Directors urged the authorities to cut spending, given that the Consolidated Investment Fund (CIF) available for budget financing will be depleted soon at the current pace of spending. They called for a front-loaded adjustment mainly through cuts in capital spending, and subsidies and transfers, which increased rapidly in recent years. Freezing wages and reducing travel costs will also be important.

Directors agreed that to ensure fiscal sustainability, it will also be necessary to increase domestic revenue, particularly by boosting efforts to increase tax compliance. At the same time, saving any windfall revenue from offshore earnings into the CIF and formulating a medium-term budget framework will strengthen fiscal management.

Directors agreed that use of the Australian dollar as Tuvalu’s currency is appropriate. They underscored however that fiscal adjustment will be key to maintaining external stability.

Directors commended the authorities for their structural reform efforts. They welcomed the ongoing public enterprise reform and looked forward to further progress in regularization of government’s financial relations with the public enterprises. Directors stressed that continued improvements in the banking sector and credit culture will help support private-sector development. Noting the steps being taken to address the high level of nonperforming loans, they urged the authorities to accelerate progress on putting in place the supervisory and prudential requirements. Improving the country’s statistical capacity will be critical for policy analysis and formulation.

Background

Despite its geographic remoteness, Tuvalu has not been immune to the global financial crisis. Even with higher government spending, the economy is expected to have almost no growth in 2010 after contracting by about 2 percent in 2009. Major construction projects to build a wharf and a power station have been completed, and seafarer employment—Tuvalu’s main foreign exchange earning source for the private sector—is weak. Annual inflation has been negative since mid-2009 (-1¾ percent in November 2010) due to lower global food prices and the strong Australian dollar.

In response to the global crisis, the government continued to support the economy by increasing spending. The large spending increases in the last few years have resulted in a sharp increase in the fiscal deficit from 4 percent of GDP in 2009 to almost 30 percent of GDP in 2010, as domestic revenue, offshore income, and grants fell. The large deficit has led to a rapid decline in the fund available for budget financing to about 20 percent of GDP from 45 percent in 2009. Total spending relative to GDP has increased by 20 percentage points since 2005, mainly due to sharp increases in subsidies, transfers and capital spending.

The current account deficit is estimated to increase sharply to almost 25 percent of GDP in 2010 due to low income and grants. Tuvalu exports little and depends heavily on imports. Gross official reserves have declined substantially in 2010, but still remain high at about 8 months of imports of goods and services. External public debt is at over 30 percent of GDP, but mostly on concessional terms, resulting in low debt servicing obligations. However, total public debt remains high by regional standards at about 44 percent of GDP.

The financial sector is underdeveloped and lending constrained, following rapid credit growth in the early 2000s. Nonperforming loans are high at around 40 percent of total loans. Banks have started addressing high nonperforming loans by sharing borrowers’ information and tightening lending standards, including lowering the maximum debt service to income ratio from 50 to 40 percent for all personal loans. Interest rates on lending have changed little in recent years, reflecting limited competition in the financial system.

The growth outlook remains clouded. Growth is projected to be zero or even turn negative in 2011, led by lower government spending, and remain low over the medium term. The outlook is subject to risks related to a delay in fiscal adjustment and the pace of the global recovery. Moreover, Tuvalu is vulnerable to natural disasters and climate change will be a major challenge in light of rising sea levels.