Public Information Notice No. 06/11

Public Information Notice: IMF Executive Board Concludes 2005 Article IV Consultation with St. Kitts and Nevis

February 1, 2006

On December 21, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with St. Kitts and Nevis.¹

Background

Over the past decade, St. Kitts and Nevis was adversely affected by a series of large exogenous shocks. Three major hurricanes in the second half of the 1990s caused combined damage estimated at more than double annual GDP at the time. The decline in tourism following the 9/11 terrorist attacks also had a pronounced negative impact on the economy. While those shocks were temporary, the damage took years to repair. Moreover, rising production costs, and an announced loss of preferential market access, permanently impaired the sugar industry, the mainstay of the economy for more than 300 years.

The economy has rebounded since 2004, driven by tourism and construction. Real GDP growth exceeded 6 percent in 2004, and is projected at almost 5 percent this year. A surge in tourism since 2003 was facilitated by favorable global growth and large recent investments in infrastructure. Construction activity also rebounded, with a number of new tourism developments and preparations for the 2007 Cricket World Cup underway. Inflation has been well-contained under the currency board arrangement. Higher oil prices are worrisome, although the effect has so far been limited to increasing fiscal costs rather than leading to higher inflation or lower growth.

The government decided to close the loss-making, state-owned sugar company following the July 2005 harvest. Burdened by high costs, the sugar industry had become a major contributor to the fiscal deficit, with annual losses on the order of 4 percent of GDP, and accumulated debt of about 30 percent of GDP. The situation was only set to worsen with the impending loss of preferential access to EU markets. With the marked drop in sugar production in recent years, the industry's closure should have only a modest adverse impact on growth. Near-term fiscal savings are unlikely owing to transition costs, but the industry's closure should strengthen fiscal balances and growth prospects over the medium term.

Government finances have improved during 2004−05, but the sharp rise in oil prices and prospective investments are constraining further fiscal consolidation. Based on the fiscal performance during the first half of 2005, a primary surplus will likely be achieved this year, compared to an average primary deficit of 6.5 percent of GDP over the previous five years. Revenue collection has shown continued strength—owing to the upturn in economic activity and administrative improvements by the Inland Revenue and Customs Departments—but has been mostly offset by increasing current expenditure, in large part reflecting the limited pass-through of higher fuel costs to consumers. While a reduction in net lending and nongrant-financed capital expenditure have contributed to the improvement in overall balances, a series of planned investment projects are in the offing. Moreover, the restructuring of the sugar industry will put substantial pressures on the budget for some time to come.

Despite the strong recovery in economic growth, total public debt has continued to rise and is projected to reach 180 percent of GDP by end-2005. While government finances have improved this year, developments in the broader public sector are more worrisome. The debt of public enterprises increased rapidly, reflecting a substantial rise in their capital expenditure combined with inadequate fiscal oversight.

External competitiveness of the economy has improved, boosted by the U.S. dollar's depreciation against major currencies. The real effective exchange rate has thus fallen sharply since 2002. Supported by strong foreign direct investment (FDI) inflows oriented toward the services sector, St. Kitts and Nevis gained market share in the Caribbean tourist market. Looking forward, wage pressures stemming from both the public and private sectors could undermine these gains in competitiveness.

External sector performance has improved. The buoyant tourism sector has more than offset a decline in sugar exports, leading to a substantial narrowing of the external current account deficit. Nonfuel imports have declined from their FDI-related peak around 2002, but overall imports have remained largely unchanged on account of rising oil prices. FDI is expected to be boosted by Cricket World Cup-related investments, including a projected rise in visitor accommodation capacity, and should finance most of the current account deficit in the near term.

The growth in monetary aggregates remains high, with broad money 15 percent higher for June 2005 compared to the same month last year. Gross credit to the public sector grew by 70 percent (30 percent of GDP) from end-2003 to June 2005, over five times the rate of growth in private sector credit.

The offshore sector has fully recovered following the removal of the country from the OECD and FATF lists of noncooperating territories in 2002. Following substantial enhancement of the supervisory and regulatory frameworks to meet international standards during 2000-2002, the authorities have concentrated on some remaining weaknesses, including the regulation of brokers' investment activities and the difficulties in revoking practitioners' licenses, and have embarked on the development of new products.

Executive Board Assessment

Directors welcomed the economy's strong rebound after a series of adverse shocks, and noted the promising outlook for growth. They were encouraged by the government's efforts to strengthen revenue collection, which have underpinned an improvement in central government finances. Directors commended the country's achievement of favorable social and human development indicators. They praised the authorities' courageous decision to close the nonviable sugar industry, laying the groundwork for bolstering growth and the fiscal position in the long term. Directors underscored nevertheless that the country's extremely high debt level leaves it vulnerable to shocks. They considered that the government's solid political mandate and the current favorable economic outlook provide a window of opportunity for the authorities to set in place durable measures to put the debt level on a declining trend, and to implement the structural reforms that will be essential to secure sustainable strong growth in the period ahead.

Directors considered that an overarching priority must be frontloaded and broad-based fiscal consolidation, which would signal the government's commitment to tackling the debt problem and underpin investor confidence. On the expenditure side, Directors encouraged the authorities to pursue civil service reform and wage containment, tighter control and prioritization of capital investments, and strict limits to land development investments, which should be left largely to the private sector. On the revenue side, Directors recommended extending fully the coverage of consumption taxes to services and better capturing higher-income households in the tax net. They emphasized in particular the need to curb discretionary tax concessions and make transparent those that remain. More broadly, a regional approach to the phase-out of concessions is needed so as to avoid destructive competition for investments. Directors supported giving consideration to introducing a value-added tax in the medium term. They welcomed the recent increase in retail prices for gasoline and electricity, but also stressed the critical importance of moving to a fully flexible petroleum pricing mechanism, and ensuring that utility prices are set at cost recovery levels.

Directors expressed particular concern that, while the central government's fiscal performance has strengthened, borrowing by the broader public sector, especially the public enterprises, has continued to grow. The debt problem is unlikely to be resolved until spending by these enterprises is brought under control. Against this background, Directors encouraged the authorities to improve the transparency, accountability, and fiscal oversight of public enterprises, and they called for rapid passage and enforcement of the draft Financial Administration Act.

Directors viewed the closure of the sugar industry as providing an opportunity to enhance the country's growth potential by reorienting sugar industry resources to more productive uses. At the same time, it presents substantial short-term social and fiscal challenges. Directors encouraged the authorities to develop a comprehensive framework to privatize the former sugar lands, facilitate labor mobility of sugar industry workers through retraining programs, and resolve the sugar company's debt, which is of particular urgency given the need to safeguard the financial health of the local banks. Directors recommended that the government assume the sugar company's obligations and cover them through a bond issuance, and use the proceeds from land sales to retire the debt.

Directors expressed concern that the burden of financing the public sector deficit falls largely on the domestic financial market, sharply increasing the vulnerability of locally-owned banks. Directors underscored the importance of strengthening prudential supervision to enable a more accurate assessment of the financial sector's health. In this regard, full implementation of the amendments to the Uniform Banking Act would help to prevent potential banking problems.

In light of the economy's high degree of vulnerability, Directors highlighted the importance of precautionary measures and contingency planning, with a focus on dealing with potential natural disasters and financial sector shocks. Because the country's high debt level limits the government's capacity to provide financing in response to adverse shocks, emphasis will need to be placed instead on identifying low-priority expenditures that could be cut or delayed, and building up deposits that could be used in the event of a crisis.

Given the changing structure of the economy, Directors called for increased flexibility in labor and product markets, supported by greater regional cooperation. Further efforts at enhancing regional cooperation would support economic diversification, allow for economies of scale, and make the overall environment more conducive to investment. Directors encouraged the authorities to implement the Fourth Phase of the Common External Tariff, which would reduce impediments to regional trade.

Directors encouraged the authorities to work toward providing more timely and accurate economic data in order to support effective policy making.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.