Public Information Notice No. 05/86

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

July 7, 2005

On June 24, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Bahamas.¹

Background

Economic activity recovered in 2003-04, following two years of low growth that reflected the effects on tourism of the U.S. recession and the September 2001 terrorist attacks. Real GDP growth increased to 2 percent in 2003, owing to a rapid pick-up in financial and other services, and reached 3 percent in 2004 as the tourism sector began to turn around despite two strong hurricanes in September 2004. The recovery also led to a decline in the unemployment rate in 2004, to just over 10 percent. The economic expansion is expected to strengthen slightly in 2005, with real GDP rising by 3.5 percent.

The medium-term outlook appears broadly favorable, but challenges remain. Low inflation, a sound banking system, and generally prudent fiscal policies have set the stage for private-sector led growth.

The government deficit rose sharply during the economic slowdown of 2001-02, albeit from a low level, and remained above 3 percent of GDP over the three years to FY 2003/04 and above the authorities' 2¼ percent of GDP target for 2003/04. Although current outlays on nonwage goods and services and capital expenditure were compressed, tax revenues remained depressed, and public sector wages continued to rise.

The government deficit in 2004/05 is estimated to have declined to 2½ percent of GDP, but the debt-to-GDP ratio continued to rise, to about 37 percent of GDP. The revenue effort improved in 2004/05, albeit less than projected, aided by a boost from the settlement of tax arrears by a hotel being sold to a large developer. Total expenditure remained stable in relation to GDP as post-hurricane repairs were accommodated through budget reallocations that kept outlays within budget limits.

The balance of payments strengthened markedly in 2004, and net international reserves (NIR) rose substantially. A widening of the trade deficit, owing mainly to the higher oil import bill, was offset by an expansion of tourism receipts and reinsurance-related inflows following the hurricanes. As a result, the current account deficit narrowed to 5½ percent of GDP.

In response to the increase in NIR, the central bank relaxed credit controls in August 2004. The bank-by-bank credit freeze—which had been introduced in 2001—was lifted, and it was replaced by prudential guidelines for consumer loans and mortgages that were aimed at containing the growth of household debt. In early 2005, NIR continued to rise, reaching 117 percent of base money at end-March, and excess bank reserves rose strongly, as credit growth remained subdued. A reduction in the central bank discount rate of 50 basis points in February 2005 led commercial banks to lower the prime lending rate by the same amount, to 5.5 percent.

The regulation and supervision of the domestic and offshore financial sectors have strengthened over the last two years. The IMF's Module 2 assessment report on the offshore financial center (OFC) was generally favorable, including with regard to compliance with the Basel core principles for bank supervision. Steps were taken in 2003-04 to implement the report's recommendations, including the closure by mid-2004 of all banks without a meaningful physical presence. Bank soundness indicators improved somewhat in 2004, as the share of nonperforming loans fell to just under 5 percent and provisioning increased.

Executive Board Assessment

The Directors observed that the Bahamas economy has recovered well from the 2001-02 slowdown, with some acceleration of activity in 2004 having been achieved even in the face of two hurricanes, and that economic growth is expected to strengthen further in 2005. Inflation has been contained, international reserves have rebounded, and the banking sector has remained sound.

Directors noted, however, that the fiscal position has been relatively weak in recent years, and that public debt has risen significantly. Although prospects for the tourism sector appear generally favorable, realizing the economy's growth potential would require a strengthening of the fiscal stance over the medium term to place the debt-to-GDP ratio on a downward path. This fiscal strengthening should be supported by structural policies and private infrastructure investment that would help promote the diversification of the economy. Several Directors also suggested that, in light of the significantly adverse impact of hurricanes on the Bahamas economy, consideration could be given to establishing a system to improve disaster management.

Against this background, Directors welcomed the authorities' intention to lower the government debt-to-GDP ratio to 30 percent over the medium term, as well as their preparation of multi-year budget forecasts. Nonetheless, in part to provide greater room for policy responses to adverse shocks, Directors recommended a further strengthening of the 2005/06 fiscal stance relative to the budget proposal and closer monitoring of budgetary developments to help ensure that the more stringent objective is achieved.

Directors suggested that both revenue and expenditure measures could be used to support fiscal tightening. While welcoming the ongoing modernization of the customs administration, they noted that other revenue measures, such as adjustments to user fees, also would likely be needed. Directors noted that a comprehensive tax reform, entailing the introduction of a VAT or sales tax and a lowering of import tariffs, would help sustain revenues and reduce the vulnerability of the economy to external shocks, while also facilitating the possible accession to the World Trade Organization (WTO) that the authorities are presently considering. Noting the importance of adequate preparatory work for the introduction of a value added tax, Directors welcomed the studies commissioned by the government on operational and other aspects of the proposed system. On the expenditure side, Directors emphasized the importance of containing public sector wages—which have risen significantly in recent years—for maintaining international competitiveness, especially in the tourism industry. They also recommended reducing and rationalizing transfers to public corporations.

Directors observed that the fixed exchange rate peg to the U.S. dollar has served the Bahamas well, and welcomed the authorities' plans to strengthen the monetary policy framework in support of the exchange rate peg. They considered that the development of a secondary market for government securities could provide a useful basis for developing more market-oriented instruments for effective central bank control over commercial bank liquidity. Directors supported the authorities' intention to relax exchange controls on capital transactions to improve the efficiency of the domestic financial sector. However, they cautioned that controls would need to be eased in a gradual and prudent manner, while keeping prudential systems strong and international reserves at an adequate level, and therefore welcomed the authorities' intention to proceed cautiously in this area. Directors supported the monetary authorities' strategy of keeping international reserves at a level of at least the equivalent of base money, and stressed that the central bank should be prepared to withdraw some of the banks' excess liquidity if such a step were needed to protect international reserves.

Directors commended the authorities on their implementation of recommendations in the Fund's offshore financial center assessment report. They encouraged the finalization of guidelines for overseas regulators that will permit the efficient exchange of information while meeting the need for confidentiality. They welcomed the actions to strengthen the Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) framework.

Directors encouraged the authorities to reinvigorate the privatization program with an appropriate regulatory framework. In particular, they recommended that opportunities to divest the state airline and public utilities be actively pursued, and that other public enterprises be managed on a commercial basis or be privatized.

Directors welcomed the authorities' efforts to promote diversification of the economy, including the development of a National Information and Communications Framework to help promote e-commerce in the Bahamas. They considered that these efforts will help foster a more broadly based growth and reduce the vulnerabilities arising from the high degree of dependence on the tourism sector. Directors encouraged closer integration into the global economy through accession to the WTO, and emphasized that the multilateral trading system would provide the Bahamas with formal mechanisms to resolve trade differences.

Directors welcomed the recent publication of revised national accounts statistics. They encouraged participation in the data module of the Report on Observance of Standards and Codes (ROSC) to help identify further steps to improve the quality of economic statistics.