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Fiscal Discipline Can Help the Pacific Navigate Global Financial Instability
Recent uncertainties over sovereign debt in the Eurozone and U.S. fiscal policy are expected to have only direct limited impact on the Pacific islands, Papua New Guinea, and Timor-Leste. The economies are largely insulated from these ongoing problems as they are more closely tied to the economies of Australia and New Zealand. Growth prospects of Australia and New Zealand remain relatively buoyant due to strong demand from Asian markets for their commodity exports.
However, the Pacific economies remain vulnerable to indirect impacts, says ADB’s latest Pacific Economic Monitor. Impacts will be felt through trade and investment linkages between the European Union and the Pacific’s leading economic partners, declining values of Pacific trust funds, and, possibly, falls in tourism arrivals.
Many Pacific governments exceeded their revenue targets in 2011 and had tax collections that were higher than in 2010. Expenditures were also higher in most countries, but expenditure rises were more than offset by the revenue increases. This contributed to a general improvement in fiscal balances in the region. Better-than-expected revenue performance in 2011 contributed to improvements in the fiscal balances of many Pacific economies.
A review of 2012 budgets indicates that revenue increases are projected to increase again and are expected to exceed planned expenditure growth. Fiji, Samoa, and Tonga are targeting smaller budget deficits in 2012, stepping back from higher deficits incurred due to fiscal stimulus or disaster recovery efforts. The resource-rich economies of Papua New Guinea and Timor-Leste are making use of high revenues to pursue expansionary policies and high levels of economic growth. Several countries are developing new revenue measures to strengthen government finances.
“Pacific economies’ progress in fiscal consolidation is commendable,” said Robert Wihtol, Director General of ADB’s Pacific Department, “But it is important to sustain these efforts to increase their ability to maneuver in case of any shocks arising from the Eurozone situation.”
However, fiscal challenges persist in the region. Political instability in Kiribati, Solomon Islands, and Vanuatu is delaying finalization of 2012 budgets and raising uncertainty about medium- term fiscal plans.
Achieving longer-term fiscal self-sufficiency will remain a challenge in most Pacific countries given their limited resources. The y need fiscal space for responding to economic shocks. Recent gains could be quickly undone if the ongoing Eurozone crisis persists and leads to a more general weakening in the global economy.
Highlights from the review of 2011 fiscal outcomes and 2012
Cook Islands realized a smaller-than-projected budget deficit equivalent to about 1.8% of gross domestic product (GDP) in FY2011. Revenues exceeded budget projections by 1.4%. Th is came mostly from higher-than-expected earnings from nontax instruments.
Latest government estimates show that the Fiji economy grew by 2.1% in 2011. This was higher than the 2011 budget forecast of 1.3% and ADB‘s estimate of 1.5%. The recovery in 2011, which followed 2 years of contraction, was driven largely by a post-cyclone rebound in agriculture, increased tourism, as well as the stronger performance of the manufacturing and forestry industries. A budget deficit equivalent to 1.9% of GDP is projected for 2012, which represents a higher level of fiscal consolidation than was planned in the government’s 2011 Fiscal Framework.
Structural reforms are critical to improve growth prospects in Fiji. A recent ADB assessment of private sector development in Fiji identified the following strategies for improvement: creating a stable policy environment, minimizing the role of the state in the economy, and streamlining business regulatory processes.
The election schedule has delayed the enactment of the 2012 budget. The 2011 fiscal deficit is estimated at 15% of GDP. The government plans to finance this by drawing down its Revenue Equalization Reserve Fund (RERF). However, the value of the RERF assets has already declined as a result of the global financial and economic crisis and by drawdowns to finance previous budgetary shortfalls. This raises concerns about the fund’s long-term sustainability.
Marshall Islands saw a fiscal surplus equivalent to about 1.4% of GDP in FY2011, which was substantially smaller than the surplus of 4.6% of GDP in FY2010. In the long term, however, the country has to build up its Republic of the Marshall Islands Compact Trust Fund to compensate for the loss of annual US financial assistance, which will end in FY2023. This will require targeted expenditure cuts, broadening the tax base, improving revenue collection, and enhancements to public financial management to increase the efficiency of public spending.
Federated States of Micronesia
The consolidated government fiscal account posted a small surplus equivalent to about 0.4% of GDP in FY2011. For FY2012, the International Monetary Fund (IMF) is projecting another small surplus equal to about 0.5% of GDP. Total domestic revenue is expected to remain at about 20% of GDP over the medium term under prevailing conditions. Rising capital expenditure on infrastructure and public works projects in FY2012 will be financed primarily through an increase in grants from the US.
The FY2012 budget continues the recent trend of nearly balanced budgets. It projects a small fiscal deficit of about 1.3% of GDP . However, the ongoing political instability has cast doubt on the economic reform and development plans in the country.
Following a spending cut of almost 7% in the previous year, fiscal consolidation progressed further in FY2011 as total public expenditure was reduced by an additional 4% from FY2010 levels. However, the longer-term fiscal sustainability requires broader tax reform, particularly introduction of a value-added tax, to broaden the tax base and boost Palau’s ratio of tax revenues to GDP.
Samoa’s recovery from the combined impacts of the global economic crisis and a major tsunami in 2009 is underway, with the economy estimated to have grown by 2.1% in FY2011 compared with 0.2% in FY2010.
This reflected strong growth in construction, due to the implementation of ongoing and new infrastructure projects, and increased consumer spending based on higher remittances. Continued efforts to advance fiscal consolidation and wind back debt are essential to create the fiscal space necessary for the government to be able to respond to any external shocks–be this in the form of continued global weakness or weather-related events.
The Solomon Islands recorded a budget surplus equivalent to 2.1% of GDP in 2011. Public debt declined from 24% of GDP to 21.6% in late 2011 due to debt repayments and the write-down of all external debt arrears. Despite the recent change in Prime Minister and Finance Minister, the government is moving forward with its plans to pass the 2012 budget by the end of this year. The draft budget forecasts a small fiscal surplus for 2012 .
The FY2011 fiscal deficit (including budget support grants) is estimated at 7.5% of GDP, financed mainly by loans from the Export-Import Bank of China and draw downs on domestic cash balances. Without the budget support grants, the deficit would have been 10.5% of GDP.
Improved prospects for the Tongan economy depend upon the government implementing necessary fiscal adjustment, continuing with structural reforms, and developing infrastructure. These measures are important given the deterioration in global economic activity and its likely impact on remittances, tourism, and export demand.
In the 2012 budget, total revenue is projected to decline by 7% from 2011, while total expenditure is projected to be reduced by 13% . These would result in a budget deficit equivalent to 14% of GDP.
Given the performance of global markets, there is likely to be limited scope for drawing on the Consolidated Investment Fund to finance budget deficits. The fund‘s balance is expected to be depleted in 2012.
Tax revenues increased by 9.3% in the first half of the year mainly due to higher value-added tax collection, but this was not sufficient to offset a 44.1% fall in external grants during the same period. The government approved a supplementary budget equivalent to 6.1% of the original budget in September 2011. This was not enough to offset the decline in donor-funded spending in the first 8 months of the year. Construction is key to Vanuatu‘s growth prospects in the short- and medium term. To make the best use of concessional funding from development partners, it is important that Vanuatu prioritize infrastructure spending and improve its capacity to manage infrastructure funds.
Papua New Guinea
Expected revenue increases in 2012 are underpinned by strong economic growth and a continuation of high commodity prices for many of PNG‘s key exports.
A dverse economic shocks during 2012 that could impact on the economy either by slowing domestic investment or lower global commodity prices, would make it difficult for the government to meet its growing expenditure commitments.
Any significant deviation from fiscal discipline would undermine investor confidence, add to inflationary pressures, and disrupt the macroeconomic stability that has underpinned the last 9 years of economic growth.
The large 2011 budget continued to drive the economy. Although full budget allocation is unlikely to be spent, government expenditure including development partner-funded activities is on track to exceed 2010 expenditures by about 40%. The overall budget execution rate is expected to stay high in 2011 at around 90%, matching the performance of the previous 2 years. The 2012 budget provides for a further large increase of about 20% in government expenditure.
Key financial market issues
The latest issue of the Monitor also includes three articles discussing key financial market issues in the Pacific.
The first article analyzes the valuations and asset allocations of sovereign investment funds in the Pacific, and finds that despite considerable volatility in global stock and bond markets, declines in value of the sovereign funds to date have been smaller than those incurred in 2008. However, substantial downside risks of declines in the values of the funds remain.
A contribution from the Pacific Financial Technical Assistance Centre assesses interest rates and charges offered by banks operating in the Pacific Islands. It finds these to generally be in line with the financial characteristics of the Pacific Island countries, and with rates and charges encountered in other developing markets. The article cautions Pacific policymakers against taking short-term measures to control interest rates or regulate bank profits in the region.
A special article from Standard & Poor’s provides an update on the sovereign credit ratings of selected Pacific economies in light of weaker global growth and ongoing volatility in financial markets.
This issue of the monitor concludes with an article on the economic and financial benefits of developing a domestic bond market in PNG and discusses the issues that must be addressed to make such a market viable, and a note on inflation rises in Timor-Leste.