On August 25, 2014, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation¹ with Tuvalu.

Growth is picking up modestly on a generally stable outlook, and inflation has been moderate. Activity has benefited from increased competition in the retail sector and a recent boom in the fisheries sector as well as development partners’ support, while banking weaknesses have constrained financial support for the private sector, and the poorly managed public enterprises have strained government finances and hampered the country’s business climate.

The balance of payments has been supported by large fishing-related receipts and official aid. Fishing exports and receipts of fishing license fees have more than doubled in the past few years, and official aid by development partners has also risen sharply. Remittances, however, have shrunk markedly since the global financial crisis largely as a result of limited human capacity and weak competitiveness. Meanwhile, imports have been generally stable on account of restrained budget spending until recently. As a result, foreign exchange reserves have risen to 8 months of imports.

The fiscal policy achieved a substantial surplus in 2013. In addition to record high fishing license fees, tax revenues also outperformed the budget mainly because of improved compliance by public enterprises. The favorable revenue has been reinforced by higher-than-expected foreign grants. As a result, fiscal buffers have been built up to comfortable levels. However, a large budget expansion in 2014 has increased risks to fiscal sustainability. The 2014 budget envisages a more than 20 percent increase in expenditures, mostly current spending, which is financed by a temporary large increase in foreign grants and transfers—once it is unwound, the fiscal balance would likely move into a significant deficit over the medium term.

Vulnerabilities in banks and public enterprises could compound fiscal risks. The unsupervised state-owned banking system suffers from severe asset quality problems. Non-bank public enterprises continue to make losses as a whole, reflecting weak governance and the cost of assuming social responsibilities. These weaknesses could ultimately result in a large increase in public liabilities.

Executive Board Assessment²

Executive Directors welcomed the authorities’ significant progress in implementing reforms on a broad front, in particular as regards public financial management. They noted that, while Tuvalu’s growth prospects over the medium term are generally positive, debt sustainability remains a key concern, and vulnerabilities in banks and public enterprises pose large fiscal risks. Challenges arising from climate change and Tuvalu’s remoteness and small size also need to be addressed.

Directors called for urgent actions to strengthen the fiscal position. While buffers have been built up in the past two years as revenues over-performed, the budget expansion in 2014 could undermine debt sustainability. Accordingly, they encouraged the authorities to unwind this expansion by cutting expenditures, keeping public sector wages aligned with productivity growth, and rationalizing social spending. More broadly, the adoption of a medium-term fiscal framework that targets a structural budget surplus and builds up savings will boost resilience against adverse shocks.

Directors also underscored the importance of further reform of public enterprises that continue to burden the budget. They encouraged the authorities to enhance the transparency and accountability of these entities and better identify their social responsibilities. Stricter control of public guarantees will also be needed, going forward.

Directors expressed concern about unaddressed fragilities in the banking system. They encouraged the authorities to take actions to resolve nonperforming loans and develop contingency plans. More broadly, they recommended the establishment of a sound regulatory framework and a comprehensive review of bank balance sheets. In this context, Directors welcomed the decision to set up a banking commission that will play a key role in ensuring financial stability.

Directors took note of the staff assessment that Tuvalu’s real effective exchange rate is broadly in line with fundamentals. Nonetheless, they emphasized that continued reforms are essential to enhance competitiveness. They encouraged the authorities to implement the next phase of the Policy Reform Matrix, and highlighted the importance of strengthening education as well as the institutional capacity of the public sector, including as regards the compilation of economic statistics. Continued engagement with development partners will be key to mitigate the effects of climate change.