Public Information Notice No. 07/100

Public Information Notice: IMF Executive Board Concludes 2007 Article IV Consultation with Maldives

August 9, 2007

On July 30, 2007, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Maldives.¹

Background

The Maldives economy has recovered strongly from the 2004 tsunami. In 2005, the decline in tourism weighed heavily on the economy, which contracted by 4.5 percent. However, strong recovery in tourism arrivals underpinned growth in 2006, and the economy grew by an estimated 19 percent.

Meanwhile, fiscal expenditures in Maldives have increased sharply in the years following the natural disaster, and, correspondingly, the fiscal deficit has deteriorated from 1.9 percent of GDP in 2004 to 11 and 7 percent of GDP in 2005 and 2006, respectively.

The 2007 budget confirms this trend by including a further rise in planned expenditures.Overall expenditure is projected to rise by 45 percent, while the domestically financed portion of the budget—excluding development grants and loans—would increase by 31 percent, and the domestic expenditures-to-GDP ratio would rise from 46 percent in 2006 to 54 percent in 2007. The 2007 budget carries risks of a significant deficit as the large spending program is based on optimistic revenue assumptions.

Price pressures resulting from higher fiscal deficits remained limited due to the openness of the economy. Inflation has remained relatively subdued—although rising-at 3.3 percent in 2005 and 3.7 percent in 2006 against a pre-tsunami average of 2.5 percent.

Higher fiscal deficits have, however, resulted in sizable external current account deficits. The current account deficit widened from 36 percent of GDP in 2005 to 41 percent in 2006. External debt has risen from 43 percent of GDP in 2004 to about 65 percent in 2006, while the debt service ratio has increased from 5.1 percent to 8.8 percent.

Progress has been made recently with the implementation of the first T-bill issue, and the government commenced weekly issuance in September 2006. The authorities have also embarked on several structural reform initiatives—fiscal, legal, and state-owned enterprises—to create a business environment conducive to private investment and to support growth.

Executive Board Assessment

Executive Directors noted that GDP growth in Maldives has rebounded strongly from the devastating Indian Ocean tsunami of 2004, underpinned by booming tourism and construction sectors. Per capita income has doubled over the last decade. Inflation remains low—albeit rising, anchored by the pegged exchange rate regime, which has served the country well. At the same time, large fiscal deficits and an ambitious foreign borrowing program, as well as an acceleration in private sector credit, have led to a substantial current account deficit and pressures on the balance of payments.

Against this background, Directors agreed that the main challenge for Maldives will be to ensure that the broadly favorable growth prospects are supported by a prudent fiscal policy and a viable macroeconomic framework. They stressed the need to keep expenditures in line with a realistic resource envelope, in order to contain inflation, strengthen private investment and growth, and safeguard the external position.

Directors expressed concern that the 2007 budget accommodates a substantial increase in domestically financed expenditures—mostly unrelated to post-tsunami rehabilitation. Moreover, a number of new revenue measures depend on an overly ambitious resort development schedule, and the expected revenues may fail to materialize. Directors therefore encouraged the authorities to prioritize expenditures and bring them in line with realistic revenue estimates, so as to achieve the stated objective of zero domestic financing of the budget. They recommended developing a medium-term expenditure framework to help accommodate the desired level of development spending within the available resource envelope.

Directors supported revenue-enhancing reforms to ensure fiscal sustainability over the medium term. These include the introduction of corporate taxation, a broad-based sales tax, and replacing the current "per head" tourism tax with an ad valorem tax.

Directors agreed that external vulnerabilities need to be monitored carefully, given the recent rise in external debt and debt service. They cautioned that in a small, open economy like that of Maldives, fiscal slippages tend to magnify external vulnerabilities and could cause the already low level of international reserves to fall rapidly.

Directors acknowledged that Maldives' U.S. dollar peg exchange rate regime, and the current level of the exchange rate, seem appropriate, as long as fiscal policy is tightened. The dollar's decline against the euro has enhanced the country's competitiveness in recent years, and downside risks to competitiveness seem unlikely. They were concerned, however, that with unchanged fiscal policies, the resulting sharp fall in reserves would undermine the dollar peg. Against this background, many Directors noted that adequate information was not available to make a determination whether or not the Maldives' exchange rate is in fundamental misalignment. However, some Directors concurred with the staff's assessment that Maldives is in a situation of fundamental misalignment.

Directors welcomed the passage of the Maldives Monetary Authority Act as an important step in establishing an independent central bank. They observed that the recent introduction of treasury bills would help eliminate the practice of automatic central bank financing of fiscal deficits, and that further incremental steps to develop this market should be pursued. Directors encouraged the authorities to accept the obligations of Article VIII of the Articles of Agreement.

Directors pointed to the need for further structural reforms, including privatization, with the objective to improve competitiveness and the climate for private investment. They commended the authorities for identifying several state-owned enterprises for divestment of shares, and for the recent passage of the Audit Act and the Civil Services Act.

¹ Under Article IV of the IMF's Articles of Agreement, the IMF holds bilateral discussions with members, usually every year. A staff team visits the country, collects economic and financial information, and discusses with officials the country's economic developments and policies. On return to headquarters, the staff prepares a report, which forms the basis for discussion by the Executive Board. At the conclusion of the discussion, the Managing Director, as Chairman of the Board, summarizes the views of Executive Directors, and this summary is transmitted to the country's authorities.