Mission Concluding Statement 

Principality of Andorra: Staff Concluding Statement of the 2023 Article IV Mission

December 18, 2023

Andorra La Vella:

Economic Outlook

The Andorra economy is showing resilience and is growing slightly above the potential. Strong growth in 2022 closed the output gap after a deep COVID recession. Despite external headwinds, the economy is growing above potential, at an estimated 2.3 percent in 2023, driven by the service sector and a record number of visitors. With limited economic slack, the labor market is tight with almost no unemployment. Inflation is projected to remain high at 5.8 percent in 2023 amidst persistent core inflation. Despite shortage of affordable housing, a large population increase helped match high labor demand. The current account surplus remains large, estimated above 17 percent of GDP in 2023.

Going forward, GDP is expected to slow to the level of potential growth. Real GDP growth is forecasted at 1.8 percent in 2024 and at 1.5 percent from 2025 onwards, comparable to average growth in the euro area. Inflation is projected to subside from 4.3 percent in 2024 to 2 percent only by end-2025, in line with price developments in neighboring countries and domestic second-round effects. Risks to the outlook are balanced but there are concerns about still-high inflation and housing affordability. Solid macroeconomic buffers—low debt and fiscal space, newly constituted foreign reserves, a large current account surplus, and well capitalized and liquid banks—serve as buffers to mitigate downside risks should they materialize.

Managing fiscal policy to strengthen growth and buffers

After a rapid fiscal consolidation, the authorities have room within the fiscal framework to implement needed growth-enhancing investments, address structural bottlenecks, while maintaining appropriate fiscal discipline. Automatic stabilizers, i.e., higher tax revenues and lower expenditures during the recovery, helped the authorities to restore fiscal space and to decrease the debt level back to below the fiscal rule threshold in 2022. In the absence of monetary policy tools, maintaining fiscal policy space and reducing public sector liabilities is warranted for a microstate vulnerable to external shocks. Given the persistent inflation and the positive output gap, the balance between maintaining primary fiscal surpluses and expanding public investment (notably in social housing) in 2023 and 2024 is appropriate. The fiscal framework—with a central government debt ceiling of 40 percent of GDP and an overall deficit limit of 1 percent—has worked well to anchor the credibility of fiscal policy. The government is expected to continue running primary balance surpluses of about 1 percent of GDP over the medium term, resulting in a reduction of debt to about 30 percent of GDP by 2028. Fiscal rules provide room for higher public spending, targeted towards growth-enhancing investment in social and affordable housing, upskilling the workforce and addressing labor shortages, and in improving the connectivity of the country to support economic diversification. Climate change is gaining significance for the Andorran economy and will require stepped up adaptation measures from both the public and private sectors.

The authorities should continue to strengthen the public sector balance sheet through reserve and debt management. The authorities took steps to build up international reserves on a precautionary basis—adding borrowed funds to the 2021 allocation of IMF Special Drawing Rights to bring reserves up to 10 percent of GDP. Well-timed issuance of Eurobonds in 2020-22 allowed the government to extend the maturity of debt at favorable rates. The authorities should continue the policy of diversifying debt and extending its maturity to decrease rollover risks and mitigate consequences from increases in interest rates.

Over the medium term, population aging creates substantial contingent liabilities and the pension reform should be a priority. Andorra’s aging population will increase healthcare and pensions costs going forward. The authorities should study the effect of aging on future public expenditures and create plans to address them. Public pension expenditure as a share of GDP is expected to see one of the largest increases in the region and to create an unsustainable dynamic for the Andorran social security fund. Concluding the reform in an expeditious and comprehensive manner is needed to ensure its sustainability.

Ensuring financial sector stability

Banks have a robust financial position, but their large size remains a risk. While the main source of income for Andorran banks is the relatively low-risk private banking business and capital and liquidity ratios are high, banks are systemically important. At the end of 2022, bank assets were 5.5 times GDP, and off-balance sheet assets under management were 20 times GDP, with each of the three banks’ assets exceeding the country’s GDP. The introduction of the lender of the last resort facility (LOLR) in 2022 to mitigate a temporary liquidity shock to a bank is welcome. Given the systemic size of the banking sector, it is important for the LOLR to be supported by continued close supervision and a well-designed resolution framework to ensure that critical problems are identified and addressed early.

While higher interest rates helped to boost banks’ profitability, continued vigilance by the supervisor is warranted. A substantial widening of interest margins supported profitability in 2022 and 2023. Credit risks are mitigated by relatively low financial intermediation and limited leverage as two-third of companies use their own funds for financing. However, given the prevalence of variable rate loans, higher interest rates can put a pressure on some borrowers’ ability to pay and lead to an increase in nonperforming loans. The supervisor should monitor the effect of interest rate increases on the banks’ asset quality and require banks to act proactively in case of a significant deterioration. Large exposures and connected lending, typical in a small economy, should be closely monitored and resolved. The banking turmoil in the US and Europe in 2023 revealed how bank stress could propagate quickly due to abrupt shifts in market sentiment. Ensuring that the Andorran Financial Authority is an autonomous, fully resourced supervisor that has the power to conduct in-depth risk-based assessments, enforce its findings, and deploy a solid crisis management capacity if needed, is paramount.

Structural reforms to support economic diversification, GDP and income growth

Economic diversification would support real GDP and real income growth. Andorra remains highly dependent on the hospitality sector, and on winter tourism in particular. The authorities and the private sector are taking steps to extend the tourist season throughout the year. Better connectivity and infrastructure will enhance the attractiveness of Andorra for tourism and for the development of new economic activities.

The recently finalized EU Association Agreement has the potential to unlock substantial benefits by opening markets for a more diversified economy. The agreement will eventually result in full access to the EU market. Significant transition periods for various sectors allow the government to prepare the economy to take full advantage of the access to the single market and to avoid disruptions, particularly in the financial sector. The agreement does not impose restrictions on tax policy areas where Andorra has a model of low taxes compared to neighboring EU countries.

Addressing emerging bottlenecks is crucial to avoid long-term costs for the economy:

• Housing affordability is an increasing social and economic concern. A fast-growing population, a rapid economic recovery, and rising real estate prices have decreased housing affordability in Andorra. Low-skilled workers and low-income households are disproportionately affected by affordability concerns. Increasing the stock of rental housing is essential. Public investment in affordable housing is a direct answer to this issue, and the authorities have started taking actions in the 2024 budget. Measures to redirect investment towards affordable housing should be consistent with other goals such as attracting investments and highly qualified workers to the country and minimize counterproductive distortions.
• Climate change is macro-critical for Andorra. With (mostly winter) tourism accounting for one third of its economy, Andorra is directly exposed to climate change. Because of its higher altitude, Andorra is more resilient than other winter tourism locations in the region and should use this window of opportunity to enact needed policies. The promotion of renewable and high energy efficiency technologies, and of efficient energy use across sectors is welcome. The authorities’ climate change strategy—with ambitious goals—is focused on mitigation but its adaptation component needs to be accelerated. According to staff calculations, achieving the decarbonization objectives would require a considerable increase in the carbon tax and very substantial efficiency gains in the power, transport, and residential sectors.

Continuing to improve the governance framework to enhance investor trust and confidence

Continued progress to strengthen the transparency and accountability of public spending, counter corruption, and improve macroeconomic data are important. The reform of the public procurement framework and the introduction of an electronic contracting and invoicing platform are welcome. Ratifying the United Nations Convention Against Corruption and developing an anti-corruption strategy that systematizes the efforts to combat corruption should be key priorities. Further improving the effectiveness of the AML/CFT framework is necessary to ensure financial stability, in particular in the provision of services related to virtual assets. Andorra should continue its efforts in developing macroeconomic statistics after significant progress in improving data reporting since joining the IMF.

*

The mission thanks the authorities and all our counterparts for a constructive policy dialogue, for engaging in a productive and transparent collaboration, and for their hospitality during the official visit of the IMF to Andorra.