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Asian Development Outlook 2002 : II. Economic Trends and Prospects in Developing Asia

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Vanuatu

The economy contracted slightly during 2001, a key factor being the loss of agricultural production following two damaging cyclones early in the year. Over the medium term, a tighter fiscal stance will be necessary to avoid macroeconomic instability and to underpin efforts to promote a favorable investment climate.

Macroeconomic Assessment

GDP is estimated to have declined by 0.5% in 2001 after a 3.7% expansion in the previous year (Figure 2.38). Much of the decline is attributed to a contraction in agriculture, forestry, and fisheries. Tourism also performed poorly, particularly in the last few months of the year. Two cyclones that hit Vanuatu early in 2001 led to considerable destruction of coconut palms, and copra exports fell by nearly 50%; exports of kava and beef also weakened.

Government revenues fell below forecast levels in 2001 as the economic slowdown reduced import duties and VAT collections. Revenues from Internet gambling and the Asset Management Unit’s sale of public assets failed to live up to expectations. As a result of the deteriorating fiscal position, the Government reduced spending on recruitment of new staff and introduced other restrictions. These controls were projected to have lowered total expenditures to 7.4% below the original appropriation and to have kept the budget deficit for the year to within 1% of GDP. However, the actual outcome for the year showed that total recurrent expenditures exceeded the budget by 4%. Due to the weakening fiscal position, the Government resorted to net domestic market borrowing of approximately US$4.3 million, mostly accounted for by an increased overdraft with the Reserve Bank of Vanuatu.

Private sector credit grew from US$81 million at the end of 2000 to US$85 million at the end of 2001, due to increased borrowing by construction, distribution (wholesale and retail), transport, manufacturing, and tourism. Broad money supply expanded by 5.5% over the year. Interest rates remained well above international levels during the year.

Poor export performance resulted in a deterioration of the trade balance. Nevertheless, international reserves remained comfortable, covering about 5.7 months of imports at the end of September. Inflation accelerated to 3.6% from 2.5% in the previous year, mainly because of higher prices for housing and utilities, and for transport and communications.

The vatu depreciated slightly against the US dollar in 2001. The annual average exchange rate in 2000 was 137.8 to the US dollar, but it fell to 147.0 by the end of 2001. Against the Australian dollar, the vatu showed a slight appreciation over the year.

Public debt surged in the 1990s, from 16% of GDP in 1990 to more than 40% in 2001, partly due to the need to fund losses by the National Provident Fund. The increased debt led to higher debt service costs, which rose by 13% in 2001. Around 80% of the public debt is external.

Policy Developments

The Vanuatu Public Finance and Economic Management Act restricts the level of external debt and debt service costs to “prudent” levels, defined as an external debt-to-GDP ratio of 40% and a ratio of debt service costs (excluding principal repayments of domestic debt) to domestic revenues of 8%. External public debt is currently 33% of GDP and so well within the limit set. Annual debt service costs are anticipated to rise to 7.4% of domestic revenues in 2003 and to reach their ceiling in 2007.

The Government has responded to the situation by planning for small budget deficits over the medium term. Domestic debt incurs a higher interest cost than concessional external loans, and domestically financed deficits run the risk of deteriorating the exchange rate and increasing inflation.

To strengthen the fiscal position through a broadening of the tax base, the Government recently established a Revenue Review Committee to prepare a strategic tax policy framework. The intention was to lift the ratio of revenues to GDP from the current level of 22–23% to 27%. However, none of the major recommendations made by the Committee in mid-2001 has yet been implemented.

The fiscal position could also be improved through better revenue administration, and additional resources are now being allocated to both the Department of Customs and Inland Revenue to improve compliance. Unfortunately, the resources required to administer VAT, which was introduced in 1998, meant that the collection of import duties and other revenues suffered.

Outlook for 2002-2003

The Government is aiming to achieve GDP growth of 4.5% over the medium term by encouraging private, including foreign, investment. Accordingly, the Foreign Investment Act was amended in 2001 to promote investment from overseas. The reform efforts pursued since 1997 under the country’s Comprehensive Reform Program also remain important in improving the climate for the private sector.

However, the budget forecasts recognize the difficulties that will be faced in rapidly building economic activity, and project GDP growth of only 0.7% in 2002 and 1.9% in 2003. A budget deficit equal to 1.5% of GDP is projected for 2002, but the Government will find it hard to achieve this unless it significantly improves current revenue collections and expenditure control.

There is some risk of a further increase in inflation if fiscal policy loosens over the medium term or if external shocks lift import prices. The Reserve Bank of Vanuatu views the current level of inflation of 4% as a critical level, and any further increase may trigger a tightening of monetary policy. The high level of international reserves and prospects of a rebuilding of export revenues during 2002 mean that a stable exchange rate and a sustainable balance-of-payments position should be achievable over the medium term.

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