Public Information Notice No. 98/50

Press Information Notice: IMF Concludes Article IV Consultation with Solomon Islands

July 16, 1998

On June 10, 1998 the IMF Executive Board concluded the Article IV consultation with Solomon Islands¹.

Background

The Solomon Islands has made only limited headway in meeting its development needs in recent years. Beginning in 1992, surging timber prices led to an unsustainable boom in log exports, which temporarily underpinned output. However, the over-exploitation of forests strained relations with donors, undermined external viability, and spurred demand pressures, while failing to generate sustained increases in investment and growth. Following a collapse in demand for hardwood logs in East Asia, logging activity came to a standstill, giving rise to a large balance of payments deficit in late 1997.

On the policy front, fiscal mismanagement has been a major cause of the country’s macro economic problems. Generous exemptions from customs duties, together with inadequate valuation and monitoring procedures, led to a steady decrease in the effective rate of taxation of logs in the mid-1990s. Weak administration also eroded receipts from import duties and from domestic taxes. But expenditures were spurred by a growing public service wage bill and inadequate budgetary controls. Until August 1995, the resulting deficits led to heavy government borrowing from the banking system and, following a breaching of the statutory ceiling for central bank credit to government in 1995, an accumulation of domestic and external arrears. The situation became untenable as export duty receipts and grant inflows plummeted in 1997. While the overall budget deficit rose to about 5 percent of GDP, a shift in the composition of expenditure towards public wages led to a curtailment of needed operations and maintenance and development expenditure. With outstanding government arrears rising to the equivalent of 13 percent of GDP by end-1997, a continuing erosion of public confidence discouraged official and private capital inflows and undermined investment incentives.

Against this background, the new government, which took office in September 1997, undertook to launch a comprehensive Policy and Structural Reform Program (PSRP). To redress the underlying imbalances, the top priority of the PSRP is to rehabilitate public finances, streamline public services, and provide for a resumption of timely debt servicing. To those ends, one of the first measures by the new government was to withdraw most discretionary exemptions from customs duties. In December 1997, to stem official reserve losses, the Solomon Islands dollar was devalued by 20 percent and exchange controls were temporarily tightened. In early 1998, the government agreed to clear interest arrears on treasury paper over a two-year period and resumed domestic interest payments, albeit at a reduced interest rate of 6 percent. Progress was also made in clearing external arrears vis-à-vis multilateral financial institutions. The 1998 budget, which was approved on April 30, 1998, envisages the elimination of the budget deficit. In addition, a number of public assets are to be privatized, with the proceeds earmarked in large part for a reduction of arrears. These objectives are to be achieved with the help of measures to raise tax receipts, freeze public wages, and reduce government employment.

The authorities have also begun to tighten monetary conditions, which were eased markedly following the suspension of government debt-service payments. With the statutory liquid asset ratio having been raised to the maximum allowed under the Central Bank Act (40 percent), banks effectively became captive holders of a large stock of non-performing treasury paper in 1996–97. To protect liquidity and solvency, bank lending was restrained. The resulting accumulation of excess reserves, and the consequent reduction of bank deposit rates, were reinforced by a lowering of interest rates on central bank (Bokolo) bills. In March 1998, the earlier decline in Bokolo bill rates was partly reversed and commercial banks followed suit by nudging up their own interest rates. However, with inflation remaining in the double-digit range, deposit rates have remained highly negative in real terms, reflecting, in part, the low yield on treasury bills.

Exchange market pressures eased during the first half of 1998 and the level of net interna tional reserves stabilized, but the economic picture has remained clouded. While a new gold mine will be coming on stream in mid-1998 and the cash crop and fish export markets have been strong, the log market has remained moribund and the external current account is projected to record a large deficit. The financing of the deficit should be facilitated by an increase in aid inflows following the clearing of arrears to key multilateral financialinstitutions. However, given the uncertain economic conditions in major partner countries in the region, the external position is expected to remain vulnerable.

Executive Board Assessment

Executive Directors noted that, despite growing receipts from the logging sector, lax tax administration and poor expenditure controls had given rise to a large budget deficit and growing government arrears. More recently, the collapse of log exports and weak economic governance had eroded confidence of investors and donors, and had undermined the Solomon Islands’ overall economic performance. In this regard, Directors welcomed the new government’s decision to embark on the PSRP, focusing on macroeconomic stabilization. They urged the authorities to pursue their reform plans with determination, with a view to securing more rapid and enduring development led by the private sector and based on a smaller and more efficient government.

Directors endorsed the authorities’ plans to make fiscal consolidation and public service reform the centerpiece of the PSRP. To provide for an early reduction of arrears, Directors remarked that, at a minimum, the authorities should eliminate the budget deficit (excluding receipts from privatization) as soon as possible. In this context, they welcomed the objectives of the 1998 budget and, in particular, the measures to boost revenues and protect debt service payments. To help achieve the budget targets, Directors urged the authorities to broaden the revenue base and take decisive measures to strengthen tax administration. On the expenditure side, Directors called for steadfast adherence to the freeze in civil service wages and recruitment, and for downsizing of the public sector, so as to provide for adequate investment in public infrastructure and human resource development. Directors welcomed the authorities’ privatization program, and they stressed that an early settlement of government domestic and external arrears would be essential to regain the confidence of the banking, investor, and international communities.

Directors welcomed the modest tightening of monetary conditions since March 1998, but felt that further action along these lines will be necessary to quickly return inflation to the single-digit range and restore confidence in the domestic currency. An early return to positive real treasury bill rates will also be necessary to resuscitate the treasury securities market, lighten the burden on captive holders of government paper, and prompt a more decisive move toward positive real deposit rates.

Directors noted that the devaluation of December 1997 was a proper response to the worsening external environment, and that it had restored a broadly adequate level of competitiveness. There was a need for supportive measures to shore up public confidence and prevent undue depreciation. Aside from the actions to tighten fiscal and monetary policies and settle arrears, market-based reforms needed to be fostered to promote foreign direct investment. Directors welcomed the reversal of the recent tightening of exchange controls and urged the authorities to avoid future recourse to such controls.

While Directors agreed that the PSRP should be initially focused on macroeconomic stabilization, a far-reaching structural reform program will also be necessary to encourage private investment, maintain external viability, and promote sustainable improvement in living standards. Directors welcomed the recent simplification and reduction of tariff rates and the withdrawal of most discretionary exemptions from customs duties, but stressed that further action will be needed to replace export duties with nontrade distorting taxes and to further curb exemptions and reduce the level and dispersion of import tariffs.

Directors reaffirmed that Solomon Islands would continue to benefit from technical assistance from the IMF and from regional arrangements and donors. It was also stressed that regular contact between IMF staff and the authorities should be maintained between formal Article IV consultation discussions and that, whenever possible, IMF staff should consider joining World Bank and Asian Development Bank missions.