Public Information Notice No. 05/149

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Dominica

October 25, 2005

On October, 14, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Dominica.¹

Background

Dominica is recovering from the aftermath of an economic and financial crisis in 2001-02 when output contracted by 10 percent. The crisis originated in the expansionary fiscal policies of the preceding decade, when the authorities sought to prop-up activity by increasing public spending. The primary balance of the central government turned strongly negative in the mid-1990s, public debt quickly reached unsustainable levels, and financing constraints soon led to a rapid accumulation of mostly domestic arrears. By 2001, financing was available only at precipitously high interest rates and the government faced a major liquidity crisis. Additionally, the adverse effects of a severe drought on agriculture and the September 2001 terrorist attacks on the nascent tourism sector, precipitated a steep recession.

Dominica has come a long way from the low-point of the crisis. In mid-2002, the government initiated a stabilization program aimed at ensuring an orderly adjustment, strengthening public finances and implementing measures to reinvigorate growth. With the debt-to-GDP ratio approaching 130 percent, the authorities concluded in December 2003 that the debt situation was unsustainable and launched a debt exchange offer. The IMF has supported the authorities' reforms since 2002 initially through a Stand-By Arrangement (SBA) and since end-2003 through a PRGF arrangement.

The reform strategy has been very successful. Economic growth has recovered to over 3 percent a year and is set to record the second straight year of above average growth in 2005. Inflation declined in 2004 and remains subdued in 2005 despite the higher energy prices. Reflecting strong fiscal consolidation and a collaborative debt restructuring agreement, public finances are now on a firmer footing. The central government primary balance has swung to a surplus of 4½ percent of GDP in 2004/05, with both higher revenues and lower spending contributing to the improvement. The debt restructuring process coupled with the fiscal consolidation effort allowed the debt stock to decline to 117 percent of GDP at end-2004. However, progress on structural reforms has been slower than expected, reflecting in part a limited implementation capacity and difficulties in building consensus.

Developments in the external position mirrors the economic recovery and the improved global environment. Import growth has been robust on account of the economic recovery but the impact on the current account has been partially offset by increased tourism receipts. Financial intermediation has also rebounded, and having contracted since early 2001, credit to the private sector has been growing from mid-2004. Private sector deposits grew moderately while net lending to government fell with the improved fiscal position, resulting in a substantial increase of the net foreign assets of commercial banks. Prudential indicators for the banking system's asset quality have remained broadly unchanged. However, poverty and unemployment remain serious concerns.

Executive Board Assessment

Executive Directors commended the Dominican authorities for the successful implementation of their economic program that has been supported by a PRGF arrangement since end-2003. Directors applauded the remarkable rebound in economic performance over the past two years, from the economic and financial crisis experienced in 2001−02. They attributed this turnaround to the strong policies being pursued by the authorities.

Directors pointed to the strong improvement in public finances, which has engendered confidence and restored the foundation for economic growth. Fiscal consolidation, which contributed to reversing the debt build-up, has helped reestablish macroeconomic stability. With the stability provided by the regional currency board arrangement and aided by the depreciation of the U.S. dollar in recent years, Directors considered that the competitiveness of the economy is adequate. Still, they stressed that Dominica continues to face significant challenges. They pointed in particular to the continuing very high level of debt, structural rigidities, and to the economy's large exposure to exogenous shocks, as evidenced by the recent rise in oil prices and the impact of preference erosion on the banana sector. Directors underscored the critical importance of policies to strengthen the resilience of the economy and sustain the growth momentum. They therefore called on the authorities to consolidate the gains thus far, with particular focus on fiscal discipline and consolidation and accelerated structural reforms.

Directors welcomed the recent steps to bolster public finances, but emphasized the need to reduce the debt burden further. They noted the adoption of value-added and excise tax legislation to allow for a VAT to come into effect on March 1, 2006, which should help improve the efficiency of the tax system. Directors welcomed the government's decision to publish information on tax concessions as an important step toward improving the transparency of public finances. They also noted the need for boosting the efficiency of government spending, streamlining public sector employment, and limiting the public sector investment program to well-targeted projects with high returns. In this regard, they welcomed the actions in the 2005/06 budget as further steps in the right direction. Directors also supported the government's objective of a smaller, more efficient, and better paid public service, but emphasized that this would require extensive rationalization of the structure and functions of ministries and departments. It will be important that the authorities continue targeting a primary surplus of 3 percent of GDP or higher, with a view to reducing debt to at least 60 percent of GDP over the next decade.

Directors commended the authorities for their efforts to reach collaborative agreements with creditors in the debt-restructuring process. They noted the depositing of payments to nonparticipating creditors into an escrow account as evidence of the authorities' good-faith approach. Directors were concerned, however, that reaching agreement with the last few hold-out creditors is taking time, and noted in particular the recent unfortunate actions by one large creditor. Directors recognized the importance of these creditors engaging with the authorities in a timely and constructive manner in order to reach a collaborative agreement. They also urged the authorities to complete expeditiously the issuance of the new bonds to participating creditors, and finalize the legislative changes needed to make these bonds tradable on the Eastern Caribbean Securities Exchange.

Directors emphasized the need for deepening structural reforms to sustain the current growth momentum. They welcomed the authorities' efforts towards removing bottlenecks that are impeding private investment. They noted the potential in the energy sector, and pointed to the benefits of liberalizing the electricity market to allow new entrants. Directors saw merit in rationalizing the operations of existing investment promotion agencies with a view to creating a one-stop investment promotion center. Directors also noted the need for modernizing the land registration process to ensure comprehensive coverage. Directors considered that, by creating a more enabling business environment, such reforms would do more, over time, to attract investment and stimulate private sector-led growth than the current reliance on tax incentives. In any event, it was considered that the region as a whole would be better served by a cooperative-rather than a competitive-solution to the tax incentive issue.

While noting that much progress had been made over the past two years, Directors pointed to the many challenges that persist in addressing vulnerabilities in the economy. They called for polices to prepare better for exogenous shocks, including those stemming from the high exposure to natural disasters. Directors also underscored the need to address the large unfunded liabilities of the social security system, which constitute a major risk to public finances. They stressed the importance of early and significant actions for social security reform, and were encouraged by the authorities' intention to review recommendations to overhaul the scheme. Directors also pointed to vulnerabilities in the financial sector, and the scope for strengthening regulatory oversight of nonbank institutions. They supported the provision of Fund technical assistance to strengthen the supervisory framework for AML/CFT in the nonbank sector, and encouraged the authorities to take the requisite actions. While the banking system remains generally sound, closer scrutiny of new bank lending was seen as helpful in reducing nonperforming loans. Directors noted that the manner in which these challenges are addressed will have a bearing on the durability of the economic recovery and sustainability of public finances.

Directors commended the authorities for seeking to bring the different elements of the reform agenda together in their forthcoming Growth and Social Protection Strategy document. They emphasized that progress in lowering unemployment and reducing poverty would depend critically on consolidating the gains made in macroeconomic stabilization and on fostering growth by creating a more conducive business environment. Directors noted that the present economic rebound and the government's renewed political mandate offer an important opportunity for the government to advance reforms. They called on the international community to support Dominica's reform effort, not least through speedy disbursement of already promised funds.

Directors encouraged the authorities to improve the quality of core statistics, which they considered key for effective surveillance.