Regions and Countries

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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 2006-2009: Vanuatu

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II. Current Development Trends and Issues

A. Recent Political and Social Developments

3. The political situation in Vanuatu is currently unstable—11 of the 12 coalition parties are presently in government, resulting in an ineffective governing coalition. This has caused inconsistency in policy and leadership direction. This situation has (i) created uncertainty for foreign investors and development partners, (ii) derailed various reforms, and (iii) drained government finances through gratuity payments for outgoing members of parliament and their political advisors. It has been hard to respond to critical government issues because coordination is difficult between the diverse coalition, whose constituencies often have competing views and interests. In this context, government management requires a balancing act, without which important government business decisions are deferred. However, there is general recognition of the need to (i) boost investor confidence; and (ii) strengthen governance reforms in parliament, public finances, rule of law, and public service. Appendix 2, Table A2.1, indicates the country's progress toward the Millennium Development Goals and targets.

4. Vanuatu ranks 118^th on the 2005 United Nations (UN) Human Development Index (HDI) table of 177 developing countries, placing it in the medium human development category ahead of Solomon Islands, Papua New Guinea, and Timor-Leste. Vanuatu’s score on the HDI’s education index is 0.69, which is below the average of 0.75 for the medium development group and reflects relatively low enrolment rates, particularly at secondary level. Vanuatu ranks 52^nd on the 2005 Human Poverty Index (HPI): 40% of the population does not have sustainable access to an improved water source, 20% of children are underweight, and 19% are under height for their age. The infant mortality rate is 31 per 1,000 births.⁵ The rate of immunization of 1-year old children is only 63% for tuberculosis and 48% for measles. The maternal mortality rate is 130 per 100,000 live births (adjusted for underreporting and misclassification). Vanuatu has ratified the UN Convention on the Elimination of All Forms of Discrimination Against Women and Convention on the Rights of the Child. The challenge of improving HDI and HPI rankings and other social indicators is complicated by rapid population growth (2.5% per annum) and ayoung population (41% less than 15 years of age).

B. Economic Assessment and Outlook

1. Recent Performance

5. Real gross domestic product (GDP) grew for the third successive year in 2005, increasing by an estimated 2.9% compared with 3.7% in 2004. ⁶ Growth was led by the services sector, with the tourism-driven wholesale and retail trade, and hotels and restaurants subsectors recording particularly strong expansion. Real estate and other services also expanded rapidly as property development in the Port Vila area accelerated. The industry sector grew by 4.3%, primarily as a result of increased construction activity. In contrast, the primary sector contracted because of declining copra and kava production.⁷ As a result, economic growth in 2005 remained concentrated rather than broad-based, and barely exceeded the high population growth rate of 2.5%. Growth in 2005 occurred in a stable macroeconomic environment. An overall budget surplus of about 1% of GDP was reported, reflecting strong tax revenue collection and recurrent spending below budgeted levels. The share of wages and salaries in total recurrent expenditure remained at around 56%, while expenditure on other goods and services rose as a percentage of total recurrent spending. Development expenditure grew by almost 12%. Total public debt at the end of 2005 was Vt12,724 million or 31.6% of GDP (22.7% external, 8.9% domestic).

6. Inflation continued at a low rate of 1.2% in 2005 as the vatu remained strong against trading partner currencies and domestic food prices dropped. Low inflation, combined with an improved fiscal position and a healthy level of official international reserves, encouraged an easing of monetary policy. Broad money supply rose by 13.2% in the year to December 2005, with private sector credit growth of 15.9%. The spread between commercial banks’ interest rates on loans and deposits narrowed slightly but remained high at around 9.5%.

7. By the end of 2005, import cover of official international reserves had risen to 5.8 months compared with the policy target of 4.0 months. This growth was the result of an increased surplus on the capital and financial account which outweighed deterioration on the current account—largely attributable to a 14.1% rise in imports.

2. Outlook

8. The medium-term outlook⁸ is for a slight acceleration in economic growth within a stable macroeconomic environment. Real GDP growth is expected to reach 3.5% in 2006 and increase to 3.6–3.7% in 2007–2008. Accelerated growth in 2006 is driven by an anticipated return to modest agricultural growth of 2.7%. Growth in the industry and services sectors are expected tobe 3.4% and 3.7%, respectively. Tourism is likely to be boosted by the inauguration of two new international air carriers and completion of a new air terminal in Santo. In 2007, a major boost to aggregate growth is expected to result from a rise in construction activity as infrastructure projects funded by the Millennium Challenge Corporation (MCC) are implemented throughout the country. Agriculture sector growth is forecast to accelerate to just over 3% per annum— about three times the trend growth rate. Achieving this rate assumes the elimination of current uncertainty in the agricultural policy environment, which has been created by (i) the December 2005 decision to return marketing of export products to the Vanuatu Commodities Marketing Board (VCMB), and (ii) the early 2006 decision to impose 30% export taxes on live animal exports. Improved physical infrastructure in rural areas may contribute to agricultural growth towards the end of the forecast period.

9. The 2006 budget continues the stated policy of ensuring aggregate fiscal discipline, reducing domestic debt, and funding development expenditure from project grants. A small overall budget deficit of 0.1% of GDP is projected for 2006, to be followed by surpluses of under 1% of GDP in 2007 and 2008. This is based on the assumption that growth will be just over 3% and inflation will rise to 2.5%, as the exchange rate depreciates slightly against the US and Australian dollars. Revenue projections are conservative, with the focus on improving compliance. Total expenditure in 2006 is budgeted to increase 4.6% on the 2005 budget level, largely because of an increased allocation to wages and other goods and services. The wage bill continues to absorb 55% of the recurrent budget at the end of the forecast period. The 2006 budget’s medium-term projections of a stable level of nominal development expenditure must be revised upwards to reflect the large expenditures that will occur under the MCC grant.

10. The 2006 wage bill estimate will be conservative if the late 2005 decision of the Government Remuneration Tribunal—recommending public service salary increases on the basis of job evaluations by the Public Service Commission—is implemented. There is no provision for this in the 2006 budget and it could undermine efforts to improve the strategic allocation of public resources. Additional pressure on public finances may arise from an April 2006 Supreme Court decision to award damages of over Vt750 million against the Government in favor of Kakula Island Resorts. This decision is subject to appeal in mid-2006.

11. The balance of payments current account deficit is expected to fall from about 7% of GDP to under 4% by the end of the period 2006–2008, mainly because of increased merchandise exports and tourism receipts, supported by a reduction in net outflows on the investment account. The capital and financial account surplus is forecast to rise slightly. Consequently, foreign reserves are expected to remain in excess of 5 months of import cover. Official external debt is forecast to drop to 18% of GDP by the end of 2008, as loans are repaid and no new borrowing occurs. The primary downside risks to this scenario are deterioration in commodity export price trends and further rises in international oil prices.

3. Development Issues, Challenges, and Policy Developments

12. The population growth rate means that the moderate increase in economic activity to date will be insufficient to engage future generations productively and ensure their access to basic social services. The foundations for growth are fragile and need to be addressed.

13. The PAA identifies seven strategic priorities that are consistent with the CRP, and which have been confirmed in successive annual budget policy statements, consultative national summits, and business fora: (i) PSD and employment creation; (ii) macroeconomic stability and equitable growth; (iii) good governance and public sector reform; (iv) primary sector development (natural resources and the environment); (v) provision of better basic services, especially in rural areas; (vi) education and human resource development; and (vii) economic infrastructure and support services.⁴

14. In the area of PSD, the PAA and ADB’s 2003 private sector assessment (PSA)⁹ identify key issues and constraints for private sector investment that require government policy action, including (i) lack of predictability in economic policy direction, evident in the current uncertainty over VCMB’s role and the Government’s public threat to withdraw Westpac’s banking license,¹⁰ which reflect the general problems of political instability and weak governance; (ii) high cost of doing business, reflected in high input costs as well as high risks and transactions costs; (iii) difficulties in securing and enforcing business transactions as a reflection of weaknesses in the existing commercial legal framework; (iv) difficulties in mobilizing land for economic and productive uses; and (v) capacity constraints in the private and public sectors that increase the difficulties of interacting with a globalizing and increasingly complex world economy.

15. Vanuatu’s legal and regulatory framework for business is outdated and ineffective as a means of supporting modern business transactions and establishing Vanuatu as an internationally reputable and commercially attractive financial center. The legal system requires a broad range of costly licenses, registrations, regulatory requirements and approvals which have no compensating public policy objective but raise uncertainty and transactions costs for investors. Contract disputes are costly and enforcement is weak. The bankruptcy framework is effectively nonexistent,¹¹ which raises risks for operating businesses and granting trade credit. Legal issues also impede the operation of infrastructure-related activities, including ownership and governance of government business enterprises (GBE).

16. Neither state nor private provision of infrastructure provides low cost or effective service. Government provision regularly fails because of little incentive for efficiency, political interference, and the tendency to overstaff and under-maintain. Long-term monopoly concessions to private suppliers in the telecommunications and utilities sectors are suboptimal and poorly regulated, resulting in reliable yet very costly services in Port Vila and a few other urban centers, and hardly any service provision in rural areas. With World Bank support, the Government is initiating a contract management unit to improve oversight of private monopoly suppliers but more efforts will be required to improve the service delivery of GBEs, strengthen GBE corporate governance, and decrease the Government’s exposure to financial obligations incurred, directly or indirectly, through GBE ownership.

17. Vanuatu’s underdeveloped onshore financial sector provides a minimal range of banking services that have just started to reach beyond main urban areas. Commercial banks have little outreach to low-income households, high interest rate spreads reflect high unit costs and risk premiums, and microfinance is in its infancy. A major impediment to financial sector development is the lack of an effective framework to facilitate the economic use of immovable (land) and movable assets (chattels) as collateral. Establishment of a well-functioning secured transactions system for chattels has been successfully initiated, with ADB support,¹² and is expected to reduce transaction costs, lower interest rates, and enhance credit intermediation. The Government has also made progress, with ADB support, in facilitating the expansion of rural and microfinance services,¹³ such as those provided by the National Bank of Vanuatu (NBV).

18. Vanuatu’s offshore financial sector is economically significant.¹⁴ However, the sector’s viability has been challenged by greater competition from other jurisdictions offering similar services; and an assessment by the International Monetary Fund (IMF) concluded that its legal and regulatory framework requires a comprehensive overhaul.¹⁵ Progress has been made in this area. In 2002, the International Bank Act was revised and banking supervision was transferred from the Vanuatu Financial Services Commission (VFSC) to RBV. In 2005, parliament passed a new Insurance Act, Protected Cell Companies Act, Mutual Funds Act, and Unit Trust Funds Act. Revision of the International Companies Act is under way, and a new Trust Law and Companies Services Providers Bill is being drafted. However, further policy, institutional, and legal reform is required.

19. The above issues are addressed in large part by the PAA’s policy objectives and strategies for PSD, which support the PAA’s broad strategic priorities (para. 14). These objectives are to lower costs of doing business, improve access to rural financial services, facilitate long-term secure access to land, provide better support services to business and ensure a conducive environment for increased commodity exports. Specific priorities and strategies to promote tourism development are also presented, centering on improving marketing, air services, and accommodation. Financial sector supervision is addressed in PAA policy objectives for maintaining macroeconomic stability and promoting equitable growth. The PAA acknowledges that good governance is a prerequisite for the effective implementation of development strategies and that achievement of the PAA policy objectives will require political will, formulation of sector-specific strategies, and preparation of a medium-term expenditure framework to guide corporate planning and annual budget allocations.

C. Implications for the Country Strategy and Program

20. Given the country’s development challenges and the Government’s strategic development priorities, and taking into account ADB’s Pacific Strategy 2005–2009 and other donor programs, a PSD focus for ADB assistance is indicated. The primary lesson learned from the CRP is to ensure that the assistance areas are clearly defined and that support is focused. ADB’s approach in Vanuatu will (i) build upon the PSA (footnote 9), (ii) intensify support for recent successes in areas where there is a momentum for reform, (iii) focus on supporting institutions with sufficient absorptive capacity, and (iv) cover areas in which ADB has comparative advantages and which are sparsely covered by other funding agencies. ADB’s lead role in establishing a favorable environment for PSD is agreed by our development partners. Dialogue with the Government and key stakeholders has underscored the need to remain focused on the PSD core areas of business law environment and access to finance, where ADB has established a lead role throughout the Pacific.

21. The non-lending program focuses exclusively on creating an enabling environment for private sector growth through improved institutions and access to finance. Therefore, a key success determinant of this investment and its sustainability will be the Government’s ability to manage the programs; and provide focused, stable leadership and counterparts. This will require a strong political consensus on the need for a stable and predictable business environment. A further key success determinant will be the private sector’s ability to deliver the services. Thus, policy dialogue in support of the grant activities will be critical.

22. ADB will continue to closely monitor and engage with the Government and stakeholders, on GBE reform and infrastructure issues. These are core ADB competencies that have a crucial impact on the cost of doing business and delivery of basic services. The possibility of more active engagement has been discussed with the Government and will be based on Government demonstration of commitment to reform in these areas.

23. The CSPU was formulated on the assumption that Vanuatu would not borrow because of its economic and fiscal priorities, and that a minimal grant program was available. The program was based on technical assistance (TA) allocation of $800,000 (2006), $600,000 (2007), and $1,100,000 (2008).

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