Public Information Notice No. 05/159

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with Trinidad and Tobago

November 30, 2005

On November 11, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Trinidad and Tobago.¹

Background

Trinidad and Tobago's economy, which is endowed with large energy reserves, is experiencing a strong energy sector-based expansion. The energy sector already accounts for about 40 percent of GDP, over 80 percent of exports, and approximately half of government revenues. However, its contribution to employment is less than 5 percent. Within the Caribbean, Trinidad and Tobago has become a major financial center and a source of capital for regional entities. Trinidad and Tobago is one of the larger Caribbean nations in terms of GDP and population. Its energy wealth has enabled it to achieve one of the highest standards of living in the region. Nevertheless, income inequality and poverty rates are only at about regional averages.

Macroeconomic performance and financial developments are currently being driven by a highly favorable external environment. Surging oil prices have strengthened the external current account balance, financed an expansion of aggregate demand, and contributed to high levels of liquidity in the financial system. There are tentative signs that the economy is producing at, or near, capacity and inflationary pressures are emerging.

The economy is growing robustly and unemployment has fallen to historical lows. Real GDP grew by 6½ percent during 2004. While this is lower than the outturn of 13 percent growth during 2003, the latter was driven primarily by the coming on stream of some large energy projects. The nonenergy sector has remained vigorous, growing by just under 6 percent during 2004 on the back of a surge in government spending financed by the oil bonanza. The latter has also led to a boom in construction. Under the official definition of unemployment, which includes some discouraged workers, the average unemployment rate stood at 8¼ percent in 2004, the lowest in decades.

The balance of payments is in large surplus, driven by exports, which rose by US$1.2 billion (10 percent of GDP) in 2004, significantly outpacing import growth and lifting the current account surplus to 14½ percent of GDP from 9 percent of GDP in 2003. While some of the higher current account receipts were offset by private capital outflows, the overall balance of payments surplus still doubled to US$0.7 billion (6 percent of GDP). With oil prices rising further, these trends are accelerating in 2005—the foreign assets of both the commercial banks and the central bank have continued to rise rapidly this year.

There has been a substantial widening of the nonenergy fiscal deficit (the overall deficit, excluding energy revenues) although the overall budget balance remains in surplus on account of buoyant energy revenues. The budget for FY 2005/06 envisages a significant further expansion of the nonenergy deficit, due to a reduction in nonenergy revenues (from lower income tax rates, and other changes to both direct and indirect taxes), as well as a further increase in non-interest expenditures. High energy prices as well as some recent changes to the energy tax regime should, however, lead to increased receipts from the oil and gas sector.

Monetary conditions have largely been accommodative, although signs of accelerating inflation have led to a recent shift toward tightening. The monetization of energy receipts by the government to finance the nonenergy deficit is the major source of liquidity injection into the financial system. Despite a sustained freeze of public utility tariffs and gasoline prices, headline inflation has crept up to 7 percent for the 12-month period ending in September 2005, up from 2¾ percent a year and a half ago. A significant part of this reflects movements in volatile food prices. Nevertheless, core inflation is also up and the Central Bank of Trinidad and Tobago (CBTT) has raised the benchmark repo rate on three occasions this year, each time by 25 basis points.

Financial markets have generally been buoyant in reflection of the ample liquidity. Insurance, pension funds, finance companies and mutual funds have all experienced rapid expansion, with mutual fund investments reaching roughly two-thirds of bank assets and stock market capitalization approaching 140 percent of GDP in 2004. The financial system as a whole increased credit to the private sector by 18 percent in 2004, a leap compared with single-digit annual growth since 2001. Banking soundness indicators generally improved in 2004.

Executive Board Assessment

Executive Directors noted the currently highly favorable external environment for Trinidad and Tobago and the benefits that were accruing from surging energy export prices and track record of strong economic policies. Economic growth was robust, unemployment was at historical lows, and government finances, as well as the balance of payments, were registering large surpluses. Financial markets had generally remained buoyant and credit ratings were up. Directors remarked that the current circumstances, where high energy prices were driving macroeconomic developments, provided a unique opportunity for Trinidad and Tobago to make significant progress toward securing sustainable high living standards for its population.

Directors noted that maximizing the gains from the energy windfall required a prudent mix of fiscal, monetary, and structural policies. Such policies should ensure that the public sector was getting value for its money and private sector competitiveness was maintained and enhanced. Directors considered that a careful balancing of priorities and policies was called for.

While mindful of the potential long-term benefits of reducing tax rates and increasing capital spending, Directors expressed some apprehensions about the recent significant expansion of the nonenergy fiscal deficit, i.e., the deficit excluding energy revenues. They noted that the plans for current spending needed to be assessed against institutional limitations and the economy's capacity to absorb the higher levels of expenditures. There were, in particular, emerging concerns about inflation and the risks of Dutch disease down the road. Directors also indicated that the expanding nonenergy deficit rendered the public finances vulnerable to sudden downward swings in energy prices.

Against this background, Directors called on the authorities to consider increasing the share of energy revenues that is saved. Noting the limited energy reserves, Directors underscored the importance of ensuring long-term sustainability of public finances. They also emphasized the benefits greater savings would provide in terms of helping shield the economy from the adverse consequences of a pro-cyclical fiscal stance, in terms of high inflation, loss of competitiveness, and a "boom bust" pattern of economic growth.

Directors praised the authorities' efforts to simplify the nonenergy tax regime to increase its efficiency and predictability. They indicated a preference, however, for a more gradual approach to the reforms, given their uncertain revenue and distributional impacts in the context of a widening nonenergy deficit, and the need to assure predictability about future tax levels for investors. Directors welcomed the intention to establish a Tax Policy Unit in the Ministry of Finance with a mandate for continuous reform of the tax regime.

Directors underscored the role of institutions in ensuring that the benefits from the current high oil prices were realized. In this regard, they welcomed the authorities' intentions to establish a permanent energy fund. Noting the importance of designing the fund well from the outset, Directors advised the authorities to avoid using the fund for extra budgetary spending and urged them to channel all public spending to compete for scarce resources within the standard budgetary process in parliament.

Directors welcomed the authorities' assurances that there would be adequate checks and balances on the special new agencies that were being set up to expedite expenditure execution. However, most Directors encouraged the authorities to consider reforming and restructuring the existing government apparatus, rather than setting up new entities. In any case, Directors suggested that a comprehensive public expenditure review (PER), carried out with external assistance, and a fiscal Report on Standards and Codes (ROSC) prepared with assistance from the Fund, could be useful inputs to policy-making at this time. They noted the potential benefits of these studies—the PER in helping identify ways to better target and focus public interventions; and the ROSC in helping strengthen budgetary management processes and accountability.

Looking forward, and given the strong external inflows and widening nonenergy fiscal deficits, most Directors advised a reconsideration of exchange rate policy to achieve greater exchange rate flexibility. Directors noted the pressures for a real appreciation and pointed to the limits to monetary policy alone successfully addressing these pressures in an environment of improving terms of trade and expanding fiscal nonenergy deficits, although increased investments abroad by the private sector would mitigate to a certain extent the appreciation pressures stemming from the strengthened current account position. They considered that in the absence of sufficient fiscal tightening or changes in private sector behavior, the choice was whether real appreciation occurred through inflation, which would have an adverse impact on poor households, or by other means.

Directors encouraged the authorities to take advantage of the current favorable economic environment to press ahead with structural reforms to support private sector led growth. In this regard, continued progress on utility prices, privatization, and labor market reforms will be critical. Directors praised the authorities' efforts to reform the financial sector. They welcomed the FSAP findings, urged the authorities to undertake the necessary legal reforms, and agreed that the Fund would help coordinate the necessary technical assistance following from the FSAP recommendations. Directors called on other technical assistance providers to extend support to the authorities' reform program. They concurred that the authorities' financial sector reform program, upon its successful completion, should help further secure Trinidad's position as the financial center of the Caribbean.