Public Information Notice No. 05/70

Public Information Notice: IMF Concludes 2005 Article IV Consultation with the Kingdom of the Netherlands--Aruba

June 1, 2005

On May 25, 2005, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Kingdom of the Netherlands—Aruba.¹

Background

After a two-year long recession, GDP growth reached 1.4 percent in 2003, helped by strong private investment, and accelerated to an estimated 3½ percent in 2004. Growth is projected to level off at about 3¼ percent in 2005, as hotel capacity constraints slow tourism growth. Planned investments in the oil refinery and the hotels are expected to keep growth at about 2½ percent in the medium term.

Strong domestic demand, fueled by double-digit private credit growth and fiscal expansion, and a sharp increase in the oil price in 2002, had reignited inflation, which peaked at about 4.3 percent in mid-2003. To stem inflationary pressures, credit ceilings were reintroduced in 2003 and subsequently tightened in 2004. Average inflation fell to 2½ percent in 2004. The real effective exchange rate of the Aruban florin, which has been pegged to the U.S. dollar since 1986, has remained largely unchanged since 1998. Declining net tourism revenue and robust import demand widened the (rolling 12-month) non-oil current account deficit to almost 12 percent of GDP by mid-2003, but the deficit has narrowed subsequently with the strengthening of tourism revenue. The debt-creating external deficit (non-oil current account deficit plus FDI), however, has remained significantly lower and improved faster than the headline deficit. Reflecting these trends and government payment obligations, international reserves have declined since 2002, to about 5¼ months of imports in September 2004.

The fiscal deficit, which widened sharply during the recession, continued to deteriorate, from 3½ percent of GDP (including health care) in 2003 to an estimated 5½ percent in 2004. The health care fund has experienced large spending overruns since the introduction of universal health care in 2001. Moreover, despite a nominal freeze, total wage costs increased by a cumulative 12 percent in 2001-03, reflecting a rapid increase in public sector employment. Large deficits and called guarantees increased public debt sharply, from 28½ percent of GDP in 2000 to some 46 percent in 2004.

Executive Board Assessment

Executive Directors commended the authorities for Aruba's strong record of sustained high growth and macroeconomic stability since gaining autonomy in 1986. These achievements have been underpinned by strong public institutions and prudent macroeconomic policies. Looking ahead, Directors encouraged the authorities to build on their successes and pursue further wide-ranging policy and institutional reforms to secure Aruba's long-term prosperity. The key tasks are to consolidate public finances, to pursue a strategy to enhance the economy's long-term growth potential and diversification and address the problem of rapid population aging, and to improve further the quality of public institutions. Directors welcomed the authorities' commitment to pursue the policies and reforms required to achieve these objectives.

Directors urged the authorities to take advantage of the favorable cyclical position in order to rein in the widening fiscal deficit, and make strong efforts to meet the original 2005 budget deficit target. They viewed fiscal consolidation as essential to narrow further the non-oil current account deficit and reduce the burden on monetary policy.

Looking forward, Directors stressed the need for ambitious fiscal adjustment over the medium term to lower public debt to a safer level. In this context, they encouraged the authorities to introduce a fiscal responsibility law and a medium-term fiscal framework, which should facilitate the required fiscal consolidation and enhance policy credibility. They considered that a key medium-term objective should be to eliminate the budget deficit and reduce the public debt by the end of the decade. This will require wide-ranging expenditure reforms, including with respect to health care, civil service, and pension reforms. In this context, they welcomed the recent measures to reduce health care costs and the reform of the public sector pension scheme for new participants. Directors welcomed the progress made in eliminating expenditure arrears, and encouraged the authorities to continue strengthening budget management to prevent their recurrence. Directors highlighted the need for further tax reforms to broaden the tax base, narrow the tax wedge on labor, and simplify taxes. In particular, the introduction of a broad-based consumption tax and a simplification of the income tax were regarded as important. In the area of tax policy, Directors commended the authorities' decision to phase out tax holidays and guarantees.

Directors encouraged the authorities to take early action to sustain growth in the face of rapid population aging. In addition to fiscal consolidation and pension reforms, they recommended measures to maintain high labor utilization and create the conditions for faster productivity growth, including by improving education and public infrastructure. Directors also called for faster progress in restructuring public enterprises to open up markets for private sector activity. Underscoring the importance of economic diversification to enhance the country's growth potential, they welcomed Aruba's request for a World Bank Foreign Investment Advisory Service report on Aruba's development strategy.

Directors commended the authorities for successfully taming the inflationary pressures that had emerged at the beginning of the recent recovery. Noting that the inflation outlook is favorable and the underlying current account deficit of the non-oil sector has been narrowing, Directors saw no immediate need for further monetary tightening. Given the uncertainties, however, they called on the central bank to continue to monitor price and non-oil current account developments closely, and to stand ready to tighten the monetary policy stance if necessary. Directors noted that credit controls have been effective in dampening inflationary pressures. They encouraged the authorities to strengthen efforts to develop indirect monetary policy instruments over the medium term.

Directors noted that the peg to the U.S. dollar remains appropriate, and that Aruba has broadly maintained its competitiveness. Given the economy's dependence on highly volatile tourism revenue and the rapid increase in public sector external debt, Directors saw a case for rebuilding reserves to end-2002 levels.

Directors noted that the financial sector is generally sound and well supervised. Overcoming the capacity constraints that have slowed drafting and vetting of supervisory and anti-money laundering legislation should be given priority. Directors also considered it particularly urgent to proceed with extending central bank supervision to company service providers and insurance intermediaries.

Directors noted that long existing practices in Aruba provide the central bank with a high degree of operational independence. Nonetheless, they considered strengthening the legal guarantees for central bank independence as an important way to enhance policy credibility further. In this context, they welcomed the authorities' intention to move toward modernization of the central bank law and encouraged the authorities to seek IMF technical assistance with drafting the new law. Directors called on the authorities to eliminate the remaining exchange restriction subject to Fund approval under Article VIII as soon as possible.

Directors urged the authorities to renew their efforts to strengthen statistics. They judged that improvements are particularly needed in national accounts, government finance, and labor market statistics, as well as social indicators.