Mission Concluding Statement 

Tuvalu: Staff Concluding Statement of the 2023 Article IV Mission

April 25, 2023

Washington, DC: An International Monetary Fund (IMF) mission held discussions for the 2023 Article IV consultation for Tuvalu in Funafuti, during April 18-25. The mission issued the following statement at the conclusion of the mission:

A successful vaccination strategy allowed Tuvalu to lift COVID containment measures at the end of 2022, but the economic cost of the pandemic has been significant. Real GDP growth was -4.3 percent in 2020, with at-the-border containment measures leading to delays in much-needed infrastructure projects. Activity has not fully recovered to its pre-pandemic level, with growth in 2021 at 1.8 percent and estimated at 0.7 percent for 2022. Headline inflation rose to 11.5 percent in 2022 in the context of higher global inflationary pressures, an increase in transportation costs around the world, and the increase in global food prices in the wake of Russia’s invasion of Ukraine. The external position temporarily strengthened as COVID containment measures and their impact on import-intensive infrastructure projects led to a sharp increase in the current account balance, implying that its level for 2022 was broadly in line with fundamentals and desirable policy settings.

Fiscal savings from pandemic-related reduced capital spending were partly offset by elevated current spending. The overall fiscal balance had an average surplus over 2020-2022 of only around 3 percent, despite a halving of public capital expenditures from their 2019 levels. Current expenditures have been elevated, with purchases of goods and services rising from 19 percent of GDP in 2019 to 31 percent in 2022, primarily because of once-in-50-years land-lease renegotiations with landowners where public buildings are located. Expenditures related to the Tuvalu Overseas Medical Referral Scheme (TOMRS) and scholarships are also estimated to have crept up to 16.6 percent of GDP in 2022, from 12.6 percent before the pandemic. While tax revenues remained broadly stable, weaker nontax revenues (from fishing licenses and the .tv domain) led to a widening of the deficit on the domestic current balance [1] to 60 percent of GDP in 2022, up from 37 percent pre-pandemic.

Growth is expected to accelerate . Growth is projected at 3.9 percent in 2023 as the lifting of COVID restrictions leads to the resumption of construction activity and the trade and small hospitality sectors recover, with some reopening effects spilling over to 2024 as logistics bottlenecks in shipments to outer islands ease. Inflation is expected to decline but remain elevated at 5.9 percent in 2023, on the back of still-high global inflation and the effects of the drought on domestically-produced food, slowly converging to around 2.8 percent by 2028.

The fiscal balance is expected to deteriorate starting in 2023. Large increases in current expenditures in the 2023 budget and the resumption of infrastructure projects are expected to reduce the fiscal surplus to 1.1 percent of GDP, from 8.8 percent in 2022. The domestic current balance is expected to improve marginally to -57 percent in ratio to GDP. Even with a significant reduction in on-budget infrastructure spending and with total capital expenditures expected to return to their pre-pandemic levels in the medium term, the elevated levels of current expenditures combined with the narrow domestic revenue base imply that the fiscal accounts are projected to move into deficit starting in 2025 and remain in deficit through to 2043, also leading to a deterioration of the current account. Foreign financing will eventually be required to finance the fiscal deficit, including because of the expected inability to draw from the sovereign fund. Under these projections, Tuvalu is assessed to remain at a high risk of debt distress.

Downside risks to the outlook are high. Delays in donor grants pose large risks to the fiscal outlook, and therefore also to the economy. As in other small economies, a loss of correspondent banking relationships would create severe balance of payments problems. The lack of effective financial supervision creates contingent risks for the government via the financial sector. Higher global commodity prices could result in higher inflation that leads to greater fiscal expenditure pressures. Natural disasters and climate change remain latent threats to the economy—including through their possible impact on fishing license revenues, potential human and physical capital losses, ^[2] and food and water security.

Staff advises a gradual fiscal consolidation to support the dual goals of ensuring sustainability while meeting climate adaptation needs. Fiscal consolidation will be necessary to ensure sustainability as well as to build buffers against the many downside risks. At the same time, the narrow domestic revenue base and lack of access to local and international debt markets make necessary climate-adaptation investments impossible without significant donor support. That support will benefit from continued public financial management reforms to facilitate easier access to climate funds, with the Fund committed to continue to provide technical assistance. Reduced risks, both macro-fiscal and climate-related, would in turn help create a more conducive environment for private sector activity.

Medium term macro-fiscal sustainability would be well served by pursuing a fiscal framework anchored on the domestic current balance. Staff recommend a gradual adjustment commencing in 2023 with a consolidation of 1 percent of GDP relative to the baseline, achieving a current deficit of 48 percent by 2026 and 40 percent of GDP by 2039. This would raise fiscal buffers, defined as the combined value of the Tuvalu Survival Fund and the Consolidated Investment Fund (CIF), to 6 percent of GDP by 2043 and would continue the trend of declining debt seen in recent years, and stabilize debt at 2-5 percent of GDP from 2029 onwards. The domestic current balance’s endpoint in this gradual consolidation path is similar to the pre-pandemic level of 37 percent of GDP. Such buffers would be sufficient to cover most shocks, including a sharp fall in fishing revenues and a natural disaster. Structural reforms that would raise medium-term growth to 3 percent would allow for a quicker attainment of the deficit target.

Fiscal policy reforms to support medium term sustainability include a combination of expenditure and revenue measures to achieve consolidation. Expenditures can be moderated by rationalizing public sector wages by linking them to performance and avoiding increases in the wage bill that do not ultimately address shortages, partially unwinding the sharp increase in goods and services spending of 2021, reviewing all subsidies, and rationalizing spending on the Tuvalu Overseas Medical Referral Scheme (TOMRS) and overseas scholarships. The latter should include exploring options to reduce the costs of overseas treatments, minimizing patient wait times abroad, and enforcing the conditions of medical scholarships to ensure the return of health professionals to the country. Revenue mobilization can be pursued by increasing the VAT statutory rate, to bring it more in line with regional peers, pushing ahead with plans to increase tax compliance, especially among large taxpayers, and ensuring an adequately-staffed tax authority; improving corporate income tax efficiency; including tax expenditures in budget documents; and enforcing timely corporate reporting and audits of financial statements of SOEs to improve tax payments.

Efforts to deepen and modernize financial services would need to be accompanied by strengthened regulation and supervision. Staff advise implementing regulatory measures encouraging (i) loan pricing that is a function of borrowers’ credit risk, (ii) upgrading financial institutions’ credit assessment capacity, and (iii) introducing a resolution regime for non-performing loans. Ensuring that the perimeter of the supervisory framework covers not only banks but also Tuvalu’s National Provident Fund (TNPF) would strengthen supervision. So would strengthening the ability to conduct off-site supervision based on standardized, timely reporting and analysis, including through further Fund technical assistance. For these efforts to succeed, it will be critical that the understaffing of the supervisor is urgently addressed.

Building resilience in Tuvalu’s connectivity to the global payments system is crucial. Staff supports the authorities’ plan to join the Asia-Pacific Group (APG) on Money Laundering (a FATF-style regional body). This will unlock additional potential technical assistance, in turn supporting the ongoing work of the Anti-Money Laundering Coordination Committee, including the updating of the legal framework and implementation of the authorities’ policy reform matrix. These efforts can further contribute to strengthening correspondent banking relationships. Staff encourages the authorities to continue pursuing help from technical assistance partners, and to use the APG platform to engage with other members to address issues of common regional concern. Plans to digitalize the nation should be pursued in a way that does not interfere with policy reform actions geared toward building resilient correspondent banking relationships.

Three broad areas of focus for structural reforms would help diversify the economy and promote growth. First, building on the ratification of Pacific Agreement on Closer Economic Cooperation (PACER) Plus, further diversification could be pursued through the development of niche tourism markets, and expanding the country’s participation in the fishing value chain. Second, there is scope for strengthening disaster resilience by (i) enforcing building codes across all nine islands, (ii) developing risk maps that further incentivize and guide investments in resilient infrastructure, and (iii) revamping the Disaster Risk Management Act to modernize the preparedness and response to a disaster. Third, human capital can be enhanced by (i) adopting a comprehensive strategy on overseas scholarships to ensure alignment with Tuvalu’s needs, including to fill key positions in the public sector and enforcing stringent contracts to bind scholarships to service; (ii) strengthening the legal framework on patient privacy to connect health data with personal characteristics for better prevention, identification, and treatment, and deepening recent measures against tobacco, salt, and sugar; and (iii) adopting legislation and improving connectivity to support remotely delivered health services from offshore sources. A more diversified economy that succeeds in building resilience to climate change should also help incentivize Tuvaluans to deploy their human capital in the country, thus reducing migration pressures.

Given the substantial role of the public sector in the economy, reforms to improve SOE performance and delivery are important. Staff recommends (i) aligning prices with recovery levels by phasing out Community Service Obligations (and replacing them with targeted subsidies where needed); (ii) enhancing performance-based management; (iii) improving fiscal risk management by producing a plan to address loss-making SOEs through strengthening their commercial orientation and (iv) close monitoring of losses from fishing joint ventures.

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The IMF team is grateful to the government of Tuvalu for their warm welcome, cooperation, and open and candid discussions.