I. Introduction

1. In light of the recent Decision on Bilateral Surveillance, this supplement to the staff report (SM/07/207, 6/12/07) highlights staff views on the exchange rate level and external sustainability in the Maldives, as well as the authorities’ views on the staff assessment. These views do not change the overall analysis and policy recommendations contained in the staff report, and paragraphs 5–7 below should be considered part of the staff appraisal.

II. Recent Developments

2. Fiscal developments in the first half of 2007 have been unfavorable. While domestically-financed expenditures are running at broadly the pace envisaged in the budget, revenues fell below budget estimates. Consequently, the domestic deficit in the first half of the year was almost 870 million rufiyaas, equivalent to about 6.6 percent of GDP. Hence a major effort is needed to cut back budgetary expenditures over the remainder of the year. However, the indications so far are that the cutbacks advocated by staff are unlikely to occur.

3. The authorities have conveyed to staff that based on the experience so far this year, it is likely that some of the new revenue sources assumed in the budget will not materialize. Hence the authorities intend to scale back budgetary expenditures, and cabinet guidance is being sought on the fiscal path for the remainder of the year.

4. International reserves have held up well this year, increasing from US$ 232 million at end-2006 to about US$ 250 million in June, and staying broadly unchanged in months of imports.

III. The 2007 Decision on Bilateral Surveillance: The Maldives

5. As explained in the Staff Report, Maldives has rebounded strongly from the tsunami of late 2004, with rapid GDP growth underpinned by a robust increase in tourist arrivals and construction activity pertaining to new resorts. However, fiscal expenditures have increased sharply, with a further large increase proposed in the 2007 budget, entailing a quadrupling of the overall budget deficit to 28 percent of GDP. Unless expenditures are kept in line with realistic revenue forecasts, financing the fiscal deficit could undermine macroeconomic management. Staff forecast that with unchanged fiscal policies there would be a sharp fall in reserves in months of import coverage, which could put pressure on the dollar peg. In other words, on unchanged fiscal policies, the exchange rate is fundamentally misaligned.

6. In this regard, the underlying concern is the current stance of fiscal policy, which has negative implications for external stability and the equilibrium REER, and not the nominal exchange rate per se. As detailed in the Staff Report, the current exchange rate regime (a peg against the U.S. dollar) and the current level of the exchange rate are appropriate and sustainable, as long as fiscal policy is tightened. The REER has depreciated substantially in recent years, and would depreciate further if, as expected, the U.S. dollar were to continue its decline against the euro.

7. Various available indicators suggest that the current level of competitiveness in the Maldives is appropriate. The cumulative real depreciation since 2001 has been greater than that of competitors like Seychelles, Mauritius, Madagascar, and Sri Lanka. In addition, the World Bank’s report on “Doing Business in South Asia in 2007” ranks the Maldives as the best in the region in terms of ease of doing business, while ranking the country in the top third globally.

8. The authorities agree with the staff assessment in paragraphs 6–7, but do not concur with the concluding assessment in paragraph 5. They recognize that unchanged fiscal policies could lead to a loss of reserves and pressure on the dollar peg, and lead to a fundamental misalignment of the exchange rate. However, they do not think that based on the 2007 fiscal position the exchange rate is currently misaligned. They note that during the first six months of 2007 international reserves have increased slightly, and there has been no pressure on the dollar peg. Moreover, given the sensitivities associated with a pegged exchange rate regime, they are concerned that to say the level of the exchange rate is currently appropriate, and at the same time that the exchange rate is fundamentally misaligned, will be confusing to market participants and lead to unwarranted speculation. Staff clarified that, without a correction of the fiscal imbalance, the current exchange rate would not be sustainable.