Public Information Notice No. 06/125

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with Trinidad and Tobago

October 26, 2006

On October 11, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Trinidad and Tobago.¹

Background

Trinidad and Tobago has one of the highest per capita incomes in Latin America and the Caribbean. Its wealth partially stems from a rich enddowment of oil and gas reserves. The energy sector accounts for over 40 percent of GDP, about 90 percent of exports, and over half of government revenues. In terms of broader social and development indicators, Trinidad and Tobago's life expectancy and literacy rates are among the highest in the Caribbean, however, its Human Development Index ranking is slightly above the regional average. Within the Caribbean region, Trinidad and Tobago is also a regional financial center and a significant source of capital flows to sovereign and private entities in the Caribbean.

Economic developments continue to be underpinned by a favorable international environment. Surging energy prices, the exploitation of new gas fields, and an expansion of industrial capacity helped sustain robust economic activity, contributed to a strengthening of external accounts, and contributed to excess liquidity in the financial system. However, there are signs that the economy is operating at, or near, potential. Capacity constraints have become evident in some sectors (notably construction), the labor market has tightened with the unemployment falling to 6¾ percent-an all time low-and inflation has accelerated.

In 2005, the economy expanded at about 8 percent underpinned by generally strong growth in the energy sector totaling 8¼ percent. The nonenergy sector also showed signs of strength, expanding, by 7¾ percent, supported by public infrastructure spending and rapid credit growth that fueled private spending. Against the backdrop of sustained high energy prices, the economy is on pace to expand by 12½ in real terms in 2006, driven by double digit growth in the energy sector in excess of 20 percent.

The balance of payments is in large surplus, reflecting a sharp improvement in the trade surplus to 24 percent of GDP in 2005. Imports grew by 17 percent but rising energy exports pushed total exports up by 51 percent. As in previous years, some of the gains on the current account were offset by private capital outflows but the overall balance of payments surplus strengthened sharply to 11 percent of GDP in 2005 as compared to about 5½ percent last year. Net foreign assets continued to rise in 2005 and gross international reserves reached US$4.8 billion (10 months of imports). Looking ahead, the external sector is set to exhibit a similar strong performance in 2006 with a projected trade and balance of payments surplus of about 27 percent of GDP and 15 percent of GDP respectively.

Although rising energy revenues has contributed to an improvement in the government's balance sheet, the underlying fiscal position has deteriorated. A rapid increase in public spending contributed to a widening in the non-energy deficit-the overall deficit excluding energy revenues-by about 2 percentage points to 10¼ percent of GDP in FY 2004/05. This outturn reflects rising transfers and subsidies on utilities and fuels and mounting public investment. Moreover, preliminary figures indicate that the nonenergy deficit rose to nearly 15 percent of GDP, partly reflecting an increase in spending execution of the ambitious public investment program.

The monetization of foreign currency energy receipts by the government has introduced a substantial degree of liquidity into the financial system. Although monetary policy was largely accommodative in 2005, the Central Bank of Trinidad and Tobago (CBTT) has actively been trying to regain control of liquidity in the system this year through stepped-up foreign exchange sales, sustained open market operations, and steady increases in the policy rate. Headline inflation for the 12-month period ending in August was 9 percent, up from 7¼ percent and 5½ percent at end 2005 and 2004 respectively. Furthermore, core inflation, which excludes food prices, has reached and remained at 4 percent since July. The CBTT has raised the benchmark repo rate by a cumulative 300 basis points since February 2005 to 8.0 percent as of September 2006.

Local financial markets have gone through an orderly correction since mid-2005. The local stock market index has fallen by over 20 percent from its peak in May 2005. Mirroring developments in the stock market, mutual funds' growth rate slowed to 16 percent, compared to an average growth rate of 44 percent in the previous five years. In 2005, the primary bond market continued to be very active with 37 placements with a face value equivalent to 8 percent of GDP, about one-third in foreign currency. The banking sector remains profitable, nonperforming loans are low, and provisioning increased compared to last year.

Executive Board Assessment

Executive Directors welcomed Trinidad and Tobago's strong economic performance in the context of a favorable external environment, and noted that economic activity remains robust. Directors were encouraged by the overall improvement in the external accounts and the government's balance sheet.

Directors stressed that the current favorable environment of high energy prices presents both opportunities for economic development and challenges for macroeconomic management. They stressed that raising living standards for current and future generations involves striking a delicate balance of investing energy windfalls efficiently to promote economic diversification and social objectives, while pacing the use of energy revenues to avoid overheating the economy and pushing up inflation.

Directors noted that, despite an overall improvement in fiscal balances due to rising energy receipts, the nonenergy fiscal deficit has widened in recent years with a rapid increase in public spending. They supported the objectives of the authorities' development initiatives through high-quality spending on human development and infrastructure. At the same time, Directors cautioned that the authorities should exercise greater overall budgetary restraint so as to avoid putting further upward pressure on inflation and the real exchange rate, which would have potential implications for the development of the nonenergy sector over the short and longer run.

While agreeing that fiscal policy has an important role in containing demand pressures in the near term, Directors underscored that sustainability considerations should ultimately underpin policy decisions so as to avoid disruptive policy reversals when energy resources are eventually depleted. In that context, they recommended that the authorities target a nonenergy deficit of about 10 percent of current GDP over the medium term. Directors welcomed the submission to Parliament of the Heritage and Stabilization Fund (HSF) bill with the aim of saving and prudently investing surplus petroleum revenues. They stressed that the legislation's effectiveness depends on disciplined fiscal policies, adequate oversight, and transparency in HSF management in relation with the budget.

Directors considered that the current favorable economic environment provides an opportunity to improve the quality of fiscal spending. While Directors noted that the authorities have put in place checks and balances with respect to the special purpose vehicles (SPVs), they pointed out the need to resolve institutional constraints that prompted the creation of these agencies. In addition, generalized subsidies should be replaced by well-targeted income supporting programs for the poor. Directors encouraged the authorities to participate in a fiscal ROSC.

As regards monetary policy, Directors agreed that containing mounting inflationary pressures was a top priority. They encouraged the central bank to continue to tighten monetary policy, making full use of its instruments to regain control over the stock of excess liquidity in the system. Given the de facto fixed exchange rate regime, Directors remarked that the central bank should increase foreign exchange sales, and continue to let treasury bill rates rise to further tighten the monetary stance. They also encouraged the authorities to address market characteristics that may have contributed to unsatisfied customer demands for foreign exchange.

Directors noted that, while the current exchange rate regime had served Trinidad and Tobago well, the de facto peg could complicate the conduct of macroeconomic policy, given increasing inflationary pressures from a potentially overheating economy, the monetization of the nonenergy deficit, and excess liquidity. In this context, they encouraged the authorities to remain vigilant to accumulating inflation pressures, and take further measures as needed, including consideration of greater exchange rate flexibility in the medium term in the event that the positive terms of trade shock persists.

Directors supported the authorities' structural agenda, which was appropriately focused on growth and diversification and improved macroeconomic management. They highlighted as key among the reform priorities to strengthen the financial sector regulatory and supervisory frameworks. Directors welcomed the progress that has been made in preparing for consolidated supervision of financial groups and in drafting amendments to financial institutions and insurance legislation along the lines of the 2005 FSAP recommendations. They urged the authorities to take this process forward in a timely manner by securing swift passage of these amendments and draft legislation.

Directors stressed the need to raise productivity in the nonenergy sector by removing impediments to growth and diversification of the sector. They clarified that diversification efforts should be firmly based on initiatives to foster the development of the private sector by improving the business environment. In that respect, Directors stressed that the authorities' industrial development plans should concentrate on industries that are viable over the long term without the benefit of government subsidies.

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. This PIN summarizes the views of the Executive Board as expressed during the October 11, 2006 Executive Board discussion based on the staff report.