Public Information Notice No. 02/60

Public Information Notice: IMF Concludes 2002 Article IV Consultation with St. Kitts and Nevis

June 14, 2002

On June 7, 2002, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with St. Kitts and Nevis.¹

Background

Following the widespread damage caused by hurricanes in 1998-99, real GDP rose sharply in 2000, reflecting an increase in domestic demand that stemmed from spending on post-hurricane repair and reconstruction. Economic activity continued to be robust in the first three quarters of 2001, based on construction, a rebound in tourist arrivals, and increased sugar production. However, following the September 11 attacks, the number of stayover tourists fell sharply; activity in tourism-dependent sectors, such as road transportation and retail sales declined; and exports to the U.S. were virtually halted. As a result, real GDP growth slowed to just below 2 percent for 2001 as a whole. Preliminary indicators point to a decline in real GDP by 2-3 percent in 2002. No current information is available on employment, but hours worked in the tourism and manufacturing declined in 2001 and the first quarter of 2002. In recent years, inflation has been contained to 2-3 percent.

Notwithstanding the surge in reconstruction-related imports, the external current account deficit narrowed to 17½ percent of GDP in 2000 (23 percent in 1999) owing to a sharp increase in private transfers that represented mainly the settlement of hurricane-related insurance claims. The deficit widened to 33 percent of GDP in 2001, reflecting the weakening of tourism demand and exports, and lower private transfers. The deficits in recent years have been financed by official commercial loans and direct investment.

The central government finances have weakened in recent years, as the rapid growth of expenditure—mainly on the wage bill, interest, and infrastructure—combined with a weak revenue performance that stemmed, in part, from tax exemptions to the tourism and manufacturing sectors. These factors, together with the rapid growth in spending on post-hurricane reconstruction, led to a widening of the overall central government deficit to 14½ percent of GDP in 2000 (from 6 percent in 1998). Fiscal performance began to improve in 2001, in response to increases in some tax rates, while the growth in spending was contained. Following the September attacks, the authorities cut back sharply on spending in the fourth quarter, including canceling the end-year bonus to civil servants. As a result, the overall deficit narrowed to 12½ percent of GDP in 2001. Preliminary data for the first quarter of 2002 indicate that government revenue increased by about ½ of one percentage point of GDP, owing to a strengthening of tax collection efforts. The central government deficits and the losses of the sugar company have resulted in a sharp increase in the public debt, from 86 percent of GDP at end-1998 to 122 percent of GDP at end-2001, among the highest ratios in the Eastern Caribbean Currency Union (ECCU).

Broad money growth slowed in 2001, but the commercial banks' liquidity position continued to increase, owing to the government's refinancing of part of its bank debt, and a decline in private sector credit. Despite these factors, and a lowering of the discount rate by the ECCB in October, domestic interest rates remained unchanged in 2001, with the average lending rate at 11.2 percent, and the average deposit rate at 4.3 percent. The first quarter of 2002 witnessed a further decline in private sector credit.

During 2001 emphasis in the area of structural reform was placed on upgrading the skills of civil servants, and setting up a Public Sector Reform Unit in which all civil service reform efforts are centralized. Also, the liberalization of the telecommunications sector began with the breakup of the monopoly on domestic cellular services. In the offshore sector, a Financial Intelligence Unit was established; legislation was approved that permits the sharing of information with other jurisdictions, and criminalizes the laundering of proceeds from all crimes; and the authorities have begun to implement the recommendations based on the Module I self-assessment conducted with the assistance of the Fund and the ECCB. St. Kitts and Nevis remains on the FATF list of weak jurisdictions for offshore financial services and anti-money laundering efforts, but was removed from the OECD's list of non-cooperative tax jurisdictions in March 2002. The country's inclusion in the FATF list will be reviewed in June 2002. On the domestic front, the Eastern Caribbean Securities Exchange (ECSE), a regional market in corporate securities based at the central bank in St. Kitts, began operations in January 2002. Trading on the Regional Government Securities Market (RGSM) is expected to commence later this year.

Executive Board Assessment

Directors commended the authorities for their prompt response to the serious challenges that the economy has faced in recent years—which included natural disasters, continuing financial weakness in the sugar industry, and the effects of September 11. As a result of the authorities' efforts, damaged infrastructure is being repaired, hotels refurbished, and new tourist resorts constructed, which should help promote a marked economic upturn in 2003.

Directors expressed concern, however, about the sizable budget deficit and the sharp increase in the public debt—which stems not only from the costs of reconstruction, but also from a rapid growth in other expenditure, from a steady erosion of the tax base caused by exemptions, and from the losses in the sugar industry. They considered that prompt action to tackle these issues is essential in order to avoid jeopardizing the recovery, damaging the country's creditworthiness, and weakening the banking system.

Directors welcomed the authorities' actions to begin reducing the fiscal deficit in 2002 and their plan to balance the budget within three to four years. They noted, in particular, the initial steps taken to tighten wage and hiring policies as well as strengthen procurement rules and tax administration. However, Directors considered that a number of additional measures are required to achieve the government's fiscal goals for 2002 and the medium term-such as limiting capital spending to priority social and infrastructure projects as well as reducing transfers to weak public enterprises. Turning to the revenue side, they urged closing the remaining loopholes in tax assessment, collection, and penalties; reducing tax exemptions; continuing the updating of the property register and valuations; and introducing an ad valorem excise tax on alcohol, tobacco, and fuel. In addition, at the regional level, the authorities were encouraged to continue working toward a common value-added tax (VAT).

Directors emphasized that attaining a sustainable fiscal position will depend crucially on action to address the large and persistent losses of the sugar industry as well as financial weakness and inadequate reporting in other state enterprises. They urged the authorities to ensure that the sugar company's losses are eliminated—if necessary through a phasing out of production. At the same time, Directors stressed the importance of putting in place a clear strategy for the use of the sugar lands, an adequate framework of retraining, and safety net arrangements for displaced workers. Other public enterprises, Directors recommended, should be subjected promptly to financial audits—the results of which should be published—and to closer Ministry of Finance review of the contracting of debt. They also recommended strengthening the actuarial position of the Social Security Board by diversifying its investments away from the public sector.

Directors noted the close linkage between fiscal sustainability and financial sector stability, and the indicators compiled by the Eastern Caribbean Central Bank, which showed that the overall financial condition of the banking system appears sound. In view of the government's majority interest in the National Bank, they welcomed the recent issuance of shares by the National Bank, which had strengthened its capital and broadened its ownership base. However, Directors emphasized the importance of continuing in this direction and, crucially, phasing out the National Bank's role as the main source of finance to the public sector, while reducing its reliance on the social security system for funding. In a broader regional context, they saw merit in an independent assessment of all locally-owned banks in the currency union, which, together with a review of competition in the financial system, might also shed light on the high level of banking spreads.

Directors welcomed the authorities' progress in identifying and beginning to address weaknesses in offshore sector regulation. They stressed, however, that additional efforts were needed to remedy the inadequate staffing of the Financial Services Commission as well as the absence of consolidated supervision and full record keeping by companies and trust services providers. In the area of efforts to counter money laundering and terrorist financing, Directors underscored an urgent need to strengthen enforcement and sanctions. These priorities, they noted, would need to be pursued at the regional level also.

Directors considered that the exchange rate regime operated by the Eastern Caribbean Central Bank has served St. Kitts and Nevis well—fostering price stability, investor confidence, and broadly satisfactory rates of economic growth. In an increasingly complex external environment however, policies must remain adequately supportive of the exchange rate peg. This calls for determined efforts to strengthen the fiscal position, reduce the public debt, and ensure a sound and well-regulated financial sector. Progress in reforming the public sector will also be crucial in this connection—together with policies to enhance labor productivity and assure satisfactory competitiveness.