Debt Management Strategy

Transcription

1 Debt Management Strategy Debt Management Unit Ministry of Finance & Treasury March 2012

2 EXECUTIVE SUMMARY This debt management strategy is the first to be developed by the Solomon Island Government (SIG). In the past, SIG did not have a strategy and debt was not managed effectively. Borrowing decisions were made on an ad hoc basis. Full use was not made of borrowed funds to contribute to SIG s wealth and public debt reached unsustainable levels. Poor financial management and lack of controls surrounding borrowing by State Owned Enterprises (SOEs) and Provincial Governments contributed to the central Government s debt problems. The Honiara Club Agreement (HCA), signed in 2005 after SIG went into debt arrears (following a period of instability caused by ethnic tensions) set a policy of no new borrowing. This provided the discipline to reduce debt levels. Now that SIG has reached medium risk of debt distress, government and donors are ready for SIG to resume prudent borrowing. This strategy, by providing a strong framework, is proposed as an alternative to the HCA. Borrowing can increase the wellbeing of Solomon Islands by being used for projects that provide revenue or key infrastructure but, to do this, debt must be managed effectively. A debt strategy provides clear objectives for debt management as well as a framework for achieving these objectives. There are two key objectives. The first is to ensure that the servicing and management of SIG s financing requirements and payment obligations are met on a timely basis, and at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk. The second objective is to support the development of the domestic securities market. In practical terms, SIG must not go into arrears when it resumes borrowing, decisions must not be made on an ad hoc basis, debt levels must be sustainable and affordable, and borrowed funds must be used to increase the wellbeing of Solomon Islands. This document lays out plans for SIG s debt management for the next five years. It targets three different ways to help SIG achieve its objectives. Firstly, it sets out the analysis required for a debt strategy and to determine annual borrowing limits, secondly it puts in place a borrowing framework that is intended to be incorporated into Fiscal Responsibility Legislation and lastly, clarifies the responsibilities of the Debt Management Unit (DMU) of the Ministry of Finance and Treasury. The main debt strategy is to limit borrowing to concessional terms and prudent levels. The domestic securities market will be built up by extending the terms of Treasury Bills on issue. At present the market is limited to 182 days and Treasury Bills are mainly used for cash ii

3 management. Issuing longer term Treasury Bonds is not recommended due to high interest cost and refinancing risk. To develop the debt strategy DMU assessed the past and present debt situation, examined available alternatives and decided on the best plan for action to achieve the objectives. The next step was to do a Debt Sustainability Analysis (DSA). The World Bank / IMF DSA framework provides thresholds for sustainable and affordable debt levels for Lower Income Countries (LIC) like Solomon Islands. This document sets out the information used in the DSA, including a description of the composition of the debt portfolio, costs and risks of the portfolio and associated economic indicators such as revenue and GDP, and assumptions on how the economy will perform under stress. Prudent levels of borrowing that are below the thresholds will be calculated each year, as part of the budget process, to establish an annual borrowing limit and borrowing plan. Controlling and centralizing the approval process for all borrowing proposals (including borrowing by SOEs, issuing guarantees and on-lending) will ensure that the Government knows what its total liabilities are and that debt remains at affordable and sustainable levels. A Debt Management Advisory Committee (DMAC) will assess borrowing proposals to make sure that projects increase government revenue and GDP, or fund essential infrastructure that can benefit all citizens. Borrowing must be from an allowable source and with acceptable terms and conditions. Assessment of borrowing proposals will be part of the budget process to make sure that projects can be compared and only the best projects are funded. Borrowing also needs to be consistent with the Medium Term Fiscal Strategy, Central Bank policy and macroeconomic conditions. The DMAC will make recommendations to the Minister for Finance in relation to borrowing proposals. Based on recommendations from the DMAC, the Minister for Finance will have sole authority for approving loans and guarantees. This Strategy document was prepared by DMU, in the Ministry of Finance and Treasury, which is responsible for SIG s Sovereign debt management, including debt repayments, debt recording and reporting, formulating the debt strategy and annual borrowing plan, loan negotiations and debt sustainability analysis. iii

4 Table of Contents EXECUTIVE SUMMARY...ii 1. OBJECTIVES FOR PUBLIC DEBT MANAGEMENT AND SCOPE OF THE DEBT MANAGEMENT STRATEGY Introduction Overall Objectives for Public Debt Management Definition of Debt Definition of a Medium-Term Debt Management Strategy Scope BACKGROUND Current debt situation and de facto debt management strategy Need to review the Honiara Club Agreement Background on domestic debt market: THE CURRENT STATUS OF THE DEBT PORTFOLIO * Profile of existing debt Cost of existing debt Affordability and Sustainability of existing debt levels Domestic security market Risk of existing debt REPAYMENT (DEBT SERVICE COST) RISK FOREIGN EXCHANGE RATE RISK INTEREST RATE RISK ROLLOVER RISK CREDITOR CONCENTRATION RISK INFLATION RISK RISKS IN MANAGING THE PORTFOLIO DEBT SUSTAINABILITY ANALYSIS What is a Debt Sustainability Analysis and why is it important? The Solomon Islands economy iv

5 1. GDP FISCAL MONETARY Economic baseline, projections and assumptions GDP FISCAL MONETARY POLICY Economic indicators, risks and thresholds Stress testing FALL IN REVENUES DECREASE IN GDP DECREASE IN EXPORTS DEPRECIATION OF CURRENCY FUTURE GROWTH Results of the IMF Debt Sustainability Analysis DEBT MANAGEMENT STRATEGY Maintain debt at sustainable and affordable levels Ensure that any new borrowing follows legal and fiscal responsibility guidelines ENSURE THAT ANY NEW BORROWING IS FOR A FIT PURPOSE ENSURE THAT ANY NEW BORROWING IS FROM AN ACCEPTABLE SOURCE ENSURE THAT TERMS AND CONDITIONS ARE ACCEPTABLE Develop the domestic debt market STRENGTHEN CURRENT MARKET EXTEND CURRENT CAPABILITIES Introduce and consolidate fiscal, legal, institutional and operational measures that ensure that the above three objectives are met FISCAL MEASURES LEGAL MEASURES INSTITUTIONAL FRAMEWORK OPERATIONAL FRAMEWORK v

6 LIST OF TABLES TABLE 1 Debt situation (SI$million)* 5 TABLE 2 Debt sustainability indicators (per cent) 6 TABLE 3 Outstanding debt as at 31 December 2011 (SI$million) 9 TABLE 4 Debt servicing payments (SI$million) 2005 TO TABLE 5 Projected debt affordability and sustainability 2010 TO 2016 (per cent) 12 TABLE 6 Volume of Treasury Bills as at 31 December 2011 (SI$million) 12 TABLE 7 Thresholds for a weak policy country 26 TABLE 8 Effect of a 30 per cent depreciation on debt stock and servicing costs 29 (SI$million) TABLE 9 Examples of multilateral loan terms 35 LIST OF CHARTS CHART 1 Debt balances outstanding (SI$billion) 10 CHART 2 Foreign currency proportion of external debt 11 CHART 3 Weighted average yields for Treasury Bills (per cent) 13 CHART 4 Ratio of bids received to allocation for Treasury Bills 14 CHART 5 Projected debt servicing cost (SI$million) 15 CHART 6 Monthly pattern of debt repayments (SI$million) 15 CHART 7 Volume of debt outstanding by currency (SI$billion) 16 CHART 8 Volume of debt by creditor (SI$million) 18 CHART 9 Export earnings (SI$billion, f.o.b.) 21 CHART 10 Contribution to GDP CHART 11 Historic and projected GDP growth 24 CHART 12 Historic and projected revenue and expenditure growth SI$billion) 24 Annexure I IMF definition of debt Annexure II Solomon Islands total debt attributed by creditors as at 29 February 2004 Annexure III Joint World Bank IMF Debt Sustainability Framework for Low-Income Countries Annexure IV Extract from Technical Memorandum of Understanding between Solomon Islands Government and IMF November, 2011 Annexure V Debt Status as at 31 December 2011 Annexure VI DSA using IMF template charts vi

7 1. OBJECTIVES FOR PUBLIC DEBT MANAGEMENT AND SCOPE OF THE DEBT MANAGEMENT STRATEGY 1.1 Introduction Sovereign governments need to prepare a strategy for managing their debt this fact is recognised around the world and contained in guidelines prepared by the World Bank, the IMF and the United Nations, for example. 1 One of the key recommendations that came out of the Debt Management Performance Assessment conducted in 2009 by a team led by the World Bank 2 was that Solomon Islands develop a Debt Management Strategy. Worldwide, developing sound debt management strategies has been identified as an important factor in avoiding debt and financial crises, and the hardship that such crises bring to all citizens. 1.2 Overall Objectives for Public Debt Management Public debt management is more than making debt payments. There are two overall objectives for Solomon Islands: 1. Ensure that the servicing and management of the Solomon Islands government s financing requirements and payment obligations are met on a timely basis, and at the lowest possible cost over the medium to long run, consistent with a prudent degree of risk; and 2. Support the development of a domestic debt market. 1.3 Definition of Debt Government debt, or borrowing, includes the contracting or guaranteeing of domestic and external (foreign) debt through loans, financial leasing, on-lending and any other type of borrowing, including concessional and non-concessional borrowing, whatever the source. Borrowing and debt of SOEs and other public corporations are included in the definition of total government debt. Even if this debt is not guaranteed by the government, experience around the world and in Solomon Islands has shown that when SOEs get into debt service difficulties governments are obliged to pay. This definition of debt is broader than the IMF definition of debt (see Annexure IV for the IMF definition of public sector debt). 1 For example in the World Bank/IMF (2003) Guidelines for Public Debt Management and United Nations Institute of Training and Research (UNITAR) course notes for Effective Public Debt Management. 2 Solomon Islands Debt Management and Performance Assessment was published on the WB website at 1

8 1.4 Definition of a Medium-Term Debt Management Strategy This Medium-Term Debt Management Strategy (Debt Strategy) is a framework that the government intends to use over the medium-term (five years) to ensure that debt levels stay affordable and sustainable, that any new borrowing is for a good purpose and that the costs and risks of borrowing are minimized. 1.5 Scope This Debt Strategy covers (domestic and external) both central government and SOE debt, including the portfolio of government guarantees and contingent liabilities. External debt is defined as debt denominated in currencies other than Solomon Island dollars. Domestic debt is defined as debt denominated in Solomon Island dollars, even when the creditor is a foreign entity. Although the focus of the Debt Strategy is on actual direct liabilities of the Government, contingent liabilities (whether explicit or implicit) may have an important bearing on the sustainability of debt and robustness of the Debt Strategy. Consequently, it is prudent to consider, when preparing a Debt Strategy, the potential risk that contingent exposures could materialize under specific scenarios. For example the Solomon Islands Government may be obliged to assume liabilities from SOEs 3. Note that the scope of a Debt Strategy does not prescribe borrowing amounts. These are typically determined in a government s Fiscal Strategy and prescribed in an annual Borrowing Plan. For Solomon Islands, where borrowing is not to fund recurrent expenditure, but only for development expenditure, the Debt Strategy will be aligned to the Medium Term Fiscal Strategy (MTFS) 4 as well as to the National Development Strategy. The key elements of the Debt Strategy will be incorporated into the MTFS, and updated every year as part of the budget process. In the proposed amendments to the Public Finance Act this will be a requirement. 3 This requires the Debt Management Unit (DMU) to have good information on the nature of these liabilities. 4 Available at 2

9 2. BACKGROUND 2.1 Current debt situation and de facto debt management strategy This is the first true debt management strategy for Solomon Islands. Knowing about the historical context helps understand the need for and the form of this Debt Strategy. After Independence and in the period 1978 to 1998, there were no systems in place to guide borrowing decisions. Multilateral and bilateral loans with what appeared to be generous terms and long grace periods were agreed to on an ad hoc basis without any consideration of debt sustainability, risks and future impact on budgets or, in some cases, what was best for development in Solomon Islands. At Independence in 1978, SIG had loans with Asian Development Bank (ADB) of around US $2 million and in the period to 1995, SIG took out loans with the ADB, the European Commission (EC), the World Bank (International Development Assistance (IDA)), the European Investment Bank (EIB) and the International Fund for Agricultural Development (IFAD). These loans were to fund education, agriculture, infrastructure projects, and for the Development Bank Solomon Islands (DBSI). Debt servicing payments were made regularly. The finances of SIG gradually deteriorated from around 1995 to 1998, as evidenced by late or delayed payments and loan rescheduling. In 1995, SIG borrowed around SI$60 million from Kuwait and OPEC at higher interest rates (3.5 to 4 per cent) to fund main road upgrades. To help mitigate payment difficulties, SIG set up a debt servicing account in 1998 for the purpose of paying debt servicing expenses and committed 15 per cent of consolidated revenues to the Debt Servicing Account (this was reduced to 10 per cent in 2009). In the period of ethnic tension from 1998 to 2003, and as economic activity declined and public service systems were threatened, government revenue collection became increasingly difficult. This, together with uncontrolled expenditure and a currency devaluation of 30 per cent, precipitated a financial crisis. Loan repayments were made late or not at all because it was difficult for public servants to perform their duties and because there were insufficient funds. By 2001 SIG had defaulted on all its external loans. Continued non-servicing of World Bank and ADB loans caused both these institutions to suspend new lending and technical assistance programs to Solomon Islands. The government was unable to redeem its domestic securities, which amounted to around SI$29 million in Treasury Bills and SI$269 million in Treasury Bonds. In this period SIG again borrowed at an interest rate of 3.5 per cent from EXIM Republic of China and the International Cooperation and Development Fund (ICDF) for general commercial use and to prop up the DBSI. Advances of SI$209 million were also obtained from the Central Bank Solomon Islands (CBSI), at levels well above the legal limit. Failure of Provincial Governments and SOEs to repay their debts, and large trade creditors arrears that were accumulated by the central government compounded the debt crisis. As can be seen in 3

10 Annexure II, a significant proportion of SIG debt post 2003 was informal, comprising government guarantees and contingent liabilities, particularly with State-Owned Enterprises (SOEs), the national superannuation provider (NPF) and provincial debt. In addition, the large number, complexity and political sensitivity of trade creditor arrears added to the difficulties of normalising SIG s debts. In 2003, and with assistance from the Regional Assistance Mission Solomon Islands (RAMSI), the process of putting debt management on a sound footing began. This is described in the Comprehensive Debt Management Plan for Solomon Islands, As a result of this plan, the Debt Management Unit (DMU) was established. The focus of this plan was debt restructuring and developing a repayment plan for trade creditors. The first step was to verify and determine the correct amounts for all debt obligations (see the chart in Annexure II), and then establish an equitable way of prioritizing arrears payments, including trade creditors arrears. In August 2003, the Australian Government settled SIG s World Bank and ADB arrears and continued servicing these loans until mid There was a one-off restructure of domestic debt in Domestic debt, including Treasury Bonds in default, large trade creditor arrears and advances from CBSI, were securitised and restructured as bonds, with a monthly coupon and amortising principal and with maturity dates from 2011 to For restructured Treasury Bonds, the interest rate was set at 2 per cent (2.5 per cent for the longest tranche) with a contingent bonus interest component of 1 per cent set annually and paid when SIG revenue grew in excess of 15 per cent per annum. TABLE 1: DEBT SITUATION (SI$million)* Stock External 1,158 1,201 1,123 Domestic Total 1,661 1,728 1,642 Debt Service Cost External Domestic Total Debt Sustainability Indicators Debt to GDP (per cent) Debt to Solomon Islands Government revenue (per cent) * This is an underestimate, because it does not include contingent liabilities and trade creditors arrears, which were approximately SI$450 million in 2004, for example. 4

11 Servicing the high levels of debt arrears made it difficult to make scheduled debt servicing payments. In 2004, the volume of domestic arrears was SI$400 million, with external debt arrears of SI$100 million and SI$300 million of informal debts such as trade creditor arrears. As shown in Table 1, debt payments were a significant (and unaffordable) proportion of the Solomon Islands government revenue. However, although debt levels for SIG were unsustainable and unaffordable, Solomon Islands did not qualify under the joint IMF/World Bank Heavily Indebted Poor Countries (HIPC) Assistance Initiative for debt relief, for example through a Paris Club agreement 5. The decision was made for Solomon Islands to have its own Honiara Club 6 meeting with external creditors. The agreement signed at this meeting, held in October 2005, has become known as the Honiara Club Agreement. Since then, Solomon Islands debt management has been determined by the conditions of the Honiara Club Agreement (paragraph 13 of the Minute) which states: (1) No further borrowing or sovereign guarantees until the Government of Solomon Islands reaches green light status under the Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries Debt Distress Rating system 7 (2) Maintaining a fully funded recurrent budget excluding the use of borrowing to fund recurrent expenditure for the duration of any loans held at this time by creditors who are party to the [Honiara Club Agreement], subject to five yearly reviews; and (3) Debt servicing funds are only to be used for meeting debt servicing costs. 8 The immediate outcome of the Honiara Club Agreement and the associated Action Reform Plan was that external creditors agreed to a moratorium on debt repayments for two years. The Australian Export Finance and Insurance Corporation (EFIC) forgave around 70 per cent of Solomon Islands debt. Other debt write-offs have been from Maruha and EIB. In 2010 Maruha Nichiro Seafood wrote off SI$123 million in long-term debt owed by the Investment Corporation of Solomon Islands). In 2011 EIB wrote off SI$14.6 million of long-term debt owed by DBSI. 5 The Paris Club is the first stage to gaining HIPC relief. Solomon Islands Government only had one external loan with a permanent member of the Paris Club (Australia). Following a possible Paris Club settlement, Solomon Islands Government would still have been required to convince, through negotiation, all its other external creditors. 6 Signatories were a representative from Australia (with Export Finance and Insurance Corporation as the creditor), European Investment Bank and International Fund for Agricultural Development with representatives of the World Bank, Asian Development Bank and Taiwan (all creditors) and IMF as observers. 7 See Annexure III for details. 8 A fixed per cent of revenue is currently set aside to meet debt servicing costs. 5

12 Since the Honiara Club Agreement, the implicit Debt Strategy for Solomon Islands has been built around crisis recovery reducing the cost of debt and improving debt sustainability. Debt Management Plans produced in 2004 and 2009 focussed on normalisation of the debt position and of relations with SIG s creditors. The Honiara Club Agreement, in imposing a regime of no new borrowing, has been very successful. It, together with an environment of increased fiscal responsibility, has meant that debt has been reduced to sustainable and affordable levels. In 2010, following the IMF 2009 Article IV consultation, Solomon Islands was moved from red to yellow light status in the Joint World Bank/IMF Debt Sustainability Framework for Low-Income Countries (see Annexure III). As shown in Table 2, official debt levels fell from 53 to 24 per cent of GDP from 2005 to By the end of May 2011, the Solomon Islands Government no longer had any debt arrears 9. TABLE 2: DEBT SUSTAINABILITY INDICATORS (Per cent) Per cent Debt*/GDP Debt*/Government revenue Debt*/Exports Debt Servicing/Government revenue Debt Servicing/Exports * Note this figure does not include unofficial debt such as Trade Creditors arrears and contingent liabilities which were around SI$360 million in 2006, SI$100 million in 2008 and 2009, SI$70 million in 2010 and SI$100 million in However, poor management and accountability of SOEs continues to be a source of risk to the Government. For example, the Solomon Island Water Authority (SIWA) still owes the Solomon Islands Electricity Authority (SIEA) around $38 million, although in 2008 the Government paid $10 million of SIWA s debts to SIEA. The Solomon Islands Postal Service and the Solomon Islands College of Higher Education are also experiencing financial difficulties. 2.2 Need to review the Honiara Club Agreement There are three reasons why SIG now needs to review the Honiara Club Agreement. Firstly, it was part of the original agreement, signed in October 2005, that it would be reviewed after five years. The second reason is that moving to yellow light status means that the Solomon Islands Government is no longer eligible for 100 per cent grant funding from the World Bank or ADB. If SIG wants to fund future development projects that will increase GDP or help the country reach its Millennium Development Goals, then it may no longer be able to rely entirely on grants to provide the funding to do this. Lastly, it is unlikely that the conditions for borrowing (reaching 9 On 23 May 2011, and in response to Solomon Islands remitting the proceeds from the sale of DBSI properties, EIB wrote off the remaining SI$14.6m of the loans to DBSI. 6

13 green light status) will be met in the foreseeable future 10. Even if all debt were repaid in early 2012, Solomon Islands would not reach green light status until 2022 at the earliest. SIG therefore needs to make provisions to allow for prudent borrowing again, but must replace the Honiara Club Agreement with a strong fiscal, legal and operational framework. This framework must be in place before borrowing resumes to allow for fiscally responsible borrowing for a fit purpose. SIG must ensure that borrowing is for good quality development projects and that Solomon Islands does not return to situation of poor borrowing decisions leading to high debt levels, expensive debt and borrowed funds not contributing to the welfare of its people. An additional consideration is that borrowing is also limited by the conditions of a Memorandum of Understanding (MOU) that was signed in November 2011 between Solomon Islands and IMF 11. This MOU provides for the use the IMF s Standby Credit Facility (SDR million for 12 months) on the condition that the Government continues with its fiscal reform agenda. A number of items in the agreed reform program relate to debt management. For example, the MOU requires no new debt or government guarantees, with the exception of concessional borrowing (see Annexure IV). If this or a similar arrangement is renewed, the conditions on borrowing are likely to continue. The Honiara Club Agreement needs to be reframed, amended or replaced to take account of borrowing opportunities in the short to medium term and to ensure that if any borrowing occurs, it is guided and restricted by a strong framework. 2.3 Background on domestic debt market: The Solomon Islands domestic debt market consists of Treasury Bills and Treasury Bonds. Treasury Bills are short-term debt securities (up to one year) that carry an annual rate of fixed interest over the life of the security, payable on maturity. The Solomon Islands Treasury Bill market has been operating since Treasury Bonds are longer-term debt securities. The issue of Treasury Bills and Bonds is governed by the Government Loans and Securities Act During the period of ethnic tension, and as investor confidence decreased, interest rates for Treasury Bills increased, and at their peak were 16 per cent for 91 day Bills. The Treasury Bill market collapsed in August SIG was unable to redeem around SI$29 million of Treasury Bills. In April 1999 Treasury Bills that were in default were restructured and the Treasury Bill 10 This is because the mathematical methodology on which the Debt Sustainability Framework is based uses standard deviations. A standard deviation is a measure of variability. Countries, such as Solomon Islands, which have a narrow economic base, are subject to greater variability and therefore the shocks the analysis applies to these countries are relatively larger SDR is a monetary unit of international reserve assets defined and maintained by the IMF. It is defined as a weighted sum of contributions of four major currencies, the euro, the US dollar, the British pound, and the Japanese yen, and is re-evaluated and adjusted every five years 7

14 market was reinstated. The Treasury Bill market was essentially there to maintain a SIG presence and yields were capped at 4 per cent. Since July 2010, the Treasury Bill market has been reinvigorated, with the operational cap extended to SI$40 million, the publication of a monthly issuance calendar, and the extension of the terms offered to 182 days. SIG also defaulted on around SI$270 million of Treasury Bonds (see Annexure II) in In 2004, Treasury Bonds in default were restructured as amortizing bonds. There has been no resumption of Treasury Bond issuance. The current status of the domestic securities market is discussed in section

15 3. THE CURRENT STATUS OF THE DEBT PORTFOLIO * * (as at 31 December 2011) 3.1 Profile of existing debt The total volume of outstanding debt and as shown in Table 3, is SI$1,191 million, with an additional SI$100 million of contingent liabilities. (See Annexure V for the Government s Debt Statistical Bulletin for 31 December 2011.) The existing portfolio is composed of 27 per cent domestic debt and 73 per cent external debt (by definition debt not denominated in SBD). The majority (85 per cent) of external debt comes from multilateral creditors, dominated by the (ADB (SI$387 million) and the World Bank (SI$298 million). Domestic debt is predominantly held by commercial banks, the superannuation provider (NPF) and the Central Bank (CBSI). TABLE 3: OUTSTANDING DEBT AS AT 31 DECEMBER 2011 (SI$million) Domestic Debt Treasury Bills 37.6 Government Bonds Advances from Central Bank External Debt Multilateral Creditors Bilateral Creditors Explicit Informal Debts and Contingent Liabilities Loan Guarantees 50.0 Other Grand Total 1,290.6 All bonds and external debt are in the form of amortizing bonds. Therefore, the maturity profile (shown in Chart 1) of all debt is fixed. All domestic debt is amortized on a reducing balance basis (with regular constant payments and a reducing principal component). External debt is amortized with a fixed principal repayment. 9

16 CHART 1: DEBT BALANCES OUTSTANDING (SI$billion) $billion External Debt Arrears External Debt Principal Domestic Debt Arrears Domestic Debt Principal In addition to official debt, the debt portfolio includes SI$100 million of contingent liabilities. Of this, SI$50 million is a government guarantee to Soltai that the government assumed when NPF refinanced Soltai s debt with ANZ. The guarantee has a sunset clause and expires on 24 August SIG also has a contingent liability with Solomon Telekom Ltd which, as at 31 December 2011, was SI$35.2 million. SIG signed an agreement with Telekom for a total settlement amount of SI$86.31 million, for compensation for the termination of Solomon Telekom s exclusive licence. Under the Telecommunications Act 2009, license fees will be collected by the Telecommunications Commission, and then SIG will facilitate the payment of these fees from a special compensation fund to Telekom. If after 15 October 2015, license fee collection has been insufficient to pay this settlement amount, then the Solomon Islands Government is liable to pay the remainder. In practice, this would be undertaken by reducing the amount of sales tax due from Telekom. The Government needs to have a better understanding of the extent of implicit contingent liabilities associated with SOEs. 3.2 Cost of existing debt Table 4 below shows actual debt servicing payments (of both interest and principal) from 2005 to

17 TABLE 4: DEBT SERVICING PAYMENTS (SI$million) 2005 TO Domestic Debts Principal Interest External Debts Principal Interest Total As shown in Chart 2, the largest portion of SIG s external debt is denominated in United States Dollars (USD) (47 per cent,) followed by Euros (EUR) with 22 per cent, Japanese Yen (JPY) 17 per cent, and British Pounds (GBP) and Australian Dollars (AUD) both 5 per cent. The other category includes Kuwaiti Dinars (KWD), New Zealand Dollars (NZD), Swedish Kronor (SEK), Canadian Dollars (CAD), Norwegian Krone (NOK) and Korean Won (KRW). CHART 2: FOREIGN CURRENCY PROPORTION OF EXTERNAL DEBT AUD OTHER GBP JPY USD EUR 11

18 3.3 Affordability and Sustainability of existing debt levels The debt to GDP ratio is currently 19 per cent and with no new borrowing is projected to fall to 15 per cent by the end of 2012 (see Table 5 below). Other parameters are also below the Joint World Bank/IMF Debt Sustainability Framework thresholds for low-income countries, with debt servicing cost to revenue ratio currently being at 4 per cent. TABLE 5: PROJECTED DEBT AFFORDABILITY AND SUSTAINABILITY 2010 TO 2016 (Per cent) (Assuming no new borrowing) Measure Threshold Debt to GDP Debt to Solomon Islands Government revenue Debt to exports Debt service to Solomon Islands Government revenue Debt service to exports Domestic security market The primary domestic securities market is currently made up of Treasury Bills issued by the government most of the take up has been by domestic financial institutions. Treasury Bills are discount instruments with a term of up to one year. Currently issuance is limited to terms of 56, 91 and 182 days. Table 6 shows the volume on issue for each term. Issuance is authorised for up to SI$100 million, and capped operationally by the Minister of Finance at SI$40 million. Since early March 2011, CBSI has auctioned SI$60 million of its own Bokolo Bills with a term of 28 days and a yield of 1 per cent. Treasury Bill auctions are held weekly with a settlement period of trade + 1 day. The prospectus is published on the CBSI website, and monthly calendars are published in advance. The calendar is devised so that issuance is on a rolling basis, with maturing Treasury Bills being funded out of the proceeds raised from new issuance. TABLE 6: VOLUME OF TREASURY BILLS AS AT 31 DECEMBER 2011 (SI$million) Tenor Volume ($million) 56 days days days TOTAL

19 24/08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/2011 Since July 2010, SIG has used Treasury Bills as a short-term cash management tool. Up to 50 per cent of the volume of Treasury Bills on issue can be used for cash management purposes (to smooth fluctuations in the cash balance) according to strict guidelines. Improved investor confidence following the revitalisation of the Treasury Bill market in mid 2010 is evidenced by declining weighted average yields and increasing bid ratios (Charts 3 and 4). The period of reduced appetite from March 2011 shown in Chart 4 resulted from CBSI commencing issuance of large volumes of Bokolo Bills. Currently, the primary market for Treasury Bills is narrow, with a small domestic investor base and lack of foreign investors. There is no secondary market (interbank trading) in Treasury Bills at present. Many of the commercial investors have limits on the volume of SIG securities that they can hold, and the lack of a Sovereign Credit Rating precludes increasing this cap. There is no primary market of Treasury Bonds at present. Restructured Treasury Bonds issued to commercial banks and the NPF in the past are tradeable. The maturity dates of these bonds are in 2014, 2017 and 2018 or CHART 3: WEIGHTED AVERAGE YIELDS FOR TREASURY BILLS (Per cent) 4.0 Per cent Per cent Days 91 Days 182 Days 13

20 24/08/ /09/ /10/ /11/ /12/ /01/ /02/ /03/ /04/ /05/ /06/ /07/ /08/ /09/ /10/ /11/ /12/2011 CHART 4: RATIO OF BIDS RECEIVED TO ALLOCATION FOR TREASURY BILLS 12.0 Per cent Per cent Days 91 Days 182 Days 3.5 Risk of existing debt The extent of the risk will depend on risk factors and risk exposure. The main risk factors, together with the extent of SIG exposure, are discussed below. 1. REPAYMENT (DEBT SERVICE COST) RISK Servicing debt is the primary concern for debt management. The Government must make sure that total expenditure including debt service costs do not exceed revenue collected. The main risk for the debt portfolio for the Solomon Islands Government is the government s inability to make repayments or repayment risk. This risk can be expressed as the cost of debt repayments compared with funds available. This risk is currently mitigated by setting aside ten per cent of domestically sourced revenue to service debt. The risk is that revenue could decrease so much that ten per cent is less than the debt servicing cost. If this happens, there will be insufficient funds available to make debt payments. The dollar value of the projected debt servicing cost, assuming no new borrowing, is given in Chart 5. Debt servicing costs increase in 2012 and 2013 because grace periods for current loans are ending. 14

21 CHART 5: PROJECTED DEBT SERVICING COST (SI$million) (Assuming no new borrowing) $million As shown in Chart 6, the repayment profile exhibits periodicity, with peak repayment volumes in June and December. There is a risk that in a period of falling revenues, there will be insufficient funds set aside to make debt repayments during these months CHART 6: MONTHLY PATTERN OF DEBT REPAYMENTS (SI$million) $million Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Note: does not include additional, one-off, principal payments 15

22 FOREIGN EXCHANGE RATE RISK Foreign exchange rate risk relates to vulnerability of the debt portfolio, and therefore the government s debt servicing cost, to a depreciation or devaluation in the external value of the domestic currency. Of the debt portfolio, SI$866 million (73 per cent) is denominated in currencies other than the Solomon Islands Dollar (SBD) and therefore exposed to exchange rate changes. Therefore, foreign exchange rate risk dominates the portfolio. Debt servicing costs fluctuate from month to month according to exchange rate changes. Foreign exchange movements will also change the value of debt outstanding and therefore the ratio of debt to GDP. SBD has generally moved in line with the USD. Chart 7 shows that the about half of external debt is denominated in USD. CHART 7: VOLUME OF DEBT OUTSTANDING BY CURRENCY (SI$billion) 1,400 $million 1,200 1, KRW NOK CAD SEK NZD KWD GBP AUD YEN EUR USD SBD 3. INTEREST RATE RISK The weighted average interest rate of external debt is 1.14 per cent and 2.87 per cent for domestic debt. Interest rate risk is the risk associated with interest rate changes. All external debt is at a fixed interest rate, and about half of the domestic debt portfolio is subject to interest rate changes. The total volume exposure to interest rate changes is around SI$162 million. Of this, for SI$114 million, the possible interest rate change is limited to a 1 per cent bonus interest that is payable in the event that SIG domestically sourced revenue increases 16

23 from year to year by 15 per cent or more. The interest rate increases to 3 per cent for the shorter two tranches and to 3.5 per cent for the longest tranche (with a maturity of 2018 or 2019). The remaining SI$10 million is subject to annual resets of the interest rate based on the 91-day Treasury Bill weighted average yield plus 1.5 per cent. The interest rate on Treasury Bills changes according to market forces (as indicated in Chart 3). 4. ROLLOVER RISK Rollover risk is the risk that maturing debt cannot be replaced or refinanced, or that the replacement debt will be more expensive. With the exception of Treasury Bills, SIG debt is legacy debt (maturing debt is for projects that have been completed) with an amortizing principal. Rollover risk is limited to Treasury Bills, which are currently capped at SI$40 million. Treasury Bills are essentially funded on a rolling system, with new issuance funding maturities. Therefore, rollover risk is the risk that auctions will be undersubscribed or that new issuance will be at higher yields than for maturing Bills. SIG has put in place a mechanism to mitigate this risk by allowing the use of Debt Servicing Account at the CBSI to pay off maturing Treasury Bills in the event that funding from new issuance is insufficient. As Table 6 indicates, there is a greater proportion of longer tenor dated Treasury Bills, which have a lower rollover risk. 5. CREDITOR CONCENTRATION RISK Creditor concentration risk refers to risks associated with most of the debt portfolio being held by one or two creditors. Creditors who hold a large proportion of debt could have a vested interest in the course of a country s affairs. Large creditors could potentially have an undue influence in government policy development. In the case of Solomon Islands (see Chart 8), the ADB and the World Bank dominate the external debt portfolio. 17

24 CHART 8: VOLUME OF DEBT BY CREDITOR (SI$million) External Domestic Other $28 ANZ $19 Other $25 IDA $298 ADB $387 NPF $89 BSP $50 EXIM $121 Other: Kuwait, IFAD & ICDF EU $32 CBSI $88 Other: Westpac, Maruha & QBE 6. INFLATION RISK SIG does not hold any inflation-linked debt, therefore the portfolio is not directly exposed to inflation risk. The impact of inflation on debt affordability and sustainability can be mediated through currency valuation, GDP and government revenues and is difficult to predict. Inflation could actually have the effect of decreasing the debt burden, as has been the case in Solomon Islands during RISKS IN MANAGING THE PORTFOLIO Operational risk: Operational risk is defined by the Bank of International Settlements as the risk of losses resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk, but excludes strategic and reputational risk. The operational risks facing debt management in Solomon Islands stem from the very small size of the DMU and its vulnerability to staff movements. For example, as at 30 June 2011 only two of its four positions were filled. The DMU therefore cannot take advantage of the controls that come with separations between front, back and middle office, as is the case with larger 18

25 Sovereign Debt Management offices. The difficulty in developing and retaining skilled staff is a risk for Ministry of Finance and Treasury in general. Legal risk: Legal risk is the risk that the DMU and, by extension, SIG do not execute their legal obligations as stated in the deed documents, loan agreement contracts or in the legislation dealing with debt. Possible examples are failure to make payments on time or for the correct amount. The loss of senior staff members makes the DMU vulnerable because corporate knowledge about legal requirements can be lost The DMU is also exposed to payment demands that do not have a sound legal basis. Reputational risk: The failure of past SIG to make payments on time and the accumulation of debt arrears has damaged the country s reputation, making debt more expensive or institutions unwilling to lend. The use of borrowed funds for inappropriate or wasteful expenditure gives investors and donors a very strong negative signal. Evidence of an ill-disciplined approach to debt management will undermine donor and creditor confidence in the Government, which will in turn complicate future access to debt financing. In a similar vein, a policy stance that leaves open the possibility of using debt to delay or to avoid having to make difficult budgetary decisions must also be avoided. Strategic risk: Strategic risk is the risk that decisions made about the management of the debt portfolio have a high opportunity cost. For example, if SIG decides not to borrow, then it could miss out on grant funding (if grant funding for these projects is not available from other sources). If SIG decides to borrow for particular projects that do not match expectations, then this money could have been better spent elsewhere on other, more beneficial projects. Money spent on servicing debt might be better spent on providing essential services, for example. Alternatively, it is better to pay down debt (which saves the Government future interest payments and increases borrowing opportunities in the future) rather than spending funds unwisely. Financial risk: Financial risk is the risk that the government s portfolio management is a source of instability for the private sector. The risk for Solomon Islands is that a poorly managed debt portfolio will mean that less money is available for servicing the country s basic needs. A burgeoning debt portfolio or a build-up of debt arrears will cause a collapse in investor confidence, which will also impact the private sector, leading to a withdrawal of investment in the country, a decline in 19

26 GDP growth and a further increase in debt to GDP ratios. Donors will also withdraw funding and technical assistance if SIG goes into debt arrears. 20

27 4. DEBT SUSTAINABILITY ANALYSIS 4.1 What is a Debt Sustainability Analysis and why is it important? A debt sustainability analysis is an evaluation of the ability of a country to continue to be able to afford to repay its debts, even when faced with financial and economic difficulties. It involves an assessment of the current economic situation and projections based on past patterns, current developments and likely trends, and an analysis of a country s projected debt burden over the long term and its vulnerability to external and policy shocks. 4.2 The Solomon Islands economy Solomon Islands has a small, open economy based on primary commodities, principally logs, fish, agricultural production (cocoa, copra and palm oil), and from April 2011, mining. Chart 9 shows that logging is currently the largest contributor to export earnings. The main trading partners are China (with close to 50 per cent of export earnings) followed, after a significant margin, by the Philippines and Spain. CHART 9: EXPORT EARNING (SI$billion, f.o.b.) Logs Palm Oil & Kernels Fish Cocoa Copra & Coconut Timber Other Exports Minerals (Source: CBSI Annual Report 2010) The economy is small, vulnerable to external demand shocks and terms of trade vulnerability. The economy is based on a few key commodities and therefore is susceptible to changes in 21

28 commodity prices and to weather conditions affecting agricultural production, forestry and fisheries. Solomon Islands is remote and dispersed consisting of almost one thousand islands. It is heavily reliant on imported fuel (and therefore vulnerable to changes in the oil price), and manufactured items, machinery and other general merchandised goods. Fuel and food make up 40 per cent of imports. Solomon Islands is heavily reliant on foreign aid. The vulnerability of the Solomon Islands economy was evident during the global financial crisis. A decrease in demand for logs resulted in a 5 per cent contraction in GDP. Falls in revenue led to cash flow difficulties and an accumulation of domestic arrears. In 2010 the Solomon Islands economy rebounded strongly from the negative growth experienced in 2009 as a consequence of the global financial crisis. 1. GDP GDP, as a measure of the total goods and services produced in a country, indicates the capacity of a country to generate income in the future that can be used for repaying debt. A low debt to GDP ratio suggests that a country can withstand economic shocks and, if needed, borrow to stimulate the economy without defaulting on debt repayments. For Solomon Islands, GDP comprises the primary (agriculture, forestry and fisheries), industry (including mining) and services sectors. The current contribution of each sector to GDP is shown in Chart 10. GDP growth in 2010 was 7 per cent and is estimated to be around 10 ¾ per cent in 2011, rebounding from a contraction of 5 per cent in These relatively high rates of real GDP growth were driven primarily by unsustainable logging. CHART 10: CONTRIBUTION TO GDP 2010 Forestry, Logging, Sawmilling Transport & Communications Electricity & Water Finance Other Services Agriculture Retail & Wholesale Trade Manufacturing Fishing Construction Mining & Exploration Source: CBSI Annual report

29 2. FISCAL Revenue collection during 2010 and 2011 was strong, recovering from weak growth during The Government continues to operate a fully funded consolidated budget, and has budgeted for a small surplus in MONETARY The annual inflation rate to December 2011 (calculated on a 3 months moving average basis) was 10 per cent. Inflation pressures came from rising fuel and food import prices. Inflation pressures have been relieved by appreciation of the currency from SBD:USD 1: to 1: over Excess liquidity has been partly sterilized by CBSI recommencing market operations. Since March 2011, around $200 million of 28 day Bokolo Bills have been issued each month. During 2011, the trade balance shifted from deficit to surplus for the first time since This was driven by exceptionally strong logging and gold exports and as a result, the balance of payment position improved, supported by large Foreign Direct Investment (FDI) and aid flows. Gross international reserves increased to US$355 million (6 months imports cover) in June 2011 from less than US$100 million in mid Three months imports cover is considered to be a minimum reserve buffer. 4.3 Economic baseline, projections and assumptions Economic data is collected by the Ministry of Finance and Treasury and CBSI. Historical and current information is used to form a baseline or an expectation of how the economy will perform provided that everything goes well and there are no shocks. Economic modelling is carried out by the Economic Reform Unit (ERU) within the Ministry of Finance to project (predict) values for key economic variables such as GDP, inflation, revenue in future years. 1. GDP Baseline projections assume annual growth in real GDP of about 4 ½ per cent in the projection period 2012 to The IMF expects GDP growth to be 6 per cent in 2012, with gold mining being the driver of growth. The Gold Ridge Mine is expected to have a life of ten years and from 2013 onwards but will add very little to real GDP growth. Logging volumes are forecast to fall from 2011 levels (1.8 million cubic metres) but remain at historically strong levels over the next decade due to unsustainable secondary forest logging (in the absence of significant primary forest supply). The anticipated slowing in logging will have a negative effect on GDP growth. These changes can be seen in Chart 11 which shows past and projected future GDP growth and the lower levels of average GDP growth from Annual GDP growth over the medium to long term is expected to be around 4 per cent. GDP deflator growth is assumed to be equal to CPI increases. GDP growth in the medium to long 23