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p. 2 of 5 BACK | NEXT I. Country Strategy II. Current Development Trends and Issues III. Implementation of the Country Strategy and Program IV. Portfolio Management Issues V. Country Performance and Lending Level

Country Strategy and Program Update 2003-2005: Vanuatu

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II. Current Development Trends and Issues

A. Recent Political and Social Developments

3. Following four changes of government during 1998-2002, a general election was held on 2 May 2002. It resulted in the Vanuaku Pati (VP), Union of Moderate Parties (UMP) and several independents sharing power, with the posts of Prime Minister and Minister of Finance going to VP, and of Deputy Prime Minister to UMP. For only the third time, and the first time since 1991, a woman was elected to Parliament. A proliferation of political parties, most organized around allegiance to a leader rather than around a political platform, and the opportunity for parliamentarians to cross the floor has resulted in frequent changes in government, policies and administration. Although the role of custom chiefs is recognized in the constitution, there is often a lack of understanding of the role of chiefs at the national level and of civil authorities at the local level. Civil and social order is being maintained by only a narrow margin. In early 1998, for example, there was civil unrest due to the near-collapse of the Provident Fund and other financial institutions. In the middle of 2002, there was an armed standoff between the police and the government over the appointment of a police commissioner. The free press has helped keep the public informed and will continue to be essential to good governance. Although the courts, the State Law Office (SLO) and the police are all being strengthened, it will be some time until they are able to maintain civil order and enforce contracts without resort to outside assistance. Crime may be increasing as joblessness and migration from rural to urban areas continue.

4. Under the Government’s Comprehensive Reform Program (CRP), begun in 1997 and supported by ADB, substantial efforts have been made to improve governance and strengthen institutions, by (i) creating the Council of Ministers and the Development Committee of Officials to identify and consider policy measures, (ii) consolidating the various departments into 13 ministries, (iii) rightsizing the civil service, (iv) passing laws redefining the roles and responsibilities of civil servants and political advisors, (v) strengthening the Civil Service Commission, (vi) strengthening the rule of law, and (vii) creating local land tribunals to expedite the resolution of land disputes. Performance has improved in some areas, such as maintenance of roads and other infrastructure. However, in many areas of public service, performance has been held back by the lack of senior professional staff and a budget that has grown progressively tighter over the last four years. The civil service lacks senior professionals (lawyers, engineers, accountants). As a result, the delivery of services has not improved and, in some areas, such as in agriculture, it may have declined.

5. Geographic remoteness and isolation, and the lack of jobs, contribute to poverty. The significant income disparities between urban and rural areas are related in part to low agricultural productivity. Only about 500 jobs are created each year in the formal sector, while about 2,000 people, mostly youth, seek employment. The country is near the bottom among ADB’s Pacific developing member countries (PDMCs) for adult literacy (34%), gross primary enrollment (72%) and gross secondary enrollment (22%). The low rates of primary and secondary school enrollment, and high levels of adult illiteracy, are real obstacles to efforts to modernize and develop. While the infant mortality rate improved between 1979 and 2000 (from 94 to 30 deaths per 1,000 births), it remains high (see Appendix 2, Table A2.1). Basic education services, both public and private, have been extended from sixth to eighth grade, but teachers are lacking, as are funds to pay their salaries. Gender inequalities are significant.

B. Economic Assessment and Outlook

6. The economic outlook is not good. Real GDP declined by 0.5% in 2001, and is not expected to grow more than 2-3% any time soon. Meanwhile, the rate of population growth is a high 2.5%. In 2001, exports of copra, cocoa, beef, and timber were all down, while only exports of kava increased. Copra and cocoa exports fell due to low world prices, while beef and timber exports fell due to low demand. Tourism has been held back by high prices relative to Fiji and the Polynesian countries, in most of which tourism is booming, and the limited capacity of the national airline. An intensified international focus on anti-money-laundering and anticorruption measures, such as the listing of Vanuatu as an uncooperative tax haven by the Organisation for Economic Co-operation and Development (OECD), could have significant implications for the economy. Offshore businesses (nonresident banks, international businesses and international shipping) account for about 8% of GDP. Inflation as measured by the consumer price index (CPI) stabilized at 3.6%, and foreign reserves increased slightly to 5.3 months coverage at the end of 2001. However, the trade balance worsened in 2001. While exports declined by almost 8%, imports increased by almost 10%, with increases in imports of machinery, transportation, equipment, food, and live animals. Tourism was down, and cyclones disrupted the local food supply, resulting in higher food prices and food imports (see Appendix 2, Table A2.2).

7. The financial sector, comprising the Reserve Bank, three domestic commercial banks, several offshore banks, the Provident Fund and an Asset Management Unit, is only moderately effective in financial intermediation. The commercial banks, although quite liquid, are mainly involved in trade and property financing and only provide development financing for large clients, most located in or near the two main urban areas. Outside these areas land can seldom be used as collateral and there are difficulties in enforcing debt contracts. The commercial banks’ interest rate spread of more than 10% is among the highest in the Pacific. The Provident Fund is becoming interested in income-earning deals. ADB has helped strengthen the National Bank and the Provident Fund, following their near-collapse in early 1998, and is now helping the National Bank develop a rural small business loan program. The Government is aware of the need to improve the financial system and is considering methods of improving its oversight of financial institutions, as well as enhancing competition between them.

8. Vanuatu’s costs are among the highest in the Pacific; only in New Caledonia and Tahiti are they higher. Vanuatu’s high costs, which exist in most sectors, arise from a number of factors, including lack of confidence in the currency; an exchange rate policy which although it keeps prices stable for domestic consumers can raise prices for tourists, adversely affecting the tourism industry; lack of competition and/or effective regulation in key sectors such as shipping and utilities; insufficient ni-Vanuatu participation in the business sector; and the small size and geographic dispersion of many economic activities.

9. Over the last several years, the Government’s fiscal position has not improved. While the value-added tax (VAT), introduced in August 1998, has performed well, customs revenues have plummeted in the wake of rate reductions and, possibly, increased evasion due at least in part to shortages of staff. Revenues for 2001 fell behind budget estimates as the economy contracted. The overall fiscal deficit in 2001, estimated at 3.9% of GDP,² was absorbed by overdrafts from the Reserve Bank and short-term borrowings from commercial banks, sending the wrong messages to the economy. Most of the fiscal benefits of staff reductions during 1998 and 1999 were offset by a subsequent drift upward in the number of staff. As a result, the Government has at times had difficulty paying salaries. ADB has helped prepare an action plan to improve fiscal management, with an emphasis on more realistic forecasting, greater compliance and better controls. The Government is increasing the staff of the customs department, and developing improved fiscal management systems with the assistance of the Australian Agency for International Development (AusAID). While these efforts will help correct the situation, an enhanced revenue system with a broader tax base is highly desirable. New Zealand has expressed interest in helping enhance the revenue system.

10. Although Vanuatu has recently benefited from some private sector investment in the cattle industry, shipping, and hotels, new private sector investment has been much lower than desired. Over the last several years, some older businesses, including those which previously may have enjoyed protective tariffs, have failed. A politically and economically stable enabling environment to promote and develop the private sector is urgently needed. Investment licensing should be simplified, financing made less costly and more readily available, the cost of utilities and other inputs reduced, labor skills upgraded and land acquisition streamlined. In the agriculture and forestry subsectors, there is a need to use Vanuatu’s natural resources more effectively. In the tourism sector, there is a need for a stronger marketing strategy and for better coordination between industry stakeholders, including hotel and tour operators and the airlines.

11. To improve its macroeconomic policy framework and induce investment, over the last five years the Government has (i) passed the Foreign Investment Act; (ii) created the Vanuatu Investment Promotion Authority (VIPA) to provide a one-stop service for investors; (iii) passed the Finance and Economic Management Act to provide better procedures and stronger safeguards for the budget process; (iv) introduced a VAT and reduced customs duties on many items; (v) created the Asset Management Unit (AMU) to handle bad debts of government-owned financial institutions; (vi) strengthened the National Bank and the Provident Fund; and (vii) created the Financial Intelligence Unit to identify and investigate illegal transactions. Among these, the introduction of VAT (which has helped generate revenues), the strengthening of the National Bank and Provident Fund (both now self-sufficient), and the creation of the Financial Intelligence Unit (now working effectively), have been the most successful. VIPA appears to be working well, but has been unable, perhaps because of lack of reform in other areas, to enhance investment. Similarly, the Finance and Economic Management Act has helped modernize budget management, and prevented some abuses, but it has not yet resulted in a balanced budget. ADB is helping identify methods of enhancing private sector investment and improving fiscal management.

C. Implications for Country Strategy and Program

12. The conditions, trends, and policy agenda described above have several implications for ADB’s program for Vanuatu. Even if Vanuatu is able to reverse its present economic decline, it will have difficulty increasing its rate of economic development to more than moderate levels. Maintenance of civil and social order will remain problematic. The courts, the SLO, and the police are being strengthened, but it will be years before they are able to effectively keep up with their caseloads. It will continue to be difficult to retain qualified professionals in the civil service, and to effectively manage the economy without them. There will be strong pressures for increased expenditure, particularly for the education and health services needed by a rapidly growing and young population, making it difficult to balance the budget until additional revenue sources are developed. Development of new revenue resources will require extensive dialogue and take a number of years to implement. ADB’s strategy must therefore be long term. ADB should be prepared to provide assistance to a sector over a number of years—until such time as the local institutions are able to sustain themselves. ADB assistance will be necessary to provide support for better management as well as for policy development and capacity building.

13. The recent political, social and economic developments also confirm the priority given to the three components of ADB’s strategy and program for Vanuatu.

14. Economic Management and Good Governance. Although the governance and economic reforms carried out under the CRP have created a broad framework for development, much remains to be done to make the new arrangements work effectively. Appropriate roles for politicians and civil servants, now contained in legislation, need to be made operational through improvements in the business processes of government agencies (strategic plans, corporate plans and performance agreements) and building up the capacity of civil servants. Methods must be found to retain senior professionals in government. There must be a continuing effort to strengthen economic management with the aim of developing the financial sector, improving the Government’s fiscal position, increasing private sector investment, facilitating the processes of acquiring land and using land as collateral, and strengthening the judiciary, the legal sector and the police. The Government must continue its efforts to prevent money laundering and illegal practices. With its experience in supporting the CRP, and its expertise in economic management, ADB will continue to help build capacity for sound economic management and good governance. ADB can also help in policy development and capacity building in the agricultural, educational, infrastructure and finance sectors.

15. Poverty Reduction. The geographic isolation of Vanuatu’s rural population, the prevalence of subsistence agriculture, the lack of jobs and of cash to send children to school, the difficulty of accessing services in rural areas, the existence of substantial gender inequality and the low level of social sector development, all suggest that ADB and other donors should place very high priority on reducing poverty, reducing income disparities and improving the quality of life, particularly in rural areas. ADB can help in development of rural economic activities, particularly in the agricultural sector, and for women. Although other donors are involved in the primary and secondary education subsectors, ADB can assist in formal and informal skills development and training, including at the village level. ADB can also help improve access to social services and markets through support for the provision of sustainable rural infrastructure.

16. Private Sector Development. The continued low level of economic growth is indicative of both underlying and other problems with the environment for private sector investment. Most of the underlying problems, which include high levels of political uncertainty and reversals in policy, the difficulties of acquiring land and using it for collateral, shortages of skilled labor, the high costs of doing business and the difficulties of bringing products to market, will be resolved over time with help from nonlending and lending assistance from ADB and other donors, including support for provision of infrastructure, for development of human resources, and for improvement of land management. The other problems, which have to do with eliminating regulatory and administrative barriers to development, improving financial services, strengthening small business advisory services and creating more supportive sector policies, will be addressed through a combination of nonlending and lending assistance, including support for private sector and agricultural sector development.

17. ADB should also continue to play a key role in donor coordination. Substantial donor resources are flowing into the country, but gaps in several key areas are apparent. These are in areas such as economic and fiscal policy, strategic planning, education, agriculture, tourism and investment promotion. In some cases, such as fiscal management, education and tourism, ADB is encouraging other donors to close the gaps, while in others, such as in economic policy, strategic planning, skills development, agriculture and investment promotion, ADB will provide support directly.

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