Mission Concluding Statement 

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.

Improving governance and reducing vulnerability to corruption are essential.

• ECP and AML/CFT concerns. Significant deficiencies in Vanuatu’s AML/CFT regime, particularly in the mitigation of financial integrity risks associated with the ECP, are some of the factors contributing to fewer corresponding banking relationships, even though the latter also requires solutions at the regional level. The upcoming Mutual Evaluation of Vanuatu by the Asia-Pacific Group on Money Laundering (APG), led by the Vanuatu Financial Intelligence Unit, is a significant opportunity to show tangible progress toward compliance with FATF standards.

• Central bank governance. Implementation of the recommendations of the 2016 Safeguard Assessment is essential to strengthen the RBV’s autonomy and governance.

• Tax Transparency. Legislative amendments to meet international standards on tax information exchange and tangible action to pursue delisting from the EU’s blacklist are needed.

• SOE governance. The mission welcomes the new government’s support for the Government Business Enterprise Act, which is expected to be passed in Parliament in the coming months. Further efforts to enhance SOE supervision and transparency—including through timely publication of financial statements—are critical to reduce corruption vulnerabilities and fiscal risks.

• Cybersecurity. The destabilizing 2022 ransomware attack highlights the need to build greater cyber resilience and a more robust ICT infrastructure.

The mission would like to thank the authorities for the frank and engaging discussions, and their warm hospitality.