Asian Development Outlook 2004 : II. Economic Trends and Prospects in Developing Asia


The economy emerged from recession to record moderate, agriculture-led growth in 2003. The budget deficit was reduced through expenditure cuts. The Government anticipates a slight acceleration over the medium term, but this will require increased smallholder production in agriculture and more tourist arrivals.

Economic Assessment

After 2 successive years of contraction, GDP posted growth of an estimated 1.6% in 2003, below the annual population increase rate of 2.6% (Figure 2.37). Figure 2.37The growth was led by an 8.7% rise in the agriculture, fishing, and forestry sector. Boosted by strong world commodity prices, cocoa, copra, and cattle production surged. The industry sector contracted by 1.1% as manufacturing, electricity, and commercial construction all fell.

The services sector was virtually stagnant, with the trade subsector recording just 1.0% growth, government services stationary, and the transport and communications, and hotels and restaurants subsectors both contracting.

Total tourist arrivals in the first 3 quarters of 2003 were 1.2% down on the same period in 2002, largely because of relatively low numbers in the first half of the year. Tourism picked up in the third quarter as a result of supplementary flights from Australia, and the hotel occupancy rate rose to 53.8% from 38.8% in the previous quarter.

The economic recovery contributed to a limited reversal in the downward trend in formal sector employment that was seen in 2001 and 2002. However, employment growth fell well short of the 10% rate required to absorb the 3,500 school leavers entering the workforce in 2003. With limited emigration possibilities, the majority of these new entrants to the labor market had to seek work in the subsistence or urban informal sectors.

The 2003 fiscal target of a budget surplus of 0.4% of GDP was based on a 7.7% rise in revenues and grants and a 7.8% drop in total expenditures and net lending, relative to the actual levels in 2002. On the basis of actual outcomes in the first three quarters of 2003, the deficit target will not be met. Revenues and grants were 4.0% lower than the corresponding figure for 2002, largely because of a shortfall in grants and import duties. Total expenditure and net lending was 12.2% down on the corresponding figure for 2002 as a result of tighter expenditure control on both wages and nonsalary outlays. The overall budget deficit for 2003 is estimated to be about 1.0% of GDP, with domestic financing in the form of central bank advances. Nonetheless, this outcome represents an improvement from a deficit of 3.2% of GDP in 2002. In 2003, the Government's external debt was estimated at 28.2% of GDP, and its domestic debt at 11.0% of GDP. Debt servicing costs were equivalent to approximately 7% of domestic revenues and 4% of recurrent expenditures.

The inflation rate 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 excise duties; higher education and health fees; and because the domestic currency, the vatu, depreciated significantly against the Australian and New Zealand dollars, in which approximately 60% of Vanuatu's imports are denominated. The vatu in 2003 appreciated slightly against the yen, and substantially against the US dollar (13.2%). Broad money supply dropped by 0.8% in 2003 as net domestic and foreign assets registered a decline. Domestic credit, however, grew by 5.3% because of strong growth in credit to the private sector, consisting 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 from 9.5% in January to 9.1% in June. The Reserve Bank of Vanuatu's repurchase facility rate remained at 6.5% throughout the year, indicating an unchanged monetary policy stance.

Official balance-of-payments projections presented in the 2004 budget suggested that the current account deficit would decline to 0.3% of GDP in 2003. These projections are likely to prove overoptimistic. In the first 3 quarters of 2003, merchandise export growth was strong enough to lead to a slight narrowing of the trade deficit, but the foreign reserves level in October had fallen to $37 million, some Vt200 million short of the projected figure, and sufficient to cover just over 4 months of imports. The overall balance-of-payments was on track to record a small deficit in 2003.

Policy Developments

An amendment to the Debits Tax Act of December 2002 effectively increased the tax levied on bank accounts without addressing community concerns that it was an antipoor tax. The Vanuatu National Provident Fund Amendment Act reduced the rate of 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, long-term Comprehensive Reform Program, aimed at improving corporate governance in the public enterprise sector. Political interference in the operations of public enterprises continued. The public enterprise sector remained a drain on the public purse, and privatization of several larger enterprises was delayed.

At the same time, trade reform was pursued with the passage of 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 join WTO, but also raised the issue of future loss of government revenues 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. As a result, Vanuatu was removed from the OECD List of Uncooperative Tax Havens.

In September 2003, the Government outlined a Prioritized Action Agenda intended to more effectively link the Comprehensive Reform Program with the Government's medium-term investment program and annual budget. The agenda identifies three key objectives: (i) 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. Economic growth is constrained by low private investment, with foreign investors continuing to be concerned about political instability, an uncertain policy environment, and the economy's high cost structure (including transaction costs of obtaining investment approvals and business licenses).

The 2004 budget aims at further fiscal consolidation. On the assumption that growth will pick up to about 2% and inflation will moderate slightly, an overall budget surplus of 0.4% of GDP is targeted for 2004. Other than the removal of the debit tax on bank account withdrawals below Vt5,000, no revenue initiatives are envisaged, and reaching the estimated revenue level will require a considerable improvement in revenue collection. Recurrent expenditures are to be reduced from the 2003 budget level through cuts in expenditure on wages, nonsalary goods and services, and transfers to government bodies, with education and health receiving reduced budget allocations. The share of wages in total recurrent expenditures is still high at 58.3%. No change is envisaged in capital expenditures, funded mostly by external grants. Given a substantial negative external financing, a small domestic financing requirement is to be met from government cash balances.

Outlook for 2004-2005

The 2004 budget forecasts GDP growth to accelerate to 2.1% in 2004 and to 2.6% in 2005. The agriculture sector is expected to be the driving force behind this, with the industry and services sectors playing increasingly supportive roles. For agriculture to perform as expected, weather conditions and world commodity prices will need to remain favorable, and smallholder cattle and cocoa production will need to be further encouraged. World commodity prices are likely to be strong, but tropical cyclone Ivy hit Vanuatu in late February 2004 and damaged property and crops to an extent yet to be assessed. At present, there is no comprehensive agricultural development strategy in place. Growth in the services sector requires tourism expansion in a context of strong and increasing competition from other Pacific destinations. Given the country's relatively high costs of international and domestic air travel and accommodation, this expansion will be difficult to achieve, unless a tourism marketing strategy successfully differentiates what Vanuatu has to offer. The Government's decision to opt for an open skies policy could lead to an increased and more competitive international air service, however.

Given the population growth rate, the projected 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 live 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 can be addressed effectively.

The Government forecasts budget surpluses of 0.4% in 2004 and 2005, on the assumption that the recurrent and capital expenditure cuts planned for 2004 can be locked in. Assuming a slight deceleration of inflation to the 2.0-2.5% range, there would be a decline in real spending and little growth in real revenue. The wage bill is forecast to rise at 2.0% annually in nominal terms but to decline only marginally as a share of total recurrent spending. This will leave limited room for improving the strategic allocation of public resources.

The current account of the balance of payments is expected to continue to be characterized by trade deficits, a surplus on the services account, and inflows of foreign aid, with the net result being small current account deficits. The Government forecasts a rising surplus on the capital account in 2004 and 2005 and an increase in foreign reserves to over 5 months of import cover. However, these forecasts rest on expectations of a rise in foreign investment, which is unlikely to be forthcoming. Official external debt is forecast to drop to 24.9% of GDP in 2005.