger growth in the medium term.

Table 4.

Solomon Islands: Sensitivity Analysis for Key Indicators of Public Debt 2018–28

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Sources: Country authorities; and staff estimates and projections.

Variables include real GDP growth, GDP deflator and primary deficit in percent of GDP.

Includes official and private transfers and FDI.