More From IMF Report

More from the IMF Report 2005

Last week we published the first part of the recommendations from the IMF to solve the ongoing but worsening economic problems on a long term basis. This week we follow up with two other critical policy recommendations from the international institution.

D. Monetary and Financial Sector Policies

26. The authorities agreed that, in the context of the move to a more flexible exchange rate regime, the monetary policy framework would need to be modified. In light of thin money markets and uncertainty about the appropriate level on interest rates, staff recommended monetary aggregate targeting, starting with reserve money as the operating target. The choice of the future monetary policy framework would require further study as the monetary transmission mechanism, given the long history of the exchange rate peg and distortions in inflation measurement, remained unclear.

27. There was also agreement that monetary operations needed to be improved in order to conduct effective monetary policy. Staff recommended that the key first steps in preparation for a more active monetary policy should include an increase in the frequency of treasury bill auctions, the gradual dismantling of interest rate controls, and the replacement of the tap issue of government bonds at pre-set interest rates with auctions. Staff advised the authorities to consider converting part of the central bank’s long-term, non-marketable government bond to short term, marketable securities and recommended further refinements in monetary instruments. The authorities indicated that the central bank would start deliberating the details of the future monetary policy strategy and conduct a comprehensive review of its monetary operations in early 2006.

E. Reducing the role of the Sate in the Economy

29. Acknowledging the authorities’ ongoing reform initiatives, staff emphasized the importance of a comprehensive liberalization process as part of the proposed adjustment scenario. Key elements would include:

Continued, transparent privatization, ensuring that public assets would be sold on a transparent, arm-length basis, and at fair market value.

Further domestic price liberalization. Staff recommended that prices for petroleum products and utilities be liberalized and allowed to move in line with costs.

Deeper and broader trade liberalization. While welcoming the implementation of trade tax reductions and the cut in import license fees, staff noted that the intended imposition of seasonal import restrictions for domestic agricultural products would be a step back in terms of liberalization commitments, and was likely to create opportunities for rent seeking. The authorities were also encouraged to make progress toward joining the COMESA Free Trade Area.

An improved business environment. As noted in recent study by the World Bank’s Foreign Investment Advisory Services (FIAS), the entire business regulatory environment remained characterized by excessive government controls and a high degree of discretion. The adoption of the new investment code was a welcome step, but staff recommended that overall government intervention in private sector activities should be further reduced.

31. Economic performance in Seychelles has continued to weaken over the last year. The authorities’ economic reform program, which started in 2003 and was premised primarily on a significant fiscal adjustment, has not adequately addressed the fundamental imbalances of the economy nor has it restored competitiveness. While public debt has stabilized at a high level, it remains unsustainable. External arrears keep accumulating international reserves remain low. Economic activity has continued to dwindle, having declined by over 11 percent since 2000, and there is a risk that some of the gains in improving living standards and the high development indicators could be jeopardized unless there is a fundamental change in economic policy.

32. The decisive and prompt implementation of a comprehensive reform program aiming at correcting that country’s macroeconomic imbalances and at further liberalization the economy is of critical importance. The centerpiece of the program should be a sizable adjustment of the exchange rate and the phased removal of foreign exchange controls, accompanied by the implementation of tight fiscal and monetary policies, as well as the undertaking of structural reforms aiming at reducing the role of the state in the economy. Foreign investment would thus flow more readily (without resorting to tax concessions) and have greater domestic spillover in a liberalization economic environment. While cognizant of electoral considerations and of the need to adopt a pragmatic approach in order to minimize negative social impacts, the authorities’ desire to proceed cautiously with further reform implementation has to be balanced against the need to avoid a further deterioration of the economic situation.

33. The overvaluation of the Seychelles rupee needs be addressed and the foreign exchange controls progressively removed. With a significant portion of private sector economic activity already functioning on the basis of the more depreciated parallel market exchange rate, a move toward the unification of the exchange rate should have only a limited adverse impact on economic growth. Moving toward a market-clearing exchange rate, through an up-front devaluation followed by the introduction of a system to guide further adjustment should provide a jump-start inn terms of competitiveness. Combined with the steady elimination of the extremely burdensome foreign exchange allocation system and related controls, such a move would attract private capital flows and spark a resurgence of broad-based economic growth.

34. With further fiscal adjustment being necessary over the medium term, the rather un-ambitious 2006 budget is a missed opportunity in making significant inroads into further debt reduction. The 2006 budget aims at a modest fiscal deficit, bowing partly to spending pressures in the run-up to the upcoming elections. However, large primary surpluses will be necessary over the medium term in order to pay down public debt and curtail liquidity. Such an adjustment should focus mainly on expenditures, given Seychelles’ high tax-to-GDP ratio.

35. In considering a move to a more flexible exchange rate regime, monetary policy should be tightened, a monetary anchor adopted, and monetary operations would need to improved. Consideration should be given to reserve money targeting in the first instance. Monetary operations could be enhanced by increasing the frequency of treasury bill auctions and a gradual dismantling of interest rate controls.

36. The authorities would be well served by further structural reforms, capitalizing on recent advances. The start of the privatization process is welcome, though the staff wishes to reiterate the importance of an open, transparent, arms-length privatization process. The authorities are to be commended for their commitment to increase trade liberalization, although commitments to regional trade initiatives could be strengthened and pressures to impose new protectionist measures should be resisted. The staff welcomes the accelerated pace at which the trade tax is being reduced, as well as the liberalization of the system of import permits. The authorities are encouraged to liberalize prices for petroleum products and utilities and allow them to move in line with costs. Finally, further reduction in the level of government intervention in private sector activities would help to improve the business environment.

37. Vulnerabilities will remain high over the medium term. Even assuming full implementation of the adjustment scenario, public debt would remain unsustainable and reserves would be uncomfortably low for a few years to come. The balance sheet of the consolidated public sector would be exposed to currency risk, while the financial sector would face interest rate risk. Strengthened liability management and the implementation of a comprehensive debt strategy, mindful of inter-creditor equity, and of domestic balance sheet exposures, would help further reduce the debt burden.

38. Further efforts are required to normalize relations with external creditors. Staff welcomes the advances in discussions with bilateral and multilateral creditors. Further efforts to reaching an agreement with the African Development Bank on a plan to clear the arrears should be undertaken. Relations with private creditors should be improve and authorities should refrain from additional access to collateralized debt, which limit’s Seychelles’s flexibility to respond to external shocks and has complicated the task of normalizing relations with official creditors.