Staff Concluding Statement of the 2023 Article IV Mission

Vanuatu: Staff Concluding Statement of the 2023 Article IV Mission

January 24, 2023

Port Vila, Vanuatu:

Economic Context, Outlook, and Risks

Vanuatu re-opened its borders in 2022, after a challenging start to the
year.

After the first domestic transmission in late March 2022 and a temporary
lockdown, domestic restrictions were fully lifted in mid-June. Vanuatu
resumed international travel in July, and several airlines and cruise lines
have re-established connections with the country.

Growth is returning.
The gradual economic recovery started in 2022, with estimated real GDP
growth at 1.9 percent y/y. Growth is expected to strengthen in 2023,
reaching 3.4 percent y/y, driven by the return of tourism, higher public
infrastructure spending (construction), which slowed down during lockdowns,
and the ongoing recovery of trading partners. Inflation is expected to
accelerate and remain elevated, potentially above the Reserve Bank of
Vanuatu’s (RBV) 4 percent upper end of the inflation target, though
potential measurement issues complicate an accurate assessment. A current account deficit is forecast for 2023 on the
back of higher import prices (including commodities) but will narrow over
the medium-term on the return of tourism and strong remittances.

However, the new government faces many challenges.
The pandemic and surging commodity prices have reduced macroeconomic policy
buffers and aggravated structural vulnerabilities. In 2022, the European
Union and Switzerland suspended visa waiver agreements for Vanuatu passport
holders, citing weaknesses in due diligence for Economic Citizenship
Program (ECP) applicants, and triggered a steep decline in revenue. Air
Vanuatu faces operational and financial distress and is posing substantial
risks to the economy given its systemically important status. Bold reforms
are needed to build climate resilient infrastructure, strengthen public
finances and the banking system, and meet long-term development goals.

There are substantial downside risks to the outlook.
Near-term risks include: i) the spread of COVID variants which could lead
to new lockdowns; ii) weaker tourism and lower remittances due to a
potential slowdown among main trading partners; and iii) a greater loss of
ECP revenue which could jeopardize medium-term fiscal and debt
sustainability, and quickly erode reserve buffers. Key structural risks
include: i) further increases in non-performing loans (NPLs), which could
impact bank profitability and capital, thus affecting credit availability;
and ii) weak governance and financial integrity, as well as AML/CFT issues.
Natural disasters remain a significant risk.

Fiscal Policy

Staff advises fiscal prudence as the economy recovers.
The fiscal deficit is estimated around 3 percent of GDP in 2022 partly as
delays in donor-financed infrastructure projects have postponed spending,
but is expected to widen in 2023, in line with greater donor-financed
capital expenditure. The 2023 budget is currently being prepared, and
Parliament is expected to approve it in March. While the fiscal stance is
expected to be expansionary, scaling back non-priority spending is
essential to protect the limited fiscal space and avoid the erosion of
buffers, especially given the decline in ECP revenue. Staff welcomes the
unwinding of pandemic-related support and recommends containing public wage
growth. Weaknesses in tax administration should also be addressed,
especially with respect to VAT collection.

A medium-term fiscal strategy is needed to secure adequate
consolidation and ensure consistency with fiscal targets.

The fiscal anchor of public and publicly guaranteed (PPG) debt below 60
percent of GDP has served Vanuatu well but is expected to be breached by
2029 in the context of declining ECP revenue and elevated current spending.
A medium-term fiscal strategy should incorporate substantial tax revenue
mobilization and expenditure rationalization to reduce deficits and ensure
consistency with fiscal targets, including: i) completing the proposed 2017
tax reforms which envision the introduction of corporate and personal
income taxes; ii) gradually reducing the size of the wage bill; and iii)
streamlining transfers to state-owned enterprises (SOEs). Staff analysis
suggests that an additional two percent of GDP in savings as early as
possible, but at least from 2026, could help build buffers to improve
resilience and keep PPG debt below 60 percent of GDP over the next decade.

The approval of the medium-term debt management strategy and a swift
resolution of financial distress of Air Vanuatu are essential to
preserve debt sustainability.

Staff assesses that the risk of debt distress remains moderate, with
limited space to absorb shocks. However, given a projected gradual decline
in donor support and persistent fiscal deficits, Vanuatu will need to
increasingly rely on domestic issuance to meet financing needs over the
long term. In this context, staff welcome plans to develop domestic bond
markets as part of the forthcoming debt management strategy, while
continuing efforts to secure new sources of concessional external
financing. The financial distress of Air Vanuatu must be resolved in a
sustainable way that minimizes contingent liabilities and stems the flow of
fiscal transfers. Staff welcomes the recent request for a rapid assessment
of the airline by Australia’s Department of Foreign Affairs and Trade.

Monetary Policy

The Reserve Bank of Vanuatu should stand ready to tighten if there are
signs of second round effects on inflation.

The monetary policy stance remains appropriate given the ongoing recovery,
slow private sector credit growth, and subdued underlying
inflation. However, the RBV should tighten if rapid increases in underlying
inflation emerge. Monetary policy tightening could be achieved by
increasing the Statutory Reserve Deposits ratio and reducing excess
liquidity through open market operations. The currency basket-peg has
allowed for flexibility and the exchange rate should continue to act as a
shock absorber amid still elevated global commodity prices.

Financial Sector Issues

The authorities should strengthen the supervisory framework, increase
loan-loss provisioning, and tackle elevated NPLs.


The banking system remains profitable and liquid, but elevated NPLs,
particularly among household loans, remain a concern especially for the
largest domestic bank. Greater regulatory scrutiny and supervision is
needed to monitor and reduce vulnerabilities. Moratoria on loan repayments
and the easing of prudential requirements on asset quality introduced to
cushion the effects of the pandemic on the financial system expired in
September 2022, although some lenders extended relief through the end of
2022 in some cases. As a result, impaired loans could increase further,
especially in sectors where the recovery has not taken hold yet. The level
of provisioning appears low in some banks which need to accumulate higher
reserves to preempt the decline in loan servicing capacity. While bank
capital levels are adequate, increasing minimum regulatory capital
requirements can help shore up stronger buffers. There is also a need to
strengthen supervisory and resolution frameworks and resume on-site
inspections of banks. The mission welcomes the development of a new
prudential guideline in line with Basel III that may strengthen bank
capital, improve asset classifications, and introduce a
debt-service-to-income ratio to contain unsustainable household debt.

Enhancing digital finance and the successful rollout of the payment
system could boost financial inclusion and improve the efficiency of
the financial sector.

Establishing a retail CBDC could facilitate the digitalization of financial
services for the rural and unbanked population. Appropriate legal,
supervisory, and regulatory frameworks, as well as the technological
infrastructure should be in place before considering a CBDC or allowing for
crypto asset activity to be conducted by way of business in the
jurisdiction. The Vanuatu Financial Service Commission will undertake
regulatory efforts for virtual assets and provide needed clarity. The
planned launch of the national payments system for real time and more
efficient settlements in June 2023 will contribute to strengthening the
financial infrastructure.

Macro-Structural and Governance Issues

Economic diversification and the development of quality infrastructure
will be essential for sustained and inclusive growth and resilience to
shocks.

The authorities should continue to promote greater development of the
agricultural sector, strengthen their capacity to implement large-scale
infrastructure projects, and improve the business environment including by
streamlining administrative processes for FDI, such as high fees and long
processing times.

Enhancing climate resilience remains an urgent priority given Vanuatu’s
vulnerability to natural disasters.

It will be crucial to clearly articulate the country’s medium-term
adaptation priorities and to develop a financing roadmap, based on the
August 2022 revised and enhanced Nationally Determined Contribution. This
roadmap should be integrated into the medium-term fiscal strategy.

Policies to address skill shortages and improve labor market conditions
should be

expedited.
Following the reopening of borders, key economic sectors like tourism are
facing labor shortages due to the increased participation of Vanuatu’s
workforce in international seasonal worker programs . Reintegrating these labor resources in the
domestic market could alleviate shortages and help skills transfer. In
addition, the authorities should improve domestic labor market
opportunities by developing skills locally through apprenticeships and
vocational training and seeking the help of official bilateral partners.
Expanding tourism and hospitality training and improving female labor force
participation could also help meet labor demand.