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p. 65 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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Vanuatu

Growth in 2004 was modest in a macroeconomic environment of low inflation, improving public finances, and rising foreign reserves. The outlook is for further growth at a rate that barely keeps pace with population expansion.

Macroeconomic assessment of 2004

GDP growth accelerated slightly from 1.6% in 2003 to an estimated 2.2% in 2004, led by the agriculture, forestry, and fishing sector, which expanded by 3.3%. Cocoa production fell because of cyclone Ivy in February and cattle production was sluggish, but copra and kava producers responded strongly to the higher farm-gate prices that resulted from stronger world market prices and from greater competition in commodity marketing following the ending of the Vanuatu Commodities Marketing Board monopoly. Forestry production also picked up from the level seen in 2003. In industry, manufacturing grew because of a substantial rise in coconut oil production, while electricity and commercial construction crept up at less than 2%. After registering zero growth in 2003, the services sector expanded by an estimated 1.9% in 2004 in response to a rise in domestic demand, in turn generated by stronger incomes from agricultural exports, real estate development in Port Vila, and tourism growth. Visitor arrivals in the first 3 quarters of 2004 were 17.5% above the corresponding prior-year period, reflecting the combined impact of an increase in cruise ship visits, an expansion in Air Vanuatu’s carrying capacity, and price competition after the entry of the airline Pacific Blue into the market.

Following an overall budget deficit in 2003 of 1.7% of GDP, the 2004 budget targeted a surplus of 0.4%. Although unbudgeted expenditures were made, associated with the snap general election in July, a surplus equivalent to 0.6% of GDP was recorded over the first 3 quarters of 2004, with internal revenue collection exceeding expectations and control exercised over spending. Some reduction in the surplus is to be anticipated as a result of fourth quarter spending, but the aggregate fiscal outcome for the year nonetheless was set to improve significantly on the 2003 result (Figure 2.36). Less progress was made in shifting the allocation of public resources away from meeting the public service wage bill and toward operation, maintenance, and capital expenditures, with the latter at less than 75% of the 2003 level in nominal terms. Spending on wages and salaries was 56.6% of expenditures and net lending in the first 3 quarters of 2004, compared with 38% of actual expenditures and net lending in 2000. In the intervening years, the number of public servants rose in line with population growth and their average real wages grew faster than total real government spending. Public debt declined from 39.2% of GDP in 2003 to 37.6% in 2004 as a result of a reduction in external debt to 27.0% of GDP, while domestic debt remained steady at 10.6% of GDP. In 2004, debt service costs were 13.4% higher than in 2003 and were equivalent to 7.5% of budgeted revenues and grants.

Inflation diminished from 3.0% in 2003 to 1.8% in 2004 as the domestic currency appreciated slightly against the Australian dollar (1.6%) and New Zealand dollar (0.7%), and substantially against the US dollar (13.0%). Food prices registered the largest rise of almost 4% because of cyclone Ivy’s impact on domestic food supplies, with all other expenditure groups showing moderate increases. Broad money supply in October 2004 stood at 9.4% above the October 2003 level because of a 12.8% rise in net foreign assets and a 7.4% expansion in domestic credit. The growth in domestic credit consisted of a 10.6% decline in net credit to government and a 9.0% rise in private sector credit that was concentrated in the transport sector. Commercial bank efforts to encourage deposits and then promote lending culminated in a narrowing of the interest rate spread from 9.6% at end-2003 to 9.1% in mid-2004. Increasing liquidity in the banking system was reflected in a rise in excess reserves held at the Reserve Bank and in a declining yield on 91-day Reserve Bank of Vanuatu notes, which fell to 3.75% by October.

The level of official foreign reserves rose to $51.0 million by mid-October 2004, equivalent to 5.2 months of import cover compared with 4.4 months a year earlier. This resulted largely from a 40% rise in merchandise exports in the first 3 quarters of 2004 compared with the same period in 2003, and substantial inflows of official transfers in the wake of the cyclone and earthquake damage. The bulk of the rise in exports was accounted for by copra and coconut oil to European markets, but this was insufficient to prevent a worsening trade balance as postcyclone imports of food and basic manufactures rose, as did imports of machinery, transport equipment, and mineral fuels. Tourism growth contributed to a rise in the services account surplus, and the current account deficit in the first 2 quarters of 2004 was almost 14% below that of the same period in 2003. Direct investment flows made a positive contribution to the balance-of-payments financial account and, with tourism accelerating in the second half of 2004, foreign reserves were projected to rise further by end-December.

Macroeconomic policy developments

Political instability in 2004 hampered policy development and implementation of the Prioritized Action Agenda, which is intended to link the long-term Comprehensive Reform Program with the Government’s medium-term investment program and annual budget. In particular, the intensification of political instability in the second half of the year constrained the formulation of fiscal policy. The July general election was called to forestall an opposition motion of no confidence, but the incumbent Government lost office to a shaky coalition. This coalition itself was soon subject to a no-confidence motion and another coalition administration took office in December.

The new administration’s budget was presented for parliamentary approval in February 2005. An overall budget deficit of 0.2% of GDP is projected, with revenues and grants in 2005 rising by 8.0% from the 2004 budget level and total expenditures and net lending rising by 11.4%. The bulk of the rise in revenues and grants is expected to come from external grants, supplemented by improved collection of tax revenues. All of the projected increase in total expenditures and net lending is attributable to increased recurrent spending, most notably an 8.4% rise in the public service wage bill. There is therefore little prospect in the short term of improving the strategic allocation of public resources.

Tightened liquidity conditions led the Reserve Bank to reduce the liquid assets ratio from 15% to 12% in January 2004. The stance of monetary policy remained unchanged for the rest of the year as liquidity increased and policy targets for inflation (4%) and international reserves (4 months of import cover) were met comfortably. The weights used in the basket of major trading partner currencies, against which the vatu is pegged, were reviewed and adjusted in June 2004, but remained confidential. The Vanuatu Financial Sector Assessment Group continued its work on ensuring that the regulatory and supervisory framework for offshore and domestic banks met international standards.

The most worrying policy issue is still that of how to deal with the long-term decline in income per head, particularly in rural areas. In 2004, real GDP per head was below the level of 20 years earlier, with the benefits of economic growth largely captured by those in urban employment in the public, tourism, and financial sectors. Real value added in the primary sector has grown at below the rate of aggregate GDP during this period, leaving village populations in a situation of worsening economic hardship. Reversing this trend requires, among other interventions, improving rural producers’ access to credit through the development of a secured lending framework, as has been done informally in a rural finance project administered by the National Bank of Vanuatu. In addition, the Government has made a major commitment to the development of a formal secured transactions framework, which will permit a broader distribution of credit via nonbank financial intermediaries.

The private sector remained hampered by the relatively high costs of utility services and of carrying out business activities. The costs of starting a business, the rigidity of employment conditions, and the costs of firing employees are the highest in the region, according to the World Bank’s Doing Business Indicators.

Outlook for 2005-2007 and medium-term trends

GDP growth in 2005-2007 is forecast to remain in the modest 2-3% range, edging up to 2.5% in 2005 as cocoa and cattle production recover from their 2004 decline and then tapering off to 2.2% in 2006-2007. Agriculture is foreseen as the driving force, while services expand at about 2% annually and industry at 1.5%. The outlook for agriculture assumes favorable weather conditions, some easing in agricultural commodity prices and, crucially, a sustained aggregate supply response to the recent deregulation of export marketing, as opposed to the switching of production between different crops. Growth in services depends on continued tourism expansion, which is expected from the ongoing provision of competitive international air services and more effective marketing, though its pace will be constrained by accommodation capacity. In industry, little improvement is anticipated in manufacturing, while electricity and construction are expected to expand at annual rates of 2.5% and 1.5%, respectively. Given an annual population growth rate of 2.7%, these forecasts imply a further medium-term decline in per capita income, increased under- and unemployment, and little alleviation of hardship in rural areas.

The Government will target budget surpluses of around 0.5% of GDP in 2006 and 2007, on the basis that improved compliance will generate sufficiently stronger tax revenues to cover growth in nominal total expenditures at about the forecast inflation rate of 2.5%. Fiscal prudence may be under threat from political instability, but if maintained will involve a stagnation of aggregate government spending in real terms and a decline in the per capita provision of government services. Limited progress is likely in improving the strategic allocation of public resources because of the relatively heavy weight of the wage bill in total spending and because of the political difficulties of reducing public sector employment and real wages. The achievement of budget surpluses and a policy of no new external borrowing will reduce the stock of public debt from 38% of GDP in 2004 to an estimated 32% in 2007. Continued fiscal discipline and moderate inflation will enable the Reserve Bank to maintain a neutral monetary policy stance in the medium term.

Domestic export volumes are forecast to rise at modest rates in line with agriculture, but--with some weakening in commodity prices--little growth is expected in the value of exports. The value of imports is projected to continue rising faster than that of exports, such that the trade deficit will widen. The net surplus on the services account is expected to increase as a result of tourism growth and, with official transfers, will ensure a virtual balance on the current account. This outcome and the maintenance of a capital and financial account surplus will keep foreign reserve levels above target, at approximately 5 months of import cover. Official external debt is forecast to drop to 22% of GDP in 2007.

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