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p. 64 of 77 BACK | NEXT Foreword, Acknowledgments, Acronyms and Abbreviations, Definitions I. Developing Asia and the world II. Economic trends and prospects in developing Asia East Asia Southeast Asia South Asia Central Asia The Pacific Cook Islands Fiji Islands Kiribati Republic of the Marshall Islands Federated States of Micronesia Nauru Republic of Palau Papua New Guinea Samoa Solomon Islands Democratic Republic of Timor-Leste Tonga Tuvalu Vanuatu III. Promoting competition for long-term development Statistical appendix

Asian Development Outlook 2005 : II. Economic trends and prospects in developing Asia

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Tuvalu

Reflecting the completion of major construction projects, the economy contracted. This coincided with a second year of relatively low offshore revenues for the Government, generating a large budget deficit. Over the medium term, new construction projects are expected to result in increased activity. However, even with an expected pickup in revenues, expenditure control will be required to stabilize the fiscal position.

Macroeconomic assessment of 2004

Economic activity subsided in 2004 following the completion of major construction projects. These included a hospital renovation and extension, and a government office block, both donor funded and on the main island of Funafuti. The total value of these two projects alone almost equaled the value of GDP in 2002. Construction had created substantial casual employment opportunities in 2003 and labor income rose by more than 10% that year. Preliminary estimates suggest that in 2004, labor income fell back to the 2002 level.

Internal revenue collection was boosted in 2003 by the surge in economic activity but fell by 12% in 2004 as activity slowed. Import duties, the main source of internal revenues, were projected to decline by 20% to 2002’s level, indicating a large fall in consumption in 2004. Sales tax revenues and income tax collection were projected to decline by 20% and 13%, respectively, over the year. The fall in internal revenues corresponded with the second consecutive year of low offshore revenues. In 2001, the Government sold its investment in the operator of the country’s “.tv” Internet domain name and now only receives a small ongoing royalty. Revenues from the foreign fishing fleet operating in Tuvalu’s exclusive economic zone were considerably higher than in 2003 but well below trend. An improvement in world equity markets allowed the first distribution since 2001 from the Tuvalu Trust Fund, one of the Government’s two offshore investment funds (the other being the Falekaupule Trust Fund). However, distribution was also well below trend (Figure 2.35).

From the mid-1990s to 2002, a strong upward trend in revenues had been seen and, while some of the “windfall” revenues received over the period were placed in the Tuvalu Trust Fund, capital projects and the wage bill also surged. The buildup in expenditures and community expectations has therefore made it difficult to quickly trim back spending as the revenue position has weakened, with the result that large budget deficits emerged in 2003 and 2004--the overall deficit in 2004 was estimated to be approximately 9% of GDP. The deficits have been financed by a rundown of cash reserves, and the tight cash position for much of 2004 necessitated a midyear review of expenditures: cuts fell heaviest on allowances, maintenance, basic supplies, and capital projects, though a 5% wage increase that was provided for at the start of 2004 was preserved, and the number of government employees continued to rise over the year.

The gross net value of government debt is estimated at $16 million, equivalent to 80% of GDP. As almost all of the debt is concessional, the net present value of the debt is much lower at 40% of GDP. Against this, $2 million was held as cash reserves as of September 2004 and $63 million was invested in the two offshore investment funds.

Macroeconomic policy developments

Fiscal management in Tuvalu is greatly complicated by the volatility of the main revenue items. Income from the sale of rights to the “.tv” domain name will remain below trend, but other revenue items have the potential to rebuild. The issue to be faced in framing a budget is whether to cut expenditures to fit the low levels of the last 2 years or whether to be less aggressive in cutting spending in the hope that revenues increase. Budget management also has to deal with the difficulties created by one of the largest revenue items, fishing licenses, coming in over the last month of the financial year. Not only are these revenues received late, but it is difficult to predict changes from year to year. The likely income is only known with confidence well into the second half of the financial year.

Cash reserves had been built up in the Government’s buffer fund, the Consolidated Investment Fund, to help manage the volatility and uncertainty in revenues. However, the buffer has declined recently, and once a government overdraft equivalent to 9% of GDP is taken into account, net cash holdings as of end-2004 will only be sufficient to fund the planned 2005 deficit.

One of the main pressures on the budget is the growing wage bill. This has increased by 17% in real terms since 2001, and by 146% since 1996. As of late 2004, 1,100 public servants--some 10% of the population--were on the payroll. If the recent growth in wages continues, personnel costs will inevitably put pressure on the overall budget outcome and displace other expenditures, with an adverse impact on the quality of government services. Budget management faces the additional challenge of providing the funding to maintain and make effective use of recent investments. This includes equipping and staffing the new hospital facility, and maintaining new buildings and newly surfaced roads on Funafuti. These investments create a new, ongoing need in a difficult fiscal environment.

Public debt consists of loans from ADB, the European Investment Bank, and the government-owned (and country’s only) National Bank of Tuvalu. There is some doubt as to whether the two loans secured from the National Bank of Tuvalu will generate any income to cover debt service costs. These loans were used to purchase a share of the only airline operating to Tuvalu and for the National Fishing Corporation of Tuvalu; however, these loans represent less than 10% of gross public debt. The largest single loan, secured to provide funds for the Falekaupule Trust Fund (for the outer islands), is fully invested offshore. The remaining large loans are for economic activities and are at least partly backed by revenue flows, either directly or indirectly. Current debt service costs are 2% of the trend level of revenues and grants, and are projected to rise steadily over the next 10 years. They should remain relatively low at no more than 3% of this trend level, provided that the debt stock remains close to current levels.

Outlook for 2005-2007 and medium-term trends

The economy is dominated by a public sector supported by a high level of foreign grants and offshore income. The main sources of the latter for the Government are returns from the Tuvalu Trust Fund invested in international financial markets, the sale of access to fishing resources, and the country’s “.tv” domain name. Households earn offshore income from seafarers who are working for international shipping companies; their remittances amount to some 20% of GDP. Prospects for the economy and the limited private sector will remain dependent on changes in these inflows.

The Government anticipates receipt of a grant from the Japanese Government to rebuild the electricity generation and distribution system on Funafuti in 2005-2006. At an expected cost of approximately 75% of 2002 GDP, construction would provide another temporary, but major, boost to the economy. Grants, excluding those provided for major building projects, are projected to remain steady over the medium term.

Economic activity will also be boosted over the forecast period with the launching of a second major project, the upgrade of the Tuvalu Maritime Training Institute. This is in part motivated by the need to ensure that the institute retains its accreditation from the International Maritime Organisation. Loss of accreditation would put at risk continued growth in seafarers’ remittances, which not only represent an important source of aggregate demand for the overall economy, but are particularly important for the outer islands, which offer limited alternative income-earning opportunities.

A distribution from the Tuvalu Trust Fund to the budget is only possible when the market value of the fund exceeds the maintained value, being the real value as measured by the Australian CPI. The market value was below the maintained value in 2002 and 2003, but a 13% gain over the first 9 months of 2004 saw the positions reverse. As long as market returns continue to exceed the low Australian inflation rate, a distribution will be possible.

Current official forecasts are for a deficit rising in 2006 to about 15% of GDP (excluding the effect of the large construction projects which are off budget), mainly because of a poor revenue performance. These forecasts appear too cautious. The likely pickup in economic activity and a more favorable outlook for offshore revenues suggest that the budget position should improve over the next few years, provided that expenditures are controlled. Additionally, a proposal is being considered to introduce a VAT to help generate revenue, and provide for a more efficient tax system. Introduction of such a tax will become increasingly important if the Pacific Island Countries Trade Agreement is ratified as expected, since Tuvalu would forgo duty revenues on imports from the region under the agreement. If large deficits are incurred in the medium term, cash-flow difficulties can be expected to continue. This may require the development of new methods of deficit financing. Options include the sale of government businesses, the main candidate being the National Bank of Tuvalu.

The sharp rise in the Government’s overdraft at the National Bank of Tuvalu since 2001 has necessitated a substantial fall in lending to the private sector. Consumer lending for housing has been frozen, assistance to seafarers (to cover traveling costs, etc.) has been curtailed, and the maximum size of other loans has been reduced. This is despite a continuing demand for such loans, particularly to fuel growth of the small private sector. Such crowding-out effects are likely to persist until the Government’s overall fiscal position improves.

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