Against this backdrop, Directors welcomed the authorities' commitment to implement a credible fiscal framework to achieve fiscal sustainability, while minimizing adverse implications for growth and employment. They encouraged the authorities to move ahead with the implementation of the planned value-added tax in 2010, and to embark on a measured withdrawal of discretionary spending, including by scaling back capital spending. Over the medium term, Directors emphasized the need to prioritize and improve the efficiency of public spending, to contain the growth of the public wage bill, and to seek more concessional financing in order to create fiscal space for higher targeted social spending and to absorb external shocks.

Directors noted staff's assessment that St. Lucia's exchange rate does not show clear evidence of an overvaluation. Given risks of lower FDI inflows, and to increase the growth potential, they encouraged the authorities to move forward on structural reforms, including improving the business climate and boosting labor productivity.

Directors observed that the financial system has been hit by both the economic downturn and the collapse of the CL-Financial Group. Given the deterioration in bank soundness indicators, they encouraged the authorities to closely monitor the financial sector and take action as needed. Directors welcomed the authorities' regional approach to the strengthening of regulation and supervision of nonbank financial institutions and the resolution of the insurance company BAICO. They looked forward to the adoption of the Financial Services Regulatory Act and related legislation. Directors commended the authorities' intention to keep the SDR allocation as a pooled liquidity buffer.

Background

Macroeconomic outcomes have weakened significantly. Real GDP is estimated to have contracted by 5.2 percent in 2009, reflecting a sharp decline in visitor arrivals and construction activity related to Foreign Direct Investment (FDI). For 2010, the outlook is for a nascent recovery, supported by higher advance hotel bookings and additional flights to the island. However, there are a number of downside risks to the outlook, including lower than the anticipated recovery in St. Lucia's main trading partners and FDI inflows. Inflation has declined from 7.2 percent in 2008 to 0.6 percent in 2009, and is expected to remain in the low single digits over the medium term.

The fiscal position is estimated to have deteriorated sharply in FY2009/10, mainly on account of an increase in public expenditure. The primary fiscal balance is expected to shift from a surplus of about 2.3 percent of GDP in FY2008/09 to a deficit of about 2.5 percent in FY2009/10. On the revenue side, the cyclical decline was somewhat contained by a 20 percent increase in the prices of petroleum products in August 2009 and the adoption of a flexible energy-pricing regime. The implementation of other revenue-enhancing measures (including a value-added tax) envisaged by the authorities at the time of the approval by the Executive Board of the Rapid Access Credit - Exogenous Shock Facility, however, has yet to occur. On the expenditure side, the authorities undertook a large public works program, resulting in capital expenditure increase of about 3 percent of GDP. The fiscal deficit is expected to be financed mainly by issuing securities on the Regional Government Securities Market (RGSM).

External imbalances have narrowed in 2009. The external current account deficit is projected to have declined by about 11 percentage points of GDP in 2009, reflecting lower FDI-related imports and smaller food and fuel import bills. Stayover arrivals are projected to decline by 6 percent (year-on-year), but discounting of hotel room rates and lower spending by tourists would result in a larger decline in tourism receipts. In addition, remittances are projected to decline in line with employment opportunities in migrant host countries. At about 20 percent of GDP, the estimated external current account deficit is close to its historical level and consistent with identified external financing.

In 2009, credit to the private sector continued to decline and financial sector vulnerabilities have increased. The contraction in economic activity has resulted in a significant slowdown in private sector credit demand. At the same time, the weakening economic environment has led to an increase in non-performing loans and deterioration in other bank soundness indicators. While domestic bank lending rates have remained broadly stable, there are signs that conditions in the RGSM have tightened recently. The collapse of the Trinidad and Tobago-based CL Financial Group with operations in St. Lucia and other Eastern Caribbean Currency Union countries has highlighted weaknesses in the regulation and supervision of the non-bank financial sector.