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p. 2 of 6 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 Levels Appendixes

Country Strategy and Program Update 2005-2006: Vanuatu

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II. Current Development Trends and Issues

A. Recent Political and Social Developments

3. As a result of the general election held on 6 July 2004, a coalition led by Serge Vohor's Union of Moderate Parties won a mandate to form the next government. In the weeks that followed, however, the new administration was prevented from sitting by the lodging of a motion of no-confidence by the Opposition, and the threat of defections from disaffected members within its own ranks. In the interim, a consensus between both factions was reached on the election of a new President and Head of State, the position having been vacant since the resignation of the previous incumbent in June 2004 after only 20 days in office. Given the continuing political instability and inconsistency in policy and leadership direction, the Prime Minister in early October 2004 took the bold step of calling for amendments to the Constitution that will, if passed, see the life of Parliament extended from 4 to 5 years, with the first and final year free of motions of no-confidence, and sanctions of expulsion for MPs who "cross the floor" during the life of a parliament. While it is unlikely that such far-reaching amendments will be passed without the approval of a referendum there is, however, growing recognition that such reforms are essential for the promotion of public service reforms and private sector initiatives introduced under the comprehensive reform program (CRP),³ and boosting of investor confidence.

4. Vanuatu’s geographic isolation, the remoteness of the islands from one another, and the lack of job-creation opportunities contribute to poverty. The wide income disparities between urban and rural areas are related in part to low agricultural productivity and poor outer island infrastructure facilities and services. Less than 500 jobs are created each year in the formal sector, while around 3,500 school leavers seek employment annually. Vanuatu ranks among the lowest of ADB’s Pacific developing member countries (PDMCs) for adult literacy (75%) and net secondary enrollment (23%). The low rate of secondary enrollment and high levels of adult illiteracy are substantial obstacles to modernization and development. The Education for All initiative is being advocated as the priority program and female enrollment ratios are increasing. The public service is addressing its own gender balance issue, with one female director-general appointed and several women holding director-level positions.

B. Economic Assessment and Outlook

1. Recent Performance

5. After 2 successive years of contraction, real GDP grew by an estimated 1.6% in 2003. Economic growth was led by an 8.7% expansion in the agriculture, fisheries, and forestry sector that was stimulated by strong commodity prices. However, the industrial sector contracted by 1.1% and services were virtually stagnant, with tourist arrivals lower than 2002 and government services recording zero growth. Economic recovery contributed to a limited improvement in formal sector employment during 2001–2002, but employment growth fell well short of the 10% growth rate required to absorb the 3,500 school leavers entering the workforce in 2003. Many school leavers are employed in traditional livelihoods such as farming and fishing.

6. The overall budget deficit for 2003 was about 1.0% of GDP, with domestic financing in the form of central bank advances. This did not match the original target of a surplus equivalent to 0.4% of GDP, but represented an improvement on the 2002 budget deficit of 3.2% of GDP. The improvement was attributable to tight expenditure control in the context of below-budget levels of revenue and external grants. In 2003, the Government’s external debt was estimated at 28.2% of GDP and domestic debt at 11.0% of GDP, with debt-servicing costs absorbing approximately 7% of domestic revenue.

7. Inflation accelerated from 2.0% in 2002 to 3.0% in 2003 because of the one-off impact of increased duties on imported food, increased alcohol and tobacco excises, and higher education and health fees. The domestic currency depreciated significantly against the Australian and New Zealand dollars during that time, as well, contributing to inflation. Broad money supply dropped by 2.8% in the 12 months to November 2003 as net foreign assets declined. Domestic credit grew by 4.3% because of strong growth in credit to the private sector, which consisted mainly of personal and household loans. Interest rates on housing and commercial loans were reduced in early 2003, with a consequent narrowing of the interest rate spread. The Reserve Bank of Vanuatu’s repurchase facility rate remained at 6.5% throughout the year, indicating an unchanged monetary policy stance.

8. Official balance of payments projections in the 2004 budget suggested that the current account deficit would decline to 0.3% of GDP in 2003, largely as a result of increased transfers. The government expected foreign reserves to rise from 4.7 months of imports at end–2002 to 4.8 months’ imports at end–2003. These projections were optimistic. Despite strong merchandise export growth, the foreign reserves level in October had fallen to 4,800 million vatu, some 200 million vatu short of the projected figure but sufficient to cover slightly more than 4 months’ imports. The overall balance of payments was on track to record a small deficit in 2003.

2. Outlook

9. The 2004 budget forecasts real GDP growth to be 2.1% in 2004 and 2.6% in 2005. The agriculture sector is expected to drive economic growth, with industry and services playing increasingly supportive roles. There is considerable potential for agricultural development, but for agriculture to perform as expected, weather conditions and world commodity prices will need to be favorable and smallholder cattle and cocoa production encouraged. World commodity prices are likely to be strong, but tropical cyclone Ivy hit Vanuatu in late February 2004 and damaged property and crops. At present, there is no comprehensive agricultural development strategy in place. Growth in the services sector requires tourism expansion at a time when competition from other Pacific Island destinations is strong and increasing. Given Vanuatu’s relatively high costs of international and domestic air travel and accommodation, this expansion will be difficult to achieve unless a marketing strategy successfully differentiates Vanuatu as a tourist destination. The Government’s open sky policy will lead to an increased and more competitive international air service, and the growing popularity of Vanuatu as a cruise ship destination is expected to lead to more ship calls in 2004.

10. Given Vanuatu’s rapid population growth, even achieving the forecast economic growth would imply a decline in per-capita income in the medium-term, increased unemployment and underemployment, and little alleviation of hardship in rural areas, where 51% of the population lives below the poverty line of $1 per day. The private investment necessary for faster growth in income and employment is unlikely to be forthcoming unless the factors deterring foreign investors are addressed. These factors include political instability, an uncertain policy environment, and the high economic cost structure (including transaction costs of obtaining investment approvals and business licenses).

11. The 2004 budget projects overall budget surpluses of 0.4% of GDP in both 2004 and 2005 on the assumptions that economic growth will pick up and inflation will moderate to 2.0– 2.5%. No major revenue initiatives are envisaged, and reaching the projected revenue levels will require a considerable improvement in revenue collection. Recurrent expenditure is to be reduced from the 2003 budget level through cuts in expenditure on wages, non-salary goods and services, and transfers to government bodies, with education and health receiving reduced budget allocations. The projected share of wages in total recurrent expenditure is still high at about 58%, leaving limited room for improving the strategic allocation of public resources in the context of a decline in total real spending. No change is envisaged in capital expenditure, which is funded mostly by external grants. Given a substantial negative external financing requirement, a small domestic financing requirement is to be met from government cash balances.

12. The current account is expected to continue to be characterized by trade deficits, a surplus on the services account, and inflows of foreign aid. The net result is expected to be small current account deficits. Government forecasts are for a rising capital account surplus in 2004–2005 and an increase in foreign reserves to more than 5 months’ imports. However, these forecasts rest on expectations of a rise in foreign investment that, as noted, is unlikely to occur. Official external debt is forecast to drop to 24.9% of GDP in 2005.

3. Policy Developments

13. At parliament’s first session in 2003, 19 bills were presented that included some controversial amendments to previous legislation that raised governance concerns. Of most note, the Vanuatu National Provident Fund Amendment Act reduced its contributions from 12% to 8% of salaries, reduced the percentage of funds potentially invested overseas from 50% to 15%, and increased the power of the Minister of Finance over the fund, including approval of the appointment of the general manager. This last development constituted a significant reversal of policy initiatives introduced under the 5-year-old CRP, which aimed at improving corporate governance in the public enterprise sector. The consequences of political interference in the operations of public enterprises was demonstrated by political appointments to the board of the Vanuatu Maritime Authority and the subsequent dismissal of the chief executive officer following accusations of impropriety. The public enterprise sector remained a drain on public funds and privatization of several larger enterprises was delayed.

14. At the same time, trade reform was pursued. The Government passed the Pacific Islands Countries Free Trade Agreement Act and the Pacific Agreement on Closer Economic Relations Act, which paved the way for a resurrection of efforts to accede to the World Trade Organization. Trade reform, however, also raised the issue of future loss of government revenue from import duties. Legislation was finalized to align the regulatory and supervisory framework for offshore banks with that for domestic banks, and to bring that framework under the control of the Reserve Bank of Vanuatu. As a result, Vanuatu was removed from the Organisation for Economic Co-operation and Development’s (OECD) list of uncooperative tax havens in 2003.

15. In September 2003, government signed a poverty partnership agreement with ADB and presented a PAA intended to more effectively link the long-term CRP with government’s medium-term investment program and annual budget. The PAA identifies three key strategies that have been stated formally on previous occasions: (i) ensuring macroeconomic stability; (ii) achieving faster sustainable economic growth; and (iii) improving public service delivery, especially in rural areas. Successful implementation of the last two strategies has proven difficult.

C. Implications for the Country Strategy and Program

16. The conditions and trends described above indicate that Vanuatu should aim over the medium-term (3–5 years) to increase the pace of economic development to a level moderately in excess of population growth. Expansion of tourism is expected in 2004 with P & O Cruises scheduling of a second ship on the Vanuatu route, and the scheduled entry in September 2004 of low-cost carrier Pacific Blue on routes to Australia. Growth of agricultural production, particularly of beef and organic crops, is also likely provided that sea and air freight services are available and affordable. Ongoing strengthening of the courts, the State Law Office, and the police will effectively keep up with their caseloads and help maintain social order. Land management is being improved, but disputes over a lack of clarity of ownership and the difficulty of acquiring land for economic investment due to complex ownership patterns will continue. 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 for the infrastructure to support the productive sectors, and for the education and health services needed by a young, rapidly growing population. However, revenue growth will be substantially constrained until the tax base is broadened.

17. For these reasons, ADB’s assistance should focus on the underlying constraints on development. Transfer of knowledge will be as important as transfer of capital. It should continue to help therefore in

1. development of a Government and bureaucracy operating in a transparent, accountable, and fully accessible manner, with decisions on economic matters taken after public deliberation;
2. creation of an enabling environment for private-sector development by reducing costs, encouraging competition, creating an effective secure transactions framework, and expanding business development finance; and
3. reduction in poverty, through improvements in governance and economic growth, as well as provision of services for the poor, particularly to address the problems of the outer islands.

18. The Government has requested ADB assistance primarily as grant-funded technical assistance (TA). Loan assistance, if requested, would be used only sparingly, and only where sustainability is strongly indicated.

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