Abstract
2007 Article IV Consultation-Public Information Notice; Staff Report; and Statement by the Executive Director for Maldives
1. Following considerable damage inflicted by the December 2004 tsunami and the ensuing economic contraction, the Maldivian economy rebounded in 2006 with an unprecedented uptick in growth. Despite this strong growth rate, the country remains vulnerable to external shocks on account of its geography and high dependence on tourism and fishing. These vulnerabilities highlight the importance of a steady stream of concessional financing, which fortunately picked up to a generous level in 2006. Such financing helped support the authorities’ continued reforms and sustain the gains made thus far in the country’s economic performance.
2. In view of the recent recurrent wave swells, which caused considerable flooding and property damage, the authorities have contacted several multilateral agencies seeking assistance. These developments led the authorities to step up domestically financed community assistance. Thus, while overall projections for 2007 remain very tentative, the authorities wish to assure the Board that they remain committed to sound macroeconomic policies while addressing the challenges facing their economy. The Minister of Finance recently submitted to the Cabinet a paper on the fiscal outturn for the first five months of 2007 and projections for the full year. The aim of this paper was to seek Cabinet’s guidance in view of lower revenue estimates and external loan financing. Furthermore, the paper submitted to Cabinet includes a medium-term fiscal scenario that progressively aims for smaller deficits of 14, 10 and 9 percent of GDP in 2008, 2009 and 2010, respectively. A decision by Cabinet on the fiscal outlook for the remainder of the year and the medium term is expected shortly, with due consideration to any further deterioration in the fiscal position and the risks this would pose for the sustainability of the pegged exchange rate regime.
3. In terms of the sustainability of the pegged exchange rate regime, staff has been in consultation with the authorities and has issued a supplement —in the context of the application of the transitional procedures of the 2007 Decision on Bilateral Surveillance. While the authorities agree with staff that the current fiscal position could lead to an exchange rate misalignment, they do not agree with the view that the currency is presently misaligned. Indeed, reserves have increased in the first half of this year to around US$250 million and there is no pressure on the exchange rate. Therefore, not only is the staff’s supplement inconsistent with the staff report’s assessment on competitiveness, but the authorities are concerned that the assessment of “fundamental misalignment based on a forecast of unchanged fiscal policies” would confuse markets, potentially precipitating speculative pressures. Moreover, as mentioned above, such a forecast ignores the Cabinet’s current deliberations on measures to rectify the course of fiscal policy.
Recent Developments and Outlook
4. The economy witnessed an unprecedented expansion in 2006. GDP growth accelerated to about 19 percent, inflation was moderately low, and foreign exchange reserves increased. The unprecedented growth rate was driven by tourism, construction, and government spending. Financial policies remained supportive of the fixed exchange rate regime. The government, supported by generous grants, continued to address the medium-and long-term challenges of developing the economy and improving the living standards by building a reliable infrastructure and investing in human capital and community development. The continued development of the tourism sector and export growth have contributed to increased current account receipts, which more than offset the slightly slower growth in imports. However, these increased receipts were not large enough to compensate for the substantial fall in net official transfers at a time of a significant expansion in GDP. The net effect was a widening of the already large current account deficit, which persisted due to intermediate and capital goods imports. These imports were in line with the reconstruction-induced acceleration of GDP growth and investment. This investment pickup was shared by both public and private sector participation, as manifested in the large private capital inflows and bank borrowing in 2006.
5. The outlook for GDP growth and the balance of payments is broadly favorable. The competitiveness of both the tourism and fishing sectors is adequate, benefiting from continued U.S. dollar depreciation considering that net foreign exchange receipts are Euro-denominated. While external debt increased to 65 percent of GDP in 2006, over two-thirds of the increase was driven by private sector borrowing. Given the large expansion in exports and GDP, the total debt-service ratio and the domestic debt stock as a share of GDP actually fell. The authorities, however, are cognizant of a pickup in banking sector vulnerability indicators owing to the booming private sector activity. They will remain vigilant in monitoring these developments. In terms of the fiscal outlook, and despite growing receipts, the continued exposure to natural devastation undermines the reliability of medium-term scenarios at this juncture. Nevertheless, the authorities wish to reassure Directors that their medium-term fiscal objectives will be balanced so as to ensure macroeconomic stability. In this context, their assessment is that the staff’s base line scenario is unduly pessimistic.
Financial Policies
6. The fixed exchange rate regime has served the economy well by providing a simple and transparent nominal anchor while limiting inflationary pressures. External competitiveness strengthened over the recent past, with the real exchange rate depreciating in line with the U.S. dollar. The authorities are determined to continue to support the peg with appropriate fiscal and monetary policies. To this end, in April 2007 a new central bank act was passed, which separates the functions of the minister of finance from the governor of the central bank. Furthermore, issuance of weekly treasury bills commenced last year with the aim of developing a treasury bill market and ceasing the automatic financing of the government deficit from the central bank. With technical assistance from the Fund’s MCM department, a well-functioning liquidity-forecasting framework is also being developed to facilitate movement to an auction system for the issuance of treasury bills in the near future. This will modernize the central bank’s toolkit away from administrative instruments, while providing the government with a credible instrument to finance its deficit. The government is working towards further gradual independence of the central bank and improving its monetary instruments. While the authorities will consider the staff’s recommendation to reduce further the required reserves ratio, it is worth noting that this ratio has been reduced gradually since 2003, from 35 to 25 percent.
7. Progress continued to be made in improving central government finances. Tax revenues demonstrated a significant increase, from 18 to 21 percent of GDP between 2005 and 2006, while nontax revenues also rose from 21 to 24 percent. This improvement, along with a significant increase in grants amounting to 18 percent of GDP, allowed the authorities to scale up their expenditures considerably in 2006. This expenditure increase needs to be placed in context. It comes after wide spread tsunami-related devastation, on the back of an already weak and challenging infrastructural base. Moreover, as shown in the staff’s statistical appendix, social services and capital spending accounted for the largest share of this increase, while the wage bill as a share of GDP did not increase. While the overall fiscal balance for 2006 actually improved year-on-year, from a deficit of about 11 percent of GDP to just over 7 percent, this reflected in large measure the increase in foreign financing.
8. In terms of the near to medium term, the authorities are fully cognizant that while grants are expected to remain high in 2007, any temporary or new expenditures should be fully financed before they are disbursed. Moreover, any permanency in future expenditures would be financed by domestic revenues. In this context, the Macroeconomic Coordination Committee will be convening to monitor the situation and the authorities are committed to prioritizing intended 2007 expenditures in line with revenue and grants receipts.
9. To support the authorities’ difficult expenditure environment, the World Bank has been strengthening fiscal systems aimed at increasing the effectiveness of public spending, budget formulation, and expenditure management. Further capacity building by the World Bank in this important area is envisaged. In terms of domestic revenue reforms, the authorities are committed to gradually improving its performance, including through finalizing and tabling to parliament the Business Profit Tax Bill. They will proceed with this and other reforms as soon as feasible.
Other Structural Reforms
10. The banking sector has benefited from a booming economy with a strong pick up in private sector credit financing of the real economy. Concurrently, the public sector’s share in credit diminished last year due to debt repayments from the government to the central bank. Non-performing loans have been falling, while risk exposure has been minimized through foreign-owned bank borrowing and collateralization of commercial domestic property.
11. The World Bank’s report on “Doing Business in South Asia in 2007,” released in the first quarter of 2007, ranks the Maldives as the best of the region in terms of business regulations, while ranking in the top third globally. Moreover, since the corporatization of state-owned enterprises, the authorities take note of staff’s support for an expansion in the equity base of these enterprises and a limitation in their debt ratios. In this regard, they intend to privatize the number of firms through a public share issuance, while restructuring others. Recently, the Cabinet has approved the formation of a holding company for all such enterprises, to ensure an arms-length relationship with the government. This has now been submitted for the President’s approval and, if approved, will be governed under the Companies Act of the Maldives. As such, the Public Enterprises Bill will no longer be implemented. Other reforms, such as the Banking Bill, are being finalized.
12. The authorities would like to express their appreciation for the staff’s valuable analysis and policy advice and the Fund’s technical assistance and training, which have been instrumental in the implementation of their reform and reconstruction efforts. Moreover, they wish to express their gratitude to the international community at large for their support through generous grant and project assistance. They look forward to continued close collaboration with the Fund and the international community in the years ahead.