IMF Evaluates Vanuatu's Economy in 2023 Consultation

Washington, DC: The Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation^[1]with Vanuatu on March [20], 2023 and endorsed the staff appraisal without a meeting on a lapse-of-time basis.[2]

The reopening of borders and strong public infrastructure investment are paving the way for a faster recovery. GDP growth is expected to rise to 3.5 percent in 2023. Agricultural production, remittance inflows, and strong recovery in trading partners will support the economic activity. High energy and global commodity prices are pushing up headline inflation and widening the current account deficit, but core inflation remains subdued for now. Fiscal policy is expected to remain expansionary in the near term as the implementation of externally financed infrastructure projects accelerates. Monetary policy remains appropriately on hold amid weak private credit growth and negative output gap.

The Economic Citizenship Program (ECP) is facing significant challenges, with important implications for revenue collection and governance. The financial and operational challenges of Air Vanuatu are worsening and affecting the economy in general, particularly the tourism sector. The banking sector weathered the pandemic well. However, elevated non-performing loans (NPLs), particularly for households, remain a concern.

Risks to the outlook are substantial and tilted to the downside. Labor and materials shortages and cost overruns could delay the implementation of externally financed infrastructure projects. A slowdown in main trading partners' economic activity could negatively weigh on tourism and remittances. Additional challenges to the ECP could impact revenue collection and derail medium-term fiscal sustainability. Finally, structural risks include high and increasing NPLs, weak governance and anti-corruption framework, and extreme vulnerability to climate change.

Executive Board Assessment

In concluding the 2023 Article IV consultation with Vanuatu, Executive Directors endorsed the staff's appraisal, as follows:

The new government faces daunting challenges that require bold reforms. The pandemic, increase in global commodity prices, and lower revenues from the ECP reduced macroeconomic policy buffers. Prospects for the return of tourism are at risk due to the operational and financial challenges faced by the national airline, and labor shortages.

Vulnerability to natural disasters increases uncertainty and reduces policy space. Bold reforms are needed to lift the country's growth potential.

Stronger GDP growth is expected in 2023 supported by public infrastructure spending and resumption in tourism. An expansionary fiscal policy geared toward more capital spending and a gradual recovery in tourism are expected to be the main drivers of growth in 2023. Growth will also be supported by higher agriculture production on the back of government support, ongoing recovery in trading partners, and resilient remittances.

Risks to the outlook are tilted to the downside. Short-term to near-term risks include: (i) the spread of COVID-19 variants following the reopening of borders delaying the implementation of major infrastructure projects; (ii) a slowdown in main trading partners' growth negatively weighing on tourism and remittances; and (iii) additional losses in ECP revenue that could derail medium-term fiscal sustainability. Structural risks include: (i) increasing NPLs and their effects on banks' financial performance and lending capacity; (ii) weak governance and anti-corruption framework; and (iii) extreme vulnerability to climate change.

A credible medium-term fiscal strategy that secures adequate consolidation is essential for preserving debt sustainability. Given the projected decline in ECP revenues, Vanuatu's ambitious infrastructure agenda must be accompanied by tax revenue mobilization and expenditure rationalization efforts to reduce the already high deficits and keep debt below 60 percent of GDP over the next decade. Increasing tax revenues—including through the introduction of corporate or personal income taxes and through base broadening—should be at the core of any fiscal strategy. Promptly launching fiscal consolidation efforts and securing at least two percent of GDP in savings would help meet the fiscal anchor while protecting capital spending. Fiscal buffers should be strengthened given Vanuatu's vulnerability to natural disasters which includes expanding the sizeable cash reserves built in recent years.

The restructuring of Air Vanuatu must be completed urgently to reduce fiscal risks. Despite financial support from the government in recent years, the national airline's operational and financial challenges are worsening, with implications for tourism and domestic connectivity. The rapid assessment by Australia's Department of Foreign Affairs and Trade (DFAT) is an important first step, but a careful analysis of restructuring options is needed to identify a sustainable solution that minimizes contingent liabilities and transfers from the government while preserving the airline's systemic economic role.

The current monetary policy stance is appropriate. Weak private credit growth, subdued core inflation, and negative output gap calls for keeping monetary policy on hold to support the fragile recovery. Monetary policy should remain data-driven, and the Reserve Bank of Vanuatu should stand ready to tighten if there are signs of second round effects such as rapid increases in core inflation.

Financial sector policies should focus on tackling elevated non-performing loans. The financial system appears to be sound overall, but the high level of NPLs are a concern. There is a need to strengthen the supervisory and resolution framework, increase the minimum capital requirements, and provisioning for some banks. Going forward, introducing a debt-service-to-income ratio can help contain the formation of unsustainable debt.

Bold structural reforms are needed to unlock growth potential. The authorities should continue to promote economic diversification particularly in the agricultural sector. Improving the public investment management process is essential for strengthening the capacity to implement large-scale projects. The authorities must also prioritize streamlining administrative processes for FDI and implementing policies that may help address labor shortages.

Strengthening Anti-Money Laundering/Combating the Financing of Terrorism (AML/CFT) and improving governance remains essential. The authorities need to address significant deficiencies in Vanuatu's AML/CFT regime, including by better assessing and understanding ML/TF risks faced by the jurisdiction, strengthening the AML/CFT framework in line with international standards (including to regulate virtual asset service provider activities), and bolstering the capacity of competent authorities and law enforcement, and addressing governance risks surrounding the ECP. The upcoming APG review offers an opportunity to show tangible results. It is also necessary to strengthen governance in the public sector particularly with respect to the central bank and state-owned enterprises.