Public Information Notice No. 06/122

Public Information Notice: IMF Executive Board Concludes 2006 Article IV Consultation with the Solomon Islands

October 23, 2006

On October 4, 2006, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with the Solomon Islands.¹

Background

The economic recovery and stability prevailing since the 2003 intervention of the Regional Assistance Mission to the Solomon Islands (RAMSI) has continued. Per capita real GDP growth has remained respectable, inflation is under control, and budget discipline has been maintained. Thanks to official development assistance (ODA) and private foreign direct investment (FDI) mainly in two new large projects, international reserves have continued to increase.

Real GDP growth was 5 percent in 2005, about 2¼ percentage points above the Pacific Islands Countries' (PICs) average, driven by agriculture, fishing, and fiscal stimulus, with logging still over four times the sustainable level. In 2006, logging is not anticipated to contribute for the first time since 2001, but real GDP growth is still projected to exceed 5 percent, driven by agriculture, mainly the start of palm oil production, and services. Inflation ended in the high single digits in 2005, reflecting high oil prices, expatriates' demand, and

rapid private credit growth. Inflation is expected to be broadly unchanged in 2006, thus remaining about 2 percent above the PICs' average.

The 2006 budget of the central government envisages a shift to a deficit of ¾ percent of GDP from a 2¼ percent surplus in 2005, due to a 21 percent real increase in goods and services purchases and domestically financed development spending. But, the outturn is projected to be about 1 percentage point of GDP better than budgeted, with higher spending in low-priority areas (wage bill, tertiary scholarships, and representation) likely to be more than offset by revenue overperformance and investment underspending.

With soaring fuel and investment-related imports, the current account swung into an 11 percent of GDP deficit in 2005. However, official international reserves climbed to US$95 million (5¼ months of projected 2006 imports) due to robust ODA and FDI flows—mainly by the palm oil company and for the rehabilitation of a gold mine. The current account deficit is projected to widen in 2006, owing to higher oil prices and investment-related imports. But, continued strong ODA and FDI flows are expected to keep reserves above 5 months of imports.

Reserve money growth eased reflecting a moderation in net foreign assets growth in 2005, while broad money increased by 28 percent as the remonetization of the economy continued. Private sector credit rebounded strongly from a low base, growing 50 percent in real terms, reducing banks' excess reserves to 36 percent of deposits from 40 percent at end-2004. The growth of all monetary aggregates is expected to moderate in 2006.

Although the economy has performed well in the past three years, structural reforms remain essential to raise the prospects of sustainable growth, reduce poverty, and lessen the economy's vulnerability to shocks. Progress on this front has been mixed. Logging duty exemptions have been curtailed and tax exemptions guidelines have been issued. The Foreign Investment Bill has been passed and is now in effect. However, further reforms are urgent in the area of governance, state-owned enterprises, infrastructure, and business environment.

Executive Board Assessment

Executive Directors commended the authorities for maintaining macroeconomic stability and noted that near-term growth prospects are reasonably favorable. Looking ahead, Directors underscored the need to promote new sources of growth to raise living standards, particularly in light of the unsustainable pace of logging activities. Given the deep-rooted obstacles to private investment, weak institutions, and rapid population growth, this formidable task will require continued acceleration of the structural reform agenda and the maintenance of financial stability.

Directors encouraged the authorities to craft the 2007-10 national development strategy into the main vehicle for policy formulation and aid coordination, and called on the authorities to incorporate all projects and programs in this strategy, including those run by donors, and to set up a system to track aid delivery. Directors underscored that backing the strategy with a realistic medium-term framework and linking it to the budget will be instrumental for its effective implementation.

Directors welcomed the authorities' commitment to remain within the budget in 2006 and encouraged them to refrain from spending unutilized investment project appropriations and revenue overperformance. Over the medium term, they emphasized that budget consolidation is necessary in light of the limited domestic and external financing sources and the need to reduce the high public debt. Directors stressed the need to replace declining logging and import revenues with domestic taxes, improve expenditure quality, and reorient spending from the wage bill toward infrastructure, especially transport and communications.

Directors welcomed the introduction of tax exemption guidelines and the gazetting of the new foreign investment bill. They urged the authorities to accelerate tax reform to widen the base and reduce cascading, and public financial management reforms to ensure better governance in the use of public funds and aid flows. Directors considered that the poor performance of state-owned enterprises (SOEs), especially in the utilities sector, required urgent attention and recommended a comprehensive restructuring to improve service delivery and their financial position. They also cautioned that fiscal decentralization should be approached very carefully, as it would likely weaken fiscal discipline under present circumstances.

Directors agreed that the risk of debt distress remains high given the sizable public debt level, the country's vulnerability to shocks, and the possible increase in contingent liabilities given the weak finances of SOEs and provincial governments. They welcomed the authorities' progress in regularizing debt and the government's policy of no new borrowing, which should apply to all public entities, including SOEs, until the public debt profile has improved substantially.

Directors endorsed the current exchange rate policy, and agreed that downward pressure on the exchange rate should not be resisted. They were of the view that competitiveness appears adequate, in light of the prospects for nontimber exports, including agricultural and mineral products. Directors supported efforts to develop the central bank's inflation forecasting ability, which they viewed as critical in ensuring a timely monetary policy response should inflation pressures intensify or reserves come under pressure.

Directors agreed that the commercial banks appear sound. To strengthen the overall financial sector, they recommended the liquidation of the troubled Development Bank of Solomon Islands. Directors encouraged the continued use of commercially-based mechanisms to broaden access to banking services and credit, and the development of conservative investment guidelines to enable the National Provident Fund (NPF) to improve its profitability by investing abroad. They added that approving the new NPF bill would enhance the institution's governance.

Directors regretted that the weak statistical database hampers surveillance, but were encouraged by measures underway to improve real and external sector data.

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.